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MRK | 2 | 2,008 | 2008-07-22 17:00:00 | Operator: Good day, everyone and welcome to Merck's Second Quarter 2008 Earnings Conference Call. Today's call is being recorded. At this time, I would like to turn the call over to Ms. Eva Boratto, Vice President of Investor Relations. Please go ahead.
Eva Boratto: Thank you, Kiera and good evening everyone. Welcome to our call this morning to review our business performance for the second quarter of 2008. We appreciate everyone's participation after a full day of news flow. Joining me on the call today is our Chairman, President and CEO, Dick Clark. We also have Ken Frazier, our Executive Vice President and President of Global Human Health, here to provide commentary on revenue trends on several of our key inline and recently launched products. And Peter Kellogg, our Executive Vice President and Chief Financial Officer will focus in on the key financial takeaways from the quarter, and provide an overview of Merck's 2008 financial guidance. Before we get into the details, I'd like to go over some logistics. On this call, we will review the results contained in the release we issued at 4:30 today. You can access this through the Investor Relations section on merck.com and I would remind you that this conference call is being webcast live and recorded. The replay of this event will be available this evening via phone, webcast and podcast. As we begin our review, let me remind you that some of the statements made during this call may discuss certain subjects that may contain forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and involve risks and uncertainties which may cause results to differ materially from those set forth in the statements. The forward-looking statements may include statements regarding product development, product potential or financial performance. No forward-looking statements can be guaranteed and any actual results may differ materially from those projected. Merck undertakes no obligation to publicly update any forward-looking statements whether as a result of new information, future events or otherwise. Forward-looking statements in this press release should be evaluated together with the many uncertainties that affect Merck's business. Particularly, those mentioned in the risk factors and cautionary statements in Item 1A of Merck's Form 10-K for the year ended December 31st, 2007 and in any risk factors or cautionary statements contained in the company's periodic report on Form 10-Q or current reports on Form 8-K, which the company incorporates by reference. We will begin the call with brief remarks from our senior management, and then open the call up for your questions. And expect the total call to last approximately an hour. With that, I'll turn the call over and we will begin with remarks from our Chairman and President, CEO, Mr. Clark.
Richard T. Clark: Thank you, Eva and good evening everyone. Thank you for your flexibility in adjusting your schedules to unavoidable last minute change we made this morning. In the timing of our sales and earnings announcement, we felt it was important for you to first have the scientific perspective of the SEAS results, which were presented earlier today by the study's principal investigator. In a few movements Ken Frazier and Peter Kellogg will provide an overview of our performance in the second quarter along with updates to our 2008 guidance. But first, let me make a couple of points. It is important to understand that the results for SEAS have just been presented publicly today and we ourselves just recently received this study results from the outside researchers. While we are moving quickly to assess the data in a substantial implication for our cholesterol joint venture, it is just too early to make informed judgments about the potential impact of SEAS on our performance for 2008 and longer term. I know you undoubtedly have questions on SEAS but please appreciate our scientist are working diligently to evaluated the data on this. And on this call we are not in a position to add to the lengthy discussion that took place this afternoon. Also, we believe it's appropriate to take some time before we provide equity income and EPS guidance for 2008 or longer term guidance. We will provide an update at a letter time. While I know you dislike uncertainty almost as much as I do, I hope you understand our position. We remain fully committed in helping you understand our business and its prospects. Also it is important to know that before these results were made available, we were within our previously disclosed GAAP and non-GAAP EPS guidance range. Next, I want to share an update on manufacturing. Previously we told you that Merck was working with the U.S. regulatory authorities to adequately adjust the agency's manufacturing concerns in an expeditious manner. On July 10th, Merck received a letter from the FDA closing out its recent inspection of the West Point manufacturing facility. As a result, any filed sBLA which were held up due to the inspection can now move through the agency's normal review and approval process. As always, we will continue to work with the regulatory authorities in a cooperative manner to ensure that the public health is served by continued supply of our quality vaccine products. In addition, varicella supply issues, which were unrelated to the issuance of the warning letter, have been resolved, and we have resumed manufacturing of bulk varicella. We're producing doses of VARIVAX, and we don't anticipate any supply interruption of VARIVAX. Finally, I wanted to provide you with some perspective on how our leadership team and I are thinking about positioning Merck for success now and in the future, even in the face of very tough industry environment and some unexpected difficulties. These factors made for an intense review of our business at our recent annual strategy meeting. At that meeting, my team and I identified opportunities and actions necessary to drive future growth. During the session, we decided to move forward on several immediate and long-term steps designed to accelerate our revenue growth. To give you a flavor of some of these steps, emerging markets will become an even more central part of the company's business strategy. In addition, we will aggressively seek out the best partners in the regions outside United States to support in line product acquisitions, co-marketing and promotion agreements, as well as country and regional licensing opportunities. We are accelerating development programs or novel mechanisms and fixed dose combinations in some of our key therapeutic areas. All of these moves have significant incremental revenue potential. In the mean time, it remains vital that we operate our business in more lean and flexible manner, by having the discipline and leadership to make significant but necessary changes. That means continuing to embrace both internal and external innovation to enhance productivity and the long-term sustainability of our pipeline. We've advanced the robust research and development of pipeline that contains nine late stage breakthrough investigational candidates that are just critical unmet medical needs. We are continuing to launch new medicines around the world, and we're investing heavily in the lifecycle management plans for those brands. We remain committed to doing what it takes to regaining leadership in the pharmaceutical industry. Now, I'd like to turn first to Ken, who'll followed by Peter. And, after their remarks, we'll take your questions. Ken?
Kenneth C. Frazier: Thank you, Dick. And good evening everyone. Merck's revenue performance in the second quarter reflects continued strong growth of a number of our recently launched new products, offset by challenges to key brands, such as GARDASIL and SINGULAIR, and the continued impact of the loss of marketing exclusivity for FOSAMAX. Overall, revenue was down 1% in the second quarter. However, excluding FOSAMAX, revenue in the second quarter increased by 6%. Our international business, aided by the prevailing exchange rates, continues to perform very well, increasing by 12%. As we enter the second half of the year, we believe that we have the plans in place to address a number of the challenges facing our products, and we can continue to drive growth around the world at the launches of JANUVIA, JANUMET, ISENTRESS and GARDASIL roll out. Now let's discuss some of the key drivers of Merck's business in the second quarter, beginning with our HPV vaccine, GARDASIL. In the second quarter, we continued to make progress in our attempt to reduce the global burden of cervical cancer with GARDASIL. Merck sales in the second quarter were $326 million, a 9% decrease when compared to the second quarter of last year. In addition, during the second quarter, our vaccine joint venture Sanofi Pasteur-MSD recorded end market sales for GARDASIL of $234 million. Global end market sales for GARDASIL in the second quarter of 2008 increased 28% versus the prior year, driven by the continued roll out of GARDASIL in Europe. Sales of GARDASIL in the U.S. were sequentially down in the second quarter as a result of three factors. First, a decrease in second and third dose administration. As new starts peak in the back-to-school period with the recommended dosing regimen over six months, second and third dose immunizations occurred disproportionately in the fourth and first quarters. Second, a deceleration in the penetration rate among the 13 to 18-year old cohort. Considering the strong cumulative utilization in this cohort since launch, continued growth requires substantially higher penetration rates among the remaining eligible cohort. The adolescent penetration rate for GARDASIL is nearly two times higher than the average cumulative penetration rate of Menactra and the Diphtheria, Tetanus, and Pertussis vaccine, at comparable points in their lifecycles. Third, lack of significant progress in our ability to increase the penetration rate in the 19 to 26-year old cohorts. While our launch efforts achieved unprecedented uptake in the 11 to 18-year old cohort, the penetration rate in the 19 to 26-year old cohort have thus far proven harder to increase. Despite our efforts to increase the penetration rates in this population, we clearly underestimated the attitudinal and behavioral barriers with both the 19 to 26-year old female themselves as well as the doctors that treat them. Fortunately, the opportunity in this population is still very much in front of us. And we remain fully committed to achieving broad vaccination in this cohort as per ACIP and physicians to file [ph] recommendations. To increase the action among these women, we recently implemented programs to help reduce reimbursement concerns, and assist physicians in their recommendation for these women. In addition, we recently developed and launched new DTC ads, an interactive way of portal. In the third quarter, we're planning to launch additional healthcare provider and consumer initiatives to drive increased immunization in the 19 to 26 year old cohort. Importantly, as we look forward, we continue to anticipate that origination will peak in the third quarter, based on the fact that historically, approximately 40% of adolescent well visits occur in that quarter. As with all of our products, Peter will provide you with an update of our guidance for GARDASIL in a few minutes. Now, turning to SINGULAIR, sales of SINGULAIR were down 1% in the second quarter. This performance in the second quarter of '08 was due to a decline in the U.S. business, partially offset by continued growth outside the U.S. In the second quarter, U.S. prescriptions, that's TRX were down approximately 8% versus second quarter of '07, while the overall respiratory market, which is the combined allergy and asthma market, ex-ZYRTEC was down approximately 3%. Ex-U.S. sales of SINGULAIR grew 15%, driven by continued growth in Japan, the second largest market for SINGULAIR worldwide. In Japan, the successful launch of the allergic rhinitis indication in the spring of 2008, and the introduction of the oral granules formulation for pre-school age children since late 2007 are contributing to the growth. Three main factors contributed to the year-over-year U.S. performance of SINGULAIR. First, the switch of ZYRTEC to OTC in January. Despite SINGULAIR's continued strong positioning on formulary, ZYRTEC OTC has clearly had an impact on the overall allergic rhinitis market including SINGULAIR. We continue to believe that SINGULAIR offers a compelling value proposition among new and dissatisfied allergic rhinitis patients. As dissatisfied patients try multiple products to treat allergic rhinitis over time including OTC products, we believe that they will continue to visit their physicians and seek additional alternatives including SINGULAIR. Second, the timing of and the public reaction to the FDA early communication, created uncertainty in the marketplace just as the allergy season was about to start. The October 2007 label change was based on a very limited number of post-marketing adverse event reports that Merck received. Since that time, Merck has worked with the FDA to provide further clarity in the product label as well as to further communicate this information to physicians. Based on feedback from our sales force and Merck's proprietary research, physicians continue to rate SINGULAIR as the brand that best represents having a side effect profile similar to placebo in the asthma market. We continue to have confidence in the safety and efficacy profile of SINGULAIR. Third, the spring allergy season was shorter and milder compared to recent years. Fortunately, recent weekly domestic performance for SINGULAIR has shown signs of improvement relative to the growth of the overall respiratory market. And we are taking additional steps to further support the brand including accelerating a new outlook program initiating expanded multi-channel promotion and delivering compelling health care provider, consumer and disease awareness programs to market. Despite these challenges, SINGULAIR continues to be the number one product in the U.S. respiratory market. Moving to JANUVIA and JANUMET, two of our newest growth drivers, global revenue for these two products reached $406 million in the second quarter, up 23% sequentially versus first quarter of this year. In the U.S., JANUVIA continues to be the second leading branded oral anti-diabetic agent in terms of new prescription share. Recent data presented at ADA, including a compelling analysis comparing JANUVIA versus sulfonylureas, which showed treatment with JANUVIA dramatically lowered hypoglycemia compared to treatment with FFUs. Based on our post-marketing experience for JANUVIA and with over $5 million prescriptions written in the U.S. since launch, we continue to be extremely confident in the efficacy and safety profile for JANUVIA and JANUMET. In addition, we are extremely pleased with the ex-U.S. performance of JANUVIA and JANUMET in the second quarter. Sales outside the U.S. were $77 million as recent launches in key markets such as France, Spain, Italy and Canada continue to progress. The recent European approval for JANUMET will provide an additional growth opportunity for our diabetes franchise in the 27 markets in which the regulatory decision is applicable. Now, I would like to take a moment to provide an update on the revenue performance of our cholesterol JV. Before doing that, as you know, based on today's announcement in the press conference, the company has recently received a clinical data from the SEAS study. In view of this, I am not in a position to provide an immediate perspective on the future performance of ZETIA or VYTORIN. We will do everything we can to ensure that the data are communicated effectively and understood in the appropriate context. We continue to believe that both ZETIA and VYTORIN provide physicians with valuable treatment options to help get more patients to their LDL goal. Worldwide sales of ZETIA and VYTORIN as reported by the Merck/Schering-Plough joint venture were $560 million and $592 million respectively in the second quarter. In the second quarter, sales declines in the U.S. were partially offset by strong growth outside the U.S. Before turning the call over to Peter, I would like to take a moment to update you on the progress we are making in terms of optimizing our cost base as we pursue our new commercial model. In the second quarter, marketing and admin expenses excluding the legal defense reserve in the base period, was up 3% versus the second quarter 2007. The year-over-year increase in marketing and the administrative expense is solely attributable to the impact of exchange. Excluding exchange and legal defense reserve in the base period, operationally marketing and administrative expenses were down 3% in second quarter '08 versus second quarter '07. As you know, in May, Merck announced plans to reduce the size of its U.S. sales force by 1200 physicians. The reduction in the U.S. sales force is part of our previously disclosed and continuing efforts to optimize our cost base and improve Merck's effectiveness and efficiency across all aspects of our business. These actions are consistent with our imperative at the company to continue to look for opportunities to improve business processes and practices and to create a leaner, more cost effective and customer-focused operating model. In closing, we continue to believe that tremendous commercial opportunities exist for our inline and new products. We are confident that the plans we have in place will enable us to maximize the revenue potential of our pharmaceutical products and vaccines. And while we have faced a number of commercial challenges in the first half of 2008, we continue to believe that our established franchises along with our new first-in-class vaccines and medicines, such as GARDASIL, ROTATEQ, JANUVIA, JANUMET and ISENTRESS provide us with a diverse product portfolio well positioned to drive revenue growth. At the same time, our continued focus on efficiency on the marketing and administrative line will help drive overall margin improvement. So with that, I'll turn the call over to my colleague, Peter Kellogg.
Peter N. Kellogg: Thank you, Ken and good evening. To wrap up the call, I will discuss key elements of Q2 results not previously covered, provide an overview of the extent of our 2008 guidance, and comment on other financial matters such as our dividends. So, let's get started. Merck reported second quarter non-GAAP earnings per share of $0.86 per share, representing growth of 5% over the second quarter of 2007. On a GAAP basis, earnings per share for the second quarter were $0.82, a growth of 6%. For the first half of 2008, the company recorded non-GAAP EPS of $1.75, also up 5% versus the first half of 2007. Year-to-date GAAP EPS were $2.34, 51% above 2007 GAAP EPS. Our second quarter results reflect our continued efforts to create a leaner, more cost effective and customer-focused operating model as evidenced by first product gross margin. That showed continued strength. There was an impact of restructuring charge in the second quarter. Excluding this charge, PGM was 77.2%, maintaining performance at pre-Zocor patent expiry level. Sequentially, PGM was down 1.8 points, primarily attributable to product mix and some inventory write-offs. Secondly, as Ken, mentioned, marketing and administrative expense in the second quarter was down 7% and as he mentioned, excluding both the legal defense charge in the prior year and the unfavorable impact of foreign exchange, expenses were down 3% rate progress. This excellent result was due to the improvement that Ken walked us through and some additional efficiencies throughout our G&A organizations. And finally research and development expenses of $1.2 billion increased 13%. This increase was generally attributable to several areas of clinical spending for late stage programs. Next, as anticipated equity income was down year-over-year because of two factors. First, the equity income contribution from the Merck/Schering-Plough joint venture was down 22% or $100 million as a result of ZETIA and VYTORIN market share losses in the U.S. The lower revenue in the U.S. was partially offset by the strong performance outside the U.S. Additionally, the respiratory joint venture was terminated during Q2, which will result in the payment by Merck of $105 million to Schering-Plough. Consequently, Merck's second quarter equity income contribution from the Merck/Schering-Plough joint venture includes a $43 million expense related to this termination. The remainder of this payment will be amortized over the life of the partnership in accordance with U.S. GAAP. Second, contributions in the AstraZeneca joint venture was a $154 million lower in Q2 versus prior year. This decrease in the equity contribution from the AZN partnership is attributable to the previously disclosed events surrounding the JV restructuring that occurred toward the end of the first quarter this year, and some inherent variability of timing and payments from AstraZeneca. As a result or as a reminder rather, Merck's priority return was decreased to $55 million per quarter from $75 million per quarter, and Merck no longer received the 10% loyalty payments from the Astra USA products. Finally, in the second quarter, our effective tax rate realized a 9 percentage point benefit from various tax settlements. The reported effective tax rate was 14.1% and excluding the impact of restructuring charges, the non-GAAP underlying effective tax rate was 15.2%. Both rates reflect the impact of various tax settlements that resulted in a reduction of our corporate FIN 48 reserves. As you can appreciate, we're not in a position to disclose the details of these settlements; however, they are unrelated to the foreign tax credit that we announced in Q1. Moving to the bottom line as I mentioned earlier, Merck's second quarter non-GAAP EPS was $0.86 and the GAAP EPS was $0.82. Now moving to guidance, as Dick and Ken discussed, we are assessing the impact of SEAS on the performance ZETIA and VYTORIN, and are not in a position to provide an immediate perspective. Therefore at this time, we're not able to provide 2008 equity income guidance, 2008 GAAP and non-GAAP EPS guidance, and any long-term financial performance. We are fully committed to helping you understand our business and its prospects, and we are not stepping away from that commitment. We will provide an update at a later date. Now, Ken talked about a number of challenges and opportunities of the business that may change our 2008 product performance. And accordingly, we are changing several elements of our product guidance, and some will be increases and some will be reductions. As always, to assist your modeling, we provide a breakdown of the product revenue guidance in our other financial disclosure schedules attached to the press release issued earlier today. So, let me walk through those changes. Regarding SINGULAIR, we're lowering our full year guidance by $200 million and now anticipate revenue in the range of $4.4 billion to $4.6 billion for the reasons Ken discussed. For COZAAR/HYZAAR, we are raising our guidance by $100 million, and now anticipate revenue in the range of $3.5 billion to $3.7 billion. This is primarily driven by the strong performance in Japan, and the positive effect of foreign exchange, considering the geographical segmentation of revenue for these products. Guidance for GARDASIL revenue as recorded by Merck is now anticipated to be in the range of $1.4 billion to $1.6 billion. This $500 million reduction is due to the several factors that Ken just reviewed. Additionally, since this is full year guidance, it also incorporates some impact for the delay in the mid adult women indication. Other vaccines guidance of $2.7 billion to $2.9 billion has been reduced by $200 million. This reduction is largely attributable to the lower than anticipated VARIVAX second dose penetration, which we can now take steps to address with the implied or the improved supply situation which Dick mentioned earlier. Regarding FOSAMAX, we continue to be pleased with the performance of the domestic FOSAMAX PLUS D year-to-date. And as a result, we are increasing our full year guidance by $100 million to $1.4 billion to $1.7 billion. Now regarding marketing and administrative expense, we are reducing our guidance by $200 million to $7.5 billion to $7.7 billion. This reduction is possible because of the delay of MK524A in the U.S. and the domestic sales force reduction of 1200 positions announced in May, which has now become... is now being completed, and our ongoing company wide aggressive expense management program. Let's turn to restructuring. As part of the company's restructuring of its operations, we anticipate the aggregate 2008 pre-tax expense related to these activities to be in the range of $200 million to $300 million. Moving to taxes, we are reducing our full year 2008 non-GAAP tax rate guidance range to approximately 18% to 21%. This guidance incorporates the impact of the foreign tax credit benefit recorded in Q1 and the discreet tax settlements recorded in Q2. It does not reflect that tax rate impact of gain on distribution from AstraZeneca or restructuring charges. Turning to other financial matters, it should be clear though that we have the financial strength and are remained fully committed to maintaining our dividend at the current level. At the same time, we continue to fully invest in our keys strategic priorities. So let me summarize. There have been several changes to our revenue guidance pipe as ken reviewed. Our inline product portfolio includes numerous young therapies that continue to show real promise. We continue to roll out and launch our eight new products globally. We also continue to aggressively manage our overall cost structure as demonstrated by the reduction in marketing and administrative guidance. And with our robust late stage pipeline of nine new vaccines and medicines, we remain confident in the company's ability to deliver strong results. We are however taking some time to assess the impact of SEAS announcements and will re-establish guidance on the equity income and EPS for 2008 and on our long-term guidance in the future. Now I'd like to turn it back over to Eva. Eva?
Eva Boratto: Thank you, Peter. We will now open the call to take your questions. We will take your questions in the order they are received and try to get through as many as possible. Also joining us for the Q&A is Bruce Kuhlik, our Executive Vice President and General Counsel. At this point, I will turn it over to Kiera, who will communicate the instructions for our Q&A format and then introduce the first question. Question And Answer
Operator: [Operator Instructions]. Your first question comes from the Chris Schott with J.P. Morgan.
Chris Schott: Ken, first just to clarify, did you mention your plan was to maintain the 2008 EPS guidance prior to the SEAS study results released today. And then second on GARDASIL, the cuts of the guidance, what age group specifically was driving bulk of the clients here. It sounds like the trends with the 13 to 18-year olds was particularly surprising, is that a fair statement? And then are you factoring in any impact from some of the adverse event kind of media publicity we've seen kind of scattered through this month on GARDASIL? Thank you.
Richard T. Clark: Chris, your first question before the SEAS announcement we were going to reaffirm our guidance for 2008 that is correct.
Kenneth C. Frazier: And on the GARDASIL question, the cohort I think that we've seen the most difficulty with is the 19 to 26-year old cohort. And then that's for couple of reasons. As I mentioned before, trying to get actual the women even when you can drive high levels of awareness has proven more difficult than we anticipated. In addition, these women primarily visit PCP then OBGYNs who are not typical routine vaccinators. And who in many cases have no established infrastructure for routine vaccination of this age group. In addition, there is some lack of consistency around benefit design with the portion of these women which causes additional confusion with their physician, despite the fact that there are high levels of this individual have some coverage if they are privately insured. So the biggest issue for us has been us with 19 to 26-year old, although I also mentioned that given the high cumulative strong utilization we have in the 13 to 18-year old, continued growth will also require substantially higher penetration rates among those remaining to be vaccinated.
Eva Boratto: Kiera, next question please.
Operator: Your next question comes from the line of Tim Anderson with Sanford Bernstein.
Timothy Anderson: Thank you. Can you give an update on the ongoing SINGULAIR safety review by FDA in terms of when we might learn more? And really what are the chances that something could blow up here, because this is obviously a very key and high margin product for you. And then of SINGULAIR sales, can you talk about what percent goes to a pure allergy indication versus the pure asthma indication versus concurrent disease?
Kenneth C. Frazier: Well, we can't obviously predict what the FDA will do. We are in the process of interacting with the FDA now, and providing that information to the FDA. As for the relative breakdown of asthma and allergic rhinitis, we do not generally provide that information. So, I can't provide that. I also I noticed that and in response to the last question I did not respond to the question about whether or not GARDASIL sales were anyway impacted by the most recent publicity around adverse event. We're aware of that, we are monitoring that. I can't say that that has not had an impact. We hope that that impact will not be a substantial one going forward. But it certainly is an issue that we're contending with now.
Eva Boratto: Kiera, next question please.
Operator: Your next question comes from Barbara Ryan with Deutsche Bank.
Barbara Ryan: Chris, sort of had my question, thank you. But, maybe as I can just expand a little bit, I think Dick when you did start out, you said that you were ready to reiterate guidance until the SEAS results came out. And I'm just wondering, beyond 2008, but I would imagine that the growth outlook would be somewhat impeded by the shortfall in GARDASIL. Maybe that's not the case, I can see adding up the various pluses and minuses in 2008, how the guidance on GARDASIL could be offset with tax rate, lower spending et cetera. But, on a longer term basis, is that a fair assessment with GARDASIL?
Richard T. Clark: Yes, first of all Barbara, the... when you look at 2008, you are right, there are many other things that are going right, as Ken and Peter were able to tell you. And we continue, obviously to surprise ourselves when we look at our new operating models for the major parts of the company and what impact we're having on flexibility in expenses and we'd be able to drive that to something that meets our expectations, in many cases it exceeds it. But we also look at where we are from, when putting our long range plan together for 2008, 2009 and 2010. What we had a commit to in order to get to double-digit growth, and where we actually are, with some of the other products, which is very, very positive. The comment I'll make about GARDASIL is that, still the... although there is a... obviously a delay in the penetration for this cohorts, we have not lost that market share to a competitor. So it's our ability to bring that home within '08, '09 and 10 and so when you bring all of these factors into play if until we evaluate the SEAS activity, I would've been very comfortable with eight as well as ten.
Eva Boratto: Okay, thank you. Next question please.
Operator: Your next question comes from the line of Roopesh Patel with UBS.
Roopesh Patel: Yes, thank you. I have a couple of questions on GARDASIL. I look at the revise guidance for this year, it implies that second half sales will decline year-over-year somewhere between 5% and 27%. And I am curios as to when you expect the drug to resume growth and what the drivers will be. Secondly what's the estimated penetration that you've reached in the U.S. in the two age groups, the 13 to 18 year olds and then the 19 to 26 years olds? And lastly, given the challenges experienced with penetrating the 19 to 26 years olds, what you believe the company will have to do differently when it gets approved for adult women 27 to 45 year olds? Thanks.
Kenneth C. Frazier: Okay,I will go and try to get all of those; I'll try to work backwards on those. I think as we deal with older population including adult women, we obviously will be dealing with very different populations than we did with adolescent girls. What we found in the adolescent population was that our efforts to motivate the primary actors in that case, largely mothers of young girls as well as pediatrician, that's something that our early efforts were relatively successful and that created a very large uptake in the first year. I think as we deal with older populations, we are going to have to find strategies and we are in fact defining and working on strategies that allow us to communicate what is clearly a valuable therapeutic offerings to those women as well as to their doctors and get people to begin acting on it, when they have that level of awareness. So that is the challenge. As for the question of, what's the relative penetration in cohorts, that's not data that we provide, and so I can't answer that and so I think the last question was when and how do we expect to see growth resume later in this year. I think that goes back to what I said, which is that we have a number of programs in place to address some of the primary concerns and barriers that we've experienced in the market particularly from the 19 to 26-year old. They include, financial issues that affect the physician as well as actions that are intended to drive more action among our young adult females including new consumer DTC campaigns that are end directly at young adult women. We think those are the kinds of things that we'll have to do in order for us to drive greater awareness during the course of the year. We have distributed a significant number of doses. I would say the penetration has been 30 million worldwide and 18 million in the U.S. So we have done relatively well and we continue to believe that there is a lot of opportunity out there as Dick said, we are the sole source for a number of these vaccines GARDASIL, ZOSTAVAX, VARIVAX and the fact that our current demand is less than anticipated is something that leaves us a great opportunity going forward to penetrate in the future because you have more of an opportunity in the fact because you haven't penetrated much now. I don't say that by way of excuse, I just say that's the challenge before us and that's the challenge that we are taking on.
Eva Boratto: Next question please, Kiera.
Operator: Your next question comes from David Risinger with Merrill Lynch.
David Risinger: Yes, hello. I have a couple of questions. First of all, with respect to the vaccine supply constraints in the second quarter, can you just help us understand what the sales constraints were and what level of improvement will occur as a result of the FDA okaying the facility? And I guess just follow on to that, are there any manufacturing overhangs ongoing, so that's my first question. Second, can you just explain the surprising tax settlements in the second quarter that yielded your lower tax rate guidance for the full year of '08? And then third, with respect to going back to the manufacturing issue, I think your press release said that there won't be any limitations on filed vaccine supplements that are pending approval. Could you just run through what those filed vaccine supplements are? Thank you.
Peter N. Kellogg: So, David first... this is Peter, let me take the tax item first then we'll get into the manufacturing topic. So, as you know, FIN48 is the accounting standard referred to as accounting for uncertainty in income taxes. And what it requires is the company to determine whether the benefits of the tax position are more likely than not are sustained upon audit and so based on the technical merits of the tax position. So for all of our tax positions around the world, we do set up... for the appropriate ones, we set up a FIN 48 tax reserve and so that's on our balance sheet. And basically, as we go through and results are in tax positions with different authority through audits and what not, either those reserves turn out to be appropriate or not. What happened in the second quarter was, we did finish a few different tax audits and reviews of different times in our prior year filings. And overall, we came out very favorably versus what we had on our balance sheet for the FIN 48 reserves. And so, the way it works is once you have clarity on that you've made the settlements, you make the payment, then you go back to reserve, and if you have reserves in excess of what were called for, you release that. And so, that's where we got the benefit for in Q2, is the release of certain reserves that turned out in hindsight to be a little bit conservative. But, at the time we made them, we thought they were appropriate, but we turned out to do better under audit than we anticipated. So, that within FIN 48... that's what the tax benefit was in Q2. It's a one-time item for those particular items. It really doesn't have any recurring nature going forward except that the way the overall effective tax rate is calculated. So, moving then to manufacturing topics, I'll let Ken and Dick handle those.
Kenneth C. Frazier: So, the question was to what extent were issues in the second quarter relative to our vaccines the product of supply interruptions. So, well as it relates to certain vaccines as you probably know, we've stopped taking orders temporarily for our pediatric and adult vial formulations of that as well as our HIB containing vaccines. As it relates to VARIVAX, we did have supply adequate to meet the demand in the second quarter of '08, and now that we have resolved the supply situation for VARIVAX, we're working with our customers in the private and public sector to continue to increase second dose immunizations for the catch up cohort through the rest of 2008.
Richard T. Clark: And concerning supplements, we have at least two supplements with the FDA concerning GARDASIL and they will move through the process now.
Eva Boratto: Take our next question please.
Operator: Your next question comes from the line of John Boris with Citi. Mr. Boris your line is open.
Eva Boratto: Hello, next question please.
Operator: Your next question comes from line of James Kelly with Goldman Sachs.
James Kelly: Thank you, and good evening. My question has to do with the progression of gross margins. In this quarter where I'm just really interested I guess Peter, in some of the pushes and pulls on gross margins. I would think that when the royalty burden on a product like GARDASIL, and the way that that one has been trending. One, that that could have led to a higher sort of gross margins for this quarter, but two, could also have upward pressure on the gross margin guidance for the year. So, give us some thoughts and some of the other important pushes and pulls, and if I have the other one correct, that will be great? Thank you.
Peter N. Kellogg: Yes, sure. So, you're right, I mean, when you go to PGM, I just want to make sure, your premise is exactly right. There is a lot of different pushes and pulls, product mix and so forth, so it is sort of a weighted average effect. I think that as I mentioned on the call, the PGM line had really just some product write-offs as well as some restructuring charges as well in the quarter. So, there are a couple of different effects. Overall, I think the PGM, we've done very well in the way the team, the manufacturing organization and global operations have worked on their cost structure, and obviously that comes into the couple of different ways that one is just the overall amount of overhead that goes into our PGM but also the efficiencies that go through manufacturer. As we provide guidance, obviously, we're always within the range that we are giving guidance and it can move around a little bit. But in general, that's we do, we do the forecasts as the team works through kind of what the pushes and pulls are, which we try to say what the run rates are and what the trends are. So we are very comfortable with our guidance and we don't like to get... to make it a nervous guidance so we don't move it around by 0.3 to 0.4s, but we stay within that range. But yes, you are right. The product mix could have a slight impact over time, but at this point, we feel pretty good about the guidance we have out there.
Eva Boratto: Kiera, next question please.
Operator: Your next question comes from Tony Butler with Lehman Brothers.
Tony Butler: Thanks very much. Can you make at least on my estimation some slightly and concurrent comments regarding GARDASIL in that you stated that in this particular quarter, the 19 to 26-year old population being treated by OBGYNs, who do not normally vaccinate, actually might have had an effect on the overall demand and yet you also stated or perhaps Peter stated that the change in full year guidance was effected because the timing of the over 26 population did not occur when you anticipated. Again, I would assume that's an OBGYN population. So I guess I am just looking to reconcile that especially when I have the impression that you were likely throwing some refrigeration units into those OBGYNs realizing that they are not the primary population of physicians who tend to be historically vaccinators. And then as a second question, I might think candidly much like myself, the JV or the VYTORIN ZETIA sales folks are pretty battle worn and bad scarred from the full year so I would be interested, Dick if you might be able to just provide a couple of words on how you think about resurrecting their energy especially given a lot of the bad information that seems to be hitting him in the face going forward. I appreciate the time.
Richard T. Clark: I'll start with the VYTORIN ZETIA joint venture question. I think we begin the discussion around leadership. We have an outstanding leadership team in place in the joint venture and it is an experienced team that's been through marketing and sales battles before with competition. And we make sure that we give them the right support as a joint venture. I know that Schering-Plough said you the same, and they like the competition and they like the challenge. And the major reason is because they believe in their products. They are good products and they are important products in order to reduce cholesterol and to help people of cardiovascular risk moving forward. So with that as a part of it, it's an important mission and we've got some of our best people in there and although this is a very difficult time, I have a tremendous amount of confidence in their capabilities and when you see some of the mistruth that were spoken particularly around the enhanced that makes us even more engaged in order to get the right information to physicians so that they can make that decision. And so, we hear a lot passion about our products from the joint venture and you heard a lot passion on the call today from chief investigators.
Kenneth C. Frazier: With respect to GARDASIL, let me start by clarifying that for the populations over the age of 26. Given the original July PDUFA date and our original assumptions around the timing and then APIP vote for this cohort, we had only forecast a partial year contribution for this population. So I think that might have been what we alluded to earlier is that that contributes to some of the difference in what we thought we would do this year. But the predominant issue coming back before is the challenge that we have with respect to the penetration rate for 19 to 26-year old and what I was trying to say there is that while compared to historical norms, penetration remains high across all the established GARDASIL age cohorts that we have stronger uptake for girls 11 to 18 than we do for the 19 to 26-year olds. And there the uptake is not nearly as high and the issues are more diverse. And they include challenges and getting those woman to translate the awareness into action making it relevant for those people to want to come in and demand vaccines. But the other issue is getting OBGYN who are not typically vaccinators to adopt that as a business model and to strongly recommend this to their patients. So, we are dealing with issues with respect to the 19 to 26-year old women, with respect to their physicians, we're dealing with financial issues that their physicians and their offices are encountering. And we're trying to change the behaviors and the attitudes across there. We believe we can, as I've said, I'll try to be very candid in saying that we clearly underestimated the difficulty of it. But we have lot to programs in place, and we're going to continue to get after that. It's a great vaccine, physicians believe in the therapeutic promises of vaccine. We've just now got to get them to a place where universal same day vaccination is the standard of care for those OBGYNs as it is for pediatricians.
Eva Boratto: Okay. And just to note, given the time we'll take one or two more questions. Kiera, please next question.
Operator: Your next question comes from the line of Catherine Arnold with Credit Suisse.
Catherine Arnold: Thank you very much. Dick, I was wondering, given the substantial focus for investors on the 11, 12 horizon, and despite the near term challenges that you need to face, are you still considering giving longer term guidance at your December analyst meeting, is that something we can look forward to? And on a micro level, I just wondered if you could comment on the ZOSTAVAX performance. It seems, they have declined sequentially and we haven't seen that in the United States. I wondered if you could comment on that for me. Thanks.
Richard T. Clark: Sure, as I mentioned in my talk, we are coming out of our strategic planning meeting, where we looked at several initiatives to increase revenue growth. During the period particularly with SINGULAIR going off the patent and the ability to change our operating models in our three divisions, even more significantly than we did with our first plan to win. So, I am not in the position yet to evaluate what impact that has, giving guidance to that period we have to discuss that. And certainly we have teams working on that. What we're focused on now, is to be able to get back to you as quickly as I can, where 2008 and 2010 guidance is my first step and that's our priority. But I can tell you, I was extremely encouraged with the week strategic planning meeting we had, where we focused on 11 to 16, and we're evaluating that now.
Kenneth C. Frazier: As it relates to ZOSTAVAX, as we've pointed out, due to the supply issues that had existed with varicella containing vaccine, we prioritize VARIVAX, particularly to ensure that we had a supply to support the second dose vaccination recommendations. As a result, we were not in the same way publicizing or promoting ZOSTAVAX. So, I think if you look at the patents around ZOSTAVAX, they are not as reflective of the product's potential as they are, the priority being given to VARIVAX.
Eva Boratto: Okay. And we'll take our final question.
Operator: Your final question comes from the line of Seamus Fernandez with Leerink Swann.
Seamus Fernandez: Thank you very much. So, just hoping that you could provide a little bit more clarity on maybe the elements that drove the $700 million reduction in the equity income that you choose in the first quarter so that we have something off of which to base the incremental guidance that you are expecting to provide to us in the near future. And then, second, can you just help us better understand ROTATEQ had a strong quarter, $178 million in global revenue? Was there any stocking in the quarter for ROTATEQ and also how do you plan to defend against GlaxoSmithKline's Rotarix and since in the second quarter the ACIP recommended for harmonization of the two products? Thank you.
Peter N. Kellogg: Okay. So let me... this is Peter. Let me get started on the equity income line since there is a couple of moving parts as you have indicated in the call... in the question. So, the first thing is as I said earlier, the Merck/Schering-Plough joint venture was down 22%. Now, the one thing to remember was, there was a charge of $43 million of expense in the quarter related to the termination of the respiratory joint venture. And so, that $43 million is an expense that occurred in Q2. And then after that we will be amortizing the balance, which is $62 million over the remaining life of the franchise of the IP for ZETIA, which goes out 2015. So, we won't have a charge like that as big as $43 million going forward, it will be lot smaller. Obviously, I think that I am very impressed by how accurately and closely everybody tracks the VYTORIN and ZETIA script. So, I have no doubt that you can make, you can respond to that and view forecasting off of those trends as well as we see those emerge. But, there is... I don't think there is any usual otherwise in the joint venture performance of Merck/Schering-Plough. And as Dick said before, I just wanted to reiterate, we have enormous faith in that organization and in that team. Very seasoned team to go out, come out fighting, in the second half of this year. The way the AstraZeneca joint venture which I will acknowledge is a lot more complicated. The equity income... the income was $154 million lower than Q2 last year and as you go back to your notes on some more deals, certainly remember there is a lot of moving parts, because of the way we went through the joint venture restructuring towards the end of the first quarter this year. And some of the pieces of that were the priority return, actually decreased to $55 million per quarter, from what it had been... roughly $55 million per quarter, in that neighborhood, from what had been closer to something like $75 million per quarter. That was one change. Another is that we used to receive 10% royalty on the Astra USA products and we don't receive that again going forward. And then the third one which I alluded to, is that there is some inherent variability in the timing of how we receive payments from AstraZeneca and there was a significant change to that effect in the second quarter that created a volatility downside in the second quarter that we don't expect to see recurring hopefully like that. But there is always some volatility in the bouncing around of those numbers. So in terms of going forward, we think that Q2 was overall weaker because of that volatility. But the other items become part of the new trend. So hopefully that gives you enough to work out some estimate on it, but certainly the bigger impact was on the volatility this quarter. Ken?
Kenneth C. Frazier: As it relates to ROTATEQ. In the second quarter, we recorded revenue about $13 million that was attributable to the CVC stockpile and we do have a competitor now in the U.S. but we feel it had no real impact in the second quarter. And we continue to be extremely confident in ROTATEQ as far as how it's going to perform in the U.S. with over 75% of U.S. birth cohort now being vaccinated with ROTATEQ. And we are also pursuing a systematic thoughtful approach to the global introduction of ROTATEQ. So, we continue to have great confidence in that vaccine going forward and we think the ACIP recommendation will be extremely positive for ROTATEQ going forward, so those would be my response.
Eva Boratto: That last question concludes today's conference call. The information from today's call, both the transcript and replay will be available at our website for the next several months and Mike Nally and I will be available to take your calls and any incremental questions. Operator?
Operator: That concludes Merck's second quarter 2008 earnings conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day, everyone and welcome to Merck's Second Quarter 2008 Earnings Conference Call. Today's call is being recorded. At this time, I would like to turn the call over to Ms. Eva Boratto, Vice President of Investor Relations. Please go ahead."
},
{
"speaker": "Eva Boratto",
"text": "Thank you, Kiera and good evening everyone. Welcome to our call this morning to review our business performance for the second quarter of 2008. We appreciate everyone's participation after a full day of news flow. Joining me on the call today is our Chairman, President and CEO, Dick Clark. We also have Ken Frazier, our Executive Vice President and President of Global Human Health, here to provide commentary on revenue trends on several of our key inline and recently launched products. And Peter Kellogg, our Executive Vice President and Chief Financial Officer will focus in on the key financial takeaways from the quarter, and provide an overview of Merck's 2008 financial guidance. Before we get into the details, I'd like to go over some logistics. On this call, we will review the results contained in the release we issued at 4:30 today. You can access this through the Investor Relations section on merck.com and I would remind you that this conference call is being webcast live and recorded. The replay of this event will be available this evening via phone, webcast and podcast. As we begin our review, let me remind you that some of the statements made during this call may discuss certain subjects that may contain forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and involve risks and uncertainties which may cause results to differ materially from those set forth in the statements. The forward-looking statements may include statements regarding product development, product potential or financial performance. No forward-looking statements can be guaranteed and any actual results may differ materially from those projected. Merck undertakes no obligation to publicly update any forward-looking statements whether as a result of new information, future events or otherwise. Forward-looking statements in this press release should be evaluated together with the many uncertainties that affect Merck's business. Particularly, those mentioned in the risk factors and cautionary statements in Item 1A of Merck's Form 10-K for the year ended December 31st, 2007 and in any risk factors or cautionary statements contained in the company's periodic report on Form 10-Q or current reports on Form 8-K, which the company incorporates by reference. We will begin the call with brief remarks from our senior management, and then open the call up for your questions. And expect the total call to last approximately an hour. With that, I'll turn the call over and we will begin with remarks from our Chairman and President, CEO, Mr. Clark."
},
{
"speaker": "Richard T. Clark",
"text": "Thank you, Eva and good evening everyone. Thank you for your flexibility in adjusting your schedules to unavoidable last minute change we made this morning. In the timing of our sales and earnings announcement, we felt it was important for you to first have the scientific perspective of the SEAS results, which were presented earlier today by the study's principal investigator. In a few movements Ken Frazier and Peter Kellogg will provide an overview of our performance in the second quarter along with updates to our 2008 guidance. But first, let me make a couple of points. It is important to understand that the results for SEAS have just been presented publicly today and we ourselves just recently received this study results from the outside researchers. While we are moving quickly to assess the data in a substantial implication for our cholesterol joint venture, it is just too early to make informed judgments about the potential impact of SEAS on our performance for 2008 and longer term. I know you undoubtedly have questions on SEAS but please appreciate our scientist are working diligently to evaluated the data on this. And on this call we are not in a position to add to the lengthy discussion that took place this afternoon. Also, we believe it's appropriate to take some time before we provide equity income and EPS guidance for 2008 or longer term guidance. We will provide an update at a letter time. While I know you dislike uncertainty almost as much as I do, I hope you understand our position. We remain fully committed in helping you understand our business and its prospects. Also it is important to know that before these results were made available, we were within our previously disclosed GAAP and non-GAAP EPS guidance range. Next, I want to share an update on manufacturing. Previously we told you that Merck was working with the U.S. regulatory authorities to adequately adjust the agency's manufacturing concerns in an expeditious manner. On July 10th, Merck received a letter from the FDA closing out its recent inspection of the West Point manufacturing facility. As a result, any filed sBLA which were held up due to the inspection can now move through the agency's normal review and approval process. As always, we will continue to work with the regulatory authorities in a cooperative manner to ensure that the public health is served by continued supply of our quality vaccine products. In addition, varicella supply issues, which were unrelated to the issuance of the warning letter, have been resolved, and we have resumed manufacturing of bulk varicella. We're producing doses of VARIVAX, and we don't anticipate any supply interruption of VARIVAX. Finally, I wanted to provide you with some perspective on how our leadership team and I are thinking about positioning Merck for success now and in the future, even in the face of very tough industry environment and some unexpected difficulties. These factors made for an intense review of our business at our recent annual strategy meeting. At that meeting, my team and I identified opportunities and actions necessary to drive future growth. During the session, we decided to move forward on several immediate and long-term steps designed to accelerate our revenue growth. To give you a flavor of some of these steps, emerging markets will become an even more central part of the company's business strategy. In addition, we will aggressively seek out the best partners in the regions outside United States to support in line product acquisitions, co-marketing and promotion agreements, as well as country and regional licensing opportunities. We are accelerating development programs or novel mechanisms and fixed dose combinations in some of our key therapeutic areas. All of these moves have significant incremental revenue potential. In the mean time, it remains vital that we operate our business in more lean and flexible manner, by having the discipline and leadership to make significant but necessary changes. That means continuing to embrace both internal and external innovation to enhance productivity and the long-term sustainability of our pipeline. We've advanced the robust research and development of pipeline that contains nine late stage breakthrough investigational candidates that are just critical unmet medical needs. We are continuing to launch new medicines around the world, and we're investing heavily in the lifecycle management plans for those brands. We remain committed to doing what it takes to regaining leadership in the pharmaceutical industry. Now, I'd like to turn first to Ken, who'll followed by Peter. And, after their remarks, we'll take your questions. Ken?"
},
{
"speaker": "Kenneth C. Frazier",
"text": "Thank you, Dick. And good evening everyone. Merck's revenue performance in the second quarter reflects continued strong growth of a number of our recently launched new products, offset by challenges to key brands, such as GARDASIL and SINGULAIR, and the continued impact of the loss of marketing exclusivity for FOSAMAX. Overall, revenue was down 1% in the second quarter. However, excluding FOSAMAX, revenue in the second quarter increased by 6%. Our international business, aided by the prevailing exchange rates, continues to perform very well, increasing by 12%. As we enter the second half of the year, we believe that we have the plans in place to address a number of the challenges facing our products, and we can continue to drive growth around the world at the launches of JANUVIA, JANUMET, ISENTRESS and GARDASIL roll out. Now let's discuss some of the key drivers of Merck's business in the second quarter, beginning with our HPV vaccine, GARDASIL. In the second quarter, we continued to make progress in our attempt to reduce the global burden of cervical cancer with GARDASIL. Merck sales in the second quarter were $326 million, a 9% decrease when compared to the second quarter of last year. In addition, during the second quarter, our vaccine joint venture Sanofi Pasteur-MSD recorded end market sales for GARDASIL of $234 million. Global end market sales for GARDASIL in the second quarter of 2008 increased 28% versus the prior year, driven by the continued roll out of GARDASIL in Europe. Sales of GARDASIL in the U.S. were sequentially down in the second quarter as a result of three factors. First, a decrease in second and third dose administration. As new starts peak in the back-to-school period with the recommended dosing regimen over six months, second and third dose immunizations occurred disproportionately in the fourth and first quarters. Second, a deceleration in the penetration rate among the 13 to 18-year old cohort. Considering the strong cumulative utilization in this cohort since launch, continued growth requires substantially higher penetration rates among the remaining eligible cohort. The adolescent penetration rate for GARDASIL is nearly two times higher than the average cumulative penetration rate of Menactra and the Diphtheria, Tetanus, and Pertussis vaccine, at comparable points in their lifecycles. Third, lack of significant progress in our ability to increase the penetration rate in the 19 to 26-year old cohorts. While our launch efforts achieved unprecedented uptake in the 11 to 18-year old cohort, the penetration rate in the 19 to 26-year old cohort have thus far proven harder to increase. Despite our efforts to increase the penetration rates in this population, we clearly underestimated the attitudinal and behavioral barriers with both the 19 to 26-year old female themselves as well as the doctors that treat them. Fortunately, the opportunity in this population is still very much in front of us. And we remain fully committed to achieving broad vaccination in this cohort as per ACIP and physicians to file [ph] recommendations. To increase the action among these women, we recently implemented programs to help reduce reimbursement concerns, and assist physicians in their recommendation for these women. In addition, we recently developed and launched new DTC ads, an interactive way of portal. In the third quarter, we're planning to launch additional healthcare provider and consumer initiatives to drive increased immunization in the 19 to 26 year old cohort. Importantly, as we look forward, we continue to anticipate that origination will peak in the third quarter, based on the fact that historically, approximately 40% of adolescent well visits occur in that quarter. As with all of our products, Peter will provide you with an update of our guidance for GARDASIL in a few minutes. Now, turning to SINGULAIR, sales of SINGULAIR were down 1% in the second quarter. This performance in the second quarter of '08 was due to a decline in the U.S. business, partially offset by continued growth outside the U.S. In the second quarter, U.S. prescriptions, that's TRX were down approximately 8% versus second quarter of '07, while the overall respiratory market, which is the combined allergy and asthma market, ex-ZYRTEC was down approximately 3%. Ex-U.S. sales of SINGULAIR grew 15%, driven by continued growth in Japan, the second largest market for SINGULAIR worldwide. In Japan, the successful launch of the allergic rhinitis indication in the spring of 2008, and the introduction of the oral granules formulation for pre-school age children since late 2007 are contributing to the growth. Three main factors contributed to the year-over-year U.S. performance of SINGULAIR. First, the switch of ZYRTEC to OTC in January. Despite SINGULAIR's continued strong positioning on formulary, ZYRTEC OTC has clearly had an impact on the overall allergic rhinitis market including SINGULAIR. We continue to believe that SINGULAIR offers a compelling value proposition among new and dissatisfied allergic rhinitis patients. As dissatisfied patients try multiple products to treat allergic rhinitis over time including OTC products, we believe that they will continue to visit their physicians and seek additional alternatives including SINGULAIR. Second, the timing of and the public reaction to the FDA early communication, created uncertainty in the marketplace just as the allergy season was about to start. The October 2007 label change was based on a very limited number of post-marketing adverse event reports that Merck received. Since that time, Merck has worked with the FDA to provide further clarity in the product label as well as to further communicate this information to physicians. Based on feedback from our sales force and Merck's proprietary research, physicians continue to rate SINGULAIR as the brand that best represents having a side effect profile similar to placebo in the asthma market. We continue to have confidence in the safety and efficacy profile of SINGULAIR. Third, the spring allergy season was shorter and milder compared to recent years. Fortunately, recent weekly domestic performance for SINGULAIR has shown signs of improvement relative to the growth of the overall respiratory market. And we are taking additional steps to further support the brand including accelerating a new outlook program initiating expanded multi-channel promotion and delivering compelling health care provider, consumer and disease awareness programs to market. Despite these challenges, SINGULAIR continues to be the number one product in the U.S. respiratory market. Moving to JANUVIA and JANUMET, two of our newest growth drivers, global revenue for these two products reached $406 million in the second quarter, up 23% sequentially versus first quarter of this year. In the U.S., JANUVIA continues to be the second leading branded oral anti-diabetic agent in terms of new prescription share. Recent data presented at ADA, including a compelling analysis comparing JANUVIA versus sulfonylureas, which showed treatment with JANUVIA dramatically lowered hypoglycemia compared to treatment with FFUs. Based on our post-marketing experience for JANUVIA and with over $5 million prescriptions written in the U.S. since launch, we continue to be extremely confident in the efficacy and safety profile for JANUVIA and JANUMET. In addition, we are extremely pleased with the ex-U.S. performance of JANUVIA and JANUMET in the second quarter. Sales outside the U.S. were $77 million as recent launches in key markets such as France, Spain, Italy and Canada continue to progress. The recent European approval for JANUMET will provide an additional growth opportunity for our diabetes franchise in the 27 markets in which the regulatory decision is applicable. Now, I would like to take a moment to provide an update on the revenue performance of our cholesterol JV. Before doing that, as you know, based on today's announcement in the press conference, the company has recently received a clinical data from the SEAS study. In view of this, I am not in a position to provide an immediate perspective on the future performance of ZETIA or VYTORIN. We will do everything we can to ensure that the data are communicated effectively and understood in the appropriate context. We continue to believe that both ZETIA and VYTORIN provide physicians with valuable treatment options to help get more patients to their LDL goal. Worldwide sales of ZETIA and VYTORIN as reported by the Merck/Schering-Plough joint venture were $560 million and $592 million respectively in the second quarter. In the second quarter, sales declines in the U.S. were partially offset by strong growth outside the U.S. Before turning the call over to Peter, I would like to take a moment to update you on the progress we are making in terms of optimizing our cost base as we pursue our new commercial model. In the second quarter, marketing and admin expenses excluding the legal defense reserve in the base period, was up 3% versus the second quarter 2007. The year-over-year increase in marketing and the administrative expense is solely attributable to the impact of exchange. Excluding exchange and legal defense reserve in the base period, operationally marketing and administrative expenses were down 3% in second quarter '08 versus second quarter '07. As you know, in May, Merck announced plans to reduce the size of its U.S. sales force by 1200 physicians. The reduction in the U.S. sales force is part of our previously disclosed and continuing efforts to optimize our cost base and improve Merck's effectiveness and efficiency across all aspects of our business. These actions are consistent with our imperative at the company to continue to look for opportunities to improve business processes and practices and to create a leaner, more cost effective and customer-focused operating model. In closing, we continue to believe that tremendous commercial opportunities exist for our inline and new products. We are confident that the plans we have in place will enable us to maximize the revenue potential of our pharmaceutical products and vaccines. And while we have faced a number of commercial challenges in the first half of 2008, we continue to believe that our established franchises along with our new first-in-class vaccines and medicines, such as GARDASIL, ROTATEQ, JANUVIA, JANUMET and ISENTRESS provide us with a diverse product portfolio well positioned to drive revenue growth. At the same time, our continued focus on efficiency on the marketing and administrative line will help drive overall margin improvement. So with that, I'll turn the call over to my colleague, Peter Kellogg."
},
{
"speaker": "Peter N. Kellogg",
"text": "Thank you, Ken and good evening. To wrap up the call, I will discuss key elements of Q2 results not previously covered, provide an overview of the extent of our 2008 guidance, and comment on other financial matters such as our dividends. So, let's get started. Merck reported second quarter non-GAAP earnings per share of $0.86 per share, representing growth of 5% over the second quarter of 2007. On a GAAP basis, earnings per share for the second quarter were $0.82, a growth of 6%. For the first half of 2008, the company recorded non-GAAP EPS of $1.75, also up 5% versus the first half of 2007. Year-to-date GAAP EPS were $2.34, 51% above 2007 GAAP EPS. Our second quarter results reflect our continued efforts to create a leaner, more cost effective and customer-focused operating model as evidenced by first product gross margin. That showed continued strength. There was an impact of restructuring charge in the second quarter. Excluding this charge, PGM was 77.2%, maintaining performance at pre-Zocor patent expiry level. Sequentially, PGM was down 1.8 points, primarily attributable to product mix and some inventory write-offs. Secondly, as Ken, mentioned, marketing and administrative expense in the second quarter was down 7% and as he mentioned, excluding both the legal defense charge in the prior year and the unfavorable impact of foreign exchange, expenses were down 3% rate progress. This excellent result was due to the improvement that Ken walked us through and some additional efficiencies throughout our G&A organizations. And finally research and development expenses of $1.2 billion increased 13%. This increase was generally attributable to several areas of clinical spending for late stage programs. Next, as anticipated equity income was down year-over-year because of two factors. First, the equity income contribution from the Merck/Schering-Plough joint venture was down 22% or $100 million as a result of ZETIA and VYTORIN market share losses in the U.S. The lower revenue in the U.S. was partially offset by the strong performance outside the U.S. Additionally, the respiratory joint venture was terminated during Q2, which will result in the payment by Merck of $105 million to Schering-Plough. Consequently, Merck's second quarter equity income contribution from the Merck/Schering-Plough joint venture includes a $43 million expense related to this termination. The remainder of this payment will be amortized over the life of the partnership in accordance with U.S. GAAP. Second, contributions in the AstraZeneca joint venture was a $154 million lower in Q2 versus prior year. This decrease in the equity contribution from the AZN partnership is attributable to the previously disclosed events surrounding the JV restructuring that occurred toward the end of the first quarter this year, and some inherent variability of timing and payments from AstraZeneca. As a result or as a reminder rather, Merck's priority return was decreased to $55 million per quarter from $75 million per quarter, and Merck no longer received the 10% loyalty payments from the Astra USA products. Finally, in the second quarter, our effective tax rate realized a 9 percentage point benefit from various tax settlements. The reported effective tax rate was 14.1% and excluding the impact of restructuring charges, the non-GAAP underlying effective tax rate was 15.2%. Both rates reflect the impact of various tax settlements that resulted in a reduction of our corporate FIN 48 reserves. As you can appreciate, we're not in a position to disclose the details of these settlements; however, they are unrelated to the foreign tax credit that we announced in Q1. Moving to the bottom line as I mentioned earlier, Merck's second quarter non-GAAP EPS was $0.86 and the GAAP EPS was $0.82. Now moving to guidance, as Dick and Ken discussed, we are assessing the impact of SEAS on the performance ZETIA and VYTORIN, and are not in a position to provide an immediate perspective. Therefore at this time, we're not able to provide 2008 equity income guidance, 2008 GAAP and non-GAAP EPS guidance, and any long-term financial performance. We are fully committed to helping you understand our business and its prospects, and we are not stepping away from that commitment. We will provide an update at a later date. Now, Ken talked about a number of challenges and opportunities of the business that may change our 2008 product performance. And accordingly, we are changing several elements of our product guidance, and some will be increases and some will be reductions. As always, to assist your modeling, we provide a breakdown of the product revenue guidance in our other financial disclosure schedules attached to the press release issued earlier today. So, let me walk through those changes. Regarding SINGULAIR, we're lowering our full year guidance by $200 million and now anticipate revenue in the range of $4.4 billion to $4.6 billion for the reasons Ken discussed. For COZAAR/HYZAAR, we are raising our guidance by $100 million, and now anticipate revenue in the range of $3.5 billion to $3.7 billion. This is primarily driven by the strong performance in Japan, and the positive effect of foreign exchange, considering the geographical segmentation of revenue for these products. Guidance for GARDASIL revenue as recorded by Merck is now anticipated to be in the range of $1.4 billion to $1.6 billion. This $500 million reduction is due to the several factors that Ken just reviewed. Additionally, since this is full year guidance, it also incorporates some impact for the delay in the mid adult women indication. Other vaccines guidance of $2.7 billion to $2.9 billion has been reduced by $200 million. This reduction is largely attributable to the lower than anticipated VARIVAX second dose penetration, which we can now take steps to address with the implied or the improved supply situation which Dick mentioned earlier. Regarding FOSAMAX, we continue to be pleased with the performance of the domestic FOSAMAX PLUS D year-to-date. And as a result, we are increasing our full year guidance by $100 million to $1.4 billion to $1.7 billion. Now regarding marketing and administrative expense, we are reducing our guidance by $200 million to $7.5 billion to $7.7 billion. This reduction is possible because of the delay of MK524A in the U.S. and the domestic sales force reduction of 1200 positions announced in May, which has now become... is now being completed, and our ongoing company wide aggressive expense management program. Let's turn to restructuring. As part of the company's restructuring of its operations, we anticipate the aggregate 2008 pre-tax expense related to these activities to be in the range of $200 million to $300 million. Moving to taxes, we are reducing our full year 2008 non-GAAP tax rate guidance range to approximately 18% to 21%. This guidance incorporates the impact of the foreign tax credit benefit recorded in Q1 and the discreet tax settlements recorded in Q2. It does not reflect that tax rate impact of gain on distribution from AstraZeneca or restructuring charges. Turning to other financial matters, it should be clear though that we have the financial strength and are remained fully committed to maintaining our dividend at the current level. At the same time, we continue to fully invest in our keys strategic priorities. So let me summarize. There have been several changes to our revenue guidance pipe as ken reviewed. Our inline product portfolio includes numerous young therapies that continue to show real promise. We continue to roll out and launch our eight new products globally. We also continue to aggressively manage our overall cost structure as demonstrated by the reduction in marketing and administrative guidance. And with our robust late stage pipeline of nine new vaccines and medicines, we remain confident in the company's ability to deliver strong results. We are however taking some time to assess the impact of SEAS announcements and will re-establish guidance on the equity income and EPS for 2008 and on our long-term guidance in the future. Now I'd like to turn it back over to Eva. Eva?"
},
{
"speaker": "Eva Boratto",
"text": "Thank you, Peter. We will now open the call to take your questions. We will take your questions in the order they are received and try to get through as many as possible. Also joining us for the Q&A is Bruce Kuhlik, our Executive Vice President and General Counsel. At this point, I will turn it over to Kiera, who will communicate the instructions for our Q&A format and then introduce the first question. Question And Answer"
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Your first question comes from the Chris Schott with J.P. Morgan."
},
{
"speaker": "Chris Schott",
"text": "Ken, first just to clarify, did you mention your plan was to maintain the 2008 EPS guidance prior to the SEAS study results released today. And then second on GARDASIL, the cuts of the guidance, what age group specifically was driving bulk of the clients here. It sounds like the trends with the 13 to 18-year olds was particularly surprising, is that a fair statement? And then are you factoring in any impact from some of the adverse event kind of media publicity we've seen kind of scattered through this month on GARDASIL? Thank you."
},
{
"speaker": "Richard T. Clark",
"text": "Chris, your first question before the SEAS announcement we were going to reaffirm our guidance for 2008 that is correct."
},
{
"speaker": "Kenneth C. Frazier",
"text": "And on the GARDASIL question, the cohort I think that we've seen the most difficulty with is the 19 to 26-year old cohort. And then that's for couple of reasons. As I mentioned before, trying to get actual the women even when you can drive high levels of awareness has proven more difficult than we anticipated. In addition, these women primarily visit PCP then OBGYNs who are not typical routine vaccinators. And who in many cases have no established infrastructure for routine vaccination of this age group. In addition, there is some lack of consistency around benefit design with the portion of these women which causes additional confusion with their physician, despite the fact that there are high levels of this individual have some coverage if they are privately insured. So the biggest issue for us has been us with 19 to 26-year old, although I also mentioned that given the high cumulative strong utilization we have in the 13 to 18-year old, continued growth will also require substantially higher penetration rates among those remaining to be vaccinated."
},
{
"speaker": "Eva Boratto",
"text": "Kiera, next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Tim Anderson with Sanford Bernstein."
},
{
"speaker": "Timothy Anderson",
"text": "Thank you. Can you give an update on the ongoing SINGULAIR safety review by FDA in terms of when we might learn more? And really what are the chances that something could blow up here, because this is obviously a very key and high margin product for you. And then of SINGULAIR sales, can you talk about what percent goes to a pure allergy indication versus the pure asthma indication versus concurrent disease?"
},
{
"speaker": "Kenneth C. Frazier",
"text": "Well, we can't obviously predict what the FDA will do. We are in the process of interacting with the FDA now, and providing that information to the FDA. As for the relative breakdown of asthma and allergic rhinitis, we do not generally provide that information. So, I can't provide that. I also I noticed that and in response to the last question I did not respond to the question about whether or not GARDASIL sales were anyway impacted by the most recent publicity around adverse event. We're aware of that, we are monitoring that. I can't say that that has not had an impact. We hope that that impact will not be a substantial one going forward. But it certainly is an issue that we're contending with now."
},
{
"speaker": "Eva Boratto",
"text": "Kiera, next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Barbara Ryan with Deutsche Bank."
},
{
"speaker": "Barbara Ryan",
"text": "Chris, sort of had my question, thank you. But, maybe as I can just expand a little bit, I think Dick when you did start out, you said that you were ready to reiterate guidance until the SEAS results came out. And I'm just wondering, beyond 2008, but I would imagine that the growth outlook would be somewhat impeded by the shortfall in GARDASIL. Maybe that's not the case, I can see adding up the various pluses and minuses in 2008, how the guidance on GARDASIL could be offset with tax rate, lower spending et cetera. But, on a longer term basis, is that a fair assessment with GARDASIL?"
},
{
"speaker": "Richard T. Clark",
"text": "Yes, first of all Barbara, the... when you look at 2008, you are right, there are many other things that are going right, as Ken and Peter were able to tell you. And we continue, obviously to surprise ourselves when we look at our new operating models for the major parts of the company and what impact we're having on flexibility in expenses and we'd be able to drive that to something that meets our expectations, in many cases it exceeds it. But we also look at where we are from, when putting our long range plan together for 2008, 2009 and 2010. What we had a commit to in order to get to double-digit growth, and where we actually are, with some of the other products, which is very, very positive. The comment I'll make about GARDASIL is that, still the... although there is a... obviously a delay in the penetration for this cohorts, we have not lost that market share to a competitor. So it's our ability to bring that home within '08, '09 and 10 and so when you bring all of these factors into play if until we evaluate the SEAS activity, I would've been very comfortable with eight as well as ten."
},
{
"speaker": "Eva Boratto",
"text": "Okay, thank you. Next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Roopesh Patel with UBS."
},
{
"speaker": "Roopesh Patel",
"text": "Yes, thank you. I have a couple of questions on GARDASIL. I look at the revise guidance for this year, it implies that second half sales will decline year-over-year somewhere between 5% and 27%. And I am curios as to when you expect the drug to resume growth and what the drivers will be. Secondly what's the estimated penetration that you've reached in the U.S. in the two age groups, the 13 to 18 year olds and then the 19 to 26 years olds? And lastly, given the challenges experienced with penetrating the 19 to 26 years olds, what you believe the company will have to do differently when it gets approved for adult women 27 to 45 year olds? Thanks."
},
{
"speaker": "Kenneth C. Frazier",
"text": "Okay,I will go and try to get all of those; I'll try to work backwards on those. I think as we deal with older population including adult women, we obviously will be dealing with very different populations than we did with adolescent girls. What we found in the adolescent population was that our efforts to motivate the primary actors in that case, largely mothers of young girls as well as pediatrician, that's something that our early efforts were relatively successful and that created a very large uptake in the first year. I think as we deal with older populations, we are going to have to find strategies and we are in fact defining and working on strategies that allow us to communicate what is clearly a valuable therapeutic offerings to those women as well as to their doctors and get people to begin acting on it, when they have that level of awareness. So that is the challenge. As for the question of, what's the relative penetration in cohorts, that's not data that we provide, and so I can't answer that and so I think the last question was when and how do we expect to see growth resume later in this year. I think that goes back to what I said, which is that we have a number of programs in place to address some of the primary concerns and barriers that we've experienced in the market particularly from the 19 to 26-year old. They include, financial issues that affect the physician as well as actions that are intended to drive more action among our young adult females including new consumer DTC campaigns that are end directly at young adult women. We think those are the kinds of things that we'll have to do in order for us to drive greater awareness during the course of the year. We have distributed a significant number of doses. I would say the penetration has been 30 million worldwide and 18 million in the U.S. So we have done relatively well and we continue to believe that there is a lot of opportunity out there as Dick said, we are the sole source for a number of these vaccines GARDASIL, ZOSTAVAX, VARIVAX and the fact that our current demand is less than anticipated is something that leaves us a great opportunity going forward to penetrate in the future because you have more of an opportunity in the fact because you haven't penetrated much now. I don't say that by way of excuse, I just say that's the challenge before us and that's the challenge that we are taking on."
},
{
"speaker": "Eva Boratto",
"text": "Next question please, Kiera."
},
{
"speaker": "Operator",
"text": "Your next question comes from David Risinger with Merrill Lynch."
},
{
"speaker": "David Risinger",
"text": "Yes, hello. I have a couple of questions. First of all, with respect to the vaccine supply constraints in the second quarter, can you just help us understand what the sales constraints were and what level of improvement will occur as a result of the FDA okaying the facility? And I guess just follow on to that, are there any manufacturing overhangs ongoing, so that's my first question. Second, can you just explain the surprising tax settlements in the second quarter that yielded your lower tax rate guidance for the full year of '08? And then third, with respect to going back to the manufacturing issue, I think your press release said that there won't be any limitations on filed vaccine supplements that are pending approval. Could you just run through what those filed vaccine supplements are? Thank you."
},
{
"speaker": "Peter N. Kellogg",
"text": "So, David first... this is Peter, let me take the tax item first then we'll get into the manufacturing topic. So, as you know, FIN48 is the accounting standard referred to as accounting for uncertainty in income taxes. And what it requires is the company to determine whether the benefits of the tax position are more likely than not are sustained upon audit and so based on the technical merits of the tax position. So for all of our tax positions around the world, we do set up... for the appropriate ones, we set up a FIN 48 tax reserve and so that's on our balance sheet. And basically, as we go through and results are in tax positions with different authority through audits and what not, either those reserves turn out to be appropriate or not. What happened in the second quarter was, we did finish a few different tax audits and reviews of different times in our prior year filings. And overall, we came out very favorably versus what we had on our balance sheet for the FIN 48 reserves. And so, the way it works is once you have clarity on that you've made the settlements, you make the payment, then you go back to reserve, and if you have reserves in excess of what were called for, you release that. And so, that's where we got the benefit for in Q2, is the release of certain reserves that turned out in hindsight to be a little bit conservative. But, at the time we made them, we thought they were appropriate, but we turned out to do better under audit than we anticipated. So, that within FIN 48... that's what the tax benefit was in Q2. It's a one-time item for those particular items. It really doesn't have any recurring nature going forward except that the way the overall effective tax rate is calculated. So, moving then to manufacturing topics, I'll let Ken and Dick handle those."
},
{
"speaker": "Kenneth C. Frazier",
"text": "So, the question was to what extent were issues in the second quarter relative to our vaccines the product of supply interruptions. So, well as it relates to certain vaccines as you probably know, we've stopped taking orders temporarily for our pediatric and adult vial formulations of that as well as our HIB containing vaccines. As it relates to VARIVAX, we did have supply adequate to meet the demand in the second quarter of '08, and now that we have resolved the supply situation for VARIVAX, we're working with our customers in the private and public sector to continue to increase second dose immunizations for the catch up cohort through the rest of 2008."
},
{
"speaker": "Richard T. Clark",
"text": "And concerning supplements, we have at least two supplements with the FDA concerning GARDASIL and they will move through the process now."
},
{
"speaker": "Eva Boratto",
"text": "Take our next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of John Boris with Citi. Mr. Boris your line is open."
},
{
"speaker": "Eva Boratto",
"text": "Hello, next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from line of James Kelly with Goldman Sachs."
},
{
"speaker": "James Kelly",
"text": "Thank you, and good evening. My question has to do with the progression of gross margins. In this quarter where I'm just really interested I guess Peter, in some of the pushes and pulls on gross margins. I would think that when the royalty burden on a product like GARDASIL, and the way that that one has been trending. One, that that could have led to a higher sort of gross margins for this quarter, but two, could also have upward pressure on the gross margin guidance for the year. So, give us some thoughts and some of the other important pushes and pulls, and if I have the other one correct, that will be great? Thank you."
},
{
"speaker": "Peter N. Kellogg",
"text": "Yes, sure. So, you're right, I mean, when you go to PGM, I just want to make sure, your premise is exactly right. There is a lot of different pushes and pulls, product mix and so forth, so it is sort of a weighted average effect. I think that as I mentioned on the call, the PGM line had really just some product write-offs as well as some restructuring charges as well in the quarter. So, there are a couple of different effects. Overall, I think the PGM, we've done very well in the way the team, the manufacturing organization and global operations have worked on their cost structure, and obviously that comes into the couple of different ways that one is just the overall amount of overhead that goes into our PGM but also the efficiencies that go through manufacturer. As we provide guidance, obviously, we're always within the range that we are giving guidance and it can move around a little bit. But in general, that's we do, we do the forecasts as the team works through kind of what the pushes and pulls are, which we try to say what the run rates are and what the trends are. So we are very comfortable with our guidance and we don't like to get... to make it a nervous guidance so we don't move it around by 0.3 to 0.4s, but we stay within that range. But yes, you are right. The product mix could have a slight impact over time, but at this point, we feel pretty good about the guidance we have out there."
},
{
"speaker": "Eva Boratto",
"text": "Kiera, next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Tony Butler with Lehman Brothers."
},
{
"speaker": "Tony Butler",
"text": "Thanks very much. Can you make at least on my estimation some slightly and concurrent comments regarding GARDASIL in that you stated that in this particular quarter, the 19 to 26-year old population being treated by OBGYNs, who do not normally vaccinate, actually might have had an effect on the overall demand and yet you also stated or perhaps Peter stated that the change in full year guidance was effected because the timing of the over 26 population did not occur when you anticipated. Again, I would assume that's an OBGYN population. So I guess I am just looking to reconcile that especially when I have the impression that you were likely throwing some refrigeration units into those OBGYNs realizing that they are not the primary population of physicians who tend to be historically vaccinators. And then as a second question, I might think candidly much like myself, the JV or the VYTORIN ZETIA sales folks are pretty battle worn and bad scarred from the full year so I would be interested, Dick if you might be able to just provide a couple of words on how you think about resurrecting their energy especially given a lot of the bad information that seems to be hitting him in the face going forward. I appreciate the time."
},
{
"speaker": "Richard T. Clark",
"text": "I'll start with the VYTORIN ZETIA joint venture question. I think we begin the discussion around leadership. We have an outstanding leadership team in place in the joint venture and it is an experienced team that's been through marketing and sales battles before with competition. And we make sure that we give them the right support as a joint venture. I know that Schering-Plough said you the same, and they like the competition and they like the challenge. And the major reason is because they believe in their products. They are good products and they are important products in order to reduce cholesterol and to help people of cardiovascular risk moving forward. So with that as a part of it, it's an important mission and we've got some of our best people in there and although this is a very difficult time, I have a tremendous amount of confidence in their capabilities and when you see some of the mistruth that were spoken particularly around the enhanced that makes us even more engaged in order to get the right information to physicians so that they can make that decision. And so, we hear a lot passion about our products from the joint venture and you heard a lot passion on the call today from chief investigators."
},
{
"speaker": "Kenneth C. Frazier",
"text": "With respect to GARDASIL, let me start by clarifying that for the populations over the age of 26. Given the original July PDUFA date and our original assumptions around the timing and then APIP vote for this cohort, we had only forecast a partial year contribution for this population. So I think that might have been what we alluded to earlier is that that contributes to some of the difference in what we thought we would do this year. But the predominant issue coming back before is the challenge that we have with respect to the penetration rate for 19 to 26-year old and what I was trying to say there is that while compared to historical norms, penetration remains high across all the established GARDASIL age cohorts that we have stronger uptake for girls 11 to 18 than we do for the 19 to 26-year olds. And there the uptake is not nearly as high and the issues are more diverse. And they include challenges and getting those woman to translate the awareness into action making it relevant for those people to want to come in and demand vaccines. But the other issue is getting OBGYN who are not typically vaccinators to adopt that as a business model and to strongly recommend this to their patients. So, we are dealing with issues with respect to the 19 to 26-year old women, with respect to their physicians, we're dealing with financial issues that their physicians and their offices are encountering. And we're trying to change the behaviors and the attitudes across there. We believe we can, as I've said, I'll try to be very candid in saying that we clearly underestimated the difficulty of it. But we have lot to programs in place, and we're going to continue to get after that. It's a great vaccine, physicians believe in the therapeutic promises of vaccine. We've just now got to get them to a place where universal same day vaccination is the standard of care for those OBGYNs as it is for pediatricians."
},
{
"speaker": "Eva Boratto",
"text": "Okay. And just to note, given the time we'll take one or two more questions. Kiera, please next question."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Catherine Arnold with Credit Suisse."
},
{
"speaker": "Catherine Arnold",
"text": "Thank you very much. Dick, I was wondering, given the substantial focus for investors on the 11, 12 horizon, and despite the near term challenges that you need to face, are you still considering giving longer term guidance at your December analyst meeting, is that something we can look forward to? And on a micro level, I just wondered if you could comment on the ZOSTAVAX performance. It seems, they have declined sequentially and we haven't seen that in the United States. I wondered if you could comment on that for me. Thanks."
},
{
"speaker": "Richard T. Clark",
"text": "Sure, as I mentioned in my talk, we are coming out of our strategic planning meeting, where we looked at several initiatives to increase revenue growth. During the period particularly with SINGULAIR going off the patent and the ability to change our operating models in our three divisions, even more significantly than we did with our first plan to win. So, I am not in the position yet to evaluate what impact that has, giving guidance to that period we have to discuss that. And certainly we have teams working on that. What we're focused on now, is to be able to get back to you as quickly as I can, where 2008 and 2010 guidance is my first step and that's our priority. But I can tell you, I was extremely encouraged with the week strategic planning meeting we had, where we focused on 11 to 16, and we're evaluating that now."
},
{
"speaker": "Kenneth C. Frazier",
"text": "As it relates to ZOSTAVAX, as we've pointed out, due to the supply issues that had existed with varicella containing vaccine, we prioritize VARIVAX, particularly to ensure that we had a supply to support the second dose vaccination recommendations. As a result, we were not in the same way publicizing or promoting ZOSTAVAX. So, I think if you look at the patents around ZOSTAVAX, they are not as reflective of the product's potential as they are, the priority being given to VARIVAX."
},
{
"speaker": "Eva Boratto",
"text": "Okay. And we'll take our final question."
},
{
"speaker": "Operator",
"text": "Your final question comes from the line of Seamus Fernandez with Leerink Swann."
},
{
"speaker": "Seamus Fernandez",
"text": "Thank you very much. So, just hoping that you could provide a little bit more clarity on maybe the elements that drove the $700 million reduction in the equity income that you choose in the first quarter so that we have something off of which to base the incremental guidance that you are expecting to provide to us in the near future. And then, second, can you just help us better understand ROTATEQ had a strong quarter, $178 million in global revenue? Was there any stocking in the quarter for ROTATEQ and also how do you plan to defend against GlaxoSmithKline's Rotarix and since in the second quarter the ACIP recommended for harmonization of the two products? Thank you."
},
{
"speaker": "Peter N. Kellogg",
"text": "Okay. So let me... this is Peter. Let me get started on the equity income line since there is a couple of moving parts as you have indicated in the call... in the question. So, the first thing is as I said earlier, the Merck/Schering-Plough joint venture was down 22%. Now, the one thing to remember was, there was a charge of $43 million of expense in the quarter related to the termination of the respiratory joint venture. And so, that $43 million is an expense that occurred in Q2. And then after that we will be amortizing the balance, which is $62 million over the remaining life of the franchise of the IP for ZETIA, which goes out 2015. So, we won't have a charge like that as big as $43 million going forward, it will be lot smaller. Obviously, I think that I am very impressed by how accurately and closely everybody tracks the VYTORIN and ZETIA script. So, I have no doubt that you can make, you can respond to that and view forecasting off of those trends as well as we see those emerge. But, there is... I don't think there is any usual otherwise in the joint venture performance of Merck/Schering-Plough. And as Dick said before, I just wanted to reiterate, we have enormous faith in that organization and in that team. Very seasoned team to go out, come out fighting, in the second half of this year. The way the AstraZeneca joint venture which I will acknowledge is a lot more complicated. The equity income... the income was $154 million lower than Q2 last year and as you go back to your notes on some more deals, certainly remember there is a lot of moving parts, because of the way we went through the joint venture restructuring towards the end of the first quarter this year. And some of the pieces of that were the priority return, actually decreased to $55 million per quarter, from what it had been... roughly $55 million per quarter, in that neighborhood, from what had been closer to something like $75 million per quarter. That was one change. Another is that we used to receive 10% royalty on the Astra USA products and we don't receive that again going forward. And then the third one which I alluded to, is that there is some inherent variability in the timing of how we receive payments from AstraZeneca and there was a significant change to that effect in the second quarter that created a volatility downside in the second quarter that we don't expect to see recurring hopefully like that. But there is always some volatility in the bouncing around of those numbers. So in terms of going forward, we think that Q2 was overall weaker because of that volatility. But the other items become part of the new trend. So hopefully that gives you enough to work out some estimate on it, but certainly the bigger impact was on the volatility this quarter. Ken?"
},
{
"speaker": "Kenneth C. Frazier",
"text": "As it relates to ROTATEQ. In the second quarter, we recorded revenue about $13 million that was attributable to the CVC stockpile and we do have a competitor now in the U.S. but we feel it had no real impact in the second quarter. And we continue to be extremely confident in ROTATEQ as far as how it's going to perform in the U.S. with over 75% of U.S. birth cohort now being vaccinated with ROTATEQ. And we are also pursuing a systematic thoughtful approach to the global introduction of ROTATEQ. So, we continue to have great confidence in that vaccine going forward and we think the ACIP recommendation will be extremely positive for ROTATEQ going forward, so those would be my response."
},
{
"speaker": "Eva Boratto",
"text": "That last question concludes today's conference call. The information from today's call, both the transcript and replay will be available at our website for the next several months and Mike Nally and I will be available to take your calls and any incremental questions. Operator?"
},
{
"speaker": "Operator",
"text": "That concludes Merck's second quarter 2008 earnings conference call. You may now disconnect."
}
] | null | null |
MRK | 1 | 2,008 | 2008-04-21 17:00:00 | Operator: Good day, everyone, and welcome to Merck's First Quarter 2008 Earnings Conference Call. Today's call is being recorded. At this time, I would like to turn the call over to Mr. Graeme Bell, Vice President, Head of Investor Relations. Please go ahead, sir.
Graeme Bell: Thank you, Cynthia and good morning. Welcome to our call this morning to review our business performance for the first quarter of 2008. We have a different line-up for you today, so let me make some comments on that. Joining me on the call today as always is our Chairman, President and CEO, Dick Clark. We also have Ken Frazier, our Executive Vice President and President of Global Human Health, he will provide commentary on our revenue trend, several of our inline products, recently launched products, as well as to provide some perspective on recent news flows. One of the benefits of having Ken on the call today is that it will allow Peter Kellogg, our Executive Vice President and Chief Financial Officer to focus on the key financial takeaways from the quarter and provide an overview of the 2008 financial guidance and the rationale for it. And we are also joined by Executive Vice President and General Counsel, Mr. Bruce Kuhlik. Before we get into the details, let me go over some logistics. On this call we will review the results contained in the release we issued at 7:30 this morning. You can access this through the Investor Relations section at merck.com and I would recommend that you do this and also follow along on the live webcast. The replay of the event will be available later today via phone, webcast and as always our podcast. As we began our review of the results, let me remind you that some of the statements made during this call may discuss certain subjects that may contain forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and involve risks and uncertainties, which may cause results to differ materially from those set forth in the statements. The forward-looking statements may include statements regarding product development, product potential or financial performance. No forward-looking statement can be guaranteed and actual results may differ materially from those projected. Merck undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. Forward-looking statements on this call should be evaluated together with the many uncertainties that affect Merck's business, particularly those mentioned in the risk factors and cautionary statements in Item 1A of Merck's Form 10-K for the year ended December 31, 2007 and in any risk factors or cautionary statements contained in the company's periodic report on Form 10-Q or current report on Form 8-K, which the company incorporates by reference and all of these are available and posted on our website. We will begin with brief remarks from our senior management, then open the call for your questions. And expect the total call to last approximately 60 minutes with a stop time of 10 A.M. With that, I will turn over the call and we will begin with our prepared remarks from our Chairman, President and CEO Mr. Clark.
Richard T. Clark: Thank you, Graeme and good morning everyone. Earlier this morning, we announced Merck's results for the first quarter of 2008 and we're joining you now to discuss them in greater detail. Today, we reported another solid set of results, including growth of non-GAAP EPS and revenue from key products. We delivered those results even in the face of slowdown themselves from the Merck/Schering-Plough joint venture and a lot of market exclusivity for FOSAMAX. As you know back in 2005, this management team outlined a strategic roadmap and called it our plan to win. Our plan has allowed us to improve efficiency while at the same time growing the top line. That plan set the stage for our consistent performance throughout 2006 and 2007 and into the first quarter of 2008 as well. And that plan enabled us today to reaffirm financial guidance for the year and to revigorate our confidence in meeting our goal of double-digit compound annual EPS growth to 2010, excluding certain items. Based on the strengths of our broad portfolio of established medicine on the launch of the eight new medicines in that field, we are well-positioned to sustain growth in 2008 and beyond. The result we reported today non-GAAP earnings per share of $0.89 exclude the certain items and the GAAP EPS of $1.52 show that Merck continues to deliver. For the first quarter, we reported revenue of $5.8 billion, which represents top line growth of 1% compared to the first quarter of 2007. Key inline medicines and vaccines including SINGULAIR, COZAAR/HYZAAR and VARIVAX delivered solid year-over-year growth as did our newer products such as JANUVIA, JANUMET, GARDASIL and ISENTRESS. Ken will discuss the product highlights in more detail. Our overall financial results for the quarter was supported by our partnerships and alliances. Specifically the Merck/Schering-Plough joint venture which in the first quarter continued to drive our equity income. However, sales growth in the quarter from the joint venture was lower than expected. At this point, we anticipate that the continued confusion in the market have caused sales of VYTORIN and ZETIA to be significantly lower than expected for the entire year. As a result, we are lowering our full year guidance for equity income of $700 million. Ken, will go with a more detail about this issue in a few minutes. But I want to make a few comments now. With Ken, I have been personally engaged in this issue and have strong feelings on this subject. First and foremost VYTORIN and ZETIA remain valuable treatment options to lower LDL cholesterol. In addition, the lack of a scientific discussion debate at ACC regarding ENHANCE was disappointing to put it modestly. We are encouraged to see a growing course from the cardiology field, begin to seek out about how ENHANCE trial should not change constant at the tier or what we know about the importance of lowering LDL cholesterol. Merck continues to engage directly with leaders in the field and what’s described as [inaudible] point of view. And we will continue to advocate for appropriate use of these important medicines. Merck has been a leader in the cholesterol filed since introduction of MECTIZAN 20 years ago and we are committed to remain the leader in this field. I also want to assure you that we take the criticisms of our practices and our integrity very seriously. Merck is committed to operating with the highest standards of ethics and scientific integrity. Those standards are the foundation of this company and we will not loose focus on our overarching mission delivering medicines and vaccines that safe and improve people’s life. We are now more than halfway through the five-year plan that we first outlined in 2005. At the time when many were counting Merck out our strategy is working and we are moving ahead with a high sense of urgency. Even though several of our plan to win initiatives are ahead of schedule, we're picking up the pace of change. We have already made good progress with a number of initiatives including, we are overhauling our supply networks, we originally said we would sale across five of Merck’s 31 manufacturing sites by the end of 2008. Well, we have already done that, nine months ahead of schedule. Now we're identifying additional opportunities in our manufacturing networks to increase efficiencies. We have moved up our plants to close, sell or reduce operations at four other sites outside of the US pending compliance for global [ph] obligation. This year we plan to close or sell the new lab [ph] facility in Italy. In addition, we have entered into an agreement with a Pakistani pharmaceutical company under the ownership of Merck's entire business in Pakistan will be transferred to that company later this year. The facility in South Korea is scheduled to be sold or closed in 2009. And finally we plan to phase out solid dose manufacturing operations in Australia over the next few years to focus that site on packaging. As a result of these concerted efforts, I believe Merck is leading the industry and creating a lean and flexible manufacturing pipeline. In the lab we are reducing our cycle time relative to the rest of the fields, a leading indicator of the productivity of our research. On the commercial side in the US in particular we and others have known for some time that the current entity model is not sustainable. Here too, I believe Merck is ahead of that field in accelerating to a new pharmaceutical business model that is centered around our customers. We look… we look every day for opportunities to improve our efficiency. We’ve now eliminated more than 8,000 positions throughout the company as part of our strategy to reduce our cost structure and create a linear and vulnerable business model. In this new area for the pharmaceutical industry, we must create a new way of operating if we are to succeed. We remain confident that our current portfolio and our pipeline along with the fundamental changes we are making in every aspect of our business position Merck well to drive against their goals now and in the long-term. To summarize, in the face of those expected and unexpected challenges, Merck delivered sound first quarter results. Our ability to reaffirm our 2008 non-GAAP EPS guidance despite business set back in the challenging industrial environment shows that we have the right strategy in place to drive Merck's long-term growth. We remain confident that our customers will continue to find value in our medicines and vaccines. In spite of the quarter’s solid performance and performance in the past prior few years make no mistake, we are not content. We are accelerating the pace of change in every area of Merck’s business. We have much to do to reach our 2010 goals and we need to do even more to achieve and sustain the benefit of our strategy through 2010, 2015 and beyond. Though we must and we will to ensure that Merck keeps doing what Merck does best, bringing forward medicines and vaccines that save and improve people's lives. Now I would like to first turn to... the call over to Ken and then Peter. After their brief remarks, we will take your questions. Ken?
Kenneth C. Frazier: Thank you Dick and good morning everyone. Merck's top line performance in the first quarter reflects continued strength across our diverse portfolio of product and in markets around the world. As Dick said, in the quarter where we sustained the impact of the loss of U.S. marketing exclusivity for FOSAMAX, total revenue in the quarter was up 1%, thanks to the positive contributions from both our in line and new products. In the first quarter, our international business performed very well increasing by 12%. While we clearly benefited from the prevailing exchange rates, we saw volume growth of 5% outside the U.S. driven by strong results in Japan, Asia and Europe. To drive further growth we will continue to roll out our new product globally and we anticipate conducting approximately 300 launches this year. In the U.S., when we exclude all products that recently lost patent protection and I remind you that FOSAMAX, COZAAR and ZOCOR sales were up 12%. Before discussing some of the specific product highlights for the quarter, I would like to take a moment to add to some of this comments regarding our cholesterol JV with Schering-Plough. The use of clinical trials and treatment guidelines for high cholesterol recognize LDL-C as the primary target of lipid-altering therapy. Both VYTORIN and adding value of simvastatin lower LDL more than simvastatin alone and get more patients to their LDL goals. Of greatest concern to Merck is that in the 10 weeks since the ENHANCE summary results were first provided, tens of thousands of patients have switched from VYTORIN to therapies that on average are less effective than VYTORIN at lowering LDL. And some patients, have simply stopped taking their medication altogether. This reaction directly contributing to what we know about the importance of lowering LDL. Together with our joint venture partner, we are doing as much as we can to remedy this situation. We are engaging directly with our customers to set the record straight about ENHANCE and the value that VYTORIN and that will bring to lipid management therapy. Within the first week after AETC, we reached out to or visited all managed-care customers and sent a letter and the press release directly to approximately 500,000 healthcare professionals. We also provided our sales representatives with appropriate materials for physicians so that the physicians felt informed about results of ENHANCE and were prepared for discussions with their patients. Managed Care organizations understand that simvastatin alone is not enough to get many patients to goal. Which is why patients need to have access to the LDL lowering benefits of VYTORIN and ZETIA. As of today, most of our Managed Care customers have reviewed the ENHANCE data and there has been no changes to the second tier status for VYTORIN and ZETIA. Many physicians put this study into the right context to feel that the AETC discussion has created confusion in the field. Most we expect will continue to prescribe VYTORIN and ZETIA but may increasingly reserve these medicines for their high-risk patients or for patients who cannot tolerate high doses of statin at least in the short term. Following January 14th, NRS [ph] market share dropped for about two weeks then began to stabilize. Unfortunately the events at AETC at the end of March created further confusion and although the reduction in share was not as steep as what we thought for January 14, we were already starting from a lower share. In the quarter worldwide sales of ZETIA and VYTORIN as reported by the Merck/Schering-Plough joint venture were $582 million and $651 million respectively in the quarter. In the US, sales of ZETIA were $395 million, down 3% and sales of VYTORIN were $456 million, down 7%. Ex-US, sales of ZETIA were $186 million, an increase of 37% and sales of VYTORIN were $196 million, an increase of 45%. In a few minutes, Peter will provide you with the financial implication of these events when he discusses the changes to our equity income guidance. But I want to reiterate what Dick said on this. We are very much engaged in this issue and are committed to helping our customers appreciate the unique values that these two medicines provide. Now I would like to discuss some of the key drivers of Merck's business in the first quarter beginning with our HPV vaccine GARDASIL. We're pleased with the global performance of GARDASIL in 1Q '08. Sales in the first quarter were $390 million, a 7% increase when compared to the first quarter of last year. In addition, during this first quarter our vaccine joint venture Sanofi Pasteur MSD recorded end market sales for GARDASIL of $240 billion. Taken together, global end market sales for GARDASIL reached a new high in 1Q, up 11% sequentially from the fourth quarter of 2007. I would like to update you on doses sold since approval for those who are tracking this measure. As of the end of the first quarter more than 26 million doses of GARDASIL have been sold since March. In the US, we estimate that more than 8 million 9 to 26 year-old females or roughly 23% of the eligible cohort have received at least their first dose. Peter will provide you with some details regarding our financial expectations for GARDASIL in 2008 but I would like to review for you some of the things we're doing to grow this important franchise for Merck. In the US, sales in the quarter reflected underlying market demand for GARDASIL and we saw continued growth in origination and utilization versus first quarter 2007. Allow me to remind you that our first quarter revenue last year benefited from initial purchases from a number of the VFC projects as they ramped up vaccination programs. Throughout the rest of this year we anticipate quarterly purchasing from the VFC to be more in line with the underlying demand. In the private sector GARDASIL experienced strong growth in the quarter increasing by 29% over the prior year. As we have previously mentioned, there is a seasonal component to the GARDASIL business in the US, in that nearly two thirds of well visit for 9 to 18 year olds occurred during the second and third quarters, with the third quarter being the highest. We continue to anticipate robust 2008 growth for GARDASIL in US and to see the seasonality again. We are focused on increasing vaccination rates across the entire 9 to 26 year old cohorts with specific emphasis on the 19 to 26 year olds. First, we are addressing the awareness versus action gap. While we have achieved high levels of awareness of the vaccine among 19 to 26 year olds, origination levels are not nearly as highly as those levels of awareness. We recently developed and launched new DTC ads, an interactive web portal to assist in this regard. We are also continuing to help OBGYN and primary care offices establish vaccination as part of their practices including addressing reimbursement. Although 99% of privately insured 19 to 26 olds have some level of coverage, there is a lack of consistency of vaccination coverage in many benefit plans and we're working to address this with our customers. We also continue working to increase compliance levels with for example, our “3 IS KEY” program and partnership with MCOs. “3 IS KEY” is being enhanced to make it easier for our customers to participate in this reminder program. Compliance rate for GARDASIL remain high compared to historical norms and private practices. Compliance rates are about 75%, for second dose and 50% for third dose. To drive further growth, we are expanding into other cohorts as well. Later this year, we anticipate launching GARDASIL for use by woman aged 26 through 45 and we plan to submit a regulatory application for use in males later this year. On a global basis, GARDASIL has been approved in 101 countries, most under accelerated review and based on the international approvals, recommendations, reimbursement, and launches, we are well positioned to continue to build on this success of this franchise in 2008. While GARDASIL continues its unprecedented launch, our other new and established vaccines are also performing extremely well and I note that this quarter our vaccine business nearly made it to the 1 billion mark. The launches for ROTATEQ and ZOSTAVAX continue to progress as reflected in the strong quarterly results. Please note that the sales of the ROTATEQ in 1Q08 benefited from a $41 million purchase to support the CDC stockpile. Moving to two more of our growth drivers, global revenue for JANUVIA and JANUMET reached $330 million in the first quarter reflecting the high-value that physicians, patients, and payers are placing on these personal medicines. We continue to build on the momentum we achieve with our product launch over the last 18 months. In the US, JANUVIA remains the second leading branded oral anti-diabetic agent in terms of the new prescription share behind only Actos. Our diabetes franchise continues to grow in both volume and market share. Both products continue to enjoy excellent position on formulary and the response from patient disposition continues to be positive. As you may have noticed, last week we initiated broadcast DTC for JANUVIA. With JANUVIA well established as a valuable treatment option, we believe the time is right to encourage patients with Type 2 diabetes to discuss their condition and available treatment options with their physician. Outside the US, sales for JANUVIA and JANUMET were $48 million, a two-fold increase over the fourth quarter 2007. In the first quarter, we launched JANUVIA at a number of major markets such as France, Spain, Italy and Canada. Based on early feedbacks from these markets we are off to a great start. We continue to focus on the global rollout for JANUVIA and JANUMET and we look forward to additional regulatory approvals, reimbursement decisions and market launches during the remainder of this year. Now I'd like to turn to ISENTRESS. We are extremely pleased with the uptake of ISENTRESS, the first-in-class integrase inhibitor since launched in the fourth quarter of 2007. First quarter sales of ISENTRESS was $47 million, up 58% sequentially. In the US the weekly NRS market share for ISENTRESS has already surpassed the weekly share of the last five new products introduced into the HIV market. ISENTRESS continues to benefit from strong managed care access that is available through AIDAC and Medicaid in all 50 states. In the quarter, ISENTRESS became available in 11 additional markets including the UK, Germany, France and Spain. By the end of the first quarter, ISENTRESS had received regulatory approval in a total of 43 countries on five continents. Uptake in our largest market has been strong already and we look forward to the continued success in 2008 to filing our application to expand the use of ISENTRESS to treatment-naïve patients. To ensure this breakthrough medicine gets to those who need it most, we continue to work closely with all stakeholders to foster patient access to ISENTRESS here in the US and around the world. We were very pleased with the global performance of SINGULAIR in the first quarter and sales grew 10%. The US Allergy scene has been somewhat slow to start this year compared to recent years and so far it also appears to be mild, although it's still early in this season. SINGULAIR is... and we expect it to remain the number one product in US respiratory market. The continued strong growth of SINGULAIR is a testament to the need for an effective non-steroidal medicine and it's effectiveness in adult and children with asthma or allergic rhinitis. Now I would like to take a couple of minutes to provide an update on the progress we're making in implementing our new commercial model. As I mentioned at the annual business briefing in December, our US pilot program spans six state and 11% of Merck's primary care business and involve some 700 Merck’s field and headquarters employees. In the pilot, we re-aligned our sales teams based on input from our customers and have begun creating new capabilities within the field in that headquarters. Our teams have also been gathering feedback from customers and employees involved in the pilot. We are now seeing the results of the pilot and we are finding that our new approaches are working. The early progress we have seen in the pilot has increased our confidence in our new customer-facing model and we have decided to move quickly to the next phase of our plan and begin working towards national deployment. Similar initiatives are also underway in international markets across our commercial organization with the same goal of evolving to a new business model that is centered around customers. A model designed to build trust and demonstrate value that is efficient and effective, expands Merck’s opportunities, fortifies our product performance and provides a platform for long-term business success. In closing, Merck's overall commercial operations continue to perform well. Merck enjoyed a leadership position in most of the therapeutic categories in which we have products. Our more established products continue to deliver strong performances including SINGULAIR, COZAAR/HYZAAR and VARIVAX. Taken together these established franchises along with our new first-in class vaccines and medicines such as GARDASIL, ROTATEQ, JANUVIA, JANUMET and ISENTRESS give us a diverse and broad product portfolio well positioned to drive revenue growth through 2010 and beyond. In addition, we are accelerating the deployment of our new customer-centric commercial model that we strongly believe will help deliver continued strong future performance. So with that, I'll turn the call over to my colleague, Peter Kellogg.
Peter N. Kellogg: Thank you, Ken and good morning everybody. And as Dick and Ken have both mentioned, Merck posted a solid first quarter results despite the loss of patent protection for FOSAMAX as well as a decline in the expected sales from our Merck/Schering-Plough joint venture. The business is performing well. Merck reported first quarter non-GAAP earnings per share of $0.89, excluding $1.4 billion net after-tax gain from distribution received from the AstraZeneca Limited Partnership and restructuring charges. On a GAAP basis, as Dick mentioned earlier EPS for the quarter was $1.52. Now given the perspective that Dick and Ken have just provided and the extent of the details contained in our sales and earnings release, I'm not going to walk through all of the line items today. Instead, I will focus on how the key elements in the quarter has been incorporated into our full-year guidance. We have done a fair bit of work on this and after a lot of exhausted evaluation of all of our business drivers we've refreshed our financial guidance. I would like to discuss this and focus on how we thought about the business relative to our guidance. I will cover our guidance changes in four areas: first, how we have updated our revenue ranges for the current trends and expectations, many of which Ken just walked through. Second, how our cost performance to date has reflected in our guidance. Third, the implications of the Merck/Schering-Plough joint venture's revised forecast on equity income guidance and fourth the revised 2008 tax rate. Now let's begin with how we've changed our 2008 revenue guidance. As Ken talked about the health of the business, he provided context on the current trends and dynamics. As always to assist your modeling, we provide a breakdown of the product revenues in our other financial disclosure schedule attached in the press release issued this morning and you will note the following changes. Regarding 2008 revenue guidance, we are increasing several lines and reducing one element of our full-year revenue guidance. Net-net we increased our revenue guidance by $0.5 billion. So let me walk through that. On COZAAR and HYZAAR, we are increasing our expectation for 2008 by $200 million and now anticipate revenue in the range of $3.4 billion to $3.6 billion. This is primarily driven by the positive effect of foreign exchange considering the geographic segmentation of revenue for these products. Regarding FOSAMAX, we are pleased with the performance of the domestic FOSAMAX plus vitamin D product in the first quarter and the strength of our business internationally. And as a result, we are increasing our full-year guidance by $200 million to $1.3 billion to $1.6 billion. Considering the portfolio of key growth drivers captured within other reported products, we are increasing our expectation by $300 million and now anticipate revenue in the range of $7.8 billion to $8.2 billion for these products. This increase is supported by the positive effect of foreign exchange on these products as well. Given the non-complexity of the end market for vaccine and that there is no routine way to monitor utilization and importantly the fact that GARDASIL is becoming an increasingly large contributor to our vaccine revenue, we recognize that it's valuable to provide product specific guidance on GARDASIL. So to assist with your modeling we are now providing further breakdown. For GARDASIL, we anticipate full-year revenue as recorded by Merck to be in the range of $1.9 billion to $2.1 billion. We foresee robust growth for GARDASIL in the US in 2008 and quarterly purchasing from the VFC to be more in-line with underlying quarterly demand. To provide additional perspective, as Ken mentioned earlier, historically 63% of all penetration in the 9 to 18-year-old cohort occurred in the second and third quarter with the third quarter being the highest as Ken mentioned. And I think that perspective is very important to help you model out the quarters and understand the seasonality that we expect to see this year. By isolating GARDASIL for you, by difference, we anticipate the full-year revenue as recorded by Merck for other vaccines to be in the range of $2.9 billion to $3.1 billion. Regarding our agreement with AstraZeneca based on the Q4 results of supply sales to AZN and the Q1 performance of NEXIUM, we anticipate incremental pricing pressures in 2008 to negatively affect the revenue that Merck records from AZN. As a result, we are lowering our 2008 guidance for AZN supply sales by $200 million to reflect the current market conditions and now anticipate that these revenues will be approximately $1.3 billion to $1.5 billion. This lowering of guidance is solely attributable to the current market conditions for NEXIUM and in no way it signals a loss in economics following the settlement agreement and the patent-infringement litigation announced last week. Now let's turn to talk about how cost have been incorporated into our guidance, beginning with product gross margins. As a result of the strong PGM performance in the first quarter, we are increasing our full-year PGM guidance by 0.5%. The new range is now 77.5% to 78.5%. This increase in PGM was driven by favorable product mix in the first quarter. In addition, our gross margin improvements continue to be driven by establishing lean supply chains, leveraging low cost in external manufacturing and consolidating our manufacturing plant network much of which Dick commented on earlier. During the remaining three quarters in 2008, we anticipate a less favorable product mix to negatively affect PGM compared to the first quarter and particularly over the next three quarters, we will experience the full impact of the loss of marketing exclusivity for FOSAMAX on PGM. As always, this guidance excludes the portion of the restructuring cost that will be included in product cost and will affect reported PGM in 2008. So let's move down the P&L to marketing and administrative guidance. In 2008, we continue to anticipate marketing and administrative expense to be approximately $7.8 billion to $8 billion. For R&D, we reaffirm our 2008 R&D guidance of $4.7 billion to $4.9 billion and on the restructuring line as part of the company's restructuring of its operations additional cost related to site closings, physician eliminations and related costs will be incurred in 2008 and Dick discussed many of these earlier. We anticipate the aggregate 2008 pre-tax expense related to these activities to be in the range of $100 million to $300 million. Now let's turn to equity income. The disappointing events surrounding the ENHANCE results that Ken reviewed earlier has caused us to evaluate what scenario regarding the potential impact of the franchise is appropriate. As Ken mentioned, following the January 14th announcement market share dropped for about two weeks, then prescribing behavior moderated and share trends began to stabilize. Unfortunately the more recent statements and opinions expressed at the ACC at the end of the March created further confusion in the marketplace. So the Merck/Schering-Plough joint venture builds its new view of the 2008 outlook, it had to consider the following factors. Now let me go through them all. One, it appears that in both cases of share drop the NRS trends quickly stabilized and defined a new steady prescribing level as we have seen in the daily and weekly script data. Two, we have seen the more recent drop and share appears to stabilize although it is really still quite early, but it is not as much of a drop as we saw post January 14th. Three, in Q1 customers did reduce inventories in line with the lower demand in the US as well as inventory build that sometimes occurs when we are in the holiday period in the fourth quarter. That said, there may be some further adjustment in inventory in the second quarter in the US based on any additional decline in demand post ACC. Now just a note, we don't expect any change in the weeks of supply in the inventory channel. This is just a response to any changes in market share. Fourth, following the events of January 14th the Merck/Schering-Plough joint venture had carefully evaluated its entire cost base in an effort to optimize the income contribution to both its parents. We continue to carefully assess our investment strategy and we have incorporated our plan into this guidance. Now we do consider these further details on our investment and proprietary strategies to be proprietary so we won't be covering details of those today. And five, outside the US, the coverage and the impact following the January event was relatively minor and the international media coverage following the ACC Conference was somewhat higher but it really is too early to tell how full year results may be affected. Sales growth outside the US was up 41% versus Q1 in 2007 and we expect ex-US revenue to continue to grow. Accordingly with all of these factors considered, we are now incorporating revised Merck/Schering-Plough joint venture outlook into our 2008 equity income guidance. We now expected to be approximately $2.3 billion to $2.6 billion for 2008. The $700 million decrease in equity income guidance is solely attributable to lower anticipated contribution for the Merck/Schering-Plough joint venture. Just to be clear as previously disclosed the equity income guidance already included the impact of the reduction of the AZLP priority return and the buyout of the Astra USA products which occurred in March of 2008. So moving down the P&L, let's talk about taxes. As you can see our Q1 tax rate included two impacts. First the impact of the gain on distribution from the AstraZeneca Limited Partnership and restructuring charges. And both of these are taxed at roughly US domestic rates. Second we included the first quarter benefit of approximately 8 percentage points related to the realization of foreign tax credits. This is a discreet event based on operational aspects of our business and the full benefit of this change was captured in Q1. As a result of these two impacts, the first quarter effective tax rate on the GAAP P&L was 25.1% and the effective tax rate on the non-GAAP P&L excluding the impact of these items was 14.5%. Now I'd like to take a second to explain the revised tax guidance. The foreign tax credits rose as a result of prior year tax payments made outside the US in several countries in the normal course of conducting our business. The company was not able to recognize the benefits of these foreign tax credits in prior periods. However, based on the change in the planed distribution of certain prior year’s foreign earning, the company has determined that such credits are now realizable. So with these impacts incorporated into our P&L in the first quarter, this affects the full-year rate. There are no other changes anticipated to our tax rate in 2008 but the implication of this Q1 impact is that our rate for each of the next three quarters will be changed to drive the full-year rate. We are reducing our full-year 2008 non-GAAP tax rate guidance range to be approximately 20% to 23%. This guidance does not reflect the tax impact of the gain on distribution from AstraZeneca or restructuring costs. Now moving to share repurchase. Merck has been actively repurchasing shares. During the first quarter, the company continued its stock buyback program and purchased approximately $1.4 billion of treasury stock. This level of purchasing was triggered by the following factors. We do not repurchase in the second half of 2007 very many shares and we pulled forward some of our 2008 planed activity as we saw the value of the Merck equity debt and we viewed it as a buying opportunity. So in total to recap our 2008 guidance, the company continues to anticipate that many of our in-line and newer franchises will maintain their solid performance. We anticipate that worldwide revenue will be driven by additional indications of the company's product, the continued market uptick in global rollout of our new products, as well as other potential new introductions. On earnings per share, we are confident in our ability to execute against our plan and are reaffirming our full-year 2008 non-GAAP EPS range of $3.28 to $3.38 excluding certain items. We're making a slight revision to our 2008 GAAP EPS, which we now anticipate to be in the range of $3.84 to $4 per share. Now, given that we had an $0.89 non-GAAP EPS first quarter, we have analyzed the trends quarter-to-quarter and the company expects a generally even distribution of non-GAAP EPS across the remaining quarters in 2008. So in summary the company remains on track in terms of both strategy and performance to deliver a long-term double-digit earnings per share growth from 2005 to 2010 excluding certain items. We have financial strength, and remain fully committed to maintaining our dividend at the current level. At the same time, we continue to fully invest in our key strategic priorities. 2008 represented an important step in the multi-year journey to return Merck to its leadership position in the pharmaceutical industry. While we have faced certain challenges in the first three months of this year, it is important to note that much has been accomplished over the last 24 months. Many opportunities still remain and we look forward to capitalizing on them in 2008 and going forward. Thank you very much. Now, I’d like to turn the call back over to Graeme.
Graeme Bell: Hey, thank you Peter. We will now open the call to take your questions. We will take the questions as always in the order they are received and try to get through as many as possible. So, at this point, I will turn the call back over to Cynthia, who will communicate instructions of our Q&A format and introduce the first question. Question and Answer
Operator: [Operator Instructions]. Your first question comes from Tim Anderson with Sanford Bernstein.
Tim Anderson: Thank you, a couple of questions. SINGULAIR is now your biggest product and if I look at script growth in the US it’s recently slowed quite a bit. I think it's down in negative territory by about 15% or so and I'm hoping you can parse out that slowed growth rate by seasonality versus the safety issues that came up recently, what to expect from here in the US specifically? And then on VYTORIN and ZETIA I think Ken’s comments I am assuming formulary positioning that was for 2008 and with contracting from Managed Care for 2009 being essentially done, I am hoping you can give us an idea of how much 2Q slippage you might see with those products in 2009?
Kenneth C. Frazier: Thank you for those questions, Tim. Let me start with the second question. We continue to see from our Managed Care customers very strong understanding of the unique and valuable role of these two agents and we don't foresee significant changes at all in our Managed Care position. We've seen no changes and so we have no basis to actually predict changes going forward. We're very... we're very pleased with the reception that we've gotten in Managed Care, we've reached out to them. I think the Managed Care providers understand the limitations of the ENHANCE study and they understand the importance of these drugs are for their patients. On a SINGULAIR issue, we believe that the changes that you've seen largely at this time or the slow start if you will, has to do with the relatively late start for the Allergy season as well as a sort of a modest impact of the new NIH guidelines which gave a little bit of boost to inhaled corticosteroids. As it relates to the safety issue, I will remind you that those label changes were made in the fall of last year. Merck has been communicating those changes to it's customer base since that time and while I can't say that there is no impact yet because it's too early to say that there will be no impact of the concerns from the safety perspective we have not yet seen any substantial impact on SINGULAIR as a result of that. It's a drug that has 10 years of excellent experience on the market, it's got strong clinical trial data in the background, 32 million patient years of good faith experience that we continue to anticipate that it will continue to be the number one drug in the US respiratory market.
Graeme Bell: Next question, please.
Operator: Your next question comes from Roopesh Patel with UBS.
Roopesh Patel: Thank you. Just a couple of questions. First on GARDASIL, I was wondering if you could just clarify if the VFC purchase in this quarter was in line with underlying demand or was it higher or lower? And then separately on the tax rate, I just wanted to clarify, is the change in the full year guidance all due to the benefit of the foreign tax credits that has been recorded this quarter. I am trying to understand what could be the sustainable tax rate beyond 2008? Thank you.
Peter N. Kellogg: Great. This is Peter. First let me answer the second question first, if I can on the tax rate. So yes, the full... the full year impact on our tax rate is solely driven by the impact of the foreign tax credit that we're now being able to recognize the benefit for. And the impact is larger than first one because it does capture, add a little bit of catch-up element to it and that will affect the... it obviously affected the first quarter tax rate but it will affect Q2, Q3 and Q4 because you're driving now the tax rate towards the full year rate. It will have a slight impact going forward beyond that because obviously this is now... these foreign tax credits we anticipate being benefit to us but if we are not getting guidance and it won't be anything of this magnitude going forward. Related... as regarding to the question on tax, now on GARDASIL Ken, do you want to --
Kenneth C. Frazier: Yes. With respect to VFC, as I mentioned earlier, last year's first quarter had the substantial benefit of the initial stocking in the public sector as programs ramped up for GARDASIL vaccination. We did not have a similar impact this first quarter and I would say that one of the issues that we continue to watch closely is the timing of large government orders which are not as predictable as the underlying demand. And that's why I pointed out, if you look at the underlying demand as measured by what’s happening in the private sector, we saw very strong growth year-on-year of almost 30% and that gives us confidence that GARDASIL is still a vaccine that is beginning a strong reception by patients, by women, their mothers and their caregivers.
Graeme Bell: Thank you, Ken. Next question please.
Operator: Your next question comes from Jami Rubin with Morgan Stanley.
Graeme Bell: Jami, please go ahead.
Jami Rubin: Can you hear me?
Kenneth C. Frazier: Please go ahead, yes.
Jami Rubin: Can you hear me?
Peter N. Kellogg: Yes, we can, now we can.
Jami Rubin: Okay, great. Just a question, sort of a policy question. To what extent do you view the recent action surrounding the ENHANCE trial involving the government investigation, the media attack, the ACC curveball etcetera as a passing storm or is this the brave new world that pharma executives have to come to terms with and make significant changes in the way you allocate capital to outcomes trials etcetera? I mean it seems to me that in this world, in this brave new world, the cost of failure in an outcome trial is obviously way too high. You've lost $40 billion of market cap over this among other things. So I'm just wondering if you could kind of talk around that? And secondary, if you could talk about plans for DTC for VYTORIN going forward?
Kenneth C. Frazier: Good morning, Jami, this is Ken Frazier. I think we all are looking into the future and through sort of a murky crystal ball now as it relates to policy. It is clear that the world has changed to some degree. It is clear that outcome studies are going to continue to be important going forward. But I think when the dust settles around ENHANCE people will come back to the primary goal of treatment which is LDL lowering and I think that people will continue to recognize that these drugs lower LDL more than simvastatin alone and will therefore continue to be very valuable drug and we will continue to go forward. As you know Merck has always been a company that believed in investing behind its products, investing in outcome studies. And so that will continue to be something that was important. We did that before. You remember going back to the 4S study we did those kinds of studies. We had those studies around COZAAR. We will continue to do those studies because we think they are important to patients as well as to the marketing of these drugs going forward and then what's the second question? I am sorry.
Graeme Bell: DTC VYTORIN.
Kenneth C. Frazier: Oh, I am sorry. On DTC, we made a decision to voluntarily suspend DTC advertising in the current environment. I will only say that we will continue to invest behind these two products as appropriate. We have not made any specific decisions as to when will we resume our DTC advertising at this time.
Graeme Bell: Thank you. Cynthia, could we have the next question please.
Operator: Your next question comes from Norman Fidel with Alliance Bernstein.
Norman Fidel: Thank you, it was already asked.
Graeme Bell: Next question please, Cynthia.
Operator: Your next question comes from Tony Butler with Lehman Brothers.
Tony Butler: Thank you. Two brief questions. One, Peter you commented quite extensively on the tax rate, but could you say if in fact the tax credits were variable? That is to say, could you have taken less of a credit this quarter and spread it more evenly throughout the remainder of the year or did you need to take as much as you did and then the second... and if so why? And the second question, Ken you may be able to ask is, when you... assuming you do receive approval for GARDASIL for those over the age of 26 or 26 to 45, how does the message then to OBQ volumes and toward that population change, if at all? Thank you.
Peter N. Kellogg: Great. Tony, it's Peter. I will take the first one. So, basically when you have an [inaudible] outlook for foreign tax credits like this, these foreign tax credits are basically taxes paid in other countries outside the US and then getting the benefit, an offset for those against US taxes. And basically when you conclude as you do a change in your plan distribution of earnings which then allows you to take a benefit of these foreign credit, you from an accounting standpoint, from a GAAP standpoint you actually have to book the full amount right there in the first quarter. It becomes as soon as discreet event from accounting problems. Obviously, it does affect the full-year tax rate though in fact you get the full-year tax rate impact but you do have to book it in the first quarter and that's appropriate and it's been reviewed by everybody. So we're very comfortable with that. And so we really don't have a choice per se, for example to spread it out during the year but obviously it does, it is an impact that rolls through the year. I hope that answers your question. The second question was related to the 26 to 45-year-old GARDASIL, the answer is --.
Kenneth C. Frazier: Hi, Tony thanks for your question, let me start by saying that we do recognize that there are significant differences among audiences and we continue to learn as we do our market research from our customers about the kinds of programs and messages and materials that resonate well across these different age groups. As you might be able to see in our new television and advertising and our web presence, we continue to remain focused on providing innovative and large-scale initiatives that highlight the benefits of this vaccine for cervical cancer for general wards but actually tailor them to the lifestyles and interests and concerns of different age groups as well as their position within the coverage spectrum. So while I won't be able to say at this time for proprietary reasons what our specific messages are to this most senior cohort among our patient population, I will say that we recognize that there are differences in how they approach things but the core value of proposition of the product remains the same.
Graeme Bell: Next question please, Cynthia.
Operator: Your next question comes from Barbara Ryan with Deutsche Bank.
Barbara Ryan: I am sorry, mine was answered. Thank you.
Graeme Bell: Thank you, Barbara. Next question please.
Operator: Your next question comes from Catherine Arnold with Credit Suisse.
Catherine Arnold: Good morning. I had two questions. First of all, if you could just give us some perspective on the change in equity income you had talked about some give-and-take on prescription trends and how it did seem like you've settled out after January pretty quickly and although you made the comment that the prescription trends after ACC dropped, but now seem to have stabilized again, is your assumption in the equity income forecast change that there is another drop to add some conservatism or are you assuming that we have reached bottom in terms of market share trends? And my second question is related to share repurchase, it looks like you've bought as much stock in the first quarter as you'd almost... pretty much comparable to last year's total. So given the share price and given what you have done, I guess it’s safe to say that your share repurchase might be much higher this year.
Peter N. Kellogg: Catherine, let me take first. So first of all on the... second one, I think that is quicker and easy to take. The share repurchase you are right. So last year we actually... if you went to the second half of last year we did not repurchase a lot of shares. I mean, some ways were blocked as we went through the lot of the VIOXX dynamics. And so we had a much lower share repurchase activity last year. As we came into our 2008 planning and this was obviously get in sort of the capital planning for the company, we had a certain amount that we'd anticipated repurchasing and we didn't buy the whole amount in the first quarter but we did put forward some of what you might have considered to be a smooth purchase rate. We took some of the amount that we would have purchased in the balance of the year into the first quarter and blow it a little bit more heavily because we felt the value within, there had been some reaction perhaps in stock price. So I think that our ongoing share repurchase program is characterized more by stabilizing the number of shares outstanding and what we're seeing just as more of the timing and phasing when we actually made the purchases. But you're correct in that it did result and because of those two factors, a much heavier purchase activity in the first quarter. Regarding the equity income forecast and how we looked at that so obviously this is a sort of complex situation. I would just caution everybody. I think everyone in the call is [inaudible] this with this but obviously we have daily scripts, weekly scripts and monthly scripts and if you go from one or the other, you have to be careful what you look at. And we tend to work much more with the weekly and monthly scripts because it includes… the monthly includes the mail order and the weekly includes the long-term care channels. But as we have evaluated that, we did see a slight drop after ACC. We feel that that has stabilized somewhat, particularly on the new script side and we have modeled out what our expectations for the balance of the year. We don't really anticipate a dramatic further drop at any point. In fact, we feel that there has been a very strong reaction in the market already and I think Ken talked to that quite a bit in terms of the actions and communications that are important for patients who are trying to lower LDL. So, as we have modeled that out, we actually feel that at this point we've seen the reaction from ACC and we realize it is early but we had to make a call relative to how we forecasted and how we made our guidance.
Graeme Bell: Next question please, Cynthia.
Operator: Your next question comes from David Risinger with Merrill Lynch.
David Risinger: Yes. Thanks very much. I have a couple of questions. First, would Merck management be surprised if Cordaptive is not approved at the end of the month? Second, could you just comment on how much US wholesaler inventory was worked down for VYTORIN and ZETIA in the first quarter? And then on ex-US VYTORIN and ZETIA sales were flat sequentially. Can you discuss the prescription trends since ENHANCE and whether prescriptions are flat on a month-by-month basis ex-US? Thank you.
Richard T. Clark: Let me take the first and this is Dick Clark concerning Cordaptive. Obviously and this has been our policy from the beginning, the status of the pending application is really considered proprietary and therefore we can't make any comments on and so the FDA has taken action. But we do continue to anticipate an FDA action by the end of this month.
Kenneth C. Frazier: On the two VYTORIN questions, first let me take the inventory question. In the first quarter of this year we noticed that customers were reducing inventories in line with the lower demand in the US as well as inventory build that occurred around the holiday quarter... holiday period in the last quarter. There may be some further adjustment in inventory in the second quarter in the US associated with any additional decline in the demand post-ACC. So that's basically what we know about the inventory levels. On the ex-US business as was mentioned earlier the immediate coverage and the impact following the January press release were minor. There was somewhat more extensive and more negative media coverage following the entire ACC conference, which could impact performance. But it is much too early to tell how the full year results might be affected. Sales outside the US or non-US, 41% versus the first quarter of 2007. So despite the controversies around ENHANCE, we expect sales to continue to grow ex-US. There was a modest sequential decline ex-US from the fourth quarter to the first quarter. And that trend reflects the typical seasonal pattern of stable franchises rather than I believe indicating any adverse effect from ENHANCE.
Graeme Bell: Thank you, Ken. Next question please, Cynthia.
Operator: Your next question comes from Jim Kelly with Goldman Sachs.
Jim Kelly: Great, thank you very much. First on GARDASIL, if you said this and I missed it I apologize, is there any assumptions inside your guidance for the cohort of 26 to 45? And then secondly, cost of goods, very impressive decline year-on-year at a time when a lot of the other companies are seeing some more currency pressures, is there something different about the amount of currency or with currency adjusted that would the decline have been even more material year-on-year? Thank you.
Kenneth C. Frazier: On GARDASIL, we anticipate FDA action on the 26 to 45 year-old. But we can't speculate on the exact timing of the FDA's response and so we're not in a position to talk about any estimates around our marketing expectations for that cohort.
Peter N. Kellogg: And on the cost of good Jim, thanks. So there is a lot of questions involved in the cost of goods sold and I do think that actually as we planned and managed our cost of goods around the world, we don't tend to see an big FOREX impact relative to revenue and so forth and so I don't think it was a bigger driver. There is some impact and we can follow-up on that point but in general, we tend to have a little bit more US denominated cost of goods sold. But I think, as I mentioned, this quarter and as you go through this year, you will see a fair bit of product mix effect and so you're seeing the combination of efficiencies that we have been talking about for quite some time and ENHANCE off to the whole Merck manufacturing division team on that, they have done a great job. But also you know, as you have FOSAMAX going on patent, as you have the very rapid growth of vaccines, and you also have the mix effects as well. So I think those are probably the bigger dive... the biggest drivers of all.
Graeme Bell: So, given the time, we might have time for one or two more questions here. So Cynthia could we have the next question?
Operator: Your next question comes from Seamus Fernandez with Leerink Swann.
Seamus Fernandez: Hello, and thanks very much. Just hoping that you could gives us a couple of data points. One, it's our understanding that the Phase... first Phase III data on the migraine drug MK-0974 could be presented in the near future. Could you confirm whether or not those data will be presented at the American Headache Society or is that still unclear? And then separately just on cordaptive, as you kind of think about your expectations coming into the year and guidance that you provided in late last year, can you just give us your expectations? Have those expectations changed at all given the volatility in the current environment assuming that cordaptive is approved?
Kenneth C. Frazier: Yes, Seamus, let me take the first... the second one rather on cordaptive relative to guidance. So, we... yes we have included some prospective on cordaptive in their guidance, but I would caution everybody it’s very minor. This is a year of launch, it’s initial year so it’s a very minor impact. So I think our 2008 guidance does not inch one way or the other on the... any outcome here this month with the FDA. Obviously there was an impact going forward. But right now, it really isn't a big 2008 factor, relative to the migraine drug, Graeme?
Graeme Bell: Yes, I can confirm these changes, you are correct, June 26 through the 29 is indeed The American Headache Society and we will be presenting Phase III data on MK-0974 in that scientific forum. So Ken and Peter given the time, we will take the last question, please.
Operator: Your final question comes from Stephen Scala with Cowen. Stephen Scala - Cowen and Company Oh, thank you. Two questions. First, what is the status of varicella manufacturing validation efforts? And secondly, I am not clear why the change in the tax guidance is not due in part to the sizable cut in the guidance for cholesterol franchise equity income or are you saying that there are operational offsets that have boosted the tax rates to a similar extent? Thank you.
Peter N. Kellogg: Okay. So, Steve I can take the second question first and then pass the varicella manufacturing to others. On the tax rate, there are... it's a fair question, there are always pushes and pulls and our different profit lines do have basically different tax rates. And so it's a different product mix, yes, you do have mix effect within our tax rate. We've always modeled that. Obviously, some of these things come up as surprise such as ENHANCE that we can deal with that. But those... and so, yes, we incorporate that. That's why we always give range of tax rates that we plan for. In fact, perhaps the ENHANCE results and the impact that had on the joint venture has actually perhaps hurt the tax rate probably. But the bigger factor really is the fact that we are now getting the benefit of these foreign tax credits for taxes paid overseas in our core operations. And this is obviously just for a select number of countries. So I'd say it's more of that event, the foreign tax credit utilization benefit than anything related to the Merck/Schering-Plough joint venture. On the varicella manufacturing.
Richard T. Clark: Steve, in relationship to your question about varicella, the FDA is in the process of reviewing our regulatory submissions. We cannot provide a specific approval date. However, we expect to hear back from the FDA regarding the status of the review in the next few months. So, it's positive from the standpoint of our manufacturing process standpoint.
Graeme Bell: Thank you, Dick. So that last question concludes the Q&A session of the call. The information from today's call, both the transcript and replay will be available on our website for the next several months. And as always, Mike and I will be available whole day to take your calls and any incremental questions. So let me now turn it back to Dick Clark for some final comments.
Richard T. Clark: Thank you Graeme and thank you all for joining us on the call today. The plan-to-win strategy we put in place back in 2005 has enabled us to improve efficiency while at the same time growing the top line. 2008 represents the half-way point of our plan and we are on track. Of course, new challenges will always emerge. So we have proven before that Merck is a resilient company and I am confident that this management team along with the entire organization has the sense of urgency and the sharp focus that are essential to our success. We'll continue to work hard to grow our pipeline and re-engineer our business. We'll lead to deliver sustained revenue and earnings growth through 2010 and beyond. So thank you again. We appreciate your interest and your participation. Have a good day.
Operator: Ladies and gentlemen, this concludes today's Merck first quarter 2008 earnings conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day, everyone, and welcome to Merck's First Quarter 2008 Earnings Conference Call. Today's call is being recorded. At this time, I would like to turn the call over to Mr. Graeme Bell, Vice President, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Graeme Bell",
"text": "Thank you, Cynthia and good morning. Welcome to our call this morning to review our business performance for the first quarter of 2008. We have a different line-up for you today, so let me make some comments on that. Joining me on the call today as always is our Chairman, President and CEO, Dick Clark. We also have Ken Frazier, our Executive Vice President and President of Global Human Health, he will provide commentary on our revenue trend, several of our inline products, recently launched products, as well as to provide some perspective on recent news flows. One of the benefits of having Ken on the call today is that it will allow Peter Kellogg, our Executive Vice President and Chief Financial Officer to focus on the key financial takeaways from the quarter and provide an overview of the 2008 financial guidance and the rationale for it. And we are also joined by Executive Vice President and General Counsel, Mr. Bruce Kuhlik. Before we get into the details, let me go over some logistics. On this call we will review the results contained in the release we issued at 7:30 this morning. You can access this through the Investor Relations section at merck.com and I would recommend that you do this and also follow along on the live webcast. The replay of the event will be available later today via phone, webcast and as always our podcast. As we began our review of the results, let me remind you that some of the statements made during this call may discuss certain subjects that may contain forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and involve risks and uncertainties, which may cause results to differ materially from those set forth in the statements. The forward-looking statements may include statements regarding product development, product potential or financial performance. No forward-looking statement can be guaranteed and actual results may differ materially from those projected. Merck undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. Forward-looking statements on this call should be evaluated together with the many uncertainties that affect Merck's business, particularly those mentioned in the risk factors and cautionary statements in Item 1A of Merck's Form 10-K for the year ended December 31, 2007 and in any risk factors or cautionary statements contained in the company's periodic report on Form 10-Q or current report on Form 8-K, which the company incorporates by reference and all of these are available and posted on our website. We will begin with brief remarks from our senior management, then open the call for your questions. And expect the total call to last approximately 60 minutes with a stop time of 10 A.M. With that, I will turn over the call and we will begin with our prepared remarks from our Chairman, President and CEO Mr. Clark."
},
{
"speaker": "Richard T. Clark",
"text": "Thank you, Graeme and good morning everyone. Earlier this morning, we announced Merck's results for the first quarter of 2008 and we're joining you now to discuss them in greater detail. Today, we reported another solid set of results, including growth of non-GAAP EPS and revenue from key products. We delivered those results even in the face of slowdown themselves from the Merck/Schering-Plough joint venture and a lot of market exclusivity for FOSAMAX. As you know back in 2005, this management team outlined a strategic roadmap and called it our plan to win. Our plan has allowed us to improve efficiency while at the same time growing the top line. That plan set the stage for our consistent performance throughout 2006 and 2007 and into the first quarter of 2008 as well. And that plan enabled us today to reaffirm financial guidance for the year and to revigorate our confidence in meeting our goal of double-digit compound annual EPS growth to 2010, excluding certain items. Based on the strengths of our broad portfolio of established medicine on the launch of the eight new medicines in that field, we are well-positioned to sustain growth in 2008 and beyond. The result we reported today non-GAAP earnings per share of $0.89 exclude the certain items and the GAAP EPS of $1.52 show that Merck continues to deliver. For the first quarter, we reported revenue of $5.8 billion, which represents top line growth of 1% compared to the first quarter of 2007. Key inline medicines and vaccines including SINGULAIR, COZAAR/HYZAAR and VARIVAX delivered solid year-over-year growth as did our newer products such as JANUVIA, JANUMET, GARDASIL and ISENTRESS. Ken will discuss the product highlights in more detail. Our overall financial results for the quarter was supported by our partnerships and alliances. Specifically the Merck/Schering-Plough joint venture which in the first quarter continued to drive our equity income. However, sales growth in the quarter from the joint venture was lower than expected. At this point, we anticipate that the continued confusion in the market have caused sales of VYTORIN and ZETIA to be significantly lower than expected for the entire year. As a result, we are lowering our full year guidance for equity income of $700 million. Ken, will go with a more detail about this issue in a few minutes. But I want to make a few comments now. With Ken, I have been personally engaged in this issue and have strong feelings on this subject. First and foremost VYTORIN and ZETIA remain valuable treatment options to lower LDL cholesterol. In addition, the lack of a scientific discussion debate at ACC regarding ENHANCE was disappointing to put it modestly. We are encouraged to see a growing course from the cardiology field, begin to seek out about how ENHANCE trial should not change constant at the tier or what we know about the importance of lowering LDL cholesterol. Merck continues to engage directly with leaders in the field and what’s described as [inaudible] point of view. And we will continue to advocate for appropriate use of these important medicines. Merck has been a leader in the cholesterol filed since introduction of MECTIZAN 20 years ago and we are committed to remain the leader in this field. I also want to assure you that we take the criticisms of our practices and our integrity very seriously. Merck is committed to operating with the highest standards of ethics and scientific integrity. Those standards are the foundation of this company and we will not loose focus on our overarching mission delivering medicines and vaccines that safe and improve people’s life. We are now more than halfway through the five-year plan that we first outlined in 2005. At the time when many were counting Merck out our strategy is working and we are moving ahead with a high sense of urgency. Even though several of our plan to win initiatives are ahead of schedule, we're picking up the pace of change. We have already made good progress with a number of initiatives including, we are overhauling our supply networks, we originally said we would sale across five of Merck’s 31 manufacturing sites by the end of 2008. Well, we have already done that, nine months ahead of schedule. Now we're identifying additional opportunities in our manufacturing networks to increase efficiencies. We have moved up our plants to close, sell or reduce operations at four other sites outside of the US pending compliance for global [ph] obligation. This year we plan to close or sell the new lab [ph] facility in Italy. In addition, we have entered into an agreement with a Pakistani pharmaceutical company under the ownership of Merck's entire business in Pakistan will be transferred to that company later this year. The facility in South Korea is scheduled to be sold or closed in 2009. And finally we plan to phase out solid dose manufacturing operations in Australia over the next few years to focus that site on packaging. As a result of these concerted efforts, I believe Merck is leading the industry and creating a lean and flexible manufacturing pipeline. In the lab we are reducing our cycle time relative to the rest of the fields, a leading indicator of the productivity of our research. On the commercial side in the US in particular we and others have known for some time that the current entity model is not sustainable. Here too, I believe Merck is ahead of that field in accelerating to a new pharmaceutical business model that is centered around our customers. We look… we look every day for opportunities to improve our efficiency. We’ve now eliminated more than 8,000 positions throughout the company as part of our strategy to reduce our cost structure and create a linear and vulnerable business model. In this new area for the pharmaceutical industry, we must create a new way of operating if we are to succeed. We remain confident that our current portfolio and our pipeline along with the fundamental changes we are making in every aspect of our business position Merck well to drive against their goals now and in the long-term. To summarize, in the face of those expected and unexpected challenges, Merck delivered sound first quarter results. Our ability to reaffirm our 2008 non-GAAP EPS guidance despite business set back in the challenging industrial environment shows that we have the right strategy in place to drive Merck's long-term growth. We remain confident that our customers will continue to find value in our medicines and vaccines. In spite of the quarter’s solid performance and performance in the past prior few years make no mistake, we are not content. We are accelerating the pace of change in every area of Merck’s business. We have much to do to reach our 2010 goals and we need to do even more to achieve and sustain the benefit of our strategy through 2010, 2015 and beyond. Though we must and we will to ensure that Merck keeps doing what Merck does best, bringing forward medicines and vaccines that save and improve people's lives. Now I would like to first turn to... the call over to Ken and then Peter. After their brief remarks, we will take your questions. Ken?"
},
{
"speaker": "Kenneth C. Frazier",
"text": "Thank you Dick and good morning everyone. Merck's top line performance in the first quarter reflects continued strength across our diverse portfolio of product and in markets around the world. As Dick said, in the quarter where we sustained the impact of the loss of U.S. marketing exclusivity for FOSAMAX, total revenue in the quarter was up 1%, thanks to the positive contributions from both our in line and new products. In the first quarter, our international business performed very well increasing by 12%. While we clearly benefited from the prevailing exchange rates, we saw volume growth of 5% outside the U.S. driven by strong results in Japan, Asia and Europe. To drive further growth we will continue to roll out our new product globally and we anticipate conducting approximately 300 launches this year. In the U.S., when we exclude all products that recently lost patent protection and I remind you that FOSAMAX, COZAAR and ZOCOR sales were up 12%. Before discussing some of the specific product highlights for the quarter, I would like to take a moment to add to some of this comments regarding our cholesterol JV with Schering-Plough. The use of clinical trials and treatment guidelines for high cholesterol recognize LDL-C as the primary target of lipid-altering therapy. Both VYTORIN and adding value of simvastatin lower LDL more than simvastatin alone and get more patients to their LDL goals. Of greatest concern to Merck is that in the 10 weeks since the ENHANCE summary results were first provided, tens of thousands of patients have switched from VYTORIN to therapies that on average are less effective than VYTORIN at lowering LDL. And some patients, have simply stopped taking their medication altogether. This reaction directly contributing to what we know about the importance of lowering LDL. Together with our joint venture partner, we are doing as much as we can to remedy this situation. We are engaging directly with our customers to set the record straight about ENHANCE and the value that VYTORIN and that will bring to lipid management therapy. Within the first week after AETC, we reached out to or visited all managed-care customers and sent a letter and the press release directly to approximately 500,000 healthcare professionals. We also provided our sales representatives with appropriate materials for physicians so that the physicians felt informed about results of ENHANCE and were prepared for discussions with their patients. Managed Care organizations understand that simvastatin alone is not enough to get many patients to goal. Which is why patients need to have access to the LDL lowering benefits of VYTORIN and ZETIA. As of today, most of our Managed Care customers have reviewed the ENHANCE data and there has been no changes to the second tier status for VYTORIN and ZETIA. Many physicians put this study into the right context to feel that the AETC discussion has created confusion in the field. Most we expect will continue to prescribe VYTORIN and ZETIA but may increasingly reserve these medicines for their high-risk patients or for patients who cannot tolerate high doses of statin at least in the short term. Following January 14th, NRS [ph] market share dropped for about two weeks then began to stabilize. Unfortunately the events at AETC at the end of March created further confusion and although the reduction in share was not as steep as what we thought for January 14, we were already starting from a lower share. In the quarter worldwide sales of ZETIA and VYTORIN as reported by the Merck/Schering-Plough joint venture were $582 million and $651 million respectively in the quarter. In the US, sales of ZETIA were $395 million, down 3% and sales of VYTORIN were $456 million, down 7%. Ex-US, sales of ZETIA were $186 million, an increase of 37% and sales of VYTORIN were $196 million, an increase of 45%. In a few minutes, Peter will provide you with the financial implication of these events when he discusses the changes to our equity income guidance. But I want to reiterate what Dick said on this. We are very much engaged in this issue and are committed to helping our customers appreciate the unique values that these two medicines provide. Now I would like to discuss some of the key drivers of Merck's business in the first quarter beginning with our HPV vaccine GARDASIL. We're pleased with the global performance of GARDASIL in 1Q '08. Sales in the first quarter were $390 million, a 7% increase when compared to the first quarter of last year. In addition, during this first quarter our vaccine joint venture Sanofi Pasteur MSD recorded end market sales for GARDASIL of $240 billion. Taken together, global end market sales for GARDASIL reached a new high in 1Q, up 11% sequentially from the fourth quarter of 2007. I would like to update you on doses sold since approval for those who are tracking this measure. As of the end of the first quarter more than 26 million doses of GARDASIL have been sold since March. In the US, we estimate that more than 8 million 9 to 26 year-old females or roughly 23% of the eligible cohort have received at least their first dose. Peter will provide you with some details regarding our financial expectations for GARDASIL in 2008 but I would like to review for you some of the things we're doing to grow this important franchise for Merck. In the US, sales in the quarter reflected underlying market demand for GARDASIL and we saw continued growth in origination and utilization versus first quarter 2007. Allow me to remind you that our first quarter revenue last year benefited from initial purchases from a number of the VFC projects as they ramped up vaccination programs. Throughout the rest of this year we anticipate quarterly purchasing from the VFC to be more in line with the underlying demand. In the private sector GARDASIL experienced strong growth in the quarter increasing by 29% over the prior year. As we have previously mentioned, there is a seasonal component to the GARDASIL business in the US, in that nearly two thirds of well visit for 9 to 18 year olds occurred during the second and third quarters, with the third quarter being the highest. We continue to anticipate robust 2008 growth for GARDASIL in US and to see the seasonality again. We are focused on increasing vaccination rates across the entire 9 to 26 year old cohorts with specific emphasis on the 19 to 26 year olds. First, we are addressing the awareness versus action gap. While we have achieved high levels of awareness of the vaccine among 19 to 26 year olds, origination levels are not nearly as highly as those levels of awareness. We recently developed and launched new DTC ads, an interactive web portal to assist in this regard. We are also continuing to help OBGYN and primary care offices establish vaccination as part of their practices including addressing reimbursement. Although 99% of privately insured 19 to 26 olds have some level of coverage, there is a lack of consistency of vaccination coverage in many benefit plans and we're working to address this with our customers. We also continue working to increase compliance levels with for example, our “3 IS KEY” program and partnership with MCOs. “3 IS KEY” is being enhanced to make it easier for our customers to participate in this reminder program. Compliance rate for GARDASIL remain high compared to historical norms and private practices. Compliance rates are about 75%, for second dose and 50% for third dose. To drive further growth, we are expanding into other cohorts as well. Later this year, we anticipate launching GARDASIL for use by woman aged 26 through 45 and we plan to submit a regulatory application for use in males later this year. On a global basis, GARDASIL has been approved in 101 countries, most under accelerated review and based on the international approvals, recommendations, reimbursement, and launches, we are well positioned to continue to build on this success of this franchise in 2008. While GARDASIL continues its unprecedented launch, our other new and established vaccines are also performing extremely well and I note that this quarter our vaccine business nearly made it to the 1 billion mark. The launches for ROTATEQ and ZOSTAVAX continue to progress as reflected in the strong quarterly results. Please note that the sales of the ROTATEQ in 1Q08 benefited from a $41 million purchase to support the CDC stockpile. Moving to two more of our growth drivers, global revenue for JANUVIA and JANUMET reached $330 million in the first quarter reflecting the high-value that physicians, patients, and payers are placing on these personal medicines. We continue to build on the momentum we achieve with our product launch over the last 18 months. In the US, JANUVIA remains the second leading branded oral anti-diabetic agent in terms of the new prescription share behind only Actos. Our diabetes franchise continues to grow in both volume and market share. Both products continue to enjoy excellent position on formulary and the response from patient disposition continues to be positive. As you may have noticed, last week we initiated broadcast DTC for JANUVIA. With JANUVIA well established as a valuable treatment option, we believe the time is right to encourage patients with Type 2 diabetes to discuss their condition and available treatment options with their physician. Outside the US, sales for JANUVIA and JANUMET were $48 million, a two-fold increase over the fourth quarter 2007. In the first quarter, we launched JANUVIA at a number of major markets such as France, Spain, Italy and Canada. Based on early feedbacks from these markets we are off to a great start. We continue to focus on the global rollout for JANUVIA and JANUMET and we look forward to additional regulatory approvals, reimbursement decisions and market launches during the remainder of this year. Now I'd like to turn to ISENTRESS. We are extremely pleased with the uptake of ISENTRESS, the first-in-class integrase inhibitor since launched in the fourth quarter of 2007. First quarter sales of ISENTRESS was $47 million, up 58% sequentially. In the US the weekly NRS market share for ISENTRESS has already surpassed the weekly share of the last five new products introduced into the HIV market. ISENTRESS continues to benefit from strong managed care access that is available through AIDAC and Medicaid in all 50 states. In the quarter, ISENTRESS became available in 11 additional markets including the UK, Germany, France and Spain. By the end of the first quarter, ISENTRESS had received regulatory approval in a total of 43 countries on five continents. Uptake in our largest market has been strong already and we look forward to the continued success in 2008 to filing our application to expand the use of ISENTRESS to treatment-naïve patients. To ensure this breakthrough medicine gets to those who need it most, we continue to work closely with all stakeholders to foster patient access to ISENTRESS here in the US and around the world. We were very pleased with the global performance of SINGULAIR in the first quarter and sales grew 10%. The US Allergy scene has been somewhat slow to start this year compared to recent years and so far it also appears to be mild, although it's still early in this season. SINGULAIR is... and we expect it to remain the number one product in US respiratory market. The continued strong growth of SINGULAIR is a testament to the need for an effective non-steroidal medicine and it's effectiveness in adult and children with asthma or allergic rhinitis. Now I would like to take a couple of minutes to provide an update on the progress we're making in implementing our new commercial model. As I mentioned at the annual business briefing in December, our US pilot program spans six state and 11% of Merck's primary care business and involve some 700 Merck’s field and headquarters employees. In the pilot, we re-aligned our sales teams based on input from our customers and have begun creating new capabilities within the field in that headquarters. Our teams have also been gathering feedback from customers and employees involved in the pilot. We are now seeing the results of the pilot and we are finding that our new approaches are working. The early progress we have seen in the pilot has increased our confidence in our new customer-facing model and we have decided to move quickly to the next phase of our plan and begin working towards national deployment. Similar initiatives are also underway in international markets across our commercial organization with the same goal of evolving to a new business model that is centered around customers. A model designed to build trust and demonstrate value that is efficient and effective, expands Merck’s opportunities, fortifies our product performance and provides a platform for long-term business success. In closing, Merck's overall commercial operations continue to perform well. Merck enjoyed a leadership position in most of the therapeutic categories in which we have products. Our more established products continue to deliver strong performances including SINGULAIR, COZAAR/HYZAAR and VARIVAX. Taken together these established franchises along with our new first-in class vaccines and medicines such as GARDASIL, ROTATEQ, JANUVIA, JANUMET and ISENTRESS give us a diverse and broad product portfolio well positioned to drive revenue growth through 2010 and beyond. In addition, we are accelerating the deployment of our new customer-centric commercial model that we strongly believe will help deliver continued strong future performance. So with that, I'll turn the call over to my colleague, Peter Kellogg."
},
{
"speaker": "Peter N. Kellogg",
"text": "Thank you, Ken and good morning everybody. And as Dick and Ken have both mentioned, Merck posted a solid first quarter results despite the loss of patent protection for FOSAMAX as well as a decline in the expected sales from our Merck/Schering-Plough joint venture. The business is performing well. Merck reported first quarter non-GAAP earnings per share of $0.89, excluding $1.4 billion net after-tax gain from distribution received from the AstraZeneca Limited Partnership and restructuring charges. On a GAAP basis, as Dick mentioned earlier EPS for the quarter was $1.52. Now given the perspective that Dick and Ken have just provided and the extent of the details contained in our sales and earnings release, I'm not going to walk through all of the line items today. Instead, I will focus on how the key elements in the quarter has been incorporated into our full-year guidance. We have done a fair bit of work on this and after a lot of exhausted evaluation of all of our business drivers we've refreshed our financial guidance. I would like to discuss this and focus on how we thought about the business relative to our guidance. I will cover our guidance changes in four areas: first, how we have updated our revenue ranges for the current trends and expectations, many of which Ken just walked through. Second, how our cost performance to date has reflected in our guidance. Third, the implications of the Merck/Schering-Plough joint venture's revised forecast on equity income guidance and fourth the revised 2008 tax rate. Now let's begin with how we've changed our 2008 revenue guidance. As Ken talked about the health of the business, he provided context on the current trends and dynamics. As always to assist your modeling, we provide a breakdown of the product revenues in our other financial disclosure schedule attached in the press release issued this morning and you will note the following changes. Regarding 2008 revenue guidance, we are increasing several lines and reducing one element of our full-year revenue guidance. Net-net we increased our revenue guidance by $0.5 billion. So let me walk through that. On COZAAR and HYZAAR, we are increasing our expectation for 2008 by $200 million and now anticipate revenue in the range of $3.4 billion to $3.6 billion. This is primarily driven by the positive effect of foreign exchange considering the geographic segmentation of revenue for these products. Regarding FOSAMAX, we are pleased with the performance of the domestic FOSAMAX plus vitamin D product in the first quarter and the strength of our business internationally. And as a result, we are increasing our full-year guidance by $200 million to $1.3 billion to $1.6 billion. Considering the portfolio of key growth drivers captured within other reported products, we are increasing our expectation by $300 million and now anticipate revenue in the range of $7.8 billion to $8.2 billion for these products. This increase is supported by the positive effect of foreign exchange on these products as well. Given the non-complexity of the end market for vaccine and that there is no routine way to monitor utilization and importantly the fact that GARDASIL is becoming an increasingly large contributor to our vaccine revenue, we recognize that it's valuable to provide product specific guidance on GARDASIL. So to assist with your modeling we are now providing further breakdown. For GARDASIL, we anticipate full-year revenue as recorded by Merck to be in the range of $1.9 billion to $2.1 billion. We foresee robust growth for GARDASIL in the US in 2008 and quarterly purchasing from the VFC to be more in-line with underlying quarterly demand. To provide additional perspective, as Ken mentioned earlier, historically 63% of all penetration in the 9 to 18-year-old cohort occurred in the second and third quarter with the third quarter being the highest as Ken mentioned. And I think that perspective is very important to help you model out the quarters and understand the seasonality that we expect to see this year. By isolating GARDASIL for you, by difference, we anticipate the full-year revenue as recorded by Merck for other vaccines to be in the range of $2.9 billion to $3.1 billion. Regarding our agreement with AstraZeneca based on the Q4 results of supply sales to AZN and the Q1 performance of NEXIUM, we anticipate incremental pricing pressures in 2008 to negatively affect the revenue that Merck records from AZN. As a result, we are lowering our 2008 guidance for AZN supply sales by $200 million to reflect the current market conditions and now anticipate that these revenues will be approximately $1.3 billion to $1.5 billion. This lowering of guidance is solely attributable to the current market conditions for NEXIUM and in no way it signals a loss in economics following the settlement agreement and the patent-infringement litigation announced last week. Now let's turn to talk about how cost have been incorporated into our guidance, beginning with product gross margins. As a result of the strong PGM performance in the first quarter, we are increasing our full-year PGM guidance by 0.5%. The new range is now 77.5% to 78.5%. This increase in PGM was driven by favorable product mix in the first quarter. In addition, our gross margin improvements continue to be driven by establishing lean supply chains, leveraging low cost in external manufacturing and consolidating our manufacturing plant network much of which Dick commented on earlier. During the remaining three quarters in 2008, we anticipate a less favorable product mix to negatively affect PGM compared to the first quarter and particularly over the next three quarters, we will experience the full impact of the loss of marketing exclusivity for FOSAMAX on PGM. As always, this guidance excludes the portion of the restructuring cost that will be included in product cost and will affect reported PGM in 2008. So let's move down the P&L to marketing and administrative guidance. In 2008, we continue to anticipate marketing and administrative expense to be approximately $7.8 billion to $8 billion. For R&D, we reaffirm our 2008 R&D guidance of $4.7 billion to $4.9 billion and on the restructuring line as part of the company's restructuring of its operations additional cost related to site closings, physician eliminations and related costs will be incurred in 2008 and Dick discussed many of these earlier. We anticipate the aggregate 2008 pre-tax expense related to these activities to be in the range of $100 million to $300 million. Now let's turn to equity income. The disappointing events surrounding the ENHANCE results that Ken reviewed earlier has caused us to evaluate what scenario regarding the potential impact of the franchise is appropriate. As Ken mentioned, following the January 14th announcement market share dropped for about two weeks, then prescribing behavior moderated and share trends began to stabilize. Unfortunately the more recent statements and opinions expressed at the ACC at the end of the March created further confusion in the marketplace. So the Merck/Schering-Plough joint venture builds its new view of the 2008 outlook, it had to consider the following factors. Now let me go through them all. One, it appears that in both cases of share drop the NRS trends quickly stabilized and defined a new steady prescribing level as we have seen in the daily and weekly script data. Two, we have seen the more recent drop and share appears to stabilize although it is really still quite early, but it is not as much of a drop as we saw post January 14th. Three, in Q1 customers did reduce inventories in line with the lower demand in the US as well as inventory build that sometimes occurs when we are in the holiday period in the fourth quarter. That said, there may be some further adjustment in inventory in the second quarter in the US based on any additional decline in demand post ACC. Now just a note, we don't expect any change in the weeks of supply in the inventory channel. This is just a response to any changes in market share. Fourth, following the events of January 14th the Merck/Schering-Plough joint venture had carefully evaluated its entire cost base in an effort to optimize the income contribution to both its parents. We continue to carefully assess our investment strategy and we have incorporated our plan into this guidance. Now we do consider these further details on our investment and proprietary strategies to be proprietary so we won't be covering details of those today. And five, outside the US, the coverage and the impact following the January event was relatively minor and the international media coverage following the ACC Conference was somewhat higher but it really is too early to tell how full year results may be affected. Sales growth outside the US was up 41% versus Q1 in 2007 and we expect ex-US revenue to continue to grow. Accordingly with all of these factors considered, we are now incorporating revised Merck/Schering-Plough joint venture outlook into our 2008 equity income guidance. We now expected to be approximately $2.3 billion to $2.6 billion for 2008. The $700 million decrease in equity income guidance is solely attributable to lower anticipated contribution for the Merck/Schering-Plough joint venture. Just to be clear as previously disclosed the equity income guidance already included the impact of the reduction of the AZLP priority return and the buyout of the Astra USA products which occurred in March of 2008. So moving down the P&L, let's talk about taxes. As you can see our Q1 tax rate included two impacts. First the impact of the gain on distribution from the AstraZeneca Limited Partnership and restructuring charges. And both of these are taxed at roughly US domestic rates. Second we included the first quarter benefit of approximately 8 percentage points related to the realization of foreign tax credits. This is a discreet event based on operational aspects of our business and the full benefit of this change was captured in Q1. As a result of these two impacts, the first quarter effective tax rate on the GAAP P&L was 25.1% and the effective tax rate on the non-GAAP P&L excluding the impact of these items was 14.5%. Now I'd like to take a second to explain the revised tax guidance. The foreign tax credits rose as a result of prior year tax payments made outside the US in several countries in the normal course of conducting our business. The company was not able to recognize the benefits of these foreign tax credits in prior periods. However, based on the change in the planed distribution of certain prior year’s foreign earning, the company has determined that such credits are now realizable. So with these impacts incorporated into our P&L in the first quarter, this affects the full-year rate. There are no other changes anticipated to our tax rate in 2008 but the implication of this Q1 impact is that our rate for each of the next three quarters will be changed to drive the full-year rate. We are reducing our full-year 2008 non-GAAP tax rate guidance range to be approximately 20% to 23%. This guidance does not reflect the tax impact of the gain on distribution from AstraZeneca or restructuring costs. Now moving to share repurchase. Merck has been actively repurchasing shares. During the first quarter, the company continued its stock buyback program and purchased approximately $1.4 billion of treasury stock. This level of purchasing was triggered by the following factors. We do not repurchase in the second half of 2007 very many shares and we pulled forward some of our 2008 planed activity as we saw the value of the Merck equity debt and we viewed it as a buying opportunity. So in total to recap our 2008 guidance, the company continues to anticipate that many of our in-line and newer franchises will maintain their solid performance. We anticipate that worldwide revenue will be driven by additional indications of the company's product, the continued market uptick in global rollout of our new products, as well as other potential new introductions. On earnings per share, we are confident in our ability to execute against our plan and are reaffirming our full-year 2008 non-GAAP EPS range of $3.28 to $3.38 excluding certain items. We're making a slight revision to our 2008 GAAP EPS, which we now anticipate to be in the range of $3.84 to $4 per share. Now, given that we had an $0.89 non-GAAP EPS first quarter, we have analyzed the trends quarter-to-quarter and the company expects a generally even distribution of non-GAAP EPS across the remaining quarters in 2008. So in summary the company remains on track in terms of both strategy and performance to deliver a long-term double-digit earnings per share growth from 2005 to 2010 excluding certain items. We have financial strength, and remain fully committed to maintaining our dividend at the current level. At the same time, we continue to fully invest in our key strategic priorities. 2008 represented an important step in the multi-year journey to return Merck to its leadership position in the pharmaceutical industry. While we have faced certain challenges in the first three months of this year, it is important to note that much has been accomplished over the last 24 months. Many opportunities still remain and we look forward to capitalizing on them in 2008 and going forward. Thank you very much. Now, I’d like to turn the call back over to Graeme."
},
{
"speaker": "Graeme Bell",
"text": "Hey, thank you Peter. We will now open the call to take your questions. We will take the questions as always in the order they are received and try to get through as many as possible. So, at this point, I will turn the call back over to Cynthia, who will communicate instructions of our Q&A format and introduce the first question. Question and Answer"
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Your first question comes from Tim Anderson with Sanford Bernstein."
},
{
"speaker": "Tim Anderson",
"text": "Thank you, a couple of questions. SINGULAIR is now your biggest product and if I look at script growth in the US it’s recently slowed quite a bit. I think it's down in negative territory by about 15% or so and I'm hoping you can parse out that slowed growth rate by seasonality versus the safety issues that came up recently, what to expect from here in the US specifically? And then on VYTORIN and ZETIA I think Ken’s comments I am assuming formulary positioning that was for 2008 and with contracting from Managed Care for 2009 being essentially done, I am hoping you can give us an idea of how much 2Q slippage you might see with those products in 2009?"
},
{
"speaker": "Kenneth C. Frazier",
"text": "Thank you for those questions, Tim. Let me start with the second question. We continue to see from our Managed Care customers very strong understanding of the unique and valuable role of these two agents and we don't foresee significant changes at all in our Managed Care position. We've seen no changes and so we have no basis to actually predict changes going forward. We're very... we're very pleased with the reception that we've gotten in Managed Care, we've reached out to them. I think the Managed Care providers understand the limitations of the ENHANCE study and they understand the importance of these drugs are for their patients. On a SINGULAIR issue, we believe that the changes that you've seen largely at this time or the slow start if you will, has to do with the relatively late start for the Allergy season as well as a sort of a modest impact of the new NIH guidelines which gave a little bit of boost to inhaled corticosteroids. As it relates to the safety issue, I will remind you that those label changes were made in the fall of last year. Merck has been communicating those changes to it's customer base since that time and while I can't say that there is no impact yet because it's too early to say that there will be no impact of the concerns from the safety perspective we have not yet seen any substantial impact on SINGULAIR as a result of that. It's a drug that has 10 years of excellent experience on the market, it's got strong clinical trial data in the background, 32 million patient years of good faith experience that we continue to anticipate that it will continue to be the number one drug in the US respiratory market."
},
{
"speaker": "Graeme Bell",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Roopesh Patel with UBS."
},
{
"speaker": "Roopesh Patel",
"text": "Thank you. Just a couple of questions. First on GARDASIL, I was wondering if you could just clarify if the VFC purchase in this quarter was in line with underlying demand or was it higher or lower? And then separately on the tax rate, I just wanted to clarify, is the change in the full year guidance all due to the benefit of the foreign tax credits that has been recorded this quarter. I am trying to understand what could be the sustainable tax rate beyond 2008? Thank you."
},
{
"speaker": "Peter N. Kellogg",
"text": "Great. This is Peter. First let me answer the second question first, if I can on the tax rate. So yes, the full... the full year impact on our tax rate is solely driven by the impact of the foreign tax credit that we're now being able to recognize the benefit for. And the impact is larger than first one because it does capture, add a little bit of catch-up element to it and that will affect the... it obviously affected the first quarter tax rate but it will affect Q2, Q3 and Q4 because you're driving now the tax rate towards the full year rate. It will have a slight impact going forward beyond that because obviously this is now... these foreign tax credits we anticipate being benefit to us but if we are not getting guidance and it won't be anything of this magnitude going forward. Related... as regarding to the question on tax, now on GARDASIL Ken, do you want to --"
},
{
"speaker": "Kenneth C. Frazier",
"text": "Yes. With respect to VFC, as I mentioned earlier, last year's first quarter had the substantial benefit of the initial stocking in the public sector as programs ramped up for GARDASIL vaccination. We did not have a similar impact this first quarter and I would say that one of the issues that we continue to watch closely is the timing of large government orders which are not as predictable as the underlying demand. And that's why I pointed out, if you look at the underlying demand as measured by what’s happening in the private sector, we saw very strong growth year-on-year of almost 30% and that gives us confidence that GARDASIL is still a vaccine that is beginning a strong reception by patients, by women, their mothers and their caregivers."
},
{
"speaker": "Graeme Bell",
"text": "Thank you, Ken. Next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jami Rubin with Morgan Stanley."
},
{
"speaker": "Graeme Bell",
"text": "Jami, please go ahead."
},
{
"speaker": "Jami Rubin",
"text": "Can you hear me?"
},
{
"speaker": "Kenneth C. Frazier",
"text": "Please go ahead, yes."
},
{
"speaker": "Jami Rubin",
"text": "Can you hear me?"
},
{
"speaker": "Peter N. Kellogg",
"text": "Yes, we can, now we can."
},
{
"speaker": "Jami Rubin",
"text": "Okay, great. Just a question, sort of a policy question. To what extent do you view the recent action surrounding the ENHANCE trial involving the government investigation, the media attack, the ACC curveball etcetera as a passing storm or is this the brave new world that pharma executives have to come to terms with and make significant changes in the way you allocate capital to outcomes trials etcetera? I mean it seems to me that in this world, in this brave new world, the cost of failure in an outcome trial is obviously way too high. You've lost $40 billion of market cap over this among other things. So I'm just wondering if you could kind of talk around that? And secondary, if you could talk about plans for DTC for VYTORIN going forward?"
},
{
"speaker": "Kenneth C. Frazier",
"text": "Good morning, Jami, this is Ken Frazier. I think we all are looking into the future and through sort of a murky crystal ball now as it relates to policy. It is clear that the world has changed to some degree. It is clear that outcome studies are going to continue to be important going forward. But I think when the dust settles around ENHANCE people will come back to the primary goal of treatment which is LDL lowering and I think that people will continue to recognize that these drugs lower LDL more than simvastatin alone and will therefore continue to be very valuable drug and we will continue to go forward. As you know Merck has always been a company that believed in investing behind its products, investing in outcome studies. And so that will continue to be something that was important. We did that before. You remember going back to the 4S study we did those kinds of studies. We had those studies around COZAAR. We will continue to do those studies because we think they are important to patients as well as to the marketing of these drugs going forward and then what's the second question? I am sorry."
},
{
"speaker": "Graeme Bell",
"text": "DTC VYTORIN."
},
{
"speaker": "Kenneth C. Frazier",
"text": "Oh, I am sorry. On DTC, we made a decision to voluntarily suspend DTC advertising in the current environment. I will only say that we will continue to invest behind these two products as appropriate. We have not made any specific decisions as to when will we resume our DTC advertising at this time."
},
{
"speaker": "Graeme Bell",
"text": "Thank you. Cynthia, could we have the next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Norman Fidel with Alliance Bernstein."
},
{
"speaker": "Norman Fidel",
"text": "Thank you, it was already asked."
},
{
"speaker": "Graeme Bell",
"text": "Next question please, Cynthia."
},
{
"speaker": "Operator",
"text": "Your next question comes from Tony Butler with Lehman Brothers."
},
{
"speaker": "Tony Butler",
"text": "Thank you. Two brief questions. One, Peter you commented quite extensively on the tax rate, but could you say if in fact the tax credits were variable? That is to say, could you have taken less of a credit this quarter and spread it more evenly throughout the remainder of the year or did you need to take as much as you did and then the second... and if so why? And the second question, Ken you may be able to ask is, when you... assuming you do receive approval for GARDASIL for those over the age of 26 or 26 to 45, how does the message then to OBQ volumes and toward that population change, if at all? Thank you."
},
{
"speaker": "Peter N. Kellogg",
"text": "Great. Tony, it's Peter. I will take the first one. So, basically when you have an [inaudible] outlook for foreign tax credits like this, these foreign tax credits are basically taxes paid in other countries outside the US and then getting the benefit, an offset for those against US taxes. And basically when you conclude as you do a change in your plan distribution of earnings which then allows you to take a benefit of these foreign credit, you from an accounting standpoint, from a GAAP standpoint you actually have to book the full amount right there in the first quarter. It becomes as soon as discreet event from accounting problems. Obviously, it does affect the full-year tax rate though in fact you get the full-year tax rate impact but you do have to book it in the first quarter and that's appropriate and it's been reviewed by everybody. So we're very comfortable with that. And so we really don't have a choice per se, for example to spread it out during the year but obviously it does, it is an impact that rolls through the year. I hope that answers your question. The second question was related to the 26 to 45-year-old GARDASIL, the answer is --."
},
{
"speaker": "Kenneth C. Frazier",
"text": "Hi, Tony thanks for your question, let me start by saying that we do recognize that there are significant differences among audiences and we continue to learn as we do our market research from our customers about the kinds of programs and messages and materials that resonate well across these different age groups. As you might be able to see in our new television and advertising and our web presence, we continue to remain focused on providing innovative and large-scale initiatives that highlight the benefits of this vaccine for cervical cancer for general wards but actually tailor them to the lifestyles and interests and concerns of different age groups as well as their position within the coverage spectrum. So while I won't be able to say at this time for proprietary reasons what our specific messages are to this most senior cohort among our patient population, I will say that we recognize that there are differences in how they approach things but the core value of proposition of the product remains the same."
},
{
"speaker": "Graeme Bell",
"text": "Next question please, Cynthia."
},
{
"speaker": "Operator",
"text": "Your next question comes from Barbara Ryan with Deutsche Bank."
},
{
"speaker": "Barbara Ryan",
"text": "I am sorry, mine was answered. Thank you."
},
{
"speaker": "Graeme Bell",
"text": "Thank you, Barbara. Next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Catherine Arnold with Credit Suisse."
},
{
"speaker": "Catherine Arnold",
"text": "Good morning. I had two questions. First of all, if you could just give us some perspective on the change in equity income you had talked about some give-and-take on prescription trends and how it did seem like you've settled out after January pretty quickly and although you made the comment that the prescription trends after ACC dropped, but now seem to have stabilized again, is your assumption in the equity income forecast change that there is another drop to add some conservatism or are you assuming that we have reached bottom in terms of market share trends? And my second question is related to share repurchase, it looks like you've bought as much stock in the first quarter as you'd almost... pretty much comparable to last year's total. So given the share price and given what you have done, I guess it’s safe to say that your share repurchase might be much higher this year."
},
{
"speaker": "Peter N. Kellogg",
"text": "Catherine, let me take first. So first of all on the... second one, I think that is quicker and easy to take. The share repurchase you are right. So last year we actually... if you went to the second half of last year we did not repurchase a lot of shares. I mean, some ways were blocked as we went through the lot of the VIOXX dynamics. And so we had a much lower share repurchase activity last year. As we came into our 2008 planning and this was obviously get in sort of the capital planning for the company, we had a certain amount that we'd anticipated repurchasing and we didn't buy the whole amount in the first quarter but we did put forward some of what you might have considered to be a smooth purchase rate. We took some of the amount that we would have purchased in the balance of the year into the first quarter and blow it a little bit more heavily because we felt the value within, there had been some reaction perhaps in stock price. So I think that our ongoing share repurchase program is characterized more by stabilizing the number of shares outstanding and what we're seeing just as more of the timing and phasing when we actually made the purchases. But you're correct in that it did result and because of those two factors, a much heavier purchase activity in the first quarter. Regarding the equity income forecast and how we looked at that so obviously this is a sort of complex situation. I would just caution everybody. I think everyone in the call is [inaudible] this with this but obviously we have daily scripts, weekly scripts and monthly scripts and if you go from one or the other, you have to be careful what you look at. And we tend to work much more with the weekly and monthly scripts because it includes… the monthly includes the mail order and the weekly includes the long-term care channels. But as we have evaluated that, we did see a slight drop after ACC. We feel that that has stabilized somewhat, particularly on the new script side and we have modeled out what our expectations for the balance of the year. We don't really anticipate a dramatic further drop at any point. In fact, we feel that there has been a very strong reaction in the market already and I think Ken talked to that quite a bit in terms of the actions and communications that are important for patients who are trying to lower LDL. So, as we have modeled that out, we actually feel that at this point we've seen the reaction from ACC and we realize it is early but we had to make a call relative to how we forecasted and how we made our guidance."
},
{
"speaker": "Graeme Bell",
"text": "Next question please, Cynthia."
},
{
"speaker": "Operator",
"text": "Your next question comes from David Risinger with Merrill Lynch."
},
{
"speaker": "David Risinger",
"text": "Yes. Thanks very much. I have a couple of questions. First, would Merck management be surprised if Cordaptive is not approved at the end of the month? Second, could you just comment on how much US wholesaler inventory was worked down for VYTORIN and ZETIA in the first quarter? And then on ex-US VYTORIN and ZETIA sales were flat sequentially. Can you discuss the prescription trends since ENHANCE and whether prescriptions are flat on a month-by-month basis ex-US? Thank you."
},
{
"speaker": "Richard T. Clark",
"text": "Let me take the first and this is Dick Clark concerning Cordaptive. Obviously and this has been our policy from the beginning, the status of the pending application is really considered proprietary and therefore we can't make any comments on and so the FDA has taken action. But we do continue to anticipate an FDA action by the end of this month."
},
{
"speaker": "Kenneth C. Frazier",
"text": "On the two VYTORIN questions, first let me take the inventory question. In the first quarter of this year we noticed that customers were reducing inventories in line with the lower demand in the US as well as inventory build that occurred around the holiday quarter... holiday period in the last quarter. There may be some further adjustment in inventory in the second quarter in the US associated with any additional decline in the demand post-ACC. So that's basically what we know about the inventory levels. On the ex-US business as was mentioned earlier the immediate coverage and the impact following the January press release were minor. There was somewhat more extensive and more negative media coverage following the entire ACC conference, which could impact performance. But it is much too early to tell how the full year results might be affected. Sales outside the US or non-US, 41% versus the first quarter of 2007. So despite the controversies around ENHANCE, we expect sales to continue to grow ex-US. There was a modest sequential decline ex-US from the fourth quarter to the first quarter. And that trend reflects the typical seasonal pattern of stable franchises rather than I believe indicating any adverse effect from ENHANCE."
},
{
"speaker": "Graeme Bell",
"text": "Thank you, Ken. Next question please, Cynthia."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jim Kelly with Goldman Sachs."
},
{
"speaker": "Jim Kelly",
"text": "Great, thank you very much. First on GARDASIL, if you said this and I missed it I apologize, is there any assumptions inside your guidance for the cohort of 26 to 45? And then secondly, cost of goods, very impressive decline year-on-year at a time when a lot of the other companies are seeing some more currency pressures, is there something different about the amount of currency or with currency adjusted that would the decline have been even more material year-on-year? Thank you."
},
{
"speaker": "Kenneth C. Frazier",
"text": "On GARDASIL, we anticipate FDA action on the 26 to 45 year-old. But we can't speculate on the exact timing of the FDA's response and so we're not in a position to talk about any estimates around our marketing expectations for that cohort."
},
{
"speaker": "Peter N. Kellogg",
"text": "And on the cost of good Jim, thanks. So there is a lot of questions involved in the cost of goods sold and I do think that actually as we planned and managed our cost of goods around the world, we don't tend to see an big FOREX impact relative to revenue and so forth and so I don't think it was a bigger driver. There is some impact and we can follow-up on that point but in general, we tend to have a little bit more US denominated cost of goods sold. But I think, as I mentioned, this quarter and as you go through this year, you will see a fair bit of product mix effect and so you're seeing the combination of efficiencies that we have been talking about for quite some time and ENHANCE off to the whole Merck manufacturing division team on that, they have done a great job. But also you know, as you have FOSAMAX going on patent, as you have the very rapid growth of vaccines, and you also have the mix effects as well. So I think those are probably the bigger dive... the biggest drivers of all."
},
{
"speaker": "Graeme Bell",
"text": "So, given the time, we might have time for one or two more questions here. So Cynthia could we have the next question?"
},
{
"speaker": "Operator",
"text": "Your next question comes from Seamus Fernandez with Leerink Swann."
},
{
"speaker": "Seamus Fernandez",
"text": "Hello, and thanks very much. Just hoping that you could gives us a couple of data points. One, it's our understanding that the Phase... first Phase III data on the migraine drug MK-0974 could be presented in the near future. Could you confirm whether or not those data will be presented at the American Headache Society or is that still unclear? And then separately just on cordaptive, as you kind of think about your expectations coming into the year and guidance that you provided in late last year, can you just give us your expectations? Have those expectations changed at all given the volatility in the current environment assuming that cordaptive is approved?"
},
{
"speaker": "Kenneth C. Frazier",
"text": "Yes, Seamus, let me take the first... the second one rather on cordaptive relative to guidance. So, we... yes we have included some prospective on cordaptive in their guidance, but I would caution everybody it’s very minor. This is a year of launch, it’s initial year so it’s a very minor impact. So I think our 2008 guidance does not inch one way or the other on the... any outcome here this month with the FDA. Obviously there was an impact going forward. But right now, it really isn't a big 2008 factor, relative to the migraine drug, Graeme?"
},
{
"speaker": "Graeme Bell",
"text": "Yes, I can confirm these changes, you are correct, June 26 through the 29 is indeed The American Headache Society and we will be presenting Phase III data on MK-0974 in that scientific forum. So Ken and Peter given the time, we will take the last question, please."
},
{
"speaker": "Operator",
"text": "Your final question comes from Stephen Scala with Cowen. Stephen Scala - Cowen and Company Oh, thank you. Two questions. First, what is the status of varicella manufacturing validation efforts? And secondly, I am not clear why the change in the tax guidance is not due in part to the sizable cut in the guidance for cholesterol franchise equity income or are you saying that there are operational offsets that have boosted the tax rates to a similar extent? Thank you."
},
{
"speaker": "Peter N. Kellogg",
"text": "Okay. So, Steve I can take the second question first and then pass the varicella manufacturing to others. On the tax rate, there are... it's a fair question, there are always pushes and pulls and our different profit lines do have basically different tax rates. And so it's a different product mix, yes, you do have mix effect within our tax rate. We've always modeled that. Obviously, some of these things come up as surprise such as ENHANCE that we can deal with that. But those... and so, yes, we incorporate that. That's why we always give range of tax rates that we plan for. In fact, perhaps the ENHANCE results and the impact that had on the joint venture has actually perhaps hurt the tax rate probably. But the bigger factor really is the fact that we are now getting the benefit of these foreign tax credits for taxes paid overseas in our core operations. And this is obviously just for a select number of countries. So I'd say it's more of that event, the foreign tax credit utilization benefit than anything related to the Merck/Schering-Plough joint venture. On the varicella manufacturing."
},
{
"speaker": "Richard T. Clark",
"text": "Steve, in relationship to your question about varicella, the FDA is in the process of reviewing our regulatory submissions. We cannot provide a specific approval date. However, we expect to hear back from the FDA regarding the status of the review in the next few months. So, it's positive from the standpoint of our manufacturing process standpoint."
},
{
"speaker": "Graeme Bell",
"text": "Thank you, Dick. So that last question concludes the Q&A session of the call. The information from today's call, both the transcript and replay will be available on our website for the next several months. And as always, Mike and I will be available whole day to take your calls and any incremental questions. So let me now turn it back to Dick Clark for some final comments."
},
{
"speaker": "Richard T. Clark",
"text": "Thank you Graeme and thank you all for joining us on the call today. The plan-to-win strategy we put in place back in 2005 has enabled us to improve efficiency while at the same time growing the top line. 2008 represents the half-way point of our plan and we are on track. Of course, new challenges will always emerge. So we have proven before that Merck is a resilient company and I am confident that this management team along with the entire organization has the sense of urgency and the sharp focus that are essential to our success. We'll continue to work hard to grow our pipeline and re-engineer our business. We'll lead to deliver sustained revenue and earnings growth through 2010 and beyond. So thank you again. We appreciate your interest and your participation. Have a good day."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's Merck first quarter 2008 earnings conference call. You may now disconnect."
}
] | null | null |
MRK | 4 | 2,007 | 2008-01-30 17:00:00 | Operator: Good day, everyone, and welcome to Merck's Fourth Quarter 2007 Earnings Conference Call. Today's call is being recorded. At this time I would like to turn the call over to Mr. Graeme Bell, Head of Investor Relations. Please go ahead, sir.
Graeme Bell: Thank you Amanda and good morning. Welcome to our call this morning to review our business results for the fourth quarter of 2007. Joining me on the call today is our Chairman, President and CEO, Dick Clark; Mr. Peter Kellogg our Executive Vice President and Chief Financial Officer and we are also joined by Executive Vice President and General Council Bruce Kuhlik. Before we get into the details, I would like to go with our logistics as always. On this call, we will review the results contained in the release we issued at 07:30 this morning and you can access this through the Investor Relations section on merck.com and I would remind you that this conference call is being web cast live and recorded. The replay of this event will be available later today via phone, web cast and as always our pod cast. As we begin to review the results, let me remind you that some of the statements made during this call may discuss certain subjects that may contain forward-looking statement as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and involve risks and uncertainty, which may cause results to differ materially from those set forth in the statements. The forward-looking statements may include statements regarding product development, product potential or financial performance. No forward-looking statements can be guaranteed, and actual results may differ materially from those projected. Merck you undertakes no obligation to publicly update any forward-looking statements whether as a result of new information, future events or otherwise. Forward-looking statements on this call should be evaluated together with the many uncertainties that affects Merck's business, particularly those mentioned in the risk factors and cautionary section set forth in Item 1A of Merck's form 10-K for the year ended December 31, 2006, and in its periodic reports of Form 10-Q and Form 8K which the company incorporates by reference and that are all posted on our website. We'll begin the call with brief remarks from Mr. Clark and Mr. Kellogg, then we'll open the call for questions and expect the call to last approximately an hour. So, with that, I will turn the call over, and we'll begin with remarks from our Chairman, President and CEO, Mr. Clark.
Richard T. Clark: Thank you Graeme and good morning, everyone. Earlier this morning we announced the results for the fourth quarter and full-year 2007 and we're joining you now to discuss them in greater detail. I am pleased that today we have another solid set of results with growing revenue and non-GAAP EPS to talk about. The momentum Merck has gained through our consistent performance over the prior seven quarters is seen in our strong quarter and overall annual results. And we delivered those results notwithstanding an uncertain short-term economic outlook and the impact of major patent expirations. I want to thank everyone at Merck for helping to get the company back on track and out performing in terms of innovation, execution of our new commercial model, and delivering shareholder value. I am confident that our continued focus on our plan to win will enable us to accomplish our business goals, help us address emerging challenges, and achieve Merck's purpose to discover and develop break through medicines and vaccines. The results reported today show that Merck continues to deliver on our promise to remain a leader in the pharmaceutical industry. For the fourth quarter we reported revenue of $6.2 billion, which represents top-line growth of plus 3% versus the prior year. For the full-year 2007 we recorded revenue at $24.2 billion, plus 7% higher than 2006. Based on a continued market penetration and global rollouts of our new product introductions over the past two years, including GARDASIL, ROTATEQ, JANUVIA, JANUMET and ISENTRESS we're on track for sustained growth in 2008 and deliver long-term double-digit EPS growth from 2005 to 2010 excluding certain items. During 2008, we will continue to assertively launch our new products globally and ensure that as many patients as possible worldwide have access to our innovated and needed medicine and vaccines. Our most established products also continue to deliver strong performances, including SINGULAIR, COZAAR, HYZAAR, ZETIA, and VYTORIN. Taken together, these established franchises along with our new first-in-class vaccines and medicines such as GARDASIL, ROTATEQ, JANUVIA and JANUMET and ISENTRESS give us a diverse product portfolio that is well positioned to drive revenue growth through 2010. Merck reported full-year 2007 non-GAAP earnings per share of $3.20, which excludes fourth quarter charges related to the U.S. VIOXX settlement agreement and several government investigations. Restructuring charges and an insurance arbitration gain. Our full-year GAAP EPS were $1.49. For the fourth quarter, non-GAAP EPS were $0.80 excluding previously disclosed items. On a GAAP basis, we had a $0.75 loss per share. Looking at our next-generation products, I am please to report that with the most recent approval EMEND for Injection, we have achieved eight approvals in 24 months. That's a great example of the benefit of our new business model as it relates to the regulatory filing processes. GARDASIL’s performance in 2007, its first full year on the market was an exceptional $1.5 billion in sales. Fourth quarter sales were $339 million. To date we had distributed more than 20 million doses of the vaccine worldwide since its market launch just a year and half ago in June of 2006. GARDASIL has been approved in 93 countries, and is being ready for launch in 76 of those countries. Together global revenue for JANUVIA and JANUMET reached nearly $300 million in the fourth quarter reflecting the high value that physicians, patients and payers are placing on our products and on the healthcare benefits they provide. This result also demonstrates that we continue to build on momentum established with our product launches last year. In fact, JANUVIA has already become the second leading branded oral antidiabetic agent in the U.S. in terms of new prescription shares. As we move into 2008, JANUVIA has achieved second tier reimbursement coverage in more than 200 million lives across managed care commercial formularies in the U.S. Ex-U.S. it is available in more than 65 countries including the recent approval in Canada. In the European Union, JANUVIA already has received full reimbursement in 14 countries. The introduction of ISENTRESS is realization of Merck's 20-year commitment to HIV AIDS. We're working hard to build on the successful launch of ISENTRESS to ensure that it reaches its full market potential. We will continue to work closely with all stakeholders to foster patient access to ISENTRESS. And to assist patients in need, we have established a support program in the U.S. I'm very encouraged that our business continuous to deliver substantial growth. This has been another outstanding quarter for Merck as our new products establish their leadership in an increasing competitive market even as old products have got off patent. We are leveraging lessons learned from our new product in vaccine launches and utilizing the new commercial model to further support and consolidate the strong positioning of our established in line brands. Our success is helping us invest in Merck's future as we continue to fully fund our research spending on investigational product development, the acquisition of NovaCardia and more than 50 new license opportunities in therapeutic areas that are of strategic importance to Merck. Our overall financial results were supported by the strong performance of our partnership and alliances, specifically the Merck/Schering-Plough partnership which is… in 2007 continued to drive our equity income. I want to take a moment now to address the ENHANCE trial. There are couple of points I would like you to take away from this subject today. First of all, Merck stands behind the safety and efficacy profiles of both ZETIA and VYTORIN. Next, we acted with integrity and with faith in connection with the clinical trial. Third, let's keep this trial perspective. ENHANCE was not powered or designed to assess cardiovascular clinical event outcomes. As many know, we have a large clinical outcomes trial underway called IMPROVE-IT. IMPROVE-IT trial is intended to measure clinical event dates in more than 10,000 patients with acute coronary syndrome. IMPROVE-IT is examining ezetimibe/simvastatin 1040 versus simvastatin 40, and the relationship between LDL lowering and overall reduction in cardiovascular mobility and mortality in this patient population. Fourth and perhaps most overlooked in the ENHANCE trial. VYTORIN significantly lower LDL cholesterol compared to simvastatin alone. As the FDA noted last week in a news conference, elevated LDL cholesterol is very well established risk factor for heart disease. These important findings are also reflected in the National Cholesterol Educational Panel guidelines that continue to identify LDL cholesterol as a primary target for lipid modifying therapy, and that recommended lower target goal levels for LDL over time. Clinical studies, which are included in VYTORIN's prescription information, had demonstrated that VYTORIN lowers patient's LDL cholesterol more than the TORVASTATIN or [inaudible] or simvastatin at the doses study. Many patients with elevated cholesterol cannot achieve their cholesterol treatment goals with diet and exercise. Many of those patients also cannot achieve their treatment goals with statins alone. As we said, we plan to discuss the enhanced data in a proper scientific context at the American College of Cardiology Meeting in March. Again, let me emphasize that operating with the highest standard of ethics and scientific integrity are the utmost personal importance to me, and are the foundation of this company. We will continue to work hard to respond to any allegations to the contrary. At the same time, Merck will not for a second lose focus of our overarching message and that is improving [inaudible]. For 2008, the company continues to anticipate that many of our in-line and newer franchises will maintain their strong performance, and we look forward to launching additional new products such as Cordaptive if approved and our investigational atherosclerosis compound currently under standard review with the FDA. We anticipate that worldwide revenue will be driven by additional indication for our company's products, and that continued marketing up take and global rollout of our new products as well as other potential new introductions. When taken together, all of this should help us offset the upcoming loss of marketing exclusivity for FOSAMAX our second largest product in the U.S. In addition during 2008 we plan to file two NDAs for products currently in Phase III, mainly MK-524B for atherosclerosis and MK-364 for obesity. To position ourselves for commercial success in 2008 and beyond we will begin to prepare for their perspective launches. On earnings per share we are confident in our ability to execute against our plan and are reaffirming our full-year 2008 non-GAAP EPS range of $3.28 to $3.38 excluding certain items. We're making a slide revision to our 2008 GAAP EPS, which now anticipates to be in the range of $3.80 to $4. Peter will provide additional details in a moment. We are halfway through the strategy outlined in 2005 in our Plan to Win. We have made some real strides realizing the benefits of our strategy. We implemented a new research model, and I am confident that we will bring greater focus and efficiency to our early compound development. We’ve also made significant progress towards creating standard global processes for late stage clinical development. Our new Global Human Health organization is in place representing a significant change from the way we have operated in the past. We're beginning to make in-roads towards a new customer centric commercial model both in the U.S. and in other key markets around the world while also changing the way we support our global market franchises. Across our global franchises we have introduced new stage gates to help us fine-tune the focus of our research activities on the highest value areas in terms of customer need and probabilities of success. These changes are bringing us closer to achieving our goal of becoming a more flexible, effective and efficient company. For example, our manufacturing division and the Merck supply strategy have led the way in returning Merck to pre-Zocor patent expiry PGM, a year earlier than we anticipated, establishing lead supply chains, leveraging low costs and external manufacturing, and consolidating our manufacturing plant network. As you know, such global restructuring activities are a part of our overall strategy to further reduce our cost structure and create a leaner and more nimble business model so that we can respond quickly and efficiently to customer expectations, address emerging market demand, and support the drug discovery and development efforts that are core to our business model. As we implement fundamental changes to every aspect of our business, we remain confident that our current products and anticipated new product introductions as well as our cost savings initiatives will help us position the company to deliver what we promised in December of 2005. To generate revenue growth in the range of 4 to 6% on a compound annualized basis from 2005 to 2010, including 50% of the revenue from the joint ventures from which the company derives equity income. By sustaining our cost management initiative, Merck expects to fulfill our promise to expand the product portfolio while maintaining marketing and administrative expense flat in 2010 relative to 2006 base, and we continue to expect compound annual double-digit earnings growth excluding restructuring charges and one-time items by 2010 from a 2005 base. In summary, our performance in 2007 is proof that the customer focused more efficient business model we began implementing more than two years ago is delivering results. With our strong portfolio of products, our robust pipeline of potential new therapies, and our leadership team focused daily on improving operational performance, I am convinced that Merck is well-positioned to build on its record of delivering essentially break through medicine and vaccines to the global marketplace. However, despite a strong 2007 performance, I see no room for complacency. As I will tell my senior management in our Annual Strategy Meeting this week, it is way too soon to declare victory, although we remain confident that our customers will continue to find value in our products, we have much to do to reach our 2010 goals. And we'll need to do even more to realize and sustain the benefit our strategy through 2010, 2015, and beyond. Now I would like to turn the call over to Peter who will provide additional comment on the details of our 2007 results and 2007 financial guidance. Then we will take your questions. Peter.
Peter Kellogg: Thank you, and good morning. As Dick mentioned, we're pleased with the fourth quarter and full-year business results. Throughout 2007 our in-line product portfolio and our newly launched pharmaceutical products and vaccines help drive strong organic growth overcoming the impact of the Zocor and Proscar patent expiries. We continue to significantly reengineer our business to ensure that we have a sustainable operating model that can weather the upcoming loss of marketing exclusivity for FOSAMAX. These successes allowed us in 2007 to deliver 10% revenue growth including 50% of our JVs and 27% non-GAAP EPS growth despite patent expirations that exceeded $2 billion. Finally, we continue to make the necessary pipeline investments both internally and externally to position the company for long-term success. For 2008, we remain on track and we are reaffirming our non-GAAP EPS guidance and the guidance elements for the operating line that support this. Now related to our GAAP guidance we are, one, increasing our restructuring reserve, or restructuring guidance rather for 2008 as we continue to drive efficiencies, and, two, lowering the estimate for the minimum gain associated with the AVLP restructuring in 2008 based on new information that has come in and basically just update the calculation for the minimum gain. Accordingly, I will discuss our adjusted GAAP EPS guidance for 2008 later. The fourth quarter non-GAAP EPS growth, excluding restructuring costs and certain items was driven by several lines in the P&L, all with strong results. Let's go through these lines individually. First, the revenue line grew 3% reflecting strong performance of our new vaccines and [inaudible], the continued market leadership for SINGULAIR and our newly launched pharmaceutical products including as Dick mentioned; JANUVIA, JANUMET, and ISENTRESS. Secondly, our product gross margin line showed continued strength and this is the result of sustained operational efficiencies and favorable mix. Finally we benefited in the fourth quarter on the tax line. Now I will go through each of these lines in more detail in a minute, but let me start with revenue. In the fourth quarter our total revenue was $6.2 billion, that's a 3% increase over the same period last year as I just mentioned and it is composed of the following. 1% decline in volume, a 4% increase from foreign exchange, and a 1-point increase from price. On a full-year basis for 2007 our total revenue was $24.2 billion, and that's a 7% increase over the same period last year including a 4% increase in volume, 2 points of increase from foreign exchange and no growth from prices. And again, this growth was achieved in a year where we overcame $2 billion of patent expires. Now, a major contributing factor to our top line growth continues to be our vaccine business. In the fourth quarter, the vaccines revenue as reported by Merck was approximately $1.1 billion that's a 59% increase as compared to the same period in 2006. On a full year basis in 2007 our vaccine revenue as recorded by Merck was approximately $4.3 billion. That is a 130% increase over 2006. So, now let's discuss the specific products beginning with GARDASIL. We continue to be extremely pleased with the progress of GARDASIL in terms of the U.S. market penetration and the global rollout. Based on the international approvals, recommendations, reimbursements and launches, we're well positioned to continue to build on the success of this franchise in 2008. In the fourth quarter our revenue of was $339 million, $268 million of which was in the United States. Now, U.S. GARDASIL sales were down sequentially in Q4 due to seasonality and some supply chain dynamics in the public sector, I would like to discuss each of these separately. First, seasonality in what we call well visits for the adolescent cohort is heaviest in Q2 and Q3, really not surprisingly given the typical pattern of back-to-school visits by this cohort group. This results in a 63% of well visits typically occurring in Q2 and Q3. Secondly, in 2007 the public sector sales were heavily weighted towards Q1 and Q2 driven by very rapid adoption by all 55 projects following the November 2006 VFC contract. As a result, please note that 64% of the VFC sales occurred in Q1 and Q2. Now, outside the U.S. the Sanofi Pasteur MSD joint venture recorded end market sales for GARDASIL of $231 million in the fourth quarter. Despite the seasonal spike in the U.S. demand for GARDASIL in Q3, global end market sales for GARDASIL reached a new high in Q4, and in its first full year on the market, 2007 revenue as recorded by Merck for GARDASIL was roughly $1.5 billion. GARDASIL’s performance in 2007 has been unprecedented for a vaccine launch. Now, looking forward in the U.S. we estimate that more than 7 million nine to 26-year-old females have received at least their first dose of GARDASIL, and significant opportunity remains with over 29 million nine to 26-year-old females that is yet to receive a dose of GARDASIL. In 2008, we are focusing on increasing penetration across the initial nine to 26-year-old cohort and improving the compliance rates for second and third doses. We also anticipate expanding label for GARDASIL through incremental indications, including an indication for adult women through 45 years old, an indication for adult women with more than double the eligible population for GARDASIL in the U.S. To date, GARDASIL has been approved in 93 countries, most under accelerated review, and has launched in 76 countries. In 2008 we anticipate launching GARDASIL in over 20 markets, and as continue the global rollout of GARDASIL, we look forward to capitalizing on this significant international opportunity. So, as per plan, the international launches are just now beginning to pick up, and they will be a significant driver for the franchise in 2008 and beyond. Now let's move to VARIVAX. In the fourth quarter revenue was $270 million. That's a 187% increase over prior year. This strong quarterly result is the function of two major factors. First, we continue to make progress within the cohort's eligible for second dose Varicella in the first full year of the new recommendation. As of December 31, we estimate 80 to 85% penetration of the routine four to six-year old second dose cohort, and 20 to 25% penetration of the cumulative catch-up population. Second as a result of the back-to-school surge that makes Q3 the peak period for the youth vaccine business and the unprecedented demand for VARIVAX in 2007, we were able to ship approximately $75 million in back orders for VERIVAX in Q4. By the end of Q4, the back orders for VARIVAX were pretty much negligible. Accordingly, Merck is further increasing production of VARIVAX and expects to meet anticipated market demand for Varicella measles, mumps, rubella vaccine through VARIVAX and MMR2. Now let’s turn to SINGULAIR. In the fourth quarter our SINGULAIR revenue was $1.2 billion, that's up 20% year-over-year, and on a full-year 2007 basis our revenue was $4.3 billion, up 19% over prior year. The strong growth for SINGULAIR was driven by continued market share gains in the U.S. for both asthma and allergic rhinitis claims, and secondly rapid growth in foreign markets where on a full-year basis we saw 27% year-over-year growth, as a result of additional indications and a differentiated product profile. Despite the recent slow down in respiratory market share and potential new competitive threats, we continue to anticipate strong growth for SINGULAIR in 2008. Now turning to FOSAMAX, our fourth quarter revenue was $796 million, up 1%, and on a full-year basis for 2007 the revenue was $3 billion, that's a 3% decline. In its last full quarter of marketing exclusivity, FOSAMAX has performed extremely well as a result of differentiation on efficacy, that relates to hip fracture indications and spine fracture indications as well as the relevant managed care status of the brand now and its generic counterpart in the future. An authorized generic strategy is in place to maximize the value of the franchise after patent expires. As we have illustrated with the Zocor expiry in the past, we have the necessary new and in-line products to drive revenue growth through this event in 2008. Now let's look at total revenues including 50% of joint ventures. In the fourth quarter, our total revenue including the 50% of joint ventures was $7.5 billion, that's a 7% increase if you do the same adjustment in the base period. On a full-year basis for 2007, revenue including 50% of joint ventures was $28.8 billion, a 10% increase over the comparable 2006 figure. As we have stated many times, we have the opportunity to capitalize on our robust product portfolio and deliver solid revenue growth through 2010. Despite certain patent expires during the time frame that we talked about, we continue to expect revenue growth of 4 to 6% including 50% of our JVs on a compounded annual basis, of course this is driven by our in-line products, our launched products and our potential new products. And of course this 4 to 6% as I mentioned includes 50% of the revenues of the joint ventures from our 2005 base. Now regarding 2008 revenue guidance, we are reaffirming all elements of our full-year revenue guide guidance. As always to assist your modeling, we provide a breakdown of the product revenues in our other financial disclosure schedule attached to the press release issued this morning. Let's go down to P&L over the next line, which is materials and production. In the fourth quarter materials and production were $1.5 billion. This quarter includes $118 million for costs associated with the global restructuring program, primarily related to accelerated depreciation and asset impairment costs. Excluding these costs, material and production decreased 5% in the quarter. Our fourth quarter product gross margin was 75.3%. This reflected a 1.9 percentage point unfavorable impact related to the restructuring costs, excluding these restructuring costs, we had a fourth quarter PGM of 77.1%. Just as in previous periods these results were affected by the final product mix. On a full-year 2007 basis, our adjusted product gross margin was 76.6%. Looking forward in 2008 we anticipate… or we continue to anticipate PGM in the 77 to 78% range. This guidance excludes the portion of the restructuring costs that will be included in product costs and will affect the reported PGM in 2008. Moving to the next line, marketing and administrative. Our Q4 marketing and administrative expense was $1.7 billion, and that's a 27% decrease over prior year. But let me provide you with some additional perspective on that. Included in the fourth quarter marketing and administrative expense is a previously disclosed $455 million gain related to insurance proceeds which the company was awarded in the arbitration with the company's upper level excess product liability insurance carriers. These claims related to coverage for costs incurred in the VIOXX product liability litigation. Also as previously disclosed, in connection with the U.S. VIOXX settlement agreement, the company recorded a pre-tax charge of $4.85 billion, which represents the fixed amount to be paid by the company to settle qualifying claims. Note that we have broken out this charge on its own line in the income statement. During the fourth quarter the company did not increase the reserve related solely for future legal defense costs of VIOXX litigation. However, in the fourth quarter the company spent approximately $200 million in VIOXX legal defense costs which resulted in a reserve as of December 31, 2007, of approximately $522 million solely for its future legal defense costs related to the VIOXX litigation of which approximately $80 million has now been allocated to Merck's anticipated future costs to administer the settlement. Consequently as of December 31, 2007, if you add this up, the company had an aggregate reserve of approximately $5.372 billion related to the VIOXX litigation. Excluding these charges in 2006 and 2007, M&A decreased 2% in the fourth quarter and increased 4% for the full year. A significant portion of the increased spending is attributable to fluctuations in foreign exchange rates, which have increased significantly during the last twelve months as I am sure you're all aware. Of course we do see this as a benefit on our top line revenues as I mentioned earlier, but this does increase our marketing and administrative dollars and dollar build. So, regardless of foreign exchange, we maintain a healthy amount of support behind our growing core and successful new franchises many of which are continuing their global launch activities market by market in 2008. Reflecting our commitment to realizing efficiencies throughout the company and optimizing our cost structure, the component of marketing and administrative consisting of selling and general administrative costs that support our core operations remained down over the prior year. Finally, we are comfortable with the focus of these investments and it is important to note that we continue our increased focus on cost management, and we are seeing the positive benefits of practical ongoing cost management initiatives including the redesign of many of our critical business processes. Now looking forward in 2008, we continue to anticipate marketing and administrative expense to be approximately 7.8 to $8 billion for 2008. Moving to research and development, our fourth quarter R&D expenses were $1.4 billion, that's a 20% decrease year-over-year. However, it is a 10% growth when you… if you were to exclude the Sirna in-process R&D charge in the prior year. Our full year 2007 R&D expenses were $4.9 billion, that's a 2% increase year-over-year but again if you make the adjustment for the Sirna in-process R&D charge and restructuring in the base period, it is a 15% growth. Let me take a moment to explain the R&D result. We remain committed to fully funding our core internal R&D ensuring the continued success of all compounds in all phases of development. Our internal R&D growth remains strong. We continue to invest in Lifecycle Management programs for GARDASIL, JANUVIA, and ISENTRESS and late-stage clinical trials on our MK-524 program, the MK-364, MK-974, MK-7418 from NovaCardia and MK-8669 from ARIAD and the MK-822 and our other investigational vaccines. And I guess it is a good thing that I have to read off that many numbers related to Phase III programs. In addition, the company continues an active external collaboration and business development agenda funding clinical grant programs, third-party scientific collaborations and licensing transactions, and of course all of that is in our R&D line. Our guidance for R&D in 2008 is that we reaffirm the guidance that we previously given of $4.7 billion to $4.9 billion. Now turning to restructuring costs, the fourth quarter total cost associated with the global restructuring program was $274 million, $118 million as I mentioned earlier for asset related charges were included in the materials and production line. The restructuring cost line reflects $156 million of costs for employee separation and other related costs associated with approximately 1,200 position eliminations bringing the total to 7200 since the initiative started. As we continue to reengineer our business, we will look for opportunities to drive further efficiencies. As part of the company's restructuring of its operations, additional costs related to site closings, position eliminations, and related costs will be incurred in 2008. We anticipate the aggregate 2008 pre-tax expense related to these activities to be in the range of $100 million to $300 million. Now let's turn to equity income. In the fourth quarter our equity income from affiliates was $796 million. Our Q4 performance reflects the continued success of the Merck/Schering-Plough cholesterol franchise in the U.S. and Europe and an increasing contribution from our European vaccine joint venture, Sanofi Pasteur MSD, which I am sure is not a surprise to any of you. Turning to guidance for equity income, the recent public confusion surrounding the enhanced results although disappointing has caused us to consider whether any different scenarios regarding the potential impact to the franchise are appropriate. At this time, based on the limited data it is too early to make informed judgments or to change the long-term trajectory that is expected for this franchise. At this time, we believe we're looking at more of a reaction in the market than a real ongoing trend. In addition, the equity income contribution that we record is from a portfolio of several joint ventures and partnerships. On an annual basis there are always positives as well as negatives within the portfolio. At this time, we feel no need to adjust our 2008 equity income guidance and are not changing our range of $3 billion to $3.3 billion. Now turning to the taxes on income, the effective tax rate of 48.7% and 2.8% for the fourth quarter and full-year 2007 respectively reflects the impact of the U.S. VIOXX settlement agreement charge, civil government investigations charge, and the gain related to the insurance arbitration settlement previously referenced. Given the charges in the fourth quarter and the full year, it is helpful to look at the non-GAAP tax rate. Our non-GAAP tax rate for Q4 and full-year 2007 were 18.4% and 24.1%. Of course that 24.1% is at the low-end of our guidance range. These rates reflect the favorable impact of an adjustment related to the termination of Puerto Rico tax benefits and fourth quarter adjustments related to certain federal and state tax items. Looking forward, we are reaffirming that our full-year 2008 tax rate guidance range stays intact, and I would direct to you today's press release for details. So coming to the bottom line on net income and earnings per share, in the fourth quarter on a GAAP basis we had a net loss of $1.6 billion or on a per share basis that was a loss of $0.75. However, excluding the restructuring charges, the big litigation reserves, and proceeds from an insurance gain, the Q4 non-GAAP earnings per share was $0.80 per share. On a full-year basis, our net income was $3.3 billion, and the GAAP earnings per share was 1… was $1.49, again excluding the restructuring charges, litigation reserves and proceeds from an insurance gain the full-year 2007 non-GAAP earnings per share was $3.20. Turning briefly to 2008 guidance, I have mentioned several elements as part of the results review, and I would direct to you the details of our guidance contained in today's press release. In summary we are reaffirming our 2008 non-GAAP EPS guidance of $3.28 to $3.38 excluding certain items. On a GAAP basis, we now anticipate GAAP full-year 2008 EPS of $3.80 to $4. So in summary, the company remains on track, both in terms of strategy and performance to deliver long-term double-digit earnings per share growth from 2005 to 2010, excluding certain items. We have financial strength, and we remain fully committed to maintaining our dividend at the current level. At the same time, we continue to fully invest in all of our key strategic priorities. 2007 represented an important step in a multi-year journey to return Merck to its leadership position in the pharmaceutical industry. While much has been accomplished over the last 12 months, many opportunities remain, and we look forward to capitalizing on them in 2008 and beyond. So, with that said, I will turn the call back over to Graeme. Graeme?
Graeme Bell: Thank you, Peter. We appreciate your patience as we go through the prepared remarks. We will now open the call to take your questions. We will take them as always in the order they're received and try to get through as many as possible for the duration of the call. So, at this point I will turn the call back over to Amanda who will communicate instructions for the Q&A format, then introduce the first question. Amanda? Question and Answer
Operator: Thank you. [Operator Instructions]. Your first question is from Barbara Ryan with Deutsche Bank.
Barbara Ryan: Oh, thank you so much for taking my question. Just a short one Peter for you and I guess you addressed it that was really related to the tax rate, and I know you went through the other reasons. But I know in Pfizer's case two there was a lower tax rate in part because of the geographic mix, which really swung and then it happened to be in their instance low tax countries as well. And I was just wondering if that played a role as well?
Peter Kellogg: Yes, Barbara, this is Peter. Thanks. Every quarter, we have a little bit of geographic mix, in fact, although I wouldn't say that that was the primary driver this quarter. The reason our tax rate was little off trend in the fourth quarter was… again I am referring this now on a non-GAAP basis, which is I'm assuming what you are looking at. It was more related to the termination of the Puerto Rico tax benefits that we were seeing and also some fourth-quarter adjustments to certain Federal and State tax items, and these were really kind of items that touched our reserves relative what our expectations were as we closed the things out we were able then adjust the reserve. So it is sort of a… each quarter we looked at our reserves relative to our… what we know about our tax positions and quite frankly in the fourth quarter these were more adjustments to that. So it's a little bit of mix but it is much more the adjustments later those three items that caused this benefit. Again, I would just highlight that it's more happened in the fourth quarter. As we move into 2008, I think we run right back into our ongoing tax rate that we’ve always talked about both in terms of guidance and what you should expect.
Graeme Bell: Next question please.
Operator: Your next question is from Jamie Rubin with Morgan Stanley.
Graeme Bell: Amanda, perhaps you can move on to the next question, maybe that Jamie's phone is on mute.
Operator: Yes sir. Your next question is from John Boris with Bear Stearns.
John Boris: Okay. Thanks for taking the questions. Peter, I think you characterized the ZETIA/VYTORIN situation as a reaction in the media rather than an ongoing trend, just three-part question to this. How many weeks or months do you need to be able to establish your trend for the joint venture? Secondly, are you seeing any impact on your ex-U.S. business from all of the media hype in the United States over the enhanced results? And then the third part, can you just talk about first line use in the United States for VYTORIN and what percent of first line use is made above of VYTORIN’s use? Thanks.
Peter Kellogg: Okay, John thanks. So first of all, I think the data we have right now is obviously the daily scripts and then we have one-weekly tabulation in excel [ph]. We are very cautious about leading daily scripts. We acknowledge that's the only thing that's out there to look at, but we often find it doesn't always represent exactly the trend that you would want for the… it doesn't think well with the weekly and monthly recap. So we're very cautious about looking at daily scripts and join broad full-year conclusions on that. And I think that quite frankly there just has been a tremendous amount of various points of view and opinions floating around the market. It can be a little bit disruptive and create reactions. I really believe that as the full body of evidence is kind of digested in the medical community and as the full data of course of the trial is released, I would expect to see the market trends really emerge at that point based on a much more complete and scientific evaluation of what this trial really means or doesn't mean. Secondly, the ex-US business really has not been affected. This has been pretty much of a US phenomenon at this point, and I think again the international medical community is… I think, not reacting quite as much to some of the news lines, and probably most of the new lines are a little bit more US centric. Related to the first line usage of VYTORIN… I little bit apologize not able to answer that question, and I think maybe we can come back to you on that later in the call. But John we've noted that, let me come back to that later in the call if we have that data. Okay, apologize for that one.
Richard T. Clark: I other point John, when you think about ZETIA and VYTORIN ex-US, we certainly had a very strong fourth quarter. So for example ZETIA grew at 40% versus fourth quarter ‘06 and VYTORIN grew at 84% in Europe. And in the Far East, it was 67% for ZETIA and greater than 100% for VYTORIN. So we continue to see strong growth for ZETIA and VYTORIN outside the U.S.
Graeme Bell: The next question please, Amanda.
Operator: Your next question is from Jami Rubin with Morgan Stanley.
Jami Rubin: Thank you. Can you hear me, okay?
Graeme Bell: Hi Jami.
Jami Rubin: Can you hear me? Okay, great, just a comment. Peter, we’ve discussed this a lot before in the past, but your stock is down 25% since the ENHANCE controversy on January 14, and I would just think with $10 billion in cash from operations, you've just received $2.5 billion from Astrazeneca, VIOXX settlement is now behind you, hopefully, or really closed. I can't think of a better time to announce a major stock buyback program. But my question also has to do with, again going back to ENHANCE, are you aware that the negative publicity has in any way affected patient dropouts in the IMPROVE-IT trial? And then my second question… I just wanted to just ask this, but GARDASIL sales outside the U.S. or rest of world sales that you’ve book, your sales were $70 million versus $90 million in the third quarter, yet you are in the process of launching in a number of markets, can you give us a sense of what's going on and how we think about that trajectory going forward? Thanks.
Peter Kellogg: So couple of questions. Let me… why don’t we take them in order that you laid them out. So I think you are just making a comment about the stock buyback. I think the only thing I would just remind everybody and you see it in our press release is that as of December 31, we had $5.1 billion approved by our Board under the current buyback authorization. And that obviously compares to $6 billion outstanding as of September and clearly the points you made are not lost on us, we understand that, in fact we were just saying. On ENHANCE, on the IMPROVE-IT dropout, I don't think we've seen any reaction at all in that trial approval or participation and nor we necessarily expect to see that at this point. Related to GARDASIL sales, I think clearly one of the things that you do see as you roll out sort of bumps and ins and outs and so forth, and some volatility sometimes as you go through quarters. There were a couple of markets that had pretty heavy activity in Q3 and then didn't have this quite same activity in Q4. But we don't really read that as a trend at all and these are kind of some of the short-term volatility elements that you get in supply chain or just the roll out activity in the market. Quite frankly, when we stack up all the different data points and the approvals and the authorizations and the activity level, and the awareness of GARDASIL in international market that we're looking at, you know, the kind of things we look at when we put together our plan, really GARDASIL is poised to have a really good year internationally. So, we've… we aren't really concerned about quarter fluctuations and I would encourage everybody to look forward and recognize not only the number of approvals that have come through, but how many of them were actually accelerated approvals and have got our authorization and reimbursement status that is around the world. So I really think we're headed for something, you know, where I wouldn't raise much of that quarterly fluctuations during a launch as really look at the preponderance of all that positioning.
Richard T. Clark: I would make two other comments on that Jami. First, as we said GARDASIL sales in 2007 were $1.5 billion and we have a tremendous amount of confidence and expect continued growth globally for GARDASIL in 2008 above that number. And so, we are very confident as we roll it out throughout the world. The second point which we've said in the past is that females 9 to 26, if you look at the EU and US and other high-income markets it is about 118 million. And as you know with our December submission for 27 to 45 year old women that 118 goes up to 264. And so, there is a substantial up tick and up growth that we can provide based on the enhanced indications for the vaccine. But we are very confident where GARDASIL is going to be in 2008.
Peter Kellogg: And could I just go back to John Boris' question if I may for a moment, just… with regard to managed cash and the use of VYTORIN. So, in the aggregate managed care organizations have all recognize the need for a product with excellent LDL efficacy, notwithstanding the availability of generic simva. But in terms of, the book of business, we basically indicate that about 93% of the business comes from continued therapy, 4% of our business comes from patients who are new to market, who are initiating therapy and who are being naive to therapy previously. 2% of it comes from brand switches and about 1% of utilities with add-on. So that just give us some perspective in terms of where the business comes from relative to VYTORIN. So, with that Amanda, could I have the next question please?
Operator: Your next question is from Tony Butler with Lehman Brothers.
Tony Butler: Thanks very much. Given much of the coupons [ph] from the Congressional investigation, I'm curious that how you are feeling about the regulatory nature of Cordaptive and do you think that the FDA is actually shy about approving a new therapy despite the fact that, there were very bullish about nice based outcome studies on the call Friday. And second to that question is, are you actually increasing the number of details today for VYTORIN and ZETIA. And moreover could you go over or at least expressing some comments regarding the future for DTC adds? Thanks.
Peter Kellogg: Well certainly, speaking first of VYTORIN and ZETIA. I think that the joint venture between Merck and Schering-Plough in the last few weeks has done an outstanding job of reaching out to healthcare professionals, possibly 95% of the top specialist and 90% of the PCP's have been called on by our representatives post the press release. All these representatives were provided with a letter that we have sent and really have follow-up calls and so we're really helping the physicians… physician products come correctly and I think we have got favorable response from that as well, favorable response from the patient as that have been put in the majority of the [inaudible]. I think, in addition all the managed care organizations have been contacted by us, there haven't been any changes and so I think we have done a fairly good job of really focusing on physicians to make sure we could put this in proper context and provide them the information that they needed and we are continuing to get good feedback from that. To your question about Cordaptive, it was reassuring on the FDA call on Friday where they said at this point, we believe it is premature to embark on any systemic changes, now approved with the lower end drugs because we believe there is a long track record of success in the approach that we've followed over the past several decades. So I think that's reassuring from a… not only a Cordaptive basis but to make sure patients stay on their cholesterol lowering products in order to lower their LDL, patients will give off of it based on some of the media hype that you see that would be a terrible [inaudible] from a healthcare stand point. I think that's important and we are evaluating our DTC advertising as we move forward.
Richard T. Clark: And Tony, you know I would just add that as we stated in December, with Peter Kim at the Annual Business Briefing we went through with you how extensively we have studied Cordaptive as we were approaching this regulatory submission. So we won't go through that again, but I would just point you that, as a point of reference to our confidence in terms of the filing relative to those remarks. So next question please Amanda.
Operator: Your next question is from Tim Anderson with Sanford Bernstein.
Tim Anderson: Thank you, a few questions please. I would have to imagine that you guys have heavily contemplated getting full enhanced results out earlier than the late March meeting of ACC, you know may be published in something like a medical journal, because until results are published, your reps of course are very limited in what they can say to prescribers, so any comments on that. The second question just going back to DTC, I thought the original word out of Merck was that DTC was temporarily suspended, but that it would resume in a very short course and I'm wondering if that's changed, and then on Cordaptive do you expect that will likely go up for an FDA advisory committee?
Richard T. Clark: On the last point, we have not been advised of any advisory committee to date, on your point concerning publishing, we are working with the lead investigator, who will submit the enhanced study for publication and attribute that is done, it assumes we can… and so that is being certainly studied.
Tim Anderson: Regarding DTC?
Richard T. Clark: DTC we are still evaluating to make sure we do it the proper way and so it is, I would say temporarily on-hold.
Graeme Bell: Thanks Tim, Next question please Amanda.
Operator: The next question is from Harlan Sonderling with Columbia Management.
Harlan Sonderling: Yes, thank you very much. I wanted to ask, in light of the enhanced trial, whether you're changing the sales effort on the ground that is, you're not changing yet the DTC advertising beyond the temporary suspension, you have commented on the results of the enhanced… getting the enhanced results out. What are your reps telling physicians and have you changed that message please?
Richard T. Clark: We are making sure that we have all available resources for both the joint venture and the companies to make sure that we are able to get out our press release to make sure that we are able to share the health care providers the physician we put together from the later standpoint. The most critical thing we have to make sure is that we are able to continue to deliver the message that LDL lowering is key, and so in some cases, for LDL lowering the patient may do well on a generic simvastatin. In many other cases, they won't be able to reach full and if that's the case, VYTORIN and ZETIA are the brand products that we have been able to prove clinically lower LDL to the right impact and have the better chance to reach the goal. And those messages haven't deviated. We got a very safe products in the marketplace and they are very important part of the management program. And our perhaps [ph] the representatives continue to deliver those message and ask those questions. But we are obviously not backing off those two products, because they are so important from a health management standpoint and we are making sure that we can answer any questions, because with the media hype there is a great deal of confusion out there. And we have obviously the excellent comments by the FDA and the other societies that have come out and said LDL lowering is key to this and quite frankly there are no better products for LDL lowering than VYTORIN and ZETIA.
Graeme Bell: Next question please, Amanda?
Operator: Your next question is from James Kelly with Goldman Sachs.
James Kelly: Thank you very much. I just wanted to ask a question to get a little bit more detail on the trajectory of the vaccines. I know you mentioned about the seasonality elements, but there were also some other elements, and I apologize if you did address this in the prepared comments, and I missed it, of some catch up vaccinations, and whether or not that's already substantially done as far as you're hearing back in the chickenpox second dose and catch up there, or any of the other pieces that may be other than… may be other than seasonality? Thank you.
Peter Kellogg: James, this is Peter. Thanks. So lot of different parts to your question quite frankly. So, yes there is seasonality in the vaccines business, as I mentioned just… at least on the pattern of well visits for adolescent, you do see a fairly healthy back-to-school surge. I also commented on the call, I hope this is directly addressing that as of year-end, we estimate that 80 to 85% penetration of the routine 4 to 6 year old second dose cohort of VARIVAX has been achieved and 20 to 25% penetration of the cumulative catch-up population has been achieved. The other thing is we did have some back orders coming at the end Q3 and I mentioned that in Q4 we shifted $75 million to completely fulfill that backorder situation. I think that is the point that you're asking, if I missed it, please come back, I apologize.
Graeme Bell: Next question please, Amanda?
Operator: Your next question is from Roopesh Patel with UBS.
Roopesh Patel: Thanks. Just a couple of questions, first on VYTORIN and ZETIA, can you summarize for us of the clinical data that is expected to be presented for VYTORIN and ZETIA, besides ENHANCE over the course of the next 12 months. And then on GARDASIL just a clarification, Peter you mentioned that supply-chain dynamics influenced fourth quarter sales, was that just the VFC purchasing patterns over the course of the year or was there something else that influenced fourth-quarter sales? Thanks.
Peter Kellogg: Yes, hi, Roopesh this is Peter. Let me take it in reverse order. I will take your last question first. So the supply-chain dynamics were more in the public sector, you are right. So it was really the VFC contract. And what we saw was very rapid adoption and pick-up of the product by all the different various public sector sales entities. So, as a result that drove heavier sales volume in Q1 and Q2 of us shipping product out, and then as we went to the balance of the year, we saw that some of the supply chain items balanced out and get kind of sorted through and so as we came to the third and fourth quarter, we ended up with a little bit of a rebalancing some of that inventory. And that's… it's a very fragmented system and obviously that is kind of just a dynamic at first sometimes when you roll out these vaccines. Hard to know exactly also what's going on as we go, because there isn't just enormous amount of inventory reporting out here, but it was all public sector.
Richard T. Clark: And Roopesh, with regards to the first part of the question with regard to expectations of clinical data dissemination, obviously, we got ACC in March for ENHANCE. With regard to CEASE [ph], we expect to have the data in 2008 on CEASE, then you have Sharp. The expectation is we have clinical data in 2011 and as we’ve mentioned IMPROVE-IT, which is still enrolling, we expect the data to be out in 2011 as well. So between now and 2011, 2000, the four studies will be disseminated. Next question please, Amanda.
Operator: Your next question is from David Risinger with Merrill Lynch.
Richard T. Clark: David, please go ahead.
David Risinger: Yes, can you hear me?
Richard T. Clark: Yes.
Peter Kellogg: Yes.
David Risinger: Yes, so to follow-up on CEASE and IMPROVE-IT, if you could please characterize what Merck expects out of the CEASE study that would be helpful. And also if you could please comment on whether there is a possibility of accelerating IMPROVE-IT or the possibility of an interim look at the data before 2011 that could be made public. Thank you.
Richard T. Clark: Dave, with regard to those two studies, clearly there are protocols in place and we've shared some of that information with you. We certainly can't foreshadow when exactly the results will be available nor do we have here the exact setup in terms of the Data Monitoring Boards and how the data will roll out of those studies. Clearly the protocols are in process and as you know, this one particular study looking at aortic stenosis and the other one is looking at another patient population. So, across ENHANCE, CEASE, Sharp and IMPROVE-IT, obviously IMPROVE-IT is the critical outcome study in all of that. We feel that there will be an awful lot of incremental data that will gather with regard to these compounds. Next question please, Amanda.
Operator: Your next question is from Chris Schott with the Bank of America.
Christopher Schott: Great, thank you. Just three quick questions, maybe just on GARDASIL in Europe, obviously we saw some strong acceleration this quarter. Could you give us a more color in terms of what countries are driving this system and just initial contracts driving that and maybe where you stand versus your competitor in those markets with regards to any tenders that have occurred? For GARDASIL in the U.S., just to clarify, do you expect the vaccine for children sales to continue to be front-half loaded going forward or was that really just been our fact of what you're mentioning it of initial rollout? And then finally if you could give us an update on the potential timing FDA sign off for new batches of Varicella, both [ph] please. Thanks.
Bruce Kuhlik: Yes, let me take, if I can, the second one, which is the vaccines for children dynamic and supply chain. Good question. We don't anticipate this to be an annual cycle at all. This is very much in artifact of the appeasable and the new contract was established in late 2006, and so then the market reaction is picking up the supply and so forth. So this is not a manual cycle, we'd expect. It was much more related to a, if you will, a approval and changing conditions since the market reacted to that. I don't think that there will be any expectation of a seasonality per se and it’s a buy dynamics for the year in public sector. Related to the GARDASIL international markets, in some ways international rollout… first of all, I think it's way too early to have a lot of input on tenders and so forth. But I would say is that, we don't see anything that's kind of an unusual biased at this point relative to any of the markets start rolling out. Typically you do see certain markets pick-up vaccine, rollout internationally a little more rapidly than others, but in some of the bigger markets obviously, you are playing a role, but I don't think there is anything really that a strange dynamic, let's say and the rollout at this point. In fact, I did say that all the numbers are relatively early based. So we are just beginning to roll out and expect 2008 to be an interesting year to watch. Maybe more specifically, Dick [ph] do you have anything to comment on?
Richard T. Clark: On the bulk [ph] issue with the FDA, [inaudible] Varicella… it’s too early to tell exactly when we would finalize our submission and they would have approval. As I said on our last call, we continue to see excellent progress and excellent potency out of the lots that are being manufactured. And so we are putting all of the required data together and the submission for the FDA, and if we can't get the data on this.
Richard T. Clark: So, Amanda given the time, we have time for one more question, please.
Operator: Your final question is from Seamus Fernandez with Leerink Swann.
Seamus Fernandez: Thanks very much. Just a couple of quick questions. Can you give us a little bit of visibility on when the 30-month stay expires on Nexium and how -- any kind of a possibility of a Nexium patent settlement would impact the contribution to Merck from AZLP, if there were a settlement, it’s unclear to me, how that would be booked into the overall scope of the partnership. Just a second quick question, Peter, you mentioned new competitive threats in asthma and allergic rhinitis. Can you just give us a little bit more of a sense of what those new competitive threats are in your view? And also last year we had a very, very strong allergy season and the seasonality and I think that it was high. Can you just give us a sense, do we have any visibility right now on whether or not that that season is expected to be equally strong this year or not? And then just a last question quickly on Q4 costs related to the vaccine recalls that we saw, were those material in any way and can we kind of expect those to recur or not recur in the first half of this year? Thanks very much.
Peter Kellogg: Okay. So, you get the award for the most comprehensive set of questions, and let me quickly go through them. But I am afraid, if I miss one, we need to kind of recap. So let me get a little Bruce’s help here. So first let me start back with the Nexium, and basically the stay goes through April of this year. So that's the date where you are going to see the 30-month of stay will expire. Quite frankly, after that when we have no idea of what might happen. However, obviously we are going through normal legal steps right now and have been working on that. If there was some sort of a settlement, it's unclear what that settlement would be, but it’s unclear that it will really affect 2008 anyway. I mean, that would be something that we would all be in the work. So, you are way too early to comment on that, but I'd say at this point we are following the normal steps in a number of legal processes related to that. So, nothing really new to report in nor any sense of anything new that would happen really in that situation. Bruce Kuhlik, Bruce, do you have any other comment on that?
Bruce Kuhlik: No, Peter. Thanks. I mean the stay does, the initial one expire in April. But the fact, the stay expires do not have any bearing on meaning actually that a generic will launch at that time, and we are continuing actively [inaudible].
Peter Kellogg: Okay. In terms of the asthma season, I don't, I think it’s little bit too early to start reading into the asthma season. We would – as the CFO I would love to have a crystal ball, but at this point, I just don't have it. So we just have to play that that season as it goes. So we really don't have any leading indicators and in fact I am not sure there are. On the competitive threats relative to SINGULAIR, really what I was referring to was just new brand entrance in 2008 that we are anticipating a phenomenal lift. I think we are pretty confident in the guidance we have given for 2008 on SINGULAIR. So I didn't mean to create any concern I just want to highlight that SINGULAIR has just been whirling ahead. As you mentioned probably because the asthma seasons, we have been experiencing so forth and to have a $4.3 billion growing to 19% full year in 2007 is something is pretty great. On the other hand, what we are just highlighting is there are the factors as you said, naturally '08, exactly in asthma season and/or new competitors in the market. That was all I will tell you.
Richard T. Clark: And then Seamus with regard to your question on the cost of the recall during the quarter, it wasn't material in any particular way. So let me just give you some perspective. The total cost of the recall was approximately $40 million in the fourth quarter, approximately half of that cost was associated with sales credits to customers and the other half was associated with inventory that we had to write down that we had it in supply chain. So, we didn't consider the PEDVAXHIB and COM recall to be a material event to our results.
Peter Kellogg: So, I think that covers all the points they were. So good towards the question, thanks.
Graeme Bell: So that last question concludes today's conference call. The intimation from today's call both the transcript and the replay will be available on the website for the next several months. And as always Mike Nally whose birthday is today and I will be available all day to take your calls and answer your incremental questions. So with that let me pass it back to Dick for some concluding remarks.
Richard T. Clark: Thank you, Graeme, and thanks for joining us on the call today. As we have clearly stated we are very pleased with the fourth quarter and full-year 2007 results. We are not wasting any time looking at where we mirror and congratulate ourselves. We are proud of how far we have come, but we have tremendous amount to do before we hit that finish line. 2008 represents the halfway point towards our long-term guidance. And new challenges pop up every day. We begin our 2008 with a sense of urgency and a sharp focus on what we need to do. We will continue to work hard to build our pipeline and re-engine our business to deliver sustained revenue and earnings growth beyond 2007. I think it's also important to note that in addition to all the activities we are talking about, we have a 150 country launches in 2008 for our products in vaccine, that’s a 150 new product launches. So thank you again. We appreciate your interest and participation. Operator, thank you very much for your assistance.
Operator: This concludes today's conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day, everyone, and welcome to Merck's Fourth Quarter 2007 Earnings Conference Call. Today's call is being recorded. At this time I would like to turn the call over to Mr. Graeme Bell, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Graeme Bell",
"text": "Thank you Amanda and good morning. Welcome to our call this morning to review our business results for the fourth quarter of 2007. Joining me on the call today is our Chairman, President and CEO, Dick Clark; Mr. Peter Kellogg our Executive Vice President and Chief Financial Officer and we are also joined by Executive Vice President and General Council Bruce Kuhlik. Before we get into the details, I would like to go with our logistics as always. On this call, we will review the results contained in the release we issued at 07:30 this morning and you can access this through the Investor Relations section on merck.com and I would remind you that this conference call is being web cast live and recorded. The replay of this event will be available later today via phone, web cast and as always our pod cast. As we begin to review the results, let me remind you that some of the statements made during this call may discuss certain subjects that may contain forward-looking statement as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and involve risks and uncertainty, which may cause results to differ materially from those set forth in the statements. The forward-looking statements may include statements regarding product development, product potential or financial performance. No forward-looking statements can be guaranteed, and actual results may differ materially from those projected. Merck you undertakes no obligation to publicly update any forward-looking statements whether as a result of new information, future events or otherwise. Forward-looking statements on this call should be evaluated together with the many uncertainties that affects Merck's business, particularly those mentioned in the risk factors and cautionary section set forth in Item 1A of Merck's form 10-K for the year ended December 31, 2006, and in its periodic reports of Form 10-Q and Form 8K which the company incorporates by reference and that are all posted on our website. We'll begin the call with brief remarks from Mr. Clark and Mr. Kellogg, then we'll open the call for questions and expect the call to last approximately an hour. So, with that, I will turn the call over, and we'll begin with remarks from our Chairman, President and CEO, Mr. Clark."
},
{
"speaker": "Richard T. Clark",
"text": "Thank you Graeme and good morning, everyone. Earlier this morning we announced the results for the fourth quarter and full-year 2007 and we're joining you now to discuss them in greater detail. I am pleased that today we have another solid set of results with growing revenue and non-GAAP EPS to talk about. The momentum Merck has gained through our consistent performance over the prior seven quarters is seen in our strong quarter and overall annual results. And we delivered those results notwithstanding an uncertain short-term economic outlook and the impact of major patent expirations. I want to thank everyone at Merck for helping to get the company back on track and out performing in terms of innovation, execution of our new commercial model, and delivering shareholder value. I am confident that our continued focus on our plan to win will enable us to accomplish our business goals, help us address emerging challenges, and achieve Merck's purpose to discover and develop break through medicines and vaccines. The results reported today show that Merck continues to deliver on our promise to remain a leader in the pharmaceutical industry. For the fourth quarter we reported revenue of $6.2 billion, which represents top-line growth of plus 3% versus the prior year. For the full-year 2007 we recorded revenue at $24.2 billion, plus 7% higher than 2006. Based on a continued market penetration and global rollouts of our new product introductions over the past two years, including GARDASIL, ROTATEQ, JANUVIA, JANUMET and ISENTRESS we're on track for sustained growth in 2008 and deliver long-term double-digit EPS growth from 2005 to 2010 excluding certain items. During 2008, we will continue to assertively launch our new products globally and ensure that as many patients as possible worldwide have access to our innovated and needed medicine and vaccines. Our most established products also continue to deliver strong performances, including SINGULAIR, COZAAR, HYZAAR, ZETIA, and VYTORIN. Taken together, these established franchises along with our new first-in-class vaccines and medicines such as GARDASIL, ROTATEQ, JANUVIA and JANUMET and ISENTRESS give us a diverse product portfolio that is well positioned to drive revenue growth through 2010. Merck reported full-year 2007 non-GAAP earnings per share of $3.20, which excludes fourth quarter charges related to the U.S. VIOXX settlement agreement and several government investigations. Restructuring charges and an insurance arbitration gain. Our full-year GAAP EPS were $1.49. For the fourth quarter, non-GAAP EPS were $0.80 excluding previously disclosed items. On a GAAP basis, we had a $0.75 loss per share. Looking at our next-generation products, I am please to report that with the most recent approval EMEND for Injection, we have achieved eight approvals in 24 months. That's a great example of the benefit of our new business model as it relates to the regulatory filing processes. GARDASIL’s performance in 2007, its first full year on the market was an exceptional $1.5 billion in sales. Fourth quarter sales were $339 million. To date we had distributed more than 20 million doses of the vaccine worldwide since its market launch just a year and half ago in June of 2006. GARDASIL has been approved in 93 countries, and is being ready for launch in 76 of those countries. Together global revenue for JANUVIA and JANUMET reached nearly $300 million in the fourth quarter reflecting the high value that physicians, patients and payers are placing on our products and on the healthcare benefits they provide. This result also demonstrates that we continue to build on momentum established with our product launches last year. In fact, JANUVIA has already become the second leading branded oral antidiabetic agent in the U.S. in terms of new prescription shares. As we move into 2008, JANUVIA has achieved second tier reimbursement coverage in more than 200 million lives across managed care commercial formularies in the U.S. Ex-U.S. it is available in more than 65 countries including the recent approval in Canada. In the European Union, JANUVIA already has received full reimbursement in 14 countries. The introduction of ISENTRESS is realization of Merck's 20-year commitment to HIV AIDS. We're working hard to build on the successful launch of ISENTRESS to ensure that it reaches its full market potential. We will continue to work closely with all stakeholders to foster patient access to ISENTRESS. And to assist patients in need, we have established a support program in the U.S. I'm very encouraged that our business continuous to deliver substantial growth. This has been another outstanding quarter for Merck as our new products establish their leadership in an increasing competitive market even as old products have got off patent. We are leveraging lessons learned from our new product in vaccine launches and utilizing the new commercial model to further support and consolidate the strong positioning of our established in line brands. Our success is helping us invest in Merck's future as we continue to fully fund our research spending on investigational product development, the acquisition of NovaCardia and more than 50 new license opportunities in therapeutic areas that are of strategic importance to Merck. Our overall financial results were supported by the strong performance of our partnership and alliances, specifically the Merck/Schering-Plough partnership which is… in 2007 continued to drive our equity income. I want to take a moment now to address the ENHANCE trial. There are couple of points I would like you to take away from this subject today. First of all, Merck stands behind the safety and efficacy profiles of both ZETIA and VYTORIN. Next, we acted with integrity and with faith in connection with the clinical trial. Third, let's keep this trial perspective. ENHANCE was not powered or designed to assess cardiovascular clinical event outcomes. As many know, we have a large clinical outcomes trial underway called IMPROVE-IT. IMPROVE-IT trial is intended to measure clinical event dates in more than 10,000 patients with acute coronary syndrome. IMPROVE-IT is examining ezetimibe/simvastatin 1040 versus simvastatin 40, and the relationship between LDL lowering and overall reduction in cardiovascular mobility and mortality in this patient population. Fourth and perhaps most overlooked in the ENHANCE trial. VYTORIN significantly lower LDL cholesterol compared to simvastatin alone. As the FDA noted last week in a news conference, elevated LDL cholesterol is very well established risk factor for heart disease. These important findings are also reflected in the National Cholesterol Educational Panel guidelines that continue to identify LDL cholesterol as a primary target for lipid modifying therapy, and that recommended lower target goal levels for LDL over time. Clinical studies, which are included in VYTORIN's prescription information, had demonstrated that VYTORIN lowers patient's LDL cholesterol more than the TORVASTATIN or [inaudible] or simvastatin at the doses study. Many patients with elevated cholesterol cannot achieve their cholesterol treatment goals with diet and exercise. Many of those patients also cannot achieve their treatment goals with statins alone. As we said, we plan to discuss the enhanced data in a proper scientific context at the American College of Cardiology Meeting in March. Again, let me emphasize that operating with the highest standard of ethics and scientific integrity are the utmost personal importance to me, and are the foundation of this company. We will continue to work hard to respond to any allegations to the contrary. At the same time, Merck will not for a second lose focus of our overarching message and that is improving [inaudible]. For 2008, the company continues to anticipate that many of our in-line and newer franchises will maintain their strong performance, and we look forward to launching additional new products such as Cordaptive if approved and our investigational atherosclerosis compound currently under standard review with the FDA. We anticipate that worldwide revenue will be driven by additional indication for our company's products, and that continued marketing up take and global rollout of our new products as well as other potential new introductions. When taken together, all of this should help us offset the upcoming loss of marketing exclusivity for FOSAMAX our second largest product in the U.S. In addition during 2008 we plan to file two NDAs for products currently in Phase III, mainly MK-524B for atherosclerosis and MK-364 for obesity. To position ourselves for commercial success in 2008 and beyond we will begin to prepare for their perspective launches. On earnings per share we are confident in our ability to execute against our plan and are reaffirming our full-year 2008 non-GAAP EPS range of $3.28 to $3.38 excluding certain items. We're making a slide revision to our 2008 GAAP EPS, which now anticipates to be in the range of $3.80 to $4. Peter will provide additional details in a moment. We are halfway through the strategy outlined in 2005 in our Plan to Win. We have made some real strides realizing the benefits of our strategy. We implemented a new research model, and I am confident that we will bring greater focus and efficiency to our early compound development. We’ve also made significant progress towards creating standard global processes for late stage clinical development. Our new Global Human Health organization is in place representing a significant change from the way we have operated in the past. We're beginning to make in-roads towards a new customer centric commercial model both in the U.S. and in other key markets around the world while also changing the way we support our global market franchises. Across our global franchises we have introduced new stage gates to help us fine-tune the focus of our research activities on the highest value areas in terms of customer need and probabilities of success. These changes are bringing us closer to achieving our goal of becoming a more flexible, effective and efficient company. For example, our manufacturing division and the Merck supply strategy have led the way in returning Merck to pre-Zocor patent expiry PGM, a year earlier than we anticipated, establishing lead supply chains, leveraging low costs and external manufacturing, and consolidating our manufacturing plant network. As you know, such global restructuring activities are a part of our overall strategy to further reduce our cost structure and create a leaner and more nimble business model so that we can respond quickly and efficiently to customer expectations, address emerging market demand, and support the drug discovery and development efforts that are core to our business model. As we implement fundamental changes to every aspect of our business, we remain confident that our current products and anticipated new product introductions as well as our cost savings initiatives will help us position the company to deliver what we promised in December of 2005. To generate revenue growth in the range of 4 to 6% on a compound annualized basis from 2005 to 2010, including 50% of the revenue from the joint ventures from which the company derives equity income. By sustaining our cost management initiative, Merck expects to fulfill our promise to expand the product portfolio while maintaining marketing and administrative expense flat in 2010 relative to 2006 base, and we continue to expect compound annual double-digit earnings growth excluding restructuring charges and one-time items by 2010 from a 2005 base. In summary, our performance in 2007 is proof that the customer focused more efficient business model we began implementing more than two years ago is delivering results. With our strong portfolio of products, our robust pipeline of potential new therapies, and our leadership team focused daily on improving operational performance, I am convinced that Merck is well-positioned to build on its record of delivering essentially break through medicine and vaccines to the global marketplace. However, despite a strong 2007 performance, I see no room for complacency. As I will tell my senior management in our Annual Strategy Meeting this week, it is way too soon to declare victory, although we remain confident that our customers will continue to find value in our products, we have much to do to reach our 2010 goals. And we'll need to do even more to realize and sustain the benefit our strategy through 2010, 2015, and beyond. Now I would like to turn the call over to Peter who will provide additional comment on the details of our 2007 results and 2007 financial guidance. Then we will take your questions. Peter."
},
{
"speaker": "Peter Kellogg",
"text": "Thank you, and good morning. As Dick mentioned, we're pleased with the fourth quarter and full-year business results. Throughout 2007 our in-line product portfolio and our newly launched pharmaceutical products and vaccines help drive strong organic growth overcoming the impact of the Zocor and Proscar patent expiries. We continue to significantly reengineer our business to ensure that we have a sustainable operating model that can weather the upcoming loss of marketing exclusivity for FOSAMAX. These successes allowed us in 2007 to deliver 10% revenue growth including 50% of our JVs and 27% non-GAAP EPS growth despite patent expirations that exceeded $2 billion. Finally, we continue to make the necessary pipeline investments both internally and externally to position the company for long-term success. For 2008, we remain on track and we are reaffirming our non-GAAP EPS guidance and the guidance elements for the operating line that support this. Now related to our GAAP guidance we are, one, increasing our restructuring reserve, or restructuring guidance rather for 2008 as we continue to drive efficiencies, and, two, lowering the estimate for the minimum gain associated with the AVLP restructuring in 2008 based on new information that has come in and basically just update the calculation for the minimum gain. Accordingly, I will discuss our adjusted GAAP EPS guidance for 2008 later. The fourth quarter non-GAAP EPS growth, excluding restructuring costs and certain items was driven by several lines in the P&L, all with strong results. Let's go through these lines individually. First, the revenue line grew 3% reflecting strong performance of our new vaccines and [inaudible], the continued market leadership for SINGULAIR and our newly launched pharmaceutical products including as Dick mentioned; JANUVIA, JANUMET, and ISENTRESS. Secondly, our product gross margin line showed continued strength and this is the result of sustained operational efficiencies and favorable mix. Finally we benefited in the fourth quarter on the tax line. Now I will go through each of these lines in more detail in a minute, but let me start with revenue. In the fourth quarter our total revenue was $6.2 billion, that's a 3% increase over the same period last year as I just mentioned and it is composed of the following. 1% decline in volume, a 4% increase from foreign exchange, and a 1-point increase from price. On a full-year basis for 2007 our total revenue was $24.2 billion, and that's a 7% increase over the same period last year including a 4% increase in volume, 2 points of increase from foreign exchange and no growth from prices. And again, this growth was achieved in a year where we overcame $2 billion of patent expires. Now, a major contributing factor to our top line growth continues to be our vaccine business. In the fourth quarter, the vaccines revenue as reported by Merck was approximately $1.1 billion that's a 59% increase as compared to the same period in 2006. On a full year basis in 2007 our vaccine revenue as recorded by Merck was approximately $4.3 billion. That is a 130% increase over 2006. So, now let's discuss the specific products beginning with GARDASIL. We continue to be extremely pleased with the progress of GARDASIL in terms of the U.S. market penetration and the global rollout. Based on the international approvals, recommendations, reimbursements and launches, we're well positioned to continue to build on the success of this franchise in 2008. In the fourth quarter our revenue of was $339 million, $268 million of which was in the United States. Now, U.S. GARDASIL sales were down sequentially in Q4 due to seasonality and some supply chain dynamics in the public sector, I would like to discuss each of these separately. First, seasonality in what we call well visits for the adolescent cohort is heaviest in Q2 and Q3, really not surprisingly given the typical pattern of back-to-school visits by this cohort group. This results in a 63% of well visits typically occurring in Q2 and Q3. Secondly, in 2007 the public sector sales were heavily weighted towards Q1 and Q2 driven by very rapid adoption by all 55 projects following the November 2006 VFC contract. As a result, please note that 64% of the VFC sales occurred in Q1 and Q2. Now, outside the U.S. the Sanofi Pasteur MSD joint venture recorded end market sales for GARDASIL of $231 million in the fourth quarter. Despite the seasonal spike in the U.S. demand for GARDASIL in Q3, global end market sales for GARDASIL reached a new high in Q4, and in its first full year on the market, 2007 revenue as recorded by Merck for GARDASIL was roughly $1.5 billion. GARDASIL’s performance in 2007 has been unprecedented for a vaccine launch. Now, looking forward in the U.S. we estimate that more than 7 million nine to 26-year-old females have received at least their first dose of GARDASIL, and significant opportunity remains with over 29 million nine to 26-year-old females that is yet to receive a dose of GARDASIL. In 2008, we are focusing on increasing penetration across the initial nine to 26-year-old cohort and improving the compliance rates for second and third doses. We also anticipate expanding label for GARDASIL through incremental indications, including an indication for adult women through 45 years old, an indication for adult women with more than double the eligible population for GARDASIL in the U.S. To date, GARDASIL has been approved in 93 countries, most under accelerated review, and has launched in 76 countries. In 2008 we anticipate launching GARDASIL in over 20 markets, and as continue the global rollout of GARDASIL, we look forward to capitalizing on this significant international opportunity. So, as per plan, the international launches are just now beginning to pick up, and they will be a significant driver for the franchise in 2008 and beyond. Now let's move to VARIVAX. In the fourth quarter revenue was $270 million. That's a 187% increase over prior year. This strong quarterly result is the function of two major factors. First, we continue to make progress within the cohort's eligible for second dose Varicella in the first full year of the new recommendation. As of December 31, we estimate 80 to 85% penetration of the routine four to six-year old second dose cohort, and 20 to 25% penetration of the cumulative catch-up population. Second as a result of the back-to-school surge that makes Q3 the peak period for the youth vaccine business and the unprecedented demand for VARIVAX in 2007, we were able to ship approximately $75 million in back orders for VERIVAX in Q4. By the end of Q4, the back orders for VARIVAX were pretty much negligible. Accordingly, Merck is further increasing production of VARIVAX and expects to meet anticipated market demand for Varicella measles, mumps, rubella vaccine through VARIVAX and MMR2. Now let’s turn to SINGULAIR. In the fourth quarter our SINGULAIR revenue was $1.2 billion, that's up 20% year-over-year, and on a full-year 2007 basis our revenue was $4.3 billion, up 19% over prior year. The strong growth for SINGULAIR was driven by continued market share gains in the U.S. for both asthma and allergic rhinitis claims, and secondly rapid growth in foreign markets where on a full-year basis we saw 27% year-over-year growth, as a result of additional indications and a differentiated product profile. Despite the recent slow down in respiratory market share and potential new competitive threats, we continue to anticipate strong growth for SINGULAIR in 2008. Now turning to FOSAMAX, our fourth quarter revenue was $796 million, up 1%, and on a full-year basis for 2007 the revenue was $3 billion, that's a 3% decline. In its last full quarter of marketing exclusivity, FOSAMAX has performed extremely well as a result of differentiation on efficacy, that relates to hip fracture indications and spine fracture indications as well as the relevant managed care status of the brand now and its generic counterpart in the future. An authorized generic strategy is in place to maximize the value of the franchise after patent expires. As we have illustrated with the Zocor expiry in the past, we have the necessary new and in-line products to drive revenue growth through this event in 2008. Now let's look at total revenues including 50% of joint ventures. In the fourth quarter, our total revenue including the 50% of joint ventures was $7.5 billion, that's a 7% increase if you do the same adjustment in the base period. On a full-year basis for 2007, revenue including 50% of joint ventures was $28.8 billion, a 10% increase over the comparable 2006 figure. As we have stated many times, we have the opportunity to capitalize on our robust product portfolio and deliver solid revenue growth through 2010. Despite certain patent expires during the time frame that we talked about, we continue to expect revenue growth of 4 to 6% including 50% of our JVs on a compounded annual basis, of course this is driven by our in-line products, our launched products and our potential new products. And of course this 4 to 6% as I mentioned includes 50% of the revenues of the joint ventures from our 2005 base. Now regarding 2008 revenue guidance, we are reaffirming all elements of our full-year revenue guide guidance. As always to assist your modeling, we provide a breakdown of the product revenues in our other financial disclosure schedule attached to the press release issued this morning. Let's go down to P&L over the next line, which is materials and production. In the fourth quarter materials and production were $1.5 billion. This quarter includes $118 million for costs associated with the global restructuring program, primarily related to accelerated depreciation and asset impairment costs. Excluding these costs, material and production decreased 5% in the quarter. Our fourth quarter product gross margin was 75.3%. This reflected a 1.9 percentage point unfavorable impact related to the restructuring costs, excluding these restructuring costs, we had a fourth quarter PGM of 77.1%. Just as in previous periods these results were affected by the final product mix. On a full-year 2007 basis, our adjusted product gross margin was 76.6%. Looking forward in 2008 we anticipate… or we continue to anticipate PGM in the 77 to 78% range. This guidance excludes the portion of the restructuring costs that will be included in product costs and will affect the reported PGM in 2008. Moving to the next line, marketing and administrative. Our Q4 marketing and administrative expense was $1.7 billion, and that's a 27% decrease over prior year. But let me provide you with some additional perspective on that. Included in the fourth quarter marketing and administrative expense is a previously disclosed $455 million gain related to insurance proceeds which the company was awarded in the arbitration with the company's upper level excess product liability insurance carriers. These claims related to coverage for costs incurred in the VIOXX product liability litigation. Also as previously disclosed, in connection with the U.S. VIOXX settlement agreement, the company recorded a pre-tax charge of $4.85 billion, which represents the fixed amount to be paid by the company to settle qualifying claims. Note that we have broken out this charge on its own line in the income statement. During the fourth quarter the company did not increase the reserve related solely for future legal defense costs of VIOXX litigation. However, in the fourth quarter the company spent approximately $200 million in VIOXX legal defense costs which resulted in a reserve as of December 31, 2007, of approximately $522 million solely for its future legal defense costs related to the VIOXX litigation of which approximately $80 million has now been allocated to Merck's anticipated future costs to administer the settlement. Consequently as of December 31, 2007, if you add this up, the company had an aggregate reserve of approximately $5.372 billion related to the VIOXX litigation. Excluding these charges in 2006 and 2007, M&A decreased 2% in the fourth quarter and increased 4% for the full year. A significant portion of the increased spending is attributable to fluctuations in foreign exchange rates, which have increased significantly during the last twelve months as I am sure you're all aware. Of course we do see this as a benefit on our top line revenues as I mentioned earlier, but this does increase our marketing and administrative dollars and dollar build. So, regardless of foreign exchange, we maintain a healthy amount of support behind our growing core and successful new franchises many of which are continuing their global launch activities market by market in 2008. Reflecting our commitment to realizing efficiencies throughout the company and optimizing our cost structure, the component of marketing and administrative consisting of selling and general administrative costs that support our core operations remained down over the prior year. Finally, we are comfortable with the focus of these investments and it is important to note that we continue our increased focus on cost management, and we are seeing the positive benefits of practical ongoing cost management initiatives including the redesign of many of our critical business processes. Now looking forward in 2008, we continue to anticipate marketing and administrative expense to be approximately 7.8 to $8 billion for 2008. Moving to research and development, our fourth quarter R&D expenses were $1.4 billion, that's a 20% decrease year-over-year. However, it is a 10% growth when you… if you were to exclude the Sirna in-process R&D charge in the prior year. Our full year 2007 R&D expenses were $4.9 billion, that's a 2% increase year-over-year but again if you make the adjustment for the Sirna in-process R&D charge and restructuring in the base period, it is a 15% growth. Let me take a moment to explain the R&D result. We remain committed to fully funding our core internal R&D ensuring the continued success of all compounds in all phases of development. Our internal R&D growth remains strong. We continue to invest in Lifecycle Management programs for GARDASIL, JANUVIA, and ISENTRESS and late-stage clinical trials on our MK-524 program, the MK-364, MK-974, MK-7418 from NovaCardia and MK-8669 from ARIAD and the MK-822 and our other investigational vaccines. And I guess it is a good thing that I have to read off that many numbers related to Phase III programs. In addition, the company continues an active external collaboration and business development agenda funding clinical grant programs, third-party scientific collaborations and licensing transactions, and of course all of that is in our R&D line. Our guidance for R&D in 2008 is that we reaffirm the guidance that we previously given of $4.7 billion to $4.9 billion. Now turning to restructuring costs, the fourth quarter total cost associated with the global restructuring program was $274 million, $118 million as I mentioned earlier for asset related charges were included in the materials and production line. The restructuring cost line reflects $156 million of costs for employee separation and other related costs associated with approximately 1,200 position eliminations bringing the total to 7200 since the initiative started. As we continue to reengineer our business, we will look for opportunities to drive further efficiencies. As part of the company's restructuring of its operations, additional costs related to site closings, position eliminations, and related costs will be incurred in 2008. We anticipate the aggregate 2008 pre-tax expense related to these activities to be in the range of $100 million to $300 million. Now let's turn to equity income. In the fourth quarter our equity income from affiliates was $796 million. Our Q4 performance reflects the continued success of the Merck/Schering-Plough cholesterol franchise in the U.S. and Europe and an increasing contribution from our European vaccine joint venture, Sanofi Pasteur MSD, which I am sure is not a surprise to any of you. Turning to guidance for equity income, the recent public confusion surrounding the enhanced results although disappointing has caused us to consider whether any different scenarios regarding the potential impact to the franchise are appropriate. At this time, based on the limited data it is too early to make informed judgments or to change the long-term trajectory that is expected for this franchise. At this time, we believe we're looking at more of a reaction in the market than a real ongoing trend. In addition, the equity income contribution that we record is from a portfolio of several joint ventures and partnerships. On an annual basis there are always positives as well as negatives within the portfolio. At this time, we feel no need to adjust our 2008 equity income guidance and are not changing our range of $3 billion to $3.3 billion. Now turning to the taxes on income, the effective tax rate of 48.7% and 2.8% for the fourth quarter and full-year 2007 respectively reflects the impact of the U.S. VIOXX settlement agreement charge, civil government investigations charge, and the gain related to the insurance arbitration settlement previously referenced. Given the charges in the fourth quarter and the full year, it is helpful to look at the non-GAAP tax rate. Our non-GAAP tax rate for Q4 and full-year 2007 were 18.4% and 24.1%. Of course that 24.1% is at the low-end of our guidance range. These rates reflect the favorable impact of an adjustment related to the termination of Puerto Rico tax benefits and fourth quarter adjustments related to certain federal and state tax items. Looking forward, we are reaffirming that our full-year 2008 tax rate guidance range stays intact, and I would direct to you today's press release for details. So coming to the bottom line on net income and earnings per share, in the fourth quarter on a GAAP basis we had a net loss of $1.6 billion or on a per share basis that was a loss of $0.75. However, excluding the restructuring charges, the big litigation reserves, and proceeds from an insurance gain, the Q4 non-GAAP earnings per share was $0.80 per share. On a full-year basis, our net income was $3.3 billion, and the GAAP earnings per share was 1… was $1.49, again excluding the restructuring charges, litigation reserves and proceeds from an insurance gain the full-year 2007 non-GAAP earnings per share was $3.20. Turning briefly to 2008 guidance, I have mentioned several elements as part of the results review, and I would direct to you the details of our guidance contained in today's press release. In summary we are reaffirming our 2008 non-GAAP EPS guidance of $3.28 to $3.38 excluding certain items. On a GAAP basis, we now anticipate GAAP full-year 2008 EPS of $3.80 to $4. So in summary, the company remains on track, both in terms of strategy and performance to deliver long-term double-digit earnings per share growth from 2005 to 2010, excluding certain items. We have financial strength, and we remain fully committed to maintaining our dividend at the current level. At the same time, we continue to fully invest in all of our key strategic priorities. 2007 represented an important step in a multi-year journey to return Merck to its leadership position in the pharmaceutical industry. While much has been accomplished over the last 12 months, many opportunities remain, and we look forward to capitalizing on them in 2008 and beyond. So, with that said, I will turn the call back over to Graeme. Graeme?"
},
{
"speaker": "Graeme Bell",
"text": "Thank you, Peter. We appreciate your patience as we go through the prepared remarks. We will now open the call to take your questions. We will take them as always in the order they're received and try to get through as many as possible for the duration of the call. So, at this point I will turn the call back over to Amanda who will communicate instructions for the Q&A format, then introduce the first question. Amanda? Question and Answer"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions]. Your first question is from Barbara Ryan with Deutsche Bank."
},
{
"speaker": "Barbara Ryan",
"text": "Oh, thank you so much for taking my question. Just a short one Peter for you and I guess you addressed it that was really related to the tax rate, and I know you went through the other reasons. But I know in Pfizer's case two there was a lower tax rate in part because of the geographic mix, which really swung and then it happened to be in their instance low tax countries as well. And I was just wondering if that played a role as well?"
},
{
"speaker": "Peter Kellogg",
"text": "Yes, Barbara, this is Peter. Thanks. Every quarter, we have a little bit of geographic mix, in fact, although I wouldn't say that that was the primary driver this quarter. The reason our tax rate was little off trend in the fourth quarter was… again I am referring this now on a non-GAAP basis, which is I'm assuming what you are looking at. It was more related to the termination of the Puerto Rico tax benefits that we were seeing and also some fourth-quarter adjustments to certain Federal and State tax items, and these were really kind of items that touched our reserves relative what our expectations were as we closed the things out we were able then adjust the reserve. So it is sort of a… each quarter we looked at our reserves relative to our… what we know about our tax positions and quite frankly in the fourth quarter these were more adjustments to that. So it's a little bit of mix but it is much more the adjustments later those three items that caused this benefit. Again, I would just highlight that it's more happened in the fourth quarter. As we move into 2008, I think we run right back into our ongoing tax rate that we’ve always talked about both in terms of guidance and what you should expect."
},
{
"speaker": "Graeme Bell",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "Your next question is from Jamie Rubin with Morgan Stanley."
},
{
"speaker": "Graeme Bell",
"text": "Amanda, perhaps you can move on to the next question, maybe that Jamie's phone is on mute."
},
{
"speaker": "Operator",
"text": "Yes sir. Your next question is from John Boris with Bear Stearns."
},
{
"speaker": "John Boris",
"text": "Okay. Thanks for taking the questions. Peter, I think you characterized the ZETIA/VYTORIN situation as a reaction in the media rather than an ongoing trend, just three-part question to this. How many weeks or months do you need to be able to establish your trend for the joint venture? Secondly, are you seeing any impact on your ex-U.S. business from all of the media hype in the United States over the enhanced results? And then the third part, can you just talk about first line use in the United States for VYTORIN and what percent of first line use is made above of VYTORIN’s use? Thanks."
},
{
"speaker": "Peter Kellogg",
"text": "Okay, John thanks. So first of all, I think the data we have right now is obviously the daily scripts and then we have one-weekly tabulation in excel [ph]. We are very cautious about leading daily scripts. We acknowledge that's the only thing that's out there to look at, but we often find it doesn't always represent exactly the trend that you would want for the… it doesn't think well with the weekly and monthly recap. So we're very cautious about looking at daily scripts and join broad full-year conclusions on that. And I think that quite frankly there just has been a tremendous amount of various points of view and opinions floating around the market. It can be a little bit disruptive and create reactions. I really believe that as the full body of evidence is kind of digested in the medical community and as the full data of course of the trial is released, I would expect to see the market trends really emerge at that point based on a much more complete and scientific evaluation of what this trial really means or doesn't mean. Secondly, the ex-US business really has not been affected. This has been pretty much of a US phenomenon at this point, and I think again the international medical community is… I think, not reacting quite as much to some of the news lines, and probably most of the new lines are a little bit more US centric. Related to the first line usage of VYTORIN… I little bit apologize not able to answer that question, and I think maybe we can come back to you on that later in the call. But John we've noted that, let me come back to that later in the call if we have that data. Okay, apologize for that one."
},
{
"speaker": "Richard T. Clark",
"text": "I other point John, when you think about ZETIA and VYTORIN ex-US, we certainly had a very strong fourth quarter. So for example ZETIA grew at 40% versus fourth quarter ‘06 and VYTORIN grew at 84% in Europe. And in the Far East, it was 67% for ZETIA and greater than 100% for VYTORIN. So we continue to see strong growth for ZETIA and VYTORIN outside the U.S."
},
{
"speaker": "Graeme Bell",
"text": "The next question please, Amanda."
},
{
"speaker": "Operator",
"text": "Your next question is from Jami Rubin with Morgan Stanley."
},
{
"speaker": "Jami Rubin",
"text": "Thank you. Can you hear me, okay?"
},
{
"speaker": "Graeme Bell",
"text": "Hi Jami."
},
{
"speaker": "Jami Rubin",
"text": "Can you hear me? Okay, great, just a comment. Peter, we’ve discussed this a lot before in the past, but your stock is down 25% since the ENHANCE controversy on January 14, and I would just think with $10 billion in cash from operations, you've just received $2.5 billion from Astrazeneca, VIOXX settlement is now behind you, hopefully, or really closed. I can't think of a better time to announce a major stock buyback program. But my question also has to do with, again going back to ENHANCE, are you aware that the negative publicity has in any way affected patient dropouts in the IMPROVE-IT trial? And then my second question… I just wanted to just ask this, but GARDASIL sales outside the U.S. or rest of world sales that you’ve book, your sales were $70 million versus $90 million in the third quarter, yet you are in the process of launching in a number of markets, can you give us a sense of what's going on and how we think about that trajectory going forward? Thanks."
},
{
"speaker": "Peter Kellogg",
"text": "So couple of questions. Let me… why don’t we take them in order that you laid them out. So I think you are just making a comment about the stock buyback. I think the only thing I would just remind everybody and you see it in our press release is that as of December 31, we had $5.1 billion approved by our Board under the current buyback authorization. And that obviously compares to $6 billion outstanding as of September and clearly the points you made are not lost on us, we understand that, in fact we were just saying. On ENHANCE, on the IMPROVE-IT dropout, I don't think we've seen any reaction at all in that trial approval or participation and nor we necessarily expect to see that at this point. Related to GARDASIL sales, I think clearly one of the things that you do see as you roll out sort of bumps and ins and outs and so forth, and some volatility sometimes as you go through quarters. There were a couple of markets that had pretty heavy activity in Q3 and then didn't have this quite same activity in Q4. But we don't really read that as a trend at all and these are kind of some of the short-term volatility elements that you get in supply chain or just the roll out activity in the market. Quite frankly, when we stack up all the different data points and the approvals and the authorizations and the activity level, and the awareness of GARDASIL in international market that we're looking at, you know, the kind of things we look at when we put together our plan, really GARDASIL is poised to have a really good year internationally. So, we've… we aren't really concerned about quarter fluctuations and I would encourage everybody to look forward and recognize not only the number of approvals that have come through, but how many of them were actually accelerated approvals and have got our authorization and reimbursement status that is around the world. So I really think we're headed for something, you know, where I wouldn't raise much of that quarterly fluctuations during a launch as really look at the preponderance of all that positioning."
},
{
"speaker": "Richard T. Clark",
"text": "I would make two other comments on that Jami. First, as we said GARDASIL sales in 2007 were $1.5 billion and we have a tremendous amount of confidence and expect continued growth globally for GARDASIL in 2008 above that number. And so, we are very confident as we roll it out throughout the world. The second point which we've said in the past is that females 9 to 26, if you look at the EU and US and other high-income markets it is about 118 million. And as you know with our December submission for 27 to 45 year old women that 118 goes up to 264. And so, there is a substantial up tick and up growth that we can provide based on the enhanced indications for the vaccine. But we are very confident where GARDASIL is going to be in 2008."
},
{
"speaker": "Peter Kellogg",
"text": "And could I just go back to John Boris' question if I may for a moment, just… with regard to managed cash and the use of VYTORIN. So, in the aggregate managed care organizations have all recognize the need for a product with excellent LDL efficacy, notwithstanding the availability of generic simva. But in terms of, the book of business, we basically indicate that about 93% of the business comes from continued therapy, 4% of our business comes from patients who are new to market, who are initiating therapy and who are being naive to therapy previously. 2% of it comes from brand switches and about 1% of utilities with add-on. So that just give us some perspective in terms of where the business comes from relative to VYTORIN. So, with that Amanda, could I have the next question please?"
},
{
"speaker": "Operator",
"text": "Your next question is from Tony Butler with Lehman Brothers."
},
{
"speaker": "Tony Butler",
"text": "Thanks very much. Given much of the coupons [ph] from the Congressional investigation, I'm curious that how you are feeling about the regulatory nature of Cordaptive and do you think that the FDA is actually shy about approving a new therapy despite the fact that, there were very bullish about nice based outcome studies on the call Friday. And second to that question is, are you actually increasing the number of details today for VYTORIN and ZETIA. And moreover could you go over or at least expressing some comments regarding the future for DTC adds? Thanks."
},
{
"speaker": "Peter Kellogg",
"text": "Well certainly, speaking first of VYTORIN and ZETIA. I think that the joint venture between Merck and Schering-Plough in the last few weeks has done an outstanding job of reaching out to healthcare professionals, possibly 95% of the top specialist and 90% of the PCP's have been called on by our representatives post the press release. All these representatives were provided with a letter that we have sent and really have follow-up calls and so we're really helping the physicians… physician products come correctly and I think we have got favorable response from that as well, favorable response from the patient as that have been put in the majority of the [inaudible]. I think, in addition all the managed care organizations have been contacted by us, there haven't been any changes and so I think we have done a fairly good job of really focusing on physicians to make sure we could put this in proper context and provide them the information that they needed and we are continuing to get good feedback from that. To your question about Cordaptive, it was reassuring on the FDA call on Friday where they said at this point, we believe it is premature to embark on any systemic changes, now approved with the lower end drugs because we believe there is a long track record of success in the approach that we've followed over the past several decades. So I think that's reassuring from a… not only a Cordaptive basis but to make sure patients stay on their cholesterol lowering products in order to lower their LDL, patients will give off of it based on some of the media hype that you see that would be a terrible [inaudible] from a healthcare stand point. I think that's important and we are evaluating our DTC advertising as we move forward."
},
{
"speaker": "Richard T. Clark",
"text": "And Tony, you know I would just add that as we stated in December, with Peter Kim at the Annual Business Briefing we went through with you how extensively we have studied Cordaptive as we were approaching this regulatory submission. So we won't go through that again, but I would just point you that, as a point of reference to our confidence in terms of the filing relative to those remarks. So next question please Amanda."
},
{
"speaker": "Operator",
"text": "Your next question is from Tim Anderson with Sanford Bernstein."
},
{
"speaker": "Tim Anderson",
"text": "Thank you, a few questions please. I would have to imagine that you guys have heavily contemplated getting full enhanced results out earlier than the late March meeting of ACC, you know may be published in something like a medical journal, because until results are published, your reps of course are very limited in what they can say to prescribers, so any comments on that. The second question just going back to DTC, I thought the original word out of Merck was that DTC was temporarily suspended, but that it would resume in a very short course and I'm wondering if that's changed, and then on Cordaptive do you expect that will likely go up for an FDA advisory committee?"
},
{
"speaker": "Richard T. Clark",
"text": "On the last point, we have not been advised of any advisory committee to date, on your point concerning publishing, we are working with the lead investigator, who will submit the enhanced study for publication and attribute that is done, it assumes we can… and so that is being certainly studied."
},
{
"speaker": "Tim Anderson",
"text": "Regarding DTC?"
},
{
"speaker": "Richard T. Clark",
"text": "DTC we are still evaluating to make sure we do it the proper way and so it is, I would say temporarily on-hold."
},
{
"speaker": "Graeme Bell",
"text": "Thanks Tim, Next question please Amanda."
},
{
"speaker": "Operator",
"text": "The next question is from Harlan Sonderling with Columbia Management."
},
{
"speaker": "Harlan Sonderling",
"text": "Yes, thank you very much. I wanted to ask, in light of the enhanced trial, whether you're changing the sales effort on the ground that is, you're not changing yet the DTC advertising beyond the temporary suspension, you have commented on the results of the enhanced… getting the enhanced results out. What are your reps telling physicians and have you changed that message please?"
},
{
"speaker": "Richard T. Clark",
"text": "We are making sure that we have all available resources for both the joint venture and the companies to make sure that we are able to get out our press release to make sure that we are able to share the health care providers the physician we put together from the later standpoint. The most critical thing we have to make sure is that we are able to continue to deliver the message that LDL lowering is key, and so in some cases, for LDL lowering the patient may do well on a generic simvastatin. In many other cases, they won't be able to reach full and if that's the case, VYTORIN and ZETIA are the brand products that we have been able to prove clinically lower LDL to the right impact and have the better chance to reach the goal. And those messages haven't deviated. We got a very safe products in the marketplace and they are very important part of the management program. And our perhaps [ph] the representatives continue to deliver those message and ask those questions. But we are obviously not backing off those two products, because they are so important from a health management standpoint and we are making sure that we can answer any questions, because with the media hype there is a great deal of confusion out there. And we have obviously the excellent comments by the FDA and the other societies that have come out and said LDL lowering is key to this and quite frankly there are no better products for LDL lowering than VYTORIN and ZETIA."
},
{
"speaker": "Graeme Bell",
"text": "Next question please, Amanda?"
},
{
"speaker": "Operator",
"text": "Your next question is from James Kelly with Goldman Sachs."
},
{
"speaker": "James Kelly",
"text": "Thank you very much. I just wanted to ask a question to get a little bit more detail on the trajectory of the vaccines. I know you mentioned about the seasonality elements, but there were also some other elements, and I apologize if you did address this in the prepared comments, and I missed it, of some catch up vaccinations, and whether or not that's already substantially done as far as you're hearing back in the chickenpox second dose and catch up there, or any of the other pieces that may be other than… may be other than seasonality? Thank you."
},
{
"speaker": "Peter Kellogg",
"text": "James, this is Peter. Thanks. So lot of different parts to your question quite frankly. So, yes there is seasonality in the vaccines business, as I mentioned just… at least on the pattern of well visits for adolescent, you do see a fairly healthy back-to-school surge. I also commented on the call, I hope this is directly addressing that as of year-end, we estimate that 80 to 85% penetration of the routine 4 to 6 year old second dose cohort of VARIVAX has been achieved and 20 to 25% penetration of the cumulative catch-up population has been achieved. The other thing is we did have some back orders coming at the end Q3 and I mentioned that in Q4 we shifted $75 million to completely fulfill that backorder situation. I think that is the point that you're asking, if I missed it, please come back, I apologize."
},
{
"speaker": "Graeme Bell",
"text": "Next question please, Amanda?"
},
{
"speaker": "Operator",
"text": "Your next question is from Roopesh Patel with UBS."
},
{
"speaker": "Roopesh Patel",
"text": "Thanks. Just a couple of questions, first on VYTORIN and ZETIA, can you summarize for us of the clinical data that is expected to be presented for VYTORIN and ZETIA, besides ENHANCE over the course of the next 12 months. And then on GARDASIL just a clarification, Peter you mentioned that supply-chain dynamics influenced fourth quarter sales, was that just the VFC purchasing patterns over the course of the year or was there something else that influenced fourth-quarter sales? Thanks."
},
{
"speaker": "Peter Kellogg",
"text": "Yes, hi, Roopesh this is Peter. Let me take it in reverse order. I will take your last question first. So the supply-chain dynamics were more in the public sector, you are right. So it was really the VFC contract. And what we saw was very rapid adoption and pick-up of the product by all the different various public sector sales entities. So, as a result that drove heavier sales volume in Q1 and Q2 of us shipping product out, and then as we went to the balance of the year, we saw that some of the supply chain items balanced out and get kind of sorted through and so as we came to the third and fourth quarter, we ended up with a little bit of a rebalancing some of that inventory. And that's… it's a very fragmented system and obviously that is kind of just a dynamic at first sometimes when you roll out these vaccines. Hard to know exactly also what's going on as we go, because there isn't just enormous amount of inventory reporting out here, but it was all public sector."
},
{
"speaker": "Richard T. Clark",
"text": "And Roopesh, with regards to the first part of the question with regard to expectations of clinical data dissemination, obviously, we got ACC in March for ENHANCE. With regard to CEASE [ph], we expect to have the data in 2008 on CEASE, then you have Sharp. The expectation is we have clinical data in 2011 and as we’ve mentioned IMPROVE-IT, which is still enrolling, we expect the data to be out in 2011 as well. So between now and 2011, 2000, the four studies will be disseminated. Next question please, Amanda."
},
{
"speaker": "Operator",
"text": "Your next question is from David Risinger with Merrill Lynch."
},
{
"speaker": "Richard T. Clark",
"text": "David, please go ahead."
},
{
"speaker": "David Risinger",
"text": "Yes, can you hear me?"
},
{
"speaker": "Richard T. Clark",
"text": "Yes."
},
{
"speaker": "Peter Kellogg",
"text": "Yes."
},
{
"speaker": "David Risinger",
"text": "Yes, so to follow-up on CEASE and IMPROVE-IT, if you could please characterize what Merck expects out of the CEASE study that would be helpful. And also if you could please comment on whether there is a possibility of accelerating IMPROVE-IT or the possibility of an interim look at the data before 2011 that could be made public. Thank you."
},
{
"speaker": "Richard T. Clark",
"text": "Dave, with regard to those two studies, clearly there are protocols in place and we've shared some of that information with you. We certainly can't foreshadow when exactly the results will be available nor do we have here the exact setup in terms of the Data Monitoring Boards and how the data will roll out of those studies. Clearly the protocols are in process and as you know, this one particular study looking at aortic stenosis and the other one is looking at another patient population. So, across ENHANCE, CEASE, Sharp and IMPROVE-IT, obviously IMPROVE-IT is the critical outcome study in all of that. We feel that there will be an awful lot of incremental data that will gather with regard to these compounds. Next question please, Amanda."
},
{
"speaker": "Operator",
"text": "Your next question is from Chris Schott with the Bank of America."
},
{
"speaker": "Christopher Schott",
"text": "Great, thank you. Just three quick questions, maybe just on GARDASIL in Europe, obviously we saw some strong acceleration this quarter. Could you give us a more color in terms of what countries are driving this system and just initial contracts driving that and maybe where you stand versus your competitor in those markets with regards to any tenders that have occurred? For GARDASIL in the U.S., just to clarify, do you expect the vaccine for children sales to continue to be front-half loaded going forward or was that really just been our fact of what you're mentioning it of initial rollout? And then finally if you could give us an update on the potential timing FDA sign off for new batches of Varicella, both [ph] please. Thanks."
},
{
"speaker": "Bruce Kuhlik",
"text": "Yes, let me take, if I can, the second one, which is the vaccines for children dynamic and supply chain. Good question. We don't anticipate this to be an annual cycle at all. This is very much in artifact of the appeasable and the new contract was established in late 2006, and so then the market reaction is picking up the supply and so forth. So this is not a manual cycle, we'd expect. It was much more related to a, if you will, a approval and changing conditions since the market reacted to that. I don't think that there will be any expectation of a seasonality per se and it’s a buy dynamics for the year in public sector. Related to the GARDASIL international markets, in some ways international rollout… first of all, I think it's way too early to have a lot of input on tenders and so forth. But I would say is that, we don't see anything that's kind of an unusual biased at this point relative to any of the markets start rolling out. Typically you do see certain markets pick-up vaccine, rollout internationally a little more rapidly than others, but in some of the bigger markets obviously, you are playing a role, but I don't think there is anything really that a strange dynamic, let's say and the rollout at this point. In fact, I did say that all the numbers are relatively early based. So we are just beginning to roll out and expect 2008 to be an interesting year to watch. Maybe more specifically, Dick [ph] do you have anything to comment on?"
},
{
"speaker": "Richard T. Clark",
"text": "On the bulk [ph] issue with the FDA, [inaudible] Varicella… it’s too early to tell exactly when we would finalize our submission and they would have approval. As I said on our last call, we continue to see excellent progress and excellent potency out of the lots that are being manufactured. And so we are putting all of the required data together and the submission for the FDA, and if we can't get the data on this."
},
{
"speaker": "Richard T. Clark",
"text": "So, Amanda given the time, we have time for one more question, please."
},
{
"speaker": "Operator",
"text": "Your final question is from Seamus Fernandez with Leerink Swann."
},
{
"speaker": "Seamus Fernandez",
"text": "Thanks very much. Just a couple of quick questions. Can you give us a little bit of visibility on when the 30-month stay expires on Nexium and how -- any kind of a possibility of a Nexium patent settlement would impact the contribution to Merck from AZLP, if there were a settlement, it’s unclear to me, how that would be booked into the overall scope of the partnership. Just a second quick question, Peter, you mentioned new competitive threats in asthma and allergic rhinitis. Can you just give us a little bit more of a sense of what those new competitive threats are in your view? And also last year we had a very, very strong allergy season and the seasonality and I think that it was high. Can you just give us a sense, do we have any visibility right now on whether or not that that season is expected to be equally strong this year or not? And then just a last question quickly on Q4 costs related to the vaccine recalls that we saw, were those material in any way and can we kind of expect those to recur or not recur in the first half of this year? Thanks very much."
},
{
"speaker": "Peter Kellogg",
"text": "Okay. So, you get the award for the most comprehensive set of questions, and let me quickly go through them. But I am afraid, if I miss one, we need to kind of recap. So let me get a little Bruce’s help here. So first let me start back with the Nexium, and basically the stay goes through April of this year. So that's the date where you are going to see the 30-month of stay will expire. Quite frankly, after that when we have no idea of what might happen. However, obviously we are going through normal legal steps right now and have been working on that. If there was some sort of a settlement, it's unclear what that settlement would be, but it’s unclear that it will really affect 2008 anyway. I mean, that would be something that we would all be in the work. So, you are way too early to comment on that, but I'd say at this point we are following the normal steps in a number of legal processes related to that. So, nothing really new to report in nor any sense of anything new that would happen really in that situation. Bruce Kuhlik, Bruce, do you have any other comment on that?"
},
{
"speaker": "Bruce Kuhlik",
"text": "No, Peter. Thanks. I mean the stay does, the initial one expire in April. But the fact, the stay expires do not have any bearing on meaning actually that a generic will launch at that time, and we are continuing actively [inaudible]."
},
{
"speaker": "Peter Kellogg",
"text": "Okay. In terms of the asthma season, I don't, I think it’s little bit too early to start reading into the asthma season. We would – as the CFO I would love to have a crystal ball, but at this point, I just don't have it. So we just have to play that that season as it goes. So we really don't have any leading indicators and in fact I am not sure there are. On the competitive threats relative to SINGULAIR, really what I was referring to was just new brand entrance in 2008 that we are anticipating a phenomenal lift. I think we are pretty confident in the guidance we have given for 2008 on SINGULAIR. So I didn't mean to create any concern I just want to highlight that SINGULAIR has just been whirling ahead. As you mentioned probably because the asthma seasons, we have been experiencing so forth and to have a $4.3 billion growing to 19% full year in 2007 is something is pretty great. On the other hand, what we are just highlighting is there are the factors as you said, naturally '08, exactly in asthma season and/or new competitors in the market. That was all I will tell you."
},
{
"speaker": "Richard T. Clark",
"text": "And then Seamus with regard to your question on the cost of the recall during the quarter, it wasn't material in any particular way. So let me just give you some perspective. The total cost of the recall was approximately $40 million in the fourth quarter, approximately half of that cost was associated with sales credits to customers and the other half was associated with inventory that we had to write down that we had it in supply chain. So, we didn't consider the PEDVAXHIB and COM recall to be a material event to our results."
},
{
"speaker": "Peter Kellogg",
"text": "So, I think that covers all the points they were. So good towards the question, thanks."
},
{
"speaker": "Graeme Bell",
"text": "So that last question concludes today's conference call. The intimation from today's call both the transcript and the replay will be available on the website for the next several months. And as always Mike Nally whose birthday is today and I will be available all day to take your calls and answer your incremental questions. So with that let me pass it back to Dick for some concluding remarks."
},
{
"speaker": "Richard T. Clark",
"text": "Thank you, Graeme, and thanks for joining us on the call today. As we have clearly stated we are very pleased with the fourth quarter and full-year 2007 results. We are not wasting any time looking at where we mirror and congratulate ourselves. We are proud of how far we have come, but we have tremendous amount to do before we hit that finish line. 2008 represents the halfway point towards our long-term guidance. And new challenges pop up every day. We begin our 2008 with a sense of urgency and a sharp focus on what we need to do. We will continue to work hard to build our pipeline and re-engine our business to deliver sustained revenue and earnings growth beyond 2007. I think it's also important to note that in addition to all the activities we are talking about, we have a 150 country launches in 2008 for our products in vaccine, that’s a 150 new product launches. So thank you again. We appreciate your interest and participation. Operator, thank you very much for your assistance."
},
{
"speaker": "Operator",
"text": "This concludes today's conference call. You may now disconnect."
}
] | null | null |
MRK | 3 | 2,007 | 2007-10-22 09:00:00 | Operator: Good day, everyone, and welcome to Merck's Third Quarter2007 Earnings Conference Call. Today's call is being recorded. At this time, I would like to turn the conference over toMr. Graeme Bell, Executive Director of Investor Relations. Please go ahead,sir.
Graeme Bell: Thank you, Crystal,and good morning. Welcome to our call this morning to review our results forthe third quarter of 2007. Joining me on the call today are our Chairman,President and CEO, Dick Clark, and for the first time we welcome Peter Kellogg,our Executive Vice President and Chief Financial Officer. Before we go into the details, I would like to go over somelogistics. On this call, we will review the results contained in the release weissued at 7:30 this morning. You can access this through the Investor Relationssection of merck.com, and I would remind you that this conference call is beingwebcast live and recorded. The replay of the event will be available latertoday via phone, webcast and as always, our podcast. As we begin to review the results, let me remind you thatsome of the statements made during this call may contain subjects that maycontain forward-looking statements as that term is defined in the PrivateSecurities Litigation Reform Act of 1995. These statements are based onmanagement's current expectations and involve risks and uncertainties, whichmay cause results to differ materially from those set forth in the statements. The forward-looking statements may include statements regardingproduct development, product potential or financial performance. No forward-looking statement can be guaranteed, and actualresults may differ materially from those projected. Merck undertakes noobligation to publicly update any forward-looking statement whether as a resultof new information, future events or otherwise. Forward-looking statements on this call should be evaluatedtogether with the many uncertainties that affects Merck business, particularlythose mentioned in the risk factors and cautionary statements set forth in item1A of Merck's Form 10-K for the year ending December 31, 2006, and in itsperiodic report on Form 10-Q and Form 8-K, which the Company incorporates byreference and that are also posted on our website. As always, we will begin with remarks from our seniormanagement, then open the call for all of your questions, and expect the callto last approximately 60 minutes. So with that, I will turn the call over and we will beginwith remarks from our Chairman, President and CEO, Mr. Clark.
Dick Clark: Thank you, Graeme, and good morning, everyone. I am pleasedto report that the momentum that Merck began to build last year continues, asproven by the strong performance in this last quarter. In an increasinglydifficult healthcare environment, our company has been resilient whiledemonstrating an outstanding capacity to innovate, driving near-flawlessexecution, as shown by our regulatory and commercial success, and postsignificant revenue growth, show gains in market share and increase operatingincome. The results reported today show that Merck continues todeliver on its promise to remain a leader in the pharmaceutical industry. Year-to-date, we have reported solid growth of 8% on thetop-line and 24% on the bottom line. We are also working to ensure sustainedgrowth in 2007. We remain convinced our plan will enable us to achieve ourbusiness targets, meet emerging challenges,and discover and develop breakthrough medicines and vaccines. Merck's reported earning per share for the quarter was $0.70.Third quarter EPS, excluding restructuring charges was $0.75. That represents a47% increase compared to third quarter 2006. This increase includes the impact theNovaCardia charge in 3Q '07, as well as the legal defense cost in '07 and '06. The company's worldwide revenue was $6.1 billion during thequarter, which is an increase of 12.3% over the third quarter in 2006.Year-to-date, our worldwide revenue was $18 billion, up 8.2% compared to the firstnine months of 2006. Net income for the quarter was $1.5 billion. What distinguishes our performance is that it was driven bythe rapid uptake and strong growth of our new first-in-class vaccines andmedicines like GARDASIL and JANUVIA, as well as sustained growth from our broadrange of estimated franchises, including SINGULAIR. GARDASIL's performance has been up outstanding. In the thirdquarter, total Merck revenue for GARDASIL was $418 million. Year-to-daterevenue exceeds $1.1 billion. Merck has distributed more than 13 million dosesof the vaccine worldwide since it came to market in June of 2006. Today, GARDASILhas been approved in more than 86 countries and it is in various stages oflaunch in 72. Looking forward, study to evaluate the efficacy of GARDASIL inwomen up to age of 45 and 16 to 26-year-old young men are underway. Based on dataavailable at this time, a presentation of the mid-adult women data are expectedthis quarter. We also have two supplemental Biological License Applications forGARDASIL under standard review at the U.S. Food & Drug Administration toupdate the leveling for GARDASIL. Global revenue for JANUVIA and JANUMET reached $185 millionand $19 million respectively in the third quarter. Our revenues reflect thehigh value that physicians, patients and payers are placing on our products andon the healthcare benefits they provide. They also demonstrate that we continueto build on momentum established with our product launches last year. JANUVIA has already become the second leading branded oralantidiabetic agents in U.S.in terms of new prescription share. Going in to the fourth quarter, JANUVIA hasachieved reimbursement coverage in approximately 200 million lives on Tier 2,representing over 80% of targeted lives and more than 210 million lives in Tier2 and Tier 3, combined in the U.S. And JANUMET has achieved reimbursementcoverage in more than 179 million lives on Tier 2 and more than 200 millionlives in Tiers 2 and 3 combined, in the United States. Our overall financial results were also supported by thestrong performance of our partnership and alliances, specifically theMerck/Schering-Plough partnership, which continues to drive our equity income.[That positive] contribution helped us fund our increasing research spending oninvestigational product development, the acquisition of NovaCardia, and variouslicensing activities. It is encouraging that our business continues to deliversubstantial growth. This has been an outstanding quarter for Merck, as our newproducts established their leadership in an increasing competitive market. Evenas older products have gone off-patent, we are leveraging earnings from our newproducts and vaccine launches, while utilizing the new commercial model tofurther support and consolidate the strong positioning of our establishedin-line brands. As we look to the final quarter for this year and into 2008,we are purposely moving ahead the launch of ISENTRESS after the FDA granted theproduct accelerated-approval on October 12th. This represents the eighth approvalfor Merck in the last 24 months. This FDA approval clearly demonstrates ourability to deliver on our strategy of providing physician and patients withinnovative medicines that meet unmet medical needs. Introduction of ISENTRESS is the realization of thecompany's 20-year commitment to HIV/AIDS, and we are prepared to ensure thatISENTRESS launches well and reaches its full market potential. We will continue to work closely with our stakeholders toensure access when we have the SUPPORT program available in the U.S. to assistpatients in need. I want you to know the following approvals. Within one day wewere printing the product circulars. Within two days we began packaging andshipping products to our distribution centers, and within three days we beganto process and ship initial customer orders. The first business day after approval, our fully trainedspecialty representatives went to doctor's offices, informing them aboutISENTRESS. And as of today the first prescription has been filled. And we earmarked strong financial performance in the firstnine months of this year. We are raising our EPS guidance range for the fullyear 2007. We now anticipate a full year EPS range of $3.08 and $3.14,excluding restructuring charges and reported full-year EPS range of $2.87 to$2.93. I also want to tell you that CORDAPTIVE, proposed trademarkfor MK-524A, which is our investigated atherosclerosis compound, has been filedwith the FDA. This compound combines Merck's extended-release niacin with anovel Merck compound that reduces flushing, the common side effect of niacintherapy. Over and above that, we've added three compounds to thePhase III pipelines in the third quarter. MK-822 for osteoporosis, MK-7418 foractive CHF and we licensed MK-8669, an oncology compound from ARIADPharmaceuticals, with whom we've signed a licensing agreement last quarter. In addition to our internal pipeline progress, we continueto seek new licensing opportunities and targeted acquisitions in therapeuticareas that are of strategic importance to Merck. Indeed, our externalpartnerships and alliances have become an integral part of our considerableresearch efforts towards discovery and development of effective medicines. Meanwhile, our global restructuring initiatives is proceedingand on track. And ongoing initiatives will further reduce our cost structure;create a leaner and more nimble business model, so that we can respond quicklyand efficiently to customer's expectations. We can address emerging marketingdemands and so that we can support the drug discovery and development effortsthat are core to our business model. As we implement fundamental changes to every aspect of ourbusiness, we remain confident that our current products and anticipated newproduct introductions, as well as our cost saving initiatives will helpposition this company to deliver what we promised in December 2005. That is, wecontinue to believe that we can generate top-line growth in the range of 4% to6% on a compound annualized basis from 2005 through 2010, including 50% of therevenue from the joint ventures from which the company derives equity income. By sustaining our cost management initiative, Merck expectsto fulfill our promise to expand the product portfolio while maintainingmarketing and administrative expenses flat in 2010, relative to thereof 2006,and compound annual double-digit earnings growth excluding restructuringcharges and one-time items by 2010 from a 2005 base. Although the healthcare market continues to be challenging,we are confident that our customers will continue to find value in our productsthat are our products sets us apart from the rest of the industry. I want to add a note about one other thing that makes meproud to work at Merck. Today marks the 20th anniversary of our commitment todonate MECTIZAN to all those in need of the treatment of river blindness andprevention of LF for as long as these diseases continue to be public healthproblems. And today after seeing both the positive health on the demonic impactof Merck's Mectizan Donation Program in areas affected by the disease, we haverenewed our commitment to this initiative. Thanks to the efforts of Merck andour many partners since 1987, we have distributed more than 530 milliontreatments in 33 countries where these diseases are epidemic. This is but one reflection of our company's philosophy andpractice to ensure that the outcome of our discovery and development effortsreach the patients who need them most. Now, I would like to take a moment to introduce to Mr. PeterKellogg, our new Chief Financial Officer. This is his first earnings call atMerck and we are pleased to welcome here today. Peter will provide more detailsof Merck's financial performance and guidance, and we will be happy to answeryour questions at the end of the call. So with that, I am pleased to turn the call over to Peter.
Peter Kellogg: Thank you, Dick and good morning. It's a pleasure to behere. As Dick said, we are extremely pleased with our business results. In thethird quarter, the company reported double-digit growth in the top-line anddouble-digit growth on the bottom line. The performance is achieved while thecompany is actively re-engineering the way we work, Merck operate in severalareas. It included the impact of R&D charge for NovaCardia of $325 millionor $0.15 per share, and it is in a period when we are lapping a major part ofproduct exploration last year. The third quarter reported EPS, excluding restructuringcosts, was driven by several lines in the P&L, all with strong results.First, revenue growth of 12% reflects strong performance of our new and in-linevaccine, the continued uptake of JANUVIA and JANUMET, and the continued marketleadership and strong performance of SINGULAIR. Secondly, product gross margin continued to improve and thistrend is the result of both operational efficiencies and certainly Q3 favorablemix. Finally, we continue to see outstanding performance in ourpartnerships and alliances, which resulted in strong equity income growth. So, while I'll go into more detail about the underlyingdrivers of our performance in a minute, I should note that this exceptionalperformance has led us to increase our full-year 2007 EPS guidance yet again.So, let's begin with top-line revenue. Dick mentioned several of the highlightsof the quarter a moment ago, so I'll build on that. Let's start with Q3 total revenue, which was $6.1 billion,that's a 12% increase over the same period last year and it, included ninepoints of growth in volume, two points of benefit coming from foreign exchangeand one point from price. A major contributing factor to our top-line growth came fromour vaccines business. In Q3, vaccines revenue as recorded by Merck was over$1.2 billion. That's a 124% increase as compared with the same period in 2006.And this is driven by the continued uptake of GARDASIL, ROTATEQ, and ZOSTAVAX.So, our three new vaccines accounted for roughly $650 million in Q3. Let's start with GARDASIL. We are obviously extremelypleased with global sales for GARDASIL, as recorded by Merck, which reflectsthe continued strong underlying demand for the vaccine in both the public andprivate sector. Of the $418 million recorded in the quarter, $328 million wasin the United States.Sales outside the U.S.continue to show strong growth and increased 27% sequentially, as we continueto successfully navigate the processes surrounding regulatory approval, countryrecommendations and reimbursement with government. Merck's year-to-date revenue for GARDASIL is now over $1.1billion, as Dick said. So it is already a blockbuster after only nine months,and remember this is a vaccine. When you take the end market sales as recordedby Merck and include end market sales recorded by the Sanofi Pasteur MSD jointventure, global sales of GARDASIL increased 28% sequentially in the thirdquarter. Now let's turn to VARIVAX. In the third quarter revenue was$284 million, a 218% increase over prior year. This strong quarterly result wasthe function of two major factors. First, as of September 30th, all 55 VFCprojects had adopted the second dose varicella recommendation. 52 had adoptedthe recommendation for all children, including catch-up, while the other threeprojects have adopted for 4 to 6-year-olds. Now the cohort where we are seeingthe most uptake in the second dose is in the 4 to 6-year-olds. Secondly, the use of vaccine business experiences a certainback-to-school surge. It does make Q3 a peak period. Indeed, recent demand forVARIVAX has been unprecedented, and when coupled with the ACIP recommendation,we have to acknowledge that there is some seasonality here. Now, Merck isfurther increasing production of VARIVAX and we fully expect to meetanticipated market demand for varicella, measles, mumps and rubella vaccine. So let's move to the category of other promoted medicine. InQ3, total sales were $1.5 billion and that's an 18% increase compared with thesame period in 2006. And of course, we have to go straight to JANUVIA. As youknow, we launched JANUVIA late last year. It is currently approved in 58countries worldwide. With this JANUVIA is the only DPP-4 inhibitor available inevery region of the world for use in the treatment of type 2 diabetes when dietand exercise are not enough. In a third full quarter in the market, globalrevenue for JANUVIA reached to $185 million, of which $171 million is in the U.S. Then turning to alliance revenue, that obviously contributedto our top-line revenues as well and primarily AstraZeneca is the key playerthere. Q3 revenue recorded by Merck from our relationship with AstraZeneca was$416 million, and that's a slight decrease versus prior year. As always, keepin mind that there is inherent variability relating to this revenue, given thatMerck is not actively managing these products. Our revenue recognition takes into account inventory levelsat AstraZeneca, for PPI and non-PPI products, as well as their productshipment. So, we try to capture and adjust for any fluctuations in inventory. So, moving to the total revenues for medicines and vaccines,as we have stated many times, we have the opportunity to capitalize on ourrobust product portfolio and deliver compound annual growth rate that areattracted through 2010. Despite certain patent expirations during this timeframe, wecontinue to expect revenue growth of 4% to 6% on a compounded annualized basis,driven by our in-line products, our launch products and our new potentialproducts in the pipeline. And of course, this includes 50% of the revenues ofthe joint ventures moving out of the 2005 base. Taking the third quarter revenue announced today and adding50% of the revenues from the Merck/Schering-Plough, Merial, Sanofi Pasteur MSD,and Johnson & Johnson-Merck joint ventures and partnerships. Our Q3 revenuewith $7.3 billion, that's a 15% increase if you do the same adjustment in thebase period. Year-to-date, the same measure is $21.3 billion, and an 11%increase over the same period last year. And again, this stellar, year-to-date top-line growth isover a base period that included ZOCOR prior to the loss of marketingexclusivity. Just to take that a little further, if we were to exclude ZOCOR,PROSCAR, and the revenue associated with the supply of authorized generics fromthe first nine months of 2007 and the first nine months of 2006, then for whatyou might consider the ongoing portion of business, our year-over-year revenuegrowth would have been 25%. This again emphasize the strength of our organic business,fueled by our established brands and the newer recently launched nextgeneration of products that will take us forward. Regarding 2007, this third quarter and year-to-dateperformance has driven us to revise our full year revenue guidance to supportour increased full year EPS guidance. This guidance revision includes five ofour product guidance elements. SINGULAIR, where we narrowed the full year rangeby $100 million, that now stands at $4.1 billion to $4.3 billion, vaccines,where we increased by $300 million the full year range. That now stands at $4.2billion to $4.6 billion. COZAAR and HYZAAR, where we narrowed the full yearrange by $100 million, so that's $3.2 billion to $3.4 billion. FOSAMAX, wherewe also narrowed the full range by $100 million and that stands at $2.9 billionto $3.1 billion. And ZOCOR, where we narrowed the full year range by $100million as well, and that now stands at $0.7 billion to $0.9 billion. We are reaffirming full year guidance for other reportedproducts and AstraZeneca, and as always the AstraZeneca guidance is an updatebased on recent results, as well as future expectations and reflects thedynamics of the PPI market, which includes multiple generics, OTC products andthe uncertainty these create with regard to future volume and pricing. Alsokeep in mind that our reaffirmed guidance incorporates the expectations of thenon-PPI products. As always, to assist your modeling, we provide a breakdownof the product revenues in our other financial disclosure schedule attached tothe press release issued this morning. So moving past revenue into the materials and productionline, in the third quarter materials and production were $1.5 billion. Now,this quarter includes $129 million for costs associated with the globalrestructuring program, primarily related to accelerated depreciation and assetimpairment costs. Excluding these costs, materials and production increased 3%in the quarter. Our Q3 product gross margin with 75% and this reflected a2.1 percentage point unfavorable impact related to the restructuring cost thatI just mentioned. Excluding these restructuring charges, we have the thirdquarter product gross margin of 77.1%. Just as in previous periods theseresults were indeed, affected by the final product mix. Our year-to-date adjusted gross margin therefore is 76.4%.Given the strength of this result, we are raising our full year 2007 guidancerange and now anticipate our product gross margin to be approximately 76% to76.5%. This guidance excludes the portion of the restructuring cost that willbe included in product cost and will affect reported PGM in 2007. Moving to the marketing and administrative line, in thirdquarter our marketing and admin expense was $2 billion, an 18% decrease versusthe same period last year. In the third quarter, after reviewing the actualcost incurred and estimates for future costs, the company determined that itwas appropriate to record a charge of $70 million to increase the reservesolely for the future legal defense cost related to the VIOXX litigation, andthat takes it up to $720 million as of September 30, 2007. Regarding the legal defense reserve charge, the company accrueslegal defense cost expected to be incurred in connection with the losscontingency when such costs are probable and reasonably estimable. In the third quarter, the company spent a $160 million inthe aggregate for legal defense costs worldwide related to VIOXX litigation. In adjusting the reserve the company considered the samefactors that it considered when it previously established reserves for theVIOXX litigation, including the actual cost incurred by the company, thedevelopment of the company's legal strategy and structure, in light of thescope of the VIOXX litigation, the number of cases being brought against thecompany, and the cost and outcomes ofcompleted trials and the most current information regarding anticipated timing,progression and related costs of pre-trial and trial activities. Events such as scheduled trials, which are expected to occurinto 2008, and the inherent inability to predict the ultimate outcome of such trials,limits the company's ability to reasonably estimate its legal cost beyond theend of 2008. Accordingly, the reserve at September 30, 2007 represents thecompany's best estimates of legal cost that will be incurred through 2008. While the company does not anticipate that it will need toincrease the reserve every quarter, it will continue to monitor its legaldefense cost and review the adequacy of the associated reserves. They maydetermine to increase its reserves for legal defense cost at any time in thefuture if based on the factors mentioned above, it believe it would beappropriate to do so. To date, the company has not established any reserves forany potential liability relating to the VIOXX litigation itself. Excluding the charges in 2006 and 2007, M&A actincreased 6% in the quarter. Regarding underlying level of spend, once again,the primary drivers of the marketing and administrative increases werepromotional spend for JANUVIA and JANUMET, and continuing efforts to moreaggressively support the ZOSTAVAX launch. While appropriate, these were deliberate choices made inresponse to the evolving competitive dynamics that we felt could provideadditional advantages as we have the first-in class product. As you see fromour revised product specific financial revenue guidance, we are increasing ourrevenue guidance to reflect this incremental investment. Reflecting on our commitment to realizing efficienciesthroughout the company and optimizing our cost structure, the component ofmarketing and administrative consisting of selling and general administrativecosts, which support our core operations, remained down year-to-date over theprior year. So, let's turn to guidance for marketing and administration.It's pretty clear from the Dick's comments and what should view the commercialteam continues to have a very full agenda there really indeed. We are beginningto launch ISENTRESS and continue to build on the momentum on the previous sevenlaunches over the last 24 months, that's quite a handful to juggle. As we look at trends and opportunities in the rest of 2007,we are increasing our guidance for marketing and admin to 2.5% to 3.5% growthover prior year. Now, a good part of this change is driven by the Euro, whichhas significantly increased during 2007. It now stands above 140 to a dollar ascompared to mid 120 at the beginning of the year. Now, of course, we see this is as a benefit on our top-linerevenues, adding roughly two points to the overall Merck revenue growthyear-to-date and in Q3.But this will also add roughly 2.5 points to the fullyear marketing admin growth. Secondly, we are maintaining a healthy amount ofsupport behind the success of our growing core and new franchises. In Q4, we anticipate DTC efforts for SINGULAIR and JANUVIA,as well as increased promotional support for GARDASIL, ROTATEQ and ZOSTVAX. Wewill also be supporting our ongoing launch agenda at Merck, MK-524A and ISENTRESSfor the U.S.and continued support for the international rollouts of the JANUVIA andGARDASIL. Finally, we are comfortable with the focus and management ofthis investment. It is being very well spent and managed. It is important tonote that in Q4, we anticipate a reduction in marketing and admin spendingversus the prior year. Now, let's turn to research and development. In Q3, ourR&D expenses were $1.4 billion, that's a 52% increase from the comparableperiod in 2006. And of course, it included the NovaCardia in-process R&Dcharge. Excluding NovaCardia, R&D was up 18% versus 2006. I want to take an extra minute to explain this result andour R&D guidance for the remainder of year. At Merck, we remain committedto fully funding core, internal R&D to ensure the continued progress ofcompounds in all phases of development. Internal R&D growth remainedstrong. We continue to invest in late-stage, clinical programs on ISENTRESSMK-524A, MK-524B, MK-364, MK-822, MK-974, you get the point. In addition, allof our vaccine developments and progress. So, in addition, the company continues in active externalcollaboration and business development agenda, funding clinical grant programs,third-party scientific collaborations and important licensing transaction. Sooverall, our R&D spend is focused on progressing our pipeline and adding toit any outsider as well. So regarding the full year, we are raising our 2007 guidancefor research and development expense to adequately resource incrementalexternal R&D opportunities. And now anticipate R&D spend to increase 13to 15 percentage points over the full year 2006 level. Our R&D guidance includes the impact of the acquiredresearch charge associated with NovaCardia and I would refer you to our pressrelease to see how we define the base period on a similar basis. Although, Ibelieve all of you have it captured correctly in your models and reports. So, in the third quarter, turning to the restructuring, ourtotal cost associated with the global restructuring programs was a $178million. Now, as I mentioned before, $129 million was for asset related chargesthat are included in materials and production. The restructuring cost line itself reflects $49 million ofcost for employee separation, and other related costs associated wasapproximately 250 positions eliminated and that is now a total to 6,000 todate. So, we remain on track to eliminate 7,000 positions by the end of 2008.Restructuring guidance for the full-year 2007 would indicate that our aggregate2007 pre-tax expense related to these activities is estimated to beapproximately $700 million. Now, let's turn to the equity income line. In the thirdquarter, equity income from affiliates was $769 million. Just to remind to you,this line relates to the contribution from all of our JVs, AstraZeneca, Merck/Schering-Plough,Merial, Sanofi Pasteur, Johnson & Johnson. Our Q3 performance reflects the continued success of theMerck/Schering-Plough cholesterol franchise in the U.S.and Europe, The seasonality of the MerialAnimal Health Business and an increasing contribution from our Europeanvaccine, JV Sanofi Pasteur. Regarding the Merck/Schering-Plough partnership, the thirdquarter combined MSP cholesterol franchise global revenue as reported by theMerck/Schering-Plough partnership continued to grow at $1.3 billion. Q3revenues of VYTORIN and ZETIA were $693 million and $607 million respectively. In the U.S.,VYTORIN was $526 million, up 22% and ZETIA was $443 million, up 14%. WithinMerck's quarterly equity income result, the Merck/Schering-Plough partnershipcontributed $481 million and that reflects a 37% increase over the prior year. Returning to AstraZeneca, as always, I have to remind youthat there are several components to AstraZeneca equity income that make itinappropriate to draw significant conclusions just based on PPI products. Thereare complexities involved with a minimum timing and tax differences. That said,the third quarter equity income contribution for Merck's share of thepartnership with AstraZeneca was a $181 million. The balance of equity income comes from our other jointventures namely Merial, Sanofi-Pasteur and Johnson & Johnson-Merck. Given this result we are narrowing our guidance for fullyear 2007 by $100 million and now expect equity income from affiliates to beapproximately $2.8 billion to $3 billion. So, let's move to our tax line. First, our Q3 income beforetaxes was $2.1 billion. So, our taxes on income in the period were $539 millionand the reported tax rate was 26.1%. This reflects in general the changes inforeign and domestic mix and currency fluctuations. These elements changethroughout the quarters as always. We are reaffirming our full year 2007 tax rate guidancerange and I would direct you to today's press release for details. So, moving to net income, our Q3 net income was $1.5 billionand our Q3 earnings per share was $0.75, excluding a 5% charge for siteclosures and position eliminations, primarily associated with the globalrestructuring. Our reported third quarter EPS was $0.70. So, let's turn to 2007 guidance. I had mentioned severalchanges as part of the results review already and I will direct to you to thedetails of our financial guidance contained in today's press release. We areraising or changing many elements of our full year 2007 guidance and as aresult, Merck is raising the full year 2007 EPS range to $3.08 to $3.14,excluding the restructuring charges related to site closures and positioneliminations. In another words, we anticipate that the EPS,ex-restructuring will grow in the range of 36% to 48% in the fourth quarter ofthis year versus prior year. On a reported basis, we now anticipate GAAP fullyear 2007 EPS of $2.87 to $2.93. As stated, this guidance does not reflect theestablishment of any additional reserves or any potential liability regardingthe VIOXX litigation. We are committed to providing quality full year guidance andupdating it during the year. We believe that there is value in providingquality financial guidance, because it assists investors and we do recognizethat our business is complex, and we serve our investors well by communicatingour financial performance expectations. So in summary, the company remains on track, both in termsof strategy and performance, to delivery long-term double-digit earning per sharegrowth from 2005 to 2010, excluding one-time items and restructuring charges.We have the financial strength to support our dividend and we remain fullycommitted to maintaining our dividend at the current level, at the same time wecontinuing to fully invest in our key strategic priorities. With our year-to-date performance and our guidance for fullyear it is clear that the products are driving a healthy top-line, despitelapping the ZOCOR expiry. We anticipate continued strong performance from ourkey franchises in the remainder of this year. So, if you take this all together, Merck is clearly verybusy with its successful product launches worldwide. And behind the scenes, wecontinue to reengineer the company into a lean and effective competitor for thefuture, for the good quarter. With that said, I will turn the call back to Graeme. Graeme?
Graeme Bell: Thank you, Peter, and we certainly appreciate your patienceduring the prepared remarks. We will now open the call and take your questions.We will take the questions in the order in which they are received and try to getthrough as many as possible. Please help us to keep on track by asking a one ortwo part question only. So at this point, I will turn the call back over to Crystal,who will communicate instructions of our Q&A format, and then introduce ourfirst question.
Operator: (Operator Instructions). Your first question comes from theline of Tony Butler with Lehman Brothers.
Tony Butler: Yes. Thanks very much. Just back to the gross margin, Peter,if possible, the rise to 76%, to 76.5% from 75% to 76% is curious. And youmentioned the principal driver, if I am not correct please help me, is mix.However, if I am not mistaken, the greatest delta from the beginning of thisyear until today has been the growth in the vaccines component of revenue. Do Ihave just the wrong impression that vaccines might be a lower margin component,yet the increase in overall GM is critical? If you could help us with someunderstanding of the income grew and see of that of that notion. Thanks.
Peter Kellogg: Sure. Tony, let me just make some general comments. First ofall, your observation is correct, and that is, vaccine has been doing verywell. But, obviously the other product lines we have as well, are very big, andso you take kind of the weighted average of all those, you got factors movingboth ways. But in fact, as we went from the second quarter to third quarter andas we projected out for the full-year, you do see some mix affect that helpedus in Q3. What I would recommend is that we updated it and narrowedthe range for product gross margin and excluding restructuring charges. So, Iwould go with that. But, in fact, you are right, there are different mixeffects, some of which based on like, for example, vaccines would cause you togo one way, but some of the other products over way that for the time being.But in general, obviously, as we narrow the range, we actually also increasethe range, excluding restructuring. So obviously, the general conclusion is thetrend is positive despite some of the vaccine business activity.
Tony Butler: Thanks, Peter.
Dick Clark: And Tony, another point is around supply strategy as well.So, as our strategy is put in place, and as we do the right combination ofoutsourcing and put the Merck the production system, which is Six Sigma Lean processin place, and you are seeing improvements. And as I have mentioned many times,it's not only on the pharmaceutical side of business, the biological vaccines,which is obviously very critical to us ensuring a volume increase, to be ableto improve them and our ability to improve those PGM will be substantial, ofcourse, looking forward.
Tony Butler: Okay.
Graeme Bell: Next question please.
Operator: Your next question comes from the line of Barbara Ryan with DeutscheBank
Barbara Ryan -Deutsche Bank: Good morning. Thanks for taking my question. I wonder if youcould just speak to some of the trends for JANUVIA in the U.S., relative to the reportedresults in the scrip because, obviously the scrips are up about 50% in thethird quarter versus the second. Although, those revenues reported in the U.S.are relatively flat. So, I am assuming that there were some stocking in thesecond quarter and maybe de-stocking in the third. But maybe, if you could justhelp us understand that sequential line, just for the purposes of understandingbetter the fourth quarter, thank you.
Dick Clark: Yes. Thank you, Barbara.
Barbara Ryan -Deutsche Bank: Thanks, Dick.
Dick Clark: You are absolutely right. Even though we mentioned thatManaged Care Advisory increasing for JANUVIA, and JANUVIA also ranks second inbranded New Rx volume. There is some stocking impact in the second quarter,particularly for JANUMET since some initial purchases for whole of the launchof the product is in April of 2007. And as you also know is that it's a provenin 58 countries, but we are just beginning a process outside of the U.S.So we are very, very optimistic and very strong with the future of JANUVIA, andthat's not only for this year, but obviously in the future years and it's offto a great start with a great franchise team in the U.S. and global franchise teamthat's holding it up across the globe. Thank you.
Graeme Bell: Next question, please.
Operator: Your next question comes from the line of David Risingerwith Merrill Lynch.
David Risinger -Merrill Lynch: Yes. I am now French. I have two questions. First, onGARDASIL, could you please comment on government purchases in the third quarterrelative to the second quarter? If you could provide any detail, that would behelpful and also, if you could talk about compliance with the three doses, andwhat you are seeing to date? And then in addition, if you could just discussthe ZOSTAVAX opportunity going forward, it seems to me that that is asubstantial opportunity yet the trajectory to date has not been thatsignificant. And, as part of your answer, if you could just discuss anychanges, in reimbursement for 2008?
Dick Clark: Well certainly starting withZOSTAVAX. As you know, what we have said that we are back in production againfor various double component of ZOSTAVAX. And so, as that continues to moveforward from a production standpoint, that will put us in a refrigeratedZOSTAVAX versus the frozen ZOSTAVAX, which we need globally. ZOSTAVAX in myopinion is a key vaccine for our future, and that we'll see growth. We areworking with our customers, and with physicians, and with CMS to try to come upwith a process in place that makes it less onerous from a reimbursementstandpoint for the physician, as well as, for the client and patients toovercome that. And we haven't been able to come up the right partnership for that.I think we are making process on it, and so I am very happy with where we'removing forward as long as we can consolidate that, and particularly with thevolume depth moving forward. Obviously, in the third quarterwith everything that we have done from a vaccines standpoint, with GARDASIL inthe uptick, particularly with the initial dose, one of the keys is to make surethat we don't lock it in for the second and third dose. And so, we have put inplace substantial reminder programs that allow them to improve the ability toremember to go back to the second and third dose. So, we're doing it by mail,we're doing it by e-mail, we're doing it by text messages, and a variety ofdifferent technologies to be able to make sure as they come, particularly collegestudents as they come back for grades, that they get to second, and third dose.And so that compliance capability is extremely important to us.
Graeme Bell: And Dave, just on your initial question with regards torevenue, domestic revenue for GARDASIL in the quarter, you know, we are stillseeing that contribution coming from both the public and private. There was nomarked increase in the orders being placed by the public sector through VFC andCDC. So, we're seeing this leveling off in terms of underlying demand in themarket and the 3Q revenue reflects that.
David Risinger -Merrill Lynch: Thank you.
Graeme Bell: Next question please.
Operator: Your next question comes from the line of Tim Anderson with SanfordBernstein.
Tim Anderson: Thank you. Couple of questions, on GARDASIL, in the U.S.specifically, can you give us a rough idea for what percent of the time theproduct is being used in a population different from what's technically indicatedin the label? And then the second question is, just looking at FOSAMAX sales inthe quarter, in international markets can you update us on what's happening orwhat's likely to happen with generic FOSAMAX in Europe, following the previousrestatement of the patent protection there. I am just wondering what to expectin terms of future brand performance as long as it technically remains on patent.
Graeme Bell: All right, gentlemen, I'll take that if you don't mind. So,with regard to GARDASIL in the U.S.in terms of percentage used outside the approved range, so again, it is 9% through26% at this point. We are seeing very, very limited use beyond that initialindication, primarily because physicians are focused in obviously on the datathat we have in hand and as we've communicated to all including the physiciancommunity who are administering, that we will not have efficacy data pertainingto the mid-adult woman in-house until the fourth quarter. So, as Dick mentionedin his prepared remark, the expectation is that we will have that data andbegin to move that forward for labeling expansion. With regard to the age range that was currently indicated,we began to see a little more use in the twelve through eighteen-year-old range.Initially, when we launched the product we were seeing even distribution fromnine through twenty six-year-olds. But, clearly with the concentrated effortthat Dick just articulated pertaining to going after college students and theappropriate age range, you'd expect to see the origination all the immunizationoccurring in the twelve through eighteen-year-old. And that is also a phenomenon,which is taking place ex-U.S. as well. With regard to your FOSAMAX question internationally,obviously you are aware of the reinstatement by the European patent office.Where we are with regard to that is, clearly were in a process of identifyingwhere there is currently illegal weekly alendronate on the market and takingappropriate legal steps to determine what actions we can take to remove thatoff the market. The other complexity comes of course, in the fact that towardthe end of this year and as to early part of next year there will be legalalendronate sodium available in the EU for the daily dosing. So we got a twopart challenge really, that is to A). remove from the market the illegal weeklyand keep it off while simultaneously, B). renegotiating with countries in termsof ensuring that we can continue to have weekly branded in Europethrough the period immediately following patent expiry all the way through2018.
Tim Anderson: Thank you.
Graeme Bell: Next question please.
Operator: Your next question comes from the line of Chris Schott withBanc of America.
Chris Schott: Great, thank you, just got two quick questions. Maybe, firston your gross margin side, you get a strong increase year-over-year. Can youmaybe talk about, aside from the mix, the benefits of restructuring program?How far are we through that program at this point? I guess, another way lookingat it, are our current numbers reflecting much of that benefit or should weexpect additional opportunities over the next couple of years? And then just quickly in your CT pre-inhibitor, has adecision been made moving into Phase III? I know the Phase IIB [cetropib] datathat showed some strong LDL reductions, I guess, and based on your discussionswith the FDA, do you believe LDL could be part of a filing pathway there?Thanks.
Dick Clark: Regarding the second question, we have not made a decisionyet to go in Phase III. So we are still evaluating, not only our compound butthe mechanism in general, and are waiting for an additional externalinformation before we make the decision. Concerning our PGM's moving into future and in our supplystrategy, as we said positional eliminations around 6,000 of the 7,000 that wecommitted to back in December 2005. But when it comes to where we are from aLean and Six-Sigma process and our outsourcing capabilities, and our ability toincrease the PGMs within the vaccine areas by using any of this methodology. I would say, we are probably around 50% where we want to be,and so within the next two years we will be continuing to make progress ineffectiveness in standard efficiency within the supply chain. And alsosomething that we are very excited about when it comes to PGM, we alsonaturally gravitate towards the supply strategy and production, but many partsof the PGM are also based on marketing concepts and packaging, and whatcustomer's and physicians need and distribution. And so there is many parts of that we integrate, that weneed to think about and I think Merck has this one Merck approach, of how wethink about PGMs now across all the functions in a company. So, I am verybullish in where I think our PGMs will be moving based on the statements wemade in December 2005 and our ability to achieve a pre-ZOCOR numbers in thenear future.
Graeme Bell: Next question, please?
Operator: You next question comes from the line of Bert Hazlett withBMO Capital Markets.
Bert Hazlett: Thanks, good morning. Thanks for taking my questions. Firston SINGULAIR, could you just comment on international trends you are seeingthere. Again, uptake in foreign sales has been significant, could you justcomment on currency effects, price volume and maybe what's driving that? Andthen secondly, with regard to ROTATEQ, again it's proved in sixty ninecountries we have a significant pickup in the U.S., what's holding back theinternational sales, is it the question of the bulk of them being driventhrough Sanofi Pasteur, or is it a question of pricing or reimbursement or justa little color there? Thank you.
Dick Clark: I think with the ROTATEQ question is that obviously, ourreimbursement act that we need to be able to put in place throughout the world.The supply is available and we're now rolling it across and then in many othercountries. But it just takes times. As you know, vaccines are different thanpharmaceutical products and getting them positions approved and reimbursed positivelyin degree and though Merck also has a responsibility to as we've been throughthis in the developed world, as also think about accessing this in developingworld and to make sure that we put programs in place to have it availablethere. From a SINGULAIR standpoint, I can't give you the specificstowards your question other then say that we are pleasantly surprised about notonly SINGULAIR in United States with its labeling and where it'spositioned from a formula standpoint. But, it is an outstanding product and itstill is receiving uptake throughout the world, and much of it is based onvolume.
Graeme Bell: Yeah. So, I would just add to that I mean, in Europe, MiddleEast and Africa as we see it SINGULAIR washealthy in the quarter. We seldom breakdown revenue by geographical region, butI can't tell you that in the region it was up over 20%, about 22%, the majorityof which was volume. So the volume growth is primarily a function of labelexpansion of montelukast sodium and the label carries off these indication forallergic rhinitis and it is one of the, in fact, it is the only product on themarket with that indication. So, that's what is fuelling that strong Europeandrive.
Bert Hazlett: Thank you.
Graeme Bell: Next question please.
Operator: Your next question comes from the line of John Boris withBear Stearns.
John Boris: Just have two questions. And thanks for taking the questionand congratulations on the quarter. First question you, Dick, on the JANUVIA,JANUMET, there appear to be case studies on how to decrease cycle times. Isthere any additional room for taking additional days, months, years out of thecycle time with respect to products and other any that you would like to key usin on as to what you might be applying to those products going forward that areentering or have entered the clinic? And then on GARDASIL, of the $328 million reported in thequarter, can you comment on the stocking at the physician level? How many dosesis the physician stocking and can you comment on the total number of patientsin the U.S. that have been treated to-date and with your three key strategyhere what percentage of them have been treated once, twice, or three times.Thanks.
Dick Clark: With your first question concerning cycle time with JANUVIAand JANUMET, I believe as you look at the progress we made from a cycle-timereduction, not only a clinical base in these products but in the manufacturing,the supply side has been significant and we believe that there is moreopportunity there. And so we've actually made a commitment. What's importantabout it is, and the practices were put in place across the company is not onlyto do it, obviously with JANUVIA and JANUMET, but to do it for the entireportfolio. So, if you can do that for the portfolio, you can imaginethe impact this is going to have on a companywide basis. And so, we've putsubstantial resources in focus on our clinical development, as well as ourother aspects of the company to be able to continue that. And I think you'llsee much more progress in the next several years in continued cycle timereduction. And as you know, once you are able to reach a steady state, itcontinues improvement, methodologies tell you that there's always room forfurther improvement. So, I am never going declare victory when it comes to cycletime reduction, either in research or in the manufacturing side. There isminimum stocking on GARDASIL from our physician level standpoint. I can't tellyou specifics around where we are with our three key areas of going for thesecond dose and the third dose or what that minimum is. It's still too earlyfor us to be able to provide data on.
Graeme Bell: And part of the reason why we can't do that John, is thatI'd have to remind you that, we are going after approximately 118 million girlsand women in the U.S., EU and other highly developed markets that are withinthe appropriate age range for GARDASIL indications. So, even if you pad up backand look in the United States alone, there are thirty six millionfemales who are eligible to receive this vaccines and the intent here is toensure that all of them, obviously receive all three doses from a complianceperspective. And as you've heard from the prepared remarks, since June of 2006 whenthe product was approved we have shipped and sold 13 million doses. So there's certainly a long way to go and we continue togather the intelligence. But one data point that I would point to you is, ifyou go on gardasil.com, which we constantly update, you can see and read as dothe individuals who are getting GARDASIL, the new banner there which is threeis key. And three is key, is the compliance message that we're basicallycommunicating to the physician community, to pediatricians, and the OB/GYN.
John Boris: Okay. That helps.
Graeme Bell: Next question please.
Operator: (Operator Instructions). Your next question comes from theline of Seamus Fernandez with Leerink Swann. Seamus Fernandez- Leerink Swann Thank you. Just a couple of quick questions, I just steppedout of the room for a second, but I apologize. I wanted to know if you couldupdate us on timing of the PROQUAD, re-launch and manufacturing and just giveus a manufacturing update on that front. And then secondly, SINGULAIR after theend of this year will be the last allergic rhinitis drug or branded allergicrhinitis drug on the market to our knowledge and as the Zyrtec comes offpatent, are there potential formulary risks for Merck here in 2008, whether itbe on prior authorization or on formulary changes and how would that impactyour growth rate? Thanks.
Dick Clark: Your question on PROQUAD is, and I mentioned that in earlierquestion that we are now back in production with the varicella component ofPROQUAD and started up and are waiting for the results. We are very optimisticabout the result of that. It's really difficult to commit to a specific datehere once till we see titers and the potency performance for that movingforward. But, I am optimistic that we have a solution there, and manufacturingis back in action and that's very positive. From a SINGULAIR standpoint, when you think about theclinical indications we have, and the success we've had with SINGULAIR to date,it reminds me a little bit of the simvastatin situation. And so, when a productlike that goes off the patent, there's still obviously a focus on that from ageneric standpoint. But, when you have such an excellent label and indicationsfor SINGULAIR to be able to have them remain on the second tier of formularies,I think SINGULAIR will do very, very positive.
Graeme Bell: So next question, please. I am conscious of the time and Ibelieve we have three more questions in the queue. So we will take that and putit off. So, next question please Crystal.
Operator: Your next question comes from the line Steve Scala withCowen
Steve Scala: Well, thank you. I was just wondering, do you believe yourtop and bottom line guidance through a 2010 is achievable? If you exercise yourput to AstraZeneca for the non-PPI products in Q1 of '08 or will your guidanceneed to altered when you take the non-PPI part? The concern is that, if you doput in Q1 of '08, can't AstraZeneca call the PPI's in Q1 of 2010 and aren'tthey at non-trivial component of your earnings?
Dick Clark: Steve, as we put the December 2005 targets in place, it wasex any impact from the AstraZeneca activity.
Graeme Bell: Next question please
Operator: Your next question comes from the line of Roopesh Patel withUBS
Roopesh Patel: Thank you. Just a couple of question. First on ROTATEQ. Iwas wondering, if you could just elaborate on the outlook for the product salesbeing very strong for this quarter. Is this the run rate we should be lookingat moving forward? And then just separately on VIOXX litigation charges, I wasjust wondering if the year-to-date spending is a rough representative of thegeneral run rate we should be again looking at moving forward, if not, what arethe factors that led through? Thanks.
Peter Kellogg: Bell,if you want, I’ll take the question on the VIOXX litigation, and I had justhighlighted. What we tried to do is sort out exactly what we know is coming,and so to talk about a run rate beyond 2008 is very difficult for us to do. Iam obviously involved in situation where we had a number of trials with andoutcomes from that. So, it would be hard for us to speculate exactly what therun rate may or may not be because it's really specific to the circumstancesthat we are looking at, and exactly what the trial count is, what the pre-triallegal activity is, and that’s obviously evolving as we go. So I would cautionyou to kind of jump too quickly to a run rate assumption, one way or the other,but I think we are pretty pleased with how things have gone so far. And your question on the ROTATEQ, there has been more than 9million doses of ROTATEQ that has been distributed, and it's estimated thatabout 62% of the birth cohort is now being vaccinated. So there is an uptickbased on the cohorts that we have today. And it is available through theVaccine for Children’s Fund in all 50 states and is 100% covered under ManagedCare. So we are very enthusiastic about the future of the product. Concerningthe global bases, it’s approved in 69 countries, and we have only launched in30 countries around the world to date. So, we are still very strong on what theperformance is moving forward, but at the same time as you know we’ll havecompetition in the near term with ROTATEQ.
Graeme Bell: And Crystal? Yes, sir?
Graeme Bell: Our last question for the day,and by no means least, I think we have Jami Rubin on the line.
Operator: Yes sir, that's correct, withMorgan Stanley.
Jami Rubin: Thank you, Graeme. I'm soflattered. Just I had a couple of follow-on questions on GARDASIL. You -- Peterhad talked about VARIVAX, it was a back-to-school effect, I was wondering ifthere was a back-to-school effect with GARDASIL? And well Graeme, I canappreciate why it's very difficult to pinpoint precisely where this vaccine isbeing used and what penetration rates are within that VFC market where I wouldimagine data is much stronger since they are ordering directly from you. Canyou tell us what is the penetration of the 11- to 12-year-old cohorts, where myunderstanding is the goal is over 80%? And then lastly, on international, saleswere $90 million, can you tell us what markets that represents and how much ofthat is stockings? Thanks.
Peter Kellogg: Jami, let me take a shot at thefirst one, which is the back-to-school dynamic. Obviously, we're dealing with apopulation where there is, does have a lot of school activity and some of themgoing and obviously hitting up the couch, so there is always that chance.However, we don't really feel -- it is clear that there is a strongback-to-school effect just yet, we haven't really concluded on that as much asthere is perhaps on the VARIVAX going. But nonetheless, it's certainly clearthat we are working with young women who are in the school age area and they maywell be visiting physicians before they go back to the universities and soforth, that's a possibility. Relating to the cohort question, actually let mejust hold up on that.
Graeme Bell: So Jami, with regard to the cohort question, we're stillseeing a very encouraging uptake within the VFC programs. So the age range thatthey are addressing particularly, right slightly younger female, that’s stillvery, very healthy and certainly moving along as we would expect. With regard to your question on international revenue, youare absolutely correct. We recorded -- we [Merck], Inc. recorded 91millionex-US, and I would point that out notwithstanding the statistics pertaining tothe approvals and the launches, when you look at the revenue contribution thereare basically six countries that are contributing to the $480 million. So, oneof those countries, I think US at 308, the remaining five countries includesthe likes of Australia and Canada,and that's just starting to continue to launch. So, your question on stockingisn't really a driver for the ex-US business, it is just basically countriescoming on line, but because you can appreciate we moved from approval intolaunch phase, and as we move into launch phase, it progresses through the revenuerecognition. I would point out that though, on the other financialdisclosures that Sanofi Pasteur MSD recorded revenue for the GARDASIL so endmarket as recorded by SP MSD was $137 million in the quarter, and again theycovered the 19 countries on territory. But again that $137 million onlyreflects three or four countries that are contributing in a meaningful wayabout revenue number.
Dick Clark: Well, thank you Graeme, and thanks for listening to our calltoday. As we stated, we are very pleased with the third quarter results, and weare certainly looking forward to updating you further on our future progress atour annual business briefing that will be held in Whitehouse Station onDecember 11. We'll be in touch with the details on this meeting very soon. So, thank you again, we appreciate your interest andparticipation. Operator, thank you very much.
Operator: Thank you, sir. This does conclude today's conference call.You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day, everyone, and welcome to Merck's Third Quarter2007 Earnings Conference Call. Today's call is being recorded. At this time, I would like to turn the conference over toMr. Graeme Bell, Executive Director of Investor Relations. Please go ahead,sir."
},
{
"speaker": "Graeme Bell",
"text": "Thank you, Crystal,and good morning. Welcome to our call this morning to review our results forthe third quarter of 2007. Joining me on the call today are our Chairman,President and CEO, Dick Clark, and for the first time we welcome Peter Kellogg,our Executive Vice President and Chief Financial Officer. Before we go into the details, I would like to go over somelogistics. On this call, we will review the results contained in the release weissued at 7:30 this morning. You can access this through the Investor Relationssection of merck.com, and I would remind you that this conference call is beingwebcast live and recorded. The replay of the event will be available latertoday via phone, webcast and as always, our podcast. As we begin to review the results, let me remind you thatsome of the statements made during this call may contain subjects that maycontain forward-looking statements as that term is defined in the PrivateSecurities Litigation Reform Act of 1995. These statements are based onmanagement's current expectations and involve risks and uncertainties, whichmay cause results to differ materially from those set forth in the statements. The forward-looking statements may include statements regardingproduct development, product potential or financial performance. No forward-looking statement can be guaranteed, and actualresults may differ materially from those projected. Merck undertakes noobligation to publicly update any forward-looking statement whether as a resultof new information, future events or otherwise. Forward-looking statements on this call should be evaluatedtogether with the many uncertainties that affects Merck business, particularlythose mentioned in the risk factors and cautionary statements set forth in item1A of Merck's Form 10-K for the year ending December 31, 2006, and in itsperiodic report on Form 10-Q and Form 8-K, which the Company incorporates byreference and that are also posted on our website. As always, we will begin with remarks from our seniormanagement, then open the call for all of your questions, and expect the callto last approximately 60 minutes. So with that, I will turn the call over and we will beginwith remarks from our Chairman, President and CEO, Mr. Clark."
},
{
"speaker": "Dick Clark",
"text": "Thank you, Graeme, and good morning, everyone. I am pleasedto report that the momentum that Merck began to build last year continues, asproven by the strong performance in this last quarter. In an increasinglydifficult healthcare environment, our company has been resilient whiledemonstrating an outstanding capacity to innovate, driving near-flawlessexecution, as shown by our regulatory and commercial success, and postsignificant revenue growth, show gains in market share and increase operatingincome. The results reported today show that Merck continues todeliver on its promise to remain a leader in the pharmaceutical industry. Year-to-date, we have reported solid growth of 8% on thetop-line and 24% on the bottom line. We are also working to ensure sustainedgrowth in 2007. We remain convinced our plan will enable us to achieve ourbusiness targets, meet emerging challenges,and discover and develop breakthrough medicines and vaccines. Merck's reported earning per share for the quarter was $0.70.Third quarter EPS, excluding restructuring charges was $0.75. That represents a47% increase compared to third quarter 2006. This increase includes the impact theNovaCardia charge in 3Q '07, as well as the legal defense cost in '07 and '06. The company's worldwide revenue was $6.1 billion during thequarter, which is an increase of 12.3% over the third quarter in 2006.Year-to-date, our worldwide revenue was $18 billion, up 8.2% compared to the firstnine months of 2006. Net income for the quarter was $1.5 billion. What distinguishes our performance is that it was driven bythe rapid uptake and strong growth of our new first-in-class vaccines andmedicines like GARDASIL and JANUVIA, as well as sustained growth from our broadrange of estimated franchises, including SINGULAIR. GARDASIL's performance has been up outstanding. In the thirdquarter, total Merck revenue for GARDASIL was $418 million. Year-to-daterevenue exceeds $1.1 billion. Merck has distributed more than 13 million dosesof the vaccine worldwide since it came to market in June of 2006. Today, GARDASILhas been approved in more than 86 countries and it is in various stages oflaunch in 72. Looking forward, study to evaluate the efficacy of GARDASIL inwomen up to age of 45 and 16 to 26-year-old young men are underway. Based on dataavailable at this time, a presentation of the mid-adult women data are expectedthis quarter. We also have two supplemental Biological License Applications forGARDASIL under standard review at the U.S. Food & Drug Administration toupdate the leveling for GARDASIL. Global revenue for JANUVIA and JANUMET reached $185 millionand $19 million respectively in the third quarter. Our revenues reflect thehigh value that physicians, patients and payers are placing on our products andon the healthcare benefits they provide. They also demonstrate that we continueto build on momentum established with our product launches last year. JANUVIA has already become the second leading branded oralantidiabetic agents in U.S.in terms of new prescription share. Going in to the fourth quarter, JANUVIA hasachieved reimbursement coverage in approximately 200 million lives on Tier 2,representing over 80% of targeted lives and more than 210 million lives in Tier2 and Tier 3, combined in the U.S. And JANUMET has achieved reimbursementcoverage in more than 179 million lives on Tier 2 and more than 200 millionlives in Tiers 2 and 3 combined, in the United States. Our overall financial results were also supported by thestrong performance of our partnership and alliances, specifically theMerck/Schering-Plough partnership, which continues to drive our equity income.[That positive] contribution helped us fund our increasing research spending oninvestigational product development, the acquisition of NovaCardia, and variouslicensing activities. It is encouraging that our business continues to deliversubstantial growth. This has been an outstanding quarter for Merck, as our newproducts established their leadership in an increasing competitive market. Evenas older products have gone off-patent, we are leveraging earnings from our newproducts and vaccine launches, while utilizing the new commercial model tofurther support and consolidate the strong positioning of our establishedin-line brands. As we look to the final quarter for this year and into 2008,we are purposely moving ahead the launch of ISENTRESS after the FDA granted theproduct accelerated-approval on October 12th. This represents the eighth approvalfor Merck in the last 24 months. This FDA approval clearly demonstrates ourability to deliver on our strategy of providing physician and patients withinnovative medicines that meet unmet medical needs. Introduction of ISENTRESS is the realization of thecompany's 20-year commitment to HIV/AIDS, and we are prepared to ensure thatISENTRESS launches well and reaches its full market potential. We will continue to work closely with our stakeholders toensure access when we have the SUPPORT program available in the U.S. to assistpatients in need. I want you to know the following approvals. Within one day wewere printing the product circulars. Within two days we began packaging andshipping products to our distribution centers, and within three days we beganto process and ship initial customer orders. The first business day after approval, our fully trainedspecialty representatives went to doctor's offices, informing them aboutISENTRESS. And as of today the first prescription has been filled. And we earmarked strong financial performance in the firstnine months of this year. We are raising our EPS guidance range for the fullyear 2007. We now anticipate a full year EPS range of $3.08 and $3.14,excluding restructuring charges and reported full-year EPS range of $2.87 to$2.93. I also want to tell you that CORDAPTIVE, proposed trademarkfor MK-524A, which is our investigated atherosclerosis compound, has been filedwith the FDA. This compound combines Merck's extended-release niacin with anovel Merck compound that reduces flushing, the common side effect of niacintherapy. Over and above that, we've added three compounds to thePhase III pipelines in the third quarter. MK-822 for osteoporosis, MK-7418 foractive CHF and we licensed MK-8669, an oncology compound from ARIADPharmaceuticals, with whom we've signed a licensing agreement last quarter. In addition to our internal pipeline progress, we continueto seek new licensing opportunities and targeted acquisitions in therapeuticareas that are of strategic importance to Merck. Indeed, our externalpartnerships and alliances have become an integral part of our considerableresearch efforts towards discovery and development of effective medicines. Meanwhile, our global restructuring initiatives is proceedingand on track. And ongoing initiatives will further reduce our cost structure;create a leaner and more nimble business model, so that we can respond quicklyand efficiently to customer's expectations. We can address emerging marketingdemands and so that we can support the drug discovery and development effortsthat are core to our business model. As we implement fundamental changes to every aspect of ourbusiness, we remain confident that our current products and anticipated newproduct introductions, as well as our cost saving initiatives will helpposition this company to deliver what we promised in December 2005. That is, wecontinue to believe that we can generate top-line growth in the range of 4% to6% on a compound annualized basis from 2005 through 2010, including 50% of therevenue from the joint ventures from which the company derives equity income. By sustaining our cost management initiative, Merck expectsto fulfill our promise to expand the product portfolio while maintainingmarketing and administrative expenses flat in 2010, relative to thereof 2006,and compound annual double-digit earnings growth excluding restructuringcharges and one-time items by 2010 from a 2005 base. Although the healthcare market continues to be challenging,we are confident that our customers will continue to find value in our productsthat are our products sets us apart from the rest of the industry. I want to add a note about one other thing that makes meproud to work at Merck. Today marks the 20th anniversary of our commitment todonate MECTIZAN to all those in need of the treatment of river blindness andprevention of LF for as long as these diseases continue to be public healthproblems. And today after seeing both the positive health on the demonic impactof Merck's Mectizan Donation Program in areas affected by the disease, we haverenewed our commitment to this initiative. Thanks to the efforts of Merck andour many partners since 1987, we have distributed more than 530 milliontreatments in 33 countries where these diseases are epidemic. This is but one reflection of our company's philosophy andpractice to ensure that the outcome of our discovery and development effortsreach the patients who need them most. Now, I would like to take a moment to introduce to Mr. PeterKellogg, our new Chief Financial Officer. This is his first earnings call atMerck and we are pleased to welcome here today. Peter will provide more detailsof Merck's financial performance and guidance, and we will be happy to answeryour questions at the end of the call. So with that, I am pleased to turn the call over to Peter."
},
{
"speaker": "Peter Kellogg",
"text": "Thank you, Dick and good morning. It's a pleasure to behere. As Dick said, we are extremely pleased with our business results. In thethird quarter, the company reported double-digit growth in the top-line anddouble-digit growth on the bottom line. The performance is achieved while thecompany is actively re-engineering the way we work, Merck operate in severalareas. It included the impact of R&D charge for NovaCardia of $325 millionor $0.15 per share, and it is in a period when we are lapping a major part ofproduct exploration last year. The third quarter reported EPS, excluding restructuringcosts, was driven by several lines in the P&L, all with strong results.First, revenue growth of 12% reflects strong performance of our new and in-linevaccine, the continued uptake of JANUVIA and JANUMET, and the continued marketleadership and strong performance of SINGULAIR. Secondly, product gross margin continued to improve and thistrend is the result of both operational efficiencies and certainly Q3 favorablemix. Finally, we continue to see outstanding performance in ourpartnerships and alliances, which resulted in strong equity income growth. So, while I'll go into more detail about the underlyingdrivers of our performance in a minute, I should note that this exceptionalperformance has led us to increase our full-year 2007 EPS guidance yet again.So, let's begin with top-line revenue. Dick mentioned several of the highlightsof the quarter a moment ago, so I'll build on that. Let's start with Q3 total revenue, which was $6.1 billion,that's a 12% increase over the same period last year and it, included ninepoints of growth in volume, two points of benefit coming from foreign exchangeand one point from price. A major contributing factor to our top-line growth came fromour vaccines business. In Q3, vaccines revenue as recorded by Merck was over$1.2 billion. That's a 124% increase as compared with the same period in 2006.And this is driven by the continued uptake of GARDASIL, ROTATEQ, and ZOSTAVAX.So, our three new vaccines accounted for roughly $650 million in Q3. Let's start with GARDASIL. We are obviously extremelypleased with global sales for GARDASIL, as recorded by Merck, which reflectsthe continued strong underlying demand for the vaccine in both the public andprivate sector. Of the $418 million recorded in the quarter, $328 million wasin the United States.Sales outside the U.S.continue to show strong growth and increased 27% sequentially, as we continueto successfully navigate the processes surrounding regulatory approval, countryrecommendations and reimbursement with government. Merck's year-to-date revenue for GARDASIL is now over $1.1billion, as Dick said. So it is already a blockbuster after only nine months,and remember this is a vaccine. When you take the end market sales as recordedby Merck and include end market sales recorded by the Sanofi Pasteur MSD jointventure, global sales of GARDASIL increased 28% sequentially in the thirdquarter. Now let's turn to VARIVAX. In the third quarter revenue was$284 million, a 218% increase over prior year. This strong quarterly result wasthe function of two major factors. First, as of September 30th, all 55 VFCprojects had adopted the second dose varicella recommendation. 52 had adoptedthe recommendation for all children, including catch-up, while the other threeprojects have adopted for 4 to 6-year-olds. Now the cohort where we are seeingthe most uptake in the second dose is in the 4 to 6-year-olds. Secondly, the use of vaccine business experiences a certainback-to-school surge. It does make Q3 a peak period. Indeed, recent demand forVARIVAX has been unprecedented, and when coupled with the ACIP recommendation,we have to acknowledge that there is some seasonality here. Now, Merck isfurther increasing production of VARIVAX and we fully expect to meetanticipated market demand for varicella, measles, mumps and rubella vaccine. So let's move to the category of other promoted medicine. InQ3, total sales were $1.5 billion and that's an 18% increase compared with thesame period in 2006. And of course, we have to go straight to JANUVIA. As youknow, we launched JANUVIA late last year. It is currently approved in 58countries worldwide. With this JANUVIA is the only DPP-4 inhibitor available inevery region of the world for use in the treatment of type 2 diabetes when dietand exercise are not enough. In a third full quarter in the market, globalrevenue for JANUVIA reached to $185 million, of which $171 million is in the U.S. Then turning to alliance revenue, that obviously contributedto our top-line revenues as well and primarily AstraZeneca is the key playerthere. Q3 revenue recorded by Merck from our relationship with AstraZeneca was$416 million, and that's a slight decrease versus prior year. As always, keepin mind that there is inherent variability relating to this revenue, given thatMerck is not actively managing these products. Our revenue recognition takes into account inventory levelsat AstraZeneca, for PPI and non-PPI products, as well as their productshipment. So, we try to capture and adjust for any fluctuations in inventory. So, moving to the total revenues for medicines and vaccines,as we have stated many times, we have the opportunity to capitalize on ourrobust product portfolio and deliver compound annual growth rate that areattracted through 2010. Despite certain patent expirations during this timeframe, wecontinue to expect revenue growth of 4% to 6% on a compounded annualized basis,driven by our in-line products, our launch products and our new potentialproducts in the pipeline. And of course, this includes 50% of the revenues ofthe joint ventures moving out of the 2005 base. Taking the third quarter revenue announced today and adding50% of the revenues from the Merck/Schering-Plough, Merial, Sanofi Pasteur MSD,and Johnson & Johnson-Merck joint ventures and partnerships. Our Q3 revenuewith $7.3 billion, that's a 15% increase if you do the same adjustment in thebase period. Year-to-date, the same measure is $21.3 billion, and an 11%increase over the same period last year. And again, this stellar, year-to-date top-line growth isover a base period that included ZOCOR prior to the loss of marketingexclusivity. Just to take that a little further, if we were to exclude ZOCOR,PROSCAR, and the revenue associated with the supply of authorized generics fromthe first nine months of 2007 and the first nine months of 2006, then for whatyou might consider the ongoing portion of business, our year-over-year revenuegrowth would have been 25%. This again emphasize the strength of our organic business,fueled by our established brands and the newer recently launched nextgeneration of products that will take us forward. Regarding 2007, this third quarter and year-to-dateperformance has driven us to revise our full year revenue guidance to supportour increased full year EPS guidance. This guidance revision includes five ofour product guidance elements. SINGULAIR, where we narrowed the full year rangeby $100 million, that now stands at $4.1 billion to $4.3 billion, vaccines,where we increased by $300 million the full year range. That now stands at $4.2billion to $4.6 billion. COZAAR and HYZAAR, where we narrowed the full yearrange by $100 million, so that's $3.2 billion to $3.4 billion. FOSAMAX, wherewe also narrowed the full range by $100 million and that stands at $2.9 billionto $3.1 billion. And ZOCOR, where we narrowed the full year range by $100million as well, and that now stands at $0.7 billion to $0.9 billion. We are reaffirming full year guidance for other reportedproducts and AstraZeneca, and as always the AstraZeneca guidance is an updatebased on recent results, as well as future expectations and reflects thedynamics of the PPI market, which includes multiple generics, OTC products andthe uncertainty these create with regard to future volume and pricing. Alsokeep in mind that our reaffirmed guidance incorporates the expectations of thenon-PPI products. As always, to assist your modeling, we provide a breakdownof the product revenues in our other financial disclosure schedule attached tothe press release issued this morning. So moving past revenue into the materials and productionline, in the third quarter materials and production were $1.5 billion. Now,this quarter includes $129 million for costs associated with the globalrestructuring program, primarily related to accelerated depreciation and assetimpairment costs. Excluding these costs, materials and production increased 3%in the quarter. Our Q3 product gross margin with 75% and this reflected a2.1 percentage point unfavorable impact related to the restructuring cost thatI just mentioned. Excluding these restructuring charges, we have the thirdquarter product gross margin of 77.1%. Just as in previous periods theseresults were indeed, affected by the final product mix. Our year-to-date adjusted gross margin therefore is 76.4%.Given the strength of this result, we are raising our full year 2007 guidancerange and now anticipate our product gross margin to be approximately 76% to76.5%. This guidance excludes the portion of the restructuring cost that willbe included in product cost and will affect reported PGM in 2007. Moving to the marketing and administrative line, in thirdquarter our marketing and admin expense was $2 billion, an 18% decrease versusthe same period last year. In the third quarter, after reviewing the actualcost incurred and estimates for future costs, the company determined that itwas appropriate to record a charge of $70 million to increase the reservesolely for the future legal defense cost related to the VIOXX litigation, andthat takes it up to $720 million as of September 30, 2007. Regarding the legal defense reserve charge, the company accrueslegal defense cost expected to be incurred in connection with the losscontingency when such costs are probable and reasonably estimable. In the third quarter, the company spent a $160 million inthe aggregate for legal defense costs worldwide related to VIOXX litigation. In adjusting the reserve the company considered the samefactors that it considered when it previously established reserves for theVIOXX litigation, including the actual cost incurred by the company, thedevelopment of the company's legal strategy and structure, in light of thescope of the VIOXX litigation, the number of cases being brought against thecompany, and the cost and outcomes ofcompleted trials and the most current information regarding anticipated timing,progression and related costs of pre-trial and trial activities. Events such as scheduled trials, which are expected to occurinto 2008, and the inherent inability to predict the ultimate outcome of such trials,limits the company's ability to reasonably estimate its legal cost beyond theend of 2008. Accordingly, the reserve at September 30, 2007 represents thecompany's best estimates of legal cost that will be incurred through 2008. While the company does not anticipate that it will need toincrease the reserve every quarter, it will continue to monitor its legaldefense cost and review the adequacy of the associated reserves. They maydetermine to increase its reserves for legal defense cost at any time in thefuture if based on the factors mentioned above, it believe it would beappropriate to do so. To date, the company has not established any reserves forany potential liability relating to the VIOXX litigation itself. Excluding the charges in 2006 and 2007, M&A actincreased 6% in the quarter. Regarding underlying level of spend, once again,the primary drivers of the marketing and administrative increases werepromotional spend for JANUVIA and JANUMET, and continuing efforts to moreaggressively support the ZOSTAVAX launch. While appropriate, these were deliberate choices made inresponse to the evolving competitive dynamics that we felt could provideadditional advantages as we have the first-in class product. As you see fromour revised product specific financial revenue guidance, we are increasing ourrevenue guidance to reflect this incremental investment. Reflecting on our commitment to realizing efficienciesthroughout the company and optimizing our cost structure, the component ofmarketing and administrative consisting of selling and general administrativecosts, which support our core operations, remained down year-to-date over theprior year. So, let's turn to guidance for marketing and administration.It's pretty clear from the Dick's comments and what should view the commercialteam continues to have a very full agenda there really indeed. We are beginningto launch ISENTRESS and continue to build on the momentum on the previous sevenlaunches over the last 24 months, that's quite a handful to juggle. As we look at trends and opportunities in the rest of 2007,we are increasing our guidance for marketing and admin to 2.5% to 3.5% growthover prior year. Now, a good part of this change is driven by the Euro, whichhas significantly increased during 2007. It now stands above 140 to a dollar ascompared to mid 120 at the beginning of the year. Now, of course, we see this is as a benefit on our top-linerevenues, adding roughly two points to the overall Merck revenue growthyear-to-date and in Q3.But this will also add roughly 2.5 points to the fullyear marketing admin growth. Secondly, we are maintaining a healthy amount ofsupport behind the success of our growing core and new franchises. In Q4, we anticipate DTC efforts for SINGULAIR and JANUVIA,as well as increased promotional support for GARDASIL, ROTATEQ and ZOSTVAX. Wewill also be supporting our ongoing launch agenda at Merck, MK-524A and ISENTRESSfor the U.S.and continued support for the international rollouts of the JANUVIA andGARDASIL. Finally, we are comfortable with the focus and management ofthis investment. It is being very well spent and managed. It is important tonote that in Q4, we anticipate a reduction in marketing and admin spendingversus the prior year. Now, let's turn to research and development. In Q3, ourR&D expenses were $1.4 billion, that's a 52% increase from the comparableperiod in 2006. And of course, it included the NovaCardia in-process R&Dcharge. Excluding NovaCardia, R&D was up 18% versus 2006. I want to take an extra minute to explain this result andour R&D guidance for the remainder of year. At Merck, we remain committedto fully funding core, internal R&D to ensure the continued progress ofcompounds in all phases of development. Internal R&D growth remainedstrong. We continue to invest in late-stage, clinical programs on ISENTRESSMK-524A, MK-524B, MK-364, MK-822, MK-974, you get the point. In addition, allof our vaccine developments and progress. So, in addition, the company continues in active externalcollaboration and business development agenda, funding clinical grant programs,third-party scientific collaborations and important licensing transaction. Sooverall, our R&D spend is focused on progressing our pipeline and adding toit any outsider as well. So regarding the full year, we are raising our 2007 guidancefor research and development expense to adequately resource incrementalexternal R&D opportunities. And now anticipate R&D spend to increase 13to 15 percentage points over the full year 2006 level. Our R&D guidance includes the impact of the acquiredresearch charge associated with NovaCardia and I would refer you to our pressrelease to see how we define the base period on a similar basis. Although, Ibelieve all of you have it captured correctly in your models and reports. So, in the third quarter, turning to the restructuring, ourtotal cost associated with the global restructuring programs was a $178million. Now, as I mentioned before, $129 million was for asset related chargesthat are included in materials and production. The restructuring cost line itself reflects $49 million ofcost for employee separation, and other related costs associated wasapproximately 250 positions eliminated and that is now a total to 6,000 todate. So, we remain on track to eliminate 7,000 positions by the end of 2008.Restructuring guidance for the full-year 2007 would indicate that our aggregate2007 pre-tax expense related to these activities is estimated to beapproximately $700 million. Now, let's turn to the equity income line. In the thirdquarter, equity income from affiliates was $769 million. Just to remind to you,this line relates to the contribution from all of our JVs, AstraZeneca, Merck/Schering-Plough,Merial, Sanofi Pasteur, Johnson & Johnson. Our Q3 performance reflects the continued success of theMerck/Schering-Plough cholesterol franchise in the U.S.and Europe, The seasonality of the MerialAnimal Health Business and an increasing contribution from our Europeanvaccine, JV Sanofi Pasteur. Regarding the Merck/Schering-Plough partnership, the thirdquarter combined MSP cholesterol franchise global revenue as reported by theMerck/Schering-Plough partnership continued to grow at $1.3 billion. Q3revenues of VYTORIN and ZETIA were $693 million and $607 million respectively. In the U.S.,VYTORIN was $526 million, up 22% and ZETIA was $443 million, up 14%. WithinMerck's quarterly equity income result, the Merck/Schering-Plough partnershipcontributed $481 million and that reflects a 37% increase over the prior year. Returning to AstraZeneca, as always, I have to remind youthat there are several components to AstraZeneca equity income that make itinappropriate to draw significant conclusions just based on PPI products. Thereare complexities involved with a minimum timing and tax differences. That said,the third quarter equity income contribution for Merck's share of thepartnership with AstraZeneca was a $181 million. The balance of equity income comes from our other jointventures namely Merial, Sanofi-Pasteur and Johnson & Johnson-Merck. Given this result we are narrowing our guidance for fullyear 2007 by $100 million and now expect equity income from affiliates to beapproximately $2.8 billion to $3 billion. So, let's move to our tax line. First, our Q3 income beforetaxes was $2.1 billion. So, our taxes on income in the period were $539 millionand the reported tax rate was 26.1%. This reflects in general the changes inforeign and domestic mix and currency fluctuations. These elements changethroughout the quarters as always. We are reaffirming our full year 2007 tax rate guidancerange and I would direct you to today's press release for details. So, moving to net income, our Q3 net income was $1.5 billionand our Q3 earnings per share was $0.75, excluding a 5% charge for siteclosures and position eliminations, primarily associated with the globalrestructuring. Our reported third quarter EPS was $0.70. So, let's turn to 2007 guidance. I had mentioned severalchanges as part of the results review already and I will direct to you to thedetails of our financial guidance contained in today's press release. We areraising or changing many elements of our full year 2007 guidance and as aresult, Merck is raising the full year 2007 EPS range to $3.08 to $3.14,excluding the restructuring charges related to site closures and positioneliminations. In another words, we anticipate that the EPS,ex-restructuring will grow in the range of 36% to 48% in the fourth quarter ofthis year versus prior year. On a reported basis, we now anticipate GAAP fullyear 2007 EPS of $2.87 to $2.93. As stated, this guidance does not reflect theestablishment of any additional reserves or any potential liability regardingthe VIOXX litigation. We are committed to providing quality full year guidance andupdating it during the year. We believe that there is value in providingquality financial guidance, because it assists investors and we do recognizethat our business is complex, and we serve our investors well by communicatingour financial performance expectations. So in summary, the company remains on track, both in termsof strategy and performance, to delivery long-term double-digit earning per sharegrowth from 2005 to 2010, excluding one-time items and restructuring charges.We have the financial strength to support our dividend and we remain fullycommitted to maintaining our dividend at the current level, at the same time wecontinuing to fully invest in our key strategic priorities. With our year-to-date performance and our guidance for fullyear it is clear that the products are driving a healthy top-line, despitelapping the ZOCOR expiry. We anticipate continued strong performance from ourkey franchises in the remainder of this year. So, if you take this all together, Merck is clearly verybusy with its successful product launches worldwide. And behind the scenes, wecontinue to reengineer the company into a lean and effective competitor for thefuture, for the good quarter. With that said, I will turn the call back to Graeme. Graeme?"
},
{
"speaker": "Graeme Bell",
"text": "Thank you, Peter, and we certainly appreciate your patienceduring the prepared remarks. We will now open the call and take your questions.We will take the questions in the order in which they are received and try to getthrough as many as possible. Please help us to keep on track by asking a one ortwo part question only. So at this point, I will turn the call back over to Crystal,who will communicate instructions of our Q&A format, and then introduce ourfirst question."
},
{
"speaker": "Operator",
"text": "(Operator Instructions). Your first question comes from theline of Tony Butler with Lehman Brothers."
},
{
"speaker": "Tony Butler",
"text": "Yes. Thanks very much. Just back to the gross margin, Peter,if possible, the rise to 76%, to 76.5% from 75% to 76% is curious. And youmentioned the principal driver, if I am not correct please help me, is mix.However, if I am not mistaken, the greatest delta from the beginning of thisyear until today has been the growth in the vaccines component of revenue. Do Ihave just the wrong impression that vaccines might be a lower margin component,yet the increase in overall GM is critical? If you could help us with someunderstanding of the income grew and see of that of that notion. Thanks."
},
{
"speaker": "Peter Kellogg",
"text": "Sure. Tony, let me just make some general comments. First ofall, your observation is correct, and that is, vaccine has been doing verywell. But, obviously the other product lines we have as well, are very big, andso you take kind of the weighted average of all those, you got factors movingboth ways. But in fact, as we went from the second quarter to third quarter andas we projected out for the full-year, you do see some mix affect that helpedus in Q3. What I would recommend is that we updated it and narrowedthe range for product gross margin and excluding restructuring charges. So, Iwould go with that. But, in fact, you are right, there are different mixeffects, some of which based on like, for example, vaccines would cause you togo one way, but some of the other products over way that for the time being.But in general, obviously, as we narrow the range, we actually also increasethe range, excluding restructuring. So obviously, the general conclusion is thetrend is positive despite some of the vaccine business activity."
},
{
"speaker": "Tony Butler",
"text": "Thanks, Peter."
},
{
"speaker": "Dick Clark",
"text": "And Tony, another point is around supply strategy as well.So, as our strategy is put in place, and as we do the right combination ofoutsourcing and put the Merck the production system, which is Six Sigma Lean processin place, and you are seeing improvements. And as I have mentioned many times,it's not only on the pharmaceutical side of business, the biological vaccines,which is obviously very critical to us ensuring a volume increase, to be ableto improve them and our ability to improve those PGM will be substantial, ofcourse, looking forward."
},
{
"speaker": "Tony Butler",
"text": "Okay."
},
{
"speaker": "Graeme Bell",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Barbara Ryan with DeutscheBank"
},
{
"speaker": "Barbara Ryan -Deutsche Bank",
"text": "Good morning. Thanks for taking my question. I wonder if youcould just speak to some of the trends for JANUVIA in the U.S., relative to the reportedresults in the scrip because, obviously the scrips are up about 50% in thethird quarter versus the second. Although, those revenues reported in the U.S.are relatively flat. So, I am assuming that there were some stocking in thesecond quarter and maybe de-stocking in the third. But maybe, if you could justhelp us understand that sequential line, just for the purposes of understandingbetter the fourth quarter, thank you."
},
{
"speaker": "Dick Clark",
"text": "Yes. Thank you, Barbara."
},
{
"speaker": "Barbara Ryan -Deutsche Bank",
"text": "Thanks, Dick."
},
{
"speaker": "Dick Clark",
"text": "You are absolutely right. Even though we mentioned thatManaged Care Advisory increasing for JANUVIA, and JANUVIA also ranks second inbranded New Rx volume. There is some stocking impact in the second quarter,particularly for JANUMET since some initial purchases for whole of the launchof the product is in April of 2007. And as you also know is that it's a provenin 58 countries, but we are just beginning a process outside of the U.S.So we are very, very optimistic and very strong with the future of JANUVIA, andthat's not only for this year, but obviously in the future years and it's offto a great start with a great franchise team in the U.S. and global franchise teamthat's holding it up across the globe. Thank you."
},
{
"speaker": "Graeme Bell",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of David Risingerwith Merrill Lynch."
},
{
"speaker": "David Risinger -Merrill Lynch",
"text": "Yes. I am now French. I have two questions. First, onGARDASIL, could you please comment on government purchases in the third quarterrelative to the second quarter? If you could provide any detail, that would behelpful and also, if you could talk about compliance with the three doses, andwhat you are seeing to date? And then in addition, if you could just discussthe ZOSTAVAX opportunity going forward, it seems to me that that is asubstantial opportunity yet the trajectory to date has not been thatsignificant. And, as part of your answer, if you could just discuss anychanges, in reimbursement for 2008?"
},
{
"speaker": "Dick Clark",
"text": "Well certainly starting withZOSTAVAX. As you know, what we have said that we are back in production againfor various double component of ZOSTAVAX. And so, as that continues to moveforward from a production standpoint, that will put us in a refrigeratedZOSTAVAX versus the frozen ZOSTAVAX, which we need globally. ZOSTAVAX in myopinion is a key vaccine for our future, and that we'll see growth. We areworking with our customers, and with physicians, and with CMS to try to come upwith a process in place that makes it less onerous from a reimbursementstandpoint for the physician, as well as, for the client and patients toovercome that. And we haven't been able to come up the right partnership for that.I think we are making process on it, and so I am very happy with where we'removing forward as long as we can consolidate that, and particularly with thevolume depth moving forward. Obviously, in the third quarterwith everything that we have done from a vaccines standpoint, with GARDASIL inthe uptick, particularly with the initial dose, one of the keys is to make surethat we don't lock it in for the second and third dose. And so, we have put inplace substantial reminder programs that allow them to improve the ability toremember to go back to the second and third dose. So, we're doing it by mail,we're doing it by e-mail, we're doing it by text messages, and a variety ofdifferent technologies to be able to make sure as they come, particularly collegestudents as they come back for grades, that they get to second, and third dose.And so that compliance capability is extremely important to us."
},
{
"speaker": "Graeme Bell",
"text": "And Dave, just on your initial question with regards torevenue, domestic revenue for GARDASIL in the quarter, you know, we are stillseeing that contribution coming from both the public and private. There was nomarked increase in the orders being placed by the public sector through VFC andCDC. So, we're seeing this leveling off in terms of underlying demand in themarket and the 3Q revenue reflects that."
},
{
"speaker": "David Risinger -Merrill Lynch",
"text": "Thank you."
},
{
"speaker": "Graeme Bell",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Tim Anderson with SanfordBernstein."
},
{
"speaker": "Tim Anderson",
"text": "Thank you. Couple of questions, on GARDASIL, in the U.S.specifically, can you give us a rough idea for what percent of the time theproduct is being used in a population different from what's technically indicatedin the label? And then the second question is, just looking at FOSAMAX sales inthe quarter, in international markets can you update us on what's happening orwhat's likely to happen with generic FOSAMAX in Europe, following the previousrestatement of the patent protection there. I am just wondering what to expectin terms of future brand performance as long as it technically remains on patent."
},
{
"speaker": "Graeme Bell",
"text": "All right, gentlemen, I'll take that if you don't mind. So,with regard to GARDASIL in the U.S.in terms of percentage used outside the approved range, so again, it is 9% through26% at this point. We are seeing very, very limited use beyond that initialindication, primarily because physicians are focused in obviously on the datathat we have in hand and as we've communicated to all including the physiciancommunity who are administering, that we will not have efficacy data pertainingto the mid-adult woman in-house until the fourth quarter. So, as Dick mentionedin his prepared remark, the expectation is that we will have that data andbegin to move that forward for labeling expansion. With regard to the age range that was currently indicated,we began to see a little more use in the twelve through eighteen-year-old range.Initially, when we launched the product we were seeing even distribution fromnine through twenty six-year-olds. But, clearly with the concentrated effortthat Dick just articulated pertaining to going after college students and theappropriate age range, you'd expect to see the origination all the immunizationoccurring in the twelve through eighteen-year-old. And that is also a phenomenon,which is taking place ex-U.S. as well. With regard to your FOSAMAX question internationally,obviously you are aware of the reinstatement by the European patent office.Where we are with regard to that is, clearly were in a process of identifyingwhere there is currently illegal weekly alendronate on the market and takingappropriate legal steps to determine what actions we can take to remove thatoff the market. The other complexity comes of course, in the fact that towardthe end of this year and as to early part of next year there will be legalalendronate sodium available in the EU for the daily dosing. So we got a twopart challenge really, that is to A). remove from the market the illegal weeklyand keep it off while simultaneously, B). renegotiating with countries in termsof ensuring that we can continue to have weekly branded in Europethrough the period immediately following patent expiry all the way through2018."
},
{
"speaker": "Tim Anderson",
"text": "Thank you."
},
{
"speaker": "Graeme Bell",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Chris Schott withBanc of America."
},
{
"speaker": "Chris Schott",
"text": "Great, thank you, just got two quick questions. Maybe, firston your gross margin side, you get a strong increase year-over-year. Can youmaybe talk about, aside from the mix, the benefits of restructuring program?How far are we through that program at this point? I guess, another way lookingat it, are our current numbers reflecting much of that benefit or should weexpect additional opportunities over the next couple of years? And then just quickly in your CT pre-inhibitor, has adecision been made moving into Phase III? I know the Phase IIB [cetropib] datathat showed some strong LDL reductions, I guess, and based on your discussionswith the FDA, do you believe LDL could be part of a filing pathway there?Thanks."
},
{
"speaker": "Dick Clark",
"text": "Regarding the second question, we have not made a decisionyet to go in Phase III. So we are still evaluating, not only our compound butthe mechanism in general, and are waiting for an additional externalinformation before we make the decision. Concerning our PGM's moving into future and in our supplystrategy, as we said positional eliminations around 6,000 of the 7,000 that wecommitted to back in December 2005. But when it comes to where we are from aLean and Six-Sigma process and our outsourcing capabilities, and our ability toincrease the PGMs within the vaccine areas by using any of this methodology. I would say, we are probably around 50% where we want to be,and so within the next two years we will be continuing to make progress ineffectiveness in standard efficiency within the supply chain. And alsosomething that we are very excited about when it comes to PGM, we alsonaturally gravitate towards the supply strategy and production, but many partsof the PGM are also based on marketing concepts and packaging, and whatcustomer's and physicians need and distribution. And so there is many parts of that we integrate, that weneed to think about and I think Merck has this one Merck approach, of how wethink about PGMs now across all the functions in a company. So, I am verybullish in where I think our PGMs will be moving based on the statements wemade in December 2005 and our ability to achieve a pre-ZOCOR numbers in thenear future."
},
{
"speaker": "Graeme Bell",
"text": "Next question, please?"
},
{
"speaker": "Operator",
"text": "You next question comes from the line of Bert Hazlett withBMO Capital Markets."
},
{
"speaker": "Bert Hazlett",
"text": "Thanks, good morning. Thanks for taking my questions. Firston SINGULAIR, could you just comment on international trends you are seeingthere. Again, uptake in foreign sales has been significant, could you justcomment on currency effects, price volume and maybe what's driving that? Andthen secondly, with regard to ROTATEQ, again it's proved in sixty ninecountries we have a significant pickup in the U.S., what's holding back theinternational sales, is it the question of the bulk of them being driventhrough Sanofi Pasteur, or is it a question of pricing or reimbursement or justa little color there? Thank you."
},
{
"speaker": "Dick Clark",
"text": "I think with the ROTATEQ question is that obviously, ourreimbursement act that we need to be able to put in place throughout the world.The supply is available and we're now rolling it across and then in many othercountries. But it just takes times. As you know, vaccines are different thanpharmaceutical products and getting them positions approved and reimbursed positivelyin degree and though Merck also has a responsibility to as we've been throughthis in the developed world, as also think about accessing this in developingworld and to make sure that we put programs in place to have it availablethere. From a SINGULAIR standpoint, I can't give you the specificstowards your question other then say that we are pleasantly surprised about notonly SINGULAIR in United States with its labeling and where it'spositioned from a formula standpoint. But, it is an outstanding product and itstill is receiving uptake throughout the world, and much of it is based onvolume."
},
{
"speaker": "Graeme Bell",
"text": "Yeah. So, I would just add to that I mean, in Europe, MiddleEast and Africa as we see it SINGULAIR washealthy in the quarter. We seldom breakdown revenue by geographical region, butI can't tell you that in the region it was up over 20%, about 22%, the majorityof which was volume. So the volume growth is primarily a function of labelexpansion of montelukast sodium and the label carries off these indication forallergic rhinitis and it is one of the, in fact, it is the only product on themarket with that indication. So, that's what is fuelling that strong Europeandrive."
},
{
"speaker": "Bert Hazlett",
"text": "Thank you."
},
{
"speaker": "Graeme Bell",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of John Boris withBear Stearns."
},
{
"speaker": "John Boris",
"text": "Just have two questions. And thanks for taking the questionand congratulations on the quarter. First question you, Dick, on the JANUVIA,JANUMET, there appear to be case studies on how to decrease cycle times. Isthere any additional room for taking additional days, months, years out of thecycle time with respect to products and other any that you would like to key usin on as to what you might be applying to those products going forward that areentering or have entered the clinic? And then on GARDASIL, of the $328 million reported in thequarter, can you comment on the stocking at the physician level? How many dosesis the physician stocking and can you comment on the total number of patientsin the U.S. that have been treated to-date and with your three key strategyhere what percentage of them have been treated once, twice, or three times.Thanks."
},
{
"speaker": "Dick Clark",
"text": "With your first question concerning cycle time with JANUVIAand JANUMET, I believe as you look at the progress we made from a cycle-timereduction, not only a clinical base in these products but in the manufacturing,the supply side has been significant and we believe that there is moreopportunity there. And so we've actually made a commitment. What's importantabout it is, and the practices were put in place across the company is not onlyto do it, obviously with JANUVIA and JANUMET, but to do it for the entireportfolio. So, if you can do that for the portfolio, you can imaginethe impact this is going to have on a companywide basis. And so, we've putsubstantial resources in focus on our clinical development, as well as ourother aspects of the company to be able to continue that. And I think you'llsee much more progress in the next several years in continued cycle timereduction. And as you know, once you are able to reach a steady state, itcontinues improvement, methodologies tell you that there's always room forfurther improvement. So, I am never going declare victory when it comes to cycletime reduction, either in research or in the manufacturing side. There isminimum stocking on GARDASIL from our physician level standpoint. I can't tellyou specifics around where we are with our three key areas of going for thesecond dose and the third dose or what that minimum is. It's still too earlyfor us to be able to provide data on."
},
{
"speaker": "Graeme Bell",
"text": "And part of the reason why we can't do that John, is thatI'd have to remind you that, we are going after approximately 118 million girlsand women in the U.S., EU and other highly developed markets that are withinthe appropriate age range for GARDASIL indications. So, even if you pad up backand look in the United States alone, there are thirty six millionfemales who are eligible to receive this vaccines and the intent here is toensure that all of them, obviously receive all three doses from a complianceperspective. And as you've heard from the prepared remarks, since June of 2006 whenthe product was approved we have shipped and sold 13 million doses. So there's certainly a long way to go and we continue togather the intelligence. But one data point that I would point to you is, ifyou go on gardasil.com, which we constantly update, you can see and read as dothe individuals who are getting GARDASIL, the new banner there which is threeis key. And three is key, is the compliance message that we're basicallycommunicating to the physician community, to pediatricians, and the OB/GYN."
},
{
"speaker": "John Boris",
"text": "Okay. That helps."
},
{
"speaker": "Graeme Bell",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "(Operator Instructions). Your next question comes from theline of Seamus Fernandez with Leerink Swann. Seamus Fernandez- Leerink Swann Thank you. Just a couple of quick questions, I just steppedout of the room for a second, but I apologize. I wanted to know if you couldupdate us on timing of the PROQUAD, re-launch and manufacturing and just giveus a manufacturing update on that front. And then secondly, SINGULAIR after theend of this year will be the last allergic rhinitis drug or branded allergicrhinitis drug on the market to our knowledge and as the Zyrtec comes offpatent, are there potential formulary risks for Merck here in 2008, whether itbe on prior authorization or on formulary changes and how would that impactyour growth rate? Thanks."
},
{
"speaker": "Dick Clark",
"text": "Your question on PROQUAD is, and I mentioned that in earlierquestion that we are now back in production with the varicella component ofPROQUAD and started up and are waiting for the results. We are very optimisticabout the result of that. It's really difficult to commit to a specific datehere once till we see titers and the potency performance for that movingforward. But, I am optimistic that we have a solution there, and manufacturingis back in action and that's very positive. From a SINGULAIR standpoint, when you think about theclinical indications we have, and the success we've had with SINGULAIR to date,it reminds me a little bit of the simvastatin situation. And so, when a productlike that goes off the patent, there's still obviously a focus on that from ageneric standpoint. But, when you have such an excellent label and indicationsfor SINGULAIR to be able to have them remain on the second tier of formularies,I think SINGULAIR will do very, very positive."
},
{
"speaker": "Graeme Bell",
"text": "So next question, please. I am conscious of the time and Ibelieve we have three more questions in the queue. So we will take that and putit off. So, next question please Crystal."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line Steve Scala withCowen"
},
{
"speaker": "Steve Scala",
"text": "Well, thank you. I was just wondering, do you believe yourtop and bottom line guidance through a 2010 is achievable? If you exercise yourput to AstraZeneca for the non-PPI products in Q1 of '08 or will your guidanceneed to altered when you take the non-PPI part? The concern is that, if you doput in Q1 of '08, can't AstraZeneca call the PPI's in Q1 of 2010 and aren'tthey at non-trivial component of your earnings?"
},
{
"speaker": "Dick Clark",
"text": "Steve, as we put the December 2005 targets in place, it wasex any impact from the AstraZeneca activity."
},
{
"speaker": "Graeme Bell",
"text": "Next question please"
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Roopesh Patel withUBS"
},
{
"speaker": "Roopesh Patel",
"text": "Thank you. Just a couple of question. First on ROTATEQ. Iwas wondering, if you could just elaborate on the outlook for the product salesbeing very strong for this quarter. Is this the run rate we should be lookingat moving forward? And then just separately on VIOXX litigation charges, I wasjust wondering if the year-to-date spending is a rough representative of thegeneral run rate we should be again looking at moving forward, if not, what arethe factors that led through? Thanks."
},
{
"speaker": "Peter Kellogg",
"text": "Bell,if you want, I’ll take the question on the VIOXX litigation, and I had justhighlighted. What we tried to do is sort out exactly what we know is coming,and so to talk about a run rate beyond 2008 is very difficult for us to do. Iam obviously involved in situation where we had a number of trials with andoutcomes from that. So, it would be hard for us to speculate exactly what therun rate may or may not be because it's really specific to the circumstancesthat we are looking at, and exactly what the trial count is, what the pre-triallegal activity is, and that’s obviously evolving as we go. So I would cautionyou to kind of jump too quickly to a run rate assumption, one way or the other,but I think we are pretty pleased with how things have gone so far. And your question on the ROTATEQ, there has been more than 9million doses of ROTATEQ that has been distributed, and it's estimated thatabout 62% of the birth cohort is now being vaccinated. So there is an uptickbased on the cohorts that we have today. And it is available through theVaccine for Children’s Fund in all 50 states and is 100% covered under ManagedCare. So we are very enthusiastic about the future of the product. Concerningthe global bases, it’s approved in 69 countries, and we have only launched in30 countries around the world to date. So, we are still very strong on what theperformance is moving forward, but at the same time as you know we’ll havecompetition in the near term with ROTATEQ."
},
{
"speaker": "Graeme Bell",
"text": "And Crystal? Yes, sir?"
},
{
"speaker": "Graeme Bell",
"text": "Our last question for the day,and by no means least, I think we have Jami Rubin on the line."
},
{
"speaker": "Operator",
"text": "Yes sir, that's correct, withMorgan Stanley."
},
{
"speaker": "Jami Rubin",
"text": "Thank you, Graeme. I'm soflattered. Just I had a couple of follow-on questions on GARDASIL. You -- Peterhad talked about VARIVAX, it was a back-to-school effect, I was wondering ifthere was a back-to-school effect with GARDASIL? And well Graeme, I canappreciate why it's very difficult to pinpoint precisely where this vaccine isbeing used and what penetration rates are within that VFC market where I wouldimagine data is much stronger since they are ordering directly from you. Canyou tell us what is the penetration of the 11- to 12-year-old cohorts, where myunderstanding is the goal is over 80%? And then lastly, on international, saleswere $90 million, can you tell us what markets that represents and how much ofthat is stockings? Thanks."
},
{
"speaker": "Peter Kellogg",
"text": "Jami, let me take a shot at thefirst one, which is the back-to-school dynamic. Obviously, we're dealing with apopulation where there is, does have a lot of school activity and some of themgoing and obviously hitting up the couch, so there is always that chance.However, we don't really feel -- it is clear that there is a strongback-to-school effect just yet, we haven't really concluded on that as much asthere is perhaps on the VARIVAX going. But nonetheless, it's certainly clearthat we are working with young women who are in the school age area and they maywell be visiting physicians before they go back to the universities and soforth, that's a possibility. Relating to the cohort question, actually let mejust hold up on that."
},
{
"speaker": "Graeme Bell",
"text": "So Jami, with regard to the cohort question, we're stillseeing a very encouraging uptake within the VFC programs. So the age range thatthey are addressing particularly, right slightly younger female, that’s stillvery, very healthy and certainly moving along as we would expect. With regard to your question on international revenue, youare absolutely correct. We recorded -- we [Merck], Inc. recorded 91millionex-US, and I would point that out notwithstanding the statistics pertaining tothe approvals and the launches, when you look at the revenue contribution thereare basically six countries that are contributing to the $480 million. So, oneof those countries, I think US at 308, the remaining five countries includesthe likes of Australia and Canada,and that's just starting to continue to launch. So, your question on stockingisn't really a driver for the ex-US business, it is just basically countriescoming on line, but because you can appreciate we moved from approval intolaunch phase, and as we move into launch phase, it progresses through the revenuerecognition. I would point out that though, on the other financialdisclosures that Sanofi Pasteur MSD recorded revenue for the GARDASIL so endmarket as recorded by SP MSD was $137 million in the quarter, and again theycovered the 19 countries on territory. But again that $137 million onlyreflects three or four countries that are contributing in a meaningful wayabout revenue number."
},
{
"speaker": "Dick Clark",
"text": "Well, thank you Graeme, and thanks for listening to our calltoday. As we stated, we are very pleased with the third quarter results, and weare certainly looking forward to updating you further on our future progress atour annual business briefing that will be held in Whitehouse Station onDecember 11. We'll be in touch with the details on this meeting very soon. So, thank you again, we appreciate your interest andparticipation. Operator, thank you very much."
},
{
"speaker": "Operator",
"text": "Thank you, sir. This does conclude today's conference call.You may now disconnect."
}
] | null | null |
MRK | 2 | 2,007 | 2007-07-23 09:00:00 | Operator: Good day, everyone, and welcome to Merck's second quarter 2007 earnings conference call. Today's call is being recorded. At this time, I would like to turn the call over to Mr. Graeme Bell, Executive Director of Investor Relations. Please go ahead, sir.
Graeme Bell: Thank you, Cynthia, and good morning. Welcome to our call this morning to review the business results for the second quarter of 2007. Joining me on the call today are our Chairman, President and CEO, Dick Clark, and for the last time prior to her formal retirement, Miss Judy Lewent, our Executive Vice President and Chief Financial Officer. Before we get into the details, let me go over the logistics as usual. On this call, we will review the results contained on the release we issued at 7:30 AM this morning. You can access this through the in Investor Relations section of merck.com, and I would remind you that this conference call is being webcast live and recorded. The replay of this event will be available later today via phone, webcast and our usual podcast. As we begin to review the results, let me remind you that some of the statements made during this call may discuss certain subjects that may contain forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and involve risks and uncertainty, which may cause results to differ materially from those set forth in the statements. The forward-looking statements may include statements regarding product development, product potential or financial performance. No forward-looking statement can be guaranteed, and actual results may differ materially from those projected. Merck undertakes no obligation to publicly update any forward-looking statements whether as a result of new information, future events or otherwise. Forward-looking statements in this call should be evaluated together with the many uncertainties that affects Merck business, particularly those mentioned in the risk factors and cautionary statements set forth in item 1A of the Merck's Form 10-K for the year ending December 31, 2006, and its periodic report of Form 10-Q and Form 8-K which the Company incorporates by reference and that are posted on our website. With that, let me turn the call over to Dick Clark, for prepared remarks.
Richard Clark: Thank you, Graeme, and good morning, everyone. The results we are reporting to you today reinforce our confidence that Merck's plan to regain our leadership position in the pharmaceutical industry is the right one and that we are successfully executing our plan. Our overall performance has positioned us well to achieve our business targets, meet the challenges that lie ahead, and continue to invest in drug discovery. I am pleased to announce that our second quarter 2007 earnings per share were $0.82, excluding restructuring charges, a 12% increase from the second quarter of 2006. Our reported EPS for the second quarter were $0.77 both results include the impact, the reserving and additional $210 million for future VIOXX legal defense costs. In addition, our worldwide sales were $6.1 billion during the quarter, and $11.9 billion for the first six months of 2007. This revenue in the first half of 2007 is up 6% from the same period last year, and I would note that our results include ZOCOR in the base. This better than expected performance was driven by a broad range of both our newer and our established products delivering strong growth again during the second quarter. SINGULAIR continues to be the number one prescribed product in the United States respiratory market, with worldwide sales last quarter reaching $1.1 billion, an increase of 15% from the same quarter last year. VYTORIN and ZETIA achieved all-time highs in both new and total prescription share in the quarter, posting combined global sales of $1.3 billion, an increase of 30% compared to the second quarter of 2006. GARDASIL, along with our pediatric vaccines, helped drive total worldwide vaccine sales over the $1 billion mark in the quarter, nearly tripling the total vaccine sales in the second quarter of last year. Global revenue for JANUVIA and JANUMET reached $144 million, and $24 million respectively in the second quarter. Managed care acceptance of these medicines has been strong and we're pleased that all major pharmacy benefit managers in the United States have added both of them to their formularies. Our revenues reflect the high value that physicians, patients and payors are placing on our products and on the healthcare benefits they provide. They also demonstrate that we continue to build on momentum established with our product launches last year. Regarding the full year 2007, we are raising our EPS guidance range to reflect the impressive sales growth that our products have achieved during the first half of the year. We now anticipate a full year EPS range of $3 to $3.10, excluding restructuring charges and reported full-year EPS range of $2.80 to $2.95. Judy Lewent will provide more details on the financial performance and guidance in a few minutes. As we look at the third and fourth quarter of 2007 and into 2008, we are working to ensure our expected launches of Isentress and of MK-0524A are accomplished with the same level of energy and success that distinguished our product launches in 2006 and 2007. We are pleased that the FDA has granted Isentress priority review status, and we anticipate regulatory action by mid-October following the FDA Advisory Committee meeting scheduled for September 5th. If approved, Isentress would be the first in a new class of anti-retroviral agents called integrase inhibitors. And in clinical trials, Isentress has demonstrated the ability to block the ability of the HIV virus to replicate and infect new cells in human patients. Isentress has the potential to represent a significant step forward in meeting one of the world's major unmet medical needs. We continue to anticipate an NDA will be filed with the FDA in the second half of 2007 for MK-0524A, our investigational atherosclerosis compound. MK-0524A combines Merck's extended release niacin with the Merck compound that reduces flushing, a common side effect of niacin therapy. In addition to the progress we are making in our own pipeline, we are also continuing to seek new licensing opportunities and targeted acquisition in therapeutic areas that are of strategic importance to Merck. Earlier this month, we announced an important licensing agreement with ARIAD pharmaceutical. This agreement expands Merck's investment in the field of oncology and holds the potential of bringing a novel medicine to cancer patients worldwide. Our future success clearly depends on our ability to discover, develop, and market novel medicines that address unmet medical needs, and entering into these types of agreements clearly complement our in-house efforts. To support these efforts, we also remain focused on controlling expenses to further reduce our cost structure and creating a leaner and more nimble business model, so that we can respond quickly and efficiently to customers' expectations and the demands of the market. We remain on track to deliver what we promised eighteen months ago, double-digit compound annual EPS growth excluding one-time items and restructuring charges by 2010 from a 2005 base. When I reflect on what this quarter means to Merck, I see it as significant for several reasons. New product launches are continuing to gain momentum and strong acceptance in the marketplace. We are translating lessons learned from our new launches to our established brands and seeing greater market acceptance as a result. The quality of our external partnerships and alliances are reinforcing our considerable internal research efforts that are commitment to the development of new medicines, and all of these factors, when looked at in context with our 2010 stated goals, give us confidence that we can sustain our strong overall growth. Before I turn the call over to Judy for what really will be her last earnings call with Merck, I wanted to take this opportunity again to thank her for 27 years of service to Merck, to thank her for her leadership, her commitment, her dedication and her accomplishments as CFO of Merck and Company. So with that, I am pleased to turn the call over to Judy.
Judy Lewent: Thank you, Dick, very much, and thank you for joining us today and good morning. As Dick said, we are extremely pleased with our reported results. In the second quarter of 2007, the company reported mid single digit growth on the top-line and double-digit growth on the bottom line, as we continue to work toward our stated long-term performance targets. The second quarter recorded EPS growth, excluding restructuring costs, was driven by revenue that reflects strong performance of our inline franchises like SINGULAIR and COZAAR, as well as the rapid early up take of JANUVIA and JANUMET, and the continued strong growth of GARDASIL. Other notable contributions to this result came from our improving product gross margin and the outstanding performance of our partnership and alliances, which resulted in enhanced equity income. As usual, I will go into more detail about the important underlying drivers of our performance and explain why we remain confident in our abilities to achieve our higher full year EPS guidance for 2007. Dick mentioned several of the highlights of the quarterly results a moment ago, so I will build on that. In the second quarter we saw revenue of $6.1 billion. That represents a 6% increase over the same period last year including in the aggregate, an overall 4% growth in volume and a 2% positive impact coming from foreign exchange. Collectively, worldwide revenue was above our initial expectations, and we saw encouraging sales performances from our newer and in-line franchises. A major contributing factor to on our top line growth came from or vaccines business. Collectively, vaccine revenue as recorded by Merck, was in excess of $1 billion for the second quarter, representing a 199% increase as compared to the same period in 2006. Driven by the continued up take of GARDASIL, ROTATEQ, and ZOSTAVAX in the second quarter, our three new vaccines collectively accounted for greater than $0.5 billion of revenue. As always, to assist in your modeling, we provide a breakdown of the product revenues in our other financial disclosure schedule. We are extremely pleased that the global sales for GARDASIL as recorded by Merck reflect the continued strong underlying demand for the vaccine in both the public and private sector. Of the $358 million recorded in the quarter, $286 million was in the United States. Sales outside the U.S. continued to show strong growth and increase 34% sequentially as we continued to successfully navigate the processes surrounding regulatory approval, country recommendations, and reimbursement with governments. GARDASIL has been approved in 80 countries, mostly under accelerated reviews, and has been launched in 69 of those countries. When you take the end market sales as recorded by Merck, and include end market sales recorded by the ST-MSD JV, global sales of GARDASIL increased 10% sequentially in the second quarter. Total sales of Merck's other promoted medicines were collectively $1.4 billion for the second quarter, representing a 17% increase compared to same period in 2006. As you know, late last year we launched JANUVIA. It is currently approved in 61 countries worldwide as the only DPP-4 inhibitor available for use in the treatment of type 2 diabetes when diet and exercise are not enough. In its second full quarter on the market, global revenue of JANUVIA reached $144 million, of which $137 million was in the U.S. In the domestic market, we have shown strong growth in new and total prescriptions since March, indicative of robust underlying demand and the broad utility of JANUVIA and JANUMET in the clinical setting, and as market share data shows, the introduction of JANUMET is not cannibalizing JANUVIA, and it is clearly adding to the overall value of the franchise. In the U.S., JANUVIA has achieved reimbursement coverage for more than 164 million lives on Tier 2, and for more than 210 million lives in Tiers 2 and 3 combined. JANUMET has achieved reimbursement coverage for more than 112 million lives in Tier 2 and more than 200 million lives in Tiers 2 and 3 combined. Also contributing to our top line, our revenues from our alliances, primarily ASTRAZENECA LP. In the second quarter, revenue recorded by Merck from the company's relationship with AZLP was $524 million. As always, keep in mind that there is inherent variability relating to this revenue given that Merck is not actively managing these products. Our revenue recognition takes into account inventory levels at AZLP for PPI and non-PPI products as well as their product shipments. As we have stated many times, we have the opportunity to capitalize on our robust product portfolio and deliver compound annual revenue growth through 2010. Despite the patent expirations that we all know will occur during this time frame, we continue to expect that our in-line products, our launch products and our potential new products if approved can drive revenue growth of 4% to 6% on a compound annualized basis including 50% of the revenues of the joint ventures from the 2005 base. Taking the second quarter revenue announced today and adding 50% of the revenues from the Merck Schering-Plough, Merial, Sanofi Pasteur MSD, and Johnson and Johnson Merck joint ventures and partnerships, revenue was $7.2 billion. If you do the same adjustment in the base period, the revenue growth was 8%. Year-to-date, our reported sales were $11.9 billion, an increase of 6% over the same period last year. I need not remind you that this stellar top line growth is over a base period that included ZOCOR and PROSCAR prior to their loss of marketing exclusivity. If we were to exclude ZOCAR, PROSCAR, and the revenue associated with the supply of authorized generics from the first half of 2007, and the first half of 2006, then our year-over-year revenue growth would have been 28%. This again emphasizes the strength of our organic growth, fueled by our established brands and newer products. Regarding 2007, given the second quarter and year-to-date performance, we are revising upward our full year revenue guidance by more than $1 billion to support our increased full year EPS guidance provided today. This guidance revision includes five of our product guidance elements. Regarding SINGULAIR, we are increasing by $100 million the full year range, which makes that $4.0 to $4.3 billion. Regarding vaccines, we are increasing by $600 million the full year range, which makes that $3.9 to $4.3 billion. Regarding COZAAR HYZAAR, we're increasing by $100 million the full year range, which makes that $3.2 to $3.5 billion. Regarding FOSAMAX, we are increasing by $200 million the full year range, which makes that $2.8 to $3.1 billion. Regarding other reported products; we're raising the full year range and now anticipate that to be $5.6 to $5.9 billion. We are reaffirming full year guidance for ZOCOR and ASTRAZENECA. As always, the AZLP guidance is an update based on recent results as well as future expectations and reflects the dynamics of the PPI market, multiple generics, OTC products and the uncertainty these create with regard to future volume and pricing. Also keep in mind that our reaffirmed guidance incorporates the expectations of the non-PPI products such as ATACAND, PLENDIL, LEXXEL, and ENTOCORT. Moving down the P&L, materials and production came in at $1.6 billion for the quarter. The quarter includes $119 million for costs associated with the global restructuring program primarily related to accelerated depreciation and asset impairment costs. Excluding these costs, materials and production increased 12% in the quarter. Our gross margin in this quarter was 74.6%, reflecting a 1.9 percentage point unfavorable impact relating to the restructuring costs. Excluding restructuring charges, we had a second quarter product gross margin of 76.5%. Just as in previous periods these results were affected by the final product mix. For the half year, our adjusted gross margin is 76.1%. Given the strength of this result, we are raising our full year 2007 guidance range and now anticipate our product gross margin to be approximately 75% to 76%. This guidance excludes the portion of the restructuring costs that will be included in product costs and will affect reported product gross margins in 2007. Regarding marketing administrative, second quarter expense came in at $2.1 billion, an increase of 20% over the same period last year. In the second quarter, after reviewing the actual costs incurred and estimates of future costs, the Company determined that it was appropriate to record a charge of $210 million to increase the reserves solely for its future legal defense costs related to the VIOXX litigation to $810 million at June 30, 2007. Regarding the legal defense reserve charge, the company accrued legal defense costs expected to be incurred in connection with a loss contingency, where such costs are probable and reasonably estimable. In the second quarter, the company spent $137 million in the aggregate for legal defense costs worldwide related to the VIOXX litigation. In adjusting the reserve, the company considered the same factors that they considered when it previously established reserves for the VIOXX litigation, including the actual costs incurred by the company, the development of the company's legal strategy and structure in light of the scope of the VIOXX litigation. The number of cases being brought against the company, the costs and outcomes of completed trials, and most current information regarding anticipated timing, progression, and related costs of pretrial activities and trials in the VIOXX product liability losses. Events, such as scheduled trials which are expected to occur throughout 2007 and into 2008 and the inherent inability to predict the ultimate outcomes of such trials limits the Company's ability to reasonably estimate its legal costs beyond the end of 2008. Accordingly, the reserve at June 30, 2007, represents the company's best estimate of legal costs that will be incurred through 2008. While the company does not anticipate that it will need to increase the reserves every quarter. It will continue to monitor its legal defense costs and review the adequacy of the associated reserves. It may determine to increase its reserves for legal defense costs at any time in the future, if, based on the factors set forth, it believes it would be appropriate to do so. The company has not established any reserves for any potential liabilities relating to the VIOXX litigation. We continue to believe that every case contains a unique set of facts, and the appropriate strategy is to defend these matters on a case-by-case basis. So excluding the charge, marketing and administrative increased 8% in the quarter. Regarding the underlying level of spend once again, the primary driver of the marketing administrative increase was promotional spend for GARDASIL, ZOSTAVAX, and continuing efforts to more aggressively support the JANUVIA and JANUMET launches. Where appropriate, these were deliberate choices made in response to the evolving competitive dynamics that we felt could provide additional advantages, as we have the first in class products. As you've seen from our revised product-specific financial guidance, we are adjusting revenue upward to reflect these incremental investments in order to enhance our opportunity to better position our products in 2007 and beyond. Reflecting our commitment to realizing efficiencies throughout the company and optimizing our cost structure, the component of marketing administrative consisting of selling administrative and general administrative costs, which support our core operations remain down through the first half of 2007 over the prior year. Even, as we plan to launch additional new products this year, and continue building on the momentum of our successful 2007 launches, we expect that our cost containment efforts and initiatives will allow us to us meet our guidance on marketing and administrative spending in 2007 and our commitment to maintain flat marketing and administrative expenses in 2010 relative to the 2006 based excluding charges taken to increase the legal defense reserves. Regarding 2007 guidance, we're continuing to provide it on the change in marketing and administrative expense relative to the base period, excluding one-time items to help in your modeling, and we are reaffirming our full-year 2007 guidance. That is, we anticipate marketing and administrative expense to increase between 0 and 2 percentage points over the full year 2006 level. Regarding research and development, expenses were $1 billion for the quarter. This represents a decrease from the comparable period in 2006 of 12%, but we should note that this time last year we acquired GlycoFi. I want to take an extra minute to explain this result and our R&D guidance for the remainder of the year. At Merck we remain committed to fully funding core internal R&D to ensure that continued progress of compounds in all phases of development. Internal R&D growth remained strong, as we continue to invest in late stage clinical trials on Isentris, MK-0524A, MK-0524B, MK-0364, MK-0822, MK-0974, Sitagliptin and vaccines. In addition to this significant investment in our internal research capabilities, the company continues to fully fund clinical grant programs, third party scientific collaborations, and licensing transactions. When we provide R&D guidance, it includes certain assumptions regarding the timing of partnering and licensing transactions. For example, earlier this month, we announced the licensing transaction with ARIAD that includes significant upfront and incremental payments we now anticipate to occur in the third quarter. Originally, we anticipated the ARIAD transaction closing in the second quarter of 2007. At Merck, partnering is an essential component of our strategy to discover and development novel medicines that meet major unmet medical needs. We place a premium on our ability to identify the best external opportunities and these opportunities require ongoing and incremental investment. However, given the nature of transactions, there is inherent variability. Therefore, we now anticipate that research and development expense, excluding restructuring charges to be higher in the third quarter than in this quarter. Regarding the full year, we are raising our 2007 guidance for research and development expense to adequately resource incremental external R&D opportunities, and now I anticipate R&D spend to increase at a mid to high single-digit percentage growth rate over the full year 2006 level, and I would refer you to our press release to see how we define the base period. Moving on to restructuring, total costs associated with the company's global restructuring program were $172 million for the second quarter, and as I just mentioned, there were $119 million within there for asset related charges that are included in materials and production. The restructuring cost line reflects $55.8 million of costs for employee separation, and other related costs associated with the approximately 625 positions eliminated, bringing the total to 5,700 to date. We remained on track to eliminate 7,000 positions by the end of 2008. During our ongoing restructuring process, we have identified opportunities to accelerate schedule closures, and therefore we are raising our guidance for 2007. As part of the company's restructuring of its operations, additional costs related to site closings, position eliminations and related costs will be incurred in 2007. The aggregate 2007 pre-tax expense related to these activities is estimated to be $500 to $700 million. In reviewing equity income from affiliates, you'll see $759 million in income in this quarter related to the contributions from all of our joint ventures. This result reflects the continued success of the Merck Schering-Plough cholesterol franchise in the U.S. and Europe, and the seasonality of the Merial Animal Health Business. As always, I would remind you that there are several components to AZLP equity income, which make it inappropriate to draw a significant conclusions just based on PPI products. There are complexities that involve at a minimum timing and tax differences. That said, the second quarter equity income contribution from Merck's share of the partnership with AstraZeneca LP was $215 million. Regarding the Merck Schering-Plough partnership, the second quarter combined MSP cholesterol franchise global revenue as reported by the Merck Schering-Plough partnership, continued to grow to $1.3 billion. In the quarter, revenues of VYTORIN and ZETIA were $686 and $578 million respectively. In the U.S., VYTORIN was $534 million, up 27%, and ZETIA was $424 million, up 17%. Within Merck's quarterly equity income results, the Merck Schering-Plough partnership contributed $465 million, and that reflects a 45% increase over the prior year. The balance of equity income comes from our other joint ventures, namely MERIAL, Sanofi Pasteur MSD, and Johnson & Johnson Merck. Given this result, we're raising our guidance for full year 2007 equity income by $100 million, and now expect equity income from affiliates to be approximately 2.7 to $3.0 billion. For the quarter, income before taxes was $2.2 billion. Taxes on income in the period were $556 million, and the reported tax rate was 24.9%. This reflects in general the changes in foreign and domestic mix and currency fluctuations and these elements change throughout the quarter. We are reaffirming our full year 2007 tax rate guidance range, and I would direct you to today's press release for the details. Moving on to net income and earnings per share, net income for the second quarter was $1.7 billion, compared to $1.5 billion in the second quarter of 2006, and that represents growth of 12%. During the quarter, we spent $250 million in treasury stock and now have $6 billion under the current authorization from the Board with no time limit. In summary, earnings per share for the second quarter were $0.82 excluding a $0.05 charge for site closures and position eliminations primarily associated with the global restructuring, and our reported second quarter EPS was $0.77. Turning briefly to our guidance, I have mentioned several changes as a part of the results review, and I would direct you to the details of our financial guidance contained in today's release. We are raising or changing many elements of our full year 2007 guidance, and as a result, Merck is raising the full year 2007 EPS range to $3 to $3.10 a share, excluding the restructuring charges related to site closures and position eliminations. We now anticipate reported full year 2007 EPS of $2.80 to $2.95 a share. In other words, we anticipate that EPS, excluding restructuring, will grow in the range of 33 to 43% in the second half of this year versus the last six months of the base period. As stated, this guidance does not reflect the establishment of any additional reserves or any addition to reserves for any potential reliability relating to the VIOXX Litigation. We're committed to providing quality full year guidance and updating it during the year. We believe that there is value in providing quality financial guidance because of it assists investors and promotes strong capital markets. We also recognize that our business is complex, and we serve our investors well by communicating our financial performance expectations. At this point in the year, we are halfway through. You now have six months of actual results, and to assist in your modeling, we have provided you with an upward revision on EPS and refreshed the detailed elements of our full year financial guidance. Our revised product specific financial guidance reflects that we continue to anticipate strong performance from our key franchises in the second half of the year. Regarding R&D, partnering is an essential component of our strategy to discover and develop novel medicines. We place a premium on our ability to identify the best external opportunities, and these opportunities require ongoing and incremental investment. However, given the inherent variability associated with transactions, we now anticipate research and development expense, excluding restructuring charges, to be higher in the third quarter than the amount reported in the second quarter. We believe it is prudent not to give specific EPS guidance for the third quarter of 2007, as this year progresses and we gain more clarity on many opportunities we have, we will evaluate the best way to provide you with insight into our progress towards our annual financial guidance. In addition, as Dick noted, the company remains on-track in terms of both strategy and performance to deliver long-term double-digit compound annual earnings per share growth from 2005 to 2010, excluding one-time items and restructuring charges. I also want to continue to emphasize that we have the financial strength to support our dividend and we remain fully committed to maintaining it at the current level while at the same time continuing to fully invest in our key priorities for our strategy going forward. With that said, I will turn the call back over to Graeme.
Graeme Bell: Thank you, Judy. We will now open the call and take your questions. We will take the questions in the order they are received and try get through as many as possible in the allocated time. At this point, I will turn the call over to Cynthia, who will communicate instructions for our Q&A format, then introduce the first question.
Operator: (Operator Instructions) Your first question comes from David Risinger with Merrill Lynch.
David Risinger: Thanks very much, and thank you, Judy, and best of luck to you. With respect to my questions, first, if you could please provide an update on the Zostavax and ProQuad manufacturing issues and the outlook for resolution? Second, with respect to GARDASIL, the product was down sequentially in the U.S. If there is any help you can provide to help us understand how much stocking may have inflated the first quarter '07 sales and what the underlying sequential demand was in the second quarter that you have seen, that would be helpful? And then finally, if you could comment on the factors that you expect will hold back the second half of '07 adjusted EPS relative to what you booked for first half of '07 adjusted EPS, you have obviously called out the R&D item for the third quarter, but any more color on that would be helpful? Thank you.
Richard Clark: With regards to your first question, on the varicella potency issue, we're making excellent progress on finalizing the manufacturing and technological changes we have to make for varicella, and I have a great deal of confidence from a planning standpoint that we will actually start a varicella in that fashion this month. Obviously, it will take us a period of time to know the results, but I think we're there from an ability and confidence level to start up again. Concerning your question with GARDASIL, talking about stocking and inventory, that's a very difficult question to answer. We can tell you that 50 of the vaccine for children projects did make purchase at the end of the first quarter and obviously that that inventory is being utilized in the country as a part of those projects. As Judy said, we still see strong growth in the U.S. and outside the U.S., so I think it will just take us a period of time as we get the stocking and inventory levels, but there is no question as we can see by our relationship with health plans and other formularies, that the utilization of GARDASIL in the United States is very, very positive.
Judy Lewent: And I’ll take the last question. Thank you for your good wishes, Dave. You're absolutely right, first of all. As you think about progression on R&D expense, both the continued growth and supporting the rollout of our pipeline, and making sure we're supporting that as well as a real focus on external opportunities, that's contributing to the different expense level in R&D in the second half versus the first half. But I would also point you to marketing administrative. Even though as I noted, we are reaffirming that for the year marketing administrative will be growing between 0% and 2% on normalized basis excluding the one-time charges. I do call your attention to the fact that not only are we continuing to roll out launches for products, but typically the second half is a heavier half in terms of spending, so in terms of change versus prior year for the year, we expect to be 0% to 2%. In terms of absolute level, I call your attention to what the spending patterns tend to be in the third and in particularly the fourth quarter. You need to factor that into the analysis.
Richard Clark: What's exciting about what we're talking about from a launch standpoint, when you look at the numbers that Judy and I presented this morning, if you look at JANUVIA, it is approved in 51 countries, but only launched in 25 so far. And with GARDASIL approved in 80, launched in 59 and under-review in another 40, and with ROTATEQ, 61 countries approved and only launched in 22 and JANUMET moving forward will have the same numbers and Isentress is in addition, so we are definitely even though we launched these important products and vaccines, and in several countries, we're still in the launch phase, and we have to make sure we support that launch phase the right way.
Graeme Bell: Next question, please.
Operator: Your next question comes from Jamie Rubin with Morgan Stanley.
Jamie Rubin: Thank you. And ditto to you Judy. My best wishes. So, I have two specific questions. One, I am wondering if you can provide an update on VIOXX litigation, specifically, are there any forthcoming cases that we should be aware of, that on the case front it has been pretty quiet. And, just wondering what's coming down, what's in the calendar going forward. Secondly, what is the status of the New Jersey Consumer Protection Act and are there other consumer protection acts forming outside of New Jersey. And lastly, we'll continue to argue the 18 month window, or has that now been discredited because of the Victor trial. And then a question on gross margins, Judy, the guidance for the year now has been adjusted to 75% to 76%; but on an adjusted basis this quarter it was 76.5% and that's with a heavy drag from ZOCOR, which goes away in the second half. So, is this typical Merck conservatism, or is there something that we should be aware of that acts as a natural drag on gross margins. Could it be that as GARDASIL sales add another, whatever in the second half that the actually gross margin contribution becomes a detriment, but because of the royalty payments and lower yields. But if you can address that, I would appreciate it. Thanks.
Graeme Bell: Jamie, let me start if you wouldn't mind on the VIOXX related questions. As always, we commit to posting the trial schedule on Merck.com, and as of July the 20th, you will see that there are seven trials scheduled for the balance of 2007, starting on September 17th in California. And we are currently posting that there are four starting on January the 7th, 2008, up through April of 2008. With regard to the seven, as posted to Merck.com, you will see that, for instance, some are consolidated. And I would direct you back to that for the details, but I would point out, for instance, in New Jersey and Atlantic County on October 15th, the current schedule calls for New Jersey coordinator trials where there will be four trials, and up to two or three plaintiffs in each respective trial. And also in California in November the 26th, a trial is scheduled to start with up to five plaintiffs. So, I would just point you to that, and it gives you a sense of the activity and schedule going forward. With regard to Victor and the science behind that, I think we’ve indicated many times that, that is but one study. And you know the history in terms of it being stopped prematurely, and that data such in and of itself has been available to all plaintiff, and this has been argued and presented many times in the 15, 16 trials that have actually gone through to juries. And we feel that, that one data point in and of itself can draw no conclusion whatsoever, so we remain steadfast based on the scientific evidence relating to the long-term trial. With regard to consumer fraud here in New Jersey, that really was just in a holding pattern so to speak, and that the judges have yet to render their specific opinion. And we just don't have a sense of when that decision will come down, and right now that is the only consumer case that is currently work in progress awaiting a decision. And once we communicate that decision, then clearly we'll take appropriate steps. But just as a reminder, if it does cause a decision pertaining to whether a class action will be created as opposed to anything else. So, that's the update on VIOXX right now, and I’ll pass it over to Judy or Richard for the PDM question.
Judy Lewent: Yeah so -- and thank you, Jamie. So, first of all, as I believe you noted, we did tighten the product gross margin guidance range, so we were at 74 to 76, and given the performance of the first six months, we are comfortable with 65 to 76. But, you do have to bear in mind, although the first half looks promising, that product mix is a very key factor here. And, so that's what we have taken into account as we think about the full year.
Graeme Bell: Thank you. Next question, please.
Operator: Your next question comes from Bert Hazlett with BMO Capital Markets.
Bert Hazlett: Yes, thanks. I’ll just take a follow-on to Jamie's question. As we see the vaccine business continuing to grow, not only with GARDASIL, but with the other vaccines, ROTATEQ in particular. How should we think about the pushes and pulls on the margins? Again, gross margins and SG&A, and then secondly, you made a comment on 524A in terms of filing in the second half. Could you remind us as to 524 B, and are you still supporting the timelines with that particular combination? Thanks.
Judy Lewent: So, relative to the pushing and pull on vaccines, as we don't get into details across the product line, we have noted from time to time that vaccines tend to have a slightly lower product gross margin than some of our other in-line products. And of course as you know GARDASIL in particular carries a royalty burden that we discussed in the 24% to 26% range. That said, what we continue to see in our performance year-to-date, and what we expect in the future, are improvements across the board including vaccines in terms of productivity improvements, that will continue to improve the possibility for a product gross margins. And as we guided to product gross margins through 2010, we did note that we expect to return to pre-ZOCOR patent ex levels, and we continue to reaffirm that, and that is in full recognition of the product mix that we see going forward. So it’s really, continued improvement on manufacturing productivity improvements, and a recognition of the product mix we have, but still delivering that uptick in product gross margin by 2010.
Richard Clark: And your question with 524B, as we stated along our clinical trials.gov, protocol number 63 is an MK524-B lipid study. And we're currently rolling patients for that study, and really there is no change from a timing standpoint, and we're committed to the 2008 filing for 524B, so we feel that's on track for '08.
Graeme Bell: And with regard to 524A, we remain committed as indicated in the prepared remarks, that an MDA will be filed with the FDA in the second half of 2007. Cynthia, could we have the next question, please.
Operator: Your next question comes from James Kelly with Goldman Sachs.
James Kelly: Good morning, and let me also echo my best wish to Judy. I have a question about GARDASIL and how we should be thinking about GARDASIL in the various patient cohorts. And how adoption is going there, and any sense of how it might have changed from the first quarter into the second quarter, and anything that's coming back from the sales force about people using above the age of 26. Thank you.
Richard Clark: We certainly don't have information that we can provide you on the specifics, the detailed specifics that you're asking at this time. The important thing that we're focusing our attention on from a compliant standpoint and precision standpoint is to make sure that when young women receive their first shot of GARDASIL. The first vaccination they're able to come back and get the second and third which is critical. So, we're working to making sure that physician offices with healthcare practices, there are reminder mechanisms and capabilities put in place, that a second and third vaccine is put in place. But we can't give you specifics on the questions that you asked.
Graeme Bell: Thank you. Next question, please.
Operator: Your next question comes from Tony Butler with Lehman Brothers.
Tony Butler: Yes, thanks very much. My question also is gross margin related, but it’s related to the restructuring costs, Judy. The increase in this quarter for future activities of $500 million to $700 million I believe is a change from the previous quarter of $300 million to $500 million. And the question I have is the change principally related to those site closings, which could have some positive impact to gross margin. And/or to product eliminations or position eliminations as it relates to SG&A, which I guess could help operating margins, and the reason I’m asking this is to offset may be the dynamic growth in vaccines, which could possibly put that as Jamie alluded to the drag on, on the overall gross margins. And this is principally related to the back half of the year, but more importantly to 2008. Thanks.
Judy Lewent: Yeah, so exactly. This is timing, this is strictly a timing issue, so this doesn't really change even our overall expectations of the network strategy that we rolled out in November of 2005. But it is positive in terms of acceleration of some of our plans for site closures. So, yes, we're moving that along more rapidly than we originally anticipated in 2007. It is predominantly accelerated depreciation. It is not really driven by position eliminations per se, but really driven by the timing of site closures.
Graeme Bell: Next question, please.
Operator: Your next question comes from Chris Schott with Banc of America Securities.
Chris Schott: Quick questions. First you've had a very successful JV with one of your major firm here; obviously, ZETIA and VYTORIN. When you’re talking about more in licensing transactions going forward, how would you characterize the opportunity for additional partnerships with some of major pharma company's I guessing out there and not specific questions but compounds that interest you or are you looking at or should we see these deals more along the line of the area deal. And then specifically on pipeline question your CB1 MK364, how comfortable are you with the Phase III program following the recent panel, is there even many or do you intend to or have you altered any of those Phase III programs? Thanks.
Richard Clark: Concerns your first question, we're interested in any relationship with either our pharma colleagues or licensing capability in Biotech that really add long-term shareholder value. If there's a relationship based on the synergies between those two companies, then whatever they are would be important to consider them as we move forward. And we have always stated, target acquisition is sincerely a key part of our strategy as well, and we're looking at those from a Biotech company as well, not only for the relationship and the research but the relationship that we would have that would help the top line, so we're very flexible and open to those kind of relationships, and I think to Judy's credit, and she has built these relationships over the years, that we've been very successful with our joint venture partnership in the past, and I think Merck is looked upon as a company to be able to have comments and objectives and to be successful for both parent company shareholders. In relation ship to your second question, it is really hard for us to speculate on the class effect, the CB1s, and obviously we're scoring the clinical profile of our product as an ongoing part of our Phase III clinical programs.
Graeme Bell: Next question, please, Cynthia.
Operator: Your next question is from Steve Scala with Cowen.
Steve Scala: Thank you. I have two questions. First, does Merck have an understanding of the level of GARDASIL stock in physicians offices and if so has that changed quarter-over-quarter, and in the past I believe Merck has implied that there was not much stock in physicians offices. But that could be one explanation for a flattish quarter-over-quarter trend, and secondly, if the bio equivalent study is successful, then what would that suggest for the timing of MK-0524B in 2008, as a late 2008 filing more likely than mid or vice versa?
Richard Clark: On MK-524B, we can't speculate, Steve on, what part of 2008. Our comment now is just based on 2008, and in your first question, I think we're gaining more information, but I don't think you will see a tremendous amount of stocking in the physicians offices for GARDASIL particularly with the cost of GARDASIL and the reimbursement process that we're trying to help as well. But don't forget there is a difference between public and private, and so in the physicians office it could be more private, and very small. In public it could be building inventory as I said at the end of the first quarter for 50 to 55, and now it is being penetrated out, and we'll see what happens in the third and fourth quarter as that inventory is reduced.
Steve Scala: Thank you, Richard.
Richard Clark: So given the time we might have about time for one or two more questions. Cynthia.
Operator: Your final question comes from Seamus Fernandez with Leerink Swann.
Seamus Ferndandez: Hi, thanks very much. I have a few questions. I was just wondering if you can update us on the timing of AZLP and if given your close involvement in the original deal and restructuring if Judy will be available as a consultant to Merck on these issues. Separately, Richard, if you could give us, it given the strong performance year-to-date, could you just give us an update on what you're keenly focused on to continue delivering P&L leverage in 2008 particularly given the upcoming U.S. patent expiration of FOSAMAX, I mean, obviously it will be balanced over the P&L, but if you could give us your biggest focus for execution where you see the best opportunity post 2007? And then as a last question, it took Merck six months to get full reimbursement approval under the vaccines for children program, which clearly was very rapid, but is there any reason why the timeframe would be shorter or longer for a new competitor and what is Merck planning for relative to new entrants for next year? Thanks very much.
Graeme Bell: Why don't we start with AstraZeneca.
Judy Lewent: So I told you what you're referring to is a potential upcoming series of events in 2008 relative to the Merck option, and as many of you know, there will be events that are even independent of the exercise or options that were triggered back in the 1998, 99 period when Astra merged with Zeneca. Namely we will see the equity income priority return reduced from about $300 million to about $210 million, and we have recognition of some of the advance payments and other parts of the transaction that were put in place in '98 in the first quarter of 2008. We also will be repaying the $1.4 billion loan in the first half of 2008, and so really what is left to reflect on is whether we are going to exercise the option for non-CPI products, and that will be evaluated in the coming months and really probably formally decided in the first quarter of 2008, and if Richard wants, he is more than welcome to give me a call as I get closer to that practice.
Richard Clark: There is no question that Judy will always be a close adviser to the current Chairman and CEO, and so there is no hesitation that there will be a loss in the leadership that she’s provided in that relationship. Regarding your question, we cannot speculate on the Zerbrex timeline and what that means or does not mean in the United States. And certainly my focus, Winston Churchill once said however beautiful the strategy you should occasionally look at the results, and I think we have looked at the results. I think we have shown you that our results are good, and that our strategy is validated by the results, and so my focus on 2007, 2008, 2009 and 2010 hopefully is to keep executing the strategy to make sure that we have strong and talented business leaders in place and than our franchise strategies are being executed by listening to our customers, that we continue to invest wisely in basic research and in our clinical development, organizations continue accelerate our pipeline, and that we're able to become a lean and flexible organization by taking the right costs out at the right time.
Graeme Bell: So with that last question, it concludes today’s conference call. The information and all of the Q&A on today's call and the transcript and the replays will be available on our website for the next several months, and as always, Mike Nally and I will be available all day to take your calls and any of your incremental questions. Richard?
Richard Clark: Thank you, Graeme, and thanks to all of you who participated and listened in to our call today, including our operator who kept things running smoothly. We look forward to speaking to you in October about our third quarter results. Thank you.
Operator: Ladies and gentlemen, this concludes today's Merck second quarter 2007 earnings conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day, everyone, and welcome to Merck's second quarter 2007 earnings conference call. Today's call is being recorded. At this time, I would like to turn the call over to Mr. Graeme Bell, Executive Director of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Graeme Bell",
"text": "Thank you, Cynthia, and good morning. Welcome to our call this morning to review the business results for the second quarter of 2007. Joining me on the call today are our Chairman, President and CEO, Dick Clark, and for the last time prior to her formal retirement, Miss Judy Lewent, our Executive Vice President and Chief Financial Officer. Before we get into the details, let me go over the logistics as usual. On this call, we will review the results contained on the release we issued at 7:30 AM this morning. You can access this through the in Investor Relations section of merck.com, and I would remind you that this conference call is being webcast live and recorded. The replay of this event will be available later today via phone, webcast and our usual podcast. As we begin to review the results, let me remind you that some of the statements made during this call may discuss certain subjects that may contain forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and involve risks and uncertainty, which may cause results to differ materially from those set forth in the statements. The forward-looking statements may include statements regarding product development, product potential or financial performance. No forward-looking statement can be guaranteed, and actual results may differ materially from those projected. Merck undertakes no obligation to publicly update any forward-looking statements whether as a result of new information, future events or otherwise. Forward-looking statements in this call should be evaluated together with the many uncertainties that affects Merck business, particularly those mentioned in the risk factors and cautionary statements set forth in item 1A of the Merck's Form 10-K for the year ending December 31, 2006, and its periodic report of Form 10-Q and Form 8-K which the Company incorporates by reference and that are posted on our website. With that, let me turn the call over to Dick Clark, for prepared remarks."
},
{
"speaker": "Richard Clark",
"text": "Thank you, Graeme, and good morning, everyone. The results we are reporting to you today reinforce our confidence that Merck's plan to regain our leadership position in the pharmaceutical industry is the right one and that we are successfully executing our plan. Our overall performance has positioned us well to achieve our business targets, meet the challenges that lie ahead, and continue to invest in drug discovery. I am pleased to announce that our second quarter 2007 earnings per share were $0.82, excluding restructuring charges, a 12% increase from the second quarter of 2006. Our reported EPS for the second quarter were $0.77 both results include the impact, the reserving and additional $210 million for future VIOXX legal defense costs. In addition, our worldwide sales were $6.1 billion during the quarter, and $11.9 billion for the first six months of 2007. This revenue in the first half of 2007 is up 6% from the same period last year, and I would note that our results include ZOCOR in the base. This better than expected performance was driven by a broad range of both our newer and our established products delivering strong growth again during the second quarter. SINGULAIR continues to be the number one prescribed product in the United States respiratory market, with worldwide sales last quarter reaching $1.1 billion, an increase of 15% from the same quarter last year. VYTORIN and ZETIA achieved all-time highs in both new and total prescription share in the quarter, posting combined global sales of $1.3 billion, an increase of 30% compared to the second quarter of 2006. GARDASIL, along with our pediatric vaccines, helped drive total worldwide vaccine sales over the $1 billion mark in the quarter, nearly tripling the total vaccine sales in the second quarter of last year. Global revenue for JANUVIA and JANUMET reached $144 million, and $24 million respectively in the second quarter. Managed care acceptance of these medicines has been strong and we're pleased that all major pharmacy benefit managers in the United States have added both of them to their formularies. Our revenues reflect the high value that physicians, patients and payors are placing on our products and on the healthcare benefits they provide. They also demonstrate that we continue to build on momentum established with our product launches last year. Regarding the full year 2007, we are raising our EPS guidance range to reflect the impressive sales growth that our products have achieved during the first half of the year. We now anticipate a full year EPS range of $3 to $3.10, excluding restructuring charges and reported full-year EPS range of $2.80 to $2.95. Judy Lewent will provide more details on the financial performance and guidance in a few minutes. As we look at the third and fourth quarter of 2007 and into 2008, we are working to ensure our expected launches of Isentress and of MK-0524A are accomplished with the same level of energy and success that distinguished our product launches in 2006 and 2007. We are pleased that the FDA has granted Isentress priority review status, and we anticipate regulatory action by mid-October following the FDA Advisory Committee meeting scheduled for September 5th. If approved, Isentress would be the first in a new class of anti-retroviral agents called integrase inhibitors. And in clinical trials, Isentress has demonstrated the ability to block the ability of the HIV virus to replicate and infect new cells in human patients. Isentress has the potential to represent a significant step forward in meeting one of the world's major unmet medical needs. We continue to anticipate an NDA will be filed with the FDA in the second half of 2007 for MK-0524A, our investigational atherosclerosis compound. MK-0524A combines Merck's extended release niacin with the Merck compound that reduces flushing, a common side effect of niacin therapy. In addition to the progress we are making in our own pipeline, we are also continuing to seek new licensing opportunities and targeted acquisition in therapeutic areas that are of strategic importance to Merck. Earlier this month, we announced an important licensing agreement with ARIAD pharmaceutical. This agreement expands Merck's investment in the field of oncology and holds the potential of bringing a novel medicine to cancer patients worldwide. Our future success clearly depends on our ability to discover, develop, and market novel medicines that address unmet medical needs, and entering into these types of agreements clearly complement our in-house efforts. To support these efforts, we also remain focused on controlling expenses to further reduce our cost structure and creating a leaner and more nimble business model, so that we can respond quickly and efficiently to customers' expectations and the demands of the market. We remain on track to deliver what we promised eighteen months ago, double-digit compound annual EPS growth excluding one-time items and restructuring charges by 2010 from a 2005 base. When I reflect on what this quarter means to Merck, I see it as significant for several reasons. New product launches are continuing to gain momentum and strong acceptance in the marketplace. We are translating lessons learned from our new launches to our established brands and seeing greater market acceptance as a result. The quality of our external partnerships and alliances are reinforcing our considerable internal research efforts that are commitment to the development of new medicines, and all of these factors, when looked at in context with our 2010 stated goals, give us confidence that we can sustain our strong overall growth. Before I turn the call over to Judy for what really will be her last earnings call with Merck, I wanted to take this opportunity again to thank her for 27 years of service to Merck, to thank her for her leadership, her commitment, her dedication and her accomplishments as CFO of Merck and Company. So with that, I am pleased to turn the call over to Judy."
},
{
"speaker": "Judy Lewent",
"text": "Thank you, Dick, very much, and thank you for joining us today and good morning. As Dick said, we are extremely pleased with our reported results. In the second quarter of 2007, the company reported mid single digit growth on the top-line and double-digit growth on the bottom line, as we continue to work toward our stated long-term performance targets. The second quarter recorded EPS growth, excluding restructuring costs, was driven by revenue that reflects strong performance of our inline franchises like SINGULAIR and COZAAR, as well as the rapid early up take of JANUVIA and JANUMET, and the continued strong growth of GARDASIL. Other notable contributions to this result came from our improving product gross margin and the outstanding performance of our partnership and alliances, which resulted in enhanced equity income. As usual, I will go into more detail about the important underlying drivers of our performance and explain why we remain confident in our abilities to achieve our higher full year EPS guidance for 2007. Dick mentioned several of the highlights of the quarterly results a moment ago, so I will build on that. In the second quarter we saw revenue of $6.1 billion. That represents a 6% increase over the same period last year including in the aggregate, an overall 4% growth in volume and a 2% positive impact coming from foreign exchange. Collectively, worldwide revenue was above our initial expectations, and we saw encouraging sales performances from our newer and in-line franchises. A major contributing factor to on our top line growth came from or vaccines business. Collectively, vaccine revenue as recorded by Merck, was in excess of $1 billion for the second quarter, representing a 199% increase as compared to the same period in 2006. Driven by the continued up take of GARDASIL, ROTATEQ, and ZOSTAVAX in the second quarter, our three new vaccines collectively accounted for greater than $0.5 billion of revenue. As always, to assist in your modeling, we provide a breakdown of the product revenues in our other financial disclosure schedule. We are extremely pleased that the global sales for GARDASIL as recorded by Merck reflect the continued strong underlying demand for the vaccine in both the public and private sector. Of the $358 million recorded in the quarter, $286 million was in the United States. Sales outside the U.S. continued to show strong growth and increase 34% sequentially as we continued to successfully navigate the processes surrounding regulatory approval, country recommendations, and reimbursement with governments. GARDASIL has been approved in 80 countries, mostly under accelerated reviews, and has been launched in 69 of those countries. When you take the end market sales as recorded by Merck, and include end market sales recorded by the ST-MSD JV, global sales of GARDASIL increased 10% sequentially in the second quarter. Total sales of Merck's other promoted medicines were collectively $1.4 billion for the second quarter, representing a 17% increase compared to same period in 2006. As you know, late last year we launched JANUVIA. It is currently approved in 61 countries worldwide as the only DPP-4 inhibitor available for use in the treatment of type 2 diabetes when diet and exercise are not enough. In its second full quarter on the market, global revenue of JANUVIA reached $144 million, of which $137 million was in the U.S. In the domestic market, we have shown strong growth in new and total prescriptions since March, indicative of robust underlying demand and the broad utility of JANUVIA and JANUMET in the clinical setting, and as market share data shows, the introduction of JANUMET is not cannibalizing JANUVIA, and it is clearly adding to the overall value of the franchise. In the U.S., JANUVIA has achieved reimbursement coverage for more than 164 million lives on Tier 2, and for more than 210 million lives in Tiers 2 and 3 combined. JANUMET has achieved reimbursement coverage for more than 112 million lives in Tier 2 and more than 200 million lives in Tiers 2 and 3 combined. Also contributing to our top line, our revenues from our alliances, primarily ASTRAZENECA LP. In the second quarter, revenue recorded by Merck from the company's relationship with AZLP was $524 million. As always, keep in mind that there is inherent variability relating to this revenue given that Merck is not actively managing these products. Our revenue recognition takes into account inventory levels at AZLP for PPI and non-PPI products as well as their product shipments. As we have stated many times, we have the opportunity to capitalize on our robust product portfolio and deliver compound annual revenue growth through 2010. Despite the patent expirations that we all know will occur during this time frame, we continue to expect that our in-line products, our launch products and our potential new products if approved can drive revenue growth of 4% to 6% on a compound annualized basis including 50% of the revenues of the joint ventures from the 2005 base. Taking the second quarter revenue announced today and adding 50% of the revenues from the Merck Schering-Plough, Merial, Sanofi Pasteur MSD, and Johnson and Johnson Merck joint ventures and partnerships, revenue was $7.2 billion. If you do the same adjustment in the base period, the revenue growth was 8%. Year-to-date, our reported sales were $11.9 billion, an increase of 6% over the same period last year. I need not remind you that this stellar top line growth is over a base period that included ZOCOR and PROSCAR prior to their loss of marketing exclusivity. If we were to exclude ZOCAR, PROSCAR, and the revenue associated with the supply of authorized generics from the first half of 2007, and the first half of 2006, then our year-over-year revenue growth would have been 28%. This again emphasizes the strength of our organic growth, fueled by our established brands and newer products. Regarding 2007, given the second quarter and year-to-date performance, we are revising upward our full year revenue guidance by more than $1 billion to support our increased full year EPS guidance provided today. This guidance revision includes five of our product guidance elements. Regarding SINGULAIR, we are increasing by $100 million the full year range, which makes that $4.0 to $4.3 billion. Regarding vaccines, we are increasing by $600 million the full year range, which makes that $3.9 to $4.3 billion. Regarding COZAAR HYZAAR, we're increasing by $100 million the full year range, which makes that $3.2 to $3.5 billion. Regarding FOSAMAX, we are increasing by $200 million the full year range, which makes that $2.8 to $3.1 billion. Regarding other reported products; we're raising the full year range and now anticipate that to be $5.6 to $5.9 billion. We are reaffirming full year guidance for ZOCOR and ASTRAZENECA. As always, the AZLP guidance is an update based on recent results as well as future expectations and reflects the dynamics of the PPI market, multiple generics, OTC products and the uncertainty these create with regard to future volume and pricing. Also keep in mind that our reaffirmed guidance incorporates the expectations of the non-PPI products such as ATACAND, PLENDIL, LEXXEL, and ENTOCORT. Moving down the P&L, materials and production came in at $1.6 billion for the quarter. The quarter includes $119 million for costs associated with the global restructuring program primarily related to accelerated depreciation and asset impairment costs. Excluding these costs, materials and production increased 12% in the quarter. Our gross margin in this quarter was 74.6%, reflecting a 1.9 percentage point unfavorable impact relating to the restructuring costs. Excluding restructuring charges, we had a second quarter product gross margin of 76.5%. Just as in previous periods these results were affected by the final product mix. For the half year, our adjusted gross margin is 76.1%. Given the strength of this result, we are raising our full year 2007 guidance range and now anticipate our product gross margin to be approximately 75% to 76%. This guidance excludes the portion of the restructuring costs that will be included in product costs and will affect reported product gross margins in 2007. Regarding marketing administrative, second quarter expense came in at $2.1 billion, an increase of 20% over the same period last year. In the second quarter, after reviewing the actual costs incurred and estimates of future costs, the Company determined that it was appropriate to record a charge of $210 million to increase the reserves solely for its future legal defense costs related to the VIOXX litigation to $810 million at June 30, 2007. Regarding the legal defense reserve charge, the company accrued legal defense costs expected to be incurred in connection with a loss contingency, where such costs are probable and reasonably estimable. In the second quarter, the company spent $137 million in the aggregate for legal defense costs worldwide related to the VIOXX litigation. In adjusting the reserve, the company considered the same factors that they considered when it previously established reserves for the VIOXX litigation, including the actual costs incurred by the company, the development of the company's legal strategy and structure in light of the scope of the VIOXX litigation. The number of cases being brought against the company, the costs and outcomes of completed trials, and most current information regarding anticipated timing, progression, and related costs of pretrial activities and trials in the VIOXX product liability losses. Events, such as scheduled trials which are expected to occur throughout 2007 and into 2008 and the inherent inability to predict the ultimate outcomes of such trials limits the Company's ability to reasonably estimate its legal costs beyond the end of 2008. Accordingly, the reserve at June 30, 2007, represents the company's best estimate of legal costs that will be incurred through 2008. While the company does not anticipate that it will need to increase the reserves every quarter. It will continue to monitor its legal defense costs and review the adequacy of the associated reserves. It may determine to increase its reserves for legal defense costs at any time in the future, if, based on the factors set forth, it believes it would be appropriate to do so. The company has not established any reserves for any potential liabilities relating to the VIOXX litigation. We continue to believe that every case contains a unique set of facts, and the appropriate strategy is to defend these matters on a case-by-case basis. So excluding the charge, marketing and administrative increased 8% in the quarter. Regarding the underlying level of spend once again, the primary driver of the marketing administrative increase was promotional spend for GARDASIL, ZOSTAVAX, and continuing efforts to more aggressively support the JANUVIA and JANUMET launches. Where appropriate, these were deliberate choices made in response to the evolving competitive dynamics that we felt could provide additional advantages, as we have the first in class products. As you've seen from our revised product-specific financial guidance, we are adjusting revenue upward to reflect these incremental investments in order to enhance our opportunity to better position our products in 2007 and beyond. Reflecting our commitment to realizing efficiencies throughout the company and optimizing our cost structure, the component of marketing administrative consisting of selling administrative and general administrative costs, which support our core operations remain down through the first half of 2007 over the prior year. Even, as we plan to launch additional new products this year, and continue building on the momentum of our successful 2007 launches, we expect that our cost containment efforts and initiatives will allow us to us meet our guidance on marketing and administrative spending in 2007 and our commitment to maintain flat marketing and administrative expenses in 2010 relative to the 2006 based excluding charges taken to increase the legal defense reserves. Regarding 2007 guidance, we're continuing to provide it on the change in marketing and administrative expense relative to the base period, excluding one-time items to help in your modeling, and we are reaffirming our full-year 2007 guidance. That is, we anticipate marketing and administrative expense to increase between 0 and 2 percentage points over the full year 2006 level. Regarding research and development, expenses were $1 billion for the quarter. This represents a decrease from the comparable period in 2006 of 12%, but we should note that this time last year we acquired GlycoFi. I want to take an extra minute to explain this result and our R&D guidance for the remainder of the year. At Merck we remain committed to fully funding core internal R&D to ensure that continued progress of compounds in all phases of development. Internal R&D growth remained strong, as we continue to invest in late stage clinical trials on Isentris, MK-0524A, MK-0524B, MK-0364, MK-0822, MK-0974, Sitagliptin and vaccines. In addition to this significant investment in our internal research capabilities, the company continues to fully fund clinical grant programs, third party scientific collaborations, and licensing transactions. When we provide R&D guidance, it includes certain assumptions regarding the timing of partnering and licensing transactions. For example, earlier this month, we announced the licensing transaction with ARIAD that includes significant upfront and incremental payments we now anticipate to occur in the third quarter. Originally, we anticipated the ARIAD transaction closing in the second quarter of 2007. At Merck, partnering is an essential component of our strategy to discover and development novel medicines that meet major unmet medical needs. We place a premium on our ability to identify the best external opportunities and these opportunities require ongoing and incremental investment. However, given the nature of transactions, there is inherent variability. Therefore, we now anticipate that research and development expense, excluding restructuring charges to be higher in the third quarter than in this quarter. Regarding the full year, we are raising our 2007 guidance for research and development expense to adequately resource incremental external R&D opportunities, and now I anticipate R&D spend to increase at a mid to high single-digit percentage growth rate over the full year 2006 level, and I would refer you to our press release to see how we define the base period. Moving on to restructuring, total costs associated with the company's global restructuring program were $172 million for the second quarter, and as I just mentioned, there were $119 million within there for asset related charges that are included in materials and production. The restructuring cost line reflects $55.8 million of costs for employee separation, and other related costs associated with the approximately 625 positions eliminated, bringing the total to 5,700 to date. We remained on track to eliminate 7,000 positions by the end of 2008. During our ongoing restructuring process, we have identified opportunities to accelerate schedule closures, and therefore we are raising our guidance for 2007. As part of the company's restructuring of its operations, additional costs related to site closings, position eliminations and related costs will be incurred in 2007. The aggregate 2007 pre-tax expense related to these activities is estimated to be $500 to $700 million. In reviewing equity income from affiliates, you'll see $759 million in income in this quarter related to the contributions from all of our joint ventures. This result reflects the continued success of the Merck Schering-Plough cholesterol franchise in the U.S. and Europe, and the seasonality of the Merial Animal Health Business. As always, I would remind you that there are several components to AZLP equity income, which make it inappropriate to draw a significant conclusions just based on PPI products. There are complexities that involve at a minimum timing and tax differences. That said, the second quarter equity income contribution from Merck's share of the partnership with AstraZeneca LP was $215 million. Regarding the Merck Schering-Plough partnership, the second quarter combined MSP cholesterol franchise global revenue as reported by the Merck Schering-Plough partnership, continued to grow to $1.3 billion. In the quarter, revenues of VYTORIN and ZETIA were $686 and $578 million respectively. In the U.S., VYTORIN was $534 million, up 27%, and ZETIA was $424 million, up 17%. Within Merck's quarterly equity income results, the Merck Schering-Plough partnership contributed $465 million, and that reflects a 45% increase over the prior year. The balance of equity income comes from our other joint ventures, namely MERIAL, Sanofi Pasteur MSD, and Johnson & Johnson Merck. Given this result, we're raising our guidance for full year 2007 equity income by $100 million, and now expect equity income from affiliates to be approximately 2.7 to $3.0 billion. For the quarter, income before taxes was $2.2 billion. Taxes on income in the period were $556 million, and the reported tax rate was 24.9%. This reflects in general the changes in foreign and domestic mix and currency fluctuations and these elements change throughout the quarter. We are reaffirming our full year 2007 tax rate guidance range, and I would direct you to today's press release for the details. Moving on to net income and earnings per share, net income for the second quarter was $1.7 billion, compared to $1.5 billion in the second quarter of 2006, and that represents growth of 12%. During the quarter, we spent $250 million in treasury stock and now have $6 billion under the current authorization from the Board with no time limit. In summary, earnings per share for the second quarter were $0.82 excluding a $0.05 charge for site closures and position eliminations primarily associated with the global restructuring, and our reported second quarter EPS was $0.77. Turning briefly to our guidance, I have mentioned several changes as a part of the results review, and I would direct you to the details of our financial guidance contained in today's release. We are raising or changing many elements of our full year 2007 guidance, and as a result, Merck is raising the full year 2007 EPS range to $3 to $3.10 a share, excluding the restructuring charges related to site closures and position eliminations. We now anticipate reported full year 2007 EPS of $2.80 to $2.95 a share. In other words, we anticipate that EPS, excluding restructuring, will grow in the range of 33 to 43% in the second half of this year versus the last six months of the base period. As stated, this guidance does not reflect the establishment of any additional reserves or any addition to reserves for any potential reliability relating to the VIOXX Litigation. We're committed to providing quality full year guidance and updating it during the year. We believe that there is value in providing quality financial guidance because of it assists investors and promotes strong capital markets. We also recognize that our business is complex, and we serve our investors well by communicating our financial performance expectations. At this point in the year, we are halfway through. You now have six months of actual results, and to assist in your modeling, we have provided you with an upward revision on EPS and refreshed the detailed elements of our full year financial guidance. Our revised product specific financial guidance reflects that we continue to anticipate strong performance from our key franchises in the second half of the year. Regarding R&D, partnering is an essential component of our strategy to discover and develop novel medicines. We place a premium on our ability to identify the best external opportunities, and these opportunities require ongoing and incremental investment. However, given the inherent variability associated with transactions, we now anticipate research and development expense, excluding restructuring charges, to be higher in the third quarter than the amount reported in the second quarter. We believe it is prudent not to give specific EPS guidance for the third quarter of 2007, as this year progresses and we gain more clarity on many opportunities we have, we will evaluate the best way to provide you with insight into our progress towards our annual financial guidance. In addition, as Dick noted, the company remains on-track in terms of both strategy and performance to deliver long-term double-digit compound annual earnings per share growth from 2005 to 2010, excluding one-time items and restructuring charges. I also want to continue to emphasize that we have the financial strength to support our dividend and we remain fully committed to maintaining it at the current level while at the same time continuing to fully invest in our key priorities for our strategy going forward. With that said, I will turn the call back over to Graeme."
},
{
"speaker": "Graeme Bell",
"text": "Thank you, Judy. We will now open the call and take your questions. We will take the questions in the order they are received and try get through as many as possible in the allocated time. At this point, I will turn the call over to Cynthia, who will communicate instructions for our Q&A format, then introduce the first question."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from David Risinger with Merrill Lynch."
},
{
"speaker": "David Risinger",
"text": "Thanks very much, and thank you, Judy, and best of luck to you. With respect to my questions, first, if you could please provide an update on the Zostavax and ProQuad manufacturing issues and the outlook for resolution? Second, with respect to GARDASIL, the product was down sequentially in the U.S. If there is any help you can provide to help us understand how much stocking may have inflated the first quarter '07 sales and what the underlying sequential demand was in the second quarter that you have seen, that would be helpful? And then finally, if you could comment on the factors that you expect will hold back the second half of '07 adjusted EPS relative to what you booked for first half of '07 adjusted EPS, you have obviously called out the R&D item for the third quarter, but any more color on that would be helpful? Thank you."
},
{
"speaker": "Richard Clark",
"text": "With regards to your first question, on the varicella potency issue, we're making excellent progress on finalizing the manufacturing and technological changes we have to make for varicella, and I have a great deal of confidence from a planning standpoint that we will actually start a varicella in that fashion this month. Obviously, it will take us a period of time to know the results, but I think we're there from an ability and confidence level to start up again. Concerning your question with GARDASIL, talking about stocking and inventory, that's a very difficult question to answer. We can tell you that 50 of the vaccine for children projects did make purchase at the end of the first quarter and obviously that that inventory is being utilized in the country as a part of those projects. As Judy said, we still see strong growth in the U.S. and outside the U.S., so I think it will just take us a period of time as we get the stocking and inventory levels, but there is no question as we can see by our relationship with health plans and other formularies, that the utilization of GARDASIL in the United States is very, very positive."
},
{
"speaker": "Judy Lewent",
"text": "And I’ll take the last question. Thank you for your good wishes, Dave. You're absolutely right, first of all. As you think about progression on R&D expense, both the continued growth and supporting the rollout of our pipeline, and making sure we're supporting that as well as a real focus on external opportunities, that's contributing to the different expense level in R&D in the second half versus the first half. But I would also point you to marketing administrative. Even though as I noted, we are reaffirming that for the year marketing administrative will be growing between 0% and 2% on normalized basis excluding the one-time charges. I do call your attention to the fact that not only are we continuing to roll out launches for products, but typically the second half is a heavier half in terms of spending, so in terms of change versus prior year for the year, we expect to be 0% to 2%. In terms of absolute level, I call your attention to what the spending patterns tend to be in the third and in particularly the fourth quarter. You need to factor that into the analysis."
},
{
"speaker": "Richard Clark",
"text": "What's exciting about what we're talking about from a launch standpoint, when you look at the numbers that Judy and I presented this morning, if you look at JANUVIA, it is approved in 51 countries, but only launched in 25 so far. And with GARDASIL approved in 80, launched in 59 and under-review in another 40, and with ROTATEQ, 61 countries approved and only launched in 22 and JANUMET moving forward will have the same numbers and Isentress is in addition, so we are definitely even though we launched these important products and vaccines, and in several countries, we're still in the launch phase, and we have to make sure we support that launch phase the right way."
},
{
"speaker": "Graeme Bell",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jamie Rubin with Morgan Stanley."
},
{
"speaker": "Jamie Rubin",
"text": "Thank you. And ditto to you Judy. My best wishes. So, I have two specific questions. One, I am wondering if you can provide an update on VIOXX litigation, specifically, are there any forthcoming cases that we should be aware of, that on the case front it has been pretty quiet. And, just wondering what's coming down, what's in the calendar going forward. Secondly, what is the status of the New Jersey Consumer Protection Act and are there other consumer protection acts forming outside of New Jersey. And lastly, we'll continue to argue the 18 month window, or has that now been discredited because of the Victor trial. And then a question on gross margins, Judy, the guidance for the year now has been adjusted to 75% to 76%; but on an adjusted basis this quarter it was 76.5% and that's with a heavy drag from ZOCOR, which goes away in the second half. So, is this typical Merck conservatism, or is there something that we should be aware of that acts as a natural drag on gross margins. Could it be that as GARDASIL sales add another, whatever in the second half that the actually gross margin contribution becomes a detriment, but because of the royalty payments and lower yields. But if you can address that, I would appreciate it. Thanks."
},
{
"speaker": "Graeme Bell",
"text": "Jamie, let me start if you wouldn't mind on the VIOXX related questions. As always, we commit to posting the trial schedule on Merck.com, and as of July the 20th, you will see that there are seven trials scheduled for the balance of 2007, starting on September 17th in California. And we are currently posting that there are four starting on January the 7th, 2008, up through April of 2008. With regard to the seven, as posted to Merck.com, you will see that, for instance, some are consolidated. And I would direct you back to that for the details, but I would point out, for instance, in New Jersey and Atlantic County on October 15th, the current schedule calls for New Jersey coordinator trials where there will be four trials, and up to two or three plaintiffs in each respective trial. And also in California in November the 26th, a trial is scheduled to start with up to five plaintiffs. So, I would just point you to that, and it gives you a sense of the activity and schedule going forward. With regard to Victor and the science behind that, I think we’ve indicated many times that, that is but one study. And you know the history in terms of it being stopped prematurely, and that data such in and of itself has been available to all plaintiff, and this has been argued and presented many times in the 15, 16 trials that have actually gone through to juries. And we feel that, that one data point in and of itself can draw no conclusion whatsoever, so we remain steadfast based on the scientific evidence relating to the long-term trial. With regard to consumer fraud here in New Jersey, that really was just in a holding pattern so to speak, and that the judges have yet to render their specific opinion. And we just don't have a sense of when that decision will come down, and right now that is the only consumer case that is currently work in progress awaiting a decision. And once we communicate that decision, then clearly we'll take appropriate steps. But just as a reminder, if it does cause a decision pertaining to whether a class action will be created as opposed to anything else. So, that's the update on VIOXX right now, and I’ll pass it over to Judy or Richard for the PDM question."
},
{
"speaker": "Judy Lewent",
"text": "Yeah so -- and thank you, Jamie. So, first of all, as I believe you noted, we did tighten the product gross margin guidance range, so we were at 74 to 76, and given the performance of the first six months, we are comfortable with 65 to 76. But, you do have to bear in mind, although the first half looks promising, that product mix is a very key factor here. And, so that's what we have taken into account as we think about the full year."
},
{
"speaker": "Graeme Bell",
"text": "Thank you. Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bert Hazlett with BMO Capital Markets."
},
{
"speaker": "Bert Hazlett",
"text": "Yes, thanks. I’ll just take a follow-on to Jamie's question. As we see the vaccine business continuing to grow, not only with GARDASIL, but with the other vaccines, ROTATEQ in particular. How should we think about the pushes and pulls on the margins? Again, gross margins and SG&A, and then secondly, you made a comment on 524A in terms of filing in the second half. Could you remind us as to 524 B, and are you still supporting the timelines with that particular combination? Thanks."
},
{
"speaker": "Judy Lewent",
"text": "So, relative to the pushing and pull on vaccines, as we don't get into details across the product line, we have noted from time to time that vaccines tend to have a slightly lower product gross margin than some of our other in-line products. And of course as you know GARDASIL in particular carries a royalty burden that we discussed in the 24% to 26% range. That said, what we continue to see in our performance year-to-date, and what we expect in the future, are improvements across the board including vaccines in terms of productivity improvements, that will continue to improve the possibility for a product gross margins. And as we guided to product gross margins through 2010, we did note that we expect to return to pre-ZOCOR patent ex levels, and we continue to reaffirm that, and that is in full recognition of the product mix that we see going forward. So it’s really, continued improvement on manufacturing productivity improvements, and a recognition of the product mix we have, but still delivering that uptick in product gross margin by 2010."
},
{
"speaker": "Richard Clark",
"text": "And your question with 524B, as we stated along our clinical trials.gov, protocol number 63 is an MK524-B lipid study. And we're currently rolling patients for that study, and really there is no change from a timing standpoint, and we're committed to the 2008 filing for 524B, so we feel that's on track for '08."
},
{
"speaker": "Graeme Bell",
"text": "And with regard to 524A, we remain committed as indicated in the prepared remarks, that an MDA will be filed with the FDA in the second half of 2007. Cynthia, could we have the next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from James Kelly with Goldman Sachs."
},
{
"speaker": "James Kelly",
"text": "Good morning, and let me also echo my best wish to Judy. I have a question about GARDASIL and how we should be thinking about GARDASIL in the various patient cohorts. And how adoption is going there, and any sense of how it might have changed from the first quarter into the second quarter, and anything that's coming back from the sales force about people using above the age of 26. Thank you."
},
{
"speaker": "Richard Clark",
"text": "We certainly don't have information that we can provide you on the specifics, the detailed specifics that you're asking at this time. The important thing that we're focusing our attention on from a compliant standpoint and precision standpoint is to make sure that when young women receive their first shot of GARDASIL. The first vaccination they're able to come back and get the second and third which is critical. So, we're working to making sure that physician offices with healthcare practices, there are reminder mechanisms and capabilities put in place, that a second and third vaccine is put in place. But we can't give you specifics on the questions that you asked."
},
{
"speaker": "Graeme Bell",
"text": "Thank you. Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Tony Butler with Lehman Brothers."
},
{
"speaker": "Tony Butler",
"text": "Yes, thanks very much. My question also is gross margin related, but it’s related to the restructuring costs, Judy. The increase in this quarter for future activities of $500 million to $700 million I believe is a change from the previous quarter of $300 million to $500 million. And the question I have is the change principally related to those site closings, which could have some positive impact to gross margin. And/or to product eliminations or position eliminations as it relates to SG&A, which I guess could help operating margins, and the reason I’m asking this is to offset may be the dynamic growth in vaccines, which could possibly put that as Jamie alluded to the drag on, on the overall gross margins. And this is principally related to the back half of the year, but more importantly to 2008. Thanks."
},
{
"speaker": "Judy Lewent",
"text": "Yeah, so exactly. This is timing, this is strictly a timing issue, so this doesn't really change even our overall expectations of the network strategy that we rolled out in November of 2005. But it is positive in terms of acceleration of some of our plans for site closures. So, yes, we're moving that along more rapidly than we originally anticipated in 2007. It is predominantly accelerated depreciation. It is not really driven by position eliminations per se, but really driven by the timing of site closures."
},
{
"speaker": "Graeme Bell",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Chris Schott with Banc of America Securities."
},
{
"speaker": "Chris Schott",
"text": "Quick questions. First you've had a very successful JV with one of your major firm here; obviously, ZETIA and VYTORIN. When you’re talking about more in licensing transactions going forward, how would you characterize the opportunity for additional partnerships with some of major pharma company's I guessing out there and not specific questions but compounds that interest you or are you looking at or should we see these deals more along the line of the area deal. And then specifically on pipeline question your CB1 MK364, how comfortable are you with the Phase III program following the recent panel, is there even many or do you intend to or have you altered any of those Phase III programs? Thanks."
},
{
"speaker": "Richard Clark",
"text": "Concerns your first question, we're interested in any relationship with either our pharma colleagues or licensing capability in Biotech that really add long-term shareholder value. If there's a relationship based on the synergies between those two companies, then whatever they are would be important to consider them as we move forward. And we have always stated, target acquisition is sincerely a key part of our strategy as well, and we're looking at those from a Biotech company as well, not only for the relationship and the research but the relationship that we would have that would help the top line, so we're very flexible and open to those kind of relationships, and I think to Judy's credit, and she has built these relationships over the years, that we've been very successful with our joint venture partnership in the past, and I think Merck is looked upon as a company to be able to have comments and objectives and to be successful for both parent company shareholders. In relation ship to your second question, it is really hard for us to speculate on the class effect, the CB1s, and obviously we're scoring the clinical profile of our product as an ongoing part of our Phase III clinical programs."
},
{
"speaker": "Graeme Bell",
"text": "Next question, please, Cynthia."
},
{
"speaker": "Operator",
"text": "Your next question is from Steve Scala with Cowen."
},
{
"speaker": "Steve Scala",
"text": "Thank you. I have two questions. First, does Merck have an understanding of the level of GARDASIL stock in physicians offices and if so has that changed quarter-over-quarter, and in the past I believe Merck has implied that there was not much stock in physicians offices. But that could be one explanation for a flattish quarter-over-quarter trend, and secondly, if the bio equivalent study is successful, then what would that suggest for the timing of MK-0524B in 2008, as a late 2008 filing more likely than mid or vice versa?"
},
{
"speaker": "Richard Clark",
"text": "On MK-524B, we can't speculate, Steve on, what part of 2008. Our comment now is just based on 2008, and in your first question, I think we're gaining more information, but I don't think you will see a tremendous amount of stocking in the physicians offices for GARDASIL particularly with the cost of GARDASIL and the reimbursement process that we're trying to help as well. But don't forget there is a difference between public and private, and so in the physicians office it could be more private, and very small. In public it could be building inventory as I said at the end of the first quarter for 50 to 55, and now it is being penetrated out, and we'll see what happens in the third and fourth quarter as that inventory is reduced."
},
{
"speaker": "Steve Scala",
"text": "Thank you, Richard."
},
{
"speaker": "Richard Clark",
"text": "So given the time we might have about time for one or two more questions. Cynthia."
},
{
"speaker": "Operator",
"text": "Your final question comes from Seamus Fernandez with Leerink Swann."
},
{
"speaker": "Seamus Ferndandez",
"text": "Hi, thanks very much. I have a few questions. I was just wondering if you can update us on the timing of AZLP and if given your close involvement in the original deal and restructuring if Judy will be available as a consultant to Merck on these issues. Separately, Richard, if you could give us, it given the strong performance year-to-date, could you just give us an update on what you're keenly focused on to continue delivering P&L leverage in 2008 particularly given the upcoming U.S. patent expiration of FOSAMAX, I mean, obviously it will be balanced over the P&L, but if you could give us your biggest focus for execution where you see the best opportunity post 2007? And then as a last question, it took Merck six months to get full reimbursement approval under the vaccines for children program, which clearly was very rapid, but is there any reason why the timeframe would be shorter or longer for a new competitor and what is Merck planning for relative to new entrants for next year? Thanks very much."
},
{
"speaker": "Graeme Bell",
"text": "Why don't we start with AstraZeneca."
},
{
"speaker": "Judy Lewent",
"text": "So I told you what you're referring to is a potential upcoming series of events in 2008 relative to the Merck option, and as many of you know, there will be events that are even independent of the exercise or options that were triggered back in the 1998, 99 period when Astra merged with Zeneca. Namely we will see the equity income priority return reduced from about $300 million to about $210 million, and we have recognition of some of the advance payments and other parts of the transaction that were put in place in '98 in the first quarter of 2008. We also will be repaying the $1.4 billion loan in the first half of 2008, and so really what is left to reflect on is whether we are going to exercise the option for non-CPI products, and that will be evaluated in the coming months and really probably formally decided in the first quarter of 2008, and if Richard wants, he is more than welcome to give me a call as I get closer to that practice."
},
{
"speaker": "Richard Clark",
"text": "There is no question that Judy will always be a close adviser to the current Chairman and CEO, and so there is no hesitation that there will be a loss in the leadership that she’s provided in that relationship. Regarding your question, we cannot speculate on the Zerbrex timeline and what that means or does not mean in the United States. And certainly my focus, Winston Churchill once said however beautiful the strategy you should occasionally look at the results, and I think we have looked at the results. I think we have shown you that our results are good, and that our strategy is validated by the results, and so my focus on 2007, 2008, 2009 and 2010 hopefully is to keep executing the strategy to make sure that we have strong and talented business leaders in place and than our franchise strategies are being executed by listening to our customers, that we continue to invest wisely in basic research and in our clinical development, organizations continue accelerate our pipeline, and that we're able to become a lean and flexible organization by taking the right costs out at the right time."
},
{
"speaker": "Graeme Bell",
"text": "So with that last question, it concludes today’s conference call. The information and all of the Q&A on today's call and the transcript and the replays will be available on our website for the next several months, and as always, Mike Nally and I will be available all day to take your calls and any of your incremental questions. Richard?"
},
{
"speaker": "Richard Clark",
"text": "Thank you, Graeme, and thanks to all of you who participated and listened in to our call today, including our operator who kept things running smoothly. We look forward to speaking to you in October about our third quarter results. Thank you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's Merck second quarter 2007 earnings conference call. You may now disconnect."
}
] | null | null |
MRK | 1 | 2,007 | 2007-04-19 09:00:00 | Operator: Good day, everyone. And welcome to Merck’s First Quarter 2007 Earnings Conference Call. Today's call is being recorded. At this time, I would like to turn the call over to Mr. Graeme Bell, Executive Director of Investor Relations. Please go ahead, sir.
Graeme Bell: Thank you, Taylor and good morning. Welcome to our call this morning to review our business results for the first quarter of 2007. We know it's been a busy morning for you already and you may have participated in two calls. Joining me on this call today is our CEO and President, Dick Clark and Miss Judy Lewent, our Executive Vice-President and Chief Financial Officer. Before we get into the details, I would like to through the logistics. On this call, we will review the results contained in the release we issued at 7:30 this morning. You can access this by the Investor section of Merck.com and I would remind you that this conference call is being webcast live and recorded for replay later via phone, webcast and our podcast. As we begin our review of the results, let me remind you that some the statements made during this call may disclose certain subjects that may contain forward-looking statements as that term is defined in the Private Securities Litigation Act of 1995. These statements are based on management's current expectation and involve risks and uncertainty and may cause results to differ materially from those set forth in the statement. The forward-looking statements may include statements regarding product development, product potential or financial performance and no forward-looking statements can be guaranteed and actual results may differ materially from those projected. Merck undertakes no obligation to publicly update any forward-looking statement whether as a result of new information, future events or otherwise. Forward-looking statements on this call should be evaluated together with the many uncertainties that affect Merck's business, particularly those mentioned in the risk factors and cautionary statements set forth in Item 1A of Merck's Form 10-K for the year ending December 31, 2006 and in its periodic report of Form 10-Q and Form 8-K, which the company incorporates by reference and then are posted on our website. We will begin with some brief remarks from senior management and then open the call for questions and expect the call to take approximately hour and conclude around about 10 am. So with that, I’ll turn the call over and we will begin with our remarks from our CEO and President, Mr. Clark.
Dick Clark: Thank you, Graeme and good morning everyone. As we announced last week, our first quarter earnings for 2007 were $0.84 per share, excluding restructuring charges related to site closures and position eliminations. Our reported EPS for the first quarter were $0.78, certain one-time gains from asset sales and product divestitures accounted for increased revenue in that quarter. We exceeded our own expectations for the first quarter, as a result of strong market performance, across all product lines and as a result raised our full year EPS range to $2.75 to $2.85. Excluding restructuring charges and our full year reported EPS range to $2.60 to $2.75. We anticipate second quarter EPS of $0.67 to $0.71, excluding restructuring charges and reported EPS of $0.62 to $0.68 for the same quarter. Judy will speak to this in more details in a few minutes. Our newly launched products, combined with our inline product portfolio, led us to realize strong gains across all markets. Worldwide sales reached $5.8 billion for the first quarter, an increase of 7% from the same period last year. Let me summarize some of the product performance highlights. SINGULAIR continues to be the number one prescribed product in the U.S. respiratory market, with year-over-year sales growth of 25%, reaching $1 billion this quarter. Both ZETIA and VYTORIN, which we market in partnership with Schering-Plough, also performed very well this past quarter. They posted a combined $1.2 billion in sales, a 47% increase from the first quarter of 2006. GARDASIL, the first and only cervical cancer vaccine approved, is being quickly accepted by patients, physicians and traders. First quarter sales were $365 million and included initial purchase, by many states, the vaccine for children program. JANUVIA, our first in class treatment for type 2 diabetes, also experienced impressive sales of $87 million in the first quarter. And now that it has been joined by the approval earlier this month of Janumet, we expect that Merck's ability to meet the needs of growing population of people with type 2 diabetes will continue to grow as well. With each of these products, we are continuing to look for new opportunities, strengthen their value to patients and to Merck. The recent FDA approval of SINGULAIR, by patients aged 15 years and older, who suffer from exercise-induced bronchoconstriction, is expected to further increase the strength of this product in the marketplace. It is estimated that exercise can trigger an episode of EIB in 80% to 90% of people with asthma. We announced an agreement last month with Schering-Plough to begin development of a new medicine that we combine ZETIA with the atorvastatin once marketed exclusivity for atorvastatin expires. We are very pleased to have submitted the supplement biological license applications to the FDA and GARDASIL's cross protection data. It shows that GARDASIL provides some protection against additional HPV types, it cause more 10% of cervical cancer worldwide. And the FDA accepted two supplemental new drug applications, to expand the U.S. label for JANUVIA. These actions reflect our commitment to maximizing the value of all of our inline products; from the day they are launched until the day their patent expires. While we are taking advantage of opportunities like these to drive our future growth, we remain focused on controlling expenses. Our performance in the first quarter is we believe, further evidence the path we have chartered to return Merck to a leadership position in our industry, is the right one. We still have a long road to travel to realize our long-term goals, but we are executing on our plan with confidence. And while we were disappointed by the recommendation last week of the FDA advisory committee regarding ARCOXIA and by the decision we reached with Lundbeck to discontinue our joint development program for gaboxadol. Our overall pipeline continues to advance and grow. By building on the strong foundation we established in 2006, we remain confident that we will continue to progress toward the goal, we set to delivering double-digit compound annual EPS growth, excluding one time items and restructuring charges, by 2010 from the 2005 dates. Before I turn the call over to Judy Lewent, for what will be her last sales and earnings call at Merck, I want to take just a minute to express to her and to all of you, my deep appreciation for the enormous contribution she has made during her course of her career here at Merck. For 27 years Judy has been an indispensable quite a Merck's leadership team. Her vision, expertise and her integrity have made her one of the most respected incredible people in the field of American business. I will miss her as a colleague and Merck will miss her as a leader. And certainly when I took over as CEO of the company in May of 2005, it was Judy's support and partnership that really helped us put a strategic planning process together for the company and her leadership really developed the strategic planning initiatives and activity that you see that we are executing against. So as a company and a shareholder, there is a tremendous amount that we owe to Judy. So, Judy for one more time I'm pleased to turn the call over to you. Thank you.
Judy Lewent: Thank you, Dick. And maybe on this very special occasion and thank you for the kind words, everyone listening on the phone will just pass all the difficult questions over to Dick and I will enjoy my last call. So thank you and good morning, everyone. As Dick said, we are extremely pleased with our reported results for the first quarter of 2007. And we are working toward insuring sustaining growth in 2007. The first quarter reported EPS growth was driven by top-line revenue that reflects strong performance of our inline franchises, as well as the rapid early uptake of our first in class DPP-4 inhibitor JANUVIA and a continued strong growth of GARDASIL. Another notable contributor was the outstanding performance of our partnerships and alliances, resulting in improved equity income, along with the benefits from gains from certain product and asset divestitures. Dick mentioned several of the highlights of the quarter results, a moment ago. So to build up that in the first quarter we saw revenue of $5.8 billion. That represents a 7% increase over the same period last year, including in the aggregate, an overall 0.5% decrease from price, offset by 6% growth in volume and 1.5% positive impact of foreign exchange. Collectively, worldwide revenue was above our initial expectations and we saw encouraging sales performance from our newer and in line franchises. Within the quarter, we saw the anticipated decline of ZOCOR and PROSCAR in the U.S. as well as a decline in FOSAMAX in several international markets where there is access to other alginate sodium product. However, these declines were more than offset by the positive performance of SINGULAIR that showed strong global growth as it continues to experience robust demand driven by continued strength in the asthma and allergic rhinitis market as well as our other inline product and the early success of our newly launched products JANUVIA and GARDASIL. A major contributing factor to our top line growth came from our vaccine business. Collectively vaccine revenue is recorded by Merck with $903 million for the first quarter representing a 233% increase when compared with the same period in 2006. Driven by the continued uptake of GARDASIL, ROTATEQ and ZOSTAVAX in the first quarter, our three new vaccines collectively accounted for close to $0.5 billion of revenue and to assist in your modeling, we provided a breakdown of the product revenues with our other financial disclosures. As Rick mentioned, we are extremely pleased that global sales as recorded by Merck for GARDASIL continued to grow and reach $365 million of which $312 million was recorded in the United States. This quarterly figure includes initial purchases by many states through the CDC's Vaccines For Children program. Total sales of Merck's other promoted medicines were collectively $1.4 billion for the first quarter, representing a 13% increase as compared with the same period in 2006. As you know, in the fourth quarter we launched JANUVIA, which is currently approved in 42 countries and now available in every region around the world as the only DPP-4 Inhibitor available for use in the treatment of type 2 diabetes when diet and exercise are not enough. In its first full quarter, global revenue of JANUVIA reached $87 million of which $83 million was in the U.S. Also contributing to our top line revenues from our alliances, primarily AstraZeneca LP, in the first quarter, revenue recorded by Merck from the company relationship with ADLP was $534 million. As always, keep in mind that there is inherent variability relating to this revenue given that Merck is not actively managing these products. Our revenue recognition takes into account inventory levels at ADLP for PPI and non-PPI products as well as their product shipments. Taking the first quarter revenue announced today and adding 50% of the revenues from the Merck Schering-Plough, Merial, Sanofi Pasteur MSD and Johnson & Johnson Merck joint ventures and partnership revenue was $6.8 billion. If you do the same adjustment in the base period, the revenue growth rate was 10%. Regarding 2007, given the first quarter performance, we are revising upwards, full year revenue guidance for three of our product guidance elements by $900 million to support the higher full year EPS guidance that we initially provided on April 12. Regarding SINGULAIR, we are increasing the full year range by $200 million to $3.9 to $4.2 billion. Regarding vaccines, we are increasing the full year range by $500 million to $3.3 to $3.7 billion. And regarding other reported products we are increasing the full year range by $200 million to $5.4 to $5.8 billion. And we were reaffirming guidance for COZAAR HYZAAR, FOSAMAX, ZOCOR and AstraZeneca. Again, as always the AZLP guidance is an update based on recent results as well as future expectations and reflects the dynamics to the PPI markets, multiple generic, OTC products and the uncertainty these create with regard to future volume and pricing. Also keep in mind that our reaffirmed guidance incorporates the expectations of the non-PPI products as ATACAND, PLENDIL, LEXXEL and ENTOCORT. Moving down to P&L, materials and production came in at $1.5 billion for the quarter. The quarter includes $118 million for costs associated with the global restructuring program primarily related to accelerated depreciation and asset impairment costs. Excluding these costs, materials and production increased 24% for the quarter. The gross margin in this quarter was 73.6% reflecting a 2-percentage point unfavorable impact relating to the restructuring cost. Excluding restructuring charges, the first quarter PGM of 75.6% was within our disclosed guidance range and just as in previous periods these results were affected by the final product mix. Given this result, we are comfortable with our full year 2007 guidance range and we are reaffirming that our product gross margin is estimated to be approximately 74% to 76%. This guidance excludes the portion of the restructuring cost that will be included in product cost and will affect reported PGM in 2007. On marketing and administrative, first quarter expense came in at $1.8 billion, which is an increase of 5% over the same period last year. Once again, the primary driver of the marketing and administrative increase was promotional spend for GARDASIL and continuing efforts to more aggressively support the JANUVIA, JANUMET launch. Again, these were choices made in response to the evolving competitive dynamics to fully support our first-in-class products. These incremental investments are reflected in the strong revenue performance reported this quarter as well as in the higher full year product guidance provided this morning. Reflecting our commitment to realizing efficiencies throughout the company and optimizing our cost structure, the component of M&A consisting of selling administrative and general administrative costs, which support our core operations, was down year-over-year. Even as we launch additional new products as they anticipated this year and continue building on the momentum of our successful 2006 launches, we expect that our cost containment efforts and initiatives will allow us to meet our guidance on M&A spending in 2007 and our commitment to maintain flat M&A expenses in 2010 relative to the 2006 base excluding charge taken to increase the legal defense reserves. Regarding guidance, we’re continuing to provide it on the change in marketing and administrative expense relative to the base period excluding one-time items to help your modeling and we are reaffirming our full year 2007 guidance. That is we anticipate marketing and administrative expense to increase between 0 and 2 percentage points over the full year 2006 level. The 2006 marketing and administrative expense level referred to, excludes the charges taken during 2006 related solely to future legal defense costs of VIOXX and FOSAMAX litigation. During the first quarter, the company did not increase the reserve relating solely for future legal defense costs of VIOXX litigation and the company has not established any reserves for any potential liability relating to the VIOXX lawsuits and the VIOXX investigations. We continue to believe that every case contains unique set of facts and the appropriate strategy is to defend these matters on a case-by-case basis. Regarding research and development, expenses were $1 billion for the quarter, an increase from the comparable period in 2006 of 9%. R&D growth in the first quarter was driven by an increase in both basic and clinical R&D spend. Basic research spend increased as a result of the integration and underlying operating expenses of the Sirna, GlycoFi and Abmaxis acquisitions. In addition, clinical research expenses were higher in support of Phase III trial for MK-0524A and MK-0364, Incretin and other late stage products. During the first quarter of ’06, Merck entered into several agreements reflecting our strategy and let me correct that during the first quarter of ’07, Merck entered into several agreements reflecting our strategy of establishing strong external alliances to drive both near and long term growth. And currently, Merck is in discussions with more than 35 companies regarding potential transactions and is also actively monitoring the landscape for a range of targeted acquisitions that meet the company's strategic needs. We are reaffirming our 2007 guidance for research and development expense and anticipate it to increase at a low to mid single digit percentage growth rate over the full year 2006 level. The 2006 level we are referring to includes the $296 million acquired research charge relating to GlycoFi that occurred in the second quarter, but excludes the impact of the acquired research charge relating to the Sirna acquisition. The full year 2006 level also excludes the portion of the restructuring costs that are reported in research and development expense. Moving on to restructuring, total costs associated with the company's global restructuring program were 186 million for the first quarter. As I just mentioned, $118 million of those were for asset related charges and are included in the materials and production. So, in our first quarter results, the restructuring cost line reflects $65.8 million of costs related to the global restructuring program for employees separation and other related costs associated with approximately 230 positions eliminated, bringing the total to 5100 today, and then remaining, keeping us on track, to eliminate 7000 positions by the end of 2008. However, the company does continue to hire new employees, as a company's business requires it. Accordingly, we are reaffirming the guidance associated with our global restructuring program for 2007. Additional costs related to site closings, position eliminations and related costs will be incurred in 2007 as part of the company's restructuring of its operations. The aggregate 2007 pre-tax expense related to these activities is estimated to be $300 million to $500 million. In reviewing equity income from affiliates, roughly $653 million of income in this quarter, related to the contributions from all of our joint ventures. This result reflects the continued success of the Merck Schering-Plough cholesterol franchise in the U.S. and Europe, and the performance of the Merial animal health business. As always, I would remind you that there are several components to AZLP equity income, which make it inappropriate to draw significant conclusion just based on PPI products. There are complexities that involved at a minimum timing and tax differences. That said, the first quarter equity income contribution from Merck share of the partnership with AstraZeneca LP with $212 million. Regarding the Merck Schering-Plough partnership. The first quarter combined MSP cholesterol franchise global revenue, as reported by the Merck Schering-Plough partnership, continued to grow to $1.2 billion. In the quarter, revenue of VYTORIN and ZETIA were $624 and $544 million respectively. Within Merck's quarterly income results, the Merck Schering-Plough partnership contributed $347 million. And that reflects an 85% increase over the prior year. The balance of equity income comes from other joint ventures, namely Merial, Sanofi Pasteur MSD and Johnson&Johnson Merck. Again, Merck's 50% of the revenues from the Merck Schering-Plough, Merial, Sanofi Pasteur MSD and Johnson&Johnson and Merck joint ventures and partnership, totaled $1.1 billion in the first quarter, up from $800 million in 2006. Given this result, we were reaffirming our guidance for full year 2007, and continue to expect equity income from affiliates to be approximately $2.6 to $2.9 billion. Turning to other income in the quarter, you see we recorded $256 million of income as disclosed in our other financial disclosures. And then in another gain, you will see of $188 million. This primarily reflects the favorable impact of gains on sales of assets and products divestitures. During the quarter, it wasn't disclosed that the company divested the U.S. prescription pharmaceutical rights to tested oral suspension entire oral suspension to Cerus Pharmaceuticals Limited and divested the worldwide rights to Ambrilia tablets and INDOCIN capsule, the pain relief capsules, suppositories and oral suspension to a local pharmaceutical LLP. Now for the quarter, income before taxes was $2.3 billion. Taxes on income in the period were $550 million, and the reported tax rate was 24.4%. This reflects in general the changes in foreign and domestic mix and currency fluctuations, and as you know these elements changed throughout the quarter. Effective January 1st, 2007, the company adopted FIN 48 accounting from certainty and income factors. This adoption resulted in increasing retained earnings of approximately $80 million. Of course, this does not affect net income. We are reaffirming our full year 2007 tax rate guidance range, and I would direct you to today's press release for the details. Moving to net income and earnings per share. Net income for the first quarter of 2007 was $1.7 billion, compared to $1.5 billion in the first quarter of 2006. And that represents growth of 12%. During the quarter, we spent $240 million in treasury stock, and we now have $6.3 billion under the current authorization from the board with no time limit. And in summary, earnings per share for the first quarter were $0.84, when one excludes a $0.06 charge for site closures and positions eliminations primarily associated with the global restructuring. Our reported first quarter EPS was $0.78. Now let me turn briefly to our guidance. I have mentioned it several times as part of the results review. But, as you will see in today's release, with the exception of our upward revision to SINGULAIR vaccines and other reported products, we are reaffirming all the elements of our 2007 guidance. And all the details of the guidance are provided for you in the earnings release. Given these guidance elements, Merck anticipates second quarter EPS of $0.67 to $0.71 excluding restructuring charges. And anticipates reported second quarter EPS of $0.62 to $0.68. In the second quarter, the company anticipates that revenue will be comparable to the amount reported in the first quarter of 2007. In addition, it's worthy of note that research and development expense excluding restructuring charges, is anticipated to be higher than the amount reported in the comparable period of 2006. The company reaffirms full year 2007 EPS of $2.75 to $2.85 excluding the restructuring charges related to site closures and position eliminations, and anticipates reported full year 2007 EPS of $2.60 to $2.75. While we were pleased with our performance in the first quarter, it is important to note that we are still only three months into the year, and we need to continue to execute on our business plan. Based on our current full year guidance, we anticipate that earnings per share excluding restructuring will grow in the range of 10 to 16% in the last three quarters of the year, versus the last three quarters of 2006, excluding Sirna and restructuring. There are many factors that impact the variability within the given year that needs to be considered when modeling. For example, in the first half of 2007, we are still facing the annualization of the loss of marketing exclusivity for simvastatin and finasteride. In addition, while we were very pleased with the initial successes of the recent launches, you all know there is inherent variability of a continued uptake of new product launches. As part of the full year guidance, we anticipate the promotional spend will moderate. That is decline particularly when we think about the pattern last year and the fourth quarter 2006 levels, and decline across divisions as products move out of early launch phase and commercialization efficiencies are realized. We also expect efficiencies to be delivered from new initiatives and provide savings within our general administration costs structure. As stated, this guidance does not reflect the establishment of any reserves for any potential liability related to the VIOXX litigation. And in addition as Dick noted, the company remains on track in terms of both strategy and performance, to deliver long-term double-digit compound annual earnings per share growth from 2005 to 2010, excluding one-time items and restructuring charges. I also want to continue to emphasize, that we have the financial strength to support our dividends, and we remain fully committed to maintaining it at the current level, while at the same time continuing to fund our investment priorities. With that, I will turn the call back over to Graeme.
Graeme Bell: Thank you, Judy. We will now open the call to take your questions. As usual, we will take the questions in the order, in which they were received, and try to get through as many as possible. And at this point, I will turn the call back to Tiler, who will communicate instructions about Q&A format and then introduce the first question.
Operator: (Operator Instructions) Your first question comes from Chris Shibutani of J.P. Morgan.
Chris Shibutani: Thanks very much. Could you provide us with an update on GARDASIL, obviously good uptake from the state, what percentage of the state do you expect we’ve already seen that and the timeline for additional state? And also what do you are seeing in terms of the actual compliance for the second and third dose at any given patient or process? And then finally, could you provide us with an update on your cardiovascular pipeline at 524B anything to know incrementally there and also sometime better -- commented on their commitment?
Dick Clark: Thank you, Chris. Just to, there was an audio problem, just so I understand your questions. You had two with regard to GARDASIL, one with regard to compliance in terms of second and third dose and another one with regard to the build of the revenue in terms of how much has been consumed. And then there was a question with regard to the pipeline in the cardiovascular profile. So let me start with the last question first in terms of the cardiovascular pipeline. As we’ve indicated, and we remained committed to our 524 program in the form of 524A and 524B and we remained on track with both of those products. And as we previously disclosed it indicated there was an expectation that we file 524A in the calendar year 2007. And we will file 524B in the calendar year 2008. With regard to GARDASIL.
Judy Lewent: Peter, I think it's too early yet to talk about the uptake for the second and third dose for GARDASIL. However, we have worked with the payers and physicians to put reminders programs in place and be able trigger from a compliance standpoint that we have more success and will be able to monitor that. Just another comment around the CDC contract. To date, 53 out of 55 projects have adopted GARDASIL. Each of the 50 states and project in five cities until we are happy with that. And from an uptake on the state standpoint, it’s going take the time it takes to get through the committee, the vaccine committee in each state and then the uptake and discussion with the state within the legislature. So, it's hard for the timeframe on all of that.
Graeme Bell: Next question, please.
Operator: Your next question comes from Tony Butler of Lehman Brothers.
Tony Butler: Thank you, very much. First, Judy, thank you very much and certainly all the best. Second, if we can expand upon the GARDASIL commentary, when we think about the fraction of states you mentioned that, Dick. Does this just simply imply that we’ve got a fair inventory build on GARDASIL currently that we have to work through based upon the state legislation, legislators throughout the remaining part of the year? That's really the first question. The second question is, Graeme, if I'm not mistaken was 524A to be filed in Q2 of this year, was that the previous guidance. And moreover, could you comment about the integration inhibitor 0518 again, the timing on that project. Thanks a lot.
Dick Clark: Thank you Tony. I’ll take the last part of the question first. So, we have always said and remain committed to the 524A being filed in the calendar year 2007. We have not been specific on the exact timing. And with regards to the ISENTRESS question, on that particular NDA, we have indicated that we will file the NDA with the FDA in the second quarter of 2007.
Judy Lewent: I think regarding GARDASIL, we obviously know that the initial purchases by many states has and is affected. Now the pipeline is full and we have to get it to the children. But there is also vaccine and there are also for second and potentially third dose. So, we feel comfortable with where the future pipeline is. But there are obviously some initial stockings. I think the other good news is that, the managed care plans representing about 97% of privately insured life U.S. more than 140 insurance plans have implemented coverage for GARDASIL. And that even better news I think approximately 75% of the plan members have first dollar coverage for GARDASIL which essentially means no co-pay. And I think when you put those combinations together with the fact that there’s a 118 million girls and women in the U.S. and EU and at highly developed markets, so the appropriate age we feel very comfortable with the future forecast.
Graeme Bell: Thank you. Next question, please.
Operator: Your next question comes from Timothy Anderson of Prudential Equity Group.
Timothy Anderson: Thank you. I have a couple of questions. Can you talk about the company's inclination to do corporate acquisitions that are bigger in size than what you have been doing over the past few years? And second question is, kind of a another general question, which is that revenues for Merck and I think almost all of the drug companies have thus far have come in well above forecast in the first quarter. And I'm wondering if there is seasonality to this purchasing now that Part D is in full effect. My question is whether these very strong trends you think, will they continue unabated throughout the rest of 2007, or is there some new structural dynamic that could reverse these trends later on? And the reason I ask you is because of your big beep this quarter, but not really raising full year earnings as much as would otherwise be suggested?
Richard Clark: I think I am answering your first question, the issue around corporate acquisitions. We have said in the past that we are interested not only in science and technology acquisitions, which obviously we did in 2006, but acquisitions that would help build the top line from a revenue standpoint and at the same time hopefully aligned with our therapeutic areas that our research organizations focused on. Having said that, when we look at those potential acquisitions, we also have a responsibility from a shareholders standpoint to make sure that there is long-term value there. And that as we go through that process and as other companies are going through their process, that it's appropriate that value is there for the long-term. And so we were focused on that, but we are not going to do an acquisition just to do an acquisition. It really has to strengthen where we are today in the future and quite frankly where we are with our pipeline and where we are with some of our results, have to be taken into the equation because the internal growth, the organic growth of the company right now is pretty positive.
Judy Lewent: I think just relative to some of the questions on the top line. Just a couple of thoughts, first of all, for Merck, I will speak to Merck. What you are seeing here is really just successful uptake of our new product launch, that's fundamental. That's not a structural change per se in the marketplace. That's the result of the performance that we just discussed with you about the vaccine and the stellar performance of the vaccines, the new vaccines as well as JANUVIA. And then the excellent performance of SINGULAIR, which as you know has doesn't really have that kind of seasonality to it, except perhaps as we go into the allergic rhinitis season, which doesn't start until late in the first quarter. And so that's something that unfolds during the year. And in terms of the guidance, we increased our guidance $900 million and that is for the full year. So we are driving that increase in our earnings per share guidance based on taking up the revenue element. But as we noted, we are continuing to fund R&D and stay in line with all of our guidance on our expense elements. We think a combination of that those factors lead you to the range that we guided to today and then starting on April 12th.
Richard Clark: One other point is one thing I'm pleased about is that when you see the results of the first quarter and the growth as Judy said earlier, it really is across all regions of the company. So it's not just in the United States. Every region has performed and why we feel confident in that and many of the new products even though we launched GARDASIL and JANUVIA obviously in the United States and other countries, there is still a substantial amount of countries where it 's even approved then we have to get ready for launch and then in some countries have approval and a launch. So we are still in a very launch growth pattern from a company standpoint with our new products. Globally.
Graeme Bell: Thank you. Next question, please.
Operator: Your next question comes from comes from Jamie Rubin of Morgan Stanley
Jamie Rubin: Thank you, and again, Judy, you had a remarkable career and you’ve got huge shoes to fill. So congratulations. Just a couple questions. First related to the gross margin, the guidance this year is you have kept the guidance at 74% to 76%. Yet this quarter your gross margins excluding restructuring was 75.6% and what would arguably be your toughest comparison with U.S. ZOCOR sales up the strongest first quarter last year and I would also think that GARDASIL margins are probably at its lowest as you continue to launch that product, so 75.6% seems to be a good start for the year, yet you are sticking to your 74% to 76%. So maybe you could speak to that a bit? Secondly, my question relates to FOSAMAX and the newly issued EU patent. Just wondering how we should think about our modeling of international or European FOSAMAX sales 2008 and beyond, as I think most of us assumed patent expiration. And then my third question relates to the integrase inhibitor. If you could talk about the profile, what you are planning to include in your initial filing? If you are planning to include front line results and where you are with your once a day version? And just so if you could also comment on what you see in terms of the competitive dynamics of Gilead. Thanks.
Judy Lewent: So thank you, Jamie. Let me start with the question on gross margin. Basically, you do need to think about the evolution of sales over the year. So where as yet GARDASIL had a major impact in the first quarter, we increased our guidance on the vaccine -- total vaccines per year, $500 million. As you know, GARDASIL carries with it a royalty obligation of 24 to 26%. So, we continue to factor in our annual guidance sort of the dynamics of the product mix. In addition, bear in mind that COZAAR continues to be a strong contributor, and as you know because of our relationship with DuPont has a lower product gross margin than some of our other inline products. I think again we were factoring in our view of how the year evolved, and some of the uncertainty in these dynamics of the product mix that just continue to give us comfort with the 74 to 76% ex restructuring.
Dick Clark: Jaime, regarding FOSAMAX, as you stated, we have done the filing of our lawsuit and the new patents effectively needling 23 countries in Europe. And the patent expires on July 17, 2018 now. And obviously for this reason the filing of the suits against these manufactures is an effort A to recoup our financial losses caused by these infringement activities. And then I have these products removed from the market. It's hard to say the impact of this and what it is going to be in the future. The outcome of Merck's legal actions may not be realized for several years. And so obviously we are studying it hard that it's very difficult to have any answer to that.
Graeme Bell: And Jaime, I will take your question with regard to ISENTRESS. So, as previously stated we remain on track and are committed to ensuring the NDA has filed with the FDA in the second quarter for treatment experience indication for which we have received the fast track designation. We therefore anticipate action on 518 by the end of 2007, and if approved, we plan to launch ISENTRESS in 2007. In addition, there is a phase III program underway in treatments naïve patients. And with regard to the clinical data in the profile on February 27 of this past year, at the CROI meeting, we presented interim Phase III, 16 weeks data for two of the ongoing studies for ISENTRESS in treatment experienced patients whose HIV was resistant to at least one drug in each of the three classes of oral antiretroviral therapies. And the investigational drug ISENTRESS was generally well tolerated in all of the studies and would be happy to share that CROI data with you. With regard to what is happening in the program, on August 17 of last year, we announced the establishment of the worldwide-expanded access program for ISENTRESS, for HIV and AIDS patients with limited or no treatment options. And that program is enrolled, and we are seeing that patients are using the product. Next question, please.
Operator: Your next question comes from David Risinger of Merrill Lynch.
David Risinger: Yes, thanks very much. I have three questions. First, and I apologize if maybe have been asked before because I have been on and off the call. First question is in terms of other net; the number in your press release was 187.7 million in the first quarter of '07 versus 47 million in the first quarter of '06. If you could explain that and tell us what type of anomalies were in there and whether we should expect that figure to decline sequentially in the second quarter of '07? And then second, in terms of revenue, the revenue came in impressively at three -- I'm sorry, at $5.8 billion in the quarter. Looking forward over to the next three quarters, is there any reason why that revenue figure should go down? And then the final question is, in terms of ex-U.S. FOSAMAX; I understand that it's generic in the U.K., but that the generic penetration is very low. However, generics have launched in other countries and if you could just walk through where the patent had been broken in other countries. And if it hadn't been broken yet there have been generic incursions into other countries, if you could just help us explain why Merck wasn't able to stop the generic launches in other countries where the patents hadn't been invalidated? Thank you.
Judy Lewent: So, let me start with the question on other net income. As I noted earlier, that $188 million reflects certain one-time items from asset and product divestitures such as our sale of Pepcid Oral Suspension as well as ultimate some of andesine products. So, as you can appreciate those are one-time events, and therefore they are not going to recur in the second quarter. We, as you know, don't forecast when those other opportunities might occur. We always re-assess our product line, and a lot of these particular transactions are linked to our network strategy in terms of how we are leaning on our supply chain and so on. So, we continue to evaluate our product line in that regard, but I can't really forecast what if anything might happen other than what happened in the first quarter of '07. And therefore you sort of need to take that as a one-time event. Last year, in the first quarter there was really nothing of note. There were the normal pushes and pulls of, you know, again, some other income and other one-time adjustments, but nothing really worth calling out. So, I think that provides some of the perspective there.
Dick Clark: I think in the question also around the guidance for the remainder of the year where we are in the first quarter, you know, and Judy and I spent a lot of time talking about this. Although we are pleased with the first quarter obviously, we also know that we were only three months into the year and we need to execute against the business and do it flawlessly to continue that growth pattern. And as Judy said, the base of our current full year guidance, we anticipate that EPS ex restructuring will grow in the range of 10 to 16% in the last three quarters of this year versus the last nine-months of the base period, which is very important. And with that said, there could be a lot of variabilities around business profiles for the year as we launch our new products, continue to launch our new products. And we still have the issue with first half of '07 with the loss of the Simvastatin, ZOCOR patent. So there is still a lot to do and there is obviously variability in the continued uptake in new product launches and potential competition. And we also want to make sure with the quality our full year guidance and we maintain our credibility. And as we see changes, we will obviously react to them. But I think that 10 to 16% growth range for the last nine months compared to -- for the next nine months compared to last year is significant for us.
Graeme Bell: Dave, with regard to your question on FOSAMAX, I would point you back to our 10-K filing in that we state the following and it hasn't been updated since then. So, it basically indicates that Merck's basic patent covering the use of the alendronate sodium has been challenged in several European countries. And the company has reviewed adverse decisions in Germany, Holland and the United Kingdom. So the decision in the U.K. was upheld on appeal and you know the situation there. We have appealed the decision in Germany and Holland, and yet company expects a significant decline in European sales of FOSAMAX after the loss of exclusivity period. So, the countries where there is current generic penetration predominantly are in Germany and Holland and obviously the United Kingdom. So, I refer you back to that section in the 10-K. Next question, please.
Operator: Your next question comes from Bert Hazlett of BMO Capital Market.
Bert Hazlett: Thanks. I have couple of product questions. First on ROTATEQ, do you expect any impact as a result of the MTES assumption, discussions earlier this year? CANCIDAS saw some pressure in the U.S. Should we expect that to continue? And last on ZOLINZA, again a modest rollout initially, but there seems to be a considerable amount of interest in this product. Can you discuss the timing and rollout of the data? What should we expect and what additional indications are being sought? Thanks.
Judy Lewent: So, let me just start on CANCIDAS. As you may recall, there was a price reduction last year and of over 20% on one of the major dosage strengths there and that really had the impact on the product profile. So that really stole dynamic, which we must take into consideration as you look at how Cancidas is progressing.
Dick Clark: And with regard to your question on ZOLINZA, our novel HDAC which we acquired through the acquisition of Aton, October the 6th, marked the approval for the treatment of Cutaneous T-cell Lymphoma, and that initial indication as you can see has began to roll out by virtue of the fact that we recorded revenue this quarter. And ZOLINZA is Merck's first targeted cancer therapy for quite sometime. With regard to incremental studies, we have studies on going in hematological melanoma, solid tumor types including acute myelogenous leukemia, multi-Mellamias. I believe we’ve got ongoing studies in Non-Small-Cell Lung Cancers. In addition, ZOLINZA is being evaluated broadly across a wide range of solid tumor types. So, we have an extensive program underway and we are certainly committed to the HDAC program and oncology generally.
Graeme Bell: Thank you. Next question, please.
Operator: Your next question comes from Chris Schott of Banc of America.
Chris Schott: Great, Thank you. Just two quick questions. First on MK-859, your CTP, following the recent to your subscripted data, anything you took away from that. I guess specifically have you made decision whether to move forward into Phase III. If so are you expecting you have run imaging studies before the larger morbidity mortality study? And then a second question, ARCOXIA following the recent panel review, can I know what’s your next step here assuming the FDA request for additional data? Is this a product you would run further studies if they were required to get on the U.S. market. Thank you.
Dick Clark: I think the question on 859 is its still under evaluation by us based on the limited information that was provided. And what we are looking at internally and it's interesting to note that in addition the product development criteria that we have for 859 that we established previously increase in HDL greater than 50%, reduction of LDL of greater than 20% and the important affect on blood pressure that was similar to placebo, that 859 really hit those end points. And so it's important that we take that good information that we have and relate it to the issues that may exist or may not exist for the class. It's early for us to be able to talk about that yet. Certainly, when you talk about ARCOXIA, we are disappointed in the outcome. We continue to believe that ARCOXIA has the potential to become the valuable treatment option for many Americans suffering from osteoarthritis. And the anticipated date for the action by the FDA is April 27 for the six-month timeframe. And we are going to continue to work with FDA on that. Obviously, we are continuing to market ARCOXIA outside the U.S. where it has been approved where broadly with some indications and where they have seen this data that we submitted to the FDA. So, it's too early to tell for the next steps.
Graeme Bell: Well, we will continue on. We still have many questions in the queue. We have inquisitive group this morning. So let's keep ongoing. Next question, please.
Operator: Your next question comes from George Grofik of Citigroup.
George Grofik: Thanks for taking my question. On GARDASIL, can you comment on what kind of off label uptake you may have had in the mid adult female population? And secondly, if you can give us an update on the timing and venue of the presentation of enhanced study results for VYTORIN? Thank you.
Dick Clark: With regard to enhanced, as we have indicated the analysis that's good ongoing, we are still going with that information and we will pick an appropriate scientific forum in order to disseminate the enhanced data when we are ready to do that. With regard to GARDASIL…
Judy Lewent: Think we can't comment on that. I just don't know that information.
Dick Clark: I think what we have seen anecdotally, is this within the age range that is approved, we have seen broad uptake across all of that age cohort, whether it's 9 all the way through 26 at this stage. But again we don't have any off label specifics. Next question, please.
Operator: Your next question comes from Steve Scala of Cowen
Steve Scala: Thank you. I have two questions. First on the Q4 call, Judy, you mentioned that GARDASIL sales were demand-pull and not inclusive of stocking in clinics and so forth. I assume this is still the case. But, perhaps you can confirm. And secondly, when will we get visibility on whether Merck will exercise its 2008 option on AZLP, or should we assume that Merck will not exercise that option? Thank you.
Judy Lewent: So, you know, whereas I don't have my transcript in front of me, Steve, I do have a recollection that the fourth quarter of '06 was noteworthy in terms of getting approval for the VFD contract. So there was uptick in the fourth quarter for the VFD contract. And that's really consistent with my comments in the first quarter of '07. As far as the 2008 options, as you know, it's too early to call that. We do not have to really declare anything on that until really into the first quarter of 2008. I will say that part of the transition, I am working both internally and with our partner Astra just to ensure that there is a smooth hang off there so that we are all aligned on the process and we understand what needs to be done in the months ahead.
Graeme Bell: Next question, please.
Operator: Your next question comes from John McCoy (Ph) of Natexis.
John McCoy: Yes, thanks for taking my call. Did you guys see any affect from the so-called doughnut hole in the Medicare plan, in that or did people buy into January trying to avoid hitting that doughnut hole in December towards the end of last year? Thanks.
Dick Clark: That data really isn't available to us. That's really hard to make a prediction based on that.
Graeme Bell: Next question, please.
Operator: Your next question comes from Seamus Fernandez of Leerink Swann.
Seamus Fernandez: Thank you. Can you hear me?
Dick Clark: Yes.
Seamus Fernandez: Okay, great. I just wanted to get an update on the timing of the first VIOXX appeal, when we might see that? Second, can you verify for us that the trials that have started with 524B are with the single pill combination? Third, can you also update us on the potency efforts regarding the Varizella based vaccines and where you are in that process? And then, just finally in terms of this suit that you have filed versus Teva and Barr, which is a manufacturing suit on FOSAMAX in the U.S., is there a possibility that this suit could allow generic exclusivity? And if so, is there some form of an agreement that you have for an authorized generic that we could possibly see with FOSAMAX in the U.S.? Thank you.
Dick Clark: Lets take them in reverse order. With regard to the FOSAMAX situation, we are a party by name only in that ongoing discussion, by virtue of some intellectual property that was licensed. So we are not integrally involved in that ongoing discussion and dialogue. And then, jumping to your first question, if I may, Seamus, with regard to the appeals process. In terms of where we are on that, as you know, the first case, which was Ernst in Texas, the appeal brief in that case was filed on April the 5th. So at this point we are still in the very formative stages of that appeals process. And today that is the most advanced of the appeal. So again, we are appealing and in the process of appealing Ernst, Garza, Conna/McDarby, Plunkett, Barnett and Humeston and we will progress and continue to provide you updates. But as I say, even the most advanced of those is Ernst and appeals briefs were only filed on April 5th.
Dick Clark: Your question concerning Varizella potency. We were making excellent progress on the issue. We certainly have narrowed it down to three variables and we are looking at these variables and validating the variables and at then taking it into full production to see the impact. So the progress is being made. We were in validation stage now to see whether the probable cost is where we think it is and we should know that very shortly.
Graeme Bell: Next question, please.
Operator: Your next question comes from David Merris (ph) of Balyasny Asset Management.
David Merris: Good morning. Just a follow-up on, is this the most extensive oncology program that you have on going? And then is there going to be any data at the upcoming ASCO and if so what data should we expect?
Dick Clark: All right, thank you. I’ll take that quickly. The answer is yes. It is the most advance program that we have in terms of the HDOT program within oncology at this time and its extensive in nature with many on going studies. And as you know, oncology is certainly a focus of area. And with regard to when and where, we have not disclosed this point in what forum we would be disseminating the next round of the data. And with regard to the prior participant's question, I just want to be very clear, with regard to 524B; at this moment in time that trial is being run co-administering 524A with Simvastatin. So at this moment in time, none of the participants are ingesting the triple combo. Next question, please.
Operator: Your next question comes from Joe Tooley of AG Edwards.
Joe Tooley: Hi. Good morning. I just want to follow up on the earlier pipeline questions with one on the CB-1 antagonistic MK-0364. It's my understanding you may be looking at lower doses than were originally studied for the drug and given FDA's long-term follow-up requirement for obesity compounds. I was wondering if you could confirm your 2008 filing guidance or the potentially lower dosage range could result many filing delays?
Dick Clark: I think it's something that we can't comment at - comment with right now from a statement on what’s going to happen in 2008 with that product. You know, it's an important study for us. We've initiated a focus Phase III program in fourth quarter of '06 and we still anticipate filing in this drug in 2008 but we aren't ready nor do we know a lot of the details around the particularly around Phase III outcomes.
Graeme Bell: Next question, please, Taylor.
Operator: Your next question comes from Roopesh Patel of UBS.
Roopesh Patel: Thank you. Just couple of questions, first on GARDASIL in terms of the first quarter GARDASIL sales, can you give us a rough sense as to what proportion the sales were first dose versus second or third dose on GARDASIL. And then separately if I look at the total vaccine sales reported this quarter approximately $900 million, you’ve raised the guidance for total vaccines for the full year to between 3.3 to 3.7 but that implies that sales in subsequent quarters relative to the first quarter will be flat to down looking forward. And I was wondering if you just offer a little more clarity as to what are the dynamics that could influence the trend in that direction? Thanks.
Dick Clark: Well, certainly. Your first question, it is early for us to be able to give statistics around the uptake in the second and obviously the third dose. And that data really isn't available other than you know some dialogues with physicians. So that we’ll have to wait until we get much more experience and much more uptake. And as I said earlier, we have programs in place to help reminder down from both from the physician and the patient. But it is a good question. It's just too early to answer it.
Graeme Bell: Thank you, so given the time, we have one or two more questions. So Taylor, please.
Operator: Thank you. Your next question comes from John Boris if Bear Stearns.
John Boris: Good morning, and thanks for taking my questions. I just have three; first one, just as or is more related to cost of goods. Dick, can you just talk about vaccine yields and I think this year's pretty important year for improving vaccine yields. The type of progress you are making there? And then secondly it seems like there were a fair amount of asset sales going forward. I guess, while all of a sudden are we seeing more asset sales and should be anticipating asset sales of the smaller products going forward. Secondly, I think, this question relates more on the acquisition side. I think earlier in the year you did mention that you were interested in a Biotech acquisition that was aligned from a research therapeutic standpoint with your R&D operations. But would have inline revenues that are actually approved and sold and marketed and have a P&L. Can you just comment on for that type of acquisition what Merck's defined internal rate of return would be for that type of acquisition? And then third on ISENTRESS, I think you wanted to file it in the second quarter I think this is one of your important projects for compressing cycle times. Can you comment as to whether the product has been filed already and you are just waiting for the FDA to indicate that they have accepted the filing. So any type of insight there would helpful? Thank you.
Dick Clark: On your last question, we cannot comment on filing and the timing of it. Other than what we have been already stated publicly. So that is our information we are very comfortable with it. Your question about cost of goods in biologics and vaccines, the good news is that we are making progress there and I think the manufacturing organization is doing a great job of looking at the cost of goods line and trying to focus all the efficiency and effectiveness that we need to be able to accomplish that and obviously when you see the increase in the forecast of vaccine and biological is a part of that is, is productivity and throughput to be able to support that. So it is a major initiative for us, not only for this year, but for the five year plan that we have and that we are making the progress in manufacturing to be able to accomplish that, so I feel good about that. And I would say on the asset sales, there is no integrated focus on selling assets of those types. It was just an opportunity, it was the right thing for the company, and the other companies who are interested in it. So it was a one-time impact. Obviously, from an asset standpoint, as we look at the manufacturing strategy moving forward, there are going to be assets and available based on potential plant closings and when you do that you really step back and look at those assets and see what kind of values they brings to other partners that we have that would be help, but nothing more specific than that.
Graeme Bell: So, with that last question, it concludes today's call. The information on today's call both in transcript and replay will be available on our website for the next seven days and as always we and IR remain available for the rest of the day. We certainly appreciate your interest in participation. So with that operator thank you very much.
Operator: Thank you. This concludes today's first quarter 2007 earnings conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day, everyone. And welcome to Merck’s First Quarter 2007 Earnings Conference Call. Today's call is being recorded. At this time, I would like to turn the call over to Mr. Graeme Bell, Executive Director of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Graeme Bell",
"text": "Thank you, Taylor and good morning. Welcome to our call this morning to review our business results for the first quarter of 2007. We know it's been a busy morning for you already and you may have participated in two calls. Joining me on this call today is our CEO and President, Dick Clark and Miss Judy Lewent, our Executive Vice-President and Chief Financial Officer. Before we get into the details, I would like to through the logistics. On this call, we will review the results contained in the release we issued at 7:30 this morning. You can access this by the Investor section of Merck.com and I would remind you that this conference call is being webcast live and recorded for replay later via phone, webcast and our podcast. As we begin our review of the results, let me remind you that some the statements made during this call may disclose certain subjects that may contain forward-looking statements as that term is defined in the Private Securities Litigation Act of 1995. These statements are based on management's current expectation and involve risks and uncertainty and may cause results to differ materially from those set forth in the statement. The forward-looking statements may include statements regarding product development, product potential or financial performance and no forward-looking statements can be guaranteed and actual results may differ materially from those projected. Merck undertakes no obligation to publicly update any forward-looking statement whether as a result of new information, future events or otherwise. Forward-looking statements on this call should be evaluated together with the many uncertainties that affect Merck's business, particularly those mentioned in the risk factors and cautionary statements set forth in Item 1A of Merck's Form 10-K for the year ending December 31, 2006 and in its periodic report of Form 10-Q and Form 8-K, which the company incorporates by reference and then are posted on our website. We will begin with some brief remarks from senior management and then open the call for questions and expect the call to take approximately hour and conclude around about 10 am. So with that, I’ll turn the call over and we will begin with our remarks from our CEO and President, Mr. Clark."
},
{
"speaker": "Dick Clark",
"text": "Thank you, Graeme and good morning everyone. As we announced last week, our first quarter earnings for 2007 were $0.84 per share, excluding restructuring charges related to site closures and position eliminations. Our reported EPS for the first quarter were $0.78, certain one-time gains from asset sales and product divestitures accounted for increased revenue in that quarter. We exceeded our own expectations for the first quarter, as a result of strong market performance, across all product lines and as a result raised our full year EPS range to $2.75 to $2.85. Excluding restructuring charges and our full year reported EPS range to $2.60 to $2.75. We anticipate second quarter EPS of $0.67 to $0.71, excluding restructuring charges and reported EPS of $0.62 to $0.68 for the same quarter. Judy will speak to this in more details in a few minutes. Our newly launched products, combined with our inline product portfolio, led us to realize strong gains across all markets. Worldwide sales reached $5.8 billion for the first quarter, an increase of 7% from the same period last year. Let me summarize some of the product performance highlights. SINGULAIR continues to be the number one prescribed product in the U.S. respiratory market, with year-over-year sales growth of 25%, reaching $1 billion this quarter. Both ZETIA and VYTORIN, which we market in partnership with Schering-Plough, also performed very well this past quarter. They posted a combined $1.2 billion in sales, a 47% increase from the first quarter of 2006. GARDASIL, the first and only cervical cancer vaccine approved, is being quickly accepted by patients, physicians and traders. First quarter sales were $365 million and included initial purchase, by many states, the vaccine for children program. JANUVIA, our first in class treatment for type 2 diabetes, also experienced impressive sales of $87 million in the first quarter. And now that it has been joined by the approval earlier this month of Janumet, we expect that Merck's ability to meet the needs of growing population of people with type 2 diabetes will continue to grow as well. With each of these products, we are continuing to look for new opportunities, strengthen their value to patients and to Merck. The recent FDA approval of SINGULAIR, by patients aged 15 years and older, who suffer from exercise-induced bronchoconstriction, is expected to further increase the strength of this product in the marketplace. It is estimated that exercise can trigger an episode of EIB in 80% to 90% of people with asthma. We announced an agreement last month with Schering-Plough to begin development of a new medicine that we combine ZETIA with the atorvastatin once marketed exclusivity for atorvastatin expires. We are very pleased to have submitted the supplement biological license applications to the FDA and GARDASIL's cross protection data. It shows that GARDASIL provides some protection against additional HPV types, it cause more 10% of cervical cancer worldwide. And the FDA accepted two supplemental new drug applications, to expand the U.S. label for JANUVIA. These actions reflect our commitment to maximizing the value of all of our inline products; from the day they are launched until the day their patent expires. While we are taking advantage of opportunities like these to drive our future growth, we remain focused on controlling expenses. Our performance in the first quarter is we believe, further evidence the path we have chartered to return Merck to a leadership position in our industry, is the right one. We still have a long road to travel to realize our long-term goals, but we are executing on our plan with confidence. And while we were disappointed by the recommendation last week of the FDA advisory committee regarding ARCOXIA and by the decision we reached with Lundbeck to discontinue our joint development program for gaboxadol. Our overall pipeline continues to advance and grow. By building on the strong foundation we established in 2006, we remain confident that we will continue to progress toward the goal, we set to delivering double-digit compound annual EPS growth, excluding one time items and restructuring charges, by 2010 from the 2005 dates. Before I turn the call over to Judy Lewent, for what will be her last sales and earnings call at Merck, I want to take just a minute to express to her and to all of you, my deep appreciation for the enormous contribution she has made during her course of her career here at Merck. For 27 years Judy has been an indispensable quite a Merck's leadership team. Her vision, expertise and her integrity have made her one of the most respected incredible people in the field of American business. I will miss her as a colleague and Merck will miss her as a leader. And certainly when I took over as CEO of the company in May of 2005, it was Judy's support and partnership that really helped us put a strategic planning process together for the company and her leadership really developed the strategic planning initiatives and activity that you see that we are executing against. So as a company and a shareholder, there is a tremendous amount that we owe to Judy. So, Judy for one more time I'm pleased to turn the call over to you. Thank you."
},
{
"speaker": "Judy Lewent",
"text": "Thank you, Dick. And maybe on this very special occasion and thank you for the kind words, everyone listening on the phone will just pass all the difficult questions over to Dick and I will enjoy my last call. So thank you and good morning, everyone. As Dick said, we are extremely pleased with our reported results for the first quarter of 2007. And we are working toward insuring sustaining growth in 2007. The first quarter reported EPS growth was driven by top-line revenue that reflects strong performance of our inline franchises, as well as the rapid early uptake of our first in class DPP-4 inhibitor JANUVIA and a continued strong growth of GARDASIL. Another notable contributor was the outstanding performance of our partnerships and alliances, resulting in improved equity income, along with the benefits from gains from certain product and asset divestitures. Dick mentioned several of the highlights of the quarter results, a moment ago. So to build up that in the first quarter we saw revenue of $5.8 billion. That represents a 7% increase over the same period last year, including in the aggregate, an overall 0.5% decrease from price, offset by 6% growth in volume and 1.5% positive impact of foreign exchange. Collectively, worldwide revenue was above our initial expectations and we saw encouraging sales performance from our newer and in line franchises. Within the quarter, we saw the anticipated decline of ZOCOR and PROSCAR in the U.S. as well as a decline in FOSAMAX in several international markets where there is access to other alginate sodium product. However, these declines were more than offset by the positive performance of SINGULAIR that showed strong global growth as it continues to experience robust demand driven by continued strength in the asthma and allergic rhinitis market as well as our other inline product and the early success of our newly launched products JANUVIA and GARDASIL. A major contributing factor to our top line growth came from our vaccine business. Collectively vaccine revenue is recorded by Merck with $903 million for the first quarter representing a 233% increase when compared with the same period in 2006. Driven by the continued uptake of GARDASIL, ROTATEQ and ZOSTAVAX in the first quarter, our three new vaccines collectively accounted for close to $0.5 billion of revenue and to assist in your modeling, we provided a breakdown of the product revenues with our other financial disclosures. As Rick mentioned, we are extremely pleased that global sales as recorded by Merck for GARDASIL continued to grow and reach $365 million of which $312 million was recorded in the United States. This quarterly figure includes initial purchases by many states through the CDC's Vaccines For Children program. Total sales of Merck's other promoted medicines were collectively $1.4 billion for the first quarter, representing a 13% increase as compared with the same period in 2006. As you know, in the fourth quarter we launched JANUVIA, which is currently approved in 42 countries and now available in every region around the world as the only DPP-4 Inhibitor available for use in the treatment of type 2 diabetes when diet and exercise are not enough. In its first full quarter, global revenue of JANUVIA reached $87 million of which $83 million was in the U.S. Also contributing to our top line revenues from our alliances, primarily AstraZeneca LP, in the first quarter, revenue recorded by Merck from the company relationship with ADLP was $534 million. As always, keep in mind that there is inherent variability relating to this revenue given that Merck is not actively managing these products. Our revenue recognition takes into account inventory levels at ADLP for PPI and non-PPI products as well as their product shipments. Taking the first quarter revenue announced today and adding 50% of the revenues from the Merck Schering-Plough, Merial, Sanofi Pasteur MSD and Johnson & Johnson Merck joint ventures and partnership revenue was $6.8 billion. If you do the same adjustment in the base period, the revenue growth rate was 10%. Regarding 2007, given the first quarter performance, we are revising upwards, full year revenue guidance for three of our product guidance elements by $900 million to support the higher full year EPS guidance that we initially provided on April 12. Regarding SINGULAIR, we are increasing the full year range by $200 million to $3.9 to $4.2 billion. Regarding vaccines, we are increasing the full year range by $500 million to $3.3 to $3.7 billion. And regarding other reported products we are increasing the full year range by $200 million to $5.4 to $5.8 billion. And we were reaffirming guidance for COZAAR HYZAAR, FOSAMAX, ZOCOR and AstraZeneca. Again, as always the AZLP guidance is an update based on recent results as well as future expectations and reflects the dynamics to the PPI markets, multiple generic, OTC products and the uncertainty these create with regard to future volume and pricing. Also keep in mind that our reaffirmed guidance incorporates the expectations of the non-PPI products as ATACAND, PLENDIL, LEXXEL and ENTOCORT. Moving down to P&L, materials and production came in at $1.5 billion for the quarter. The quarter includes $118 million for costs associated with the global restructuring program primarily related to accelerated depreciation and asset impairment costs. Excluding these costs, materials and production increased 24% for the quarter. The gross margin in this quarter was 73.6% reflecting a 2-percentage point unfavorable impact relating to the restructuring cost. Excluding restructuring charges, the first quarter PGM of 75.6% was within our disclosed guidance range and just as in previous periods these results were affected by the final product mix. Given this result, we are comfortable with our full year 2007 guidance range and we are reaffirming that our product gross margin is estimated to be approximately 74% to 76%. This guidance excludes the portion of the restructuring cost that will be included in product cost and will affect reported PGM in 2007. On marketing and administrative, first quarter expense came in at $1.8 billion, which is an increase of 5% over the same period last year. Once again, the primary driver of the marketing and administrative increase was promotional spend for GARDASIL and continuing efforts to more aggressively support the JANUVIA, JANUMET launch. Again, these were choices made in response to the evolving competitive dynamics to fully support our first-in-class products. These incremental investments are reflected in the strong revenue performance reported this quarter as well as in the higher full year product guidance provided this morning. Reflecting our commitment to realizing efficiencies throughout the company and optimizing our cost structure, the component of M&A consisting of selling administrative and general administrative costs, which support our core operations, was down year-over-year. Even as we launch additional new products as they anticipated this year and continue building on the momentum of our successful 2006 launches, we expect that our cost containment efforts and initiatives will allow us to meet our guidance on M&A spending in 2007 and our commitment to maintain flat M&A expenses in 2010 relative to the 2006 base excluding charge taken to increase the legal defense reserves. Regarding guidance, we’re continuing to provide it on the change in marketing and administrative expense relative to the base period excluding one-time items to help your modeling and we are reaffirming our full year 2007 guidance. That is we anticipate marketing and administrative expense to increase between 0 and 2 percentage points over the full year 2006 level. The 2006 marketing and administrative expense level referred to, excludes the charges taken during 2006 related solely to future legal defense costs of VIOXX and FOSAMAX litigation. During the first quarter, the company did not increase the reserve relating solely for future legal defense costs of VIOXX litigation and the company has not established any reserves for any potential liability relating to the VIOXX lawsuits and the VIOXX investigations. We continue to believe that every case contains unique set of facts and the appropriate strategy is to defend these matters on a case-by-case basis. Regarding research and development, expenses were $1 billion for the quarter, an increase from the comparable period in 2006 of 9%. R&D growth in the first quarter was driven by an increase in both basic and clinical R&D spend. Basic research spend increased as a result of the integration and underlying operating expenses of the Sirna, GlycoFi and Abmaxis acquisitions. In addition, clinical research expenses were higher in support of Phase III trial for MK-0524A and MK-0364, Incretin and other late stage products. During the first quarter of ’06, Merck entered into several agreements reflecting our strategy and let me correct that during the first quarter of ’07, Merck entered into several agreements reflecting our strategy of establishing strong external alliances to drive both near and long term growth. And currently, Merck is in discussions with more than 35 companies regarding potential transactions and is also actively monitoring the landscape for a range of targeted acquisitions that meet the company's strategic needs. We are reaffirming our 2007 guidance for research and development expense and anticipate it to increase at a low to mid single digit percentage growth rate over the full year 2006 level. The 2006 level we are referring to includes the $296 million acquired research charge relating to GlycoFi that occurred in the second quarter, but excludes the impact of the acquired research charge relating to the Sirna acquisition. The full year 2006 level also excludes the portion of the restructuring costs that are reported in research and development expense. Moving on to restructuring, total costs associated with the company's global restructuring program were 186 million for the first quarter. As I just mentioned, $118 million of those were for asset related charges and are included in the materials and production. So, in our first quarter results, the restructuring cost line reflects $65.8 million of costs related to the global restructuring program for employees separation and other related costs associated with approximately 230 positions eliminated, bringing the total to 5100 today, and then remaining, keeping us on track, to eliminate 7000 positions by the end of 2008. However, the company does continue to hire new employees, as a company's business requires it. Accordingly, we are reaffirming the guidance associated with our global restructuring program for 2007. Additional costs related to site closings, position eliminations and related costs will be incurred in 2007 as part of the company's restructuring of its operations. The aggregate 2007 pre-tax expense related to these activities is estimated to be $300 million to $500 million. In reviewing equity income from affiliates, roughly $653 million of income in this quarter, related to the contributions from all of our joint ventures. This result reflects the continued success of the Merck Schering-Plough cholesterol franchise in the U.S. and Europe, and the performance of the Merial animal health business. As always, I would remind you that there are several components to AZLP equity income, which make it inappropriate to draw significant conclusion just based on PPI products. There are complexities that involved at a minimum timing and tax differences. That said, the first quarter equity income contribution from Merck share of the partnership with AstraZeneca LP with $212 million. Regarding the Merck Schering-Plough partnership. The first quarter combined MSP cholesterol franchise global revenue, as reported by the Merck Schering-Plough partnership, continued to grow to $1.2 billion. In the quarter, revenue of VYTORIN and ZETIA were $624 and $544 million respectively. Within Merck's quarterly income results, the Merck Schering-Plough partnership contributed $347 million. And that reflects an 85% increase over the prior year. The balance of equity income comes from other joint ventures, namely Merial, Sanofi Pasteur MSD and Johnson&Johnson Merck. Again, Merck's 50% of the revenues from the Merck Schering-Plough, Merial, Sanofi Pasteur MSD and Johnson&Johnson and Merck joint ventures and partnership, totaled $1.1 billion in the first quarter, up from $800 million in 2006. Given this result, we were reaffirming our guidance for full year 2007, and continue to expect equity income from affiliates to be approximately $2.6 to $2.9 billion. Turning to other income in the quarter, you see we recorded $256 million of income as disclosed in our other financial disclosures. And then in another gain, you will see of $188 million. This primarily reflects the favorable impact of gains on sales of assets and products divestitures. During the quarter, it wasn't disclosed that the company divested the U.S. prescription pharmaceutical rights to tested oral suspension entire oral suspension to Cerus Pharmaceuticals Limited and divested the worldwide rights to Ambrilia tablets and INDOCIN capsule, the pain relief capsules, suppositories and oral suspension to a local pharmaceutical LLP. Now for the quarter, income before taxes was $2.3 billion. Taxes on income in the period were $550 million, and the reported tax rate was 24.4%. This reflects in general the changes in foreign and domestic mix and currency fluctuations, and as you know these elements changed throughout the quarter. Effective January 1st, 2007, the company adopted FIN 48 accounting from certainty and income factors. This adoption resulted in increasing retained earnings of approximately $80 million. Of course, this does not affect net income. We are reaffirming our full year 2007 tax rate guidance range, and I would direct you to today's press release for the details. Moving to net income and earnings per share. Net income for the first quarter of 2007 was $1.7 billion, compared to $1.5 billion in the first quarter of 2006. And that represents growth of 12%. During the quarter, we spent $240 million in treasury stock, and we now have $6.3 billion under the current authorization from the board with no time limit. And in summary, earnings per share for the first quarter were $0.84, when one excludes a $0.06 charge for site closures and positions eliminations primarily associated with the global restructuring. Our reported first quarter EPS was $0.78. Now let me turn briefly to our guidance. I have mentioned it several times as part of the results review. But, as you will see in today's release, with the exception of our upward revision to SINGULAIR vaccines and other reported products, we are reaffirming all the elements of our 2007 guidance. And all the details of the guidance are provided for you in the earnings release. Given these guidance elements, Merck anticipates second quarter EPS of $0.67 to $0.71 excluding restructuring charges. And anticipates reported second quarter EPS of $0.62 to $0.68. In the second quarter, the company anticipates that revenue will be comparable to the amount reported in the first quarter of 2007. In addition, it's worthy of note that research and development expense excluding restructuring charges, is anticipated to be higher than the amount reported in the comparable period of 2006. The company reaffirms full year 2007 EPS of $2.75 to $2.85 excluding the restructuring charges related to site closures and position eliminations, and anticipates reported full year 2007 EPS of $2.60 to $2.75. While we were pleased with our performance in the first quarter, it is important to note that we are still only three months into the year, and we need to continue to execute on our business plan. Based on our current full year guidance, we anticipate that earnings per share excluding restructuring will grow in the range of 10 to 16% in the last three quarters of the year, versus the last three quarters of 2006, excluding Sirna and restructuring. There are many factors that impact the variability within the given year that needs to be considered when modeling. For example, in the first half of 2007, we are still facing the annualization of the loss of marketing exclusivity for simvastatin and finasteride. In addition, while we were very pleased with the initial successes of the recent launches, you all know there is inherent variability of a continued uptake of new product launches. As part of the full year guidance, we anticipate the promotional spend will moderate. That is decline particularly when we think about the pattern last year and the fourth quarter 2006 levels, and decline across divisions as products move out of early launch phase and commercialization efficiencies are realized. We also expect efficiencies to be delivered from new initiatives and provide savings within our general administration costs structure. As stated, this guidance does not reflect the establishment of any reserves for any potential liability related to the VIOXX litigation. And in addition as Dick noted, the company remains on track in terms of both strategy and performance, to deliver long-term double-digit compound annual earnings per share growth from 2005 to 2010, excluding one-time items and restructuring charges. I also want to continue to emphasize, that we have the financial strength to support our dividends, and we remain fully committed to maintaining it at the current level, while at the same time continuing to fund our investment priorities. With that, I will turn the call back over to Graeme."
},
{
"speaker": "Graeme Bell",
"text": "Thank you, Judy. We will now open the call to take your questions. As usual, we will take the questions in the order, in which they were received, and try to get through as many as possible. And at this point, I will turn the call back to Tiler, who will communicate instructions about Q&A format and then introduce the first question."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Chris Shibutani of J.P. Morgan."
},
{
"speaker": "Chris Shibutani",
"text": "Thanks very much. Could you provide us with an update on GARDASIL, obviously good uptake from the state, what percentage of the state do you expect we’ve already seen that and the timeline for additional state? And also what do you are seeing in terms of the actual compliance for the second and third dose at any given patient or process? And then finally, could you provide us with an update on your cardiovascular pipeline at 524B anything to know incrementally there and also sometime better -- commented on their commitment?"
},
{
"speaker": "Dick Clark",
"text": "Thank you, Chris. Just to, there was an audio problem, just so I understand your questions. You had two with regard to GARDASIL, one with regard to compliance in terms of second and third dose and another one with regard to the build of the revenue in terms of how much has been consumed. And then there was a question with regard to the pipeline in the cardiovascular profile. So let me start with the last question first in terms of the cardiovascular pipeline. As we’ve indicated, and we remained committed to our 524 program in the form of 524A and 524B and we remained on track with both of those products. And as we previously disclosed it indicated there was an expectation that we file 524A in the calendar year 2007. And we will file 524B in the calendar year 2008. With regard to GARDASIL."
},
{
"speaker": "Judy Lewent",
"text": "Peter, I think it's too early yet to talk about the uptake for the second and third dose for GARDASIL. However, we have worked with the payers and physicians to put reminders programs in place and be able trigger from a compliance standpoint that we have more success and will be able to monitor that. Just another comment around the CDC contract. To date, 53 out of 55 projects have adopted GARDASIL. Each of the 50 states and project in five cities until we are happy with that. And from an uptake on the state standpoint, it’s going take the time it takes to get through the committee, the vaccine committee in each state and then the uptake and discussion with the state within the legislature. So, it's hard for the timeframe on all of that."
},
{
"speaker": "Graeme Bell",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Tony Butler of Lehman Brothers."
},
{
"speaker": "Tony Butler",
"text": "Thank you, very much. First, Judy, thank you very much and certainly all the best. Second, if we can expand upon the GARDASIL commentary, when we think about the fraction of states you mentioned that, Dick. Does this just simply imply that we’ve got a fair inventory build on GARDASIL currently that we have to work through based upon the state legislation, legislators throughout the remaining part of the year? That's really the first question. The second question is, Graeme, if I'm not mistaken was 524A to be filed in Q2 of this year, was that the previous guidance. And moreover, could you comment about the integration inhibitor 0518 again, the timing on that project. Thanks a lot."
},
{
"speaker": "Dick Clark",
"text": "Thank you Tony. I’ll take the last part of the question first. So, we have always said and remain committed to the 524A being filed in the calendar year 2007. We have not been specific on the exact timing. And with regards to the ISENTRESS question, on that particular NDA, we have indicated that we will file the NDA with the FDA in the second quarter of 2007."
},
{
"speaker": "Judy Lewent",
"text": "I think regarding GARDASIL, we obviously know that the initial purchases by many states has and is affected. Now the pipeline is full and we have to get it to the children. But there is also vaccine and there are also for second and potentially third dose. So, we feel comfortable with where the future pipeline is. But there are obviously some initial stockings. I think the other good news is that, the managed care plans representing about 97% of privately insured life U.S. more than 140 insurance plans have implemented coverage for GARDASIL. And that even better news I think approximately 75% of the plan members have first dollar coverage for GARDASIL which essentially means no co-pay. And I think when you put those combinations together with the fact that there’s a 118 million girls and women in the U.S. and EU and at highly developed markets, so the appropriate age we feel very comfortable with the future forecast."
},
{
"speaker": "Graeme Bell",
"text": "Thank you. Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Timothy Anderson of Prudential Equity Group."
},
{
"speaker": "Timothy Anderson",
"text": "Thank you. I have a couple of questions. Can you talk about the company's inclination to do corporate acquisitions that are bigger in size than what you have been doing over the past few years? And second question is, kind of a another general question, which is that revenues for Merck and I think almost all of the drug companies have thus far have come in well above forecast in the first quarter. And I'm wondering if there is seasonality to this purchasing now that Part D is in full effect. My question is whether these very strong trends you think, will they continue unabated throughout the rest of 2007, or is there some new structural dynamic that could reverse these trends later on? And the reason I ask you is because of your big beep this quarter, but not really raising full year earnings as much as would otherwise be suggested?"
},
{
"speaker": "Richard Clark",
"text": "I think I am answering your first question, the issue around corporate acquisitions. We have said in the past that we are interested not only in science and technology acquisitions, which obviously we did in 2006, but acquisitions that would help build the top line from a revenue standpoint and at the same time hopefully aligned with our therapeutic areas that our research organizations focused on. Having said that, when we look at those potential acquisitions, we also have a responsibility from a shareholders standpoint to make sure that there is long-term value there. And that as we go through that process and as other companies are going through their process, that it's appropriate that value is there for the long-term. And so we were focused on that, but we are not going to do an acquisition just to do an acquisition. It really has to strengthen where we are today in the future and quite frankly where we are with our pipeline and where we are with some of our results, have to be taken into the equation because the internal growth, the organic growth of the company right now is pretty positive."
},
{
"speaker": "Judy Lewent",
"text": "I think just relative to some of the questions on the top line. Just a couple of thoughts, first of all, for Merck, I will speak to Merck. What you are seeing here is really just successful uptake of our new product launch, that's fundamental. That's not a structural change per se in the marketplace. That's the result of the performance that we just discussed with you about the vaccine and the stellar performance of the vaccines, the new vaccines as well as JANUVIA. And then the excellent performance of SINGULAIR, which as you know has doesn't really have that kind of seasonality to it, except perhaps as we go into the allergic rhinitis season, which doesn't start until late in the first quarter. And so that's something that unfolds during the year. And in terms of the guidance, we increased our guidance $900 million and that is for the full year. So we are driving that increase in our earnings per share guidance based on taking up the revenue element. But as we noted, we are continuing to fund R&D and stay in line with all of our guidance on our expense elements. We think a combination of that those factors lead you to the range that we guided to today and then starting on April 12th."
},
{
"speaker": "Richard Clark",
"text": "One other point is one thing I'm pleased about is that when you see the results of the first quarter and the growth as Judy said earlier, it really is across all regions of the company. So it's not just in the United States. Every region has performed and why we feel confident in that and many of the new products even though we launched GARDASIL and JANUVIA obviously in the United States and other countries, there is still a substantial amount of countries where it 's even approved then we have to get ready for launch and then in some countries have approval and a launch. So we are still in a very launch growth pattern from a company standpoint with our new products. Globally."
},
{
"speaker": "Graeme Bell",
"text": "Thank you. Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from comes from Jamie Rubin of Morgan Stanley"
},
{
"speaker": "Jamie Rubin",
"text": "Thank you, and again, Judy, you had a remarkable career and you’ve got huge shoes to fill. So congratulations. Just a couple questions. First related to the gross margin, the guidance this year is you have kept the guidance at 74% to 76%. Yet this quarter your gross margins excluding restructuring was 75.6% and what would arguably be your toughest comparison with U.S. ZOCOR sales up the strongest first quarter last year and I would also think that GARDASIL margins are probably at its lowest as you continue to launch that product, so 75.6% seems to be a good start for the year, yet you are sticking to your 74% to 76%. So maybe you could speak to that a bit? Secondly, my question relates to FOSAMAX and the newly issued EU patent. Just wondering how we should think about our modeling of international or European FOSAMAX sales 2008 and beyond, as I think most of us assumed patent expiration. And then my third question relates to the integrase inhibitor. If you could talk about the profile, what you are planning to include in your initial filing? If you are planning to include front line results and where you are with your once a day version? And just so if you could also comment on what you see in terms of the competitive dynamics of Gilead. Thanks."
},
{
"speaker": "Judy Lewent",
"text": "So thank you, Jamie. Let me start with the question on gross margin. Basically, you do need to think about the evolution of sales over the year. So where as yet GARDASIL had a major impact in the first quarter, we increased our guidance on the vaccine -- total vaccines per year, $500 million. As you know, GARDASIL carries with it a royalty obligation of 24 to 26%. So, we continue to factor in our annual guidance sort of the dynamics of the product mix. In addition, bear in mind that COZAAR continues to be a strong contributor, and as you know because of our relationship with DuPont has a lower product gross margin than some of our other inline products. I think again we were factoring in our view of how the year evolved, and some of the uncertainty in these dynamics of the product mix that just continue to give us comfort with the 74 to 76% ex restructuring."
},
{
"speaker": "Dick Clark",
"text": "Jaime, regarding FOSAMAX, as you stated, we have done the filing of our lawsuit and the new patents effectively needling 23 countries in Europe. And the patent expires on July 17, 2018 now. And obviously for this reason the filing of the suits against these manufactures is an effort A to recoup our financial losses caused by these infringement activities. And then I have these products removed from the market. It's hard to say the impact of this and what it is going to be in the future. The outcome of Merck's legal actions may not be realized for several years. And so obviously we are studying it hard that it's very difficult to have any answer to that."
},
{
"speaker": "Graeme Bell",
"text": "And Jaime, I will take your question with regard to ISENTRESS. So, as previously stated we remain on track and are committed to ensuring the NDA has filed with the FDA in the second quarter for treatment experience indication for which we have received the fast track designation. We therefore anticipate action on 518 by the end of 2007, and if approved, we plan to launch ISENTRESS in 2007. In addition, there is a phase III program underway in treatments naïve patients. And with regard to the clinical data in the profile on February 27 of this past year, at the CROI meeting, we presented interim Phase III, 16 weeks data for two of the ongoing studies for ISENTRESS in treatment experienced patients whose HIV was resistant to at least one drug in each of the three classes of oral antiretroviral therapies. And the investigational drug ISENTRESS was generally well tolerated in all of the studies and would be happy to share that CROI data with you. With regard to what is happening in the program, on August 17 of last year, we announced the establishment of the worldwide-expanded access program for ISENTRESS, for HIV and AIDS patients with limited or no treatment options. And that program is enrolled, and we are seeing that patients are using the product. Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from David Risinger of Merrill Lynch."
},
{
"speaker": "David Risinger",
"text": "Yes, thanks very much. I have three questions. First, and I apologize if maybe have been asked before because I have been on and off the call. First question is in terms of other net; the number in your press release was 187.7 million in the first quarter of '07 versus 47 million in the first quarter of '06. If you could explain that and tell us what type of anomalies were in there and whether we should expect that figure to decline sequentially in the second quarter of '07? And then second, in terms of revenue, the revenue came in impressively at three -- I'm sorry, at $5.8 billion in the quarter. Looking forward over to the next three quarters, is there any reason why that revenue figure should go down? And then the final question is, in terms of ex-U.S. FOSAMAX; I understand that it's generic in the U.K., but that the generic penetration is very low. However, generics have launched in other countries and if you could just walk through where the patent had been broken in other countries. And if it hadn't been broken yet there have been generic incursions into other countries, if you could just help us explain why Merck wasn't able to stop the generic launches in other countries where the patents hadn't been invalidated? Thank you."
},
{
"speaker": "Judy Lewent",
"text": "So, let me start with the question on other net income. As I noted earlier, that $188 million reflects certain one-time items from asset and product divestitures such as our sale of Pepcid Oral Suspension as well as ultimate some of andesine products. So, as you can appreciate those are one-time events, and therefore they are not going to recur in the second quarter. We, as you know, don't forecast when those other opportunities might occur. We always re-assess our product line, and a lot of these particular transactions are linked to our network strategy in terms of how we are leaning on our supply chain and so on. So, we continue to evaluate our product line in that regard, but I can't really forecast what if anything might happen other than what happened in the first quarter of '07. And therefore you sort of need to take that as a one-time event. Last year, in the first quarter there was really nothing of note. There were the normal pushes and pulls of, you know, again, some other income and other one-time adjustments, but nothing really worth calling out. So, I think that provides some of the perspective there."
},
{
"speaker": "Dick Clark",
"text": "I think in the question also around the guidance for the remainder of the year where we are in the first quarter, you know, and Judy and I spent a lot of time talking about this. Although we are pleased with the first quarter obviously, we also know that we were only three months into the year and we need to execute against the business and do it flawlessly to continue that growth pattern. And as Judy said, the base of our current full year guidance, we anticipate that EPS ex restructuring will grow in the range of 10 to 16% in the last three quarters of this year versus the last nine-months of the base period, which is very important. And with that said, there could be a lot of variabilities around business profiles for the year as we launch our new products, continue to launch our new products. And we still have the issue with first half of '07 with the loss of the Simvastatin, ZOCOR patent. So there is still a lot to do and there is obviously variability in the continued uptake in new product launches and potential competition. And we also want to make sure with the quality our full year guidance and we maintain our credibility. And as we see changes, we will obviously react to them. But I think that 10 to 16% growth range for the last nine months compared to -- for the next nine months compared to last year is significant for us."
},
{
"speaker": "Graeme Bell",
"text": "Dave, with regard to your question on FOSAMAX, I would point you back to our 10-K filing in that we state the following and it hasn't been updated since then. So, it basically indicates that Merck's basic patent covering the use of the alendronate sodium has been challenged in several European countries. And the company has reviewed adverse decisions in Germany, Holland and the United Kingdom. So the decision in the U.K. was upheld on appeal and you know the situation there. We have appealed the decision in Germany and Holland, and yet company expects a significant decline in European sales of FOSAMAX after the loss of exclusivity period. So, the countries where there is current generic penetration predominantly are in Germany and Holland and obviously the United Kingdom. So, I refer you back to that section in the 10-K. Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bert Hazlett of BMO Capital Market."
},
{
"speaker": "Bert Hazlett",
"text": "Thanks. I have couple of product questions. First on ROTATEQ, do you expect any impact as a result of the MTES assumption, discussions earlier this year? CANCIDAS saw some pressure in the U.S. Should we expect that to continue? And last on ZOLINZA, again a modest rollout initially, but there seems to be a considerable amount of interest in this product. Can you discuss the timing and rollout of the data? What should we expect and what additional indications are being sought? Thanks."
},
{
"speaker": "Judy Lewent",
"text": "So, let me just start on CANCIDAS. As you may recall, there was a price reduction last year and of over 20% on one of the major dosage strengths there and that really had the impact on the product profile. So that really stole dynamic, which we must take into consideration as you look at how Cancidas is progressing."
},
{
"speaker": "Dick Clark",
"text": "And with regard to your question on ZOLINZA, our novel HDAC which we acquired through the acquisition of Aton, October the 6th, marked the approval for the treatment of Cutaneous T-cell Lymphoma, and that initial indication as you can see has began to roll out by virtue of the fact that we recorded revenue this quarter. And ZOLINZA is Merck's first targeted cancer therapy for quite sometime. With regard to incremental studies, we have studies on going in hematological melanoma, solid tumor types including acute myelogenous leukemia, multi-Mellamias. I believe we’ve got ongoing studies in Non-Small-Cell Lung Cancers. In addition, ZOLINZA is being evaluated broadly across a wide range of solid tumor types. So, we have an extensive program underway and we are certainly committed to the HDAC program and oncology generally."
},
{
"speaker": "Graeme Bell",
"text": "Thank you. Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Chris Schott of Banc of America."
},
{
"speaker": "Chris Schott",
"text": "Great, Thank you. Just two quick questions. First on MK-859, your CTP, following the recent to your subscripted data, anything you took away from that. I guess specifically have you made decision whether to move forward into Phase III. If so are you expecting you have run imaging studies before the larger morbidity mortality study? And then a second question, ARCOXIA following the recent panel review, can I know what’s your next step here assuming the FDA request for additional data? Is this a product you would run further studies if they were required to get on the U.S. market. Thank you."
},
{
"speaker": "Dick Clark",
"text": "I think the question on 859 is its still under evaluation by us based on the limited information that was provided. And what we are looking at internally and it's interesting to note that in addition the product development criteria that we have for 859 that we established previously increase in HDL greater than 50%, reduction of LDL of greater than 20% and the important affect on blood pressure that was similar to placebo, that 859 really hit those end points. And so it's important that we take that good information that we have and relate it to the issues that may exist or may not exist for the class. It's early for us to be able to talk about that yet. Certainly, when you talk about ARCOXIA, we are disappointed in the outcome. We continue to believe that ARCOXIA has the potential to become the valuable treatment option for many Americans suffering from osteoarthritis. And the anticipated date for the action by the FDA is April 27 for the six-month timeframe. And we are going to continue to work with FDA on that. Obviously, we are continuing to market ARCOXIA outside the U.S. where it has been approved where broadly with some indications and where they have seen this data that we submitted to the FDA. So, it's too early to tell for the next steps."
},
{
"speaker": "Graeme Bell",
"text": "Well, we will continue on. We still have many questions in the queue. We have inquisitive group this morning. So let's keep ongoing. Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from George Grofik of Citigroup."
},
{
"speaker": "George Grofik",
"text": "Thanks for taking my question. On GARDASIL, can you comment on what kind of off label uptake you may have had in the mid adult female population? And secondly, if you can give us an update on the timing and venue of the presentation of enhanced study results for VYTORIN? Thank you."
},
{
"speaker": "Dick Clark",
"text": "With regard to enhanced, as we have indicated the analysis that's good ongoing, we are still going with that information and we will pick an appropriate scientific forum in order to disseminate the enhanced data when we are ready to do that. With regard to GARDASIL…"
},
{
"speaker": "Judy Lewent",
"text": "Think we can't comment on that. I just don't know that information."
},
{
"speaker": "Dick Clark",
"text": "I think what we have seen anecdotally, is this within the age range that is approved, we have seen broad uptake across all of that age cohort, whether it's 9 all the way through 26 at this stage. But again we don't have any off label specifics. Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Steve Scala of Cowen"
},
{
"speaker": "Steve Scala",
"text": "Thank you. I have two questions. First on the Q4 call, Judy, you mentioned that GARDASIL sales were demand-pull and not inclusive of stocking in clinics and so forth. I assume this is still the case. But, perhaps you can confirm. And secondly, when will we get visibility on whether Merck will exercise its 2008 option on AZLP, or should we assume that Merck will not exercise that option? Thank you."
},
{
"speaker": "Judy Lewent",
"text": "So, you know, whereas I don't have my transcript in front of me, Steve, I do have a recollection that the fourth quarter of '06 was noteworthy in terms of getting approval for the VFD contract. So there was uptick in the fourth quarter for the VFD contract. And that's really consistent with my comments in the first quarter of '07. As far as the 2008 options, as you know, it's too early to call that. We do not have to really declare anything on that until really into the first quarter of 2008. I will say that part of the transition, I am working both internally and with our partner Astra just to ensure that there is a smooth hang off there so that we are all aligned on the process and we understand what needs to be done in the months ahead."
},
{
"speaker": "Graeme Bell",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from John McCoy (Ph) of Natexis."
},
{
"speaker": "John McCoy",
"text": "Yes, thanks for taking my call. Did you guys see any affect from the so-called doughnut hole in the Medicare plan, in that or did people buy into January trying to avoid hitting that doughnut hole in December towards the end of last year? Thanks."
},
{
"speaker": "Dick Clark",
"text": "That data really isn't available to us. That's really hard to make a prediction based on that."
},
{
"speaker": "Graeme Bell",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Seamus Fernandez of Leerink Swann."
},
{
"speaker": "Seamus Fernandez",
"text": "Thank you. Can you hear me?"
},
{
"speaker": "Dick Clark",
"text": "Yes."
},
{
"speaker": "Seamus Fernandez",
"text": "Okay, great. I just wanted to get an update on the timing of the first VIOXX appeal, when we might see that? Second, can you verify for us that the trials that have started with 524B are with the single pill combination? Third, can you also update us on the potency efforts regarding the Varizella based vaccines and where you are in that process? And then, just finally in terms of this suit that you have filed versus Teva and Barr, which is a manufacturing suit on FOSAMAX in the U.S., is there a possibility that this suit could allow generic exclusivity? And if so, is there some form of an agreement that you have for an authorized generic that we could possibly see with FOSAMAX in the U.S.? Thank you."
},
{
"speaker": "Dick Clark",
"text": "Lets take them in reverse order. With regard to the FOSAMAX situation, we are a party by name only in that ongoing discussion, by virtue of some intellectual property that was licensed. So we are not integrally involved in that ongoing discussion and dialogue. And then, jumping to your first question, if I may, Seamus, with regard to the appeals process. In terms of where we are on that, as you know, the first case, which was Ernst in Texas, the appeal brief in that case was filed on April the 5th. So at this point we are still in the very formative stages of that appeals process. And today that is the most advanced of the appeal. So again, we are appealing and in the process of appealing Ernst, Garza, Conna/McDarby, Plunkett, Barnett and Humeston and we will progress and continue to provide you updates. But as I say, even the most advanced of those is Ernst and appeals briefs were only filed on April 5th."
},
{
"speaker": "Dick Clark",
"text": "Your question concerning Varizella potency. We were making excellent progress on the issue. We certainly have narrowed it down to three variables and we are looking at these variables and validating the variables and at then taking it into full production to see the impact. So the progress is being made. We were in validation stage now to see whether the probable cost is where we think it is and we should know that very shortly."
},
{
"speaker": "Graeme Bell",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from David Merris (ph) of Balyasny Asset Management."
},
{
"speaker": "David Merris",
"text": "Good morning. Just a follow-up on, is this the most extensive oncology program that you have on going? And then is there going to be any data at the upcoming ASCO and if so what data should we expect?"
},
{
"speaker": "Dick Clark",
"text": "All right, thank you. I’ll take that quickly. The answer is yes. It is the most advance program that we have in terms of the HDOT program within oncology at this time and its extensive in nature with many on going studies. And as you know, oncology is certainly a focus of area. And with regard to when and where, we have not disclosed this point in what forum we would be disseminating the next round of the data. And with regard to the prior participant's question, I just want to be very clear, with regard to 524B; at this moment in time that trial is being run co-administering 524A with Simvastatin. So at this moment in time, none of the participants are ingesting the triple combo. Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Joe Tooley of AG Edwards."
},
{
"speaker": "Joe Tooley",
"text": "Hi. Good morning. I just want to follow up on the earlier pipeline questions with one on the CB-1 antagonistic MK-0364. It's my understanding you may be looking at lower doses than were originally studied for the drug and given FDA's long-term follow-up requirement for obesity compounds. I was wondering if you could confirm your 2008 filing guidance or the potentially lower dosage range could result many filing delays?"
},
{
"speaker": "Dick Clark",
"text": "I think it's something that we can't comment at - comment with right now from a statement on what’s going to happen in 2008 with that product. You know, it's an important study for us. We've initiated a focus Phase III program in fourth quarter of '06 and we still anticipate filing in this drug in 2008 but we aren't ready nor do we know a lot of the details around the particularly around Phase III outcomes."
},
{
"speaker": "Graeme Bell",
"text": "Next question, please, Taylor."
},
{
"speaker": "Operator",
"text": "Your next question comes from Roopesh Patel of UBS."
},
{
"speaker": "Roopesh Patel",
"text": "Thank you. Just couple of questions, first on GARDASIL in terms of the first quarter GARDASIL sales, can you give us a rough sense as to what proportion the sales were first dose versus second or third dose on GARDASIL. And then separately if I look at the total vaccine sales reported this quarter approximately $900 million, you’ve raised the guidance for total vaccines for the full year to between 3.3 to 3.7 but that implies that sales in subsequent quarters relative to the first quarter will be flat to down looking forward. And I was wondering if you just offer a little more clarity as to what are the dynamics that could influence the trend in that direction? Thanks."
},
{
"speaker": "Dick Clark",
"text": "Well, certainly. Your first question, it is early for us to be able to give statistics around the uptake in the second and obviously the third dose. And that data really isn't available other than you know some dialogues with physicians. So that we’ll have to wait until we get much more experience and much more uptake. And as I said earlier, we have programs in place to help reminder down from both from the physician and the patient. But it is a good question. It's just too early to answer it."
},
{
"speaker": "Graeme Bell",
"text": "Thank you, so given the time, we have one or two more questions. So Taylor, please."
},
{
"speaker": "Operator",
"text": "Thank you. Your next question comes from John Boris if Bear Stearns."
},
{
"speaker": "John Boris",
"text": "Good morning, and thanks for taking my questions. I just have three; first one, just as or is more related to cost of goods. Dick, can you just talk about vaccine yields and I think this year's pretty important year for improving vaccine yields. The type of progress you are making there? And then secondly it seems like there were a fair amount of asset sales going forward. I guess, while all of a sudden are we seeing more asset sales and should be anticipating asset sales of the smaller products going forward. Secondly, I think, this question relates more on the acquisition side. I think earlier in the year you did mention that you were interested in a Biotech acquisition that was aligned from a research therapeutic standpoint with your R&D operations. But would have inline revenues that are actually approved and sold and marketed and have a P&L. Can you just comment on for that type of acquisition what Merck's defined internal rate of return would be for that type of acquisition? And then third on ISENTRESS, I think you wanted to file it in the second quarter I think this is one of your important projects for compressing cycle times. Can you comment as to whether the product has been filed already and you are just waiting for the FDA to indicate that they have accepted the filing. So any type of insight there would helpful? Thank you."
},
{
"speaker": "Dick Clark",
"text": "On your last question, we cannot comment on filing and the timing of it. Other than what we have been already stated publicly. So that is our information we are very comfortable with it. Your question about cost of goods in biologics and vaccines, the good news is that we are making progress there and I think the manufacturing organization is doing a great job of looking at the cost of goods line and trying to focus all the efficiency and effectiveness that we need to be able to accomplish that and obviously when you see the increase in the forecast of vaccine and biological is a part of that is, is productivity and throughput to be able to support that. So it is a major initiative for us, not only for this year, but for the five year plan that we have and that we are making the progress in manufacturing to be able to accomplish that, so I feel good about that. And I would say on the asset sales, there is no integrated focus on selling assets of those types. It was just an opportunity, it was the right thing for the company, and the other companies who are interested in it. So it was a one-time impact. Obviously, from an asset standpoint, as we look at the manufacturing strategy moving forward, there are going to be assets and available based on potential plant closings and when you do that you really step back and look at those assets and see what kind of values they brings to other partners that we have that would be help, but nothing more specific than that."
},
{
"speaker": "Graeme Bell",
"text": "So, with that last question, it concludes today's call. The information on today's call both in transcript and replay will be available on our website for the next seven days and as always we and IR remain available for the rest of the day. We certainly appreciate your interest in participation. So with that operator thank you very much."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today's first quarter 2007 earnings conference call. You may now disconnect."
}
] | null | null |
MSFT | 4 | 2,008 | 2008-07-18 17:30:00 | Operator: Welcome to the Microsoft 2008 fourth quarter and fiscal year-end conference call. (Operator Instructions) I would now like to turn the meeting over to Ms. Colleen Healy, General Manager, Investor Relations. Madam, you may begin.
Colleen Healy: Good afternoon, everyone, and thank you for joining us today. This afternoon I am joined by: Chris Liddell, Senior Vice President and Chief Financial Officer; Frank Brod, Corporate Vice President and Chief Accounting Officer; and John [Setok], Deputy General Counsel. Today’s call will start with Chris providing some key takeaways for the fourth quarter of fiscal year 2008 and an overview of expectations for fiscal year ‘09. I will then provide details around our fourth quarter results and then hand it back to Chris for a more detailed discussion of our guidance for the full year and first quarter of fiscal 2009. After that, we’ll take your questions. Our earnings release includes and addendum of financial highlights, which contains more detailed information about revenue, operating expenses, and other items. We also posted our quarterly financial summary slide deck, which is intended to follow the flow of our prepared remarks in order to assist you. The slide deck offers highlights from the quarter, outlines our guidance, and provides a reconciliation of differences between GAAP and non-GAAP financial measures [inaudible]. You can find the earnings release, the financial highlights, and the quarterly financial summary slide deck on the investor relations website at www.microsoft.com/msft. Today’s call will be recorded. Please be aware that if you decide to ask a question, it will be included in both our live transmission as well as any future use of the recording. As always, shareholders and analysts can listen to a live webcast of today’s call at the Microsoft investor relations website. A replay of the call will be available at the same site through the close of business on July 25, 2009. This conference call report is protected by copyright law and international treaties. Unauthorized reproduction or distribution of this report, or any portion of it, may result in civil and criminal penalties. Any recording or other use or transmission of the text or audio of today’s call is not allowed without the express permission of Microsoft. We will be making statements during this call that are forward-looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in today’s earnings press release, in the comments made during this conference call, and in our most recent Form 10-K, subsequent quarterly reports on Form 10-Q, and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statement. With that, let me now turn it over to Chris.
Christopher P. Liddell: Thanks, Colleen, and good afternoon, everyone. I will start today’s call with a few highlights from the year and then give you an overview of our expectations for fiscal year 2009. Quarter four results capped off an outstanding year for the company in terms of both operating and financial performance. All three of our key financial measures met or exceeded the guidance we provided entering the year, despite a challenging economic environment. For the year, revenue, operating income, and earnings per share increased 18%, 21%, and 32% respectively. Furthermore, the 18% revenue growth represents our fastest annual revenue growth in almost a decade. These results demonstrate the breadth of our business model, revenue growth being fueled by strong customer demand for our products and services across all of our businesses. Our core businesses of client, Microsoft business division, and server and tools turned in fantastic results, growing revenue a combined 15% in the year. The online services business grew revenue 32%, while entertainment and devices division was up 34% for the year. Looking at the fiscal year results from a geographic perspective, revenue in the U.S. increased approximately 15%. Other mature markets were up 16% and emerging markets grew a tremendous 35%. Now for a couple of key points on our outlook for fiscal 2009, with our planning and budgeting process [in place]. Our revenue and operating income [growth trends] remain relatively consistent with what we told you in April. Specifically, we expect revenue growth of 11% to 13%, operating income growth of 17% to 20%, and earnings per share growth of [13% to 17%]. Since we last gave you guidance, we’ve increased investments in three ways. First, we’ve continued to make a number of important inorganic acquisitions. We’re taking the view that the current environment is in fact a positive one to acquire companies if you are in the fortunate position of having a strong balance sheet and a willingness to take a long-term view. Second, we’ve increased organic investments in operating expenses, driven in particular by a deliberate decision to invest more aggressively in our online services strategy. Last, we remain committed to investing in ourselves through our ongoing share repurchases. For the year, we repurchased over $12 billion of our stock, with $5 billion of that amount occurring in the fourth quarter. One final comment before we get into the details; clearly we’re disappointed that our strong financial results are not reflected in our share price because of general market turbulence combined with Microsoft specific issues, including the uncertainty over the outcome of Yahoo! discussions. In this environment, we remain focused on driving the factors inside our control. In particular, from my perspective, improving long-term earnings per share. I’m satisfied that despite difficult economic conditions, should we achieve the middle of our guidance for fiscal year ’09, we will have increased our earnings per share from $1.42 to $2.15 in two years, an increase of 50% over that period. With those high level themes for 2008 and 2009, I’m going to turn the call over to Colleen now for more details on how we closed out last year.
Colleen Healy: Thanks, Chris. The fourth quarter was a solid finish to an outstanding year. For the quarter we met our top and bottom line guidance, driven by 18% revenue growth. Let me provide you with the details of our financial performance, starting with revenue. I will discuss top line financial and business momentum points and then follow with revenue performance for each of the business units. Then I’ll review the rest of the income statement. All growth comparisons relate to the comparable quarter of last year unless otherwise specified. Revenue grew 18% to $15.8 billion, with every business growing in the mid-teens or higher. Our annuity sales mix, which is approximately 40% of our billing revenue, continued to grow on both a year-over-year and sequential basis, with enterprise agreement renewal rates in line with historical trends. The remainder of our product billings for the quarter was approximately 25% from OEM, around 15% from license only sales, and the balance from our other businesses. Our unearned revenue grew 21% to $15.3 billion, over $600 million above our high-end guidance. Our contracted not billed balance increased both sequentially and year over year to over $13 billion, about $3 billion above where we started the fiscal year. When taken together with reported revenue, total bookings for the company grew 23%, driven by over 20% bookings growth for our core businesses of server and tools, client, and the Microsoft business division. Overall, changes in foreign exchange rates added about four percentage points to our revenue growth. Now I will provide revenue highlights by business segment, starting with client and its biggest driver, the PC market. We estimate that the PC unit growth rates for the quarter returned to the 12% to 14% range that we experienced in the first half of the fiscal year. This is about three points above our forecast, due to improvements in mature markets, including in the United States. This helps to drive client revenue growth of 15% to $4.4 billion, which was over $150 million above our high-end guidance. During the quarter, our OEM license units increased by 22%, about nine points faster than the overall hardware market. OEM unit growth outpaced that of the PC market, primarily driven by a couple of factors: one, our OEM partners always have channel fluctuations. With this quarter, we estimate were a combination of replenishing the channel from lower Q3 levels as well as buying [hit some] pricing tiers during the quarter; and two, we returned to the trend of making gains on piracy, including in Asia. OEM revenue increased by 13%. The difference between OEM revenue and unit growth is due to three trends, which you are already well familiar: one, volume mix shift towards emerging markets, which generally have lower ASPs; two, channel mix shift towards large OEMs with volume pricing; and three, premium mix shift toward consumer premium offerings. Specifically, while business and consumer premium units were up year-on-year and the overall OEM premium mix remained unchanged from the prior year at 72%, the premium mix composition shifted down four points of business premium and up four points of consumer premium. The remaining roughly 20% of client revenue comes from commercial and retail licensing. This portion of the business grew over 20%, driven by continued strength in client annuity licensing as business customers continued to demand our enterprise offerings, including those that help them more efficiently manage their desktop infrastructure. During the quarter, we surpassed the 180 million for Windows Vista licenses sold to date and Windows Vista had driven client revenue to an average growth rate of 16% since it became generally available. Moving to server and tools, revenue was $3.7 billion, growing an outstanding 21% on top of the string of Q4 double-digit growth quarters. And this quarter marks the group’s 24th consecutive quarter of double-digit growth. [inaudible] for annuity contracts, covering our [server and tools] offerings continued during the quarter, driving server and tools unearned revenues increased 37% from the beginning of the year. This customer commitment to annuity contracts demonstrates the increasingly critical role our server products perform in information technology infrastructure, as well as an increasing interest in the value offered in our long-term product roadmap. Demand for our consulting and support services remains strong, driving associated revenue growth of 30%. On the product side during the quarter, we released our eagerly anticipated virtualization feature, Hyper-V, two months ahead of schedule. We also made significant progress on SQL Server 2008, which is targeted for release during this, the first quarter of fiscal year 2009. Online services business grew revenue 24% to $838 million. Online advertising grew 18%, including $33 million of ad revenue from aQuantive. While both search queries and page views were up and in line with expectations, monetization lagged, driven by tightening advertising budgets combined with a more competitive display pricing environment. We continued to attract users to our properties with live IDs hitting 460 million, up 80 million from last year. And we grew the number of advertisers utilizing our advertising platform by 28% during the year. We closed the acquisitions of FairCast, which offers technology to aid in the purchase of online tickets at the lowest price, and Navic Networks, which develops tools to deliver targeted ads to television set-top boxes. In May, we announced the beta launch of Live Search Cashback. Since then, we have 680 merchants participating in the program with about 200,000 registered users. Microsoft business division revenue was up 14% to $5.3 billion. The business element of MBD revenue grew almost $700 million, or 19% on both strong enterprise agreement signings and license only sales. Consumer revenue declined $66 million, down 7%. This reflects both a difficult comparison to last year’s quarter following the Office 2007 launch, and a continuation of a shift towards our lower price consumer SKUs. Our emerging business product momentum continues, with SharePoint revenue up over 30% and unified communications revenue up over 20%. During the quarter, we completed the acquisition of Fast Search & Transfer, expanding our spectrum of enterprise search solutions for customers. Our Dynamics business also had a good quarter, with customer billings growth of 22% and two product releases, Dynamics AX2009 and Dynamics CRM Online. Dynamics CRM continues to deliver the function and flexibility customers want, evidenced by over 120,000 CRM seats being sold in the quarter. Entertainment and devices division grew revenues 37% to $1.6 billion. We sold 1.3 million Xbox 360 consoles, representing 88% growth over the prior year and passing the milestone of 20 million consoles sold life to date. In May, we announced that Xbox Live reached 12 million members, roughly doubling in membership for each of the last two years. Software attach rate continued to lead the industry at 7.7 software titles per console. As was evident at E3 earlier this week, the interactive entertainment business was extremely busy during the quarter, securing industry-leading media content providers such as Netflix, NBC, Universal, Constantine, MGM International, as well as developing innovative new gaming and social experiences that will continue to expand our audiences. The mobility business within the entertainment and devices division completed the acquisition of Danger and released System Center Mobile Device Manager 2008, which has created the opportunity for our sales force to partner with customers’ IT departments, helping them manage their mobile device assets with capabilities similar to those already used to manage PCs. And Microsoft Surface moved into early commercial deployment in AT&T stores and [inaudible], [as you know.] Now for the rest of the income statement: adjusting last year for the impact of the $1.1 billion charge related to the expansion of the Xbox 360 warranty policy, cost of revenue as a percent of sales increased one point to 18%, driven by increasing Xbox 360 console sales, costs associated with the growth of our consulting and support services, as well as data center equipment and online content expenses in our online services business. Operating expenses increased $1.1 billion, or 19%, driven primarily by headcount related costs, acquisition related expenses, and marketing related expenses. Expenses came in $500 million higher than our guidance, split rather evenly between cost of revenue and operating expenses. First, cost of revenue; we sold more Xbox 360 consoles than our guidance had reflected. In server and tools, the higher revenue growth in our consulting and support services carries higher associated costs than does software revenue. In our online services business, we were able to bring servers in our data centers online faster than expected and we invested in premium online content, which is [higher creative and agency fees associated with it]. Moving on to operating expenses, we took advantage of the economic environment out there to attract top talent for the company, yielding higher close rates and filling headcount openings. Also, across a number of our businesses, we spent more on product development and efforts to ready marketing campaigns, and foreign currency rates presented some headwind. Operating income was $5.7 billion, up 42% or 13% after adjusting for the impacts of the warranty related charge in the year-ago period. Investment income and other totaled $284 million, as the Microsoft treasury team continues to successfully navigate a challenging capital market environment. Our effective tax rate for the quarter was 28%, a couple points lower than expected, driven by an earnings mix increase in lower tax jurisdictions. During the quarter, we repurchased 171 million shares, or almost $5 billion of company stock, and paid out about $1 billion in dividends to shareholders. Diluted shares outstanding were $9.4 billion, down 3% from the prior year, as a result of share repurchases. Earnings per share were $0.46, in line with our guidance and growing 48%, or 18% after adjusting for the warranty related charge in the prior year. So in summary, we had our fastest growing fourth quarter revenue since 1999. Adjusting of the year-ago Xbox warranty charge, operating income and EPS grew 13% and 18% respectively. With that, let me turn it back to Chris who will provide you with our first quarter and full year guidance for fiscal 2009.
Christopher P. Liddell: Thanks, Colleen. I’m going to spend my remaining time on the call talking about what we see coming for the full year and for the first quarter. Let me begin by outlining some of our key assumptions around the economy and general demand in the industry. The forecast generally assumes a continuation of the economic conditions and demand we experienced in the fourth quarter to continue into the first half of fiscal year ’09, with some improvement over the second half of the year. We expect PC unit to remain healthy with growth rates similar to those in 2008. Specifically, we expect PC unit growth in fiscal 2009 to be 12% to 14% for the year and between 10% to 12% for the first quarter. We estimate that growth rates will continue to be driven by roughly 20% growth in emerging markets, with high-single-digit growth in mature markets. Now let me go through our detailed guidance; for the full year, we expect our revenue to come in between $67.3 billion to $68.1 billion, growing 11% to 13%. For the first quarter, we expect revenue of $14.7 billion to $14.9 billion, which represents an increase of 7% to 8%. With that, revenue guidance by business group is as follows: for client, we expect full year growth to be 9% to 10% and Q1 growth to be 6% to 7%. The PC market growth will outpace that of client revenue because of a continuation of the underlying PC market dynamic, namely emerging market PC growth outpacing mature markets, consumer growth exceeding business growth, and the shift in the system build channel to large OEM. Server and tools revenue should be up 18% to 19% for the year and 19% to 20% for the first quarter. Coming off another impressive year of growth in fiscal year ’08, the server and tools business is expected to continue to show double-digit growth across the breadth of our server platform products and services, driven by strong customer demand for the recently refreshed Windows Server and Digital Studio offerings, and the soon-to-be-available SQL Server 2008. We forecast revenue in the online services business to increase 18% to 20% for the year, and 7% to 11% for the first quarter. The advertising component of revenue is expected to grow at approximately 25% for the year and 15% for the quarter. Our Q1 guidance assumes the continuation of the challenging online advertising market experienced in the fourth quarter. We expect revenue growth will accelerate through the year as we begin seeing returns from the additional investments we are making in the business. Our business division revenue should be up 14% to 15% for the year and 15% to 16% in the first quarter. We should continue to see business demand for Microsoft Office 2007, SharePoint, and Dynamic products. Combined with growth in our emerging unified communication and business intelligence offering, this will drive another year of very strong growth. Fiscal 2009 also represents an important year in delivering on our software for services strategy, with the upcoming releases of Exchange Online, SharePoint Online, and Office Communications Online later this calendar year. For the entertainment and devices division, we expect revenue to be down 4% to flat for the full year, and down 23% to 26% in Q1. The strong customer demand for Halo 3 following its launch in fiscal 2008 makes for challenging year-over-year comparisons in the entertainment and devices division. But having said that, we remain committed to a profitable performance in fiscal year ’09. Turning back to company wide performance, operating income for the year is expected to be between $26.3 billion and $26.9 billion, increasing 17% to 20%, or 10% to 12% excluding certain tax and legal charges in fiscal 2008. For the first quarter, we expect operating income to be between $5.9 billion and $6 billion. Q1 operating income includes the impact of increased spending associated with our online services business, costs associated with a number of new acquisitions, and investments in a new Windows consumer marketing campaign. I would like to address the overall level of -- the impact of the overall level of spending on the company margin. To do so, as I’ve told you before, we need to look at the three individual parts of the company that have distinct margin structures. The core businesses of client, server and tools, and Microsoft business division collectively will have an operating margin in fiscal 2009 that’s essentially flat. This performance is obviously very good, given that we are making a number of investments to drive the overall health of the business and absorbing a number of acquisitions we’ve made this year and growing revenue in mid-teens. The margin for entertainment and devices should also remain roughly the same year-on-year in fiscal year ’09, even without a first party game release of Halo 3’s magnitude. So taken together, our businesses representing over 90% of our revenue will grow double-digits next year with the margin structure intact. Clearly the online services business has a totally different dynamic and is in a period of significant investment. We do not make these investments lightly, as the loss in this division will be a drag on an otherwise exceptionally good performance. However, we believe that the additional investments of several hundreds of millions of dollars is worth the short-term cost, given the opportunity to participate in a market where the opportunity is measured in the tens of billions of dollars. So I wanted on the call to take a few minutes to frame our reasoning behind the additional online service business investments. I will start with an overview of our broad strategy and then provide details into the additional investments. With the online ad spending expected to reach $80 billion by 2012, this area represents one of the largest growth opportunities for the company. We segment the market for online advertising in four distinct categories -- search, advertising platforms, information content, and communication and social networking. For search, we’re focused on driving query share improvements and business model innovation, specifically in the area of high value commercial search. Our recent release of Cashback is a good example of executing on our strategy, which combines innovation in the shopping experience with a shift in the distribution of advertiser economic towards the end users. Additionally, we also [seek to win] targeted distribution through OEMs, ISPs, ISVs, and retailers. The recently announced deal with HP in the U.S. is an example of [this]. Turning to the ad platform, our strategy can be summarized as consolidate [when in] display, and there we are focused on integrating our advertising assets into a single comprehensive system that can deliver our publishing partners’ industry leading yields and our advertisers optimal return on their ad spend. In the area of communication and social networking, which includes our mail, messenger, and social networking assets, such as Spaces, we’ll deliver the leading end-to-end experiences across the PC, phone, and web. And finally, in the category of information content, we plan to invigorate our MSN portal experience with improvements in user experience, social media consumption, and premium content. As well as overall advertising revenue, which is clearly the overall measure of success, we have aggressive growth targets in each of the above areas over the next five to 10 years. These targets can be broken down in terms of the percentage of share of worldwide page views, percentage of share of Internet [inaudible], the percentage share of search queries, and percentage of the growth of the online advertising dollars that pass through our platform. Clearly the Yahoo! transaction, which I’ll make some more comments on later, would have accelerated our progress towards these goals. However, during the quarter, a transaction became increasingly unlikely. Further, as you know, during the quarter Yahoo! signed a search outsourcing agreement with Google. Given that environment, we made some decisions to accelerate our online services’ organic growth strategy. Mainly we decided to increase our investment in the high-margin scalable areas of search and ad platforms. So about two-thirds of the incremental spend that we are planning is related to investments to drive usage of our search offering. We’re dialing up our search distribution initiatives with targeted OEM toolbar [alt] search deals, scaling search globally with investments in localized engineering and data centers, pursuing acquisitions and partnerships to build vertical content to support our commercial strategy, accelerating the rollout of our Cashback program, and increasing marketing in the business to grow awareness and drive traffic. Second, we are upping the investments in our ad platform and increasing the number of advertisers and high quality inventory on that platform. Specifically, these investments are in the area of accelerating the integration of our ad platform assets, expanding our sales and service capabilities, small acquisitions to enhance the platform technology, and investments in strategic partnerships to increase third-party inventory available to advertisers on our ad platform. So turning to EPS, our diluted earnings per share for the year are expected to come in at $2.12 to $2.18, representing growth of 13% to 17%, two to four points faster than revenue. To put this performance in context, as I mentioned at the front of the call, if we achieve the middle of our guidance, we’ll have increased earnings per share from $1.42 to $2.15 in two years, an increase of 50%. But first quarter we expect earnings per share of $0.47 to $0.48, and these earnings assume an effective tax rate of 28%. From a balance sheet perspective, we expect total unearned revenue to finish fiscal 2009 up 8% to 9%. [Contracts not filled] should also finish 2009 up from current levels. When thinking about sequential changes in unearned revenue from Q4 fiscal year ’08 to Q1 fiscal year ’09, we expect a sequential decrease from Q4 to Q1 to exceed the rate of decline we experienced the last few years. As always, when thinking about the guidance we provide, you should also consider the risks. These include competitors, legal, execution and general market risks such as foreign exchange rate movements, fluctuations in PC and server hardware growth rates, IT spending, changes in the piracy rate, and customer acceptance of our new and existing products. Additionally, changes in the mix of our billings between annuity and license only can have an impact on revenue, operating income, and EPS by delaying revenue recognition into future periods. So in closing, the strong results of fiscal year ’08 were the outcome of both business and engineering execution. In addition to the financial out-performance, we delivered the final phase in our multi-year product refresh cycle with the availability of Windows Server 2008 and Visual Studio 2008, and are well-positioned to continue that momentum into fiscal 2009. The next fiscal year will be an important year, driving mass adoption across the portfolio of products. With our breadth of products and global diversification, we are confident in our ability to continue to deliver double-digit revenue increases even off our base of over $60 billion, and we will continue to use our strong cash flow to invest in our organic growth, inorganic growth through acquisitions, and in ourselves through buy-backs. Before I hand the call back to Colleen, I want to take a moment to clarify the terms of our recent proposal for a search transaction with Yahoo!. Given the upcoming Yahoo! shareholder meeting, I won’t be taking any questions on this topic in the Q&A section that will follow this presentation and we won’t be providing any additional comments on matters we’ve already discussed. But with that, let me outline for you the key elements of our proposal. Firstly, we are providing significant revenue guarantees. Microsoft proposed a 10-year minimum revenue guarantee totaling between $19.5 billion and $26.5 billion. For the first five years, the guarantee is $2.3 billion per year. There afterwards, both Yahoo! and Microsoft have the option to extend the agreement for an additional five-year period. If Yahoo! unilaterally chooses to extend the agreement, the guarantee would be for $1.6 billion per year after the extension. Conversely, if Microsoft unilaterally chooses to extend the agreement, the guarantee to Yahoo! would be $3 billion per year after the extension. These guarantees are not conditional on Yahoo!’s search queries, but rather the guarantees are tied to Yahoo!’s homepage performance. Our proposal includes an 85% TAC rate for the first three years of the agreement and 70% there afterwards. Microsoft would pay Yahoo! $1 billion for its search assets, provide $2.8 billion of senior debt to Yahoo! on favorable terms, and make a significant equity investment in Yahoo! through the purchase of $3.9 billion of Yahoo! stock at $19.50 per share, reflecting our view of the value of the company as a result of our proposed transaction and the distribution of cash and the Yahoo! Asian investments by Yahoo! to its stockholders. I should also note that Microsoft’s proposal did not and does not include changes to Yahoo!’s governance. We clearly continue to believe that our proposal is a compelling one. With that, I am going to hand the call back to Colleen so we can get started taking your questions, and I clearly look forward to seeing a number of you at our financial analyst meeting, which is next Thursday.
Colleen Healy: Thanks, Chris. Let’s now proceed to questions. We want to accommodate questions from as many people as possible, so please avoid multi-part questions and limit yourselves to just one question. Operator, will you please repeat your instructions?
Operator: (Operator Instructions) The first question comes from Sara Friar with Goldman Sachs.
Sara Friar: Good afternoon, everyone. Thanks for taking my question. Chris, just firstly, could you give us a little bit of your overview on the macro environment and how that’s changed when you think back to giving earnings three months ago? And then, just on your cash flow, it came in a little weaker than we were anticipating. DSOs were up higher than we have seen in perhaps ever for Microsoft. Was there a collections issue, more back-end loading? If you could perhaps talk to the weakness there.
Christopher P. Liddell: Sure. Okay, taking those in turn, in terms of the macro environment, it’s broadly speaking the same as what we were expecting in April. Clearly people are getting concerned now about the length of softness here in the U.S., but as you’ve seen for revenue, we’ve taken it up slightly since April, so in terms of the visibility into our products, we are actually feeling very good about our position, not only here in the U.S. but outside the U.S. I mentioned in my comments, if you look at the company overall, our sales in the U.S. in the year that we just completed were up 15%. The company overall is up 18% so clearly we grew faster outside the U.S. than we did inside the U.S., but at 15%, given it’s been a difficult environment for a number of companies, growing at 15% off our base was very good. So going into next year, we are clearly cautious like everyone is about the impact of the environment but for our products overall, we are feeling very good. I’d say the one proviso to that is in the online advertising space, where we are seeing a direct impact. It was weak in the fourth quarter and I think you are seeing from results of other companies as to the weakness in that general space. So there is a direct impact and we are not immune to that in the online space and we’ll probably see that continuing certainly for the next quarter. But overall in terms of our core business growth, it feels very good. In terms of your other questions on cash flow, the biggest thing in the cash flow that was probably a negative was the payment of the fine to the E.U., which was over $1 billion, so -- $1.5 billion, so that was clearly a big negative from a cash flow point of view. Other than that, there really wasn’t anything remarkable from a cash flow point of view. In fact, it was quite a strong quarter, given the results overall.
Colleen Healy: And on a DSO standpoint, Q4 seasonally does tend to be a little higher than some of the other quarters. We do close a lot of business in our fiscal Q4 as the sale force is out there closing deals. But we didn’t see anything unusual from a DSO standpoint.
Christopher P. Liddell: But overall, I’d say revenue growth of 18% last year, guiding to revenue growth of 11% to 13%, so you combine those and so that’s 30% broadly for the two years that cover what was hopefully the worst of the economic condition, so we’re feeling good about it.
Sara Friar: Okay. And there were -- okay, thanks.
Colleen Healy: Okay, thanks, Sara. Next question, please.
Operator: The next question comes from Heather Bellini with UBS.
Heather Bellini: Good afternoon. I was just wondering, Chris, if you could talk a little bit about the OSB business. Given how far behind you guys are, if you’re unsuccessful in getting all or even a part of Yahoo!, can you walk us through how you are going to be able to compete with Google? And also, are we in a critical period here in this segment where if you continue to go down the path of going it alone that we are going to be seeing this accelerating spending from current levels so that it’s going to adversely impact overall op-margin, so we’re actually not going to see op-margins expand for the next few years? Thanks.
Christopher P. Liddell: Sure. Okay, overall, clearly regardless of what happens with Yahoo!, it’s a space that we’re committed to. I said that in the prepared remarks and it’s one that we’re committed to on a long-term basis. I would split the market, as I did in my prepared remarks, into four areas, of which search is only one -- ad platform, communications, central networking, and information content being the other ones, and clearly we have a very good position in information content and communications in an ad platform with the acquisition of aQuantive. So we feel very good about our relative position in those areas and a number of our investments are going into that. In the search area, clearly that’s the one where, relatively speaking, we are the most behind and that’s why we’re taking a different approach, which again I mentioned in the prepared remarks where we are focusing in particular on the areas of search where there’s a strong commercial intent, our verticals like retail, travel, real estate, local. We’re looking at different approaches where we might potentially take a disruptive and innovative business model, for example, Cashback, and then looking at winning distribution deals. Now in the short-term, that isn’t going to make the division profitable and I think clearly from our guidance, that’s not the case. So as I said in the remarks, if you look at the operating margin structure of the company, you really have to look at the three distinct businesses. We feel good about the margin structure for our core businesses in particular growing double-digit revenue on. Entertainment and devices will be broadly flat but online is going to be negative --
Heather Bellini: Chris, yeah, I totally get what you are saying. I guess the question that I’m getting asked a lot is how long are you going to spend -- you are obviously performing well on the top line but your spending the upside so that people aren’t getting margin expansion. I guess the question that I’m getting asked is how long should we expect that to continue?
Christopher P. Liddell: We’re not going to make -- certainly on this call we’re not going to give guidance for fiscal year ’10 and ’11. Some of these investments that we are making will be multi-year, so it will depend to a large extent on our revenue growth as to when that division becomes profitable. So it will need to continue to grow relatively substantially in order to cover the level of investments that we are making, but it is going to be, and I think we’ve made this point on previous calls, it is going to be an investment [in the] area, in particular things like the ad platform, where we see it converging to two natural players over time, of which we clearly would expect to be one, and that’s an area where spending in particular on infrastructure is likely to be high. So I can’t promise you that you are going to see a massive turnaround in the short-term, and certainly in fiscal year ’09, which is the year that we are guiding to today, it is going to be a continuation of an investment. But again, put it in the context of what we would describe as the overall opportunity and the size of the company overall.
Heather Bellini: Thank you.
Colleen Healy: Thanks, Heather. Next question, please.
Operator: The next question comes from Charles Di Bona with Sanford Bernstein.
Charles Di Bona: I would like to circle back to the Q4 results and really particularly the margins here -- I think the Xbox issue is fairly straightforward but in something like five of the last eight Q4s, you guys have had an issue about being disappointing on margins, and maybe you can give us some color and comfort on what sort of looks to be a fairly persistent control issue in Q4, and in some cases it looks like you might be pulling some of the expenses forward. Are we going to see that in the fiscal ’09 numbers?
Christopher P. Liddell: I always distinguish, Charlie, between the costs, which were, if you like, a function of the revenue, a function of decisions that we made, and functions of unexpected low quality spend, if you like. But I can give you some comfort -- it’s the areas that we spent more of in the fourth quarter were more [inaudible] in the first two. For example, on the revenue side, we sold more Xboxes, so we had more COGS. That’s good news, okay? We don’t make any money from those but overall in terms of long-term health of the business, the more consoles we sell, the better. In server and tools, the higher enterprise services revenue carries higher COGS with it -- again, that’s just a factor of it. So the mix inside server and tools might not be as strong as you would like from a revenue point of view, but that’s just a natural consequence. In terms of decisions that we made, we have budgeted headcount and people hired to their budgeted levels. That’s a good thing in the sense that we actually hired people that we want to hire and we were particularly successful. I think that’s a reflection to a large extent of the economic environment and the fact that if anything at the moment, we are an even more attractive company than we have been to people. So again, that hits us from an expense point of view, but I’d describe it in one of the categories, you know, it’s a conscious decision to hire people. In terms of things that were outside our control, FX was a factor. FX has been our friend pretty much throughout the year in terms of driving more revenue upside than more expense, net net it’s been a positive, clearly because we have more revenue outside the U.S. than we do expenses. In the fourth quarter, it was an unusual quarter in that we hired a lot of people outside the U.S. and the mix of expenses was such that the FX impact was higher on OpEx than it was on revenue. If you look across the year, that’s not the case but in the quarter, it was. So I’m comfortable that there’s not any lack of control over spending. Most of the decisions I’ve talked about were either conscious ones or were a reflection of better revenue performance in certain areas.
Colleen Healy: Great, thanks, Charlie. Next question, please.
Operator: The next question comes from Kash Rangan with Merrill Lynch.
Kash Rangan: Thank you very much. It looks like stepping up investments in the online services business seems like the right thing to do. I’m just curious, Chris, what -- I would have expected that to be accompanied by an increase to the revenue guidance, yet when you look back over the last 12 months, if I exclude aQuantive, I still come up with much faster revenue growth in the online services business. So my question is, is the return on these investments going to take more than one year sort of a lag to show up in the financials, or is there some conservatism in how you are budgeting for the revenue productivity as a result of these investments? Is there a longer lag to these OpEx investments? And also, maybe three of our seconds of your thoughts on client guidance. I know Colleen didn’t want multi-part questions, but I couldn’t resist this; the 6% to 7% growth absent currency looks to be very low on the 2% to 3%, so I’m just curious what was the thought process that went into that guidance as well. Thanks.
Christopher P. Liddell: Okay, sure. Kash, you went blank through the start of your question, so if I don’t cover it exactly, please come back to me. We missed just the first few words of your question, but in terms of online spending, is it likely to be more of a fiscal year ’10 impact on revenue? The answer is yes, and that’s not only because of the nature of some of the investments that we are making. Things like marketing Cashback, that’s going to take time in terms of seeing the real impact from that. But also, just because -- as I mentioned I think to Sara’s question, the online advertising area is probably the part of the business certainly in the short-term which we think is most challenging. From an economic environment point of view, we have actually done remarkably well in our commercial businesses and overall for PCs, getting through difficult and choppy economic waters. The online advertising area is very difficult at the moment and I think that’s across the board. That’s not just us, so I don’t want to promise -- you know, we might see benefits, for example, in share but I’m not sure that share is necessarily [in best display] in the search area. Again, it translates in the -- certainly in the first six months and possibly across the year to significant revenue growth but I think you could expect to see us make progress in the areas that I talked about, which is the underlying dynamics, the driver of the -- percentage minutes, percentage share, et cetera. That’s really how we are going to have to measure ourselves over the next year. I think the second half of your question was client-specific, is that right?
Kash Rangan: That’s correct, yes.
Christopher P. Liddell: In the 6% to 7%, yeah, that is relatively light. To some extent, it’s because of the very high, strong quarter one that we had last year. If you’ll recall, we had a very strong quarter one piracy performance in last year. It’s also part of the strong Q4 performance from this year, which Colleen mentioned in the prepared remarks, was some channel inventory. We -- if you like, it was a very strong unit growth in quarter four fiscal year ’08. Some of that was because of a weak Q3. You’ll recall our Q3 call, we talked about some of the inventory issues there and that was one of the reasons why Q3 of last year was weak. So it feels like a bit of a borrowing from Q3 into Q4, and also we think a little bit of some of our customers may have bought forward from Q1 into Q4 as well, so that’s one of the reasons. The other is we’ve got 10% to 12% PC unit growth expectation, which relative to the year of 12% to 14%, we’re just seeing that quarter as being one of the low points. So you combine all of those factors and we think that’s going to be the lowest revenue growth quarter for client in the year.
Colleen Healy: Great, thanks a lot, Kash. Next question, please.
Operator: The next question comes from Brent Thill with Citigroup.
Brent Thill: Thanks. Chris, the overall buy-back for ’08 was more than cut in half from ’07. Obviously that’s understandable considering the acquisition strategy, but I guess as it relates to the overall plan, you only have $3 billion left on the current $36 billion plan. How aggressive at 25 and change will you be with the stock here?
Christopher P. Liddell: Okay, yeah -- going backwards and then going forwards, backwards -- yes, you are right, it was lower than the previous year. One of the reasons for that is we were getting down to a level of cash that we feel more comfortable with, so there was some accelerated buying in the previous year. The other impact was we see that the aQuantive acquisition, which was relatively expensive this year, and the last factor is when we announced the Yahoo! acquisition earlier this year, we went out of the market but from a sensitivity point of view, and clearly at that stage we’re envisaging having to use a large part of that cash for the acquisition. Subsequent to May when it was clear that the overall transaction wasn’t going to happen, we went back into the market and we have been buying at levels that are more like historic levels. So those are the reasons why we’ve been less in the year. It was $5 billion I believe for the quarter, so it was a reasonably strong buy-back quarter. Clearly at these prices, it’s incredibly attractive from a buy-back perspective. I can’t tell you, as I never do on a quarter by quarter basis exactly how much we will buy back. You’re right that we only have about $3 billion worth of our buy-back left. That’s good news in the sense that I think we gave ourselves until 2012 to complete it, so we can put it at a little ahead of schedule. What we do here is we complete the current buy-back, and then we go back to the board for authorization of any subsequent buy-back, and that would be exactly the process that we do here and if and when we get authorization from the board to do further buy-backs, we’d clearly announce the amount at that stage. But similarly wouldn’t announce exactly the shape of what we do. But clearly the value of the company relative to the last three years is as good as it’s been.
Colleen Healy: Thanks a lot, Brent. Next question, please.
Operator: The next question comes from Adam Holt from Morgan Stanley.
Adam Holt: Good afternoon. I have a question about Office and MBD. Obviously Office 2007 has been a terrific product cycle, but MBD has been a little bit light relative to guidance for the last couple of quarters. Could you maybe talk about where you think we are in the Office 2007 cycle, and what gives you confidence that we’ll see a reacceleration of growth in MBD next year versus what we saw in the back half of this year?
Christopher P. Liddell: Well overall, obviously the MBD division did extremely well last year, so put that in context but you’re right in the sense that Office was slightly lighter than we might have thought, mainly to be honest in the consumer area, and that’s around lower price SKUs in retail. So we’re seeing more of a buy from the volume that we’re seeing. The volumes are very good and business sales are very good but the volumes in the retail side tend to be more in the lower priced SKUs, so that’s having an impact overall. But the overall volume and the overall adoption and reaction to Office 2007 has been extremely good, so we feel good and we’ve put it inside our business group, which grew at 15% to 20% last year.
Adam Holt: So as we look at it next year, should we be thinking about dynamics and share points being the key drivers, or should we expect office to reaccelerate?
Christopher P. Liddell: I think those emerging products are certainly going to make a big difference. We’re guiding 14% to 15%. That’s very good. I mean, Office is unlikely to grow at 14% to 15%. It’s likely to grow at more like high to single digits. But the other parts of the business will grow extremely well, and that is going to average it up to 14% to 15%, so you’re right. SharePoint, Office Communications, some of the online services that we are bringing in will start to have an impact. So overall, it’s now our biggest division in terms of revenue, 14% to 15% looks very good.
Adam Holt: Terrific. Thank you.
Colleen Healy: Thanks, Adam. Our next question, please.
Operator: The next question comes from Robert Breza with RBC.
Robert Breza: Just looking at the $500 million in expenses that you are talking about, how should we think about that trending through the year? And then, depending on any outcome from an acquisition perspective, would you look to accelerate that investment or decelerate that investment? Thanks.
Christopher P. Liddell: It has slightly different dynamics. In terms of the consumer marketing, that’s probably going to be front loaded in the year, and one of the reasons for our first quarter being relatively light compared to the other quarters would be some of the marketing spend that we see in the first quarter. In terms of some of the online spending, that’s probably going to be more progressive through the year. In terms of acquisitions, that’s really going to be opportunistic. We closed a lot in the fourth quarter, and one of the things that is impacting our results is clearly the amount of non-cash amortization associated with acquisitions, and that was relatively substantial last year. It was over $300 million. We don’t call that out, as some companies do, and take the benefit of adjusting our results to reflect that. We take that probably through the P&L and next year in terms of the guidance we’ve given you, we expect it to be more than $300 million. How much more and exactly the shape will depend on acquisitions. We have an expectation of it that we build in and -- but it will grow progressively through the year. It’s all non-cash but we’ll continue to take the full impact through the P&L.
Robert Breza: That’s helpful. Thank you.
Colleen Healy: Thanks, Robert, and our last question, please, Operator.
Operator: The last question comes from Kirk Materne with Banc of America Securities.
Kirk Materne: Thanks very much. Chris, you talked in the guidance just on entertainment and devices about maintaining profitability. Given that there’s no sort of new cycle of the hardware this year, is there any reason why profitability shouldn’t start to trend up as attach rates get better? Is there anything going on in that business that’s going to require say more advertising dollars or spending in that?
Christopher P. Liddell: One of the impacts obviously as we dropped prices during the course of last year, so year-on-year we have slightly difficult price comparisons. The other thing is there’s more than just X-Box sitting in there. There’s obviously Windows Mobile, which has got a lot of opportunities, so there are other areas that we will be spending on. We aren’t in the comments of today giving any guidance on profitability. My comment was simply that it will sustainable profitability, but we’re not saying whether that’s going to be significantly up or down from where it was last year.
Kirk Materne: Okay. Thanks very much.
Colleen Healy: Thank you and thank you to everyone for your participation in today’s call. If you have any further questions, please feel free to call me or my team directly. We’re very much looking forward to seeing you at our financial analyst meeting next week. As I mentioned at the beginning of this call, this conference call will be available on replay at our investor website through close of business July 17, 2009. In addition, you can hear the replay by dialing 866-515-1618, or for international calls, dial 203-369-2027. The dial-in replay will be available through the close of business July 25, 2008. Thanks again for joining us today.
Operator: That concludes today’s call. Please disconnect your line at this time. | [
{
"speaker": "Operator",
"text": "Welcome to the Microsoft 2008 fourth quarter and fiscal year-end conference call. (Operator Instructions) I would now like to turn the meeting over to Ms. Colleen Healy, General Manager, Investor Relations. Madam, you may begin."
},
{
"speaker": "Colleen Healy",
"text": "Good afternoon, everyone, and thank you for joining us today. This afternoon I am joined by: Chris Liddell, Senior Vice President and Chief Financial Officer; Frank Brod, Corporate Vice President and Chief Accounting Officer; and John [Setok], Deputy General Counsel. Today’s call will start with Chris providing some key takeaways for the fourth quarter of fiscal year 2008 and an overview of expectations for fiscal year ‘09. I will then provide details around our fourth quarter results and then hand it back to Chris for a more detailed discussion of our guidance for the full year and first quarter of fiscal 2009. After that, we’ll take your questions. Our earnings release includes and addendum of financial highlights, which contains more detailed information about revenue, operating expenses, and other items. We also posted our quarterly financial summary slide deck, which is intended to follow the flow of our prepared remarks in order to assist you. The slide deck offers highlights from the quarter, outlines our guidance, and provides a reconciliation of differences between GAAP and non-GAAP financial measures [inaudible]. You can find the earnings release, the financial highlights, and the quarterly financial summary slide deck on the investor relations website at www.microsoft.com/msft. Today’s call will be recorded. Please be aware that if you decide to ask a question, it will be included in both our live transmission as well as any future use of the recording. As always, shareholders and analysts can listen to a live webcast of today’s call at the Microsoft investor relations website. A replay of the call will be available at the same site through the close of business on July 25, 2009. This conference call report is protected by copyright law and international treaties. Unauthorized reproduction or distribution of this report, or any portion of it, may result in civil and criminal penalties. Any recording or other use or transmission of the text or audio of today’s call is not allowed without the express permission of Microsoft. We will be making statements during this call that are forward-looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in today’s earnings press release, in the comments made during this conference call, and in our most recent Form 10-K, subsequent quarterly reports on Form 10-Q, and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statement. With that, let me now turn it over to Chris."
},
{
"speaker": "Christopher P. Liddell",
"text": "Thanks, Colleen, and good afternoon, everyone. I will start today’s call with a few highlights from the year and then give you an overview of our expectations for fiscal year 2009. Quarter four results capped off an outstanding year for the company in terms of both operating and financial performance. All three of our key financial measures met or exceeded the guidance we provided entering the year, despite a challenging economic environment. For the year, revenue, operating income, and earnings per share increased 18%, 21%, and 32% respectively. Furthermore, the 18% revenue growth represents our fastest annual revenue growth in almost a decade. These results demonstrate the breadth of our business model, revenue growth being fueled by strong customer demand for our products and services across all of our businesses. Our core businesses of client, Microsoft business division, and server and tools turned in fantastic results, growing revenue a combined 15% in the year. The online services business grew revenue 32%, while entertainment and devices division was up 34% for the year. Looking at the fiscal year results from a geographic perspective, revenue in the U.S. increased approximately 15%. Other mature markets were up 16% and emerging markets grew a tremendous 35%. Now for a couple of key points on our outlook for fiscal 2009, with our planning and budgeting process [in place]. Our revenue and operating income [growth trends] remain relatively consistent with what we told you in April. Specifically, we expect revenue growth of 11% to 13%, operating income growth of 17% to 20%, and earnings per share growth of [13% to 17%]. Since we last gave you guidance, we’ve increased investments in three ways. First, we’ve continued to make a number of important inorganic acquisitions. We’re taking the view that the current environment is in fact a positive one to acquire companies if you are in the fortunate position of having a strong balance sheet and a willingness to take a long-term view. Second, we’ve increased organic investments in operating expenses, driven in particular by a deliberate decision to invest more aggressively in our online services strategy. Last, we remain committed to investing in ourselves through our ongoing share repurchases. For the year, we repurchased over $12 billion of our stock, with $5 billion of that amount occurring in the fourth quarter. One final comment before we get into the details; clearly we’re disappointed that our strong financial results are not reflected in our share price because of general market turbulence combined with Microsoft specific issues, including the uncertainty over the outcome of Yahoo! discussions. In this environment, we remain focused on driving the factors inside our control. In particular, from my perspective, improving long-term earnings per share. I’m satisfied that despite difficult economic conditions, should we achieve the middle of our guidance for fiscal year ’09, we will have increased our earnings per share from $1.42 to $2.15 in two years, an increase of 50% over that period. With those high level themes for 2008 and 2009, I’m going to turn the call over to Colleen now for more details on how we closed out last year."
},
{
"speaker": "Colleen Healy",
"text": "Thanks, Chris. The fourth quarter was a solid finish to an outstanding year. For the quarter we met our top and bottom line guidance, driven by 18% revenue growth. Let me provide you with the details of our financial performance, starting with revenue. I will discuss top line financial and business momentum points and then follow with revenue performance for each of the business units. Then I’ll review the rest of the income statement. All growth comparisons relate to the comparable quarter of last year unless otherwise specified. Revenue grew 18% to $15.8 billion, with every business growing in the mid-teens or higher. Our annuity sales mix, which is approximately 40% of our billing revenue, continued to grow on both a year-over-year and sequential basis, with enterprise agreement renewal rates in line with historical trends. The remainder of our product billings for the quarter was approximately 25% from OEM, around 15% from license only sales, and the balance from our other businesses. Our unearned revenue grew 21% to $15.3 billion, over $600 million above our high-end guidance. Our contracted not billed balance increased both sequentially and year over year to over $13 billion, about $3 billion above where we started the fiscal year. When taken together with reported revenue, total bookings for the company grew 23%, driven by over 20% bookings growth for our core businesses of server and tools, client, and the Microsoft business division. Overall, changes in foreign exchange rates added about four percentage points to our revenue growth. Now I will provide revenue highlights by business segment, starting with client and its biggest driver, the PC market. We estimate that the PC unit growth rates for the quarter returned to the 12% to 14% range that we experienced in the first half of the fiscal year. This is about three points above our forecast, due to improvements in mature markets, including in the United States. This helps to drive client revenue growth of 15% to $4.4 billion, which was over $150 million above our high-end guidance. During the quarter, our OEM license units increased by 22%, about nine points faster than the overall hardware market. OEM unit growth outpaced that of the PC market, primarily driven by a couple of factors: one, our OEM partners always have channel fluctuations. With this quarter, we estimate were a combination of replenishing the channel from lower Q3 levels as well as buying [hit some] pricing tiers during the quarter; and two, we returned to the trend of making gains on piracy, including in Asia. OEM revenue increased by 13%. The difference between OEM revenue and unit growth is due to three trends, which you are already well familiar: one, volume mix shift towards emerging markets, which generally have lower ASPs; two, channel mix shift towards large OEMs with volume pricing; and three, premium mix shift toward consumer premium offerings. Specifically, while business and consumer premium units were up year-on-year and the overall OEM premium mix remained unchanged from the prior year at 72%, the premium mix composition shifted down four points of business premium and up four points of consumer premium. The remaining roughly 20% of client revenue comes from commercial and retail licensing. This portion of the business grew over 20%, driven by continued strength in client annuity licensing as business customers continued to demand our enterprise offerings, including those that help them more efficiently manage their desktop infrastructure. During the quarter, we surpassed the 180 million for Windows Vista licenses sold to date and Windows Vista had driven client revenue to an average growth rate of 16% since it became generally available. Moving to server and tools, revenue was $3.7 billion, growing an outstanding 21% on top of the string of Q4 double-digit growth quarters. And this quarter marks the group’s 24th consecutive quarter of double-digit growth. [inaudible] for annuity contracts, covering our [server and tools] offerings continued during the quarter, driving server and tools unearned revenues increased 37% from the beginning of the year. This customer commitment to annuity contracts demonstrates the increasingly critical role our server products perform in information technology infrastructure, as well as an increasing interest in the value offered in our long-term product roadmap. Demand for our consulting and support services remains strong, driving associated revenue growth of 30%. On the product side during the quarter, we released our eagerly anticipated virtualization feature, Hyper-V, two months ahead of schedule. We also made significant progress on SQL Server 2008, which is targeted for release during this, the first quarter of fiscal year 2009. Online services business grew revenue 24% to $838 million. Online advertising grew 18%, including $33 million of ad revenue from aQuantive. While both search queries and page views were up and in line with expectations, monetization lagged, driven by tightening advertising budgets combined with a more competitive display pricing environment. We continued to attract users to our properties with live IDs hitting 460 million, up 80 million from last year. And we grew the number of advertisers utilizing our advertising platform by 28% during the year. We closed the acquisitions of FairCast, which offers technology to aid in the purchase of online tickets at the lowest price, and Navic Networks, which develops tools to deliver targeted ads to television set-top boxes. In May, we announced the beta launch of Live Search Cashback. Since then, we have 680 merchants participating in the program with about 200,000 registered users. Microsoft business division revenue was up 14% to $5.3 billion. The business element of MBD revenue grew almost $700 million, or 19% on both strong enterprise agreement signings and license only sales. Consumer revenue declined $66 million, down 7%. This reflects both a difficult comparison to last year’s quarter following the Office 2007 launch, and a continuation of a shift towards our lower price consumer SKUs. Our emerging business product momentum continues, with SharePoint revenue up over 30% and unified communications revenue up over 20%. During the quarter, we completed the acquisition of Fast Search & Transfer, expanding our spectrum of enterprise search solutions for customers. Our Dynamics business also had a good quarter, with customer billings growth of 22% and two product releases, Dynamics AX2009 and Dynamics CRM Online. Dynamics CRM continues to deliver the function and flexibility customers want, evidenced by over 120,000 CRM seats being sold in the quarter. Entertainment and devices division grew revenues 37% to $1.6 billion. We sold 1.3 million Xbox 360 consoles, representing 88% growth over the prior year and passing the milestone of 20 million consoles sold life to date. In May, we announced that Xbox Live reached 12 million members, roughly doubling in membership for each of the last two years. Software attach rate continued to lead the industry at 7.7 software titles per console. As was evident at E3 earlier this week, the interactive entertainment business was extremely busy during the quarter, securing industry-leading media content providers such as Netflix, NBC, Universal, Constantine, MGM International, as well as developing innovative new gaming and social experiences that will continue to expand our audiences. The mobility business within the entertainment and devices division completed the acquisition of Danger and released System Center Mobile Device Manager 2008, which has created the opportunity for our sales force to partner with customers’ IT departments, helping them manage their mobile device assets with capabilities similar to those already used to manage PCs. And Microsoft Surface moved into early commercial deployment in AT&T stores and [inaudible], [as you know.] Now for the rest of the income statement: adjusting last year for the impact of the $1.1 billion charge related to the expansion of the Xbox 360 warranty policy, cost of revenue as a percent of sales increased one point to 18%, driven by increasing Xbox 360 console sales, costs associated with the growth of our consulting and support services, as well as data center equipment and online content expenses in our online services business. Operating expenses increased $1.1 billion, or 19%, driven primarily by headcount related costs, acquisition related expenses, and marketing related expenses. Expenses came in $500 million higher than our guidance, split rather evenly between cost of revenue and operating expenses. First, cost of revenue; we sold more Xbox 360 consoles than our guidance had reflected. In server and tools, the higher revenue growth in our consulting and support services carries higher associated costs than does software revenue. In our online services business, we were able to bring servers in our data centers online faster than expected and we invested in premium online content, which is [higher creative and agency fees associated with it]. Moving on to operating expenses, we took advantage of the economic environment out there to attract top talent for the company, yielding higher close rates and filling headcount openings. Also, across a number of our businesses, we spent more on product development and efforts to ready marketing campaigns, and foreign currency rates presented some headwind. Operating income was $5.7 billion, up 42% or 13% after adjusting for the impacts of the warranty related charge in the year-ago period. Investment income and other totaled $284 million, as the Microsoft treasury team continues to successfully navigate a challenging capital market environment. Our effective tax rate for the quarter was 28%, a couple points lower than expected, driven by an earnings mix increase in lower tax jurisdictions. During the quarter, we repurchased 171 million shares, or almost $5 billion of company stock, and paid out about $1 billion in dividends to shareholders. Diluted shares outstanding were $9.4 billion, down 3% from the prior year, as a result of share repurchases. Earnings per share were $0.46, in line with our guidance and growing 48%, or 18% after adjusting for the warranty related charge in the prior year. So in summary, we had our fastest growing fourth quarter revenue since 1999. Adjusting of the year-ago Xbox warranty charge, operating income and EPS grew 13% and 18% respectively. With that, let me turn it back to Chris who will provide you with our first quarter and full year guidance for fiscal 2009."
},
{
"speaker": "Christopher P. Liddell",
"text": "Thanks, Colleen. I’m going to spend my remaining time on the call talking about what we see coming for the full year and for the first quarter. Let me begin by outlining some of our key assumptions around the economy and general demand in the industry. The forecast generally assumes a continuation of the economic conditions and demand we experienced in the fourth quarter to continue into the first half of fiscal year ’09, with some improvement over the second half of the year. We expect PC unit to remain healthy with growth rates similar to those in 2008. Specifically, we expect PC unit growth in fiscal 2009 to be 12% to 14% for the year and between 10% to 12% for the first quarter. We estimate that growth rates will continue to be driven by roughly 20% growth in emerging markets, with high-single-digit growth in mature markets. Now let me go through our detailed guidance; for the full year, we expect our revenue to come in between $67.3 billion to $68.1 billion, growing 11% to 13%. For the first quarter, we expect revenue of $14.7 billion to $14.9 billion, which represents an increase of 7% to 8%. With that, revenue guidance by business group is as follows: for client, we expect full year growth to be 9% to 10% and Q1 growth to be 6% to 7%. The PC market growth will outpace that of client revenue because of a continuation of the underlying PC market dynamic, namely emerging market PC growth outpacing mature markets, consumer growth exceeding business growth, and the shift in the system build channel to large OEM. Server and tools revenue should be up 18% to 19% for the year and 19% to 20% for the first quarter. Coming off another impressive year of growth in fiscal year ’08, the server and tools business is expected to continue to show double-digit growth across the breadth of our server platform products and services, driven by strong customer demand for the recently refreshed Windows Server and Digital Studio offerings, and the soon-to-be-available SQL Server 2008. We forecast revenue in the online services business to increase 18% to 20% for the year, and 7% to 11% for the first quarter. The advertising component of revenue is expected to grow at approximately 25% for the year and 15% for the quarter. Our Q1 guidance assumes the continuation of the challenging online advertising market experienced in the fourth quarter. We expect revenue growth will accelerate through the year as we begin seeing returns from the additional investments we are making in the business. Our business division revenue should be up 14% to 15% for the year and 15% to 16% in the first quarter. We should continue to see business demand for Microsoft Office 2007, SharePoint, and Dynamic products. Combined with growth in our emerging unified communication and business intelligence offering, this will drive another year of very strong growth. Fiscal 2009 also represents an important year in delivering on our software for services strategy, with the upcoming releases of Exchange Online, SharePoint Online, and Office Communications Online later this calendar year. For the entertainment and devices division, we expect revenue to be down 4% to flat for the full year, and down 23% to 26% in Q1. The strong customer demand for Halo 3 following its launch in fiscal 2008 makes for challenging year-over-year comparisons in the entertainment and devices division. But having said that, we remain committed to a profitable performance in fiscal year ’09. Turning back to company wide performance, operating income for the year is expected to be between $26.3 billion and $26.9 billion, increasing 17% to 20%, or 10% to 12% excluding certain tax and legal charges in fiscal 2008. For the first quarter, we expect operating income to be between $5.9 billion and $6 billion. Q1 operating income includes the impact of increased spending associated with our online services business, costs associated with a number of new acquisitions, and investments in a new Windows consumer marketing campaign. I would like to address the overall level of -- the impact of the overall level of spending on the company margin. To do so, as I’ve told you before, we need to look at the three individual parts of the company that have distinct margin structures. The core businesses of client, server and tools, and Microsoft business division collectively will have an operating margin in fiscal 2009 that’s essentially flat. This performance is obviously very good, given that we are making a number of investments to drive the overall health of the business and absorbing a number of acquisitions we’ve made this year and growing revenue in mid-teens. The margin for entertainment and devices should also remain roughly the same year-on-year in fiscal year ’09, even without a first party game release of Halo 3’s magnitude. So taken together, our businesses representing over 90% of our revenue will grow double-digits next year with the margin structure intact. Clearly the online services business has a totally different dynamic and is in a period of significant investment. We do not make these investments lightly, as the loss in this division will be a drag on an otherwise exceptionally good performance. However, we believe that the additional investments of several hundreds of millions of dollars is worth the short-term cost, given the opportunity to participate in a market where the opportunity is measured in the tens of billions of dollars. So I wanted on the call to take a few minutes to frame our reasoning behind the additional online service business investments. I will start with an overview of our broad strategy and then provide details into the additional investments. With the online ad spending expected to reach $80 billion by 2012, this area represents one of the largest growth opportunities for the company. We segment the market for online advertising in four distinct categories -- search, advertising platforms, information content, and communication and social networking. For search, we’re focused on driving query share improvements and business model innovation, specifically in the area of high value commercial search. Our recent release of Cashback is a good example of executing on our strategy, which combines innovation in the shopping experience with a shift in the distribution of advertiser economic towards the end users. Additionally, we also [seek to win] targeted distribution through OEMs, ISPs, ISVs, and retailers. The recently announced deal with HP in the U.S. is an example of [this]. Turning to the ad platform, our strategy can be summarized as consolidate [when in] display, and there we are focused on integrating our advertising assets into a single comprehensive system that can deliver our publishing partners’ industry leading yields and our advertisers optimal return on their ad spend. In the area of communication and social networking, which includes our mail, messenger, and social networking assets, such as Spaces, we’ll deliver the leading end-to-end experiences across the PC, phone, and web. And finally, in the category of information content, we plan to invigorate our MSN portal experience with improvements in user experience, social media consumption, and premium content. As well as overall advertising revenue, which is clearly the overall measure of success, we have aggressive growth targets in each of the above areas over the next five to 10 years. These targets can be broken down in terms of the percentage of share of worldwide page views, percentage of share of Internet [inaudible], the percentage share of search queries, and percentage of the growth of the online advertising dollars that pass through our platform. Clearly the Yahoo! transaction, which I’ll make some more comments on later, would have accelerated our progress towards these goals. However, during the quarter, a transaction became increasingly unlikely. Further, as you know, during the quarter Yahoo! signed a search outsourcing agreement with Google. Given that environment, we made some decisions to accelerate our online services’ organic growth strategy. Mainly we decided to increase our investment in the high-margin scalable areas of search and ad platforms. So about two-thirds of the incremental spend that we are planning is related to investments to drive usage of our search offering. We’re dialing up our search distribution initiatives with targeted OEM toolbar [alt] search deals, scaling search globally with investments in localized engineering and data centers, pursuing acquisitions and partnerships to build vertical content to support our commercial strategy, accelerating the rollout of our Cashback program, and increasing marketing in the business to grow awareness and drive traffic. Second, we are upping the investments in our ad platform and increasing the number of advertisers and high quality inventory on that platform. Specifically, these investments are in the area of accelerating the integration of our ad platform assets, expanding our sales and service capabilities, small acquisitions to enhance the platform technology, and investments in strategic partnerships to increase third-party inventory available to advertisers on our ad platform. So turning to EPS, our diluted earnings per share for the year are expected to come in at $2.12 to $2.18, representing growth of 13% to 17%, two to four points faster than revenue. To put this performance in context, as I mentioned at the front of the call, if we achieve the middle of our guidance, we’ll have increased earnings per share from $1.42 to $2.15 in two years, an increase of 50%. But first quarter we expect earnings per share of $0.47 to $0.48, and these earnings assume an effective tax rate of 28%. From a balance sheet perspective, we expect total unearned revenue to finish fiscal 2009 up 8% to 9%. [Contracts not filled] should also finish 2009 up from current levels. When thinking about sequential changes in unearned revenue from Q4 fiscal year ’08 to Q1 fiscal year ’09, we expect a sequential decrease from Q4 to Q1 to exceed the rate of decline we experienced the last few years. As always, when thinking about the guidance we provide, you should also consider the risks. These include competitors, legal, execution and general market risks such as foreign exchange rate movements, fluctuations in PC and server hardware growth rates, IT spending, changes in the piracy rate, and customer acceptance of our new and existing products. Additionally, changes in the mix of our billings between annuity and license only can have an impact on revenue, operating income, and EPS by delaying revenue recognition into future periods. So in closing, the strong results of fiscal year ’08 were the outcome of both business and engineering execution. In addition to the financial out-performance, we delivered the final phase in our multi-year product refresh cycle with the availability of Windows Server 2008 and Visual Studio 2008, and are well-positioned to continue that momentum into fiscal 2009. The next fiscal year will be an important year, driving mass adoption across the portfolio of products. With our breadth of products and global diversification, we are confident in our ability to continue to deliver double-digit revenue increases even off our base of over $60 billion, and we will continue to use our strong cash flow to invest in our organic growth, inorganic growth through acquisitions, and in ourselves through buy-backs. Before I hand the call back to Colleen, I want to take a moment to clarify the terms of our recent proposal for a search transaction with Yahoo!. Given the upcoming Yahoo! shareholder meeting, I won’t be taking any questions on this topic in the Q&A section that will follow this presentation and we won’t be providing any additional comments on matters we’ve already discussed. But with that, let me outline for you the key elements of our proposal. Firstly, we are providing significant revenue guarantees. Microsoft proposed a 10-year minimum revenue guarantee totaling between $19.5 billion and $26.5 billion. For the first five years, the guarantee is $2.3 billion per year. There afterwards, both Yahoo! and Microsoft have the option to extend the agreement for an additional five-year period. If Yahoo! unilaterally chooses to extend the agreement, the guarantee would be for $1.6 billion per year after the extension. Conversely, if Microsoft unilaterally chooses to extend the agreement, the guarantee to Yahoo! would be $3 billion per year after the extension. These guarantees are not conditional on Yahoo!’s search queries, but rather the guarantees are tied to Yahoo!’s homepage performance. Our proposal includes an 85% TAC rate for the first three years of the agreement and 70% there afterwards. Microsoft would pay Yahoo! $1 billion for its search assets, provide $2.8 billion of senior debt to Yahoo! on favorable terms, and make a significant equity investment in Yahoo! through the purchase of $3.9 billion of Yahoo! stock at $19.50 per share, reflecting our view of the value of the company as a result of our proposed transaction and the distribution of cash and the Yahoo! Asian investments by Yahoo! to its stockholders. I should also note that Microsoft’s proposal did not and does not include changes to Yahoo!’s governance. We clearly continue to believe that our proposal is a compelling one. With that, I am going to hand the call back to Colleen so we can get started taking your questions, and I clearly look forward to seeing a number of you at our financial analyst meeting, which is next Thursday."
},
{
"speaker": "Colleen Healy",
"text": "Thanks, Chris. Let’s now proceed to questions. We want to accommodate questions from as many people as possible, so please avoid multi-part questions and limit yourselves to just one question. Operator, will you please repeat your instructions?"
},
{
"speaker": "Operator",
"text": "(Operator Instructions) The first question comes from Sara Friar with Goldman Sachs."
},
{
"speaker": "Sara Friar",
"text": "Good afternoon, everyone. Thanks for taking my question. Chris, just firstly, could you give us a little bit of your overview on the macro environment and how that’s changed when you think back to giving earnings three months ago? And then, just on your cash flow, it came in a little weaker than we were anticipating. DSOs were up higher than we have seen in perhaps ever for Microsoft. Was there a collections issue, more back-end loading? If you could perhaps talk to the weakness there."
},
{
"speaker": "Christopher P. Liddell",
"text": "Sure. Okay, taking those in turn, in terms of the macro environment, it’s broadly speaking the same as what we were expecting in April. Clearly people are getting concerned now about the length of softness here in the U.S., but as you’ve seen for revenue, we’ve taken it up slightly since April, so in terms of the visibility into our products, we are actually feeling very good about our position, not only here in the U.S. but outside the U.S. I mentioned in my comments, if you look at the company overall, our sales in the U.S. in the year that we just completed were up 15%. The company overall is up 18% so clearly we grew faster outside the U.S. than we did inside the U.S., but at 15%, given it’s been a difficult environment for a number of companies, growing at 15% off our base was very good. So going into next year, we are clearly cautious like everyone is about the impact of the environment but for our products overall, we are feeling very good. I’d say the one proviso to that is in the online advertising space, where we are seeing a direct impact. It was weak in the fourth quarter and I think you are seeing from results of other companies as to the weakness in that general space. So there is a direct impact and we are not immune to that in the online space and we’ll probably see that continuing certainly for the next quarter. But overall in terms of our core business growth, it feels very good. In terms of your other questions on cash flow, the biggest thing in the cash flow that was probably a negative was the payment of the fine to the E.U., which was over $1 billion, so -- $1.5 billion, so that was clearly a big negative from a cash flow point of view. Other than that, there really wasn’t anything remarkable from a cash flow point of view. In fact, it was quite a strong quarter, given the results overall."
},
{
"speaker": "Colleen Healy",
"text": "And on a DSO standpoint, Q4 seasonally does tend to be a little higher than some of the other quarters. We do close a lot of business in our fiscal Q4 as the sale force is out there closing deals. But we didn’t see anything unusual from a DSO standpoint."
},
{
"speaker": "Christopher P. Liddell",
"text": "But overall, I’d say revenue growth of 18% last year, guiding to revenue growth of 11% to 13%, so you combine those and so that’s 30% broadly for the two years that cover what was hopefully the worst of the economic condition, so we’re feeling good about it."
},
{
"speaker": "Sara Friar",
"text": "Okay. And there were -- okay, thanks."
},
{
"speaker": "Colleen Healy",
"text": "Okay, thanks, Sara. Next question, please."
},
{
"speaker": "Operator",
"text": "The next question comes from Heather Bellini with UBS."
},
{
"speaker": "Heather Bellini",
"text": "Good afternoon. I was just wondering, Chris, if you could talk a little bit about the OSB business. Given how far behind you guys are, if you’re unsuccessful in getting all or even a part of Yahoo!, can you walk us through how you are going to be able to compete with Google? And also, are we in a critical period here in this segment where if you continue to go down the path of going it alone that we are going to be seeing this accelerating spending from current levels so that it’s going to adversely impact overall op-margin, so we’re actually not going to see op-margins expand for the next few years? Thanks."
},
{
"speaker": "Christopher P. Liddell",
"text": "Sure. Okay, overall, clearly regardless of what happens with Yahoo!, it’s a space that we’re committed to. I said that in the prepared remarks and it’s one that we’re committed to on a long-term basis. I would split the market, as I did in my prepared remarks, into four areas, of which search is only one -- ad platform, communications, central networking, and information content being the other ones, and clearly we have a very good position in information content and communications in an ad platform with the acquisition of aQuantive. So we feel very good about our relative position in those areas and a number of our investments are going into that. In the search area, clearly that’s the one where, relatively speaking, we are the most behind and that’s why we’re taking a different approach, which again I mentioned in the prepared remarks where we are focusing in particular on the areas of search where there’s a strong commercial intent, our verticals like retail, travel, real estate, local. We’re looking at different approaches where we might potentially take a disruptive and innovative business model, for example, Cashback, and then looking at winning distribution deals. Now in the short-term, that isn’t going to make the division profitable and I think clearly from our guidance, that’s not the case. So as I said in the remarks, if you look at the operating margin structure of the company, you really have to look at the three distinct businesses. We feel good about the margin structure for our core businesses in particular growing double-digit revenue on. Entertainment and devices will be broadly flat but online is going to be negative --"
},
{
"speaker": "Heather Bellini",
"text": "Chris, yeah, I totally get what you are saying. I guess the question that I’m getting asked a lot is how long are you going to spend -- you are obviously performing well on the top line but your spending the upside so that people aren’t getting margin expansion. I guess the question that I’m getting asked is how long should we expect that to continue?"
},
{
"speaker": "Christopher P. Liddell",
"text": "We’re not going to make -- certainly on this call we’re not going to give guidance for fiscal year ’10 and ’11. Some of these investments that we are making will be multi-year, so it will depend to a large extent on our revenue growth as to when that division becomes profitable. So it will need to continue to grow relatively substantially in order to cover the level of investments that we are making, but it is going to be, and I think we’ve made this point on previous calls, it is going to be an investment [in the] area, in particular things like the ad platform, where we see it converging to two natural players over time, of which we clearly would expect to be one, and that’s an area where spending in particular on infrastructure is likely to be high. So I can’t promise you that you are going to see a massive turnaround in the short-term, and certainly in fiscal year ’09, which is the year that we are guiding to today, it is going to be a continuation of an investment. But again, put it in the context of what we would describe as the overall opportunity and the size of the company overall."
},
{
"speaker": "Heather Bellini",
"text": "Thank you."
},
{
"speaker": "Colleen Healy",
"text": "Thanks, Heather. Next question, please."
},
{
"speaker": "Operator",
"text": "The next question comes from Charles Di Bona with Sanford Bernstein."
},
{
"speaker": "Charles Di Bona",
"text": "I would like to circle back to the Q4 results and really particularly the margins here -- I think the Xbox issue is fairly straightforward but in something like five of the last eight Q4s, you guys have had an issue about being disappointing on margins, and maybe you can give us some color and comfort on what sort of looks to be a fairly persistent control issue in Q4, and in some cases it looks like you might be pulling some of the expenses forward. Are we going to see that in the fiscal ’09 numbers?"
},
{
"speaker": "Christopher P. Liddell",
"text": "I always distinguish, Charlie, between the costs, which were, if you like, a function of the revenue, a function of decisions that we made, and functions of unexpected low quality spend, if you like. But I can give you some comfort -- it’s the areas that we spent more of in the fourth quarter were more [inaudible] in the first two. For example, on the revenue side, we sold more Xboxes, so we had more COGS. That’s good news, okay? We don’t make any money from those but overall in terms of long-term health of the business, the more consoles we sell, the better. In server and tools, the higher enterprise services revenue carries higher COGS with it -- again, that’s just a factor of it. So the mix inside server and tools might not be as strong as you would like from a revenue point of view, but that’s just a natural consequence. In terms of decisions that we made, we have budgeted headcount and people hired to their budgeted levels. That’s a good thing in the sense that we actually hired people that we want to hire and we were particularly successful. I think that’s a reflection to a large extent of the economic environment and the fact that if anything at the moment, we are an even more attractive company than we have been to people. So again, that hits us from an expense point of view, but I’d describe it in one of the categories, you know, it’s a conscious decision to hire people. In terms of things that were outside our control, FX was a factor. FX has been our friend pretty much throughout the year in terms of driving more revenue upside than more expense, net net it’s been a positive, clearly because we have more revenue outside the U.S. than we do expenses. In the fourth quarter, it was an unusual quarter in that we hired a lot of people outside the U.S. and the mix of expenses was such that the FX impact was higher on OpEx than it was on revenue. If you look across the year, that’s not the case but in the quarter, it was. So I’m comfortable that there’s not any lack of control over spending. Most of the decisions I’ve talked about were either conscious ones or were a reflection of better revenue performance in certain areas."
},
{
"speaker": "Colleen Healy",
"text": "Great, thanks, Charlie. Next question, please."
},
{
"speaker": "Operator",
"text": "The next question comes from Kash Rangan with Merrill Lynch."
},
{
"speaker": "Kash Rangan",
"text": "Thank you very much. It looks like stepping up investments in the online services business seems like the right thing to do. I’m just curious, Chris, what -- I would have expected that to be accompanied by an increase to the revenue guidance, yet when you look back over the last 12 months, if I exclude aQuantive, I still come up with much faster revenue growth in the online services business. So my question is, is the return on these investments going to take more than one year sort of a lag to show up in the financials, or is there some conservatism in how you are budgeting for the revenue productivity as a result of these investments? Is there a longer lag to these OpEx investments? And also, maybe three of our seconds of your thoughts on client guidance. I know Colleen didn’t want multi-part questions, but I couldn’t resist this; the 6% to 7% growth absent currency looks to be very low on the 2% to 3%, so I’m just curious what was the thought process that went into that guidance as well. Thanks."
},
{
"speaker": "Christopher P. Liddell",
"text": "Okay, sure. Kash, you went blank through the start of your question, so if I don’t cover it exactly, please come back to me. We missed just the first few words of your question, but in terms of online spending, is it likely to be more of a fiscal year ’10 impact on revenue? The answer is yes, and that’s not only because of the nature of some of the investments that we are making. Things like marketing Cashback, that’s going to take time in terms of seeing the real impact from that. But also, just because -- as I mentioned I think to Sara’s question, the online advertising area is probably the part of the business certainly in the short-term which we think is most challenging. From an economic environment point of view, we have actually done remarkably well in our commercial businesses and overall for PCs, getting through difficult and choppy economic waters. The online advertising area is very difficult at the moment and I think that’s across the board. That’s not just us, so I don’t want to promise -- you know, we might see benefits, for example, in share but I’m not sure that share is necessarily [in best display] in the search area. Again, it translates in the -- certainly in the first six months and possibly across the year to significant revenue growth but I think you could expect to see us make progress in the areas that I talked about, which is the underlying dynamics, the driver of the -- percentage minutes, percentage share, et cetera. That’s really how we are going to have to measure ourselves over the next year. I think the second half of your question was client-specific, is that right?"
},
{
"speaker": "Kash Rangan",
"text": "That’s correct, yes."
},
{
"speaker": "Christopher P. Liddell",
"text": "In the 6% to 7%, yeah, that is relatively light. To some extent, it’s because of the very high, strong quarter one that we had last year. If you’ll recall, we had a very strong quarter one piracy performance in last year. It’s also part of the strong Q4 performance from this year, which Colleen mentioned in the prepared remarks, was some channel inventory. We -- if you like, it was a very strong unit growth in quarter four fiscal year ’08. Some of that was because of a weak Q3. You’ll recall our Q3 call, we talked about some of the inventory issues there and that was one of the reasons why Q3 of last year was weak. So it feels like a bit of a borrowing from Q3 into Q4, and also we think a little bit of some of our customers may have bought forward from Q1 into Q4 as well, so that’s one of the reasons. The other is we’ve got 10% to 12% PC unit growth expectation, which relative to the year of 12% to 14%, we’re just seeing that quarter as being one of the low points. So you combine all of those factors and we think that’s going to be the lowest revenue growth quarter for client in the year."
},
{
"speaker": "Colleen Healy",
"text": "Great, thanks a lot, Kash. Next question, please."
},
{
"speaker": "Operator",
"text": "The next question comes from Brent Thill with Citigroup."
},
{
"speaker": "Brent Thill",
"text": "Thanks. Chris, the overall buy-back for ’08 was more than cut in half from ’07. Obviously that’s understandable considering the acquisition strategy, but I guess as it relates to the overall plan, you only have $3 billion left on the current $36 billion plan. How aggressive at 25 and change will you be with the stock here?"
},
{
"speaker": "Christopher P. Liddell",
"text": "Okay, yeah -- going backwards and then going forwards, backwards -- yes, you are right, it was lower than the previous year. One of the reasons for that is we were getting down to a level of cash that we feel more comfortable with, so there was some accelerated buying in the previous year. The other impact was we see that the aQuantive acquisition, which was relatively expensive this year, and the last factor is when we announced the Yahoo! acquisition earlier this year, we went out of the market but from a sensitivity point of view, and clearly at that stage we’re envisaging having to use a large part of that cash for the acquisition. Subsequent to May when it was clear that the overall transaction wasn’t going to happen, we went back into the market and we have been buying at levels that are more like historic levels. So those are the reasons why we’ve been less in the year. It was $5 billion I believe for the quarter, so it was a reasonably strong buy-back quarter. Clearly at these prices, it’s incredibly attractive from a buy-back perspective. I can’t tell you, as I never do on a quarter by quarter basis exactly how much we will buy back. You’re right that we only have about $3 billion worth of our buy-back left. That’s good news in the sense that I think we gave ourselves until 2012 to complete it, so we can put it at a little ahead of schedule. What we do here is we complete the current buy-back, and then we go back to the board for authorization of any subsequent buy-back, and that would be exactly the process that we do here and if and when we get authorization from the board to do further buy-backs, we’d clearly announce the amount at that stage. But similarly wouldn’t announce exactly the shape of what we do. But clearly the value of the company relative to the last three years is as good as it’s been."
},
{
"speaker": "Colleen Healy",
"text": "Thanks a lot, Brent. Next question, please."
},
{
"speaker": "Operator",
"text": "The next question comes from Adam Holt from Morgan Stanley."
},
{
"speaker": "Adam Holt",
"text": "Good afternoon. I have a question about Office and MBD. Obviously Office 2007 has been a terrific product cycle, but MBD has been a little bit light relative to guidance for the last couple of quarters. Could you maybe talk about where you think we are in the Office 2007 cycle, and what gives you confidence that we’ll see a reacceleration of growth in MBD next year versus what we saw in the back half of this year?"
},
{
"speaker": "Christopher P. Liddell",
"text": "Well overall, obviously the MBD division did extremely well last year, so put that in context but you’re right in the sense that Office was slightly lighter than we might have thought, mainly to be honest in the consumer area, and that’s around lower price SKUs in retail. So we’re seeing more of a buy from the volume that we’re seeing. The volumes are very good and business sales are very good but the volumes in the retail side tend to be more in the lower priced SKUs, so that’s having an impact overall. But the overall volume and the overall adoption and reaction to Office 2007 has been extremely good, so we feel good and we’ve put it inside our business group, which grew at 15% to 20% last year."
},
{
"speaker": "Adam Holt",
"text": "So as we look at it next year, should we be thinking about dynamics and share points being the key drivers, or should we expect office to reaccelerate?"
},
{
"speaker": "Christopher P. Liddell",
"text": "I think those emerging products are certainly going to make a big difference. We’re guiding 14% to 15%. That’s very good. I mean, Office is unlikely to grow at 14% to 15%. It’s likely to grow at more like high to single digits. But the other parts of the business will grow extremely well, and that is going to average it up to 14% to 15%, so you’re right. SharePoint, Office Communications, some of the online services that we are bringing in will start to have an impact. So overall, it’s now our biggest division in terms of revenue, 14% to 15% looks very good."
},
{
"speaker": "Adam Holt",
"text": "Terrific. Thank you."
},
{
"speaker": "Colleen Healy",
"text": "Thanks, Adam. Our next question, please."
},
{
"speaker": "Operator",
"text": "The next question comes from Robert Breza with RBC."
},
{
"speaker": "Robert Breza",
"text": "Just looking at the $500 million in expenses that you are talking about, how should we think about that trending through the year? And then, depending on any outcome from an acquisition perspective, would you look to accelerate that investment or decelerate that investment? Thanks."
},
{
"speaker": "Christopher P. Liddell",
"text": "It has slightly different dynamics. In terms of the consumer marketing, that’s probably going to be front loaded in the year, and one of the reasons for our first quarter being relatively light compared to the other quarters would be some of the marketing spend that we see in the first quarter. In terms of some of the online spending, that’s probably going to be more progressive through the year. In terms of acquisitions, that’s really going to be opportunistic. We closed a lot in the fourth quarter, and one of the things that is impacting our results is clearly the amount of non-cash amortization associated with acquisitions, and that was relatively substantial last year. It was over $300 million. We don’t call that out, as some companies do, and take the benefit of adjusting our results to reflect that. We take that probably through the P&L and next year in terms of the guidance we’ve given you, we expect it to be more than $300 million. How much more and exactly the shape will depend on acquisitions. We have an expectation of it that we build in and -- but it will grow progressively through the year. It’s all non-cash but we’ll continue to take the full impact through the P&L."
},
{
"speaker": "Robert Breza",
"text": "That’s helpful. Thank you."
},
{
"speaker": "Colleen Healy",
"text": "Thanks, Robert, and our last question, please, Operator."
},
{
"speaker": "Operator",
"text": "The last question comes from Kirk Materne with Banc of America Securities."
},
{
"speaker": "Kirk Materne",
"text": "Thanks very much. Chris, you talked in the guidance just on entertainment and devices about maintaining profitability. Given that there’s no sort of new cycle of the hardware this year, is there any reason why profitability shouldn’t start to trend up as attach rates get better? Is there anything going on in that business that’s going to require say more advertising dollars or spending in that?"
},
{
"speaker": "Christopher P. Liddell",
"text": "One of the impacts obviously as we dropped prices during the course of last year, so year-on-year we have slightly difficult price comparisons. The other thing is there’s more than just X-Box sitting in there. There’s obviously Windows Mobile, which has got a lot of opportunities, so there are other areas that we will be spending on. We aren’t in the comments of today giving any guidance on profitability. My comment was simply that it will sustainable profitability, but we’re not saying whether that’s going to be significantly up or down from where it was last year."
},
{
"speaker": "Kirk Materne",
"text": "Okay. Thanks very much."
},
{
"speaker": "Colleen Healy",
"text": "Thank you and thank you to everyone for your participation in today’s call. If you have any further questions, please feel free to call me or my team directly. We’re very much looking forward to seeing you at our financial analyst meeting next week. As I mentioned at the beginning of this call, this conference call will be available on replay at our investor website through close of business July 17, 2009. In addition, you can hear the replay by dialing 866-515-1618, or for international calls, dial 203-369-2027. The dial-in replay will be available through the close of business July 25, 2008. Thanks again for joining us today."
},
{
"speaker": "Operator",
"text": "That concludes today’s call. Please disconnect your line at this time."
}
] | null | null |
MSFT | 3 | 2,008 | 2008-04-25 17:30:00 | Operator: Welcome to the Microsoft third quarter earnings call. (Operator Instructions) I would now like to turn the meeting over to Colleen Heally, General Manager, Investor Relations; ma’am you may begin.
Colleen Heally: Good afternoon everyone. This afternoon I am joined by Chris Liddell, Senior Vice President and Chief Financial Officer, Frank Brod, Corporate Vice President and Chief Accounting Officer and John C. Top, Deputy General Counsel. Today’s call will start with Chris providing key takeaways for the third quarter of fiscal year 2008 and an overview of expectations for what remains of the fiscal year. I will then provide detail around our third quarter results and then turn it back to Chris for a more detailed discussion of our guidance for the fourth quarter and a preliminary outlook for fiscal year ‘09. After that we’ll take your questions. We filed our 10-Q today in conjunction with our earnings release, therefore you have available the earnings release, MD&A, financial statements and footnotes. We have also posted our quarterly financial summary slide deck which is intended to follow the flow of our prepared remarks in order to assist you. The slide deck offers highlights from the quarter, outlines our guidance and provides a reconciliation of differences between GAAP and non-GAAP financial measures that we will talk about today. You can find the earnings release, the 10-Q and quarterly financial summary slide deck at the Investor Relations website at www.microsoft.com/msft. Today’s call will be recorded, please be aware that if you decide to ask a question it will be included in both our live transmission as well as any future use of the recording. As always, shareholders and analysts can listen to a live webcast of today’s call at the Microsoft Investor Relations website. A replay of the call will be available at this same site through the close of business on April 24, 2009. This conference call report is protected by copyright law and international treaties. Unauthorized reproduction or distribution of this report or any portion of it may result in civil and criminal penalties. Any recording or other use or transmission of the text or audio of today’s call is not allowed without the express permission of Microsoft. Because we will be discussing on this call our proposal to purchase all of the outstanding shares of Yahoo we are providing the following statement. This conference call does not constitute an offer to sell or the solicitation of an offer to buy any securities or a solicitation of any vote or approval. The material covered in this conference call is not a substitute for the prospectus or proxy statement Microsoft would have to file with the Securities and Exchange Commission if an agreement between Microsoft and Yahoo is reached or for any other documents with Microsoft may file with the SEC and sent to Yahoo stockholders in connection with the proposed transaction. Investors and security holders of Yahoo are urged to read any such documents filed with the SEC carefully in their entirety when they become available because they will contain important information about the proposed transaction. Statements in this communication are forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in today’s earnings press release and the comments made during this conference call and in the risk factors in the MD&A sections of our Form 10-Q, our 2007 Form 10-K and other reports and filings with the SEC. Actual results also could differ materially because of factors such as Microsoft’s ability to achieve the synergies and value creation contemplated by the proposed transaction with Yahoo, Microsoft’s ability to promptly and affectively integrate the business of Yahoo and Microsoft, the timing to consummate the proposed transaction and any necessary actions to obtain regulatory approvals and the diversion of management time on transaction related issues. You may obtain copies of Microsoft’s SEC reports and filings by contacting our Investor Relations Department at 1-800-285-7772 or at our website at www.microsoft.com/msft. All information in this conference call is as of today April 24, 2008. We do not undertake any duty to update any forward-looking statements, to conform the statements to actual or changes in the company’s expectations. Okay with that, let me now turn it over to Chris.
Chris Liddell: Thanks Colleen and good afternoon everyone. The sense of our third quarter results demonstrates the benefits of our diversified business model. As you will see our broad span across geographies, product categories and customer segments is a tremendous asset in any economic environment and produced third quarter results of 14% revenue growth normalized for the tech guarantee and 27% earnings per share adjusted for the tech guarantee, legal charges and tax benefits beating our earnings per share guidance by $0.02 to $0.04. Let me mention a few highlights about third quarter performance before turning to guidance. When looking at the drivers of revenue growth this quarter it’s clear that we are reaping the benefits of the diversification of our business. In the first two quarters of the year our core business of client and the Microsoft business division significantly outperformed our expectations and this quarter entertainment and devices division drove our results. Despite the tough economic environment this has allowed us to deliver consecutive earnings per share growth of 29%, 32% and 27% this year adjusted for the tech guarantee, legal charges and tax benefits. Revenue growth in the client and Microsoft business division businesses were normalized for the prior year results for the impacts of the tech guarantee and retail launch spikes had combined growth of $700 million or 9%. Server and tools had yet another quarter of double-digit revenue growth while kicking off our largest enterprise product launch in the company’s history. Our consumer businesses of entertainment and devices division and online service business grew revenue of combined 57% or over $850 million. And the treasury department continued to take some work delivering investment income exceeding our forecast and managing to avoid any significant write-offs in our portfolio despite the [massive] dislocation in the financial markets. In the fourth quarter we expect a strong finish to what has been an excellent year. Revenue, operating income and earnings per share guidance for the year remain largely in line with our January guidance and significantly above our expectations upon entering the year. Since this time last year our revenue outlook for fiscal year ’08 has increased by about $3 billion, operating income margins are expected to expand by over a point and earnings per share guidance is higher by $0.18. On a more macro level there has been some uncertainty regarding the strength of the IT spending environment but our business has remained robust in the face of that uncertainty. While clearly no business can be immune from the impact of an economic slowdown, we remain confident in the benefits of our diversified business model and the investment approach we have taken in recent years. We’ve delivered earnings per share results above the high end of our guidance every quarter this year and have raised our full year earnings per share guidance in each quarter. We are not expecting earnings per share growth of 33% to 35% this year normalized for legal charges and tax benefit which is an outstanding achievement in the current economic environment. With those high level themes I’m going to turn over the call to Colleen for more details of our third quarter performance.
Colleen Heally: Thanks Chris. It was an excellent quarter with normalized revenue and operating income growth of 14% and 15% respectively. Normalized EPS growth at 27% was five points above high end guidance. Revenue growth was driven by continued enterprise customer demand for our core products as well as consumer demand for products and services in the entertainment and devices division and our online services business. Let me provide you with details of our financial performance starting with revenue. I’ll discuss top line financial and business momentum points and then follow with revenue performance for each of the business units. Then I’ll review the rest of the income statement. All growth comparisons relate to the comparable quarter of last year unless otherwise specified. Revenue was $14.5 billion. Adjusting the year-ago quarter by the $1.7 billion of revenue recognition primarily related to the technology guarantee programs from Windows Vista and Office 2007 total revenue grew 14%. We estimate PC unit growth rates moderated from our January expectations by a couple of points in mature markets partially offset by an extra point of strength in emerging markets resulting in an estimate of approximately 8% to 10% for the entire PC market during the quarter. Our mix of product billings for the quarter was approximately 30% from OEMs, 30% from multi-year agreements, 25% from license only sales and the balance from our other businesses. Annuity sales mix continued to increase on both a year-over-year and sequential basis while enterprise agreement renewal rates were in line with historical trends. As we guided our unearned revenue balance was consistent with historical seasonality patterns and remained roughly flat on a sequential basis at $12.1 billion up 18% year-over-year. Our contracted not billed balance remains above $11.5 billion and increased sequentially up well over $1 billion from where we started the fiscal year. When taken together with reported revenue total bookings for the company grew 14%. Now I will provide revenue highlights by business segment starting with clients. Client revenue of $4 billion was down 24% or down 2% adjusted for the tech guarantees. Adjusting that further for a retail launch bump from last year client revenue would have been up 4%. Let’s break down the main drivers behind client revenue first for OEM license units and then for OEM revenue. During the quarter our OEM license units increased by 5%, about four points than the overall hardware market. We believe this reversal of the OEM unit trend outpacing that of the PC market was primarily driven by three factors. One, last year OEMs particularly in the system builder channel rebuilt inventory levels following the launch of Windows Vista driving OEM unit growth over 20% during that quarter and making it a tough comp. Two, inventory levels at our OEM partners this year were higher than normal exiting fiscal Q2 impacting this quarter’s purchases. Three, we believe there was an increase in shipments of unlicensed PCs particularly in Asia. While we generally feel good about the gains we are making in piracy for the year, piracy is a tough battle in an area where we will need to continue investing in order to make progress. Looking past the individual quarters, PC market growth was up 12% to 14% year to date with OEM license units growing about a point faster which is in line with our historical rate of progress against piracy. OEM revenue declined 25% but grew a point when normalized for the tech guarantees in the prior year. The four percentage difference between OEM license unit growth and revenue growth was caused by two roughly equivalent factors; mainly the increasing volume in emerging markets and a channel shift to large OEMs from the system builder channel. Partially offsetting these impacts was in increase in premium mix. Premium mix grew five points during the quarter to 76% driven by an increase in the consumer element of the mix while the business portion was unchanged. The remaining roughly 20% of client revenue comes from the commercial and retail licensing portion of the business which declined 18% or was down 13% after adjusting for tech guarantees. Normalizing last year’s Windows Vista launch bump at approximately $225 million growth would have been up 23%. We continue to see healthy growth in the commercial portion of the business as sales of software assurance were once again strong as evidenced by the 29% in the client volume licensing portion of the unearned revenue balance. Since the launch of Windows Vista revenue for the client business has grown 16% with a license growth rate of one to two points above that of the PC hardware market. Over 140 million licenses of Windows Vista have been sold to date and Service Pack 1 was released in the quarter. Moving to server and tools, revenue of $3.3 billion represented an increase of 18% marking its 23rd consecutive quarter of double-digit growth. Customers continue to gravitate towards premium versions of Windows Server and SQL Server as well as to annuity contracts. The increased billing mix of annuity contracts drove the unearned revenue balance for the division up by over 35% versus last year. Our consulting and support services revenue increased 24% as we’ve experienced high demand following the recent launches across our product lines. The third quarter also marked the launch activities of the new versions of our flagship products in the server and tools division, namely Windows Server 2008, SQL Server 2008 and Visual Studio 2008. These products bring powerful new tools to our customers and partners looking to turn their IT departments into a strategic asset. For example Windows Server 2008 with virtualization technology will help customers increase reliability and flexibility of their server infrastructure, reduce costs and increase security. Online services business grew revenue 40% to $843 million this included $143 million from the addition of aQuantive. Online advertising grew 39% or was up 29% excluding the $47 million of ad revenue from aQuantive. Our online audience continues to grow. Live IDs increased to 18% to 448 million while usage deepened with search queries and page views up from the prior year. In the quarter we announced a number of acquisitions including Caligari for collaborative 3D modeling, YaData for customer micro segment management, and Rapt for behavioral targeting. And of course in February we proposed to purchase Yahoo. Chris will go into more detail about Yahoo later in the call. Microsoft business division revenue was $4.7 billion down 2% but up 9% adjusted for tech guarantees in fiscal year 2008. Adjusted for last year’s retail launch bump of about $150 million revenue would have grown 13% with business customer revenue growth of 17%. Our expanded portfolio of productivity products are thriving with share point revenue up over 35%, unified communications up over 20% and dynamic customer billings up 13%. On the strategic front we announced the acquisition of FAST Search and Transfer to enhance our enterprise search offerings. During the quarter we also held our SharePoint and Convergent conferences which both saw record attendance by customers and partners. And we expanded on our software plus services vision by announcing that the Beta of SharePoint online and exchange online will be opened to companies of all sizes. Entertainment and devices division grew revenue of 68% to $1.6 billion over $300 million above our high end guidance driven by the sale of 1.3 million Xbox 360 consoles. High holiday demand for Xbox 360 consoles during the preceding quarter in which Xbox 360 outsold PlayStation 3 by over 1 million units in the US led to a short channel inventory for much of this quarter. However according to US MPG data by March Xbox 360 had reclaimed its monthly console sales lead over the PS3. With retail inventory restored to more healthy levels Xbox 360 is well positioned as the industry anticipates next week’s launch of Grand Theft Auto 4. During the quarter we announced the acquisition of Danger which closed last week and announced the November target release date for Gears of War the highly anticipated sequel to the fastest selling video game of 2007. Now for the rest of the income statement. Cost of revenue increased by $370 million primarily driven by higher Xbox 360 console sales, growth in our consulting business, and expansion of data center operations and the addition of aQuantive costs. After adjusting the year-ago quarter for the impact of tech guarantees cost of revenue held flat at 17% of sales. Operating expenses increased almost $1.9 billion or up 33% primarily due to $1.4 billion of legal charges relating to the European commission fine assessed in February. Adjusting for that charge in the current quarter and $150 million of legal charges in the same quarter of last year, operating expenses increased $600 million, up 11%. This is favorable to our expectations due to lower headcount driven costs and some shift of marketing expense into the fourth quarter. Operating income was $4.4 billion. After adjusting for the impact of tech guarantees and legal charges, operating income grew 15%, one point faster than revenue growth. Investment income and other totaled $401 million for the quarter as the treasury team continued to do an outstanding job in challenging capital markets. Our effective tax rate for the quarter was 9%. During the quarter we settled a 2000 to 2003 examination with the IRS. As a result we reduced our previously accrued tax provision by $1.4 billion which was partially offset by the non-tax deductibility of the European commission fines resulting in our adjusted effective tax rate for the quarter of 29%. During the quarter we repurchased 30 million shares or $1 billion of company stock and paid out over $1 billion in dividends to shareholders. Diluted shares outstanding for the quarter were 9.4 billion down 4% from the prior year as a result of share repurchases. Earnings per share for the quarter were $0.47 which was $0.02 to $0.04 above our guidance after adjusting for the offsetting impacts of the $0.15 EPS charge from the European commission fine and the $0.15 benefit from the resolution of the tax examination. So in summary our diversification across geographies, product lines, customer segments and product life cycles produced 14% top line and 27% bottom line growth. This allowed us to generate over $7 billion of operating cash flow, the second highest level in the history of Microsoft. With that let me turn it back to Chris who will provide you with our fourth quarter guidance and our preliminary outlook for fiscal year 2009.
Chris Liddell: Thanks Colleen, I’m going to spend my remaining time on the call giving you a view of our expectations for the fourth quarter followed by a preliminary view of fiscal 2009. I also note that we have about twice the number of people on the call as normal so for some of the newcomers I’ll also make some brief comments on our proposed acquisition of Yahoo. Let me begin by outlining some of our key assumptions for the fourth quarter. We’ll assume the following macroeconomic conditions for the remainder of the year; we expect the software spending environment to remain mixed but positive overall on a global basis especially for the positioning of our products and the value they offer. Like you we are cautious on the reported economic softness in the US but at this point we have not seen any significant spillover to our businesses. We continue to benefit from strong underlying growth in non-US and emerging markets which has also been assisted by stronger international currencies. For the fourth quarter we expect PC hardware unit growth of 9% to 11%. Growth will continue to be driven by strength in emerging markets while we are tempering our forecast to growth rates in mature markets. [inaudible] fourth quarter guidance and year-over-year growth rates, we expect revenue of $15.5 billion to $15.8 billion representing excellent growth of 16% to 18% over fiscal 2007. Revenue guidance by business unit is as follows: for client we expect revenue growth of 7% to 11% for the fourth quarter. The guidance of [power] units, OEM units will grow in line slightly ahead of the PC hardware market and underlying PC market dynamics in the consumer and emerging market segments will drive OEM unit growth in excess of OEM revenue. Sever and tools revenue should 18% to 20% in fourth quarter. We expect corporate demand for our server products to remain strong which will drive double-digit growth across the [bricks] of our server platform products and services. In the online services business we forecast revenue to be up 37% to 41% for the fourth quarter. Microsoft business division revenue should grow 15% to 16% on continued demand for the 2007 Office Suites, SharePoint and Office communication server. Lastly entertainment and devices division revenue is expected to grow 32% to 34% driven by strong demand for Xbox 360 consoles and games. Turning back to company wide performance operating income for the fourth quarter is expect to be between $5.8 billion and $6.2 billion representing 46% to 54% growth over the prior year which included the Xbox 360 warranty charges. Excluding those charges operating income should grow a very healthy 15% to 22%. Fully diluted earnings per share expected to come in at $0.45 to $0.48 for the fourth quarter and this guidance assumes an effective tax rate of 30%. So with that fourth quarter guidance we arrived at the following expectations for the full fiscal year 2008. Revenue of $60.1 billion to $60.3 billion representing year-over-year growth of 17% to 18%; operating income of $22.6 billion to $23 billion, excluding the European commission fine of $1.4 billion in the quarter, operating income would have been $24 billion to $24.4 billion; and for fully diluted earnings per share we expect $1.87 to $1.90 representing growth of 33% to 35% when normalized for legal charges and tax benefits. So with the close of the FAST Search and Transfer acquisition since the last time we provided you with guidance in January we’ve updated our fiscal ’08 guidance to include and estimate of about $50 million of in process R&D and integration costs related to the acquisition. From a balance sheet perspective we are maintaining our previous forecast of total unearned revenue balance to finish fiscal 2008 up 14% to 16% over prior years. Contract but not billed should also finish 2008 up from current levels. With that let’s turn our current thinking about the next fiscal year. Remember this represents our preliminary view prior to completing our internal budgeting and planning process which occurs during the fiscal fourth quarter. This guidance does not include any impacts from our proposed acquisition of Yahoo. Our current forecast for fiscal 2009 revenue is $66.9 billion to $68.0 billion which represents growth of 11% to 13%. On an absolute basis that represents an increase of approximately $7 billion to $8 billion of incremental revenues. We expect operating income to be between $26.7 billion and $27.4 billion or growing 18% to 19%. Excluding the European commission fine in fiscal 2008 operating income is expected to grow roughly in line with revenue growth. Although [inaudible] about costs and operating expenses [inaudible] is still preliminary we expect operating income margins to remain generally flat year-on-year which includes the impact of about $0.50 billion of additional expenses related to recently announced acquisitions including FAST and Danger which were not in our forecast when we saw many of you in New York in February. We look forward to providing more detail on the fiscal ’09 investments on our fourth quarter earnings call and our fiscal analyst meeting on July 24th. So for the rest of the income statement we expect investment income to be lower in fiscal ’09 due to lower yields on the investment portfolio as a result of lower interest rate environment but we are also modeling a decline in our tax rate to 28% in fiscal 2009 driven by continued shift in our earnings mix towards lower tax rate jurisdictions. We expect fully diluted earnings per share of $2.13 to $2.19 representing growth of 14% to 15%. As always I’ll remind you to think about the guidance that we provided. You must also consider the risks. These included competitors, legal, execution and general market risks such as foreign exchange for instance, fluctuations in PC and server hardware growth rates, IT spendings, changes in the piracy rates of our products and customer acceptance of our new and existing products. Additionally changes in the mix of our sellings between the new [inaudible] and license only can have an impact on revenue, operating income and earnings per share by delaying revenue recognition into future periods. I’d like to wrap up with a couple of final comments. First as you consider the performance we’re delivering in fiscal 2008, and the preliminary view of fiscal ’09, they are great examples of the growth model we’ve had for the company which I outlined previously. It begins by focusing on the growth opportunities where we can differentiate ourselves through software and in particular business IT spending but also increasing the online advertising and consumer entertainment. Add to that a truly global approach to our sales, two-thirds of our revenue driven from users outside of the US and about 15% in high growth emerging markets. These opportunities set the stage for healthy broad based revenue growth across our businesses. That revenue growth allows us to reinvest into our existing business, pursue both organic and inorganic growth opportunities while continuing to grow operating profits. Operating profits combined with reductions in our share count and improvements in our tax rate drive earnings per share growth. If we achieve the guidance we have outlined today over the three year period through fiscal year ’09 during one of the most difficult economic environments we have faced we will grow earnings per share approximately 80%. Lastly before handing the call back to Colleen, I wanted to provide a brief update on our proposal to acquire Yahoo. With or without a Yahoo combination Microsoft is focused on the online advertising market which is expected to double by 2010 to $80 billion. Although Yahoo would accelerate our efforts we have an existing strategy that is already centered on three key pillars; drive innovation and search, increase value to advertisers and publishers through innovation and scale and grow user engagement across our MSN and Windows Live properties. We have an extremely talented engineering team, a great portfolio of advertiser and publisher tools and key assets in information content, communications and social networking. Lastly we are committed to compete in online advertising through organic investments, partnerships and acquisitions such as aQuantive and Rapt. With respect to Yahoo we have been as evidenced in the size of our offer premium that speed is of the essence for the deal to make sense and get folded into our online strategy. Unfortunately the transaction has been anything but speedy as is being characterized by what would appear to be unrealistic expectations of value. Our initial offer was an extremely generous more than 100% premium fee [inaudible] core business. And our view on value is shaped by the long-term value of the company and we intend to remain disciplined in our approach. The strongest argument that I’ve heard on why we should increase our bid, simply that we can afford to, is not one that I favor. We’ve yet to see tangible evidence that our bid substantially undervalues the company. In fact we see the opposite. Yahoo continues to lose search share and profitability continues to decline year-on-year. The results that they announced on Tuesday were in line with the guidance that they gave on their last earnings call on January 29, after which their stock price closes at $19.05 and Wall Street analysts’ consensus on value was significantly decreased. As outlined in our recent letter to the Yahoo Board, unless we make progress with Yahoo towards an agreement by this weekend, we will reconsider our alternatives. We will provide updates as appropriate next week. These alternatives clearly include taking the offer to Yahoo shareholders or to withdraw our proposal and focus on other opportunities both organic and inorganic. With that being said I’d like to remind you that we’re here today to discuss our earnings and we hope you understand that we can’t go beyond in the Q&A session what I’ve just said. With that I’ll hand the call back to Colleen so we can get started taking your questions.
Colleen Heally: Thank you Chris. Let’s now proceed to questions. We want to accommodate questions from as many people as possible so please avoid multi part questions and limit yourself to just one question. Operator, will you please repeat your instructions.
Operator: Your first question comes from Charlie DiBona - Sanford Bernstein
Charlie DiBona: I know it’s early but I was wondering if we could maybe dive a little bit into your fiscal ’09 guidance, in particular you’re calling for something around 12% revenue growth here. With the US economy looking like its getting weaker, it doesn’t sound like you’ve included any kind of recession in your forecasting but can you maybe characterize your view of your business and how insolated it would be from a US based downturn and how solid that number looks if the economy starts to get weaker?
Chris Liddell: The first thing to comment on is in line with some of the prepared remarks that we made. One of the great things about our business from my perspective is the diversification and the diversification across geographies and across business types. So clearly we like everyone else would be impacted by an economic downturn if one was to get worse than where it is, but we have built in what we consider to be an appropriate level of conservatism at this stage for next year. And I’ll just remind you that two-thirds of our business is now out the US and some we’ve seen some very strong growth from emerging markets. So a very good geographic spread and also fairly a weak US dollar helps us in that perspective. The other thing to mention is this year would be one year that most people would say has been one of relatively difficult economic conditions so this is a year where if we finish out along the guidance that we have talked about we will have grown revenue by 17% to 18% and earnings per share by 33% to 35% so if we can turn in a performance like that in what a lot of people are finding to be a particularly difficult year, then that gives me a lot of confidence in our business model going forward.
Operator: Your next question comes from Sarah Friar - Goldman Sachs
Sarah Friar: Chris the FY09 EPS guidance is quite robust so could you give us a sense for what does that assume in terms of the investment required for your goals in the online services business and if for whatever reason you don’t get Yahoo do you have to come back and revise down the margin for a build versus a buy decision?
Chris Liddell: There’s a reasonable amount of additional growth in our expense line for the online and is already imbedded into fiscal year ’09 so we’ll obviously give you more detail in three months because we haven’t completed our internal budgeting but if you look at the makeup of the expense growth then it’s around 20% to 25% of that growth will be to drive our online services division with those final numbers to be determined in the next three months. The balance will go into other high growth areas in the other divisions into things like building our sales force and in particular outside of the US and then we’re getting other impacts like FX and so forth coming in as well. But there is already a reasonably high proportion of expense growth allocated to the online services area and also in terms of CapEx we’re expecting to spend more next year and that’s imbedded in our numbers as well than this year. So clearly if Yahoo was to happen we’d have to overlay that impact. We would still think about spending I would think virtually all of that money in terms of organic growth anyway. If Yahoo wasn’t to happen, could we consider other investments, yes but we’ll cross that bridge when we come to it.
Sarah Friar: Great, the currency impact on the quarter, could you just give us a sense for that?
Chris Liddell: Yes, around 3% benefit both on the revenue and the expense side so if you like in the expense it’s a negative but a 3% impact broadly speaking in both revenue and expenses.
Operator: Your next question comes from Heather Bellini – UBS
Heather Bellini: I know piracy is a difficult thing to solve for each quarter but I know your comps here are getting tough in the second half of calendar year ’08, so how should we think about your progress – the progress you made in the second half of ’07 how much of a tough comp does that give you for the client business than in the second half of ’08 and then just about the buybacks, I believe I read in your Q you cut them to about a billion dollars this quarter, should we expect that level to stay until we know the outcome of the Yahoo transaction?
Chris Liddell: Starting with piracy, you’re right on a quarter-by-quarter basis and I’ll talk to you and other investors about this its difficult to look at piracy on a quarter-by-quarter because we can see individual enforcement actions make a big difference in any one quarter so we had a very good performance in the first two quarters of the year. The first and second quarter of our fiscal year a relatively weak performance, in fact it was a negative in this quarter so overall for the year, we still think that we will drive unit growth 1% to 2% higher than underlying market growth as a result of our combating piracy but relative to the first couple of quarters when we had very good performance that’s a little lower. So we still think it’s a positive trend overall but you are correct it does get progressively harder. In this particular quarter we had a couple of distributors had a particularly high distribution of unlicensed PCs in China due to some market conditions there. You can have that sort of one-off impact so it’s much better to look at it on a year by year rather than a quarter by quarter.
Heather Bellini: Just to understand that topic just because that means that in the September and December quarter of calendar year ’08 you’ve got pretty tough comps, is that the situation where we should expect your OEM to be below PC shipments for your revenue to grow less than PC shipment?
Chris Liddell: Are you talking about for the fourth quarter?
Heather Bellini: No I’m talking about for September and December given the tough comps you have September and December of ’08, you’ve got tough comps in piracy versus September and December of ’07.
Chris Liddell: Yes I think for next year but I just don’t want to get into too much guidance. We still think that we will grow units more than PC demand but for the same, you’ll get the same impact that you’ve seen for this year which is the extent that it grows faster in emerging than mature markets et cetera then revenue will be slightly lower than unit growth and that will probably wash out to mean that revenue will be broadly in line or just slightly below overall market growth but we still think that our unit growth will be higher than market growth.
Heather Bellini: Okay and then just the buyback question.
Chris Liddell: On the buyback, yes you are correct it was low this quarter in particular because of the Yahoo transaction. I want to maintain the most amount of flexibility for that transaction in terms of our cash buildup and how the final transaction might work if it does. Therefore I don’t intend to get into quarter by quarter and I don’t want to give specifics but also just from a legal perspective, its difficult for us to be too active in the buyback market so I would expect us to be relative modest from a buyback perspective until we get clarity on Yahoo one way or the other.
Operator: Your next question comes from Kash Rangan - Merrill Lynch
Kash Rangan: If you just look at the guidance philosophically Chris compared to the last couple of years the same time of the year when we you were giving guidance for the upcoming year I think guidance has been generally below consensus or bracketing consensus – mainly conservative giving you the opportunity to outperform as you execute on your model. I’m just curious this time around I think the guidance tests certainly as Charlie indicated assumes some US – actually a reasonable level of execution on the revenue side range of 12% growth but I’m wondering on the earnings side if you’re not giving enough flexibility for potential spending in the online business if the Yahoo transaction were not to come through just philosophically I guess my question is how do you think about guidance relative to the trend – it seems like there’s a bit of a change here and I’m just curious what your thought process there is.
Chris Liddell: There’s a few trends here, from a revenue point of view, as I mentioned to Charlie I feel very good about our revenue forecast 11% to 13% for next year. I think that’s very good in the current economic environment and as I said I think that is a testament to the strength of our particular investment business model and also the fact that we have made a lot of investments in the past. We have talked to investors about the benefits of those investments and I think that is starting to pay. Clearly in this year where we’ve driven revenue by over 16% and next year 11% to 13% feels very good. So I feel good on the revenue side. On the operating expense side I think we’re making at this stage plenty of provisions for what I consider to be appropriate OpEx not just in the online services but across the whole business. So I don’t feel bad that we are leaving anything out there. Clearly if we were to make another acquisition or to acquire Yahoo that does change the game but in terms of allowing us to do what we want to do organically and through some level of acquisition not only in online services but in other businesses I feel good about the level that we have built in at this stage. And overall earnings per share growing 14% to 15% I guess some assumptions there about buybacks and investment income, I mentioned the tax rate is starting to come down and I talked about this at the last couple of financial analyst meeting that we are now in a period where you can expect to see our tax rate start to go down year after year not only in fiscal year ’09 but in fiscal year ’10 as well as a result of the changes in our business models. So if you look at the individual parts of guidance for fiscal year ’09 at this stage I feel we are hanging together very well.
Kash Rangan: and also the bookings growth rate, coming in at 14% do you think that is more indicative of what we should expect over the few quarters because I think and right after the product launches you had 30% and then it looks like we’ve seen some deceleration but is this the real run rate going forward given that we’re entering a more mature aspect of the product cycle?
Chris Liddell: You would expect over the long-term that bookings growth and overall revenue growth to be broadly both the same as each other so if we can continue to get bookings growth excluding Vista unearned impact but general bookings growth in the mid teens that would support low to mid teens revenue growth. If that’s the mature part of the cycle then that’s pretty healthy from my perspective.
Operator: Your next question comes from John Difucci - Bear Stearns
John Difucci: I have a follow-up to Heather’s question and it has to do with the anti piracy efforts. The September to December quarters we saw some big benefits from that and actually seemed to take us by surprise and you by surprise and this quarter that looks to have reversed. Chris you mentioned I guess government crackdowns and we had heard some of those in the second half of last year, is there any other color you can give us on that because trying to understand this and obviously its going to be a fight as you move along but if its always going to be you get a foot and you give up a yard kind of thing, I’m just trying to figure out what you see and in Asia this quarter why would it sort of reverse and then secondly on that I’m just curious why you expect an acceleration in PC growth into the next quarter especially given the macroeconomic backdrop.
Chris Liddell: On piracy or more particularly on license shipments which become pirated, you are true that on a quarter by quarter basis it can move around quite a lot and hopefully you recall in particular in the first quarter that I said don’t take too much from this positive number. You can get an aberration like this on a quarterly basis and you could have a negative one by implication and that’s what we have seen this quarter. So again I’ll just reinforce you really need to look at things like piracy on a long-term basis and average them out to really get a sense of how it’s happening. In the first quarter in particular we saw a very strong performance in our Russian subsidiary which helped enormously when you spread that volume over the total business. In this quarter in China because of some specific market dynamics that happened in that country you saw a relatively negative performance. You have got to wash those things out. You have got to look at it on the course of the year. We still think for the year we are going to have PC unit growth of 11% to 13%. We think we are going to ship our units of 12% to 14%. So we still think we are going to pick up one maybe two percent of shipment growth relative to overall market growth and that washes out the unders and overs and that’s how I prefer to think of it.
Colleen Heally: And just to put that into a little more context too on the unlicensed PCs aspect, just keep in mind that when we were looking at the PC units to OEM units that was one of three factors that we talked you through in bridging that, so that is one of three factors.
Chris Liddell: In terms of overall PC demand what I would say is we started the year believing that we were going to have about 9% to 11% in terms of unit shipments. The third quarter came in at 8% to 10%. So broadly speaking it was in line with where we started the year. It was a little bit weaker in mature markets which I think picks up some of the economic issues that we are seeing particularly in the US but it was stronger in emerging markets. So the mix was different to what we thought but the overall market was about in line, 1% lower which is [around the area] really to where we started the year. What we saw really was a particularly strong performance in Q1 and Q2 so it’s difficult to continue to extrapolate an out performance, 8 to 10 I don’t feel bad about. And if we can end the year at 11 to 13 which is how we feel relative to a starting point of 9 to 11 we still feel that’s a good robust year but obviously on a quarter by quarter basis again you can read too much into an individual quarter if you look at the year it looks pretty good.
John Difucci: Yes but how could you I mean given the macro backdrop it just seems kind of odd that you would assume that PC sales would increase in this current quarter versus the 8 to 10.
Chris Liddell: Well we’re talking about 9 to 11 for the fourth quarter relative to 8 to 10 for the third quarter. So it’s a 1% change. And don’t forget the third quarter, this quarter [lept] Vista launch last year so you’ve got some aberrations on a year on year basis but accelerating from 8 to 10 to a 9 to 11 third quarter to fourth quarter doesn’t feel like its – we haven’t got the foot on the accelerator very hard to achieve that.
Operator: Your next question comes from Robert Breza - UBS Capital Markets
Robert Breza: I was wondering if you could talk a little bit about the integration of aQuantive and I guess where does that sit relative to your estimates and how is that tracking to your plan?
Chris Liddell: There's a number of ways of looking at how it’s integrated. The first and most important is from an employee integration point of view given that the real revenue potential is some years out. From the employee point of view we couldn’t have been happier. All of the key executives have remained. Brian [Makendries] is doing a great job leading that and is taking a broader role inside Microsoft in terms of driving that part of the strategy. We’ve integrated in my view the cultures very well and we’ve got people from aQuantive taking a broader role and Microsoft people from the previous Microsoft working inside and helping drive aQuantive strategy and they’re very active and thinking the way in which they can not only build aQuantive as it was but use the financial and other resources of Microsoft to make aQuantive go faster. So if you take that as the sort of first determinate of how well things have gone, I’m extremely happy with that. In terms of the underlying business, leading indicator would be just number of publishers we’re getting on board again that’s going very healthy. We’ve talked through the quarter I think we’ve made a few announcements. There are 96 I believe new publishers of various sizes have switched on to the Atlas Publisher Suite in the last quarter, since we announced sorry. So very good growth in the underlying dynamic in the business. From a profitability point of view, we’re carrying the costs of the acquisition but we are managing to achieve the results that we talked about despite the fact that at this stage its early days for aQuantive and we’re carrying in particular some of the non-cash charges associated with the acquisition. So the revenue growth is still ahead of us, from a cost point of view we’re in line but it’s a negative. From a publisher business point of view good early indicators and from a people point of view it’s excellent.
Operator: Your next question comes from Kirk Materne - Banc of America Securities
Kirk Materne: Operating margins for the fourth quarter appear to be going down just a tad versus the third fiscal quarter, could you just explain some of the dynamics around that. I realize you have just made some acquisitions. Is it mainly headcount related? Is there some mix shift going on between the businesses? Anything to do with E&D, obviously its going to have a strong quarter with Grand Theft Auto, I’m just trying to get the dynamics about that.
Chris Liddell: The problem looking at margins for the business overall is you inevitably get quite a lot of difference between the individual businesses and how they make up one quarter. So that’s the first statement and its best to look at the year overall where you’re looking at margin expansion but if you look at the trends through the quarters. I think quarter one was 43%, quarter two was 39.6, quarter three was 40.3, and quarter four was 37.6, overall 40. So in any one quarter you can get quite different movements and that reflects (a) the mix of businesses and (b) if you have a strong Xbox quarter you get a lot of the [cogs] associated with that that tends to decrease the margins. Fourth quarter we get a lot of marketing and signup costs associated with our enterprise businesses which generally are buying annuities. So we don’t get a lot of the revenue associated with it, we get some of the costs and we get the benefits of that revenue flying through for the next year. So the short answer to your question is there is nothing unusual in the fourth quarter. We typically see it if you look back in previous years it’s a low margin quarter relative to the first, second and third. There’s nothing unusual about this fourth quarter. Its part of the normal cycle.
Kirk Materne: If I could just follow-up on John’s question just on the acceleration in PCs into the fourth quarter, one of the comments you had about the last quarter was just the inventory levels being a little bit higher heading into the third quarter, I assume those have been drawn down to levels you feel more comfortable with heading into the fourth quarter?
Chris Liddell: Yes, although just to be clear I think John’s question was PC units overall and inventory levels tend to be a comment about our shipments to OEM so those are very tightly related to each other clearly but in answer to your question, yes they are [inaudible] more normal. Although I will say it’s quite early in the quarter. Sometimes we get that information over the next few weeks but there’s nothing that we’re seeing that’s unusual going into this quarter and that’s embedded in our guidance.
Operator: Your final question comes from the line of Brent Thill - Citigroup
Brent Thill: Chris just drilling into the client line item, that was clearly probably the biggest disappointment relative to all of our models and understanding the licensing change but when you drill into what’s happening with Vista and XP are you still happy with what you’re seeing in the Vista upgrade cycle or are you still seeming more units of XP going than you like and that wouldn’t obviously have an impact on the pricing?
Chris Liddell: Yes, with respect to the quarter, the third quarter in particular there’s really no Vista-related issues at all. In terms of the impacts, firstly the overall PC market, unlicensed PCs which is not a Vista issue. Emerging markets growing faster than mature markets, that’s not really a Vista issue. A bit of a channel shift to larger OEMs again not a Vista issue. And obviously if we sell a unit of XP rather than selling a unit of Vista we’re still relatively happy because of the realization and so there’s nothing in the third quarter that is specific to Vista in terms of the walkthrough from the overall PC market down to overall client revenue. I guess the only Vista impact really is the launch last year and the very strong comparables that we have but that’s not really a comment about this quarter its more a comment on the year-ago quarter and the comparable.
Colleen Heally: Yes I think if you look at whether it’s Vista, [inaudible] or from a mix standpoint we can let you know we’re up a bit sequentially in terms of Vista -- shared with you 140 million licenses sold so you know I think things are tracking well and as expected from our perspective.
Chris Liddell: So with that I’ll thank you all, I’ll hand it back to Colleen to finish but I look forward to talking to a number of you in three months and in particular seeing a number of you at the financial analyst meeting a few days later.
Colleen Heally: Thanks everyone for your participation in today’s call. If you have any further questions, please feel free to call me or my team directly. As I mentioned at the beginning of this call, this conference call will be available on replay at our Investor Relations website through close of business April 24, 2009. In addition, you can hear the replay by dialing 1-800-756-0715 or for international calls dial 203-369-3427; the dial in replay will be available through the close of business May 2, 2008. Thanks again for joining us today. | [
{
"speaker": "Operator",
"text": "Welcome to the Microsoft third quarter earnings call. (Operator Instructions) I would now like to turn the meeting over to Colleen Heally, General Manager, Investor Relations; ma’am you may begin."
},
{
"speaker": "Colleen Heally",
"text": "Good afternoon everyone. This afternoon I am joined by Chris Liddell, Senior Vice President and Chief Financial Officer, Frank Brod, Corporate Vice President and Chief Accounting Officer and John C. Top, Deputy General Counsel. Today’s call will start with Chris providing key takeaways for the third quarter of fiscal year 2008 and an overview of expectations for what remains of the fiscal year. I will then provide detail around our third quarter results and then turn it back to Chris for a more detailed discussion of our guidance for the fourth quarter and a preliminary outlook for fiscal year ‘09. After that we’ll take your questions. We filed our 10-Q today in conjunction with our earnings release, therefore you have available the earnings release, MD&A, financial statements and footnotes. We have also posted our quarterly financial summary slide deck which is intended to follow the flow of our prepared remarks in order to assist you. The slide deck offers highlights from the quarter, outlines our guidance and provides a reconciliation of differences between GAAP and non-GAAP financial measures that we will talk about today. You can find the earnings release, the 10-Q and quarterly financial summary slide deck at the Investor Relations website at www.microsoft.com/msft. Today’s call will be recorded, please be aware that if you decide to ask a question it will be included in both our live transmission as well as any future use of the recording. As always, shareholders and analysts can listen to a live webcast of today’s call at the Microsoft Investor Relations website. A replay of the call will be available at this same site through the close of business on April 24, 2009. This conference call report is protected by copyright law and international treaties. Unauthorized reproduction or distribution of this report or any portion of it may result in civil and criminal penalties. Any recording or other use or transmission of the text or audio of today’s call is not allowed without the express permission of Microsoft. Because we will be discussing on this call our proposal to purchase all of the outstanding shares of Yahoo we are providing the following statement. This conference call does not constitute an offer to sell or the solicitation of an offer to buy any securities or a solicitation of any vote or approval. The material covered in this conference call is not a substitute for the prospectus or proxy statement Microsoft would have to file with the Securities and Exchange Commission if an agreement between Microsoft and Yahoo is reached or for any other documents with Microsoft may file with the SEC and sent to Yahoo stockholders in connection with the proposed transaction. Investors and security holders of Yahoo are urged to read any such documents filed with the SEC carefully in their entirety when they become available because they will contain important information about the proposed transaction. Statements in this communication are forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in today’s earnings press release and the comments made during this conference call and in the risk factors in the MD&A sections of our Form 10-Q, our 2007 Form 10-K and other reports and filings with the SEC. Actual results also could differ materially because of factors such as Microsoft’s ability to achieve the synergies and value creation contemplated by the proposed transaction with Yahoo, Microsoft’s ability to promptly and affectively integrate the business of Yahoo and Microsoft, the timing to consummate the proposed transaction and any necessary actions to obtain regulatory approvals and the diversion of management time on transaction related issues. You may obtain copies of Microsoft’s SEC reports and filings by contacting our Investor Relations Department at 1-800-285-7772 or at our website at www.microsoft.com/msft. All information in this conference call is as of today April 24, 2008. We do not undertake any duty to update any forward-looking statements, to conform the statements to actual or changes in the company’s expectations. Okay with that, let me now turn it over to Chris."
},
{
"speaker": "Chris Liddell",
"text": "Thanks Colleen and good afternoon everyone. The sense of our third quarter results demonstrates the benefits of our diversified business model. As you will see our broad span across geographies, product categories and customer segments is a tremendous asset in any economic environment and produced third quarter results of 14% revenue growth normalized for the tech guarantee and 27% earnings per share adjusted for the tech guarantee, legal charges and tax benefits beating our earnings per share guidance by $0.02 to $0.04. Let me mention a few highlights about third quarter performance before turning to guidance. When looking at the drivers of revenue growth this quarter it’s clear that we are reaping the benefits of the diversification of our business. In the first two quarters of the year our core business of client and the Microsoft business division significantly outperformed our expectations and this quarter entertainment and devices division drove our results. Despite the tough economic environment this has allowed us to deliver consecutive earnings per share growth of 29%, 32% and 27% this year adjusted for the tech guarantee, legal charges and tax benefits. Revenue growth in the client and Microsoft business division businesses were normalized for the prior year results for the impacts of the tech guarantee and retail launch spikes had combined growth of $700 million or 9%. Server and tools had yet another quarter of double-digit revenue growth while kicking off our largest enterprise product launch in the company’s history. Our consumer businesses of entertainment and devices division and online service business grew revenue of combined 57% or over $850 million. And the treasury department continued to take some work delivering investment income exceeding our forecast and managing to avoid any significant write-offs in our portfolio despite the [massive] dislocation in the financial markets. In the fourth quarter we expect a strong finish to what has been an excellent year. Revenue, operating income and earnings per share guidance for the year remain largely in line with our January guidance and significantly above our expectations upon entering the year. Since this time last year our revenue outlook for fiscal year ’08 has increased by about $3 billion, operating income margins are expected to expand by over a point and earnings per share guidance is higher by $0.18. On a more macro level there has been some uncertainty regarding the strength of the IT spending environment but our business has remained robust in the face of that uncertainty. While clearly no business can be immune from the impact of an economic slowdown, we remain confident in the benefits of our diversified business model and the investment approach we have taken in recent years. We’ve delivered earnings per share results above the high end of our guidance every quarter this year and have raised our full year earnings per share guidance in each quarter. We are not expecting earnings per share growth of 33% to 35% this year normalized for legal charges and tax benefit which is an outstanding achievement in the current economic environment. With those high level themes I’m going to turn over the call to Colleen for more details of our third quarter performance."
},
{
"speaker": "Colleen Heally",
"text": "Thanks Chris. It was an excellent quarter with normalized revenue and operating income growth of 14% and 15% respectively. Normalized EPS growth at 27% was five points above high end guidance. Revenue growth was driven by continued enterprise customer demand for our core products as well as consumer demand for products and services in the entertainment and devices division and our online services business. Let me provide you with details of our financial performance starting with revenue. I’ll discuss top line financial and business momentum points and then follow with revenue performance for each of the business units. Then I’ll review the rest of the income statement. All growth comparisons relate to the comparable quarter of last year unless otherwise specified. Revenue was $14.5 billion. Adjusting the year-ago quarter by the $1.7 billion of revenue recognition primarily related to the technology guarantee programs from Windows Vista and Office 2007 total revenue grew 14%. We estimate PC unit growth rates moderated from our January expectations by a couple of points in mature markets partially offset by an extra point of strength in emerging markets resulting in an estimate of approximately 8% to 10% for the entire PC market during the quarter. Our mix of product billings for the quarter was approximately 30% from OEMs, 30% from multi-year agreements, 25% from license only sales and the balance from our other businesses. Annuity sales mix continued to increase on both a year-over-year and sequential basis while enterprise agreement renewal rates were in line with historical trends. As we guided our unearned revenue balance was consistent with historical seasonality patterns and remained roughly flat on a sequential basis at $12.1 billion up 18% year-over-year. Our contracted not billed balance remains above $11.5 billion and increased sequentially up well over $1 billion from where we started the fiscal year. When taken together with reported revenue total bookings for the company grew 14%. Now I will provide revenue highlights by business segment starting with clients. Client revenue of $4 billion was down 24% or down 2% adjusted for the tech guarantees. Adjusting that further for a retail launch bump from last year client revenue would have been up 4%. Let’s break down the main drivers behind client revenue first for OEM license units and then for OEM revenue. During the quarter our OEM license units increased by 5%, about four points than the overall hardware market. We believe this reversal of the OEM unit trend outpacing that of the PC market was primarily driven by three factors. One, last year OEMs particularly in the system builder channel rebuilt inventory levels following the launch of Windows Vista driving OEM unit growth over 20% during that quarter and making it a tough comp. Two, inventory levels at our OEM partners this year were higher than normal exiting fiscal Q2 impacting this quarter’s purchases. Three, we believe there was an increase in shipments of unlicensed PCs particularly in Asia. While we generally feel good about the gains we are making in piracy for the year, piracy is a tough battle in an area where we will need to continue investing in order to make progress. Looking past the individual quarters, PC market growth was up 12% to 14% year to date with OEM license units growing about a point faster which is in line with our historical rate of progress against piracy. OEM revenue declined 25% but grew a point when normalized for the tech guarantees in the prior year. The four percentage difference between OEM license unit growth and revenue growth was caused by two roughly equivalent factors; mainly the increasing volume in emerging markets and a channel shift to large OEMs from the system builder channel. Partially offsetting these impacts was in increase in premium mix. Premium mix grew five points during the quarter to 76% driven by an increase in the consumer element of the mix while the business portion was unchanged. The remaining roughly 20% of client revenue comes from the commercial and retail licensing portion of the business which declined 18% or was down 13% after adjusting for tech guarantees. Normalizing last year’s Windows Vista launch bump at approximately $225 million growth would have been up 23%. We continue to see healthy growth in the commercial portion of the business as sales of software assurance were once again strong as evidenced by the 29% in the client volume licensing portion of the unearned revenue balance. Since the launch of Windows Vista revenue for the client business has grown 16% with a license growth rate of one to two points above that of the PC hardware market. Over 140 million licenses of Windows Vista have been sold to date and Service Pack 1 was released in the quarter. Moving to server and tools, revenue of $3.3 billion represented an increase of 18% marking its 23rd consecutive quarter of double-digit growth. Customers continue to gravitate towards premium versions of Windows Server and SQL Server as well as to annuity contracts. The increased billing mix of annuity contracts drove the unearned revenue balance for the division up by over 35% versus last year. Our consulting and support services revenue increased 24% as we’ve experienced high demand following the recent launches across our product lines. The third quarter also marked the launch activities of the new versions of our flagship products in the server and tools division, namely Windows Server 2008, SQL Server 2008 and Visual Studio 2008. These products bring powerful new tools to our customers and partners looking to turn their IT departments into a strategic asset. For example Windows Server 2008 with virtualization technology will help customers increase reliability and flexibility of their server infrastructure, reduce costs and increase security. Online services business grew revenue 40% to $843 million this included $143 million from the addition of aQuantive. Online advertising grew 39% or was up 29% excluding the $47 million of ad revenue from aQuantive. Our online audience continues to grow. Live IDs increased to 18% to 448 million while usage deepened with search queries and page views up from the prior year. In the quarter we announced a number of acquisitions including Caligari for collaborative 3D modeling, YaData for customer micro segment management, and Rapt for behavioral targeting. And of course in February we proposed to purchase Yahoo. Chris will go into more detail about Yahoo later in the call. Microsoft business division revenue was $4.7 billion down 2% but up 9% adjusted for tech guarantees in fiscal year 2008. Adjusted for last year’s retail launch bump of about $150 million revenue would have grown 13% with business customer revenue growth of 17%. Our expanded portfolio of productivity products are thriving with share point revenue up over 35%, unified communications up over 20% and dynamic customer billings up 13%. On the strategic front we announced the acquisition of FAST Search and Transfer to enhance our enterprise search offerings. During the quarter we also held our SharePoint and Convergent conferences which both saw record attendance by customers and partners. And we expanded on our software plus services vision by announcing that the Beta of SharePoint online and exchange online will be opened to companies of all sizes. Entertainment and devices division grew revenue of 68% to $1.6 billion over $300 million above our high end guidance driven by the sale of 1.3 million Xbox 360 consoles. High holiday demand for Xbox 360 consoles during the preceding quarter in which Xbox 360 outsold PlayStation 3 by over 1 million units in the US led to a short channel inventory for much of this quarter. However according to US MPG data by March Xbox 360 had reclaimed its monthly console sales lead over the PS3. With retail inventory restored to more healthy levels Xbox 360 is well positioned as the industry anticipates next week’s launch of Grand Theft Auto 4. During the quarter we announced the acquisition of Danger which closed last week and announced the November target release date for Gears of War the highly anticipated sequel to the fastest selling video game of 2007. Now for the rest of the income statement. Cost of revenue increased by $370 million primarily driven by higher Xbox 360 console sales, growth in our consulting business, and expansion of data center operations and the addition of aQuantive costs. After adjusting the year-ago quarter for the impact of tech guarantees cost of revenue held flat at 17% of sales. Operating expenses increased almost $1.9 billion or up 33% primarily due to $1.4 billion of legal charges relating to the European commission fine assessed in February. Adjusting for that charge in the current quarter and $150 million of legal charges in the same quarter of last year, operating expenses increased $600 million, up 11%. This is favorable to our expectations due to lower headcount driven costs and some shift of marketing expense into the fourth quarter. Operating income was $4.4 billion. After adjusting for the impact of tech guarantees and legal charges, operating income grew 15%, one point faster than revenue growth. Investment income and other totaled $401 million for the quarter as the treasury team continued to do an outstanding job in challenging capital markets. Our effective tax rate for the quarter was 9%. During the quarter we settled a 2000 to 2003 examination with the IRS. As a result we reduced our previously accrued tax provision by $1.4 billion which was partially offset by the non-tax deductibility of the European commission fines resulting in our adjusted effective tax rate for the quarter of 29%. During the quarter we repurchased 30 million shares or $1 billion of company stock and paid out over $1 billion in dividends to shareholders. Diluted shares outstanding for the quarter were 9.4 billion down 4% from the prior year as a result of share repurchases. Earnings per share for the quarter were $0.47 which was $0.02 to $0.04 above our guidance after adjusting for the offsetting impacts of the $0.15 EPS charge from the European commission fine and the $0.15 benefit from the resolution of the tax examination. So in summary our diversification across geographies, product lines, customer segments and product life cycles produced 14% top line and 27% bottom line growth. This allowed us to generate over $7 billion of operating cash flow, the second highest level in the history of Microsoft. With that let me turn it back to Chris who will provide you with our fourth quarter guidance and our preliminary outlook for fiscal year 2009."
},
{
"speaker": "Chris Liddell",
"text": "Thanks Colleen, I’m going to spend my remaining time on the call giving you a view of our expectations for the fourth quarter followed by a preliminary view of fiscal 2009. I also note that we have about twice the number of people on the call as normal so for some of the newcomers I’ll also make some brief comments on our proposed acquisition of Yahoo. Let me begin by outlining some of our key assumptions for the fourth quarter. We’ll assume the following macroeconomic conditions for the remainder of the year; we expect the software spending environment to remain mixed but positive overall on a global basis especially for the positioning of our products and the value they offer. Like you we are cautious on the reported economic softness in the US but at this point we have not seen any significant spillover to our businesses. We continue to benefit from strong underlying growth in non-US and emerging markets which has also been assisted by stronger international currencies. For the fourth quarter we expect PC hardware unit growth of 9% to 11%. Growth will continue to be driven by strength in emerging markets while we are tempering our forecast to growth rates in mature markets. [inaudible] fourth quarter guidance and year-over-year growth rates, we expect revenue of $15.5 billion to $15.8 billion representing excellent growth of 16% to 18% over fiscal 2007. Revenue guidance by business unit is as follows: for client we expect revenue growth of 7% to 11% for the fourth quarter. The guidance of [power] units, OEM units will grow in line slightly ahead of the PC hardware market and underlying PC market dynamics in the consumer and emerging market segments will drive OEM unit growth in excess of OEM revenue. Sever and tools revenue should 18% to 20% in fourth quarter. We expect corporate demand for our server products to remain strong which will drive double-digit growth across the [bricks] of our server platform products and services. In the online services business we forecast revenue to be up 37% to 41% for the fourth quarter. Microsoft business division revenue should grow 15% to 16% on continued demand for the 2007 Office Suites, SharePoint and Office communication server. Lastly entertainment and devices division revenue is expected to grow 32% to 34% driven by strong demand for Xbox 360 consoles and games. Turning back to company wide performance operating income for the fourth quarter is expect to be between $5.8 billion and $6.2 billion representing 46% to 54% growth over the prior year which included the Xbox 360 warranty charges. Excluding those charges operating income should grow a very healthy 15% to 22%. Fully diluted earnings per share expected to come in at $0.45 to $0.48 for the fourth quarter and this guidance assumes an effective tax rate of 30%. So with that fourth quarter guidance we arrived at the following expectations for the full fiscal year 2008. Revenue of $60.1 billion to $60.3 billion representing year-over-year growth of 17% to 18%; operating income of $22.6 billion to $23 billion, excluding the European commission fine of $1.4 billion in the quarter, operating income would have been $24 billion to $24.4 billion; and for fully diluted earnings per share we expect $1.87 to $1.90 representing growth of 33% to 35% when normalized for legal charges and tax benefits. So with the close of the FAST Search and Transfer acquisition since the last time we provided you with guidance in January we’ve updated our fiscal ’08 guidance to include and estimate of about $50 million of in process R&D and integration costs related to the acquisition. From a balance sheet perspective we are maintaining our previous forecast of total unearned revenue balance to finish fiscal 2008 up 14% to 16% over prior years. Contract but not billed should also finish 2008 up from current levels. With that let’s turn our current thinking about the next fiscal year. Remember this represents our preliminary view prior to completing our internal budgeting and planning process which occurs during the fiscal fourth quarter. This guidance does not include any impacts from our proposed acquisition of Yahoo. Our current forecast for fiscal 2009 revenue is $66.9 billion to $68.0 billion which represents growth of 11% to 13%. On an absolute basis that represents an increase of approximately $7 billion to $8 billion of incremental revenues. We expect operating income to be between $26.7 billion and $27.4 billion or growing 18% to 19%. Excluding the European commission fine in fiscal 2008 operating income is expected to grow roughly in line with revenue growth. Although [inaudible] about costs and operating expenses [inaudible] is still preliminary we expect operating income margins to remain generally flat year-on-year which includes the impact of about $0.50 billion of additional expenses related to recently announced acquisitions including FAST and Danger which were not in our forecast when we saw many of you in New York in February. We look forward to providing more detail on the fiscal ’09 investments on our fourth quarter earnings call and our fiscal analyst meeting on July 24th. So for the rest of the income statement we expect investment income to be lower in fiscal ’09 due to lower yields on the investment portfolio as a result of lower interest rate environment but we are also modeling a decline in our tax rate to 28% in fiscal 2009 driven by continued shift in our earnings mix towards lower tax rate jurisdictions. We expect fully diluted earnings per share of $2.13 to $2.19 representing growth of 14% to 15%. As always I’ll remind you to think about the guidance that we provided. You must also consider the risks. These included competitors, legal, execution and general market risks such as foreign exchange for instance, fluctuations in PC and server hardware growth rates, IT spendings, changes in the piracy rates of our products and customer acceptance of our new and existing products. Additionally changes in the mix of our sellings between the new [inaudible] and license only can have an impact on revenue, operating income and earnings per share by delaying revenue recognition into future periods. I’d like to wrap up with a couple of final comments. First as you consider the performance we’re delivering in fiscal 2008, and the preliminary view of fiscal ’09, they are great examples of the growth model we’ve had for the company which I outlined previously. It begins by focusing on the growth opportunities where we can differentiate ourselves through software and in particular business IT spending but also increasing the online advertising and consumer entertainment. Add to that a truly global approach to our sales, two-thirds of our revenue driven from users outside of the US and about 15% in high growth emerging markets. These opportunities set the stage for healthy broad based revenue growth across our businesses. That revenue growth allows us to reinvest into our existing business, pursue both organic and inorganic growth opportunities while continuing to grow operating profits. Operating profits combined with reductions in our share count and improvements in our tax rate drive earnings per share growth. If we achieve the guidance we have outlined today over the three year period through fiscal year ’09 during one of the most difficult economic environments we have faced we will grow earnings per share approximately 80%. Lastly before handing the call back to Colleen, I wanted to provide a brief update on our proposal to acquire Yahoo. With or without a Yahoo combination Microsoft is focused on the online advertising market which is expected to double by 2010 to $80 billion. Although Yahoo would accelerate our efforts we have an existing strategy that is already centered on three key pillars; drive innovation and search, increase value to advertisers and publishers through innovation and scale and grow user engagement across our MSN and Windows Live properties. We have an extremely talented engineering team, a great portfolio of advertiser and publisher tools and key assets in information content, communications and social networking. Lastly we are committed to compete in online advertising through organic investments, partnerships and acquisitions such as aQuantive and Rapt. With respect to Yahoo we have been as evidenced in the size of our offer premium that speed is of the essence for the deal to make sense and get folded into our online strategy. Unfortunately the transaction has been anything but speedy as is being characterized by what would appear to be unrealistic expectations of value. Our initial offer was an extremely generous more than 100% premium fee [inaudible] core business. And our view on value is shaped by the long-term value of the company and we intend to remain disciplined in our approach. The strongest argument that I’ve heard on why we should increase our bid, simply that we can afford to, is not one that I favor. We’ve yet to see tangible evidence that our bid substantially undervalues the company. In fact we see the opposite. Yahoo continues to lose search share and profitability continues to decline year-on-year. The results that they announced on Tuesday were in line with the guidance that they gave on their last earnings call on January 29, after which their stock price closes at $19.05 and Wall Street analysts’ consensus on value was significantly decreased. As outlined in our recent letter to the Yahoo Board, unless we make progress with Yahoo towards an agreement by this weekend, we will reconsider our alternatives. We will provide updates as appropriate next week. These alternatives clearly include taking the offer to Yahoo shareholders or to withdraw our proposal and focus on other opportunities both organic and inorganic. With that being said I’d like to remind you that we’re here today to discuss our earnings and we hope you understand that we can’t go beyond in the Q&A session what I’ve just said. With that I’ll hand the call back to Colleen so we can get started taking your questions."
},
{
"speaker": "Colleen Heally",
"text": "Thank you Chris. Let’s now proceed to questions. We want to accommodate questions from as many people as possible so please avoid multi part questions and limit yourself to just one question. Operator, will you please repeat your instructions."
},
{
"speaker": "Operator",
"text": "Your first question comes from Charlie DiBona - Sanford Bernstein"
},
{
"speaker": "Charlie DiBona",
"text": "I know it’s early but I was wondering if we could maybe dive a little bit into your fiscal ’09 guidance, in particular you’re calling for something around 12% revenue growth here. With the US economy looking like its getting weaker, it doesn’t sound like you’ve included any kind of recession in your forecasting but can you maybe characterize your view of your business and how insolated it would be from a US based downturn and how solid that number looks if the economy starts to get weaker?"
},
{
"speaker": "Chris Liddell",
"text": "The first thing to comment on is in line with some of the prepared remarks that we made. One of the great things about our business from my perspective is the diversification and the diversification across geographies and across business types. So clearly we like everyone else would be impacted by an economic downturn if one was to get worse than where it is, but we have built in what we consider to be an appropriate level of conservatism at this stage for next year. And I’ll just remind you that two-thirds of our business is now out the US and some we’ve seen some very strong growth from emerging markets. So a very good geographic spread and also fairly a weak US dollar helps us in that perspective. The other thing to mention is this year would be one year that most people would say has been one of relatively difficult economic conditions so this is a year where if we finish out along the guidance that we have talked about we will have grown revenue by 17% to 18% and earnings per share by 33% to 35% so if we can turn in a performance like that in what a lot of people are finding to be a particularly difficult year, then that gives me a lot of confidence in our business model going forward."
},
{
"speaker": "Operator",
"text": "Your next question comes from Sarah Friar - Goldman Sachs"
},
{
"speaker": "Sarah Friar",
"text": "Chris the FY09 EPS guidance is quite robust so could you give us a sense for what does that assume in terms of the investment required for your goals in the online services business and if for whatever reason you don’t get Yahoo do you have to come back and revise down the margin for a build versus a buy decision?"
},
{
"speaker": "Chris Liddell",
"text": "There’s a reasonable amount of additional growth in our expense line for the online and is already imbedded into fiscal year ’09 so we’ll obviously give you more detail in three months because we haven’t completed our internal budgeting but if you look at the makeup of the expense growth then it’s around 20% to 25% of that growth will be to drive our online services division with those final numbers to be determined in the next three months. The balance will go into other high growth areas in the other divisions into things like building our sales force and in particular outside of the US and then we’re getting other impacts like FX and so forth coming in as well. But there is already a reasonably high proportion of expense growth allocated to the online services area and also in terms of CapEx we’re expecting to spend more next year and that’s imbedded in our numbers as well than this year. So clearly if Yahoo was to happen we’d have to overlay that impact. We would still think about spending I would think virtually all of that money in terms of organic growth anyway. If Yahoo wasn’t to happen, could we consider other investments, yes but we’ll cross that bridge when we come to it."
},
{
"speaker": "Sarah Friar",
"text": "Great, the currency impact on the quarter, could you just give us a sense for that?"
},
{
"speaker": "Chris Liddell",
"text": "Yes, around 3% benefit both on the revenue and the expense side so if you like in the expense it’s a negative but a 3% impact broadly speaking in both revenue and expenses."
},
{
"speaker": "Operator",
"text": "Your next question comes from Heather Bellini – UBS"
},
{
"speaker": "Heather Bellini",
"text": "I know piracy is a difficult thing to solve for each quarter but I know your comps here are getting tough in the second half of calendar year ’08, so how should we think about your progress – the progress you made in the second half of ’07 how much of a tough comp does that give you for the client business than in the second half of ’08 and then just about the buybacks, I believe I read in your Q you cut them to about a billion dollars this quarter, should we expect that level to stay until we know the outcome of the Yahoo transaction?"
},
{
"speaker": "Chris Liddell",
"text": "Starting with piracy, you’re right on a quarter-by-quarter basis and I’ll talk to you and other investors about this its difficult to look at piracy on a quarter-by-quarter because we can see individual enforcement actions make a big difference in any one quarter so we had a very good performance in the first two quarters of the year. The first and second quarter of our fiscal year a relatively weak performance, in fact it was a negative in this quarter so overall for the year, we still think that we will drive unit growth 1% to 2% higher than underlying market growth as a result of our combating piracy but relative to the first couple of quarters when we had very good performance that’s a little lower. So we still think it’s a positive trend overall but you are correct it does get progressively harder. In this particular quarter we had a couple of distributors had a particularly high distribution of unlicensed PCs in China due to some market conditions there. You can have that sort of one-off impact so it’s much better to look at it on a year by year rather than a quarter by quarter."
},
{
"speaker": "Heather Bellini",
"text": "Just to understand that topic just because that means that in the September and December quarter of calendar year ’08 you’ve got pretty tough comps, is that the situation where we should expect your OEM to be below PC shipments for your revenue to grow less than PC shipment?"
},
{
"speaker": "Chris Liddell",
"text": "Are you talking about for the fourth quarter?"
},
{
"speaker": "Heather Bellini",
"text": "No I’m talking about for September and December given the tough comps you have September and December of ’08, you’ve got tough comps in piracy versus September and December of ’07."
},
{
"speaker": "Chris Liddell",
"text": "Yes I think for next year but I just don’t want to get into too much guidance. We still think that we will grow units more than PC demand but for the same, you’ll get the same impact that you’ve seen for this year which is the extent that it grows faster in emerging than mature markets et cetera then revenue will be slightly lower than unit growth and that will probably wash out to mean that revenue will be broadly in line or just slightly below overall market growth but we still think that our unit growth will be higher than market growth."
},
{
"speaker": "Heather Bellini",
"text": "Okay and then just the buyback question."
},
{
"speaker": "Chris Liddell",
"text": "On the buyback, yes you are correct it was low this quarter in particular because of the Yahoo transaction. I want to maintain the most amount of flexibility for that transaction in terms of our cash buildup and how the final transaction might work if it does. Therefore I don’t intend to get into quarter by quarter and I don’t want to give specifics but also just from a legal perspective, its difficult for us to be too active in the buyback market so I would expect us to be relative modest from a buyback perspective until we get clarity on Yahoo one way or the other."
},
{
"speaker": "Operator",
"text": "Your next question comes from Kash Rangan - Merrill Lynch"
},
{
"speaker": "Kash Rangan",
"text": "If you just look at the guidance philosophically Chris compared to the last couple of years the same time of the year when we you were giving guidance for the upcoming year I think guidance has been generally below consensus or bracketing consensus – mainly conservative giving you the opportunity to outperform as you execute on your model. I’m just curious this time around I think the guidance tests certainly as Charlie indicated assumes some US – actually a reasonable level of execution on the revenue side range of 12% growth but I’m wondering on the earnings side if you’re not giving enough flexibility for potential spending in the online business if the Yahoo transaction were not to come through just philosophically I guess my question is how do you think about guidance relative to the trend – it seems like there’s a bit of a change here and I’m just curious what your thought process there is."
},
{
"speaker": "Chris Liddell",
"text": "There’s a few trends here, from a revenue point of view, as I mentioned to Charlie I feel very good about our revenue forecast 11% to 13% for next year. I think that’s very good in the current economic environment and as I said I think that is a testament to the strength of our particular investment business model and also the fact that we have made a lot of investments in the past. We have talked to investors about the benefits of those investments and I think that is starting to pay. Clearly in this year where we’ve driven revenue by over 16% and next year 11% to 13% feels very good. So I feel good on the revenue side. On the operating expense side I think we’re making at this stage plenty of provisions for what I consider to be appropriate OpEx not just in the online services but across the whole business. So I don’t feel bad that we are leaving anything out there. Clearly if we were to make another acquisition or to acquire Yahoo that does change the game but in terms of allowing us to do what we want to do organically and through some level of acquisition not only in online services but in other businesses I feel good about the level that we have built in at this stage. And overall earnings per share growing 14% to 15% I guess some assumptions there about buybacks and investment income, I mentioned the tax rate is starting to come down and I talked about this at the last couple of financial analyst meeting that we are now in a period where you can expect to see our tax rate start to go down year after year not only in fiscal year ’09 but in fiscal year ’10 as well as a result of the changes in our business models. So if you look at the individual parts of guidance for fiscal year ’09 at this stage I feel we are hanging together very well."
},
{
"speaker": "Kash Rangan",
"text": "and also the bookings growth rate, coming in at 14% do you think that is more indicative of what we should expect over the few quarters because I think and right after the product launches you had 30% and then it looks like we’ve seen some deceleration but is this the real run rate going forward given that we’re entering a more mature aspect of the product cycle?"
},
{
"speaker": "Chris Liddell",
"text": "You would expect over the long-term that bookings growth and overall revenue growth to be broadly both the same as each other so if we can continue to get bookings growth excluding Vista unearned impact but general bookings growth in the mid teens that would support low to mid teens revenue growth. If that’s the mature part of the cycle then that’s pretty healthy from my perspective."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Difucci - Bear Stearns"
},
{
"speaker": "John Difucci",
"text": "I have a follow-up to Heather’s question and it has to do with the anti piracy efforts. The September to December quarters we saw some big benefits from that and actually seemed to take us by surprise and you by surprise and this quarter that looks to have reversed. Chris you mentioned I guess government crackdowns and we had heard some of those in the second half of last year, is there any other color you can give us on that because trying to understand this and obviously its going to be a fight as you move along but if its always going to be you get a foot and you give up a yard kind of thing, I’m just trying to figure out what you see and in Asia this quarter why would it sort of reverse and then secondly on that I’m just curious why you expect an acceleration in PC growth into the next quarter especially given the macroeconomic backdrop."
},
{
"speaker": "Chris Liddell",
"text": "On piracy or more particularly on license shipments which become pirated, you are true that on a quarter by quarter basis it can move around quite a lot and hopefully you recall in particular in the first quarter that I said don’t take too much from this positive number. You can get an aberration like this on a quarterly basis and you could have a negative one by implication and that’s what we have seen this quarter. So again I’ll just reinforce you really need to look at things like piracy on a long-term basis and average them out to really get a sense of how it’s happening. In the first quarter in particular we saw a very strong performance in our Russian subsidiary which helped enormously when you spread that volume over the total business. In this quarter in China because of some specific market dynamics that happened in that country you saw a relatively negative performance. You have got to wash those things out. You have got to look at it on the course of the year. We still think for the year we are going to have PC unit growth of 11% to 13%. We think we are going to ship our units of 12% to 14%. So we still think we are going to pick up one maybe two percent of shipment growth relative to overall market growth and that washes out the unders and overs and that’s how I prefer to think of it."
},
{
"speaker": "Colleen Heally",
"text": "And just to put that into a little more context too on the unlicensed PCs aspect, just keep in mind that when we were looking at the PC units to OEM units that was one of three factors that we talked you through in bridging that, so that is one of three factors."
},
{
"speaker": "Chris Liddell",
"text": "In terms of overall PC demand what I would say is we started the year believing that we were going to have about 9% to 11% in terms of unit shipments. The third quarter came in at 8% to 10%. So broadly speaking it was in line with where we started the year. It was a little bit weaker in mature markets which I think picks up some of the economic issues that we are seeing particularly in the US but it was stronger in emerging markets. So the mix was different to what we thought but the overall market was about in line, 1% lower which is [around the area] really to where we started the year. What we saw really was a particularly strong performance in Q1 and Q2 so it’s difficult to continue to extrapolate an out performance, 8 to 10 I don’t feel bad about. And if we can end the year at 11 to 13 which is how we feel relative to a starting point of 9 to 11 we still feel that’s a good robust year but obviously on a quarter by quarter basis again you can read too much into an individual quarter if you look at the year it looks pretty good."
},
{
"speaker": "John Difucci",
"text": "Yes but how could you I mean given the macro backdrop it just seems kind of odd that you would assume that PC sales would increase in this current quarter versus the 8 to 10."
},
{
"speaker": "Chris Liddell",
"text": "Well we’re talking about 9 to 11 for the fourth quarter relative to 8 to 10 for the third quarter. So it’s a 1% change. And don’t forget the third quarter, this quarter [lept] Vista launch last year so you’ve got some aberrations on a year on year basis but accelerating from 8 to 10 to a 9 to 11 third quarter to fourth quarter doesn’t feel like its – we haven’t got the foot on the accelerator very hard to achieve that."
},
{
"speaker": "Operator",
"text": "Your next question comes from Robert Breza - UBS Capital Markets"
},
{
"speaker": "Robert Breza",
"text": "I was wondering if you could talk a little bit about the integration of aQuantive and I guess where does that sit relative to your estimates and how is that tracking to your plan?"
},
{
"speaker": "Chris Liddell",
"text": "There's a number of ways of looking at how it’s integrated. The first and most important is from an employee integration point of view given that the real revenue potential is some years out. From the employee point of view we couldn’t have been happier. All of the key executives have remained. Brian [Makendries] is doing a great job leading that and is taking a broader role inside Microsoft in terms of driving that part of the strategy. We’ve integrated in my view the cultures very well and we’ve got people from aQuantive taking a broader role and Microsoft people from the previous Microsoft working inside and helping drive aQuantive strategy and they’re very active and thinking the way in which they can not only build aQuantive as it was but use the financial and other resources of Microsoft to make aQuantive go faster. So if you take that as the sort of first determinate of how well things have gone, I’m extremely happy with that. In terms of the underlying business, leading indicator would be just number of publishers we’re getting on board again that’s going very healthy. We’ve talked through the quarter I think we’ve made a few announcements. There are 96 I believe new publishers of various sizes have switched on to the Atlas Publisher Suite in the last quarter, since we announced sorry. So very good growth in the underlying dynamic in the business. From a profitability point of view, we’re carrying the costs of the acquisition but we are managing to achieve the results that we talked about despite the fact that at this stage its early days for aQuantive and we’re carrying in particular some of the non-cash charges associated with the acquisition. So the revenue growth is still ahead of us, from a cost point of view we’re in line but it’s a negative. From a publisher business point of view good early indicators and from a people point of view it’s excellent."
},
{
"speaker": "Operator",
"text": "Your next question comes from Kirk Materne - Banc of America Securities"
},
{
"speaker": "Kirk Materne",
"text": "Operating margins for the fourth quarter appear to be going down just a tad versus the third fiscal quarter, could you just explain some of the dynamics around that. I realize you have just made some acquisitions. Is it mainly headcount related? Is there some mix shift going on between the businesses? Anything to do with E&D, obviously its going to have a strong quarter with Grand Theft Auto, I’m just trying to get the dynamics about that."
},
{
"speaker": "Chris Liddell",
"text": "The problem looking at margins for the business overall is you inevitably get quite a lot of difference between the individual businesses and how they make up one quarter. So that’s the first statement and its best to look at the year overall where you’re looking at margin expansion but if you look at the trends through the quarters. I think quarter one was 43%, quarter two was 39.6, quarter three was 40.3, and quarter four was 37.6, overall 40. So in any one quarter you can get quite different movements and that reflects (a) the mix of businesses and (b) if you have a strong Xbox quarter you get a lot of the [cogs] associated with that that tends to decrease the margins. Fourth quarter we get a lot of marketing and signup costs associated with our enterprise businesses which generally are buying annuities. So we don’t get a lot of the revenue associated with it, we get some of the costs and we get the benefits of that revenue flying through for the next year. So the short answer to your question is there is nothing unusual in the fourth quarter. We typically see it if you look back in previous years it’s a low margin quarter relative to the first, second and third. There’s nothing unusual about this fourth quarter. Its part of the normal cycle."
},
{
"speaker": "Kirk Materne",
"text": "If I could just follow-up on John’s question just on the acceleration in PCs into the fourth quarter, one of the comments you had about the last quarter was just the inventory levels being a little bit higher heading into the third quarter, I assume those have been drawn down to levels you feel more comfortable with heading into the fourth quarter?"
},
{
"speaker": "Chris Liddell",
"text": "Yes, although just to be clear I think John’s question was PC units overall and inventory levels tend to be a comment about our shipments to OEM so those are very tightly related to each other clearly but in answer to your question, yes they are [inaudible] more normal. Although I will say it’s quite early in the quarter. Sometimes we get that information over the next few weeks but there’s nothing that we’re seeing that’s unusual going into this quarter and that’s embedded in our guidance."
},
{
"speaker": "Operator",
"text": "Your final question comes from the line of Brent Thill - Citigroup"
},
{
"speaker": "Brent Thill",
"text": "Chris just drilling into the client line item, that was clearly probably the biggest disappointment relative to all of our models and understanding the licensing change but when you drill into what’s happening with Vista and XP are you still happy with what you’re seeing in the Vista upgrade cycle or are you still seeming more units of XP going than you like and that wouldn’t obviously have an impact on the pricing?"
},
{
"speaker": "Chris Liddell",
"text": "Yes, with respect to the quarter, the third quarter in particular there’s really no Vista-related issues at all. In terms of the impacts, firstly the overall PC market, unlicensed PCs which is not a Vista issue. Emerging markets growing faster than mature markets, that’s not really a Vista issue. A bit of a channel shift to larger OEMs again not a Vista issue. And obviously if we sell a unit of XP rather than selling a unit of Vista we’re still relatively happy because of the realization and so there’s nothing in the third quarter that is specific to Vista in terms of the walkthrough from the overall PC market down to overall client revenue. I guess the only Vista impact really is the launch last year and the very strong comparables that we have but that’s not really a comment about this quarter its more a comment on the year-ago quarter and the comparable."
},
{
"speaker": "Colleen Heally",
"text": "Yes I think if you look at whether it’s Vista, [inaudible] or from a mix standpoint we can let you know we’re up a bit sequentially in terms of Vista -- shared with you 140 million licenses sold so you know I think things are tracking well and as expected from our perspective."
},
{
"speaker": "Chris Liddell",
"text": "So with that I’ll thank you all, I’ll hand it back to Colleen to finish but I look forward to talking to a number of you in three months and in particular seeing a number of you at the financial analyst meeting a few days later."
},
{
"speaker": "Colleen Heally",
"text": "Thanks everyone for your participation in today’s call. If you have any further questions, please feel free to call me or my team directly. As I mentioned at the beginning of this call, this conference call will be available on replay at our Investor Relations website through close of business April 24, 2009. In addition, you can hear the replay by dialing 1-800-756-0715 or for international calls dial 203-369-3427; the dial in replay will be available through the close of business May 2, 2008. Thanks again for joining us today."
}
] | null | null |
MSFT | 2 | 2,008 | 2008-01-25 17:30:00 | Operator: Welcome to the Microsoft second quarter earnings call. At this time all participants are in a listen only mode. During the question and answer session, please press star one on your touchtone phone. Today’s call is being recorded. If you have any objections you may disconnect at this time. I would now like to turn the meeting over to Colleen Healy, general manager investor relations.
Colleen Healy: Thank you and good afternoon everyone. Thanks for joining us today. This afternoon I am joined by Chris Liddell, Senior Vice President and Chief Financial Officer, Frank Brod, Corporate Vice President and Chief Accounting Officer and John C. Top, Deputy General Counsel. Today’s call will start with Chris providing key takeaways for the second quarter of fiscal year 2008 and an overview of expectations for the rest of the fiscal year. I will then provide detail around our second quarter results and then turn it back to Chris for a more detailed discussion of our guidance for the full year and third quarter fiscal 2008. After that we’ll take your questions. We filed our 10Q today in conjunction with our earnings release, therefore you have available the earnings release, MD&A, financial statements and footnotes. We have also posted our quarterly financial summary slide deck which is intended to follow the flow of our prepared remarks in order to assist you. The slide deck offers highlights from the quarter, outlines our guidance and provides a reconciliation of differences between GAAP and non GAAP financial measures that we will talk about today. You can find the earnings release, the financial highlights and the quarterly financial summary slide deck on the investor relations website at www.microsoft.com/MSFT. Today’s call will be recorded, please be aware that if you decide to ask a question it will be included in both our live transmission as well as any future use of the recording. As always, shareholders and analysts can listen to a live webcast of today’s call at the Microsoft investor relations website. A replay of the call will be available at the same site through the close of business on January 25, 2009. This conference call report is protected by copyright law and international treaties. Unauthorized reproduction or distribution of this report or any portion of it may result in civil and criminal penalties. Any recording or other use or transmission of the text or audio of today’s call is not allowed without the express permission of Microsoft. We will be making statements during this call that are forward looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in today’s earnings press release and the comments made during this conference call and in the risk factors section of our 10Q or 2007 form 10K and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward looking statement. With that, let me now turn it over to Chris.
Chris Liddell: Thanks Colleen and good afternoon everyone. I’ll begin today’s call by providing you with the highlights from our second quarter results and discuss our outlook for the remainder of fiscal 2008. Results for the quarter were outstanding. Revenues surpassed our previous record high by $2 billion and at $16.4 billion that exceeded the high end of our expectations by over $300 million. We are benefitting from the investments we’ve made over recent years plus excellent execution performance from our field sales force. Revenue in the quarter grew 30% or 15% adjusted for the technology guarantees in the comparable period last year. Besides just the sheer size and pace of growth, the breadth was notable as we saw strength across all customer segments, divisions, channels and geographies. For example, demand from enterprise customers combined with healthy holiday consumer spending for Windows Vista and the 2007 Microsoft Office system drove revenue for the business group a combined 18% for the quarter. Server and tools, once again delivered double digit revenue growth in the quarter, the 22nd in a row. Healthy enterprise agreements signings across the company drove our unearned revenue balance up over $0.5 billion, $500 million above our guidance. The successful integration of our eQuantive acquisition plus good organic growth helped our online business grow 38% and a compelling lineup of Xbox games drove our performance for our entertainment and devices division. E&D had its second consecutive quarter in the black, on its way to our target of full year profitability. From a geographic perspective, over 60% of our sales are from users in regions outside of the US. Revenue in those regions continue to drive growth for the company with non-US mature markets up over 20% for the first half of the year and emerging markets up nearly 30%. During the quarter we combined revenue growth with cost efficiencies resulting in operating income growth of 27%, even adjusted for the tech guarantees of last year. Operating margins during the quarter were a healthy 40%. Lastly, earnings per share growth of 32% after adjusting for last year’s tech guarantee continued to benefit from the accommodation of strong operating performance and execution of our share repurchase program. So overall the quarter and half one performance demonstrates that we’re realizing the benefits from our expanding business lines, product SKUs and global presence. The investments we’ve made, including in our sales force and new product offerings have positioned us well to offer the right product in the right markets worldwide. And during the quarter we refreshed and bolstered our product line up with releases of Microsoft Dynamic CRM, Visual Studio 2008, new Zune devices and progress towards the upcoming server offerings, including release candidate one of Windows Server 2008 and a beta of our server virtualization technology, Hyper-V. In light of the strong second quarter, we are increasing our revenue, operating income and earnings per share guidance for the year. We now expect revenue growth of 17-18% and operating income growth of 31-32% and finally we’re raising our earnings per share forecast by $0.07 for the year to $1.85-$1.88, a growth of 30-32%. With those high level themes, I’m going to turn the call over to Colleen for more details on our second quarter performance.
Colleen Healy: Thanks Chris. The strong momentum that kicked off our fiscal year continued in our second quarter. As Chris mentioned, revenue exceeded the high end of our expectations by $300 million during the quarter. This was driven by demand for our flagship product of Windows Vista and Office 2007 as well as a good holiday season for our Xbox franchise. This revenue outperformance combined with decreasing Xbox 360 console costs flowed through to operating income and earnings per share. Let me provide you with details of our financial performance starting with revenue. I’ll discuss top line financial and business momentum points and then follow up with revenue performance for each of the business units. Then I’ll review the rest of the income statement. All growth comparisons relate to the comparable quarter of last year unless otherwise specified. Revenue is $16.4 billion, an increase of 30%. Adjusting the year ago quarter by the $1.6 billion of revenue deferrals primarily related to the technology guarantee program for Windows and Office, total revenue grew 15%. With business and consumer PCs each experiencing double digit growth rates, the underlying PC hardware market increased an estimated 14-16% during the quarter, about 3 points higher than our expectations. PC growth rates in emerging markets continue to outpace that of mature markets. Europe led the mature markets and we again saw significant improvement in the US and especially in Japan. Our mix of product billings for the quarter was approximately 30% from OEMs, 30% from multi-year agreements, 20% from license only sales and the balance from our other businesses. Annuities sales were robust, particularly for server and tools in anticipation of the major product releases scheduled for the second half. This combined with enterprise agreement renewal rates, consistent with historical trends, drove our unearned revenue balance over $0.5 billion above our guidance to $12.2 billion, up 20% year over year normalizing for the impact of the tech guarantee deferrals. Our contracted not billed balance increased sequentially to over $11.5 billion, up well over $1 billion from where we started the fiscal year. When taken together with reported revenue, total bookings for the company were almost 20%. Now I will provide revenue highlights by business segment, starting with clients. A robust personal computer market and progress against software piracy drove client revenues to $4.3 billion, up 68%, or 16% after adjusting for tech guarantees. Over 80% of client revenue comes from our OEM business. During the quarter, we grew our OEM unit shipments at 18%, approximately 3 percentage points faster than the overall hardware market. Curbing software piracy has been a significant investment area for the company over the last several years and those investments are paying off. OEM revenue grew 80% or 18% when normalized for the tech guarantee and in line with our OEM unit growth rate. In terms of premium mix, three out of every four Windows customers adopted premium versions during the quarter. Consumer premium units grew over 50% while business premium units grew 12%. As a result, the OEM premium mix increased by 8 points to 75%, driven by an 11 point increase in the consumer element of the mix and offset by a 3 point decline in the business portion due to the pricing differences between business premium and consumer premium SKUs, these changes in the premium have largely offsetting impacts to revenue. The commercial and retail licensing portion of the business increased 18%, up 8% adjusted for tech guarantees as business customers continue to add client products to their annuity agreements. Next week will mark the one year anniversary of the general availability of Windows Vista. We feel extremely good about the performance it has driven this first year. Specifically, client revenue is growing on average over 40%, up over 20% adjusted for tech guarantees. Client volume licensing portion of the unearned revenue balance has increased 29% year over year. And sales of Windows Vista have surpassed 100 million licenses. Server and tools revenue increased 15% to $3.3 billion, driven by double digit revenue growth in each of the Windows Server and SQL Server businesses. Coupled with the significant shift in our billings to annuity licensing in advance of the upcoming product releases, this resulted in the server and tools portion of the unearned revenue balance increasing by over $1 billion, up by over 35% year over year. License growth for Windows Server and SQL Server grew at healthy double digit rates in the quarter. Our premium SKU Windows Server Enterprise Edition with its virtualization capabilities grew 35%. Our consulting revenue increased 28% as we’ve experienced higher demand following the recent business product launches across the company. Online services business revenue grew 38% to $863 million, including $154 million from the addition of aQuantis. Online advertising growth for the quarter was also 38%, up 26% excluding aQuantis. Our online audience continues to grow. Windows Live usage broadened as Live IDs increased over 20% to $427 million and the Windows Live Suite was downloaded 45 million times since its launch in November. We also continue to expand our advertising and content partnerships. During the quarter, we became the exclusive third-party advertising partner on a worldwide basis for Facebook and we announced strategic alliances with Viacom and CNBC. Since we announced our acquisition of aQuantis, 60 new publishers have switched to the atlas publishers suite offering. Microsoft business division revenue was $4.8 billion, up 37% or 20% normalized for tech guarantees. Returns on our investment in field sales specialists were evident as they contributed to double digit revenue growth across a broad range of productivity offerings. Revenue from business customers was up 23% in the quarter on continued broad based demand for not only versions of Office 2007 but also for Sharepoint Exchange, Office Communications Server and the Dynamic product. Sharepoint and Office Communications Server had a great quarter with each experiencing growth in excess of 50% and Dynamic’s customer billings were up 26%. Consumer revenue grew 10% adjusted for tech guarantees. Entertainment and Devices revenue grew 3% to $3.1 billion, over $90 million above our high end guidance, driven by an abundance of high demand game titles which contributed to setting a record lifetime to date software attach rate of 7.0. In addition to normalized for the impact, in order to normalize for the impact of retailers advancing some of their holiday console purchases into Q1, spurred by the September launch of Halo 3, performance of the two quarters should be assessed together. With that in mind, entertainment and devices revenue grew 25% in the first half of the fiscal year. Exiting the calendar year, life to date sales of Xbox 360 consoles hit 17.7 million units. Based on US and PD data released last week, Xbox 360 sold over 1 million more consoles than PS3 in the holiday quarter. From a shared wallet perspective, consumers spent 27% more on Xbox 360 consoles, games and accessories than on the Wii and twice as much than on the PS3. Xbox 360 had four titles that sold over 1 million copies in the quarter, compared to three for the Wii and none for PS3. Xbox Live rapidly achieved its 10 million members goal six months ahead of schedule. On the music scene, we are pleased by the favorable editorial reviews received by the second generation of Zune. 1.5 million people joined the Zune social online community during the holiday season and music downloads from our marketplace approximately doubled from last year. Now for the rest of the income statement. Cost of revenue decreased by $75 million, primarily driven by more Xbox 360 component costs that were partially offset by growth in our consulting business, expansion of data center operations and the addition of aQuanits cost. After adjusting prior year second quarter for the impact of tech guarantees, cost of revenue decreased by 4 points to 22% of sales. Operating expenses increased 16%, expense growth was slightly higher than head count growth due to legal charges taken in the quarter. Operating income grew at a faster rate than revenue to $6.5 billion, adjusting for the prior year for the tech guarantee, cost of revenue improvement drove margin expansion, increasing our operating margin by 4 points to 40%. Investment income and other totaled $339 million for the quarter. Our effective tax rate for the quarter was 31%, half a point higher than what we previously guided. Cash flow from operations increased 124% to $4.6 billion. During the quarter we repurchased 120 million shares or $4.1 billion of company stock and paid out over $1 billion in dividends to shareholders. Diluted shares outstanding for the quarter were 9.5 billion, down 4% from the prior year as a result of share repurchases, but flat sequentially primarily due to stock options exercise in the quarter. Earnings per share for the quarter was $0.50 which was $0.04 above our high end guidance, driven by the revenue outperformance. So in summary we are extremely pleased with this quarter’s revenue performance. When combined with decreasing cost of revenue, operating income and EPS growth were also impressive. With that, let me turn it back to Chris who will provide you with our third quarter guidance and outlook for the remainder of fiscal 2008.
Chris Liddell: Thanks Colleen. So let turn to the details of our forecast for the third quarter and the full year, beginning with some of the key underlying assumptions. For our fiscal 2008 forecast we’ll assume the following macroeconomic conditions for the remainder of the year. As I mentioned before, over 60% of our business originates from countries outside of the US and we expect the overall software spending environment to remain healthy on a global basis. In US markets, although clearly the risk of an economic slowdown exists, we have not seen any significant spillover to our businesses and lastly we continue to benefit from strong underlying growth in non-US and emerging markets which has also been assisted by stronger international currencies. No company is immune from macroeconomic factors but overall we believe our business is extremely well positioned in the technology industry with diversification across a broad set of products, channels, geographies, currencies and customer segments, supported by excellent product value and sales execution. For PC hardware units, we expect growth of 11-13% for the fiscal year, an increase of one percentage point from our prior outlook, reflecting the upside we saw in the quarter. Third quarter growth is forecasted to be 9-11%, slightly lower than the year because of the difficult prior year comparables from the launch of Windows Vista. We expect PC hardware shipment units to decline sequentially from the first half to the second half of the fiscal year, in line with historic seasonality. Growth will continue to be driven by strength in emerging markets and we expect growth rates in the consumer segment to outpace that in the business segment. In terms of our detailed guidance, we expect fiscal year revenue to be in the range of $59.9-$60.5 billion, growing 17-18%, which is an increase of over $700 million from our prior forecast, based on the strong exit from Q2. We expect revenue in the third quarter of $14.3-$14.6 billion, up 12-15%, excluding the impact of the technology guarantee deferrals in the prior year. And with that I’ll provide details of this guidance by segment. Starting with client, we expect full year growth to be 13-14% with OEM revenue growing roughly in line with the PC market. The third quarter, growth should be 3-5%, excluding the impact for tech guarantees. When thinking about the third quarter revenue growth for client, keep in mind that the strong customer sections for launch of Windows Vista in the year ago period makes it a difficult comparable. Server tools revenue should grow 17-18% for the full year and 17-19% for the third quarter. We expect continued corporate demand for our server products which will drive double digit growth across the breadth of our server platform, products and services. We’re forecasting the billings mix of server and tools to continue to shift towards annuity agreements ahead of the upcoming releases. Next month marks and important milestone to the group with the commencement of the joint launch activities for Windows Server 2008, SQL Server 2008 and Visual Studio 2008. Together these products will allow IT departments to be more productive by providing them with a secure, trusted and manageable platforms and which will underpin growth in the server and tools business over the next several years. With the online services business, we forecast revenue to grow between 37-40% for the year and to be up 40-45% in the third quarter. Online advertising is expected to grow approximately 35% for both the quarter and the full year. Microsoft business division continues to be truly outstanding financial performance. We’ve raised our full year revenue guidance to 16-17% for the year and 11-12% for the third quarter, we’re normalizing for last year’s tech guarantee. Growth in the second half of the year will be largely driven by the same factors that made the first half a success. We expect to see continued demand for the 2007 Office Suite and Sharepoint and Office Communication Server should continue to grow double digits. When thinking about growth in the second half of the year for the business division, bear in mind the growth of retail demand for the Office 2007 last year created the tough comparable. Our [unintelligible] does not include the any impact on the recently announced acquisition of FAST which we anticipate to close during our fourth quarter of the fiscal year and is not expected to have a material impact on earnings per share during this fiscal year. For the entertainment and devices division, expect revenue growth of 21-24% for the full year and 25-30% for the third quarter. We’ve raised the full year second half revenue forecast to reflect the record software attach rates and strength in Xbox console sales we experienced in the first half of the year. Turning back to companywide performance, operating income for the year is expected to be between $24.2-$24.4 billion, up 31-32% for the year, an increase of 3-4 points from our outlook in October. Our higher revenue forecast is responsible for the increase in operating income as we expect greater than 75% of the incremental revenue to flow through to operating profit. For the third quarter, we expect operating income to be between $5.6-$5.7 billion. As a result of the higher operating income guidance, we’re increasing our full year earnings per share results to be $1.85-$1.88, an increase of $0.07 from our previous guidance. For the third quarter we expect earnings per share of $0.43-$0.45. This guidance assumes an effective tax rate of 30.5% for the full year. From balance sheet perspective, total unearned revenue should finish fiscal 2008, up 14-16%, 6 points or about $750 million above our October guidance, driven by strong annuity billings in our core businesses of client MBD and server and tools as well as an increase in an annuity licensing mix. Excluding deferred revenue for undelivered elements, the remaining portion of the unearned revenue should increase 20-23%. When thinking about sequential changes in unearned revenue from Q2 to Q3, we expect the balance to follow historical patterns and remain roughly flat. Contracted not billed should also finish 2008 up from current levels. As always, I’ll remind you to think about guidance we’re providing, you must also consider risks. These risks include competitors, legal, execution and general market risks, such as foreign exchange rate movements, fluctuations in PC and server hardware growth rates, IT spending and customer acceptance of our new and existing products. Additionally, changes in the mix of our billings between annuity and license only can have an impact on revenues, operating income and earnings per share by delaying revenue recognition into future periods. Before moving on to questions, let me mention a few things. Firstly I’d like to welcome Stephen Elop to Microsoft. Stephen has a wealth of experience from both an operational and leadership perspective and he will add a new dimension to our leadership team. However I will also personally will miss working with Jeff Raikes who will retire from the company in September. He’s done a fantastic job over the years and leaves us not only with a strong Office franchise, but he has redefined the role of business productivity software at Microsoft by expanding the business into new areas of productivity offerings to collaboration, unified communications, business intelligence, DRP and CRM, resulting in a near doubling of MBD annual revenues since the year 2000. It’s notable that MBD is now the largest division of Microsoft in size of revenue. Lastly I will look forward to seeing a number of you a week from Monday in New York where Steve Ballmer and I will provide you an update on the strategic direction of the company. For those of you who are unable to join us for this, we’ll make available a live webcast as well as on demand replay of the presentation. So with those comments I’ll hand the call back Colleen so we can get started taking your questions.
Colleen Healy: Great, thanks Chris. Let’s now proceed to questions. We want to accommodate questions from as many people as possible so please avoid multiple part questions and limit yourself to just one question. Operator, will you repeat your instructions please?
Operator: Thank you. We will now begin the question and answer session. If you would like to ask a question, please press star one. If you need to withdraw your request, press star two. Our first question comes from Heather Bellini with UBS.
Heather Bellini: Hi, thank you. Excuse my voice, good afternoon everybody. Chris, I was wondering, you’ve shown a lot of impressive top line performance over the last few quarters and in particular some nice upside in operating income. I guess my question is after the past few years when we’ve seen operating margins contract, do you feel now you’re in a position where you’ve made some of the big catch up investments you discussed in April of ’06 and now looking forward the spending will be more incremental in nature and then I just have a follow up for that when you’re done.
Chris Liddell: Sure, as I’ve said in previous calls and certainly at financial analyst meeting, I think you have to look at the company in three parts. The core businesses, the entertainment and devices business and the online business because the dynamics from a margin perspective are quite different in each of those and obviously the company is an amalgam of the three. In the core businesses, if you put them together collectively, certainly the operating margin has remained an impressively constant, in fact slightly up over the last few years and so we see revenue growth sort of broadly in line with operating income growth, operating [unintelligible] in those. The entertainment and devices division has moved from a loss to a profit so clearly the margins have improved there. On the online business, it has been and will continue certainly for the foreseeable future to be in investment mode so that has a different dynamic altogether. When you put those three together then the operating margin for the company will be very good this year and you can see that in our guidance for the year. So overall we’re not making any predictions including on the call at the moment about past the next couple of quarters but the operating margin performance as an average of those three trends is good for this year.
Heather Bellini: Okay, that was my follow up is really you’ve been in operating margin contraction mode for the past few years, you finally seem to be kicking it into high gear there where you’re going to have well over 100 basis points, so should we expect Steve, when he’s in town in two weeks to kind of discuss an operating plan for the company going forward where we might hear more about the increased leverage in the business?
Chris Liddell: I want to qualify the purpose of the February call, we’ve always seen that as a good chance to talk about the strategic direction of the company. So you can certainly expect to hear the investment themes, but as you know we’re a quarter ahead of most companies in terms of giving out fiscal year guidance by doing it in April, and what I don’t want to do is raise expectations that suddenly we’re going to start doing that in February and then maybe we’ll start doing it in November and we’ll do it a year ahead of time. It is a time to talk about the strategy of the company and the strategic themes and at a very high level that will give some indication of our thoughts about where we will invest, but it’s not going to be a financial guidance exercise.
Heather Bellini: Okay great, thank you.
Colleen Healy: Thanks Heather, we hope you’re feeling better than your voice sounds. Next question please.
Operator: The next question comes from Sarah Friar with Goldman Sachs.
Sarah Friar: Good afternoon guys, good quarter. So following on that ending comment there Chris about areas where you’ll invest, if you look at the online services business, it’s still relatively small, the growth kind of ex-aQuantive is still not quite at the levels you might see from competitors. How are you thinking about strategically where you need to go with that business and what are some of the big milestones we should be looking for over the next couple of quarters, maybe over the next year?
Chris Liddell: Well we certainly see it as a multi-year journey that we’re going on and so we’re investing with an expectation of hoping to be at a critical mass in several years. I’m happy if you look at the quarter [unintelligible] if you like the incremental progress we’ve made, revenue growth of 38%, ex-aQuantive in the mid 20’s, it certainly very respectable. You are right in the sense it’s not at the size of critical mass we’d like to see and we are building a business we believe and hope will be at critical mass in the next few years. But I come back to the theme that we have talked about on several quarters and certainly at financial analyst meetings, we make decisions on investments now which have multi-year implications and when you look at the revenue performance over the last couple of quarters, that didn’t happen by accident. That happened as a result of investments that we made several years ago so you have to look back two or three years to look at the leading indicators of how we’ve been able to drive revenue growth at extremely good levels and higher than most people’s expectations than the last couple of quarters. So when you look forward in the online business, you have to think about the revenue, several years out and the infrastructure we are building for that. Unfortunately from a financial perspective, that means investment now, but that’s the way that we think about the company and that’s the way we’ll continue to run it.
Sarah Friar: And just a follow up on that. So that has been an area where you’ve definitely been willing to look for inorganic growth, successfully with aQuantive and so on. Is that also part of the ongoing strategy there, could we expect to see some more acquisitions go on for OSB that are of size?
Chris Liddell: We obviously don’t speculate on acquisitions in any particular area. We’ve been willing to drive inorganic growth really across all of the divisions. It probably gets a little more attention than the online business because of its nature, but in fact when you look at the acquisitions we’ve made, they’re across a broad spread, server and tools, the FAST acquisition that we made in the enterprise search area, some of the ones we’ve made in the entertainment and devices division. So, we have been willing to use our balance sheet to drive inorganic growth right across the company. I don’t expect that to not continue, I think that trend will continue and again we’ve signaled, I think Steve and I, our willingness to do acquisitions over the last couple of years. I don’t think you’ll necessarily see some dramatic increase in the number that we do, they’ve been going along at about a couple of months for the last couple of years and where we see opportunities where the situation is right, we’ll look to use acquisitions.
Sarah Friar: Great, thanks very much.
Operator: Our next question comes from Charlie Di Bona with Sanford Bernstein.
Charlie Di Bona: Hi, Chris, for the last two quarters you’ve called out anti-piracy as a driver in the client business. Could you maybe give a little more color on the sort of specific impact that that’s had an how you see that playing out as a driver for client going forward. And then maybe also touch on some of the other divisions, I’m thinking particularly the MBD division with Office where anti-piracy has some potential to effect results as well.
Chris Liddell: Sure, it is an interesting trend Charlie and it’s a good one to call out. Historically we’ve seen the difference between the unit shipments that we have relative to the overall PC market. A benefit in our anti-piracy of 1-2%, so our sales if you like grow 1-2% faster than the market as a result of taking piracy away. Over the last couple of quarters that’s picked up, it was around 5% in the first quarter and around 3% in the second quarter. So that’s giving us the confidence to raise in terms of our expectations that to the 1-2%, more like 2-3% going forward. If you say, why is that happening, there’s a few factors. Firstly, better enforcement, so we’ve had a significant enforcement activity over the last few quarters, something like 74 legal actions in 22 countries, so working with local governments who are becoming much more sensitive to this as an issue and very strong government partnerships from us. We’ve seen some of the technology advances in Vista helping us, relative to previous additions of Windows. Also we’ve seen a shift to laptops and in particular sales through multi-national OEMs who typically have a lower piracy rate. Now, not all of those factors are beneficial from a revenue point of view, you know the average selling price through large multi-national OEMs is typically lower than in the smaller entities, but overall from a unit perspective it’s helping us about 3% and it’s offsetting some of the mix shift that we see and some of the other factors and so it’s just been a very good trend and it certainly in the last two to three quarters has picked up from what we’ve seen in previous two to three years.
Colleen Healy: And then I would say as a broader theme, the company is focused on piracy really across all of our software offerings, including Office and MBD as you also asked about. With Office it’s tougher to quantify than we can with client because with Office we sell through so many different channels, volume licensing retail as well as OEMs. We estimate about half of the worldwide base out there is pirated, so there is opportunities to make gains there as well. And we’re doing a lot of those same sort of partnering with governments and educating people on the value of buying genuine software and keeping an eye really on retail sales of Office to see how that’s progressing. And you know it’s been really robust since the launch of Office 2007, but unlike client we can’t give you a specific of a number in terms of how we’re doing on piracy.
Charlie Di Bona: Okay, thank you.
Operator: Adam Holt with J.P. Morgan, your line is open.
Adam Holt: Good afternoon. I wanted to drill down on the strength in MBD and Office which has been a consistent theme over the last several quarters. Another quarter of better than 20% revenue growth in business office and related. I wanted to see if that is primarily unit driven at this point or whether you’re actually starting to see an ASP uplift on the Office side and how long do you think you can sustain better than 20% growth for business revenue?
Chris Liddell: Yeah, firstly, specifically, it is very much around units, it’s not ASP driven. And I’d pick out a couple of themes in particular. One is just customer acceptance of the Office product itself which has been extremely good, you know it’s right at the top end of our expectations. So when you talk to people, their like of the product is extremely high and we’re seeing that manifest itself from a financial perspective and very strong license sales right across the board. So from consumer to small business to large businesses, the underlying office business and the office product has been a real success since launch. That’s number one, number two is some of the other products are starting to become significant in their own right, so when you look at Sharepoint, growing over 20-30% year on year, that’s over $1 billion business now, so it’s a significant business in its own right and it’s incredibly successful again in terms of customer acceptance in rollout through the enterprise. Unified Communications a similar story. Some of the Dynamics products, CRM and ERP which don’t get a lot of attention because we focus on the big parts but also growing at 30-40% growth. So you’re seeing a very strong portfolio of products anchored around the Office product but with some extremely good secondary ones as well making a big contribution. How long can that last? Well we will start to lap the launch of Office 2007, so that impact won’t be necessary be a significant going forward, but if you look at the second half guidance we certainly see a lot of the same factors for the first half continuing to the second half.
Adam Holt: If I could actually just ask a follow up on that. You mentioned in your prepared comments that you’re taking a little bit more of a conservative view on spending in the US for the second half. As we think about the back half guidance, how should we or where do you think that’s being reflected, it looks like you’re being conservative against a tough comp on the PC growth expectations, where else are you reflecting that conservatism in the guidance?
Chris Liddell: Well I don’t think, when you look at the growth rates, they’re still very healthy in the second half so when we think about product portfolio we actually feel very optimistic for the second half. Certainly, if there’s you know a substantial economic slowdown you could see PC growth rates come down but we’re guiding for the second half in 11-13% or thereabouts so it’s still very healthy growth from an overall perspective. You look at individual verticals, probably we can find a couple of soft spots, but each of those individual verticals represents less than 5% of our sales and they’re made up for by strength in other areas. So when you look at the combined portfolio of our products, what we’re being, it’s just like everyone else about what might happen in the US economy, when you look at the overall suite of product we have and the overall growth rates we have, we actually feel very optimistic.
Adam Holt: Thanks very much.
Operator: And the next question comes from Kash Rangan with Merrill Lynch.
Kash Rangan: Hi, thank you very much, when I look at the double digit operating profit percentage of the reported in the entertainment and devices business, despite having a record Xbox unit quarter, how should we think about the margin profile of this business going into the next fiscal year. Are you at the point that console costs have been driven low enough and you’re getting a healthier mix of software due to rising attached rising attach rate. It looks to me that the business [unintelligible] for a breakout on operating margins but how do you think about that looking into the next two to four quarters?
Chris Liddell: Yeah, well the first thing to note is as we’ve talked about before the first time we start talking about fiscal year ’09 is in April, so happy to make some comments about it then. In these calls we’re really trying to focus on this fiscal year, it’s the main purpose. In terms of some of the underlying drivers though that you can think about when you start populate your model, you know one of the things to point out is a very, very good attach rate for Xbox. So we’re looking at a life to date average attach of 7 games per console. You know, interesting when you look at that now people on average are spending more in terms of the software and accessories than they are on the underlying console itself, so that model of selling the console as a way of generating future revenue is really paying off. That 7 on average is well above anything historically were on on previous consoles. So that’s a very healthy leading indicator. But the entertainment and devices division is much more than just the Xbox, there’s obviously a music player in there, Windows for Mac and various other parts of it as well, so there’s other dynamics when those mobile that are going to play in terms of our investment in the future. We’re not making any long term predictions about the margins structure, the one thing that is positive is its clearly profitable and we believe on target to be profitable for the year which is the commitment we made some 18 months ago.
Kash Rangan: Thanks and also one metric that you gave last quarter was the bookings growth rate in the core business being 25%. What was the same number this quarter, I do see that overall bookings growth rate was 20% but I was just curious about the core business? That’s it thanks.
Chris Liddell: Yeah, greater than 20%. I’ll look if I can give you a more detailed number after the call but certainly off my head it’s greater than 20%.
Operator: John Difucci from Bear Stearns, your line is open.
John Difucci: Thank you. Chris, you talked a little bit about US risk and I think you were quoted in Routers I think after the close today saying something similar. Did you see any of it this quarter, I mean the aggregate results were obviously pretty impressive, but the server and tools division was a little bit below your expectations and that’s really enterprise infrastructure software in aggregate, did you see it and is that what you’re seeing now, is that an area where you might be seeing a little more pressure than perhaps some of the other areas?
Chris Liddell: Actually you have to look really hard to find any weakness in our results in the first half. So, in terms of server and tools, there was actually a shift to an annuity mix, so that may be what you’re looking at, in fact that’s a positive trend because it means our unearned is up significantly which we reported as you know over $500 million higher than expectations and it’s a reflection of our company’s commitment to our products as a platform in anticipation of some of the server products coming up. So from an accounting point of view you notice a difference, from an underlying business point of view that’s an incredibly positive trend. But if you look at the first half of the year, I mentioned over 60% of our sales come from customers outside the US. If you look at non-US, it grew over 20%, non-US mature markets, if you look at emerging markets, it grew at almost 30%, but the interesting factors that I didn’t say which I’m happy to say is that US markets are up 15%. So that’s a total our sales in the US for the first half grew by 15%. Now, clearly if the softness going forward, that would impact that, but that’s still a very healthy growth rate from our point of view.
John Difucci: Yeah but I would think you would expect that shift to an annuity at the beginning of the quarter when you gave guidance and it was a little bit shy there but are you saying you just didn’t expect that and it was customer driven?
Chris Liddell: Yup, absolutely. There’s a vast number of contracts that come up for renewal every quarter and the nature of how those renewals flow through to annuity mix quite significantly quarter on quarter. But yes it was an unexpected positive surprise.
Colleen Healy: You’re seeing on the low end on server and tools as revenue is about a $20 million miss and on the unearned balance you’re talking 100’s of millions, net-net on a bookings point, server and tools although the mix was different, the business was just healthier actually than we had expected.
Chris Liddell: Thank you.
Operator: The next comes from Ben Thill with Citi Investment Research.
Ben Thill: Thanks, Chris can you characterize any meaningful differences in consumer versus enterprise demand. Are you seeing any changes in patterns in each of those two divisions?
Chris Liddell: No, they’re broadly in line with our expectations and in terms of the enterprise, as I mentioned and Colleen just referred to, the unearned balance is extremely good and so we’re feeling good about the relative commitment of our enterprise customers to multi-year agreements, so that’s good. On the, I mentioned about Office and the strength there. A lot of very good license earnings sales in the Office area right across the spectrum of businesses from small medium and large businesses. And lastly on the Xbox side, you know the consumer sales are very good, that’s a good leading indicator of consumer acceptance and I guess the last one would be PC sales overall which poured in to 16% in the quarter was a hit of our expectations. So really everything was slightly better than what we had hoped for but there wasn’t any significant mix change if you like, all those factors were good.
Ben Thill: And just as a quick follow up, just as you look at the second half of this calendar year, how would you characterize your visibility and I guess the confidence of this macro overhanging the US, doesn’t catch up, I think you mentioned there were a couple soft spots, what gives you confidence that this doesn’t spillover into some of the other sectors in the US and catch up with you later in the year?
Chris Liddell: Well we’ve just gone through our mid-year reviews with where we go country by country and segment by segment across the world and the sales force, so the people who are in charge of delivering. Their results, sitting in on all of those and listening to them certainly is factored into our guidance. And you know at this state we’re obviously not giving fiscal year ’09 guidance but again you have to take a step back and look at the overall environment we’re selling into. The next six months we feel very good about. In terms of more general factors, we’re a global company, I talked about the sales mix, I feel good about global GDP over the medium to long term, I think software spending is going to be faster than global GDP and I think we’re going to grow faster than overall global software spending. So could we be impacted by global slowdown, of course we could, but if you look at the overall growth rates from the products we have and the markets we compete, we still feel very good if we think about our business on a multiyear basis.
Ben Thill: Thanks Chris.
Operator: Our next is Jason Maynard with Credit Suisse.
Jason Maynard: Hey good afternoon guys. I had a little different tact on the questioning. I’m just curious to get your opinion on how you expect the recent EU commission new investigations to play out and what impact you think that may have on not only Vista but I guess perhaps the not yet released Windows 7 product that’s being talked about?
Chris Liddell: Yeah, overall obviously we’ll cooperate fully with the commission’s investigation and provide any and all information necessary. We’re committed to insuring that we’re in full compliance with their law and our obligations as established by the court. So I don’t really have a sort of general business comment, happy to leave it at that.
Jason Maynard: Is this, post the settlement I guess was like three or four months ago, is this is any way shape or form impacting perhaps your M&A strategy or maybe decisions to do something bigger within the online services area?
Chris Liddell: No, not at all.
Jason Maynard: Okay, thank you.
Operator: And the last question comes from Brendan Barnicle with Pacific Crest Securities.
Brendan Barnicle: Thanks so much, Chris I had a quick follow up question on the online business. Specifically, where is it you’re spending the money for the investment you’re making now. Is that around infrastructure or R&D, sales, and then secondly, where do you envision that going, is it just always going to be an online advertising business or do you see a point where you charge for content or applications, music, any of these other potential revenue streams? Thanks.
Chris Liddell: Yeah the investments are across a broad spectrums o we believe to be successful in that business you really need to commit substantially across the whole gamut of investments, so we’re investing in search, improving the relevancy of our search results, focusing on some key verticals like commerce, local entertainment, health. We’re obviously investing in the advertiser and publisher tools. You know after our aQuantive acquisitions that’s given us a substantial leg up in the advertising platform area, so we’re continuing to build on that. We’re investing in content and services through Windows Live and other Live services through the MSN portal and then lastly but not leastly in operational infrastructure. So a lot of [tapics] going into data centers to improve performance and reliability and generate global sales for the business and some of those costs are feeding through in terms of depreciation. So there is no one particular area that we’re focused on, we are focused on all the areas and we think to be successful in that business going forward, that’s the approach you have to take.
Brendan Barnicle: And then second question in envisioning where it goes?
Chris Liddell: Yeah, just go over that one again.
Brendan Barnicle: Yeah, I mean do you ever see a point where you may charge for content, charge for applications or are you always going to be basically in online advertising and advertising driven type model?
Chris Liddell: Well we’re obviously moving to a software plus services world, so there are certainly areas of products that we have where you can see us moving from a license only to a on demand situation. We already are, in terms of the basic online advertising business as you think about OSB, to a large extent that’s going to be an advertising driven, advertising supported business. But there will be other parts of the business you know as we already are with CRM, delivered online and charged for on a subscription basis where it won’t be advertising driven. So we’ll live in a multi-business model world going forward.
Colleen Healy: Great, thanks a lot Brendan and thanks everyone for your participation in today’s call. If you have any further questions, please feel free to call me or my team directly. As I mentioned at the beginning of this call, this conference call will be available on replay at our investor relations website through close of business January 26, 2009. In addition, you can hear the replay by dialing 1-800-297-0771 or for international calls dial 203-369-3238, the dial in replay will be available through the close of business February 1, 2008. Thanks again for joining us today.
Operator: And that concludes today’s call, please disconnect your line at this time. | [
{
"speaker": "Operator",
"text": "Welcome to the Microsoft second quarter earnings call. At this time all participants are in a listen only mode. During the question and answer session, please press star one on your touchtone phone. Today’s call is being recorded. If you have any objections you may disconnect at this time. I would now like to turn the meeting over to Colleen Healy, general manager investor relations."
},
{
"speaker": "Colleen Healy",
"text": "Thank you and good afternoon everyone. Thanks for joining us today. This afternoon I am joined by Chris Liddell, Senior Vice President and Chief Financial Officer, Frank Brod, Corporate Vice President and Chief Accounting Officer and John C. Top, Deputy General Counsel. Today’s call will start with Chris providing key takeaways for the second quarter of fiscal year 2008 and an overview of expectations for the rest of the fiscal year. I will then provide detail around our second quarter results and then turn it back to Chris for a more detailed discussion of our guidance for the full year and third quarter fiscal 2008. After that we’ll take your questions. We filed our 10Q today in conjunction with our earnings release, therefore you have available the earnings release, MD&A, financial statements and footnotes. We have also posted our quarterly financial summary slide deck which is intended to follow the flow of our prepared remarks in order to assist you. The slide deck offers highlights from the quarter, outlines our guidance and provides a reconciliation of differences between GAAP and non GAAP financial measures that we will talk about today. You can find the earnings release, the financial highlights and the quarterly financial summary slide deck on the investor relations website at www.microsoft.com/MSFT. Today’s call will be recorded, please be aware that if you decide to ask a question it will be included in both our live transmission as well as any future use of the recording. As always, shareholders and analysts can listen to a live webcast of today’s call at the Microsoft investor relations website. A replay of the call will be available at the same site through the close of business on January 25, 2009. This conference call report is protected by copyright law and international treaties. Unauthorized reproduction or distribution of this report or any portion of it may result in civil and criminal penalties. Any recording or other use or transmission of the text or audio of today’s call is not allowed without the express permission of Microsoft. We will be making statements during this call that are forward looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in today’s earnings press release and the comments made during this conference call and in the risk factors section of our 10Q or 2007 form 10K and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward looking statement. With that, let me now turn it over to Chris."
},
{
"speaker": "Chris Liddell",
"text": "Thanks Colleen and good afternoon everyone. I’ll begin today’s call by providing you with the highlights from our second quarter results and discuss our outlook for the remainder of fiscal 2008. Results for the quarter were outstanding. Revenues surpassed our previous record high by $2 billion and at $16.4 billion that exceeded the high end of our expectations by over $300 million. We are benefitting from the investments we’ve made over recent years plus excellent execution performance from our field sales force. Revenue in the quarter grew 30% or 15% adjusted for the technology guarantees in the comparable period last year. Besides just the sheer size and pace of growth, the breadth was notable as we saw strength across all customer segments, divisions, channels and geographies. For example, demand from enterprise customers combined with healthy holiday consumer spending for Windows Vista and the 2007 Microsoft Office system drove revenue for the business group a combined 18% for the quarter. Server and tools, once again delivered double digit revenue growth in the quarter, the 22nd in a row. Healthy enterprise agreements signings across the company drove our unearned revenue balance up over $0.5 billion, $500 million above our guidance. The successful integration of our eQuantive acquisition plus good organic growth helped our online business grow 38% and a compelling lineup of Xbox games drove our performance for our entertainment and devices division. E&D had its second consecutive quarter in the black, on its way to our target of full year profitability. From a geographic perspective, over 60% of our sales are from users in regions outside of the US. Revenue in those regions continue to drive growth for the company with non-US mature markets up over 20% for the first half of the year and emerging markets up nearly 30%. During the quarter we combined revenue growth with cost efficiencies resulting in operating income growth of 27%, even adjusted for the tech guarantees of last year. Operating margins during the quarter were a healthy 40%. Lastly, earnings per share growth of 32% after adjusting for last year’s tech guarantee continued to benefit from the accommodation of strong operating performance and execution of our share repurchase program. So overall the quarter and half one performance demonstrates that we’re realizing the benefits from our expanding business lines, product SKUs and global presence. The investments we’ve made, including in our sales force and new product offerings have positioned us well to offer the right product in the right markets worldwide. And during the quarter we refreshed and bolstered our product line up with releases of Microsoft Dynamic CRM, Visual Studio 2008, new Zune devices and progress towards the upcoming server offerings, including release candidate one of Windows Server 2008 and a beta of our server virtualization technology, Hyper-V. In light of the strong second quarter, we are increasing our revenue, operating income and earnings per share guidance for the year. We now expect revenue growth of 17-18% and operating income growth of 31-32% and finally we’re raising our earnings per share forecast by $0.07 for the year to $1.85-$1.88, a growth of 30-32%. With those high level themes, I’m going to turn the call over to Colleen for more details on our second quarter performance."
},
{
"speaker": "Colleen Healy",
"text": "Thanks Chris. The strong momentum that kicked off our fiscal year continued in our second quarter. As Chris mentioned, revenue exceeded the high end of our expectations by $300 million during the quarter. This was driven by demand for our flagship product of Windows Vista and Office 2007 as well as a good holiday season for our Xbox franchise. This revenue outperformance combined with decreasing Xbox 360 console costs flowed through to operating income and earnings per share. Let me provide you with details of our financial performance starting with revenue. I’ll discuss top line financial and business momentum points and then follow up with revenue performance for each of the business units. Then I’ll review the rest of the income statement. All growth comparisons relate to the comparable quarter of last year unless otherwise specified. Revenue is $16.4 billion, an increase of 30%. Adjusting the year ago quarter by the $1.6 billion of revenue deferrals primarily related to the technology guarantee program for Windows and Office, total revenue grew 15%. With business and consumer PCs each experiencing double digit growth rates, the underlying PC hardware market increased an estimated 14-16% during the quarter, about 3 points higher than our expectations. PC growth rates in emerging markets continue to outpace that of mature markets. Europe led the mature markets and we again saw significant improvement in the US and especially in Japan. Our mix of product billings for the quarter was approximately 30% from OEMs, 30% from multi-year agreements, 20% from license only sales and the balance from our other businesses. Annuities sales were robust, particularly for server and tools in anticipation of the major product releases scheduled for the second half. This combined with enterprise agreement renewal rates, consistent with historical trends, drove our unearned revenue balance over $0.5 billion above our guidance to $12.2 billion, up 20% year over year normalizing for the impact of the tech guarantee deferrals. Our contracted not billed balance increased sequentially to over $11.5 billion, up well over $1 billion from where we started the fiscal year. When taken together with reported revenue, total bookings for the company were almost 20%. Now I will provide revenue highlights by business segment, starting with clients. A robust personal computer market and progress against software piracy drove client revenues to $4.3 billion, up 68%, or 16% after adjusting for tech guarantees. Over 80% of client revenue comes from our OEM business. During the quarter, we grew our OEM unit shipments at 18%, approximately 3 percentage points faster than the overall hardware market. Curbing software piracy has been a significant investment area for the company over the last several years and those investments are paying off. OEM revenue grew 80% or 18% when normalized for the tech guarantee and in line with our OEM unit growth rate. In terms of premium mix, three out of every four Windows customers adopted premium versions during the quarter. Consumer premium units grew over 50% while business premium units grew 12%. As a result, the OEM premium mix increased by 8 points to 75%, driven by an 11 point increase in the consumer element of the mix and offset by a 3 point decline in the business portion due to the pricing differences between business premium and consumer premium SKUs, these changes in the premium have largely offsetting impacts to revenue. The commercial and retail licensing portion of the business increased 18%, up 8% adjusted for tech guarantees as business customers continue to add client products to their annuity agreements. Next week will mark the one year anniversary of the general availability of Windows Vista. We feel extremely good about the performance it has driven this first year. Specifically, client revenue is growing on average over 40%, up over 20% adjusted for tech guarantees. Client volume licensing portion of the unearned revenue balance has increased 29% year over year. And sales of Windows Vista have surpassed 100 million licenses. Server and tools revenue increased 15% to $3.3 billion, driven by double digit revenue growth in each of the Windows Server and SQL Server businesses. Coupled with the significant shift in our billings to annuity licensing in advance of the upcoming product releases, this resulted in the server and tools portion of the unearned revenue balance increasing by over $1 billion, up by over 35% year over year. License growth for Windows Server and SQL Server grew at healthy double digit rates in the quarter. Our premium SKU Windows Server Enterprise Edition with its virtualization capabilities grew 35%. Our consulting revenue increased 28% as we’ve experienced higher demand following the recent business product launches across the company. Online services business revenue grew 38% to $863 million, including $154 million from the addition of aQuantis. Online advertising growth for the quarter was also 38%, up 26% excluding aQuantis. Our online audience continues to grow. Windows Live usage broadened as Live IDs increased over 20% to $427 million and the Windows Live Suite was downloaded 45 million times since its launch in November. We also continue to expand our advertising and content partnerships. During the quarter, we became the exclusive third-party advertising partner on a worldwide basis for Facebook and we announced strategic alliances with Viacom and CNBC. Since we announced our acquisition of aQuantis, 60 new publishers have switched to the atlas publishers suite offering. Microsoft business division revenue was $4.8 billion, up 37% or 20% normalized for tech guarantees. Returns on our investment in field sales specialists were evident as they contributed to double digit revenue growth across a broad range of productivity offerings. Revenue from business customers was up 23% in the quarter on continued broad based demand for not only versions of Office 2007 but also for Sharepoint Exchange, Office Communications Server and the Dynamic product. Sharepoint and Office Communications Server had a great quarter with each experiencing growth in excess of 50% and Dynamic’s customer billings were up 26%. Consumer revenue grew 10% adjusted for tech guarantees. Entertainment and Devices revenue grew 3% to $3.1 billion, over $90 million above our high end guidance, driven by an abundance of high demand game titles which contributed to setting a record lifetime to date software attach rate of 7.0. In addition to normalized for the impact, in order to normalize for the impact of retailers advancing some of their holiday console purchases into Q1, spurred by the September launch of Halo 3, performance of the two quarters should be assessed together. With that in mind, entertainment and devices revenue grew 25% in the first half of the fiscal year. Exiting the calendar year, life to date sales of Xbox 360 consoles hit 17.7 million units. Based on US and PD data released last week, Xbox 360 sold over 1 million more consoles than PS3 in the holiday quarter. From a shared wallet perspective, consumers spent 27% more on Xbox 360 consoles, games and accessories than on the Wii and twice as much than on the PS3. Xbox 360 had four titles that sold over 1 million copies in the quarter, compared to three for the Wii and none for PS3. Xbox Live rapidly achieved its 10 million members goal six months ahead of schedule. On the music scene, we are pleased by the favorable editorial reviews received by the second generation of Zune. 1.5 million people joined the Zune social online community during the holiday season and music downloads from our marketplace approximately doubled from last year. Now for the rest of the income statement. Cost of revenue decreased by $75 million, primarily driven by more Xbox 360 component costs that were partially offset by growth in our consulting business, expansion of data center operations and the addition of aQuanits cost. After adjusting prior year second quarter for the impact of tech guarantees, cost of revenue decreased by 4 points to 22% of sales. Operating expenses increased 16%, expense growth was slightly higher than head count growth due to legal charges taken in the quarter. Operating income grew at a faster rate than revenue to $6.5 billion, adjusting for the prior year for the tech guarantee, cost of revenue improvement drove margin expansion, increasing our operating margin by 4 points to 40%. Investment income and other totaled $339 million for the quarter. Our effective tax rate for the quarter was 31%, half a point higher than what we previously guided. Cash flow from operations increased 124% to $4.6 billion. During the quarter we repurchased 120 million shares or $4.1 billion of company stock and paid out over $1 billion in dividends to shareholders. Diluted shares outstanding for the quarter were 9.5 billion, down 4% from the prior year as a result of share repurchases, but flat sequentially primarily due to stock options exercise in the quarter. Earnings per share for the quarter was $0.50 which was $0.04 above our high end guidance, driven by the revenue outperformance. So in summary we are extremely pleased with this quarter’s revenue performance. When combined with decreasing cost of revenue, operating income and EPS growth were also impressive. With that, let me turn it back to Chris who will provide you with our third quarter guidance and outlook for the remainder of fiscal 2008."
},
{
"speaker": "Chris Liddell",
"text": "Thanks Colleen. So let turn to the details of our forecast for the third quarter and the full year, beginning with some of the key underlying assumptions. For our fiscal 2008 forecast we’ll assume the following macroeconomic conditions for the remainder of the year. As I mentioned before, over 60% of our business originates from countries outside of the US and we expect the overall software spending environment to remain healthy on a global basis. In US markets, although clearly the risk of an economic slowdown exists, we have not seen any significant spillover to our businesses and lastly we continue to benefit from strong underlying growth in non-US and emerging markets which has also been assisted by stronger international currencies. No company is immune from macroeconomic factors but overall we believe our business is extremely well positioned in the technology industry with diversification across a broad set of products, channels, geographies, currencies and customer segments, supported by excellent product value and sales execution. For PC hardware units, we expect growth of 11-13% for the fiscal year, an increase of one percentage point from our prior outlook, reflecting the upside we saw in the quarter. Third quarter growth is forecasted to be 9-11%, slightly lower than the year because of the difficult prior year comparables from the launch of Windows Vista. We expect PC hardware shipment units to decline sequentially from the first half to the second half of the fiscal year, in line with historic seasonality. Growth will continue to be driven by strength in emerging markets and we expect growth rates in the consumer segment to outpace that in the business segment. In terms of our detailed guidance, we expect fiscal year revenue to be in the range of $59.9-$60.5 billion, growing 17-18%, which is an increase of over $700 million from our prior forecast, based on the strong exit from Q2. We expect revenue in the third quarter of $14.3-$14.6 billion, up 12-15%, excluding the impact of the technology guarantee deferrals in the prior year. And with that I’ll provide details of this guidance by segment. Starting with client, we expect full year growth to be 13-14% with OEM revenue growing roughly in line with the PC market. The third quarter, growth should be 3-5%, excluding the impact for tech guarantees. When thinking about the third quarter revenue growth for client, keep in mind that the strong customer sections for launch of Windows Vista in the year ago period makes it a difficult comparable. Server tools revenue should grow 17-18% for the full year and 17-19% for the third quarter. We expect continued corporate demand for our server products which will drive double digit growth across the breadth of our server platform, products and services. We’re forecasting the billings mix of server and tools to continue to shift towards annuity agreements ahead of the upcoming releases. Next month marks and important milestone to the group with the commencement of the joint launch activities for Windows Server 2008, SQL Server 2008 and Visual Studio 2008. Together these products will allow IT departments to be more productive by providing them with a secure, trusted and manageable platforms and which will underpin growth in the server and tools business over the next several years. With the online services business, we forecast revenue to grow between 37-40% for the year and to be up 40-45% in the third quarter. Online advertising is expected to grow approximately 35% for both the quarter and the full year. Microsoft business division continues to be truly outstanding financial performance. We’ve raised our full year revenue guidance to 16-17% for the year and 11-12% for the third quarter, we’re normalizing for last year’s tech guarantee. Growth in the second half of the year will be largely driven by the same factors that made the first half a success. We expect to see continued demand for the 2007 Office Suite and Sharepoint and Office Communication Server should continue to grow double digits. When thinking about growth in the second half of the year for the business division, bear in mind the growth of retail demand for the Office 2007 last year created the tough comparable. Our [unintelligible] does not include the any impact on the recently announced acquisition of FAST which we anticipate to close during our fourth quarter of the fiscal year and is not expected to have a material impact on earnings per share during this fiscal year. For the entertainment and devices division, expect revenue growth of 21-24% for the full year and 25-30% for the third quarter. We’ve raised the full year second half revenue forecast to reflect the record software attach rates and strength in Xbox console sales we experienced in the first half of the year. Turning back to companywide performance, operating income for the year is expected to be between $24.2-$24.4 billion, up 31-32% for the year, an increase of 3-4 points from our outlook in October. Our higher revenue forecast is responsible for the increase in operating income as we expect greater than 75% of the incremental revenue to flow through to operating profit. For the third quarter, we expect operating income to be between $5.6-$5.7 billion. As a result of the higher operating income guidance, we’re increasing our full year earnings per share results to be $1.85-$1.88, an increase of $0.07 from our previous guidance. For the third quarter we expect earnings per share of $0.43-$0.45. This guidance assumes an effective tax rate of 30.5% for the full year. From balance sheet perspective, total unearned revenue should finish fiscal 2008, up 14-16%, 6 points or about $750 million above our October guidance, driven by strong annuity billings in our core businesses of client MBD and server and tools as well as an increase in an annuity licensing mix. Excluding deferred revenue for undelivered elements, the remaining portion of the unearned revenue should increase 20-23%. When thinking about sequential changes in unearned revenue from Q2 to Q3, we expect the balance to follow historical patterns and remain roughly flat. Contracted not billed should also finish 2008 up from current levels. As always, I’ll remind you to think about guidance we’re providing, you must also consider risks. These risks include competitors, legal, execution and general market risks, such as foreign exchange rate movements, fluctuations in PC and server hardware growth rates, IT spending and customer acceptance of our new and existing products. Additionally, changes in the mix of our billings between annuity and license only can have an impact on revenues, operating income and earnings per share by delaying revenue recognition into future periods. Before moving on to questions, let me mention a few things. Firstly I’d like to welcome Stephen Elop to Microsoft. Stephen has a wealth of experience from both an operational and leadership perspective and he will add a new dimension to our leadership team. However I will also personally will miss working with Jeff Raikes who will retire from the company in September. He’s done a fantastic job over the years and leaves us not only with a strong Office franchise, but he has redefined the role of business productivity software at Microsoft by expanding the business into new areas of productivity offerings to collaboration, unified communications, business intelligence, DRP and CRM, resulting in a near doubling of MBD annual revenues since the year 2000. It’s notable that MBD is now the largest division of Microsoft in size of revenue. Lastly I will look forward to seeing a number of you a week from Monday in New York where Steve Ballmer and I will provide you an update on the strategic direction of the company. For those of you who are unable to join us for this, we’ll make available a live webcast as well as on demand replay of the presentation. So with those comments I’ll hand the call back Colleen so we can get started taking your questions."
},
{
"speaker": "Colleen Healy",
"text": "Great, thanks Chris. Let’s now proceed to questions. We want to accommodate questions from as many people as possible so please avoid multiple part questions and limit yourself to just one question. Operator, will you repeat your instructions please?"
},
{
"speaker": "Operator",
"text": "Thank you. We will now begin the question and answer session. If you would like to ask a question, please press star one. If you need to withdraw your request, press star two. Our first question comes from Heather Bellini with UBS."
},
{
"speaker": "Heather Bellini",
"text": "Hi, thank you. Excuse my voice, good afternoon everybody. Chris, I was wondering, you’ve shown a lot of impressive top line performance over the last few quarters and in particular some nice upside in operating income. I guess my question is after the past few years when we’ve seen operating margins contract, do you feel now you’re in a position where you’ve made some of the big catch up investments you discussed in April of ’06 and now looking forward the spending will be more incremental in nature and then I just have a follow up for that when you’re done."
},
{
"speaker": "Chris Liddell",
"text": "Sure, as I’ve said in previous calls and certainly at financial analyst meeting, I think you have to look at the company in three parts. The core businesses, the entertainment and devices business and the online business because the dynamics from a margin perspective are quite different in each of those and obviously the company is an amalgam of the three. In the core businesses, if you put them together collectively, certainly the operating margin has remained an impressively constant, in fact slightly up over the last few years and so we see revenue growth sort of broadly in line with operating income growth, operating [unintelligible] in those. The entertainment and devices division has moved from a loss to a profit so clearly the margins have improved there. On the online business, it has been and will continue certainly for the foreseeable future to be in investment mode so that has a different dynamic altogether. When you put those three together then the operating margin for the company will be very good this year and you can see that in our guidance for the year. So overall we’re not making any predictions including on the call at the moment about past the next couple of quarters but the operating margin performance as an average of those three trends is good for this year."
},
{
"speaker": "Heather Bellini",
"text": "Okay, that was my follow up is really you’ve been in operating margin contraction mode for the past few years, you finally seem to be kicking it into high gear there where you’re going to have well over 100 basis points, so should we expect Steve, when he’s in town in two weeks to kind of discuss an operating plan for the company going forward where we might hear more about the increased leverage in the business?"
},
{
"speaker": "Chris Liddell",
"text": "I want to qualify the purpose of the February call, we’ve always seen that as a good chance to talk about the strategic direction of the company. So you can certainly expect to hear the investment themes, but as you know we’re a quarter ahead of most companies in terms of giving out fiscal year guidance by doing it in April, and what I don’t want to do is raise expectations that suddenly we’re going to start doing that in February and then maybe we’ll start doing it in November and we’ll do it a year ahead of time. It is a time to talk about the strategy of the company and the strategic themes and at a very high level that will give some indication of our thoughts about where we will invest, but it’s not going to be a financial guidance exercise."
},
{
"speaker": "Heather Bellini",
"text": "Okay great, thank you."
},
{
"speaker": "Colleen Healy",
"text": "Thanks Heather, we hope you’re feeling better than your voice sounds. Next question please."
},
{
"speaker": "Operator",
"text": "The next question comes from Sarah Friar with Goldman Sachs."
},
{
"speaker": "Sarah Friar",
"text": "Good afternoon guys, good quarter. So following on that ending comment there Chris about areas where you’ll invest, if you look at the online services business, it’s still relatively small, the growth kind of ex-aQuantive is still not quite at the levels you might see from competitors. How are you thinking about strategically where you need to go with that business and what are some of the big milestones we should be looking for over the next couple of quarters, maybe over the next year?"
},
{
"speaker": "Chris Liddell",
"text": "Well we certainly see it as a multi-year journey that we’re going on and so we’re investing with an expectation of hoping to be at a critical mass in several years. I’m happy if you look at the quarter [unintelligible] if you like the incremental progress we’ve made, revenue growth of 38%, ex-aQuantive in the mid 20’s, it certainly very respectable. You are right in the sense it’s not at the size of critical mass we’d like to see and we are building a business we believe and hope will be at critical mass in the next few years. But I come back to the theme that we have talked about on several quarters and certainly at financial analyst meetings, we make decisions on investments now which have multi-year implications and when you look at the revenue performance over the last couple of quarters, that didn’t happen by accident. That happened as a result of investments that we made several years ago so you have to look back two or three years to look at the leading indicators of how we’ve been able to drive revenue growth at extremely good levels and higher than most people’s expectations than the last couple of quarters. So when you look forward in the online business, you have to think about the revenue, several years out and the infrastructure we are building for that. Unfortunately from a financial perspective, that means investment now, but that’s the way that we think about the company and that’s the way we’ll continue to run it."
},
{
"speaker": "Sarah Friar",
"text": "And just a follow up on that. So that has been an area where you’ve definitely been willing to look for inorganic growth, successfully with aQuantive and so on. Is that also part of the ongoing strategy there, could we expect to see some more acquisitions go on for OSB that are of size?"
},
{
"speaker": "Chris Liddell",
"text": "We obviously don’t speculate on acquisitions in any particular area. We’ve been willing to drive inorganic growth really across all of the divisions. It probably gets a little more attention than the online business because of its nature, but in fact when you look at the acquisitions we’ve made, they’re across a broad spread, server and tools, the FAST acquisition that we made in the enterprise search area, some of the ones we’ve made in the entertainment and devices division. So, we have been willing to use our balance sheet to drive inorganic growth right across the company. I don’t expect that to not continue, I think that trend will continue and again we’ve signaled, I think Steve and I, our willingness to do acquisitions over the last couple of years. I don’t think you’ll necessarily see some dramatic increase in the number that we do, they’ve been going along at about a couple of months for the last couple of years and where we see opportunities where the situation is right, we’ll look to use acquisitions."
},
{
"speaker": "Sarah Friar",
"text": "Great, thanks very much."
},
{
"speaker": "Operator",
"text": "Our next question comes from Charlie Di Bona with Sanford Bernstein."
},
{
"speaker": "Charlie Di Bona",
"text": "Hi, Chris, for the last two quarters you’ve called out anti-piracy as a driver in the client business. Could you maybe give a little more color on the sort of specific impact that that’s had an how you see that playing out as a driver for client going forward. And then maybe also touch on some of the other divisions, I’m thinking particularly the MBD division with Office where anti-piracy has some potential to effect results as well."
},
{
"speaker": "Chris Liddell",
"text": "Sure, it is an interesting trend Charlie and it’s a good one to call out. Historically we’ve seen the difference between the unit shipments that we have relative to the overall PC market. A benefit in our anti-piracy of 1-2%, so our sales if you like grow 1-2% faster than the market as a result of taking piracy away. Over the last couple of quarters that’s picked up, it was around 5% in the first quarter and around 3% in the second quarter. So that’s giving us the confidence to raise in terms of our expectations that to the 1-2%, more like 2-3% going forward. If you say, why is that happening, there’s a few factors. Firstly, better enforcement, so we’ve had a significant enforcement activity over the last few quarters, something like 74 legal actions in 22 countries, so working with local governments who are becoming much more sensitive to this as an issue and very strong government partnerships from us. We’ve seen some of the technology advances in Vista helping us, relative to previous additions of Windows. Also we’ve seen a shift to laptops and in particular sales through multi-national OEMs who typically have a lower piracy rate. Now, not all of those factors are beneficial from a revenue point of view, you know the average selling price through large multi-national OEMs is typically lower than in the smaller entities, but overall from a unit perspective it’s helping us about 3% and it’s offsetting some of the mix shift that we see and some of the other factors and so it’s just been a very good trend and it certainly in the last two to three quarters has picked up from what we’ve seen in previous two to three years."
},
{
"speaker": "Colleen Healy",
"text": "And then I would say as a broader theme, the company is focused on piracy really across all of our software offerings, including Office and MBD as you also asked about. With Office it’s tougher to quantify than we can with client because with Office we sell through so many different channels, volume licensing retail as well as OEMs. We estimate about half of the worldwide base out there is pirated, so there is opportunities to make gains there as well. And we’re doing a lot of those same sort of partnering with governments and educating people on the value of buying genuine software and keeping an eye really on retail sales of Office to see how that’s progressing. And you know it’s been really robust since the launch of Office 2007, but unlike client we can’t give you a specific of a number in terms of how we’re doing on piracy."
},
{
"speaker": "Charlie Di Bona",
"text": "Okay, thank you."
},
{
"speaker": "Operator",
"text": "Adam Holt with J.P. Morgan, your line is open."
},
{
"speaker": "Adam Holt",
"text": "Good afternoon. I wanted to drill down on the strength in MBD and Office which has been a consistent theme over the last several quarters. Another quarter of better than 20% revenue growth in business office and related. I wanted to see if that is primarily unit driven at this point or whether you’re actually starting to see an ASP uplift on the Office side and how long do you think you can sustain better than 20% growth for business revenue?"
},
{
"speaker": "Chris Liddell",
"text": "Yeah, firstly, specifically, it is very much around units, it’s not ASP driven. And I’d pick out a couple of themes in particular. One is just customer acceptance of the Office product itself which has been extremely good, you know it’s right at the top end of our expectations. So when you talk to people, their like of the product is extremely high and we’re seeing that manifest itself from a financial perspective and very strong license sales right across the board. So from consumer to small business to large businesses, the underlying office business and the office product has been a real success since launch. That’s number one, number two is some of the other products are starting to become significant in their own right, so when you look at Sharepoint, growing over 20-30% year on year, that’s over $1 billion business now, so it’s a significant business in its own right and it’s incredibly successful again in terms of customer acceptance in rollout through the enterprise. Unified Communications a similar story. Some of the Dynamics products, CRM and ERP which don’t get a lot of attention because we focus on the big parts but also growing at 30-40% growth. So you’re seeing a very strong portfolio of products anchored around the Office product but with some extremely good secondary ones as well making a big contribution. How long can that last? Well we will start to lap the launch of Office 2007, so that impact won’t be necessary be a significant going forward, but if you look at the second half guidance we certainly see a lot of the same factors for the first half continuing to the second half."
},
{
"speaker": "Adam Holt",
"text": "If I could actually just ask a follow up on that. You mentioned in your prepared comments that you’re taking a little bit more of a conservative view on spending in the US for the second half. As we think about the back half guidance, how should we or where do you think that’s being reflected, it looks like you’re being conservative against a tough comp on the PC growth expectations, where else are you reflecting that conservatism in the guidance?"
},
{
"speaker": "Chris Liddell",
"text": "Well I don’t think, when you look at the growth rates, they’re still very healthy in the second half so when we think about product portfolio we actually feel very optimistic for the second half. Certainly, if there’s you know a substantial economic slowdown you could see PC growth rates come down but we’re guiding for the second half in 11-13% or thereabouts so it’s still very healthy growth from an overall perspective. You look at individual verticals, probably we can find a couple of soft spots, but each of those individual verticals represents less than 5% of our sales and they’re made up for by strength in other areas. So when you look at the combined portfolio of our products, what we’re being, it’s just like everyone else about what might happen in the US economy, when you look at the overall suite of product we have and the overall growth rates we have, we actually feel very optimistic."
},
{
"speaker": "Adam Holt",
"text": "Thanks very much."
},
{
"speaker": "Operator",
"text": "And the next question comes from Kash Rangan with Merrill Lynch."
},
{
"speaker": "Kash Rangan",
"text": "Hi, thank you very much, when I look at the double digit operating profit percentage of the reported in the entertainment and devices business, despite having a record Xbox unit quarter, how should we think about the margin profile of this business going into the next fiscal year. Are you at the point that console costs have been driven low enough and you’re getting a healthier mix of software due to rising attached rising attach rate. It looks to me that the business [unintelligible] for a breakout on operating margins but how do you think about that looking into the next two to four quarters?"
},
{
"speaker": "Chris Liddell",
"text": "Yeah, well the first thing to note is as we’ve talked about before the first time we start talking about fiscal year ’09 is in April, so happy to make some comments about it then. In these calls we’re really trying to focus on this fiscal year, it’s the main purpose. In terms of some of the underlying drivers though that you can think about when you start populate your model, you know one of the things to point out is a very, very good attach rate for Xbox. So we’re looking at a life to date average attach of 7 games per console. You know, interesting when you look at that now people on average are spending more in terms of the software and accessories than they are on the underlying console itself, so that model of selling the console as a way of generating future revenue is really paying off. That 7 on average is well above anything historically were on on previous consoles. So that’s a very healthy leading indicator. But the entertainment and devices division is much more than just the Xbox, there’s obviously a music player in there, Windows for Mac and various other parts of it as well, so there’s other dynamics when those mobile that are going to play in terms of our investment in the future. We’re not making any long term predictions about the margins structure, the one thing that is positive is its clearly profitable and we believe on target to be profitable for the year which is the commitment we made some 18 months ago."
},
{
"speaker": "Kash Rangan",
"text": "Thanks and also one metric that you gave last quarter was the bookings growth rate in the core business being 25%. What was the same number this quarter, I do see that overall bookings growth rate was 20% but I was just curious about the core business? That’s it thanks."
},
{
"speaker": "Chris Liddell",
"text": "Yeah, greater than 20%. I’ll look if I can give you a more detailed number after the call but certainly off my head it’s greater than 20%."
},
{
"speaker": "Operator",
"text": "John Difucci from Bear Stearns, your line is open."
},
{
"speaker": "John Difucci",
"text": "Thank you. Chris, you talked a little bit about US risk and I think you were quoted in Routers I think after the close today saying something similar. Did you see any of it this quarter, I mean the aggregate results were obviously pretty impressive, but the server and tools division was a little bit below your expectations and that’s really enterprise infrastructure software in aggregate, did you see it and is that what you’re seeing now, is that an area where you might be seeing a little more pressure than perhaps some of the other areas?"
},
{
"speaker": "Chris Liddell",
"text": "Actually you have to look really hard to find any weakness in our results in the first half. So, in terms of server and tools, there was actually a shift to an annuity mix, so that may be what you’re looking at, in fact that’s a positive trend because it means our unearned is up significantly which we reported as you know over $500 million higher than expectations and it’s a reflection of our company’s commitment to our products as a platform in anticipation of some of the server products coming up. So from an accounting point of view you notice a difference, from an underlying business point of view that’s an incredibly positive trend. But if you look at the first half of the year, I mentioned over 60% of our sales come from customers outside the US. If you look at non-US, it grew over 20%, non-US mature markets, if you look at emerging markets, it grew at almost 30%, but the interesting factors that I didn’t say which I’m happy to say is that US markets are up 15%. So that’s a total our sales in the US for the first half grew by 15%. Now, clearly if the softness going forward, that would impact that, but that’s still a very healthy growth rate from our point of view."
},
{
"speaker": "John Difucci",
"text": "Yeah but I would think you would expect that shift to an annuity at the beginning of the quarter when you gave guidance and it was a little bit shy there but are you saying you just didn’t expect that and it was customer driven?"
},
{
"speaker": "Chris Liddell",
"text": "Yup, absolutely. There’s a vast number of contracts that come up for renewal every quarter and the nature of how those renewals flow through to annuity mix quite significantly quarter on quarter. But yes it was an unexpected positive surprise."
},
{
"speaker": "Colleen Healy",
"text": "You’re seeing on the low end on server and tools as revenue is about a $20 million miss and on the unearned balance you’re talking 100’s of millions, net-net on a bookings point, server and tools although the mix was different, the business was just healthier actually than we had expected."
},
{
"speaker": "Chris Liddell",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next comes from Ben Thill with Citi Investment Research."
},
{
"speaker": "Ben Thill",
"text": "Thanks, Chris can you characterize any meaningful differences in consumer versus enterprise demand. Are you seeing any changes in patterns in each of those two divisions?"
},
{
"speaker": "Chris Liddell",
"text": "No, they’re broadly in line with our expectations and in terms of the enterprise, as I mentioned and Colleen just referred to, the unearned balance is extremely good and so we’re feeling good about the relative commitment of our enterprise customers to multi-year agreements, so that’s good. On the, I mentioned about Office and the strength there. A lot of very good license earnings sales in the Office area right across the spectrum of businesses from small medium and large businesses. And lastly on the Xbox side, you know the consumer sales are very good, that’s a good leading indicator of consumer acceptance and I guess the last one would be PC sales overall which poured in to 16% in the quarter was a hit of our expectations. So really everything was slightly better than what we had hoped for but there wasn’t any significant mix change if you like, all those factors were good."
},
{
"speaker": "Ben Thill",
"text": "And just as a quick follow up, just as you look at the second half of this calendar year, how would you characterize your visibility and I guess the confidence of this macro overhanging the US, doesn’t catch up, I think you mentioned there were a couple soft spots, what gives you confidence that this doesn’t spillover into some of the other sectors in the US and catch up with you later in the year?"
},
{
"speaker": "Chris Liddell",
"text": "Well we’ve just gone through our mid-year reviews with where we go country by country and segment by segment across the world and the sales force, so the people who are in charge of delivering. Their results, sitting in on all of those and listening to them certainly is factored into our guidance. And you know at this state we’re obviously not giving fiscal year ’09 guidance but again you have to take a step back and look at the overall environment we’re selling into. The next six months we feel very good about. In terms of more general factors, we’re a global company, I talked about the sales mix, I feel good about global GDP over the medium to long term, I think software spending is going to be faster than global GDP and I think we’re going to grow faster than overall global software spending. So could we be impacted by global slowdown, of course we could, but if you look at the overall growth rates from the products we have and the markets we compete, we still feel very good if we think about our business on a multiyear basis."
},
{
"speaker": "Ben Thill",
"text": "Thanks Chris."
},
{
"speaker": "Operator",
"text": "Our next is Jason Maynard with Credit Suisse."
},
{
"speaker": "Jason Maynard",
"text": "Hey good afternoon guys. I had a little different tact on the questioning. I’m just curious to get your opinion on how you expect the recent EU commission new investigations to play out and what impact you think that may have on not only Vista but I guess perhaps the not yet released Windows 7 product that’s being talked about?"
},
{
"speaker": "Chris Liddell",
"text": "Yeah, overall obviously we’ll cooperate fully with the commission’s investigation and provide any and all information necessary. We’re committed to insuring that we’re in full compliance with their law and our obligations as established by the court. So I don’t really have a sort of general business comment, happy to leave it at that."
},
{
"speaker": "Jason Maynard",
"text": "Is this, post the settlement I guess was like three or four months ago, is this is any way shape or form impacting perhaps your M&A strategy or maybe decisions to do something bigger within the online services area?"
},
{
"speaker": "Chris Liddell",
"text": "No, not at all."
},
{
"speaker": "Jason Maynard",
"text": "Okay, thank you."
},
{
"speaker": "Operator",
"text": "And the last question comes from Brendan Barnicle with Pacific Crest Securities."
},
{
"speaker": "Brendan Barnicle",
"text": "Thanks so much, Chris I had a quick follow up question on the online business. Specifically, where is it you’re spending the money for the investment you’re making now. Is that around infrastructure or R&D, sales, and then secondly, where do you envision that going, is it just always going to be an online advertising business or do you see a point where you charge for content or applications, music, any of these other potential revenue streams? Thanks."
},
{
"speaker": "Chris Liddell",
"text": "Yeah the investments are across a broad spectrums o we believe to be successful in that business you really need to commit substantially across the whole gamut of investments, so we’re investing in search, improving the relevancy of our search results, focusing on some key verticals like commerce, local entertainment, health. We’re obviously investing in the advertiser and publisher tools. You know after our aQuantive acquisitions that’s given us a substantial leg up in the advertising platform area, so we’re continuing to build on that. We’re investing in content and services through Windows Live and other Live services through the MSN portal and then lastly but not leastly in operational infrastructure. So a lot of [tapics] going into data centers to improve performance and reliability and generate global sales for the business and some of those costs are feeding through in terms of depreciation. So there is no one particular area that we’re focused on, we are focused on all the areas and we think to be successful in that business going forward, that’s the approach you have to take."
},
{
"speaker": "Brendan Barnicle",
"text": "And then second question in envisioning where it goes?"
},
{
"speaker": "Chris Liddell",
"text": "Yeah, just go over that one again."
},
{
"speaker": "Brendan Barnicle",
"text": "Yeah, I mean do you ever see a point where you may charge for content, charge for applications or are you always going to be basically in online advertising and advertising driven type model?"
},
{
"speaker": "Chris Liddell",
"text": "Well we’re obviously moving to a software plus services world, so there are certainly areas of products that we have where you can see us moving from a license only to a on demand situation. We already are, in terms of the basic online advertising business as you think about OSB, to a large extent that’s going to be an advertising driven, advertising supported business. But there will be other parts of the business you know as we already are with CRM, delivered online and charged for on a subscription basis where it won’t be advertising driven. So we’ll live in a multi-business model world going forward."
},
{
"speaker": "Colleen Healy",
"text": "Great, thanks a lot Brendan and thanks everyone for your participation in today’s call. If you have any further questions, please feel free to call me or my team directly. As I mentioned at the beginning of this call, this conference call will be available on replay at our investor relations website through close of business January 26, 2009. In addition, you can hear the replay by dialing 1-800-297-0771 or for international calls dial 203-369-3238, the dial in replay will be available through the close of business February 1, 2008. Thanks again for joining us today."
},
{
"speaker": "Operator",
"text": "And that concludes today’s call, please disconnect your line at this time."
}
] | null | null |
MSFT | 1 | 2,008 | 2007-10-26 17:30:00 | Operator: Welcome to the Microsoft first quarter earnings conferencecall. (Operator Instructions) I would now like to turn the meeting over toColleen Healy, General Manager, Investor Relations. Madam, you may begin.
Colleen Healy: Thank you very much and good afternoon, everyone. Thanks somuch for joining us today. This afternoon I am joined by: Chris Liddell, SeniorVice President and Chief Financial Officer; Frank Brod, Corporate VicePresident and Chief Accounting Officer; and John [Setok], Deputy GeneralCounsel. Today’s call will start with Chris providing some keytakeaways for the first quarter of fiscal year 2008 and an overview ofexpectations for the rest of fiscal year. I will then provide details aroundour first quarter results and then turn it back to Chris for a more detaileddiscussion of our guidance for the full year and second quarter of fiscal 2008.After that, we’ll take your questions. We filed our 10-Q today in conjunction with our earningsrelease. Therefore, you have available the earnings release, MD&A,financial statements, and footnote. We have also posted our quarterly financialsummary slide deck which is intended to follow the flow of our prepared remarksin order to assist you. The slide deck offers highlights from the quarter,outlines our guidance, and provides a reconciliation of differences betweenGAAP and non-GAAP financial measures that we will talk about today. You can find the earnings release, the financial highlights,and the quarterly financial summary slide deck on the investor relationswebsite at www.microsoft.com/msft. Today’s call will be recorded. Please be aware that if youdecide to ask a question, it will be included in both our live transmission aswell as any future use of the recording. As always, shareholders and analystscan listen to a live webcast of today’s call at the Microsoft investorrelations website. A replay of the call will be available at the same sitethrough the close of business on October 25, 2008. This conference call report is protected by copyright lawand international treaties. Unauthorized reproduction or distribution of thisreport, or any portion of it, may result in civil and criminal penalties. Anyrecording or other use of the transmission of the text or audio of today’s callis not allowed without express permission of Microsoft. We will be making statements during this call that areforward-looking. These statements are based on current expectations andassumptions that are subject to risks and uncertainties. Actual results coulddiffer materially because of factors discussed in today’s earnings pressrelease, in the comments made during this conference call, and in the riskfactors section of our 10-Q, our 2007 Form 10-K, and other reports and filingswith the Securities and Exchange Commission. We do not undertake any duty toupdate any forward-looking statement. With that, let me turn it over to Chris.
Christopher P.Liddell: Thanks, Colleen, and good afternoon, everyone. Thanks forjoining us. I’ll start today’s call with highlights from our first quarterperformance and how we see the rest of fiscal 2008 shaping up. The first quarter represented an outstanding start to thefiscal year, with every part of the company performing at or aboveexpectations. In particular, we are very happy the consumer demand across ourtotal product range propelled revenue, operating income, and earnings per sharegrowth by 27%, 32%, and 29% respectively. Also, we successfully closed aQuantive and a number ofsmaller acquisitions, and we continued setting the platform for future growth withthe availability of products and services, such as an updated live search, BizTalkServer, Silverlight, Performance Point Server, Halo 3, and Office CommunicationServer. In terms of our financial performance, there are some keytrends that I would like to highlight. On the revenue side, the benefits of ourmulti-year product cycle are obvious. Q1 was our fastest growing first quarterin seven years, with revenue up 27%, or $3 billion, over Q1 of last year. Theperformance was across all positions, customer segments, channels, andgeographies. Looking specifically at the growth coming from our variousgeographies, emerging markets continued to be a strength. The nations that makeup the G7 grew 29% for the quarter, but even better was an over 40% increaseturned in by the combined group of Brazil, Russia, India, and China. A quarter like this demonstrates how enlarging ourgeographic presence has positioned us to benefit from the continued worldwideeconomic expansion. We also did a good job this quarter of converting revenuegrowth into profit growth. Operating income grew five percentage points fasterthan revenue, expanding our operating margin from 41% to 43%. Solid marketing and sales execution, combined withefficiency on operating expenses, kept costs in line with expectations. Earnings per share was up 29% over last year, up to $0.45,assisted by our ongoing share buy-back program. Given the start in the firstquarter, the acquisition of aQuantive, and an improved outlook, we areincreasing our revenue, operating income, and earnings per share guidance forthe year. We now expect revenue growth of 15% to 17%, and this wouldput the top end of that revenue approaching nearly $60 billion, representing a$2 billion increase over our guidance in July. We are also increasing our operating income and earnings pershare guidance, the latter to a range of $1.78 to $1.81, $0.08 to $0.09 higherthan our previous outlook. With those high level things for the quarter and 2008, I amgoing to turn the call over to Colleen now for more details on how we closedout the first quarter.
Colleen Healy: Thanks, Chris. As Chris mentioned, we are off to the fasteststart for revenue and operating income growth of any recent fiscal year. Let meprovide you with details of our financial performance, starting with revenue.I’ll discuss top line financial and business momentum points and then follow upwith revenue performance for each of the business units. Then I’ll review therest of the income statement. All growth comparisons relate to the comparablequarter of last year, unless otherwise specified. Revenue increased 27% to $13.8 billion, significantlyexceeding our expectations by over $1 billion. Every business grew atdouble-digit rates, with particular strength in client, the business division,and server and tools, which grew in excess of 20% combined, as well as growthof over 90% by our entertainment and devices division. The underlying PC hardware market was strong, with estimatedgrowth of 14% to 16% during the quarter, about three points higher than ourexpectations. From a customer segment standpoint, the business PC shipmentgrowth rate increased almost three times to over 12%, while continuing to beoutpaced by the consumer segment. From a geographical point of view, PC growth rates inemerging markets continued to outpace that of mature markets, driven by robustgrowth in Brazil, Russia, India, and China, which grew a combined 20%. Europeand Canada led the mature markets, while we began to see recovery in the U.S.and Japan. Our mix of product billings for the quarter was approximately35% from OEMs, 25% from multi-year agreements, 20% from license-only sales, andthe balance from our other businesses. Non-annuity sales were particularly robust, which isconsistent with the post product launch stage for Windows Vista and the 2007Office system. Strong annuity licensing performance with enterprise agreementrenewal rates consistent with historical trends drove our unearned revenuebalance 15% higher to $11.6 billion. Our [contracted and not billed] balance increased sequentiallyto over $11 billion. When taken together with reported revenue, total bookingfor the company grew an impressive over 30%. I will close out the revenue overview by adding that changesin foreign exchange rates added about two percentage points to our overallrevenue growth and was slightly above our forecast heading in to the quarter. Now, I will provide revenue highlights by business segment,starting with client. Since Windows Vista became available for consumers,client revenue has grown over 20% on average. This quarter, a rapidly expandingpersonal computer market, progress against software piracy, and three quartersof Windows customers adopting premium versions drove client revenue to $4.1billion, an increase of 25%. OEM revenue, which makes up over 80% of client revenue, grew25%. After adjusting for three points of revenue recognition fromdeferred revenue, OEM revenue increased slightly faster then OEM unit shipmentsof 20%, due to a higher mix of Premium Windows SKUs. Consumer premium units grew over 150%, while businesspremium units grew closer to 11%. As a result, the OEM premium mix increased by16 points to 75%, driven by a 19-point increase in the consumer element ofpremium mix, and partially offset by a three-point decline in the businesselement. Because business premium SKUs have a five-to-one pricingimpact over consumer premium SKUs, these changes in the premium mix havelargely offset any impact to revenue. Client, commercial and retail licensing, which makes upabout 20% of client revenue, increased 23%, as business customers continue toadd client products to their annuity agreement. During the quarter, we saw a 27% increase in the clientvolume licensing portion of the unearned revenue balance. We view this to be apositive leading indicator of intent by businesses to deploy Windows Vista. Server and tools revenue increased 16% to $2.9 billion,driven by strong annuity license growth in Windows Server and SQL Server, whichwe are happy to see ahead of the upcoming new releases. More specifically, we saw healthy unit growth in our WindowsServer business, particularly in our premium enterprise edition SKU, which grewby over 35%. And SQL Server unit and revenue growth each exceeded 15%. During the quarter, we release Silverlight, a Windows homeserver. We also gained significant product development momentum with betareleases of Visual Studio and SQL Server. Since the availability of the initialrelease candidate of Windows Server about a month ago, it has been downloadedover 1 million times, indicating high interest in the coming final products. Our consulting revenue increased 32%, as we’ve experiencedhigher utilization rates following the recent business product launches acrossthe company. Online services business revenue grew 25% to $671 million,including $80 million for the half quarter of aQuantive revenue since close.Excluding aQuantive, consistent with the way we guided you back in July, growthwas in line with our expectations. Online advertising growth for the quartergrew 33%, or 25% before aQuantive. Microsoft Business Division revenue grew 20% to $4.1billion. As a result of our focus on delivering greater desktop value tobusiness customers, we achieved double-digit revenue growth across a broadrange of products within our Office system, unified communications, andbusiness solution areas. Looking at how the various customer segments performed,revenue from business customers jumped 25% over the prior year. We benefitedfrom strong, mid-market transactional sales and good Enterprise demand forbusiness productivity infrastructure, such as SharePoint and enterprise [COW]. Healthy sales through retailers for the back-to-schoolseason helped drive consumer growth in the quarter. Entertainment and devices revenue grew over 90% to $1.9billion, driven by higher-than-expected console sales and Halo 3, whichachieved the biggest entertainment launch day in history. The strong demand forHalo 3 generated approximately $330 million of Microsoft revenue in thequarter, as well as significant consumer interest for the X-Box 360 console. X-Box 360 console units increased over 90%, with over 1.8million units sold. This was driven by our August price cut, excitement aroundHalo 3 generating console demand, and an earlier ramp-up to the holiday seasonin anticipation of the most compelling line-up of game titles available on anyplatform. In addition to the success of Halo 3, X-Box 360 continues tolead third-party games sales against all current generation platforms, which isnot only good for us and our gaming audience, but also good for our gamedeveloper partners in the X-Box ecosystem. For example, according to NPD for the U.S., all four of thecurrent generation third-party titles in the top 10 last month were for theX-Box 360. Infact, over the last year, game developers have seen their titles hit the top 10list 27 times for X-Box 360 compared to only twice for the PS3 and only oncefor the Wii. This helps X-Box 360 software attach rates remain at record levelsfor any console at this stage in its lifecycle. Now for the rest of the income statement. Cost of revenueincreased three points to 19% of sales, primarily driven by the high volume ofX-Box 360 unit sales, increased consulting business, and expanded onlineservices operations. Operating expenses increased 11%, dropping from 43% of salesto 38% of sales. Expense growth was largely in line with headcount growth andis tracking to our expectations, despite the higher-than-expected revenue asgenerated during the quarter. Operating income grew faster than revenue at 32% to $5.9billion, exceeding high-end guidance by $750 million and expanding ouroperating margin by two percentage points. Investment income and other totaled $298 million for thequarter. Our effective tax rate for the quarter was 31%, half a point higherthan we previously guided. Cash flow from operations increased 45% to $5.9billion. Cash flow from operations outpaced operating income due to collectionson the large volume of business close at the end of the fiscal year. During the quarter, we repurchased 81 million shares, or$2.3 billion of company stock. $2.9 billion settled in the quarter due to thehigh volume of repurchases at the end of fiscal year 2007, and we paid out $938million in dividends to shareholders in the quarter. Diluted shares outstanding for the quarter were 9.5 billion,down 5% from the prior year as a result of share repurchases. Earnings pershare for the quarter were $0.45. So in summary, we are extremely pleased with this quarter’sperformance. Revenue for the fiscal year is off to the fastest start in recenthistory, fueled by strength across our products launched over the last ninemonths. Operating expenses came in line with expectations while generatingsignificantly higher-than-expected revenue. This resulted in operating incomegrowing faster than revenue at an impressive 30% clip. With that, let me turn it back to Chris who will provide youwith our second quarter guidance and outlook for fiscal 2008.
Christopher P.Liddell: Thanks, Colleen. Before we get into the specific guidance,let me outline some of our key underlying assumptions. First, our fiscal 2008forecast assumes stable macro economic conditions through the remainder of thefiscal year. We remain optimistic about the overall outlook for the ITindustry. In mature markets, we haven’t seen a spillover from problems in otherareas of the economy, although clearly the risk of an economic slowdown hasincreased. Emerging markets in particular appear healthy to us. Notonly are we getting the benefits of strong growth offshore, but it is assistedby stronger international currencies. The FX impact alone we believe will addabout one point to our yearly revenue growth. Overall, our business is benefiting from our diversificationacross products, channels, geographies, and customer segments. We are increasing our expectations for PC unit growth forfiscal 2008 by one percentage point to 10% to 12% for the year, and 11% to 13%for the second quarter. Growth rates in both the Asia-Pacific and EMEA regionsappear to be stronger than we thought coming into the year. We estimate thatthe growth rate will continue to be higher in the consumer segment and thebusiness segment, and recent regional trends should continue with growth inemerging markets outpacing that of mature markets. Now let me go through our detailed guidance. For the fullyear, we expect our revenue to come in between $58.8 billion to $59.7 billion,growing 15% to 17%, up four percentage points from our last guidance. The full year forecast now includes revenue from aQuantive,which contributes approximately one point of revenue growth. The remainingthree point increase from July is driven by an improved outlook for our threebusinesses of client, the business division, and server and tools. For the second quarter, we expect revenue of $15.6 billionto $16.1 billion, which represents a year-over-year increase of 25% to 28%. With that, revenue guidance in our divisions is as follows:for client, we expect full-year growth to be 12% to 13%, and second quartergrowth to be 62% to 64%, or 13% to 14% excluding certain revenue deferrals inthe prior year. For the full year, we expect OEM revenue to grow in line withthe PC hardware markets. On the commercial and retail side of the business, we expectdouble-digit growth for the year from continued demand through our volumelicensing channels. The client growth rate benefits by two percentage pointsfor the full year and by four percentage points in Q2 from recognition ofundelivered elements, consistent with our guidance in July in both percentageand absolute dollars. Server and tools revenue should be up 16% to 18% for theyear, and 16% to 17% for the second quarter. We expect double-digit growthacross our server platform products and services. The division is completingthe new releases of Windows Server, SQL Server, and Visual Studio inpreparation for the upcoming launch event starting in February. These productswill allow IT departments to be more productive by providing them with asecure, trusted, scalable and manageable platform that will underpin growth inthe server and tools business over the next several years. We forecast revenue in the online service business toincrease 33% to 37% for the year, and 32% to 35% in Q2. This implies onlineadvertising growth in excess of 30% for the quarter and for the year. This guidance includes the revenue from aQuantive, whichadds approximately 25 points of growth for Q2 and for the full year. Organicrevenue guidance for the fiscal year is unchanged for both the business groupand advertising. We’re aiming to become one of the major players in theonline advertising space, and we are pleased by the progress we are making inputting the building blocks in place. For example, the launch of our new searchproduct with much stronger relevance, using industry standard measurementmethodology; our core algorithmic relevance is now on par with the market leaderand better than all other search engines in the U.S. market today; we saw solidgrowth, 23%, in our display business; we saw rapid growth in our live IDs,growing 19% to over 400 million; our partnership, which we announced yesterdaywith Facebook; and the acquisition and successful integration of aQuantiveduring the quarter. We will continue to invest in this business, as we’ve toldyou before. For example, in building a differentiated search experience in thefour high value verticals of commerce, local search and mapping, entertainmentand health, which collectively represent 40% of all global searches. Microsoft Business Division revenue should be up 14% to 15%for the year and 31% to 33% in the second quarter. Normalizing for the impactof the technology guarantee and pre-shipment deferrals in the prior year, thesecond quarter growth should be 15% to 16%. Looking at the applied growth rate from the second half,I’ll remind you that due to last year’s strong sales of the 2007 MicrosoftOffice system, we will have tough comparisons but are predicting double-digitgrowth nevertheless. 2008 is another important product launch year for thebusiness division, as we roll out our offering in the important investmentareas of business intelligence and unified communications. These two areas areprojected to have a combined addressable market size of about $65 billion in2009, representing sizable growth opportunities for the division. Performance point server, which is our business intelligenceoffering, had over 10,000 customers on its CTP program, an amount larger thansome competitors’ installed bases. In unified communications, Office Communication Server alsohas been gathering interest, with over 80,000 beta downloads of the software. The entertainment and devices division, we’re forecastingrevenue growth of 15% to 20% for the full year, and flat to down 8% for Q2. OurQ2 revenue growth, however, should be viewed in conjunction with theearlier-than-expected ramp-up of console sales in Q1 in preparation for thecoming holiday season. If you look at our overall, for the first six months --that’s the first quarter and the second quarter combined, growth would havebeen about 15%. [inaudible] has historically comprised almost half of industryhardware and software sales. With competitively priced console bundles andaccessories, combined with a great first and third-party software titleline-up, we feel very good about our position heading into the holidays. We also look forward to bringing more choice to digitalmusic consumers with our expanded families of Zune devices and updated musicmarketplace and new software updates, such as podcasting support, new wirelesssend and sync functionalities, and an attractive user interface. And in appreciationof our early Zune adopters, the new software features will be updateable tocurrent owners’ devices as well. Turning back to company-wide performance, operating incomefor the year is expected to be between $23.3 billion and $23.7 billion, increasing26% to 28%. Our higher revenue forecast is responsible for the improvement versusour July guidance, as we expect over half the incremental revenue to flowthrough to operating profits. For the second quarter, we expect operating income to be between$5.9 billion and $6.1 billion. As a result of the higher operating income guidance, we areincreasing our full year earnings per share results to $1.78 to $1.81,including a $0.01 impact from integration and deal costs associated withaQuantive. This is an increase of $0.08 to $0.09 on a GAAP basis, or $0.09 to$0.10, excluding deal costs. For the second quarter, we expect $0.44 to $0.46. Theseearnings then assume both for the year and for the quarter an effective taxrate of 30.5%. From a balance sheet perspective, we expect total unearnedrevenue to finish fiscal 2008 up 8% to 10%, in line with our prior guidance.Excluding deferred revenue for undelivered elements, the remaining portion ofunearned revenue should increase 14% to 16%. When thinking about sequential changes in unearned revenuefrom Q1 to Q2, we expect the balance to follow historical patterns and remainroughly flat. Contracted not billed should also finish 2008 up from currentlevels. It is clearly important, especially in the currentenvironment, that you consider some of the risks of this forecast. These risksinclude competitors, legal, execution, and general market risks, such asforeign exchange rate movement, fluctuations in PC and server hardware growthrates, and consumer acceptance of our new and existing products. Additionally, changes in the mix of our billing betweenannuity and license only can have an impact on revenue, operating income, andearnings per share by delaying revenue recognition in the future periods. So to wrap up, the first quarter was an outstanding startfor the year. A strong PC hardware market, healthy demand by business customersfor our product, and overwhelming consumer response to the launch of Halo 3helped propel us to the fastest Q1 revenue growth in seven years. To put that in context, our revenue base is about 2.5 timeslarger than it was the last time we grew this fast. The fact that we can beatthe law of large numbers is a tribute to our products and sales teams. Good execution and cost discipline allowed the majority ofour revenue upside to flow through to operating income, and for the balance ofthis year, we will continue to deliver the strategies for shareholder value weoutlined at our financial analyst meeting in July, in particular, driving ourtop line growth, continuing to invest in technology offerings that will providethe platform for future growth, and using our strong cash flow and balancesheet to benefit shareholders through dividends and share repurchases. With that, I will hand the call over to Colleen so we canget started taking some of your questions. Thank you.
Colleen Healy: Okay, great. Let’s proceed to questions. We want toaccommodate as many questions as we can from as many of you, so please avoidmulti-part questions and please limit yourself to just one question. Operator,can you please repeat your instructions?
Operator: (Operator Instructions) Our first question comes fromHeather Bellini with UBS.
Heather Bellini: Congratulations on the quarter. I was wondering if you couldgive us an update on your view of Vista adoption thus far, and in particular,how the uptake of premium SKUs, both on the consumer side and also with VistaEnterprise, are tracking versus your original expectations, and how should wethink about that going forward?
Christopher P.Liddell: Clearly we are very happy with the client division overall.As you’ve seen since we launched Vista, the revenue growth has been in excessof 20% three quarters in a row, so the overall [headline] number, very good. In terms of the premium mix, also very happy about that.Now, in this case, premium mix brings in both Vista and XP premium sales aswell, and that’s tracking in the mid-70s, so 75% for the quarter, and thatcompares to I believe 59% in the equivalent quarter last year, so up 16 pointsyear over year. So we’re very happy with the adoption of Vista Premium and alsohappy with the old XP Media sales as well. The other thing I’ll point to is on the client annuityagreements, which is probably the best leading indicator we can think of ofpeople’s intention to adopt, that’s still very early in the adoption cycle forbusinesses, but the volume licensing portion of our business was up 27% in theclient area, so that’s a very good leading indicator from our point of view. And sort of finally, as a wrapper, year-to-date sales arenow 85 million units for Vista. That compares to about 45 million for XP overthe same period, so almost twice as much. So it’s still early days but progress, we’re very happy withso far.
Heather Bellini: And just on the premium SKUs, would you say that they aretracking above what you guys had expected when you originally launched theproduct?
Christopher P. Liddell: Yes.
Heather Bellini: Great. Thank you.
Colleen Healy: Next question, please.
Operator: Our next question comes from Adam Holt with J.P. Morgan.
Adam Holt: Good afternoon, and I’ll also let go the congratulations. Ihave two questions on the business uptake. In particular, you had a meaningfulacceleration on the client side in terms of business units and I was hoping maybeyou could detail what you thought was behind that acceleration. And then on the Office front, still another quarter ofbetter than 20% Office growth on the business front. Where do you think we areon the enterprise upgrade cycle for Office? Thank you.
Christopher P.Liddell: Sure, Adam. We’ll start with client. The business saleswere, to be honest, a function of underlying demand, so the PC unit came in at14% to 16% for the quarter overall, compared to our expectations of around 10%to 12%, so we saw a good uplift in overall PC units, and that was both on theconsumer and the business side. I think the benefit that we saw on the business aspect wasprobably most particular in some of the emerging markets, so we saw goodstrength in business and that really helped us with the anti-piracy andlegalization aspect of our growth. So if PC units grew by 14% to 16%, ourshipped units that we were paid for grew by 20%, and all of that delta waseffectively a fight against unlicensed PCs, so the growth that we saw in thebusiness segment, in particular internationally, really helped us in terms ofoverall unit sales. So felt very good about that and we still think thatconsumers will grow faster than businesses, but overall a very good story onthe client side. In terms of the Office, that has a slightly differentimpact, mainly because it’s a much stronger impact from annuity there ratherthan non-annuity sales, although interestingly, non-annuity sales, whichtypically go to smaller businesses, were strong as well, which is a very directimpact with Office. In the annuity sales, which tend to have a multi-yearimpact, you recall I talked last quarter about how we saw a very strong sign-upfor maturing agreements right at the top end of our expectations, and that wasreally a very good leading indicator of people’s acceptance of or expectationthat they would roll out Office, but also the other products in MBD. So it’sclearly strong from our point of view that people are seeing not only a valuein Office, but products that are related to Office, for example, in the unifiedcommunications and business intelligence area. So overall, we’re feeling good about the rollout.
Adam Holt: Terrific. Thank you.
Colleen Healy: Great. Thanks a lot, Adam. Next question, please.
Operator: Our next question comes from Sara Friar with Goldman Sachs.
Sara Friar: Good afternoon, everyone. I think everyone is going to saycongratulations, but it is quite an amazing quarter you put up. Following onone more comment on the client Vista adoption side; I think a lot of folks hadthought SP1 would be the catalyst. Why do you think we saw it a little bitahead of that and do you have a timing update on SP1? And then I just have aquick follow-up question, if I may, after that.
Christopher P.Liddell: Vista adoption, as I say, it is still early and I talkedabout intention to adopt rather than actual adoption. I think you are rightthat certainly some businesses will be waiting for SP1 to roll it out, but interms of their willingness to sign up for the client element of the multi-yearagreements, their intention to roll out is I guess signaled by that. So it isstill early days as to what the actual adoption numbers are, and we think itwill increase during the year and obviously will be helped to some extent bySP1. But some of the leading indicators are what we feel good about.
Sara Friar: And then just turning to the EDD division, great quarter. Itseems like you do think there was some pull forward on consoles just based onyour guidance. Is there anything implied in your guidance on broader commentaryabout health of consumer spending in the fourth quarter? Are you leavingyourself a little bit more cushion there?
Christopher P.Liddell: No, it’s principally around the pull forward, as youmentioned. And as I said in my prepared remarks, I tend to look at the businessfor the first six months rather than the quarters. In particular in the firstquarter, console sales were 1.8 million units, which is relatively small. So itwas ahead of our expectations, but it’s a quarter where you can beatexpectations because the volumes are small. I mean, Halo was obviously a clearbeat but in terms of consoles, I’d rather think that the volume over that sixmonths, because there’s a lot of stocking in anticipation of Christmas going on,and movements like that. So I feel good about it. There’s no particularsignaling on weakness for Christmas. In fact, we feel very good about theline-up we’ve got, not only from the box itself but obviously the gamesassociated with it as well.
Sara Friar: Terrific. Okay, well, thanks a lot.
Colleen Healy: Thanks a lot, Sara. Next question, please.
Operator: Charlie Di Bona with Sanford Bernstein, your line is open.
Charles Di Bona -Sanford Bernstein: I guess no surprise here, but I’m going to go back to thewell on OSB. It was probably the only division that didn’t really outperformsignificantly, only about 10% growth, excluding aQuantive, and the comScoreshare is back down to sort of the lows that they were in your fiscal Q4. Especially in light of yesterday’s announcement aroundFacebook, maybe you can give us a little insight into the strategy andexecution here, and is there any shift towards sort of buying traffic andcommunity rather than building it internally? And in general, how do you gobalancing those two alternatives and valuing those two alternatives?
Christopher P.Liddell: First thing to note obviously is we met expectations, so itwasn’t a beat, I agree, but it was a meet, so start with that. Underlying business growth or revenue growth, you mentionedthe 10%, which is correct. Clearly in this case it’s a negative from the Accessbusiness going away, so -- if you look at underlying revenue growth, underlyingadvertising revenue growth, it grew in the mid 20s, around 25% for the quarteryear on year, which we think is acceptable. It’s nor certainly stellar. We’dlike to see it higher but it’s acceptable and it is higher than where we guidedat the start of the year, roughly speaking. So I think reasonable progress onthe organic side of the business. In terms of putting the building blocks in place and how wetrade off organic growth through inorganic growth, it’s both. The strategy hasbeen both and will continue to be both, so we are investing heavily in the organicaspects of the business, so a lot of investment in particular has gone into thesearch product itself, and we clearly are extremely happy with the improvementswe are seeing on aspects like relevance, which are critical going forward. Weare putting a lot of investment into things like data centers, which arecreating the platform of the future and the experience, so we are increasingCapEx quite considerably there. We are looking at CapEx overall for the year of$3.2 billion to $3.3 billion, about half of which is going into the OSB area.And we are putting investment in some of the verticals that I talked about onsearch organically and all the other areas as well, content on the displayside. So there’s a strong organic side, there’s a strong inorganicside, but clearly aQuantive is the most obvious representation of that andwe’re particularly happy that we not only closed aQuantive but we’ve retainedall of the employees. We think that integration has gone extremely well and webelieve that’s going to generate some significant benefits going forward. We also did some other smaller acquisitions, ones which wethink are important for the ad platform, like AdECN during the quarter, andthen the announcement yesterday on Facebook, which is a willingness on our partto make a commitment to a multi-year agreement with a partner who we think hasgot some tremendous growth opportunities. So we are willing to do both. We are quite clearly willingto suffer an operating loss in that position as a result of those commitments,and we’ll share that there I think both in our financial analyst meeting and inour guidance. But to date, in terms of underlying financial metrics, we’reon track. In terms of some of the other things that we wanted to do, if anythingwe are slightly ahead of where we would like to be.
Colleen Healy: Thanks, Charlie. Next question, please.
Operator: Our next question comes from Brent Thill with Citigroup.
Brent Thill -Citigroup: Thanks. Good afternoon. Chris, I think your guidance for thefiscal year implies roughly a 40% operating margin, and clearly with Q1, it washigher than 40%. Why do you expect the operating margin will drift to thatlower level for the year?
Christopher P.Liddell: Overall for the year, we feel very good about the operatingincome growth relative to revenue growth and it will still be an increaseyear-on-year. So there’s some COGS impacts, for example, the mix of COGS duringthe course of the year and we just saw an outstanding performance in the firstquarter, some really, really strong growth in particular in client and MBD. We think that out-performance is going to continue, but notat the same rate, so operating margins improve but I think quarter one was justan outstanding one in terms of our ability to take the revenue out-performanceand drive it to the bottom line, and as I say, there is a different COGS mix tothe rest of the year, which impact it as well. But overall margin, we are going to grow operating incomefaster than revenue growth this year, which means our margins are going toexpand, and the other impact which you know I’ve talked to you about is weexpect earnings per share to grow very fast as well, backing out all of theone-offs, if you like. We think EPS is going to grow faster than 20% this year,which is the benefit of the operating margin expansion and also the benefit ofthings like share buy-backs flowing through. So at this stage of the cycle for the company and for acompany that started to grow earnings per share greater than 20%, upsignificantly from where we were, we feel good about it.
Brent Thill -Citigroup: And just one quick one, if I could; relative to enterprisedemand, it sounds like it’s improved slightly over the past couple of quarters.Do you think it stabilizes from here or has room to improve even from here?
Christopher P.Liddell: It’s just the renewals. It was back to more traditionallevels in the first quarter and that’s about two-thirds of the three-quartersramp that we talked about, so we saw a particularly good renewal rate in thefourth quarter and we are back down to more traditional levels, but levelswhich we feel obviously very good about, so I don’t think -- we’re notexpecting an out-performance or an increase back to the very, very good levelsthat we saw in the fourth quarter, but if we can maintain traditional levelsand obviously start to sell the new product range that we have coming throughto our existing clients, and hence get the benefits of all of the additionalproducts that we’ve either launched or are going to launch, [that is up] verywell from a business point of view in terms of overall billings growth.
Brent Thill -Citigroup: Thanks, Chris.
Colleen Healy: Thanks a lot, Brent. Next question, please.
Operator: Our next question comes from John DiFucci with Bear Stearns.
John DiFucci: Thanks. Just a follow-up question I guess to Brent; themargins were really impressive here, Chris, and even next quarter, you have ameaningful increase in revenue and a pretty I guess meaningful decline inoperating margin. Is there any reason for us to think that you can’t do a lotbetter than what you are saying here? I mean, I understand what you are sayingabout the COGS, but it looks like it is something that can continue.
Christopher P.Liddell: Probably the first thing to do is to normalize of aQuantive,so that may be distorting the numbers. But we are bringing that in for thefirst time and that’s bringing in revenue but no operating income -- in fact,with amortization of intangibles, it will be a slight loss for the year. Sothat’s probably a drag on the margins that you might want to normalize for, orat least give us the benefit of. If you take that out, the way that I look at it is what isour ability to meet our operating expenditure guidance and potentiallyoutperform on the revenue side, as opposed to drive the business on a marginbasis. And I would say I’m particularly happy with the fact that we deliveredincreased revenue in the quarter whilst keeping operating expenditure literallyright on guidance. You’ll recall from last year, I was certainly happy that wedelivered the whole year right on operating expenditures, so I feel really goodabout the business groups, discipline, the sales force discipline to a largeextent keeping operating expenses under control, which will allow us to, theextent that we beat revenue, to drive it to the bottom line. I can’t promise this is necessarily going to significantlyincrease margins, but it will increase margin every dollar that drops through,and perhaps if you back out aQuantive, that will give you a better comparison.
Colleen Healy: From a fiscal year on fiscal year, I mean, if you arelooking at organic, fiscal year ’07 you were see us sort of a bit above themid-30s. You pull out aQuantive and legal charges and tax, guaranteed bonds andthe rest of it, for the year you are sort of in that 40% range, and then ofcourse, with Q2, given that X-Box with the hardware is such a big driver forholiday, Q2 for the year, in terms of for the year, you’d probably see a dip,but year on year, when you look at the true underlying organic, pulling outaQuantive and some of those other things, you are going to see I think prettygood margin there, John.
Christopher P.Liddell: aQuantive will -- to help you, and obviously we’ll have togive more detail as we go on, but aQuantive will add $500 million of revenuefor the year. We will pull out deal costs and IP R&D that we write off ofclose to $100 million, but we’ll still leave in things like amortization ofintangibles, which we know other companies tend to call out. We’ll leave thosein, which means that will be a drag on the operating income of close to acouple hundred million towards this year. So perhaps that will help younormalize for that.
John DiFucci: Thank you.
Colleen Healy: Thanks a lot, John. Next question, please.
Operator: Our next question comes from Kash Rangan from Merrill Lynch.
Kash Rangan: Thank you very much. Good to see a quarter like that andmore particularly, the stock break out to a multi-year high. That’s got to lookgood. I just have a question on the online business, Chris. It looks likeyou’ve done a good job restoring or bringing profitability, let’s say, to theentertainment and devices business. At what point are we in making similarprogress on the profitability of the online business, especially with aQuantivebeing integrated into the operations of the company? And as a follow-up, I was also curious to get your thoughtson the client side. I know you do [inaudible], and correct me if I’m wrong, andthere’s some concerns in certain segments of Wall Street that there might be aninventory issue on Wall Street, especially on the PC side. Intel had a goodquarter, you guys had a good quarter, but with retail sort of weakening or atleast suspected to weaken during the holiday season, who knows, I’m justwondering if you share that concern and if you don’t, what specifically makesyou feel that this inventory build-up could actually lead to sell-through inthe Christmas holiday season? Thanks.
Christopher P.Liddell: Entertainment and devices and OSB are really at differentparts of their business cycle. It was a very strong commitment from our pointof view to try and drive profitability in the entertainment and devicesdivision this year, and we feel like we are on track for that. So they are on,if you like an upswing to a part of their business cycle where we believe wecan be profitable. In the OSB case, there isn’t a primary driver of thebusiness at the moment. The primary driver is to invest in the right areas andcreate the platform for a very strong growth in economic value over the nextfew years. So it’s not one where we are the [clearly the] -- but if we wereprofitable, but it is one where it is not going to be our primary determiner ofsuccess this year. I will be keen to ensure that the expenses come in wherethey are. I’ll obviously be keen to see that our revenue growth is in line withexpectations, but assuming we meet those two things, it is going to be a lossfor the year. So they are just different -- the businesses are atdifferent parts of their business cycle, and so we have different tests againstthem. On the client side, we are not seeing any significantinventory issues that we are aware of, and so from our point of view, if youlook at the guidance, we feel good about PC unit growth guidance of 11% to 13%.Anything in double digits or greater we think is good and that’s like a sell-innumber, using your terminology. So we think that’s good and we think we shouldbe able to drive OEM units in our area around that same level. So there’s noparticular issues of significance that we are aware of.
Kash Rangan: It just looks like the emerging markets and the [inaudible]countries, perhaps business there is accelerating and that’s why your OEM unitsare looking better than they have in the last few quarters?
Christopher P.Liddell: That’s absolutely right. Those countries really did anoutstanding job -- countries like Russia, the business overall grew there bygreater than 100% in the OEM area and client grew by something like 50%. Sosome of those countries are growing at a tremendous rate, which is a functionof the underlying economies growing well, but as we see business growth inthose areas and a greater desire to obviously have legitimate PCs, we areseeing good progress on piracy as well, and that’s really helping us with ouroverall OEM unit.
Kash Rangan: Great. Thanks a lot.
Colleen Healy: Thanks a lot, Kash. We have time for one, maybe two more questions,please.
Operator: Our next question comes from Kirk Materne with Banc ofAmerica.
Kirk Materne: Thanks very much. Chris, I might be jumping ahead a littlebit here, but clearly you guys haven’t seen any slowdown in terms of demandaround either SQL Server or Windows Server 2008 in front of those launches. Whatis your expectation in terms of the impact of those launches on the growthrates? Do you think that we’ll see demand come in at a steady pace? Or do youexpect that as we get into the back half of the year, that can help acceleratethe growth rates in that division? Thanks.
Christopher P. Liddell: I think it will help continue the growth rates that we’veseen, to a large extent. You have to realize that the structure of our businessreally has matured significantly to one that’s driven much more aroundmulti-year expectations. So people are -- to the extent we’re seeing strengthin annuity agreements now, it’s an anticipation of those products. The factthose product launch won’t in itself drive an enormous amount of accountingactivity. We’ll see that over a slow -- to a large extent, that’s the samephenomena we talked about with Vista. These things will happen over time aspeople adapt and adopt the particular systems. But from a revenue and economic point of view, ourrelationship with our customers, our ability to continue to sign them up anddrive growth is much more of a multi-period rather than a single event basedphenomena, and we just think a continuation of very strong products rolling outcontinuously quarter after quarter, year after year, is the best way of drivingthat business.
Kirk Materne: Just a really quick follow-up on Windows Server 2008, thebeta for Veridian is still expected to be released with that, with thefull-blown version released 180 days afterward? Is that still on track?
Christopher P.Liddell: Yes, that’s correct.
Kirk Materne: Thanks very much.
Colleen Healy: Great. Thanks so much, and our last question, please,Operator.
Operator: Our last question comes from Brandon Barnicle from PacificCrest Securities. BrandonBarnicle - Pacific Crest Securities Thanks so much. I just have two quick ones. Chris, first onpremium edition, obviously a great move, year over year up 75%. As we have SP1come, where we potentially get more enterprises pulling in, can we see thatpremium edition even move up higher still? And then secondly, over on aQuantive, have you given anythought again to the agency business and whether that’s something that stayswithin the business or needs to be divested? Thanks.
Christopher P.Liddell: Yeah, we are very happy with XP business. That’s continuedto do a great job. I mentioned before, I think the integration has goneextremely well. As far as we can tell, the employees are very happy, who arerunning the XP business in particular on a standing independent basis andreally letting them continue getting on with their life. We think it is a verygood business and no intention to do anything other than continue to run it. On the client side -- just go over your question again,sorry.
Brandon Barnicle -Pacific Crest Securities: Premium edition, 75%, very impressive. Can we see it go to85%?
Christopher P.Liddell: We’re just looking -- in terms of our guidance and ourthoughts and what’s embedded with, we believe we can continue to drive that atover 70%, but too early to predict anything higher than that.
Brandon Barnicle -Pacific Crest Securities: And would SP1 have any impact on accelerating that?
Christopher P.Liddell: It might help but those rates of 70% are very high, so -- itmight assist but it may just simply just help us continue at that sort of rate.So we are not [anticipating] a particular pick-up as a result of that alone.
Brandon Barnicle -Pacific Crest Securities: Thank you very much.
Colleen Healy: Thanks, Brandon, and thanks everyone for joining us today.If you have any further questions, please feel free to call me or my teamdirectly. As I mentioned at the beginning of this call, this conference callwill be available on replay at our investor relations website through close ofbusiness October 25, 2008. In addition, you can hear the replay by dialing800-835-8067, or for international calls, please dial 203-369-3354. The dial-inreplay will be available through the close of business November 2, 2007. Thanksagain, everyone, for joining us today.
Operator: And that concludes today’s call. Thank you for joining. | [
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"text": "Welcome to the Microsoft first quarter earnings conferencecall. (Operator Instructions) I would now like to turn the meeting over toColleen Healy, General Manager, Investor Relations. Madam, you may begin."
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{
"speaker": "Colleen Healy",
"text": "Thank you very much and good afternoon, everyone. Thanks somuch for joining us today. This afternoon I am joined by: Chris Liddell, SeniorVice President and Chief Financial Officer; Frank Brod, Corporate VicePresident and Chief Accounting Officer; and John [Setok], Deputy GeneralCounsel. Today’s call will start with Chris providing some keytakeaways for the first quarter of fiscal year 2008 and an overview ofexpectations for the rest of fiscal year. I will then provide details aroundour first quarter results and then turn it back to Chris for a more detaileddiscussion of our guidance for the full year and second quarter of fiscal 2008.After that, we’ll take your questions. We filed our 10-Q today in conjunction with our earningsrelease. Therefore, you have available the earnings release, MD&A,financial statements, and footnote. We have also posted our quarterly financialsummary slide deck which is intended to follow the flow of our prepared remarksin order to assist you. The slide deck offers highlights from the quarter,outlines our guidance, and provides a reconciliation of differences betweenGAAP and non-GAAP financial measures that we will talk about today. You can find the earnings release, the financial highlights,and the quarterly financial summary slide deck on the investor relationswebsite at www.microsoft.com/msft. Today’s call will be recorded. Please be aware that if youdecide to ask a question, it will be included in both our live transmission aswell as any future use of the recording. As always, shareholders and analystscan listen to a live webcast of today’s call at the Microsoft investorrelations website. A replay of the call will be available at the same sitethrough the close of business on October 25, 2008. This conference call report is protected by copyright lawand international treaties. Unauthorized reproduction or distribution of thisreport, or any portion of it, may result in civil and criminal penalties. Anyrecording or other use of the transmission of the text or audio of today’s callis not allowed without express permission of Microsoft. We will be making statements during this call that areforward-looking. These statements are based on current expectations andassumptions that are subject to risks and uncertainties. Actual results coulddiffer materially because of factors discussed in today’s earnings pressrelease, in the comments made during this conference call, and in the riskfactors section of our 10-Q, our 2007 Form 10-K, and other reports and filingswith the Securities and Exchange Commission. We do not undertake any duty toupdate any forward-looking statement. With that, let me turn it over to Chris."
},
{
"speaker": "Christopher P.Liddell",
"text": "Thanks, Colleen, and good afternoon, everyone. Thanks forjoining us. I’ll start today’s call with highlights from our first quarterperformance and how we see the rest of fiscal 2008 shaping up. The first quarter represented an outstanding start to thefiscal year, with every part of the company performing at or aboveexpectations. In particular, we are very happy the consumer demand across ourtotal product range propelled revenue, operating income, and earnings per sharegrowth by 27%, 32%, and 29% respectively. Also, we successfully closed aQuantive and a number ofsmaller acquisitions, and we continued setting the platform for future growth withthe availability of products and services, such as an updated live search, BizTalkServer, Silverlight, Performance Point Server, Halo 3, and Office CommunicationServer. In terms of our financial performance, there are some keytrends that I would like to highlight. On the revenue side, the benefits of ourmulti-year product cycle are obvious. Q1 was our fastest growing first quarterin seven years, with revenue up 27%, or $3 billion, over Q1 of last year. Theperformance was across all positions, customer segments, channels, andgeographies. Looking specifically at the growth coming from our variousgeographies, emerging markets continued to be a strength. The nations that makeup the G7 grew 29% for the quarter, but even better was an over 40% increaseturned in by the combined group of Brazil, Russia, India, and China. A quarter like this demonstrates how enlarging ourgeographic presence has positioned us to benefit from the continued worldwideeconomic expansion. We also did a good job this quarter of converting revenuegrowth into profit growth. Operating income grew five percentage points fasterthan revenue, expanding our operating margin from 41% to 43%. Solid marketing and sales execution, combined withefficiency on operating expenses, kept costs in line with expectations. Earnings per share was up 29% over last year, up to $0.45,assisted by our ongoing share buy-back program. Given the start in the firstquarter, the acquisition of aQuantive, and an improved outlook, we areincreasing our revenue, operating income, and earnings per share guidance forthe year. We now expect revenue growth of 15% to 17%, and this wouldput the top end of that revenue approaching nearly $60 billion, representing a$2 billion increase over our guidance in July. We are also increasing our operating income and earnings pershare guidance, the latter to a range of $1.78 to $1.81, $0.08 to $0.09 higherthan our previous outlook. With those high level things for the quarter and 2008, I amgoing to turn the call over to Colleen now for more details on how we closedout the first quarter."
},
{
"speaker": "Colleen Healy",
"text": "Thanks, Chris. As Chris mentioned, we are off to the fasteststart for revenue and operating income growth of any recent fiscal year. Let meprovide you with details of our financial performance, starting with revenue.I’ll discuss top line financial and business momentum points and then follow upwith revenue performance for each of the business units. Then I’ll review therest of the income statement. All growth comparisons relate to the comparablequarter of last year, unless otherwise specified. Revenue increased 27% to $13.8 billion, significantlyexceeding our expectations by over $1 billion. Every business grew atdouble-digit rates, with particular strength in client, the business division,and server and tools, which grew in excess of 20% combined, as well as growthof over 90% by our entertainment and devices division. The underlying PC hardware market was strong, with estimatedgrowth of 14% to 16% during the quarter, about three points higher than ourexpectations. From a customer segment standpoint, the business PC shipmentgrowth rate increased almost three times to over 12%, while continuing to beoutpaced by the consumer segment. From a geographical point of view, PC growth rates inemerging markets continued to outpace that of mature markets, driven by robustgrowth in Brazil, Russia, India, and China, which grew a combined 20%. Europeand Canada led the mature markets, while we began to see recovery in the U.S.and Japan. Our mix of product billings for the quarter was approximately35% from OEMs, 25% from multi-year agreements, 20% from license-only sales, andthe balance from our other businesses. Non-annuity sales were particularly robust, which isconsistent with the post product launch stage for Windows Vista and the 2007Office system. Strong annuity licensing performance with enterprise agreementrenewal rates consistent with historical trends drove our unearned revenuebalance 15% higher to $11.6 billion. Our [contracted and not billed] balance increased sequentiallyto over $11 billion. When taken together with reported revenue, total bookingfor the company grew an impressive over 30%. I will close out the revenue overview by adding that changesin foreign exchange rates added about two percentage points to our overallrevenue growth and was slightly above our forecast heading in to the quarter. Now, I will provide revenue highlights by business segment,starting with client. Since Windows Vista became available for consumers,client revenue has grown over 20% on average. This quarter, a rapidly expandingpersonal computer market, progress against software piracy, and three quartersof Windows customers adopting premium versions drove client revenue to $4.1billion, an increase of 25%. OEM revenue, which makes up over 80% of client revenue, grew25%. After adjusting for three points of revenue recognition fromdeferred revenue, OEM revenue increased slightly faster then OEM unit shipmentsof 20%, due to a higher mix of Premium Windows SKUs. Consumer premium units grew over 150%, while businesspremium units grew closer to 11%. As a result, the OEM premium mix increased by16 points to 75%, driven by a 19-point increase in the consumer element ofpremium mix, and partially offset by a three-point decline in the businesselement. Because business premium SKUs have a five-to-one pricingimpact over consumer premium SKUs, these changes in the premium mix havelargely offset any impact to revenue. Client, commercial and retail licensing, which makes upabout 20% of client revenue, increased 23%, as business customers continue toadd client products to their annuity agreement. During the quarter, we saw a 27% increase in the clientvolume licensing portion of the unearned revenue balance. We view this to be apositive leading indicator of intent by businesses to deploy Windows Vista. Server and tools revenue increased 16% to $2.9 billion,driven by strong annuity license growth in Windows Server and SQL Server, whichwe are happy to see ahead of the upcoming new releases. More specifically, we saw healthy unit growth in our WindowsServer business, particularly in our premium enterprise edition SKU, which grewby over 35%. And SQL Server unit and revenue growth each exceeded 15%. During the quarter, we release Silverlight, a Windows homeserver. We also gained significant product development momentum with betareleases of Visual Studio and SQL Server. Since the availability of the initialrelease candidate of Windows Server about a month ago, it has been downloadedover 1 million times, indicating high interest in the coming final products. Our consulting revenue increased 32%, as we’ve experiencedhigher utilization rates following the recent business product launches acrossthe company. Online services business revenue grew 25% to $671 million,including $80 million for the half quarter of aQuantive revenue since close.Excluding aQuantive, consistent with the way we guided you back in July, growthwas in line with our expectations. Online advertising growth for the quartergrew 33%, or 25% before aQuantive. Microsoft Business Division revenue grew 20% to $4.1billion. As a result of our focus on delivering greater desktop value tobusiness customers, we achieved double-digit revenue growth across a broadrange of products within our Office system, unified communications, andbusiness solution areas. Looking at how the various customer segments performed,revenue from business customers jumped 25% over the prior year. We benefitedfrom strong, mid-market transactional sales and good Enterprise demand forbusiness productivity infrastructure, such as SharePoint and enterprise [COW]. Healthy sales through retailers for the back-to-schoolseason helped drive consumer growth in the quarter. Entertainment and devices revenue grew over 90% to $1.9billion, driven by higher-than-expected console sales and Halo 3, whichachieved the biggest entertainment launch day in history. The strong demand forHalo 3 generated approximately $330 million of Microsoft revenue in thequarter, as well as significant consumer interest for the X-Box 360 console. X-Box 360 console units increased over 90%, with over 1.8million units sold. This was driven by our August price cut, excitement aroundHalo 3 generating console demand, and an earlier ramp-up to the holiday seasonin anticipation of the most compelling line-up of game titles available on anyplatform. In addition to the success of Halo 3, X-Box 360 continues tolead third-party games sales against all current generation platforms, which isnot only good for us and our gaming audience, but also good for our gamedeveloper partners in the X-Box ecosystem. For example, according to NPD for the U.S., all four of thecurrent generation third-party titles in the top 10 last month were for theX-Box 360. Infact, over the last year, game developers have seen their titles hit the top 10list 27 times for X-Box 360 compared to only twice for the PS3 and only oncefor the Wii. This helps X-Box 360 software attach rates remain at record levelsfor any console at this stage in its lifecycle. Now for the rest of the income statement. Cost of revenueincreased three points to 19% of sales, primarily driven by the high volume ofX-Box 360 unit sales, increased consulting business, and expanded onlineservices operations. Operating expenses increased 11%, dropping from 43% of salesto 38% of sales. Expense growth was largely in line with headcount growth andis tracking to our expectations, despite the higher-than-expected revenue asgenerated during the quarter. Operating income grew faster than revenue at 32% to $5.9billion, exceeding high-end guidance by $750 million and expanding ouroperating margin by two percentage points. Investment income and other totaled $298 million for thequarter. Our effective tax rate for the quarter was 31%, half a point higherthan we previously guided. Cash flow from operations increased 45% to $5.9billion. Cash flow from operations outpaced operating income due to collectionson the large volume of business close at the end of the fiscal year. During the quarter, we repurchased 81 million shares, or$2.3 billion of company stock. $2.9 billion settled in the quarter due to thehigh volume of repurchases at the end of fiscal year 2007, and we paid out $938million in dividends to shareholders in the quarter. Diluted shares outstanding for the quarter were 9.5 billion,down 5% from the prior year as a result of share repurchases. Earnings pershare for the quarter were $0.45. So in summary, we are extremely pleased with this quarter’sperformance. Revenue for the fiscal year is off to the fastest start in recenthistory, fueled by strength across our products launched over the last ninemonths. Operating expenses came in line with expectations while generatingsignificantly higher-than-expected revenue. This resulted in operating incomegrowing faster than revenue at an impressive 30% clip. With that, let me turn it back to Chris who will provide youwith our second quarter guidance and outlook for fiscal 2008."
},
{
"speaker": "Christopher P.Liddell",
"text": "Thanks, Colleen. Before we get into the specific guidance,let me outline some of our key underlying assumptions. First, our fiscal 2008forecast assumes stable macro economic conditions through the remainder of thefiscal year. We remain optimistic about the overall outlook for the ITindustry. In mature markets, we haven’t seen a spillover from problems in otherareas of the economy, although clearly the risk of an economic slowdown hasincreased. Emerging markets in particular appear healthy to us. Notonly are we getting the benefits of strong growth offshore, but it is assistedby stronger international currencies. The FX impact alone we believe will addabout one point to our yearly revenue growth. Overall, our business is benefiting from our diversificationacross products, channels, geographies, and customer segments. We are increasing our expectations for PC unit growth forfiscal 2008 by one percentage point to 10% to 12% for the year, and 11% to 13%for the second quarter. Growth rates in both the Asia-Pacific and EMEA regionsappear to be stronger than we thought coming into the year. We estimate thatthe growth rate will continue to be higher in the consumer segment and thebusiness segment, and recent regional trends should continue with growth inemerging markets outpacing that of mature markets. Now let me go through our detailed guidance. For the fullyear, we expect our revenue to come in between $58.8 billion to $59.7 billion,growing 15% to 17%, up four percentage points from our last guidance. The full year forecast now includes revenue from aQuantive,which contributes approximately one point of revenue growth. The remainingthree point increase from July is driven by an improved outlook for our threebusinesses of client, the business division, and server and tools. For the second quarter, we expect revenue of $15.6 billionto $16.1 billion, which represents a year-over-year increase of 25% to 28%. With that, revenue guidance in our divisions is as follows:for client, we expect full-year growth to be 12% to 13%, and second quartergrowth to be 62% to 64%, or 13% to 14% excluding certain revenue deferrals inthe prior year. For the full year, we expect OEM revenue to grow in line withthe PC hardware markets. On the commercial and retail side of the business, we expectdouble-digit growth for the year from continued demand through our volumelicensing channels. The client growth rate benefits by two percentage pointsfor the full year and by four percentage points in Q2 from recognition ofundelivered elements, consistent with our guidance in July in both percentageand absolute dollars. Server and tools revenue should be up 16% to 18% for theyear, and 16% to 17% for the second quarter. We expect double-digit growthacross our server platform products and services. The division is completingthe new releases of Windows Server, SQL Server, and Visual Studio inpreparation for the upcoming launch event starting in February. These productswill allow IT departments to be more productive by providing them with asecure, trusted, scalable and manageable platform that will underpin growth inthe server and tools business over the next several years. We forecast revenue in the online service business toincrease 33% to 37% for the year, and 32% to 35% in Q2. This implies onlineadvertising growth in excess of 30% for the quarter and for the year. This guidance includes the revenue from aQuantive, whichadds approximately 25 points of growth for Q2 and for the full year. Organicrevenue guidance for the fiscal year is unchanged for both the business groupand advertising. We’re aiming to become one of the major players in theonline advertising space, and we are pleased by the progress we are making inputting the building blocks in place. For example, the launch of our new searchproduct with much stronger relevance, using industry standard measurementmethodology; our core algorithmic relevance is now on par with the market leaderand better than all other search engines in the U.S. market today; we saw solidgrowth, 23%, in our display business; we saw rapid growth in our live IDs,growing 19% to over 400 million; our partnership, which we announced yesterdaywith Facebook; and the acquisition and successful integration of aQuantiveduring the quarter. We will continue to invest in this business, as we’ve toldyou before. For example, in building a differentiated search experience in thefour high value verticals of commerce, local search and mapping, entertainmentand health, which collectively represent 40% of all global searches. Microsoft Business Division revenue should be up 14% to 15%for the year and 31% to 33% in the second quarter. Normalizing for the impactof the technology guarantee and pre-shipment deferrals in the prior year, thesecond quarter growth should be 15% to 16%. Looking at the applied growth rate from the second half,I’ll remind you that due to last year’s strong sales of the 2007 MicrosoftOffice system, we will have tough comparisons but are predicting double-digitgrowth nevertheless. 2008 is another important product launch year for thebusiness division, as we roll out our offering in the important investmentareas of business intelligence and unified communications. These two areas areprojected to have a combined addressable market size of about $65 billion in2009, representing sizable growth opportunities for the division. Performance point server, which is our business intelligenceoffering, had over 10,000 customers on its CTP program, an amount larger thansome competitors’ installed bases. In unified communications, Office Communication Server alsohas been gathering interest, with over 80,000 beta downloads of the software. The entertainment and devices division, we’re forecastingrevenue growth of 15% to 20% for the full year, and flat to down 8% for Q2. OurQ2 revenue growth, however, should be viewed in conjunction with theearlier-than-expected ramp-up of console sales in Q1 in preparation for thecoming holiday season. If you look at our overall, for the first six months --that’s the first quarter and the second quarter combined, growth would havebeen about 15%. [inaudible] has historically comprised almost half of industryhardware and software sales. With competitively priced console bundles andaccessories, combined with a great first and third-party software titleline-up, we feel very good about our position heading into the holidays. We also look forward to bringing more choice to digitalmusic consumers with our expanded families of Zune devices and updated musicmarketplace and new software updates, such as podcasting support, new wirelesssend and sync functionalities, and an attractive user interface. And in appreciationof our early Zune adopters, the new software features will be updateable tocurrent owners’ devices as well. Turning back to company-wide performance, operating incomefor the year is expected to be between $23.3 billion and $23.7 billion, increasing26% to 28%. Our higher revenue forecast is responsible for the improvement versusour July guidance, as we expect over half the incremental revenue to flowthrough to operating profits. For the second quarter, we expect operating income to be between$5.9 billion and $6.1 billion. As a result of the higher operating income guidance, we areincreasing our full year earnings per share results to $1.78 to $1.81,including a $0.01 impact from integration and deal costs associated withaQuantive. This is an increase of $0.08 to $0.09 on a GAAP basis, or $0.09 to$0.10, excluding deal costs. For the second quarter, we expect $0.44 to $0.46. Theseearnings then assume both for the year and for the quarter an effective taxrate of 30.5%. From a balance sheet perspective, we expect total unearnedrevenue to finish fiscal 2008 up 8% to 10%, in line with our prior guidance.Excluding deferred revenue for undelivered elements, the remaining portion ofunearned revenue should increase 14% to 16%. When thinking about sequential changes in unearned revenuefrom Q1 to Q2, we expect the balance to follow historical patterns and remainroughly flat. Contracted not billed should also finish 2008 up from currentlevels. It is clearly important, especially in the currentenvironment, that you consider some of the risks of this forecast. These risksinclude competitors, legal, execution, and general market risks, such asforeign exchange rate movement, fluctuations in PC and server hardware growthrates, and consumer acceptance of our new and existing products. Additionally, changes in the mix of our billing betweenannuity and license only can have an impact on revenue, operating income, andearnings per share by delaying revenue recognition in the future periods. So to wrap up, the first quarter was an outstanding startfor the year. A strong PC hardware market, healthy demand by business customersfor our product, and overwhelming consumer response to the launch of Halo 3helped propel us to the fastest Q1 revenue growth in seven years. To put that in context, our revenue base is about 2.5 timeslarger than it was the last time we grew this fast. The fact that we can beatthe law of large numbers is a tribute to our products and sales teams. Good execution and cost discipline allowed the majority ofour revenue upside to flow through to operating income, and for the balance ofthis year, we will continue to deliver the strategies for shareholder value weoutlined at our financial analyst meeting in July, in particular, driving ourtop line growth, continuing to invest in technology offerings that will providethe platform for future growth, and using our strong cash flow and balancesheet to benefit shareholders through dividends and share repurchases. With that, I will hand the call over to Colleen so we canget started taking some of your questions. Thank you."
},
{
"speaker": "Colleen Healy",
"text": "Okay, great. Let’s proceed to questions. We want toaccommodate as many questions as we can from as many of you, so please avoidmulti-part questions and please limit yourself to just one question. Operator,can you please repeat your instructions?"
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Our first question comes fromHeather Bellini with UBS."
},
{
"speaker": "Heather Bellini",
"text": "Congratulations on the quarter. I was wondering if you couldgive us an update on your view of Vista adoption thus far, and in particular,how the uptake of premium SKUs, both on the consumer side and also with VistaEnterprise, are tracking versus your original expectations, and how should wethink about that going forward?"
},
{
"speaker": "Christopher P.Liddell",
"text": "Clearly we are very happy with the client division overall.As you’ve seen since we launched Vista, the revenue growth has been in excessof 20% three quarters in a row, so the overall [headline] number, very good. In terms of the premium mix, also very happy about that.Now, in this case, premium mix brings in both Vista and XP premium sales aswell, and that’s tracking in the mid-70s, so 75% for the quarter, and thatcompares to I believe 59% in the equivalent quarter last year, so up 16 pointsyear over year. So we’re very happy with the adoption of Vista Premium and alsohappy with the old XP Media sales as well. The other thing I’ll point to is on the client annuityagreements, which is probably the best leading indicator we can think of ofpeople’s intention to adopt, that’s still very early in the adoption cycle forbusinesses, but the volume licensing portion of our business was up 27% in theclient area, so that’s a very good leading indicator from our point of view. And sort of finally, as a wrapper, year-to-date sales arenow 85 million units for Vista. That compares to about 45 million for XP overthe same period, so almost twice as much. So it’s still early days but progress, we’re very happy withso far."
},
{
"speaker": "Heather Bellini",
"text": "And just on the premium SKUs, would you say that they aretracking above what you guys had expected when you originally launched theproduct?"
},
{
"speaker": "Christopher P. Liddell",
"text": "Yes."
},
{
"speaker": "Heather Bellini",
"text": "Great. Thank you."
},
{
"speaker": "Colleen Healy",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Our next question comes from Adam Holt with J.P. Morgan."
},
{
"speaker": "Adam Holt",
"text": "Good afternoon, and I’ll also let go the congratulations. Ihave two questions on the business uptake. In particular, you had a meaningfulacceleration on the client side in terms of business units and I was hoping maybeyou could detail what you thought was behind that acceleration. And then on the Office front, still another quarter ofbetter than 20% Office growth on the business front. Where do you think we areon the enterprise upgrade cycle for Office? Thank you."
},
{
"speaker": "Christopher P.Liddell",
"text": "Sure, Adam. We’ll start with client. The business saleswere, to be honest, a function of underlying demand, so the PC unit came in at14% to 16% for the quarter overall, compared to our expectations of around 10%to 12%, so we saw a good uplift in overall PC units, and that was both on theconsumer and the business side. I think the benefit that we saw on the business aspect wasprobably most particular in some of the emerging markets, so we saw goodstrength in business and that really helped us with the anti-piracy andlegalization aspect of our growth. So if PC units grew by 14% to 16%, ourshipped units that we were paid for grew by 20%, and all of that delta waseffectively a fight against unlicensed PCs, so the growth that we saw in thebusiness segment, in particular internationally, really helped us in terms ofoverall unit sales. So felt very good about that and we still think thatconsumers will grow faster than businesses, but overall a very good story onthe client side. In terms of the Office, that has a slightly differentimpact, mainly because it’s a much stronger impact from annuity there ratherthan non-annuity sales, although interestingly, non-annuity sales, whichtypically go to smaller businesses, were strong as well, which is a very directimpact with Office. In the annuity sales, which tend to have a multi-yearimpact, you recall I talked last quarter about how we saw a very strong sign-upfor maturing agreements right at the top end of our expectations, and that wasreally a very good leading indicator of people’s acceptance of or expectationthat they would roll out Office, but also the other products in MBD. So it’sclearly strong from our point of view that people are seeing not only a valuein Office, but products that are related to Office, for example, in the unifiedcommunications and business intelligence area. So overall, we’re feeling good about the rollout."
},
{
"speaker": "Adam Holt",
"text": "Terrific. Thank you."
},
{
"speaker": "Colleen Healy",
"text": "Great. Thanks a lot, Adam. Next question, please."
},
{
"speaker": "Operator",
"text": "Our next question comes from Sara Friar with Goldman Sachs."
},
{
"speaker": "Sara Friar",
"text": "Good afternoon, everyone. I think everyone is going to saycongratulations, but it is quite an amazing quarter you put up. Following onone more comment on the client Vista adoption side; I think a lot of folks hadthought SP1 would be the catalyst. Why do you think we saw it a little bitahead of that and do you have a timing update on SP1? And then I just have aquick follow-up question, if I may, after that."
},
{
"speaker": "Christopher P.Liddell",
"text": "Vista adoption, as I say, it is still early and I talkedabout intention to adopt rather than actual adoption. I think you are rightthat certainly some businesses will be waiting for SP1 to roll it out, but interms of their willingness to sign up for the client element of the multi-yearagreements, their intention to roll out is I guess signaled by that. So it isstill early days as to what the actual adoption numbers are, and we think itwill increase during the year and obviously will be helped to some extent bySP1. But some of the leading indicators are what we feel good about."
},
{
"speaker": "Sara Friar",
"text": "And then just turning to the EDD division, great quarter. Itseems like you do think there was some pull forward on consoles just based onyour guidance. Is there anything implied in your guidance on broader commentaryabout health of consumer spending in the fourth quarter? Are you leavingyourself a little bit more cushion there?"
},
{
"speaker": "Christopher P.Liddell",
"text": "No, it’s principally around the pull forward, as youmentioned. And as I said in my prepared remarks, I tend to look at the businessfor the first six months rather than the quarters. In particular in the firstquarter, console sales were 1.8 million units, which is relatively small. So itwas ahead of our expectations, but it’s a quarter where you can beatexpectations because the volumes are small. I mean, Halo was obviously a clearbeat but in terms of consoles, I’d rather think that the volume over that sixmonths, because there’s a lot of stocking in anticipation of Christmas going on,and movements like that. So I feel good about it. There’s no particularsignaling on weakness for Christmas. In fact, we feel very good about theline-up we’ve got, not only from the box itself but obviously the gamesassociated with it as well."
},
{
"speaker": "Sara Friar",
"text": "Terrific. Okay, well, thanks a lot."
},
{
"speaker": "Colleen Healy",
"text": "Thanks a lot, Sara. Next question, please."
},
{
"speaker": "Operator",
"text": "Charlie Di Bona with Sanford Bernstein, your line is open."
},
{
"speaker": "Charles Di Bona -Sanford Bernstein",
"text": "I guess no surprise here, but I’m going to go back to thewell on OSB. It was probably the only division that didn’t really outperformsignificantly, only about 10% growth, excluding aQuantive, and the comScoreshare is back down to sort of the lows that they were in your fiscal Q4. Especially in light of yesterday’s announcement aroundFacebook, maybe you can give us a little insight into the strategy andexecution here, and is there any shift towards sort of buying traffic andcommunity rather than building it internally? And in general, how do you gobalancing those two alternatives and valuing those two alternatives?"
},
{
"speaker": "Christopher P.Liddell",
"text": "First thing to note obviously is we met expectations, so itwasn’t a beat, I agree, but it was a meet, so start with that. Underlying business growth or revenue growth, you mentionedthe 10%, which is correct. Clearly in this case it’s a negative from the Accessbusiness going away, so -- if you look at underlying revenue growth, underlyingadvertising revenue growth, it grew in the mid 20s, around 25% for the quarteryear on year, which we think is acceptable. It’s nor certainly stellar. We’dlike to see it higher but it’s acceptable and it is higher than where we guidedat the start of the year, roughly speaking. So I think reasonable progress onthe organic side of the business. In terms of putting the building blocks in place and how wetrade off organic growth through inorganic growth, it’s both. The strategy hasbeen both and will continue to be both, so we are investing heavily in the organicaspects of the business, so a lot of investment in particular has gone into thesearch product itself, and we clearly are extremely happy with the improvementswe are seeing on aspects like relevance, which are critical going forward. Weare putting a lot of investment into things like data centers, which arecreating the platform of the future and the experience, so we are increasingCapEx quite considerably there. We are looking at CapEx overall for the year of$3.2 billion to $3.3 billion, about half of which is going into the OSB area.And we are putting investment in some of the verticals that I talked about onsearch organically and all the other areas as well, content on the displayside. So there’s a strong organic side, there’s a strong inorganicside, but clearly aQuantive is the most obvious representation of that andwe’re particularly happy that we not only closed aQuantive but we’ve retainedall of the employees. We think that integration has gone extremely well and webelieve that’s going to generate some significant benefits going forward. We also did some other smaller acquisitions, ones which wethink are important for the ad platform, like AdECN during the quarter, andthen the announcement yesterday on Facebook, which is a willingness on our partto make a commitment to a multi-year agreement with a partner who we think hasgot some tremendous growth opportunities. So we are willing to do both. We are quite clearly willingto suffer an operating loss in that position as a result of those commitments,and we’ll share that there I think both in our financial analyst meeting and inour guidance. But to date, in terms of underlying financial metrics, we’reon track. In terms of some of the other things that we wanted to do, if anythingwe are slightly ahead of where we would like to be."
},
{
"speaker": "Colleen Healy",
"text": "Thanks, Charlie. Next question, please."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brent Thill with Citigroup."
},
{
"speaker": "Brent Thill -Citigroup",
"text": "Thanks. Good afternoon. Chris, I think your guidance for thefiscal year implies roughly a 40% operating margin, and clearly with Q1, it washigher than 40%. Why do you expect the operating margin will drift to thatlower level for the year?"
},
{
"speaker": "Christopher P.Liddell",
"text": "Overall for the year, we feel very good about the operatingincome growth relative to revenue growth and it will still be an increaseyear-on-year. So there’s some COGS impacts, for example, the mix of COGS duringthe course of the year and we just saw an outstanding performance in the firstquarter, some really, really strong growth in particular in client and MBD. We think that out-performance is going to continue, but notat the same rate, so operating margins improve but I think quarter one was justan outstanding one in terms of our ability to take the revenue out-performanceand drive it to the bottom line, and as I say, there is a different COGS mix tothe rest of the year, which impact it as well. But overall margin, we are going to grow operating incomefaster than revenue growth this year, which means our margins are going toexpand, and the other impact which you know I’ve talked to you about is weexpect earnings per share to grow very fast as well, backing out all of theone-offs, if you like. We think EPS is going to grow faster than 20% this year,which is the benefit of the operating margin expansion and also the benefit ofthings like share buy-backs flowing through. So at this stage of the cycle for the company and for acompany that started to grow earnings per share greater than 20%, upsignificantly from where we were, we feel good about it."
},
{
"speaker": "Brent Thill -Citigroup",
"text": "And just one quick one, if I could; relative to enterprisedemand, it sounds like it’s improved slightly over the past couple of quarters.Do you think it stabilizes from here or has room to improve even from here?"
},
{
"speaker": "Christopher P.Liddell",
"text": "It’s just the renewals. It was back to more traditionallevels in the first quarter and that’s about two-thirds of the three-quartersramp that we talked about, so we saw a particularly good renewal rate in thefourth quarter and we are back down to more traditional levels, but levelswhich we feel obviously very good about, so I don’t think -- we’re notexpecting an out-performance or an increase back to the very, very good levelsthat we saw in the fourth quarter, but if we can maintain traditional levelsand obviously start to sell the new product range that we have coming throughto our existing clients, and hence get the benefits of all of the additionalproducts that we’ve either launched or are going to launch, [that is up] verywell from a business point of view in terms of overall billings growth."
},
{
"speaker": "Brent Thill -Citigroup",
"text": "Thanks, Chris."
},
{
"speaker": "Colleen Healy",
"text": "Thanks a lot, Brent. Next question, please."
},
{
"speaker": "Operator",
"text": "Our next question comes from John DiFucci with Bear Stearns."
},
{
"speaker": "John DiFucci",
"text": "Thanks. Just a follow-up question I guess to Brent; themargins were really impressive here, Chris, and even next quarter, you have ameaningful increase in revenue and a pretty I guess meaningful decline inoperating margin. Is there any reason for us to think that you can’t do a lotbetter than what you are saying here? I mean, I understand what you are sayingabout the COGS, but it looks like it is something that can continue."
},
{
"speaker": "Christopher P.Liddell",
"text": "Probably the first thing to do is to normalize of aQuantive,so that may be distorting the numbers. But we are bringing that in for thefirst time and that’s bringing in revenue but no operating income -- in fact,with amortization of intangibles, it will be a slight loss for the year. Sothat’s probably a drag on the margins that you might want to normalize for, orat least give us the benefit of. If you take that out, the way that I look at it is what isour ability to meet our operating expenditure guidance and potentiallyoutperform on the revenue side, as opposed to drive the business on a marginbasis. And I would say I’m particularly happy with the fact that we deliveredincreased revenue in the quarter whilst keeping operating expenditure literallyright on guidance. You’ll recall from last year, I was certainly happy that wedelivered the whole year right on operating expenditures, so I feel really goodabout the business groups, discipline, the sales force discipline to a largeextent keeping operating expenses under control, which will allow us to, theextent that we beat revenue, to drive it to the bottom line. I can’t promise this is necessarily going to significantlyincrease margins, but it will increase margin every dollar that drops through,and perhaps if you back out aQuantive, that will give you a better comparison."
},
{
"speaker": "Colleen Healy",
"text": "From a fiscal year on fiscal year, I mean, if you arelooking at organic, fiscal year ’07 you were see us sort of a bit above themid-30s. You pull out aQuantive and legal charges and tax, guaranteed bonds andthe rest of it, for the year you are sort of in that 40% range, and then ofcourse, with Q2, given that X-Box with the hardware is such a big driver forholiday, Q2 for the year, in terms of for the year, you’d probably see a dip,but year on year, when you look at the true underlying organic, pulling outaQuantive and some of those other things, you are going to see I think prettygood margin there, John."
},
{
"speaker": "Christopher P.Liddell",
"text": "aQuantive will -- to help you, and obviously we’ll have togive more detail as we go on, but aQuantive will add $500 million of revenuefor the year. We will pull out deal costs and IP R&D that we write off ofclose to $100 million, but we’ll still leave in things like amortization ofintangibles, which we know other companies tend to call out. We’ll leave thosein, which means that will be a drag on the operating income of close to acouple hundred million towards this year. So perhaps that will help younormalize for that."
},
{
"speaker": "John DiFucci",
"text": "Thank you."
},
{
"speaker": "Colleen Healy",
"text": "Thanks a lot, John. Next question, please."
},
{
"speaker": "Operator",
"text": "Our next question comes from Kash Rangan from Merrill Lynch."
},
{
"speaker": "Kash Rangan",
"text": "Thank you very much. Good to see a quarter like that andmore particularly, the stock break out to a multi-year high. That’s got to lookgood. I just have a question on the online business, Chris. It looks likeyou’ve done a good job restoring or bringing profitability, let’s say, to theentertainment and devices business. At what point are we in making similarprogress on the profitability of the online business, especially with aQuantivebeing integrated into the operations of the company? And as a follow-up, I was also curious to get your thoughtson the client side. I know you do [inaudible], and correct me if I’m wrong, andthere’s some concerns in certain segments of Wall Street that there might be aninventory issue on Wall Street, especially on the PC side. Intel had a goodquarter, you guys had a good quarter, but with retail sort of weakening or atleast suspected to weaken during the holiday season, who knows, I’m justwondering if you share that concern and if you don’t, what specifically makesyou feel that this inventory build-up could actually lead to sell-through inthe Christmas holiday season? Thanks."
},
{
"speaker": "Christopher P.Liddell",
"text": "Entertainment and devices and OSB are really at differentparts of their business cycle. It was a very strong commitment from our pointof view to try and drive profitability in the entertainment and devicesdivision this year, and we feel like we are on track for that. So they are on,if you like an upswing to a part of their business cycle where we believe wecan be profitable. In the OSB case, there isn’t a primary driver of thebusiness at the moment. The primary driver is to invest in the right areas andcreate the platform for a very strong growth in economic value over the nextfew years. So it’s not one where we are the [clearly the] -- but if we wereprofitable, but it is one where it is not going to be our primary determiner ofsuccess this year. I will be keen to ensure that the expenses come in wherethey are. I’ll obviously be keen to see that our revenue growth is in line withexpectations, but assuming we meet those two things, it is going to be a lossfor the year. So they are just different -- the businesses are atdifferent parts of their business cycle, and so we have different tests againstthem. On the client side, we are not seeing any significantinventory issues that we are aware of, and so from our point of view, if youlook at the guidance, we feel good about PC unit growth guidance of 11% to 13%.Anything in double digits or greater we think is good and that’s like a sell-innumber, using your terminology. So we think that’s good and we think we shouldbe able to drive OEM units in our area around that same level. So there’s noparticular issues of significance that we are aware of."
},
{
"speaker": "Kash Rangan",
"text": "It just looks like the emerging markets and the [inaudible]countries, perhaps business there is accelerating and that’s why your OEM unitsare looking better than they have in the last few quarters?"
},
{
"speaker": "Christopher P.Liddell",
"text": "That’s absolutely right. Those countries really did anoutstanding job -- countries like Russia, the business overall grew there bygreater than 100% in the OEM area and client grew by something like 50%. Sosome of those countries are growing at a tremendous rate, which is a functionof the underlying economies growing well, but as we see business growth inthose areas and a greater desire to obviously have legitimate PCs, we areseeing good progress on piracy as well, and that’s really helping us with ouroverall OEM unit."
},
{
"speaker": "Kash Rangan",
"text": "Great. Thanks a lot."
},
{
"speaker": "Colleen Healy",
"text": "Thanks a lot, Kash. We have time for one, maybe two more questions,please."
},
{
"speaker": "Operator",
"text": "Our next question comes from Kirk Materne with Banc ofAmerica."
},
{
"speaker": "Kirk Materne",
"text": "Thanks very much. Chris, I might be jumping ahead a littlebit here, but clearly you guys haven’t seen any slowdown in terms of demandaround either SQL Server or Windows Server 2008 in front of those launches. Whatis your expectation in terms of the impact of those launches on the growthrates? Do you think that we’ll see demand come in at a steady pace? Or do youexpect that as we get into the back half of the year, that can help acceleratethe growth rates in that division? Thanks."
},
{
"speaker": "Christopher P. Liddell",
"text": "I think it will help continue the growth rates that we’veseen, to a large extent. You have to realize that the structure of our businessreally has matured significantly to one that’s driven much more aroundmulti-year expectations. So people are -- to the extent we’re seeing strengthin annuity agreements now, it’s an anticipation of those products. The factthose product launch won’t in itself drive an enormous amount of accountingactivity. We’ll see that over a slow -- to a large extent, that’s the samephenomena we talked about with Vista. These things will happen over time aspeople adapt and adopt the particular systems. But from a revenue and economic point of view, ourrelationship with our customers, our ability to continue to sign them up anddrive growth is much more of a multi-period rather than a single event basedphenomena, and we just think a continuation of very strong products rolling outcontinuously quarter after quarter, year after year, is the best way of drivingthat business."
},
{
"speaker": "Kirk Materne",
"text": "Just a really quick follow-up on Windows Server 2008, thebeta for Veridian is still expected to be released with that, with thefull-blown version released 180 days afterward? Is that still on track?"
},
{
"speaker": "Christopher P.Liddell",
"text": "Yes, that’s correct."
},
{
"speaker": "Kirk Materne",
"text": "Thanks very much."
},
{
"speaker": "Colleen Healy",
"text": "Great. Thanks so much, and our last question, please,Operator."
},
{
"speaker": "Operator",
"text": "Our last question comes from Brandon Barnicle from PacificCrest Securities. BrandonBarnicle - Pacific Crest Securities Thanks so much. I just have two quick ones. Chris, first onpremium edition, obviously a great move, year over year up 75%. As we have SP1come, where we potentially get more enterprises pulling in, can we see thatpremium edition even move up higher still? And then secondly, over on aQuantive, have you given anythought again to the agency business and whether that’s something that stayswithin the business or needs to be divested? Thanks."
},
{
"speaker": "Christopher P.Liddell",
"text": "Yeah, we are very happy with XP business. That’s continuedto do a great job. I mentioned before, I think the integration has goneextremely well. As far as we can tell, the employees are very happy, who arerunning the XP business in particular on a standing independent basis andreally letting them continue getting on with their life. We think it is a verygood business and no intention to do anything other than continue to run it. On the client side -- just go over your question again,sorry."
},
{
"speaker": "Brandon Barnicle -Pacific Crest Securities",
"text": "Premium edition, 75%, very impressive. Can we see it go to85%?"
},
{
"speaker": "Christopher P.Liddell",
"text": "We’re just looking -- in terms of our guidance and ourthoughts and what’s embedded with, we believe we can continue to drive that atover 70%, but too early to predict anything higher than that."
},
{
"speaker": "Brandon Barnicle -Pacific Crest Securities",
"text": "And would SP1 have any impact on accelerating that?"
},
{
"speaker": "Christopher P.Liddell",
"text": "It might help but those rates of 70% are very high, so -- itmight assist but it may just simply just help us continue at that sort of rate.So we are not [anticipating] a particular pick-up as a result of that alone."
},
{
"speaker": "Brandon Barnicle -Pacific Crest Securities",
"text": "Thank you very much."
},
{
"speaker": "Colleen Healy",
"text": "Thanks, Brandon, and thanks everyone for joining us today.If you have any further questions, please feel free to call me or my teamdirectly. As I mentioned at the beginning of this call, this conference callwill be available on replay at our investor relations website through close ofbusiness October 25, 2008. In addition, you can hear the replay by dialing800-835-8067, or for international calls, please dial 203-369-3354. The dial-inreplay will be available through the close of business November 2, 2007. Thanksagain, everyone, for joining us today."
},
{
"speaker": "Operator",
"text": "And that concludes today’s call. Thank you for joining."
}
] | null | null |
MSFT | 4 | 2,007 | 2007-07-20 17:30:00 | Operator: Good afternoon and welcome to the Microsoft fourth quarter fiscal year 2007 earnings conference call. (Operator Instructions) I would now like to turn the call over to Ms. Colleen Healy, General Manager, Investor Relations. Please go ahead.
Colleen Healy: Good afternoon, everyone and thank you for joining us today. This afternoon I'm joined by Chris Liddell, Senior Vice President and Chief Financial Officer; Frank Brod, Corporate Vice President and Chief Accounting Officer; and John Seethoff, Deputy General Counsel. Today's call will start with Chris providing some key takeaways for the fourth quarter of fiscal year 2007 and an overview of expectations for fiscal year 2008. I will then provide detail around our fourth quarter results, and then turn it back to Chris for a more detailed discussion of our guidance for the full year and first quarter of fiscal 2008. After that, we will take your questions. Our earnings release includes an addendum of financial highlights which contains more detailed information about revenue, operating expenses and other items. We have also posted our quarterly financial summary slide deck, which is intended to follow the flow of our prepared remarks in order to assist you. The slide deck offers highlights from the quarter, outlines our guidance, and provides a reconciliation of differences between GAAP and non-GAAP financial measures that we will talk about today. You can find the earnings release, the financial highlights and the quarterly financial summary slide deck on the investor relations website at www.Microsoft.com/msft. Today's call will be recorded. Please be aware that if you decide to ask a question, it will be included in both our live transmission as well as any future use of the recording. As always, shareholders and analysts can listen to a live webcast of today's call at the Microsoft Investor Relations website. A replay of the call will be available at this same site through the close of business on July 19, 2008. This conference call report is protected by copyright law and international treaties. Unauthorized reproduction or distribution of this report or any portion of it may result in civil and criminal penalties. Any recording or other use or transmission of the text or audio of today's call is not allowed without the expressed permission of Microsoft. We will make forward statements during this call. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in today's earnings press release and the comments made during this conference call and in our 2006 Form 10-K, subsequent quarterly reports on Form 10-Q and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statement. With that, let me now turn it over to Chris.
Chris Liddell: Thanks Colleen, and good afternoon, everyone. Thanks for joining us today. I'll start today's call with highlights from last fiscal year's performance and then give you an overview of our expectations for fiscal 2008. Our quarter 4 performance capped an extremely strong year for our company, and helped set the stage for fiscal 2008 to be another year of double-digit revenue, operating income and earnings per share growth. I'm extremely pleased with the traction our sales force and partners are experiencing with business customers, evidenced by billings growth in the quarter for enterprise agreements in excess of 25%, and non-annuity licensing up of over 15%. When you combine those figures with billings for OEM and packaged products each growing 10% plus in the quarter, you'll see that demand was strong across all of our channels and customers. Looking at our full year results, fiscal 2007 was a year of $7 billion of revenue growth, fueled by robust customer acceptance of products in both our emerging and mature businesses including Windows Vista, Microsoft Office 2007, SQL Server, Windows Server, and Xbox 360 consoles. Our core businesses accounted for $5 billion of absolute revenue growth, with the business division, client, and server and tools growing 13%, 14% and 16%, respectively for the year. Operating income for the year also grew double-digits. We were able to achieve this while still be being able to make a number of significant investments in our businesses. For example, the launch of over 40 new products into the marketplace, as well as a number of updates and enhancements to our online service offerings, continued development of a number of upcoming products such as new versions of Windows Server, SQL Server, and Visual Studio, the enhancement of our online service infrastructure by continuing to refine adCenter; increasing our database capacity; and necessary investments in Xbox customer satisfaction. We also announced eight strategic acquisitions including: aQuantive, to provide the advertising industry with a world-class, Internet-wide advertising platform; Tellme, for its voice response services; and Softricity for its application virtualization and streaming capabilities. Earnings for the year came in at $1.42, up 18% over last year, which was faster than both revenue and operating income. Finally, during fiscal ‘07 we made significant progress on our strategy of returning cash to shareholders. Last year at this time we announced authorization for programs to repurchase up to $40 billion worth of our stock over five years. Today, one year after that announcement, I am happy to say that we have passed the halfway mark on the program by repurchasing approximately $25 billion worth of our stock during the year. When you combine the share repurchases we made this year with the $3.8 billion worth of dividends paid, we returned about 175% of operating cash flow to shareholders. Now I would like to move to our outlook for fiscal ‘08. Given the good exit from fiscal ‘07 we are increasing our revenue, operating income and earnings per share guidance for next year on an absolute basis. We expect revenue growth of 11% to 13%, with operating income and earnings per share growing even faster than that. I'm particularly pleased that the high end of our guidance reflects each of our businesses growing revenue at double-digit rates for the year, especially given our robust performance in fiscal ‘07. Looking to our product lineup in ‘08, next year represents another significant launch year for the company. We will intensify our pursuit of important market opportunities for the company with product launches in business intelligence, unified communications, security and business applications. By the time we exit next year, we will have refreshed a major portion of our server lineup within a period of 15 months with the addition of new versions of Windows Server and SQL. Additionally, the consumers will have a great lineup of first and third-party games heading into the holidays, led by the release of Halo 3, plus continuing enhancements to our Windows Live services. With those high level themes for 2007 and 2008, I am going to turn the call over to Colleen now for more details on how we closed out last year.
Colleen Healy: Thanks, Chris. As Chris mentioned, the fourth quarter delivered a strong finish to the year with revenue near the high end of our guidance provided on the April earnings call. Specifically, demand for our offerings was excellent, with revenue growing 13% and core bookings increasing over 20%, characterized by high annuity revenue growth, driven by outstanding field sales force execution on enterprise agreement renewals. This speaks not only to the healthy customer acceptance of the products recently launched, but also to the anticipation of our offerings still to come. Let me provide you with details of our financial performance, starting with revenue. I'll discuss top line, financial and business momentum points, and then follow-up with revenue performance for each of the business units. Then I'll review the rest of the income statement. All growth comparisons I mention relate to the comparable quarter of last year, unless otherwise specified. As I mentioned, revenue grew 13% to $13.4 billion, driven by client, the Microsoft business division and server and tools. Online services also had a good quarter. Each of these four businesses grew in the mid to high teens, and collectively at 16%. The underlying PC hardware market remained robust, with estimated growth of 11% to 13% during the quarter, about a point higher than our expectations. PC shipment growth rates in emerging markets continue to outpace that of mature markets, and consumer PC shipment growth outpaced that of the Business Segment. Every region, except the US and Japan, increased PC shipments at double-digit rates. Our mix of product billings for the quarter was approximately 30% from OEMs, over 40% from multi-year licensing agreements, around 15% from license-only sales, and the balance from our other businesses. Over the past couple of years we have seen a mix shift from license-only sales to annuity agreements, driven by standing adoption of enterprise agreements. Enterprise agreement renewal rates exceeded the high end of our historical range of 66% to 75%. We are delighted that the value proposition from our current product lineup and future roadmap -- beyond the recently launched flagship desktop product even -- are resonating with customers. This strong annuity licensing performance drove our unearned revenue balance 16% higher to $12.6 billion and our contracted, not billed balance was driven higher on both a sequential and year-over-year basis, exceeding $10 billion at the end of June. As a result, total bookings grew over 15%, and core bookings of client, Microsoft business division and server and tools increased over 20%, as I previously mentioned. I'll close out the revenue overview by adding that changes in foreign exchange rates added about 2 percentage points to our overall revenue growth. Now I will provide revenue highlights by business segment. Client revenue grew 14% to $3.8 billion, characterized by strong OEM revenue growth, driven by continued demand for Windows Vista and a healthy PC hardware market. OEM revenue increased 15% and includes 3 points of revenue recognition from undelivered elements. Adjusting for this impact, OEM revenue grew roughly in line with OEM unit shipments at 11%. OEM premium mix was 72%, a 17 percentage point increase over this period last year. This was driven by a 20 percentage point increase in the consumer element of premium mix, and around a 3 percentage point decline in the business element. Given the over 5:1 pricing uplift we received from the business premium SKUs over consumer premium SKUs, these changes within the premium mix have largely an offsetting impact to revenue. For further background on this new disclosure, we have included a slide in the earnings deck on our website that illustrates these metrics, as well as lists of SKUs comprising each of the consumer and business premium mixes. Client, commercial and retail licensing increased 7%. Businesses are recognizing the value that Windows Vista and Software Assurance provides them, as evidenced by high renewal and new annuity attach rates, driving about a 25% increase in the volume licensing portion of the unearned revenue balance. Server and tools revenue grew 15% to $3.1 billion, driven by SQL Server, Windows Server, Visual Studio and consulting services revenue. Fiscal 2007 capped a decade of consecutive years of double-digit revenue growth for SQL Server. During the quarter, significant product development momentum was achieved with beta releases of the upcoming versions of Windows Server and Visual Studio, and a community technology preview of SQL Server 2008. In our online services business we saw advertising revenue growth of 33%, exceeding our expectations. Search ad revenue benefited from both increased search queries and revenue per search, while display ad revenue enjoyed both increased number of page views and revenue per page view. Overall, online services business revenue grew 19% to $688 million. Microsoft business division revenue grew 19% to $4.6 billion, beating high end guidance by over $150 million. Highlights in the quarter included solid revenue growth through enterprise agreements for Office, and continued momentum for Share Point. Enterprise agreement momentum continued after the launch of the Office 2007 system, and renewal rates are higher now than they were a year ago. We are also pleased with the results of our Dynamic business, which showed healthy performance across both the ERP and CRM product lines, driving a 24% increase in dynamic customer billings. An impressive 85,000 new seats of our dynamic CRM offering were sold during the quarter. Consistent with our guidance, entertainment and devices revenues decreased 10% to $1.2 billion as a result of lower Xbox 360 sales. Software and accessory attach rates remained at record levels, and we passed the 7 million member mark for Xbox Live. During the quarter, Halo 3 concluded beta testing, and on September 25th will lead the charge of hotly anticipated game titles into this 2007 holiday season. Entertainment and devices achieved its goal of selling over 1 million Zune units on a sell-in basis in its first eight months in the market. Licenses for Windows Mobile-based phones grew in excess of 75% to end the year with sales of over $11 million, and an increased unit market share in the smart phone category. Now for the rest of the income statement. Positive revenue increased 52%, primarily driven by a charge relating to the current and enhanced Xbox 360 warranty policies that were announced earlier this month. At this time, let me provide you with the details of that charge, now that they have been finalized. First, the total amount was $1.06 billion, within the range we provided a couple of weeks ago. Second, the makeup is largely consistent with the guidance we provided with about half of the total charge driven by existing warranty policies and the other half driven by the new warranty enhancements. Of the total amount of the charge, approximately 35% is attributable to inventory valuation adjustment. Before the Xbox 360 charge, cost of revenue would have increased 5% year over year. Other operating expenses increased 13%, excluding legal charges of $351 million in the year-ago period. Expense growth was driven by headcount-related costs and sales support cost for our enterprise software advisory channel partners. Operating income was $4 billion. Excluding the impact of the Xbox 360 charge and certain legal charges in the year-ago period, operating income for the quarter would have increased 19% to $5 billion. Investment income and other totaled $295 million for the quarter. Our effective tax rate for the quarter was 29% to align to our annual effective tax rate of 30% for fiscal 2007. Before non-recurring items the effective tax rate for the year would have been 31%. Cash flow from operations increased 34% to $4.4 billion. During the quarter we repurchased 243 million shares, or $7.4 billion of company stock, of which $7.2 billion settled in the quarter. We paid out $952 million in dividends to shareholders. Diluted shares outstanding for the quarter were 9.7 billion, down 6% from the prior year as a result of share repurchases. Earnings per share for the quarter were $0.31, which included $0.08 related to the Xbox charge. Before this charge, earnings would have been $0.39 per share. So in summary, during the quarter we made a needed investment into our Xbox business to assure customers that we fully stand behind our products. Before this charge, the fourth quarter was a strong end to fiscal 2007 with double-digit revenue, operating income and EPS growth, robust bookings and solid progress on the fiscal 2008 product pipeline. With that, let me turn it back to Chris, who will provide you with our expectations for the first quarter and all of fiscal 2008.
Chris Liddell: Thanks, Colleen. I'm going to spend my remaining time on the call talking about what we see for the full year ahead and first quarter. Before we get into the specific guidance, let me outline some of our key assumptions. The fiscal 2008 forecast generally assumed a continuation of the economic conditions and demand from where we exited in 2007. Our forecast did not include any significant unexpected impacts from foreign exchange rate movements. We expect PC unit demand to continue to remain healthy with growth rates similar to what we saw in 2007. Specifically, we expect PC unit growth for fiscal 2008 to be 9% to 11% for the year and between 11% to 13% for the first quarter. We estimate that growth rates will continue to be higher in the consumer segment than in the business segment, and recent regional trends should continue with growth in emerging markets outpacing that of mature markets. Now let me go through our detailed guidance. For the full year we expect our revenue to come in between $56.8 billion to $57.8 billion, growing 11% to 13%. This represents a 1 percentage point improvement on the high-end and is about $300 million better in absolute dollar terms from our April guidance. The $5.7 billion to $6.7 billion yearly represents yearly increases driven by expected solid performance across our five segments. In the first quarter, we expect revenue of $12.4 billion to $12.6 billion, which represents an increase of 15% to 17%. With that revenue guidance in our divisions is as follows: For client, we expect full year growth to be 9% to 10%, and quarter one growth to being 15% to 16%. For the first quarter we expect OEM revenue to grow faster than the PC hardware market due to a higher premium mix than the year-ago quarter and to be in line for the full year. On the commercial and retail side of the business, we expect double-digit growth for both quarter one and the year from continued demand through our volume licensing channels. Combined growth rate benefits by 3 percentage points in Q1 and 2 percentage points for the full year from recognition of undelivered elements. As in our April call, we have included a slide in our slide deck containing additional information on the impact of client revenue. Server and tools revenue should be 14% to 15% for the year and 11% to 12% for the first quarter. Coming off another impressive year in fiscal 2007, Server and tools is expected to again achieve double-digit revenue growth, while delivering the next wave of server innovation with the upcoming February launch of the new versions of Windows Server, SQL Server and Visual Studio. Together, these products form a highly reliable and secure next-generation enterprise platform, which will fuel growth in the server and tools business over the next several years. We forecast revenue in the online services business to increase 10% to 13% for the year and 10% to 11% in Q1. This implies advertising growth in excess of 20% for the year and for the quarter. Fiscal 2008 will bring many important structural enhancements to our online services business. First, we expect to close both of our recently announced acquisitions for ScreenTonic and aQuantive in the first quarter. These acquisitions represent important next steps as we continue building out our vision of a centralized advertising platform that allows advertisers exposure across the various IP-enabled media. Second, we will be making usability improvements by providing better integration between our Windows Live services. Third, we will continue to build out our data centers to provide capacity for online services that can be used across the company. I mentioned our acquisition of aQuantive, and I want to clarify that the guidance we are giving you for the company and for OSB does not include the financial impact of aQuantive. We expect to close the aQuantive acquisition in August, sometime after the shareholder vote. Assuming a positive vote and a subsequent close, we plan to update our corporate guidance for the inclusion of that business on our next earnings call in October. As we stated in May, the transaction will have revenue and operating expenses, but we do not expect a significant affect to fiscal 2008 operating income and earnings per share, excluding transaction costs. Microsoft business division revenue should be 11% to 12% for the year and 14% to 15% in the first quarter. Q1 will continue to benefit from strong customer acceptance of the Microsoft Office system. Fiscal 2008 represents another important launch year for the business division, with the impending releases of Office Communications Server, Performance Point Server and a new versions of Dynamic CRM. These products continue Microsoft's push into the field of unified communications, business intelligence and business applications. While overall revenue growth remained healthy, direct comparisons for the second half of 2008 are more difficult due to our out performance in 2007. For the entertainment and devices division, we're forecasting revenue growth of 10% to 19% for the full year and 30% to 40% for Q1. Growth in our most profitable revenue streams will be a key driver in achieving our goal of segment profitability in fiscal 2008. We had the best first and third-party software title lineup we have ever had, highlighted by the launch of Halo 3 this September. These games, combined with Xbox accessory attach and an expanding line of Xbox LIVE installed base, set us up for an excellent year in our Xbox business. 2008 will be another year of continued momentum for our mobile communications business as well. We expect to sell over 20 million licenses for Windows Mobile-based phone as our carrier and OEM partners roll out a broad and compelling lineup of devices based on Windows Mobile 6. Getting back to companywide performance, operating income for the year is expected to be between $22.2 billion and $22.7 billion, increasing 20% to 22% and 12% to 15%, excluding certain charges in fiscal 2007. The higher revenue forecast is responsible for the improvement versus our April operating income guidance. For the first quarter, we expect operating income to be between $5 billion and $5.2 billion. As a result of the higher operating income guidance, we have increased our full year earnings per share results by $0.01. Therefore diluted earnings per share for the year are expected to come in at $1.69 to $1.73. For the first quarter we expect $0.38 to $0.40. These earnings assume an effective tax rate of 30.5%. From a balance sheet prospective, we expect total unearned revenue to finish fiscal 2008 up 7% to 10%. Excluding undelivered elements, the remaining portion of our unearned revenue should increase 13% to 16%. Contracted not billed should also finish 2008 up from current levels. When thinking about sequential changes in unearned revenue from quarter four 2007 to quarter one 2008, we expect the sequential decrease from the fourth quarter to be about 10%, due to the large amount of billings in that fourth quarter. When thinking about the guidance we just provided you, I would suggest that you consider some of the risks. These risks include competitive, legal, execution and general market risks, as well as customer acceptance of our new and existing products and fluctuations in PC and server hardware growth rates. Additionally, changes in the mix of our billings between and annuity and license-only can have an impact on GAAP revenue, operating income and earnings per share by delaying revenue recognition into future periods. So to wrap up, fiscal 2007 was an excellent year from my perspective. Launches of Windows Vista, the 2007 Microsoft Office System, Exchange 2007, Zune, and Windows Mobile 6 have brought new capabilities into the marketplace so it is exciting to see them off to such strong starts. Many of the same factors that helped us be successful in 2007, such as a healthy PC hardware market, customer acceptance of our new versions of Office and Windows, an impressive lineup of new product offerings, as well as solid execution by our R&D and sales and marketing teams will help propel us into the next fiscal year. In ‘08 we're looking to deliver another year of double-digit revenue, operating income and earnings per share growth. Next year product releases represent significant improvements over our existing products, as well as a continued push into new areas for the company. Given the operational backdrop and our ability to generate meaningful free cash flow for the company, we will look to continue to execute on our strategy of returning cash to shareholders. This brings me to the end of my financial comments. I'm very much looking forward to catching up with many of you at our financial analyst meeting next week. As a result of your feedback, we have made some slight adjustments to the overall flow of the day. There will still be presentations by Bill, Steve and the senior management team, but we have also allowed more executive interactions than in prior years, with Q&A sessions throughout the day with all the speakers. We have left some time now for your questions. I will hand the call over to Colleen so we can get started. Thank you.
Colleen Healy: Great. Let's now proceed to questions. We want to accommodate questions from as many people as possible, so please avoid multi-part questions and limit yourselves to just one question. Operator, will you please repeat your instructions?
Operator: (Operator Instructions) Your first question comes from Charlie DiBona - Sanford Bernstein.
Charlie DiBona: Thank you, operator. Chris, I guess it will come as no surprise that I have a question about the online services group. I know you promised more metrics next week, but more generally, you have had some solid results here and a good recovery of search share by all the independent metrics in the last month, both sequentially and year over year. But there has been some speculation that those gains were driven by special programs. Now your Q1 guidance points to a relatively significant deceleration of that business. Can you talk a little bit about the strategy here and about the sustainability of particularly last month's momentum?
Chris Liddell: Yes. Let me talk about the quarter and then how it flows through to the year. From the quarter point of view, the underlying advertising revenue was up 33%. The good news from my perspective was that really it was across the board. So we had good search volumes, we had good monetization of those search volumes. We are lapping the transition to adCenter so we're getting some benefit, if you like, from revenue per search uplift, as well as the overall volumes. Better than that growth rate is also on our display business, which doesn't tend to get talked about as much. That was up a healthy number in terms of volume and monetization as well, so it was a good quarter all around. Vis-a-vis next year, inside the guidance is revenue growth in advertising of greater than 20%. Now the comparables start to get harder because we're off a bigger base, obviously, and we don't have for the full year quite as strong a momentum in terms of the adCenter transition. I would just say mid 20s or higher is a good result for the business overall. I think that clearly if we can do better than that, that's great, but that's not a bad result. In terms of the last part of your question on how much we were assisted in the fourth quarter by some of the one-off impacts, we were certainly helped by that but I think the interesting thing from my point of view is not necessarily the sustainability of that because that was one or two months. It’s just that when we put a new product into the marketplace, it is capable of shifting share. I am certainly not going to extrapolate that through next year but I think it is interesting from, if you like, an experiment point of view that when we try something different, we were able to get some movement in the market in a relatively short period of time. I haven’t built a lot of that into next year and we’ll wait to see other more sustainable products have some influence but overall, I think next year, having revenue of advertising growing at greater than 20% off a higher base is at least a good starting point at this stage.
Colleen Healy: Thank you, Charlie. Next question, please.
Operator: Thank you. Our next question comes from Heather Bellini with UBS.
Heather Bellini: Thanks, Chris and Colleen. I was wondering if you could comment on two things; one, where do you think the premium mix could go? It went from 71, I believe to 72 this quarter. Again, that’s much higher than what you had forecasted before you went into the Vista cycle but where do you think we could go, especially as we get into the heart of consumer spending maybe more around back to school and holiday? Also, could you comment on the significance of SP1 for Vista adoption? Do you have any comments on timing? Thanks.
Chris Liddell: With the premium mix, we think that sort of level is sustainable through next year, so we would expect the same sort of premium mix next year as for this year. We will see a difference in business premium versus consumer premium. As we talked about last quarter, we thought we would give you more visibility into what’s happening in those two different segments or those two different components of the premium mix because they have such different monetization impact, the business premium having much more significance than the consumer premium. Colin shared with you the makeup of those numbers. In terms of next year, because we expect consumer growth to be higher than business growth in terms of PCs, we would still expect a mix shift in the premium segment towards the consumer premium but the overall premium mix for the company to be relatively healthy and high in the 70 odd percent range. So we think it’s sustainable at that level but with a change inside business and consumer. In terms of SP1, clearly there will be an SP1 but it looks like we’re not talking about exactly when that is. We don’t see it as a massive driver of uptake in its own right. It’s early days yet and we are broadly happy with how we are seeing Vista adoption, both from a consumer and a business point of view. We were always expecting, and I think we talked about this for the last two or three quarters, that the business uptake would be driven by their needs rather than the availability of Vista per se, so that’s going to be progressive over the next 12 to 18 months and I think will be relatively independent of when the first service pack comes out.
Heather Bellini: Thank you.
Colleen Healy: Thanks a lot, Heather. Next question, please.
Operator: Thank you. Our next question comes from Sara Friar with Goldman Sachs.
Sara Friar: Good afternoon, guys. In the entertainment and device area, that guidance for fiscal year ’08 is quite a wide spread. Chris, could you just talk us through what the major swing factors will be? Also, you did say the profitability of the segment for FY08 but can you give us any sense on timing? Could Halo 3 launching at the end of September help drive profitability as early as December?
Chris Liddell: It’s profitability overall for the year and that’s the key from my point of view. Because of the seasonality in that business, you could see some quite different swings in profitability on a quarter by quarter basis, not only because of Halo that you mentioned but obviously the Christmas quarter is a substantial one from a console and gaming point of view. So it won’t necessarily be a linear improvement during the course of the year, although in terms of COGS it will help. The COGS will progressively degrade through the year but the volumes will go up and down with the quarter. So profitability overall for the year but it will be non-linear in the way that it rolls out during the course of the year. In terms of the width of the guidance, I guess that is purposeful. It’s one of those businesses which, from a demand point of view, is relatively hard to anticipate. Obviously console demand in itself is a big variable there but the other thing and better than that, to be honest, we have a pricing strategy for the next 12 to 24 months that’s embedded in that and a console strategy as well, and those two are related to each other. At this stage, we’re keeping relatively quiet about that from a competitive point of view. We really don’t want to signal anything, so that will become more clear as the year comes through. But at this stage we’re keeping, if you like, a relatively wide range to accommodate that.
Sara Friar: Could I ask one more quick follow-up? On the macro environment, a number of other tech and others have alluded to a much better spending backdrop. I would just love to hear your quick thoughts on any changes you are seeing in the various geographic areas, where you are seeing strength and weakness.
Chris Liddell: We are certainly seeing strength in all of the emerging markets. For example, countries like Russia which has just had a phenomenal year for us, so some of those Eastern Europe countries, South America and obviously the Asian countries are very strong form our perspective, albeit off a relatively small basis. In terms of overall level of spending, we aren’t seeing a significant positive there. The thing that we believe that we are seeing is a higher share of the wallet from some of our customers and that’s reflected in the relatively higher renewals that we are getting and people’s uptake of the products. So from our fields point of view, we are seeing a really healthy and encouraging trend from just being a desktop software provider to being much more of an infrastructure provider to enterprises. So we aren’t necessarily seeing the amount of their spending going up but we believe that the amount that they are spending with us on the suite of products that we’ve got, not only the ones obviously that we’ve launched in the last couple of years but the ones that are coming up, is increasing in what we consider to be a promising way.
Sara Friar: Got it. Thanks a lot.
Colleen Healy: Thanks, Sara. Next question, please.
Operator: Thank you. Our next question comes from Brent Thill with Citigroup.
Brent Thill: Thanks. Chris, on the client guidance for fiscal ’08, it seems it’s fairly prudent considering the industry is expecting a reacceleration in PC unit growth for the second-half of this year. Can you just talk to some of the characteristics and why you are expecting that line to slow down more than any of the other lines that you’ve given guidance for the year?
Chris Liddell: If you start with PC unit growth rates, and that’s clearly the main driver inside there, we are expecting for next year, as I mentioned on the call, around 9% to 11%, so we’re sticking pretty much in line with industry expectations. We think we can grow OEM units at the top end of that range because of our continued progress that we make in piracy, so we think we can grow units at the top end of that range. And then we’ll be assisted to some extent by the Vista revenue recognition that we talked about on the last couple of calls. But because of the premium mix change, and this is something that Steve obviously alluded to in February and we talked a bit about on the last few calls, we will lose a couple of percentage points between OEM unit growth and OEM revenue growth, you know, the strong drive in emerging markets, growth in emerging markets, and consumers will take a little bit of a shaving relative from revenue relative to units. Lastly, from our perspective in terms of revenue growth, the commercial and retail will have a strong comparable in FY07, so the growth rate will be relatively hard to repeat, given the FTP spike that we had in fiscal year ’07. So there’s a lot of moving parts in the way that we look at it, but if you start with PC unit growth, we think we can grow OEM units at the top end of that and we think we can grow client revenue overall broadly equal to OEM units at around that 9% to 10% mark. So we think that will be a good healthy result from our perspective, but in order to get out-performance on that, we’d have to see PC units at stronger levels than that.
Brent Thill: Just a quick follow-up; Longhorn is still on track for a calendar year ’07 ship?
Colleen Healy: No update on the Longhorn. You can expect second-half calendar ’07 for RTM.
Brent Thill: Thanks.
Colleen Healy: Thanks a lot, Brent. Next question, please.
Operator: Thank you. Our next question comes from John DiFucci with Bear Stearns.
John DiFucci: Thank you. I have a question, Chris, on cash flow. It looks like other current assets are down a little bit and there’s a note right at the end of the press release, or the report on your website. I just want to make sure I understood it. It looks like this year relative to a year ago benefited by about $1.2 billion because you were not building X-Box inventory, so just I guess confirm that that’s actually true. We know that you had some channel issues where there was an over supply to the channel in the December quarter, but this 35% of that $1 billion charge due to inventory valuation adjustments, is this at all related to that? What exactly are you adjusting here? I mean, does that in any way allude to what you were talking about as far as your pricing strategy going forward or do you have to go in and fix all these things? And does that have to do with the three flashing light issue or just any issue? Sorry for such a long one there.
Chris Liddell: Let me try and strike all the components and hopefully I get them all. In terms of the cash flow impact, yes, there is a difference between our billed inventory a year ago and a declining inventory situation this year, so that is certainly true from a cash flow point of view. In terms of the write-down component of the charge associated with X-Box, that is a write-down on the balance sheet of the holding costs of those X-Box, so that’s a non-cash charge clearly but it does have an influence on the overall carrying costs of the boxes that are associated with that, a direct charge to that. In terms of the linkage between that and the three flashing red lights, it is not so much a direct linkage. There’s obviously an indirect linkage in the sense that because of that, as people return them we need to repair them, but this is very much, the inventory write-down is very much a write-down of the inventory that we have had returned to date that we believe that we will not be able to sell as a repaired unit, and hence it’s impaired from a valuation perspective. It is clearly all part of the same manufacturing issue but it is slightly different from a physical and hence an accounting perspective. Did I grab all the parts to your question?
John DiFucci: I think you did but one of the things here with this write-down and some of those other components, other 15% -- I’m having a hard time understanding why this is like a special charge and it’s taken out of this non-GAAP, the non-GAAP numbers for you.
Chris Liddell: I think the important thing from my point of view is the visibility of what we did and what we tried to do a couple of weeks ago -- I’d be happy to go over it again -- is give people all of the components of the charge and what they were and then obviously people can treat them as they see appropriate. I think the important thing is that they relate effectively to boxes that have already been produced, so have been produced in the fiscal year ’06 or fiscal year ’07 area. From a GAAP point of view, it is clearly a charge and the important thing from my perspective is that people understand the magnitude of the charge and the major components of it in terms of what they -- what people can expect in the future will be a cash cost and what is simply an accounting charge against balance sheet items now. So people, depending on whether they are looking at cash flow as it sounds like you are or balance sheet or overall GAAP accounting, they’ve got hopefully all the major components to slice and dice the way they want to.
John DiFucci: Thanks a lot, Chris.
Colleen Healy: Thank you, John. Next question, please.
Operator: Thank you. Our next question comes from Adam Holt with JP Morgan.
Adam Holt: Good afternoon. I have two questions about expenses and operating margins. You had relatively significant growth in headcount related expenses, both in the quarter as well as for the year. Could you talk a little bit about what we should expect for headcount growth as we look into next year? Secondly, if you look at the midpoint of the guidance for next year, you’re looking at maybe 60, 70 basis points of operating margin expansion year on year. How should we think about your strategy or your medium term margin expansion goals say over the next several years? Thanks.
Chris Liddell: We’ll talk more extensively in terms of years other than next year at FAM, so if I can leave the longer term picture until then and then talk to last year and this year and hopefully that will give you some flavor. In terms of headcount growth, from my point of view, the good trend that we are seeing is a slowing of the headcount growth so I am certainly keen to see us grow from lower rates of headcount growth than we have seen in the last couple of years. We got down on a year-on-year basis in the last quarter to around 10%. Now that’s still relatively high but relative to our level of revenue growth. I’m much more comfortable with that than the mid-teen levels that we were seeing six to 12 months ago. Headcount growth is in a better shape than it has been from my perspective. In terms of next year, embedded inside the guidance, as you can imagine, is both headcount growth and cost per head at those more moderated levels. That is going to vary quite differently between the different divisions, though. For example, we are building headcount in our online business and headcount is relatively flat in our client business, so you are seeing quite different trends in where the heads are being added, adding up to the overall picture. It’s a little similar comment to the margin structure. From my perspective in terms of margins, I think of the business in three parts. There’s our core businesses of client, MBD and server and tools, and next year collectively you should expect their margins to be broadly equal to this year, which I think is a good result when you see what the growth rates are inherent in those businesses. You see EDD moving to profitability, so clearly that’s a margin improvement but obviously still being very much in the investment phase, so it will be in a loss position and hence a negative margin next year and some of the improvement that we are making in EDD effectively we are reinvesting in [OSD]. But net overall, as you say, midpoint of the guidance will be a slight improvement in margins next year and I’ll talk a little bit more next week about how I feel overall for margins longer term.
Adam Holt: Great. Thank you.
Colleen Healy: Thanks a lot, Adam. Next question, please.
Operator: Thank you. Our next question comes from Jason Maynard with Credit Suisse.
Jason Maynard: Good afternoon. Chris, client and server and tools both came in a little bit lower than your guidance range. I was just curious if you would attribute that maybe to the stronger-than-expected strength in the EAs, or if you think some of the chatter around the timing of SP1 might have had an impact? Or any commentary on what virtualization is doing to the server market?
Chris Liddell: Client was very much in line with our guidance. It might have been a shave off and to the extent that the Vista revenue recognition was a little lower than what we had indicated, but that was in the $20 million to $30 million category. Other than that, it was very much in line. Server and tools, you are correct, was a little light and was for the reasons that you mentioned, that we had a very strong annuity mix of revenue inside server and tools which helped us obviously from an un-earned perspective. That’s one of the reasons why our unearned was so strong and also one of the reasons consequently why we flowed that through the higher revenues the next year. But in the quarter, it hurts us in the sense that when we ship license only that we recognize all up front to annuity that we recognize over the length of the contract, we don’t get quite as much of a pop. That was the principal reason why server and tools was at the light end of what we guided.
Jason Maynard: Maybe just a follow-up on that then; when you take into consideration your guidance around unearned for next year, are you assuming more normal historical type of EA mix rates or do you think it is going to continue on this path that you saw in Q4?
Chris Liddell: I think it could well continue. I think that the really interesting trend underlying this and the strength of the product suite and offering that we have to customers and their desire and willingness to stay on enterprise agreements for all sorts of reasons. Firstly, obviously the product that we have; secondly, the ones that we have coming out; and people clearly focused on Vista and Office as the big products that we’ve launched but when you look at next year, which most people would not have thought was a big launch year and you think of new versions of Visual Studio, new versions of Window Server, new versions of SQL Server. You have Performance Point, our business intelligence coming out. CRM Live. There’s a lot of different products that are appealing from a customer point of view and staying on annuity also helps them from an administration and cost perspective. I think there’s lots of good reasons to think that we are seeing a potentially more sustainable trend on annuity mix, which hurts us a little bit in terms of up-front revenue recognition but in terms of the overall health of the business, is very positive from my perspective.
Jason Maynard: Thank you. Very helpful.
Colleen Healy: Thanks, Jason. Next question, please.
Operator: Thank you. Our next question comes from Kash Rangan with Merrill Lynch.
Kash Rangan: Thank you very much, Chris and Colleen. Just an observation; I’m just looking to get your explanation behind this -- the rev rec positive change to the client business seems to have changed relative to your earlier guidance. In looking at the presentation, it says $540 million. The previous guidance was for $660 million of positive change in the rev rec. Does that mean that you've made any changes in your assumptions of Vista relative to XP in your mix for fiscal 2008 client guidance? As it relates to that, maybe if you could comment on, Chris, how are you seeing adoption of Vista in the enterprise? Because it occurs to me that I think you have given us a very neat explanation as to how you get to the client guidance. You have parsed out different elements. But the one piece that could be a swing factor is the business adoption seems like if we get better business adoption going into 2008, you might have a positive swing factor. I just was wondering if you had any comments on what kind of update we should expect that could cause the business premium mix to shift towards the positive. So it is really a two-part question there. Sorry about that.
Chris Liddell: I'll cover both of them, if I can. In terms of the unearned, you're absolutely right. As we went from target seating, which we do around the March timeframe, the budgeting which we did last month, we fine-tuned the Vista/XP mix for next year. We changed it from 85% to 78%. Now it's a lower number, but it's still a very high number overall from our perspective, so 78% Vista mix in terms of sales next year. Because of that change, then the amount of undelivered element that comes from Vista is slightly lower than it would be otherwise. The underlying sales are still exactly the same, but that accounting impact, as you correctly say, decreases from $660 million to $540 million. So from our point of view, it's good that our outlook has pretty much exactly the same revenue overall, but the composition as a result of the accounting recognition is slightly different. In terms of the adoption from business, that is a slightly different parameter. Obviously, those two are linked to each other. It's early days here, We are seeing what we consider to be good customer response. But the next 12 to 18 months is really going to be the time when people are going to be looking seriously to roll it out. Looking out at the first stage we think it's early days, but it's good. Could there be some upside there if we see businesses adopt it? Not necessarily earlier, but have a refresh cycle which is a bit stronger than it is and hence we get a bit more business premium relative to customer premium? Yes. That's not so much a rollout then because we tend to get paid either way for XP or Vista, but it could help with the overall premium mix that I talked about a few minutes ago.
Kash Rangan: That's the fiscal 2008 forecast, right?
Chris Liddell: Correct, yes.
Kash Rangan: Okay, great. Thanks.
Operator: Your final question comes from Kirk Materne - Banc of America.
Kirk Materne: This is a little bit of a follow-up on Kash's question. Chris, on the business premium mix can you give us an idea of what is in your forecast? It seems that your assumptions for the actual unit side of the business are pretty conservative in light of what you all have seen. Have you made any assumptions in terms of the premium mix getting better? I think it was down 3% this quarter. Is that forecasted to get a little better as we head into fiscal '08 or are you assuming it stays at the same rate? And if it does get better that is upside to what you are looking for?
Chris Liddell: In terms of the overall premium mix, I'd say it's going to be in line with fiscal year 2007, which was 68% for the year. So plus or minus a percent here or there, I think it's going to be broadly in line next year with what it was this year. As we have with our forecasts, and clearly external ones may differ, in terms of the business and consumer mix we would see business premium being down slightly and consumer premium being up, so it's the same trend that we saw this year. That's entirely driven by the fact that we expect the consumer segment to grow faster than the business segment, so therefore by definition the percentage will increase in favor relative to the customers. That could change around a bit. We're relatively conservative, I think, on business growth overall, but I think it's appropriately conservative. We are seeing consumer sales consistently outpacing business sales for a number of years now, and I think that's the right starting place. Now obviously I would love to see some upside there, to the extent that we get a good price for business premium, but we have built in what I think is an appropriate mix going forward.
Kirk Materne: Maybe just one follow-up on that. In terms of the business premium, is there any gating factors from say a technology or cost standpoint, meaning I think the enterprise edition comes along with Software Assurance. Is there anything structurally that's keeping people from going to a higher premium mix on the business side, or is it simply just an adoption issue?
Chris Liddell: Well, you have two impacts. Consumers tend to buy consumer, and businesses tend to buy business SKUs. So you've got that mix impact. Inside businesses, there's nothing structurally which is stopping them from buying one particular SKU or another. You are right, the Software Assurance gets you the enterprises edition, which most large businesses would favor. But it's about the features; it's not about the technology that probably drives the decision as to which SKU to take.
Kirk Materne: Thanks very much.
Colleen Healy: Thanks a lot, Kirk. Thanks to everyone for your participation in today's call. If you have any further questions, please feel free to call me or my team directly. As I mentioned at the beginning of this call, this conference call will be available on replay at our Investor Relations website through close of business July 19, 2008. In addition, you can hear the replay by dialing 866-517-3727 or for international calls dial 203-369-2039. The dial-in replay will be available through the close of business July 27, 2007. Thanks again for joining us today and we look forward to seeing you next week at the financial analyst meeting. | [
{
"speaker": "Operator",
"text": "Good afternoon and welcome to the Microsoft fourth quarter fiscal year 2007 earnings conference call. (Operator Instructions) I would now like to turn the call over to Ms. Colleen Healy, General Manager, Investor Relations. Please go ahead."
},
{
"speaker": "Colleen Healy",
"text": "Good afternoon, everyone and thank you for joining us today. This afternoon I'm joined by Chris Liddell, Senior Vice President and Chief Financial Officer; Frank Brod, Corporate Vice President and Chief Accounting Officer; and John Seethoff, Deputy General Counsel. Today's call will start with Chris providing some key takeaways for the fourth quarter of fiscal year 2007 and an overview of expectations for fiscal year 2008. I will then provide detail around our fourth quarter results, and then turn it back to Chris for a more detailed discussion of our guidance for the full year and first quarter of fiscal 2008. After that, we will take your questions. Our earnings release includes an addendum of financial highlights which contains more detailed information about revenue, operating expenses and other items. We have also posted our quarterly financial summary slide deck, which is intended to follow the flow of our prepared remarks in order to assist you. The slide deck offers highlights from the quarter, outlines our guidance, and provides a reconciliation of differences between GAAP and non-GAAP financial measures that we will talk about today. You can find the earnings release, the financial highlights and the quarterly financial summary slide deck on the investor relations website at www.Microsoft.com/msft. Today's call will be recorded. Please be aware that if you decide to ask a question, it will be included in both our live transmission as well as any future use of the recording. As always, shareholders and analysts can listen to a live webcast of today's call at the Microsoft Investor Relations website. A replay of the call will be available at this same site through the close of business on July 19, 2008. This conference call report is protected by copyright law and international treaties. Unauthorized reproduction or distribution of this report or any portion of it may result in civil and criminal penalties. Any recording or other use or transmission of the text or audio of today's call is not allowed without the expressed permission of Microsoft. We will make forward statements during this call. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in today's earnings press release and the comments made during this conference call and in our 2006 Form 10-K, subsequent quarterly reports on Form 10-Q and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statement. With that, let me now turn it over to Chris."
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{
"speaker": "Chris Liddell",
"text": "Thanks Colleen, and good afternoon, everyone. Thanks for joining us today. I'll start today's call with highlights from last fiscal year's performance and then give you an overview of our expectations for fiscal 2008. Our quarter 4 performance capped an extremely strong year for our company, and helped set the stage for fiscal 2008 to be another year of double-digit revenue, operating income and earnings per share growth. I'm extremely pleased with the traction our sales force and partners are experiencing with business customers, evidenced by billings growth in the quarter for enterprise agreements in excess of 25%, and non-annuity licensing up of over 15%. When you combine those figures with billings for OEM and packaged products each growing 10% plus in the quarter, you'll see that demand was strong across all of our channels and customers. Looking at our full year results, fiscal 2007 was a year of $7 billion of revenue growth, fueled by robust customer acceptance of products in both our emerging and mature businesses including Windows Vista, Microsoft Office 2007, SQL Server, Windows Server, and Xbox 360 consoles. Our core businesses accounted for $5 billion of absolute revenue growth, with the business division, client, and server and tools growing 13%, 14% and 16%, respectively for the year. Operating income for the year also grew double-digits. We were able to achieve this while still be being able to make a number of significant investments in our businesses. For example, the launch of over 40 new products into the marketplace, as well as a number of updates and enhancements to our online service offerings, continued development of a number of upcoming products such as new versions of Windows Server, SQL Server, and Visual Studio, the enhancement of our online service infrastructure by continuing to refine adCenter; increasing our database capacity; and necessary investments in Xbox customer satisfaction. We also announced eight strategic acquisitions including: aQuantive, to provide the advertising industry with a world-class, Internet-wide advertising platform; Tellme, for its voice response services; and Softricity for its application virtualization and streaming capabilities. Earnings for the year came in at $1.42, up 18% over last year, which was faster than both revenue and operating income. Finally, during fiscal ‘07 we made significant progress on our strategy of returning cash to shareholders. Last year at this time we announced authorization for programs to repurchase up to $40 billion worth of our stock over five years. Today, one year after that announcement, I am happy to say that we have passed the halfway mark on the program by repurchasing approximately $25 billion worth of our stock during the year. When you combine the share repurchases we made this year with the $3.8 billion worth of dividends paid, we returned about 175% of operating cash flow to shareholders. Now I would like to move to our outlook for fiscal ‘08. Given the good exit from fiscal ‘07 we are increasing our revenue, operating income and earnings per share guidance for next year on an absolute basis. We expect revenue growth of 11% to 13%, with operating income and earnings per share growing even faster than that. I'm particularly pleased that the high end of our guidance reflects each of our businesses growing revenue at double-digit rates for the year, especially given our robust performance in fiscal ‘07. Looking to our product lineup in ‘08, next year represents another significant launch year for the company. We will intensify our pursuit of important market opportunities for the company with product launches in business intelligence, unified communications, security and business applications. By the time we exit next year, we will have refreshed a major portion of our server lineup within a period of 15 months with the addition of new versions of Windows Server and SQL. Additionally, the consumers will have a great lineup of first and third-party games heading into the holidays, led by the release of Halo 3, plus continuing enhancements to our Windows Live services. With those high level themes for 2007 and 2008, I am going to turn the call over to Colleen now for more details on how we closed out last year."
},
{
"speaker": "Colleen Healy",
"text": "Thanks, Chris. As Chris mentioned, the fourth quarter delivered a strong finish to the year with revenue near the high end of our guidance provided on the April earnings call. Specifically, demand for our offerings was excellent, with revenue growing 13% and core bookings increasing over 20%, characterized by high annuity revenue growth, driven by outstanding field sales force execution on enterprise agreement renewals. This speaks not only to the healthy customer acceptance of the products recently launched, but also to the anticipation of our offerings still to come. Let me provide you with details of our financial performance, starting with revenue. I'll discuss top line, financial and business momentum points, and then follow-up with revenue performance for each of the business units. Then I'll review the rest of the income statement. All growth comparisons I mention relate to the comparable quarter of last year, unless otherwise specified. As I mentioned, revenue grew 13% to $13.4 billion, driven by client, the Microsoft business division and server and tools. Online services also had a good quarter. Each of these four businesses grew in the mid to high teens, and collectively at 16%. The underlying PC hardware market remained robust, with estimated growth of 11% to 13% during the quarter, about a point higher than our expectations. PC shipment growth rates in emerging markets continue to outpace that of mature markets, and consumer PC shipment growth outpaced that of the Business Segment. Every region, except the US and Japan, increased PC shipments at double-digit rates. Our mix of product billings for the quarter was approximately 30% from OEMs, over 40% from multi-year licensing agreements, around 15% from license-only sales, and the balance from our other businesses. Over the past couple of years we have seen a mix shift from license-only sales to annuity agreements, driven by standing adoption of enterprise agreements. Enterprise agreement renewal rates exceeded the high end of our historical range of 66% to 75%. We are delighted that the value proposition from our current product lineup and future roadmap -- beyond the recently launched flagship desktop product even -- are resonating with customers. This strong annuity licensing performance drove our unearned revenue balance 16% higher to $12.6 billion and our contracted, not billed balance was driven higher on both a sequential and year-over-year basis, exceeding $10 billion at the end of June. As a result, total bookings grew over 15%, and core bookings of client, Microsoft business division and server and tools increased over 20%, as I previously mentioned. I'll close out the revenue overview by adding that changes in foreign exchange rates added about 2 percentage points to our overall revenue growth. Now I will provide revenue highlights by business segment. Client revenue grew 14% to $3.8 billion, characterized by strong OEM revenue growth, driven by continued demand for Windows Vista and a healthy PC hardware market. OEM revenue increased 15% and includes 3 points of revenue recognition from undelivered elements. Adjusting for this impact, OEM revenue grew roughly in line with OEM unit shipments at 11%. OEM premium mix was 72%, a 17 percentage point increase over this period last year. This was driven by a 20 percentage point increase in the consumer element of premium mix, and around a 3 percentage point decline in the business element. Given the over 5:1 pricing uplift we received from the business premium SKUs over consumer premium SKUs, these changes within the premium mix have largely an offsetting impact to revenue. For further background on this new disclosure, we have included a slide in the earnings deck on our website that illustrates these metrics, as well as lists of SKUs comprising each of the consumer and business premium mixes. Client, commercial and retail licensing increased 7%. Businesses are recognizing the value that Windows Vista and Software Assurance provides them, as evidenced by high renewal and new annuity attach rates, driving about a 25% increase in the volume licensing portion of the unearned revenue balance. Server and tools revenue grew 15% to $3.1 billion, driven by SQL Server, Windows Server, Visual Studio and consulting services revenue. Fiscal 2007 capped a decade of consecutive years of double-digit revenue growth for SQL Server. During the quarter, significant product development momentum was achieved with beta releases of the upcoming versions of Windows Server and Visual Studio, and a community technology preview of SQL Server 2008. In our online services business we saw advertising revenue growth of 33%, exceeding our expectations. Search ad revenue benefited from both increased search queries and revenue per search, while display ad revenue enjoyed both increased number of page views and revenue per page view. Overall, online services business revenue grew 19% to $688 million. Microsoft business division revenue grew 19% to $4.6 billion, beating high end guidance by over $150 million. Highlights in the quarter included solid revenue growth through enterprise agreements for Office, and continued momentum for Share Point. Enterprise agreement momentum continued after the launch of the Office 2007 system, and renewal rates are higher now than they were a year ago. We are also pleased with the results of our Dynamic business, which showed healthy performance across both the ERP and CRM product lines, driving a 24% increase in dynamic customer billings. An impressive 85,000 new seats of our dynamic CRM offering were sold during the quarter. Consistent with our guidance, entertainment and devices revenues decreased 10% to $1.2 billion as a result of lower Xbox 360 sales. Software and accessory attach rates remained at record levels, and we passed the 7 million member mark for Xbox Live. During the quarter, Halo 3 concluded beta testing, and on September 25th will lead the charge of hotly anticipated game titles into this 2007 holiday season. Entertainment and devices achieved its goal of selling over 1 million Zune units on a sell-in basis in its first eight months in the market. Licenses for Windows Mobile-based phones grew in excess of 75% to end the year with sales of over $11 million, and an increased unit market share in the smart phone category. Now for the rest of the income statement. Positive revenue increased 52%, primarily driven by a charge relating to the current and enhanced Xbox 360 warranty policies that were announced earlier this month. At this time, let me provide you with the details of that charge, now that they have been finalized. First, the total amount was $1.06 billion, within the range we provided a couple of weeks ago. Second, the makeup is largely consistent with the guidance we provided with about half of the total charge driven by existing warranty policies and the other half driven by the new warranty enhancements. Of the total amount of the charge, approximately 35% is attributable to inventory valuation adjustment. Before the Xbox 360 charge, cost of revenue would have increased 5% year over year. Other operating expenses increased 13%, excluding legal charges of $351 million in the year-ago period. Expense growth was driven by headcount-related costs and sales support cost for our enterprise software advisory channel partners. Operating income was $4 billion. Excluding the impact of the Xbox 360 charge and certain legal charges in the year-ago period, operating income for the quarter would have increased 19% to $5 billion. Investment income and other totaled $295 million for the quarter. Our effective tax rate for the quarter was 29% to align to our annual effective tax rate of 30% for fiscal 2007. Before non-recurring items the effective tax rate for the year would have been 31%. Cash flow from operations increased 34% to $4.4 billion. During the quarter we repurchased 243 million shares, or $7.4 billion of company stock, of which $7.2 billion settled in the quarter. We paid out $952 million in dividends to shareholders. Diluted shares outstanding for the quarter were 9.7 billion, down 6% from the prior year as a result of share repurchases. Earnings per share for the quarter were $0.31, which included $0.08 related to the Xbox charge. Before this charge, earnings would have been $0.39 per share. So in summary, during the quarter we made a needed investment into our Xbox business to assure customers that we fully stand behind our products. Before this charge, the fourth quarter was a strong end to fiscal 2007 with double-digit revenue, operating income and EPS growth, robust bookings and solid progress on the fiscal 2008 product pipeline. With that, let me turn it back to Chris, who will provide you with our expectations for the first quarter and all of fiscal 2008."
},
{
"speaker": "Chris Liddell",
"text": "Thanks, Colleen. I'm going to spend my remaining time on the call talking about what we see for the full year ahead and first quarter. Before we get into the specific guidance, let me outline some of our key assumptions. The fiscal 2008 forecast generally assumed a continuation of the economic conditions and demand from where we exited in 2007. Our forecast did not include any significant unexpected impacts from foreign exchange rate movements. We expect PC unit demand to continue to remain healthy with growth rates similar to what we saw in 2007. Specifically, we expect PC unit growth for fiscal 2008 to be 9% to 11% for the year and between 11% to 13% for the first quarter. We estimate that growth rates will continue to be higher in the consumer segment than in the business segment, and recent regional trends should continue with growth in emerging markets outpacing that of mature markets. Now let me go through our detailed guidance. For the full year we expect our revenue to come in between $56.8 billion to $57.8 billion, growing 11% to 13%. This represents a 1 percentage point improvement on the high-end and is about $300 million better in absolute dollar terms from our April guidance. The $5.7 billion to $6.7 billion yearly represents yearly increases driven by expected solid performance across our five segments. In the first quarter, we expect revenue of $12.4 billion to $12.6 billion, which represents an increase of 15% to 17%. With that revenue guidance in our divisions is as follows: For client, we expect full year growth to be 9% to 10%, and quarter one growth to being 15% to 16%. For the first quarter we expect OEM revenue to grow faster than the PC hardware market due to a higher premium mix than the year-ago quarter and to be in line for the full year. On the commercial and retail side of the business, we expect double-digit growth for both quarter one and the year from continued demand through our volume licensing channels. Combined growth rate benefits by 3 percentage points in Q1 and 2 percentage points for the full year from recognition of undelivered elements. As in our April call, we have included a slide in our slide deck containing additional information on the impact of client revenue. Server and tools revenue should be 14% to 15% for the year and 11% to 12% for the first quarter. Coming off another impressive year in fiscal 2007, Server and tools is expected to again achieve double-digit revenue growth, while delivering the next wave of server innovation with the upcoming February launch of the new versions of Windows Server, SQL Server and Visual Studio. Together, these products form a highly reliable and secure next-generation enterprise platform, which will fuel growth in the server and tools business over the next several years. We forecast revenue in the online services business to increase 10% to 13% for the year and 10% to 11% in Q1. This implies advertising growth in excess of 20% for the year and for the quarter. Fiscal 2008 will bring many important structural enhancements to our online services business. First, we expect to close both of our recently announced acquisitions for ScreenTonic and aQuantive in the first quarter. These acquisitions represent important next steps as we continue building out our vision of a centralized advertising platform that allows advertisers exposure across the various IP-enabled media. Second, we will be making usability improvements by providing better integration between our Windows Live services. Third, we will continue to build out our data centers to provide capacity for online services that can be used across the company. I mentioned our acquisition of aQuantive, and I want to clarify that the guidance we are giving you for the company and for OSB does not include the financial impact of aQuantive. We expect to close the aQuantive acquisition in August, sometime after the shareholder vote. Assuming a positive vote and a subsequent close, we plan to update our corporate guidance for the inclusion of that business on our next earnings call in October. As we stated in May, the transaction will have revenue and operating expenses, but we do not expect a significant affect to fiscal 2008 operating income and earnings per share, excluding transaction costs. Microsoft business division revenue should be 11% to 12% for the year and 14% to 15% in the first quarter. Q1 will continue to benefit from strong customer acceptance of the Microsoft Office system. Fiscal 2008 represents another important launch year for the business division, with the impending releases of Office Communications Server, Performance Point Server and a new versions of Dynamic CRM. These products continue Microsoft's push into the field of unified communications, business intelligence and business applications. While overall revenue growth remained healthy, direct comparisons for the second half of 2008 are more difficult due to our out performance in 2007. For the entertainment and devices division, we're forecasting revenue growth of 10% to 19% for the full year and 30% to 40% for Q1. Growth in our most profitable revenue streams will be a key driver in achieving our goal of segment profitability in fiscal 2008. We had the best first and third-party software title lineup we have ever had, highlighted by the launch of Halo 3 this September. These games, combined with Xbox accessory attach and an expanding line of Xbox LIVE installed base, set us up for an excellent year in our Xbox business. 2008 will be another year of continued momentum for our mobile communications business as well. We expect to sell over 20 million licenses for Windows Mobile-based phone as our carrier and OEM partners roll out a broad and compelling lineup of devices based on Windows Mobile 6. Getting back to companywide performance, operating income for the year is expected to be between $22.2 billion and $22.7 billion, increasing 20% to 22% and 12% to 15%, excluding certain charges in fiscal 2007. The higher revenue forecast is responsible for the improvement versus our April operating income guidance. For the first quarter, we expect operating income to be between $5 billion and $5.2 billion. As a result of the higher operating income guidance, we have increased our full year earnings per share results by $0.01. Therefore diluted earnings per share for the year are expected to come in at $1.69 to $1.73. For the first quarter we expect $0.38 to $0.40. These earnings assume an effective tax rate of 30.5%. From a balance sheet prospective, we expect total unearned revenue to finish fiscal 2008 up 7% to 10%. Excluding undelivered elements, the remaining portion of our unearned revenue should increase 13% to 16%. Contracted not billed should also finish 2008 up from current levels. When thinking about sequential changes in unearned revenue from quarter four 2007 to quarter one 2008, we expect the sequential decrease from the fourth quarter to be about 10%, due to the large amount of billings in that fourth quarter. When thinking about the guidance we just provided you, I would suggest that you consider some of the risks. These risks include competitive, legal, execution and general market risks, as well as customer acceptance of our new and existing products and fluctuations in PC and server hardware growth rates. Additionally, changes in the mix of our billings between and annuity and license-only can have an impact on GAAP revenue, operating income and earnings per share by delaying revenue recognition into future periods. So to wrap up, fiscal 2007 was an excellent year from my perspective. Launches of Windows Vista, the 2007 Microsoft Office System, Exchange 2007, Zune, and Windows Mobile 6 have brought new capabilities into the marketplace so it is exciting to see them off to such strong starts. Many of the same factors that helped us be successful in 2007, such as a healthy PC hardware market, customer acceptance of our new versions of Office and Windows, an impressive lineup of new product offerings, as well as solid execution by our R&D and sales and marketing teams will help propel us into the next fiscal year. In ‘08 we're looking to deliver another year of double-digit revenue, operating income and earnings per share growth. Next year product releases represent significant improvements over our existing products, as well as a continued push into new areas for the company. Given the operational backdrop and our ability to generate meaningful free cash flow for the company, we will look to continue to execute on our strategy of returning cash to shareholders. This brings me to the end of my financial comments. I'm very much looking forward to catching up with many of you at our financial analyst meeting next week. As a result of your feedback, we have made some slight adjustments to the overall flow of the day. There will still be presentations by Bill, Steve and the senior management team, but we have also allowed more executive interactions than in prior years, with Q&A sessions throughout the day with all the speakers. We have left some time now for your questions. I will hand the call over to Colleen so we can get started. Thank you."
},
{
"speaker": "Colleen Healy",
"text": "Great. Let's now proceed to questions. We want to accommodate questions from as many people as possible, so please avoid multi-part questions and limit yourselves to just one question. Operator, will you please repeat your instructions?"
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Charlie DiBona - Sanford Bernstein."
},
{
"speaker": "Charlie DiBona",
"text": "Thank you, operator. Chris, I guess it will come as no surprise that I have a question about the online services group. I know you promised more metrics next week, but more generally, you have had some solid results here and a good recovery of search share by all the independent metrics in the last month, both sequentially and year over year. But there has been some speculation that those gains were driven by special programs. Now your Q1 guidance points to a relatively significant deceleration of that business. Can you talk a little bit about the strategy here and about the sustainability of particularly last month's momentum?"
},
{
"speaker": "Chris Liddell",
"text": "Yes. Let me talk about the quarter and then how it flows through to the year. From the quarter point of view, the underlying advertising revenue was up 33%. The good news from my perspective was that really it was across the board. So we had good search volumes, we had good monetization of those search volumes. We are lapping the transition to adCenter so we're getting some benefit, if you like, from revenue per search uplift, as well as the overall volumes. Better than that growth rate is also on our display business, which doesn't tend to get talked about as much. That was up a healthy number in terms of volume and monetization as well, so it was a good quarter all around. Vis-a-vis next year, inside the guidance is revenue growth in advertising of greater than 20%. Now the comparables start to get harder because we're off a bigger base, obviously, and we don't have for the full year quite as strong a momentum in terms of the adCenter transition. I would just say mid 20s or higher is a good result for the business overall. I think that clearly if we can do better than that, that's great, but that's not a bad result. In terms of the last part of your question on how much we were assisted in the fourth quarter by some of the one-off impacts, we were certainly helped by that but I think the interesting thing from my point of view is not necessarily the sustainability of that because that was one or two months. It’s just that when we put a new product into the marketplace, it is capable of shifting share. I am certainly not going to extrapolate that through next year but I think it is interesting from, if you like, an experiment point of view that when we try something different, we were able to get some movement in the market in a relatively short period of time. I haven’t built a lot of that into next year and we’ll wait to see other more sustainable products have some influence but overall, I think next year, having revenue of advertising growing at greater than 20% off a higher base is at least a good starting point at this stage."
},
{
"speaker": "Colleen Healy",
"text": "Thank you, Charlie. Next question, please."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Heather Bellini with UBS."
},
{
"speaker": "Heather Bellini",
"text": "Thanks, Chris and Colleen. I was wondering if you could comment on two things; one, where do you think the premium mix could go? It went from 71, I believe to 72 this quarter. Again, that’s much higher than what you had forecasted before you went into the Vista cycle but where do you think we could go, especially as we get into the heart of consumer spending maybe more around back to school and holiday? Also, could you comment on the significance of SP1 for Vista adoption? Do you have any comments on timing? Thanks."
},
{
"speaker": "Chris Liddell",
"text": "With the premium mix, we think that sort of level is sustainable through next year, so we would expect the same sort of premium mix next year as for this year. We will see a difference in business premium versus consumer premium. As we talked about last quarter, we thought we would give you more visibility into what’s happening in those two different segments or those two different components of the premium mix because they have such different monetization impact, the business premium having much more significance than the consumer premium. Colin shared with you the makeup of those numbers. In terms of next year, because we expect consumer growth to be higher than business growth in terms of PCs, we would still expect a mix shift in the premium segment towards the consumer premium but the overall premium mix for the company to be relatively healthy and high in the 70 odd percent range. So we think it’s sustainable at that level but with a change inside business and consumer. In terms of SP1, clearly there will be an SP1 but it looks like we’re not talking about exactly when that is. We don’t see it as a massive driver of uptake in its own right. It’s early days yet and we are broadly happy with how we are seeing Vista adoption, both from a consumer and a business point of view. We were always expecting, and I think we talked about this for the last two or three quarters, that the business uptake would be driven by their needs rather than the availability of Vista per se, so that’s going to be progressive over the next 12 to 18 months and I think will be relatively independent of when the first service pack comes out."
},
{
"speaker": "Heather Bellini",
"text": "Thank you."
},
{
"speaker": "Colleen Healy",
"text": "Thanks a lot, Heather. Next question, please."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Sara Friar with Goldman Sachs."
},
{
"speaker": "Sara Friar",
"text": "Good afternoon, guys. In the entertainment and device area, that guidance for fiscal year ’08 is quite a wide spread. Chris, could you just talk us through what the major swing factors will be? Also, you did say the profitability of the segment for FY08 but can you give us any sense on timing? Could Halo 3 launching at the end of September help drive profitability as early as December?"
},
{
"speaker": "Chris Liddell",
"text": "It’s profitability overall for the year and that’s the key from my point of view. Because of the seasonality in that business, you could see some quite different swings in profitability on a quarter by quarter basis, not only because of Halo that you mentioned but obviously the Christmas quarter is a substantial one from a console and gaming point of view. So it won’t necessarily be a linear improvement during the course of the year, although in terms of COGS it will help. The COGS will progressively degrade through the year but the volumes will go up and down with the quarter. So profitability overall for the year but it will be non-linear in the way that it rolls out during the course of the year. In terms of the width of the guidance, I guess that is purposeful. It’s one of those businesses which, from a demand point of view, is relatively hard to anticipate. Obviously console demand in itself is a big variable there but the other thing and better than that, to be honest, we have a pricing strategy for the next 12 to 24 months that’s embedded in that and a console strategy as well, and those two are related to each other. At this stage, we’re keeping relatively quiet about that from a competitive point of view. We really don’t want to signal anything, so that will become more clear as the year comes through. But at this stage we’re keeping, if you like, a relatively wide range to accommodate that."
},
{
"speaker": "Sara Friar",
"text": "Could I ask one more quick follow-up? On the macro environment, a number of other tech and others have alluded to a much better spending backdrop. I would just love to hear your quick thoughts on any changes you are seeing in the various geographic areas, where you are seeing strength and weakness."
},
{
"speaker": "Chris Liddell",
"text": "We are certainly seeing strength in all of the emerging markets. For example, countries like Russia which has just had a phenomenal year for us, so some of those Eastern Europe countries, South America and obviously the Asian countries are very strong form our perspective, albeit off a relatively small basis. In terms of overall level of spending, we aren’t seeing a significant positive there. The thing that we believe that we are seeing is a higher share of the wallet from some of our customers and that’s reflected in the relatively higher renewals that we are getting and people’s uptake of the products. So from our fields point of view, we are seeing a really healthy and encouraging trend from just being a desktop software provider to being much more of an infrastructure provider to enterprises. So we aren’t necessarily seeing the amount of their spending going up but we believe that the amount that they are spending with us on the suite of products that we’ve got, not only the ones obviously that we’ve launched in the last couple of years but the ones that are coming up, is increasing in what we consider to be a promising way."
},
{
"speaker": "Sara Friar",
"text": "Got it. Thanks a lot."
},
{
"speaker": "Colleen Healy",
"text": "Thanks, Sara. Next question, please."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Brent Thill with Citigroup."
},
{
"speaker": "Brent Thill",
"text": "Thanks. Chris, on the client guidance for fiscal ’08, it seems it’s fairly prudent considering the industry is expecting a reacceleration in PC unit growth for the second-half of this year. Can you just talk to some of the characteristics and why you are expecting that line to slow down more than any of the other lines that you’ve given guidance for the year?"
},
{
"speaker": "Chris Liddell",
"text": "If you start with PC unit growth rates, and that’s clearly the main driver inside there, we are expecting for next year, as I mentioned on the call, around 9% to 11%, so we’re sticking pretty much in line with industry expectations. We think we can grow OEM units at the top end of that range because of our continued progress that we make in piracy, so we think we can grow units at the top end of that range. And then we’ll be assisted to some extent by the Vista revenue recognition that we talked about on the last couple of calls. But because of the premium mix change, and this is something that Steve obviously alluded to in February and we talked a bit about on the last few calls, we will lose a couple of percentage points between OEM unit growth and OEM revenue growth, you know, the strong drive in emerging markets, growth in emerging markets, and consumers will take a little bit of a shaving relative from revenue relative to units. Lastly, from our perspective in terms of revenue growth, the commercial and retail will have a strong comparable in FY07, so the growth rate will be relatively hard to repeat, given the FTP spike that we had in fiscal year ’07. So there’s a lot of moving parts in the way that we look at it, but if you start with PC unit growth, we think we can grow OEM units at the top end of that and we think we can grow client revenue overall broadly equal to OEM units at around that 9% to 10% mark. So we think that will be a good healthy result from our perspective, but in order to get out-performance on that, we’d have to see PC units at stronger levels than that."
},
{
"speaker": "Brent Thill",
"text": "Just a quick follow-up; Longhorn is still on track for a calendar year ’07 ship?"
},
{
"speaker": "Colleen Healy",
"text": "No update on the Longhorn. You can expect second-half calendar ’07 for RTM."
},
{
"speaker": "Brent Thill",
"text": "Thanks."
},
{
"speaker": "Colleen Healy",
"text": "Thanks a lot, Brent. Next question, please."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from John DiFucci with Bear Stearns."
},
{
"speaker": "John DiFucci",
"text": "Thank you. I have a question, Chris, on cash flow. It looks like other current assets are down a little bit and there’s a note right at the end of the press release, or the report on your website. I just want to make sure I understood it. It looks like this year relative to a year ago benefited by about $1.2 billion because you were not building X-Box inventory, so just I guess confirm that that’s actually true. We know that you had some channel issues where there was an over supply to the channel in the December quarter, but this 35% of that $1 billion charge due to inventory valuation adjustments, is this at all related to that? What exactly are you adjusting here? I mean, does that in any way allude to what you were talking about as far as your pricing strategy going forward or do you have to go in and fix all these things? And does that have to do with the three flashing light issue or just any issue? Sorry for such a long one there."
},
{
"speaker": "Chris Liddell",
"text": "Let me try and strike all the components and hopefully I get them all. In terms of the cash flow impact, yes, there is a difference between our billed inventory a year ago and a declining inventory situation this year, so that is certainly true from a cash flow point of view. In terms of the write-down component of the charge associated with X-Box, that is a write-down on the balance sheet of the holding costs of those X-Box, so that’s a non-cash charge clearly but it does have an influence on the overall carrying costs of the boxes that are associated with that, a direct charge to that. In terms of the linkage between that and the three flashing red lights, it is not so much a direct linkage. There’s obviously an indirect linkage in the sense that because of that, as people return them we need to repair them, but this is very much, the inventory write-down is very much a write-down of the inventory that we have had returned to date that we believe that we will not be able to sell as a repaired unit, and hence it’s impaired from a valuation perspective. It is clearly all part of the same manufacturing issue but it is slightly different from a physical and hence an accounting perspective. Did I grab all the parts to your question?"
},
{
"speaker": "John DiFucci",
"text": "I think you did but one of the things here with this write-down and some of those other components, other 15% -- I’m having a hard time understanding why this is like a special charge and it’s taken out of this non-GAAP, the non-GAAP numbers for you."
},
{
"speaker": "Chris Liddell",
"text": "I think the important thing from my point of view is the visibility of what we did and what we tried to do a couple of weeks ago -- I’d be happy to go over it again -- is give people all of the components of the charge and what they were and then obviously people can treat them as they see appropriate. I think the important thing is that they relate effectively to boxes that have already been produced, so have been produced in the fiscal year ’06 or fiscal year ’07 area. From a GAAP point of view, it is clearly a charge and the important thing from my perspective is that people understand the magnitude of the charge and the major components of it in terms of what they -- what people can expect in the future will be a cash cost and what is simply an accounting charge against balance sheet items now. So people, depending on whether they are looking at cash flow as it sounds like you are or balance sheet or overall GAAP accounting, they’ve got hopefully all the major components to slice and dice the way they want to."
},
{
"speaker": "John DiFucci",
"text": "Thanks a lot, Chris."
},
{
"speaker": "Colleen Healy",
"text": "Thank you, John. Next question, please."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Adam Holt with JP Morgan."
},
{
"speaker": "Adam Holt",
"text": "Good afternoon. I have two questions about expenses and operating margins. You had relatively significant growth in headcount related expenses, both in the quarter as well as for the year. Could you talk a little bit about what we should expect for headcount growth as we look into next year? Secondly, if you look at the midpoint of the guidance for next year, you’re looking at maybe 60, 70 basis points of operating margin expansion year on year. How should we think about your strategy or your medium term margin expansion goals say over the next several years? Thanks."
},
{
"speaker": "Chris Liddell",
"text": "We’ll talk more extensively in terms of years other than next year at FAM, so if I can leave the longer term picture until then and then talk to last year and this year and hopefully that will give you some flavor. In terms of headcount growth, from my point of view, the good trend that we are seeing is a slowing of the headcount growth so I am certainly keen to see us grow from lower rates of headcount growth than we have seen in the last couple of years. We got down on a year-on-year basis in the last quarter to around 10%. Now that’s still relatively high but relative to our level of revenue growth. I’m much more comfortable with that than the mid-teen levels that we were seeing six to 12 months ago. Headcount growth is in a better shape than it has been from my perspective. In terms of next year, embedded inside the guidance, as you can imagine, is both headcount growth and cost per head at those more moderated levels. That is going to vary quite differently between the different divisions, though. For example, we are building headcount in our online business and headcount is relatively flat in our client business, so you are seeing quite different trends in where the heads are being added, adding up to the overall picture. It’s a little similar comment to the margin structure. From my perspective in terms of margins, I think of the business in three parts. There’s our core businesses of client, MBD and server and tools, and next year collectively you should expect their margins to be broadly equal to this year, which I think is a good result when you see what the growth rates are inherent in those businesses. You see EDD moving to profitability, so clearly that’s a margin improvement but obviously still being very much in the investment phase, so it will be in a loss position and hence a negative margin next year and some of the improvement that we are making in EDD effectively we are reinvesting in [OSD]. But net overall, as you say, midpoint of the guidance will be a slight improvement in margins next year and I’ll talk a little bit more next week about how I feel overall for margins longer term."
},
{
"speaker": "Adam Holt",
"text": "Great. Thank you."
},
{
"speaker": "Colleen Healy",
"text": "Thanks a lot, Adam. Next question, please."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Jason Maynard with Credit Suisse."
},
{
"speaker": "Jason Maynard",
"text": "Good afternoon. Chris, client and server and tools both came in a little bit lower than your guidance range. I was just curious if you would attribute that maybe to the stronger-than-expected strength in the EAs, or if you think some of the chatter around the timing of SP1 might have had an impact? Or any commentary on what virtualization is doing to the server market?"
},
{
"speaker": "Chris Liddell",
"text": "Client was very much in line with our guidance. It might have been a shave off and to the extent that the Vista revenue recognition was a little lower than what we had indicated, but that was in the $20 million to $30 million category. Other than that, it was very much in line. Server and tools, you are correct, was a little light and was for the reasons that you mentioned, that we had a very strong annuity mix of revenue inside server and tools which helped us obviously from an un-earned perspective. That’s one of the reasons why our unearned was so strong and also one of the reasons consequently why we flowed that through the higher revenues the next year. But in the quarter, it hurts us in the sense that when we ship license only that we recognize all up front to annuity that we recognize over the length of the contract, we don’t get quite as much of a pop. That was the principal reason why server and tools was at the light end of what we guided."
},
{
"speaker": "Jason Maynard",
"text": "Maybe just a follow-up on that then; when you take into consideration your guidance around unearned for next year, are you assuming more normal historical type of EA mix rates or do you think it is going to continue on this path that you saw in Q4?"
},
{
"speaker": "Chris Liddell",
"text": "I think it could well continue. I think that the really interesting trend underlying this and the strength of the product suite and offering that we have to customers and their desire and willingness to stay on enterprise agreements for all sorts of reasons. Firstly, obviously the product that we have; secondly, the ones that we have coming out; and people clearly focused on Vista and Office as the big products that we’ve launched but when you look at next year, which most people would not have thought was a big launch year and you think of new versions of Visual Studio, new versions of Window Server, new versions of SQL Server. You have Performance Point, our business intelligence coming out. CRM Live. There’s a lot of different products that are appealing from a customer point of view and staying on annuity also helps them from an administration and cost perspective. I think there’s lots of good reasons to think that we are seeing a potentially more sustainable trend on annuity mix, which hurts us a little bit in terms of up-front revenue recognition but in terms of the overall health of the business, is very positive from my perspective."
},
{
"speaker": "Jason Maynard",
"text": "Thank you. Very helpful."
},
{
"speaker": "Colleen Healy",
"text": "Thanks, Jason. Next question, please."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Kash Rangan with Merrill Lynch."
},
{
"speaker": "Kash Rangan",
"text": "Thank you very much, Chris and Colleen. Just an observation; I’m just looking to get your explanation behind this -- the rev rec positive change to the client business seems to have changed relative to your earlier guidance. In looking at the presentation, it says $540 million. The previous guidance was for $660 million of positive change in the rev rec. Does that mean that you've made any changes in your assumptions of Vista relative to XP in your mix for fiscal 2008 client guidance? As it relates to that, maybe if you could comment on, Chris, how are you seeing adoption of Vista in the enterprise? Because it occurs to me that I think you have given us a very neat explanation as to how you get to the client guidance. You have parsed out different elements. But the one piece that could be a swing factor is the business adoption seems like if we get better business adoption going into 2008, you might have a positive swing factor. I just was wondering if you had any comments on what kind of update we should expect that could cause the business premium mix to shift towards the positive. So it is really a two-part question there. Sorry about that."
},
{
"speaker": "Chris Liddell",
"text": "I'll cover both of them, if I can. In terms of the unearned, you're absolutely right. As we went from target seating, which we do around the March timeframe, the budgeting which we did last month, we fine-tuned the Vista/XP mix for next year. We changed it from 85% to 78%. Now it's a lower number, but it's still a very high number overall from our perspective, so 78% Vista mix in terms of sales next year. Because of that change, then the amount of undelivered element that comes from Vista is slightly lower than it would be otherwise. The underlying sales are still exactly the same, but that accounting impact, as you correctly say, decreases from $660 million to $540 million. So from our point of view, it's good that our outlook has pretty much exactly the same revenue overall, but the composition as a result of the accounting recognition is slightly different. In terms of the adoption from business, that is a slightly different parameter. Obviously, those two are linked to each other. It's early days here, We are seeing what we consider to be good customer response. But the next 12 to 18 months is really going to be the time when people are going to be looking seriously to roll it out. Looking out at the first stage we think it's early days, but it's good. Could there be some upside there if we see businesses adopt it? Not necessarily earlier, but have a refresh cycle which is a bit stronger than it is and hence we get a bit more business premium relative to customer premium? Yes. That's not so much a rollout then because we tend to get paid either way for XP or Vista, but it could help with the overall premium mix that I talked about a few minutes ago."
},
{
"speaker": "Kash Rangan",
"text": "That's the fiscal 2008 forecast, right?"
},
{
"speaker": "Chris Liddell",
"text": "Correct, yes."
},
{
"speaker": "Kash Rangan",
"text": "Okay, great. Thanks."
},
{
"speaker": "Operator",
"text": "Your final question comes from Kirk Materne - Banc of America."
},
{
"speaker": "Kirk Materne",
"text": "This is a little bit of a follow-up on Kash's question. Chris, on the business premium mix can you give us an idea of what is in your forecast? It seems that your assumptions for the actual unit side of the business are pretty conservative in light of what you all have seen. Have you made any assumptions in terms of the premium mix getting better? I think it was down 3% this quarter. Is that forecasted to get a little better as we head into fiscal '08 or are you assuming it stays at the same rate? And if it does get better that is upside to what you are looking for?"
},
{
"speaker": "Chris Liddell",
"text": "In terms of the overall premium mix, I'd say it's going to be in line with fiscal year 2007, which was 68% for the year. So plus or minus a percent here or there, I think it's going to be broadly in line next year with what it was this year. As we have with our forecasts, and clearly external ones may differ, in terms of the business and consumer mix we would see business premium being down slightly and consumer premium being up, so it's the same trend that we saw this year. That's entirely driven by the fact that we expect the consumer segment to grow faster than the business segment, so therefore by definition the percentage will increase in favor relative to the customers. That could change around a bit. We're relatively conservative, I think, on business growth overall, but I think it's appropriately conservative. We are seeing consumer sales consistently outpacing business sales for a number of years now, and I think that's the right starting place. Now obviously I would love to see some upside there, to the extent that we get a good price for business premium, but we have built in what I think is an appropriate mix going forward."
},
{
"speaker": "Kirk Materne",
"text": "Maybe just one follow-up on that. In terms of the business premium, is there any gating factors from say a technology or cost standpoint, meaning I think the enterprise edition comes along with Software Assurance. Is there anything structurally that's keeping people from going to a higher premium mix on the business side, or is it simply just an adoption issue?"
},
{
"speaker": "Chris Liddell",
"text": "Well, you have two impacts. Consumers tend to buy consumer, and businesses tend to buy business SKUs. So you've got that mix impact. Inside businesses, there's nothing structurally which is stopping them from buying one particular SKU or another. You are right, the Software Assurance gets you the enterprises edition, which most large businesses would favor. But it's about the features; it's not about the technology that probably drives the decision as to which SKU to take."
},
{
"speaker": "Kirk Materne",
"text": "Thanks very much."
},
{
"speaker": "Colleen Healy",
"text": "Thanks a lot, Kirk. Thanks to everyone for your participation in today's call. If you have any further questions, please feel free to call me or my team directly. As I mentioned at the beginning of this call, this conference call will be available on replay at our Investor Relations website through close of business July 19, 2008. In addition, you can hear the replay by dialing 866-517-3727 or for international calls dial 203-369-2039. The dial-in replay will be available through the close of business July 27, 2007. Thanks again for joining us today and we look forward to seeing you next week at the financial analyst meeting."
}
] | null | null |
MSFT | 3 | 2,007 | 2007-04-27 17:30:00 | Operator: Welcome to the Microsoft 2007 fiscal year third quarter earnings conference call. (Operator Instructions) I would now like to turn the call over to Ms. Colleen Healy, General Manager, Investor Relations. Please go ahead.
Colleen Healy: Good afternoon, everyone and thank you for joining us today. This afternoon I am joined by Chris Liddell, Senior Vice President and Chief Financial Officer; Frank Brod, Corporate Vice President and Chief Accounting Officer; and John Seethoff, Deputy General Counsel. Today's call will start with Chris providing some key takeaways for the third quarter of fiscal year 2007, and an overview of expectations for what remains of the fiscal year. I will then provide detail around our third quarter results, and then turn it back to Chris for a more detailed discussion of our guidance for the fourth quarter, as well as a preliminary outlook for fiscal year 2008. After that we will take your questions. We filed our 10-Q today in conjunction with our earnings release, therefore you have available the earnings release, MD&A, financial statements and footnotes. We have also posted our quarterly financial summary slide deck, which is intended to follow the flow of our prepared remarks in order to assist you. This slide deck offers highlights from the quarter, outlines our guidance and provides a reconciliation of differences between GAAP and non-GAAP financial measures that we will talk about today. You can find the earnings release, the 10-Q, and the quarterly financial summary slide deck on the Investor Relations website at www.Microsoft.com/MSFT . Today’s call will be recorded. Please be aware that if you decide to ask a question, it will be included in both our live transmission as well as any future use of the recording. As always, shareholders and analysts can listen to a live webcast of today's call at the Microsoft Investor Relations website. A replay of the call will be available at the same site through the close of business on April 26, 2008. This conference call report is protected by copyright law and international treaty. Unauthorized reproduction or distribution of this report, or any portion of it, may result in civil and criminal penalties. Any recording or other use or transmission of the text or audio of today's call is not allowed without the expressed permission of Microsoft. We will be making statements during this call that are forward-looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in today's earnings press release, in the comments made during this conference call, and in the Risk Factors section of our 10-Q, our 2006 Form 10-K, and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statements. With that, let me now turn it over to Chris.
Chris Liddell: Thanks, Colleen. Good afternoon, everyone. Thanks for joining us today. We're going to use our prepared remarks this afternoon to share our third quarter results, discuss our outlook for the fourth quarter, and provide a preliminary view of fiscal 2008. I'm extremely pleased with the company's financial performance during the quarter, as revenue, operating income and earnings per share exceeded our expectations and each grew at strong double-digit rates. Our results were primarily driven by strength in our core products. Windows Vista and 2007 Microsoft Office System will have a multi-year impact, and both are off to a very good start. Revenue growth in the third quarter was 32% and even if you were to exclude the $1.7 billion in recognition of previously deferred revenue associated predominately with our Technology Guarantee Programs for Windows and Office, our revenue growth would have been an extremely good 17%. Four of our five businesses delivered double-digit growth and we saw forward strength across all customer segments and channels. Excluding $0.01 in legal charges and a $0.02 tax benefit in the quarter, the revenue upside flowed through to operating income and earnings per share, which came in at $0.03 to $0.04 higher than our guidance in January. Cash flow from operations was also over $7 billion, indicative of the underlying strength of our business, and was a record for the company. Lastly, we continue to execute on our financial strategy. During the quarter we repurchased over $6.7 billion in company stock, and paid out just under $1 billion in dividends. This brings combined year-to-date repurchases and dividends to over $22.5 billion, which represents over 150% of our cash flow from operations over that same period. Moving now to the full fiscal year, we expect a strong finish to what has been an excellent year. We are increasing our revenue, operating income and earnings per share guidance for the year on the strength of our new product launches. Excluding certain legal charges and tax benefits in the prior and current years, we expect revenue growth in excess of 15% and earnings per share growth in excess of 16%. For both high level themes for the quarter and for the full year 2007, I'm going to turn the call over to Colleen for more details on our third quarter performance.
Colleen Healy: Thanks, Chris. As Chris mentioned, the results for Q3 were excellent. Let me provide you with details on our financial performance, starting with revenue. I will discuss top line financial and business momentum points, and then follow-up with revenue performance for each of the business units. All growth comparisons I mention relate to the comparable quarter of last year, unless otherwise specified. Revenue for the quarter grew 32% to $14.4 billion, which includes $1.7 billion in recognition primarily from the Technology Guarantee Program. Excluding the recognition of these deferrals, revenue growth would have been 17%. Growth this quarter was driven by sales in our Client and Microsoft Business Division, following the general availability of Windows Vista and the 2007 Microsoft Office System in January. Server and Tools had another solid quarter. These three core businesses turned in notable performance, each growing at a double-digit rate, and collectively growing revenues 22%, or over $2 billion in absolute growth before the recognition of the Tech Guarantees. We saw continued strength in the underlying PC hardware market, which we estimate grew 10% to 12% during the quarter, a bit faster than we had expected. Growth in emerging markets continues to outpace that of mature markets, and the consumer PC shipment growth outpaced business shipments. Europe, Asia excluding Japan and Latin America maintained double-digit growth rates, while the remaining regions grew at single-digits. Our mix of product billings for the quarter was approximately 30% from OEMs, over 25% from multi-year licensing agreements, over 20% from license only sales, and the balance from our other businesses. The mix this quarter versus the same period in the prior year is higher in license only sales, primarily due to retail sales following the consumer launches of Windows Vista and the 2007 Microsoft Office System, and lower in our other businesses due to our core product making up a higher mix of revenue this quarter, as you would expect given where we are in our various product lifecycles. Our field sales force saw broad strength across our customer segments and regions. Our small, midmarket and retail sales group actively engaged with our customers and partners, readying the market for the product launches. The entertainment sales force drove robust volume license sales, and entertainment and enterprise agreements renewal rates at the high end of our historical range of 66% to 75%. We are delighted that the benefits and value proposition offered in the recent releases of our flagship products are resonating with customers. As a result of a strong annuity licensing results, our unearned revenue balance ended the quarter at $10.3 billion, up 16% over the same period in the prior year. Our contracted not billed balance at the end of March was sequentially higher and continues to exceed $9.5 billion. Taking into account reported revenue and changes in the unearned and contracted not billed balances, bookings growth totaled 20%, with bookings in our core business of Client, Microsoft Business Division and Server and Tools growing 25%. Before closing out the revenue overview, let me add that changes in foreign exchange rates added about 2 percentage points to our overall revenue growth rate in the quarter, and was generally in line with our expectations going into the quarter. Now I will provide revenue highlights by business segment. Client revenue of $5.3 billion, an increase of 67%, includes the recognition of $1.2 billion from Tech Guarantees and pre-shipments. Adjusting for this impact, Client revenue would have been $4.1 billion, up 30%, driven by growth in all channels due to the successful consumer launches of Windows Vista during the quarter. OEM revenue increased 24%, excluding the recognition of the Tech Guarantee deferrals, driven by 20% growth in OEM license units. The 8 to 10 point difference between OEM license unit growth and the overall PC market growth during the quarter is a result of a normal spike in license sales on the launch of a new operating system in our system builder channel, restocking of retail inventory levels by OEMs as a result of the consumer launch, and continued progress on unlicensed PCs under our existing program. Consistent with the results we saw last quarter and the relative strength in the Consumer segment following the launch, we continue to see a change within the mix of sales of our Premium Edition operating system. OEM Premium mix was 71%, an increase of 18 percentage points from the prior year, driven by sales of Windows Vista Home Premium, while our other business editions of Windows declined a few points in the overall mix. As we shared with you previously, Windows Vista business generates over five times the pricing of our Windows Vista Home Basic and of Windows Vista Home Premium. So the net result is that the increase in Premium mix added about 1 percentage point of growth to OEM revenue. Client, commercial and retail licensing grew 63%, excluding the recognition of pre-launch revenue deferrals, driven by strong sales to the retail channel following the consumer launch of Windows Vista and a very healthy commercial business. Server and Tools revenue of $2.7 billion grew 15%, primarily driven by double-digit growth in Windows Server, SQL Server and Visual Studio, as well as growth in our consulting and Premier services. Also, during the quarter we launched Systems Center Operations Manager 2007, which provides end-to-end management for the monitoring and reporting of Windows environments. In our Online Services business we saw continued improvement in our advertising platform monetization, which resulted in advertising revenue growth of 23%. Revenue for our Online Services business overall increased 11% to $6.2 million, driven by the growth in advertising revenue, partially offset by an expected decline in access revenue. Search revenue benefited from a higher number of search queries, and increased revenue per search on both a year on year and consequential basis. We are now monetizing more effectively in the U.S. on our own Ad Center platform than we had under third-party Overture at this time last year. Our display growth was in line with what is a healthy market, driven by an increase in page views. This quarter we forged content partnerships with Newscorp, NBC and CBS to enhance MSN's premium video inventory. Microsoft Business Division revenue of $4.8 billion grew 34%, or 20% after adjusting for the Tech Guarantee. Growth was driven by both consumer and business sales of the 2007 Microsoft Office system following the recent launches. The performance for the quarter was highlighted by a strong consumer response to the 2007 Microsoft Office system, which drove better than expected retail sales. We are also pleased with the results of our Dynamics business which showed healthy performance across both the ERP and CRM product lines, driving a 20% increase in customer billing. During the quarter we announced plans to acquire TellMe Networks, bringing this industry-leading expertise and voice services to our existing speech platform and unified communications offering. Consistent with our guidance, Entertainment and Devices revenue decreased 21% as a result of lower Xbox 360 sales. We sold over 5,000 Xbox 360 consoles during the quarter, bringing our life-to-date sell-in to approximately $11 million. Software and accessory attach rates remain at record levels in the U.S. per MPV, and we have passed the 6 million member mark for Xbox Live. Our Mobile and Embedded Devices business continued to turn in strong performance, with revenue growth in excess of 30%. During the quarter we unveiled Windows Mobile 6, the next version of our Windows Mobile software platform. We expect to see an increasing number of Windows Mobile 6 powered devices coming to market through the rest of this year. Now for the rest of the income statement. Cost of revenue increased 6%, primarily driven by data center costs, product costs associated with the launch of Windows Vista, and the growth in consulting services, partially offset by a decline in Xbox 360 console sales. Other operating expenses increased $928 million, or 20%, excluding legal charges of $154 million in the current quarter and $397 million in the same quarter from the prior year. This is favorable to our expectations, due primarily to shifting some marketing and product development costs into the fourth quarter. Operating income of $6.6 billion, or $5.1 billion after adjusting for the impact of the Tech Guarantee deferrals and legal charges, is up 18% from the prior year, driven by the 22% revenue growth in our core businesses of Client, Microsoft Business Division, and Server and Tools. Investment income and other totaled $382 million for the quarter. Our effective tax rate for the quarter was 29%, and was lower than expected due to a $195 million one-time tax benefit. Cash flow from operations increased 60% to $7.3 billion. During the quarter we repurchased 237 million shares, or $6.7 billion of company stock, and paid out $976 million in dividends to shareholders. Diluted shares outstanding for the quarter were 9.9 billion, down 5% from the prior year as a result of execution against our share repurchase program. Earnings per share for the quarter were $0.50, which includes the following non-recurring items: $0.12 related to the impact of the Tech Guarantees, a tax benefit of $0.02 offset by $0.01 in legal charges. So in summary, the third quarter broadly exceeded our expectations, driven by the extremely positive consumer response to the launches of our flagship products. With that, let me now turn it back to Chris, who will now provide you with our expectations for the fourth quarter and a preliminary outlook for fiscal year 2008.
Chris Liddell: Thanks, Colleen. Let me now outline some key assumptions that we have used in putting together the outlook for the fourth quarter. Firstly, we estimate that PC unit growth for the quarter will be 10% to 12%. Within the overall PC market we expect current trends to continue, with a consumer segment growth exceeding that of the business segment, and emerging market growth exceeding that of mature markets. In contrast, third party analysts have lowered their full year server hardware growth estimate to 4% to 6% and although Server and Tools revenue is impacted by many additional factors, we have incorporated that into our guidance. Lastly, our guidance for the fourth quarter assumes that changes in foreign exchange rates will not have a significant impact on revenue growth rates for the quarter. So now for our detailed guidance. We expect fourth quarter revenue of $13.1 billion to $13.4 billion, growing 11% to 14%. Revenue guidance by business group is largely consistent with what we provided in January and so in the interested time I will simply provide you with the numbers. For Client we expect revenue growth of 14% to 15% for the fourth quarter. For Server and Tools, 16% to 17%. For Online Services, 10% to 15%, although excluding access subscription and transactions revenue, this implies advertising growth of 19% to 27%. For Microsoft Business Division, 13% to 14%. Finally, Entertainment and Devices revenue is expected to be down 2% to 11% in the fourth quarter. Now moving on to operating income. For the fourth quarter we expect to generate between $5.0 billion and $5.2 billion of operating income, representing 28% to 33% growth over the prior year. Well, 17% to 22% when legal charges of $351 million from the year-ago quarter are excluded. This was lower than the implied guidance from January due primarily to two factors. The first is a shift in operating expenses from the third quarter, as our full year total remains consistent with what we said in January. The second is higher COGS related to Xbox console and Windows Vista retail sales. We now estimate a fourth quarter effective tax rate of 31.5% due to a greater mix of forecasted earnings in higher tax rate jurisdictions. For diluted earnings per share, we expect $0.37 to $0.39 for the fourth quarter. So with that fourth quarter guidance we arrive at the following expectations for the fiscal year. Revenue between $50.9 billion and $51.2 billion, representing growth of 15% to 16%. Operating income of $19.5 billion to $19.7 billion, or excluding certain legal charges, $19.7 billion to $19.9 billion, representing growth of 12% to 13% and for fully diluted earnings per share of $1.48 to $1.50 or adjusting for certain legal charges and tax benefits, $1.47 to $1.49, and representing growth of 16% to 17%. We are clearly pleased that our strong performance in Q3 has allowed us to raise our revenue, operating income and earnings per share estimates for the full year. From a balance sheet perspective, we expect unearned revenue to finish the year up 8% to 10%, an increase of 2 percentage points from our January guidance. This increase reflects our growing confidence in multi-year contract billings in Q4, where the revenue opportunity and undoubtedly risk, is the largest we have seen in two years. The deal pipeline is robust. The value proposition for multi-year contracts are strong and the product portfolio is broad and deep. With that, let's turn to our fiscal year '08 preliminary outlook. As is always the case at this time of year, we are providing you with our first look at the next fiscal year prior to finalizing our internal budgeting and planning process. Reflecting where we are in the planning cycle and consistent with our past practice, we're not currently in a position to give specific business group detail. I should also highlight that this guidance provides you with a view that balances both the risks and opportunities as we currently see them. For context, our expectations are based on a stable IT spending environment. 2007 IT spending has been generally healthy and although we may see softening in select areas such as server hardware growth, we're not expecting any significant changes on a regional basis in fiscal 2008. Also, we're not modeling any significant impact to year-over-year revenue growth from changes in foreign exchange rates. The continuous product innovation we have been stressing for two years is driving our expected growth and our product cycle continues in the next 12 months with the launches of, for example, Longhorn Server, the next version of our CRM software and live CRM service, Halo 3, the next version of Visual Studio, new Windows Live Search and Communication Services, Office Communications Server, Expressions Studio, Office Performance Point Server, Forefront Client Security, and many other products and services from across the company. We expect our product line ought to generate revenue of $56.5 billion to $57.5 billion in fiscal '08, representing growth of 11% to 12%. On an absolute basis, this translates into an increase of over $5.5 billion, an amount larger than the total annual revenue of some Fortune 500 companies. As we have previewed with you since October, this guidance reflects the requirements for Windows Vista revenue recognition, which results in a relatively faster revenue recognition as compared to Windows XP, where we have stood at 5% to 25% of license revenue. We are committed to transparency on this, so I would like to provide you with our revenue guidance adjusted for the impact of Windows Vista revenue recognition. We have included slide 20 in our earnings slide deck, which provide you with detail on the associated underlying balance sheet and P&L adjustments. Had we never deferred some delivered elements on Windows XP sales, our expected accounting revenue would be approximately $220 million lower in fiscal '07 and $660 million lower in fiscal '08. These figures represent the near annual amount of revenue we expect to recognize from the undelivered elements accounts on the balance sheet. From a year-over-year growth perspective, this impact represents approximately half a percentage point of consolidated corporate revenue growth in fiscal '07, and approximately 1 percentage point of consolidated corporate revenue growth in fiscal '08. Applied specifically to the Client business in fiscal '08, we expect a 3 percentage point impact in year-over-year Client revenue growth as a result of the Windows Vista revenue recognition methodology. Of course, the magnitude of revenue impact varies with the underlying sales mix between Windows Vista and Windows XP. Our fiscal '08 guidance numbers assume a unit mix of 85% Windows Vista, and 15% Windows XP. The amount of impact we have highlighted today could differ materially to the extent that transition to Windows Vista from Windows XP differs from our forecast. In other words, the faster the transition to Windows Vista, the bigger and more positive the impact will be in fiscal '08. While on the subject of Client revenue, we recognize there's a lot of interest in our outlook for fiscal '08. Although we won't be providing specific Client business guidance on the call today, I would like to briefly provide you with some directional expectations. For your convenience, we have laid these out for you on slide 21 of our earnings slide deck. The starting point for any analysis in our Client business should begin with PC sales in mature markets, which we expect to grow in mid single-digit range. We expect to get a modest uplift from emerging markets, where the underlying market growth is higher and we have the opportunity to reduce piracy. Offsetting this uplift is the successful launch of Windows Vista in 2007, which creates a difficult retail comp in fiscal '08. Adding these together, our expectation is that Client organic revenue growth in fiscal '08 will be in line with, or slightly better than, the mid single-digit growth rate for PC sales in mature markets and that Client’s GAAP revenue growth will be 3 percentage points higher than the organic growth rate, due to Windows Vista revenue recognition methodology. We will provide our specific Client revenue guidance for fiscal '08 in July, but I hope this provide you with some insight into how we're thinking about our forecast, and assist you with your modeling. Now moving on to operating income. Operating income is expected to be between $22.0 billion and $22.5 billion. Excluding certain legal charges in fiscal '07, operating income growth of 12% to 14% is slightly faster than revenue growth. This guidance implies incremental year-over-year COGS plus OpEx spending of between $3.3 billion and $3.6 billion, when you exclude legal charges in fiscal '07. Of these amounts, somewhat less than $2.7 billion is operating expenses, which is consistent with our commentary at the February analyst meeting in New York. I would like to take time here to provide you with some of the key drivers behind our COGS and OpEx spending in fiscal '08. First, let's cover COGS. Incremental COGS spending will be in excess of $600 million, driven primarily by two factors. One, higher network infrastructure costs and delivering online services such as Windows Live, Office Live, CRM Live and Xbox Live. Two, increased scale of our consultant services business. Higher overall revenues and greater unit sales of Zune and Xbox 360 will have some impact as well. In terms of incremental operating expenses, I would like to describe the underlying drivers using the same four categories we used for fiscal '07. The largest category remains our broad array of investments in high growth areas. As we continue to stress, innovation drives long-term growth, and we intend to continue to invest in the best opportunities. This makes up over one-third of the incremental OpEx in fiscal '08. The second largest category is our investment in services, which makes up about a quarter of the incremental OpEx in the business. The online services area is also critical to our future success, and we have built up an appropriate level of potential future investment that reflects our current thinking. The third category is marketing and field sales costs, which makes up about 25% of the total. The remainder of the incremental operating expenses are driven by general increases in costs, as well as unallocated spending related to small acquisitions that we may do during the year. Now for the rest of the income statement. We expect investment income to be lower in fiscal '08 due to lower cash balances resulting from our stock repurchases in fiscal '07. We're also modeling a 30.5% tax rate in fiscal '08, driven by a higher mix of earnings in lower tax rate jurisdictions. Our forecast for fully diluted earnings per share is therefore $1.58 to $1.72, representing growth of 14% to 15%, excluding legal charges and tax benefits in fiscal '07. Similar to fiscal '07, we expect to grow earnings this year at a rate faster than revenue and operating income. As always, I will remind you that as you think about the guidance we have provided that you also consider the risks. Those risks include competitive, legal, execution and general market risks, as well as PC and Turbo hardware growth rates and customer acceptance of our product. Also, our emerging businesses are harder to forecast when compared to our mature businesses and as they become a larger part of the overall financial mix, they may contribute to increased volatility in our performance. I would like to wrap up today with two final and brief observations. The first is that if we take a step back and look at the results we have delivered, as well as the guidance provided for fiscal '08, you find that we're growing revenue, profits and earnings per share at impressive rates on both an absolute and relative basis for a company our size. For example, excluding legal charges and tax benefits, our fiscal '08 guidance implies earnings per share growth of $0.41 to $0.45, or 32% to 35% over two years. The second observation is that I believe the third quarter results and the guidance we have provided are indicative of how we build long-term shareholder value in the company. We do so by driving robust revenue growth for our established cores in the desktop and server markets, as well as by building new cores in online services and entertainment. By translating that revenue growth into strong operating profits and cash flow, allows us the flexibility to make significant investments to drive future growth, and finally by returning capital to shareholders through repurchases and dividends. We believe this is an optimal model for delivering long-term shareholder value and I'm pleased that our third quarter and our forward-looking outlook reflect our execution against this. Thank you for your time today and I will now hand the call over to Colleen so we can take your questions.
Colleen Healy: Let’s now proceed to questions. We want to accommodate questions from as many people as possible, so please avoid multi part questions and limit yourselves to just one question. Operator, will you please repeat your instructions?
Operator: (Operator Instructions) Your first question comes from Heather Bellini - UBS.
Heather Bellini: Thanks Rick and Colleen. I actually had a question about the premium mix that you reported. It seems to be coming in much better than what you guys had forecasted prior to Vista launching. I just wanted to get your sense for how you think this is going to track over time, and should we hold constant this type of Vista Premium mix adoption? In terms of the 85/15 mix that you're forecasting between Vista and XP, how would that have compared to your expectations of what actually happened when XP launched? Thank you.
Chris Liddell: In terms of the Premium mix, you're right, it is coming in above our expectations and are good. Within that obviously you do have a shift between Pro and what was previously Media standard. There's a mix shift within the mix. We think that we are going to see in fiscal year '08 a continuation of the trend that we saw in fiscal year '07 so the numbers from a Premium point of view will be broadly the same. What we're thinking of doing probably for next year is to start to give you some more visibility into how that Premium mix is made up, because, as we have talked about on previous calls, this is quite a different economic impact, depending on in this case whether it is Vista Premium or Vista Business, one being five times the economic benefit relative to the other. So we'll continue to give you the Premium mix as we see, which you can think of as being broadly equal to fiscal year '07 a lot of the benefit that we are seeing. But will also start to give you some visibility into the split of that Premium mix going forward as well. What was the second half of your question?
Heather Bellini: You commented about a 85% Windows Vista mix, 15% XP. What did you see during the last cycle when XP launched, what was the mix?
Colleen Healy: It is not going to be terribly comparable just because of also the SKUs structure.
Chris Liddell: But generally speaking it is faster. So 85/15 is very healthy. Now it obviously may vary on that, it is going to depend on the consumer versus the business.
Heather Bellini: Are you forecasting faster adoption of Vista than what you saw for adoption of XP, is the question?
Chris Liddell: We don't think of it that way. We don't do a comparison back to that. But if you look at the math of it, that is likely to be the result. What we are looking at is the underlying trends we see in the business relative to Vista, regardless of what might have happened four years ago. As we see the mix in consumer versus business, and as we see the overall growth rates and as we see the current adoption, we think 85% is a reasonable starting point for next year.
Colleen Healy: You know, obviously, the variable there that people look to is on the business side and how quickly they're adopting. We feel like because this version, as you'll remember when was in beta was very widely tested, we feel like the tools and costs associated with it and ease of images, we are optimistic but we still don't want to get ahead of ourselves.
Operator: Your next question comes from Charlie DiBona - Sanford Bernstein.
Charlie DiBona: Chris, you spent a lot of time clarifying client guidance and accounting, but I'm wondering if I could maybe change gears for a second and look at my favorite group, the Online Services group? It seems like from your financial results this quarter and from some of the external metrics that you maybe stopped some of the deterioration there. Certainly any metrics more that you want to share there would be appreciated. Going forward, now that you have sort of stabilized the patient, can you maybe talk strategically about how you want to get him up off the table and move in the right direction? Maybe also how you're going to build share and community and how OSG relates in that process to the other business groups, both in building its business and then feeding back into those ones?
Chris Liddell: Lots to digest in that one. But let me cover the ground, and then get back on any particular aspect. You're absolutely right. From a quarterly point of view this was a much better quarter for OSB. If you exclude the Access and Subscription business, the advertising revenue, which is probably the single best metric to look at in terms of growth year on year, was up 23%. If you look at the guidance that we're talking about for next quarter, we're looking at greater than 20% again in the fourth quarter as well. That is a reflection of a number of factors. One is display growth revenue growing broadly in line with market. The second is the benefits now of Ad Center are coming on stream. So we have talked with you about this a lot. We said that we would lap our previous monetization rate on Ad Center at some stage in this fiscal year. Well, we did that in that third quarter. So we're a little ahead of ourselves. We were expecting more like fourth quarter, but we did it in the third quarter. So we are ahead of where we were on the Overture platform of a year ago now and obviously on an appreciating trend. When you look at the number of advertisers that we are getting on the platform, we're getting at or above the rates that we were expecting and with considerably less advertisers than on the Overture platform, we're getting a higher monetization. So we are feeling very good about the rates that we are seeing in terms of Ad Center overall. That is feeding through to the revenue growth numbers that you see, if you exclude the Access. Again, we will try quarter by quarter to give you that advertising number to give you a sense of the health of the underlying business. To your broader question about strategy, from our point of view it is a continuation of what we have talked about, which is we are going to invest in this business because we see it as a long-term one. We like a lot of the growth that we are getting on the display side. We are happy with it. On the communication side, you have the growth in Hotmail and Messenger accounts, which we don't currently monetize to any great extent, but it still is extremely healthy and we're very happy with, for example, some of the relevancy in the underlying product in our search. We aren't happy, clearly, with the market share we have. So some things we are happy with, some things that we're not happy with, or I would like to see a lot better but we are going to continue to invest. We're going to continue to invest in the infrastructure of the business, we will continue to invest in new products, we will continue to invest in the search relevancy side of things. And in terms of the infrastructure, that will support not only the online business, but it will support Office Live. It will support Xbox Live. That is another healthy statistic from our point of view, with greater than 6 million customers now on Xbox Live. So that is a very good platform. The platform will support that area. In terms of accounting, to a large extent we bear the costs inside the Online Services area without trying to change accounting around. We may try and give you more visibility into how it helps some of the other businesses, but certainly strategically it helps them quite a lot.
Operator: Your next question comes from Adam Holt - JP Morgan.
Adam Holt: My question is about the underlying strength in the Office business or the MBD category. If you strip out the one-time events in the quarter, it looks like you still had about 20% growth in MBD. I guess what I'm trying to understand is what was the mix between what came off the balance sheet relative to what was new business? And understanding there's a little bit of retail spike here, how should we think about the Enterprise business feathering in over the next couple of quarters, particularly in the context of how you compare that to Vista?
Chris Liddell: I think it is great. We tend to get 90% of our questions about Client, and to a large extent the MBD business is a real success story in the third quarter. We exceeded our revenue expectations by around $200 million and that was on the back of, to a large extent, just very good retail sales, so sales of units out the door. We feel like that is a direct customer acceptance of a very good product. It didn't result from any balance sheet movements. In fact, we are slightly penalized because of the change in revenue recognition inside that division but to a large extent, very good customer acceptance, very good retail sales inside the quarter. In terms of annuities going forward, which is probably more of the case; obviously we're not going to at this date give you fiscal year '08 numbers, but for the fourth quarter a continuation of very good revenue growth numbers inside that division. Embedded inside fiscal year '08 we think the business will continue to do well. I am happy, very happy with the retail acceptance of the product. From an annuity point of view and a business point of view at this stage it is early days, but it is good as well.
Colleen Healy: Just in terms of that housekeeping matter, we had about $0.5 billion of Tech Guarantee. Your 20% year on year is the normalized growth, and we think it speaks to the strength of the business and the launch in the quarter.
Chris Liddell: But to be clear, 20% is excluding the Tech Guarantee impact.
Adam Holt: If I could just ask a follow-up on that, if you were to look at this business adding into the next quarter with respect to the small business segment of it, are you seeing small businesses gravitate towards long-term contracts, or do you think the small business activity is going to be principally more like licensing and more like the consumer?
Chris Liddell: We aren't seeing any marked difference in the pick up to any great extent. The same split that we have seen in terms of 40% annuity, 40% license only is, broadly speaking, what we are expecting going forward.
Colleen Healy: Just to add to that, the metrics, certainly the 20% billings growth does speak to the Dynamics business, which targets more of that segment that you're talking about. And then on the CRM side, we did announce in March reaching that milestone of 10,000 customers and 400,000 users. We're continuing to work the value proposition there.
Operator: Your next question comes from John DiFucci - Bear Stearns.
John DiFucci: Chris, you told us what the impact of the Technology Guaranteed Program was on the Client business, but you also mentioned a couple of other events that are different this quarter versus previous quarters. There was a revenue recognition change and also the channel preparation for the launch. Can you tell us what the growth would have been if you excluded both of those? Along the same lines, just to follow, on the revenue rec change, the numbers you threw out there seemed a little low to me, looking at the rest of this year and next. Are you going to give us what the impact has been on a quarterly basis?
Chris Liddell: We will certainly give you the Vista revenue recognition impact on a quarter-by-quarter basis. That is what we can do right at the start. We are very happy to do it. If you look at the chart that I referred to, I'm not sure you had a chance to as I was speaking, it gives you it in black and white. It is $220 million in fiscal year '07 and $660 million in fiscal year '08. Of that $220 million in fiscal year '07, it was broadly equal in Q3 and Q4. That would have had about 0.5% impact from a growth rate point of view. That is just for the Vista revenue recognition impact. For the company overall and for Client it was around 3%. We are certainly happy to work through the math. I know there's a lot of moving parts, but we will give you total transparency to the extent we can.
John DiFucci: Even though in Q3 there was only two months out of the three that really had the impact, you think it will be evenly split? If you included that impact, plus the channel preparation for the launches, I think either you or Colleen mentioned generally usually you see a spike in the revenue due to that. During a launch quarter what would the Client growth have been?
Chris Liddell: If I work through the math, if you start with PC unit growth in the quarter, it was around 10% to 12%. We saw OEM unit growth of 20%. So the units grew in excess of PC units and that is people stocking obviously or restocking, and some of the system builder channel impacts as well, so unit growth of around 20%. If you exclude the Vista and the Tech Guarantee, the OEM revenue grew broadly in line to 21% relative to 20% growth. The commercial and retail, which was obviously the retail spike, grew 53% and Client revenue overall would have grown 27%. So if you exclude all the accounting impacts, that is probably the easiest way to work through it. But it is still a very healthy quarter, up 27%.
Operator: Your next question comes from Sara Friar - Goldman Sachs.
Sara Friar: Maybe you could switch to just the Entertainment and Devices division. Could you just give us some clarity, Chris, on whether you are still expecting profitability for that division in FY’08? Obviously that has been a big milestone. I think last quarter it seemed as if you were managing that inventory, but I assumed that was somewhat ahead of a price cut, so any further color you could give us there would be great. And then just one more on the Halo 3 launch. What are you expecting in terms of impact from Halo 3, and just overall attach rates as the cycle gets a little bit more mature?
Chris Liddell: The sales during the quarter in terms of sell-in were around 500,000 consoles. The sell-through, that is what the retailers sells, was higher than that, so our inventory levels did come down to more around normal levels we would expect. We did a good inventory movement during the course of the quarter. In terms of profitability for next year, that is certainly the target. We're working through our budgeting process now, but from my point of view anyway, that is the starting point going into next year. Obviously, there's a lot of moving parts there in terms of our ability to take COGS of the system, how many units we sell and factors like that. But that is certainly the starting point. In terms of Halo 3, that is clearly going to have a positive impact in two senses. One, it gives us more confidence with the number of consoles that we think we are going to be able to sell next year. In terms of a direct impact, obviously it is a third-party product, so it is reasonably profitable from our point of view. It will be several hundreds of millions of dollars in revenue next year.
Sara Friar: Terrific. No change competitively this quarter in terms of Sony and Wii and so on?
Chris Liddell: I'm sorry, what was that?
Sara Friar: Any changes competitively from the other two big game vendors, Sony and Nintendo?
Chris Liddell: No, nothing of significance. We are obviously very happy from a competitive point of view with the response in the marketplace, but nothing of significance.
Operator: Your next question comes from Kirk Materne - Banc of America Securities.
Kirk Materne: Chris, you mentioned going into your fourth quarter you have a number of large multi-year deals up for renewal. Can you just give us some color perhaps around how many of those deals involves say upselling a large enterprise from the Business version to get them on the Enterprise version, which would also take them into a longer-term agreement with you guys around software assurance? I'm just trying to get a sense on how many of those type of deals are still out there where a customer might be on software assurance for Office but not for Vista, for example. Any color around that would be helpful.
Chris Liddell: I can't give you a proportion, but I think if I talk about it the way the field thinks about it, every license that comes up for renewal is an opportunity to sell additional products. When you think about it, it is a three-year anniversary, generally speaking. So in the last three years if you think about the products we have launched, it is not just the obvious ones of Vista and Office. There's a significant amount of additional products that the field now has the ability to sell as part of an enterprise agreement. So there is a significant number of contracts coming up and clearly, there is some risk to the extent those people now have an entitlement to Vista and Office, but there is an opportunity because of all the other products. I don't want to say there is an X percent where we think we will be successful but we certainly feel good about maintaining the renewal rate of two-thirds to three-quarters, and in some instances they would be additional products as well.
Operator: Your next question comes from Kash Rangan - Merrill Lynch.
Kash Rangan: I just want to clarify on the EPS guidance for fiscal '08, that does include the positive impact from the rev rec rate, so how would you quantify that if you look at the $1.68 to $1.72, does $0.04 to $0.05 positive impact from the rev rec seem like a reasonable assumption?
Chris Liddell: We give the specific number, so depending on how you treat it. But if we look at the GAAP unearned income that comes off our balance sheet and we expect to flow through the income statement next year, it is $660 million. So that will equate to around $0.04 a share, if you take an after-tax and divide it by our number of shares. So that number may go up or down slightly depending on our actual sales and the mix of Vista and XP. But if you just take our guidance as it sits, it would be around $0.04 a share.
Kash Rangan: What is the confidence level at this early point in the cycle, Chris, with 85% Vista, 15% XP assumption? What we hear from our surveys is that a lot of the Enterprises seem to want to do an implementation of Vista in 2008. So how are you thinking about the confidence level in the 85/15 mix between Vista and XP?
Chris Liddell: It is early days, so the standard deviation is quite high. But I will just say that our fiscal year '08 picks up the first six months of calendar year 2008. So to the extent that some people are on the sidelines waiting, they may well be looking at a position of early next year and that would pick up our fiscal year. It could be a relatively high swing between 85/15. From a revenue recognition point of view that might move around from an accounting perspective. From a cash flow point of view, it is not really going to have a significant impact.
Kash Rangan: Finally, the units on Vista you disclosed, I think one month after the launch, was 20 million. Any update on that during the quarter how many units of Vista? If you could break that out between OEM and retail, that would be useful.
Chris Liddell: No, I don't have a number to give you today. I'm happy to talk to the Client people, and if there's a number they would like to give out, we will follow-up with that.
Operator: Your next question comes from Brent Thill - Citigroup.
Brent Thill: Thanks, good afternoon. Chris, next year for fiscal '08 on operating margins, I believe that implies roughly flat with '07. Can you help us reconcile, considering that you're headed in probably the strongest point of your product cycle in a number of years, how you expect that operating margin to play out with regard to what your long-term model looks like and where you were at a couple of years ago at much higher operating margins?
Chris Liddell: Sure. I will start with just the guidance we have given you, at least on a GAAP basis. So we talk about revenue growth of 11% to 12%, and operating income growth of 12% to 14%. So you see a slight margin expansion based on that, although some of that is obviously the Vista accounting impact, and obviously earnings per share growing at 14% to 15%, so higher again; so a little bit improved margins in that respect. When I look at next year, we are still in investment mode in Online Services. We are looking at year-on-year growth on expenses broadly in line with what we have talked about. We're talking about growing the company's revenue base 11% to 12%. So if we can get margin expansion, I think that is tremendous. I think you have to look at the underlying businesses and look at them one by one. But if we can grow the company top line 11% to 12% and maintain or possibly slightly enhance our margin structure, I think that is a good starting base for a company of our size.
Brent Thill: I would just be curious to get your thoughts. A number of the hardware companies have mentioned a sluggish March. It appears that you're not seeing that. Maybe offer some thoughts in terms of what the difference is there. As a follow-up on the business segment, you mentioned the consumer segment is tracking ahead of the business. When do you expect the business segment to really start to kick in?
Chris Liddell: Obviously we have a lot of different cycles from a hardware manufacturer, given the number of businesses that we're in. You have to look at it across the whole suite of our businesses. The thing that I would say is we are not seeing any significant slowdown in aggregate across our businesses. Individual businesses may have some, but certainly for the company overall, given the multiplicity of businesses we're involved in, we are seeing healthy demand. We have a good international business as well, which helps as well. I assume your question was mainly around North America, but a large number of our sales are outside North America and the economies are doing very well there and we're certainly seeing growth rates that are very good there as well. So no particular aspects there. What was the second part of your question?
Brent Thill: Just in terms of when do you think the business segment starts to maybe eclipse the consumer segment, when you see that strength kicking in?
Chris Liddell: I think the business segment is probably going to continue to be broadly equal to what it is at the moment. So it is really around consumer growth and whether that changes or not. But if the business growth continues in the sort of mid single-digits, the consumer growth is probably growing in excess of 10%. I don't necessarily see that inverting for the foreseeable future. I think customer growth would have to slide down quite a lot in order to dip below business growth, which I think is going to remain relatively healthy.
Colleen Healy: Thanks so much. Thanks to everyone for your participation in today's call. If you have any further questions, please feel free to call me or my team directly. As I mentioned at the beginning of this call, this conference call will be available on replay at our Investor Relations website through close of business April 26, 2008. In addition, you can hear the replay by dialing 866-479-2456, or for international calls dial 203-369-1531. The dial-in replay will be available through the close of business May 4, 2007. Thanks again for joining us today. | [
{
"speaker": "Operator",
"text": "Welcome to the Microsoft 2007 fiscal year third quarter earnings conference call. (Operator Instructions) I would now like to turn the call over to Ms. Colleen Healy, General Manager, Investor Relations. Please go ahead."
},
{
"speaker": "Colleen Healy",
"text": "Good afternoon, everyone and thank you for joining us today. This afternoon I am joined by Chris Liddell, Senior Vice President and Chief Financial Officer; Frank Brod, Corporate Vice President and Chief Accounting Officer; and John Seethoff, Deputy General Counsel. Today's call will start with Chris providing some key takeaways for the third quarter of fiscal year 2007, and an overview of expectations for what remains of the fiscal year. I will then provide detail around our third quarter results, and then turn it back to Chris for a more detailed discussion of our guidance for the fourth quarter, as well as a preliminary outlook for fiscal year 2008. After that we will take your questions. We filed our 10-Q today in conjunction with our earnings release, therefore you have available the earnings release, MD&A, financial statements and footnotes. We have also posted our quarterly financial summary slide deck, which is intended to follow the flow of our prepared remarks in order to assist you. This slide deck offers highlights from the quarter, outlines our guidance and provides a reconciliation of differences between GAAP and non-GAAP financial measures that we will talk about today. You can find the earnings release, the 10-Q, and the quarterly financial summary slide deck on the Investor Relations website at www.Microsoft.com/MSFT . Today’s call will be recorded. Please be aware that if you decide to ask a question, it will be included in both our live transmission as well as any future use of the recording. As always, shareholders and analysts can listen to a live webcast of today's call at the Microsoft Investor Relations website. A replay of the call will be available at the same site through the close of business on April 26, 2008. This conference call report is protected by copyright law and international treaty. Unauthorized reproduction or distribution of this report, or any portion of it, may result in civil and criminal penalties. Any recording or other use or transmission of the text or audio of today's call is not allowed without the expressed permission of Microsoft. We will be making statements during this call that are forward-looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in today's earnings press release, in the comments made during this conference call, and in the Risk Factors section of our 10-Q, our 2006 Form 10-K, and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statements. With that, let me now turn it over to Chris."
},
{
"speaker": "Chris Liddell",
"text": "Thanks, Colleen. Good afternoon, everyone. Thanks for joining us today. We're going to use our prepared remarks this afternoon to share our third quarter results, discuss our outlook for the fourth quarter, and provide a preliminary view of fiscal 2008. I'm extremely pleased with the company's financial performance during the quarter, as revenue, operating income and earnings per share exceeded our expectations and each grew at strong double-digit rates. Our results were primarily driven by strength in our core products. Windows Vista and 2007 Microsoft Office System will have a multi-year impact, and both are off to a very good start. Revenue growth in the third quarter was 32% and even if you were to exclude the $1.7 billion in recognition of previously deferred revenue associated predominately with our Technology Guarantee Programs for Windows and Office, our revenue growth would have been an extremely good 17%. Four of our five businesses delivered double-digit growth and we saw forward strength across all customer segments and channels. Excluding $0.01 in legal charges and a $0.02 tax benefit in the quarter, the revenue upside flowed through to operating income and earnings per share, which came in at $0.03 to $0.04 higher than our guidance in January. Cash flow from operations was also over $7 billion, indicative of the underlying strength of our business, and was a record for the company. Lastly, we continue to execute on our financial strategy. During the quarter we repurchased over $6.7 billion in company stock, and paid out just under $1 billion in dividends. This brings combined year-to-date repurchases and dividends to over $22.5 billion, which represents over 150% of our cash flow from operations over that same period. Moving now to the full fiscal year, we expect a strong finish to what has been an excellent year. We are increasing our revenue, operating income and earnings per share guidance for the year on the strength of our new product launches. Excluding certain legal charges and tax benefits in the prior and current years, we expect revenue growth in excess of 15% and earnings per share growth in excess of 16%. For both high level themes for the quarter and for the full year 2007, I'm going to turn the call over to Colleen for more details on our third quarter performance."
},
{
"speaker": "Colleen Healy",
"text": "Thanks, Chris. As Chris mentioned, the results for Q3 were excellent. Let me provide you with details on our financial performance, starting with revenue. I will discuss top line financial and business momentum points, and then follow-up with revenue performance for each of the business units. All growth comparisons I mention relate to the comparable quarter of last year, unless otherwise specified. Revenue for the quarter grew 32% to $14.4 billion, which includes $1.7 billion in recognition primarily from the Technology Guarantee Program. Excluding the recognition of these deferrals, revenue growth would have been 17%. Growth this quarter was driven by sales in our Client and Microsoft Business Division, following the general availability of Windows Vista and the 2007 Microsoft Office System in January. Server and Tools had another solid quarter. These three core businesses turned in notable performance, each growing at a double-digit rate, and collectively growing revenues 22%, or over $2 billion in absolute growth before the recognition of the Tech Guarantees. We saw continued strength in the underlying PC hardware market, which we estimate grew 10% to 12% during the quarter, a bit faster than we had expected. Growth in emerging markets continues to outpace that of mature markets, and the consumer PC shipment growth outpaced business shipments. Europe, Asia excluding Japan and Latin America maintained double-digit growth rates, while the remaining regions grew at single-digits. Our mix of product billings for the quarter was approximately 30% from OEMs, over 25% from multi-year licensing agreements, over 20% from license only sales, and the balance from our other businesses. The mix this quarter versus the same period in the prior year is higher in license only sales, primarily due to retail sales following the consumer launches of Windows Vista and the 2007 Microsoft Office System, and lower in our other businesses due to our core product making up a higher mix of revenue this quarter, as you would expect given where we are in our various product lifecycles. Our field sales force saw broad strength across our customer segments and regions. Our small, midmarket and retail sales group actively engaged with our customers and partners, readying the market for the product launches. The entertainment sales force drove robust volume license sales, and entertainment and enterprise agreements renewal rates at the high end of our historical range of 66% to 75%. We are delighted that the benefits and value proposition offered in the recent releases of our flagship products are resonating with customers. As a result of a strong annuity licensing results, our unearned revenue balance ended the quarter at $10.3 billion, up 16% over the same period in the prior year. Our contracted not billed balance at the end of March was sequentially higher and continues to exceed $9.5 billion. Taking into account reported revenue and changes in the unearned and contracted not billed balances, bookings growth totaled 20%, with bookings in our core business of Client, Microsoft Business Division and Server and Tools growing 25%. Before closing out the revenue overview, let me add that changes in foreign exchange rates added about 2 percentage points to our overall revenue growth rate in the quarter, and was generally in line with our expectations going into the quarter. Now I will provide revenue highlights by business segment. Client revenue of $5.3 billion, an increase of 67%, includes the recognition of $1.2 billion from Tech Guarantees and pre-shipments. Adjusting for this impact, Client revenue would have been $4.1 billion, up 30%, driven by growth in all channels due to the successful consumer launches of Windows Vista during the quarter. OEM revenue increased 24%, excluding the recognition of the Tech Guarantee deferrals, driven by 20% growth in OEM license units. The 8 to 10 point difference between OEM license unit growth and the overall PC market growth during the quarter is a result of a normal spike in license sales on the launch of a new operating system in our system builder channel, restocking of retail inventory levels by OEMs as a result of the consumer launch, and continued progress on unlicensed PCs under our existing program. Consistent with the results we saw last quarter and the relative strength in the Consumer segment following the launch, we continue to see a change within the mix of sales of our Premium Edition operating system. OEM Premium mix was 71%, an increase of 18 percentage points from the prior year, driven by sales of Windows Vista Home Premium, while our other business editions of Windows declined a few points in the overall mix. As we shared with you previously, Windows Vista business generates over five times the pricing of our Windows Vista Home Basic and of Windows Vista Home Premium. So the net result is that the increase in Premium mix added about 1 percentage point of growth to OEM revenue. Client, commercial and retail licensing grew 63%, excluding the recognition of pre-launch revenue deferrals, driven by strong sales to the retail channel following the consumer launch of Windows Vista and a very healthy commercial business. Server and Tools revenue of $2.7 billion grew 15%, primarily driven by double-digit growth in Windows Server, SQL Server and Visual Studio, as well as growth in our consulting and Premier services. Also, during the quarter we launched Systems Center Operations Manager 2007, which provides end-to-end management for the monitoring and reporting of Windows environments. In our Online Services business we saw continued improvement in our advertising platform monetization, which resulted in advertising revenue growth of 23%. Revenue for our Online Services business overall increased 11% to $6.2 million, driven by the growth in advertising revenue, partially offset by an expected decline in access revenue. Search revenue benefited from a higher number of search queries, and increased revenue per search on both a year on year and consequential basis. We are now monetizing more effectively in the U.S. on our own Ad Center platform than we had under third-party Overture at this time last year. Our display growth was in line with what is a healthy market, driven by an increase in page views. This quarter we forged content partnerships with Newscorp, NBC and CBS to enhance MSN's premium video inventory. Microsoft Business Division revenue of $4.8 billion grew 34%, or 20% after adjusting for the Tech Guarantee. Growth was driven by both consumer and business sales of the 2007 Microsoft Office system following the recent launches. The performance for the quarter was highlighted by a strong consumer response to the 2007 Microsoft Office system, which drove better than expected retail sales. We are also pleased with the results of our Dynamics business which showed healthy performance across both the ERP and CRM product lines, driving a 20% increase in customer billing. During the quarter we announced plans to acquire TellMe Networks, bringing this industry-leading expertise and voice services to our existing speech platform and unified communications offering. Consistent with our guidance, Entertainment and Devices revenue decreased 21% as a result of lower Xbox 360 sales. We sold over 5,000 Xbox 360 consoles during the quarter, bringing our life-to-date sell-in to approximately $11 million. Software and accessory attach rates remain at record levels in the U.S. per MPV, and we have passed the 6 million member mark for Xbox Live. Our Mobile and Embedded Devices business continued to turn in strong performance, with revenue growth in excess of 30%. During the quarter we unveiled Windows Mobile 6, the next version of our Windows Mobile software platform. We expect to see an increasing number of Windows Mobile 6 powered devices coming to market through the rest of this year. Now for the rest of the income statement. Cost of revenue increased 6%, primarily driven by data center costs, product costs associated with the launch of Windows Vista, and the growth in consulting services, partially offset by a decline in Xbox 360 console sales. Other operating expenses increased $928 million, or 20%, excluding legal charges of $154 million in the current quarter and $397 million in the same quarter from the prior year. This is favorable to our expectations, due primarily to shifting some marketing and product development costs into the fourth quarter. Operating income of $6.6 billion, or $5.1 billion after adjusting for the impact of the Tech Guarantee deferrals and legal charges, is up 18% from the prior year, driven by the 22% revenue growth in our core businesses of Client, Microsoft Business Division, and Server and Tools. Investment income and other totaled $382 million for the quarter. Our effective tax rate for the quarter was 29%, and was lower than expected due to a $195 million one-time tax benefit. Cash flow from operations increased 60% to $7.3 billion. During the quarter we repurchased 237 million shares, or $6.7 billion of company stock, and paid out $976 million in dividends to shareholders. Diluted shares outstanding for the quarter were 9.9 billion, down 5% from the prior year as a result of execution against our share repurchase program. Earnings per share for the quarter were $0.50, which includes the following non-recurring items: $0.12 related to the impact of the Tech Guarantees, a tax benefit of $0.02 offset by $0.01 in legal charges. So in summary, the third quarter broadly exceeded our expectations, driven by the extremely positive consumer response to the launches of our flagship products. With that, let me now turn it back to Chris, who will now provide you with our expectations for the fourth quarter and a preliminary outlook for fiscal year 2008."
},
{
"speaker": "Chris Liddell",
"text": "Thanks, Colleen. Let me now outline some key assumptions that we have used in putting together the outlook for the fourth quarter. Firstly, we estimate that PC unit growth for the quarter will be 10% to 12%. Within the overall PC market we expect current trends to continue, with a consumer segment growth exceeding that of the business segment, and emerging market growth exceeding that of mature markets. In contrast, third party analysts have lowered their full year server hardware growth estimate to 4% to 6% and although Server and Tools revenue is impacted by many additional factors, we have incorporated that into our guidance. Lastly, our guidance for the fourth quarter assumes that changes in foreign exchange rates will not have a significant impact on revenue growth rates for the quarter. So now for our detailed guidance. We expect fourth quarter revenue of $13.1 billion to $13.4 billion, growing 11% to 14%. Revenue guidance by business group is largely consistent with what we provided in January and so in the interested time I will simply provide you with the numbers. For Client we expect revenue growth of 14% to 15% for the fourth quarter. For Server and Tools, 16% to 17%. For Online Services, 10% to 15%, although excluding access subscription and transactions revenue, this implies advertising growth of 19% to 27%. For Microsoft Business Division, 13% to 14%. Finally, Entertainment and Devices revenue is expected to be down 2% to 11% in the fourth quarter. Now moving on to operating income. For the fourth quarter we expect to generate between $5.0 billion and $5.2 billion of operating income, representing 28% to 33% growth over the prior year. Well, 17% to 22% when legal charges of $351 million from the year-ago quarter are excluded. This was lower than the implied guidance from January due primarily to two factors. The first is a shift in operating expenses from the third quarter, as our full year total remains consistent with what we said in January. The second is higher COGS related to Xbox console and Windows Vista retail sales. We now estimate a fourth quarter effective tax rate of 31.5% due to a greater mix of forecasted earnings in higher tax rate jurisdictions. For diluted earnings per share, we expect $0.37 to $0.39 for the fourth quarter. So with that fourth quarter guidance we arrive at the following expectations for the fiscal year. Revenue between $50.9 billion and $51.2 billion, representing growth of 15% to 16%. Operating income of $19.5 billion to $19.7 billion, or excluding certain legal charges, $19.7 billion to $19.9 billion, representing growth of 12% to 13% and for fully diluted earnings per share of $1.48 to $1.50 or adjusting for certain legal charges and tax benefits, $1.47 to $1.49, and representing growth of 16% to 17%. We are clearly pleased that our strong performance in Q3 has allowed us to raise our revenue, operating income and earnings per share estimates for the full year. From a balance sheet perspective, we expect unearned revenue to finish the year up 8% to 10%, an increase of 2 percentage points from our January guidance. This increase reflects our growing confidence in multi-year contract billings in Q4, where the revenue opportunity and undoubtedly risk, is the largest we have seen in two years. The deal pipeline is robust. The value proposition for multi-year contracts are strong and the product portfolio is broad and deep. With that, let's turn to our fiscal year '08 preliminary outlook. As is always the case at this time of year, we are providing you with our first look at the next fiscal year prior to finalizing our internal budgeting and planning process. Reflecting where we are in the planning cycle and consistent with our past practice, we're not currently in a position to give specific business group detail. I should also highlight that this guidance provides you with a view that balances both the risks and opportunities as we currently see them. For context, our expectations are based on a stable IT spending environment. 2007 IT spending has been generally healthy and although we may see softening in select areas such as server hardware growth, we're not expecting any significant changes on a regional basis in fiscal 2008. Also, we're not modeling any significant impact to year-over-year revenue growth from changes in foreign exchange rates. The continuous product innovation we have been stressing for two years is driving our expected growth and our product cycle continues in the next 12 months with the launches of, for example, Longhorn Server, the next version of our CRM software and live CRM service, Halo 3, the next version of Visual Studio, new Windows Live Search and Communication Services, Office Communications Server, Expressions Studio, Office Performance Point Server, Forefront Client Security, and many other products and services from across the company. We expect our product line ought to generate revenue of $56.5 billion to $57.5 billion in fiscal '08, representing growth of 11% to 12%. On an absolute basis, this translates into an increase of over $5.5 billion, an amount larger than the total annual revenue of some Fortune 500 companies. As we have previewed with you since October, this guidance reflects the requirements for Windows Vista revenue recognition, which results in a relatively faster revenue recognition as compared to Windows XP, where we have stood at 5% to 25% of license revenue. We are committed to transparency on this, so I would like to provide you with our revenue guidance adjusted for the impact of Windows Vista revenue recognition. We have included slide 20 in our earnings slide deck, which provide you with detail on the associated underlying balance sheet and P&L adjustments. Had we never deferred some delivered elements on Windows XP sales, our expected accounting revenue would be approximately $220 million lower in fiscal '07 and $660 million lower in fiscal '08. These figures represent the near annual amount of revenue we expect to recognize from the undelivered elements accounts on the balance sheet. From a year-over-year growth perspective, this impact represents approximately half a percentage point of consolidated corporate revenue growth in fiscal '07, and approximately 1 percentage point of consolidated corporate revenue growth in fiscal '08. Applied specifically to the Client business in fiscal '08, we expect a 3 percentage point impact in year-over-year Client revenue growth as a result of the Windows Vista revenue recognition methodology. Of course, the magnitude of revenue impact varies with the underlying sales mix between Windows Vista and Windows XP. Our fiscal '08 guidance numbers assume a unit mix of 85% Windows Vista, and 15% Windows XP. The amount of impact we have highlighted today could differ materially to the extent that transition to Windows Vista from Windows XP differs from our forecast. In other words, the faster the transition to Windows Vista, the bigger and more positive the impact will be in fiscal '08. While on the subject of Client revenue, we recognize there's a lot of interest in our outlook for fiscal '08. Although we won't be providing specific Client business guidance on the call today, I would like to briefly provide you with some directional expectations. For your convenience, we have laid these out for you on slide 21 of our earnings slide deck. The starting point for any analysis in our Client business should begin with PC sales in mature markets, which we expect to grow in mid single-digit range. We expect to get a modest uplift from emerging markets, where the underlying market growth is higher and we have the opportunity to reduce piracy. Offsetting this uplift is the successful launch of Windows Vista in 2007, which creates a difficult retail comp in fiscal '08. Adding these together, our expectation is that Client organic revenue growth in fiscal '08 will be in line with, or slightly better than, the mid single-digit growth rate for PC sales in mature markets and that Client’s GAAP revenue growth will be 3 percentage points higher than the organic growth rate, due to Windows Vista revenue recognition methodology. We will provide our specific Client revenue guidance for fiscal '08 in July, but I hope this provide you with some insight into how we're thinking about our forecast, and assist you with your modeling. Now moving on to operating income. Operating income is expected to be between $22.0 billion and $22.5 billion. Excluding certain legal charges in fiscal '07, operating income growth of 12% to 14% is slightly faster than revenue growth. This guidance implies incremental year-over-year COGS plus OpEx spending of between $3.3 billion and $3.6 billion, when you exclude legal charges in fiscal '07. Of these amounts, somewhat less than $2.7 billion is operating expenses, which is consistent with our commentary at the February analyst meeting in New York. I would like to take time here to provide you with some of the key drivers behind our COGS and OpEx spending in fiscal '08. First, let's cover COGS. Incremental COGS spending will be in excess of $600 million, driven primarily by two factors. One, higher network infrastructure costs and delivering online services such as Windows Live, Office Live, CRM Live and Xbox Live. Two, increased scale of our consultant services business. Higher overall revenues and greater unit sales of Zune and Xbox 360 will have some impact as well. In terms of incremental operating expenses, I would like to describe the underlying drivers using the same four categories we used for fiscal '07. The largest category remains our broad array of investments in high growth areas. As we continue to stress, innovation drives long-term growth, and we intend to continue to invest in the best opportunities. This makes up over one-third of the incremental OpEx in fiscal '08. The second largest category is our investment in services, which makes up about a quarter of the incremental OpEx in the business. The online services area is also critical to our future success, and we have built up an appropriate level of potential future investment that reflects our current thinking. The third category is marketing and field sales costs, which makes up about 25% of the total. The remainder of the incremental operating expenses are driven by general increases in costs, as well as unallocated spending related to small acquisitions that we may do during the year. Now for the rest of the income statement. We expect investment income to be lower in fiscal '08 due to lower cash balances resulting from our stock repurchases in fiscal '07. We're also modeling a 30.5% tax rate in fiscal '08, driven by a higher mix of earnings in lower tax rate jurisdictions. Our forecast for fully diluted earnings per share is therefore $1.58 to $1.72, representing growth of 14% to 15%, excluding legal charges and tax benefits in fiscal '07. Similar to fiscal '07, we expect to grow earnings this year at a rate faster than revenue and operating income. As always, I will remind you that as you think about the guidance we have provided that you also consider the risks. Those risks include competitive, legal, execution and general market risks, as well as PC and Turbo hardware growth rates and customer acceptance of our product. Also, our emerging businesses are harder to forecast when compared to our mature businesses and as they become a larger part of the overall financial mix, they may contribute to increased volatility in our performance. I would like to wrap up today with two final and brief observations. The first is that if we take a step back and look at the results we have delivered, as well as the guidance provided for fiscal '08, you find that we're growing revenue, profits and earnings per share at impressive rates on both an absolute and relative basis for a company our size. For example, excluding legal charges and tax benefits, our fiscal '08 guidance implies earnings per share growth of $0.41 to $0.45, or 32% to 35% over two years. The second observation is that I believe the third quarter results and the guidance we have provided are indicative of how we build long-term shareholder value in the company. We do so by driving robust revenue growth for our established cores in the desktop and server markets, as well as by building new cores in online services and entertainment. By translating that revenue growth into strong operating profits and cash flow, allows us the flexibility to make significant investments to drive future growth, and finally by returning capital to shareholders through repurchases and dividends. We believe this is an optimal model for delivering long-term shareholder value and I'm pleased that our third quarter and our forward-looking outlook reflect our execution against this. Thank you for your time today and I will now hand the call over to Colleen so we can take your questions."
},
{
"speaker": "Colleen Healy",
"text": "Let’s now proceed to questions. We want to accommodate questions from as many people as possible, so please avoid multi part questions and limit yourselves to just one question. Operator, will you please repeat your instructions?"
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Heather Bellini - UBS."
},
{
"speaker": "Heather Bellini",
"text": "Thanks Rick and Colleen. I actually had a question about the premium mix that you reported. It seems to be coming in much better than what you guys had forecasted prior to Vista launching. I just wanted to get your sense for how you think this is going to track over time, and should we hold constant this type of Vista Premium mix adoption? In terms of the 85/15 mix that you're forecasting between Vista and XP, how would that have compared to your expectations of what actually happened when XP launched? Thank you."
},
{
"speaker": "Chris Liddell",
"text": "In terms of the Premium mix, you're right, it is coming in above our expectations and are good. Within that obviously you do have a shift between Pro and what was previously Media standard. There's a mix shift within the mix. We think that we are going to see in fiscal year '08 a continuation of the trend that we saw in fiscal year '07 so the numbers from a Premium point of view will be broadly the same. What we're thinking of doing probably for next year is to start to give you some more visibility into how that Premium mix is made up, because, as we have talked about on previous calls, this is quite a different economic impact, depending on in this case whether it is Vista Premium or Vista Business, one being five times the economic benefit relative to the other. So we'll continue to give you the Premium mix as we see, which you can think of as being broadly equal to fiscal year '07 a lot of the benefit that we are seeing. But will also start to give you some visibility into the split of that Premium mix going forward as well. What was the second half of your question?"
},
{
"speaker": "Heather Bellini",
"text": "You commented about a 85% Windows Vista mix, 15% XP. What did you see during the last cycle when XP launched, what was the mix?"
},
{
"speaker": "Colleen Healy",
"text": "It is not going to be terribly comparable just because of also the SKUs structure."
},
{
"speaker": "Chris Liddell",
"text": "But generally speaking it is faster. So 85/15 is very healthy. Now it obviously may vary on that, it is going to depend on the consumer versus the business."
},
{
"speaker": "Heather Bellini",
"text": "Are you forecasting faster adoption of Vista than what you saw for adoption of XP, is the question?"
},
{
"speaker": "Chris Liddell",
"text": "We don't think of it that way. We don't do a comparison back to that. But if you look at the math of it, that is likely to be the result. What we are looking at is the underlying trends we see in the business relative to Vista, regardless of what might have happened four years ago. As we see the mix in consumer versus business, and as we see the overall growth rates and as we see the current adoption, we think 85% is a reasonable starting point for next year."
},
{
"speaker": "Colleen Healy",
"text": "You know, obviously, the variable there that people look to is on the business side and how quickly they're adopting. We feel like because this version, as you'll remember when was in beta was very widely tested, we feel like the tools and costs associated with it and ease of images, we are optimistic but we still don't want to get ahead of ourselves."
},
{
"speaker": "Operator",
"text": "Your next question comes from Charlie DiBona - Sanford Bernstein."
},
{
"speaker": "Charlie DiBona",
"text": "Chris, you spent a lot of time clarifying client guidance and accounting, but I'm wondering if I could maybe change gears for a second and look at my favorite group, the Online Services group? It seems like from your financial results this quarter and from some of the external metrics that you maybe stopped some of the deterioration there. Certainly any metrics more that you want to share there would be appreciated. Going forward, now that you have sort of stabilized the patient, can you maybe talk strategically about how you want to get him up off the table and move in the right direction? Maybe also how you're going to build share and community and how OSG relates in that process to the other business groups, both in building its business and then feeding back into those ones?"
},
{
"speaker": "Chris Liddell",
"text": "Lots to digest in that one. But let me cover the ground, and then get back on any particular aspect. You're absolutely right. From a quarterly point of view this was a much better quarter for OSB. If you exclude the Access and Subscription business, the advertising revenue, which is probably the single best metric to look at in terms of growth year on year, was up 23%. If you look at the guidance that we're talking about for next quarter, we're looking at greater than 20% again in the fourth quarter as well. That is a reflection of a number of factors. One is display growth revenue growing broadly in line with market. The second is the benefits now of Ad Center are coming on stream. So we have talked with you about this a lot. We said that we would lap our previous monetization rate on Ad Center at some stage in this fiscal year. Well, we did that in that third quarter. So we're a little ahead of ourselves. We were expecting more like fourth quarter, but we did it in the third quarter. So we are ahead of where we were on the Overture platform of a year ago now and obviously on an appreciating trend. When you look at the number of advertisers that we are getting on the platform, we're getting at or above the rates that we were expecting and with considerably less advertisers than on the Overture platform, we're getting a higher monetization. So we are feeling very good about the rates that we are seeing in terms of Ad Center overall. That is feeding through to the revenue growth numbers that you see, if you exclude the Access. Again, we will try quarter by quarter to give you that advertising number to give you a sense of the health of the underlying business. To your broader question about strategy, from our point of view it is a continuation of what we have talked about, which is we are going to invest in this business because we see it as a long-term one. We like a lot of the growth that we are getting on the display side. We are happy with it. On the communication side, you have the growth in Hotmail and Messenger accounts, which we don't currently monetize to any great extent, but it still is extremely healthy and we're very happy with, for example, some of the relevancy in the underlying product in our search. We aren't happy, clearly, with the market share we have. So some things we are happy with, some things that we're not happy with, or I would like to see a lot better but we are going to continue to invest. We're going to continue to invest in the infrastructure of the business, we will continue to invest in new products, we will continue to invest in the search relevancy side of things. And in terms of the infrastructure, that will support not only the online business, but it will support Office Live. It will support Xbox Live. That is another healthy statistic from our point of view, with greater than 6 million customers now on Xbox Live. So that is a very good platform. The platform will support that area. In terms of accounting, to a large extent we bear the costs inside the Online Services area without trying to change accounting around. We may try and give you more visibility into how it helps some of the other businesses, but certainly strategically it helps them quite a lot."
},
{
"speaker": "Operator",
"text": "Your next question comes from Adam Holt - JP Morgan."
},
{
"speaker": "Adam Holt",
"text": "My question is about the underlying strength in the Office business or the MBD category. If you strip out the one-time events in the quarter, it looks like you still had about 20% growth in MBD. I guess what I'm trying to understand is what was the mix between what came off the balance sheet relative to what was new business? And understanding there's a little bit of retail spike here, how should we think about the Enterprise business feathering in over the next couple of quarters, particularly in the context of how you compare that to Vista?"
},
{
"speaker": "Chris Liddell",
"text": "I think it is great. We tend to get 90% of our questions about Client, and to a large extent the MBD business is a real success story in the third quarter. We exceeded our revenue expectations by around $200 million and that was on the back of, to a large extent, just very good retail sales, so sales of units out the door. We feel like that is a direct customer acceptance of a very good product. It didn't result from any balance sheet movements. In fact, we are slightly penalized because of the change in revenue recognition inside that division but to a large extent, very good customer acceptance, very good retail sales inside the quarter. In terms of annuities going forward, which is probably more of the case; obviously we're not going to at this date give you fiscal year '08 numbers, but for the fourth quarter a continuation of very good revenue growth numbers inside that division. Embedded inside fiscal year '08 we think the business will continue to do well. I am happy, very happy with the retail acceptance of the product. From an annuity point of view and a business point of view at this stage it is early days, but it is good as well."
},
{
"speaker": "Colleen Healy",
"text": "Just in terms of that housekeeping matter, we had about $0.5 billion of Tech Guarantee. Your 20% year on year is the normalized growth, and we think it speaks to the strength of the business and the launch in the quarter."
},
{
"speaker": "Chris Liddell",
"text": "But to be clear, 20% is excluding the Tech Guarantee impact."
},
{
"speaker": "Adam Holt",
"text": "If I could just ask a follow-up on that, if you were to look at this business adding into the next quarter with respect to the small business segment of it, are you seeing small businesses gravitate towards long-term contracts, or do you think the small business activity is going to be principally more like licensing and more like the consumer?"
},
{
"speaker": "Chris Liddell",
"text": "We aren't seeing any marked difference in the pick up to any great extent. The same split that we have seen in terms of 40% annuity, 40% license only is, broadly speaking, what we are expecting going forward."
},
{
"speaker": "Colleen Healy",
"text": "Just to add to that, the metrics, certainly the 20% billings growth does speak to the Dynamics business, which targets more of that segment that you're talking about. And then on the CRM side, we did announce in March reaching that milestone of 10,000 customers and 400,000 users. We're continuing to work the value proposition there."
},
{
"speaker": "Operator",
"text": "Your next question comes from John DiFucci - Bear Stearns."
},
{
"speaker": "John DiFucci",
"text": "Chris, you told us what the impact of the Technology Guaranteed Program was on the Client business, but you also mentioned a couple of other events that are different this quarter versus previous quarters. There was a revenue recognition change and also the channel preparation for the launch. Can you tell us what the growth would have been if you excluded both of those? Along the same lines, just to follow, on the revenue rec change, the numbers you threw out there seemed a little low to me, looking at the rest of this year and next. Are you going to give us what the impact has been on a quarterly basis?"
},
{
"speaker": "Chris Liddell",
"text": "We will certainly give you the Vista revenue recognition impact on a quarter-by-quarter basis. That is what we can do right at the start. We are very happy to do it. If you look at the chart that I referred to, I'm not sure you had a chance to as I was speaking, it gives you it in black and white. It is $220 million in fiscal year '07 and $660 million in fiscal year '08. Of that $220 million in fiscal year '07, it was broadly equal in Q3 and Q4. That would have had about 0.5% impact from a growth rate point of view. That is just for the Vista revenue recognition impact. For the company overall and for Client it was around 3%. We are certainly happy to work through the math. I know there's a lot of moving parts, but we will give you total transparency to the extent we can."
},
{
"speaker": "John DiFucci",
"text": "Even though in Q3 there was only two months out of the three that really had the impact, you think it will be evenly split? If you included that impact, plus the channel preparation for the launches, I think either you or Colleen mentioned generally usually you see a spike in the revenue due to that. During a launch quarter what would the Client growth have been?"
},
{
"speaker": "Chris Liddell",
"text": "If I work through the math, if you start with PC unit growth in the quarter, it was around 10% to 12%. We saw OEM unit growth of 20%. So the units grew in excess of PC units and that is people stocking obviously or restocking, and some of the system builder channel impacts as well, so unit growth of around 20%. If you exclude the Vista and the Tech Guarantee, the OEM revenue grew broadly in line to 21% relative to 20% growth. The commercial and retail, which was obviously the retail spike, grew 53% and Client revenue overall would have grown 27%. So if you exclude all the accounting impacts, that is probably the easiest way to work through it. But it is still a very healthy quarter, up 27%."
},
{
"speaker": "Operator",
"text": "Your next question comes from Sara Friar - Goldman Sachs."
},
{
"speaker": "Sara Friar",
"text": "Maybe you could switch to just the Entertainment and Devices division. Could you just give us some clarity, Chris, on whether you are still expecting profitability for that division in FY’08? Obviously that has been a big milestone. I think last quarter it seemed as if you were managing that inventory, but I assumed that was somewhat ahead of a price cut, so any further color you could give us there would be great. And then just one more on the Halo 3 launch. What are you expecting in terms of impact from Halo 3, and just overall attach rates as the cycle gets a little bit more mature?"
},
{
"speaker": "Chris Liddell",
"text": "The sales during the quarter in terms of sell-in were around 500,000 consoles. The sell-through, that is what the retailers sells, was higher than that, so our inventory levels did come down to more around normal levels we would expect. We did a good inventory movement during the course of the quarter. In terms of profitability for next year, that is certainly the target. We're working through our budgeting process now, but from my point of view anyway, that is the starting point going into next year. Obviously, there's a lot of moving parts there in terms of our ability to take COGS of the system, how many units we sell and factors like that. But that is certainly the starting point. In terms of Halo 3, that is clearly going to have a positive impact in two senses. One, it gives us more confidence with the number of consoles that we think we are going to be able to sell next year. In terms of a direct impact, obviously it is a third-party product, so it is reasonably profitable from our point of view. It will be several hundreds of millions of dollars in revenue next year."
},
{
"speaker": "Sara Friar",
"text": "Terrific. No change competitively this quarter in terms of Sony and Wii and so on?"
},
{
"speaker": "Chris Liddell",
"text": "I'm sorry, what was that?"
},
{
"speaker": "Sara Friar",
"text": "Any changes competitively from the other two big game vendors, Sony and Nintendo?"
},
{
"speaker": "Chris Liddell",
"text": "No, nothing of significance. We are obviously very happy from a competitive point of view with the response in the marketplace, but nothing of significance."
},
{
"speaker": "Operator",
"text": "Your next question comes from Kirk Materne - Banc of America Securities."
},
{
"speaker": "Kirk Materne",
"text": "Chris, you mentioned going into your fourth quarter you have a number of large multi-year deals up for renewal. Can you just give us some color perhaps around how many of those deals involves say upselling a large enterprise from the Business version to get them on the Enterprise version, which would also take them into a longer-term agreement with you guys around software assurance? I'm just trying to get a sense on how many of those type of deals are still out there where a customer might be on software assurance for Office but not for Vista, for example. Any color around that would be helpful."
},
{
"speaker": "Chris Liddell",
"text": "I can't give you a proportion, but I think if I talk about it the way the field thinks about it, every license that comes up for renewal is an opportunity to sell additional products. When you think about it, it is a three-year anniversary, generally speaking. So in the last three years if you think about the products we have launched, it is not just the obvious ones of Vista and Office. There's a significant amount of additional products that the field now has the ability to sell as part of an enterprise agreement. So there is a significant number of contracts coming up and clearly, there is some risk to the extent those people now have an entitlement to Vista and Office, but there is an opportunity because of all the other products. I don't want to say there is an X percent where we think we will be successful but we certainly feel good about maintaining the renewal rate of two-thirds to three-quarters, and in some instances they would be additional products as well."
},
{
"speaker": "Operator",
"text": "Your next question comes from Kash Rangan - Merrill Lynch."
},
{
"speaker": "Kash Rangan",
"text": "I just want to clarify on the EPS guidance for fiscal '08, that does include the positive impact from the rev rec rate, so how would you quantify that if you look at the $1.68 to $1.72, does $0.04 to $0.05 positive impact from the rev rec seem like a reasonable assumption?"
},
{
"speaker": "Chris Liddell",
"text": "We give the specific number, so depending on how you treat it. But if we look at the GAAP unearned income that comes off our balance sheet and we expect to flow through the income statement next year, it is $660 million. So that will equate to around $0.04 a share, if you take an after-tax and divide it by our number of shares. So that number may go up or down slightly depending on our actual sales and the mix of Vista and XP. But if you just take our guidance as it sits, it would be around $0.04 a share."
},
{
"speaker": "Kash Rangan",
"text": "What is the confidence level at this early point in the cycle, Chris, with 85% Vista, 15% XP assumption? What we hear from our surveys is that a lot of the Enterprises seem to want to do an implementation of Vista in 2008. So how are you thinking about the confidence level in the 85/15 mix between Vista and XP?"
},
{
"speaker": "Chris Liddell",
"text": "It is early days, so the standard deviation is quite high. But I will just say that our fiscal year '08 picks up the first six months of calendar year 2008. So to the extent that some people are on the sidelines waiting, they may well be looking at a position of early next year and that would pick up our fiscal year. It could be a relatively high swing between 85/15. From a revenue recognition point of view that might move around from an accounting perspective. From a cash flow point of view, it is not really going to have a significant impact."
},
{
"speaker": "Kash Rangan",
"text": "Finally, the units on Vista you disclosed, I think one month after the launch, was 20 million. Any update on that during the quarter how many units of Vista? If you could break that out between OEM and retail, that would be useful."
},
{
"speaker": "Chris Liddell",
"text": "No, I don't have a number to give you today. I'm happy to talk to the Client people, and if there's a number they would like to give out, we will follow-up with that."
},
{
"speaker": "Operator",
"text": "Your next question comes from Brent Thill - Citigroup."
},
{
"speaker": "Brent Thill",
"text": "Thanks, good afternoon. Chris, next year for fiscal '08 on operating margins, I believe that implies roughly flat with '07. Can you help us reconcile, considering that you're headed in probably the strongest point of your product cycle in a number of years, how you expect that operating margin to play out with regard to what your long-term model looks like and where you were at a couple of years ago at much higher operating margins?"
},
{
"speaker": "Chris Liddell",
"text": "Sure. I will start with just the guidance we have given you, at least on a GAAP basis. So we talk about revenue growth of 11% to 12%, and operating income growth of 12% to 14%. So you see a slight margin expansion based on that, although some of that is obviously the Vista accounting impact, and obviously earnings per share growing at 14% to 15%, so higher again; so a little bit improved margins in that respect. When I look at next year, we are still in investment mode in Online Services. We are looking at year-on-year growth on expenses broadly in line with what we have talked about. We're talking about growing the company's revenue base 11% to 12%. So if we can get margin expansion, I think that is tremendous. I think you have to look at the underlying businesses and look at them one by one. But if we can grow the company top line 11% to 12% and maintain or possibly slightly enhance our margin structure, I think that is a good starting base for a company of our size."
},
{
"speaker": "Brent Thill",
"text": "I would just be curious to get your thoughts. A number of the hardware companies have mentioned a sluggish March. It appears that you're not seeing that. Maybe offer some thoughts in terms of what the difference is there. As a follow-up on the business segment, you mentioned the consumer segment is tracking ahead of the business. When do you expect the business segment to really start to kick in?"
},
{
"speaker": "Chris Liddell",
"text": "Obviously we have a lot of different cycles from a hardware manufacturer, given the number of businesses that we're in. You have to look at it across the whole suite of our businesses. The thing that I would say is we are not seeing any significant slowdown in aggregate across our businesses. Individual businesses may have some, but certainly for the company overall, given the multiplicity of businesses we're involved in, we are seeing healthy demand. We have a good international business as well, which helps as well. I assume your question was mainly around North America, but a large number of our sales are outside North America and the economies are doing very well there and we're certainly seeing growth rates that are very good there as well. So no particular aspects there. What was the second part of your question?"
},
{
"speaker": "Brent Thill",
"text": "Just in terms of when do you think the business segment starts to maybe eclipse the consumer segment, when you see that strength kicking in?"
},
{
"speaker": "Chris Liddell",
"text": "I think the business segment is probably going to continue to be broadly equal to what it is at the moment. So it is really around consumer growth and whether that changes or not. But if the business growth continues in the sort of mid single-digits, the consumer growth is probably growing in excess of 10%. I don't necessarily see that inverting for the foreseeable future. I think customer growth would have to slide down quite a lot in order to dip below business growth, which I think is going to remain relatively healthy."
},
{
"speaker": "Colleen Healy",
"text": "Thanks so much. Thanks to everyone for your participation in today's call. If you have any further questions, please feel free to call me or my team directly. As I mentioned at the beginning of this call, this conference call will be available on replay at our Investor Relations website through close of business April 26, 2008. In addition, you can hear the replay by dialing 866-479-2456, or for international calls dial 203-369-1531. The dial-in replay will be available through the close of business May 4, 2007. Thanks again for joining us today."
}
] | null | null |
MSFT | 2 | 2,007 | 2007-01-26 17:30:00 | Operator: Welcome to the Microsoft 2007 fiscal year second quarter earnings conference call. (Operator Instructions) I would now like to turn the call over to Ms. Colleen Healy, General Manager, Investor Relations. Please go ahead.
Colleen Healy: Thank you. Good afternoon, everyone and thank you for joining us today. This afternoon I am joined by Chris Liddell, Senior Vice President and Chief Financial Officer and John Seethoff, Deputy General Counsel. Today's call will start with Chris providing some key takeaways for the second quarter of fiscal year 2007 and an overview of expectations for the rest of the fiscal year. I will then provide detail around our second quarter results, and then turn it back to Chris for a more detailed discussion of our guidance for the full year and the third quarter of fiscal 2007. After that, we will take your questions. We filed our 10-Q today in conjunction with our earnings release. Therefore, you have available the earnings release, MD&A, financial statements and footnotes. We have also posted our quarterly financial summary slide deck, which is intended to follow the flow of our prepared remarks in order to assist you. The slide deck offers highlights from the quarter, outlines our guidance and provides a reconciliation of differences between GAAP and non-GAAP financial measures that we will talk about today. You can find the earnings release, the 10-Q and the quarterly financial summary slide deck on the Investor Relations website at www.microsoft.com/msft. Today's call will be recorded. Please be aware that if you decide to ask a question, it will be included in both our live transmission as well as any future uses of the recording. As always, shareholders and analysts can listen to a live webcast of today's call at the Microsoft investor relations website. A replay of the call will be available at this same site through the close of business on January 25, 2008. This conference call report is protected by copyright law and international treaty. Unauthorized reproduction or distribution of this report, or any portion of it, may result in civil and criminal penalties. Any recording or other use or transmission of the text or audio of today's call is not allowed without the express permission of Microsoft. We will be making statements during this call that are forward looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in today's earnings press release, in the comments made during this conference call and in the risk factors section of our 10-Q, our 2006 Form 10-K and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statement. With that, let me now turn it over to Chris.
Chris Liddell: Thanks, Colleen and good afternoon, everyone. We are pleased to be with you today to share our second quarter results and discuss our outlook for the remainder of fiscal 2007. Looking back over the second quarter, I would characterize it as a very good close to the first half of the year, and it continues our progress for an excellent year overall. All aspects of our financial performance came in at or above the high end of our guidance. We were happy to see the PC hardware market strength in the quarter. And, by launching our flagship products to business customers at the end of November, we passed the last significant milestone towards forward availability. Looking at our second quarter financial performance, revenue grew 6%. If you were to exclude the $1.6 billion revenue deferral associated predominately with our technology guarantee program for Windows and Office, our revenue growth would have been 20%. That is impressive growth for any company, let alone one of our size. Business customer demand for our server and tools and Microsoft business division products was healthy across major geographies in both our large and small customer segments. Looking specifically at sales in December, we saw encouraging signs of early demand for the 2007 Microsoft Office system, Exchange Server 2007 and Windows Vista. Retail demand during the holiday quarter was robust for consumer PCs as well as for Xbox 360 consoles and games, helping to push revenue for both client and entertainment and devices to the upper end of our quarterly guidance. Operating income benefited from both the strong revenue as well as lower spending, primarily on marketing programs, most of which shifted out of quarter 2 and into the rest of the year. The operating income results flowed through the P&L and drove EPS numbers that came in $0.02 to $0.04 above what we told you in October. Moving to the full fiscal year, 2007 continues to deliver excellent financial performance. Next week, we celebrate the consumer launches of Windows Vista and the 2007 Office system. Our product groups will have put in significant work to deliver what are truly compelling products, and now our customers can benefit from those efforts. Let me make two key points about fiscal 2007. First, I'm very pleased that we continue to expect full year double-digit revenue growth. Overall, this is in line with what we told you last quarter, although we are making some adjustments to the mix of revenue. Second, excluding legal charges and tax benefits in the prior year, we expect earnings per share will also grow double-digits and faster than revenue. This growth is even after we launch the major products and continue to invest in future growth opportunities in all our divisions. With those high level themes for the quarter and for the full year of 2007, I'm going to the turn the call over to Colleen now for more details on our second quarter performance.
Colleen Healy: Thanks, Chris. As Chris mentioned, Q2 was a strong quarter overall, contributing to a good first half of the fiscal year. During the quarter revenue, operating income and EPS exceeded the high end of our guidance and we continued executing on our product cycle, with the business launch of Windows Vista, the 2007 Microsoft Office system and Exchange Server 2007. Let me provide you with details on our financial performance, starting with revenue. I will discuss top line financial and business momentum points and then follow up with revenue performance for each of the business units. All growth comparisons I mention relate to the comparable quarter of last year, unless otherwise specified. Revenue for the quarter was $12.5 billion, up 6%. Growth for the quarter was impacted by $1.6 billion in revenue deferrals out of Q2 that will be recognized in Q3, primarily related to the Windows and Office Technology Guarantee Program. The deferral amount is up slightly from the $1.5 billion that we previously guided, driven by strength in the PC market. Adjusting for these revenue deferrals, revenue growth would have been 20%. Revenue growth for the quarter was driven by a 76% increase in entertainment and devices and robust growth in our core businesses of client, server and tools, and the Microsoft business division, which grew a combined 11% after adjusting for the deferrals, primarily from the tech guarantees. Healthy growth in the hardware market was a key contributor to the results for the quarter. We estimate the PC market grew faster than we expected at 8% to 10% during the quarter. This growth is particularly strong, considering the upcoming consumer launch of Windows Vista, illustrating the success of our Tech Guarantee Program, as well as the continuing value proposition of Windows XP. Consumer PC shipment growth once again outpaced business shipments, driven by a strong holiday sales season. From a form factor perspective, growth in notebook PC shipments continues to outpace that of desktops. PC unit growth continues to be led by the emerging markets. Asia, excluding Japan, and Latin America maintained double-digit growth rates, while the remaining regions grew at single digits. Server hardware shipment growth remained consistent with our full year estimate of 10% to 12%. Our mix of products billings was approximately 30% from OEM, 25% from multi-year licensing agreements, 20% from license-only sales, and the balance from our other businesses. Relative to prior year, our billing mix continues to shift to our other businesses, driven by the increasing revenue from our entertainment and devices divisions. We had a very strong quarter overall from a volume licensing perspective, with broad-based strength across our customer segments and regions, which drove growth in enterprise agreements, as well as select and open annuity licenses. We estimate that EA renewal rates were at the high end of our historical range of 56% to 75%. In addition, select and open license-only growth accelerated in December after the business launches of Windows Vista, the 2007 Office system and Exchange Server 2007. Our unearned revenue balance ended the quarter a bit higher than we expected at $11.9 billion, including the $1.7 billion of deferrals primarily related to the technology guarantees. Excluding this impact, the unearned balance would have grown 15% over the prior year and still have been up sequentially. Our contracted, non-billed balance at the end of December was also sequentially higher and now exceeds $9.5 billion. If you consider our reported revenue and changes in the unearned and contracted, non-billed balances, our bookings growth exceeded 20% for the quarter. Before I get into the revenue details for each business group, let me point out that changes in foreign exchange rates added about 1 point to our overall revenue growth rate. Client revenue of $2.6 billion, a decline of 25%, includes the impact of $1.1 billion of revenue deferrals, primarily related to the tech guarantee. Adjusting for this impact, Client revenue would have been $3.7 billion, up 9%, driven by growth in the OEM business. OEM revenue increased 8%, excluding the tech guarantee, due to 10% growth in OEM license units. OEM revenue grew at a slightly slower pace than license units, due to the continued increased volume in emerging markets and the shift in channel mix towards larger OEMs, partially offset by the impact from the increase in premium mix. OEM premium mix increased 18 percentage points from the prior year to 67%. Consistent with the relative strength in the consumer segment, especially during holiday, and deferred by the technology guarantee program, we saw a shift within the premium mix itself. Specifically, the growth in the premium mix was a result of consumers purchasing Windows XP Media Center, driven by the upgrade pricing structure offered under the technology guarantee program. So while Windows XP Professional grew year on year, its portion of the premium mix declined a couple of percentage points. While we are delighted to see the increasing trend of consumers recognizing the value offered in premium Windows, we want to point out to you that in the U.S., Windows XP Professional generates over five times the pricing uplift over Windows XP Home than does Windows XP Media Center. Client commercial and retail licensing grew 13%, primarily from sales of Windows Vista into the retail channel, and our partners began readying for Windows Vista general availability. Our commercial business remained healthy, fueled by growth in multi-year contract agreements. The client business made significant progress on the product front this quarter with the business launch of Windows Vista, the most significant operating system release since Windows 95. Server and tools delivered double-digit revenue growth for the 18th consecutive quarter. Its 17% revenue growth was driven by broad adoption of our server and tools product line, particularly SQL Server, which had another quarter of over 30% revenue growth. Revenue for our online services business grew 5% to $624 million, driven by an increase in advertising revenue of 20%, partially offset by an expected decline in access revenue. Healthy growth in display, coupled with a modest increase in search, drove the rise in the total advertising revenue. Increasing search queries contributed to search revenue growth on a year-over-year basis for the first time since we began our transition to AdCenter in the U.S. last year. Microsoft business division revenue was $3.5 billion, or $4 billion after adjusting for the $500 million tech guarantee and preshipment deferral. Growth was driven by the strength of our annuity business and earlier than expected uptake in our license-only business following the business launches of the 2007 Office system and Exchange Server 2007. The Dynamics business continued its strong performance in Q2, as demonstrated by a 19% increase in customer billings. Lastly, entertainment and devices growth of 76% for the quarter was driven by Xbox 360 sales. We have now sold 10.4 million consoles life to date. And according to NTB, consumers in the U.S. purchased more Xbox 360s than both the Wii and PlayStation 3 combined during the month of December. Software attach rates remain at record levels in the U.S., bolstered by the broad success of Gears of War, which sold over 2.7 million copies in its first eight weeks in market. Our mobile and embedded device business also performed well, selling over 3 million licenses for Windows mobile phone-enabled devices, up over 90% year over year. During the quarter, we launched the Zune digital media player in the United States, which furthers our strategy of connected entertainment. Now for the rest of the income statement: positive revenue increase 62%, due primarily to an increase in Xbox 360 sales. As a result, gross margin relative to the prior year was down about 10 percentage points, a slightly larger drop than the guidance we provided in October. This was primarily driven by stronger than expected sales of Xbox 360, as well as an extension of the Xbox 360 warranty from 90 days to one year in the U.S. and Canada. Q2 operating expenses other than cost of revenue increased $509 million or 10%. This was a little higher than expected, due to the timing of certain spending, particularly for sales and marketing programs. Operating income was $3.5 billion. Adjusting for the tech guarantee deferrals, operating income would have been $5.1 billion, up 10% from the prior year, driven by strength in our core businesses. Investment income and other totaled $333 million. Our effective tax rate for the quarter was 31%, up from 29% last year. This year over year rate increase was impacted by a $108 million tax benefit in the prior year. During the quarter, we repurchased 205 million shares or $6 billion worth of our stock and paid $980 million in dividends to shareholders. Diluted shares outstanding were 9.9 billion, down 7% from the prior year, as a result of execution on our share repurchase program. Our diluted shares outstanding for the quarter were impacted by the issuance of 113 million shares in December related to options exercised by JP Morgan for the employee stock option transfer program completed in December 2003. This settlement marks the final expiration of all remaining options under its program. Earnings per share for the quarter were $0.26, which includes approximately an $0.11 per share deferral, primarily from tech guarantees. So in summary, Q2 delivered strong results across the board. Revenue results for all of the segments met or exceeded the top end of our guidance and translated to out performance for both operating income and EPS. Additionally, the quarter marked the business launch of our flagship products. With that, let me turn it back to Chris, who will provide you with our expectations for Q3 and the remainder of fiscal 2007.
Chris Liddell: Thanks, Colleen. Before we get into the specific guidance, let me outline some of our key assumptions. Our fiscal 2007 forecast assumes no major changes in the economic conditions from where we exited the first half, and we're not forecasting any significant impacts from foreign exchange rate movements. We expect PC unit growth to be 8% to 10% for the fiscal year, in line with the guidance we gave you last quarter, and between 9% to 11% for the third quarter. We continue to estimate the PC unit growth rates will be higher in the consumer segment than in the business segment, and higher in the emerging markets than in mature markets. On the server hardware front, we remain comfortable with our estimate for total market price of 10% to 12% for the year. Now let me get into our detailed guidance. For the full year, we expect our revenues to come in at $50.2 billion to $50.7 billion, growing 13% to 14%. We are narrowing our revenue range to reflect how we finished the second quarter, as well as to incorporate changes to the mix of revenue. Our growth is driven by broad-based revenue growth across our five segments, with each of our core businesses growing double-digits. For the third quarter, we expect revenue of $13.7 billion to $14.0 billion, which represents growth of 26% to 28% year over year. Our third quarter will benefit from recognition of the $1.7 billion of revenue that we deferred out of the first half, $45 million from Q1 and $1.64 billion from Q2, primarily associated with our technology guarantee program. Before these impacts, third quarter revenue guidance would have been $12 billion to $12.3 billion, which would have represented growth of 10% to 13%. There's clearly no impact to the full year, as we have discussed. With that, revenue guidance in our five business units is as follows: For client, we have increased our full year growth forecast to 11% to 12%, up from the 9% to 10% we gave you in October and this has been driven by a higher premium mix in our OEMs revenue and a faster transition to Windows Vista. We expect third quarter growth to be 54% to 56%, although our third quarter guidance includes the recognition of approximately $1.2 billion in revenue primarily associated with our tech guarantee program. Before that deferral, third quarter revenue would be growing 16% to 18%. Growth accelerates in the second half of the year for the commercial and retail portion of the client segment, beginning in quarter 3, driven by broad availability of Windows Vista. Client OEM revenue should grow roughly in line with the PC hardware market for the year. We are increasing our expectation for premium mix in the second half of the year and we now expect our full-year premium mix to be about 60%. The increase is driven by mix assumptions for our consumer premium products such as Windows XP Media Center and Windows Vista Home Premium. As Colleen mentioned earlier, we have received modest revenue upside from our consumer premium SKUs versus what we get on Windows XP Pro or Windows Vista Business. Server and tools revenue should grow 16% to 17% for the year from continued growth of SQL Server, development tools and our enterprise services. Revenue for the third quarter should also be up 16% to 17%. We forecast revenue in the online services business to grow between 3% and 8% for the year and 4% to 10% in quarter 3. Although we're still forecasting growth in search queries and page views, our plans now include a more measured rate of growth for the balance of the year. Our full year forecast anticipates total advertising growth in the mid-teens, and we expect this to be driven in particular by our display business, which is growing at a healthy rate, as we see good page growth in our key properties. We continue to have high aspirations to grow this business and we will continue to invest in the business during the second half. Microsoft business division revenue should increased 10% to 11% for the year, an increase of 2 percentage points from the guidance we gave you last quarter on increased business uptake of the 2007 Office system. Q3 revenue should grow 27% to 28%. Our third quarter revenue guidance includes the recognition of approximately $0.5 billion of revenue deferred from the second quarter related to our tech guarantee program and 2007 Office system preshipments into the channel. If you were to adjust for that impact, revenue growth for quarter 3 would have been 13% into 14%. We are encouraged by the favorable customer response we saw in December surrounding our new products. In the entertainment and devices division, we are pleased with what we have been able to accomplish in the past year, including achieving our goal of having sold over 10 million consoles life to date, outselling competitive next-generation consoles during this holiday season, achieving record software attach rates and reaching 5 million Xbox Live members. With that strong momentum, we are making tradeoffs and choices in managing the Xbox business to achieve our targeted profitability in fiscal year '08. In the near term, this means we will optimize for profitability. We believe this puts us in a strong market and financial position as we go into fiscal 2008, a year that will feature a number of catalysts, highlighted by the strongest first and third-party game lineup we've ever had. As we look at historical seasonality, pricing and inventory levels, we're taking a more cautious view of the market, and our half 2 revenue and console guidance reflects that. We are now forecasting full year revenue growth of 26% to 31% and a decline of 15% to 25% for the third quarter and expect to exit June having sold about 12 million Xbox 360 units since launch, down from our previous guidance of 13 million to 15 million. That reduction in console units also results in a reduction in revenue related to attached software, accessories and Live. Moving on to operating income, for the year we expect to generate between $19.3 billion and $19.7 billion of operating income, representing growth of 10% to 12%, excluding legal charges taken in fiscal 2006. This is an increase of approximately $200 million on both the low end and high end, this is what we told you in October, now representing double-digit growth even at the low end. We are flowing through some of the revenue upside and keeping full year spending in line with what we had in October. For the third quarter, we expect operating income to be between $6.1 billion and $6.3 billion, including the impact from revenue recognized from our tech guarantee and preshipments. Excluding this impact, operating income for the third quarter would be between $4.4 billion and $4.6 billion. Third quarter operating income includes some costs deferred from the second quarter, as well as operating costs in preparation for the launches of Windows Vista and the 2007 Office system. Cost of goods sold as a percentage of revenue for the full year should increase by 1 percentage point over last year, in line with what we said in October. We continue to estimate a full year tax rate of 31%, consistent with what we saw in the second quarter and with our October guidance. Diluted earnings per share, we're bringing up the range for the year by $0.02 at the low end and $0.01 at the high end due to higher revenue in our core businesses of client, server and tools, and MBD. This translates into a full-year expected range of $1.45 to $1.47 and $0.45 to $0.46 for the third quarter. The third quarter earnings per share includes approximately $0.12 per share associated with the impact of the tech guarantee program. From a balance sheet perspective, we expect unearned revenue to finish fiscal 2007 up 6% to 8% due to our better performance in Q2. Contracted not billed should also finished 2007 up from where we exited fiscal 2006. When thinking about sequential changes in unearned revenue from quarter 2 to quarter 3, we expect a decline of slightly greater than $1.7 billion of revenue we'll recognize associate with our tech guarantee program and presales. This decline would be consistent with normal seasonality. For our full year unearned revenue guidance, we're modeling a moderation in the recent annuity mix of our billings as both the 2007 Office system and Windows Vista will be available to customers in the second half of the year. I'll remind you though, as you think about guidance for the rest of the year, we still face the risks and opportunities I have highlighted in our previous two earnings calls: for example, competitive, legal, execution and general market risks; as well as PC and server hardware growth rates, customer acceptance of our products, and the costs to remain competitive, such as those to acquire and serve customers in our online businesses. Also, our emerging businesses are harder to forecast when compared to our mature businesses, so as they continue to become a larger part of our overall financial mix, they may contribute to increased volatility in our quarterly performance. Before moving to questions and answers, I would like to make a couple of quick comments. I committed to you at our financial analyst meeting last year to provide you with a more continuous flow of information throughout the year, and that would include communication from Steve and me. We will do that on February 15 in New York City, and for those of you unable to join us for that, we will make available a live webcast as well as an on-demand replay of the presentation. The intention of this presentation is for Steve and me to meet with investors and provide an update on our strategic direction after completing our internal strategy meetings. Although we may generally discuss revenue and spending trend levels, we will not give any detailed financial information. As in past years, we will provide our first preliminary review of fiscal 2008 guidance on our third quarter earnings call in April. Since the financial analyst meeting in July, we have also had executives out talking with the financial community in a variety of forums at a pace over once a month outside of our quiet periods. Looking forward into half 2, we will double that frequency. In general, we have been trying to give you more overall exposure to all of our senior executives and we look forward to seeing you. With that, I'll hand the call over to Colleen so we can get started with some of your questions. Thank you.
Colleen Healy: Thanks, Chris. Let's now proceed to questions. We want to accommodate questions from as many people as possible, so please avoid multi-part questions and please limit yourself to just one question. Operator, will you please repeat your instructions?
Operator: (Operator Instructions) Your first question comes from Heather Bellini - UBS.
Heather Bellini: Good afternoon, Chris and Colleen. I was wondering if you could give us your assumptions for higher price SKU mix in the March quarter, because if we adjust for the technology reversal that you are going to have in March, then it appears that you're looking for client segment growth of roughly 20% versus a PC shipment forecast that is about half that. The second question I would have is that for Service Pack 1, it typically comes out one year after the release of Windows, if we look back historically. I'm just wondering if we should be thinking less than that now, given your desire to shorten Windows development cycles.
Chris Liddell: In terms of the quarter 3, if I work through the math of taking you from the shipment units that we see down to the revenue, that will probably help you the most. And then I will talk about service packs. As I mentioned in the formal remarks, we expect shipments in the third quarter to be 9% to 11%. We are assuming that our units that we sell will be at the top end of that range, 11%, so we'll still have a modest improvement. The main factor that is going to drive the revenue is going to be on the commercial and retail. So we will, again as I mentioned in the prepared remarks, we will certainly get a significant impact from that element of the revenue that is commercial and retail. As you'll recall, that's only about 20% of the total revenue but we're expecting it to grow significantly relative to the previous year, obviously, with Vista being available for the first time. So those will be, in essence, the main drivers. You are right, that will get us up to revenue growth that is close to 20% for the quarter.
Heather Bellini: On the service pack side?
Colleen Healy: On the service pack side, Heather, we have seen a lot of the same rumors that you probably have in the press in terms of dates. The company hasn't put a date out there. It always makes sense to see how the product does out of the gate, continue to get feedback and we don't have an SP date to share with you today.
Operator: Your next question comes from Charlie DiBona - Sanford Bernstein.
Charlie DiBona: Hi, Chris. I was wondering if we could turn to the online services business. It looks like the display ads are doing fine, but search is slipping share pretty consistently in all the independent numbers. You have now lowered guidance, it looks like while you might be growing search a little bit you are certainly going to continue to slip share if you stick to this guidance. How should we be looking at this business? How can we evaluate progress here? When can we expect a turnaround?
Chris Liddell: You are right, Charlie, to break the business down into its different bits. Clearly, the overall results are impacted by adCenter decline. but if I take that out and look at the advertising revenue overall, it grew 20% for the quarter, which we're happy with. If you break that down into display and search, clearly there is a better story on the display side, and we are growing broadly in line market. So I'd like to think we can put a tick in that box and we are comfortable with the progress we are making there. On the search side, you are correct that we lost market share certainly relative to the independent assessment during the quarter, and are clearly not happy with that. We continue to take a long term view of this business. We continue to invest in it, and we are making progress in the short term on some of the factors that we think are important: getting advertisers onto our adCenter platform, turning the corner in terms of revenue on a quarter-by-quarter basis. Since we went off Overture, the second quarter is the first quarter where we are seeing consecutive growth in revenue and we still expect to get revenue per search equal to where we were a year ago by the end of this year. So we are making progress in some of the underlying factors and we are continuing to invest. But I expect you should and we should expect to see more progress in the long term on the search side.
Charlie DiBona: Does there come a time when you can share some of those metrics you say are doing better internally? Because we don't see them out here.
Colleen Healy: From a communications standpoint, Charlie, what we've really set up is at our financial analyst meeting there are some specific metrics that we told you you will hear, really from Kevin Johnson: breadth of usage, depth of usage and how we're doing on monetization, really similar to our competitors in terms of providing some of those underlying drivers quarter by quarter. It is not something that we are doing, it doesn't necessarily make sense from a competitive standpoint. There tends to also be pretty decent third-party information out there. But you will continue to hear from the business leaders, as well as Chris, directly at FAM on those metrics that we outlined at the financial analyst meeting last year, and we'll update you again on at least a yearly basis.
Chris Liddell: Charlie, the other thing I would say is once we lap coming off Overture you'll be able to do a much better comparison because then we are comparing ourselves to ourselves. So in two or three quarters I think the comparables year on year will be much easier for you to make an assessment of progress. Also, as the impact of the access business decline becomes much less significant, then you are really looking at the underlying business growth. So it won't necessarily get to the level of granularity that I know you have consistently been looking for. But I think it will become, hopefully, more useful to you.
Operator: Your next question comes from Kash Rangan - Merrill Lynch.
Kash Rangan: Hi, thank you very much. Just to clarify the Xbox commentary, Chris, is that more of an inventory flush-out that causes you to lower the guidance for the rest of the year? Also, if you could comment on the premium mix. If you experience better mix shift to the higher-end versions of Vista after the launch, will that cause the company to raise its guidance for the client business or is that already factored into the guidance? That’s it, thanks.
Chris Liddell: On the Xbox side, certainly the healthy inventory that we have seen which is partially a result of the very good sales that we saw into the channel in the second quarter last year, is one of the factors behind what we're looking for in the second half. Also, as we start to think about fiscal year '08 and what's the best approach to take for fiscal year '08 in terms of profitability, so we're just making some strategic decisions around what we might do there, too. So it is those two things, broadly speaking, which are the reasons why we are giving the guidance we are. On the premium side, we have embedded inside the guidance that we have given you the premium mix that we now have of 60%. So that is reflected in the guidance for fiscal year '07. Clearly, as Colleen mentioned, inside that 60% there is a mix within a mix, so depending on how that came out between the consumer SKUs and the business SKUs, if that changed, the 60% could still be the case, but we could have a different revenue number there. But at this stage, based on our expectation of the premium mix and how the business and consumer elements of that were made up, that is reflected in the guidance.
Kash Rangan: So you are not assuming any change in the business versus the consumer within the premium as it relates to '07 guidance just as yet? You're basically using the same experience as with XP to make your forecast, right?
Chris Liddell: It is not the same experience as XP. It is the same experience, if you like, as what we forecast at the beginning of the year.
Operator: Your next question comes from Rick Sherlund - Goldman Sachs.
Rick Sherlund: Thanks. Chris, the launch of Vista, Office 2007 and Exchange Server coming up at the end of this month, if I want to be a little more optimistic about the revenues in Q3, you've given a little bit of precise guidance there and I'm just not sure how predictable the demand is going to be. I'd just ask you to talk to that issue in terms of your ability to forecast for Q3, given the launch of some pretty major new products and whether you might think it reasonable to think that we could see more upside in Q3.
Chris Liddell: Richard, we've talked about it before, I think this is different from if you go back a decade, obviously, to a Windows 95 impact. We certainly think it would be positive, but more gradual as it rolls out into the marketplace. In terms of the impact on overall sales, we were heartened by the quarter 2 results. We are certainly heartened by the fact that the tech guarantee appeared to avoid any stalling of sales in that quarter. But we are sticking with the external numbers that you have seen and that is flowing through in turn to our second half. Could there be some upside to that? Yes, clearly there is, but obviously there could be some downside as well. I talk about that on the risks and opportunities side. If the product was extremely well received and if there was very strong demand at say the top end of our expectations for the second half, clearly that would flow through. At this stage, it is launching next week, and we're taking what we consider to be just an appropriately conservative view of the second half.
Rick Sherlund: SQL Server up 30%-plus again this quarter against a launch last year of the new product, I'm a little surprised that we are continuing to see 30%-plus growth from that product, particularly on a tougher comparison. Any light you can shed on what is happening or why we're seeing such robust growth there?
Chris Liddell: Yes, we were positively surprised on the upside there, too. The only thing I would say is that the price increase went in during the quarter. So you've got some part of the quarter which is price impacted, if you like. So it will definitely become a much harder comparable in the second half. But in terms of underlying sales, it was a good quarter, you are right.
Rick Sherlund: Chris, on the Xbox, just finally, I hear what you're saying that you want to manage inventory levels down it sounds like, over the next couple of quarters. Certainly if there were a price reduction coming, you would want to minimize your channel inventory levels before you would do something like that. Am I understanding correctly that what you're trying to do is manage inventory levels down for Xbox in the second fiscal half?
Chris Liddell: I wouldn't put it in those terms. We are looking at the numbers that we sell into the channel based on where we see the inventory at the start of the year and the patterns of sales that we think will come up. So the net result of that may well be that we see inventory come down. But if you like, it is an outcome, not a management of that.
Rick Sherlund: You're not seeing any change in the competitive environment; there's no change in your assumptions of market share?
Chris Liddell: No.
Operator: Your next question comes from Adam Holt – JP Morgan.
Adam Holt: Good afternoon. You made a number of comments about the ASP and premium mix expectations around Windows. I was hoping maybe you could talk a little bit about what you are expecting within Office. Obviously, you have got a number of new SKUs with Small Business Pro/Ultimate. What does the guidance imply in terms of ASP improvement and what do you think is reasonable for us to expect?
Chris Liddell: Well, to the extent that obviously we're just giving guidance for the balance of this year it is not a huge impact. There is clearly revenue coming through from the first half which is not significantly impacted by that and so there is not a huge impact in the whole of fiscal year '07. Having said that, we did see renewal rates, as Colleen mentioned, at the top end of our 66% to 75% historic range. One of the reasons for that we feel was people anticipating the Office and therefore being attracted to renew. So that, to some extent, flows through in the second half. But in terms of an overall mix shift, it's not a significant component of the fiscal year '07 revenue.
Adam Holt: If I could just ask a follow up on the strength in unearned, what I was particularly taken with was the client side. If you net out undelivered, it looks like you had better than 30% growth in client unearned. Could you talk about what you are seeing in terms of enterprise renewal activity, reattachment to enterprise licensing, and maybe refresh us on your thinking in terms of what you're expecting for enterprise adoption as we get further into the cycle?
Colleen Healy: On the annuity side, as with Office, a bit with client as you're talking, we have seen really nice renewal rates. They have been really trending at the high end. In particular, to your point, when you look at the various parts going into unearned, we are seeing a bit of an uptick in terms of customers adding Windows under their enterprise agreements. We think the value proposition from the enterprise view is compelling. And of course, you can only get if you are an annuity customer, so that looks promising. But really, I would say at this point, a bit too early to get ahead of ourselves. But we have been noticing that a bit as well.
Operator: Thank you. Your next question comes from Brent Thill - Citigroup.
Brent Thill: Thanks. Chris, just a follow-up to Adam's question on Office. The reviews have been very solid, and just wondering if you could help us understand what the rationale is, why pricing can't go up in the face of that, considering this is a pretty big release. If you look at the server business, you have raised pricing and it doesn't feel like there has been any pushback.
Colleen Healy: What we could say on the pricing side, actually, is certainly in terms of the upper end views, we have put more value into those offerings. For example, on the Professional Plus offering, which adds the Communicator IM Client and other things, pricing went up a bit, call it 5% or so. On the enterprise SKU, which has Pro and Windows and grew, we did take the opportunity to add more value there. We expect to see some pricing uplift there. So really what you're seeing, whether it is SQL or Office or some of the other products you mentioned, it is really more SKU differentiation that you heard from us really at the financial analyst meeting a year ago, and we are really continuing to look for opportunities to provide value in higher-end SKUs and price accordingly. But again, we don't want to get too far ahead of ourselves in terms of adoption rates. Keep in mind that a lot of these products, in particular on Office, because there's already quite a bit going into annuity, you actually recognize that over a period of time on the P&L.
Chris Liddell: From our perspective, at a particular price point, the concept of increasingly trying to add value at that price point over time through software development is just a good philosophy. So we certainly don't think just because we are adding functionality that we should necessarily increase price. In terms of our renewals now in the post-Vista and Office era, the ability to actually offer new products and hence look at enterprise agreements that are much broader, much more of infrastructure-based agreements rather than desktop agreements, is more of the potential.
Operator: Your next question comes from Jason Maynard - Credit Suisse.
Jason Maynard: Hi, guys. I have a question on spending. You had indicated that Q2 was a little lower than expected in marketing program spend. Server and tools, I think, did $1 billion in op income. How do you think about Q2 in terms of its impact on spending in the back half of the year and even longer term as you look to invest in places like online services and then even potentially in entertainment devices?
Chris Liddell: We have kept, again, our expenses very much in the context of the year and we have kept our expense number for the year the same as where it has been essentially all year. I am increasingly happy with the discipline we are showing there for the year. In terms of the quarter-by-quarter movement, we certainly give the people flexibility on a quarterly basis to spend on programs as is necessary. We can see swings, in particular in some of the marketing spends with some of the launches on a quarter-by-quarter basis. So I wouldn't get too concerned one way or the other. In this case, it's a positive trend on the expenses year to date. I tend to focus on what our expectations are for the year and at this stage, they haven't changed.
Jason Maynard: Maybe just help me reconcile, operating cash flow came in just a touch above $2 billion, which was a little lower than I think most of us were modeling. Can you maybe help us understand the puts and takes on the cash flow number?
Chris Liddell: To some extent, there was obviously inventory builds. We had a relatively high number of Xbox sales and so that does tend to impact our cash flow for the quarter. There could well be, depending on the line you're looking at, the big billings area. So a big unearned can influence the cash flow aspect of it as well. But there were no significant issues. Buyback was relatively high, but we also had the JP Morgan options exercised, so nothing unusual there. I would describe it as a reasonably predictable cash flow quarter, albeit with some big movements inside it.
Colleen Healy: Thanks so much. We have time for a just a few more questions. Our next question please.
Operator: Your next question comes from Robert Breza - RBC Capital Markets.
Robert Breza: Hi, good afternoon. Real quickly, Chris, maybe as a follow-up to the last question, when you look at the leverage you showed this quarter and a little bit of lack of spending in the back half of the year, where do you see additional leverage coming from? What levers do you think that are there that you could execute to deliver upside?
Chris Liddell: Well it's more likely to be on the revenue side. Clearly, we have the opportunity to cut expenses and some of the decisions that we can make, we could, for example, decide to cut back on marketing for the second half of the year. I don't think we will, but we could do it. The upside potential really comes more on the revenue side and that really comes across the board. So clearly, in our client and office division, as Rick's question alluded to earlier, with a launch there's a big amount of variability around that. So there could be some upside there. But we've guided to what we think is probably the appropriate level. In the online services area, there's probably not such a big swing factor there in the overall context of the company, but clearly our ability to continue to generate display advertising and change market share in search has some impact. And then on the entertainment and devices, really it's to a large extent on the revenue side, it is an Xbox story. Again, we have taken what we think is the most likely scenario there. Given the relative seasonality, the June half is a lot less significant than the December half in the Xbox business, so I don't see a high degree of variability. But again, that would be something that would be a big factor. Each of the businesses has their own dynamic. But if you're looking for the things that could swing, it is really in our core businesses with those big launches.
Robert Breza: Great, thank you, nice quarter.
Operator: Your next question comes from Tim Klasell - Thomas Weisel Partners.
Tim Klasell: Going to Vista, you've mentioned in the past that you won't be having to hold back the 5% to 25% going into deferred. That should be about $150 million to $250 million a quarter as that rolls off the next three years. Is that the right way to think about that, and is that still the way you plan on doing it?
Chris Liddell: We had quite an extensive discussion last quarter about that. I think we stated that we will give you guidance for fiscal year '08 in our next quarter in terms of exactly how much we expect from that. We want to be transparent about how much is the underlying business, how much is simply just the different revenue recognition. It will be order of magnitude in the sort of numbers you're talking about, but it is too early at this stage to give actual numbers out.
Tim Klasell: Good. One final question, Longhorn, if we look out a little further, how is that tracking and are you still planning on an end of the year release?
Chris Liddell: Yes, we are.
Colleen Healy: Longhorn is tracking. We are expecting really to RTM for the second half of calendar year 2007 and I think you'll hear more from us over time on that. Great, thanks so much. We have time for one last question, please.
Operator: Your final question comes from John McPeake - Prudential.
John McPeake: A question about online offering and dynamics [inaudible] Could you talk a little bit about how Codename Titan, the online product, is going to roll out and the timing there?
Chris Liddell: You are little faint there, sorry. But I picked up your question in terms of Titan, have we gone public on the timing for that?
Colleen Healy: We have.
Chris Liddell: That's the summer this year. So we are on track for that, as we talked about. So that will be in the summer, in six months, if you like.
John McPeake: Does Xbox inventory drawdown have anything to do with potentially a new version of Xbox coming out first fiscal half?
Chris Liddell: No. That was an easy one.
Colleen Healy: Great. Thanks a lot, John. Thank you, everybody for your participation in today's call. If you have any further questions, please feel free to call me or my team directly. As I mentioned at the beginning of this call, this conference call will be available on replay at our investor relations website through close of business January 25, 2008. In addition, you can hear the replay by dialing 800-873-5569 or for international calls, dial 203-369-3995. The dial-in replay will be available through the close of business February 2, 2007. Thanks again for joining us today.
Chris Liddell: Thank you.
Operator: Thank you. This does conclude today's conference call. We thank you for your participation. | [
{
"speaker": "Operator",
"text": "Welcome to the Microsoft 2007 fiscal year second quarter earnings conference call. (Operator Instructions) I would now like to turn the call over to Ms. Colleen Healy, General Manager, Investor Relations. Please go ahead."
},
{
"speaker": "Colleen Healy",
"text": "Thank you. Good afternoon, everyone and thank you for joining us today. This afternoon I am joined by Chris Liddell, Senior Vice President and Chief Financial Officer and John Seethoff, Deputy General Counsel. Today's call will start with Chris providing some key takeaways for the second quarter of fiscal year 2007 and an overview of expectations for the rest of the fiscal year. I will then provide detail around our second quarter results, and then turn it back to Chris for a more detailed discussion of our guidance for the full year and the third quarter of fiscal 2007. After that, we will take your questions. We filed our 10-Q today in conjunction with our earnings release. Therefore, you have available the earnings release, MD&A, financial statements and footnotes. We have also posted our quarterly financial summary slide deck, which is intended to follow the flow of our prepared remarks in order to assist you. The slide deck offers highlights from the quarter, outlines our guidance and provides a reconciliation of differences between GAAP and non-GAAP financial measures that we will talk about today. You can find the earnings release, the 10-Q and the quarterly financial summary slide deck on the Investor Relations website at www.microsoft.com/msft. Today's call will be recorded. Please be aware that if you decide to ask a question, it will be included in both our live transmission as well as any future uses of the recording. As always, shareholders and analysts can listen to a live webcast of today's call at the Microsoft investor relations website. A replay of the call will be available at this same site through the close of business on January 25, 2008. This conference call report is protected by copyright law and international treaty. Unauthorized reproduction or distribution of this report, or any portion of it, may result in civil and criminal penalties. Any recording or other use or transmission of the text or audio of today's call is not allowed without the express permission of Microsoft. We will be making statements during this call that are forward looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in today's earnings press release, in the comments made during this conference call and in the risk factors section of our 10-Q, our 2006 Form 10-K and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statement. With that, let me now turn it over to Chris."
},
{
"speaker": "Chris Liddell",
"text": "Thanks, Colleen and good afternoon, everyone. We are pleased to be with you today to share our second quarter results and discuss our outlook for the remainder of fiscal 2007. Looking back over the second quarter, I would characterize it as a very good close to the first half of the year, and it continues our progress for an excellent year overall. All aspects of our financial performance came in at or above the high end of our guidance. We were happy to see the PC hardware market strength in the quarter. And, by launching our flagship products to business customers at the end of November, we passed the last significant milestone towards forward availability. Looking at our second quarter financial performance, revenue grew 6%. If you were to exclude the $1.6 billion revenue deferral associated predominately with our technology guarantee program for Windows and Office, our revenue growth would have been 20%. That is impressive growth for any company, let alone one of our size. Business customer demand for our server and tools and Microsoft business division products was healthy across major geographies in both our large and small customer segments. Looking specifically at sales in December, we saw encouraging signs of early demand for the 2007 Microsoft Office system, Exchange Server 2007 and Windows Vista. Retail demand during the holiday quarter was robust for consumer PCs as well as for Xbox 360 consoles and games, helping to push revenue for both client and entertainment and devices to the upper end of our quarterly guidance. Operating income benefited from both the strong revenue as well as lower spending, primarily on marketing programs, most of which shifted out of quarter 2 and into the rest of the year. The operating income results flowed through the P&L and drove EPS numbers that came in $0.02 to $0.04 above what we told you in October. Moving to the full fiscal year, 2007 continues to deliver excellent financial performance. Next week, we celebrate the consumer launches of Windows Vista and the 2007 Office system. Our product groups will have put in significant work to deliver what are truly compelling products, and now our customers can benefit from those efforts. Let me make two key points about fiscal 2007. First, I'm very pleased that we continue to expect full year double-digit revenue growth. Overall, this is in line with what we told you last quarter, although we are making some adjustments to the mix of revenue. Second, excluding legal charges and tax benefits in the prior year, we expect earnings per share will also grow double-digits and faster than revenue. This growth is even after we launch the major products and continue to invest in future growth opportunities in all our divisions. With those high level themes for the quarter and for the full year of 2007, I'm going to the turn the call over to Colleen now for more details on our second quarter performance."
},
{
"speaker": "Colleen Healy",
"text": "Thanks, Chris. As Chris mentioned, Q2 was a strong quarter overall, contributing to a good first half of the fiscal year. During the quarter revenue, operating income and EPS exceeded the high end of our guidance and we continued executing on our product cycle, with the business launch of Windows Vista, the 2007 Microsoft Office system and Exchange Server 2007. Let me provide you with details on our financial performance, starting with revenue. I will discuss top line financial and business momentum points and then follow up with revenue performance for each of the business units. All growth comparisons I mention relate to the comparable quarter of last year, unless otherwise specified. Revenue for the quarter was $12.5 billion, up 6%. Growth for the quarter was impacted by $1.6 billion in revenue deferrals out of Q2 that will be recognized in Q3, primarily related to the Windows and Office Technology Guarantee Program. The deferral amount is up slightly from the $1.5 billion that we previously guided, driven by strength in the PC market. Adjusting for these revenue deferrals, revenue growth would have been 20%. Revenue growth for the quarter was driven by a 76% increase in entertainment and devices and robust growth in our core businesses of client, server and tools, and the Microsoft business division, which grew a combined 11% after adjusting for the deferrals, primarily from the tech guarantees. Healthy growth in the hardware market was a key contributor to the results for the quarter. We estimate the PC market grew faster than we expected at 8% to 10% during the quarter. This growth is particularly strong, considering the upcoming consumer launch of Windows Vista, illustrating the success of our Tech Guarantee Program, as well as the continuing value proposition of Windows XP. Consumer PC shipment growth once again outpaced business shipments, driven by a strong holiday sales season. From a form factor perspective, growth in notebook PC shipments continues to outpace that of desktops. PC unit growth continues to be led by the emerging markets. Asia, excluding Japan, and Latin America maintained double-digit growth rates, while the remaining regions grew at single digits. Server hardware shipment growth remained consistent with our full year estimate of 10% to 12%. Our mix of products billings was approximately 30% from OEM, 25% from multi-year licensing agreements, 20% from license-only sales, and the balance from our other businesses. Relative to prior year, our billing mix continues to shift to our other businesses, driven by the increasing revenue from our entertainment and devices divisions. We had a very strong quarter overall from a volume licensing perspective, with broad-based strength across our customer segments and regions, which drove growth in enterprise agreements, as well as select and open annuity licenses. We estimate that EA renewal rates were at the high end of our historical range of 56% to 75%. In addition, select and open license-only growth accelerated in December after the business launches of Windows Vista, the 2007 Office system and Exchange Server 2007. Our unearned revenue balance ended the quarter a bit higher than we expected at $11.9 billion, including the $1.7 billion of deferrals primarily related to the technology guarantees. Excluding this impact, the unearned balance would have grown 15% over the prior year and still have been up sequentially. Our contracted, non-billed balance at the end of December was also sequentially higher and now exceeds $9.5 billion. If you consider our reported revenue and changes in the unearned and contracted, non-billed balances, our bookings growth exceeded 20% for the quarter. Before I get into the revenue details for each business group, let me point out that changes in foreign exchange rates added about 1 point to our overall revenue growth rate. Client revenue of $2.6 billion, a decline of 25%, includes the impact of $1.1 billion of revenue deferrals, primarily related to the tech guarantee. Adjusting for this impact, Client revenue would have been $3.7 billion, up 9%, driven by growth in the OEM business. OEM revenue increased 8%, excluding the tech guarantee, due to 10% growth in OEM license units. OEM revenue grew at a slightly slower pace than license units, due to the continued increased volume in emerging markets and the shift in channel mix towards larger OEMs, partially offset by the impact from the increase in premium mix. OEM premium mix increased 18 percentage points from the prior year to 67%. Consistent with the relative strength in the consumer segment, especially during holiday, and deferred by the technology guarantee program, we saw a shift within the premium mix itself. Specifically, the growth in the premium mix was a result of consumers purchasing Windows XP Media Center, driven by the upgrade pricing structure offered under the technology guarantee program. So while Windows XP Professional grew year on year, its portion of the premium mix declined a couple of percentage points. While we are delighted to see the increasing trend of consumers recognizing the value offered in premium Windows, we want to point out to you that in the U.S., Windows XP Professional generates over five times the pricing uplift over Windows XP Home than does Windows XP Media Center. Client commercial and retail licensing grew 13%, primarily from sales of Windows Vista into the retail channel, and our partners began readying for Windows Vista general availability. Our commercial business remained healthy, fueled by growth in multi-year contract agreements. The client business made significant progress on the product front this quarter with the business launch of Windows Vista, the most significant operating system release since Windows 95. Server and tools delivered double-digit revenue growth for the 18th consecutive quarter. Its 17% revenue growth was driven by broad adoption of our server and tools product line, particularly SQL Server, which had another quarter of over 30% revenue growth. Revenue for our online services business grew 5% to $624 million, driven by an increase in advertising revenue of 20%, partially offset by an expected decline in access revenue. Healthy growth in display, coupled with a modest increase in search, drove the rise in the total advertising revenue. Increasing search queries contributed to search revenue growth on a year-over-year basis for the first time since we began our transition to AdCenter in the U.S. last year. Microsoft business division revenue was $3.5 billion, or $4 billion after adjusting for the $500 million tech guarantee and preshipment deferral. Growth was driven by the strength of our annuity business and earlier than expected uptake in our license-only business following the business launches of the 2007 Office system and Exchange Server 2007. The Dynamics business continued its strong performance in Q2, as demonstrated by a 19% increase in customer billings. Lastly, entertainment and devices growth of 76% for the quarter was driven by Xbox 360 sales. We have now sold 10.4 million consoles life to date. And according to NTB, consumers in the U.S. purchased more Xbox 360s than both the Wii and PlayStation 3 combined during the month of December. Software attach rates remain at record levels in the U.S., bolstered by the broad success of Gears of War, which sold over 2.7 million copies in its first eight weeks in market. Our mobile and embedded device business also performed well, selling over 3 million licenses for Windows mobile phone-enabled devices, up over 90% year over year. During the quarter, we launched the Zune digital media player in the United States, which furthers our strategy of connected entertainment. Now for the rest of the income statement: positive revenue increase 62%, due primarily to an increase in Xbox 360 sales. As a result, gross margin relative to the prior year was down about 10 percentage points, a slightly larger drop than the guidance we provided in October. This was primarily driven by stronger than expected sales of Xbox 360, as well as an extension of the Xbox 360 warranty from 90 days to one year in the U.S. and Canada. Q2 operating expenses other than cost of revenue increased $509 million or 10%. This was a little higher than expected, due to the timing of certain spending, particularly for sales and marketing programs. Operating income was $3.5 billion. Adjusting for the tech guarantee deferrals, operating income would have been $5.1 billion, up 10% from the prior year, driven by strength in our core businesses. Investment income and other totaled $333 million. Our effective tax rate for the quarter was 31%, up from 29% last year. This year over year rate increase was impacted by a $108 million tax benefit in the prior year. During the quarter, we repurchased 205 million shares or $6 billion worth of our stock and paid $980 million in dividends to shareholders. Diluted shares outstanding were 9.9 billion, down 7% from the prior year, as a result of execution on our share repurchase program. Our diluted shares outstanding for the quarter were impacted by the issuance of 113 million shares in December related to options exercised by JP Morgan for the employee stock option transfer program completed in December 2003. This settlement marks the final expiration of all remaining options under its program. Earnings per share for the quarter were $0.26, which includes approximately an $0.11 per share deferral, primarily from tech guarantees. So in summary, Q2 delivered strong results across the board. Revenue results for all of the segments met or exceeded the top end of our guidance and translated to out performance for both operating income and EPS. Additionally, the quarter marked the business launch of our flagship products. With that, let me turn it back to Chris, who will provide you with our expectations for Q3 and the remainder of fiscal 2007."
},
{
"speaker": "Chris Liddell",
"text": "Thanks, Colleen. Before we get into the specific guidance, let me outline some of our key assumptions. Our fiscal 2007 forecast assumes no major changes in the economic conditions from where we exited the first half, and we're not forecasting any significant impacts from foreign exchange rate movements. We expect PC unit growth to be 8% to 10% for the fiscal year, in line with the guidance we gave you last quarter, and between 9% to 11% for the third quarter. We continue to estimate the PC unit growth rates will be higher in the consumer segment than in the business segment, and higher in the emerging markets than in mature markets. On the server hardware front, we remain comfortable with our estimate for total market price of 10% to 12% for the year. Now let me get into our detailed guidance. For the full year, we expect our revenues to come in at $50.2 billion to $50.7 billion, growing 13% to 14%. We are narrowing our revenue range to reflect how we finished the second quarter, as well as to incorporate changes to the mix of revenue. Our growth is driven by broad-based revenue growth across our five segments, with each of our core businesses growing double-digits. For the third quarter, we expect revenue of $13.7 billion to $14.0 billion, which represents growth of 26% to 28% year over year. Our third quarter will benefit from recognition of the $1.7 billion of revenue that we deferred out of the first half, $45 million from Q1 and $1.64 billion from Q2, primarily associated with our technology guarantee program. Before these impacts, third quarter revenue guidance would have been $12 billion to $12.3 billion, which would have represented growth of 10% to 13%. There's clearly no impact to the full year, as we have discussed. With that, revenue guidance in our five business units is as follows: For client, we have increased our full year growth forecast to 11% to 12%, up from the 9% to 10% we gave you in October and this has been driven by a higher premium mix in our OEMs revenue and a faster transition to Windows Vista. We expect third quarter growth to be 54% to 56%, although our third quarter guidance includes the recognition of approximately $1.2 billion in revenue primarily associated with our tech guarantee program. Before that deferral, third quarter revenue would be growing 16% to 18%. Growth accelerates in the second half of the year for the commercial and retail portion of the client segment, beginning in quarter 3, driven by broad availability of Windows Vista. Client OEM revenue should grow roughly in line with the PC hardware market for the year. We are increasing our expectation for premium mix in the second half of the year and we now expect our full-year premium mix to be about 60%. The increase is driven by mix assumptions for our consumer premium products such as Windows XP Media Center and Windows Vista Home Premium. As Colleen mentioned earlier, we have received modest revenue upside from our consumer premium SKUs versus what we get on Windows XP Pro or Windows Vista Business. Server and tools revenue should grow 16% to 17% for the year from continued growth of SQL Server, development tools and our enterprise services. Revenue for the third quarter should also be up 16% to 17%. We forecast revenue in the online services business to grow between 3% and 8% for the year and 4% to 10% in quarter 3. Although we're still forecasting growth in search queries and page views, our plans now include a more measured rate of growth for the balance of the year. Our full year forecast anticipates total advertising growth in the mid-teens, and we expect this to be driven in particular by our display business, which is growing at a healthy rate, as we see good page growth in our key properties. We continue to have high aspirations to grow this business and we will continue to invest in the business during the second half. Microsoft business division revenue should increased 10% to 11% for the year, an increase of 2 percentage points from the guidance we gave you last quarter on increased business uptake of the 2007 Office system. Q3 revenue should grow 27% to 28%. Our third quarter revenue guidance includes the recognition of approximately $0.5 billion of revenue deferred from the second quarter related to our tech guarantee program and 2007 Office system preshipments into the channel. If you were to adjust for that impact, revenue growth for quarter 3 would have been 13% into 14%. We are encouraged by the favorable customer response we saw in December surrounding our new products. In the entertainment and devices division, we are pleased with what we have been able to accomplish in the past year, including achieving our goal of having sold over 10 million consoles life to date, outselling competitive next-generation consoles during this holiday season, achieving record software attach rates and reaching 5 million Xbox Live members. With that strong momentum, we are making tradeoffs and choices in managing the Xbox business to achieve our targeted profitability in fiscal year '08. In the near term, this means we will optimize for profitability. We believe this puts us in a strong market and financial position as we go into fiscal 2008, a year that will feature a number of catalysts, highlighted by the strongest first and third-party game lineup we've ever had. As we look at historical seasonality, pricing and inventory levels, we're taking a more cautious view of the market, and our half 2 revenue and console guidance reflects that. We are now forecasting full year revenue growth of 26% to 31% and a decline of 15% to 25% for the third quarter and expect to exit June having sold about 12 million Xbox 360 units since launch, down from our previous guidance of 13 million to 15 million. That reduction in console units also results in a reduction in revenue related to attached software, accessories and Live. Moving on to operating income, for the year we expect to generate between $19.3 billion and $19.7 billion of operating income, representing growth of 10% to 12%, excluding legal charges taken in fiscal 2006. This is an increase of approximately $200 million on both the low end and high end, this is what we told you in October, now representing double-digit growth even at the low end. We are flowing through some of the revenue upside and keeping full year spending in line with what we had in October. For the third quarter, we expect operating income to be between $6.1 billion and $6.3 billion, including the impact from revenue recognized from our tech guarantee and preshipments. Excluding this impact, operating income for the third quarter would be between $4.4 billion and $4.6 billion. Third quarter operating income includes some costs deferred from the second quarter, as well as operating costs in preparation for the launches of Windows Vista and the 2007 Office system. Cost of goods sold as a percentage of revenue for the full year should increase by 1 percentage point over last year, in line with what we said in October. We continue to estimate a full year tax rate of 31%, consistent with what we saw in the second quarter and with our October guidance. Diluted earnings per share, we're bringing up the range for the year by $0.02 at the low end and $0.01 at the high end due to higher revenue in our core businesses of client, server and tools, and MBD. This translates into a full-year expected range of $1.45 to $1.47 and $0.45 to $0.46 for the third quarter. The third quarter earnings per share includes approximately $0.12 per share associated with the impact of the tech guarantee program. From a balance sheet perspective, we expect unearned revenue to finish fiscal 2007 up 6% to 8% due to our better performance in Q2. Contracted not billed should also finished 2007 up from where we exited fiscal 2006. When thinking about sequential changes in unearned revenue from quarter 2 to quarter 3, we expect a decline of slightly greater than $1.7 billion of revenue we'll recognize associate with our tech guarantee program and presales. This decline would be consistent with normal seasonality. For our full year unearned revenue guidance, we're modeling a moderation in the recent annuity mix of our billings as both the 2007 Office system and Windows Vista will be available to customers in the second half of the year. I'll remind you though, as you think about guidance for the rest of the year, we still face the risks and opportunities I have highlighted in our previous two earnings calls: for example, competitive, legal, execution and general market risks; as well as PC and server hardware growth rates, customer acceptance of our products, and the costs to remain competitive, such as those to acquire and serve customers in our online businesses. Also, our emerging businesses are harder to forecast when compared to our mature businesses, so as they continue to become a larger part of our overall financial mix, they may contribute to increased volatility in our quarterly performance. Before moving to questions and answers, I would like to make a couple of quick comments. I committed to you at our financial analyst meeting last year to provide you with a more continuous flow of information throughout the year, and that would include communication from Steve and me. We will do that on February 15 in New York City, and for those of you unable to join us for that, we will make available a live webcast as well as an on-demand replay of the presentation. The intention of this presentation is for Steve and me to meet with investors and provide an update on our strategic direction after completing our internal strategy meetings. Although we may generally discuss revenue and spending trend levels, we will not give any detailed financial information. As in past years, we will provide our first preliminary review of fiscal 2008 guidance on our third quarter earnings call in April. Since the financial analyst meeting in July, we have also had executives out talking with the financial community in a variety of forums at a pace over once a month outside of our quiet periods. Looking forward into half 2, we will double that frequency. In general, we have been trying to give you more overall exposure to all of our senior executives and we look forward to seeing you. With that, I'll hand the call over to Colleen so we can get started with some of your questions. Thank you."
},
{
"speaker": "Colleen Healy",
"text": "Thanks, Chris. Let's now proceed to questions. We want to accommodate questions from as many people as possible, so please avoid multi-part questions and please limit yourself to just one question. Operator, will you please repeat your instructions?"
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Heather Bellini - UBS."
},
{
"speaker": "Heather Bellini",
"text": "Good afternoon, Chris and Colleen. I was wondering if you could give us your assumptions for higher price SKU mix in the March quarter, because if we adjust for the technology reversal that you are going to have in March, then it appears that you're looking for client segment growth of roughly 20% versus a PC shipment forecast that is about half that. The second question I would have is that for Service Pack 1, it typically comes out one year after the release of Windows, if we look back historically. I'm just wondering if we should be thinking less than that now, given your desire to shorten Windows development cycles."
},
{
"speaker": "Chris Liddell",
"text": "In terms of the quarter 3, if I work through the math of taking you from the shipment units that we see down to the revenue, that will probably help you the most. And then I will talk about service packs. As I mentioned in the formal remarks, we expect shipments in the third quarter to be 9% to 11%. We are assuming that our units that we sell will be at the top end of that range, 11%, so we'll still have a modest improvement. The main factor that is going to drive the revenue is going to be on the commercial and retail. So we will, again as I mentioned in the prepared remarks, we will certainly get a significant impact from that element of the revenue that is commercial and retail. As you'll recall, that's only about 20% of the total revenue but we're expecting it to grow significantly relative to the previous year, obviously, with Vista being available for the first time. So those will be, in essence, the main drivers. You are right, that will get us up to revenue growth that is close to 20% for the quarter."
},
{
"speaker": "Heather Bellini",
"text": "On the service pack side?"
},
{
"speaker": "Colleen Healy",
"text": "On the service pack side, Heather, we have seen a lot of the same rumors that you probably have in the press in terms of dates. The company hasn't put a date out there. It always makes sense to see how the product does out of the gate, continue to get feedback and we don't have an SP date to share with you today."
},
{
"speaker": "Operator",
"text": "Your next question comes from Charlie DiBona - Sanford Bernstein."
},
{
"speaker": "Charlie DiBona",
"text": "Hi, Chris. I was wondering if we could turn to the online services business. It looks like the display ads are doing fine, but search is slipping share pretty consistently in all the independent numbers. You have now lowered guidance, it looks like while you might be growing search a little bit you are certainly going to continue to slip share if you stick to this guidance. How should we be looking at this business? How can we evaluate progress here? When can we expect a turnaround?"
},
{
"speaker": "Chris Liddell",
"text": "You are right, Charlie, to break the business down into its different bits. Clearly, the overall results are impacted by adCenter decline. but if I take that out and look at the advertising revenue overall, it grew 20% for the quarter, which we're happy with. If you break that down into display and search, clearly there is a better story on the display side, and we are growing broadly in line market. So I'd like to think we can put a tick in that box and we are comfortable with the progress we are making there. On the search side, you are correct that we lost market share certainly relative to the independent assessment during the quarter, and are clearly not happy with that. We continue to take a long term view of this business. We continue to invest in it, and we are making progress in the short term on some of the factors that we think are important: getting advertisers onto our adCenter platform, turning the corner in terms of revenue on a quarter-by-quarter basis. Since we went off Overture, the second quarter is the first quarter where we are seeing consecutive growth in revenue and we still expect to get revenue per search equal to where we were a year ago by the end of this year. So we are making progress in some of the underlying factors and we are continuing to invest. But I expect you should and we should expect to see more progress in the long term on the search side."
},
{
"speaker": "Charlie DiBona",
"text": "Does there come a time when you can share some of those metrics you say are doing better internally? Because we don't see them out here."
},
{
"speaker": "Colleen Healy",
"text": "From a communications standpoint, Charlie, what we've really set up is at our financial analyst meeting there are some specific metrics that we told you you will hear, really from Kevin Johnson: breadth of usage, depth of usage and how we're doing on monetization, really similar to our competitors in terms of providing some of those underlying drivers quarter by quarter. It is not something that we are doing, it doesn't necessarily make sense from a competitive standpoint. There tends to also be pretty decent third-party information out there. But you will continue to hear from the business leaders, as well as Chris, directly at FAM on those metrics that we outlined at the financial analyst meeting last year, and we'll update you again on at least a yearly basis."
},
{
"speaker": "Chris Liddell",
"text": "Charlie, the other thing I would say is once we lap coming off Overture you'll be able to do a much better comparison because then we are comparing ourselves to ourselves. So in two or three quarters I think the comparables year on year will be much easier for you to make an assessment of progress. Also, as the impact of the access business decline becomes much less significant, then you are really looking at the underlying business growth. So it won't necessarily get to the level of granularity that I know you have consistently been looking for. But I think it will become, hopefully, more useful to you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Kash Rangan - Merrill Lynch."
},
{
"speaker": "Kash Rangan",
"text": "Hi, thank you very much. Just to clarify the Xbox commentary, Chris, is that more of an inventory flush-out that causes you to lower the guidance for the rest of the year? Also, if you could comment on the premium mix. If you experience better mix shift to the higher-end versions of Vista after the launch, will that cause the company to raise its guidance for the client business or is that already factored into the guidance? That’s it, thanks."
},
{
"speaker": "Chris Liddell",
"text": "On the Xbox side, certainly the healthy inventory that we have seen which is partially a result of the very good sales that we saw into the channel in the second quarter last year, is one of the factors behind what we're looking for in the second half. Also, as we start to think about fiscal year '08 and what's the best approach to take for fiscal year '08 in terms of profitability, so we're just making some strategic decisions around what we might do there, too. So it is those two things, broadly speaking, which are the reasons why we are giving the guidance we are. On the premium side, we have embedded inside the guidance that we have given you the premium mix that we now have of 60%. So that is reflected in the guidance for fiscal year '07. Clearly, as Colleen mentioned, inside that 60% there is a mix within a mix, so depending on how that came out between the consumer SKUs and the business SKUs, if that changed, the 60% could still be the case, but we could have a different revenue number there. But at this stage, based on our expectation of the premium mix and how the business and consumer elements of that were made up, that is reflected in the guidance."
},
{
"speaker": "Kash Rangan",
"text": "So you are not assuming any change in the business versus the consumer within the premium as it relates to '07 guidance just as yet? You're basically using the same experience as with XP to make your forecast, right?"
},
{
"speaker": "Chris Liddell",
"text": "It is not the same experience as XP. It is the same experience, if you like, as what we forecast at the beginning of the year."
},
{
"speaker": "Operator",
"text": "Your next question comes from Rick Sherlund - Goldman Sachs."
},
{
"speaker": "Rick Sherlund",
"text": "Thanks. Chris, the launch of Vista, Office 2007 and Exchange Server coming up at the end of this month, if I want to be a little more optimistic about the revenues in Q3, you've given a little bit of precise guidance there and I'm just not sure how predictable the demand is going to be. I'd just ask you to talk to that issue in terms of your ability to forecast for Q3, given the launch of some pretty major new products and whether you might think it reasonable to think that we could see more upside in Q3."
},
{
"speaker": "Chris Liddell",
"text": "Richard, we've talked about it before, I think this is different from if you go back a decade, obviously, to a Windows 95 impact. We certainly think it would be positive, but more gradual as it rolls out into the marketplace. In terms of the impact on overall sales, we were heartened by the quarter 2 results. We are certainly heartened by the fact that the tech guarantee appeared to avoid any stalling of sales in that quarter. But we are sticking with the external numbers that you have seen and that is flowing through in turn to our second half. Could there be some upside to that? Yes, clearly there is, but obviously there could be some downside as well. I talk about that on the risks and opportunities side. If the product was extremely well received and if there was very strong demand at say the top end of our expectations for the second half, clearly that would flow through. At this stage, it is launching next week, and we're taking what we consider to be just an appropriately conservative view of the second half."
},
{
"speaker": "Rick Sherlund",
"text": "SQL Server up 30%-plus again this quarter against a launch last year of the new product, I'm a little surprised that we are continuing to see 30%-plus growth from that product, particularly on a tougher comparison. Any light you can shed on what is happening or why we're seeing such robust growth there?"
},
{
"speaker": "Chris Liddell",
"text": "Yes, we were positively surprised on the upside there, too. The only thing I would say is that the price increase went in during the quarter. So you've got some part of the quarter which is price impacted, if you like. So it will definitely become a much harder comparable in the second half. But in terms of underlying sales, it was a good quarter, you are right."
},
{
"speaker": "Rick Sherlund",
"text": "Chris, on the Xbox, just finally, I hear what you're saying that you want to manage inventory levels down it sounds like, over the next couple of quarters. Certainly if there were a price reduction coming, you would want to minimize your channel inventory levels before you would do something like that. Am I understanding correctly that what you're trying to do is manage inventory levels down for Xbox in the second fiscal half?"
},
{
"speaker": "Chris Liddell",
"text": "I wouldn't put it in those terms. We are looking at the numbers that we sell into the channel based on where we see the inventory at the start of the year and the patterns of sales that we think will come up. So the net result of that may well be that we see inventory come down. But if you like, it is an outcome, not a management of that."
},
{
"speaker": "Rick Sherlund",
"text": "You're not seeing any change in the competitive environment; there's no change in your assumptions of market share?"
},
{
"speaker": "Chris Liddell",
"text": "No."
},
{
"speaker": "Operator",
"text": "Your next question comes from Adam Holt – JP Morgan."
},
{
"speaker": "Adam Holt",
"text": "Good afternoon. You made a number of comments about the ASP and premium mix expectations around Windows. I was hoping maybe you could talk a little bit about what you are expecting within Office. Obviously, you have got a number of new SKUs with Small Business Pro/Ultimate. What does the guidance imply in terms of ASP improvement and what do you think is reasonable for us to expect?"
},
{
"speaker": "Chris Liddell",
"text": "Well, to the extent that obviously we're just giving guidance for the balance of this year it is not a huge impact. There is clearly revenue coming through from the first half which is not significantly impacted by that and so there is not a huge impact in the whole of fiscal year '07. Having said that, we did see renewal rates, as Colleen mentioned, at the top end of our 66% to 75% historic range. One of the reasons for that we feel was people anticipating the Office and therefore being attracted to renew. So that, to some extent, flows through in the second half. But in terms of an overall mix shift, it's not a significant component of the fiscal year '07 revenue."
},
{
"speaker": "Adam Holt",
"text": "If I could just ask a follow up on the strength in unearned, what I was particularly taken with was the client side. If you net out undelivered, it looks like you had better than 30% growth in client unearned. Could you talk about what you are seeing in terms of enterprise renewal activity, reattachment to enterprise licensing, and maybe refresh us on your thinking in terms of what you're expecting for enterprise adoption as we get further into the cycle?"
},
{
"speaker": "Colleen Healy",
"text": "On the annuity side, as with Office, a bit with client as you're talking, we have seen really nice renewal rates. They have been really trending at the high end. In particular, to your point, when you look at the various parts going into unearned, we are seeing a bit of an uptick in terms of customers adding Windows under their enterprise agreements. We think the value proposition from the enterprise view is compelling. And of course, you can only get if you are an annuity customer, so that looks promising. But really, I would say at this point, a bit too early to get ahead of ourselves. But we have been noticing that a bit as well."
},
{
"speaker": "Operator",
"text": "Thank you. Your next question comes from Brent Thill - Citigroup."
},
{
"speaker": "Brent Thill",
"text": "Thanks. Chris, just a follow-up to Adam's question on Office. The reviews have been very solid, and just wondering if you could help us understand what the rationale is, why pricing can't go up in the face of that, considering this is a pretty big release. If you look at the server business, you have raised pricing and it doesn't feel like there has been any pushback."
},
{
"speaker": "Colleen Healy",
"text": "What we could say on the pricing side, actually, is certainly in terms of the upper end views, we have put more value into those offerings. For example, on the Professional Plus offering, which adds the Communicator IM Client and other things, pricing went up a bit, call it 5% or so. On the enterprise SKU, which has Pro and Windows and grew, we did take the opportunity to add more value there. We expect to see some pricing uplift there. So really what you're seeing, whether it is SQL or Office or some of the other products you mentioned, it is really more SKU differentiation that you heard from us really at the financial analyst meeting a year ago, and we are really continuing to look for opportunities to provide value in higher-end SKUs and price accordingly. But again, we don't want to get too far ahead of ourselves in terms of adoption rates. Keep in mind that a lot of these products, in particular on Office, because there's already quite a bit going into annuity, you actually recognize that over a period of time on the P&L."
},
{
"speaker": "Chris Liddell",
"text": "From our perspective, at a particular price point, the concept of increasingly trying to add value at that price point over time through software development is just a good philosophy. So we certainly don't think just because we are adding functionality that we should necessarily increase price. In terms of our renewals now in the post-Vista and Office era, the ability to actually offer new products and hence look at enterprise agreements that are much broader, much more of infrastructure-based agreements rather than desktop agreements, is more of the potential."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jason Maynard - Credit Suisse."
},
{
"speaker": "Jason Maynard",
"text": "Hi, guys. I have a question on spending. You had indicated that Q2 was a little lower than expected in marketing program spend. Server and tools, I think, did $1 billion in op income. How do you think about Q2 in terms of its impact on spending in the back half of the year and even longer term as you look to invest in places like online services and then even potentially in entertainment devices?"
},
{
"speaker": "Chris Liddell",
"text": "We have kept, again, our expenses very much in the context of the year and we have kept our expense number for the year the same as where it has been essentially all year. I am increasingly happy with the discipline we are showing there for the year. In terms of the quarter-by-quarter movement, we certainly give the people flexibility on a quarterly basis to spend on programs as is necessary. We can see swings, in particular in some of the marketing spends with some of the launches on a quarter-by-quarter basis. So I wouldn't get too concerned one way or the other. In this case, it's a positive trend on the expenses year to date. I tend to focus on what our expectations are for the year and at this stage, they haven't changed."
},
{
"speaker": "Jason Maynard",
"text": "Maybe just help me reconcile, operating cash flow came in just a touch above $2 billion, which was a little lower than I think most of us were modeling. Can you maybe help us understand the puts and takes on the cash flow number?"
},
{
"speaker": "Chris Liddell",
"text": "To some extent, there was obviously inventory builds. We had a relatively high number of Xbox sales and so that does tend to impact our cash flow for the quarter. There could well be, depending on the line you're looking at, the big billings area. So a big unearned can influence the cash flow aspect of it as well. But there were no significant issues. Buyback was relatively high, but we also had the JP Morgan options exercised, so nothing unusual there. I would describe it as a reasonably predictable cash flow quarter, albeit with some big movements inside it."
},
{
"speaker": "Colleen Healy",
"text": "Thanks so much. We have time for a just a few more questions. Our next question please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Robert Breza - RBC Capital Markets."
},
{
"speaker": "Robert Breza",
"text": "Hi, good afternoon. Real quickly, Chris, maybe as a follow-up to the last question, when you look at the leverage you showed this quarter and a little bit of lack of spending in the back half of the year, where do you see additional leverage coming from? What levers do you think that are there that you could execute to deliver upside?"
},
{
"speaker": "Chris Liddell",
"text": "Well it's more likely to be on the revenue side. Clearly, we have the opportunity to cut expenses and some of the decisions that we can make, we could, for example, decide to cut back on marketing for the second half of the year. I don't think we will, but we could do it. The upside potential really comes more on the revenue side and that really comes across the board. So clearly, in our client and office division, as Rick's question alluded to earlier, with a launch there's a big amount of variability around that. So there could be some upside there. But we've guided to what we think is probably the appropriate level. In the online services area, there's probably not such a big swing factor there in the overall context of the company, but clearly our ability to continue to generate display advertising and change market share in search has some impact. And then on the entertainment and devices, really it's to a large extent on the revenue side, it is an Xbox story. Again, we have taken what we think is the most likely scenario there. Given the relative seasonality, the June half is a lot less significant than the December half in the Xbox business, so I don't see a high degree of variability. But again, that would be something that would be a big factor. Each of the businesses has their own dynamic. But if you're looking for the things that could swing, it is really in our core businesses with those big launches."
},
{
"speaker": "Robert Breza",
"text": "Great, thank you, nice quarter."
},
{
"speaker": "Operator",
"text": "Your next question comes from Tim Klasell - Thomas Weisel Partners."
},
{
"speaker": "Tim Klasell",
"text": "Going to Vista, you've mentioned in the past that you won't be having to hold back the 5% to 25% going into deferred. That should be about $150 million to $250 million a quarter as that rolls off the next three years. Is that the right way to think about that, and is that still the way you plan on doing it?"
},
{
"speaker": "Chris Liddell",
"text": "We had quite an extensive discussion last quarter about that. I think we stated that we will give you guidance for fiscal year '08 in our next quarter in terms of exactly how much we expect from that. We want to be transparent about how much is the underlying business, how much is simply just the different revenue recognition. It will be order of magnitude in the sort of numbers you're talking about, but it is too early at this stage to give actual numbers out."
},
{
"speaker": "Tim Klasell",
"text": "Good. One final question, Longhorn, if we look out a little further, how is that tracking and are you still planning on an end of the year release?"
},
{
"speaker": "Chris Liddell",
"text": "Yes, we are."
},
{
"speaker": "Colleen Healy",
"text": "Longhorn is tracking. We are expecting really to RTM for the second half of calendar year 2007 and I think you'll hear more from us over time on that. Great, thanks so much. We have time for one last question, please."
},
{
"speaker": "Operator",
"text": "Your final question comes from John McPeake - Prudential."
},
{
"speaker": "John McPeake",
"text": "A question about online offering and dynamics [inaudible] Could you talk a little bit about how Codename Titan, the online product, is going to roll out and the timing there?"
},
{
"speaker": "Chris Liddell",
"text": "You are little faint there, sorry. But I picked up your question in terms of Titan, have we gone public on the timing for that?"
},
{
"speaker": "Colleen Healy",
"text": "We have."
},
{
"speaker": "Chris Liddell",
"text": "That's the summer this year. So we are on track for that, as we talked about. So that will be in the summer, in six months, if you like."
},
{
"speaker": "John McPeake",
"text": "Does Xbox inventory drawdown have anything to do with potentially a new version of Xbox coming out first fiscal half?"
},
{
"speaker": "Chris Liddell",
"text": "No. That was an easy one."
},
{
"speaker": "Colleen Healy",
"text": "Great. Thanks a lot, John. Thank you, everybody for your participation in today's call. If you have any further questions, please feel free to call me or my team directly. As I mentioned at the beginning of this call, this conference call will be available on replay at our investor relations website through close of business January 25, 2008. In addition, you can hear the replay by dialing 800-873-5569 or for international calls, dial 203-369-3995. The dial-in replay will be available through the close of business February 2, 2007. Thanks again for joining us today."
},
{
"speaker": "Chris Liddell",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. This does conclude today's conference call. We thank you for your participation."
}
] | null | null |
MSFT | 1 | 2,007 | 2006-10-27 16:00:00 | Operator: Good afternoon, and welcome to the Microsoft 2007 fiscal year first quarter conference call. (Operator Instructions) I would now like to turn the call over to Ms. Colleen Healy, General Manager, Investor Relations. Please go ahead.
Colleen Healy: Thank you. Good afternoon, everyone and thank you for joining us today. This afternoon I am joined by Chris Liddell, Senior Vice President and Chief Financial Officer; Frank Brod, Corporate Vice President of Finance and Administration and Chief Accounting Officer; and John Seethoff, Deputy General Counsel. Today's call will start with Chris providing some key takeaways for the first quarter of fiscal year 2007 and an overview of expectations for the rest of the fiscal year. I will then provide detail around our first quarter results, and then turn it back to Chris for a more detailed discussion of our guidance for the full year and the second quarter of fiscal 2007. After that, we'll take your questions. We filed our 10-Q today in conjunction with our earnings release. Therefore, you have available the earnings release, MD&A, financial statements and footnotes. We have also posted our quarterly financial summary slide deck, which is intended to follow the flow of our prepared remarks in order to assist you. The slide deck offers highlights from the quarter, outlines our guidance, and provides a reconciliation of differences between GAAP and non-GAAP financial measures that we will talk about today. You can find the earnings release, the 10-Q, and the quarterly financial summary slide deck on the investor relations website, at www.Microsoft.com/MSFT. Today's call will be recorded. Please be aware that if you decide to ask a question, it will be included in both our live transmission as well as any future use of the recording. As always, shareholders and analysts can listen to a live webcast of today's call at the Microsoft investor relations website. A replay of the call will be available at this same site through the close of business on October 26, 2007. This conference call report is protected by copyright law and international treaties. Unauthorized reproduction or distribution of this report, or any portion of it, may result in civil and criminal penalties. Any recording or other use or transmission of the text or audio of today's call is not allowed without the express permission of Microsoft. We will be making statements during this call that are forward-looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in today's earnings press release, and the comments made during this conference call, and in the risk factors section of our 10-Q, our 2006 Form 10-K, and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statement. With that, let me now turn it over to Chris.
Chris Liddell: Thanks, Colleen, and good afternoon, everyone. We're pleased to be with you today to share our first quarter results and talk with you about how we see the rest of fiscal 2007 shaping up. Looking back over the first quarter, I would characterize it as a very good start to what we are expecting to be an excellent year. All aspects of our financial performance came in at or above the high end of our guidance. Our product groups made considerable progress executing on major product milestones towards their launches in quarter two and beyond, and we continued our progress on returning cash to shareholders, including through our tender offer. Looking back to our first quarter financial performance, revenue came in at the high-end of our guidance, growing 11%, which represents over $1 billion in absolute revenue growth. Server and Tools and our Entertainment and Devices division were particularly strong in the quarter, benefiting from continued customer demand for SQL Server and the Xbox 360. Operating income benefited from both the strong revenue growth, as well as lower spending, primarily on marketing programs, which we shifted out of quarter one and into the rest of the year. Combining that with increased investment income, as we increased liquidity in preparation for the tender offer, our earnings per share results were excellent. This was an important quarter for our business groups, as we made significant progress towards a number of milestones leading up to our product launches in coming months. During the quarter we rolled out Release Candidate 1 of Windows Vista, a Beta 2 technical refresh of the 2007 Office system, a Beta of Exchange Server 2007, and announced the upcoming launch of Zune. To date, these trial versions have been made available to about 5 million Windows Vista users and over 3 million 2007 Office System users. We've been receiving encouraging feedback from partners and customers who are using the betas, which are the most widely-tested releases in the history of these products. We also continue to be active on the acquisition front, averaging more than one a month. This quarter the bulk of our acquisitions were companies that augment the offerings of our Server and Tools business. Our acquisitions focused on the areas of systems recovery and data protection, virtualization, and security. Finally, on the capital structure front, we continue to make steady progress. We finished our prior $30 billion repurchase plan, as we shared with you on the last earnings call, announced a new authorization that runs through July 2011, completed our tender offer, made additional share repurchases outside of the tender offer in the quarter, and increased our quarterly dividend. Moving now to the full fiscal year, 2007 is shaping up well. We will be delivering the second major installment on our multi-year product cycle, helping to fuel revenue growth for the Company. So, let me make a couple of key points about fiscal 2007. First, we continue to expect full-year double-digit revenue growth. In terms of quarterly trends, revenue growth will be impacted by the deferral of approximately $1.5 billion of Client and MBD revenue out of the second quarter and into our third quarter, as a result of the recently-announced technology guarantee programs. As we discussed on the call hosted by Frank and Scott earlier in the week, this movement has no impact on our full-year numbers. Second, growth in operating income in the first half of the year will be impacted by the increasing mix of Xbox 360 console revenue and related costs, coupled with significant investments to support the launches of our flagship products, and the accounting impact of the technology guarantee programs. This trend should reverse in the second half of the year, when we expect operating income will grow considerably faster than revenue. Finally, excluding legal charges in the prior year, we will grow earnings per share 13% to 15% while launching major products and continuing to invest in the future growth opportunities in all our business divisions. I'm particularly happy that we've been able to broadly maintain our full year earnings per share guidance. Better business performance and higher investment income have helped offset the impact of lower share repurchases in our tender offer and the higher effective tax rate. With those high level things for the quarter and the full year 2007, I'm going to turn the call over to Colleen now for more details on our first quarter performance.
Colleen Healy: Thanks, Chris. In the interest of providing more time for your questions, I'm going to keep my remarks regarding the fiscal first quarter brief. Overall, we are off to a good start in what is a significant year for the Company. Specifically during the quarter, we delivered revenue, operating income and EPS growth at or above the high end of our guidance. We made significant progress on development and launch readiness for key products in the pipeline, including Windows Vista, Office 2007, Exchange Server 2007, and Zune. We returned $7.9 million in capital to shareholders in the form of dividends and share repurchases. I will now provide more detail on our financial performance, starting with revenue. I will discuss top line financial and business momentum points, and then follow up with revenue performance for each of the business units. All growth comparisons I mention relate to the comparable quarter of last year unless otherwise specified. Revenue growth for the quarter was 11%, driven primarily by the business groups significant product launches over the past 12 months, as our new product cycles have been well received by customers. Specifically, Entertainment and Devices and Server and Tools accounted for over 70% of the absolute revenue growth in the quarter. Healthy PC and server hardware market growth were also key contributors to our results. The PC market grew 8% to 10% in the quarter, driven by a good back-to-school sales season. Consumer growth outpaced that of business, consistent with the trend of the past several quarters. Geographically, we saw double-digit growth in Asia and Latin America, with the remaining regions growing at single digits. Server hardware shipment growth was consistent with our full-year estimate of 10% to 12%. Our mix of product billings was approximately 40% from OEMs; 25% from multi-year licensing agreements; 20% from license-only sales; and the balance from our other businesses. These results were generally consistent with the prior year. We had a good quarter from a volume licensing perspective and saw strong performance in our small and medium business channel in particular. In terms of enterprise agreements, we highlighted in July that there was a relatively small amount of EA contract value up for renewals in the first quarter, which would impact EA. Of the business that was up for renewal, we continued to see EA renewal rates within our historical range of 66% to 75%. Non-annuity growth was relatively weak, as expected, in front of major product launches later this year. Our unearned revenue balance ended the quarter at $10.1 billion, up 15% over the prior year and slightly stronger than we expected. The sequential decline in the unearned balance in the first quarter was driven by the absolute size of our fiscal Q4 annuity billings relative to Q1, as well as the small amount of EA contract value up for renewal, as previously discussed. Our contracted not-billed balance at the end of September was sequentially lower, but continues to exceed $9 billion. Now I'd like to provide revenue highlights by business segment. Starting with Client, revenue for the quarter grew 4% to $3.3 billion. OEM revenue growth of 4% resulted from 11% growth in license units. The 7 percentage point difference between OEM license unit growth and revenue growth was caused primarily by increasing volumes in emerging markets, the relative strength of the consumer segment of the market, and a $45 million revenue deferral related to the Express upgrade to Windows Vista program. We were particularly pleased with the continued adoption of Windows Media Center Edition, which represented over 15% of OEM license mix in the quarter, and has now sold over 20 million units to date. Client, commercial and retail licensing product growth of 5% was primarily driven by growth in multi-year contract agreements in front of the Windows Vista launch. We made significant progress on Windows Vista development during the quarter, as evidenced by the recent availability of the second release candidate. We made pre-release versions of Windows Vista available to over 5 million customers worldwide. Server and Tools revenue growth of 17% represents the 17th consecutive quarter of double-digit revenue growth for the segment. Results for the quarter were driven by broad adoption of our Server and Tools product line, particularly SQL Server, which grew over 30%, Windows Server and Digital Studio. During the quarter we completed the acquisition of Softricity, Whale Communications, Winternals Software and DesktopStandard, which will strengthen our growing Server business around virtualization, enterprise security and management. Revenue for our Online Service business was down 4% to $539 million, with 5% advertising growth and a 30% decline in access revenue. Increased advertising revenue was driven by growth in display advertising, offset by lower search revenues. With respect to search, although our search queries grew, our search pricing was below the prior-year levels as a result of the transition to our new adCenter platform, which began in earnest during the December quarter. We experienced sequential growth in revenue per search as we increased the number of advertisers on our platform. During the quarter we also released a number of new or updated Internet services, including Live.com, Live Search, Live Local Search and Live Spaces. Microsoft Business division revenue grew 4% to $3.4 billion, a good result in front of the upcoming product launches of Office 2007 and Exchange Server 2007, and in line with our expectations entering the quarter. As with Windows Vista, we also made considerable progress on the development of the 2007 Office system. We released the Beta 2 technical refresh of the product during the quarter and over 3 million customers have pre-release versions of Office 2007. Business momentum and customer interest for both Office 2007 and Exchange Server 2007 remains strong, leading us to the launches later this year. We also delivered strong performance in our Dynamic business in the first quarter, with customer billings growth of 19%. Lastly, Entertainment and Devices growth of 70% for the quarter was driven by strong performance across all of its businesses. Interactive gaming revenue in particular more than doubled as a result of Xbox 360 platform momentum. We have sold 6 million consoles life to date, and Xbox 360 software and accessory attach rates have remained at record levels in the U.S. relative to any previous console launches from competitors. Momentum for Xbox Live continued to build as well, passing the 4 million member mark during the quarter. In addition to strength in gaming, our Mobile and Embedded Device business recorded its sixth consecutive quarter of revenue growth in excess of 40%, as licenses for Windows mobile-based phones more than tripled. Finally, we announced the next step in our Connected Entertainment division with the coming availability of the Zune digital media player and online service for U.S. consumers starting on November 14. Now for the rest of the income statement. While revenue increased 11% for the quarter, the cost of revenue increased 35%, due primarily to Xbox 360. As a result, gross margin relative to the prior year was down 3 percentage points for the quarter, consistent with the guidance we provided in July. First quarter operating expenses, other than cost of revenue, increased $560 million, or 14%, excluding certain legal charges in the prior year quarter. While we continue to invest aggressively in both R&D and sales and marketing to drive future growth, expenses this quarter were lighter than we expected, primarily due to the timing of marketing program spend. Operating income for the quarter was $4.5 billion, up modestly from the prior year excluding certain legal charges in that year-ago quarter. Investment income and other totaled $567 million, driven by larger than expected gains on investment sales to fund our tender offer during the quarter. Our effective tax rate came in at 31%, slightly higher than the estimate provided to you in our guidance last call, due to the change in the mix of earnings in various tax jurisdictions. During the quarter we continued to execute against our strategy of returning capital to shareholders. We repurchased $7 billion of company stock, including nearly $4 billion through our tender offer, and paid out $9 million in dividends during the quarter. Diluted shares outstanding were 10 billion, down 7% from the prior year as a result of execution against our share repurchase program. Earnings per share for the quarter were $0.35, $0.03 above the high end of the range we provided in July. So, in summary, Q1 was a good start to fiscal 2007. The solid revenue results for the quarter were at the top end of our expectations, and EPS exceeded our expectations with an exciting and important fiscal year now underway. Chris will now provide you with our expectations for the second quarter and fiscal year 2007.
Chris Liddell: Thanks, Colleen. I'm going to spend my remaining time on the call talking about what we see coming for the full year and the second quarter. Before we get into the specific guidance, let me outline some of our key assumptions. Our fiscal 2007 forecast assumes no major changes in the economic conditions and demand from where we exited the first quarter, and we are not forecasting any significant impacts from foreign exchange rate movements. We expect PC unit growth for fiscal 2007 to be 8% to 10% for the year, in line with the guidance we gave you last quarter, and between 6% and 8% for the second quarter. We continue to estimate that PC unit growth rates will be higher in the Consumer segment than in the Business segment, and higher in emerging markets than in mature markets. On the server hardware front, we remain comfortable with our estimates for total market growth of 10% to 12% for the year. Now let me go through our detailed guidance. For the full year we expect our revenue to come in between $50 billion and $50.9 billion, growing 13% to 15%. We are bringing up our revenue range to reflect how we finished quarter one, as well as also raising the top slightly. Our growth is driven by forward-based revenue growth across our five segments. For the second quarter we expect revenue of $11.8 billion to $12.4 billion, which represents quarterly growth of flat to up 5%. There are a couple of items to note when you consider our second-quarter revenue. First, the revenue figures for the second quarter include the impact of us deferring approximately $1.5 billion, primarily from our technology guarantee programs. Again, this simply defers the recognition of revenue from the second quarter into the third quarter. There is no full-year impact of these programs on revenue. Before these impacts, revenue guidance would have been $13.3 billion to $13.9 billion, which represents growth of 12% to 17%. Second, we expect PC unit growth in the second quarter to remain healthy, but moderate from the growth rate we saw in our fiscal first quarter, as well as from the growth rates we saw last year in second quarter. With that, revenue guidance in our five business units is as follows: For Client, we expect full-year growth to be 9% to 10% and second-quarter growth to be down 25% to 27%. This full-year guidance includes the impact of revenue recognition changes for Windows Vista, as was discussed on our call on Tuesday. Our second quarter guidance includes the deferral of approximately $1 billion in revenue out of the quarter and into the third quarter. $1 billion covers revenue associated with both our technology guarantee program, as well as amounts for Windows Vista pre-shipments into the channel ahead of launch. If you were to normalize for the $1 billion of deferrals, second-quarter revenue would be growing 4% to 6%. Looking at the full-year growth, the commercial and retail portion of the Client segment should pick up in the second half due to our launch of Windows Vista targeted for volume licensing customers in November, and with broad availability in January. We expect Client OEM revenue to grow slightly below the PC hardware market for the year, due to increased concentration among larger OEMs, consumer hardware shipments growing faster than business shipments, and relatively faster growth in emerging markets. Server and Tools revenue should grow 15% to 16% for the year and 14% to 15% for the second quarter. We continue to expect double-digit growth throughout the year from the sustained momentum of SQL Server and from growth in Windows Server, developer tools, our application business, and enterprise services. As we approach the anniversary of the SQL Server and Visual Studio launches, quarterly performance in the second half of the year will face tougher year-over-year comparables. We forecast revenue in the Online Services business to grow between 7% and 11% for the year and to be up 3% to 5% in quarter two. The full-year growth number implies significant year-over-year growth in the second half, based upon growth in both search and display advertising revenues. While we continue to make investments in various aspects of the business, we did make progress on a number of fronts in the quarter. For example, we rolled out the Live Search, which now powers searches on both MSN.com and Live.com, moved our Live Local Search out of beta and into final availability in both the U.S. and the UK, continued to grow and broaden our social networking presence with spaces and the recent beta rollout of Soapbox, and we're making good progress getting advertisers on adCenter, as well as looking at opportunities to extend our reach through partnerships. Microsoft Business division revenues should grow 8% to 9% for the year and be down 8% to 10% in the second quarter. The full year guidance now includes the impact of Dynamics revenue recognition we talked about earlier in the week, and that's close to what we gave you in July. Our second quarter revenue guidance includes approximately $500 million being deferred out of the second quarter and into the third quarter, due to both our technology guarantee program as well as a small amount of revenue associated with Office 2007 pre-shipments into the channel. If you were to normalize for the impact of the technology guarantee program, revenue growth for quarter two would be 3% to 5%. Fiscal 2007 is MBD's biggest year ever for product launches, with major releases in all areas of the business: Office, Exchange, Dynamics, and Office Live. For the Entertainment and Devices division, we're forecasting full year revenue growth of 33% to 46% and second quarter growth of 50% to 75%. With 6 million Xbox 360 consoles sold life to date and a portfolio of 160 high-definition games by the end of the year, we remain optimistic that we will exit the holiday having sold over 10 million units since launch and end our fiscal year having sold 13 million to 15 million units since launch. Operating income for the year is expected to be between $19.1 billion and $19.5 billion, growing 9% to 11%, excluding legal charges taken in fiscal 2006. In the second quarter we expect operating income to be between $2.9 billion and $3.1 billion, including approximately $1.5 billion of impact from revenue deferred from our technology guarantee and preshipment. The $1.5 billion results from revenue recognition that is deferred from the second quarter into the third quarter and there's no full year impact to this program to operating income, as we've mentioned. Excluding the impact of the technology guarantee, operating income for the second quarter would be between $4.4 billion and $4.7 billion. Second quarter operating income includes the impact of higher overall mix of lower-margin hardware revenue from Xbox 360 and Zune, increased costs associated with the Online Services group, as well as operating costs in preparation for the launches of Windows Vista and the 2007 Office system. On our last earnings call we gave you additional color and guidance on cost of goods sold, given the evolving mix of our businesses. Even though we may not always do so each quarter, let me give you an update on COGS today. Cost of goods sold as a percentage of revenue for the second quarter should increase by $0.08 to $0.09 over quarter two of last year. The increase results from a larger number of Xbox 360 consoles, plus the inclusion of Zune units. We're remaining with our previous guidance on the full year being up one to two points. We're also updating our guidance on our effective tax rate for the year. In July we estimated the full year effective tax rate of 30.5%, but due to a change in the mix of earnings in various tax jurisdictions, we are now estimating a full year tax rate of 31%, consistent with what we saw in the first quarter. Diluted earnings per share for the year are expected to come in at $1.43 to $1.46, and $0.22 to $0.24 for the second quarter. Second quarter EPS, excluding the impact of the technology guarantee, would have been $0.33 to $0.35. I'm pleased that, as a result of better business results and investment income, we have been able to keep our guidance largely in line with the full year guidance we gave you in July. I'd like to take a moment now to drill down a bit on the makeup of our full-year EPS numbers. We told you back in July that we estimated the impact of the full completion of our tender offer would be $0.05 to $0.06 for the full fiscal year. Since only a portion of the shares were tendered, I wanted to do a quick reconciliation from our full year guidance in July to what we're giving you today. First, instead of buying the previously contemplated $20 billion worth of shares during the quarter through our tender offer, we repurchased a total of $4.8 billion, which comprised of $3.8 billion worth of stock through our tender offer, plus an additional $1 billion we made in open market purchases during the quarter. The lower repurchases will reduce our estimate by approximately $0.03 to both our low and high ranges. Second, offsetting that decrease would be higher operating income associated with better revenue growth, higher investment income for the year, negated somewhat by a higher effective tax rate. We estimate the net impact to add approximately $0.02 on the low-end and $0.01 on the high-end. Finally, the remaining $0.01 improvement to both our low and high end EPS guidance comes from our ongoing buyback activity. As with past practice, we do not intend to share the expected pace of our prospective buyback execution, and it could differ from our expectations embedded in the guidance. We expect unearned revenues to finish fiscal 2007 up 5% to 7%. Contracts not-billed should also finish 2007 up from where we exited fiscal 2006. In thinking about sequential changes in unearned revenue from quarter one to quarter two, we expect seasonality similar to last year, plus the addition of the 1.5 in revenue associated primarily with our technology guarantee programs. For our full-year unearned revenue guidance, we're modeling a moderation in the recent annuity mix of our billings, as both Office 2007 and Windows Vista will be available to customers in the second half of the year. As we think about our guidance for the rest of the year, many of the risks and opportunities I talked about last quarter still exist. Aside from our normal competitive, legal and general market risks, in particular, PC and server growth rates, we have our share of execution risks in the year. Our plan relies on execution on a number of important product launches starting in the second quarter and extending through the rest of the fiscal year. Customer acceptance of our new products is uncertain and, in particular, customer acceptance of our products such as Xbox 360 and Zune, are particularly difficult to predict during the holiday sales season. Also, the cost of acquiring and serving customers in our online business could increase. Potential upside to our guidance in some cases is a mirror image of our risks. For example, customer acceptance and demand for Windows Vista, the Office 2007 system, Xbox 360 and Zune could exceed our expectations. Customer demand for our hardware products like Xbox 360 and Zune units with a fiscal revenue growth but not necessarily operating income growth. And finally, PC and server hardware shipments could grow faster than we anticipate. Before moving to Q&A, then, I'd like to make a couple of quick comments. We continue to execute well against our strategy for delivering long-term shareholder value. We are committed, and continue to be, to growth through innovation. By investing in innovation across a broad array of high-growth markets, as well as in the development of a services capability to complement our current software offerings, we are positioning the Company to grow operating income faster than our technology peers over the long term. With profitable growth, we generate significant operating cash flow, which enables two very important outcomes: First, it unleashes the virtuous cycle of reinvestment back into our business for further growth. Second, it allows us to advance our financial strategy of returning capital to shareholders. Overall we remain optimistic about our ability to innovate, to generate growth, and as a result of those, to create long-term shareholder value. That wraps up my financial comments. I'd like to hand the call over to Colleen so we can get started with your questions.
Colleen Healy: Thanks, Chris. Let's now proceed to questions. We want to accommodate questions from as many people as possible, so please avoid multi-part questions and limit yourself to just one question. Operator, will you please repeat your instructions?
Operator: (Operator Instructions) Your first question comes from Heather Bellini - UBS.
Heather Bellini: Hi, thank you. Good afternoon. I was wondering if you could give us an idea, what was the premium SKU mix for the first 12 months of the Windows XP launch? What's implicit in your guidance for Vista? As a follow-up, what do you view as negating factors of whether or not Client growth will be faster than PC shipment growth in calendar '07?
Chris Liddell: Thanks very much. In terms of premium SKU mix, we're sticking with what Kevin Johnson told you at FAM, which is we're looking at 52% to 54% I believe, is what he quoted for the year. That's this fiscal year, so we still feel good about that. Obviously it was higher than in the first quarter. But at this stage we're certainly comfortable with that number. In terms of the calendar year growth, I think, which was the second half of your question, clearly, we are feeling good about growth in revenue in the Client area relative to PC units. So, in the first quarter and the second quarter, revenue growth will lag PC units. But then in the second half of the year, it's actually going to be at or above it, and equal to for the full year. So, we're looking at fiscal year '07, PC units growing at 8% to 10%, and Client revenue growing in fact slightly higher than that, 9% to 10%. That's a result of not only good unit shipments, obviously, but also the positive impacts of our commercial and retail part of the Client business. In terms of XP and premium mix, I'll get one of my colleagues to grab that number. I don't have that at hand straightaway.
Operator: Your next question comes from Adam Holt - J.P. Morgan.
Adam Holt: Two questions on the cost structure for the second quarter. You mentioned that you're going to be able to get some improvements in the Xbox margins. I was wondering if that's coming from software attach or component pricing? Secondly, as we look at the cost that shifted out of the first quarter, it looks like the operating margins, net the impact of the deferrals, were a little bit lower than I was looking for in Q2. Should we assume that entire amount falls in the second quarter, and then that's going to go in the marketing line? Thank you.
Chris Liddell: Sure, Adam. In terms of the better margin for Xbox, it's both those impacts. So, we are seeing lower cost per console, we're coming down the manufacturing cost line, and in fact, we're doing better than what we had hoped for. So, last year we saw slightly higher costs to console than we were expecting; this year, certainly to date, we're experiencing better costs per console. We're sticking, clearly, with our view of being cost-neutral over the console life. This year is shaping up very well. On top of that, we did also get good software attach. So, we saw software attach, I believe, over five for the quarter, which when you spread over the number of units that we sold, meant that our revenue per unit for software was very good in the quarter. We continue to be very pleased with that. Also from some of the other sources of revenue, they're not as significant, but, obviously, with the number of people that we're seeing on Xbox Live, we're starting to see some benefit from that. So, all of those are helping with the Xbox margins. In terms of the second half of your question, which was on the operating costs, most of that marketing spend was a shift from quarter one to quarter two. So, you are correct; to the extent that we saved some revenue on OpEx, to a large extent you'll see that in the second quarter. As you'll see from our full year guidance, that's still intact. exactly the same from an overall OpEx point of view. So, there's some spread, I believe, in the third and fourth quarter, but it's primarily a quarter one to quarter two shift.
Operator: Your next question comes from Charles DiBona - Sanford Bernstein.
Charles DiBona: Chris, you sound pretty upbeat about the online services group, even though the numbers seem to be going pretty much sideways. Could you give us some insight, other than the product launches, to some of the metrics that you're looking at that give you confidence that this is really headed in the right direction? Maybe it's conversion rates or share or the size of the advertising community, but something that underlies your confidence in that group.
Chris Liddell: The revenue per search is, clearly, the one that we've got closest on our eye at the moment. We look at probably 10 to 12 metrics across that group fairly closely. But in terms of the revenue per search, that is going up sequentially as we get more advertisers onto the adCenter platform. We're close to now lapping where we were when we came off the Overture platform from last year. So, with the revenue expectations that we have in the back half of the year, I am expecting us certainly in the U.S. anyway to equal or go above our revenue per search on a year-over-year basis, not just a quarter-over-quarter basis, and that will help drive revenue in the second half. On the display advertising side, we obviously look at both the volume and the monetization there. Both those figures again, we look at the back half of the year and are expecting that to be pretty good, but from our point of view, those numbers are reasonable as well.
Operator: Your next question comes from Rick Sherlund - Goldman Sachs.
Rick Sherlund: Chris, if I could take you back to the call you did a couple days ago on the change in accounting for the undelivered elements for Windows versus the Dynamics, where you're going to move to ratable recognition. I wasn't on that call; I was in the air, but I just wanted a chance to come back to that issue. If you could clarify that. So, for Dynamics, starting in the third quarter, we're going to shift to ratable recognition?
Chris Liddell: No, it's in the first quarter for Dynamics.
Rick Sherlund: First quarter of next year?
Chris Liddell: No, the first quarter of this year. There's a full-year impact for this year. And then obviously, only a couple quarters of impact on the Vista side.
Rick Sherlund: I'm curious about how big that is, because I would think that the Windows change is bigger than the Dynamics change.
Chris Liddell: In absolute terms going forward, in particular as you look forward to fiscal year '08, you'll be absolutely correct. In terms of fiscal year '07, because one is for a full year and the other is only for a part year as the product phases in, then they basically offset each other. As we look to fiscal year '08, you'll see a much more significant impact from the Vista change relative to the Dynamics, obviously, because of the scale of those businesses. When we give you guidance for next year, we will absolutely call that out and be transparent about it. Because as you know, it's purely an accounting change; it doesn't change the underlying economics. So, we will tell you exactly how much of the guidance for next year we anticipate with both of them. And you are right; it will be much more significant for Windows than it will be for Dynamics in fiscal year '08.
Rick Sherlund: The reason for the change in Dynamics, should I anticipate that you're going to move to an on-demand, software-as-a-service model, where you can charge over time and you'd be relatively indifferent from a revenue recognition standpoint, whether it was on premise or on demand?
Chris Liddell: Because it's more in the accounting area, let me just hand over to Frank and he'll give you the technical answer.
Frank Brod: We have actually changed the way we are marketing the licenses there. In the past we've licensed on a per-module basis. Our new licensing program actually licenses on a per-seat basis. So with that, because all future software and upgrades and functionality are available to the new licensees, we will actually move to a ratable recognition rather than an up-front recognition.
Operator: Your next question comes from Kash Rangan - Merrill Lynch.
Kash Rangan: Just a quick clarification on the EPS guidance. So, the tender offer, the shortfall in the buyback on account of that is balanced by the investment income, right? Is that how you get to pretty much the same EPS guidance as before, or am I missing something? I just wanted to clarify that.
Chris Liddell: There's three elements that help us get back. Two downward elements and three upward elements. One is the lower tender, we also have a slightly higher tax rate that we're anticipating for the year. So those, all other things being equal, would lower our EPS guidance for the year. In terms of upward impacts which offset that, we are obviously continuing to buy back shares during the course of the year. We have a better investment income, as you mentioned. But also, we have got better operating income. So, we are guiding to higher revenue, and the benefits of that higher revenues are flowing through to operating income. So, I primarily call out better business performance, which is helping offset some of the lower earnings per share impacts of buyback.
Operator: Your next question comes from Brent Thill - Citigroup.
Brent Thill: With the new stiff antipiracy features in Vista, are you assuming similar piracy as in past cycle, or are you expecting a slight improvement with the Vista launch?
Chris Liddell: We're certainly looking at the back half of the fiscal year which is the only one at this stage, clearly, that we're guiding to, to OEM unit sales being higher than PC units as a result of our antipiracy. So, we're looking at, I believe, for the full year something like a 1% to 2% benefit as a result of that. So, we're not looking at significantly different rates relative to XP. Clearly, as we go into fiscal year '08 and onwards, we'll give you some guidance at that stage. But certainly it is helping, but we're already seeing some positive benefits from what we're doing on the XP side.
Brent Thill: Okay. And the blended ASP, is that fair that 6% to 8% with Vista? Is that a fair rate, or do you think it's a little lower?
Chris Liddell: I'm not sure where you're getting the 16% from, to be honest.
Brent Thill: No, I'm sorry. 6% to 8%; would that be a fair blended ASP increase with Vista versus XP? Would that be a fair range to assume for an ASP lift?
Chris Liddell: Look, obviously, we're giving or talking about the individual products. At this stage we're not talking about blended rates. We're talking about the premium mix that we expect. But we'll let the market determine what that's going to be in the second half of the year. We have some anticipation in the guidance we've given, but I don't want to comment on a specific number for ASP.
Operator: Your next question comes from Jason Maynard - Credit Suisse.
Jason Maynard: Just a question about use of cash. There's a lot of acquisitions going on at fairly high prices in the online property space. I'm just curious, what are your parameters around contemplating a transaction like that, and how you think about some of those larger deals? And also, just maybe as the flip-side of this is what are your plans for CapEx for this fiscal year, and have they changed at all since last quarter?
Chris Liddell: We are very rigorous on the acquisition side. We bought 23 companies last year, and as Colleen mentioned in her statement, we bought four in the first quarter. But we have an incredibly disciplined process for acquisitions that go through a number of stages, and clearly they need to be ROI and economic value-positive. So, you are correct that we are seeing some price inflation in some of the acquisitions that we're talking about. For every one we do, we probably turn down one or two. So, we don't buy everything that we look at and we are selective on not only what we buy, but how much we pay for it. In terms of our attitude going forward on acquisitions, I think we've said a number of times at financial analyst meetings and outside of that, we do see acquisitions playing a role in our growth. So, I would certainly expect us to still buy companies. In the first quarter it tended to be more in the Server and Tools area. Going forward it could well be in the online services area, in particularly with the speed of how that market is developing and some of the opportunities we're being shown, obviously that's a possibility. But we are not going to buy anything that we don't think creates economic value. In terms of CapEx, it's very much in line with what we guided you to in July. So, we're looking at just over $2 billion for the year. I believe we spent $400 million in the first quarter. In terms of online spend on CapEx, which is one of the areas people are primarily interested in, we're looking at around $700 million for the full year, and we spent about $150 million in the first quarter.
Operator: Your next question comes from John McPeake - Prudential.
John McPeake: Back on the undelivered elements, you're now going to be recognizing that revenue versus deferring it. Could you talk a little bit about the give and takes there, with the fact that Vista Enterprise in particular is only available to customers with some sort of an SA or an EA that covers Client, and historically they've been able to buy that from the OEMs? I'm trying to get a sense as to how those two dynamics play out in the unearned over the course of the year.
Frank Brod: Your question is about the undelivered elements and the enterprise agreements?
Chris Liddell: In terms of enterprise agreements, we'll still, obviously, ratably spread enterprise agreement income over the life of the contract. So, that won't change. It will only be for the undelivered elements of sales through, in particular, OEMs of the Vista software, where it's not delivered under a software assurance program; it's delivered under a sale of a PC. When we sell under the sale of a PC, those undelivered elements will not be deferred as they were in XP. So, it doesn't really influence the enterprise agreement recognition, if I'm understanding your question correctly.
John McPeake: That's correct. So, you've got about 15% that used to be deferred in the OEM agreements that's now being recognized. But you also have new SKUs that can only be purchased for the Client business. So, Vista Enterprise in particular, you need to have that covered by an SA. And that's a new thing for Microsoft, so I'm trying to get a sense as to whether that's going to have an incremental positive impact, potentially, over the course of the year to your unearned. So, you have a new SKU that is a Client SKU.
Colleen Healy: If more users find that particular SKU, which you can only get under an SA, very compelling, then yes, you would see more unearned. That's a big assumption to make. But certainly, the accounting there has not changed. To the extent that we see more business done through volume licensing, you would continue to expect to see that same impact on unearned and contracted not-billed.
Operator: Your next question comes from Peter Misek - Canaccord Adams.
Peter Misek: Just one quick question on other product cycles. We haven't heard an update recently on how the Longhorn server cycle appears to be progressing. Clearly, we're coming to the end of the Vista launch cycle. Can you provide us any update on that product cycle, please?
Chris Liddell: That's still on track for the second half of next calendar year. So, no change for that.
Colleen Healy: Thanks so much. We probably have time for just one or two more questions.
Operator: Your next question comes from Kevin Buttigieg - A.G. Edwards.
Kevin Buttigieg: On the forecast for the Server and Tools unit revenue growth of 10% to 12%, I was wondering if you could talk a little bit about how you see the impact of virtualization on that growth rate? Obviously, you have Microsoft Virtual Server, but perhaps offsetting that might be some lower unit sales of Windows Server. Could you just sort of help form the parameters around virtualization's impact on that business?
Colleen Healy: Our thinking around virtualization is that it's good for customers. We feel like our offerings address those well. The industry is going there, and that's reflected in the hardware server numbers that you see from the Company. We feel like our pricing is very competitive, especially to other pricing out there; pretty easy to understand, pretty competitive. We think that we're well positioned there, and we welcome ushering it in, and we've got good products there.
Kevin Buttigieg: So, 10% to 12% seems like it sustainable, then, even in light of virtualization's adoption rate?
Colleen Healy: Today we're giving you second quarter fiscal year '07 guidance. But virtualization, we think, is a good thing for the industry. Just like with Moore's Law, getting more power out of your hardware is a good thing for the ecosystem. Great, thanks so much. Time for one last question, please.
Operator: Your next question comes from Laura Lederman - William Blair.
Laura Lederman: I have two quick questions. One is, can you give us an update on cash flow, what your expectations are for this year? And also, a phenomenal result for SQL Server. Can you talk about where you're particularly seeing strength in that product? Thank you.
Chris Liddell: On the cash flow side, it will follow traditional patterns. Clearly, cash flows for the quarter and the second quarter are impacted to some extent by inventory builds for Xbox, but that will wash itself out through the system. So, when you look at our cash flow for the year, the only real elements of significance are probably slightly higher CapEx. But in the overall scheme of Microsoft, that's not huge. But spending just over $2 billion of CapEx will clearly be an impact on cash flow. Our inventory and working capital should be broadly in line with historic patterns. And then the buyback is the last thing, which will depend to some extent on what we buy in the second half of the year. But other than that, cash flow trends will be typical from what you've seen in previous years.
Laura Lederman: SQL Server was a great result. Where are you particularly seeing strength? Vertical markets, company size, applications? Just give us some context on why that growth rate is still so strong.
Colleen Healy: I'll take out one, Lauren. So, SQL strong really across the board, as evidenced by 30% growth, really means you do need to have some nice broad strength. We've been particularly delighted in the larger enterprises really looking to SQL for their critical applications. We continue to do well in the mid-size space as well. So, really it's been nice, broad strength there.
Laura Lederman: What about U.S. versus international?
Colleen Healy: Again, with nice 30% growth, you're going to see really good adoption, really, across the board. Thanks, Laura. And thank you, everyone, for your participation in today's call. If you have any further questions, please feel free to call me or my team directly. As I mentioned at the beginning of this call, this conference call will be available on replay at our investor relations website through close of business October 26, 2007. In addition, you can hear the replay by dialing 866-505-6378, or for international calls, dial 203-369-1866. The dial-in replay will be available through the close of business November 2, 2006. Thanks again for joining us today.
Operator: Thank you. This does conclude today's conference call. We thank you for your participation. | [
{
"speaker": "Operator",
"text": "Good afternoon, and welcome to the Microsoft 2007 fiscal year first quarter conference call. (Operator Instructions) I would now like to turn the call over to Ms. Colleen Healy, General Manager, Investor Relations. Please go ahead."
},
{
"speaker": "Colleen Healy",
"text": "Thank you. Good afternoon, everyone and thank you for joining us today. This afternoon I am joined by Chris Liddell, Senior Vice President and Chief Financial Officer; Frank Brod, Corporate Vice President of Finance and Administration and Chief Accounting Officer; and John Seethoff, Deputy General Counsel. Today's call will start with Chris providing some key takeaways for the first quarter of fiscal year 2007 and an overview of expectations for the rest of the fiscal year. I will then provide detail around our first quarter results, and then turn it back to Chris for a more detailed discussion of our guidance for the full year and the second quarter of fiscal 2007. After that, we'll take your questions. We filed our 10-Q today in conjunction with our earnings release. Therefore, you have available the earnings release, MD&A, financial statements and footnotes. We have also posted our quarterly financial summary slide deck, which is intended to follow the flow of our prepared remarks in order to assist you. The slide deck offers highlights from the quarter, outlines our guidance, and provides a reconciliation of differences between GAAP and non-GAAP financial measures that we will talk about today. You can find the earnings release, the 10-Q, and the quarterly financial summary slide deck on the investor relations website, at www.Microsoft.com/MSFT. Today's call will be recorded. Please be aware that if you decide to ask a question, it will be included in both our live transmission as well as any future use of the recording. As always, shareholders and analysts can listen to a live webcast of today's call at the Microsoft investor relations website. A replay of the call will be available at this same site through the close of business on October 26, 2007. This conference call report is protected by copyright law and international treaties. Unauthorized reproduction or distribution of this report, or any portion of it, may result in civil and criminal penalties. Any recording or other use or transmission of the text or audio of today's call is not allowed without the express permission of Microsoft. We will be making statements during this call that are forward-looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in today's earnings press release, and the comments made during this conference call, and in the risk factors section of our 10-Q, our 2006 Form 10-K, and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statement. With that, let me now turn it over to Chris."
},
{
"speaker": "Chris Liddell",
"text": "Thanks, Colleen, and good afternoon, everyone. We're pleased to be with you today to share our first quarter results and talk with you about how we see the rest of fiscal 2007 shaping up. Looking back over the first quarter, I would characterize it as a very good start to what we are expecting to be an excellent year. All aspects of our financial performance came in at or above the high end of our guidance. Our product groups made considerable progress executing on major product milestones towards their launches in quarter two and beyond, and we continued our progress on returning cash to shareholders, including through our tender offer. Looking back to our first quarter financial performance, revenue came in at the high-end of our guidance, growing 11%, which represents over $1 billion in absolute revenue growth. Server and Tools and our Entertainment and Devices division were particularly strong in the quarter, benefiting from continued customer demand for SQL Server and the Xbox 360. Operating income benefited from both the strong revenue growth, as well as lower spending, primarily on marketing programs, which we shifted out of quarter one and into the rest of the year. Combining that with increased investment income, as we increased liquidity in preparation for the tender offer, our earnings per share results were excellent. This was an important quarter for our business groups, as we made significant progress towards a number of milestones leading up to our product launches in coming months. During the quarter we rolled out Release Candidate 1 of Windows Vista, a Beta 2 technical refresh of the 2007 Office system, a Beta of Exchange Server 2007, and announced the upcoming launch of Zune. To date, these trial versions have been made available to about 5 million Windows Vista users and over 3 million 2007 Office System users. We've been receiving encouraging feedback from partners and customers who are using the betas, which are the most widely-tested releases in the history of these products. We also continue to be active on the acquisition front, averaging more than one a month. This quarter the bulk of our acquisitions were companies that augment the offerings of our Server and Tools business. Our acquisitions focused on the areas of systems recovery and data protection, virtualization, and security. Finally, on the capital structure front, we continue to make steady progress. We finished our prior $30 billion repurchase plan, as we shared with you on the last earnings call, announced a new authorization that runs through July 2011, completed our tender offer, made additional share repurchases outside of the tender offer in the quarter, and increased our quarterly dividend. Moving now to the full fiscal year, 2007 is shaping up well. We will be delivering the second major installment on our multi-year product cycle, helping to fuel revenue growth for the Company. So, let me make a couple of key points about fiscal 2007. First, we continue to expect full-year double-digit revenue growth. In terms of quarterly trends, revenue growth will be impacted by the deferral of approximately $1.5 billion of Client and MBD revenue out of the second quarter and into our third quarter, as a result of the recently-announced technology guarantee programs. As we discussed on the call hosted by Frank and Scott earlier in the week, this movement has no impact on our full-year numbers. Second, growth in operating income in the first half of the year will be impacted by the increasing mix of Xbox 360 console revenue and related costs, coupled with significant investments to support the launches of our flagship products, and the accounting impact of the technology guarantee programs. This trend should reverse in the second half of the year, when we expect operating income will grow considerably faster than revenue. Finally, excluding legal charges in the prior year, we will grow earnings per share 13% to 15% while launching major products and continuing to invest in the future growth opportunities in all our business divisions. I'm particularly happy that we've been able to broadly maintain our full year earnings per share guidance. Better business performance and higher investment income have helped offset the impact of lower share repurchases in our tender offer and the higher effective tax rate. With those high level things for the quarter and the full year 2007, I'm going to turn the call over to Colleen now for more details on our first quarter performance."
},
{
"speaker": "Colleen Healy",
"text": "Thanks, Chris. In the interest of providing more time for your questions, I'm going to keep my remarks regarding the fiscal first quarter brief. Overall, we are off to a good start in what is a significant year for the Company. Specifically during the quarter, we delivered revenue, operating income and EPS growth at or above the high end of our guidance. We made significant progress on development and launch readiness for key products in the pipeline, including Windows Vista, Office 2007, Exchange Server 2007, and Zune. We returned $7.9 million in capital to shareholders in the form of dividends and share repurchases. I will now provide more detail on our financial performance, starting with revenue. I will discuss top line financial and business momentum points, and then follow up with revenue performance for each of the business units. All growth comparisons I mention relate to the comparable quarter of last year unless otherwise specified. Revenue growth for the quarter was 11%, driven primarily by the business groups significant product launches over the past 12 months, as our new product cycles have been well received by customers. Specifically, Entertainment and Devices and Server and Tools accounted for over 70% of the absolute revenue growth in the quarter. Healthy PC and server hardware market growth were also key contributors to our results. The PC market grew 8% to 10% in the quarter, driven by a good back-to-school sales season. Consumer growth outpaced that of business, consistent with the trend of the past several quarters. Geographically, we saw double-digit growth in Asia and Latin America, with the remaining regions growing at single digits. Server hardware shipment growth was consistent with our full-year estimate of 10% to 12%. Our mix of product billings was approximately 40% from OEMs; 25% from multi-year licensing agreements; 20% from license-only sales; and the balance from our other businesses. These results were generally consistent with the prior year. We had a good quarter from a volume licensing perspective and saw strong performance in our small and medium business channel in particular. In terms of enterprise agreements, we highlighted in July that there was a relatively small amount of EA contract value up for renewals in the first quarter, which would impact EA. Of the business that was up for renewal, we continued to see EA renewal rates within our historical range of 66% to 75%. Non-annuity growth was relatively weak, as expected, in front of major product launches later this year. Our unearned revenue balance ended the quarter at $10.1 billion, up 15% over the prior year and slightly stronger than we expected. The sequential decline in the unearned balance in the first quarter was driven by the absolute size of our fiscal Q4 annuity billings relative to Q1, as well as the small amount of EA contract value up for renewal, as previously discussed. Our contracted not-billed balance at the end of September was sequentially lower, but continues to exceed $9 billion. Now I'd like to provide revenue highlights by business segment. Starting with Client, revenue for the quarter grew 4% to $3.3 billion. OEM revenue growth of 4% resulted from 11% growth in license units. The 7 percentage point difference between OEM license unit growth and revenue growth was caused primarily by increasing volumes in emerging markets, the relative strength of the consumer segment of the market, and a $45 million revenue deferral related to the Express upgrade to Windows Vista program. We were particularly pleased with the continued adoption of Windows Media Center Edition, which represented over 15% of OEM license mix in the quarter, and has now sold over 20 million units to date. Client, commercial and retail licensing product growth of 5% was primarily driven by growth in multi-year contract agreements in front of the Windows Vista launch. We made significant progress on Windows Vista development during the quarter, as evidenced by the recent availability of the second release candidate. We made pre-release versions of Windows Vista available to over 5 million customers worldwide. Server and Tools revenue growth of 17% represents the 17th consecutive quarter of double-digit revenue growth for the segment. Results for the quarter were driven by broad adoption of our Server and Tools product line, particularly SQL Server, which grew over 30%, Windows Server and Digital Studio. During the quarter we completed the acquisition of Softricity, Whale Communications, Winternals Software and DesktopStandard, which will strengthen our growing Server business around virtualization, enterprise security and management. Revenue for our Online Service business was down 4% to $539 million, with 5% advertising growth and a 30% decline in access revenue. Increased advertising revenue was driven by growth in display advertising, offset by lower search revenues. With respect to search, although our search queries grew, our search pricing was below the prior-year levels as a result of the transition to our new adCenter platform, which began in earnest during the December quarter. We experienced sequential growth in revenue per search as we increased the number of advertisers on our platform. During the quarter we also released a number of new or updated Internet services, including Live.com, Live Search, Live Local Search and Live Spaces. Microsoft Business division revenue grew 4% to $3.4 billion, a good result in front of the upcoming product launches of Office 2007 and Exchange Server 2007, and in line with our expectations entering the quarter. As with Windows Vista, we also made considerable progress on the development of the 2007 Office system. We released the Beta 2 technical refresh of the product during the quarter and over 3 million customers have pre-release versions of Office 2007. Business momentum and customer interest for both Office 2007 and Exchange Server 2007 remains strong, leading us to the launches later this year. We also delivered strong performance in our Dynamic business in the first quarter, with customer billings growth of 19%. Lastly, Entertainment and Devices growth of 70% for the quarter was driven by strong performance across all of its businesses. Interactive gaming revenue in particular more than doubled as a result of Xbox 360 platform momentum. We have sold 6 million consoles life to date, and Xbox 360 software and accessory attach rates have remained at record levels in the U.S. relative to any previous console launches from competitors. Momentum for Xbox Live continued to build as well, passing the 4 million member mark during the quarter. In addition to strength in gaming, our Mobile and Embedded Device business recorded its sixth consecutive quarter of revenue growth in excess of 40%, as licenses for Windows mobile-based phones more than tripled. Finally, we announced the next step in our Connected Entertainment division with the coming availability of the Zune digital media player and online service for U.S. consumers starting on November 14. Now for the rest of the income statement. While revenue increased 11% for the quarter, the cost of revenue increased 35%, due primarily to Xbox 360. As a result, gross margin relative to the prior year was down 3 percentage points for the quarter, consistent with the guidance we provided in July. First quarter operating expenses, other than cost of revenue, increased $560 million, or 14%, excluding certain legal charges in the prior year quarter. While we continue to invest aggressively in both R&D and sales and marketing to drive future growth, expenses this quarter were lighter than we expected, primarily due to the timing of marketing program spend. Operating income for the quarter was $4.5 billion, up modestly from the prior year excluding certain legal charges in that year-ago quarter. Investment income and other totaled $567 million, driven by larger than expected gains on investment sales to fund our tender offer during the quarter. Our effective tax rate came in at 31%, slightly higher than the estimate provided to you in our guidance last call, due to the change in the mix of earnings in various tax jurisdictions. During the quarter we continued to execute against our strategy of returning capital to shareholders. We repurchased $7 billion of company stock, including nearly $4 billion through our tender offer, and paid out $9 million in dividends during the quarter. Diluted shares outstanding were 10 billion, down 7% from the prior year as a result of execution against our share repurchase program. Earnings per share for the quarter were $0.35, $0.03 above the high end of the range we provided in July. So, in summary, Q1 was a good start to fiscal 2007. The solid revenue results for the quarter were at the top end of our expectations, and EPS exceeded our expectations with an exciting and important fiscal year now underway. Chris will now provide you with our expectations for the second quarter and fiscal year 2007."
},
{
"speaker": "Chris Liddell",
"text": "Thanks, Colleen. I'm going to spend my remaining time on the call talking about what we see coming for the full year and the second quarter. Before we get into the specific guidance, let me outline some of our key assumptions. Our fiscal 2007 forecast assumes no major changes in the economic conditions and demand from where we exited the first quarter, and we are not forecasting any significant impacts from foreign exchange rate movements. We expect PC unit growth for fiscal 2007 to be 8% to 10% for the year, in line with the guidance we gave you last quarter, and between 6% and 8% for the second quarter. We continue to estimate that PC unit growth rates will be higher in the Consumer segment than in the Business segment, and higher in emerging markets than in mature markets. On the server hardware front, we remain comfortable with our estimates for total market growth of 10% to 12% for the year. Now let me go through our detailed guidance. For the full year we expect our revenue to come in between $50 billion and $50.9 billion, growing 13% to 15%. We are bringing up our revenue range to reflect how we finished quarter one, as well as also raising the top slightly. Our growth is driven by forward-based revenue growth across our five segments. For the second quarter we expect revenue of $11.8 billion to $12.4 billion, which represents quarterly growth of flat to up 5%. There are a couple of items to note when you consider our second-quarter revenue. First, the revenue figures for the second quarter include the impact of us deferring approximately $1.5 billion, primarily from our technology guarantee programs. Again, this simply defers the recognition of revenue from the second quarter into the third quarter. There is no full-year impact of these programs on revenue. Before these impacts, revenue guidance would have been $13.3 billion to $13.9 billion, which represents growth of 12% to 17%. Second, we expect PC unit growth in the second quarter to remain healthy, but moderate from the growth rate we saw in our fiscal first quarter, as well as from the growth rates we saw last year in second quarter. With that, revenue guidance in our five business units is as follows: For Client, we expect full-year growth to be 9% to 10% and second-quarter growth to be down 25% to 27%. This full-year guidance includes the impact of revenue recognition changes for Windows Vista, as was discussed on our call on Tuesday. Our second quarter guidance includes the deferral of approximately $1 billion in revenue out of the quarter and into the third quarter. $1 billion covers revenue associated with both our technology guarantee program, as well as amounts for Windows Vista pre-shipments into the channel ahead of launch. If you were to normalize for the $1 billion of deferrals, second-quarter revenue would be growing 4% to 6%. Looking at the full-year growth, the commercial and retail portion of the Client segment should pick up in the second half due to our launch of Windows Vista targeted for volume licensing customers in November, and with broad availability in January. We expect Client OEM revenue to grow slightly below the PC hardware market for the year, due to increased concentration among larger OEMs, consumer hardware shipments growing faster than business shipments, and relatively faster growth in emerging markets. Server and Tools revenue should grow 15% to 16% for the year and 14% to 15% for the second quarter. We continue to expect double-digit growth throughout the year from the sustained momentum of SQL Server and from growth in Windows Server, developer tools, our application business, and enterprise services. As we approach the anniversary of the SQL Server and Visual Studio launches, quarterly performance in the second half of the year will face tougher year-over-year comparables. We forecast revenue in the Online Services business to grow between 7% and 11% for the year and to be up 3% to 5% in quarter two. The full-year growth number implies significant year-over-year growth in the second half, based upon growth in both search and display advertising revenues. While we continue to make investments in various aspects of the business, we did make progress on a number of fronts in the quarter. For example, we rolled out the Live Search, which now powers searches on both MSN.com and Live.com, moved our Live Local Search out of beta and into final availability in both the U.S. and the UK, continued to grow and broaden our social networking presence with spaces and the recent beta rollout of Soapbox, and we're making good progress getting advertisers on adCenter, as well as looking at opportunities to extend our reach through partnerships. Microsoft Business division revenues should grow 8% to 9% for the year and be down 8% to 10% in the second quarter. The full year guidance now includes the impact of Dynamics revenue recognition we talked about earlier in the week, and that's close to what we gave you in July. Our second quarter revenue guidance includes approximately $500 million being deferred out of the second quarter and into the third quarter, due to both our technology guarantee program as well as a small amount of revenue associated with Office 2007 pre-shipments into the channel. If you were to normalize for the impact of the technology guarantee program, revenue growth for quarter two would be 3% to 5%. Fiscal 2007 is MBD's biggest year ever for product launches, with major releases in all areas of the business: Office, Exchange, Dynamics, and Office Live. For the Entertainment and Devices division, we're forecasting full year revenue growth of 33% to 46% and second quarter growth of 50% to 75%. With 6 million Xbox 360 consoles sold life to date and a portfolio of 160 high-definition games by the end of the year, we remain optimistic that we will exit the holiday having sold over 10 million units since launch and end our fiscal year having sold 13 million to 15 million units since launch. Operating income for the year is expected to be between $19.1 billion and $19.5 billion, growing 9% to 11%, excluding legal charges taken in fiscal 2006. In the second quarter we expect operating income to be between $2.9 billion and $3.1 billion, including approximately $1.5 billion of impact from revenue deferred from our technology guarantee and preshipment. The $1.5 billion results from revenue recognition that is deferred from the second quarter into the third quarter and there's no full year impact to this program to operating income, as we've mentioned. Excluding the impact of the technology guarantee, operating income for the second quarter would be between $4.4 billion and $4.7 billion. Second quarter operating income includes the impact of higher overall mix of lower-margin hardware revenue from Xbox 360 and Zune, increased costs associated with the Online Services group, as well as operating costs in preparation for the launches of Windows Vista and the 2007 Office system. On our last earnings call we gave you additional color and guidance on cost of goods sold, given the evolving mix of our businesses. Even though we may not always do so each quarter, let me give you an update on COGS today. Cost of goods sold as a percentage of revenue for the second quarter should increase by $0.08 to $0.09 over quarter two of last year. The increase results from a larger number of Xbox 360 consoles, plus the inclusion of Zune units. We're remaining with our previous guidance on the full year being up one to two points. We're also updating our guidance on our effective tax rate for the year. In July we estimated the full year effective tax rate of 30.5%, but due to a change in the mix of earnings in various tax jurisdictions, we are now estimating a full year tax rate of 31%, consistent with what we saw in the first quarter. Diluted earnings per share for the year are expected to come in at $1.43 to $1.46, and $0.22 to $0.24 for the second quarter. Second quarter EPS, excluding the impact of the technology guarantee, would have been $0.33 to $0.35. I'm pleased that, as a result of better business results and investment income, we have been able to keep our guidance largely in line with the full year guidance we gave you in July. I'd like to take a moment now to drill down a bit on the makeup of our full-year EPS numbers. We told you back in July that we estimated the impact of the full completion of our tender offer would be $0.05 to $0.06 for the full fiscal year. Since only a portion of the shares were tendered, I wanted to do a quick reconciliation from our full year guidance in July to what we're giving you today. First, instead of buying the previously contemplated $20 billion worth of shares during the quarter through our tender offer, we repurchased a total of $4.8 billion, which comprised of $3.8 billion worth of stock through our tender offer, plus an additional $1 billion we made in open market purchases during the quarter. The lower repurchases will reduce our estimate by approximately $0.03 to both our low and high ranges. Second, offsetting that decrease would be higher operating income associated with better revenue growth, higher investment income for the year, negated somewhat by a higher effective tax rate. We estimate the net impact to add approximately $0.02 on the low-end and $0.01 on the high-end. Finally, the remaining $0.01 improvement to both our low and high end EPS guidance comes from our ongoing buyback activity. As with past practice, we do not intend to share the expected pace of our prospective buyback execution, and it could differ from our expectations embedded in the guidance. We expect unearned revenues to finish fiscal 2007 up 5% to 7%. Contracts not-billed should also finish 2007 up from where we exited fiscal 2006. In thinking about sequential changes in unearned revenue from quarter one to quarter two, we expect seasonality similar to last year, plus the addition of the 1.5 in revenue associated primarily with our technology guarantee programs. For our full-year unearned revenue guidance, we're modeling a moderation in the recent annuity mix of our billings, as both Office 2007 and Windows Vista will be available to customers in the second half of the year. As we think about our guidance for the rest of the year, many of the risks and opportunities I talked about last quarter still exist. Aside from our normal competitive, legal and general market risks, in particular, PC and server growth rates, we have our share of execution risks in the year. Our plan relies on execution on a number of important product launches starting in the second quarter and extending through the rest of the fiscal year. Customer acceptance of our new products is uncertain and, in particular, customer acceptance of our products such as Xbox 360 and Zune, are particularly difficult to predict during the holiday sales season. Also, the cost of acquiring and serving customers in our online business could increase. Potential upside to our guidance in some cases is a mirror image of our risks. For example, customer acceptance and demand for Windows Vista, the Office 2007 system, Xbox 360 and Zune could exceed our expectations. Customer demand for our hardware products like Xbox 360 and Zune units with a fiscal revenue growth but not necessarily operating income growth. And finally, PC and server hardware shipments could grow faster than we anticipate. Before moving to Q&A, then, I'd like to make a couple of quick comments. We continue to execute well against our strategy for delivering long-term shareholder value. We are committed, and continue to be, to growth through innovation. By investing in innovation across a broad array of high-growth markets, as well as in the development of a services capability to complement our current software offerings, we are positioning the Company to grow operating income faster than our technology peers over the long term. With profitable growth, we generate significant operating cash flow, which enables two very important outcomes: First, it unleashes the virtuous cycle of reinvestment back into our business for further growth. Second, it allows us to advance our financial strategy of returning capital to shareholders. Overall we remain optimistic about our ability to innovate, to generate growth, and as a result of those, to create long-term shareholder value. That wraps up my financial comments. I'd like to hand the call over to Colleen so we can get started with your questions."
},
{
"speaker": "Colleen Healy",
"text": "Thanks, Chris. Let's now proceed to questions. We want to accommodate questions from as many people as possible, so please avoid multi-part questions and limit yourself to just one question. Operator, will you please repeat your instructions?"
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Heather Bellini - UBS."
},
{
"speaker": "Heather Bellini",
"text": "Hi, thank you. Good afternoon. I was wondering if you could give us an idea, what was the premium SKU mix for the first 12 months of the Windows XP launch? What's implicit in your guidance for Vista? As a follow-up, what do you view as negating factors of whether or not Client growth will be faster than PC shipment growth in calendar '07?"
},
{
"speaker": "Chris Liddell",
"text": "Thanks very much. In terms of premium SKU mix, we're sticking with what Kevin Johnson told you at FAM, which is we're looking at 52% to 54% I believe, is what he quoted for the year. That's this fiscal year, so we still feel good about that. Obviously it was higher than in the first quarter. But at this stage we're certainly comfortable with that number. In terms of the calendar year growth, I think, which was the second half of your question, clearly, we are feeling good about growth in revenue in the Client area relative to PC units. So, in the first quarter and the second quarter, revenue growth will lag PC units. But then in the second half of the year, it's actually going to be at or above it, and equal to for the full year. So, we're looking at fiscal year '07, PC units growing at 8% to 10%, and Client revenue growing in fact slightly higher than that, 9% to 10%. That's a result of not only good unit shipments, obviously, but also the positive impacts of our commercial and retail part of the Client business. In terms of XP and premium mix, I'll get one of my colleagues to grab that number. I don't have that at hand straightaway."
},
{
"speaker": "Operator",
"text": "Your next question comes from Adam Holt - J.P. Morgan."
},
{
"speaker": "Adam Holt",
"text": "Two questions on the cost structure for the second quarter. You mentioned that you're going to be able to get some improvements in the Xbox margins. I was wondering if that's coming from software attach or component pricing? Secondly, as we look at the cost that shifted out of the first quarter, it looks like the operating margins, net the impact of the deferrals, were a little bit lower than I was looking for in Q2. Should we assume that entire amount falls in the second quarter, and then that's going to go in the marketing line? Thank you."
},
{
"speaker": "Chris Liddell",
"text": "Sure, Adam. In terms of the better margin for Xbox, it's both those impacts. So, we are seeing lower cost per console, we're coming down the manufacturing cost line, and in fact, we're doing better than what we had hoped for. So, last year we saw slightly higher costs to console than we were expecting; this year, certainly to date, we're experiencing better costs per console. We're sticking, clearly, with our view of being cost-neutral over the console life. This year is shaping up very well. On top of that, we did also get good software attach. So, we saw software attach, I believe, over five for the quarter, which when you spread over the number of units that we sold, meant that our revenue per unit for software was very good in the quarter. We continue to be very pleased with that. Also from some of the other sources of revenue, they're not as significant, but, obviously, with the number of people that we're seeing on Xbox Live, we're starting to see some benefit from that. So, all of those are helping with the Xbox margins. In terms of the second half of your question, which was on the operating costs, most of that marketing spend was a shift from quarter one to quarter two. So, you are correct; to the extent that we saved some revenue on OpEx, to a large extent you'll see that in the second quarter. As you'll see from our full year guidance, that's still intact. exactly the same from an overall OpEx point of view. So, there's some spread, I believe, in the third and fourth quarter, but it's primarily a quarter one to quarter two shift."
},
{
"speaker": "Operator",
"text": "Your next question comes from Charles DiBona - Sanford Bernstein."
},
{
"speaker": "Charles DiBona",
"text": "Chris, you sound pretty upbeat about the online services group, even though the numbers seem to be going pretty much sideways. Could you give us some insight, other than the product launches, to some of the metrics that you're looking at that give you confidence that this is really headed in the right direction? Maybe it's conversion rates or share or the size of the advertising community, but something that underlies your confidence in that group."
},
{
"speaker": "Chris Liddell",
"text": "The revenue per search is, clearly, the one that we've got closest on our eye at the moment. We look at probably 10 to 12 metrics across that group fairly closely. But in terms of the revenue per search, that is going up sequentially as we get more advertisers onto the adCenter platform. We're close to now lapping where we were when we came off the Overture platform from last year. So, with the revenue expectations that we have in the back half of the year, I am expecting us certainly in the U.S. anyway to equal or go above our revenue per search on a year-over-year basis, not just a quarter-over-quarter basis, and that will help drive revenue in the second half. On the display advertising side, we obviously look at both the volume and the monetization there. Both those figures again, we look at the back half of the year and are expecting that to be pretty good, but from our point of view, those numbers are reasonable as well."
},
{
"speaker": "Operator",
"text": "Your next question comes from Rick Sherlund - Goldman Sachs."
},
{
"speaker": "Rick Sherlund",
"text": "Chris, if I could take you back to the call you did a couple days ago on the change in accounting for the undelivered elements for Windows versus the Dynamics, where you're going to move to ratable recognition. I wasn't on that call; I was in the air, but I just wanted a chance to come back to that issue. If you could clarify that. So, for Dynamics, starting in the third quarter, we're going to shift to ratable recognition?"
},
{
"speaker": "Chris Liddell",
"text": "No, it's in the first quarter for Dynamics."
},
{
"speaker": "Rick Sherlund",
"text": "First quarter of next year?"
},
{
"speaker": "Chris Liddell",
"text": "No, the first quarter of this year. There's a full-year impact for this year. And then obviously, only a couple quarters of impact on the Vista side."
},
{
"speaker": "Rick Sherlund",
"text": "I'm curious about how big that is, because I would think that the Windows change is bigger than the Dynamics change."
},
{
"speaker": "Chris Liddell",
"text": "In absolute terms going forward, in particular as you look forward to fiscal year '08, you'll be absolutely correct. In terms of fiscal year '07, because one is for a full year and the other is only for a part year as the product phases in, then they basically offset each other. As we look to fiscal year '08, you'll see a much more significant impact from the Vista change relative to the Dynamics, obviously, because of the scale of those businesses. When we give you guidance for next year, we will absolutely call that out and be transparent about it. Because as you know, it's purely an accounting change; it doesn't change the underlying economics. So, we will tell you exactly how much of the guidance for next year we anticipate with both of them. And you are right; it will be much more significant for Windows than it will be for Dynamics in fiscal year '08."
},
{
"speaker": "Rick Sherlund",
"text": "The reason for the change in Dynamics, should I anticipate that you're going to move to an on-demand, software-as-a-service model, where you can charge over time and you'd be relatively indifferent from a revenue recognition standpoint, whether it was on premise or on demand?"
},
{
"speaker": "Chris Liddell",
"text": "Because it's more in the accounting area, let me just hand over to Frank and he'll give you the technical answer."
},
{
"speaker": "Frank Brod",
"text": "We have actually changed the way we are marketing the licenses there. In the past we've licensed on a per-module basis. Our new licensing program actually licenses on a per-seat basis. So with that, because all future software and upgrades and functionality are available to the new licensees, we will actually move to a ratable recognition rather than an up-front recognition."
},
{
"speaker": "Operator",
"text": "Your next question comes from Kash Rangan - Merrill Lynch."
},
{
"speaker": "Kash Rangan",
"text": "Just a quick clarification on the EPS guidance. So, the tender offer, the shortfall in the buyback on account of that is balanced by the investment income, right? Is that how you get to pretty much the same EPS guidance as before, or am I missing something? I just wanted to clarify that."
},
{
"speaker": "Chris Liddell",
"text": "There's three elements that help us get back. Two downward elements and three upward elements. One is the lower tender, we also have a slightly higher tax rate that we're anticipating for the year. So those, all other things being equal, would lower our EPS guidance for the year. In terms of upward impacts which offset that, we are obviously continuing to buy back shares during the course of the year. We have a better investment income, as you mentioned. But also, we have got better operating income. So, we are guiding to higher revenue, and the benefits of that higher revenues are flowing through to operating income. So, I primarily call out better business performance, which is helping offset some of the lower earnings per share impacts of buyback."
},
{
"speaker": "Operator",
"text": "Your next question comes from Brent Thill - Citigroup."
},
{
"speaker": "Brent Thill",
"text": "With the new stiff antipiracy features in Vista, are you assuming similar piracy as in past cycle, or are you expecting a slight improvement with the Vista launch?"
},
{
"speaker": "Chris Liddell",
"text": "We're certainly looking at the back half of the fiscal year which is the only one at this stage, clearly, that we're guiding to, to OEM unit sales being higher than PC units as a result of our antipiracy. So, we're looking at, I believe, for the full year something like a 1% to 2% benefit as a result of that. So, we're not looking at significantly different rates relative to XP. Clearly, as we go into fiscal year '08 and onwards, we'll give you some guidance at that stage. But certainly it is helping, but we're already seeing some positive benefits from what we're doing on the XP side."
},
{
"speaker": "Brent Thill",
"text": "Okay. And the blended ASP, is that fair that 6% to 8% with Vista? Is that a fair rate, or do you think it's a little lower?"
},
{
"speaker": "Chris Liddell",
"text": "I'm not sure where you're getting the 16% from, to be honest."
},
{
"speaker": "Brent Thill",
"text": "No, I'm sorry. 6% to 8%; would that be a fair blended ASP increase with Vista versus XP? Would that be a fair range to assume for an ASP lift?"
},
{
"speaker": "Chris Liddell",
"text": "Look, obviously, we're giving or talking about the individual products. At this stage we're not talking about blended rates. We're talking about the premium mix that we expect. But we'll let the market determine what that's going to be in the second half of the year. We have some anticipation in the guidance we've given, but I don't want to comment on a specific number for ASP."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jason Maynard - Credit Suisse."
},
{
"speaker": "Jason Maynard",
"text": "Just a question about use of cash. There's a lot of acquisitions going on at fairly high prices in the online property space. I'm just curious, what are your parameters around contemplating a transaction like that, and how you think about some of those larger deals? And also, just maybe as the flip-side of this is what are your plans for CapEx for this fiscal year, and have they changed at all since last quarter?"
},
{
"speaker": "Chris Liddell",
"text": "We are very rigorous on the acquisition side. We bought 23 companies last year, and as Colleen mentioned in her statement, we bought four in the first quarter. But we have an incredibly disciplined process for acquisitions that go through a number of stages, and clearly they need to be ROI and economic value-positive. So, you are correct that we are seeing some price inflation in some of the acquisitions that we're talking about. For every one we do, we probably turn down one or two. So, we don't buy everything that we look at and we are selective on not only what we buy, but how much we pay for it. In terms of our attitude going forward on acquisitions, I think we've said a number of times at financial analyst meetings and outside of that, we do see acquisitions playing a role in our growth. So, I would certainly expect us to still buy companies. In the first quarter it tended to be more in the Server and Tools area. Going forward it could well be in the online services area, in particularly with the speed of how that market is developing and some of the opportunities we're being shown, obviously that's a possibility. But we are not going to buy anything that we don't think creates economic value. In terms of CapEx, it's very much in line with what we guided you to in July. So, we're looking at just over $2 billion for the year. I believe we spent $400 million in the first quarter. In terms of online spend on CapEx, which is one of the areas people are primarily interested in, we're looking at around $700 million for the full year, and we spent about $150 million in the first quarter."
},
{
"speaker": "Operator",
"text": "Your next question comes from John McPeake - Prudential."
},
{
"speaker": "John McPeake",
"text": "Back on the undelivered elements, you're now going to be recognizing that revenue versus deferring it. Could you talk a little bit about the give and takes there, with the fact that Vista Enterprise in particular is only available to customers with some sort of an SA or an EA that covers Client, and historically they've been able to buy that from the OEMs? I'm trying to get a sense as to how those two dynamics play out in the unearned over the course of the year."
},
{
"speaker": "Frank Brod",
"text": "Your question is about the undelivered elements and the enterprise agreements?"
},
{
"speaker": "Chris Liddell",
"text": "In terms of enterprise agreements, we'll still, obviously, ratably spread enterprise agreement income over the life of the contract. So, that won't change. It will only be for the undelivered elements of sales through, in particular, OEMs of the Vista software, where it's not delivered under a software assurance program; it's delivered under a sale of a PC. When we sell under the sale of a PC, those undelivered elements will not be deferred as they were in XP. So, it doesn't really influence the enterprise agreement recognition, if I'm understanding your question correctly."
},
{
"speaker": "John McPeake",
"text": "That's correct. So, you've got about 15% that used to be deferred in the OEM agreements that's now being recognized. But you also have new SKUs that can only be purchased for the Client business. So, Vista Enterprise in particular, you need to have that covered by an SA. And that's a new thing for Microsoft, so I'm trying to get a sense as to whether that's going to have an incremental positive impact, potentially, over the course of the year to your unearned. So, you have a new SKU that is a Client SKU."
},
{
"speaker": "Colleen Healy",
"text": "If more users find that particular SKU, which you can only get under an SA, very compelling, then yes, you would see more unearned. That's a big assumption to make. But certainly, the accounting there has not changed. To the extent that we see more business done through volume licensing, you would continue to expect to see that same impact on unearned and contracted not-billed."
},
{
"speaker": "Operator",
"text": "Your next question comes from Peter Misek - Canaccord Adams."
},
{
"speaker": "Peter Misek",
"text": "Just one quick question on other product cycles. We haven't heard an update recently on how the Longhorn server cycle appears to be progressing. Clearly, we're coming to the end of the Vista launch cycle. Can you provide us any update on that product cycle, please?"
},
{
"speaker": "Chris Liddell",
"text": "That's still on track for the second half of next calendar year. So, no change for that."
},
{
"speaker": "Colleen Healy",
"text": "Thanks so much. We probably have time for just one or two more questions."
},
{
"speaker": "Operator",
"text": "Your next question comes from Kevin Buttigieg - A.G. Edwards."
},
{
"speaker": "Kevin Buttigieg",
"text": "On the forecast for the Server and Tools unit revenue growth of 10% to 12%, I was wondering if you could talk a little bit about how you see the impact of virtualization on that growth rate? Obviously, you have Microsoft Virtual Server, but perhaps offsetting that might be some lower unit sales of Windows Server. Could you just sort of help form the parameters around virtualization's impact on that business?"
},
{
"speaker": "Colleen Healy",
"text": "Our thinking around virtualization is that it's good for customers. We feel like our offerings address those well. The industry is going there, and that's reflected in the hardware server numbers that you see from the Company. We feel like our pricing is very competitive, especially to other pricing out there; pretty easy to understand, pretty competitive. We think that we're well positioned there, and we welcome ushering it in, and we've got good products there."
},
{
"speaker": "Kevin Buttigieg",
"text": "So, 10% to 12% seems like it sustainable, then, even in light of virtualization's adoption rate?"
},
{
"speaker": "Colleen Healy",
"text": "Today we're giving you second quarter fiscal year '07 guidance. But virtualization, we think, is a good thing for the industry. Just like with Moore's Law, getting more power out of your hardware is a good thing for the ecosystem. Great, thanks so much. Time for one last question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Laura Lederman - William Blair."
},
{
"speaker": "Laura Lederman",
"text": "I have two quick questions. One is, can you give us an update on cash flow, what your expectations are for this year? And also, a phenomenal result for SQL Server. Can you talk about where you're particularly seeing strength in that product? Thank you."
},
{
"speaker": "Chris Liddell",
"text": "On the cash flow side, it will follow traditional patterns. Clearly, cash flows for the quarter and the second quarter are impacted to some extent by inventory builds for Xbox, but that will wash itself out through the system. So, when you look at our cash flow for the year, the only real elements of significance are probably slightly higher CapEx. But in the overall scheme of Microsoft, that's not huge. But spending just over $2 billion of CapEx will clearly be an impact on cash flow. Our inventory and working capital should be broadly in line with historic patterns. And then the buyback is the last thing, which will depend to some extent on what we buy in the second half of the year. But other than that, cash flow trends will be typical from what you've seen in previous years."
},
{
"speaker": "Laura Lederman",
"text": "SQL Server was a great result. Where are you particularly seeing strength? Vertical markets, company size, applications? Just give us some context on why that growth rate is still so strong."
},
{
"speaker": "Colleen Healy",
"text": "I'll take out one, Lauren. So, SQL strong really across the board, as evidenced by 30% growth, really means you do need to have some nice broad strength. We've been particularly delighted in the larger enterprises really looking to SQL for their critical applications. We continue to do well in the mid-size space as well. So, really it's been nice, broad strength there."
},
{
"speaker": "Laura Lederman",
"text": "What about U.S. versus international?"
},
{
"speaker": "Colleen Healy",
"text": "Again, with nice 30% growth, you're going to see really good adoption, really, across the board. Thanks, Laura. And thank you, everyone, for your participation in today's call. If you have any further questions, please feel free to call me or my team directly. As I mentioned at the beginning of this call, this conference call will be available on replay at our investor relations website through close of business October 26, 2007. In addition, you can hear the replay by dialing 866-505-6378, or for international calls, dial 203-369-1866. The dial-in replay will be available through the close of business November 2, 2006. Thanks again for joining us today."
},
{
"speaker": "Operator",
"text": "Thank you. This does conclude today's conference call. We thank you for your participation."
}
] | null | null |
NVDA | 4 | 2,007 | 2007-02-13 17:00:00 | TRANSCRIPT SPONSOR :
Executives: Michael Hara - Vice President, Investor Relations Jen-Hsun Huang - President, Chief Executive Officer Marvin D. Burkett - Chief Financial Officer
Analysts: Mark Edelstone - Morgan Stanley Gurinder Kalra - Bear Stearns Satya Chillara - Pacific Growth Equities Krishna Shankar - JMP Securities Devan Moodley - Scotia Capital Arnab Chanda - Lehman Brothers Naser Iqbal - Salman Partners Simona Jankowski - Goldman Sachs David Wu - Global Crown Capital Doug Freedman - American Technology Research Shawn Webster - JP Morgan
Operator: Good afternoon and thank you for holding. I would now like to turn the call over to Mr. Michael Hara, NVIDIA's Vice President of Investor Relations. Thank you. Sir, you may begin your conference.
Michael Hara: Thank you, Operator. Good afternoon, and thank you for holding. Good afternoon and welcome to NVIDIA's conference call for the fourth fiscal quarter ended January 28, 2007. On the call today for NVIDIA are: Jen-Hsun Huang, NVIDIA's President and Chief Executive Officer; and Marv Burkett, NVIDIA's Chief Financial Officer. Before we begin today's call, I would like to take care of some general administrative items. Your lines have been placed on a listen-only mode until the question-and-answer segment of today’s call. During this call, we will discuss some non-GAAP measures about net income, net income per share and gross margin, and other line items from our consolidated statements of income in talking about our results. You can find a full reconciliation of these measures to GAAP in our financial release, which is posted on the investor relations page of our website at www.nvidia.com. This call is being recorded. If you have any objections, you may disconnect at this time. Please beware that if you decide to ask a question, it will be included in both our live transmission as well as any future use of the recording. Also, shareholders can listen to a live webcast of today's call and view our financial release at the NVIDIA investor relations website. The webcast will be available for replay until the company's conference call to discuss its financial results for its first quarter fiscal 2008. During the course of this conference call, we may make forward-looking statements based on current expectations. Forward-looking statements, including statements as to our outlook, the use of non-GAAP measures, the benefit and impact of acquisitions, our products and technologies, design wins, key objectives, growth and growth drivers, market share, Windows Vista, the X-10 and HD Blu-ray DVD, pertain to future events and are subject to a number of significant risks and uncertainties. The company's actual results may differ materially from results discussed in any forward-looking statements. For a complete discussion of factors that could affect the company's future financial results and business, please refer to the company's Form 10-K/A for the fiscal year ended January 29, 2006, quarterly reports on Forms 10-Q and 10-Q/A, and the reports on Form 8-K filed with the Securities and Exchange Commission. All forward-looking statements are made as of the date hereof based on information available to us today and, except as required by law, the company assumes no obligation to update any such statements. The content of the webcast contains time-sensitive information that is accurate only as of February 15, 2007. Consistent with the requirements under Regulation FD, we will provide public guidance directly on the conference call and will be unable to provide significantly more information in offline conversations or during the quarter. Therefore, questions around our financial expectations should be asked during this call. At the end of our remarks, there will be time for your questions. In order to allow more people to ask questions, please limit yourself to one question. After our response, we will allow one follow-up question. I will now hand the call over to Jen-Hsun.
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Jen-Hsun Huang: Thanks, Mike. Good afternoon, and thank you for joining us. Today we are pleased to report record revenue of $878.9 million for our fourth quarter. This is our fourth consecutive record quarter. Year over year, fourth quarter revenue grew 39%. For the year, we delivered record revenue of $3.07 billion, an increase of 29% over the previous year. Let me highlight some of our fourth quarter and fiscal year 2007 results and achievements. As a note, all share numbers quoted are from Mercury Research unless otherwise noted. Non-GAAP annual gross margin for the year reached a company-high of 43.2%, an increase of 490 basis points year over year. GAAP annual gross margin was 42.4%. Non-GAAP gross margin for the fourth quarter reached a company-high of 44.2%, an increase of 130 basis points sequentially from the third quarter of fiscal 2007 and 400 basis points year over year. GAAP gross margin was 43.9%. Non-GAAP net income was $577.9 million, an increase of 91% year over year. GAAP net income was a record $448.8 million. We launched multiple industry-defining products during the year: the revolutionary GeForce 8800, the industry's most powerful GPU and the first DX10 unified shader GPU; nForce 400 family, the industry's first single-chip motherboard GPU chipset; PureVideo HD, the industry's first solution for full HD Blu-ray processing; Quadro Plex, the world's first ultra high-density visual computing system; and the revolutionary CUDA architecture for GPU computing. We maintained our number one position in desktop GPUs. The desktop GPU business delivered a record year, with $1.24 billion in revenue, growing 11% year over year. Our share in the performance segment grew to over 85%, up from 79% a year earlier. We captured the number one notebook GPU position, with our share increasing to 58%, up 20% from the previous year. Notebook GPU revenue grew 122% year over year. Our overall PC graphics share increased from 18% a year ago to 29% today. The nForce MCP product line achieved record revenue for its tenth consecutive quarter. Revenue grew over 16% sequentially from the third quarter and 89% year over year. The Quadro professional product line achieved a record revenue, an increase of 24% from the fourth quarter fiscal 2006. The handheld GPU product line delivered $108 million in revenue, an increase of 85% from the previous year. Sony launched the PlayStation 3 with our RSX GPU. We completed the acquisition of PortalPlayer, a leading supplier of software and SOC application processors for mobile devices like Apple's iPods. NVIDIA was named the most respected public company by the members of the Fabless Semiconductor Association. Finally, with AMD's acquisition of ATI, NVIDIA became the only independent GPU company in the world. We are pleased with our record year -- particularly, we are very pleased with our strategic position going into fiscal 2008. Let me turn the call over to Marv to discuss our financial results in more detail. I will return in a moment to address our growth opportunities.
Marvin D. Burkett: Thanks, Jen-Hsun. Today, we are reporting both GAAP and non-GAAP P&Ls for our Q4 and fiscal year '07. As Jen-Hsun said, revenue for the fourth quarter was $879 million, which is up 7.1% or $58 million from the third quarter. Revenue for the fiscal year was $3.07 billion, which is up 29% year over year. In the fourth quarter, growth was led by MCP products, which increased by 16% quarter to quarter and, as Jen-Hsun said, was a record for the tenth consecutive quarter. Total MCP revenue grew 88% for the whole fiscal year. Professional solutions products grew by 14% sequentially and also set a record for revenue. In the desktop GPU business, the GeForce 8800 products grew by more than $50 million but were offset by weakness in some of the GeForce 7 products, particularly in the channel. Memory grew by $10 million quarter to quarter. Our consumer electronics revenue increased 40% sequentially, driven by significantly higher contributions of royalty payments, which more than offset a decline in MRE. ASPs were slightly down in desktop GPUs, and relatively flat everywhere else. We closed the purchase of PortalPlayer on January 5th, but the revenue contribution from Portal was not significant, approximately $1 million. For gross margin in the quarter, we reported non-GAAP gross margin of 44.2% and GAAP gross margin of 43.9%. Our 45% target is getting close. GPUs, MCPs and handheld business units all improved gross margin quarter to quarter. As a company, we continue to work hard on improvement. Operating expenses for the quarter were $247 million on a GAAP basis and $203 million on a non-GAAP. The non-GAAP eliminated stock-based compensation of $34 million before tax effect and it eliminated $13.4 million of in-process R&D associated with the PortalPlayer acquisition. The $203 million included one month of PortalPlayer expenses, which totaled approximately $5 million, and it also included legal and accounting fees associated with the restatement of approximately $4 million, the restatement which was filed in December. Including PortalPlayer, we added 456 new employees during the quarter and exited the year with 4,083 employees. For the year, we added over 1,300 new employees. Depreciation in the quarter was $30 million. The tax rate for the fiscal year and for the fourth quarter included the benefit of Congress passing the R&D tax credit retroactive to the beginning of calendar year 2006. This resulted in lowering both our GAAP and non-GAAP tax rates. It lowered the GAAP tax rate by 7 percentage points to slightly over 9% for the year and obviously a negative tax rate of 8% for the fourth quarter. For non-GAAP, it lowered our fiscal year '07 rate by 6 percentage points to 10% and resulted in a negative tax rate of 3% for the quarter. All of this resulted in GAAP net income for the quarter of $164 million, or $0.41 per diluted share, and a non-GAAP net income of $206 million, or $0.53 per diluted share. On the balance sheet, we exited the year with $1.12 billion in cash and marketable securities, which was down $56 million from the prior quarter. This is after paying approximately $160 million net of cash and marketable securities for the acquisition of PortalPlayer and repurchasing $100 million worth of stock. For the year, we repurchased $276 million worth of shares at an average cost of $26.80. As a company, we generated more than $500 million in operating cash flow during the year. Accounts receivable grew by $79 million quarter to quarter, as Q4 was back-end loaded. Our receivables are current and DSO was at 53.7 days. Inventory declined by $19 million and resulted in days sales of inventory of 65 days. We grew inventory of the GeForce 8 family and decreased the inventory of older products. Accounts Payable decreased by $52 million quarter to quarter. Now for the outlook for Q1 fiscal year '08: for revenue, we expect a normal seasonal decline associated with the PC business of approximately 5%. Although we believe our market and competitive position in each of our business units continues to be very strong, there are no significant industry growth drivers to offset seasonality. Although we are enthusiastic about Vista's impact on our business, we will be cautious in the first quarter. We expect a decline in memory from the Q4 levels. We expect a revenue contribution from PortalPlayer of less than $10 million in the quarter. For gross margin, we will continue to work hard to keep them flat to perhaps slightly improving. On operating expenses, we have to absorb a full quarter of PortalPlayer, which will cause an increase of approximately $10 million from Q4. However, we believe that even with the additional expense, we may be able to keep operating expenses flat with Q4 as we focus on expense controls and restrict headcount additions. We will get a small benefit in tax rate for the first quarter of fiscal year '08, as we are projecting a tax rate of 14% for both GAAP and non-GAAP. With that, I will turn it back to Jen-Hsun.
Jen-Hsun Huang: Thanks, Marv. As we look ahead at fiscal 2008, we are very excited of our numerous growth drivers impacting each of our product lines. Let me discuss each of them in detail. First, our GeForce desktop and notebook GPU business: GeForce 8800 is the world's first DX10 unified shader architecture GPU. It also incorporates PureVideo HD, the highest visual quality video processor for PCs and the only full HD video processing solution for HD and Blu-ray DVD. The GeForce 8800 is now available from virtually every PC OEM system builder worldwide and in most e-tail and retail outlet. Since October, we shipped nearly 400,000 GeForce 8800s. Our focus for desktop GPU is to leverage our leadership position with GeForce 8 into the mainstream market. We are ramping production on our GeForce 8 family of notebook GPUs, the industry's first DX10 and high-definition video GPU for notebooks. GeForce 8 will be the only DX10 GPU shipping in the upcoming Santa Rosa notebook launch. We expect our share of notebook GPUs to take another step up after this spring transition. We are looking forward to an exciting year for our GPU business. Vista has shipped. This is the first operating system to present as a standard the power of the GPU to all applications -- applications from Office to Web 2.0 applications can now incorporate beautiful 3D effects because hundreds of millions of PCs will have Vista. With Vista, DX10 and HD Blu-ray DVD at the height of technologies for PC this year, 3D graphics will become an ever-central part of our computing experience and the GPU will be more important than ever. Our nForce MCP business: driven by the broadest product line of AMD-based chipsets supporting 8P commercial servers to consumer desktops and notebooks, we have become the number one supplier of MCPs for AMD-based PCs. We ended the calendar year as the industry's second-largest supplier of chipsets, having more than tripled our share from just two years ago. OEMs have embraced our unique strategy of offering single-chip MCPs designed specifically to reduce space and power consumption, while offering outstanding quality and performance. Our motherboard GPU product line is favored by PC manufacturers around the world. These customers prominently feature our GeForce brand to differentiate their PCs from basic integrated graphics. Our “Graphics by NVIDIA” logo is proudly on display on new Windows Vista PCs on retail shelves all around the world. In Q4, we announced our new nForce 680i SLI for Intel CPUs. Our new product line was received enthusiastically by customers and reviewers around the world and quickly became the top-selling, high-end motherboard in multiple e-tail and retail chains. The NVIDIA nForce brand is unambiguously recognized as the best chipset for performance PCs and dominates the top 10 rankings in the majority of industry motherboard reviews worldwide. For fiscal 2008, our key growth objectives are to deliver exciting new motherboard GPU products for the Intel CPU segment and maintain our leadership position on [inaudible] platforms. We believe that Intel-based customers will demand the NVIDIA GeForce-branded motherboard GPUs and we expect an enthusiastic response to our launch later this year. Now our Quadro professional solutions group business: NVIDIA's Quadro professional business had an outstanding year. Annual revenue grew 21% versus fiscal 2006. NVIDIA Quadro is recognized as the standard for professional graphic solutions needed to solve the world's most complex visual computing challenges in the manufacturing, entertainment, medical, science and aerospace industries. This year, we introduced Quadro Plex, an entirely new category of visual computing solutions. Quadro Plex brings the level of graphics scalability and processing density that was simply not possible before. In Q4, we began feeding the industry with our GeForce 8 GPU enabled with CUDA, a revolutionary technology and compiler that for the first time allows programmers to write “C” language applications for GPUs. GeForce 8 and CUDA will enable a new class of high-performance computing we call GPU computing. With a CUDA-enabled GPU, the PC will enable engineers and scientists to harness the awesome power of programmable GPUs to solve mathematically intensive problems that were previously cost-prohibitive. Based on the early response we are getting from programmers, scientists and engineers, it is apparent that we are delivering an enabling technology that will profoundly change a number of computing industries. We believe GPU computing will usher in an era of the personal super-computer and will dramatically accelerate the adoption of new methods from computational chemistry to computational finance to computational genomics. This is an exciting new application to the programmable GPU. We look forward to telling you more about GPU computing throughout the coming year. Our GoForce mobile application processor and GPU business: in fiscal year 2007, our mobile business grew revenue to $108 million, an increase of over 85%. The mobile group enjoyed tremendous success in Europe this summer with the successful rollout of the world's largest DVB-H trial. The Samsung P910 device delivered World Cup content to well over half-a-million consumers. Our mobile TV success continues in the APAC region with two exciting new handsets coming from Japan this month: the Kyocera W51K and W52K both support the ISDB-T Japanese mobile TV standard. We completed the PortalPlayer acquisition on January 5th and it marks our entry into the SOC application processor business. Up to now, our mobile strategy has been to focus on establishing ourselves in the mobile market as the leader of multimedia technologies, leveraging our deep expertise in graphics, video and image processing. With PortalPlayer's expertise in building extremely low-power application processors for personal media players, we are now positioned to deliver amazing SOCs that combine our world-class application processors and GPUs. Our objective in the mobile business group is to build a new class of application processors that will power next generation devices like Apple's iPhone, the Blackberry Pearl and other exciting smartphones and PNPs over the horizon, and help drive what I believe will be the next computer revolution: where the mobile device is no longer just a phone, but becomes our most personal computer. We would be happy to take your questions now.
Operator: (Operator Instructions) Your first question comes from Mark Edelstone with Morgan Stanley.
Jen-Hsun Huang: Hello, Mark?
Michael Hara: No Mark.
Mark Edelstone - Morgan Stanley: -- over the next six months or so, and then I have a follow-up on the application processor.
Michael Hara: Mark, your question got cut out in the first part. Can you repeat it, please?
Mark Edelstone - Morgan Stanley: Sorry, I just wanted to see if Jen-Hsun could talk a little bit about the rollout of the rest of the [GeForce 8000] family here over the next several quarters.
Jen-Hsun Huang: You know, the core of our business starts from first building in the basic architecture itself, and it usually starts at the [enthusiast] [inaudible]. The GeForce 8800 has beaten the competition to market by well over six months and counting. It is the core by which we build our notebook GPU family, the rest of our desktop GPU family, our professional graphics solutions, our GPU computing products, as well as our motherboard GPU products, what other people call integrated graphics. It is the core to a lot of other businesses that we are in today. The GeForce 8800 has ramped up very nicely, as you know, Mark, and at the moment, every single one of the businesses I just mentioned are in the process of taking that GeForce 8 core and driving it deep into their business. We are not ready to announce any products today but I can assure you that every single one of those businesses have GeForce 8 throughout their product and are either ramping already or on the verge of ramping production.
Mark Edelstone - Morgan Stanley: So can you just give us a sense as to when you would expect to see the crossover so that the GeForce 8 family overall becomes your highest unit volume product?
Marvin D. Burkett: Unit volume, Mark?
Jen-Hsun Huang: Unit volume or revenue?
Mark Edelstone - Morgan Stanley: Well, whichever one you’d like to address would be fine.
Jen-Hsun Huang: I think in terms of units, it is going to take well into the latter part of the year, if not early next year, and the reason for that is because the GeForce 7 is such an incredibly efficient architecture and it is the lowest cost Vista premium solution that we know. My sense is that we are going to continue to see quite a bit of success in GeForce 7 for people who would like to put together the lowest cost Vista premium machine, and so the volumes of the GeForce 7 family are going to continue well through this year and probably well through next year. The unit volume should be pretty high there. In terms of the revenue crossover, I will let Marvin guess at it, but my guess is that it is probably going to be late Q3, Q4 timeframe.
Mark Edelstone - Morgan Stanley: Okay, great, and then just lastly, I saw your 6100 in Barcelona here this week and just wanted to see if you could provide some additional thoughts on how long it takes you to really get the application processor strategy going to where you would like it, and what you see as the potential here for that business over the next several years?
Jen-Hsun Huang: Yes, we introduced our first application processor today, or this week, and this application processor, I hope you will agree, is just absolutely amazing. It was really the core reason why we acquired PortalPlayer. They have a really, really talented team that arguably built the world's first computer on a chip. It was the reason why the Apple engineers used it to build the iPod, which is really a computer with an operating system and a file system and connectivity and was dedicated to media processing. Their obsession about low-power design has really enabled them to build some amazing products. They had this application processor in the back room and what you are seeing now, the 6100, is the first of its kind. Our companies are now, our two engineering groups are now completely combined and the roadmap has been integrated. We brought the company on board on January 5th and in a very short period of time, we have realigned our strategies and now we are going to go build application processors that combine their expertise of building SOCs and our expertise of building GPUs. My hope is that this year, we will introduce an amazing product towards the end of the year and next year, I hope that we get a lot of business traction as a result of that. This is by far the single largest new [team] that our company has grown into. It is hard to say exactly how big this [inaudible] is going to be, but you know, application processors, it is probably close to $4 billion to $6 billion in size already. This particular marketplace is quickly transitioning to multimedia and graphics processing because of all the smartphones and portable media players and the combining of these two types of devices that we are seeing out there. My sense is that we are going to be right in the epicenter of a lot of exciting new devices pretty soon. This is a very, very exciting development for our company.
Mark Edelstone - Morgan Stanley: Thanks a lot, guys.
Operator: Your next question comes from Gurinder Kalra with Bear Stearns.
Gurinder Kalra - Bear Stearns: Hi, a couple of questions: firstly, can you update us on your roadmap as far as Intel-based chipsets are concerned? Where do you see volume ramp of that as we look through the year?
Jen-Hsun Huang: We have not really announced any of our products yet. I think the market has been very vocal about inviting us, if you will, to come and participate in this marketplace and the reason for that is because even in the Intel market, there needs to be a branded motherboard GPU alternative for the consumer segments and the multimedia rich type segments where graphics are really important. Now, with Vista Premium coming out and all the applications that are coming out in 3D, it is really important to make sure that your GPU software and architecture is as prolific as possible, and so we know that the market has a significant demand for our product. We are just racing as fast as we can to get there. I do not have anything to announce to you today but we have a lot of focus inside the company to develop products for that segment.
Gurinder Kalra - Bear Stearns: Thanks. My second question is with AMD talking about Fusion and with there being talk that Intel is looking to do something on the Discrete GPU lines, how do you suppose you are going to counteract that effort? Is there any talk that you might be looking to do something on the microprocessor front?
Jen-Hsun Huang: You know, we have all kinds of plans for developing products in the future. I do not really see the benefit of telling the market, or the competition particularly, what we are building several years out. I do not know why they are, to tell you the truth, unless they are panicked about something or feel somewhat apologetic about something else. I think we have to keep all of our product roadmaps to ourselves. You know, ultimately the thing that I do know is this: we are really good at building the technologies that you guys know we are great at building and we are focused as a company to differentiate by building products that consumers want to buy. My sense is that if the market wants to buy those products, we are going to know well in advance and we will build the right products for the marketplace. So I do not see any particular reason why -- well, I guess just no comment.
Gurinder Kalra - Bear Stearns: All right. Thanks very much.
Operator: Your next question comes from Satya Chillara with Pacific Growth Equities.
Satya Chillara - Pacific Growth Equities: Hi, good afternoon. Jen-Hsun, can you talk about the cell-phone traction in fiscal '08? It seems in the last analyst day, you were pretty bullish on the cell-phone traction, with 2G as well as the 3G and so on. So where do you see the revenues growing from about a $100 million level to -- what kind of revenue growth do you expect here?
Jen-Hsun Huang: Yes, I still remain incredibly bullish about our mobile efforts. In terms of 2.5G, we absolutely achieved our objective of capturing the design wins we wanted to capture. Unfortunately, a lot of our focus was on Motorola and, as you saw in some of the reports already, some of the phones that we were designed into were not as successful as we would like. Net net, we ended up at $108 million for the year and grew 85% year-over-year. I am pretty sure, based on all the design wins that we have now, that this coming year is going to be more than $108 million. The question is how much more. Secondarily, our focus now is we are going to continue to invest in GPUs but our primary focus is going to be in taking the GPU and the application processor components and putting them into an SOC. Our customers are all asking us for that and, based on the type of vision that the phone industry has conveyed to all of us, and some of the exciting new phones that are being talked about, the type of technology is very clear. Graphics processing is going to be important -- 3D graphics processing, so that you could do the type of user interfaces like Vista except doing it on the phone, is very exciting, and video processing and encoding. There are all kinds of new capabilities that the phone manufacturers want to bring to the marketplace next year. So I think we are strategically extremely well-positioned. We just need to go execute and turn those design wins into business.
Satya Chillara - Pacific Growth Equities: Okay, so as a follow-up, in terms of Intel’s low-end strategy, is that a single-chip strategy? Or only with single-chip would you enter the market? What is your thinking and strategy in terms of the Intel low-end strategy?
Jen-Hsun Huang: We started this trend of building a single-chip motherboard GPU, and it is the core logic -- all the connectivity, all of the graphics, all of the platform technologies, all integrated into one chip. The marketplace really, really likes it and the reason for that is because computers want to be smaller than ever and we want to drive the power down. The fewer chips you have in the system, the lower the cost, the lower the space requirement, the lower the power. From our perspective, fewer chips allow us to improve our margins. Technically, it is extremely complicated in the sense that you have to get mixed signal technology and IO technology and all of your connectivity technology on the same process, which tends to be very [inaudible] for GPUs, you know, all under the same process. Technologically, it is a great challenge, but I think we happen to be one of those companies that really know how to pull it altogether, and so we are going to continue to take advantage of that leadership position.
Satya Chillara - Pacific Growth Equities: Thanks.
Operator: Your next question comes from Jason [Fellum] with Thomas Weisel Partners. Jason, your line is open.
Michael Hara: Operator, go ahead and go to the next question.
Operator: Your next question comes from Krishna Shankar with JMP Securities.
Krishna Shankar - JMP Securities: Yes, I was wondering if you can, Jen-Hsun, talk about the attach rate of discrete graphics for Vista and what you are seeing in terms of initial Vista demand and of the demand for the more Premium version of the operating system versus Basic, which will really drive requirements for your 8800 GPU.
Jen-Hsun Huang: I can tell you what logic would compel and what we believe, and in terms of real experiences, it is really hard to tell yet because Vista really just started shipping. But what logic would compel is that Vista is the first operating system that is fully based on the programmability and the shading capability and the graphics rendering processing capability of a GPU, and it exposes this capability to not just the user interface but it exposes this capability to all applications. The compelling logic is that if the GPU is much more taxed and all of the applications use more 3D graphics capability, you would think that the GPU would be more relevant. I think that there is no question as you use Vista, the experience is just far better with the GPU than when it is not. It is snappier and that is just the user interface, right? And so all of the operating system, all of the applications that use 3D graphics have not really even been exposed to this yet. We know that there are many applications that are being developed where 3D graphics are going to make the application richer, many Web 2.0 applications, and we see many from Microsoft already that really exploits the capability of 3D. Even iTunes renders the album covers in 3D now. There are all kinds of applications that are coming that take advantage of 3D graphics, so logic would certainly compel us to believe that GPUs will be more prevalently used. We believe that to be the case and so we are cautious in the first quarter as we go into it, but our belief is that GPUs will become more important than ever before.
Krishna Shankar - JMP Securities: Do you see the trend for notebooks also, where obviously Intel would be, the Centrino platform, they have 70% of that market. Do you see the trend reversing to where you see [an alternative] for discrete notebook solutions, and also MCPs for the notebook market?
Jen-Hsun Huang: Well, the way we see it is that the notebook is really a form factor issue, and so we are going to go to the marketplace. If the form factor allows for a discrete GPU, we would offer the market a discrete GPU. But if the market would like a motherboard GPU, what is commonly called an integrated graphics chip, if motherboard GPU is the way they would like to power Vista, we are delighted by that as well and in fact, if you see our core logic business, the MCP business, it has grown dramatically year over year. A lot of that growth is because of motherboard graphics. I think that there is some evidence that motherboard GPUs are just another way of accessing the capabilities of GPUs and we are going to see some continuous growth there.
Krishna Shankar - JMP Securities: Great. Thank you.
Operator: Your next question comes from Devan Moodley with Scotia Capital.
Devan Moodley - Scotia Capital: Hi, guys, just a follow-up question on Vista. If I look at the Mercury Research forecast currently for desktop discrete, they are looking for a single-digit decline in '07 but surprisingly, they are looking for almost 20% to 30% ASP growth in the desktop segment. Can you give me your perspective on what you are looking for and what would be the impact of Vista on the GF8 family tier?
Jen-Hsun Huang: I am not sure I picked up on the question.
Devan Moodley - Scotia Capital: Just ASPs, I guess -- Mercury is looking for ASPs to be up significantly this year in desktop discrete. What is your perspective of where your ASPs in that area will go?
Jen-Hsun Huang: You know, Devan, our ASP has been growing pretty steadily over the years. I think it is logical to me because more and more of our computing experience is around the visual experience, and all of the most exciting applications, or many of the most exciting applications that we know, are really, really graphics rich. The resolution of the display is being driven by Moore's Law and the color depth. On the other dimension, each pixel is moving faster than Moore's Law in the sense that the number of objects we render on each pixel and the color fidelity of each pixel is really going up quite dramatically. It stands to reason that more and more work needs to be done on the GPU, and if that is the case -- and more of your computing experience is depending on a GPU -- if that is the case, then ASPs ought to continue to grow. If somebody told that ASP is going to grow steadily over the next several years, I guess I am not going to be surprised by that because historical evidence would suggest that is the case.
Devan Moodley - Scotia Capital: Okay, and just a quick housekeeping question: what was CapEx for the quarter and the year?
Marvin D. Burkett: Yes, our CapEx in the quarter was roughly $70 million, $71 million. However, there are a couple of factors in there that you should be aware of. There was roughly $37 million of what I would call the normal CapEx, which is equipment and software that we bought. There is about $14 million worth of IP intangibles from investments that we made, and there is about $20 million of a re-class from our long-term assets into that account, so I would say that the normal CapEx was $37 million.
Devan Moodley - Scotia Capital: And do you expect that to change significantly going into next year?
Marvin D. Burkett: No.
Devan Moodley - Scotia Capital: Thanks, guys.
Operator: Your next question comes from Arnab Chanda with Lehman Brothers.
Arnab Chanda - Lehman Brothers: Thank you. Just a couple of questions. First of all, if you look at your MCP business, would that grow until your new Intel chipset is launched, or was it going to be sort of seasonal in the first part of the year? And then a follow-up, please.
Jen-Hsun Huang: We are expecting seasonal dynamics in the first quarter. We do have Intel core logic that we announced, as I mentioned earlier, the 680i, and the 680i has other segments that we are introducing. We are going to grow in the Intel core logic business through Q1. I do not know whether it is going to make up for the seasonal decline but we are not counting on it at the moment. Then later, as the year progresses and as we launch our Intel CPU-based motherboard GPUs, we are expecting quite a bit of growth from that.
Arnab Chanda - Lehman Brothers: Thanks, Jen-Hsun, and last question: the computing GPU product that -- maybe I did not quite understand it properly, but is it something that will be sort of additive to your workstation business or is it sort of a new category? What type of additional market opportunity does that get for you guys? Thank you.
Jen-Hsun Huang: The GPU computing initiative is absolutely additive, and I would argue that the industry has had a vacuum, or a super-computing crisis, for sometime. Scientists and researchers have been clamoring for more computing horsepower for quite a bit of time, and yet the technology has not existed that enables them to do some of the computational methods that they want to try. GPU computing is really going to help address that. I frankly think that the combination between the CPU and a GPU with GPU computing capabilities will really create a new class of workstations -- one not necessarily for design but one for computation. It is almost like a personal super-computer that the researchers and the scientists will get to leverage. This is absolutely a new class of computing and it is a new initiative for us, and our early response from the people we have spoken to, and many of them in the financial industry, are just incredibly enthusiastic, so we are very excited about it.
Arnab Chanda - Lehman Brothers: Thanks, Jen-Hsun.
Operator: Your next question comes from Naser Iqbal with Salman Partners.
Naser Iqbal - Salman Partners : Hi, guys. Marv, just really a clarification on the impact of Portal, and if I heard you correctly, that in terms of the R&D and expenses, you had a $5 million hit, a $4 million hit but a net income contribution of about $1 million. Were there any revenues for the quarter?
Marvin D. Burkett: The revenue in Q4 was roughly $1 million, so there was roughly $5 million worth of expenses and $1 million worth of revenue. When you look into Q1, we are looking at something slightly less than $10 million in revenue and approximately $15 million in expenses.
Naser Iqbal - Salman Partners : Right, which is my follow-up, in terms of when you talked about the outlook for the quarter, that you expected that $10 million to come from Portal; but did I hear you correctly that you think your overall op-ex could be flat quarter on quarter?
Marvin D. Burkett: Yes, we think that we can, you know, obviously we had the one-time cost in Q4 for the restatement and there are some other one-time costs in Q4. I think we are very cost-conscious right now and the company does a very good job of responding to those circumstances, so I think we have a very good chance of holding op-ex flat, even though we are going to have to absorb the $10 million increase in the PortalPlayer.
Naser Iqbal - Salman Partners : Okay, great. Thanks a lot, guys.
Operator: Your next question comes from Simona Jankowski with Goldman Sachs.
Simona Jankowski - Goldman Sachs: Hi, guys, also a clarification on the guidance. Was the 5% seasonal decline, was that a comment just on the PC-facing segments of your business or was that for your overall revenue expectations?
Marvin D. Burkett: Simona, I think it was more overall, but I would classify that we expect memory to decline, and that would be probably in my view the single largest component of that 5%. But if you had to pick a point estimate, we are saying overall revenue declined 5%.
Simona Jankowski - Goldman Sachs: Terrific, and then secondly, Marv or Jen-Hsun, can you comment on how you see your channel inventories right now, both for graphics cards and also motherboards?
Jen-Hsun Huang: Channel sell-through is picking up. Q3 and Q4 were a bit choppier than -- and I think all of you guys saw that -- a bit choppier than we all expected. I think some of that had to do with AM2 gap out in the channel, but AM2s are back and there are plenty of Conroes as well, and both of those CPUs are really wonderful CPUs. When they are available in the channel, it really helps our GPU business. We are seeing business sell-through certainly very quite brisk right now.
Simona Jankowski - Goldman Sachs: Okay, that is very helpful. As far as the actual build-up though of motherboards in the channel, is that now done and over with now that the CPUs are available? Or do we still have a bit of back-up that maybe takes a couple more weeks to get through?
Jen-Hsun Huang: It depends on what segments we are talking about. Our Intel motherboards, for example, are still ramping and we are still doing quite well with our Intel motherboard business. I have not really checked on the AMD side of it, but now that the CPUs are back, and quite a few CPUs were taken out of the channel, as you know, so the return of the CPUs is really, really a good thing for all of us.
Simona Jankowski - Goldman Sachs: Okay, and then just a last quick one for me, if I could: on the gross margin improvement, which was very nice in the first quarter, can you can just comment on the various puts and takes within that? In other words, I know ATI, or AMD now, had commented on a tough [inaudible] environment. It did not seem to have affected you guys, given your positioning, so that is just one aspect I wanted to see if you could comment on. Secondly, on the TSMC pricing, which seems to have been favorable in the quarter, is that a quantifiable benefit to your margins in the quarter?
Marvin D. Burkett: Let me start. In the GPU business, we improved gross margins quarter to quarter. Some of that improvement came from the fact that the workstation business grew very nicely during the quarter, so we benefited in the GPU business because of that. MCPs, they improved the gross margin and the revenue increase. There is just a continued focus there on improving gross margins. Handheld improved gross margins, even though revenue was relatively flat. Memory went up during the quarter, which would have had a drag on gross margins. I would say that each of the business units contributed to gross margin improvement. The increase in memory was a slight drag on it. The TSMC issue, I do not know if you want to comment, Jen-Hsun.
Jen-Hsun Huang: It is nothing special.
Marvin D. Burkett: Yes, I do not think there was anything out of the ordinary.
Simona Jankowski - Goldman Sachs: Great, thank you very much.
Operator: Your next question comes from David Wu with Global Crown Capital.
David Wu - Global Crown Capital: Yes, Marv, on the subject of gross margin, can you talk about or remind us of what your gross margin target, the new level is, since 44% is no longer an issue anymore and 45% looks like within reach? And I have a question for Jen-Hsun on the PortalPlayer application processor. What is the difference between their application processor and a whole ream of these ARM-based application processors out there? Can you also comment on the likelihood you are going to see some competition from the X-86 in the form of these, what they call the ultra mobile PCs?
Marvin D. Burkett: I will start with the gross margin, David. Jen-Hsun established the target of a 45% gross margin just about a year ago and I think there were a lot of skeptics out there -- maybe even me, who knows -- but we have made a lot of progress and things have gone well. I think that we are going to have to sit down and establish a new goal because yes, I agree: 45% is achievable. Now the question is, we cannot let up. We can improve gross margins from the [inaudible].
David Wu - Global Crown Capital: But at this point, you will not, you cannot elaborate what that might be?
Marvin D. Burkett: Well, our public target is still 45%.
David Wu - Global Crown Capital: Okay. Jen-Hsun, can you talk about the application processor for that PortalPlayer and what is different from all these other ARM-based application processors out there?
Jen-Hsun Huang: Sure. First of all, PortalPlayer's focus has always been in the personal media player market, and in that marketplace, the digital media processing is really important. Extreme low-power is extremely important. If you get a chance to see the new 6100, and see it do decoding [VJ] resolution video and watch it do it at just barely, barely a sweat, it is really, really amazing. So their focus is building a complete computer on a chip that is capable of doing multimedia processing at extremely low-power levels. That is really where their focus was. Relative to us, the reason why PortalPlayer is so valuable to us is because we do not have an application processor, but we do have a very deep investment in GPU technologies over the years and the combination of our graphics and video and image processing capabilities in combination with their application processor really gives us a unique position in the marketplace. I would say their positioning in the mobile marketplace was good but challenging because of the amount of R&D they could really invest, and our positioning was good in the high-end markets, where the flagship phones really needed the multimedia capabilities we brought. In combination, now we can build some SOCs that are absolutely amazing, and that is the reason our two management teams decided to combine the companies.
David Wu - Global Crown Capital: Who do you see as competitors in that space, besides Texas Instruments?
Jen-Hsun Huang: I would say TI is a competitor. Obviously Samsung is a competitor. Samsung has been very successful there. The XScale business that Intel sold to Marvell -- these are all competitors in the marketplace. But this is also one of the largest markets that we know of in the semiconductor industry and there are a whole lot of segments. Some of those segments just want your basic, best microprocessor. Some of those segments want the lowest, lowest cost SOC for your basic smartphone, and some of them need rich graphics and rich multimedia for consumer applications where you want to have your phone also be your e-mail device and music player and video player and such. That is where I think NVIDIA would really shine.
David Wu - Global Crown Capital: Thank you.
Operator: Your next question comes from Doug Freedman with AmTech Research.
Doug Freedman - American Technology Research: Good afternoon, guys. A quick question for you, Jen-Hsun, if you could talk about -- you have taken quite a bit of share in several of the markets now from your closest competitor that was acquired by AMD. Can you talk about what you think might be their response, and if there is anything that you can do to offset it or continue the track record that you have put up?
Jen-Hsun Huang: Well, first of all, that is a really good question and I hope I do not answer it -- not publicly, anyhow, so please do not encourage me. You know what I would say is that our market share is in fact, although improving year over year, I think we came out of the year last year at about 18%, 19% overall graphics market share. We are at 29%. As far as I am concerned, whether it is a discrete GPU or a motherboard GPU, they are both GPUs. We believe that there are segments of the marketplace that really prefer to have a better GPU than not. Our GPU brand, the GeForce brand, is just so strong that I think we still have a lot of opportunities. Now we are the only GPU company in the world that is completely focused, number one, but also participates in building and selling GPUs into both microprocessor markets, both the AMD market as well as the Intel market. We are the distinguishing brand of both platforms. I am excited about that. Our job is to grow our overall GPU business from 29% to something much higher than that.
Doug Freedman - American Technology Research: All right. If I could, Marv, turn to you for a quick second, and I guess Jen-Hsun also plays a role in this: what is your view on the share buy-back? What should we be thinking about on the stock dilution level? Clearly this quarter the share count came in very close to unchanged. Any guidance you can offer on what we should think about going forward?
Marvin D. Burkett: Yes, we evaluate it every quarter. We still have authorization from the Board to do stock buy-backs. I probably do not see any reason to deviate from our practices in the current environment, but we evaluate it every quarter. Totally separate from that, the annual dilution level on what I call a gross basis, meaning how many shares we issue, is established by the comp committee, and so we have been bringing that down for several years now. It was roughly 3% last year -- that is excluding stock buy-backs -- and I think it will be less than that in fiscal year '08, but that is exclusive of any buy-backs.
Doug Freedman - American Technology Research: Okay. Thank you.
Operator: Your next question comes from Shawn Webster with JP Morgan.
Shawn Webster - JP Morgan: Good afternoon. Thanks for squeezing me in, guys. On the chipset business, can you give us a quick update on what the mix is in terms of units and/or revenues on Intel versus AMD chipsets?
Jen-Hsun Huang: I would say that today it is vastly, it is mostly, by far AMD, and we had just entered the Intel chipset marketplace with the 680i I guess late Q3. We did well in Q3, we ramped more in Q4 and we are expecting to ramp even more in Q1 and ramp it into Q2. As Conroe continues to grow into the marketplace, we expect our 680i family to follow that. I also think that is our core Intel chipset product right now and hopefully in the near future, we will try to add something to that with our motherboard GPUs for the Intel processor.
Shawn Webster - JP Morgan: I see. And then, for your overall GPU business in Q4, can you tell us what your units and ASPs did sequentially?
Marvin D. Burkett: Overall, units were very, very, very slightly up and ASP was very slightly down. I indicated that in my comments, that the desktop ASP declined slightly in the quarter.
Shawn Webster - JP Morgan: Okay, and then Marv, can you give us some guidance on your effective tax rate for the full year fiscal '08?
Marvin D. Burkett: Our best guess right now is 14% for both GAAP and non-GAAP, but we will evaluate that as we go through the year. We get the benefit of the R&D tax credit, which we got a full year's worth in the fourth quarter, and that is one of the drivers in being able to reduce the tax rate down to 14% for this year.
Shawn Webster - JP Morgan: That makes sense. Thanks a lot.
Operator: Ladies and gentlemen, we have reached the end of the allotted time for questions and answers this afternoon. I would now like to turn the call back over to Jen-Hsun Huang for closing remarks.
Jen-Hsun Huang: Thank you. Our goal is to be one of the most influential and respected technology companies in the world by being the premier supplier of visual computing technologies and solutions. We believe the programmable GPU is becoming one of the most important technologies of the digital era, as it powers multimedia rich applications on a growing number of consumer devices. As the only GPU company in the world, we have dedicated ourselves to making this vision a reality. Fiscal 2007 was a milestone year for NVIDIA. Because of the number of growth and technology initiatives that we have set in motion last year, we believe we are well-positioned to have another strong year. Thank you for joining us today. We look forward to reporting on our progress for Q1.
Operator: This concludes today's conference call. You may now disconnect.
TRANSCRIPT SPONSOR :
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{
"speaker": "TRANSCRIPT SPONSOR",
"text": ""
},
{
"speaker": "Executives",
"text": "Michael Hara - Vice President, Investor Relations Jen-Hsun Huang - President, Chief Executive Officer Marvin D. Burkett - Chief Financial Officer"
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{
"speaker": "Analysts",
"text": "Mark Edelstone - Morgan Stanley Gurinder Kalra - Bear Stearns Satya Chillara - Pacific Growth Equities Krishna Shankar - JMP Securities Devan Moodley - Scotia Capital Arnab Chanda - Lehman Brothers Naser Iqbal - Salman Partners Simona Jankowski - Goldman Sachs David Wu - Global Crown Capital Doug Freedman - American Technology Research Shawn Webster - JP Morgan"
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"speaker": "Operator",
"text": "Good afternoon and thank you for holding. I would now like to turn the call over to Mr. Michael Hara, NVIDIA's Vice President of Investor Relations. Thank you. Sir, you may begin your conference."
},
{
"speaker": "Michael Hara",
"text": "Thank you, Operator. Good afternoon, and thank you for holding. Good afternoon and welcome to NVIDIA's conference call for the fourth fiscal quarter ended January 28, 2007. On the call today for NVIDIA are: Jen-Hsun Huang, NVIDIA's President and Chief Executive Officer; and Marv Burkett, NVIDIA's Chief Financial Officer. Before we begin today's call, I would like to take care of some general administrative items. Your lines have been placed on a listen-only mode until the question-and-answer segment of today’s call. During this call, we will discuss some non-GAAP measures about net income, net income per share and gross margin, and other line items from our consolidated statements of income in talking about our results. You can find a full reconciliation of these measures to GAAP in our financial release, which is posted on the investor relations page of our website at www.nvidia.com. This call is being recorded. If you have any objections, you may disconnect at this time. Please beware that if you decide to ask a question, it will be included in both our live transmission as well as any future use of the recording. Also, shareholders can listen to a live webcast of today's call and view our financial release at the NVIDIA investor relations website. The webcast will be available for replay until the company's conference call to discuss its financial results for its first quarter fiscal 2008. During the course of this conference call, we may make forward-looking statements based on current expectations. Forward-looking statements, including statements as to our outlook, the use of non-GAAP measures, the benefit and impact of acquisitions, our products and technologies, design wins, key objectives, growth and growth drivers, market share, Windows Vista, the X-10 and HD Blu-ray DVD, pertain to future events and are subject to a number of significant risks and uncertainties. The company's actual results may differ materially from results discussed in any forward-looking statements. For a complete discussion of factors that could affect the company's future financial results and business, please refer to the company's Form 10-K/A for the fiscal year ended January 29, 2006, quarterly reports on Forms 10-Q and 10-Q/A, and the reports on Form 8-K filed with the Securities and Exchange Commission. All forward-looking statements are made as of the date hereof based on information available to us today and, except as required by law, the company assumes no obligation to update any such statements. The content of the webcast contains time-sensitive information that is accurate only as of February 15, 2007. Consistent with the requirements under Regulation FD, we will provide public guidance directly on the conference call and will be unable to provide significantly more information in offline conversations or during the quarter. Therefore, questions around our financial expectations should be asked during this call. At the end of our remarks, there will be time for your questions. In order to allow more people to ask questions, please limit yourself to one question. After our response, we will allow one follow-up question. I will now hand the call over to Jen-Hsun."
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{
"speaker": "Jen-Hsun Huang",
"text": "Thanks, Mike. Good afternoon, and thank you for joining us. Today we are pleased to report record revenue of $878.9 million for our fourth quarter. This is our fourth consecutive record quarter. Year over year, fourth quarter revenue grew 39%. For the year, we delivered record revenue of $3.07 billion, an increase of 29% over the previous year. Let me highlight some of our fourth quarter and fiscal year 2007 results and achievements. As a note, all share numbers quoted are from Mercury Research unless otherwise noted. Non-GAAP annual gross margin for the year reached a company-high of 43.2%, an increase of 490 basis points year over year. GAAP annual gross margin was 42.4%. Non-GAAP gross margin for the fourth quarter reached a company-high of 44.2%, an increase of 130 basis points sequentially from the third quarter of fiscal 2007 and 400 basis points year over year. GAAP gross margin was 43.9%. Non-GAAP net income was $577.9 million, an increase of 91% year over year. GAAP net income was a record $448.8 million. We launched multiple industry-defining products during the year: the revolutionary GeForce 8800, the industry's most powerful GPU and the first DX10 unified shader GPU; nForce 400 family, the industry's first single-chip motherboard GPU chipset; PureVideo HD, the industry's first solution for full HD Blu-ray processing; Quadro Plex, the world's first ultra high-density visual computing system; and the revolutionary CUDA architecture for GPU computing. We maintained our number one position in desktop GPUs. The desktop GPU business delivered a record year, with $1.24 billion in revenue, growing 11% year over year. Our share in the performance segment grew to over 85%, up from 79% a year earlier. We captured the number one notebook GPU position, with our share increasing to 58%, up 20% from the previous year. Notebook GPU revenue grew 122% year over year. Our overall PC graphics share increased from 18% a year ago to 29% today. The nForce MCP product line achieved record revenue for its tenth consecutive quarter. Revenue grew over 16% sequentially from the third quarter and 89% year over year. The Quadro professional product line achieved a record revenue, an increase of 24% from the fourth quarter fiscal 2006. The handheld GPU product line delivered $108 million in revenue, an increase of 85% from the previous year. Sony launched the PlayStation 3 with our RSX GPU. We completed the acquisition of PortalPlayer, a leading supplier of software and SOC application processors for mobile devices like Apple's iPods. NVIDIA was named the most respected public company by the members of the Fabless Semiconductor Association. Finally, with AMD's acquisition of ATI, NVIDIA became the only independent GPU company in the world. We are pleased with our record year -- particularly, we are very pleased with our strategic position going into fiscal 2008. Let me turn the call over to Marv to discuss our financial results in more detail. I will return in a moment to address our growth opportunities."
},
{
"speaker": "Marvin D. Burkett",
"text": "Thanks, Jen-Hsun. Today, we are reporting both GAAP and non-GAAP P&Ls for our Q4 and fiscal year '07. As Jen-Hsun said, revenue for the fourth quarter was $879 million, which is up 7.1% or $58 million from the third quarter. Revenue for the fiscal year was $3.07 billion, which is up 29% year over year. In the fourth quarter, growth was led by MCP products, which increased by 16% quarter to quarter and, as Jen-Hsun said, was a record for the tenth consecutive quarter. Total MCP revenue grew 88% for the whole fiscal year. Professional solutions products grew by 14% sequentially and also set a record for revenue. In the desktop GPU business, the GeForce 8800 products grew by more than $50 million but were offset by weakness in some of the GeForce 7 products, particularly in the channel. Memory grew by $10 million quarter to quarter. Our consumer electronics revenue increased 40% sequentially, driven by significantly higher contributions of royalty payments, which more than offset a decline in MRE. ASPs were slightly down in desktop GPUs, and relatively flat everywhere else. We closed the purchase of PortalPlayer on January 5th, but the revenue contribution from Portal was not significant, approximately $1 million. For gross margin in the quarter, we reported non-GAAP gross margin of 44.2% and GAAP gross margin of 43.9%. Our 45% target is getting close. GPUs, MCPs and handheld business units all improved gross margin quarter to quarter. As a company, we continue to work hard on improvement. Operating expenses for the quarter were $247 million on a GAAP basis and $203 million on a non-GAAP. The non-GAAP eliminated stock-based compensation of $34 million before tax effect and it eliminated $13.4 million of in-process R&D associated with the PortalPlayer acquisition. The $203 million included one month of PortalPlayer expenses, which totaled approximately $5 million, and it also included legal and accounting fees associated with the restatement of approximately $4 million, the restatement which was filed in December. Including PortalPlayer, we added 456 new employees during the quarter and exited the year with 4,083 employees. For the year, we added over 1,300 new employees. Depreciation in the quarter was $30 million. The tax rate for the fiscal year and for the fourth quarter included the benefit of Congress passing the R&D tax credit retroactive to the beginning of calendar year 2006. This resulted in lowering both our GAAP and non-GAAP tax rates. It lowered the GAAP tax rate by 7 percentage points to slightly over 9% for the year and obviously a negative tax rate of 8% for the fourth quarter. For non-GAAP, it lowered our fiscal year '07 rate by 6 percentage points to 10% and resulted in a negative tax rate of 3% for the quarter. All of this resulted in GAAP net income for the quarter of $164 million, or $0.41 per diluted share, and a non-GAAP net income of $206 million, or $0.53 per diluted share. On the balance sheet, we exited the year with $1.12 billion in cash and marketable securities, which was down $56 million from the prior quarter. This is after paying approximately $160 million net of cash and marketable securities for the acquisition of PortalPlayer and repurchasing $100 million worth of stock. For the year, we repurchased $276 million worth of shares at an average cost of $26.80. As a company, we generated more than $500 million in operating cash flow during the year. Accounts receivable grew by $79 million quarter to quarter, as Q4 was back-end loaded. Our receivables are current and DSO was at 53.7 days. Inventory declined by $19 million and resulted in days sales of inventory of 65 days. We grew inventory of the GeForce 8 family and decreased the inventory of older products. Accounts Payable decreased by $52 million quarter to quarter. Now for the outlook for Q1 fiscal year '08: for revenue, we expect a normal seasonal decline associated with the PC business of approximately 5%. Although we believe our market and competitive position in each of our business units continues to be very strong, there are no significant industry growth drivers to offset seasonality. Although we are enthusiastic about Vista's impact on our business, we will be cautious in the first quarter. We expect a decline in memory from the Q4 levels. We expect a revenue contribution from PortalPlayer of less than $10 million in the quarter. For gross margin, we will continue to work hard to keep them flat to perhaps slightly improving. On operating expenses, we have to absorb a full quarter of PortalPlayer, which will cause an increase of approximately $10 million from Q4. However, we believe that even with the additional expense, we may be able to keep operating expenses flat with Q4 as we focus on expense controls and restrict headcount additions. We will get a small benefit in tax rate for the first quarter of fiscal year '08, as we are projecting a tax rate of 14% for both GAAP and non-GAAP. With that, I will turn it back to Jen-Hsun."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks, Marv. As we look ahead at fiscal 2008, we are very excited of our numerous growth drivers impacting each of our product lines. Let me discuss each of them in detail. First, our GeForce desktop and notebook GPU business: GeForce 8800 is the world's first DX10 unified shader architecture GPU. It also incorporates PureVideo HD, the highest visual quality video processor for PCs and the only full HD video processing solution for HD and Blu-ray DVD. The GeForce 8800 is now available from virtually every PC OEM system builder worldwide and in most e-tail and retail outlet. Since October, we shipped nearly 400,000 GeForce 8800s. Our focus for desktop GPU is to leverage our leadership position with GeForce 8 into the mainstream market. We are ramping production on our GeForce 8 family of notebook GPUs, the industry's first DX10 and high-definition video GPU for notebooks. GeForce 8 will be the only DX10 GPU shipping in the upcoming Santa Rosa notebook launch. We expect our share of notebook GPUs to take another step up after this spring transition. We are looking forward to an exciting year for our GPU business. Vista has shipped. This is the first operating system to present as a standard the power of the GPU to all applications -- applications from Office to Web 2.0 applications can now incorporate beautiful 3D effects because hundreds of millions of PCs will have Vista. With Vista, DX10 and HD Blu-ray DVD at the height of technologies for PC this year, 3D graphics will become an ever-central part of our computing experience and the GPU will be more important than ever. Our nForce MCP business: driven by the broadest product line of AMD-based chipsets supporting 8P commercial servers to consumer desktops and notebooks, we have become the number one supplier of MCPs for AMD-based PCs. We ended the calendar year as the industry's second-largest supplier of chipsets, having more than tripled our share from just two years ago. OEMs have embraced our unique strategy of offering single-chip MCPs designed specifically to reduce space and power consumption, while offering outstanding quality and performance. Our motherboard GPU product line is favored by PC manufacturers around the world. These customers prominently feature our GeForce brand to differentiate their PCs from basic integrated graphics. Our “Graphics by NVIDIA” logo is proudly on display on new Windows Vista PCs on retail shelves all around the world. In Q4, we announced our new nForce 680i SLI for Intel CPUs. Our new product line was received enthusiastically by customers and reviewers around the world and quickly became the top-selling, high-end motherboard in multiple e-tail and retail chains. The NVIDIA nForce brand is unambiguously recognized as the best chipset for performance PCs and dominates the top 10 rankings in the majority of industry motherboard reviews worldwide. For fiscal 2008, our key growth objectives are to deliver exciting new motherboard GPU products for the Intel CPU segment and maintain our leadership position on [inaudible] platforms. We believe that Intel-based customers will demand the NVIDIA GeForce-branded motherboard GPUs and we expect an enthusiastic response to our launch later this year. Now our Quadro professional solutions group business: NVIDIA's Quadro professional business had an outstanding year. Annual revenue grew 21% versus fiscal 2006. NVIDIA Quadro is recognized as the standard for professional graphic solutions needed to solve the world's most complex visual computing challenges in the manufacturing, entertainment, medical, science and aerospace industries. This year, we introduced Quadro Plex, an entirely new category of visual computing solutions. Quadro Plex brings the level of graphics scalability and processing density that was simply not possible before. In Q4, we began feeding the industry with our GeForce 8 GPU enabled with CUDA, a revolutionary technology and compiler that for the first time allows programmers to write “C” language applications for GPUs. GeForce 8 and CUDA will enable a new class of high-performance computing we call GPU computing. With a CUDA-enabled GPU, the PC will enable engineers and scientists to harness the awesome power of programmable GPUs to solve mathematically intensive problems that were previously cost-prohibitive. Based on the early response we are getting from programmers, scientists and engineers, it is apparent that we are delivering an enabling technology that will profoundly change a number of computing industries. We believe GPU computing will usher in an era of the personal super-computer and will dramatically accelerate the adoption of new methods from computational chemistry to computational finance to computational genomics. This is an exciting new application to the programmable GPU. We look forward to telling you more about GPU computing throughout the coming year. Our GoForce mobile application processor and GPU business: in fiscal year 2007, our mobile business grew revenue to $108 million, an increase of over 85%. The mobile group enjoyed tremendous success in Europe this summer with the successful rollout of the world's largest DVB-H trial. The Samsung P910 device delivered World Cup content to well over half-a-million consumers. Our mobile TV success continues in the APAC region with two exciting new handsets coming from Japan this month: the Kyocera W51K and W52K both support the ISDB-T Japanese mobile TV standard. We completed the PortalPlayer acquisition on January 5th and it marks our entry into the SOC application processor business. Up to now, our mobile strategy has been to focus on establishing ourselves in the mobile market as the leader of multimedia technologies, leveraging our deep expertise in graphics, video and image processing. With PortalPlayer's expertise in building extremely low-power application processors for personal media players, we are now positioned to deliver amazing SOCs that combine our world-class application processors and GPUs. Our objective in the mobile business group is to build a new class of application processors that will power next generation devices like Apple's iPhone, the Blackberry Pearl and other exciting smartphones and PNPs over the horizon, and help drive what I believe will be the next computer revolution: where the mobile device is no longer just a phone, but becomes our most personal computer. We would be happy to take your questions now."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Mark Edelstone with Morgan Stanley."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Hello, Mark?"
},
{
"speaker": "Michael Hara",
"text": "No Mark."
},
{
"speaker": "Mark Edelstone - Morgan Stanley",
"text": "-- over the next six months or so, and then I have a follow-up on the application processor."
},
{
"speaker": "Michael Hara",
"text": "Mark, your question got cut out in the first part. Can you repeat it, please?"
},
{
"speaker": "Mark Edelstone - Morgan Stanley",
"text": "Sorry, I just wanted to see if Jen-Hsun could talk a little bit about the rollout of the rest of the [GeForce 8000] family here over the next several quarters."
},
{
"speaker": "Jen-Hsun Huang",
"text": "You know, the core of our business starts from first building in the basic architecture itself, and it usually starts at the [enthusiast] [inaudible]. The GeForce 8800 has beaten the competition to market by well over six months and counting. It is the core by which we build our notebook GPU family, the rest of our desktop GPU family, our professional graphics solutions, our GPU computing products, as well as our motherboard GPU products, what other people call integrated graphics. It is the core to a lot of other businesses that we are in today. The GeForce 8800 has ramped up very nicely, as you know, Mark, and at the moment, every single one of the businesses I just mentioned are in the process of taking that GeForce 8 core and driving it deep into their business. We are not ready to announce any products today but I can assure you that every single one of those businesses have GeForce 8 throughout their product and are either ramping already or on the verge of ramping production."
},
{
"speaker": "Mark Edelstone - Morgan Stanley",
"text": "So can you just give us a sense as to when you would expect to see the crossover so that the GeForce 8 family overall becomes your highest unit volume product?"
},
{
"speaker": "Marvin D. Burkett",
"text": "Unit volume, Mark?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Unit volume or revenue?"
},
{
"speaker": "Mark Edelstone - Morgan Stanley",
"text": "Well, whichever one you’d like to address would be fine."
},
{
"speaker": "Jen-Hsun Huang",
"text": "I think in terms of units, it is going to take well into the latter part of the year, if not early next year, and the reason for that is because the GeForce 7 is such an incredibly efficient architecture and it is the lowest cost Vista premium solution that we know. My sense is that we are going to continue to see quite a bit of success in GeForce 7 for people who would like to put together the lowest cost Vista premium machine, and so the volumes of the GeForce 7 family are going to continue well through this year and probably well through next year. The unit volume should be pretty high there. In terms of the revenue crossover, I will let Marvin guess at it, but my guess is that it is probably going to be late Q3, Q4 timeframe."
},
{
"speaker": "Mark Edelstone - Morgan Stanley",
"text": "Okay, great, and then just lastly, I saw your 6100 in Barcelona here this week and just wanted to see if you could provide some additional thoughts on how long it takes you to really get the application processor strategy going to where you would like it, and what you see as the potential here for that business over the next several years?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yes, we introduced our first application processor today, or this week, and this application processor, I hope you will agree, is just absolutely amazing. It was really the core reason why we acquired PortalPlayer. They have a really, really talented team that arguably built the world's first computer on a chip. It was the reason why the Apple engineers used it to build the iPod, which is really a computer with an operating system and a file system and connectivity and was dedicated to media processing. Their obsession about low-power design has really enabled them to build some amazing products. They had this application processor in the back room and what you are seeing now, the 6100, is the first of its kind. Our companies are now, our two engineering groups are now completely combined and the roadmap has been integrated. We brought the company on board on January 5th and in a very short period of time, we have realigned our strategies and now we are going to go build application processors that combine their expertise of building SOCs and our expertise of building GPUs. My hope is that this year, we will introduce an amazing product towards the end of the year and next year, I hope that we get a lot of business traction as a result of that. This is by far the single largest new [team] that our company has grown into. It is hard to say exactly how big this [inaudible] is going to be, but you know, application processors, it is probably close to $4 billion to $6 billion in size already. This particular marketplace is quickly transitioning to multimedia and graphics processing because of all the smartphones and portable media players and the combining of these two types of devices that we are seeing out there. My sense is that we are going to be right in the epicenter of a lot of exciting new devices pretty soon. This is a very, very exciting development for our company."
},
{
"speaker": "Mark Edelstone - Morgan Stanley",
"text": "Thanks a lot, guys."
},
{
"speaker": "Operator",
"text": "Your next question comes from Gurinder Kalra with Bear Stearns."
},
{
"speaker": "Gurinder Kalra - Bear Stearns",
"text": "Hi, a couple of questions: firstly, can you update us on your roadmap as far as Intel-based chipsets are concerned? Where do you see volume ramp of that as we look through the year?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "We have not really announced any of our products yet. I think the market has been very vocal about inviting us, if you will, to come and participate in this marketplace and the reason for that is because even in the Intel market, there needs to be a branded motherboard GPU alternative for the consumer segments and the multimedia rich type segments where graphics are really important. Now, with Vista Premium coming out and all the applications that are coming out in 3D, it is really important to make sure that your GPU software and architecture is as prolific as possible, and so we know that the market has a significant demand for our product. We are just racing as fast as we can to get there. I do not have anything to announce to you today but we have a lot of focus inside the company to develop products for that segment."
},
{
"speaker": "Gurinder Kalra - Bear Stearns",
"text": "Thanks. My second question is with AMD talking about Fusion and with there being talk that Intel is looking to do something on the Discrete GPU lines, how do you suppose you are going to counteract that effort? Is there any talk that you might be looking to do something on the microprocessor front?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "You know, we have all kinds of plans for developing products in the future. I do not really see the benefit of telling the market, or the competition particularly, what we are building several years out. I do not know why they are, to tell you the truth, unless they are panicked about something or feel somewhat apologetic about something else. I think we have to keep all of our product roadmaps to ourselves. You know, ultimately the thing that I do know is this: we are really good at building the technologies that you guys know we are great at building and we are focused as a company to differentiate by building products that consumers want to buy. My sense is that if the market wants to buy those products, we are going to know well in advance and we will build the right products for the marketplace. So I do not see any particular reason why -- well, I guess just no comment."
},
{
"speaker": "Gurinder Kalra - Bear Stearns",
"text": "All right. Thanks very much."
},
{
"speaker": "Operator",
"text": "Your next question comes from Satya Chillara with Pacific Growth Equities."
},
{
"speaker": "Satya Chillara - Pacific Growth Equities",
"text": "Hi, good afternoon. Jen-Hsun, can you talk about the cell-phone traction in fiscal '08? It seems in the last analyst day, you were pretty bullish on the cell-phone traction, with 2G as well as the 3G and so on. So where do you see the revenues growing from about a $100 million level to -- what kind of revenue growth do you expect here?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yes, I still remain incredibly bullish about our mobile efforts. In terms of 2.5G, we absolutely achieved our objective of capturing the design wins we wanted to capture. Unfortunately, a lot of our focus was on Motorola and, as you saw in some of the reports already, some of the phones that we were designed into were not as successful as we would like. Net net, we ended up at $108 million for the year and grew 85% year-over-year. I am pretty sure, based on all the design wins that we have now, that this coming year is going to be more than $108 million. The question is how much more. Secondarily, our focus now is we are going to continue to invest in GPUs but our primary focus is going to be in taking the GPU and the application processor components and putting them into an SOC. Our customers are all asking us for that and, based on the type of vision that the phone industry has conveyed to all of us, and some of the exciting new phones that are being talked about, the type of technology is very clear. Graphics processing is going to be important -- 3D graphics processing, so that you could do the type of user interfaces like Vista except doing it on the phone, is very exciting, and video processing and encoding. There are all kinds of new capabilities that the phone manufacturers want to bring to the marketplace next year. So I think we are strategically extremely well-positioned. We just need to go execute and turn those design wins into business."
},
{
"speaker": "Satya Chillara - Pacific Growth Equities",
"text": "Okay, so as a follow-up, in terms of Intel’s low-end strategy, is that a single-chip strategy? Or only with single-chip would you enter the market? What is your thinking and strategy in terms of the Intel low-end strategy?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "We started this trend of building a single-chip motherboard GPU, and it is the core logic -- all the connectivity, all of the graphics, all of the platform technologies, all integrated into one chip. The marketplace really, really likes it and the reason for that is because computers want to be smaller than ever and we want to drive the power down. The fewer chips you have in the system, the lower the cost, the lower the space requirement, the lower the power. From our perspective, fewer chips allow us to improve our margins. Technically, it is extremely complicated in the sense that you have to get mixed signal technology and IO technology and all of your connectivity technology on the same process, which tends to be very [inaudible] for GPUs, you know, all under the same process. Technologically, it is a great challenge, but I think we happen to be one of those companies that really know how to pull it altogether, and so we are going to continue to take advantage of that leadership position."
},
{
"speaker": "Satya Chillara - Pacific Growth Equities",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jason [Fellum] with Thomas Weisel Partners. Jason, your line is open."
},
{
"speaker": "Michael Hara",
"text": "Operator, go ahead and go to the next question."
},
{
"speaker": "Operator",
"text": "Your next question comes from Krishna Shankar with JMP Securities."
},
{
"speaker": "Krishna Shankar - JMP Securities",
"text": "Yes, I was wondering if you can, Jen-Hsun, talk about the attach rate of discrete graphics for Vista and what you are seeing in terms of initial Vista demand and of the demand for the more Premium version of the operating system versus Basic, which will really drive requirements for your 8800 GPU."
},
{
"speaker": "Jen-Hsun Huang",
"text": "I can tell you what logic would compel and what we believe, and in terms of real experiences, it is really hard to tell yet because Vista really just started shipping. But what logic would compel is that Vista is the first operating system that is fully based on the programmability and the shading capability and the graphics rendering processing capability of a GPU, and it exposes this capability to not just the user interface but it exposes this capability to all applications. The compelling logic is that if the GPU is much more taxed and all of the applications use more 3D graphics capability, you would think that the GPU would be more relevant. I think that there is no question as you use Vista, the experience is just far better with the GPU than when it is not. It is snappier and that is just the user interface, right? And so all of the operating system, all of the applications that use 3D graphics have not really even been exposed to this yet. We know that there are many applications that are being developed where 3D graphics are going to make the application richer, many Web 2.0 applications, and we see many from Microsoft already that really exploits the capability of 3D. Even iTunes renders the album covers in 3D now. There are all kinds of applications that are coming that take advantage of 3D graphics, so logic would certainly compel us to believe that GPUs will be more prevalently used. We believe that to be the case and so we are cautious in the first quarter as we go into it, but our belief is that GPUs will become more important than ever before."
},
{
"speaker": "Krishna Shankar - JMP Securities",
"text": "Do you see the trend for notebooks also, where obviously Intel would be, the Centrino platform, they have 70% of that market. Do you see the trend reversing to where you see [an alternative] for discrete notebook solutions, and also MCPs for the notebook market?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Well, the way we see it is that the notebook is really a form factor issue, and so we are going to go to the marketplace. If the form factor allows for a discrete GPU, we would offer the market a discrete GPU. But if the market would like a motherboard GPU, what is commonly called an integrated graphics chip, if motherboard GPU is the way they would like to power Vista, we are delighted by that as well and in fact, if you see our core logic business, the MCP business, it has grown dramatically year over year. A lot of that growth is because of motherboard graphics. I think that there is some evidence that motherboard GPUs are just another way of accessing the capabilities of GPUs and we are going to see some continuous growth there."
},
{
"speaker": "Krishna Shankar - JMP Securities",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Devan Moodley with Scotia Capital."
},
{
"speaker": "Devan Moodley - Scotia Capital",
"text": "Hi, guys, just a follow-up question on Vista. If I look at the Mercury Research forecast currently for desktop discrete, they are looking for a single-digit decline in '07 but surprisingly, they are looking for almost 20% to 30% ASP growth in the desktop segment. Can you give me your perspective on what you are looking for and what would be the impact of Vista on the GF8 family tier?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "I am not sure I picked up on the question."
},
{
"speaker": "Devan Moodley - Scotia Capital",
"text": "Just ASPs, I guess -- Mercury is looking for ASPs to be up significantly this year in desktop discrete. What is your perspective of where your ASPs in that area will go?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "You know, Devan, our ASP has been growing pretty steadily over the years. I think it is logical to me because more and more of our computing experience is around the visual experience, and all of the most exciting applications, or many of the most exciting applications that we know, are really, really graphics rich. The resolution of the display is being driven by Moore's Law and the color depth. On the other dimension, each pixel is moving faster than Moore's Law in the sense that the number of objects we render on each pixel and the color fidelity of each pixel is really going up quite dramatically. It stands to reason that more and more work needs to be done on the GPU, and if that is the case -- and more of your computing experience is depending on a GPU -- if that is the case, then ASPs ought to continue to grow. If somebody told that ASP is going to grow steadily over the next several years, I guess I am not going to be surprised by that because historical evidence would suggest that is the case."
},
{
"speaker": "Devan Moodley - Scotia Capital",
"text": "Okay, and just a quick housekeeping question: what was CapEx for the quarter and the year?"
},
{
"speaker": "Marvin D. Burkett",
"text": "Yes, our CapEx in the quarter was roughly $70 million, $71 million. However, there are a couple of factors in there that you should be aware of. There was roughly $37 million of what I would call the normal CapEx, which is equipment and software that we bought. There is about $14 million worth of IP intangibles from investments that we made, and there is about $20 million of a re-class from our long-term assets into that account, so I would say that the normal CapEx was $37 million."
},
{
"speaker": "Devan Moodley - Scotia Capital",
"text": "And do you expect that to change significantly going into next year?"
},
{
"speaker": "Marvin D. Burkett",
"text": "No."
},
{
"speaker": "Devan Moodley - Scotia Capital",
"text": "Thanks, guys."
},
{
"speaker": "Operator",
"text": "Your next question comes from Arnab Chanda with Lehman Brothers."
},
{
"speaker": "Arnab Chanda - Lehman Brothers",
"text": "Thank you. Just a couple of questions. First of all, if you look at your MCP business, would that grow until your new Intel chipset is launched, or was it going to be sort of seasonal in the first part of the year? And then a follow-up, please."
},
{
"speaker": "Jen-Hsun Huang",
"text": "We are expecting seasonal dynamics in the first quarter. We do have Intel core logic that we announced, as I mentioned earlier, the 680i, and the 680i has other segments that we are introducing. We are going to grow in the Intel core logic business through Q1. I do not know whether it is going to make up for the seasonal decline but we are not counting on it at the moment. Then later, as the year progresses and as we launch our Intel CPU-based motherboard GPUs, we are expecting quite a bit of growth from that."
},
{
"speaker": "Arnab Chanda - Lehman Brothers",
"text": "Thanks, Jen-Hsun, and last question: the computing GPU product that -- maybe I did not quite understand it properly, but is it something that will be sort of additive to your workstation business or is it sort of a new category? What type of additional market opportunity does that get for you guys? Thank you."
},
{
"speaker": "Jen-Hsun Huang",
"text": "The GPU computing initiative is absolutely additive, and I would argue that the industry has had a vacuum, or a super-computing crisis, for sometime. Scientists and researchers have been clamoring for more computing horsepower for quite a bit of time, and yet the technology has not existed that enables them to do some of the computational methods that they want to try. GPU computing is really going to help address that. I frankly think that the combination between the CPU and a GPU with GPU computing capabilities will really create a new class of workstations -- one not necessarily for design but one for computation. It is almost like a personal super-computer that the researchers and the scientists will get to leverage. This is absolutely a new class of computing and it is a new initiative for us, and our early response from the people we have spoken to, and many of them in the financial industry, are just incredibly enthusiastic, so we are very excited about it."
},
{
"speaker": "Arnab Chanda - Lehman Brothers",
"text": "Thanks, Jen-Hsun."
},
{
"speaker": "Operator",
"text": "Your next question comes from Naser Iqbal with Salman Partners."
},
{
"speaker": "Naser Iqbal - Salman Partners",
"text": "Hi, guys. Marv, just really a clarification on the impact of Portal, and if I heard you correctly, that in terms of the R&D and expenses, you had a $5 million hit, a $4 million hit but a net income contribution of about $1 million. Were there any revenues for the quarter?"
},
{
"speaker": "Marvin D. Burkett",
"text": "The revenue in Q4 was roughly $1 million, so there was roughly $5 million worth of expenses and $1 million worth of revenue. When you look into Q1, we are looking at something slightly less than $10 million in revenue and approximately $15 million in expenses."
},
{
"speaker": "Naser Iqbal - Salman Partners",
"text": "Right, which is my follow-up, in terms of when you talked about the outlook for the quarter, that you expected that $10 million to come from Portal; but did I hear you correctly that you think your overall op-ex could be flat quarter on quarter?"
},
{
"speaker": "Marvin D. Burkett",
"text": "Yes, we think that we can, you know, obviously we had the one-time cost in Q4 for the restatement and there are some other one-time costs in Q4. I think we are very cost-conscious right now and the company does a very good job of responding to those circumstances, so I think we have a very good chance of holding op-ex flat, even though we are going to have to absorb the $10 million increase in the PortalPlayer."
},
{
"speaker": "Naser Iqbal - Salman Partners",
"text": "Okay, great. Thanks a lot, guys."
},
{
"speaker": "Operator",
"text": "Your next question comes from Simona Jankowski with Goldman Sachs."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Hi, guys, also a clarification on the guidance. Was the 5% seasonal decline, was that a comment just on the PC-facing segments of your business or was that for your overall revenue expectations?"
},
{
"speaker": "Marvin D. Burkett",
"text": "Simona, I think it was more overall, but I would classify that we expect memory to decline, and that would be probably in my view the single largest component of that 5%. But if you had to pick a point estimate, we are saying overall revenue declined 5%."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Terrific, and then secondly, Marv or Jen-Hsun, can you comment on how you see your channel inventories right now, both for graphics cards and also motherboards?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Channel sell-through is picking up. Q3 and Q4 were a bit choppier than -- and I think all of you guys saw that -- a bit choppier than we all expected. I think some of that had to do with AM2 gap out in the channel, but AM2s are back and there are plenty of Conroes as well, and both of those CPUs are really wonderful CPUs. When they are available in the channel, it really helps our GPU business. We are seeing business sell-through certainly very quite brisk right now."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Okay, that is very helpful. As far as the actual build-up though of motherboards in the channel, is that now done and over with now that the CPUs are available? Or do we still have a bit of back-up that maybe takes a couple more weeks to get through?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "It depends on what segments we are talking about. Our Intel motherboards, for example, are still ramping and we are still doing quite well with our Intel motherboard business. I have not really checked on the AMD side of it, but now that the CPUs are back, and quite a few CPUs were taken out of the channel, as you know, so the return of the CPUs is really, really a good thing for all of us."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Okay, and then just a last quick one for me, if I could: on the gross margin improvement, which was very nice in the first quarter, can you can just comment on the various puts and takes within that? In other words, I know ATI, or AMD now, had commented on a tough [inaudible] environment. It did not seem to have affected you guys, given your positioning, so that is just one aspect I wanted to see if you could comment on. Secondly, on the TSMC pricing, which seems to have been favorable in the quarter, is that a quantifiable benefit to your margins in the quarter?"
},
{
"speaker": "Marvin D. Burkett",
"text": "Let me start. In the GPU business, we improved gross margins quarter to quarter. Some of that improvement came from the fact that the workstation business grew very nicely during the quarter, so we benefited in the GPU business because of that. MCPs, they improved the gross margin and the revenue increase. There is just a continued focus there on improving gross margins. Handheld improved gross margins, even though revenue was relatively flat. Memory went up during the quarter, which would have had a drag on gross margins. I would say that each of the business units contributed to gross margin improvement. The increase in memory was a slight drag on it. The TSMC issue, I do not know if you want to comment, Jen-Hsun."
},
{
"speaker": "Jen-Hsun Huang",
"text": "It is nothing special."
},
{
"speaker": "Marvin D. Burkett",
"text": "Yes, I do not think there was anything out of the ordinary."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Great, thank you very much."
},
{
"speaker": "Operator",
"text": "Your next question comes from David Wu with Global Crown Capital."
},
{
"speaker": "David Wu - Global Crown Capital",
"text": "Yes, Marv, on the subject of gross margin, can you talk about or remind us of what your gross margin target, the new level is, since 44% is no longer an issue anymore and 45% looks like within reach? And I have a question for Jen-Hsun on the PortalPlayer application processor. What is the difference between their application processor and a whole ream of these ARM-based application processors out there? Can you also comment on the likelihood you are going to see some competition from the X-86 in the form of these, what they call the ultra mobile PCs?"
},
{
"speaker": "Marvin D. Burkett",
"text": "I will start with the gross margin, David. Jen-Hsun established the target of a 45% gross margin just about a year ago and I think there were a lot of skeptics out there -- maybe even me, who knows -- but we have made a lot of progress and things have gone well. I think that we are going to have to sit down and establish a new goal because yes, I agree: 45% is achievable. Now the question is, we cannot let up. We can improve gross margins from the [inaudible]."
},
{
"speaker": "David Wu - Global Crown Capital",
"text": "But at this point, you will not, you cannot elaborate what that might be?"
},
{
"speaker": "Marvin D. Burkett",
"text": "Well, our public target is still 45%."
},
{
"speaker": "David Wu - Global Crown Capital",
"text": "Okay. Jen-Hsun, can you talk about the application processor for that PortalPlayer and what is different from all these other ARM-based application processors out there?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Sure. First of all, PortalPlayer's focus has always been in the personal media player market, and in that marketplace, the digital media processing is really important. Extreme low-power is extremely important. If you get a chance to see the new 6100, and see it do decoding [VJ] resolution video and watch it do it at just barely, barely a sweat, it is really, really amazing. So their focus is building a complete computer on a chip that is capable of doing multimedia processing at extremely low-power levels. That is really where their focus was. Relative to us, the reason why PortalPlayer is so valuable to us is because we do not have an application processor, but we do have a very deep investment in GPU technologies over the years and the combination of our graphics and video and image processing capabilities in combination with their application processor really gives us a unique position in the marketplace. I would say their positioning in the mobile marketplace was good but challenging because of the amount of R&D they could really invest, and our positioning was good in the high-end markets, where the flagship phones really needed the multimedia capabilities we brought. In combination, now we can build some SOCs that are absolutely amazing, and that is the reason our two management teams decided to combine the companies."
},
{
"speaker": "David Wu - Global Crown Capital",
"text": "Who do you see as competitors in that space, besides Texas Instruments?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "I would say TI is a competitor. Obviously Samsung is a competitor. Samsung has been very successful there. The XScale business that Intel sold to Marvell -- these are all competitors in the marketplace. But this is also one of the largest markets that we know of in the semiconductor industry and there are a whole lot of segments. Some of those segments just want your basic, best microprocessor. Some of those segments want the lowest, lowest cost SOC for your basic smartphone, and some of them need rich graphics and rich multimedia for consumer applications where you want to have your phone also be your e-mail device and music player and video player and such. That is where I think NVIDIA would really shine."
},
{
"speaker": "David Wu - Global Crown Capital",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Doug Freedman with AmTech Research."
},
{
"speaker": "Doug Freedman - American Technology Research",
"text": "Good afternoon, guys. A quick question for you, Jen-Hsun, if you could talk about -- you have taken quite a bit of share in several of the markets now from your closest competitor that was acquired by AMD. Can you talk about what you think might be their response, and if there is anything that you can do to offset it or continue the track record that you have put up?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Well, first of all, that is a really good question and I hope I do not answer it -- not publicly, anyhow, so please do not encourage me. You know what I would say is that our market share is in fact, although improving year over year, I think we came out of the year last year at about 18%, 19% overall graphics market share. We are at 29%. As far as I am concerned, whether it is a discrete GPU or a motherboard GPU, they are both GPUs. We believe that there are segments of the marketplace that really prefer to have a better GPU than not. Our GPU brand, the GeForce brand, is just so strong that I think we still have a lot of opportunities. Now we are the only GPU company in the world that is completely focused, number one, but also participates in building and selling GPUs into both microprocessor markets, both the AMD market as well as the Intel market. We are the distinguishing brand of both platforms. I am excited about that. Our job is to grow our overall GPU business from 29% to something much higher than that."
},
{
"speaker": "Doug Freedman - American Technology Research",
"text": "All right. If I could, Marv, turn to you for a quick second, and I guess Jen-Hsun also plays a role in this: what is your view on the share buy-back? What should we be thinking about on the stock dilution level? Clearly this quarter the share count came in very close to unchanged. Any guidance you can offer on what we should think about going forward?"
},
{
"speaker": "Marvin D. Burkett",
"text": "Yes, we evaluate it every quarter. We still have authorization from the Board to do stock buy-backs. I probably do not see any reason to deviate from our practices in the current environment, but we evaluate it every quarter. Totally separate from that, the annual dilution level on what I call a gross basis, meaning how many shares we issue, is established by the comp committee, and so we have been bringing that down for several years now. It was roughly 3% last year -- that is excluding stock buy-backs -- and I think it will be less than that in fiscal year '08, but that is exclusive of any buy-backs."
},
{
"speaker": "Doug Freedman - American Technology Research",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Shawn Webster with JP Morgan."
},
{
"speaker": "Shawn Webster - JP Morgan",
"text": "Good afternoon. Thanks for squeezing me in, guys. On the chipset business, can you give us a quick update on what the mix is in terms of units and/or revenues on Intel versus AMD chipsets?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "I would say that today it is vastly, it is mostly, by far AMD, and we had just entered the Intel chipset marketplace with the 680i I guess late Q3. We did well in Q3, we ramped more in Q4 and we are expecting to ramp even more in Q1 and ramp it into Q2. As Conroe continues to grow into the marketplace, we expect our 680i family to follow that. I also think that is our core Intel chipset product right now and hopefully in the near future, we will try to add something to that with our motherboard GPUs for the Intel processor."
},
{
"speaker": "Shawn Webster - JP Morgan",
"text": "I see. And then, for your overall GPU business in Q4, can you tell us what your units and ASPs did sequentially?"
},
{
"speaker": "Marvin D. Burkett",
"text": "Overall, units were very, very, very slightly up and ASP was very slightly down. I indicated that in my comments, that the desktop ASP declined slightly in the quarter."
},
{
"speaker": "Shawn Webster - JP Morgan",
"text": "Okay, and then Marv, can you give us some guidance on your effective tax rate for the full year fiscal '08?"
},
{
"speaker": "Marvin D. Burkett",
"text": "Our best guess right now is 14% for both GAAP and non-GAAP, but we will evaluate that as we go through the year. We get the benefit of the R&D tax credit, which we got a full year's worth in the fourth quarter, and that is one of the drivers in being able to reduce the tax rate down to 14% for this year."
},
{
"speaker": "Shawn Webster - JP Morgan",
"text": "That makes sense. Thanks a lot."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, we have reached the end of the allotted time for questions and answers this afternoon. I would now like to turn the call back over to Jen-Hsun Huang for closing remarks."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thank you. Our goal is to be one of the most influential and respected technology companies in the world by being the premier supplier of visual computing technologies and solutions. We believe the programmable GPU is becoming one of the most important technologies of the digital era, as it powers multimedia rich applications on a growing number of consumer devices. As the only GPU company in the world, we have dedicated ourselves to making this vision a reality. Fiscal 2007 was a milestone year for NVIDIA. Because of the number of growth and technology initiatives that we have set in motion last year, we believe we are well-positioned to have another strong year. Thank you for joining us today. We look forward to reporting on our progress for Q1."
},
{
"speaker": "Operator",
"text": "This concludes today's conference call. You may now disconnect."
},
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NVDA | 4 | 2,008 | 2008-02-13 17:00:00 | Executives: Michael Hara - Investor Relations Jen-Hsun Huang - President, Chief Executive Officer and Director Marvin D. Burkett - Chief Financial Officer
Analysts: Tim Luke - Lehman Brothers Krishna Shankar - JMP Securities Gurinder Kalra - Bear Stearns Brian Piccioni - BMO Capital Markets David Wu - Global Crown Capital Doug Freedman - American Technology Research Hans Mosesmann - Raymond James Heidi Poon - Thomas Weisel Partners Shawn Webster - J.P. Morgan Securities Michael McConnell - Pacific Crest Securities Tayyib Shah - Longbow Research Glen Yeung - Citigroup
Michael Hara: …fourth fiscal quarter ended January 27, 2008. On the call today for NVIDIA are Jen-Hsun Huang, NVIDIA's President and Chief Executive Officer; and Marv Burkett, NVIDIA's Chief Financial Officer. Before we begin today’s call, I would like to take care of some general administrative items. Your lines have been placed on a listen-only mode until the question-and-answer segment of today’s call. During this call, we will discuss some non-GAAP financial measures about net income, diluted net income per share, and gross margin when talking about our results. You can find a reconciliation of these non-GAAP financial measures to GAAP financial measures in our financial release, which is posted on the investor relations page of our website at www.nvidia.com. Unless otherwise noted, all references to research market and market share numbers throughout the call come from Mercury Research or John Petty Research. This call is being recorded. If you have any objections, you may disconnect at this time. Please be aware that if you decide to ask a question, it will be included in both our live transmission as well as any future use of the recording. Also, shareholders can listen to a live webcast of today’s call via the investor relations page of our website. The webcast will be available for replay until the company’s conference call to discuss its financial results for its first fiscal quarter 2009. During the course of this conference call, we may make forward-looking statements based on current expectations. Forward-looking statements, including statements as to the importance of and uses for the GPU, our outlook, the impact, performance and availability of and demand for our products and technologies, our growth and strategies, and the future of -- pertaining to future events and are subject to a number of significant risks and uncertainties. The company’s actual results may differ materially from results discussed in any forward-looking statements. For a complete discussion of factors that could affect the company’s future financial results and business, please refer to the company’s Form 10-Q for the period ended October 28, 2007, and the reports on Form 8-K filed with the Securities and Exchange Commission. All forward-looking statements are made as of the date hereof based on information available to us today and, except as required by law, the company assumes no obligation to update any such statements. The content of the webcast contains time-sensitive information that is accurate only as of February 13, 2008. Consistent with the requirements under Regulation FD, we will be providing public guidance directly in the conference call and will be unable to provide significantly more information in offline conversations or during the quarter. Therefore, questions around our financial expectations should be asked during this call. At the end of our remarks, there will be time for your questions. In order to allow more people to ask questions, please limit yourself to one question. After our response, we will allow one follow-up question. I will now hand the call over to Jen-Hsun.
Jen-Hsun Huang: Thanks, Mike. Good afternoon and thank you for joining us. We are pleased to report another record quarter and fiscal 2008 was another record year. We had many achievements this past year. Q4 revenue grew 37% year over year to a record $1.2 billion. Annual revenue increased 34% year over year to a record $4.1 billion. Annual net income increased 78% year over year to a record $797.6 million. Annual gross margin reached a new high of 45.6%, an increase of 320 basis points from a year ago. We launched a record number of industry-defining products and initiatives this year -- GeForce 8800 family, including the highly acclaimed 8800GT. We’ve sold over 2 million 8800GTs in just four months of production and demand continues to exceed our forecast. GeForce 7000 -- the first motherboard GeForce for Intel systems. Together with the CPU, the GeForce 7000 enables the first two-chip Intel processor PC. CUDA -- the industry’s first parallel programming environment that puts the massively parallel processing capability of a GPU in the hands of all programmers. CUDA is available on every one of the 50 million GeForce 8000 series GPUs that we’ve shipped. We expect to ship several hundred million CUDA GPUs over the next several years. CUDA has quickly become of the most pervasive and accessible parallel programming environments ever. There is increasing recognition that the traditional CPU alone architecture, or homogenous architecture, is not optimal for every application. With CUDA, we have launched a new computing movement towards heterogeneous computing, where a traditional CPU is combined with a massively parallel processing GPU to achieve a giant step up in performance. Visual computing is one of the most well-known parallel computing applications. There are many others. Applications such as physics processing, computer vision, video image processing, are just a few examples that are dramatically enhanced by CUDA and heterogeneous computing. Engineers and researchers in software companies, computer companies, and in universities around the world are recognizing the importance of heterogeneous computing. This is a major movement in computing. Tesla -- our new family of server workstation class GPUs with supporting system and software technologies for high performance computing. The first Tesla 1-U rack contains four GPUs, each with 128 processors, delivering a whopping 1.1 teraflops of sustained super computing performance in a real world application. Hybrid SLI -- like a hybrid car, Hybrid SLI allows a small GPU and a large GPU to work together. The small GPU runs light visual computing workloads while conserving power. When heavy workload is required, both GPUs combine their capabilities to deliver the most delightful experience. With Hybrid SLI, we can deliver the ultimate visual computing experience while enabling an environmentally friendly power efficient design. And lastly, PureVideo HD -- the first video decode and post-processing technology for Blu-Ray and High-definition DVD. Year over year, annual revenue of each core product line turned in strong results. Desktop GPU revenue grew 38%. Notebook GPU revenue grew 114%. Workstation grew 27%, MCP revenue grew 7%. NVIDIA held the number one segment share in desktop GPU, notebook GPU, all of DX9 and DX10 GPUs and workstation solutions. NVIDIA was named the most respected public company by the members of the Fabless Semiconductor Association for the second consecutive year. NVIDIA was named Company of the Year by Forbes Magazine. We acquired Mental Images, the industry's leading photorealistic rendering technology provider. Mental Image's Mental Ray is the most pervasive ray tracer in the industry. And lastly, just this week we announced the completion of the acquisition of AGEIA, the industry leader in gaming physics technology. We are pleased with our achievement this year. Particularly, we are very pleased with our strategic position heading into fiscal 2009. Let me turn the call over to Mark to discuss our financial results. I will return in a moment to address our growth opportunities for the coming year.
Marvin D. Burkett: Thanks, Jen-Hsun. Today we’ll be looking at both GAAP and non-GAAP results for the fourth quarter of fiscal year ’08 and for the full year of fiscal year ’08. The difference between GAAP and non-GAAP is primarily stock-based compensation and its tax effect. In Q4, there is also an in-process R&D write-off from the Mental Images acquisition. As Jen-Hsun stated, revenue for the fourth quarter was $1.2 billion, which is an 8% increase quarter to quarter. The growth quarter to quarter came from desktop GPUs, which grew 19% and workstation, which grew 9%. Notebook and MCP were up slightly at 1% and 2%. The strength in desktop came from new products such as the GeForce 8800 family. Comparing Q4 fiscal year ’08 with Q4 fiscal year ’07, revenue was up 37%, led by notebook and desktop. Notebook was up 124% year to year and desktop was up 69%. Workstation grew by 31%. The consumer business declined 22% for the year. The strength that we saw in desktop GPUs for Q2 and Q3 has continued through Q4 and shows signs of continuing in Q1, demonstrating the growing importance of the GPU in the PC system. For the year, we had revenue of $4.1 billion, which is up 34%. Gross margin for the quarter was 45.7% GAAP and 45.9% non-GAAP. This was the first time in 13 quarters that we haven’t had a non-GAAP gross margin increase quarter to quarter. During the quarter, we experienced some cost issues with regard to the 8800GT, which we hope to resolve in the next two quarters. For the year, GAAP gross margin was 45.6%, which is up 320 basis points. Operating expenses for the quarter were $287 million GAAP and $251 million non-GAAP. The GAAP number includes a $4 million write-off of in-process R&D associated with the Mental Images acquisition. It also includes approximately $32 million of stock-based compensation. The non-GAAP operating expenses were up $13 million quarter to quarter, or 5.5%. And this includes an additional $3 million of operating expenses associated with Mental Images. The revenue for Mental Images in the quarter was less than $1 million. We continued to aggressively hire during the quarter and ended the year with a headcount of 4,985, which is up 376 from the prior quarter and up 902 over the prior year. Approximately two-thirds of the headcount additions for the quarter and the year were in the R&D sector. So for the year, revenue was up 34%, non-GAAP operating expenses were up 25%, and headcount was up 22%. The tax rate for the year was 11.5%, which is slightly lower than we anticipated as the mix of international sales was slightly higher than we had forecast. This resulted in a GAAP tax rate for the quarter of 8.2%. For the quarter, the GAAP earnings per share were $0.42 and the non-GAAP were $0.49. For the year, GAAP earnings were $1.31 and the non-GAAP was $1.56. On the balance sheet, cash and marketable securities was $1.8 billion, down $43 million from Q3 and up $692 million year to year. In the quarter, we repurchased $178 million of stock, purchased Mental Images for cash, and also purchased some EDA equipment and services. The operating cash flow in the quarter was a little over $250 million. Accounts receivable grew by $114 million, reflecting both the shipment profile in the quarter and the increase in revenue. The accounts receivable is very current and there are no issues with regard to payment. DSO in the quarter was 50 days. We built $52 million in inventory during the quarter, all of which was in new products. Inventory continued to be lean at 50 days, up only slightly from Q3. Depreciation was $37 million in the quarter and capital expenditures were $70 million. For the year, capital expenditures was $188 million. On the outlook, we expect revenue in Q1 to be better than seasonal. We expect continued strength in desktop GPUs, seasonal weakness in some others, and the result is we believe revenue will be slightly down. For gross margins, we’ll certainly try to get back on track of increasing gross margins and would expect margins to be flat to slightly up. We expect operating expenses to increase quarter to quarter because of the normal Q1 issues of less vacation in Q1 than Q4, higher FICA expense in Q1 and Q4. In addition, we expect to have approximately $7 million of incremental expenses in Q1 that will come from acquisitions we’ve recently made. The result is that we expect operating expenses to increase 8% to 10%. Since the R&D tax credit has not yet been renewed, we expect there will be an increase in the tax rate until that happens. If the R&D tax credit is renewed, we would expect a tax rate of 13% to 14% for the year. Until that happens, our expected tax rate will be approximately 17%. With that, I will turn it back over to Jen-Hsun.
Jen-Hsun Huang: Thanks, Mark. We are entering the era of digital computing. Applications with rich graphics are growing with astounding numbers. Videogames is now a $43 billion industry and larger than movie box office receipts and music. World of Warcraft, commonly known as WoW, is a massively multi-player 3D online roleplaying game with over 10 million active users. According to Comscore, a leader in measuring the digital world, 217 million videogame players immerse themselves in online 3D worlds and that number is expected to grow 17% annually. Google Earth combines the power of search with rich imagery and 3D terrain and is transforming the way we navigate. There have been over 350 million unique downloads of Google Earth to date. Modern operating systems, Windows Vista and Apple OS 10 Leopard, deliver amazing 3D user interfaces. Combined, the two operating systems have shipped over 100 million copies to date. Our growth reflects the increasing importance of the GPU in these applications. We shipped a record 80 million discrete GPUs last year. Including motherboard GeForces, we shipped a total of 111 million GPUs. Our annual discrete GPU revenue grew 50% year over year. Our Q4 discrete GPU revenue grew 80% from a year ago. Consumer demand for the richest visual computing experience is driving a movement to rebalance the architecture of the PC. The CPU has become good enough for the vast majority of users. Meanwhile, a higher performance GPU will directly result in a dramatically more beautiful and fluid user experience. PC enthusiasts, gamers, and design professionals have known this for some time. They have long been the strongest proponents and consumers of the GPU. Let me give you some recent examples from Gateway. The Gateway P series FX, a very thin gaming HD video notebook, priced at $1249 and features a GeForce 8800 GPU and a lower-end 1.6-gigahertz CPU. Relative to a notebook with a higher end CPU and lower end GPU, the Gateway FX is twice the performance and yet $200 lower cost. Here is a recent quote from a CNET review of the Gateway FX 7020 desktop PC: “Gateway’s FX 7020 represents the type of PC we expect to see a lot of in 2008. The $1,000 to $1,500 gamer that finally has the graphics horsepower to handle the newest 3D PC games. Its AMD Phenom quad-core CPU isn’t the fastest CPU around, although it is quick enough. But the real horsepower lies in its GeForce 8800 GT graphics card. Until now, few PCs in this price range have been able to handle the likes of Crysis, Unreal Tournament 3, and other new PC games with any kind of decent image quality. This PC and the forthcoming systems like it should finally deliver the promise of next-gen PC gaming to a wider audience.” OEMs and consumers around the world are learning the same thing -- the CPU is good enough. Investing more on the GPU will deliver a several-fold jump in application performance and experience. We call this trend the optimized PC design approach. The balance of CPU and GPU processing should reflect a category of PCs, whether it is gaming PC, lifestyle PC, workstation PC, all-in-one PC or enterprise desktop PC. We are excited about the coming years. The era of visual computing and the movement towards optimized PC design approach will make the GPU evermore central to our computing experience. At the core of that experience is the GPU. This is the decade of the GPU. We’d be happy to take your questions now.
Operator: (Operator Instructions) Tim Luke, Lehman Brothers.
Tim Luke - Lehman Brothers: Thank you so much. Marv, I was wondering, as you guide for the first quarter to be slightly stronger than seasonal, if you could frame for us how you have perceived seasonal in terms of recent percentages, either down or -- and maybe within that, you talked a little about the strength that you’ve seen in desktop, how we would perceive some of the different segments to look through the first quarter.
Marvin D. Burkett: Okay. Seasonal to me is for our business is usually down nominally 5%. I think that the PC in general is down 5% to 10% but for us, it’s historically been around nominally 5%. So when I say down, I say it will be down less than that. And with regard to the strength in the desktop GPUs, the strength in Q4 and Q3 has been very, very good in the performance segment, the 8800 GT. As Jen-Hsun said, is selling very, very well and so we would expect continued strength there. So I would say anything in the performance and up segment, the desktop GPUs is doing very well.
Tim Luke - Lehman Brothers: In some of your recent updates, Marv, you had suggested that while you had seen the strength in the performance end of the desktop area, you’d seen a little bit of volatility in the notebook arena and I was wondering if you had any recent updates as to how you’ve seen that. And then separately in recent updates you had said that you had been targeting growth for the calendar year coming of at least in the 20% range, I believe. And I was wondering if you could give some flavor on how you see the different building blocks of that rate of growth going forward.
Marvin D. Burkett: Well, notebook in Q4 was up 1% quarter to quarter, so it certainly didn’t decline. I think that’s pretty good performance. I would expect it to come off seasonally in the first quarter. With regard to ’08 in total, I don’t think I have any change to what we previously talked about.
Tim Luke - Lehman Brothers: And with respect to the segments within that, do you have any feel for how we should think about modeling the different areas?
Marvin D. Burkett: Growth in desktop GPUs, growth in MCP, growth in workstation.
Tim Luke - Lehman Brothers: Thank you so much. I’ll pass it on.
Operator: Krishna Shankar, JMP Securities.
Krishna Shankar - JMP Securities: Yes, as you look at your April quarter, you indicated strength in the desktop GPU market. Do you see sort of broad-based strength there across all segments of the desktop graphics market or is it more in the high-end enthusiastic performance class market?
Jen-Hsun Huang: No, we’re seeing growth in the GPU business. I mean, it’s year over year, our GPU business grew 80% and you can’t grow that in just one particular segment. We’re seeing growth across all of the segments. We’re seeing increasing adoption of GPUs. We’ll seeing simultaneously a bias towards slightly higher end GPU and all of that is consistent with our belief and what I’m sure you believe and most consumers experience today, that more and more of the applications they enjoy are graphically rich. And so I think that people understand increasingly that rebalancing the system so that more GPU horsepower could be dedicated to the experience will result in a much higher performance and so PC OEMs, consumers, gamers, have already known this. Workstation professionals have always known this. Design professionals have known this and one PC OEM after another are building computers where the CPU is just good enough and a lot more resources are dedicated towards the GPU and the products are selling incredibly well, because frankly they benchmark well, they use well, and it’s just a much more delightful experience overall.
Krishna Shankar - JMP Securities: And just to follow-up, in terms of the competitive landscape, do you see -- how do you describe the competitive landscape in MCPs, especially in the notebook market? And also the dual-chip X2 configuration that AMD has come out with recently -- can you talk about the NVIDIA products that would be coming out to compete with that?
Jen-Hsun Huang: Okay. So let’s see -- you asked -- I think there were four questions all together. Okay, so competition in MCP space -- the way we see it is this; we have the only GeForce motherboard solution for both Intel and AMD platforms. We are bringing Hybrid SLI to those platforms and for anybody who enjoys a -- who don’t want to sacrifice a rich graphics experience and all the compatibility with all of the applications around the world, even though they purchased an entry level PC, a GeForce on a motherboard is really the best way to go. And so we continue to see success there. My expectation, our expectation this year is that we are going to grow the MCP business pretty substantially. A lot of that has to do with the fact that this is the first year where we have GeForce motherboard GPUs for the Intel systems, and so we are expecting that to be -- to do quite well. With respect to the notebook area, my sense is that wherever we don’t differentiate substantially, we won’t win the business. And if the customers don’t care about graphics performance, if it’s an enterprise notebook or the competition has a GPU solution just as good as ours, you know, certainly we won’t expect to win the business. But other than that, I think we are going to do quite well. Overall, I think we are going to have a great year for MCP. With respect to X2, you know, you would only put two GPUs -- well, let me come at it another way. If you want to put two GPUs in an add-in card and you deliver the absolute highest performance in the world, the enthusiast that uses that particular PC will certainly tolerate the fact that it’s a much larger solution. But if it’s not the highest performance solution in the world, as in the case of the X2, then it’s just really problematic. You know, there’s no market really for a product that’s larger, louder, and not as high performance. And so I think that GeForce 8800 GTX is still absolutely the best DX10 and highest graphics performance GPU in the world and works great in SLI and we’re going to shortly announce, or shortly ship, three-way SLI. And so multiple GPUs on an add-in card is only tolerated if it is unambiguously the highest performance. Anything short of that is just too clumsy to be successful.
Krishna Shankar - JMP Securities: Thank you.
Operator: Gurinder Kalra, Bear Stearns.
Gurinder Kalra - Bear Stearns: Thanks for taking my question. My first question is on the cost issues you experienced with the desktop GPUs in the current quarter. Can you discuss them in more detail and how you expect them to get resolved?
Jen-Hsun Huang: You know, 8800 GT was ramped probably faster than any high-end GPU in our history. As I mentioned in my comments earlier, in just four months of production we shipped over 2 million 8800 GTs, and this is a high-end GPU. The die size and the number of transistors of the 8800 GT is far more than any microprocessor you currently have -- core-two dual and otherwise. And so this is a very complex processor and yet we ramped it incredibly hard. We had some manufacturing challenges in the beginning and we caught it, we fixed it, and now we are going to see far better yields going forward. But it affected our cost in Q4.
Marvin D. Burkett: From my standpoint, our focus was delivering the product to the customer. Demand outstrips supply, so rather than focus on bringing the costs down, we focused on getting the product out.
Gurinder Kalra - Bear Stearns: Okay, great. And then secondly on the AGEIA acquisition -- hope I’m saying that name correctly -- now, where do you think it enhances revenue opportunities and does it mean that you are open to more end markets?
Jen-Hsun Huang: Well, you know, physics processing and bringing dynamics to games is an area of a lot of excitement and many games already have physics in it but rudimentary physics, and people want to put a lot more physics, a lot more dynamics into games. It just brings the whole game to life. Now it looks beautiful and it behaves realistically, whether it’s water or cloth or emotion or -- you know, particle systems or whatever it happens to be. Physics processing and the AGEIA engine happens to be extremely computationally intensive. It requires just a lot of processors to deliver the type of real time performance that the games need. Our strategy is to take the AGEIA physics engine, which has been integrated into tools and games all over the world, and we’re going to port the AGEIA physics engine onto CUDA. You know, you heard in my comments that CUDA has now shipped into 50 million processors, GeForce 8 series processors and over the next several years, we’ll ship a few hundred million more. The ability to port the physics engine on top of CUDA and accelerate the physics is going to add a ton more value to gamers around the world. Our expectation is that this is going to encourage people to buy even better GPUs. It might and probably will encourage people to buy a second GPU for the SLI slot and for the highest end gamers, it will encourage them to buy three GPUs, potentially two for graphics and one for physics or one for graphics and two for physics, or any combination of -- you know, any dynamic combination thereof. So I’m very enthusiastic about the work that we’re doing here and the game developers are really excited about it. You know, finally they are able to get a physics engine accelerated into a very large population of gamers. And so I think this is a -- this combination between us and AGEIA really kick-started the physics industry.
Gurinder Kalra - Bear Stearns: Okay, great. Thank you very much.
Operator: Brian Piccioni, BMO Capital Markets.
Brian Piccioni - BMO Capital Markets: Hello there. Just following on with the question with respect to the AGEIA acquisition, would you have a timeline where we would expect to start seeing the impact in the actual product offering?
Jen-Hsun Huang: We’re working towards the physics engine to CUDA port as we speak and we intend to -- we’re going to throw a lot of resources at it. I wouldn’t be surprised if it helps our GPU sales even advance of that, and the reason for that is in the end, it’s just going to be a software download. Every single GPU that is CUDA enabled will be able to run the physics engine when it comes.
Brian Piccioni - BMO Capital Markets: So we are primarily talking a software rather than physical changes to the internal organizations of the GPU then?
Jen-Hsun Huang: That’s right, because what makes it possible is CUDA. You know, every one of our GeForce 8 DX10 GPUs run CUDA. CUDA is a parallel programming model that is programmable through C. And so we are going to port physics, the name of their engine is physics, we’re going to port physics, the physics engine onto CUDA and access all of the parallel processing capabilities. And in the case of the 8800, 128 processors in our chip so instead of running it on only two cores, now we can run it on 128 cores. And so our expectation is that the parallel processing capability would really dramatically enhance the performance.
Brian Piccioni - BMO Capital Markets: I see. And I guess you wouldn’t agree with your competitors’ comment that physics is dead then?
Jen-Hsun Huang: Why would physics be dead?
Brian Piccioni - BMO Capital Markets: Thank you.
Operator: David Wu, Global Crown Capital.
David Wu - Global Crown Capital: Yes, good afternoon. Thanks for taking my call, or question, rather. Marv, can you sort of split us the various business segments in Q4 of your -- you know, the typical breakout in your 10-Qs? And the other thing I wondered is the -- can you talk a little bit about the economics of AGEIA? It sounded like the first quarter will be dilutive but when could it be accretive? And lastly, on the situation on the 8800, to improve your cost, does it mean that you can still run on 90-nanometer process, just tune it a bit or do something to get your costs down? Or do you need to -- are we talking about a potential die shrink down to 65-nanometer or 55-nanometer to get the required traditional margins that you get on these high-end discrete chips?
Marvin D. Burkett: Wow. All right, David, let me start through the business segment breakout that we would show in the Qs. The GPU business, which includes desktop, notebook, and memory, was up 11% quarter to quarter. The PSB area, which is workstation and some other products, was up 10% quarter to quarter. MCP, which is our platform products group, was up 2% quarter to quarter. And then that leaves you with the consumer business, which was down roughly 18% quarter to quarter. So that’s the segment breakout that I think that you were looking for?
David Wu - Global Crown Capital: Yeah, yeah.
Marvin D. Burkett: All right. Now, with regard to the 8800 on the cost bank, it doesn’t require us to do anything differently in terms of process technology or a redesign of the chip. It’s just a focus on getting -- you know, improving the yields and doing the product engineering, which we haven’t been able to focus on because of demand outstripping supply. So -- it’s just hard work and we’ll do it. It does not require a process change or anything else. With regard to AGEIA, obviously it will be dilutive because of the lack of revenue in the first quarter and probably until -- being able to classify it as accretive is going to be associated with how many more GPUs we sell because of that. So I’m not worried about it from that standpoint. Mental Images obviously in Q4 was dilutive and probably will be dilutive in Q1. We’ll see about that.
David Wu - Global Crown Capital: Okay. So AGEIA, it’s not such a big -- not that you need to have a lot of revenue to cover it and some incremental hardware you sell?
Marvin D. Burkett: No.
David Wu - Global Crown Capital: Okay, great. Thank you very much.
Operator: Doug Freedman, American Technology Research.
Doug Freedman - American Technology Research: Hi, guys. Thanks for taking my questions. You spent a lot of time talking about the GPU computing opportunity. Can you spend a little time talking about how a general purpose computing engine might be required to grow that market and what your view is for your needs going forward of a general purpose computing engine?
Jen-Hsun Huang: Let me make sure I understand your question, Doug -- your question is -- when you say general purpose computing engine, do you mean the general purpose application for GPU computing?
Doug Freedman - American Technology Research: I’m referring to a -- whether it’s a MIPS processor, a general purpose computing processor as opposed to a strictly parallel machine.
Jen-Hsun Huang: No, GPU computing already has a processor. We believe in heterogeneous computing and basically the CPU that’s already in your system, it’s good enough. It’s fabulous. Billions and billions of dollars of R&D has gone into making that CPU as good as it can be and for single-threaded applications, you know, I think it’s a -- the performance of the CPU is a miracle of mankind. I mean, it’s fabulous. But they’ll never scale very well from here on out and for the type of parallel applications that we believe are really interesting to solve, and so the problem space that we focus on are all of the type of applications that require a lot of parallel processing capability. So we believe that the world needs a heterogeneous computing model where the single-threaded, flexible CPU is combined with or collaborates with a massively parallel processor, in this particular case we call a GPU. And when we introduced CUDA, which allows the GPU to be programmed with C and compiled to with a C compiler, we really, really opened up that computing paradigm and it’s just because C developers don’t really want to program their problems in OpenGL and Direct 3D and C is a much more natural approach for them. And so heterogeneous computing includes the CPU and the GPU and in terms of answering maybe a related question about what is the consumer mainstream application for GPU computing, physics is a really good example of the first one. Physics processing is already in so many games, as you know, and it’s going to be in almost every single game in the future. And all of a sudden, with physics on CUDA, we’re able to bring accelerated physics processing to every PC in the world. And so I think CUDA and GPU computing, or heterogeneous computing, however you want to think through it, is -- this year will officially be a consumer-oriented mainstream processing model.
Doug Freedman - American Technology Research: All right. Could you help us understand a little bit of what expectations you guys have for the DX10 chipset marketplace? How soon and how quickly you think the chipset market is going to move to a DX10-based solution -- what percentage by the end of the year, if that’s possible?
Jen-Hsun Huang: I believe in order to get Vista certification by the second half of the year, you require DX10. And so it becomes a requirement for Vista starting the second half of the year. So I think the answer is we ought to get there as fast as possible and we are trying to get there as fast as possible.
Doug Freedman - American Technology Research: All right, great. Thanks, guys.
Operator: Hans Mosesmann, Raymond James.
Hans Mosesmann - Raymond James: Thanks. A couple of questions; Jen-Hsun, in terms of the X2 type or class of products that are out there, will NVIDIA introduce a product like that and will that establish or become over time the standard at the very, very high-end of the market? And I have a follow-up for Marv.
Jen-Hsun Huang: We would do an X2 like product only if it delivers performance that is simply not possible anywhere with a single GPU. But there’s no question that a single GPU is a better approach. It’s better use of bandwidth, it’s -- the processors collaborate much, much better and the overall performance is just unbeatable. And so if we can’t deliver that performance with a single GPU, we’ll do it with double GPUs and -- but either way, it has to be the absolutely highest performance. So you know my preference and you know we have -- we have a lot of evidence and certainly know for sure that a single GPU is the best approach and -- but if a double GPU can deliver the highest performance on the planet, it would be accepted. If it’s not, then you’re going to have problems.
Hans Mosesmann - Raymond James: And so, just to kind of go further there, what you are saying is that in the near-term, it’s unlikely that you are going to see something like that from NVIDIA, that you’ll stick with the single solutions in the near-term?
Jen-Hsun Huang: Hans, I don’t talk about -- we can’t talk about future products.
Hans Mosesmann - Raymond James: All right. Well, I understand your preference and --
Jen-Hsun Huang: I’m so happy selling my current products.
Hans Mosesmann - Raymond James: All right, fair enough, Jen-Hsun. Marv, real quick, just a share count or an expectation for number of shares in the April quarter? And that’s it for me.
Marvin D. Burkett: Well, it was around 600 million I think as you’ve seen at the end of the fiscal year. I don’t expect a significant change going out of Q1. It might be up a little bit but basically not much change. That telegraphs the fact that we intend to buy more stock back in Q1.
Hans Mosesmann - Raymond James: Fair enough. Congratulations. Thank you.
Operator: Heidi Poon, Thomas Weisel Partners.
Heidi Poon - Thomas Weisel Partners: Hi, guys. Responding to the earlier question about your growth target for the year, I think you mentioned that it is still around 20%, so that’s seriously above the industry growth rate. Could you discuss, you know, of course the MCP growth is in there but are we also talking about maybe some serious share gains or holding off AMD in the notebook area?
Jen-Hsun Huang: First of all, and we -- we’re just -- maybe just unsuccessful in communicating this but I think the GPU, the entire GPU market is growing. We’re gaining a little bit of share but it’s not significant. They’re single digits, low teens. The whole GPU market is growing and the whole GPU market is growing because the computing experience is more visual than ever. And the reason why it’s more visual than ever is because more applications than ever before require rich graphics or take advantage of rich graphics. And so we are just selling more GPUs and the GPUs we are selling are slightly more powerful all the time. And so Heidi, that’s really where the growth is coming from. I think GPUs is our growth engine and we really believe that this is going to be a big year for GPUs again.
Heidi Poon - Thomas Weisel Partners: And is that expectation across the different platforms, like desktops, laptops, workstations, incremental gains in Tesla for this year?
Jen-Hsun Huang: Absolutely. We’re expecting growth everywhere.
Heidi Poon - Thomas Weisel Partners: Okay, great. Secondly, could you comment on for the growth in Q1 and Q2, maybe the pricing environment and also what you are seeing in terms of any demand differentials in international versus U.S.-based demand?
Jen-Hsun Huang: I don’t know that we’re seeing dramatically different demand in all the different regions. Heidi, if you look at our growth Q4 to Q4, it’s 80%, and so -- I’m not suggesting that Q4 to Q4 will be 80% again. I hope it will be but I’m not suggesting that. But the point being that there is some evidence that the consumption demand for GPUs is increasing and our expectation is that the growth of GPUs will overcome the seasonalities, whatever seasonalities that there is in Q1 and Q2.
Heidi Poon - Thomas Weisel Partners: Great, and the pricing environment?
Marvin D. Burkett: Pricing environment -- pricing is good. We’re seeing more money spent on GPUs so it has an appreciation in the average selling price for all of the GPU business.
Heidi Poon - Thomas Weisel Partners: Okay, great. Thank you.
Operator: Shawn Webster, J.P. Morgan Securities.
Shawn Webster - J.P. Morgan Securities: Good afternoon. Thanks for taking my questions and good quarter. On the -- just to follow-up on the pricing question, can you tell us what your sequential change in pricing was for your GPU business?
Marvin D. Burkett: Up nicely.
Shawn Webster - J.P. Morgan Securities: Up nicely? Okay.
Marvin D. Burkett: Yeah, it’s because we shipped a lot of the 8800 GTs, as Jen-Hsun said, so you would expect that. And so, you know, in the various segments the pricing was good. We would have had an ASP appreciation because of the higher volume of 8800 GTs.
Shawn Webster - J.P. Morgan Securities: Okay, and then Marv, on the OpEx growth in Q1, can you give us a sense of how you expect your OpEx to grow after Q1?
Marvin D. Burkett: Oh, internally Jen-Hsun and I are working hard to keep it flat. We’ll see how successful we are.
Shawn Webster - J.P. Morgan Securities: Like what, like very small incremental changes?
Marvin D. Burkett: We’ll see how successful we are.
Shawn Webster - J.P. Morgan Securities: Okay, and then finally, can you talk about the supply environment and do you have any of your products where they are seeing lead times extended?
Jen-Hsun Huang: Supply is certainly an area of great concern of mine. You know, we are becoming -- we are the world’s largest fabless semiconductor company. The products that we build are very complex and the die sizes of our high-end GPUs is significantly bigger than CPUs and we now sell, as you heard earlier, over 100 million units a year and it’s still growing. And so these processors are -- consumer a lot of wafers and we are already the world’s largest, so it is important that we work very, very closely with our foundry partners. TSMC has done a wonderful job for us, UMC has done a wonderful job for us and my expectation that we’re going to take the fabless model to new heights. But when you are as large as we are and running as fast as we are, you can never take supply too seriously. So we obviously take it very seriously.
Shawn Webster - J.P. Morgan Securities: And are you seeing your lead times stretch out or pull in for your graphics or chipsets? What’s the lead time environment like?
Jen-Hsun Huang: The lead time hasn’t really changed.
Shawn Webster - J.P. Morgan Securities: No change? Okay. Thank you.
Operator: Michael McConnell, Pacific Crest Securities.
Michael McConnell - Pacific Crest Securities: Thank you. Looking at the guidance, Marv, for better than seasonal for Q1, is this really unique do you think to NVIDIA with respect to you had a lot of pent-up demand obviously for the 8800 GT, supply now is starting to improve, so with that dynamic that leads to, like you said, some growth in the desktop GPU business? Is that it or is there something more here?
Jen-Hsun Huang: I think -- Michael, let me take that question. I think the GPU is just growing. I think the GPU market is growing and frankly, it ought to help anybody who builds a GPU. And so I consider -- the way I see it is visual computing is just becoming evermore important and so if other suppliers of GPUs are seeing ever-increasing demand, I’m not surprised by that. That’s kind of -- it’s not to do with -- I don’t think we’re capturing that much share.
Michael McConnell - Pacific Crest Securities: Okay, and then if we look at just the competitive landscape for the fiscal year, can you just talk about what you think from a unit share perspective or a revenue share perspective, probably more importantly, with each of the three main business lines? Or even the four, if you talk out maybe desktop GPU, notebook GPU, MCP, and then workstations, relative to this last fiscal year?
Jen-Hsun Huang: I don’t know that we’re that prepared to answer that question.
Marvin D. Burkett: Not for a full year.
Jen-Hsun Huang: I don’t think we break it out quite clearly that way.
Michael McConnell - Pacific Crest Securities: Any timeframe though that you’re comfortable with at this point to discuss?
Marvin D. Burkett: Yeah, last quarter.
Michael McConnell - Pacific Crest Securities: Okay.
Jen-Hsun Huang: I really couldn’t -- I’m really trying to say this so that we all kind of hear it -- I believe we are growing the market. I mean, the share gains are nice and we’re going to continue to fight for our share and fight for more than that but -- but I honestly believe the market is growing. But you can’t look at the size of the GPU market by combining the -- by looking at last year’s GPU market of all suppliers, okay? And then try to think that this year, the opportunity is shifting a few dollars from here to there, because I don’t think that makes any sense. If that was the case and you added S3 and Cirrus Logic’s revenues together and Trident’s together of when we started, NVIDIA would be a $300 million company. And so obviously the GPU market and visual computing is becoming more and more important and what we are seeing here is and what we believe and what we had hoped all along is that the GPU is -- the overall market for GPUs is growing. And so you have to look at -- I frankly think that you have to look at -- in order to see the opportunities, you have to look at the entire electronics spend of the PC industry. There is a vast movement to re-architect the PC, to shift the resources around to deliver the best possible experience. And the best possible experience for each market category or each PC category [inaudible]. A gamer’s PC would have a different allocation of electronic spend. A all-in-one consumer multimedia oriented PC will have a different, another allocation. And so you have to look at all of the electronics dollars in order to decide how best to estimate the growth opportunity. But I think share is just simply not that interesting anymore and certainly it doesn’t explain our growth.
Michael McConnell - Pacific Crest Securities: Okay, and then just a final one for me on the gross margin -- obviously the company has done a great job through the years of continuing to expand the gross margins. Taiwan Semiconductors talked ad nauseam over the second half of last year about trying to renegotiate pricing with some of their larger fabless customers. I understand the rationale behind what happened with the 8800 GT from a cost standpoint. Is there any type of pricing negotiations that also came into this with respect to the gross margin in Q4, or is that just -- it’s just purely demand exceeding supply and then as that -- we start to see more balance, the gross margins should start to come back?
Jen-Hsun Huang: The gross margin impact of 8800 GT or the increased cost of 8800 GT was completely my fault. It has nothing to do with Taiwan Semiconductor Manufacturing Corporation. And we will have to accept all of that responsibility ourselves, unfortunately, and so -- now, the good news, of course, is that because it was completely our fault, we can completely fix it. I think that that one -- let blame where blame needs to go here.
Michael McConnell - Pacific Crest Securities: Okay, so this is not anything in terms of pricing negotiations -- this is something that you think we can start to look -- we can continue to expand gross margins as we work through the fiscal year, you’re fairly confident on that?
Jen-Hsun Huang: We would love to blame other people, Michael. Sometimes you have -- (Multiple Speakers)
Michael McConnell - Pacific Crest Securities: Okay, thanks.
Operator: Tayyib Shah, Longbow Research.
Tayyib Shah - Longbow Research: Hi, guys. Jen-Hsun, can you please describe the competitive landscape in the notebook space -- you versus AMD and then also discrete graphics versus integrated, as you head into the next refresh cycle?
Jen-Hsun Huang: In the notebook segment, AMD has wonderful offerings. Don’t forget that AMD still has a terrific GPU design organization and so between NVIDIA and ATI, or AMD, it is the unambiguously the two best GPU design teams the world has ever seen. And so I give them a lot of respect and in the AMD notebook segments, the lower end segments, it is hard for us to differentiate relative to AMD. And as I said earlier, if we can’t differentiate, we don’t typically win the business. And so I’m not surprised and we’re not expecting to win any of those. We are going to fight hard for them but in the final analysis, I think AMD has good offerings there. In the upper half of the market, we have quite a bit of differentiation. Our advantage is that we invest more in GPU development than any company in the world today and potentially all of the competitors combined. And so our R&D investment, our commitment to GPUs, our velocity of innovation, that is our advantage on the upper half of the market, whether it’s notebooks or otherwise. So we have to -- that’s a -- that’s our velocity, our commitment and our level of innovation and level of investment is a structural advantage and so we have to sustain that.
Tayyib Shah - Longbow Research: Okay, and Marv, just curious how you were able to build some inventory during the quarter -- does that reflect slightly better supply from the foundry or was this related to demand trends?
Marvin D. Burkett: No, it’s new products in the pipeline. You know, if you looked at the inventory build where it actually happened, it’s all new products which are just in the pipeline.
Tayyib Shah - Longbow Research: Thank you.
Operator: Our final question comes from the line of Glen Yeung from Citigroup.
Glen Yeung - Citigroup: Thanks. So Jen-Hsun, can you just be clear as to what you think the PC market is actually doing in this environment? I understand that GPUs are growing and you may or may not be taking share within that, but just your overall sense of the PC market.
Jen-Hsun Huang: We monitor sell-through and we’re fine. I mean, what we see is fine. We monitor our own sell-through. I guess I don’t monitor other people’s sell-through but sell-throughs look fine. You know, we watch it every single week around the world and it looks good. I don’t really know what else to say.
Glen Yeung - Citigroup: No, fair enough. Any [differentiation] with what you see between an OEM basis or a white box basis?
Jen-Hsun Huang: Not really. Not really.
Glen Yeung - Citigroup: Okay.
Jen-Hsun Huang: You know, I think that it’s possible that the SKUs that we are in are selling well. It’s possible that people are preferring platforms that we’re designed into but I don’t really know. I think that overall, overall I believe that the movement -- there’s two things that are happening that are very, very big deals that I believe that we’re experiencing and we’re experiencing all over the world. The first thing is the importance of visual computing and therefore the GPU at the core of that. The second thing is the re-architecture of the reallocation of resources within the PC, that for different types of PCs, you ought to spend and invest your resources in different components. And so the balance between the CPU and the GPU is changing and I think those two factors combined are really, really important and we -- I don’t believe that to be a one quarter thing. I think it’s logical that is should be a permanent thing. It should be a forever thing. It happened to cars. It happened to just about any other mature industry that as the industry matures, you see all of these -- it bifurcates into the niches and the niches become large and in order to make a niche product specific, you can’t use the basic platform. You have to optimize it for the needs of that niche.
Glen Yeung - Citigroup: I think I hear you and when I think -- I guess I’m thinking if we can add the product strength of the 8800 GT, then one can conclude that even if we were seeing some slowing in PC units at the moment, those trends may outweigh that -- fair assessment?
Jen-Hsun Huang: Yeah, I do, I think that’s fair.
Glen Yeung - Citigroup: Okay. And then just a quick question, Marv, for you -- you’d mentioned you’ve had some cost issues with the 8800, working through it. In your inventories that you had exiting the fourth quarter, are some of those, the high cost or lower margin parts, still in that inventory and do you expect to work them through in the course of the first quarter?
Marvin D. Burkett: No, I mean, if we had a cost issue, it means the parts aren’t there. It means that they were written off, so no, they’re not in that inventory.
Glen Yeung - Citigroup: Okay, great. Thanks.
Operator: There are no more questions at this time. I would now like to turn the call back over to Jen-Hsun. Please go ahead.
Jen-Hsun Huang: Thank you all for joining us today. We look forward to reporting our progress for Q1.
Operator: Ladies and gentlemen, that does conclude the conference call for today. We do thank you for your participation and ask that you please disconnect your lines. | [
{
"speaker": "Executives",
"text": "Michael Hara - Investor Relations Jen-Hsun Huang - President, Chief Executive Officer and Director Marvin D. Burkett - Chief Financial Officer"
},
{
"speaker": "Analysts",
"text": "Tim Luke - Lehman Brothers Krishna Shankar - JMP Securities Gurinder Kalra - Bear Stearns Brian Piccioni - BMO Capital Markets David Wu - Global Crown Capital Doug Freedman - American Technology Research Hans Mosesmann - Raymond James Heidi Poon - Thomas Weisel Partners Shawn Webster - J.P. Morgan Securities Michael McConnell - Pacific Crest Securities Tayyib Shah - Longbow Research Glen Yeung - Citigroup"
},
{
"speaker": "Michael Hara",
"text": "…fourth fiscal quarter ended January 27, 2008. On the call today for NVIDIA are Jen-Hsun Huang, NVIDIA's President and Chief Executive Officer; and Marv Burkett, NVIDIA's Chief Financial Officer. Before we begin today’s call, I would like to take care of some general administrative items. Your lines have been placed on a listen-only mode until the question-and-answer segment of today’s call. During this call, we will discuss some non-GAAP financial measures about net income, diluted net income per share, and gross margin when talking about our results. You can find a reconciliation of these non-GAAP financial measures to GAAP financial measures in our financial release, which is posted on the investor relations page of our website at www.nvidia.com. Unless otherwise noted, all references to research market and market share numbers throughout the call come from Mercury Research or John Petty Research. This call is being recorded. If you have any objections, you may disconnect at this time. Please be aware that if you decide to ask a question, it will be included in both our live transmission as well as any future use of the recording. Also, shareholders can listen to a live webcast of today’s call via the investor relations page of our website. The webcast will be available for replay until the company’s conference call to discuss its financial results for its first fiscal quarter 2009. During the course of this conference call, we may make forward-looking statements based on current expectations. Forward-looking statements, including statements as to the importance of and uses for the GPU, our outlook, the impact, performance and availability of and demand for our products and technologies, our growth and strategies, and the future of -- pertaining to future events and are subject to a number of significant risks and uncertainties. The company’s actual results may differ materially from results discussed in any forward-looking statements. For a complete discussion of factors that could affect the company’s future financial results and business, please refer to the company’s Form 10-Q for the period ended October 28, 2007, and the reports on Form 8-K filed with the Securities and Exchange Commission. All forward-looking statements are made as of the date hereof based on information available to us today and, except as required by law, the company assumes no obligation to update any such statements. The content of the webcast contains time-sensitive information that is accurate only as of February 13, 2008. Consistent with the requirements under Regulation FD, we will be providing public guidance directly in the conference call and will be unable to provide significantly more information in offline conversations or during the quarter. Therefore, questions around our financial expectations should be asked during this call. At the end of our remarks, there will be time for your questions. In order to allow more people to ask questions, please limit yourself to one question. After our response, we will allow one follow-up question. I will now hand the call over to Jen-Hsun."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks, Mike. Good afternoon and thank you for joining us. We are pleased to report another record quarter and fiscal 2008 was another record year. We had many achievements this past year. Q4 revenue grew 37% year over year to a record $1.2 billion. Annual revenue increased 34% year over year to a record $4.1 billion. Annual net income increased 78% year over year to a record $797.6 million. Annual gross margin reached a new high of 45.6%, an increase of 320 basis points from a year ago. We launched a record number of industry-defining products and initiatives this year -- GeForce 8800 family, including the highly acclaimed 8800GT. We’ve sold over 2 million 8800GTs in just four months of production and demand continues to exceed our forecast. GeForce 7000 -- the first motherboard GeForce for Intel systems. Together with the CPU, the GeForce 7000 enables the first two-chip Intel processor PC. CUDA -- the industry’s first parallel programming environment that puts the massively parallel processing capability of a GPU in the hands of all programmers. CUDA is available on every one of the 50 million GeForce 8000 series GPUs that we’ve shipped. We expect to ship several hundred million CUDA GPUs over the next several years. CUDA has quickly become of the most pervasive and accessible parallel programming environments ever. There is increasing recognition that the traditional CPU alone architecture, or homogenous architecture, is not optimal for every application. With CUDA, we have launched a new computing movement towards heterogeneous computing, where a traditional CPU is combined with a massively parallel processing GPU to achieve a giant step up in performance. Visual computing is one of the most well-known parallel computing applications. There are many others. Applications such as physics processing, computer vision, video image processing, are just a few examples that are dramatically enhanced by CUDA and heterogeneous computing. Engineers and researchers in software companies, computer companies, and in universities around the world are recognizing the importance of heterogeneous computing. This is a major movement in computing. Tesla -- our new family of server workstation class GPUs with supporting system and software technologies for high performance computing. The first Tesla 1-U rack contains four GPUs, each with 128 processors, delivering a whopping 1.1 teraflops of sustained super computing performance in a real world application. Hybrid SLI -- like a hybrid car, Hybrid SLI allows a small GPU and a large GPU to work together. The small GPU runs light visual computing workloads while conserving power. When heavy workload is required, both GPUs combine their capabilities to deliver the most delightful experience. With Hybrid SLI, we can deliver the ultimate visual computing experience while enabling an environmentally friendly power efficient design. And lastly, PureVideo HD -- the first video decode and post-processing technology for Blu-Ray and High-definition DVD. Year over year, annual revenue of each core product line turned in strong results. Desktop GPU revenue grew 38%. Notebook GPU revenue grew 114%. Workstation grew 27%, MCP revenue grew 7%. NVIDIA held the number one segment share in desktop GPU, notebook GPU, all of DX9 and DX10 GPUs and workstation solutions. NVIDIA was named the most respected public company by the members of the Fabless Semiconductor Association for the second consecutive year. NVIDIA was named Company of the Year by Forbes Magazine. We acquired Mental Images, the industry's leading photorealistic rendering technology provider. Mental Image's Mental Ray is the most pervasive ray tracer in the industry. And lastly, just this week we announced the completion of the acquisition of AGEIA, the industry leader in gaming physics technology. We are pleased with our achievement this year. Particularly, we are very pleased with our strategic position heading into fiscal 2009. Let me turn the call over to Mark to discuss our financial results. I will return in a moment to address our growth opportunities for the coming year."
},
{
"speaker": "Marvin D. Burkett",
"text": "Thanks, Jen-Hsun. Today we’ll be looking at both GAAP and non-GAAP results for the fourth quarter of fiscal year ’08 and for the full year of fiscal year ’08. The difference between GAAP and non-GAAP is primarily stock-based compensation and its tax effect. In Q4, there is also an in-process R&D write-off from the Mental Images acquisition. As Jen-Hsun stated, revenue for the fourth quarter was $1.2 billion, which is an 8% increase quarter to quarter. The growth quarter to quarter came from desktop GPUs, which grew 19% and workstation, which grew 9%. Notebook and MCP were up slightly at 1% and 2%. The strength in desktop came from new products such as the GeForce 8800 family. Comparing Q4 fiscal year ’08 with Q4 fiscal year ’07, revenue was up 37%, led by notebook and desktop. Notebook was up 124% year to year and desktop was up 69%. Workstation grew by 31%. The consumer business declined 22% for the year. The strength that we saw in desktop GPUs for Q2 and Q3 has continued through Q4 and shows signs of continuing in Q1, demonstrating the growing importance of the GPU in the PC system. For the year, we had revenue of $4.1 billion, which is up 34%. Gross margin for the quarter was 45.7% GAAP and 45.9% non-GAAP. This was the first time in 13 quarters that we haven’t had a non-GAAP gross margin increase quarter to quarter. During the quarter, we experienced some cost issues with regard to the 8800GT, which we hope to resolve in the next two quarters. For the year, GAAP gross margin was 45.6%, which is up 320 basis points. Operating expenses for the quarter were $287 million GAAP and $251 million non-GAAP. The GAAP number includes a $4 million write-off of in-process R&D associated with the Mental Images acquisition. It also includes approximately $32 million of stock-based compensation. The non-GAAP operating expenses were up $13 million quarter to quarter, or 5.5%. And this includes an additional $3 million of operating expenses associated with Mental Images. The revenue for Mental Images in the quarter was less than $1 million. We continued to aggressively hire during the quarter and ended the year with a headcount of 4,985, which is up 376 from the prior quarter and up 902 over the prior year. Approximately two-thirds of the headcount additions for the quarter and the year were in the R&D sector. So for the year, revenue was up 34%, non-GAAP operating expenses were up 25%, and headcount was up 22%. The tax rate for the year was 11.5%, which is slightly lower than we anticipated as the mix of international sales was slightly higher than we had forecast. This resulted in a GAAP tax rate for the quarter of 8.2%. For the quarter, the GAAP earnings per share were $0.42 and the non-GAAP were $0.49. For the year, GAAP earnings were $1.31 and the non-GAAP was $1.56. On the balance sheet, cash and marketable securities was $1.8 billion, down $43 million from Q3 and up $692 million year to year. In the quarter, we repurchased $178 million of stock, purchased Mental Images for cash, and also purchased some EDA equipment and services. The operating cash flow in the quarter was a little over $250 million. Accounts receivable grew by $114 million, reflecting both the shipment profile in the quarter and the increase in revenue. The accounts receivable is very current and there are no issues with regard to payment. DSO in the quarter was 50 days. We built $52 million in inventory during the quarter, all of which was in new products. Inventory continued to be lean at 50 days, up only slightly from Q3. Depreciation was $37 million in the quarter and capital expenditures were $70 million. For the year, capital expenditures was $188 million. On the outlook, we expect revenue in Q1 to be better than seasonal. We expect continued strength in desktop GPUs, seasonal weakness in some others, and the result is we believe revenue will be slightly down. For gross margins, we’ll certainly try to get back on track of increasing gross margins and would expect margins to be flat to slightly up. We expect operating expenses to increase quarter to quarter because of the normal Q1 issues of less vacation in Q1 than Q4, higher FICA expense in Q1 and Q4. In addition, we expect to have approximately $7 million of incremental expenses in Q1 that will come from acquisitions we’ve recently made. The result is that we expect operating expenses to increase 8% to 10%. Since the R&D tax credit has not yet been renewed, we expect there will be an increase in the tax rate until that happens. If the R&D tax credit is renewed, we would expect a tax rate of 13% to 14% for the year. Until that happens, our expected tax rate will be approximately 17%. With that, I will turn it back over to Jen-Hsun."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks, Mark. We are entering the era of digital computing. Applications with rich graphics are growing with astounding numbers. Videogames is now a $43 billion industry and larger than movie box office receipts and music. World of Warcraft, commonly known as WoW, is a massively multi-player 3D online roleplaying game with over 10 million active users. According to Comscore, a leader in measuring the digital world, 217 million videogame players immerse themselves in online 3D worlds and that number is expected to grow 17% annually. Google Earth combines the power of search with rich imagery and 3D terrain and is transforming the way we navigate. There have been over 350 million unique downloads of Google Earth to date. Modern operating systems, Windows Vista and Apple OS 10 Leopard, deliver amazing 3D user interfaces. Combined, the two operating systems have shipped over 100 million copies to date. Our growth reflects the increasing importance of the GPU in these applications. We shipped a record 80 million discrete GPUs last year. Including motherboard GeForces, we shipped a total of 111 million GPUs. Our annual discrete GPU revenue grew 50% year over year. Our Q4 discrete GPU revenue grew 80% from a year ago. Consumer demand for the richest visual computing experience is driving a movement to rebalance the architecture of the PC. The CPU has become good enough for the vast majority of users. Meanwhile, a higher performance GPU will directly result in a dramatically more beautiful and fluid user experience. PC enthusiasts, gamers, and design professionals have known this for some time. They have long been the strongest proponents and consumers of the GPU. Let me give you some recent examples from Gateway. The Gateway P series FX, a very thin gaming HD video notebook, priced at $1249 and features a GeForce 8800 GPU and a lower-end 1.6-gigahertz CPU. Relative to a notebook with a higher end CPU and lower end GPU, the Gateway FX is twice the performance and yet $200 lower cost. Here is a recent quote from a CNET review of the Gateway FX 7020 desktop PC: “Gateway’s FX 7020 represents the type of PC we expect to see a lot of in 2008. The $1,000 to $1,500 gamer that finally has the graphics horsepower to handle the newest 3D PC games. Its AMD Phenom quad-core CPU isn’t the fastest CPU around, although it is quick enough. But the real horsepower lies in its GeForce 8800 GT graphics card. Until now, few PCs in this price range have been able to handle the likes of Crysis, Unreal Tournament 3, and other new PC games with any kind of decent image quality. This PC and the forthcoming systems like it should finally deliver the promise of next-gen PC gaming to a wider audience.” OEMs and consumers around the world are learning the same thing -- the CPU is good enough. Investing more on the GPU will deliver a several-fold jump in application performance and experience. We call this trend the optimized PC design approach. The balance of CPU and GPU processing should reflect a category of PCs, whether it is gaming PC, lifestyle PC, workstation PC, all-in-one PC or enterprise desktop PC. We are excited about the coming years. The era of visual computing and the movement towards optimized PC design approach will make the GPU evermore central to our computing experience. At the core of that experience is the GPU. This is the decade of the GPU. We’d be happy to take your questions now."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Tim Luke, Lehman Brothers."
},
{
"speaker": "Tim Luke - Lehman Brothers",
"text": "Thank you so much. Marv, I was wondering, as you guide for the first quarter to be slightly stronger than seasonal, if you could frame for us how you have perceived seasonal in terms of recent percentages, either down or -- and maybe within that, you talked a little about the strength that you’ve seen in desktop, how we would perceive some of the different segments to look through the first quarter."
},
{
"speaker": "Marvin D. Burkett",
"text": "Okay. Seasonal to me is for our business is usually down nominally 5%. I think that the PC in general is down 5% to 10% but for us, it’s historically been around nominally 5%. So when I say down, I say it will be down less than that. And with regard to the strength in the desktop GPUs, the strength in Q4 and Q3 has been very, very good in the performance segment, the 8800 GT. As Jen-Hsun said, is selling very, very well and so we would expect continued strength there. So I would say anything in the performance and up segment, the desktop GPUs is doing very well."
},
{
"speaker": "Tim Luke - Lehman Brothers",
"text": "In some of your recent updates, Marv, you had suggested that while you had seen the strength in the performance end of the desktop area, you’d seen a little bit of volatility in the notebook arena and I was wondering if you had any recent updates as to how you’ve seen that. And then separately in recent updates you had said that you had been targeting growth for the calendar year coming of at least in the 20% range, I believe. And I was wondering if you could give some flavor on how you see the different building blocks of that rate of growth going forward."
},
{
"speaker": "Marvin D. Burkett",
"text": "Well, notebook in Q4 was up 1% quarter to quarter, so it certainly didn’t decline. I think that’s pretty good performance. I would expect it to come off seasonally in the first quarter. With regard to ’08 in total, I don’t think I have any change to what we previously talked about."
},
{
"speaker": "Tim Luke - Lehman Brothers",
"text": "And with respect to the segments within that, do you have any feel for how we should think about modeling the different areas?"
},
{
"speaker": "Marvin D. Burkett",
"text": "Growth in desktop GPUs, growth in MCP, growth in workstation."
},
{
"speaker": "Tim Luke - Lehman Brothers",
"text": "Thank you so much. I’ll pass it on."
},
{
"speaker": "Operator",
"text": "Krishna Shankar, JMP Securities."
},
{
"speaker": "Krishna Shankar - JMP Securities",
"text": "Yes, as you look at your April quarter, you indicated strength in the desktop GPU market. Do you see sort of broad-based strength there across all segments of the desktop graphics market or is it more in the high-end enthusiastic performance class market?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "No, we’re seeing growth in the GPU business. I mean, it’s year over year, our GPU business grew 80% and you can’t grow that in just one particular segment. We’re seeing growth across all of the segments. We’re seeing increasing adoption of GPUs. We’ll seeing simultaneously a bias towards slightly higher end GPU and all of that is consistent with our belief and what I’m sure you believe and most consumers experience today, that more and more of the applications they enjoy are graphically rich. And so I think that people understand increasingly that rebalancing the system so that more GPU horsepower could be dedicated to the experience will result in a much higher performance and so PC OEMs, consumers, gamers, have already known this. Workstation professionals have always known this. Design professionals have known this and one PC OEM after another are building computers where the CPU is just good enough and a lot more resources are dedicated towards the GPU and the products are selling incredibly well, because frankly they benchmark well, they use well, and it’s just a much more delightful experience overall."
},
{
"speaker": "Krishna Shankar - JMP Securities",
"text": "And just to follow-up, in terms of the competitive landscape, do you see -- how do you describe the competitive landscape in MCPs, especially in the notebook market? And also the dual-chip X2 configuration that AMD has come out with recently -- can you talk about the NVIDIA products that would be coming out to compete with that?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Okay. So let’s see -- you asked -- I think there were four questions all together. Okay, so competition in MCP space -- the way we see it is this; we have the only GeForce motherboard solution for both Intel and AMD platforms. We are bringing Hybrid SLI to those platforms and for anybody who enjoys a -- who don’t want to sacrifice a rich graphics experience and all the compatibility with all of the applications around the world, even though they purchased an entry level PC, a GeForce on a motherboard is really the best way to go. And so we continue to see success there. My expectation, our expectation this year is that we are going to grow the MCP business pretty substantially. A lot of that has to do with the fact that this is the first year where we have GeForce motherboard GPUs for the Intel systems, and so we are expecting that to be -- to do quite well. With respect to the notebook area, my sense is that wherever we don’t differentiate substantially, we won’t win the business. And if the customers don’t care about graphics performance, if it’s an enterprise notebook or the competition has a GPU solution just as good as ours, you know, certainly we won’t expect to win the business. But other than that, I think we are going to do quite well. Overall, I think we are going to have a great year for MCP. With respect to X2, you know, you would only put two GPUs -- well, let me come at it another way. If you want to put two GPUs in an add-in card and you deliver the absolute highest performance in the world, the enthusiast that uses that particular PC will certainly tolerate the fact that it’s a much larger solution. But if it’s not the highest performance solution in the world, as in the case of the X2, then it’s just really problematic. You know, there’s no market really for a product that’s larger, louder, and not as high performance. And so I think that GeForce 8800 GTX is still absolutely the best DX10 and highest graphics performance GPU in the world and works great in SLI and we’re going to shortly announce, or shortly ship, three-way SLI. And so multiple GPUs on an add-in card is only tolerated if it is unambiguously the highest performance. Anything short of that is just too clumsy to be successful."
},
{
"speaker": "Krishna Shankar - JMP Securities",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Gurinder Kalra, Bear Stearns."
},
{
"speaker": "Gurinder Kalra - Bear Stearns",
"text": "Thanks for taking my question. My first question is on the cost issues you experienced with the desktop GPUs in the current quarter. Can you discuss them in more detail and how you expect them to get resolved?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "You know, 8800 GT was ramped probably faster than any high-end GPU in our history. As I mentioned in my comments earlier, in just four months of production we shipped over 2 million 8800 GTs, and this is a high-end GPU. The die size and the number of transistors of the 8800 GT is far more than any microprocessor you currently have -- core-two dual and otherwise. And so this is a very complex processor and yet we ramped it incredibly hard. We had some manufacturing challenges in the beginning and we caught it, we fixed it, and now we are going to see far better yields going forward. But it affected our cost in Q4."
},
{
"speaker": "Marvin D. Burkett",
"text": "From my standpoint, our focus was delivering the product to the customer. Demand outstrips supply, so rather than focus on bringing the costs down, we focused on getting the product out."
},
{
"speaker": "Gurinder Kalra - Bear Stearns",
"text": "Okay, great. And then secondly on the AGEIA acquisition -- hope I’m saying that name correctly -- now, where do you think it enhances revenue opportunities and does it mean that you are open to more end markets?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Well, you know, physics processing and bringing dynamics to games is an area of a lot of excitement and many games already have physics in it but rudimentary physics, and people want to put a lot more physics, a lot more dynamics into games. It just brings the whole game to life. Now it looks beautiful and it behaves realistically, whether it’s water or cloth or emotion or -- you know, particle systems or whatever it happens to be. Physics processing and the AGEIA engine happens to be extremely computationally intensive. It requires just a lot of processors to deliver the type of real time performance that the games need. Our strategy is to take the AGEIA physics engine, which has been integrated into tools and games all over the world, and we’re going to port the AGEIA physics engine onto CUDA. You know, you heard in my comments that CUDA has now shipped into 50 million processors, GeForce 8 series processors and over the next several years, we’ll ship a few hundred million more. The ability to port the physics engine on top of CUDA and accelerate the physics is going to add a ton more value to gamers around the world. Our expectation is that this is going to encourage people to buy even better GPUs. It might and probably will encourage people to buy a second GPU for the SLI slot and for the highest end gamers, it will encourage them to buy three GPUs, potentially two for graphics and one for physics or one for graphics and two for physics, or any combination of -- you know, any dynamic combination thereof. So I’m very enthusiastic about the work that we’re doing here and the game developers are really excited about it. You know, finally they are able to get a physics engine accelerated into a very large population of gamers. And so I think this is a -- this combination between us and AGEIA really kick-started the physics industry."
},
{
"speaker": "Gurinder Kalra - Bear Stearns",
"text": "Okay, great. Thank you very much."
},
{
"speaker": "Operator",
"text": "Brian Piccioni, BMO Capital Markets."
},
{
"speaker": "Brian Piccioni - BMO Capital Markets",
"text": "Hello there. Just following on with the question with respect to the AGEIA acquisition, would you have a timeline where we would expect to start seeing the impact in the actual product offering?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "We’re working towards the physics engine to CUDA port as we speak and we intend to -- we’re going to throw a lot of resources at it. I wouldn’t be surprised if it helps our GPU sales even advance of that, and the reason for that is in the end, it’s just going to be a software download. Every single GPU that is CUDA enabled will be able to run the physics engine when it comes."
},
{
"speaker": "Brian Piccioni - BMO Capital Markets",
"text": "So we are primarily talking a software rather than physical changes to the internal organizations of the GPU then?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "That’s right, because what makes it possible is CUDA. You know, every one of our GeForce 8 DX10 GPUs run CUDA. CUDA is a parallel programming model that is programmable through C. And so we are going to port physics, the name of their engine is physics, we’re going to port physics, the physics engine onto CUDA and access all of the parallel processing capabilities. And in the case of the 8800, 128 processors in our chip so instead of running it on only two cores, now we can run it on 128 cores. And so our expectation is that the parallel processing capability would really dramatically enhance the performance."
},
{
"speaker": "Brian Piccioni - BMO Capital Markets",
"text": "I see. And I guess you wouldn’t agree with your competitors’ comment that physics is dead then?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Why would physics be dead?"
},
{
"speaker": "Brian Piccioni - BMO Capital Markets",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "David Wu, Global Crown Capital."
},
{
"speaker": "David Wu - Global Crown Capital",
"text": "Yes, good afternoon. Thanks for taking my call, or question, rather. Marv, can you sort of split us the various business segments in Q4 of your -- you know, the typical breakout in your 10-Qs? And the other thing I wondered is the -- can you talk a little bit about the economics of AGEIA? It sounded like the first quarter will be dilutive but when could it be accretive? And lastly, on the situation on the 8800, to improve your cost, does it mean that you can still run on 90-nanometer process, just tune it a bit or do something to get your costs down? Or do you need to -- are we talking about a potential die shrink down to 65-nanometer or 55-nanometer to get the required traditional margins that you get on these high-end discrete chips?"
},
{
"speaker": "Marvin D. Burkett",
"text": "Wow. All right, David, let me start through the business segment breakout that we would show in the Qs. The GPU business, which includes desktop, notebook, and memory, was up 11% quarter to quarter. The PSB area, which is workstation and some other products, was up 10% quarter to quarter. MCP, which is our platform products group, was up 2% quarter to quarter. And then that leaves you with the consumer business, which was down roughly 18% quarter to quarter. So that’s the segment breakout that I think that you were looking for?"
},
{
"speaker": "David Wu - Global Crown Capital",
"text": "Yeah, yeah."
},
{
"speaker": "Marvin D. Burkett",
"text": "All right. Now, with regard to the 8800 on the cost bank, it doesn’t require us to do anything differently in terms of process technology or a redesign of the chip. It’s just a focus on getting -- you know, improving the yields and doing the product engineering, which we haven’t been able to focus on because of demand outstripping supply. So -- it’s just hard work and we’ll do it. It does not require a process change or anything else. With regard to AGEIA, obviously it will be dilutive because of the lack of revenue in the first quarter and probably until -- being able to classify it as accretive is going to be associated with how many more GPUs we sell because of that. So I’m not worried about it from that standpoint. Mental Images obviously in Q4 was dilutive and probably will be dilutive in Q1. We’ll see about that."
},
{
"speaker": "David Wu - Global Crown Capital",
"text": "Okay. So AGEIA, it’s not such a big -- not that you need to have a lot of revenue to cover it and some incremental hardware you sell?"
},
{
"speaker": "Marvin D. Burkett",
"text": "No."
},
{
"speaker": "David Wu - Global Crown Capital",
"text": "Okay, great. Thank you very much."
},
{
"speaker": "Operator",
"text": "Doug Freedman, American Technology Research."
},
{
"speaker": "Doug Freedman - American Technology Research",
"text": "Hi, guys. Thanks for taking my questions. You spent a lot of time talking about the GPU computing opportunity. Can you spend a little time talking about how a general purpose computing engine might be required to grow that market and what your view is for your needs going forward of a general purpose computing engine?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Let me make sure I understand your question, Doug -- your question is -- when you say general purpose computing engine, do you mean the general purpose application for GPU computing?"
},
{
"speaker": "Doug Freedman - American Technology Research",
"text": "I’m referring to a -- whether it’s a MIPS processor, a general purpose computing processor as opposed to a strictly parallel machine."
},
{
"speaker": "Jen-Hsun Huang",
"text": "No, GPU computing already has a processor. We believe in heterogeneous computing and basically the CPU that’s already in your system, it’s good enough. It’s fabulous. Billions and billions of dollars of R&D has gone into making that CPU as good as it can be and for single-threaded applications, you know, I think it’s a -- the performance of the CPU is a miracle of mankind. I mean, it’s fabulous. But they’ll never scale very well from here on out and for the type of parallel applications that we believe are really interesting to solve, and so the problem space that we focus on are all of the type of applications that require a lot of parallel processing capability. So we believe that the world needs a heterogeneous computing model where the single-threaded, flexible CPU is combined with or collaborates with a massively parallel processor, in this particular case we call a GPU. And when we introduced CUDA, which allows the GPU to be programmed with C and compiled to with a C compiler, we really, really opened up that computing paradigm and it’s just because C developers don’t really want to program their problems in OpenGL and Direct 3D and C is a much more natural approach for them. And so heterogeneous computing includes the CPU and the GPU and in terms of answering maybe a related question about what is the consumer mainstream application for GPU computing, physics is a really good example of the first one. Physics processing is already in so many games, as you know, and it’s going to be in almost every single game in the future. And all of a sudden, with physics on CUDA, we’re able to bring accelerated physics processing to every PC in the world. And so I think CUDA and GPU computing, or heterogeneous computing, however you want to think through it, is -- this year will officially be a consumer-oriented mainstream processing model."
},
{
"speaker": "Doug Freedman - American Technology Research",
"text": "All right. Could you help us understand a little bit of what expectations you guys have for the DX10 chipset marketplace? How soon and how quickly you think the chipset market is going to move to a DX10-based solution -- what percentage by the end of the year, if that’s possible?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "I believe in order to get Vista certification by the second half of the year, you require DX10. And so it becomes a requirement for Vista starting the second half of the year. So I think the answer is we ought to get there as fast as possible and we are trying to get there as fast as possible."
},
{
"speaker": "Doug Freedman - American Technology Research",
"text": "All right, great. Thanks, guys."
},
{
"speaker": "Operator",
"text": "Hans Mosesmann, Raymond James."
},
{
"speaker": "Hans Mosesmann - Raymond James",
"text": "Thanks. A couple of questions; Jen-Hsun, in terms of the X2 type or class of products that are out there, will NVIDIA introduce a product like that and will that establish or become over time the standard at the very, very high-end of the market? And I have a follow-up for Marv."
},
{
"speaker": "Jen-Hsun Huang",
"text": "We would do an X2 like product only if it delivers performance that is simply not possible anywhere with a single GPU. But there’s no question that a single GPU is a better approach. It’s better use of bandwidth, it’s -- the processors collaborate much, much better and the overall performance is just unbeatable. And so if we can’t deliver that performance with a single GPU, we’ll do it with double GPUs and -- but either way, it has to be the absolutely highest performance. So you know my preference and you know we have -- we have a lot of evidence and certainly know for sure that a single GPU is the best approach and -- but if a double GPU can deliver the highest performance on the planet, it would be accepted. If it’s not, then you’re going to have problems."
},
{
"speaker": "Hans Mosesmann - Raymond James",
"text": "And so, just to kind of go further there, what you are saying is that in the near-term, it’s unlikely that you are going to see something like that from NVIDIA, that you’ll stick with the single solutions in the near-term?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Hans, I don’t talk about -- we can’t talk about future products."
},
{
"speaker": "Hans Mosesmann - Raymond James",
"text": "All right. Well, I understand your preference and --"
},
{
"speaker": "Jen-Hsun Huang",
"text": "I’m so happy selling my current products."
},
{
"speaker": "Hans Mosesmann - Raymond James",
"text": "All right, fair enough, Jen-Hsun. Marv, real quick, just a share count or an expectation for number of shares in the April quarter? And that’s it for me."
},
{
"speaker": "Marvin D. Burkett",
"text": "Well, it was around 600 million I think as you’ve seen at the end of the fiscal year. I don’t expect a significant change going out of Q1. It might be up a little bit but basically not much change. That telegraphs the fact that we intend to buy more stock back in Q1."
},
{
"speaker": "Hans Mosesmann - Raymond James",
"text": "Fair enough. Congratulations. Thank you."
},
{
"speaker": "Operator",
"text": "Heidi Poon, Thomas Weisel Partners."
},
{
"speaker": "Heidi Poon - Thomas Weisel Partners",
"text": "Hi, guys. Responding to the earlier question about your growth target for the year, I think you mentioned that it is still around 20%, so that’s seriously above the industry growth rate. Could you discuss, you know, of course the MCP growth is in there but are we also talking about maybe some serious share gains or holding off AMD in the notebook area?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "First of all, and we -- we’re just -- maybe just unsuccessful in communicating this but I think the GPU, the entire GPU market is growing. We’re gaining a little bit of share but it’s not significant. They’re single digits, low teens. The whole GPU market is growing and the whole GPU market is growing because the computing experience is more visual than ever. And the reason why it’s more visual than ever is because more applications than ever before require rich graphics or take advantage of rich graphics. And so we are just selling more GPUs and the GPUs we are selling are slightly more powerful all the time. And so Heidi, that’s really where the growth is coming from. I think GPUs is our growth engine and we really believe that this is going to be a big year for GPUs again."
},
{
"speaker": "Heidi Poon - Thomas Weisel Partners",
"text": "And is that expectation across the different platforms, like desktops, laptops, workstations, incremental gains in Tesla for this year?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Absolutely. We’re expecting growth everywhere."
},
{
"speaker": "Heidi Poon - Thomas Weisel Partners",
"text": "Okay, great. Secondly, could you comment on for the growth in Q1 and Q2, maybe the pricing environment and also what you are seeing in terms of any demand differentials in international versus U.S.-based demand?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "I don’t know that we’re seeing dramatically different demand in all the different regions. Heidi, if you look at our growth Q4 to Q4, it’s 80%, and so -- I’m not suggesting that Q4 to Q4 will be 80% again. I hope it will be but I’m not suggesting that. But the point being that there is some evidence that the consumption demand for GPUs is increasing and our expectation is that the growth of GPUs will overcome the seasonalities, whatever seasonalities that there is in Q1 and Q2."
},
{
"speaker": "Heidi Poon - Thomas Weisel Partners",
"text": "Great, and the pricing environment?"
},
{
"speaker": "Marvin D. Burkett",
"text": "Pricing environment -- pricing is good. We’re seeing more money spent on GPUs so it has an appreciation in the average selling price for all of the GPU business."
},
{
"speaker": "Heidi Poon - Thomas Weisel Partners",
"text": "Okay, great. Thank you."
},
{
"speaker": "Operator",
"text": "Shawn Webster, J.P. Morgan Securities."
},
{
"speaker": "Shawn Webster - J.P. Morgan Securities",
"text": "Good afternoon. Thanks for taking my questions and good quarter. On the -- just to follow-up on the pricing question, can you tell us what your sequential change in pricing was for your GPU business?"
},
{
"speaker": "Marvin D. Burkett",
"text": "Up nicely."
},
{
"speaker": "Shawn Webster - J.P. Morgan Securities",
"text": "Up nicely? Okay."
},
{
"speaker": "Marvin D. Burkett",
"text": "Yeah, it’s because we shipped a lot of the 8800 GTs, as Jen-Hsun said, so you would expect that. And so, you know, in the various segments the pricing was good. We would have had an ASP appreciation because of the higher volume of 8800 GTs."
},
{
"speaker": "Shawn Webster - J.P. Morgan Securities",
"text": "Okay, and then Marv, on the OpEx growth in Q1, can you give us a sense of how you expect your OpEx to grow after Q1?"
},
{
"speaker": "Marvin D. Burkett",
"text": "Oh, internally Jen-Hsun and I are working hard to keep it flat. We’ll see how successful we are."
},
{
"speaker": "Shawn Webster - J.P. Morgan Securities",
"text": "Like what, like very small incremental changes?"
},
{
"speaker": "Marvin D. Burkett",
"text": "We’ll see how successful we are."
},
{
"speaker": "Shawn Webster - J.P. Morgan Securities",
"text": "Okay, and then finally, can you talk about the supply environment and do you have any of your products where they are seeing lead times extended?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Supply is certainly an area of great concern of mine. You know, we are becoming -- we are the world’s largest fabless semiconductor company. The products that we build are very complex and the die sizes of our high-end GPUs is significantly bigger than CPUs and we now sell, as you heard earlier, over 100 million units a year and it’s still growing. And so these processors are -- consumer a lot of wafers and we are already the world’s largest, so it is important that we work very, very closely with our foundry partners. TSMC has done a wonderful job for us, UMC has done a wonderful job for us and my expectation that we’re going to take the fabless model to new heights. But when you are as large as we are and running as fast as we are, you can never take supply too seriously. So we obviously take it very seriously."
},
{
"speaker": "Shawn Webster - J.P. Morgan Securities",
"text": "And are you seeing your lead times stretch out or pull in for your graphics or chipsets? What’s the lead time environment like?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "The lead time hasn’t really changed."
},
{
"speaker": "Shawn Webster - J.P. Morgan Securities",
"text": "No change? Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Michael McConnell, Pacific Crest Securities."
},
{
"speaker": "Michael McConnell - Pacific Crest Securities",
"text": "Thank you. Looking at the guidance, Marv, for better than seasonal for Q1, is this really unique do you think to NVIDIA with respect to you had a lot of pent-up demand obviously for the 8800 GT, supply now is starting to improve, so with that dynamic that leads to, like you said, some growth in the desktop GPU business? Is that it or is there something more here?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "I think -- Michael, let me take that question. I think the GPU is just growing. I think the GPU market is growing and frankly, it ought to help anybody who builds a GPU. And so I consider -- the way I see it is visual computing is just becoming evermore important and so if other suppliers of GPUs are seeing ever-increasing demand, I’m not surprised by that. That’s kind of -- it’s not to do with -- I don’t think we’re capturing that much share."
},
{
"speaker": "Michael McConnell - Pacific Crest Securities",
"text": "Okay, and then if we look at just the competitive landscape for the fiscal year, can you just talk about what you think from a unit share perspective or a revenue share perspective, probably more importantly, with each of the three main business lines? Or even the four, if you talk out maybe desktop GPU, notebook GPU, MCP, and then workstations, relative to this last fiscal year?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "I don’t know that we’re that prepared to answer that question."
},
{
"speaker": "Marvin D. Burkett",
"text": "Not for a full year."
},
{
"speaker": "Jen-Hsun Huang",
"text": "I don’t think we break it out quite clearly that way."
},
{
"speaker": "Michael McConnell - Pacific Crest Securities",
"text": "Any timeframe though that you’re comfortable with at this point to discuss?"
},
{
"speaker": "Marvin D. Burkett",
"text": "Yeah, last quarter."
},
{
"speaker": "Michael McConnell - Pacific Crest Securities",
"text": "Okay."
},
{
"speaker": "Jen-Hsun Huang",
"text": "I really couldn’t -- I’m really trying to say this so that we all kind of hear it -- I believe we are growing the market. I mean, the share gains are nice and we’re going to continue to fight for our share and fight for more than that but -- but I honestly believe the market is growing. But you can’t look at the size of the GPU market by combining the -- by looking at last year’s GPU market of all suppliers, okay? And then try to think that this year, the opportunity is shifting a few dollars from here to there, because I don’t think that makes any sense. If that was the case and you added S3 and Cirrus Logic’s revenues together and Trident’s together of when we started, NVIDIA would be a $300 million company. And so obviously the GPU market and visual computing is becoming more and more important and what we are seeing here is and what we believe and what we had hoped all along is that the GPU is -- the overall market for GPUs is growing. And so you have to look at -- I frankly think that you have to look at -- in order to see the opportunities, you have to look at the entire electronics spend of the PC industry. There is a vast movement to re-architect the PC, to shift the resources around to deliver the best possible experience. And the best possible experience for each market category or each PC category [inaudible]. A gamer’s PC would have a different allocation of electronic spend. A all-in-one consumer multimedia oriented PC will have a different, another allocation. And so you have to look at all of the electronics dollars in order to decide how best to estimate the growth opportunity. But I think share is just simply not that interesting anymore and certainly it doesn’t explain our growth."
},
{
"speaker": "Michael McConnell - Pacific Crest Securities",
"text": "Okay, and then just a final one for me on the gross margin -- obviously the company has done a great job through the years of continuing to expand the gross margins. Taiwan Semiconductors talked ad nauseam over the second half of last year about trying to renegotiate pricing with some of their larger fabless customers. I understand the rationale behind what happened with the 8800 GT from a cost standpoint. Is there any type of pricing negotiations that also came into this with respect to the gross margin in Q4, or is that just -- it’s just purely demand exceeding supply and then as that -- we start to see more balance, the gross margins should start to come back?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "The gross margin impact of 8800 GT or the increased cost of 8800 GT was completely my fault. It has nothing to do with Taiwan Semiconductor Manufacturing Corporation. And we will have to accept all of that responsibility ourselves, unfortunately, and so -- now, the good news, of course, is that because it was completely our fault, we can completely fix it. I think that that one -- let blame where blame needs to go here."
},
{
"speaker": "Michael McConnell - Pacific Crest Securities",
"text": "Okay, so this is not anything in terms of pricing negotiations -- this is something that you think we can start to look -- we can continue to expand gross margins as we work through the fiscal year, you’re fairly confident on that?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "We would love to blame other people, Michael. Sometimes you have -- (Multiple Speakers)"
},
{
"speaker": "Michael McConnell - Pacific Crest Securities",
"text": "Okay, thanks."
},
{
"speaker": "Operator",
"text": "Tayyib Shah, Longbow Research."
},
{
"speaker": "Tayyib Shah - Longbow Research",
"text": "Hi, guys. Jen-Hsun, can you please describe the competitive landscape in the notebook space -- you versus AMD and then also discrete graphics versus integrated, as you head into the next refresh cycle?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "In the notebook segment, AMD has wonderful offerings. Don’t forget that AMD still has a terrific GPU design organization and so between NVIDIA and ATI, or AMD, it is the unambiguously the two best GPU design teams the world has ever seen. And so I give them a lot of respect and in the AMD notebook segments, the lower end segments, it is hard for us to differentiate relative to AMD. And as I said earlier, if we can’t differentiate, we don’t typically win the business. And so I’m not surprised and we’re not expecting to win any of those. We are going to fight hard for them but in the final analysis, I think AMD has good offerings there. In the upper half of the market, we have quite a bit of differentiation. Our advantage is that we invest more in GPU development than any company in the world today and potentially all of the competitors combined. And so our R&D investment, our commitment to GPUs, our velocity of innovation, that is our advantage on the upper half of the market, whether it’s notebooks or otherwise. So we have to -- that’s a -- that’s our velocity, our commitment and our level of innovation and level of investment is a structural advantage and so we have to sustain that."
},
{
"speaker": "Tayyib Shah - Longbow Research",
"text": "Okay, and Marv, just curious how you were able to build some inventory during the quarter -- does that reflect slightly better supply from the foundry or was this related to demand trends?"
},
{
"speaker": "Marvin D. Burkett",
"text": "No, it’s new products in the pipeline. You know, if you looked at the inventory build where it actually happened, it’s all new products which are just in the pipeline."
},
{
"speaker": "Tayyib Shah - Longbow Research",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our final question comes from the line of Glen Yeung from Citigroup."
},
{
"speaker": "Glen Yeung - Citigroup",
"text": "Thanks. So Jen-Hsun, can you just be clear as to what you think the PC market is actually doing in this environment? I understand that GPUs are growing and you may or may not be taking share within that, but just your overall sense of the PC market."
},
{
"speaker": "Jen-Hsun Huang",
"text": "We monitor sell-through and we’re fine. I mean, what we see is fine. We monitor our own sell-through. I guess I don’t monitor other people’s sell-through but sell-throughs look fine. You know, we watch it every single week around the world and it looks good. I don’t really know what else to say."
},
{
"speaker": "Glen Yeung - Citigroup",
"text": "No, fair enough. Any [differentiation] with what you see between an OEM basis or a white box basis?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Not really. Not really."
},
{
"speaker": "Glen Yeung - Citigroup",
"text": "Okay."
},
{
"speaker": "Jen-Hsun Huang",
"text": "You know, I think that it’s possible that the SKUs that we are in are selling well. It’s possible that people are preferring platforms that we’re designed into but I don’t really know. I think that overall, overall I believe that the movement -- there’s two things that are happening that are very, very big deals that I believe that we’re experiencing and we’re experiencing all over the world. The first thing is the importance of visual computing and therefore the GPU at the core of that. The second thing is the re-architecture of the reallocation of resources within the PC, that for different types of PCs, you ought to spend and invest your resources in different components. And so the balance between the CPU and the GPU is changing and I think those two factors combined are really, really important and we -- I don’t believe that to be a one quarter thing. I think it’s logical that is should be a permanent thing. It should be a forever thing. It happened to cars. It happened to just about any other mature industry that as the industry matures, you see all of these -- it bifurcates into the niches and the niches become large and in order to make a niche product specific, you can’t use the basic platform. You have to optimize it for the needs of that niche."
},
{
"speaker": "Glen Yeung - Citigroup",
"text": "I think I hear you and when I think -- I guess I’m thinking if we can add the product strength of the 8800 GT, then one can conclude that even if we were seeing some slowing in PC units at the moment, those trends may outweigh that -- fair assessment?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yeah, I do, I think that’s fair."
},
{
"speaker": "Glen Yeung - Citigroup",
"text": "Okay. And then just a quick question, Marv, for you -- you’d mentioned you’ve had some cost issues with the 8800, working through it. In your inventories that you had exiting the fourth quarter, are some of those, the high cost or lower margin parts, still in that inventory and do you expect to work them through in the course of the first quarter?"
},
{
"speaker": "Marvin D. Burkett",
"text": "No, I mean, if we had a cost issue, it means the parts aren’t there. It means that they were written off, so no, they’re not in that inventory."
},
{
"speaker": "Glen Yeung - Citigroup",
"text": "Okay, great. Thanks."
},
{
"speaker": "Operator",
"text": "There are no more questions at this time. I would now like to turn the call back over to Jen-Hsun. Please go ahead."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thank you all for joining us today. We look forward to reporting our progress for Q1."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, that does conclude the conference call for today. We do thank you for your participation and ask that you please disconnect your lines."
}
] | null | null |
NVDA | 3 | 2,008 | 2007-11-08 17:00:00 | Executives: Michael Hara - Vice President, Investor Relations Jen-Hsun Huang - President, Chief Executive Officer andDirector Marvin D. Burkett - Chief Financial Officer Ajay K. Puri - Senior Vice President - Worldwide Sales
Analysts: Hans Mosesmann - Raymond James Heidi Poon - Thomas Weisel Partners Shawn Webster - J.P. Morgan Simona Jankowski -Goldman Sachs Gurinder Kalra - Bear Stearns Michael McConnell - Pacific Crest Securities Tayyib Shah - Longbow Research Peter Karzaris - Citigroup Uche Orji - UBS Daniel Ernst - Hudson Square Research Sidney Ho - Merrill Lynch Nicholas Aberle -Caris & Company
Operator: Good afternoon. Thank you for holding. I would now like to turn the call to Mr.Michael Hara, Vice President, Investor Relations. Thank you, sir. You maybegin.
Michael Hara: Good afternoon and welcome to NVIDIA's conference call forthe third fiscal quarter ended October 28, 2007. On the call today for NVIDIAare Jen-Hsun Huang, NVIDIA's President and Chief Executive Officer; and MarvBurkett, NVIDIA's Chief Financial Officer. Before we begin today’s call, I would like to take care ofsome general administrative items. Your line has been placed on a listen-onlymode until the question-and-answer segment of today’s call. During this call, we will discuss some non-GAAP financialmeasures about net income, diluted net income per share, and gross margin whentalking about our results. You can find a reconciliation of these non-GAAPfinancial measures to GAAP financial measures in our financial release, whichhis posted on the investor relations page of our website at www.nvidia.com. Unless otherwise noted, all references to research numbersthroughout the call come from Mercury Research. This call is being recorded. If you have any objections, youmay disconnect at this time. Please be aware that if you decide to ask aquestion, it will be included in both our live transmission as well as anyfuture use of the recording. Also, shareholders can listen to a live webcast oftoday’s call via the investor relations page of our website at www.nvidia.com. The webcast will be available for replay until the company’sconference call to discuss its financial results for its fourth quarter fiscal2008. During the course of this conference call, we may makeforward-looking statements based on current expectations. Forward-lookingstatements, including statements as to the importance of uses for [VB use], ouroutlook, the impact, features, performance and availability of our products andtechnologies, our strategies, our growth and growth drivers, pertaining tofuture events and are subject to a number of significant risks anduncertainties. The company’s actual results may differ materially from resultsdiscussed in any forward-looking statements. For a complete discussion of factors that could affect thecompany’s future financial results and business, please refer to the company’sForm 10-Q for the period ended July 29, 2007, and the reports on Form 8-K filedwith the Securities and Exchange Commission. All forward-looking statements are made as of the datehereof based on information available to us today and, except as required bylaw, the company assumes no obligation to update any such statements. Thecontent of the webcast contains time-sensitive information that is accurateonly as of November 8, 2007. Consistent with the requirements under Regulation FD, wewill be providing public guidance directly in the conference call and will beunable to provide significantly more information in offline conversations orduring the quarter. Therefore, questions around our financial expectations shouldbe asked during this call. At the end of our remarks, there will be time for yourquestions. In order to allow more people to ask questions, please limityourself to one question. After our response, we will allow one follow-upquestion. I will now hand the call over to Jen-Hsun.
Jen-Hsun Huang: Thanks, Mike. Good afternoon and thank you for joining us.Today we are pleased to report record revenue, record net income, and recordgross margin. This is also our first billion dollar quarter. For our third quarter, revenue grew approximately 19%sequentially from Q2 and 36% from last year to a record $1.12 billion. GAAP netincome increased more than 121% year over year and GAAP gross margin improvedby 550 basis points from a year ago to a record 46.2%. Let me review some of our recent achievements. As the firstGPU company to reach the billion dollar quarter level, NVIDIA continues to beone of the fastest growing semiconductor companies in the world. Our GeForcedesktop and notebook GPU product lines each achieved record revenue. Thedesktop GPU product line grew 33% year over year and the notebook GPU productline grew 120% from last year. Our standalone notebook GPU share grew to 72%, up from 52% ayear ago. In September, we shipped our first ever single-chipmotherboard GPU for Inter processor based desktop PCs, the NVIDIA GeForce 7000GPU family. The GeForce 7000 family delivers the performance of an entry leveldiscrete GPU and leading graphics compatibilities when compared againsttraditional integrated graphic solutions. We estimate the Intel segmentrepresents approximately 40 million units of new addressable market opportunitynext year and expect it to be a strong growth driver for our GeForcemotherboard GPU business. In October, we launched the new GeForce 8800 GT GPU, thefirst in our family of 65-nanometer desktop GPUs. The 8800 GT combinesbest-of-gaming performance and best in HD playback at the $199 price point.Reviewers are calling the 8800 GT the next GeForce 4 TI4200. The TI4200 wascalled the perfect GPU at its time because it was simultaneously modern, highperformance, and well-priced. The TI4400 was one of the most successfulproducts in our history. The widely recognized tech website, AnandTech, wrote: “It’sreally not often that we have the pleasure to review such a product soimpressively positioned. The 8800 GT is a terrific part and is hitting thestreet at a terrific price. The performance advantage and price utterlydestroys our perception of the GPU landscape.” Our Quadro Professional Solutions business achieved recordrevenue and grew 37% year over year. During the quarter, we launched seven newQuadro solutions and most notably, the Quadro FX 370 and 570, which deliver ISBcertified hardware at sub $200 price points. The computer aided design industry is undergoing a massivetransition from 2D illustration to worldwide collaborative 3D design, and couldrepresent tens of millions of new CAD seats over the coming years. We believe the FX 370 and 570 are ideal solutions for theentry-level designer and we’ll continue to accelerate our growth in theprofessional solutions segment. And finally, we began shipments of the Tesla C870 GPUcomputing processor and the 870 desk side super computer products this quarter.The adoption of Tesla and the CUDA C language programming environment and toolsuite continues to accelerate. We believe we now have more than 3,600developers and 14 industry categories working with CUDA on excitingapplications ranging from automotive visions systems, biological simulations,computational fluid dynamics, seismic processing and imaging, speech synthesis,computational finance, quantum molecular dynamics, protein folding to computervision. Let me turn the call over to Marv to discuss our financialresults in more detail. I will return in a moment to discuss our businesses andgrowth drivers for Q4 and beyond.
Marvin D. Burkett: Thanks, Jen-Hsun. Today we’ll be looking at both GAAP andnon-GAAP results for our Q3 and nine months ended October 28, 2007. The onlydifference between GAAP and non-GAAP is stock-based compensation and its taxeffect. As Jen-Hsun stated earlier, revenue for the third quarterwas $1.12 billion, which is up 19% quarter to quarter and up 36% year to year.Obviously it was a very strong quarter, and our concerns at the beginning ofthe quarter as to the sustainability of the strength we saw in Q2 nevermanifested. Also at the beginning of the quarter, there were concernsrelated to production limitations. Through the efforts of our partners and ouroperation staff, we were able to overcome most of those limitations. In a few cases, our revenue was limited by production butrelative to our concerns at the beginning of the quarter, these were minor. In our GPU business, the growth was led by notebook, whichgrew 41% quarter to quarter and 120% year to year. The desktop business grew14% over the second quarter and was up 33% over the prior year. In the quarter,GeForce 8X products accounted for more than 80% of our desktop and notebookbusiness. Our MCP business grew 23% quarter to quarter, as we begin tosee traction in our new Intel platform products. PSB, our workstation business, grew 20% over the secondquarter and 37% over the prior year. Even our consumer business grew 6% overQ2. All in all, there was strong growth in all segments. On gross margins, we reported GAAP gross margin of 46.2%,which is up 90 basis points from Q2. Non-GAAP gross margin was 46.4%. We hadanticipated strong gross margin based on the growth in GeForce 8X products, theincrease in professional solutions, and the increase in PlayStation 3royalties. All of these contributed to the increase in gross margin. We are again pleased with our progress. Operating expenses were $268 million GAAP and $238 millionnon-GAAP. This was slightly higher than our guidance. A major factor in thisincrease was the improved performance and outlook for the whole fiscal year andhow that affected our variable compensation programs. For the quarter, we had to accrue an additional $8 millionas a catch-up based on the increased financial performance and expectations.This is a one-time catch-up. We ended the quarter with 4,609 employees, which is up 236from the second quarter, as we continue to aggressively higher, particularly onR&D. One-hundred-and-fifty-five of the 236 new employees were in R&D. Depreciation for the quarter was $33 million and capitalexpenditures were $70.4 million. The increase in capital expenditures can beattributed to two factors. We bought additional testers of $22 million. Thesetesters are consigned to our contractors in Asia for the increased production.We also purchased some land for $27 million in anticipation of buildingadditional space. Interest and other income was $19 million in the quarter,and the tax rate was adjusted down to 12% for the year-to-date. This resultedin a tax rate for the third quarter of 11.7%. This slight downward adjustmentresults from more international sales than anticipated, as well as higherR&D tax credits. On the balance sheet, cash and marketable securities endedthe quarter at $1.85 billion, which is an increase of $281 million from thesecond quarter, despite repurchasing $125 million of stock during the quarter. Operating cash flow hit $400 million in the quarter for thefirst time. Accounts receivable were $552 million, an increase of only $44million from the second quarter as the even profile of shipments during thequarter helped collections. DSO for the quarter was 45 days, down from 50 days in Q2. Inventory grew slightly to $306 million in spite of thestrong sales and production limitations. Most of the increase can be attributedto new products that were not introduced until after the end of the quarter.DSI for the quarter was 46 days. On the outlook, we’ve had two consecutive excellent quarterswhere revenue has exceeded our expectations. Even with this, we currently seestrong demand for our products and as a result, we expect revenue to grow inour fourth quarter. Revenue growth in the 5% to 7% range would be within ourexpectations. We expect our growth to be led by the continued strength inGPUs and new products in both GPUs and MCP. For gross margin, we’ve made excellent progress and we’llwork very hard to maintain our gross margin. New products will help but we arecurrently ahead of our plan and -- currently ahead of our plan in our progress. Operating expenses will increase in the fourth quarterdespite the catch-up that occurred in the third quarter. This increase is theresult of additional hiring and increased R&D expenses associated with newproducts. A total operating expense increase in the 3% to 5% is reasonable. We would expect the tax rate to stay close to our 13% but ifthere is any adjustment, it would have a downward bias. In summary, we expect an excellent Q4. I’ll now turn it backover to Jen-Hsun.
Jen-Hsun Huang: Thanks, Marv. We are entering the era of visual computing.Some of the most exciting applications required a GPU for the best experience.Industry expert PWC estimates the world wide videogame market to be $30 billionin size and expects the market to grow to $50 billion by 2010. According to ComScore, 217 million videogamers immersethemselves in online virtual worlds and expect that number to grow 17%annually. To date, there has been over 200 million unique downloads ofGoogle Earth. SketchUp makes it easy for millions of users around the world toconvert Google Earth into a full 3D world. Microsoft has shipped 85 millionunits of Vista and Apple’s new Leopard looks amazing and is a step forward inUI design. Both demand GPU to deliver the best experience. Our computing experience is increasingly enhanced by theGPU. As the largest GPU company and the world’s leading visual computingcompany, we are very well-positioned to continue to lead this revolution. Near term, we see multiple growth drivers. First, GeForcediscrete GPU -- GeForce GPU grew to 21 million units in Q3, up 30% from a yearago. The combination of our technology leadership, great content support, andthe ever-increasing importance of the GPU in our computing experience arecontributing to drive our growth. We estimate the installed base of GeForce tobe approximately 200 million units. That makes GeForce the largest game consolecommunity and a target-rich environment for game and application developers. We believe the PC game market is continuing to grow. Ouroverall enthusiast GPU segment grew 35% year over year. The GPU enthusiast GPUmarket grew 170%. Our strategy is to make GeForce one of the most importantprocessors of the visual computing era through technology leadership,increasing programmability, great content experience, and promoting our greatbrands. Second, GeForce motherboard GPU -- GeForce motherboard GPUsgrew to 10 million units per quarter, up 50% from a year ago. The GeForce 7000is off to a great start. We are now the only chipset supplier to support bothIntel and AMD processor platforms, and the only branded integrated GPU supplierfor the Intel processor platform. The integrated graphics opportunity represents approximately60% of the world’s PC market. Our strategy is to bring the benefits of GeForceto the most sensitive price segments while creating exciting platformarchitectures like SLI, hybrid SLI, and ESA. ESA, which was recently announced, stands for enthusiastsystem architecture. It’s a standard for system information protocol that linksthe systems various critical components, such as fan, power supply, smartchassis, GPU cards, and motherboards. It enables a unified architecture forapplications and users to control and optimize performance of their system. SLI, hybrid SLI, and ESA are examples of how NVIDIA createsarchitectures that advance the capabilities of the PC. Third, global proliferation of industrial design is drivingQuadro growth -- NVIDIA's Quadro brand is the de facto standard for [inaudible]visualization. Quadro is not just a GPU. Quadro is a professional class of GPUsthat incorporate features demanded by creative professionals, as well assoftware that completes a solution need for each vertical market, whether auto,medical imaging, film, or financial markets. We are experiencing multiply simultaneous dynamics in theprofessional market. Traditional 2D design and illustration is transitioning tocollaborative 3D design and product lifecycle management. Globalization isforcing multi-side design teams around the world to adopt common platforms, andis fostering the growth of local industries in China and in India. All thesedynamics are expanding the workstation TAM. Fourth, GPU computing with CUDA and Tesla -- CUDA is a dataparallel programming environment build on C. CUDA runs on all the millions ofG80 based and beyond GPUs, whether Quadro, GeForce, or Tesla. Tesla is the brand of GPU software systems solutions that istargeted at the high-performance computing market. The initial adoption ofTesla will be inclusion into super-computing clusters. Next year, we should seedesk side personal super-computing workstations powered by Tesla for dataparallel super-computing and Quadro for interactive visualization. And with CUDA on GeForce, we will quickly reach 100 millionunit per year run-rate for CUDA powered GPUs for the consumer market. Forconsumers, CUDA on GeForce will enhance applications like video and imageprocessing and physics processing for games. CUDA is one of the most revolutionary and disruptive ideasfrom our company. CUDA has ignited interest on GPU computing all of the world.There is growing understanding that the data parallel architecture of a GPU isradically different than that of a CPU and for a large class ofcompute-intensive data parallel applications, the GPU can increase performancefrom 10 to several hundred times. Fifth, we expect our first application processor to sampleat the beginning of next year. We believe another personal computer revolutionis about to happen. Mobile devices like phones, music players and portablenavigation devices will all increasingly become multi-function, multi-taskingpersonal computers. If so, the architecture of these devices will increasinglybecome consumer PC like and be capable of delivering all the entertainment andweb experiences we enjoy on a PC today but in the form factor that fits nicelyin your hands. Our mobile strategy is to drive the second personal computerrevolution by creating a from the ground up application processor and system ona chip that enables this experience. AP15, as it is called internally, is the culmination ofseveral hundred man years of R&D. The mobile application processor is anarea where we can add a tremendous amount of value and represents a severalhundred million units a year growth opportunity. We are happy to take your questions now.
Operator: (Operator Instructions) Our first question comes from theline of Hans Mosesmann from Raymond James. Please go ahead, sir.
Hans Mosesmann -Raymond James: Hello, can you hear me? Congratulations, guys. A quickquestion; the GeForce 7000 motherboard GPU, what kind of average selling priceare we talking about here, and are they consistent with the average sellingprices of the A&B platform version?
Jen-Hsun Huang: The ASPs on the MCP73 or the GeForce 7000 is slightly higheron the Intel side, but it should be targeted -- we are targeting that productto be in the mainstream price sensitive segment so that we can bring GeForce toas many people as possible. That’s a rather large segment and we think itrepresents about 40 million units of incremental opportunity for us next year.
Hans Mosesmann -Raymond James: Is that a $50 ASP, a $100 ASP? I just want to get a generalsense of the magnitude.
Jen-Hsun Huang: Oh no, it’s in the teens. It’s designed to be on themotherboard. It’s intended to be in the teens and we want it to be asaffordable as possible so that we can address the largest possible marketsegments.
Hans Mosesmann -Raymond James: Okay, great. That’s it. Thanks a lot and congratulations.
Operator: Our next question comes from the line of Heidi Poon fromThomas Weisel Partners. Please go ahead.
Heidi Poon - ThomasWeisel Partners: Hello? Can you hear me?
Jen-Hsun Huang: Yes.
Heidi Poon - ThomasWeisel Partners: Can you describe what you expect further for notebooks? Iknow the general trend of desktop to notebook transition is still there, butmost of your wins have been indiscrete. As AMD and Intel come up with theirintegrated graphics platform, also supporting DX10, where do you think you cantake your market share gains to next year and after that?
Jen-Hsun Huang: Well, it’s really hard to say what our market share will bein the future but we’ve been competing against integrated graphics for quite along time and our ability to succeed will depend on continuing to do the typeof things that we do well, which is come up with great ideas, like SLI andhybrid SLI, and bring value to the marketplace like we do with GeForce andQuadro. So we’re going to continue to do those things and if we do our jobswell, we should continue to grow and if we don’t, then obviously thecompetition will do better.
Heidi Poon - ThomasWeisel Partners: But do you think you might have a disadvantage because ofthe power consumption factor?
Jen-Hsun Huang: How is their integrated graphics lower power consumptionthan ours? In fact, I think that you know, probably, that NVIDIA's G8Xarchitecture is the most efficient performance per watt GPU in the marketplacetoday and that explains why we’re able to get our enthusiast level GPUs into asingle slot with a single slot fan, why our fan noise is substantially lowerand obviously our measured power to be substantially lower. That’s somethingyou can do with architecture, that’s something you can do with innovativecircuit design techniques, and so on and so forth, and system technologies tomanage it at the system level. So there are all kinds of competitive capabilities for us toinnovate and power and we believe we are absolutely world class in that area.
Heidi Poon - ThomasWeisel Partners: Okay, great. Thank you.
Operator: Our next question comes from the line of Shawn Webster fromJ.P. Morgan. Please go ahead, sir.
Shawn Webster - J.P.Morgan: Thank you very much for taking my question. Can you give anupdate -- I mean, a lot of folks, especially investors in the PC chip relatedcompanies, are concerned on linearity, risk of double ordering, have thingsbeen too good for too long -- can you guys share with us some of your thoughts?I think Marv, you had some comments on linearity. Maybe you could talk about orderlinearity as the quarter progressed, how your backlog looks, and any risk thatyou can tell in terms of doubleordering?
Marvin D. Burkett: Our Q3 was one of the most linear that we’ve had. Thestrength that we saw in orders in Q2 continued straight through Q3, and so ifyou wanted to look at a backlog, we are not a backlog focused type company butthere was no change. The orders and the shipments were ratable all the waythrough. Obviously you are always concerned about is there any double ordering goingon, but we don’t see the evidence of that.
Jen-Hsun Huang: The way I would -- the way I think through that problem isfirst of all, we don’t know what we don’t know, and obviously nobody does. Andthe marketplace is rather robust, and I think it’s rather robust for us for avariety of reasons. I think the -- first of all is new products always helps,and the 8800 GT is arguably the best product that NVIDIA has built in fiveyears. That’s what everybody is telling us, that’s how we feel about it, and wehave very, very big hopes for it. We have MPC73, which is our first product of that categoryand bringing GeForce to the Intel motherboard is pretty exciting stuff, and theearly adoption has been wonderful. Both of those products we just can’t make enough of, andthere are good reasons for their growth. I think overall, the GPU dynamic ispretty clear now, that PC games, online games is one of the fastest growingapplication sectors. Vista is doing well. Leopard is amazing. There are moreand more applications that in combination with a GPU is just a betterexperience. And then we have new innovations like Tesla and CUDA, andthere is a very logical reason why there is industrial growth in design. Whenwe globalize the China and India and other Eastern European countries and wecollaborate across the network and we design 24 hours a day, it makes perfectsense that you would need compatible workstations all over the world. And simultaneously, some of these economies are no longerjust manufacturing economies but they are moving into design economies, and soas you know, China is moving very, very quickly up the food chain and more andmore unique designs are coming out of China. Well, they need workstations forthat. I think if you combine whether it’s new products that we areintroducing in the market that we serve today, the importance of the GPU, newindustry growth form workstations, or a new disruptive technology that we’vecreated with Tesla and CUDA -- those are all important reasons why we are growing.
Shawn Webster - J.P.Morgan: Thank you. You guys mentioned that you had a couple of areasthat were still tight from a capacity perspective. Could you share with us whatareas those are?
Marvin D. Burkett: Jen-Hsun just mentioned a couple of them; MCP73 and some ofour GeForce 8 products were capacity limited or production limited in thequarter.
Shawn Webster - J.P.Morgan: Okay. Thank you very much.
Operator: (Operator Instructions) Our next question comes from theline of Simona Jankowski with Goldman Sachs. Please go ahead.
Simona Jankowski - Goldman Sachs: Thanks very much. I just wanted to get a better sense onyour Q4 guidance; how much of that is based on your expectations for furthershare gains versus the end market growth for other factors, such as potentiallyASP increases?
Jen-Hsun Huang: We don’t count on share growth. That happens after you aredone counting it and so -- unless it’s a design win or whatever it is that weknow, we don’t typically count on share growth. So we count -- we look at thestrategic position of our products, we look at the new products that we’reintroducing and therefore we’ve got some confidence on its pricing power. Wecount on new markets that we are entering opening up and so we count on avariety of things. And of course, OEM design wins are OEM design wins, butotherwise we try not to be too bullish on market share wins.
Marvin D. Burkett: We also don’t anticipate any changes in ASPs in the variousmarket segments. That’s not [ending growth].
Simona Jankowski - Goldman Sachs: Okay, so it sounds like a lot of it is just the end marketcontinues to be very robust.
Jen-Hsun Huang: Yes. And we are entering new markets and we are creating newproducts for existing markets as well. So those are -- when somebody -- when westarted to ship Tesla, that’s a product that’s one of its -- it’s the first ofits kind and it adds so much value and the people that buy it initially arepeople who are desperate to have more computing resources. Products like the 8800 GT, it’s an existing market that weserve but it’s very disruptive because of its price performance is just soterrific and it really promotes very, very quick adoption and oftentimes iteven encourages pretty broad-based upgrades. And you know that there’s a whole bunch of games coming outthis Christmas with DX10 and the games look really terrific, so -- so there’sjust a lot of reasons why the GPU is doing well.
Simona Jankowski - Goldman Sachs: I appreciate that color. Just one other question that issomewhat related; you mentioned that you think the motherboard GPU is anincremental 40 million unit opportunity. These products seem to be competingvery effectively against the low end of the discrete GPU market and seem tohave a significantly lower price point. So do you view this as an incremental opportunity or do youview this to some extent as asubstitution of some of the existing stack of the product?
Jen-Hsun Huang: The GeForce 7000 really isn’t high performance enough to bea replacement for even our entry level GPU, so that’s not -- and you know ourdiscrete GPU, as one of the data points that Marv just mentioned, our discreteGPU will be vastly converted to DX10 very, very shortly. So this is reallytargeting the segment that’s underneath it, the 60% of the marketplace that wedon’t really serve today.
Simona Jankowski - Goldman Sachs: That’s very helpful. Thank you.
Operator: Our next question comes from the line of Gurinder Kalra withBear Stearns. Please go ahead.
Gurinder Kalra - BearStearns: Thanks for taking my questions. My first question is on theGeForce 8800 GT. It’s a great product but do you think there is any chance itmight be cannibalizing some other very high priced products? And given that it’s priced around $200, $249 but on65-nanometer, how does it affect your gross margins going forward?
Jen-Hsun Huang: Well, we always try to be thoughtful about how our productscan cannibalize their own products, but I think we understand this marketpretty well and if it’s possible to cannibalize our products, well, I’d ratherdo it myself than wait around for somebody else to come and do it, and so I’mnot too worried about that. That’s just really the nature of our business andwe have to stay aggressive. We want to stay aggressive and we want to bring asmuch as we can to the market. I’m not inclined really to slow down because it somehowprotects my own business. My own business will have to figure out a way to dealwith my own business. So that’s our strategy there, nice and simple. But I thinkour high-end products will continue to be best of its kind, best of its class,and I think the market will be fine there.
Marvin D. Burkett: As far as margins go, the margins on the 8800 GT areexcellent, well above corporate margins.
Gurinder Kalra - BearStearns: Thanks. Just a follow-up question on the general purposeGPU/Tesla, can you discuss some of the traction or the design wins you areseeing in the financial services industry and the headway you made there?
Jen-Hsun Huang: There is a lot of development going on using GPU computingfor computational finance. As you guys know, your industry has some of thebrightest mathematicians in the world and the amount of computation you guysneed is completely unbounded. You just don’t seem to be able to get a largeenough server or enough of them. We’ve demonstrated that GPU can be used to acceleratefinancial computational finance by 10 times, 20 times, and severalapplications, 50 to 100 times. And that’s a very, very large step up inperformance improvement, and so there’s quite a bit of development in thatarea. It’s happening all over the world. It’s happening in London. It’shappening in New York. This is an area that I think is going to be prettyinteresting for GPU computing.
Gurinder Kalra - BearStearns: Thanks very much.
Operator: Our next question comes from the line of Michael McConnellof Pacific Crest Securities. Please go ahead.
Michael McConnell -Pacific Crest Securities: Thanks. On the G92 or the 8800 GT, when are you expectingcrossover on that, relative to the 8800 GTS?
Jen-Hsun Huang: Crossover -- let me --
MichaelMcConnell - Pacific Crest Securities:
Jen-Hsun Huang: Let me explain it this way. I think this will do it. We willship more 8800 GTs this quarter then we shipped last quarter of 8800 GTS. [Multiple Speakers]
Jen-Hsun Huang: Go ahead.
Michael McConnell -Pacific Crest Securities: I’m sorry to interrupt -- this will be -- would you say thisis probably your most aggressive ramp in history, maybe of a product?
Jen-Hsun Huang: This is one of our most aggressive ramps and the reason forthat is because it is such a great product. We have a really rich backlog oforders for 8800 GT. And although the market now knows what the competition hasand our customers know what the competition has and they are voting with theirorders. We are going to be very, very aggressive with 8800 GT. It’sjust such a great product. Five years ago we had the 4200TI, TI4200 and themarket called it the perfect GPU. And the reason for that was because it was abrand new architecture, it was extremely high performance, and it was veryaffordable. It was $199 and it lit that segment on fire and it was -- wecouldn’t build enough of that 4200 for a very long time. We think we’ve got another 4200 on our hands and certainlythe market has effectively called it that.
Michael McConnell -Pacific Crest Securities: I guess -- I know you don’t -- it’s tough to predict marketshare. You guys have obviously dominated this segment in the high-end. With the-- could you talk about just the basis for having such an aggressive ramp? Imean, do you really feel like you could take more market share, or is this justyou are ramping in accordance to the demand out there, which is quite strong?
Jen-Hsun Huang: There’s always competition in our space. This is one of the-- the GPU industry is one of the most vibrant industries and the reason forthat has to do with the fact that Moore’s Law is still GPU’s friend, or GPU isstill Moore Law’s friend. This is one of the few technology segments left wheremore transistors and new algorithms and new technology could enable betterexperiences. Almost all of the other semiconductor sectors are seeing smallerdie sizes every year and lower ASPs every year, but not the case with the GPU. I expect this to be an area of quite a bit of vibrance for adecade to come. In terms of how quickly we ramp, that’s just the way we dothings. We need to bring out new architectures and we need to bring it out asbroadly as we can because as soon as we launch one unit of 8800 GT, everybodyin the world is going to want it and so you might as well assume that you are buildingfor everybody in the world and so that’s kind of the approach that we take. And we want to stay aggressive as a company. That’s just ournature.
Michael McConnell -Pacific Crest Securities: And then a final question, just on the GeForce 7 series chipsetsfor Intel’s platforms, can you talk about the early traction you are seeing,both at OEMs and then maybe separately in the channel, and just how that’sprogressing and the outlook, if you have one, for next year?
Jen-Hsun Huang: We’re expecting to be every successful with OEMs as well asthe channel, and so it’s designed -- it’s designed to -- NVIDIA's brand and thequality of our technology and the rich support that we offer in drivers, as theindustry gets more complex with DX10s and OpenGLs and high definition videosand all of these different applications, our software capability becomes anincreasing advantage. And just because it’s integrated on the motherboarddoesn’t mean the software isn’t complex. That’s an area that we are extremely good at, and so it’s --my sense is that we will be very successful in both OEMs and the channel. Andyou’ll see it soon.
Michael McConnell -Pacific Crest Securities: Okay, and Marv, have you guys thrown out a target for nextyear within that business, or just quantified what the opportunity could be fornext year? I don’t know if you have or have not.
Marvin D. Burkett: No, we have not.
Michael McConnell -Pacific Crest Securities: Would you care to, or --
Marvin D. Burkett: Only it’s a significant growth driver next year, but no, wehaven’t quantified it.
Michael McConnell -Pacific Crest Securities: Okay, great. Thanks, guys.
Operator: Our next question comes from the line of Tayyib Shah withLongbow Research. Please go ahead.
Tayyib Shah - LongbowResearch: Congratulations on the quarter. The notebook market has beendoing very well lately, but maybe partly at the expense of the desktop segment,where you have higher exposure. Can you help us understand how desktopreplacement by notebooks is likely to affect your business going forward, nowthat you already have 70%-plus share in notebooks?
Jen-Hsun Huang: The notebook market is certainly doing very well and Iexpect that one of the areas where the notebook market is just starting to seegrowth but it will see a lot more growth in the coming years is the gamingnotebook segment, and the mobile workstation segment. These two segments aregrowing very quickly and I expect that we’ll be able to add a lot of value tothose two platforms in the future. We’re not too hung up about where people buy our GPUs. We’redelighted by the proliferation of platforms and whereas people typically tendto have one or two PCs, desktop PCs in their house, they may have four, and inmy case eight, laptops at home. It’s a little bit like a cellphone, I guess andyou just buy a whole bunch of them over time. I think that the notebook market is not completely areplacement market, frankly. I think that a lot of it is an additive market andcertainly it has exceeded most people’s expectations.
Tayyib Shah - LongbowResearch: Another question along the same lines, as your footprintwithin the notebook market has grown, have you been finding this market morecompetitive than your discrete GPU business, given that in this business, Intelcan bundle their chipsets with their CPUs, if they want to?
Jen-Hsun Huang: Intel is definitely a very competitive company and we are --we’ve been competing against bundling for quite some time, whether it’s pricebundling or other bundling. The bottom line is we just have to add value. We just haveto add value. NVIDIA is not a commodity player and we serve the marketplaceswhere we could -- where visual computing is really important. If 3D matters toyou, and if your work matters to you and you do 3D work, whether it’s in designor film or medical imaging, then we could add a lot of value to you. And ifyour business really depends on having a great GPU and visual computingcapability, I think NVIDIA is really your partner.
Tayyib Shah - LongbowResearch: Thank you.
Operator: (Operator Instructions) Our next question comes from theline of Glen Yeung with Citigroup. Please go ahead.
Peter Karzaris -Citigroup: This is Peter [Karzaris] for Glen Yeung. A question just onASPs; I was wondering if on a mixed basis, your ASPs were able to improve indesktops and notebooks from second to third quarter?
Marvin D. Burkett: No, they were relatively flat.
Peter Karzaris -Citigroup: Despite mix? And then on -- I noticed margins were up andyou talked about I think royalties from Sony as being one of the drivers. Butconsumer revenue was up about 6%. I was wondering if you could give us anyother color around consumer revenue and then also, if you could just help usunderstand maybe the total impact that that had on, that royalties had on grossmargin improvement?
Marvin D. Burkett: Well, you know, any increase in royalties is 100% grossmargin, so I would say that our royalty income from PS3 increased significantlyfrom Q2 to Q3. It more than doubled, so that had an impact on our grossmargins. Was it the driving factor? Probably not, but it was one of the factorsthat improved gross margins. The fact that that increase would probably account for mostof the increase in the consumer business is probably true.
Peter Karzaris -Citigroup: Great. Thanks.
Operator: Our next question comes from the line of Uche Orji with UBSInvestment Bank. Please go ahead.
Uche Orji - UBS: Can I just get a sense of where the professional servicesbusiness will go next quarter? I mean, I see your guidance and your[inaudible], but that division is pretty critical for driving overall grossmargin, so if you can give us some color as to what we should expect withinthat division next quarter, that would be helpful. And a second question is about your handset strategy. Iunderstand your push on the apps processor direction, but do you see the lackof a baseline solution as something that could become a problem for theapplication of that strategy? If you can give me some color, that would behelpful. Thanks.
Jen-Hsun Huang: I guess on the first one, we really haven’t and we don’tgive too much granular guidance at the business unit level. All I can tell youis that the professional solutions group is doing well and they arestrategically very well-positioned and they add a lot of value to themarketplace. Our business of -- what some people call the workstationsbusiness, what we call the professional solutions business is really acombination of technology, GPU technology and a lot of software, systemcomponent technology, and expertise. We have one -- we have one of the, if notmy expectation to be the largest developer technology organization in the worldand we help inspire and we help solve some of the most challenging visualcomputing problems in the world through that organization. So I expect it to do well. We haven’t really given it muchguidance. With respect to our application processor business, we aregoing to focus on the segments of the handheld marketplace where computing isparticularly important. If you take a look at all the handhelds in the world,really with the exception of the iPhone, every other phone in the world wantsto be a computer but has a long way to go. And this is where we could add a lotof value. NVIDIA is fundamentally a computer technology company. Weare one of the world’s largest computer technology companies and there are veryfew consumer oriented computing platforms where we can’t, from the ground up,design an entire computer for you. So this is an area that we could add a lot of value. We areseeing a lot of interest in the work that we are doing and when I said severalyears ago that this is going to be the second personal computer revolution andthat the phone is going to become a computer first and a phone second, at thetime it sounded kind of odd but I think it makes a lot of sense now.
Uche Orji - UBS: That’s helpful. Thank you very much.
Operator: (Operator Instructions) Our next question comes from theline of Daniel Ernst from Hudson Square Research. Please go ahead.
Daniel Ernst - HudsonSquare Research: Thanks for taking the call. Two, if I might; first, on themainstream growth and maybe also the low end of the discrete, obviously in thedomestic market, so much enthusiasm around digital video and high resolutionphotography with things like YouTube and digital SLRs, and so that’s about --and the uptake of Premium Vista, I assume that that’s been a lot of the growththere. But can you talk about that same market overseas where so much more ofthe overall PC market growth is, and particularly in developing countries like Indiaand China whereI assume the market is more price sensitive. And then secondly on the mobile phone business, you gave usa little bit of mapping for the app processor, but can you just give us alittle bit of color about the current mobile phones business and how that istracking, relative to expectations? Thanks.
Jen-Hsun Huang: I would say that the developing markets are being drivenright now by online games, which is really a craze in China and India and theonline game market is really doing fabulously out there. Games are free and youpay for the service and you pay as you go, and it’s a really great way for themto meet their friends and meet people on the web. So those -- that’s a real growth driver. Another one, ofcourse, is their purchasing power in the foreign countries are becoming quitegood and as a result, they can buy up on their configurations. And one of thebest ways to improve your experience to buy up on the configuration is to add aGPU. Those factors are quite important growth drivers for us internationally,irrespective of Vista. Internationally, Vista is doing well everywhere. I don’tthink it’s not doing well in China. I frankly think that it is doing very wellin China and it will do very well in India as well. Any consumer will [enjoy]Vista. With respect to the application processors, the handheldbusiness, we haven’t shipped much application processors. We haven’t shippedany of our AP15 yet, so all of our current handheld business is from theexisting handheld GPU business, which met expectations. It’s not intended togrow and it’s likely to continue to decline. This quarter I think it declinedbut we are not expecting that business to grow because we are not out trying toget anymore design wins. We are really focusing now on building our applicationprocessor and this is where we are going to drive the market.
Daniel Ernst - HudsonSquare Research: Do you see a bit of an air pocket then between the currentgen, the mobile GPU that you have now and the integrated app processor?
Marvin D. Burkett: No, not really, mainly because it’s not significant portionof our business right now.
Daniel Ernst - HudsonSquare Research: Got it. Thank you.
Operator: Our next question comes from the line of Sidney Ho fromMerrill Lynch. Please go ahead.
Sidney Ho - MerrillLynch: Thanks for taking my question. It’s a question on grossmargin. You are at 46.2% this quarter and I’m not going to ask for specificguidance, but if you look forward say for the next 12 months, what are some ofthe biggest endeavors that can improve margins, both at the gross and operatingmargin level? Is it more like a product mix between chipsets, [GPU Tesla] orbetween product families like the G92, or is there something else?
Jen-Hsun Huang: We’ve not increased our gross margins by raising pricesonce, and the reason for that is because it’s hard to grow while you areraising prices. And so we remain very competitive in the marketplace. Where we’ve improved all of our gross margins is internaloperational improvements. And I’ll tell you that I have a lot of work left todo, so -- there are quite a bit of -- just the things that we can do inside,all within the walls of our company, we have many, many ideas on improvinggross margins through better operations, better execution.
Marvin D. Burkett: The mix will affect gross margins, depending on where thegrowth comes from. But having said that, our total focus is improving the grossmargins on each of the business segments, and Jen-Hsun is right; there’s lotsof things that we could do better so I still see room for gross marginimprovement in each of the businesses.
Sidney Ho - MerrillLynch: One follow-up question; for the professional services group,can you tell us how did the average selling price do for the quarter? And also,if you can tell us how much was the contribution from Tesla during the quarter,which I don’t expect much, that would be great. Thanks.
Jen-Hsun Huang: Tesla was very little. It’s just beginning to ship, so it’svery little. And we’re expecting it to be small relative to the overall size ofthe company in its first year. The most important thing about Tesla is targeting it at thetype of applications where they can really use the help right away, whetherit’s oil and gas or imaging, medical imaging, or computational finance. Thereare all kinds of applications out there that could really benefit from it.Meanwhile, we are driving CUDA, which is the programming environment, into allof our GPUs so that we can bring GPU computing to the masses. Both of those efforts are ongoing and I frankly think thatthe progress is extremely high and better than we had expected by far, by a lot.
Marvin D. Burkett: As far as the ASPs go, ASPs are in the hundreds of dollars.They are not -- it gets to be a complex mix of products there, so let me justsay it’s hundreds of dollars.
Sidney Ho - MerrillLynch: So was it up from last quarter?
Marvin D. Burkett: No, relatively flat.
Sidney Ho - MerrillLynch: Okay, great. Thanks.
Operator: Our next question comes from the line of Nicholas Aberlefrom Caris & Company. Please go ahead.
Nicholas Aberle - Caris & Company: Good afternoon. Nice quarter, guys. Question had to do withASPs; I know we talked about ASPs here in the most recent quarter. You guyshave done a great job over the last couple of years in improving those. What isthe expectation over time for ASPs? Do we have a substantial move higher fromcurrent levels based on Tesla?
Jen-Hsun Huang: The way we think about ASPs here, the way I think about ASPsis we have to make the GPU more valuable. The more programmable we make it andthe more applications take advantage of it, the more people will spend inbuying GPUs because it will enhance our computing experience. Now that trend has been moving very aggressively over thelast couple of years, with all of the applications that I’ve already talkedabout and the growth of the gaming market and amazing applications like GoogleEarth and Microsoft’s Virtual Earth 3D. These types of applications are justcontinuing to make the GPU more important and so that’s our focus. My expectation is absolutely the GPU ASP will continue toincrease, and the reason for that is because I expect to make it more valuableand people will see the value and hopefully choose to buy a better GPU.
Nicholas Aberle - Caris & Company: Perfect. Looking back over the last couple of years, youguys have refreshed the halo product, the enthusiast desktop product abouttwice a year, it looks like every fall and spring. You guys just did 8800 Ultraback in the spring. Should we be expecting another enthusiast refresh herebefore the end of the year?
Jen-Hsun Huang: Well, we are at the end of the year and -- we decided thatthe refresh that we would do this time was 8800 GT, and this is just a barnburner refresh. We are really, really proud of the 8800 GT and we are going toput our focus here. From 8800 GT, you could obviously do SLI and soon you’ll beable to do three-way SLI, so you are going to be able to put a lot of GPUhorsepower into your system, starting with a very affordable 8800 GT, and so --this is our focus for now.
Nicholas Aberle - Caris & Company: I’ll just sneak one more question in; Intel back inSeptember bought a small company called Havoc, does acceleration, physicsacceleration software. Just was wondering if you guys are in the market forthat IP. I know you guys have worked with them in the past and how that maybehas an effect on the longer term landscape.
Jen-Hsun Huang: No, no current plans.
Nicholas Aberle - Caris & Company: But no commentary regarding how their purchase of Havocaffects maybe their IP positioning relative to yours in physics acceleration?
Jen-Hsun Huang: Oh, I didn’t know that was the question you asked. You askedme about my plans. I don’t have any plans. I don’t know why they bought Havoc. Physics is -- physicsprocessing has a long ways to go and there are so many companies out there.There’s quite a few -- quite a few middleware companies out there that arecreating technology in this area, and many gamers, many game developersincorporate their own physics engine. So my sense is that there’s a lot ofinvention still left to do in this area. I’m not sure why they bought thatcompany, to tell you the truth. It might give them some advantages with respectto Havoc but it obviously creates negative synergies everywhere else. But that’s -- I don’t know why they did it, and so you’reasking really the wrong person. Strategically, I don’t know that it has anyreal bearing on the work that we are doing.
Nicholas Aberle - Caris & Company: Thanks. Good luck in Q4, guys.
Operator: Thank you. There are no more questions at this time. I wouldnow like to turn the call back over to Jen-Hsun. Please go ahead.
Jen-Hsun Huang: Thank you. NVIDIA's strategy is to be the world leader invisual computing by leading the GPU revolution while creating innovativetechnologies that enable and inspire amazing applications. The GPU is increasingly central to our computing experienceand although hundreds of millions of users already enjoy 3D applications andUIs like Vista and Leopard, this is just the tip of the iceberg of thepotential of the GPU. We intend to drive our growth by continuing to extend theGPU to more applications, more platforms, and to more people. Thank you forjoining us today. We look forward to reporting on our results for Q4.
Operator: Ladies and gentlemen, that does conclude the conference callfor today. We thank you for your participation and ask that you pleasedisconnect your lines. | [
{
"speaker": "Executives",
"text": "Michael Hara - Vice President, Investor Relations Jen-Hsun Huang - President, Chief Executive Officer andDirector Marvin D. Burkett - Chief Financial Officer Ajay K. Puri - Senior Vice President - Worldwide Sales"
},
{
"speaker": "Analysts",
"text": "Hans Mosesmann - Raymond James Heidi Poon - Thomas Weisel Partners Shawn Webster - J.P. Morgan Simona Jankowski -Goldman Sachs Gurinder Kalra - Bear Stearns Michael McConnell - Pacific Crest Securities Tayyib Shah - Longbow Research Peter Karzaris - Citigroup Uche Orji - UBS Daniel Ernst - Hudson Square Research Sidney Ho - Merrill Lynch Nicholas Aberle -Caris & Company"
},
{
"speaker": "Operator",
"text": "Good afternoon. Thank you for holding. I would now like to turn the call to Mr.Michael Hara, Vice President, Investor Relations. Thank you, sir. You maybegin."
},
{
"speaker": "Michael Hara",
"text": "Good afternoon and welcome to NVIDIA's conference call forthe third fiscal quarter ended October 28, 2007. On the call today for NVIDIAare Jen-Hsun Huang, NVIDIA's President and Chief Executive Officer; and MarvBurkett, NVIDIA's Chief Financial Officer. Before we begin today’s call, I would like to take care ofsome general administrative items. Your line has been placed on a listen-onlymode until the question-and-answer segment of today’s call. During this call, we will discuss some non-GAAP financialmeasures about net income, diluted net income per share, and gross margin whentalking about our results. You can find a reconciliation of these non-GAAPfinancial measures to GAAP financial measures in our financial release, whichhis posted on the investor relations page of our website at www.nvidia.com. Unless otherwise noted, all references to research numbersthroughout the call come from Mercury Research. This call is being recorded. If you have any objections, youmay disconnect at this time. Please be aware that if you decide to ask aquestion, it will be included in both our live transmission as well as anyfuture use of the recording. Also, shareholders can listen to a live webcast oftoday’s call via the investor relations page of our website at www.nvidia.com. The webcast will be available for replay until the company’sconference call to discuss its financial results for its fourth quarter fiscal2008. During the course of this conference call, we may makeforward-looking statements based on current expectations. Forward-lookingstatements, including statements as to the importance of uses for [VB use], ouroutlook, the impact, features, performance and availability of our products andtechnologies, our strategies, our growth and growth drivers, pertaining tofuture events and are subject to a number of significant risks anduncertainties. The company’s actual results may differ materially from resultsdiscussed in any forward-looking statements. For a complete discussion of factors that could affect thecompany’s future financial results and business, please refer to the company’sForm 10-Q for the period ended July 29, 2007, and the reports on Form 8-K filedwith the Securities and Exchange Commission. All forward-looking statements are made as of the datehereof based on information available to us today and, except as required bylaw, the company assumes no obligation to update any such statements. Thecontent of the webcast contains time-sensitive information that is accurateonly as of November 8, 2007. Consistent with the requirements under Regulation FD, wewill be providing public guidance directly in the conference call and will beunable to provide significantly more information in offline conversations orduring the quarter. Therefore, questions around our financial expectations shouldbe asked during this call. At the end of our remarks, there will be time for yourquestions. In order to allow more people to ask questions, please limityourself to one question. After our response, we will allow one follow-upquestion. I will now hand the call over to Jen-Hsun."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks, Mike. Good afternoon and thank you for joining us.Today we are pleased to report record revenue, record net income, and recordgross margin. This is also our first billion dollar quarter. For our third quarter, revenue grew approximately 19%sequentially from Q2 and 36% from last year to a record $1.12 billion. GAAP netincome increased more than 121% year over year and GAAP gross margin improvedby 550 basis points from a year ago to a record 46.2%. Let me review some of our recent achievements. As the firstGPU company to reach the billion dollar quarter level, NVIDIA continues to beone of the fastest growing semiconductor companies in the world. Our GeForcedesktop and notebook GPU product lines each achieved record revenue. Thedesktop GPU product line grew 33% year over year and the notebook GPU productline grew 120% from last year. Our standalone notebook GPU share grew to 72%, up from 52% ayear ago. In September, we shipped our first ever single-chipmotherboard GPU for Inter processor based desktop PCs, the NVIDIA GeForce 7000GPU family. The GeForce 7000 family delivers the performance of an entry leveldiscrete GPU and leading graphics compatibilities when compared againsttraditional integrated graphic solutions. We estimate the Intel segmentrepresents approximately 40 million units of new addressable market opportunitynext year and expect it to be a strong growth driver for our GeForcemotherboard GPU business. In October, we launched the new GeForce 8800 GT GPU, thefirst in our family of 65-nanometer desktop GPUs. The 8800 GT combinesbest-of-gaming performance and best in HD playback at the $199 price point.Reviewers are calling the 8800 GT the next GeForce 4 TI4200. The TI4200 wascalled the perfect GPU at its time because it was simultaneously modern, highperformance, and well-priced. The TI4400 was one of the most successfulproducts in our history. The widely recognized tech website, AnandTech, wrote: “It’sreally not often that we have the pleasure to review such a product soimpressively positioned. The 8800 GT is a terrific part and is hitting thestreet at a terrific price. The performance advantage and price utterlydestroys our perception of the GPU landscape.” Our Quadro Professional Solutions business achieved recordrevenue and grew 37% year over year. During the quarter, we launched seven newQuadro solutions and most notably, the Quadro FX 370 and 570, which deliver ISBcertified hardware at sub $200 price points. The computer aided design industry is undergoing a massivetransition from 2D illustration to worldwide collaborative 3D design, and couldrepresent tens of millions of new CAD seats over the coming years. We believe the FX 370 and 570 are ideal solutions for theentry-level designer and we’ll continue to accelerate our growth in theprofessional solutions segment. And finally, we began shipments of the Tesla C870 GPUcomputing processor and the 870 desk side super computer products this quarter.The adoption of Tesla and the CUDA C language programming environment and toolsuite continues to accelerate. We believe we now have more than 3,600developers and 14 industry categories working with CUDA on excitingapplications ranging from automotive visions systems, biological simulations,computational fluid dynamics, seismic processing and imaging, speech synthesis,computational finance, quantum molecular dynamics, protein folding to computervision. Let me turn the call over to Marv to discuss our financialresults in more detail. I will return in a moment to discuss our businesses andgrowth drivers for Q4 and beyond."
},
{
"speaker": "Marvin D. Burkett",
"text": "Thanks, Jen-Hsun. Today we’ll be looking at both GAAP andnon-GAAP results for our Q3 and nine months ended October 28, 2007. The onlydifference between GAAP and non-GAAP is stock-based compensation and its taxeffect. As Jen-Hsun stated earlier, revenue for the third quarterwas $1.12 billion, which is up 19% quarter to quarter and up 36% year to year.Obviously it was a very strong quarter, and our concerns at the beginning ofthe quarter as to the sustainability of the strength we saw in Q2 nevermanifested. Also at the beginning of the quarter, there were concernsrelated to production limitations. Through the efforts of our partners and ouroperation staff, we were able to overcome most of those limitations. In a few cases, our revenue was limited by production butrelative to our concerns at the beginning of the quarter, these were minor. In our GPU business, the growth was led by notebook, whichgrew 41% quarter to quarter and 120% year to year. The desktop business grew14% over the second quarter and was up 33% over the prior year. In the quarter,GeForce 8X products accounted for more than 80% of our desktop and notebookbusiness. Our MCP business grew 23% quarter to quarter, as we begin tosee traction in our new Intel platform products. PSB, our workstation business, grew 20% over the secondquarter and 37% over the prior year. Even our consumer business grew 6% overQ2. All in all, there was strong growth in all segments. On gross margins, we reported GAAP gross margin of 46.2%,which is up 90 basis points from Q2. Non-GAAP gross margin was 46.4%. We hadanticipated strong gross margin based on the growth in GeForce 8X products, theincrease in professional solutions, and the increase in PlayStation 3royalties. All of these contributed to the increase in gross margin. We are again pleased with our progress. Operating expenses were $268 million GAAP and $238 millionnon-GAAP. This was slightly higher than our guidance. A major factor in thisincrease was the improved performance and outlook for the whole fiscal year andhow that affected our variable compensation programs. For the quarter, we had to accrue an additional $8 millionas a catch-up based on the increased financial performance and expectations.This is a one-time catch-up. We ended the quarter with 4,609 employees, which is up 236from the second quarter, as we continue to aggressively higher, particularly onR&D. One-hundred-and-fifty-five of the 236 new employees were in R&D. Depreciation for the quarter was $33 million and capitalexpenditures were $70.4 million. The increase in capital expenditures can beattributed to two factors. We bought additional testers of $22 million. Thesetesters are consigned to our contractors in Asia for the increased production.We also purchased some land for $27 million in anticipation of buildingadditional space. Interest and other income was $19 million in the quarter,and the tax rate was adjusted down to 12% for the year-to-date. This resultedin a tax rate for the third quarter of 11.7%. This slight downward adjustmentresults from more international sales than anticipated, as well as higherR&D tax credits. On the balance sheet, cash and marketable securities endedthe quarter at $1.85 billion, which is an increase of $281 million from thesecond quarter, despite repurchasing $125 million of stock during the quarter. Operating cash flow hit $400 million in the quarter for thefirst time. Accounts receivable were $552 million, an increase of only $44million from the second quarter as the even profile of shipments during thequarter helped collections. DSO for the quarter was 45 days, down from 50 days in Q2. Inventory grew slightly to $306 million in spite of thestrong sales and production limitations. Most of the increase can be attributedto new products that were not introduced until after the end of the quarter.DSI for the quarter was 46 days. On the outlook, we’ve had two consecutive excellent quarterswhere revenue has exceeded our expectations. Even with this, we currently seestrong demand for our products and as a result, we expect revenue to grow inour fourth quarter. Revenue growth in the 5% to 7% range would be within ourexpectations. We expect our growth to be led by the continued strength inGPUs and new products in both GPUs and MCP. For gross margin, we’ve made excellent progress and we’llwork very hard to maintain our gross margin. New products will help but we arecurrently ahead of our plan and -- currently ahead of our plan in our progress. Operating expenses will increase in the fourth quarterdespite the catch-up that occurred in the third quarter. This increase is theresult of additional hiring and increased R&D expenses associated with newproducts. A total operating expense increase in the 3% to 5% is reasonable. We would expect the tax rate to stay close to our 13% but ifthere is any adjustment, it would have a downward bias. In summary, we expect an excellent Q4. I’ll now turn it backover to Jen-Hsun."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks, Marv. We are entering the era of visual computing.Some of the most exciting applications required a GPU for the best experience.Industry expert PWC estimates the world wide videogame market to be $30 billionin size and expects the market to grow to $50 billion by 2010. According to ComScore, 217 million videogamers immersethemselves in online virtual worlds and expect that number to grow 17%annually. To date, there has been over 200 million unique downloads ofGoogle Earth. SketchUp makes it easy for millions of users around the world toconvert Google Earth into a full 3D world. Microsoft has shipped 85 millionunits of Vista and Apple’s new Leopard looks amazing and is a step forward inUI design. Both demand GPU to deliver the best experience. Our computing experience is increasingly enhanced by theGPU. As the largest GPU company and the world’s leading visual computingcompany, we are very well-positioned to continue to lead this revolution. Near term, we see multiple growth drivers. First, GeForcediscrete GPU -- GeForce GPU grew to 21 million units in Q3, up 30% from a yearago. The combination of our technology leadership, great content support, andthe ever-increasing importance of the GPU in our computing experience arecontributing to drive our growth. We estimate the installed base of GeForce tobe approximately 200 million units. That makes GeForce the largest game consolecommunity and a target-rich environment for game and application developers. We believe the PC game market is continuing to grow. Ouroverall enthusiast GPU segment grew 35% year over year. The GPU enthusiast GPUmarket grew 170%. Our strategy is to make GeForce one of the most importantprocessors of the visual computing era through technology leadership,increasing programmability, great content experience, and promoting our greatbrands. Second, GeForce motherboard GPU -- GeForce motherboard GPUsgrew to 10 million units per quarter, up 50% from a year ago. The GeForce 7000is off to a great start. We are now the only chipset supplier to support bothIntel and AMD processor platforms, and the only branded integrated GPU supplierfor the Intel processor platform. The integrated graphics opportunity represents approximately60% of the world’s PC market. Our strategy is to bring the benefits of GeForceto the most sensitive price segments while creating exciting platformarchitectures like SLI, hybrid SLI, and ESA. ESA, which was recently announced, stands for enthusiastsystem architecture. It’s a standard for system information protocol that linksthe systems various critical components, such as fan, power supply, smartchassis, GPU cards, and motherboards. It enables a unified architecture forapplications and users to control and optimize performance of their system. SLI, hybrid SLI, and ESA are examples of how NVIDIA createsarchitectures that advance the capabilities of the PC. Third, global proliferation of industrial design is drivingQuadro growth -- NVIDIA's Quadro brand is the de facto standard for [inaudible]visualization. Quadro is not just a GPU. Quadro is a professional class of GPUsthat incorporate features demanded by creative professionals, as well assoftware that completes a solution need for each vertical market, whether auto,medical imaging, film, or financial markets. We are experiencing multiply simultaneous dynamics in theprofessional market. Traditional 2D design and illustration is transitioning tocollaborative 3D design and product lifecycle management. Globalization isforcing multi-side design teams around the world to adopt common platforms, andis fostering the growth of local industries in China and in India. All thesedynamics are expanding the workstation TAM. Fourth, GPU computing with CUDA and Tesla -- CUDA is a dataparallel programming environment build on C. CUDA runs on all the millions ofG80 based and beyond GPUs, whether Quadro, GeForce, or Tesla. Tesla is the brand of GPU software systems solutions that istargeted at the high-performance computing market. The initial adoption ofTesla will be inclusion into super-computing clusters. Next year, we should seedesk side personal super-computing workstations powered by Tesla for dataparallel super-computing and Quadro for interactive visualization. And with CUDA on GeForce, we will quickly reach 100 millionunit per year run-rate for CUDA powered GPUs for the consumer market. Forconsumers, CUDA on GeForce will enhance applications like video and imageprocessing and physics processing for games. CUDA is one of the most revolutionary and disruptive ideasfrom our company. CUDA has ignited interest on GPU computing all of the world.There is growing understanding that the data parallel architecture of a GPU isradically different than that of a CPU and for a large class ofcompute-intensive data parallel applications, the GPU can increase performancefrom 10 to several hundred times. Fifth, we expect our first application processor to sampleat the beginning of next year. We believe another personal computer revolutionis about to happen. Mobile devices like phones, music players and portablenavigation devices will all increasingly become multi-function, multi-taskingpersonal computers. If so, the architecture of these devices will increasinglybecome consumer PC like and be capable of delivering all the entertainment andweb experiences we enjoy on a PC today but in the form factor that fits nicelyin your hands. Our mobile strategy is to drive the second personal computerrevolution by creating a from the ground up application processor and system ona chip that enables this experience. AP15, as it is called internally, is the culmination ofseveral hundred man years of R&D. The mobile application processor is anarea where we can add a tremendous amount of value and represents a severalhundred million units a year growth opportunity. We are happy to take your questions now."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Our first question comes from theline of Hans Mosesmann from Raymond James. Please go ahead, sir."
},
{
"speaker": "Hans Mosesmann -Raymond James",
"text": "Hello, can you hear me? Congratulations, guys. A quickquestion; the GeForce 7000 motherboard GPU, what kind of average selling priceare we talking about here, and are they consistent with the average sellingprices of the A&B platform version?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "The ASPs on the MCP73 or the GeForce 7000 is slightly higheron the Intel side, but it should be targeted -- we are targeting that productto be in the mainstream price sensitive segment so that we can bring GeForce toas many people as possible. That’s a rather large segment and we think itrepresents about 40 million units of incremental opportunity for us next year."
},
{
"speaker": "Hans Mosesmann -Raymond James",
"text": "Is that a $50 ASP, a $100 ASP? I just want to get a generalsense of the magnitude."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Oh no, it’s in the teens. It’s designed to be on themotherboard. It’s intended to be in the teens and we want it to be asaffordable as possible so that we can address the largest possible marketsegments."
},
{
"speaker": "Hans Mosesmann -Raymond James",
"text": "Okay, great. That’s it. Thanks a lot and congratulations."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Heidi Poon fromThomas Weisel Partners. Please go ahead."
},
{
"speaker": "Heidi Poon - ThomasWeisel Partners",
"text": "Hello? Can you hear me?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yes."
},
{
"speaker": "Heidi Poon - ThomasWeisel Partners",
"text": "Can you describe what you expect further for notebooks? Iknow the general trend of desktop to notebook transition is still there, butmost of your wins have been indiscrete. As AMD and Intel come up with theirintegrated graphics platform, also supporting DX10, where do you think you cantake your market share gains to next year and after that?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Well, it’s really hard to say what our market share will bein the future but we’ve been competing against integrated graphics for quite along time and our ability to succeed will depend on continuing to do the typeof things that we do well, which is come up with great ideas, like SLI andhybrid SLI, and bring value to the marketplace like we do with GeForce andQuadro. So we’re going to continue to do those things and if we do our jobswell, we should continue to grow and if we don’t, then obviously thecompetition will do better."
},
{
"speaker": "Heidi Poon - ThomasWeisel Partners",
"text": "But do you think you might have a disadvantage because ofthe power consumption factor?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "How is their integrated graphics lower power consumptionthan ours? In fact, I think that you know, probably, that NVIDIA's G8Xarchitecture is the most efficient performance per watt GPU in the marketplacetoday and that explains why we’re able to get our enthusiast level GPUs into asingle slot with a single slot fan, why our fan noise is substantially lowerand obviously our measured power to be substantially lower. That’s somethingyou can do with architecture, that’s something you can do with innovativecircuit design techniques, and so on and so forth, and system technologies tomanage it at the system level. So there are all kinds of competitive capabilities for us toinnovate and power and we believe we are absolutely world class in that area."
},
{
"speaker": "Heidi Poon - ThomasWeisel Partners",
"text": "Okay, great. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Shawn Webster fromJ.P. Morgan. Please go ahead, sir."
},
{
"speaker": "Shawn Webster - J.P.Morgan",
"text": "Thank you very much for taking my question. Can you give anupdate -- I mean, a lot of folks, especially investors in the PC chip relatedcompanies, are concerned on linearity, risk of double ordering, have thingsbeen too good for too long -- can you guys share with us some of your thoughts?I think Marv, you had some comments on linearity. Maybe you could talk about orderlinearity as the quarter progressed, how your backlog looks, and any risk thatyou can tell in terms of doubleordering?"
},
{
"speaker": "Marvin D. Burkett",
"text": "Our Q3 was one of the most linear that we’ve had. Thestrength that we saw in orders in Q2 continued straight through Q3, and so ifyou wanted to look at a backlog, we are not a backlog focused type company butthere was no change. The orders and the shipments were ratable all the waythrough. Obviously you are always concerned about is there any double ordering goingon, but we don’t see the evidence of that."
},
{
"speaker": "Jen-Hsun Huang",
"text": "The way I would -- the way I think through that problem isfirst of all, we don’t know what we don’t know, and obviously nobody does. Andthe marketplace is rather robust, and I think it’s rather robust for us for avariety of reasons. I think the -- first of all is new products always helps,and the 8800 GT is arguably the best product that NVIDIA has built in fiveyears. That’s what everybody is telling us, that’s how we feel about it, and wehave very, very big hopes for it. We have MPC73, which is our first product of that categoryand bringing GeForce to the Intel motherboard is pretty exciting stuff, and theearly adoption has been wonderful. Both of those products we just can’t make enough of, andthere are good reasons for their growth. I think overall, the GPU dynamic ispretty clear now, that PC games, online games is one of the fastest growingapplication sectors. Vista is doing well. Leopard is amazing. There are moreand more applications that in combination with a GPU is just a betterexperience. And then we have new innovations like Tesla and CUDA, andthere is a very logical reason why there is industrial growth in design. Whenwe globalize the China and India and other Eastern European countries and wecollaborate across the network and we design 24 hours a day, it makes perfectsense that you would need compatible workstations all over the world. And simultaneously, some of these economies are no longerjust manufacturing economies but they are moving into design economies, and soas you know, China is moving very, very quickly up the food chain and more andmore unique designs are coming out of China. Well, they need workstations forthat. I think if you combine whether it’s new products that we areintroducing in the market that we serve today, the importance of the GPU, newindustry growth form workstations, or a new disruptive technology that we’vecreated with Tesla and CUDA -- those are all important reasons why we are growing."
},
{
"speaker": "Shawn Webster - J.P.Morgan",
"text": "Thank you. You guys mentioned that you had a couple of areasthat were still tight from a capacity perspective. Could you share with us whatareas those are?"
},
{
"speaker": "Marvin D. Burkett",
"text": "Jen-Hsun just mentioned a couple of them; MCP73 and some ofour GeForce 8 products were capacity limited or production limited in thequarter."
},
{
"speaker": "Shawn Webster - J.P.Morgan",
"text": "Okay. Thank you very much."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Our next question comes from theline of Simona Jankowski with Goldman Sachs. Please go ahead."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Thanks very much. I just wanted to get a better sense onyour Q4 guidance; how much of that is based on your expectations for furthershare gains versus the end market growth for other factors, such as potentiallyASP increases?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "We don’t count on share growth. That happens after you aredone counting it and so -- unless it’s a design win or whatever it is that weknow, we don’t typically count on share growth. So we count -- we look at thestrategic position of our products, we look at the new products that we’reintroducing and therefore we’ve got some confidence on its pricing power. Wecount on new markets that we are entering opening up and so we count on avariety of things. And of course, OEM design wins are OEM design wins, butotherwise we try not to be too bullish on market share wins."
},
{
"speaker": "Marvin D. Burkett",
"text": "We also don’t anticipate any changes in ASPs in the variousmarket segments. That’s not [ending growth]."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Okay, so it sounds like a lot of it is just the end marketcontinues to be very robust."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yes. And we are entering new markets and we are creating newproducts for existing markets as well. So those are -- when somebody -- when westarted to ship Tesla, that’s a product that’s one of its -- it’s the first ofits kind and it adds so much value and the people that buy it initially arepeople who are desperate to have more computing resources. Products like the 8800 GT, it’s an existing market that weserve but it’s very disruptive because of its price performance is just soterrific and it really promotes very, very quick adoption and oftentimes iteven encourages pretty broad-based upgrades. And you know that there’s a whole bunch of games coming outthis Christmas with DX10 and the games look really terrific, so -- so there’sjust a lot of reasons why the GPU is doing well."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "I appreciate that color. Just one other question that issomewhat related; you mentioned that you think the motherboard GPU is anincremental 40 million unit opportunity. These products seem to be competingvery effectively against the low end of the discrete GPU market and seem tohave a significantly lower price point. So do you view this as an incremental opportunity or do youview this to some extent as asubstitution of some of the existing stack of the product?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "The GeForce 7000 really isn’t high performance enough to bea replacement for even our entry level GPU, so that’s not -- and you know ourdiscrete GPU, as one of the data points that Marv just mentioned, our discreteGPU will be vastly converted to DX10 very, very shortly. So this is reallytargeting the segment that’s underneath it, the 60% of the marketplace that wedon’t really serve today."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "That’s very helpful. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Gurinder Kalra withBear Stearns. Please go ahead."
},
{
"speaker": "Gurinder Kalra - BearStearns",
"text": "Thanks for taking my questions. My first question is on theGeForce 8800 GT. It’s a great product but do you think there is any chance itmight be cannibalizing some other very high priced products? And given that it’s priced around $200, $249 but on65-nanometer, how does it affect your gross margins going forward?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Well, we always try to be thoughtful about how our productscan cannibalize their own products, but I think we understand this marketpretty well and if it’s possible to cannibalize our products, well, I’d ratherdo it myself than wait around for somebody else to come and do it, and so I’mnot too worried about that. That’s just really the nature of our business andwe have to stay aggressive. We want to stay aggressive and we want to bring asmuch as we can to the market. I’m not inclined really to slow down because it somehowprotects my own business. My own business will have to figure out a way to dealwith my own business. So that’s our strategy there, nice and simple. But I thinkour high-end products will continue to be best of its kind, best of its class,and I think the market will be fine there."
},
{
"speaker": "Marvin D. Burkett",
"text": "As far as margins go, the margins on the 8800 GT areexcellent, well above corporate margins."
},
{
"speaker": "Gurinder Kalra - BearStearns",
"text": "Thanks. Just a follow-up question on the general purposeGPU/Tesla, can you discuss some of the traction or the design wins you areseeing in the financial services industry and the headway you made there?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "There is a lot of development going on using GPU computingfor computational finance. As you guys know, your industry has some of thebrightest mathematicians in the world and the amount of computation you guysneed is completely unbounded. You just don’t seem to be able to get a largeenough server or enough of them. We’ve demonstrated that GPU can be used to acceleratefinancial computational finance by 10 times, 20 times, and severalapplications, 50 to 100 times. And that’s a very, very large step up inperformance improvement, and so there’s quite a bit of development in thatarea. It’s happening all over the world. It’s happening in London. It’shappening in New York. This is an area that I think is going to be prettyinteresting for GPU computing."
},
{
"speaker": "Gurinder Kalra - BearStearns",
"text": "Thanks very much."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Michael McConnellof Pacific Crest Securities. Please go ahead."
},
{
"speaker": "Michael McConnell -Pacific Crest Securities",
"text": "Thanks. On the G92 or the 8800 GT, when are you expectingcrossover on that, relative to the 8800 GTS?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Crossover -- let me --"
},
{
"speaker": "MichaelMcConnell - Pacific Crest Securities",
"text": ""
},
{
"speaker": "Jen-Hsun Huang",
"text": "Let me explain it this way. I think this will do it. We willship more 8800 GTs this quarter then we shipped last quarter of 8800 GTS. [Multiple Speakers]"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Go ahead."
},
{
"speaker": "Michael McConnell -Pacific Crest Securities",
"text": "I’m sorry to interrupt -- this will be -- would you say thisis probably your most aggressive ramp in history, maybe of a product?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "This is one of our most aggressive ramps and the reason forthat is because it is such a great product. We have a really rich backlog oforders for 8800 GT. And although the market now knows what the competition hasand our customers know what the competition has and they are voting with theirorders. We are going to be very, very aggressive with 8800 GT. It’sjust such a great product. Five years ago we had the 4200TI, TI4200 and themarket called it the perfect GPU. And the reason for that was because it was abrand new architecture, it was extremely high performance, and it was veryaffordable. It was $199 and it lit that segment on fire and it was -- wecouldn’t build enough of that 4200 for a very long time. We think we’ve got another 4200 on our hands and certainlythe market has effectively called it that."
},
{
"speaker": "Michael McConnell -Pacific Crest Securities",
"text": "I guess -- I know you don’t -- it’s tough to predict marketshare. You guys have obviously dominated this segment in the high-end. With the-- could you talk about just the basis for having such an aggressive ramp? Imean, do you really feel like you could take more market share, or is this justyou are ramping in accordance to the demand out there, which is quite strong?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "There’s always competition in our space. This is one of the-- the GPU industry is one of the most vibrant industries and the reason forthat has to do with the fact that Moore’s Law is still GPU’s friend, or GPU isstill Moore Law’s friend. This is one of the few technology segments left wheremore transistors and new algorithms and new technology could enable betterexperiences. Almost all of the other semiconductor sectors are seeing smallerdie sizes every year and lower ASPs every year, but not the case with the GPU. I expect this to be an area of quite a bit of vibrance for adecade to come. In terms of how quickly we ramp, that’s just the way we dothings. We need to bring out new architectures and we need to bring it out asbroadly as we can because as soon as we launch one unit of 8800 GT, everybodyin the world is going to want it and so you might as well assume that you are buildingfor everybody in the world and so that’s kind of the approach that we take. And we want to stay aggressive as a company. That’s just ournature."
},
{
"speaker": "Michael McConnell -Pacific Crest Securities",
"text": "And then a final question, just on the GeForce 7 series chipsetsfor Intel’s platforms, can you talk about the early traction you are seeing,both at OEMs and then maybe separately in the channel, and just how that’sprogressing and the outlook, if you have one, for next year?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "We’re expecting to be every successful with OEMs as well asthe channel, and so it’s designed -- it’s designed to -- NVIDIA's brand and thequality of our technology and the rich support that we offer in drivers, as theindustry gets more complex with DX10s and OpenGLs and high definition videosand all of these different applications, our software capability becomes anincreasing advantage. And just because it’s integrated on the motherboarddoesn’t mean the software isn’t complex. That’s an area that we are extremely good at, and so it’s --my sense is that we will be very successful in both OEMs and the channel. Andyou’ll see it soon."
},
{
"speaker": "Michael McConnell -Pacific Crest Securities",
"text": "Okay, and Marv, have you guys thrown out a target for nextyear within that business, or just quantified what the opportunity could be fornext year? I don’t know if you have or have not."
},
{
"speaker": "Marvin D. Burkett",
"text": "No, we have not."
},
{
"speaker": "Michael McConnell -Pacific Crest Securities",
"text": "Would you care to, or --"
},
{
"speaker": "Marvin D. Burkett",
"text": "Only it’s a significant growth driver next year, but no, wehaven’t quantified it."
},
{
"speaker": "Michael McConnell -Pacific Crest Securities",
"text": "Okay, great. Thanks, guys."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Tayyib Shah withLongbow Research. Please go ahead."
},
{
"speaker": "Tayyib Shah - LongbowResearch",
"text": "Congratulations on the quarter. The notebook market has beendoing very well lately, but maybe partly at the expense of the desktop segment,where you have higher exposure. Can you help us understand how desktopreplacement by notebooks is likely to affect your business going forward, nowthat you already have 70%-plus share in notebooks?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "The notebook market is certainly doing very well and Iexpect that one of the areas where the notebook market is just starting to seegrowth but it will see a lot more growth in the coming years is the gamingnotebook segment, and the mobile workstation segment. These two segments aregrowing very quickly and I expect that we’ll be able to add a lot of value tothose two platforms in the future. We’re not too hung up about where people buy our GPUs. We’redelighted by the proliferation of platforms and whereas people typically tendto have one or two PCs, desktop PCs in their house, they may have four, and inmy case eight, laptops at home. It’s a little bit like a cellphone, I guess andyou just buy a whole bunch of them over time. I think that the notebook market is not completely areplacement market, frankly. I think that a lot of it is an additive market andcertainly it has exceeded most people’s expectations."
},
{
"speaker": "Tayyib Shah - LongbowResearch",
"text": "Another question along the same lines, as your footprintwithin the notebook market has grown, have you been finding this market morecompetitive than your discrete GPU business, given that in this business, Intelcan bundle their chipsets with their CPUs, if they want to?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Intel is definitely a very competitive company and we are --we’ve been competing against bundling for quite some time, whether it’s pricebundling or other bundling. The bottom line is we just have to add value. We just haveto add value. NVIDIA is not a commodity player and we serve the marketplaceswhere we could -- where visual computing is really important. If 3D matters toyou, and if your work matters to you and you do 3D work, whether it’s in designor film or medical imaging, then we could add a lot of value to you. And ifyour business really depends on having a great GPU and visual computingcapability, I think NVIDIA is really your partner."
},
{
"speaker": "Tayyib Shah - LongbowResearch",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Our next question comes from theline of Glen Yeung with Citigroup. Please go ahead."
},
{
"speaker": "Peter Karzaris -Citigroup",
"text": "This is Peter [Karzaris] for Glen Yeung. A question just onASPs; I was wondering if on a mixed basis, your ASPs were able to improve indesktops and notebooks from second to third quarter?"
},
{
"speaker": "Marvin D. Burkett",
"text": "No, they were relatively flat."
},
{
"speaker": "Peter Karzaris -Citigroup",
"text": "Despite mix? And then on -- I noticed margins were up andyou talked about I think royalties from Sony as being one of the drivers. Butconsumer revenue was up about 6%. I was wondering if you could give us anyother color around consumer revenue and then also, if you could just help usunderstand maybe the total impact that that had on, that royalties had on grossmargin improvement?"
},
{
"speaker": "Marvin D. Burkett",
"text": "Well, you know, any increase in royalties is 100% grossmargin, so I would say that our royalty income from PS3 increased significantlyfrom Q2 to Q3. It more than doubled, so that had an impact on our grossmargins. Was it the driving factor? Probably not, but it was one of the factorsthat improved gross margins. The fact that that increase would probably account for mostof the increase in the consumer business is probably true."
},
{
"speaker": "Peter Karzaris -Citigroup",
"text": "Great. Thanks."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Uche Orji with UBSInvestment Bank. Please go ahead."
},
{
"speaker": "Uche Orji - UBS",
"text": "Can I just get a sense of where the professional servicesbusiness will go next quarter? I mean, I see your guidance and your[inaudible], but that division is pretty critical for driving overall grossmargin, so if you can give us some color as to what we should expect withinthat division next quarter, that would be helpful. And a second question is about your handset strategy. Iunderstand your push on the apps processor direction, but do you see the lackof a baseline solution as something that could become a problem for theapplication of that strategy? If you can give me some color, that would behelpful. Thanks."
},
{
"speaker": "Jen-Hsun Huang",
"text": "I guess on the first one, we really haven’t and we don’tgive too much granular guidance at the business unit level. All I can tell youis that the professional solutions group is doing well and they arestrategically very well-positioned and they add a lot of value to themarketplace. Our business of -- what some people call the workstationsbusiness, what we call the professional solutions business is really acombination of technology, GPU technology and a lot of software, systemcomponent technology, and expertise. We have one -- we have one of the, if notmy expectation to be the largest developer technology organization in the worldand we help inspire and we help solve some of the most challenging visualcomputing problems in the world through that organization. So I expect it to do well. We haven’t really given it muchguidance. With respect to our application processor business, we aregoing to focus on the segments of the handheld marketplace where computing isparticularly important. If you take a look at all the handhelds in the world,really with the exception of the iPhone, every other phone in the world wantsto be a computer but has a long way to go. And this is where we could add a lotof value. NVIDIA is fundamentally a computer technology company. Weare one of the world’s largest computer technology companies and there are veryfew consumer oriented computing platforms where we can’t, from the ground up,design an entire computer for you. So this is an area that we could add a lot of value. We areseeing a lot of interest in the work that we are doing and when I said severalyears ago that this is going to be the second personal computer revolution andthat the phone is going to become a computer first and a phone second, at thetime it sounded kind of odd but I think it makes a lot of sense now."
},
{
"speaker": "Uche Orji - UBS",
"text": "That’s helpful. Thank you very much."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Our next question comes from theline of Daniel Ernst from Hudson Square Research. Please go ahead."
},
{
"speaker": "Daniel Ernst - HudsonSquare Research",
"text": "Thanks for taking the call. Two, if I might; first, on themainstream growth and maybe also the low end of the discrete, obviously in thedomestic market, so much enthusiasm around digital video and high resolutionphotography with things like YouTube and digital SLRs, and so that’s about --and the uptake of Premium Vista, I assume that that’s been a lot of the growththere. But can you talk about that same market overseas where so much more ofthe overall PC market growth is, and particularly in developing countries like Indiaand China whereI assume the market is more price sensitive. And then secondly on the mobile phone business, you gave usa little bit of mapping for the app processor, but can you just give us alittle bit of color about the current mobile phones business and how that istracking, relative to expectations? Thanks."
},
{
"speaker": "Jen-Hsun Huang",
"text": "I would say that the developing markets are being drivenright now by online games, which is really a craze in China and India and theonline game market is really doing fabulously out there. Games are free and youpay for the service and you pay as you go, and it’s a really great way for themto meet their friends and meet people on the web. So those -- that’s a real growth driver. Another one, ofcourse, is their purchasing power in the foreign countries are becoming quitegood and as a result, they can buy up on their configurations. And one of thebest ways to improve your experience to buy up on the configuration is to add aGPU. Those factors are quite important growth drivers for us internationally,irrespective of Vista. Internationally, Vista is doing well everywhere. I don’tthink it’s not doing well in China. I frankly think that it is doing very wellin China and it will do very well in India as well. Any consumer will [enjoy]Vista. With respect to the application processors, the handheldbusiness, we haven’t shipped much application processors. We haven’t shippedany of our AP15 yet, so all of our current handheld business is from theexisting handheld GPU business, which met expectations. It’s not intended togrow and it’s likely to continue to decline. This quarter I think it declinedbut we are not expecting that business to grow because we are not out trying toget anymore design wins. We are really focusing now on building our applicationprocessor and this is where we are going to drive the market."
},
{
"speaker": "Daniel Ernst - HudsonSquare Research",
"text": "Do you see a bit of an air pocket then between the currentgen, the mobile GPU that you have now and the integrated app processor?"
},
{
"speaker": "Marvin D. Burkett",
"text": "No, not really, mainly because it’s not significant portionof our business right now."
},
{
"speaker": "Daniel Ernst - HudsonSquare Research",
"text": "Got it. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Sidney Ho fromMerrill Lynch. Please go ahead."
},
{
"speaker": "Sidney Ho - MerrillLynch",
"text": "Thanks for taking my question. It’s a question on grossmargin. You are at 46.2% this quarter and I’m not going to ask for specificguidance, but if you look forward say for the next 12 months, what are some ofthe biggest endeavors that can improve margins, both at the gross and operatingmargin level? Is it more like a product mix between chipsets, [GPU Tesla] orbetween product families like the G92, or is there something else?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "We’ve not increased our gross margins by raising pricesonce, and the reason for that is because it’s hard to grow while you areraising prices. And so we remain very competitive in the marketplace. Where we’ve improved all of our gross margins is internaloperational improvements. And I’ll tell you that I have a lot of work left todo, so -- there are quite a bit of -- just the things that we can do inside,all within the walls of our company, we have many, many ideas on improvinggross margins through better operations, better execution."
},
{
"speaker": "Marvin D. Burkett",
"text": "The mix will affect gross margins, depending on where thegrowth comes from. But having said that, our total focus is improving the grossmargins on each of the business segments, and Jen-Hsun is right; there’s lotsof things that we could do better so I still see room for gross marginimprovement in each of the businesses."
},
{
"speaker": "Sidney Ho - MerrillLynch",
"text": "One follow-up question; for the professional services group,can you tell us how did the average selling price do for the quarter? And also,if you can tell us how much was the contribution from Tesla during the quarter,which I don’t expect much, that would be great. Thanks."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Tesla was very little. It’s just beginning to ship, so it’svery little. And we’re expecting it to be small relative to the overall size ofthe company in its first year. The most important thing about Tesla is targeting it at thetype of applications where they can really use the help right away, whetherit’s oil and gas or imaging, medical imaging, or computational finance. Thereare all kinds of applications out there that could really benefit from it.Meanwhile, we are driving CUDA, which is the programming environment, into allof our GPUs so that we can bring GPU computing to the masses. Both of those efforts are ongoing and I frankly think thatthe progress is extremely high and better than we had expected by far, by a lot."
},
{
"speaker": "Marvin D. Burkett",
"text": "As far as the ASPs go, ASPs are in the hundreds of dollars.They are not -- it gets to be a complex mix of products there, so let me justsay it’s hundreds of dollars."
},
{
"speaker": "Sidney Ho - MerrillLynch",
"text": "So was it up from last quarter?"
},
{
"speaker": "Marvin D. Burkett",
"text": "No, relatively flat."
},
{
"speaker": "Sidney Ho - MerrillLynch",
"text": "Okay, great. Thanks."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Nicholas Aberlefrom Caris & Company. Please go ahead."
},
{
"speaker": "Nicholas Aberle - Caris & Company",
"text": "Good afternoon. Nice quarter, guys. Question had to do withASPs; I know we talked about ASPs here in the most recent quarter. You guyshave done a great job over the last couple of years in improving those. What isthe expectation over time for ASPs? Do we have a substantial move higher fromcurrent levels based on Tesla?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "The way we think about ASPs here, the way I think about ASPsis we have to make the GPU more valuable. The more programmable we make it andthe more applications take advantage of it, the more people will spend inbuying GPUs because it will enhance our computing experience. Now that trend has been moving very aggressively over thelast couple of years, with all of the applications that I’ve already talkedabout and the growth of the gaming market and amazing applications like GoogleEarth and Microsoft’s Virtual Earth 3D. These types of applications are justcontinuing to make the GPU more important and so that’s our focus. My expectation is absolutely the GPU ASP will continue toincrease, and the reason for that is because I expect to make it more valuableand people will see the value and hopefully choose to buy a better GPU."
},
{
"speaker": "Nicholas Aberle - Caris & Company",
"text": "Perfect. Looking back over the last couple of years, youguys have refreshed the halo product, the enthusiast desktop product abouttwice a year, it looks like every fall and spring. You guys just did 8800 Ultraback in the spring. Should we be expecting another enthusiast refresh herebefore the end of the year?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Well, we are at the end of the year and -- we decided thatthe refresh that we would do this time was 8800 GT, and this is just a barnburner refresh. We are really, really proud of the 8800 GT and we are going toput our focus here. From 8800 GT, you could obviously do SLI and soon you’ll beable to do three-way SLI, so you are going to be able to put a lot of GPUhorsepower into your system, starting with a very affordable 8800 GT, and so --this is our focus for now."
},
{
"speaker": "Nicholas Aberle - Caris & Company",
"text": "I’ll just sneak one more question in; Intel back inSeptember bought a small company called Havoc, does acceleration, physicsacceleration software. Just was wondering if you guys are in the market forthat IP. I know you guys have worked with them in the past and how that maybehas an effect on the longer term landscape."
},
{
"speaker": "Jen-Hsun Huang",
"text": "No, no current plans."
},
{
"speaker": "Nicholas Aberle - Caris & Company",
"text": "But no commentary regarding how their purchase of Havocaffects maybe their IP positioning relative to yours in physics acceleration?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Oh, I didn’t know that was the question you asked. You askedme about my plans. I don’t have any plans. I don’t know why they bought Havoc. Physics is -- physicsprocessing has a long ways to go and there are so many companies out there.There’s quite a few -- quite a few middleware companies out there that arecreating technology in this area, and many gamers, many game developersincorporate their own physics engine. So my sense is that there’s a lot ofinvention still left to do in this area. I’m not sure why they bought thatcompany, to tell you the truth. It might give them some advantages with respectto Havoc but it obviously creates negative synergies everywhere else. But that’s -- I don’t know why they did it, and so you’reasking really the wrong person. Strategically, I don’t know that it has anyreal bearing on the work that we are doing."
},
{
"speaker": "Nicholas Aberle - Caris & Company",
"text": "Thanks. Good luck in Q4, guys."
},
{
"speaker": "Operator",
"text": "Thank you. There are no more questions at this time. I wouldnow like to turn the call back over to Jen-Hsun. Please go ahead."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thank you. NVIDIA's strategy is to be the world leader invisual computing by leading the GPU revolution while creating innovativetechnologies that enable and inspire amazing applications. The GPU is increasingly central to our computing experienceand although hundreds of millions of users already enjoy 3D applications andUIs like Vista and Leopard, this is just the tip of the iceberg of thepotential of the GPU. We intend to drive our growth by continuing to extend theGPU to more applications, more platforms, and to more people. Thank you forjoining us today. We look forward to reporting on our results for Q4."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, that does conclude the conference callfor today. We thank you for your participation and ask that you pleasedisconnect your lines."
}
] | null | null |
NVDA | 2 | 2,008 | 2007-08-09 17:00:00 | Executives: Michael Hara - VP of IR Jen-Hsun Huang - President and CEO Marv Burkett - CFO
Analysts: Arnab Chanda – Lehman Brothers Doug Freedman - ATR David Wu – Global Crown Capital Nick Aberle - Caris and Company Daniel Ernst - Hudson Square Research Tayyib Shah - Longbow Research Gurinder Kalra - Bear Stearns Simona Jankowski - Goldman Sachs
Michael Hara : Thanks, Frank. Good afternoon and welcome to [Gap in audio] NVIDIA’s Chief Financial Officer. Before we begin today's call, I would like to take care of some general administrative items. Your lines have been placed on a listen-only mode until the question-and-answer segment of today's call. During this call, we will discuss some non-GAAP financial measures about net income, diluted net income per share and gross margin in talking about our results. You can find a reconciliation of these non-GAAP financial measures to GAAP financial measures in our financial release, which is posted on the investor relations page of our website at www.nvidia.com. Unless otherwise noted, all references to research numbers throughout the call come from Mercury Research. This call is being recorded. If you have any objections, you may disconnect at this time. Please be aware that if you decide to ask a question, it will be included in both our live transmission as well as any future use of the recording. Also, shareholders can listen to a live webcast of today's call via the investor relations page of our website at www.nvidia.com. The webcast will be available for replay until the company's conference call to discuss its financial results for its third quarter fiscal 2008. During the course of this conference call, we may make forward-looking statements based on current expectations. Forward-looking statements, including statements as to our outlook, seasonality, the impact, features, performance and availability of our products and technologies, our strategies, growth and growth drivers, market share and the importance of and uses for GPUs pertain to future events and are subject to a number of significant risks and uncertainties. The company's actual results may differ materially from results discussed in any forward-looking statements. For a complete discussion of factors that could affect the company's future financial results and business, please refer to the company's Form 10-Q for the period ended April 29, 2007 and the reports on Form 8-K filed with the Securities and Exchange Commission. All forward-looking statements are made as of the date hereof, based on information available to us today. Except as required by law, the company assumes no obligation to update any such statements. The content of the webcast contains time-sensitive information that is accurate only as of August 9, 2007. Consistent with the requirements under Regulation FD, we will be providing public guidance directly in the conference call, and will be unable to provide significantly more information in offline conversations or during the quarter. Therefore, questions around our financial expectations should be asked during this call. At the end of our remarks, there will be time for your questions. In order to allow more people to ask questions, please limit yourself to one question. After our response, we will allow one follow-up question. I would now hand the call over to Jen-Hsun.
Jen-Hsun Huang: [Gap in audio] revenue, record net income and record gross margin. For our second quarter, revenue grew 36% from last year to a record $935 million, and non-GAAP net income increased 77% year over year. Non-GAAP gross margin improved to a record 45.6%, an increase of 290 basis points from a year ago. GAAP net income nearly doubled year over year, and GAAP gross margin improved by 280 basis points from a year ago to a record 45.3%. We achieved a record quarter despite Q2 being historically the seasonally slowest quarter of the year. Let me highlight some of our achievements for Q2. The GeForce desktop and notebook product lines each achieved record revenue. The desktop GPU product line grew 37% year over year, and the notebook GPU product line grew 129% from last year. We continued to capture leading share in five categories. Total standalone GPU share grew to 66% from 48% a year ago. Total standalone desktop GPU share grew to 65% from 51% a year ago. Total standalone notebook GPU share grew to 68% from 37% a year ago. Our DirectX 9 generation share was 64% and DirectX 10 generation share was 75%. During the quarter, we launched a new family of GeForce 8M series GPUs in support of the production ramp of nearly every notebook PC OEM in the world including Acer, Apple, ASUS, Dell, HP, Lenovo, Samsung, Sony and Toshiba. The global notebook PC segment continues to grow significantly faster than the overall PC market. We believe Q3 growth will continue its strong momentum. In June, we launched Tesla, our entry into the high-performance computing industry. HPC Wire, the most recognized and accessed news and information site covering the entire ecosystem of high-performance computing, named Tesla as one of the most significant launches in the HPC industry in the first half of 2007. The Tesla family consists of the C870 GPU computing processor, the D870 desk-sized supercomputer and the S870 1U computing server. nForce 65i SLI powers the new maximum PC Dream Machine 2007. This is the third consecutive year nForce has been selected as its motherboard of choice by the number-one magazine for home computing enthusiasts. Maximum PC chose nForce 65i SLI because of its performance, its overclock ability with quad-core CPUs and SLI support. We introduced an entirely new line of notebook workstation GPU's based on G8X architecture, the NVIDIA Quadro FX 1600M, 570M and 360M. Let me now turn the call over to Marv to discuss our financial results in more detail. I will return in a moment to discuss our business and growth drivers for Q3 and beyond.
Marv Burkett: Thanks, Jen-Hsun. Before I get started, I would like to apologize for the irritating coughing you may hear in the background. That's me. I'm fighting a little case of bronchitis so I apologize for that. Today, we're reporting both GAAP and non-GAAP P&Ls for Q2 fiscal year 2008 and for the first six months of fiscal year 2008. The only difference between GAAP and non-GAAP is equity-based compensation and its tax effect. As mentioned, revenue for the second quarter was $935.3 million, which is up $91 million or 11% from the first quarter and up $248 million or 36% over the prior year. Obviously, strong revenue growth exceeded our guidance. The strength was primarily in the GPU business. While MCP grew $12 million or 8% quarter to quarter, we had expected this in our guidance. The strength in the GPU business included both desktop and notebook. In total, the GPU business grew 20% quarter to quarter. Within the GPU business, notebook grew 50% quarter to quarter, as the Santa Rosa launch was well accepted. Much of the growth in desktop was in mainstream products. Year to year, GPU revenue was up 55% and MCP was up 16%. For the quarter, GAAP gross margin was 45.3%, which is up 30 basis points quarter to quarter. Non-GAAP gross margin was 45.6%, up 20 basis points quarter to quarter. With the very high growth we experienced in mainstream GPUs, we expected margin pressure, but we were able to overcome that with continued execution of the transition to GeForce 8X products and good operational execution. Non-GAAP operating expenses in the quarter were $212.5 million, and within our guidance. The GAAP operating expenses were relatively flat quarter to quarter, as the total equity-based compensation dropped by approximately $8 million from the first quarter. We had expected this roll off due to several contributing factors, one of which is the transition from Black-Scholes to a binomial valuation model that we made several years ago. During the quarter, we continue to hire and added 299 new employees. Two-thirds of the additions were in the R&D area. The tax rate stayed constant at 14%, and this resulted in GAAP earnings of $172.7 million or $0.43 per diluted share. Non-GAAP earnings were $198.1 million or $0.51 per diluted share. On the balance sheet, we ended the quarter with $1.57 billion in cash, even though we repurchased almost $125 million in stock. The operating cash flow was over $300 million for the second quarter in a row. Accounts receivable were $508 million, which generated days sales outstanding of 50 days. The fact that the quarter was more evenly loaded than expected helped with the reduction in days sales outstanding. Inventory was down $56 million to $276 million, and resulted in days sales in inventory of 49 days. In my opinion, this inventory level is too low. Capital expenditures in the quarter were $30 million and depreciation was $32 million. Both for the quarter and year to date, capital expenditures and depreciation almost offset each other. There was not much else of significance on the balance sheet. I will also like to point out that today we announced a 3-for-2 stock split in the form of a stock dividend. On the outlook, for the quarter, we're starting from a higher base, given our Q2 performance. Still, we expect revenue growth in most areas, particularly notebook and workstations. The result is we believe revenue will grow 5% to 7%. We believe there may be some product limitations, as manufacturing capacity is somewhat limited and our inventories are low. For gross margins, we will work hard to continue to improve gross margins, and with the continued transition to GeForce 8X products and the expected increase in workstation revenue, we believe some improvement is possible. For operating expenses, with our continued hiring and salary increases, we expect OpEx to also grow in the 5% to 7% range. We believe the tax rate will hold at 14%. With that, I will turn the call back over to Jen-Hsun.
Jen-Hsun Huang: Thanks, Marv. Although Q2 is typically the weakest seasonal quarter for the industry, we experienced growth in desktop and notebook GPU and MCP. We are now heading into what are historically the two strongest quarters of the year, driven by back-to-school and holiday cycles. As we head into the seasonally strong second half, we will enjoy several dynamics that continue to enhance the importance of the GPU. First, exciting DX 10 games are launching shortly. Crysis from EA is particularly exciting and will help drive GPU upgrades. Second, HD and Blu-ray disk drives continue to come down in price, and title availability is now plenty. Third, discrete GPU technology has advanced substantially relative to integrated graphics, creating a large technology gap between our discrete GPUs and high-volume integrated graphics chips at a time when the graphics demand from modern operating systems like Vista and OS 10 continue to increase. As a result, we expect to see the overall GPU segment to grow. Lastly, we have a strong position in both desktop as well as notebook, and believe we can continue to grow share. At our analyst day in June, we announced several brand new growth areas and exciting new strategies. I would like to take this opportunity to discuss them again. First is the highly anticipated launch of our first motherboard GPU for Intel processors. Directly attached to the motherboard, our new products will bring the NVIDIA brand of GPUs to a new price point for Intel processor customers. This is a first for NVIDIA and an exciting new growth opportunity. Second, we announced an exciting new technology called Hybrid SLI. Future motherboard GPUs and discrete GPUs will collaborate to enhance capabilities, performance as well as reducing power. We call it Hybrid because this technology combines a powerful as well as an energy-efficient engine; and SLI because this is our multi-GPU technology. When GeForce N-cards are connected to GeForce motherboards, Hybrid SLI kicks in, combining their processing power to deliver an additive experience. The technology is application aware. Depending on the processing demands of each application, the discrete GPU may be completely shut down to save power. For the most powerful systems, where the combined power of dual GeForce 8800 GTX SLI can reach 400 watts, both GPUs can be powered down when the user is just doing e-mail, surfing the Web or watching a Blu-ray movie, keeping the system completely quiet and consuming the least possible energy. But when a game or other demanding GPU application is launched, the dual 8800 GTXs are powered up to deliver an immersive experience. For performance systems, Hybrid SLI will give users the benefit of energy efficiency, as well as uncompromising performance. For mainstream systems, Hybrid SLI will enhance the performance and features by combining the benefits of the motherboard and the add-in card GPU. Hybrid SLI will be available starting with our GeForce 8 series motherboard GPUs this fall. Third, we announced Tesla, a new line of high-performance computing processors based on our revolutionary G8X GPU architecture. Tesla leverages the massive computational resources inherent in our GPUs, which can be over 100 times greater than the fastest microprocessor alone. This breakthrough innovation centers around technologies that will enable programmers to access this massive computational resource. The Tesla architecture and supporting C language compiler and development environment is called CUDA. The adoption of Tesla and CUDA has far exceeded my expectations. We have known for some time that the world has a supercomputing crisis. The enthusiasm around Tesla is a reflection of this vacuum. Thousands of programmers worldwide are already creating parallel GPU programs using CUDA and Tesla. The Tesla family includes a GPU computing board, a Quadro Plex style desk-sized system and the world's first 1U GPU computing server. I believe Tesla and CUDA will represent one of the most significant technology discontinuities in the supercomputing industry since Cray introduced vector processing. We anticipate Tesla will enable fundamental new discoveries in a broad range of industries. Customers in the field of computational chemistry, neurological science, medicine and seismic processing have seen computation times reduced by as much as 5,000% using Tesla. Tesla is yet another example of the power of the GPU and its increasing impact on the computer and consumer electronics industry. NVIDIA now has three major brands, GeForce for enjoyment, Quadro for creation and now Tesla for discovery. The diversity of our brands reflect the versatility and the importance of the GPU. Let us now take your questions.
Operator: Your first question comes from Arnab Chanda – Lehman Brothers.
Arnab Chanda – Lehman Brothers : Obviously the performance in the graphics business has been superlative. Do you think any of this is other than, obviously, share gain? Are you seeing a Vista effect here? If so, what do you think? Is this the beginning of it, or how long do you think that continues?
Jen-Hsun Huang: Well, this can't be all share gain. It's very clear that the size of the GPU market is larger than several quarters ago. We can only attribute that to a variety of things which we think either falls into the category of Vista, as we know that Vista is becoming better and better, and consumer PC adoption is certainly very high with Vista. We know that the experience of Vista is significantly better with the GPU in your system. We also believe that DX 10 applications and the new generation of video games are rather taxing, and it's because of the technology gap between the GPU and integrated graphics, the separation has become so large that it makes it clear that a GPU is better. Then the third reason is Blu-ray and high-definition video. I think all of these things are really playing together and helping the GPU market substantially.
Arnab Chanda – Lehman Brothers : We think maybe we understand what's going on in the PC business and what kind of growth rate that would create. However, you have obviously had much better growth rates than that in the last three years, above 20%. I knew you don't want to give guidance. But for next year, what type of growth in non-PC segments, whether it's Tesla, whether it's your cell phone business, perhaps consumer or other things you haven't really talked about, how much can the add to your core business, your PC business growth?
Jen-Hsun Huang: The growth of our GPU business, whether it's discrete GPUs or motherboard GPUs, is a function of the growth rate of the PC. It's related to the share gains that we have, but it's also related to how much of the PC marketplace appreciates a GPU. NVIDIA's market share is about 30% in the overall GPU market and so there's still 60% of the PCs that can benefit from better GPUs. I think that, over time, as more and more of the computing experience is related to computer graphics and what you see on your display, and as the size of displays become larger and as the content that we see become richer, it's just evident that more and more people appreciate the GPU. So that's one factor. With respect to going forward, how we think about the market, we think about the new markets that we enter as we grow. In the second half of this year, I just mentioned that we're going to bring our GeForce brand for the first time to motherboards for Intel processors. Hard to say exactly how big that marketplace is, but I think the overall market for core logic is somewhere between $6 billion to $8 billion, of which we have a relatively small part of that. So that's a growth opportunity for us. We also look at the TAM of the application processors that we're building. We are entering into a marketplace that is in the process of transitioning from being a cell phone, a telephone, to being a mobile computer. We are targeting this discontinuity and building, effectively, a modern multimedia computer on a single chip. We call it an application processor. I think this is going to be a phenomenal opportunity for us, and one that we can add a lot of value to the industry, bringing computing expertise to the cell phone marketplace. That marketplace, it is hard to say exactly how big that's going to be, but it's many billion dollars large, as you know. Tesla is probably the hardest of all to guess, and the reason for that is because it's the product that is the most disruptive, in terms of what it can do to the marketplace. It accelerates and certainly reduces the processing time for supercomputing applications, high-performance applications, whether it's in a server configuration or a desk side configuration. So from workstations to servers, I think we have a real significant play there. So it's hard to guess exactly what it is, but I can't imagine it being too small. So the way that we think about our growth is partly related to share, partly related to the inherent growth of the PC marketplace, but mostly it's related to new markets.
Arnab Chanda – Lehman Brothers : Just one last question. Maybe Marv is getting a little bored there. Do you think that 20% last-three-year growth rate should be able to be a sustainable growth rate longer term, or how do you feel about that?
Marv Burkett: You want me to give you a long-range forecast. I'm not going to do that. We have some significant growth opportunities. We've executed very well. I hope and believe that we will continue to execute very well. So the real issue then is how quickly do some of these markets develop, and what is our success rate? But beyond that, I won't comment.
Operator: Your next question comes from Doug Freedman - ATR.
Doug Freedman - ATR : At the analyst day, you spoke about new products in the notebook arena. I know that G80 is really just ramping in production now. But given what we've seen in the marketplace, can you talk about what your timing is for the next-generation GPU out of NVIDIA?
Jen-Hsun Huang: We don't announce products until they are actually on the shelf. But I think the NVIDIA rhythm is sustainable, and it's a rhythm that we're committed to. So the rhythm that you've seen from us over the past several years is something that we are still very committed to.
Doug Freedman - ATR : Can you talk a little bit more about the front end or back end constraints that you're seeing? You mentioned that there may be some supply constraints in the October quarter. Can you talk a little bit about whether they are front or back end, or give us some clarity on what's happening there?
Marv Burkett: All of the above. Obviously, certainly in the fab areas, some of the fabs that we use are at capacity now. We would like more wafers, let's put it that way, in some of the fabs that we use. So there is a limitation there. There has been some constraints in both assembly and test as well. I think we can manage our way around most of the constraints in the back end more easily than we can around the constraints in the front end, but there are constraints on both sides.
Doug Freedman - ATR : I noticed in the July quarter, the tax rate came in at less than we were modeling here. Is there an update for the tax rate going forward? Is there something that happened there?
Marv Burkett: The tax rate was 14% in Q2, consistent with Q1. We're anticipating a 14% tax rate in Q3. So tax rate is flat, 14%.
Doug Freedman - ATR : The quarter-to-quarter growth in both professional and consumer?
Marv Burkett: Consumer was relatively flat quarter to quarter. Professional was down about 10%. Before somebody jumps on that one, we didn't have to push it. Revenue was good.
Doug Freedman - ATR : Clearly. Congratulations on the excellent execution.
Operator: Your next question comes from David Wu – Global Crown Capital.
David Wu – Global Crown Capital: Marv, I'm going to take advantage of your vocal chords. Can you talk a little bit about the strength of your Q2 results? Because the AMD unit volumes snapped back very sharply and I thought it would show up in much higher chipset volume. Instead, it showed up in your mainstream desktop volume. Can you explain the difference between the 31% drop off in your first fiscal quarter and a more moderate rebound in the second quarter on the chipset business?
Marv Burkett: Same answer that we had in the professional workstation business. We didn't have to push it. Revenue was good, and we had to satisfy the GPU customers first. So we didn't have to push it at all.
David Wu – Global Crown Capital: Second question is, your guidance for Q3 appears to be below normal seasonality. I know there are issues with Taiwan foundries and some back end guys. But if you didn't have the constraint on production, would you be having less than seasonal increase in Q3?
Marv Burkett: Who knows? If we had plenty of inventory and we had no manufacturing constraints, I don't believe there's any reason we shouldn't grow at industry rates in the quarter. But who knows? We depleted inventories quite dramatically in Q2, so we're left with less of a reserve in inventory than we would like, reserve meaning inventories to be shipped. So that, combined with the manufacturing constraints, just leaves us with some caution.
Operator: Your next question comes from Nick Aberle – Caris.
Nick Aberle – Caris : Nice quarter. The question had to do with just PC markets. Obviously, Q2 probably better than seasonal , looks like the back half is going to be at least seasonal. How do you guys go about monitoring inventory out at the OEMs and in the channel, just for fear of double ordering or perhaps overheating here exiting 2007?
Jen-Hsun Huang: Over the years, we have developed more rigorous channel monitoring capabilities. We monitor sell-in, we monitor sell-out at each juncture in the channel, and we monitor our customers' inventory the best we can. So based on what we're seeing right now, inventory looks pretty lean in the marketplace. We expect it to remain lean in the marketplace for some time, and so we'll just monitor as we go.
Nick Aberle – Caris : With respect to the Intel IGP product, should we be thinking of that as just beginning to ramp in Q3 and then more of a sequential contribution in Q4?
Jen-Hsun Huang: I think that's a fair estimate.
Nick Aberle – Caris : Very last question, just because of the constraints at foundry, are you guys going about qualifying any new foundry partners?
Jen-Hsun Huang: No, we have no plans. We have very close working relationships with our foundries and they are the best foundries in the world, and we do as rigorous of a job planning with them as just about anybody on the planet, and they have come through for us time and time again. My estimation is that they will come through for us again and everything is going to work out just fine.
Nick Aberle – Caris : What would the target days of inventory be? Where do you feel comfortable, Marv?
Marv Burkett: I have always had a target of around 70 days, and I think we have been around 70 days for the most part. We have been a little bit above it in some cases, but to be down at 49 days means we have pretty lean inventory.
Operator: Your next question comes from Daniel Ernst - Hudson Square Research.
Daniel Ernst - Hudson Square Research: Jen-Hsun, you mentioned that the graphics capabilities are becoming more and more appreciated by a wider audience, and I think that is a theme that a lot of us share. Can you talk about what progress you have made there, anecdotally and say in the last six months, what percentage of NVIDIA GPU buyers either embedded or after-market, would be gamers versus non-gamers? Where was that six months, a year ago? Where does it go a year from now?
Jen-Hsun Huang: The question you asked is a good one. It's hard to quantify, but let me give you some directional evidence. If you were to go back five years, the only thing that really took advantage of the GPU was videogames for consumer applications. Today, you have Google Earth, you have photo editing tools that take advantage of GPUs, you have video editing tools that take advantage of GPUs. You have the operating system that takes advantage of the GPU and all of the animation and all the special effects, and all those beautiful things that you see on your display are all rendered by the GPU. You have video processing that's done by the GPU now, because high-definition video is so taxing. To think about running it on the CPU is just not something that you would even dream about. So there are so many things now that requires a GPU. There's Second Life that requires a GPU. That's a social networking application. So the number of applications out there that reaches different areas is just really, really growing quickly. It's at a time when the GPU is getting harder and harder to build. You notice that the number of second-tier chipset companies in the world who are building DX 10 or even DX 9-level GPUs have really fallen off a cliff. When we say that it costs us $400 million to build a new generation of GPU, we actually mean that. NVIDIA's R&D and most of the company today is in R&D is running close to $1 billion a year run rate now. So I think it's safe to say that the GPU is very, very hard to build. It's one of the most complex processors ever, anywhere in the computing industry, and that explains its processing capabilities. The number of applications that take advantage of it over time is increasing. So I hope that anecdotal gives you a bit of a directional, both in number of applications and the fact that chipsets, second-tier chipset companies are finding it very, very hard to keep up with the technology creates ever more opportunities for us.
Daniel Ernst - Hudson Square Research: Yes, agreed. It was a good anecdotal directional. We will have to drill down later on it. But my follow-up question would be on pricing. Can you talk about recent pricing trends, and then given commentary on yours and the industry's supply constraints, is there any pricing leverage you have here in the back half?
Jen-Hsun Huang: The GPU is probably one of the only semiconductor devices in the industries that has kept a relatively flat to slightly up ASPs over the last several years. My sense is that it reflects the importance of the GPU, the increasing number of applications that take advantage of the GPU. With respect to pricing, we're expecting to work through our tightness of supply. We are not lines down, we are not gapped out, we are not in a bad situation like that. We are just tight, and we know that the entire industry is tight, from PCBs to DRAMs to others. So my sense is that we're going to be just fine. In this environment, it is not our style and it is not our practice to raise prices. We don't do that to our customers, and we're just going to work through it.
Operator: Your next question comes from Tayyib Shah - Longbow Research.
Tayyib Shah - Longbow Research: Congratulations on the quarter. You talked about how mainstream desktop GPU is driving the market-share gains, which is understandable, given the timing of your product refresh versus your competitors'. Can you talk about the impact you are seeing from AMD's product launch in the OEM channel, especially in the enterprise segment? Is that where you see them concentrating their effort? How does that affect your ability to grow your desktop market share in the near term?
Jen-Hsun Huang: Our mainstream DX 10 GPUs entered the market a solid quarter or two quarters ahead, and the momentum is clearly very strong. The market share data reflects that. We don't win everything in the marketplace, and we still see a lot of competition from our competitors. We have to fight hard for every socket and every design win that we have. So my sense is that we're going to continue to see a lot of competition, and I don't think anything is going to change, despite the environment. So we are prepared for the competition, we will deal with it the best we can and my hope is that we are in a position, because of the superiority of our products and our market position that we will be able to capture even more share, but we will see how it turns out.
Tayyib Shah - Longbow Research: The follow-up question is for Marv. Can you give us an idea of what you are leaving on the table because of capacity constraints? Can you talk about the chances that eventually you may end up getting all of the supply that you want? Or the fact that what you cannot ship in the third quarter, you still capture that in the early fourth due to the holiday season window?
Marv Burkett: We are going to work very hard to eliminate any supply constraints in Q3, so we will have to see how it goes, but we think we can work our way through it. We will just have to see. The question of something left on the table in Q3 rolling into Q4, who knows. We will have to see what it is, what the problem is, and what the competition is. There are too many unknowns.
Jen-Hsun Huang: We are not gapped out, it is just tight and we know it is tight because we know our foundries are near capacity, and so we have to be much more focused, we have to be much more precise in our forecasting and planning with our partners, but all of that is happening and so we are optimistic that we are going to serve all of our customers needs and we are just communicating the industry is tight, but we are telling you something you already know.
Operator: Your next question comes from Gurinder Kalra - Bear Stearns.
Gurinder Kalra - Bear Stearns : Marv, how much of the margin potential, the margin appreciation you might have expected with the G89 is already in the numbers, and how much more could it impact your margins going forward?
Marv Burkett: It is a combination of factors. A substantial portion of our current GPU revenue is in the G8x family, but we continue to make progress in reducing costs, even within that family. So there is still a ways to go. We can still do better. Are we more than 50% into the G8x family? Yes. Are we 100%? No. So we have a ways to go, but even if it were 100% we can make further cost reductions.
Jen-Hsun Huang: Just to add some flavor to that, where we have the opportunity to improve gross margins going forward remains in the same well where we found the last, nearly 18% of gross margin improvement; that is operational excellence. We still have plenty of ideas on ways that we can improve the operational efficiency of our company and eliminating waste and improving quality. There are so many things we can still do, and that is where we will focus. I think G7x was a wonderful architecture for us, and G8x is an even better architecture for us, but nonetheless I think that the well for gross margin improvements is right over operational efficiency.
Gurinder Kalra - Bear Stearns : Where do you think margins are for your Tesla products as compared to your corporate average, or what you get in your professional solutions business?
Marv Burkett: Much higher.
Gurinder Kalra - Bear Stearns : Any way to quantify that?
Jen-Hsun Huang: I think in the end it is going to reflect the speed by which we deliver for applications. That still remains to be seen. We are working on that now. It ranges anywhere from a lot to a ton, so we are trying to figure all of that stuff out. It is also a brand new product in a brand new market. This is something that the world has never seen before, so it is hard to precisely set the right price. But we are working with our partners and all of the customers around the world now to make sure we do something that enables rapid adoption and allows us to substantially increase our level of investment for it.
Operator: Your next question comes from Simona Jankowski - Goldman Sachs.
Simona Jankowski - Goldman Sachs: Thank you. A question for Marv first. What was your pricing change in the GPU business in the quarter sequentially?
Marv Burkett: Relatively flat.
Simona Jankowski - Goldman Sachs: Just on pricing or generally, we had noticed in the retail channel some price cuts in the very high end and also in some of the lower end segments. Curious if those kind of pricing actions were done by people in the channel or in retail, regardless of what you guys did as far as pricing goes? If you can give us a little bit more color on that, especially given it comes on the heels of six to eight months of pretty stable pricing.
Jen-Hsun Huang: The 8800 demand is really, really solid and it continues to be very good going into the second half of the year. We haven’t done any substantial pricing actions that I know of, but we have a lot of partners in the world and they have their own strategies and we don’t mandate our strategies on them. So maybe what you are seeing is something that is reflected from that.
Simona Jankowski - Goldman Sachs: Lastly for Marv, given that a lot of the strength in the business is coming from the GPU side, is that in any way affecting the timing of when you think you would reach the 47% gross margin target?
Marv Burkett: No, I don’t think so. I want to emphasize again, don’t put too much into the fact that the MCC and the workstation group didn’t grow as much as you might have thought. We just didn’t have to push it, and so I still think that in a mix that is inherent in the business that we are going to achieve that gross margin. We will see.
Simona Jankowski - Goldman Sachs: So you have some of that flexibility, I guess, to the upside in the workstation business in the next couple of quarters?
Marv Burkett: I would think so.
Operator: Sir, we have no further questions at this time. I will turn the call back to you.
Jen-Hsun Huang: NVIDIA delivered an outstanding quarter with record revenue, record gross margin and record net income. These results reflect the growing importance of the GPU, as well as great execution across the company. Our ongoing strategy to extend the reach of the GPU is paying off. There is a fast-growing universe of applications that rely on the processing capability of the GPU, from 3D design and styling tools, video and photo editing software, 3D maps and video games, to be using our interfaces with the Mac and Vista. The GPU can surely enhance the computing experience for everyone, from artists to engineers to scientists to gamers and everyday PC users. As the leading and only dedicated GPU company in the world, our opportunity has never been more exciting as the number of applications and digital devices that benefit from the GPU continues to grow. Thank you for joining us today. We look forward to reporting on our results for Q3. | [
{
"speaker": "Executives",
"text": "Michael Hara - VP of IR Jen-Hsun Huang - President and CEO Marv Burkett - CFO"
},
{
"speaker": "Analysts",
"text": "Arnab Chanda – Lehman Brothers Doug Freedman - ATR David Wu – Global Crown Capital Nick Aberle - Caris and Company Daniel Ernst - Hudson Square Research Tayyib Shah - Longbow Research Gurinder Kalra - Bear Stearns Simona Jankowski - Goldman Sachs"
},
{
"speaker": "Michael Hara",
"text": "Thanks, Frank. Good afternoon and welcome to [Gap in audio] NVIDIA’s Chief Financial Officer. Before we begin today's call, I would like to take care of some general administrative items. Your lines have been placed on a listen-only mode until the question-and-answer segment of today's call. During this call, we will discuss some non-GAAP financial measures about net income, diluted net income per share and gross margin in talking about our results. You can find a reconciliation of these non-GAAP financial measures to GAAP financial measures in our financial release, which is posted on the investor relations page of our website at www.nvidia.com. Unless otherwise noted, all references to research numbers throughout the call come from Mercury Research. This call is being recorded. If you have any objections, you may disconnect at this time. Please be aware that if you decide to ask a question, it will be included in both our live transmission as well as any future use of the recording. Also, shareholders can listen to a live webcast of today's call via the investor relations page of our website at www.nvidia.com. The webcast will be available for replay until the company's conference call to discuss its financial results for its third quarter fiscal 2008. During the course of this conference call, we may make forward-looking statements based on current expectations. Forward-looking statements, including statements as to our outlook, seasonality, the impact, features, performance and availability of our products and technologies, our strategies, growth and growth drivers, market share and the importance of and uses for GPUs pertain to future events and are subject to a number of significant risks and uncertainties. The company's actual results may differ materially from results discussed in any forward-looking statements. For a complete discussion of factors that could affect the company's future financial results and business, please refer to the company's Form 10-Q for the period ended April 29, 2007 and the reports on Form 8-K filed with the Securities and Exchange Commission. All forward-looking statements are made as of the date hereof, based on information available to us today. Except as required by law, the company assumes no obligation to update any such statements. The content of the webcast contains time-sensitive information that is accurate only as of August 9, 2007. Consistent with the requirements under Regulation FD, we will be providing public guidance directly in the conference call, and will be unable to provide significantly more information in offline conversations or during the quarter. Therefore, questions around our financial expectations should be asked during this call. At the end of our remarks, there will be time for your questions. In order to allow more people to ask questions, please limit yourself to one question. After our response, we will allow one follow-up question. I would now hand the call over to Jen-Hsun."
},
{
"speaker": "Jen-Hsun Huang",
"text": "[Gap in audio] revenue, record net income and record gross margin. For our second quarter, revenue grew 36% from last year to a record $935 million, and non-GAAP net income increased 77% year over year. Non-GAAP gross margin improved to a record 45.6%, an increase of 290 basis points from a year ago. GAAP net income nearly doubled year over year, and GAAP gross margin improved by 280 basis points from a year ago to a record 45.3%. We achieved a record quarter despite Q2 being historically the seasonally slowest quarter of the year. Let me highlight some of our achievements for Q2. The GeForce desktop and notebook product lines each achieved record revenue. The desktop GPU product line grew 37% year over year, and the notebook GPU product line grew 129% from last year. We continued to capture leading share in five categories. Total standalone GPU share grew to 66% from 48% a year ago. Total standalone desktop GPU share grew to 65% from 51% a year ago. Total standalone notebook GPU share grew to 68% from 37% a year ago. Our DirectX 9 generation share was 64% and DirectX 10 generation share was 75%. During the quarter, we launched a new family of GeForce 8M series GPUs in support of the production ramp of nearly every notebook PC OEM in the world including Acer, Apple, ASUS, Dell, HP, Lenovo, Samsung, Sony and Toshiba. The global notebook PC segment continues to grow significantly faster than the overall PC market. We believe Q3 growth will continue its strong momentum. In June, we launched Tesla, our entry into the high-performance computing industry. HPC Wire, the most recognized and accessed news and information site covering the entire ecosystem of high-performance computing, named Tesla as one of the most significant launches in the HPC industry in the first half of 2007. The Tesla family consists of the C870 GPU computing processor, the D870 desk-sized supercomputer and the S870 1U computing server. nForce 65i SLI powers the new maximum PC Dream Machine 2007. This is the third consecutive year nForce has been selected as its motherboard of choice by the number-one magazine for home computing enthusiasts. Maximum PC chose nForce 65i SLI because of its performance, its overclock ability with quad-core CPUs and SLI support. We introduced an entirely new line of notebook workstation GPU's based on G8X architecture, the NVIDIA Quadro FX 1600M, 570M and 360M. Let me now turn the call over to Marv to discuss our financial results in more detail. I will return in a moment to discuss our business and growth drivers for Q3 and beyond."
},
{
"speaker": "Marv Burkett",
"text": "Thanks, Jen-Hsun. Before I get started, I would like to apologize for the irritating coughing you may hear in the background. That's me. I'm fighting a little case of bronchitis so I apologize for that. Today, we're reporting both GAAP and non-GAAP P&Ls for Q2 fiscal year 2008 and for the first six months of fiscal year 2008. The only difference between GAAP and non-GAAP is equity-based compensation and its tax effect. As mentioned, revenue for the second quarter was $935.3 million, which is up $91 million or 11% from the first quarter and up $248 million or 36% over the prior year. Obviously, strong revenue growth exceeded our guidance. The strength was primarily in the GPU business. While MCP grew $12 million or 8% quarter to quarter, we had expected this in our guidance. The strength in the GPU business included both desktop and notebook. In total, the GPU business grew 20% quarter to quarter. Within the GPU business, notebook grew 50% quarter to quarter, as the Santa Rosa launch was well accepted. Much of the growth in desktop was in mainstream products. Year to year, GPU revenue was up 55% and MCP was up 16%. For the quarter, GAAP gross margin was 45.3%, which is up 30 basis points quarter to quarter. Non-GAAP gross margin was 45.6%, up 20 basis points quarter to quarter. With the very high growth we experienced in mainstream GPUs, we expected margin pressure, but we were able to overcome that with continued execution of the transition to GeForce 8X products and good operational execution. Non-GAAP operating expenses in the quarter were $212.5 million, and within our guidance. The GAAP operating expenses were relatively flat quarter to quarter, as the total equity-based compensation dropped by approximately $8 million from the first quarter. We had expected this roll off due to several contributing factors, one of which is the transition from Black-Scholes to a binomial valuation model that we made several years ago. During the quarter, we continue to hire and added 299 new employees. Two-thirds of the additions were in the R&D area. The tax rate stayed constant at 14%, and this resulted in GAAP earnings of $172.7 million or $0.43 per diluted share. Non-GAAP earnings were $198.1 million or $0.51 per diluted share. On the balance sheet, we ended the quarter with $1.57 billion in cash, even though we repurchased almost $125 million in stock. The operating cash flow was over $300 million for the second quarter in a row. Accounts receivable were $508 million, which generated days sales outstanding of 50 days. The fact that the quarter was more evenly loaded than expected helped with the reduction in days sales outstanding. Inventory was down $56 million to $276 million, and resulted in days sales in inventory of 49 days. In my opinion, this inventory level is too low. Capital expenditures in the quarter were $30 million and depreciation was $32 million. Both for the quarter and year to date, capital expenditures and depreciation almost offset each other. There was not much else of significance on the balance sheet. I will also like to point out that today we announced a 3-for-2 stock split in the form of a stock dividend. On the outlook, for the quarter, we're starting from a higher base, given our Q2 performance. Still, we expect revenue growth in most areas, particularly notebook and workstations. The result is we believe revenue will grow 5% to 7%. We believe there may be some product limitations, as manufacturing capacity is somewhat limited and our inventories are low. For gross margins, we will work hard to continue to improve gross margins, and with the continued transition to GeForce 8X products and the expected increase in workstation revenue, we believe some improvement is possible. For operating expenses, with our continued hiring and salary increases, we expect OpEx to also grow in the 5% to 7% range. We believe the tax rate will hold at 14%. With that, I will turn the call back over to Jen-Hsun."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks, Marv. Although Q2 is typically the weakest seasonal quarter for the industry, we experienced growth in desktop and notebook GPU and MCP. We are now heading into what are historically the two strongest quarters of the year, driven by back-to-school and holiday cycles. As we head into the seasonally strong second half, we will enjoy several dynamics that continue to enhance the importance of the GPU. First, exciting DX 10 games are launching shortly. Crysis from EA is particularly exciting and will help drive GPU upgrades. Second, HD and Blu-ray disk drives continue to come down in price, and title availability is now plenty. Third, discrete GPU technology has advanced substantially relative to integrated graphics, creating a large technology gap between our discrete GPUs and high-volume integrated graphics chips at a time when the graphics demand from modern operating systems like Vista and OS 10 continue to increase. As a result, we expect to see the overall GPU segment to grow. Lastly, we have a strong position in both desktop as well as notebook, and believe we can continue to grow share. At our analyst day in June, we announced several brand new growth areas and exciting new strategies. I would like to take this opportunity to discuss them again. First is the highly anticipated launch of our first motherboard GPU for Intel processors. Directly attached to the motherboard, our new products will bring the NVIDIA brand of GPUs to a new price point for Intel processor customers. This is a first for NVIDIA and an exciting new growth opportunity. Second, we announced an exciting new technology called Hybrid SLI. Future motherboard GPUs and discrete GPUs will collaborate to enhance capabilities, performance as well as reducing power. We call it Hybrid because this technology combines a powerful as well as an energy-efficient engine; and SLI because this is our multi-GPU technology. When GeForce N-cards are connected to GeForce motherboards, Hybrid SLI kicks in, combining their processing power to deliver an additive experience. The technology is application aware. Depending on the processing demands of each application, the discrete GPU may be completely shut down to save power. For the most powerful systems, where the combined power of dual GeForce 8800 GTX SLI can reach 400 watts, both GPUs can be powered down when the user is just doing e-mail, surfing the Web or watching a Blu-ray movie, keeping the system completely quiet and consuming the least possible energy. But when a game or other demanding GPU application is launched, the dual 8800 GTXs are powered up to deliver an immersive experience. For performance systems, Hybrid SLI will give users the benefit of energy efficiency, as well as uncompromising performance. For mainstream systems, Hybrid SLI will enhance the performance and features by combining the benefits of the motherboard and the add-in card GPU. Hybrid SLI will be available starting with our GeForce 8 series motherboard GPUs this fall. Third, we announced Tesla, a new line of high-performance computing processors based on our revolutionary G8X GPU architecture. Tesla leverages the massive computational resources inherent in our GPUs, which can be over 100 times greater than the fastest microprocessor alone. This breakthrough innovation centers around technologies that will enable programmers to access this massive computational resource. The Tesla architecture and supporting C language compiler and development environment is called CUDA. The adoption of Tesla and CUDA has far exceeded my expectations. We have known for some time that the world has a supercomputing crisis. The enthusiasm around Tesla is a reflection of this vacuum. Thousands of programmers worldwide are already creating parallel GPU programs using CUDA and Tesla. The Tesla family includes a GPU computing board, a Quadro Plex style desk-sized system and the world's first 1U GPU computing server. I believe Tesla and CUDA will represent one of the most significant technology discontinuities in the supercomputing industry since Cray introduced vector processing. We anticipate Tesla will enable fundamental new discoveries in a broad range of industries. Customers in the field of computational chemistry, neurological science, medicine and seismic processing have seen computation times reduced by as much as 5,000% using Tesla. Tesla is yet another example of the power of the GPU and its increasing impact on the computer and consumer electronics industry. NVIDIA now has three major brands, GeForce for enjoyment, Quadro for creation and now Tesla for discovery. The diversity of our brands reflect the versatility and the importance of the GPU. Let us now take your questions."
},
{
"speaker": "Operator",
"text": "Your first question comes from Arnab Chanda – Lehman Brothers."
},
{
"speaker": "Arnab Chanda – Lehman Brothers",
"text": "Obviously the performance in the graphics business has been superlative. Do you think any of this is other than, obviously, share gain? Are you seeing a Vista effect here? If so, what do you think? Is this the beginning of it, or how long do you think that continues?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Well, this can't be all share gain. It's very clear that the size of the GPU market is larger than several quarters ago. We can only attribute that to a variety of things which we think either falls into the category of Vista, as we know that Vista is becoming better and better, and consumer PC adoption is certainly very high with Vista. We know that the experience of Vista is significantly better with the GPU in your system. We also believe that DX 10 applications and the new generation of video games are rather taxing, and it's because of the technology gap between the GPU and integrated graphics, the separation has become so large that it makes it clear that a GPU is better. Then the third reason is Blu-ray and high-definition video. I think all of these things are really playing together and helping the GPU market substantially."
},
{
"speaker": "Arnab Chanda – Lehman Brothers",
"text": "We think maybe we understand what's going on in the PC business and what kind of growth rate that would create. However, you have obviously had much better growth rates than that in the last three years, above 20%. I knew you don't want to give guidance. But for next year, what type of growth in non-PC segments, whether it's Tesla, whether it's your cell phone business, perhaps consumer or other things you haven't really talked about, how much can the add to your core business, your PC business growth?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "The growth of our GPU business, whether it's discrete GPUs or motherboard GPUs, is a function of the growth rate of the PC. It's related to the share gains that we have, but it's also related to how much of the PC marketplace appreciates a GPU. NVIDIA's market share is about 30% in the overall GPU market and so there's still 60% of the PCs that can benefit from better GPUs. I think that, over time, as more and more of the computing experience is related to computer graphics and what you see on your display, and as the size of displays become larger and as the content that we see become richer, it's just evident that more and more people appreciate the GPU. So that's one factor. With respect to going forward, how we think about the market, we think about the new markets that we enter as we grow. In the second half of this year, I just mentioned that we're going to bring our GeForce brand for the first time to motherboards for Intel processors. Hard to say exactly how big that marketplace is, but I think the overall market for core logic is somewhere between $6 billion to $8 billion, of which we have a relatively small part of that. So that's a growth opportunity for us. We also look at the TAM of the application processors that we're building. We are entering into a marketplace that is in the process of transitioning from being a cell phone, a telephone, to being a mobile computer. We are targeting this discontinuity and building, effectively, a modern multimedia computer on a single chip. We call it an application processor. I think this is going to be a phenomenal opportunity for us, and one that we can add a lot of value to the industry, bringing computing expertise to the cell phone marketplace. That marketplace, it is hard to say exactly how big that's going to be, but it's many billion dollars large, as you know. Tesla is probably the hardest of all to guess, and the reason for that is because it's the product that is the most disruptive, in terms of what it can do to the marketplace. It accelerates and certainly reduces the processing time for supercomputing applications, high-performance applications, whether it's in a server configuration or a desk side configuration. So from workstations to servers, I think we have a real significant play there. So it's hard to guess exactly what it is, but I can't imagine it being too small. So the way that we think about our growth is partly related to share, partly related to the inherent growth of the PC marketplace, but mostly it's related to new markets."
},
{
"speaker": "Arnab Chanda – Lehman Brothers",
"text": "Just one last question. Maybe Marv is getting a little bored there. Do you think that 20% last-three-year growth rate should be able to be a sustainable growth rate longer term, or how do you feel about that?"
},
{
"speaker": "Marv Burkett",
"text": "You want me to give you a long-range forecast. I'm not going to do that. We have some significant growth opportunities. We've executed very well. I hope and believe that we will continue to execute very well. So the real issue then is how quickly do some of these markets develop, and what is our success rate? But beyond that, I won't comment."
},
{
"speaker": "Operator",
"text": "Your next question comes from Doug Freedman - ATR."
},
{
"speaker": "Doug Freedman - ATR",
"text": "At the analyst day, you spoke about new products in the notebook arena. I know that G80 is really just ramping in production now. But given what we've seen in the marketplace, can you talk about what your timing is for the next-generation GPU out of NVIDIA?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "We don't announce products until they are actually on the shelf. But I think the NVIDIA rhythm is sustainable, and it's a rhythm that we're committed to. So the rhythm that you've seen from us over the past several years is something that we are still very committed to."
},
{
"speaker": "Doug Freedman - ATR",
"text": "Can you talk a little bit more about the front end or back end constraints that you're seeing? You mentioned that there may be some supply constraints in the October quarter. Can you talk a little bit about whether they are front or back end, or give us some clarity on what's happening there?"
},
{
"speaker": "Marv Burkett",
"text": "All of the above. Obviously, certainly in the fab areas, some of the fabs that we use are at capacity now. We would like more wafers, let's put it that way, in some of the fabs that we use. So there is a limitation there. There has been some constraints in both assembly and test as well. I think we can manage our way around most of the constraints in the back end more easily than we can around the constraints in the front end, but there are constraints on both sides."
},
{
"speaker": "Doug Freedman - ATR",
"text": "I noticed in the July quarter, the tax rate came in at less than we were modeling here. Is there an update for the tax rate going forward? Is there something that happened there?"
},
{
"speaker": "Marv Burkett",
"text": "The tax rate was 14% in Q2, consistent with Q1. We're anticipating a 14% tax rate in Q3. So tax rate is flat, 14%."
},
{
"speaker": "Doug Freedman - ATR",
"text": "The quarter-to-quarter growth in both professional and consumer?"
},
{
"speaker": "Marv Burkett",
"text": "Consumer was relatively flat quarter to quarter. Professional was down about 10%. Before somebody jumps on that one, we didn't have to push it. Revenue was good."
},
{
"speaker": "Doug Freedman - ATR",
"text": "Clearly. Congratulations on the excellent execution."
},
{
"speaker": "Operator",
"text": "Your next question comes from David Wu – Global Crown Capital."
},
{
"speaker": "David Wu – Global Crown Capital",
"text": "Marv, I'm going to take advantage of your vocal chords. Can you talk a little bit about the strength of your Q2 results? Because the AMD unit volumes snapped back very sharply and I thought it would show up in much higher chipset volume. Instead, it showed up in your mainstream desktop volume. Can you explain the difference between the 31% drop off in your first fiscal quarter and a more moderate rebound in the second quarter on the chipset business?"
},
{
"speaker": "Marv Burkett",
"text": "Same answer that we had in the professional workstation business. We didn't have to push it. Revenue was good, and we had to satisfy the GPU customers first. So we didn't have to push it at all."
},
{
"speaker": "David Wu – Global Crown Capital",
"text": "Second question is, your guidance for Q3 appears to be below normal seasonality. I know there are issues with Taiwan foundries and some back end guys. But if you didn't have the constraint on production, would you be having less than seasonal increase in Q3?"
},
{
"speaker": "Marv Burkett",
"text": "Who knows? If we had plenty of inventory and we had no manufacturing constraints, I don't believe there's any reason we shouldn't grow at industry rates in the quarter. But who knows? We depleted inventories quite dramatically in Q2, so we're left with less of a reserve in inventory than we would like, reserve meaning inventories to be shipped. So that, combined with the manufacturing constraints, just leaves us with some caution."
},
{
"speaker": "Operator",
"text": "Your next question comes from Nick Aberle – Caris."
},
{
"speaker": "Nick Aberle – Caris",
"text": "Nice quarter. The question had to do with just PC markets. Obviously, Q2 probably better than seasonal , looks like the back half is going to be at least seasonal. How do you guys go about monitoring inventory out at the OEMs and in the channel, just for fear of double ordering or perhaps overheating here exiting 2007?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Over the years, we have developed more rigorous channel monitoring capabilities. We monitor sell-in, we monitor sell-out at each juncture in the channel, and we monitor our customers' inventory the best we can. So based on what we're seeing right now, inventory looks pretty lean in the marketplace. We expect it to remain lean in the marketplace for some time, and so we'll just monitor as we go."
},
{
"speaker": "Nick Aberle – Caris",
"text": "With respect to the Intel IGP product, should we be thinking of that as just beginning to ramp in Q3 and then more of a sequential contribution in Q4?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "I think that's a fair estimate."
},
{
"speaker": "Nick Aberle – Caris",
"text": "Very last question, just because of the constraints at foundry, are you guys going about qualifying any new foundry partners?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "No, we have no plans. We have very close working relationships with our foundries and they are the best foundries in the world, and we do as rigorous of a job planning with them as just about anybody on the planet, and they have come through for us time and time again. My estimation is that they will come through for us again and everything is going to work out just fine."
},
{
"speaker": "Nick Aberle – Caris",
"text": "What would the target days of inventory be? Where do you feel comfortable, Marv?"
},
{
"speaker": "Marv Burkett",
"text": "I have always had a target of around 70 days, and I think we have been around 70 days for the most part. We have been a little bit above it in some cases, but to be down at 49 days means we have pretty lean inventory."
},
{
"speaker": "Operator",
"text": "Your next question comes from Daniel Ernst - Hudson Square Research."
},
{
"speaker": "Daniel Ernst - Hudson Square Research",
"text": "Jen-Hsun, you mentioned that the graphics capabilities are becoming more and more appreciated by a wider audience, and I think that is a theme that a lot of us share. Can you talk about what progress you have made there, anecdotally and say in the last six months, what percentage of NVIDIA GPU buyers either embedded or after-market, would be gamers versus non-gamers? Where was that six months, a year ago? Where does it go a year from now?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "The question you asked is a good one. It's hard to quantify, but let me give you some directional evidence. If you were to go back five years, the only thing that really took advantage of the GPU was videogames for consumer applications. Today, you have Google Earth, you have photo editing tools that take advantage of GPUs, you have video editing tools that take advantage of GPUs. You have the operating system that takes advantage of the GPU and all of the animation and all the special effects, and all those beautiful things that you see on your display are all rendered by the GPU. You have video processing that's done by the GPU now, because high-definition video is so taxing. To think about running it on the CPU is just not something that you would even dream about. So there are so many things now that requires a GPU. There's Second Life that requires a GPU. That's a social networking application. So the number of applications out there that reaches different areas is just really, really growing quickly. It's at a time when the GPU is getting harder and harder to build. You notice that the number of second-tier chipset companies in the world who are building DX 10 or even DX 9-level GPUs have really fallen off a cliff. When we say that it costs us $400 million to build a new generation of GPU, we actually mean that. NVIDIA's R&D and most of the company today is in R&D is running close to $1 billion a year run rate now. So I think it's safe to say that the GPU is very, very hard to build. It's one of the most complex processors ever, anywhere in the computing industry, and that explains its processing capabilities. The number of applications that take advantage of it over time is increasing. So I hope that anecdotal gives you a bit of a directional, both in number of applications and the fact that chipsets, second-tier chipset companies are finding it very, very hard to keep up with the technology creates ever more opportunities for us."
},
{
"speaker": "Daniel Ernst - Hudson Square Research",
"text": "Yes, agreed. It was a good anecdotal directional. We will have to drill down later on it. But my follow-up question would be on pricing. Can you talk about recent pricing trends, and then given commentary on yours and the industry's supply constraints, is there any pricing leverage you have here in the back half?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "The GPU is probably one of the only semiconductor devices in the industries that has kept a relatively flat to slightly up ASPs over the last several years. My sense is that it reflects the importance of the GPU, the increasing number of applications that take advantage of the GPU. With respect to pricing, we're expecting to work through our tightness of supply. We are not lines down, we are not gapped out, we are not in a bad situation like that. We are just tight, and we know that the entire industry is tight, from PCBs to DRAMs to others. So my sense is that we're going to be just fine. In this environment, it is not our style and it is not our practice to raise prices. We don't do that to our customers, and we're just going to work through it."
},
{
"speaker": "Operator",
"text": "Your next question comes from Tayyib Shah - Longbow Research."
},
{
"speaker": "Tayyib Shah - Longbow Research",
"text": "Congratulations on the quarter. You talked about how mainstream desktop GPU is driving the market-share gains, which is understandable, given the timing of your product refresh versus your competitors'. Can you talk about the impact you are seeing from AMD's product launch in the OEM channel, especially in the enterprise segment? Is that where you see them concentrating their effort? How does that affect your ability to grow your desktop market share in the near term?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Our mainstream DX 10 GPUs entered the market a solid quarter or two quarters ahead, and the momentum is clearly very strong. The market share data reflects that. We don't win everything in the marketplace, and we still see a lot of competition from our competitors. We have to fight hard for every socket and every design win that we have. So my sense is that we're going to continue to see a lot of competition, and I don't think anything is going to change, despite the environment. So we are prepared for the competition, we will deal with it the best we can and my hope is that we are in a position, because of the superiority of our products and our market position that we will be able to capture even more share, but we will see how it turns out."
},
{
"speaker": "Tayyib Shah - Longbow Research",
"text": "The follow-up question is for Marv. Can you give us an idea of what you are leaving on the table because of capacity constraints? Can you talk about the chances that eventually you may end up getting all of the supply that you want? Or the fact that what you cannot ship in the third quarter, you still capture that in the early fourth due to the holiday season window?"
},
{
"speaker": "Marv Burkett",
"text": "We are going to work very hard to eliminate any supply constraints in Q3, so we will have to see how it goes, but we think we can work our way through it. We will just have to see. The question of something left on the table in Q3 rolling into Q4, who knows. We will have to see what it is, what the problem is, and what the competition is. There are too many unknowns."
},
{
"speaker": "Jen-Hsun Huang",
"text": "We are not gapped out, it is just tight and we know it is tight because we know our foundries are near capacity, and so we have to be much more focused, we have to be much more precise in our forecasting and planning with our partners, but all of that is happening and so we are optimistic that we are going to serve all of our customers needs and we are just communicating the industry is tight, but we are telling you something you already know."
},
{
"speaker": "Operator",
"text": "Your next question comes from Gurinder Kalra - Bear Stearns."
},
{
"speaker": "Gurinder Kalra - Bear Stearns",
"text": "Marv, how much of the margin potential, the margin appreciation you might have expected with the G89 is already in the numbers, and how much more could it impact your margins going forward?"
},
{
"speaker": "Marv Burkett",
"text": "It is a combination of factors. A substantial portion of our current GPU revenue is in the G8x family, but we continue to make progress in reducing costs, even within that family. So there is still a ways to go. We can still do better. Are we more than 50% into the G8x family? Yes. Are we 100%? No. So we have a ways to go, but even if it were 100% we can make further cost reductions."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Just to add some flavor to that, where we have the opportunity to improve gross margins going forward remains in the same well where we found the last, nearly 18% of gross margin improvement; that is operational excellence. We still have plenty of ideas on ways that we can improve the operational efficiency of our company and eliminating waste and improving quality. There are so many things we can still do, and that is where we will focus. I think G7x was a wonderful architecture for us, and G8x is an even better architecture for us, but nonetheless I think that the well for gross margin improvements is right over operational efficiency."
},
{
"speaker": "Gurinder Kalra - Bear Stearns",
"text": "Where do you think margins are for your Tesla products as compared to your corporate average, or what you get in your professional solutions business?"
},
{
"speaker": "Marv Burkett",
"text": "Much higher."
},
{
"speaker": "Gurinder Kalra - Bear Stearns",
"text": "Any way to quantify that?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "I think in the end it is going to reflect the speed by which we deliver for applications. That still remains to be seen. We are working on that now. It ranges anywhere from a lot to a ton, so we are trying to figure all of that stuff out. It is also a brand new product in a brand new market. This is something that the world has never seen before, so it is hard to precisely set the right price. But we are working with our partners and all of the customers around the world now to make sure we do something that enables rapid adoption and allows us to substantially increase our level of investment for it."
},
{
"speaker": "Operator",
"text": "Your next question comes from Simona Jankowski - Goldman Sachs."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Thank you. A question for Marv first. What was your pricing change in the GPU business in the quarter sequentially?"
},
{
"speaker": "Marv Burkett",
"text": "Relatively flat."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Just on pricing or generally, we had noticed in the retail channel some price cuts in the very high end and also in some of the lower end segments. Curious if those kind of pricing actions were done by people in the channel or in retail, regardless of what you guys did as far as pricing goes? If you can give us a little bit more color on that, especially given it comes on the heels of six to eight months of pretty stable pricing."
},
{
"speaker": "Jen-Hsun Huang",
"text": "The 8800 demand is really, really solid and it continues to be very good going into the second half of the year. We haven’t done any substantial pricing actions that I know of, but we have a lot of partners in the world and they have their own strategies and we don’t mandate our strategies on them. So maybe what you are seeing is something that is reflected from that."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Lastly for Marv, given that a lot of the strength in the business is coming from the GPU side, is that in any way affecting the timing of when you think you would reach the 47% gross margin target?"
},
{
"speaker": "Marv Burkett",
"text": "No, I don’t think so. I want to emphasize again, don’t put too much into the fact that the MCC and the workstation group didn’t grow as much as you might have thought. We just didn’t have to push it, and so I still think that in a mix that is inherent in the business that we are going to achieve that gross margin. We will see."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "So you have some of that flexibility, I guess, to the upside in the workstation business in the next couple of quarters?"
},
{
"speaker": "Marv Burkett",
"text": "I would think so."
},
{
"speaker": "Operator",
"text": "Sir, we have no further questions at this time. I will turn the call back to you."
},
{
"speaker": "Jen-Hsun Huang",
"text": "NVIDIA delivered an outstanding quarter with record revenue, record gross margin and record net income. These results reflect the growing importance of the GPU, as well as great execution across the company. Our ongoing strategy to extend the reach of the GPU is paying off. There is a fast-growing universe of applications that rely on the processing capability of the GPU, from 3D design and styling tools, video and photo editing software, 3D maps and video games, to be using our interfaces with the Mac and Vista. The GPU can surely enhance the computing experience for everyone, from artists to engineers to scientists to gamers and everyday PC users. As the leading and only dedicated GPU company in the world, our opportunity has never been more exciting as the number of applications and digital devices that benefit from the GPU continues to grow. Thank you for joining us today. We look forward to reporting on our results for Q3."
}
] | null | null |
NVDA | 1 | 2,008 | 2007-05-10 17:00:00 |
Executives | [] | null | null |
NVDA | 3 | 2,007 | 2006-11-09 20:00:00 | Executives: Michael Hara - VP of IR Jen-Hsun Huang - President and CEO Marv Burkett - CFO
Analysts: Shawn Webster - JP Morgan Mark Edelstone - Morgan Stanley Daniel Ernst - Hudson Square Research Doug Freedman - AmTech Research Tayyib Shah - Longbow Research Pranay Laharia - Deutsche Bank Dan Morris - CIBC World Markets Peter Karzaris - Citigroup Michael McConnell - Pacific Crest Devan Moodley - Scotia Capital Robert Dennison - UBS
Operator: Good afternoon and thank you for holding. I would now like to turn the call over to Michael Hara, NVIDIA's Vice President of Investor Relations. Sir, you may begin your conference.
Michael Hara: Thank you. Good afternoon and welcome to NVIDIA's conference call for the third fiscal quarter ended October 29, 2006. On the call today for NVIDIA are Jen-Hsun Huang, NVIDIA's President and Chief Executive Officer; and Marv Burkett, NVIDIA's Chief Financial Officer. Before we begin today's call I would like to take care of some general administrative items. Your lines have been placed on a listen-only mode until the question-and-answer segment of today's call. During this call we will discuss some non-GAAP measures about net income, net income per share and gross margin and other line items from our consolidated statements of income when talking about our results. You can find a full reconciliation of these measures to GAAP in our financial release, which is posted on the Investor Relations page of our website at www.nvidia.com. This call is being recorded. If you have any objections you may disconnect at this time. Please be aware that if you decide to ask a question it will be included in both our live transmission as well as any future use of the recording. Also shareholders can listen to a live webcast of today's call and view our financial release at the NVIDIA Investors Relations website. The webcast will be available for replay until the company's conference call to discuss its financial results for its fourth quarter fiscal 2007. During the course of this conference call, we may make forward-looking statements based on current expectations. Forward-looking statements, including statements as to our fourth quarter 2007 outlook, a review of the stock option practices by our audit committee, the restatement, the use of non-GAAP measures, the benefits and impact of the acquisition of PortalPlayer, new and forthcoming products, our products and technologies, growth drivers, market share, Windows Vista, PlayStation 3, design wins, strategic focus, and customers and partners pertain to future events, and are subject to a number of significant risks and uncertainties. The company's actual results may differ materially from results discussed in any forward-looking statements. For a complete discussion of factors that could affect the company's future financial results and business, please refer to the company's Form 10-K, an annual report for the fiscal year ended January 29, 2006, quarterly reports on Form 10-Q, and reports on Form 8-K filed with the Securities and Exchange Commission. All forward-looking statements are made as of the day hereof based on information available to us today. And except as required by law, the company assumes no obligation to update any such statement. The content of the webcast contains time sensitive information that is accurate only as of November 9, 2006. Consistent with the requirements under Regulation FD, we will be providing public guidance directly in the conference call and will be unable to provide significantly more information in off-line conversations or during the quarter, therefore questions around our financial expectations should be asked during this call. At the end of our remarks, there will be time for your questions. In order to allow more people to ask questions, please limit yourself to one question. After our response we will allow one follow-up question. As previously announced in June 2006, the Audit Committee of the Board of Directors of NVIDIA began a review of the company's stock option practices based on results of an interim review voluntarily undertaken by management. The Audit Committee's review covered the time from the company's initial public offering in 1999 to the current fiscal year, and as previously disclosed, found instances of the use of incorrect measurement base for certain option grants. The Audit Committee is being assisted by independent legal counsel and outside accounting experts. At this time, the Audit Committee has completed its forensic review of the option grants, is now working with the company's management to finalize the financial impact of using incorrect measurement dates. NVIDIA will publish the balance sheet as of the end of the third quarter and the statement of income for the nine months ended October 29, 2006, as well as restated statements of income for the comparable periods of fiscal 2006 as soon as practical upon completion of the Audit Committee's review. The company's current and former independent registered public accounting firms have not completed their review of the findings of the Audit Committee. Our financial results for the second and third quarters of fiscal year 2007 are not audited and may change as a result of the ongoing Audit Committee review. The stock option practices under review and related matters can also lead to the potential claims and proceedings relating to such matters, including litigation or action by the Securities and Exchange Commission and/or other regulatory agencies. I'll now hand the call over to Jen-Hsun.
Jen-Hsun Huang: Thanks, Mike. Good afternoon and thank you for joining us. Today, we are pleased to report record revenue of $820.6 million for our third quarter. This is our third consecutive record quarter. Year-over-year, third quarter revenue grew nearly 41%. Our growth was driven by strong performance and share gains from numerous product groups -- desktop GPU, notebook GPU and MCP, resulting in record revenue for the quarter that is well above normal seasonal patterns. Let me review the highlights and achievements for each of our business units during the quarter. Our desktop GPU business continued to deliver strong results in Q3. In addition to the seasonal strength of the PC market, we increased our desktop GPU share 5 points to 56%. GeForce achieved 89% share of the performance segment. Our desktop GPU revenue grew 13% year-over-year. With over 265 media awards worldwide in Q3, demand for our GeForce 7 series GPU remained very strong, even as we launch our next generation GPU. Yesterday, we announced GeForce 8800 to the world. Held in secrecy for four years and code-named G80, this is the most ambitious undertaking in our history. G80 is the product of hundreds of the world's best engineers, over 1,000 man years of effort, and over $400 million to develop. G80 is a revolutionary architecture and a completely ground up design. This is only the third fundamentally new architecture in our 13-year history. The last fundamentally new architecture was GeForce 256, the now famous GeForce introduced in 1999. G80 is based on a unified shader architecture. Instead of a separate vertex and pixel shading processors, G80 has 128 stream processors operating at 1.35 gigahertz that can process either vertex or pixel shaded programs. With a unified architecture, G80 can adapt its vast computational resources to the changing vertex or pixel shading workload from team to team. G80 is the world's first DX10 GPU. DX10 is a major new API for Microsoft Windows Vista, and includes many new important features. One of the most exciting DX10 and G80 features is the geometry shader. By programming the unified shader processes of G80, designers can programmatically create, destroy and manipulate geometric mesh. Game designers can do amazing things like procedural geometry to programmatically generate landscapes, particle systems to create realistic looking smoke and clouds, displacement maps to create incredibly high geometric modality, fast environment mapping, and even motion blur. Yesterday, we also announced CUDA, a new mode of operation on GPUs where the massive computational power of the GPU can be utilized for computation intensive applications. We envision CUDA enabling PCs to solve problems traditionally solved on supercomputers and custom ASICs. This breakthrough architecture is complemented by another first, the NVIDIA C-compiler for GPUs. We envision CUDA will open a whole new field called GPU computing, providing for engineers and scientists and digital content creators tools they need to solve computation intense problems. The performance of GeForce 8800 is simply awesome. A single 8800 GTX is twice the performance of our 7950 GTX, our previous flagship GPU. In fact, 8800 GTX is faster than two 7950 GTX and SLI. GeForce 8800 GTX is also a breakthrough in power efficiency. Although 8800 GTX has twice the performance and tons more features, the power is just a bit higher than 7950 GTX. Its on architectural efficiency and low-power design has really paid off. The GeForce 8 architecture is twice the performance per watt of GeForce 7. The most exciting news about GeForce 8800 is that it is available in stores now, and will soon be shipping from nearly every PC supplier around the world. Our notebook GPU business achieved a major milestone in Q3. We achieved record revenue for the third consecutive quarter, and grew shares at 52%, and became the number one notebook GPU supplier for the first time in our history. Our notebook GPU revenue grew 47% -- 46% quarter-over-quarter and over 100% year-over-year. We expect our share gain to continue through the year, and then accelerate as we ship design wins based on Intel's Santa Rosa platform. The nForce MCP product line achieved record revenue for its eighth consecutive quarter. The MCP business doubled in revenue from the same quarter of last year, and grew 33% sequentially from Q2. Market Research now ranks NVIDIA the second largest PC core logic supplier with 17% of the total volumes and 61% of all AMD core logic. Our AMD share grew 9 points and our overall share grew 5 points. Our MCP growth was driven in part by the increased adoption of our nForce notebook solutions by large PC manufacturers, including HP, Acer, Fujitsu Siemens and Gateway. OEMs have embraced our unique strategy of offering single chip MCP designed specifically to reduce space and power consumption. This week we were also pleased to have announced Dell shipping nForce products in their new AMD-based OptiPlex 740 commercial PC. These new Dell OptiPlex products are specifically offered to large corporations who demand the highest quality platforms deployed with stable software drivers designed to lower support costs. One of the major reasons Dell selected nForce was the high level of quality of our NVIDIA stable image software drivers that we developed as part of our NVIDIA business platform. NVIDIA business platform, or NBP, is the platform level commercial PC solution we introduced last year for smaller PC manufacturers, and have been adopted by over 100 companies in North America, Europe and Asia. This week we are extending our nForce products for Intel CPUs with the announcement of what many customers claim to be the best performance platform for Intel's Core2 Duo, and new Core2 Quad CPUs. Our new NVIDIA nForce 680i SLI MCP delivered top performance in Intel CPUs and are designed specifically for enthusiasts with features such as SLI, DualNet gigabit Ethernet and MediaShield RAID. A particularly exciting feature of nForce 680 SLI is its ability to allow the most enthusiastic of PC customers to over clock their CPUs, which offer the users the benefit of tapping into additional CPU performance. These new nForce 680i SLI products are immediately available from etailers and retailers. NVIDIA's Quadro professional business had another sequential strong quarter with shipments up nearly 25% year-over-year. Our professional business continues to be strong in all segments, particularly with new notebook workstation design wins with HP, and shipments for high-end workstation solutions and system products. In August at SIGGRAPH, we launched NVIDIA Quadro Plex, an entirely new category of professional digital computing solutions. Any SLI ready server or workstation can now support two external Quadro Plexes to build an 8 GPU graphic supercomputer solution. And when clustered, able to offer up to 25 times more graphics compute density than traditional data center solutions. We began volume shipments of Quadro Plex in September. Acceptance is strong in key markets like simulation, medical, styling design and oil and gas. It enables thousands of engineers and designers to experience advanced personal visualization solutions previously only accessible in large visualization centers. We also unveiled a new version of our Gelato 2.1 final frame film quality rendering software, which includes next generation features such as texture baking, enhanced raytracing performance, and improved lightening functionality for 3D rendering. To date, we have surpassed 70,000 downloads of Gelato. We anticipate putting this technology in the hands of many users will usher in a wave of new, high-quality rendered content. Our handheld GPU business achieved another record -- another strong quarter. We saw continued demand for DVB-H services, even after the initial demand generated by the World Cup. Our flagship DVB-H design wins, the Samsung P910 and P920 handsets have been adopted for further trials in Sweden and in South Africa. The launch of the first North American rollout of DVB-H services have been publicly confirmed by Crown Castle, who will launch the Modeo mobile TV services in New York City before the end of the calendar year. The HTC manufactured Modeo phone is powered by the NVIDIA GoForce 5500 GPU. During the quarter, we began shipping our first North American market phone, the iconic Motorola RAZR V3xx. Our handheld GPU will also power the upcoming Motorola RAZR MAXX, targeted at the international market. As you can see, NVIDIA has become far more than a PC graphics chip company. We are passionately focused on being the world's premier provider of visual computing solutions, whether it is on PCs or consoles, the most powerful image generators to miniaturized mobile devices. Let me turn the call over to Marv to discuss our financial results in more detail. I will return in a moment to highlight our growth opportunities.
Marv Burkett: Thanks Jen-Hsun. Today, we are reporting GAAP and non-GAAP P&Ls for both Q2 and Q3, as we do not believe the restatement that is in progress will have a material impact on our current fiscal 2007 P&Ls. We will not be able to report a balance sheet until the restatement is completed, although we will comment on select balance sheet items that we do not believe will be impacted by the restatement. I'm going to focus most my comments on Q3 results, but we have included both GAAP and non-GAAP P&L for Q2 as well. GAAP results for the three months ended October 29, 2006 show revenue of $820.6 million and net income of $106.5 million or $0.27 per diluted share. This compares to revenue of $687.5 million in Q2 and net income of $86.8 million or $0.22 per diluted share. The non-GAAP statement for Q3 removes non-recurring expenses of $42.6 million net of tax, which is comprised primarily of stock compensation expense, plus a one-time charge associated with the confidential patent licensing arrangement. This results in a non-GAAP P&L net income of $149 million or $0.39 per diluted share. Revenue for the third quarter, as I said, was $820.6 million. The quarter-to-quarter growth in revenue of approximately $130 million or 19% was composed of several business units which grew significantly. Year-to-year growth for Q3 was 41%. Desktop GPU grew $49 million quarter-to-quarter with most of that growth in the mainstream and performance segments. ASPs held flat in all segments. We had initial shipments of GeForce 8800, but it was not a big impact to revenue. Growth in GeForce 7 Series products accounted for almost all of the $49 million. As Jen-Hsun noted, notebook grew 46% quarter to quarter, and is now more than $80 million in revenue per quarter. All of this growth is in GeForce 7 series products. MCP continued its string of record quarters, and also grew by $48 million quarter-to-quarter, and is up by more than 100% year-to-year. Both professional solutions and handheld GPUs were slightly down in the quarter. Memory grew by $20 million quarter-to-quarter, and was slightly more than $50 million. Consumer electronics was relatively flat quarter-to-quarter, but we recognized our first royalties for PlayStation 3, even though it was at a very low level. On the gross margin side, GAAP gross margin was 40.7% in the quarter, including the one-time charge associated with licensing certain patents and the stock compensation expenses. On a non-GAAP basis, gross margin was 42.9%. The gross margin percentage was negatively impacted by the higher growth in the lower margin businesses, such as memory, mainstream, desktop GPUs and MCP. Each of the individual business unit continues to make progress in improving gross margins, but the overall margins were affected by the mix. The revenue increase in memory alone would account for almost a full percentage point reduction in gross margin. So despite what might appear to be relatively flat margins, we believe we are continuing to make progress in improving gross margins. I will only be able to comment on selected items on the balance sheet until the restatement is completed. We do not believe these items will be affected by the restatement. Cash at the end of the quarter was $1.174 billion, up more than $300 million quarter-to-quarter. Obviously, this is led by profits, but we also decreased both receivables and inventory. Accounts receivable were down by $20 million, and inventory was down by $5 million. Receivables now stand at $439 million and DSO for the quarter is at 49 days, which is down from 60 days in the prior quarter. Inventory was at $373 million and days sales in inventory were at 70 compared to 87 in the prior quarter. There was no stock repurchases during the quarter. Headcount at the end of the quarter stood at 3,627, which is up 200 from Q2. Of the 200, approximately 150 were added internationally. Year-to-year headcount is up by 1,033, of which 735 were international hires. I would like to give you an update on the restatement. We're making good progress and are receiving excellent cooperation from both PWC and KPMG. I wish I could give you a precise filing date for our restated and delinquent SEC filings, but we can't be precise at this time. We have an internal plan to complete the work before the end of the month, however, neither PWC nor KPMG has completed their work, and there are unresolved items. We're committed to re-filing as soon as possible. Now for the outlook. On the revenue side, because of our strong competitive lineup and new products, including the GeForce 8800, we expect revenue growth in the fourth fiscal quarter. The magnitude may be difficult to forecast, but we feel comfortable with 5% growth over Q3, even if memory declines. We expect growth in desktop GPUs, continued growth in MCP, and resumed growth in professional solutions. We expect handheld to be relatively flat and consumer electronics to be up slightly, but with increased gross margins. For gross margins, we expect continued improvement. While we may not achieve our internal goal of 45% by year end, we're comfortable with a gross margin increase of 100 basis points or more in Q4 from Q3. New products, including GeForce 8800 and the new MCP products, will help gross margin, and the incremental royalties from Sony will also be a benefit. Even though 44% gross margins might be admirable, we do not believe we're done. There are further improvements to be made and we're pursuing them. We believe that a gross margin of 45% in the near future is certainly not impossible. Operating expenses will increase in Q4 on the order of 3 to 5% as we continue to hire. We believe the tax rate will hold at 17% for GAAP and 16% for non-GAAP. We have not included any PortalPlayer revenue or expenses in this outlook. Depending on when the acquisition closes, there could be both revenue and expenses in our fourth quarter results. Now I will turn it back over to Jen-Hsun
Jen-Hsun Huang: Thanks Marv. On Monday of this week, we announced the signing of a definitive agreement to acquire PortalPlayer, the pioneer of application processors for portable media players. Their products power many of the world's most recognized digital music players. Their processors also power the upcoming Vista SideShow, secondary display for notebooks. With this acquisition, we're combining the two essential technologies for next generation mobile devices, PortalPlayer's application processor and NVIDIA's handheld GPU. IDC predicts that the combined market for application processors and GPUs will grow to approximately $4.1 billion by 2010. Semiconductors that enable connectivity and multimedia features in handsets are expected to show the greatest growth over the next several years. We're very excited about growth opportunities for the year ahead. The reviews of our new products are fabulous. Let me give you a flavor. According to PC Perspective, and I quote, in my seven years of covering the world of PC hardware, no other graphics architecture shift has been as dramatic as the one we are seeing here today with NVIDIA's GeForce 8800 GTX. I am quoting Kyle Bennett at HardOCP, the EVGA nForce 680i motherboard is easily one of the best enthusiast motherboards I have ever used. The 680i NVIDIA reference motherboard will make it into my next system build no question asked. We expect a rapid production ramp of the new GeForce 8800 and NVIDIA nForce 680 SLI product families to drive Q4 growth. In Q4, we will also witness the launch of the most anticipated next generation video game console, the PlayStation 3. We expect our notebook GPU share increase to continue as we fully ramp our map of design wins. Our share increase should continue through the spring Santa Rosa cycle as we achieve an even higher level of success than Napa. We expect our Santa Rosa design wins to ramp in Q1. Q1 will also benefit from the continuing ramp of the 2.5G North American phone design wins in our handheld GPU business. And with the recent acquisition of AMD and -- recent combination of AMD and ATI, we are in a unique position to offer branded integrated graphics for the Intel processor market. Market demand for our product has been very high. We will respond to market demand and offer our first Intel integrated solution early next year. We expect this will significantly increase our addressable market for MCPs. Finally, we're about to experience the biggest combination of discontinuity to simultaneously impact our ecosystem in over 10 years. Next generation Microsoft DX10-based games, Vista, and high-definition DVD, each of these discontinuities by themselves significantly increase the amount of graphics processing power necessary to deliver a compelling end-user experience. As the adoption of each of these grow throughout the year and beyond, so will the need for next generation GPUs, like the nForce -- like the GeForce 8 family. It is very evident that 3D graphics and GPU is becoming an evermore essential part of our computing experience. Some of the most exciting and popular applications are enabled by 3D including Google Earth, Microsoft’s new Virtual Earth 3D, Apple's iTunes 7 uses 3D to elegantly rendered album covers. With this, they are providing 3D foundation for all future applications. We expect to all of them to many more innovative ways to use 3D. This is truly a great time to be the single most focused GPU company in the world. Thank you, and we would be happy to take your questions now.
Operator: (Operator Instructions). Your first question comes from the line of Shawn Webster with JP Morgan.
Shawn Webster - JP Morgan: Good afternoon. Can you comment at all first off on any guidance you can give us on PortalPlayer, what you expect in terms of revenues, maybe a run rate and OpEx? And then I have a follow-up please.
Jen-Hsun Huang: I guess the answer is no. First of all, the deal is not done yet. We have just signed a definitive and -- so it is probably too early to do that.
Marv Burkett: Yes, I think so, Shawn. It requires shareholder vote and we will see. We are very excited about acquiring them, but it does requires shareholder vote.
Shawn Webster - JP Morgan: Okay. Maybe turning into the PC end demand environment, you guys are obviously gaining share. Is there any color you can give us on how you see PC end demand going in as we move through Q4 actually and maybe into calendar Q1?
Jen-Hsun Huang: There is a whole lot of different dynamics that are going on. There is obviously Q4 is seasonally a large quarter. There are some concerns about this about this, but we are seeing that. Most of the PC OEMs that we work with and most of the channel are relatively comfortable with the transition at this point. Our biggest focus right now is just ramping GeForce 8800 and nForce 680. And the market demand for both products are incredibly high. And so, we're going to focus on ramping those products and that should be the focus of our growth drivers in the Q4 timeframe.
Shawn Webster - JP Morgan: Okay. Thanks.
Operator: Your next question comes from Mark Edelstone with Morgan Stanley.
Mark Edelstone - Morgan Stanley: First off, congratulations on another outstanding quarter guys.
Jen-Hsun Huang: Thanks Mark.
Mark Edelstone - Morgan Stanley: Hey, Jen-Hsun, you talked a little bit about Quadro Plex and that certainly is a whole new strategy for the company. Can you talk a little bit about the opportunities you see there, just maybe size of market and how we should think about that from a business model perspective as you go forward?
Jen-Hsun Huang: Yes. First of all, Quadro Plex leverages of our SLI presence and our workstation presence and the vast amount of software that we developed over the years for workstation applications and SLI applications. Quadro Plex is an external stand-alone image generator that allows our customers to scale their rendering density by just enormous factors. The application, of course, is targeted within all of the same customer bases that historical image generators have gone into, in addition to desk side workstations that would have wanted image generator type capability, but does simply couldn't afford it. There has been several billion dollars worth of image generators that have been installed into the world over the last, I guess, decade and a half. All of those image generators still require quite a bit of maintenance. They're pretty outdated. They consume a great deal of power. And I think that replacing those over time is just going to be a really huge opportunity for us. Not to mention creating a whole new class of desk sized imaging workstations that weren't possible before. It is hard exactly for us to scope out how big the opportunities are, but it is quite significant. It is certainly several times larger than the workstation business it is today. And in combination with the GPU computing technology that we recently -- that we announced yesterday called CUDA, we think that these desk side image generators, or super computers by your desk, are going to be really interesting applications for us to grow into. The business model with Quadro Plex is based off of system sales. The configuration is proprietary. It is based off of SLI, and it goes with quite a large suite of software to enable scalability. And so we will sell systems through our OEMs. They're branded Quadro Plexes. We would also sell it through VARs, and it is also sold directly on our website to professionals who work directly with us.
Mark Edelstone - Morgan Stanley: I guess it would seem like that business would have potential to be pretty chunky over time. Would that be your expectation? And if so, would you have visibility as the, sort of, backlog begins to build for that business over time?
Jen-Hsun Huang: Our expectation is that it is going to be a very large business. I don't know exactly how large it is going to be yet. But I agree with you. It is going to be very chunky business. It should be a very significant business. The number of installation of image generators in the world, just thinking through that, large workstation companies use to -- multibillion dollar workstation companies use to serve that market. And so we're going to replace those aging image generators. We're going to create new categories of desk-sized super workstations. And then in combination with GPU computing, I think it is a whole new computing model that we are excited about. It is hard for us to guess exactly what it is right now, but I think it is going to be very large, Mark.
Mark Edelstone - Morgan Stanley: Then just one last question on memory. As you were ramping up the G80 family here over the next couple of quarters, should we see memory going up, or do you think it can hold here at current levels?
Marv Burkett: I guess my feeling is that we hope it is down in Q4. That is our current expectation. We had to ramp up for the 8800 launch, but we don't anticipate that that goes up.
Mark Edelstone - Morgan Stanley: Great. Thanks a lot. Nice job guys.
Jen-Hsun Huang: Thanks Mark
Operator: Your next question comes from the line of Daniel Ernst.
Daniel Ernst - Hudson Square Research: Thanks for taking the question. Just not looking for guidance on the PortalPlayer revenues, but just thinking about the opportunity there, how quickly could you realistically integrate your video graphics processing capabilities with their on-base SOCs? And then what are you thinking is the best opportunity there? Is it still where they have been focused on the stand-alone media players, or do you think it is the mobile phones? Secondly on that, how serious do you think OEMs are about adopting the SideShow technology?
Jen-Hsun Huang: So, what I'm going to do is I am going to answer the question probably from a more strategic perspective. And the reason for that is because the deal is just not done. And any speculation about our businesses -- about their business and our combination of the business is just a little too premature. But I think if you look at it strategically we feel that future mobile devices will become more and more intelligent, would incorporate operating systems, will be multitasking, will support all kinds of rich media. And over the course of certainly by within the next ten years, these mobile devices are going to become amazing little portable computers that allows you to do everything that you can imagine a digital device to be able to do today, whether it is music or movies or television or Web viewing or 3D games, or whatever happens to be. And certainly well within the next ten years, this dynamic will happen, and these portable devices will become your most personal computer. And we expect that this is going to be when it all -- when these various dynamics come together, particularly as the rich operating system becomes available for these mobile devices, it is really going to become the second PC revolution and so we are excited from that perspective. The two really critical ingredients to enable this new era to happen is application processors in combination with GPUs. The baseband processor is innovating quite nicely. And I think that the technology is maturing, and the capability is certainly available on every single phone already, obviously. So where we need to innovate is application processors and GPUs, and that is reason why we are so excited about the PortalPlayer opportunity. How excited are people about SideShow? I believe they have a numerous number of design wins, and they are real OEMs, and they really, really, really going to ship with it. And the way I think about it is the utility to the end-user. How many of us frequently carry our notebooks around, and just want to quickly glance at the calendar or the time or send a very quick message or see a quick message? I think that all of us would like to do that. And so without having to boot-up and log in to your personal computer. And so I think this is a capability that is a real differentiator for the notebook. And if a cell phone has two displays and some of them have three displays, why shouldn't a notebook have a couple of two, three displays?
Daniel Ernst - Hudson Square Research: Great. That is helpful color. And then just a follow-up to your new platform launch and your comments on GPU-based computing. Earlier this year at NAB, Sony and IBM showed off a prototype cell-based media server for the broadcasting industry, as video is recently going digital and not tape-based. Is that an area that since you would be computing with that platform on, or would you have GPU-based media servers?
Jen-Hsun Huang: It is too early to tell whether we're going to compete or not. But I think is interesting is that there's a whole new area of computing that is just not well served today. Some people think that supercomputers ought to serve it. We all know that over the course of the last ten years there has been a drought of supercomputer technology. And the reason for that, of course, is it has been really the workstation and the PC era. Now the world knows that there is a -- we have a supercomputer crisis, if you will, that there are so many problems that are very, very data intensive, very computer intensive, but the innovation and the investment around supercomputers has really lagged over the years. We think that we can transform the PC into a supercomputer. This is a wonderful opportunity for all the entire PC ecosystem. And by adding a GPU with a technology like CUDA, we can turn the PC, with the addition of GPU computing, into a deskside supercomputer. You could do this obviously in a server configuration as well with a bunch of blades. And the applications for these are wherever all these supercomputers are required and where people are using FPGAs potentially, or even designing custom ASICs to do the intensive number crunching. So, I think this is going to be opening up a whole new era of new style of computing, and we call that GPU computing.
Daniel Ernst - Hudson Square Research: Great. It sounds exciting. Thank you.
Jen-Hsun Huang: Yes. Thank you.
Operator: Your next question comes from Doug Freedman with AmTech Research.
Doug Freedman - AmTech Research: A quick one for you. Can you give us a little bit more color on the chipset business and what you're doing there to improve the gross margins? And where do you think you can take those gross margins over the longer term? If you could just describe the landscape of the chipset market that I think is changing quite a bit recently.
Jen-Hsun Huang: I think gross margins could be achieved -- could be improved in a lot of variety of ways. The number one best way is architectural. And I probably prefer to keep them as trade secrets, but architectural efficiency, doing more with less or doing more through extreme high integrations, or whatever the technology is -- approach is very important, so architectural. The second thing is operational. We have to make sure that the products are built just in time to benefit from the lowest wafer cost. We have to make sure that the yields are as high as we can make it. The scraps are low as we can make it, and the quality as high as we can. People have always known that through perfect quality is your best way to improve profitability. And the rest of it, the market dictates. We don't set the price; the competition and the customers set the price. And so on our side have to make sure we develop products that the market really highly desires. And that is one of the advantages of nForce. Our brand, our nForce brand is really becoming, if not already, the number one brand of core logic. If you're somebody who cares about the performance and stability and the availability of the best technology on a motherboard, nForce is really your choice. And I think we have demonstrated that on both the Intel as well as the AMD platforms. Between the combination of great architecture, efficient architecture, operational excellence, and building brands that the market highly desires those are basically our approach. And we hammer on all three every day.
Doug Freedman - AmTech Research: What do you see as the price trend in that marketplace? And then if you could give us an idea of when we can -- when you believe you'll see revenue from the Intel integrated solution?
Jen-Hsun Huang: The pricing trend in core logic -- I don't know if there's a particular trend -- it depends on what products and what segments we launch at any given point in time. This quarter, we are launching our nForce 680i and the 680a, and both of them are targeted at the enthusiast market. They tend to have higher ASPs and so -- because we're ramping those products there's probably a good likelihood that we trend upward. It has a lot to do with what we introduce more than what is happening in the marketplace. With respect to the Intel chipset, my expectation is that we -- I guess the market's expectation, which is customers would like us to be in the marketplace by spring of next year, and we are working as hard as we can to do that.
Doug Freedman - AmTech Research: All right. Great. Thank you so much.
Jen-Hsun Huang: Thanks Doug.
Operator: Your next question comes from the line of Tayyib Shah with Longbow Research.
Tayyib Shah - Longbow Research: Hi guys. Congratulations on the quarter.
Jen-Hsun Huang: Thank you.
Tayyib Shah - Longbow Research: In the past you guys have kind of restricted yourself to the high end of the Intel platform MCP market. Now you're talking about significantly expanding your footprint there. Can you maybe talk about do you see yourself going after the mainstream Intel MCP segment in a major way in 2007? And if so, how much of that changed approach was because of the AMD ATI merger?
Jen-Hsun Huang: The answer to your question is yes. We're going to go after the mainstream part of the market with our GeForce and nForce branded integrated graphics. And that market is obviously very, very large. And the opportunity to us is now quite significant, and the reason for that is directly related to ATI being sold to AMD. Now there is really a void of a branded, integrated graphics supplier in the Intel market, and that is an opportunity that we have stayed away from because there were other players that were serving that market before. But now with DX10 and high-definition and Blu-ray video and Vista, the bar for graphics capability has gone up so high in just one year's time we believe that that raised bar, as well as the fact that there is now a vacuum because ATI has left that market, it is just a wonderful opportunity for us. This is just the perfect time for us to enter it.
Tayyib Shah - Longbow Research: Okay .Then can you talk about the supply situation for graphics memory? How do you see that shaping up over the next quarter? And if Marv can put this in the context of gross margins, have you had to absorb some of our memory cost increase in the last quarter?
Marv Burkett: What was that last portion? I didn't hear that.
Tayyib Shah - Longbow Research: Have you had to absorb some of the memory cost increase in the fiscal third quarter?
Jen-Hsun Huang: I guess the first thing is the comment about the memory shortage. There is a memory shortage, or memory tightness. But the memory tightness is by and large alleviated at this point. But during the tightness we worked really closely with all of our add-in card partners and OEMs. And because we're such a close partner of all the memory suppliers, we have been helpful at helping them secure the memories that they needed in a price that was fair to the marketplace. We were frankly very, very helpful to the graphics ecosystem to help them secure memories during Q3. But I think the shortage is by and large stabilized at this point.
Tayyib Shah - Longbow Research: Thank you
Marv Burkett: On the comment with regard to gross margins, obviously our gross margins were impacted by the increase in memory last quarter. If you look at it very, very simplistically, a $20 million increase in memory business which we had Q2 to Q3, if you had gotten 40% margin on that, that is $8 million. That is a full percentage point in gross margin. Now that is not quite what happened, we do get some margin off of memory. To answer your other portion of the question, no, we don't lose money on memory, but it is just not a high margin business.
Tayyib Shah - Longbow Research: Thank you.
Jen-Hsun Huang: Yes, Tayyib. Thank you.
Operator: Your next question comes from the line of Pranay Laharia with Deutsche Bank.
Pranay Laharia - Deutsche Bank: A question on die size. So your G80 die size looks to be a lot larger than your G70 and it appears likely that in this new generation you'll lose the die size advantage that you guys had over your competition last time around. Can you talk about what gross margin impact these two factors will have?
Jen-Hsun Huang: First of all, I guess I all answer the second question first. This time around the competition hasn't even shown their products yet. I guess at this point their die size would be infinitely large, and so I would say that we have -- we still have a competitive advantage relative to that. The die size is larger, but the ASP is also higher, and so you have to balance those two things. You know GeForce 7900 is now well into the $299 segment. And I have seen some prices down that are even below that. But that is not where GeForce 8800 is positioned right now. The GeForce 8800 is positioned at the enthusiast segment and the very high-performance segment where either the gamer or the enthusiast demands to have the absolute best, and has a real need to run games at extreme high resolutions and the most modern games. We have repositioned the 7900 starting last quarter into the lower parts of the performance segment, and it is now solidly there, and it is doing fabulously. And so the two products are simply positioned at different price points in different parts of the marketplace.
Pranay Laharia - Deutsche Bank: Let me just sort of follow-up on that. Do you think when your G80 line ramps up across the stack on a full stack for full stack comparison, will you be the same die size as you were with G70 or will you be higher? Thinking logically that ought to dictate your gross margins for the next one year.
Jen-Hsun Huang: That is a good question. G80 is just the first of the G8X family. And there are many other G8X families, probably nine others. We're going to -- all the numbers in between. So the GPU is designed to be scalable in architecture. And our engineers are very, very rapidly and very hard at work in building all kinds of products derived from the G8X family.
Pranay Laharia - Deutsche Bank: Okay. And then just one last question. For the Santa Rosa platform, do you compete with G70 or with G80 derivatives? And where do you think your product -- where do you think your market share goes in notebook discrete graphics with Santa Rosa?
Jen-Hsun Huang: Santa Rosa notebooks are DX10 notebooks. They are Vista, DX10, Blu-ray disk, high-definition video notebooks. And we are the only supplier of DX10 GPUs today, and the only one sampling notebook GPUs. And my expectation is that we -- our success on the Santa Rosa transition should be quite a bit higher than our success even with Napa.
Pranay Laharia - Deutsche Bank: Thank you.
Jen-Hsun Huang: Yup.
Operator: Your next question comes from the line of Rick Schafer with CIBC World Markets.
Dan Morris - CIBC World Markets: Good afternoon guys. Congratulations. This is actually Dan Morris calling for Rick.
Jen-Hsun Huang: Thanks Dan.
Dan Morris - CIBC World Markets: The first question. Your guidance for the consumer division sits slightly up. I might have expected that to be a little bit higher. It is something going on with maybe the NREs and the levels that you're getting there, if you could give an update there?
Marv Burkett: Yes. The NREs are rolling off. And until we have other programs that replace them, we don't anticipate but we're anticipating that they roll off, so you will see a decline in NRE, offset by the increase in royalties.
Dan Morris - CIBC World Markets: How is the NRE recognized and about how much was left?
Marv Burkett: A small amount is left, and it is recognized on a percentage of completion basis.
Dan Morris - CIBC World Markets: Good.
Jen-Hsun Huang: Or if I can just add to that. They are ongoing projects on a NRE basis. It is just that it is recognized on a completion basis, and some of the projects that we're currently working on right now are further away from completion, but we're working on those projects.
Dan Morris - CIBC World Markets: Thank you.
Operator: Your next question comes from the line of Glen Yeung with Citigroup.
Peter Karzaris - Citigroup: This is [Peter Karzaris] for Glen Yeung. You put up a good quarter. I'm just curious actually for your inventory it looks like it is down a bit quarter on quarter. You have the new product launch and you have been seeing some substantial share gain. What is your ability to I guess service potential upside for next quarter if you had to? And I have something to follow that.
Jen-Hsun Huang: All first of all, I think we actually -- we're actually as passionate as you guys are in reducing our inventories, and still be able to run our business. I know what you are saying is true too. Having inventory allows you to address unexpected demand. But what we're trying to do operationally is to put ourselves in a position where we can continue to address unexpected demand but work down our inventory. That is an intense focus in our company, and our expectation and our goal is to reduce our inventory even further, and yet still be able to address unexpected demands.
Peter Karzaris - Citigroup: So, let me ask just a little differently.
Jen-Hsun Huang: I guess maybe our -- let me just say just one more thing. It is reduced not by accident. And it didn't reduce unexpectedly. And we hope that it in fact goes down even further in the future. That is our hope. That is our goal.
Peter Karzaris - Citigroup: I guess -- let me ask a slightly different way. It looks like this quarter one of places you had upside was in mainstream. You had new products out there. Can you give me a sense of the mix of your inventory and how it has changed?
Marv Burkett: The mix of our inventory it is waited heavily to the new product. And so are we going to be in perfect mix? Probably not, never happen. But we think we are in good shape from an inventory standpoint to support upside.
Peter Karzaris - Citigroup: Thank you.
Operator: Your next question comes from the line of Michael McConnell with Pacific Crest.
Michael McConnell - Pacific Crest: Thank you. Jen-Hsun, if we looked maybe a little bit longer out to next year and looked at the growth drivers kind of from a product segment, what do you -- it sounds like notebooks are only going to be getting better next year with Santa Rosa. Should we be looking at notebook chipsets as being on a year-over-year basis probably the two major product drivers next year, or can we lump wireless in there as well?
Jen-Hsun Huang: Let's see, what did should grow next year. I think GPUs will grow next year because Vista, high def, DX10, they are just amazing, amazing things happening in our PC industry. I haven't felt this excited about all the new technologies coming since Windows 95. And Windows 95 was big, big, as you recall. I think that is going to happen next year. Our handheld business should continue to grow substantially. In fact it should accelerate its growth next year because of our entry into 2.5G. I think our chipset business is going to grow. And the reason for that is partly because of the dynamics I have explained already about Vista and DX10. Vista, DX10 and high def have just raised the bar so that second-tier core logic suppliers are going to have a much, much harder time competing in the future. And they either would have had to invest already hundreds of millions of dollars to get here with DX10 or they are just not going to be able to compete next year. I think our core logic business would do very well. I also think that our serviceable market is going to grow dramatically with the branded Intel core logic business. I think that is going to be big for us. I can't help but believe that Sony is going to incredibly well next year. The early reviews are already really very exciting and so --. And then workstations. Frankly, my psychology right now is that we are in a position to grow all of our businesses next year. And we have strategies to grow all of our businesses next year. And we have reason to believe that the market dynamics will allow us to grow every single one of our businesses next year.
Michael McConnell - Pacific Crest: If we look at the desktop GPU business, you have obviously got a pretty significant head start here with the G80 architecture relative to the competition. You had stated in your prepared remarks that you have 89% share in performance segment. Your share relatively in the mainstream segment below that level. So with this head start do we have an opportunity to take some share in that segment relative to the competition as well next year, given the head start?
Jen-Hsun Huang: That is a good point. We are certainly still focused on increasing share. We are also focused on increasing revenue [TAM]. I want to continue to emphasize that we -- although we enjoyed talking about share and we enjoy gaining share, one of the focus of our company has always been is creating a larger market for all of us to share, and SLI certainly created a larger TAM. The introduction of DX10 will increase the revenue TAM hopefully because DX10 is so exciting and Vista is so exciting and high-definition video is so exciting it might drive the ASP up. People are looking for more GPU experience, more GPU performance to get the best experience. That will increase the TAM. And so we look for ways to increase the unit attached. We look for ways to help consumers experience better content, and those things always increase TAMs. But we're still very hyper focused in increasing share.
Michael McConnell - Pacific Crest: Thank you. That was very helpful.
Operator: Your next question comes from the line of Devan Moodley with Scotia Capital.
Devan Moodley - Scotia Capital: Hi guys, great quarter.
Jen-Hsun Huang: Thank you.
Devan Moodley - Scotia Capital: And you guys almost delivered a Q3 that is kind of what the Street was expecting for next year. In that context, obviously things are going pretty well ahead of expectations. What have you done to secure the wafer capacity you think you're going to need? Clearly that has changed from even two quarters ago.
Jen-Hsun Huang: We are being one of the largest, and I think we probably are at this point from wafer consumption perspective, the largest in the world, and having such close relationships with TSMC, our single largest foundry partner, and others, I think that really plays a role in this. We have a rigorous forward-looking and forward planning process. Internally we have expected to be here for some time to be honest, and so it didn't happen accidentally. We expected to be here, and so we have been planning for that. And we're planning for next quarter. We're planning for next year. And our alignment with TSMC and other foundries is excellent. They have a perfect understanding of exactly what we need. And there's no evidence whatsoever that they're not going to be able to support us in every way.
Devan Moodley - Scotia Capital: Just one follow-up. If we look at a year from now, where would you like the percentage of your desktop GPU business to be in terms of the G80 family?
Jen-Hsun Huang: Marv, go ahead.
Marv Burkett: The normal transition would put it above 50%.
Devan Moodley - Scotia Capital: Sorry, desktop and mobile?
Marv Burkett: Yes. I don't know about mobile [heard about live], so I'm talking about desktop, that is what you asked.
Devan Moodley - Scotia Capital: Okay. Thanks guys.
Jen-Hsun Huang: Thank you.
Operator: Your next question comes from the line of Robert Dennison with UBS.
Robert Dennison - UBS: Thanks guys. Good quarter. I'm wondering if you can give me just a little bit more color on the patent license fee. I don't need to know what it is about or what it is for, but I'm not understanding how it is an one-time item. It would seem to me that it would be meaningful for gross margin if you guys had to pay patent license fees.
Marv Burkett: I wish I can give you more information, but it is a confidential arrangement. It includes payments for use of those patents. It is a significant number of patents. Beyond that I really don't think we can comment.
Robert Dennison - UBS: So is it something that you have used this technology for in the past, and so it didn't show up in past margins and you're putting it in this margin, or is it for the future or --?
Marv Burkett: It is primarily for the past.
Robert Dennison - UBS: And Jen-Hsun, I heard you say that you were getting into the Intel integrated MCP market. I also heard Marv say that MCP margins should come up. This is a notoriously tough margin business. It is Intel integrated. Can you give me a little color on how you guys expect to bring margins up in that business, particularly given the 44% range you are talking about next quarter?
Jen-Hsun Huang: I'm not sure yet. That is kind of the truth. I don't have a product to sell yet, and so I really don't have very much experience there. But my general experience with -- and you know that gross margin improvement has been a passion of mine and our company for quite a few years now. We have been increasing it quarter by quarter by quarter, and we doing all kinds of great stuff. What I had learned about it is there's probably on balance about three major factors. One of them is your architecture. And so that relies on just the really innovative and the talented, the really creative engineers that we have to come up with innovative architecture. The second one is operational excellence. And that one just those from the front of your company all the way to the back of your company. You just have no waste whatsoever. And perfect yields, but no waste, perfect quality, if you just hit everything at 100% and everything at 0%, you're going to be -- everything else at 0%, you will be in good shape. And the last part of it is just building a great product. You need to have a great brand in this marketplace. And the market that we will serve, the market we will continue to serve is where we believe we can capture the value from the products that we sell. You know that we're not fanatical about revenues; we're fanatical about profits. We don't need to go chase profitless prosperity. We're just not going to do it. We are going to target the segments of the marketplace where our work and our brand is valued. And we will leave the other segments to other people.
Robert Dennison - UBS: Okay. Great. Finally, I know you guys aren't offering much in the way of color on PortalPlayer, but do you expect this to be helpful or a drag on margins going forward should the deal go through?
Jen-Hsun Huang: It should be slightly dilutive in the first year. And in the second year I hope it is wonderfully accretive.
Robert Dennison - UBS: Thank you very much.
Operator: Ladies and gentlemen, we have reached the end of the allotted time for questions and answers this afternoon. I would now like to turn the call back over to Jen-Hsun Huang for closing remarks.
Jen-Hsun Huang: I want to thank all of you guys for joining us today. We look forward to reporting our progress for Q4. Thank you.
Operator: This concludes the fiscal year 2007 third quarter financial results conference call. You may now disconnect. | [
{
"speaker": "Executives",
"text": "Michael Hara - VP of IR Jen-Hsun Huang - President and CEO Marv Burkett - CFO"
},
{
"speaker": "Analysts",
"text": "Shawn Webster - JP Morgan Mark Edelstone - Morgan Stanley Daniel Ernst - Hudson Square Research Doug Freedman - AmTech Research Tayyib Shah - Longbow Research Pranay Laharia - Deutsche Bank Dan Morris - CIBC World Markets Peter Karzaris - Citigroup Michael McConnell - Pacific Crest Devan Moodley - Scotia Capital Robert Dennison - UBS"
},
{
"speaker": "Operator",
"text": "Good afternoon and thank you for holding. I would now like to turn the call over to Michael Hara, NVIDIA's Vice President of Investor Relations. Sir, you may begin your conference."
},
{
"speaker": "Michael Hara",
"text": "Thank you. Good afternoon and welcome to NVIDIA's conference call for the third fiscal quarter ended October 29, 2006. On the call today for NVIDIA are Jen-Hsun Huang, NVIDIA's President and Chief Executive Officer; and Marv Burkett, NVIDIA's Chief Financial Officer. Before we begin today's call I would like to take care of some general administrative items. Your lines have been placed on a listen-only mode until the question-and-answer segment of today's call. During this call we will discuss some non-GAAP measures about net income, net income per share and gross margin and other line items from our consolidated statements of income when talking about our results. You can find a full reconciliation of these measures to GAAP in our financial release, which is posted on the Investor Relations page of our website at www.nvidia.com. This call is being recorded. If you have any objections you may disconnect at this time. Please be aware that if you decide to ask a question it will be included in both our live transmission as well as any future use of the recording. Also shareholders can listen to a live webcast of today's call and view our financial release at the NVIDIA Investors Relations website. The webcast will be available for replay until the company's conference call to discuss its financial results for its fourth quarter fiscal 2007. During the course of this conference call, we may make forward-looking statements based on current expectations. Forward-looking statements, including statements as to our fourth quarter 2007 outlook, a review of the stock option practices by our audit committee, the restatement, the use of non-GAAP measures, the benefits and impact of the acquisition of PortalPlayer, new and forthcoming products, our products and technologies, growth drivers, market share, Windows Vista, PlayStation 3, design wins, strategic focus, and customers and partners pertain to future events, and are subject to a number of significant risks and uncertainties. The company's actual results may differ materially from results discussed in any forward-looking statements. For a complete discussion of factors that could affect the company's future financial results and business, please refer to the company's Form 10-K, an annual report for the fiscal year ended January 29, 2006, quarterly reports on Form 10-Q, and reports on Form 8-K filed with the Securities and Exchange Commission. All forward-looking statements are made as of the day hereof based on information available to us today. And except as required by law, the company assumes no obligation to update any such statement. The content of the webcast contains time sensitive information that is accurate only as of November 9, 2006. Consistent with the requirements under Regulation FD, we will be providing public guidance directly in the conference call and will be unable to provide significantly more information in off-line conversations or during the quarter, therefore questions around our financial expectations should be asked during this call. At the end of our remarks, there will be time for your questions. In order to allow more people to ask questions, please limit yourself to one question. After our response we will allow one follow-up question. As previously announced in June 2006, the Audit Committee of the Board of Directors of NVIDIA began a review of the company's stock option practices based on results of an interim review voluntarily undertaken by management. The Audit Committee's review covered the time from the company's initial public offering in 1999 to the current fiscal year, and as previously disclosed, found instances of the use of incorrect measurement base for certain option grants. The Audit Committee is being assisted by independent legal counsel and outside accounting experts. At this time, the Audit Committee has completed its forensic review of the option grants, is now working with the company's management to finalize the financial impact of using incorrect measurement dates. NVIDIA will publish the balance sheet as of the end of the third quarter and the statement of income for the nine months ended October 29, 2006, as well as restated statements of income for the comparable periods of fiscal 2006 as soon as practical upon completion of the Audit Committee's review. The company's current and former independent registered public accounting firms have not completed their review of the findings of the Audit Committee. Our financial results for the second and third quarters of fiscal year 2007 are not audited and may change as a result of the ongoing Audit Committee review. The stock option practices under review and related matters can also lead to the potential claims and proceedings relating to such matters, including litigation or action by the Securities and Exchange Commission and/or other regulatory agencies. I'll now hand the call over to Jen-Hsun."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks, Mike. Good afternoon and thank you for joining us. Today, we are pleased to report record revenue of $820.6 million for our third quarter. This is our third consecutive record quarter. Year-over-year, third quarter revenue grew nearly 41%. Our growth was driven by strong performance and share gains from numerous product groups -- desktop GPU, notebook GPU and MCP, resulting in record revenue for the quarter that is well above normal seasonal patterns. Let me review the highlights and achievements for each of our business units during the quarter. Our desktop GPU business continued to deliver strong results in Q3. In addition to the seasonal strength of the PC market, we increased our desktop GPU share 5 points to 56%. GeForce achieved 89% share of the performance segment. Our desktop GPU revenue grew 13% year-over-year. With over 265 media awards worldwide in Q3, demand for our GeForce 7 series GPU remained very strong, even as we launch our next generation GPU. Yesterday, we announced GeForce 8800 to the world. Held in secrecy for four years and code-named G80, this is the most ambitious undertaking in our history. G80 is the product of hundreds of the world's best engineers, over 1,000 man years of effort, and over $400 million to develop. G80 is a revolutionary architecture and a completely ground up design. This is only the third fundamentally new architecture in our 13-year history. The last fundamentally new architecture was GeForce 256, the now famous GeForce introduced in 1999. G80 is based on a unified shader architecture. Instead of a separate vertex and pixel shading processors, G80 has 128 stream processors operating at 1.35 gigahertz that can process either vertex or pixel shaded programs. With a unified architecture, G80 can adapt its vast computational resources to the changing vertex or pixel shading workload from team to team. G80 is the world's first DX10 GPU. DX10 is a major new API for Microsoft Windows Vista, and includes many new important features. One of the most exciting DX10 and G80 features is the geometry shader. By programming the unified shader processes of G80, designers can programmatically create, destroy and manipulate geometric mesh. Game designers can do amazing things like procedural geometry to programmatically generate landscapes, particle systems to create realistic looking smoke and clouds, displacement maps to create incredibly high geometric modality, fast environment mapping, and even motion blur. Yesterday, we also announced CUDA, a new mode of operation on GPUs where the massive computational power of the GPU can be utilized for computation intensive applications. We envision CUDA enabling PCs to solve problems traditionally solved on supercomputers and custom ASICs. This breakthrough architecture is complemented by another first, the NVIDIA C-compiler for GPUs. We envision CUDA will open a whole new field called GPU computing, providing for engineers and scientists and digital content creators tools they need to solve computation intense problems. The performance of GeForce 8800 is simply awesome. A single 8800 GTX is twice the performance of our 7950 GTX, our previous flagship GPU. In fact, 8800 GTX is faster than two 7950 GTX and SLI. GeForce 8800 GTX is also a breakthrough in power efficiency. Although 8800 GTX has twice the performance and tons more features, the power is just a bit higher than 7950 GTX. Its on architectural efficiency and low-power design has really paid off. The GeForce 8 architecture is twice the performance per watt of GeForce 7. The most exciting news about GeForce 8800 is that it is available in stores now, and will soon be shipping from nearly every PC supplier around the world. Our notebook GPU business achieved a major milestone in Q3. We achieved record revenue for the third consecutive quarter, and grew shares at 52%, and became the number one notebook GPU supplier for the first time in our history. Our notebook GPU revenue grew 47% -- 46% quarter-over-quarter and over 100% year-over-year. We expect our share gain to continue through the year, and then accelerate as we ship design wins based on Intel's Santa Rosa platform. The nForce MCP product line achieved record revenue for its eighth consecutive quarter. The MCP business doubled in revenue from the same quarter of last year, and grew 33% sequentially from Q2. Market Research now ranks NVIDIA the second largest PC core logic supplier with 17% of the total volumes and 61% of all AMD core logic. Our AMD share grew 9 points and our overall share grew 5 points. Our MCP growth was driven in part by the increased adoption of our nForce notebook solutions by large PC manufacturers, including HP, Acer, Fujitsu Siemens and Gateway. OEMs have embraced our unique strategy of offering single chip MCP designed specifically to reduce space and power consumption. This week we were also pleased to have announced Dell shipping nForce products in their new AMD-based OptiPlex 740 commercial PC. These new Dell OptiPlex products are specifically offered to large corporations who demand the highest quality platforms deployed with stable software drivers designed to lower support costs. One of the major reasons Dell selected nForce was the high level of quality of our NVIDIA stable image software drivers that we developed as part of our NVIDIA business platform. NVIDIA business platform, or NBP, is the platform level commercial PC solution we introduced last year for smaller PC manufacturers, and have been adopted by over 100 companies in North America, Europe and Asia. This week we are extending our nForce products for Intel CPUs with the announcement of what many customers claim to be the best performance platform for Intel's Core2 Duo, and new Core2 Quad CPUs. Our new NVIDIA nForce 680i SLI MCP delivered top performance in Intel CPUs and are designed specifically for enthusiasts with features such as SLI, DualNet gigabit Ethernet and MediaShield RAID. A particularly exciting feature of nForce 680 SLI is its ability to allow the most enthusiastic of PC customers to over clock their CPUs, which offer the users the benefit of tapping into additional CPU performance. These new nForce 680i SLI products are immediately available from etailers and retailers. NVIDIA's Quadro professional business had another sequential strong quarter with shipments up nearly 25% year-over-year. Our professional business continues to be strong in all segments, particularly with new notebook workstation design wins with HP, and shipments for high-end workstation solutions and system products. In August at SIGGRAPH, we launched NVIDIA Quadro Plex, an entirely new category of professional digital computing solutions. Any SLI ready server or workstation can now support two external Quadro Plexes to build an 8 GPU graphic supercomputer solution. And when clustered, able to offer up to 25 times more graphics compute density than traditional data center solutions. We began volume shipments of Quadro Plex in September. Acceptance is strong in key markets like simulation, medical, styling design and oil and gas. It enables thousands of engineers and designers to experience advanced personal visualization solutions previously only accessible in large visualization centers. We also unveiled a new version of our Gelato 2.1 final frame film quality rendering software, which includes next generation features such as texture baking, enhanced raytracing performance, and improved lightening functionality for 3D rendering. To date, we have surpassed 70,000 downloads of Gelato. We anticipate putting this technology in the hands of many users will usher in a wave of new, high-quality rendered content. Our handheld GPU business achieved another record -- another strong quarter. We saw continued demand for DVB-H services, even after the initial demand generated by the World Cup. Our flagship DVB-H design wins, the Samsung P910 and P920 handsets have been adopted for further trials in Sweden and in South Africa. The launch of the first North American rollout of DVB-H services have been publicly confirmed by Crown Castle, who will launch the Modeo mobile TV services in New York City before the end of the calendar year. The HTC manufactured Modeo phone is powered by the NVIDIA GoForce 5500 GPU. During the quarter, we began shipping our first North American market phone, the iconic Motorola RAZR V3xx. Our handheld GPU will also power the upcoming Motorola RAZR MAXX, targeted at the international market. As you can see, NVIDIA has become far more than a PC graphics chip company. We are passionately focused on being the world's premier provider of visual computing solutions, whether it is on PCs or consoles, the most powerful image generators to miniaturized mobile devices. Let me turn the call over to Marv to discuss our financial results in more detail. I will return in a moment to highlight our growth opportunities."
},
{
"speaker": "Marv Burkett",
"text": "Thanks Jen-Hsun. Today, we are reporting GAAP and non-GAAP P&Ls for both Q2 and Q3, as we do not believe the restatement that is in progress will have a material impact on our current fiscal 2007 P&Ls. We will not be able to report a balance sheet until the restatement is completed, although we will comment on select balance sheet items that we do not believe will be impacted by the restatement. I'm going to focus most my comments on Q3 results, but we have included both GAAP and non-GAAP P&L for Q2 as well. GAAP results for the three months ended October 29, 2006 show revenue of $820.6 million and net income of $106.5 million or $0.27 per diluted share. This compares to revenue of $687.5 million in Q2 and net income of $86.8 million or $0.22 per diluted share. The non-GAAP statement for Q3 removes non-recurring expenses of $42.6 million net of tax, which is comprised primarily of stock compensation expense, plus a one-time charge associated with the confidential patent licensing arrangement. This results in a non-GAAP P&L net income of $149 million or $0.39 per diluted share. Revenue for the third quarter, as I said, was $820.6 million. The quarter-to-quarter growth in revenue of approximately $130 million or 19% was composed of several business units which grew significantly. Year-to-year growth for Q3 was 41%. Desktop GPU grew $49 million quarter-to-quarter with most of that growth in the mainstream and performance segments. ASPs held flat in all segments. We had initial shipments of GeForce 8800, but it was not a big impact to revenue. Growth in GeForce 7 Series products accounted for almost all of the $49 million. As Jen-Hsun noted, notebook grew 46% quarter to quarter, and is now more than $80 million in revenue per quarter. All of this growth is in GeForce 7 series products. MCP continued its string of record quarters, and also grew by $48 million quarter-to-quarter, and is up by more than 100% year-to-year. Both professional solutions and handheld GPUs were slightly down in the quarter. Memory grew by $20 million quarter-to-quarter, and was slightly more than $50 million. Consumer electronics was relatively flat quarter-to-quarter, but we recognized our first royalties for PlayStation 3, even though it was at a very low level. On the gross margin side, GAAP gross margin was 40.7% in the quarter, including the one-time charge associated with licensing certain patents and the stock compensation expenses. On a non-GAAP basis, gross margin was 42.9%. The gross margin percentage was negatively impacted by the higher growth in the lower margin businesses, such as memory, mainstream, desktop GPUs and MCP. Each of the individual business unit continues to make progress in improving gross margins, but the overall margins were affected by the mix. The revenue increase in memory alone would account for almost a full percentage point reduction in gross margin. So despite what might appear to be relatively flat margins, we believe we are continuing to make progress in improving gross margins. I will only be able to comment on selected items on the balance sheet until the restatement is completed. We do not believe these items will be affected by the restatement. Cash at the end of the quarter was $1.174 billion, up more than $300 million quarter-to-quarter. Obviously, this is led by profits, but we also decreased both receivables and inventory. Accounts receivable were down by $20 million, and inventory was down by $5 million. Receivables now stand at $439 million and DSO for the quarter is at 49 days, which is down from 60 days in the prior quarter. Inventory was at $373 million and days sales in inventory were at 70 compared to 87 in the prior quarter. There was no stock repurchases during the quarter. Headcount at the end of the quarter stood at 3,627, which is up 200 from Q2. Of the 200, approximately 150 were added internationally. Year-to-year headcount is up by 1,033, of which 735 were international hires. I would like to give you an update on the restatement. We're making good progress and are receiving excellent cooperation from both PWC and KPMG. I wish I could give you a precise filing date for our restated and delinquent SEC filings, but we can't be precise at this time. We have an internal plan to complete the work before the end of the month, however, neither PWC nor KPMG has completed their work, and there are unresolved items. We're committed to re-filing as soon as possible. Now for the outlook. On the revenue side, because of our strong competitive lineup and new products, including the GeForce 8800, we expect revenue growth in the fourth fiscal quarter. The magnitude may be difficult to forecast, but we feel comfortable with 5% growth over Q3, even if memory declines. We expect growth in desktop GPUs, continued growth in MCP, and resumed growth in professional solutions. We expect handheld to be relatively flat and consumer electronics to be up slightly, but with increased gross margins. For gross margins, we expect continued improvement. While we may not achieve our internal goal of 45% by year end, we're comfortable with a gross margin increase of 100 basis points or more in Q4 from Q3. New products, including GeForce 8800 and the new MCP products, will help gross margin, and the incremental royalties from Sony will also be a benefit. Even though 44% gross margins might be admirable, we do not believe we're done. There are further improvements to be made and we're pursuing them. We believe that a gross margin of 45% in the near future is certainly not impossible. Operating expenses will increase in Q4 on the order of 3 to 5% as we continue to hire. We believe the tax rate will hold at 17% for GAAP and 16% for non-GAAP. We have not included any PortalPlayer revenue or expenses in this outlook. Depending on when the acquisition closes, there could be both revenue and expenses in our fourth quarter results. Now I will turn it back over to Jen-Hsun"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks Marv. On Monday of this week, we announced the signing of a definitive agreement to acquire PortalPlayer, the pioneer of application processors for portable media players. Their products power many of the world's most recognized digital music players. Their processors also power the upcoming Vista SideShow, secondary display for notebooks. With this acquisition, we're combining the two essential technologies for next generation mobile devices, PortalPlayer's application processor and NVIDIA's handheld GPU. IDC predicts that the combined market for application processors and GPUs will grow to approximately $4.1 billion by 2010. Semiconductors that enable connectivity and multimedia features in handsets are expected to show the greatest growth over the next several years. We're very excited about growth opportunities for the year ahead. The reviews of our new products are fabulous. Let me give you a flavor. According to PC Perspective, and I quote, in my seven years of covering the world of PC hardware, no other graphics architecture shift has been as dramatic as the one we are seeing here today with NVIDIA's GeForce 8800 GTX. I am quoting Kyle Bennett at HardOCP, the EVGA nForce 680i motherboard is easily one of the best enthusiast motherboards I have ever used. The 680i NVIDIA reference motherboard will make it into my next system build no question asked. We expect a rapid production ramp of the new GeForce 8800 and NVIDIA nForce 680 SLI product families to drive Q4 growth. In Q4, we will also witness the launch of the most anticipated next generation video game console, the PlayStation 3. We expect our notebook GPU share increase to continue as we fully ramp our map of design wins. Our share increase should continue through the spring Santa Rosa cycle as we achieve an even higher level of success than Napa. We expect our Santa Rosa design wins to ramp in Q1. Q1 will also benefit from the continuing ramp of the 2.5G North American phone design wins in our handheld GPU business. And with the recent acquisition of AMD and -- recent combination of AMD and ATI, we are in a unique position to offer branded integrated graphics for the Intel processor market. Market demand for our product has been very high. We will respond to market demand and offer our first Intel integrated solution early next year. We expect this will significantly increase our addressable market for MCPs. Finally, we're about to experience the biggest combination of discontinuity to simultaneously impact our ecosystem in over 10 years. Next generation Microsoft DX10-based games, Vista, and high-definition DVD, each of these discontinuities by themselves significantly increase the amount of graphics processing power necessary to deliver a compelling end-user experience. As the adoption of each of these grow throughout the year and beyond, so will the need for next generation GPUs, like the nForce -- like the GeForce 8 family. It is very evident that 3D graphics and GPU is becoming an evermore essential part of our computing experience. Some of the most exciting and popular applications are enabled by 3D including Google Earth, Microsoft’s new Virtual Earth 3D, Apple's iTunes 7 uses 3D to elegantly rendered album covers. With this, they are providing 3D foundation for all future applications. We expect to all of them to many more innovative ways to use 3D. This is truly a great time to be the single most focused GPU company in the world. Thank you, and we would be happy to take your questions now."
},
{
"speaker": "Operator",
"text": "(Operator Instructions). Your first question comes from the line of Shawn Webster with JP Morgan."
},
{
"speaker": "Shawn Webster - JP Morgan",
"text": "Good afternoon. Can you comment at all first off on any guidance you can give us on PortalPlayer, what you expect in terms of revenues, maybe a run rate and OpEx? And then I have a follow-up please."
},
{
"speaker": "Jen-Hsun Huang",
"text": "I guess the answer is no. First of all, the deal is not done yet. We have just signed a definitive and -- so it is probably too early to do that."
},
{
"speaker": "Marv Burkett",
"text": "Yes, I think so, Shawn. It requires shareholder vote and we will see. We are very excited about acquiring them, but it does requires shareholder vote."
},
{
"speaker": "Shawn Webster - JP Morgan",
"text": "Okay. Maybe turning into the PC end demand environment, you guys are obviously gaining share. Is there any color you can give us on how you see PC end demand going in as we move through Q4 actually and maybe into calendar Q1?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "There is a whole lot of different dynamics that are going on. There is obviously Q4 is seasonally a large quarter. There are some concerns about this about this, but we are seeing that. Most of the PC OEMs that we work with and most of the channel are relatively comfortable with the transition at this point. Our biggest focus right now is just ramping GeForce 8800 and nForce 680. And the market demand for both products are incredibly high. And so, we're going to focus on ramping those products and that should be the focus of our growth drivers in the Q4 timeframe."
},
{
"speaker": "Shawn Webster - JP Morgan",
"text": "Okay. Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark Edelstone with Morgan Stanley."
},
{
"speaker": "Mark Edelstone - Morgan Stanley",
"text": "First off, congratulations on another outstanding quarter guys."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks Mark."
},
{
"speaker": "Mark Edelstone - Morgan Stanley",
"text": "Hey, Jen-Hsun, you talked a little bit about Quadro Plex and that certainly is a whole new strategy for the company. Can you talk a little bit about the opportunities you see there, just maybe size of market and how we should think about that from a business model perspective as you go forward?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yes. First of all, Quadro Plex leverages of our SLI presence and our workstation presence and the vast amount of software that we developed over the years for workstation applications and SLI applications. Quadro Plex is an external stand-alone image generator that allows our customers to scale their rendering density by just enormous factors. The application, of course, is targeted within all of the same customer bases that historical image generators have gone into, in addition to desk side workstations that would have wanted image generator type capability, but does simply couldn't afford it. There has been several billion dollars worth of image generators that have been installed into the world over the last, I guess, decade and a half. All of those image generators still require quite a bit of maintenance. They're pretty outdated. They consume a great deal of power. And I think that replacing those over time is just going to be a really huge opportunity for us. Not to mention creating a whole new class of desk sized imaging workstations that weren't possible before. It is hard exactly for us to scope out how big the opportunities are, but it is quite significant. It is certainly several times larger than the workstation business it is today. And in combination with the GPU computing technology that we recently -- that we announced yesterday called CUDA, we think that these desk side image generators, or super computers by your desk, are going to be really interesting applications for us to grow into. The business model with Quadro Plex is based off of system sales. The configuration is proprietary. It is based off of SLI, and it goes with quite a large suite of software to enable scalability. And so we will sell systems through our OEMs. They're branded Quadro Plexes. We would also sell it through VARs, and it is also sold directly on our website to professionals who work directly with us."
},
{
"speaker": "Mark Edelstone - Morgan Stanley",
"text": "I guess it would seem like that business would have potential to be pretty chunky over time. Would that be your expectation? And if so, would you have visibility as the, sort of, backlog begins to build for that business over time?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Our expectation is that it is going to be a very large business. I don't know exactly how large it is going to be yet. But I agree with you. It is going to be very chunky business. It should be a very significant business. The number of installation of image generators in the world, just thinking through that, large workstation companies use to -- multibillion dollar workstation companies use to serve that market. And so we're going to replace those aging image generators. We're going to create new categories of desk-sized super workstations. And then in combination with GPU computing, I think it is a whole new computing model that we are excited about. It is hard for us to guess exactly what it is right now, but I think it is going to be very large, Mark."
},
{
"speaker": "Mark Edelstone - Morgan Stanley",
"text": "Then just one last question on memory. As you were ramping up the G80 family here over the next couple of quarters, should we see memory going up, or do you think it can hold here at current levels?"
},
{
"speaker": "Marv Burkett",
"text": "I guess my feeling is that we hope it is down in Q4. That is our current expectation. We had to ramp up for the 8800 launch, but we don't anticipate that that goes up."
},
{
"speaker": "Mark Edelstone - Morgan Stanley",
"text": "Great. Thanks a lot. Nice job guys."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks Mark"
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Daniel Ernst."
},
{
"speaker": "Daniel Ernst - Hudson Square Research",
"text": "Thanks for taking the question. Just not looking for guidance on the PortalPlayer revenues, but just thinking about the opportunity there, how quickly could you realistically integrate your video graphics processing capabilities with their on-base SOCs? And then what are you thinking is the best opportunity there? Is it still where they have been focused on the stand-alone media players, or do you think it is the mobile phones? Secondly on that, how serious do you think OEMs are about adopting the SideShow technology?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "So, what I'm going to do is I am going to answer the question probably from a more strategic perspective. And the reason for that is because the deal is just not done. And any speculation about our businesses -- about their business and our combination of the business is just a little too premature. But I think if you look at it strategically we feel that future mobile devices will become more and more intelligent, would incorporate operating systems, will be multitasking, will support all kinds of rich media. And over the course of certainly by within the next ten years, these mobile devices are going to become amazing little portable computers that allows you to do everything that you can imagine a digital device to be able to do today, whether it is music or movies or television or Web viewing or 3D games, or whatever happens to be. And certainly well within the next ten years, this dynamic will happen, and these portable devices will become your most personal computer. And we expect that this is going to be when it all -- when these various dynamics come together, particularly as the rich operating system becomes available for these mobile devices, it is really going to become the second PC revolution and so we are excited from that perspective. The two really critical ingredients to enable this new era to happen is application processors in combination with GPUs. The baseband processor is innovating quite nicely. And I think that the technology is maturing, and the capability is certainly available on every single phone already, obviously. So where we need to innovate is application processors and GPUs, and that is reason why we are so excited about the PortalPlayer opportunity. How excited are people about SideShow? I believe they have a numerous number of design wins, and they are real OEMs, and they really, really, really going to ship with it. And the way I think about it is the utility to the end-user. How many of us frequently carry our notebooks around, and just want to quickly glance at the calendar or the time or send a very quick message or see a quick message? I think that all of us would like to do that. And so without having to boot-up and log in to your personal computer. And so I think this is a capability that is a real differentiator for the notebook. And if a cell phone has two displays and some of them have three displays, why shouldn't a notebook have a couple of two, three displays?"
},
{
"speaker": "Daniel Ernst - Hudson Square Research",
"text": "Great. That is helpful color. And then just a follow-up to your new platform launch and your comments on GPU-based computing. Earlier this year at NAB, Sony and IBM showed off a prototype cell-based media server for the broadcasting industry, as video is recently going digital and not tape-based. Is that an area that since you would be computing with that platform on, or would you have GPU-based media servers?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "It is too early to tell whether we're going to compete or not. But I think is interesting is that there's a whole new area of computing that is just not well served today. Some people think that supercomputers ought to serve it. We all know that over the course of the last ten years there has been a drought of supercomputer technology. And the reason for that, of course, is it has been really the workstation and the PC era. Now the world knows that there is a -- we have a supercomputer crisis, if you will, that there are so many problems that are very, very data intensive, very computer intensive, but the innovation and the investment around supercomputers has really lagged over the years. We think that we can transform the PC into a supercomputer. This is a wonderful opportunity for all the entire PC ecosystem. And by adding a GPU with a technology like CUDA, we can turn the PC, with the addition of GPU computing, into a deskside supercomputer. You could do this obviously in a server configuration as well with a bunch of blades. And the applications for these are wherever all these supercomputers are required and where people are using FPGAs potentially, or even designing custom ASICs to do the intensive number crunching. So, I think this is going to be opening up a whole new era of new style of computing, and we call that GPU computing."
},
{
"speaker": "Daniel Ernst - Hudson Square Research",
"text": "Great. It sounds exciting. Thank you."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yes. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Doug Freedman with AmTech Research."
},
{
"speaker": "Doug Freedman - AmTech Research",
"text": "A quick one for you. Can you give us a little bit more color on the chipset business and what you're doing there to improve the gross margins? And where do you think you can take those gross margins over the longer term? If you could just describe the landscape of the chipset market that I think is changing quite a bit recently."
},
{
"speaker": "Jen-Hsun Huang",
"text": "I think gross margins could be achieved -- could be improved in a lot of variety of ways. The number one best way is architectural. And I probably prefer to keep them as trade secrets, but architectural efficiency, doing more with less or doing more through extreme high integrations, or whatever the technology is -- approach is very important, so architectural. The second thing is operational. We have to make sure that the products are built just in time to benefit from the lowest wafer cost. We have to make sure that the yields are as high as we can make it. The scraps are low as we can make it, and the quality as high as we can. People have always known that through perfect quality is your best way to improve profitability. And the rest of it, the market dictates. We don't set the price; the competition and the customers set the price. And so on our side have to make sure we develop products that the market really highly desires. And that is one of the advantages of nForce. Our brand, our nForce brand is really becoming, if not already, the number one brand of core logic. If you're somebody who cares about the performance and stability and the availability of the best technology on a motherboard, nForce is really your choice. And I think we have demonstrated that on both the Intel as well as the AMD platforms. Between the combination of great architecture, efficient architecture, operational excellence, and building brands that the market highly desires those are basically our approach. And we hammer on all three every day."
},
{
"speaker": "Doug Freedman - AmTech Research",
"text": "What do you see as the price trend in that marketplace? And then if you could give us an idea of when we can -- when you believe you'll see revenue from the Intel integrated solution?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "The pricing trend in core logic -- I don't know if there's a particular trend -- it depends on what products and what segments we launch at any given point in time. This quarter, we are launching our nForce 680i and the 680a, and both of them are targeted at the enthusiast market. They tend to have higher ASPs and so -- because we're ramping those products there's probably a good likelihood that we trend upward. It has a lot to do with what we introduce more than what is happening in the marketplace. With respect to the Intel chipset, my expectation is that we -- I guess the market's expectation, which is customers would like us to be in the marketplace by spring of next year, and we are working as hard as we can to do that."
},
{
"speaker": "Doug Freedman - AmTech Research",
"text": "All right. Great. Thank you so much."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks Doug."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Tayyib Shah with Longbow Research."
},
{
"speaker": "Tayyib Shah - Longbow Research",
"text": "Hi guys. Congratulations on the quarter."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thank you."
},
{
"speaker": "Tayyib Shah - Longbow Research",
"text": "In the past you guys have kind of restricted yourself to the high end of the Intel platform MCP market. Now you're talking about significantly expanding your footprint there. Can you maybe talk about do you see yourself going after the mainstream Intel MCP segment in a major way in 2007? And if so, how much of that changed approach was because of the AMD ATI merger?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "The answer to your question is yes. We're going to go after the mainstream part of the market with our GeForce and nForce branded integrated graphics. And that market is obviously very, very large. And the opportunity to us is now quite significant, and the reason for that is directly related to ATI being sold to AMD. Now there is really a void of a branded, integrated graphics supplier in the Intel market, and that is an opportunity that we have stayed away from because there were other players that were serving that market before. But now with DX10 and high-definition and Blu-ray video and Vista, the bar for graphics capability has gone up so high in just one year's time we believe that that raised bar, as well as the fact that there is now a vacuum because ATI has left that market, it is just a wonderful opportunity for us. This is just the perfect time for us to enter it."
},
{
"speaker": "Tayyib Shah - Longbow Research",
"text": "Okay .Then can you talk about the supply situation for graphics memory? How do you see that shaping up over the next quarter? And if Marv can put this in the context of gross margins, have you had to absorb some of our memory cost increase in the last quarter?"
},
{
"speaker": "Marv Burkett",
"text": "What was that last portion? I didn't hear that."
},
{
"speaker": "Tayyib Shah - Longbow Research",
"text": "Have you had to absorb some of the memory cost increase in the fiscal third quarter?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "I guess the first thing is the comment about the memory shortage. There is a memory shortage, or memory tightness. But the memory tightness is by and large alleviated at this point. But during the tightness we worked really closely with all of our add-in card partners and OEMs. And because we're such a close partner of all the memory suppliers, we have been helpful at helping them secure the memories that they needed in a price that was fair to the marketplace. We were frankly very, very helpful to the graphics ecosystem to help them secure memories during Q3. But I think the shortage is by and large stabilized at this point."
},
{
"speaker": "Tayyib Shah - Longbow Research",
"text": "Thank you"
},
{
"speaker": "Marv Burkett",
"text": "On the comment with regard to gross margins, obviously our gross margins were impacted by the increase in memory last quarter. If you look at it very, very simplistically, a $20 million increase in memory business which we had Q2 to Q3, if you had gotten 40% margin on that, that is $8 million. That is a full percentage point in gross margin. Now that is not quite what happened, we do get some margin off of memory. To answer your other portion of the question, no, we don't lose money on memory, but it is just not a high margin business."
},
{
"speaker": "Tayyib Shah - Longbow Research",
"text": "Thank you."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yes, Tayyib. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Pranay Laharia with Deutsche Bank."
},
{
"speaker": "Pranay Laharia - Deutsche Bank",
"text": "A question on die size. So your G80 die size looks to be a lot larger than your G70 and it appears likely that in this new generation you'll lose the die size advantage that you guys had over your competition last time around. Can you talk about what gross margin impact these two factors will have?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "First of all, I guess I all answer the second question first. This time around the competition hasn't even shown their products yet. I guess at this point their die size would be infinitely large, and so I would say that we have -- we still have a competitive advantage relative to that. The die size is larger, but the ASP is also higher, and so you have to balance those two things. You know GeForce 7900 is now well into the $299 segment. And I have seen some prices down that are even below that. But that is not where GeForce 8800 is positioned right now. The GeForce 8800 is positioned at the enthusiast segment and the very high-performance segment where either the gamer or the enthusiast demands to have the absolute best, and has a real need to run games at extreme high resolutions and the most modern games. We have repositioned the 7900 starting last quarter into the lower parts of the performance segment, and it is now solidly there, and it is doing fabulously. And so the two products are simply positioned at different price points in different parts of the marketplace."
},
{
"speaker": "Pranay Laharia - Deutsche Bank",
"text": "Let me just sort of follow-up on that. Do you think when your G80 line ramps up across the stack on a full stack for full stack comparison, will you be the same die size as you were with G70 or will you be higher? Thinking logically that ought to dictate your gross margins for the next one year."
},
{
"speaker": "Jen-Hsun Huang",
"text": "That is a good question. G80 is just the first of the G8X family. And there are many other G8X families, probably nine others. We're going to -- all the numbers in between. So the GPU is designed to be scalable in architecture. And our engineers are very, very rapidly and very hard at work in building all kinds of products derived from the G8X family."
},
{
"speaker": "Pranay Laharia - Deutsche Bank",
"text": "Okay. And then just one last question. For the Santa Rosa platform, do you compete with G70 or with G80 derivatives? And where do you think your product -- where do you think your market share goes in notebook discrete graphics with Santa Rosa?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Santa Rosa notebooks are DX10 notebooks. They are Vista, DX10, Blu-ray disk, high-definition video notebooks. And we are the only supplier of DX10 GPUs today, and the only one sampling notebook GPUs. And my expectation is that we -- our success on the Santa Rosa transition should be quite a bit higher than our success even with Napa."
},
{
"speaker": "Pranay Laharia - Deutsche Bank",
"text": "Thank you."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yup."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Rick Schafer with CIBC World Markets."
},
{
"speaker": "Dan Morris - CIBC World Markets",
"text": "Good afternoon guys. Congratulations. This is actually Dan Morris calling for Rick."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks Dan."
},
{
"speaker": "Dan Morris - CIBC World Markets",
"text": "The first question. Your guidance for the consumer division sits slightly up. I might have expected that to be a little bit higher. It is something going on with maybe the NREs and the levels that you're getting there, if you could give an update there?"
},
{
"speaker": "Marv Burkett",
"text": "Yes. The NREs are rolling off. And until we have other programs that replace them, we don't anticipate but we're anticipating that they roll off, so you will see a decline in NRE, offset by the increase in royalties."
},
{
"speaker": "Dan Morris - CIBC World Markets",
"text": "How is the NRE recognized and about how much was left?"
},
{
"speaker": "Marv Burkett",
"text": "A small amount is left, and it is recognized on a percentage of completion basis."
},
{
"speaker": "Dan Morris - CIBC World Markets",
"text": "Good."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Or if I can just add to that. They are ongoing projects on a NRE basis. It is just that it is recognized on a completion basis, and some of the projects that we're currently working on right now are further away from completion, but we're working on those projects."
},
{
"speaker": "Dan Morris - CIBC World Markets",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Glen Yeung with Citigroup."
},
{
"speaker": "Peter Karzaris - Citigroup",
"text": "This is [Peter Karzaris] for Glen Yeung. You put up a good quarter. I'm just curious actually for your inventory it looks like it is down a bit quarter on quarter. You have the new product launch and you have been seeing some substantial share gain. What is your ability to I guess service potential upside for next quarter if you had to? And I have something to follow that."
},
{
"speaker": "Jen-Hsun Huang",
"text": "All first of all, I think we actually -- we're actually as passionate as you guys are in reducing our inventories, and still be able to run our business. I know what you are saying is true too. Having inventory allows you to address unexpected demand. But what we're trying to do operationally is to put ourselves in a position where we can continue to address unexpected demand but work down our inventory. That is an intense focus in our company, and our expectation and our goal is to reduce our inventory even further, and yet still be able to address unexpected demands."
},
{
"speaker": "Peter Karzaris - Citigroup",
"text": "So, let me ask just a little differently."
},
{
"speaker": "Jen-Hsun Huang",
"text": "I guess maybe our -- let me just say just one more thing. It is reduced not by accident. And it didn't reduce unexpectedly. And we hope that it in fact goes down even further in the future. That is our hope. That is our goal."
},
{
"speaker": "Peter Karzaris - Citigroup",
"text": "I guess -- let me ask a slightly different way. It looks like this quarter one of places you had upside was in mainstream. You had new products out there. Can you give me a sense of the mix of your inventory and how it has changed?"
},
{
"speaker": "Marv Burkett",
"text": "The mix of our inventory it is waited heavily to the new product. And so are we going to be in perfect mix? Probably not, never happen. But we think we are in good shape from an inventory standpoint to support upside."
},
{
"speaker": "Peter Karzaris - Citigroup",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Michael McConnell with Pacific Crest."
},
{
"speaker": "Michael McConnell - Pacific Crest",
"text": "Thank you. Jen-Hsun, if we looked maybe a little bit longer out to next year and looked at the growth drivers kind of from a product segment, what do you -- it sounds like notebooks are only going to be getting better next year with Santa Rosa. Should we be looking at notebook chipsets as being on a year-over-year basis probably the two major product drivers next year, or can we lump wireless in there as well?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Let's see, what did should grow next year. I think GPUs will grow next year because Vista, high def, DX10, they are just amazing, amazing things happening in our PC industry. I haven't felt this excited about all the new technologies coming since Windows 95. And Windows 95 was big, big, as you recall. I think that is going to happen next year. Our handheld business should continue to grow substantially. In fact it should accelerate its growth next year because of our entry into 2.5G. I think our chipset business is going to grow. And the reason for that is partly because of the dynamics I have explained already about Vista and DX10. Vista, DX10 and high def have just raised the bar so that second-tier core logic suppliers are going to have a much, much harder time competing in the future. And they either would have had to invest already hundreds of millions of dollars to get here with DX10 or they are just not going to be able to compete next year. I think our core logic business would do very well. I also think that our serviceable market is going to grow dramatically with the branded Intel core logic business. I think that is going to be big for us. I can't help but believe that Sony is going to incredibly well next year. The early reviews are already really very exciting and so --. And then workstations. Frankly, my psychology right now is that we are in a position to grow all of our businesses next year. And we have strategies to grow all of our businesses next year. And we have reason to believe that the market dynamics will allow us to grow every single one of our businesses next year."
},
{
"speaker": "Michael McConnell - Pacific Crest",
"text": "If we look at the desktop GPU business, you have obviously got a pretty significant head start here with the G80 architecture relative to the competition. You had stated in your prepared remarks that you have 89% share in performance segment. Your share relatively in the mainstream segment below that level. So with this head start do we have an opportunity to take some share in that segment relative to the competition as well next year, given the head start?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "That is a good point. We are certainly still focused on increasing share. We are also focused on increasing revenue [TAM]. I want to continue to emphasize that we -- although we enjoyed talking about share and we enjoy gaining share, one of the focus of our company has always been is creating a larger market for all of us to share, and SLI certainly created a larger TAM. The introduction of DX10 will increase the revenue TAM hopefully because DX10 is so exciting and Vista is so exciting and high-definition video is so exciting it might drive the ASP up. People are looking for more GPU experience, more GPU performance to get the best experience. That will increase the TAM. And so we look for ways to increase the unit attached. We look for ways to help consumers experience better content, and those things always increase TAMs. But we're still very hyper focused in increasing share."
},
{
"speaker": "Michael McConnell - Pacific Crest",
"text": "Thank you. That was very helpful."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Devan Moodley with Scotia Capital."
},
{
"speaker": "Devan Moodley - Scotia Capital",
"text": "Hi guys, great quarter."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thank you."
},
{
"speaker": "Devan Moodley - Scotia Capital",
"text": "And you guys almost delivered a Q3 that is kind of what the Street was expecting for next year. In that context, obviously things are going pretty well ahead of expectations. What have you done to secure the wafer capacity you think you're going to need? Clearly that has changed from even two quarters ago."
},
{
"speaker": "Jen-Hsun Huang",
"text": "We are being one of the largest, and I think we probably are at this point from wafer consumption perspective, the largest in the world, and having such close relationships with TSMC, our single largest foundry partner, and others, I think that really plays a role in this. We have a rigorous forward-looking and forward planning process. Internally we have expected to be here for some time to be honest, and so it didn't happen accidentally. We expected to be here, and so we have been planning for that. And we're planning for next quarter. We're planning for next year. And our alignment with TSMC and other foundries is excellent. They have a perfect understanding of exactly what we need. And there's no evidence whatsoever that they're not going to be able to support us in every way."
},
{
"speaker": "Devan Moodley - Scotia Capital",
"text": "Just one follow-up. If we look at a year from now, where would you like the percentage of your desktop GPU business to be in terms of the G80 family?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Marv, go ahead."
},
{
"speaker": "Marv Burkett",
"text": "The normal transition would put it above 50%."
},
{
"speaker": "Devan Moodley - Scotia Capital",
"text": "Sorry, desktop and mobile?"
},
{
"speaker": "Marv Burkett",
"text": "Yes. I don't know about mobile [heard about live], so I'm talking about desktop, that is what you asked."
},
{
"speaker": "Devan Moodley - Scotia Capital",
"text": "Okay. Thanks guys."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Robert Dennison with UBS."
},
{
"speaker": "Robert Dennison - UBS",
"text": "Thanks guys. Good quarter. I'm wondering if you can give me just a little bit more color on the patent license fee. I don't need to know what it is about or what it is for, but I'm not understanding how it is an one-time item. It would seem to me that it would be meaningful for gross margin if you guys had to pay patent license fees."
},
{
"speaker": "Marv Burkett",
"text": "I wish I can give you more information, but it is a confidential arrangement. It includes payments for use of those patents. It is a significant number of patents. Beyond that I really don't think we can comment."
},
{
"speaker": "Robert Dennison - UBS",
"text": "So is it something that you have used this technology for in the past, and so it didn't show up in past margins and you're putting it in this margin, or is it for the future or --?"
},
{
"speaker": "Marv Burkett",
"text": "It is primarily for the past."
},
{
"speaker": "Robert Dennison - UBS",
"text": "And Jen-Hsun, I heard you say that you were getting into the Intel integrated MCP market. I also heard Marv say that MCP margins should come up. This is a notoriously tough margin business. It is Intel integrated. Can you give me a little color on how you guys expect to bring margins up in that business, particularly given the 44% range you are talking about next quarter?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "I'm not sure yet. That is kind of the truth. I don't have a product to sell yet, and so I really don't have very much experience there. But my general experience with -- and you know that gross margin improvement has been a passion of mine and our company for quite a few years now. We have been increasing it quarter by quarter by quarter, and we doing all kinds of great stuff. What I had learned about it is there's probably on balance about three major factors. One of them is your architecture. And so that relies on just the really innovative and the talented, the really creative engineers that we have to come up with innovative architecture. The second one is operational excellence. And that one just those from the front of your company all the way to the back of your company. You just have no waste whatsoever. And perfect yields, but no waste, perfect quality, if you just hit everything at 100% and everything at 0%, you're going to be -- everything else at 0%, you will be in good shape. And the last part of it is just building a great product. You need to have a great brand in this marketplace. And the market that we will serve, the market we will continue to serve is where we believe we can capture the value from the products that we sell. You know that we're not fanatical about revenues; we're fanatical about profits. We don't need to go chase profitless prosperity. We're just not going to do it. We are going to target the segments of the marketplace where our work and our brand is valued. And we will leave the other segments to other people."
},
{
"speaker": "Robert Dennison - UBS",
"text": "Okay. Great. Finally, I know you guys aren't offering much in the way of color on PortalPlayer, but do you expect this to be helpful or a drag on margins going forward should the deal go through?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "It should be slightly dilutive in the first year. And in the second year I hope it is wonderfully accretive."
},
{
"speaker": "Robert Dennison - UBS",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, we have reached the end of the allotted time for questions and answers this afternoon. I would now like to turn the call back over to Jen-Hsun Huang for closing remarks."
},
{
"speaker": "Jen-Hsun Huang",
"text": "I want to thank all of you guys for joining us today. We look forward to reporting our progress for Q4. Thank you."
},
{
"speaker": "Operator",
"text": "This concludes the fiscal year 2007 third quarter financial results conference call. You may now disconnect."
}
] | null | null |
NVDA | 2 | 2,007 | 2006-08-10 23:00:00 | Executives: Michael Hara - VP, IR Jen-Hsun Huang - President, CEO Marv Burkett - CFO
Analysts: Glen Yeung – Citigroup Chris Caso – Friedman, Billings, Ramsey Michael McConnell– Pacific Crest Securities Hans Mosesmann – Moors & Cabot Robert Dennison – UBS Arnab Chanda – Lehman Brothers Naser Iqbal - Salman Partners Han Lee - Global Crown Capital Nicholas Aberle - Caris & Co Devan Moodley - Scotia Capital Simona Jankowski - Goldman Sachs
Operator: Good afternoon and thank you for holding. I will now turn the call over to Mr. Michael Hara, NVIDIA’s Vice President of Investor Relations. Thank you, sir. You may begin your conference.
Michael Hara: Thank you. Good afternoon and welcome to NVIDIA’s conference call for the first fiscal quarter ended July 30, 2006. Pardon me, the second. On the call today for NVIDIA are Jen-Hsun Huang, NVIDIA’s President and Chief Executive Officer, and Marv Burkett, NVIDIA’s Chief Financial Officer. Before we being today’s call, I would like to take care of some general administrative items. Your lines have been placed on a listen-only mode until the question-and-answer segment of today’s call. This call is being recorded. If you have objections, you may disconnect at this time. Please be aware that if you decide to ask a question, it will be included in both our live transmission as well as future use of a recording. Also, shareholders can listen to a live webcast of today’s call and view our financial release at the NVIDIA Investor Relations website. The webcast will be available for replay until the company’s conference call to discuss its financial results for the third fiscal quarter of 2007. During the course of this conference call, we may make forward-looking statements based on current expectations. Forward-looking statements, including statements as to our third quarter 2007 outlook, the option review by our Audit Committee and possible adjustments to our preliminary results for the second quarter of fiscal 2007, our outlook for the third quarter of 2007, the Audit Committee review, any expenses that may be recorded as a result of the Audit Committee’s review, the release of our complete financial results for the second quarter of fiscal 2007, growth drivers, market share, Windows Vista, design wins, strategic focus, customers and partners, new and forthcoming products, and products and technologies pertain to future events and are subject to a number of significant risks and uncertainties. The company’s actual results may differ materially from results discussed in any forward-looking statements. For a complete discussion of factors that could affect the company’s future financial results and business, please refer to the company’s Form 10 K and annual report for the fiscal year ended January 29, 2006, quarterly reports on Form 10 Q, and the reports on Form 8 K fled with the Securities and Exchange Commission. All forward-looking statements are made as of the date hereof based on information available to us today, and as required by law. The company assumes no obligation to update any such statements. The content of the webcast contains time-sensitive information that is accurate only as of August 10, 2006. Consistent with requirements under Regulation FD, we will be providing public guidance directly in the conference call and will unable to provide significantly more information in offline conversations or during the quarter. Therefore, questions around our financial expectations should be asked during this call. At the end of our remarks there will be time for your questions. In order to allow more people to ask questions, please limit yourself to one question. After our response, we will allow one follow up question. I’m sure everyone has seen our press release earlier today announcing that the Audit Committee of the Board of Directors is conducting a voluntary review of the company’s stock option practices covering the time from the company’s initial public offering in 1999 to the fiscal current year. As a result of the ongoing review, we had to limit the scope of our financial information that we released today. In addition, on this call we will not be able to provide any specifics about our gross margin or operating expenses for the second quarter or year-to date as we cannot determine those amounts in accordance with GAAP until the review is complete. In today’s call we will provide some information and guidance about general trends for these metrics, but cannot provide any greater detail than what we state on the call. We will, of course, make every effort to provide you with more detailed information soon. Note NVIDIA does not expect to be in a position to announce additional financial results for the second quarter until the Audit Committee has completed its review. At this time, the company does not expect to be in a position to file its Form 10 Q for the second fiscal quarter by September 8, 2006 following deadline, or the permitted extension to September 13, 2006. The company is focused on resolving these issues as quickly as possible and plans to file its Form 10 Q and any required financial statements following the completion of the review. I will now hand the call over to Jen Hsun.
Jen Hsun Huang: Thanks, Mike. Good afternoon, and thank you for joining us. Today, we’re pleased to report record revenue of $687.5 million for our second quarter. Year-over-year, second quarter revenue grew 20%. Our growth was driven by strong performance from numerous product groups. Desktop GPU, notebook GPU, MCP, professional solutions and handheld GPU, resulting in record revenue for the second quarter, which is a seasonally slow quarter. Let me review the highlights and achievements of each of our business units during the quarter. Our desktop GPU business delivered a strong Q2. We maintained a leading share of over 50%. Our year-on year revenue grew 13% and our market share grew 5%. Demand for our GeForce 7600 and 7900 series GPUs with SLI continues to be strong. NVIDIA is dedicated to delivering the highest performance and best gaming experience to PC gamers. With the launch of our revolutionary graphics card, the GeForce 7950 GX2 will once again raise the bar on PC gaming. With 7950 GX2, gamers can now enjoy the latest games at incredible resolution of 2500 x 1600. That is the resolution of cinematic film. Thirteen times the resolution of television, and brings the 16 x 9 panoramic experience of cinema to gaming. We call this next level experience extreme, high-definition gaming. It is really something to witness. The 7950 GX2 is the fastest graphics card available today. It was launched by over 28 leading enthusiast OEMs include Dell’s flagship, XPS 700. We continue to expand the SLI platform by delivering SLI-enabled GPUs from Quad SLI 7950 GX2 and down into the mainstream of our product line. We have shipped over 20 million SLI GPUs to date. The popularity of NVIDIA’s SLI has been further validated by the recent publication release by Guru3D of a comprehensive review of multi GPU platforms. This review was performed by some of the most respected hardware review sites over several weeks of testing. NVIDIA’s SLI platform was found to be the clear winner in performance, game capability and software stability. In the performance segment where price performance ratio is critical, we continued to gain momentum. We fully transitioned from our highly popular GeForce 6600 to the GeForce 7600, which delivers almost 100% performance improvement at the same price point. In Q2, our performance segment shipments grew nearly 50%. We expect the GeForce 7600 will break sales records set by the 6600. NVIDIA’s focus on the stringent power, performance and video requirements of the notebook segment have delivered solid results in Q2. Our notebook GPU revenue grew over 50% year-over-year and while the notebook segment was seasonally down in Q2, our notebook GPU revenue was up 12% quarter to question. Year-over-year, two of our key notebook segments realized substantial increases in volume shipments: performance segments up 80% and mainstream segments up 172%. During the quarter we launched SLI for high-end gaming notebooks, bringing the best of PC gaming experiences to notebooks. We also introduced PureVideo HD, the industry’s only complete solution for enjoying high-definition Blue ray and HD movie experiences on PCs. PureVideo HD is a complete solution that consists of the video processor in G47, complex video processing algorithms, Blue ray disc and high-definition movie player, and content protection technologies. The G47 series with PureVideo HD powered the first HD DVD in Blue ray notebooks from Toshiba, Sony and Acer in Q2. Overall, there were approximately 20 new notebooks launched in Q2 based on NVIDIA’s GeForce 7 Series notebook GPUs. As a result, our share in the notebook GPU segment grew from 24% to 37% from the first quarter to the second quarter of calendar 2006 as reported by Mercury Research. We expect our share gains to continue as new notebooks based on GeForce 7 Series GPUs continue to ramp. Looking forward, we’re excited about the upcoming launch of Microsoft’s Vista operating system. Microsoft Vista will bring focus on 3 D performance to the mass market. We believe that Vista’s demand on 3 D graphics performance will drive an increased adoption of the discrete GPUs. OEMs will start over the next two quarters to offer desktop and notebook PCs that are Vista-ready as consumers will want to be sure their new PCs will fully support the new operating system. Our MCP business achieved record revenue for its eighth consecutive quarter and grew revenue over 80% year-over-year. Driven by substantial increases in server and notebook design wins, we increased share of the AMD 64 segment from 42% in calendar Q1 to 52% in calendar Q2 as reported by Mercury Research. With the upcoming transition to AMD Rev F CPU, we have captured design wins with all the leading server and workstation OEMs and ODMs, which we believe will double our AMD server segment share as we exit the fiscal year. It was a record quarter for notebook chip sets. We had revenues growing substantially over Q1. We believe we’re in a position to capture approximately 60% of the AMD Rev F CPU notebook segment business. We are thrilled that HP has incorporated our mobile nForce and GeForce products in their best-selling 15-inch and 17 inch consumer notebooks. We now ship our integrated GPUs to top PCL OEMs including HP, Gateway eMachines, Lenovo, Acer, Packard Bell, Fujitsu Siemens and we expect that list of OEMs to continue to grow. During the quarter we introduced and shipped our new nForce 590 SLI, an enthusiast platform for AMD’s latest AM2 CPU. Several weeks later, we introduced nForce 590 SLI support for Intel’s new Core 2 Duo CPU. nForce SLI is offered in flagship PCs for both AMD and Intel processors from leading companies like Dell, Alienware, Falcon, Northwoods, Voodoo and many others. Maximum PC selected our SLI platform for their Intel Core 2 Duo-based dream PC. We continue to execute our nForce commercial PC strategy and are pleased to include Lenovo’s business PC group among our latest customers. We now have over 80 PC OEMs and system builders who now offer our NVIDIA business platform in their business PC product lines. VeriTest, a highly respected third-party testing service, reported that PCs built with NVIDIA’s business platform offer excellent stability on par with those purchased by top global enterprises. The NVIDIA business platform is the only stable image, enterprise class PC platform that supports both AMD and Intel CPUs. We believe as enterprisers adopt AMD and Intel processors interchangeably, our unique position will be an important advantage for us. NVIDIA Quadro Professional business achieved a record quarter. Quadro revenues were up 27% year-over-year, and 17% quarter-over-quarter. Business was strong in all segments, especially in mobile work station and high-end Quadro. We launched an entire spectrum of new products in Q2. Our new products addressed professional segments from business desktop to HD video content creation and broadcast, to the most demanding CAD and visual simulation applications. The new Quadro line offers industry leading performance and quality for each segment, culminating with the flagship, 1 gigabyte Quadro FX 5500, the most powerful workstation GPU in the world. This new Quadro lineup is complimented by a range of solutions like Gelato, JemLock, NFDI that are becoming standards for advanced visualization and broadcast. Two weeks ago, we launched the NVIDIA Quadro Plex, an entire new category of professional graphic solution. Quadro Plex is the world’s first PCI Express base standalone external graphics subsystem, and can be connected to any workstation or server with a 16-lane PCI Express slot. An SLI-ready workstation can support two external GPU Quadro Plexes to support a GPU graphics supercomputer solution. When integrated in a typical, rack-based server, Quadro Plex offers 25 times more graphics compute density than traditional data center solutions. Quadro Plex is a whole new class of visual computing solution. It enables thousands of engineers and designers to experience advanced personal visualization solutions previously only accessible in large visualization centers. Applications of Quadro Plex include HD broadcast video, industrial design, visual simulation, oil and gas exploration and medical imaging. Our handheld GPU business achieved record shipments of GPUs in Q2. This success was largely due to three factors. We are leading the rollout of mobile, digital TV with DVDH. These included the Samsung P910 handset used in Italy for the production rollout for the World Cup and trials elsewhere in Europe as well as the HTC Foreseer used in the first North American deployment. Two, we significantly grew our number of designs at Motorola, with several new phones starting to ship now, and three, we broadened our customer base to include phones developed in Japan, China, Taiwan and Korea. We are starting to see the benefits from several key design wins at Motorola in their highly successful Razr and Sliver lines, with the Sliver L6i and L7i, as well as the Razr V3XX and the MotoRAZR MAX. We launched a MobileMedia platform for handheld devices running Windows Mobile 5.0 at Computex in June. The MobileMedia platform is a complete development containing both software and hardware components that enables handheld manufacturers to rapidly design and release digital media rich devices with Windows Mobile 5.0. Our MobileMedia platform continues to gain acceptance with additional design wins added to the Samsung, HTC and Raincom devices announced at our launch. Let me turn the call over to Marv to discuss our financial results in more detail. When I return, I would like to address our opportunities as they relate to the AMD announcement in July.
Marv Burkett: Thanks, Jen-Hsun. I’d like to start by saying that since we cannot release GAAP financial statements for Q2, my comments will be limited. I will be able to comment on revenue and some balance sheet items, but I will not be able to comment on margins, expenses or earnings. Revenue for the second quarter was $687.5 million, which is up 1% from the first quarter and up 20% from the prior year. The revenue is in line or slightly above our guidance of flat. The composition of the revenue was particularly positive. Memory sales declined by around $21 million quarter-to quarter and this was more than offset by growth in workstation and MCP. Professional products increased by 17% quarter-to quarter and MCP also increased by 17%. Notebook also increased by 12% quarter-to-quarter. Desktop GPUs declined by only 5% quarter-to-quarter as growth in the high-end GPUs offset some of the normal seasonal decline in mainstream. The result was that the unit volume decreased in desktop GPUs which you expect in Q2 was somewhat offset by a significant ASP increase. So we had revenue growth in high-margin products and revenue declines in lower-margin products. Year to year, our core product revenue, which excludes Xbox, PS3 and memory, grew by 34% with notebook and MCP both growing more than 50%. During the quarter, we repurchased $125 million of stock, which equated to 5.4 million shares. This caused cash to decline by approximately $100 million, as we also had an increase in accounts receivable. The accounts receivable increase in Q2 is normal as the quarter tends to be weighted towards the back of the quarter. The accounts receivable are still in good shape, with very little delinquency. We had unit growth in inventory of new products, and unit declines in older products, as we had anticipated. This may have resulted in a slight inventory increase. Depreciation in the quarter was $24.2 million and capital expenditures were $20.1 million. During the quarter we added 252 employees and exited the quarter with 3,427 employees worldwide. Of the 252 additions, only 78 were in the U.S. as we continued our aggressive hiring internationally. We believe spending for the quarter reflected a small quarter-to-quarter increase. The outlook for the third quarter revenue is as follows: We expect increases in both desktop and notebook GPUs. Notebook increase is a continuation of our notebook design wins and the desktop increase is a reflection of the normal Q3 PC growth and the strength of our competitive offerings. We also expect good growth in MCP, again from normal market improvement as well as from our new products. We expect workstation and handheld to be relatively flat. When you put it all together, we expect quarter-to-quarter revenue growth of 8% to 10%. We also expect to continue our emphasis on gross margin improvements and very slight increases in operating expenses. With that, I’ll turn it back over to Jen-Hsun.
Jen-Hsun Huang: Thanks, Marv. On July 24, AMD announced that they were acquiring ATI. Once the acquisition is completed, NVIDIA will become the only GPU and platform technology company that supports Intel and AMD processors. Our company focus is to be the innovation partner for leaders of the computer and consumer electronics industry, to build high-brand, high-image, market-defining products. GeForce is the No. 1 GPU brand. nForce is the No. 1 core logic brand. Quadro is the No. 1 professional and workstation brand, and SLI is the No. 1 multi-GPU brand. Each and every one of these brands is sought out by end-users of both Intel and AMD processors. AMD’s pending acquisition of ATI only enhances our strategy. The GPU is becoming increasingly important in all digital platforms. Our strategy is to extend the utility of GPUs to all types of multimedia processing and establish the GPU as the DSP of the digital media era. As we want to expand the reach of GPU into all computing devices, from PCs to servers to phones to automobiles, and in each of these markets we will support Intel or AMD CPUs, or ARM or PowerPC or Cell. Our strategic focus is the GPU. We will continue to partner closely with both processor companies and we will absolutely continue to provide MCPs for AMD as well as Intel processors. We will continue to invest around the AMD processors and continue to work with them to bring our brands to our mutual customers. We also see increased opportunities in serving Intel’s core logic segment, particularly since it is unlikely that AMD will do so. We have many exciting growth drivers ahead of this year. With the leadership position of our GPU, MCP, workstation and handheld GPU, we are positioned to continue to take share. We expect the grade three processing demand of Vista’s new UI will increase the adoption of discrete GPUs in notebook and desktop PCs. The ramp of Blue-ray and HD DVD will play into a significant advantage we have with PureVideo HD. The highly anticipated launch of PlayStation III later this year and with the pending acquisition of ATI, the new PC industry dynamics puts us in a unique position. At the core of our growth is the continuing shift in focus of the industry to build products that are multimedia centric and consumer experience centric rather than a traditional focus on mix and megabytes. As the GPU is essentially the experiential processor of digital platforms, we see tremendous growth opportunities as we extend the reach of our GPUs into all digital devices. We’d be happy to take your questions now.
Operator: (Operator Instructions) Your first question comes from Glen Yeung with Citigroup.
Glen Yeung - Citigroup: Thanks for taking my call today. I have three questions, basically. The first one is, if you look back at how revenues formed over the course of the quarter, can you talk about what linearity looked like? When did you actually see the bottom of the business and when did things start to get better?
Jen-Hsun Huang: Well, Q2 is not typically a linear quarter. It’s seasonally slow in a variety of geographies as you know and it typically tends to be a very slow May and it picks up very strongly in July, as people gear up for back-to-school. It’s pretty much the same year-over-year from that seasonal pattern. Some parts of our market tend to see a little bit less of that. For example, the professional market tends to have a bit more linearity than that because enterprises tend to buy on a continuous basis. But it’s pretty seasonal from that perspective.
Glen Yeung - Citigroup: Okay. I’ve been visiting with a bunch of board makers and box makers over the last few days and a lot of them are telling me that the attach rates for discrete GPUs are going up pretty substantially in the third quarter. I wonder if that’s something that you’re seeing consistent in your business? This may seem a bit odd, but I’m wondering if the delay of the 865G chip from Intel, which seems to be having issues with graphics quality, is helping attach rates at all for you in the October quarter?
Jen-Hsun Huang: Yeah, our belief is that as people gear up for Vista and because the user interface of Vista is so, well, it’s completely built around 3 D graphics; every part of the Vista experience requires the GPU to render each and every one of the pixels from the transparencies, the special effects and the way that it’s composited. The whole experience around Vista is really made possible by the GPU. So our belief is that as Vista ramp starts and Vista-ready PC ramp starts towards the second half of the year, the number of GPUs that would be included in PCs will increase. So that’s our general belief. I really don’t know very much about the issues with the 865G.
Glen Yeung - Citigroup: Okay, well thanks.
Jen-Hsun Huang: Thanks, Glen.
Operator: Your next question comes from Chris Caso with Friedman, Billings, Ramsey.
Chris Caso – Friedman, Billings, Ramsey: Yes, hi. Thanks. You made some comments with regard to substantial increase in ASP and decline in units on the graphics side. Could you give us a little more color on magnitude of that? What you guys consider substantial?
Marv Burkett: Yeah, well the ASP in desktop GPUs was up 16% quarter-to-quarter. Now, obviously that’s mix related because the unit volume decline was primarily in the mainstream and we did very, very well in the high-end GPUs.
Chris Caso – Friedman, Billings, Ramsey: Okay, great. I guess – is that tied into the inventory increase that you guys saw? I mean, is that part of a change in mix and if you can give us some indication of what you guys expect for inventory going forward.
Marv Burkett: Well, the inventory increases in the quarter were all in the new products, the new products we’re announcing or about to announce. The inventory of the older products declined, and I’m referring in this case to unit volume of those inventories declined. Going forward, we’ll continue to emphasize having enough inventory but I think that from a dollar-volume standpoint we probably have enough. So we will try to make sure that we don’t grow inventory very much in the rest of the year.
Chris Caso – Friedman, Billings, Ramsey: Okay and just as a final question, just, you know, kind of speaking strategically with the AMD acquisition, what can you guys tell us about any kind of discussion or programs you guys have running with Intel right now. Just maybe you can kind of give us some sense of what you think that relationship might be going forward?
Jen-Hsun Huang: Well, you know we have developments and collaborations going with both companies and we’ll continue to invest around the AMD processors. Now, with the new industry organization, obviously it’s unlikely that AMD will be designing core logic for Intel and so we see that as a pretty significant opportunity for us to participate in that. But we have so many collaborations going on with both companies, there’s not really anything that we can talk about here.
Chris Caso – Friedman, Billings, Ramsey: Okay. Thank you.
Jen-Hsun Huang: Yeah, thanks a lot, Chris.
Operator: Your next question comes from Michael McConnell with Pacific Crest Securities.
Michael McConnell– Pacific Crest Securities: Thank you. If we look at the wireless business, can you talk a little bit more about what exactly is happening at Motorola? Why you’ve been able to take some share and if we look at the rest of the year, how that revenue line should start to shape up?
Jen-Hsun Huang: Our strategy, they’re basically two – that’s not true. I guess there’s two or four GPU companies, depending on how you count them, in the handheld space. There are a couple of GPU companies in Korea who also build discrete GPUs for handsets. Our strategy is different than all the other GPU suppliers because we focus on the high-end, the multimedia-rich segments of the marketplace. Historically we focused on 3G. We expanded that focus to include smart phones and that’s why we developed the multimedia, what we call the Mobile Media chip for Windows Mobile 5.0, Windows, you know, 5.0. We’ve expanded our scope to that. We’ve also expanded our scope to personal media players. But our focus is very narrowly the multimedia rich and the high-end portable devices because we happen to believe that that’s an area where we can add a lot of value. We also happen to believe that that’s an area that’s going to grow very fast as the majority of the world’s handheld devices are going to become intelligent and they’re going to become our most personal of computing devices, and multimedia is going to pay a huge role in that. So we’ve historically focused on the high end and now those multimedia features, whether it’s digital video camcorder functionality or digital photography or 3 D graphics for better user interfaces, those devices and those capabilities are becoming very, very popular and so we think that we’re in a really terrific position to expand reach into the marketplace including at Motorola because of that.
Michael McConnell– Pacific Crest Securities: Then, if we look at operating expenses and directionally, you can only talk about directionally, should we be looking after a pretty big spike here in the April quarter? The rest of the year to kind of just bump along, maybe flattish? Or are we expecting maybe it to work higher or lower?
Marv Burkett: Well, I indicated last quarter that we’d seen a spike in Q1 and we expected to. The growth for the rest of the year would be moderate. I think that’s what you should plan on. You know, I think moderate growth from the Q1 step function.
Michael McConnell– Pacific Crest Securities: That’ very helpful. Thank you.
Jen-Hsun Huang: Thanks, Michael.
Operator: Your next question comes from Hans Mosesmann with Moors & Cabot.
Hans Mosesmann – Moors & Cabot: Thanks. Jen-Hsun, can you give us commentary regarding any sales to Sony or any in terms of the royalty ramp in October and beyond quarters? Thanks.
Jen-Hsun Huang: We have two types of activities with Sony. One of them is related to engineering and so it’s expanding their manufacturing capacity as well as reducing feature sizes by porting them to new geometries. And so there’s a very large amount of activity associated with that each and every quarter and I expect that activity to continue, certainly throughout this year and probably throughout next year. The royalty component of Sony we expect to happen this quarter. We don’t know exactly how much yet, but Sony is in volume production as you know and they’re gearing up for their highly anticipated launch towards the later part of this year so we’re expecting revenue contribution this quarter. We just don’t know how much yet.
Hans Mosesmann – Moors & Cabot: To follow up, the 8% to 10% sequentially growth is incorporating no contribution or some contribution from Sony?
Marv Burkett: Small.
Hans Mosesmann – Moors & Cabot: Okay.
Marv Burkett: When we say small, we’re referring to royalties, not the fact that Sony would be small.
Hans Mosesmann – Moors & Cabot: Right. Right. Okay. Thank you.
Marv Burkett: But I want to emphasis, Hans, that that’s the worst – no royalty in Q2.
Hans Mosesmann – Moors & Cabot: Okay. Fair enough. Thanks.
Operator: Your next question comes from Robert Dennison with UBS.
Robert Dennison - UBS: Yeah. Thank you. I’m pretty sure I heard on the call, Marv, you say that revenues were up in higher margin products and revenues were down in lower margin products. Does that give us any sort of directionality in what we should be looking at for gross margin this quarter?
Marv Burkett: You know, yes I did say that we had revenue growth in higher margin products and revenue decline in lower margin products. You’ll have to draw your own conclusions.
Robert Dennison - UBS: Okay. Thanks. So did I miss anything on handheld growth rates? Did I miss a number there?
Marv Burkett: Handheld revenue was up 12% quarter-to-quarter.
Robert Dennison - UBS: Thank you.
Operator: Your next question comes from Arnab Chanda with Lehman Brothers.
Arnab Chanda – Lehman Brothers: Thank you. Jen-Hsun, if you could explain a little bit about your MCP business, how much opportunity would you get at Intel and are you assuming that if this merger goes through, some of the internal demand at AMD would be fulfilled internally? Do you think – is that how you’re planning to address the business and do you think that business continues to grow at sort of the type of rates you’ve seen or maybe at PC growth rates? I have a follow up, please.
Jen-Hsun Huang: Yeah, Arnab, our strategy with MCP is to focus on the segments where either the GPU, the leadership of our GPU position, or GPU technology could play a large role in those segments and so, as you can imagine, GeForce and SLI are two such incredibly important brands in the end market that it’s unreasonable to expect an end user to have to pick which microprocessor GeForce and SLI supports. So these gamers they want to buy the latest in GeForce, they want to have SLI capability in their system. We want to give them the flexibility of whichever processor they would like to choose. So those segments we’ll continue to serve and it’s my expectation is that it will continue to be very successful in those segments. In the segments where integrated graphics, or graphics technology, is important, the segments that we will see the most success is where branded graphics and the leadership of our technology plays a large role. I'm hoping that the coming year, as Vista and nearly all of the office automation applications that we know of today, starts to make the migration to use 3-D graphics, that 3-D graphics will be important in a much, much larger part of the overall market. I think that creates a lot of opportunity for us. So our focus is going to continue to be where our brands are important, where graphics technology is important. If we stay focused on that, I think we'll do a fine job for you guys.
Arnab Chanda - Lehman Brothers: Thanks. One sort of qualitative question. You talked before about both operational improvements as well as royalties from Sony that could drive your gross margins higher. It seems like you had benefit on mix in the second quarter, if I understood you correctly. Do you think that going forward, over the next sort of 12 months or so, those aspects that you're talking about, the operations and the royalty structure, could continue to drive those margins higher to your old target of 45% or so? Or can you maybe give us a qualitative understanding of that? Thanks.
Jen-Hsun Huang: We haven't changed our expectation that our gross margins should be 45%, and in fact higher in the future. We ought to raise our expectations as soon as we get to 45%. There are broad and numerous operational improvement activities throughout the Company, and our operation, frankly, is world-class. The reason why is in the graphics industry, it requires an extraordinary level of operational excellence is because the technology is, obviously, extremely complex. These are some of the most complex semiconductor devices built anywhere, and the velocity of the business is very, very high. So when you have very complex devices with very high-velocity businesses, you have to be on your toes, and you have to have extraordinary operational capabilities in order to reduce waste. So that's been an area where we've put a lot of energy over the last several years, and I'm going to continue to put energy around that.
Operator: Our next question comes from Naser Iqbal - Salman Partners.
Naser Iqbal - Salman Partners: Congratulations on the quarter and the forward guidance, - great numbers. I only just have one question. Jen-Hsun, I guess, with all the announcements that have been that happening in the semiconductor space, and based on the comments you made -- and I know you're limited as to how much you can actually say. But what kind of comfort can we take in the announcement of what's happening with the stock options? Can you share any other color or comments?
Jen-Hsun Huang: The audit committee's reviews are still ongoing, and we ought to give them every benefit to complete their analysis. So at this point I don't think there's really that much that we ought to say beyond everything that we've already said.
Naser Iqbal - Salman Partners: I appreciate that. Congratulations on the quarter.
Operator: Our next question comes from David Wu - Global Crown Capital.
Han Lee - Global Crown Capital: This is Han Lee for David Wu. Congratulations on the quarter. Jen-Hsun, you mentioned in your speech that you want to be the GPU for the digital media era. So, do you have any plans again to do business such as, say, TV tuners for the PC, or the very high growth high-definition TV area?
Jen-Hsun Huang: That's a good question. I think our focus tends to be where the computing and digital technology intersects consumer applications. That tends to be our focus. Two very important words in there is computing technologies, and the other one, obviously, is consumer, which conveys multimedia and experiential elements to the technology. The digital television is not really a computing device today. It's not much more of a computer then a DVD player is. It's not much more of a computer than a set-top box is. Although it uses some embedded microprocessors and uses memory and such, the behavior and the nature of those devices tend to not follow those of computing devices. As a result of that, historically we've stayed away from it, because they don't tend to be sustainable businesses. People have told me that flat-panel displays were exciting businesses and we ought to get into that because we know a lot about image quality. That's true. But, as you know, the flat-panel transceiver business has not scaled the way that GPUs have scaled. So we tend to follow the marketplaces where the experience continues to improve, the applications continue to improve, and the reach and the usefulness of the devices continue to improve; which, certainly, personal computers is one of them, handheld devices is becoming one of them, game consoles is one of them. I foresee many other types of digital devices in the future that will have these characteristics. That's where our focus will be.
Han Lee - Global Crown Capital: Thank you. Also I have some questions about your inventory levels. You said that inventory will again increase this quarter slightly. So I'm wondering which kind of products is the inventory increasing? Is it in the higher-end graphics, or is the increase mostly in the newer MCP area?
Marv Burkett: I think what you're referring to is that I said that the inventory probably increased in Q2. I don't anticipate that inventory will increase in Q3.
Han Lee - Global Crown Capital: Do expect the ASP trend to go on in Q3?
Marv Burkett: Beg your pardon?
Han Lee - Global Crown Capital: In Q2 your ASPs increased by 15% quarter-over-quarter. So, what's your expectation for Q3?
Marv Burkett: I think it really is dependent upon mix, because a major portion of that increase quarter-to-quarter was the mix, the fact that we did very well in the high-end and the mainstream had a unit volume decline. If we do very, very well in mainstream, you could even see ASP decline in Q3. It really depends on mix more than any individual product's ASP.
Jen-Hsun Huang: One of the comments that I will make is that we made a prediction a long time ago that SLI will increase the TAM of high-end GPUs. I think for all intents and purposes, whenever you have SLI in your system, and it has the opportunity to accept two high-end graphics cards, that's a perfect example of the doubling of TAM. So I think that the adoption of SLI and the popularity of SLI, and the increasing popularity of SLI, is quite a boon for high-end GPU markets.
Operator: Our next question comes from Nicholas Aberle - Caris & Co.
Nicholas Aberle - Caris & Co: First question is for Marv. I'm trying to figure out what the Q2 gross margin was. You did imply that Q3 gross margin was going to be up from whatever that level was in Q2, correct?
Marv Burkett: No, I didn't. I didn't imply anything. I just said that we would continue to work very hard to improve gross margins.
Nicholas Aberle - Caris & Co: Okay. You said that OpEx would actually be slightly higher in Q3 then. That was the --
Marv Burkett: That's correct.
Nicholas Aberle - Caris & Co: Going into Q3, in terms of gross margin, I would expect that mix would revert somewhat. Could a potential boost be the PS3 royalties and get that margin up again in Q3?
Marv Burkett: That's certainly one of the factors. Any royalties we get is 100% margin, so that helps. So, it really depends on the magnitude of the royalties. It depends on a lot of factors, but certainly that helps.
Nicholas Aberle - Caris & Co: Secondly, Jen-Hsun, I was wondering if you could just comment on the thought process of down the road, the convergence of CPU and GPU, and perhaps the integration of the two sometime in the future, what your take is on that and how NVIDIA plays into that scenario.
Jen-Hsun Huang: GPU is a very complex device. If you pop the lid of some chips, you'll discover that GPU is substantially larger than a lot of CPUs. So I guess one could argue that long-term, Moore's Law would enable some device to integrate some other device. But frankly, markets don't care about Moore's Law. Markets don't care about Moore’s Law. They just care about what they need. The reason why the GPU has been separated from the CPU historically is because the two work off of completely different rhythms. And because of the different segmentations and the velocity of innovation, and all of those things, the GPU continues to be a standalone device for the segments in the marketplace that we serve. Our job isn't really to worry about which is going to integrate which; our job is to make the GPU valuable. That has been the historical focus of our company, to invest in helping people see how to program our GPUs, to invest in pushing the industry forward, and enabling the next level of games, or for industrial styling, or different applications of GPUs. Focusing our energy around that has been a much more productive exercise for us. Now, in some segments, we could imagine GPUs integrating with CPUs, or CPUs integrating with GPUs. But we'll approach those segments as it makes sense. Because oftentimes it's not necessarily one CPU. It could be x86. It could be ASICs, it could be PowerPC. It could be cell. It could be ARM. It could be something else. So we believe that what we ought to do is focus on the market, and focus in advancing the utility and usefulness of GPUs, and focusing on advancing the GPU technology. I think we've been very true to that historically. We're true to it right now, and I think people are seeing the wisdom of it.
Operator: Our next question comes from Devan Moodley - Scotia Capital.
Devan Moodley - Scotia Capital: Good quarter. Just quickly, can you give us the split for the 7000 versus the 6000 series family this quarter?
Marv Burkett: Heavily, heavily weighted towards the 7000 family.
Devan Moodley - Scotia Capital: Can you talk about sort of where you might expect, once G80 launches, the split to be towards the end of the year?
Jen-Hsun Huang: We haven't announced G80. I don't know what G80 is, but we sell a lot of G7Xs.
Devan Moodley - Scotia Capital: A general question in relation to the AMD ATI situation. Do you think it creates any input cost advantage for you guys down the road, with potentially maybe the fear from the pure play foundry guys that AMD might take some of that business in-house?
Jen-Hsun Huang: I don't know if that is specifically the reason. Our focus is to be a strategic and a meaningful partner of the partners we work with. TSMC is our largest-single partner, and a terrific partner, and they've done a great job for us. Our job is to make sure that we can be as large and bring as much business as we can to this relationship. Typically, when you bring a lot of business to a relationship, there's some benefits. So my sense is that that is going to continue to be a dynamic that makes sense, and that's our focus.
Devan Moodley - Scotia Capital: Last question. Where do you guys see the PC market, in terms of growth back-half of this year, with Vista launching in Q1 '07? What's your expectation for growth?
Jen-Hsun Huang: I think everybody is thinking through that. Some of the smartest things that I've heard in talking to leaders of PC companies is that here in Silicon Valley in the high-tech industry, we're sitting here talking a lot about Vista, but the vast majority of America and the rest of the world aren't spending any time talking about Vista. They think of the PC as the PC. When Vista comes out, Microsoft will be incredibly energetic to promote Vista and get that in the forethought of just about everybody on the planet. When that happens, I think the Vista demand will drive up. In the meantime, my sense is that the back half is all going to be about Conroe and AM2. Conroe is a very exciting microprocessor, and it's brought a lot of enthusiasm and excitement back into the high-end segment. And I'm excited to see that. When there is energy in the high-end excitement and people are excited about Conroe and AM2, it's going to bring a lot of people back to buy high-end PCs. And most of those high-end PCs will, hopefully, have SLI and, hopefully, have GeForces in them.
Operator: Our next question comes from Simona Jankowski - Goldman Sachs.
Simona Jankowski - Goldman Sachs: Jen-Hsun, you touched on the collaboration with Intel on the MCP side as a result of the AMD announcement. Can you maybe also comment if there is any opportunity or possibility for collaboration on the GPU side, whether marketing or otherwise -- maybe specifically, if you have noticed any change in the trajectory of your design wins alongside Conroe before and after the announcement, for GPUs specifically?
Jen-Hsun Huang: Thanks for the question. I would say that we're the only standalone GPU supplier in the world today, and we are CPU-neutral. We could be a partner for either company. I think we're a much more natural partner for either company today than ever before. I think you could derive from that that we're much more a natural partner today working with Intel than AMD would be working with Intel, in collaborating to build markets and otherwise. So I do think that's a very significant advantage.
Simona Jankowski - Goldman Sachs: But did you see anything specific so far, any kind of inflection as far as how many people are designing a GeForce GPU alongside with a Conroe, as opposed to perhaps going down the path of a 1900 in a Conroe? Is that something where the perception has changed, or anything you've been able to track?
Jen-Hsun Huang: I guess there's probably some anecdotal stuff, but I think the high-level is that Conroe is all about high-end PCs. And high-end PCs really need SLI. And so we were in all of those design wins anyhow, and SLI only works with GeForce, so we were already in those platforms. There's probably a lot more enthusiasm and energy in working together on Conroe platforms between Intel and our team, and I think that's a wonderful positive. But that's a segment of the marketplace that we already are quite successful in.
Simona Jankowski - Goldman Sachs: Just a quick follow-up on the MCP side. Given the different margin structure historically in AMD Core Logic versus Intel Core Logic, would you expect any meaningful change in your gross margins long-term as that mix shifts just a little bit more to Intel than AMD?
Marv Burkett:
Operator: Ladies and gentlemen, we have reached the end of the allotted time for questions-and-answers this afternoon. I would now like to turn the call back over to Jen-Hsun Huang for closing remarks.
Jen-Hsun Huang: Thank you all for joining us today. We look forward to reporting our progress for Q3.
Operator: Thank you. This concludes the conference. You may now disconnect. | [
{
"speaker": "Executives",
"text": "Michael Hara - VP, IR Jen-Hsun Huang - President, CEO Marv Burkett - CFO"
},
{
"speaker": "Analysts",
"text": "Glen Yeung – Citigroup Chris Caso – Friedman, Billings, Ramsey Michael McConnell– Pacific Crest Securities Hans Mosesmann – Moors & Cabot Robert Dennison – UBS Arnab Chanda – Lehman Brothers Naser Iqbal - Salman Partners Han Lee - Global Crown Capital Nicholas Aberle - Caris & Co Devan Moodley - Scotia Capital Simona Jankowski - Goldman Sachs"
},
{
"speaker": "Operator",
"text": "Good afternoon and thank you for holding. I will now turn the call over to Mr. Michael Hara, NVIDIA’s Vice President of Investor Relations. Thank you, sir. You may begin your conference."
},
{
"speaker": "Michael Hara",
"text": "Thank you. Good afternoon and welcome to NVIDIA’s conference call for the first fiscal quarter ended July 30, 2006. Pardon me, the second. On the call today for NVIDIA are Jen-Hsun Huang, NVIDIA’s President and Chief Executive Officer, and Marv Burkett, NVIDIA’s Chief Financial Officer. Before we being today’s call, I would like to take care of some general administrative items. Your lines have been placed on a listen-only mode until the question-and-answer segment of today’s call. This call is being recorded. If you have objections, you may disconnect at this time. Please be aware that if you decide to ask a question, it will be included in both our live transmission as well as future use of a recording. Also, shareholders can listen to a live webcast of today’s call and view our financial release at the NVIDIA Investor Relations website. The webcast will be available for replay until the company’s conference call to discuss its financial results for the third fiscal quarter of 2007. During the course of this conference call, we may make forward-looking statements based on current expectations. Forward-looking statements, including statements as to our third quarter 2007 outlook, the option review by our Audit Committee and possible adjustments to our preliminary results for the second quarter of fiscal 2007, our outlook for the third quarter of 2007, the Audit Committee review, any expenses that may be recorded as a result of the Audit Committee’s review, the release of our complete financial results for the second quarter of fiscal 2007, growth drivers, market share, Windows Vista, design wins, strategic focus, customers and partners, new and forthcoming products, and products and technologies pertain to future events and are subject to a number of significant risks and uncertainties. The company’s actual results may differ materially from results discussed in any forward-looking statements. For a complete discussion of factors that could affect the company’s future financial results and business, please refer to the company’s Form 10 K and annual report for the fiscal year ended January 29, 2006, quarterly reports on Form 10 Q, and the reports on Form 8 K fled with the Securities and Exchange Commission. All forward-looking statements are made as of the date hereof based on information available to us today, and as required by law. The company assumes no obligation to update any such statements. The content of the webcast contains time-sensitive information that is accurate only as of August 10, 2006. Consistent with requirements under Regulation FD, we will be providing public guidance directly in the conference call and will unable to provide significantly more information in offline conversations or during the quarter. Therefore, questions around our financial expectations should be asked during this call. At the end of our remarks there will be time for your questions. In order to allow more people to ask questions, please limit yourself to one question. After our response, we will allow one follow up question. I’m sure everyone has seen our press release earlier today announcing that the Audit Committee of the Board of Directors is conducting a voluntary review of the company’s stock option practices covering the time from the company’s initial public offering in 1999 to the fiscal current year. As a result of the ongoing review, we had to limit the scope of our financial information that we released today. In addition, on this call we will not be able to provide any specifics about our gross margin or operating expenses for the second quarter or year-to date as we cannot determine those amounts in accordance with GAAP until the review is complete. In today’s call we will provide some information and guidance about general trends for these metrics, but cannot provide any greater detail than what we state on the call. We will, of course, make every effort to provide you with more detailed information soon. Note NVIDIA does not expect to be in a position to announce additional financial results for the second quarter until the Audit Committee has completed its review. At this time, the company does not expect to be in a position to file its Form 10 Q for the second fiscal quarter by September 8, 2006 following deadline, or the permitted extension to September 13, 2006. The company is focused on resolving these issues as quickly as possible and plans to file its Form 10 Q and any required financial statements following the completion of the review. I will now hand the call over to Jen Hsun."
},
{
"speaker": "Jen Hsun Huang",
"text": "Thanks, Mike. Good afternoon, and thank you for joining us. Today, we’re pleased to report record revenue of $687.5 million for our second quarter. Year-over-year, second quarter revenue grew 20%. Our growth was driven by strong performance from numerous product groups. Desktop GPU, notebook GPU, MCP, professional solutions and handheld GPU, resulting in record revenue for the second quarter, which is a seasonally slow quarter. Let me review the highlights and achievements of each of our business units during the quarter. Our desktop GPU business delivered a strong Q2. We maintained a leading share of over 50%. Our year-on year revenue grew 13% and our market share grew 5%. Demand for our GeForce 7600 and 7900 series GPUs with SLI continues to be strong. NVIDIA is dedicated to delivering the highest performance and best gaming experience to PC gamers. With the launch of our revolutionary graphics card, the GeForce 7950 GX2 will once again raise the bar on PC gaming. With 7950 GX2, gamers can now enjoy the latest games at incredible resolution of 2500 x 1600. That is the resolution of cinematic film. Thirteen times the resolution of television, and brings the 16 x 9 panoramic experience of cinema to gaming. We call this next level experience extreme, high-definition gaming. It is really something to witness. The 7950 GX2 is the fastest graphics card available today. It was launched by over 28 leading enthusiast OEMs include Dell’s flagship, XPS 700. We continue to expand the SLI platform by delivering SLI-enabled GPUs from Quad SLI 7950 GX2 and down into the mainstream of our product line. We have shipped over 20 million SLI GPUs to date. The popularity of NVIDIA’s SLI has been further validated by the recent publication release by Guru3D of a comprehensive review of multi GPU platforms. This review was performed by some of the most respected hardware review sites over several weeks of testing. NVIDIA’s SLI platform was found to be the clear winner in performance, game capability and software stability. In the performance segment where price performance ratio is critical, we continued to gain momentum. We fully transitioned from our highly popular GeForce 6600 to the GeForce 7600, which delivers almost 100% performance improvement at the same price point. In Q2, our performance segment shipments grew nearly 50%. We expect the GeForce 7600 will break sales records set by the 6600. NVIDIA’s focus on the stringent power, performance and video requirements of the notebook segment have delivered solid results in Q2. Our notebook GPU revenue grew over 50% year-over-year and while the notebook segment was seasonally down in Q2, our notebook GPU revenue was up 12% quarter to question. Year-over-year, two of our key notebook segments realized substantial increases in volume shipments: performance segments up 80% and mainstream segments up 172%. During the quarter we launched SLI for high-end gaming notebooks, bringing the best of PC gaming experiences to notebooks. We also introduced PureVideo HD, the industry’s only complete solution for enjoying high-definition Blue ray and HD movie experiences on PCs. PureVideo HD is a complete solution that consists of the video processor in G47, complex video processing algorithms, Blue ray disc and high-definition movie player, and content protection technologies. The G47 series with PureVideo HD powered the first HD DVD in Blue ray notebooks from Toshiba, Sony and Acer in Q2. Overall, there were approximately 20 new notebooks launched in Q2 based on NVIDIA’s GeForce 7 Series notebook GPUs. As a result, our share in the notebook GPU segment grew from 24% to 37% from the first quarter to the second quarter of calendar 2006 as reported by Mercury Research. We expect our share gains to continue as new notebooks based on GeForce 7 Series GPUs continue to ramp. Looking forward, we’re excited about the upcoming launch of Microsoft’s Vista operating system. Microsoft Vista will bring focus on 3 D performance to the mass market. We believe that Vista’s demand on 3 D graphics performance will drive an increased adoption of the discrete GPUs. OEMs will start over the next two quarters to offer desktop and notebook PCs that are Vista-ready as consumers will want to be sure their new PCs will fully support the new operating system. Our MCP business achieved record revenue for its eighth consecutive quarter and grew revenue over 80% year-over-year. Driven by substantial increases in server and notebook design wins, we increased share of the AMD 64 segment from 42% in calendar Q1 to 52% in calendar Q2 as reported by Mercury Research. With the upcoming transition to AMD Rev F CPU, we have captured design wins with all the leading server and workstation OEMs and ODMs, which we believe will double our AMD server segment share as we exit the fiscal year. It was a record quarter for notebook chip sets. We had revenues growing substantially over Q1. We believe we’re in a position to capture approximately 60% of the AMD Rev F CPU notebook segment business. We are thrilled that HP has incorporated our mobile nForce and GeForce products in their best-selling 15-inch and 17 inch consumer notebooks. We now ship our integrated GPUs to top PCL OEMs including HP, Gateway eMachines, Lenovo, Acer, Packard Bell, Fujitsu Siemens and we expect that list of OEMs to continue to grow. During the quarter we introduced and shipped our new nForce 590 SLI, an enthusiast platform for AMD’s latest AM2 CPU. Several weeks later, we introduced nForce 590 SLI support for Intel’s new Core 2 Duo CPU. nForce SLI is offered in flagship PCs for both AMD and Intel processors from leading companies like Dell, Alienware, Falcon, Northwoods, Voodoo and many others. Maximum PC selected our SLI platform for their Intel Core 2 Duo-based dream PC. We continue to execute our nForce commercial PC strategy and are pleased to include Lenovo’s business PC group among our latest customers. We now have over 80 PC OEMs and system builders who now offer our NVIDIA business platform in their business PC product lines. VeriTest, a highly respected third-party testing service, reported that PCs built with NVIDIA’s business platform offer excellent stability on par with those purchased by top global enterprises. The NVIDIA business platform is the only stable image, enterprise class PC platform that supports both AMD and Intel CPUs. We believe as enterprisers adopt AMD and Intel processors interchangeably, our unique position will be an important advantage for us. NVIDIA Quadro Professional business achieved a record quarter. Quadro revenues were up 27% year-over-year, and 17% quarter-over-quarter. Business was strong in all segments, especially in mobile work station and high-end Quadro. We launched an entire spectrum of new products in Q2. Our new products addressed professional segments from business desktop to HD video content creation and broadcast, to the most demanding CAD and visual simulation applications. The new Quadro line offers industry leading performance and quality for each segment, culminating with the flagship, 1 gigabyte Quadro FX 5500, the most powerful workstation GPU in the world. This new Quadro lineup is complimented by a range of solutions like Gelato, JemLock, NFDI that are becoming standards for advanced visualization and broadcast. Two weeks ago, we launched the NVIDIA Quadro Plex, an entire new category of professional graphic solution. Quadro Plex is the world’s first PCI Express base standalone external graphics subsystem, and can be connected to any workstation or server with a 16-lane PCI Express slot. An SLI-ready workstation can support two external GPU Quadro Plexes to support a GPU graphics supercomputer solution. When integrated in a typical, rack-based server, Quadro Plex offers 25 times more graphics compute density than traditional data center solutions. Quadro Plex is a whole new class of visual computing solution. It enables thousands of engineers and designers to experience advanced personal visualization solutions previously only accessible in large visualization centers. Applications of Quadro Plex include HD broadcast video, industrial design, visual simulation, oil and gas exploration and medical imaging. Our handheld GPU business achieved record shipments of GPUs in Q2. This success was largely due to three factors. We are leading the rollout of mobile, digital TV with DVDH. These included the Samsung P910 handset used in Italy for the production rollout for the World Cup and trials elsewhere in Europe as well as the HTC Foreseer used in the first North American deployment. Two, we significantly grew our number of designs at Motorola, with several new phones starting to ship now, and three, we broadened our customer base to include phones developed in Japan, China, Taiwan and Korea. We are starting to see the benefits from several key design wins at Motorola in their highly successful Razr and Sliver lines, with the Sliver L6i and L7i, as well as the Razr V3XX and the MotoRAZR MAX. We launched a MobileMedia platform for handheld devices running Windows Mobile 5.0 at Computex in June. The MobileMedia platform is a complete development containing both software and hardware components that enables handheld manufacturers to rapidly design and release digital media rich devices with Windows Mobile 5.0. Our MobileMedia platform continues to gain acceptance with additional design wins added to the Samsung, HTC and Raincom devices announced at our launch. Let me turn the call over to Marv to discuss our financial results in more detail. When I return, I would like to address our opportunities as they relate to the AMD announcement in July."
},
{
"speaker": "Marv Burkett",
"text": "Thanks, Jen-Hsun. I’d like to start by saying that since we cannot release GAAP financial statements for Q2, my comments will be limited. I will be able to comment on revenue and some balance sheet items, but I will not be able to comment on margins, expenses or earnings. Revenue for the second quarter was $687.5 million, which is up 1% from the first quarter and up 20% from the prior year. The revenue is in line or slightly above our guidance of flat. The composition of the revenue was particularly positive. Memory sales declined by around $21 million quarter-to quarter and this was more than offset by growth in workstation and MCP. Professional products increased by 17% quarter-to quarter and MCP also increased by 17%. Notebook also increased by 12% quarter-to-quarter. Desktop GPUs declined by only 5% quarter-to-quarter as growth in the high-end GPUs offset some of the normal seasonal decline in mainstream. The result was that the unit volume decreased in desktop GPUs which you expect in Q2 was somewhat offset by a significant ASP increase. So we had revenue growth in high-margin products and revenue declines in lower-margin products. Year to year, our core product revenue, which excludes Xbox, PS3 and memory, grew by 34% with notebook and MCP both growing more than 50%. During the quarter, we repurchased $125 million of stock, which equated to 5.4 million shares. This caused cash to decline by approximately $100 million, as we also had an increase in accounts receivable. The accounts receivable increase in Q2 is normal as the quarter tends to be weighted towards the back of the quarter. The accounts receivable are still in good shape, with very little delinquency. We had unit growth in inventory of new products, and unit declines in older products, as we had anticipated. This may have resulted in a slight inventory increase. Depreciation in the quarter was $24.2 million and capital expenditures were $20.1 million. During the quarter we added 252 employees and exited the quarter with 3,427 employees worldwide. Of the 252 additions, only 78 were in the U.S. as we continued our aggressive hiring internationally. We believe spending for the quarter reflected a small quarter-to-quarter increase. The outlook for the third quarter revenue is as follows: We expect increases in both desktop and notebook GPUs. Notebook increase is a continuation of our notebook design wins and the desktop increase is a reflection of the normal Q3 PC growth and the strength of our competitive offerings. We also expect good growth in MCP, again from normal market improvement as well as from our new products. We expect workstation and handheld to be relatively flat. When you put it all together, we expect quarter-to-quarter revenue growth of 8% to 10%. We also expect to continue our emphasis on gross margin improvements and very slight increases in operating expenses. With that, I’ll turn it back over to Jen-Hsun."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks, Marv. On July 24, AMD announced that they were acquiring ATI. Once the acquisition is completed, NVIDIA will become the only GPU and platform technology company that supports Intel and AMD processors. Our company focus is to be the innovation partner for leaders of the computer and consumer electronics industry, to build high-brand, high-image, market-defining products. GeForce is the No. 1 GPU brand. nForce is the No. 1 core logic brand. Quadro is the No. 1 professional and workstation brand, and SLI is the No. 1 multi-GPU brand. Each and every one of these brands is sought out by end-users of both Intel and AMD processors. AMD’s pending acquisition of ATI only enhances our strategy. The GPU is becoming increasingly important in all digital platforms. Our strategy is to extend the utility of GPUs to all types of multimedia processing and establish the GPU as the DSP of the digital media era. As we want to expand the reach of GPU into all computing devices, from PCs to servers to phones to automobiles, and in each of these markets we will support Intel or AMD CPUs, or ARM or PowerPC or Cell. Our strategic focus is the GPU. We will continue to partner closely with both processor companies and we will absolutely continue to provide MCPs for AMD as well as Intel processors. We will continue to invest around the AMD processors and continue to work with them to bring our brands to our mutual customers. We also see increased opportunities in serving Intel’s core logic segment, particularly since it is unlikely that AMD will do so. We have many exciting growth drivers ahead of this year. With the leadership position of our GPU, MCP, workstation and handheld GPU, we are positioned to continue to take share. We expect the grade three processing demand of Vista’s new UI will increase the adoption of discrete GPUs in notebook and desktop PCs. The ramp of Blue-ray and HD DVD will play into a significant advantage we have with PureVideo HD. The highly anticipated launch of PlayStation III later this year and with the pending acquisition of ATI, the new PC industry dynamics puts us in a unique position. At the core of our growth is the continuing shift in focus of the industry to build products that are multimedia centric and consumer experience centric rather than a traditional focus on mix and megabytes. As the GPU is essentially the experiential processor of digital platforms, we see tremendous growth opportunities as we extend the reach of our GPUs into all digital devices. We’d be happy to take your questions now."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Glen Yeung with Citigroup."
},
{
"speaker": "Glen Yeung - Citigroup",
"text": "Thanks for taking my call today. I have three questions, basically. The first one is, if you look back at how revenues formed over the course of the quarter, can you talk about what linearity looked like? When did you actually see the bottom of the business and when did things start to get better?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Well, Q2 is not typically a linear quarter. It’s seasonally slow in a variety of geographies as you know and it typically tends to be a very slow May and it picks up very strongly in July, as people gear up for back-to-school. It’s pretty much the same year-over-year from that seasonal pattern. Some parts of our market tend to see a little bit less of that. For example, the professional market tends to have a bit more linearity than that because enterprises tend to buy on a continuous basis. But it’s pretty seasonal from that perspective."
},
{
"speaker": "Glen Yeung - Citigroup",
"text": "Okay. I’ve been visiting with a bunch of board makers and box makers over the last few days and a lot of them are telling me that the attach rates for discrete GPUs are going up pretty substantially in the third quarter. I wonder if that’s something that you’re seeing consistent in your business? This may seem a bit odd, but I’m wondering if the delay of the 865G chip from Intel, which seems to be having issues with graphics quality, is helping attach rates at all for you in the October quarter?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yeah, our belief is that as people gear up for Vista and because the user interface of Vista is so, well, it’s completely built around 3 D graphics; every part of the Vista experience requires the GPU to render each and every one of the pixels from the transparencies, the special effects and the way that it’s composited. The whole experience around Vista is really made possible by the GPU. So our belief is that as Vista ramp starts and Vista-ready PC ramp starts towards the second half of the year, the number of GPUs that would be included in PCs will increase. So that’s our general belief. I really don’t know very much about the issues with the 865G."
},
{
"speaker": "Glen Yeung - Citigroup",
"text": "Okay, well thanks."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks, Glen."
},
{
"speaker": "Operator",
"text": "Your next question comes from Chris Caso with Friedman, Billings, Ramsey."
},
{
"speaker": "Chris Caso – Friedman, Billings, Ramsey",
"text": "Yes, hi. Thanks. You made some comments with regard to substantial increase in ASP and decline in units on the graphics side. Could you give us a little more color on magnitude of that? What you guys consider substantial?"
},
{
"speaker": "Marv Burkett",
"text": "Yeah, well the ASP in desktop GPUs was up 16% quarter-to-quarter. Now, obviously that’s mix related because the unit volume decline was primarily in the mainstream and we did very, very well in the high-end GPUs."
},
{
"speaker": "Chris Caso – Friedman, Billings, Ramsey",
"text": "Okay, great. I guess – is that tied into the inventory increase that you guys saw? I mean, is that part of a change in mix and if you can give us some indication of what you guys expect for inventory going forward."
},
{
"speaker": "Marv Burkett",
"text": "Well, the inventory increases in the quarter were all in the new products, the new products we’re announcing or about to announce. The inventory of the older products declined, and I’m referring in this case to unit volume of those inventories declined. Going forward, we’ll continue to emphasize having enough inventory but I think that from a dollar-volume standpoint we probably have enough. So we will try to make sure that we don’t grow inventory very much in the rest of the year."
},
{
"speaker": "Chris Caso – Friedman, Billings, Ramsey",
"text": "Okay and just as a final question, just, you know, kind of speaking strategically with the AMD acquisition, what can you guys tell us about any kind of discussion or programs you guys have running with Intel right now. Just maybe you can kind of give us some sense of what you think that relationship might be going forward?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Well, you know we have developments and collaborations going with both companies and we’ll continue to invest around the AMD processors. Now, with the new industry organization, obviously it’s unlikely that AMD will be designing core logic for Intel and so we see that as a pretty significant opportunity for us to participate in that. But we have so many collaborations going on with both companies, there’s not really anything that we can talk about here."
},
{
"speaker": "Chris Caso – Friedman, Billings, Ramsey",
"text": "Okay. Thank you."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yeah, thanks a lot, Chris."
},
{
"speaker": "Operator",
"text": "Your next question comes from Michael McConnell with Pacific Crest Securities."
},
{
"speaker": "Michael McConnell– Pacific Crest Securities",
"text": "Thank you. If we look at the wireless business, can you talk a little bit more about what exactly is happening at Motorola? Why you’ve been able to take some share and if we look at the rest of the year, how that revenue line should start to shape up?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Our strategy, they’re basically two – that’s not true. I guess there’s two or four GPU companies, depending on how you count them, in the handheld space. There are a couple of GPU companies in Korea who also build discrete GPUs for handsets. Our strategy is different than all the other GPU suppliers because we focus on the high-end, the multimedia-rich segments of the marketplace. Historically we focused on 3G. We expanded that focus to include smart phones and that’s why we developed the multimedia, what we call the Mobile Media chip for Windows Mobile 5.0, Windows, you know, 5.0. We’ve expanded our scope to that. We’ve also expanded our scope to personal media players. But our focus is very narrowly the multimedia rich and the high-end portable devices because we happen to believe that that’s an area where we can add a lot of value. We also happen to believe that that’s an area that’s going to grow very fast as the majority of the world’s handheld devices are going to become intelligent and they’re going to become our most personal of computing devices, and multimedia is going to pay a huge role in that. So we’ve historically focused on the high end and now those multimedia features, whether it’s digital video camcorder functionality or digital photography or 3 D graphics for better user interfaces, those devices and those capabilities are becoming very, very popular and so we think that we’re in a really terrific position to expand reach into the marketplace including at Motorola because of that."
},
{
"speaker": "Michael McConnell– Pacific Crest Securities",
"text": "Then, if we look at operating expenses and directionally, you can only talk about directionally, should we be looking after a pretty big spike here in the April quarter? The rest of the year to kind of just bump along, maybe flattish? Or are we expecting maybe it to work higher or lower?"
},
{
"speaker": "Marv Burkett",
"text": "Well, I indicated last quarter that we’d seen a spike in Q1 and we expected to. The growth for the rest of the year would be moderate. I think that’s what you should plan on. You know, I think moderate growth from the Q1 step function."
},
{
"speaker": "Michael McConnell– Pacific Crest Securities",
"text": "That’ very helpful. Thank you."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks, Michael."
},
{
"speaker": "Operator",
"text": "Your next question comes from Hans Mosesmann with Moors & Cabot."
},
{
"speaker": "Hans Mosesmann – Moors & Cabot",
"text": "Thanks. Jen-Hsun, can you give us commentary regarding any sales to Sony or any in terms of the royalty ramp in October and beyond quarters? Thanks."
},
{
"speaker": "Jen-Hsun Huang",
"text": "We have two types of activities with Sony. One of them is related to engineering and so it’s expanding their manufacturing capacity as well as reducing feature sizes by porting them to new geometries. And so there’s a very large amount of activity associated with that each and every quarter and I expect that activity to continue, certainly throughout this year and probably throughout next year. The royalty component of Sony we expect to happen this quarter. We don’t know exactly how much yet, but Sony is in volume production as you know and they’re gearing up for their highly anticipated launch towards the later part of this year so we’re expecting revenue contribution this quarter. We just don’t know how much yet."
},
{
"speaker": "Hans Mosesmann – Moors & Cabot",
"text": "To follow up, the 8% to 10% sequentially growth is incorporating no contribution or some contribution from Sony?"
},
{
"speaker": "Marv Burkett",
"text": "Small."
},
{
"speaker": "Hans Mosesmann – Moors & Cabot",
"text": "Okay."
},
{
"speaker": "Marv Burkett",
"text": "When we say small, we’re referring to royalties, not the fact that Sony would be small."
},
{
"speaker": "Hans Mosesmann – Moors & Cabot",
"text": "Right. Right. Okay. Thank you."
},
{
"speaker": "Marv Burkett",
"text": "But I want to emphasis, Hans, that that’s the worst – no royalty in Q2."
},
{
"speaker": "Hans Mosesmann – Moors & Cabot",
"text": "Okay. Fair enough. Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from Robert Dennison with UBS."
},
{
"speaker": "Robert Dennison - UBS",
"text": "Yeah. Thank you. I’m pretty sure I heard on the call, Marv, you say that revenues were up in higher margin products and revenues were down in lower margin products. Does that give us any sort of directionality in what we should be looking at for gross margin this quarter?"
},
{
"speaker": "Marv Burkett",
"text": "You know, yes I did say that we had revenue growth in higher margin products and revenue decline in lower margin products. You’ll have to draw your own conclusions."
},
{
"speaker": "Robert Dennison - UBS",
"text": "Okay. Thanks. So did I miss anything on handheld growth rates? Did I miss a number there?"
},
{
"speaker": "Marv Burkett",
"text": "Handheld revenue was up 12% quarter-to-quarter."
},
{
"speaker": "Robert Dennison - UBS",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Arnab Chanda with Lehman Brothers."
},
{
"speaker": "Arnab Chanda – Lehman Brothers",
"text": "Thank you. Jen-Hsun, if you could explain a little bit about your MCP business, how much opportunity would you get at Intel and are you assuming that if this merger goes through, some of the internal demand at AMD would be fulfilled internally? Do you think – is that how you’re planning to address the business and do you think that business continues to grow at sort of the type of rates you’ve seen or maybe at PC growth rates? I have a follow up, please."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yeah, Arnab, our strategy with MCP is to focus on the segments where either the GPU, the leadership of our GPU position, or GPU technology could play a large role in those segments and so, as you can imagine, GeForce and SLI are two such incredibly important brands in the end market that it’s unreasonable to expect an end user to have to pick which microprocessor GeForce and SLI supports. So these gamers they want to buy the latest in GeForce, they want to have SLI capability in their system. We want to give them the flexibility of whichever processor they would like to choose. So those segments we’ll continue to serve and it’s my expectation is that it will continue to be very successful in those segments. In the segments where integrated graphics, or graphics technology, is important, the segments that we will see the most success is where branded graphics and the leadership of our technology plays a large role. I'm hoping that the coming year, as Vista and nearly all of the office automation applications that we know of today, starts to make the migration to use 3-D graphics, that 3-D graphics will be important in a much, much larger part of the overall market. I think that creates a lot of opportunity for us. So our focus is going to continue to be where our brands are important, where graphics technology is important. If we stay focused on that, I think we'll do a fine job for you guys."
},
{
"speaker": "Arnab Chanda - Lehman Brothers",
"text": "Thanks. One sort of qualitative question. You talked before about both operational improvements as well as royalties from Sony that could drive your gross margins higher. It seems like you had benefit on mix in the second quarter, if I understood you correctly. Do you think that going forward, over the next sort of 12 months or so, those aspects that you're talking about, the operations and the royalty structure, could continue to drive those margins higher to your old target of 45% or so? Or can you maybe give us a qualitative understanding of that? Thanks."
},
{
"speaker": "Jen-Hsun Huang",
"text": "We haven't changed our expectation that our gross margins should be 45%, and in fact higher in the future. We ought to raise our expectations as soon as we get to 45%. There are broad and numerous operational improvement activities throughout the Company, and our operation, frankly, is world-class. The reason why is in the graphics industry, it requires an extraordinary level of operational excellence is because the technology is, obviously, extremely complex. These are some of the most complex semiconductor devices built anywhere, and the velocity of the business is very, very high. So when you have very complex devices with very high-velocity businesses, you have to be on your toes, and you have to have extraordinary operational capabilities in order to reduce waste. So that's been an area where we've put a lot of energy over the last several years, and I'm going to continue to put energy around that."
},
{
"speaker": "Operator",
"text": "Our next question comes from Naser Iqbal - Salman Partners."
},
{
"speaker": "Naser Iqbal - Salman Partners",
"text": "Congratulations on the quarter and the forward guidance, - great numbers. I only just have one question. Jen-Hsun, I guess, with all the announcements that have been that happening in the semiconductor space, and based on the comments you made -- and I know you're limited as to how much you can actually say. But what kind of comfort can we take in the announcement of what's happening with the stock options? Can you share any other color or comments?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "The audit committee's reviews are still ongoing, and we ought to give them every benefit to complete their analysis. So at this point I don't think there's really that much that we ought to say beyond everything that we've already said."
},
{
"speaker": "Naser Iqbal - Salman Partners",
"text": "I appreciate that. Congratulations on the quarter."
},
{
"speaker": "Operator",
"text": "Our next question comes from David Wu - Global Crown Capital."
},
{
"speaker": "Han Lee - Global Crown Capital",
"text": "This is Han Lee for David Wu. Congratulations on the quarter. Jen-Hsun, you mentioned in your speech that you want to be the GPU for the digital media era. So, do you have any plans again to do business such as, say, TV tuners for the PC, or the very high growth high-definition TV area?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "That's a good question. I think our focus tends to be where the computing and digital technology intersects consumer applications. That tends to be our focus. Two very important words in there is computing technologies, and the other one, obviously, is consumer, which conveys multimedia and experiential elements to the technology. The digital television is not really a computing device today. It's not much more of a computer then a DVD player is. It's not much more of a computer than a set-top box is. Although it uses some embedded microprocessors and uses memory and such, the behavior and the nature of those devices tend to not follow those of computing devices. As a result of that, historically we've stayed away from it, because they don't tend to be sustainable businesses. People have told me that flat-panel displays were exciting businesses and we ought to get into that because we know a lot about image quality. That's true. But, as you know, the flat-panel transceiver business has not scaled the way that GPUs have scaled. So we tend to follow the marketplaces where the experience continues to improve, the applications continue to improve, and the reach and the usefulness of the devices continue to improve; which, certainly, personal computers is one of them, handheld devices is becoming one of them, game consoles is one of them. I foresee many other types of digital devices in the future that will have these characteristics. That's where our focus will be."
},
{
"speaker": "Han Lee - Global Crown Capital",
"text": "Thank you. Also I have some questions about your inventory levels. You said that inventory will again increase this quarter slightly. So I'm wondering which kind of products is the inventory increasing? Is it in the higher-end graphics, or is the increase mostly in the newer MCP area?"
},
{
"speaker": "Marv Burkett",
"text": "I think what you're referring to is that I said that the inventory probably increased in Q2. I don't anticipate that inventory will increase in Q3."
},
{
"speaker": "Han Lee - Global Crown Capital",
"text": "Do expect the ASP trend to go on in Q3?"
},
{
"speaker": "Marv Burkett",
"text": "Beg your pardon?"
},
{
"speaker": "Han Lee - Global Crown Capital",
"text": "In Q2 your ASPs increased by 15% quarter-over-quarter. So, what's your expectation for Q3?"
},
{
"speaker": "Marv Burkett",
"text": "I think it really is dependent upon mix, because a major portion of that increase quarter-to-quarter was the mix, the fact that we did very well in the high-end and the mainstream had a unit volume decline. If we do very, very well in mainstream, you could even see ASP decline in Q3. It really depends on mix more than any individual product's ASP."
},
{
"speaker": "Jen-Hsun Huang",
"text": "One of the comments that I will make is that we made a prediction a long time ago that SLI will increase the TAM of high-end GPUs. I think for all intents and purposes, whenever you have SLI in your system, and it has the opportunity to accept two high-end graphics cards, that's a perfect example of the doubling of TAM. So I think that the adoption of SLI and the popularity of SLI, and the increasing popularity of SLI, is quite a boon for high-end GPU markets."
},
{
"speaker": "Operator",
"text": "Our next question comes from Nicholas Aberle - Caris & Co."
},
{
"speaker": "Nicholas Aberle - Caris & Co",
"text": "First question is for Marv. I'm trying to figure out what the Q2 gross margin was. You did imply that Q3 gross margin was going to be up from whatever that level was in Q2, correct?"
},
{
"speaker": "Marv Burkett",
"text": "No, I didn't. I didn't imply anything. I just said that we would continue to work very hard to improve gross margins."
},
{
"speaker": "Nicholas Aberle - Caris & Co",
"text": "Okay. You said that OpEx would actually be slightly higher in Q3 then. That was the --"
},
{
"speaker": "Marv Burkett",
"text": "That's correct."
},
{
"speaker": "Nicholas Aberle - Caris & Co",
"text": "Going into Q3, in terms of gross margin, I would expect that mix would revert somewhat. Could a potential boost be the PS3 royalties and get that margin up again in Q3?"
},
{
"speaker": "Marv Burkett",
"text": "That's certainly one of the factors. Any royalties we get is 100% margin, so that helps. So, it really depends on the magnitude of the royalties. It depends on a lot of factors, but certainly that helps."
},
{
"speaker": "Nicholas Aberle - Caris & Co",
"text": "Secondly, Jen-Hsun, I was wondering if you could just comment on the thought process of down the road, the convergence of CPU and GPU, and perhaps the integration of the two sometime in the future, what your take is on that and how NVIDIA plays into that scenario."
},
{
"speaker": "Jen-Hsun Huang",
"text": "GPU is a very complex device. If you pop the lid of some chips, you'll discover that GPU is substantially larger than a lot of CPUs. So I guess one could argue that long-term, Moore's Law would enable some device to integrate some other device. But frankly, markets don't care about Moore's Law. Markets don't care about Moore’s Law. They just care about what they need. The reason why the GPU has been separated from the CPU historically is because the two work off of completely different rhythms. And because of the different segmentations and the velocity of innovation, and all of those things, the GPU continues to be a standalone device for the segments in the marketplace that we serve. Our job isn't really to worry about which is going to integrate which; our job is to make the GPU valuable. That has been the historical focus of our company, to invest in helping people see how to program our GPUs, to invest in pushing the industry forward, and enabling the next level of games, or for industrial styling, or different applications of GPUs. Focusing our energy around that has been a much more productive exercise for us. Now, in some segments, we could imagine GPUs integrating with CPUs, or CPUs integrating with GPUs. But we'll approach those segments as it makes sense. Because oftentimes it's not necessarily one CPU. It could be x86. It could be ASICs, it could be PowerPC. It could be cell. It could be ARM. It could be something else. So we believe that what we ought to do is focus on the market, and focus in advancing the utility and usefulness of GPUs, and focusing on advancing the GPU technology. I think we've been very true to that historically. We're true to it right now, and I think people are seeing the wisdom of it."
},
{
"speaker": "Operator",
"text": "Our next question comes from Devan Moodley - Scotia Capital."
},
{
"speaker": "Devan Moodley - Scotia Capital",
"text": "Good quarter. Just quickly, can you give us the split for the 7000 versus the 6000 series family this quarter?"
},
{
"speaker": "Marv Burkett",
"text": "Heavily, heavily weighted towards the 7000 family."
},
{
"speaker": "Devan Moodley - Scotia Capital",
"text": "Can you talk about sort of where you might expect, once G80 launches, the split to be towards the end of the year?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "We haven't announced G80. I don't know what G80 is, but we sell a lot of G7Xs."
},
{
"speaker": "Devan Moodley - Scotia Capital",
"text": "A general question in relation to the AMD ATI situation. Do you think it creates any input cost advantage for you guys down the road, with potentially maybe the fear from the pure play foundry guys that AMD might take some of that business in-house?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "I don't know if that is specifically the reason. Our focus is to be a strategic and a meaningful partner of the partners we work with. TSMC is our largest-single partner, and a terrific partner, and they've done a great job for us. Our job is to make sure that we can be as large and bring as much business as we can to this relationship. Typically, when you bring a lot of business to a relationship, there's some benefits. So my sense is that that is going to continue to be a dynamic that makes sense, and that's our focus."
},
{
"speaker": "Devan Moodley - Scotia Capital",
"text": "Last question. Where do you guys see the PC market, in terms of growth back-half of this year, with Vista launching in Q1 '07? What's your expectation for growth?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "I think everybody is thinking through that. Some of the smartest things that I've heard in talking to leaders of PC companies is that here in Silicon Valley in the high-tech industry, we're sitting here talking a lot about Vista, but the vast majority of America and the rest of the world aren't spending any time talking about Vista. They think of the PC as the PC. When Vista comes out, Microsoft will be incredibly energetic to promote Vista and get that in the forethought of just about everybody on the planet. When that happens, I think the Vista demand will drive up. In the meantime, my sense is that the back half is all going to be about Conroe and AM2. Conroe is a very exciting microprocessor, and it's brought a lot of enthusiasm and excitement back into the high-end segment. And I'm excited to see that. When there is energy in the high-end excitement and people are excited about Conroe and AM2, it's going to bring a lot of people back to buy high-end PCs. And most of those high-end PCs will, hopefully, have SLI and, hopefully, have GeForces in them."
},
{
"speaker": "Operator",
"text": "Our next question comes from Simona Jankowski - Goldman Sachs."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Jen-Hsun, you touched on the collaboration with Intel on the MCP side as a result of the AMD announcement. Can you maybe also comment if there is any opportunity or possibility for collaboration on the GPU side, whether marketing or otherwise -- maybe specifically, if you have noticed any change in the trajectory of your design wins alongside Conroe before and after the announcement, for GPUs specifically?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks for the question. I would say that we're the only standalone GPU supplier in the world today, and we are CPU-neutral. We could be a partner for either company. I think we're a much more natural partner for either company today than ever before. I think you could derive from that that we're much more a natural partner today working with Intel than AMD would be working with Intel, in collaborating to build markets and otherwise. So I do think that's a very significant advantage."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "But did you see anything specific so far, any kind of inflection as far as how many people are designing a GeForce GPU alongside with a Conroe, as opposed to perhaps going down the path of a 1900 in a Conroe? Is that something where the perception has changed, or anything you've been able to track?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "I guess there's probably some anecdotal stuff, but I think the high-level is that Conroe is all about high-end PCs. And high-end PCs really need SLI. And so we were in all of those design wins anyhow, and SLI only works with GeForce, so we were already in those platforms. There's probably a lot more enthusiasm and energy in working together on Conroe platforms between Intel and our team, and I think that's a wonderful positive. But that's a segment of the marketplace that we already are quite successful in."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Just a quick follow-up on the MCP side. Given the different margin structure historically in AMD Core Logic versus Intel Core Logic, would you expect any meaningful change in your gross margins long-term as that mix shifts just a little bit more to Intel than AMD?"
},
{
"speaker": "Marv Burkett",
"text": ""
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, we have reached the end of the allotted time for questions-and-answers this afternoon. I would now like to turn the call back over to Jen-Hsun Huang for closing remarks."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thank you all for joining us today. We look forward to reporting our progress for Q3."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes the conference. You may now disconnect."
}
] | null | null |
NVDA | 1 | 2,007 | 2006-05-11 17:00:00 | Executives: Michael W. Hara - Vice President, Investor Relations Jen-Hsun Huang - President and Chief Executive Officer Marv Burkett - Chief Financial Officer
Analysts: Tayyib Shah - Longbow Research Randy Abrams - Credit Suisse First Boston Mark Edelstone - Morgan Stanley Hun Lee - Global Crown Capital Jason Pflaum - Thomas Weisel Partners Nicholas Aberle - Caris & Company Quinn Bolton - Needham Incorporated Pranay Laharia - Deutsche Bank Dan Morris - CIBC World Markets Krishna Shankar - JMP Securities Simona Jankowski - Goldman Sachs
Operator: Good afternoon and thank you for holding. I would now like to turn the call over to Mr. Michael Hara, NVIDIA’s Vice President of Investor Relations. Thank you. Sir, you may begin your conference.
Michael W. Hara: Thank you. Good afternoon and welcome to NVIDIA’s conference call for the first, fiscal quarter ended April 30, 2006. On the call today for NVIDIA are Jen-Hsun Huang, NVIDIA’s President and Chief Executive Officer; and Marv Burkett, NVIDIA’s Chief Financial Officer. Before we begin today’s call, I would like to take care of some general administrative items. Your lines have been placed on a listen-only mode until the question and answer segment of today’s call. During this call, we will discuss some non-GAAP measures about net income, net income per share and gross margins and other line items from our consolidated statements of income when talking about our results. You can find the full reconciliation of these measures to GAAP in our financial release which is posted on the investor relations page of our website at www.nvidia.com. This call is being recorded. If you have any objections, you may disconnect at this time. Please be aware that if you decide to ask a question, it will be included in both our live transmission, as well as any future use of the recording. Also, shareholders can listen to a live webcast of today’s call and view our financial release at the NVIDIA Investor Relations website. The webcast will be available for replay until the company’s conference call to discuss its financial results for the second quarter of fiscal 2007. This conference call is the property of NVIDIA. Any redistribution, retransmission or rebroadcast of this call or any portion of it, without the express written consent of NVIDIA is strictly prohibited, and may result in civil and criminal penalties. During the course of this conference call, we may make forward-looking statements based on current expectations. Forward-looking statements, including statements as to our second quarter 2007 outlook, growth, growth drivers, market share, investments, competitive position, design wins, customer demand, new and forthcoming products and products and technologies pertain future events and are subject to a number of significant risks and uncertainties. The company’s actual results may differ materially from results discussed in any forward-looking statements. For a complete discussion of factors that could affect the company’s future financial results and business, please refer to the company’s Form 10-K and annual report for the fiscal year ended January 29, 2006, quarterly reports on Form 10-Q, and the reports on Form 8-K filed with the Securities and Exchange Commission. All forward-looking statements are made as of the date hereof based on information available to us today and the company assumes no obligation to update any such statements. The content of the webcast contains time-sensitive information that is accurate only as of May 11, 2006. Consistent with the requirements under Regulation FD, we will be providing public guidance directly in the conference call and will be unable to provide significantly more information in offline conversations or during the quarter. Therefore, questions around our financial expectations should be asked during this call. At the end of our remarks, there will be time for your questions. In order to allow more people to ask questions, please limit yourself to one question. After our response we will allow one follow-up question. I will now like to hand the call over to Jen-Hsun.
Jen-Hsun Huang: Thanks, Mike. Good afternoon, and welcome to NVIDIA’s first quarter conference call. Today we are pleased to report record revenue of $681.8 million and net income of $0.23 per share for our first quarter. Year-over-year, first quarter revenue grew 17% and net income grew 41%. We experienced growth in each of our businesses, GPU, MCP, handheld GPU and consumer electronics resulting in record revenue for the first quarter. We also entered multiple new product cycles during the quarter continuing our leadership in each of the markets we serve. As we move further into the new fiscal year, the growth drivers we outlined at our Analyst Day in March which included the adoption of Microsoft Vista, high definition video, and the launch of Sony PlayStation 3 will continue to accelerate and give us the opportunity for another strong year of growth. Let me highlight some of our first quarter fiscal 2007 results and achievements. Non-GAAP gross margin reached a company high of 42.5%, an increase of 230 basis points sequentially from the fourth quarter of fiscal 2006 and 650 basis points year-over-year. GAAP gross margin was 42.4% for the first quarter of fiscal 2007. We shipped 8 new GeForce 7 series GPUs for desktop and notebook PCs and now offer a complete top to bottom family of GeForce 7 GPUs. NVIDIA grew share in the performance DX9 and combined DX9 desktop GPU segments from 79% to 83% and from 57% to 60% respectively from the fourth quarter of calendar 2005 to the first quarter of calendar 2006 as reported Mercury Research’s First Quarter PC Graphics Report 2006. The NVIDIA nForce MCP product line achieved record revenue for its seventh consecutive quarter. nForce MCPs increased their share of the AMD64 segment from 35% to 42% from the fourth quarter of calendar 2005 to the first quarter of calendar 2006 as reported in Mercury Research’s First Quarter Worldwide Chipset Report 2006. We continued to advance our leadership position in multi-GPU technology. The company shipped its first Quad SLI system for desktop PCs enabling 4 GPUs per system. We also brought our SLI technology to notebook PCs enthusiasts. NVIDIA demonstrated the world’s first GPU-powered game physics solution at the Game Developer’s Conference with Havok, the game industry’s leading supplier of cross-platform physics engine middleware. Lifelike physics will bring a new dimension of realism and interactivity to games. We shipped our first integrated graphics processor (IGP) core-logic solution for AMD-based notebook PCs, the GeForce Go 6100 GPU and nForce Go 430 MCP. The core-logic solution is the industry’s first high-definition IGP to provide hardware accelerated H.264 high-definition video playback. The Professional Solutions Group introduced 11 new desktop and notebook workstation solutions, designed to improve workstation graphics performance and representing the most extensive line of professional graphics solutions in the industry. NVIDIA and Intel announced a collaboration to bring high-performance 3D gaming and multimedia platform to handheld devices. The collaboration combines the NVIDIA GoForce family of handheld GPUs with Intel’s newest processor family, codenamed Monahans, which is based on third-generation Intel XScale architecture, to develop a powerful development platform to content developers. We successfully completed our acquisition of ULi Electronics, a leading developer of core logic technology. And finally we acquired Hybrid Graphics Ltd., a leading developer of embedded 2D and 3D graphics software for handheld devices. The acquisition will enable customers of both companies to deploy rich graphic solutions for the entire worldwide handheld market. Let me turn the call over to Marv to discuss our financial results in more detail. I will return to discuss our progress and outlook.
Marvin Burkett: Thanks Jen-Hsun. I would like to begin with some comments about the P&L for the first quarter of fiscal year 2007 and then move to the balance sheet. I’ll end with a few comments about the outlook for Q2. On the P&L, as Jen-Hsun said it earlier, revenue for the quarter was $681.8 million which is up 7.6% from the fourth quarter. The growth of almost $50 million was led by the GPU business which grew $21 million quarter-to-quarter. Within the GPU business, notebook grew by 34% and achieved record revenue. Desktop also grew slightly in spite of a seasonally down first quarter for the PC industry. MCP grew only 4% which was less than we anticipated but still achieved record revenue for the seventh consecutive quarter. Handheld GPUs grew almost 20% and also achieved record revenue. Memory and other also grew $12 million in the quarter. All of our business segments had some growth quarter-to-quarter. Year-over-year our overall revenue grew by 17% led by MCP and GTU businesses. MCP grew 65% year-over-year and GPUs grew by 10%. Our handheld devices almost quadrupled year-over-year but from a very low base last year. Xbox contributed $44 million in revenue in last year’s Q1, therefore our core business grew 24% year-to-year. For gross margins we achieved 42.5% on a non-GAAP basis, which exceeded even our expectations. The introduction and success of several new GeForce 7 products contributed significantly to the improvement. The GeForce 7 family contributed approximately $245 million in revenue for the quarter at excellent gross margins. This resulted in a noticeable increase in gross margin for our GPU business. We also had very good margin improvements in our handheld GPU business and it is now close to breakeven on an operating income level. Operating expenses were higher than we anticipated. There are many factors that contributed to this and I will outline a few. Going into the quarter we had not anticipated the acquisition of Hybrid or the hiring of significant number of employees from 3D Labs. These two contributed approximately $2 million of expense in the quarter. Also during the quarter there were significant option exercises by employees, this causes an expense for the company for FICA and other taxes that must be paid upon the exercise. This added about $4 million of unanticipated expense for the quarter. We will get this back later in the year when these employees matches our on FICA. Exclusive of these items operating expenses were still higher than we anticipated, as we were able to hire aggressively in other areas. We added 438 employees during the quarter approximately 200 of these were from ULI and another 70 were from Hybrid and 3D labs. When you put that together with our normal hiring the result was a significant increase in headcount. Headcount at the end of the quarter was 3175. The GAAP tax rate for the quarter was 17%, as we were not able to include the benefit of the R&D tax credit and so that is renewed by congress. When it does get renewed our tax rate will go down. Our non-GAAP tax rate was 16% and that was also negatively impacted by the lack of an R&D tax credit. GAAP net income for the first quarter of fiscal 2007 includes stock based compensation expense of $23.0 million as a result where adoption of SFAS 123R during the quarter. Our non-GAAP results adjust our GAAP results to exclude SFAS 123R stock based compensation and related tax differences. The net result was GAAP earnings of $90.7 million or $0.23 per share on a fully diluted basis. The shares outstanding reflect a stock split which occurred on April 6 and also reflect the new accounting per dilution under 123R. Under the non-GAAP earnings were $0.29 per share with the shares outstanding accounting for under APB 25, which is consistent with the prior year. On the balance sheet cash was up to $955 million and reflects that we spend approximately $90 million for the acquisitions of ULi and Hybrid. We also repurchased $50 million of stocks during the quarter. Operating cash flow in the quarter was 50 million. Accounts receivable was up by $73 million and reflects that the quarter was back end loaded due to the new product ramps all of which are now in full production. The aging of the receivables remains very good. Inventory was up $92 million as we started the production of several new GeForce 7 products. The increase in inventory can be accounted for by the new products. Depreciation during the quarter was $24 million and capital additions were $21 million. On the outlook Q2 is the most difficult quarter to forecast. It is the seasonally lowest quarter of the year for the PC industry, in addition our visibility is limited until later in the quarter. Our expectations for PCs are not substantially different from other companies in the industry. Normally in Q2 our desktop business declines along with the PC industry, and this has to be offset with growth in other areas. For Q2 this fiscal year we believe we can achieve growth in the notebook and MCP businesses and believe this can offset any other declines. Because of our new products we anticipate that our desktop business will be relatively flat. Overall we expect flat revenue. I would like to point out that with flat revenue in Q2 our core businesses would grow 35% year-over-year because last year’s Q2 included $69.9 million of Xbox revenue. For gross margin our results for the first quarter exceeded our expectations and we will work very hard to hold gross margins at this level for the second quarter. We believe the actual gross margin will be a function of mix and any decline would come from significant revenue growth in lower margin businesses. Consistent with relatively flat sales, we expect relatively flat gross margin on both a GAAP and a non-GAAP basis. Operating expenses, both GAAP and non-GAAP will grow only slightly even though we will have the additional headcount for the entire quarter because of some benefit from the non-recurring cost that were in Q1. If the R&D tax credit is renewed we should expect to see the GAAP tax rate reduced in the second quarter. Thanks and I will turn it back to Jen-Hsun.
Jen-Hsun Huang: Thanks Marv. During the quarter we enhanced our leadership position in to market. In Q1 we successfully delivered our entire family of desktop and notebook GeForce 7 GPUs to our OEM and channel partners. Our new GeForce 7900 GTX has captured design wins with nearly every major OEM offering enthusiast and performance PCs. Our calendar Q1 market share of the performance GPU segment increased from 70% to 83% year-over-year. SLI has become a standard feature in performance PCs. Over 4 million SLI enabled nForce MCPs and over 10 million SLI enabled GeForce GPUs have been shipped creating a large eco system of interoperable SLI components for gamers. According to the Valve Steam Engine which reports user’s systems configuration we have over 98% share of the multi-GPU market. At E3 this week Dell demonstrated their next generation flagship PC powered by Intel’s Conroe microprocessor and our next generation nForce and GeForce technologies. Also at E3 Alienware unveiled the world’s first GeForce 7900 SLI notebook. Over 22 system builders around the world now offer SLI notebooks; we look forward to their transition to the GeForce 7900. In the mainstream segment we’ve been focused on increasing our share. Whereas we have virtually no mainstream PC OEM wins last year, we are ramping design wins at Dell, HP, Gateway, Acer, Legend, Samsung, Medion, Packard Bell, TCL and others. The result of our design win success is starting to reflect in our segment share. Our calendar Q1 combined desktop DX9 GPU share increased from 54% to 60% year-over-year. We are gaining share in the notebook segment as well. The production ramp of our NASA design win refresh is underway. The notebook GPU product lines achieved record revenue for Q1 and as our OEM designs continue to roll out their new notebooks we expect our revenue and share growth to continue throughout the year. The DX9 generation of GPU is important to achieve the best experience with the new Microsoft Vista user interface called Aero Glass. Enabled by programmable shaders, Aero Glass will feature transparencies, textures, lighting and shadows making the Windows and objects on our PC look virtually real. John Peddie Research recently produced a research piece discussing the impact of Vista Premium’s Aero Glass on the market. According to report, over 600 million PCs shipped in the last 3 years and are still in service. These are the ones that are the most logical to upgrade with the new Vista operating system. Because of the low graphics performance of integrated graphics chips found in most of the PCs they will not be able to take advantage of the richness and benefits of Vista’s new Aero Glass GUI and graphics-based operating system would be unusable on most of them. It will take a performance level add-in board to pull out the richness built into Vista. When users see a system running Vista on a PC with integrated graphics, and then Vista on a PC with a powerful graphics add-in card in it, there will be no discussion, they will go for the better looking system as they can possibly afforded, those were quotes from the John Peddie Report. In the coming months, we will witness of the next-generation high-generation video formats. The introduction of Blu-ray disc and HD-DVD will bring high-definition movies to our homes. The BD/HD associations have announced that nearly 100 movie titles will be available in these new HD formats by the end of the year. As a standard for PlayStation 3, millions of Blu-ray players will be available this year, with 6 times the resolution of today’s DVD. Blu-ray disc and HD-DVD is a major advance in resolution and quality from the 7-year old DVD format. The image processing requirement is nearly 30 times that of DVD and will require a special video processor to achieve full performance. Our investment in our PureVideo, dedicated video processors and algorithms will help us bring the HD experience to PC and media center users. We believe we have won every major OEM HD-DVD and Blu-ray design win to-date. Blu-ray and HD-DVD equipped desktops and notebook PCs that incorporate our GeForce 7 GPU and PureVideo video playback technology are going to deliver incredible high-definition movies. We continue to gain share in the AMD server, workstation desktop and notebooks segments. Our share of the AMD platform increased 6% to 42%. On Tuesday this week, HP announced the HP Pavilion DV2000 and Compaq Presario D3000 thin and light notebooks with the GeForce Go 6150 and nForce Go 430 marking NVIDIA’s entry into notebook integrated chip set business. We are preparing our next-generation nForce pipe on the series MCP for the upcoming launches of both the Intel Conroe Microprocessor and AMD Socket AM2 Interconnect. We will be introducing some new and exciting technologies in the 500 families that will raise the performance bar for the industry. The digital media revolution is also driving the growth of our handheld GPU business. Downloaded video like episodic TV shows, broadcast digital TV for sports and news. And high resolution graphics for rich user interface, rich user interfaces, and games are driving the demand for handheld GPUs. Our target segments are 3G phones, Smartphones and portable entertainment devices. We believe that the graphics and multimedia capability of our handheld GPUs has put us in the perfect position to benefit from the increasing multimedia demands of Smartphones which was only 17 million units in 2004 and growing to 100 million units in 2006. The increasing availability of digital media content for 3G has driven demand of our handheld GPUs. Our share of the 3G market grew from 7% in 2005 to 12% this year. In a market that has grown from 72 million handsets last year to an estimated 210 million in 2007. Our newest handheld GoForce 5500 GPU has been designed into DVB-H phones in North America, Europe, and ISDB-T phones in Japan. These are phones that are capable of receiving digital television. Two out of the first three DVB-H Television service launches in the world are based on phones powered by NVIDIA’s handheld GPU. Because of our dedicated H.264 and WMD processors, we are able to deliver the highest image quality at a power level that will enable several hours of enjoyment, and at E3. Sony announced that the highly anticipated PlayStation 3 will be available in Japan on November 11, followed by simultaneous availability in North America, Europe and Australia one week later on November 17. Sony committed to ship 4 million PS3s by December 31 and another 2 million units by March 31, 2007. There are number of positive industry dynamics taking place this year and we believe our product roadmaps and technology leadership, technology leadership uniquely positioned us to drive these trends and produce another year of strong growth. Thank you and we will be happy to take your questions now.
Operator: (Operator's Instructions). The first question comes from Tayyib Shah with Longbow Research.
Tayyib Shah - Longbow Research: Congratulations on the quarter. Can you talk about what, what’s happening in the MCP business, it seems like the share gains against in the AMD platform were kind of flat lesser, is that likely to change in the fiscal second quarter?
Jen-Hsun Huang: First of all thank you. Yeah our market share of the, of the MCP business was below our expectation as well. And there is a variety of theories and I think that this one makes the most sense. We experienced that early on the quarter there was, there were some obsolete inventory that were, were sold by one of our competitors in Asia and these were extremely low cost, low cost products and they were based with integrated graphics with AGP. And so I think that reduced the overall market for our products, but it did increase the demand for GPUs because those, the integrated graphics in those products were simply too obsolete, and so we experienced an increasing demand of entry level AGP, GPUs as a result of that. Now my sense is that, that’s not going to continue but that’s our estimation of what happened in Q1.
Tayyib Shah - Longbow Research: Okay and then if I can ask about the margins, can you talk about the opportunity for your 7300 product line in the value segment replacing your 6200 products, how rapid that transition is going to be and what does that do for your overall margins?
Marv Burkett: Well easy answer is that it improves our margins because the margins on that type of product are better than the GeForce 7 family than they are in the GeForce 6 family. How rapid we can make that transition I don’t think its much a matter of production as it, as it has market acceptance.
Tayyib Shah - Longbow Research: Okay thank you.
Jen-Hsun Huang: Thank you.
Operator: Your next question comes from Randy Abrams with Credit Suisse.
Randy Abrams - Credit Suisse First Boston: Yes good afternoon guys. Wanted to see if you can pull up on the revenue guidance I think you made some flat desktops and then up notebooks, and chipsets to get to a flatter role is that employment some of the smaller businesses like handset and other declines or maybe you could clarify that over?
Marv Burkett: Yeah I don’t think that you should take into that that we expect a decline in handset. Remember the memory and other was a fairly large number in Q1, we don’t know what’s going to happen to that in Q2. If that number did not go down and desktop did not go down I think that we can achieve revenue growth but there is just a lot of unknowns along those lines.
Randy Abrams - Credit Suisse First Boston: Okay and maybe the follow-up question, just on the inventory, maybe when if you go into, again I think you met new products ramping. But wanted to understand just the driver of building inventory, if the revenue trajectory is roughly flat in the coming quarter and is there some motivation from tighter supply to form your back end without inventory at this stage?
Jen-Hsun Huang: Yeah that the way to think about that Randy is that, Q1 was our product transition quarter and we transition down our GeForce 6 family and we, ramped up GeForce 7 family. And typically, in the beginning of a product ramp, we want to be prepared to make available as much of our products to the marketplace as possible and give our OEMs and the channel the opportunity to sell their pipelines. And so, that’s, this is pretty typical stock and its, its reflective of how we make product transitions. I mean the most important thing is just make sure that we have enough 7900s and 7600s and 7300s for the marketplace.
Randy Abrams - Credit Suisse First Boston: Okay, thanks a lot.
Operator: Your next question comes from Mark Edelstone with Morgan Stanley.
Mark Edelstone - Morgan Stanley: Thanks a lot. Nice job on the gross margins, guys.
Jen-Hsun Huang: Thanks Mark.
Mark Edelstone - Morgan Stanley: Let’s see a couple of quick ones first Marv, can you give us what the NRE was in the quarter and what you expect NRE to do in Q2?
Marvin Burkett: Roughly, $20 million to $25 million in the quarter, around numbers 23 that was the Sony NRE and licensing together. Then your second question is what you are expected to do, roughly flat.
Mark Edelstone - Morgan Stanley: Okay, great. And then Jen-Hsun to me under stand all the issues here that you’d look for the current quarter, can you just give us your senses to what see here the most important drivers as you look at the second half of the year and maybe you can try to put those in the context of seasonality. It seems like, you’d actually have quite a few things that ought to give you a better than seasonal lift even some of the things you’re approaching right now.
Jen-Hsun Huang: Yeah, we entered Q2, we always enter Q2 with caution and as just, there is a lot of markets that are taking a pause but we have a lot of good things going for us, GeForce 7 is really a terrific architecture and we continue to ramp into the marketplace with GeForce 7. We have the benefit this year of also winning a lot of the OEM design wins that we simply didn’t have last year, both on the desktop as well as the notebook segments. And so we’ll be ramping into those OEM design wins. We also have, have some pretty terrific handheld GPU products. We have the benefits of PlayStation 3 ramping, they have obviously announced pretty wide availability and simultaneous worldwide launches of, in the November timeframe, which means that that at this point they are clearly manufacturing at full throttle, and so you have that going for us. And then, our MCP business continues to grow. Its, our expectation is that this year over last year we should, we should be in a position to grow substantially in MCP. Two reasons, one of which is when Intel’s Conroe microprocessor does well, it creates a larger performance segment and we have a strong presence in the performance segment as you know, and so that that should help us. And then secondarily, this is our first year with, first full year with integrated graphics built on, built on the desktop as well as notebook computers and so this is very exciting. And then, the last one, it’s not insignificant, it’s blu-ray disc in high definition video. This is first major consumer electronics transition in 7 years. And if you take a look at what’s been going on in the consumer electronics world over the last 5 years or so, it’s really been about High Definition displays and flat displays. Well, finally, they have something they can really drive it and that’s blu-ray disc and HD-DVD. And the processing requirement for BD and HD are so high compared to DVD that you really need to have a dedicated video processor, and this is something that we been talking about and offering to the marketplace. Obviously, with standard definition it was kind of hard to demonstrate the value proposition, but now with HD becoming the value of our video processor is crystal clear, and it’s reflected in all the design wins we have from media centers, and notebooks and PCs that are going to out in blu-ray and HD-DVD. So, I think that we’re positioned than ever before. We have more product drivers and market drivers than ever before, and if we continue to execute, I think that we’re going to have a pretty good year.
Mark Edelstone - Morgan Stanley: That’s great. Just one last one if I could, based on this opportunities should we expect inventories to increase again in this quarter as you basically get prepared for the second half of the year?
Jen-Hsun Huang: Our expectation is not, it just that when we’re ramping new products, we have to make sure that we help our OEMs and help our channel partners to fill their pipeline. And so, there is always that initial surge of supply, to just supply everybody with GeForce 7s. And so, my expectation is that once we get through, get going here we are going to level out to typical ways of managing our inventory.
Mark Edelstone - Morgan Stanley: Okay thanks a lot guys.
Jen-Hsun Huang: Yeah thanks a lot Mark.
Operator: Your next question comes from David Wu with Global Crown.
Hun Lee - Global Crown Capital: Hi, this is Hun Lee calling for David Wu, thank you for taking my question, I have a few question, regarding you said for the gross margin upside, primarily due to the GeForce 7 increase in sales, and I have been checking up on a few, online websites, and I have seen some shortages so that doesn’t quite match the picture that you provide. So could you please give some more clarity to that?
Jen-Hsun Huang: Well at some level I think it’s perfectly aligned with the picture we have provided. We just went through a production transition in Q1. And we ramped down the 6800 and the various GeForce 6 products and we ramped into the GeForce 7 products. And the demand has been really strong. The 7900 has been a product that we have had a hard time catching up with. And that’s one of the reasons why we are building aggressively to fill the market pipeline and to meet the market demand. And I think as I said in the prepared comments, that our performance segment, GPU market share is increasing. And so it reflects that the demand for GeForce 7900 is quite high. And the 7600 is incredibly high. And so you just got to take that into consideration. And the other thing to remember is that SLI takes 2 GPUs per PC. And so the number of gamers in the world and the number of game enthusiasts haven’t declined, and in fact, they have probably grown. But now they consume 2 GPUs per PC. We have always felt that SLI would increase our TAM and I think in a lot of ways, it has.
Hun Lee - Global Crown Capital: Okay, that makes a lot more sense to me now. And another question is for your upcoming nForce5 or the Tritium chipset or could you please comment a little bit about the performance and the gross margin for those? Thank you.
Jen-Hsun Huang: Well, our next generation core logic, our next generation MCP nForce5 will unambiguously be the highest performance core logic in the world. And that’s what it was designed to do and that’s our expectation. And it’s intended to bring some new exciting features at a marketplace that the market’s never seen. Give me a chance to launch that product and I’ll come back next quarter to report on the things that we said.
Hun Lee - Global Crown Capital: Sure. And how about the gross margin, are they going to be above, below, or at the popular level?
Jen-Hsun Huang: Above.
Hun Lee - Global Crown Capital: Okay, thank you.
Operator: Your next question comes from Jason Pflaum with Thomas Weisel Partners.
Jason Pflaum - Thomas Weisel Partners: Yeah, good afternoon and good job guys.
Jen-Hsun Huang: Thanks Jason.
Jason Pflaum - Thomas Weisel Partners: Just to circle back again on the inventories little bit, if you could just help on the composition of the composition of those inventories again and the fact that MCPs is kind of little bit lighter than you expected it was out partly reflective of the build there as well?
Marv Burkett: Yeah I think that’s unique take a look at, we grew inventory round numbers, $19 million quarter-to-quarter. But on the new products we grew inventory roughly $115 million. So of the older GeForce 6 product suite decreased inventory commensurate with what we are trying to do. We did build a little bit more MCP inventory that we anticipated because the MCP sales didn’t achieve what we thought. So there is a little bit more there. But I think that what you should understand is that in general the growth in inventory was driven by the new products.
Jason Pflaum - Thomas Weisel Partners: Okay. And then just can you give us a sense of what portion of your revenues, are going to distribution this quarter? You continue to look that down and was that also a contributor perhaps in holding a little bit more inventory?
Marv Burkett: Yeah I mean it does contribute as we take customers more direct. I don’t know that it was significant though. There two major distributors that everyone focuses on for us even in Atlantic we’re below 12% of our business together, each of them below 6%.
Jason Pflaum - Thomas Weisel Partners: Okay. And then just ask question on the handset side of your business, obviously saw some nice growth there this quarter and good momentum. Can you just characterize or give us a sense for the breadth of some of the design wins that you have now going into the second half, maybe just give a flavor for how many the top shooters maybe shifting to there?
Jen-Hsun Huang: I guess we have design wins with 4 to 5 top handset manufacturers in the world. Most of our handset design wins are focused on 3G cell phones. Many of the new handset design wins are now being designed into digital television cell phones and smart phones. Those are really our target markets. We haven’t played much in the basics graphics GPU business in handsets and there the reason for that is just there is not just much value to add. We tend to focus all our energy on the really rich multimedia capabilities like digital television or video playback or digital camcorder functionality or digital cameras and of course graphics. And so, we tend to focus a lot of our efforts around those types of applications and we are trying to play into emerging and growing market trends. And this is a, we have been talking about how we believe that your handset device is going to become one of your most important computers in your life and increasingly becoming less perceived as just a modem or just as a handset, as a telephone and I think that vision is really playing out and if you believe in that vision then you have to believe that graphics and multimedia technologies are going to be important in that that's really our focus.
Jason Pflaum - Thomas Weisel Partners: Okay. Thanks guys.
Jen-Hsun Huang: Yeah. Thank you.
Operator: Your next question comes from Nicholas Aberle with Caris & Company.
Nicholas Aberle - Caris & Company: Good afternoon. Just why don't you just touch base a little bit more on the performance mainstream segments for discrete desktop, based on our analysis really seems like you guys have got a nice competitive advantage there, superficially on the 7600 products. Can you talk a little bit about the strategy in that particular segment of the market, and some of your expectations for market share gain there, over the course of the year?
Jen-Hsun Huang: I guess our strategy is to build the living daylights out of it.
Marv Burkett: We can't.
Jen-Hsun Huang: Yeah, that's a, it's a pretty sizable market and it's an interesting segment because the volumes are large and also the ASPs are high. And so the technology requirements are pretty demanding and the gamer want the absolute best. And the distribution channel wants to have the best brand and wanted the price they believe and they know they can sell. And so the 7600 family is really perfect for that and it's, follow-on to our 6600 family and so my expectation is that we will do better with 7600 than we do with 6600.
Nicholas Aberle - Caris & Company: Perfect. And then just one more quick follow-on, you guys did touch base on the impact of delayed just operating system, more chatter about that being pushed out even further into mid’07. Does that change you guys, outlook on the effects of that operating system launch at all?
Jen-Hsun Huang: Not really, I think that ending end in the grand scheme of things this is what this is the first major operating system upgrade in quite a long time. I think it's probably close to 7 years, isn't it. And this is the first operating system in the history of humanity that requires a GPU. And as more and more applications get loaded with more and more wedges, and more and more of the Vista Aero Glass capabilities, the graphics demand on your desktop is. On your desktop is going to just continue to increase and there is just not been a single person that is ever seen it that says I can go back. Everything is better, the fonts are better, the resolution is better, the way that the window glides across the desktop is just, everything is just delightful about it and so my sense is that that this Aero Glass is going to create quite a bump for GPUs for quite some time. And so were looking forward to that. We are disappointed as anybody does, that is surpass, go surpass this year but it doesn't fundamentally change anything in the final analysis.
Nicholas Aberle - Caris & Company: Perfect good luck and keep you.
Jen-Hsun Huang: Hey thanks a lot.
Operator: Your next question comes from Quinn Bolton with Needham Incorporated.
Quinn Bolton - Needham Incorporated: Let me add the congratulations on a great margin. Wanted to see if you just look back historically over the various generations of GeForce processors, you guys tended to match out it, sort of match market share readers an performance from the overall desktop segment, when you guys were getting pretty high over 80% now in the performance segment, 605 of the discreet, historically have you gotten a lot higher than that?
Jen-Hsun Huang: Yeah I guess so, I mean, I think that, I am trying to think here. Our focus really isn't just share. We have always been since the beginning of our company focused #1 on increasing the market and it’s about bringing new ideas and new technologies and new features and capabilities to this marketplace and also about expanding the reach of it. One of the best things that we ever did was, was working with Microsoft and folks out in Redman to talk about the importance of the GPU and helping them understand how it could really transform the computing experience. With that's going to increase the markets of GPUs. Our SLI increased the TAM of GPUs. This recent addition of a feature that we added to our GPUs called Physics, it's going to make your SLI system that much more valuable. You could either use both graphics for, both GPUs for game rendering or if particular has a great deal of physics you can use one of the GPUs for physics processing. There is sort of versatility in the new capability that we bring to the marketplace. We just continue to increase the scope in the reach of the marketplace. So, that's always been our focus just to continue to add more value.
Quinn Bolton - Needham Incorporated: And then second I might have a missed a bit I just wonder if you could make any comments sort of the how the workstations business quarter-over-quarter was that another record?
Jen-Hsun Huang: We grew slightly and had a record quarter.
Quinn Bolton - Needham Incorporated: Great, okay, thanks.
Jen-Hsun Huang: Thank you, Quinn.
Operator: Your next question comes from Pranay Laharia with Deutsche Bank.
Pranay Laharia - Deutsche Bank: Hi, a question for you Marv, can you please rank your segments, sort of MCPs, notebook graphics, desktop graphics, workstation, cell phones in the order of gross margin growth that you expect to see in those segments from here onwards through the end of fiscal '06, or fiscal '07?
Marvin Burkett: Well, wow.
Jen-Hsun Huang: Hey Pranay, I think that was like 6 questions.
Pranay Laharia - Deutsche Bank: Okay, I will abbreviate that. Rank your segments in the order of gross margin growth from here onwards?
Marvin Burkett: I don't even, you even broke it down between segments…
Pranay Laharia - Deutsche Bank: Okay, just combined GPU then…
Jen-Hsun Huang: Very good question…
Marvin Burkett: The desktop GPU business should increase gross margin because of the GeForce 7. I mean, margins are excellent of GeForce 7, beyond that, are we going to increase gross margins in workstation, I don't know they are pretty high right now. Are we going to increase gross margins in notebooks? Yeah because, it's going to transition to GeForce 7.
Jen-Hsun Huang: MCP should have some gross margin left and also on the other hand has a deeper market penetration which was against gross margins, because the gross margin lift comes from new generation of products that you will be launching obviously, and then on the other hand, you have got our integrated graphics ramping into desktops and notebooks, let's see what was it, the handsets…
Marvin Burkett: So you have a lot of things going in different directions like Jen-Hsun said. The individual components of MCP might be growing, but if we ship more of the integrated, it will have a negative effect on the whole business unit. Handheld, gross margins have been pretty good, are we going to be able to sustain it, we will see.
Jen-Hsun Huang: I think that the question that you asked ultimately is, highlights the fundamental dynamic for all companies who are simultaneously pushing new technologies and new features which helps gross margins as well as capturing more of the market, bringing that technology to more people which tend to commoditize the technology. So we have those fundamental tensions in our business like everybody else, and hopefully overall we are improving gross margins as a company, our gross margin improvement in the company is not just coming from new products. I mean it's coming from just a corporate wide operational enhancement and drive in the company and its, our business is extremely high velocity, so its not easy to do what we are doing, but we have to create a lot of new ideas to enhance our operational performance, and so that's where we great at those things, coming up with great ideas.
Pranay Laharia - Deutsche Bank: Okay very good. Just a quick follow-up if I may. Trying to reconcile some of this impact, it seems like all the leading integrated graphics vendors pulling yourself ATI and even Intel with broad warrant test line, I was stating that their chipsets, integrated graphics chipsets are either already they’re premium capable or they will be very, very soon. And despite these plans, it seems like you guys still think that to speed traffic it's going to take bump up with Vista launch now. Can you help me reconcile these two views on some of these Vista premium capability claim is it just hollow or not up to mark?
Jen-Hsun Huang: Absolutely you asked a really good question, I’m glad you asked it. The way to think about it is this, today on non-Vista just Windows XP the performance experience of your Windows experience and my Windows experience is identical and I don't even know what you have. Everybody's Windows XP experience is identical because the graphics technology far exceeds anything that Windows XP requires. However the moment that Windows Premium, Vista Premium and Aero Glass comes out people who have GPUs will have a noticeably better experience, noticeably better experience I mean you would have to fallen asleep to not notice that you have a noticeably better experience, its almost no different than video games which based on the same technology. So you would expect similar dynamics that somebody with a GPU is just going to have a better experience with the game then somebody who has who doesn't have a good graphics technology and so you are going to have exactly the same thing. Now when somebody can actually notice the different when a consumer can get an appreciable better experience with a GPU those are the type of dynamics that we love. We’re encouraging to by a better GPU, we’re encouraging incursion to upgrade and we're encouraging to buy a GPU from the retail market to enhance their computer all of that is good for us.
Pranay Laharia - Deutsche Bank: Okay thanks.
Jen-Hsun Huang: Yeah thanks a lot.
Operator: Your next question comes from Rick Schafer with CIBC World Markets.
Dan Morris - CIBC World Markets: Hi guys this Dan Morris calling in for Rick first of all, good quarter.
Jen-Hsun Huang: Thank you.
Dan Morris - CIBC World Markets: Just a house keeping question you mentioned that high grade and 3D effects added about 2 million to OpEx, could you also quantify how much you added to OpEx during the quarter and what contribution that was on the top line from the acquisitions?
Jen-Hsun Huang: Just as a quick clarification that was 3DLabs.
Dan Morris - CIBC World Markets: Okay.
Marvin Burkett: For the OpEx.
Jen-Hsun Huang: For you and for all of us, this brings back memories.
Marv Burkett: Yeah Hybrid and 3DLabs, the people that we picked up from there, plus the amortization associated with Hybrid cost us about $2 million in the quarter. We acquired ULi sometime in February so we picked up roughly 2 months, little over 2 months worth of ULi. It contributed somewhere around 8 to 10 million in revenue and about 3 to 4 million in expenses.
Dan Morris - CIBC World Markets: Okay, great. And then a follow up, there has been a lot press recently about physics and specifically physics processors. You have also added few press releases and demos of your mechanic and Intel gate. I was wondering if you could talk more about your views on the discreet solution and also elaborate on some of these announcements and physics plans?
Jen-Hsun Huang: Sure. I guess what I will do, I will elaborate on physics and why it’s so good. I mean obviously if you take a look at most of the environments that you see in video games and others the environment is by and large static. I mean there are some movement of water and leaves and what not, but they are contrived. And so I think that physics and applying physics to all of those objects in the environment in the world will just make the world look a lot more alive. And whether the way you interact with it or just the way you look at it, so, physics is going to terrific. The second thing is the more objects that you create, the more objects you have to render and so from a graphics perspective that's really terrific as well. It just creates more workload for us to have to go and overcome and we like that. With respect to physics processors it’s hard to say exactly whether there is a unique market for it. But that's not what we are too concerned about it. We wish those guys well. Anybody who wants to build physics processors as well and it's good for the gaming industry. But from our perspective the GPU is a completely programmable device and it does, floating point and mathematics probably faster than any processor know to man since the beginning of computing and for us to redeploy the physics processing is a wonderful use of the investment that's already been made.
Dan Morris - CIBC World Markets: Thank you.
Jen-Hsun Huang: Thank you.
Operator: Your next question comes from Krishna Shankar with JMP Securities.
Krishna Shankar - JMP Securities: Yes, you alluded to be chip business being somewhat weaker because some IGP chipsets having a different pricing, do you feel that the if the cemetery is there, and have been worked off and we are returning to a more demand supply environment, in the AMD platform market, or whether this refer to just AMD platform for both Intel and AMD?
Jen-Hsun Huang: At the price of those, the fact that it was so far below market pricing and frankly, so far below cost, I can't imagine anybody enjoying that kind of business unless its really just to get rid of the excess inventory. And so my sense is that that it’s, it's not going to happen on a regular basis. But we have to keep our eyes on. But the important thing to realize is that we know, we are not just offered core logic as a company, we also our GPU supplier and when those integrated graphics are sold they tend to be, they tend to be very, very low end and have to create some opportunity for us to sell a discrete GPU. And so it probably works its all, works itself out in the grand scheme of things, but on balance we still prefer people go to market.
Krishna Shankar - JMP Securities: And then just a follow-on question, you talked about the requirements for discrete, graphics on desktop, do you see an equally comparative need for desktop and notebooks, so will the caller excitement for notebooks will keep the trend towards integrated graphic there?
Jen-Hsun Huang: I think you have compelling desire in both. And I think the, of you want to dedicate a processor at something, always will do a better job than a general purpose processor in a power environment, power sensitive environment and so that the discrete GPU will do a wonderful job for you as well as do a good job monitoring power as we go. My sense is that this is going to be good for GPUs all the way around.
Krishna Shankar - JMP Securities: Great. And my final question Marv, can you give me some sense for how to model the licensing and raise your revenues going forward for PS3 in the August and November quarter?
Marv Burkett: Well, certainly for Q2, we expect that Q2 will just be a combination of NRE and license fee and the numbers that I gave you for outlook we do not incorporate any expectations for a royalty. I would expect that we will receive royalty income in Q3 the magnitude with, give you a number right now. So Q3 would be more of the same plus royalty.
Krishna Shankar - JMP Securities: Okay thank you.
Jen-Hsun Huang: Thank you, Krishna.
Operator: Your next question comes from Simona Jankowski with Goldman Sachs.
Simona Jankowski - Goldman Sachs: Hi thanks very much. Can you tell us what percent of your GPU sales in the quarter that you spent, it was from the GeForce 7 family, and do you have an estimate as to what percent of sales for GPUs is going to be GeForce 7 in the second quarter?
Marvin Burkett: Well, I think I said in my comments Simona that we spent more than $250 million in GeForce 7 in the GPU business in Q1. And so that was well more than 50%.
Simona Jankowski - Goldman Sachs: Okay, and how much do you think that will be in the second quarter?
Jen-Hsun Huang: It should be a lot more.
Simona Jankowski - Goldman Sachs: Okay. It just seems that with your inventory build of $150 million of new products, that would kind of growth up to $330 million in revenues of the new products, if you kind of apply 45% gross margins, so would that be kind of what you guys are looking for, that seems like it will be a pretty aggressive number?
Marvin Burkett: Well I mean, obviously it depends on the market, but there is nothing wrong with the kind of numbers that we have laid out there. The GeForce 7 is a very good product finally.
Simona Jankowski - Goldman Sachs: Okay, and then maybe just somewhat relatedly, when you are expecting your desktop business to be roughly flat in a PC environment that's likely going to be down, are you expecting that to be a function of share gains or higher blended ASPs or both?
Jen-Hsun Huang: Share gains.
Simona Jankowski - Goldman Sachs: Okay. And then just lastly for your gross margin guidance were flat, it seems like with such a significant mix of your GeForce 7 business as a percent of the total, and then the same thing happening in notebook, what is going to be driving it down to kind of flat gross margin in the second quarter?
Marvin Burkett: Mixed, we expect MCP to do better.
Simona Jankowski - Goldman Sachs: Okay. And you think that's going to be in a thought that all of the other notebooks in the desktop GPU transition?
Marvin Burkett: Yes.
Simona Jankowski - Goldman Sachs: Okay, thanks very much.
Jen-Hsun Huang: Thanks Simona. So previously I had answered a question incorrectly, I was asked whether workstation revenues was a record, we broke 100 million again, but it was not a record. It was down quarter-to-quarter by 1%.
Marvin Burkett: Yeah, down close.
Jen-Hsun Huang: So, it was basically flat.
Operator: Ladies, we have reached the end of the allotted time for questions and answers this afternoon. I would now like to turn the call back over to Jen-Hsun Huang for closing remarks.
Jen-Hsun Huang: Thank you all for joining us today and we look forward to reporting our progress for 2Q this month.
Operator: Ladies and gentlemen, we do appreciate your joining us today. This does conclude our conference call and you may now disconnect. | [
{
"speaker": "Executives",
"text": "Michael W. Hara - Vice President, Investor Relations Jen-Hsun Huang - President and Chief Executive Officer Marv Burkett - Chief Financial Officer"
},
{
"speaker": "Analysts",
"text": "Tayyib Shah - Longbow Research Randy Abrams - Credit Suisse First Boston Mark Edelstone - Morgan Stanley Hun Lee - Global Crown Capital Jason Pflaum - Thomas Weisel Partners Nicholas Aberle - Caris & Company Quinn Bolton - Needham Incorporated Pranay Laharia - Deutsche Bank Dan Morris - CIBC World Markets Krishna Shankar - JMP Securities Simona Jankowski - Goldman Sachs"
},
{
"speaker": "Operator",
"text": "Good afternoon and thank you for holding. I would now like to turn the call over to Mr. Michael Hara, NVIDIA’s Vice President of Investor Relations. Thank you. Sir, you may begin your conference."
},
{
"speaker": "Michael W. Hara",
"text": "Thank you. Good afternoon and welcome to NVIDIA’s conference call for the first, fiscal quarter ended April 30, 2006. On the call today for NVIDIA are Jen-Hsun Huang, NVIDIA’s President and Chief Executive Officer; and Marv Burkett, NVIDIA’s Chief Financial Officer. Before we begin today’s call, I would like to take care of some general administrative items. Your lines have been placed on a listen-only mode until the question and answer segment of today’s call. During this call, we will discuss some non-GAAP measures about net income, net income per share and gross margins and other line items from our consolidated statements of income when talking about our results. You can find the full reconciliation of these measures to GAAP in our financial release which is posted on the investor relations page of our website at www.nvidia.com. This call is being recorded. If you have any objections, you may disconnect at this time. Please be aware that if you decide to ask a question, it will be included in both our live transmission, as well as any future use of the recording. Also, shareholders can listen to a live webcast of today’s call and view our financial release at the NVIDIA Investor Relations website. The webcast will be available for replay until the company’s conference call to discuss its financial results for the second quarter of fiscal 2007. This conference call is the property of NVIDIA. Any redistribution, retransmission or rebroadcast of this call or any portion of it, without the express written consent of NVIDIA is strictly prohibited, and may result in civil and criminal penalties. During the course of this conference call, we may make forward-looking statements based on current expectations. Forward-looking statements, including statements as to our second quarter 2007 outlook, growth, growth drivers, market share, investments, competitive position, design wins, customer demand, new and forthcoming products and products and technologies pertain future events and are subject to a number of significant risks and uncertainties. The company’s actual results may differ materially from results discussed in any forward-looking statements. For a complete discussion of factors that could affect the company’s future financial results and business, please refer to the company’s Form 10-K and annual report for the fiscal year ended January 29, 2006, quarterly reports on Form 10-Q, and the reports on Form 8-K filed with the Securities and Exchange Commission. All forward-looking statements are made as of the date hereof based on information available to us today and the company assumes no obligation to update any such statements. The content of the webcast contains time-sensitive information that is accurate only as of May 11, 2006. Consistent with the requirements under Regulation FD, we will be providing public guidance directly in the conference call and will be unable to provide significantly more information in offline conversations or during the quarter. Therefore, questions around our financial expectations should be asked during this call. At the end of our remarks, there will be time for your questions. In order to allow more people to ask questions, please limit yourself to one question. After our response we will allow one follow-up question. I will now like to hand the call over to Jen-Hsun."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks, Mike. Good afternoon, and welcome to NVIDIA’s first quarter conference call. Today we are pleased to report record revenue of $681.8 million and net income of $0.23 per share for our first quarter. Year-over-year, first quarter revenue grew 17% and net income grew 41%. We experienced growth in each of our businesses, GPU, MCP, handheld GPU and consumer electronics resulting in record revenue for the first quarter. We also entered multiple new product cycles during the quarter continuing our leadership in each of the markets we serve. As we move further into the new fiscal year, the growth drivers we outlined at our Analyst Day in March which included the adoption of Microsoft Vista, high definition video, and the launch of Sony PlayStation 3 will continue to accelerate and give us the opportunity for another strong year of growth. Let me highlight some of our first quarter fiscal 2007 results and achievements. Non-GAAP gross margin reached a company high of 42.5%, an increase of 230 basis points sequentially from the fourth quarter of fiscal 2006 and 650 basis points year-over-year. GAAP gross margin was 42.4% for the first quarter of fiscal 2007. We shipped 8 new GeForce 7 series GPUs for desktop and notebook PCs and now offer a complete top to bottom family of GeForce 7 GPUs. NVIDIA grew share in the performance DX9 and combined DX9 desktop GPU segments from 79% to 83% and from 57% to 60% respectively from the fourth quarter of calendar 2005 to the first quarter of calendar 2006 as reported Mercury Research’s First Quarter PC Graphics Report 2006. The NVIDIA nForce MCP product line achieved record revenue for its seventh consecutive quarter. nForce MCPs increased their share of the AMD64 segment from 35% to 42% from the fourth quarter of calendar 2005 to the first quarter of calendar 2006 as reported in Mercury Research’s First Quarter Worldwide Chipset Report 2006. We continued to advance our leadership position in multi-GPU technology. The company shipped its first Quad SLI system for desktop PCs enabling 4 GPUs per system. We also brought our SLI technology to notebook PCs enthusiasts. NVIDIA demonstrated the world’s first GPU-powered game physics solution at the Game Developer’s Conference with Havok, the game industry’s leading supplier of cross-platform physics engine middleware. Lifelike physics will bring a new dimension of realism and interactivity to games. We shipped our first integrated graphics processor (IGP) core-logic solution for AMD-based notebook PCs, the GeForce Go 6100 GPU and nForce Go 430 MCP. The core-logic solution is the industry’s first high-definition IGP to provide hardware accelerated H.264 high-definition video playback. The Professional Solutions Group introduced 11 new desktop and notebook workstation solutions, designed to improve workstation graphics performance and representing the most extensive line of professional graphics solutions in the industry. NVIDIA and Intel announced a collaboration to bring high-performance 3D gaming and multimedia platform to handheld devices. The collaboration combines the NVIDIA GoForce family of handheld GPUs with Intel’s newest processor family, codenamed Monahans, which is based on third-generation Intel XScale architecture, to develop a powerful development platform to content developers. We successfully completed our acquisition of ULi Electronics, a leading developer of core logic technology. And finally we acquired Hybrid Graphics Ltd., a leading developer of embedded 2D and 3D graphics software for handheld devices. The acquisition will enable customers of both companies to deploy rich graphic solutions for the entire worldwide handheld market. Let me turn the call over to Marv to discuss our financial results in more detail. I will return to discuss our progress and outlook."
},
{
"speaker": "Marvin Burkett",
"text": "Thanks Jen-Hsun. I would like to begin with some comments about the P&L for the first quarter of fiscal year 2007 and then move to the balance sheet. I’ll end with a few comments about the outlook for Q2. On the P&L, as Jen-Hsun said it earlier, revenue for the quarter was $681.8 million which is up 7.6% from the fourth quarter. The growth of almost $50 million was led by the GPU business which grew $21 million quarter-to-quarter. Within the GPU business, notebook grew by 34% and achieved record revenue. Desktop also grew slightly in spite of a seasonally down first quarter for the PC industry. MCP grew only 4% which was less than we anticipated but still achieved record revenue for the seventh consecutive quarter. Handheld GPUs grew almost 20% and also achieved record revenue. Memory and other also grew $12 million in the quarter. All of our business segments had some growth quarter-to-quarter. Year-over-year our overall revenue grew by 17% led by MCP and GTU businesses. MCP grew 65% year-over-year and GPUs grew by 10%. Our handheld devices almost quadrupled year-over-year but from a very low base last year. Xbox contributed $44 million in revenue in last year’s Q1, therefore our core business grew 24% year-to-year. For gross margins we achieved 42.5% on a non-GAAP basis, which exceeded even our expectations. The introduction and success of several new GeForce 7 products contributed significantly to the improvement. The GeForce 7 family contributed approximately $245 million in revenue for the quarter at excellent gross margins. This resulted in a noticeable increase in gross margin for our GPU business. We also had very good margin improvements in our handheld GPU business and it is now close to breakeven on an operating income level. Operating expenses were higher than we anticipated. There are many factors that contributed to this and I will outline a few. Going into the quarter we had not anticipated the acquisition of Hybrid or the hiring of significant number of employees from 3D Labs. These two contributed approximately $2 million of expense in the quarter. Also during the quarter there were significant option exercises by employees, this causes an expense for the company for FICA and other taxes that must be paid upon the exercise. This added about $4 million of unanticipated expense for the quarter. We will get this back later in the year when these employees matches our on FICA. Exclusive of these items operating expenses were still higher than we anticipated, as we were able to hire aggressively in other areas. We added 438 employees during the quarter approximately 200 of these were from ULI and another 70 were from Hybrid and 3D labs. When you put that together with our normal hiring the result was a significant increase in headcount. Headcount at the end of the quarter was 3175. The GAAP tax rate for the quarter was 17%, as we were not able to include the benefit of the R&D tax credit and so that is renewed by congress. When it does get renewed our tax rate will go down. Our non-GAAP tax rate was 16% and that was also negatively impacted by the lack of an R&D tax credit. GAAP net income for the first quarter of fiscal 2007 includes stock based compensation expense of $23.0 million as a result where adoption of SFAS 123R during the quarter. Our non-GAAP results adjust our GAAP results to exclude SFAS 123R stock based compensation and related tax differences. The net result was GAAP earnings of $90.7 million or $0.23 per share on a fully diluted basis. The shares outstanding reflect a stock split which occurred on April 6 and also reflect the new accounting per dilution under 123R. Under the non-GAAP earnings were $0.29 per share with the shares outstanding accounting for under APB 25, which is consistent with the prior year. On the balance sheet cash was up to $955 million and reflects that we spend approximately $90 million for the acquisitions of ULi and Hybrid. We also repurchased $50 million of stocks during the quarter. Operating cash flow in the quarter was 50 million. Accounts receivable was up by $73 million and reflects that the quarter was back end loaded due to the new product ramps all of which are now in full production. The aging of the receivables remains very good. Inventory was up $92 million as we started the production of several new GeForce 7 products. The increase in inventory can be accounted for by the new products. Depreciation during the quarter was $24 million and capital additions were $21 million. On the outlook Q2 is the most difficult quarter to forecast. It is the seasonally lowest quarter of the year for the PC industry, in addition our visibility is limited until later in the quarter. Our expectations for PCs are not substantially different from other companies in the industry. Normally in Q2 our desktop business declines along with the PC industry, and this has to be offset with growth in other areas. For Q2 this fiscal year we believe we can achieve growth in the notebook and MCP businesses and believe this can offset any other declines. Because of our new products we anticipate that our desktop business will be relatively flat. Overall we expect flat revenue. I would like to point out that with flat revenue in Q2 our core businesses would grow 35% year-over-year because last year’s Q2 included $69.9 million of Xbox revenue. For gross margin our results for the first quarter exceeded our expectations and we will work very hard to hold gross margins at this level for the second quarter. We believe the actual gross margin will be a function of mix and any decline would come from significant revenue growth in lower margin businesses. Consistent with relatively flat sales, we expect relatively flat gross margin on both a GAAP and a non-GAAP basis. Operating expenses, both GAAP and non-GAAP will grow only slightly even though we will have the additional headcount for the entire quarter because of some benefit from the non-recurring cost that were in Q1. If the R&D tax credit is renewed we should expect to see the GAAP tax rate reduced in the second quarter. Thanks and I will turn it back to Jen-Hsun."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks Marv. During the quarter we enhanced our leadership position in to market. In Q1 we successfully delivered our entire family of desktop and notebook GeForce 7 GPUs to our OEM and channel partners. Our new GeForce 7900 GTX has captured design wins with nearly every major OEM offering enthusiast and performance PCs. Our calendar Q1 market share of the performance GPU segment increased from 70% to 83% year-over-year. SLI has become a standard feature in performance PCs. Over 4 million SLI enabled nForce MCPs and over 10 million SLI enabled GeForce GPUs have been shipped creating a large eco system of interoperable SLI components for gamers. According to the Valve Steam Engine which reports user’s systems configuration we have over 98% share of the multi-GPU market. At E3 this week Dell demonstrated their next generation flagship PC powered by Intel’s Conroe microprocessor and our next generation nForce and GeForce technologies. Also at E3 Alienware unveiled the world’s first GeForce 7900 SLI notebook. Over 22 system builders around the world now offer SLI notebooks; we look forward to their transition to the GeForce 7900. In the mainstream segment we’ve been focused on increasing our share. Whereas we have virtually no mainstream PC OEM wins last year, we are ramping design wins at Dell, HP, Gateway, Acer, Legend, Samsung, Medion, Packard Bell, TCL and others. The result of our design win success is starting to reflect in our segment share. Our calendar Q1 combined desktop DX9 GPU share increased from 54% to 60% year-over-year. We are gaining share in the notebook segment as well. The production ramp of our NASA design win refresh is underway. The notebook GPU product lines achieved record revenue for Q1 and as our OEM designs continue to roll out their new notebooks we expect our revenue and share growth to continue throughout the year. The DX9 generation of GPU is important to achieve the best experience with the new Microsoft Vista user interface called Aero Glass. Enabled by programmable shaders, Aero Glass will feature transparencies, textures, lighting and shadows making the Windows and objects on our PC look virtually real. John Peddie Research recently produced a research piece discussing the impact of Vista Premium’s Aero Glass on the market. According to report, over 600 million PCs shipped in the last 3 years and are still in service. These are the ones that are the most logical to upgrade with the new Vista operating system. Because of the low graphics performance of integrated graphics chips found in most of the PCs they will not be able to take advantage of the richness and benefits of Vista’s new Aero Glass GUI and graphics-based operating system would be unusable on most of them. It will take a performance level add-in board to pull out the richness built into Vista. When users see a system running Vista on a PC with integrated graphics, and then Vista on a PC with a powerful graphics add-in card in it, there will be no discussion, they will go for the better looking system as they can possibly afforded, those were quotes from the John Peddie Report. In the coming months, we will witness of the next-generation high-generation video formats. The introduction of Blu-ray disc and HD-DVD will bring high-definition movies to our homes. The BD/HD associations have announced that nearly 100 movie titles will be available in these new HD formats by the end of the year. As a standard for PlayStation 3, millions of Blu-ray players will be available this year, with 6 times the resolution of today’s DVD. Blu-ray disc and HD-DVD is a major advance in resolution and quality from the 7-year old DVD format. The image processing requirement is nearly 30 times that of DVD and will require a special video processor to achieve full performance. Our investment in our PureVideo, dedicated video processors and algorithms will help us bring the HD experience to PC and media center users. We believe we have won every major OEM HD-DVD and Blu-ray design win to-date. Blu-ray and HD-DVD equipped desktops and notebook PCs that incorporate our GeForce 7 GPU and PureVideo video playback technology are going to deliver incredible high-definition movies. We continue to gain share in the AMD server, workstation desktop and notebooks segments. Our share of the AMD platform increased 6% to 42%. On Tuesday this week, HP announced the HP Pavilion DV2000 and Compaq Presario D3000 thin and light notebooks with the GeForce Go 6150 and nForce Go 430 marking NVIDIA’s entry into notebook integrated chip set business. We are preparing our next-generation nForce pipe on the series MCP for the upcoming launches of both the Intel Conroe Microprocessor and AMD Socket AM2 Interconnect. We will be introducing some new and exciting technologies in the 500 families that will raise the performance bar for the industry. The digital media revolution is also driving the growth of our handheld GPU business. Downloaded video like episodic TV shows, broadcast digital TV for sports and news. And high resolution graphics for rich user interface, rich user interfaces, and games are driving the demand for handheld GPUs. Our target segments are 3G phones, Smartphones and portable entertainment devices. We believe that the graphics and multimedia capability of our handheld GPUs has put us in the perfect position to benefit from the increasing multimedia demands of Smartphones which was only 17 million units in 2004 and growing to 100 million units in 2006. The increasing availability of digital media content for 3G has driven demand of our handheld GPUs. Our share of the 3G market grew from 7% in 2005 to 12% this year. In a market that has grown from 72 million handsets last year to an estimated 210 million in 2007. Our newest handheld GoForce 5500 GPU has been designed into DVB-H phones in North America, Europe, and ISDB-T phones in Japan. These are phones that are capable of receiving digital television. Two out of the first three DVB-H Television service launches in the world are based on phones powered by NVIDIA’s handheld GPU. Because of our dedicated H.264 and WMD processors, we are able to deliver the highest image quality at a power level that will enable several hours of enjoyment, and at E3. Sony announced that the highly anticipated PlayStation 3 will be available in Japan on November 11, followed by simultaneous availability in North America, Europe and Australia one week later on November 17. Sony committed to ship 4 million PS3s by December 31 and another 2 million units by March 31, 2007. There are number of positive industry dynamics taking place this year and we believe our product roadmaps and technology leadership, technology leadership uniquely positioned us to drive these trends and produce another year of strong growth. Thank you and we will be happy to take your questions now."
},
{
"speaker": "Operator",
"text": "(Operator's Instructions). The first question comes from Tayyib Shah with Longbow Research."
},
{
"speaker": "Tayyib Shah - Longbow Research",
"text": "Congratulations on the quarter. Can you talk about what, what’s happening in the MCP business, it seems like the share gains against in the AMD platform were kind of flat lesser, is that likely to change in the fiscal second quarter?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "First of all thank you. Yeah our market share of the, of the MCP business was below our expectation as well. And there is a variety of theories and I think that this one makes the most sense. We experienced that early on the quarter there was, there were some obsolete inventory that were, were sold by one of our competitors in Asia and these were extremely low cost, low cost products and they were based with integrated graphics with AGP. And so I think that reduced the overall market for our products, but it did increase the demand for GPUs because those, the integrated graphics in those products were simply too obsolete, and so we experienced an increasing demand of entry level AGP, GPUs as a result of that. Now my sense is that, that’s not going to continue but that’s our estimation of what happened in Q1."
},
{
"speaker": "Tayyib Shah - Longbow Research",
"text": "Okay and then if I can ask about the margins, can you talk about the opportunity for your 7300 product line in the value segment replacing your 6200 products, how rapid that transition is going to be and what does that do for your overall margins?"
},
{
"speaker": "Marv Burkett",
"text": "Well easy answer is that it improves our margins because the margins on that type of product are better than the GeForce 7 family than they are in the GeForce 6 family. How rapid we can make that transition I don’t think its much a matter of production as it, as it has market acceptance."
},
{
"speaker": "Tayyib Shah - Longbow Research",
"text": "Okay thank you."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Randy Abrams with Credit Suisse."
},
{
"speaker": "Randy Abrams - Credit Suisse First Boston",
"text": "Yes good afternoon guys. Wanted to see if you can pull up on the revenue guidance I think you made some flat desktops and then up notebooks, and chipsets to get to a flatter role is that employment some of the smaller businesses like handset and other declines or maybe you could clarify that over?"
},
{
"speaker": "Marv Burkett",
"text": "Yeah I don’t think that you should take into that that we expect a decline in handset. Remember the memory and other was a fairly large number in Q1, we don’t know what’s going to happen to that in Q2. If that number did not go down and desktop did not go down I think that we can achieve revenue growth but there is just a lot of unknowns along those lines."
},
{
"speaker": "Randy Abrams - Credit Suisse First Boston",
"text": "Okay and maybe the follow-up question, just on the inventory, maybe when if you go into, again I think you met new products ramping. But wanted to understand just the driver of building inventory, if the revenue trajectory is roughly flat in the coming quarter and is there some motivation from tighter supply to form your back end without inventory at this stage?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yeah that the way to think about that Randy is that, Q1 was our product transition quarter and we transition down our GeForce 6 family and we, ramped up GeForce 7 family. And typically, in the beginning of a product ramp, we want to be prepared to make available as much of our products to the marketplace as possible and give our OEMs and the channel the opportunity to sell their pipelines. And so, that’s, this is pretty typical stock and its, its reflective of how we make product transitions. I mean the most important thing is just make sure that we have enough 7900s and 7600s and 7300s for the marketplace."
},
{
"speaker": "Randy Abrams - Credit Suisse First Boston",
"text": "Okay, thanks a lot."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mark Edelstone with Morgan Stanley."
},
{
"speaker": "Mark Edelstone - Morgan Stanley",
"text": "Thanks a lot. Nice job on the gross margins, guys."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks Mark."
},
{
"speaker": "Mark Edelstone - Morgan Stanley",
"text": "Let’s see a couple of quick ones first Marv, can you give us what the NRE was in the quarter and what you expect NRE to do in Q2?"
},
{
"speaker": "Marvin Burkett",
"text": "Roughly, $20 million to $25 million in the quarter, around numbers 23 that was the Sony NRE and licensing together. Then your second question is what you are expected to do, roughly flat."
},
{
"speaker": "Mark Edelstone - Morgan Stanley",
"text": "Okay, great. And then Jen-Hsun to me under stand all the issues here that you’d look for the current quarter, can you just give us your senses to what see here the most important drivers as you look at the second half of the year and maybe you can try to put those in the context of seasonality. It seems like, you’d actually have quite a few things that ought to give you a better than seasonal lift even some of the things you’re approaching right now."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yeah, we entered Q2, we always enter Q2 with caution and as just, there is a lot of markets that are taking a pause but we have a lot of good things going for us, GeForce 7 is really a terrific architecture and we continue to ramp into the marketplace with GeForce 7. We have the benefit this year of also winning a lot of the OEM design wins that we simply didn’t have last year, both on the desktop as well as the notebook segments. And so we’ll be ramping into those OEM design wins. We also have, have some pretty terrific handheld GPU products. We have the benefits of PlayStation 3 ramping, they have obviously announced pretty wide availability and simultaneous worldwide launches of, in the November timeframe, which means that that at this point they are clearly manufacturing at full throttle, and so you have that going for us. And then, our MCP business continues to grow. Its, our expectation is that this year over last year we should, we should be in a position to grow substantially in MCP. Two reasons, one of which is when Intel’s Conroe microprocessor does well, it creates a larger performance segment and we have a strong presence in the performance segment as you know, and so that that should help us. And then secondarily, this is our first year with, first full year with integrated graphics built on, built on the desktop as well as notebook computers and so this is very exciting. And then, the last one, it’s not insignificant, it’s blu-ray disc in high definition video. This is first major consumer electronics transition in 7 years. And if you take a look at what’s been going on in the consumer electronics world over the last 5 years or so, it’s really been about High Definition displays and flat displays. Well, finally, they have something they can really drive it and that’s blu-ray disc and HD-DVD. And the processing requirement for BD and HD are so high compared to DVD that you really need to have a dedicated video processor, and this is something that we been talking about and offering to the marketplace. Obviously, with standard definition it was kind of hard to demonstrate the value proposition, but now with HD becoming the value of our video processor is crystal clear, and it’s reflected in all the design wins we have from media centers, and notebooks and PCs that are going to out in blu-ray and HD-DVD. So, I think that we’re positioned than ever before. We have more product drivers and market drivers than ever before, and if we continue to execute, I think that we’re going to have a pretty good year."
},
{
"speaker": "Mark Edelstone - Morgan Stanley",
"text": "That’s great. Just one last one if I could, based on this opportunities should we expect inventories to increase again in this quarter as you basically get prepared for the second half of the year?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Our expectation is not, it just that when we’re ramping new products, we have to make sure that we help our OEMs and help our channel partners to fill their pipeline. And so, there is always that initial surge of supply, to just supply everybody with GeForce 7s. And so, my expectation is that once we get through, get going here we are going to level out to typical ways of managing our inventory."
},
{
"speaker": "Mark Edelstone - Morgan Stanley",
"text": "Okay thanks a lot guys."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yeah thanks a lot Mark."
},
{
"speaker": "Operator",
"text": "Your next question comes from David Wu with Global Crown."
},
{
"speaker": "Hun Lee - Global Crown Capital",
"text": "Hi, this is Hun Lee calling for David Wu, thank you for taking my question, I have a few question, regarding you said for the gross margin upside, primarily due to the GeForce 7 increase in sales, and I have been checking up on a few, online websites, and I have seen some shortages so that doesn’t quite match the picture that you provide. So could you please give some more clarity to that?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Well at some level I think it’s perfectly aligned with the picture we have provided. We just went through a production transition in Q1. And we ramped down the 6800 and the various GeForce 6 products and we ramped into the GeForce 7 products. And the demand has been really strong. The 7900 has been a product that we have had a hard time catching up with. And that’s one of the reasons why we are building aggressively to fill the market pipeline and to meet the market demand. And I think as I said in the prepared comments, that our performance segment, GPU market share is increasing. And so it reflects that the demand for GeForce 7900 is quite high. And the 7600 is incredibly high. And so you just got to take that into consideration. And the other thing to remember is that SLI takes 2 GPUs per PC. And so the number of gamers in the world and the number of game enthusiasts haven’t declined, and in fact, they have probably grown. But now they consume 2 GPUs per PC. We have always felt that SLI would increase our TAM and I think in a lot of ways, it has."
},
{
"speaker": "Hun Lee - Global Crown Capital",
"text": "Okay, that makes a lot more sense to me now. And another question is for your upcoming nForce5 or the Tritium chipset or could you please comment a little bit about the performance and the gross margin for those? Thank you."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Well, our next generation core logic, our next generation MCP nForce5 will unambiguously be the highest performance core logic in the world. And that’s what it was designed to do and that’s our expectation. And it’s intended to bring some new exciting features at a marketplace that the market’s never seen. Give me a chance to launch that product and I’ll come back next quarter to report on the things that we said."
},
{
"speaker": "Hun Lee - Global Crown Capital",
"text": "Sure. And how about the gross margin, are they going to be above, below, or at the popular level?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Above."
},
{
"speaker": "Hun Lee - Global Crown Capital",
"text": "Okay, thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jason Pflaum with Thomas Weisel Partners."
},
{
"speaker": "Jason Pflaum - Thomas Weisel Partners",
"text": "Yeah, good afternoon and good job guys."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks Jason."
},
{
"speaker": "Jason Pflaum - Thomas Weisel Partners",
"text": "Just to circle back again on the inventories little bit, if you could just help on the composition of the composition of those inventories again and the fact that MCPs is kind of little bit lighter than you expected it was out partly reflective of the build there as well?"
},
{
"speaker": "Marv Burkett",
"text": "Yeah I think that’s unique take a look at, we grew inventory round numbers, $19 million quarter-to-quarter. But on the new products we grew inventory roughly $115 million. So of the older GeForce 6 product suite decreased inventory commensurate with what we are trying to do. We did build a little bit more MCP inventory that we anticipated because the MCP sales didn’t achieve what we thought. So there is a little bit more there. But I think that what you should understand is that in general the growth in inventory was driven by the new products."
},
{
"speaker": "Jason Pflaum - Thomas Weisel Partners",
"text": "Okay. And then just can you give us a sense of what portion of your revenues, are going to distribution this quarter? You continue to look that down and was that also a contributor perhaps in holding a little bit more inventory?"
},
{
"speaker": "Marv Burkett",
"text": "Yeah I mean it does contribute as we take customers more direct. I don’t know that it was significant though. There two major distributors that everyone focuses on for us even in Atlantic we’re below 12% of our business together, each of them below 6%."
},
{
"speaker": "Jason Pflaum - Thomas Weisel Partners",
"text": "Okay. And then just ask question on the handset side of your business, obviously saw some nice growth there this quarter and good momentum. Can you just characterize or give us a sense for the breadth of some of the design wins that you have now going into the second half, maybe just give a flavor for how many the top shooters maybe shifting to there?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "I guess we have design wins with 4 to 5 top handset manufacturers in the world. Most of our handset design wins are focused on 3G cell phones. Many of the new handset design wins are now being designed into digital television cell phones and smart phones. Those are really our target markets. We haven’t played much in the basics graphics GPU business in handsets and there the reason for that is just there is not just much value to add. We tend to focus all our energy on the really rich multimedia capabilities like digital television or video playback or digital camcorder functionality or digital cameras and of course graphics. And so, we tend to focus a lot of our efforts around those types of applications and we are trying to play into emerging and growing market trends. And this is a, we have been talking about how we believe that your handset device is going to become one of your most important computers in your life and increasingly becoming less perceived as just a modem or just as a handset, as a telephone and I think that vision is really playing out and if you believe in that vision then you have to believe that graphics and multimedia technologies are going to be important in that that's really our focus."
},
{
"speaker": "Jason Pflaum - Thomas Weisel Partners",
"text": "Okay. Thanks guys."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yeah. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Nicholas Aberle with Caris & Company."
},
{
"speaker": "Nicholas Aberle - Caris & Company",
"text": "Good afternoon. Just why don't you just touch base a little bit more on the performance mainstream segments for discrete desktop, based on our analysis really seems like you guys have got a nice competitive advantage there, superficially on the 7600 products. Can you talk a little bit about the strategy in that particular segment of the market, and some of your expectations for market share gain there, over the course of the year?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "I guess our strategy is to build the living daylights out of it."
},
{
"speaker": "Marv Burkett",
"text": "We can't."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yeah, that's a, it's a pretty sizable market and it's an interesting segment because the volumes are large and also the ASPs are high. And so the technology requirements are pretty demanding and the gamer want the absolute best. And the distribution channel wants to have the best brand and wanted the price they believe and they know they can sell. And so the 7600 family is really perfect for that and it's, follow-on to our 6600 family and so my expectation is that we will do better with 7600 than we do with 6600."
},
{
"speaker": "Nicholas Aberle - Caris & Company",
"text": "Perfect. And then just one more quick follow-on, you guys did touch base on the impact of delayed just operating system, more chatter about that being pushed out even further into mid’07. Does that change you guys, outlook on the effects of that operating system launch at all?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Not really, I think that ending end in the grand scheme of things this is what this is the first major operating system upgrade in quite a long time. I think it's probably close to 7 years, isn't it. And this is the first operating system in the history of humanity that requires a GPU. And as more and more applications get loaded with more and more wedges, and more and more of the Vista Aero Glass capabilities, the graphics demand on your desktop is. On your desktop is going to just continue to increase and there is just not been a single person that is ever seen it that says I can go back. Everything is better, the fonts are better, the resolution is better, the way that the window glides across the desktop is just, everything is just delightful about it and so my sense is that that this Aero Glass is going to create quite a bump for GPUs for quite some time. And so were looking forward to that. We are disappointed as anybody does, that is surpass, go surpass this year but it doesn't fundamentally change anything in the final analysis."
},
{
"speaker": "Nicholas Aberle - Caris & Company",
"text": "Perfect good luck and keep you."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Hey thanks a lot."
},
{
"speaker": "Operator",
"text": "Your next question comes from Quinn Bolton with Needham Incorporated."
},
{
"speaker": "Quinn Bolton - Needham Incorporated",
"text": "Let me add the congratulations on a great margin. Wanted to see if you just look back historically over the various generations of GeForce processors, you guys tended to match out it, sort of match market share readers an performance from the overall desktop segment, when you guys were getting pretty high over 80% now in the performance segment, 605 of the discreet, historically have you gotten a lot higher than that?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yeah I guess so, I mean, I think that, I am trying to think here. Our focus really isn't just share. We have always been since the beginning of our company focused #1 on increasing the market and it’s about bringing new ideas and new technologies and new features and capabilities to this marketplace and also about expanding the reach of it. One of the best things that we ever did was, was working with Microsoft and folks out in Redman to talk about the importance of the GPU and helping them understand how it could really transform the computing experience. With that's going to increase the markets of GPUs. Our SLI increased the TAM of GPUs. This recent addition of a feature that we added to our GPUs called Physics, it's going to make your SLI system that much more valuable. You could either use both graphics for, both GPUs for game rendering or if particular has a great deal of physics you can use one of the GPUs for physics processing. There is sort of versatility in the new capability that we bring to the marketplace. We just continue to increase the scope in the reach of the marketplace. So, that's always been our focus just to continue to add more value."
},
{
"speaker": "Quinn Bolton - Needham Incorporated",
"text": "And then second I might have a missed a bit I just wonder if you could make any comments sort of the how the workstations business quarter-over-quarter was that another record?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "We grew slightly and had a record quarter."
},
{
"speaker": "Quinn Bolton - Needham Incorporated",
"text": "Great, okay, thanks."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thank you, Quinn."
},
{
"speaker": "Operator",
"text": "Your next question comes from Pranay Laharia with Deutsche Bank."
},
{
"speaker": "Pranay Laharia - Deutsche Bank",
"text": "Hi, a question for you Marv, can you please rank your segments, sort of MCPs, notebook graphics, desktop graphics, workstation, cell phones in the order of gross margin growth that you expect to see in those segments from here onwards through the end of fiscal '06, or fiscal '07?"
},
{
"speaker": "Marvin Burkett",
"text": "Well, wow."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Hey Pranay, I think that was like 6 questions."
},
{
"speaker": "Pranay Laharia - Deutsche Bank",
"text": "Okay, I will abbreviate that. Rank your segments in the order of gross margin growth from here onwards?"
},
{
"speaker": "Marvin Burkett",
"text": "I don't even, you even broke it down between segments…"
},
{
"speaker": "Pranay Laharia - Deutsche Bank",
"text": "Okay, just combined GPU then…"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Very good question…"
},
{
"speaker": "Marvin Burkett",
"text": "The desktop GPU business should increase gross margin because of the GeForce 7. I mean, margins are excellent of GeForce 7, beyond that, are we going to increase gross margins in workstation, I don't know they are pretty high right now. Are we going to increase gross margins in notebooks? Yeah because, it's going to transition to GeForce 7."
},
{
"speaker": "Jen-Hsun Huang",
"text": "MCP should have some gross margin left and also on the other hand has a deeper market penetration which was against gross margins, because the gross margin lift comes from new generation of products that you will be launching obviously, and then on the other hand, you have got our integrated graphics ramping into desktops and notebooks, let's see what was it, the handsets…"
},
{
"speaker": "Marvin Burkett",
"text": "So you have a lot of things going in different directions like Jen-Hsun said. The individual components of MCP might be growing, but if we ship more of the integrated, it will have a negative effect on the whole business unit. Handheld, gross margins have been pretty good, are we going to be able to sustain it, we will see."
},
{
"speaker": "Jen-Hsun Huang",
"text": "I think that the question that you asked ultimately is, highlights the fundamental dynamic for all companies who are simultaneously pushing new technologies and new features which helps gross margins as well as capturing more of the market, bringing that technology to more people which tend to commoditize the technology. So we have those fundamental tensions in our business like everybody else, and hopefully overall we are improving gross margins as a company, our gross margin improvement in the company is not just coming from new products. I mean it's coming from just a corporate wide operational enhancement and drive in the company and its, our business is extremely high velocity, so its not easy to do what we are doing, but we have to create a lot of new ideas to enhance our operational performance, and so that's where we great at those things, coming up with great ideas."
},
{
"speaker": "Pranay Laharia - Deutsche Bank",
"text": "Okay very good. Just a quick follow-up if I may. Trying to reconcile some of this impact, it seems like all the leading integrated graphics vendors pulling yourself ATI and even Intel with broad warrant test line, I was stating that their chipsets, integrated graphics chipsets are either already they’re premium capable or they will be very, very soon. And despite these plans, it seems like you guys still think that to speed traffic it's going to take bump up with Vista launch now. Can you help me reconcile these two views on some of these Vista premium capability claim is it just hollow or not up to mark?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Absolutely you asked a really good question, I’m glad you asked it. The way to think about it is this, today on non-Vista just Windows XP the performance experience of your Windows experience and my Windows experience is identical and I don't even know what you have. Everybody's Windows XP experience is identical because the graphics technology far exceeds anything that Windows XP requires. However the moment that Windows Premium, Vista Premium and Aero Glass comes out people who have GPUs will have a noticeably better experience, noticeably better experience I mean you would have to fallen asleep to not notice that you have a noticeably better experience, its almost no different than video games which based on the same technology. So you would expect similar dynamics that somebody with a GPU is just going to have a better experience with the game then somebody who has who doesn't have a good graphics technology and so you are going to have exactly the same thing. Now when somebody can actually notice the different when a consumer can get an appreciable better experience with a GPU those are the type of dynamics that we love. We’re encouraging to by a better GPU, we’re encouraging incursion to upgrade and we're encouraging to buy a GPU from the retail market to enhance their computer all of that is good for us."
},
{
"speaker": "Pranay Laharia - Deutsche Bank",
"text": "Okay thanks."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Yeah thanks a lot."
},
{
"speaker": "Operator",
"text": "Your next question comes from Rick Schafer with CIBC World Markets."
},
{
"speaker": "Dan Morris - CIBC World Markets",
"text": "Hi guys this Dan Morris calling in for Rick first of all, good quarter."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thank you."
},
{
"speaker": "Dan Morris - CIBC World Markets",
"text": "Just a house keeping question you mentioned that high grade and 3D effects added about 2 million to OpEx, could you also quantify how much you added to OpEx during the quarter and what contribution that was on the top line from the acquisitions?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Just as a quick clarification that was 3DLabs."
},
{
"speaker": "Dan Morris - CIBC World Markets",
"text": "Okay."
},
{
"speaker": "Marvin Burkett",
"text": "For the OpEx."
},
{
"speaker": "Jen-Hsun Huang",
"text": "For you and for all of us, this brings back memories."
},
{
"speaker": "Marv Burkett",
"text": "Yeah Hybrid and 3DLabs, the people that we picked up from there, plus the amortization associated with Hybrid cost us about $2 million in the quarter. We acquired ULi sometime in February so we picked up roughly 2 months, little over 2 months worth of ULi. It contributed somewhere around 8 to 10 million in revenue and about 3 to 4 million in expenses."
},
{
"speaker": "Dan Morris - CIBC World Markets",
"text": "Okay, great. And then a follow up, there has been a lot press recently about physics and specifically physics processors. You have also added few press releases and demos of your mechanic and Intel gate. I was wondering if you could talk more about your views on the discreet solution and also elaborate on some of these announcements and physics plans?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Sure. I guess what I will do, I will elaborate on physics and why it’s so good. I mean obviously if you take a look at most of the environments that you see in video games and others the environment is by and large static. I mean there are some movement of water and leaves and what not, but they are contrived. And so I think that physics and applying physics to all of those objects in the environment in the world will just make the world look a lot more alive. And whether the way you interact with it or just the way you look at it, so, physics is going to terrific. The second thing is the more objects that you create, the more objects you have to render and so from a graphics perspective that's really terrific as well. It just creates more workload for us to have to go and overcome and we like that. With respect to physics processors it’s hard to say exactly whether there is a unique market for it. But that's not what we are too concerned about it. We wish those guys well. Anybody who wants to build physics processors as well and it's good for the gaming industry. But from our perspective the GPU is a completely programmable device and it does, floating point and mathematics probably faster than any processor know to man since the beginning of computing and for us to redeploy the physics processing is a wonderful use of the investment that's already been made."
},
{
"speaker": "Dan Morris - CIBC World Markets",
"text": "Thank you."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Krishna Shankar with JMP Securities."
},
{
"speaker": "Krishna Shankar - JMP Securities",
"text": "Yes, you alluded to be chip business being somewhat weaker because some IGP chipsets having a different pricing, do you feel that the if the cemetery is there, and have been worked off and we are returning to a more demand supply environment, in the AMD platform market, or whether this refer to just AMD platform for both Intel and AMD?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "At the price of those, the fact that it was so far below market pricing and frankly, so far below cost, I can't imagine anybody enjoying that kind of business unless its really just to get rid of the excess inventory. And so my sense is that that it’s, it's not going to happen on a regular basis. But we have to keep our eyes on. But the important thing to realize is that we know, we are not just offered core logic as a company, we also our GPU supplier and when those integrated graphics are sold they tend to be, they tend to be very, very low end and have to create some opportunity for us to sell a discrete GPU. And so it probably works its all, works itself out in the grand scheme of things, but on balance we still prefer people go to market."
},
{
"speaker": "Krishna Shankar - JMP Securities",
"text": "And then just a follow-on question, you talked about the requirements for discrete, graphics on desktop, do you see an equally comparative need for desktop and notebooks, so will the caller excitement for notebooks will keep the trend towards integrated graphic there?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "I think you have compelling desire in both. And I think the, of you want to dedicate a processor at something, always will do a better job than a general purpose processor in a power environment, power sensitive environment and so that the discrete GPU will do a wonderful job for you as well as do a good job monitoring power as we go. My sense is that this is going to be good for GPUs all the way around."
},
{
"speaker": "Krishna Shankar - JMP Securities",
"text": "Great. And my final question Marv, can you give me some sense for how to model the licensing and raise your revenues going forward for PS3 in the August and November quarter?"
},
{
"speaker": "Marv Burkett",
"text": "Well, certainly for Q2, we expect that Q2 will just be a combination of NRE and license fee and the numbers that I gave you for outlook we do not incorporate any expectations for a royalty. I would expect that we will receive royalty income in Q3 the magnitude with, give you a number right now. So Q3 would be more of the same plus royalty."
},
{
"speaker": "Krishna Shankar - JMP Securities",
"text": "Okay thank you."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thank you, Krishna."
},
{
"speaker": "Operator",
"text": "Your next question comes from Simona Jankowski with Goldman Sachs."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Hi thanks very much. Can you tell us what percent of your GPU sales in the quarter that you spent, it was from the GeForce 7 family, and do you have an estimate as to what percent of sales for GPUs is going to be GeForce 7 in the second quarter?"
},
{
"speaker": "Marvin Burkett",
"text": "Well, I think I said in my comments Simona that we spent more than $250 million in GeForce 7 in the GPU business in Q1. And so that was well more than 50%."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Okay, and how much do you think that will be in the second quarter?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "It should be a lot more."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Okay. It just seems that with your inventory build of $150 million of new products, that would kind of growth up to $330 million in revenues of the new products, if you kind of apply 45% gross margins, so would that be kind of what you guys are looking for, that seems like it will be a pretty aggressive number?"
},
{
"speaker": "Marvin Burkett",
"text": "Well I mean, obviously it depends on the market, but there is nothing wrong with the kind of numbers that we have laid out there. The GeForce 7 is a very good product finally."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Okay, and then maybe just somewhat relatedly, when you are expecting your desktop business to be roughly flat in a PC environment that's likely going to be down, are you expecting that to be a function of share gains or higher blended ASPs or both?"
},
{
"speaker": "Jen-Hsun Huang",
"text": "Share gains."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Okay. And then just lastly for your gross margin guidance were flat, it seems like with such a significant mix of your GeForce 7 business as a percent of the total, and then the same thing happening in notebook, what is going to be driving it down to kind of flat gross margin in the second quarter?"
},
{
"speaker": "Marvin Burkett",
"text": "Mixed, we expect MCP to do better."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Okay. And you think that's going to be in a thought that all of the other notebooks in the desktop GPU transition?"
},
{
"speaker": "Marvin Burkett",
"text": "Yes."
},
{
"speaker": "Simona Jankowski - Goldman Sachs",
"text": "Okay, thanks very much."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thanks Simona. So previously I had answered a question incorrectly, I was asked whether workstation revenues was a record, we broke 100 million again, but it was not a record. It was down quarter-to-quarter by 1%."
},
{
"speaker": "Marvin Burkett",
"text": "Yeah, down close."
},
{
"speaker": "Jen-Hsun Huang",
"text": "So, it was basically flat."
},
{
"speaker": "Operator",
"text": "Ladies, we have reached the end of the allotted time for questions and answers this afternoon. I would now like to turn the call back over to Jen-Hsun Huang for closing remarks."
},
{
"speaker": "Jen-Hsun Huang",
"text": "Thank you all for joining us today and we look forward to reporting our progress for 2Q this month."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, we do appreciate your joining us today. This does conclude our conference call and you may now disconnect."
}
] | null | null |
PFE | 4 | 2,008 | 2009-01-28 08:30:00 | Operator: Good morning ladies and gentlemen and welcome to Quarter Earnings Release Conference Call. (Operator Instructions). I would now like to turn the call over to Mr. Charles Triano Pfizer’s Senior Vice President of Investor Relations.
Charles Triano: Good morning everyone. Thank you for joining us today to discuss today’s announcement that Pfizer has entered into an agreement to acquire Wyeth. I am here with our Chairman and Chief Executive Officer Jeff Kindler. The presentation that accompanies today’s call can be viewed on pfizer.com. This call is scheduled to last one hour and I would also add that today’s call is in lieu of our earnings conference call that was originally scheduled for this Wednesday. Discussions during this conference call will include certain financial measures that were not prepared in accordance with US Generally Accepted Accounting Principles. Reconciliation of those non-US GAAP financial measures to the most directly comparable US GAAP financial measures can be found in Pfizer’s current report on Form 8-K dated January 26, 2009. Discussions during this conference call will also include forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. The factors that could cause actual results to differ are discussed in Pfizer’s 2007 annual report on Form 10-K and in our reports on Form 10-Q and Form 8-K. These reports are available at our website www.pfizer.com in the Investor SEC Filing section. With that I would like to turn the call over to Jeff Kindler.
Jeff Kindler: Thank you, Chuck good morning everyone, and thank you for joining us today. I am here with members of Pfizer’s senior management and we are also very honored this morning to be joined by Bernard Poussot, Chairman and Chief Executive of Wyeth. With Bernard are three members of his senior management team, Greg Norden, Chief Financial Officer; Larry Stein, General Counsel; and Justin Victoria, Vice President of Investor Relations. We are very excited about today’s announcement that Pfizer and Wyeth will combine to become the world’s premier biopharmaceutical company. I know that Bernard shares my enthusiasm for this combination and for the opportunities it will create for patients today, for patients tomorrow and for patients around the world, so I would like to begin by asking Bernard to share his thoughts with you. Bernard?
Bernard Poussot: Thank you very much Jeff and good morning everyone. I appreciate the invitation to comment on the value that Wyeth will bring to this great company in the making. Our vision at Wyeth for about 20 years has been to establish a very strong foundation in science, focus on providing new solutions to patients and their families. As a result, we have created over the years what is today a global biopharmaceutical company with striking diversity. We established ranks in biotechnology and vaccines when others were just recognizing recently this highly desirable, strategic, objective. Our execution has been relentless about building what I just described. We created diverse business platforms ranging from pharmaceuticals, biopharma, vaccines, but also nutritionals, consumer health care and more. Today, at the end of 2008, 60% of our revenues are from no traditional pharmaceuticals. We have built industry leading biotechnology and vaccine manufacturing capacity and capabilities. As a result, we established a diverse business sector leadership. Biopharma Enbrel has become now the number one biologic product in the world. The vaccine Prevnar is today’s largest selling vaccine in the world. At the same time we established pharmaceuticals block busters such as Effexor and Zosyn which are both number one in their categories. We are also a strong nutritional franchise and we are number one in markets where we compete. Consumer health is an important piece of our business with brands like Advil, Centrum, and Robitussin. In the name of health we have been a key provider on biologics and vaccines for animals. There are many opportunities remaining in those key franchises. Just to name a few, in the field of rheumatoid arthritis and the psoriasis market, where we are leading with Enbrel we expect a $10 billion expansion between now and 2012. The fever vaccines we are preparing our Prevnar products not only for infants, there is also a totally new indication in adults. Even in consumer health we have been adding the Thermacare acquisition to our consumer pain franchise led by Advil. We are also pleased to add a diverse portfolio of innovative new products. Tygacil, Torisel, Pristiq, Xyntha, and Relistor are all recent new product pools and we are still in the process of launching those products worldwide. Collectively they offer a multi-billion dollar peak potential. I just want to finish highlighting prevention as a key driver in our view to manage rising healthcare costs. Nothing is more efficient than prevention to do this. We have built that key business over the years, which Prevnar, as I mentioned and we are working actively on a meningitis additional vaccine that could prove instrumental to children around the world. We are doing the same in animals in providing the world with the first vaccines in West Nile virus, but also H5N3 against avian flu. So we are very concerned about safe guarding the food chain also, as nutrition is also the ultimate form of prevention. Along the same lines vitamins and supplements in our consumer division with Centrum and Caltrate also offer chances to people to manage their health better. Lastly, our infant formula business is a benefit also, quality food at a very critical age, which is another form of prevention. I think we have done all of this in fostering a culture of science first at Wyeth. We have actually encouraged our scientists to go for the stars and look for diseases that are very difficult to fight. Such an example is Alzheimer’s our approach has an unprecedented size and diversity of approaches ranging from biotechnology small molecule or even vaccine to fight this terrible disease, but I could also mention cancer, meningitis, as I said, pneumonia a number of significant problems. So that is what are scientists have been doing and building and I am very proud to present their good work. At Wyeth we have said that our scientists are our strategic planners and they should be the ones leading the direction of the company. So not surprisingly, Jeff and Pfizer realized what we had built over the years and I am very proud to acknowledge here what people have been building patiently year after year. We believe that we have now reached a level which is structured in such a way that our board and our shareholders will find it very attractive. Thank you.
Jeff Kindler: Thank you, Bernard. That is a terrific summary of the great work that you and your leadership team at Wyeth have done in building a great company. What I am going to do now is to talk a little bit about the transaction from my perspective, then I will turn it over to Frank who will give a brief overview of our fourth quarter results and then we will have a financial overview of the transaction for Frank together with our targets for the combined company and then we will turn to your questions. So, this acquisition comes after months of careful consideration. As we reviewed literally hundreds of strategic options, it became clear that the acquisition of Wyeth would most meaningfully advance our strategic priorities. As we told you in the past these priorities include enhancing our in line and pipeline patent protected portfolio in key invest to win disease areas, areas where there are significant unmet medical needs and where we believe we can help address those needs; becoming a top tier player in biotherapeutics and vaccines; accelerating our growth in emerging markets; creating new opportunities for established products; investing in complimentary businesses and establishing a lower, more flexible cost base. In one single step this acquisition advances each and every one of those strategies that we have put forward. Combing with Wyeth will extend our global healthcare leadership, clearly establishing Pfizer as a leader in human health, animal health, consumer health, and nutritionals as the number one company in primary care and the number two company in specialty care, as a top tier player in biotherapeutics and vaccines and as the company with unrivaled geographic reach. The operational discipline that we have been shaping at Pfizer for more than two years will drive this diverse product base forward and produce ever-improving performance. Our unique model combining the speed and agility of our smaller, more focused business units, with the scale and resources of a global enterprise will enable us to seize new opportunities in markets around the world while maintaining clear accountability for each P&L. Investors will be pleased to know that this deal definitively addresses the revenue loss from Lipitor’s loss of exclusivity. The combined company will solidify Pfizer’s ability to deliver consistent and stable earnings growth and strong operating cash flow and it will bring us many new points of product entry across the world to better serve patients, physicians, and customers. Finally and fundamentally this deal will significantly enhance the ability of our world-class people to advance our core mission, applying innovative science to improve world health. The reason why we are able today to seize the unique opportunity created by this combination is because of all the hard work that the people at Pfizer have done over the last two years to strengthen our company. Frankly, until we improve the leadership structure and culture of this company and establish the critical importance of accountability, discipline and meeting our commitments, we simply weren’t prepared to move forward in this way. And, while the job is never done, we have made so much progress over the last two years that we are now highly confident that we can successfully integrate and operate the great company that this combination will produce. Let me just take a moment to summarize how we have strengthened the foundation of this company. First, we assembled a world-class leadership team from inside and outside of Pfizer. Second, we set out to establish a lower and more flexible cost base. Just two years ago this week, we said we would reduce our cost base by between $1.5 and $2 billion on a constant currency basis by the end of 2008. This morning we reported that we have substantially exceeded that goal. Over that two year time period we reduced our total adjusted cost base by $2.8 billion. The difficult, painful, but very necessary work that had to be done to achieve that included, among other things, reducing headcount by approximately 16,000 employees, eliminating unnecessary layers of bureaucracy, refocusing the work in our R&D labs to high priority disease areas and optimizing our manufacturing network by closing 15 manufacturing sites. As a result of these and other actions we are now a much leaner, more agile organization than we were just two years ago. Third, we revamped our research enterprise, narrowing our focus on those disease areas with significant unmet medical needs in which we believe we can make a difference; establishing therapeutic research organizations led by world-class chief scientific officer; creating the unique biotherapeutics and bioinnovation center and aggressively seeking new science and technology from the world outside our labs. Fourth, we established distinct business units, each focused on a different customer segment; each with a clearly accountable leader; and each with responsibility for everything from deciding which compounds with proofs of concept warrant the significant investment required to develop them, all the way to how to maximize the opportunities for products that have lost exclusivity. Finally, while again, this work is never done, I believe we have meaningfully changed our culture to one that is financially disciplined and focused on clear accountability for results. These changes and others put us in a very strong position from which we can successfully seize the unique opportunity presented by combining Wyeth and Pfizer, and Wyeth is without doubt, the perfect partner for Pfizer. With this transaction we will be on our way to becoming the third largest biotherapeutics company in the world. Enbrel is the worlds leading biologic. Along with it comes a robust pipeline of biopharmaceutical candidates as well as Wyeth’s world-class pharmaceuticals science capabilities and its high-quality and high-volume manufacturing plants, including the one in Grange Castle, Ireland, the largest integrated biotechnology manufacturing facility in the world. The Wyeth combination also allows us to enter the growing vaccines market in a powerful position. We will have the fourth largest vaccines business globally and our portfolio will include Prevnar, the largest vaccine in the world. This deal will also expand our in line and pipeline portfolio in many of they key disease areas that we have identified as ones in which we want to invest to win. It will also support our expansion in emerging markets and our established products business and it will add complimentary businesses in nutritionals and consumer health as well as strengthening our animal health business. Now this transaction also meaningfully diversifies our therapeutics offerings and platforms. Within human health it decreases our reliance on primary care medicines and creates the number two specialty company. By 2012 the proportion of our revenue that comes from primary care products will decrease by approximately a full 20% to just over half of revenues and we expect no drug will account for more than 10% of the combined company’s revenue. As I noted, this acquisition further diversifies the company by strengthening our position in the attractive biologics and vaccine spaces. As you see on this slide, this diversification creates a more desirable balance in our portfolio reducing small molecule dependence from 90% to 70% by 2012. On their own, Pfizer and Wyeth both have strong pipelines, but bringing them together creates a single pipeline that’s larger and more diverse with world-class technology platforms and a talent pool of scientists that is best in class. Such a broad pipeline requires expensive investments in multiple platform technologies. Bringing the pipelines of these two companies together will enable us to realize their potential more fully than if they remained separate. As an example, Wyeth’s expertise in commercial and medical immunology, particularly across rheumatology and dermatology, will help advance development of our JAK3 inhibitor. In addition, we will be able to apply Pfizer’s commercial scale and clinical developing capability to Wyeth’s products and registration, Phase III and Phase II and our patient marketing expertise will help maximize the global potential of the Prevnar vaccine. Now this slide shows the impressive industry rankings that the combined company will have in many of the fastest growing therapeutic areas. With this acquisition we remain the leader in primary care, of course, we will also advance our CNS infectious disease and specialty franchises to become number two in those important areas and, as I have noted, we will bolster our leading position in animal health as well. Geographically the companies combined global footprint will be unrivaled. Going forward we will lead the pharmaceutical markets of the United States, Europe, Latin America, Japan and the rest of Asia. In addition, we will have leading market share positions in important growth areas such as Brazil, Russian, India and China. We see continued upside in emerging markets and we expect that to come from, among many other things, applying Pfizer’s commercial presence to Wyeth’s portfolio, particularly Enbrel, Prevnar, and Wyeth’s well-known and well-regarded nutritionals. In the context of a fast changing global healthcare environment, the new company will be a well balanced biopharmaceutical enterprise made up of diverse businesses with the scale, breadth, and reach to deliver healthcare solutions and address the needs of patients, physicians, and other customers around the world. Before Frank discusses the numbers I would like to emphasize one last point about the structural benefits of the new organization and some of the reasons why we believe we are positioned to successfully and quickly integrate the company and move forward. Now as a $70 billion global company, clearly we will be an enterprise with significant scale and resources and real relevance to payers and patients. This gives us great competitive advantages. We will have the ability to benefit from the fixed costs of research, commercialization, and manufacturing and enable important platform investments while also maintaining financial flexibility. At the same time, we know that a company that is that large cannot be managed in a centralized, monolithic way and that is why we remain committed to our operating model of focused, agile, patient centric business units. This model provides us clear accountability for performance. The world-class leaders of these businesses can manage their businesses to achieve the greatest return while taking advantage of the benefits of the global enterprise. We will continue to promote an entrepreneurial culture and the ability to harness scale where it is a competitive advantage for the business. With that I will turn the call over to Frank to review the fourth quarter results, our 2009 guidance and the terms and details of this transaction. Frank?
Frank D’Amelio: Thank you, Jeff. I want to start by saying how pleased I am to talk to you today about what we believe is a great opportunity for both Pfizer and for Wyeth. The potential for the combination of our companies is greater than each company could have achieved on its own. With that, let me briefly review our fourth quarter 2008 results before we review the transaction. We delivered solid results in 2008, achieving our key financial metrics including exceeding our cost reduction target in the face of a very challenging global economy. Reported revenues were $12.3 billion, a year-over-year decrease of 4% driven by the negative impact of the loss of US exclusivity of Zyrtec and Camptosar and the loss of exclusivity for Norvasc in Korea and Japan whose collective fourth quarter revenue decreased year-over-year by $515 million; foreign exchange which decreased revenues by approximately $380 million or 3% which were partially offset by the solid performance of key products. Reported net income was $266 million for the quarter compared with $2.7 billion in the year ago quarter, reported diluted EPS was $0.04 versus $0.40. These significant year-over-year decreases were primarily driven by a $2.3 billion pre-tax and after-tax charge resulting from an agreement in principle to resolve previously disclosed investigations regarding allegations of past off-label promotional practices concerning Bextra as well as other open investigations. And, to a lesser extent are the $1.2 billion pre tax increase or restructuring implementation charges related to cost reduction initiatives as well as the increased effective tax rate which were partially offset by savings resulting from cost reduction initiatives. Adjusted revenues were $12.3 billion, a 4% decrease year-over-year, driven by the unfavorable impact of the loss of the exclusivity of Norvasc, Zyrtec and Camptosar and foreign exchange which, once again, partially offset the solid performance of key products. Adjusted income increased 29% year-over-year to $4.4 billion and adjusted, diluted EPS increased 30% to $0.65, both of which benefited from savings associate with our cost reduction initiatives which were partially offset by an increase in the effective tax rate. As you can see, we achieved essentially all elements of our full year guidance with the exception of reported, diluted EPS which includes the negative impact of the previously mentioned litigation related matters. We achieved our adjusted revenue and adjusted diluted EPS guidance and we exceeded our adjusted total cost target, adjusted cost of sales, adjusted cost of sales, adjusted SI&A and adjusted, diluted EPS targets. We also expect to achieve cash flows from operations within our estimated range of $17 to $18 billion. Looking to 2009 we expect, on the top line, annual revenues in the range of $44 to $46 billion which assumes a $3 billion year-over-year reduction versus 2008 directly related to the strengthening of the US dollar. On the bottom line adjusted diluted EPS in the range of $185 to $195. It is important to note that this guidance includes a $1 billion reinvestment in key, high-growth areas of our business including later-stage research and development programs, emerging markets, and established product strategies. Now I would like to provide a bridge from ’08 actual to 2009 guidance. We expect ’09 adjusted diluted EPS to be negatively impacted by approximately $0.21 due to the expected $3 billion year-over-year revenue decline related to foreign exchange; $0.21 related to increasing the effective tax rate to 30% reflecting financial strategies in connection with the proposed acquisition of Wyeth; $0.04 due to increased pension expenses and $0.04 resulting from a decrease in interest income. All of these factors translate into a negative impact of roughly $0.50 on 2009 adjusted diluted EPS versus 2008. Now, under the terms of the agreement Pfizer is acquiring all of Wyeth’s outstanding common shares at a current value of about $50.00 per share. Wyeth’s shareowners will receive $33.00 per share in cash, plus a current value of approximately $17.00 per share of Pfizer’s stock based on a fixed exchange ratio of 0.985. The transaction will be funded through a combination of cash, debt, and equity. Upon completion, Pfizer shareowners will own approximately 84% in stock in the combined company and Wyeth shareowners will own 16%. We anticipate the transaction to be accretive within the second full year following the close which we expect to occur at the end of the third quarter or during the fourth quarter of 2009. The resulting transaction is currently valued at approximately $68 billion. As I mentioned, the sources of funding for the transaction include $22.5 billion in cash, $22.5 billion of debt and about $23 billion in Pfizer’s stock. We have received commitments for debt financing from a syndicate of five banks. Based on recent discussions with rating agencies, wherein we have reviewed this transaction, we expect to receive the following ratings: A Moody’s rating of A1 stable long term and P1 affirmed short term and an S&P rating of AA stable long term and A1+ confirmed short term. Given the amount of cash and debt being used to fund this transaction, beginning in the second quarter we are reducing our quarterly dividend to $0.16 per share which continues to be competitive [inaudible] years. As part of this transaction we expect to realize about $4 billion in synergies. It is important to note that the $4 billion in synergies is incremental to the $400 million already achieved by Wyeth, $2.8 billion of savings that Pfizer achieved at the end of ’08 under our previous cost reduction initiative and in addition to the $2 billion of anticipated net savings from our new cost reduction initiative announced today. We anticipate achieving 50% of these synergies within the first 12 months after the close, 75% within the first 24 months and the full benefit of the synergies in the first 36 months. We expect about half of these synergies to come from SI&A with the remaining from R&D and manufacturing resulting from a variety of activities which include the consolidation of support functions; implementing a global procurement structure; achieving economies of scale; rationalizing our global network of plants; and using a single platform for core research, among other things. As a result of these actions we expect to reduce the combined companies’ global workforce by approximately 15%. This reduction includes the 10% reduction to Pfizer’s workforce associated with its new cost reduction initiative. Now I would like to move on to our 2012 financial targets which are based on our current long-range forecast. Please note that these are to be subject to changes as a result of potential material negative impacts related to foreign exchange fluctuations, macro economic volatility, industry specific challenges, and changes to government healthcare policy, among other things. We expect the revenue level of the combined company to be comparable with our pro forma 2008 revenue level of approximately $70 billion. By managing our mix of business and the total cost structure of the company, we expect overall operating margins in the high 30s to low 40s percentage range which we believe appropriately aligns with our expected revenue levels. We anticipate adjusted diluted EPS to be roughly the same as Pfizer’s 2008 level of $242 per share. We also expect our operating cash flow to be in the low $20 billions and we expect that in 2012 the combined company will be in a net cash position. As you can see, the combination of Pfizer and Wyeth clearly addresses the revenue decline resulting from the loss of exclusivity of both Lipitor and Effexor. Now I will turn it back to Jeff.
Jeff Kindler: Thanks so much, Frank. We will turn to your questions in a moment, first let me just sum up. This is the right transaction at the right time for both Pfizer and for Wyeth and we are entering into it for the right reasons, to create value for shareholders, customers, and patients today, patients tomorrow and patients everywhere. Going forward we will have a greater ability to maximize our product portfolio while having the resources to invest in break through science and valuable therapeutic areas. A versified revenue base will better position the company for long-term growth. We will continue to operate with business units empowered to meet the needs of specific customers and able to benefit from the scale of an even stronger global organization. Te new combined company is one with a broader portfolio; a stronger pipeline of innovative new products; more opportunities for growth, and an ability to offer patients a range of treatments for every stage of life. By joining together with Wyeth, Pfizer is creating the world’s premier biopharmaceutical company and we are excited about the opportunities to come. So, let’s turn to your questions.
Operator: (Operator Instructions) Your first question comes from Catherine Arnold of Credit Suisse.
Catherine Arnold: I wanted to ask you about the leadership of the combined company. I think the press is reporting that Bernard will not be staying with the company? I don’t think that was addressed in your comments. I also wonder if you can talk about how you plan to integrate the expertise of Wyeth into the new Pfizer organization to prevent exodus of key employees, because it is obviously key to the integration. Then I wondered if you could comment on biosimilars? Will this accelerate your ability to pursue biosimilars new strategy and is that one of the arguments for the deal?
Jeff Kindler: Bernard and I have gotten to know each other quite well, as you can imagine. I have enormous respect for his experience and talents and skills. We share similar values and similar views about where our healthcare environment is going and what we need to do, as a company and I have been very gratified that he has agreed, after the closing, to continue to work with us, to ensure a smooth transition, and to see where we go from there. Obviously he is running Wyeth until the closing, but we are very grateful that he has agreed to stay on. With regard to the rest of the management at Wyeth and the tremendously talented group of people there both in leadership and across the company, we are very excited about looking for the right opportunities for people. You are absolutely right that we have to focus on retention. We are not just buying assets and buildings and compounds, we are building an enterprise that was created by people, great people that have done a fabulous job creating a great company, and we are very mindful of that. I will let Bernard elaborate on those two points maybe and then I will go to your question about biosimilars.
Bernard Poussot: Yes, Catherine, my commitment is certainly to run Wyeth and present Wyeth the closing and the best possible conditions, you can count on that, number one. Second I will dedicate a lot of my time and energy to work through the combination and make sure that Pfizer builds a very strong team. It is all about the talents that drive these businesses. It is not just products or assets it is the people. Of course I have observed that many, many times in the past. As far as my own role I think I will do that and I will have some time with Jeff to discuss what could happen after that. In terms of biotechnology it is definitely an apparent sometimes more than a science. We have seen that not only from the research side, but also from the manufacturing side that the product is a process in this area and that is very different from small molecules. I think we have lined up some unbelievable talents, Ph.D.s, engineers, who design state of the art manufacturing sites who can do things that not even some of our peers can. I mean the Genentech came to us to a septin two years ago. That tells you about the kind of technology and know-how we have so we would be very happy to make sure that Jeff and his team see the pattern that we have brought and help to build this into a very strong company.
Jeff Kindler: Thank you. One more point on that Catherine, I think Bernard expressed it truly well, one of the major attractions and capabilities of Wyeth that contributes to the value or this transaction, we are very proud of our pharmaceutical sciences group both in small and large molecules, but we also appreciate the tremendous value and capability and scientific expertise that Wyeth has developed over many years. I mentioned their world-class facility in Castle Grange and as Bernard said, the ability to manufacture biotherapeutical products at scale. It is a very complicated and intensive process and the ability to do that is absolutely a competitive advantage and certainly we will be looking at whether or not to bring that advantage to bear on biosimilars as well as our branded products.
Operator: Your next question comes from David Lessinger of Bank of America.
David Lessinger: I actually have a number of questions; I will try to be quick though. First, can you discuss the necessity for the dividend cut in light of the much stronger 2012 cash flow outlook and earnings and specifically you have provided a target for 2012 earnings that I think is much higher than consensus expectations. Second, with respect to repatriation of XUS cash can you discuss the negative impact on earnings per share? Then third, I am not sure if it is possible, but I am hoping that you can discuss the interest rate on the debt that you expect to take on.
Frank D’Amelio: First, on the dividend cut, let’s look at that from a couple of perspectives. One is clearly to assist in the financing of the transaction. Two, is to redeploy capital. We have talked about total shareholders return as the focus of how we deploy capital. It is not just about paying the dividend, but also about redeploying some of that capital to get revenue and earnings expansion, price earnings multiple expansions, so clearly this is very consistent with what we have talked about before relative to shareholder return and redeploying capital opportunistically to get that. In terms of the re-pad impact on EPS think about that as the effective tax rate going from what was about 22% in 2008 to 30% in 2009 and that having a negative impact on 2009 earnings relative to 2008 of $0.21 which we called out in the bridge trounce that I used in the deck. Then on the interest rate, relative to the deal, it will be at market rates.
Operator: Your next question comes from Barbara Ryan of Deutsche Bank Securities.
Barbara Ryan: My question is a follow-on to David’s for you, Frank. I sort of came up with a pro forma of 243 in 2012 and probably the biggest unknown is what rate we should assume on the debt. So when you say a market rate, obviously this is a challenged market so we don’t have a lot of referenced transactions to look at. I am assuming that you have the lost interest income on the $22 billion in your own cash, which would be, in this environment, pretty de minimus maybe 2% and then assuming that the cost of the other $22 billion would be in the range of 75 to 9% I am just wondering if you can comment on where you see that range.
Frank D’Amelio: Yes, so without giving a specific rate, I think, once again, in market rates the numbers that you used I wouldn’t dispute. Then the other thing I would say is remember one of the things I called out on that 2012 chart, Barbara, is that we would be in a net cash position. I think it is important to note that we will be in a net cash position from 2012 which needs to be factored into your modeling on combination of interest expense, but also interest income.
Barbara Ryan: Right, so should we also assume that as the years go forward and you pay down big chunks, I mean of course we may have a changed interest rate environment, but that your rate may start out higher than it winds up in the end?
Frank D’Amelio: What I would say is, once again, it will depend on what is going on in the market and then it also depends on how much of the bridge facility we have remaining. So I think the short answer to that, for now, is market rates and I tried to guide you a little bit based on your comments.
Operator: Your next question comes from Anthony Butler of Barclays Capital.
Anthony Butler: Clearly you can drive some accretion with the combination of this transaction and that is great, but I am curious about couple of things. When you mention lower cost base and greater flexibility and you repeat that over and over again, I am just curious if today, given the past two years and the cost cutting initiatives that you have undertaken, if actually even today Pfizer is totally right sized. I ask this because if you think about the combination and the 15% cost reductions out of the combined operating expenses that seems relatively low to me, so I would like some additional color on that. I would have argued much higher. Then second, and it is more to Frank’s comment about total shareholder return and price earnings multiples, if you think longer term, even 2012 and beyond, given the consolidated large revenue base it strikes me as very difficult to see that growth coming from revenues. So, if you could incorporate some thoughts into revenue growth, is that even on the chart with respect to total shareholder return and expansion of key multiples?
Frank D’Amelio: On the 15%, that 15% was, I called it a combined company workforce number. If you think about it Wyeth has about 50,000 employees, slightly below that, we have about 80,000 employees, slightly above that and we were talking about 15% of that combined number which includes the 10% for the stand-alone Pfizer number which was the $2 billion net. And you have to realize, as you know, there will be synergies above and beyond workforce related savings. So that is the way to think about the 15%, it was really talking about the workforce. In terms of revenue, what we did is we put a target out there for 2012 that is comparable to 2008 and clearly we see a lot of opportunities for revenue growth. Quite frankly it is much like we have been talking about before as a leadership team, leveraging established products, leveraging emerging markets. We talked about complimentary space. We now have lots of that complimentary space as a result of this transaction with Wyeth. So it is the things we have talked about and, quite frankly, what it all comes down to is executing, which is what we are going to do.
Jeff Kindler: I would just add one qualitative comment to all of that. The business units that we have created and that will be enhanced by virtue of this transaction are in a position to really maximize revenues and identify the appropriate cost base that are in both cases appropriate to their business. And by empowering these business leaders, giving them clear accountability, we are really going to unleash their ability to find new sources of revenues, to grow their respective businesses, as well as to manage the cost base that is best for them, which may be different in different cases. So that is where I think there is a tremendous amount of dynamism in the way we are approaching running the business.
Operator: Your next question comes from Jami Rubin of Goldman Sachs.
Jami Rubin: My first question relates to the timing of the deal being closed. You said third to fourth quarter. I am wondering if you feel there is any upside to that and if you could comment on where you see potential issues with respect to FTC, any overlaps in the business. We don’t see much in the pharma business, but maybe there are in the animal health. Secondly, we were curious to know if Wyeth is allowed to pay their quarterly dividend up until the deal closes. My third question relates to opportunities going beyond just the $4 billion in cost savings. I am wondering if you can elaborate on whether or not there are any specific restrictions to spinning off assets to pay down debt.
Jeff Kindler: With regard to anti-trust, one of the many beautiful things about this deal is the companies are very, very complimentary and we are looking forward to working constructively with the anti-trust authorities to review any potential issues that may come down the pike. With regard to closing and the opportunities beyond the $4 billion and the possibilities of other dispositions of assets I will turn it over to Frank.
Frank D’Amelio: First Jami had asked a question about the Wyeth dividend. On the dividend the answer is that we expect current plans are for Wyeth to continue to pays its dividend. Then in terms of restrictions on assets, obviously once the deal closes there is no restriction on anything relative to asset sales, relative to between now and where we are collaboratively with Wyeth based on certain terms and conditions in the contract. As far as closing, we will close as quickly as we can.
Operator: Your next question comes from Roopesh Patel with UBS.
Roopesh Patel: Jeff, I was wondering if you could kindly address the risk the deal poses to R&D momentum and the steps the company plans to take to minimize this. Secondly, on revenue growth, the presentation states that 2012 revenues will be roughly the same as 2008. In light of several patent expirees that are scheduled in 2013, 2014 and 2015 I am curious if you expect any revenue growth even in those out years. Lastly, between now and the deal closing I am wondering whether Wyeth will continue with its cost cutting initiatives or whether, now that the deal is announced, that is on hold.
Jeff Kindler: I will make a couple of comments and then I will ask Frank, Martin and Bernard to add to them. With regard first to R&D we are obviously mindful that the research and development is the core innovation engine for our business. We have learned a lot from prior transactions as well as some of the other activities that we have undertaken the last couple of years. We intend to proceed with great speed and focus and we are very mindful of the importance of protecting that very, very important core of our business. Let me ask Martin Mackay, our head of R&D to elaborate a little bit about that and then I will come back to your other questions.
Martin Mackay: Just briefly to build on what Jeff said, I have been a long time admirer of the Wyeth R&D organization and a very long time admirer of Michael Dolsten the head of R&D. I have had the opportunity over the last period to speak with Michael and we both have very similar thoughts on productivity on the absolute necessity [inaudible] productivity. There are no acquisitions in the past to pull on our organization. I think we have learned from that lately so when this deal closes we will be able to launch an R&D organization, maintain our goals and commitments and I think really build up given the complementarily of both R& organizations.
Jeff Kindler: With regard to your question about post 2012 Roopesh, we really believe we are creating a company here with a wide range of diverse assets, investments in growth opportunities and the financial wherewithal to move the business forward. We are obviously very focused on the here and now and 2012, but this is a very long-term business and we believe this deal positions us extremely well for long-term shareholder value creation through this collection of businesses and their various opportunities in the future. I will ask Frank if he wants to add anything to that and then I will ask Bernard to comment on Wyeth’s cost cutting.
Frank D’Amelio: I think what I will do to punctuate Jeff’s comments on revenue growth, I will come back a little bit to what I talked on to Tony Butler about, maybe put a little bit more detail to that, then I will ask Greg Norden to comment on the cost question relative to Wyeth. Once again, I talked about opportunities we see, significant opportunities in emerging markets, established products and other parts of the industry. Let me just punctuate it with some numbers. If you look at Asia Pacific, if you take our Japan, New Zealand and Australia, the current market there review, addressable market, about $50 billion of which we have 4%; 4% on $50 billion is $2 billion. We see that market growing between now and 2012 from $50 billion to $80 billion. We believe we can not only maintain our share there, but grow our share to 6%. 4% on $80 billion is $3.2 billion. Just by holding share we pick up $1.2 billion. If we can pick up two points of share and go to 6% that is $4.8 billion versus today’s $2 billion, almost $3 billion of incremental growth. Our job is to execute on those opportunities, build a strong platform, get real strong momentum, get the number that we have targeted for 2012 and then build upon that momentum going forward into 2013 and beyond. That is what we plan on doing which is why I talked about we need to execute and we will execute. Greg, do you want to talk about the Wyeth cost reduction?
Gregory Norden: Yes, thanks Frank. As it relates to Wyeth I think what you have seen over the past couple of years and we see continuing into this year is very strong and disciplined financial management and we have been able to execute on our cost management strategies for quite some time. Between now and the time of closing we certainly have an obligation and a responsibility to continue to run our business as if we were going to remain independent. As such, we will continue to run this business the best we can and along the lines of the way we have in the past and that includes continuing with the cost containment initiatives that we started with project impact. We are going to continue that through 2009 is the answer to your question.
Operator: Your next question comes from Chris Schott of J.P. Morgan.
Chris Schott: First of all when you think about the debt you are taking on with this transaction, how aggressively should we think about Pfizer paying down that debt, I know you mentioned about 2012 net cash, but I am trying to get at here, tax rate is in the 30% in 2009, should we think of it up in that 30% range a couple of years after that? Then maybe when we look at 2012 and beyond should we think about the tax rate maybe coming back down to this low to mid 20% range? Then on the top line guidance for 2009, adjusting for currency it doesn’t seem like you’ve got much organic growth here. I would just be interested in your comments or thoughts overall on the impact the weakened economy is having on the pharma business as a whole as it relates to your business as well as Wyeth’s.
Frank D’Amelio: On the tax rate, we will be looking to pay down the debt, I will call it kind of in a consistent way going forward, which is why we said net cash by 2012. So in terms of your assumptions I would assume that 30% and I would keep it at roughly that level going forward for the next couple of years. That would be point one. In terms of the revenue guidance for ’09, we put a range out there of $44 to $46 and we said a $3 billion negative impact from foreign exchange. Just to run the numbers, if you added that $3 billion back, if foreign exchange was constant, $44 to $46 would be $47 to $49, mid point to that is roughly $48 which is pretty much what we printed this year. And we did, to your point, we did assume some negative impact of the macro economic environment on the guidance that we are providing for 2009.
Operator: Your next question comes from Tim Anderson - Sanford Bernstein
Tim Anderson: I have three questions. Jeff this transaction goes against what you described in March of ’08 which was that you would not likely do another big pharma deal. My question to you is what changed over the course of those ten months. My second question is whether at some point you might consider splitting up the combined company into something like truly separate, publicly traded entities? The third question is for Bernard. Can you talk about how Wyeth arrived at a $50.00 share as being fair value? I think a case could be made that it is a pretty low price given what the future prospects for Wyeth have looked like.
Jeff Kindler: As far as what I have said in the past, I have always been very clear that we never say never and we are open to every opportunity and I have identified the conditions that would have to prevail for us to undertake a transaction like this, including obviously the strategic value and our ability to manage the inevitable risks and disruptions that come from any large scale merger of that kind. We, as I said in my opening comments, are in a much stronger position than we were two years ago. In fact, I would have to say that we have gotten there faster than I might have even hoped and our confidence in our ability to execute on a transaction like this is very high, thanks to the hard work of our people. We have also very clearly laid out all of the strategic priorities that we had and I went through them earlier this morning. This is a very, very unique deal. I don’t think there is anything else that could have been done that would have more perfectly matched those strategic priorities, all achieved in a single transaction. So it is, for all of the reasons I said in the beginning, the right deal, at the right time and for the right reasons. As far as potential future considerations of the portfolio are concerned, what we are very excited about is that this transaction creates a very broad based, diversified portfolio of businesses that are complimentary with one another and I continue to believe that these various businesses benefit from the combination both of their own ability to maximize their opportunities, but at the same time take advantages of the scale and resources of the combined company.
Bernard Poussot: The answer to your question is this. The board of Wyeth obviously reviewed this question very, very thoroughly and evaluated exactly what this offer was at, this is our standard on prospects. I will just tell you that this transaction at Friday closing values for the Pfizer stock represented a $16 billion premium which in the current environment is not bad. 85% of the synergies created to Wyeth, I would remind you also that the deal is structured with 65% in cash and lastly the 35% component of the Pfizer stock offers, also, an ability to go up when the deal is understood and people realize the strengths of the combination. So between now and closing we will have adjusted for that.
Operator: Your next question comes from Seamus Fernandez of Leerink Swann.
Seamus Fernandez: Frank, I was hoping you could discuss the context of the $1 billion reinvestment that you mentioned would occur this year on the R&D side and in some of the other parts of the business. Then you mentioned the market share that Pfizer would hold in emerging markets and the growth you anticipate in those markets. Can you tell us what the combined share of the two companies would be? Then also, Frank, could you just clarify for us the combined cost reductions, as I read them, are $4 billion from the combination with Wyeth with an incremental $2 billion from the additional cost program that you envisioned for Pfizer itself, is that correct?
Frank D’Amelio: I will answer the last question first, then Ian you are going to talk about the reinvesting question, and then on the revenue growth question that I gave with the addressable markets, I think what we will do is just keep that to those Pfizer numbers only for now, unless Ian wants to add anything to that. The answer to your last question is yes. You take the $4 billion in synergies that we talked about from the combined company and you would add the $2 billion that we laid out from the stand-alone Pfizer. So the short answer to the last question is yes.
Ian Read: The reinvestment is to ensure we continue to drive the revenue the top line so it includes probably a portion into supporting the portfolio, progressing the Phase II and Phase III pipeline, which is very important to our 2012 and post revenue opportunities. It is building infrastructure as a field force in emerging markets that is in Turkey and in China and in Russia, Korea, and lastly building our offering of established products. As we widen our portfolio offering in these markets we should invest in ensuring we have supply and we have appropriate dossiers so to widen that offer.
Operator: Your next question comes from Steve Scala with Cowen and Company.
Steve Scala: Pfizer sold its consumer business a few years ago because it apparently did not make strategic sense. Why does the Wyeth OTC business make greater strategic sense or should we assume a similar fate? Second has an FTC review of the Lipitor patent settlement been finalized and if not Bernard, what analysis has Wyeth completed regarding the Lipitor patent settlement? It would appear to be a key variable in your ability to make 2012 targets. Lastly, Bernard when was your most recent update on the Bapineuzumab Phase III trial such as perhaps a DSMV update or some other knowledge of how things are progressing in Phase III.
Jeff Kindler: I will address the first question, then I will ask Amy Schulman our General Counsel to give you a Lipitor patent update and then I will turn it over the Bernard for the questions you have asked him. On the consumer business a decision was made at the time based on the view that prevailed at that time. Where we are today is I think this is a terrific business and one that is very complimentary with our portfolio and one that we believe creates tremendous opportunities for increased shareholder value. Amy, if I could ask you to give Steve an update on the Lipitor patent situation.
Amy Schulman: We are very comfortable with the FTC’s review of the Lipitor patent situation and as the course of the diligence both Wyeth and we went for each others products and various issues at some length and both of us were comfortable with what we found. The FTC review is completed, they have not yet issued a decision.
Bernard Poussot: On the Bapineuzumab question, first of all we do not commence on DSMB reviews. Regarding the ongoing Phase III program I can tell you that they are advancing. In most cases we have resumed activities XUS. In most countries a couple of situations still need to be addressed, but we are confident that within weeks we will be back in full gear in those countries, I mean the North American portion is progressing accordingly, so we are pleased and continue to hope for the original timing that we had for Bapineuzumab.
Operator: Your last question comes from Robert Hazlett of BMO Capital Markets.
Robert Hazlett: My question is specific to the Alzheimer’s therapeutic area and the pipeline compounds. Jeff clearly Pfizer has an effort there with multiple compounds, multiple licenses, as well as the monoclonal antibodies as does Wyeth. Do you expect there to be a divestiture in this area of one of the monoclonal anti-A beta monoclonal antibodies from the pipeline?
Jeff Kindler: Let me start by saying that you are right to point out that both companies have invested a great deal into this very, very important area of critical unmet medical need and both have very exciting programs which we believe are very complimentary of one another. We do not anticipate any issues along the lines you are talking about. We actually think these two efforts put together will be very complimentary and most importantly give us the opportunity to really see if we can’t address this very serious unmet medical need. I think that concludes the time we have available. I appreciate everybody listening in today. Thank you and have a great day. | [
{
"speaker": "Operator",
"text": "Good morning ladies and gentlemen and welcome to Quarter Earnings Release Conference Call. (Operator Instructions). I would now like to turn the call over to Mr. Charles Triano Pfizer’s Senior Vice President of Investor Relations."
},
{
"speaker": "Charles Triano",
"text": "Good morning everyone. Thank you for joining us today to discuss today’s announcement that Pfizer has entered into an agreement to acquire Wyeth. I am here with our Chairman and Chief Executive Officer Jeff Kindler. The presentation that accompanies today’s call can be viewed on pfizer.com. This call is scheduled to last one hour and I would also add that today’s call is in lieu of our earnings conference call that was originally scheduled for this Wednesday. Discussions during this conference call will include certain financial measures that were not prepared in accordance with US Generally Accepted Accounting Principles. Reconciliation of those non-US GAAP financial measures to the most directly comparable US GAAP financial measures can be found in Pfizer’s current report on Form 8-K dated January 26, 2009. Discussions during this conference call will also include forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. The factors that could cause actual results to differ are discussed in Pfizer’s 2007 annual report on Form 10-K and in our reports on Form 10-Q and Form 8-K. These reports are available at our website www.pfizer.com in the Investor SEC Filing section. With that I would like to turn the call over to Jeff Kindler."
},
{
"speaker": "Jeff Kindler",
"text": "Thank you, Chuck good morning everyone, and thank you for joining us today. I am here with members of Pfizer’s senior management and we are also very honored this morning to be joined by Bernard Poussot, Chairman and Chief Executive of Wyeth. With Bernard are three members of his senior management team, Greg Norden, Chief Financial Officer; Larry Stein, General Counsel; and Justin Victoria, Vice President of Investor Relations. We are very excited about today’s announcement that Pfizer and Wyeth will combine to become the world’s premier biopharmaceutical company. I know that Bernard shares my enthusiasm for this combination and for the opportunities it will create for patients today, for patients tomorrow and for patients around the world, so I would like to begin by asking Bernard to share his thoughts with you. Bernard?"
},
{
"speaker": "Bernard Poussot",
"text": "Thank you very much Jeff and good morning everyone. I appreciate the invitation to comment on the value that Wyeth will bring to this great company in the making. Our vision at Wyeth for about 20 years has been to establish a very strong foundation in science, focus on providing new solutions to patients and their families. As a result, we have created over the years what is today a global biopharmaceutical company with striking diversity. We established ranks in biotechnology and vaccines when others were just recognizing recently this highly desirable, strategic, objective. Our execution has been relentless about building what I just described. We created diverse business platforms ranging from pharmaceuticals, biopharma, vaccines, but also nutritionals, consumer health care and more. Today, at the end of 2008, 60% of our revenues are from no traditional pharmaceuticals. We have built industry leading biotechnology and vaccine manufacturing capacity and capabilities. As a result, we established a diverse business sector leadership. Biopharma Enbrel has become now the number one biologic product in the world. The vaccine Prevnar is today’s largest selling vaccine in the world. At the same time we established pharmaceuticals block busters such as Effexor and Zosyn which are both number one in their categories. We are also a strong nutritional franchise and we are number one in markets where we compete. Consumer health is an important piece of our business with brands like Advil, Centrum, and Robitussin. In the name of health we have been a key provider on biologics and vaccines for animals. There are many opportunities remaining in those key franchises. Just to name a few, in the field of rheumatoid arthritis and the psoriasis market, where we are leading with Enbrel we expect a $10 billion expansion between now and 2012. The fever vaccines we are preparing our Prevnar products not only for infants, there is also a totally new indication in adults. Even in consumer health we have been adding the Thermacare acquisition to our consumer pain franchise led by Advil. We are also pleased to add a diverse portfolio of innovative new products. Tygacil, Torisel, Pristiq, Xyntha, and Relistor are all recent new product pools and we are still in the process of launching those products worldwide. Collectively they offer a multi-billion dollar peak potential. I just want to finish highlighting prevention as a key driver in our view to manage rising healthcare costs. Nothing is more efficient than prevention to do this. We have built that key business over the years, which Prevnar, as I mentioned and we are working actively on a meningitis additional vaccine that could prove instrumental to children around the world. We are doing the same in animals in providing the world with the first vaccines in West Nile virus, but also H5N3 against avian flu. So we are very concerned about safe guarding the food chain also, as nutrition is also the ultimate form of prevention. Along the same lines vitamins and supplements in our consumer division with Centrum and Caltrate also offer chances to people to manage their health better. Lastly, our infant formula business is a benefit also, quality food at a very critical age, which is another form of prevention. I think we have done all of this in fostering a culture of science first at Wyeth. We have actually encouraged our scientists to go for the stars and look for diseases that are very difficult to fight. Such an example is Alzheimer’s our approach has an unprecedented size and diversity of approaches ranging from biotechnology small molecule or even vaccine to fight this terrible disease, but I could also mention cancer, meningitis, as I said, pneumonia a number of significant problems. So that is what are scientists have been doing and building and I am very proud to present their good work. At Wyeth we have said that our scientists are our strategic planners and they should be the ones leading the direction of the company. So not surprisingly, Jeff and Pfizer realized what we had built over the years and I am very proud to acknowledge here what people have been building patiently year after year. We believe that we have now reached a level which is structured in such a way that our board and our shareholders will find it very attractive. Thank you."
},
{
"speaker": "Jeff Kindler",
"text": "Thank you, Bernard. That is a terrific summary of the great work that you and your leadership team at Wyeth have done in building a great company. What I am going to do now is to talk a little bit about the transaction from my perspective, then I will turn it over to Frank who will give a brief overview of our fourth quarter results and then we will have a financial overview of the transaction for Frank together with our targets for the combined company and then we will turn to your questions. So, this acquisition comes after months of careful consideration. As we reviewed literally hundreds of strategic options, it became clear that the acquisition of Wyeth would most meaningfully advance our strategic priorities. As we told you in the past these priorities include enhancing our in line and pipeline patent protected portfolio in key invest to win disease areas, areas where there are significant unmet medical needs and where we believe we can help address those needs; becoming a top tier player in biotherapeutics and vaccines; accelerating our growth in emerging markets; creating new opportunities for established products; investing in complimentary businesses and establishing a lower, more flexible cost base. In one single step this acquisition advances each and every one of those strategies that we have put forward. Combing with Wyeth will extend our global healthcare leadership, clearly establishing Pfizer as a leader in human health, animal health, consumer health, and nutritionals as the number one company in primary care and the number two company in specialty care, as a top tier player in biotherapeutics and vaccines and as the company with unrivaled geographic reach. The operational discipline that we have been shaping at Pfizer for more than two years will drive this diverse product base forward and produce ever-improving performance. Our unique model combining the speed and agility of our smaller, more focused business units, with the scale and resources of a global enterprise will enable us to seize new opportunities in markets around the world while maintaining clear accountability for each P&L. Investors will be pleased to know that this deal definitively addresses the revenue loss from Lipitor’s loss of exclusivity. The combined company will solidify Pfizer’s ability to deliver consistent and stable earnings growth and strong operating cash flow and it will bring us many new points of product entry across the world to better serve patients, physicians, and customers. Finally and fundamentally this deal will significantly enhance the ability of our world-class people to advance our core mission, applying innovative science to improve world health. The reason why we are able today to seize the unique opportunity created by this combination is because of all the hard work that the people at Pfizer have done over the last two years to strengthen our company. Frankly, until we improve the leadership structure and culture of this company and establish the critical importance of accountability, discipline and meeting our commitments, we simply weren’t prepared to move forward in this way. And, while the job is never done, we have made so much progress over the last two years that we are now highly confident that we can successfully integrate and operate the great company that this combination will produce. Let me just take a moment to summarize how we have strengthened the foundation of this company. First, we assembled a world-class leadership team from inside and outside of Pfizer. Second, we set out to establish a lower and more flexible cost base. Just two years ago this week, we said we would reduce our cost base by between $1.5 and $2 billion on a constant currency basis by the end of 2008. This morning we reported that we have substantially exceeded that goal. Over that two year time period we reduced our total adjusted cost base by $2.8 billion. The difficult, painful, but very necessary work that had to be done to achieve that included, among other things, reducing headcount by approximately 16,000 employees, eliminating unnecessary layers of bureaucracy, refocusing the work in our R&D labs to high priority disease areas and optimizing our manufacturing network by closing 15 manufacturing sites. As a result of these and other actions we are now a much leaner, more agile organization than we were just two years ago. Third, we revamped our research enterprise, narrowing our focus on those disease areas with significant unmet medical needs in which we believe we can make a difference; establishing therapeutic research organizations led by world-class chief scientific officer; creating the unique biotherapeutics and bioinnovation center and aggressively seeking new science and technology from the world outside our labs. Fourth, we established distinct business units, each focused on a different customer segment; each with a clearly accountable leader; and each with responsibility for everything from deciding which compounds with proofs of concept warrant the significant investment required to develop them, all the way to how to maximize the opportunities for products that have lost exclusivity. Finally, while again, this work is never done, I believe we have meaningfully changed our culture to one that is financially disciplined and focused on clear accountability for results. These changes and others put us in a very strong position from which we can successfully seize the unique opportunity presented by combining Wyeth and Pfizer, and Wyeth is without doubt, the perfect partner for Pfizer. With this transaction we will be on our way to becoming the third largest biotherapeutics company in the world. Enbrel is the worlds leading biologic. Along with it comes a robust pipeline of biopharmaceutical candidates as well as Wyeth’s world-class pharmaceuticals science capabilities and its high-quality and high-volume manufacturing plants, including the one in Grange Castle, Ireland, the largest integrated biotechnology manufacturing facility in the world. The Wyeth combination also allows us to enter the growing vaccines market in a powerful position. We will have the fourth largest vaccines business globally and our portfolio will include Prevnar, the largest vaccine in the world. This deal will also expand our in line and pipeline portfolio in many of they key disease areas that we have identified as ones in which we want to invest to win. It will also support our expansion in emerging markets and our established products business and it will add complimentary businesses in nutritionals and consumer health as well as strengthening our animal health business. Now this transaction also meaningfully diversifies our therapeutics offerings and platforms. Within human health it decreases our reliance on primary care medicines and creates the number two specialty company. By 2012 the proportion of our revenue that comes from primary care products will decrease by approximately a full 20% to just over half of revenues and we expect no drug will account for more than 10% of the combined company’s revenue. As I noted, this acquisition further diversifies the company by strengthening our position in the attractive biologics and vaccine spaces. As you see on this slide, this diversification creates a more desirable balance in our portfolio reducing small molecule dependence from 90% to 70% by 2012. On their own, Pfizer and Wyeth both have strong pipelines, but bringing them together creates a single pipeline that’s larger and more diverse with world-class technology platforms and a talent pool of scientists that is best in class. Such a broad pipeline requires expensive investments in multiple platform technologies. Bringing the pipelines of these two companies together will enable us to realize their potential more fully than if they remained separate. As an example, Wyeth’s expertise in commercial and medical immunology, particularly across rheumatology and dermatology, will help advance development of our JAK3 inhibitor. In addition, we will be able to apply Pfizer’s commercial scale and clinical developing capability to Wyeth’s products and registration, Phase III and Phase II and our patient marketing expertise will help maximize the global potential of the Prevnar vaccine. Now this slide shows the impressive industry rankings that the combined company will have in many of the fastest growing therapeutic areas. With this acquisition we remain the leader in primary care, of course, we will also advance our CNS infectious disease and specialty franchises to become number two in those important areas and, as I have noted, we will bolster our leading position in animal health as well. Geographically the companies combined global footprint will be unrivaled. Going forward we will lead the pharmaceutical markets of the United States, Europe, Latin America, Japan and the rest of Asia. In addition, we will have leading market share positions in important growth areas such as Brazil, Russian, India and China. We see continued upside in emerging markets and we expect that to come from, among many other things, applying Pfizer’s commercial presence to Wyeth’s portfolio, particularly Enbrel, Prevnar, and Wyeth’s well-known and well-regarded nutritionals. In the context of a fast changing global healthcare environment, the new company will be a well balanced biopharmaceutical enterprise made up of diverse businesses with the scale, breadth, and reach to deliver healthcare solutions and address the needs of patients, physicians, and other customers around the world. Before Frank discusses the numbers I would like to emphasize one last point about the structural benefits of the new organization and some of the reasons why we believe we are positioned to successfully and quickly integrate the company and move forward. Now as a $70 billion global company, clearly we will be an enterprise with significant scale and resources and real relevance to payers and patients. This gives us great competitive advantages. We will have the ability to benefit from the fixed costs of research, commercialization, and manufacturing and enable important platform investments while also maintaining financial flexibility. At the same time, we know that a company that is that large cannot be managed in a centralized, monolithic way and that is why we remain committed to our operating model of focused, agile, patient centric business units. This model provides us clear accountability for performance. The world-class leaders of these businesses can manage their businesses to achieve the greatest return while taking advantage of the benefits of the global enterprise. We will continue to promote an entrepreneurial culture and the ability to harness scale where it is a competitive advantage for the business. With that I will turn the call over to Frank to review the fourth quarter results, our 2009 guidance and the terms and details of this transaction. Frank?"
},
{
"speaker": "Frank D’Amelio",
"text": "Thank you, Jeff. I want to start by saying how pleased I am to talk to you today about what we believe is a great opportunity for both Pfizer and for Wyeth. The potential for the combination of our companies is greater than each company could have achieved on its own. With that, let me briefly review our fourth quarter 2008 results before we review the transaction. We delivered solid results in 2008, achieving our key financial metrics including exceeding our cost reduction target in the face of a very challenging global economy. Reported revenues were $12.3 billion, a year-over-year decrease of 4% driven by the negative impact of the loss of US exclusivity of Zyrtec and Camptosar and the loss of exclusivity for Norvasc in Korea and Japan whose collective fourth quarter revenue decreased year-over-year by $515 million; foreign exchange which decreased revenues by approximately $380 million or 3% which were partially offset by the solid performance of key products. Reported net income was $266 million for the quarter compared with $2.7 billion in the year ago quarter, reported diluted EPS was $0.04 versus $0.40. These significant year-over-year decreases were primarily driven by a $2.3 billion pre-tax and after-tax charge resulting from an agreement in principle to resolve previously disclosed investigations regarding allegations of past off-label promotional practices concerning Bextra as well as other open investigations. And, to a lesser extent are the $1.2 billion pre tax increase or restructuring implementation charges related to cost reduction initiatives as well as the increased effective tax rate which were partially offset by savings resulting from cost reduction initiatives. Adjusted revenues were $12.3 billion, a 4% decrease year-over-year, driven by the unfavorable impact of the loss of the exclusivity of Norvasc, Zyrtec and Camptosar and foreign exchange which, once again, partially offset the solid performance of key products. Adjusted income increased 29% year-over-year to $4.4 billion and adjusted, diluted EPS increased 30% to $0.65, both of which benefited from savings associate with our cost reduction initiatives which were partially offset by an increase in the effective tax rate. As you can see, we achieved essentially all elements of our full year guidance with the exception of reported, diluted EPS which includes the negative impact of the previously mentioned litigation related matters. We achieved our adjusted revenue and adjusted diluted EPS guidance and we exceeded our adjusted total cost target, adjusted cost of sales, adjusted cost of sales, adjusted SI&A and adjusted, diluted EPS targets. We also expect to achieve cash flows from operations within our estimated range of $17 to $18 billion. Looking to 2009 we expect, on the top line, annual revenues in the range of $44 to $46 billion which assumes a $3 billion year-over-year reduction versus 2008 directly related to the strengthening of the US dollar. On the bottom line adjusted diluted EPS in the range of $185 to $195. It is important to note that this guidance includes a $1 billion reinvestment in key, high-growth areas of our business including later-stage research and development programs, emerging markets, and established product strategies. Now I would like to provide a bridge from ’08 actual to 2009 guidance. We expect ’09 adjusted diluted EPS to be negatively impacted by approximately $0.21 due to the expected $3 billion year-over-year revenue decline related to foreign exchange; $0.21 related to increasing the effective tax rate to 30% reflecting financial strategies in connection with the proposed acquisition of Wyeth; $0.04 due to increased pension expenses and $0.04 resulting from a decrease in interest income. All of these factors translate into a negative impact of roughly $0.50 on 2009 adjusted diluted EPS versus 2008. Now, under the terms of the agreement Pfizer is acquiring all of Wyeth’s outstanding common shares at a current value of about $50.00 per share. Wyeth’s shareowners will receive $33.00 per share in cash, plus a current value of approximately $17.00 per share of Pfizer’s stock based on a fixed exchange ratio of 0.985. The transaction will be funded through a combination of cash, debt, and equity. Upon completion, Pfizer shareowners will own approximately 84% in stock in the combined company and Wyeth shareowners will own 16%. We anticipate the transaction to be accretive within the second full year following the close which we expect to occur at the end of the third quarter or during the fourth quarter of 2009. The resulting transaction is currently valued at approximately $68 billion. As I mentioned, the sources of funding for the transaction include $22.5 billion in cash, $22.5 billion of debt and about $23 billion in Pfizer’s stock. We have received commitments for debt financing from a syndicate of five banks. Based on recent discussions with rating agencies, wherein we have reviewed this transaction, we expect to receive the following ratings: A Moody’s rating of A1 stable long term and P1 affirmed short term and an S&P rating of AA stable long term and A1+ confirmed short term. Given the amount of cash and debt being used to fund this transaction, beginning in the second quarter we are reducing our quarterly dividend to $0.16 per share which continues to be competitive [inaudible] years. As part of this transaction we expect to realize about $4 billion in synergies. It is important to note that the $4 billion in synergies is incremental to the $400 million already achieved by Wyeth, $2.8 billion of savings that Pfizer achieved at the end of ’08 under our previous cost reduction initiative and in addition to the $2 billion of anticipated net savings from our new cost reduction initiative announced today. We anticipate achieving 50% of these synergies within the first 12 months after the close, 75% within the first 24 months and the full benefit of the synergies in the first 36 months. We expect about half of these synergies to come from SI&A with the remaining from R&D and manufacturing resulting from a variety of activities which include the consolidation of support functions; implementing a global procurement structure; achieving economies of scale; rationalizing our global network of plants; and using a single platform for core research, among other things. As a result of these actions we expect to reduce the combined companies’ global workforce by approximately 15%. This reduction includes the 10% reduction to Pfizer’s workforce associated with its new cost reduction initiative. Now I would like to move on to our 2012 financial targets which are based on our current long-range forecast. Please note that these are to be subject to changes as a result of potential material negative impacts related to foreign exchange fluctuations, macro economic volatility, industry specific challenges, and changes to government healthcare policy, among other things. We expect the revenue level of the combined company to be comparable with our pro forma 2008 revenue level of approximately $70 billion. By managing our mix of business and the total cost structure of the company, we expect overall operating margins in the high 30s to low 40s percentage range which we believe appropriately aligns with our expected revenue levels. We anticipate adjusted diluted EPS to be roughly the same as Pfizer’s 2008 level of $242 per share. We also expect our operating cash flow to be in the low $20 billions and we expect that in 2012 the combined company will be in a net cash position. As you can see, the combination of Pfizer and Wyeth clearly addresses the revenue decline resulting from the loss of exclusivity of both Lipitor and Effexor. Now I will turn it back to Jeff."
},
{
"speaker": "Jeff Kindler",
"text": "Thanks so much, Frank. We will turn to your questions in a moment, first let me just sum up. This is the right transaction at the right time for both Pfizer and for Wyeth and we are entering into it for the right reasons, to create value for shareholders, customers, and patients today, patients tomorrow and patients everywhere. Going forward we will have a greater ability to maximize our product portfolio while having the resources to invest in break through science and valuable therapeutic areas. A versified revenue base will better position the company for long-term growth. We will continue to operate with business units empowered to meet the needs of specific customers and able to benefit from the scale of an even stronger global organization. Te new combined company is one with a broader portfolio; a stronger pipeline of innovative new products; more opportunities for growth, and an ability to offer patients a range of treatments for every stage of life. By joining together with Wyeth, Pfizer is creating the world’s premier biopharmaceutical company and we are excited about the opportunities to come. So, let’s turn to your questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Catherine Arnold of Credit Suisse."
},
{
"speaker": "Catherine Arnold",
"text": "I wanted to ask you about the leadership of the combined company. I think the press is reporting that Bernard will not be staying with the company? I don’t think that was addressed in your comments. I also wonder if you can talk about how you plan to integrate the expertise of Wyeth into the new Pfizer organization to prevent exodus of key employees, because it is obviously key to the integration. Then I wondered if you could comment on biosimilars? Will this accelerate your ability to pursue biosimilars new strategy and is that one of the arguments for the deal?"
},
{
"speaker": "Jeff Kindler",
"text": "Bernard and I have gotten to know each other quite well, as you can imagine. I have enormous respect for his experience and talents and skills. We share similar values and similar views about where our healthcare environment is going and what we need to do, as a company and I have been very gratified that he has agreed, after the closing, to continue to work with us, to ensure a smooth transition, and to see where we go from there. Obviously he is running Wyeth until the closing, but we are very grateful that he has agreed to stay on. With regard to the rest of the management at Wyeth and the tremendously talented group of people there both in leadership and across the company, we are very excited about looking for the right opportunities for people. You are absolutely right that we have to focus on retention. We are not just buying assets and buildings and compounds, we are building an enterprise that was created by people, great people that have done a fabulous job creating a great company, and we are very mindful of that. I will let Bernard elaborate on those two points maybe and then I will go to your question about biosimilars."
},
{
"speaker": "Bernard Poussot",
"text": "Yes, Catherine, my commitment is certainly to run Wyeth and present Wyeth the closing and the best possible conditions, you can count on that, number one. Second I will dedicate a lot of my time and energy to work through the combination and make sure that Pfizer builds a very strong team. It is all about the talents that drive these businesses. It is not just products or assets it is the people. Of course I have observed that many, many times in the past. As far as my own role I think I will do that and I will have some time with Jeff to discuss what could happen after that. In terms of biotechnology it is definitely an apparent sometimes more than a science. We have seen that not only from the research side, but also from the manufacturing side that the product is a process in this area and that is very different from small molecules. I think we have lined up some unbelievable talents, Ph.D.s, engineers, who design state of the art manufacturing sites who can do things that not even some of our peers can. I mean the Genentech came to us to a septin two years ago. That tells you about the kind of technology and know-how we have so we would be very happy to make sure that Jeff and his team see the pattern that we have brought and help to build this into a very strong company."
},
{
"speaker": "Jeff Kindler",
"text": "Thank you. One more point on that Catherine, I think Bernard expressed it truly well, one of the major attractions and capabilities of Wyeth that contributes to the value or this transaction, we are very proud of our pharmaceutical sciences group both in small and large molecules, but we also appreciate the tremendous value and capability and scientific expertise that Wyeth has developed over many years. I mentioned their world-class facility in Castle Grange and as Bernard said, the ability to manufacture biotherapeutical products at scale. It is a very complicated and intensive process and the ability to do that is absolutely a competitive advantage and certainly we will be looking at whether or not to bring that advantage to bear on biosimilars as well as our branded products."
},
{
"speaker": "Operator",
"text": "Your next question comes from David Lessinger of Bank of America."
},
{
"speaker": "David Lessinger",
"text": "I actually have a number of questions; I will try to be quick though. First, can you discuss the necessity for the dividend cut in light of the much stronger 2012 cash flow outlook and earnings and specifically you have provided a target for 2012 earnings that I think is much higher than consensus expectations. Second, with respect to repatriation of XUS cash can you discuss the negative impact on earnings per share? Then third, I am not sure if it is possible, but I am hoping that you can discuss the interest rate on the debt that you expect to take on."
},
{
"speaker": "Frank D’Amelio",
"text": "First, on the dividend cut, let’s look at that from a couple of perspectives. One is clearly to assist in the financing of the transaction. Two, is to redeploy capital. We have talked about total shareholders return as the focus of how we deploy capital. It is not just about paying the dividend, but also about redeploying some of that capital to get revenue and earnings expansion, price earnings multiple expansions, so clearly this is very consistent with what we have talked about before relative to shareholder return and redeploying capital opportunistically to get that. In terms of the re-pad impact on EPS think about that as the effective tax rate going from what was about 22% in 2008 to 30% in 2009 and that having a negative impact on 2009 earnings relative to 2008 of $0.21 which we called out in the bridge trounce that I used in the deck. Then on the interest rate, relative to the deal, it will be at market rates."
},
{
"speaker": "Operator",
"text": "Your next question comes from Barbara Ryan of Deutsche Bank Securities."
},
{
"speaker": "Barbara Ryan",
"text": "My question is a follow-on to David’s for you, Frank. I sort of came up with a pro forma of 243 in 2012 and probably the biggest unknown is what rate we should assume on the debt. So when you say a market rate, obviously this is a challenged market so we don’t have a lot of referenced transactions to look at. I am assuming that you have the lost interest income on the $22 billion in your own cash, which would be, in this environment, pretty de minimus maybe 2% and then assuming that the cost of the other $22 billion would be in the range of 75 to 9% I am just wondering if you can comment on where you see that range."
},
{
"speaker": "Frank D’Amelio",
"text": "Yes, so without giving a specific rate, I think, once again, in market rates the numbers that you used I wouldn’t dispute. Then the other thing I would say is remember one of the things I called out on that 2012 chart, Barbara, is that we would be in a net cash position. I think it is important to note that we will be in a net cash position from 2012 which needs to be factored into your modeling on combination of interest expense, but also interest income."
},
{
"speaker": "Barbara Ryan",
"text": "Right, so should we also assume that as the years go forward and you pay down big chunks, I mean of course we may have a changed interest rate environment, but that your rate may start out higher than it winds up in the end?"
},
{
"speaker": "Frank D’Amelio",
"text": "What I would say is, once again, it will depend on what is going on in the market and then it also depends on how much of the bridge facility we have remaining. So I think the short answer to that, for now, is market rates and I tried to guide you a little bit based on your comments."
},
{
"speaker": "Operator",
"text": "Your next question comes from Anthony Butler of Barclays Capital."
},
{
"speaker": "Anthony Butler",
"text": "Clearly you can drive some accretion with the combination of this transaction and that is great, but I am curious about couple of things. When you mention lower cost base and greater flexibility and you repeat that over and over again, I am just curious if today, given the past two years and the cost cutting initiatives that you have undertaken, if actually even today Pfizer is totally right sized. I ask this because if you think about the combination and the 15% cost reductions out of the combined operating expenses that seems relatively low to me, so I would like some additional color on that. I would have argued much higher. Then second, and it is more to Frank’s comment about total shareholder return and price earnings multiples, if you think longer term, even 2012 and beyond, given the consolidated large revenue base it strikes me as very difficult to see that growth coming from revenues. So, if you could incorporate some thoughts into revenue growth, is that even on the chart with respect to total shareholder return and expansion of key multiples?"
},
{
"speaker": "Frank D’Amelio",
"text": "On the 15%, that 15% was, I called it a combined company workforce number. If you think about it Wyeth has about 50,000 employees, slightly below that, we have about 80,000 employees, slightly above that and we were talking about 15% of that combined number which includes the 10% for the stand-alone Pfizer number which was the $2 billion net. And you have to realize, as you know, there will be synergies above and beyond workforce related savings. So that is the way to think about the 15%, it was really talking about the workforce. In terms of revenue, what we did is we put a target out there for 2012 that is comparable to 2008 and clearly we see a lot of opportunities for revenue growth. Quite frankly it is much like we have been talking about before as a leadership team, leveraging established products, leveraging emerging markets. We talked about complimentary space. We now have lots of that complimentary space as a result of this transaction with Wyeth. So it is the things we have talked about and, quite frankly, what it all comes down to is executing, which is what we are going to do."
},
{
"speaker": "Jeff Kindler",
"text": "I would just add one qualitative comment to all of that. The business units that we have created and that will be enhanced by virtue of this transaction are in a position to really maximize revenues and identify the appropriate cost base that are in both cases appropriate to their business. And by empowering these business leaders, giving them clear accountability, we are really going to unleash their ability to find new sources of revenues, to grow their respective businesses, as well as to manage the cost base that is best for them, which may be different in different cases. So that is where I think there is a tremendous amount of dynamism in the way we are approaching running the business."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jami Rubin of Goldman Sachs."
},
{
"speaker": "Jami Rubin",
"text": "My first question relates to the timing of the deal being closed. You said third to fourth quarter. I am wondering if you feel there is any upside to that and if you could comment on where you see potential issues with respect to FTC, any overlaps in the business. We don’t see much in the pharma business, but maybe there are in the animal health. Secondly, we were curious to know if Wyeth is allowed to pay their quarterly dividend up until the deal closes. My third question relates to opportunities going beyond just the $4 billion in cost savings. I am wondering if you can elaborate on whether or not there are any specific restrictions to spinning off assets to pay down debt."
},
{
"speaker": "Jeff Kindler",
"text": "With regard to anti-trust, one of the many beautiful things about this deal is the companies are very, very complimentary and we are looking forward to working constructively with the anti-trust authorities to review any potential issues that may come down the pike. With regard to closing and the opportunities beyond the $4 billion and the possibilities of other dispositions of assets I will turn it over to Frank."
},
{
"speaker": "Frank D’Amelio",
"text": "First Jami had asked a question about the Wyeth dividend. On the dividend the answer is that we expect current plans are for Wyeth to continue to pays its dividend. Then in terms of restrictions on assets, obviously once the deal closes there is no restriction on anything relative to asset sales, relative to between now and where we are collaboratively with Wyeth based on certain terms and conditions in the contract. As far as closing, we will close as quickly as we can."
},
{
"speaker": "Operator",
"text": "Your next question comes from Roopesh Patel with UBS."
},
{
"speaker": "Roopesh Patel",
"text": "Jeff, I was wondering if you could kindly address the risk the deal poses to R&D momentum and the steps the company plans to take to minimize this. Secondly, on revenue growth, the presentation states that 2012 revenues will be roughly the same as 2008. In light of several patent expirees that are scheduled in 2013, 2014 and 2015 I am curious if you expect any revenue growth even in those out years. Lastly, between now and the deal closing I am wondering whether Wyeth will continue with its cost cutting initiatives or whether, now that the deal is announced, that is on hold."
},
{
"speaker": "Jeff Kindler",
"text": "I will make a couple of comments and then I will ask Frank, Martin and Bernard to add to them. With regard first to R&D we are obviously mindful that the research and development is the core innovation engine for our business. We have learned a lot from prior transactions as well as some of the other activities that we have undertaken the last couple of years. We intend to proceed with great speed and focus and we are very mindful of the importance of protecting that very, very important core of our business. Let me ask Martin Mackay, our head of R&D to elaborate a little bit about that and then I will come back to your other questions."
},
{
"speaker": "Martin Mackay",
"text": "Just briefly to build on what Jeff said, I have been a long time admirer of the Wyeth R&D organization and a very long time admirer of Michael Dolsten the head of R&D. I have had the opportunity over the last period to speak with Michael and we both have very similar thoughts on productivity on the absolute necessity [inaudible] productivity. There are no acquisitions in the past to pull on our organization. I think we have learned from that lately so when this deal closes we will be able to launch an R&D organization, maintain our goals and commitments and I think really build up given the complementarily of both R& organizations."
},
{
"speaker": "Jeff Kindler",
"text": "With regard to your question about post 2012 Roopesh, we really believe we are creating a company here with a wide range of diverse assets, investments in growth opportunities and the financial wherewithal to move the business forward. We are obviously very focused on the here and now and 2012, but this is a very long-term business and we believe this deal positions us extremely well for long-term shareholder value creation through this collection of businesses and their various opportunities in the future. I will ask Frank if he wants to add anything to that and then I will ask Bernard to comment on Wyeth’s cost cutting."
},
{
"speaker": "Frank D’Amelio",
"text": "I think what I will do to punctuate Jeff’s comments on revenue growth, I will come back a little bit to what I talked on to Tony Butler about, maybe put a little bit more detail to that, then I will ask Greg Norden to comment on the cost question relative to Wyeth. Once again, I talked about opportunities we see, significant opportunities in emerging markets, established products and other parts of the industry. Let me just punctuate it with some numbers. If you look at Asia Pacific, if you take our Japan, New Zealand and Australia, the current market there review, addressable market, about $50 billion of which we have 4%; 4% on $50 billion is $2 billion. We see that market growing between now and 2012 from $50 billion to $80 billion. We believe we can not only maintain our share there, but grow our share to 6%. 4% on $80 billion is $3.2 billion. Just by holding share we pick up $1.2 billion. If we can pick up two points of share and go to 6% that is $4.8 billion versus today’s $2 billion, almost $3 billion of incremental growth. Our job is to execute on those opportunities, build a strong platform, get real strong momentum, get the number that we have targeted for 2012 and then build upon that momentum going forward into 2013 and beyond. That is what we plan on doing which is why I talked about we need to execute and we will execute. Greg, do you want to talk about the Wyeth cost reduction?"
},
{
"speaker": "Gregory Norden",
"text": "Yes, thanks Frank. As it relates to Wyeth I think what you have seen over the past couple of years and we see continuing into this year is very strong and disciplined financial management and we have been able to execute on our cost management strategies for quite some time. Between now and the time of closing we certainly have an obligation and a responsibility to continue to run our business as if we were going to remain independent. As such, we will continue to run this business the best we can and along the lines of the way we have in the past and that includes continuing with the cost containment initiatives that we started with project impact. We are going to continue that through 2009 is the answer to your question."
},
{
"speaker": "Operator",
"text": "Your next question comes from Chris Schott of J.P. Morgan."
},
{
"speaker": "Chris Schott",
"text": "First of all when you think about the debt you are taking on with this transaction, how aggressively should we think about Pfizer paying down that debt, I know you mentioned about 2012 net cash, but I am trying to get at here, tax rate is in the 30% in 2009, should we think of it up in that 30% range a couple of years after that? Then maybe when we look at 2012 and beyond should we think about the tax rate maybe coming back down to this low to mid 20% range? Then on the top line guidance for 2009, adjusting for currency it doesn’t seem like you’ve got much organic growth here. I would just be interested in your comments or thoughts overall on the impact the weakened economy is having on the pharma business as a whole as it relates to your business as well as Wyeth’s."
},
{
"speaker": "Frank D’Amelio",
"text": "On the tax rate, we will be looking to pay down the debt, I will call it kind of in a consistent way going forward, which is why we said net cash by 2012. So in terms of your assumptions I would assume that 30% and I would keep it at roughly that level going forward for the next couple of years. That would be point one. In terms of the revenue guidance for ’09, we put a range out there of $44 to $46 and we said a $3 billion negative impact from foreign exchange. Just to run the numbers, if you added that $3 billion back, if foreign exchange was constant, $44 to $46 would be $47 to $49, mid point to that is roughly $48 which is pretty much what we printed this year. And we did, to your point, we did assume some negative impact of the macro economic environment on the guidance that we are providing for 2009."
},
{
"speaker": "Operator",
"text": "Your next question comes from Tim Anderson - Sanford Bernstein"
},
{
"speaker": "Tim Anderson",
"text": "I have three questions. Jeff this transaction goes against what you described in March of ’08 which was that you would not likely do another big pharma deal. My question to you is what changed over the course of those ten months. My second question is whether at some point you might consider splitting up the combined company into something like truly separate, publicly traded entities? The third question is for Bernard. Can you talk about how Wyeth arrived at a $50.00 share as being fair value? I think a case could be made that it is a pretty low price given what the future prospects for Wyeth have looked like."
},
{
"speaker": "Jeff Kindler",
"text": "As far as what I have said in the past, I have always been very clear that we never say never and we are open to every opportunity and I have identified the conditions that would have to prevail for us to undertake a transaction like this, including obviously the strategic value and our ability to manage the inevitable risks and disruptions that come from any large scale merger of that kind. We, as I said in my opening comments, are in a much stronger position than we were two years ago. In fact, I would have to say that we have gotten there faster than I might have even hoped and our confidence in our ability to execute on a transaction like this is very high, thanks to the hard work of our people. We have also very clearly laid out all of the strategic priorities that we had and I went through them earlier this morning. This is a very, very unique deal. I don’t think there is anything else that could have been done that would have more perfectly matched those strategic priorities, all achieved in a single transaction. So it is, for all of the reasons I said in the beginning, the right deal, at the right time and for the right reasons. As far as potential future considerations of the portfolio are concerned, what we are very excited about is that this transaction creates a very broad based, diversified portfolio of businesses that are complimentary with one another and I continue to believe that these various businesses benefit from the combination both of their own ability to maximize their opportunities, but at the same time take advantages of the scale and resources of the combined company."
},
{
"speaker": "Bernard Poussot",
"text": "The answer to your question is this. The board of Wyeth obviously reviewed this question very, very thoroughly and evaluated exactly what this offer was at, this is our standard on prospects. I will just tell you that this transaction at Friday closing values for the Pfizer stock represented a $16 billion premium which in the current environment is not bad. 85% of the synergies created to Wyeth, I would remind you also that the deal is structured with 65% in cash and lastly the 35% component of the Pfizer stock offers, also, an ability to go up when the deal is understood and people realize the strengths of the combination. So between now and closing we will have adjusted for that."
},
{
"speaker": "Operator",
"text": "Your next question comes from Seamus Fernandez of Leerink Swann."
},
{
"speaker": "Seamus Fernandez",
"text": "Frank, I was hoping you could discuss the context of the $1 billion reinvestment that you mentioned would occur this year on the R&D side and in some of the other parts of the business. Then you mentioned the market share that Pfizer would hold in emerging markets and the growth you anticipate in those markets. Can you tell us what the combined share of the two companies would be? Then also, Frank, could you just clarify for us the combined cost reductions, as I read them, are $4 billion from the combination with Wyeth with an incremental $2 billion from the additional cost program that you envisioned for Pfizer itself, is that correct?"
},
{
"speaker": "Frank D’Amelio",
"text": "I will answer the last question first, then Ian you are going to talk about the reinvesting question, and then on the revenue growth question that I gave with the addressable markets, I think what we will do is just keep that to those Pfizer numbers only for now, unless Ian wants to add anything to that. The answer to your last question is yes. You take the $4 billion in synergies that we talked about from the combined company and you would add the $2 billion that we laid out from the stand-alone Pfizer. So the short answer to the last question is yes."
},
{
"speaker": "Ian Read",
"text": "The reinvestment is to ensure we continue to drive the revenue the top line so it includes probably a portion into supporting the portfolio, progressing the Phase II and Phase III pipeline, which is very important to our 2012 and post revenue opportunities. It is building infrastructure as a field force in emerging markets that is in Turkey and in China and in Russia, Korea, and lastly building our offering of established products. As we widen our portfolio offering in these markets we should invest in ensuring we have supply and we have appropriate dossiers so to widen that offer."
},
{
"speaker": "Operator",
"text": "Your next question comes from Steve Scala with Cowen and Company."
},
{
"speaker": "Steve Scala",
"text": "Pfizer sold its consumer business a few years ago because it apparently did not make strategic sense. Why does the Wyeth OTC business make greater strategic sense or should we assume a similar fate? Second has an FTC review of the Lipitor patent settlement been finalized and if not Bernard, what analysis has Wyeth completed regarding the Lipitor patent settlement? It would appear to be a key variable in your ability to make 2012 targets. Lastly, Bernard when was your most recent update on the Bapineuzumab Phase III trial such as perhaps a DSMV update or some other knowledge of how things are progressing in Phase III."
},
{
"speaker": "Jeff Kindler",
"text": "I will address the first question, then I will ask Amy Schulman our General Counsel to give you a Lipitor patent update and then I will turn it over the Bernard for the questions you have asked him. On the consumer business a decision was made at the time based on the view that prevailed at that time. Where we are today is I think this is a terrific business and one that is very complimentary with our portfolio and one that we believe creates tremendous opportunities for increased shareholder value. Amy, if I could ask you to give Steve an update on the Lipitor patent situation."
},
{
"speaker": "Amy Schulman",
"text": "We are very comfortable with the FTC’s review of the Lipitor patent situation and as the course of the diligence both Wyeth and we went for each others products and various issues at some length and both of us were comfortable with what we found. The FTC review is completed, they have not yet issued a decision."
},
{
"speaker": "Bernard Poussot",
"text": "On the Bapineuzumab question, first of all we do not commence on DSMB reviews. Regarding the ongoing Phase III program I can tell you that they are advancing. In most cases we have resumed activities XUS. In most countries a couple of situations still need to be addressed, but we are confident that within weeks we will be back in full gear in those countries, I mean the North American portion is progressing accordingly, so we are pleased and continue to hope for the original timing that we had for Bapineuzumab."
},
{
"speaker": "Operator",
"text": "Your last question comes from Robert Hazlett of BMO Capital Markets."
},
{
"speaker": "Robert Hazlett",
"text": "My question is specific to the Alzheimer’s therapeutic area and the pipeline compounds. Jeff clearly Pfizer has an effort there with multiple compounds, multiple licenses, as well as the monoclonal antibodies as does Wyeth. Do you expect there to be a divestiture in this area of one of the monoclonal anti-A beta monoclonal antibodies from the pipeline?"
},
{
"speaker": "Jeff Kindler",
"text": "Let me start by saying that you are right to point out that both companies have invested a great deal into this very, very important area of critical unmet medical need and both have very exciting programs which we believe are very complimentary of one another. We do not anticipate any issues along the lines you are talking about. We actually think these two efforts put together will be very complimentary and most importantly give us the opportunity to really see if we can’t address this very serious unmet medical need. I think that concludes the time we have available. I appreciate everybody listening in today. Thank you and have a great day."
}
] | null | null |
PFE | 3 | 2,008 | 2008-10-21 10:00:00 | Operator: Welcome to Pfizer's Third Quarter Earnings Call. And now, Chuck Triano, Senior Vise President of Investor Relations.
Charles E. Triano: Thank you, operator and good morning everybody. And thank you for joining us today to review our third quarter 2008 performance. I am here where Jeff Kindler, Frank D'Amelio, Ian Read, Martin Mackay, and Amy Schulman. The financial charts that will be presented on this call can be viewed on our home page at www.pfizer.com in the Investor Presentations tab by clicking on the link, quarterly corporate performance third quarter 2008. We know this is a busy day for many of you with other company's reporting earnings and our conference call will last an hour, and we will end at 11 o'clock. Before we start, I would like to remind you that our discussions during this conference call will include forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. The factors that could cause actual results to differ are discussed in Pfizer's 2007 Annual Report on Form 10-K, and in our reports on Form 10-Q and Form 8-K. Also, the discussions during the conference call will include certain financial measures that were not prepared in accordance with Generally Accepted Accounting Principles. Reconciliation of those non-GAAP financial measures to the most directly comparable GAAP financial measures can be found in Pfizer's current report on Form 8-K dated October 21, 2008. These reports are available on our website at www.pfizer.com in the Investors' SEC filing section. With that I'll now turn the call over to Jeff Kindler. Jeff?
Jeffrey Kindler: Thanks, Chuck. Good morning everyone and thanks again for joining us. Well to state the obvious, none of us has ever seen anything like the unprecedented turbulence of the past few weeks. But while the outlook for the global economy is uncertain and while no one, including us, is immune from its effects, I want to be very clear about two things. One, Pfizer remains in a very solid financial position to address the challenges and seize the opportunities ahead. And two, the changes that we have made over the past three years have enabled us to adapt quickly and effectively to a fast changing and often uncertain operating environment. Now, on the first point, we have a strong balance sheet, excellent liquidity, high quality credit ratings and substantial operating cash flow. We also have a solid and conservative investment portfolio. In short Pfizer is a financially strong company. On the second point, the changes that we've made over the past two years enable us to operate quickly and effectively in an industry and a world marked by uncertainty. While, this work is never finished, I am very proud of what our colleagues have achieved in a very short time and in a very difficult environment. Even as compared to just a year ago at this time, we are in much leaner, more disciplined and more agile organization. We have stronger leadership throughout the company, our strategies are clear and well understood by our collogues, we are much better at managing costs and at allocating capital. And we are also getting better and better at the basic and fundamental requirements of executing and keeping our commitments. I believe that the quarterly and year-to-date results that we've announced today, the guidance we've given for the balance of the year on revenues, costs and earnings, the progress we've made on the strategies we shared in March particularly in our pipeline, all of these and more demonstrate that we've made meaningful progress in reshaping Pfizer into a company that has the capability and the agility to manage through uncertainty and challenges. And of course we have faced significant challenges and uncertainties this year. That as you will know is the nature of our business. But that said, we know that it is our job to manage our way to these challenges and still deliver on our commitments and we are doing so. For that reason although no one can predict with certainly what will happen in the global economy, I have confidence that we and our colleagues around the world will continue to manage our way through the uncertainty and challenges ahead. Now, in that regard one of the most important changes we've made is our reshaping the company into smaller, more focused business units. As you will recall, this was a priority that I first highlighted for you a few months after I was appointed to this position, when we spoke at the beginning of last year. Since then, we have made very significant progress. In particular after having created business units in Oncology and then established products earlier this year, in this quarter we added three new global units within our pharmaceutical operations to serve primary care, specialty care and emerging markets. Along with animal health each of our six global units spans clinical and commercial development, medical, marketing, and sales, including management of the life cycles of our medicines after they lose exclusivity. Each unit is led by an experienced world class general manager, a leader with the authority and resources to respond quickly to the needs of their distinct customers around the world while aggressively pursuing new avenues for growth. Each of the respective leaders of these six units represents a single point of accountability for all aspects of their business, after our research and bio-therapeutics and bio-innovation center of organizations delivered quality compounds that have achieved proof of concept and that are ready for further clinical development and commercialization. Now, this is a marked departure from the way that Pfizer and, I believe, most companies in our industry have operated in the past. It enables us to move forward with the entrepreneurial zeal of six smaller but still very substantial businesses backed by the strength and the global reach of a strong global enterprise. The combination of these two attributes, the spirit of small, in those areas we are being small improves results, and the power of scale in those areas where scales and advantage represent a unique competitive advantage for Pfizer in these different markets, and these fast changing time. Now I'd like to give you a few examples of how this approach is already changing the way we do business. Let's look at emerging markets, where we are operating with ever increasing speed and agility. In China for example, we told you in March that we had set a goal of moving into a 126 cities by the end of this year. We achieved that goal seven months ahead of schedule, and we are now expecting to be in 137 cities in China by the end of the year. Now China has 160 cities with population above one million people. That makes each of them roughly the size of Dallas or even bigger. That should give you some sense of the opportunities that we have. In Latin America, revenues were up 14% operationally over last year, making it our fastest growing region. Within that region, Brazil is seeing revenues grow at double-digit rates. Despite of that, that several of our products have no patent protection there. Indeed marketing a portfolio that includes some products that lack patent protection is just one of the kinds of distinct challenges and opportunities that we face in emerging markets. Our very experienced teams in these countries will now be lead by John Michelle Helfa [ph], a dynamic leader with 31 years of experience operating I pharmaceutical businesses around the world. John Michelle and his colleagues will bring greater focus and authority in seeking opportunities to create value in the fastest growing markets on earth. And believe me, having spent time with colleagues in many of these markets, I can tell you that they are enthusiastically and aggressively pursuing those opportunities to create new value. That to be sure, the current challenges in the global economy may diminish the recent rate of growth in some of these markets. But, in both the short and the long term the opportunities in these parts of the world remain enormous. The urgent need to provide millions of people with greater access to valuable medicine that are patent protected or not primary specialty, will not change in these countries. We are excited about bringing our broad portfolio of such medicines to new consumers. As I've said before, we believe that we are uniquely position to take advantage of these opportunities because, we've have been there longer than most of our competitors. We have a very positive reputation with governments and key opinion leaders. The Pfizer brand and the brands of our various medicines have significant equity with doctors and patients. And we have a uniquely broad range of therapeutic offerings both on and off patent. Now in addition to these advantages another factor driving results in these markets is the establish products unit led by Dave Symonds. Dave is responsible for Pfizer's business in what is and is likely to continue to be especially in challenging economic times, a fast growing segment of the global bio pharmaceutical industry. And I am pleased to tell you today that in the 10 months since we formed that unit, Dave and his team have turned a number of products with flat or declining revenues into products that are growing again. In fact among these unit's many brand, six products with aggregate annual sales in excess of $1 billion are all experiencing accelerated growth year-to-date, some of them moving from declines to positive growth [ph]. Over time we expect profitable growth from these important part of our business as we introduce new products and formulations and develop new and innovative selling models. More over Dave's team is demonstrating in a very tangible way, what happens when we in senior management get out of the way of the people that are closest to our customers, a concrete and current example. As you know, a few weeks ago, the FDA banned one of our competitors from importing more than 30 generic drugs into the U.S. because of serious violations at their Indian manufacturing plant. The outstanding quality track record of Pfizer's world leading manufacturing colleagues, the fact that regulators and patients know that they can count on us, is a great competitive advantage in a situation like this. So Dave and his team will quickly and without letting any bureaucracy get in their way, within about 48 hours from the announcement of the FDA ban, the Pfizer established product business captured about 60% of our customers... of our competitor's business in two important medicines. Now I recognize that this particular action won't produce a large amount of new revenue but I think it clearly demonstrates very vividly, how things have changed here and it is a model for how we are operating and will continue to operate with all of the business units. And I want to say this very clearly, this could not have happened at Pfizer two years ago, and probably not even a year ago. But fast, customer focused, value creating actions driven by decisive accountable leaders are happening now world over Pfizer. Now while established products is a multi billion dollar business with significant growth opportunities, our core business of course remains providing innovative patent protected medicines. In that regard, the branded bio-pharmaceutical industry in the United States is certainly facing a tough environment. Overall, U.S. prescription volume has been more or less flat this year for the industry, and most of the growth has come from generics. Of course each product represents distinct challenges and opportunities, and Ian will be prepared to address any of those with you in Q&A. But I'd like to make a couple of overarching points about the U.S. marketplace. First, I think it's fair to say that partly as result of the changes that Pfizer's field force and marketing organization is more than holding its own against branded competitors. These colleagues are building on Pfizer's outstanding heritage in sales and marketing and re-earning their proud reputation as the best in the business, the representatives most responsive to patients and physicians. Specifically, in the US we have seven products that are outperforming the branded competition in their respective categories, and four more that are holding steady against newer agents. Now, of course success against branded competitors doesn't by itself fully address one of the most significant features of the U.S. operating environment, the increased use of generics. But it's noteworthy that overall, more than 10 of our U.S. medicines posted double-digit gains in the quarter. In that regard, I think it's important to note that if you look at worldwide therapeutic categories as a whole, branded and generic, we have at least 10 products that are ranked number 1 based on IMS sales volume and we continue to build, maintain, and demonstrate category leadership unmatched in the industry. Even Lipitor, faced with heightened generic competitive and payer pressures, the likes of which has never been seen before, still captures 43% of global lipid lowering market value share. In fact, I think the recent stabilization of Lipitor's total prescription volume in the U.S. is a good example of how we are learning to operate better in this challenging environment. Beyond that, however, we know that we must and we will continue to adapt our commercial model in the most innovative and efficient way possible in the U.S. as elsewhere to respond successfully to pricing pressures in generic competition. Our new business units, with their intense focus on what works best in their particular categories and with their freedom to deploy new commercial models, will accelerate our progress in doing so. Of course at the end of the day, patients, physicians and payers will continue to value innovated and meaningfully differentiated products, even as pricing pressures continue. So, our R&D and business development activities continue to focus on providing exactly those kinds of medicines. Meanwhile, the encouraging progress our commercial organization has made gives me confidence that overtime we can provide growing numbers of U.S. patients access to those kinds of medicines, whether it is currently available medicines like Lyrica, Chantix and Sutent or future medicines now in development. The challenges in US also on my view reinforce the value of our international businesses which are leaders in the vast majority of the therapeutic and geographic markets in which they compete. As you can see from today's release, outside the U.S. in the markets that accounted for nearly 60% of our total reported revenue so far this year, we have more than 10 inline products achieving double-digit operational growth year-to-date, excluding the effects of foreign exchange. While there's certainly more work to be done, I believe these results demonstrate that the geographical and therapeutic diversification of our business, combined with an increasingly fast and nimble organization, give us good reason for confidence that we're getting better and better at managing our business in the face of tough challenges and uncertainties here and around the world. Now the kinds of changes I've described implemented by an organization that is intensely focused on execution have kept us on track to meet and even improve upon our full-year objectives for 2008 despite the challenges specific to our company and those more general to the economy and the industry. In that regard today, we've reaffirmed and tightened our revenue and earnings guidance for the year within the previously announced ranges. And we've increased our cost reduction target for the year. Now that last point bears emphasize. We told you at the beginning of the last year, that by the end of this year we would reduce our absolute cost by at least $1.5 billion to $2 billion compared to 2006 on a constant currency basis. As you have seen from our release, we have now achieved that goal a full quarter ahead of schedule and it's worth noting that we achieved our goal even after absorbing inflation and reinvesting in the business. Since we announced this goal in January of last year, we've reduced our absolute cost by more than $1.7 billion. I'm aware of no other company in our industry that is reducing absolute cost to that degree, either in dollars or percentage terms. As a result of our progress today, we're now projecting that our absolute cost reduction on a constant currency basis will be at least $2 billion by the end of the year. And of course, we would continue to focus on cost. As I've said before, we will establish a cost structure appropriate to our revenues going forward. Now perhaps more importantly than these particular numbers, I'm confident in telling you today that cost management and a commitment to continuously improving productivity along with a relentless pursuit of new avenues per revenue growth has become a fundamental part of our everyday life at Pfizer. Now first cost cutting alone obviously can't create the long-term growth that our owners expect and deserve. In that regard, I am pleased to report that we remain on track to meet the pipeline commitments we made to you in March. At that time we told our goal, to grow our Phase III pipeline to at least 24 and as many as 28 new molecular entities or new indications by the end of next year. Since we announced those targets in March, we've increased over late stage portfolio from 16 to 25 programs. We're targeting 15 to 20 regulatory submissions in the period 2010 to 2012. And we are vigorously driving our investments in biotechnology with 16 bio-therapeutics now in development including a fully human monoclonal antibody which recently began Phase III testing against non-small cell lung cancer, the leading cause of cancer death in the United States. These are important advances and we're proud that so many of them are coming from our own lab. But we also know that we must supplement our activities internally by accessing the best possible opportunities outside the company. In September, for example, we entered into agreement with Medivation to jointly develop Dimebon, their late stage medication to treat Alzheimer's and Huntington's disease. Medivation's choice of us from among many competitors is a solid endorsement of our capabilities, and we are looking forward to a long and productive relationship with them. So, in sum, we've been building a strong organizational and cultural foundation for the future. While that work continues, we are now well about executing on our strategies and quickly adapting to changing conditions and successfully managing through the uncertainty that has become a way of life for our industry and now perhaps for the global economy, and on seizing the many opportunities ahead. With that I'll turn it over to Frank.
Frank D'Amelio: Thanks Jeff, good morning everyone. I want to start by punctuating a few items that Jeff mentioned. Pfizer maintains a strong financial position despite challenging macroeconomic environment. We have a strong balance sheet and excellent liquidity that provides us with financial flexibility. We have approximately $26 billion in cash and short-term investment and we continue to expect to generate $17 billion to $18 billion of cash flow from operations in 2008. Our long-term debt is rated high quality and investment grade. We're rated AAA by S&P and AA1 from Moody's. We have and we'll continue to take a conservative approach to our investment; both short-term and long-term investment consists primarily of high quality, highly liquid, well diversified investment grade available for sale debt security. As a result, the credit markets remain open to us and we continue to have ample liquidity. Now, on to our third quarter results. The charts I'm reviewing today are included in our webcast and will help facilitate the discussion of our third quarter 2008 results. Now, let me get to our financials. Reported revenues for the third quarter of 2008 were $12 billion, consistent with year-ago quarter. This included the positive impact of foreign exchange, which increased revenues by approximately $620 million or 5% and the solid performance of many key products. This was offset by the negative impact of the loss of US exclusivity for Zyrtec and Camptosar, whose revenues decreased year-over-year by $428 million and $121 million respectively, and an adjustment of $217 million for prior year product return. This adjustment was the result of a detailed review that we recently initiated addressing the actual returns experienced for various products. We determined that the length of time from when a product is sold to when a return is made, was longer than had been assumed. Consequently, we increased our returns approvals and recorded a full amount again, current period revenues and income, although essentially, all the adjustment relates back several years. Third quarter 2008 reported net income was $2.3 billion, compared with $761 million in the year-ago quarter. And reported diluted EPS increased to $0.34 versus a $0.11 in the prior year quarter, primarily driven by the after-tax charges of $2.1 billion related to the decision tax at Exubera in the year-ago quarter, partially offset by after tax charges in the current quarter of approximately $640 million associated with our agreements in principle to resolve certain litigation involving NSAID pain medicines, and $152 million associated with the previously mentioned returns adjustment. Adjusted revenues were $12.2 billion, an increase of 2% year-over-year, driven by the favorable impact of foreign exchange into a lesser extent the growth of many key products. These offset the impact of the loss of U.S. exclusivity of Norvasc, Zyrtec and Camptosar. Adjusted income increased 5% to $4.2 billion year-over-year and adjusted diluted EPS increased 7% to $0.62 which included the favorable impact of savings associated with cost reduction initiatives at foreign exchange. These were partially offset by a decrease in other income primarily due to decreased net interest income. Both reported and adjusted diluted EPS in the third quarter were favorably impacted by the full benefit of our $10 billion share repurchase in 2007. Several significant items impacted our reported pre-tax results this quarter by approximately $2 billion including charges of approximately $900 million associated with the aforementioned agreements in principle to resolve certain NSAID litigation, $338 million for restructuring, $378 million for implementation cost and $217 million associated with the previously mentioned returns adjustment. Now I'd like to provide more details regarding our third quarter adjusted income components. Adjusted process sales as a percentage of revenue was 14.5% versus 15.1% for the prior year quarter driven by the benefits of our ongoing cost reduction initiatives, which were partially offset by a less favorable geographic mix. Adjusted SI&A expenses were $3.4 billion, a decrease of 6% year-over-year driven by ongoing cost reduction initiatives which were partially offset by the unfavorable impact of foreign exchange. Adjusted R&D expenses were 1.8 billion, an increase of 2% year-over-year. R&D expenses included increased spending on a larger number of higher cost, phase III clinical trials and increased spending in our biotechnology and bio-innovation center. These will partially offset by savings from our cost reduction initiatives. Higher clinical trial costs were primarily due to the progress we've made on our phase III pipeline, which has increased from 16 to 25 programs over the last six months. Our effected tax rate on adjusted income for the quarter was 22.3% versus 21.7% in the year-ago quarter. For the first nine months of 2008, adjusted revenues increased 2% to $36 billion year-over-year, driven by the favorable impact of foreign exchange of approximately $2 billion or 6% and to a lesser extent a solid performance of many key products. This was partially offset by the unfavorable impact of the loss of U.S. exclusivity Norvasc, Zyrtec and Camptosar whose collective revenues decreased approximately $2.1 billion versus the prior year period. Year-to-date adjusted cost of sales as a percentage of revenue was 15.5% compared with 15.3% in the prior year period. Year-to-date adjusted SI&A expenses decreased 1% versus the prior year period. Year-to-date adjusted R&D expenses decreased 2% versus the prior year period. The effective tax rate on adjusted income for the first nine month of 2008 was 21.4% versus 21.8% in the prior year period. We posted year-to-date adjusted income of $12 billion; an increase of 2% compared with the prior year period and adjusted diluted EPS of $1.77 an increase of 5% which were positively impacted by savings associated with our ongoing cost reduction initiatives and foreign exchange. These were primarily offset by the aforementioned decrease and net interest income. In addition, the prior period's adjusted results included the upfront payment in 2007, the Bristol-Myers Squibb. As I previously mentioned in the third quarter, foreign exchange increased revenues by approximately $620 million or 5%. While, our cost reduction initiatives continue to have a positive impact on our adjusted total cost this quarter, foreign exchange unfavorably impacted these costs by approximately $240 million or 3% compared to the prior year quarter. Excluding foreign exchange, adjusted total cost decreased operationally by approximately $460 million or 6% year-over-year. The net effect to foreign exchange in our adjusted diluted EPS during the third quarter as compared with the year-ago quarter was a positive impact of $0.05. We continue to make excellent progress on our cost reduction efforts. Total cost of the third quarter declined by about 460 million excluding foreign exchange compared with the year-ago quarter. It's important to note that we continue to achieve these absolute reductions even after absorbing inflation and reinvesting in the business. Our cost reductions in the third quarter were realized more quickly than we had originally anticipated. We now expect to achieve a total adjustment cost reduction of at least $2 billion versus our pervious expectation of at least $1.5 billion to $2 billion on a constant currency basis for 2008 compared with 2006. Our cost reduction initiatives continue to span essentially all divisions, functions, markets and sites across Pfizer, broad categories of activity, including manufacturing and research side exits, outsourcing, and targeted workforce reductions. We reduced our global network of manufacturing plants from 78 four years ago to 51 currently. By the end of 2009, we expect to further reduce this global network to 43. Of the six R&D sites that have been identified for closure, we have closed two of the sites, ceased R&D operations at three, and significantly scaled back operations in the remaining sites. In addition, we have a wide array of outsourcing opportunities in various stages of implementation. Manufacturing, logistics, finance, facilities, legal and IT are among the functions contributing to the financial and operational benefits of the strategy. Finally, we are continuing to size our workforce level with current market dynamics. Since January of 2007 our workforce level has decreased by approximately 14,600; 83,400 at the end of the third quarter. Now, I would like to provide some select product results. Lipitor revenues decreased 1% year-over-year to approximately $3.1 billion, including the positive impact of foreign exchange which increased revenues by approximately $130 million or 4%. Year-over-year, Lipitor revenues in the U.S. decreased 13% and revenues from international markets increased 16%. Lyrica continued to deliver strong performance with revenues of $675 million, an increase of 45% year-over-year. Sutent, our treatment for advanced kidney cancer and gastrointestinal stromal tumors, posted revenues of $226 million, an increase of 49% compared with the year-ago quarter. And Viagra revenues increased 13% to $509 million. Chantix revenues decreased 24% year-over-year to $182 million. Chantix results in the U.S. continued to be negatively impacted by label changes. As a result, third quarter U.S. revenues of $96 million decreased 49% compared with the year ago quarter. However, Chantix continued to perform well outside the U.S., Chantix revenues from international markets grew 60% year-over-year to $86 million. As expected, revenues from products that recently lost US exclusivity declined year-over-year, with Norvasc declining 12% to $562 million, Camptosar declining 50% to $122 million and there were no sales for Zyrtec this quarter, compared with $428 million in the year ago quarter. Based on our year-to-date performance and outlook for the remainder of 2008, we're increasing the lower end of our revenue guidance range. We now expect 2008 revenues to be between $48 billion to $49 billion compared with our previous expectation of $47 billion to $49 billion. In addition, we're tightening the range of our adjusted diluted EPS guidance and now expect the adjusted diluted EPS range to be from $236 million to $241 million compared with previous range of $235 million to $245 million. In addition, we tightened our adjusted SI&A expenses guidance range to $14.4 billion to $14.7 billion, from $14.4 billion to $14.9 billion. Finally, as I previously mentioned, we now expect to achieve at least $2 billion in absolute adjusted total cost reduction versus 2006 on a constant currency basis compared with our previous expectation of at least $1.5 billion to $2 billion. So, to summarize the key takeaways, we've increased the lower end of our '08 revenue and adjusted diluted EPS guidance ranges. We continue to see steady growth in several key products, including Lyrica, Celebrex, Viagra, Sutent, Xalatan, Zyvox and Geodon. We're pleased of the solid results we delivered this quarter including achieving our absolute adjusted total cost reduction target for 2008 in the third quarter and finally our EPS growth continues to outpace our revenue growth. And now, I'll turn it back to Chuck.
Charles E. Triano: Thanks for the review Frank. And at this point if we could pause. Operator, if you could please pool for questions. Thank you. Question And Answer
Operator: [Operator Instructions]. Sir, our first question comes from David Risinger of Merrill Lynch. Please proceed with your question.
David Risinger: Thanks very much. I have two questions. The first is related to Lipitor. On the Lipitor sales, where sales impacted in 2008 or in 2007 by stocking? It seems like the reported sales performance in the U.S. was a little weaker than what underlying demand would imply? The other question on Lipitor is that... is related to the outlook. Prescriptions have been stabilizing sequentially recently, could you comment on the outlook? And then the final question is for Frank. Frank at your analyst meeting in March, you had projected a mid 30s to a high 30s operating margin in 2012. I think some investors have wondered how such a post expiry margin is possible without big blockbuster brand but it seems like you are pretty confident because you are assuming that the organization will be downsized. Could you just talk about your level of confidence and your visibility for that level of operating margin? Thank you.
Jeffrey Kindler: Okay, good morning Dave. I am going to obviously ask Ian to address the first two questions on Lipitor.
Ian C. Read: Dave, on inventory, there was no impact in the third quarter for inventory movements on Lipitor and a very small impact on the year-to-date. So nothing material from inventories affecting Lipitor's performance. And on our sequential performance I think it's a reflection of the way we are focusing the field force, our access programs, our focus on reducing the switches and I expect us to continue to do what we are doing, fighting for every script in the marketplace.
Frank D'Amelio: And then Dave on the question for me, what I have said is operating margins in the mid to high 30s am going forward, of basically what you said. In terms of getting there, it's really a combination effect. One is the items Jeff mentioned relative to creating new sources of revenue, still maximizing our patent protected portfolio, establishing opportunities and for our established products/units, seeking opportunities in emerging markets, looking at adjacent space as well as business development and advancing our internal pipeline. So you know it's a combination of creating new sources of revenue combined with continuing to be more efficient, more productive and executing on the cost reduction initiatives that we talked about. So it's really a two pronged approach that gets us to the mid to high 30s on the operating margins.
Charles E. Triano: Thanks Frank, next question.
Operator: Thank you, sir. And our next question comes from Roopesh Patel of UBS. Please proceed with your question.
Roopesh Patel: Thank you. I have a couple of questions. First for Jeff, I'm wondering if you could please comment on the M&A outlook for Pfizer in light of what's occurred in the stock market in the past couple of months. Specifically, do you believe that acquisition opportunities have increased in the context of current valuation? And related to that, has your thinking on M&A for Pfizer changed over these past couple of months, if so, how? And then, separately for Frank, FX related question, if I look at year-to-date adjusted EPS growth for Pfizer it's been up 2%. The year-to-date benefit from FX to EPS has been plus 7%. If FX stays where it is to date, can you give us a rough sense for what it's impact would be on earnings over the next year or so? Thanks.
Jeffrey Kindler: Okay, thank you Roopesh, good morning. So, let me start on business development. We've been clear that focused business development continue to be an important enabler of all of our growth strategies. And we've said before that we are open to all opportunities and we never say never. I can tell you that under Bill Ringo's leadership, we engage in a very robust and ongoing process to constantly look at all opportunities. And in that process we are always taking account of the very dynamic landscape and the challenges and the opportunities that the environment may create. But while the environment changes, the fundamentals don't change and the considerations I have outlined previously still apply to any deal, large or small. First, it has to have strategic value, the price must be right, it must... we must manage the disruption and risks to productivity. In short, it must create shareholder value, and none of that has changed, as the environment changes, we continue to observe and monitor very carefully and review those opportunities on a constant basis. Frank, you want to talk about foreign exchange?
Frank D'Amelio: Yes. So let me... let me cover this. Let me run a couple of numbers first and then I'll talk about going forward. So if you look at Q3, we benefited from foreign exchange on revenues by 620 million on EPS by a nickel, which is part of the specific statistics that you have reported. If you look at foreign exchange going forward, if you look at our guidance, we said in our guidance obviously other than those $2 billion, everything's at current October foreign exchange rates. If you were to leave current foreign exchange rates and run now for the rest of the year, FX in Q4 would actually not help our EPS numbers. It would actually be detrimental to the numbers by a couple of cents which we included, factored into our guidance. Beyond Q4, if you look at 2009, we are not ready to comment on that, and the reason I say that is there's lots of volatility right now in foreign exchange and the various currencies. And so to try to call that number today we think isn't a prudent thing to do. We will... I will talk about that number on the January earnings call.
Charles E. Triano: Thanks Frank. Next question please?
Operator: Thank you. Our next question comes from Mr. Tim Anderson of Stanford Bernstein. Please proceed with your question.
Tim Anderson: Thank you. A couple of questions. Can you talk about Lipitor formulary positioning in Medicare and commercial plan going into '09? Wondering how much slippage in tier II coverage you anticipate and if your impression is that, all the branded cholesterol products would be in a similar situation; Schering had their call this morning, they said they see broad-based formulary tightening across all cholesterol drugs, and I'm wondering if you share that view? Second question is on Sutent. In the U.S., the sales have been flat for several quarters; internationally, they continue to grow well. But I'm wondering if at some point, in the not too distant future of international, it will similarly cap out, kind of flatten out like the U.S. has done in the absence of new indications?
Jeffrey Kindler: Hey, thank you Tim. Ian can you take both of those questions?
Ian C. Read: So, Lipitor access, we enjoy, we worked hard to get very positive access from Lipitor. I think it's... in the mid 70s to close to 80% on across our book to business. We've actually seen this year, 75 formulary changes that have either improved Lipitor status or put restrictions on Vytorin over the year. So I'd... I entail [ph] similar types of access in '09 on tier II. I'd just... but tier II is harder than the... in the sense that generic competition does tend to drive against tier II by their marketing practices with physicians. So while tier II is valuable, it's not as valuable as it was 2 to 3 years ago. On Sutent, we've seen as you said what we saw growth in U.S. sales this quarter, we are focusing on the full cycle, we are focusing on the effective dose and you will expect to continue to see growth. We do have substantial shares in renal cell about 60% in most countries. And in the international arena, the population based is quite larger than the U.S. and uptake it somewhat slower. So we expect to see continued growth internationally on Sutent prior to the new indications.
Jeffrey Kindler: And yes, thanks. Tim, I thought maybe Martin could elaborate little bit on the new indications. Go ahead Martin.
Martin Mackay: Yes Tim, just briefly in terms of the new indications, I think in phase B for colorectal cancer, lung cancer, and breast, which are the big three following close behind for the renal cell carcinoma and gastrointestinal stromal tumor, and then, coming up shortly behind that in hepatocellular carcinoma and hormone refractory prostate cancer, so we have several new indications which are following on to the... currently on the market.
Charles E. Triano: Thanks Martin. Next question please.
Operator: Thank you, sir. Our next question comes from Mr. Chris Schott of JP Morgan. Please proceed with your question.
Chris Schott: Great, thanks. Just two quick questions. First on the R&D side. As Pfizer gets more selective in the therapeutic categories that you're investing in, I guess first of all, what becomes of those early stage assets? These things will be looked... the out-licenses are sold off. And then how do we think about them in the context of your longer term R&D budget. Should we be looking at these moves that's creating longer term reductions in overall R&D spend or is it just simply creating more funding to go after late stage assets in your more core areas of focus like oncology? Then can you just quickly about your US based cash flow in the quarter and your cash balances, how much is currently based in the US? But as relates that on repatriation, Bill, as you look into 2009? And then just given all the controversy this year can you just again run through your commitment to the dividends that currently stand? Thanks.
Jeffrey Kindler: Okay, Martin, do you want to start on R&D?
Martin Mackay: Yes, thank you Chris. In terms of the question to the early stage asset, we are starting to look in a number of things now where we would lose to out-licensing partners some of these what we believe to be valuable assets, just know as valuable as others that are in our portfolio? And this will range from single asset to maybe group of assets. You remember recently our spin-off at RaQualia in Japan, where we put some of those early stage assets into that company, and you'll see a number of things over the next period. In terms of the second part to your question, it's exactly right. We are making trade-offs across a very large portfolio now. We have a terrific R&D budget and of course when you have a Phase 3 pipeline that's becoming so replete with a mixture of new chemical entities, product line extensions, license and development activity and pediatric indication on a phase II pipeline is also very healthy. We are making choices both in terms of the disease areas that we work in and the assets we prosecute.
Jeffrey Kindler: Thank you Martin. Frank?
Frank D'Amelio: Yes, let me hit the dividend item first; and just to say as we've said before certain significant events aside we expect to generate sufficient cash flow funded dividend at least at current levels on a going-forward basis. That's what we have said previously, that's obviously where we continue to be. On cash flow, third quarter operating cash flow in the 10-Q that we filed later on but I'm... I think the way I can answer this from a cash flow perspective is to the first half of the year, we generated almost $8.5 billion in cash flow from operations, about $8.3 billion, and we reiterated our guidance on operating cash flow this quarter for the year, which is $17 billion to $18 billion which is up from the previous year from 2007 of about $13.5 billion. In terms of breaking that out by country, we don't break out cash flow by country; we don't think that's a prudent thing to do, because of the overall numbers.
Charles E. Triano: Thank you, Frank. Next question please?
Operator: Our next question comes from Steve Scala of Cowen. Please proceed with your question.
Steve Scala: Thank you. I have two questions. First, has Pfizer received an inquiry from the SEC regarding the Lipitor patent litigation settlement? If so, what are the issues, and when, or where does this investigation stand? I'm also curious as to why you haven't, to my knowledge, announced the status of any review as other companies have when they receive these inquiries unless of course you haven't received one, which would be in my opinion, surprising. Secondly, on Dimebon, can you update us on enrollment in the current phase III trial, and do you plan to conduct a Dimebon plus Aricept combination trial as part of the phase III program. Thank you.
Jeffrey Kindler: Okay, Steve. I'll let Amy talk about the Lipitor patent settlement, and Martin will talk about Dimebon.
Amy Schulman: Hi, Steve. And as disclosed in our quarterly filings, the SEC review of the Lipitor patent settlement is occurring in the normal course, and we think it will read out on an expected timeline, and there's nothing unusual about that. Martin?
Martin Mackay: Yes. In terms of Dimebon, Steve, we are now moving full steam ahead for the Phase III study. As you know we... Medivation conducted a very nice phase II study in Alzheimer's patients, which was positive and we're progressing to phase III with all speed. We will have a number of plans for the phase III including a combinations with such drug as Aricept; essentially we have... we will have a full phase III program with this exciting compound.
Charles E. Triano: Thank you Martin. Next question please.
Operator: Thank you sir. And our next question comes from John Boris of Citibank. Please proceed with your question.
John Boris: Thanks for taking the questions, two-part question. First part as to the adapting to the scaling issues, if you do look forward to the 2011, 2013 time period, a lot of your, quite a few of your peers any way have already outlined cost saving initiatives going forward to attack that cliff, your cliff is relatively substantial in that period, a little over 9 billion of U.S. revenue exposed to exclusivity losses. When... what is the timing for potentially initiating another adapting to scale initiative that can certainly... potentially right-size the organization for that cliff in the future? And then, secondly, Jeff, you mentioned about making the organization smaller and certainly the power of scale and have outlined six units. And certainly, you riveted on increasing shareholder value. Can you elaborate on your thoughts of how you might be able to unleash some shareholders value from any of these six units to either a spin or a split off, is that any part of your consideration to improve growth of the organization, long-term sustainable growth of the organization by containing some of that risks in one of those units that you could split or spin? And then your thoughts of the combination of M&A possibly in the mix with that also? Thanks.
Jeffrey Kindler: Okay John, I will let Frank address the first question. And then I'll respond to your second question.
Frank D'Amelio: Yes John. So, the way I think about this is, first, we've made very nice progress this year on our cost reduction initiatives. So, $1.7 billion achieved now cumulatively; we had a target of $1.5 billion to $2 billion, we've now increased that to least $2 billion. So you can think about that as at least another $300 million between now and the end of the year as we have finish off those numbers. I think we're demonstrating good execution, positive track record relative to being able to improve our process to take cost out of the business efficiently. I think secondly, from our perspective, efficiency improvements, operational improvements, cost reductions is a continuous trend, it never ends, it's something that we do perpetually and that we will continue to do. In terms of going forward and the way I think about this is what happened in other earnings call in January, as we do on in the January earnings calls, something we typically do as in normal course of business, we will provide guidance on that call for 2009. As we give guidance on that call, we will also include the various elements of our income statement and that will include levels of costs, and guidance on costs of sales and some of the other line items on the income statement. So we will provide information on this as we normally do on the January earnings call.
Jeffrey Kindler: Thanks Frank. And on your second question John, I understand the question, we're always looking at opportunities to increase shareholder value. These units are relentlessly focused on creating value and setting up businesses in which they can pursue, revenue opportunities appropriate to their customers and established cost structures that are appropriate to their businesses. Next question please?
Operator: Thank you. And our last question comes from Seamus Fernandez of Leerink Swann. Please proceed with your question.
Jeffrey Kindler: Seamus? Seamus there?
Operator: Yes he is. Please proceed with your questions Mr. Fernandez.
Jeffrey Kindler: Okay, maybe we covered it. Operator my understanding is there are no other questions in the queue. So I want to thank everybody for your time today. I know how busy everyone is and we look forward to talking to you again soon. Have a good day. . | [
{
"speaker": "Operator",
"text": "Welcome to Pfizer's Third Quarter Earnings Call. And now, Chuck Triano, Senior Vise President of Investor Relations."
},
{
"speaker": "Charles E. Triano",
"text": "Thank you, operator and good morning everybody. And thank you for joining us today to review our third quarter 2008 performance. I am here where Jeff Kindler, Frank D'Amelio, Ian Read, Martin Mackay, and Amy Schulman. The financial charts that will be presented on this call can be viewed on our home page at www.pfizer.com in the Investor Presentations tab by clicking on the link, quarterly corporate performance third quarter 2008. We know this is a busy day for many of you with other company's reporting earnings and our conference call will last an hour, and we will end at 11 o'clock. Before we start, I would like to remind you that our discussions during this conference call will include forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. The factors that could cause actual results to differ are discussed in Pfizer's 2007 Annual Report on Form 10-K, and in our reports on Form 10-Q and Form 8-K. Also, the discussions during the conference call will include certain financial measures that were not prepared in accordance with Generally Accepted Accounting Principles. Reconciliation of those non-GAAP financial measures to the most directly comparable GAAP financial measures can be found in Pfizer's current report on Form 8-K dated October 21, 2008. These reports are available on our website at www.pfizer.com in the Investors' SEC filing section. With that I'll now turn the call over to Jeff Kindler. Jeff?"
},
{
"speaker": "Jeffrey Kindler",
"text": "Thanks, Chuck. Good morning everyone and thanks again for joining us. Well to state the obvious, none of us has ever seen anything like the unprecedented turbulence of the past few weeks. But while the outlook for the global economy is uncertain and while no one, including us, is immune from its effects, I want to be very clear about two things. One, Pfizer remains in a very solid financial position to address the challenges and seize the opportunities ahead. And two, the changes that we have made over the past three years have enabled us to adapt quickly and effectively to a fast changing and often uncertain operating environment. Now, on the first point, we have a strong balance sheet, excellent liquidity, high quality credit ratings and substantial operating cash flow. We also have a solid and conservative investment portfolio. In short Pfizer is a financially strong company. On the second point, the changes that we've made over the past two years enable us to operate quickly and effectively in an industry and a world marked by uncertainty. While, this work is never finished, I am very proud of what our colleagues have achieved in a very short time and in a very difficult environment. Even as compared to just a year ago at this time, we are in much leaner, more disciplined and more agile organization. We have stronger leadership throughout the company, our strategies are clear and well understood by our collogues, we are much better at managing costs and at allocating capital. And we are also getting better and better at the basic and fundamental requirements of executing and keeping our commitments. I believe that the quarterly and year-to-date results that we've announced today, the guidance we've given for the balance of the year on revenues, costs and earnings, the progress we've made on the strategies we shared in March particularly in our pipeline, all of these and more demonstrate that we've made meaningful progress in reshaping Pfizer into a company that has the capability and the agility to manage through uncertainty and challenges. And of course we have faced significant challenges and uncertainties this year. That as you will know is the nature of our business. But that said, we know that it is our job to manage our way to these challenges and still deliver on our commitments and we are doing so. For that reason although no one can predict with certainly what will happen in the global economy, I have confidence that we and our colleagues around the world will continue to manage our way through the uncertainty and challenges ahead. Now, in that regard one of the most important changes we've made is our reshaping the company into smaller, more focused business units. As you will recall, this was a priority that I first highlighted for you a few months after I was appointed to this position, when we spoke at the beginning of last year. Since then, we have made very significant progress. In particular after having created business units in Oncology and then established products earlier this year, in this quarter we added three new global units within our pharmaceutical operations to serve primary care, specialty care and emerging markets. Along with animal health each of our six global units spans clinical and commercial development, medical, marketing, and sales, including management of the life cycles of our medicines after they lose exclusivity. Each unit is led by an experienced world class general manager, a leader with the authority and resources to respond quickly to the needs of their distinct customers around the world while aggressively pursuing new avenues for growth. Each of the respective leaders of these six units represents a single point of accountability for all aspects of their business, after our research and bio-therapeutics and bio-innovation center of organizations delivered quality compounds that have achieved proof of concept and that are ready for further clinical development and commercialization. Now, this is a marked departure from the way that Pfizer and, I believe, most companies in our industry have operated in the past. It enables us to move forward with the entrepreneurial zeal of six smaller but still very substantial businesses backed by the strength and the global reach of a strong global enterprise. The combination of these two attributes, the spirit of small, in those areas we are being small improves results, and the power of scale in those areas where scales and advantage represent a unique competitive advantage for Pfizer in these different markets, and these fast changing time. Now I'd like to give you a few examples of how this approach is already changing the way we do business. Let's look at emerging markets, where we are operating with ever increasing speed and agility. In China for example, we told you in March that we had set a goal of moving into a 126 cities by the end of this year. We achieved that goal seven months ahead of schedule, and we are now expecting to be in 137 cities in China by the end of the year. Now China has 160 cities with population above one million people. That makes each of them roughly the size of Dallas or even bigger. That should give you some sense of the opportunities that we have. In Latin America, revenues were up 14% operationally over last year, making it our fastest growing region. Within that region, Brazil is seeing revenues grow at double-digit rates. Despite of that, that several of our products have no patent protection there. Indeed marketing a portfolio that includes some products that lack patent protection is just one of the kinds of distinct challenges and opportunities that we face in emerging markets. Our very experienced teams in these countries will now be lead by John Michelle Helfa [ph], a dynamic leader with 31 years of experience operating I pharmaceutical businesses around the world. John Michelle and his colleagues will bring greater focus and authority in seeking opportunities to create value in the fastest growing markets on earth. And believe me, having spent time with colleagues in many of these markets, I can tell you that they are enthusiastically and aggressively pursuing those opportunities to create new value. That to be sure, the current challenges in the global economy may diminish the recent rate of growth in some of these markets. But, in both the short and the long term the opportunities in these parts of the world remain enormous. The urgent need to provide millions of people with greater access to valuable medicine that are patent protected or not primary specialty, will not change in these countries. We are excited about bringing our broad portfolio of such medicines to new consumers. As I've said before, we believe that we are uniquely position to take advantage of these opportunities because, we've have been there longer than most of our competitors. We have a very positive reputation with governments and key opinion leaders. The Pfizer brand and the brands of our various medicines have significant equity with doctors and patients. And we have a uniquely broad range of therapeutic offerings both on and off patent. Now in addition to these advantages another factor driving results in these markets is the establish products unit led by Dave Symonds. Dave is responsible for Pfizer's business in what is and is likely to continue to be especially in challenging economic times, a fast growing segment of the global bio pharmaceutical industry. And I am pleased to tell you today that in the 10 months since we formed that unit, Dave and his team have turned a number of products with flat or declining revenues into products that are growing again. In fact among these unit's many brand, six products with aggregate annual sales in excess of $1 billion are all experiencing accelerated growth year-to-date, some of them moving from declines to positive growth [ph]. Over time we expect profitable growth from these important part of our business as we introduce new products and formulations and develop new and innovative selling models. More over Dave's team is demonstrating in a very tangible way, what happens when we in senior management get out of the way of the people that are closest to our customers, a concrete and current example. As you know, a few weeks ago, the FDA banned one of our competitors from importing more than 30 generic drugs into the U.S. because of serious violations at their Indian manufacturing plant. The outstanding quality track record of Pfizer's world leading manufacturing colleagues, the fact that regulators and patients know that they can count on us, is a great competitive advantage in a situation like this. So Dave and his team will quickly and without letting any bureaucracy get in their way, within about 48 hours from the announcement of the FDA ban, the Pfizer established product business captured about 60% of our customers... of our competitor's business in two important medicines. Now I recognize that this particular action won't produce a large amount of new revenue but I think it clearly demonstrates very vividly, how things have changed here and it is a model for how we are operating and will continue to operate with all of the business units. And I want to say this very clearly, this could not have happened at Pfizer two years ago, and probably not even a year ago. But fast, customer focused, value creating actions driven by decisive accountable leaders are happening now world over Pfizer. Now while established products is a multi billion dollar business with significant growth opportunities, our core business of course remains providing innovative patent protected medicines. In that regard, the branded bio-pharmaceutical industry in the United States is certainly facing a tough environment. Overall, U.S. prescription volume has been more or less flat this year for the industry, and most of the growth has come from generics. Of course each product represents distinct challenges and opportunities, and Ian will be prepared to address any of those with you in Q&A. But I'd like to make a couple of overarching points about the U.S. marketplace. First, I think it's fair to say that partly as result of the changes that Pfizer's field force and marketing organization is more than holding its own against branded competitors. These colleagues are building on Pfizer's outstanding heritage in sales and marketing and re-earning their proud reputation as the best in the business, the representatives most responsive to patients and physicians. Specifically, in the US we have seven products that are outperforming the branded competition in their respective categories, and four more that are holding steady against newer agents. Now, of course success against branded competitors doesn't by itself fully address one of the most significant features of the U.S. operating environment, the increased use of generics. But it's noteworthy that overall, more than 10 of our U.S. medicines posted double-digit gains in the quarter. In that regard, I think it's important to note that if you look at worldwide therapeutic categories as a whole, branded and generic, we have at least 10 products that are ranked number 1 based on IMS sales volume and we continue to build, maintain, and demonstrate category leadership unmatched in the industry. Even Lipitor, faced with heightened generic competitive and payer pressures, the likes of which has never been seen before, still captures 43% of global lipid lowering market value share. In fact, I think the recent stabilization of Lipitor's total prescription volume in the U.S. is a good example of how we are learning to operate better in this challenging environment. Beyond that, however, we know that we must and we will continue to adapt our commercial model in the most innovative and efficient way possible in the U.S. as elsewhere to respond successfully to pricing pressures in generic competition. Our new business units, with their intense focus on what works best in their particular categories and with their freedom to deploy new commercial models, will accelerate our progress in doing so. Of course at the end of the day, patients, physicians and payers will continue to value innovated and meaningfully differentiated products, even as pricing pressures continue. So, our R&D and business development activities continue to focus on providing exactly those kinds of medicines. Meanwhile, the encouraging progress our commercial organization has made gives me confidence that overtime we can provide growing numbers of U.S. patients access to those kinds of medicines, whether it is currently available medicines like Lyrica, Chantix and Sutent or future medicines now in development. The challenges in US also on my view reinforce the value of our international businesses which are leaders in the vast majority of the therapeutic and geographic markets in which they compete. As you can see from today's release, outside the U.S. in the markets that accounted for nearly 60% of our total reported revenue so far this year, we have more than 10 inline products achieving double-digit operational growth year-to-date, excluding the effects of foreign exchange. While there's certainly more work to be done, I believe these results demonstrate that the geographical and therapeutic diversification of our business, combined with an increasingly fast and nimble organization, give us good reason for confidence that we're getting better and better at managing our business in the face of tough challenges and uncertainties here and around the world. Now the kinds of changes I've described implemented by an organization that is intensely focused on execution have kept us on track to meet and even improve upon our full-year objectives for 2008 despite the challenges specific to our company and those more general to the economy and the industry. In that regard today, we've reaffirmed and tightened our revenue and earnings guidance for the year within the previously announced ranges. And we've increased our cost reduction target for the year. Now that last point bears emphasize. We told you at the beginning of the last year, that by the end of this year we would reduce our absolute cost by at least $1.5 billion to $2 billion compared to 2006 on a constant currency basis. As you have seen from our release, we have now achieved that goal a full quarter ahead of schedule and it's worth noting that we achieved our goal even after absorbing inflation and reinvesting in the business. Since we announced this goal in January of last year, we've reduced our absolute cost by more than $1.7 billion. I'm aware of no other company in our industry that is reducing absolute cost to that degree, either in dollars or percentage terms. As a result of our progress today, we're now projecting that our absolute cost reduction on a constant currency basis will be at least $2 billion by the end of the year. And of course, we would continue to focus on cost. As I've said before, we will establish a cost structure appropriate to our revenues going forward. Now perhaps more importantly than these particular numbers, I'm confident in telling you today that cost management and a commitment to continuously improving productivity along with a relentless pursuit of new avenues per revenue growth has become a fundamental part of our everyday life at Pfizer. Now first cost cutting alone obviously can't create the long-term growth that our owners expect and deserve. In that regard, I am pleased to report that we remain on track to meet the pipeline commitments we made to you in March. At that time we told our goal, to grow our Phase III pipeline to at least 24 and as many as 28 new molecular entities or new indications by the end of next year. Since we announced those targets in March, we've increased over late stage portfolio from 16 to 25 programs. We're targeting 15 to 20 regulatory submissions in the period 2010 to 2012. And we are vigorously driving our investments in biotechnology with 16 bio-therapeutics now in development including a fully human monoclonal antibody which recently began Phase III testing against non-small cell lung cancer, the leading cause of cancer death in the United States. These are important advances and we're proud that so many of them are coming from our own lab. But we also know that we must supplement our activities internally by accessing the best possible opportunities outside the company. In September, for example, we entered into agreement with Medivation to jointly develop Dimebon, their late stage medication to treat Alzheimer's and Huntington's disease. Medivation's choice of us from among many competitors is a solid endorsement of our capabilities, and we are looking forward to a long and productive relationship with them. So, in sum, we've been building a strong organizational and cultural foundation for the future. While that work continues, we are now well about executing on our strategies and quickly adapting to changing conditions and successfully managing through the uncertainty that has become a way of life for our industry and now perhaps for the global economy, and on seizing the many opportunities ahead. With that I'll turn it over to Frank."
},
{
"speaker": "Frank D'Amelio",
"text": "Thanks Jeff, good morning everyone. I want to start by punctuating a few items that Jeff mentioned. Pfizer maintains a strong financial position despite challenging macroeconomic environment. We have a strong balance sheet and excellent liquidity that provides us with financial flexibility. We have approximately $26 billion in cash and short-term investment and we continue to expect to generate $17 billion to $18 billion of cash flow from operations in 2008. Our long-term debt is rated high quality and investment grade. We're rated AAA by S&P and AA1 from Moody's. We have and we'll continue to take a conservative approach to our investment; both short-term and long-term investment consists primarily of high quality, highly liquid, well diversified investment grade available for sale debt security. As a result, the credit markets remain open to us and we continue to have ample liquidity. Now, on to our third quarter results. The charts I'm reviewing today are included in our webcast and will help facilitate the discussion of our third quarter 2008 results. Now, let me get to our financials. Reported revenues for the third quarter of 2008 were $12 billion, consistent with year-ago quarter. This included the positive impact of foreign exchange, which increased revenues by approximately $620 million or 5% and the solid performance of many key products. This was offset by the negative impact of the loss of US exclusivity for Zyrtec and Camptosar, whose revenues decreased year-over-year by $428 million and $121 million respectively, and an adjustment of $217 million for prior year product return. This adjustment was the result of a detailed review that we recently initiated addressing the actual returns experienced for various products. We determined that the length of time from when a product is sold to when a return is made, was longer than had been assumed. Consequently, we increased our returns approvals and recorded a full amount again, current period revenues and income, although essentially, all the adjustment relates back several years. Third quarter 2008 reported net income was $2.3 billion, compared with $761 million in the year-ago quarter. And reported diluted EPS increased to $0.34 versus a $0.11 in the prior year quarter, primarily driven by the after-tax charges of $2.1 billion related to the decision tax at Exubera in the year-ago quarter, partially offset by after tax charges in the current quarter of approximately $640 million associated with our agreements in principle to resolve certain litigation involving NSAID pain medicines, and $152 million associated with the previously mentioned returns adjustment. Adjusted revenues were $12.2 billion, an increase of 2% year-over-year, driven by the favorable impact of foreign exchange into a lesser extent the growth of many key products. These offset the impact of the loss of U.S. exclusivity of Norvasc, Zyrtec and Camptosar. Adjusted income increased 5% to $4.2 billion year-over-year and adjusted diluted EPS increased 7% to $0.62 which included the favorable impact of savings associated with cost reduction initiatives at foreign exchange. These were partially offset by a decrease in other income primarily due to decreased net interest income. Both reported and adjusted diluted EPS in the third quarter were favorably impacted by the full benefit of our $10 billion share repurchase in 2007. Several significant items impacted our reported pre-tax results this quarter by approximately $2 billion including charges of approximately $900 million associated with the aforementioned agreements in principle to resolve certain NSAID litigation, $338 million for restructuring, $378 million for implementation cost and $217 million associated with the previously mentioned returns adjustment. Now I'd like to provide more details regarding our third quarter adjusted income components. Adjusted process sales as a percentage of revenue was 14.5% versus 15.1% for the prior year quarter driven by the benefits of our ongoing cost reduction initiatives, which were partially offset by a less favorable geographic mix. Adjusted SI&A expenses were $3.4 billion, a decrease of 6% year-over-year driven by ongoing cost reduction initiatives which were partially offset by the unfavorable impact of foreign exchange. Adjusted R&D expenses were 1.8 billion, an increase of 2% year-over-year. R&D expenses included increased spending on a larger number of higher cost, phase III clinical trials and increased spending in our biotechnology and bio-innovation center. These will partially offset by savings from our cost reduction initiatives. Higher clinical trial costs were primarily due to the progress we've made on our phase III pipeline, which has increased from 16 to 25 programs over the last six months. Our effected tax rate on adjusted income for the quarter was 22.3% versus 21.7% in the year-ago quarter. For the first nine months of 2008, adjusted revenues increased 2% to $36 billion year-over-year, driven by the favorable impact of foreign exchange of approximately $2 billion or 6% and to a lesser extent a solid performance of many key products. This was partially offset by the unfavorable impact of the loss of U.S. exclusivity Norvasc, Zyrtec and Camptosar whose collective revenues decreased approximately $2.1 billion versus the prior year period. Year-to-date adjusted cost of sales as a percentage of revenue was 15.5% compared with 15.3% in the prior year period. Year-to-date adjusted SI&A expenses decreased 1% versus the prior year period. Year-to-date adjusted R&D expenses decreased 2% versus the prior year period. The effective tax rate on adjusted income for the first nine month of 2008 was 21.4% versus 21.8% in the prior year period. We posted year-to-date adjusted income of $12 billion; an increase of 2% compared with the prior year period and adjusted diluted EPS of $1.77 an increase of 5% which were positively impacted by savings associated with our ongoing cost reduction initiatives and foreign exchange. These were primarily offset by the aforementioned decrease and net interest income. In addition, the prior period's adjusted results included the upfront payment in 2007, the Bristol-Myers Squibb. As I previously mentioned in the third quarter, foreign exchange increased revenues by approximately $620 million or 5%. While, our cost reduction initiatives continue to have a positive impact on our adjusted total cost this quarter, foreign exchange unfavorably impacted these costs by approximately $240 million or 3% compared to the prior year quarter. Excluding foreign exchange, adjusted total cost decreased operationally by approximately $460 million or 6% year-over-year. The net effect to foreign exchange in our adjusted diluted EPS during the third quarter as compared with the year-ago quarter was a positive impact of $0.05. We continue to make excellent progress on our cost reduction efforts. Total cost of the third quarter declined by about 460 million excluding foreign exchange compared with the year-ago quarter. It's important to note that we continue to achieve these absolute reductions even after absorbing inflation and reinvesting in the business. Our cost reductions in the third quarter were realized more quickly than we had originally anticipated. We now expect to achieve a total adjustment cost reduction of at least $2 billion versus our pervious expectation of at least $1.5 billion to $2 billion on a constant currency basis for 2008 compared with 2006. Our cost reduction initiatives continue to span essentially all divisions, functions, markets and sites across Pfizer, broad categories of activity, including manufacturing and research side exits, outsourcing, and targeted workforce reductions. We reduced our global network of manufacturing plants from 78 four years ago to 51 currently. By the end of 2009, we expect to further reduce this global network to 43. Of the six R&D sites that have been identified for closure, we have closed two of the sites, ceased R&D operations at three, and significantly scaled back operations in the remaining sites. In addition, we have a wide array of outsourcing opportunities in various stages of implementation. Manufacturing, logistics, finance, facilities, legal and IT are among the functions contributing to the financial and operational benefits of the strategy. Finally, we are continuing to size our workforce level with current market dynamics. Since January of 2007 our workforce level has decreased by approximately 14,600; 83,400 at the end of the third quarter. Now, I would like to provide some select product results. Lipitor revenues decreased 1% year-over-year to approximately $3.1 billion, including the positive impact of foreign exchange which increased revenues by approximately $130 million or 4%. Year-over-year, Lipitor revenues in the U.S. decreased 13% and revenues from international markets increased 16%. Lyrica continued to deliver strong performance with revenues of $675 million, an increase of 45% year-over-year. Sutent, our treatment for advanced kidney cancer and gastrointestinal stromal tumors, posted revenues of $226 million, an increase of 49% compared with the year-ago quarter. And Viagra revenues increased 13% to $509 million. Chantix revenues decreased 24% year-over-year to $182 million. Chantix results in the U.S. continued to be negatively impacted by label changes. As a result, third quarter U.S. revenues of $96 million decreased 49% compared with the year ago quarter. However, Chantix continued to perform well outside the U.S., Chantix revenues from international markets grew 60% year-over-year to $86 million. As expected, revenues from products that recently lost US exclusivity declined year-over-year, with Norvasc declining 12% to $562 million, Camptosar declining 50% to $122 million and there were no sales for Zyrtec this quarter, compared with $428 million in the year ago quarter. Based on our year-to-date performance and outlook for the remainder of 2008, we're increasing the lower end of our revenue guidance range. We now expect 2008 revenues to be between $48 billion to $49 billion compared with our previous expectation of $47 billion to $49 billion. In addition, we're tightening the range of our adjusted diluted EPS guidance and now expect the adjusted diluted EPS range to be from $236 million to $241 million compared with previous range of $235 million to $245 million. In addition, we tightened our adjusted SI&A expenses guidance range to $14.4 billion to $14.7 billion, from $14.4 billion to $14.9 billion. Finally, as I previously mentioned, we now expect to achieve at least $2 billion in absolute adjusted total cost reduction versus 2006 on a constant currency basis compared with our previous expectation of at least $1.5 billion to $2 billion. So, to summarize the key takeaways, we've increased the lower end of our '08 revenue and adjusted diluted EPS guidance ranges. We continue to see steady growth in several key products, including Lyrica, Celebrex, Viagra, Sutent, Xalatan, Zyvox and Geodon. We're pleased of the solid results we delivered this quarter including achieving our absolute adjusted total cost reduction target for 2008 in the third quarter and finally our EPS growth continues to outpace our revenue growth. And now, I'll turn it back to Chuck."
},
{
"speaker": "Charles E. Triano",
"text": "Thanks for the review Frank. And at this point if we could pause. Operator, if you could please pool for questions. Thank you. Question And Answer"
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Sir, our first question comes from David Risinger of Merrill Lynch. Please proceed with your question."
},
{
"speaker": "David Risinger",
"text": "Thanks very much. I have two questions. The first is related to Lipitor. On the Lipitor sales, where sales impacted in 2008 or in 2007 by stocking? It seems like the reported sales performance in the U.S. was a little weaker than what underlying demand would imply? The other question on Lipitor is that... is related to the outlook. Prescriptions have been stabilizing sequentially recently, could you comment on the outlook? And then the final question is for Frank. Frank at your analyst meeting in March, you had projected a mid 30s to a high 30s operating margin in 2012. I think some investors have wondered how such a post expiry margin is possible without big blockbuster brand but it seems like you are pretty confident because you are assuming that the organization will be downsized. Could you just talk about your level of confidence and your visibility for that level of operating margin? Thank you."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay, good morning Dave. I am going to obviously ask Ian to address the first two questions on Lipitor."
},
{
"speaker": "Ian C. Read",
"text": "Dave, on inventory, there was no impact in the third quarter for inventory movements on Lipitor and a very small impact on the year-to-date. So nothing material from inventories affecting Lipitor's performance. And on our sequential performance I think it's a reflection of the way we are focusing the field force, our access programs, our focus on reducing the switches and I expect us to continue to do what we are doing, fighting for every script in the marketplace."
},
{
"speaker": "Frank D'Amelio",
"text": "And then Dave on the question for me, what I have said is operating margins in the mid to high 30s am going forward, of basically what you said. In terms of getting there, it's really a combination effect. One is the items Jeff mentioned relative to creating new sources of revenue, still maximizing our patent protected portfolio, establishing opportunities and for our established products/units, seeking opportunities in emerging markets, looking at adjacent space as well as business development and advancing our internal pipeline. So you know it's a combination of creating new sources of revenue combined with continuing to be more efficient, more productive and executing on the cost reduction initiatives that we talked about. So it's really a two pronged approach that gets us to the mid to high 30s on the operating margins."
},
{
"speaker": "Charles E. Triano",
"text": "Thanks Frank, next question."
},
{
"speaker": "Operator",
"text": "Thank you, sir. And our next question comes from Roopesh Patel of UBS. Please proceed with your question."
},
{
"speaker": "Roopesh Patel",
"text": "Thank you. I have a couple of questions. First for Jeff, I'm wondering if you could please comment on the M&A outlook for Pfizer in light of what's occurred in the stock market in the past couple of months. Specifically, do you believe that acquisition opportunities have increased in the context of current valuation? And related to that, has your thinking on M&A for Pfizer changed over these past couple of months, if so, how? And then, separately for Frank, FX related question, if I look at year-to-date adjusted EPS growth for Pfizer it's been up 2%. The year-to-date benefit from FX to EPS has been plus 7%. If FX stays where it is to date, can you give us a rough sense for what it's impact would be on earnings over the next year or so? Thanks."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay, thank you Roopesh, good morning. So, let me start on business development. We've been clear that focused business development continue to be an important enabler of all of our growth strategies. And we've said before that we are open to all opportunities and we never say never. I can tell you that under Bill Ringo's leadership, we engage in a very robust and ongoing process to constantly look at all opportunities. And in that process we are always taking account of the very dynamic landscape and the challenges and the opportunities that the environment may create. But while the environment changes, the fundamentals don't change and the considerations I have outlined previously still apply to any deal, large or small. First, it has to have strategic value, the price must be right, it must... we must manage the disruption and risks to productivity. In short, it must create shareholder value, and none of that has changed, as the environment changes, we continue to observe and monitor very carefully and review those opportunities on a constant basis. Frank, you want to talk about foreign exchange?"
},
{
"speaker": "Frank D'Amelio",
"text": "Yes. So let me... let me cover this. Let me run a couple of numbers first and then I'll talk about going forward. So if you look at Q3, we benefited from foreign exchange on revenues by 620 million on EPS by a nickel, which is part of the specific statistics that you have reported. If you look at foreign exchange going forward, if you look at our guidance, we said in our guidance obviously other than those $2 billion, everything's at current October foreign exchange rates. If you were to leave current foreign exchange rates and run now for the rest of the year, FX in Q4 would actually not help our EPS numbers. It would actually be detrimental to the numbers by a couple of cents which we included, factored into our guidance. Beyond Q4, if you look at 2009, we are not ready to comment on that, and the reason I say that is there's lots of volatility right now in foreign exchange and the various currencies. And so to try to call that number today we think isn't a prudent thing to do. We will... I will talk about that number on the January earnings call."
},
{
"speaker": "Charles E. Triano",
"text": "Thanks Frank. Next question please?"
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Mr. Tim Anderson of Stanford Bernstein. Please proceed with your question."
},
{
"speaker": "Tim Anderson",
"text": "Thank you. A couple of questions. Can you talk about Lipitor formulary positioning in Medicare and commercial plan going into '09? Wondering how much slippage in tier II coverage you anticipate and if your impression is that, all the branded cholesterol products would be in a similar situation; Schering had their call this morning, they said they see broad-based formulary tightening across all cholesterol drugs, and I'm wondering if you share that view? Second question is on Sutent. In the U.S., the sales have been flat for several quarters; internationally, they continue to grow well. But I'm wondering if at some point, in the not too distant future of international, it will similarly cap out, kind of flatten out like the U.S. has done in the absence of new indications?"
},
{
"speaker": "Jeffrey Kindler",
"text": "Hey, thank you Tim. Ian can you take both of those questions?"
},
{
"speaker": "Ian C. Read",
"text": "So, Lipitor access, we enjoy, we worked hard to get very positive access from Lipitor. I think it's... in the mid 70s to close to 80% on across our book to business. We've actually seen this year, 75 formulary changes that have either improved Lipitor status or put restrictions on Vytorin over the year. So I'd... I entail [ph] similar types of access in '09 on tier II. I'd just... but tier II is harder than the... in the sense that generic competition does tend to drive against tier II by their marketing practices with physicians. So while tier II is valuable, it's not as valuable as it was 2 to 3 years ago. On Sutent, we've seen as you said what we saw growth in U.S. sales this quarter, we are focusing on the full cycle, we are focusing on the effective dose and you will expect to continue to see growth. We do have substantial shares in renal cell about 60% in most countries. And in the international arena, the population based is quite larger than the U.S. and uptake it somewhat slower. So we expect to see continued growth internationally on Sutent prior to the new indications."
},
{
"speaker": "Jeffrey Kindler",
"text": "And yes, thanks. Tim, I thought maybe Martin could elaborate little bit on the new indications. Go ahead Martin."
},
{
"speaker": "Martin Mackay",
"text": "Yes Tim, just briefly in terms of the new indications, I think in phase B for colorectal cancer, lung cancer, and breast, which are the big three following close behind for the renal cell carcinoma and gastrointestinal stromal tumor, and then, coming up shortly behind that in hepatocellular carcinoma and hormone refractory prostate cancer, so we have several new indications which are following on to the... currently on the market."
},
{
"speaker": "Charles E. Triano",
"text": "Thanks Martin. Next question please."
},
{
"speaker": "Operator",
"text": "Thank you, sir. Our next question comes from Mr. Chris Schott of JP Morgan. Please proceed with your question."
},
{
"speaker": "Chris Schott",
"text": "Great, thanks. Just two quick questions. First on the R&D side. As Pfizer gets more selective in the therapeutic categories that you're investing in, I guess first of all, what becomes of those early stage assets? These things will be looked... the out-licenses are sold off. And then how do we think about them in the context of your longer term R&D budget. Should we be looking at these moves that's creating longer term reductions in overall R&D spend or is it just simply creating more funding to go after late stage assets in your more core areas of focus like oncology? Then can you just quickly about your US based cash flow in the quarter and your cash balances, how much is currently based in the US? But as relates that on repatriation, Bill, as you look into 2009? And then just given all the controversy this year can you just again run through your commitment to the dividends that currently stand? Thanks."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay, Martin, do you want to start on R&D?"
},
{
"speaker": "Martin Mackay",
"text": "Yes, thank you Chris. In terms of the question to the early stage asset, we are starting to look in a number of things now where we would lose to out-licensing partners some of these what we believe to be valuable assets, just know as valuable as others that are in our portfolio? And this will range from single asset to maybe group of assets. You remember recently our spin-off at RaQualia in Japan, where we put some of those early stage assets into that company, and you'll see a number of things over the next period. In terms of the second part to your question, it's exactly right. We are making trade-offs across a very large portfolio now. We have a terrific R&D budget and of course when you have a Phase 3 pipeline that's becoming so replete with a mixture of new chemical entities, product line extensions, license and development activity and pediatric indication on a phase II pipeline is also very healthy. We are making choices both in terms of the disease areas that we work in and the assets we prosecute."
},
{
"speaker": "Jeffrey Kindler",
"text": "Thank you Martin. Frank?"
},
{
"speaker": "Frank D'Amelio",
"text": "Yes, let me hit the dividend item first; and just to say as we've said before certain significant events aside we expect to generate sufficient cash flow funded dividend at least at current levels on a going-forward basis. That's what we have said previously, that's obviously where we continue to be. On cash flow, third quarter operating cash flow in the 10-Q that we filed later on but I'm... I think the way I can answer this from a cash flow perspective is to the first half of the year, we generated almost $8.5 billion in cash flow from operations, about $8.3 billion, and we reiterated our guidance on operating cash flow this quarter for the year, which is $17 billion to $18 billion which is up from the previous year from 2007 of about $13.5 billion. In terms of breaking that out by country, we don't break out cash flow by country; we don't think that's a prudent thing to do, because of the overall numbers."
},
{
"speaker": "Charles E. Triano",
"text": "Thank you, Frank. Next question please?"
},
{
"speaker": "Operator",
"text": "Our next question comes from Steve Scala of Cowen. Please proceed with your question."
},
{
"speaker": "Steve Scala",
"text": "Thank you. I have two questions. First, has Pfizer received an inquiry from the SEC regarding the Lipitor patent litigation settlement? If so, what are the issues, and when, or where does this investigation stand? I'm also curious as to why you haven't, to my knowledge, announced the status of any review as other companies have when they receive these inquiries unless of course you haven't received one, which would be in my opinion, surprising. Secondly, on Dimebon, can you update us on enrollment in the current phase III trial, and do you plan to conduct a Dimebon plus Aricept combination trial as part of the phase III program. Thank you."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay, Steve. I'll let Amy talk about the Lipitor patent settlement, and Martin will talk about Dimebon."
},
{
"speaker": "Amy Schulman",
"text": "Hi, Steve. And as disclosed in our quarterly filings, the SEC review of the Lipitor patent settlement is occurring in the normal course, and we think it will read out on an expected timeline, and there's nothing unusual about that. Martin?"
},
{
"speaker": "Martin Mackay",
"text": "Yes. In terms of Dimebon, Steve, we are now moving full steam ahead for the Phase III study. As you know we... Medivation conducted a very nice phase II study in Alzheimer's patients, which was positive and we're progressing to phase III with all speed. We will have a number of plans for the phase III including a combinations with such drug as Aricept; essentially we have... we will have a full phase III program with this exciting compound."
},
{
"speaker": "Charles E. Triano",
"text": "Thank you Martin. Next question please."
},
{
"speaker": "Operator",
"text": "Thank you sir. And our next question comes from John Boris of Citibank. Please proceed with your question."
},
{
"speaker": "John Boris",
"text": "Thanks for taking the questions, two-part question. First part as to the adapting to the scaling issues, if you do look forward to the 2011, 2013 time period, a lot of your, quite a few of your peers any way have already outlined cost saving initiatives going forward to attack that cliff, your cliff is relatively substantial in that period, a little over 9 billion of U.S. revenue exposed to exclusivity losses. When... what is the timing for potentially initiating another adapting to scale initiative that can certainly... potentially right-size the organization for that cliff in the future? And then, secondly, Jeff, you mentioned about making the organization smaller and certainly the power of scale and have outlined six units. And certainly, you riveted on increasing shareholder value. Can you elaborate on your thoughts of how you might be able to unleash some shareholders value from any of these six units to either a spin or a split off, is that any part of your consideration to improve growth of the organization, long-term sustainable growth of the organization by containing some of that risks in one of those units that you could split or spin? And then your thoughts of the combination of M&A possibly in the mix with that also? Thanks."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay John, I will let Frank address the first question. And then I'll respond to your second question."
},
{
"speaker": "Frank D'Amelio",
"text": "Yes John. So, the way I think about this is, first, we've made very nice progress this year on our cost reduction initiatives. So, $1.7 billion achieved now cumulatively; we had a target of $1.5 billion to $2 billion, we've now increased that to least $2 billion. So you can think about that as at least another $300 million between now and the end of the year as we have finish off those numbers. I think we're demonstrating good execution, positive track record relative to being able to improve our process to take cost out of the business efficiently. I think secondly, from our perspective, efficiency improvements, operational improvements, cost reductions is a continuous trend, it never ends, it's something that we do perpetually and that we will continue to do. In terms of going forward and the way I think about this is what happened in other earnings call in January, as we do on in the January earnings calls, something we typically do as in normal course of business, we will provide guidance on that call for 2009. As we give guidance on that call, we will also include the various elements of our income statement and that will include levels of costs, and guidance on costs of sales and some of the other line items on the income statement. So we will provide information on this as we normally do on the January earnings call."
},
{
"speaker": "Jeffrey Kindler",
"text": "Thanks Frank. And on your second question John, I understand the question, we're always looking at opportunities to increase shareholder value. These units are relentlessly focused on creating value and setting up businesses in which they can pursue, revenue opportunities appropriate to their customers and established cost structures that are appropriate to their businesses. Next question please?"
},
{
"speaker": "Operator",
"text": "Thank you. And our last question comes from Seamus Fernandez of Leerink Swann. Please proceed with your question."
},
{
"speaker": "Jeffrey Kindler",
"text": "Seamus? Seamus there?"
},
{
"speaker": "Operator",
"text": "Yes he is. Please proceed with your questions Mr. Fernandez."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay, maybe we covered it. Operator my understanding is there are no other questions in the queue. So I want to thank everybody for your time today. I know how busy everyone is and we look forward to talking to you again soon. Have a good day. ."
}
] | null | null |
PFE | 2 | 2,008 | 2008-07-23 11:00:00 | Operator: Welcome, ladies and gentlemen. Please welcome Chuck Triano, Head of Investor Relations.
Charles E. Triano: Good morning and thank you for joining us today to review our second quarter 2008 performance. I am here where Jeff Kindler, Chairman and CEO; Frank D'Amelio, Chief Financial Officer, and other members of our senior management team. The financial charts that will be presented on this call can be viewed on our home page at www.Pfizer.com in the Investor Presentations tab by clicking on the link, quarterly corporate performance second quarter 2008. We know this is a busy day for many of you, and our conference call will last an hour, and we will end at noon. As we would like to hear from as many of you as we can in this time, we ask that you limit your question to just one question please. Before we start, I would like to remind you that our discussions during this conference call will include forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. The factors that could cause actual results to differ are discussed in Pfizer's 2007 annual report on Form 10-K and in our reports on Form 10-Q and Form 8-K. Also, the discussions during this conference call will include certain financial measures that were not prepared in accordance with Generally Accepted Accounting Principles. Reconciliation of those non-GAAP financial measures to the most directly comparable GAAP financial measures can be found in Pfizer's current report on Form 8-K dated July 23rd, 2008. These reports are available on our website at www.Pfizer.com in the Investors SEC filing section. I will now turn the call over to Jeff Kindler. Jeff?
Jeffrey Kindler: Thanks, Chuck, and hello, everyone. I would like to welcome Chuck to Pfizer, along with Amy Schulman, our new General Counsel, who is here this morning and who joined us just last month. It is great to have you both on board. We are pleased with our second quarter financial performance, especially at this time of great uncertainty in the world economy and capital markets and significant challenges in our industry. Pfizer continues to be on track to deliver the revenue and adjusted diluted EPS guidance that we set out for 2008. Our pharmaceutical and animal health businesses grew at a healthy rate this quarter, and our cost reduction efforts remained solidly on track with our second quarter adjusted total costs decreasing by $475 million compared to the year ago quarter, excluding foreign exchange. In short, we are doing what we said we would do. As you know, the U.S. pharmaceutical market continues to be challenging given the regulatory environment, generic competition, payer pressures and an uncertain political environment. But despite this and despite the loss of U.S. exclusivity of Norvasc, Zyrtec and Camptosar, which collectively decreased revenues by approximately $500 million during the quarter, our U.S. revenues in the quarter nevertheless declined by only 2% versus the previous year. Without these LOE products, our U.S. pharmaceutical business actually increased by 10%. In this tough U.S. marketplace, we have six products outperforming the branded competition; Chantix, Aricept, Lyrica, Spiriva, Rebif and Sutent. As well as four more mature in-line products successfully defending their positions against newer agents;Viagra, Xalatan, Lipitor and Geodon. Bottom-line, there is certainly more work to be done, but we're more than holding our own against the competition in a particularly challenging U.S. environment. Meanwhile outside the United States, we have one of the strongest global footprints and broadest portfolios in the industry, now accounting for more than half of our total revenues. Revenues from international markets grew a solid 5% this quarter compared to last year, even before the benefit of foreign exchange. Our primary growth strategy around the world is to refocus and optimize our patent protected portfolio of both marketed medicines and compounds in development. In that connection, the agreement we made with Ranbaxy this quarter brings substantially certainly that a generic version of Lipitor won't be introduced in the U.S. for another nearly three-and-a-half years. While the lipid-lowering market is one of the world's most challenging, Lipitor is holding its own as we continue to fight for market share and to press the essential message that Lipitor has no generic or branded equivalent. Pfizer is far more than Lipitor, of course, and our year-to-date results show positive trends for a number of key medicines in our patent-protected portfolio. Lyrica is up 50% year-to-date with growth driven by strong efficacy in managing nerve pain associated with diabetes and shingles, as well as in managing fibromyalgia, which increasingly is being understood as a serious and debilitating disease. Revenues for our cancer agent, Sutent, were up 62% year-to-date. Currently Sutent's international growth is outpacing its growth in the U.S. where it has been available longer. That said, we are pursuing additional indications for Sutent and conducting Phase III trials for patients with breast, colorectal and lung cancer among others. Sutent represents our commitment to emerge quickly as a leader in fighting cancer. To advance that goal, we created this quarter a dedicated global oncology business unit within our pharmaceutical segment led by Gary Nicholson, formerly the head of Lily's U.S. oncology business unit. This unit will serve as the single point of accountability for Pfizer's worldwide oncology business in keeping with our commitment to reorganize into more focused and agile business units. Now, of course, we would all prefer to prevent cancer and heart disease than to have to treat them, and that's why smoking cessation is so important. Smoking is expected to be the largest preventable cause of death in this century with some estimates that the toll may be one billion people. There are few things that provide greater health benefits than quitting smoking. And our innovative smoking cessation aid, Chantix, is an effective option for those who want to quit. In fact, we get letters day after day from patients who had given up all hope of quitting smoking until they used Chantix. Its global sales grew 3% this quarter compared with the same period a year ago. Strong international growth was largely offset by a 35% decline in U.S. revenues, which was due mainly to labeling changes and to external reports about adverse events. Let me be clear; we believe the Chantix labeling appropriately reflects the medication's risks and benefits, and we will continue to encourage doctors and patients to have a robust dialogue about the dangers of smoking and appropriate treatment options. Meanwhile, we're seeing strong performance among other important brands. So far this year Geodon is up 20%. Viagra is up 13%. Xalatan is up 12%, and Celebrex is also up 12%. In addition, we continue to pursue [ph] new opportunities for our in-line medicines. We recently launched Champix in Japan, where we also earned approval for Sutent for certain types of cancer and submitted Lyrica for nerve pain after shingles. And in Europe last month we launched the product we licensed from Schwartz Pharma called Toviaz fesoterodine to treat overactive bladder. Efforts like these extend the lifecycles of our in-line medicines, complementing our R&D work on new compounds. In that connection, we also continue to make steady progress advancing one of the most robust pipelines in the industry. In our R&D labs, we are looking to significantly increase our return on invested capital by making smart and focused decisions, including where appropriate exiting certain areas of activity. And we're seeing progress in productivity. Since our last pipeline update in March, we had begun Phase III development of five new molecular entities and product line extensions. We now have 20 Phase III projects underway. A noteworthy example is CP-751871, a biologic discovered by Pfizer and proposed for the treatment of non-small cell lung cancer. We advanced apixaban, our development project with Bristol-Myers Squibb into a Phase III study for treatment of Venous Thromboembolism. In addition to line extensions to maximize the value of Geodon and Celebrex, we also added Thelin, a once daily oral treatment for pulmonary arterial hypertension which is already approved in Europe, Canada and Australia. It was acquired through our purchase of Encysive. In addition, we expect seven Phase III oncology studies in 2008 with two already open and enrolling, reflecting Pfizer's commitment to oncology which currently accounts for 22% of our R&D budget. One of the milestones this quarter was a license agreement with Quad for CDX-110, a Phase II oncology vaccine candidate for the treatment of brain cancer. We continue to move ahead on our goal of 15 to 20 Phase III starts this year and next with the objective of having 24 to 28 compounds in Phase III by the end of next year. We are on track to meet these goals. An important research initiative this quarter was the establishment of the Pfizer Regenerative Medicine Unit, which will provide us with new targets, new tools and ultimately new therapies across a number of disease areas including Alzheimer's disease, cancer and other debilitating disorders. Now just as our R&D work is shaping Pfizer's future, changes in our business strategy are shaping the future as well. The fast growth of Pfizer's business outside the United States points to significant potential in emerging markets where we have set a goal of outpacing market growth, which is expected to be 11% per year between now and 2012, the year after Lipitor loses exclusivity. In addition by then, we aim to be the number one pharmaceutical company by revenues in six of our seven top priority emerging markets. Namely Brazil, China, Mexico, Russia, South Korea and Turkey. The competitive advantages of our broad portfolio of established products and our strong global footprint lie at the heart of our strategy to grow in emerging markets, many of which have more than half of their total sales being driven by established products compared to about 12% in the United States. To understand the potential of these markets for Pfizer, consider the fact that $80 billion in new revenues from increased use of established products is expected between now and 2012, and we currently have about a 4% share. There is an enormous opportunity here for us to take a greater share of this growth over the next three to five years. Steady execution of all of this commercial, R&D and strategic work demonstrates that Pfizer is continuing to change and change fast. A new culture of innovation and continuous improvement is shaping a new, leaner and smarter Pfizer. Throughout the Company we have new, smaller, more accountable business units which have been given much more freedom to innovate. Over the past two years, while building an outstanding management team, we have challenged colleagues to think differently, to work differently and to examine our business in new ways and from all angles but, especially from that of the customer. We have shaped a new corporate culture that is cost conscious where employees are encouraged to think and act like entrepreneurs. These efforts are supported by our financial strength, a competitive advantage that allows us to balance our strategic needs while meeting our financial commitments. We have also kept our commitment to greater candor and transparency. Just this past quarter, we stood alone in reforming the way we finance continuing medical education in the United States to remove any appearance of conflict of interest. We begun to build the strong new presence in biotherapeutics, made progress in rebuilding our pipeline, particularly in the late stages; streamlined our manufacturing; attracted a new generation of leaders to Pfizer; and created the path forward for our future. The hard work is far from over, and it will never truly be over. But in this quarter's results, we see some reflection of our hard work and one more important step in doing what we said we would do, build a Pfizer that can and will succeed. And now for the financial details, please welcome Frank D'Amelio.
Frank D'Amelio: Thank, Jeff. Good morning, everyone. The charts I am reviewing today are included in our webcast and will help facilitate the discussion of our second quarter 2008 results. Now let me get to our financials. Today we reported revenues for the second quarter 2008 of $12.1 billion, a 9% increase year-over-year which reflects the positive impact of foreign exchange, which increased revenues by approximately $800 million or 7% and solid performance of many key products, which more than offset the negative impact of revenue declines resulting from the loss of exclusivity in 2008 for Zyrtec whose revenues decreased $377 million and Camptosar whose revenues decreased $104 million. Reported net income increased year-over-year by 119% to $2.8 billion in the second quarter, and reported diluted EPS of $0.41 increased to 128%. These increases were primarily driven by lower restructuring charges related to our cost reduction initiatives, as well as savings resulting from these initiatives; the positive impact of foreign exchange; and favorable income tax adjustments related to the sale of Esperion and favorable tax settlements, which were partially offset by increased in-process R&D expenses associated with the acquisitions of Serenex and Encysive Pharmaceuticals, which closed during the quarter, and the impact from the loss of U.S. exclusivity for certain products. We generated adjusted income of $3.7 billion in the second quarter, an increase of 26% year-over-year and adjusted diluted EPS of $0.55, an increase of 31%, driven by the savings resulting from our cost reduction initiatives; the positive impact of foreign exchange; the non-recurrence of the one-time '07 payment to Bristol-Myers Squibb in connection with our collaboration to develop and commercialize apixaban; and tax settlements, which more than offset the impact from the loss of U.S. exclusivity for certain products. Both reported and adjusted diluted EPS in the second quarter were favorably impacted by the full-year benefit of our 10 billion share repurchase in 2007. During the second quarter of 2008, we repurchased approximately $500 million or 26.4 million shares of our common stock. I would also like to point out that our debt level at the end of the second quarter decreased sequentially by approximately $400 million, notwithstanding our dividend payment, share repurchases and the funding of our operations. We had several significant items included in our reported results this quarter. More detailed disclosures will be provided in our Form 10-Q filing with the SEC. In the second quarter, we incurred $562 million in restructuring charges compared with $1 billion in the prior year quarter. This significant decrease was driven by greater restructuring charges associated with employee related cost in the year ago quarter. We also incurred $405 million of implementation cost compared with $317 million in the prior year quarter, primarily related to sites we exited or are in the process of exiting. These implementation amounts are reported in cost of sales, R&D, SI&A expenses and other income deductions and are detailed more fully in supplemental information accompanying the release. Now I would like to provide more details regarding our second quarter adjusted income components. Adjusted revenues were $12.1 billion, an increase of 9% year-over-year. Adjusted cost of sales as a percentage of revenue was 16.9% versus 17% in the prior year quarter, notwithstanding less favorable geographic mix and the impact of foreign exchange. Excluding foreign exchange, adjusted cost of sales as a percentage of revenue was 16.1%. Adjusted SI&A expenses were $3.7 billion, a decrease of 1% year-over-year, reflecting a decrease in marketing expenses which more than offset the negative impact of foreign exchange. Adjusted R&D expenses were $1.9 billion, a decrease of 8% year-over-year due primarily to realized savings resulting from our cost reduction initiatives and the non-recurrence of the one-time payment to Bristol-Myers Squibb in '07 associated with our collaboration to develop and commercialize apixaban. Our effective tax rate on adjusted income for the quarter was 20% versus 22.2% in the year ago quarter, due to favorable tax settlements. Our EPS growth is outpacing our revenue growth, which clearly reflects positive leverage. Now I would like to provide a mid-year update on our adjusted results. Revenues increased 2% to $24 billion in the first half of 2008 compared with the prior year period, driven by the solid performance of many key products. First-half revenues reflect the favorable impact of foreign exchange, which increased revenues by approximately $1.4 billion or 6%, which was offset by the negative impact of the loss of U.S. exclusivity of Norvasc in 2007 and Camptosar and Zyrtec in 2008, which collectively decreased revenues by $1.4 billion. Adjusted cost of sales as a percentage of revenue for the first half was 16.1% compared with 15.4% in the prior year period, primarily due to less favorable geographic mix and the negative impact of foreign exchange. Excluding foreign exchange, adjusted cost of sales as a percentage of revenues for the first half of the year was 15.3%. Adjusted SI&A expenses increased 1% in the first half compared with the prior year period, and adjusted R&D expenses decreased 4%. We posted adjusted income of $7.8 billion in the first half of 2008, an increase of 1% compared to prior year period, and adjusted diluted EPS of $1.15, an increase of 5%, reflecting the benefit of savings associated with our cost reduction initiatives; the positive impact of foreign exchange; the non-recurrence of the one-time '07 payment to Bristol-Myers Squibb; favorable income tax adjustments and our share repurchases in 2007, which were offset by the impact from the loss of U.S. exclusivity for certain products. As I previously mentioned, this quarter foreign exchange increased revenues by approximately $800 million or 7%. We continued to achieve cost reductions this quarter, and our ongoing cost reduction initiatives continue to have the positive impact on our results. That said, foreign exchange continued to have an unfavorable impact on our cost and expenses this quarter. Overall foreign exchange unfavorably impacted adjusted total cost by approximately $440 million or 6% this quarter compared with the prior year quarter. Excluding foreign exchange, our adjusted total cost decreased operationally by approximately $475 million or 6% year-over-year. The net effect of foreign exchange on our adjusted diluted EPS during the second quarter as compared with the year ago quarter was a positive impact of $0.04. This positive impact was not incremental to our EPS guidance since the guidance we provided in January of '08 and reiterated during the second quarter was given at current exchange rates. We continue to make progress against our objective to reduce absolute adjusted total costs by at least $1.5 billion to $2 billion at the end of '08 compared with '06 on a constant currency basis. To date we have achieved a cumulative operational cost reduction of $1.2 billion. We expect to achieve much of the remaining reduction in the fourth quarter, which will favorably impact that quarter's adjusted diluted EPS. I want to point out that we expect to achieve this reduction even after absorbing inflation, which adds approximately $1 billion to adjusted total cost annually and reinvesting in our business. While our cost reduction initiatives will continue to reduce absolute costs for the balance of 2008, the timing of the realization of these reductions is also a function of spending patterns in both '06 and '08. The spending level in the fourth quarter of '06 was higher than usual due to establishing research collaborations with third parties and sales and marketing investments in international markets. By comparison, quarterly spending patterns in '08 have been and are expected to be more consistent with historical norms. Because of the different spending levels between '06 and '08, much of the remainder of our absolute cost reduction target will be achieved in the fourth quarter of this year. Our cost reduction initiatives continue to span essentially all divisions, functions, markets and sites across Pfizer. Broad categories of activity include manufacturing and research side exits, outsourcing and targeted work force reductions such as our ongoing previously announced European field force reduction. We reduced our global network of manufacturing plants from 78 four years ago to 54 currently. By the end of '09, we expect to further reduce this global network to 44. As part of this effort, we recently announced our decision to cease operations at our Terre Haute facility by the middle of '09. We also recently announced the spin-off of our R&D laboratory in Nagoya, Japan. We are continuing to exit the three remaining R&D sites of the six that have been identified for closure. Also, we have a wide array of outsourcing opportunities in various stages of implementation, manufacturing, logistics, finance, facilities, legal and IT are among the functions contributing to the financial and operational benefits of this strategy. Finally, we are continuing to match our workforce level with the current market. Over the past 18 months, our workforce level has decreased by 13,500 to 84,500 as of June 29, '08 from 98,000 at the end of 2006. And, as a result of recent actions this month, our current level is approximately 84,100. All key in line and new product revenues increased in the second quarter compared with the year ago period. Lipitor revenues increased 9% year-over-year to approximately $3 billion, including the positive impact of foreign exchange which increased revenues by approximately $170 million or 6%. Year-over-year Lipitor revenues in the U.S. increased 1%, and revenues from international markets increased 18%. Lyrica continued to deliver strong performance with revenues of $614 million, an increase of 52% year-over-year. Sutent, our treatment for advanced kidney cancer and gastrointestinal stromal tumors, posted revenues of $211 million, an increase of 45% compared with the year ago quarter. I want to point out that while Sutent revenues in the U.S. declined 2% year-over-year during the second quarter, first-half U.S. revenues increased 10% versus the prior year period. Year-over-year Chantix revenues increased 3% to $207 million. As Jeff stated, Chantix's results reflect the negative impact resulting from updates to the U.S. label to include additional safety information, as well as from certain external events. As a result, U.S. revenues decreased 35% year-over-year to $109 million. That said, Chanpix continued to perform well outside the U.S. Chanpix revenues from international markets grew 197% year-over-year to $98 million. As we expected, revenues from products that recently lost U.S. exclusivity declined year-over-year with Norvasc declining 2% to $627 million, Camptosar declining 43% to $137 million, and Zyrtec declining 98% to $8 million. Today we are reaffirming full year 2008 revenue and adjusted diluted EPS guidance. As a result of the significant unfavorable impact of foreign exchange on adjusted cost of sales in the first half of '08 we are tightening our guidance on the lower end of the range. We currently expect adjusted cost of sales as a percentage of revenue to be between 15 and 15.5% compared with our previous expectation of 14.5% to 15.5%. We continue to be on track to achieve the reduction in absolute adjusted total cost of at least $1.5 billion to $2 billion at the end of '08 compared with '06 on a constant currency basis. As I previously stated, we have achieved $1.2 billion of the targeted reduction to date. We expect the balance of this reduction to gain momentum throughout the second half of the year with much of the remaining savings to be realized in the fourth quarter to favorably impact that quarters adjusted diluted EPS. Finally, we are updating our guidance on our 2008 effective tax rate. We now expect the effective tax rate on adjusted income for the year to be between 21.5% and 22% versus our previous expectation of 22% to 22.5%. So, to summarize the key takeaways, we are reaffirming our '08 revenue and adjusted diluted EPS guidance. We continued to see steady growth in several key products, including Lyrica, Geodon, Viagra, Celebrex and Sutent. As we expected, this quarter's results were negatively impacted by the decline in revenues from the loss of U.S. exclusivity of Zyrtec and Camptosar. We are continuing to execute and make progress, and our cost reduction initiatives on track to achieve our adjusted total cost reduction target. To date we've achieved $1.2 billion in adjusted total cost reductions. We expect to realize the majority of the remaining cost reductions in the fourth quarter. Finally, we're pleased with the solid results that we delivered in the second quarter, including the benefit of our cost reduction initiatives. Our EPS growth this quarter outpaced our revenue growth, demonstrating the benefit of these initiatives to our bottom-line. And now I will turn it back over to Chuck.
Charles E. Triano: Thanks Frank and at this point if we could ask the operator to begin pulling for questions please. Question and Answer
Operator: Thank you very much. [Operator Instructions]. The first question is from John Boris with Citi. Please proceed with your question.
John Boris: Thanks for taking the question. Largely financial related questions. Free cash flow, Frank, in the first quarter and second quarter, can you just share what free cash flow was? The second part has to do with price and volume, what that contributed to growth and then the third question just has to do with sequential borrowings. They went up by about $3 billion to $9 billion. Can you just share with us or provide a little color on the use of those funds? Thanks.
Frank D'Amelio: Sure, John. So operating cash flow in Q1 was $3.3 billion and Q2 will be part of the Q that we filed in a few weeks. In terms of price, volume and foreign exchange for Q2, price was down 2%, volume was up 4% and the foreign exchange we got benefit of 7%, which was the $800 million that I alluded to in my comments. And then on the third item, which was borrowing let me just run the numbers. At the beginning of the year, we had about $13 billion in debt. At the end of last quarter, we had about $17 billion. At the end of this past quarter, we had about $16.5 billion and I am rounding. That's about $400 million down quarter-to-quarter, and that $400 million decrease was while we purchased $500 million of our stock.
Operator: Thank you very much. And next question is from David Risinger with Merrill Lynch. Please proceed with your question.
David Risinger: Yes, thanks very much. There is obviously a significant market opportunity for the JAK-3 for rheumatoid arthritis, but there has been some investor noise about its toxicity profile. I was hoping that you could walk us through the JAK-3 side effects and tell us what to focus on at ACR in October? And then separately, if you could just discuss Sutent's U.S. trends in more detail? Thank you.
Jeffrey Kindler: Okay. Martin, do you want to take the first part of that?
Martin Mackay: Surely, happy to. Thank you for the questions. As you correctly see, JAK-3 continues very well in Phase II. We will report at the ACR meeting later this year, and obviously we will report on both efficacy and side effects. Given the mechanism as we've discussed before, we know the side effects to look for in the clinical trials. We're monitoring those very carefully. Given those badly published in Phase IIa data that we published some time ago, we were really very pleased with the side effect profile of the compound and that continues.
Jeffrey Kindler: Okay and the second question, Ian.
Ian Read: Yes. So, David on Sutent's second quarter, so second quarter down 2%, first semester up 10%. I would like to point out in the U.S. I suppose your question was directed to the U.S. there our share is 56% in RCC and 88% in second line for GIST. So we're not satisfied with a 56% share in the U.S., and we need to advance our share there by focusing on Sutent's efficacy and keeping patients on therapy at the appropriate dose throughout all treatment cycles. One of the key programs we're going to use on that or data is the two year survival data recently presented at the 2008 ASCO where our survival data represented the longest medium overall survival to date of any agent in first line settings.
Frank D'Amelio: And then just overall Sutent sales globally for the quarter were up 45% year-over-year, and then outside the U.S. internationally, they were up 80% year-over-year. So that's a product that is doing well in the U.S. and continues to do very well outside of the U.S.
David Risinger: Okay.
Jeffrey Kindler: Thank you Frank. Next question please.
Operator: Thank you. The next question is from Roopesh Patel from UBS. Please proceed with your question.
Roopesh Patel: Thank you. My question is on U.S. Lipitor sales. I was wondering if you could help us reconcile the 20% sequential decline in U.S. Lipitor sales versus the first quarter. With the 3% drop in prescriptions that have been reported over the same period. My understanding was that inventory levels were normal when exiting the first quarter. There have been no price increases over the course of the second quarter. So if you could just help us there. And then separately, what impact do you expect the recent reporting of Vytorin's SEAS trial to have on the cholesterol market growth and on Lipitor?
Jeffrey Kindler: Okay, thanks Roopesh. I'll let Ian take both of those questions.
Ian Read: So we normally have fluctuations between first and second quarter difficult to reconcile those. So just look at the first semester for Lipitor where sales growth was down 11%. Pricing was basically flat between price increase and rebates. And the net of market growth and share was down about 16%, and the differential between that and the 11% is driven partly by increased number of units both per TRX and partly via a normalization of the inventory level at the end of '08. Vis-à-vis the Vytorin trial, I think it is too early to tell the impact on market growth, and certainly what we're focusing on is Lipitor's positioning at getting the goal, the efficacy across the dosage rang range, our safety and our landmark trials.
Jeffrey Kindler: Thanks Ian. Next question please.
Operator: Thank you very much. The next question is from Catherine Arnold with Credit Suisse. Please proceed with your question.
Catherine Arnold: Sure, good morning.
Jeffrey Kindler: Good morning.
Frank D'Amelio: Good morning Catherine.
Catherine Arnold: Good morning. In the spirit of greater candor and transparency, which I applaud Jeff, can you tell us the split of targets for absolute adjusted total cost savings in terms of U.S. versus non-U.S.? You gave us the target of $1.5 to $2 billion by the end of the year. And I was wondering also you mentioned -- you used the phrase at least in the press release, and I would love to know what the magnitude of upside might be to that in your optimistic case for this year?
Jeffrey Kindler: Okay. I am sorry, I didn't completely understand the second question Catherine. The upside of cost do you mean?
Catherine Arnold: Yeah, yeah. The target $1.5 to $2 billion in the press release, it says at least $1.5 to $2 billion can be achieved. So I am wondering what the magnitude of upside might be for those targets?
Jeffrey Kindler: Okay, I'll let Frank to take both those questions Catherine.
Frank D'Amelio: Yes, so Catherine, let me do it this way. In the release we said we've achieved $1.2 billion to date. If you look at the rhythm in terms of what we've have done there, it was $600 million in '07, a $170 million in Q1 and then $465 million in Q2. We haven't provided details on that relative to U.S., non-U.S. But know those savings and the target of $1.5 to 2 are global in nature. They reflect actions that are being taken both in the U.S. and outside the U.S. kind of point one. In terms of the second question with the at least language, we're at 1.2. Our job is to do as much as we can relative to the range. So understand when we get to $1.5, we're not going to stop; we're going to deliver as much as we can to get as high into the range as we possibly can. In terms of what's available above and beyond the range, my answer is we're at $1.2, we will get every dollar we possibly can, and we will get that by the end of the year.
Jeffrey Kindler: Thanks Frank. Next question please.
Operator: Thank you very much. And the next question is from Tim Anderson with Sanford Bernstein. Please proceed with your question.
Jeffrey Kindler: Hi Tim.
Frank D'Amelio: Hello Tim.
Tim Anderson: Yeah, hi. Can you talk about Pfizer's potential interest to get into the generics business beyond what you currently do with Greenstone? Glaxo today announced that they'll sell branded generics in emerging markets, and Sanofi is trying to buy Zentiva, and there was talks that you guys were looking at Ranbaxy fairly recently. And secondly, on Lyrica sales have been pretty flat in the U.S. for the last three quarters, and recently new prescriptions look like they are actually trending down. And I am wondering if you can address what might be going on in the U.S. market specifically?
Jeffrey Kindler: Okay Tim. I'll take the first one and let Ian take the second one. As you know, the established product strategy is a very important one and important enough that we established, pardon the pun, a business unit specifically focused on that and led by Dave Simmons who has tremendous experience in those parts of the world where established products continue to retain brand equity and we can drive sales based on physician and patient preferences. And Norvasc this quarter actually is not a bad example of that, and we're still experiencing goods sales even on a product like that that has lost exclusivity in a lot of markets. The established opportunity, if you put aside products that are just going off patent and flipping from the patent protected to the established marketplace and just look at organic growth, just volume increases, it is a $80 billion opportunity by the time Lipitor goes off pat. We currently have a 4% share of that. We believe that we have a unique set of competitive advantages to increase that share and to exploit that market. And those include the breadth of our therapeutic portfolio and product portfolio, which is very important in those markets, and our geographic presence. We have been in these markets a very, very long time, and we have established relationships with key opinion leaders and the like. And we really think there are very, very few companies that are going to be able to compete the way we compete in those markets. And those markets are more than just China. Tim there is emerging markets in Latin America, Eastern Europe, Asia. But if you just look at Asia, and I am talking about more than China that is an opportunity that goes from $47 billion to $80 billion by 2012, and our current share is 4%, and we have a goal of increasing that share by the time Lipitor goes off pat. And just to take China as an example, we said in our March 5th meeting that we're going to increase our field force presence from 110 cities to 126 by the end of the year. We've already achieved that goal. So now we've raised the bar, and we're going to be in 137 cities by the end of the year. So this is a tremendous opportunity for us. And to answer your specific question, we've been clear that all our strategies are going to be supplemented by appropriate business development. And we'll look at opportunities for enhancing our ability to compete and when in the established markets in the emerging markets. We really think this is a big winner for us and a big opportunity, and we've already seeing early signs of success in the way that we focused on it. The second question was about Lyrica progress, so I'll turn that over to Ian.
Ian Read: Well Tim, I just want to go back on the data. We did, in fact, grow in the quarter 52% with Lyrica. If I look at the script trends, I can't really validate the data you gave. I can see sequential growth in TRXs quarter-on-quarter. That being said, I acknowledge they are slower than they were post the fibromyalgia launch -- that growth. So the game plan for us really is to further grow leadership by being a treatment of choice in DPN and PHN, and there is very low diagnosis treatment rates in those two conditions, and we do have a good market share already in about 30% in those conditions and all the treatment of choice. And in fibromyalgia we continue to develop that market. There is about six million patients that suffer from fibromyalgia. Only 22% are diagnosed, and that requires market development. So optimistic about the performance going forward.
Jeffrey Kindler: Thanks Ian. Next question please.
Operator: Thank you very much. The next question is from Chris Schott with JPMorgan. Please proceed.
Chris Schott: Thank you. Just a couple of quick questions. First, on Lyrica, what are your expectations on any potential label change for the drug given the recent FDA panel on the epilepsy class in general? On Chantix I was just kind of surprised, happy to see the international sales kind of hanging in there as much as they had given what has happened in the U.S.? Can you talk a little bit about the feedback you're getting on the drug ex-U.S.? Are you expecting a delayed reaction to some of the safety concerns, or just generally speaking are these markets less sensitive to that type of news than we see in the U.S? And then maybe just finally, just generally speaking, we've seen across the industry a number of therapeutic categories in the U.S. with weaker than expected volume growth this year. As with higher co-pays and a weak economy, just interested in your thoughts in general. Are we seeing more economic sensitivity to the prescription pharma market in the U.S. than maybe historically? Thanks.
Jeffrey Kindler: Okay Ian. I am going to give you all three of those.
Ian Read: Okay. So Lyrica, we're pleased with our recommendation from the advisory committee the FDA, and we will await the final decision from the FDA. But it was a pretty strong positive vote from the advisory committee vis-à-vis not putting a black-box on. Secondly, I think your discussion was Chantix vis-à-vis --
Chris Schott: International, the difference between international… kind of I think you hear --
Ian Read: International you have got to realize that there are two factors going in international. Number one, the label changes have not been anywhere near as dramatic as in the U.S. with the EMEA taking a different view than perhaps the FDA took. A rollout that is slower internationally as the market penetration is not as fast when you launch internationally. So you will see sort of a more consistent growth pattern internationally. So I think those are the two differentiations in the international vis-à-vis the U.S. on Chantix. And then the third one was…
Chris Schott: The effect of the U.S. economy given co-pays and --?
Ian Read: I think we are seeing a… you are seeing a slow-up in the U.S. market growth rate. I think the IMS came out with a report on that and undoubtedly is affected by the way managed care has shifted higher co-pays. It is I think a factor. There was a report that came out from Kaiser which indicates that scripts are not being filled or pills are being split due to the economic pressures that are being caused by these co-pays.
Jeffrey Kindler: One thing I would just add to that Chris, is that one of the trends that's starting to emerge, which is a very positive one is that employers, large companies, that are concerned about health care costs and the long-term health of their employees are beginning to see the value of reducing and even in some cases eliminating co-pays in order to improve adherents to medicines and actually increase the adoption of medicines. Ian do you have --
Ian Read: Example of that is the success we've had in working with employees to cover Chantix. Where we have offered about… what we have added about 1.6 million lives on Chantix coverage due to employees' focus on overall health care.
Jeffrey Kindler: Okay. Thanks. Next question please.
Operator: Thank you very much. And next question is from Tony Butler with Lehman Brothers. Please proceed with your question.
Tony Butler: Thanks very much. A couple of strategic questions, Jeff, directed to you and then one for Martin. I believe early last year or earlier this year you had added Bill Ringo to strategy and/or BD. I am curious if strategy and BD has actually changed its direction, and if you can share with us if, in fact, it has, if you can share with us maybe directionally where that may be heading? And second, you ticked off a number of or a list of… I am going to say completed items that you and your management team have done over the past couple of years, in particular the issues around cost reduction the issues of trying to force more into Phase III etc. I am curious where you may be turning your focus or your attention today or perhaps over the next 6 to 12 months? And that as to say, is that an increasing opportunity internationally? Is that the direction? And then for Martin, there has been reference to obviously JAK-3 kinase inhibitors. There has been a reference to apixaban. Some excitement on those couple of products. But if, in fact Pfizer is to have 24 to 28 Phase III products by the end of 2009 could you actually name two or three others that again you tend to be most excited about in the portfolio? Thanks.
Jeffrey Kindler: Okay. Thanks Tony. Actually the two questions you posed to me I think are quite related. We did bring in Bill Ringo. He has now been here, I think a couple of months at most, and he is already making a big difference because he has vast experience in our industry, not just at Lily but at Biotech and Venture Capital, and he is incredibly well respected and well known figure in the biopharmaceutical in general. And he is bringing a sharper focus on execution of the strategies. And the broader point about strategies that you raised, we've laid out I think quite clearly our growth strategies, and we've also said that all of them are going to be augmented as appropriate supplemented by business development. And what we're focused on now is execution. I think we've seen evidence in this quarter that we're beginning to really see some results from a sharp focus on the execution of our strategies by the foundational changes that we have made over the last couple of years in terms of leadership and structure, and the rest of it I think as we said a strong foundation that we are now beginning to capitalize on. And, those strategies range from advancing the pipeline which you mentioned. We have talked about international and established and emerging markets. We have talked about getting more out of our in line portfolio, and all of these things will continue to be supplemented by business development, and Bill is off to a great start assessing the opportunities and helping us move forward, and he is a great addition to our team. Beyond that position that he holds, but also by virtue of his real terrific experience and knowledge of our industry. And I will turn it over to Martin for the other question that Tony asked.
Martin Mackay: Thank you, Tony. Clearly you mentioned the JAK-3 inhibitor and apixaban which we are very excited about. I would name another couple I will be presenting data on shortly that we have equal excitement about. The IGF-1R antibody for non-small cell lung carcinoma just went into Phase III. We are ahead in this game of this particular mechanism in antibody, and we're very pleased with the results we're seeing. Another one that we've published recently and will give further publications on later in the year is Denosumab, which is the NGF antibody that was discovered at Rinat, part of the Rinat acquisition, in pain. And we described our results at ULAR around six weeks ago and again will be showing more results and be looking to push that into Phase III in a very short timeframe. There is some other NC Phase II that we're very pleased about, the Sulopenem antibacterial, and clearly we continue to work on the DPP-4 mechanism. Just one other area I would mention, though, and that goes to our product enhancements, which you will remember I spoke about as our golden assets. If I think about our oncology pipeline alone, think about the work we're doing in Sutent, we are already in Phase III with breast, lung and colorectal, and we will be following up very shortly into Phase III with a patch of cellular carcinoma and hormone refractory prostate cancer, and these results continue unabated. With Axitinib we have Phase II studies in renal cell carcinoma and others. So really just to wrap up, Tony, we have a very exciting Phase II/Phase III pipeline emerging.
Jeffrey Kindler: Okay. Thank you Martin. Next question please.
Operator: Thank you very much. The next question is from Steve Scala with Cowen and Company. Please proceed with your question.
Steve Scala: Oh, thank you. Where does the Lipitor patent litigation settlement with Ranbaxy stand relative to FTC review? It would seem that the FTC might be interested in a settlement given that the amorphous form patent does not appear applicable to the form that is commercialized, and there might be no apparent offsetting benefit to U.S. consumers. So how confident are you on this settlement? Thanks.
Jeffrey Kindler: Steve, as you know, we have a long tradition here of great general counsels protecting our intellectual property, a record that I know Amy is going to maintain, so I will let Amy respond to that question.
Amy Schulman: Thanks, Steve. I think that we're comfortable with the terms of the Lipitor settlement, and we don't expect any problems.
Jeffrey Kindler: Specifically we're very comfortable that the FTC will not have an issue.
Jeffrey Kindler: Okay. Next question please.
Operator: Thank you very much. The next question is from Barbara Ryan with Deutsche Bank. Please proceed with your question.
Barbara Ryan: Oh, thank you. Good morning.
Jeffrey Kindler: Good morning Barbara.
Frank D'Amelio: Good morning.
Barbara Ryan: How are you? I had a question about emerging markets, but I think you have gone through a lot of that. But maybe also just following along with that Jeff, it seems as though there has been a lot of work necessary to be done in the organization to restructure the organization to change the culture to bring in people. And is it fair to look at this in sort of a step function approach over a continuum looking out towards the Lipitor patent expiration? And some of the things that you have talked about having accomplished, it seems as though a lot of those things are well in motion. You brought in your new team. Would it be appropriate given that we would be… we should be looking for the next step to be a lot more business development driven to bolt on to the kinds of changes that have already been put in place that maybe improve the foundation from which you are working?
Jeffrey Kindler: Well, let me try to answer it this way Barbara. I think as you point out, we have made a lot of progress in establishing a very strong foundation for success. I am extremely pleased with how much progress we've made in that regard in a very short period of time. That work is never over, but to your point we're in a very good position now in terms of our leadership team, our culture, our organization. We'll always be continuing to improve all that, but we're moving forward and we are executing. We outlined our five growth strategies. We have outlined our cost approach, and we are all about executing against those strategies, and as I said before where appropriate supplementing them with business development.
Jeffrey Kindler: Next question please.
Operator: Thank you very much. The next question is from Bert Hazlett with BMO Capital Markets. Please proceed with your question.
Bert Hazlett: Thank you. Thanks for taking the question. My question is actually on Denosumab, the '08 product that you showed data on at ULAR and for the Alzheimer's compound. Regarding Denosumab, I think it was in IV dosing and it was every eight weeks. Is that what you anticipate going forward with in Phase III, or is there a sub-Q dose in the works? And then regarding the Alzheimer's program and the ICCAT data coming up, you have Phase II data being presented for your rage antagonist and some Phase I data for the Anti-Amyloid Monoclonal. How rapidly can you move these forward, and can you just talk the general enthusiasm about those programs? Thanks.
Jeffrey Kindler: Okay. Thanks for the question. Martin?
Martin Mackay: Yeah, happy to do that. Certainly the eight weeks dosing was very successful in the data that we looked at, and we will be pushing that into Phase III. We will obviously be looking to other formulations that helped physicians and patients also. So that's very much on the cards. Clearly it was very important to get the positive proof of concept with this mechanism and also the good data that we showed. That opens up several possibilities for this antibody now. Not only in '08 actually but we are also extending our studies in terms of looking at other pain indications. And as you can probably tell, I am particularly excited about this one. In terms of the Alzheimer's approaches, again we have built up quite a nice portfolio, all be it early. You mentioned two in particular, the Amyloid antibody and the rage program, and again we're very excited about both of those. They are early though and this is a tough area to work in. We are certainly… we'll push these through. You mentioned specifically how can we push them through fast? As I think everyone knows, we brought Briggs Morrison into the back end of last year to run our Clinical Development Group, and he has just had a laser focus on accelerating all our late stage programs and has had actually terrific success so far. And certainly the Alzheimer's approaches are very much in his mind.
Jeffrey Kindler: Thanks Martin. Next question please.
Operator: Thank you very much. The next question is from James Kelly with Goldman Sachs. Please proceed with your question.
James Kelly: Great, thank you very much and good morning.
Jeffrey Kindler: Good morning.
James Kelly: I just have a couple more to follow-up. First on Lipitor, I know a lot of different questions came out on Lipitor, but I think this is the first quarter that Lipitor international sales have exceeded the U.S. sales. And I am interested just if there is anymore color about what the mix is of those revenues between the more protected versus the less protected markets? And just how we should think about… relative size of those pieces growing versus where there might be some patent risk over the coming years there? Secondly, as we watched the Chantix prescriptions end up with pressure having to do, of course, primarily with the questions that have come out around safety, but is there also something happening here where the number of patients that can be penetrated and take the drug, I think at one point when it was at its peak, something like 4% or 5% of smokers were on it. So what is the portion of the market that actually is willing to quit, because once you have taken it for whatever it might be, three or six months, it would tend to lose the successful patients. Of course, this is a good thing for public health, but does impact scripts. And then lastly, alliance revenues, very strong line item, and if you can give… but has a lot of pieces in it. Could you give any particular granularity around some of the pieces that are doing particularly well, or is that it need a little extra focus? Thanks.
Jeffrey Kindler: Okay. Let me start. I think Frank is going to give you some numbers on the Lipitor piece and then Ian will give some commentary on that. And Ian will address your Chantix questions and then look to the alliance revenue. I think both Frank and Ian will have some thoughts to say. So go ahead, Frank.
Frank D'Amelio: So on the Lipitor revenues, let me just run the numbers. And what I'll do is make the point you made, but I will do it with numbers and convert it to percentages. So for the quarter Lipitor revenues were about $3 billion, $2.976 billion. They were up 9% from the prior year quarter of 27.19. Now to your point of that $3 billion, $1.4 billion was in the U.S. and I am rounding. $1.6 billion was outside the U.S., which resulted in a percentage mix of 47% in the U.S., 53% outside the U.S., which is the basis of the question. Ian, just wanted to frame the numbers.
Ian Read: Yes, so we're seeing operational growth outside of the U.S. and I don't have the exact numbers. But I mean we see growth in Asia, we see it in Latin America, and we're seeing it in Europe. And especially in Europe it's that we're further past the generalization [inaudible] entry, and we're focusing on the high risk patients, the high doses, and we're driving operational growth, which is where our strategy is both in the U.S. and globally. So it's good to see that working internationally. Vis-à-vis Chantix, it is number… it's the sort of number one cause of preventable death, and this medicine is highly efficacious. And just looking at the U.S. specifically, I am taking these numbers from memory, I think we identified 54 million smokers who were sort of in the pool to quit, of which there was a segment which we call immature, not yet ready to quit, and about 24 million that were either motivated or could be motivated to quit. And we've treated I think globally something like 5 million. So clearly there is a huge reservoir of patients that need to quit, and there are social pressures and educational pressures making them aware of the need to quit. So I am not particularly concerned about exhausting the supply of available patients as yet. The real key is motivating them to get to see a physician.
James Kelly: Very good. Frank is going to comment on alliance revenues.
Frank D'Amelio: Yes, and then Jim on alliance revenues, I'll just run the numbers again, and then I'll answer the question. So for the quarter, alliance revenues were up about 44%. It was 563 versus about 393 Q2 '08, Q2 '07. Year-to-date it's up about 32%, 33%. Call it 1.50 billion over 790 year-over-year. And if you look at what's driving some of the positives there, Spiriva and Aricept are really two of the products that are driving what's going on relative to the rhythm of the numbers.
Jeffrey Kindler: Okay. And Ian, do you want to highlight any of the particular alliance products, or I guess…
Ian Read: Frank covered it.
Jeffrey Kindler: Okay. We have time for one last question.
Operator: Thank you very much. The next question is from Seamus Fernandez with Leerink Swann. Please proceed with your question.
Seamus Fernandez: Thanks very much. So just a couple of quick questions both for actually Martin Mackay. Martin, can you just give us an update on the timing of the uplift study for Spiriva and when you expect that to report out? And then separately on the anti-NGF antibody, were the Phase II studies here prospectively designed specifically for the pain signal that you saw? And if not, how do you plan to address this before you move into Phase III?
Jeffrey Kindler: Hey Martin --
Martin Mackay: In terms of Spiriva uplift, the data will be shown at EHS in October later this year. And in terms of the NGF antibody, yes, it was prospectively designed for the pain. We saw obviously… we have Phase I data and Phase II data to look at in that respect and that will continue in terms of the Phase III studies. And, as I mentioned earlier, we are also now looking at other pain indications for this antibody.
Jeffrey Kindler: Okay. Thank you, Martin, and thank you, everyone, for taking time out of what I know is a busy day for all of you. Thanks very much, and have a good day. | [
{
"speaker": "Operator",
"text": "Welcome, ladies and gentlemen. Please welcome Chuck Triano, Head of Investor Relations."
},
{
"speaker": "Charles E. Triano",
"text": "Good morning and thank you for joining us today to review our second quarter 2008 performance. I am here where Jeff Kindler, Chairman and CEO; Frank D'Amelio, Chief Financial Officer, and other members of our senior management team. The financial charts that will be presented on this call can be viewed on our home page at www.Pfizer.com in the Investor Presentations tab by clicking on the link, quarterly corporate performance second quarter 2008. We know this is a busy day for many of you, and our conference call will last an hour, and we will end at noon. As we would like to hear from as many of you as we can in this time, we ask that you limit your question to just one question please. Before we start, I would like to remind you that our discussions during this conference call will include forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. The factors that could cause actual results to differ are discussed in Pfizer's 2007 annual report on Form 10-K and in our reports on Form 10-Q and Form 8-K. Also, the discussions during this conference call will include certain financial measures that were not prepared in accordance with Generally Accepted Accounting Principles. Reconciliation of those non-GAAP financial measures to the most directly comparable GAAP financial measures can be found in Pfizer's current report on Form 8-K dated July 23rd, 2008. These reports are available on our website at www.Pfizer.com in the Investors SEC filing section. I will now turn the call over to Jeff Kindler. Jeff?"
},
{
"speaker": "Jeffrey Kindler",
"text": "Thanks, Chuck, and hello, everyone. I would like to welcome Chuck to Pfizer, along with Amy Schulman, our new General Counsel, who is here this morning and who joined us just last month. It is great to have you both on board. We are pleased with our second quarter financial performance, especially at this time of great uncertainty in the world economy and capital markets and significant challenges in our industry. Pfizer continues to be on track to deliver the revenue and adjusted diluted EPS guidance that we set out for 2008. Our pharmaceutical and animal health businesses grew at a healthy rate this quarter, and our cost reduction efforts remained solidly on track with our second quarter adjusted total costs decreasing by $475 million compared to the year ago quarter, excluding foreign exchange. In short, we are doing what we said we would do. As you know, the U.S. pharmaceutical market continues to be challenging given the regulatory environment, generic competition, payer pressures and an uncertain political environment. But despite this and despite the loss of U.S. exclusivity of Norvasc, Zyrtec and Camptosar, which collectively decreased revenues by approximately $500 million during the quarter, our U.S. revenues in the quarter nevertheless declined by only 2% versus the previous year. Without these LOE products, our U.S. pharmaceutical business actually increased by 10%. In this tough U.S. marketplace, we have six products outperforming the branded competition; Chantix, Aricept, Lyrica, Spiriva, Rebif and Sutent. As well as four more mature in-line products successfully defending their positions against newer agents;Viagra, Xalatan, Lipitor and Geodon. Bottom-line, there is certainly more work to be done, but we're more than holding our own against the competition in a particularly challenging U.S. environment. Meanwhile outside the United States, we have one of the strongest global footprints and broadest portfolios in the industry, now accounting for more than half of our total revenues. Revenues from international markets grew a solid 5% this quarter compared to last year, even before the benefit of foreign exchange. Our primary growth strategy around the world is to refocus and optimize our patent protected portfolio of both marketed medicines and compounds in development. In that connection, the agreement we made with Ranbaxy this quarter brings substantially certainly that a generic version of Lipitor won't be introduced in the U.S. for another nearly three-and-a-half years. While the lipid-lowering market is one of the world's most challenging, Lipitor is holding its own as we continue to fight for market share and to press the essential message that Lipitor has no generic or branded equivalent. Pfizer is far more than Lipitor, of course, and our year-to-date results show positive trends for a number of key medicines in our patent-protected portfolio. Lyrica is up 50% year-to-date with growth driven by strong efficacy in managing nerve pain associated with diabetes and shingles, as well as in managing fibromyalgia, which increasingly is being understood as a serious and debilitating disease. Revenues for our cancer agent, Sutent, were up 62% year-to-date. Currently Sutent's international growth is outpacing its growth in the U.S. where it has been available longer. That said, we are pursuing additional indications for Sutent and conducting Phase III trials for patients with breast, colorectal and lung cancer among others. Sutent represents our commitment to emerge quickly as a leader in fighting cancer. To advance that goal, we created this quarter a dedicated global oncology business unit within our pharmaceutical segment led by Gary Nicholson, formerly the head of Lily's U.S. oncology business unit. This unit will serve as the single point of accountability for Pfizer's worldwide oncology business in keeping with our commitment to reorganize into more focused and agile business units. Now, of course, we would all prefer to prevent cancer and heart disease than to have to treat them, and that's why smoking cessation is so important. Smoking is expected to be the largest preventable cause of death in this century with some estimates that the toll may be one billion people. There are few things that provide greater health benefits than quitting smoking. And our innovative smoking cessation aid, Chantix, is an effective option for those who want to quit. In fact, we get letters day after day from patients who had given up all hope of quitting smoking until they used Chantix. Its global sales grew 3% this quarter compared with the same period a year ago. Strong international growth was largely offset by a 35% decline in U.S. revenues, which was due mainly to labeling changes and to external reports about adverse events. Let me be clear; we believe the Chantix labeling appropriately reflects the medication's risks and benefits, and we will continue to encourage doctors and patients to have a robust dialogue about the dangers of smoking and appropriate treatment options. Meanwhile, we're seeing strong performance among other important brands. So far this year Geodon is up 20%. Viagra is up 13%. Xalatan is up 12%, and Celebrex is also up 12%. In addition, we continue to pursue [ph] new opportunities for our in-line medicines. We recently launched Champix in Japan, where we also earned approval for Sutent for certain types of cancer and submitted Lyrica for nerve pain after shingles. And in Europe last month we launched the product we licensed from Schwartz Pharma called Toviaz fesoterodine to treat overactive bladder. Efforts like these extend the lifecycles of our in-line medicines, complementing our R&D work on new compounds. In that connection, we also continue to make steady progress advancing one of the most robust pipelines in the industry. In our R&D labs, we are looking to significantly increase our return on invested capital by making smart and focused decisions, including where appropriate exiting certain areas of activity. And we're seeing progress in productivity. Since our last pipeline update in March, we had begun Phase III development of five new molecular entities and product line extensions. We now have 20 Phase III projects underway. A noteworthy example is CP-751871, a biologic discovered by Pfizer and proposed for the treatment of non-small cell lung cancer. We advanced apixaban, our development project with Bristol-Myers Squibb into a Phase III study for treatment of Venous Thromboembolism. In addition to line extensions to maximize the value of Geodon and Celebrex, we also added Thelin, a once daily oral treatment for pulmonary arterial hypertension which is already approved in Europe, Canada and Australia. It was acquired through our purchase of Encysive. In addition, we expect seven Phase III oncology studies in 2008 with two already open and enrolling, reflecting Pfizer's commitment to oncology which currently accounts for 22% of our R&D budget. One of the milestones this quarter was a license agreement with Quad for CDX-110, a Phase II oncology vaccine candidate for the treatment of brain cancer. We continue to move ahead on our goal of 15 to 20 Phase III starts this year and next with the objective of having 24 to 28 compounds in Phase III by the end of next year. We are on track to meet these goals. An important research initiative this quarter was the establishment of the Pfizer Regenerative Medicine Unit, which will provide us with new targets, new tools and ultimately new therapies across a number of disease areas including Alzheimer's disease, cancer and other debilitating disorders. Now just as our R&D work is shaping Pfizer's future, changes in our business strategy are shaping the future as well. The fast growth of Pfizer's business outside the United States points to significant potential in emerging markets where we have set a goal of outpacing market growth, which is expected to be 11% per year between now and 2012, the year after Lipitor loses exclusivity. In addition by then, we aim to be the number one pharmaceutical company by revenues in six of our seven top priority emerging markets. Namely Brazil, China, Mexico, Russia, South Korea and Turkey. The competitive advantages of our broad portfolio of established products and our strong global footprint lie at the heart of our strategy to grow in emerging markets, many of which have more than half of their total sales being driven by established products compared to about 12% in the United States. To understand the potential of these markets for Pfizer, consider the fact that $80 billion in new revenues from increased use of established products is expected between now and 2012, and we currently have about a 4% share. There is an enormous opportunity here for us to take a greater share of this growth over the next three to five years. Steady execution of all of this commercial, R&D and strategic work demonstrates that Pfizer is continuing to change and change fast. A new culture of innovation and continuous improvement is shaping a new, leaner and smarter Pfizer. Throughout the Company we have new, smaller, more accountable business units which have been given much more freedom to innovate. Over the past two years, while building an outstanding management team, we have challenged colleagues to think differently, to work differently and to examine our business in new ways and from all angles but, especially from that of the customer. We have shaped a new corporate culture that is cost conscious where employees are encouraged to think and act like entrepreneurs. These efforts are supported by our financial strength, a competitive advantage that allows us to balance our strategic needs while meeting our financial commitments. We have also kept our commitment to greater candor and transparency. Just this past quarter, we stood alone in reforming the way we finance continuing medical education in the United States to remove any appearance of conflict of interest. We begun to build the strong new presence in biotherapeutics, made progress in rebuilding our pipeline, particularly in the late stages; streamlined our manufacturing; attracted a new generation of leaders to Pfizer; and created the path forward for our future. The hard work is far from over, and it will never truly be over. But in this quarter's results, we see some reflection of our hard work and one more important step in doing what we said we would do, build a Pfizer that can and will succeed. And now for the financial details, please welcome Frank D'Amelio."
},
{
"speaker": "Frank D'Amelio",
"text": "Thank, Jeff. Good morning, everyone. The charts I am reviewing today are included in our webcast and will help facilitate the discussion of our second quarter 2008 results. Now let me get to our financials. Today we reported revenues for the second quarter 2008 of $12.1 billion, a 9% increase year-over-year which reflects the positive impact of foreign exchange, which increased revenues by approximately $800 million or 7% and solid performance of many key products, which more than offset the negative impact of revenue declines resulting from the loss of exclusivity in 2008 for Zyrtec whose revenues decreased $377 million and Camptosar whose revenues decreased $104 million. Reported net income increased year-over-year by 119% to $2.8 billion in the second quarter, and reported diluted EPS of $0.41 increased to 128%. These increases were primarily driven by lower restructuring charges related to our cost reduction initiatives, as well as savings resulting from these initiatives; the positive impact of foreign exchange; and favorable income tax adjustments related to the sale of Esperion and favorable tax settlements, which were partially offset by increased in-process R&D expenses associated with the acquisitions of Serenex and Encysive Pharmaceuticals, which closed during the quarter, and the impact from the loss of U.S. exclusivity for certain products. We generated adjusted income of $3.7 billion in the second quarter, an increase of 26% year-over-year and adjusted diluted EPS of $0.55, an increase of 31%, driven by the savings resulting from our cost reduction initiatives; the positive impact of foreign exchange; the non-recurrence of the one-time '07 payment to Bristol-Myers Squibb in connection with our collaboration to develop and commercialize apixaban; and tax settlements, which more than offset the impact from the loss of U.S. exclusivity for certain products. Both reported and adjusted diluted EPS in the second quarter were favorably impacted by the full-year benefit of our 10 billion share repurchase in 2007. During the second quarter of 2008, we repurchased approximately $500 million or 26.4 million shares of our common stock. I would also like to point out that our debt level at the end of the second quarter decreased sequentially by approximately $400 million, notwithstanding our dividend payment, share repurchases and the funding of our operations. We had several significant items included in our reported results this quarter. More detailed disclosures will be provided in our Form 10-Q filing with the SEC. In the second quarter, we incurred $562 million in restructuring charges compared with $1 billion in the prior year quarter. This significant decrease was driven by greater restructuring charges associated with employee related cost in the year ago quarter. We also incurred $405 million of implementation cost compared with $317 million in the prior year quarter, primarily related to sites we exited or are in the process of exiting. These implementation amounts are reported in cost of sales, R&D, SI&A expenses and other income deductions and are detailed more fully in supplemental information accompanying the release. Now I would like to provide more details regarding our second quarter adjusted income components. Adjusted revenues were $12.1 billion, an increase of 9% year-over-year. Adjusted cost of sales as a percentage of revenue was 16.9% versus 17% in the prior year quarter, notwithstanding less favorable geographic mix and the impact of foreign exchange. Excluding foreign exchange, adjusted cost of sales as a percentage of revenue was 16.1%. Adjusted SI&A expenses were $3.7 billion, a decrease of 1% year-over-year, reflecting a decrease in marketing expenses which more than offset the negative impact of foreign exchange. Adjusted R&D expenses were $1.9 billion, a decrease of 8% year-over-year due primarily to realized savings resulting from our cost reduction initiatives and the non-recurrence of the one-time payment to Bristol-Myers Squibb in '07 associated with our collaboration to develop and commercialize apixaban. Our effective tax rate on adjusted income for the quarter was 20% versus 22.2% in the year ago quarter, due to favorable tax settlements. Our EPS growth is outpacing our revenue growth, which clearly reflects positive leverage. Now I would like to provide a mid-year update on our adjusted results. Revenues increased 2% to $24 billion in the first half of 2008 compared with the prior year period, driven by the solid performance of many key products. First-half revenues reflect the favorable impact of foreign exchange, which increased revenues by approximately $1.4 billion or 6%, which was offset by the negative impact of the loss of U.S. exclusivity of Norvasc in 2007 and Camptosar and Zyrtec in 2008, which collectively decreased revenues by $1.4 billion. Adjusted cost of sales as a percentage of revenue for the first half was 16.1% compared with 15.4% in the prior year period, primarily due to less favorable geographic mix and the negative impact of foreign exchange. Excluding foreign exchange, adjusted cost of sales as a percentage of revenues for the first half of the year was 15.3%. Adjusted SI&A expenses increased 1% in the first half compared with the prior year period, and adjusted R&D expenses decreased 4%. We posted adjusted income of $7.8 billion in the first half of 2008, an increase of 1% compared to prior year period, and adjusted diluted EPS of $1.15, an increase of 5%, reflecting the benefit of savings associated with our cost reduction initiatives; the positive impact of foreign exchange; the non-recurrence of the one-time '07 payment to Bristol-Myers Squibb; favorable income tax adjustments and our share repurchases in 2007, which were offset by the impact from the loss of U.S. exclusivity for certain products. As I previously mentioned, this quarter foreign exchange increased revenues by approximately $800 million or 7%. We continued to achieve cost reductions this quarter, and our ongoing cost reduction initiatives continue to have the positive impact on our results. That said, foreign exchange continued to have an unfavorable impact on our cost and expenses this quarter. Overall foreign exchange unfavorably impacted adjusted total cost by approximately $440 million or 6% this quarter compared with the prior year quarter. Excluding foreign exchange, our adjusted total cost decreased operationally by approximately $475 million or 6% year-over-year. The net effect of foreign exchange on our adjusted diluted EPS during the second quarter as compared with the year ago quarter was a positive impact of $0.04. This positive impact was not incremental to our EPS guidance since the guidance we provided in January of '08 and reiterated during the second quarter was given at current exchange rates. We continue to make progress against our objective to reduce absolute adjusted total costs by at least $1.5 billion to $2 billion at the end of '08 compared with '06 on a constant currency basis. To date we have achieved a cumulative operational cost reduction of $1.2 billion. We expect to achieve much of the remaining reduction in the fourth quarter, which will favorably impact that quarter's adjusted diluted EPS. I want to point out that we expect to achieve this reduction even after absorbing inflation, which adds approximately $1 billion to adjusted total cost annually and reinvesting in our business. While our cost reduction initiatives will continue to reduce absolute costs for the balance of 2008, the timing of the realization of these reductions is also a function of spending patterns in both '06 and '08. The spending level in the fourth quarter of '06 was higher than usual due to establishing research collaborations with third parties and sales and marketing investments in international markets. By comparison, quarterly spending patterns in '08 have been and are expected to be more consistent with historical norms. Because of the different spending levels between '06 and '08, much of the remainder of our absolute cost reduction target will be achieved in the fourth quarter of this year. Our cost reduction initiatives continue to span essentially all divisions, functions, markets and sites across Pfizer. Broad categories of activity include manufacturing and research side exits, outsourcing and targeted work force reductions such as our ongoing previously announced European field force reduction. We reduced our global network of manufacturing plants from 78 four years ago to 54 currently. By the end of '09, we expect to further reduce this global network to 44. As part of this effort, we recently announced our decision to cease operations at our Terre Haute facility by the middle of '09. We also recently announced the spin-off of our R&D laboratory in Nagoya, Japan. We are continuing to exit the three remaining R&D sites of the six that have been identified for closure. Also, we have a wide array of outsourcing opportunities in various stages of implementation, manufacturing, logistics, finance, facilities, legal and IT are among the functions contributing to the financial and operational benefits of this strategy. Finally, we are continuing to match our workforce level with the current market. Over the past 18 months, our workforce level has decreased by 13,500 to 84,500 as of June 29, '08 from 98,000 at the end of 2006. And, as a result of recent actions this month, our current level is approximately 84,100. All key in line and new product revenues increased in the second quarter compared with the year ago period. Lipitor revenues increased 9% year-over-year to approximately $3 billion, including the positive impact of foreign exchange which increased revenues by approximately $170 million or 6%. Year-over-year Lipitor revenues in the U.S. increased 1%, and revenues from international markets increased 18%. Lyrica continued to deliver strong performance with revenues of $614 million, an increase of 52% year-over-year. Sutent, our treatment for advanced kidney cancer and gastrointestinal stromal tumors, posted revenues of $211 million, an increase of 45% compared with the year ago quarter. I want to point out that while Sutent revenues in the U.S. declined 2% year-over-year during the second quarter, first-half U.S. revenues increased 10% versus the prior year period. Year-over-year Chantix revenues increased 3% to $207 million. As Jeff stated, Chantix's results reflect the negative impact resulting from updates to the U.S. label to include additional safety information, as well as from certain external events. As a result, U.S. revenues decreased 35% year-over-year to $109 million. That said, Chanpix continued to perform well outside the U.S. Chanpix revenues from international markets grew 197% year-over-year to $98 million. As we expected, revenues from products that recently lost U.S. exclusivity declined year-over-year with Norvasc declining 2% to $627 million, Camptosar declining 43% to $137 million, and Zyrtec declining 98% to $8 million. Today we are reaffirming full year 2008 revenue and adjusted diluted EPS guidance. As a result of the significant unfavorable impact of foreign exchange on adjusted cost of sales in the first half of '08 we are tightening our guidance on the lower end of the range. We currently expect adjusted cost of sales as a percentage of revenue to be between 15 and 15.5% compared with our previous expectation of 14.5% to 15.5%. We continue to be on track to achieve the reduction in absolute adjusted total cost of at least $1.5 billion to $2 billion at the end of '08 compared with '06 on a constant currency basis. As I previously stated, we have achieved $1.2 billion of the targeted reduction to date. We expect the balance of this reduction to gain momentum throughout the second half of the year with much of the remaining savings to be realized in the fourth quarter to favorably impact that quarters adjusted diluted EPS. Finally, we are updating our guidance on our 2008 effective tax rate. We now expect the effective tax rate on adjusted income for the year to be between 21.5% and 22% versus our previous expectation of 22% to 22.5%. So, to summarize the key takeaways, we are reaffirming our '08 revenue and adjusted diluted EPS guidance. We continued to see steady growth in several key products, including Lyrica, Geodon, Viagra, Celebrex and Sutent. As we expected, this quarter's results were negatively impacted by the decline in revenues from the loss of U.S. exclusivity of Zyrtec and Camptosar. We are continuing to execute and make progress, and our cost reduction initiatives on track to achieve our adjusted total cost reduction target. To date we've achieved $1.2 billion in adjusted total cost reductions. We expect to realize the majority of the remaining cost reductions in the fourth quarter. Finally, we're pleased with the solid results that we delivered in the second quarter, including the benefit of our cost reduction initiatives. Our EPS growth this quarter outpaced our revenue growth, demonstrating the benefit of these initiatives to our bottom-line. And now I will turn it back over to Chuck."
},
{
"speaker": "Charles E. Triano",
"text": "Thanks Frank and at this point if we could ask the operator to begin pulling for questions please. Question and Answer"
},
{
"speaker": "Operator",
"text": "Thank you very much. [Operator Instructions]. The first question is from John Boris with Citi. Please proceed with your question."
},
{
"speaker": "John Boris",
"text": "Thanks for taking the question. Largely financial related questions. Free cash flow, Frank, in the first quarter and second quarter, can you just share what free cash flow was? The second part has to do with price and volume, what that contributed to growth and then the third question just has to do with sequential borrowings. They went up by about $3 billion to $9 billion. Can you just share with us or provide a little color on the use of those funds? Thanks."
},
{
"speaker": "Frank D'Amelio",
"text": "Sure, John. So operating cash flow in Q1 was $3.3 billion and Q2 will be part of the Q that we filed in a few weeks. In terms of price, volume and foreign exchange for Q2, price was down 2%, volume was up 4% and the foreign exchange we got benefit of 7%, which was the $800 million that I alluded to in my comments. And then on the third item, which was borrowing let me just run the numbers. At the beginning of the year, we had about $13 billion in debt. At the end of last quarter, we had about $17 billion. At the end of this past quarter, we had about $16.5 billion and I am rounding. That's about $400 million down quarter-to-quarter, and that $400 million decrease was while we purchased $500 million of our stock."
},
{
"speaker": "Operator",
"text": "Thank you very much. And next question is from David Risinger with Merrill Lynch. Please proceed with your question."
},
{
"speaker": "David Risinger",
"text": "Yes, thanks very much. There is obviously a significant market opportunity for the JAK-3 for rheumatoid arthritis, but there has been some investor noise about its toxicity profile. I was hoping that you could walk us through the JAK-3 side effects and tell us what to focus on at ACR in October? And then separately, if you could just discuss Sutent's U.S. trends in more detail? Thank you."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Martin, do you want to take the first part of that?"
},
{
"speaker": "Martin Mackay",
"text": "Surely, happy to. Thank you for the questions. As you correctly see, JAK-3 continues very well in Phase II. We will report at the ACR meeting later this year, and obviously we will report on both efficacy and side effects. Given the mechanism as we've discussed before, we know the side effects to look for in the clinical trials. We're monitoring those very carefully. Given those badly published in Phase IIa data that we published some time ago, we were really very pleased with the side effect profile of the compound and that continues."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay and the second question, Ian."
},
{
"speaker": "Ian Read",
"text": "Yes. So, David on Sutent's second quarter, so second quarter down 2%, first semester up 10%. I would like to point out in the U.S. I suppose your question was directed to the U.S. there our share is 56% in RCC and 88% in second line for GIST. So we're not satisfied with a 56% share in the U.S., and we need to advance our share there by focusing on Sutent's efficacy and keeping patients on therapy at the appropriate dose throughout all treatment cycles. One of the key programs we're going to use on that or data is the two year survival data recently presented at the 2008 ASCO where our survival data represented the longest medium overall survival to date of any agent in first line settings."
},
{
"speaker": "Frank D'Amelio",
"text": "And then just overall Sutent sales globally for the quarter were up 45% year-over-year, and then outside the U.S. internationally, they were up 80% year-over-year. So that's a product that is doing well in the U.S. and continues to do very well outside of the U.S."
},
{
"speaker": "David Risinger",
"text": "Okay."
},
{
"speaker": "Jeffrey Kindler",
"text": "Thank you Frank. Next question please."
},
{
"speaker": "Operator",
"text": "Thank you. The next question is from Roopesh Patel from UBS. Please proceed with your question."
},
{
"speaker": "Roopesh Patel",
"text": "Thank you. My question is on U.S. Lipitor sales. I was wondering if you could help us reconcile the 20% sequential decline in U.S. Lipitor sales versus the first quarter. With the 3% drop in prescriptions that have been reported over the same period. My understanding was that inventory levels were normal when exiting the first quarter. There have been no price increases over the course of the second quarter. So if you could just help us there. And then separately, what impact do you expect the recent reporting of Vytorin's SEAS trial to have on the cholesterol market growth and on Lipitor?"
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay, thanks Roopesh. I'll let Ian take both of those questions."
},
{
"speaker": "Ian Read",
"text": "So we normally have fluctuations between first and second quarter difficult to reconcile those. So just look at the first semester for Lipitor where sales growth was down 11%. Pricing was basically flat between price increase and rebates. And the net of market growth and share was down about 16%, and the differential between that and the 11% is driven partly by increased number of units both per TRX and partly via a normalization of the inventory level at the end of '08. Vis-à-vis the Vytorin trial, I think it is too early to tell the impact on market growth, and certainly what we're focusing on is Lipitor's positioning at getting the goal, the efficacy across the dosage rang range, our safety and our landmark trials."
},
{
"speaker": "Jeffrey Kindler",
"text": "Thanks Ian. Next question please."
},
{
"speaker": "Operator",
"text": "Thank you very much. The next question is from Catherine Arnold with Credit Suisse. Please proceed with your question."
},
{
"speaker": "Catherine Arnold",
"text": "Sure, good morning."
},
{
"speaker": "Jeffrey Kindler",
"text": "Good morning."
},
{
"speaker": "Frank D'Amelio",
"text": "Good morning Catherine."
},
{
"speaker": "Catherine Arnold",
"text": "Good morning. In the spirit of greater candor and transparency, which I applaud Jeff, can you tell us the split of targets for absolute adjusted total cost savings in terms of U.S. versus non-U.S.? You gave us the target of $1.5 to $2 billion by the end of the year. And I was wondering also you mentioned -- you used the phrase at least in the press release, and I would love to know what the magnitude of upside might be to that in your optimistic case for this year?"
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. I am sorry, I didn't completely understand the second question Catherine. The upside of cost do you mean?"
},
{
"speaker": "Catherine Arnold",
"text": "Yeah, yeah. The target $1.5 to $2 billion in the press release, it says at least $1.5 to $2 billion can be achieved. So I am wondering what the magnitude of upside might be for those targets?"
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay, I'll let Frank to take both those questions Catherine."
},
{
"speaker": "Frank D'Amelio",
"text": "Yes, so Catherine, let me do it this way. In the release we said we've achieved $1.2 billion to date. If you look at the rhythm in terms of what we've have done there, it was $600 million in '07, a $170 million in Q1 and then $465 million in Q2. We haven't provided details on that relative to U.S., non-U.S. But know those savings and the target of $1.5 to 2 are global in nature. They reflect actions that are being taken both in the U.S. and outside the U.S. kind of point one. In terms of the second question with the at least language, we're at 1.2. Our job is to do as much as we can relative to the range. So understand when we get to $1.5, we're not going to stop; we're going to deliver as much as we can to get as high into the range as we possibly can. In terms of what's available above and beyond the range, my answer is we're at $1.2, we will get every dollar we possibly can, and we will get that by the end of the year."
},
{
"speaker": "Jeffrey Kindler",
"text": "Thanks Frank. Next question please."
},
{
"speaker": "Operator",
"text": "Thank you very much. And the next question is from Tim Anderson with Sanford Bernstein. Please proceed with your question."
},
{
"speaker": "Jeffrey Kindler",
"text": "Hi Tim."
},
{
"speaker": "Frank D'Amelio",
"text": "Hello Tim."
},
{
"speaker": "Tim Anderson",
"text": "Yeah, hi. Can you talk about Pfizer's potential interest to get into the generics business beyond what you currently do with Greenstone? Glaxo today announced that they'll sell branded generics in emerging markets, and Sanofi is trying to buy Zentiva, and there was talks that you guys were looking at Ranbaxy fairly recently. And secondly, on Lyrica sales have been pretty flat in the U.S. for the last three quarters, and recently new prescriptions look like they are actually trending down. And I am wondering if you can address what might be going on in the U.S. market specifically?"
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay Tim. I'll take the first one and let Ian take the second one. As you know, the established product strategy is a very important one and important enough that we established, pardon the pun, a business unit specifically focused on that and led by Dave Simmons who has tremendous experience in those parts of the world where established products continue to retain brand equity and we can drive sales based on physician and patient preferences. And Norvasc this quarter actually is not a bad example of that, and we're still experiencing goods sales even on a product like that that has lost exclusivity in a lot of markets. The established opportunity, if you put aside products that are just going off patent and flipping from the patent protected to the established marketplace and just look at organic growth, just volume increases, it is a $80 billion opportunity by the time Lipitor goes off pat. We currently have a 4% share of that. We believe that we have a unique set of competitive advantages to increase that share and to exploit that market. And those include the breadth of our therapeutic portfolio and product portfolio, which is very important in those markets, and our geographic presence. We have been in these markets a very, very long time, and we have established relationships with key opinion leaders and the like. And we really think there are very, very few companies that are going to be able to compete the way we compete in those markets. And those markets are more than just China. Tim there is emerging markets in Latin America, Eastern Europe, Asia. But if you just look at Asia, and I am talking about more than China that is an opportunity that goes from $47 billion to $80 billion by 2012, and our current share is 4%, and we have a goal of increasing that share by the time Lipitor goes off pat. And just to take China as an example, we said in our March 5th meeting that we're going to increase our field force presence from 110 cities to 126 by the end of the year. We've already achieved that goal. So now we've raised the bar, and we're going to be in 137 cities by the end of the year. So this is a tremendous opportunity for us. And to answer your specific question, we've been clear that all our strategies are going to be supplemented by appropriate business development. And we'll look at opportunities for enhancing our ability to compete and when in the established markets in the emerging markets. We really think this is a big winner for us and a big opportunity, and we've already seeing early signs of success in the way that we focused on it. The second question was about Lyrica progress, so I'll turn that over to Ian."
},
{
"speaker": "Ian Read",
"text": "Well Tim, I just want to go back on the data. We did, in fact, grow in the quarter 52% with Lyrica. If I look at the script trends, I can't really validate the data you gave. I can see sequential growth in TRXs quarter-on-quarter. That being said, I acknowledge they are slower than they were post the fibromyalgia launch -- that growth. So the game plan for us really is to further grow leadership by being a treatment of choice in DPN and PHN, and there is very low diagnosis treatment rates in those two conditions, and we do have a good market share already in about 30% in those conditions and all the treatment of choice. And in fibromyalgia we continue to develop that market. There is about six million patients that suffer from fibromyalgia. Only 22% are diagnosed, and that requires market development. So optimistic about the performance going forward."
},
{
"speaker": "Jeffrey Kindler",
"text": "Thanks Ian. Next question please."
},
{
"speaker": "Operator",
"text": "Thank you very much. The next question is from Chris Schott with JPMorgan. Please proceed."
},
{
"speaker": "Chris Schott",
"text": "Thank you. Just a couple of quick questions. First, on Lyrica, what are your expectations on any potential label change for the drug given the recent FDA panel on the epilepsy class in general? On Chantix I was just kind of surprised, happy to see the international sales kind of hanging in there as much as they had given what has happened in the U.S.? Can you talk a little bit about the feedback you're getting on the drug ex-U.S.? Are you expecting a delayed reaction to some of the safety concerns, or just generally speaking are these markets less sensitive to that type of news than we see in the U.S? And then maybe just finally, just generally speaking, we've seen across the industry a number of therapeutic categories in the U.S. with weaker than expected volume growth this year. As with higher co-pays and a weak economy, just interested in your thoughts in general. Are we seeing more economic sensitivity to the prescription pharma market in the U.S. than maybe historically? Thanks."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay Ian. I am going to give you all three of those."
},
{
"speaker": "Ian Read",
"text": "Okay. So Lyrica, we're pleased with our recommendation from the advisory committee the FDA, and we will await the final decision from the FDA. But it was a pretty strong positive vote from the advisory committee vis-à-vis not putting a black-box on. Secondly, I think your discussion was Chantix vis-à-vis --"
},
{
"speaker": "Chris Schott",
"text": "International, the difference between international… kind of I think you hear --"
},
{
"speaker": "Ian Read",
"text": "International you have got to realize that there are two factors going in international. Number one, the label changes have not been anywhere near as dramatic as in the U.S. with the EMEA taking a different view than perhaps the FDA took. A rollout that is slower internationally as the market penetration is not as fast when you launch internationally. So you will see sort of a more consistent growth pattern internationally. So I think those are the two differentiations in the international vis-à-vis the U.S. on Chantix. And then the third one was…"
},
{
"speaker": "Chris Schott",
"text": "The effect of the U.S. economy given co-pays and --?"
},
{
"speaker": "Ian Read",
"text": "I think we are seeing a… you are seeing a slow-up in the U.S. market growth rate. I think the IMS came out with a report on that and undoubtedly is affected by the way managed care has shifted higher co-pays. It is I think a factor. There was a report that came out from Kaiser which indicates that scripts are not being filled or pills are being split due to the economic pressures that are being caused by these co-pays."
},
{
"speaker": "Jeffrey Kindler",
"text": "One thing I would just add to that Chris, is that one of the trends that's starting to emerge, which is a very positive one is that employers, large companies, that are concerned about health care costs and the long-term health of their employees are beginning to see the value of reducing and even in some cases eliminating co-pays in order to improve adherents to medicines and actually increase the adoption of medicines. Ian do you have --"
},
{
"speaker": "Ian Read",
"text": "Example of that is the success we've had in working with employees to cover Chantix. Where we have offered about… what we have added about 1.6 million lives on Chantix coverage due to employees' focus on overall health care."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Thanks. Next question please."
},
{
"speaker": "Operator",
"text": "Thank you very much. And next question is from Tony Butler with Lehman Brothers. Please proceed with your question."
},
{
"speaker": "Tony Butler",
"text": "Thanks very much. A couple of strategic questions, Jeff, directed to you and then one for Martin. I believe early last year or earlier this year you had added Bill Ringo to strategy and/or BD. I am curious if strategy and BD has actually changed its direction, and if you can share with us if, in fact, it has, if you can share with us maybe directionally where that may be heading? And second, you ticked off a number of or a list of… I am going to say completed items that you and your management team have done over the past couple of years, in particular the issues around cost reduction the issues of trying to force more into Phase III etc. I am curious where you may be turning your focus or your attention today or perhaps over the next 6 to 12 months? And that as to say, is that an increasing opportunity internationally? Is that the direction? And then for Martin, there has been reference to obviously JAK-3 kinase inhibitors. There has been a reference to apixaban. Some excitement on those couple of products. But if, in fact Pfizer is to have 24 to 28 Phase III products by the end of 2009 could you actually name two or three others that again you tend to be most excited about in the portfolio? Thanks."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Thanks Tony. Actually the two questions you posed to me I think are quite related. We did bring in Bill Ringo. He has now been here, I think a couple of months at most, and he is already making a big difference because he has vast experience in our industry, not just at Lily but at Biotech and Venture Capital, and he is incredibly well respected and well known figure in the biopharmaceutical in general. And he is bringing a sharper focus on execution of the strategies. And the broader point about strategies that you raised, we've laid out I think quite clearly our growth strategies, and we've also said that all of them are going to be augmented as appropriate supplemented by business development. And what we're focused on now is execution. I think we've seen evidence in this quarter that we're beginning to really see some results from a sharp focus on the execution of our strategies by the foundational changes that we have made over the last couple of years in terms of leadership and structure, and the rest of it I think as we said a strong foundation that we are now beginning to capitalize on. And, those strategies range from advancing the pipeline which you mentioned. We have talked about international and established and emerging markets. We have talked about getting more out of our in line portfolio, and all of these things will continue to be supplemented by business development, and Bill is off to a great start assessing the opportunities and helping us move forward, and he is a great addition to our team. Beyond that position that he holds, but also by virtue of his real terrific experience and knowledge of our industry. And I will turn it over to Martin for the other question that Tony asked."
},
{
"speaker": "Martin Mackay",
"text": "Thank you, Tony. Clearly you mentioned the JAK-3 inhibitor and apixaban which we are very excited about. I would name another couple I will be presenting data on shortly that we have equal excitement about. The IGF-1R antibody for non-small cell lung carcinoma just went into Phase III. We are ahead in this game of this particular mechanism in antibody, and we're very pleased with the results we're seeing. Another one that we've published recently and will give further publications on later in the year is Denosumab, which is the NGF antibody that was discovered at Rinat, part of the Rinat acquisition, in pain. And we described our results at ULAR around six weeks ago and again will be showing more results and be looking to push that into Phase III in a very short timeframe. There is some other NC Phase II that we're very pleased about, the Sulopenem antibacterial, and clearly we continue to work on the DPP-4 mechanism. Just one other area I would mention, though, and that goes to our product enhancements, which you will remember I spoke about as our golden assets. If I think about our oncology pipeline alone, think about the work we're doing in Sutent, we are already in Phase III with breast, lung and colorectal, and we will be following up very shortly into Phase III with a patch of cellular carcinoma and hormone refractory prostate cancer, and these results continue unabated. With Axitinib we have Phase II studies in renal cell carcinoma and others. So really just to wrap up, Tony, we have a very exciting Phase II/Phase III pipeline emerging."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Thank you Martin. Next question please."
},
{
"speaker": "Operator",
"text": "Thank you very much. The next question is from Steve Scala with Cowen and Company. Please proceed with your question."
},
{
"speaker": "Steve Scala",
"text": "Oh, thank you. Where does the Lipitor patent litigation settlement with Ranbaxy stand relative to FTC review? It would seem that the FTC might be interested in a settlement given that the amorphous form patent does not appear applicable to the form that is commercialized, and there might be no apparent offsetting benefit to U.S. consumers. So how confident are you on this settlement? Thanks."
},
{
"speaker": "Jeffrey Kindler",
"text": "Steve, as you know, we have a long tradition here of great general counsels protecting our intellectual property, a record that I know Amy is going to maintain, so I will let Amy respond to that question."
},
{
"speaker": "Amy Schulman",
"text": "Thanks, Steve. I think that we're comfortable with the terms of the Lipitor settlement, and we don't expect any problems."
},
{
"speaker": "Jeffrey Kindler",
"text": "Specifically we're very comfortable that the FTC will not have an issue."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Next question please."
},
{
"speaker": "Operator",
"text": "Thank you very much. The next question is from Barbara Ryan with Deutsche Bank. Please proceed with your question."
},
{
"speaker": "Barbara Ryan",
"text": "Oh, thank you. Good morning."
},
{
"speaker": "Jeffrey Kindler",
"text": "Good morning Barbara."
},
{
"speaker": "Frank D'Amelio",
"text": "Good morning."
},
{
"speaker": "Barbara Ryan",
"text": "How are you? I had a question about emerging markets, but I think you have gone through a lot of that. But maybe also just following along with that Jeff, it seems as though there has been a lot of work necessary to be done in the organization to restructure the organization to change the culture to bring in people. And is it fair to look at this in sort of a step function approach over a continuum looking out towards the Lipitor patent expiration? And some of the things that you have talked about having accomplished, it seems as though a lot of those things are well in motion. You brought in your new team. Would it be appropriate given that we would be… we should be looking for the next step to be a lot more business development driven to bolt on to the kinds of changes that have already been put in place that maybe improve the foundation from which you are working?"
},
{
"speaker": "Jeffrey Kindler",
"text": "Well, let me try to answer it this way Barbara. I think as you point out, we have made a lot of progress in establishing a very strong foundation for success. I am extremely pleased with how much progress we've made in that regard in a very short period of time. That work is never over, but to your point we're in a very good position now in terms of our leadership team, our culture, our organization. We'll always be continuing to improve all that, but we're moving forward and we are executing. We outlined our five growth strategies. We have outlined our cost approach, and we are all about executing against those strategies, and as I said before where appropriate supplementing them with business development."
},
{
"speaker": "Jeffrey Kindler",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "Thank you very much. The next question is from Bert Hazlett with BMO Capital Markets. Please proceed with your question."
},
{
"speaker": "Bert Hazlett",
"text": "Thank you. Thanks for taking the question. My question is actually on Denosumab, the '08 product that you showed data on at ULAR and for the Alzheimer's compound. Regarding Denosumab, I think it was in IV dosing and it was every eight weeks. Is that what you anticipate going forward with in Phase III, or is there a sub-Q dose in the works? And then regarding the Alzheimer's program and the ICCAT data coming up, you have Phase II data being presented for your rage antagonist and some Phase I data for the Anti-Amyloid Monoclonal. How rapidly can you move these forward, and can you just talk the general enthusiasm about those programs? Thanks."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Thanks for the question. Martin?"
},
{
"speaker": "Martin Mackay",
"text": "Yeah, happy to do that. Certainly the eight weeks dosing was very successful in the data that we looked at, and we will be pushing that into Phase III. We will obviously be looking to other formulations that helped physicians and patients also. So that's very much on the cards. Clearly it was very important to get the positive proof of concept with this mechanism and also the good data that we showed. That opens up several possibilities for this antibody now. Not only in '08 actually but we are also extending our studies in terms of looking at other pain indications. And as you can probably tell, I am particularly excited about this one. In terms of the Alzheimer's approaches, again we have built up quite a nice portfolio, all be it early. You mentioned two in particular, the Amyloid antibody and the rage program, and again we're very excited about both of those. They are early though and this is a tough area to work in. We are certainly… we'll push these through. You mentioned specifically how can we push them through fast? As I think everyone knows, we brought Briggs Morrison into the back end of last year to run our Clinical Development Group, and he has just had a laser focus on accelerating all our late stage programs and has had actually terrific success so far. And certainly the Alzheimer's approaches are very much in his mind."
},
{
"speaker": "Jeffrey Kindler",
"text": "Thanks Martin. Next question please."
},
{
"speaker": "Operator",
"text": "Thank you very much. The next question is from James Kelly with Goldman Sachs. Please proceed with your question."
},
{
"speaker": "James Kelly",
"text": "Great, thank you very much and good morning."
},
{
"speaker": "Jeffrey Kindler",
"text": "Good morning."
},
{
"speaker": "James Kelly",
"text": "I just have a couple more to follow-up. First on Lipitor, I know a lot of different questions came out on Lipitor, but I think this is the first quarter that Lipitor international sales have exceeded the U.S. sales. And I am interested just if there is anymore color about what the mix is of those revenues between the more protected versus the less protected markets? And just how we should think about… relative size of those pieces growing versus where there might be some patent risk over the coming years there? Secondly, as we watched the Chantix prescriptions end up with pressure having to do, of course, primarily with the questions that have come out around safety, but is there also something happening here where the number of patients that can be penetrated and take the drug, I think at one point when it was at its peak, something like 4% or 5% of smokers were on it. So what is the portion of the market that actually is willing to quit, because once you have taken it for whatever it might be, three or six months, it would tend to lose the successful patients. Of course, this is a good thing for public health, but does impact scripts. And then lastly, alliance revenues, very strong line item, and if you can give… but has a lot of pieces in it. Could you give any particular granularity around some of the pieces that are doing particularly well, or is that it need a little extra focus? Thanks."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Let me start. I think Frank is going to give you some numbers on the Lipitor piece and then Ian will give some commentary on that. And Ian will address your Chantix questions and then look to the alliance revenue. I think both Frank and Ian will have some thoughts to say. So go ahead, Frank."
},
{
"speaker": "Frank D'Amelio",
"text": "So on the Lipitor revenues, let me just run the numbers. And what I'll do is make the point you made, but I will do it with numbers and convert it to percentages. So for the quarter Lipitor revenues were about $3 billion, $2.976 billion. They were up 9% from the prior year quarter of 27.19. Now to your point of that $3 billion, $1.4 billion was in the U.S. and I am rounding. $1.6 billion was outside the U.S., which resulted in a percentage mix of 47% in the U.S., 53% outside the U.S., which is the basis of the question. Ian, just wanted to frame the numbers."
},
{
"speaker": "Ian Read",
"text": "Yes, so we're seeing operational growth outside of the U.S. and I don't have the exact numbers. But I mean we see growth in Asia, we see it in Latin America, and we're seeing it in Europe. And especially in Europe it's that we're further past the generalization [inaudible] entry, and we're focusing on the high risk patients, the high doses, and we're driving operational growth, which is where our strategy is both in the U.S. and globally. So it's good to see that working internationally. Vis-à-vis Chantix, it is number… it's the sort of number one cause of preventable death, and this medicine is highly efficacious. And just looking at the U.S. specifically, I am taking these numbers from memory, I think we identified 54 million smokers who were sort of in the pool to quit, of which there was a segment which we call immature, not yet ready to quit, and about 24 million that were either motivated or could be motivated to quit. And we've treated I think globally something like 5 million. So clearly there is a huge reservoir of patients that need to quit, and there are social pressures and educational pressures making them aware of the need to quit. So I am not particularly concerned about exhausting the supply of available patients as yet. The real key is motivating them to get to see a physician."
},
{
"speaker": "James Kelly",
"text": "Very good. Frank is going to comment on alliance revenues."
},
{
"speaker": "Frank D'Amelio",
"text": "Yes, and then Jim on alliance revenues, I'll just run the numbers again, and then I'll answer the question. So for the quarter, alliance revenues were up about 44%. It was 563 versus about 393 Q2 '08, Q2 '07. Year-to-date it's up about 32%, 33%. Call it 1.50 billion over 790 year-over-year. And if you look at what's driving some of the positives there, Spiriva and Aricept are really two of the products that are driving what's going on relative to the rhythm of the numbers."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. And Ian, do you want to highlight any of the particular alliance products, or I guess…"
},
{
"speaker": "Ian Read",
"text": "Frank covered it."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. We have time for one last question."
},
{
"speaker": "Operator",
"text": "Thank you very much. The next question is from Seamus Fernandez with Leerink Swann. Please proceed with your question."
},
{
"speaker": "Seamus Fernandez",
"text": "Thanks very much. So just a couple of quick questions both for actually Martin Mackay. Martin, can you just give us an update on the timing of the uplift study for Spiriva and when you expect that to report out? And then separately on the anti-NGF antibody, were the Phase II studies here prospectively designed specifically for the pain signal that you saw? And if not, how do you plan to address this before you move into Phase III?"
},
{
"speaker": "Jeffrey Kindler",
"text": "Hey Martin --"
},
{
"speaker": "Martin Mackay",
"text": "In terms of Spiriva uplift, the data will be shown at EHS in October later this year. And in terms of the NGF antibody, yes, it was prospectively designed for the pain. We saw obviously… we have Phase I data and Phase II data to look at in that respect and that will continue in terms of the Phase III studies. And, as I mentioned earlier, we are also now looking at other pain indications for this antibody."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Thank you, Martin, and thank you, everyone, for taking time out of what I know is a busy day for all of you. Thanks very much, and have a good day."
}
] | null | null |
PFE | 1 | 2,008 | 2008-04-17 10:00:00 | Operator: Now we have Amal Naj, Head of Investor Development. You may now begin.
Amal Naj: Good morning, and thank you for joining us today to review our first quarter 2008 performance. I am here with Jeff Kindler, Chairman and CEO; Frank D'Amelio, Chief Financial Officer; Ian Read, Head of our Worldwide Pharmaceutical Operations; Martin Mackay, Head of our Worldwide Research and Development; David Reid, General Counsel. We will start this morning with a review of our results, and the financial charts that will be presented on this call can be viewed on our home page at www.pfizer.com in the Investor Presentations tab by clicking on the link, Quarterly Corporate Performance - First Quarter 2008. Our conference call will last an hour and we will end at 11:00 AM. We'd like to hear from as many of you as we can in this time. So we ask you to limit yourself to just one question. Time permitting, we'll come back to you for any additional questions. Before we start, I would like to remind you that our discussions during this conference call will include forward-looking statements. Actual results could materially vary from those projected in the forward-looking statements. The factors that could cause actual results to differ are discussed in Pfizer's 2007 Annual Report on Form 10-K and in our reports on Form 10-Q and Form 8-K. Also, the discussions during this conference call will include certain financial measures that were not prepared in accordance with Generally Accepted Accounting Principles. Reconciliations of those non-GAAP financial measures to the most directly comparable GAAP financial measures can be found in Pfizer's current report on Form 8-K dated April 17th, 2008. These reports are available on our website at www.pfizer.com in the Investors – SEC Filings section. I will now turn the call over to Jeff Kindler. Jeff?
Jeffrey Kindler: Thanks, Amal. Good morning, everyone, and thanks for joining us today. Before Frank reviews the numbers, I would like to make a few brief comments. The first quarter reflects a business reality that we highlighted in January. Our quarterly results may vary depending upon the seasonality of revenues and spending as well as the timing of the loss of U.S. exclusivity and patent expiration of certain products among other things. Due to the loss of U.S. exclusivity of two major products, the comparison of our 2008 quarterly results to 2007 is difficult this quarter. We lost U.S. exclusivity for Norvasc in late March 2007 and we lost U.S. exclusivity for Zyrtec in late January 2008, we stopped selling that product at that time. Together, the revenues from these products declined by approximately $900 million in the quarter. Further, we also lost U.S. exclusivity of Camptosar in February 2008, but impact of that LOE in this quarter was much less in comparison to the other two products. Now, we all know that losses of exclusivity are a fact of life in the branded pharmaceutical business, but nevertheless there were a number successes in other areas that partially offset the revenue decline associated with Norvasc and Zyrtec. For example, we’ve continued to generate steady overall growth from our diversified portfolio of in-line products including Lyrica, Viagra, Xalatan and Geodon. Additionally, Lipitor continues to be a strong global brand, demonstrating operational growth in China, Latin America, Spain, Canada and other international markets. Around the world and particularly in the U.S., we continue to execute a comprehensive communication strategy to reinforce the extensive evidence supporting Lipitor's strong clinical profile. And two of our new products, Sutent and Chantix, are containing to perform well. Now, we've seen some impact in the U.S. from the Chantix label changes in January, but we're moving forward on many fronts including aggressive educational and promotional efforts to drive growth as this innovative medicine continues to roll out around the world. We've now launched Chantix or Champix in 56 countries, including 20 countries within the past 12 months, countries like Italy, India and Korea. Launches in more than 20 additional countries are anticipated in the next 12 months. Further, we've launched Sutent in 61 countries and are developing this important medicine for additional tumors, including breast, lung and colorectal cancer in late-stage clinical trials. I am also very pleased that we recently approved... we received approval in Japan, which is the largest pharmaceutical market in the world outside the United States for these two important medicines, Chantix in January and Sutent just yesterday. This was accomplished in part by the great collaboration between our R&D organization and the Japanese regulatory authorities, and we look forward to more of these opportunities to bring products to market quickly in this important market. But beyond individual product performances, we continue to see operational growth in many of our major international markets. The significance of this trend goes well beyond just one quarter. As we said at our March 5th Analyst Meeting, we pursuing strategies to take advantage of these opportunities and we believe our international business will be a significant source of growth for us in the coming years. And finally, we're continuing to see the benefits of productivity and efficiency improvements throughout our company. We're on tack to meet our goal of reducing our adjusted total costs by at least $1.5 billion to $2 billion by the end of this year compared to 2006 on a constant currency basis. We are sharply focused on meeting our full-year guidance. With growth in many of our new and in-line products, strong performances in key markets and aggressive cost reductions, we are reaffirming that guidance today. At the same time, we continue to make fundamental changes in the operations, structure and culture of the business by executing on the strategies we outlined at our March Analyst Meeting to build long-term value. Through the hard work and dedication of our colleagues, we have over the past year fixed many of the key elements of our business and established a strong foundation with which to overcome our challenges and seize the many opportunities before us, and we're making substantial progress in other elements of our business. For example, we're pursuing new revenue opportunities across geographies, therapeutic areas and products, particularly in those areas that we've identified where we will invest to win. In one very important-to-win disease area, oncology, I'm pleased to tell you that we're now initiating a Phase III clinical trial of our IGF-1R antibody for the treatment of non-small cell lung cancer, an area with significant unmet medical need and large market potential. In addition, we are active in business development and scanning the marketplace for opportunities while maintaining discipline in how we invest our shareholders’ capital. During the quarter, we announced an agreement to acquire Serenex, which will bring us proprietary compounds in science, in oncology. And we recently acquired a controlling interest in Encysive, which fits very well with our strong cardiovascular franchise. Additionally, yesterday we announced an agreement with AVANT to license a Phase II therapeutic vaccine for a specific type of brain tumor. We're also applying innovative approaches and new business models across our business to both our existing assets and new products. Now, one of the main objectives of these strategies and something that I would like to emphasize is risk diversification. We all know that we are and we're going to remain in an industry with many risks, not only those inherent in drug development but also those associated, for example, with things like safety and pricing. Our path forward, including the five strategies we outlined at our March 5th Analyst Meeting, is designed to mitigate and diversify that risk while maximizing revenues. Pfizer has a uniquely strong and broad global footprint, which we consider a powerful competitive advantage. We are a leader in most of the markets and many of the disease areas in which we compete. This allows us to execute on a range of strategies, involving a portfolio of both patent protected and established products in developed as well as emerging markets. Our goal over time is to take advantage of the many opportunities this presents and to become less dependent on any one in-line or pipeline product. Let me give you an example. Unlocking the value of our established products with a new comprehensive focus and a business unit within our Pharmaceutical segment that will be run like an entrepreneurial venture, as we outlined on March 5, is another tangible step towards divorcing our risk and maximizing of revenues. The established products market around the world is big, profitable and growing at double-digit rates right now. It's expected to grow to over $500 billion by 2012. Two things are required to succeed and grow share in this market and we have them both, a significant commercial footprint and strong brands. Our new established business unit is intensely focused on increasing revenues and taking a greater share of this market through our broad and diversified existing portfolio of brands as well as through the potential acquisition of additional established brands and value-adding technologies. We see a very real opportunity to gain a larger share of a fast-growing market with good operating margins and as a result drive new profitable revenues. Just to pick one example among many, we have very strong prospects in Latin America due to the strengthening of the economy and a growing, emerging middle class. Brazil and Mexico are beginning part of the leading world economies and Pfizer is already acting to take a growing share of these important markets. Brazil is currently the tenth largest economy in the world and is expected to grow to the eighth largest by 2012. In this one of the most important emerging markets in the world, our business continues to grow at double-digit rates, despite the fact that several of our products have no patent protection. The power of the Pfizer brand combined with the well-respected brands of our established products enables us to remain the market leader in Latin America despite the presence of multiple generic versions of our products. We see similar successes across the developing world, giving us confidence that our new focus on emerging markets and established products will produce significant value for Pfizer in the years up to and beyond the Lipitor loss of exclusivity. With these and all of our initiatives, we're focused on driving sustainable changes across Pfizer, improving our performance, and enhancing the total return we deliver to our shareholders. And now, I will turn it over to Frank to talk about this quarter's numbers.
Frank D'Amelio: Thanks, Jeff. Good morning, everyone. Now, to the results. The charts I'm reviewing today are included in our webcast and will help facilitate the discussion of our first quarter 2008 results. Now, let me get to our financials. Today, we reported revenues for the first quarter 2008 of $11.8 billion, a 5% decrease year-over-year. To remind you, we discussed on our year-end earnings call that first quarter 2008 revenues might not be comparable to first quarter 2007 revenues due to loss of U.S. exclusivity of Norvasc in March of 2007; Zyrtec in January of 2008, which we ceased selling late that month; and Camptosar in February of 2008, for a total decrease of $937 million. As we expected, first quarter revenues were negatively impacted by these factors. Specifically, Norvasc revenues decreased $556 million, Zyrtec revenues decreased $344 million, Camptosar revenues decreased to a much lesser extent by $37 million [ph]. Again, these results are as we expected and clearly considered in our full-year 2008 guidance, which we are reaffirming today. Partially offsetting this negative impact were foreign exchange, which increased reported revenues by approximately $570 million or 5% and the solid performance of many new and in-line products. First quarter, reported net income of $2.8 billion decreased 18% and reported diluted EPS of $0.41 decreased 15% year-over-year, primarily attributable to this quarter's expected decrease in Norvasc and Zyrtec revenues and to a lesser extent increased in-process R&D expenses associated with our acquisitions, primarily CovX and Coley. These were partially offset by lower cost and expenses related to our cost reduction initiatives and foreign exchange. First quarter adjusted income of $4.1 billion decreased 15% and adjusted diluted EPS of $0.61 decreased 10% year-over-year, again driven by expected decrease in Norvasc and Zyrtec revenues and partially offset by savings from our cost-reduction initiatives and foreign exchange. Finally, both reported and adjusted diluted EPS were favorably impacted by the full-year benefit of our $10 billion share repurchase program in 2007. We had several significant items included in our reported results this quarter. More detailed disclosures will be provided in our Form 10-Q filing with SEC. In the first quarter, we incurred $177 million in restructuring charges compared with $795 million in the prior-year quarter. This significant decrease was driven by charges related to employ severance payments and costs related to [inaudible] recorded in the year-ago quarter. Restructuring charges are primarily associated with employee costs and asset impairments. We also incurred $357 million of implementation costs compared with $174 million in the prior-year quarter, primarily related to sites we exited or are in the process of exiting. These implementation amounts are primarily reported in cost of sales, R&D and SI&A expenses and are detailed more fully in the supplemental information accompanying the release. Now, I would like to provide more details regarding our first-quarter adjusted income components. Adjusted revenues were $11.8 billion, a decrease of 5% year-over-year. Adjusted cost of sales as a percentage of revenue was 15.3% in the first quarter versus 14% in the year-ago quarter. This year-over-year increase reflects the negative effect of foreign exchange. In fact, adjusted cost of sales as a percentage of revenue would have been 14.5% excluding the effect of foreign exchange. In addition, cost of sales was to a lesser extent unfavorably impacted by geographic and business mix. These two factors more than offset the savings we achieved from our ongoing cost reduction initiatives. Adjusted SI&A expenses were $3.4 billion, a year-over-year increase of 3%. Adjusted R&D expenses were $1.6 billion, a slight increase of 1% year-over-year. Although adjusted cost of sales, SI&A and R&D expenses benefited from our ongoing cost-reduction initiatives, the $330 million negative impact of foreign exchange on adjusted total cost more than offset that benefit. That said, excluding foreign exchange, our first quarter adjusted total cost actually decreased by $170 million operationally year-over-year. Our effective tax rate on adjusted income for the quarter is 21.9% versus 21.7% in the year-ago quarter. I would also like to provide some quarterly product highlights. As you can see, most key in-line products grew year-over-year with the exception of Lipitor, which had revenues of $3.1 billion, a year-over-year decrease of 7% including the favorable impact of foreign exchange, which increased revenues by approximately $135 million or 4%. In the U.S., Lipitor revenues declined 18% due to the continuing intensely competitive generic market and the overall stat market growing at a slower rate than we had previously expected. Internationally, Lipitor revenues increased 13%, of which 10% was due to foreign exchange and the remainder due to operating growth. Lyrica, the only FDA-approved treatment for fibromyalgia continued to deliver strong performance with revenues of $582 million, an increase of 47% year-over-year. We expect Lyrica to be a key contributor to Pfizer's performance in 2008 and beyond, and U.S. volume for fibromyalgia will be the largest contributor to Lyrica's growth as our prescription volume and market share continues to grow significantly. In addition, Lyrica continues to lead in DPN and PHN pain conditions with limited treatment options, which combined accounts for a larger proportion of prescriptions than any other single condition. Finally, we anticipate continued growth across indications supported by an active lifecycle management program. Xalatan and Geodon also posted solid performance with revenue increases of 13% and 12% respectively and demonstrated growth in both the U.S. and international markets. Key new products, especially Chantix and Sutent, continued to deliver strong growth during the first quarter as compared to prior-year quarter. Year-over-year, overall Chantix revenues increased 71% and U.S. revenues increased 33%. In January, we updated the Chantix U.S. label to include additional safety information and as a result we've recently seen in the U.S. an unfavorable impact on prescription trends, which has been considered in our full-year 2008 guidance. We believe that the issues raised in the label change can be managed with an active patient-physician dialogue. In addition, as a result of our initial interactions with physicians over the past several months, we believe that the benefit-risk proposition for Chantix is sound. Finally, we will continue our aggressive educational promotional efforts with a focus on the Chantix benefit-risk proposition, significant health consequences of smoking and the importance of the physician-patient dialogue. That said, in international markets Chantix achieved triple-digit revenue growth year-over-year, albeit off of a smaller base. Chantix launches are continuing outside the U.S. In fact, over the past year we have launched Chantix in 20 countries and most recently in Singapore, India and Japan, the world's second-largest pharmaceutical market. Currently, we have launched Chantix in 56 countries and we expect launches in 20 more countries in the next 12 months. Sutent, our treatment for advanced kidney cancer and gastrointestinal stromal tumors, posted revenues of $190 million, an increase of 86% compared with the year-ago quarter. Sutent was recently approved for these indications in Japan. In Europe, Sutent has achieved access wins in Northern England and Birmingham, and we are currently conducting Phase III trials with Sutent for patients with breast, colorectal and lung cancer. As we expected, revenues from products that recently lost U.S. exclusivity declined year-over-year. Norvasc revenues declined 52% to $513 million, Zyrtec revenues declined 75% to $117 million, and Camptosar revenues declined 16% to $192 million. Today, we are reaffirming adjusted income and its components as well as adjusted diluted EPS guidance for full-year 2008 based on a number of factors. From a revenue perspective, the continued growth in many of our new and in-line products such as Chantix and Sutent as well as Lyrica, Geodon, Xalatan and Viagra. It's important to remember that beginning in the second quarter of 2008 and through the remainder of year, the impact from the decline in Norvasc revenue will be included in the quarterly results for both 2007 and 2008 because Norvasc lost U.S. exclusivity in March 2007. And we continue to expect operational growth in many international markets. From a cost perspective, we expect to generate savings in 2008 from our continued cost reduction efforts. These efforts continue to span essentially all divisions, functions and markets and sites across Pfizer. Broad categories of activity include manufacturing and research site exits, outsourcing, and targeted workforce reduction such as our ongoing, previously announced European field force reduction. We are continuing our process to exit an additional 13 [ph] manufacturing plants. By the end of 2009, we expect to reduce our network of these plants around the world to 44. In addition, we are continuing to exit the four remaining R&D sites of the six that has been identified for closure. In 2008, we will recognize the full-year benefit from 2007 site exits and a partial-year benefit from 2008 exits. In addition, we are decommissioning the insulin-related operations at two dedicated facilities as a result of our decision to exit Exubera. Also, we have a wide array of outsourcing opportunities at various stages of implementation. Manufacturing, logistics, finance, facilities, legal and IT are among the functions contributing to the financial and operational benefits of the strategy. Finally, we're continuing to match our workforce level with market reality. At the end of 2006, our colleagues totaled about 98,000. At the end of 2007, we had approximately 86,600 colleagues, and as of March 30th, 2008, our headcount level was approximately 85, 000, representing a sequential decrease of about 1600 colleagues. As a result of our continuing efforts, we are on track to decrease our adjusted total cost by at least $1.5 billion to $2 billion on a constant currency basis by the end of '08 versus 2006. To reflect the effects of business development transactions completed this quarter, we're updating the range of our reported diluted EPS guidance to $1.73 to $1.88, from $1.78 to $1.93. As we noted last quarter, the reported diluted EPS guidance did not reflect the charges associated with business development transaction that had not yet closed as of December the 31st, 2007. This range we are providing today includes the impact of IPR&D charges associated with acquisitions that closed in the first quarter, Coley, CovX and two smaller acquisitions related to Animal Health. As always, results may vary from quarter to quarter based on the seasonality of revenues, spending, timing of the loss of U.S. exclusivity, and patent expirations of certain products among other things. So to summarize the key takeaways, we are reaffirming our 2008 revenue guidance and are on track to meet our commitments. This quarter, many new products, including Chantix and Sutent continued to deliver solid performance and we are seeing steady growth in several in-line products, including Lyrica, Geodon, Viagra and Xalatan. This quarter's results were negatively impacted by loss of exclusivity products. We've considered this impact and clearly factored it into our full-year guidance. And we are continuing to execute and make progress on our cost-reduction plan and continue to expect to generate savings in 2008.
Jeffrey Kindler: Thank you very much, Frank, and now we're happy to take your questions. Question and Answer
Operator: [Operator Instructions]. Our first question comes from James Kelly of Goldman Sachs. Please proceed with your question.
James Kelly: Thank you very much, and good morning. My question has to do with cash balances and where they are domiciled currently and just helping us get comfortable with the longer-term guidance around the dividend being maintained at least at the current levels due to the loss of Lipitor exclusivity. Could you please take us through that, maybe a little bit on a mechanistic way, on how we should think about that when we deal with that big of a change in the earnings at that time? Thank you.
Jeffrey Kindler: Thanks, Jim. Frank, do you want to take the question?
Frank D'Amelio: Sure. Jim, let me... so let me address the question this way. There is really in my mind two underlining... underlying points to this question. The first point is the sustainability of the dividend and the second issue being if we expect to sustain the dividend will that cause a decrease in future earnings. So now given that, let me talk to each of them. First, we are a global company, we generate a significant amount of operating cash from both inside the U.S. and outside the U.S. Last year, that was $13.4 billion. This year we’ve forecasted that to be $17 billion to $18 billion per our guidance. Now, we have a variety of options available to us to fund our business including the dividend. One of those options is obviously cash flow from operations, including by the way increasing our cash flow from operations. Another option that's available to us is repatriating cash from foreign tax jurisdictions, which is something we do from time to time as a normal course of business. Now, to the extent that we repatriate cash from high tax jurisdictions, that will have a minimal impact on the effective tax rate. To the extent that we repatriate cash from low tax jurisdictions, that will put upward pressure on the effective tax rate. I will come back to that. Another option that is available to us is of the capital markets to borrow money. We have a very strong balance sheet that provides us with flexibility and capacity to borrow money at favorable rates. Once again, this is something we do from time to time as a normal course of business. In fact, you'll see at the end of Q1 when we file our 10-Q, you'll see that our debt levels are somewhat higher at the end of Q1 than [ph] they are at the beginning of the year. However, by the end of the year we expect those debt levels to be lower than where they are at the end of Q1. And the incremental interest associated with that debt to get [ph] incorporated into our guidance and is not material relative to our overall results for the year. Now, all that said and done, the potential impact on our EPS going forward, or more specifically, the potential negative impact on our EPS if we were to choose to borrow money or repatriate cash can be mitigated through a variety of actions. Let me go through what some of those actions are. First, I am continuing with our tax planning initiatives. We have a very good track record in this area of tax planning and obviously we expect to continue to want to do very prudent, very effective tax planning on a going-forward basis. Second area of opportunity is what I call, where and how we choose to deploy capital. We clearly have choices that we can make that would increase, for example, our U.S. cash flow. Third is our ongoing cost reduction initiatives. Cost reduction initiatives will generate incremental cash flow in multiple tax jurisdictions, all of which I view is good. Cash is fungible. The interest on that cash can be repatriated back to the U.S. through [inaudible] tax regulations. So, all that I view is good. So to kind of wrap this up, the way I think about it is based on all those factors I believe that the dividend is sustainable and the potential negative effects can be mitigated.
Jeffrey Kindler: Thank you, Frank. Next question please.
Operator: Our next question comes from Jamie Rubin, Morgan Stanley. Please proceed with your question.
Jamie Rubin: Thank you. I just wanted to follow-up on Jim's question. So, when I look at cash flow from operations, Frank, and as you’ve said most of this comes from outside the U.S., it looks to me and it has become abundantly clear that U.S. cash flow is actually running at a deficit. And just based on the way we see it, it's hard to see how that's going to improve over the near-term and certainly over the long-term, given the lack of visibility post-Lipitor. So, my question to you is how concerned are you about being in a negative U.S. cash flow situation? And while you’ve highlighted a number of options available to you, I'm still confused as to how those options don't hurt earnings when obviously repatriating cash you do so at a much higher tax rate. I understand that your Head of Taxation recently left. So I'm a little confused about that. If you deploy capital such that you decide to sell asset, doesn't that increase your exposure to Lipitor? Obviously, taking now more debt increases, your interest expense, all that to fund the dividend and working capital, how can that not hurt earnings? If you can just elaborate on that a little bit, it would be very helpful. Thanks.
Frank D'Amelio: Yes, sure. Thanks, Jamie. So, let me say it again and I won't go through everything I just said in the previous answer, I'll just kind of touch on some of the points you made. So you talked about through [ph] Lipitor, so let me touch on that part of the question and then I'll come back to the earnings part of the question. So, relative to through Lipitor, the LOE on Lipitor I assume is June of 2011, so give or take three years away. Clearly, one of the things we're trying do in addition to some of the other options I called out is continue to grow revenues, generate new sources of revenues through the five growth strategies that we laid out at our Analyst Meeting in the beginning of the month. Clearly, to the extent that we generate incremental revenues, those incremental revenues will generate incremental cash flow and then it's basically all the things that I alluded to before, one. Two, in terms of earnings, what I said before was that basically we can do things that I believe can mitigate the potential negative impact on earnings, and I went through some of them. Tax planning initiatives clearly have the ability to mitigate the impact on earnings. And cost reduction initiatives clearly have the ability to mitigate the impact on earnings. So, when I factor all that in, all the things that we're doing that I made the statement that I made relative to the options that are available to us, relative to how we fund the business and the variety of actions that are available to us to mitigate the potential impact of those actions on our earnings in the future.
Jeffrey Kindler: And just... I'd just add Jamie, you made reference to the news [ph] that our Head of Tax, who did an extraordinary job, retired after a very long and distinguished career and has been succeeded by an outstanding global expert on taxes. He’s a terrific guy and will do a great job.
Frank D'Amelio: And they are in transition mode, [inaudible] the new person is here, they are transitioning and that transition will take place over the next several months.
Jeffrey Kindler: Okay. Thank you, Jamie. Next question, please.
Operator: Our next question comes from Roopesh Patel, UBS. Please proceed with your question.
Roopesh Patel: Yes, thank you. My question is on Lipitor. I was wondering if you could please discuss the current competitive dynamics in the cholesterol lowering market, both in the U.S. and internationally. So far, it appears that Lipitor doesn't seem to be benefiting a lot from Vytorin’s declines, why not, and what should we expect going forward? It also appears that the enhanced study result hasn't had much of an impact internationally on Lipitor. I was wondering if you could comment on that as well. Thanks.
Jeffrey Kindler: Thank you, Roopesh. I'll turn that question over to Ian Read.
Ian Read: So, Roopesh, thanks for the question. International sales, to deal with that first, are quite strong, up 13% and up I think 3% operationally. So I think you've seen, especially in Europe, a stabilization of Lipitor post the generic onslaught in simvastatin. Vytorin will not really particularly impact our international operations as it was never a big player, I'd say, to begin with. If we turn to the U.S., our sales in the quarter were down 18%, scripts are down 12%. This is the usual fluctuations we see, especially in the first quarter between the recorded data on our net sales. That will smooth itself out over the full year. Now regarding ENHANCE, we've only seen in the script so for two days impact from ENHANCE… from the second round of ENHANCE and I tend to agree with you that initially most of the gains will be made by generic simvastatin, which is paradoxical as patients are on Vytorin because they can't get to go with simvastatin. So I do expect initially to see most of the gains going to generics simvastatin and then as these patients come back into the physicians’ office for their lipid testing and their levels, there will not be [inaudible] and then you begin to see a transition towards Lipitor, which is positioned in that space. So overall, I sort of see a sustained impact on Lipitor over the year as we've positioned statin of first choice, strength across the range, landmark trial, get to go with Lipitor, and I think the best we have been positioned for some time. Does that cover your questions?
Jeffrey Kindler: Okay. Thank you, Roopesh.
Operator: Thank you. Our next question comes from Mr. Tim Anderson of Sanford Bernstein. Please proceed with your question, sir.
Tim Anderson: Thank you. A couple of big picture questions for Jeff. When I look at your scheduled expirations through 2015, it seems like you stand us up for losses that are almost the highest in that group, and it's not just Lipitor but a lot of other drugs. And I guess I still struggle with how you are realistically going to deal with these pending losses, given the approach you outlined in your recent Analyst Day. So I'm hoping you can reiterate what the longer-term strategy is here? And then Jeff, on the call today you mentioned diversifying your risk. Back in 2006 you sold off your sizable consumer business and I guess I question the rational behind that fission. In retrospect, I'm wondering if you think that was a wise thing to do, and maybe you can give us some details on your comments about how you might diversify risk in the future?
Jeffrey Kindler: Okay. Thanks, Tim. Yes, absolutely we're looking ahead at significant losses of exclusivity on products, there is no question about that. And what we're all about is as I said before finding every opportunity that we can to maximize revenue across a whole host of opportunities that we have; whether they be in branded and patent protected therapeutic areas where we're making decisions to invest to win, in significant areas of high-end medical needs like oncology; whether they be in our in-line products, which as we discussed earlier, many of them are growing quite healthily; whether they be an established products, which as I indicated before we see is a huge opportunity for us, and in all these ways and others we think there is a whole host of opportunities to maximize revenues, and that's our job, that's what we're all about trying to do. Now, I've acknowledged that when Lipitor goes off patent, that's going to be a meaningful event, there is no question about it. It will have a meaningful impact when it occurs on our revenues and earnings. But the important point is that as we come out of that, all of these opportunities that we have to grow revenues are addressed and optimized to the maximum extent possible. And moreover, as I've also said, we'll size the business appropriate to the revenues that we have at that time. So that's sort of the overall big picture. Regarding diversifying our risk, the consumer sale produced substantial shareholder value [inaudible] an asset for which there was a price of $16 billion paid for it. That decision was made, we're beyond that now. But what I'm talking about in terms of diversifying risk is I think that sometimes it's under-appreciated that the number of therapeutic areas that we're in, the number of products we sell, our global footprint as you travel around the world, I think in just about every market is second to none. And I think that as I look at the pharmaceutical industry in general, Tim, it is a risky business. And I think, we all want to find a way not to be so dependent on a particular huge blockbuster, which when it loses patent in the United States has such a big impact. And so, we have to find ways and we will find ways of taking advantage of this tremendous global footprint that we have and that includes obviously the pipeline where we feel we have an extremely strong pipeline that is going to hopefully generate a lot of products in the time period that you are talking about and we've made very clear commitments in that regard that Martin described on March 5th and we intend to meet those commitments. And beyond that this global footprint that we have, the range of products we have, the range of therapeutic areas that we're in has the opportunity for us to really not just diversify risk, but create a multitude of opportunities for revenue enhancement. And another way we are going about doing that, as I've said many times, is by trying to establish very clear focused accountability on the different parts of this very large business, so that each leader of these different components of the business is highly incentivized to maximize his or her contribution to the overall picture. And that's in a few words the overall approach that we are taking, and we are pursuing it very aggressively.
Operator: Thank you, sir. Our next question comes from David Risinger of Merrill Lynch. Please proceed with your question.
David Risinger: Yes, thanks very much. So my question is a legal one. I was just hoping that you could discuss the departure of Allen Waxman after the Analyst Meeting and update us on Lipitor's patent expiration in March of '10. I think Frank said that you're assuming June of '11 is loss of exclusivity, but the U.S. Patent Office took patent away. So, if you could discuss the timeline to get that reinstated. Thank you.
Jeffrey Kindler: Okay. Thank you, David. Regarding Allen, it was an entirely personal matter that had to do with his own personal circumstances and absolutely nothing to do with the business and we regret that he has left the company. He made great contributions. And I will turn the rest of your question over to David Reid who is the acting General Counsel.
David Reid: Yes, David here. The questions about the status of the two Lipitor patents, the main ones, the first is the basic, the 893 patent that is in for re-examination. We responded to the Patent Office's communication on that. Our response went in on March 7, 2008 and so we await their response to that most recent communication. On the second patent, the enantiomer patent, that's the 995 patent that expires in June 2011. We filed for re-issuance of that in early 2007. We had a response from the Patent Office. We responded to that response in October 2007 and we are waiting for further communication from them on that.
Jeffrey Kindler: David, does that answer your question? Okay. I'm told they’re muting you because cannot persist your questions. I want to make sure you are okay with it. So, Dave, if you have further questions, just come back, and that's true of everybody of course. Can I have the next question please?
Operator: Yes, sir. Our next question comes from Kevin Scotcher of HSBC. Please proceed with your question.
Kevin Scotcher: Thanks for taking my question. Jeff, you mentioned that in the first quarter, the significance of the international growth goes beyond the quarter. You also mentioned that the gross margin in the first quarter was impacted by geographic mix. Can you tell whether the gross margin impact will also go beyond the first quarter?
Jeffrey Kindler: I'll let Frank address that, and the whole impact, Frank, about international growth as it pertains to our overall margins.
Frank D'Amelio: Sure. So, the way to think about this is, I'll start with the revenues and then I'll peel down to cost of sales, talk about it for the quarter and then talk about it for the year. So if you look at our overall business, the rhythm of the revenue numbers, last year in Q1 of '07, U.S. revenues were 55% of the business, international revenues were 45% of the business. If you look now at Q1 of '08, U.S. revenues are about 46.5% of the business, international revenues about 53.5% of the business, so a big swing in terms of the geographic mix of revenues from, I'll call it, 45 international last year to 53.5 international this quarter, kind of point one. Point two, it's clearly not all revenues are created equally, so some of the revenues we generate outside the U.S. have lower gross margins than revenues that we generated in the U.S. So, that's part of what we call geographic mix, and when we explain our gross margin. Now, for this quarter, cost of sales went from 14% last year to 15.3% this year for the quarter, so 130 basis points increase. In that 130 basis points increase, 80 basis points is foreign exchange. Without foreign exchange, the cost of sales will be 14.5%. Then, the bridge between the 14% and the 14.5% is a combination of geographic mix and some business mix, which is what I just covered relative to the geographic mix. Now, the year, we provided guidance for the year on cost of sales of 14.5% to 15.5% and we've clearly included this geographic mix trend in that guidance. So, we have obviously had the trend, we've incorporated that trend into the overall guidance for the year, and so the 14.5% to 15.5% factors that in.
Jeffrey Kindler: Okay, thank you. Next question, please.
Operator: Yes, sir. Our next question comes from Mr. John Boris of Bear Stearns. Please proceed with your question.
John Boris: Thanks for taking the question. Just financial related question, can you comment at all, Frank, on... in the quarter, what operational cash flow was and free cash flow in particular was and any split you can give between U.S., ex-U.S would be helpful. And then on share repurchase, were there any shares re-bought in the quarter? Thanks.
Frank D'Amelio: So John, on a cash flow from ops, we will have that when we file the Q. So that will be available to everybody in a couple of weeks. And then in terms of share purchases, we did not buy back any shares this quarter. You remember, last year we brought back 10 billion shares... $10 billion worth of shares, 395 million shares is what it translated to, but for the quarter we did not buy back any shares. And the way I think about this is we have many choices for our capital, one of which is our purchasing shares, and clearly what we are trying to do and what we do is deploy capital in ways that we believe provides the best return to our shareholders and that's what we will continue to do on a going forward basis.
Jeffrey Kindler: Okay. Thank you. Next question, please.
Operator: Thank you. And our next question comes from Mr. Steve Scala of Cowan. Please proceed with your questions, sir.
Steve Scala: Thank you. To achieve even the low end of your full-year EPS guidance, earnings growth needs to average mid-teens or so for the next three quarters. Other than the second quarter, the compares are not particularly easy, and I appreciate that Norvasc pressure has annualized but Zyrtec and Camptosar pressure is just beginning and Lipitor is unlikely to accelerate dramatically. Do you still believe that the high end of your earnings range is as likely as the low end or would you care to direct us one way or the other at this point? Thank you.
Frank D'Amelio: Yes, so Steve, I think… it's Frank, I'll start on the question and then I think Ian will add some comments. So first, the one thing you said in the question that I just want to come back to is the impact of Zyrtec because the fact is we saw a big impact of Zyrtec in the quarter. On a going-forward basis, that impact will not be any larger than what it was in Q1, just to be clear. So that’s just one point you have, but then Camptosar to your point [inaudible] going through the year. All of that has been factored into the guidance that we provided for the year. In terms of where are we in the guidance, quite frankly, the reason we provide a range is so that we can basically work within that range. Now obviously, we want to be as much into the range as we can possibly be, but the reason we provide a range is so that we can work within the range, given the size of the company and the fact that there is lots and lots of different things that can work for us and that can work against us. So, I don't want to pinpoint where we are in the range. Obviously, we want to be as high into the range as we can be. Well, we give a range so that we can work within the range given all those things that can change during the course of the year.
Ian Read: I'll just add to that. I mean, if you look at the revenues and the components of that, I mean we've had very strong performance on the international arena with Canada up 36%, Latin America up 28%, Asia up 19%. If you look at products, Lyrica is growing at 47%. We continue to… we’ll continue to focus on Lyrica and drive its growth in fibromyalgia and DPN and PHN. Xalatan has been a strong performer. We expect to focus on Geodon in the second half of this year. I think [inaudible] our products that we partner a very strong growth with Spiriva and with Aricept. Sutent is... has aggressive growth internationally. And we have work to do on Chantix in the U.S. to continue to grow that and we have plans in place to do that. So… and I agree with you, the second quarter last year is an easier comparator, but overall we have growth products in both in-line and new.
Jeffrey Kindler: Thanks, Ian. Next question, please.
Operator: From Barbara Ryan, Deutsche Bank. Please proceed with your question, ma'am.
Barbara Ryan: Good morning. Thank you for taking my question. Frank, I'm just wondering since obviously you've laid out what you anticipate on a spending basis during the year, we have no idea obviously what you're expecting for the first quarter. So, I'm just wondering if you can tell us where you’ve come in relative to your expectations specifically on spending for the quarter and with that… obviously talked about currency, mitigating some of the benefits, and so what are you assuming about currency in your guidance going forward, because you did say ex-currency $1.5 billion to $2 billion reduction in the cost base relative to the end of '06? And what kind of wiggle room do you have to maneuver around a negative impact from currency on your spending?
Frank D'Amelio: Okay.
Barbara Ryan: Thanks.
Frank D'Amelio: You are welcome. So Barbara, in terms of I'll call it our expectations, the results that we presented today were very much as we expected. In fact we tried to say that in the release and in some of our comments, and really as we expected in multiple dimensions, in terms top line, in terms of spending levels, right through to the bottom line, so very much I would say as we expected. That's what I would say on that. Relative to currency, the way we handle this or the way I handle this for the quarter is, we basically provided guidance based on current exchange rates, so through April. So think about the guidance based on April current exchange rates and that's what we assume basically in the annual guidance. Now, to the extent that the exchange rates change and move between now and the end of the year, that's something we'll obviously have to continue to monitor. But then, once again, it’s part of the reason why we provide a range in our guidance, to accommodate that. So you used the term wiggle room, to me part of the wiggle room is while we provide a range, so that we can accommodate some of these kinds of things to a degree. And then back to the question I had before, obviously we will work as best we can to be as high in the range as we can, but there is lots of things that can move during a year, which is why we provide a range on the numbers.
Jeffrey Kindler: Okay. Thank you. Next question, please.
Operator: Yes, sir. Our next question comes from Seamus Fernandez of Leerink Swann & Company. Please proceed with your question.
Seamus Fernandez: Thanks very much. So, just a couple of questions, on the last comment there in terms of the expectation, I guess one expectation that I certainly didn't have coming into the quarter was the impact of the ENHANCE study on the overall cholesterol marketplace. So, can you just help me understand what your expectations were for Lipitor overall? And then in the fourth quarter... on the fourth quarter conference call, Frank, you actually mentioned that the inventory levels were running at about 2.5 weeks. Jeff, you actually mentioned seasonality. So, can you just help me understand the mix of those two things? When we talk about seasonality, are we talking about wholesaler buying patterns? And on that front and if we are at 2.5 weeks, where are we at the inventory at this point on the overall business? And can you update us in terms of where we are on Lipitor in terms of overall wholesaler stocking levels?
Jeffrey Kindler: Okay. Thanks. I'll ask Ian to talk about the Lipitor part of your question and then Frank will address the seasonality issues that you raised.
Ian Read: Seamus, on Lipitor, in the quarter Lipitor was on our expectations. So, on your second question, vis-à-vis the ENHANCE impact I'm not quite sure what you're ENHANCE do. We've seen initially in the switch part of the market a reasonably dramatic impact where our switches have dropped in half away from Lipitor. So that's a very positive impact for us. The issue of course is new patient acquisition, and as I was describing before, I think initially [ph] a lot of the Vytorin loss of volume will go to simvastatin because of the pressure of managed care and then subsequently I think when cholesterol levels are measured they will have to go back to Lipitor to get to go. So I think that covers the part of it.
Jeffrey Kindler: So, Ian, I think part of Seamus' question had to do with the overall statin market growth. You want to talk about that?
Ian Read: Well, the market growth is, I think in January we talked about market growth as mid-single to high-single digits. We're now seeing it at mid-single, perhaps slightly lower, and we'll see what happens post-ENHANCE and what happens in the statin market. It is difficult to predict it right now what the growth will be.
Jeffrey Kindler: Okay, thank you. Thanks, Ian. Frank, do you want to talk about the seasonality and inventory question.
Frank D'Amelio: Yes, I mean, in terms of weeks on hand, the way that we look at this is really on a year-over-year basis. If you look at the weeks on hand, that's in our wholesalers now. From Q1 of '07 to Q1 of '08, the weeks on hands are essentially flat. There was no change from one quarter to the next, so constant year-over-year.
Jeffrey Kindler: Okay. Thank you. Next question, please.
Operator: A follow-up question coming from Roopesh Patel of UBS. Please proceed, sir.
Roopesh Patel: Yes, thank you. What was the impact of price on overall revenue growth? If you could give us a rough sense, that would be very helpful. And then, in terms of the $1.5 billion to $2 billion in overall targeted cost cuts this year, can you clarify what those numbers would be in today's dollars, in other words, at current exchange rates? Thanks.
Jeffrey Kindler: Okay. Frank?
Frank D'Amelio: Yes, so in terms of… the first part of the question.
Jeffrey Kindler: Price impact on revenues.
Frank D'Amelio: So on price, it was favorable for the quarter to the tune of 2%. In fact, the way the quarter worked overall, price helped, volume hurt and FX helped, and the [inaudible] that were essentially 2% on price to answer your question specific. In terms of the $1.5 billion to $2 billion, the way I think about that is kind of in almost '06 dollar terms, because what we were really doing is looking at that based on constant currency that goes back to 2006 where we were deriving the $1.5 billion to $2 billion. We obviously achieved some of that through last year through 2007. We are working to achieve the rest of that through this year. We reaffirm that number and it is based on those constant currency rates as of 2006.
Jeffrey Kindler: Okay. Thank you. Next question, please.
Operator: And this question comes from Mr. Mike Krensavage of Raymond James. Please proceed with your question, sir.
Michael Krensavage: Good morning. I want to know how much of a tail Lipitor might have after it goes generic in the U.S.? If you look at Merck's Zocor, for example, it’s still annualizing at more than $800 million, but mostly with the international sale. So would Lipitor have a similar tail? Thank you.
Jeffrey Kindler: Well, let me just say, and I will turn this over to Ian for a minute… in a minute, but obviously there is a big difference between international and U.S. when it comes to that. And as I mentioned earlier… and this is one of the reasons why I think there is a lot of opportunity in our established products markets. As Dave Simmons laid out on March 5th, the world is very different in different parts of the world and there are markets in which there has been no patent protection and we are selling Lipitor in competition with a whole variety of atorvastatin products and in fact still leading those particular markets. So, in many parts of the world, particularly in the developing markets, brand remains very important because the driving force from the consumption side are the physicians and the patients. And obviously, it is quite different here in the United States where managed care is much more dominant and therefore the fall-off [ph] is much more precipitous. I certainly wouldn't want to predict exactly what sorts of sales we might have in the U.S. at that time, but if you want it, Ian can give some qualitative thoughts about it?
Ian Read: Well, I think as Jeff said, we're focused on maximizing value from Lipitor post-patent expiration. And in that sense, we're focused on ensuring that in percentage wise vis-à-vis perhaps other patent expirations like Zocor that we maintain as good or not higher percentage of that business. An important factor to look into on the size of the tail in fact will be a dynamic that’s difficult to calculate, but when Lipitor goes off patent, I think there will be... I think it's a fundamentally large expansion in the use of atorvastatin in the lipid market, which will also influence the tail of Lipitor. So I think the dynamics of Lipitor patent expiration will be very different from the dynamics of Zocor patent expiration.
Jeffrey Kindler: Thanks very much, Ian. Next question, please.
Operator: And our last question comes from Mr. David Risinger of Merrill Lynch. Please proceed sir.
David Risinger: Yes. Thanks very much. There has been a lot of discussion about foreign exchange, but Frank, I was hoping that you could tell us what the bottom line EPS impact of FX was in the first quarter of '08 and if you can... if you could compare that to the bottom line EPS impact of FX a year ago in the first quarter of '07 and also in the fourth quarter of '07 sequentially? Thank you.
Frank D'Amelio: So Dave, for this quarter it was $0.03. So… and basically, we called out in the quarter to $560 million, $570 million of revenue depending on reported versus adjusted. And then the impact on cost was 330 million. So when you do the math, you get roughly $0.03. And quite frankly, in terms of the EPS numbers for first quarter and fourth quarter of last year, I don't remember the specific number. It was a comparable number, but I just don't remember what the exact numbers were. So that's something we can obviously... we can get back to you on. But it was $0.03 for this quarter.
Jeffrey Kindler: Okay. Thank you, David. And thank you everyone for listening in this morning. We appreciate your time, and that will be it for today. Have a good day. | [
{
"speaker": "Operator",
"text": "Now we have Amal Naj, Head of Investor Development. You may now begin."
},
{
"speaker": "Amal Naj",
"text": "Good morning, and thank you for joining us today to review our first quarter 2008 performance. I am here with Jeff Kindler, Chairman and CEO; Frank D'Amelio, Chief Financial Officer; Ian Read, Head of our Worldwide Pharmaceutical Operations; Martin Mackay, Head of our Worldwide Research and Development; David Reid, General Counsel. We will start this morning with a review of our results, and the financial charts that will be presented on this call can be viewed on our home page at www.pfizer.com in the Investor Presentations tab by clicking on the link, Quarterly Corporate Performance - First Quarter 2008. Our conference call will last an hour and we will end at 11:00 AM. We'd like to hear from as many of you as we can in this time. So we ask you to limit yourself to just one question. Time permitting, we'll come back to you for any additional questions. Before we start, I would like to remind you that our discussions during this conference call will include forward-looking statements. Actual results could materially vary from those projected in the forward-looking statements. The factors that could cause actual results to differ are discussed in Pfizer's 2007 Annual Report on Form 10-K and in our reports on Form 10-Q and Form 8-K. Also, the discussions during this conference call will include certain financial measures that were not prepared in accordance with Generally Accepted Accounting Principles. Reconciliations of those non-GAAP financial measures to the most directly comparable GAAP financial measures can be found in Pfizer's current report on Form 8-K dated April 17th, 2008. These reports are available on our website at www.pfizer.com in the Investors – SEC Filings section. I will now turn the call over to Jeff Kindler. Jeff?"
},
{
"speaker": "Jeffrey Kindler",
"text": "Thanks, Amal. Good morning, everyone, and thanks for joining us today. Before Frank reviews the numbers, I would like to make a few brief comments. The first quarter reflects a business reality that we highlighted in January. Our quarterly results may vary depending upon the seasonality of revenues and spending as well as the timing of the loss of U.S. exclusivity and patent expiration of certain products among other things. Due to the loss of U.S. exclusivity of two major products, the comparison of our 2008 quarterly results to 2007 is difficult this quarter. We lost U.S. exclusivity for Norvasc in late March 2007 and we lost U.S. exclusivity for Zyrtec in late January 2008, we stopped selling that product at that time. Together, the revenues from these products declined by approximately $900 million in the quarter. Further, we also lost U.S. exclusivity of Camptosar in February 2008, but impact of that LOE in this quarter was much less in comparison to the other two products. Now, we all know that losses of exclusivity are a fact of life in the branded pharmaceutical business, but nevertheless there were a number successes in other areas that partially offset the revenue decline associated with Norvasc and Zyrtec. For example, we’ve continued to generate steady overall growth from our diversified portfolio of in-line products including Lyrica, Viagra, Xalatan and Geodon. Additionally, Lipitor continues to be a strong global brand, demonstrating operational growth in China, Latin America, Spain, Canada and other international markets. Around the world and particularly in the U.S., we continue to execute a comprehensive communication strategy to reinforce the extensive evidence supporting Lipitor's strong clinical profile. And two of our new products, Sutent and Chantix, are containing to perform well. Now, we've seen some impact in the U.S. from the Chantix label changes in January, but we're moving forward on many fronts including aggressive educational and promotional efforts to drive growth as this innovative medicine continues to roll out around the world. We've now launched Chantix or Champix in 56 countries, including 20 countries within the past 12 months, countries like Italy, India and Korea. Launches in more than 20 additional countries are anticipated in the next 12 months. Further, we've launched Sutent in 61 countries and are developing this important medicine for additional tumors, including breast, lung and colorectal cancer in late-stage clinical trials. I am also very pleased that we recently approved... we received approval in Japan, which is the largest pharmaceutical market in the world outside the United States for these two important medicines, Chantix in January and Sutent just yesterday. This was accomplished in part by the great collaboration between our R&D organization and the Japanese regulatory authorities, and we look forward to more of these opportunities to bring products to market quickly in this important market. But beyond individual product performances, we continue to see operational growth in many of our major international markets. The significance of this trend goes well beyond just one quarter. As we said at our March 5th Analyst Meeting, we pursuing strategies to take advantage of these opportunities and we believe our international business will be a significant source of growth for us in the coming years. And finally, we're continuing to see the benefits of productivity and efficiency improvements throughout our company. We're on tack to meet our goal of reducing our adjusted total costs by at least $1.5 billion to $2 billion by the end of this year compared to 2006 on a constant currency basis. We are sharply focused on meeting our full-year guidance. With growth in many of our new and in-line products, strong performances in key markets and aggressive cost reductions, we are reaffirming that guidance today. At the same time, we continue to make fundamental changes in the operations, structure and culture of the business by executing on the strategies we outlined at our March Analyst Meeting to build long-term value. Through the hard work and dedication of our colleagues, we have over the past year fixed many of the key elements of our business and established a strong foundation with which to overcome our challenges and seize the many opportunities before us, and we're making substantial progress in other elements of our business. For example, we're pursuing new revenue opportunities across geographies, therapeutic areas and products, particularly in those areas that we've identified where we will invest to win. In one very important-to-win disease area, oncology, I'm pleased to tell you that we're now initiating a Phase III clinical trial of our IGF-1R antibody for the treatment of non-small cell lung cancer, an area with significant unmet medical need and large market potential. In addition, we are active in business development and scanning the marketplace for opportunities while maintaining discipline in how we invest our shareholders’ capital. During the quarter, we announced an agreement to acquire Serenex, which will bring us proprietary compounds in science, in oncology. And we recently acquired a controlling interest in Encysive, which fits very well with our strong cardiovascular franchise. Additionally, yesterday we announced an agreement with AVANT to license a Phase II therapeutic vaccine for a specific type of brain tumor. We're also applying innovative approaches and new business models across our business to both our existing assets and new products. Now, one of the main objectives of these strategies and something that I would like to emphasize is risk diversification. We all know that we are and we're going to remain in an industry with many risks, not only those inherent in drug development but also those associated, for example, with things like safety and pricing. Our path forward, including the five strategies we outlined at our March 5th Analyst Meeting, is designed to mitigate and diversify that risk while maximizing revenues. Pfizer has a uniquely strong and broad global footprint, which we consider a powerful competitive advantage. We are a leader in most of the markets and many of the disease areas in which we compete. This allows us to execute on a range of strategies, involving a portfolio of both patent protected and established products in developed as well as emerging markets. Our goal over time is to take advantage of the many opportunities this presents and to become less dependent on any one in-line or pipeline product. Let me give you an example. Unlocking the value of our established products with a new comprehensive focus and a business unit within our Pharmaceutical segment that will be run like an entrepreneurial venture, as we outlined on March 5, is another tangible step towards divorcing our risk and maximizing of revenues. The established products market around the world is big, profitable and growing at double-digit rates right now. It's expected to grow to over $500 billion by 2012. Two things are required to succeed and grow share in this market and we have them both, a significant commercial footprint and strong brands. Our new established business unit is intensely focused on increasing revenues and taking a greater share of this market through our broad and diversified existing portfolio of brands as well as through the potential acquisition of additional established brands and value-adding technologies. We see a very real opportunity to gain a larger share of a fast-growing market with good operating margins and as a result drive new profitable revenues. Just to pick one example among many, we have very strong prospects in Latin America due to the strengthening of the economy and a growing, emerging middle class. Brazil and Mexico are beginning part of the leading world economies and Pfizer is already acting to take a growing share of these important markets. Brazil is currently the tenth largest economy in the world and is expected to grow to the eighth largest by 2012. In this one of the most important emerging markets in the world, our business continues to grow at double-digit rates, despite the fact that several of our products have no patent protection. The power of the Pfizer brand combined with the well-respected brands of our established products enables us to remain the market leader in Latin America despite the presence of multiple generic versions of our products. We see similar successes across the developing world, giving us confidence that our new focus on emerging markets and established products will produce significant value for Pfizer in the years up to and beyond the Lipitor loss of exclusivity. With these and all of our initiatives, we're focused on driving sustainable changes across Pfizer, improving our performance, and enhancing the total return we deliver to our shareholders. And now, I will turn it over to Frank to talk about this quarter's numbers."
},
{
"speaker": "Frank D'Amelio",
"text": "Thanks, Jeff. Good morning, everyone. Now, to the results. The charts I'm reviewing today are included in our webcast and will help facilitate the discussion of our first quarter 2008 results. Now, let me get to our financials. Today, we reported revenues for the first quarter 2008 of $11.8 billion, a 5% decrease year-over-year. To remind you, we discussed on our year-end earnings call that first quarter 2008 revenues might not be comparable to first quarter 2007 revenues due to loss of U.S. exclusivity of Norvasc in March of 2007; Zyrtec in January of 2008, which we ceased selling late that month; and Camptosar in February of 2008, for a total decrease of $937 million. As we expected, first quarter revenues were negatively impacted by these factors. Specifically, Norvasc revenues decreased $556 million, Zyrtec revenues decreased $344 million, Camptosar revenues decreased to a much lesser extent by $37 million [ph]. Again, these results are as we expected and clearly considered in our full-year 2008 guidance, which we are reaffirming today. Partially offsetting this negative impact were foreign exchange, which increased reported revenues by approximately $570 million or 5% and the solid performance of many new and in-line products. First quarter, reported net income of $2.8 billion decreased 18% and reported diluted EPS of $0.41 decreased 15% year-over-year, primarily attributable to this quarter's expected decrease in Norvasc and Zyrtec revenues and to a lesser extent increased in-process R&D expenses associated with our acquisitions, primarily CovX and Coley. These were partially offset by lower cost and expenses related to our cost reduction initiatives and foreign exchange. First quarter adjusted income of $4.1 billion decreased 15% and adjusted diluted EPS of $0.61 decreased 10% year-over-year, again driven by expected decrease in Norvasc and Zyrtec revenues and partially offset by savings from our cost-reduction initiatives and foreign exchange. Finally, both reported and adjusted diluted EPS were favorably impacted by the full-year benefit of our $10 billion share repurchase program in 2007. We had several significant items included in our reported results this quarter. More detailed disclosures will be provided in our Form 10-Q filing with SEC. In the first quarter, we incurred $177 million in restructuring charges compared with $795 million in the prior-year quarter. This significant decrease was driven by charges related to employ severance payments and costs related to [inaudible] recorded in the year-ago quarter. Restructuring charges are primarily associated with employee costs and asset impairments. We also incurred $357 million of implementation costs compared with $174 million in the prior-year quarter, primarily related to sites we exited or are in the process of exiting. These implementation amounts are primarily reported in cost of sales, R&D and SI&A expenses and are detailed more fully in the supplemental information accompanying the release. Now, I would like to provide more details regarding our first-quarter adjusted income components. Adjusted revenues were $11.8 billion, a decrease of 5% year-over-year. Adjusted cost of sales as a percentage of revenue was 15.3% in the first quarter versus 14% in the year-ago quarter. This year-over-year increase reflects the negative effect of foreign exchange. In fact, adjusted cost of sales as a percentage of revenue would have been 14.5% excluding the effect of foreign exchange. In addition, cost of sales was to a lesser extent unfavorably impacted by geographic and business mix. These two factors more than offset the savings we achieved from our ongoing cost reduction initiatives. Adjusted SI&A expenses were $3.4 billion, a year-over-year increase of 3%. Adjusted R&D expenses were $1.6 billion, a slight increase of 1% year-over-year. Although adjusted cost of sales, SI&A and R&D expenses benefited from our ongoing cost-reduction initiatives, the $330 million negative impact of foreign exchange on adjusted total cost more than offset that benefit. That said, excluding foreign exchange, our first quarter adjusted total cost actually decreased by $170 million operationally year-over-year. Our effective tax rate on adjusted income for the quarter is 21.9% versus 21.7% in the year-ago quarter. I would also like to provide some quarterly product highlights. As you can see, most key in-line products grew year-over-year with the exception of Lipitor, which had revenues of $3.1 billion, a year-over-year decrease of 7% including the favorable impact of foreign exchange, which increased revenues by approximately $135 million or 4%. In the U.S., Lipitor revenues declined 18% due to the continuing intensely competitive generic market and the overall stat market growing at a slower rate than we had previously expected. Internationally, Lipitor revenues increased 13%, of which 10% was due to foreign exchange and the remainder due to operating growth. Lyrica, the only FDA-approved treatment for fibromyalgia continued to deliver strong performance with revenues of $582 million, an increase of 47% year-over-year. We expect Lyrica to be a key contributor to Pfizer's performance in 2008 and beyond, and U.S. volume for fibromyalgia will be the largest contributor to Lyrica's growth as our prescription volume and market share continues to grow significantly. In addition, Lyrica continues to lead in DPN and PHN pain conditions with limited treatment options, which combined accounts for a larger proportion of prescriptions than any other single condition. Finally, we anticipate continued growth across indications supported by an active lifecycle management program. Xalatan and Geodon also posted solid performance with revenue increases of 13% and 12% respectively and demonstrated growth in both the U.S. and international markets. Key new products, especially Chantix and Sutent, continued to deliver strong growth during the first quarter as compared to prior-year quarter. Year-over-year, overall Chantix revenues increased 71% and U.S. revenues increased 33%. In January, we updated the Chantix U.S. label to include additional safety information and as a result we've recently seen in the U.S. an unfavorable impact on prescription trends, which has been considered in our full-year 2008 guidance. We believe that the issues raised in the label change can be managed with an active patient-physician dialogue. In addition, as a result of our initial interactions with physicians over the past several months, we believe that the benefit-risk proposition for Chantix is sound. Finally, we will continue our aggressive educational promotional efforts with a focus on the Chantix benefit-risk proposition, significant health consequences of smoking and the importance of the physician-patient dialogue. That said, in international markets Chantix achieved triple-digit revenue growth year-over-year, albeit off of a smaller base. Chantix launches are continuing outside the U.S. In fact, over the past year we have launched Chantix in 20 countries and most recently in Singapore, India and Japan, the world's second-largest pharmaceutical market. Currently, we have launched Chantix in 56 countries and we expect launches in 20 more countries in the next 12 months. Sutent, our treatment for advanced kidney cancer and gastrointestinal stromal tumors, posted revenues of $190 million, an increase of 86% compared with the year-ago quarter. Sutent was recently approved for these indications in Japan. In Europe, Sutent has achieved access wins in Northern England and Birmingham, and we are currently conducting Phase III trials with Sutent for patients with breast, colorectal and lung cancer. As we expected, revenues from products that recently lost U.S. exclusivity declined year-over-year. Norvasc revenues declined 52% to $513 million, Zyrtec revenues declined 75% to $117 million, and Camptosar revenues declined 16% to $192 million. Today, we are reaffirming adjusted income and its components as well as adjusted diluted EPS guidance for full-year 2008 based on a number of factors. From a revenue perspective, the continued growth in many of our new and in-line products such as Chantix and Sutent as well as Lyrica, Geodon, Xalatan and Viagra. It's important to remember that beginning in the second quarter of 2008 and through the remainder of year, the impact from the decline in Norvasc revenue will be included in the quarterly results for both 2007 and 2008 because Norvasc lost U.S. exclusivity in March 2007. And we continue to expect operational growth in many international markets. From a cost perspective, we expect to generate savings in 2008 from our continued cost reduction efforts. These efforts continue to span essentially all divisions, functions and markets and sites across Pfizer. Broad categories of activity include manufacturing and research site exits, outsourcing, and targeted workforce reduction such as our ongoing, previously announced European field force reduction. We are continuing our process to exit an additional 13 [ph] manufacturing plants. By the end of 2009, we expect to reduce our network of these plants around the world to 44. In addition, we are continuing to exit the four remaining R&D sites of the six that has been identified for closure. In 2008, we will recognize the full-year benefit from 2007 site exits and a partial-year benefit from 2008 exits. In addition, we are decommissioning the insulin-related operations at two dedicated facilities as a result of our decision to exit Exubera. Also, we have a wide array of outsourcing opportunities at various stages of implementation. Manufacturing, logistics, finance, facilities, legal and IT are among the functions contributing to the financial and operational benefits of the strategy. Finally, we're continuing to match our workforce level with market reality. At the end of 2006, our colleagues totaled about 98,000. At the end of 2007, we had approximately 86,600 colleagues, and as of March 30th, 2008, our headcount level was approximately 85, 000, representing a sequential decrease of about 1600 colleagues. As a result of our continuing efforts, we are on track to decrease our adjusted total cost by at least $1.5 billion to $2 billion on a constant currency basis by the end of '08 versus 2006. To reflect the effects of business development transactions completed this quarter, we're updating the range of our reported diluted EPS guidance to $1.73 to $1.88, from $1.78 to $1.93. As we noted last quarter, the reported diluted EPS guidance did not reflect the charges associated with business development transaction that had not yet closed as of December the 31st, 2007. This range we are providing today includes the impact of IPR&D charges associated with acquisitions that closed in the first quarter, Coley, CovX and two smaller acquisitions related to Animal Health. As always, results may vary from quarter to quarter based on the seasonality of revenues, spending, timing of the loss of U.S. exclusivity, and patent expirations of certain products among other things. So to summarize the key takeaways, we are reaffirming our 2008 revenue guidance and are on track to meet our commitments. This quarter, many new products, including Chantix and Sutent continued to deliver solid performance and we are seeing steady growth in several in-line products, including Lyrica, Geodon, Viagra and Xalatan. This quarter's results were negatively impacted by loss of exclusivity products. We've considered this impact and clearly factored it into our full-year guidance. And we are continuing to execute and make progress on our cost-reduction plan and continue to expect to generate savings in 2008."
},
{
"speaker": "Jeffrey Kindler",
"text": "Thank you very much, Frank, and now we're happy to take your questions. Question and Answer"
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Our first question comes from James Kelly of Goldman Sachs. Please proceed with your question."
},
{
"speaker": "James Kelly",
"text": "Thank you very much, and good morning. My question has to do with cash balances and where they are domiciled currently and just helping us get comfortable with the longer-term guidance around the dividend being maintained at least at the current levels due to the loss of Lipitor exclusivity. Could you please take us through that, maybe a little bit on a mechanistic way, on how we should think about that when we deal with that big of a change in the earnings at that time? Thank you."
},
{
"speaker": "Jeffrey Kindler",
"text": "Thanks, Jim. Frank, do you want to take the question?"
},
{
"speaker": "Frank D'Amelio",
"text": "Sure. Jim, let me... so let me address the question this way. There is really in my mind two underlining... underlying points to this question. The first point is the sustainability of the dividend and the second issue being if we expect to sustain the dividend will that cause a decrease in future earnings. So now given that, let me talk to each of them. First, we are a global company, we generate a significant amount of operating cash from both inside the U.S. and outside the U.S. Last year, that was $13.4 billion. This year we’ve forecasted that to be $17 billion to $18 billion per our guidance. Now, we have a variety of options available to us to fund our business including the dividend. One of those options is obviously cash flow from operations, including by the way increasing our cash flow from operations. Another option that's available to us is repatriating cash from foreign tax jurisdictions, which is something we do from time to time as a normal course of business. Now, to the extent that we repatriate cash from high tax jurisdictions, that will have a minimal impact on the effective tax rate. To the extent that we repatriate cash from low tax jurisdictions, that will put upward pressure on the effective tax rate. I will come back to that. Another option that is available to us is of the capital markets to borrow money. We have a very strong balance sheet that provides us with flexibility and capacity to borrow money at favorable rates. Once again, this is something we do from time to time as a normal course of business. In fact, you'll see at the end of Q1 when we file our 10-Q, you'll see that our debt levels are somewhat higher at the end of Q1 than [ph] they are at the beginning of the year. However, by the end of the year we expect those debt levels to be lower than where they are at the end of Q1. And the incremental interest associated with that debt to get [ph] incorporated into our guidance and is not material relative to our overall results for the year. Now, all that said and done, the potential impact on our EPS going forward, or more specifically, the potential negative impact on our EPS if we were to choose to borrow money or repatriate cash can be mitigated through a variety of actions. Let me go through what some of those actions are. First, I am continuing with our tax planning initiatives. We have a very good track record in this area of tax planning and obviously we expect to continue to want to do very prudent, very effective tax planning on a going-forward basis. Second area of opportunity is what I call, where and how we choose to deploy capital. We clearly have choices that we can make that would increase, for example, our U.S. cash flow. Third is our ongoing cost reduction initiatives. Cost reduction initiatives will generate incremental cash flow in multiple tax jurisdictions, all of which I view is good. Cash is fungible. The interest on that cash can be repatriated back to the U.S. through [inaudible] tax regulations. So, all that I view is good. So to kind of wrap this up, the way I think about it is based on all those factors I believe that the dividend is sustainable and the potential negative effects can be mitigated."
},
{
"speaker": "Jeffrey Kindler",
"text": "Thank you, Frank. Next question please."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jamie Rubin, Morgan Stanley. Please proceed with your question."
},
{
"speaker": "Jamie Rubin",
"text": "Thank you. I just wanted to follow-up on Jim's question. So, when I look at cash flow from operations, Frank, and as you’ve said most of this comes from outside the U.S., it looks to me and it has become abundantly clear that U.S. cash flow is actually running at a deficit. And just based on the way we see it, it's hard to see how that's going to improve over the near-term and certainly over the long-term, given the lack of visibility post-Lipitor. So, my question to you is how concerned are you about being in a negative U.S. cash flow situation? And while you’ve highlighted a number of options available to you, I'm still confused as to how those options don't hurt earnings when obviously repatriating cash you do so at a much higher tax rate. I understand that your Head of Taxation recently left. So I'm a little confused about that. If you deploy capital such that you decide to sell asset, doesn't that increase your exposure to Lipitor? Obviously, taking now more debt increases, your interest expense, all that to fund the dividend and working capital, how can that not hurt earnings? If you can just elaborate on that a little bit, it would be very helpful. Thanks."
},
{
"speaker": "Frank D'Amelio",
"text": "Yes, sure. Thanks, Jamie. So, let me say it again and I won't go through everything I just said in the previous answer, I'll just kind of touch on some of the points you made. So you talked about through [ph] Lipitor, so let me touch on that part of the question and then I'll come back to the earnings part of the question. So, relative to through Lipitor, the LOE on Lipitor I assume is June of 2011, so give or take three years away. Clearly, one of the things we're trying do in addition to some of the other options I called out is continue to grow revenues, generate new sources of revenues through the five growth strategies that we laid out at our Analyst Meeting in the beginning of the month. Clearly, to the extent that we generate incremental revenues, those incremental revenues will generate incremental cash flow and then it's basically all the things that I alluded to before, one. Two, in terms of earnings, what I said before was that basically we can do things that I believe can mitigate the potential negative impact on earnings, and I went through some of them. Tax planning initiatives clearly have the ability to mitigate the impact on earnings. And cost reduction initiatives clearly have the ability to mitigate the impact on earnings. So, when I factor all that in, all the things that we're doing that I made the statement that I made relative to the options that are available to us, relative to how we fund the business and the variety of actions that are available to us to mitigate the potential impact of those actions on our earnings in the future."
},
{
"speaker": "Jeffrey Kindler",
"text": "And just... I'd just add Jamie, you made reference to the news [ph] that our Head of Tax, who did an extraordinary job, retired after a very long and distinguished career and has been succeeded by an outstanding global expert on taxes. He’s a terrific guy and will do a great job."
},
{
"speaker": "Frank D'Amelio",
"text": "And they are in transition mode, [inaudible] the new person is here, they are transitioning and that transition will take place over the next several months."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Thank you, Jamie. Next question, please."
},
{
"speaker": "Operator",
"text": "Our next question comes from Roopesh Patel, UBS. Please proceed with your question."
},
{
"speaker": "Roopesh Patel",
"text": "Yes, thank you. My question is on Lipitor. I was wondering if you could please discuss the current competitive dynamics in the cholesterol lowering market, both in the U.S. and internationally. So far, it appears that Lipitor doesn't seem to be benefiting a lot from Vytorin’s declines, why not, and what should we expect going forward? It also appears that the enhanced study result hasn't had much of an impact internationally on Lipitor. I was wondering if you could comment on that as well. Thanks."
},
{
"speaker": "Jeffrey Kindler",
"text": "Thank you, Roopesh. I'll turn that question over to Ian Read."
},
{
"speaker": "Ian Read",
"text": "So, Roopesh, thanks for the question. International sales, to deal with that first, are quite strong, up 13% and up I think 3% operationally. So I think you've seen, especially in Europe, a stabilization of Lipitor post the generic onslaught in simvastatin. Vytorin will not really particularly impact our international operations as it was never a big player, I'd say, to begin with. If we turn to the U.S., our sales in the quarter were down 18%, scripts are down 12%. This is the usual fluctuations we see, especially in the first quarter between the recorded data on our net sales. That will smooth itself out over the full year. Now regarding ENHANCE, we've only seen in the script so for two days impact from ENHANCE… from the second round of ENHANCE and I tend to agree with you that initially most of the gains will be made by generic simvastatin, which is paradoxical as patients are on Vytorin because they can't get to go with simvastatin. So I do expect initially to see most of the gains going to generics simvastatin and then as these patients come back into the physicians’ office for their lipid testing and their levels, there will not be [inaudible] and then you begin to see a transition towards Lipitor, which is positioned in that space. So overall, I sort of see a sustained impact on Lipitor over the year as we've positioned statin of first choice, strength across the range, landmark trial, get to go with Lipitor, and I think the best we have been positioned for some time. Does that cover your questions?"
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Thank you, Roopesh."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Mr. Tim Anderson of Sanford Bernstein. Please proceed with your question, sir."
},
{
"speaker": "Tim Anderson",
"text": "Thank you. A couple of big picture questions for Jeff. When I look at your scheduled expirations through 2015, it seems like you stand us up for losses that are almost the highest in that group, and it's not just Lipitor but a lot of other drugs. And I guess I still struggle with how you are realistically going to deal with these pending losses, given the approach you outlined in your recent Analyst Day. So I'm hoping you can reiterate what the longer-term strategy is here? And then Jeff, on the call today you mentioned diversifying your risk. Back in 2006 you sold off your sizable consumer business and I guess I question the rational behind that fission. In retrospect, I'm wondering if you think that was a wise thing to do, and maybe you can give us some details on your comments about how you might diversify risk in the future?"
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Thanks, Tim. Yes, absolutely we're looking ahead at significant losses of exclusivity on products, there is no question about that. And what we're all about is as I said before finding every opportunity that we can to maximize revenue across a whole host of opportunities that we have; whether they be in branded and patent protected therapeutic areas where we're making decisions to invest to win, in significant areas of high-end medical needs like oncology; whether they be in our in-line products, which as we discussed earlier, many of them are growing quite healthily; whether they be an established products, which as I indicated before we see is a huge opportunity for us, and in all these ways and others we think there is a whole host of opportunities to maximize revenues, and that's our job, that's what we're all about trying to do. Now, I've acknowledged that when Lipitor goes off patent, that's going to be a meaningful event, there is no question about it. It will have a meaningful impact when it occurs on our revenues and earnings. But the important point is that as we come out of that, all of these opportunities that we have to grow revenues are addressed and optimized to the maximum extent possible. And moreover, as I've also said, we'll size the business appropriate to the revenues that we have at that time. So that's sort of the overall big picture. Regarding diversifying our risk, the consumer sale produced substantial shareholder value [inaudible] an asset for which there was a price of $16 billion paid for it. That decision was made, we're beyond that now. But what I'm talking about in terms of diversifying risk is I think that sometimes it's under-appreciated that the number of therapeutic areas that we're in, the number of products we sell, our global footprint as you travel around the world, I think in just about every market is second to none. And I think that as I look at the pharmaceutical industry in general, Tim, it is a risky business. And I think, we all want to find a way not to be so dependent on a particular huge blockbuster, which when it loses patent in the United States has such a big impact. And so, we have to find ways and we will find ways of taking advantage of this tremendous global footprint that we have and that includes obviously the pipeline where we feel we have an extremely strong pipeline that is going to hopefully generate a lot of products in the time period that you are talking about and we've made very clear commitments in that regard that Martin described on March 5th and we intend to meet those commitments. And beyond that this global footprint that we have, the range of products we have, the range of therapeutic areas that we're in has the opportunity for us to really not just diversify risk, but create a multitude of opportunities for revenue enhancement. And another way we are going about doing that, as I've said many times, is by trying to establish very clear focused accountability on the different parts of this very large business, so that each leader of these different components of the business is highly incentivized to maximize his or her contribution to the overall picture. And that's in a few words the overall approach that we are taking, and we are pursuing it very aggressively."
},
{
"speaker": "Operator",
"text": "Thank you, sir. Our next question comes from David Risinger of Merrill Lynch. Please proceed with your question."
},
{
"speaker": "David Risinger",
"text": "Yes, thanks very much. So my question is a legal one. I was just hoping that you could discuss the departure of Allen Waxman after the Analyst Meeting and update us on Lipitor's patent expiration in March of '10. I think Frank said that you're assuming June of '11 is loss of exclusivity, but the U.S. Patent Office took patent away. So, if you could discuss the timeline to get that reinstated. Thank you."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Thank you, David. Regarding Allen, it was an entirely personal matter that had to do with his own personal circumstances and absolutely nothing to do with the business and we regret that he has left the company. He made great contributions. And I will turn the rest of your question over to David Reid who is the acting General Counsel."
},
{
"speaker": "David Reid",
"text": "Yes, David here. The questions about the status of the two Lipitor patents, the main ones, the first is the basic, the 893 patent that is in for re-examination. We responded to the Patent Office's communication on that. Our response went in on March 7, 2008 and so we await their response to that most recent communication. On the second patent, the enantiomer patent, that's the 995 patent that expires in June 2011. We filed for re-issuance of that in early 2007. We had a response from the Patent Office. We responded to that response in October 2007 and we are waiting for further communication from them on that."
},
{
"speaker": "Jeffrey Kindler",
"text": "David, does that answer your question? Okay. I'm told they’re muting you because cannot persist your questions. I want to make sure you are okay with it. So, Dave, if you have further questions, just come back, and that's true of everybody of course. Can I have the next question please?"
},
{
"speaker": "Operator",
"text": "Yes, sir. Our next question comes from Kevin Scotcher of HSBC. Please proceed with your question."
},
{
"speaker": "Kevin Scotcher",
"text": "Thanks for taking my question. Jeff, you mentioned that in the first quarter, the significance of the international growth goes beyond the quarter. You also mentioned that the gross margin in the first quarter was impacted by geographic mix. Can you tell whether the gross margin impact will also go beyond the first quarter?"
},
{
"speaker": "Jeffrey Kindler",
"text": "I'll let Frank address that, and the whole impact, Frank, about international growth as it pertains to our overall margins."
},
{
"speaker": "Frank D'Amelio",
"text": "Sure. So, the way to think about this is, I'll start with the revenues and then I'll peel down to cost of sales, talk about it for the quarter and then talk about it for the year. So if you look at our overall business, the rhythm of the revenue numbers, last year in Q1 of '07, U.S. revenues were 55% of the business, international revenues were 45% of the business. If you look now at Q1 of '08, U.S. revenues are about 46.5% of the business, international revenues about 53.5% of the business, so a big swing in terms of the geographic mix of revenues from, I'll call it, 45 international last year to 53.5 international this quarter, kind of point one. Point two, it's clearly not all revenues are created equally, so some of the revenues we generate outside the U.S. have lower gross margins than revenues that we generated in the U.S. So, that's part of what we call geographic mix, and when we explain our gross margin. Now, for this quarter, cost of sales went from 14% last year to 15.3% this year for the quarter, so 130 basis points increase. In that 130 basis points increase, 80 basis points is foreign exchange. Without foreign exchange, the cost of sales will be 14.5%. Then, the bridge between the 14% and the 14.5% is a combination of geographic mix and some business mix, which is what I just covered relative to the geographic mix. Now, the year, we provided guidance for the year on cost of sales of 14.5% to 15.5% and we've clearly included this geographic mix trend in that guidance. So, we have obviously had the trend, we've incorporated that trend into the overall guidance for the year, and so the 14.5% to 15.5% factors that in."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay, thank you. Next question, please."
},
{
"speaker": "Operator",
"text": "Yes, sir. Our next question comes from Mr. John Boris of Bear Stearns. Please proceed with your question."
},
{
"speaker": "John Boris",
"text": "Thanks for taking the question. Just financial related question, can you comment at all, Frank, on... in the quarter, what operational cash flow was and free cash flow in particular was and any split you can give between U.S., ex-U.S would be helpful. And then on share repurchase, were there any shares re-bought in the quarter? Thanks."
},
{
"speaker": "Frank D'Amelio",
"text": "So John, on a cash flow from ops, we will have that when we file the Q. So that will be available to everybody in a couple of weeks. And then in terms of share purchases, we did not buy back any shares this quarter. You remember, last year we brought back 10 billion shares... $10 billion worth of shares, 395 million shares is what it translated to, but for the quarter we did not buy back any shares. And the way I think about this is we have many choices for our capital, one of which is our purchasing shares, and clearly what we are trying to do and what we do is deploy capital in ways that we believe provides the best return to our shareholders and that's what we will continue to do on a going forward basis."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Thank you. Next question, please."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from Mr. Steve Scala of Cowan. Please proceed with your questions, sir."
},
{
"speaker": "Steve Scala",
"text": "Thank you. To achieve even the low end of your full-year EPS guidance, earnings growth needs to average mid-teens or so for the next three quarters. Other than the second quarter, the compares are not particularly easy, and I appreciate that Norvasc pressure has annualized but Zyrtec and Camptosar pressure is just beginning and Lipitor is unlikely to accelerate dramatically. Do you still believe that the high end of your earnings range is as likely as the low end or would you care to direct us one way or the other at this point? Thank you."
},
{
"speaker": "Frank D'Amelio",
"text": "Yes, so Steve, I think… it's Frank, I'll start on the question and then I think Ian will add some comments. So first, the one thing you said in the question that I just want to come back to is the impact of Zyrtec because the fact is we saw a big impact of Zyrtec in the quarter. On a going-forward basis, that impact will not be any larger than what it was in Q1, just to be clear. So that’s just one point you have, but then Camptosar to your point [inaudible] going through the year. All of that has been factored into the guidance that we provided for the year. In terms of where are we in the guidance, quite frankly, the reason we provide a range is so that we can basically work within that range. Now obviously, we want to be as much into the range as we can possibly be, but the reason we provide a range is so that we can work within the range, given the size of the company and the fact that there is lots and lots of different things that can work for us and that can work against us. So, I don't want to pinpoint where we are in the range. Obviously, we want to be as high into the range as we can be. Well, we give a range so that we can work within the range given all those things that can change during the course of the year."
},
{
"speaker": "Ian Read",
"text": "I'll just add to that. I mean, if you look at the revenues and the components of that, I mean we've had very strong performance on the international arena with Canada up 36%, Latin America up 28%, Asia up 19%. If you look at products, Lyrica is growing at 47%. We continue to… we’ll continue to focus on Lyrica and drive its growth in fibromyalgia and DPN and PHN. Xalatan has been a strong performer. We expect to focus on Geodon in the second half of this year. I think [inaudible] our products that we partner a very strong growth with Spiriva and with Aricept. Sutent is... has aggressive growth internationally. And we have work to do on Chantix in the U.S. to continue to grow that and we have plans in place to do that. So… and I agree with you, the second quarter last year is an easier comparator, but overall we have growth products in both in-line and new."
},
{
"speaker": "Jeffrey Kindler",
"text": "Thanks, Ian. Next question, please."
},
{
"speaker": "Operator",
"text": "From Barbara Ryan, Deutsche Bank. Please proceed with your question, ma'am."
},
{
"speaker": "Barbara Ryan",
"text": "Good morning. Thank you for taking my question. Frank, I'm just wondering since obviously you've laid out what you anticipate on a spending basis during the year, we have no idea obviously what you're expecting for the first quarter. So, I'm just wondering if you can tell us where you’ve come in relative to your expectations specifically on spending for the quarter and with that… obviously talked about currency, mitigating some of the benefits, and so what are you assuming about currency in your guidance going forward, because you did say ex-currency $1.5 billion to $2 billion reduction in the cost base relative to the end of '06? And what kind of wiggle room do you have to maneuver around a negative impact from currency on your spending?"
},
{
"speaker": "Frank D'Amelio",
"text": "Okay."
},
{
"speaker": "Barbara Ryan",
"text": "Thanks."
},
{
"speaker": "Frank D'Amelio",
"text": "You are welcome. So Barbara, in terms of I'll call it our expectations, the results that we presented today were very much as we expected. In fact we tried to say that in the release and in some of our comments, and really as we expected in multiple dimensions, in terms top line, in terms of spending levels, right through to the bottom line, so very much I would say as we expected. That's what I would say on that. Relative to currency, the way we handle this or the way I handle this for the quarter is, we basically provided guidance based on current exchange rates, so through April. So think about the guidance based on April current exchange rates and that's what we assume basically in the annual guidance. Now, to the extent that the exchange rates change and move between now and the end of the year, that's something we'll obviously have to continue to monitor. But then, once again, it’s part of the reason why we provide a range in our guidance, to accommodate that. So you used the term wiggle room, to me part of the wiggle room is while we provide a range, so that we can accommodate some of these kinds of things to a degree. And then back to the question I had before, obviously we will work as best we can to be as high in the range as we can, but there is lots of things that can move during a year, which is why we provide a range on the numbers."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Thank you. Next question, please."
},
{
"speaker": "Operator",
"text": "Yes, sir. Our next question comes from Seamus Fernandez of Leerink Swann & Company. Please proceed with your question."
},
{
"speaker": "Seamus Fernandez",
"text": "Thanks very much. So, just a couple of questions, on the last comment there in terms of the expectation, I guess one expectation that I certainly didn't have coming into the quarter was the impact of the ENHANCE study on the overall cholesterol marketplace. So, can you just help me understand what your expectations were for Lipitor overall? And then in the fourth quarter... on the fourth quarter conference call, Frank, you actually mentioned that the inventory levels were running at about 2.5 weeks. Jeff, you actually mentioned seasonality. So, can you just help me understand the mix of those two things? When we talk about seasonality, are we talking about wholesaler buying patterns? And on that front and if we are at 2.5 weeks, where are we at the inventory at this point on the overall business? And can you update us in terms of where we are on Lipitor in terms of overall wholesaler stocking levels?"
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Thanks. I'll ask Ian to talk about the Lipitor part of your question and then Frank will address the seasonality issues that you raised."
},
{
"speaker": "Ian Read",
"text": "Seamus, on Lipitor, in the quarter Lipitor was on our expectations. So, on your second question, vis-à-vis the ENHANCE impact I'm not quite sure what you're ENHANCE do. We've seen initially in the switch part of the market a reasonably dramatic impact where our switches have dropped in half away from Lipitor. So that's a very positive impact for us. The issue of course is new patient acquisition, and as I was describing before, I think initially [ph] a lot of the Vytorin loss of volume will go to simvastatin because of the pressure of managed care and then subsequently I think when cholesterol levels are measured they will have to go back to Lipitor to get to go. So I think that covers the part of it."
},
{
"speaker": "Jeffrey Kindler",
"text": "So, Ian, I think part of Seamus' question had to do with the overall statin market growth. You want to talk about that?"
},
{
"speaker": "Ian Read",
"text": "Well, the market growth is, I think in January we talked about market growth as mid-single to high-single digits. We're now seeing it at mid-single, perhaps slightly lower, and we'll see what happens post-ENHANCE and what happens in the statin market. It is difficult to predict it right now what the growth will be."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay, thank you. Thanks, Ian. Frank, do you want to talk about the seasonality and inventory question."
},
{
"speaker": "Frank D'Amelio",
"text": "Yes, I mean, in terms of weeks on hand, the way that we look at this is really on a year-over-year basis. If you look at the weeks on hand, that's in our wholesalers now. From Q1 of '07 to Q1 of '08, the weeks on hands are essentially flat. There was no change from one quarter to the next, so constant year-over-year."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Thank you. Next question, please."
},
{
"speaker": "Operator",
"text": "A follow-up question coming from Roopesh Patel of UBS. Please proceed, sir."
},
{
"speaker": "Roopesh Patel",
"text": "Yes, thank you. What was the impact of price on overall revenue growth? If you could give us a rough sense, that would be very helpful. And then, in terms of the $1.5 billion to $2 billion in overall targeted cost cuts this year, can you clarify what those numbers would be in today's dollars, in other words, at current exchange rates? Thanks."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Frank?"
},
{
"speaker": "Frank D'Amelio",
"text": "Yes, so in terms of… the first part of the question."
},
{
"speaker": "Jeffrey Kindler",
"text": "Price impact on revenues."
},
{
"speaker": "Frank D'Amelio",
"text": "So on price, it was favorable for the quarter to the tune of 2%. In fact, the way the quarter worked overall, price helped, volume hurt and FX helped, and the [inaudible] that were essentially 2% on price to answer your question specific. In terms of the $1.5 billion to $2 billion, the way I think about that is kind of in almost '06 dollar terms, because what we were really doing is looking at that based on constant currency that goes back to 2006 where we were deriving the $1.5 billion to $2 billion. We obviously achieved some of that through last year through 2007. We are working to achieve the rest of that through this year. We reaffirm that number and it is based on those constant currency rates as of 2006."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Thank you. Next question, please."
},
{
"speaker": "Operator",
"text": "And this question comes from Mr. Mike Krensavage of Raymond James. Please proceed with your question, sir."
},
{
"speaker": "Michael Krensavage",
"text": "Good morning. I want to know how much of a tail Lipitor might have after it goes generic in the U.S.? If you look at Merck's Zocor, for example, it’s still annualizing at more than $800 million, but mostly with the international sale. So would Lipitor have a similar tail? Thank you."
},
{
"speaker": "Jeffrey Kindler",
"text": "Well, let me just say, and I will turn this over to Ian for a minute… in a minute, but obviously there is a big difference between international and U.S. when it comes to that. And as I mentioned earlier… and this is one of the reasons why I think there is a lot of opportunity in our established products markets. As Dave Simmons laid out on March 5th, the world is very different in different parts of the world and there are markets in which there has been no patent protection and we are selling Lipitor in competition with a whole variety of atorvastatin products and in fact still leading those particular markets. So, in many parts of the world, particularly in the developing markets, brand remains very important because the driving force from the consumption side are the physicians and the patients. And obviously, it is quite different here in the United States where managed care is much more dominant and therefore the fall-off [ph] is much more precipitous. I certainly wouldn't want to predict exactly what sorts of sales we might have in the U.S. at that time, but if you want it, Ian can give some qualitative thoughts about it?"
},
{
"speaker": "Ian Read",
"text": "Well, I think as Jeff said, we're focused on maximizing value from Lipitor post-patent expiration. And in that sense, we're focused on ensuring that in percentage wise vis-à-vis perhaps other patent expirations like Zocor that we maintain as good or not higher percentage of that business. An important factor to look into on the size of the tail in fact will be a dynamic that’s difficult to calculate, but when Lipitor goes off patent, I think there will be... I think it's a fundamentally large expansion in the use of atorvastatin in the lipid market, which will also influence the tail of Lipitor. So I think the dynamics of Lipitor patent expiration will be very different from the dynamics of Zocor patent expiration."
},
{
"speaker": "Jeffrey Kindler",
"text": "Thanks very much, Ian. Next question, please."
},
{
"speaker": "Operator",
"text": "And our last question comes from Mr. David Risinger of Merrill Lynch. Please proceed sir."
},
{
"speaker": "David Risinger",
"text": "Yes. Thanks very much. There has been a lot of discussion about foreign exchange, but Frank, I was hoping that you could tell us what the bottom line EPS impact of FX was in the first quarter of '08 and if you can... if you could compare that to the bottom line EPS impact of FX a year ago in the first quarter of '07 and also in the fourth quarter of '07 sequentially? Thank you."
},
{
"speaker": "Frank D'Amelio",
"text": "So Dave, for this quarter it was $0.03. So… and basically, we called out in the quarter to $560 million, $570 million of revenue depending on reported versus adjusted. And then the impact on cost was 330 million. So when you do the math, you get roughly $0.03. And quite frankly, in terms of the EPS numbers for first quarter and fourth quarter of last year, I don't remember the specific number. It was a comparable number, but I just don't remember what the exact numbers were. So that's something we can obviously... we can get back to you on. But it was $0.03 for this quarter."
},
{
"speaker": "Jeffrey Kindler",
"text": "Okay. Thank you, David. And thank you everyone for listening in this morning. We appreciate your time, and that will be it for today. Have a good day."
}
] | null | null |
PG | 4 | 2,007 | 2007-08-03 08:30:00 | TRANSCRIPT SPONSOR :
Executives: Clayt Daley - CFO A.G. Lafley - CEO Jon Moeller – Treasurer
Analysts: Bill Pecoriello - Morgan Stanley Amy Chasen - Goldman Sachs Bill Schmitz - Deutsche Bank Wendy Nicholson - Citigroup Investment Research Nik Modi - UBS John Faucher - JP Morgan Chris Ferrara - Merrill Lynch Joe Altobello - CIBC World Markets Jason Gere - A.G. Edwards Lauren Lieberman - Lehman Brothers Justin Hott - Bear Stearns Ali Dibadj - Sanford Bernstein Bill Chappell - SunTrust Robinson-Humphrey Linda Bolton Weiser - Oppenheimer Alice Longley - Buckingham Research Connie Maneaty - BMO Capital Markets
Operator: Good day, everyone and welcome to Procter & Gamble's fourth quarter conference call. Today's discussion will include a number of forward-looking statements. If you will refer to P&G's most recent 10-K and 8-K reports, you will see a discussion of factors that could cause the company's actual results to differ materially from these projections. As required by Regulation G, P&G needs to make you aware that during the call the company will make a number of references to non-GAAP and other financial measures. Management believes these measures provide investors valuable information on the underlying growth trends of the business. Organic refers to reported results excluding the impacts of acquisitions and divestitures and foreign exchange where applicable. Free cash flow represents operating cash flow less capital expenditures. P&G has posted on its website, www.PG.com, a full reconciliation of non-GAAP and other financial measures. Now I would like to turn the call over to P&G's Chief Financial Officer, Clayt Daley. Please go ahead.
Clayt Daley: Thank you and good morning, everyone. A.G. Lafley, our CEO, and Jon Moeller, our new Treasurer, join me this morning, and as always we have a lot of information to cover on the year end call. I will begin with a summary of our fourth quarter results. Jon will cover business highlights by operating segment. A.G. will follow with his perspective on the year, and I will wrap up with an update on the Gillette integration and our expectations for both the new fiscal year and the September quarter. Following the call, Jon Moeller, John Chevalier and I will be available to provide additional perspective as needed. Chris Peterson will not be available today as he is with his wife who is recovering from major surgery. I know you will all join me in wishing Chris, Maureen and his family the very best for their recovery. Now on to our results. We concluded another fiscal year with sales, earnings per share and free cash flow at or ahead of our long-term targets. We delivered these strong results despite higher commodity and energy prices, a tough base period comparison and a challenging competitive environment, while at the same time managing the Gillette integration. Earnings per share for the June quarter increased 22% to $0.67 per share. EPS growth was driven by strong operating margin improvement and a lower than expected Gillette dilution. The total sales increased 8% to $19.3 billion, driven by 5% volume growth and 3 points of foreign exchange. Organic volume and sales for the quarter were each up 5% against a very strong base period, which included organic sales growth of 8%. Developing markets set the pace with double-digit organic and sales growth. Blades and Razors, Fabric and Home Care and Health Care led the segments with each delivering at or above 7% organic growth. The Snacks, Coffee and Pet Care segment delivered the lowest segment growth due to negative impact from the Pet Care recall. We expect results to improve for this segment over the next few quarters. Importantly, market share trends over the past three months continue to be strong with about 60% of our business growing share globally. Price mix was neutral as pricing actions to recover higher commodity costs were offset by negative mix from strong developing market growth. Next, earnings and margin performance. Operating income increased 15% to $3.4 billion, driven by sales growth and operating margin expansion. Operating margin was up 110 basis points, driven by better gross margins and lower SG&A costs. Gross margin was up 70 basis points to 50.8%. Volume leverage and cost-savings projects more than offset the impact of higher commodity costs. Higher commodity and energy costs hurt gross margins by about 40 basis points. Selling, general and administrative expenses were down 40 basis points. This was driven primarily by lower overhead costs as a percent of sales and Gillette cost synergies. The tax rate for the fiscal year came in at 29.7%, down 30 basis points versus year ago and in line with previous guidance due to strong growth in developing markets. Gillette dilution for the fiscal year came in at $0.10 to $0.12. This was better than expected due to the faster than planned realization of cost synergies. One-time items related to Gillette were $0.07 per share, in line with previous guidance. Advertising spending for the fiscal year increased double digits in line with sales growth. The company reinvested marketing productivity savings behind its leading brands and innovation programs. Now let's turn to cash performance. Operating cash flow in the quarter was $3.6 billion, up $400 million from the same period last year. The improvement was largely due to earnings growth. Working capital was a net cash help in the quarter due to a reduction in both receivable and inventory days and an increase in payable days. Capital spending was $950 million in the quarter. For the fiscal year, capital spending as a percent of sales was 3.9%, just below our 4% target. Free cash flow for the quarter was $2.6 billion. Free cash flow productivity came in at 116%, bringing the fiscal year cash flow productivity to 101%, well ahead of our 90% target. We repurchased 1.5 billion of P&G stock during the June quarter as part of our ongoing discretionary share repurchases. This brings the fiscal year repurchase total to 5.6 billion combined with 4.2 billion in dividends. P&G distributed 9.8 billion to shareholders in fiscal 2007 or 95% of earnings. To summarize, P&G continues to derive balanced top and bottom line growth despite the challenging costs and competitive environment. We are converting earnings to free cash flow ahead of target, and we are now ahead of plan on Gillette. Now I will turn it over to Jon for a discussion of business unit results by segment.
Jon Moeller: Thanks, Clayt. Starting with our Beauty business, sales grew 8%, led by double-digit growth in Feminine Care and Prestige Fragrances, and high single-digit growth in retail Hair Care. Skin Care shipments were also up high single-digits as double-digit growth on the Olay brand was partially offset by depressed sales for SK-II. Similar to last quarter, the continued impact of the SK-II disruption in China was roughly a 1 point drag on Beauty sales growth. Strong Feminine Care results were driven by continued share growth in the US and midteens sales growth of the Always brand in developing markets. In the US, Always and Tampax continued to gain share. US Always value share was up 3 points to 56%, and Tampax added 2 points to over 51% of the market. The Fragrance business delivered very strong results behind recent innovation on Dolce & Gabbana, Lacoste and Escada. Retail Hair Care sales growth was led by the Pantene and Head & Shoulders brands. Pantene saw strong customer support for the base brand restage that launched in mid-June in North America, and we are already seeing positive market share response now that the full marketing program has started. Head & Shoulders' strong results were driven by over 20% growth in the Greater China and Central and Eastern Europe, Middle East and Africa regions. In Skin Care, Olay delivered double-digit growth globally behind low teens growth in North America and high teens growth in China. Growth in both regions was due to the successful launch of Olay Definity and continued growth of the Regenerist franchise. Health Care sales were up 11%, led by high-teens growth in Oral Care. Sales were also strong in the OTC and pharmaceutical categories with each delivering high single digit sales growth. Global Oral Care sales were driven by strong growth of both the Crest and Oral-B brands. In the US Toothpaste Business, Crest extended its brand leadership position. All-outlet value share was up 2 points to over 38% behind the success of the Pro-Health line. In China, where Crest is also the leading toothpaste brand, value share was up more than a point. Oral-B sales were driven by the growth of the Pulsar, Vitality and Triumph innovations and distribution increases in developing markets. Rapid demand increase for manual brushes has outstripped our supply capability, which has resulted in modest share losses in a few markets. We are adding capacity to meet the higher demand, and we expect to be shipping at unconstrained levels in the fall. In Personal Health Care, the addition of the new joint venture with Inverness Medical, called Swiss Precision Diagnostics, was the primary driver of sales growth. In Pharma, pricing, favorable geographic mix on Actonel, and the growth of Enablex drove higher sales. Next, Fabric and Home Care continued to deliver very strong results with sales growth of 10%. Growth was again broad-based with all regions increasing shipment volume and sales for the segment. Fabric Care sales increased double-digits behind growth across the brand portfolio. Tide, Ariel, Gain and Downy each delivered 8% or better global volume growth of the quarter. The North American laundry compaction conversion continues to proceed as planned with the first conversion wave scheduled to begin in September. Home Care grew high single-digits behind recent Swiffer Wet Jet and Duster upgrades, the continued growth of Febreze Air Care products and the expansion of Fairy auto-dishwashing in Western Europe. Baby and Family Care sales grew 5%. Baby Care achieved high single-digit growth, and Family Care increased low single-digits. Pampers shipments were up high single-digits in North America behind the continued success of the Baby-Dry Caterpillar Flex initiative and the new Baby Stages Wipes launch. Pampers shipments to developing markets were also very strong with China, Russia and Turkey each up more than 20%. In Family Care, Bounty sales increased behind the recent absorbency and softness initiative and continued growth of Bounty Basic. The rapid growth of Bounty Basic and Charmin Basic, combined with the continued market shift toward larger-sized packs, has driven some negative sales mix for the quarter. Sales for the Snacks, Coffee and Pet Care segment were up 2% for the quarter. Coffee sales were up double-digits, driven by price increases earlier in the fiscal year to recover higher commodity costs, market share growth and a soft base period. Folgers US all-outlet value share increased about a point to 32%, more than double the share of the next competitor. Pet Care sales were down as the business continues to recover from the negative effects of the wet pet food recall last quarter. Iams US all-outlet value share is down roughly 2 points to 11%. We have increased marketing investments in the pet business to build consumer trial of our Healthy Naturals dry dog food and Digestive Care dry cat food initiatives which launched in June. Blades and Razors delivered 18% sales growth for the quarter. Strong shipment volume and product mix, driven by Fusion and Venus Breeze, were the key contributors to sales growth. Sales growth also benefited from the soft base period in North America following the Fusion launch in the March quarter of 2006. Fusion's share of male systems Blades and Razors in the US is up about 10 points versus prior year to over 32% as new users continue to trade up to the best performing system in the market. Importantly, Fusion and Mach 3's combined share of US male systems Blades and Razors also continues to grow. The two brands now account for 76% of market value, up nearly 3 points from last year. Fusion and Mach 3 combined male systems blade share in key international markets is also up significantly. In the UK combined share is up nearly 7 points to over 81%. In Japan, Fusion and Mach 3 are up nearly 6 points. Germany, France, Spain, Italy and Australia are all up 4 to 5 points. In female razors Venus Breeze is driving significant trial. All-outlet value share for Venus razors in the US is up more than 8 points to 27% for the quarter. We will be continuing to invest behind Venus Breeze and a strong disposables initiative pipeline next fiscal year. Duracell and Braun reported sales grew 4% for the quarter. Duracell posted high single-digit sales growth behind strong shipments in China and Latin America. These gains were partially offset by soft results in North America and in Western Europe. Braun sales were down slightly versus the prior year, good results from the brand's recent Pulsonic, 360 Complete and Contour initiatives were offset by intense competitive activity in Europe and soft results on household appliances. Sales were also impacted by the divestiture of the blood pressure and thermometer businesses earlier in the fiscal year. That concludes the business segment review, and now I will hand the call to A.G..
A.G. Lafley: Thanks, Jon. Fiscal 2007 was another very good year for P&G. 5% reported organic sales growth; actually it rounded down to 5% due to the product recall impact from SK-II and pet food; 15% earnings per share growth; strong gross margin expansion, up 60 basis points; and strong operating margin expansion up 80 basis points. Cash performance also excellent. $10.5 billion of free cash flow and 101% of earnings converted to free cash. This cash, of course, is critical, because it funds dividend payments to shareholders, and as you know, we have increased dividends every year for the past 51 years at a compound average rate of 10%. This cash also funds share repurchases, and as you saw in the press release and Clayt will talk further, we are going to substantially increase share buyback in the year ahead. At the end of the fiscal year, I like to step back and look at where we have been strategically and where we are going. There is no doubt in my mind that P&G has a more robust business strategy and business model, a stronger portfolio of businesses and brands, stronger core capabilities and strengths and a stronger leadership team and overall organization in 2007 than it has at anytime in the 30 years I have been with the company. In the decade of the '90s, just three businesses accounted for 80% of the value creation of the company. Five businesses accounted for 80% of sales growth, and four accounted for 80% of profit growth. In the first two-thirds of this decade, P&G has 13 very strong businesses that account for more than 80% of enterprise value created in the decade so far. Using our operating TSR model, we have already created 2.5 times as much value for shareholders this decade as we created in the entire decade of the '90s. Organic sales growth in this decade has averaged 6% versus just 4% in the second half of the '90s. In 2000 our focus was on growing the $10 billion brand that accounted for about 50% of net sales and slightly more than that of profits. Between 2000 and 2007, we extended this focus on big leading brands from 50% of company sales and profits to brands accounting for now 80% of sales and 90% of profits. In the year just completed, P&G's 18 heritage billion-dollar brands grew organic sales 6% and profits double-digits. Including Gillette's five heritage billion-dollar brands, our 23 biggest brands grew organic sales 5% and profits double-digits. The 18 next generation billion-dollar brands, those brands with $0.5 billion to $1 billion in annual sales, built organic sales 8% and profits in the high-teens. So combined, these 41 big -- and for the most part, category-leading brands -- account for over 80% of P&G sales and nearly 90% of profit. They are growing organic sales at a rate of 6% and profits 15%, well ahead of the growth of our small brands and at or above long-term company targets. The point is simply this. Where we are focusing strategically and operationally on leading brands with leading market shares driven by leading innovation and widening the market share advantage versus competition, things are going very well. It is instructive to look at market shares over the longer-term. This past year we built significant share in Western Europe and Central and Eastern Europe, Middle East and Africa and in China. We held on to leading shares in North America, Southeast Asia and Latin America. What is interesting is to see what has happened to critical growth category and leading brand shares over the longer term. We have significantly widened our share advantage in Fabric Care. In the early '90s, we were the #2 global player. Today P&G has a 34 share, nearly double the next competitor, and we have grown share for seven consecutive years. In Hair Care we achieved global share leadership in 2003 and have maintained our margin of leadership despite intense competitive activity and trade spending. More importantly, we are well-positioned to continue to strengthen our Hair Care position, not only in shampoos where we have been historically strong, but also in conditioners and treatments, styling and yes, even colorings. Our focus on leading Nice 'n Easy brand this last year has paid off with a 2 share point gain. Nice 'n Easy is now the leading home care color brand in the US, and we have a significant new innovation, Perfect 10, in the pipeline. We just announced its launch to retail partners, and Perfect 10 will be on shelves early next calendar year. We are now the leading Oral Care and dentifrice brand and company in the US and within reach of oral care category leadership worldwide. We have dramatically strengthened our position in retail Skin Care. Olay is now the number one Skin Care brand in the world, and P&G has been one of the fastest-growing Skin Care companies over the past five years. We're now surprisingly the number one Fine Fragrance company in the world, with nearly $2.5 billion in sales. We're growing faster than key competitors and generating much stronger returns. We're the global leader in Fem Care with a 37 share. Last year we added a full share point to our global position and more than 2 share points in the US. I think it is important to understand what we have delivered and how we have delivered: with deep consumer understanding, creating and building stronger brands, brands that are built to last, leading innovation year-end and year out, partnering with customers and suppliers, and leveraging our global scale and scope advantages. It is important to understand this history and this track record so you also understand why I am so confident about what we will deliver in the future. I am confident because there is still significant upside for P&G. We have plenty of room to keep growing in each of our strategic growth focus areas. We have a lot of opportunity to keep growing P&G's $23 billion brands. We are proving in category after category that a leading share, even a relatively high share, is not a barrier to growth. We have over a 70 global share in Blades and Razors, but we see plenty of opportunities to grow. We have over 34% global share in Fabric Care, and our innovation leadership is helping us grow share broadly in that business. We have over 36% share of the global diaper market, but we have just started our first big push into India, the country with the largest number of diapering aged babies in the world, and as Jon reported, we're growing strongly in developing markets. There's even greater upside in our Beauty, Health and Personal Care businesses. The Beauty and Health Care categories in which P&G competes are a combined $370 billion market today and are projected to grow 3% to 4% a year for the balance of the decade. We have doubled our share of Beauty and Health over the past decade, and yet we still have only about a 10 share globally. The upside potential in developing markets is also enormous for P&G. We have significant opportunities to increase household penetration, consumer usage frequency and to enter categories where we're not yet present. Countries like China and Russia, the average household today buys about five P&G products per year. The average American households by comparison buys over 20 P&G products a year. Closing this gap, which I'm sure we will do over time, will continue to drive strong growth for years to come. I'm confident in our ability to keep growing P&G's organic sales at least 4% to 6% a year. I'm equally confident in our ability to convert this top line growth to double-digit earnings per share growth, primarily because of the margin expansion opportunities we see across the business. Our sustainable growth model calls for us to deliver 50 to 75 basis points of margin expansion per year, in addition to Gillette synergies. We expect this to come from both gross margin improvement and lower overhead costs as a percent of sales. On gross margin, we have a strong track record of improvement. Over the last ten years, P&G's gross margin has grown 930 basis points or more than 90 basis points per year. To improve gross margin going forward, we're going to keep doing the things that drove our progress over the last ten years, generating volume leverage on our fixed cost base, shifting the portfolio to higher gross margin businesses and driving cost savings projects, including better leveraging P&G purchasing scale, increasing our manufacturing base in lower-cost locations and consolidating distribution centers. To improve SG&A costs, we're driving productivity and overhead costs. Since the beginning of this decade, we have reduced overheads of more than 350 basis points, an average of about 50 basis points per year despite the negative impact from the Wella end Gillette acquisitions. If we just hold overhead growth to half the rate of sales growth, we pick up 25 to 50 basis points of margin improvement per year. As we look across the business, we see a number of opportunities, including simplifying our GBU/MDO structure, optimizing how we manage small countries and improving the productivity on our smaller brands. One thing you can expect us to do in the year ahead is to increase our investment in ongoing restructuring. Driving efficiency gains and cost savings in both gross and operating margins sometimes requires restructuring spending. We have an internal budget to fund these investments without the need for big disruptive restructuring programs and separate charges against earnings. Fiscal 2008 will be an investment year to increase productivity and help ensure we sustain growth through the end of this decade and well beyond. So what I want you to take away today is that P&G is well positioned to continue to lead this industry over the long term. We have the right strategies with plenty of room to keep growing. We have a strong portfolio of businesses and brands that represents an attractive mix of categories, leading brands and geographies, and it will get stronger. And we have the right core strengths to keep P&G growing reliably year after year, regardless of the competitive or economic challenges we may face. I'm looking forward to meeting or exceeding the company's growth targets through the end of this decade and beyond. Now I will turn the call back to Clayt.
Clayt Daley: Thanks, A.G.. First, an update on Gillette. The integration continues to progress very well thanks to the excellent work by all the Gillette integration sub teams around the world. Although there is still work to be done, fiscal 2007 was the most significant year in terms of integration workload. Let me highlight a few areas. During fiscal 2007 we completed our business systems integration. Specifically we integrated systems, sales forces and distribution networks. We managed these conversions without any significant business interruptions. We are now selling, taking orders, shipping products, receiving payments and operating our back office as a single company in 99% of the business. The distribution center consolidation project is now well underway. As of June 30, we have reduced our number of distribution centers by about 25%, and we are on track to get to our 50% target by the end of fiscal 2009. We also made significant progress on staffing efficiencies during fiscal 2007. We have eliminated about 5,000 positions as of June 30 and are now working toward the top end of the 5,000 to 6,000 target range. Most important, dilution for the year came in at $0.10 to $0.12, well below our original $0.12 to $0.18 estimate. The improvement was largely due to better than expected earnings from the Gillette base business and faster than expected delivery of synergies. We previously announced the integration of the Gillette GBU into P&G effective July 1. From a segment reporting basis, we will move from seven to six segments. Details of the new reporting structure were highlighted in the press release this morning. In summary, we remain on track with both the integration and the acquisition economics. We continue to expect cost synergies to be at the top end of the $1 billion to $1.2 billion target range, and revenue synergies to be $750 million next fiscal year, and we remain on track for Gillette to be neutral to EPS for fiscal 2007/2008. Now there are three topics I want to discuss in broad terms before getting into the guidance details. They are first share repurchase; second, the business portfolio; and third, ongoing restructuring. First, on share repurchase. This morning we announced a $24 billion to $30 billion share repurchase plan over three years. At the current price, this represents about 12% to 15% of our market cap. We plan to buy the shares back over the next three fiscal years at a rate of $8 billion to $10 billion per year. This represents a significant increase to the $5.6 billion we repurchased in 2007 and our previous target range of $6 billion to $7 billion for fiscal 2008. We are increasing our share repurchases due to the attractiveness of interest rates, the current P&G stock price and most importantly, our continued confidence in the long-term growth prospects for this company. Our intent is to maximize share repurchase within our current credit ratings. So whether we actually purchase $8 billion or $10 billion in any year will be a function of our actual cash performance. Our current AA credit rating reflects a combination of single A financial ratios and AAA qualities. We have discussed these plans with the rating agencies, and they have confirmed our AA credit ratings this morning. We expect the increase in share repurchase to be about $0.01 accretive to EPS in fiscal 2008. We expect the combination of share repurchase and dividends to result in well over 100% of free cash flow being returned to shareholders in each of the next three years. Next, I want to provide some perspective on our portfolio plans. As A.G. mentioned, we regularly review our portfolio of businesses to determine how to best maximize shareholder value. This process includes a thorough portfolio review with the Board of Directors in June and a series of business strategy reviews in the months of August and September. If this process reveals a situation where value is maximized by P&G exiting a business, we will take action as we have done in the past. Over the past few years, we have exited the juice business, the peanut butter business, the shortening and oil business and most recently, the tissue/towel business in Western Europe. Looking forward, over the next couple of years, we expect P&G to be more likely to be a seller of businesses than a net buyer, and we are not actively looking for large acquisitions. Of course, this philosophy is reflected in our decision to increase share repurchases. Finally, let me discuss our ongoing restructuring plans. We are doubling our internal restructuring budget to $300 million to $400 million after-tax, up from $150 million to $200 million. This increase reflects the fact that we have identified a number of efficiency and effectiveness improvement projects for the near term, and it reflects the fact that the size of the company has essentially doubled since we established the original range. For fiscal 2008, we expect our internal restructuring spending to be toward the top end of the new $300 million to $400 million range. This represents a significant increase in our restructuring activities following the Gillette integration. Now let's get to the guidance details. For fiscal year 2008, the priority for the company is to sustain strong organic sales growth. As such, we plan to invest in our leading brand equities. We plan to launch a strong innovation pipeline, and we plan to make significant progress on go to market reinvention. We again expect to deliver our annual double-digit EPS growth commitments, excluding the positive one-year impact of the Gillette dilution. Consistent with our plans since we announced the deal, we expect Gillette to be neutral to EPS in fiscal 2008. In addition to the share repurchase increase and higher restructuring investments, there are several other factors that will affect earnings per share in fiscal 2008. First, we expect to continue to be in a tough competitive environment as many of our competitors are continuing to spend savings from restructuring programs on increased price discounting, trade promotions and marketing spending. Where necessary, we will increase spending to defend our business. Second, we plan to convert our North American liquid laundry detergent business to a 2X concentrated formula over the course of the next fiscal year. We expect this to be a win for consumers, retailers, the environment and P&G. However, there are a number of one-time costs that we will incur during the transition. These include the costs of new molds, manufacturing changeover costs, retail conversion costs and higher marketing support. As such, we expect next fiscal year to be a net investment year for this initiative. The biggest impact will likely be in the July/September quarter and, of course, in the Fabric and Home Care segment. Third, at current levels we expect raw material and energy cost to increase again in fiscal 2008. The amount of the increase should be about in line with the impact we saw in fiscal 2007 in the range of 60 to 75 basis points. This is roughly double the impact we expected when we gave our initial outlook on fiscal 2008. Even with higher input costs and the laundry compaction investments, we still expect gross margins to improve, mainly due to the benefits of cost savings projects and volume leverage. Fourth, our shareholders will need to expect greater quarter-to-quarter earnings volatility in fiscal 2008. This is mainly due to the timing of investments in the laundry compact initiative, internal restructuring of cost projects, and the timing of initiatives and marketing investments in the grooming business. Of course, our quarterly guidance numbers will include our best estimate for these impacts. Now to the numbers. For fiscal 2008 we expect organic sales growth of 4% to 6%, in line with our long-term target range. With this, we expect the combination of pricing and mix to be flat to up 1%. Foreign exchange should have a positive impact of 1% to 2%. Acquisitions and divestitures are expected to have a zero to 1% negative impact on our top line results. In total, we expect all-in sales growth of 5% to 7% for the year. Turning to the bottom line, we expect earnings per share to be in the range of $3.44 to $3.47, up 13% to 14% versus the prior year. We expect operating margins to improve by 70 to 100 basis points, driven by both gross margin improvement and lower overhead costs as a percent of sales. We expect the tax rate to be at or slightly above 29%. Now some of you may ask why the benefits from increased share repurchase and lower tax rate are not showing up as increased EPS guidance? The answer is really very simple. The benefits from these items are being offset by higher commodity costs and higher restructuring investments compared to what we anticipated back on May 1 on our last earnings call. We will deliver double-digit core earnings per share growth despite higher restructuring costs, and we want to maintain the flexibility to take advantage of opportunities to leverage our innovation programs and respond to competitive threats as they occur. Turning to the September quarter, organic sales are expected to grow in the 4% to 6% range. With this, we expect a combination of pricing and mix to be neutral to up 1%. Foreign exchange should add 2% to 3% to sales. Acquisitions and divestitures are expected to have a zero to 1% negative impact on P&G's top line, and therefore in total we expect all-in sales growth of 6% to 8%. Turning to the bottom line, we expect operating margins to improve modestly as SG&A improvement will largely be offset by lower gross margins. Gross margins are expected to temporarily be lower due to the higher commodity and energy costs and the investments needed behind the North America laundry compaction initiative. In that, we expect earnings per share to be in the range of $0.88 to $0.90 for the quarter, up 11% to 14%. In closing, P&G continues to deliver balanced top and bottom line growth at or above our long-term targets. We are converting earnings to free cash flow ahead of target, and we will begin returning more than 100% of this cash to shareholders through share repurchase and dividends. We are ahead of plan on the Gillette integration, and confident in our sustainable growth model going forward. Now, A.J., Jon and I would be happy to open up the call and take your questions. There is just one comment I want to make before we open it up for questions, just to remind you, that this will be the last quarter that we will be giving a mid-quarter guidance update, and we expect that to come out in early to mid-September. With that, we would be happy to take your questions.
Operator: (Operator Instructions) Your first question comes from Bill Pecoriello - Morgan Stanley.
Bill Pecoriello - Morgan Stanley: Good morning, everybody. Can you tell us how fast the developing markets grew in the fourth quarter, and do you think you can accelerate that growth rate in ’08, assuming macros don’t deteriorate through filling in some of the brand white space? I know A.G. mentioned some of this in the prepared comments as a goal over the longer term. Thanks.
Clayt Daley: We said they grew double-digits actually it was around low teens. As I think we have said before, Bill, the developing markets have done really very well on organic sales growth during the Gillette integration. But now that the Gillette integration is largely behind us, we are obviously going to be targeting on trying to move the developing market growth rates up. We have specific plans on both the base business and as you suggest, in some geographies expanding our portfolio of businesses over time.
Jon Moeller: Bill, our fastest-growing developing markets by far have been in CEEMEA, Central and Eastern Europe, Middle East and Africa. We have pretty comfortably maintained 15% to 20% growth rates there. We have gotten Latin America to double-digit in the last quarter, and we have really sort of doubled the growth rate from Latin America which has been good. While we have done well in Asia, especially in China, we think Asia has got a lot of opportunity and we just reorganized. We put our Asia market development operations together. We've put them all under Deb Henretta, and we are focused, prepared and ready to accelerate the growth rate in that fast-growing part of the world.
Operator: Your next question comes from Amy Chasen - Goldman Sachs.
Amy Chasen - Goldman Sachs: I was hoping that you can quantify the laundry compaction? You did that with the increased restructuring, and it was very helpful. What I mean is the charges obviously, the costs associated with that and the timing of it throughout the year in terms of quarters.
Clayt Daley: Well, the quarter impact, mostly the heavy lifting is in the first quarter. So the impact is greatest in the first quarter. And then, of course, in the second quarter, we are also going to see a significant impact because that is the first wave of rollout, and that is the time during while the factories are preparing for the final two waves that occur in the second half of the fiscal year. So the impact will be mostly in the first half. We have not quantified it. It is going to be broadly, a few cents a share.
Jon Moeller: Amy, the way to think about it, it is three big waves. Most of the incremental charges come in the first half as Clayt said. I'm going to tell you, we are going to stay agile and flexible in terms of the investment we make. Because if we get a fast conversion, if we can drive the kind of awareness and trial rates we would like to drive quickly, we're going to keep investing. I mean one of our major competitors has just basically said they are withdrawing from the market, and this is an opportunity for us to get significant trial among consumers with a product line that is better, with a range of innovation and innovative products across most of our laundry brands and frankly, with a proposition that is a win-win-win for consumers for customers for the supply chain and for us. Because it is a big win from a product performance, quality and value standpoint. It is a big win from an environment and sustainability standpoint, and we're getting a lot of support on that basis, and it is a big win from a convenience and full supply chain standpoint, because basically half of the volume in queue goes through the system to deliver the same amount of business. So this one is big, and we're going to stay flexible on what we invest.
Operator: Your next question comes from Bill Schmitz - Deutsche Bank.
Bill Schmitz - Deutsche Bank: Can you just talk about what North America or specifically US growth was in the quarter? And then just some broad sort of strategic thoughts on the health of the US consumer?
A.G. Lafley: Yes, our growth was mostly for the quarter it was 4%. We are in mid singles. So 4% to 5% on organic volume and sales. I'm actually very proud of our North American operation and our North America business because there was clearly some market softness and some pressure on consumers and some pressure on our retailers in the April/June period, and they turned in a good quarter. Our market share position is still pretty doggone good. We're up 60% to 70% of our business. The shares are up. The other thing about North America is despite our market share position, which in aggregate across all the businesses is north of 30%, we still have a lot of upside trial opportunity. The business units have just went through this over the last 100 days or so, and we are very focused across a number of brands and categories on lifting our trial rates. I will not go into all the details, but we have major new product initiatives and major new brands that we launched in the last two, three, four, five, six, seven years that still have relatively low trial rates, and we think we can generate $1 billion or more in incremental business if we hit the target trial rate. So I like the North America business. You have got to remember most of our categories and brands are weekly purchase, daily consumption. We're not in a lot of discretionary categories which will be impacted if there is any drawdown. So I think we are in pretty good shape. And I guess the last thing I would say, and I think you know this, our industry and our company generally performs well in slow downtimes and even in recessions. So I like our prospects in North America. I like our position. It is a market that responds to innovation. We're really strong with consumers and customers in this market.
Operator: Your next question comes from Wendy Nicolson - Citigroup Investment Research.
Wendy Nicolson - Citigroup Investment Research: My question goes back to what A.G. was talking about when you talked about the strength of I think the 18 core brands and how they grew 6% for the year, and then when you added the Gillette brands, they only grew 5%. I guess it just surprises me. I understand in the first year, there was a lot of inventory destocking and that kind of thing. But going back to whatever when you announced the deal, I think the idea was that that acquisition was supposed to accelerate the company's growth rate, and it just amazes me that those brands continue to under perform relative to the core P&G business, despite all the incremental distribution they have had. So can you kind of talk about what is up with that and specifically what is going on with Duracell?
A.G. Lafley: Sure. It is really simple. We have done real well on Gillette Blades and Razors, driven primarily by Fusion and more recently by Venus, and as you mentioned, the distribution gains. We have done real well, we in fact ran ourselves out of capacity in Oral Care. We would have and could have done better in Oral Care, and we are fixing that. By this fall, we will have all the toothbrushes of all kinds needed to cover the business. That is in a funny way, a pleasant surprise. I think we have been very clear about our Duracell and Braun strategies. On Braun we consciously have focused on margin and we have focused on restructuring. And we stepped out and took a major piece of restructuring action in Western Europe to shut down a major manufacturing site. We have been very selective about where we will go for volume and sales. We're only going for profitable margin, accretive volume and sales, and that whole program is on fix the cost structure and get the margins right and make it a really investment-grade business. The leadership team is on that course. In batteries it has been a couple of things. Again, we have focused on profit, profitability and cash, and frankly the competition grabbed some of the short-term space and merchandising in what is a pretty tactical and executional game. I think you will see us get more than our fair share of it in the months ahead, and that will be a little bit of a tit for tat. The other big thing, which is not clear in the numbers, is as we grow Fusion we cannibalize Mach 3. Mach 3 is one of our top five Gillette brands, and sales were down over 10% on Mach 3. So that is what is really throwing off the Gillette five brand impact. But as we reported, if you put Fusion and Mach 3 together, it has been fantastic, and we're driving sort of mid 70 to 80 plus shares there. So I am really not concerned about it. I think we're growing where we should be growing in the Gillette portfolio. We're getting our cost structure and our innovation programs right in a couple of other places. I do not see a business that cannot grow in the Gillette portfolio at the 4% to 6%, at least top line organic rate.
Operator: Your next question comes from Nik Modi - UBS.
Nik Modi - UBS: A.G., Just a quick question. When you take a look back at the last two years and you think about the organic sales growth, and granted obviously it's within the top end of your target. but could you just kind of reflect and help us understand if you think the business was perhaps maybe distracted somewhat with the Gillette integration? Focusing more on that rather than maybe perhaps some in store stuff which is so critical to your business. Just to get the feel that now with the Gillette integration fully complete, maybe the focus can go back more to growth and white space expansion as you suggested earlier?
A.G. Lafley: Yes, I'm going to take a couple of minutes on this one because it is a great question, and it is one that we think about a lot. If you step back and look at the Gillette acquisition, it was the biggest ever in our industry by a fairly wide margin. I think at the time we made the acquisition, it was one of the top 10 biggest acquisitions ever. It is probably in the top 15 now. But it was a major piece of work. There was absolutely no doubt about it. When we got into it, after we got through the first six months or so, the team -- and that was when Jim was still on the team and with Clayt leading the integration -- but the whole team, the Gillette team and the P&G team, made I think a critical decision, and the critical decision we made was to accelerate. So if you think about what we have done, we accelerated the organization integration by a full year. We accelerated everywhere we could the operational integration, which Clayt talked about in some detail, which is virtually done. In the short-term, that increased the organization's workload significantly. So I don't think we made any conscious trade-offs versus the established businesses, but we definitely increased the workload on an organization that has got a pretty strong work ethic to begin with. I think it is important to understand that. So where does that show up? That shows up in some of the little glitches like the Tennessee distribution center, which nicked us back in the second quarter. It shows up in maybe we did not win in a couple of cases, there is no doubt that competitors came in and in the very short run captured more space in the trade at a given account in a given channel. It would be harder for them to do it. Now it is interesting, when you look at those very short-term tactical skirmishes that go on all the time in our industry -- and this is a very important point -- what I always look at is does the volume and sales growth translate into sustainable share growth that improves your margin, cash and return? That is the real question. The answer is, some of it does and some of it does not. I will give you a couple of examples. In coffee we lost the trade featuring and merchandising war in a fairly significant period. There are two big periods for coffee. There is a Thanksgiving and Christmas period; there is the Easter period. Our major competitor won, but our share went up. Theirs went down So even though we did not win the tactical short-term battles, the combined impact of our brand, our innovation and our program resulted in share growth. We have continually widened the share gap. I think it is quite clear in Oral Care. The pricing has widened a bit between our brand and brands and our principal competitor. They have probably won a few more of the tactical short-term wars, but our market share has continued to grow because I think we have had a strong innovation programs. We have had a strong consumer-oriented marketing program. Batteries, as I talked about with Wendy, has gone the other way. It is a little more impulse driven. It is a little more space driven. It is a little more display driven. And the fact of the matter is you have got to hold onto your share territory in the store in batteries, and we are now organized, focused and prepared to do it. But I think that is the key question. Now so what does that mean going forward? I think what it means going forward is we now have virtually all of the P&G resources focused on what are now all organic businesses. Because the Gillette businesses are now residing in P&G where they belong, where they can generate the most synergies, get the most resources. The second thing I would say is we have a very good innovation pipeline. The third thing I would say, and I won't belabor this, but we have got a lot of upside trial potential. The fourth thing, as Clayt said, and it was maybe a little subtle, so I will try to make it clearer; Clayt is not usually subtle. But one of the reasons why we're going to be agile and flexible, and frankly we're going to have a war chest for this next year, and the war chest is going to be to invest in opportunities that we have in the innovation program and market expansion, especially in the developing world. We're going to come out of this next year leaner, faster, more agile and stronger. But the key issue is, how much of that volume and sales converts to sustainable market share growth? That is why I wanted to talk about the sustainability of our market share growth. We are still, despite a 5% organic net sales growth rate, we are still growing share on 60% to 65% of our business worldwide, and that is pretty doggone good.
Operator: Your next question comes from John Faucher – JP Morgan.
John Faucher – JP Morgan: A.G, Are you sure that Clayt is not subtle? I seem to remember that going the other direction there. A quick question for you. I think you guys made some divestitures on the Beauty business. So can you talk to us a little bit about how you see maybe some changes in that portfolio? I know you feel like the overall business is doing well, but you are sort of hung up by a couple of categories where you are struggling a little bit. So can you give us how we should look at that portfolio over time?
A.G. Lafley: Yes, John, we think Beauty can grow a bit faster than it has been growing. Our strategy, I think it has been fairly clear our two top priorities are Hair and Skin, and I think you see what we do year-end and year out in Hair. We are strong and getting stronger in Hair, and we have really had a nice run in Skin, and we have a lot of upside in Skin. I think Fine Fragrances has been a pleasant surprise, and I think it will continue to surprise because we have a unique business model in getting ourselves in a pretty advantaged position there. What we have been doing is trimming portfolios, especially out of the Clairol and Wella acquisitions. Without going into all the gory details, while there were some assets there are of real value, they had a lot of small, local and channel-specific brands. Our game is consolidation. Our game is a smaller portfolio. Our game is leadership brands. So we have been sort of managing the divestiture and in some cases just shutdown of these businesses in a way so that they are not a big impact on our sales growth. But we're still prepared to do it because if we clean up the portfolio, we will be able to focus on the businesses that can grow. We're pretty much done in Clairol. We have a little bit more work to do in Wella. But I think we are going to be in good shape going forward, and I really like the innovation pipeline across the Beauty Care business. You have also got to remember that this SK-II event hurt us. It did cost us a full point of net sales growth. Because of the way we have gone about building it back, which I think is very strategic and very deliberate and we will end up in a very strong sustainable position when we are all the way back, we have taken a little bit more time to rebuild it. We are now organized with one global SK-II operation run out of Singapore and all the rest of it. So I think a slightly long-winded way of saying I like our strategic position in Beauty. I like the industry because there's a lot of room to grow, and even the biggest players have small shares, 10 or under. I like our brand. I like our innovation program, and we are building a very strong Beauty organization. So I think we are going to see Beauty growth accelerate in the years ahead.
Operator: Your next question comes from Chris Ferrara - Merrill Lynch.
Chris Ferrara - Merrill Lynch: I just wanted to ask about the rationale of the size of the buyback. Was keeping the AA rating the priority when you picked the number? Because it seems like you guys might generate $24 billion in cash flow after dividends over the next few years anyway. Also as a follow-up to that, you have said you're going to be more likely to be a divester than an acquirer. Where do the proceeds go to that? Would that be incremental on top of the potential $24 billion to $30 billion in buyback?
Clayt Daley: Well, of course, as we have said before, we are already planning to put the Western European tissue proceeds in the buyback in the first year of this program. So I think the answer is you could assume that should we at some point divest businesses, it is highly likely that we would put net proceeds into even additional buybacks. The rationale for the buyback level is very much related to credit. We have been in an interesting environment for a couple of years where credit spreads have been very narrow, and I think the events of the last two weeks have pretty much dramatized the importance over the long-term of having high quality credit as we have seen spreads widen out very rapidly at various credit levels. And so you're exactly right. What we're doing is we are maxing out share repurchase within our current AA credit. But I want to emphasize again as I did my comments, we're AA credit with single A credit metrics and AAA qualitatives. So what we're really able to do is take advantage of the strength of this company, its size, its consistency of sales, earnings and cash flow growth to actually do more share repurchase than maybe some other companies could do given a certain amount of capacity. We think we're doing the right thing in terms of striking the balance between doing as much share repurchase as we can and yet doing the right thing for the company long-term relative to its credit.
A.G. Lafley: Chris, if we generate more cash, then we're going to come up to a decision about what we do with it, and one of the options is going to be more buyback.
Operator: Your next question comes from Joe Altobello - CIBC World Markets.
Joe Altobello - CIBC World Markets: Actually going back to a comment that A.G. made earlier. You talked about pressure on the North American consumer and the retailer in the June quarter. I was wondering if that got worse as the quarter progressed? Are you seeing it getting worse in the September quarter? Are you seeing any trade-down activity in some of your non-innovative sort of categories at this point?
A.G. Lafley: No, actually it has gotten better. The toughest months were April and May. We watch very carefully the sub-prime mortgage phenomenon. We watch very carefully all the information on credit cards. We watch very carefully what is going on with all of our different consumer segments. But no, I think it has gotten better for retailers, and we will just have to see what they reported. It has certainly gotten better for us. Without going into details, we have had a very fine July, and we're looking forward to a good quarter. I think on the second question, clearly in a business like tissue/towel, again as Jon said in his remarks, when consumers are buying larger packs, when Basics which is our affordable entry offering of our three offerings in the Charmin and Bounty lines is growing at the rate that it is growing at, lower-income households are feeling a bit pinched, and that is a way that people generate better value. It still works well for us because even though we're relatively low single-digits net sales growth in that business, we generate very strong operating margins, and we've generated very strong operating TSR, and it is always a balancing act. So that is probably one business where we see a little bit of pressure. We frankly have not seen the pressure in the big Fabric and Home Care businesses, like laundry and dish. We continue to grow our market shares. Consumers continue to buy middle and upper price detergents because they represent a good value, and frankly they are the only ones that perform anymore; and for them performance matters, performance is value. So, so far, so good. The point I was trying to make is, I think we're well-positioned no matter which way it goes. That is really the key. I think we're well positioned. We have broader, tiered offerings on most of our major household businesses. We are in a good consumer value position. We are leading innovation for the most part, and we have strong partnerships with our retailers, and we are building value and we are growing their sales profitably for them.
Clayt Daley: Private label shares are very flat during this period. So you're not seeing some of the things that would lead you to believe that consumers are trading down.
A.G. Lafley: Clayt makes a really good point there. I mean there are very few categories in the US in the top 20 categories that we are in where private-label is growing any share right now. So that means I think that the branded manufacturers are offering consumers pretty doggone good value equations.
Operator: Your next question comes from Jason Gere - A.G. Edwards.
Jason Gere - A.G. Edwards: Just in terms of looking at '08 versus '07 and talking about the competitive pressures that you're seeing in North America predominantly, can you talk about the split maybe between promotional spending and advertising? I think you did say advertising was up double-digit for the year. I guess in terms of looking ahead and in light of some of these competitive pressures, you do see that allocation between the two?
Clayt Daley: The businesses decide.
A.G. Lafley: Each business decides what the right mix is for its business. I mean that is certainly not a decision we would ever try to make from our vantage point. The second thing I would say is we continue to invest in what I would call brand equity building, advertising and marketing activity. So yes, advertising is a part of that, but I think we're doing more online. We're doing more public relations. We're doing more event marketing. We're doing everything we can to be where she or he is most receptive to receiving the message and most responsive to trying. On the promotional side, we're trying to shift more and more of our promotion into proven trial-generating activity because we still have a fair amount of trial opportunity. And I guess the last thing I would say, we have talked for several quarters, maybe a couple of years about this, on both the brand support side and on the trade spending side, we're working real hard to improve effectiveness and efficiencies. We're now in our third or fourth year of running marketing, ROIs and marketing mix models for the brand support side, and we're now moving into a program. Recall we moved closer to the more flexible Gillette model for managing our trade funds and trade incentives with our retail partners. As part of this, we now are looking at something, I would call it trade spending effectiveness and efficiency modeling. So I think what you will see us do is we want to spend the dollar where we get a positive consumer reaction where the consumer purchases and the consumer tries. And we're trying to make sure that we funnel our money to the consumer either through the trade or directly in a way that is most effective and most efficient. Some businesses spend 30% to 35% of net sales on brand support. Some businesses spend 5% to 10%. It just depends on the industry that they are in and what is required to be competitive in that industry.
Operator: Your next question comes from Lauren Lieberman - Lehman Brothers.
Lauren Lieberman - Lehman Brothers: First off, Clayt, thank you for all the detail on the moving parts of '08 and also the priority on the process of the portfolio review. That was very helpful. But just following up on the topic of divestitures -- and I'm not going to ask you, of course, to name any specifics -- but just curious about a couple of things. One would be the business' tolerance for dilution. Two, would be the decision criteria for the businesses versus for the board. Third would be, are there any challenges out there given there are probably more assets for sale than there might have been a few months ago with the changes in the debt market?
Clayt Daley: Well, starting out, obviously as we said we go through a process with the board and then we go thorough our strategy reviews, and our criteria is really pretty simple. That is, if a business cannot deliver sales growth at least at the low end of our target ranges, if they cannot deliver at least upper single-digit operating profit growth, if it cannot deliver a CFROI, or TSR measure several hundred basis points above the cost of capital, then it becomes a candidate to exit the portfolio. Now we never sell a business because they have a bad year. We look at this over longer timeframes, three years, five years or longer. Of course, we have to be forward-looking. We have to look at their initiative plan, the market and the industry to say, is this a place we want to be longer term? So I think the decision criteria is relatively clear. Relative to dilution, of course, it is a consideration, but it is not a controlling factor. Although obviously we are going to want to execute anything we do in a way to minimize tax friction and dilution as part of that process. Because obviously what we want to do if we choose to exit a business is we want to build value for our shareholders by exiting the business and not destroy value. So that is really the way we are thinking about it.
A.G. Lafley: Regarding the timing, Lauren, some of these assets are going to be even if they don't end up being core strategic for us, they are going to be core strategic for somebody else. There are good buyers for some of these assets.
Clayt Daley: We're really not that worried about the market because most of the assets that we would be looking at disposing of would be highly likely to go to strategic buyers, and therefore, I don't believe what is going on in the credit markets first of all, it is not at all clear that that is a long-term phenomenon. I mean the credit markets could be in a very different place six months than they are today. But still I'm not sure it is going to be a big factor on our plans.
Operator: Your next question comes from Justin Hott - Bear Stearns.
Justin Hott - Bear Stearns: Maybe we could continue with the comments on the tactical battles and wars. Could you talk to us about that maybe on US diapers, with Pampers and Luvs versus their competitors, Wella professional and pet food? A second part, if you could give us any more clarity on what you're thinking on key commodities like oil, pulp and gas that would help too.
A.G. Lafley: Well, I think I will maybe answer the last one first. We frankly had hoped that oil was going to moderate at a lower level than it is. But it has not. Now we have gotten some relief in natural gas, but the impact of natural gas is primarily a North American phenomenon, whereas, of course, oil and its derivatives are a worldwide phenomenon. As I mentioned earlier, that is one of the reasons in our mind of caution on this year because we had expected energy and raw materials to frankly moderate more this fiscal year than it looks like they are going to. Now, as we have said before, if pricing actions are appropriate, we're not going to be afraid to do that, and that is obviously something that we are going to have to review around the world in markets where we are the leader in the market. Coming back to the specific businesses, which I guess were diapers, pet and Wella Professional?
Jon Moeller: Baby is obviously a core business for us. It is a big business for us. Pampers just passed $7 billion in net sales this last year. The basic Pampers story is we have been holding our sure essentially in North America up a cent, flat, up a cent. We have been growing our sure again in Western Europe, and we're growing our share very strongly in developing markets. Our strategy on Pampers is to slowly but surely improve on our developed market position, 50 plus share in Western Europe, sort of 35 to 40 share in the US, and then to hard in developing markets. We have some interesting, affordable products for developing markets that have been doing pretty well. I think we have done well with our Baby Stages of Development line. Our key competitor came back with their comparable offering and has done reasonably well with that, and that is no surprise. We expected them to eventually come. And, as we have said, we have been doing well with this sort of Pampers entry product called Caterpillar Stretch. There is no doubt that Luvs has been a little bit weak, but we will have Stretch on Luvs. There is a segment that buys Luvs, and Luvs, frankly, provides us a little bit of cushion against private labels which are active in developed markets in that category. But I like the category. Rational competitors. It is a consumer-oriented business. It is an innovation responsive business, and it is a business where we get good retailer support. So I think it will ebb and flow. But I think what will happen is the two leading companies will continue to improve their relative positions. Pet, I mean let's face it, I think I have been very straightforward on this one. We had a very nice run from acquisitions for about five years, a very nice run. We ran to the point where we were the leading brand in the US retail market and that is good. And we have two good brands in Iams and Eukanuba. We stalled. Much of it was of our own doing. We were working on the program to get growing again, and we got hit with the China sourcing and contract manufacturer problem. unfortunately even though those wet and semi-moist products are a small, less than 10% of our product line weight, we, frankly, got hit pretty hard by it. I think we said in Jon's remarks, we have a couple of key initiatives going. We have been working with our retail partners. You're going to see a stronger Pet Care program out of it. I like the business. I like the market. Again, we have good competitors in the market. There is a place for us in the market. We are differentiated and unique, and that will end up being a good business for us. Wella is a tale of three cities. The Fragrance brands have been a nice little set of jewels. You know we integrated them faster than we thought we could into our own Fragrance business, and Gucci and Escada and those brands have been an important part of what we have accomplished in Fine Fragrances. So that has been a plus. The retail colorants business, we have been working our way up the learning curve. We now are in a position where we have totally integrated that business and in fact, we have integrated the R&D and innovation centers with the salon business. So you will see more from us in retail colorants. I talked about Perfect 10, which has already been sold into the trade. But you will see more from us on the innovation side in retail hair colorants and in styling where Wella was pretty strong. Wella is the styling leader in the salon business, and we have got some good assets there. The third piece is, of course, the salon business, and frankly, we're taking the approach to the salon business, the same approach to the salon business we are taking to Braun, which is get the cost structure right, get the thing operating well, and then when we have got an operating well and the cost structure right and the right people in place, you will see us start investing. So we have been comfortable with a slow top line growth rate. We have been working on improving the margins, and we have been working on getting into the right configuration, right organization and right program to grow going forward.
Operator: Your next question comes from Ali Dibadj - Sanford Bernstein.
Ali Dibadj - Sanford Bernstein: In the context of this 50 to 75 basis point operating margin improvement yearly on top of Gillette, if we use maybe this quarter or two quarters as a jump off point. I'm just trying to get underneath this 110 basis points this time around. How much was from Gillette synergies, purchasing savings, the DC consolidations, and in particular I would love to get a lot more detail around the advertising spend as a percentage of sales. If I could throw in something separate but linked to that, a little bit more understanding on some of the trade spend issues?
A.G. Lafley: I think I will hit a couple on a high note. You're going to be better off talking to Jon about some of the other details. But our advertising spend has been very consistent at between 10% and 11% of sales for the company aggregate average. As I said before, we have some businesses in Beauty that run 30% to 35% of net sales. We have some businesses in the more commodity-like, but of course, we don't sell commodities, categories that are closer to 7% to 10% of sales. I will tell you, we are very consumer focused. We are very brand equity focused and very innovation program focused in our spending of brand support and in our spending of trade funds. On the trade fund side, I think also if you step back, I think we're somewhere around $9 billion to $10 billion all-in on each side. So we spend about the same amount of money on both. Of course, it varies by channel, it varies by geography, it varies by category. But our objective is very simple. We want to get leverage from our leadership in the strength of our brand equities, and we would like to be in a position where we are spending a little bit less as a percent of net sales and getting a lot more. Because we buy more efficiently, and frankly we should be executing more effectively. So that is sort of where we are in the advertising and trade side. In terms of the gross margin buildup, it is the same combination of factors with different weights in different quarters.
Clayt Daley: There is, of course, as we said, the 50 to 75 ongoing program, I think we have talked about the things that will help make that happen. The Gillette synergies, of course, are showing up primarily in the SG&A line. I cannot really at this point decompose this thing for you the way you would like me to, other than to say that they are working together for us, and that is why we believe we're generating the overall margin improvement that we have.
A.G. Lafley: I guess I will say one thing, and this won't surprise you, but on the SG&A side, we have grouped our businesses into three groups. There are businesses that are targeting half of sales growth, half of net sales growth for SG&A growth, and those are our growth businesses. There are another group of businesses that are holding their SG&A even to a year ago. They are zero overhead growth businesses. And then we have got a couple, and I think you can guess what they are based on my comments where we're focused on margin and getting the cost structure right, where we are actually asking them for negative overhead growth. As Clayt said, if we just do half of sales growth, we pick up the targets every year, and we've actually got our businesses on a combination of half at the high-end, zero for some and negative for a couple. So we should be in good shape. The other thing I will mention is we've very quietly begun, and we talked about this once before, an initiative called the future of productivity and growth, and we just really believe that we can be even significantly more effective on the deployment of our human resources. You will see there are lots of opportunities to eliminate some duplication between MDOs and GBUs to run more effectively and efficiently between MDOs and GBUs. There are real opportunities for more effectiveness and efficiency in our smaller countries, and that is smaller countries, I'm talking about like 74 countries, because we do 90% plus of our business in 16 countries. There are some real opportunities for more effectiveness and efficiency in our small brands. If 41 of our brands are 80% plus of our sales and almost 90% of our profit, that sort of tells you we have some real efficiency opportunities on the balance of a couple of hundred brands.
Operator: Your next question comes from Bill Chappell - SunTrust Robinson-Humphrey.
Bill Chappell - SunTrust Robinson-Humphrey: Can you talk about competitive pressure? I'm just trying to understand as you look on the horizon the ability to do further price increases. With that in mind, what your outlook and the guidance for oil over the next year and resin and other costs?
Clayt Daley: Well, as I said earlier, if commodities have moved up and they have moved up significantly versus the last time there was pricing activity in the category, we will look to try to raise prices to recover commodities. The experience over the last two or three years is that has been successful about 80%, 90% of the time, and there have unfortunately been situations where based on various competitive dynamics of price increases that should have gone through have not. That is the way it is. As I said earlier as well, we do expect commodities to be up versus fiscal 2008 versus 2007. That should not be surprising because oil has found its way to the mid '70s and does not seem to be going down, and obviously that will work its way through the various things that we've purchased that are derivatives of oil. While we don't put out a specific forecast for any of these commodities, and I'm not going to do that today, we know that eventually the oil price will tend to work its way through a lot of these materials, and that is the way we have got to plan our business.
A.G. Lafley: I think another way to think about it, Bill, is we do have pricing power with consumers as long as we keep offering superior value, and that is what we look at. We have pricing power with our retail partners. I guess the second thing I would say is as Clayt mentioned, in the more commodity influenced categories, for the most part it is fairly transparent. We are all looking at the same coffee bean prices or pulp prices or energy prices or whatever or resin prices. I think the pricing is pretty transparent. It is pretty orderly, and it is sort of the way it has always been. We try to offset some and we try to cover the rest. The third thing I will say, which is really important to understand, is a lot of our pricing comes from mix and trade-up. Our basic approach is innovation drives trading the consumer up to a better product that also represents better value, and as part of that trade up, we improve our gross and operating margins, and we effectively manage our pricing. That is a very important part of how we operate. That is why we have been so successful in Fabric and Home. That has sort of been the way it has been done in Oral Care. That is what happens in the Beauty and Personal Care businesses, and that works very well for us and for our industry.
Operator: Your next question comes from Linda Bolton Weiser - Oppenheimer.
Linda Bolton Weiser - Oppenheimer: Could we go back to the Beauty business for a minute? If my numbers are right here, it seems that the Beauty EBIT margin only increased for one of the four quarters in FY '07. Can you just give a little color on, is it that gross margin is increasing, but there is heavy spending to support the brands and so the EBIT margin performance is not as good, or is it isolated to particular parts or some of this fringe pruning that you have been doing? Can you just give a little more color?
A.G. Lafley: Yes, there are three things going on, Linda. One is we have increased our investment in advertising and in trial marketing behind a pretty active innovation program, and you have seen a lot of it. I mean all of the Hair Care upgrades, major upgrades we call Parthenon and Pantene, major upgrade on Head & Shoulders, the whole restaging of Herbal Essences, which is going very well for us. I mean Herbal Essences share in the US is now nip and tuck with Fructis. So big investments in Hair, big investments in Skin and investments across many of the beauty businesses, Fem Care for example. The second piece is obviously SK-II negatively impacted our margin. But that is a very high margin business. Every case we lose on SK-II has a margin impact. The third thing is they did get pressured on raw materials. People do not think about Beauty Care right away, but there's a lot of oil-based derivatives in the resins and in the surfactants. They are not as flexible a mixing and making process as Fabric Care, for example, where we can literally formulate as we go depending on what shows up in the market. So I think they have done a reasonable job. For the year Beauty's operating margin was up a tick, up sort of 10 basis points, and that is not really too bad when you consider the SK-II hit, the commodities and energy hit and the fact that we wanted to invest in innovation.
Clayt Daley: In what are already industry-leading margins.
A.G. Lafley: Yes, that is true.
Clayt Daley: In many places well above competitive levels.
Operator: Your next question comes from Alice Longley - Buckingham Research.
Alice Longley - Buckingham Research: Could you quantify how fast your categories overall are growing in North America in the June quarter, compared to the growth for the year overall? Tell us if there might be any improvement in the first quarter, and if so, why, and does it depend on innovation?
A.G. Lafley: In aggregate, the markets grew about 2% in the June quarter. That is down from 4% over the previous six months and 5% over the previous 12 months, so there was some slowing. That is on a dollar basis. On a volume basis, they were sort of up 1% versus sort of 2% to 3% in the base periods. We don't know obviously what the markets will do in the quarter that we have just begun. As I said, we had a very good July. So that is at least a short-term indicator that the consumer is buying, because we don't know what our share is. All we do is know what we sold, right? Yes, innovation matters. Because innovation stimulates trade-up. To the extent that we get trade-up, we grow the dollar value or euro value or whatever value of the market. So basically the way to think about the unit volume market in most of our businesses, certainly in the household businesses as driven by household formation, household size and frequency of cap. The Beauty and Personal Care businesses, one of the reasons we like it is the unit volume consumption can be driven by regiment expansion and introduction of new products and new categories. As I said, the dollar value of markets can be driven by innovation, and that is why innovation is so important to us. It is not a big swing, but there was clearly a softening in the April/June quarter.
Clayt Daley: The last thing we would say too is that we have had a phenomenon over the last couple of years where there has been a lot of price increases where sales growth has exceeded unit volume growth. And as price increases begin to become annualized, there has been and will continue to be some impact on market growth simply because there's probably less aggregate pricing going on in the marketplace.
Operator: Your next question comes from Connie Maneaty - BMO Capital Markets.
Connie Maneaty - BMO Capital Markets: Could you talk a little bit about what was driving your US Oral Care growth and what kind of changes we might see on store shelves once the planograms change in the next, say, three or four months?
A.G. Lafley: I would be happy to. Obviously it is mostly innovation. Pro-Health has been a very good innovation for us. It is exceeding our expectations, and we still have relatively very low awareness in trial rates. So there's a lot of upside ahead of us. I think as you have seen, we have been building out the Pro-Health offering for that segment of consumers on the dentifrice side but also on the rinse and the brush side. So that has been terrific. Interestingly, in addition to Pro-Health, we have also done well in the other segments. So the Whitening Expressions segment continues to do well. Scope continues to do well. We've put out a couple of botanical and herbal offerings, and after literally a couple of months, they are bigger than Tom's of Maine. So that was, frankly, a little bit of upside surprise for us. But I like our Oral Care program. We've got a very strong innovation pipeline in the market and coming to market. Oral-B is a fantastic asset. It is a great brand. We are behind on capacity, but we have got a number of exciting new products. We have a new entry-level power brush in market. We have a number of excellent new manual brushes coming to market. Gillette makes a great toothbrush, just a phenomenal toothbrush in terms of performance.
Clayt Daley: Well, now Procter & Gamble makes a great toothbrush.
A.G. Lafley: That is right. So that has been terrific. In terms of the in-store question that you had, I don't know if you have been out in stores, but our work with our key retail partners has been to make the Oral Care shopping experience a lot easier, a lot simpler and a lot more intuitive. So you will see a lot of resets, and you will see resets that are designed to improve the shopping experience for consumers. That is going to benefit everybody, everybody in the category. I think it is going to benefit Crest and Oral-B, and it is certainly going to benefit shoppers and consumers. So that is where we are headed.
Operator: That is all the time we have for questions today. Gentlemen, I will go ahead and turn the conference back over to you for any additional or closing remarks.
Clayt Daley: Thank you for joining us today. It has been a little over an hour-and-a-half and we appreciate your patience. As I said at the outset, John Chevalier, Jon Moeller and I will be around for the rest of the day to take any additional questions you have directly. Thanks again for joining us. | [
{
"speaker": "TRANSCRIPT SPONSOR",
"text": ""
},
{
"speaker": "Executives",
"text": "Clayt Daley - CFO A.G. Lafley - CEO Jon Moeller – Treasurer"
},
{
"speaker": "Analysts",
"text": "Bill Pecoriello - Morgan Stanley Amy Chasen - Goldman Sachs Bill Schmitz - Deutsche Bank Wendy Nicholson - Citigroup Investment Research Nik Modi - UBS John Faucher - JP Morgan Chris Ferrara - Merrill Lynch Joe Altobello - CIBC World Markets Jason Gere - A.G. Edwards Lauren Lieberman - Lehman Brothers Justin Hott - Bear Stearns Ali Dibadj - Sanford Bernstein Bill Chappell - SunTrust Robinson-Humphrey Linda Bolton Weiser - Oppenheimer Alice Longley - Buckingham Research Connie Maneaty - BMO Capital Markets"
},
{
"speaker": "Operator",
"text": "Good day, everyone and welcome to Procter & Gamble's fourth quarter conference call. Today's discussion will include a number of forward-looking statements. If you will refer to P&G's most recent 10-K and 8-K reports, you will see a discussion of factors that could cause the company's actual results to differ materially from these projections. As required by Regulation G, P&G needs to make you aware that during the call the company will make a number of references to non-GAAP and other financial measures. Management believes these measures provide investors valuable information on the underlying growth trends of the business. Organic refers to reported results excluding the impacts of acquisitions and divestitures and foreign exchange where applicable. Free cash flow represents operating cash flow less capital expenditures. P&G has posted on its website, www.PG.com, a full reconciliation of non-GAAP and other financial measures. Now I would like to turn the call over to P&G's Chief Financial Officer, Clayt Daley. Please go ahead."
},
{
"speaker": "Clayt Daley",
"text": "Thank you and good morning, everyone. A.G. Lafley, our CEO, and Jon Moeller, our new Treasurer, join me this morning, and as always we have a lot of information to cover on the year end call. I will begin with a summary of our fourth quarter results. Jon will cover business highlights by operating segment. A.G. will follow with his perspective on the year, and I will wrap up with an update on the Gillette integration and our expectations for both the new fiscal year and the September quarter. Following the call, Jon Moeller, John Chevalier and I will be available to provide additional perspective as needed. Chris Peterson will not be available today as he is with his wife who is recovering from major surgery. I know you will all join me in wishing Chris, Maureen and his family the very best for their recovery. Now on to our results. We concluded another fiscal year with sales, earnings per share and free cash flow at or ahead of our long-term targets. We delivered these strong results despite higher commodity and energy prices, a tough base period comparison and a challenging competitive environment, while at the same time managing the Gillette integration. Earnings per share for the June quarter increased 22% to $0.67 per share. EPS growth was driven by strong operating margin improvement and a lower than expected Gillette dilution. The total sales increased 8% to $19.3 billion, driven by 5% volume growth and 3 points of foreign exchange. Organic volume and sales for the quarter were each up 5% against a very strong base period, which included organic sales growth of 8%. Developing markets set the pace with double-digit organic and sales growth. Blades and Razors, Fabric and Home Care and Health Care led the segments with each delivering at or above 7% organic growth. The Snacks, Coffee and Pet Care segment delivered the lowest segment growth due to negative impact from the Pet Care recall. We expect results to improve for this segment over the next few quarters. Importantly, market share trends over the past three months continue to be strong with about 60% of our business growing share globally. Price mix was neutral as pricing actions to recover higher commodity costs were offset by negative mix from strong developing market growth. Next, earnings and margin performance. Operating income increased 15% to $3.4 billion, driven by sales growth and operating margin expansion. Operating margin was up 110 basis points, driven by better gross margins and lower SG&A costs. Gross margin was up 70 basis points to 50.8%. Volume leverage and cost-savings projects more than offset the impact of higher commodity costs. Higher commodity and energy costs hurt gross margins by about 40 basis points. Selling, general and administrative expenses were down 40 basis points. This was driven primarily by lower overhead costs as a percent of sales and Gillette cost synergies. The tax rate for the fiscal year came in at 29.7%, down 30 basis points versus year ago and in line with previous guidance due to strong growth in developing markets. Gillette dilution for the fiscal year came in at $0.10 to $0.12. This was better than expected due to the faster than planned realization of cost synergies. One-time items related to Gillette were $0.07 per share, in line with previous guidance. Advertising spending for the fiscal year increased double digits in line with sales growth. The company reinvested marketing productivity savings behind its leading brands and innovation programs. Now let's turn to cash performance. Operating cash flow in the quarter was $3.6 billion, up $400 million from the same period last year. The improvement was largely due to earnings growth. Working capital was a net cash help in the quarter due to a reduction in both receivable and inventory days and an increase in payable days. Capital spending was $950 million in the quarter. For the fiscal year, capital spending as a percent of sales was 3.9%, just below our 4% target. Free cash flow for the quarter was $2.6 billion. Free cash flow productivity came in at 116%, bringing the fiscal year cash flow productivity to 101%, well ahead of our 90% target. We repurchased 1.5 billion of P&G stock during the June quarter as part of our ongoing discretionary share repurchases. This brings the fiscal year repurchase total to 5.6 billion combined with 4.2 billion in dividends. P&G distributed 9.8 billion to shareholders in fiscal 2007 or 95% of earnings. To summarize, P&G continues to derive balanced top and bottom line growth despite the challenging costs and competitive environment. We are converting earnings to free cash flow ahead of target, and we are now ahead of plan on Gillette. Now I will turn it over to Jon for a discussion of business unit results by segment."
},
{
"speaker": "Jon Moeller",
"text": "Thanks, Clayt. Starting with our Beauty business, sales grew 8%, led by double-digit growth in Feminine Care and Prestige Fragrances, and high single-digit growth in retail Hair Care. Skin Care shipments were also up high single-digits as double-digit growth on the Olay brand was partially offset by depressed sales for SK-II. Similar to last quarter, the continued impact of the SK-II disruption in China was roughly a 1 point drag on Beauty sales growth. Strong Feminine Care results were driven by continued share growth in the US and midteens sales growth of the Always brand in developing markets. In the US, Always and Tampax continued to gain share. US Always value share was up 3 points to 56%, and Tampax added 2 points to over 51% of the market. The Fragrance business delivered very strong results behind recent innovation on Dolce & Gabbana, Lacoste and Escada. Retail Hair Care sales growth was led by the Pantene and Head & Shoulders brands. Pantene saw strong customer support for the base brand restage that launched in mid-June in North America, and we are already seeing positive market share response now that the full marketing program has started. Head & Shoulders' strong results were driven by over 20% growth in the Greater China and Central and Eastern Europe, Middle East and Africa regions. In Skin Care, Olay delivered double-digit growth globally behind low teens growth in North America and high teens growth in China. Growth in both regions was due to the successful launch of Olay Definity and continued growth of the Regenerist franchise. Health Care sales were up 11%, led by high-teens growth in Oral Care. Sales were also strong in the OTC and pharmaceutical categories with each delivering high single digit sales growth. Global Oral Care sales were driven by strong growth of both the Crest and Oral-B brands. In the US Toothpaste Business, Crest extended its brand leadership position. All-outlet value share was up 2 points to over 38% behind the success of the Pro-Health line. In China, where Crest is also the leading toothpaste brand, value share was up more than a point. Oral-B sales were driven by the growth of the Pulsar, Vitality and Triumph innovations and distribution increases in developing markets. Rapid demand increase for manual brushes has outstripped our supply capability, which has resulted in modest share losses in a few markets. We are adding capacity to meet the higher demand, and we expect to be shipping at unconstrained levels in the fall. In Personal Health Care, the addition of the new joint venture with Inverness Medical, called Swiss Precision Diagnostics, was the primary driver of sales growth. In Pharma, pricing, favorable geographic mix on Actonel, and the growth of Enablex drove higher sales. Next, Fabric and Home Care continued to deliver very strong results with sales growth of 10%. Growth was again broad-based with all regions increasing shipment volume and sales for the segment. Fabric Care sales increased double-digits behind growth across the brand portfolio. Tide, Ariel, Gain and Downy each delivered 8% or better global volume growth of the quarter. The North American laundry compaction conversion continues to proceed as planned with the first conversion wave scheduled to begin in September. Home Care grew high single-digits behind recent Swiffer Wet Jet and Duster upgrades, the continued growth of Febreze Air Care products and the expansion of Fairy auto-dishwashing in Western Europe. Baby and Family Care sales grew 5%. Baby Care achieved high single-digit growth, and Family Care increased low single-digits. Pampers shipments were up high single-digits in North America behind the continued success of the Baby-Dry Caterpillar Flex initiative and the new Baby Stages Wipes launch. Pampers shipments to developing markets were also very strong with China, Russia and Turkey each up more than 20%. In Family Care, Bounty sales increased behind the recent absorbency and softness initiative and continued growth of Bounty Basic. The rapid growth of Bounty Basic and Charmin Basic, combined with the continued market shift toward larger-sized packs, has driven some negative sales mix for the quarter. Sales for the Snacks, Coffee and Pet Care segment were up 2% for the quarter. Coffee sales were up double-digits, driven by price increases earlier in the fiscal year to recover higher commodity costs, market share growth and a soft base period. Folgers US all-outlet value share increased about a point to 32%, more than double the share of the next competitor. Pet Care sales were down as the business continues to recover from the negative effects of the wet pet food recall last quarter. Iams US all-outlet value share is down roughly 2 points to 11%. We have increased marketing investments in the pet business to build consumer trial of our Healthy Naturals dry dog food and Digestive Care dry cat food initiatives which launched in June. Blades and Razors delivered 18% sales growth for the quarter. Strong shipment volume and product mix, driven by Fusion and Venus Breeze, were the key contributors to sales growth. Sales growth also benefited from the soft base period in North America following the Fusion launch in the March quarter of 2006. Fusion's share of male systems Blades and Razors in the US is up about 10 points versus prior year to over 32% as new users continue to trade up to the best performing system in the market. Importantly, Fusion and Mach 3's combined share of US male systems Blades and Razors also continues to grow. The two brands now account for 76% of market value, up nearly 3 points from last year. Fusion and Mach 3 combined male systems blade share in key international markets is also up significantly. In the UK combined share is up nearly 7 points to over 81%. In Japan, Fusion and Mach 3 are up nearly 6 points. Germany, France, Spain, Italy and Australia are all up 4 to 5 points. In female razors Venus Breeze is driving significant trial. All-outlet value share for Venus razors in the US is up more than 8 points to 27% for the quarter. We will be continuing to invest behind Venus Breeze and a strong disposables initiative pipeline next fiscal year. Duracell and Braun reported sales grew 4% for the quarter. Duracell posted high single-digit sales growth behind strong shipments in China and Latin America. These gains were partially offset by soft results in North America and in Western Europe. Braun sales were down slightly versus the prior year, good results from the brand's recent Pulsonic, 360 Complete and Contour initiatives were offset by intense competitive activity in Europe and soft results on household appliances. Sales were also impacted by the divestiture of the blood pressure and thermometer businesses earlier in the fiscal year. That concludes the business segment review, and now I will hand the call to A.G.."
},
{
"speaker": "A.G. Lafley",
"text": "Thanks, Jon. Fiscal 2007 was another very good year for P&G. 5% reported organic sales growth; actually it rounded down to 5% due to the product recall impact from SK-II and pet food; 15% earnings per share growth; strong gross margin expansion, up 60 basis points; and strong operating margin expansion up 80 basis points. Cash performance also excellent. $10.5 billion of free cash flow and 101% of earnings converted to free cash. This cash, of course, is critical, because it funds dividend payments to shareholders, and as you know, we have increased dividends every year for the past 51 years at a compound average rate of 10%. This cash also funds share repurchases, and as you saw in the press release and Clayt will talk further, we are going to substantially increase share buyback in the year ahead. At the end of the fiscal year, I like to step back and look at where we have been strategically and where we are going. There is no doubt in my mind that P&G has a more robust business strategy and business model, a stronger portfolio of businesses and brands, stronger core capabilities and strengths and a stronger leadership team and overall organization in 2007 than it has at anytime in the 30 years I have been with the company. In the decade of the '90s, just three businesses accounted for 80% of the value creation of the company. Five businesses accounted for 80% of sales growth, and four accounted for 80% of profit growth. In the first two-thirds of this decade, P&G has 13 very strong businesses that account for more than 80% of enterprise value created in the decade so far. Using our operating TSR model, we have already created 2.5 times as much value for shareholders this decade as we created in the entire decade of the '90s. Organic sales growth in this decade has averaged 6% versus just 4% in the second half of the '90s. In 2000 our focus was on growing the $10 billion brand that accounted for about 50% of net sales and slightly more than that of profits. Between 2000 and 2007, we extended this focus on big leading brands from 50% of company sales and profits to brands accounting for now 80% of sales and 90% of profits. In the year just completed, P&G's 18 heritage billion-dollar brands grew organic sales 6% and profits double-digits. Including Gillette's five heritage billion-dollar brands, our 23 biggest brands grew organic sales 5% and profits double-digits. The 18 next generation billion-dollar brands, those brands with $0.5 billion to $1 billion in annual sales, built organic sales 8% and profits in the high-teens. So combined, these 41 big -- and for the most part, category-leading brands -- account for over 80% of P&G sales and nearly 90% of profit. They are growing organic sales at a rate of 6% and profits 15%, well ahead of the growth of our small brands and at or above long-term company targets. The point is simply this. Where we are focusing strategically and operationally on leading brands with leading market shares driven by leading innovation and widening the market share advantage versus competition, things are going very well. It is instructive to look at market shares over the longer-term. This past year we built significant share in Western Europe and Central and Eastern Europe, Middle East and Africa and in China. We held on to leading shares in North America, Southeast Asia and Latin America. What is interesting is to see what has happened to critical growth category and leading brand shares over the longer term. We have significantly widened our share advantage in Fabric Care. In the early '90s, we were the #2 global player. Today P&G has a 34 share, nearly double the next competitor, and we have grown share for seven consecutive years. In Hair Care we achieved global share leadership in 2003 and have maintained our margin of leadership despite intense competitive activity and trade spending. More importantly, we are well-positioned to continue to strengthen our Hair Care position, not only in shampoos where we have been historically strong, but also in conditioners and treatments, styling and yes, even colorings. Our focus on leading Nice 'n Easy brand this last year has paid off with a 2 share point gain. Nice 'n Easy is now the leading home care color brand in the US, and we have a significant new innovation, Perfect 10, in the pipeline. We just announced its launch to retail partners, and Perfect 10 will be on shelves early next calendar year. We are now the leading Oral Care and dentifrice brand and company in the US and within reach of oral care category leadership worldwide. We have dramatically strengthened our position in retail Skin Care. Olay is now the number one Skin Care brand in the world, and P&G has been one of the fastest-growing Skin Care companies over the past five years. We're now surprisingly the number one Fine Fragrance company in the world, with nearly $2.5 billion in sales. We're growing faster than key competitors and generating much stronger returns. We're the global leader in Fem Care with a 37 share. Last year we added a full share point to our global position and more than 2 share points in the US. I think it is important to understand what we have delivered and how we have delivered: with deep consumer understanding, creating and building stronger brands, brands that are built to last, leading innovation year-end and year out, partnering with customers and suppliers, and leveraging our global scale and scope advantages. It is important to understand this history and this track record so you also understand why I am so confident about what we will deliver in the future. I am confident because there is still significant upside for P&G. We have plenty of room to keep growing in each of our strategic growth focus areas. We have a lot of opportunity to keep growing P&G's $23 billion brands. We are proving in category after category that a leading share, even a relatively high share, is not a barrier to growth. We have over a 70 global share in Blades and Razors, but we see plenty of opportunities to grow. We have over 34% global share in Fabric Care, and our innovation leadership is helping us grow share broadly in that business. We have over 36% share of the global diaper market, but we have just started our first big push into India, the country with the largest number of diapering aged babies in the world, and as Jon reported, we're growing strongly in developing markets. There's even greater upside in our Beauty, Health and Personal Care businesses. The Beauty and Health Care categories in which P&G competes are a combined $370 billion market today and are projected to grow 3% to 4% a year for the balance of the decade. We have doubled our share of Beauty and Health over the past decade, and yet we still have only about a 10 share globally. The upside potential in developing markets is also enormous for P&G. We have significant opportunities to increase household penetration, consumer usage frequency and to enter categories where we're not yet present. Countries like China and Russia, the average household today buys about five P&G products per year. The average American households by comparison buys over 20 P&G products a year. Closing this gap, which I'm sure we will do over time, will continue to drive strong growth for years to come. I'm confident in our ability to keep growing P&G's organic sales at least 4% to 6% a year. I'm equally confident in our ability to convert this top line growth to double-digit earnings per share growth, primarily because of the margin expansion opportunities we see across the business. Our sustainable growth model calls for us to deliver 50 to 75 basis points of margin expansion per year, in addition to Gillette synergies. We expect this to come from both gross margin improvement and lower overhead costs as a percent of sales. On gross margin, we have a strong track record of improvement. Over the last ten years, P&G's gross margin has grown 930 basis points or more than 90 basis points per year. To improve gross margin going forward, we're going to keep doing the things that drove our progress over the last ten years, generating volume leverage on our fixed cost base, shifting the portfolio to higher gross margin businesses and driving cost savings projects, including better leveraging P&G purchasing scale, increasing our manufacturing base in lower-cost locations and consolidating distribution centers. To improve SG&A costs, we're driving productivity and overhead costs. Since the beginning of this decade, we have reduced overheads of more than 350 basis points, an average of about 50 basis points per year despite the negative impact from the Wella end Gillette acquisitions. If we just hold overhead growth to half the rate of sales growth, we pick up 25 to 50 basis points of margin improvement per year. As we look across the business, we see a number of opportunities, including simplifying our GBU/MDO structure, optimizing how we manage small countries and improving the productivity on our smaller brands. One thing you can expect us to do in the year ahead is to increase our investment in ongoing restructuring. Driving efficiency gains and cost savings in both gross and operating margins sometimes requires restructuring spending. We have an internal budget to fund these investments without the need for big disruptive restructuring programs and separate charges against earnings. Fiscal 2008 will be an investment year to increase productivity and help ensure we sustain growth through the end of this decade and well beyond. So what I want you to take away today is that P&G is well positioned to continue to lead this industry over the long term. We have the right strategies with plenty of room to keep growing. We have a strong portfolio of businesses and brands that represents an attractive mix of categories, leading brands and geographies, and it will get stronger. And we have the right core strengths to keep P&G growing reliably year after year, regardless of the competitive or economic challenges we may face. I'm looking forward to meeting or exceeding the company's growth targets through the end of this decade and beyond. Now I will turn the call back to Clayt."
},
{
"speaker": "Clayt Daley",
"text": "Thanks, A.G.. First, an update on Gillette. The integration continues to progress very well thanks to the excellent work by all the Gillette integration sub teams around the world. Although there is still work to be done, fiscal 2007 was the most significant year in terms of integration workload. Let me highlight a few areas. During fiscal 2007 we completed our business systems integration. Specifically we integrated systems, sales forces and distribution networks. We managed these conversions without any significant business interruptions. We are now selling, taking orders, shipping products, receiving payments and operating our back office as a single company in 99% of the business. The distribution center consolidation project is now well underway. As of June 30, we have reduced our number of distribution centers by about 25%, and we are on track to get to our 50% target by the end of fiscal 2009. We also made significant progress on staffing efficiencies during fiscal 2007. We have eliminated about 5,000 positions as of June 30 and are now working toward the top end of the 5,000 to 6,000 target range. Most important, dilution for the year came in at $0.10 to $0.12, well below our original $0.12 to $0.18 estimate. The improvement was largely due to better than expected earnings from the Gillette base business and faster than expected delivery of synergies. We previously announced the integration of the Gillette GBU into P&G effective July 1. From a segment reporting basis, we will move from seven to six segments. Details of the new reporting structure were highlighted in the press release this morning. In summary, we remain on track with both the integration and the acquisition economics. We continue to expect cost synergies to be at the top end of the $1 billion to $1.2 billion target range, and revenue synergies to be $750 million next fiscal year, and we remain on track for Gillette to be neutral to EPS for fiscal 2007/2008. Now there are three topics I want to discuss in broad terms before getting into the guidance details. They are first share repurchase; second, the business portfolio; and third, ongoing restructuring. First, on share repurchase. This morning we announced a $24 billion to $30 billion share repurchase plan over three years. At the current price, this represents about 12% to 15% of our market cap. We plan to buy the shares back over the next three fiscal years at a rate of $8 billion to $10 billion per year. This represents a significant increase to the $5.6 billion we repurchased in 2007 and our previous target range of $6 billion to $7 billion for fiscal 2008. We are increasing our share repurchases due to the attractiveness of interest rates, the current P&G stock price and most importantly, our continued confidence in the long-term growth prospects for this company. Our intent is to maximize share repurchase within our current credit ratings. So whether we actually purchase $8 billion or $10 billion in any year will be a function of our actual cash performance. Our current AA credit rating reflects a combination of single A financial ratios and AAA qualities. We have discussed these plans with the rating agencies, and they have confirmed our AA credit ratings this morning. We expect the increase in share repurchase to be about $0.01 accretive to EPS in fiscal 2008. We expect the combination of share repurchase and dividends to result in well over 100% of free cash flow being returned to shareholders in each of the next three years. Next, I want to provide some perspective on our portfolio plans. As A.G. mentioned, we regularly review our portfolio of businesses to determine how to best maximize shareholder value. This process includes a thorough portfolio review with the Board of Directors in June and a series of business strategy reviews in the months of August and September. If this process reveals a situation where value is maximized by P&G exiting a business, we will take action as we have done in the past. Over the past few years, we have exited the juice business, the peanut butter business, the shortening and oil business and most recently, the tissue/towel business in Western Europe. Looking forward, over the next couple of years, we expect P&G to be more likely to be a seller of businesses than a net buyer, and we are not actively looking for large acquisitions. Of course, this philosophy is reflected in our decision to increase share repurchases. Finally, let me discuss our ongoing restructuring plans. We are doubling our internal restructuring budget to $300 million to $400 million after-tax, up from $150 million to $200 million. This increase reflects the fact that we have identified a number of efficiency and effectiveness improvement projects for the near term, and it reflects the fact that the size of the company has essentially doubled since we established the original range. For fiscal 2008, we expect our internal restructuring spending to be toward the top end of the new $300 million to $400 million range. This represents a significant increase in our restructuring activities following the Gillette integration. Now let's get to the guidance details. For fiscal year 2008, the priority for the company is to sustain strong organic sales growth. As such, we plan to invest in our leading brand equities. We plan to launch a strong innovation pipeline, and we plan to make significant progress on go to market reinvention. We again expect to deliver our annual double-digit EPS growth commitments, excluding the positive one-year impact of the Gillette dilution. Consistent with our plans since we announced the deal, we expect Gillette to be neutral to EPS in fiscal 2008. In addition to the share repurchase increase and higher restructuring investments, there are several other factors that will affect earnings per share in fiscal 2008. First, we expect to continue to be in a tough competitive environment as many of our competitors are continuing to spend savings from restructuring programs on increased price discounting, trade promotions and marketing spending. Where necessary, we will increase spending to defend our business. Second, we plan to convert our North American liquid laundry detergent business to a 2X concentrated formula over the course of the next fiscal year. We expect this to be a win for consumers, retailers, the environment and P&G. However, there are a number of one-time costs that we will incur during the transition. These include the costs of new molds, manufacturing changeover costs, retail conversion costs and higher marketing support. As such, we expect next fiscal year to be a net investment year for this initiative. The biggest impact will likely be in the July/September quarter and, of course, in the Fabric and Home Care segment. Third, at current levels we expect raw material and energy cost to increase again in fiscal 2008. The amount of the increase should be about in line with the impact we saw in fiscal 2007 in the range of 60 to 75 basis points. This is roughly double the impact we expected when we gave our initial outlook on fiscal 2008. Even with higher input costs and the laundry compaction investments, we still expect gross margins to improve, mainly due to the benefits of cost savings projects and volume leverage. Fourth, our shareholders will need to expect greater quarter-to-quarter earnings volatility in fiscal 2008. This is mainly due to the timing of investments in the laundry compact initiative, internal restructuring of cost projects, and the timing of initiatives and marketing investments in the grooming business. Of course, our quarterly guidance numbers will include our best estimate for these impacts. Now to the numbers. For fiscal 2008 we expect organic sales growth of 4% to 6%, in line with our long-term target range. With this, we expect the combination of pricing and mix to be flat to up 1%. Foreign exchange should have a positive impact of 1% to 2%. Acquisitions and divestitures are expected to have a zero to 1% negative impact on our top line results. In total, we expect all-in sales growth of 5% to 7% for the year. Turning to the bottom line, we expect earnings per share to be in the range of $3.44 to $3.47, up 13% to 14% versus the prior year. We expect operating margins to improve by 70 to 100 basis points, driven by both gross margin improvement and lower overhead costs as a percent of sales. We expect the tax rate to be at or slightly above 29%. Now some of you may ask why the benefits from increased share repurchase and lower tax rate are not showing up as increased EPS guidance? The answer is really very simple. The benefits from these items are being offset by higher commodity costs and higher restructuring investments compared to what we anticipated back on May 1 on our last earnings call. We will deliver double-digit core earnings per share growth despite higher restructuring costs, and we want to maintain the flexibility to take advantage of opportunities to leverage our innovation programs and respond to competitive threats as they occur. Turning to the September quarter, organic sales are expected to grow in the 4% to 6% range. With this, we expect a combination of pricing and mix to be neutral to up 1%. Foreign exchange should add 2% to 3% to sales. Acquisitions and divestitures are expected to have a zero to 1% negative impact on P&G's top line, and therefore in total we expect all-in sales growth of 6% to 8%. Turning to the bottom line, we expect operating margins to improve modestly as SG&A improvement will largely be offset by lower gross margins. Gross margins are expected to temporarily be lower due to the higher commodity and energy costs and the investments needed behind the North America laundry compaction initiative. In that, we expect earnings per share to be in the range of $0.88 to $0.90 for the quarter, up 11% to 14%. In closing, P&G continues to deliver balanced top and bottom line growth at or above our long-term targets. We are converting earnings to free cash flow ahead of target, and we will begin returning more than 100% of this cash to shareholders through share repurchase and dividends. We are ahead of plan on the Gillette integration, and confident in our sustainable growth model going forward. Now, A.J., Jon and I would be happy to open up the call and take your questions. There is just one comment I want to make before we open it up for questions, just to remind you, that this will be the last quarter that we will be giving a mid-quarter guidance update, and we expect that to come out in early to mid-September. With that, we would be happy to take your questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Bill Pecoriello - Morgan Stanley."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "Good morning, everybody. Can you tell us how fast the developing markets grew in the fourth quarter, and do you think you can accelerate that growth rate in ’08, assuming macros don’t deteriorate through filling in some of the brand white space? I know A.G. mentioned some of this in the prepared comments as a goal over the longer term. Thanks."
},
{
"speaker": "Clayt Daley",
"text": "We said they grew double-digits actually it was around low teens. As I think we have said before, Bill, the developing markets have done really very well on organic sales growth during the Gillette integration. But now that the Gillette integration is largely behind us, we are obviously going to be targeting on trying to move the developing market growth rates up. We have specific plans on both the base business and as you suggest, in some geographies expanding our portfolio of businesses over time."
},
{
"speaker": "Jon Moeller",
"text": "Bill, our fastest-growing developing markets by far have been in CEEMEA, Central and Eastern Europe, Middle East and Africa. We have pretty comfortably maintained 15% to 20% growth rates there. We have gotten Latin America to double-digit in the last quarter, and we have really sort of doubled the growth rate from Latin America which has been good. While we have done well in Asia, especially in China, we think Asia has got a lot of opportunity and we just reorganized. We put our Asia market development operations together. We've put them all under Deb Henretta, and we are focused, prepared and ready to accelerate the growth rate in that fast-growing part of the world."
},
{
"speaker": "Operator",
"text": "Your next question comes from Amy Chasen - Goldman Sachs."
},
{
"speaker": "Amy Chasen - Goldman Sachs",
"text": "I was hoping that you can quantify the laundry compaction? You did that with the increased restructuring, and it was very helpful. What I mean is the charges obviously, the costs associated with that and the timing of it throughout the year in terms of quarters."
},
{
"speaker": "Clayt Daley",
"text": "Well, the quarter impact, mostly the heavy lifting is in the first quarter. So the impact is greatest in the first quarter. And then, of course, in the second quarter, we are also going to see a significant impact because that is the first wave of rollout, and that is the time during while the factories are preparing for the final two waves that occur in the second half of the fiscal year. So the impact will be mostly in the first half. We have not quantified it. It is going to be broadly, a few cents a share."
},
{
"speaker": "Jon Moeller",
"text": "Amy, the way to think about it, it is three big waves. Most of the incremental charges come in the first half as Clayt said. I'm going to tell you, we are going to stay agile and flexible in terms of the investment we make. Because if we get a fast conversion, if we can drive the kind of awareness and trial rates we would like to drive quickly, we're going to keep investing. I mean one of our major competitors has just basically said they are withdrawing from the market, and this is an opportunity for us to get significant trial among consumers with a product line that is better, with a range of innovation and innovative products across most of our laundry brands and frankly, with a proposition that is a win-win-win for consumers for customers for the supply chain and for us. Because it is a big win from a product performance, quality and value standpoint. It is a big win from an environment and sustainability standpoint, and we're getting a lot of support on that basis, and it is a big win from a convenience and full supply chain standpoint, because basically half of the volume in queue goes through the system to deliver the same amount of business. So this one is big, and we're going to stay flexible on what we invest."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bill Schmitz - Deutsche Bank."
},
{
"speaker": "Bill Schmitz - Deutsche Bank",
"text": "Can you just talk about what North America or specifically US growth was in the quarter? And then just some broad sort of strategic thoughts on the health of the US consumer?"
},
{
"speaker": "A.G. Lafley",
"text": "Yes, our growth was mostly for the quarter it was 4%. We are in mid singles. So 4% to 5% on organic volume and sales. I'm actually very proud of our North American operation and our North America business because there was clearly some market softness and some pressure on consumers and some pressure on our retailers in the April/June period, and they turned in a good quarter. Our market share position is still pretty doggone good. We're up 60% to 70% of our business. The shares are up. The other thing about North America is despite our market share position, which in aggregate across all the businesses is north of 30%, we still have a lot of upside trial opportunity. The business units have just went through this over the last 100 days or so, and we are very focused across a number of brands and categories on lifting our trial rates. I will not go into all the details, but we have major new product initiatives and major new brands that we launched in the last two, three, four, five, six, seven years that still have relatively low trial rates, and we think we can generate $1 billion or more in incremental business if we hit the target trial rate. So I like the North America business. You have got to remember most of our categories and brands are weekly purchase, daily consumption. We're not in a lot of discretionary categories which will be impacted if there is any drawdown. So I think we are in pretty good shape. And I guess the last thing I would say, and I think you know this, our industry and our company generally performs well in slow downtimes and even in recessions. So I like our prospects in North America. I like our position. It is a market that responds to innovation. We're really strong with consumers and customers in this market."
},
{
"speaker": "Operator",
"text": "Your next question comes from Wendy Nicolson - Citigroup Investment Research."
},
{
"speaker": "Wendy Nicolson - Citigroup Investment Research",
"text": "My question goes back to what A.G. was talking about when you talked about the strength of I think the 18 core brands and how they grew 6% for the year, and then when you added the Gillette brands, they only grew 5%. I guess it just surprises me. I understand in the first year, there was a lot of inventory destocking and that kind of thing. But going back to whatever when you announced the deal, I think the idea was that that acquisition was supposed to accelerate the company's growth rate, and it just amazes me that those brands continue to under perform relative to the core P&G business, despite all the incremental distribution they have had. So can you kind of talk about what is up with that and specifically what is going on with Duracell?"
},
{
"speaker": "A.G. Lafley",
"text": "Sure. It is really simple. We have done real well on Gillette Blades and Razors, driven primarily by Fusion and more recently by Venus, and as you mentioned, the distribution gains. We have done real well, we in fact ran ourselves out of capacity in Oral Care. We would have and could have done better in Oral Care, and we are fixing that. By this fall, we will have all the toothbrushes of all kinds needed to cover the business. That is in a funny way, a pleasant surprise. I think we have been very clear about our Duracell and Braun strategies. On Braun we consciously have focused on margin and we have focused on restructuring. And we stepped out and took a major piece of restructuring action in Western Europe to shut down a major manufacturing site. We have been very selective about where we will go for volume and sales. We're only going for profitable margin, accretive volume and sales, and that whole program is on fix the cost structure and get the margins right and make it a really investment-grade business. The leadership team is on that course. In batteries it has been a couple of things. Again, we have focused on profit, profitability and cash, and frankly the competition grabbed some of the short-term space and merchandising in what is a pretty tactical and executional game. I think you will see us get more than our fair share of it in the months ahead, and that will be a little bit of a tit for tat. The other big thing, which is not clear in the numbers, is as we grow Fusion we cannibalize Mach 3. Mach 3 is one of our top five Gillette brands, and sales were down over 10% on Mach 3. So that is what is really throwing off the Gillette five brand impact. But as we reported, if you put Fusion and Mach 3 together, it has been fantastic, and we're driving sort of mid 70 to 80 plus shares there. So I am really not concerned about it. I think we're growing where we should be growing in the Gillette portfolio. We're getting our cost structure and our innovation programs right in a couple of other places. I do not see a business that cannot grow in the Gillette portfolio at the 4% to 6%, at least top line organic rate."
},
{
"speaker": "Operator",
"text": "Your next question comes from Nik Modi - UBS."
},
{
"speaker": "Nik Modi - UBS",
"text": "A.G., Just a quick question. When you take a look back at the last two years and you think about the organic sales growth, and granted obviously it's within the top end of your target. but could you just kind of reflect and help us understand if you think the business was perhaps maybe distracted somewhat with the Gillette integration? Focusing more on that rather than maybe perhaps some in store stuff which is so critical to your business. Just to get the feel that now with the Gillette integration fully complete, maybe the focus can go back more to growth and white space expansion as you suggested earlier?"
},
{
"speaker": "A.G. Lafley",
"text": "Yes, I'm going to take a couple of minutes on this one because it is a great question, and it is one that we think about a lot. If you step back and look at the Gillette acquisition, it was the biggest ever in our industry by a fairly wide margin. I think at the time we made the acquisition, it was one of the top 10 biggest acquisitions ever. It is probably in the top 15 now. But it was a major piece of work. There was absolutely no doubt about it. When we got into it, after we got through the first six months or so, the team -- and that was when Jim was still on the team and with Clayt leading the integration -- but the whole team, the Gillette team and the P&G team, made I think a critical decision, and the critical decision we made was to accelerate. So if you think about what we have done, we accelerated the organization integration by a full year. We accelerated everywhere we could the operational integration, which Clayt talked about in some detail, which is virtually done. In the short-term, that increased the organization's workload significantly. So I don't think we made any conscious trade-offs versus the established businesses, but we definitely increased the workload on an organization that has got a pretty strong work ethic to begin with. I think it is important to understand that. So where does that show up? That shows up in some of the little glitches like the Tennessee distribution center, which nicked us back in the second quarter. It shows up in maybe we did not win in a couple of cases, there is no doubt that competitors came in and in the very short run captured more space in the trade at a given account in a given channel. It would be harder for them to do it. Now it is interesting, when you look at those very short-term tactical skirmishes that go on all the time in our industry -- and this is a very important point -- what I always look at is does the volume and sales growth translate into sustainable share growth that improves your margin, cash and return? That is the real question. The answer is, some of it does and some of it does not. I will give you a couple of examples. In coffee we lost the trade featuring and merchandising war in a fairly significant period. There are two big periods for coffee. There is a Thanksgiving and Christmas period; there is the Easter period. Our major competitor won, but our share went up. Theirs went down So even though we did not win the tactical short-term battles, the combined impact of our brand, our innovation and our program resulted in share growth. We have continually widened the share gap. I think it is quite clear in Oral Care. The pricing has widened a bit between our brand and brands and our principal competitor. They have probably won a few more of the tactical short-term wars, but our market share has continued to grow because I think we have had a strong innovation programs. We have had a strong consumer-oriented marketing program. Batteries, as I talked about with Wendy, has gone the other way. It is a little more impulse driven. It is a little more space driven. It is a little more display driven. And the fact of the matter is you have got to hold onto your share territory in the store in batteries, and we are now organized, focused and prepared to do it. But I think that is the key question. Now so what does that mean going forward? I think what it means going forward is we now have virtually all of the P&G resources focused on what are now all organic businesses. Because the Gillette businesses are now residing in P&G where they belong, where they can generate the most synergies, get the most resources. The second thing I would say is we have a very good innovation pipeline. The third thing I would say, and I won't belabor this, but we have got a lot of upside trial potential. The fourth thing, as Clayt said, and it was maybe a little subtle, so I will try to make it clearer; Clayt is not usually subtle. But one of the reasons why we're going to be agile and flexible, and frankly we're going to have a war chest for this next year, and the war chest is going to be to invest in opportunities that we have in the innovation program and market expansion, especially in the developing world. We're going to come out of this next year leaner, faster, more agile and stronger. But the key issue is, how much of that volume and sales converts to sustainable market share growth? That is why I wanted to talk about the sustainability of our market share growth. We are still, despite a 5% organic net sales growth rate, we are still growing share on 60% to 65% of our business worldwide, and that is pretty doggone good."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Faucher – JP Morgan."
},
{
"speaker": "John Faucher – JP Morgan",
"text": "A.G, Are you sure that Clayt is not subtle? I seem to remember that going the other direction there. A quick question for you. I think you guys made some divestitures on the Beauty business. So can you talk to us a little bit about how you see maybe some changes in that portfolio? I know you feel like the overall business is doing well, but you are sort of hung up by a couple of categories where you are struggling a little bit. So can you give us how we should look at that portfolio over time?"
},
{
"speaker": "A.G. Lafley",
"text": "Yes, John, we think Beauty can grow a bit faster than it has been growing. Our strategy, I think it has been fairly clear our two top priorities are Hair and Skin, and I think you see what we do year-end and year out in Hair. We are strong and getting stronger in Hair, and we have really had a nice run in Skin, and we have a lot of upside in Skin. I think Fine Fragrances has been a pleasant surprise, and I think it will continue to surprise because we have a unique business model in getting ourselves in a pretty advantaged position there. What we have been doing is trimming portfolios, especially out of the Clairol and Wella acquisitions. Without going into all the gory details, while there were some assets there are of real value, they had a lot of small, local and channel-specific brands. Our game is consolidation. Our game is a smaller portfolio. Our game is leadership brands. So we have been sort of managing the divestiture and in some cases just shutdown of these businesses in a way so that they are not a big impact on our sales growth. But we're still prepared to do it because if we clean up the portfolio, we will be able to focus on the businesses that can grow. We're pretty much done in Clairol. We have a little bit more work to do in Wella. But I think we are going to be in good shape going forward, and I really like the innovation pipeline across the Beauty Care business. You have also got to remember that this SK-II event hurt us. It did cost us a full point of net sales growth. Because of the way we have gone about building it back, which I think is very strategic and very deliberate and we will end up in a very strong sustainable position when we are all the way back, we have taken a little bit more time to rebuild it. We are now organized with one global SK-II operation run out of Singapore and all the rest of it. So I think a slightly long-winded way of saying I like our strategic position in Beauty. I like the industry because there's a lot of room to grow, and even the biggest players have small shares, 10 or under. I like our brand. I like our innovation program, and we are building a very strong Beauty organization. So I think we are going to see Beauty growth accelerate in the years ahead."
},
{
"speaker": "Operator",
"text": "Your next question comes from Chris Ferrara - Merrill Lynch."
},
{
"speaker": "Chris Ferrara - Merrill Lynch",
"text": "I just wanted to ask about the rationale of the size of the buyback. Was keeping the AA rating the priority when you picked the number? Because it seems like you guys might generate $24 billion in cash flow after dividends over the next few years anyway. Also as a follow-up to that, you have said you're going to be more likely to be a divester than an acquirer. Where do the proceeds go to that? Would that be incremental on top of the potential $24 billion to $30 billion in buyback?"
},
{
"speaker": "Clayt Daley",
"text": "Well, of course, as we have said before, we are already planning to put the Western European tissue proceeds in the buyback in the first year of this program. So I think the answer is you could assume that should we at some point divest businesses, it is highly likely that we would put net proceeds into even additional buybacks. The rationale for the buyback level is very much related to credit. We have been in an interesting environment for a couple of years where credit spreads have been very narrow, and I think the events of the last two weeks have pretty much dramatized the importance over the long-term of having high quality credit as we have seen spreads widen out very rapidly at various credit levels. And so you're exactly right. What we're doing is we are maxing out share repurchase within our current AA credit. But I want to emphasize again as I did my comments, we're AA credit with single A credit metrics and AAA qualitatives. So what we're really able to do is take advantage of the strength of this company, its size, its consistency of sales, earnings and cash flow growth to actually do more share repurchase than maybe some other companies could do given a certain amount of capacity. We think we're doing the right thing in terms of striking the balance between doing as much share repurchase as we can and yet doing the right thing for the company long-term relative to its credit."
},
{
"speaker": "A.G. Lafley",
"text": "Chris, if we generate more cash, then we're going to come up to a decision about what we do with it, and one of the options is going to be more buyback."
},
{
"speaker": "Operator",
"text": "Your next question comes from Joe Altobello - CIBC World Markets."
},
{
"speaker": "Joe Altobello - CIBC World Markets",
"text": "Actually going back to a comment that A.G. made earlier. You talked about pressure on the North American consumer and the retailer in the June quarter. I was wondering if that got worse as the quarter progressed? Are you seeing it getting worse in the September quarter? Are you seeing any trade-down activity in some of your non-innovative sort of categories at this point?"
},
{
"speaker": "A.G. Lafley",
"text": "No, actually it has gotten better. The toughest months were April and May. We watch very carefully the sub-prime mortgage phenomenon. We watch very carefully all the information on credit cards. We watch very carefully what is going on with all of our different consumer segments. But no, I think it has gotten better for retailers, and we will just have to see what they reported. It has certainly gotten better for us. Without going into details, we have had a very fine July, and we're looking forward to a good quarter. I think on the second question, clearly in a business like tissue/towel, again as Jon said in his remarks, when consumers are buying larger packs, when Basics which is our affordable entry offering of our three offerings in the Charmin and Bounty lines is growing at the rate that it is growing at, lower-income households are feeling a bit pinched, and that is a way that people generate better value. It still works well for us because even though we're relatively low single-digits net sales growth in that business, we generate very strong operating margins, and we've generated very strong operating TSR, and it is always a balancing act. So that is probably one business where we see a little bit of pressure. We frankly have not seen the pressure in the big Fabric and Home Care businesses, like laundry and dish. We continue to grow our market shares. Consumers continue to buy middle and upper price detergents because they represent a good value, and frankly they are the only ones that perform anymore; and for them performance matters, performance is value. So, so far, so good. The point I was trying to make is, I think we're well-positioned no matter which way it goes. That is really the key. I think we're well positioned. We have broader, tiered offerings on most of our major household businesses. We are in a good consumer value position. We are leading innovation for the most part, and we have strong partnerships with our retailers, and we are building value and we are growing their sales profitably for them."
},
{
"speaker": "Clayt Daley",
"text": "Private label shares are very flat during this period. So you're not seeing some of the things that would lead you to believe that consumers are trading down."
},
{
"speaker": "A.G. Lafley",
"text": "Clayt makes a really good point there. I mean there are very few categories in the US in the top 20 categories that we are in where private-label is growing any share right now. So that means I think that the branded manufacturers are offering consumers pretty doggone good value equations."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jason Gere - A.G. Edwards."
},
{
"speaker": "Jason Gere - A.G. Edwards",
"text": "Just in terms of looking at '08 versus '07 and talking about the competitive pressures that you're seeing in North America predominantly, can you talk about the split maybe between promotional spending and advertising? I think you did say advertising was up double-digit for the year. I guess in terms of looking ahead and in light of some of these competitive pressures, you do see that allocation between the two?"
},
{
"speaker": "Clayt Daley",
"text": "The businesses decide."
},
{
"speaker": "A.G. Lafley",
"text": "Each business decides what the right mix is for its business. I mean that is certainly not a decision we would ever try to make from our vantage point. The second thing I would say is we continue to invest in what I would call brand equity building, advertising and marketing activity. So yes, advertising is a part of that, but I think we're doing more online. We're doing more public relations. We're doing more event marketing. We're doing everything we can to be where she or he is most receptive to receiving the message and most responsive to trying. On the promotional side, we're trying to shift more and more of our promotion into proven trial-generating activity because we still have a fair amount of trial opportunity. And I guess the last thing I would say, we have talked for several quarters, maybe a couple of years about this, on both the brand support side and on the trade spending side, we're working real hard to improve effectiveness and efficiencies. We're now in our third or fourth year of running marketing, ROIs and marketing mix models for the brand support side, and we're now moving into a program. Recall we moved closer to the more flexible Gillette model for managing our trade funds and trade incentives with our retail partners. As part of this, we now are looking at something, I would call it trade spending effectiveness and efficiency modeling. So I think what you will see us do is we want to spend the dollar where we get a positive consumer reaction where the consumer purchases and the consumer tries. And we're trying to make sure that we funnel our money to the consumer either through the trade or directly in a way that is most effective and most efficient. Some businesses spend 30% to 35% of net sales on brand support. Some businesses spend 5% to 10%. It just depends on the industry that they are in and what is required to be competitive in that industry."
},
{
"speaker": "Operator",
"text": "Your next question comes from Lauren Lieberman - Lehman Brothers."
},
{
"speaker": "Lauren Lieberman - Lehman Brothers",
"text": "First off, Clayt, thank you for all the detail on the moving parts of '08 and also the priority on the process of the portfolio review. That was very helpful. But just following up on the topic of divestitures -- and I'm not going to ask you, of course, to name any specifics -- but just curious about a couple of things. One would be the business' tolerance for dilution. Two, would be the decision criteria for the businesses versus for the board. Third would be, are there any challenges out there given there are probably more assets for sale than there might have been a few months ago with the changes in the debt market?"
},
{
"speaker": "Clayt Daley",
"text": "Well, starting out, obviously as we said we go through a process with the board and then we go thorough our strategy reviews, and our criteria is really pretty simple. That is, if a business cannot deliver sales growth at least at the low end of our target ranges, if they cannot deliver at least upper single-digit operating profit growth, if it cannot deliver a CFROI, or TSR measure several hundred basis points above the cost of capital, then it becomes a candidate to exit the portfolio. Now we never sell a business because they have a bad year. We look at this over longer timeframes, three years, five years or longer. Of course, we have to be forward-looking. We have to look at their initiative plan, the market and the industry to say, is this a place we want to be longer term? So I think the decision criteria is relatively clear. Relative to dilution, of course, it is a consideration, but it is not a controlling factor. Although obviously we are going to want to execute anything we do in a way to minimize tax friction and dilution as part of that process. Because obviously what we want to do if we choose to exit a business is we want to build value for our shareholders by exiting the business and not destroy value. So that is really the way we are thinking about it."
},
{
"speaker": "A.G. Lafley",
"text": "Regarding the timing, Lauren, some of these assets are going to be even if they don't end up being core strategic for us, they are going to be core strategic for somebody else. There are good buyers for some of these assets."
},
{
"speaker": "Clayt Daley",
"text": "We're really not that worried about the market because most of the assets that we would be looking at disposing of would be highly likely to go to strategic buyers, and therefore, I don't believe what is going on in the credit markets first of all, it is not at all clear that that is a long-term phenomenon. I mean the credit markets could be in a very different place six months than they are today. But still I'm not sure it is going to be a big factor on our plans."
},
{
"speaker": "Operator",
"text": "Your next question comes from Justin Hott - Bear Stearns."
},
{
"speaker": "Justin Hott - Bear Stearns",
"text": "Maybe we could continue with the comments on the tactical battles and wars. Could you talk to us about that maybe on US diapers, with Pampers and Luvs versus their competitors, Wella professional and pet food? A second part, if you could give us any more clarity on what you're thinking on key commodities like oil, pulp and gas that would help too."
},
{
"speaker": "A.G. Lafley",
"text": "Well, I think I will maybe answer the last one first. We frankly had hoped that oil was going to moderate at a lower level than it is. But it has not. Now we have gotten some relief in natural gas, but the impact of natural gas is primarily a North American phenomenon, whereas, of course, oil and its derivatives are a worldwide phenomenon. As I mentioned earlier, that is one of the reasons in our mind of caution on this year because we had expected energy and raw materials to frankly moderate more this fiscal year than it looks like they are going to. Now, as we have said before, if pricing actions are appropriate, we're not going to be afraid to do that, and that is obviously something that we are going to have to review around the world in markets where we are the leader in the market. Coming back to the specific businesses, which I guess were diapers, pet and Wella Professional?"
},
{
"speaker": "Jon Moeller",
"text": "Baby is obviously a core business for us. It is a big business for us. Pampers just passed $7 billion in net sales this last year. The basic Pampers story is we have been holding our sure essentially in North America up a cent, flat, up a cent. We have been growing our sure again in Western Europe, and we're growing our share very strongly in developing markets. Our strategy on Pampers is to slowly but surely improve on our developed market position, 50 plus share in Western Europe, sort of 35 to 40 share in the US, and then to hard in developing markets. We have some interesting, affordable products for developing markets that have been doing pretty well. I think we have done well with our Baby Stages of Development line. Our key competitor came back with their comparable offering and has done reasonably well with that, and that is no surprise. We expected them to eventually come. And, as we have said, we have been doing well with this sort of Pampers entry product called Caterpillar Stretch. There is no doubt that Luvs has been a little bit weak, but we will have Stretch on Luvs. There is a segment that buys Luvs, and Luvs, frankly, provides us a little bit of cushion against private labels which are active in developed markets in that category. But I like the category. Rational competitors. It is a consumer-oriented business. It is an innovation responsive business, and it is a business where we get good retailer support. So I think it will ebb and flow. But I think what will happen is the two leading companies will continue to improve their relative positions. Pet, I mean let's face it, I think I have been very straightforward on this one. We had a very nice run from acquisitions for about five years, a very nice run. We ran to the point where we were the leading brand in the US retail market and that is good. And we have two good brands in Iams and Eukanuba. We stalled. Much of it was of our own doing. We were working on the program to get growing again, and we got hit with the China sourcing and contract manufacturer problem. unfortunately even though those wet and semi-moist products are a small, less than 10% of our product line weight, we, frankly, got hit pretty hard by it. I think we said in Jon's remarks, we have a couple of key initiatives going. We have been working with our retail partners. You're going to see a stronger Pet Care program out of it. I like the business. I like the market. Again, we have good competitors in the market. There is a place for us in the market. We are differentiated and unique, and that will end up being a good business for us. Wella is a tale of three cities. The Fragrance brands have been a nice little set of jewels. You know we integrated them faster than we thought we could into our own Fragrance business, and Gucci and Escada and those brands have been an important part of what we have accomplished in Fine Fragrances. So that has been a plus. The retail colorants business, we have been working our way up the learning curve. We now are in a position where we have totally integrated that business and in fact, we have integrated the R&D and innovation centers with the salon business. So you will see more from us in retail colorants. I talked about Perfect 10, which has already been sold into the trade. But you will see more from us on the innovation side in retail hair colorants and in styling where Wella was pretty strong. Wella is the styling leader in the salon business, and we have got some good assets there. The third piece is, of course, the salon business, and frankly, we're taking the approach to the salon business, the same approach to the salon business we are taking to Braun, which is get the cost structure right, get the thing operating well, and then when we have got an operating well and the cost structure right and the right people in place, you will see us start investing. So we have been comfortable with a slow top line growth rate. We have been working on improving the margins, and we have been working on getting into the right configuration, right organization and right program to grow going forward."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ali Dibadj - Sanford Bernstein."
},
{
"speaker": "Ali Dibadj - Sanford Bernstein",
"text": "In the context of this 50 to 75 basis point operating margin improvement yearly on top of Gillette, if we use maybe this quarter or two quarters as a jump off point. I'm just trying to get underneath this 110 basis points this time around. How much was from Gillette synergies, purchasing savings, the DC consolidations, and in particular I would love to get a lot more detail around the advertising spend as a percentage of sales. If I could throw in something separate but linked to that, a little bit more understanding on some of the trade spend issues?"
},
{
"speaker": "A.G. Lafley",
"text": "I think I will hit a couple on a high note. You're going to be better off talking to Jon about some of the other details. But our advertising spend has been very consistent at between 10% and 11% of sales for the company aggregate average. As I said before, we have some businesses in Beauty that run 30% to 35% of net sales. We have some businesses in the more commodity-like, but of course, we don't sell commodities, categories that are closer to 7% to 10% of sales. I will tell you, we are very consumer focused. We are very brand equity focused and very innovation program focused in our spending of brand support and in our spending of trade funds. On the trade fund side, I think also if you step back, I think we're somewhere around $9 billion to $10 billion all-in on each side. So we spend about the same amount of money on both. Of course, it varies by channel, it varies by geography, it varies by category. But our objective is very simple. We want to get leverage from our leadership in the strength of our brand equities, and we would like to be in a position where we are spending a little bit less as a percent of net sales and getting a lot more. Because we buy more efficiently, and frankly we should be executing more effectively. So that is sort of where we are in the advertising and trade side. In terms of the gross margin buildup, it is the same combination of factors with different weights in different quarters."
},
{
"speaker": "Clayt Daley",
"text": "There is, of course, as we said, the 50 to 75 ongoing program, I think we have talked about the things that will help make that happen. The Gillette synergies, of course, are showing up primarily in the SG&A line. I cannot really at this point decompose this thing for you the way you would like me to, other than to say that they are working together for us, and that is why we believe we're generating the overall margin improvement that we have."
},
{
"speaker": "A.G. Lafley",
"text": "I guess I will say one thing, and this won't surprise you, but on the SG&A side, we have grouped our businesses into three groups. There are businesses that are targeting half of sales growth, half of net sales growth for SG&A growth, and those are our growth businesses. There are another group of businesses that are holding their SG&A even to a year ago. They are zero overhead growth businesses. And then we have got a couple, and I think you can guess what they are based on my comments where we're focused on margin and getting the cost structure right, where we are actually asking them for negative overhead growth. As Clayt said, if we just do half of sales growth, we pick up the targets every year, and we've actually got our businesses on a combination of half at the high-end, zero for some and negative for a couple. So we should be in good shape. The other thing I will mention is we've very quietly begun, and we talked about this once before, an initiative called the future of productivity and growth, and we just really believe that we can be even significantly more effective on the deployment of our human resources. You will see there are lots of opportunities to eliminate some duplication between MDOs and GBUs to run more effectively and efficiently between MDOs and GBUs. There are real opportunities for more effectiveness and efficiency in our smaller countries, and that is smaller countries, I'm talking about like 74 countries, because we do 90% plus of our business in 16 countries. There are some real opportunities for more effectiveness and efficiency in our small brands. If 41 of our brands are 80% plus of our sales and almost 90% of our profit, that sort of tells you we have some real efficiency opportunities on the balance of a couple of hundred brands."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bill Chappell - SunTrust Robinson-Humphrey."
},
{
"speaker": "Bill Chappell - SunTrust Robinson-Humphrey",
"text": "Can you talk about competitive pressure? I'm just trying to understand as you look on the horizon the ability to do further price increases. With that in mind, what your outlook and the guidance for oil over the next year and resin and other costs?"
},
{
"speaker": "Clayt Daley",
"text": "Well, as I said earlier, if commodities have moved up and they have moved up significantly versus the last time there was pricing activity in the category, we will look to try to raise prices to recover commodities. The experience over the last two or three years is that has been successful about 80%, 90% of the time, and there have unfortunately been situations where based on various competitive dynamics of price increases that should have gone through have not. That is the way it is. As I said earlier as well, we do expect commodities to be up versus fiscal 2008 versus 2007. That should not be surprising because oil has found its way to the mid '70s and does not seem to be going down, and obviously that will work its way through the various things that we've purchased that are derivatives of oil. While we don't put out a specific forecast for any of these commodities, and I'm not going to do that today, we know that eventually the oil price will tend to work its way through a lot of these materials, and that is the way we have got to plan our business."
},
{
"speaker": "A.G. Lafley",
"text": "I think another way to think about it, Bill, is we do have pricing power with consumers as long as we keep offering superior value, and that is what we look at. We have pricing power with our retail partners. I guess the second thing I would say is as Clayt mentioned, in the more commodity influenced categories, for the most part it is fairly transparent. We are all looking at the same coffee bean prices or pulp prices or energy prices or whatever or resin prices. I think the pricing is pretty transparent. It is pretty orderly, and it is sort of the way it has always been. We try to offset some and we try to cover the rest. The third thing I will say, which is really important to understand, is a lot of our pricing comes from mix and trade-up. Our basic approach is innovation drives trading the consumer up to a better product that also represents better value, and as part of that trade up, we improve our gross and operating margins, and we effectively manage our pricing. That is a very important part of how we operate. That is why we have been so successful in Fabric and Home. That has sort of been the way it has been done in Oral Care. That is what happens in the Beauty and Personal Care businesses, and that works very well for us and for our industry."
},
{
"speaker": "Operator",
"text": "Your next question comes from Linda Bolton Weiser - Oppenheimer."
},
{
"speaker": "Linda Bolton Weiser - Oppenheimer",
"text": "Could we go back to the Beauty business for a minute? If my numbers are right here, it seems that the Beauty EBIT margin only increased for one of the four quarters in FY '07. Can you just give a little color on, is it that gross margin is increasing, but there is heavy spending to support the brands and so the EBIT margin performance is not as good, or is it isolated to particular parts or some of this fringe pruning that you have been doing? Can you just give a little more color?"
},
{
"speaker": "A.G. Lafley",
"text": "Yes, there are three things going on, Linda. One is we have increased our investment in advertising and in trial marketing behind a pretty active innovation program, and you have seen a lot of it. I mean all of the Hair Care upgrades, major upgrades we call Parthenon and Pantene, major upgrade on Head & Shoulders, the whole restaging of Herbal Essences, which is going very well for us. I mean Herbal Essences share in the US is now nip and tuck with Fructis. So big investments in Hair, big investments in Skin and investments across many of the beauty businesses, Fem Care for example. The second piece is obviously SK-II negatively impacted our margin. But that is a very high margin business. Every case we lose on SK-II has a margin impact. The third thing is they did get pressured on raw materials. People do not think about Beauty Care right away, but there's a lot of oil-based derivatives in the resins and in the surfactants. They are not as flexible a mixing and making process as Fabric Care, for example, where we can literally formulate as we go depending on what shows up in the market. So I think they have done a reasonable job. For the year Beauty's operating margin was up a tick, up sort of 10 basis points, and that is not really too bad when you consider the SK-II hit, the commodities and energy hit and the fact that we wanted to invest in innovation."
},
{
"speaker": "Clayt Daley",
"text": "In what are already industry-leading margins."
},
{
"speaker": "A.G. Lafley",
"text": "Yes, that is true."
},
{
"speaker": "Clayt Daley",
"text": "In many places well above competitive levels."
},
{
"speaker": "Operator",
"text": "Your next question comes from Alice Longley - Buckingham Research."
},
{
"speaker": "Alice Longley - Buckingham Research",
"text": "Could you quantify how fast your categories overall are growing in North America in the June quarter, compared to the growth for the year overall? Tell us if there might be any improvement in the first quarter, and if so, why, and does it depend on innovation?"
},
{
"speaker": "A.G. Lafley",
"text": "In aggregate, the markets grew about 2% in the June quarter. That is down from 4% over the previous six months and 5% over the previous 12 months, so there was some slowing. That is on a dollar basis. On a volume basis, they were sort of up 1% versus sort of 2% to 3% in the base periods. We don't know obviously what the markets will do in the quarter that we have just begun. As I said, we had a very good July. So that is at least a short-term indicator that the consumer is buying, because we don't know what our share is. All we do is know what we sold, right? Yes, innovation matters. Because innovation stimulates trade-up. To the extent that we get trade-up, we grow the dollar value or euro value or whatever value of the market. So basically the way to think about the unit volume market in most of our businesses, certainly in the household businesses as driven by household formation, household size and frequency of cap. The Beauty and Personal Care businesses, one of the reasons we like it is the unit volume consumption can be driven by regiment expansion and introduction of new products and new categories. As I said, the dollar value of markets can be driven by innovation, and that is why innovation is so important to us. It is not a big swing, but there was clearly a softening in the April/June quarter."
},
{
"speaker": "Clayt Daley",
"text": "The last thing we would say too is that we have had a phenomenon over the last couple of years where there has been a lot of price increases where sales growth has exceeded unit volume growth. And as price increases begin to become annualized, there has been and will continue to be some impact on market growth simply because there's probably less aggregate pricing going on in the marketplace."
},
{
"speaker": "Operator",
"text": "Your next question comes from Connie Maneaty - BMO Capital Markets."
},
{
"speaker": "Connie Maneaty - BMO Capital Markets",
"text": "Could you talk a little bit about what was driving your US Oral Care growth and what kind of changes we might see on store shelves once the planograms change in the next, say, three or four months?"
},
{
"speaker": "A.G. Lafley",
"text": "I would be happy to. Obviously it is mostly innovation. Pro-Health has been a very good innovation for us. It is exceeding our expectations, and we still have relatively very low awareness in trial rates. So there's a lot of upside ahead of us. I think as you have seen, we have been building out the Pro-Health offering for that segment of consumers on the dentifrice side but also on the rinse and the brush side. So that has been terrific. Interestingly, in addition to Pro-Health, we have also done well in the other segments. So the Whitening Expressions segment continues to do well. Scope continues to do well. We've put out a couple of botanical and herbal offerings, and after literally a couple of months, they are bigger than Tom's of Maine. So that was, frankly, a little bit of upside surprise for us. But I like our Oral Care program. We've got a very strong innovation pipeline in the market and coming to market. Oral-B is a fantastic asset. It is a great brand. We are behind on capacity, but we have got a number of exciting new products. We have a new entry-level power brush in market. We have a number of excellent new manual brushes coming to market. Gillette makes a great toothbrush, just a phenomenal toothbrush in terms of performance."
},
{
"speaker": "Clayt Daley",
"text": "Well, now Procter & Gamble makes a great toothbrush."
},
{
"speaker": "A.G. Lafley",
"text": "That is right. So that has been terrific. In terms of the in-store question that you had, I don't know if you have been out in stores, but our work with our key retail partners has been to make the Oral Care shopping experience a lot easier, a lot simpler and a lot more intuitive. So you will see a lot of resets, and you will see resets that are designed to improve the shopping experience for consumers. That is going to benefit everybody, everybody in the category. I think it is going to benefit Crest and Oral-B, and it is certainly going to benefit shoppers and consumers. So that is where we are headed."
},
{
"speaker": "Operator",
"text": "That is all the time we have for questions today. Gentlemen, I will go ahead and turn the conference back over to you for any additional or closing remarks."
},
{
"speaker": "Clayt Daley",
"text": "Thank you for joining us today. It has been a little over an hour-and-a-half and we appreciate your patience. As I said at the outset, John Chevalier, Jon Moeller and I will be around for the rest of the day to take any additional questions you have directly. Thanks again for joining us."
}
] | null | null |
PG | 3 | 2,007 | 2007-05-01 08:30:00 |
Executives | [] | null | null |
PG | 2 | 2,007 | 2007-01-30 08:30:00 | TRANSCRIPT SPONSOR :
Executives: A.G. Lafley - CEO Clayt Daley - CFO John Goodwin - Treasurer
Analysts: Amy Chasen - Goldman Sachs Bill Schmitz - Deutsche Bank Nik Modi - UBS Wendy Nicholson - Citigroup Bill Pecoriello - Morgan Stanley Lauren Lieberman - Lehman Brothers John Faucher – JP Morgan Jason Gere - A.G. Edwards Chris Ferrara - Merrill Lynch Sandhya Beebee - HSBC Connie Maneaty - Prudential Justin Hott - Bear Stearns Joe Altobello - CIBC World Markets Bill Chappell - SunTrust Robinson-Humphrey Alice Longley - Buckingham Research Steve Morrow - Cumberland Associates Jim Baker - Neuberger Berman Alec Patterson - RCM
Operator: Good day, everyone, and welcome to the Procter & Gamble December quarter conference call. Today's discussion will include a number of forward-looking statements. If you will refer to P&G's most recent 10-K and 8-K reports, you will see a discussion of factors that could cause the company's actual results to differ materially from these projections. As required by Regulation G, P&G needs to make you aware that during the call, the company will make a number of references to non-GAAP and other financial measures. Management believes these measures provide investors valuable information on the underlying growth trends of the business. Organic refers to reported results, excluding the impacts of acquisitions and divestitures, and foreign exchange where applicable. Free cash flow represents operating cash flow less capital expenditures. P&G has posted on its website, www.PG.com, a full reconciliation of non-GAAP and other financial measures. Now I would like to turn the call over to P&G's Chief Financial Officer, Clayt Daley. Please go ahead, sir.
Clayt Daley: Thanks and good morning, everyone. A.G. Lafley, our CEO, and John Goodwin, our Treasurer, join me this morning. I will begin the call with a summary of our second quarter results, John will provide additional perspective by operating segment, and I will wrap up with a brief update of the Gillette integration and our expectations for both the March quarter and the fiscal year. A.G. will join the call for the Q&A, and as always following the call, John Goodwin, Chris Peterson and I will be available to provide additional perspective as needed. Before getting into the results of the quarter, I want to remind you that the Gillette acquisition is now in the base period. This means that year-on-year changes in the Gillette business are now part of our organic growth comparisons. Now on to the results. We maintained good momentum in the second quarter of the fiscal year. We delivered balance top and bottom line growth, driven by a strong innovation program, ongoing focus on cost discipline and continued good progress on the Gillette integration. Diluted net earnings per share for the quarter were $0.84, up 17% versus year ago. This was $0.01 ahead of both the consensus estimate and the top end of our going-in expectations. Accelerating EPS growth was driven by solid sales growth, operating margin improvement and Gillette acquisition benefits. Total sales increased 8% to $19.7 billion. This was at the top end of our guidance range, driven by solid volume growth and better than expected foreign exchange benefits. Organic volume and sales were each up 5% at the midpoint of our long-term target range. Developing markets set the pace with double-digit organic sales growth. Blades and Razors and Fabric and Home Care led the segments with 8% organic sales growth. The Snacks, Coffee and Pet businesses were at the low end with 2% organic sales growth, but we expect results to improve for these businesses over the balance of the fiscal year. The December quarter was an important period for the Gillette integration, as it included the North American selling and business systems conversion. We're very pleased with the success of the integration, but as we mentioned at the analyst meeting in December, it was not perfect. We did experience some disruption last quarter in the Cleveland Tennessee distribution center that primarily affected the Duracell and Braun businesses. This was a one-time impact, and the issue has now been resolved. The Cleveland facility is back to shipping at target levels. More importantly, as a result of the systems integrations, we have now laid the foundation to accelerate earnings per share growth through cost and revenue synergies, as well as implementation of go to market reinvention. Next, earnings and margin performance. Operating income increased 12% to $4.4 billion. The operating margin was up 90 basis points versus year ago, driven by both gross margin and SG&A improvements. Gross margin improved 50 basis points to 52.9%. Cost savings projects, pricing and volume leverage more than offset an 80 basis point drag from higher commodity costs. While commodity cost increases slowed over the past few months, costs were still higher when compared to prior-year levels. Selling, general and administrative expenses decreased by 30 basis points behind overhead cost control, Gillette synergies and volume leverage. Non-operating were a modest drag on earnings growth due to higher interest expense. The tax rate for the quarter came in at 30%, down slightly versus year ago. We continue to expect the tax rate for the year to be at or slightly below 30%, in line with previous guidance. Now let's turn to cash performance. Operating cash flow for the quarter was $2.5 billion. This was down $125 million versus year ago due to an increase in accounts receivable. Accounts receivable increased during the quarter due to business growth, holiday seasonality, but most importantly temporary impacts related to the Gillette integration. The Gillette impact is primarily due to slower collection timing during billing systems conversions. We expect this to largely reverse itself by the end of the fiscal year, now that we have integrated billing systems in countries representing 95% of sales. Free cash flow for the quarter was $1.8 million. This brings free cash flow productivity to 75% fiscal year-to-date. We continue to expect free cash flow productivity to be at or above our 90% target for the fiscal year. Capital spending was 3.4% of sales in the quarter, below our 4% target. We repurchased $1.4 billion of P&G stock during the quarter as part of our ongoing discretionary share repurchases. To summarize, P&G continues to drive balanced top and bottom line growth. Accelerating EPS growth is being driven by sales growth, operating margin improvement and Gillette acquisition benefits, and we have taken a big step toward completion of the Gillette business systems integration. Now I will turn it over to John for a discussion of the results by business segment.
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John Goodwin : Thanks, Clayt. Starting with our Beauty business, sales were up 8%, led by fine fragrances that had organic sales growth in the mid-teens. In addition, the Hair Care, Skin Care and Feminine Care categories each posted solid volume growth for the quarter. The strong fragrance results were driven by new innovations such as Boss Femme, Lacoste Inspiration, Dolce & Gabbana's The One and the addition of the Dolce & Gabbana based business. In the Skin Care business, Olay grew volume high single-digits behind the success of the Definity launch in North America and continued leverage of Regenerist. Olay's value share of the U.S. facial moisturizers market is up more than 5 share points versus the prior year to 43%. On SK-II, we did resume shipments to a limited number of stores in China in December. However, the combined impact of the shipment's stoppage in China and public relations concerns in other Asian markets drove shipment volumes down by nearly 40%, which obviously hurt the segment results for the quarter. It will likely be several quarters before sales return to prior levels. In Hair Care our two biggest brands, Pantene and Head & Shoulders, led the top line growth. Pantene global volume was up mid single-digits behind continued leverage of the premium Restoratives and Color Expressions initiatives in North America and the base brand restage in several international markets. Head & Shoulders volume grew mid-teens behind the intensive launch in North America and brand restages internationally. In addition, Herbal Essences market share in the U.S. is up 20% versus pre-restage levels, and the brand will begin expanding the restaged lineup to more markets in 2007. Health Care sales were up 7%, driven by strong growth in personal health and pharmaceuticals. Personal health from pharma sales were up high single-digits behind strong Prilosec OTC results and pricing taken on Vicks and Actonel in prior periods. Prilosec OTC all outlet value share of the heartburn segment is up 2 points to nearly 40%. Oral Care delivered mid single-digits sales growth led by double-digit growth of the Crest franchise in developing markets. Russia led developing markets with top line growth over 20%, and China was up nearly 10% for the quarter. Crest toothpaste continues to grow market share in the U.S., despite significant promotion activity from an oral care competitor. All outlet value share for Crest is up nearly 2 points to over 37%, driven by the success of the Crest Pro-Health initiative. Also, the Oral-B Vitality Toothbrush initiative is off to a great start. Vitality drove Oral-B's share of rechargeable brushes to 55% for the quarter, up 4 points versus the prior year. Next in the household businesses, Fabric Care and Home Care delivered another very strong quarter with 11% sales growth. Sales grew double-digits in both Fabric and Home Care. The main driver of the top line results was continued leverage of product innovations, many of which launched in earlier periods but are still providing strong sales momentum. Several examples are Tide Simple Pleasures, Gain Joyful Expressions, Febreze Noticeables, several Swiffer upgrades and the Fairy auto dishwashing launch in Western Europe. In the U.S. Fabric Care business, the Tide, Gain and Downy brands led P&G to a value share improvement of more than a point to over 62% of the market. The Fabric Care business was also strong in developing markets with double-digit volume growth. Also in Fabric Care, the compaction test in Cedar Rapids, Iowa continues to progress well. Our business is fully converted to smaller bottles, and we are already gaining valuable insights that are helping us sharpen our communications to consumers in the store. In Home Care the top line growth is being led by the North American market with the Dawn, Joy, Swiffer and Febreze brands all posting volume growth of mid-teens or greater. In addition, the Fairy dish brand delivered double-digit growth in Western Europe; and Essential in Eastern Europe, Middle East and Africa regions. Febreze and Swiffer continue to post healthy market share gains in the U.S. behind the new innovations mentioned earlier. Febreze value share of the U.S. Air Care market is up nearly 4 points to 23%, and Swiffer's share of U.S. Quick Clean category is up more than 2 points to 87%. Turning to Baby Care and Family Care, the business delivered a solid quarter with sales growth of 5%. Strong Baby Care volume growth in developing markets and on the Pampers diaper business in the U.S. was partially offset by volume declines in Western Europe diapers and the Luvs brand in the U.S. Pampers delivered double-digit growth in leading developing markets, and Pampers diaper shipments were up high single-digits in the U.S. Pampers all outlet value share of diapers in the U.S. is in line with prior year at 28%. Volume share is up nearly a point behind the strong consumer response to our Pampers Baby Dry Caterpillar stretch initiative. Luvs U.S. volume and value share for the quarter improved sequentially following the launch of the Leakguard core initiative in September. However, earnings share is lower versus prior year, mainly due to low pricing strategies by private-label competitors despite increasing cost trends. In Western Europe, Pampers continues to hold leadership shares above 50%. However, we have recently seen significant promotion and pricing activity from both branded and private-label competitors, again despite increasing cost trends. We will continue to monitor our competitive position on the shelf to ensure that Pampers remains an excellent value for consumers. Snacks, Coffee and Pet Care sales were up 3%. Shipments were up slightly versus prior year levels for the segment as mid single-digit volume growth on the Coffee business was offset primarily by soft results on Pet Care. Snacks volume was in line with prior year levels. Folgers delivered strong share progress behind the Simply Smooth and Gourmet Selections innovations. Folgers' value share in the U.S. coffee market is nearly 32%, up 5 points versus a base that included the impact of Hurricane Katrina. Pringles delivered good top line growth in Western Europe behind successful products and commercial initiatives. These results were offset by a weak shipment period in the U.S. due to heavy competitive merchandising and a 4% contraction of the potato chip category. Pringles value share of the U.S. potato chip market is down about a point to 13%. In December the U.S. business launched the Pringles Select initiative, a line of four gourmet flavors of Pringles chips sold in a bag. This new premium line of Pringles has been very well-received by retailers and is gaining strong merchandising and shelving support. Blades and Razors delivered very strong sales growth of 11% in the quarter on underlying global consumption growth of 7%. The 4 point differential is due mainly to 3 points of help from foreign exchange. We continued to see strong results for Fusion in all markets where it has been launched. In the first year since launch in North America, Fusion has generated $400 million in retail sales. Fusion's share of the U.S. male razor market is now at 51%, and the share of male cartridges is at 29%. Fusion's shares of male systems in the UK, Germany and Japan are already at 24%, 17% and 10% respectively, after only five months in the market. Combined, Fusion and Mach 3 system share is up more than 4 percentage points in each of these markets. We are now in the process of expanding Fusion into 11 additional Western European markets: Australia, Korea, Singapore and Eastern Europe this quarter. Also, we will soon be launching the Fusion Power Phantom razor in North America. Phantom is the first new extension of the Fusion franchise and will provide the brand with new opportunities for merchandising and sampling to drive new trial. In addition, we are launching a new female razor, Venus Breeze, in North America this quarter. Venus Breeze will be our entry into the fast-growing convenience segment of the market. Its patented, built-in, flexible shave gel bars are a breakthrough technology that releases a light lather eliminating the need for a separate shave gel. In the Duracell and Braun business, reported sales were up 5%. Duracell's strong growth in developing markets was partially offset by a flat volume in developed regions. Latin America is a bright spot for Duracell with volume growth of 20% in the quarter. Mexico led the region with nearly 30% unit growth behind top line synergies from increased distribution in more high frequency stores. In the U.S., Duracell all outlet value share of general-purpose batteries is down about a point to 47%. The decline is driven mainly by heavy competitive promotional activity that coincided with the shipment disruption of special displays that are assembled in the Cleveland, Tennessee distribution facility. The temporary integration issue restricted our ability to field promotions during the important holiday period. Braun delivered solid growth in Northeast Asia and developing markets. In addition, Braun's new top-of-the-line Power Sonic shaver is delivering good results in Japan and Germany. Western Europe and North America results were lower versus prior year, primarily due to a difficult base period comparison that included the Tassimo launch. North America results were also negatively affected by lost holiday merchandising due to the distribution issues in the Cleveland facility and soft household sales in Western Europe. That concludes the business segment review. Now I will hand the call back to Clayt.
Clayt Daley: Thanks, John. I will start with a brief update on the progress of the Gillette integration. We remain on track with our commitment to return P&G to the pre-Gillette double-digit compound EPS growth trend by fiscal 2008, and we remain on track with both revenue and cost synergy targets. The integration continues to progress very well, thanks to the excellent work by all the Gillette integration sub-teams around the world. Let me highlight a few areas. During the December quarter, we completed the third integration wave. Specifically, we integrated billing systems, sales forces and distribution networks in 13 additional countries, including our two largest markets, the U.S. and the UK. Results were very good with the only notable issue being the Cleveland, Tennessee distribution center which we have already discussed. On January 1 we started the fourth and final major integration wave. Specifically, we are integrating an additional 22 countries representing about 15% of the business. These conversions have each gone very well without any significant business interruptions. After this round is complete, 95% of the business will be running through common billing systems, sales forces and distribution networks. This is roughly 16 months after the closing of the acquisition. The remaining countries will be transitioned over the next two quarters. As a result of the strong integration progress, we announced earlier this month that we will be making organization structure changes to fold Gillette into the existing management structure. Effective July 1 Blades and Razors and Braun will be managed as part of the Beauty and Health unit, and Duracell with be managed as part of the Household unit. We will continue our current segment reporting through the end of the fiscal year, and we will announce future segment reporting plans by the end of the fiscal year. In summary, we remain on track with both integration and acquisition economics. Now let's move onto guidance. For fiscal 2007 we continue to expect raw material and energy costs to be up versus fiscal 2006. At current levels, the amount of the increase should be even smaller than what we have seen in the past two years. As such, we expect cost-savings projects and volume leverage to partially flow through to higher gross margin over the next several quarters. While oil and natural gas prices have come down significantly from recent highs, it will take a number of quarters to translate into lower input costs, and there are a number of materials, such as pulp and agricultural commodities, where prices continue to rise. As such, we expect gross margins to improve more in the June quarter than in the March quarter. With this said, an environment with flat to declining commodity and energy costs is certainly a much better operating environment than we have experienced over the past two years. Specifically for the current fiscal year, we expect P&G to deliver its sixth consecutive year of growth at or above our long-term sales targets. Organic sales, which exclude the impact of foreign exchange and acquisitions and divestitures, are now expected to grow 5% to 6% for the year. This is an increase from our previous guidance of 4% to 6% due to a positive outlook for the remainder of the fiscal year. Within this, we expect a combination of pricing and mix to have a neutral to positive 1% impact. Foreign exchange is now expected to increase sales by 1% to 2%. Acquisitions and divestitures are expected to add 4% to top line growth. As such, we now expect all-in sales growth of 10% to 12% for the year, up 1% from the previous guidance range. Turning to the bottom line, we are raising our outlook for the fiscal year based on the strong EPS results in the December quarter. We now expect EPS to be in the range of $2.99 to $3.03, and we expect operating margins to improve by over 100 basis points driven primarily by gross margin. This includes Gillette dilution, which is now expected to be toward the lower end of the previous $0.12 to $0.18 guidance range. Gillette dilution is tracking better than expected due to strong results on blades and razors and good progress on cost synergies. We continue to expect the one-time items associated with the Gillette acquisition to be $0.06 to $0.08 per share, in line with the previous guidance range. Turning to the March quarter, organic sales were expected to grow 5% to 7%. Within this, price mix is expected to have a neutral to positive 1% impact. Foreign exchange is expected to add about 2%, resulting in estimated all-in sales growth of 7% to 9%. Turning to the bottom line, we expect operating margins to be up 50 to 100 basis points in the March quarter, driven by both gross margin improvement and SG&A efficiencies. As a result, we expect strong earnings per share growth due to good base business results and the ramp-up of Gillette cost synergies. Specifically, we expect earnings per share to be up 14% to 17% in the range of $0.72 to $0.74 per share. In closing, P&G continues to deliver strong results. We are making good progress on the Gillette integration and executing with consistency and excellence on the established business. A.G., John and I would now like to open the call up for your questions. As a reminder, we will be limiting each person to one question before moving on to the next caller with the objective of completing the call by 9:45. Feedback in our last call indicated a lot of positive comments about moving to this more rapid format in the questions. Thank you.
Operator: Thank you. (Operator Instructions) Your first question comes from Amy Chasen - Goldman Sachs.
Amy Chasen - Goldman Sachs: I just wanted to clarify some of your comments about the Gillette dilution coming in at the low end of the $0.12 to $0.18. Does that mean that you feel that the cost synergies from Gillette, the $1 billion to $1.2 billion could ultimately be low as well?
Clayt Daley: Well, we have not revised our projections for the long term. What we have said is the 1.0 to 1.2 range is still the range. We had previously said we thought we were going to end up at the top end of that range. Of course, during the current fiscal year, what we are really seeing is we're getting some of those cost synergies in a little bit quicker than we had originally planned, and that certainly is good news in terms of the longer-term prospects for the Gillette business. But we still think it is a little bit early to try to consider revising that long-term range.
Operator: Your next question comes from Bill Schmitz - Deutsche Bank.
Bill Schmitz - Deutsche Bank: Can you just give us a little more detail on the Gillette charges in the quarter? Specifically how much is in gross margin, how much is in SG&A, what the actual number is, and then maybe some help on the segment side? Only because if I look at the gross margin and pro forma for last year, it looks like it was actually down year over year, excluding the inventory step-up in the year-ago quarter.
Clayt Daley: Bill, what we're probably going to have to do is call you later on some of that. Clearly everything that is associated with Gillette will be in the dilution numbers. There are some things associated with Gillette that are booked in the corporate segment, not in the Gillette segment, but I don't think it is really material from the year-ago period. But we really ought to call you back later and give you a more quality answer to that.
Operator: Your next question comes from Nik Modi - UBS.
Nik Modi - UBS : Good morning. Just a quick question in terms of go to market reinvention and the tests that you were starting in Spain. Now with a few quarters under your belt there, can you give us some perspective on what is going on?
A.G. Lafley: We're still on track. We're starting to roll out. Spain has actually been one of our better performers in Western Europe over the last six months. As we talked at the analyst and investors meeting in December, go to market reinvention is a multi-faceted, multi-year initiative for us, so you will see us begin to roll it out in various countries with various channels and with various customers. We still believe that there is significant potential to improve the top line, the cash and the profitability of the way we go to market.
Operator: Your next question comes from Wendy Nicholson - Citigroup.
Wendy Nicholson - Citigroup : Hi. I actually had a question about the Pet Care business. I know it has been struggling for a little while and you made a management change, but it sounds like it was down again year over year in the second quarter. So can you talk about what is going on there and when we should start to see a tick up?
A.G. Lafley: You are right. We changed the management team, and we have got Rob Steele and a very good team in the seat. We spent the last six months basically taking the industry and the business apart. We have set goals, we have a new strategy, and you should begin to see the innovation in the marketplace. We have announced the new moves on Eukanuba. I think you will see activity on the Iams brand, and you will see strong innovation and strong initiatives in both the pet specialty channel and in the broad mass merchandising channel. When you step back, these are still two great brands, Eukanuba and Iams, with real equity with consumers. We have a strategy that now differentiates them for the different channels and customers, and frankly, we have got the innovation rolling again in 2007. It is a very attractive category, structurally attractive, attractive from a growth standpoint, so we are optimistic about it. We look at it as an opportunity.
Operator: Your next question comes from Bill Pecoriello - Morgan Stanley.
Bill Pecoriello - Morgan Stanley : Good morning. You lowered the Gillette dilution estimate to the lower end of the $0.12 to $0.18 range, so you only flowed through a $0.01 of the upside in the full year. So were there any specific initiatives you could talk about for the reinvestment to talk about that difference? Is it higher spending in some of the competitive categories like Oral Care and Baby Care, or are you reaccelerating growth in categories such as Beauty and Health?
A.G. Lafley: Look, the simple way to think about this is we have been working for six or seven years now to build a robust innovation and initiative portfolio. Again, as we mentioned in December, every year we have built the size, we have built the strength, and we have built the success rate of this innovation portfolio. As you look at it, right now a little more than half of our innovations are succeeding when they go to market. We're delivering virtually 100% of the value creation that we set out to deliver for the whole portfolio. The successful initiatives are 70% plus of the incremental going in OS we generate, so it is working pretty well. But we still have one big opportunity, and that is the trial rate. Many of our innovations, even innovations that were introduced two or three years ago, still have significant upside trial potential. I think we have been pretty clear that we have gone back in the U.S. and we have resampled Fusion. We've got a shaving system that is an 86% conversion rate. If a man tries and shaves with a Fusion system, 86 out of 100 will convert to purchase and use. We have an Olay Regenerist and Olay Definity with a lot of upside. We have an Oral Care Pro-Health with a lot of upside. We have in Hair Care a lot of upside on all of our major brands: Pantene, Head & Shoulders, Herbal Essences. Prilosec, we have been out three years, we have a 40 share. There is still a lot of upside in Prilosec. So we want to make sure that we have the flexibility to do the activity on the brand in the category in the market where we still have trial opportunity. Frankly, that is the single biggest opportunity for this company, and it is a significant amount of upside. So we're going to try to realize some of it.
Clayt Daley: I will just make one other clarifying comment. Since we originally put out the $0.12 to $0.18 range on Gillette, obviously our guidance has moved up a lot more than what we're moving up right now. So we have seen the Gillette numbers trending positive throughout the year. It is just now is the point at which we were confident enough to go ahead and say that we are going to be in the lower end of that range.
Operator: Your next question comes from Lauren Lieberman - Lehman Brothers.
Lauren Lieberman - Lehman Brothers : I just wanted to ask about the margins in Batteries and Braun. That was a huge change, and given that you mentioned there was actually some disruption, what is driving this positive variance there? Is it a step change? What is going on there? Just to follow-up on all the questions on Gillette dilution, what was the Gillette dilution this quarter?
Clayt Daley: I think the story really there is there was an inventory write-off in the base period. That is the first quarter after we closed we do the normal acquisition accounting and the inventories are written off. So we had an unusually high cost of goods sold in the base period as that inventory was shipped out. That is the biggest reason why there is this large year-to-year comparison. But, on the other hand, I want to tell you I think that there is cost synergies starting to flow into this business too, and we're starting to see the benefits flow into this business on the integration process. So I don't want to discount the importance of that either. But the magnitude of the move is very much driven by the base period inventory write-off impact.
Operator: Your next question comes from John Faucher – JP Morgan.
John Faucher - JP Morgan : Good morning, everyone. I was wondering if you could talk a little bit about how you view your portfolio and maybe some decisions that may need to be made down the road, particularly as you look at Beauty where I would say the businesses you guys really like are growing in line with your expectations and maybe some of the businesses you're a little bit less fond of not growing quite so quickly? Do you think you need to make changes in the portfolio, or is it a question of just getting through some tough periods and getting some of these businesses down to baseline levels? Thanks.
A.G. Lafley: A great question because we're always looking at our portfolio and how it is performing industry by industry, geography by geography. The first thing I would say is we clearly want to look at Health Care as an engine of growth, and I think you saw a couple of the experiments that we're going to run in the joint ventures that we announced this month. We're in a joint venture with Inverness to do in-home diagnostics. We were pretty certain that consumers, moms at home want to take more control over their and family's health, and we think home diagnostics is a growth area and one that we want to learn more about. We also entered a joint venture with MD VIP, which is a concierge health care service where for an annual fee you and/or your family get really first-rate health care, 24X7 service from your primary care doctor group, a first-class physical and nutritional advice, physical fitness advice, all kinds of things. This is a model we want to learn more about. The first thing I would say is, if you look at our current portfolio, the one area where we are continuing to experiment and where we are continuing to broaden and deepen and learn is Health Care. Because if you just look at the dynamics around the world, you look at demographics driving it, and when you look at the cost of Health Care, it is going to be huge, and P&G has got to play in a bigger way there. The second thing I would say is, hey, we basically are pretty comfortable with the portfolio that we have right now. Where we had a little bit of underperformance in this quarter it was, frankly, shame on us. I mentioned Pet Care. We got a bit behind. But we love the industry, we like the category, and we think we've got the brands and the innovation program and the organization to succeed. Snacks and Coffee, we have talked a lot about before. Coffee is really back on a positive trend. We've got a great position and we are focused. We are in the North America market, and we are the North America market with the leading brand. Pringles, all I can say is we have got a strong innovation program over the next 12 to 18 months, and we're going to have to see how it performs. But if it performs the way we expect it to, it is going to be good. Last but not least, if you look at our Beauty business, it has been performing. We benchmark the best beauty care companies in the world. Over the last several quarters, our organic sales rate is right there with L'Oreal quarter by quarter, and cumulatively we generate very good margins in that business. We have great brands, and we have phenomenal innovation. Fabric and Home Care, incredibly strong position. We like the industry. We see growth in the industry. And our paper business, again, we know what our strategy is. We know how we want to play, and we think we have plans that will improve our performance over the next year. So yes, we are always looking at the portfolio. If something ends up where it can’t perform, we do shed it. We have shed a number of small brands over the last several months that either don't fit strategically or haven’t been performing, and we will make the choices. I can guarantee that. We will make the right choices for the consumer and the shareholder and the company.
Clayt Daley: I think we have been very clear that we have minimum sales, earnings and CFROI thresholds, but we do look at the businesses over a period of years. Because we're in this for the long term and we make those decisions over time.
Operator: Your next question comes from Jason Gere - A.G. Edwards.
Jason Gere - A.G. Edwards : Good morning, guys. A question for you on promotional spending. I know that the last couple of years we have been hearing about cutting the gross to net spending and becoming more efficient there. But certainly we have heard in certain categories some of your competitors are getting a little bit more promotional. If you think about pricings rolling off and if you look at the channel, the volume has not been all that strong. Is this the case now that you might have to start fighting fire with fire to some degree?
A.G. Lafley: It is always an issue of consumer value and how strong is our brand equity and how strong is our innovation program? We're just trying to strike the right balance. I hope it was clear in our remarks about Baby Care that we have been very patient because there has clearly been pressure on the commodity cost side. We have led pricing in North America and Western Europe, modest pricing, from a consumer and customer standpoint. But if we continue to see in this case, it is mostly retailer brands and private labels that have not recovered the pulp and other related costs, then we will take the appropriate action. We will take the appropriate action, but we will do it selectively by country, by channel, by customer; because in the end, we have to offer superior consumer value. You are right in our mix of categories now and given some of the restructuring that some of our competition is doing, there is some more spending. But I think I have said many times before -- and I deeply believe this -- that if all that spending just goes into temporary price reduction and the fundamental brand equity or product is not improved in a meaningful way for consumers, it is like a snake swallowing a frog. When the meal is over, the snake is still lying there and it is still the same size, and you have not done anything for the future of your brand. So I guess the simple way to think about it, it is the advantage of a balanced portfolio. We're trying to be very balanced and very patient and very strategic and occasionally tactical, but our eyes are on the consumer first. Our eyes are on the consumer first, and if we deliver the consumer value, we're going to be okay.
Operator: Your next question comes from Chris Ferrara - Merrill Lynch.
Chris Ferrara - Merrill Lynch : Can you talk a little bit about any potential changes in the trade promotion allocation practices that come along with the go to market reinvention? Have you guys experimented there at all in any geographies across the globe?
Clayt Daley: Well, it is not so much experimentation I think as it is a system that is clear in terms of what specific performances we will pay for, how much we will pay for them, frankly, from the ability to customize our program much more for what the retailers want to run in their stores across all classes of the retail trade. So it really amounts to more flexibility and more ability to pay for the kinds of things that move individual businesses, because our businesses are driven off of different types of activities depending on whether you are in Blades and Razors or Beauty Care or some of the household businesses. Our program is much easier to tailor to our individual businesses in what has now become a relatively diverse portfolio than it was in the past.
A.G. Lafley: Chris, your question relates to Jason's question because the move to what we call key business drivers, what specific customer activity in the store drives the brand's business in its category? Those key business drivers, the flexibility that Clayt mentioned, all enable us to differentiate better with individual customers, and they enable us to be more effective and more efficient. It is the same thing on the advertising side as we have been trying to explain. We can be more effective and more efficient because we can differentiate better, we can target better and we can give either the consumer or the customer the incentive she or he wants to move their business and our business together.
Operator: Your next question comes from Sandhya Beebee - HSBC.
Sandhya Beebee - HSBC : Good morning. I was wondering if you could give some color on the developing markets because there was a concern this time last year that maybe it slowed down. From your comments, it seems like things are back on track again. How much of the benefits that we're seeing in the developing markets are coming from Gillette?
A.G. Lafley: Well, developing markets we are counting on for double-digit organic sales growth and they delivered this quarter. They are all in pretty good shape. I would say CEMEA has been a star, a real standout. But we have come back in China. We are in good shape in what we call AAI, which is sort of Southeastern and Southern Asia, and in L.A. So we feel good about developing markets. We're still underdeveloped in developing markets. They are driven by demographics and by economics. That is where the babies are born. That is where the households are forming. That is where incomes are rising, and that is where there is a lot of under-consumption. So I think they are going to be good for our industry for many years. Regarding Gillette again, as we have said before, we are moving through the distributor rationalization and it is going pretty well. I think we mentioned in the fall comments that we're getting Gillette distribution in what we call high frequency stores, and that will continue. The example we cited today was Duracell, but our biggest channel in the world is these high frequency stores in developing markets. That is the biggest customer segment that we have, and we still have a lot of opportunity to grow there. So we remain pretty bullish on developing markets. The last thing I would say is we think we added about 1 billion consumers to P&G's -- ever purchased and used the P&G brand -- base over the prior six or seven years. We think we can add another 1 billion consumers over the next three to five years, and most of them are going to come from developing markets.
Operator: Your next question comes from Connie Maneaty - Prudential.
Connie Maneaty - Prudential : Good morning. You mentioned that you thought raw materials were creating a better cost environment than you have seen in the class couple of years. Could you talk about how the dynamics change in the way you purchase raw materials in this part of the cycle?
Clayt Daley: Well, I think that we have gone to a system of purchasing in global spend pools. So our purchasing people are looking around the world for how to execute our buys. I think during this period, not surprisingly, as raw material costs went up dramatically, we shortened up some of our positions versus some very long-term contracts that we had prior to the spike, and now hopefully that will mean as things have flattened and hopefully they will begin to go down in the next six, nine, 12 months, we will be in a position to capture that benefit. Having said that, of course, while we think that we have purchased very well, if prices go down broadly in the marketplace, there may be some give back to the consumer. So we are not planning on building a lot of gross margin as material prices cycle down. As I said before, it is sure a heck of a lot better operating environment when things are flat to down than it was when they were going up every month.
A.G. Lafley: The other thing that helped us is going through the crisis when we had not only higher prices, but a real shortage of certain materials; we have learned how to formulate very fast and very flexibly. We are now plugged into parts of the world and to suppliers that we did not previously have relationships with or strong relationships with. So I feel like we now really play on a true global basis with the supply that is available in the world, and I feel like we are much more agile and much more flexible, and that is going to help us.
Operator: Your next question comes from Justin Hott - Bear Stearns.
Justin Hott - Bear Stearns : Your prepared remarks reference the success of Crest Pro-Health. Could you talk a little about that?
A.G. Lafley: On the one hand, we're very pleased with the start of Crest Pro-Health. On the other hand, it is a classic example of trial opportunity that I talked about earlier. We're off to a good start. I think we are a 5 plus share in the U.S., which is the lead market. We have obviously grown the total Crest franchise a couple of points in the U.S. to 37 or so. The early consumer reaction has been very positive, so the right consumers are buying the brand and product line, including the rinse, for the right reasons. The rinse has enabled us to double our rinse position. Customers have been pretty pleased with Pro-Health because it has been some incremental business and some trade-up business for them. I think we all see this as a multi-year long-term initiative, and you will see us develop Pro-Health because there is a segment of consumers out there that clearly are more interested in the therapeutic benefits. If you have tried the product or tried the rinses, they really are unique versus anything else that is available in terms of the oral care experience and the oral care end result. We have done all this despite basically our major competitors have thrown everything but the kitchen sink at us. They have grown, but we have grown too, which is, as I have said several times, is what is really going to happen in the Oral Care category, is the two leaders are going to continue to grow because they are the ones that understand the science, they are the ones that invest in the technology. They are the ones that are closer to the consumer and have the brand. So I think this is the first chapter in a multi-chapter book, and we're going to be talking about Pro-Health for a long time. It is not just going to be a quarterly event.
Operator: Your next question comes from Joe Altobello - CIBC World Markets.
Joe Altobello - CIBC World Markets : Thanks, good morning. My first question is on something that A.G. said earlier to another question regarding your recent transactions. You mentioned MD VIP and Inverness obviously. You also did an acquisition of HDS, and I was curious; it seems like you have been a little more active than usual. What is the rationale and strategy behind these moves, and should we expect more of these going forward?
A.G. Lafley: Well, Joe, the rationale is from little seedlings grow big oak trees. I mean there is nothing more than that, and we have taken some small positions -- which actually we would prefer to do. I don't think people believed me, but I have said after three medium to large-sized acquisitions, we really prefer small acquisitions. But we really do because it gives us time to learn, it gets us in early in the formation of the new category or segment. So we have taken a couple of Health Care positions. We took a couple of positions in Beauty Care, and we took a position in portable power. They are all important to us. They are all strategic for us. So I think the fact that they have all got announced in January sort of reflects that some were on different timing, some took a little longer than others to put together. They are also great examples of our openness and our whole connect and develop philosophy and practice with innovation. We're quite prepared to work with the entrepreneur or the inventor or the technologists or whomever has the idea. And I think that you are seeing that more of these parties are comfortable working with us, and I think that is really important. We have said a number of times our strength is develop, qualify and commercialize. We're good inventors, but there are a lot of other good inventors in the world. So if we can tap into the invention that is available in the world, we think we're pretty decent at developing, qualifying and commercializing.
Operator: Your next question comes from Bill Chappell - SunTrust Robinson Humphrey.
Bill Chappell - SunTrust Robinson Humphrey : Good morning. A quick question on the commodity costs impacting the quarter. Is there any way to handicap how much that was related to energy, be it natural gas or oil? On a go-forward basis, I don't think you provided any update. You said last quarter was like a $0.02 to $0.03 benefit from lower commodity costs. Is that still the same number for fiscal '07?
Clayt Daley: Last quarter we said I believe that the July-September versus the same period a year ago was 100 basis points, and that is 80 basis points in the October-December quarter. So the incremental impact is somewhat less. Last quarter we did raise guidance and attributed some of that to an improved commodity environment, but we did not put any specific number with that. It was in the general context of improving our guidance for the year. This one has proven to be very difficult to forecast with any precision because a lot of these commodities, a lot of these materials have relatively long supply chains coming through, and we are just in a wait and see mode. There is really no change versus the last quarter due to the lapping impact of any major consequence. But we are cautiously optimistic. I mean this has been unprecedented run-up in costs. Frankly, I really think the Company has accomplished a lot by delivering its earnings numbers in the face of this unprecedented run-up in commodity costs, and now we will hopefully be able to extract some benefit as things cycle over. At least we are not going to be in a mode of needing to raise prices, and raising prices in the marketplace is always disruptive.
Operator: Your next question comes from Alice Longley - Buckingham Research.
Alice Longley - Buckingham Research : What was your growth in North America? Was it roughly in the mid single-digits, and was that pretty much all from price and mix?
Clayt Daley: It was low to mid single. Yes.
Operator: Your next question comes from Steve Morrow -Cumberland Associates.
Steve Morrow - Cumberland Associates: Yes, there was a big shift in your debt classification from long term to short term in the quarter. Can you just highlight what was behind that and if you are planning to come to market at any time soon to term out some of that short-term debt?
Clayt Daley: We will let the Treasurer handle that one.
John Goodwin : Yes, when we made the Gillette acquisition, we announced that we had a bank facility in order to execute the share buyback and that we would gradually convert that into a market-traded debt. During the period we issued some commercial paper, about $10 billion of commercial paper, which paid down some of the debt facility, which had been previously categorized as long-term debt. So that is really the shift; it shouldn’t really be seen as any position on the market. It is just we're going through that process of converting the facility into the combination of CP and bonds.
Operator: Your next question comes from Amy Chasen - Goldman Sachs.
Amy Chasen - Goldman Sachs : I just wanted to know of your new guidance what your assumptions on both oil and currency have been? And if they stay at current levels, whether that gives you even more flexibility than what you have already raised your numbers to?
Clayt Daley: Currency is not a big impact on our numbers because we are net-net not that exposed. We're obviously exposed on the sales line. We're less exposed on the earnings line. Although with Gillette now in the portfolio, we are a little bit more along European currency than we were before. The commodity cost environment, I think what we have done is we have assumed that there will be some softening in commodities that will have much more of an impact on April-June than it will on January-March. But we also, as I think we have said, need to be cautious about how much of that we can bring to the bottom line. Because, as we know particularly on the Household side, private labels tend to buy on spot and those prices tend to go down with commodities. And then, of course, as we alluded to earlier in a number of our businesses, we have to watch our price spreads very carefully versus private-label and also then branded competitors tend to discount down some of that as well. So we think we are in a balanced position right now where we have assumed some benefits by the end of the fiscal year, but we're hopefully realistic in terms of what will happen in that time period, and we are obviously now focusing on what we think next year is going to be, and we will be providing our initial thoughts on next year in our call three months from now.
Operator: Your next question comes from Jim Baker - Neuberger Berman.
Jim Baker - Neuberger Berman : Yes, last quarter you said there were about $0.05 to $0.06 of Gillette dilution, of which you characterize about half of that or $0.03 as one-time. I just wanted to know those numbers for this quarter.
Clayt Daley: We indicated that we would provide quarterly dilution numbers through the first year. Now that we are into year two we're not going to be disclosing dilution numbers by quarter, other than to say that we said $0.12 to $0.18. We are now saying it is going to be in the lower end of that range. You can assume that the numbers get a little bit better throughout the year, so that early in the year the dilution is going to be a little bit higher than it is going to be late in the year. But as you know, with those kinds of numbers, we are talking about dilution of in the $0.03 to $0.04 range in a quarter. It is just not really on a quarterly basis that big of a number, and I think we also updated the fact that the one-time component of that, it was I believe $0.06 to $0.08 and that has not changed. So hopefully that will give you some direction there.
Operator: Your next question comes from Lauren Lieberman - Lehman Brothers.
Lauren Lieberman - Lehman Brothers : I just wanted to follow-up on Baby Care in Western Europe. I know you have talked a little bit about competitive activities. But my sense has been that that has been your primary branded competitor’s intention for a year to two already of stepping up their spending there. So are you seeing that they are having a bigger impact on the market because something has changed in their product portfolio; their marketing is just a little bit sharper? So what were the dynamics, and how are you thinking about approaching that going forward?
A.G. Lafley: Lauren, it is this simple. Both our branded competition and the private labels are discounting more and spending more on promotion. Probably our toughest competitor in Western Europe has been the Tesco private-label brand. In several markets across Western Europe, we have seen a big increase in promotional spending. As I said earlier, we're literally working country by country, channel by channel, customer by customer to make sure that we have got our consumer value right. Our share is holding well above 50%. We have gained a little bit of ground, but we thought that it was prudent and that we were being patient because we know Ontex, which is the big private-label manufacturer in Europe, has been trying to put their prices up, and we know what the commodity cost picture is for them and for us. We can take their diapers apart diaper by diaper.
Clayt Daley: With the prices of pulp in the super absorbers, other materials that go into diapers, there has been a lot of cost pressure that has not come through in the higher pricing. So some of what is going on is not really economically rational.
A.G. Lafley: So a lot of what we're trying to do, is we're trying to not just manage this month or this quarter, we're trying to put ourselves in a position where we want to be six, 12, 18 months from now. So what you have seen from us is you have seen continuing innovation. We're now innovating at the opening price point range, our Baby Dry line, and we're innovating across our Baby Stages of Development. You will just see us continue to innovate and continue to add value and continue to watch the price spreads. But you're right. There is no doubt that there has been more spending in Western Europe on baby diapers.
Clayt Daley: We're going to take just a couple of more questions.
Operator: Your next question comes from Alec Patterson - RCM.
Alec Patterson - RCM : Clayt, on the cash flow, I just wanted to get some perspective on the full year as you swing around the receivables numbers. Could you give a read on where you think working capital ends for the year and then also the CapEx as a percent of sales?
Clayt Daley: Well, you're right. Of course, as we know, the October-December quarter on the cash flow is typically every year a low point. As I said, I expect the free cash flow, which is operating cash flow minus CapEx, to be we still think 90% or better of earnings for the year. That is going to come from the receivable situation should be largely mitigated by the end of the year. It is a temporary phenomenon. The CapEx should come in at 4% of sales or less for the year. As you know, with the terrific progress we have made on capital expenditures now, the CapEx and the D&A have largely converged. So really the 90% target for cash makes some allowance for increase in working capital because it is a reality. As the business is growing, we will have to add working capital. We are obviously working on inventories. We're going to be trying to work on getting the receivables back down, but realistically you cannot grow the business without some increases in working capital, and that is why we have established a target where we have.
Operator: Your final question comes from Alice Longley - Buckingham Research.
Alice Longley - Buckingham Research : Is it true that for the Blade division we should look for a little bit of a tough comparison in the March quarter and then maybe quite an easy comparison in the June quarter?
Clayt Daley: I think you have got it about right. Obviously, in the March quarter we have got the Fusion launch in the U.S. in the base, and we're going to be coming off a couple of big launches in Europe. So I think that is a reasonable proposition.
Alice Longley - Buckingham Research : Since you have given us the same guidance for sales in the March quarter as we got in the December quarter and Blades might be up less, what other sector might be up more?
Clayt Daley: Well, I think what we said before is some of the things were in the October-December quarter, the organic growth rates were lower, and we have already talked about those. We expect to begin to see some rebound on those, and that is what we will wrap the call up on because you have raised a good point. That is the beauty of the portfolio is the breadth and depth of the portfolio both from a product standpoint and a geographic standpoint gives us the ability to make our numbers. Yet, on any given quarter, we're going to be getting a little bit more from one business and maybe a little bit less from another. But it all works out in the end. On that note, I would like to thank everyone for joining us today, and as I said at the outset, John and Chris and I will be around the rest of the day for any follow-up calls, and we appreciate you joining us today.
Operator: With that we will conclude today's conference.
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{
"speaker": "TRANSCRIPT SPONSOR",
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{
"speaker": "Executives",
"text": "A.G. Lafley - CEO Clayt Daley - CFO John Goodwin - Treasurer"
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{
"speaker": "Analysts",
"text": "Amy Chasen - Goldman Sachs Bill Schmitz - Deutsche Bank Nik Modi - UBS Wendy Nicholson - Citigroup Bill Pecoriello - Morgan Stanley Lauren Lieberman - Lehman Brothers John Faucher – JP Morgan Jason Gere - A.G. Edwards Chris Ferrara - Merrill Lynch Sandhya Beebee - HSBC Connie Maneaty - Prudential Justin Hott - Bear Stearns Joe Altobello - CIBC World Markets Bill Chappell - SunTrust Robinson-Humphrey Alice Longley - Buckingham Research Steve Morrow - Cumberland Associates Jim Baker - Neuberger Berman Alec Patterson - RCM"
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"speaker": "Operator",
"text": "Good day, everyone, and welcome to the Procter & Gamble December quarter conference call. Today's discussion will include a number of forward-looking statements. If you will refer to P&G's most recent 10-K and 8-K reports, you will see a discussion of factors that could cause the company's actual results to differ materially from these projections. As required by Regulation G, P&G needs to make you aware that during the call, the company will make a number of references to non-GAAP and other financial measures. Management believes these measures provide investors valuable information on the underlying growth trends of the business. Organic refers to reported results, excluding the impacts of acquisitions and divestitures, and foreign exchange where applicable. Free cash flow represents operating cash flow less capital expenditures. P&G has posted on its website, www.PG.com, a full reconciliation of non-GAAP and other financial measures. Now I would like to turn the call over to P&G's Chief Financial Officer, Clayt Daley. Please go ahead, sir."
},
{
"speaker": "Clayt Daley",
"text": "Thanks and good morning, everyone. A.G. Lafley, our CEO, and John Goodwin, our Treasurer, join me this morning. I will begin the call with a summary of our second quarter results, John will provide additional perspective by operating segment, and I will wrap up with a brief update of the Gillette integration and our expectations for both the March quarter and the fiscal year. A.G. will join the call for the Q&A, and as always following the call, John Goodwin, Chris Peterson and I will be available to provide additional perspective as needed. Before getting into the results of the quarter, I want to remind you that the Gillette acquisition is now in the base period. This means that year-on-year changes in the Gillette business are now part of our organic growth comparisons. Now on to the results. We maintained good momentum in the second quarter of the fiscal year. We delivered balance top and bottom line growth, driven by a strong innovation program, ongoing focus on cost discipline and continued good progress on the Gillette integration. Diluted net earnings per share for the quarter were $0.84, up 17% versus year ago. This was $0.01 ahead of both the consensus estimate and the top end of our going-in expectations. Accelerating EPS growth was driven by solid sales growth, operating margin improvement and Gillette acquisition benefits. Total sales increased 8% to $19.7 billion. This was at the top end of our guidance range, driven by solid volume growth and better than expected foreign exchange benefits. Organic volume and sales were each up 5% at the midpoint of our long-term target range. Developing markets set the pace with double-digit organic sales growth. Blades and Razors and Fabric and Home Care led the segments with 8% organic sales growth. The Snacks, Coffee and Pet businesses were at the low end with 2% organic sales growth, but we expect results to improve for these businesses over the balance of the fiscal year. The December quarter was an important period for the Gillette integration, as it included the North American selling and business systems conversion. We're very pleased with the success of the integration, but as we mentioned at the analyst meeting in December, it was not perfect. We did experience some disruption last quarter in the Cleveland Tennessee distribution center that primarily affected the Duracell and Braun businesses. This was a one-time impact, and the issue has now been resolved. The Cleveland facility is back to shipping at target levels. More importantly, as a result of the systems integrations, we have now laid the foundation to accelerate earnings per share growth through cost and revenue synergies, as well as implementation of go to market reinvention. Next, earnings and margin performance. Operating income increased 12% to $4.4 billion. The operating margin was up 90 basis points versus year ago, driven by both gross margin and SG&A improvements. Gross margin improved 50 basis points to 52.9%. Cost savings projects, pricing and volume leverage more than offset an 80 basis point drag from higher commodity costs. While commodity cost increases slowed over the past few months, costs were still higher when compared to prior-year levels. Selling, general and administrative expenses decreased by 30 basis points behind overhead cost control, Gillette synergies and volume leverage. Non-operating were a modest drag on earnings growth due to higher interest expense. The tax rate for the quarter came in at 30%, down slightly versus year ago. We continue to expect the tax rate for the year to be at or slightly below 30%, in line with previous guidance. Now let's turn to cash performance. Operating cash flow for the quarter was $2.5 billion. This was down $125 million versus year ago due to an increase in accounts receivable. Accounts receivable increased during the quarter due to business growth, holiday seasonality, but most importantly temporary impacts related to the Gillette integration. The Gillette impact is primarily due to slower collection timing during billing systems conversions. We expect this to largely reverse itself by the end of the fiscal year, now that we have integrated billing systems in countries representing 95% of sales. Free cash flow for the quarter was $1.8 million. This brings free cash flow productivity to 75% fiscal year-to-date. We continue to expect free cash flow productivity to be at or above our 90% target for the fiscal year. Capital spending was 3.4% of sales in the quarter, below our 4% target. We repurchased $1.4 billion of P&G stock during the quarter as part of our ongoing discretionary share repurchases. To summarize, P&G continues to drive balanced top and bottom line growth. Accelerating EPS growth is being driven by sales growth, operating margin improvement and Gillette acquisition benefits, and we have taken a big step toward completion of the Gillette business systems integration. Now I will turn it over to John for a discussion of the results by business segment."
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"speaker": "John Goodwin",
"text": "Thanks, Clayt. Starting with our Beauty business, sales were up 8%, led by fine fragrances that had organic sales growth in the mid-teens. In addition, the Hair Care, Skin Care and Feminine Care categories each posted solid volume growth for the quarter. The strong fragrance results were driven by new innovations such as Boss Femme, Lacoste Inspiration, Dolce & Gabbana's The One and the addition of the Dolce & Gabbana based business. In the Skin Care business, Olay grew volume high single-digits behind the success of the Definity launch in North America and continued leverage of Regenerist. Olay's value share of the U.S. facial moisturizers market is up more than 5 share points versus the prior year to 43%. On SK-II, we did resume shipments to a limited number of stores in China in December. However, the combined impact of the shipment's stoppage in China and public relations concerns in other Asian markets drove shipment volumes down by nearly 40%, which obviously hurt the segment results for the quarter. It will likely be several quarters before sales return to prior levels. In Hair Care our two biggest brands, Pantene and Head & Shoulders, led the top line growth. Pantene global volume was up mid single-digits behind continued leverage of the premium Restoratives and Color Expressions initiatives in North America and the base brand restage in several international markets. Head & Shoulders volume grew mid-teens behind the intensive launch in North America and brand restages internationally. In addition, Herbal Essences market share in the U.S. is up 20% versus pre-restage levels, and the brand will begin expanding the restaged lineup to more markets in 2007. Health Care sales were up 7%, driven by strong growth in personal health and pharmaceuticals. Personal health from pharma sales were up high single-digits behind strong Prilosec OTC results and pricing taken on Vicks and Actonel in prior periods. Prilosec OTC all outlet value share of the heartburn segment is up 2 points to nearly 40%. Oral Care delivered mid single-digits sales growth led by double-digit growth of the Crest franchise in developing markets. Russia led developing markets with top line growth over 20%, and China was up nearly 10% for the quarter. Crest toothpaste continues to grow market share in the U.S., despite significant promotion activity from an oral care competitor. All outlet value share for Crest is up nearly 2 points to over 37%, driven by the success of the Crest Pro-Health initiative. Also, the Oral-B Vitality Toothbrush initiative is off to a great start. Vitality drove Oral-B's share of rechargeable brushes to 55% for the quarter, up 4 points versus the prior year. Next in the household businesses, Fabric Care and Home Care delivered another very strong quarter with 11% sales growth. Sales grew double-digits in both Fabric and Home Care. The main driver of the top line results was continued leverage of product innovations, many of which launched in earlier periods but are still providing strong sales momentum. Several examples are Tide Simple Pleasures, Gain Joyful Expressions, Febreze Noticeables, several Swiffer upgrades and the Fairy auto dishwashing launch in Western Europe. In the U.S. Fabric Care business, the Tide, Gain and Downy brands led P&G to a value share improvement of more than a point to over 62% of the market. The Fabric Care business was also strong in developing markets with double-digit volume growth. Also in Fabric Care, the compaction test in Cedar Rapids, Iowa continues to progress well. Our business is fully converted to smaller bottles, and we are already gaining valuable insights that are helping us sharpen our communications to consumers in the store. In Home Care the top line growth is being led by the North American market with the Dawn, Joy, Swiffer and Febreze brands all posting volume growth of mid-teens or greater. In addition, the Fairy dish brand delivered double-digit growth in Western Europe; and Essential in Eastern Europe, Middle East and Africa regions. Febreze and Swiffer continue to post healthy market share gains in the U.S. behind the new innovations mentioned earlier. Febreze value share of the U.S. Air Care market is up nearly 4 points to 23%, and Swiffer's share of U.S. Quick Clean category is up more than 2 points to 87%. Turning to Baby Care and Family Care, the business delivered a solid quarter with sales growth of 5%. Strong Baby Care volume growth in developing markets and on the Pampers diaper business in the U.S. was partially offset by volume declines in Western Europe diapers and the Luvs brand in the U.S. Pampers delivered double-digit growth in leading developing markets, and Pampers diaper shipments were up high single-digits in the U.S. Pampers all outlet value share of diapers in the U.S. is in line with prior year at 28%. Volume share is up nearly a point behind the strong consumer response to our Pampers Baby Dry Caterpillar stretch initiative. Luvs U.S. volume and value share for the quarter improved sequentially following the launch of the Leakguard core initiative in September. However, earnings share is lower versus prior year, mainly due to low pricing strategies by private-label competitors despite increasing cost trends. In Western Europe, Pampers continues to hold leadership shares above 50%. However, we have recently seen significant promotion and pricing activity from both branded and private-label competitors, again despite increasing cost trends. We will continue to monitor our competitive position on the shelf to ensure that Pampers remains an excellent value for consumers. Snacks, Coffee and Pet Care sales were up 3%. Shipments were up slightly versus prior year levels for the segment as mid single-digit volume growth on the Coffee business was offset primarily by soft results on Pet Care. Snacks volume was in line with prior year levels. Folgers delivered strong share progress behind the Simply Smooth and Gourmet Selections innovations. Folgers' value share in the U.S. coffee market is nearly 32%, up 5 points versus a base that included the impact of Hurricane Katrina. Pringles delivered good top line growth in Western Europe behind successful products and commercial initiatives. These results were offset by a weak shipment period in the U.S. due to heavy competitive merchandising and a 4% contraction of the potato chip category. Pringles value share of the U.S. potato chip market is down about a point to 13%. In December the U.S. business launched the Pringles Select initiative, a line of four gourmet flavors of Pringles chips sold in a bag. This new premium line of Pringles has been very well-received by retailers and is gaining strong merchandising and shelving support. Blades and Razors delivered very strong sales growth of 11% in the quarter on underlying global consumption growth of 7%. The 4 point differential is due mainly to 3 points of help from foreign exchange. We continued to see strong results for Fusion in all markets where it has been launched. In the first year since launch in North America, Fusion has generated $400 million in retail sales. Fusion's share of the U.S. male razor market is now at 51%, and the share of male cartridges is at 29%. Fusion's shares of male systems in the UK, Germany and Japan are already at 24%, 17% and 10% respectively, after only five months in the market. Combined, Fusion and Mach 3 system share is up more than 4 percentage points in each of these markets. We are now in the process of expanding Fusion into 11 additional Western European markets: Australia, Korea, Singapore and Eastern Europe this quarter. Also, we will soon be launching the Fusion Power Phantom razor in North America. Phantom is the first new extension of the Fusion franchise and will provide the brand with new opportunities for merchandising and sampling to drive new trial. In addition, we are launching a new female razor, Venus Breeze, in North America this quarter. Venus Breeze will be our entry into the fast-growing convenience segment of the market. Its patented, built-in, flexible shave gel bars are a breakthrough technology that releases a light lather eliminating the need for a separate shave gel. In the Duracell and Braun business, reported sales were up 5%. Duracell's strong growth in developing markets was partially offset by a flat volume in developed regions. Latin America is a bright spot for Duracell with volume growth of 20% in the quarter. Mexico led the region with nearly 30% unit growth behind top line synergies from increased distribution in more high frequency stores. In the U.S., Duracell all outlet value share of general-purpose batteries is down about a point to 47%. The decline is driven mainly by heavy competitive promotional activity that coincided with the shipment disruption of special displays that are assembled in the Cleveland, Tennessee distribution facility. The temporary integration issue restricted our ability to field promotions during the important holiday period. Braun delivered solid growth in Northeast Asia and developing markets. In addition, Braun's new top-of-the-line Power Sonic shaver is delivering good results in Japan and Germany. Western Europe and North America results were lower versus prior year, primarily due to a difficult base period comparison that included the Tassimo launch. North America results were also negatively affected by lost holiday merchandising due to the distribution issues in the Cleveland facility and soft household sales in Western Europe. That concludes the business segment review. Now I will hand the call back to Clayt."
},
{
"speaker": "Clayt Daley",
"text": "Thanks, John. I will start with a brief update on the progress of the Gillette integration. We remain on track with our commitment to return P&G to the pre-Gillette double-digit compound EPS growth trend by fiscal 2008, and we remain on track with both revenue and cost synergy targets. The integration continues to progress very well, thanks to the excellent work by all the Gillette integration sub-teams around the world. Let me highlight a few areas. During the December quarter, we completed the third integration wave. Specifically, we integrated billing systems, sales forces and distribution networks in 13 additional countries, including our two largest markets, the U.S. and the UK. Results were very good with the only notable issue being the Cleveland, Tennessee distribution center which we have already discussed. On January 1 we started the fourth and final major integration wave. Specifically, we are integrating an additional 22 countries representing about 15% of the business. These conversions have each gone very well without any significant business interruptions. After this round is complete, 95% of the business will be running through common billing systems, sales forces and distribution networks. This is roughly 16 months after the closing of the acquisition. The remaining countries will be transitioned over the next two quarters. As a result of the strong integration progress, we announced earlier this month that we will be making organization structure changes to fold Gillette into the existing management structure. Effective July 1 Blades and Razors and Braun will be managed as part of the Beauty and Health unit, and Duracell with be managed as part of the Household unit. We will continue our current segment reporting through the end of the fiscal year, and we will announce future segment reporting plans by the end of the fiscal year. In summary, we remain on track with both integration and acquisition economics. Now let's move onto guidance. For fiscal 2007 we continue to expect raw material and energy costs to be up versus fiscal 2006. At current levels, the amount of the increase should be even smaller than what we have seen in the past two years. As such, we expect cost-savings projects and volume leverage to partially flow through to higher gross margin over the next several quarters. While oil and natural gas prices have come down significantly from recent highs, it will take a number of quarters to translate into lower input costs, and there are a number of materials, such as pulp and agricultural commodities, where prices continue to rise. As such, we expect gross margins to improve more in the June quarter than in the March quarter. With this said, an environment with flat to declining commodity and energy costs is certainly a much better operating environment than we have experienced over the past two years. Specifically for the current fiscal year, we expect P&G to deliver its sixth consecutive year of growth at or above our long-term sales targets. Organic sales, which exclude the impact of foreign exchange and acquisitions and divestitures, are now expected to grow 5% to 6% for the year. This is an increase from our previous guidance of 4% to 6% due to a positive outlook for the remainder of the fiscal year. Within this, we expect a combination of pricing and mix to have a neutral to positive 1% impact. Foreign exchange is now expected to increase sales by 1% to 2%. Acquisitions and divestitures are expected to add 4% to top line growth. As such, we now expect all-in sales growth of 10% to 12% for the year, up 1% from the previous guidance range. Turning to the bottom line, we are raising our outlook for the fiscal year based on the strong EPS results in the December quarter. We now expect EPS to be in the range of $2.99 to $3.03, and we expect operating margins to improve by over 100 basis points driven primarily by gross margin. This includes Gillette dilution, which is now expected to be toward the lower end of the previous $0.12 to $0.18 guidance range. Gillette dilution is tracking better than expected due to strong results on blades and razors and good progress on cost synergies. We continue to expect the one-time items associated with the Gillette acquisition to be $0.06 to $0.08 per share, in line with the previous guidance range. Turning to the March quarter, organic sales were expected to grow 5% to 7%. Within this, price mix is expected to have a neutral to positive 1% impact. Foreign exchange is expected to add about 2%, resulting in estimated all-in sales growth of 7% to 9%. Turning to the bottom line, we expect operating margins to be up 50 to 100 basis points in the March quarter, driven by both gross margin improvement and SG&A efficiencies. As a result, we expect strong earnings per share growth due to good base business results and the ramp-up of Gillette cost synergies. Specifically, we expect earnings per share to be up 14% to 17% in the range of $0.72 to $0.74 per share. In closing, P&G continues to deliver strong results. We are making good progress on the Gillette integration and executing with consistency and excellence on the established business. A.G., John and I would now like to open the call up for your questions. As a reminder, we will be limiting each person to one question before moving on to the next caller with the objective of completing the call by 9:45. Feedback in our last call indicated a lot of positive comments about moving to this more rapid format in the questions. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. (Operator Instructions) Your first question comes from Amy Chasen - Goldman Sachs."
},
{
"speaker": "Amy Chasen - Goldman Sachs",
"text": "I just wanted to clarify some of your comments about the Gillette dilution coming in at the low end of the $0.12 to $0.18. Does that mean that you feel that the cost synergies from Gillette, the $1 billion to $1.2 billion could ultimately be low as well?"
},
{
"speaker": "Clayt Daley",
"text": "Well, we have not revised our projections for the long term. What we have said is the 1.0 to 1.2 range is still the range. We had previously said we thought we were going to end up at the top end of that range. Of course, during the current fiscal year, what we are really seeing is we're getting some of those cost synergies in a little bit quicker than we had originally planned, and that certainly is good news in terms of the longer-term prospects for the Gillette business. But we still think it is a little bit early to try to consider revising that long-term range."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bill Schmitz - Deutsche Bank."
},
{
"speaker": "Bill Schmitz - Deutsche Bank",
"text": "Can you just give us a little more detail on the Gillette charges in the quarter? Specifically how much is in gross margin, how much is in SG&A, what the actual number is, and then maybe some help on the segment side? Only because if I look at the gross margin and pro forma for last year, it looks like it was actually down year over year, excluding the inventory step-up in the year-ago quarter."
},
{
"speaker": "Clayt Daley",
"text": "Bill, what we're probably going to have to do is call you later on some of that. Clearly everything that is associated with Gillette will be in the dilution numbers. There are some things associated with Gillette that are booked in the corporate segment, not in the Gillette segment, but I don't think it is really material from the year-ago period. But we really ought to call you back later and give you a more quality answer to that."
},
{
"speaker": "Operator",
"text": "Your next question comes from Nik Modi - UBS."
},
{
"speaker": "Nik Modi - UBS",
"text": "Good morning. Just a quick question in terms of go to market reinvention and the tests that you were starting in Spain. Now with a few quarters under your belt there, can you give us some perspective on what is going on?"
},
{
"speaker": "A.G. Lafley",
"text": "We're still on track. We're starting to roll out. Spain has actually been one of our better performers in Western Europe over the last six months. As we talked at the analyst and investors meeting in December, go to market reinvention is a multi-faceted, multi-year initiative for us, so you will see us begin to roll it out in various countries with various channels and with various customers. We still believe that there is significant potential to improve the top line, the cash and the profitability of the way we go to market."
},
{
"speaker": "Operator",
"text": "Your next question comes from Wendy Nicholson - Citigroup."
},
{
"speaker": "Wendy Nicholson - Citigroup",
"text": "Hi. I actually had a question about the Pet Care business. I know it has been struggling for a little while and you made a management change, but it sounds like it was down again year over year in the second quarter. So can you talk about what is going on there and when we should start to see a tick up?"
},
{
"speaker": "A.G. Lafley",
"text": "You are right. We changed the management team, and we have got Rob Steele and a very good team in the seat. We spent the last six months basically taking the industry and the business apart. We have set goals, we have a new strategy, and you should begin to see the innovation in the marketplace. We have announced the new moves on Eukanuba. I think you will see activity on the Iams brand, and you will see strong innovation and strong initiatives in both the pet specialty channel and in the broad mass merchandising channel. When you step back, these are still two great brands, Eukanuba and Iams, with real equity with consumers. We have a strategy that now differentiates them for the different channels and customers, and frankly, we have got the innovation rolling again in 2007. It is a very attractive category, structurally attractive, attractive from a growth standpoint, so we are optimistic about it. We look at it as an opportunity."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bill Pecoriello - Morgan Stanley."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "Good morning. You lowered the Gillette dilution estimate to the lower end of the $0.12 to $0.18 range, so you only flowed through a $0.01 of the upside in the full year. So were there any specific initiatives you could talk about for the reinvestment to talk about that difference? Is it higher spending in some of the competitive categories like Oral Care and Baby Care, or are you reaccelerating growth in categories such as Beauty and Health?"
},
{
"speaker": "A.G. Lafley",
"text": "Look, the simple way to think about this is we have been working for six or seven years now to build a robust innovation and initiative portfolio. Again, as we mentioned in December, every year we have built the size, we have built the strength, and we have built the success rate of this innovation portfolio. As you look at it, right now a little more than half of our innovations are succeeding when they go to market. We're delivering virtually 100% of the value creation that we set out to deliver for the whole portfolio. The successful initiatives are 70% plus of the incremental going in OS we generate, so it is working pretty well. But we still have one big opportunity, and that is the trial rate. Many of our innovations, even innovations that were introduced two or three years ago, still have significant upside trial potential. I think we have been pretty clear that we have gone back in the U.S. and we have resampled Fusion. We've got a shaving system that is an 86% conversion rate. If a man tries and shaves with a Fusion system, 86 out of 100 will convert to purchase and use. We have an Olay Regenerist and Olay Definity with a lot of upside. We have an Oral Care Pro-Health with a lot of upside. We have in Hair Care a lot of upside on all of our major brands: Pantene, Head & Shoulders, Herbal Essences. Prilosec, we have been out three years, we have a 40 share. There is still a lot of upside in Prilosec. So we want to make sure that we have the flexibility to do the activity on the brand in the category in the market where we still have trial opportunity. Frankly, that is the single biggest opportunity for this company, and it is a significant amount of upside. So we're going to try to realize some of it."
},
{
"speaker": "Clayt Daley",
"text": "I will just make one other clarifying comment. Since we originally put out the $0.12 to $0.18 range on Gillette, obviously our guidance has moved up a lot more than what we're moving up right now. So we have seen the Gillette numbers trending positive throughout the year. It is just now is the point at which we were confident enough to go ahead and say that we are going to be in the lower end of that range."
},
{
"speaker": "Operator",
"text": "Your next question comes from Lauren Lieberman - Lehman Brothers."
},
{
"speaker": "Lauren Lieberman - Lehman Brothers",
"text": "I just wanted to ask about the margins in Batteries and Braun. That was a huge change, and given that you mentioned there was actually some disruption, what is driving this positive variance there? Is it a step change? What is going on there? Just to follow-up on all the questions on Gillette dilution, what was the Gillette dilution this quarter?"
},
{
"speaker": "Clayt Daley",
"text": "I think the story really there is there was an inventory write-off in the base period. That is the first quarter after we closed we do the normal acquisition accounting and the inventories are written off. So we had an unusually high cost of goods sold in the base period as that inventory was shipped out. That is the biggest reason why there is this large year-to-year comparison. But, on the other hand, I want to tell you I think that there is cost synergies starting to flow into this business too, and we're starting to see the benefits flow into this business on the integration process. So I don't want to discount the importance of that either. But the magnitude of the move is very much driven by the base period inventory write-off impact."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Faucher – JP Morgan."
},
{
"speaker": "John Faucher - JP Morgan",
"text": "Good morning, everyone. I was wondering if you could talk a little bit about how you view your portfolio and maybe some decisions that may need to be made down the road, particularly as you look at Beauty where I would say the businesses you guys really like are growing in line with your expectations and maybe some of the businesses you're a little bit less fond of not growing quite so quickly? Do you think you need to make changes in the portfolio, or is it a question of just getting through some tough periods and getting some of these businesses down to baseline levels? Thanks."
},
{
"speaker": "A.G. Lafley",
"text": "A great question because we're always looking at our portfolio and how it is performing industry by industry, geography by geography. The first thing I would say is we clearly want to look at Health Care as an engine of growth, and I think you saw a couple of the experiments that we're going to run in the joint ventures that we announced this month. We're in a joint venture with Inverness to do in-home diagnostics. We were pretty certain that consumers, moms at home want to take more control over their and family's health, and we think home diagnostics is a growth area and one that we want to learn more about. We also entered a joint venture with MD VIP, which is a concierge health care service where for an annual fee you and/or your family get really first-rate health care, 24X7 service from your primary care doctor group, a first-class physical and nutritional advice, physical fitness advice, all kinds of things. This is a model we want to learn more about. The first thing I would say is, if you look at our current portfolio, the one area where we are continuing to experiment and where we are continuing to broaden and deepen and learn is Health Care. Because if you just look at the dynamics around the world, you look at demographics driving it, and when you look at the cost of Health Care, it is going to be huge, and P&G has got to play in a bigger way there. The second thing I would say is, hey, we basically are pretty comfortable with the portfolio that we have right now. Where we had a little bit of underperformance in this quarter it was, frankly, shame on us. I mentioned Pet Care. We got a bit behind. But we love the industry, we like the category, and we think we've got the brands and the innovation program and the organization to succeed. Snacks and Coffee, we have talked a lot about before. Coffee is really back on a positive trend. We've got a great position and we are focused. We are in the North America market, and we are the North America market with the leading brand. Pringles, all I can say is we have got a strong innovation program over the next 12 to 18 months, and we're going to have to see how it performs. But if it performs the way we expect it to, it is going to be good. Last but not least, if you look at our Beauty business, it has been performing. We benchmark the best beauty care companies in the world. Over the last several quarters, our organic sales rate is right there with L'Oreal quarter by quarter, and cumulatively we generate very good margins in that business. We have great brands, and we have phenomenal innovation. Fabric and Home Care, incredibly strong position. We like the industry. We see growth in the industry. And our paper business, again, we know what our strategy is. We know how we want to play, and we think we have plans that will improve our performance over the next year. So yes, we are always looking at the portfolio. If something ends up where it can’t perform, we do shed it. We have shed a number of small brands over the last several months that either don't fit strategically or haven’t been performing, and we will make the choices. I can guarantee that. We will make the right choices for the consumer and the shareholder and the company."
},
{
"speaker": "Clayt Daley",
"text": "I think we have been very clear that we have minimum sales, earnings and CFROI thresholds, but we do look at the businesses over a period of years. Because we're in this for the long term and we make those decisions over time."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jason Gere - A.G. Edwards."
},
{
"speaker": "Jason Gere - A.G. Edwards",
"text": "Good morning, guys. A question for you on promotional spending. I know that the last couple of years we have been hearing about cutting the gross to net spending and becoming more efficient there. But certainly we have heard in certain categories some of your competitors are getting a little bit more promotional. If you think about pricings rolling off and if you look at the channel, the volume has not been all that strong. Is this the case now that you might have to start fighting fire with fire to some degree?"
},
{
"speaker": "A.G. Lafley",
"text": "It is always an issue of consumer value and how strong is our brand equity and how strong is our innovation program? We're just trying to strike the right balance. I hope it was clear in our remarks about Baby Care that we have been very patient because there has clearly been pressure on the commodity cost side. We have led pricing in North America and Western Europe, modest pricing, from a consumer and customer standpoint. But if we continue to see in this case, it is mostly retailer brands and private labels that have not recovered the pulp and other related costs, then we will take the appropriate action. We will take the appropriate action, but we will do it selectively by country, by channel, by customer; because in the end, we have to offer superior consumer value. You are right in our mix of categories now and given some of the restructuring that some of our competition is doing, there is some more spending. But I think I have said many times before -- and I deeply believe this -- that if all that spending just goes into temporary price reduction and the fundamental brand equity or product is not improved in a meaningful way for consumers, it is like a snake swallowing a frog. When the meal is over, the snake is still lying there and it is still the same size, and you have not done anything for the future of your brand. So I guess the simple way to think about it, it is the advantage of a balanced portfolio. We're trying to be very balanced and very patient and very strategic and occasionally tactical, but our eyes are on the consumer first. Our eyes are on the consumer first, and if we deliver the consumer value, we're going to be okay."
},
{
"speaker": "Operator",
"text": "Your next question comes from Chris Ferrara - Merrill Lynch."
},
{
"speaker": "Chris Ferrara - Merrill Lynch",
"text": "Can you talk a little bit about any potential changes in the trade promotion allocation practices that come along with the go to market reinvention? Have you guys experimented there at all in any geographies across the globe?"
},
{
"speaker": "Clayt Daley",
"text": "Well, it is not so much experimentation I think as it is a system that is clear in terms of what specific performances we will pay for, how much we will pay for them, frankly, from the ability to customize our program much more for what the retailers want to run in their stores across all classes of the retail trade. So it really amounts to more flexibility and more ability to pay for the kinds of things that move individual businesses, because our businesses are driven off of different types of activities depending on whether you are in Blades and Razors or Beauty Care or some of the household businesses. Our program is much easier to tailor to our individual businesses in what has now become a relatively diverse portfolio than it was in the past."
},
{
"speaker": "A.G. Lafley",
"text": "Chris, your question relates to Jason's question because the move to what we call key business drivers, what specific customer activity in the store drives the brand's business in its category? Those key business drivers, the flexibility that Clayt mentioned, all enable us to differentiate better with individual customers, and they enable us to be more effective and more efficient. It is the same thing on the advertising side as we have been trying to explain. We can be more effective and more efficient because we can differentiate better, we can target better and we can give either the consumer or the customer the incentive she or he wants to move their business and our business together."
},
{
"speaker": "Operator",
"text": "Your next question comes from Sandhya Beebee - HSBC."
},
{
"speaker": "Sandhya Beebee - HSBC",
"text": "Good morning. I was wondering if you could give some color on the developing markets because there was a concern this time last year that maybe it slowed down. From your comments, it seems like things are back on track again. How much of the benefits that we're seeing in the developing markets are coming from Gillette?"
},
{
"speaker": "A.G. Lafley",
"text": "Well, developing markets we are counting on for double-digit organic sales growth and they delivered this quarter. They are all in pretty good shape. I would say CEMEA has been a star, a real standout. But we have come back in China. We are in good shape in what we call AAI, which is sort of Southeastern and Southern Asia, and in L.A. So we feel good about developing markets. We're still underdeveloped in developing markets. They are driven by demographics and by economics. That is where the babies are born. That is where the households are forming. That is where incomes are rising, and that is where there is a lot of under-consumption. So I think they are going to be good for our industry for many years. Regarding Gillette again, as we have said before, we are moving through the distributor rationalization and it is going pretty well. I think we mentioned in the fall comments that we're getting Gillette distribution in what we call high frequency stores, and that will continue. The example we cited today was Duracell, but our biggest channel in the world is these high frequency stores in developing markets. That is the biggest customer segment that we have, and we still have a lot of opportunity to grow there. So we remain pretty bullish on developing markets. The last thing I would say is we think we added about 1 billion consumers to P&G's -- ever purchased and used the P&G brand -- base over the prior six or seven years. We think we can add another 1 billion consumers over the next three to five years, and most of them are going to come from developing markets."
},
{
"speaker": "Operator",
"text": "Your next question comes from Connie Maneaty - Prudential."
},
{
"speaker": "Connie Maneaty - Prudential",
"text": "Good morning. You mentioned that you thought raw materials were creating a better cost environment than you have seen in the class couple of years. Could you talk about how the dynamics change in the way you purchase raw materials in this part of the cycle?"
},
{
"speaker": "Clayt Daley",
"text": "Well, I think that we have gone to a system of purchasing in global spend pools. So our purchasing people are looking around the world for how to execute our buys. I think during this period, not surprisingly, as raw material costs went up dramatically, we shortened up some of our positions versus some very long-term contracts that we had prior to the spike, and now hopefully that will mean as things have flattened and hopefully they will begin to go down in the next six, nine, 12 months, we will be in a position to capture that benefit. Having said that, of course, while we think that we have purchased very well, if prices go down broadly in the marketplace, there may be some give back to the consumer. So we are not planning on building a lot of gross margin as material prices cycle down. As I said before, it is sure a heck of a lot better operating environment when things are flat to down than it was when they were going up every month."
},
{
"speaker": "A.G. Lafley",
"text": "The other thing that helped us is going through the crisis when we had not only higher prices, but a real shortage of certain materials; we have learned how to formulate very fast and very flexibly. We are now plugged into parts of the world and to suppliers that we did not previously have relationships with or strong relationships with. So I feel like we now really play on a true global basis with the supply that is available in the world, and I feel like we are much more agile and much more flexible, and that is going to help us."
},
{
"speaker": "Operator",
"text": "Your next question comes from Justin Hott - Bear Stearns."
},
{
"speaker": "Justin Hott - Bear Stearns",
"text": "Your prepared remarks reference the success of Crest Pro-Health. Could you talk a little about that?"
},
{
"speaker": "A.G. Lafley",
"text": "On the one hand, we're very pleased with the start of Crest Pro-Health. On the other hand, it is a classic example of trial opportunity that I talked about earlier. We're off to a good start. I think we are a 5 plus share in the U.S., which is the lead market. We have obviously grown the total Crest franchise a couple of points in the U.S. to 37 or so. The early consumer reaction has been very positive, so the right consumers are buying the brand and product line, including the rinse, for the right reasons. The rinse has enabled us to double our rinse position. Customers have been pretty pleased with Pro-Health because it has been some incremental business and some trade-up business for them. I think we all see this as a multi-year long-term initiative, and you will see us develop Pro-Health because there is a segment of consumers out there that clearly are more interested in the therapeutic benefits. If you have tried the product or tried the rinses, they really are unique versus anything else that is available in terms of the oral care experience and the oral care end result. We have done all this despite basically our major competitors have thrown everything but the kitchen sink at us. They have grown, but we have grown too, which is, as I have said several times, is what is really going to happen in the Oral Care category, is the two leaders are going to continue to grow because they are the ones that understand the science, they are the ones that invest in the technology. They are the ones that are closer to the consumer and have the brand. So I think this is the first chapter in a multi-chapter book, and we're going to be talking about Pro-Health for a long time. It is not just going to be a quarterly event."
},
{
"speaker": "Operator",
"text": "Your next question comes from Joe Altobello - CIBC World Markets."
},
{
"speaker": "Joe Altobello - CIBC World Markets",
"text": "Thanks, good morning. My first question is on something that A.G. said earlier to another question regarding your recent transactions. You mentioned MD VIP and Inverness obviously. You also did an acquisition of HDS, and I was curious; it seems like you have been a little more active than usual. What is the rationale and strategy behind these moves, and should we expect more of these going forward?"
},
{
"speaker": "A.G. Lafley",
"text": "Well, Joe, the rationale is from little seedlings grow big oak trees. I mean there is nothing more than that, and we have taken some small positions -- which actually we would prefer to do. I don't think people believed me, but I have said after three medium to large-sized acquisitions, we really prefer small acquisitions. But we really do because it gives us time to learn, it gets us in early in the formation of the new category or segment. So we have taken a couple of Health Care positions. We took a couple of positions in Beauty Care, and we took a position in portable power. They are all important to us. They are all strategic for us. So I think the fact that they have all got announced in January sort of reflects that some were on different timing, some took a little longer than others to put together. They are also great examples of our openness and our whole connect and develop philosophy and practice with innovation. We're quite prepared to work with the entrepreneur or the inventor or the technologists or whomever has the idea. And I think that you are seeing that more of these parties are comfortable working with us, and I think that is really important. We have said a number of times our strength is develop, qualify and commercialize. We're good inventors, but there are a lot of other good inventors in the world. So if we can tap into the invention that is available in the world, we think we're pretty decent at developing, qualifying and commercializing."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bill Chappell - SunTrust Robinson Humphrey."
},
{
"speaker": "Bill Chappell - SunTrust Robinson Humphrey",
"text": "Good morning. A quick question on the commodity costs impacting the quarter. Is there any way to handicap how much that was related to energy, be it natural gas or oil? On a go-forward basis, I don't think you provided any update. You said last quarter was like a $0.02 to $0.03 benefit from lower commodity costs. Is that still the same number for fiscal '07?"
},
{
"speaker": "Clayt Daley",
"text": "Last quarter we said I believe that the July-September versus the same period a year ago was 100 basis points, and that is 80 basis points in the October-December quarter. So the incremental impact is somewhat less. Last quarter we did raise guidance and attributed some of that to an improved commodity environment, but we did not put any specific number with that. It was in the general context of improving our guidance for the year. This one has proven to be very difficult to forecast with any precision because a lot of these commodities, a lot of these materials have relatively long supply chains coming through, and we are just in a wait and see mode. There is really no change versus the last quarter due to the lapping impact of any major consequence. But we are cautiously optimistic. I mean this has been unprecedented run-up in costs. Frankly, I really think the Company has accomplished a lot by delivering its earnings numbers in the face of this unprecedented run-up in commodity costs, and now we will hopefully be able to extract some benefit as things cycle over. At least we are not going to be in a mode of needing to raise prices, and raising prices in the marketplace is always disruptive."
},
{
"speaker": "Operator",
"text": "Your next question comes from Alice Longley - Buckingham Research."
},
{
"speaker": "Alice Longley - Buckingham Research",
"text": "What was your growth in North America? Was it roughly in the mid single-digits, and was that pretty much all from price and mix?"
},
{
"speaker": "Clayt Daley",
"text": "It was low to mid single. Yes."
},
{
"speaker": "Operator",
"text": "Your next question comes from Steve Morrow -Cumberland Associates."
},
{
"speaker": "Steve Morrow - Cumberland Associates",
"text": "Yes, there was a big shift in your debt classification from long term to short term in the quarter. Can you just highlight what was behind that and if you are planning to come to market at any time soon to term out some of that short-term debt?"
},
{
"speaker": "Clayt Daley",
"text": "We will let the Treasurer handle that one."
},
{
"speaker": "John Goodwin",
"text": "Yes, when we made the Gillette acquisition, we announced that we had a bank facility in order to execute the share buyback and that we would gradually convert that into a market-traded debt. During the period we issued some commercial paper, about $10 billion of commercial paper, which paid down some of the debt facility, which had been previously categorized as long-term debt. So that is really the shift; it shouldn’t really be seen as any position on the market. It is just we're going through that process of converting the facility into the combination of CP and bonds."
},
{
"speaker": "Operator",
"text": "Your next question comes from Amy Chasen - Goldman Sachs."
},
{
"speaker": "Amy Chasen - Goldman Sachs",
"text": "I just wanted to know of your new guidance what your assumptions on both oil and currency have been? And if they stay at current levels, whether that gives you even more flexibility than what you have already raised your numbers to?"
},
{
"speaker": "Clayt Daley",
"text": "Currency is not a big impact on our numbers because we are net-net not that exposed. We're obviously exposed on the sales line. We're less exposed on the earnings line. Although with Gillette now in the portfolio, we are a little bit more along European currency than we were before. The commodity cost environment, I think what we have done is we have assumed that there will be some softening in commodities that will have much more of an impact on April-June than it will on January-March. But we also, as I think we have said, need to be cautious about how much of that we can bring to the bottom line. Because, as we know particularly on the Household side, private labels tend to buy on spot and those prices tend to go down with commodities. And then, of course, as we alluded to earlier in a number of our businesses, we have to watch our price spreads very carefully versus private-label and also then branded competitors tend to discount down some of that as well. So we think we are in a balanced position right now where we have assumed some benefits by the end of the fiscal year, but we're hopefully realistic in terms of what will happen in that time period, and we are obviously now focusing on what we think next year is going to be, and we will be providing our initial thoughts on next year in our call three months from now."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jim Baker - Neuberger Berman."
},
{
"speaker": "Jim Baker - Neuberger Berman",
"text": "Yes, last quarter you said there were about $0.05 to $0.06 of Gillette dilution, of which you characterize about half of that or $0.03 as one-time. I just wanted to know those numbers for this quarter."
},
{
"speaker": "Clayt Daley",
"text": "We indicated that we would provide quarterly dilution numbers through the first year. Now that we are into year two we're not going to be disclosing dilution numbers by quarter, other than to say that we said $0.12 to $0.18. We are now saying it is going to be in the lower end of that range. You can assume that the numbers get a little bit better throughout the year, so that early in the year the dilution is going to be a little bit higher than it is going to be late in the year. But as you know, with those kinds of numbers, we are talking about dilution of in the $0.03 to $0.04 range in a quarter. It is just not really on a quarterly basis that big of a number, and I think we also updated the fact that the one-time component of that, it was I believe $0.06 to $0.08 and that has not changed. So hopefully that will give you some direction there."
},
{
"speaker": "Operator",
"text": "Your next question comes from Lauren Lieberman - Lehman Brothers."
},
{
"speaker": "Lauren Lieberman - Lehman Brothers",
"text": "I just wanted to follow-up on Baby Care in Western Europe. I know you have talked a little bit about competitive activities. But my sense has been that that has been your primary branded competitor’s intention for a year to two already of stepping up their spending there. So are you seeing that they are having a bigger impact on the market because something has changed in their product portfolio; their marketing is just a little bit sharper? So what were the dynamics, and how are you thinking about approaching that going forward?"
},
{
"speaker": "A.G. Lafley",
"text": "Lauren, it is this simple. Both our branded competition and the private labels are discounting more and spending more on promotion. Probably our toughest competitor in Western Europe has been the Tesco private-label brand. In several markets across Western Europe, we have seen a big increase in promotional spending. As I said earlier, we're literally working country by country, channel by channel, customer by customer to make sure that we have got our consumer value right. Our share is holding well above 50%. We have gained a little bit of ground, but we thought that it was prudent and that we were being patient because we know Ontex, which is the big private-label manufacturer in Europe, has been trying to put their prices up, and we know what the commodity cost picture is for them and for us. We can take their diapers apart diaper by diaper."
},
{
"speaker": "Clayt Daley",
"text": "With the prices of pulp in the super absorbers, other materials that go into diapers, there has been a lot of cost pressure that has not come through in the higher pricing. So some of what is going on is not really economically rational."
},
{
"speaker": "A.G. Lafley",
"text": "So a lot of what we're trying to do, is we're trying to not just manage this month or this quarter, we're trying to put ourselves in a position where we want to be six, 12, 18 months from now. So what you have seen from us is you have seen continuing innovation. We're now innovating at the opening price point range, our Baby Dry line, and we're innovating across our Baby Stages of Development. You will just see us continue to innovate and continue to add value and continue to watch the price spreads. But you're right. There is no doubt that there has been more spending in Western Europe on baby diapers."
},
{
"speaker": "Clayt Daley",
"text": "We're going to take just a couple of more questions."
},
{
"speaker": "Operator",
"text": "Your next question comes from Alec Patterson - RCM."
},
{
"speaker": "Alec Patterson - RCM",
"text": "Clayt, on the cash flow, I just wanted to get some perspective on the full year as you swing around the receivables numbers. Could you give a read on where you think working capital ends for the year and then also the CapEx as a percent of sales?"
},
{
"speaker": "Clayt Daley",
"text": "Well, you're right. Of course, as we know, the October-December quarter on the cash flow is typically every year a low point. As I said, I expect the free cash flow, which is operating cash flow minus CapEx, to be we still think 90% or better of earnings for the year. That is going to come from the receivable situation should be largely mitigated by the end of the year. It is a temporary phenomenon. The CapEx should come in at 4% of sales or less for the year. As you know, with the terrific progress we have made on capital expenditures now, the CapEx and the D&A have largely converged. So really the 90% target for cash makes some allowance for increase in working capital because it is a reality. As the business is growing, we will have to add working capital. We are obviously working on inventories. We're going to be trying to work on getting the receivables back down, but realistically you cannot grow the business without some increases in working capital, and that is why we have established a target where we have."
},
{
"speaker": "Operator",
"text": "Your final question comes from Alice Longley - Buckingham Research."
},
{
"speaker": "Alice Longley - Buckingham Research",
"text": "Is it true that for the Blade division we should look for a little bit of a tough comparison in the March quarter and then maybe quite an easy comparison in the June quarter?"
},
{
"speaker": "Clayt Daley",
"text": "I think you have got it about right. Obviously, in the March quarter we have got the Fusion launch in the U.S. in the base, and we're going to be coming off a couple of big launches in Europe. So I think that is a reasonable proposition."
},
{
"speaker": "Alice Longley - Buckingham Research",
"text": "Since you have given us the same guidance for sales in the March quarter as we got in the December quarter and Blades might be up less, what other sector might be up more?"
},
{
"speaker": "Clayt Daley",
"text": "Well, I think what we said before is some of the things were in the October-December quarter, the organic growth rates were lower, and we have already talked about those. We expect to begin to see some rebound on those, and that is what we will wrap the call up on because you have raised a good point. That is the beauty of the portfolio is the breadth and depth of the portfolio both from a product standpoint and a geographic standpoint gives us the ability to make our numbers. Yet, on any given quarter, we're going to be getting a little bit more from one business and maybe a little bit less from another. But it all works out in the end. On that note, I would like to thank everyone for joining us today, and as I said at the outset, John and Chris and I will be around the rest of the day for any follow-up calls, and we appreciate you joining us today."
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"speaker": "Operator",
"text": "With that we will conclude today's conference."
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PG | 1 | 2,007 | 2006-10-31 13:15:00 | Executives: Clayt Daley - CFO John Goodwin - Treasurer A.G. Lafley - Chairman, President, CEO
Analysts: Bill Pecoriello - Morgan Stanley Lauren Lieberman - Lehman Brothers Amy Chasen - Goldman Sachs Bill Schmitz - Deutsche Bank Nik Modi - UBS Warburg Wendy Nicholson - Citigroup April Scee - Banc of America Securities John Faucher – JP Morgan Chris Ferrara - Merrill Lynch Alice Longley - Buckingham Research Group Justin Hott - Bear Stearns Jason Gere - A.G. Edwards & Sons Elena Mills - Atlantic Equities Connie Maneaty - Prudential Equity Group Joe Altobello - CIBC World Markets Bill Chappell - SunTrust Robinson Humphrey Linda Bolton-Weiser - Oppenheimer & Co. Sandy Beebee - HSBC James Baker - Neuberger Berman
Operator: Good morning, everyone, and welcome to Procter & Gamble's first quarter conference call. Today's discussion will include a number of forward-looking statements. If you will refer to P&G's most recent 10-K and 8-K reports, you will see a discussion of factors that could cause the Company's actual results to differ materially from these projections. As required by Regulation G, P&G needs to make you aware that, during the call, the company will make a number of references to non-GAAP and other financial measures. Management believes these measures provide investors valuable information on the underlying growth trends of the business. Organic refers to reported results, excluding the impact of acquisitions and divestitures and foreign exchange where applicable. Free cash flow represents operating cash flow, less capital expenditures. P&G has posted on its web site, www.pg.com, a full reconciliation of non-GAAP and other financial measures. Additionally, today's conference is being recorded. Now, I'd like to turn the call over to P&G's Chief Financial Officer, Clayt Daley. Please go ahead.
Clayt Daley: Thanks and good morning, everyone. A.G. Lafley, our CEO, and John Goodwin, our Treasurer, join me this morning. I will begin the call with a summary of our first quarter results. John will cover our business results by operating segment, and I will wrap up with an update on the Gillette integration and our expectations for both the December quarter and the fiscal year. A.G. will join the call for the Q&A and as always, following the call, John Goodwin, Chris Peterson and I will be available to provide additional perspective, as needed. As a reminder, we are shortening the prepared comments this quarter to be less repetitive with the press release. Now, onto the September quarter results. We began fiscal 2007 with a strong first quarter. We delivered balanced top and bottom line growth driven by a healthy innovation program, strong operating margin improvement, and good progress on the Gillette integration. Diluted net earnings per share were $0.79, up 3% versus a year ago and $0.01 ahead of the consensus estimate. This included Gillette dilution of $0.05 to $0.06 per share, at the low end of our previous guidance range. Excluding this dilution, earnings per share were up 9% to 10% versus a year ago. Total sales increased 27% to $18.8 billion. This was at the top end of our guidance range, driven by better than expected results on the Gillette business. Sales on blades and razors were up 12% versus a year ago, due to a strong global consumption growth and better-than-expected customer sell-in behind the Fusion launch in the UK, Germany and Japan. Organic sales growth came in at 6%, driven by a robust innovation program. This was at the top end of our long-term organic growth target range of 4% to 6%. Recent innovations, such as Crest Pro Health toothpaste, Olay Definity, Tide Simple Pleasures, and the Herbal Essences brand restage are all off to a strong start. Next, onto earnings and margin performance. Operating income was up 33% to $4.1 billion, due to strong results on P&G's base business and the addition of Gillette. The operating margin was up 90 basis points versus a year ago, driven by significantly better gross margins. Gross margin was up 120 basis points to 52.8%. Higher commodity costs hurt base P&G gross margins by about 100 basis points in the quarter. Volume leverage, cost-savings efforts and pricing offset the commodity cost impact, while the mix benefit from the addition of Gillette drove margin expansion. Selling, general and administrative expenses increased by 30 basis points behind Gillette-related acquisition costs, as we expected. We repurchased $1.4 billion of P&G stock during the September quarter. This included the completion of the Gillette buyback program in July and the resumption of our discretionary share repurchases, which we expect to continue going forward. The tax rate for the quarter came in at 30.4%, about in line with a year ago. We continue to expect that the tax rate for the current fiscal year will be at or slightly below 30%, again in line with previous guidance. As expected, non-operating income increased due to higher interest income and the planned divestitures of Pert and Sure. The increase was in line with previous guidance. Earnings per share included $0.03 of one-time charges related to the Gillette acquisition, also in line with previous guidance. Now, let's turn to cash performance. Operating cash flow in the quarter was $3 billion, up about $800 million from the same period last year. The improvement was driven by the addition of Gillette and earnings growth from the P&G base business. Working capital was about neutral to cash versus year ago. Receivables increased by three days due to the mix impacts of adding Gillette and strong Fusion pipeline shipments late in the quarter. Inventory days increased due to the mix impact of adding Gillette and inventory builds in preparation for the upcoming Fusion launches in continental Europe. Excluding Gillette, inventory days were down modestly versus a year ago despite inventory builds in support of our strong innovation program. Cash generated from payables offset the increases in receivables and inventories. Free cash flow for the quarter was $2.4 billion. Capital spending was 3% of sales. Free cash flow productivity came in at 88%, slightly ahead of year ago. To summarize this strong start to the new fiscal year, P&G continues to drive balanced top and bottom line growth. Our growth strategies are working, and we continue to benefit from our balanced portfolio and robust innovation program. Now, I will turn it over to John for a discussion of our business unit results, by segment.
John Goodwin: Thanks, Clayt. Starting with our beauty business, sales were up 11% behind strong organic growth and the addition of Gillette. Skincare, feminine care and retail hair care lead the organic growth. In hair care, Pantene, Head & Shoulders and Herbal Essences all grew global volume high single-digits -- all greater -- behind strong initiatives on each brand. In total, P&G past three-month value share of the U.S. shampoo market is up more than a point to 40%, despite a high level of competitive product activity. The skincare business grew double digits, despite the temporary voluntary suspension of SK-II shipments in China. We have recently received confirmation on SK-II product safety in China, and expect to re-enter the market in the next few weeks. Within skincare, Olay volume grew mid-teens globally with the continued expansion of the Regenerist line and over 20% growth in U.S. behind the launch of Olay Definity. Olay past three-month value share of the U.S. facial moisturizers market is up nearly 6 points versus prior year to over 41%. Femcare also grew volume high single-digits globally. Always continues to deliver strong market share gains behind the Clean & Fresh initiatives. Value share in the U.S. is now 54%, up nearly 2 points versus prior year. Tampax share is also up more than a point in the U.S. to 51%, behind the continued growth of Tampax Pearl. Tampax has widened its market share lead in the tampon category, and Pearl is now a leader in the plastic applicator segments. In healthcare, reported sales were up 32%, driven mainly by the addition of the Oral-B business. Organic sales were up 4% comparing against a very strong base period for both the Prilosec OTC and Actonel brands. In oral care, organic sales grew double-digits globally behind strength in the North America and Europe, Middle East, Africa regions. In the U.S., Crest delivered strong results behind the Pro Health toothpaste launch. Crest unit volume was up double-digits in the U.S. for the quarter, and past three months all-outlet value share in toothpaste was up 2 points to 36%. These strong results were delivered despite heavy competitive spending. Moving to the household businesses, fabric care and home care delivered another very strong quarter with 9% sales growth. Both businesses grew volume high single-digits for the quarter, driven by strong innovation results. Key initiatives driving the top line were Tide Simple Pleasures, Gain Joyful Expressions, Febreze Noticeables, several Swiffer upgrades, and the Fairy auto dishwashing launch in Western Europe. Tide and Gain each grew value share in the U.S. laundry market by more than 1 point, and total P&G value share of the U.S. laundry market is up nearly 2 points to over 61%. Also, we're currently in the process of resetting the laundry detergent shelves in Cedar Rapids, Iowa, to begin our two times compaction test market. This is a full line replacement of P&G's current liquid detergents with concentrated formulas across all of P&G's brands: Tide, Gain, Cheer, Era and Dreft. All major retailers are participating in the test, and we understand that all major manufacturers will also be participating. The new concentrated products offer clear wins for consumers, retailers, manufacturers and the environment from improved convenience, better space efficiency and related supply chain benefits, and lower material usage. Febreze share of the U.S. air care market is up almost 5 points to nearly 25%. This includes over 80% share of the fabric spray segment and 18% of the instant air freshener sprays. Swiffer continues to be a great example of the power of P&G's launch and leveraged innovation approach. Swiffer's share of U.S. cleaning systems is now over 84%, up nearly 6 points versus last year behind a steady stream of product improvements across the franchise. Turning to baby care and family care, the businesses delivered a good quarter with sales growth of 5% and earnings growth of 20%. Family care growth was driven mainly by the continued expansion of Charmin and Bounty Basic. In addition, the business launched two new initiatives in September, a Puffs Plus with Lotion upgrade and the Charmin Ultra Softness improvement. Pampers posted solid growth in the quarter, led by mid-teens volume growth in developing markets. The brand had particularly strong results in China, Russia, Poland and Saudi Arabia. In developed markets, Western Europe was essentially flat and in North America, the Baby Stages of Development diaper line grew high single-digits, which offset soft results in the Luvs brand. Pampers past three month all-outlet value share of the U.S. diaper market is up 0.5 point to nearly 29%. New upgrades on Pampers, Baby Dry and Luvs are showing encouraging signs just a few weeks after the start of broad-based advertising. Pampers Baby Dry with Caterpillar Stretch led to strong growth during September, and Luvs new Leakguard Core Guarantee has helped to stabilize market share for the brand. Next is the pet health, snacks and coffee segment. Reported results for the unit are very strong with sales up 10% and earnings up 14%. However, these results are largely affected by the base period impact from Hurricane Katrina. Folgers continues to maintain strong market leadership in the U.S. with all-outlet share of 32%, bolstered by new innovations such as the Gourmet Selections and Simply Smooth product lines. Pringles sales were lower versus prior year due to inventory adjustments in Western Europe following a heavy merchandising period around the World Cup soccer tournament last quarter. Also, value share was down about 1 point in the U.S. due to heavy competitive promotional spending during the quarter. Blades and razors delivered a very strong reported sales growth of 12% on the quarter, while underlying consumption growth is estimated at 5% globally. The 7 point differential is comprised of 3 points of help from foreign exchange and roughly 4 points net benefit from trade inventory increases, primarily for the Fusion product expansion in the UK, Germany and Japan. Early results from the Fusion launch in Europe and Japan are very encouraging. We are receiving strong support from retailers in each market, as evidenced by the very strong sales results for the quarter. We do expect that a portion of the exceptionally strong sales in the September quarter are from the very strong Fusion sell-in and thus not entirely incremental to the fiscal year. In the U.S., as expected, male razor market share dipped as a result of heavy competitive promotions behind their new product introduction. Importantly, Fusion continues to deliver strong growth. The brand crossed the $0.25 billion mark in retail sales, and Fusion value share of male cartridges continues to grow, having increased every month since launch to now over 21%. In the Duracell and Braun segments, reported sales were up 7% and organic sales were up 4%. Duracell market share and sales were in line with prior year in the U.S. The sales benefits from price increases to offset higher material costs were largely offset by lower volume due to the lack of hurricanes this summer. Duracell all-outlet share of general-purpose batteries in the U.S. is holding strong at nearly 48%. In Western Europe, Duracell results have been soft due to aggressive spending in the alkaline segment from both private label and branded competitors. Duracell is responding with increased display activity and continued strong advertising support. In Latin America, Duracell had a very strong quarter, driven mainly by significant distribution increases into higher frequency stores, particularly in Mexico. This is a good example of P&G distribution advantages at work. On the Braun business, sales growth has been strong in markets where we have launched new initiatives. In North America, Braun recently launched the 360 Complete and Contour razors. The Pulsonic razor was launched last month in Germany and is on shelf this month in Japan. Pulsonic is Braun's new premium razor that features sonic pulsing action to improve shaving performance and comfort. That concludes the business segment review. Now, I will hand the call back to Clayt.
Clayt Daley: Thanks, John. First, an update on Gillette. We remain on track with our commitment to return P&G to the pre-Gillette double-digit compound EPS growth trend line by fiscal 2008 and we remain on track with revenue and cost synergy targets. The integration is progressing well due to excellent work by all of the Gillette integration sub-teams around the world, and I want to thank the whole team for all of their hard work. Let me highlight a few areas. We just completed on October 1 the third wave of business systems integrations with excellent results. Specifically, we integrated systems, sales forces and distribution networks in 13 additional countries, including our two largest markets, the U.S. and the UK. This brings us to about 80% of the Gillette business selling, taking orders, shipping products, and receiving payments now as a single company. We manage these conversions without any major business interruptions and we will largely complete the systems integration work in January. We are making excellent progress on staffing efficiencies. We have separated over 3,000 people, as of October 1, and expect to complete the majority of the remaining job reductions by the end of this fiscal year. This puts us well on track with the 5,000 to 6,000 total job reductions targeted as part of the Gillette integration. Finally, we are making strong progress on the go-to-market reinvention work. We are combining the best practices from Gillette and P&G to strengthen our capabilities. We expect improvements in distribution, customer service, trade spending efficiency, and in-store presence. We plan to expand the new approach in January. We will provide more details on this at the upcoming analyst meeting in December. In summary, we remain on track with both the integration and acquisition economics. Now, let me move on to guidance. For fiscal year 2007, we continue to expect raw material and energy costs to be up versus fiscal year 2006. At current levels, the amount of the increase should be smaller than what we have been seeing over the past two years. The largest negative impact, from a comparison standpoint, should be the just-completed September quarter. As such, we expect cost-savings projects and volume leverage to begin to flow through to gross margin improvement over the next several quarters. While oil and natural gas prices have come off recent highs, we expect this to take a number of quarters to translate this into lower input cost. Additionally, there are a number of materials, such as pulp and metals, where prices continue to increase. Having said this, clearly an environment with flat to declining commodity and energy costs is certainly a better operating environment than we've experienced over the past two fiscal years. Additionally, we continue to work with our retail partners to reduce supply chain inventories. We expect this will benefit P&G over the long term as leading brands should increase shelf space as a result of this effort. Our brands with lower inventory levels will provide an even better return to our retail partners. Specifically now for the current fiscal year, we expect P&G's base business to deliver its sixth consecutive year of growth at or above P&G's long-term sales targets. Organic sales, which exclude the impact of foreign exchange and acquisitions and divestitures, are expected to grow 4% to 6%, in line with our previous guidance range. Within this, we expect the combination of pricing and mix to have a neutral to positive 1% impact, and foreign exchange is expected to increase sales by about 1%. Acquisitions and divestitures should add about 4% growth to the top line and should result in an all-in sales growth of 9% to 11% for the year. On the blades and razors business specifically, we continue to expect strong mid single-digit consumption growth driven by Fusion. Reported sales will likely be choppy quarter-to-quarter due to continued integration-related trade inventory reductions uneven base period comparisons and initiative launch timings. Turning to the bottom line, we're raising our outlook for the fiscal year based on a better commodity and energy cost forecast for the balance of the year. We now expect EPS to be in the range of $2.97 to $3.02. We expect operating margins to improve by over 100 basis points, driven primarily by gross margins. Included in this, we continue to expect dilution from Gillette to be $0.12 to $0.18. We are maintaining the Gillette dilution forecast as the better than expected Gillette results in the first quarter were primarily due to pipeline volume behind Fusion launches in Europe and Japan. We expect one-time items associated with the Gillette acquisition to be $0.06 to $0.08 per share, in line with previous guidance. Now, turning to the December quarter, organic sales are expected to grow 4% to 7%, compared to a strong base period of 8% organic sales growth. Note that the December quarter will be the first quarter in which Gillette will be included in organic results. Our guidance reflects the higher quarterly volatility of the Gillette business. Within this, price mix is expected to be flat to up 1%, foreign exchange is expected to have a positive impact of about 1%, resulting in all-in sales growth of 5% to 8%. Turning to the bottom line, we expect operating margins to be up 50 to 100 basis points in the December quarter, driven by both gross margin improvement and SG&A efficiencies. As a result, we expect earnings per share to accelerate significantly, due to strong base business results and the ramp-up of Gillette cost synergies. Specifically, we expect earnings per share to be up 13% to 15%, in the range of $0.81 to $0.83 per share. In closing, P&G continues to deliver very strong results. We are making good progress on the Gillette integration and executing with consistency and excellence on the established business. A.G., John and I will now open the call for questions. As a reminder, we will be limiting each person to one question before moving onto the next caller with the objective of completing the call by 9:45. We've gotten a lot of feedback from particularly portfolio managers that they would like to see this call be shorter and more strategically focused. We hope we can accomplish that objective. Thank you.
Operator: (Operator Instructions) Your first question comes from Bill Pecoriello - Morgan Stanley.
Bill Pecoriello - Morgan Stanley: Good morning, everybody. If you can talk about North America sales, consumption versus shipments, if you saw any retailer deloading in the quarter? Also, we've been hearing other CPG companies talk about softness in September/October. What are you seeing in recent weeks there? Thank you.
A.G. Lafley: We had a strong quarter in July to September. In fact, we had strong mid single-digit growth and it was brought-based. October is going to be a pretty decent month, so we are about on track, I would say, in North America. In fact, I would argue that has been one of our strengths: the breadth, the balance and the progress we've made in North America. At our two biggest accounts, Wal-Mart and Target, we had double-digit volume growth in the first quarter. As we looked at our market shares through the first quarter on our top 20 brands, we were up on 17 of our top 20 brands. I mean, we've been running share growth on two-thirds of our businesses or two-thirds of our sales, and of course, that's well above that. I guess the last thing I would say is we've just launched an awful lot of innovation into the marketplace. We're still in very early days and we intend to continue to invest. Almost without exception, they are off to a very good start and we're going to sustain the investment and keep trying to drive the trial rate among the target audience. So I feel pretty good about North America. I mean there's no doubt Wal-Mart announced earlier this week that they are struggling with their same-store sales. We're going to get a lot of economic data this week that is going to help us with inflation rates and whether the consumer is still in the game. But from everything we're seeing, we're pretty optimistic.
Clayt Daley: No major trade inventory impact in the quarter.
A.G. Lafley: Bill, one last point, because what you may be hearing and what we did see is, if you look at the markets on a unit volume basis, they were off, in July-September for the first time in a long time in the U.S. But on the value side, they were up. We think that's evidence of two things. One is the strength of the middle to the high end of the market, where we are strong. Second is that our innovation, which is consistently encouraging consumers to trade up, is working. So in a period where you're not selling more volume, or we are selling more volume but where market volume growth isn't providing tailwinds for you, you've got to have a very strong trade-up program. If you think about all of our categories, whether it's laundry or dish or home care or beauty or oral care we've been running very strong trade-up programs, and I think that has benefited us.
Operator: Your next question comes from Lauren Lieberman - Lehman Brothers.
Lauren Lieberman - Lehman Brothers: Thanks, good morning. Professional hair care in Europe, I was just kind of surprised to see that business was down. I was hoping I could get a little bit of an update on what has going on with Wella in Europe. If this is a market issue or any kind of changes in your distribution in Europe in the accounts that you're serving.
A.G. Lafley: Lauren, the Western European market and the Eastern European market to a lesser extent hasn't been the robust. We are in a low period before a couple of major launches. We’ve got the Vidal Sassoon professional line going out in the second quarter starting in Germany. Actually, it started shipping in September, and we have a major Koleston Perfect relaunch that's going out starting in France on October 1, so that's also started shipping. But actually, if you look at the professional growth outside of Western Europe, it was pretty solid. It was pretty solid and about in line with our expectations, so we expect Europe and Eastern Europe will come back with the initiative launches.
Operator: Your next question comes from Amy Chasen - Goldman Sachs.
Amy Chasen - Goldman Sachs: I was hoping you could give us an update on developing markets. You usually tell us, in the quarter how much developing markets were up. I was hoping you could do that, both including and excluding Gillette, and then specifically if you could give us an update on China.
A.G. Lafley: Okay, Amy, developing markets are up double-digits, which is what we target for. In China, we were up double-digits, excluding the impact of SK-II, which obviously hit us a little bit in the first quarter. Clayt and I just came back from two weeks in Asia, and I would say we continue to be pretty positive on Asia. We think it is still going to be a growth engine for us. We were in Central and Eastern Europe and in Russia in September. Our CEMEA markets, which are Central and Eastern Europe and the Middle East and Africa, look like they are going to be engines of growth. Last but not least, we are on our third year in a row of strong growth in Latin America. We are running high single-digits on the top line there. So we are feeling pretty good about developing markets. We have strong innovation programs going in developing markets, and frankly, we have more opportunities than we can take advantage of.
Clayt Daley: Of course, that double-digit growth, excluding SK-II, is organic. Obviously, with Gillette, these numbers are huge.
Operator: Your next question comes from Bill Schmitz - Deutsche Bank.
Bill Schmitz - Deutsche Bank: Good morning. Can you talk a little bit about the Tide compaction? I know it was outside the Cedar Rapids test and it looks like there are four SKUs nationally. I mean, how much of that is based on the success of All Small & Mighty and how much of it is just increased confidence in the product and you think consumer awareness is where it needs to be?
A.G. Lafley: Obviously, we are reasonably confident in the product, in the format and in the configuration, but we are going through a series of test markets to make sure that we've got everything right, because this is a huge scale-up for us; a huge scale-up for us. We have the small test going in Cedar Rapids. We also, as part of our learning experiment we put in four SKUs at Wal-Mart. That gets us a little bit broader.
Clayt Daley: But those four SKUs are available to all companies.
A.G. Lafley: Of course. We are hoping that other customers will get involved in the early learning experiment. But we are what we're trying to do is get as many consumer purchases, as many consumer usages, and as many consumer repetitions as we can so that we can get strong consumer understanding. We do not expect to be in a position to begin expanding and to get through our learning until probably the middle of next year. We don't expect the category to be converting in a major way to the new concentrated or compacted forms until probably 2008.
John Goodwin: But we're very pleased with the take-up in the test market with regard to the other manufacturers' participation and also the retailer participation has been very strong. We feel very positive, at this stage, around the direction that we're moving in.
Operator: Your next question comes from Nik Modi - UBS.
Nik Modi - UBS Warburg: Good morning. Just a quick question strategically on Gillette. Any programs in place or that you can share with us, as we think about the next 12 to 24 months, regarding getting higher emerging market penetration on the blades and razors business?
A.G. Lafley: We spent a lot of time on that over the last couple of months. I guess I would say three things. First of all, our primary focus is and has to be the Fusion launch and the trade-up to better systems in developed markets. We still have a lot of opportunity in the U.S. to drive trial. We're very pleased with our share of systems; it's up well over 70% on Fusion and Mach 3, but we still want to drive the conversion harder. You will see stronger trial-oriented communication and you'll see more sampling, even in the U.S. Secondly, we've just started in Western Europe and Japan. We are very happy with the take-off in all three markets; it's ahead of plan. We are particularly happy with Japan. I mean, we are already up to a 38 razor share from a 20 base, and that's a big move. When you have a better product, I mean, I spent eight years of my life in Japan. When you have a really superior product, the consumer will move. So we're cautiously optimistic about Europe and Japan, and we are very focused there. We have a big opportunity in developing markets, but it's going to take us a little while to get after it because, as you probably know, those markets are fairly fragmented right now. In several developing markets, still double-edge is the razor of choice. They are fairly large disposable segments and relatively small system segments. So we are sort of attacking this as you would expect Gillette and P&G to. We're starting with deep consumer understanding. We're trying to get clear on who our primary system targets might be. Then we're trying to design a product line that allows consumers to enter the system segment at an affordable price point and then trade up over time. I think what you will see from us in the next several months is a series of learning markets and test markets going on around the world in developing markets. We will try to figure out what's the best approach and hopefully we will come to one best approach if we can, one or two best approaches. Then you'll see expansions six to 12 months after that. But it is a big opportunity; we recognize it's a big opportunity, but we have to put first things first right now.
Clayt Daley: The focus here lately has been on integrating with excellence and as you probably know, in those developing markets the Gillette business is, in general, coming into P&G distributors and that integration program has been executed very well. But the important point though is we are now moving out of the integration phase and into the phase where we're going to be focused on driving more distribution, particularly in high-frequency stores, and trying to get much better penetration and build and reach behind the Gillette business over the timeframe that we were discussing.
Operator: Your next question comes from Wendy Nicholson - Citigroup.
Wendy Nicholson - Citigroup: Hi. My question has to do on the pricing and mix guidance. If I'm looking at the numbers right, the combination of those two factors were up 3% in the current quarter, and yet your guidance for the full year is for it to be neutral to up 1%. So that means somewhere along the way we're going to see negative pricing or mix. That surprises me, given all the new product activity being so premium priced and all of the emerging market trade up. So, what am I missing? Are you seeing price roll-backs in some of the areas where you've taken pricing or what is driving that change?
Clayt Daley: It's a logical question. What you are seeing is, in the first quarter, a big mix impact from Gillette that is a function of the fact that Gillette is not in base period in July-September. If you look at the internals on the business, this is 2 or 3 points; this is a big factor. If you look at the internals on the base P&G businesses, you see much smaller numbers. The smaller numbers are consistent with the guidance that we're providing for the year. So it really has nothing to do with expecting a price to come back. It's really a function of the mechanics of how we're showing the mix.
A.G. Lafley: We've anniversaried most of list pricing that we've taken on the established P&G businesses, so what we will expect going forward is modest trade-up where we can get it and where we are driving it.
Operator: Your next question comes from April Scee - Banc of America Securities.
April Scee - Banc of America Securities: Thank you. Just another quick question on the developing markets. I just want to check. Are you done with integration of the distributors in the developing markets? What are the first opportunities that you see in terms of trying to generate an acceleration in top line with that opportunity?
A.G. Lafley: We're not done, we're in the middle of the integration, but it sort of varies by market. I mean, we're done in some markets; we are well underway in all markets. But that integration will be done in the next three to six months. The second question, the first thing we see and we are already taking advantage of it, is what I would call broader and deeper distribution in high-frequency stores. High-frequency stores have been sort of a hidden success story for the Company because part of our developing market growth has been our ability to drive double-digit top line growth in high-frequency stores. Some of it comes from broader and deeper penetration. In other words, we are covering more stores in smaller cities, villages and towns. But a lot of it comes from better presence and better distribution and better on-hand, on-premises merchandising in these stores. So the first thing we will get is the distribution and the presence advantage in high-frequency stores. The second thing we're getting is joint merchandising and marketing efforts. So if you saw what we were doing in Latin America or in Asia or Central and Eastern Europe, we're running a lot of merchandising events that combine personal care brands or combine personal care and beauty care brands, or combine several Gillette and several P&G brands at the same time. So, that's sort of the second phase. We are already getting traction there; we are already getting revenue synergies there. Then the third piece will be the kinds of things we talked about before where we bring enhanced product lines that are more affordable for consumers in those markets, designed specifically for consumers in developing markets.
Operator: Your next question comes from John Faucher – JP Morgan.
John Faucher - JP Morgan: Good morning everyone. I was wondering if you could talk a little bit about your ad-to-sales targets over the next year. You talked about a less inflationary cost environment. Do you feel comfortable with where you netted out from an ad-to-sales ratio for fiscal 2006, which was down slightly? Is that the new normalized level or do you think you need to take it back up to sort of the recent peaks you had seen?
A.G. Lafley: We are very comfortable with where we are. We've got three things here. One is, we want to stay balanced and consistent and sustainable. You know, that's our communications, advertising and marketing strategy. The second thing I would say is we are getting real traction from our marketing ROI and market mix modeling work. It's leading to two things: one, an improvement in effectiveness because we are reallocating investments from parts of the communication plan that aren't working as hard for us to parts of the communication plan that are working harder. The second thing, obviously we're making every dollar go a little bit further. The third thing, and I think this is really important for you to understand, is we watch our brand equity and trial rates. We watch our brand equity strengths, you know, what's the relative strength of our brand equity versus the relevant competitors in given categories and industries. Then we watch our trial rates and our repeat rates. That's what we are really trying to drive; we're trying to drive our brand equity strengths. Frankly, on some of our businesses, we are finding that we can do that with much more efficient advertising and marketing spending. So, we don't get hung up on that ratio of ad spending or marketing spending to sales; we try to look at the effectiveness. Are we improving our brand equity? Are we increasing our trial? Are we improving our repeat rates? Because that's really what drives our market share and drives our sales and profitability over time.
Clayt Daley: Don't forget there have been some synergies from Gillette that we have been able to capture and that has had some impact as well.
Operator: Your next question comes from Chris Ferrara - Merrill Lynch.
Chris Ferrara - Merrill Lynch: Good morning, coming out of Wal-Mart's meeting and obviously their focus on key suppliers, and you are seeing accelerated growth at Wal-Mart and Target in the U.S., are you growing share within your top retailers actually at an accelerated rate? Does that rate accelerate more as Wal-Mart executes on its plan over the next couple of years?
A.G. Lafley: Chris, we're growing share steadily at our top customers, and that's obviously our goal. Our goal is to grow share at all customers and grow share at an accelerated rate at our most successful and biggest customers. So, that's clearly the goal. I mean, obviously, in the short term, we've been doing a little bit better because our organic growth rate has been a bit ahead of several of our retailers' same-store sales growth rates, but that sort of varies over time. Over the long term, what we're really looking for is consistent, steady share growth. The more important thing here, or I should say maybe some of the more important drivers here are one of the subjects that we're going to talk at the December meeting when we are together, which is this whole change in go to market that we are undertaking, which frankly Gillette has been a big catalyst for. Our goal is to drive joint value with our leading customers. We have a very simple notion that, if we can grow the pie together, both of us will benefit over the long haul. I think it shows up in the advantage in Cannondale rankings of the company where we are consistently and again this year rated the best manufacturer. But that really is the key, and there are a whole bunch of platforms there but one is grow categories which our innovation drives; one is efficient assortments and efficient response, which we drive with the retailer; another is driving cash and costs of the system that the shopper doesn't value. I think you can see it's working. I talked about the Target and Wal-Mart results in the U.S., but if you look at our top ten customers worldwide, our unit volume was up 9% organically in this first quarter. So we are doing pretty well across the board.
Operator: Your next question comes from Alice Longley - Buckingham Research.
Alice Longley - Buckingham Research Group: Could you give us how much Western Europe the volume and pricing was up in the quarter and what the trends look like in the second quarter?
Clayt Daley: We took price increases across a number of categories in Western Europe and announced many of them. So pricing was up slightly, in particular Duracell, which we just announced. But there are also a number of other categories that have had price increases. I think our volume numbers in Western Europe were low to mid singles.
Operator: Your next question comes from Justin Hott - Bear Stearns.
Justin Hott - Bear Stearns : Questions on Pantene and Crest Pro Health. First Pro Health. Can you give us some color on where it might be gaining share from in the U.S.? Is it from the smaller competitors? Then, anything you can tell us I guess on the future plans of the brand and maybe Pantene as well. Thank you.
A.G. Lafley: We are obviously pretty pleased with our oral care overall results. I think P&G was up double-digits on the top line in terms of organic growth in this first quarter. We were up over 20% on Crest in the U.S., and we were up double digits on Oral-B. So the whole program is working pretty well for us. We are in the very early days of Crest Pro Health, so our focus is on trial build. If you look at the market shares, which I'm sure you have, you'll see that on an all-outlet basis, Crest has added over 1.5 points of growth, and our leading competitor has also held or modestly built its share. Frankly, that's what we expected. I've spent almost 30 years in this business and if you go back to all the major launches where we had a strong, entrenched competitor, when we launched Liquid Tide in the mid '80s into the U.S. and Wisk was a big, entrenched, strong competitor, the whole first year Wisk held onto every 0.10 of a share point. That's because the equity is strong and that's because they defend significantly. We expect the same from our leading competitor in the US. In fact, what I think will happen is, over time, we will attract consumers, who are interested in the Pro Health proposition and who find the Pro Health product to be superior to whatever they are using currently. It's way too early to tell where that's going to shake out. I guess the last thing I would say is clearly what's going on in oral care in the U.S., which I mentioned is going on in a lot of categories, is that the consumer is trading up; and they are trading up to better dentifrices; they are trading up to better brushes; and they are trading up to a fuller regimen. You also asked about Pantene. Pantene has frankly been one of the Company's real assets over the last ten years. We are on our way to a $3 billion brand. It is the leader in many markets around the world, not just the U.S. It has a very strong brand equity, it's got a very strong product line, and in many cases superior performance. It has just been a combination of a brand and a product line that has really resonated with women around the world. So we continue to invest in Pantene. We continue to try to bring leading hair care technology and leading products, and we hope that we can continue to build a brand that will be a leader in the hair care category worldwide.
Operator: Your next question comes from Jason Gere - A.G. Edwards.
Jason Gere - A.G. Edwards: Actually just following up a little bit on the oral care side, can you talk a little bit more about the expansionary plans, maybe even including Pro Health, going forward in regions where I guess it really wasn't your marketplace, i.e. Latin America. Can you talk a little bit about that?
A.G. Lafley: Jason, I know you'd love me to but I can't comment on any future plans. Right now, we're focused on having a good launch in the U.S.
Operator: Your next question comes from Elena Mills - Atlantic Equities.
Elena Mills - Atlantic Equities: Good morning, everyone. Just a question on Duracell, please. I was wondering if you could comment on the commodity cost outlook specifically for the battery segment and relate that to how you see pricing and promotional activity developing, whether you specifically see a need for further pricing to offset some of the margin pressure that you seem to be feeling in that business? Thank you.
Clayt Daley: We've just announced pricing on Duracell across most of the major markets in Europe and North America. That's, of course, in response to unprecedented run-up in zinc prices, which have not abated. So, the price increase that has been announced really is not effective until the second half of the fiscal year. So as a consequence, we are, unfortunately, not able to price to recover all of the commodity cost increase in the current year, but once that pricing is in place, we should be in good shape going forward relative to commodity costs.
Operator: Your next question comes from Connie Maneaty - Prudential Equity Group.
Connie Maneaty - Prudential Equity: Back to the compaction test, it seems like this is going to be a very big initiative when the test is over and all store shelves are reset for smaller sizes. I mean, I'm trying to figure out what the size of the dollar value of the fabric and home care that is affected here. So, if it's an $18 billion segment, maybe half of it is outside the U.S., and then you have fabric and powdered detergents. So is this something on the order of $8 billion? Is that a good ballpark?
A.G. Lafley: The simple way to think about it is liquids are over half of the U.S. market and we will be going based on what consumers tell us in the learning market, but assuming consumers accept and like the new product format, the new product performance and all the rest of it, then we would engage in the kind of conversion that we undertook in the mid '80s and the early '90s, when we went through the first two rounds of compaction. If we are successful and the retailers are successful and the consumer wants to convert to the smaller formats, this would be a large conversion. You're right; it is a large conversion. The other thing that you have to understand is, for us, fabric care is a very global business, and what we are in is Phase I, which is the U.S. conversion. I think you may know we went through a powder compaction conversion this last year in Western Europe and in Eastern Europe, so this has been an ongoing trend in this category. What we're trying to do is be as or more effective with the performance and quality of our fabric care products and deliver them in a format to consumers that is better from a convenience and sustainability standpoint.
Clayt Daley: Relative to the amount of sales that are impacted, because it's liquids only, not powders and only in the U.S., the amount of sales that are impacted are probably about half of that number you were referring to, probably more in the neighborhood of four-ish as opposed to $8 billion. Thanks.
Operator: Your next question comes from Joe Altobello - CIBC World Markets.
Joe Altobello - CIBC World Markets: First, a quick question on compaction again. What could be the impact on category growth? What has been the history of the impact on category growth in past compaction? Secondly, more broadly on health care, should we expect an acceleration in organic growth since you guys are starting to lap easier comparisons on Actonel and Prilosec later this year?
A.G. Lafley: On the first one, historically, we have gotten a little increase in consumption every time we've moved to more compacted or more concentrated products. Again, that's part of what we are testing for, so we make sure that we understand that. That's good for the consumer because consumers, I hate to say it, in fabric care, tend to under dose, some fairly significantly, so they get a little bit better performance and they still get a good value. So it sort of works all the way around. Regarding healthcare, yes, I mean, the sequential trends will improve. We had a very tough base period in July-September. We had a big Prilosec pull last year before the pricing, and we had a big launch on Actonel, Actonel with calcium. So yes, those trends will improve sequentially.
Operator: Your next question comes from Bill Chappell - SunTrust.
Bill Chappell - SunTrust: Just a quick question on commodity costs. Can you give us an idea what you're looking at for oil prices for the remainder of the year? Then with your forecast of seeing the benefit, is that more due to just timing of when the benefits come through, or just uncertain of where it shake out by fiscal year end?
Clayt Daley: Our thoughts on oil are that we are probably, for the rest of this year, going to be somewhere $60, $65. We are not projecting anything going lower than what it is today. The issue we have, relative to our commodity-related input costs, is most of our suppliers are using feedstocks that were purchased months ago. So, it won't surprise you that they are not that interested in taking prices down immediately; although we are, of course, having those discussions on an ongoing basis. So, we would probably expect to see some relief in the second half of the fiscal year. That's one of the reasons why we raised the earnings guidance on the fiscal year. On the other hand, we don't want to get too bullish because history suggests that, if commodity costs begin to move down, some of that made logically be given back in pricing in the marketplace. But there's no question about the fact that we are in a much better position with oil at $60 or a little bit lower at the moment than we were when we were $70-plus. Therefore, the prospects for our commodity cost in the second half of the year should improve. Thanks.
Operator: Your next question comes from Linda Bolton-Weiser - Oppenheimer.
Linda Bolton-Weiser - Oppenheimer: I was just curious about the other income line. It was a little bit higher than we had expected and up significantly year-over-year. Do you have a forecast for that going forward? Should we expect to see such a large amount it in the remaining quarters of the year?
Clayt Daley: Go ahead, John.
John Goodwin: We expect it to be about in line with last year, all-in Linda. It was higher this quarter as a consequence of the divestitures that we made on Pert and Sure. They were announced at the time that we give guidance, so it's very much in line with expectations. However, don't forget interest expense is up quite a lot as well year-over-year, so in terms of the net impact, actually there's not that much difference versus the previous year. Interest income was also up as a consequence of interest rates moving up versus last year as well.
Operator: Your next question comes from Sandy Beebee - HSBC.
Sandy Beebee - HSBC: I was hoping you could talk a little bit about the baby category in North American and Western Europe, if the new launches and the value segments in North America had been performing to your expectations and when we would probably get to see better growth in that category? Also, in Western Europe, obviously Huggies has been fighting pretty hard, so if you could talk a little bit about your performance there.
A.G. Lafley: Overall, we are pretty optimistic going forward about the baby care category. It has obviously been a fairly tough past year for all of the competitors in the baby care business because there hasn't been a lot of innovation and innovation is critical in this market. I would say three things. First of all, we are pretty pleased with the continuing progress of our Baby Stages of Development line products. This is the one from Swaddlers and Crawlers and Easy Ups. It has done quite well in the U.S., and it continues to do quite well in Western Europe. In fact, Baby Stages of Development is now the top sub-segment in the U.S. diaper category, and that has really been the engine of growth for Pampers over the last year. We will continue to market and merchandise that line and we will continue to improve that product line. The Feel and Learn entry was an extension of Stages of Development. The second thing I would say is private label is and has been a tough competitor in that business. That's why we've moved with the two initiatives that John talked about, the Baby Dry with Caterpillar Stretch, which provides a really important benefit for consumers who are buying our mid-priced line of diapers around the world. Of course, we will bring that feature to the Baby Dry line in other relevant markets. It's also why we strengthened our Luvs product so that we could compete more effectively head-on with competition from below. The third thing I would say is we obviously watch this business very carefully, country by country and customer by customer. Our key countries are growing share. We had some challenges in the UK and we are turning that around behind Baby Stages of Development. In Western Europe, we are still, despite the -- how shall I say -- aggressive merchandising and promotion and pricing from our primary competitor, we are still very stable at a 54 share, so we are the clear-cut leader in that market.
Operator: Your next question comes from Chris Ferrara - Merrill Lynch.
Chris Ferrara - Merrill Lynch: On Wave Three of the integration systems upgrade, I guess it was completed October 1. When it is the latest you could possibly, in your view, see interruption like missed sales, problems with order collection? In other words, when do you see the risk associated with that integration?
Clayt Daley: Well, Chris, there's another wave that's going in January that's of fairly substantial size. We will go from 80% integrated to 95% integrated effective in January. Then there are a few other countries that get picked up in three to six months after that, like Japan is one. We're still looking at another quarter or two where there's certainly some possibility for trade inventory impact due to the integration. There is certainly some, although I would call it very modest risk, of disruption in the supply chain, and I would say the risk is modest because it has been executed so well so far, and I think it's one of the benefits of the fact that we did have eight months to plan before we closed the deal. The fact is that we've learned from our early conversions and have reapplied that learning in the subsequent conversions. I think everybody involved in that program has done an outstanding job. So I actually don't think that there's that much of what I call supply disruption risk in the integration.
John Goodwin: In terms of the financial systems, Chris, you get a pretty good visibility soon after the cut-over as to how successful things have got. The physical supply movements take a little bit longer to settle down, so that could take a bit longer. But the actual computer system is a little bit different; you see that sooner and that has gone well. But the physical supply piece, physical movement through the warehousing, that takes a little bit longer and a few more quarters, ask Clayt mentioned, for us to fully get all of everything worked out and humming on one system.
Operator: Your next question comes from Elena Mills - Atlantic Equities.
Elena Mills - Atlantic Equities: I was just wondering if you could comment, please, on the cosmetics business in a bit more detail and talk about when you see the drag from Max Factor abating in that business. Thank you.
A.G. Lafley: A couple of background comments. First, our focus on beauty care, far and away has, been on hair and skin. Those have been the growth drivers in the beauty category. Those have been the segments where we've focused -- hair, skin and femcare -- because that's where the money is; that's where the growth is; and frankly, that's where we have the strongest brand and product technology and innovation positions. So, they have been our engines of growth. The second point, which I want to make sure that everyone understands, is for cosmetics, we are running a very focused operation. So we're focused primarily on the U.S., where we have the market-leading Cover Girl brand, and we're doing some testing in developing markets very selectively. Thirdly, to your specific question, what we've done with Max Factor is we are focusing the brand on accounts, so think retailers, where we had a decent business and where they had the interest and where it was part of their strategy in their cosmetics category to not only have Max Factor as part of the portfolio but to support and drive Max Factor. We continue to support the brand, not just from a marketing standpoint but also from a product standpoint. You may have seen our mascara launch, which has been going really well and it's called Lash Exact/Lash Perfection in some markets. So I guess, if I were to summarize, I would say cosmetics is going to stay very focused. Our primary focus is on Cover Girl. We are narrowing our focus on Max Factor. We continue to support it. We think it will stabilize and then grow modestly in the channels and customers that it's distributed in on a regular basis.
Operator: Your next question comes from April Scee - Banc of America Securities.
April Scee - Banc of America Securities: Can you give us some detail on advertising and promotion and how that trended on an absolute basis and as a percentage of sales in the quarter?
A.G. Lafley: April, I commented on advertising; I think it's been basically stable as a percent of sales. Basically, what you are seeing is the effectiveness improvements and efficiency improvements we're getting from our marketing ROI program and from our market mix modeling is being reinvested in support for our innovation programs and major brands. The second point I would make is we focus on consistency and sustainability. The third point I would make is we focus on building our brand equity and driving our trial and repeat rates. On the promotional side, that varies so much across industries and across markets that it's really difficult to generalize. But I will say this. Clearly, the promotional activity is up in some categories. An obvious case and point, you just have to pick out any Sunday circular and look at the oral care category in the U.S. There have been a number of BOGOs and high-value coupons offered by our competitors. That clearly is in response to the Crest Pro Health launch. So, you'll see that kind of activity in markets where there's a major new product or new product line launch. The other thing I would say is we have had some countries and some channels in Western Europe, including the UK, where promotional activity has been up but we have worked real hard to bring the focus back to brand, bring the focus back to product innovation, bring the focus back to good, everyday consumer value behind our brands and products. Our basic strategy is to continue to invest in our brands on the advertising, marketing and communication side, influence our marketing, all of those kinds of programs, and to offer the minimum amount of trade and consumer promotion required to stay competitive in the category in the country.
Operator: Your next question comes from Connie Maneaty - Prudential Equity Group.
Connie Maneaty - Prudential Equity: My question is on commodity costs and private label pricing. Have you seen any reflection at retail yet of lower commodity costs in categories where private label is a big enough competitor that it would suggest you would be initiating price rollbacks in the near future?
Clayt Daley: No, and that's not surprising, given the fact that we really haven't seen the raw material costs come down yet.
A.G. Lafley: Connie, actually as we looked at all of the market shares in the U.S. over the past quarter, and I think I mentioned that we are up on 17 of our top 20 brands, it's very interesting. If you look across all of the competitors, including private labels, this is one of the weakest periods for private labels in a long time. So I ask myself, why is that the case? I think there are at least two reasons. One reason is there's a lot of attractive new product offerings from us and from several of our competitors, so there are a lot of good products out there and we are in the trial period, so they are available at good introductory prices. The second thing that's going on, which is related to an earlier question, we do have a little bit more promotion intensity in categories and markets where there are big, new product launches. So the relative value of the branded offerings, because of the better product performance and the better innovation, is just better at this time. The last thing I would say is, every time we look at private labels and we try to take them apart, a lot of these private label suppliers are operating on pretty thin margins. They don't have a lot of room for additional pricing.
Operator: Your final question comes from James Baker - Neuberger Berman.
James Baker - Neuberger Berman: I just wanted to get a feel for how your gross margin and SG&A ratio did, apart from the effects of Gillette, because looking at the totals that you show here, it seems there was a little less SG&A leverage this quarter than usual. Also perhaps you could comment on whether the Fusion launches abroad had some impact on that and whether that in fact even added to earnings in the quarter.
Clayt Daley: Most of the gross margin improvement is related to Gillette. If we look at the core P&G gross margin, as we said, we had a negative impact of 100 basis points on commodities. That was completely offset by pricing, volume and cost-savings programs, so that, if you will, the core P&G gross margin was neutral and the benefit is coming from Gillette. Now, having said that, as we go into the next quarter, we are projecting gross margin improvement where Gillette will be in the base. So I think we're going to see net gross margin improvement in the October-December quarter and the balance of the year. As we said, on the SG&A line, a lot of this really relates to the fact that that's where the amortization of the purchase price is in the income statement and some mix impacts that have influenced that SG&A line. I hope that answers your question. Thank you for your participation in today's call. I think the new format worked well. It was great that we have an opportunity to get to everybody who wanted to ask a question and even come back around for some follow-ups. We appreciate your interest in the Company. As I said, John and Chris and John Chevalier and I will all be around the rest of the day for follow-up questions. Thanks a lot.
Operator: With that, we will conclude today's conference. | [
{
"speaker": "Executives",
"text": "Clayt Daley - CFO John Goodwin - Treasurer A.G. Lafley - Chairman, President, CEO"
},
{
"speaker": "Analysts",
"text": "Bill Pecoriello - Morgan Stanley Lauren Lieberman - Lehman Brothers Amy Chasen - Goldman Sachs Bill Schmitz - Deutsche Bank Nik Modi - UBS Warburg Wendy Nicholson - Citigroup April Scee - Banc of America Securities John Faucher – JP Morgan Chris Ferrara - Merrill Lynch Alice Longley - Buckingham Research Group Justin Hott - Bear Stearns Jason Gere - A.G. Edwards & Sons Elena Mills - Atlantic Equities Connie Maneaty - Prudential Equity Group Joe Altobello - CIBC World Markets Bill Chappell - SunTrust Robinson Humphrey Linda Bolton-Weiser - Oppenheimer & Co. Sandy Beebee - HSBC James Baker - Neuberger Berman"
},
{
"speaker": "Operator",
"text": "Good morning, everyone, and welcome to Procter & Gamble's first quarter conference call. Today's discussion will include a number of forward-looking statements. If you will refer to P&G's most recent 10-K and 8-K reports, you will see a discussion of factors that could cause the Company's actual results to differ materially from these projections. As required by Regulation G, P&G needs to make you aware that, during the call, the company will make a number of references to non-GAAP and other financial measures. Management believes these measures provide investors valuable information on the underlying growth trends of the business. Organic refers to reported results, excluding the impact of acquisitions and divestitures and foreign exchange where applicable. Free cash flow represents operating cash flow, less capital expenditures. P&G has posted on its web site, www.pg.com, a full reconciliation of non-GAAP and other financial measures. Additionally, today's conference is being recorded. Now, I'd like to turn the call over to P&G's Chief Financial Officer, Clayt Daley. Please go ahead."
},
{
"speaker": "Clayt Daley",
"text": "Thanks and good morning, everyone. A.G. Lafley, our CEO, and John Goodwin, our Treasurer, join me this morning. I will begin the call with a summary of our first quarter results. John will cover our business results by operating segment, and I will wrap up with an update on the Gillette integration and our expectations for both the December quarter and the fiscal year. A.G. will join the call for the Q&A and as always, following the call, John Goodwin, Chris Peterson and I will be available to provide additional perspective, as needed. As a reminder, we are shortening the prepared comments this quarter to be less repetitive with the press release. Now, onto the September quarter results. We began fiscal 2007 with a strong first quarter. We delivered balanced top and bottom line growth driven by a healthy innovation program, strong operating margin improvement, and good progress on the Gillette integration. Diluted net earnings per share were $0.79, up 3% versus a year ago and $0.01 ahead of the consensus estimate. This included Gillette dilution of $0.05 to $0.06 per share, at the low end of our previous guidance range. Excluding this dilution, earnings per share were up 9% to 10% versus a year ago. Total sales increased 27% to $18.8 billion. This was at the top end of our guidance range, driven by better than expected results on the Gillette business. Sales on blades and razors were up 12% versus a year ago, due to a strong global consumption growth and better-than-expected customer sell-in behind the Fusion launch in the UK, Germany and Japan. Organic sales growth came in at 6%, driven by a robust innovation program. This was at the top end of our long-term organic growth target range of 4% to 6%. Recent innovations, such as Crest Pro Health toothpaste, Olay Definity, Tide Simple Pleasures, and the Herbal Essences brand restage are all off to a strong start. Next, onto earnings and margin performance. Operating income was up 33% to $4.1 billion, due to strong results on P&G's base business and the addition of Gillette. The operating margin was up 90 basis points versus a year ago, driven by significantly better gross margins. Gross margin was up 120 basis points to 52.8%. Higher commodity costs hurt base P&G gross margins by about 100 basis points in the quarter. Volume leverage, cost-savings efforts and pricing offset the commodity cost impact, while the mix benefit from the addition of Gillette drove margin expansion. Selling, general and administrative expenses increased by 30 basis points behind Gillette-related acquisition costs, as we expected. We repurchased $1.4 billion of P&G stock during the September quarter. This included the completion of the Gillette buyback program in July and the resumption of our discretionary share repurchases, which we expect to continue going forward. The tax rate for the quarter came in at 30.4%, about in line with a year ago. We continue to expect that the tax rate for the current fiscal year will be at or slightly below 30%, again in line with previous guidance. As expected, non-operating income increased due to higher interest income and the planned divestitures of Pert and Sure. The increase was in line with previous guidance. Earnings per share included $0.03 of one-time charges related to the Gillette acquisition, also in line with previous guidance. Now, let's turn to cash performance. Operating cash flow in the quarter was $3 billion, up about $800 million from the same period last year. The improvement was driven by the addition of Gillette and earnings growth from the P&G base business. Working capital was about neutral to cash versus year ago. Receivables increased by three days due to the mix impacts of adding Gillette and strong Fusion pipeline shipments late in the quarter. Inventory days increased due to the mix impact of adding Gillette and inventory builds in preparation for the upcoming Fusion launches in continental Europe. Excluding Gillette, inventory days were down modestly versus a year ago despite inventory builds in support of our strong innovation program. Cash generated from payables offset the increases in receivables and inventories. Free cash flow for the quarter was $2.4 billion. Capital spending was 3% of sales. Free cash flow productivity came in at 88%, slightly ahead of year ago. To summarize this strong start to the new fiscal year, P&G continues to drive balanced top and bottom line growth. Our growth strategies are working, and we continue to benefit from our balanced portfolio and robust innovation program. Now, I will turn it over to John for a discussion of our business unit results, by segment."
},
{
"speaker": "John Goodwin",
"text": "Thanks, Clayt. Starting with our beauty business, sales were up 11% behind strong organic growth and the addition of Gillette. Skincare, feminine care and retail hair care lead the organic growth. In hair care, Pantene, Head & Shoulders and Herbal Essences all grew global volume high single-digits -- all greater -- behind strong initiatives on each brand. In total, P&G past three-month value share of the U.S. shampoo market is up more than a point to 40%, despite a high level of competitive product activity. The skincare business grew double digits, despite the temporary voluntary suspension of SK-II shipments in China. We have recently received confirmation on SK-II product safety in China, and expect to re-enter the market in the next few weeks. Within skincare, Olay volume grew mid-teens globally with the continued expansion of the Regenerist line and over 20% growth in U.S. behind the launch of Olay Definity. Olay past three-month value share of the U.S. facial moisturizers market is up nearly 6 points versus prior year to over 41%. Femcare also grew volume high single-digits globally. Always continues to deliver strong market share gains behind the Clean & Fresh initiatives. Value share in the U.S. is now 54%, up nearly 2 points versus prior year. Tampax share is also up more than a point in the U.S. to 51%, behind the continued growth of Tampax Pearl. Tampax has widened its market share lead in the tampon category, and Pearl is now a leader in the plastic applicator segments. In healthcare, reported sales were up 32%, driven mainly by the addition of the Oral-B business. Organic sales were up 4% comparing against a very strong base period for both the Prilosec OTC and Actonel brands. In oral care, organic sales grew double-digits globally behind strength in the North America and Europe, Middle East, Africa regions. In the U.S., Crest delivered strong results behind the Pro Health toothpaste launch. Crest unit volume was up double-digits in the U.S. for the quarter, and past three months all-outlet value share in toothpaste was up 2 points to 36%. These strong results were delivered despite heavy competitive spending. Moving to the household businesses, fabric care and home care delivered another very strong quarter with 9% sales growth. Both businesses grew volume high single-digits for the quarter, driven by strong innovation results. Key initiatives driving the top line were Tide Simple Pleasures, Gain Joyful Expressions, Febreze Noticeables, several Swiffer upgrades, and the Fairy auto dishwashing launch in Western Europe. Tide and Gain each grew value share in the U.S. laundry market by more than 1 point, and total P&G value share of the U.S. laundry market is up nearly 2 points to over 61%. Also, we're currently in the process of resetting the laundry detergent shelves in Cedar Rapids, Iowa, to begin our two times compaction test market. This is a full line replacement of P&G's current liquid detergents with concentrated formulas across all of P&G's brands: Tide, Gain, Cheer, Era and Dreft. All major retailers are participating in the test, and we understand that all major manufacturers will also be participating. The new concentrated products offer clear wins for consumers, retailers, manufacturers and the environment from improved convenience, better space efficiency and related supply chain benefits, and lower material usage. Febreze share of the U.S. air care market is up almost 5 points to nearly 25%. This includes over 80% share of the fabric spray segment and 18% of the instant air freshener sprays. Swiffer continues to be a great example of the power of P&G's launch and leveraged innovation approach. Swiffer's share of U.S. cleaning systems is now over 84%, up nearly 6 points versus last year behind a steady stream of product improvements across the franchise. Turning to baby care and family care, the businesses delivered a good quarter with sales growth of 5% and earnings growth of 20%. Family care growth was driven mainly by the continued expansion of Charmin and Bounty Basic. In addition, the business launched two new initiatives in September, a Puffs Plus with Lotion upgrade and the Charmin Ultra Softness improvement. Pampers posted solid growth in the quarter, led by mid-teens volume growth in developing markets. The brand had particularly strong results in China, Russia, Poland and Saudi Arabia. In developed markets, Western Europe was essentially flat and in North America, the Baby Stages of Development diaper line grew high single-digits, which offset soft results in the Luvs brand. Pampers past three month all-outlet value share of the U.S. diaper market is up 0.5 point to nearly 29%. New upgrades on Pampers, Baby Dry and Luvs are showing encouraging signs just a few weeks after the start of broad-based advertising. Pampers Baby Dry with Caterpillar Stretch led to strong growth during September, and Luvs new Leakguard Core Guarantee has helped to stabilize market share for the brand. Next is the pet health, snacks and coffee segment. Reported results for the unit are very strong with sales up 10% and earnings up 14%. However, these results are largely affected by the base period impact from Hurricane Katrina. Folgers continues to maintain strong market leadership in the U.S. with all-outlet share of 32%, bolstered by new innovations such as the Gourmet Selections and Simply Smooth product lines. Pringles sales were lower versus prior year due to inventory adjustments in Western Europe following a heavy merchandising period around the World Cup soccer tournament last quarter. Also, value share was down about 1 point in the U.S. due to heavy competitive promotional spending during the quarter. Blades and razors delivered a very strong reported sales growth of 12% on the quarter, while underlying consumption growth is estimated at 5% globally. The 7 point differential is comprised of 3 points of help from foreign exchange and roughly 4 points net benefit from trade inventory increases, primarily for the Fusion product expansion in the UK, Germany and Japan. Early results from the Fusion launch in Europe and Japan are very encouraging. We are receiving strong support from retailers in each market, as evidenced by the very strong sales results for the quarter. We do expect that a portion of the exceptionally strong sales in the September quarter are from the very strong Fusion sell-in and thus not entirely incremental to the fiscal year. In the U.S., as expected, male razor market share dipped as a result of heavy competitive promotions behind their new product introduction. Importantly, Fusion continues to deliver strong growth. The brand crossed the $0.25 billion mark in retail sales, and Fusion value share of male cartridges continues to grow, having increased every month since launch to now over 21%. In the Duracell and Braun segments, reported sales were up 7% and organic sales were up 4%. Duracell market share and sales were in line with prior year in the U.S. The sales benefits from price increases to offset higher material costs were largely offset by lower volume due to the lack of hurricanes this summer. Duracell all-outlet share of general-purpose batteries in the U.S. is holding strong at nearly 48%. In Western Europe, Duracell results have been soft due to aggressive spending in the alkaline segment from both private label and branded competitors. Duracell is responding with increased display activity and continued strong advertising support. In Latin America, Duracell had a very strong quarter, driven mainly by significant distribution increases into higher frequency stores, particularly in Mexico. This is a good example of P&G distribution advantages at work. On the Braun business, sales growth has been strong in markets where we have launched new initiatives. In North America, Braun recently launched the 360 Complete and Contour razors. The Pulsonic razor was launched last month in Germany and is on shelf this month in Japan. Pulsonic is Braun's new premium razor that features sonic pulsing action to improve shaving performance and comfort. That concludes the business segment review. Now, I will hand the call back to Clayt."
},
{
"speaker": "Clayt Daley",
"text": "Thanks, John. First, an update on Gillette. We remain on track with our commitment to return P&G to the pre-Gillette double-digit compound EPS growth trend line by fiscal 2008 and we remain on track with revenue and cost synergy targets. The integration is progressing well due to excellent work by all of the Gillette integration sub-teams around the world, and I want to thank the whole team for all of their hard work. Let me highlight a few areas. We just completed on October 1 the third wave of business systems integrations with excellent results. Specifically, we integrated systems, sales forces and distribution networks in 13 additional countries, including our two largest markets, the U.S. and the UK. This brings us to about 80% of the Gillette business selling, taking orders, shipping products, and receiving payments now as a single company. We manage these conversions without any major business interruptions and we will largely complete the systems integration work in January. We are making excellent progress on staffing efficiencies. We have separated over 3,000 people, as of October 1, and expect to complete the majority of the remaining job reductions by the end of this fiscal year. This puts us well on track with the 5,000 to 6,000 total job reductions targeted as part of the Gillette integration. Finally, we are making strong progress on the go-to-market reinvention work. We are combining the best practices from Gillette and P&G to strengthen our capabilities. We expect improvements in distribution, customer service, trade spending efficiency, and in-store presence. We plan to expand the new approach in January. We will provide more details on this at the upcoming analyst meeting in December. In summary, we remain on track with both the integration and acquisition economics. Now, let me move on to guidance. For fiscal year 2007, we continue to expect raw material and energy costs to be up versus fiscal year 2006. At current levels, the amount of the increase should be smaller than what we have been seeing over the past two years. The largest negative impact, from a comparison standpoint, should be the just-completed September quarter. As such, we expect cost-savings projects and volume leverage to begin to flow through to gross margin improvement over the next several quarters. While oil and natural gas prices have come off recent highs, we expect this to take a number of quarters to translate this into lower input cost. Additionally, there are a number of materials, such as pulp and metals, where prices continue to increase. Having said this, clearly an environment with flat to declining commodity and energy costs is certainly a better operating environment than we've experienced over the past two fiscal years. Additionally, we continue to work with our retail partners to reduce supply chain inventories. We expect this will benefit P&G over the long term as leading brands should increase shelf space as a result of this effort. Our brands with lower inventory levels will provide an even better return to our retail partners. Specifically now for the current fiscal year, we expect P&G's base business to deliver its sixth consecutive year of growth at or above P&G's long-term sales targets. Organic sales, which exclude the impact of foreign exchange and acquisitions and divestitures, are expected to grow 4% to 6%, in line with our previous guidance range. Within this, we expect the combination of pricing and mix to have a neutral to positive 1% impact, and foreign exchange is expected to increase sales by about 1%. Acquisitions and divestitures should add about 4% growth to the top line and should result in an all-in sales growth of 9% to 11% for the year. On the blades and razors business specifically, we continue to expect strong mid single-digit consumption growth driven by Fusion. Reported sales will likely be choppy quarter-to-quarter due to continued integration-related trade inventory reductions uneven base period comparisons and initiative launch timings. Turning to the bottom line, we're raising our outlook for the fiscal year based on a better commodity and energy cost forecast for the balance of the year. We now expect EPS to be in the range of $2.97 to $3.02. We expect operating margins to improve by over 100 basis points, driven primarily by gross margins. Included in this, we continue to expect dilution from Gillette to be $0.12 to $0.18. We are maintaining the Gillette dilution forecast as the better than expected Gillette results in the first quarter were primarily due to pipeline volume behind Fusion launches in Europe and Japan. We expect one-time items associated with the Gillette acquisition to be $0.06 to $0.08 per share, in line with previous guidance. Now, turning to the December quarter, organic sales are expected to grow 4% to 7%, compared to a strong base period of 8% organic sales growth. Note that the December quarter will be the first quarter in which Gillette will be included in organic results. Our guidance reflects the higher quarterly volatility of the Gillette business. Within this, price mix is expected to be flat to up 1%, foreign exchange is expected to have a positive impact of about 1%, resulting in all-in sales growth of 5% to 8%. Turning to the bottom line, we expect operating margins to be up 50 to 100 basis points in the December quarter, driven by both gross margin improvement and SG&A efficiencies. As a result, we expect earnings per share to accelerate significantly, due to strong base business results and the ramp-up of Gillette cost synergies. Specifically, we expect earnings per share to be up 13% to 15%, in the range of $0.81 to $0.83 per share. In closing, P&G continues to deliver very strong results. We are making good progress on the Gillette integration and executing with consistency and excellence on the established business. A.G., John and I will now open the call for questions. As a reminder, we will be limiting each person to one question before moving onto the next caller with the objective of completing the call by 9:45. We've gotten a lot of feedback from particularly portfolio managers that they would like to see this call be shorter and more strategically focused. We hope we can accomplish that objective. Thank you."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Bill Pecoriello - Morgan Stanley."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "Good morning, everybody. If you can talk about North America sales, consumption versus shipments, if you saw any retailer deloading in the quarter? Also, we've been hearing other CPG companies talk about softness in September/October. What are you seeing in recent weeks there? Thank you."
},
{
"speaker": "A.G. Lafley",
"text": "We had a strong quarter in July to September. In fact, we had strong mid single-digit growth and it was brought-based. October is going to be a pretty decent month, so we are about on track, I would say, in North America. In fact, I would argue that has been one of our strengths: the breadth, the balance and the progress we've made in North America. At our two biggest accounts, Wal-Mart and Target, we had double-digit volume growth in the first quarter. As we looked at our market shares through the first quarter on our top 20 brands, we were up on 17 of our top 20 brands. I mean, we've been running share growth on two-thirds of our businesses or two-thirds of our sales, and of course, that's well above that. I guess the last thing I would say is we've just launched an awful lot of innovation into the marketplace. We're still in very early days and we intend to continue to invest. Almost without exception, they are off to a very good start and we're going to sustain the investment and keep trying to drive the trial rate among the target audience. So I feel pretty good about North America. I mean there's no doubt Wal-Mart announced earlier this week that they are struggling with their same-store sales. We're going to get a lot of economic data this week that is going to help us with inflation rates and whether the consumer is still in the game. But from everything we're seeing, we're pretty optimistic."
},
{
"speaker": "Clayt Daley",
"text": "No major trade inventory impact in the quarter."
},
{
"speaker": "A.G. Lafley",
"text": "Bill, one last point, because what you may be hearing and what we did see is, if you look at the markets on a unit volume basis, they were off, in July-September for the first time in a long time in the U.S. But on the value side, they were up. We think that's evidence of two things. One is the strength of the middle to the high end of the market, where we are strong. Second is that our innovation, which is consistently encouraging consumers to trade up, is working. So in a period where you're not selling more volume, or we are selling more volume but where market volume growth isn't providing tailwinds for you, you've got to have a very strong trade-up program. If you think about all of our categories, whether it's laundry or dish or home care or beauty or oral care we've been running very strong trade-up programs, and I think that has benefited us."
},
{
"speaker": "Operator",
"text": "Your next question comes from Lauren Lieberman - Lehman Brothers."
},
{
"speaker": "Lauren Lieberman - Lehman Brothers",
"text": "Thanks, good morning. Professional hair care in Europe, I was just kind of surprised to see that business was down. I was hoping I could get a little bit of an update on what has going on with Wella in Europe. If this is a market issue or any kind of changes in your distribution in Europe in the accounts that you're serving."
},
{
"speaker": "A.G. Lafley",
"text": "Lauren, the Western European market and the Eastern European market to a lesser extent hasn't been the robust. We are in a low period before a couple of major launches. We’ve got the Vidal Sassoon professional line going out in the second quarter starting in Germany. Actually, it started shipping in September, and we have a major Koleston Perfect relaunch that's going out starting in France on October 1, so that's also started shipping. But actually, if you look at the professional growth outside of Western Europe, it was pretty solid. It was pretty solid and about in line with our expectations, so we expect Europe and Eastern Europe will come back with the initiative launches."
},
{
"speaker": "Operator",
"text": "Your next question comes from Amy Chasen - Goldman Sachs."
},
{
"speaker": "Amy Chasen - Goldman Sachs",
"text": "I was hoping you could give us an update on developing markets. You usually tell us, in the quarter how much developing markets were up. I was hoping you could do that, both including and excluding Gillette, and then specifically if you could give us an update on China."
},
{
"speaker": "A.G. Lafley",
"text": "Okay, Amy, developing markets are up double-digits, which is what we target for. In China, we were up double-digits, excluding the impact of SK-II, which obviously hit us a little bit in the first quarter. Clayt and I just came back from two weeks in Asia, and I would say we continue to be pretty positive on Asia. We think it is still going to be a growth engine for us. We were in Central and Eastern Europe and in Russia in September. Our CEMEA markets, which are Central and Eastern Europe and the Middle East and Africa, look like they are going to be engines of growth. Last but not least, we are on our third year in a row of strong growth in Latin America. We are running high single-digits on the top line there. So we are feeling pretty good about developing markets. We have strong innovation programs going in developing markets, and frankly, we have more opportunities than we can take advantage of."
},
{
"speaker": "Clayt Daley",
"text": "Of course, that double-digit growth, excluding SK-II, is organic. Obviously, with Gillette, these numbers are huge."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bill Schmitz - Deutsche Bank."
},
{
"speaker": "Bill Schmitz - Deutsche Bank",
"text": "Good morning. Can you talk a little bit about the Tide compaction? I know it was outside the Cedar Rapids test and it looks like there are four SKUs nationally. I mean, how much of that is based on the success of All Small & Mighty and how much of it is just increased confidence in the product and you think consumer awareness is where it needs to be?"
},
{
"speaker": "A.G. Lafley",
"text": "Obviously, we are reasonably confident in the product, in the format and in the configuration, but we are going through a series of test markets to make sure that we've got everything right, because this is a huge scale-up for us; a huge scale-up for us. We have the small test going in Cedar Rapids. We also, as part of our learning experiment we put in four SKUs at Wal-Mart. That gets us a little bit broader."
},
{
"speaker": "Clayt Daley",
"text": "But those four SKUs are available to all companies."
},
{
"speaker": "A.G. Lafley",
"text": "Of course. We are hoping that other customers will get involved in the early learning experiment. But we are what we're trying to do is get as many consumer purchases, as many consumer usages, and as many consumer repetitions as we can so that we can get strong consumer understanding. We do not expect to be in a position to begin expanding and to get through our learning until probably the middle of next year. We don't expect the category to be converting in a major way to the new concentrated or compacted forms until probably 2008."
},
{
"speaker": "John Goodwin",
"text": "But we're very pleased with the take-up in the test market with regard to the other manufacturers' participation and also the retailer participation has been very strong. We feel very positive, at this stage, around the direction that we're moving in."
},
{
"speaker": "Operator",
"text": "Your next question comes from Nik Modi - UBS."
},
{
"speaker": "Nik Modi - UBS Warburg",
"text": "Good morning. Just a quick question strategically on Gillette. Any programs in place or that you can share with us, as we think about the next 12 to 24 months, regarding getting higher emerging market penetration on the blades and razors business?"
},
{
"speaker": "A.G. Lafley",
"text": "We spent a lot of time on that over the last couple of months. I guess I would say three things. First of all, our primary focus is and has to be the Fusion launch and the trade-up to better systems in developed markets. We still have a lot of opportunity in the U.S. to drive trial. We're very pleased with our share of systems; it's up well over 70% on Fusion and Mach 3, but we still want to drive the conversion harder. You will see stronger trial-oriented communication and you'll see more sampling, even in the U.S. Secondly, we've just started in Western Europe and Japan. We are very happy with the take-off in all three markets; it's ahead of plan. We are particularly happy with Japan. I mean, we are already up to a 38 razor share from a 20 base, and that's a big move. When you have a better product, I mean, I spent eight years of my life in Japan. When you have a really superior product, the consumer will move. So we're cautiously optimistic about Europe and Japan, and we are very focused there. We have a big opportunity in developing markets, but it's going to take us a little while to get after it because, as you probably know, those markets are fairly fragmented right now. In several developing markets, still double-edge is the razor of choice. They are fairly large disposable segments and relatively small system segments. So we are sort of attacking this as you would expect Gillette and P&G to. We're starting with deep consumer understanding. We're trying to get clear on who our primary system targets might be. Then we're trying to design a product line that allows consumers to enter the system segment at an affordable price point and then trade up over time. I think what you will see from us in the next several months is a series of learning markets and test markets going on around the world in developing markets. We will try to figure out what's the best approach and hopefully we will come to one best approach if we can, one or two best approaches. Then you'll see expansions six to 12 months after that. But it is a big opportunity; we recognize it's a big opportunity, but we have to put first things first right now."
},
{
"speaker": "Clayt Daley",
"text": "The focus here lately has been on integrating with excellence and as you probably know, in those developing markets the Gillette business is, in general, coming into P&G distributors and that integration program has been executed very well. But the important point though is we are now moving out of the integration phase and into the phase where we're going to be focused on driving more distribution, particularly in high-frequency stores, and trying to get much better penetration and build and reach behind the Gillette business over the timeframe that we were discussing."
},
{
"speaker": "Operator",
"text": "Your next question comes from Wendy Nicholson - Citigroup."
},
{
"speaker": "Wendy Nicholson - Citigroup",
"text": "Hi. My question has to do on the pricing and mix guidance. If I'm looking at the numbers right, the combination of those two factors were up 3% in the current quarter, and yet your guidance for the full year is for it to be neutral to up 1%. So that means somewhere along the way we're going to see negative pricing or mix. That surprises me, given all the new product activity being so premium priced and all of the emerging market trade up. So, what am I missing? Are you seeing price roll-backs in some of the areas where you've taken pricing or what is driving that change?"
},
{
"speaker": "Clayt Daley",
"text": "It's a logical question. What you are seeing is, in the first quarter, a big mix impact from Gillette that is a function of the fact that Gillette is not in base period in July-September. If you look at the internals on the business, this is 2 or 3 points; this is a big factor. If you look at the internals on the base P&G businesses, you see much smaller numbers. The smaller numbers are consistent with the guidance that we're providing for the year. So it really has nothing to do with expecting a price to come back. It's really a function of the mechanics of how we're showing the mix."
},
{
"speaker": "A.G. Lafley",
"text": "We've anniversaried most of list pricing that we've taken on the established P&G businesses, so what we will expect going forward is modest trade-up where we can get it and where we are driving it."
},
{
"speaker": "Operator",
"text": "Your next question comes from April Scee - Banc of America Securities."
},
{
"speaker": "April Scee - Banc of America Securities",
"text": "Thank you. Just another quick question on the developing markets. I just want to check. Are you done with integration of the distributors in the developing markets? What are the first opportunities that you see in terms of trying to generate an acceleration in top line with that opportunity?"
},
{
"speaker": "A.G. Lafley",
"text": "We're not done, we're in the middle of the integration, but it sort of varies by market. I mean, we're done in some markets; we are well underway in all markets. But that integration will be done in the next three to six months. The second question, the first thing we see and we are already taking advantage of it, is what I would call broader and deeper distribution in high-frequency stores. High-frequency stores have been sort of a hidden success story for the Company because part of our developing market growth has been our ability to drive double-digit top line growth in high-frequency stores. Some of it comes from broader and deeper penetration. In other words, we are covering more stores in smaller cities, villages and towns. But a lot of it comes from better presence and better distribution and better on-hand, on-premises merchandising in these stores. So the first thing we will get is the distribution and the presence advantage in high-frequency stores. The second thing we're getting is joint merchandising and marketing efforts. So if you saw what we were doing in Latin America or in Asia or Central and Eastern Europe, we're running a lot of merchandising events that combine personal care brands or combine personal care and beauty care brands, or combine several Gillette and several P&G brands at the same time. So, that's sort of the second phase. We are already getting traction there; we are already getting revenue synergies there. Then the third piece will be the kinds of things we talked about before where we bring enhanced product lines that are more affordable for consumers in those markets, designed specifically for consumers in developing markets."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Faucher – JP Morgan."
},
{
"speaker": "John Faucher - JP Morgan",
"text": "Good morning everyone. I was wondering if you could talk a little bit about your ad-to-sales targets over the next year. You talked about a less inflationary cost environment. Do you feel comfortable with where you netted out from an ad-to-sales ratio for fiscal 2006, which was down slightly? Is that the new normalized level or do you think you need to take it back up to sort of the recent peaks you had seen?"
},
{
"speaker": "A.G. Lafley",
"text": "We are very comfortable with where we are. We've got three things here. One is, we want to stay balanced and consistent and sustainable. You know, that's our communications, advertising and marketing strategy. The second thing I would say is we are getting real traction from our marketing ROI and market mix modeling work. It's leading to two things: one, an improvement in effectiveness because we are reallocating investments from parts of the communication plan that aren't working as hard for us to parts of the communication plan that are working harder. The second thing, obviously we're making every dollar go a little bit further. The third thing, and I think this is really important for you to understand, is we watch our brand equity and trial rates. We watch our brand equity strengths, you know, what's the relative strength of our brand equity versus the relevant competitors in given categories and industries. Then we watch our trial rates and our repeat rates. That's what we are really trying to drive; we're trying to drive our brand equity strengths. Frankly, on some of our businesses, we are finding that we can do that with much more efficient advertising and marketing spending. So, we don't get hung up on that ratio of ad spending or marketing spending to sales; we try to look at the effectiveness. Are we improving our brand equity? Are we increasing our trial? Are we improving our repeat rates? Because that's really what drives our market share and drives our sales and profitability over time."
},
{
"speaker": "Clayt Daley",
"text": "Don't forget there have been some synergies from Gillette that we have been able to capture and that has had some impact as well."
},
{
"speaker": "Operator",
"text": "Your next question comes from Chris Ferrara - Merrill Lynch."
},
{
"speaker": "Chris Ferrara - Merrill Lynch",
"text": "Good morning, coming out of Wal-Mart's meeting and obviously their focus on key suppliers, and you are seeing accelerated growth at Wal-Mart and Target in the U.S., are you growing share within your top retailers actually at an accelerated rate? Does that rate accelerate more as Wal-Mart executes on its plan over the next couple of years?"
},
{
"speaker": "A.G. Lafley",
"text": "Chris, we're growing share steadily at our top customers, and that's obviously our goal. Our goal is to grow share at all customers and grow share at an accelerated rate at our most successful and biggest customers. So, that's clearly the goal. I mean, obviously, in the short term, we've been doing a little bit better because our organic growth rate has been a bit ahead of several of our retailers' same-store sales growth rates, but that sort of varies over time. Over the long term, what we're really looking for is consistent, steady share growth. The more important thing here, or I should say maybe some of the more important drivers here are one of the subjects that we're going to talk at the December meeting when we are together, which is this whole change in go to market that we are undertaking, which frankly Gillette has been a big catalyst for. Our goal is to drive joint value with our leading customers. We have a very simple notion that, if we can grow the pie together, both of us will benefit over the long haul. I think it shows up in the advantage in Cannondale rankings of the company where we are consistently and again this year rated the best manufacturer. But that really is the key, and there are a whole bunch of platforms there but one is grow categories which our innovation drives; one is efficient assortments and efficient response, which we drive with the retailer; another is driving cash and costs of the system that the shopper doesn't value. I think you can see it's working. I talked about the Target and Wal-Mart results in the U.S., but if you look at our top ten customers worldwide, our unit volume was up 9% organically in this first quarter. So we are doing pretty well across the board."
},
{
"speaker": "Operator",
"text": "Your next question comes from Alice Longley - Buckingham Research."
},
{
"speaker": "Alice Longley - Buckingham Research Group",
"text": "Could you give us how much Western Europe the volume and pricing was up in the quarter and what the trends look like in the second quarter?"
},
{
"speaker": "Clayt Daley",
"text": "We took price increases across a number of categories in Western Europe and announced many of them. So pricing was up slightly, in particular Duracell, which we just announced. But there are also a number of other categories that have had price increases. I think our volume numbers in Western Europe were low to mid singles."
},
{
"speaker": "Operator",
"text": "Your next question comes from Justin Hott - Bear Stearns."
},
{
"speaker": "Justin Hott - Bear Stearns",
"text": "Questions on Pantene and Crest Pro Health. First Pro Health. Can you give us some color on where it might be gaining share from in the U.S.? Is it from the smaller competitors? Then, anything you can tell us I guess on the future plans of the brand and maybe Pantene as well. Thank you."
},
{
"speaker": "A.G. Lafley",
"text": "We are obviously pretty pleased with our oral care overall results. I think P&G was up double-digits on the top line in terms of organic growth in this first quarter. We were up over 20% on Crest in the U.S., and we were up double digits on Oral-B. So the whole program is working pretty well for us. We are in the very early days of Crest Pro Health, so our focus is on trial build. If you look at the market shares, which I'm sure you have, you'll see that on an all-outlet basis, Crest has added over 1.5 points of growth, and our leading competitor has also held or modestly built its share. Frankly, that's what we expected. I've spent almost 30 years in this business and if you go back to all the major launches where we had a strong, entrenched competitor, when we launched Liquid Tide in the mid '80s into the U.S. and Wisk was a big, entrenched, strong competitor, the whole first year Wisk held onto every 0.10 of a share point. That's because the equity is strong and that's because they defend significantly. We expect the same from our leading competitor in the US. In fact, what I think will happen is, over time, we will attract consumers, who are interested in the Pro Health proposition and who find the Pro Health product to be superior to whatever they are using currently. It's way too early to tell where that's going to shake out. I guess the last thing I would say is clearly what's going on in oral care in the U.S., which I mentioned is going on in a lot of categories, is that the consumer is trading up; and they are trading up to better dentifrices; they are trading up to better brushes; and they are trading up to a fuller regimen. You also asked about Pantene. Pantene has frankly been one of the Company's real assets over the last ten years. We are on our way to a $3 billion brand. It is the leader in many markets around the world, not just the U.S. It has a very strong brand equity, it's got a very strong product line, and in many cases superior performance. It has just been a combination of a brand and a product line that has really resonated with women around the world. So we continue to invest in Pantene. We continue to try to bring leading hair care technology and leading products, and we hope that we can continue to build a brand that will be a leader in the hair care category worldwide."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jason Gere - A.G. Edwards."
},
{
"speaker": "Jason Gere - A.G. Edwards",
"text": "Actually just following up a little bit on the oral care side, can you talk a little bit more about the expansionary plans, maybe even including Pro Health, going forward in regions where I guess it really wasn't your marketplace, i.e. Latin America. Can you talk a little bit about that?"
},
{
"speaker": "A.G. Lafley",
"text": "Jason, I know you'd love me to but I can't comment on any future plans. Right now, we're focused on having a good launch in the U.S."
},
{
"speaker": "Operator",
"text": "Your next question comes from Elena Mills - Atlantic Equities."
},
{
"speaker": "Elena Mills - Atlantic Equities",
"text": "Good morning, everyone. Just a question on Duracell, please. I was wondering if you could comment on the commodity cost outlook specifically for the battery segment and relate that to how you see pricing and promotional activity developing, whether you specifically see a need for further pricing to offset some of the margin pressure that you seem to be feeling in that business? Thank you."
},
{
"speaker": "Clayt Daley",
"text": "We've just announced pricing on Duracell across most of the major markets in Europe and North America. That's, of course, in response to unprecedented run-up in zinc prices, which have not abated. So, the price increase that has been announced really is not effective until the second half of the fiscal year. So as a consequence, we are, unfortunately, not able to price to recover all of the commodity cost increase in the current year, but once that pricing is in place, we should be in good shape going forward relative to commodity costs."
},
{
"speaker": "Operator",
"text": "Your next question comes from Connie Maneaty - Prudential Equity Group."
},
{
"speaker": "Connie Maneaty - Prudential Equity",
"text": "Back to the compaction test, it seems like this is going to be a very big initiative when the test is over and all store shelves are reset for smaller sizes. I mean, I'm trying to figure out what the size of the dollar value of the fabric and home care that is affected here. So, if it's an $18 billion segment, maybe half of it is outside the U.S., and then you have fabric and powdered detergents. So is this something on the order of $8 billion? Is that a good ballpark?"
},
{
"speaker": "A.G. Lafley",
"text": "The simple way to think about it is liquids are over half of the U.S. market and we will be going based on what consumers tell us in the learning market, but assuming consumers accept and like the new product format, the new product performance and all the rest of it, then we would engage in the kind of conversion that we undertook in the mid '80s and the early '90s, when we went through the first two rounds of compaction. If we are successful and the retailers are successful and the consumer wants to convert to the smaller formats, this would be a large conversion. You're right; it is a large conversion. The other thing that you have to understand is, for us, fabric care is a very global business, and what we are in is Phase I, which is the U.S. conversion. I think you may know we went through a powder compaction conversion this last year in Western Europe and in Eastern Europe, so this has been an ongoing trend in this category. What we're trying to do is be as or more effective with the performance and quality of our fabric care products and deliver them in a format to consumers that is better from a convenience and sustainability standpoint."
},
{
"speaker": "Clayt Daley",
"text": "Relative to the amount of sales that are impacted, because it's liquids only, not powders and only in the U.S., the amount of sales that are impacted are probably about half of that number you were referring to, probably more in the neighborhood of four-ish as opposed to $8 billion. Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from Joe Altobello - CIBC World Markets."
},
{
"speaker": "Joe Altobello - CIBC World Markets",
"text": "First, a quick question on compaction again. What could be the impact on category growth? What has been the history of the impact on category growth in past compaction? Secondly, more broadly on health care, should we expect an acceleration in organic growth since you guys are starting to lap easier comparisons on Actonel and Prilosec later this year?"
},
{
"speaker": "A.G. Lafley",
"text": "On the first one, historically, we have gotten a little increase in consumption every time we've moved to more compacted or more concentrated products. Again, that's part of what we are testing for, so we make sure that we understand that. That's good for the consumer because consumers, I hate to say it, in fabric care, tend to under dose, some fairly significantly, so they get a little bit better performance and they still get a good value. So it sort of works all the way around. Regarding healthcare, yes, I mean, the sequential trends will improve. We had a very tough base period in July-September. We had a big Prilosec pull last year before the pricing, and we had a big launch on Actonel, Actonel with calcium. So yes, those trends will improve sequentially."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bill Chappell - SunTrust."
},
{
"speaker": "Bill Chappell - SunTrust",
"text": "Just a quick question on commodity costs. Can you give us an idea what you're looking at for oil prices for the remainder of the year? Then with your forecast of seeing the benefit, is that more due to just timing of when the benefits come through, or just uncertain of where it shake out by fiscal year end?"
},
{
"speaker": "Clayt Daley",
"text": "Our thoughts on oil are that we are probably, for the rest of this year, going to be somewhere $60, $65. We are not projecting anything going lower than what it is today. The issue we have, relative to our commodity-related input costs, is most of our suppliers are using feedstocks that were purchased months ago. So, it won't surprise you that they are not that interested in taking prices down immediately; although we are, of course, having those discussions on an ongoing basis. So, we would probably expect to see some relief in the second half of the fiscal year. That's one of the reasons why we raised the earnings guidance on the fiscal year. On the other hand, we don't want to get too bullish because history suggests that, if commodity costs begin to move down, some of that made logically be given back in pricing in the marketplace. But there's no question about the fact that we are in a much better position with oil at $60 or a little bit lower at the moment than we were when we were $70-plus. Therefore, the prospects for our commodity cost in the second half of the year should improve. Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from Linda Bolton-Weiser - Oppenheimer."
},
{
"speaker": "Linda Bolton-Weiser - Oppenheimer",
"text": "I was just curious about the other income line. It was a little bit higher than we had expected and up significantly year-over-year. Do you have a forecast for that going forward? Should we expect to see such a large amount it in the remaining quarters of the year?"
},
{
"speaker": "Clayt Daley",
"text": "Go ahead, John."
},
{
"speaker": "John Goodwin",
"text": "We expect it to be about in line with last year, all-in Linda. It was higher this quarter as a consequence of the divestitures that we made on Pert and Sure. They were announced at the time that we give guidance, so it's very much in line with expectations. However, don't forget interest expense is up quite a lot as well year-over-year, so in terms of the net impact, actually there's not that much difference versus the previous year. Interest income was also up as a consequence of interest rates moving up versus last year as well."
},
{
"speaker": "Operator",
"text": "Your next question comes from Sandy Beebee - HSBC."
},
{
"speaker": "Sandy Beebee - HSBC",
"text": "I was hoping you could talk a little bit about the baby category in North American and Western Europe, if the new launches and the value segments in North America had been performing to your expectations and when we would probably get to see better growth in that category? Also, in Western Europe, obviously Huggies has been fighting pretty hard, so if you could talk a little bit about your performance there."
},
{
"speaker": "A.G. Lafley",
"text": "Overall, we are pretty optimistic going forward about the baby care category. It has obviously been a fairly tough past year for all of the competitors in the baby care business because there hasn't been a lot of innovation and innovation is critical in this market. I would say three things. First of all, we are pretty pleased with the continuing progress of our Baby Stages of Development line products. This is the one from Swaddlers and Crawlers and Easy Ups. It has done quite well in the U.S., and it continues to do quite well in Western Europe. In fact, Baby Stages of Development is now the top sub-segment in the U.S. diaper category, and that has really been the engine of growth for Pampers over the last year. We will continue to market and merchandise that line and we will continue to improve that product line. The Feel and Learn entry was an extension of Stages of Development. The second thing I would say is private label is and has been a tough competitor in that business. That's why we've moved with the two initiatives that John talked about, the Baby Dry with Caterpillar Stretch, which provides a really important benefit for consumers who are buying our mid-priced line of diapers around the world. Of course, we will bring that feature to the Baby Dry line in other relevant markets. It's also why we strengthened our Luvs product so that we could compete more effectively head-on with competition from below. The third thing I would say is we obviously watch this business very carefully, country by country and customer by customer. Our key countries are growing share. We had some challenges in the UK and we are turning that around behind Baby Stages of Development. In Western Europe, we are still, despite the -- how shall I say -- aggressive merchandising and promotion and pricing from our primary competitor, we are still very stable at a 54 share, so we are the clear-cut leader in that market."
},
{
"speaker": "Operator",
"text": "Your next question comes from Chris Ferrara - Merrill Lynch."
},
{
"speaker": "Chris Ferrara - Merrill Lynch",
"text": "On Wave Three of the integration systems upgrade, I guess it was completed October 1. When it is the latest you could possibly, in your view, see interruption like missed sales, problems with order collection? In other words, when do you see the risk associated with that integration?"
},
{
"speaker": "Clayt Daley",
"text": "Well, Chris, there's another wave that's going in January that's of fairly substantial size. We will go from 80% integrated to 95% integrated effective in January. Then there are a few other countries that get picked up in three to six months after that, like Japan is one. We're still looking at another quarter or two where there's certainly some possibility for trade inventory impact due to the integration. There is certainly some, although I would call it very modest risk, of disruption in the supply chain, and I would say the risk is modest because it has been executed so well so far, and I think it's one of the benefits of the fact that we did have eight months to plan before we closed the deal. The fact is that we've learned from our early conversions and have reapplied that learning in the subsequent conversions. I think everybody involved in that program has done an outstanding job. So I actually don't think that there's that much of what I call supply disruption risk in the integration."
},
{
"speaker": "John Goodwin",
"text": "In terms of the financial systems, Chris, you get a pretty good visibility soon after the cut-over as to how successful things have got. The physical supply movements take a little bit longer to settle down, so that could take a bit longer. But the actual computer system is a little bit different; you see that sooner and that has gone well. But the physical supply piece, physical movement through the warehousing, that takes a little bit longer and a few more quarters, ask Clayt mentioned, for us to fully get all of everything worked out and humming on one system."
},
{
"speaker": "Operator",
"text": "Your next question comes from Elena Mills - Atlantic Equities."
},
{
"speaker": "Elena Mills - Atlantic Equities",
"text": "I was just wondering if you could comment, please, on the cosmetics business in a bit more detail and talk about when you see the drag from Max Factor abating in that business. Thank you."
},
{
"speaker": "A.G. Lafley",
"text": "A couple of background comments. First, our focus on beauty care, far and away has, been on hair and skin. Those have been the growth drivers in the beauty category. Those have been the segments where we've focused -- hair, skin and femcare -- because that's where the money is; that's where the growth is; and frankly, that's where we have the strongest brand and product technology and innovation positions. So, they have been our engines of growth. The second point, which I want to make sure that everyone understands, is for cosmetics, we are running a very focused operation. So we're focused primarily on the U.S., where we have the market-leading Cover Girl brand, and we're doing some testing in developing markets very selectively. Thirdly, to your specific question, what we've done with Max Factor is we are focusing the brand on accounts, so think retailers, where we had a decent business and where they had the interest and where it was part of their strategy in their cosmetics category to not only have Max Factor as part of the portfolio but to support and drive Max Factor. We continue to support the brand, not just from a marketing standpoint but also from a product standpoint. You may have seen our mascara launch, which has been going really well and it's called Lash Exact/Lash Perfection in some markets. So I guess, if I were to summarize, I would say cosmetics is going to stay very focused. Our primary focus is on Cover Girl. We are narrowing our focus on Max Factor. We continue to support it. We think it will stabilize and then grow modestly in the channels and customers that it's distributed in on a regular basis."
},
{
"speaker": "Operator",
"text": "Your next question comes from April Scee - Banc of America Securities."
},
{
"speaker": "April Scee - Banc of America Securities",
"text": "Can you give us some detail on advertising and promotion and how that trended on an absolute basis and as a percentage of sales in the quarter?"
},
{
"speaker": "A.G. Lafley",
"text": "April, I commented on advertising; I think it's been basically stable as a percent of sales. Basically, what you are seeing is the effectiveness improvements and efficiency improvements we're getting from our marketing ROI program and from our market mix modeling is being reinvested in support for our innovation programs and major brands. The second point I would make is we focus on consistency and sustainability. The third point I would make is we focus on building our brand equity and driving our trial and repeat rates. On the promotional side, that varies so much across industries and across markets that it's really difficult to generalize. But I will say this. Clearly, the promotional activity is up in some categories. An obvious case and point, you just have to pick out any Sunday circular and look at the oral care category in the U.S. There have been a number of BOGOs and high-value coupons offered by our competitors. That clearly is in response to the Crest Pro Health launch. So, you'll see that kind of activity in markets where there's a major new product or new product line launch. The other thing I would say is we have had some countries and some channels in Western Europe, including the UK, where promotional activity has been up but we have worked real hard to bring the focus back to brand, bring the focus back to product innovation, bring the focus back to good, everyday consumer value behind our brands and products. Our basic strategy is to continue to invest in our brands on the advertising, marketing and communication side, influence our marketing, all of those kinds of programs, and to offer the minimum amount of trade and consumer promotion required to stay competitive in the category in the country."
},
{
"speaker": "Operator",
"text": "Your next question comes from Connie Maneaty - Prudential Equity Group."
},
{
"speaker": "Connie Maneaty - Prudential Equity",
"text": "My question is on commodity costs and private label pricing. Have you seen any reflection at retail yet of lower commodity costs in categories where private label is a big enough competitor that it would suggest you would be initiating price rollbacks in the near future?"
},
{
"speaker": "Clayt Daley",
"text": "No, and that's not surprising, given the fact that we really haven't seen the raw material costs come down yet."
},
{
"speaker": "A.G. Lafley",
"text": "Connie, actually as we looked at all of the market shares in the U.S. over the past quarter, and I think I mentioned that we are up on 17 of our top 20 brands, it's very interesting. If you look across all of the competitors, including private labels, this is one of the weakest periods for private labels in a long time. So I ask myself, why is that the case? I think there are at least two reasons. One reason is there's a lot of attractive new product offerings from us and from several of our competitors, so there are a lot of good products out there and we are in the trial period, so they are available at good introductory prices. The second thing that's going on, which is related to an earlier question, we do have a little bit more promotion intensity in categories and markets where there are big, new product launches. So the relative value of the branded offerings, because of the better product performance and the better innovation, is just better at this time. The last thing I would say is, every time we look at private labels and we try to take them apart, a lot of these private label suppliers are operating on pretty thin margins. They don't have a lot of room for additional pricing."
},
{
"speaker": "Operator",
"text": "Your final question comes from James Baker - Neuberger Berman."
},
{
"speaker": "James Baker - Neuberger Berman",
"text": "I just wanted to get a feel for how your gross margin and SG&A ratio did, apart from the effects of Gillette, because looking at the totals that you show here, it seems there was a little less SG&A leverage this quarter than usual. Also perhaps you could comment on whether the Fusion launches abroad had some impact on that and whether that in fact even added to earnings in the quarter."
},
{
"speaker": "Clayt Daley",
"text": "Most of the gross margin improvement is related to Gillette. If we look at the core P&G gross margin, as we said, we had a negative impact of 100 basis points on commodities. That was completely offset by pricing, volume and cost-savings programs, so that, if you will, the core P&G gross margin was neutral and the benefit is coming from Gillette. Now, having said that, as we go into the next quarter, we are projecting gross margin improvement where Gillette will be in the base. So I think we're going to see net gross margin improvement in the October-December quarter and the balance of the year. As we said, on the SG&A line, a lot of this really relates to the fact that that's where the amortization of the purchase price is in the income statement and some mix impacts that have influenced that SG&A line. I hope that answers your question. Thank you for your participation in today's call. I think the new format worked well. It was great that we have an opportunity to get to everybody who wanted to ask a question and even come back around for some follow-ups. We appreciate your interest in the Company. As I said, John and Chris and John Chevalier and I will all be around the rest of the day for follow-up questions. Thanks a lot."
},
{
"speaker": "Operator",
"text": "With that, we will conclude today's conference."
}
] | null | null |
PG | 4 | 2,008 | 2008-08-05 08:30:00 | Executives: Clayt Daley - Chief Financial Officer AG Lafley - COO Jon Moeller – Treasurer
Analysts: Bill Pecoriello - Morgan Stanley Nik Modi – UBS Wendy Nicholson – Citi Chris Ferrara – Merrill Lynch Bill Schmitz – Deutsche Bank [Sophia Senis] – JP Morgan Lauren Leiberman - Lehman Brothers Ali Dibadj - Sanford Bernstein Jason Gere – Wachovia Joe Altobello – Oppenheimer Connie Maneaty – BMO Capital Filippe Goossens – Credit Suisse Bill Chappell – SunTrust Robinson Humphrey Alice Longley - Buckingham Research
Operator: Welcome to Procter & Gamble’s fiscal year-end conference call. (Operator Instructions) Today’s discussion will include a number of forward looking statements. If you will refer to P&G’s most recent 10-K and 8-K reports you will see a discussion of factors that could cause the company’s actual results to differ materially from these projections. As required by Regulation G, P&G needs to make you aware that during the call the company will make a number of references to non-GAAP and other financial measures. Management believes these measures provide investors valuable information on the underlying growth trends of the business. Organic refers to reported results excluding the impact of acquisitions and divestitures and foreign exchange where applicable. Free cash flow represents operating cash flow plus capital expenditures. P&G has posted on its website www.pg.com a full reconciliation of non-GAAP and other financial measures. Now I’d like to turn the call over to P&G’s Chief Financial Officer, Clayt Daley.
Clayt Daley: AG Lafley, our COO and Jon Moeller, our Treasurer are joining me this morning. As is typically the case, we have a lot of information to cover on the year end call. I’ll begin with a summary of fourth quarter results. Jon will cover business highlights by operating segment. I will then provide a brief update on commodities, pricing, markets and Folgers. I’ll also provide guidance for the current fiscal year and the September quarter. AG will then close out the call. On to the results, P&G’s business has performed well allowing us to complete both the quarter and the year with sales, earnings per share and free cash flow all at or above our long term targets. The June quarter is the 24th consecutive quarter in which P&G delivered top line growth at or above the company’s target. We also delivered another quarter of high quality earnings and record cash flow, despite unprecedented increases in commodity and energy costs. Our ability to consistently deliver our top and bottom line commitments is the direct result of the breadth and depth of our unique portfolio, the strength of our innovation and our disciplined cost management and productivity efforts. For the June quarter diluted net earnings per share increased 37% to $0.92 per share. This includes net tax benefits of $0.12 per share due to a number of significant adjustments to tax reserves in the US and other large countries. Excluding these tax adjustments P&G’s underlying business delivered $0.80 per share, $0.02 above the high end of our goal and expectations. Total sales increased 10% to $21.3 billion, organic sales were up 5%, and organic volume was up 4%. Pricing added 3% to sales as previously announced price increases took effect. Foreign exchange contributed six points to sales growth. This proportionate growth in developing regions large sizes and mid tier brands resulted in a negative 2% mix impact. Quality of earnings was strong, operating profit increased 13% for the quarter to $3.8 billion and non-operating profit was below year ago. Operating margin grew 50 basis points. Gross margin decreased 160 basis points. Higher commodity and energy costs impacted the quarter by over 300 basis points. Faster growth in Baby Care, Family Care, and developing markets reduced gross margin by about 50 basis points. We also increased restructuring activities in the fourth quarter in anticipation of the Folgers deal. These projects brought fiscal 2008 restructuring costs to slightly more than the top end of the range of $400 million. This resulted in a negative 30 basis point impact on gross margin in the fourth quarter. Without the change in business mix and increased restructuring gross margin would have been down about 80 basis points. SG&A expenses were down by 210 basis points. This was driven by tight cost control and overhead productivity improvements. Importantly, while SG&A has been down every quarter, advertising spending remained constant as a percent of sales for the year at 10.4%, even as we continue to improve efficiency. Turning to cash, operating cash flow in the quarter was $4.1 billion, up $0.5 billion from the same period year ago. Free cash flow was $2.9 billion up $300 million versus year ago. Free cash flow was 96% of earnings ahead of our 90% productivity target. P&G generated $12.8 billion of free cash flow during the year an increase of over 20% or $2.3 billion. Capital spending was 3.6% of sales below the company’s target of 4%. Working capital was up about two days versus year ago driven by higher inventory balances. Year end inventory values were impacted by the run up in commodity costs. During the June quarter P&G increased dividends by 14% the 52nd consecutive year dividends have increased. For the full year P&G paid $4.7 billion in dividends to shareholders. In July 2007 we announced a three year $24 to $30 billion share repurchase program as part of that program we repurchased $2 billion worth of stock in the June quarter bringing the fiscal year total to $10 billion, at the high end of our $8 to $10 billion target range for the year. Combining dividends and share repurchase, P&G distributed nearly $15 billion to shareholders in fiscal 2008 or over 120% of earnings. Based on the current market capitalization P&G is providing shareholders a cash yield of over 7%. To summarize, P&G continues to drive top and bottom line growth despite a challenging cost and competitive environment. We have been pricing to recover commodity and energy cost increases and we are driving productivity and operational efficiencies to expand operating margins. We are generating significant cash and are aggressively returning that cash to our shareholders while maintaining our AA credit rating. Now I’ll turn it over to Jon for a discussion of the business unit results by segment.
Jon Moeller: Starting with the Beauty segment, all end sales grew 11% and organic sales were up 4% in a very competitive market. Olay Skin Care volume grew mid single digits with over 40% growth in Central and Easter Europe, Middle East and Africa and mid teen’s growth in Western Europe. These strong results were driven by market share gains and continued distribution expansion. In the US, Olay Facial Moisturizers leading all outlet value share was in line with prior year at more than 44%. Retail Hair Care volume grew 3% despite a base period that included pipeline shipments for the Pantene base brand restage in North America. Excluding North America Pantene, global retail Hair Care volume grew 6% behind double digit growth of Head & Shoulders and high single digit growth of Rejoice. Head & Shoulders volume was up double digits in North America and Western Europe and tripled versus year ago in Japan behind the Head & Shoulders brand re-launch. Head & Shoulders is now the number one shampoo in the world. We expanded our retail Hair Care portfolio in June with the launch of Gillette Hair Care brand in North America. We also strengthened our Prestige Hair portfolio during the quarter with the acquisition of the Frederic Fekkai business. Professional Hair Care and retail Hair Color volume were both down slightly. Professional Hair Care shipments were down versus prior year due to soft results in North America and Northeast Asia. In retail Hair Color strong volume growth on the Nice ‘N Easy brand was more than offset by declines on several smaller brands. Nice ‘N Easy US all outlet value share is up more than three points to over 20% driven by share gains from the Perfect 10 line that launched in January. Nice ‘N Easy has now grown sales double digits for four consecutive years and has doubled its market share over this time period. The Cosmetics business has a very strong quarter with high single digit volume growth behind the continued success of Cover Girl Lash Blast Mascara. Lash Blast is on track to be the largest global cosmetics industry initiative every. Cover Girl’s market leading all outlet value share in the US is up nearly a point to 19%. In the Grooming segment all end sales were up 12% for the quarter and organic sales grew 4%. This compares to a base period that included Blades and Razors organic sales growth of 13% driven by the expansion of Fusion in European markets. Blades and Razors delivered solid sales and volume growth behind mid single digit market growth and continued market share gains. Global Gillette Blades and Razors share increased versus prior year to 71%. Volume in developing markets grew double digits with over 20% growth in developing Asian markets and double digit growth in Latin America behind continued distribution and market share increases. In the US, Fusion and Venus continued to grow value share but these gains were offset by declines on Legacy Male Systems. Fusion added four value share points versus year ago and is now over 36% of the US male systems market. Venus added nearly seven points behind the Embrace initiative and is now over 58% of the US female systems markets. Shave product shipments increased mid single digits on double digit growth in developing markets. In the US Gillette shave prep all outlet value share increased nearly six points to 36% behind the growth of the Fusion line. Braun shipments were down modestly due primarily to the exit of the Tassimo Coffee appliance business. Health Care all end sales grew 7% and organic volume increased 3%. This was the first full quarter reflecting the loss of market exclusivity for Prilosec OTC which negatively affected volume growth. Excluding Prilosec OTC health care organic volume increased 4% for the quarter. Feminine care volume grew high single digits with the Always brand up double digits and Naturella up more than 20%. In the US Always all outlet value share of the Pads segment increased more than a point to 58%. Share of the Pantiliner segment grew almost three points to nearly 32%. These results are driven by the continued strength of the Always Clean and Always Fresh initiatives that launched last calendar year. Expansion of Naturella in Central and Eastern Europe, Middle East and Africa drove shipment growth of nearly 30% in that region and Naturella volume in Latin America grew double digits. Oral care shipments were up for the quarter with growth of both the Crest and Oral-B brands. Crest [inaudible] maintained its all outlet value share leadership in the US despite intense competitive promotional activity. P&G’s leading all outlet value share of toothpaste in the US remained at about 38% and Oral-B toothbrush value share held steady at 43%. In Personal Care shipment volumes were down high single digits due to the competitive market entry against Prilosec OTC which resulted in brand volume down more than 20% for the quarter. Despite intense competitive promotional activity, Prilosec OTC maintains a very strong 34% value share of its segment in the US. Pharmaceutical volume was up low single digits versus prior year as high single digit growth of Actonel was partially offset by lower shipments of other minor brands. Sales for the Snack, Coffee and Pet segment increased 8% for the quarter and organic sales grew 4%. The Snacks business delivered high single digits volume growth and high teen sales growth driven by the Pringles Stix, Extreme Flavors and Minis initiatives. Pringles all outlet value share of the US potato chip market is up modestly versus prior year to more than 14%. Coffee sales declined in mid single digits due mainly to an expected reduction in trade inventory ahead of the Folgers brand re-stage launching this month and due to temporary price advantages versus the leading brand and competitor. P&G’s all outlet value share of the US Coffee market was in line with prior year at nearly 36% and Dunkin Donuts is now approaching 4% value share after less than a year in market. Pet care shipments increased mid single digits for the quarter behind the Iams Proactive Health initiative for dogs and the Iams Healthy Naturals initiative for cats. Sales were up double digits as pricing was taken to recover higher input costs. Fabric Care and Home Care sales grew 13% for the quarter with organic sales up 7%. Top line growth was broad based with every region posting solid volume increases. Fabric Care global shipments increased mid single digits with balanced growth in developing markets. Tide and Arial each grew volume mid singles and the Gain and Downy franchises each grew high singles or better. We completed the North American conversion to the concentrated liquid laundry format in the June quarter. We’re on track to meet or beat every element of our success criteria for this initiative including gaining distribution on new SKUs and delivering target shelf pricing. Home Care shipments were up high single digits led by North America with a double digit volume increase. Febreze volume grew double digits behind Febreze Candles and new scent innovation on Air Effects. Febreze share of the instant action air care market is up two points to nearly 21%. Dawn and Swiffer volumes were also up double digits due partially to forward volume by retailers ahead of previously announced price increased effective in the September quarter. Batteries volume grew modestly for the quarter as solid growth in greater China and Latin America offset modest declines in developed markets that were mainly due to market contraction. Duracell alkaline value share in the US was down about a point to 47%. In Western Europe lower volumes were driven by trade inventory reductions in anticipation of the September quarter launch of a new Duracell marketing and promotional campaign. Baby Care and Family Care delivered an excellent quarter with all end sales growth of 10%. Organic sales also grew 10% and organic volume increased a very strong 9%. Pampers Diapers global volume grew mid teens with each region posting shipment increases. Developed markets grew mid singles and developing markets grew high teens. China, Russia, Turkey, India, Saudi Arabia, Poland and the Philippines all delivered double diaper volume growth. In the US, Luvs diaper volume grew mid teens and Pampers Baby Dry grew high single digits. In total, P&G all outlet value share in the US Diaper market increased nearly a point to 35%. In Western Europe Pampers market leading diaper share was in line with prior year at a strong 54%. Family Care organic volume grew high single digits behind double digit growth on Charmin, and mid single digit growth on Bounty in North America. Charmin US all outlet value share increase more than two points to over 28% behind the Ultra Soft and Ultra Strong innovation launched nearly a year ago. Bounty US value share also increased more than two points to nearly 47%, a 43 year high, continuing to leverage the Best Bounty Ever initiative. That concludes the business segment review, now I’ll hand the call back to Clayt.
Clayt Daley: There are several important topics I want to discuss before getting into guidance; commodities, pricing, market growth rates and Folgers. Starting with commodities, the rate of commodity and energy cost increase has clearly accelerated. For the fiscal year just ended we incurred approximately $1.5 billion in incremental costs. There’s a great deal of volatility and uncertainty so this is a moving target. Based on where spawn and forward markets are today we expect to incur about $3 billion in additional commodity and energy costs this fiscal year. This is higher than we anticipated three months ago when we expected commodity and energy costs to be up more than $2 billion. Since that time crude oil, diesel fuel and natural gas have each made moves of 25% to 35%. Other important materials such as surfactants, alcohols and sodash have moved up sharply as well. Given the magnitude of this increase I want to help frame the margin dynamics for you. If we take the results from the fiscal year just completed and simply add $3 billion in commodity costs to cost of goods sold and $3 billion of pricing to net sales holding everything else equal our gross margin would decline by about 180 basis points and operating margin would drop by about 70 basis points, even though we would fully maintain our profit. A complete reconciliation of this is posted on our website so you can check our math. Pricing beyond commodity and energy cost increases to maintain operating margin would be very risky given the pressure that our consumers are under. We’re going to have to live with some amount of gross margin compressions throughout this fiscal year. It is important to understand this to put our April-June, July-September and fiscal ’09 results in the right context. We have also previously announced that we will incur additional restructuring costs in fiscal 2009 in order to offset the dilution caused by the Folgers transaction. I’ll say more about this later but these additional restructuring projects will lower operating margin by roughly 50 basis points. Assuming we fully price to offset the impact of commodities and we execute our plan to offset Folgers dilution gross margin would be down 180 basis points and operating margin down about 120 basis points and that’s the starting point for fiscal 2009. To manage our business against this back drop we are pricing to recover commodity costs and challenging every part of our cost structure. Since the last call we announced price increases in Oral Care, Family Care, Baby Care, Fabric Care, Health Care, Beauty Care, Home Care, Batteries, and Pet Nutrition. On the cost front each of our businesses are working to strengthen its ongoing cost savings projects in manufacturing, product formulation and capital spending efficiency. In SG&A we are broadening and accelerating the overhead productivity program we discussed at Cagney. We also continue to improve return on our marketing spending while we increase on marketing investments at roughly the same rate as sales growth. To summarize, commodity and energy increases will put pressure on margins even as we price to offset those increases but what really matters is cash and profit which will grow at our target rates this year. Turning to our markets, on a global basis market growth rates remain in the 3% to 4% range on a value basis and one to two points below this on a volume basis. Developed markets are slowing modestly but still growing for the most part. We have not yet seen a slow down in developing markets which continue to grow in the high single digit pace. We do see some evidence of trade down. For instance, in Laundry Detergents, Tide grew volume in mid single digits in the fourth quarter down from its high single digit growth previously while Gain continued to grow volume in high single digits. This highlights the benefits of our tiered portfolio. We also continue to see examples of trade up where an invention warrants it. A good example is Perfect 10, our premium priced retail hair color. Perfect 10’s value share is above 3% and almost 100% of that is incremental to the Nice ‘N Easy brand. Gillette Clinical Strength Deodorant is another good example. Gillette Clinical Strength is priced two times higher than the base offering but continues to gain distribution and share. Private label in the US is up modestly excluding Personal Health Care where Prilosec OTC came off patent exclusivity, private label shares in our categories are up less than half a share point in aggregate and most importantly P&G continues to grow or hold value share in the majority of our categories. Like commodities, market dynamics are something we will continue to closely monitor taking a balanced consistent measured approach with one eye on sales and the other on volume. Switching to Folgers, on June 4th we announced the signing of a definitive agreement to merge the Folgers Coffee business into the JM Smucker Company and an all stock reverse morse trust transaction. Since that time we have filed a preliminary S-4 with the SEC and clarified the transaction structure as a split merge where P&G shareholders tender shares in exchange for new Smucker shares. The deal structure maximizes the after tax value of the Coffee business for P&G shareholders and minimizes earnings per share dilution versus other structures. We expect to complete the transaction during the second quarter of fiscal 2009. The Folgers deal will bring with it a significant one time gain. We will not know the exact amount of the gain until the deal is completed. For now our guidance assumes that the gain will be approximately $0.50 per share and again occurring in the December quarter. As I mentioned earlier P&G will incur additional restructuring costs during fiscal 2009 in order to offset about $0.04 of dilution caused by the Folgers transaction. The cost of these additional restructuring projects will be about $400 million. Adding this amount to our ongoing base restructuring budget of $400 million brings our fiscal year 2009 restructuring budget to approximately $800 million. The Folgers gain will be outside of operating earnings and will only impact the December quarter. The incremental restructuring charges will be in operating earnings and will impact all four quarters. The September and December quarters will be the most heavily impacted as we have chosen to accelerate several projects to get as much of the benefit as possible into this fiscal year. The additional restructuring costs will be about $0.04 per share in Q1 and Q2 and about $0.02 per share in Q3 and Q4 adding to about $0.12 per share for the year. If actual results are materially different than these estimates we will update these numbers. Otherwise we will not provide further guidance or reconcile the quarterly split of restructuring charges during fiscal 2009. Before moving on I need to take a moment to reassure you that P&G’s approach and philosophy toward restructuring charges has not changed. We will continue to manage our business with ongoing versus episodic restructuring and we’ll continue to report the results including these costs. In situations where strategic portfolio decisions result in stranded overheads and earnings dilution we will take action to offset those impacts. In fiscal year 2010 we expect restructuring spending to return to fiscal 2008 levels as a percent of sales. Now on to guidance, for fiscal 2009 P&G projects organic sales growth of 4% to 6% in line with our long term target range. With that, price mix should contribute to a 3%, foreign exchange is estimated to have a positive impact of 2% to 3%, acquisitions and divestitures will reduce net sales by about 1% to 2% and therefore in total we expect all end sales growth of 5% to 7% for the year. Organic volume is likely to grow 2% to 3% this is below the 4% to 5% we have been delivering during the first half of the calendar year which we think is appropriately conservative giving the amount of pricing that we have recently announced. Also the fact is I mentioned earlier that volume growth in our categories is below sales growth by 1% to 2%. We expect gross margin to be down only 75 to 125 basis points for the year despite the fact that the combined impact of commodities and pricing will reduce gross margin by about 180 basis points. We will accomplish this through cost savings programs and volume leverage. SG&A will be 75 to 125 basis points lower on the year with productivity savings more than offsetting the approximate 50 basis points of the incremental Folgers restructuring charges. The net result of our aggressive cost savings and productivity efforts is that despite roughly 70 basis points of net commodity and pricing impacts and incremental 50 basis points from restructuring operating margins on an all end basis should be about flat for the year. The tax rate should be between 27% and 28%. Our updated fiscal 2009 EPS guidance starts with fiscal 2008 GAAP results of $3.64 a share. Backing out $0.14 per share of tax benefits this brings us to an adjusted base EPS number of $3.50 a share for fiscal 2008. From that base we are projecting EPS growth of about 10% to $3.80 to $3.87 per share. This includes the $0.04 Folgers dilution and compares to our prior guidance of $3.80 to $3.85. We took the high end of our guidance range up by $0.02 a share to reflect better results in the fourth quarter. We have also widened our guidance rate slightly which we think is prudent given the volatility and uncertainty that exists in the commodity and energy markets today. To arrive at the GAAP guidance for 2009 you need to add the Folgers one time gain of $0.50 a share and then subtract $0.12 a share in temporary increases and restructuring charges. This produces a fiscal 2009 GAAP EPS range of $4.18 to $4.25 a share. We have included a full reconciliation in the press release materials. We expect to continue to generate strong cash flow and are confident that we will deliver against our goal of 90% or greater free cash flow productivity excluding the impact of the Folgers gain which is a non-cash item but will result in substantial additional share repurchase when the transaction is executed. While we expect to deliver the fiscal year numbers in line with long term targets there is likely to be greater quarter to quarter earnings volatility in fiscal 2009. We’ve been dealing with higher input costs with pricing but pricing does not take place instantaneously. We like to couple pricing with innovation to deliver better consumer value. We also need to give our retail partners time to adequately plan for pricing. All of these dynamics are factored into our planning efforts. The lag between when we announce pricing and when it’s effective on our revenue combined with a rapid escalation that took place in commodity markets during May and June will create some gross margin compression during the September quarter. We will catch up as price increases we just announced take effect in September and October and expect to see sequential gross margin improvement throughout the year. Turning to the September quarter, organic sales are expected to grow 4% to 6% within this price mix should contribute 2% to 3%, foreign exchange is estimated to have a positive impact of 4% to 5%, acquisitions and divestitures will reduce sales by about 1% and so in total we expect all end sales growth of 7% to 10% for the quarter. Organic volume growth will be 2% to 3%. We expect earnings per share to be in the range of $0.98 to $1.00 a share including the $0.04 of additional restructuring costs. On a GAAP basis this is up 7% to 9% versus year ago and 9% to 11% excluding the $0.02 per share tax benefit in the base period. Gross margin will be down 250 to 300 basis points primarily due to commodity and energy cost increases. Business and geographic mix will also decrease gross margins. We expect gross margins to improve sequentially during the balance of the year. We will offset about 50% to 60% of the gross margin reduction with focused productivity efforts which should result in operating margins being down 100 to 150 basis points for the quarter. Excluding the 4% per share of incremental restructuring costs operating margin should be down less than 50 basis points and operating income should increase in high single digits. The other income should be up versus year ago reflecting the timing of minor brand divestitures such as ThermoCare which was announced in July. We expect the tax rate for the quarter to be about 28%. Now I’ll turn it over to AG to wrap up the call.
AG Lafley: Fiscal 2008 was another very good year for P&G. Total sales grew 9% to $83.5 billion. We’ve more than doubled the size of our business over the past six years. Sales in developing markets exceeded $25 billion and now account for 30% of our total business. P&G is now the largest consumer products company in the developing world. Organic sales grew 5% in the middle of our long term target range of 4% to 6%. For seven years running we’ve delivered these top line objectives. Two thirds of our billion dollar brands grew value share globally. Fusion became our 24th billion dollar brand and did so faster than any other P&G brand in history crossing the threshold in just under two years. Excluding the Health some significant adjustments to tax reserves diluted earnings per share increased 15% to $3.50 a share. Our cash performance was excellent. We generated $12.8 billion of free cash flow and returned over 120% of net earnings to shareholders through dividends and share repurchase. On top of all this, we beat the odds with say large acquisitions fail by successfully completing the integration of Gillette. We exceeded our cost synergy and dilution targets, revenue synergies are on target with significant up side over the next three to five years. Gillette and Oral-B brands are platforms for innovation and we’ve just begun the efforts to fully leverage these equities. Looking forward, I believe P&G is well positioned for continued success. Our portfolio, our commitment to innovation and our productivity efforts are the reasons for this. Our portfolio is stronger than at any time in our history. With the addition of Fusion, P&G now has 24 billion dollar brands far more than any other company. Billion dollar brands are platforms for innovation; they support larger investments in consumer research and R&D. They build strong equities with consumers, they become indispensable to retailers and they earn a leadership share of category profit. P&G’s billion dollar brands give P&G the number one or number two position in 18 different product categories around the world. This breadth of category leadership position is unmatched in our industry. This portfolio of brands and categories provides many unique advantages, strong growth potential and financial stability and reliability. Let me share just a couple examples of how the portfolio creates unique advantages for us. The first example is cost category innovation. Bleach technology from Laundry has been used in Health and Beauty Care products such as Crest White Strips and Clairol Perfect 10 hair colorant. Non-woven top sheet technology started in diapers, traveled to feminine care then moved on to Swiffer and Olay Daily Facials. Proprietary perfume technology has been used to enhance the performance of Bounce and Febreze our fine fragrance brands Camay and more recently Secret and Gillette Clinical Strength Deodorant. Looking forward we are very excited about the innovation possibilities we have in combining Gillette’s expertise and mechanical engineering with our expertise in chemical engineering. A second example of portfolio advantage is developing market penetration. The depth and breadth of P&G’s portfolio allows us to penetrate markets quicker and deeper than many competitors because it allows us to attract and build a network of best in class dedicated distributors in countries like China, India and Russia. These distributors have the deepest reach and the best capabilities in their respective markets. Today, our distributor network in China reaches 2,300 cities and 40% of towns and villages. This is about 60% of the population and 800 million more people than our next largest competitor. In India our distributor network now covers 4.5 million stores an increase of 2 million stores in just five years. In Russia we are now reaching 80% of the population. The third example I’ll offer is an advantage created by scale and by the unique combination of categories that comprise our portfolio. In combining Household and Health and Beauty businesses each benefits from the unique scale advantages of the other. Health and Beauty benefits from the larger raw material purchasing pool created by high tonnage, Household businesses like laundry, diapers and other paper products. They’re able to purchase packing materials and basic commodities at lower prices than direct competitors. Household care enjoys economies of scale created by Health and Beauty cares larger advertising and marketing budgets. The cost advantages created by scale provide the investment flexibility needed to build our brands with leadership levels of innovation and marketing support. These examples are just three of the many ways in which we’re advantaged by our diversified portfolio. Our portfolio as currently structured has significant potential for growth not just in Health and Beauty but also in Household care. Household care excluding acquisitions has grown sales at a five year compounded annual growth rate of about 40% in China and India, 30% in Russia and 20% in Brazil and Turkey. Household Care also had significant growth up side in the developed world. In the United States innovation, compaction and lower prioritization of the category by competition have driven meaningful growth in categories like Laundry. Other categories like Bath Tissue are growing in excess of 10% on an all outlet basis because of better consumer understanding and shopper segmentation and of course leading innovation. Household Care has increased sales in the US excluding acquisitions by almost 40% over the past five years, adding approximately $4 billion to our sales. Our Health and Beauty business gives us access to a structurally attractive $370 billion global market that is growing on average 4% to 6%, has favorable demographics and which is still fairly fragmented. P&G share of this market is still only about 10% which of course we expect to grow steadily over time. We generate 30% of our sales in developing markets today and that number is increasing every year. We have leadership shares in China, Russia, Poland, Turkey and Saudi Arabia. In China, P&G is number one in 11 of 12 categories in which we compete. We’re the largest consumer products goods manufacturer by a factor of four and we have, as I said, the deepest distribution network. In Russia our value share is now about 40% and sales are three times larger than the next largest CPG manufacturer. In Poland, value shares are approaching 30%. In Turkey, the number is closer to 40% and in Saudi we are approaching 50%. There is still an awful lot of room for growth. Despite the size of our developing market business we are frankly still under developed in these countries. We currently compete in only nine categories in India, 11 in Brazil, 12 in China and 18 in Russia. In Indonesia the fourth most populous market in the world we compete in only six. This compares to North America where we currently compete in 24 categories. Sales per person per year is another way to look at market development potential. Using the US is probably not a fair point of comparison so let’s use Mexico. In Mexico, P&G generates sales of approximately $20 per person per year. In Brazil that number is less than $10, in China less than $5 and in India still less than $1. In addition to unique advantages in growth potential our portfolio provides financial stability and reliability. This allows us to reach quickly to competitive challenges in a given area while continuing to deliver the results that shareholders expect from us. Stability allows us to think longer term which is what building enduring brands is really all about. It allows us to reliably and consistently invest in innovation and P&G’s commitment to innovation has never been stronger. Innovation is what will differentiate the winners and the losers in our industry and in the current environment. Innovation drives consumer value and builds brand equity and trust over time. Both brand value and brand equity scores for P&G brands are strong. Over 70% of our billion dollar brands have top quartile consumer value scores and approximately 80% have top quartile equity scores. P&G’s commitment to cost control and productivity has also never been stronger. Over the last year our selling, research and administrative costs as a percentage of sales dropped 100 basis points with advertising growing in line with sales. We’re committed to accelerated progress in this area; our productivity focus will provide us with the financial flexibility we need to deal with short term challenges while maintaining our focus on the long term drivers of value creation. All of these things, our category and geographic portfolio, our unwavering commitment to innovation and our focus on productivity give me the confidence that we’ll continue to deliver the results our shareholders expect from us despite the challenging and more volatile environment in which we’re now operating. Now Clayt, Jon and I would be happy to take your questions.
Operator: (Operator Instructions) Your first question comes from Bill Pecoriello - Morgan Stanley.
Bill Pecoriello - Morgan Stanley: On the price mix guidance for ’09 is that assuming that the price will be four to five and you’re holding the mix negative 2% was on the fourth quarter so no additional trade down expected and then in the volume component this is what your elasticity models are showing by category by market there’s no category market that you would single out in terms of where we might see more of the volume impact this is pretty broad based give the pricing.
Clayt Daley: I think the volume is pretty broad based and I think your assessment on the relationship between pricing and mix is actually pretty close. I think that assessment is pretty accurate.
Operator: Your next question comes from Nik Modi – UBS.
Nik Modi – UBS: In terms of going back to the volume growth what are you embedding in terms of the emerging market growth for fiscal ’09 in terms of volumes?
Clayt Daley: We think that we still expect to deliver double digit organic sales growth in emerging markets. I would say that the volume growth behind that will probably be upper singles and therefore it’s quite clear based on what’s happened to the markets. A lot of this is driven by the markets as it impacts volume growth where volume growth is now below sales growth by a couple of percentage points in North America and in Western Europe. That’s what will create the aggregate 2% to 3% volume growth for the company.
Operator: Your next question comes from Wendy Nicholson – Citi.
Wendy Nicholson – Citi: If I could follow up on Nik’s question, I think he was asking volume growth in emerging markets and my question is the 2% to 3% outlook is a little on the low end because I would have expected volume growth in markets like China, Russia and India to be healthy, healthy double digits and what we’ve heard from some other companies is that reported sales growth in those emerging markets is lower than volume growth because of the heavy levels of promotion and that kind of thing. In a market like China specifically where it sounds like you’ve got so much headroom from a category perspective and reaching more of the population what kind of outlook for volume growth do you see in China over the next 12 months.
Clayt Daley: We’re seeing the opposite; we’re seeing sales growth exceed volume growth. There are significant price increases going on in emerging markets as well. We have been raising prices in Russia and Eastern Europe some fairly sizeable percentages, in China and Latin America as well. We are seeing organic sales growth rates well above volume growth rates and that’s why as I said we think the volume growth rate in emerging markets is likely to be in the upper singles. I think its important also to note that we think that it’s prudent given the amount of pricing that is going into the marketplace to not get ahead of ourselves in terms of what volume growth is likely to be in this environment.
AG Lafley: The markets we estimate are growing, take our two biggest developing markets, SAMEA and China we think they’re growing about 7% in aggregate across all of our categories. As Clayt just said we actually have a couple quarters or more now of concrete experience where we’ve been rolling through pricing across our categories and we’re delivering very consistent double digit sales growth but it’s been on high single digit volume growth. As Clayt also said, we have pricing planned that’s not going to impact until this first quarter of the new year and into the second quarter of the new year. We’re trying to estimate the roll through there. The other thing that I think is important to understand is one of the biggest engines to growth in developing markets in the past year has been the big cities. In the big cities we’re selling more of our premium line. The kind of product lines that we’re selling in the Shanghai and Moscow and Delhi of the world right now are actually growing sales at a rate faster than volume. The third point is incredibly important, we’re one month into a new year, and we’re looking at the largest increase in commodity and energy prices at least any of us who have been with the company 30 plus years now have seen including the 70’s. We’re going to be taking pricing that is unprecedented. We just want to make sure that we’re prudent. We want to make sure that we’re cautious and we’re careful. If we do better that would be great.
Operator: Your next question comes from Chris Ferrara – Merrill Lynch.
Chris Ferrara – Merrill Lynch: I wanted to ask a little bit about the mix overall back to that. Obviously decelerated, can you quantify how much of it is geographic mix versus what mix was in developed market? Could you talk about what mix looked like in the US and Western Europe?
Clayt Daley: About 1% in geographic of the total which is pretty consistent with what we’ve been seeing for the last couple of quarters.
Chris Ferrara – Merrill Lynch: One point down for developing markets?
Clayt Daley: Yes, geographic mix.
Jon Moeller: Obviously as that becomes a bigger percentage of our business it’s a little bit bigger drag but it’s still worth it, it’s where you want to be. You want to be where babies are born, households form, incomes are rising and economies are growing faster and we just have a lot of white space.
AG Lafley: As we’ve said many times before from an all in after tax profit basis this is not a negative mix story.
Operator: Your next question comes from Bill Schmitz – Deutsche Bank.
Bill Schmitz – Deutsche Bank: Can we talk a little bit longer term on how you juxtapose the short term pressures in the business and having to really belt tighten on the SG&A side and how that impacts both the deliver the decade. What you pushed to deliver the decade and what’s left in the tank after that. A long way of saying are you guys trimming fat here in the SG&A side or is there some muscle there as well given the unprecedented rise in input costs in the short term?
AJ Lafley: I think there’s still a long runway for the kind of steady and consistent growth that our targets represent. Let me hit the key drivers, the first is the portfolio and I hope we’ve made it clear that we’re going to continue to evolve the portfolio over time. I think Clayt and I have tried to be very clear about that and I think if you look at our actions over the last eight to 10 years you’ve seen it. Very methodically move out of categories where the growth prospects aren’t as good, where they aren’t quite as structurally attractive and where they don’t lend themselves to our brand and innovation driven business model and you will continue to see that. The portfolio will be a growth driver. The second piece is innovation. We worked very hard this last eight to 10 years to build a robust innovation engine and we think we’ve got one and we’ve said before we have clear visibility out at least five years more on some of our businesses and we’re looking at an innovation pipeline that’s robust enough to deliver the growth rates that we’ve set for ourselves. Most of our organic sales growth every year is driven by new product innovation. We could talk about a lot of things there but the way we innovate the whole connect and develop program over half of our new products now have at least one outside partner. The way we cross pollinate technologies and learn from each other and reapply. There’s just a lot there. The third one in the productivity I hate to say it but this is my 32nd year and there’s still fat to trim. It’s not because we don’t work at it. It’s not because we don’t have 138,000 P&G’s working their hardest everyday around the world it’s simply because there are always ways to do things more simply and that’s what we’re focused on. We’re focused on simplicity and productivity. I’ll tick off a few really quick ones. GBS IDS we moved to the shared services structure back in the early art of this decade. It’s been a big driver for productivity and we’ve still got more productivity to grow. We’ve got five more years of productivity improvement currently identified. Look at our CapEx; 10 years ago we were running 7.8% of sales. We now arguably have a portfolio that should be as capital intensive especially when we added Blades and Razors and Batteries. We just turned in 3.6% this is fantastic work by our engineering and product supply and R&D organizations. Look at our R&D productivity, what we run as a percentage of sales; we peaked at 4.8% of sales a decade ago. We’re running 3.2%, 3.3% of sales. There’s a little bit more productivity there. We still have a lot of productivity opportunity where our organization structures connect. There is duplication and there are opportunities to be more efficient where the GBU touches the MDO, etc. The program we laid out at Cagney we’re going to accelerate and we’re going to broaden and there’s at least a five year timeline for that one.
Operator: Your next question comes from [Sophia Senis] – JP Morgan.
[Sophia Senis] – JP Morgan: Most of the consumer companies actually are seeing organic growth accelerate, they take more pricing. What are you doing differently to get your top line accelerated?
Clayt Daley: What we’re saying is that the pricing we’re taking is on top of the volume growth. The scenario where our sales growth would be a little higher is if we could get toward the upper end of our volume growth range and if the price increases are fully reflected and we don’t end up in a situation where we have to spend money back into the marketplace. That’s the scenario where organic sales growth could be on the upper end of our ranges.
Operator: Your next question comes from Lauren Leiberman - Lehman Brothers.
Lauren Leiberman - Lehman Brothers: I still had a follow up on the mix question because don’t feel like it got totally answered and then one on advertising. The geographic mix was one point but what were mix trends in developed markets is that the other negative point of mix?
Clayt Daley: Yes, that’s what we said. We have seen some mix, some trade down to lower priced brands that are still P&G brands that have created some negative mix.
AG Lafley: There are really three things going on here. One is developing markets which Clayt commented on. The second is some trade down and the third one is our mix of categories. When we do more Baby and we do more Family Care that impacts our mix. As Jon pointed out when you look at it all from a profit standpoint, on an earnings basis we do fine because there are really no negative mix effects when you get to the after tax profit line. It’s a little bit complex but that’s the way it’s working and as we continue to grow in developing markets we’re going to see this top line net sales mix impact. Frankly, when you’re in an economic period like this in Western Europe and the US the staples businesses hold up better, they’re more stable, people keep buying the staples every week and using them every day. That means we see a little bit of negative top line mix coming from the Household business.
Lauren Leiberman - Lehman Brothers: The advertising piece, you guys commented on advertising for the full year. I wanted to know what advertising grew in the quarter and then as you think about next year because of the change in the CMO is advertising becoming a target for more productivity.
Clayt Daley: No, we don’t disclose quarterly advertising spending as a percent of sales. Suffice it to say, we spent 10.4% last year which was the same as the year before and our plans for the coming year would be to sustain it at about that level. Cutting advertising is not part of our plans to cut costs.
AG Lafley: Our thrust is almost every year we’re right about at 10% usually up a few ticks. What’s changing is the mix which I think you understand obviously less TV. In developing markets TV is still powerful. The third thing that’s going on is we keep driving the market mix modeling in the marketing RLI so when we spend that 10% plus we get more bang for it. We get 11% or 12% worth of bang for it. In terms of the change from Jim to Mark, I’d say two things. One, we’re going to run the same brand building and marketing focus program with both guys, they’ve been working together on reinventing brand building over the last year. Some of the productivity things that Jim started in marketing, Mark will continue.
Clayt Daley: The productivity things related to people not to advertising spending. The advertising spending is fundamentally the decision of the business units.
Operator: Your next question comes from Ali Dibadj - Sanford Bernstein.
Ali Dibadj - Sanford Bernstein: Maybe I’m the only one confused about this but I love your clarification particularly on the restructuring on Folgers. Are you saying the $400 million that you’re spending on the restructuring of Folgers would not have been spent otherwise without Folgers? The reason I ask that is it seems a little bit disproportional to me that you’re restructuring internally at $400 million for $80 billion sales of the business…
Clayt Daley: As we’ve said, we think the ongoing restructuring program will grow over time with the business. If Folgers hadn’t happened there’s a chance that the restructuring program in fiscal ’08-‘09 would have been a little bit over, it might have been $400 to $500 million versus $300 to $400 million, $400 to $450 million I don’t know. It might have grown a little bit but it certainly would not have gone up to $800 million. The increase to $800 million is directly tied to the Folgers transaction and our desire to rapidly deal with the stranded overhead costs and rapidly deal with the earnings dilution. If you look at the $0.04 earnings dilution which on an after tax basis is about $135 million on a pre-tax basis that will be close to $200 million, I don’t think the incremental structuring relative to the amount of dilution we’re trying to mitigate is off by a lot.
Operator: Your next question comes from Jason Gere – Wachovia.
Jason Gere – Wachovia: I was wondering if you could give a little more clarity about the sales by channel in the developed market. Talking about the role of incremental in store communication to drive the innovation that you’re bringing to the marketplace.
AG Lafley: You asked a question about our channel progress in developed markets?
Jason Gere – Wachovia: Correct
AG Lafley: Obviously if you look at the monthly retailer report and if you look at consumer shopping behavior over the last several weeks and months what’s going on is she’s reducing trips and she’s consolidating her shopping and that has advantaged the club channel we’re in a higher than fair share position. For some shoppers it has been good for discounters and I think obviously Wal-Mart has done reasonably well in this environment and that’s not surprising they’re well positioned. The other channel that I think has done pretty okay is the Dollar channel in the US. If you turn to Western Europe it’s still a story of discounters. The growth channel is the discounters, although what’s changed versus a few years ago is the soft discounters are now going faster than the hard discounters which is good for branded manufacturers like P&G. The Legal’s of the world are actually growing faster than Aldi and we are well represented in Legal. We’ve spent a lot of time and effort building out our distribution with Legal over the last few years. That’s been the trend. I think you have to be careful not to look just at channels. There are winners within each channel and the grocery channel some of the grocery players are doing quite well. The second question was about; remind me of your second question.
Jason Gere – Wachovia: Thinking about more from the alternative channels from that perspective?
AG Lafley: Looking at retail channels?
Jason Gere – Wachovia: No, looking at club, looking at mass dollar from that perspective. More obviously to mass and to club if there’s any incremental in store communication needed to drive the innovation.
AG Lafley: I would say three things, one is we need to be strong in innovating where shoppers are shopping so we follow the shopper; the consumer is the boss we follow the consumer with demand creation and with our innovation we follow the shopper. Second thing is clearly there’s been a shift and you’ve seen it from us and I’m sure you’ve seen it from other players in our industry to more in store communication, more in store marketing. Thirdly, I would say we’re all experimenting continuously with what we need to do to generate more trial. I think I’ve said this on prior calls we still have a huge opportunity. We have a $1 to $2 billion net sales opportunity. We had a question earlier how could we accelerate our growth. We could close our trial opportunity just on our current brands and with our current innovation that’s in the market. We’re experimenting continuously with in store and out of store techniques to build trial faster.
Operator: Your next question comes from Joe Altobello – Oppenheimer.
Joe Altobello – Oppenheimer: In terms of the developing market growth I’m curious why haven’t we seen these emerging markets slow given that a disproportionate amount of their incomes are typically spent on food and fuel and that’s where you’re seeing a lot of the cost inflation. Is the discretionary income growth in these countries overwhelming that inflation impact? Looking ahead to ’09 I know China is one country, but typically what you see is post Olympics the GDP growth of the host country tends to slow considerably. Are you taking that into consideration in terms of your ’09 guidance?
Clayt Daley: The consumers who literally have had to shift their income to deal with higher food prices, the consumers who are that far down the economic spectrum are not heavy consumers of our products. Even in emerging markets if consumers are making choices on what to buy because of higher food prices at least so far they’re not choosing to reduce consumption in the staples categories. Those markets are continuing to grow at the rates they’ve been growing. We’ve said before we don’t know how to predict this one. Will these market growth rates continue forever, no. There will be a point at some point where we will start to see some slow down even strictly because of the law of large numbers as these markets get significantly larger bases behind them. At least for the moment we have not seen slow down and it would be difficult for us to predict it.
AG Lafley: What’s been going on is that there are broadly speaking three income levels that we’re doing business with across developing markets. I spoke about the highest income group they tend to be in the biggest cities generally two wage earners and incomes rising fairly fast. I think what’s been going on in that developing market top tier growth has been more than offsetting the developing market lowest tier pressure that’s come from food inflation. We just have to watch that. The other thing I think is important to understand is no two developing countries are alike. What we do in China is different in important ways versus what we’re doing in Brazil or Russia, Ukraine for example. The third thing I think Clayt makes the right point, we had a lot of questions about the volume guidance for next year but we’re trying to be cautious all the way around because yes, there is uncertainty. The Chinese GDP is not a consumer driven GDP. Our consumer markets are growing about 7% the one’s we’re in, in China, their GDP has been growing at a rate faster than that. We’re cautious and we’re watchful and we’re in the market everyday and we try to stay very close to consumers. We try to stay very close to our distributors and retailers and we try to be agile and flexible and adaptable.
Operator: Your next question comes from Connie Maneaty – BMO Capital.
Connie Maneaty – BMO Capital: I have a longer term question on restructuring. I understand that the plan is to do restructuring on an ongoing rather than episodic basis and the consolidation of distribution centers is part of that ongoing process. Are there circumstances under which an episodic charge might be more appropriate to move the organization to where it needs to be for a five to 10 year period especially given the higher platform for commodity costs and the opportunity still to simplify?
Clayt Daley: I think that’s a fair point. If we had projects that were not funded, in other words, if we had opportunities that the businesses had come to us and we were saying no, we’re not funding projects because we’re trying to keep an arbitrary restructuring budget then I think it’s an absolutely fair point as to why would you say no to good projects because of an arbitrary funding limit. That has not been the case. We have been funding all of the restructuring projects that have been coming to us from the various business units therefore there hasn’t been a capital constraint or a restructuring budget constraint imposed on the organization where we would be foregoing an opportunity.
AG Lafley: If we had to recapitalize to move to a new technology platform, you may recall we spent over $1 billion to re-platform Baby Care about eight to 10 years ago. We did a major re-platforming of Fem Care. If we had to do something like that we would step up to it. If you don’t have that this is a much better way to run the railroad. A lot more disciplined, a lot more operating disciplined with the way we’ve been running the last eight years.
Operator: Your next question comes from Filippe Goossens – Credit Suisse.
Filippe Goossens – Credit Suisse: I would like to go back to my question from the last earnings call related to Pantene in general and Brazil in particular. Last year our sources as well as our own research indicated that you were going to make a big push in Hair Care particularly in that country which has already resulted in the hiring of [Inaudible] your spokesperson. If you look at what’s happening to date our sources tell us that the push in Brazil with Pantene has not been as strong as they had expected so the question there is has anything changed with regard to your game plan. As it relates to the US obviously disappointing reformulation of Pantene. In order to go back to your 3% to 5% organic volume growth for the Beauty GVU it is critical in our opinion that Pantene gets turned around as well. What are your current plans there?
AG Lafley: I hope you understand that I really can’t comment on our future plans because we’re just not going to make an announcement and our competitors are probably paying attention to what we’re doing. On the main point that make I couldn’t agree with you more and I hope I’ve been very clear and very straightforward about that as well as our Hair Care business has done a lot of our brands as Jon reported earlier are doing quite well. We did stumble in some markets and you mentioned one of them, the US on the last round of Pantene innovation. We have new innovation going into the US market right now and you will see innovation from us on Pantene across the US and in other markets around the world. Regarding Brazil we are in a testing period. I believe our share is up; it’s still relatively modest, mid to high single digits. We’re learning it’s a big hair care market. Eventually we’re going to have to have a position there and we’re in the learning phase.
Operator: Your next question comes from Bill Chappell – SunTrust Robinson Humphrey.
Bill Chappell – SunTrust Robinson Humphrey: A follow up on the Folgers restructuring should we read into the fact that no additional charges in 2010 expected means we’re through with the rationalization of the portfolio or at least of the major brands? Also, with the share count, I think you said there’s a big share repurchase related to this deal can you say what you expect the average share count to be at year end fiscal ’09?
Clayt Daley: To answer your first question, this does not signal that there’s an end to the evolution of the portfolio. We’re not saying that we’re going to do more than Folgers but we’re not sitting here saying that we’re going to do nothing further. All we can plan at this point is what we know. We obviously know the impact of Folgers and we know that we’re planning to step up restructuring this year to offset it and then next year right now we’re planning to take that restructuring back down to about the prior level as a percent of sales. I would expect in fiscal 2010 the restructuring program could be above $400 million but not a huge amount above. Relative to the share count, what’s going to happen when the Folgers transaction occurs is we’re going to exchange P&G shares for newly issued shares of Smucker. What basically will happen is at the time that deal is closed there will be a substantial reduction in P&G share count that occurs with that transaction and that’s what we were talking about earlier. That’s in addition to the ongoing, if you think about share repurchase in fiscal 2009 we’re going to do the $8 to $10 billion we had previously committed to and then the share repurchase associated with the coffee, Smucker deal will be on top of that. That reduction in share count is factored into the dilution number for Folgers as well.
Operator: Your next question comes from Alice Longley - Buckingham Research.
Alice Longley - Buckingham Research: Doing the math on the volume guidance it sounds, for fiscal ’09 that volume may be up something like 8% in developing markets and maybe down 1% in Western Europe and up 1% in the US does that sound reasonable?
Clayt Daley: We can’t call it that close.
Alice Longley - Buckingham Research: Basically very little volume growth in the US and Western Europe?
Clayt Daley: It will be modest. I don’t think it’s going to go negative.
Operator: I’ll turn the conference back to you for any additional or closing remarks.
Clayt Daley: Thanks for joining us again today. As always, Jon Moeller, Mark Erceg, Jen Chelune and I will be around for the rest of the day. We’d be happy to take any questions and follow up that you have and thanks again for joining us. | [
{
"speaker": "Executives",
"text": "Clayt Daley - Chief Financial Officer AG Lafley - COO Jon Moeller – Treasurer"
},
{
"speaker": "Analysts",
"text": "Bill Pecoriello - Morgan Stanley Nik Modi – UBS Wendy Nicholson – Citi Chris Ferrara – Merrill Lynch Bill Schmitz – Deutsche Bank [Sophia Senis] – JP Morgan Lauren Leiberman - Lehman Brothers Ali Dibadj - Sanford Bernstein Jason Gere – Wachovia Joe Altobello – Oppenheimer Connie Maneaty – BMO Capital Filippe Goossens – Credit Suisse Bill Chappell – SunTrust Robinson Humphrey Alice Longley - Buckingham Research"
},
{
"speaker": "Operator",
"text": "Welcome to Procter & Gamble’s fiscal year-end conference call. (Operator Instructions) Today’s discussion will include a number of forward looking statements. If you will refer to P&G’s most recent 10-K and 8-K reports you will see a discussion of factors that could cause the company’s actual results to differ materially from these projections. As required by Regulation G, P&G needs to make you aware that during the call the company will make a number of references to non-GAAP and other financial measures. Management believes these measures provide investors valuable information on the underlying growth trends of the business. Organic refers to reported results excluding the impact of acquisitions and divestitures and foreign exchange where applicable. Free cash flow represents operating cash flow plus capital expenditures. P&G has posted on its website www.pg.com a full reconciliation of non-GAAP and other financial measures. Now I’d like to turn the call over to P&G’s Chief Financial Officer, Clayt Daley."
},
{
"speaker": "Clayt Daley",
"text": "AG Lafley, our COO and Jon Moeller, our Treasurer are joining me this morning. As is typically the case, we have a lot of information to cover on the year end call. I’ll begin with a summary of fourth quarter results. Jon will cover business highlights by operating segment. I will then provide a brief update on commodities, pricing, markets and Folgers. I’ll also provide guidance for the current fiscal year and the September quarter. AG will then close out the call. On to the results, P&G’s business has performed well allowing us to complete both the quarter and the year with sales, earnings per share and free cash flow all at or above our long term targets. The June quarter is the 24th consecutive quarter in which P&G delivered top line growth at or above the company’s target. We also delivered another quarter of high quality earnings and record cash flow, despite unprecedented increases in commodity and energy costs. Our ability to consistently deliver our top and bottom line commitments is the direct result of the breadth and depth of our unique portfolio, the strength of our innovation and our disciplined cost management and productivity efforts. For the June quarter diluted net earnings per share increased 37% to $0.92 per share. This includes net tax benefits of $0.12 per share due to a number of significant adjustments to tax reserves in the US and other large countries. Excluding these tax adjustments P&G’s underlying business delivered $0.80 per share, $0.02 above the high end of our goal and expectations. Total sales increased 10% to $21.3 billion, organic sales were up 5%, and organic volume was up 4%. Pricing added 3% to sales as previously announced price increases took effect. Foreign exchange contributed six points to sales growth. This proportionate growth in developing regions large sizes and mid tier brands resulted in a negative 2% mix impact. Quality of earnings was strong, operating profit increased 13% for the quarter to $3.8 billion and non-operating profit was below year ago. Operating margin grew 50 basis points. Gross margin decreased 160 basis points. Higher commodity and energy costs impacted the quarter by over 300 basis points. Faster growth in Baby Care, Family Care, and developing markets reduced gross margin by about 50 basis points. We also increased restructuring activities in the fourth quarter in anticipation of the Folgers deal. These projects brought fiscal 2008 restructuring costs to slightly more than the top end of the range of $400 million. This resulted in a negative 30 basis point impact on gross margin in the fourth quarter. Without the change in business mix and increased restructuring gross margin would have been down about 80 basis points. SG&A expenses were down by 210 basis points. This was driven by tight cost control and overhead productivity improvements. Importantly, while SG&A has been down every quarter, advertising spending remained constant as a percent of sales for the year at 10.4%, even as we continue to improve efficiency. Turning to cash, operating cash flow in the quarter was $4.1 billion, up $0.5 billion from the same period year ago. Free cash flow was $2.9 billion up $300 million versus year ago. Free cash flow was 96% of earnings ahead of our 90% productivity target. P&G generated $12.8 billion of free cash flow during the year an increase of over 20% or $2.3 billion. Capital spending was 3.6% of sales below the company’s target of 4%. Working capital was up about two days versus year ago driven by higher inventory balances. Year end inventory values were impacted by the run up in commodity costs. During the June quarter P&G increased dividends by 14% the 52nd consecutive year dividends have increased. For the full year P&G paid $4.7 billion in dividends to shareholders. In July 2007 we announced a three year $24 to $30 billion share repurchase program as part of that program we repurchased $2 billion worth of stock in the June quarter bringing the fiscal year total to $10 billion, at the high end of our $8 to $10 billion target range for the year. Combining dividends and share repurchase, P&G distributed nearly $15 billion to shareholders in fiscal 2008 or over 120% of earnings. Based on the current market capitalization P&G is providing shareholders a cash yield of over 7%. To summarize, P&G continues to drive top and bottom line growth despite a challenging cost and competitive environment. We have been pricing to recover commodity and energy cost increases and we are driving productivity and operational efficiencies to expand operating margins. We are generating significant cash and are aggressively returning that cash to our shareholders while maintaining our AA credit rating. Now I’ll turn it over to Jon for a discussion of the business unit results by segment."
},
{
"speaker": "Jon Moeller",
"text": "Starting with the Beauty segment, all end sales grew 11% and organic sales were up 4% in a very competitive market. Olay Skin Care volume grew mid single digits with over 40% growth in Central and Easter Europe, Middle East and Africa and mid teen’s growth in Western Europe. These strong results were driven by market share gains and continued distribution expansion. In the US, Olay Facial Moisturizers leading all outlet value share was in line with prior year at more than 44%. Retail Hair Care volume grew 3% despite a base period that included pipeline shipments for the Pantene base brand restage in North America. Excluding North America Pantene, global retail Hair Care volume grew 6% behind double digit growth of Head & Shoulders and high single digit growth of Rejoice. Head & Shoulders volume was up double digits in North America and Western Europe and tripled versus year ago in Japan behind the Head & Shoulders brand re-launch. Head & Shoulders is now the number one shampoo in the world. We expanded our retail Hair Care portfolio in June with the launch of Gillette Hair Care brand in North America. We also strengthened our Prestige Hair portfolio during the quarter with the acquisition of the Frederic Fekkai business. Professional Hair Care and retail Hair Color volume were both down slightly. Professional Hair Care shipments were down versus prior year due to soft results in North America and Northeast Asia. In retail Hair Color strong volume growth on the Nice ‘N Easy brand was more than offset by declines on several smaller brands. Nice ‘N Easy US all outlet value share is up more than three points to over 20% driven by share gains from the Perfect 10 line that launched in January. Nice ‘N Easy has now grown sales double digits for four consecutive years and has doubled its market share over this time period. The Cosmetics business has a very strong quarter with high single digit volume growth behind the continued success of Cover Girl Lash Blast Mascara. Lash Blast is on track to be the largest global cosmetics industry initiative every. Cover Girl’s market leading all outlet value share in the US is up nearly a point to 19%. In the Grooming segment all end sales were up 12% for the quarter and organic sales grew 4%. This compares to a base period that included Blades and Razors organic sales growth of 13% driven by the expansion of Fusion in European markets. Blades and Razors delivered solid sales and volume growth behind mid single digit market growth and continued market share gains. Global Gillette Blades and Razors share increased versus prior year to 71%. Volume in developing markets grew double digits with over 20% growth in developing Asian markets and double digit growth in Latin America behind continued distribution and market share increases. In the US, Fusion and Venus continued to grow value share but these gains were offset by declines on Legacy Male Systems. Fusion added four value share points versus year ago and is now over 36% of the US male systems market. Venus added nearly seven points behind the Embrace initiative and is now over 58% of the US female systems markets. Shave product shipments increased mid single digits on double digit growth in developing markets. In the US Gillette shave prep all outlet value share increased nearly six points to 36% behind the growth of the Fusion line. Braun shipments were down modestly due primarily to the exit of the Tassimo Coffee appliance business. Health Care all end sales grew 7% and organic volume increased 3%. This was the first full quarter reflecting the loss of market exclusivity for Prilosec OTC which negatively affected volume growth. Excluding Prilosec OTC health care organic volume increased 4% for the quarter. Feminine care volume grew high single digits with the Always brand up double digits and Naturella up more than 20%. In the US Always all outlet value share of the Pads segment increased more than a point to 58%. Share of the Pantiliner segment grew almost three points to nearly 32%. These results are driven by the continued strength of the Always Clean and Always Fresh initiatives that launched last calendar year. Expansion of Naturella in Central and Eastern Europe, Middle East and Africa drove shipment growth of nearly 30% in that region and Naturella volume in Latin America grew double digits. Oral care shipments were up for the quarter with growth of both the Crest and Oral-B brands. Crest [inaudible] maintained its all outlet value share leadership in the US despite intense competitive promotional activity. P&G’s leading all outlet value share of toothpaste in the US remained at about 38% and Oral-B toothbrush value share held steady at 43%. In Personal Care shipment volumes were down high single digits due to the competitive market entry against Prilosec OTC which resulted in brand volume down more than 20% for the quarter. Despite intense competitive promotional activity, Prilosec OTC maintains a very strong 34% value share of its segment in the US. Pharmaceutical volume was up low single digits versus prior year as high single digit growth of Actonel was partially offset by lower shipments of other minor brands. Sales for the Snack, Coffee and Pet segment increased 8% for the quarter and organic sales grew 4%. The Snacks business delivered high single digits volume growth and high teen sales growth driven by the Pringles Stix, Extreme Flavors and Minis initiatives. Pringles all outlet value share of the US potato chip market is up modestly versus prior year to more than 14%. Coffee sales declined in mid single digits due mainly to an expected reduction in trade inventory ahead of the Folgers brand re-stage launching this month and due to temporary price advantages versus the leading brand and competitor. P&G’s all outlet value share of the US Coffee market was in line with prior year at nearly 36% and Dunkin Donuts is now approaching 4% value share after less than a year in market. Pet care shipments increased mid single digits for the quarter behind the Iams Proactive Health initiative for dogs and the Iams Healthy Naturals initiative for cats. Sales were up double digits as pricing was taken to recover higher input costs. Fabric Care and Home Care sales grew 13% for the quarter with organic sales up 7%. Top line growth was broad based with every region posting solid volume increases. Fabric Care global shipments increased mid single digits with balanced growth in developing markets. Tide and Arial each grew volume mid singles and the Gain and Downy franchises each grew high singles or better. We completed the North American conversion to the concentrated liquid laundry format in the June quarter. We’re on track to meet or beat every element of our success criteria for this initiative including gaining distribution on new SKUs and delivering target shelf pricing. Home Care shipments were up high single digits led by North America with a double digit volume increase. Febreze volume grew double digits behind Febreze Candles and new scent innovation on Air Effects. Febreze share of the instant action air care market is up two points to nearly 21%. Dawn and Swiffer volumes were also up double digits due partially to forward volume by retailers ahead of previously announced price increased effective in the September quarter. Batteries volume grew modestly for the quarter as solid growth in greater China and Latin America offset modest declines in developed markets that were mainly due to market contraction. Duracell alkaline value share in the US was down about a point to 47%. In Western Europe lower volumes were driven by trade inventory reductions in anticipation of the September quarter launch of a new Duracell marketing and promotional campaign. Baby Care and Family Care delivered an excellent quarter with all end sales growth of 10%. Organic sales also grew 10% and organic volume increased a very strong 9%. Pampers Diapers global volume grew mid teens with each region posting shipment increases. Developed markets grew mid singles and developing markets grew high teens. China, Russia, Turkey, India, Saudi Arabia, Poland and the Philippines all delivered double diaper volume growth. In the US, Luvs diaper volume grew mid teens and Pampers Baby Dry grew high single digits. In total, P&G all outlet value share in the US Diaper market increased nearly a point to 35%. In Western Europe Pampers market leading diaper share was in line with prior year at a strong 54%. Family Care organic volume grew high single digits behind double digit growth on Charmin, and mid single digit growth on Bounty in North America. Charmin US all outlet value share increase more than two points to over 28% behind the Ultra Soft and Ultra Strong innovation launched nearly a year ago. Bounty US value share also increased more than two points to nearly 47%, a 43 year high, continuing to leverage the Best Bounty Ever initiative. That concludes the business segment review, now I’ll hand the call back to Clayt."
},
{
"speaker": "Clayt Daley",
"text": "There are several important topics I want to discuss before getting into guidance; commodities, pricing, market growth rates and Folgers. Starting with commodities, the rate of commodity and energy cost increase has clearly accelerated. For the fiscal year just ended we incurred approximately $1.5 billion in incremental costs. There’s a great deal of volatility and uncertainty so this is a moving target. Based on where spawn and forward markets are today we expect to incur about $3 billion in additional commodity and energy costs this fiscal year. This is higher than we anticipated three months ago when we expected commodity and energy costs to be up more than $2 billion. Since that time crude oil, diesel fuel and natural gas have each made moves of 25% to 35%. Other important materials such as surfactants, alcohols and sodash have moved up sharply as well. Given the magnitude of this increase I want to help frame the margin dynamics for you. If we take the results from the fiscal year just completed and simply add $3 billion in commodity costs to cost of goods sold and $3 billion of pricing to net sales holding everything else equal our gross margin would decline by about 180 basis points and operating margin would drop by about 70 basis points, even though we would fully maintain our profit. A complete reconciliation of this is posted on our website so you can check our math. Pricing beyond commodity and energy cost increases to maintain operating margin would be very risky given the pressure that our consumers are under. We’re going to have to live with some amount of gross margin compressions throughout this fiscal year. It is important to understand this to put our April-June, July-September and fiscal ’09 results in the right context. We have also previously announced that we will incur additional restructuring costs in fiscal 2009 in order to offset the dilution caused by the Folgers transaction. I’ll say more about this later but these additional restructuring projects will lower operating margin by roughly 50 basis points. Assuming we fully price to offset the impact of commodities and we execute our plan to offset Folgers dilution gross margin would be down 180 basis points and operating margin down about 120 basis points and that’s the starting point for fiscal 2009. To manage our business against this back drop we are pricing to recover commodity costs and challenging every part of our cost structure. Since the last call we announced price increases in Oral Care, Family Care, Baby Care, Fabric Care, Health Care, Beauty Care, Home Care, Batteries, and Pet Nutrition. On the cost front each of our businesses are working to strengthen its ongoing cost savings projects in manufacturing, product formulation and capital spending efficiency. In SG&A we are broadening and accelerating the overhead productivity program we discussed at Cagney. We also continue to improve return on our marketing spending while we increase on marketing investments at roughly the same rate as sales growth. To summarize, commodity and energy increases will put pressure on margins even as we price to offset those increases but what really matters is cash and profit which will grow at our target rates this year. Turning to our markets, on a global basis market growth rates remain in the 3% to 4% range on a value basis and one to two points below this on a volume basis. Developed markets are slowing modestly but still growing for the most part. We have not yet seen a slow down in developing markets which continue to grow in the high single digit pace. We do see some evidence of trade down. For instance, in Laundry Detergents, Tide grew volume in mid single digits in the fourth quarter down from its high single digit growth previously while Gain continued to grow volume in high single digits. This highlights the benefits of our tiered portfolio. We also continue to see examples of trade up where an invention warrants it. A good example is Perfect 10, our premium priced retail hair color. Perfect 10’s value share is above 3% and almost 100% of that is incremental to the Nice ‘N Easy brand. Gillette Clinical Strength Deodorant is another good example. Gillette Clinical Strength is priced two times higher than the base offering but continues to gain distribution and share. Private label in the US is up modestly excluding Personal Health Care where Prilosec OTC came off patent exclusivity, private label shares in our categories are up less than half a share point in aggregate and most importantly P&G continues to grow or hold value share in the majority of our categories. Like commodities, market dynamics are something we will continue to closely monitor taking a balanced consistent measured approach with one eye on sales and the other on volume. Switching to Folgers, on June 4th we announced the signing of a definitive agreement to merge the Folgers Coffee business into the JM Smucker Company and an all stock reverse morse trust transaction. Since that time we have filed a preliminary S-4 with the SEC and clarified the transaction structure as a split merge where P&G shareholders tender shares in exchange for new Smucker shares. The deal structure maximizes the after tax value of the Coffee business for P&G shareholders and minimizes earnings per share dilution versus other structures. We expect to complete the transaction during the second quarter of fiscal 2009. The Folgers deal will bring with it a significant one time gain. We will not know the exact amount of the gain until the deal is completed. For now our guidance assumes that the gain will be approximately $0.50 per share and again occurring in the December quarter. As I mentioned earlier P&G will incur additional restructuring costs during fiscal 2009 in order to offset about $0.04 of dilution caused by the Folgers transaction. The cost of these additional restructuring projects will be about $400 million. Adding this amount to our ongoing base restructuring budget of $400 million brings our fiscal year 2009 restructuring budget to approximately $800 million. The Folgers gain will be outside of operating earnings and will only impact the December quarter. The incremental restructuring charges will be in operating earnings and will impact all four quarters. The September and December quarters will be the most heavily impacted as we have chosen to accelerate several projects to get as much of the benefit as possible into this fiscal year. The additional restructuring costs will be about $0.04 per share in Q1 and Q2 and about $0.02 per share in Q3 and Q4 adding to about $0.12 per share for the year. If actual results are materially different than these estimates we will update these numbers. Otherwise we will not provide further guidance or reconcile the quarterly split of restructuring charges during fiscal 2009. Before moving on I need to take a moment to reassure you that P&G’s approach and philosophy toward restructuring charges has not changed. We will continue to manage our business with ongoing versus episodic restructuring and we’ll continue to report the results including these costs. In situations where strategic portfolio decisions result in stranded overheads and earnings dilution we will take action to offset those impacts. In fiscal year 2010 we expect restructuring spending to return to fiscal 2008 levels as a percent of sales. Now on to guidance, for fiscal 2009 P&G projects organic sales growth of 4% to 6% in line with our long term target range. With that, price mix should contribute to a 3%, foreign exchange is estimated to have a positive impact of 2% to 3%, acquisitions and divestitures will reduce net sales by about 1% to 2% and therefore in total we expect all end sales growth of 5% to 7% for the year. Organic volume is likely to grow 2% to 3% this is below the 4% to 5% we have been delivering during the first half of the calendar year which we think is appropriately conservative giving the amount of pricing that we have recently announced. Also the fact is I mentioned earlier that volume growth in our categories is below sales growth by 1% to 2%. We expect gross margin to be down only 75 to 125 basis points for the year despite the fact that the combined impact of commodities and pricing will reduce gross margin by about 180 basis points. We will accomplish this through cost savings programs and volume leverage. SG&A will be 75 to 125 basis points lower on the year with productivity savings more than offsetting the approximate 50 basis points of the incremental Folgers restructuring charges. The net result of our aggressive cost savings and productivity efforts is that despite roughly 70 basis points of net commodity and pricing impacts and incremental 50 basis points from restructuring operating margins on an all end basis should be about flat for the year. The tax rate should be between 27% and 28%. Our updated fiscal 2009 EPS guidance starts with fiscal 2008 GAAP results of $3.64 a share. Backing out $0.14 per share of tax benefits this brings us to an adjusted base EPS number of $3.50 a share for fiscal 2008. From that base we are projecting EPS growth of about 10% to $3.80 to $3.87 per share. This includes the $0.04 Folgers dilution and compares to our prior guidance of $3.80 to $3.85. We took the high end of our guidance range up by $0.02 a share to reflect better results in the fourth quarter. We have also widened our guidance rate slightly which we think is prudent given the volatility and uncertainty that exists in the commodity and energy markets today. To arrive at the GAAP guidance for 2009 you need to add the Folgers one time gain of $0.50 a share and then subtract $0.12 a share in temporary increases and restructuring charges. This produces a fiscal 2009 GAAP EPS range of $4.18 to $4.25 a share. We have included a full reconciliation in the press release materials. We expect to continue to generate strong cash flow and are confident that we will deliver against our goal of 90% or greater free cash flow productivity excluding the impact of the Folgers gain which is a non-cash item but will result in substantial additional share repurchase when the transaction is executed. While we expect to deliver the fiscal year numbers in line with long term targets there is likely to be greater quarter to quarter earnings volatility in fiscal 2009. We’ve been dealing with higher input costs with pricing but pricing does not take place instantaneously. We like to couple pricing with innovation to deliver better consumer value. We also need to give our retail partners time to adequately plan for pricing. All of these dynamics are factored into our planning efforts. The lag between when we announce pricing and when it’s effective on our revenue combined with a rapid escalation that took place in commodity markets during May and June will create some gross margin compression during the September quarter. We will catch up as price increases we just announced take effect in September and October and expect to see sequential gross margin improvement throughout the year. Turning to the September quarter, organic sales are expected to grow 4% to 6% within this price mix should contribute 2% to 3%, foreign exchange is estimated to have a positive impact of 4% to 5%, acquisitions and divestitures will reduce sales by about 1% and so in total we expect all end sales growth of 7% to 10% for the quarter. Organic volume growth will be 2% to 3%. We expect earnings per share to be in the range of $0.98 to $1.00 a share including the $0.04 of additional restructuring costs. On a GAAP basis this is up 7% to 9% versus year ago and 9% to 11% excluding the $0.02 per share tax benefit in the base period. Gross margin will be down 250 to 300 basis points primarily due to commodity and energy cost increases. Business and geographic mix will also decrease gross margins. We expect gross margins to improve sequentially during the balance of the year. We will offset about 50% to 60% of the gross margin reduction with focused productivity efforts which should result in operating margins being down 100 to 150 basis points for the quarter. Excluding the 4% per share of incremental restructuring costs operating margin should be down less than 50 basis points and operating income should increase in high single digits. The other income should be up versus year ago reflecting the timing of minor brand divestitures such as ThermoCare which was announced in July. We expect the tax rate for the quarter to be about 28%. Now I’ll turn it over to AG to wrap up the call."
},
{
"speaker": "AG Lafley",
"text": "Fiscal 2008 was another very good year for P&G. Total sales grew 9% to $83.5 billion. We’ve more than doubled the size of our business over the past six years. Sales in developing markets exceeded $25 billion and now account for 30% of our total business. P&G is now the largest consumer products company in the developing world. Organic sales grew 5% in the middle of our long term target range of 4% to 6%. For seven years running we’ve delivered these top line objectives. Two thirds of our billion dollar brands grew value share globally. Fusion became our 24th billion dollar brand and did so faster than any other P&G brand in history crossing the threshold in just under two years. Excluding the Health some significant adjustments to tax reserves diluted earnings per share increased 15% to $3.50 a share. Our cash performance was excellent. We generated $12.8 billion of free cash flow and returned over 120% of net earnings to shareholders through dividends and share repurchase. On top of all this, we beat the odds with say large acquisitions fail by successfully completing the integration of Gillette. We exceeded our cost synergy and dilution targets, revenue synergies are on target with significant up side over the next three to five years. Gillette and Oral-B brands are platforms for innovation and we’ve just begun the efforts to fully leverage these equities. Looking forward, I believe P&G is well positioned for continued success. Our portfolio, our commitment to innovation and our productivity efforts are the reasons for this. Our portfolio is stronger than at any time in our history. With the addition of Fusion, P&G now has 24 billion dollar brands far more than any other company. Billion dollar brands are platforms for innovation; they support larger investments in consumer research and R&D. They build strong equities with consumers, they become indispensable to retailers and they earn a leadership share of category profit. P&G’s billion dollar brands give P&G the number one or number two position in 18 different product categories around the world. This breadth of category leadership position is unmatched in our industry. This portfolio of brands and categories provides many unique advantages, strong growth potential and financial stability and reliability. Let me share just a couple examples of how the portfolio creates unique advantages for us. The first example is cost category innovation. Bleach technology from Laundry has been used in Health and Beauty Care products such as Crest White Strips and Clairol Perfect 10 hair colorant. Non-woven top sheet technology started in diapers, traveled to feminine care then moved on to Swiffer and Olay Daily Facials. Proprietary perfume technology has been used to enhance the performance of Bounce and Febreze our fine fragrance brands Camay and more recently Secret and Gillette Clinical Strength Deodorant. Looking forward we are very excited about the innovation possibilities we have in combining Gillette’s expertise and mechanical engineering with our expertise in chemical engineering. A second example of portfolio advantage is developing market penetration. The depth and breadth of P&G’s portfolio allows us to penetrate markets quicker and deeper than many competitors because it allows us to attract and build a network of best in class dedicated distributors in countries like China, India and Russia. These distributors have the deepest reach and the best capabilities in their respective markets. Today, our distributor network in China reaches 2,300 cities and 40% of towns and villages. This is about 60% of the population and 800 million more people than our next largest competitor. In India our distributor network now covers 4.5 million stores an increase of 2 million stores in just five years. In Russia we are now reaching 80% of the population. The third example I’ll offer is an advantage created by scale and by the unique combination of categories that comprise our portfolio. In combining Household and Health and Beauty businesses each benefits from the unique scale advantages of the other. Health and Beauty benefits from the larger raw material purchasing pool created by high tonnage, Household businesses like laundry, diapers and other paper products. They’re able to purchase packing materials and basic commodities at lower prices than direct competitors. Household care enjoys economies of scale created by Health and Beauty cares larger advertising and marketing budgets. The cost advantages created by scale provide the investment flexibility needed to build our brands with leadership levels of innovation and marketing support. These examples are just three of the many ways in which we’re advantaged by our diversified portfolio. Our portfolio as currently structured has significant potential for growth not just in Health and Beauty but also in Household care. Household care excluding acquisitions has grown sales at a five year compounded annual growth rate of about 40% in China and India, 30% in Russia and 20% in Brazil and Turkey. Household Care also had significant growth up side in the developed world. In the United States innovation, compaction and lower prioritization of the category by competition have driven meaningful growth in categories like Laundry. Other categories like Bath Tissue are growing in excess of 10% on an all outlet basis because of better consumer understanding and shopper segmentation and of course leading innovation. Household Care has increased sales in the US excluding acquisitions by almost 40% over the past five years, adding approximately $4 billion to our sales. Our Health and Beauty business gives us access to a structurally attractive $370 billion global market that is growing on average 4% to 6%, has favorable demographics and which is still fairly fragmented. P&G share of this market is still only about 10% which of course we expect to grow steadily over time. We generate 30% of our sales in developing markets today and that number is increasing every year. We have leadership shares in China, Russia, Poland, Turkey and Saudi Arabia. In China, P&G is number one in 11 of 12 categories in which we compete. We’re the largest consumer products goods manufacturer by a factor of four and we have, as I said, the deepest distribution network. In Russia our value share is now about 40% and sales are three times larger than the next largest CPG manufacturer. In Poland, value shares are approaching 30%. In Turkey, the number is closer to 40% and in Saudi we are approaching 50%. There is still an awful lot of room for growth. Despite the size of our developing market business we are frankly still under developed in these countries. We currently compete in only nine categories in India, 11 in Brazil, 12 in China and 18 in Russia. In Indonesia the fourth most populous market in the world we compete in only six. This compares to North America where we currently compete in 24 categories. Sales per person per year is another way to look at market development potential. Using the US is probably not a fair point of comparison so let’s use Mexico. In Mexico, P&G generates sales of approximately $20 per person per year. In Brazil that number is less than $10, in China less than $5 and in India still less than $1. In addition to unique advantages in growth potential our portfolio provides financial stability and reliability. This allows us to reach quickly to competitive challenges in a given area while continuing to deliver the results that shareholders expect from us. Stability allows us to think longer term which is what building enduring brands is really all about. It allows us to reliably and consistently invest in innovation and P&G’s commitment to innovation has never been stronger. Innovation is what will differentiate the winners and the losers in our industry and in the current environment. Innovation drives consumer value and builds brand equity and trust over time. Both brand value and brand equity scores for P&G brands are strong. Over 70% of our billion dollar brands have top quartile consumer value scores and approximately 80% have top quartile equity scores. P&G’s commitment to cost control and productivity has also never been stronger. Over the last year our selling, research and administrative costs as a percentage of sales dropped 100 basis points with advertising growing in line with sales. We’re committed to accelerated progress in this area; our productivity focus will provide us with the financial flexibility we need to deal with short term challenges while maintaining our focus on the long term drivers of value creation. All of these things, our category and geographic portfolio, our unwavering commitment to innovation and our focus on productivity give me the confidence that we’ll continue to deliver the results our shareholders expect from us despite the challenging and more volatile environment in which we’re now operating. Now Clayt, Jon and I would be happy to take your questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Bill Pecoriello - Morgan Stanley."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "On the price mix guidance for ’09 is that assuming that the price will be four to five and you’re holding the mix negative 2% was on the fourth quarter so no additional trade down expected and then in the volume component this is what your elasticity models are showing by category by market there’s no category market that you would single out in terms of where we might see more of the volume impact this is pretty broad based give the pricing."
},
{
"speaker": "Clayt Daley",
"text": "I think the volume is pretty broad based and I think your assessment on the relationship between pricing and mix is actually pretty close. I think that assessment is pretty accurate."
},
{
"speaker": "Operator",
"text": "Your next question comes from Nik Modi – UBS."
},
{
"speaker": "Nik Modi – UBS",
"text": "In terms of going back to the volume growth what are you embedding in terms of the emerging market growth for fiscal ’09 in terms of volumes?"
},
{
"speaker": "Clayt Daley",
"text": "We think that we still expect to deliver double digit organic sales growth in emerging markets. I would say that the volume growth behind that will probably be upper singles and therefore it’s quite clear based on what’s happened to the markets. A lot of this is driven by the markets as it impacts volume growth where volume growth is now below sales growth by a couple of percentage points in North America and in Western Europe. That’s what will create the aggregate 2% to 3% volume growth for the company."
},
{
"speaker": "Operator",
"text": "Your next question comes from Wendy Nicholson – Citi."
},
{
"speaker": "Wendy Nicholson – Citi",
"text": "If I could follow up on Nik’s question, I think he was asking volume growth in emerging markets and my question is the 2% to 3% outlook is a little on the low end because I would have expected volume growth in markets like China, Russia and India to be healthy, healthy double digits and what we’ve heard from some other companies is that reported sales growth in those emerging markets is lower than volume growth because of the heavy levels of promotion and that kind of thing. In a market like China specifically where it sounds like you’ve got so much headroom from a category perspective and reaching more of the population what kind of outlook for volume growth do you see in China over the next 12 months."
},
{
"speaker": "Clayt Daley",
"text": "We’re seeing the opposite; we’re seeing sales growth exceed volume growth. There are significant price increases going on in emerging markets as well. We have been raising prices in Russia and Eastern Europe some fairly sizeable percentages, in China and Latin America as well. We are seeing organic sales growth rates well above volume growth rates and that’s why as I said we think the volume growth rate in emerging markets is likely to be in the upper singles. I think its important also to note that we think that it’s prudent given the amount of pricing that is going into the marketplace to not get ahead of ourselves in terms of what volume growth is likely to be in this environment."
},
{
"speaker": "AG Lafley",
"text": "The markets we estimate are growing, take our two biggest developing markets, SAMEA and China we think they’re growing about 7% in aggregate across all of our categories. As Clayt just said we actually have a couple quarters or more now of concrete experience where we’ve been rolling through pricing across our categories and we’re delivering very consistent double digit sales growth but it’s been on high single digit volume growth. As Clayt also said, we have pricing planned that’s not going to impact until this first quarter of the new year and into the second quarter of the new year. We’re trying to estimate the roll through there. The other thing that I think is important to understand is one of the biggest engines to growth in developing markets in the past year has been the big cities. In the big cities we’re selling more of our premium line. The kind of product lines that we’re selling in the Shanghai and Moscow and Delhi of the world right now are actually growing sales at a rate faster than volume. The third point is incredibly important, we’re one month into a new year, and we’re looking at the largest increase in commodity and energy prices at least any of us who have been with the company 30 plus years now have seen including the 70’s. We’re going to be taking pricing that is unprecedented. We just want to make sure that we’re prudent. We want to make sure that we’re cautious and we’re careful. If we do better that would be great."
},
{
"speaker": "Operator",
"text": "Your next question comes from Chris Ferrara – Merrill Lynch."
},
{
"speaker": "Chris Ferrara – Merrill Lynch",
"text": "I wanted to ask a little bit about the mix overall back to that. Obviously decelerated, can you quantify how much of it is geographic mix versus what mix was in developed market? Could you talk about what mix looked like in the US and Western Europe?"
},
{
"speaker": "Clayt Daley",
"text": "About 1% in geographic of the total which is pretty consistent with what we’ve been seeing for the last couple of quarters."
},
{
"speaker": "Chris Ferrara – Merrill Lynch",
"text": "One point down for developing markets?"
},
{
"speaker": "Clayt Daley",
"text": "Yes, geographic mix."
},
{
"speaker": "Jon Moeller",
"text": "Obviously as that becomes a bigger percentage of our business it’s a little bit bigger drag but it’s still worth it, it’s where you want to be. You want to be where babies are born, households form, incomes are rising and economies are growing faster and we just have a lot of white space."
},
{
"speaker": "AG Lafley",
"text": "As we’ve said many times before from an all in after tax profit basis this is not a negative mix story."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bill Schmitz – Deutsche Bank."
},
{
"speaker": "Bill Schmitz – Deutsche Bank",
"text": "Can we talk a little bit longer term on how you juxtapose the short term pressures in the business and having to really belt tighten on the SG&A side and how that impacts both the deliver the decade. What you pushed to deliver the decade and what’s left in the tank after that. A long way of saying are you guys trimming fat here in the SG&A side or is there some muscle there as well given the unprecedented rise in input costs in the short term?"
},
{
"speaker": "AJ Lafley",
"text": "I think there’s still a long runway for the kind of steady and consistent growth that our targets represent. Let me hit the key drivers, the first is the portfolio and I hope we’ve made it clear that we’re going to continue to evolve the portfolio over time. I think Clayt and I have tried to be very clear about that and I think if you look at our actions over the last eight to 10 years you’ve seen it. Very methodically move out of categories where the growth prospects aren’t as good, where they aren’t quite as structurally attractive and where they don’t lend themselves to our brand and innovation driven business model and you will continue to see that. The portfolio will be a growth driver. The second piece is innovation. We worked very hard this last eight to 10 years to build a robust innovation engine and we think we’ve got one and we’ve said before we have clear visibility out at least five years more on some of our businesses and we’re looking at an innovation pipeline that’s robust enough to deliver the growth rates that we’ve set for ourselves. Most of our organic sales growth every year is driven by new product innovation. We could talk about a lot of things there but the way we innovate the whole connect and develop program over half of our new products now have at least one outside partner. The way we cross pollinate technologies and learn from each other and reapply. There’s just a lot there. The third one in the productivity I hate to say it but this is my 32nd year and there’s still fat to trim. It’s not because we don’t work at it. It’s not because we don’t have 138,000 P&G’s working their hardest everyday around the world it’s simply because there are always ways to do things more simply and that’s what we’re focused on. We’re focused on simplicity and productivity. I’ll tick off a few really quick ones. GBS IDS we moved to the shared services structure back in the early art of this decade. It’s been a big driver for productivity and we’ve still got more productivity to grow. We’ve got five more years of productivity improvement currently identified. Look at our CapEx; 10 years ago we were running 7.8% of sales. We now arguably have a portfolio that should be as capital intensive especially when we added Blades and Razors and Batteries. We just turned in 3.6% this is fantastic work by our engineering and product supply and R&D organizations. Look at our R&D productivity, what we run as a percentage of sales; we peaked at 4.8% of sales a decade ago. We’re running 3.2%, 3.3% of sales. There’s a little bit more productivity there. We still have a lot of productivity opportunity where our organization structures connect. There is duplication and there are opportunities to be more efficient where the GBU touches the MDO, etc. The program we laid out at Cagney we’re going to accelerate and we’re going to broaden and there’s at least a five year timeline for that one."
},
{
"speaker": "Operator",
"text": "Your next question comes from [Sophia Senis] – JP Morgan."
},
{
"speaker": "[Sophia Senis] – JP Morgan",
"text": "Most of the consumer companies actually are seeing organic growth accelerate, they take more pricing. What are you doing differently to get your top line accelerated?"
},
{
"speaker": "Clayt Daley",
"text": "What we’re saying is that the pricing we’re taking is on top of the volume growth. The scenario where our sales growth would be a little higher is if we could get toward the upper end of our volume growth range and if the price increases are fully reflected and we don’t end up in a situation where we have to spend money back into the marketplace. That’s the scenario where organic sales growth could be on the upper end of our ranges."
},
{
"speaker": "Operator",
"text": "Your next question comes from Lauren Leiberman - Lehman Brothers."
},
{
"speaker": "Lauren Leiberman - Lehman Brothers",
"text": "I still had a follow up on the mix question because don’t feel like it got totally answered and then one on advertising. The geographic mix was one point but what were mix trends in developed markets is that the other negative point of mix?"
},
{
"speaker": "Clayt Daley",
"text": "Yes, that’s what we said. We have seen some mix, some trade down to lower priced brands that are still P&G brands that have created some negative mix."
},
{
"speaker": "AG Lafley",
"text": "There are really three things going on here. One is developing markets which Clayt commented on. The second is some trade down and the third one is our mix of categories. When we do more Baby and we do more Family Care that impacts our mix. As Jon pointed out when you look at it all from a profit standpoint, on an earnings basis we do fine because there are really no negative mix effects when you get to the after tax profit line. It’s a little bit complex but that’s the way it’s working and as we continue to grow in developing markets we’re going to see this top line net sales mix impact. Frankly, when you’re in an economic period like this in Western Europe and the US the staples businesses hold up better, they’re more stable, people keep buying the staples every week and using them every day. That means we see a little bit of negative top line mix coming from the Household business."
},
{
"speaker": "Lauren Leiberman - Lehman Brothers",
"text": "The advertising piece, you guys commented on advertising for the full year. I wanted to know what advertising grew in the quarter and then as you think about next year because of the change in the CMO is advertising becoming a target for more productivity."
},
{
"speaker": "Clayt Daley",
"text": "No, we don’t disclose quarterly advertising spending as a percent of sales. Suffice it to say, we spent 10.4% last year which was the same as the year before and our plans for the coming year would be to sustain it at about that level. Cutting advertising is not part of our plans to cut costs."
},
{
"speaker": "AG Lafley",
"text": "Our thrust is almost every year we’re right about at 10% usually up a few ticks. What’s changing is the mix which I think you understand obviously less TV. In developing markets TV is still powerful. The third thing that’s going on is we keep driving the market mix modeling in the marketing RLI so when we spend that 10% plus we get more bang for it. We get 11% or 12% worth of bang for it. In terms of the change from Jim to Mark, I’d say two things. One, we’re going to run the same brand building and marketing focus program with both guys, they’ve been working together on reinventing brand building over the last year. Some of the productivity things that Jim started in marketing, Mark will continue."
},
{
"speaker": "Clayt Daley",
"text": "The productivity things related to people not to advertising spending. The advertising spending is fundamentally the decision of the business units."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ali Dibadj - Sanford Bernstein."
},
{
"speaker": "Ali Dibadj - Sanford Bernstein",
"text": "Maybe I’m the only one confused about this but I love your clarification particularly on the restructuring on Folgers. Are you saying the $400 million that you’re spending on the restructuring of Folgers would not have been spent otherwise without Folgers? The reason I ask that is it seems a little bit disproportional to me that you’re restructuring internally at $400 million for $80 billion sales of the business…"
},
{
"speaker": "Clayt Daley",
"text": "As we’ve said, we think the ongoing restructuring program will grow over time with the business. If Folgers hadn’t happened there’s a chance that the restructuring program in fiscal ’08-‘09 would have been a little bit over, it might have been $400 to $500 million versus $300 to $400 million, $400 to $450 million I don’t know. It might have grown a little bit but it certainly would not have gone up to $800 million. The increase to $800 million is directly tied to the Folgers transaction and our desire to rapidly deal with the stranded overhead costs and rapidly deal with the earnings dilution. If you look at the $0.04 earnings dilution which on an after tax basis is about $135 million on a pre-tax basis that will be close to $200 million, I don’t think the incremental structuring relative to the amount of dilution we’re trying to mitigate is off by a lot."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jason Gere – Wachovia."
},
{
"speaker": "Jason Gere – Wachovia",
"text": "I was wondering if you could give a little more clarity about the sales by channel in the developed market. Talking about the role of incremental in store communication to drive the innovation that you’re bringing to the marketplace."
},
{
"speaker": "AG Lafley",
"text": "You asked a question about our channel progress in developed markets?"
},
{
"speaker": "Jason Gere – Wachovia",
"text": "Correct"
},
{
"speaker": "AG Lafley",
"text": "Obviously if you look at the monthly retailer report and if you look at consumer shopping behavior over the last several weeks and months what’s going on is she’s reducing trips and she’s consolidating her shopping and that has advantaged the club channel we’re in a higher than fair share position. For some shoppers it has been good for discounters and I think obviously Wal-Mart has done reasonably well in this environment and that’s not surprising they’re well positioned. The other channel that I think has done pretty okay is the Dollar channel in the US. If you turn to Western Europe it’s still a story of discounters. The growth channel is the discounters, although what’s changed versus a few years ago is the soft discounters are now going faster than the hard discounters which is good for branded manufacturers like P&G. The Legal’s of the world are actually growing faster than Aldi and we are well represented in Legal. We’ve spent a lot of time and effort building out our distribution with Legal over the last few years. That’s been the trend. I think you have to be careful not to look just at channels. There are winners within each channel and the grocery channel some of the grocery players are doing quite well. The second question was about; remind me of your second question."
},
{
"speaker": "Jason Gere – Wachovia",
"text": "Thinking about more from the alternative channels from that perspective?"
},
{
"speaker": "AG Lafley",
"text": "Looking at retail channels?"
},
{
"speaker": "Jason Gere – Wachovia",
"text": "No, looking at club, looking at mass dollar from that perspective. More obviously to mass and to club if there’s any incremental in store communication needed to drive the innovation."
},
{
"speaker": "AG Lafley",
"text": "I would say three things, one is we need to be strong in innovating where shoppers are shopping so we follow the shopper; the consumer is the boss we follow the consumer with demand creation and with our innovation we follow the shopper. Second thing is clearly there’s been a shift and you’ve seen it from us and I’m sure you’ve seen it from other players in our industry to more in store communication, more in store marketing. Thirdly, I would say we’re all experimenting continuously with what we need to do to generate more trial. I think I’ve said this on prior calls we still have a huge opportunity. We have a $1 to $2 billion net sales opportunity. We had a question earlier how could we accelerate our growth. We could close our trial opportunity just on our current brands and with our current innovation that’s in the market. We’re experimenting continuously with in store and out of store techniques to build trial faster."
},
{
"speaker": "Operator",
"text": "Your next question comes from Joe Altobello – Oppenheimer."
},
{
"speaker": "Joe Altobello – Oppenheimer",
"text": "In terms of the developing market growth I’m curious why haven’t we seen these emerging markets slow given that a disproportionate amount of their incomes are typically spent on food and fuel and that’s where you’re seeing a lot of the cost inflation. Is the discretionary income growth in these countries overwhelming that inflation impact? Looking ahead to ’09 I know China is one country, but typically what you see is post Olympics the GDP growth of the host country tends to slow considerably. Are you taking that into consideration in terms of your ’09 guidance?"
},
{
"speaker": "Clayt Daley",
"text": "The consumers who literally have had to shift their income to deal with higher food prices, the consumers who are that far down the economic spectrum are not heavy consumers of our products. Even in emerging markets if consumers are making choices on what to buy because of higher food prices at least so far they’re not choosing to reduce consumption in the staples categories. Those markets are continuing to grow at the rates they’ve been growing. We’ve said before we don’t know how to predict this one. Will these market growth rates continue forever, no. There will be a point at some point where we will start to see some slow down even strictly because of the law of large numbers as these markets get significantly larger bases behind them. At least for the moment we have not seen slow down and it would be difficult for us to predict it."
},
{
"speaker": "AG Lafley",
"text": "What’s been going on is that there are broadly speaking three income levels that we’re doing business with across developing markets. I spoke about the highest income group they tend to be in the biggest cities generally two wage earners and incomes rising fairly fast. I think what’s been going on in that developing market top tier growth has been more than offsetting the developing market lowest tier pressure that’s come from food inflation. We just have to watch that. The other thing I think is important to understand is no two developing countries are alike. What we do in China is different in important ways versus what we’re doing in Brazil or Russia, Ukraine for example. The third thing I think Clayt makes the right point, we had a lot of questions about the volume guidance for next year but we’re trying to be cautious all the way around because yes, there is uncertainty. The Chinese GDP is not a consumer driven GDP. Our consumer markets are growing about 7% the one’s we’re in, in China, their GDP has been growing at a rate faster than that. We’re cautious and we’re watchful and we’re in the market everyday and we try to stay very close to consumers. We try to stay very close to our distributors and retailers and we try to be agile and flexible and adaptable."
},
{
"speaker": "Operator",
"text": "Your next question comes from Connie Maneaty – BMO Capital."
},
{
"speaker": "Connie Maneaty – BMO Capital",
"text": "I have a longer term question on restructuring. I understand that the plan is to do restructuring on an ongoing rather than episodic basis and the consolidation of distribution centers is part of that ongoing process. Are there circumstances under which an episodic charge might be more appropriate to move the organization to where it needs to be for a five to 10 year period especially given the higher platform for commodity costs and the opportunity still to simplify?"
},
{
"speaker": "Clayt Daley",
"text": "I think that’s a fair point. If we had projects that were not funded, in other words, if we had opportunities that the businesses had come to us and we were saying no, we’re not funding projects because we’re trying to keep an arbitrary restructuring budget then I think it’s an absolutely fair point as to why would you say no to good projects because of an arbitrary funding limit. That has not been the case. We have been funding all of the restructuring projects that have been coming to us from the various business units therefore there hasn’t been a capital constraint or a restructuring budget constraint imposed on the organization where we would be foregoing an opportunity."
},
{
"speaker": "AG Lafley",
"text": "If we had to recapitalize to move to a new technology platform, you may recall we spent over $1 billion to re-platform Baby Care about eight to 10 years ago. We did a major re-platforming of Fem Care. If we had to do something like that we would step up to it. If you don’t have that this is a much better way to run the railroad. A lot more disciplined, a lot more operating disciplined with the way we’ve been running the last eight years."
},
{
"speaker": "Operator",
"text": "Your next question comes from Filippe Goossens – Credit Suisse."
},
{
"speaker": "Filippe Goossens – Credit Suisse",
"text": "I would like to go back to my question from the last earnings call related to Pantene in general and Brazil in particular. Last year our sources as well as our own research indicated that you were going to make a big push in Hair Care particularly in that country which has already resulted in the hiring of [Inaudible] your spokesperson. If you look at what’s happening to date our sources tell us that the push in Brazil with Pantene has not been as strong as they had expected so the question there is has anything changed with regard to your game plan. As it relates to the US obviously disappointing reformulation of Pantene. In order to go back to your 3% to 5% organic volume growth for the Beauty GVU it is critical in our opinion that Pantene gets turned around as well. What are your current plans there?"
},
{
"speaker": "AG Lafley",
"text": "I hope you understand that I really can’t comment on our future plans because we’re just not going to make an announcement and our competitors are probably paying attention to what we’re doing. On the main point that make I couldn’t agree with you more and I hope I’ve been very clear and very straightforward about that as well as our Hair Care business has done a lot of our brands as Jon reported earlier are doing quite well. We did stumble in some markets and you mentioned one of them, the US on the last round of Pantene innovation. We have new innovation going into the US market right now and you will see innovation from us on Pantene across the US and in other markets around the world. Regarding Brazil we are in a testing period. I believe our share is up; it’s still relatively modest, mid to high single digits. We’re learning it’s a big hair care market. Eventually we’re going to have to have a position there and we’re in the learning phase."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bill Chappell – SunTrust Robinson Humphrey."
},
{
"speaker": "Bill Chappell – SunTrust Robinson Humphrey",
"text": "A follow up on the Folgers restructuring should we read into the fact that no additional charges in 2010 expected means we’re through with the rationalization of the portfolio or at least of the major brands? Also, with the share count, I think you said there’s a big share repurchase related to this deal can you say what you expect the average share count to be at year end fiscal ’09?"
},
{
"speaker": "Clayt Daley",
"text": "To answer your first question, this does not signal that there’s an end to the evolution of the portfolio. We’re not saying that we’re going to do more than Folgers but we’re not sitting here saying that we’re going to do nothing further. All we can plan at this point is what we know. We obviously know the impact of Folgers and we know that we’re planning to step up restructuring this year to offset it and then next year right now we’re planning to take that restructuring back down to about the prior level as a percent of sales. I would expect in fiscal 2010 the restructuring program could be above $400 million but not a huge amount above. Relative to the share count, what’s going to happen when the Folgers transaction occurs is we’re going to exchange P&G shares for newly issued shares of Smucker. What basically will happen is at the time that deal is closed there will be a substantial reduction in P&G share count that occurs with that transaction and that’s what we were talking about earlier. That’s in addition to the ongoing, if you think about share repurchase in fiscal 2009 we’re going to do the $8 to $10 billion we had previously committed to and then the share repurchase associated with the coffee, Smucker deal will be on top of that. That reduction in share count is factored into the dilution number for Folgers as well."
},
{
"speaker": "Operator",
"text": "Your next question comes from Alice Longley - Buckingham Research."
},
{
"speaker": "Alice Longley - Buckingham Research",
"text": "Doing the math on the volume guidance it sounds, for fiscal ’09 that volume may be up something like 8% in developing markets and maybe down 1% in Western Europe and up 1% in the US does that sound reasonable?"
},
{
"speaker": "Clayt Daley",
"text": "We can’t call it that close."
},
{
"speaker": "Alice Longley - Buckingham Research",
"text": "Basically very little volume growth in the US and Western Europe?"
},
{
"speaker": "Clayt Daley",
"text": "It will be modest. I don’t think it’s going to go negative."
},
{
"speaker": "Operator",
"text": "I’ll turn the conference back to you for any additional or closing remarks."
},
{
"speaker": "Clayt Daley",
"text": "Thanks for joining us again today. As always, Jon Moeller, Mark Erceg, Jen Chelune and I will be around for the rest of the day. We’d be happy to take any questions and follow up that you have and thanks again for joining us."
}
] | null | null |
PG | 3 | 2,008 | 2008-04-30 08:30:00 | Executives: A.G. Lafley – Chairman of the Board Chief Executive Officer Clayton Daley, Jr. – Vice Chair and Chief Financial Officer Jon Moeller - Vice President & Treasurer
Analysts: Bill Pecoriello - Morgan Stanley John Faucher – JP Morgan Wendy Nicholson – Citigroup Christopher Ferrara – Merrill Lynch William Schmitz – Deutsche Bank Securities Lauren Leiberman - Lehman Brothers Ali Dibadj - Sanford Bernstein Andrew Sawyer - Goldman Sachs Jason Gere – Wachovia Capital Markets Joseph Altobello – Oppenheimer & Co. Connie Maneaty – BMO Capital Markets Filippe Goossens – Credit Suisse William Chappell – SunTrust Robinson Humphrey Alice Longley - Buckingham Research
Operator: Good day everyone and welcome to Procter & Gamble’s third quarter earnings conference call. Today’s discussion will include a number of forward-looking statements. If you will refer to P&G’s most recent 10K and 8K reports you will see a discussion of factors that could cause the Company’s actual results to differ materially from these projections. As required by Regulation G, P&G needs to make you aware that during the call the Company will make a number of references to non-GAAP and other financial measures. Management believes these measures provide investors valuable information on the underlying growth trends of the business. Organic refers to reported results excluding the impact of acquisitions and divestitures and foreign exchange where applicable. Free cash flow represents operating cash flow less capital expenditures. P&G has posted on its web site www.PG.com a full reconciliation of non-GAAP and other financial measures. Now I’d like to turn the call over to P&G’s Chief Financial Officer, Clayton Daley. Please go ahead.
Clayton Daley: Thank you. Good morning everyone. A.G. Lafley, our CEO and Jon Moeller, our Treasurer join me this morning. I will begin with a summary of our third quarter results. Jon will cover business highlights by operating segment. I’ll then discuss our expectations for the June quarter and the current fiscal year and finally I will provide a brief outlook on fiscal 2009. Following the call, as always Jon Moeller, Mark Erceg, John Chevalierand I will be available to provide additional perspective as needed. Now on to the results. P&G maintained strong momentum in the third quarter delivering balanced top and bottom line growth in an environment of significant commodity and energy costs pressure. The breadth and depth of our portfolio, strong innovation and a focus on productivity drove our results. Earnings per share for the March quarter increased 11% to $0.82. This was $0.01 ahead of both the consensus estimate and the top end of our guidance range. Earnings per share growth was driven by solid sales growth and strong operating margin expansion. Operating margins expanded behind a continuing focus on productivity improvements and by delivering Gillette synergy benefits. Total sales increased 9% to $20.5 billion, driven by volume growth and favorable foreign exchange. Organic sales and volume were both up 5%. This was the 23rd consecutive quarter we have met or exceeded our top line growth targets. Developing markets set the pace with strong double-digit organic sales and volume growth. Pricing added one point to sales growth as many of our brands increased pricing with offset higher commodity and energy costs. Both developed and developing markets grew sales ahead of volume. However, because the developing markets are growing faster than developed markets there was a -1 point mix effect on the total company. We expect these dynamics to continue going forward. The Company’s business portfolio performed very well with five of our six reportable segments delivering mid single-digit or better organic growth. Global organic volume grew in 18 of P&G’s top 22 product categories representing over 90% of company sales. One of our strengths as a company is the fact that our results do not depend on any one category or market but rather on the diversity and breadth of our total portfolio. The diversity of our products and geographies continue to enable consistent reliable growth for the company. For example, beauty care organic sales growth for the quarter was only 3%. This was below or going in expectations. The shortfall was driven mainly by slower market growth in prestige channels and by softness in North American Pantene. But the softness in beauty care was offset by stronger growth in other parts of the portfolio. We are confident our portfolio will continue to deliver reliable sales growth of 4-6%. In terms of our markets, U.S. all outlet dollar market growth has slowed but is still growing at about 2-4% in most of our categories. Very recently we have seen a slow down in the rate of growth across several beauty care categories. Non-track channels continue to grow significantly faster than track channels and market growth is stronger on a dollar basis than on a unit basis. Private label shares in the U.S. have begun to grow in a few of our product categories. However, in nearly every instance P&G is also growing share in those same categories. In Western Europe the markets have softened a bit but are still growing 1-2% and P&G continues to grow market share overall. In developing regions market growth remains in the mid to high single-digits. Net through the third quarter, markets continue to grow and P&G brands continue to build share despite a challenging economic environment in the U.S. and the price increases we have taken to cover commodity costs. Next, earnings and margin performance. Operating income increased a strong 13% to $4.1 billion behind sales growth and margin expansion despite significant commodity and energy cost increases. Operating margin increased 60 basis points due to overhead productivity improvements and Gillette synergies. Gross margin was down 30 basis points to 51.3%. Commodity and energy costs reduced gross margin by over 220 basis points. This was largely offset by pricing, volume leverage and cost savings projects. Selling general administrative expenses were down 80 basis points as our focus on productivity significantly lowered overhead costs as a percent of sales. Market trending increased 9% in line with sales growth. We continue to support our brands with consistently high levels of advertising and marketing spending. Interest expense was up as we continue to expand debt capacity within our AA credit rating to finance our share buyback program. Other non-operating income was down significantly versus a year ago due primarily to divestiture gains in the base period and lower interest income. This was consistent with previous guidance. The tax rate for the quarter was 27.9%, also consistent with previous guidance. Now let’s turn to cash performance. We continue to convert earnings to cash at a strong rate. Operating cash flow in the quarter was $4.3 billion driven largely by strong earnings, an unusually large deferred tax benefit and a decrease in accounts receivable. Operating cash flow was down slightly versus prior year due to inventory increases to support the North American liquid laundry compaction, and other major initiative launches. Capital spending was $668 million in the quarter or 3.3% of sales, well below the Company’s 4% annual target. Free cash flow for the quarter was $3.7 billion. This was 136% of net earnings. Fiscal year to date operating cash flow as $11.7 billion, up $1.9 billion from the same period a year ago, and fiscal year to date free cash flow was $9.9 billion, an increase of $2 billion from a year ago. This brings free cash flow productivity to 109% fiscal year-to-date, 12 points ahead of last year. We remain well on pace to exceed our 90% free cash flow productivity target for the fiscal year. We repurchased $2.6 billion of P&G stock during the quarter. Fiscal year-to-date we have repurchased $8 billion, a level that is consistent with our three-year, $24-30 billion share repurchase program. Combined with $3.3 billion in dividends, P&G has distributed $11.4 billion to shareholders fiscal year-to-date or 126% of earnings. On April 8 we announced a 14% increase in our quarterly dividend from $0.35 to $0.40 per share. This represents the 52nd consecutive fiscal year in which P&G has increased dividends. Over the past 52 years, P&G’s dividends has increased at a compound annual rate of nearly 10%. To summarize, P&G continues to drive balanced top and bottom line growth at or above target levels. We are converting a significant amount of earnings to cash and we are returning this cash to shareholders through dividends and share repurchase. I’ll now turn it over to Jon for a discussion of the business unit results by segment.
Jon Moeller: Thanks Clay. Starting with the beauty segment all-in sales grew 9% with organic sales up 3%. Global hair care volume grew mid single-digits behind high teen’s growth of Head and Shoulders and double-digit growth of Rejoice. P&G’s global hair care value share was in line with prior year at nearly 26%. P&G all outlet value share in the U.S. hair care market was down slightly as declines on Pantene were largely offset by Head and Shoulders and Herbal Essences. P&G hair care in Japan was very strong this quarter behind the launch of Head and Shoulders and continued growth of Pantene. Global hair color sales were up high teens driven by the launch of Nice-n-Easy Perfect 10. Perfect 10 is a revolutionary technology that addresses key unmet needs of the home coloring consumer. Our execution of Perfect 10 has been outstanding and we are on track to beat our launch target objectives. Nice-N-Easy all outlet share of U.S. hair colorants grew more than three points to 19%. Professional hair care shipments were in line with prior year as strong growth in Central and Eastern Europe was offset by modest declines in developed markets. Prestige fragrances had a strong quarter versus prior year with sales up mid-teens. Organic sales grew 9%, well above industry average driven by the Dolce Gabana, Hugo Boss and Gucci brands. Growth was somewhat lower than expected in the U.S. and Western Europe due to slower department store sales. In skin care, global organic sales grew low single-digits behind solid growth of Olay facial moisturizers in the U.S. All outlet share of Olay facial moisturizers in the U.S. increased nearly 2 points to 43%. Skin care shipments in developing markets were in line with a very difficult year ago comparison that included the Olay brand expansion in Russia, Poland and Turkey and the launch of Olay Definity in China. Cosmetic sales grew mid single-digits driven by the launch of CoverGirl Lash Blast mascara. CoverGirl value share in the U.S. grew to nearly 20% for the quarter. As Clay said previously, organic sales growth for beauty were below our going in expectations. This was due primarily to a soft period for the Pantene brand in North America, slower than anticipated department store channel sales for Prestige and a general slow down in retail market growth of about a point. In the grooming segment sales were up 13% for the quarter with organic volume and sales growing 6%. Blazin Razors global shipments grew high single-digits driven by double-digit growth in developing markets. Shave Prep shipments also grew high single-digits. P&G is now the shave prep market leader in the U.S. with all outlet share up more than 3 points to over 35%. Braun shipments were down mid single-digits due largely to soft household appliance results including the previously announced exit of this business in the U.S. Overall, global consumption of Gillette blades and razors increased 6% for the quarter driven by the continued growth of Fusion and strong developing market results. Gillette’s global value share of blades and razors increased for the period to nearly 72%. Fusion continues to be a strong engine of growth in male shaving. Fusion share of global male systems is up more than 8 points versus prior year to 24%. Gillette’s global share of male systems is up half a point to nearly 84%. Fusion will deliver more than $1 billion in sales this year, making it P&G’s 24th Billion Dollar brand. The fastest ever to reach this milestone including Mach3. The success of Fusion is a great example of the combined strength of P&G and Gillette. In February, Gillette launched Venus Embrace, the first five-bladed female razor. Embrace is off to a good start driving Venus’ share of female systems up more than 4 points to nearly 58% in the U.S. Gillette also launched Mach3 disposables in the U.S. in the third quarter. After only a few weeks in market Mach3 holds nearly a 10% share of the U.S. male disposable razor market. Health care sales increased 11% including six points of favorable foreign exchange. Feminine care and oral care led the growth with feminine care volume up high single-digits and oral care up mid single-digits. In feminine care, Always volume was up high single-digits and Naturella grew more than 30%. Always shipments were driven by strong growth of panty liners in the U.S. Always all outlet share of the U.S. liner category is up more than two points to 31%. Feminine pad share increased nearly a point to 59%. Naturella brand growth was driven by continued expansion in Latin America, where volume grew more than 20% and in Central and Eastern Europe where volume increased more than 40%. Oral care delivered mid single-digit volume growth in both developed and developing markets. In North America volume was up high single-digits on strong growth of both Crest and Oral B brands. Crest Dentrafist maintained its all outlet value share leadership in the U.S. despite intense competitive promotional activity. P&G’s leading all outlet volume share of toothpaste in the U.S. remained at over 38% and Oral B toothbrush value share grew nearly two points to 43%. In personal health care, Vicks shipments increased high single-digits globally and more than 20% in the U.S. due to a late cold and flu season. Prilosec OTC delivered solid volume growth despite Pergo’s late quarter generic entry into the market. Prilosec’s U.S. all outlet value share grew nearly two points to 43%. While we are pleased for these results for the March quarter we do expect future sales and market growth to reflect the impact of generic competition. Pharmaceutical volume grew low single-digits. Global Actinel volume increased mid single-digits but was partially offset by lower shipments of other minor brands. Sales for the snacks, coffee and pet segment increased 11% for the quarter and organic sales grew 8%. Snacks delivered double-digit volume and sales growth behind the Pringles Rice Infusion initiative in Western Europe and the Xtreme Flavors Initiative in the U.S. Coffee sales also increased double-digits due to the combination of modest volume growth and pricing to offset increases in green coffee costs. P&G coffee all outlet share increased more than a point to 37% driven by the continued success of the Dunkin Donuts coffee expansion into retail stores. Year one retail sales estimates for Dunkin Donuts coffee are now in the range of $150-200 million. Pet care sales were up versus prior year as price entry cover commodity costs more than offset the modest shipment volume decline. Importantly, we have now annualized the wet pet food recall impacts and expect to grow the top and bottom line beginning in the April/June quarter. The fabric care and home care segment delivered 10% total sales growth and 5% organic sales growth. Fabric care global shipment volume increased high single-digits with double-digit growth in developing markets and mid single-digit growth in developed regions. In developing markets the Ariel and ACE brands each grew volume double-digits for the quarter. In developed markets growth was led by the Gain brand. Gain volume increased more than 20% driven by the Soothing Sensations launch which shipped in conjunction with Compact Liquid Detergent roll out in North America. Gain laundry all outlet value share in the U.S. is up a point to 15%. Tide grew volume mid single-digits in North America driven by the Improved Cleaning initiative launched along with the concentrated formula. Overall the conversion to compacted liquid detergent in North America remains on track with the final conversion wave shipping later this month. Importantly, P&G has continued to build share behind this initiative. Home care shipments increased mid single-digits. Febreeze volume grew double-digits behind the launch of Febreeze candles and continued growth of Air Effects. Febreeze share of the instant action air care market was up three points for the quarter to 20%. Cascade volume was up high single-digits due to heavy orders prior to a price increase which was effective in early March. Also Fairy Hand dishwashing and Auto dishwashing products grew double-digits. Batteries volume grew mid single-digits with a double-digit growth in developing markets more than offset a decline in North American shipments due to soft market trends. Duracell all outlet value share in the U.S. was up nearly a point to 44%. Baby care and family care all-in sales grew 8%. Organic sales also grew 8% and organic shipment volumes were up a very strong 7%. Pampers diapers grew volumes double-digit globally led by high teens growth in developing markets. Russia, Poland and China continue to be growth leaders for Pampers. In developed markets, Pampers Baby Stages swaddlers and Baby Dry also delivered solid growth. Pampers all outlet value share of the U.S. diaper market is up nearly a point to more than 29%. In Western Europe Pampers market leading diaper share is in line with prior year at a strong 54%. Family care organic volume grew high single-digits behind double-digit growth on Charmin and mid single-digit growth on Bounty in North America. Charmin’s strong results are due to the success of the Charmin Ultra Strong. Charmin all outlet value share in the U.S. is up more than a point to 28%. Bounty’s share is also up a point to 46%, a 43-year record high. That concludes the business segment review. I will hand the call back to Clay.
Clayton Daley: Thanks Jon. Before getting into our guidance I want to provide some perspective on the current cost environment and how we are managing it. We are facing significant cost challenges brought on by rapid increases in both commodities and energy. Almost all of our key material inputs are up double-digits and energy costs have increased even more dramatically with oil approaching $120 a barrel and natural gas in excess of $10 per million BTUs. As a result we expect to incur approximately $1.4 billion in higher material and energy costs this year. We have managed these costs while still delivering on financial commitments through a combination of pricing, cost savings projects including product reformulation and a focus on driving productivity through a disciplined approach of overhead control. We have also continued to drive innovation. Coupling innovation with pricing has allowed us in many instances to increase prices while also increasing consumer value. Material and energy forecasts for next year are even more challenging. We are in the midst of our fiscal 2009 planning process and we are building our plans on the assumption that material and energy costs will increase by over $2 billion versus the current year. We expect to manage through this challenging environment by continuing to do what we do best. First, we will innovate. Innovation is critical to maintaining superior consumer value. Better products are even more important during challenging times when consumers are even more focused on value. We will also drive cost savings. One of the ways we will drive cost savings is through product reformulation. We will use our deep technical mastery to enable us to utilize alternative inputs while maintaining or improving the performance of our products. We will accelerate our productivity efforts by reducing organizational redundancy, streamlining decision making and institutionalizing overhead cost control behind the HOG/NOG/ZOG target management for overhead costs. Finally, we will drive favorable mix by trading consumers up to value added products and we will continue to take broad pricing actions as necessary. As a result, we expect P&G and the overall market to grow sales ahead of unit volume and this is a trend we are already seeing. I am confident that with these efforts we will successfully manage through this challenging period and continue to meet the commitments we have made to our shareholders. Now, in to guidance. For the June quarter organic sales are expected to grow 4-6%. This includes one point of positive pricing mix. In addition positive foreign exchange should add 5-6% to sales growth. Acquisitions and divestitures are expected to have a negative 1-2% impact on sales so in total we expect all-in sales growth of 8-10%. Operating margins are expected to improve modestly. SG&A productivity improvements should more than offset lower gross margins as we encounter another quarter of significant commodity and energy cost increases. P&G is continuing to increase prices to offset the impact of higher input costs. Since our last earnings call we have announced that we will be taking several additional price increases in the United States including 4.5% on Always and Tampax, 7% on Crest Pro Health Rinse, 7% on hand dishwashing products, 8% on Swiffer refills and 11% on Oral B power brushes and refill heads. These price increases will become effective between May and August and we have announced additional pricing in many other countries around the world. Competitors including private label manufacturers and retailers have generally been increasing prices as well. They are facing the same commodity and energy cost pressures we have been experiencing. Therefore, we believe we will be able to implement these modest price increases without negatively affecting P&G’s market share position. Most of the pricing benefit will be seen during fiscal 2009 when there will be a positive impact on sales growth. Our tax rate in the quarter is expected to be about 28%. On the bottom line we expect earnings per share for the fourth quarter to be in the range of $0.76 to $0.78 driven by strong top line growth and double-digit operating profit growth. Next moving to fiscal 2008, with only one quarter to go organic sales and volume growth should come in at about 5%. Within this we expect pricing to contribute one point to sales growth and mix to reduce sales by one point due to fast developing market growth. In addition, foreign exchange should have a positive impact of about 5%. Acquisitions and divestitures are expected to have a -1% impact on the top line. Therefore, in total we expect all-in sales growth of about 9% for the year. We expect operating margins to improve by 20 or more basis points for the year. As we have seen throughout the year the combination of pricing, cost savings projects and overhead productivity improvements should offset the impact from higher commodity and energy costs. The tax rate on the year is expected to be at or slightly below 28%. This includes the non-recurring favorable tax item in the September quarter of $0.02 per share. On the bottom line we are increasing our EPS guidance range of $3.46 to $3.50 to $3.48 to $3.50 per share reflecting our strong March quarter results. Now turning to fiscal 2009. We currently expect to deliver another year of top and bottom line growth consistent with our long term targets. 4-6% organic sales growth. 2-5% organic volume growth. About 1% of net pricing and mix. 10% earnings per share growth and 90% or greater free tax flow productivity. Of course our GAAP EPS growth for fiscal year 2009 will be higher than 10% due to the net impact of the Folgers transaction in fiscal 2009 and the discreet tax impacts in fiscal 2008. As we report results next year we plan to give shareholders perspective on the underlying performance of the company in addition to the GAAP results. However, our primary guidance will be on a GAAP basis consistent with how we handle Gillette. To recap our plans on Folgers, during the last call we announced we will split or spin off the coffee business. We expect to decide on the deal structure in the June quarter and complete the transaction during the first half of the next fiscal year. Assuming we do a split, the transaction will create a substantial one-time gain in fiscal 2009. It will also create $0.03 to $0.05 of dilution due to the loss of Folgers’ operating profit and stranded overheads. As we said last quarter, we are planning to take a one-time increase in restructuring charges during fiscal 2009. This will be in addition to our existing $300-400 million annual restructuring budget. This additional restructuring will allow us to eliminate stranded overheads and offset the negative earnings per share impact from the coffee transaction. Net our objective for fiscal 2009 remains to deliver underlying EPS growth of 10% despite the loss of coffee earnings. Underlying EPS excludes any one-time Folgers transaction impacts and non-recurring tax impacts. Therefore if we back out the $0.02 gain from our first quarter, 10% earnings per share growth would translate into a fiscal 2009 guidance range for the underlying business of $3.80 to $3.85 per share. We will provide GAAP guidance in a range basis once our August call at year-end. Now, to summarize today’s call we are focusing on the key business drivers of long term sustainable growth. We are delivering balanced top and bottom line growth behind the strength of our portfolio, our innovation pipeline and a focus on productivity. We are converting earnings to free cash flow ahead of target, returning more than 100% of this cash to shareholders through dividends and share repurchase. Looking forward we are confident we should be able to continue to deliver consistent reliable top and bottom line growth; the growth that our shareholders expect from P&G, even during challenging times such as these. Now we’ll open up the call to your questions.
Operator: (Operator Instructions) Your first question comes from Bill Pecoriello with Morgan Stanley.
Bill Pecoriello - Morgan Stanley: Question on the $2 billion higher commodity outlook and the additional higher pricing that you are taking. Just in terms of how the consumer has been reacting. You mentioned that in some sub-categories you are seeing private label gains in share but you are also gaining share. Also we have seen North America and Western Europe overall category growth slow. So as you put through these additional prices what are you watching in some of these sub-categories both on the growth rate of the category and trade down?
Clayton Daley: We’re always watching the market shares closely including, of course, as we said private labels. The experience over the last three years, and we have been going through this now awhile, if we raise prices to recover commodity and energy costs and both other branded competitors and private labels tend to raise prices by about the same percentages because they have the exact same cost problems. We tend to see that the dynamics of the category remain relatively stable. We have not seen, as we have talked before, a substantial trade down in those circumstances, but we are continuing to watch it and the way we of course read it is to look first and foremost on our market share positions in aggregate and also watch the dynamics of the rest of the markets.
Jon Moeller: Bill, one quick addition. We watch obviously volume consumption, unit consumption and dollar market shares and market growth. We watch what I would call indicator categories. One example, paper products are generally a category that come under some pressure when there is an economic downturn. One of the things that has been heartening for us is the performance of our paper products. Especially when you get into product lines like the family care tissue towel businesses. Bath tissue, paper towels, facial tissue. In every case we are building share. We are not seeing the intensity of private label pressure that we’ve seen in past turndowns. I think the reason we are doing this is we are close to consumers. We understand the consumer value equation. We offer tiered product and pricing options from Charmin and Bounty basic through value added products. As Clay said we have kept our relative pricing sharp and we have actually improved out consumer value.
Operator: Next we’ll turn to John Faucher with JP Morgan.
John Faucher – JP Morgan: Clay I apologize for this. A point on clarification here. The $3.80 to $3.85 number is before the impact of Folgers dilution or after the impact of Folgers dilution?
Clayton Daley: That includes the impact of Folgers. In other words, we are offsetting the $0.03 to $0.05 of Folgers dilution in that guidance.
John Faucher – JP Morgan: Quickly on the inventory side your gross margin performance was definitely better than I think people were expecting or fearing from that standpoint. Your inventories looked like they were up. You talked about volume leverage in the quarter. Any impact on gross margin from that standpoint and is that something we need to account for in the fiscal fourth quarter?
Clayton Daley: No. Not really. I think the inventories are about in line with what we expected given what is going on and there should not be any fourth quarter gross margin impact.
Jon Moeller : They follow our initiative growth basically. That is what is going on. So inventories are up a little bit for one period when we have the initiative launch and they come back down when we are in more of a sustaining period.
Operator: Your next question comes from Wendy Nicholson with Citigroup.
Wendy Nicholson – Citigroup: I wanted to ask about some of the margin performance by segment, particularly in grooming and beauty. Grooming margins have just been on fire now for two years and I’m wondering at what point…I’m assuming that is benefiting from some of the integration savings and what not, but at what point do those margins start to kind of flat line or expand on a lower rate? Similarly on beauty it is kind of surprising the margins are continuing to come under pressure and I’m wondering are you spending at an outsized rate on advertising in the beauty segment yet still not getting the volume pick up. Or is that just a negative mix shift to the emerging markets?
Clayton Daley: On grooming what we have seen a lot of progress on grooming margins. That has been a combination of synergies from the Gillette acquisition and as we have reallocated our costs across the new combined company the Gillette segment has picked up some benefit there as well. Clearly we expect ongoing margin improvement from the grooming segment but not to the degree we have seen it over the last two years. In beauty, I think what you are seeing in those numbers is a combination of the impact of the divestiture where we had the business in the base period and the business is no longer in the segment. You are also seeing that beauty is a competitive business right now and we are making sure our marketing and our spending with retailers is competitive during this period.
Jon Moeller : Wendy, quickly, it is offensive investment. We are obviously investing in Head and Shoulders. You don’t drive 17% of organic volume growth and 22% organic sales growth on a mature business like that unless you are investing behind the product innovation. We’re investing in Herbal Essences, so the hot spot restage expansion and we are defending ourselves. There are some major initiatives by major competitors which we talked about a number of times and we are making sure that our consumer continues to have a chance to purchase and try our brands and products which we think offer better performance and value.
Operator: Your next question comes from Christopher Ferrara with Merrill Lynch.
Christopher Ferrara – Merrill Lynch : Just wanted to ask about beauty category deceleration. You guys and others have talked about it as well. It is contrary to things we have seen in the past. I know you talked about indicator categories, and we have seen sort of a shift but why is beauty not hanging in as well as it might have in the past? Also, do you find retailers pushing private label with better placing? We have seen that anecdotally in the channel.
A.G. Lafley : Chris I’m going to try to keep this simple, but as you can imagine we are in so many different beauty categories and channels…different product categories, different channels and different geographies, so it can be kind of complex. I think in the past we have seen slow down in more discretionary segments in beauty and in more discretionary channels. So as Jon mentioned the slow down in the department store channel for Prestige products. I don’t think that is unusual. Okay? Across our cosmetics line in the past we have seen slow down on some of the more discretionary items. We are actually pretty pleased because our cosmetics business held up well. CoverGirl particularly held up well and in fact grew share in the period. So there are discretionary fragrance purchases and Duty Free shops and on airplanes they tend to fall off during periods of economic turndown. We have seen some of that. There is no doubt that there is some slowing as Jon said but knock on wood most of these categories are still growing. I think that is important. That is what I remind our team. The are slowing but they are still growing and as long as there is growth there is business out there for us. The second thing that is going on is with the competitive intensity frankly the pricing gets reduced. When we have competitors out there basically giving away buy one-get one free for months, that obviously reduces the value of consumption that is going on in the market. Then when we feel we have to selective match, that sort of compounds that issue. We know from the past we’ll work our way through it because that kind of spending is not sustainable. The same thing goes on with some of these launches. I don’t want to pick on individual situations but there is a country in the world right now where there is a major launch by a competitor going on and they are spending five times what we are spending in that market. That is obviously not sustainable. So I think what is happening is that is depressing the consumption a little bit. I think the fundamentals in beauty are still very good. I think they are very good. The kind of beauty care brands and product offerings we have are generally affordable broadly. So, I’m still cautiously optimistic about beauty. We have a stronger initiative program coming and we have got a lot of good, strong brands and a lot of good innovation programs.
Clayton Daley: Good innovation still drives business.
A.G. Lafley : It really does.
Operator: Your next question comes from William Schmitz with Deutsche Bank Securities.
William Schmitz – Deutsche Bank Securities: You are always a bigger advertiser than, if you look broadly against your peer group, do you change that and become more promotional in this environment to make some of the products a little more reasonable for people? You have already talked about a little bit of a trade down from Tide to Gain. That’s great, it stays in the family. But will you kind of tweak your promotional spending based on the environment?
A.G. Lafley : The part of trade spending is essentially pricing. In an environment like this we watch that very carefully and we try to stay competitive as Clay said earlier. So that slice of our trade spending does increase slightly in this environment. That varies dramatically by category. Okay? Beyond that we are trying to direct the money to consumers and shoppers because our game is basically a trial game. I’ve talked about this before. If you step back and look at our biggest single upside growth opportunity is to get trial at the target goalie, the new brand and new product initiatives we already have in the market. We think that is worth at least $2 billion in incremental sales. So we try to direct our spending consumers and shoppers in a way they can try our new brands and products. The Swiffer brand has been out for a decade. We have something like 15, 16, 17% household trials in the U.S. We convert 60+% of that trial to regular usage. There are a lot more than 15, 16 or 17% of U.S. households that would be interested in purchasing Swiffer and using it on a regular basis. That is just one of 20 brands that have significant trial opportunities. So we try very hard to make sure most of our spending is directed against the consumer, whether it goes through the trade or direct to consumer. We try to make sure we are spending on trial generating activities. Regarding the Tide/Gain situation, what is really going on is we are growing share on Tide and we are growing share on Gain and we’re growing it faster. It is not unlike the tissue/towel or family care situation. We offer a tiered line of brands and product offerings that appeal to different consumer groups at different price points and different value equations.
Operator: Your next question comes from Lauren Leiberman with Lehman Brothers.
Lauren Leiberman - Lehman Brothers: I was going to ask again about mix as being part of your algorithm, particularly in developed markets because I know as you report the little business units you can’t see the impact it makes in developed markets that has been playing. I’ve been curious about this for awhile. I was surprised to hear that still as part of your plans for fiscal 2009 how you are going to offset some of the incremental cost inflation. I would just think there is maybe a little bit less appetite in the market for some of the value added and higher price point innovations that just drive a category slow down. That would apply to everybody, not just Procter. Is that not how you guys are thinking about it? What am I missing? I would think consumers wouldn’t be as interested in the next higher price point blank.
Clayton Daley: Lauren it is all about consumer value. Okay? I’ll try to give you three to four quick examples. First of all I think we need to be crystal clear here. We are trying to create the right portfolio of brands and product offerings and price points so there is an appropriately tiered offering that appeals to lower income consumers all the way up to higher income consumers. But some very quick examples, the hottest item right now in the deodorant business is clinical strength. We command a phenomenal premium on clinical strength. We sell clinical strength for twice the retail price and it is flying off the shelves. The hottest item in coffee right now is Dunkin Donuts sold at a premium price. Folgers’ gourmet line is going strong. I mentioned tissue/towel. Yes, on the one hand we are selling Downey Basic and Charmin Basic but on the other hand we are selling a number of value added products that can command 10-20% premiums in a category where the consumer watches every penny. Perfect 10 in retail coloring, we are convinced that if we could get trial of this product there is going to be a lot of conversion. That is sold at a significant premium to the at-home colorant offerings that are in the market. Laundry detergent. The Tide with Febreeze. The Tide with a touch of Downey. They sell well to their audience. In fact, one of our realizations this past six months has been yes we have got to cover ourselves on the low end or the point of entry in the market. That is important. But we also can’t miss the opportunities for trade up. If you step back we are still selling our brands and product lines at price points from $2 to $10. These are not make or break expenditures for consumers. Our hottest item in health care has been Pro Health. Our fastest growing line of oral care brushes is in the higher end manual brushes and the power brushes. I could just go on and on. Yes, the issue is value. But we can drive higher consumer value ratings and higher consumer value perception with products that are trade up products.
Operator: Your next question is from Ali Dibadj with Sanford Bernstein.
Ali Dibadj - Sanford Bernstein: I want to ask a question about one of the levers you are pulling to offset these astronomical commodity costs. In particular just around getting a little bit more flavor around the cost cutting you are doing and trying to understand first off the mix that you have seen between Gillette synergy savings versus reformulations and other overhead savings playing in so far. Then how that mix goes forward and finally if you can give us a sense of examples or metrics around those?
Clayton Daley: I think that the Gillette synergies do not end completely this year but they obviously trail off. There are some additional synergies from Gillette that come in over the next two years as we complete primarily the supply chain and distribution center consolidations although they become a much smaller factor in the total equation going forward. So really the cost savings focus stays where it has been this year on very much focused on formulation and what we do on our manufacturing costs. As we talked before and frankly spent a lot of time talking about at Cagney was our programs to really go after overhead costs, productivity, raising our targets for productivity improvement over the next couple of years. That is pretty much it.
A.G. Lafley : I’ll give you two that you can follow and a third broad area we touched on in Cagney. You look at our global business shared services operation and over the course of this decade we will basically have the cost of our back room on percent of sales basis. So that has just been a tremendous engine of productivity and every year we are finding new “shared services” we can consolidate and run in that network partnership . The other one is you can look at our R&D productivity rates. As strong as our innovation pipeline has been I have been just as proud of the ability of our business units and R&D organization to become more productive and more efficient every year. That shows up in reduced R&D as a percent of sales. We have talked about connect and develop last year. Half of the new product initiatives we brought to market had at least one external partnership. There is no end to that in sight. There are a lot of partners out there that we can work with and that of course, I think, increases the effectiveness and success rate of our innovation program but it also obviously lowers the cost. Then the third one Clay touched on. We now have a process in place that I think anchors the various businesses depending upon their sustainable growth goals. It anchors the overhead targets. There are a number of opportunities for us to get a lot more effective and a lot more efficient. We have very quietly launched a five year program that is going to make us considerably more productive. We’ll move from 5% annual productivity growth in the 80’s and 90’s to 6% in this decade so far to 7-8% and we think we can sustain it.
Operator: Your next question comes from Andrew Sawyer with Goldman Sachs.
Andrew Sawyer - Goldman Sachs: I was hoping to follow-up on a question from earlier about consumer reaction to price increases. You guys have talked a bit about what you have seen in the United States. I was wondering if you could walk us through what type of pricing you are looking at in some of the developing and emerging markets. Any early responses from consumers and retailers to that especially with the backdrop of inflation across a broader basket of goods?
Clayton Daley: Well the pricing in individual markets depends of course on what has happened in local currency to commodity costs. Of course we know with the weakness of the U.S. dollar commodity and energy costs have gone up the most in dollar denominated markets. Of course the U.S. and there are still some markets in places like the Middle East and a few other places that tend to be still dollar linked. In markets that are either Euro based or tend to move with the Euro or markets where currencies have not weakened as much we will price accordingly in the local market depending on what costs we need to recover and of course importantly what cost increases in local currency have competitors seen. We are taking price increases very broadly across the world. No matter what currency you are in, commodity and energy costs are up. We have priced broadly in Western Europe. We are pricing broadly in Eastern Europe. Across Asian markets and even in China. So we’re just seeing the need to pretty broadly increase prices in most of our categories.
A.G. Lafley : The only quick thing I’d add is if you look at the relative impact on consumers, let’s come back to the U.S., clearly gasoline at the pump is far more of a shock than our fairly modest usually 3-7% range, and the other thing is they have already seen much higher increases on most of the food items because of the pressure of agricultural commodities. There is no doubt the consumer is under fairly broad pressure, but I’ll just keep coming back to this…it all depends on the consumer value equation and we watch that like a hawk. The other thing you have to remember is virtually everything we sell is not discretionary. It is a staple. You have to go to the bathroom. You have to get up in the morning and brush your teeth. You’ve got to shower. You’ve got to shave. You’ve got to wash your clothes. We know there has been no change in shampooing frequency. Once these habits are established they become part of the routine and then it’s a matter of where do I get the best value or where do I get what I want and what I need? So far, knock on wood, it is holding up as we said.
Operator: Your next question comes from Jason Gere with Wachovia Capital Markets.
Jason Gere – Wachovia Capital Markets: Your marketing spending up 9% was pretty nice. I have just two questions. One, can you talk about what that was in the U.S. Two, with cable and network advertising rates going up over the last few months I’m just wondering if you can talk about the number of impressions you have seen and have you been doing any shifting to other alternative channels such as online advertising and how you are managing that process?
Jon Moeller : Jason you are in to details that I would be guessing at and I’m not going to guess. I will tell you broadly what we are doing. We are looking at any and all ways to reach consumers when we believe and/or hopefully know they are most receptive to our communication and our message. That means a lot more diversification in our media program. We have major brands now with a majority of their communication in non-television. You look at what we do in our fem care business, which is a big business, the vast majority of the media we run in that is what we would call alternative media. We’re looking for effectiveness and efficiency. We’re running market mix modeling and market return on investment analyses on an ongoing basis to make sure we’re spending our money wisely. In some categories we can spend a little less and be more effective. In other categories, Wendy’s question about beauty care, we are spending a little more in some places because we need to. We are trying to be strategic on the one hand and practical and pragmatic on the other.
Operator: The next question comes from Joseph Altobello with Oppenheimer & Co.
Joseph Altobello – Oppenheimer & Co. : I just want to go back to the commodity cost situation for a second. Over the last 6-8 weeks have you seen rising commodity costs start to impose some discipline in some of your more commodity intensive categories? Are competitors still heavily promoting in those catregories? Also on the $2 billion incremental for 2009, does that assume commodities continue to accelerate? Or does that assume some leveling off?
Clayton Daley: On the second part of the question it assumes that feed stock prices stay at current high levels. We’re not assuming that oil and natural gas go higher, but we are also not assuming they go down. Therefore those higher feed stock costs will eventually play through the refiner and cracker spreads and through input materials we buy. There is obviously some time lag between when we pay the higher prices for the materials that we buy but we are expecting this to all flow through into our costs for next fiscal year. The first part of the question relative to promotion spending I don’t think we’ve seen anything significant of promotion spending cut backs. I think part of that is because of the time lag. The feed stock prices are up but the actual prices in the materials move in a time lag. So what we would expect to happen is we are going to try to raise prices to recover commodities. Presumably other manufacturers will do as well and therefore there ought to be some normal stability in the marketplace. That tends to be what we have seen over the last 2-3 years.
A.G. Lafley : Joe, in terms of the trade promotion rates and consumer promotion rates, they are more dependent on the competitiveness caused by the ebb and flow of the innovation in the marketplace. So I think all of us players invest when they have a major new initiative and they defend. There are two things we have seen. One in some critical material areas there are actual shortages. It is not just an issue of cost; it is an issue of availability. Frankly it is a good time to be a leader and to be truly global because there are some instances where we have been able to get access and to get availability at a reasonable price when we know that all the players in the market were not able to get the material. That obviously enables us to continue to deliver performance, quality and value in our products.
Operator: Your next question comes from Connie Maneasty with BMO Capital Markets.
Connie Maneasty – BMO Capital Markets: I just want to ask a question on batteries. What was Duracell’s split between U.S. and international battery sales? Has Duracell regained market share it lost while Gillette was being integrated? Finally was the decline in the U.S. battery sales due more to inventory management at retail or a decline in category growth?
A.G. Lafley : That’s a three part question, Connie, and we’ll see if we can get them. Yes to the last one. Yes in part to the last one. I think the other phenomenon that is going on is there was a battery inventory at home and you can draw the battery inventory down a little bit. So there is an understandable consumer behavior pause, and then also a retailer phenomenon. But the battery market has softened but as we reported our share was up. We regained some to most depending on the market of the share that was sort of bought away from us in the first year plus.
Clayton Daley: And I think we have been candid in the past that when we integrated Gillette into P&G we were very focused on blade razor, very focused on oral care. We did not greatly integrate Duracell. I think we really though have gotten our act together.
A.G. Lafley : You saw it in the execution in the Thanksgiving and Christmas period and if you have been in stores you’ve seen it in our execution. We are just executing a lot better at retail. We have a strong, experienced Duracell team. I don’t know the exact split of developing and developed, but I will say this. We still think we have growth potential in developed and we think there is a lot of growth potential in developing. In general, Gillette was very strong in developed markets and growing off a very small base in developing and we’ve been able to expand distribution in developing markets. We have been able to deliver a lot more coverage and frankly we can deliver great value.
Clayton Daley: There is still an opportunity in a lot of developing markets to execute conversion to alkaline from carbon. That growth of course occurred in developed markets over the course of a couple of decades.
Operator: Your next question comes from Filippe Goossens with Credit Suisse.
Filippe Goossens – Credit Suisse: A question on the hair care side. Obviously hair care is a big component of your beauty business. If we look specifically at the Pantene brand, Clay, some of it is diverging in terms of performance between U.S. and emerging markets. So my question is twofold. Within the U.S. how much of the weakness is a result of category issues? Or again as you mentioned on the last earnings call is it a result of less than expected consumer acceptance of the last reformulation of the product? The other question obviously is what do you do to kind of boost the performance of Pantene in the U.S.? In emerging markets, as my second part to the question, you have stepped up your advertising spending particularly in Latin America. What is the initial lead in terms of volume and the impact on the margin structure there?
A.G. Lafley : That is a multi-part question so let me take developing markets. First, you are right, Pantene is strong in developing markets. It is one of our engines of growth in China right now. You’re seeing the investment in Brazil as we begin to build a stronger hair care position in Brazil. It has been one of our engines of growth in SAMEA. Pantene is strong there. Pantene has also been incredibly strong in Japan and Korea. In fact, our hottest brand the last few years in Japan has been Pantene. We have introduced a high end line called Clinicare. It has been received very well by Japanese consumers. In Western Europe we are solid but we are basically flat. The issue, as we have said, is the U.S. There are three things going on in the U.S. There is a little bit of market softness, but frankly the hair care market is still growing at a fine rate. There have been a lot of initiatives out there from us and from competitors and we have basically held our share. I think we were down 4/10 in the most recent period so basically the losses on Pantene were picked up by Head and Shoulders, Herbal Essences and Aussie. You are right, the last initiative did not resonate with consumers as well as we hoped it would and frankly as well as our pre-market research and learning indicated it would. So, the right people are working on this and you’ll see over the next 6-12-18 month’s initiatives on Pantene to get it growing again in the U.S. That is the issue. But if you step back we still have basically a 15 share brand that we have a 14.8 or whatever share brand on Pantene, a 13.8 or whatever share brand on Head and Shoulders and if you look at the competitive brands, the biggest ones are sort of around 6-6.5. We still have a very strong franchise. We don’t have a wounded duck here. We just have a big brand that we’ve got to take to the next level.
Operator: Your next question comes from William Chappell with SunTrust Robinson Humphrey.
William Chappell – SunTrust Robinson Humphrey: Going back to your commentary of pre or during Cagney it seemed like in the U.S. you were seeing a channel shift but no real huge softness in the consumer. Now it sounds like the consumer is slowing down a little bit, which maybe implies that March was kind of worse than January and February. Is that the case? What trends are you seeing in the U.S. as we move through April?
A.G. Lafley : Actually March was a little bit stronger. I think the channel shift you are referring to is the move to discounters and frankly discounters with what I would call clear value offerings. You see that in the retailer reports every month. The club stores led by Costco, Sams and BJ’s have held up pretty well and WalMart has performed pretty well. I don’t think that should be surprising. They have known value offerings in terms of their retail format and I think shoppers understand the vacuation very clearly and I think there has been a correlation between the retailers who have been clearer about their value offering. The only thing we’ve seen…the only changes we’ve seen is some slowing but still growth in some of the markets. The other changes we’ve seen have been in consumer behavior around number of shopping trips, how far they will go to shop. For obvious reasons with gasoline getting close to $4.00 per gallon in some parts of the U.S. people are consolidating their trips or reducing their trips. Now the baskets are going up. Then in terms of the mix that is in the basket, our mix has been holding up pretty well. We wouldn’t be holding share of 60+% of our business in the U.S. if it weren’t. I think the whole issue is how long does the downturn last and how deep does it get? We’ll know more in the months ahead. That and the energy and commodity cost pressures are why we are being appropriately conservative and cautious about next year.
Operator: Your next question comes from Alice Longley with Buckingham Research.
Alice Longley - Buckingham Research: I’m looking for an update on what your organic growth rate was by geographic region. Usually you give us a little sense of that. In the U.S. and Western Europe and local currencies and then developing markets. I think in the December quarter your U.S. organic growth was 6% and low single-digits in Western Europe. What is it now?
Clayton Daley: The North America was basically in…as far as organic sales growth North America was mid singles, Western Europe was low singles and the developing markets as we said were low double-digits. That is relatively consistent with the patterns we’ve seen in the last couple of quarters.
A.G. Lafley : Frankly relatively consistent with market growth patterns, right? Europe is 1-2. U.S. is 2-4. Developing are sort of mid to high single-digits and we’re running at the top end or above.
Operator: That is all the time we have for questions. Gentlemen I will go ahead and turn the conference back to you for any additional or closing remarks.
Clayton Daley: Thank you again for joining us this morning. As I said at the outset the IR team, myself included, will be around the rest of the day to answer any additional questions you have. Thanks for joining us again. | [
{
"speaker": "Executives",
"text": "A.G. Lafley – Chairman of the Board Chief Executive Officer Clayton Daley, Jr. – Vice Chair and Chief Financial Officer Jon Moeller - Vice President & Treasurer"
},
{
"speaker": "Analysts",
"text": "Bill Pecoriello - Morgan Stanley John Faucher – JP Morgan Wendy Nicholson – Citigroup Christopher Ferrara – Merrill Lynch William Schmitz – Deutsche Bank Securities Lauren Leiberman - Lehman Brothers Ali Dibadj - Sanford Bernstein Andrew Sawyer - Goldman Sachs Jason Gere – Wachovia Capital Markets Joseph Altobello – Oppenheimer & Co. Connie Maneaty – BMO Capital Markets Filippe Goossens – Credit Suisse William Chappell – SunTrust Robinson Humphrey Alice Longley - Buckingham Research"
},
{
"speaker": "Operator",
"text": "Good day everyone and welcome to Procter & Gamble’s third quarter earnings conference call. Today’s discussion will include a number of forward-looking statements. If you will refer to P&G’s most recent 10K and 8K reports you will see a discussion of factors that could cause the Company’s actual results to differ materially from these projections. As required by Regulation G, P&G needs to make you aware that during the call the Company will make a number of references to non-GAAP and other financial measures. Management believes these measures provide investors valuable information on the underlying growth trends of the business. Organic refers to reported results excluding the impact of acquisitions and divestitures and foreign exchange where applicable. Free cash flow represents operating cash flow less capital expenditures. P&G has posted on its web site www.PG.com a full reconciliation of non-GAAP and other financial measures. Now I’d like to turn the call over to P&G’s Chief Financial Officer, Clayton Daley. Please go ahead."
},
{
"speaker": "Clayton Daley",
"text": "Thank you. Good morning everyone. A.G. Lafley, our CEO and Jon Moeller, our Treasurer join me this morning. I will begin with a summary of our third quarter results. Jon will cover business highlights by operating segment. I’ll then discuss our expectations for the June quarter and the current fiscal year and finally I will provide a brief outlook on fiscal 2009. Following the call, as always Jon Moeller, Mark Erceg, John Chevalierand I will be available to provide additional perspective as needed. Now on to the results. P&G maintained strong momentum in the third quarter delivering balanced top and bottom line growth in an environment of significant commodity and energy costs pressure. The breadth and depth of our portfolio, strong innovation and a focus on productivity drove our results. Earnings per share for the March quarter increased 11% to $0.82. This was $0.01 ahead of both the consensus estimate and the top end of our guidance range. Earnings per share growth was driven by solid sales growth and strong operating margin expansion. Operating margins expanded behind a continuing focus on productivity improvements and by delivering Gillette synergy benefits. Total sales increased 9% to $20.5 billion, driven by volume growth and favorable foreign exchange. Organic sales and volume were both up 5%. This was the 23rd consecutive quarter we have met or exceeded our top line growth targets. Developing markets set the pace with strong double-digit organic sales and volume growth. Pricing added one point to sales growth as many of our brands increased pricing with offset higher commodity and energy costs. Both developed and developing markets grew sales ahead of volume. However, because the developing markets are growing faster than developed markets there was a -1 point mix effect on the total company. We expect these dynamics to continue going forward. The Company’s business portfolio performed very well with five of our six reportable segments delivering mid single-digit or better organic growth. Global organic volume grew in 18 of P&G’s top 22 product categories representing over 90% of company sales. One of our strengths as a company is the fact that our results do not depend on any one category or market but rather on the diversity and breadth of our total portfolio. The diversity of our products and geographies continue to enable consistent reliable growth for the company. For example, beauty care organic sales growth for the quarter was only 3%. This was below or going in expectations. The shortfall was driven mainly by slower market growth in prestige channels and by softness in North American Pantene. But the softness in beauty care was offset by stronger growth in other parts of the portfolio. We are confident our portfolio will continue to deliver reliable sales growth of 4-6%. In terms of our markets, U.S. all outlet dollar market growth has slowed but is still growing at about 2-4% in most of our categories. Very recently we have seen a slow down in the rate of growth across several beauty care categories. Non-track channels continue to grow significantly faster than track channels and market growth is stronger on a dollar basis than on a unit basis. Private label shares in the U.S. have begun to grow in a few of our product categories. However, in nearly every instance P&G is also growing share in those same categories. In Western Europe the markets have softened a bit but are still growing 1-2% and P&G continues to grow market share overall. In developing regions market growth remains in the mid to high single-digits. Net through the third quarter, markets continue to grow and P&G brands continue to build share despite a challenging economic environment in the U.S. and the price increases we have taken to cover commodity costs. Next, earnings and margin performance. Operating income increased a strong 13% to $4.1 billion behind sales growth and margin expansion despite significant commodity and energy cost increases. Operating margin increased 60 basis points due to overhead productivity improvements and Gillette synergies. Gross margin was down 30 basis points to 51.3%. Commodity and energy costs reduced gross margin by over 220 basis points. This was largely offset by pricing, volume leverage and cost savings projects. Selling general administrative expenses were down 80 basis points as our focus on productivity significantly lowered overhead costs as a percent of sales. Market trending increased 9% in line with sales growth. We continue to support our brands with consistently high levels of advertising and marketing spending. Interest expense was up as we continue to expand debt capacity within our AA credit rating to finance our share buyback program. Other non-operating income was down significantly versus a year ago due primarily to divestiture gains in the base period and lower interest income. This was consistent with previous guidance. The tax rate for the quarter was 27.9%, also consistent with previous guidance. Now let’s turn to cash performance. We continue to convert earnings to cash at a strong rate. Operating cash flow in the quarter was $4.3 billion driven largely by strong earnings, an unusually large deferred tax benefit and a decrease in accounts receivable. Operating cash flow was down slightly versus prior year due to inventory increases to support the North American liquid laundry compaction, and other major initiative launches. Capital spending was $668 million in the quarter or 3.3% of sales, well below the Company’s 4% annual target. Free cash flow for the quarter was $3.7 billion. This was 136% of net earnings. Fiscal year to date operating cash flow as $11.7 billion, up $1.9 billion from the same period a year ago, and fiscal year to date free cash flow was $9.9 billion, an increase of $2 billion from a year ago. This brings free cash flow productivity to 109% fiscal year-to-date, 12 points ahead of last year. We remain well on pace to exceed our 90% free cash flow productivity target for the fiscal year. We repurchased $2.6 billion of P&G stock during the quarter. Fiscal year-to-date we have repurchased $8 billion, a level that is consistent with our three-year, $24-30 billion share repurchase program. Combined with $3.3 billion in dividends, P&G has distributed $11.4 billion to shareholders fiscal year-to-date or 126% of earnings. On April 8 we announced a 14% increase in our quarterly dividend from $0.35 to $0.40 per share. This represents the 52nd consecutive fiscal year in which P&G has increased dividends. Over the past 52 years, P&G’s dividends has increased at a compound annual rate of nearly 10%. To summarize, P&G continues to drive balanced top and bottom line growth at or above target levels. We are converting a significant amount of earnings to cash and we are returning this cash to shareholders through dividends and share repurchase. I’ll now turn it over to Jon for a discussion of the business unit results by segment."
},
{
"speaker": "Jon Moeller",
"text": "Thanks Clay. Starting with the beauty segment all-in sales grew 9% with organic sales up 3%. Global hair care volume grew mid single-digits behind high teen’s growth of Head and Shoulders and double-digit growth of Rejoice. P&G’s global hair care value share was in line with prior year at nearly 26%. P&G all outlet value share in the U.S. hair care market was down slightly as declines on Pantene were largely offset by Head and Shoulders and Herbal Essences. P&G hair care in Japan was very strong this quarter behind the launch of Head and Shoulders and continued growth of Pantene. Global hair color sales were up high teens driven by the launch of Nice-n-Easy Perfect 10. Perfect 10 is a revolutionary technology that addresses key unmet needs of the home coloring consumer. Our execution of Perfect 10 has been outstanding and we are on track to beat our launch target objectives. Nice-N-Easy all outlet share of U.S. hair colorants grew more than three points to 19%. Professional hair care shipments were in line with prior year as strong growth in Central and Eastern Europe was offset by modest declines in developed markets. Prestige fragrances had a strong quarter versus prior year with sales up mid-teens. Organic sales grew 9%, well above industry average driven by the Dolce Gabana, Hugo Boss and Gucci brands. Growth was somewhat lower than expected in the U.S. and Western Europe due to slower department store sales. In skin care, global organic sales grew low single-digits behind solid growth of Olay facial moisturizers in the U.S. All outlet share of Olay facial moisturizers in the U.S. increased nearly 2 points to 43%. Skin care shipments in developing markets were in line with a very difficult year ago comparison that included the Olay brand expansion in Russia, Poland and Turkey and the launch of Olay Definity in China. Cosmetic sales grew mid single-digits driven by the launch of CoverGirl Lash Blast mascara. CoverGirl value share in the U.S. grew to nearly 20% for the quarter. As Clay said previously, organic sales growth for beauty were below our going in expectations. This was due primarily to a soft period for the Pantene brand in North America, slower than anticipated department store channel sales for Prestige and a general slow down in retail market growth of about a point. In the grooming segment sales were up 13% for the quarter with organic volume and sales growing 6%. Blazin Razors global shipments grew high single-digits driven by double-digit growth in developing markets. Shave Prep shipments also grew high single-digits. P&G is now the shave prep market leader in the U.S. with all outlet share up more than 3 points to over 35%. Braun shipments were down mid single-digits due largely to soft household appliance results including the previously announced exit of this business in the U.S. Overall, global consumption of Gillette blades and razors increased 6% for the quarter driven by the continued growth of Fusion and strong developing market results. Gillette’s global value share of blades and razors increased for the period to nearly 72%. Fusion continues to be a strong engine of growth in male shaving. Fusion share of global male systems is up more than 8 points versus prior year to 24%. Gillette’s global share of male systems is up half a point to nearly 84%. Fusion will deliver more than $1 billion in sales this year, making it P&G’s 24th Billion Dollar brand. The fastest ever to reach this milestone including Mach3. The success of Fusion is a great example of the combined strength of P&G and Gillette. In February, Gillette launched Venus Embrace, the first five-bladed female razor. Embrace is off to a good start driving Venus’ share of female systems up more than 4 points to nearly 58% in the U.S. Gillette also launched Mach3 disposables in the U.S. in the third quarter. After only a few weeks in market Mach3 holds nearly a 10% share of the U.S. male disposable razor market. Health care sales increased 11% including six points of favorable foreign exchange. Feminine care and oral care led the growth with feminine care volume up high single-digits and oral care up mid single-digits. In feminine care, Always volume was up high single-digits and Naturella grew more than 30%. Always shipments were driven by strong growth of panty liners in the U.S. Always all outlet share of the U.S. liner category is up more than two points to 31%. Feminine pad share increased nearly a point to 59%. Naturella brand growth was driven by continued expansion in Latin America, where volume grew more than 20% and in Central and Eastern Europe where volume increased more than 40%. Oral care delivered mid single-digit volume growth in both developed and developing markets. In North America volume was up high single-digits on strong growth of both Crest and Oral B brands. Crest Dentrafist maintained its all outlet value share leadership in the U.S. despite intense competitive promotional activity. P&G’s leading all outlet volume share of toothpaste in the U.S. remained at over 38% and Oral B toothbrush value share grew nearly two points to 43%. In personal health care, Vicks shipments increased high single-digits globally and more than 20% in the U.S. due to a late cold and flu season. Prilosec OTC delivered solid volume growth despite Pergo’s late quarter generic entry into the market. Prilosec’s U.S. all outlet value share grew nearly two points to 43%. While we are pleased for these results for the March quarter we do expect future sales and market growth to reflect the impact of generic competition. Pharmaceutical volume grew low single-digits. Global Actinel volume increased mid single-digits but was partially offset by lower shipments of other minor brands. Sales for the snacks, coffee and pet segment increased 11% for the quarter and organic sales grew 8%. Snacks delivered double-digit volume and sales growth behind the Pringles Rice Infusion initiative in Western Europe and the Xtreme Flavors Initiative in the U.S. Coffee sales also increased double-digits due to the combination of modest volume growth and pricing to offset increases in green coffee costs. P&G coffee all outlet share increased more than a point to 37% driven by the continued success of the Dunkin Donuts coffee expansion into retail stores. Year one retail sales estimates for Dunkin Donuts coffee are now in the range of $150-200 million. Pet care sales were up versus prior year as price entry cover commodity costs more than offset the modest shipment volume decline. Importantly, we have now annualized the wet pet food recall impacts and expect to grow the top and bottom line beginning in the April/June quarter. The fabric care and home care segment delivered 10% total sales growth and 5% organic sales growth. Fabric care global shipment volume increased high single-digits with double-digit growth in developing markets and mid single-digit growth in developed regions. In developing markets the Ariel and ACE brands each grew volume double-digits for the quarter. In developed markets growth was led by the Gain brand. Gain volume increased more than 20% driven by the Soothing Sensations launch which shipped in conjunction with Compact Liquid Detergent roll out in North America. Gain laundry all outlet value share in the U.S. is up a point to 15%. Tide grew volume mid single-digits in North America driven by the Improved Cleaning initiative launched along with the concentrated formula. Overall the conversion to compacted liquid detergent in North America remains on track with the final conversion wave shipping later this month. Importantly, P&G has continued to build share behind this initiative. Home care shipments increased mid single-digits. Febreeze volume grew double-digits behind the launch of Febreeze candles and continued growth of Air Effects. Febreeze share of the instant action air care market was up three points for the quarter to 20%. Cascade volume was up high single-digits due to heavy orders prior to a price increase which was effective in early March. Also Fairy Hand dishwashing and Auto dishwashing products grew double-digits. Batteries volume grew mid single-digits with a double-digit growth in developing markets more than offset a decline in North American shipments due to soft market trends. Duracell all outlet value share in the U.S. was up nearly a point to 44%. Baby care and family care all-in sales grew 8%. Organic sales also grew 8% and organic shipment volumes were up a very strong 7%. Pampers diapers grew volumes double-digit globally led by high teens growth in developing markets. Russia, Poland and China continue to be growth leaders for Pampers. In developed markets, Pampers Baby Stages swaddlers and Baby Dry also delivered solid growth. Pampers all outlet value share of the U.S. diaper market is up nearly a point to more than 29%. In Western Europe Pampers market leading diaper share is in line with prior year at a strong 54%. Family care organic volume grew high single-digits behind double-digit growth on Charmin and mid single-digit growth on Bounty in North America. Charmin’s strong results are due to the success of the Charmin Ultra Strong. Charmin all outlet value share in the U.S. is up more than a point to 28%. Bounty’s share is also up a point to 46%, a 43-year record high. That concludes the business segment review. I will hand the call back to Clay."
},
{
"speaker": "Clayton Daley",
"text": "Thanks Jon. Before getting into our guidance I want to provide some perspective on the current cost environment and how we are managing it. We are facing significant cost challenges brought on by rapid increases in both commodities and energy. Almost all of our key material inputs are up double-digits and energy costs have increased even more dramatically with oil approaching $120 a barrel and natural gas in excess of $10 per million BTUs. As a result we expect to incur approximately $1.4 billion in higher material and energy costs this year. We have managed these costs while still delivering on financial commitments through a combination of pricing, cost savings projects including product reformulation and a focus on driving productivity through a disciplined approach of overhead control. We have also continued to drive innovation. Coupling innovation with pricing has allowed us in many instances to increase prices while also increasing consumer value. Material and energy forecasts for next year are even more challenging. We are in the midst of our fiscal 2009 planning process and we are building our plans on the assumption that material and energy costs will increase by over $2 billion versus the current year. We expect to manage through this challenging environment by continuing to do what we do best. First, we will innovate. Innovation is critical to maintaining superior consumer value. Better products are even more important during challenging times when consumers are even more focused on value. We will also drive cost savings. One of the ways we will drive cost savings is through product reformulation. We will use our deep technical mastery to enable us to utilize alternative inputs while maintaining or improving the performance of our products. We will accelerate our productivity efforts by reducing organizational redundancy, streamlining decision making and institutionalizing overhead cost control behind the HOG/NOG/ZOG target management for overhead costs. Finally, we will drive favorable mix by trading consumers up to value added products and we will continue to take broad pricing actions as necessary. As a result, we expect P&G and the overall market to grow sales ahead of unit volume and this is a trend we are already seeing. I am confident that with these efforts we will successfully manage through this challenging period and continue to meet the commitments we have made to our shareholders. Now, in to guidance. For the June quarter organic sales are expected to grow 4-6%. This includes one point of positive pricing mix. In addition positive foreign exchange should add 5-6% to sales growth. Acquisitions and divestitures are expected to have a negative 1-2% impact on sales so in total we expect all-in sales growth of 8-10%. Operating margins are expected to improve modestly. SG&A productivity improvements should more than offset lower gross margins as we encounter another quarter of significant commodity and energy cost increases. P&G is continuing to increase prices to offset the impact of higher input costs. Since our last earnings call we have announced that we will be taking several additional price increases in the United States including 4.5% on Always and Tampax, 7% on Crest Pro Health Rinse, 7% on hand dishwashing products, 8% on Swiffer refills and 11% on Oral B power brushes and refill heads. These price increases will become effective between May and August and we have announced additional pricing in many other countries around the world. Competitors including private label manufacturers and retailers have generally been increasing prices as well. They are facing the same commodity and energy cost pressures we have been experiencing. Therefore, we believe we will be able to implement these modest price increases without negatively affecting P&G’s market share position. Most of the pricing benefit will be seen during fiscal 2009 when there will be a positive impact on sales growth. Our tax rate in the quarter is expected to be about 28%. On the bottom line we expect earnings per share for the fourth quarter to be in the range of $0.76 to $0.78 driven by strong top line growth and double-digit operating profit growth. Next moving to fiscal 2008, with only one quarter to go organic sales and volume growth should come in at about 5%. Within this we expect pricing to contribute one point to sales growth and mix to reduce sales by one point due to fast developing market growth. In addition, foreign exchange should have a positive impact of about 5%. Acquisitions and divestitures are expected to have a -1% impact on the top line. Therefore, in total we expect all-in sales growth of about 9% for the year. We expect operating margins to improve by 20 or more basis points for the year. As we have seen throughout the year the combination of pricing, cost savings projects and overhead productivity improvements should offset the impact from higher commodity and energy costs. The tax rate on the year is expected to be at or slightly below 28%. This includes the non-recurring favorable tax item in the September quarter of $0.02 per share. On the bottom line we are increasing our EPS guidance range of $3.46 to $3.50 to $3.48 to $3.50 per share reflecting our strong March quarter results. Now turning to fiscal 2009. We currently expect to deliver another year of top and bottom line growth consistent with our long term targets. 4-6% organic sales growth. 2-5% organic volume growth. About 1% of net pricing and mix. 10% earnings per share growth and 90% or greater free tax flow productivity. Of course our GAAP EPS growth for fiscal year 2009 will be higher than 10% due to the net impact of the Folgers transaction in fiscal 2009 and the discreet tax impacts in fiscal 2008. As we report results next year we plan to give shareholders perspective on the underlying performance of the company in addition to the GAAP results. However, our primary guidance will be on a GAAP basis consistent with how we handle Gillette. To recap our plans on Folgers, during the last call we announced we will split or spin off the coffee business. We expect to decide on the deal structure in the June quarter and complete the transaction during the first half of the next fiscal year. Assuming we do a split, the transaction will create a substantial one-time gain in fiscal 2009. It will also create $0.03 to $0.05 of dilution due to the loss of Folgers’ operating profit and stranded overheads. As we said last quarter, we are planning to take a one-time increase in restructuring charges during fiscal 2009. This will be in addition to our existing $300-400 million annual restructuring budget. This additional restructuring will allow us to eliminate stranded overheads and offset the negative earnings per share impact from the coffee transaction. Net our objective for fiscal 2009 remains to deliver underlying EPS growth of 10% despite the loss of coffee earnings. Underlying EPS excludes any one-time Folgers transaction impacts and non-recurring tax impacts. Therefore if we back out the $0.02 gain from our first quarter, 10% earnings per share growth would translate into a fiscal 2009 guidance range for the underlying business of $3.80 to $3.85 per share. We will provide GAAP guidance in a range basis once our August call at year-end. Now, to summarize today’s call we are focusing on the key business drivers of long term sustainable growth. We are delivering balanced top and bottom line growth behind the strength of our portfolio, our innovation pipeline and a focus on productivity. We are converting earnings to free cash flow ahead of target, returning more than 100% of this cash to shareholders through dividends and share repurchase. Looking forward we are confident we should be able to continue to deliver consistent reliable top and bottom line growth; the growth that our shareholders expect from P&G, even during challenging times such as these. Now we’ll open up the call to your questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Bill Pecoriello with Morgan Stanley."
},
{
"speaker": "Bill Pecoriello - Morgan Stanley",
"text": "Question on the $2 billion higher commodity outlook and the additional higher pricing that you are taking. Just in terms of how the consumer has been reacting. You mentioned that in some sub-categories you are seeing private label gains in share but you are also gaining share. Also we have seen North America and Western Europe overall category growth slow. So as you put through these additional prices what are you watching in some of these sub-categories both on the growth rate of the category and trade down?"
},
{
"speaker": "Clayton Daley",
"text": "We’re always watching the market shares closely including, of course, as we said private labels. The experience over the last three years, and we have been going through this now awhile, if we raise prices to recover commodity and energy costs and both other branded competitors and private labels tend to raise prices by about the same percentages because they have the exact same cost problems. We tend to see that the dynamics of the category remain relatively stable. We have not seen, as we have talked before, a substantial trade down in those circumstances, but we are continuing to watch it and the way we of course read it is to look first and foremost on our market share positions in aggregate and also watch the dynamics of the rest of the markets."
},
{
"speaker": "Jon Moeller",
"text": "Bill, one quick addition. We watch obviously volume consumption, unit consumption and dollar market shares and market growth. We watch what I would call indicator categories. One example, paper products are generally a category that come under some pressure when there is an economic downturn. One of the things that has been heartening for us is the performance of our paper products. Especially when you get into product lines like the family care tissue towel businesses. Bath tissue, paper towels, facial tissue. In every case we are building share. We are not seeing the intensity of private label pressure that we’ve seen in past turndowns. I think the reason we are doing this is we are close to consumers. We understand the consumer value equation. We offer tiered product and pricing options from Charmin and Bounty basic through value added products. As Clay said we have kept our relative pricing sharp and we have actually improved out consumer value."
},
{
"speaker": "Operator",
"text": "Next we’ll turn to John Faucher with JP Morgan."
},
{
"speaker": "John Faucher – JP Morgan",
"text": "Clay I apologize for this. A point on clarification here. The $3.80 to $3.85 number is before the impact of Folgers dilution or after the impact of Folgers dilution?"
},
{
"speaker": "Clayton Daley",
"text": "That includes the impact of Folgers. In other words, we are offsetting the $0.03 to $0.05 of Folgers dilution in that guidance."
},
{
"speaker": "John Faucher – JP Morgan",
"text": "Quickly on the inventory side your gross margin performance was definitely better than I think people were expecting or fearing from that standpoint. Your inventories looked like they were up. You talked about volume leverage in the quarter. Any impact on gross margin from that standpoint and is that something we need to account for in the fiscal fourth quarter?"
},
{
"speaker": "Clayton Daley",
"text": "No. Not really. I think the inventories are about in line with what we expected given what is going on and there should not be any fourth quarter gross margin impact."
},
{
"speaker": "Jon Moeller",
"text": "They follow our initiative growth basically. That is what is going on. So inventories are up a little bit for one period when we have the initiative launch and they come back down when we are in more of a sustaining period."
},
{
"speaker": "Operator",
"text": "Your next question comes from Wendy Nicholson with Citigroup."
},
{
"speaker": "Wendy Nicholson – Citigroup",
"text": "I wanted to ask about some of the margin performance by segment, particularly in grooming and beauty. Grooming margins have just been on fire now for two years and I’m wondering at what point…I’m assuming that is benefiting from some of the integration savings and what not, but at what point do those margins start to kind of flat line or expand on a lower rate? Similarly on beauty it is kind of surprising the margins are continuing to come under pressure and I’m wondering are you spending at an outsized rate on advertising in the beauty segment yet still not getting the volume pick up. Or is that just a negative mix shift to the emerging markets?"
},
{
"speaker": "Clayton Daley",
"text": "On grooming what we have seen a lot of progress on grooming margins. That has been a combination of synergies from the Gillette acquisition and as we have reallocated our costs across the new combined company the Gillette segment has picked up some benefit there as well. Clearly we expect ongoing margin improvement from the grooming segment but not to the degree we have seen it over the last two years. In beauty, I think what you are seeing in those numbers is a combination of the impact of the divestiture where we had the business in the base period and the business is no longer in the segment. You are also seeing that beauty is a competitive business right now and we are making sure our marketing and our spending with retailers is competitive during this period."
},
{
"speaker": "Jon Moeller",
"text": "Wendy, quickly, it is offensive investment. We are obviously investing in Head and Shoulders. You don’t drive 17% of organic volume growth and 22% organic sales growth on a mature business like that unless you are investing behind the product innovation. We’re investing in Herbal Essences, so the hot spot restage expansion and we are defending ourselves. There are some major initiatives by major competitors which we talked about a number of times and we are making sure that our consumer continues to have a chance to purchase and try our brands and products which we think offer better performance and value."
},
{
"speaker": "Operator",
"text": "Your next question comes from Christopher Ferrara with Merrill Lynch."
},
{
"speaker": "Christopher Ferrara – Merrill Lynch",
"text": "Just wanted to ask about beauty category deceleration. You guys and others have talked about it as well. It is contrary to things we have seen in the past. I know you talked about indicator categories, and we have seen sort of a shift but why is beauty not hanging in as well as it might have in the past? Also, do you find retailers pushing private label with better placing? We have seen that anecdotally in the channel."
},
{
"speaker": "A.G. Lafley",
"text": "Chris I’m going to try to keep this simple, but as you can imagine we are in so many different beauty categories and channels…different product categories, different channels and different geographies, so it can be kind of complex. I think in the past we have seen slow down in more discretionary segments in beauty and in more discretionary channels. So as Jon mentioned the slow down in the department store channel for Prestige products. I don’t think that is unusual. Okay? Across our cosmetics line in the past we have seen slow down on some of the more discretionary items. We are actually pretty pleased because our cosmetics business held up well. CoverGirl particularly held up well and in fact grew share in the period. So there are discretionary fragrance purchases and Duty Free shops and on airplanes they tend to fall off during periods of economic turndown. We have seen some of that. There is no doubt that there is some slowing as Jon said but knock on wood most of these categories are still growing. I think that is important. That is what I remind our team. The are slowing but they are still growing and as long as there is growth there is business out there for us. The second thing that is going on is with the competitive intensity frankly the pricing gets reduced. When we have competitors out there basically giving away buy one-get one free for months, that obviously reduces the value of consumption that is going on in the market. Then when we feel we have to selective match, that sort of compounds that issue. We know from the past we’ll work our way through it because that kind of spending is not sustainable. The same thing goes on with some of these launches. I don’t want to pick on individual situations but there is a country in the world right now where there is a major launch by a competitor going on and they are spending five times what we are spending in that market. That is obviously not sustainable. So I think what is happening is that is depressing the consumption a little bit. I think the fundamentals in beauty are still very good. I think they are very good. The kind of beauty care brands and product offerings we have are generally affordable broadly. So, I’m still cautiously optimistic about beauty. We have a stronger initiative program coming and we have got a lot of good, strong brands and a lot of good innovation programs."
},
{
"speaker": "Clayton Daley",
"text": "Good innovation still drives business."
},
{
"speaker": "A.G. Lafley",
"text": "It really does."
},
{
"speaker": "Operator",
"text": "Your next question comes from William Schmitz with Deutsche Bank Securities."
},
{
"speaker": "William Schmitz – Deutsche Bank Securities",
"text": "You are always a bigger advertiser than, if you look broadly against your peer group, do you change that and become more promotional in this environment to make some of the products a little more reasonable for people? You have already talked about a little bit of a trade down from Tide to Gain. That’s great, it stays in the family. But will you kind of tweak your promotional spending based on the environment?"
},
{
"speaker": "A.G. Lafley",
"text": "The part of trade spending is essentially pricing. In an environment like this we watch that very carefully and we try to stay competitive as Clay said earlier. So that slice of our trade spending does increase slightly in this environment. That varies dramatically by category. Okay? Beyond that we are trying to direct the money to consumers and shoppers because our game is basically a trial game. I’ve talked about this before. If you step back and look at our biggest single upside growth opportunity is to get trial at the target goalie, the new brand and new product initiatives we already have in the market. We think that is worth at least $2 billion in incremental sales. So we try to direct our spending consumers and shoppers in a way they can try our new brands and products. The Swiffer brand has been out for a decade. We have something like 15, 16, 17% household trials in the U.S. We convert 60+% of that trial to regular usage. There are a lot more than 15, 16 or 17% of U.S. households that would be interested in purchasing Swiffer and using it on a regular basis. That is just one of 20 brands that have significant trial opportunities. So we try very hard to make sure most of our spending is directed against the consumer, whether it goes through the trade or direct to consumer. We try to make sure we are spending on trial generating activities. Regarding the Tide/Gain situation, what is really going on is we are growing share on Tide and we are growing share on Gain and we’re growing it faster. It is not unlike the tissue/towel or family care situation. We offer a tiered line of brands and product offerings that appeal to different consumer groups at different price points and different value equations."
},
{
"speaker": "Operator",
"text": "Your next question comes from Lauren Leiberman with Lehman Brothers."
},
{
"speaker": "Lauren Leiberman - Lehman Brothers",
"text": "I was going to ask again about mix as being part of your algorithm, particularly in developed markets because I know as you report the little business units you can’t see the impact it makes in developed markets that has been playing. I’ve been curious about this for awhile. I was surprised to hear that still as part of your plans for fiscal 2009 how you are going to offset some of the incremental cost inflation. I would just think there is maybe a little bit less appetite in the market for some of the value added and higher price point innovations that just drive a category slow down. That would apply to everybody, not just Procter. Is that not how you guys are thinking about it? What am I missing? I would think consumers wouldn’t be as interested in the next higher price point blank."
},
{
"speaker": "Clayton Daley",
"text": "Lauren it is all about consumer value. Okay? I’ll try to give you three to four quick examples. First of all I think we need to be crystal clear here. We are trying to create the right portfolio of brands and product offerings and price points so there is an appropriately tiered offering that appeals to lower income consumers all the way up to higher income consumers. But some very quick examples, the hottest item right now in the deodorant business is clinical strength. We command a phenomenal premium on clinical strength. We sell clinical strength for twice the retail price and it is flying off the shelves. The hottest item in coffee right now is Dunkin Donuts sold at a premium price. Folgers’ gourmet line is going strong. I mentioned tissue/towel. Yes, on the one hand we are selling Downey Basic and Charmin Basic but on the other hand we are selling a number of value added products that can command 10-20% premiums in a category where the consumer watches every penny. Perfect 10 in retail coloring, we are convinced that if we could get trial of this product there is going to be a lot of conversion. That is sold at a significant premium to the at-home colorant offerings that are in the market. Laundry detergent. The Tide with Febreeze. The Tide with a touch of Downey. They sell well to their audience. In fact, one of our realizations this past six months has been yes we have got to cover ourselves on the low end or the point of entry in the market. That is important. But we also can’t miss the opportunities for trade up. If you step back we are still selling our brands and product lines at price points from $2 to $10. These are not make or break expenditures for consumers. Our hottest item in health care has been Pro Health. Our fastest growing line of oral care brushes is in the higher end manual brushes and the power brushes. I could just go on and on. Yes, the issue is value. But we can drive higher consumer value ratings and higher consumer value perception with products that are trade up products."
},
{
"speaker": "Operator",
"text": "Your next question is from Ali Dibadj with Sanford Bernstein."
},
{
"speaker": "Ali Dibadj - Sanford Bernstein",
"text": "I want to ask a question about one of the levers you are pulling to offset these astronomical commodity costs. In particular just around getting a little bit more flavor around the cost cutting you are doing and trying to understand first off the mix that you have seen between Gillette synergy savings versus reformulations and other overhead savings playing in so far. Then how that mix goes forward and finally if you can give us a sense of examples or metrics around those?"
},
{
"speaker": "Clayton Daley",
"text": "I think that the Gillette synergies do not end completely this year but they obviously trail off. There are some additional synergies from Gillette that come in over the next two years as we complete primarily the supply chain and distribution center consolidations although they become a much smaller factor in the total equation going forward. So really the cost savings focus stays where it has been this year on very much focused on formulation and what we do on our manufacturing costs. As we talked before and frankly spent a lot of time talking about at Cagney was our programs to really go after overhead costs, productivity, raising our targets for productivity improvement over the next couple of years. That is pretty much it."
},
{
"speaker": "A.G. Lafley",
"text": "I’ll give you two that you can follow and a third broad area we touched on in Cagney. You look at our global business shared services operation and over the course of this decade we will basically have the cost of our back room on percent of sales basis. So that has just been a tremendous engine of productivity and every year we are finding new “shared services” we can consolidate and run in that network partnership . The other one is you can look at our R&D productivity rates. As strong as our innovation pipeline has been I have been just as proud of the ability of our business units and R&D organization to become more productive and more efficient every year. That shows up in reduced R&D as a percent of sales. We have talked about connect and develop last year. Half of the new product initiatives we brought to market had at least one external partnership. There is no end to that in sight. There are a lot of partners out there that we can work with and that of course, I think, increases the effectiveness and success rate of our innovation program but it also obviously lowers the cost. Then the third one Clay touched on. We now have a process in place that I think anchors the various businesses depending upon their sustainable growth goals. It anchors the overhead targets. There are a number of opportunities for us to get a lot more effective and a lot more efficient. We have very quietly launched a five year program that is going to make us considerably more productive. We’ll move from 5% annual productivity growth in the 80’s and 90’s to 6% in this decade so far to 7-8% and we think we can sustain it."
},
{
"speaker": "Operator",
"text": "Your next question comes from Andrew Sawyer with Goldman Sachs."
},
{
"speaker": "Andrew Sawyer - Goldman Sachs",
"text": "I was hoping to follow-up on a question from earlier about consumer reaction to price increases. You guys have talked a bit about what you have seen in the United States. I was wondering if you could walk us through what type of pricing you are looking at in some of the developing and emerging markets. Any early responses from consumers and retailers to that especially with the backdrop of inflation across a broader basket of goods?"
},
{
"speaker": "Clayton Daley",
"text": "Well the pricing in individual markets depends of course on what has happened in local currency to commodity costs. Of course we know with the weakness of the U.S. dollar commodity and energy costs have gone up the most in dollar denominated markets. Of course the U.S. and there are still some markets in places like the Middle East and a few other places that tend to be still dollar linked. In markets that are either Euro based or tend to move with the Euro or markets where currencies have not weakened as much we will price accordingly in the local market depending on what costs we need to recover and of course importantly what cost increases in local currency have competitors seen. We are taking price increases very broadly across the world. No matter what currency you are in, commodity and energy costs are up. We have priced broadly in Western Europe. We are pricing broadly in Eastern Europe. Across Asian markets and even in China. So we’re just seeing the need to pretty broadly increase prices in most of our categories."
},
{
"speaker": "A.G. Lafley",
"text": "The only quick thing I’d add is if you look at the relative impact on consumers, let’s come back to the U.S., clearly gasoline at the pump is far more of a shock than our fairly modest usually 3-7% range, and the other thing is they have already seen much higher increases on most of the food items because of the pressure of agricultural commodities. There is no doubt the consumer is under fairly broad pressure, but I’ll just keep coming back to this…it all depends on the consumer value equation and we watch that like a hawk. The other thing you have to remember is virtually everything we sell is not discretionary. It is a staple. You have to go to the bathroom. You have to get up in the morning and brush your teeth. You’ve got to shower. You’ve got to shave. You’ve got to wash your clothes. We know there has been no change in shampooing frequency. Once these habits are established they become part of the routine and then it’s a matter of where do I get the best value or where do I get what I want and what I need? So far, knock on wood, it is holding up as we said."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jason Gere with Wachovia Capital Markets."
},
{
"speaker": "Jason Gere – Wachovia Capital Markets",
"text": "Your marketing spending up 9% was pretty nice. I have just two questions. One, can you talk about what that was in the U.S. Two, with cable and network advertising rates going up over the last few months I’m just wondering if you can talk about the number of impressions you have seen and have you been doing any shifting to other alternative channels such as online advertising and how you are managing that process?"
},
{
"speaker": "Jon Moeller",
"text": "Jason you are in to details that I would be guessing at and I’m not going to guess. I will tell you broadly what we are doing. We are looking at any and all ways to reach consumers when we believe and/or hopefully know they are most receptive to our communication and our message. That means a lot more diversification in our media program. We have major brands now with a majority of their communication in non-television. You look at what we do in our fem care business, which is a big business, the vast majority of the media we run in that is what we would call alternative media. We’re looking for effectiveness and efficiency. We’re running market mix modeling and market return on investment analyses on an ongoing basis to make sure we’re spending our money wisely. In some categories we can spend a little less and be more effective. In other categories, Wendy’s question about beauty care, we are spending a little more in some places because we need to. We are trying to be strategic on the one hand and practical and pragmatic on the other."
},
{
"speaker": "Operator",
"text": "The next question comes from Joseph Altobello with Oppenheimer & Co."
},
{
"speaker": "Joseph Altobello – Oppenheimer & Co.",
"text": "I just want to go back to the commodity cost situation for a second. Over the last 6-8 weeks have you seen rising commodity costs start to impose some discipline in some of your more commodity intensive categories? Are competitors still heavily promoting in those catregories? Also on the $2 billion incremental for 2009, does that assume commodities continue to accelerate? Or does that assume some leveling off?"
},
{
"speaker": "Clayton Daley",
"text": "On the second part of the question it assumes that feed stock prices stay at current high levels. We’re not assuming that oil and natural gas go higher, but we are also not assuming they go down. Therefore those higher feed stock costs will eventually play through the refiner and cracker spreads and through input materials we buy. There is obviously some time lag between when we pay the higher prices for the materials that we buy but we are expecting this to all flow through into our costs for next fiscal year. The first part of the question relative to promotion spending I don’t think we’ve seen anything significant of promotion spending cut backs. I think part of that is because of the time lag. The feed stock prices are up but the actual prices in the materials move in a time lag. So what we would expect to happen is we are going to try to raise prices to recover commodities. Presumably other manufacturers will do as well and therefore there ought to be some normal stability in the marketplace. That tends to be what we have seen over the last 2-3 years."
},
{
"speaker": "A.G. Lafley",
"text": "Joe, in terms of the trade promotion rates and consumer promotion rates, they are more dependent on the competitiveness caused by the ebb and flow of the innovation in the marketplace. So I think all of us players invest when they have a major new initiative and they defend. There are two things we have seen. One in some critical material areas there are actual shortages. It is not just an issue of cost; it is an issue of availability. Frankly it is a good time to be a leader and to be truly global because there are some instances where we have been able to get access and to get availability at a reasonable price when we know that all the players in the market were not able to get the material. That obviously enables us to continue to deliver performance, quality and value in our products."
},
{
"speaker": "Operator",
"text": "Your next question comes from Connie Maneasty with BMO Capital Markets."
},
{
"speaker": "Connie Maneasty – BMO Capital Markets",
"text": "I just want to ask a question on batteries. What was Duracell’s split between U.S. and international battery sales? Has Duracell regained market share it lost while Gillette was being integrated? Finally was the decline in the U.S. battery sales due more to inventory management at retail or a decline in category growth?"
},
{
"speaker": "A.G. Lafley",
"text": "That’s a three part question, Connie, and we’ll see if we can get them. Yes to the last one. Yes in part to the last one. I think the other phenomenon that is going on is there was a battery inventory at home and you can draw the battery inventory down a little bit. So there is an understandable consumer behavior pause, and then also a retailer phenomenon. But the battery market has softened but as we reported our share was up. We regained some to most depending on the market of the share that was sort of bought away from us in the first year plus."
},
{
"speaker": "Clayton Daley",
"text": "And I think we have been candid in the past that when we integrated Gillette into P&G we were very focused on blade razor, very focused on oral care. We did not greatly integrate Duracell. I think we really though have gotten our act together."
},
{
"speaker": "A.G. Lafley",
"text": "You saw it in the execution in the Thanksgiving and Christmas period and if you have been in stores you’ve seen it in our execution. We are just executing a lot better at retail. We have a strong, experienced Duracell team. I don’t know the exact split of developing and developed, but I will say this. We still think we have growth potential in developed and we think there is a lot of growth potential in developing. In general, Gillette was very strong in developed markets and growing off a very small base in developing and we’ve been able to expand distribution in developing markets. We have been able to deliver a lot more coverage and frankly we can deliver great value."
},
{
"speaker": "Clayton Daley",
"text": "There is still an opportunity in a lot of developing markets to execute conversion to alkaline from carbon. That growth of course occurred in developed markets over the course of a couple of decades."
},
{
"speaker": "Operator",
"text": "Your next question comes from Filippe Goossens with Credit Suisse."
},
{
"speaker": "Filippe Goossens – Credit Suisse",
"text": "A question on the hair care side. Obviously hair care is a big component of your beauty business. If we look specifically at the Pantene brand, Clay, some of it is diverging in terms of performance between U.S. and emerging markets. So my question is twofold. Within the U.S. how much of the weakness is a result of category issues? Or again as you mentioned on the last earnings call is it a result of less than expected consumer acceptance of the last reformulation of the product? The other question obviously is what do you do to kind of boost the performance of Pantene in the U.S.? In emerging markets, as my second part to the question, you have stepped up your advertising spending particularly in Latin America. What is the initial lead in terms of volume and the impact on the margin structure there?"
},
{
"speaker": "A.G. Lafley",
"text": "That is a multi-part question so let me take developing markets. First, you are right, Pantene is strong in developing markets. It is one of our engines of growth in China right now. You’re seeing the investment in Brazil as we begin to build a stronger hair care position in Brazil. It has been one of our engines of growth in SAMEA. Pantene is strong there. Pantene has also been incredibly strong in Japan and Korea. In fact, our hottest brand the last few years in Japan has been Pantene. We have introduced a high end line called Clinicare. It has been received very well by Japanese consumers. In Western Europe we are solid but we are basically flat. The issue, as we have said, is the U.S. There are three things going on in the U.S. There is a little bit of market softness, but frankly the hair care market is still growing at a fine rate. There have been a lot of initiatives out there from us and from competitors and we have basically held our share. I think we were down 4/10 in the most recent period so basically the losses on Pantene were picked up by Head and Shoulders, Herbal Essences and Aussie. You are right, the last initiative did not resonate with consumers as well as we hoped it would and frankly as well as our pre-market research and learning indicated it would. So, the right people are working on this and you’ll see over the next 6-12-18 month’s initiatives on Pantene to get it growing again in the U.S. That is the issue. But if you step back we still have basically a 15 share brand that we have a 14.8 or whatever share brand on Pantene, a 13.8 or whatever share brand on Head and Shoulders and if you look at the competitive brands, the biggest ones are sort of around 6-6.5. We still have a very strong franchise. We don’t have a wounded duck here. We just have a big brand that we’ve got to take to the next level."
},
{
"speaker": "Operator",
"text": "Your next question comes from William Chappell with SunTrust Robinson Humphrey."
},
{
"speaker": "William Chappell – SunTrust Robinson Humphrey",
"text": "Going back to your commentary of pre or during Cagney it seemed like in the U.S. you were seeing a channel shift but no real huge softness in the consumer. Now it sounds like the consumer is slowing down a little bit, which maybe implies that March was kind of worse than January and February. Is that the case? What trends are you seeing in the U.S. as we move through April?"
},
{
"speaker": "A.G. Lafley",
"text": "Actually March was a little bit stronger. I think the channel shift you are referring to is the move to discounters and frankly discounters with what I would call clear value offerings. You see that in the retailer reports every month. The club stores led by Costco, Sams and BJ’s have held up pretty well and WalMart has performed pretty well. I don’t think that should be surprising. They have known value offerings in terms of their retail format and I think shoppers understand the vacuation very clearly and I think there has been a correlation between the retailers who have been clearer about their value offering. The only thing we’ve seen…the only changes we’ve seen is some slowing but still growth in some of the markets. The other changes we’ve seen have been in consumer behavior around number of shopping trips, how far they will go to shop. For obvious reasons with gasoline getting close to $4.00 per gallon in some parts of the U.S. people are consolidating their trips or reducing their trips. Now the baskets are going up. Then in terms of the mix that is in the basket, our mix has been holding up pretty well. We wouldn’t be holding share of 60+% of our business in the U.S. if it weren’t. I think the whole issue is how long does the downturn last and how deep does it get? We’ll know more in the months ahead. That and the energy and commodity cost pressures are why we are being appropriately conservative and cautious about next year."
},
{
"speaker": "Operator",
"text": "Your next question comes from Alice Longley with Buckingham Research."
},
{
"speaker": "Alice Longley - Buckingham Research",
"text": "I’m looking for an update on what your organic growth rate was by geographic region. Usually you give us a little sense of that. In the U.S. and Western Europe and local currencies and then developing markets. I think in the December quarter your U.S. organic growth was 6% and low single-digits in Western Europe. What is it now?"
},
{
"speaker": "Clayton Daley",
"text": "The North America was basically in…as far as organic sales growth North America was mid singles, Western Europe was low singles and the developing markets as we said were low double-digits. That is relatively consistent with the patterns we’ve seen in the last couple of quarters."
},
{
"speaker": "A.G. Lafley",
"text": "Frankly relatively consistent with market growth patterns, right? Europe is 1-2. U.S. is 2-4. Developing are sort of mid to high single-digits and we’re running at the top end or above."
},
{
"speaker": "Operator",
"text": "That is all the time we have for questions. Gentlemen I will go ahead and turn the conference back to you for any additional or closing remarks."
},
{
"speaker": "Clayton Daley",
"text": "Thank you again for joining us this morning. As I said at the outset the IR team, myself included, will be around the rest of the day to answer any additional questions you have. Thanks for joining us again."
}
] | null | null |
PG | 2 | 2,008 | 2008-01-31 08:30:00 | Executives: Clayt Daley – CFO AG Lafley – CEO Jon Moeller - Treasurer
Analysts: William Schmitz - Deutsche Bank John Faucher - JP Morgan [Analyst] - Morgan Stanley Amy Chasen - Goldman Sachs Justin Hott - Bear Stearns Lauren Lieberman - Lehman Brothers Wendy Nicholson – Citigroup [Ali Debache – Sandford Bernstein] Jason Gere - Wachovia Capital Markets [Philippe Gusons] - Credit Suisse Nik Modi – UBS Joseph Altobello - Oppenheimer & Co. William Chappell - Suntrust Robinson Humphrey [Alice Longley – Buckingham Research]
Operator: Good day everyone and welcome to the Procter & Gamble second quarter 2008 conference call. Today’s discussion will include a number of forward-looking statements. If you will refer to P&G’s most recent 10-K and 8-K reports you will see a discussion of factors that could cause the company’s actual results to differ materially from these projections. As required by Regulation G P&G needs to make you aware that during the call the company will make a number of references to non-GAAP and other financial measures. Management believes these measures provide investors valuable information on the underlying growth trends of the business. Organic refers to reported results excluding the impact of acquisitions and divestitures and foreign exchange where applicable. Free cash flow represents operating cash flow plus capital expenditures. P&G has posted on its website www.pg.com a full reconciliation of non-GAAP and other financial measures. Now I’d like to turn the call over to P&G’s Chief Financial Officer Clayt Daley. Please go ahead.
Clayt Daley: Thanks and good morning everyone. AG Lafley our CEO and Jon Moeller our Treasurer join me this morning. I’ll begin with a summary of our second quarter results and Jon will cover business highlights by operating segment. I’ll then provide some perspective on our announcement this morning to exit the coffee business and I’ll also provide an updated outlook for the fiscal year and our expectations for the March quarter and then AG is going to wrap up with a few comments at the end. Following the call Jon Moeller, Chris Peterson, John Chevalier and I will be available for additional perspective as needed. Now on to our results. We maintained good momentum in the second quarter of the fiscal year. We delivered balanced to and bottom line growth with each geographic region and every reportable segment delivering year on year organic sales growth. Earnings per share for the December quarter increased 17% to $0.98. This was $0.01 ahead of both the consensus estimate and the top end of our going and expectations. EPS growth was driven by strong sales growth and continued Gillette synergy benefits. Total sales increased 9% to $21.6 billion. This was above the top end of our guidance range driven by solid volume growth and better than expected foreign exchange benefits. Organic volume was up 6% for the quarter and organic sales were up 5%. Developing markets set the pace with double-digit organic volume and sales growth. Baby and Family Care led the segments with 8% organic sales growth due to strong initiative performance on Pampers, Charmin and Bounty. Price mix had a negative 1% impact on sales growth due to negative mix from strong developing market growth. Now before I move on I want to address some of the questions that have been raised investors recently relative to the consumer and specifically market growth rates in the US and various markets around the world. You know the recent US FD market and share data has raised some concerns as to where the consumer is in the market. Recall this data only covers 40% to 50% of the US market. The picture on all outlet basis is much more encouraging. The US market continues to grow 2% to 3% on an all outlet basis with non track channels growing significantly faster than track channels. As we said on the last call, while we have seen a modest slowdown in US market growth rates, we are not seeing trade down to private label. In fact over the past three months P&G is growing share in about 75% of the US business while private label shares flat or declining in every one of our top 10 categories and the vast majority of the total categories in which we compete. In Western Europe the market continues to grow 1% to 2%. P&G is growing market share overall and in the majority of categories in which we compete. In developing markets, market growth rates of high single-digits are consistent with prior periods. We have seen no evidence of a slowdown in the consumer products industry. Global market share trends continue to be strong with about a two-thirds of our business growing share. So in net, market growth rates continue to be about 3% to 4% on a global basis and P&G continues to grow market share and we are really not seeing any trade-down in the marketplace. Now earnings and margin performance. Operating income increased 8% to $4.7 billion driven by strong sales growth. Operating margin was down 20 basis points due to lower gross margins. Gross margin was down 110 basis points to 51.8%. Higher commodity and energy costs reduced gross margins by over 150 basis points. This was partially offset by volume leverage and cost savings projects. Commodity energy cost increases were higher than originally anticipated. Diesel fuel, phosphates and resins, just to name a few, increased significantly during the quarter. To offset this significant commodity and energy cost pressure we have announced a number of price increases which go into affect during the Jan-March quarter. As such we expect gross margin [tens] to improve sequentially going forward. Selling, general and administrative expenses were down 90 basis points; strong cost control and Gillette synergy benefits drove significant improvement in overhead costs. Lower overhead costs as a percent of sales more than offset higher marketing spending. Non operating income was up versus a year ago in line with previous guidance due to the closing of the western European Tissue, Towel divestiture. However we continue to expect non operating income to be lower as a percentage of earnings for fiscal ’08 compared to the prior year. The tax rate for the quarter came in at 27.6%. This was slightly lower than anticipated due to geographic mix. Recall, international tax rates are significantly lower than the US. We had a higher percentage of our business outside the US due to both strong developing market growth and a stronger than expected foreign exchange impact. This lowered the tax rate for the quarter. Now let’s turn to cash performance. Operating cash flow in the quarter was $4.1 billion up $1.7 billion from the same period last year. This marks the first time P&G has delivered operating cash flow above $4 billion in a quarter. The improvement was due to earnings growth and good working capital management. Working capital was a significant cash help in the quarter versus year ago. Receivables were down two days versus year ago despite a stronger foreign exchange due to the Gillette integration benefits and a high base period comparison. Inventory days were up one day versus year ago due primarily to foreign exchange and payables were down a day as we took better advantage of supplier term discounts. Capital spending was $650 million in the quarter or 3% of sales well below the company’s 4% annual target. Pre cash flow for the quarter was $3.5 billion. This brings free cash flow productivity to 97% fiscal year to date, well ahead of our year ago level of 75%. This puts us on pace to beat our free cash flow target for the fiscal year. We repurchased 2.9 billion of P&G stock during the December quarter as part of our three year $24 billion to $30 billion share repurchase program. This brings fiscal year to date repurchases to $5.5 billion. Combined with the $2.3 billion in dividends P&G distributed nearly $8 billion to shareholders fiscal year to date or 120% of net earnings. To summarize P&G continues to drive balance top and bottom line growth. We are converting a significant amount of earnings to cash and we are returning this cash to shareholders through dividends and share repurchase. Now I’ll turn it over to Jon for a discussion of our business segment results.
Jon Moeller: Thanks Clayt. Starting with the Beauty segment, all end sales grew 10% and organic sales were up 5%. The sequential improvement in organic sales was consistent with expectations shared on the last quarterly call. Top line growth was led by the Prestige Fragrance and Skin Care businesses. In Fragrances, double-digit sales growth was driven by the Dolce and Gabbana and Hugo Boss brands. In Skin Care organic sales grew double-digits. Olay sales were up double-digits driven by the Definity Eye Illuminator initiative and the continued growth of the Regenerist franchise behind the Microsculpting Cream initiative. Olay all outlet value share of US Facial Moisturizers grew to over 42% for the past three months. Hair Care volumes were up low single-digits, Head & Shoulders grew double-digits behind brand restage initiatives in several markets which more than offset lower shipments for professional hair care. Grooming segment sales increased 9% for the quarter. Organic volume was up 8% as developing markets grew nearly 20%. Organic volume in developed markets was up low single-digits. In developed markets Braun appliance shipments were down versus prior year and Blades and Razors growth was impacted by a strong base period that included the Fusion launch in several western European markets. This geographic SKU in shipments resulted in negative sales mix for the quarter. Blades and Razors global shipments were up double-digits for the quarter. Global Blades and Razors value share has increased nearly a point and is now over 71% in a market growing 5% on a value basis and constant dollars. In Male Shaving, Fusion continues to drive strong share growth. Gillette’s global share of male razors up almost three percentage points to nearly 75%. Global share of male cartridges is approaching 86%. And Fusion share of US male cartridges is now over 34% up eight points versus prior year. In female razors, Venus Breeze share of US female razors is now at nearly 25% and total Venus system share is up nearly four points to over 53%. Health Care sales increased 11% led by double-digit growth in Oral Care, Feminine Care and Personal Health Care. Oral Care shipments were up 9% versus prior year behind mid teens growth on Oral-B and mid single-digit growth of Crest. Oral-B grew behind the Smart Guide Brush initiative, ongoing leverage of Oral-B Triumph and strong results in refills. Crest was driven by the launch of Pro Health Night and Crest Plus Scope with Extra Whitening Toothpaste. P&G’s estimated US all outlet value share for Crest Toothpaste is now at 38% up a point versus last year. Developing markets also delivered strong growth with double-digit shipment increases for the quarter. Feminine Care organic volume was up high single-digits. Developing markets led the growth with a double-digit volume increase. On a global basis, Always brand shipments were up high single-digits and the Naturella brand was up more than 20%. In the US all outlet value share for pads, panty liners and tampons improved for the quarter. Share of pads now stands at 57%, tampons at 51% and liners at 32%. In Personal Health Care higher sales were driven mainly by the addition of the Swiss Precision Diagnostics business. Organic shipment volume increased modestly for the quarter as mid teens growth on Prilosec OTC was largely offset by lower volume on Vicks due to the record mild cold and flu season. Pharma Sales were up as geographic mix, pricing and foreign exchange benefits more than offset the impact of lower shipments. Volume was lower versus prior year due mainly to a base period that included very strong western European shipments. Sales for the Snack, Coffee and Pet segment were up 4% for the quarter. The Snacks and Coffee businesses each delivered high single-digit sales growth. The strong Snacks results were driven by the Pringles Minis, Selects, Extreme Flavors and Rice and Fusion initiatives. Coffee sales growth was driven by the Dunkin’ Donuts launch and Folgers new Black Silk and House blend initiatives. Folgers all outlet value share in the US is up versus prior year and now stands at 32%. Dunkin’ Donuts coffee has reached 4% value share in just five months since launch. Pet Care was down versus the prior year due mainly to the temporary discontinuation of most wet pet foods. The business began the relaunch of wet foods in December. Encouragingly Iams dry food sales have returned to levels achieved prior to when the wet food issues occurred last March. Next the Fabric and Home Care segment delivered 10% total sales growth and f5% organic sales growth. Fabric Care global shipment volume was up high single-digits let my developing markets up double-digits behind strong growth of both Tide and Ariel. Fabric Care shipments in North America increased high single-digits behind the Tide, Downy and Bounce Pure Essentials initiative and the continued success of the liquid laundry detergent compaction initiatives. The conversion to compacted detergents has gone very well in the southern tier of the US and we are reapplying the most successful executions in the remaining conversions. Past three month US all outlet value share for P&G laundry detergents increased one point to nearly 63% of the market. Home Care shipments grew low single-digits. Febreze volume was up mid teens behind the launch of Febreze Candles and continued growth of air effects. Febreze share of the air care market including candles was up more than three percentage for the quarter to over 20%. Dish Care shipments were in line with prior year as Dawn and Cascade were comparing against very strong results in the base period. US value share for Dish Care was up modestly for the quarter. Batteries volume was up double-digits behind strong results from holiday merchandising programs and a favorable base period comparison due to supply constraints in the US. Shipments were up double-digits in both developed and developing markets. Duracell all outlet value share in the US was up more than a point versus prior year to 48%. Baby Care and Family Care all end sales grew 8% and organic sales growth was also up 8%. Organic shipment volumes were up double-digits for Baby Care and mid single-digits for Family Care. All end results for the segment were negatively impacted by the divestiture of the western European Family Care business which closed on October 1, 2007. Baby Care growth was due mainly to the ongoing success of Pampers Baby Stages Swaddlers and Cruisers products and Pampers Baby Dry with Caterpillar Flex. In the US Pampers value share is up a point to nearly 30% and in Western Europe value share is in line with prior year at 54%. Pampers also continues to deliver strong growth in developing markets. Shipments in China and Turkey were up more than 30% and Russia and Poland were up double-digits. Family Care top line growth was driven by the success of the new Charmin Ultra Strong innovation and leverage of the Best Bounty Ever initiative. Charmin all outlet value share is up a point to over 27% and Bounty share is also up a point versus prior year to 43%. That concludes the business segment review and now I’ll hand the call back to Clayt.
Clayt Daley: Thanks Jon. As part of our ongoing portfolio review process we announced this morning plans to exit the coffee business. The coffee business had sales of approximately $1.6 billion and operating income of about $350 million in fiscal 2007. Our goals in this transaction are maximizing value to P&G shareholders, minimizing earnings per share dilution and executing the transaction in a tax efficient manner. Although no decision has been made given these goals, the most likely structure is a split off transaction. This transaction has several benefits for P&G shareholders. It enhances P&G’s ability to consistently deliver annual financial goals as the expected growth rate of the coffee business is below P&G’s target range. It optimizes the after tax value of the coffee business to our shareholders. And it enables P&G to better focus its resources on faster growing categories. The transaction will also be good for the coffee business as it will get greater and attention as a stand alone company. Folgers is the leading retail coffee brand in North America. The coffee business operates with attractive operating margins and is a strong cash generator. While we could do either a split off or a spin off transaction based on current market conditions our preference is to do a split off. As this transaction structure minimizes EPS dilution. In a split off P&G shareholders will be given the option to exchange some, none or all of their P&G shares for shares in the newly formed coffee company. P&G’s outstanding share count would be reduced by the number of P&G shares exchanged. If we proceed with the split off the precise exchange ratio would be set prior to the completion of the share exchange transaction. We expect to determine the final deal structure during the April-June quarter and complete the transaction during the first half of next fiscal year. Assuming a split off we expect the deal to be dilutive to EPS by $0.03 to $0.05 on an annual basis. In addition there will be one-time impacts. P&G would recognize the significant one-time gain from the transaction. This gain would be partially offset by one-time transition costs and a one-time increase in restructuring spending associated with eliminating stranded overhead costs and offsetting the anticipated $0.03 to $0.05 dilution. We will provide more specific estimates on these amounts once we decide the final transaction structure. Given this time, we do not expect the transaction to affect fiscal 2008 EPS. For fiscal 2009 while we have not completed our planning process, our objective remains to deliver 10% or better EPS growth despite the loss of the coffee earnings, of course excluding the one-time transaction impacts. Now on to guidance. There are a few factors that have changed since we provided our fiscal year outlook last quarter. Commodity and energy costs have increased significantly over the past few months. At current levels we now expect these costs to impact gross margins by about 150 basis points in fiscal 2008. Given this increase in input costs we have announced a number of price increases which take affect over the next few months. Last quarter we announced pricing plans for coffee, fabric softeners, personal cleansing, tissue, towel, diapers and blades and razors. Since that time we have announced new pricing in the US as follows. Affective this month, a 6% increase on Eukanuba Dry Dog Food and Biscuits. An 8% increase on Ascaol. In affective in March, 2008 a 6% increase on Cascade, a 6% increase on powder laundry detergents, 6% on Iams Dry Dog Food and an 8% increase on Safeguard and Zest bar soaps. And we continue to evaluate pricing in other parts of the business. Importantly as we have implemented pricing actions to recover commodity and energy costs in almost every case competitors including private label manufacturers have also increased their prices. As they have the same commodity and energy cost pressures we do. As such we have been able to implement these modest price increases without negatively affecting category consumption or P&G’s market share progress. In total we still expect operating margin improvement in fiscal year despite higher input costs. Pricing, volume leverage, costs savings projects and overhead cost control should more than offset the increase in commodity and energy costs. Now the numbers, for fiscal 2008 we expect organic sales growth of 4% to 6% in line with previous guidance. With this we expect the combination of pricing and mix to be flat to up 1%. Foreign exchange should have a positive impact of about 4%. Acquisitions and divestitures are expected to have a 1% negative impact on top line results. So in total, we expect all end sales growth of 7% to 9% for the year. This is an increase of 1% versus our previous guidance due to the increase foreign exchange outlook. Turning to the bottom line, we are now expecting earnings per share to be in the range of $3.46 to $3.50 up 14% to 15% versus prior year. This is an improvement versus our previous guidance range of $3.46 to $3.49 due to the strong EPS results in the October to December quarter. We now expect operating margins to improve by 25 to 50 basis points as lower overhead costs as a percent of sales should more than offset the gross margin impact from higher commodity and energy costs. We have lowered our operating margin guidance to reflect the increase in input costs and any revised foreign exchange outlook. A greater contribution from non-US markets due to foreign exchange affects operating margins as the US business has a significantly higher operating margin than the international business. On the tax rate, we now expect the fiscal year to be at or slightly below 28%. This is a slight change versus prior guidance due to updated outlooks for foreign exchange and geographic sales mix. We continue to expect share repurchases of $8 billion to $10 billion for the fiscal year as such we expect interest expense to be up due to increased debt levels. Turning to the March quarter, organic sales are expected to grow in the 4% to 6% range. With this we expect the combination of price and mix to be about neutral. Foreign exchange should add about five percentage points to sales; acquisitions and divestitures are expected to have a negative 1% impact on P&G’s top line growth. In total we expect all end sales growth of 8% to 10%. Turning to the bottom line, we expect operating margins to improve modestly as SG&A improvement will largely be offset by lower gross margins. Gross margins are expected to be temporarily lower due to higher commodity and energy costs. We expect gross margins to recover as pricing plans are implemented in the market. In total operating profit is expected to accelerate to double-digits in the quarter. Interest expense is expected to increase substantially versus year ago due to a low base period comparison. And we expect non operating income to be significantly lower versus year ago due to the timing of minor divestitures. Finally the tax rate for the quarter is estimated to be at or slightly below 28%. Net we expect earnings per share to be in the range of $0.79 to $0.80 for the quarter driven by double-digit operating profit growth. To summarize P&G continues to deliver balanced top and bottom line growth. We are converting earnings and free cash flow ahead of target and returning more than 100% of this cash to shareholders through share repurchase and dividends. And we are confident in our sustainable growth model going forward. Now I would like to hand the call over to AG for a brief wrap up.
AG Lafley: Thanks Clayt. I want to take this opportunity to thank all the P&G people in our Coffee organization for all the hard work they have put into making Folgers the leading brand in retail coffee by a wide margin and creating a growing profitable business. Decisions to separate a business are never easy but we believe this is in the best interest of P&G shareholders. This is one more step, the next step, in the transformation of P&G’s portfolio and business model that we have been driving since the beginning of this decade. Over this period we have doubled the size of the company, diversified into Beauty, Health, Personal Care and developing market, and accelerate the average annual organic sales growth rate to 6%. Market shares have grown in virtually all of our core categories, in some significantly. Core operating margins have grown steadily from below 16% to now over 20%. Cash productivity has run consistently above 90% of earnings. We now generate over $10 billion in free cash flow every year which we have been aggressively returning to shareholders. This year we will complete the successful integration of the largest consumer products goods acquisition in history. Gillette will over deliver cost synergies and revenue synergies are on track with our year three goal. Most importantly Gillette will be an engine of growth for P&G and a significant contributor to strengthening company capabilities and the P&G organization around the world. So how have we done this? We’ve stayed focused. Focused first and foremost on the consumer as the real boss here. We deliver better consumer shopping and usage experiences and we build value into our brands and our product offerings. We partner with customers and with suppliers to serve consumers better and to create value together. We stay strategically focused on our core businesses, on our portfolio shift out of commodity like categories and into faster growing household and beauty, health and personal care categories. We continue to grow our developing market business at double-digit top and bottom line rates from less than $7 billion ten years ago to more than $22 billion today. By the end of this decade developing markets will approach $30 billion in sales and represent at least 30% of total company turnover. We play to our poor competencies and strengths. We continue to invest in consumer understanding. We lead innovation in most of our categories and we have built a strong multi year innovation pipeline. We continue to focus on brands that are or can become leaders in their category. Today our $23 billion brands represent two-thirds of our sales and a greater percentage of profits. Our 41 $.50 billion an up brands represent over 80% of sales and nearly 90% of profits. Going forward I’m confident we are well positioned to deliver growth goals over the long term and in the current economic environment. We have the right portfolio that is uniquely diversified and balanced across household and personal care businesses and across developed and developing geographies. Our unique combination of leadership and strength in both developing markets and the US home market will serve us well in any economic environment. We have the right strategies with plenty of room to keep growing and we have the right core strengths to keep P&G growing reliably year after year. In our industry innovation and productivity are the ultimate drivers of sustainable growth. This is particularly true in the current economic and cost environment we are facing. We look forward to seeing our investors at Cagney next month. At that time we will talk more about P&G’s innovation pipeline including Gillette revenue synergies and we will also talk about specific plans to drive productivity further and faster. Innovation and productivity will allow us to grow top and bottom line in a balanced and sustainable way through the end of this decade and into the next. Now Clayt, Jon and I are open to answer any questions. Thank you.
Operator: Your first question comes from William Schmitz - Deutsche Bank
William Schmitz - Deutsche Bank: Hey Clayt you mentioned that there’s 150 basis points of gross margin pressure from input costs, but it also seems like the business mix obviously has migrated more to developing markets, have you quantified how much mix impact there is as the business migrates more to developing markets as the developed markets slow a little bit?
Clayt Daley: We haven’t quantified it but I think you’re assumption here is accurate that as the business shifts to developing markets, you’ve seen the negative 1% on the top line on price and mix and that’s mostly due to mix and it’s mostly due to developing markets. At the end of the day when business shifts to developing markets that’s a drag on gross margin because the gross margins in developing markets are lower, and actually the operating margins are also lower but as we’ve said before after tax margins are about comparable in developing markets to develop but that’s one of the reasons why you see the tax rate go down. So I think you are exactly on the right point.
Operator: Your next question comes from John Faucher - JP Morgan
John Faucher - JP Morgan: Quick question, I was kind of surprised to see the negative price mix number given the raw material inflation that you talked about and so did you hold off on some of this pricing knowing that you had the other income line to sort of cushion that and I guess furthermore on sort of the gains on sales issues, what are you going to do over the next couple of quarters as you begin to lap bigger numbers there without the asset sales, how are you going to be able to offset that impact?
Clayt Daley: It’s a good question. The timing of price increases really has no bearing to non operating income and there will be some variation from quarter to quarter in non operating income. We obviously had a lot of it in October-December quarter which we did guide for and it’s going to be substantially less in the Jan-March quarter which we are also guiding to. Relative to pricing what we try to do is make sure that as commodity prices and energy prices go up we’re confident that they’re being sustained. You want to go out with pricing when it’s quite clear that it’s a sustained industry phenomenon and as it turns out the price increases we’ve been announcing were not in effect in the October-December quarter so we got virtually no pricing benefit in October-December and that’s what created the gross margin impact. The price increases will begin to come in, in the Jan-March quarter but really much more in the April-June quarter. So that’s why we’re still projecting some gross margin contraction in Jan-March.
AG Lafley: John, one more comment on pricing, we look at a number of factors. First what are the consumer and market conditions? Second of all we like to time our pricing with innovation because frankly it’s the value stays right for the consumer when we do that and it works better with most of our key customer strategies. We coordinate with customers. So beyond making sure that it’s sustained, we want to make sure that when we take the pricing that it’s the right level and that it will sustain at that level.
Operator: Your next question comes from [Analyst] Morgan Stanley
[Analyst] - Morgan Stanley: Just wanted to get some more color on the 3Q versus 4Q earnings flow that you are talking about. I guess the consensus might have been underestimating the falloff in the non operating income in 3Q but also sounds like with the higher commodities you’ve got the price recovery shifting into 4Q which you were just discussing, but I wanted to make sure I understood the double-digit operating profit growth in Q3 despite gross margin down, you expect higher savings in the SG&A line than you had in the second quarter.
Clayt Daley: Yes, that’s spot on. As we said we’re expecting double-digit operating profit growth in the Jan-March quarter but the bottom line is impacted by much higher interest expense and much lower non operating income and that’s just simply a timing impact of minor brand asset sales and yes as you know we hadn’t provided any impact of guidance on Jan-March prior to today so, it’s not surprising that the estimates on Jan-March were above where we’re coming out. But its then coming back just as you suggest in the fourth quarter which should be better on gross margin than in the third quarter and I think really the non operating phenomenon from quarter to quarter explains most of the variation.
Operator: Your next question comes from Amy Chasen - Goldman Sachs
Amy Chasen - Goldman Sachs: Hi, what percentage of your business are you taking price increases on?
AG Lafley: Well over the last, let’s see, Amy I’m going to guess its 40% to 50% but we’re going to get you the hard number. And ….
Clayt Daley: It’s a very high percentage of the household product side and a much lower percentage on health and beauty particularly beauty, but what we try to do in beauty is price with trade up and mix as opposed to list.
AG Lafley: Yes, that’s the key point. On the household side it’s much more in fabric, in paper, in coffee, in snacks and even now in pet, it’s driven by commodities. On the beauty, health and personal care side frankly we’ve been mixing up on virtually all of our key categories on a regular basis as we bring new innovation. The other key part of the question is how much of the commodity cost and energy cost increases are we recovering and over the last three years or so when we’ve had the biggest increases, we’ve been recovering pretty consistently somewhere around 75% to 80% in pricing. We recover the rest of it on the cost side.
Operator: Your next question comes from Justin Hott - Bear Stearns
Justin Hott - Bear Stearns: First a housekeeping item, I thought in the press release it said EPS was 79-81 for the next quarter and Clayt I thought you said 79-80.
Clayt Daley: Okay no 79-81 is correct.
Justin Hott - Bear Stearns: Okay thanks.
Clayt Daley: If I said 80 I misspoke.
Justin Hott - Bear Stearns: Maybe I got it wrong, and operating margins 25-50…
Clayt: Yes, 25-50.
Daley: Yes, 25-50.
Justin Hott - Bear Stearns: Okay just one major question on pricing, going from your comments Clayt and AG, please your insight would help anything on what we’re seeing with the consumer in this sort of environment that worries you more or less versus the past on your ability to take pricing in this environment?
AG Lafley: You know Justin I would say that first of all this will now be the third or fourth year in a row that we’ve had to do this. You have to remember oil didn’t run up from whatever it was $25 or so a barrel to $100 a barrel in the last quarter, okay, that’s been happening over several years and frankly with Katrina and Rita we saw the first big bump up in a number of our chemical commodities pricing and the AG commodity prices have been with us for some time so I would say the key is at least in our household categories, the key is the relatively modest, if you look at our increases they tend to be in the 4% to 6% occasionally a little higher, but generally in that range. The second thing that’s really important is we almost always price with innovation and price with initiative. It’s more difficult to take what we call a naked price increase. In some categories you can, consumers and customers are quite, you know that’s the practice in coffee for example, you know coffee pricing follows green bean pricing. But in May of the household categories you have to price with innovation and initiative and fortunately we’ve been leading innovation. So the strength of our household and paper innovation programs is helping us a lot as we go through this period. And then the third thing I will say is we watch our price spreads or gaps versus all of our competitors and I think as Clayt pointed out the last couple of years and especially most recently private label manufacture margins are so squeezed that they’ve had to price very quickly and in some cases, in some parts of the world, they’re pricing ahead of us. So I think we’re clearly in a situation where everybody is feeling the same commodity cost and energy cost pressure. We’ve actually you know relatively got a little bit more margin cushion. We can give a little gross margin in a quarter and manage through it so we get the timing right and we get the amount right. You know the last thing I’ll say, there are just certain indicators that we watch. How well do we do in channels that serve lower income consumers. You know we’ve been doing very well on the dollar channel. I don’t think it’s any secret that Wal-Mart has done relatively in the most recent period. We do very well with Wal-Mart. So we look at, we track our shares among our top 15 or 20 businesses that serve Hispanic Americans, African Americans who tend to be on average lower income, rural Americans, who tend to be on average lower income. Our shares are growing; you know two thirds sometimes, I think it was African Americans through December our shares have grown over 80% you know in those key brands. So we try to look at all the indicators. If the rebates come in okay, in May I think you know that will be a boost on the consumer spending side in the US and frankly we’ve just got a few months to get through to there and you know we look like as Clayt announced in the guidance we look like we’re going to stay pretty steady on the top line at our sort of 4% to 6% net sales organic growth rate. And in the US we did 6% organic growth in the most recent quarters so you know those are all the kinds of indicators, you know, I’m not going to tell you that there isn’t something out there that you know that we don’t miss, but we turn over every rock and every stone so we can try to stay close to this.
Operator: Your next question comes from Lauren Lieberman - Lehman Brothers
Lauren Lieberman - Lehman Brothers: I want to talk a little bit about overhead control. It was last year at your Analyst Day you attended I can remember you guys putting up a slide that talked about really focusing on overhead control and it’s been my sense over the last 12 months up until this quarter that this was maybe a little bit tougher to get at than you thought. This quarter was called out several times in the press release mentioning you’re going to talk more about productivity opportunities at Cagney, through in a comment about restructuring that might come along with the Folgers split which would enable some further overhead control, so if you can just talk a little bit maybe I guess first about what you started to realize in the last three months or what change in your ability to go after that overhead control and is it related to the step up in restructuring spending that started about six months ago.
AG Lafley: Lauren, first of all maybe we haven’t talked about it as much as we should have but we’ve been focused on it since 2000 and one of the issues we had back in 2000 was that our overheads had gotten too high. They peaked at near 20% of sales, I think the number was 19.8% we can confirm that that was it, and last year they were down in 6, 7 they were down to about 16.5%. Now obviously with, that’s our measure of SRAP okay, obviously with Gillette you know we’ve been driving a lot of overhead synergy and this is the third year of Gillette and as I said in my comments we’re going to, you know we’re going to beat the Gillette cost synergies and we’ll have more to say about that at Cagney. So I would say it’s the combination of being attentive to the general company position and then going through Clairol, Wella and Gillette that got us really focused on our overheads and the emphasis has been on productivity. Okay, we’ve been running about 5% to 6% a year improvement in productivity, that’s about twice, a little bit better than twice US industry average and we’re looking at ways to accelerate that over the next four to five years and we think we can do it. So I’ll just give you three specific examples. I think you know in R&D, okay at the beginning of the decade we started out spending about 4.8% of sales, you know, now despite a stronger pipeline, despite I would say in many cases category leading innovations, we’re running around 3.2% to 3.3% of sales. When we moved into global business shares services, those that bundle of costs was above 5% you know, we’re now running 2.8% or so. And then the third area of course is our whole market development operation. The reason we went to the market development operations were to be able to run a go to market operation that would be much more efficient and more affective. So we’ve been on it. We’re going to talk more about it at Cagney. It is going to be an engine of growth.
Operator: Your next question comes from Wendy Nicholson – Citigroup
Wendy Nicholson – Citigroup: I wanted to actually go back up to the gross margin line because I know it was something that you called out in your annual report last year that it was a focus for the company because your gross margins are I think across the board like below 50% of your competitors on an apples to apples basis and yet what we’re seeing from a lot of your competitors is actually gross margin expansion this year, yet yours are falling so it looks like you’ll end ’08 with a wider gap relative to your competitors set and it just doesn’t feel good and it doesn’t sound right and I understand the emerging market mix but at the same time you’d think that because emerging markets are largely I think the beauty businesses and the grooming businesses the gross margin drag shouldn’t be that bad. So I’m just wondering is there something going on from a sourcing perspective or is there something going on that is making you miss the mark on the gross margins pretty significantly. It just doesn’t’ sound right.
AG Lafley: Wendy first of all to ground us all in the facts on gross margins in our five biggest businesses, fabric care, blades and razors, feminine and baby which are 60% plus of our enterprise value sales and profits okay, we clearly have the best gross margin in fabric. We have the best gross margin in family. We have the best gross margin in hair and we have far and away the best gross margin in blades and razors so the only one of the top five that are the principle drivers of growth where we have a lower gross margin is baby which I think we’ve been pretty open and clear about and that is a function of our primary competitor having a stronger position in the pants segment of the market. On the, you know, so part of what you’re looking at in the overall gross margin number is our is the balance of our mix, it’s our business mix and we have ….
Clayt Daley: And we have been growing in not only in developing markets but also growing somewhat disproportionately in household side of the business so far this year.
AG Lafley: But if you compare our business mix to companies that are basically personal care companies or in you know higher margin segments of household that’s really what you’re looking at is mix. On the quarter to quarter progression you know frankly we want to get the pricing right before we move and I hope we explained that adequately but that really is our strategy and that is our plan and that is our practice. It works for us when you take pricing you want to make sure that the pricing sustains and I guess the last thing I would say is that we’re still focused like a laser on gross margin, it’s on most of our key businesses strategy and plan, documents and goals and it is a key driver of operating total shareholder returns so we’re going to definitely stay after that.
Clayt Daley: The other thing of course is our gross margin numbers include our restructuring and that’s another thing that might be an issue when you try to do side by side comparisons.
Operator: Your next question comes from [Ali Debache – Sandford Bernstein]
[Ali Debache – Sandford Bernstein]: I want to talk about beauty and pharma and personal health for a second, if you take beauty it doesn’t look like the underlying organic sales has grown but you really [inaudible] I thought it was about a point on SK 2, it sounds like from the press release and from what you said, hair care is suffering. First question is I really want to understand that, what are you going to do to fix hair care and then on pharma and personal health, particularly given the poor cold and flu season I want to understand how we should expect that going forward particularly given as I would assume there was probably a channel fill quote unquote in front of the season, so both beauty and pharma and personal health really on organic sales please.
AG Lafley: Unfortunately people have not been getting sick at a rate that we would all like yet. Look beauty is fairly straight forward. We actually did improve our organic sales growth rate by a point, it was 4% I believe in July-September, it’s 5% in this quarter and beauty will continue to strengthen going forward because frankly the timing of our innovation and initiatives, we just have a stronger innovation and initiative program in the first half, I’m sorry in the second half of the fiscal year, sorry first half of the next calendar. Second point about beauty is you just have to, it’s a tale of two cities, our skin care business is fine, our fragrance business is fine, our cosmetics business is relatively doing pretty okay, and even in hair. You know we’re growing share globally and in the US we’re growing share in hair on the past six and 12 month basis, we had a little bit of a drop off in the last three months and in hair, Head & Shoulders is find, Herbal is fine, Aussi, everything’s fine except for Pantene US and we’re focused like a laser on Pantene US. We didn’t get as much lift off of the last major initiative as we hoped we would. And we will be out with improved Pantene, strengthened Pantene programs for the US in the semester and year ahead. But there are a lot of good things going on in hair around the world. The other thing two things that are impacting hair are in the salon business we put Robert Yongstra into that business and we’re just absolutely positively going to get the cost structure right, you know, before we put our foot in the accelerators so we’re still working through making our strategic choices, getting our structure right before we make significant investments in the salon side and then finally and I think you know this, we’ve just announced Perfect 10 in the retail colorants side and our principle competitor has been defending for months so we’re just beginning to ship so none of that has appeared in the first half of the year. That is by the way the first major product upgrade in this category in decades. So we’ve obviously got to get it tried. But that’s really the issue in hair care. I don’t think we have a, we’re at any fundamental competitive advantage; I think it’s more about the timing of our programs and that will come back. Pharma we had a pretty okay quarter, total personal health care we actually had a pretty good quarter. You’re right the flu season and cold season hasn’t hit yet. I guess I’d leave it there.
Operator: Your next question comes from Jason Gere - Wachovia Capital Markets
Jason Gere - Wachovia Capital Markets: You were talking earlier about you haven’t seen private you know consumers trading down to private label but just I guess going on to the last question that Ali asked especially in hair care seeing that Pantene’s a little bit soft but some of your mid tier brands are doing better, can you just talk about maybe what you’re anticipating with consumers trading down within the P&G category, which categories and then can you talk about that maybe from a profitability standpoint, is that a slight negative or would that really be more of a neutral.
AG Lafley: Hair is really not about trading down at all, hair is about benefits and hair’s about new and hair is about you know bringing new benefits and bringing new products. Head & Shoulders which we premium price in a lot of markets and some markets around the world above Pantene is doing phenomenally well okay, so that’s not really the issue. Herbal is not doing terrifically well because of the price point. It was at that price point prior to the relaunch, the whole new product line, the repositioning of the brand. So you know, no hair is not [poofing] to private label. Hair is very much a branded category and it’s very much a product innovation and news driven category. The only places, you know frankly one of the places where private label is relatively strong is in the coffee business. You know I think its no secret that private label is relatively stronger in food and beverages businesses than it is in household and personal care businesses. On the household side the private label shares are a bit higher in the paper businesses but they haven’t been growing. You know, they haven’t been growing and that’s the key. You know if you look at baby care, it’s basically been P&G and KC that have been growing. If you look at family care you know it’s been the big branded players that have been growing in the principal markets. And I think that’s important. And what that means is that we’re keeping our price gaps manageable so we represent a good value to consumers and frankly we’re bringing a lot of innovation in those businesses that can be when you don’t bring the innovation and keep your price gap sharp more susceptible to private label.
Operator: Your next question comes from [Philippe Gusons - Credit Suisse]
[Philippe Gusons - Credit Suisse]: Actually a follow-up questions on AG’s earlier comment on the beauty business, AG we’re seeing a significant step up in your marketing and advertising initiatives particularly for Pantene in such countries as Brazil and Argentina, to what extent does that reflect a more competitive environment or is it more a concentrated effort on behalf of P&G to make a renewed push in the hair care category in that part of the world and should we more importantly see that within the broader context of trying to accelerate the organic volume growth within the beauty category.
AG Lafley: Philippe you ask a good question, we’re obviously continuing to move into developing markets where there’s a promising or existing attractive hair care business and the southern cone is one. Argentina was essentially our test market or lead market for the southern cone. If you followed that market we’ve done quite well there. Pantene has been quite a success there. And so we have turned our attention to, one we’re continuing to drive our position in Argentina and we’ve begun to run a lead market in Brazil and it’s off to a very good start. But there’s, the one thing I will say about hair and beauty and personal care in developing markets, there is a lot of room to grow because you’re getting a fair amount of consumption and market growth so you’re getting growth in the basic categories, you’re getting growth in regimen and they’re just fruitful areas and we I think as you know have been a little bit later to some of those markets and now we have the brands and the products and the sourcing and therefore the value equation that we think can succeed there and we’re seeing early success.
Operator: Your next question comes from Nik Modi – UBS
Nik Modi – UBS: Just a quick question on emerging market consumers, is consumption driven by GDP growth or is it just a GDP per capital threshold. If you can just give us some perspective on that.
AG: I would say its both although clearly the take off trigger tends to be household income. It tends to be household income and we know with some degree of certainty what the household income triggers are for different household and personal care categories. But most of the big developing markets that are driving most of the growth have gotten well beyond the thresholds at least in the cities, okay at least in the cities and I mean not just the largest cities but large cities and medium sized cities and one of the little known facts, our biggest customer is high frequency stores. So all of these small stores in developing markets are the biggest share of our business and they’re growing comfortably at double-digits as you might expect since developing markets are growing at double-digits and even a market like Mexico still half of the turnover, half of our turnover is in these high frequency stores that’s developed as the, as up the trade is. You know market growth has continued strong across developing markets and its running sort of on average across our household and personal care categories at high single-digits.
Lafley: I would say its both although clearly the take off trigger tends to be household income. It tends to be household income and we know with some degree of certainty what the household income triggers are for different household and personal care categories. But most of the big developing markets that are driving most of the growth have gotten well beyond the thresholds at least in the cities, okay at least in the cities and I mean not just the largest cities but large cities and medium sized cities and one of the little known facts, our biggest customer is high frequency stores. So all of these small stores in developing markets are the biggest share of our business and they’re growing comfortably at double-digits as you might expect since developing markets are growing at double-digits and even a market like Mexico still half of the turnover, half of our turnover is in these high frequency stores that’s developed as the, as up the trade is. You know market growth has continued strong across developing markets and its running sort of on average across our household and personal care categories at high single-digits.
Operator: Your next question comes from Joseph Altobello - Oppenheimer & Co.
Joseph Altobello – Oppenheimer & Co. : Just wanted to continue on with Nik’s question here in terms of the developing markets. If we do enter a period of decelerating growth in the US how much do you think that would impact consumption in some of these developing markets given that these markets are typically export economy is pretty reliant on the US for a lot of their incomes.
Clayt Daley: I don’t think it’s going to have that much of an impact in our businesses. I think it could potentially similar to what we’ve seen in the US our categories have stayed relatively strong and whereas some of the higher ticket items have softened and we would not expect that if consumption of imported goods from developing markets into the United States would trigger a change in market growth in our businesses in those developing markets. But that one’s very difficult to kind of try to square.
AG Lafley: Even if you look at the US economy over the last three to six months most of the consumption from borrowing more on your home went into discretionary items, went back into the home, went into electronics, went into more vacations, went into eating out more often. People are not reducing tooth brushing incidents, they are not going to the bathroom less often, they are not shaving meaningfully less often and there it’s a style issue, it’s not a consumption issue. Most of our business is staple. Even on the personal care side, I mean there was, there’s some discretion, we watch duty free stores in fragrances because that’s an early indicator but it’s a tiny bit of our business. Cosmetics is another area that, color cosmetics that everybody watches and you see a little bit, okay of fall off in consumption but for the most part, skin care has become a staple. Hair care has become a staple. So we’re for the most part in staple businesses. The one thing I would say about developing markets is there’s another issue and that’s whether the habit’s formed. So part of it’s driven by the economic side, part of it’s driven by habit formation. If the habit’s formed and it’s still affordable and our products are very affordable in developing markets then we’re okay. If the habit’s not formed then it could be an issue but I can’t think of any major category where we don’t have good habit formation right now.
Clayt Daley: And the other thing too is all the stuff that we, our stuff is relatively low labor content. So as I said, I just don’t see this as being a major factor.
Operator: Your next question comes from William Chappell - Suntrust Robinson Humphrey
William Chappell - Suntrust Robinson Humphrey: I’ve got a two part question here, first just an update on compaction, maybe a little more color on what you guys expect in terms of gross margin expansion in the next year as a function of the program and then second part of the question is just maybe an update on the battery business, what were the improvements and what drove the improvements and maybe how that affects, how you guys view the business going forward on a sustainable basis.
AG Lafley: Batteries is pretty straight forward. Better branding, better marketing, better merchandising, better execution in store….
Clayt Daley: And better integration of the battery business into the P&G MDO operations.
AG Lafley : And we still see Mark’s team at Duracell and now plugged in more tightly to the whole household care business with Dimitri; we still see some pretty promising upside on Duracell.
Clayt Daley: On laundry compaction it’s just so far so good. I mean the southern wave has gone well. We’ve just begun shipping the second wave and you know when we look at the market shares we look at the market size, I think the execution on the part of our organization has been brilliant and its as I say, so far so good.
AG Lafley: We’re growing the category; we’re getting consistent share growth. We just started shipping the second wave, we’re looking forward to it delivering as we expect.
Operator: Your next question comes from [Alice Longley – Buckingham Research]
[Alice Longley – Buckingham Research]: You gave us the growth rates all retailers included in the US and Western Europe, could you quantify what the slowdown has been compared to trailing 12 months and also we understand that you’re gaining share but how fast did you grow in these two regions in this period and have you slowed?
Clayt Daley: Well AG already commented about North America, I would say the market growth in North America has slowed by maybe 1% on a dollar basis. It has slowed a little bit more on a unit volume basis. And so our growth rate in these markets exceeded market growth more in the US than Western Europe, our growth rate in Western Europe was pretty close to the market growth rate.
AG Lafley: Otherwise we reported Alice, we’re still growing share on the majority of our businesses in Western Europe. No our growth rate in the US was 6%; our growth rate in Western Europe was lower single-digits.
Operator: And with that we’ll conclude our question and answer session, gentlemen I’ll turn the conference back over to you.
Clayt Daley: Thanks very much everybody for being with us today and as I said at the outset we’ll be around for the rest of the day to handle any follow-up questions you have. Thanks a lot. | [
{
"speaker": "Executives",
"text": "Clayt Daley – CFO AG Lafley – CEO Jon Moeller - Treasurer"
},
{
"speaker": "Analysts",
"text": "William Schmitz - Deutsche Bank John Faucher - JP Morgan [Analyst] - Morgan Stanley Amy Chasen - Goldman Sachs Justin Hott - Bear Stearns Lauren Lieberman - Lehman Brothers Wendy Nicholson – Citigroup [Ali Debache – Sandford Bernstein] Jason Gere - Wachovia Capital Markets [Philippe Gusons] - Credit Suisse Nik Modi – UBS Joseph Altobello - Oppenheimer & Co. William Chappell - Suntrust Robinson Humphrey [Alice Longley – Buckingham Research]"
},
{
"speaker": "Operator",
"text": "Good day everyone and welcome to the Procter & Gamble second quarter 2008 conference call. Today’s discussion will include a number of forward-looking statements. If you will refer to P&G’s most recent 10-K and 8-K reports you will see a discussion of factors that could cause the company’s actual results to differ materially from these projections. As required by Regulation G P&G needs to make you aware that during the call the company will make a number of references to non-GAAP and other financial measures. Management believes these measures provide investors valuable information on the underlying growth trends of the business. Organic refers to reported results excluding the impact of acquisitions and divestitures and foreign exchange where applicable. Free cash flow represents operating cash flow plus capital expenditures. P&G has posted on its website www.pg.com a full reconciliation of non-GAAP and other financial measures. Now I’d like to turn the call over to P&G’s Chief Financial Officer Clayt Daley. Please go ahead."
},
{
"speaker": "Clayt Daley",
"text": "Thanks and good morning everyone. AG Lafley our CEO and Jon Moeller our Treasurer join me this morning. I’ll begin with a summary of our second quarter results and Jon will cover business highlights by operating segment. I’ll then provide some perspective on our announcement this morning to exit the coffee business and I’ll also provide an updated outlook for the fiscal year and our expectations for the March quarter and then AG is going to wrap up with a few comments at the end. Following the call Jon Moeller, Chris Peterson, John Chevalier and I will be available for additional perspective as needed. Now on to our results. We maintained good momentum in the second quarter of the fiscal year. We delivered balanced to and bottom line growth with each geographic region and every reportable segment delivering year on year organic sales growth. Earnings per share for the December quarter increased 17% to $0.98. This was $0.01 ahead of both the consensus estimate and the top end of our going and expectations. EPS growth was driven by strong sales growth and continued Gillette synergy benefits. Total sales increased 9% to $21.6 billion. This was above the top end of our guidance range driven by solid volume growth and better than expected foreign exchange benefits. Organic volume was up 6% for the quarter and organic sales were up 5%. Developing markets set the pace with double-digit organic volume and sales growth. Baby and Family Care led the segments with 8% organic sales growth due to strong initiative performance on Pampers, Charmin and Bounty. Price mix had a negative 1% impact on sales growth due to negative mix from strong developing market growth. Now before I move on I want to address some of the questions that have been raised investors recently relative to the consumer and specifically market growth rates in the US and various markets around the world. You know the recent US FD market and share data has raised some concerns as to where the consumer is in the market. Recall this data only covers 40% to 50% of the US market. The picture on all outlet basis is much more encouraging. The US market continues to grow 2% to 3% on an all outlet basis with non track channels growing significantly faster than track channels. As we said on the last call, while we have seen a modest slowdown in US market growth rates, we are not seeing trade down to private label. In fact over the past three months P&G is growing share in about 75% of the US business while private label shares flat or declining in every one of our top 10 categories and the vast majority of the total categories in which we compete. In Western Europe the market continues to grow 1% to 2%. P&G is growing market share overall and in the majority of categories in which we compete. In developing markets, market growth rates of high single-digits are consistent with prior periods. We have seen no evidence of a slowdown in the consumer products industry. Global market share trends continue to be strong with about a two-thirds of our business growing share. So in net, market growth rates continue to be about 3% to 4% on a global basis and P&G continues to grow market share and we are really not seeing any trade-down in the marketplace. Now earnings and margin performance. Operating income increased 8% to $4.7 billion driven by strong sales growth. Operating margin was down 20 basis points due to lower gross margins. Gross margin was down 110 basis points to 51.8%. Higher commodity and energy costs reduced gross margins by over 150 basis points. This was partially offset by volume leverage and cost savings projects. Commodity energy cost increases were higher than originally anticipated. Diesel fuel, phosphates and resins, just to name a few, increased significantly during the quarter. To offset this significant commodity and energy cost pressure we have announced a number of price increases which go into affect during the Jan-March quarter. As such we expect gross margin [tens] to improve sequentially going forward. Selling, general and administrative expenses were down 90 basis points; strong cost control and Gillette synergy benefits drove significant improvement in overhead costs. Lower overhead costs as a percent of sales more than offset higher marketing spending. Non operating income was up versus a year ago in line with previous guidance due to the closing of the western European Tissue, Towel divestiture. However we continue to expect non operating income to be lower as a percentage of earnings for fiscal ’08 compared to the prior year. The tax rate for the quarter came in at 27.6%. This was slightly lower than anticipated due to geographic mix. Recall, international tax rates are significantly lower than the US. We had a higher percentage of our business outside the US due to both strong developing market growth and a stronger than expected foreign exchange impact. This lowered the tax rate for the quarter. Now let’s turn to cash performance. Operating cash flow in the quarter was $4.1 billion up $1.7 billion from the same period last year. This marks the first time P&G has delivered operating cash flow above $4 billion in a quarter. The improvement was due to earnings growth and good working capital management. Working capital was a significant cash help in the quarter versus year ago. Receivables were down two days versus year ago despite a stronger foreign exchange due to the Gillette integration benefits and a high base period comparison. Inventory days were up one day versus year ago due primarily to foreign exchange and payables were down a day as we took better advantage of supplier term discounts. Capital spending was $650 million in the quarter or 3% of sales well below the company’s 4% annual target. Pre cash flow for the quarter was $3.5 billion. This brings free cash flow productivity to 97% fiscal year to date, well ahead of our year ago level of 75%. This puts us on pace to beat our free cash flow target for the fiscal year. We repurchased 2.9 billion of P&G stock during the December quarter as part of our three year $24 billion to $30 billion share repurchase program. This brings fiscal year to date repurchases to $5.5 billion. Combined with the $2.3 billion in dividends P&G distributed nearly $8 billion to shareholders fiscal year to date or 120% of net earnings. To summarize P&G continues to drive balance top and bottom line growth. We are converting a significant amount of earnings to cash and we are returning this cash to shareholders through dividends and share repurchase. Now I’ll turn it over to Jon for a discussion of our business segment results."
},
{
"speaker": "Jon Moeller",
"text": "Thanks Clayt. Starting with the Beauty segment, all end sales grew 10% and organic sales were up 5%. The sequential improvement in organic sales was consistent with expectations shared on the last quarterly call. Top line growth was led by the Prestige Fragrance and Skin Care businesses. In Fragrances, double-digit sales growth was driven by the Dolce and Gabbana and Hugo Boss brands. In Skin Care organic sales grew double-digits. Olay sales were up double-digits driven by the Definity Eye Illuminator initiative and the continued growth of the Regenerist franchise behind the Microsculpting Cream initiative. Olay all outlet value share of US Facial Moisturizers grew to over 42% for the past three months. Hair Care volumes were up low single-digits, Head & Shoulders grew double-digits behind brand restage initiatives in several markets which more than offset lower shipments for professional hair care. Grooming segment sales increased 9% for the quarter. Organic volume was up 8% as developing markets grew nearly 20%. Organic volume in developed markets was up low single-digits. In developed markets Braun appliance shipments were down versus prior year and Blades and Razors growth was impacted by a strong base period that included the Fusion launch in several western European markets. This geographic SKU in shipments resulted in negative sales mix for the quarter. Blades and Razors global shipments were up double-digits for the quarter. Global Blades and Razors value share has increased nearly a point and is now over 71% in a market growing 5% on a value basis and constant dollars. In Male Shaving, Fusion continues to drive strong share growth. Gillette’s global share of male razors up almost three percentage points to nearly 75%. Global share of male cartridges is approaching 86%. And Fusion share of US male cartridges is now over 34% up eight points versus prior year. In female razors, Venus Breeze share of US female razors is now at nearly 25% and total Venus system share is up nearly four points to over 53%. Health Care sales increased 11% led by double-digit growth in Oral Care, Feminine Care and Personal Health Care. Oral Care shipments were up 9% versus prior year behind mid teens growth on Oral-B and mid single-digit growth of Crest. Oral-B grew behind the Smart Guide Brush initiative, ongoing leverage of Oral-B Triumph and strong results in refills. Crest was driven by the launch of Pro Health Night and Crest Plus Scope with Extra Whitening Toothpaste. P&G’s estimated US all outlet value share for Crest Toothpaste is now at 38% up a point versus last year. Developing markets also delivered strong growth with double-digit shipment increases for the quarter. Feminine Care organic volume was up high single-digits. Developing markets led the growth with a double-digit volume increase. On a global basis, Always brand shipments were up high single-digits and the Naturella brand was up more than 20%. In the US all outlet value share for pads, panty liners and tampons improved for the quarter. Share of pads now stands at 57%, tampons at 51% and liners at 32%. In Personal Health Care higher sales were driven mainly by the addition of the Swiss Precision Diagnostics business. Organic shipment volume increased modestly for the quarter as mid teens growth on Prilosec OTC was largely offset by lower volume on Vicks due to the record mild cold and flu season. Pharma Sales were up as geographic mix, pricing and foreign exchange benefits more than offset the impact of lower shipments. Volume was lower versus prior year due mainly to a base period that included very strong western European shipments. Sales for the Snack, Coffee and Pet segment were up 4% for the quarter. The Snacks and Coffee businesses each delivered high single-digit sales growth. The strong Snacks results were driven by the Pringles Minis, Selects, Extreme Flavors and Rice and Fusion initiatives. Coffee sales growth was driven by the Dunkin’ Donuts launch and Folgers new Black Silk and House blend initiatives. Folgers all outlet value share in the US is up versus prior year and now stands at 32%. Dunkin’ Donuts coffee has reached 4% value share in just five months since launch. Pet Care was down versus the prior year due mainly to the temporary discontinuation of most wet pet foods. The business began the relaunch of wet foods in December. Encouragingly Iams dry food sales have returned to levels achieved prior to when the wet food issues occurred last March. Next the Fabric and Home Care segment delivered 10% total sales growth and f5% organic sales growth. Fabric Care global shipment volume was up high single-digits let my developing markets up double-digits behind strong growth of both Tide and Ariel. Fabric Care shipments in North America increased high single-digits behind the Tide, Downy and Bounce Pure Essentials initiative and the continued success of the liquid laundry detergent compaction initiatives. The conversion to compacted detergents has gone very well in the southern tier of the US and we are reapplying the most successful executions in the remaining conversions. Past three month US all outlet value share for P&G laundry detergents increased one point to nearly 63% of the market. Home Care shipments grew low single-digits. Febreze volume was up mid teens behind the launch of Febreze Candles and continued growth of air effects. Febreze share of the air care market including candles was up more than three percentage for the quarter to over 20%. Dish Care shipments were in line with prior year as Dawn and Cascade were comparing against very strong results in the base period. US value share for Dish Care was up modestly for the quarter. Batteries volume was up double-digits behind strong results from holiday merchandising programs and a favorable base period comparison due to supply constraints in the US. Shipments were up double-digits in both developed and developing markets. Duracell all outlet value share in the US was up more than a point versus prior year to 48%. Baby Care and Family Care all end sales grew 8% and organic sales growth was also up 8%. Organic shipment volumes were up double-digits for Baby Care and mid single-digits for Family Care. All end results for the segment were negatively impacted by the divestiture of the western European Family Care business which closed on October 1, 2007. Baby Care growth was due mainly to the ongoing success of Pampers Baby Stages Swaddlers and Cruisers products and Pampers Baby Dry with Caterpillar Flex. In the US Pampers value share is up a point to nearly 30% and in Western Europe value share is in line with prior year at 54%. Pampers also continues to deliver strong growth in developing markets. Shipments in China and Turkey were up more than 30% and Russia and Poland were up double-digits. Family Care top line growth was driven by the success of the new Charmin Ultra Strong innovation and leverage of the Best Bounty Ever initiative. Charmin all outlet value share is up a point to over 27% and Bounty share is also up a point versus prior year to 43%. That concludes the business segment review and now I’ll hand the call back to Clayt."
},
{
"speaker": "Clayt Daley",
"text": "Thanks Jon. As part of our ongoing portfolio review process we announced this morning plans to exit the coffee business. The coffee business had sales of approximately $1.6 billion and operating income of about $350 million in fiscal 2007. Our goals in this transaction are maximizing value to P&G shareholders, minimizing earnings per share dilution and executing the transaction in a tax efficient manner. Although no decision has been made given these goals, the most likely structure is a split off transaction. This transaction has several benefits for P&G shareholders. It enhances P&G’s ability to consistently deliver annual financial goals as the expected growth rate of the coffee business is below P&G’s target range. It optimizes the after tax value of the coffee business to our shareholders. And it enables P&G to better focus its resources on faster growing categories. The transaction will also be good for the coffee business as it will get greater and attention as a stand alone company. Folgers is the leading retail coffee brand in North America. The coffee business operates with attractive operating margins and is a strong cash generator. While we could do either a split off or a spin off transaction based on current market conditions our preference is to do a split off. As this transaction structure minimizes EPS dilution. In a split off P&G shareholders will be given the option to exchange some, none or all of their P&G shares for shares in the newly formed coffee company. P&G’s outstanding share count would be reduced by the number of P&G shares exchanged. If we proceed with the split off the precise exchange ratio would be set prior to the completion of the share exchange transaction. We expect to determine the final deal structure during the April-June quarter and complete the transaction during the first half of next fiscal year. Assuming a split off we expect the deal to be dilutive to EPS by $0.03 to $0.05 on an annual basis. In addition there will be one-time impacts. P&G would recognize the significant one-time gain from the transaction. This gain would be partially offset by one-time transition costs and a one-time increase in restructuring spending associated with eliminating stranded overhead costs and offsetting the anticipated $0.03 to $0.05 dilution. We will provide more specific estimates on these amounts once we decide the final transaction structure. Given this time, we do not expect the transaction to affect fiscal 2008 EPS. For fiscal 2009 while we have not completed our planning process, our objective remains to deliver 10% or better EPS growth despite the loss of the coffee earnings, of course excluding the one-time transaction impacts. Now on to guidance. There are a few factors that have changed since we provided our fiscal year outlook last quarter. Commodity and energy costs have increased significantly over the past few months. At current levels we now expect these costs to impact gross margins by about 150 basis points in fiscal 2008. Given this increase in input costs we have announced a number of price increases which take affect over the next few months. Last quarter we announced pricing plans for coffee, fabric softeners, personal cleansing, tissue, towel, diapers and blades and razors. Since that time we have announced new pricing in the US as follows. Affective this month, a 6% increase on Eukanuba Dry Dog Food and Biscuits. An 8% increase on Ascaol. In affective in March, 2008 a 6% increase on Cascade, a 6% increase on powder laundry detergents, 6% on Iams Dry Dog Food and an 8% increase on Safeguard and Zest bar soaps. And we continue to evaluate pricing in other parts of the business. Importantly as we have implemented pricing actions to recover commodity and energy costs in almost every case competitors including private label manufacturers have also increased their prices. As they have the same commodity and energy cost pressures we do. As such we have been able to implement these modest price increases without negatively affecting category consumption or P&G’s market share progress. In total we still expect operating margin improvement in fiscal year despite higher input costs. Pricing, volume leverage, costs savings projects and overhead cost control should more than offset the increase in commodity and energy costs. Now the numbers, for fiscal 2008 we expect organic sales growth of 4% to 6% in line with previous guidance. With this we expect the combination of pricing and mix to be flat to up 1%. Foreign exchange should have a positive impact of about 4%. Acquisitions and divestitures are expected to have a 1% negative impact on top line results. So in total, we expect all end sales growth of 7% to 9% for the year. This is an increase of 1% versus our previous guidance due to the increase foreign exchange outlook. Turning to the bottom line, we are now expecting earnings per share to be in the range of $3.46 to $3.50 up 14% to 15% versus prior year. This is an improvement versus our previous guidance range of $3.46 to $3.49 due to the strong EPS results in the October to December quarter. We now expect operating margins to improve by 25 to 50 basis points as lower overhead costs as a percent of sales should more than offset the gross margin impact from higher commodity and energy costs. We have lowered our operating margin guidance to reflect the increase in input costs and any revised foreign exchange outlook. A greater contribution from non-US markets due to foreign exchange affects operating margins as the US business has a significantly higher operating margin than the international business. On the tax rate, we now expect the fiscal year to be at or slightly below 28%. This is a slight change versus prior guidance due to updated outlooks for foreign exchange and geographic sales mix. We continue to expect share repurchases of $8 billion to $10 billion for the fiscal year as such we expect interest expense to be up due to increased debt levels. Turning to the March quarter, organic sales are expected to grow in the 4% to 6% range. With this we expect the combination of price and mix to be about neutral. Foreign exchange should add about five percentage points to sales; acquisitions and divestitures are expected to have a negative 1% impact on P&G’s top line growth. In total we expect all end sales growth of 8% to 10%. Turning to the bottom line, we expect operating margins to improve modestly as SG&A improvement will largely be offset by lower gross margins. Gross margins are expected to be temporarily lower due to higher commodity and energy costs. We expect gross margins to recover as pricing plans are implemented in the market. In total operating profit is expected to accelerate to double-digits in the quarter. Interest expense is expected to increase substantially versus year ago due to a low base period comparison. And we expect non operating income to be significantly lower versus year ago due to the timing of minor divestitures. Finally the tax rate for the quarter is estimated to be at or slightly below 28%. Net we expect earnings per share to be in the range of $0.79 to $0.80 for the quarter driven by double-digit operating profit growth. To summarize P&G continues to deliver balanced top and bottom line growth. We are converting earnings and free cash flow ahead of target and returning more than 100% of this cash to shareholders through share repurchase and dividends. And we are confident in our sustainable growth model going forward. Now I would like to hand the call over to AG for a brief wrap up."
},
{
"speaker": "AG Lafley",
"text": "Thanks Clayt. I want to take this opportunity to thank all the P&G people in our Coffee organization for all the hard work they have put into making Folgers the leading brand in retail coffee by a wide margin and creating a growing profitable business. Decisions to separate a business are never easy but we believe this is in the best interest of P&G shareholders. This is one more step, the next step, in the transformation of P&G’s portfolio and business model that we have been driving since the beginning of this decade. Over this period we have doubled the size of the company, diversified into Beauty, Health, Personal Care and developing market, and accelerate the average annual organic sales growth rate to 6%. Market shares have grown in virtually all of our core categories, in some significantly. Core operating margins have grown steadily from below 16% to now over 20%. Cash productivity has run consistently above 90% of earnings. We now generate over $10 billion in free cash flow every year which we have been aggressively returning to shareholders. This year we will complete the successful integration of the largest consumer products goods acquisition in history. Gillette will over deliver cost synergies and revenue synergies are on track with our year three goal. Most importantly Gillette will be an engine of growth for P&G and a significant contributor to strengthening company capabilities and the P&G organization around the world. So how have we done this? We’ve stayed focused. Focused first and foremost on the consumer as the real boss here. We deliver better consumer shopping and usage experiences and we build value into our brands and our product offerings. We partner with customers and with suppliers to serve consumers better and to create value together. We stay strategically focused on our core businesses, on our portfolio shift out of commodity like categories and into faster growing household and beauty, health and personal care categories. We continue to grow our developing market business at double-digit top and bottom line rates from less than $7 billion ten years ago to more than $22 billion today. By the end of this decade developing markets will approach $30 billion in sales and represent at least 30% of total company turnover. We play to our poor competencies and strengths. We continue to invest in consumer understanding. We lead innovation in most of our categories and we have built a strong multi year innovation pipeline. We continue to focus on brands that are or can become leaders in their category. Today our $23 billion brands represent two-thirds of our sales and a greater percentage of profits. Our 41 $.50 billion an up brands represent over 80% of sales and nearly 90% of profits. Going forward I’m confident we are well positioned to deliver growth goals over the long term and in the current economic environment. We have the right portfolio that is uniquely diversified and balanced across household and personal care businesses and across developed and developing geographies. Our unique combination of leadership and strength in both developing markets and the US home market will serve us well in any economic environment. We have the right strategies with plenty of room to keep growing and we have the right core strengths to keep P&G growing reliably year after year. In our industry innovation and productivity are the ultimate drivers of sustainable growth. This is particularly true in the current economic and cost environment we are facing. We look forward to seeing our investors at Cagney next month. At that time we will talk more about P&G’s innovation pipeline including Gillette revenue synergies and we will also talk about specific plans to drive productivity further and faster. Innovation and productivity will allow us to grow top and bottom line in a balanced and sustainable way through the end of this decade and into the next. Now Clayt, Jon and I are open to answer any questions. Thank you."
},
{
"speaker": "Operator",
"text": "Your first question comes from William Schmitz - Deutsche Bank"
},
{
"speaker": "William Schmitz - Deutsche Bank",
"text": "Hey Clayt you mentioned that there’s 150 basis points of gross margin pressure from input costs, but it also seems like the business mix obviously has migrated more to developing markets, have you quantified how much mix impact there is as the business migrates more to developing markets as the developed markets slow a little bit?"
},
{
"speaker": "Clayt Daley",
"text": "We haven’t quantified it but I think you’re assumption here is accurate that as the business shifts to developing markets, you’ve seen the negative 1% on the top line on price and mix and that’s mostly due to mix and it’s mostly due to developing markets. At the end of the day when business shifts to developing markets that’s a drag on gross margin because the gross margins in developing markets are lower, and actually the operating margins are also lower but as we’ve said before after tax margins are about comparable in developing markets to develop but that’s one of the reasons why you see the tax rate go down. So I think you are exactly on the right point."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Faucher - JP Morgan"
},
{
"speaker": "John Faucher - JP Morgan",
"text": "Quick question, I was kind of surprised to see the negative price mix number given the raw material inflation that you talked about and so did you hold off on some of this pricing knowing that you had the other income line to sort of cushion that and I guess furthermore on sort of the gains on sales issues, what are you going to do over the next couple of quarters as you begin to lap bigger numbers there without the asset sales, how are you going to be able to offset that impact?"
},
{
"speaker": "Clayt Daley",
"text": "It’s a good question. The timing of price increases really has no bearing to non operating income and there will be some variation from quarter to quarter in non operating income. We obviously had a lot of it in October-December quarter which we did guide for and it’s going to be substantially less in the Jan-March quarter which we are also guiding to. Relative to pricing what we try to do is make sure that as commodity prices and energy prices go up we’re confident that they’re being sustained. You want to go out with pricing when it’s quite clear that it’s a sustained industry phenomenon and as it turns out the price increases we’ve been announcing were not in effect in the October-December quarter so we got virtually no pricing benefit in October-December and that’s what created the gross margin impact. The price increases will begin to come in, in the Jan-March quarter but really much more in the April-June quarter. So that’s why we’re still projecting some gross margin contraction in Jan-March."
},
{
"speaker": "AG Lafley",
"text": "John, one more comment on pricing, we look at a number of factors. First what are the consumer and market conditions? Second of all we like to time our pricing with innovation because frankly it’s the value stays right for the consumer when we do that and it works better with most of our key customer strategies. We coordinate with customers. So beyond making sure that it’s sustained, we want to make sure that when we take the pricing that it’s the right level and that it will sustain at that level."
},
{
"speaker": "Operator",
"text": "Your next question comes from [Analyst] Morgan Stanley"
},
{
"speaker": "[Analyst] - Morgan Stanley",
"text": "Just wanted to get some more color on the 3Q versus 4Q earnings flow that you are talking about. I guess the consensus might have been underestimating the falloff in the non operating income in 3Q but also sounds like with the higher commodities you’ve got the price recovery shifting into 4Q which you were just discussing, but I wanted to make sure I understood the double-digit operating profit growth in Q3 despite gross margin down, you expect higher savings in the SG&A line than you had in the second quarter."
},
{
"speaker": "Clayt Daley",
"text": "Yes, that’s spot on. As we said we’re expecting double-digit operating profit growth in the Jan-March quarter but the bottom line is impacted by much higher interest expense and much lower non operating income and that’s just simply a timing impact of minor brand asset sales and yes as you know we hadn’t provided any impact of guidance on Jan-March prior to today so, it’s not surprising that the estimates on Jan-March were above where we’re coming out. But its then coming back just as you suggest in the fourth quarter which should be better on gross margin than in the third quarter and I think really the non operating phenomenon from quarter to quarter explains most of the variation."
},
{
"speaker": "Operator",
"text": "Your next question comes from Amy Chasen - Goldman Sachs"
},
{
"speaker": "Amy Chasen - Goldman Sachs",
"text": "Hi, what percentage of your business are you taking price increases on?"
},
{
"speaker": "AG Lafley",
"text": "Well over the last, let’s see, Amy I’m going to guess its 40% to 50% but we’re going to get you the hard number. And …."
},
{
"speaker": "Clayt Daley",
"text": "It’s a very high percentage of the household product side and a much lower percentage on health and beauty particularly beauty, but what we try to do in beauty is price with trade up and mix as opposed to list."
},
{
"speaker": "AG Lafley",
"text": "Yes, that’s the key point. On the household side it’s much more in fabric, in paper, in coffee, in snacks and even now in pet, it’s driven by commodities. On the beauty, health and personal care side frankly we’ve been mixing up on virtually all of our key categories on a regular basis as we bring new innovation. The other key part of the question is how much of the commodity cost and energy cost increases are we recovering and over the last three years or so when we’ve had the biggest increases, we’ve been recovering pretty consistently somewhere around 75% to 80% in pricing. We recover the rest of it on the cost side."
},
{
"speaker": "Operator",
"text": "Your next question comes from Justin Hott - Bear Stearns"
},
{
"speaker": "Justin Hott - Bear Stearns",
"text": "First a housekeeping item, I thought in the press release it said EPS was 79-81 for the next quarter and Clayt I thought you said 79-80."
},
{
"speaker": "Clayt Daley",
"text": "Okay no 79-81 is correct."
},
{
"speaker": "Justin Hott - Bear Stearns",
"text": "Okay thanks."
},
{
"speaker": "Clayt Daley",
"text": "If I said 80 I misspoke."
},
{
"speaker": "Justin Hott - Bear Stearns",
"text": "Maybe I got it wrong, and operating margins 25-50…"
},
{
"speaker": "Clayt",
"text": "Yes, 25-50."
},
{
"speaker": "Daley",
"text": "Yes, 25-50."
},
{
"speaker": "Justin Hott - Bear Stearns",
"text": "Okay just one major question on pricing, going from your comments Clayt and AG, please your insight would help anything on what we’re seeing with the consumer in this sort of environment that worries you more or less versus the past on your ability to take pricing in this environment?"
},
{
"speaker": "AG Lafley",
"text": "You know Justin I would say that first of all this will now be the third or fourth year in a row that we’ve had to do this. You have to remember oil didn’t run up from whatever it was $25 or so a barrel to $100 a barrel in the last quarter, okay, that’s been happening over several years and frankly with Katrina and Rita we saw the first big bump up in a number of our chemical commodities pricing and the AG commodity prices have been with us for some time so I would say the key is at least in our household categories, the key is the relatively modest, if you look at our increases they tend to be in the 4% to 6% occasionally a little higher, but generally in that range. The second thing that’s really important is we almost always price with innovation and price with initiative. It’s more difficult to take what we call a naked price increase. In some categories you can, consumers and customers are quite, you know that’s the practice in coffee for example, you know coffee pricing follows green bean pricing. But in May of the household categories you have to price with innovation and initiative and fortunately we’ve been leading innovation. So the strength of our household and paper innovation programs is helping us a lot as we go through this period. And then the third thing I will say is we watch our price spreads or gaps versus all of our competitors and I think as Clayt pointed out the last couple of years and especially most recently private label manufacture margins are so squeezed that they’ve had to price very quickly and in some cases, in some parts of the world, they’re pricing ahead of us. So I think we’re clearly in a situation where everybody is feeling the same commodity cost and energy cost pressure. We’ve actually you know relatively got a little bit more margin cushion. We can give a little gross margin in a quarter and manage through it so we get the timing right and we get the amount right. You know the last thing I’ll say, there are just certain indicators that we watch. How well do we do in channels that serve lower income consumers. You know we’ve been doing very well on the dollar channel. I don’t think it’s any secret that Wal-Mart has done relatively in the most recent period. We do very well with Wal-Mart. So we look at, we track our shares among our top 15 or 20 businesses that serve Hispanic Americans, African Americans who tend to be on average lower income, rural Americans, who tend to be on average lower income. Our shares are growing; you know two thirds sometimes, I think it was African Americans through December our shares have grown over 80% you know in those key brands. So we try to look at all the indicators. If the rebates come in okay, in May I think you know that will be a boost on the consumer spending side in the US and frankly we’ve just got a few months to get through to there and you know we look like as Clayt announced in the guidance we look like we’re going to stay pretty steady on the top line at our sort of 4% to 6% net sales organic growth rate. And in the US we did 6% organic growth in the most recent quarters so you know those are all the kinds of indicators, you know, I’m not going to tell you that there isn’t something out there that you know that we don’t miss, but we turn over every rock and every stone so we can try to stay close to this."
},
{
"speaker": "Operator",
"text": "Your next question comes from Lauren Lieberman - Lehman Brothers"
},
{
"speaker": "Lauren Lieberman - Lehman Brothers",
"text": "I want to talk a little bit about overhead control. It was last year at your Analyst Day you attended I can remember you guys putting up a slide that talked about really focusing on overhead control and it’s been my sense over the last 12 months up until this quarter that this was maybe a little bit tougher to get at than you thought. This quarter was called out several times in the press release mentioning you’re going to talk more about productivity opportunities at Cagney, through in a comment about restructuring that might come along with the Folgers split which would enable some further overhead control, so if you can just talk a little bit maybe I guess first about what you started to realize in the last three months or what change in your ability to go after that overhead control and is it related to the step up in restructuring spending that started about six months ago."
},
{
"speaker": "AG Lafley",
"text": "Lauren, first of all maybe we haven’t talked about it as much as we should have but we’ve been focused on it since 2000 and one of the issues we had back in 2000 was that our overheads had gotten too high. They peaked at near 20% of sales, I think the number was 19.8% we can confirm that that was it, and last year they were down in 6, 7 they were down to about 16.5%. Now obviously with, that’s our measure of SRAP okay, obviously with Gillette you know we’ve been driving a lot of overhead synergy and this is the third year of Gillette and as I said in my comments we’re going to, you know we’re going to beat the Gillette cost synergies and we’ll have more to say about that at Cagney. So I would say it’s the combination of being attentive to the general company position and then going through Clairol, Wella and Gillette that got us really focused on our overheads and the emphasis has been on productivity. Okay, we’ve been running about 5% to 6% a year improvement in productivity, that’s about twice, a little bit better than twice US industry average and we’re looking at ways to accelerate that over the next four to five years and we think we can do it. So I’ll just give you three specific examples. I think you know in R&D, okay at the beginning of the decade we started out spending about 4.8% of sales, you know, now despite a stronger pipeline, despite I would say in many cases category leading innovations, we’re running around 3.2% to 3.3% of sales. When we moved into global business shares services, those that bundle of costs was above 5% you know, we’re now running 2.8% or so. And then the third area of course is our whole market development operation. The reason we went to the market development operations were to be able to run a go to market operation that would be much more efficient and more affective. So we’ve been on it. We’re going to talk more about it at Cagney. It is going to be an engine of growth."
},
{
"speaker": "Operator",
"text": "Your next question comes from Wendy Nicholson – Citigroup"
},
{
"speaker": "Wendy Nicholson – Citigroup",
"text": "I wanted to actually go back up to the gross margin line because I know it was something that you called out in your annual report last year that it was a focus for the company because your gross margins are I think across the board like below 50% of your competitors on an apples to apples basis and yet what we’re seeing from a lot of your competitors is actually gross margin expansion this year, yet yours are falling so it looks like you’ll end ’08 with a wider gap relative to your competitors set and it just doesn’t feel good and it doesn’t sound right and I understand the emerging market mix but at the same time you’d think that because emerging markets are largely I think the beauty businesses and the grooming businesses the gross margin drag shouldn’t be that bad. So I’m just wondering is there something going on from a sourcing perspective or is there something going on that is making you miss the mark on the gross margins pretty significantly. It just doesn’t’ sound right."
},
{
"speaker": "AG Lafley",
"text": "Wendy first of all to ground us all in the facts on gross margins in our five biggest businesses, fabric care, blades and razors, feminine and baby which are 60% plus of our enterprise value sales and profits okay, we clearly have the best gross margin in fabric. We have the best gross margin in family. We have the best gross margin in hair and we have far and away the best gross margin in blades and razors so the only one of the top five that are the principle drivers of growth where we have a lower gross margin is baby which I think we’ve been pretty open and clear about and that is a function of our primary competitor having a stronger position in the pants segment of the market. On the, you know, so part of what you’re looking at in the overall gross margin number is our is the balance of our mix, it’s our business mix and we have …."
},
{
"speaker": "Clayt Daley",
"text": "And we have been growing in not only in developing markets but also growing somewhat disproportionately in household side of the business so far this year."
},
{
"speaker": "AG Lafley",
"text": "But if you compare our business mix to companies that are basically personal care companies or in you know higher margin segments of household that’s really what you’re looking at is mix. On the quarter to quarter progression you know frankly we want to get the pricing right before we move and I hope we explained that adequately but that really is our strategy and that is our plan and that is our practice. It works for us when you take pricing you want to make sure that the pricing sustains and I guess the last thing I would say is that we’re still focused like a laser on gross margin, it’s on most of our key businesses strategy and plan, documents and goals and it is a key driver of operating total shareholder returns so we’re going to definitely stay after that."
},
{
"speaker": "Clayt Daley",
"text": "The other thing of course is our gross margin numbers include our restructuring and that’s another thing that might be an issue when you try to do side by side comparisons."
},
{
"speaker": "Operator",
"text": "Your next question comes from [Ali Debache – Sandford Bernstein]"
},
{
"speaker": "[Ali Debache – Sandford Bernstein]",
"text": "I want to talk about beauty and pharma and personal health for a second, if you take beauty it doesn’t look like the underlying organic sales has grown but you really [inaudible] I thought it was about a point on SK 2, it sounds like from the press release and from what you said, hair care is suffering. First question is I really want to understand that, what are you going to do to fix hair care and then on pharma and personal health, particularly given the poor cold and flu season I want to understand how we should expect that going forward particularly given as I would assume there was probably a channel fill quote unquote in front of the season, so both beauty and pharma and personal health really on organic sales please."
},
{
"speaker": "AG Lafley",
"text": "Unfortunately people have not been getting sick at a rate that we would all like yet. Look beauty is fairly straight forward. We actually did improve our organic sales growth rate by a point, it was 4% I believe in July-September, it’s 5% in this quarter and beauty will continue to strengthen going forward because frankly the timing of our innovation and initiatives, we just have a stronger innovation and initiative program in the first half, I’m sorry in the second half of the fiscal year, sorry first half of the next calendar. Second point about beauty is you just have to, it’s a tale of two cities, our skin care business is fine, our fragrance business is fine, our cosmetics business is relatively doing pretty okay, and even in hair. You know we’re growing share globally and in the US we’re growing share in hair on the past six and 12 month basis, we had a little bit of a drop off in the last three months and in hair, Head & Shoulders is find, Herbal is fine, Aussi, everything’s fine except for Pantene US and we’re focused like a laser on Pantene US. We didn’t get as much lift off of the last major initiative as we hoped we would. And we will be out with improved Pantene, strengthened Pantene programs for the US in the semester and year ahead. But there are a lot of good things going on in hair around the world. The other thing two things that are impacting hair are in the salon business we put Robert Yongstra into that business and we’re just absolutely positively going to get the cost structure right, you know, before we put our foot in the accelerators so we’re still working through making our strategic choices, getting our structure right before we make significant investments in the salon side and then finally and I think you know this, we’ve just announced Perfect 10 in the retail colorants side and our principle competitor has been defending for months so we’re just beginning to ship so none of that has appeared in the first half of the year. That is by the way the first major product upgrade in this category in decades. So we’ve obviously got to get it tried. But that’s really the issue in hair care. I don’t think we have a, we’re at any fundamental competitive advantage; I think it’s more about the timing of our programs and that will come back. Pharma we had a pretty okay quarter, total personal health care we actually had a pretty good quarter. You’re right the flu season and cold season hasn’t hit yet. I guess I’d leave it there."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jason Gere - Wachovia Capital Markets"
},
{
"speaker": "Jason Gere - Wachovia Capital Markets",
"text": "You were talking earlier about you haven’t seen private you know consumers trading down to private label but just I guess going on to the last question that Ali asked especially in hair care seeing that Pantene’s a little bit soft but some of your mid tier brands are doing better, can you just talk about maybe what you’re anticipating with consumers trading down within the P&G category, which categories and then can you talk about that maybe from a profitability standpoint, is that a slight negative or would that really be more of a neutral."
},
{
"speaker": "AG Lafley",
"text": "Hair is really not about trading down at all, hair is about benefits and hair’s about new and hair is about you know bringing new benefits and bringing new products. Head & Shoulders which we premium price in a lot of markets and some markets around the world above Pantene is doing phenomenally well okay, so that’s not really the issue. Herbal is not doing terrifically well because of the price point. It was at that price point prior to the relaunch, the whole new product line, the repositioning of the brand. So you know, no hair is not [poofing] to private label. Hair is very much a branded category and it’s very much a product innovation and news driven category. The only places, you know frankly one of the places where private label is relatively strong is in the coffee business. You know I think its no secret that private label is relatively stronger in food and beverages businesses than it is in household and personal care businesses. On the household side the private label shares are a bit higher in the paper businesses but they haven’t been growing. You know, they haven’t been growing and that’s the key. You know if you look at baby care, it’s basically been P&G and KC that have been growing. If you look at family care you know it’s been the big branded players that have been growing in the principal markets. And I think that’s important. And what that means is that we’re keeping our price gaps manageable so we represent a good value to consumers and frankly we’re bringing a lot of innovation in those businesses that can be when you don’t bring the innovation and keep your price gap sharp more susceptible to private label."
},
{
"speaker": "Operator",
"text": "Your next question comes from [Philippe Gusons - Credit Suisse]"
},
{
"speaker": "[Philippe Gusons - Credit Suisse]",
"text": "Actually a follow-up questions on AG’s earlier comment on the beauty business, AG we’re seeing a significant step up in your marketing and advertising initiatives particularly for Pantene in such countries as Brazil and Argentina, to what extent does that reflect a more competitive environment or is it more a concentrated effort on behalf of P&G to make a renewed push in the hair care category in that part of the world and should we more importantly see that within the broader context of trying to accelerate the organic volume growth within the beauty category."
},
{
"speaker": "AG Lafley",
"text": "Philippe you ask a good question, we’re obviously continuing to move into developing markets where there’s a promising or existing attractive hair care business and the southern cone is one. Argentina was essentially our test market or lead market for the southern cone. If you followed that market we’ve done quite well there. Pantene has been quite a success there. And so we have turned our attention to, one we’re continuing to drive our position in Argentina and we’ve begun to run a lead market in Brazil and it’s off to a very good start. But there’s, the one thing I will say about hair and beauty and personal care in developing markets, there is a lot of room to grow because you’re getting a fair amount of consumption and market growth so you’re getting growth in the basic categories, you’re getting growth in regimen and they’re just fruitful areas and we I think as you know have been a little bit later to some of those markets and now we have the brands and the products and the sourcing and therefore the value equation that we think can succeed there and we’re seeing early success."
},
{
"speaker": "Operator",
"text": "Your next question comes from Nik Modi – UBS"
},
{
"speaker": "Nik Modi – UBS",
"text": "Just a quick question on emerging market consumers, is consumption driven by GDP growth or is it just a GDP per capital threshold. If you can just give us some perspective on that."
},
{
"speaker": "AG",
"text": "I would say its both although clearly the take off trigger tends to be household income. It tends to be household income and we know with some degree of certainty what the household income triggers are for different household and personal care categories. But most of the big developing markets that are driving most of the growth have gotten well beyond the thresholds at least in the cities, okay at least in the cities and I mean not just the largest cities but large cities and medium sized cities and one of the little known facts, our biggest customer is high frequency stores. So all of these small stores in developing markets are the biggest share of our business and they’re growing comfortably at double-digits as you might expect since developing markets are growing at double-digits and even a market like Mexico still half of the turnover, half of our turnover is in these high frequency stores that’s developed as the, as up the trade is. You know market growth has continued strong across developing markets and its running sort of on average across our household and personal care categories at high single-digits."
},
{
"speaker": "Lafley",
"text": "I would say its both although clearly the take off trigger tends to be household income. It tends to be household income and we know with some degree of certainty what the household income triggers are for different household and personal care categories. But most of the big developing markets that are driving most of the growth have gotten well beyond the thresholds at least in the cities, okay at least in the cities and I mean not just the largest cities but large cities and medium sized cities and one of the little known facts, our biggest customer is high frequency stores. So all of these small stores in developing markets are the biggest share of our business and they’re growing comfortably at double-digits as you might expect since developing markets are growing at double-digits and even a market like Mexico still half of the turnover, half of our turnover is in these high frequency stores that’s developed as the, as up the trade is. You know market growth has continued strong across developing markets and its running sort of on average across our household and personal care categories at high single-digits."
},
{
"speaker": "Operator",
"text": "Your next question comes from Joseph Altobello - Oppenheimer & Co."
},
{
"speaker": "Joseph Altobello – Oppenheimer & Co.",
"text": "Just wanted to continue on with Nik’s question here in terms of the developing markets. If we do enter a period of decelerating growth in the US how much do you think that would impact consumption in some of these developing markets given that these markets are typically export economy is pretty reliant on the US for a lot of their incomes."
},
{
"speaker": "Clayt Daley",
"text": "I don’t think it’s going to have that much of an impact in our businesses. I think it could potentially similar to what we’ve seen in the US our categories have stayed relatively strong and whereas some of the higher ticket items have softened and we would not expect that if consumption of imported goods from developing markets into the United States would trigger a change in market growth in our businesses in those developing markets. But that one’s very difficult to kind of try to square."
},
{
"speaker": "AG Lafley",
"text": "Even if you look at the US economy over the last three to six months most of the consumption from borrowing more on your home went into discretionary items, went back into the home, went into electronics, went into more vacations, went into eating out more often. People are not reducing tooth brushing incidents, they are not going to the bathroom less often, they are not shaving meaningfully less often and there it’s a style issue, it’s not a consumption issue. Most of our business is staple. Even on the personal care side, I mean there was, there’s some discretion, we watch duty free stores in fragrances because that’s an early indicator but it’s a tiny bit of our business. Cosmetics is another area that, color cosmetics that everybody watches and you see a little bit, okay of fall off in consumption but for the most part, skin care has become a staple. Hair care has become a staple. So we’re for the most part in staple businesses. The one thing I would say about developing markets is there’s another issue and that’s whether the habit’s formed. So part of it’s driven by the economic side, part of it’s driven by habit formation. If the habit’s formed and it’s still affordable and our products are very affordable in developing markets then we’re okay. If the habit’s not formed then it could be an issue but I can’t think of any major category where we don’t have good habit formation right now."
},
{
"speaker": "Clayt Daley",
"text": "And the other thing too is all the stuff that we, our stuff is relatively low labor content. So as I said, I just don’t see this as being a major factor."
},
{
"speaker": "Operator",
"text": "Your next question comes from William Chappell - Suntrust Robinson Humphrey"
},
{
"speaker": "William Chappell - Suntrust Robinson Humphrey",
"text": "I’ve got a two part question here, first just an update on compaction, maybe a little more color on what you guys expect in terms of gross margin expansion in the next year as a function of the program and then second part of the question is just maybe an update on the battery business, what were the improvements and what drove the improvements and maybe how that affects, how you guys view the business going forward on a sustainable basis."
},
{
"speaker": "AG Lafley",
"text": "Batteries is pretty straight forward. Better branding, better marketing, better merchandising, better execution in store…."
},
{
"speaker": "Clayt Daley",
"text": "And better integration of the battery business into the P&G MDO operations."
},
{
"speaker": "AG Lafley",
"text": "And we still see Mark’s team at Duracell and now plugged in more tightly to the whole household care business with Dimitri; we still see some pretty promising upside on Duracell."
},
{
"speaker": "Clayt Daley",
"text": "On laundry compaction it’s just so far so good. I mean the southern wave has gone well. We’ve just begun shipping the second wave and you know when we look at the market shares we look at the market size, I think the execution on the part of our organization has been brilliant and its as I say, so far so good."
},
{
"speaker": "AG Lafley",
"text": "We’re growing the category; we’re getting consistent share growth. We just started shipping the second wave, we’re looking forward to it delivering as we expect."
},
{
"speaker": "Operator",
"text": "Your next question comes from [Alice Longley – Buckingham Research]"
},
{
"speaker": "[Alice Longley – Buckingham Research]",
"text": "You gave us the growth rates all retailers included in the US and Western Europe, could you quantify what the slowdown has been compared to trailing 12 months and also we understand that you’re gaining share but how fast did you grow in these two regions in this period and have you slowed?"
},
{
"speaker": "Clayt Daley",
"text": "Well AG already commented about North America, I would say the market growth in North America has slowed by maybe 1% on a dollar basis. It has slowed a little bit more on a unit volume basis. And so our growth rate in these markets exceeded market growth more in the US than Western Europe, our growth rate in Western Europe was pretty close to the market growth rate."
},
{
"speaker": "AG Lafley",
"text": "Otherwise we reported Alice, we’re still growing share on the majority of our businesses in Western Europe. No our growth rate in the US was 6%; our growth rate in Western Europe was lower single-digits."
},
{
"speaker": "Operator",
"text": "And with that we’ll conclude our question and answer session, gentlemen I’ll turn the conference back over to you."
},
{
"speaker": "Clayt Daley",
"text": "Thanks very much everybody for being with us today and as I said at the outset we’ll be around for the rest of the day to handle any follow-up questions you have. Thanks a lot."
}
] | null | null |
PG | 1 | 2,008 | 2007-10-30 08:30:00 | Executives: A.G. Lafley - Chairman & CEO Clayt Daley - CFO Jon Moeller - VP & Treasurer
Analysts: Nik Modi - UBS Bill Pecoriello - Morgan Stanley John Faucher – JP Morgan Amy Chasen - Goldman Sachs Bill Schmitz - Deutsche Bank Wendy Nicholson - Citigroup Justin Hott - Bear Stearns Lauren Lieberman - Lehman Brothers April Scee - Bank of America Chris Ferrara - Merrill Lynch Ali Dibadj - SanfordBernstein Jason Gere - Wachovia Capital Markets Bill Chappell - SunTrust Joe Altobello - CIBC World Markets Alice Longley - Buckingham Research Linda Bolton Weiser - Oppenheimer Bill Leach - Neuberger Berman
Operator: Good morning,everyone and welcome to Procter & Gamble's first quarter 2008 conferencecall. Today's conference is being recorded. Today's discussion will include a number of forward-lookingstatements. If you will refer to P&G's most recent 10-K and 8-K reports,you will see a discussion of factors that could cause the company's actualresults to differ materially from these projections. As required by Regulation G, P&G needs to make you awarethat during the call the Company will make a number of references to non-GAAPand other financial measures. Management believes these measures provideinvestors valuable information on the underlying growth trends of the business. Organic refers to reported results, excluding the impacts ofacquisitions and divestitures and foreign exchange where applicable. Free cashflow represents operating cash flow less capital expenditures. P&G hasposted on its website, www.PG.com, a full reconciliation of non-GAAP and otherfinancial measures. Now I would like to turn the call over to P&G's ChiefFinancial Officer, Clayt Daley. Please go ahead, sir.
Clayt Daley: Thanks and good morning, everyone. A.G. Lafley, our CEO, andJon Moeller, our Treasurer, join me this morning. I will begin with a summaryof our first quarter results, and Jon will cover business highlights byoperating segment. I will wrap up with our expectations for the Decemberquarter and updated outlook for the fiscal year. Following the call JonMoeller, Chris Peterson, John Chevalier and I will be available to provideadditional perspective as needed. Now onto our results. We began fiscal year 2008 with a firstquarter in line with our guidance and our long-term growth targets. Wedelivered balanced top and bottom line growth in each geographic region andevery reportable segment delivering year-on-year organic growth. Earnings per share for the September quarter increased 16%to $0.92 per share. This included a one-time tax benefit of $0.02 per share. Excludingthis benefit, the company's EPS growth was 14%. EPS growth was driven by strongsales growth and a modest operating margin improvement. Total sales increased 8% to $20.2 billion, driven by 5%volume growth and 3 points of foreign exchange. Organic volume of sales for thequarter were each up 5%. Developing markets set the pace with double-digitorganic and volume sales growth. Fabric and Home Care and Baby and Family Careled the segments, each delivering 7% organic sales growth. Health Care and Beauty Care were at the low end of thesegments. This was largely due to a tough base period comparison in which CrestPro-Health and Olay Definity began shipping. Also, SK-II in Asiawas a 1 point drag on Beauty Care growth. Importantly, market share in bothHealth and Beauty Care are up versus prior year. As such, we expect results toimprove for these segments in the balance of the fiscal year. Global market share trends over the past three monthscontinue to be strong with about two-thirds of our businesses growing share.Price mix was neutral as pricing actions to recover higher commodity costs wereoffset by negative mix from strong developing market growth. Next, earnings and margin performance. Operating incomeincreased 9% to $4.4 billion, driven by sales growth and operating marginexpansion. Operating margin was up 30 basis points, in line with previousguidance. Gross margin was up 10 basis points to 52.9%. Pricing,volume leverage and cost-savings projects more than offset the impact of highercommodity costs and laundry compaction conversion costs. Higher commodity andenergy costs hurt gross margins by about 80 basis points. Selling, general and administrative expenses were down 20basis points versus year ago. Lower overhead costs as a percent of sales morethan offset higher marketing spending. The tax rate for the quarter came in at27.6% due to the one-time tax benefit of $0.02 per share. This one-time taxbenefit was due to a reduction in German statutory tax rates. As a result, wehave revalued our deferred tax assets which generates a one-time gain. Weexpect this one-time tax benefit to be net incremental for the fiscal year aswell. Now let's turn to cash performance. Operating cash flow inthe quarter was $3.2 billion, up nearly $300 million from the same period lastyear. The improvement was largely due to earnings growth. Working capital was anet use of cash in the quarter versus a year ago, primarily due to strongbusiness growth. Receivable and inventory days were up one and four daysrespectively versus the year ago period. This was primarily due to strongerforeign exchange at the end of the quarter. Payable days were up four daysversus year ago as we are converting a number of suppliers to new, longerpayment terms. Capital spending was $540 million in the quarter or 2.7% ofsales, well below the company's 4% annual target. Free cash flow for thequarter was $2.7 billion. Free cash flow productivity came in at 87%, roughlyin line with year ago. This puts us on track to beat our free cash flow targetfor the fiscal year. We repurchased $2.6 billion of P&G stock at an averageprice of $64 during the September quarter, as part of our recently announcedthree-year $24 billion to $30 billion share repurchase program. Combined with$1.1 billion in dividends, P&G distributed $3.7 billion to shareholders inthe September quarter, or 120% of net earnings. To summarize, this is a good start to the new fiscal year.P&G continues to deliver broad-based, balanced top and bottom line growth. I will now turn it over to Jon for a discussion of thebusiness unit results by segment.
Jon Moeller: Thanks, Clayt. Starting with the Beauty segment, sales grew6%, led by double-digit growth in Prestige Fragrances. The impact of the SK-IIbusiness disruption in Asia that began late Septemberlast year reduced total Beauty sales by approximately 1 point this quarter. InFragrances very strong double-digit results were driven by recent initiativeson the Dolce & Gabbana, Hugo Boss and Lacoste franchises. Hair Care delivered another solid quarter with mid single-digitsales growth led by double-digit growth in developing markets behind Head &Shoulders and Pantene. In the U.S.,all-outlet value share improved for each of P&G's top three retail Hair Carebrands: Pantene, Head & Shoulders and Herbal Essences. Combined, P&G'svalue share of U.S. Hair Care increased by nearly 2 points to 34%. Retail haircolor sales were in line with prior year as the business prepares for thelaunch of the revolutionary Nice 'n Easy initiative, Perfect 10, in January. In Skin Care, Olay sales grew double-digit in developingmarkets behind continued expansion of the key Olay franchises. This includesthe launch of Olay Regenerist in Poland, new Olay Total Effects Skin CleansingSKUs in Russia and a restage of the White Radiance line in China. Olay'sexcellent developing market results more than offset lower shipments indeveloped markets where the base period included the Olay Definity launch. Importantly,Olay Facial Moisturizer U.S. all-outlet value share continues to grow with pastthree months share up more than 1 point versus prior year to 43%. Sales for the Grooming segment increased 9% for the quarter,driven by double-digit global sales growth for Blades and Razors. Global Bladesand Razors value share has increased 0.5 point and now stands at nearly 71%.These strong top line results were led by over 20% sales growth in developingmarkets. Mach3 delivered high-teens shipment growth of blades in developingmarkets, due mainly to distribution synergies. Also, the Prestobarba brand in Latin America has benefited from increased distribution and strongresults of the Prestobarba 3 initiative. In male shaving, Fusion continues to drive strong sharegrowth. In fact, Fusion has driven share growth in premium male systems in allmarkets where it has been launched. In the U.S.,Fusion's share of male systems blades is up nearly 12 percentage points versusprior year to over 32%. Fusion and Mach3 combined share of U.S.male systems blades is up 5 points to 77%. In female razors Venus Breezecontinues to drive strong share growth with U.S.all-outlet value share of razors up almost 5 percentage points to nearly 48%for the quarter. Braun shipments were lower versus prior year, due to supplyconstraints on the Home Appliance business in Western Europeand a de-emphasis of the business in the U.S. Health Care sales increased 7%, led by high single-digitgrowth in Oral Care and Feminine Care. Sales were up mid single-digits for Pharmaceuticalsand Personal Health Care. In Oral Care, Crest and Oral-B both delivered solidglobal growth on top of the base period that included the launch of CrestPro-Health toothpaste in the U.S..In the U.S.toothpaste business, Crest all-outlet value share was up more than 1 point to37% behind new initiatives such as Crest Pro-Health Night Toothpaste and CrestPlus Scope Whitening Paste and Rinse. Oral-B manual brush share in the U.S.was up versus prior year as the business improved supply capability. In Feminine Care, developing markets led the growth with amid-teens shipment volume increase. The Naturella brand was up more than 20%,and Always grew double-digits in developing markets. In the U.S.,Always and Tampax each grew all-outlet value share more than a point thisquarter and are now at 56% and 51% of the markets respectively. In Personal Health Care and Pharmaceuticals, the addition ofthe Swiss Precision Diagnostics joint venture and pricing and mix benefits in pharmawere the main sales growth drivers. Prilosec OTC U.S.all-outlet value share was up more than 2 points to 43%. Sales for the Snacks, Coffee and Pet segment were up 6% forthe quarter as Snacks and Coffee each delivered double-digit sales growth. PetCare was down versus the prior year due to the continued negative impacts ofthe wet pet food recall last fiscal year. The strong Snacks results were drivenby the Pringles Rice Infusion launch in Western Europe.Coffees sales were up due to the launch of the Dunkin' Donuts brand into massretail channels, Folgers new Black Silk and House Blend innovations, and priceincreases to recover higher commodity costs. Folgers all-outlet value share inthe U.S. is upnearly 1 point to over 31%. Next, Fabric Care and Home Care delivered another verystrong quarter with 10% total sales growth. Home Care shipments grewdouble-digits, Fabric Care volume was up high single-digits and Batteries grewmid single-digits. Home Care grew behind the restage of the Dawn brand in North America, the launch of Febreze Candles and the continued expansionof Fairy auto-dishwashing in Western Europe. In the U.S.,Home Care continues to build value share in key segments. All-outlet share forDawn, Cascade, Febreze and Swiffer all increased from prior year levels. Fabric Care volume was up in all geographic regions for thequarter, including high single-digit growth in North America.P&G launched the first wave of the North American liquid laundry compactioninitiative in September, and conversion continues to go as planned. The firstwave covered the southern portion of the United States. The second wave will begin in lateJanuary and will cover the middle and northwestern U.S..Finally, the third wave will ship in April of 2008 covering the northeastern U.S.and Canada. Tideall-outlet value share in the U.S.increased more than a point to over 41% for the quarter. Market share for Gain,the second-largest detergent brand in the U.S.,also increased. Batteries volume was up 12% or more in each developing marketbehind distribution increases and solid market growth fundamentals. Sales indeveloped markets were up mid single-digits behind volume growth and pricingtaken last fiscal year to recover higher input costs. Duracell all-outlet valueshare in the U.S.is down slightly versus prior year to just under 47%. Baby Care and Family Care grew 10% on high single-digitvolume growth for both businesses. Family Care top line growth was driven bypipeline shipments of the new Charmin Ultra Strong innovation, continued growthof Charmin basic and strong retailer support for Bounty. Bounty all-outletvalue share is up more than a point to 44%. Charmin's share is in line withyear ago levels at 27%. Baby Care top line growth was due mainly to the ongoingsuccess of Pampers Baby Stages, Swaddlers and Cruisers products and PampersBaby-Dry with Caterpillar-Flex. In the U.S.,Pampers value share is up 2 points to over 30%; and in Western Europe value share is up a point to 54%. Pampers continues toexpand its presence in developing markets with China, Russia, Poland, SaudiArabia, India and the Philippines all posting shipments up 10% or more for thequarter. That concludes the business segment review, and now I willhand the call back to Clayt.
Clayt Daley: Thanks, Jon. For fiscal year 2008, the priority for the companycontinues to be to sustain organic sales growth at or above target levels. Weplan to invest in our leading brand equities, we plan to launch a stronginnovation pipeline, and we plan to make significant progress on go-to-marketreinvention. We again expect to deliver our annual double-digit EPS growthcommitment without separately reported restructuring charges and excluding thepositive year-on-year impact of Gillette dilution. Consistent with our plan,since we announced the deal, we expected Gillette to be non-dilutive to EPS infiscal 2008. That are a few factors that have changed since we providedour initial outlook on the fiscal year that should be discussed. Raw materialand energy costs have increased significantly over the past few months. Atcurrent levels, we now expect these costs to impact gross margins by 75 to 100basis points in fiscal year 2008. Given the increase in input costs, we haveannounced a number of price increases within the last 45 days. Specifically, we have announced the following pricingactions in the U.S.: Effective this month, a 4% to 8% increase on coffee and a 9%increase on fabric softeners. Effective in January 2008, a 5% to 12% increase on Olayand Ivory Personal Cleansing products. Effective in February 2008, a 5.5% increase on Bounty andCharmin, a 5% to 8% increase on Pampers and a 3% to 5% increase on Blades andRazors. We continue to evaluate pricing in other parts of the business. In total, we still expect modest gross margin improvement inthe fiscal year despite higher input costs. Pricing, volume leverage andexcellent work in the business to implement cost savings projects should morethan offset the increase in commodities and energy. Relative to the consumer, our markets continue to grow inboth the U.S.and around the world. While we have seen a modest slowdown in market growthrates in the U.S.,international market growth rates continue to remain strong. In the U.S.we are not seeing any trade down to private label. Over the past three months,P&G is growing share in about 75% of the U.S.business, while private label share is declining in the vast majority ofcategories in which we compete. We continue to see trade-up behind compelling consumer innovations;innovation is still creating value for consumers for which they are willing topay a premium. Successful products such as Gillette Fusion, Olay Definity, TideCold Water, Downy Simple Pleasures and, of course, Crest Pro-Health are primeexamples of what great innovation and affordable price can do despite aneconomy that is putting pressure on consumer spending. Now we also know there's a lot of focus on our Beauty Carebusiness. Beauty delivered 4% organic growth in the quarter, including a negativeimpact from SK-II of about 1%. While this is within the company's overalltarget range, we are looking forward to accelerated Beauty Care going forward.Competitors have increased spending, and we plan to respond with strong supportbehind our upcoming innovation program. This includes the Perfect 10 hair colorlaunch, the Head & Shoulders restage, new premium items on Olay Regeneristand Definity, and several new Prestige Fragrance launches. Now onto the numbers. For fiscal year 2008, we expect organicsales growth of 4% to 6%, in line with previous guidance. Within this, weexpect the combination of pricing and mix to be flat to up 1%, foreign exchangeshould have a positive impact of about 3%, acquisitions/divestitures areexpected to have a 1% negative impact on top line results, and therefore intotal, we expect all-in sales growth of 6% to 8% for the fiscal year. This isan increase of 1% versus our previous guidance due to increase in foreignexchange outlook. Turning to the bottom line, we are increasing our fiscalyear earnings per share outlook by $0.02 per share due to the one-time taxbenefit. Specifically we now expect earnings per share to be in the range of $3.46to $3.49, up 14% to 15% versus the prior year. We now expect operating margins to improve by 50 to 100basis points driven by lower overhead costs as a percentage of sales and modestgross margin improvement. We have widened our operating margin guidance toreflect the increase in input costs and higher foreign exchange impacts.Foreign exchange affects operating margins as the U.S.business has significantly higher operating margins than the internationalbusiness. On the tax rate, we now expect the fiscal year to be at orslightly below 29%, excluding the 50 basis point benefit from the one-time taxitem. This change in the base business tax rate is a result of updatingoutlooks for foreign exchange impacts, geographic sales mix and the impact ofthe company's ongoing tax planning. Now I want to take a moment to provide some more perspectiveon tax. As we have said, quarterly tax rates will be more variable than in thepast. Accounting rules require companies to recognize the full impact ofdiscrete tax items in the quarter in which they occur. These include eventssuch as resolution of outstanding tax audit settlements. These types of itemsare estimated in our guidance, but we have a varying degree of visibility onthe timing and amounts. As we gain more visibility, we will update our guidancefor them as we are doing this quarter. In addition, there will occasionally be true one-timechanges that aren’t foreseen and are not included in our guidance. The Germantax rate item this quarter is a prime example. Absent these one-time impacts,we expect our tax rate to be at or slightly below 29%. We continue to expect our share repurchases to be in therange of $8 billion to $10 billion for the fiscal year. As such, we expectinterest expense to be up due to increased debt levels. Turning to the December quarter, organic sales are expectedto grow in the 4% to 6% range. Within this, we expect a combination of pricingand mix to be about neutral, foreign exchange should add 3% to 4% to sales,acquisitions and divestitures are expected to have a negative 1% to 2% impacton P&G's top line growth and therefore, in total, we expect all-in salesgrowth of 6% to 8%. Within the segments, Beauty Care results should improve.While organic sales growth and grooming is expected to be up modestly due to astrong base period comparison, Blades and Razors delivered 8% organic growthbehind the Fusion launch in several markets. Turning to the bottom line, we expect margins to improvemodestly as SG&A improvement will be largely offset by lower gross margins.Gross margins are expected to be temporarily lower due to higher commodity andenergy costs and the investments needed behind the North America laundrycompaction initiative. We expect gross margins to recover in the second half ofthe fiscal year due to pricing, the benefits of the North American laundrycompaction initiative and increased cost savings from restructuring projects. We expect non-operating income to be up versus year ago inthe quarter due to the timing of divestitures, but for the fiscal year, wecontinue to expect non-operating income to be lower than last year. Finally, we expect the tax rate for the quarter to be at orslightly above 28% due to the anticipated timing of tax settlements. Net weexpect earnings per share to be in the range of $0.95 to $0.97 for the quarter,up 13% to 15%. In closing, P&G continues to deliver balanced top andbottom line growth. We are converting earnings to free cash flow ahead oftarget and returning more than 100% of this cash flow to shareholders throughshare repurchase and dividends. We are confident in our sustainable growthmodel going forward. Now I would be happy to open up the call. A.G., Jon and Iwill take your questions.
Operator: Your first question comes from Nik Modi - UBS.
Nik Modi - UBS: If you could just walk us through the MDOs whereexpectations are in line or above and also where they are missing your internalexpectations, if you wouldn't mind doing that first?
Clayt Daley: Well, developing markets are on track as we said in thecall. I think once we get beyond developing markets, we did note a slightslowdown in the U.S.market -- certainly not market shares, but the market growth -- and that hashad some impact on the business. I think Europe ispretty much as we expected. It is not exciting growth, but it is about the sameas it has been.
Operator: Your next question comes from Bill Pecoriello - MorganStanley.
Bill Pecoriello -Morgan Stanley: I wanted to just geta little more detail on the Beauty segment. You had talked about you gainedshare overall in Beauty, but I wanted to get a feel for how the timing of yourinnovation pipeline was impacting the growth this quarter versus theacceleration you expect? Have the categories slowed in the current quarter? Youhad mentioned competitive spend.
A.G. Lafley: The first thing we're watching, of course, is the marketshare. As we reported, the market shares actually look pretty good. Our HairCare share had one of the biggest pickups we have had in a while in NorthAmerica. The good news about Hair Care in North Americais there has been a lot of competitive activity, and our share pick up wasacross all of our major brands. So we feel good about that, obviously. If you go around the world -- without getting into all ofthe details -- we're in good shape from a share standpoint everywhere but [AFIAN]and Latin America, and we have got to pick up the pace there. So we're doingpretty well. We're doing very well in SEMEA. We still earned a very strongposition in China. We're on an upswing in Japan. I just told you about the U.S.,and we're in a very solid steady growth position in Western Europe. There is a timing of initiatives issue. We had a strong baseperiod. We introduced Herbal Essences Hot Spots initiative in I think June lastyear, and it carried through the first quarter. That is when the big launchwas. We had Definity on Olay. So we had a pretty strong year ago period. If youlook at our schedule of initiatives this year, they get stronger as we gothrough the fiscal year. You've got a base period effect and you've got a postperiod effect. I will say two things. Obviously Susan and I would like tohave a couple more points of growth out of the Beauty Care business. SK-II hasnot come back as fast as we would like, and we think it can come back faster.We have got that business refocused. I just came back from a couple of weeks inAsia. We will be investing behind our initiative program in the future, and wewill be investing longer behind it because I think as I have talked before ittakes longer to build the trial, and we can build more trial over time. Finally, we are looking at ways that we can combine ourBeauty Care initiatives across markets so we get a stronger MDO execution. Ithink there are a lot of opportunities for us there. So overall the Beautystrategy I think is where we want it to be. It is all about initiatives, timingand initiative execution.
Operator: Your next question comes from John Faucher – JP Morgan.
John Faucher - JPMorgan: There has been a lotof speculation coming from the sell side in particular in terms of how you aregoing to change your portfolio in terms of divestitures. Can you talk aboutsome of the stuff we don't see in terms of the culture there and how easy do youthink it will be or how difficult will it be to make changes in terms ofselling off brands, businesses, what have you? Do you think there's a bigcultural component that maybe we're not factoring in?
Clayt Daley: I would not say the culturalfactor is an issue. I think we have been clear in the past on our criteria. Weevaluate all of our businesses in terms of their ability to deliver sustainableearnings, sales growth, earnings growth and CFROI. If they can deliver overlong periods of time, we like to have them, and businesses that are eitherunderperformers or inconsistent performers become divestiture candidates. Wehave divested a number of businesses over the years and there have not reallybeen cultural issues that have impacted those decisions. The final comment I will make though is there has been awhole lot of speculation out there in the press, and that is exactly what it is;speculation. There is no news on this subject, and the speculation is justthat.
A.G. Lafley: John, if you look at the track record from 2000 to thepresent, on a fairly regular basis we sort through our portfolio, weed it outand sold off or spun out from the businesses that either do not make strategicsense, aren't performing up to our expectations or just don't fit. We're goingto continue to do that.
Operator: Your next question comes from Amy Chasen - Goldman Sachs.
Amy Chasen - GoldmanSachs: Would you mind just running through these price increasesagain? I think you went a little fast. As a follow-up to that, I just wanted toget your sense on how easy it will be to get this pricing relative to thepricing you took over the last two years, given that the consumer is probablyin a less good place than she was two years ago?
Clayt Daley: Well, I will runthrough the list again, and then we will comment on the editorial side. 4% to8% in coffee; 9% in fabric softeners. 5% to 12% on Olay and Ivory PersonalCleansing products; 5.5% on Bounty and Charmin; 5% to 8% on Pampers; and 3% to5% on Blades and Razors. There was also a Eukanuba price increase implementedas well. Pricing is always something that can create some uncertaintyin the marketplace, but these are commodity driven. In most cases, competitorshave announced similar price increases already, including some private labelcompetitors which is virtually unprecedented. I think the chances of theseprice increases going through relatively efficiently is very high. I think what we have seen over the last two or three yearsas we have been raising prices is that these are not huge increases. They arenot sticker shock increases. Consumers have seen much larger increases in otherthings they buy than what they are buying from us. As we said before, we arenot seeing private label shares growing, and therefore, I think this round ofpricing we hope will be similar to what we have been doing over the last coupleof years.
A.G. Lafley: Amy, if you just think about it real quickly, there is notgoing to be much customer resistance because they are seeing the same energyand commodity cost increases, and as Clayt said, they are pricing their privatelabels and they have been pricing the food side of their business. Regarding the competition as Clayt said, many of the brandedcompetitors have already announced and even private label manufacturers haveannounced. Regarding the consumer, we have a pretty good idea of whatrepresents the right value equation. We have proprietary test methods and weknow what kind of increases we have been able to take. Here is the key: we'retaking increases on brands and product lines that in most cases deliversuperior performance and quality. So we will see, but they are in line with the kind ofincreases we have taken in similar circumstances before. We're not talkingabout high out-of-pocket prices for consumers here, and we're talking aboutstaple items.
Operator: Your next question comes from Bill Schmitz - Deutsche Bank.
Bill Schmitz -Deutsche Bank: For the December quarter, the new tax rate, is that going tobe another $0.01 or $0.02 benefit to numbers?
Clayt Daley: The answer is the tax rate at around 28% by itself wouldcreate about a $0.01, but that has always been baked into our plans.
Bill Schmitz -Deutsche Bank: Okay. So that isnothing new?
Clayt Daley: Right.
Bill Schmitz -Deutsche Bank: In terms of the retail environment, is it consumer softnessor is it the trade getting scared ahead of the holiday season in terms of the U.S.market softness?
A.G. Lafley: I think it is consumer, Bill. If you look at our numbersthis time, when we do low single-digits, we do 2 to 4 in Western Europeto Japan andthe U.S. Thatis all driven by macro economic and consumer. I don't think it is driven by anytrade reaction. In fact, if anything if you look to what the trade ismerchandising and what the trade is featuring and what the trade is focusingon, they are focusing on keeping the traffic flowing. In many cases, thatbenefits our leading brands and benefits our categories because they are weeklypurchase and daily consumption.
Operator: Your next question comes from Wendy Nicholson - Citigroup.
Wendy Nicholson -Citigroup: If I've interpretedyour message over the last couple of quarters the right way, it was that theemphasis of the company was going to shift more towards top line growth in '08or '09 and that you were willing to forsake your operating margin target inorder to accelerate thattop line growth. But ifI look at the numbers today, it clearly looks like you're going to miss theoperating margin target for 2010 by a couple of hundred basis points, maybe.But you are struggling to just come in line with the middle of your long-termguidance on the top line. So it does not look like all that higher spending isreally translating to faster top line growth. Do youthink that is just a function of the difficult environment in the U.S.? Second,can you talk about the restructuring charges -- that $400 million to $500million that you were supposed to see in 2008 -- how much of that showed up inthe first quarter? I know you don't want to call it out too specifically, butjust to give us a sense of how much that hit your margins?
A.G. Lafley: Wendy, I think it's all a matter of balance. First of all,we think we are on track for our operating margin targets. So we need to talkwith you in detail about that if there is a difference of opinion. We thinkwe're making our gross margin progress and our operating margin progress, andthat is important. But it is a matter of balance. As Clayt said in the preparedremarks, well, first of all, you have got to step back. We feel great about ourFabric Care results. We feel great about our Home Care results. We feel greatabout our Baby and Family Care results. In all cases they are good or betterthan anybody in the marketplace, anybody in the world. We feel good about ourBeauty and Personal Care results because the market shares continue to grow. What you're looking at basically is a difference infootprint and a difference in mix. We have more exposure in developed markets.Some of our competition has a lot more exposure in developing markets, andwe're all growing double-digits in developing markets. There is an issue of balance which I want to be crystalclear about, and that is there are two things going on in some of the BeautyCare categories in some of the countries around the world. That is that theamount of spending has increased. When it is spending behind initiatives thatdifferentiate your brands and product line, bring new consumers or increase theloyalty of current consumers, we think it is good spending and we need to staycompetitive there. There are a few places where we have not been as competitiveas we want to be. The second issue is it takes awhile to build the kind oftrial rates in a market like we are in right now, which is hotter, which ismore fragmented, which with a media plan that has far more pieces to it andwe're going to stay with our investment behind our initiatives longer. Finally, I don't want to get into specific examples, but wehave got a couple of competitors that are spending on a single brand launchmore than we spend across the whole category. We can’t sit in situations likethat and let them try to buy the market share. That just isn’t going to happen. So that is really what we're looking at. It is a dial turnto get the balance right on the Beauty and Personal Care side of the business,where it is a hot market right now. There is a lot of activity. But I think ifyou step back and look at the whole portfolio, it is pretty understandable andthe share growth is what we're really focused on. Because in the end, that isabout consumers voting for your brands and your products everyday in the storeand liking what they use at home because they come back and purchase themagain.
Clayt Daley: Obviously we're still guiding the 1,500 basispoint margin improvement in this year. The restructuring that we haveannounced, the $300 million to $400 million program, is baked into those marginplans. I think what we have said on numerous occasions before is that we have atarget to get to a certain EBIT level by the end of the decade. We're notfixated on a margin number, and that is obviously a combination of sales growthand margin expansion and we are on track to achieve our objectives by the endof the decade.
Operator: Your next question comes from Justin Hott - Bear Stearns.
Justin Hott - BearStearns: Can you tell us a little bit more about how this consumerslowdown might hurt you in the U.S.compared to some of the others you have seen? How might your strategy besimilar or different from what you have done in the past? Secondly, maybe alittle more color on the innovation pipeline, how you feel on Olay?
A.G. Lafley: I think the pressure on consumers in the U.S.is well reported and extremely well covered. I mean it is on housing, energycosts, debt and there is more pressure on lower income consumers than there ison middle and upper income consumers, and I think that shows in the profile ofretailer results and channel results. I think that is fairly well understood. The second thing I would say is this industry and our companyis a relatively good performer in these kinds of economic conditions. I thinkthat has been the history at least in the 30 plus years I have been with the company.We do relatively better in recession, and some are predicting a recession rightnow but it is not clear there is going to be one. The reason I think is fairlystraightforward. We sell almost exclusively certainly predominately every weekpurchase, everyday usage Household Care and Personal Care products. What we'reseeing is a little bit of softness in some of the markets, but they are stillgrowing. That is the key and that is important. The second thing we're seeing is that the question that wegot from Amy about pricing is a good one, but we are not seeing pressure on theconsumer value side. We would not be building share on 77% of our business inthe U.S. if ourconsumer value was out of line. So the consumer value looks about right. As youknow, we have been driving trade ups in a lot of Household Care and PersonalCare businesses. So that is fairly encouraging. In fact, the private label shares are as weak as they havebeen this decade in the U.S.So that suggests that the price premiums that we're taking still representexcellent consumer value. Now we are obviously all over that testing forpre-market and watching it in market. The last thing I would say is about the innovation program.That is when we are ready to go and for a lot of good reasons, this programgets little bit stronger each quarter as we go through this fiscal year. Wehave new lines on the Skin Care side and specifically on the Olay side. We havenew lines of Regenerist products. We have new SK-II bundles. We have Definity,a new line of Definity products. I think you have seen our clinical strength products fromSecret and Gillette, and we have got some new cosmetic products coming on CoverGirl and Max Factor, and we have a very full bundle of fragrance products thatI think as you know go in for the Christmas season for the most part everyyear. So we've got a pretty good lineup on Skin Care.
Operator: Your next question comes from Lauren Lieberman - LehmanBrothers.
Lauren Lieberman -Lehman Brothers: A question about the overall model. Going back a couple ofyears, one thing that I think I always missed was the power of the leverage youwere getting on growing the top line and controlling overhead. It does seemlike that is going a long way to offset some of the raw materials costinflation you're going to be facing. But it does feel like that leverage ismaybe decelerating a little bit. Also it feels like the higher margins, structurallyattractive mantra of a couple of years ago that some of those businesses may berequiring greater investment to get the growth than you had initially thought.Are those fair statements or what am I maybe missing?
Clayt Daley: I think obviously there has been a surge on the Gillettesynergies over two years and continuing this year that has positively impactedthe overhead costs in SG&A. But our view is that we're committed to ongoingproductivity improvements in SG&A, and we have specific targets by businessunit. We believe that those targets that we have established by business unit,they are relative to their growth plans and so they are not going to inhibittheir growth plans. So we believe we can adequately fund innovation for growthat the same time we can improve overhead cost efficiency going forward.
A.G. Lafley: Lauren, we have run 5% to 6% a year productivity improvementthis decade. We're going to continue it. We are structured to do it. We arefocused on it, and as Clayt said, we have specific goals by businesses. Your question about support is a good one, and it isactually a tale of two cities. Clearly in some of the Beauty categories theprice of poker has gone up. That is crystal clear. Part of that is driven bythe amount of new brand and new product activity. That pace has quickened. Partof it has been driven by the intensity of the competition. But one criticalpoint that you have to keep in mind, the Beauty industry is huge worldwide; hundredsof billions of dollars. If you take the top five competitors and add them up,you're still only at about 40% of any market. So there is plenty of room for everybody to grow share. Whenyou get into developing markets, there is even more room for everybody to growshare and to grow their business at a fairly good pace because you've got a lotof category development going on in addition to the markets that are there,especially in the larger urban centers. What is going on in our Household businesses is actually thecost of doing business is stable or going down a bit because there's lesscompetition. So if you look at our Fabric Care business, and you know the storythere, there have been withdrawals by a couple of major competitors from majormarkets that reduces the cost of playing poker. If you look at some of theother big businesses we're in, Home Care or Baby Care or Family Care, I thinkthe MSA and MDA spending has been fairly, what I would call measured andprudent, because of the structural nature of those kinds of businesses. So yes,it is costing a little bit more in some businesses to compete, but in otherbusinesses it is not.
Clayt Daley: Of course, part of our ongoing plans is not to reducemarketing investment as a percent of sales; that which is embedded in theSG&A.
Operator: Your next question comes from April Scee - Bank of America.
April Scee - Bank of America: Could you just give us a quick update on the litigationbetween Procter and Teva for Actonel? Specifically, how do you think about thechances of an at-launch risk by Teva given Teva's propensity to be somewhataggressive and the unusually long time for the court to make a decision? Areyou doing anything to prepare for that possibility?
A.G. Lafley: Obviously the decision is pending. We think our case and ourposition is a strong one, and we will carry the day. Yes, Teva or any othergeneric manufacturer could take the risk that you described, but it is tripledamages if they lose. So it is a big bet and that is their choice. But that isthe game in pharmaceuticals right now, and we think we will prevail. We havegot patent protection through 2013, and we're just going to have to see.
Operator: Your next question comes from Chris Ferrara - Merrill Lynch.
Chris Ferrara -Merrill Lynch: Can you talk about the combined impact of higher commoditycosts, which you said were about 15 to 25 basis points more than you had saidin the previous guidance and then all of the pricing you just cited? So, inother words, how much of that pricing you cited today is incremental relativeto your guidance? Is that overall pricing or commodity/pricing drag greaterthan it was before, and is that why the full year EPS guidance when you excludethe tax change is a little bit lower than it was before?
Clayt Daley: Well, it has nothingto do with the tax change, so let me say that right upfront. I would say thatthe pricing we have done -- and I'm not going to be specific, by the way, bybusiness -- but the pricing we have done is a little bit greater than we hadanticipated going into the fiscal year. Some of that could be timing and some of that could beamount, but clearly I think if you recall what we said three months ago, sixmonths ago, we actually were hoping commodity and energy costs would begin toplateau going into this year, and you saw the commodity impact decline in eachquarter last fiscal year and now you have seen the commodity impact step backup in July, September. We have obviously had to react to that.
A.G. Lafley: Chris, the way to think about this is the combination offirm price contracts, hedges, inventories on hand dampen the effect a bit onthe current fiscal year. But obviously we have all got our crystal balls out totry to figure out where things are going to go in 2008. We believe the prudentapproach is to take the pricing. That gives us more flexibility. If commoditiescome off, we can always adjust pricing and if they stay high or continue up,we're in a better position.
Clayt Daley: Just to try to close the loop on the tax area, as theforeign exchange has increased the percentage of our business outside the U.S.that has an impact of lowering the tax rate. It also has an impact of modestlylowering the margin because the margins outside the U.S.are lower than the U.S.So really what you're seeing here is a big mix effect as opposed to changinganything fundamentally.
Operator: Your next question comes from Ali Dibadj - SanfordBernstein.
Ali Dibadj - Sanford Bernstein: As I look at this, it looks like you are banking more andmore on this growing non-operating income line to make some of your numbers. Iwant to understand two things. One is, just to understand why that needs to be?How should we expect that growing or changing going forward? Two, really unraveling on the pure operations of the company,as far as we're concerned the gross margin was a little bit higher than we hadexpected and I think than your guidance was, and operating margin was a littlebit less. I'm just trying to get underneath the real operations of it andunderstand a little bit of the puts and takes on marketing, on savings, and inparticular how should we expect that going forward? Those two parts would bereal helpful.
Clayt Daley: Well, in non-op I think we have said the non-op is going tobe down for the year, although it varies very much for quarter to quarter. Ofcourse, a lot of that relates to an ongoing minor divestiture program that wedo that hits certain quarters. But I don't think it is a make-up factor on theyear.
A.G. Lafley: I think as we have said, we plan to continue to improve thegross margin line and the operating margin line. You asked for some additionaldetail on the components. Our marketing spending was actually up a bit thisquarter. So the issue which I tried to be clear on is if we had it to do overagain, it would have been up a bit more in Beauty, and we would have made ithappen. With a stronger initiative program going forward, you can anticipatewhere the marketing spending is going to be going forward. We're going tosupport the initiatives. Regarding the overhead, I think we have been pretty clear onthe overhead. We done a good job of managing our productivity, and we'regetting good scale leverage there. The one other piece we have not talked aboutis cost of goods, which we call total delivered costs. I would say theorganization has done a pretty doggone good job there. We have not been able toobviously offset all of the energy and commodity cost pressure, but we haveongoing programs that put a dent in it so we don't have to rely on pricing forall of it. The last piece that I think is relevant and important is howwe are managing our mix. I think we're doing a reasonably good job of managingour mix. In the Household categories, we are demonstrating that the consumerwill trade up and pay a bit more for better performing, better quality products,and that has been the case for several years in the Beauty and Personal Carecategories.
Clayt Daley: Relative to the operating income, operating income was up9%. The operating margin was up right in line with guidance. So maybe we oughtto chat on the phone later to understand what your concerns are.
Operator: Your next question comes from Jason Gere - Wachovia CapitalMarkets.
Jason Gere - WachoviaCapital Markets: I'm not sure if you have talked about products that are onallocation. Can you talk about how much that impacted organic sales thisquarter, and how that compares to last quarter, and can you talk about theprogress on building capacity?
Clayt Daley: Actually very littlenow, except Braun. There's still some Braun household items where we have asupply problem.
A.G. Lafley: We're pretty much out of the woods on brushes, toothbrushes anddisposable razors which were big issues. Braun has been an ongoing issuebecause we are converting out of the big Spanish manufacturing facility and movinginto Eastern Europe. Broadly the capacity question is we're going to keep investingin capacity, and a lot of it is going into developing markets for obvious reasons.If you're growing double-digits in developing markets on a business that iswell over $20 billion now, you are going to be investing in capacity. So inplaces like SEMEA and places like Asia, there is goingto be a lot of capacity going in. But we will get it done at 4% or less CapExwhich is our commitment.
Operator: Your next question comes from Bill Chappell - SunTrust.
Bill Chappell -SunTrust: If you could give us a little more update on compaction? Wehave heard from some vendors there is actually some volume growth as consumersare getting used to the new bottle sizes. Are you seeing that, and when willyou have an idea to quantify the benefits on gross margin for that business interms of seeing other competitors give back price or whether the prices willhold?
A.G. Lafley: Compaction andconcentration is going really well. Now I have to hasten to say we are sevenweeks into it or six weeks into it, so it is very early days. I think westarted shipping on about the 10th of September. But the sell-in has gonereally well. The distribution is in good shape. The resets in retail storesacross Americaare well underway, and we estimate that 90% of them will be done by the end ofOctober. We're seeing most of the competition is basically following.There have been public reports by some of our major customers that they aregoing to drive for full conversion as soon as the third wave is launched, whichI believe is April of next year. All of the early anecdotal -- and it isprimarily anecdotal -- qualitative feedback from consumers has been relativelyencouraging. They understand it. They are buying at the rates we expected andhoped they would buy at. We're going to know a lot more after the next quarter. We'reexpecting this to be frankly a win for consumers, a win for retailers and a winfor manufacturers. The value is holding, and the price per load is holding sofar. There are indications that some consumers are trading up. So far, so good,and we will obviously be all over it. On your question on gross margin, I don't think we have beenspecific, but obviously this is going to be a margin builder.
Clayt Daley: Well, it is a marginbuilder, and given what is going on in commodity prices right now, I think thechances that the savings get priced away are pretty low.
Operator: Your next question comes from Joe Altobello - CIBC WorldMarkets.
Joe Altobello - CIBCWorld Markets: A quick question on your margin target for 2010. Youmentioned earlier obviously that U.S.businesses have much higher margins than international but it seems like the U.S.versus rest of world growth differential has widened given the slowdown in the U.S..If we do see a protracted consumer slowdown here in the U.S.,does that put your target at risk?
Clayt Daley: Joe, the target is really an EBIT target. Our target is toexpand margin by 50 to 75 basis points per year. Really, the controllingobjective is to get to an earnings per share number, which requires us to getto an EBIT number. Therefore, the exact split between sales growth and marginexpansion is one where it will fall the way it falls. I would not say that this situation in the U.S.relative to international growth at this point would cause us to change our 50%to 75% target. I still think we're likely to fall in that range despite the mixshift that may be occurring; some of it related to currency and some of itrelated to relative market growth. So I still think we feel pretty good aboutthe goals toward the end of the decade.
A.G. Lafley: The last thing I would say, Joe, is while our margins areobviously strong in the U.S.given our share leadership positions, our margins are improving at a good ratein developing markets. We make good margins.
Clayt Daley: After-tax margins anddeveloping are comparable to developed. But there is a different mix on theinternals where we tend to be outside the U.S.:a lower tax rate, therefore a slightly lower operating margin and somewhatlower gross margins. So there can be some change in the internals, but we getto the same end point, and that is the objective.
Operator: Your next question comes from Alice Longley - BuckinghamResearch.
Alice Longley -Buckingham Research: A major theme of this call is that competition is spendingmore in some Beauty categories in some countries. Are you talking mainly aboutSkin Care in the U.S.and Europe, or are there more categories and morecountries involved?
A.G. Lafley: Well, I think it ispretty clear if you just look at the activity, there is a fair amount ofspending in Hair. You just need to look at where the competition has launched. Ijust got back from two weeks in Asia, and there is a lotof activity going on. Asia is a very hot market rightnow. So Hair has been a very competitive market. Skin has been a verycompetitive market. We're going into a very competitive season in Fragrance. Idon't think it is isolated. I think the whole thing has picked up. By the way, I don't think it is a bad thing. I have got totry to make this point again. It is good for consumers because there is a hellof a lot of new innovative products going to market, and they are getting a lotof choices and better performing and better quality products at good prices. Itis good for retailers because Beauty and Personal Care categories are growing,and they desperately need growth. Frankly, it is good for manufacturers becauseif you look at the way the beauty markets are structured and you take the bigmanufacturers and you add us all up, we're still a minority of the totalmarket. I mean there are what, 900 Chinese hair care brands and wehave half the market in shampoos. The shampooing frequency is all the way up totwo times a week. One more shampoo a week and the shampoo market grows another50%. That will happen. The conditioner and treatment market is relatively modest inChina butstarting to catch on because so many women are working. Their hair is muchthicker, and conditioning and treatment matters a lot more. The styling marketis relatively immature in China,and it is starting to take off in the cities. Retail coloring, there is a smallbut clearly viable retail coloring business. So I just think the market still remains very attractive inBeauty and Personal Care. There is a lot of growth to be had. Not surprisingly,the multi-category competitors like the Unilever's and P&G and thepure-plays are going after the growth. There is a little bit more spendinggoing on. We watch it -- of course we watch it. But it is hard to know everyminute exactly what is being spent.
Operator: Your next question comes from Linda Bolton Weiser -Oppenheimer.
Linda Bolton Weiser -Oppenheimer: A specific question on the Health Care business. PrilosecOTC is a huge part of your business, and my understanding is that there hasbeen an agreement reached between AstraZeneca and the patent challenger,Dexcel. Do you have any knowledge of what that agreement has to do with? HasAstraZeneca informed you of any of that?
Clayt Daley: That agreement isconfidential. Sorry, I can't be more specific.
Operator: Your next question comes from Bill Leach - Neuberger Berman.
Bill Leach -Neuberger Berman: Full year guidance includes about $0.10 a share inrestructuring charges, and I was just wondering how much it was in the firstquarter?
Clayt Daley: We're not disclosingit, Bill. First of all, your assumption is right. We have said $300 million to$400 million after-tax in restructuring, and therefore, the centerline on thatwould be about a dime a share. Again, the spending tends to occur reasonablyconsistently throughout the year. So I think the safe assumption is that we arespending about 25% of the annual number in the first quarter.
Operator: That is all the time we have for questions today. Gentlemen,I will go ahead and turn the conference back to you for any additional orclosing remarks.
Clayt Daley: Thank you for joiningus today, and as I said at the outset, we will be around for the rest of theday to take additional questions on the phone as needed. Thank you very muchfor joining us. | [
{
"speaker": "Executives",
"text": "A.G. Lafley - Chairman & CEO Clayt Daley - CFO Jon Moeller - VP & Treasurer"
},
{
"speaker": "Analysts",
"text": "Nik Modi - UBS Bill Pecoriello - Morgan Stanley John Faucher – JP Morgan Amy Chasen - Goldman Sachs Bill Schmitz - Deutsche Bank Wendy Nicholson - Citigroup Justin Hott - Bear Stearns Lauren Lieberman - Lehman Brothers April Scee - Bank of America Chris Ferrara - Merrill Lynch Ali Dibadj - SanfordBernstein Jason Gere - Wachovia Capital Markets Bill Chappell - SunTrust Joe Altobello - CIBC World Markets Alice Longley - Buckingham Research Linda Bolton Weiser - Oppenheimer Bill Leach - Neuberger Berman"
},
{
"speaker": "Operator",
"text": "Good morning,everyone and welcome to Procter & Gamble's first quarter 2008 conferencecall. Today's conference is being recorded. Today's discussion will include a number of forward-lookingstatements. If you will refer to P&G's most recent 10-K and 8-K reports,you will see a discussion of factors that could cause the company's actualresults to differ materially from these projections. As required by Regulation G, P&G needs to make you awarethat during the call the Company will make a number of references to non-GAAPand other financial measures. Management believes these measures provideinvestors valuable information on the underlying growth trends of the business. Organic refers to reported results, excluding the impacts ofacquisitions and divestitures and foreign exchange where applicable. Free cashflow represents operating cash flow less capital expenditures. P&G hasposted on its website, www.PG.com, a full reconciliation of non-GAAP and otherfinancial measures. Now I would like to turn the call over to P&G's ChiefFinancial Officer, Clayt Daley. Please go ahead, sir."
},
{
"speaker": "Clayt Daley",
"text": "Thanks and good morning, everyone. A.G. Lafley, our CEO, andJon Moeller, our Treasurer, join me this morning. I will begin with a summaryof our first quarter results, and Jon will cover business highlights byoperating segment. I will wrap up with our expectations for the Decemberquarter and updated outlook for the fiscal year. Following the call JonMoeller, Chris Peterson, John Chevalier and I will be available to provideadditional perspective as needed. Now onto our results. We began fiscal year 2008 with a firstquarter in line with our guidance and our long-term growth targets. Wedelivered balanced top and bottom line growth in each geographic region andevery reportable segment delivering year-on-year organic growth. Earnings per share for the September quarter increased 16%to $0.92 per share. This included a one-time tax benefit of $0.02 per share. Excludingthis benefit, the company's EPS growth was 14%. EPS growth was driven by strongsales growth and a modest operating margin improvement. Total sales increased 8% to $20.2 billion, driven by 5%volume growth and 3 points of foreign exchange. Organic volume of sales for thequarter were each up 5%. Developing markets set the pace with double-digitorganic and volume sales growth. Fabric and Home Care and Baby and Family Careled the segments, each delivering 7% organic sales growth. Health Care and Beauty Care were at the low end of thesegments. This was largely due to a tough base period comparison in which CrestPro-Health and Olay Definity began shipping. Also, SK-II in Asiawas a 1 point drag on Beauty Care growth. Importantly, market share in bothHealth and Beauty Care are up versus prior year. As such, we expect results toimprove for these segments in the balance of the fiscal year. Global market share trends over the past three monthscontinue to be strong with about two-thirds of our businesses growing share.Price mix was neutral as pricing actions to recover higher commodity costs wereoffset by negative mix from strong developing market growth. Next, earnings and margin performance. Operating incomeincreased 9% to $4.4 billion, driven by sales growth and operating marginexpansion. Operating margin was up 30 basis points, in line with previousguidance. Gross margin was up 10 basis points to 52.9%. Pricing,volume leverage and cost-savings projects more than offset the impact of highercommodity costs and laundry compaction conversion costs. Higher commodity andenergy costs hurt gross margins by about 80 basis points. Selling, general and administrative expenses were down 20basis points versus year ago. Lower overhead costs as a percent of sales morethan offset higher marketing spending. The tax rate for the quarter came in at27.6% due to the one-time tax benefit of $0.02 per share. This one-time taxbenefit was due to a reduction in German statutory tax rates. As a result, wehave revalued our deferred tax assets which generates a one-time gain. Weexpect this one-time tax benefit to be net incremental for the fiscal year aswell. Now let's turn to cash performance. Operating cash flow inthe quarter was $3.2 billion, up nearly $300 million from the same period lastyear. The improvement was largely due to earnings growth. Working capital was anet use of cash in the quarter versus a year ago, primarily due to strongbusiness growth. Receivable and inventory days were up one and four daysrespectively versus the year ago period. This was primarily due to strongerforeign exchange at the end of the quarter. Payable days were up four daysversus year ago as we are converting a number of suppliers to new, longerpayment terms. Capital spending was $540 million in the quarter or 2.7% ofsales, well below the company's 4% annual target. Free cash flow for thequarter was $2.7 billion. Free cash flow productivity came in at 87%, roughlyin line with year ago. This puts us on track to beat our free cash flow targetfor the fiscal year. We repurchased $2.6 billion of P&G stock at an averageprice of $64 during the September quarter, as part of our recently announcedthree-year $24 billion to $30 billion share repurchase program. Combined with$1.1 billion in dividends, P&G distributed $3.7 billion to shareholders inthe September quarter, or 120% of net earnings. To summarize, this is a good start to the new fiscal year.P&G continues to deliver broad-based, balanced top and bottom line growth. I will now turn it over to Jon for a discussion of thebusiness unit results by segment."
},
{
"speaker": "Jon Moeller",
"text": "Thanks, Clayt. Starting with the Beauty segment, sales grew6%, led by double-digit growth in Prestige Fragrances. The impact of the SK-IIbusiness disruption in Asia that began late Septemberlast year reduced total Beauty sales by approximately 1 point this quarter. InFragrances very strong double-digit results were driven by recent initiativeson the Dolce & Gabbana, Hugo Boss and Lacoste franchises. Hair Care delivered another solid quarter with mid single-digitsales growth led by double-digit growth in developing markets behind Head &Shoulders and Pantene. In the U.S.,all-outlet value share improved for each of P&G's top three retail Hair Carebrands: Pantene, Head & Shoulders and Herbal Essences. Combined, P&G'svalue share of U.S. Hair Care increased by nearly 2 points to 34%. Retail haircolor sales were in line with prior year as the business prepares for thelaunch of the revolutionary Nice 'n Easy initiative, Perfect 10, in January. In Skin Care, Olay sales grew double-digit in developingmarkets behind continued expansion of the key Olay franchises. This includesthe launch of Olay Regenerist in Poland, new Olay Total Effects Skin CleansingSKUs in Russia and a restage of the White Radiance line in China. Olay'sexcellent developing market results more than offset lower shipments indeveloped markets where the base period included the Olay Definity launch. Importantly,Olay Facial Moisturizer U.S. all-outlet value share continues to grow with pastthree months share up more than 1 point versus prior year to 43%. Sales for the Grooming segment increased 9% for the quarter,driven by double-digit global sales growth for Blades and Razors. Global Bladesand Razors value share has increased 0.5 point and now stands at nearly 71%.These strong top line results were led by over 20% sales growth in developingmarkets. Mach3 delivered high-teens shipment growth of blades in developingmarkets, due mainly to distribution synergies. Also, the Prestobarba brand in Latin America has benefited from increased distribution and strongresults of the Prestobarba 3 initiative. In male shaving, Fusion continues to drive strong sharegrowth. In fact, Fusion has driven share growth in premium male systems in allmarkets where it has been launched. In the U.S.,Fusion's share of male systems blades is up nearly 12 percentage points versusprior year to over 32%. Fusion and Mach3 combined share of U.S.male systems blades is up 5 points to 77%. In female razors Venus Breezecontinues to drive strong share growth with U.S.all-outlet value share of razors up almost 5 percentage points to nearly 48%for the quarter. Braun shipments were lower versus prior year, due to supplyconstraints on the Home Appliance business in Western Europeand a de-emphasis of the business in the U.S. Health Care sales increased 7%, led by high single-digitgrowth in Oral Care and Feminine Care. Sales were up mid single-digits for Pharmaceuticalsand Personal Health Care. In Oral Care, Crest and Oral-B both delivered solidglobal growth on top of the base period that included the launch of CrestPro-Health toothpaste in the U.S..In the U.S.toothpaste business, Crest all-outlet value share was up more than 1 point to37% behind new initiatives such as Crest Pro-Health Night Toothpaste and CrestPlus Scope Whitening Paste and Rinse. Oral-B manual brush share in the U.S.was up versus prior year as the business improved supply capability. In Feminine Care, developing markets led the growth with amid-teens shipment volume increase. The Naturella brand was up more than 20%,and Always grew double-digits in developing markets. In the U.S.,Always and Tampax each grew all-outlet value share more than a point thisquarter and are now at 56% and 51% of the markets respectively. In Personal Health Care and Pharmaceuticals, the addition ofthe Swiss Precision Diagnostics joint venture and pricing and mix benefits in pharmawere the main sales growth drivers. Prilosec OTC U.S.all-outlet value share was up more than 2 points to 43%. Sales for the Snacks, Coffee and Pet segment were up 6% forthe quarter as Snacks and Coffee each delivered double-digit sales growth. PetCare was down versus the prior year due to the continued negative impacts ofthe wet pet food recall last fiscal year. The strong Snacks results were drivenby the Pringles Rice Infusion launch in Western Europe.Coffees sales were up due to the launch of the Dunkin' Donuts brand into massretail channels, Folgers new Black Silk and House Blend innovations, and priceincreases to recover higher commodity costs. Folgers all-outlet value share inthe U.S. is upnearly 1 point to over 31%. Next, Fabric Care and Home Care delivered another verystrong quarter with 10% total sales growth. Home Care shipments grewdouble-digits, Fabric Care volume was up high single-digits and Batteries grewmid single-digits. Home Care grew behind the restage of the Dawn brand in North America, the launch of Febreze Candles and the continued expansionof Fairy auto-dishwashing in Western Europe. In the U.S.,Home Care continues to build value share in key segments. All-outlet share forDawn, Cascade, Febreze and Swiffer all increased from prior year levels. Fabric Care volume was up in all geographic regions for thequarter, including high single-digit growth in North America.P&G launched the first wave of the North American liquid laundry compactioninitiative in September, and conversion continues to go as planned. The firstwave covered the southern portion of the United States. The second wave will begin in lateJanuary and will cover the middle and northwestern U.S..Finally, the third wave will ship in April of 2008 covering the northeastern U.S.and Canada. Tideall-outlet value share in the U.S.increased more than a point to over 41% for the quarter. Market share for Gain,the second-largest detergent brand in the U.S.,also increased. Batteries volume was up 12% or more in each developing marketbehind distribution increases and solid market growth fundamentals. Sales indeveloped markets were up mid single-digits behind volume growth and pricingtaken last fiscal year to recover higher input costs. Duracell all-outlet valueshare in the U.S.is down slightly versus prior year to just under 47%. Baby Care and Family Care grew 10% on high single-digitvolume growth for both businesses. Family Care top line growth was driven bypipeline shipments of the new Charmin Ultra Strong innovation, continued growthof Charmin basic and strong retailer support for Bounty. Bounty all-outletvalue share is up more than a point to 44%. Charmin's share is in line withyear ago levels at 27%. Baby Care top line growth was due mainly to the ongoingsuccess of Pampers Baby Stages, Swaddlers and Cruisers products and PampersBaby-Dry with Caterpillar-Flex. In the U.S.,Pampers value share is up 2 points to over 30%; and in Western Europe value share is up a point to 54%. Pampers continues toexpand its presence in developing markets with China, Russia, Poland, SaudiArabia, India and the Philippines all posting shipments up 10% or more for thequarter. That concludes the business segment review, and now I willhand the call back to Clayt."
},
{
"speaker": "Clayt Daley",
"text": "Thanks, Jon. For fiscal year 2008, the priority for the companycontinues to be to sustain organic sales growth at or above target levels. Weplan to invest in our leading brand equities, we plan to launch a stronginnovation pipeline, and we plan to make significant progress on go-to-marketreinvention. We again expect to deliver our annual double-digit EPS growthcommitment without separately reported restructuring charges and excluding thepositive year-on-year impact of Gillette dilution. Consistent with our plan,since we announced the deal, we expected Gillette to be non-dilutive to EPS infiscal 2008. That are a few factors that have changed since we providedour initial outlook on the fiscal year that should be discussed. Raw materialand energy costs have increased significantly over the past few months. Atcurrent levels, we now expect these costs to impact gross margins by 75 to 100basis points in fiscal year 2008. Given the increase in input costs, we haveannounced a number of price increases within the last 45 days. Specifically, we have announced the following pricingactions in the U.S.: Effective this month, a 4% to 8% increase on coffee and a 9%increase on fabric softeners. Effective in January 2008, a 5% to 12% increase on Olayand Ivory Personal Cleansing products. Effective in February 2008, a 5.5% increase on Bounty andCharmin, a 5% to 8% increase on Pampers and a 3% to 5% increase on Blades andRazors. We continue to evaluate pricing in other parts of the business. In total, we still expect modest gross margin improvement inthe fiscal year despite higher input costs. Pricing, volume leverage andexcellent work in the business to implement cost savings projects should morethan offset the increase in commodities and energy. Relative to the consumer, our markets continue to grow inboth the U.S.and around the world. While we have seen a modest slowdown in market growthrates in the U.S.,international market growth rates continue to remain strong. In the U.S.we are not seeing any trade down to private label. Over the past three months,P&G is growing share in about 75% of the U.S.business, while private label share is declining in the vast majority ofcategories in which we compete. We continue to see trade-up behind compelling consumer innovations;innovation is still creating value for consumers for which they are willing topay a premium. Successful products such as Gillette Fusion, Olay Definity, TideCold Water, Downy Simple Pleasures and, of course, Crest Pro-Health are primeexamples of what great innovation and affordable price can do despite aneconomy that is putting pressure on consumer spending. Now we also know there's a lot of focus on our Beauty Carebusiness. Beauty delivered 4% organic growth in the quarter, including a negativeimpact from SK-II of about 1%. While this is within the company's overalltarget range, we are looking forward to accelerated Beauty Care going forward.Competitors have increased spending, and we plan to respond with strong supportbehind our upcoming innovation program. This includes the Perfect 10 hair colorlaunch, the Head & Shoulders restage, new premium items on Olay Regeneristand Definity, and several new Prestige Fragrance launches. Now onto the numbers. For fiscal year 2008, we expect organicsales growth of 4% to 6%, in line with previous guidance. Within this, weexpect the combination of pricing and mix to be flat to up 1%, foreign exchangeshould have a positive impact of about 3%, acquisitions/divestitures areexpected to have a 1% negative impact on top line results, and therefore intotal, we expect all-in sales growth of 6% to 8% for the fiscal year. This isan increase of 1% versus our previous guidance due to increase in foreignexchange outlook. Turning to the bottom line, we are increasing our fiscalyear earnings per share outlook by $0.02 per share due to the one-time taxbenefit. Specifically we now expect earnings per share to be in the range of $3.46to $3.49, up 14% to 15% versus the prior year. We now expect operating margins to improve by 50 to 100basis points driven by lower overhead costs as a percentage of sales and modestgross margin improvement. We have widened our operating margin guidance toreflect the increase in input costs and higher foreign exchange impacts.Foreign exchange affects operating margins as the U.S.business has significantly higher operating margins than the internationalbusiness. On the tax rate, we now expect the fiscal year to be at orslightly below 29%, excluding the 50 basis point benefit from the one-time taxitem. This change in the base business tax rate is a result of updatingoutlooks for foreign exchange impacts, geographic sales mix and the impact ofthe company's ongoing tax planning. Now I want to take a moment to provide some more perspectiveon tax. As we have said, quarterly tax rates will be more variable than in thepast. Accounting rules require companies to recognize the full impact ofdiscrete tax items in the quarter in which they occur. These include eventssuch as resolution of outstanding tax audit settlements. These types of itemsare estimated in our guidance, but we have a varying degree of visibility onthe timing and amounts. As we gain more visibility, we will update our guidancefor them as we are doing this quarter. In addition, there will occasionally be true one-timechanges that aren’t foreseen and are not included in our guidance. The Germantax rate item this quarter is a prime example. Absent these one-time impacts,we expect our tax rate to be at or slightly below 29%. We continue to expect our share repurchases to be in therange of $8 billion to $10 billion for the fiscal year. As such, we expectinterest expense to be up due to increased debt levels. Turning to the December quarter, organic sales are expectedto grow in the 4% to 6% range. Within this, we expect a combination of pricingand mix to be about neutral, foreign exchange should add 3% to 4% to sales,acquisitions and divestitures are expected to have a negative 1% to 2% impacton P&G's top line growth and therefore, in total, we expect all-in salesgrowth of 6% to 8%. Within the segments, Beauty Care results should improve.While organic sales growth and grooming is expected to be up modestly due to astrong base period comparison, Blades and Razors delivered 8% organic growthbehind the Fusion launch in several markets. Turning to the bottom line, we expect margins to improvemodestly as SG&A improvement will be largely offset by lower gross margins.Gross margins are expected to be temporarily lower due to higher commodity andenergy costs and the investments needed behind the North America laundrycompaction initiative. We expect gross margins to recover in the second half ofthe fiscal year due to pricing, the benefits of the North American laundrycompaction initiative and increased cost savings from restructuring projects. We expect non-operating income to be up versus year ago inthe quarter due to the timing of divestitures, but for the fiscal year, wecontinue to expect non-operating income to be lower than last year. Finally, we expect the tax rate for the quarter to be at orslightly above 28% due to the anticipated timing of tax settlements. Net weexpect earnings per share to be in the range of $0.95 to $0.97 for the quarter,up 13% to 15%. In closing, P&G continues to deliver balanced top andbottom line growth. We are converting earnings to free cash flow ahead oftarget and returning more than 100% of this cash flow to shareholders throughshare repurchase and dividends. We are confident in our sustainable growthmodel going forward. Now I would be happy to open up the call. A.G., Jon and Iwill take your questions."
},
{
"speaker": "Operator",
"text": "Your first question comes from Nik Modi - UBS."
},
{
"speaker": "Nik Modi - UBS",
"text": "If you could just walk us through the MDOs whereexpectations are in line or above and also where they are missing your internalexpectations, if you wouldn't mind doing that first?"
},
{
"speaker": "Clayt Daley",
"text": "Well, developing markets are on track as we said in thecall. I think once we get beyond developing markets, we did note a slightslowdown in the U.S.market -- certainly not market shares, but the market growth -- and that hashad some impact on the business. I think Europe ispretty much as we expected. It is not exciting growth, but it is about the sameas it has been."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bill Pecoriello - MorganStanley."
},
{
"speaker": "Bill Pecoriello -Morgan Stanley",
"text": "I wanted to just geta little more detail on the Beauty segment. You had talked about you gainedshare overall in Beauty, but I wanted to get a feel for how the timing of yourinnovation pipeline was impacting the growth this quarter versus theacceleration you expect? Have the categories slowed in the current quarter? Youhad mentioned competitive spend."
},
{
"speaker": "A.G. Lafley",
"text": "The first thing we're watching, of course, is the marketshare. As we reported, the market shares actually look pretty good. Our HairCare share had one of the biggest pickups we have had in a while in NorthAmerica. The good news about Hair Care in North Americais there has been a lot of competitive activity, and our share pick up wasacross all of our major brands. So we feel good about that, obviously. If you go around the world -- without getting into all ofthe details -- we're in good shape from a share standpoint everywhere but [AFIAN]and Latin America, and we have got to pick up the pace there. So we're doingpretty well. We're doing very well in SEMEA. We still earned a very strongposition in China. We're on an upswing in Japan. I just told you about the U.S.,and we're in a very solid steady growth position in Western Europe. There is a timing of initiatives issue. We had a strong baseperiod. We introduced Herbal Essences Hot Spots initiative in I think June lastyear, and it carried through the first quarter. That is when the big launchwas. We had Definity on Olay. So we had a pretty strong year ago period. If youlook at our schedule of initiatives this year, they get stronger as we gothrough the fiscal year. You've got a base period effect and you've got a postperiod effect. I will say two things. Obviously Susan and I would like tohave a couple more points of growth out of the Beauty Care business. SK-II hasnot come back as fast as we would like, and we think it can come back faster.We have got that business refocused. I just came back from a couple of weeks inAsia. We will be investing behind our initiative program in the future, and wewill be investing longer behind it because I think as I have talked before ittakes longer to build the trial, and we can build more trial over time. Finally, we are looking at ways that we can combine ourBeauty Care initiatives across markets so we get a stronger MDO execution. Ithink there are a lot of opportunities for us there. So overall the Beautystrategy I think is where we want it to be. It is all about initiatives, timingand initiative execution."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Faucher – JP Morgan."
},
{
"speaker": "John Faucher - JPMorgan",
"text": "There has been a lotof speculation coming from the sell side in particular in terms of how you aregoing to change your portfolio in terms of divestitures. Can you talk aboutsome of the stuff we don't see in terms of the culture there and how easy do youthink it will be or how difficult will it be to make changes in terms ofselling off brands, businesses, what have you? Do you think there's a bigcultural component that maybe we're not factoring in?"
},
{
"speaker": "Clayt Daley",
"text": "I would not say the culturalfactor is an issue. I think we have been clear in the past on our criteria. Weevaluate all of our businesses in terms of their ability to deliver sustainableearnings, sales growth, earnings growth and CFROI. If they can deliver overlong periods of time, we like to have them, and businesses that are eitherunderperformers or inconsistent performers become divestiture candidates. Wehave divested a number of businesses over the years and there have not reallybeen cultural issues that have impacted those decisions. The final comment I will make though is there has been awhole lot of speculation out there in the press, and that is exactly what it is;speculation. There is no news on this subject, and the speculation is justthat."
},
{
"speaker": "A.G. Lafley",
"text": "John, if you look at the track record from 2000 to thepresent, on a fairly regular basis we sort through our portfolio, weed it outand sold off or spun out from the businesses that either do not make strategicsense, aren't performing up to our expectations or just don't fit. We're goingto continue to do that."
},
{
"speaker": "Operator",
"text": "Your next question comes from Amy Chasen - Goldman Sachs."
},
{
"speaker": "Amy Chasen - GoldmanSachs",
"text": "Would you mind just running through these price increasesagain? I think you went a little fast. As a follow-up to that, I just wanted toget your sense on how easy it will be to get this pricing relative to thepricing you took over the last two years, given that the consumer is probablyin a less good place than she was two years ago?"
},
{
"speaker": "Clayt Daley",
"text": "Well, I will runthrough the list again, and then we will comment on the editorial side. 4% to8% in coffee; 9% in fabric softeners. 5% to 12% on Olay and Ivory PersonalCleansing products; 5.5% on Bounty and Charmin; 5% to 8% on Pampers; and 3% to5% on Blades and Razors. There was also a Eukanuba price increase implementedas well. Pricing is always something that can create some uncertaintyin the marketplace, but these are commodity driven. In most cases, competitorshave announced similar price increases already, including some private labelcompetitors which is virtually unprecedented. I think the chances of theseprice increases going through relatively efficiently is very high. I think what we have seen over the last two or three yearsas we have been raising prices is that these are not huge increases. They arenot sticker shock increases. Consumers have seen much larger increases in otherthings they buy than what they are buying from us. As we said before, we arenot seeing private label shares growing, and therefore, I think this round ofpricing we hope will be similar to what we have been doing over the last coupleof years."
},
{
"speaker": "A.G. Lafley",
"text": "Amy, if you just think about it real quickly, there is notgoing to be much customer resistance because they are seeing the same energyand commodity cost increases, and as Clayt said, they are pricing their privatelabels and they have been pricing the food side of their business. Regarding the competition as Clayt said, many of the brandedcompetitors have already announced and even private label manufacturers haveannounced. Regarding the consumer, we have a pretty good idea of whatrepresents the right value equation. We have proprietary test methods and weknow what kind of increases we have been able to take. Here is the key: we'retaking increases on brands and product lines that in most cases deliversuperior performance and quality. So we will see, but they are in line with the kind ofincreases we have taken in similar circumstances before. We're not talkingabout high out-of-pocket prices for consumers here, and we're talking aboutstaple items."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bill Schmitz - Deutsche Bank."
},
{
"speaker": "Bill Schmitz -Deutsche Bank",
"text": "For the December quarter, the new tax rate, is that going tobe another $0.01 or $0.02 benefit to numbers?"
},
{
"speaker": "Clayt Daley",
"text": "The answer is the tax rate at around 28% by itself wouldcreate about a $0.01, but that has always been baked into our plans."
},
{
"speaker": "Bill Schmitz -Deutsche Bank",
"text": "Okay. So that isnothing new?"
},
{
"speaker": "Clayt Daley",
"text": "Right."
},
{
"speaker": "Bill Schmitz -Deutsche Bank",
"text": "In terms of the retail environment, is it consumer softnessor is it the trade getting scared ahead of the holiday season in terms of the U.S.market softness?"
},
{
"speaker": "A.G. Lafley",
"text": "I think it is consumer, Bill. If you look at our numbersthis time, when we do low single-digits, we do 2 to 4 in Western Europeto Japan andthe U.S. Thatis all driven by macro economic and consumer. I don't think it is driven by anytrade reaction. In fact, if anything if you look to what the trade ismerchandising and what the trade is featuring and what the trade is focusingon, they are focusing on keeping the traffic flowing. In many cases, thatbenefits our leading brands and benefits our categories because they are weeklypurchase and daily consumption."
},
{
"speaker": "Operator",
"text": "Your next question comes from Wendy Nicholson - Citigroup."
},
{
"speaker": "Wendy Nicholson -Citigroup",
"text": "If I've interpretedyour message over the last couple of quarters the right way, it was that theemphasis of the company was going to shift more towards top line growth in '08or '09 and that you were willing to forsake your operating margin target inorder to accelerate thattop line growth. But ifI look at the numbers today, it clearly looks like you're going to miss theoperating margin target for 2010 by a couple of hundred basis points, maybe.But you are struggling to just come in line with the middle of your long-termguidance on the top line. So it does not look like all that higher spending isreally translating to faster top line growth. Do youthink that is just a function of the difficult environment in the U.S.? Second,can you talk about the restructuring charges -- that $400 million to $500million that you were supposed to see in 2008 -- how much of that showed up inthe first quarter? I know you don't want to call it out too specifically, butjust to give us a sense of how much that hit your margins?"
},
{
"speaker": "A.G. Lafley",
"text": "Wendy, I think it's all a matter of balance. First of all,we think we are on track for our operating margin targets. So we need to talkwith you in detail about that if there is a difference of opinion. We thinkwe're making our gross margin progress and our operating margin progress, andthat is important. But it is a matter of balance. As Clayt said in the preparedremarks, well, first of all, you have got to step back. We feel great about ourFabric Care results. We feel great about our Home Care results. We feel greatabout our Baby and Family Care results. In all cases they are good or betterthan anybody in the marketplace, anybody in the world. We feel good about ourBeauty and Personal Care results because the market shares continue to grow. What you're looking at basically is a difference infootprint and a difference in mix. We have more exposure in developed markets.Some of our competition has a lot more exposure in developing markets, andwe're all growing double-digits in developing markets. There is an issue of balance which I want to be crystalclear about, and that is there are two things going on in some of the BeautyCare categories in some of the countries around the world. That is that theamount of spending has increased. When it is spending behind initiatives thatdifferentiate your brands and product line, bring new consumers or increase theloyalty of current consumers, we think it is good spending and we need to staycompetitive there. There are a few places where we have not been as competitiveas we want to be. The second issue is it takes awhile to build the kind oftrial rates in a market like we are in right now, which is hotter, which ismore fragmented, which with a media plan that has far more pieces to it andwe're going to stay with our investment behind our initiatives longer. Finally, I don't want to get into specific examples, but wehave got a couple of competitors that are spending on a single brand launchmore than we spend across the whole category. We can’t sit in situations likethat and let them try to buy the market share. That just isn’t going to happen. So that is really what we're looking at. It is a dial turnto get the balance right on the Beauty and Personal Care side of the business,where it is a hot market right now. There is a lot of activity. But I think ifyou step back and look at the whole portfolio, it is pretty understandable andthe share growth is what we're really focused on. Because in the end, that isabout consumers voting for your brands and your products everyday in the storeand liking what they use at home because they come back and purchase themagain."
},
{
"speaker": "Clayt Daley",
"text": "Obviously we're still guiding the 1,500 basispoint margin improvement in this year. The restructuring that we haveannounced, the $300 million to $400 million program, is baked into those marginplans. I think what we have said on numerous occasions before is that we have atarget to get to a certain EBIT level by the end of the decade. We're notfixated on a margin number, and that is obviously a combination of sales growthand margin expansion and we are on track to achieve our objectives by the endof the decade."
},
{
"speaker": "Operator",
"text": "Your next question comes from Justin Hott - Bear Stearns."
},
{
"speaker": "Justin Hott - BearStearns",
"text": "Can you tell us a little bit more about how this consumerslowdown might hurt you in the U.S.compared to some of the others you have seen? How might your strategy besimilar or different from what you have done in the past? Secondly, maybe alittle more color on the innovation pipeline, how you feel on Olay?"
},
{
"speaker": "A.G. Lafley",
"text": "I think the pressure on consumers in the U.S.is well reported and extremely well covered. I mean it is on housing, energycosts, debt and there is more pressure on lower income consumers than there ison middle and upper income consumers, and I think that shows in the profile ofretailer results and channel results. I think that is fairly well understood. The second thing I would say is this industry and our companyis a relatively good performer in these kinds of economic conditions. I thinkthat has been the history at least in the 30 plus years I have been with the company.We do relatively better in recession, and some are predicting a recession rightnow but it is not clear there is going to be one. The reason I think is fairlystraightforward. We sell almost exclusively certainly predominately every weekpurchase, everyday usage Household Care and Personal Care products. What we'reseeing is a little bit of softness in some of the markets, but they are stillgrowing. That is the key and that is important. The second thing we're seeing is that the question that wegot from Amy about pricing is a good one, but we are not seeing pressure on theconsumer value side. We would not be building share on 77% of our business inthe U.S. if ourconsumer value was out of line. So the consumer value looks about right. As youknow, we have been driving trade ups in a lot of Household Care and PersonalCare businesses. So that is fairly encouraging. In fact, the private label shares are as weak as they havebeen this decade in the U.S.So that suggests that the price premiums that we're taking still representexcellent consumer value. Now we are obviously all over that testing forpre-market and watching it in market. The last thing I would say is about the innovation program.That is when we are ready to go and for a lot of good reasons, this programgets little bit stronger each quarter as we go through this fiscal year. Wehave new lines on the Skin Care side and specifically on the Olay side. We havenew lines of Regenerist products. We have new SK-II bundles. We have Definity,a new line of Definity products. I think you have seen our clinical strength products fromSecret and Gillette, and we have got some new cosmetic products coming on CoverGirl and Max Factor, and we have a very full bundle of fragrance products thatI think as you know go in for the Christmas season for the most part everyyear. So we've got a pretty good lineup on Skin Care."
},
{
"speaker": "Operator",
"text": "Your next question comes from Lauren Lieberman - LehmanBrothers."
},
{
"speaker": "Lauren Lieberman -Lehman Brothers",
"text": "A question about the overall model. Going back a couple ofyears, one thing that I think I always missed was the power of the leverage youwere getting on growing the top line and controlling overhead. It does seemlike that is going a long way to offset some of the raw materials costinflation you're going to be facing. But it does feel like that leverage ismaybe decelerating a little bit. Also it feels like the higher margins, structurallyattractive mantra of a couple of years ago that some of those businesses may berequiring greater investment to get the growth than you had initially thought.Are those fair statements or what am I maybe missing?"
},
{
"speaker": "Clayt Daley",
"text": "I think obviously there has been a surge on the Gillettesynergies over two years and continuing this year that has positively impactedthe overhead costs in SG&A. But our view is that we're committed to ongoingproductivity improvements in SG&A, and we have specific targets by businessunit. We believe that those targets that we have established by business unit,they are relative to their growth plans and so they are not going to inhibittheir growth plans. So we believe we can adequately fund innovation for growthat the same time we can improve overhead cost efficiency going forward."
},
{
"speaker": "A.G. Lafley",
"text": "Lauren, we have run 5% to 6% a year productivity improvementthis decade. We're going to continue it. We are structured to do it. We arefocused on it, and as Clayt said, we have specific goals by businesses. Your question about support is a good one, and it isactually a tale of two cities. Clearly in some of the Beauty categories theprice of poker has gone up. That is crystal clear. Part of that is driven bythe amount of new brand and new product activity. That pace has quickened. Partof it has been driven by the intensity of the competition. But one criticalpoint that you have to keep in mind, the Beauty industry is huge worldwide; hundredsof billions of dollars. If you take the top five competitors and add them up,you're still only at about 40% of any market. So there is plenty of room for everybody to grow share. Whenyou get into developing markets, there is even more room for everybody to growshare and to grow their business at a fairly good pace because you've got a lotof category development going on in addition to the markets that are there,especially in the larger urban centers. What is going on in our Household businesses is actually thecost of doing business is stable or going down a bit because there's lesscompetition. So if you look at our Fabric Care business, and you know the storythere, there have been withdrawals by a couple of major competitors from majormarkets that reduces the cost of playing poker. If you look at some of theother big businesses we're in, Home Care or Baby Care or Family Care, I thinkthe MSA and MDA spending has been fairly, what I would call measured andprudent, because of the structural nature of those kinds of businesses. So yes,it is costing a little bit more in some businesses to compete, but in otherbusinesses it is not."
},
{
"speaker": "Clayt Daley",
"text": "Of course, part of our ongoing plans is not to reducemarketing investment as a percent of sales; that which is embedded in theSG&A."
},
{
"speaker": "Operator",
"text": "Your next question comes from April Scee - Bank of America."
},
{
"speaker": "April Scee - Bank of America",
"text": "Could you just give us a quick update on the litigationbetween Procter and Teva for Actonel? Specifically, how do you think about thechances of an at-launch risk by Teva given Teva's propensity to be somewhataggressive and the unusually long time for the court to make a decision? Areyou doing anything to prepare for that possibility?"
},
{
"speaker": "A.G. Lafley",
"text": "Obviously the decision is pending. We think our case and ourposition is a strong one, and we will carry the day. Yes, Teva or any othergeneric manufacturer could take the risk that you described, but it is tripledamages if they lose. So it is a big bet and that is their choice. But that isthe game in pharmaceuticals right now, and we think we will prevail. We havegot patent protection through 2013, and we're just going to have to see."
},
{
"speaker": "Operator",
"text": "Your next question comes from Chris Ferrara - Merrill Lynch."
},
{
"speaker": "Chris Ferrara -Merrill Lynch",
"text": "Can you talk about the combined impact of higher commoditycosts, which you said were about 15 to 25 basis points more than you had saidin the previous guidance and then all of the pricing you just cited? So, inother words, how much of that pricing you cited today is incremental relativeto your guidance? Is that overall pricing or commodity/pricing drag greaterthan it was before, and is that why the full year EPS guidance when you excludethe tax change is a little bit lower than it was before?"
},
{
"speaker": "Clayt Daley",
"text": "Well, it has nothingto do with the tax change, so let me say that right upfront. I would say thatthe pricing we have done -- and I'm not going to be specific, by the way, bybusiness -- but the pricing we have done is a little bit greater than we hadanticipated going into the fiscal year. Some of that could be timing and some of that could beamount, but clearly I think if you recall what we said three months ago, sixmonths ago, we actually were hoping commodity and energy costs would begin toplateau going into this year, and you saw the commodity impact decline in eachquarter last fiscal year and now you have seen the commodity impact step backup in July, September. We have obviously had to react to that."
},
{
"speaker": "A.G. Lafley",
"text": "Chris, the way to think about this is the combination offirm price contracts, hedges, inventories on hand dampen the effect a bit onthe current fiscal year. But obviously we have all got our crystal balls out totry to figure out where things are going to go in 2008. We believe the prudentapproach is to take the pricing. That gives us more flexibility. If commoditiescome off, we can always adjust pricing and if they stay high or continue up,we're in a better position."
},
{
"speaker": "Clayt Daley",
"text": "Just to try to close the loop on the tax area, as theforeign exchange has increased the percentage of our business outside the U.S.that has an impact of lowering the tax rate. It also has an impact of modestlylowering the margin because the margins outside the U.S.are lower than the U.S.So really what you're seeing here is a big mix effect as opposed to changinganything fundamentally."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ali Dibadj - SanfordBernstein."
},
{
"speaker": "Ali Dibadj - Sanford Bernstein",
"text": "As I look at this, it looks like you are banking more andmore on this growing non-operating income line to make some of your numbers. Iwant to understand two things. One is, just to understand why that needs to be?How should we expect that growing or changing going forward? Two, really unraveling on the pure operations of the company,as far as we're concerned the gross margin was a little bit higher than we hadexpected and I think than your guidance was, and operating margin was a littlebit less. I'm just trying to get underneath the real operations of it andunderstand a little bit of the puts and takes on marketing, on savings, and inparticular how should we expect that going forward? Those two parts would bereal helpful."
},
{
"speaker": "Clayt Daley",
"text": "Well, in non-op I think we have said the non-op is going tobe down for the year, although it varies very much for quarter to quarter. Ofcourse, a lot of that relates to an ongoing minor divestiture program that wedo that hits certain quarters. But I don't think it is a make-up factor on theyear."
},
{
"speaker": "A.G. Lafley",
"text": "I think as we have said, we plan to continue to improve thegross margin line and the operating margin line. You asked for some additionaldetail on the components. Our marketing spending was actually up a bit thisquarter. So the issue which I tried to be clear on is if we had it to do overagain, it would have been up a bit more in Beauty, and we would have made ithappen. With a stronger initiative program going forward, you can anticipatewhere the marketing spending is going to be going forward. We're going tosupport the initiatives. Regarding the overhead, I think we have been pretty clear onthe overhead. We done a good job of managing our productivity, and we'regetting good scale leverage there. The one other piece we have not talked aboutis cost of goods, which we call total delivered costs. I would say theorganization has done a pretty doggone good job there. We have not been able toobviously offset all of the energy and commodity cost pressure, but we haveongoing programs that put a dent in it so we don't have to rely on pricing forall of it. The last piece that I think is relevant and important is howwe are managing our mix. I think we're doing a reasonably good job of managingour mix. In the Household categories, we are demonstrating that the consumerwill trade up and pay a bit more for better performing, better quality products,and that has been the case for several years in the Beauty and Personal Carecategories."
},
{
"speaker": "Clayt Daley",
"text": "Relative to the operating income, operating income was up9%. The operating margin was up right in line with guidance. So maybe we oughtto chat on the phone later to understand what your concerns are."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jason Gere - Wachovia CapitalMarkets."
},
{
"speaker": "Jason Gere - WachoviaCapital Markets",
"text": "I'm not sure if you have talked about products that are onallocation. Can you talk about how much that impacted organic sales thisquarter, and how that compares to last quarter, and can you talk about theprogress on building capacity?"
},
{
"speaker": "Clayt Daley",
"text": "Actually very littlenow, except Braun. There's still some Braun household items where we have asupply problem."
},
{
"speaker": "A.G. Lafley",
"text": "We're pretty much out of the woods on brushes, toothbrushes anddisposable razors which were big issues. Braun has been an ongoing issuebecause we are converting out of the big Spanish manufacturing facility and movinginto Eastern Europe. Broadly the capacity question is we're going to keep investingin capacity, and a lot of it is going into developing markets for obvious reasons.If you're growing double-digits in developing markets on a business that iswell over $20 billion now, you are going to be investing in capacity. So inplaces like SEMEA and places like Asia, there is goingto be a lot of capacity going in. But we will get it done at 4% or less CapExwhich is our commitment."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bill Chappell - SunTrust."
},
{
"speaker": "Bill Chappell -SunTrust",
"text": "If you could give us a little more update on compaction? Wehave heard from some vendors there is actually some volume growth as consumersare getting used to the new bottle sizes. Are you seeing that, and when willyou have an idea to quantify the benefits on gross margin for that business interms of seeing other competitors give back price or whether the prices willhold?"
},
{
"speaker": "A.G. Lafley",
"text": "Compaction andconcentration is going really well. Now I have to hasten to say we are sevenweeks into it or six weeks into it, so it is very early days. I think westarted shipping on about the 10th of September. But the sell-in has gonereally well. The distribution is in good shape. The resets in retail storesacross Americaare well underway, and we estimate that 90% of them will be done by the end ofOctober. We're seeing most of the competition is basically following.There have been public reports by some of our major customers that they aregoing to drive for full conversion as soon as the third wave is launched, whichI believe is April of next year. All of the early anecdotal -- and it isprimarily anecdotal -- qualitative feedback from consumers has been relativelyencouraging. They understand it. They are buying at the rates we expected andhoped they would buy at. We're going to know a lot more after the next quarter. We'reexpecting this to be frankly a win for consumers, a win for retailers and a winfor manufacturers. The value is holding, and the price per load is holding sofar. There are indications that some consumers are trading up. So far, so good,and we will obviously be all over it. On your question on gross margin, I don't think we have beenspecific, but obviously this is going to be a margin builder."
},
{
"speaker": "Clayt Daley",
"text": "Well, it is a marginbuilder, and given what is going on in commodity prices right now, I think thechances that the savings get priced away are pretty low."
},
{
"speaker": "Operator",
"text": "Your next question comes from Joe Altobello - CIBC WorldMarkets."
},
{
"speaker": "Joe Altobello - CIBCWorld Markets",
"text": "A quick question on your margin target for 2010. Youmentioned earlier obviously that U.S.businesses have much higher margins than international but it seems like the U.S.versus rest of world growth differential has widened given the slowdown in the U.S..If we do see a protracted consumer slowdown here in the U.S.,does that put your target at risk?"
},
{
"speaker": "Clayt Daley",
"text": "Joe, the target is really an EBIT target. Our target is toexpand margin by 50 to 75 basis points per year. Really, the controllingobjective is to get to an earnings per share number, which requires us to getto an EBIT number. Therefore, the exact split between sales growth and marginexpansion is one where it will fall the way it falls. I would not say that this situation in the U.S.relative to international growth at this point would cause us to change our 50%to 75% target. I still think we're likely to fall in that range despite the mixshift that may be occurring; some of it related to currency and some of itrelated to relative market growth. So I still think we feel pretty good aboutthe goals toward the end of the decade."
},
{
"speaker": "A.G. Lafley",
"text": "The last thing I would say, Joe, is while our margins areobviously strong in the U.S.given our share leadership positions, our margins are improving at a good ratein developing markets. We make good margins."
},
{
"speaker": "Clayt Daley",
"text": "After-tax margins anddeveloping are comparable to developed. But there is a different mix on theinternals where we tend to be outside the U.S.:a lower tax rate, therefore a slightly lower operating margin and somewhatlower gross margins. So there can be some change in the internals, but we getto the same end point, and that is the objective."
},
{
"speaker": "Operator",
"text": "Your next question comes from Alice Longley - BuckinghamResearch."
},
{
"speaker": "Alice Longley -Buckingham Research",
"text": "A major theme of this call is that competition is spendingmore in some Beauty categories in some countries. Are you talking mainly aboutSkin Care in the U.S.and Europe, or are there more categories and morecountries involved?"
},
{
"speaker": "A.G. Lafley",
"text": "Well, I think it ispretty clear if you just look at the activity, there is a fair amount ofspending in Hair. You just need to look at where the competition has launched. Ijust got back from two weeks in Asia, and there is a lotof activity going on. Asia is a very hot market rightnow. So Hair has been a very competitive market. Skin has been a verycompetitive market. We're going into a very competitive season in Fragrance. Idon't think it is isolated. I think the whole thing has picked up. By the way, I don't think it is a bad thing. I have got totry to make this point again. It is good for consumers because there is a hellof a lot of new innovative products going to market, and they are getting a lotof choices and better performing and better quality products at good prices. Itis good for retailers because Beauty and Personal Care categories are growing,and they desperately need growth. Frankly, it is good for manufacturers becauseif you look at the way the beauty markets are structured and you take the bigmanufacturers and you add us all up, we're still a minority of the totalmarket. I mean there are what, 900 Chinese hair care brands and wehave half the market in shampoos. The shampooing frequency is all the way up totwo times a week. One more shampoo a week and the shampoo market grows another50%. That will happen. The conditioner and treatment market is relatively modest inChina butstarting to catch on because so many women are working. Their hair is muchthicker, and conditioning and treatment matters a lot more. The styling marketis relatively immature in China,and it is starting to take off in the cities. Retail coloring, there is a smallbut clearly viable retail coloring business. So I just think the market still remains very attractive inBeauty and Personal Care. There is a lot of growth to be had. Not surprisingly,the multi-category competitors like the Unilever's and P&G and thepure-plays are going after the growth. There is a little bit more spendinggoing on. We watch it -- of course we watch it. But it is hard to know everyminute exactly what is being spent."
},
{
"speaker": "Operator",
"text": "Your next question comes from Linda Bolton Weiser -Oppenheimer."
},
{
"speaker": "Linda Bolton Weiser -Oppenheimer",
"text": "A specific question on the Health Care business. PrilosecOTC is a huge part of your business, and my understanding is that there hasbeen an agreement reached between AstraZeneca and the patent challenger,Dexcel. Do you have any knowledge of what that agreement has to do with? HasAstraZeneca informed you of any of that?"
},
{
"speaker": "Clayt Daley",
"text": "That agreement isconfidential. Sorry, I can't be more specific."
},
{
"speaker": "Operator",
"text": "Your next question comes from Bill Leach - Neuberger Berman."
},
{
"speaker": "Bill Leach -Neuberger Berman",
"text": "Full year guidance includes about $0.10 a share inrestructuring charges, and I was just wondering how much it was in the firstquarter?"
},
{
"speaker": "Clayt Daley",
"text": "We're not disclosingit, Bill. First of all, your assumption is right. We have said $300 million to$400 million after-tax in restructuring, and therefore, the centerline on thatwould be about a dime a share. Again, the spending tends to occur reasonablyconsistently throughout the year. So I think the safe assumption is that we arespending about 25% of the annual number in the first quarter."
},
{
"speaker": "Operator",
"text": "That is all the time we have for questions today. Gentlemen,I will go ahead and turn the conference back to you for any additional orclosing remarks."
},
{
"speaker": "Clayt Daley",
"text": "Thank you for joiningus today, and as I said at the outset, we will be around for the rest of theday to take additional questions on the phone as needed. Thank you very muchfor joining us."
}
] | null | null |
XOM | 4 | 2,007 | 2008-02-01 13:45:00 | Executives: Henry H Hubble - VP of IR and Secretary
Analysts: Douglas T. Terreson - Morgan Stanley Mark Flannery - Credit Suisse Nicole Decker - Bear Stearns Paul Sankey - Deutsche Bank Securities Katherine Lucas - J P Morgan Oswald Clint - Sanford C. Bernstein Doug Leggate - Citigroup
Operator: Good day everyone and welcome to this Exxon Mobil Corporation Fourth Quarter 2007 Earnings Conference Call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like turn the call over to the Vice President of Investor Relations and Secretary Mr. Henry Hubble. Please go ahead sir.
Henry H Hubble - Vice President of Investor Relations and Secretary: Good morning and welcome to ExxonMobil's teleconference and webcast on our fourth quarter and full year 2007 financial and operating results. As you are aware from this morning's press release, we had another strong quarter. In an environment of robust commodity prices, our fourth quarter results again highlight the fundamental strength of our business. We continue to deliver superior operational performance and leverage our integrated capabilities, while investing at record levels in an industry-leading portfolio of projects to bring supplies to market. Before we go further, I would like to draw your attention to our cautionary statement. Please note that estimates, plans, and projections are forward-looking statements. Actual results, including resource recoveries, volume growth and project outcomes, could differ materially due to the factors I discussed and factors noted in our SEC filings. Please see factors affecting future results and the Form 8-K, we furnished this morning, which are available through the Investors Section of our website. Please also see the frequently used terms, the supplements to this morning's press release and the 2006 financial and operating review on our website. This material defines key terms I will use today, shows ExxonMobil's net interest in specific projects and includes our SEC Regulation G disclosure. Now I'm pleased to turn your attention to the fourth quarter results. ExxonMobil's fourth quarter 2007 normalized earnings and net income were a record for the corporation, at $11.7 billion, up to $2.3 billion from the third quarter of this year, versus the fourth quarter of 2006, net income increased $1.4 billion and normalized earnings were up $1.8 billion. Fourth quarter normalized earnings per share were $2.13, up 26% from the year ago, reflecting the strength of our financial performances and the benefits of our ongoing share repurchase program. ExxonMobil's net income and normalized earnings for 2007 totaled $40.6 billion, also a record for the Corporation. Normalized earnings were up $1.5 billion from 2006, while net income increase $1.1 billion. Before I discuss the specific business results, I would like to share with you some milestones achieved since our last earnings call. Starting with our Upstream business. In October, we achieved initial oil production from the first expansion of the Tengiz development in Kazakhstan. When complete, this expansion project, Tengiz Phase 1, will fully incorporate a second-generation gas handling project with sour gas injection. The project is expected to deliver incremental production of 285,000 barrels of oil per day at full capacity. This was ExxonMobil's seventh major Upstream project startup in 2007. In January, we started up production from the Mondo field in the ExxonMobil-operated Kizomba C development, in Block 15 offshore Angola. The Kizomba C development exemplifies ExxonMobil's design one, build multiple' strategy as it includes two projects; Mondo and Saxi/Batuque. Each project utilizes a floating production storage and off-loading vessel that will handle up to a 100,000 barrels per day. Together these projects are expected to recover 600 million barrels of oil. We anticipate the start-up of Saxi and Batuque fields later this year, completing the Kizomba C development. These project start-ups demonstrate ExxonMobil's commitment to bring new energy supplies to market and deliver value to our shareholders. Also in the fourth quarter, we announced plans to seek regulatory approval for our BlueOcean Energy project. This project includes a floating LNG receiving terminal, 20 miles off the coast of New Jersey and will have the capacity to supply about 1.2 billion cubic feet of clean burning natural gas per day to help meet the growing energy needs of consumers in New York and New Jersey. During the fourth quarter, we also signed a heads of agreement with Libya's National Oil Corporation to execute an exploration and production sharing agreement. The agreement includes four blocks located in the Sirte Basin, approximately110 miles off the Libyan coast. The contract area comprises 2.5 million acres in water depths ranging from 5400 feet to more than 8700 feet. The work program includes 2D and 3D seismic and one deepwater exploration well. The contract award is expected to be ratified by the Libyan government earlier this year. This further adds to our industry-leading portfolio of exploration opportunities around the world. In our Downstream business, we also had a number of notable achievements in the fourth quarter. ExxonMobil's Baton Rouge refinery received the 2007 ENERGY STAR Award from the U.S. Environmental Protection Agency. This award recognizes our achievements in reducing energy consumption at the facility and our continuing efforts to improve energy efficiency in our operations. We continue to grow profitability at our refineries through our molecule-management technology and our ongoing crude diversification efforts. In the fourth quarter, we ran 43 crudes new to individual refineries and five new to ExxonMobil. In our lubes business, we announced that ExxonMobil will become the titled sponsor of the Penske Racing Number 77 Mobil 1 Dodge in the 2008 NASCAR Sprint Cup Series. Mobil 1 is the official motor oil of NASCAR and is used by more than 60% of the racing teams. This reflects the exceptional performance and protection that Mobil 1 provides, even under the most extreme conditions and our continued commitment to developing innovative high-quality products. In our shipping business, both of ExxonMobil's maritime affiliates, SeaRiver Maritime in the U.S. and International Marine Transportation in the U.K were again awarded the British Safety Council's Sword of Honor. As the Council's top recognition, the prestigious award highlights the exceptional quality of our people, the effectiveness of our processes and systems, and our continuous efforts to further improve safety performance. ExxonMobil also achieved a number of milestones in our Chemical business in the fourth quarter. In December, we announced the development of new film technologies for lithium-ion batteries. These technologies have the potential to improve the energy efficiency and affordability of next-generation hybrid and electric vehicles by significantly enhancing the power, safety and reliability of lithium-ion batteries. Through our Japanese affiliate, Tonen Chemical, we also signed a Memorandum of Understanding to progress a feasibility study with the construction and operation of a battery manufacturing facility in Gumi, South Korea. We look forward to working with automakers and battery manufacturers on implementing these technologies and addressing the challenges in producing the next-generation of low-emissions vehicles. In the quarter, ExxonMobil Chemical started up a new compounding facility at our integrated complex in Baton Rouge, Louisiana. This achievement, along with formation of our new business lines dedicated to specialty compound and composites, is part of our commitment to the development, production and marketing of engineered polyolefin compounds around the world. This world-class facility at Baton Rouge, will further enhance ExxonMobil's capability to supply high-performance products to the automotive, appliance and specialty consumer products industries. These developments highlight our ongoing commitment to advancing technological innovation across all of our business lines. Now turning to the business-line results. Upstream earnings in the fourth quarter were a record at $8.2 billion, up $2 billion from the fourth quarter of 2006. We continued to capture the benefit of strong industry conditions, this quarter with Upstream after-tax unit earnings, up $20.97 per barrel. Higher crude oil and natural gas realizations drove the majority of the earnings increase, with worldwide crude oil realizations up $29 per barrel from fourth quarter 2006. Volume and mix effects were negative, as lower crude oil volumes and mix effects more than offset increased natural gas volumes. Other effects reduced earnings by $600 million, primarily due to negative tax impacts and higher operating expenses, including the effect of newfield start-ups. These were partially offset by positive earnings from assets sales. Oil equivalent volumes increased nearly 1% versus the same quarter last year, driven by higher natural gas demand in Europe. Excluding the Venezuela expropriation, divestments, quotas and price and spend impacts on volumes, production was up nearly 3%. The increase in European natural gas demand combined with major project ramp ups in Russia, West Africa, Qatar and the North Sea, more than offset natural fuel decline in the PSC net interest productions. Liquids production decreased about 160,000 barrels per day versus the same quarter last year, as natural fuel decline in mature areas and PSC net interest reductions more than offset the impact of major project ramp ups in Russia and West Africa. Gas volumes increased approximately 1.1 billion cubic feet per day, were 12% versus the fourth quarter of 2006. New project volumes in Qatar and the North Sea and higher demand due to colder weather in Europe, were partly offset by natural fuel decline in mature areas. Turning now to the sequential comparison; versus the third quarter of 2007, Upstream earnings increased by $1.9 billion. Higher realizations increased earnings by $1.6 billion, driven by an almost $14 per barrel increase in crude oil prices. Volume and mix effects were also positive, due to higher natural gas volumes. Oil equivalent volumes were up nearly 9% from the third quarter, due to seasonally higher natural gas demand in Europe. Looking now at the full year results. 2007 Upstream earnings were a record $26.5 billion, an increase of $270 million over 2006. Improved realizations increased earnings by almost $2.5 billion, reflecting a nearly $8 per barrel increase in average crude oil prices, partially offset by lower natural gas realizations. Other factors included the combined effect of higher expenses, including the impact of new project start-ups, increased exploration activity and negative tax effects. Full year oil equivalent production was down 1% versus 2006. Liquid volumes were down 2%, while natural gas volumes were up just under 1%. Excluding the Venezuela expropriation, divestments, quotas and price and spend impacts on volumes, production was up nearly 1%. New project volumes in West Africa, Russia, the North Sea and Qatar, more than offset natural fuel decline in mature areas and PSC net interest reductions of approximately 100,000 barrels per day. For further data on regional volumes, please refer the press release and IR supplement. Turning now to the Downstream results. Earnings in the fourth quarter were $2.3 billion, up nearly $310 million from the fourth quarter of 2006. Lower margins reduced earnings by $410 million primarily due to lower U.S. refining margins. Volume and mix effects increased earnings by $290 million, reflecting the benefits of our ongoing refinery optimization activities. Other affects improved earnings by $430 million, driven by gains on assets sales this quarter. LIFO inventory effects were about in line with 2006. Sequentially, fourth quarter earnings increased by $265 million, lower margins reduced earnings by $660 million, driven by a weaker refining margins and marketing margins. Volume in mixed effects increased earnings by $310 million due to improved refining operations and lower turnaround activity. Other factors increased earnings by $620 million, including positive LIFO inventory effects of approximately $250 million and also higher asset sales. Full year 2007, downstream earnings were a record for the corporation at $9.6 billion, $1.1 billion higher than 2006. Lower margins reduced earnings by $230 million, reflecting lower refining margins in the U.S. Volume and mixed effects benefited earnings by $780 million, reflecting our ongoing focus on refinery feedstock flexibility, capacity utilization and product optimization. Other factors improved earnings by $570 million, including positive effects from asset sales. Focusing now on our Chemicals results. Fourth quarter Chemical earnings were $1.1 billion, $130 million lower than the fourth quarter of 2006. Margin effects reduced earnings by $520 million, as higher feedstock costs more than offset increased product realizations. Volume and mixed effects improved earnings by $170 million, reflecting higher commodity and specialty sales. Other factors were a positive $220 million, including favorable tax and foreign exchange effects. Sequentially, fourth quarter Chemical earnings decreased by $90 million. Lower margins reduced earnings by $300 million, as higher feedstock costs more than offset increased realizations. Other factors benefited earnings by $180 million, including positive tax and LIFO inventory effects. Full year 2007 Chemical earnings were a record, at $4.6 billion, up $180 million from 2006. Lower margins reduced earnings by $330 million, reflecting increased feedstock cost, partially offset by higher product realizations. Higher sales volumes and positive mixed effects increased earnings by $118 million. Other effects were a positive $330 million, including favorable foreign exchange effects. Now turning to our Corporate and Financing statement. The corporation recorded fourth quarter earnings of $77 million, down $341 million from fourth quarter 2006, primarily due to the absence of positive tax effects. For the full year 2007 Corporate and Financing segment expenses were $23 million compared to earnings of $24 million in 2006. The effective tax rate for the fourth quarter and full year 2007 was 44%. The corporation distributed almost $9 billion to shareholders in the fourth quarter through dividends and share repurchases to reduce shares outstanding. Of that total, $7 billion was distributed to purchase shares in excess of dilution, reducing the number of shares outstanding by 1.5%. For the full year 2007, we purchased $28 billion of shares in shares in excess of dilution and reduced shares outstanding by 6%, further demonstrating our ongoing commitment to return cash to our shareholders. CapEx in the fourth quarter was $6.2 billion, an increase of 21% from fourth quarter 2006, and bringing 2007 full year CapEx to $20.9 billion. This is in line with our previous guidance and an increase of $1 billion from 2006. Fourth quarter cash flow from operations and asset sales was $13.1 billion. At the end of the fourth quarter, our cash balance was $34 billion and debt was 9.6. In summary, these record results again demonstrate how ExxonMobil's longstanding commitment to the integrity of our operations, disciplined investment and integrated business model continue to deliver superior results. Finally, I would like to mention two upcoming events, first in mid-February, we will be releasing our 2007 reserves performance data and second, as many of you will already have seen, our analysts meeting this year will take place on March 5th This will include a live audio webcast beginning at 9 AM Eastern, 8 AM Central Time and an update on a forward business plans. ExxonMobil's presenters will be led by Chairman and CEO, Rex Tillerson. That concludes my prepared remarks. I would now be happy to take your questions. Question And Answer
Operator: Thank you sir. Today's question-and-answer session will be held electronically. [Operator Instructions]. And we will take our first question from Doug Terreson at Morgan Stanley.
Douglas T. Terreson - Morgan Stanley: Congratulations on record results Henry.
Henry H Hubble - Vice President of Investor Relations and Secretary: Thanks Doug.
Douglas T. Terreson - Morgan Stanley: The rate of inflation on production costs was fairly high last year for you guys and others in the industry too. And on this point, besides the successful capital and project management plans you guys have, I want to see if you provide an update on any productivity programs or initiatives that might be in place or emerging in E&P and also the result that you have to achieve if these plans are in place; meaning, in refinery for instance, you talked a little bit about molecule-management program that I think you guys expect to receive an earnings benefit of $250 million by 09 and so. The question is whether similar plans are in place in E&P and if so, any targets you might have?
Henry H Hubble - Vice President of Investor Relations and Secretary: Yes. When you look at how we approach OpEx and general cost inflation across our business, it's something that basically is an approach we take whether its upstream, downstream, chemicals we are always looking for improved efficiencies, technologies will help lower costs and basically self improvement kinds of or self help kinds of initiatives. If you look at the E&P area in particular, I mean past year is one of... if you look at one of the areas of the biggest ramp-up in cost has been in drill rigs and of course things you can do to reduce those costs, drilling faster, being able to make those, bringing those wells more productively is a big driver. We've spent over $4 billion a year in drilling alone. So it's... it can have a big drive on reducing on those costs. When you look at our developments in the Piceance's Basin, the multi-zone stimulation technology that we have there, again it's basically driven technology that helps us lower cost and improve productivity of those operations. And of course, then throughout our organization, we are constantly focused on reducing energy requirements and running operations efficiently throughout the business. So, I can share some specific targets, generally though, if you look at what we have delivered in self help kinds of things and OpEx, it's brought forward, if you look at the past, about $1 billion a year and we'll sharing with you the results of that in our upcoming analyst meetings.
Douglas T. Terreson - Morgan Stanley: Okay, great. Henry thanks a lot.
Operator: We'll go next to Mark Flannery with Credit Suisse.
Mark Flannery - Credit Suisse: Hi Henry.
Henry H Hubble - Vice President of Investor Relations and Secretary: Hi.
Mark Flannery - Credit Suisse: I'm looking for some guidance really on the PSC impact that we might want to factor in for 2008. There has been a big run up in oil prices, we are not asking you to forecast oil prices but, can you give us some rule of thumb maybe for what would happen to your expectations of 2008 production, let's say, if oil average $90 for 2008 versus averaging $70 for 2008?
Henry H Hubble - Vice President of Investor Relations and Secretary: Well we will be going through and actually updating our production profile at the analyst meeting in March. But just stepping back, I think it maybe helpful to talk about what's been going on in this area. What you see in the PSC impacts and these net interest reductions, basically it's a reflection of accelerated ... a significant acceleration in value that we have captured associated with these projects. The higher prices basically have improved the economics, but they do end up reducing the number of barrels. We have just over 20% of our production under PSC-type terms. Not all of those PSCs are the same, they can have different, both terms and characteristics, including the extent to which they changed... our volumes change over time. When you look at the effects that we have seen, most of those have occurred in Africa and then the PSC reductions and net interest reductions, basically reflect us moving through investment return thresholds at those specific developments. Now these occur at different times during the year, it depends on the price, it depends on the performance of the projects. So to go through and give you a rough estimate at this point is and especially when you are doing year-on-year comparisons and you look at where those trends changes change, we will go through and give you our best estimate of that at our March 5th meeting.
Mark Flannery - Credit Suisse: Okay, great. Thanks a lot.
Henry H Hubble - Vice President of Investor Relations and Secretary: Yes.
Operator: We will go next to Nicky Decker, Bear Stearns.
Nicole Decker - Bear Stearns: Good morning Henry. My question is on Angola, really regarding the Angola development, now that OPEC quotas have been assigned there. Are you seeing any changes in terms of the pace at which projects are able to move forward there and may be you could comment on where you are on Kizomba D?
Henry H Hubble - Vice President of Investor Relations and Secretary: We are not really, in terms of the impact from OPEC or their joining OPEC, we really haven't seen anything roll through. As you see in the Kizomba C developments, they've moved ahead first schedule. And the Kizomba A satellites are moving ahead as we expect. So we can't point anything that would say there's change there associated with that. And we've had very good relations in the... as you know, those projects have performed very well both in terms of being able to bring them in on-schedule and at our costs and so, basically we are moving ahead and on-schedule for those deliveries.
Nicole Decker - Bear Stearns: Okay, and on that note Henry, did you say Saxi/Batuque starts later this year?
Henry H Hubble - Vice President of Investor Relations and Secretary: Yes.
Nicole Decker - Bear Stearns: Is that a little ahead of schedule?
Henry H Hubble - Vice President of Investor Relations and Secretary: No, that's about on-schedule.
Nicole Decker - Bear Stearns: Okay. Thank you.
Henry H Hubble - Vice President of Investor Relations and Secretary: Yes, no problem.
Operator: And we'll go next to Paul Sankey of Deutsche Bank.
Paul Sankey - Deutsche Bank Securities: Hi Henry.
Henry H Hubble - Vice President of Investor Relations and Secretary: Hey Paul.
Paul Sankey - Deutsche Bank Securities: Henry, I was just wondering, are you expecting to replace the 100% of reserves this year?
Henry H Hubble - Vice President of Investor Relations and Secretary: Well, as you know and I mentioned, we'll give you that update in a couple of weeks here.
Paul Sankey - Deutsche Bank Securities: Is that the... is the couple of weeks kind of the timeframe to that --
Henry H Hubble - Vice President of Investor Relations and Secretary: Yes. Mid-February, we typically are coming out with that and we'll have it soon.
Paul Sankey - Deutsche Bank Securities: As a follow-up to Mark Flannery's question, I was wondering about PSC impact. Is there any idea that you can give us on how that might eat away the number?
Henry H Hubble - Vice President of Investor Relations and Secretary: Well, we will give you the update and we were really talking about all of these kinds of effects at our analysts meeting. But, I mean that's just our usual time for these things and I am just not going to prejudge those things at this point.
Paul Sankey - Deutsche Bank Securities: Yes, that was actually a trick question Henry.
Henry H Hubble - Vice President of Investor Relations and Secretary: I know that.
Paul Sankey - Deutsche Bank Securities: Henry, could you just on the line item basis go through your asset sales, because it came up a number of times. I wondered if you could be so kind to just strip out upstream, downstream?
Henry H Hubble - Vice President of Investor Relations and Secretary: Speaking in the downstream?
Paul Sankey - Deutsche Bank Securities: Upstream... international Upstream, U.S. Downstream, if possible thanks.
Henry H Hubble - Vice President of Investor Relations and Secretary: Yes, in the Upstream, there is... we have some asset sales, the largest of those was car and then if you look at the downstream --
Paul Sankey - Deutsche Bank Securities: I guess there isn't price on that, Henry?
Henry H Hubble - Vice President of Investor Relations and Secretary: No, no.
Paul Sankey - Deutsche Bank Securities: Thanks.
Henry H Hubble - Vice President of Investor Relations and Secretary: And then if you look at the Downstream as we mentioned it was about $450 million associated with the Downstream divestments. Those were made up of a number of different... none of them large in on their own, both mostly in Europe and in our marketing operations. But it's part of our normal process that we go through possibly looking at our portfolio, looking at what the market is willing to pay for things and we are constantly high-grading and basically reflects our ongoing activity.
Paul Sankey - Deutsche Bank Securities: So you have nothing in Chemicals.
Henry H Hubble - Vice President of Investor Relations and Secretary: No.
Paul Sankey - Deutsche Bank Securities: And no acquisitions?
Henry H Hubble - Vice President of Investor Relations and Secretary: Nothing on material, anyway.
Paul Sankey - Deutsche Bank Securities: And no acquisitions?
Henry H Hubble - Vice President of Investor Relations and Secretary: No.
Paul Sankey - Deutsche Bank Securities: Finally from me Henry, Nigeria, there may be some issues we understand to do with renegotiation there. Can you update us and I will leave it there. Thank you.
Henry H Hubble - Vice President of Investor Relations and Secretary: Yes, thanks. There is... I mean there has been some things in the press in that kind of business. But right now, basically the affiliates operate in several joint venture concessions there in Nigeria. And under the Nigerian law, the production sharing contract is subject to review in 2008. We are not going to... I am not going to really speculate on the future business or discuss those future business perhaps that might come out, those discussions will go on during that timeframe, so we will see.
Paul Sankey - Deutsche Bank Securities: Thank you
Henry H Hubble - Vice President of Investor Relations and Secretary: Yes.
Operator: And we will go next to Kath Lucas at J P Morgan.
Katherine Lucas - J P Morgan: Hi, good morning, it's Kath Lucas for Michael LaMotte.
Henry H Hubble - Vice President of Investor Relations and Secretary: Hi.
Katherine Lucas - J P Morgan: Hi, I have quick question on Qatar. Seems like some contractors like Techniques are announcing some charges related to some overruns. Are these negotiated settlements that would translate into higher project completion costs for Exxon or are things moving along there as you had originally anticipated?
Henry H Hubble - Vice President of Investor Relations and Secretary: Things are moving ahead, basically per schedule and we've had no changes to our assessment there in terms of the costs associated with those. I mean if you look, there has been some things, people have... different folks have talked about, potential for delays. Right now our schedule is that... as per original schedule, we anticipate start-up of Qatar gas to Train 4 in 2008, also the RasGas Train 6 is scheduled for start-up in 2008. And then Qatar gas 2, Train 5 projected in 2009 and RasGas Train 7 in 2009. So no real change to what we have laid out in the past in the schedule or cost wise.
Katherine Lucas - J P Morgan: Okay great, thanks. And if I could just ask a final on Brazil, I think the original indications were that you just got the first export trial on BM-S-22 in the fourth quarter this year, but it seems like there maybe the potential to do, can you give us an update on the timing on the first well?
Henry H Hubble - Vice President of Investor Relations and Secretary: Well, we are working to progress that and basically we will be moving ahead with this... as we have the rig available to start that. We expect to do it in the second half of this year.
Katherine Lucas - J P Morgan: Okay, great. Thanks very much.
Operator: [Operator Instructions]. Next you Oswald Clint at Sanford C. Bernstein.
Oswald Clint - Sanford C. Bernstein: Hello, Hi, Good morning Henry.
Henry H Hubble - Vice President of Investor Relations and Secretary: Hi [indiscernible]
Oswald Clint - Sanford C. Bernstein: Just a couple of question, first on the line items. Is there ... could tell us if there is a Canadian tax benefit in the international Upstream and then secondly, perhaps just an update on Venezuela. We didn't get any color on that this quarter. And then finally, just if there anything you can say on the Julia discovery in terms of can we expect an appraisal well some time later in the current year. Thank you.
Henry H Hubble - Vice President of Investor Relations and Secretary: Yes, I mean in the tax area, if you look at the biggest tax impacts in the Upstream, the largest was associated with Alaska actually, and then there were...there was impacts in Canada, but relatively small. U.K. was the other one that had had some impact in the period. And then, Julia basically as we've had indications of hydrocarbon there. We were scheduled to start in the first quarter to help basically appraise the extent of the discovery. And was there another piece on Venezuela --
Oswald Clint - Sanford C. Bernstein: Yes.
Henry H Hubble - Vice President of Investor Relations and Secretary: It's basically, it's ongoing we have filed with the... for the arbitrations and we'd like get back to the table if we can get things under discussion with the Venezuelans on that. But basically we are proceeding on the arbitration track at this point.
Oswald Clint - Sanford C. Bernstein: Okay. Thank you.
Henry H Hubble - Vice President of Investor Relations and Secretary: Yes.
Operator: [Operator Instructions]. Next to Doug Leggate of Citigroup.
Doug Leggate - Citigroup: Thank you. Good morning.
Henry H Hubble - Vice President of Investor Relations and Secretary: Hi Doug.
Doug Leggate - Citigroup: Hi, I apologies Henry, I may have missed a little bit of what you've been saying already.
Henry H Hubble - Vice President of Investor Relations and Secretary: I understand.
Doug Leggate - Citigroup: My question was on the kind of non recurring of the ... I guess you can call them anymore but the one-off items.
Henry H Hubble - Vice President of Investor Relations and Secretary: Yes.
Doug Leggate - Citigroup: Just trying to get some absolute feel for the level on the split, particularly in the Downstream and if you could going in for a little bit more detail on the $600 million, I think in the Upstream also?
Henry H Hubble - Vice President of Investor Relations and Secretary: Yes, if... again if you look at the downstream and I am assuming you are talking fourth quarter 07 fourth quarter 06.
Doug Leggate - Citigroup: Yes, If we could get the absolute number, Henry that would be great.
Henry H Hubble - Vice President of Investor Relations and Secretary: Well they were about... as we mentioned in the call or in the script they were about $450 million associated with asset sales in the period. And if you look at those were basically the biggest piece of those were in Europe and our marketing operations, just part of our ongoing, hi-grading we did talk about that just before. So none of them were by themselves very significant. And then if you look at in the Upstream the $600 million negative basically, it's a number of items as they typically are in these areas, number of them tax related, Alaska was one of the bigger pieces but we also had impacts as I mentioned in the UK, that will also increase the expenses, some of that associated with the new project start-ups. Those were kind of the big negatives in there.
Doug Leggate - Citigroup: Okay and if I may just go back to the 450 in India, there it is $450 million higher. So was it actually $450 million absolute as well.
Henry H Hubble - Vice President of Investor Relations and Secretary: That was basically... there wasn't much of anything else in the prior period. Right?
Doug Leggate - Citigroup: That's sound, that's fine. Thanks very much.
Henry H Hubble - Vice President of Investor Relations and Secretary: Yes, no problem.
Operator: It appears that we are standing by with no further questions at this time. Mr. Hubble, I would like to turn the conference back to you for any closing or additional comments.
Henry H Hubble - Vice President of Investor Relations and Secretary: Well I would just like to thank everybody for their time and questions this morning. We look forward to sharing the details on our performance and our forward business plans at the analyst meeting in March. Thank you very much.
Operator: This does conclude our conference for today. We do thank you very much for your participation. You may disconnect as this time. | [
{
"speaker": "Executives",
"text": "Henry H Hubble - VP of IR and Secretary"
},
{
"speaker": "Analysts",
"text": "Douglas T. Terreson - Morgan Stanley Mark Flannery - Credit Suisse Nicole Decker - Bear Stearns Paul Sankey - Deutsche Bank Securities Katherine Lucas - J P Morgan Oswald Clint - Sanford C. Bernstein Doug Leggate - Citigroup"
},
{
"speaker": "Operator",
"text": "Good day everyone and welcome to this Exxon Mobil Corporation Fourth Quarter 2007 Earnings Conference Call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like turn the call over to the Vice President of Investor Relations and Secretary Mr. Henry Hubble. Please go ahead sir."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Good morning and welcome to ExxonMobil's teleconference and webcast on our fourth quarter and full year 2007 financial and operating results. As you are aware from this morning's press release, we had another strong quarter. In an environment of robust commodity prices, our fourth quarter results again highlight the fundamental strength of our business. We continue to deliver superior operational performance and leverage our integrated capabilities, while investing at record levels in an industry-leading portfolio of projects to bring supplies to market. Before we go further, I would like to draw your attention to our cautionary statement. Please note that estimates, plans, and projections are forward-looking statements. Actual results, including resource recoveries, volume growth and project outcomes, could differ materially due to the factors I discussed and factors noted in our SEC filings. Please see factors affecting future results and the Form 8-K, we furnished this morning, which are available through the Investors Section of our website. Please also see the frequently used terms, the supplements to this morning's press release and the 2006 financial and operating review on our website. This material defines key terms I will use today, shows ExxonMobil's net interest in specific projects and includes our SEC Regulation G disclosure. Now I'm pleased to turn your attention to the fourth quarter results. ExxonMobil's fourth quarter 2007 normalized earnings and net income were a record for the corporation, at $11.7 billion, up to $2.3 billion from the third quarter of this year, versus the fourth quarter of 2006, net income increased $1.4 billion and normalized earnings were up $1.8 billion. Fourth quarter normalized earnings per share were $2.13, up 26% from the year ago, reflecting the strength of our financial performances and the benefits of our ongoing share repurchase program. ExxonMobil's net income and normalized earnings for 2007 totaled $40.6 billion, also a record for the Corporation. Normalized earnings were up $1.5 billion from 2006, while net income increase $1.1 billion. Before I discuss the specific business results, I would like to share with you some milestones achieved since our last earnings call. Starting with our Upstream business. In October, we achieved initial oil production from the first expansion of the Tengiz development in Kazakhstan. When complete, this expansion project, Tengiz Phase 1, will fully incorporate a second-generation gas handling project with sour gas injection. The project is expected to deliver incremental production of 285,000 barrels of oil per day at full capacity. This was ExxonMobil's seventh major Upstream project startup in 2007. In January, we started up production from the Mondo field in the ExxonMobil-operated Kizomba C development, in Block 15 offshore Angola. The Kizomba C development exemplifies ExxonMobil's design one, build multiple' strategy as it includes two projects; Mondo and Saxi/Batuque. Each project utilizes a floating production storage and off-loading vessel that will handle up to a 100,000 barrels per day. Together these projects are expected to recover 600 million barrels of oil. We anticipate the start-up of Saxi and Batuque fields later this year, completing the Kizomba C development. These project start-ups demonstrate ExxonMobil's commitment to bring new energy supplies to market and deliver value to our shareholders. Also in the fourth quarter, we announced plans to seek regulatory approval for our BlueOcean Energy project. This project includes a floating LNG receiving terminal, 20 miles off the coast of New Jersey and will have the capacity to supply about 1.2 billion cubic feet of clean burning natural gas per day to help meet the growing energy needs of consumers in New York and New Jersey. During the fourth quarter, we also signed a heads of agreement with Libya's National Oil Corporation to execute an exploration and production sharing agreement. The agreement includes four blocks located in the Sirte Basin, approximately110 miles off the Libyan coast. The contract area comprises 2.5 million acres in water depths ranging from 5400 feet to more than 8700 feet. The work program includes 2D and 3D seismic and one deepwater exploration well. The contract award is expected to be ratified by the Libyan government earlier this year. This further adds to our industry-leading portfolio of exploration opportunities around the world. In our Downstream business, we also had a number of notable achievements in the fourth quarter. ExxonMobil's Baton Rouge refinery received the 2007 ENERGY STAR Award from the U.S. Environmental Protection Agency. This award recognizes our achievements in reducing energy consumption at the facility and our continuing efforts to improve energy efficiency in our operations. We continue to grow profitability at our refineries through our molecule-management technology and our ongoing crude diversification efforts. In the fourth quarter, we ran 43 crudes new to individual refineries and five new to ExxonMobil. In our lubes business, we announced that ExxonMobil will become the titled sponsor of the Penske Racing Number 77 Mobil 1 Dodge in the 2008 NASCAR Sprint Cup Series. Mobil 1 is the official motor oil of NASCAR and is used by more than 60% of the racing teams. This reflects the exceptional performance and protection that Mobil 1 provides, even under the most extreme conditions and our continued commitment to developing innovative high-quality products. In our shipping business, both of ExxonMobil's maritime affiliates, SeaRiver Maritime in the U.S. and International Marine Transportation in the U.K were again awarded the British Safety Council's Sword of Honor. As the Council's top recognition, the prestigious award highlights the exceptional quality of our people, the effectiveness of our processes and systems, and our continuous efforts to further improve safety performance. ExxonMobil also achieved a number of milestones in our Chemical business in the fourth quarter. In December, we announced the development of new film technologies for lithium-ion batteries. These technologies have the potential to improve the energy efficiency and affordability of next-generation hybrid and electric vehicles by significantly enhancing the power, safety and reliability of lithium-ion batteries. Through our Japanese affiliate, Tonen Chemical, we also signed a Memorandum of Understanding to progress a feasibility study with the construction and operation of a battery manufacturing facility in Gumi, South Korea. We look forward to working with automakers and battery manufacturers on implementing these technologies and addressing the challenges in producing the next-generation of low-emissions vehicles. In the quarter, ExxonMobil Chemical started up a new compounding facility at our integrated complex in Baton Rouge, Louisiana. This achievement, along with formation of our new business lines dedicated to specialty compound and composites, is part of our commitment to the development, production and marketing of engineered polyolefin compounds around the world. This world-class facility at Baton Rouge, will further enhance ExxonMobil's capability to supply high-performance products to the automotive, appliance and specialty consumer products industries. These developments highlight our ongoing commitment to advancing technological innovation across all of our business lines. Now turning to the business-line results. Upstream earnings in the fourth quarter were a record at $8.2 billion, up $2 billion from the fourth quarter of 2006. We continued to capture the benefit of strong industry conditions, this quarter with Upstream after-tax unit earnings, up $20.97 per barrel. Higher crude oil and natural gas realizations drove the majority of the earnings increase, with worldwide crude oil realizations up $29 per barrel from fourth quarter 2006. Volume and mix effects were negative, as lower crude oil volumes and mix effects more than offset increased natural gas volumes. Other effects reduced earnings by $600 million, primarily due to negative tax impacts and higher operating expenses, including the effect of newfield start-ups. These were partially offset by positive earnings from assets sales. Oil equivalent volumes increased nearly 1% versus the same quarter last year, driven by higher natural gas demand in Europe. Excluding the Venezuela expropriation, divestments, quotas and price and spend impacts on volumes, production was up nearly 3%. The increase in European natural gas demand combined with major project ramp ups in Russia, West Africa, Qatar and the North Sea, more than offset natural fuel decline in the PSC net interest productions. Liquids production decreased about 160,000 barrels per day versus the same quarter last year, as natural fuel decline in mature areas and PSC net interest reductions more than offset the impact of major project ramp ups in Russia and West Africa. Gas volumes increased approximately 1.1 billion cubic feet per day, were 12% versus the fourth quarter of 2006. New project volumes in Qatar and the North Sea and higher demand due to colder weather in Europe, were partly offset by natural fuel decline in mature areas. Turning now to the sequential comparison; versus the third quarter of 2007, Upstream earnings increased by $1.9 billion. Higher realizations increased earnings by $1.6 billion, driven by an almost $14 per barrel increase in crude oil prices. Volume and mix effects were also positive, due to higher natural gas volumes. Oil equivalent volumes were up nearly 9% from the third quarter, due to seasonally higher natural gas demand in Europe. Looking now at the full year results. 2007 Upstream earnings were a record $26.5 billion, an increase of $270 million over 2006. Improved realizations increased earnings by almost $2.5 billion, reflecting a nearly $8 per barrel increase in average crude oil prices, partially offset by lower natural gas realizations. Other factors included the combined effect of higher expenses, including the impact of new project start-ups, increased exploration activity and negative tax effects. Full year oil equivalent production was down 1% versus 2006. Liquid volumes were down 2%, while natural gas volumes were up just under 1%. Excluding the Venezuela expropriation, divestments, quotas and price and spend impacts on volumes, production was up nearly 1%. New project volumes in West Africa, Russia, the North Sea and Qatar, more than offset natural fuel decline in mature areas and PSC net interest reductions of approximately 100,000 barrels per day. For further data on regional volumes, please refer the press release and IR supplement. Turning now to the Downstream results. Earnings in the fourth quarter were $2.3 billion, up nearly $310 million from the fourth quarter of 2006. Lower margins reduced earnings by $410 million primarily due to lower U.S. refining margins. Volume and mix effects increased earnings by $290 million, reflecting the benefits of our ongoing refinery optimization activities. Other affects improved earnings by $430 million, driven by gains on assets sales this quarter. LIFO inventory effects were about in line with 2006. Sequentially, fourth quarter earnings increased by $265 million, lower margins reduced earnings by $660 million, driven by a weaker refining margins and marketing margins. Volume in mixed effects increased earnings by $310 million due to improved refining operations and lower turnaround activity. Other factors increased earnings by $620 million, including positive LIFO inventory effects of approximately $250 million and also higher asset sales. Full year 2007, downstream earnings were a record for the corporation at $9.6 billion, $1.1 billion higher than 2006. Lower margins reduced earnings by $230 million, reflecting lower refining margins in the U.S. Volume and mixed effects benefited earnings by $780 million, reflecting our ongoing focus on refinery feedstock flexibility, capacity utilization and product optimization. Other factors improved earnings by $570 million, including positive effects from asset sales. Focusing now on our Chemicals results. Fourth quarter Chemical earnings were $1.1 billion, $130 million lower than the fourth quarter of 2006. Margin effects reduced earnings by $520 million, as higher feedstock costs more than offset increased product realizations. Volume and mixed effects improved earnings by $170 million, reflecting higher commodity and specialty sales. Other factors were a positive $220 million, including favorable tax and foreign exchange effects. Sequentially, fourth quarter Chemical earnings decreased by $90 million. Lower margins reduced earnings by $300 million, as higher feedstock costs more than offset increased realizations. Other factors benefited earnings by $180 million, including positive tax and LIFO inventory effects. Full year 2007 Chemical earnings were a record, at $4.6 billion, up $180 million from 2006. Lower margins reduced earnings by $330 million, reflecting increased feedstock cost, partially offset by higher product realizations. Higher sales volumes and positive mixed effects increased earnings by $118 million. Other effects were a positive $330 million, including favorable foreign exchange effects. Now turning to our Corporate and Financing statement. The corporation recorded fourth quarter earnings of $77 million, down $341 million from fourth quarter 2006, primarily due to the absence of positive tax effects. For the full year 2007 Corporate and Financing segment expenses were $23 million compared to earnings of $24 million in 2006. The effective tax rate for the fourth quarter and full year 2007 was 44%. The corporation distributed almost $9 billion to shareholders in the fourth quarter through dividends and share repurchases to reduce shares outstanding. Of that total, $7 billion was distributed to purchase shares in excess of dilution, reducing the number of shares outstanding by 1.5%. For the full year 2007, we purchased $28 billion of shares in shares in excess of dilution and reduced shares outstanding by 6%, further demonstrating our ongoing commitment to return cash to our shareholders. CapEx in the fourth quarter was $6.2 billion, an increase of 21% from fourth quarter 2006, and bringing 2007 full year CapEx to $20.9 billion. This is in line with our previous guidance and an increase of $1 billion from 2006. Fourth quarter cash flow from operations and asset sales was $13.1 billion. At the end of the fourth quarter, our cash balance was $34 billion and debt was 9.6. In summary, these record results again demonstrate how ExxonMobil's longstanding commitment to the integrity of our operations, disciplined investment and integrated business model continue to deliver superior results. Finally, I would like to mention two upcoming events, first in mid-February, we will be releasing our 2007 reserves performance data and second, as many of you will already have seen, our analysts meeting this year will take place on March 5th This will include a live audio webcast beginning at 9 AM Eastern, 8 AM Central Time and an update on a forward business plans. ExxonMobil's presenters will be led by Chairman and CEO, Rex Tillerson. That concludes my prepared remarks. I would now be happy to take your questions. Question And Answer"
},
{
"speaker": "Operator",
"text": "Thank you sir. Today's question-and-answer session will be held electronically. [Operator Instructions]. And we will take our first question from Doug Terreson at Morgan Stanley."
},
{
"speaker": "Douglas T. Terreson - Morgan Stanley",
"text": "Congratulations on record results Henry."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Thanks Doug."
},
{
"speaker": "Douglas T. Terreson - Morgan Stanley",
"text": "The rate of inflation on production costs was fairly high last year for you guys and others in the industry too. And on this point, besides the successful capital and project management plans you guys have, I want to see if you provide an update on any productivity programs or initiatives that might be in place or emerging in E&P and also the result that you have to achieve if these plans are in place; meaning, in refinery for instance, you talked a little bit about molecule-management program that I think you guys expect to receive an earnings benefit of $250 million by 09 and so. The question is whether similar plans are in place in E&P and if so, any targets you might have?"
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Yes. When you look at how we approach OpEx and general cost inflation across our business, it's something that basically is an approach we take whether its upstream, downstream, chemicals we are always looking for improved efficiencies, technologies will help lower costs and basically self improvement kinds of or self help kinds of initiatives. If you look at the E&P area in particular, I mean past year is one of... if you look at one of the areas of the biggest ramp-up in cost has been in drill rigs and of course things you can do to reduce those costs, drilling faster, being able to make those, bringing those wells more productively is a big driver. We've spent over $4 billion a year in drilling alone. So it's... it can have a big drive on reducing on those costs. When you look at our developments in the Piceance's Basin, the multi-zone stimulation technology that we have there, again it's basically driven technology that helps us lower cost and improve productivity of those operations. And of course, then throughout our organization, we are constantly focused on reducing energy requirements and running operations efficiently throughout the business. So, I can share some specific targets, generally though, if you look at what we have delivered in self help kinds of things and OpEx, it's brought forward, if you look at the past, about $1 billion a year and we'll sharing with you the results of that in our upcoming analyst meetings."
},
{
"speaker": "Douglas T. Terreson - Morgan Stanley",
"text": "Okay, great. Henry thanks a lot."
},
{
"speaker": "Operator",
"text": "We'll go next to Mark Flannery with Credit Suisse."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Hi Henry."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Hi."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "I'm looking for some guidance really on the PSC impact that we might want to factor in for 2008. There has been a big run up in oil prices, we are not asking you to forecast oil prices but, can you give us some rule of thumb maybe for what would happen to your expectations of 2008 production, let's say, if oil average $90 for 2008 versus averaging $70 for 2008?"
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Well we will be going through and actually updating our production profile at the analyst meeting in March. But just stepping back, I think it maybe helpful to talk about what's been going on in this area. What you see in the PSC impacts and these net interest reductions, basically it's a reflection of accelerated ... a significant acceleration in value that we have captured associated with these projects. The higher prices basically have improved the economics, but they do end up reducing the number of barrels. We have just over 20% of our production under PSC-type terms. Not all of those PSCs are the same, they can have different, both terms and characteristics, including the extent to which they changed... our volumes change over time. When you look at the effects that we have seen, most of those have occurred in Africa and then the PSC reductions and net interest reductions, basically reflect us moving through investment return thresholds at those specific developments. Now these occur at different times during the year, it depends on the price, it depends on the performance of the projects. So to go through and give you a rough estimate at this point is and especially when you are doing year-on-year comparisons and you look at where those trends changes change, we will go through and give you our best estimate of that at our March 5th meeting."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Okay, great. Thanks a lot."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "We will go next to Nicky Decker, Bear Stearns."
},
{
"speaker": "Nicole Decker - Bear Stearns",
"text": "Good morning Henry. My question is on Angola, really regarding the Angola development, now that OPEC quotas have been assigned there. Are you seeing any changes in terms of the pace at which projects are able to move forward there and may be you could comment on where you are on Kizomba D?"
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "We are not really, in terms of the impact from OPEC or their joining OPEC, we really haven't seen anything roll through. As you see in the Kizomba C developments, they've moved ahead first schedule. And the Kizomba A satellites are moving ahead as we expect. So we can't point anything that would say there's change there associated with that. And we've had very good relations in the... as you know, those projects have performed very well both in terms of being able to bring them in on-schedule and at our costs and so, basically we are moving ahead and on-schedule for those deliveries."
},
{
"speaker": "Nicole Decker - Bear Stearns",
"text": "Okay, and on that note Henry, did you say Saxi/Batuque starts later this year?"
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Yes."
},
{
"speaker": "Nicole Decker - Bear Stearns",
"text": "Is that a little ahead of schedule?"
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "No, that's about on-schedule."
},
{
"speaker": "Nicole Decker - Bear Stearns",
"text": "Okay. Thank you."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Yes, no problem."
},
{
"speaker": "Operator",
"text": "And we'll go next to Paul Sankey of Deutsche Bank."
},
{
"speaker": "Paul Sankey - Deutsche Bank Securities",
"text": "Hi Henry."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Hey Paul."
},
{
"speaker": "Paul Sankey - Deutsche Bank Securities",
"text": "Henry, I was just wondering, are you expecting to replace the 100% of reserves this year?"
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Well, as you know and I mentioned, we'll give you that update in a couple of weeks here."
},
{
"speaker": "Paul Sankey - Deutsche Bank Securities",
"text": "Is that the... is the couple of weeks kind of the timeframe to that --"
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Yes. Mid-February, we typically are coming out with that and we'll have it soon."
},
{
"speaker": "Paul Sankey - Deutsche Bank Securities",
"text": "As a follow-up to Mark Flannery's question, I was wondering about PSC impact. Is there any idea that you can give us on how that might eat away the number?"
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Well, we will give you the update and we were really talking about all of these kinds of effects at our analysts meeting. But, I mean that's just our usual time for these things and I am just not going to prejudge those things at this point."
},
{
"speaker": "Paul Sankey - Deutsche Bank Securities",
"text": "Yes, that was actually a trick question Henry."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "I know that."
},
{
"speaker": "Paul Sankey - Deutsche Bank Securities",
"text": "Henry, could you just on the line item basis go through your asset sales, because it came up a number of times. I wondered if you could be so kind to just strip out upstream, downstream?"
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Speaking in the downstream?"
},
{
"speaker": "Paul Sankey - Deutsche Bank Securities",
"text": "Upstream... international Upstream, U.S. Downstream, if possible thanks."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Yes, in the Upstream, there is... we have some asset sales, the largest of those was car and then if you look at the downstream --"
},
{
"speaker": "Paul Sankey - Deutsche Bank Securities",
"text": "I guess there isn't price on that, Henry?"
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "No, no."
},
{
"speaker": "Paul Sankey - Deutsche Bank Securities",
"text": "Thanks."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "And then if you look at the Downstream as we mentioned it was about $450 million associated with the Downstream divestments. Those were made up of a number of different... none of them large in on their own, both mostly in Europe and in our marketing operations. But it's part of our normal process that we go through possibly looking at our portfolio, looking at what the market is willing to pay for things and we are constantly high-grading and basically reflects our ongoing activity."
},
{
"speaker": "Paul Sankey - Deutsche Bank Securities",
"text": "So you have nothing in Chemicals."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "No."
},
{
"speaker": "Paul Sankey - Deutsche Bank Securities",
"text": "And no acquisitions?"
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Nothing on material, anyway."
},
{
"speaker": "Paul Sankey - Deutsche Bank Securities",
"text": "And no acquisitions?"
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "No."
},
{
"speaker": "Paul Sankey - Deutsche Bank Securities",
"text": "Finally from me Henry, Nigeria, there may be some issues we understand to do with renegotiation there. Can you update us and I will leave it there. Thank you."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Yes, thanks. There is... I mean there has been some things in the press in that kind of business. But right now, basically the affiliates operate in several joint venture concessions there in Nigeria. And under the Nigerian law, the production sharing contract is subject to review in 2008. We are not going to... I am not going to really speculate on the future business or discuss those future business perhaps that might come out, those discussions will go on during that timeframe, so we will see."
},
{
"speaker": "Paul Sankey - Deutsche Bank Securities",
"text": "Thank you"
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "And we will go next to Kath Lucas at J P Morgan."
},
{
"speaker": "Katherine Lucas - J P Morgan",
"text": "Hi, good morning, it's Kath Lucas for Michael LaMotte."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Hi."
},
{
"speaker": "Katherine Lucas - J P Morgan",
"text": "Hi, I have quick question on Qatar. Seems like some contractors like Techniques are announcing some charges related to some overruns. Are these negotiated settlements that would translate into higher project completion costs for Exxon or are things moving along there as you had originally anticipated?"
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Things are moving ahead, basically per schedule and we've had no changes to our assessment there in terms of the costs associated with those. I mean if you look, there has been some things, people have... different folks have talked about, potential for delays. Right now our schedule is that... as per original schedule, we anticipate start-up of Qatar gas to Train 4 in 2008, also the RasGas Train 6 is scheduled for start-up in 2008. And then Qatar gas 2, Train 5 projected in 2009 and RasGas Train 7 in 2009. So no real change to what we have laid out in the past in the schedule or cost wise."
},
{
"speaker": "Katherine Lucas - J P Morgan",
"text": "Okay great, thanks. And if I could just ask a final on Brazil, I think the original indications were that you just got the first export trial on BM-S-22 in the fourth quarter this year, but it seems like there maybe the potential to do, can you give us an update on the timing on the first well?"
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Well, we are working to progress that and basically we will be moving ahead with this... as we have the rig available to start that. We expect to do it in the second half of this year."
},
{
"speaker": "Katherine Lucas - J P Morgan",
"text": "Okay, great. Thanks very much."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Next you Oswald Clint at Sanford C. Bernstein."
},
{
"speaker": "Oswald Clint - Sanford C. Bernstein",
"text": "Hello, Hi, Good morning Henry."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Hi [indiscernible]"
},
{
"speaker": "Oswald Clint - Sanford C. Bernstein",
"text": "Just a couple of question, first on the line items. Is there ... could tell us if there is a Canadian tax benefit in the international Upstream and then secondly, perhaps just an update on Venezuela. We didn't get any color on that this quarter. And then finally, just if there anything you can say on the Julia discovery in terms of can we expect an appraisal well some time later in the current year. Thank you."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Yes, I mean in the tax area, if you look at the biggest tax impacts in the Upstream, the largest was associated with Alaska actually, and then there were...there was impacts in Canada, but relatively small. U.K. was the other one that had had some impact in the period. And then, Julia basically as we've had indications of hydrocarbon there. We were scheduled to start in the first quarter to help basically appraise the extent of the discovery. And was there another piece on Venezuela --"
},
{
"speaker": "Oswald Clint - Sanford C. Bernstein",
"text": "Yes."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "It's basically, it's ongoing we have filed with the... for the arbitrations and we'd like get back to the table if we can get things under discussion with the Venezuelans on that. But basically we are proceeding on the arbitration track at this point."
},
{
"speaker": "Oswald Clint - Sanford C. Bernstein",
"text": "Okay. Thank you."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Next to Doug Leggate of Citigroup."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Thank you. Good morning."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Hi Doug."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Hi, I apologies Henry, I may have missed a little bit of what you've been saying already."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "I understand."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "My question was on the kind of non recurring of the ... I guess you can call them anymore but the one-off items."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Yes."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Just trying to get some absolute feel for the level on the split, particularly in the Downstream and if you could going in for a little bit more detail on the $600 million, I think in the Upstream also?"
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Yes, if... again if you look at the downstream and I am assuming you are talking fourth quarter 07 fourth quarter 06."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Yes, If we could get the absolute number, Henry that would be great."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Well they were about... as we mentioned in the call or in the script they were about $450 million associated with asset sales in the period. And if you look at those were basically the biggest piece of those were in Europe and our marketing operations, just part of our ongoing, hi-grading we did talk about that just before. So none of them were by themselves very significant. And then if you look at in the Upstream the $600 million negative basically, it's a number of items as they typically are in these areas, number of them tax related, Alaska was one of the bigger pieces but we also had impacts as I mentioned in the UK, that will also increase the expenses, some of that associated with the new project start-ups. Those were kind of the big negatives in there."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Okay and if I may just go back to the 450 in India, there it is $450 million higher. So was it actually $450 million absolute as well."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "That was basically... there wasn't much of anything else in the prior period. Right?"
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "That's sound, that's fine. Thanks very much."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Yes, no problem."
},
{
"speaker": "Operator",
"text": "It appears that we are standing by with no further questions at this time. Mr. Hubble, I would like to turn the conference back to you for any closing or additional comments."
},
{
"speaker": "Henry H Hubble - Vice President of Investor Relations and Secretary",
"text": "Well I would just like to thank everybody for their time and questions this morning. We look forward to sharing the details on our performance and our forward business plans at the analyst meeting in March. Thank you very much."
},
{
"speaker": "Operator",
"text": "This does conclude our conference for today. We do thank you very much for your participation. You may disconnect as this time."
}
] | null | null |
XOM | 3 | 2,007 | 2007-11-01 11:00:00 | Executives: Henry Hubble - VP of IR and Secretary
Analysts: Daniel Barcelo - Banc of AmericaSecurities Doug Terreson - Morgan Stanley Nikki Decker - Bear Stearns Doug Leggate - Citigroup Neil McMahon - Sanford Bernstein Michael LaMotte - JP Morgan John Herrlin - Merrill Lynch Paul Cheng - Lehmann Brothers Mark Gilman - Benchmark Company Paul Sankey - Deutsche Bank Mark Flannery - Credit Suisse
Operator: Good day everyone and welcome tothis ExxonMobil Corporation Third Quarter 2007 Earnings Call. Today’s call isbeing recorded. At this time for opening remarks, I would like to turn the callover to the Vice President of Investor Relations and Secretary, Mr. HenryHubble. Please go ahead sir.
Henry Hubble: Thank you. Good morning andwelcome to ExxonMobil’s teleconference and webcast on our third quarter 2007financial and operating results. As you are aware from thismorning’s press release we had another good quarter as the fundamentals of ourbusiness remained strong. Our integrated business model, long standingcommitment to the integrity of our operations and disciplined approach toprudently invest and meet long-term demand growth continue to position thecompany to benefit from robust industry conditions. Before we go further, I’d like todraw your attention to our cautionary statement. Please note that estimates,plans, and projections are forward-looking statements. Actual results,including resource recoveries, volume growth, and project outcomes could differmaterially due to factors I discuss and factors noted in our SEC filings. Please see factors affectingfuture results and the Form 8-K we furnished this morning, which are availablethrough the Investors section of our website. Please also see the frequentlyused terms, the supplements to this morning's press release and the 2006financial and operating review on our website. This material defines key terms Iwill use today, shows ExxonMobil’s net interest in specific projects andincludes our SEC Regulation G disclosure. Now I’m pleased to turn yourattention to the third quarter. ExxonMobil’s third quarter netincome and normalized earnings were $9.4 billion, down $1.1 billion from 2006record third quarter results primarily due to lower Downstream and chemicalmargins. Earnings per share were $1.70 reflecting continued strong earningsperformance and the benefits of our ongoing share purchase program. Before I discuss specificbusiness results, I’d like to discuss some of our recently achieved milestones. In the Upstream, the Ormen Langedeepwater natural gas project off the coast of Norway began production thisquarter. At full production, the development will produce more than 2 billioncubic feet of gas per day. The gas will be exported throughthe world's longest sub-sea pipeline, approximately 750 miles to the UK. First production was alsoachieved this quarter from the ExxonMobil operated Marimba North projectoffshore Angola.The project was completed ahead of schedule and within budget. This is thefirst tie-back development to the Kizomba A infrastructure to cost effectivelydevelop new capacity by utilizing existing field facilities. The project willdevelop 80 million barrels of oil and have peak production capacity of 40,000barrels per day. On October 12, gas deliveriesfrom the Statfjord Late Life Project started up via the Tampen Link pipeline inthe Norwegian North Sea. This project will increase ultimate recovery from thefield by 360 million oil equivalent barrels and extend field life up to 2020. Peak production is expected toreach 360 million cubic feet of gas per day and 70,000 barrels of crude andcondensate per day. These three startups, togetherwith the projects, which began production earlier this year, RasGas Train 5 in Qatar, Waddenzee in the Netherlands, and Rosa offshore Angola bringour 2007 to date major product startups to six. In exploration, we had severalnotable milestones this quarter. ExxonMobil was awarded two explorationlicenses, offshore of western Greenlandfurther enhancing our strong portfolio of Arctic exploration opportunities. The West Disko Block 4 and Block6 together cover over 6 million acres and are in 150 to 1,300 feet of water. In the recent central Gulf ofMexico lease sale, ExxonMobil was the high bidder for 13 offshore blocks in theGulf of Mexico totaling over 70,000 acres. Also this quarter together withour partners we made a new discovery in the ultra-deep MTPS block 100 miles offthe coast of the Republic of the Congo. The Cassiopée discovery wellwas drilled to a depth of approximately 10,000 feet and tested at 5,600 barrelsof oil per day. ExxonMobil interest in the blockis 30%. These milestones continue to reflect the geographic diversity andstrength of our industry leading Upstream portfolio. In the Downstream, our feeddiversification activities continued this quarter. We ran 34 crudes that werenew to individual refineries and three that were new to ExxonMobil. We alsomaintained focus on our margin enhancement strategy which includes increasingthe contribution from our refining operations through reliability improvementsand effective technology deployment while incrementally adding to our crude andconversion processing capacity. Also in the third quarter Q3,ExxonMobil launched our fuels marketing joint venture in the Fujianprovince of China, with our partners, Sinopec andSaudi Aramco. This venture, which is part of our fully integrated Fujian project, coversretail and wholesale sales of gasoline, diesel, and other petroleum products. ExxonMobil’s investments in the Fujian refining,petrochemical and fuels marketing joint ventures demonstrate our commitment toadvantage strategic downstream and chemical investments to meet growing demandaround the world. In our chemical business,ExxonMobil announced that we will build a second world scale petrochemicalproject at our integrated refining and chemical facility in Singapore. The new project will include a 1million ton per year ethylene steam cracker, polyethylene, polypropylene,especially elastomer and benzene units and expansions to our exiting oxoalcoholand paraxylene units. ExxonMobil will construct a 220mega watt cogeneration unit as part of the overall investment. This project with the expectedstartup in 2011 will be key to meeting the growing demand for ExxonMobilchemical products in Asia. The project will employExxonMobil’s’ latest proprietary technologies enabling a broad range of feedstocks to be processed and converted into premium products. In the quarter, we also announcedour investment to expand the paraxylene and benzene production facilities atour Rotterdam Aromatics plant by 25 and 20% respectively. The new production unit willemploy ExxonMobil’s proprietary PxMax technology, which increased paraxyleneproduction and improves process efficiency. ExxonMobil chemical also begancommercial production of butyl rubber at the Notre Dame de Gravenchon facilityusing proprietary breakthrough technology. This technology improves energyefficiency and enables significant capacity increases at existing facilities. The integration of these newprojects into our existing refining and chemical operations are furtherexamples of our strategy to develop and rapidly deploy differentiatedtechnologies and selectively invest in advantage projects to capture the fullbenefits of integration across all ExxonMobil operations. Turning now to the business lineresults. Upstream earnings in the third quarter were$ 6.3 billion, down $200million from the third quarter of 2006. Improved crude realizations weremore than offset by reduced natural gas realizations, higher expenses,including the impact of major project startups and lower property sales. Worldwide crude realizations were$71.46 per barrel, up $6.32 from the third quarter 2006. Upstream after-tax unit earningsin the third quarter of 2007 at $17.47 per barrel were in line with last year. In total, oil equivalent volumeswere down 2% from the third quarter of 2006. As you are aware, on September6th, ExxonMobil filed a request for arbitration with the InternationalCenter for Settlement of InvestmentDisputes following the expropriation of assets in Venezuela in June. Excluding Venezuelavolume effects, as well as entitlement divestment and quota impacts, productionwas actually up 3% in the third quarter. That increase was driven by increasedvolumes from major project ramp-ups in Russia,West Africa, and Qatar,which more than offset natural field decline. Turning to liquids production,volumes fell by 111,000 barrels per day, or 4% from the same quarter last year,primarily due to entitlement effects in Africa and the absence of Venezuelavolumes. Venezuela accounted for about 40%of the reduction. Natural field decline was offsetby project related increases in Russiaand West Africa. Gas volumes were up 163 millioncubic feet per day from last year, as higher production in Qatar primarilydue to the startup of RasGas Train 5 more than offset naturalized fuel declinein mature areas. Now turning to the sequentialcomparison. Versus the second quarter of2007, Upstream earnings increased by nearly $350 million, higher realizationswere partially offset by lower liquids production and seasonally lower naturalgas demand. Liquids production decreased 5%including the impact of entitlement effects in Africa and the absence of Venezuelavolumes. Natural gas production was down5% primarily due to lower volumes in Europereflecting seasonally lower demand, divestment effects, and scheduledmaintenance. For further data on regionalvolumes please refer to the press release and IR supplement. Now turning to the Downstream results.Third quarter Downstream earnings were $2 billion, down approximately $735million from record results in the third quarter of 2006. Lower margins reducedearnings by $610 million with decreases in refining and fuels marketing marginspartially offset by improved lubes marketing margins. Volume mix effects increasedearnings by $120 million, as we benefited from our continued focus on feedstock flexibility, capacity utilization, and product optimization. These more than offset the impactof the higher plant turn around activity. Other items reduced earnings by$250 million reflecting increased maintenance activity and the absence ofpositive tax effects in third Quarter 2006. Sequentially, Q3 earningsdecreased by almost $1.4 billion, due to markedly lower refining margins.Volume mix effects were positive $110 million due to lower planned maintenancein the USand refinery optimization activities. Other factors reduced earnings by$240 million, primarily the absence of positive impact from the Inglestadtdivestment in the second quarter. Third quarter chemical earningswere $1.2 billion. Earnings were down $150 million versus the record thirdquarter 2006 as higher feed stock costs more than offset increasedrealizations. Positive mix effects benefitedearnings by $30 million. Other factors increased earnings by $65 million,including positive tax effects. Sequentially, third quarterchemicals earnings increased by $190 million versus the second quarter of 2007.Improved margins benefited earnings by $110 million, while volume mix effectswere negative $35 million. Other impacts increased earningsby $115 million, including positive tax effects. Turning now to our corporate andfinancing segment. The corporation recorded third quarter expenses of $92million in the corporate and financing segment, unchanged from the thirdquarter of 2006. The effective tax rate for thethird quarter was 46%. The corporation distributed almost $9 billion toshareholders in the third quarter, through dividends and share purchases toreduce shares outstanding. During the quarter, ExxonMobilpurchased $7 billion in shares, in excess of dilution, reducing the number ofshares outstanding by 1.5% and further demonstrating our ongoing commitment toreturn cash to our shareholders. CapEx in the third quarter was$5.4 billion, an increase of 7.5% from the third quarter 2006. At the end of the third quarterour cash balance was $36 billion and debt was $9 billion. In summary, these resultshighlight the fundamental strength of our business; our ability to deliversuperior operational performance and continue to grow our integratedcapabilities while continuing to position ourselves for future demand growthand create value for our shareholders. That concludes my preparedremarks and I would now be happy to take your questions.
Operator: Thank you Mr. Hubble. Thequestion and answer session will be conducted electronically. (OperatorInstructions). We will take our first questionfrom Dan Barcelo with Banc of America. Please go ahead.
Dan Barcelo - Banc of America: Yes, good morning Henry.Regarding one of your comments about the redistribution of cash toshareholders, you mentioned the $7 billion rate in the third quarter. Are youable to provide any color into the fourth quarter and into ‘08 at this point?And then the second question, I’ll just lay them out now, it was on theproduction side; could you just run through, you gave good detail on theentitlement effects, could you just reiterate the effects? In particular, I’mlooking at oil in West Africa, just for thisquarter; what was that impact specifically over there?
Henry Hubble: Well as you know unless we aremaking a change, we don’t provide forward guidance on our share repurchases.We’ve been at the $7 billion here, last quarter, and for the -- for about thelast year. On the other question on thevolume side and the specific entitlement effects associated in Africa. You see the African volumes were down, basicallydue to entitlement effects. There the new project volumes there have beenperforming well and they have more than offset natural field decline, butthat’s really what you are seeing and that’s really, as you look at theentitlement effects, as you know, some of that production comes from productionsharing contracts, and in some of the PSCs, the net entitlement is reduced withcumulative production or profitability thresholds are reached. And you know, as you think aboutthis, the impacts are larger with the strong crude prices that we’ve seen. Butfrankly when you step back from it, I mean the, earnings are better and theoverall financial performance of these projects are better with the higher[project]. All of the projects in the area are performing well, so that reallyis the impact, its entitlement effects.
Dan Barcelo - Banc of America: Okay, Thank you
Operator: We will take our next questionwith Doug Terreson from Morgan Stanley please go ahead
Doug Terreson - Morgan Stanley : Good morning Henry.
Henry Hubble: Hi Doug.
Doug Terreson - Morgan Stanley : Okay, so I want to ask theentitlement question too.
Henry Hubble: Alright.
Doug Terreson - Morgan Stanley : And this is really kind of aclarification. When you said, at least I think you said that production roseabout 3% before considering entitlement effects. Were you referring to theglobal base of production rather than specific geographical region or did youeven say that? Could you kind of…?
Henry Hubble: That was a global comment.
Doug Terreson - Morgan Stanley : Okay.
Henry Hubble: If you look at on an OEB basis wewere down 2% on the -- this year versus last year third quarter. About 1% ofthat effect was associated with Venezuela
Doug Terreson - Morgan Stanley : Okay.
Henry Hubble: And then there is about 3.5 thatare associated with entitlements and then you also have some other the smallereffects in quotas and divestments. But when you take those effects out, that isthe 3%. When you look at -- basically, that is coming from the projects andprojects that are coming on faster than rates of decline. So, that is what yousee there
Doug Terreson - Morgan Stanley : Okay. And while we are on thesubject of Africa, could you provide an update on the profile in Chad, investment profile in Chad and anyupdate that you might have there?
Henry Hubble: I don’t have anything specific,on Chad.There is, we are continuing with our project. Our 2007 drilling program isbasically complete at this point. There is nothing really specific to highlightthere.
Doug Terreson - Morgan Stanley : Okay. Great, thanks a lot
Henry Hubble: Okay.
Operator: We will take our next questionwith Nikki Decker with Bear Stearns. Please go ahead
Nikki Decker - Bear Stearns: Good morning Henry
Henry Hubble: Hi Nikki
Nikki Decker - Bear Stearns: Just getting back to the Africavolumes, taking entitlement effects into account, is it reasonable to expectthought from this phase that Africa volumes might rise due to new production onblock 15 and 17 in Angolaand also in Nigeria?
Henry Hubble: Well, as we bring on newprojects, they do of course add to that capacity, but as you go forward, andthat’s really the effect that we are seeing here is that at these higherprices, the prices that we are seeing today -- I don’t know what those future effectsare going to be. What happens is you -- as you have these higher prices, ofcourse, you are recovering your costs faster you are recovering -- you havemore profit barrels to share but you are doing that with less barrels. And so overall we are verypleased with the projects and they are performing very well but we do see lessvolumes associated with them. Our focus is, though on the returns associatedwith those projects. Of course, it means better performance not just for us,but for our host governments as well. And we’ve got a good slate of projects,and a good pipeline of projects coming along. So we feel confident about thefuture but that’s the impact that we are seeing in the quarter.
Nikki Decker - Bear Stearns: Okay thanks. And for my secondquestion I’d like to switch to the Downstream. Your competitors have beentalking about the difficulty in capturing margins relative to properties. Your Downstreamresults were somewhat consistent with the industry. Maybe, if you could, Henry,quantify the benefit of your feed stock flexibility and perhaps comment onyear-over-year marketing results?
Henry Hubble: If you look at the margin impactsthat we had in the quarter, we are down over $600 billion off of what were verystrong third quarter ’06 performance. The bulk of that is in refining, I guessif you look at that it's about two-thirds or a little better. And then thebalance was in marketing. If I think about our overall capability in this areathough, we have strong margins capture. The programs that we have with, inparticular, the molecule management technology that we have to help capturethe, investments that we’ve made over many years in high conversion refiningcapacity, allow us to continue to take advantage of the high clean/dirty spreadsthat are out there and the process crude processing flexibility that we have. So we are constantly going afternew crudes that are either advantaged for our processing capabilities and themolecule management technology, both on the planning standpoint as well as realtime operations. That really help us manage both on a molecular basis how tomaximize profitability in the refining units as well as our chemical plantswhen we have those integrated facilities. It's really, we think, a uniqueadvantage in the industry
Nikki Decker - Bear Stearns: Okay, that’s great. Thanks Henry.
Henry Hubble: Thanks
Operator: We will take our next questionfrom Doug Leggate with Citigroup. Please go ahead.
Doug Leggate - Citigroup: Thank you. Good morning Henry.
Henry Hubble: Hi Doug
Doug Leggate - Citigroup: Henry I’m going to flog this Africa horse a little bit more I’m afraid
Henry Hubble: Okay
Doug Leggate - Citigroup: When we look at the actualvolumes obviously we are down about 120 million barrels per day year over year,a little less than that. Oil prices on average were only up $5. Have we movedout of cost recovery, in any significant way, year-over-year in that region?
Henry Hubble: Yeah, as you know, they are madeup of individual of both components, cost recovery as well as profit sharing,and because we have number of different projects, they all have differentarrangements, they have different points of recovery. That effect is going onand you also have just the impacts from the higher prices. So yes, there areimpacts that are associated with those entitlements and cost recovery is apiece of that. And again, I think the real key here though, is there is noquestion that these projects are performing better than, certainly, when weapproved them. It worked better for us and better for the host governmentsbecause of: one, the projects are performing well. They were delivered at lowercosts than we originally anticipated, they came in on schedule, and they’vebasically been performing well. But one of the consequences of the higherprices is there are less barrels
Doug Leggate - Citigroup: I guess I’ll follow one relatedto that, so if oil prices stayed let's assume at Q3 average level, new projectscoming on, we would expect these volumes to remain at that kind of level inAfrica. Third quarter you are going to have continuing impacts,
Henry Hubble: I mean, you are going to havecontinuing impacts, but I’m not going to get into forward projection on whatthat will be. We will give… We will go through and give an update at ourAnalysts Meeting and that will reflect another year of higher prices and theimpacts associated with that in the projections that we have going forward.
Doug Leggate - Citigroup: Okay, I guess a final one fromme. And I guess this classifies as my second question. If we look at yourcapture in the Upstream you always show this chart of realized prices versusyour net income per barrel. It did appear to move off of the line quite a bitthis time, suggesting that something else is going on. You mentioned higherexpenses in the press release, can you maybe just try and quantify if it wasthat or maybe the lack of property sales, if that was a meaningful issue thisquarter. So help us understand a little bit why that capture rate appears tohave deteriorated this quarter
Henry Hubble: Yeah, if you look at the otherearnings effects and that’s really what really what can impact that or alsocontributes to it, there where. The biggest single factor is higher expenses;which is over half of the total. A lot of that higher is both cash and non-cashbut a big piece associated with non-cash associated with the new projects thatwe started up.; so you are seeing higher depreciations associated with those. In terms of the balance we didsee some positive earnings impacts from asset sales in 2006 that were higherthan what we had in this quarter so the absence of those on a relative basiscaused some of that decline. And we also had some negative Forex effects inthere, there is about $80 million associated with that. So those were the bigfactors. But again, as you point out, if you look at the absolute level of netincome per barrel, it is strong and I think that really is the best reflectionof the overall performance of the portfolio. When you think about all of thethings that go into, the quality, projects, the quality of the projectmanagement, the performance of those projects, cost control. All of thatbasically ends up being reflected in that very strong net income per barrelnumber that we have in the industry
Doug Leggate - Citigroup: Great thanks a lot, Henry
Operator: We will take out next questionwith Neil McMahon with Sanford Bernstein
Neil McMahon - SanfordBernstein: Good morning guys.
Henry Hubble: Hi Neil.
Neil McMahon - SanfordBernstein: Just two questions as you allow?The first question, really, just an update on your wildcat exploration that hasbeen going on this year, maybe first on the Columbiawell you are drilling in the Caribbean? Andsecond anything further on the Orphan Basin offshore, north of Newfoundland. And then for the secondquestion, if you look at your USoil and liquids production, year-over-year it hasn’t gone down very much atall. And I’m wondering if that is due to a reduction in any land sales there,or are you actually doing something more dramatic in terms of investing onshoreUS?
Henry Hubble: Let me just first hit -- in Colombia theTayrona block, we are drilling our first well, the Araza I and really I’d wantto refer any other questions to Petrobras who is the operator of that. The other piece, I guess, wasassociated with the Orphan. We are still progressing the technical work. We arelooking to drill the next well next year. We have drilled the Great Baraswaywell there and we are evaluating that data and we will decide what the nextprospect will be. Then, if you look at the volumes associated with the US, onthe year-on-year, basically, the net impact there has been essentially improvedreliability, a piece of that, no big story. Some of that was associated withthe Alaskaoperations, as you may recall. But basically, we have a good continuing workprogram there and that’s the net effect of it all.
Neil McMahon - SanfordBernstein: Okay, so that’s mainly an Alaska effect that’s[something like]...
Henry Hubble: That’s a piece of it, yes.
Neil McMahon - SanfordBernstein: Okay thanks.
Henry Hubble: Yes
Operator: We will take our next questionfrom Michael LaMotte with JP Morgan. Please go ahead
Michael LaMotte - JP Morgan: Thanks. Good morning Henry.
Henry Hubble: Hi
Michael LaMotte - JP Morgan: I was hoping you could shed alittle light on heavy oil and EOR opportunities in the Middle East, inparticular the chatter about your involvement in Kuwait on the heavy oil side.
Henry Hubble: Yes. You know, I can’t say a lotthere. They have a number of heavy oil prospects in Kuwait. There are studies going on,we are very interested in participating in that. We are participating instudies there at this point. But I really, you know, but if you are looking formore specific on that, I think KOC is probably the right people to talk to onthat one.
Michael LaMotte - JP Morgan: Okay, maybe I can ask thequestion a little differently then. If I understand the talk around them atthis point, there are TSA agreements that would not allow you or an operator toactually book reserves. In the past, you tended to shy away from that kind ofcontract. I am curious as to sort of maybe a change in the way of strategicthinking.
Henry Hubble: There is nothing you know. Yes, Ihave no comment on that. The studies are still underway. There has been nodecisions made. It is way premature to decide how this is going to be worked.So, I just really can’t add anything to that. Again if you want to get somespecifics on how KOC is thinking about it then I think that is the right placeto start.
Michael LaMotte - JP Morgan: Okay. And then second question,getting back to this entitlement issue, I know it is early coming into yearend. But any thought on impact on reserves associated with entitlement changes?
Henry Hubble: Well, we will go through andupdate that again with our early or first quarter release on that. So I reallycan’t give you anything at this point. All of the impacts will be reflected inthose outlooks.
Michael LaMotte - JP Morgan: Okay. Thanks Henry
Henry Hubble: Yes.
Operator: We will take our next questionfrom John Herrlin with Merrill Lynch. Please go ahead.
John Herrlin - Merrill Lynch : Yes, thanks.
Henry Hubble: Hi John.
John Herrlin - Merrill Lynch : In Europe,your gas sales were kind of low and you mentioned earlier that it was seasonaland also asset sales.
Henry Hubble: Yes
John Herrlin - Merrill Lynch : Was it mainly seasonal? Can yougive us a kind of a split?
Henry Hubble: In Europethe biggest piece was associated with, if you look at the sequential piece, thecombined effect was effect of some net based client. The higher maintenance,divestments were the next biggest piece, and then was a lower seasonal demand.So if you take a look at the demand piece, it is about fifty of that.
John Herrlin - Merrill Lynch : Okay, taking that to oil sincethose volumes were down a bunch too, was that also maintenance related ordecline?
Henry Hubble: Well, if you look at, looking onyear on year or sequentially?
John Herrlin - Merrill Lynch: Sequentially in Europe.
Henry Hubble: Okay let me look at that. Yes,it’s basically the bulk of it is field decline there in the period. Then youhave some that’s a big effect. It’s a mature area, and that’s the effect youare seeing.
John Herrlin - Merrill Lynch : Okay that’s fine. Getting back toKuwait,I will try the question a different way or a different question.
Henry Hubble: Okay.
John Herrlin - Merrill Lynch: You had success obviously with Upper Zakum, I am not familiar with the geology for whatyou are looking at. Are these carbonates?
Henry Hubble: They are heavy oil deposits. I amnot familiar with the specifics of the field there.
John Herrlin - Merrill Lynch : Okay. And then revisiting WestAfrica again, you probably won’t want to do this, but could you perhaps breakdown the entitlement effects by EG, Angolaand Nigeria,or not possible?
Henry Hubble: I don’t think it’s appropriate tobreak those down.
John Herrlin - Merrill Lynch: All right. That's fine. Iappreciate it, thank you.
Operator: We will take our next questionfrom Paul Cheng with Lehmann Brothers. Please go ahead.
Paul Cheng - Lehmann Brothers: Hey Henry, good morning. I haveto apologize first because I came in late so you may have already covered inyour prepared remarks. Did you break down what is the FX tax on inventory orasset sales gains or loss on those items in the third quarter versus the secondquarter?
Henry Hubble: No I haven’t. But the Foreximpact. If you look at the net impact for the third quarter they were prettysmall. Like $14 million something in that range, quite small. We are kind ofnaturally hedged. We see some negative impacts in the Upstream. We see positiveimpacts in Downstream in chemicals that basically offset that.
Paul Cheng - Lehmann Brothers: All right. Can you break down bydivision and force?
Henry Hubble: Upstream is about, as I mentionedabout 80 negative and then the bulk of the offsetting was in chemicals.
Paul Cheng - Lehmann Brothers: Right. I am talking aboutsequentially from the second quarter level. Is the 80 still a good number? Ithought
Henry Hubble: Yes, that's pretty close. And thesame, the net effect for total there, when you look at it sequentially therewas less offset. Not much offset from the Downstream chemicals part ofbusiness. So that kind of carried through to the bottom line.
Paul Cheng - Lehmann Brothers: So, it’s about 80 million that'ssequentially? Right?
Henry Hubble: That’s correct in total.
Paul Cheng - Lehmann Brothers: In total?
Henry Hubble: Right.
Paul Cheng - Lehmann Brothers: How about any tax adjustment? Orinventory gain or loss? Market sales?
Henry Hubble: We are in a LIFO basis, and wedon't take any, have any inventory effects during the year.
Paul Cheng - Lehmann Brothers: How about price finalization?
Henry Hubble: Price finalization, if you lookat an absolute basis we had about 50 million. Now you look, again? Talkingsequential?
Paul Cheng - Lehmann Brothers: Yes.
Henry Hubble: Yes, so about 50 million in the US onan absolute basis, 65 total and then if you look at the Delta it was like 30 intotal.
Paul Cheng - Lehmann Brothers: I presume that, that is apositive, right?
Henry Hubble: Excuse me, I’m sorry. In thethird quarter of '07 the absolute level is all negative. So, it is about 65million negative. If you look at the change it was positive relative to theprior, to the second quarter, but quite small.
Paul Cheng - Lehmann Brothers : Right. And do you indicate thatone of the reason about your perhaps a little but lower unit profitability interms of the capture rate comparing to the third quarter of last year, is thatyou have lesser after-sales gain. So, how big is the asset sales gain and on anabsolute level?
Henry Hubble: I don’t have a breakdown. The twobig factors we had in the absence of sales was associated with the Carson Creekin Canada and then we hadsome sales in Francelast year that were, but I don't have a total for you there. Those were the twothat were kind of the absence of those two. And basically mature areas.
Paul Cheng - Lehmann Brothers: I understand about last year I amtalking about in this year third quarter?
Henry Hubble: Right. In this third quarter, wedidn’t have a whole lot in there that was a little bit we had in the south North Sea sale, associated with gas. And that was it.
Paul Cheng - Lehmann Brothers: And the second question would bethe Piceance basis?
Henry Hubble: Paul, well maybe you ought tocome back at the end I think that is more than two.
Operator: (Operator Instructions). And wewill take our next question from Mark Gilman with The Benchmark Company.
Mark Gilman - Benchmark Company: Hi, Henry good morning.
Henry Hubble: Hi Mark, how are you?
Mark Gilman - Benchmark Company: Good thank you I hope you are aswell. I wanted to ask about the Statfjord Late Life and the Offshore project.My assumption on these projects, Henry, is that we will not see volumesactually rising as a result of these projects. But rather in both cases theyrepresent the ability to forego what would otherwise be declines. Marimbavis-à-vis Kizomba A and Statfjord obviously facilities and fields currently inproduction, is that an accurate assumption in both cases?
Henry Hubble: Pretty much. You're basicallytrying to maintain the capacity of full utilization of the facilities that youhave there so that's what you see from those developments for the most part.
Mark Gilman - Benchmark Company: Okay and one other one, if I could,just, one more whack at this entitlement issue from a different angle.
Henry Hubble: Yes.
Mark Gilman - Benchmark Company: Henry, there are basically twokinds of entitlement issues, that impact on reported production. One is just asimple and rather straightforward cost recovery issue. The other is a morepermanent, in terms of life of field. Change in splits associated either withcumulative returns or cumulative production thresholds and/or cost recoveryfactors. I’m assuming that what we are dealing with here is primarily thelatter. And is therefore not something that in a difference price environmentis likely to change as we go forward. Is that assumption accurate?
Henry Hubble: Well, I’m not going to break outthe split for you here. You have both effects, but they are both in acontinuing basis. And again it’s going to depend on how crude prices evolvefrom here.
Mark Gilman - Benchmark Company : Okay. Thank you, Henry.
Operator: And we’ll take our next questionfrom Paul Sankey with Deutsche Bank. Please go ahead.
Paul Sankey - Deutsche Bank : Hi, Henry. I had a three part Middle East question, but I’m not going to go there onQA. So, let’s move on to Upper Zakum. You’vegot pretty significant downtime I believe right now. Could you just quantifyhow long that’s going to be out for, and what sort of impact that will have onQ4?
Henry Hubble: I don’t have anything right atthe tips of my fingers. Let’s see if I can get you something on that. I reallydon’t have any specific data on that at this point.
Paul Sankey - Deutsche Bank : But you didn’t turn around there?
Henry Hubble: You probably ought to ask Zadcoon that.
Paul Sankey - Deutsche Bank : Okay. I’ll leave it on that onethen, obviously. The second part was about start-ups in Qatar nextyear. Can you just update us on when do you expect those two major projects tobe delivering?
Henry Hubble: As we had laid out in our earlierplans. We’re expecting those, the start-up of the Qatargas II Train 4 in 2008,and the RasGas Train 6 also scheduled for start-up in 2008, expecting one aboutmid-year, and the other closer to the end of the year; the end of the year.It’s the same as the F&O.
Paul Sankey - Deutsche Bank : Okay, that answers that one. Wehad a couple of slightly non-answers there upfront. What final one, I’ll throwin one final one. Can you quantify the extent to which disposable impacted yourDownstream numbers. It’s noticeable particularly in Europe, but also to anextent in Asia, you had lower throughputs andsales in both those regions. Thanks.
Henry Hubble: Yeah. The big impact in Europe is Inglestadt, and both on a year-on-yearcomparisons that you have there. And then, there’s ongoing on the part sales.We have ongoing high grating that we’ve got going on pretty much around theworld. Big piece of that happened in Africa, some of South America, but there’s also high grating that’s going on in theother portfolios, as well. And then, Can, you also have impacts that areassociated with turnarounds that are also impacting some of the numbers.
Paul Sankey - Deutsche Bank : Any barrel numbers you can giveme on that?
Henry Hubble: If you look at, let me just lookif I have something here. If you look at the totals, or the Downstream, we’redown on the petroleum product sales as you know, about 1%, and that basically,if you look at, you’ve got, well, I don’t have a breakdown. Basically, US, ifyou look on a third quarter '06 versus third quarter '07, throughput wise,which we were up. And basically that’s improved reliability, and that wasalmost all that. Then if you look at theturnaround impact in Asia Pacific, that was Singapore,and Japan,the total of that was about the level you see, the 116 that’s in the numbers.So those were the two impacts there.
Paul Sankey - Deutsche Bank : That’s on the throughput, then wejust take Inglestadt out of the Europe number.
Henry Hubble: That’s right.
Paul Sankey - Deutsche Bank : And on the product sales?
Henry Hubble: And on the product sales, thatagain, is I was talking about the divestments, that’s the big piece of, I amjust trying to look, we have I think that's bullet said it is the basically thebest months, the bulk of it is the best men in chief of those investments ineach of these areas, the same story. You kind of see it reflected in thenumbers in the US,basically down the same direction, and the overall total sales down about thesame direction from the throughput. It’s about down equally.
Paul Sankey - Deutsche Bank : So, the underlying market wasflat, is what you’re telling me?
Henry Hubble: Yeah, I mean, if you’re trying toget back to what was the product demand, what we’re seeing on a worldwidebasis, is that we continue to see growth overall, about, not much down at allfrom what we have historically seen, on a total global demand basis, most ofthat growth occurring, though, in the Asia Pac area. US is near flat, up alittle bit. And we’re seeing, there’s nothing there that we can really point toas a global demand response. Again, you don’t know how high itwould be if crude prices weren’t this high, but we’re not seeing big declines.We’re still seeing year on year growth, and we’re not seeing big declines inthat rate of growth on a worldwide basis.
Paul Sankey - Deutsche Bank : Sounds like you’re predicting$100 oil then, Henry?
Henry Hubble: I don’t know. I can’t tell youwhy it’s ninety-something today.
Paul Sankey - Deutsche Bank : Okay, thanks.
Operator: We’ll take our next question fromMark Flannery with Credit Suisse.
Mark Flannery - Credit Suisse: Hi, Henry. I have more of a localquestion, about ethanol blending in the US; specifically, in the Southeast.Are you guys getting ready to blend more ethanol into product in the Southeast,I’m thinking in Floridaparticularly; from next year? Are you making the necessary infrastructure andterminal end sort of investments right now, or are you holding back a littlebit?
Henry Hubble: Well, as you know, we are a majorblender of ethanol. There are incentives to blend ethanol currently. We are maximizingthat, but I’m not going to get into specific regional thoughts that we mighthave. But we’re basically meeting the Federal requirements. We’ve blendedbefore it was required because we saw economic opportunities there, and wecontinue to do that. So, we’ll take advantage of the incentives that are thereto blend ethanol. But again, I’m not going to get into specific investmentplans.
Mark Flannery - Credit Suisse: Right. Just a quick follow-up onthe refining side; when you think about ethanol blending and how it might go inthis country, just for the sake of it say, the donation goes to E-10 at someunspecified time in the future. Does that impact the way you think aboutinvestments in the domestic refining base?
Henry Hubble: Well, if you look at ourlong-term outlook for demand in the US, and actually in OECD ingeneral, our longer term outlook is that it is basically flat. And what you seethere is ongoing efficiencies that continue to come in, basically offsettingwhatever modest growth there may be in miles driven and vehicle use. So as we go forward, we are notseeing a lot of growth in our outlook, so we continue to focus on economicallycreeping our capacities, de-bottlenecking, low cost conversions ads. That’sbeen part of our base improvement, continuous improvement of our refiningfacilities. So, we’re constantly adding capacity through those kinds ofmechanisms, but we’re not seeing a lot of need for grass roots kinds ofinvestments in these mature markets. Now, on contrast, though, whenyou move out to Asia Pacific, China,some of these other areas. Our Fujianproject is a prime example there, where we’re investing to meet that growingdemand, which is substantially about what you can meet throughde-bottlenecking. And of course, in the base where we’re running our conversioncapacity full in all of the regions and there is incentive to continue tode-bottleneck that.
Mark Flannery - Credit Suisse: Great, thank you very much.
Operator: And we’re taking follow-upquestion from Mark Gilman with the Benchmark Company. Please go ahead.
Mark Gilman - Benchmark Company: Henry, I noticed that the volumemix bar in your Upstream year-over-year earning experience is essentially zero,like the fact that the production is down. Was the lifting position in thisrecently completed quarter more favorable than production, and that explainsthe bar in the chart, or was there an adverse lifting position in the year-agoperiod. Can you shed some light on that?
Henry Hubble: Basically, what you are seeingthere is a mix effect, as you point out. There is a positive effect associatedwith the Sakhalin project, where we have theexport facilities now. And so you have higher realizations associated withthat.
Mark Gilman - Benchmark Company: Okay. One other if I could.Marimba on offshore Angola,is that ringed fence with [Kiz-A] in the same PSC, or is it a separate PSC?
Henry Hubble: It’s ring fence.
Mark Gilman - Benchmark Company: Thank you.
Operator: We’ll take a follow-up questionfrom Paul Cheng with Lehman Brothers. Please go ahead.
Paul Cheng - Lehman Brothers: Hey Henry, Nigeria,the government, as a contact, you guys about change in the region or there isjust noise?
Henry Hubble: No. We have not had any contactswith them at this point.
Paul Cheng - Lehman Brothers: Final one, Piceance basin, whereare you in terms of production at this point? And what kind of rate program doyou have?
Henry Hubble: The latest numbers I have about50 million cubic feet per day. And of course, we have our phase one projectthat we’re working for. We’ve gotten the finding of no significant impactassociated with that, so we’re basically moving ahead with our developmentplans there. And expecting, that’s out in our ‘08/’09 time frame, basically.
Paul Cheng - Lehman Brothers: Are we still looking at 400million cubic feet per day kind of production by the 2010/2011, even undertoday’s gas price?
Henry Hubble: Well, when you look at the total,we have multiple phases that give out, it’s in the '06 F&O. But basically,those future phases take us out to 2011 or so, something in that, beyond,basically get us to up to that full potential.
Paul Cheng - Lehman Brothers: So the current price structure inthe natural gas did not alter your view or your program?
Henry Hubble: Well, there’s infrastructurethat’s being added there to get the gas out of the region, so that is ashort-term phenomenon that you’re seeing there.
Paul Cheng - Lehman Brothers: Okay very good. Thank you.
Operator: This will conclude today'squestion-and-answer session. Mr. Hubble, I will turn the conference back overto you for closing comments.
Henry Hubble: Well, I just want to say thanksto everybody for your questions, and for listening in. I look forward to seeingit on the road.
Operator: Ladies and Gentlemen, this willconclude ExxonMobil Corporation’s 2007 conference call. We thank you for yourparticipation, and you may disconnect at this time. | [
{
"speaker": "Executives",
"text": "Henry Hubble - VP of IR and Secretary"
},
{
"speaker": "Analysts",
"text": "Daniel Barcelo - Banc of AmericaSecurities Doug Terreson - Morgan Stanley Nikki Decker - Bear Stearns Doug Leggate - Citigroup Neil McMahon - Sanford Bernstein Michael LaMotte - JP Morgan John Herrlin - Merrill Lynch Paul Cheng - Lehmann Brothers Mark Gilman - Benchmark Company Paul Sankey - Deutsche Bank Mark Flannery - Credit Suisse"
},
{
"speaker": "Operator",
"text": "Good day everyone and welcome tothis ExxonMobil Corporation Third Quarter 2007 Earnings Call. Today’s call isbeing recorded. At this time for opening remarks, I would like to turn the callover to the Vice President of Investor Relations and Secretary, Mr. HenryHubble. Please go ahead sir."
},
{
"speaker": "Henry Hubble",
"text": "Thank you. Good morning andwelcome to ExxonMobil’s teleconference and webcast on our third quarter 2007financial and operating results. As you are aware from thismorning’s press release we had another good quarter as the fundamentals of ourbusiness remained strong. Our integrated business model, long standingcommitment to the integrity of our operations and disciplined approach toprudently invest and meet long-term demand growth continue to position thecompany to benefit from robust industry conditions. Before we go further, I’d like todraw your attention to our cautionary statement. Please note that estimates,plans, and projections are forward-looking statements. Actual results,including resource recoveries, volume growth, and project outcomes could differmaterially due to factors I discuss and factors noted in our SEC filings. Please see factors affectingfuture results and the Form 8-K we furnished this morning, which are availablethrough the Investors section of our website. Please also see the frequentlyused terms, the supplements to this morning's press release and the 2006financial and operating review on our website. This material defines key terms Iwill use today, shows ExxonMobil’s net interest in specific projects andincludes our SEC Regulation G disclosure. Now I’m pleased to turn yourattention to the third quarter. ExxonMobil’s third quarter netincome and normalized earnings were $9.4 billion, down $1.1 billion from 2006record third quarter results primarily due to lower Downstream and chemicalmargins. Earnings per share were $1.70 reflecting continued strong earningsperformance and the benefits of our ongoing share purchase program. Before I discuss specificbusiness results, I’d like to discuss some of our recently achieved milestones. In the Upstream, the Ormen Langedeepwater natural gas project off the coast of Norway began production thisquarter. At full production, the development will produce more than 2 billioncubic feet of gas per day. The gas will be exported throughthe world's longest sub-sea pipeline, approximately 750 miles to the UK. First production was alsoachieved this quarter from the ExxonMobil operated Marimba North projectoffshore Angola.The project was completed ahead of schedule and within budget. This is thefirst tie-back development to the Kizomba A infrastructure to cost effectivelydevelop new capacity by utilizing existing field facilities. The project willdevelop 80 million barrels of oil and have peak production capacity of 40,000barrels per day. On October 12, gas deliveriesfrom the Statfjord Late Life Project started up via the Tampen Link pipeline inthe Norwegian North Sea. This project will increase ultimate recovery from thefield by 360 million oil equivalent barrels and extend field life up to 2020. Peak production is expected toreach 360 million cubic feet of gas per day and 70,000 barrels of crude andcondensate per day. These three startups, togetherwith the projects, which began production earlier this year, RasGas Train 5 in Qatar, Waddenzee in the Netherlands, and Rosa offshore Angola bringour 2007 to date major product startups to six. In exploration, we had severalnotable milestones this quarter. ExxonMobil was awarded two explorationlicenses, offshore of western Greenlandfurther enhancing our strong portfolio of Arctic exploration opportunities. The West Disko Block 4 and Block6 together cover over 6 million acres and are in 150 to 1,300 feet of water. In the recent central Gulf ofMexico lease sale, ExxonMobil was the high bidder for 13 offshore blocks in theGulf of Mexico totaling over 70,000 acres. Also this quarter together withour partners we made a new discovery in the ultra-deep MTPS block 100 miles offthe coast of the Republic of the Congo. The Cassiopée discovery wellwas drilled to a depth of approximately 10,000 feet and tested at 5,600 barrelsof oil per day. ExxonMobil interest in the blockis 30%. These milestones continue to reflect the geographic diversity andstrength of our industry leading Upstream portfolio. In the Downstream, our feeddiversification activities continued this quarter. We ran 34 crudes that werenew to individual refineries and three that were new to ExxonMobil. We alsomaintained focus on our margin enhancement strategy which includes increasingthe contribution from our refining operations through reliability improvementsand effective technology deployment while incrementally adding to our crude andconversion processing capacity. Also in the third quarter Q3,ExxonMobil launched our fuels marketing joint venture in the Fujianprovince of China, with our partners, Sinopec andSaudi Aramco. This venture, which is part of our fully integrated Fujian project, coversretail and wholesale sales of gasoline, diesel, and other petroleum products. ExxonMobil’s investments in the Fujian refining,petrochemical and fuels marketing joint ventures demonstrate our commitment toadvantage strategic downstream and chemical investments to meet growing demandaround the world. In our chemical business,ExxonMobil announced that we will build a second world scale petrochemicalproject at our integrated refining and chemical facility in Singapore. The new project will include a 1million ton per year ethylene steam cracker, polyethylene, polypropylene,especially elastomer and benzene units and expansions to our exiting oxoalcoholand paraxylene units. ExxonMobil will construct a 220mega watt cogeneration unit as part of the overall investment. This project with the expectedstartup in 2011 will be key to meeting the growing demand for ExxonMobilchemical products in Asia. The project will employExxonMobil’s’ latest proprietary technologies enabling a broad range of feedstocks to be processed and converted into premium products. In the quarter, we also announcedour investment to expand the paraxylene and benzene production facilities atour Rotterdam Aromatics plant by 25 and 20% respectively. The new production unit willemploy ExxonMobil’s proprietary PxMax technology, which increased paraxyleneproduction and improves process efficiency. ExxonMobil chemical also begancommercial production of butyl rubber at the Notre Dame de Gravenchon facilityusing proprietary breakthrough technology. This technology improves energyefficiency and enables significant capacity increases at existing facilities. The integration of these newprojects into our existing refining and chemical operations are furtherexamples of our strategy to develop and rapidly deploy differentiatedtechnologies and selectively invest in advantage projects to capture the fullbenefits of integration across all ExxonMobil operations. Turning now to the business lineresults. Upstream earnings in the third quarter were$ 6.3 billion, down $200million from the third quarter of 2006. Improved crude realizations weremore than offset by reduced natural gas realizations, higher expenses,including the impact of major project startups and lower property sales. Worldwide crude realizations were$71.46 per barrel, up $6.32 from the third quarter 2006. Upstream after-tax unit earningsin the third quarter of 2007 at $17.47 per barrel were in line with last year. In total, oil equivalent volumeswere down 2% from the third quarter of 2006. As you are aware, on September6th, ExxonMobil filed a request for arbitration with the InternationalCenter for Settlement of InvestmentDisputes following the expropriation of assets in Venezuela in June. Excluding Venezuelavolume effects, as well as entitlement divestment and quota impacts, productionwas actually up 3% in the third quarter. That increase was driven by increasedvolumes from major project ramp-ups in Russia,West Africa, and Qatar,which more than offset natural field decline. Turning to liquids production,volumes fell by 111,000 barrels per day, or 4% from the same quarter last year,primarily due to entitlement effects in Africa and the absence of Venezuelavolumes. Venezuela accounted for about 40%of the reduction. Natural field decline was offsetby project related increases in Russiaand West Africa. Gas volumes were up 163 millioncubic feet per day from last year, as higher production in Qatar primarilydue to the startup of RasGas Train 5 more than offset naturalized fuel declinein mature areas. Now turning to the sequentialcomparison. Versus the second quarter of2007, Upstream earnings increased by nearly $350 million, higher realizationswere partially offset by lower liquids production and seasonally lower naturalgas demand. Liquids production decreased 5%including the impact of entitlement effects in Africa and the absence of Venezuelavolumes. Natural gas production was down5% primarily due to lower volumes in Europereflecting seasonally lower demand, divestment effects, and scheduledmaintenance. For further data on regionalvolumes please refer to the press release and IR supplement. Now turning to the Downstream results.Third quarter Downstream earnings were $2 billion, down approximately $735million from record results in the third quarter of 2006. Lower margins reducedearnings by $610 million with decreases in refining and fuels marketing marginspartially offset by improved lubes marketing margins. Volume mix effects increasedearnings by $120 million, as we benefited from our continued focus on feedstock flexibility, capacity utilization, and product optimization. These more than offset the impactof the higher plant turn around activity. Other items reduced earnings by$250 million reflecting increased maintenance activity and the absence ofpositive tax effects in third Quarter 2006. Sequentially, Q3 earningsdecreased by almost $1.4 billion, due to markedly lower refining margins.Volume mix effects were positive $110 million due to lower planned maintenancein the USand refinery optimization activities. Other factors reduced earnings by$240 million, primarily the absence of positive impact from the Inglestadtdivestment in the second quarter. Third quarter chemical earningswere $1.2 billion. Earnings were down $150 million versus the record thirdquarter 2006 as higher feed stock costs more than offset increasedrealizations. Positive mix effects benefitedearnings by $30 million. Other factors increased earnings by $65 million,including positive tax effects. Sequentially, third quarterchemicals earnings increased by $190 million versus the second quarter of 2007.Improved margins benefited earnings by $110 million, while volume mix effectswere negative $35 million. Other impacts increased earningsby $115 million, including positive tax effects. Turning now to our corporate andfinancing segment. The corporation recorded third quarter expenses of $92million in the corporate and financing segment, unchanged from the thirdquarter of 2006. The effective tax rate for thethird quarter was 46%. The corporation distributed almost $9 billion toshareholders in the third quarter, through dividends and share purchases toreduce shares outstanding. During the quarter, ExxonMobilpurchased $7 billion in shares, in excess of dilution, reducing the number ofshares outstanding by 1.5% and further demonstrating our ongoing commitment toreturn cash to our shareholders. CapEx in the third quarter was$5.4 billion, an increase of 7.5% from the third quarter 2006. At the end of the third quarterour cash balance was $36 billion and debt was $9 billion. In summary, these resultshighlight the fundamental strength of our business; our ability to deliversuperior operational performance and continue to grow our integratedcapabilities while continuing to position ourselves for future demand growthand create value for our shareholders. That concludes my preparedremarks and I would now be happy to take your questions."
},
{
"speaker": "Operator",
"text": "Thank you Mr. Hubble. Thequestion and answer session will be conducted electronically. (OperatorInstructions). We will take our first questionfrom Dan Barcelo with Banc of America. Please go ahead."
},
{
"speaker": "Dan Barcelo - Banc of America",
"text": "Yes, good morning Henry.Regarding one of your comments about the redistribution of cash toshareholders, you mentioned the $7 billion rate in the third quarter. Are youable to provide any color into the fourth quarter and into ‘08 at this point?And then the second question, I’ll just lay them out now, it was on theproduction side; could you just run through, you gave good detail on theentitlement effects, could you just reiterate the effects? In particular, I’mlooking at oil in West Africa, just for thisquarter; what was that impact specifically over there?"
},
{
"speaker": "Henry Hubble",
"text": "Well as you know unless we aremaking a change, we don’t provide forward guidance on our share repurchases.We’ve been at the $7 billion here, last quarter, and for the -- for about thelast year. On the other question on thevolume side and the specific entitlement effects associated in Africa. You see the African volumes were down, basicallydue to entitlement effects. There the new project volumes there have beenperforming well and they have more than offset natural field decline, butthat’s really what you are seeing and that’s really, as you look at theentitlement effects, as you know, some of that production comes from productionsharing contracts, and in some of the PSCs, the net entitlement is reduced withcumulative production or profitability thresholds are reached. And you know, as you think aboutthis, the impacts are larger with the strong crude prices that we’ve seen. Butfrankly when you step back from it, I mean the, earnings are better and theoverall financial performance of these projects are better with the higher[project]. All of the projects in the area are performing well, so that reallyis the impact, its entitlement effects."
},
{
"speaker": "Dan Barcelo - Banc of America",
"text": "Okay, Thank you"
},
{
"speaker": "Operator",
"text": "We will take our next questionwith Doug Terreson from Morgan Stanley please go ahead"
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Good morning Henry."
},
{
"speaker": "Henry Hubble",
"text": "Hi Doug."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Okay, so I want to ask theentitlement question too."
},
{
"speaker": "Henry Hubble",
"text": "Alright."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "And this is really kind of aclarification. When you said, at least I think you said that production roseabout 3% before considering entitlement effects. Were you referring to theglobal base of production rather than specific geographical region or did youeven say that? Could you kind of…?"
},
{
"speaker": "Henry Hubble",
"text": "That was a global comment."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Okay."
},
{
"speaker": "Henry Hubble",
"text": "If you look at on an OEB basis wewere down 2% on the -- this year versus last year third quarter. About 1% ofthat effect was associated with Venezuela"
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Okay."
},
{
"speaker": "Henry Hubble",
"text": "And then there is about 3.5 thatare associated with entitlements and then you also have some other the smallereffects in quotas and divestments. But when you take those effects out, that isthe 3%. When you look at -- basically, that is coming from the projects andprojects that are coming on faster than rates of decline. So, that is what yousee there"
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Okay. And while we are on thesubject of Africa, could you provide an update on the profile in Chad, investment profile in Chad and anyupdate that you might have there?"
},
{
"speaker": "Henry Hubble",
"text": "I don’t have anything specific,on Chad.There is, we are continuing with our project. Our 2007 drilling program isbasically complete at this point. There is nothing really specific to highlightthere."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Okay. Great, thanks a lot"
},
{
"speaker": "Henry Hubble",
"text": "Okay."
},
{
"speaker": "Operator",
"text": "We will take our next questionwith Nikki Decker with Bear Stearns. Please go ahead"
},
{
"speaker": "Nikki Decker - Bear Stearns",
"text": "Good morning Henry"
},
{
"speaker": "Henry Hubble",
"text": "Hi Nikki"
},
{
"speaker": "Nikki Decker - Bear Stearns",
"text": "Just getting back to the Africavolumes, taking entitlement effects into account, is it reasonable to expectthought from this phase that Africa volumes might rise due to new production onblock 15 and 17 in Angolaand also in Nigeria?"
},
{
"speaker": "Henry Hubble",
"text": "Well, as we bring on newprojects, they do of course add to that capacity, but as you go forward, andthat’s really the effect that we are seeing here is that at these higherprices, the prices that we are seeing today -- I don’t know what those future effectsare going to be. What happens is you -- as you have these higher prices, ofcourse, you are recovering your costs faster you are recovering -- you havemore profit barrels to share but you are doing that with less barrels. And so overall we are verypleased with the projects and they are performing very well but we do see lessvolumes associated with them. Our focus is, though on the returns associatedwith those projects. Of course, it means better performance not just for us,but for our host governments as well. And we’ve got a good slate of projects,and a good pipeline of projects coming along. So we feel confident about thefuture but that’s the impact that we are seeing in the quarter."
},
{
"speaker": "Nikki Decker - Bear Stearns",
"text": "Okay thanks. And for my secondquestion I’d like to switch to the Downstream. Your competitors have beentalking about the difficulty in capturing margins relative to properties. Your Downstreamresults were somewhat consistent with the industry. Maybe, if you could, Henry,quantify the benefit of your feed stock flexibility and perhaps comment onyear-over-year marketing results?"
},
{
"speaker": "Henry Hubble",
"text": "If you look at the margin impactsthat we had in the quarter, we are down over $600 billion off of what were verystrong third quarter ’06 performance. The bulk of that is in refining, I guessif you look at that it's about two-thirds or a little better. And then thebalance was in marketing. If I think about our overall capability in this areathough, we have strong margins capture. The programs that we have with, inparticular, the molecule management technology that we have to help capturethe, investments that we’ve made over many years in high conversion refiningcapacity, allow us to continue to take advantage of the high clean/dirty spreadsthat are out there and the process crude processing flexibility that we have. So we are constantly going afternew crudes that are either advantaged for our processing capabilities and themolecule management technology, both on the planning standpoint as well as realtime operations. That really help us manage both on a molecular basis how tomaximize profitability in the refining units as well as our chemical plantswhen we have those integrated facilities. It's really, we think, a uniqueadvantage in the industry"
},
{
"speaker": "Nikki Decker - Bear Stearns",
"text": "Okay, that’s great. Thanks Henry."
},
{
"speaker": "Henry Hubble",
"text": "Thanks"
},
{
"speaker": "Operator",
"text": "We will take our next questionfrom Doug Leggate with Citigroup. Please go ahead."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Thank you. Good morning Henry."
},
{
"speaker": "Henry Hubble",
"text": "Hi Doug"
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Henry I’m going to flog this Africa horse a little bit more I’m afraid"
},
{
"speaker": "Henry Hubble",
"text": "Okay"
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "When we look at the actualvolumes obviously we are down about 120 million barrels per day year over year,a little less than that. Oil prices on average were only up $5. Have we movedout of cost recovery, in any significant way, year-over-year in that region?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah, as you know, they are madeup of individual of both components, cost recovery as well as profit sharing,and because we have number of different projects, they all have differentarrangements, they have different points of recovery. That effect is going onand you also have just the impacts from the higher prices. So yes, there areimpacts that are associated with those entitlements and cost recovery is apiece of that. And again, I think the real key here though, is there is noquestion that these projects are performing better than, certainly, when weapproved them. It worked better for us and better for the host governmentsbecause of: one, the projects are performing well. They were delivered at lowercosts than we originally anticipated, they came in on schedule, and they’vebasically been performing well. But one of the consequences of the higherprices is there are less barrels"
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "I guess I’ll follow one relatedto that, so if oil prices stayed let's assume at Q3 average level, new projectscoming on, we would expect these volumes to remain at that kind of level inAfrica. Third quarter you are going to have continuing impacts,"
},
{
"speaker": "Henry Hubble",
"text": "I mean, you are going to havecontinuing impacts, but I’m not going to get into forward projection on whatthat will be. We will give… We will go through and give an update at ourAnalysts Meeting and that will reflect another year of higher prices and theimpacts associated with that in the projections that we have going forward."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Okay, I guess a final one fromme. And I guess this classifies as my second question. If we look at yourcapture in the Upstream you always show this chart of realized prices versusyour net income per barrel. It did appear to move off of the line quite a bitthis time, suggesting that something else is going on. You mentioned higherexpenses in the press release, can you maybe just try and quantify if it wasthat or maybe the lack of property sales, if that was a meaningful issue thisquarter. So help us understand a little bit why that capture rate appears tohave deteriorated this quarter"
},
{
"speaker": "Henry Hubble",
"text": "Yeah, if you look at the otherearnings effects and that’s really what really what can impact that or alsocontributes to it, there where. The biggest single factor is higher expenses;which is over half of the total. A lot of that higher is both cash and non-cashbut a big piece associated with non-cash associated with the new projects thatwe started up.; so you are seeing higher depreciations associated with those. In terms of the balance we didsee some positive earnings impacts from asset sales in 2006 that were higherthan what we had in this quarter so the absence of those on a relative basiscaused some of that decline. And we also had some negative Forex effects inthere, there is about $80 million associated with that. So those were the bigfactors. But again, as you point out, if you look at the absolute level of netincome per barrel, it is strong and I think that really is the best reflectionof the overall performance of the portfolio. When you think about all of thethings that go into, the quality, projects, the quality of the projectmanagement, the performance of those projects, cost control. All of thatbasically ends up being reflected in that very strong net income per barrelnumber that we have in the industry"
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Great thanks a lot, Henry"
},
{
"speaker": "Operator",
"text": "We will take out next questionwith Neil McMahon with Sanford Bernstein"
},
{
"speaker": "Neil McMahon - SanfordBernstein",
"text": "Good morning guys."
},
{
"speaker": "Henry Hubble",
"text": "Hi Neil."
},
{
"speaker": "Neil McMahon - SanfordBernstein",
"text": "Just two questions as you allow?The first question, really, just an update on your wildcat exploration that hasbeen going on this year, maybe first on the Columbiawell you are drilling in the Caribbean? Andsecond anything further on the Orphan Basin offshore, north of Newfoundland. And then for the secondquestion, if you look at your USoil and liquids production, year-over-year it hasn’t gone down very much atall. And I’m wondering if that is due to a reduction in any land sales there,or are you actually doing something more dramatic in terms of investing onshoreUS?"
},
{
"speaker": "Henry Hubble",
"text": "Let me just first hit -- in Colombia theTayrona block, we are drilling our first well, the Araza I and really I’d wantto refer any other questions to Petrobras who is the operator of that. The other piece, I guess, wasassociated with the Orphan. We are still progressing the technical work. We arelooking to drill the next well next year. We have drilled the Great Baraswaywell there and we are evaluating that data and we will decide what the nextprospect will be. Then, if you look at the volumes associated with the US, onthe year-on-year, basically, the net impact there has been essentially improvedreliability, a piece of that, no big story. Some of that was associated withthe Alaskaoperations, as you may recall. But basically, we have a good continuing workprogram there and that’s the net effect of it all."
},
{
"speaker": "Neil McMahon - SanfordBernstein",
"text": "Okay, so that’s mainly an Alaska effect that’s[something like]..."
},
{
"speaker": "Henry Hubble",
"text": "That’s a piece of it, yes."
},
{
"speaker": "Neil McMahon - SanfordBernstein",
"text": "Okay thanks."
},
{
"speaker": "Henry Hubble",
"text": "Yes"
},
{
"speaker": "Operator",
"text": "We will take our next questionfrom Michael LaMotte with JP Morgan. Please go ahead"
},
{
"speaker": "Michael LaMotte - JP Morgan",
"text": "Thanks. Good morning Henry."
},
{
"speaker": "Henry Hubble",
"text": "Hi"
},
{
"speaker": "Michael LaMotte - JP Morgan",
"text": "I was hoping you could shed alittle light on heavy oil and EOR opportunities in the Middle East, inparticular the chatter about your involvement in Kuwait on the heavy oil side."
},
{
"speaker": "Henry Hubble",
"text": "Yes. You know, I can’t say a lotthere. They have a number of heavy oil prospects in Kuwait. There are studies going on,we are very interested in participating in that. We are participating instudies there at this point. But I really, you know, but if you are looking formore specific on that, I think KOC is probably the right people to talk to onthat one."
},
{
"speaker": "Michael LaMotte - JP Morgan",
"text": "Okay, maybe I can ask thequestion a little differently then. If I understand the talk around them atthis point, there are TSA agreements that would not allow you or an operator toactually book reserves. In the past, you tended to shy away from that kind ofcontract. I am curious as to sort of maybe a change in the way of strategicthinking."
},
{
"speaker": "Henry Hubble",
"text": "There is nothing you know. Yes, Ihave no comment on that. The studies are still underway. There has been nodecisions made. It is way premature to decide how this is going to be worked.So, I just really can’t add anything to that. Again if you want to get somespecifics on how KOC is thinking about it then I think that is the right placeto start."
},
{
"speaker": "Michael LaMotte - JP Morgan",
"text": "Okay. And then second question,getting back to this entitlement issue, I know it is early coming into yearend. But any thought on impact on reserves associated with entitlement changes?"
},
{
"speaker": "Henry Hubble",
"text": "Well, we will go through andupdate that again with our early or first quarter release on that. So I reallycan’t give you anything at this point. All of the impacts will be reflected inthose outlooks."
},
{
"speaker": "Michael LaMotte - JP Morgan",
"text": "Okay. Thanks Henry"
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "We will take our next questionfrom John Herrlin with Merrill Lynch. Please go ahead."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Yes, thanks."
},
{
"speaker": "Henry Hubble",
"text": "Hi John."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "In Europe,your gas sales were kind of low and you mentioned earlier that it was seasonaland also asset sales."
},
{
"speaker": "Henry Hubble",
"text": "Yes"
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Was it mainly seasonal? Can yougive us a kind of a split?"
},
{
"speaker": "Henry Hubble",
"text": "In Europethe biggest piece was associated with, if you look at the sequential piece, thecombined effect was effect of some net based client. The higher maintenance,divestments were the next biggest piece, and then was a lower seasonal demand.So if you take a look at the demand piece, it is about fifty of that."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Okay, taking that to oil sincethose volumes were down a bunch too, was that also maintenance related ordecline?"
},
{
"speaker": "Henry Hubble",
"text": "Well, if you look at, looking onyear on year or sequentially?"
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Sequentially in Europe."
},
{
"speaker": "Henry Hubble",
"text": "Okay let me look at that. Yes,it’s basically the bulk of it is field decline there in the period. Then youhave some that’s a big effect. It’s a mature area, and that’s the effect youare seeing."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Okay that’s fine. Getting back toKuwait,I will try the question a different way or a different question."
},
{
"speaker": "Henry Hubble",
"text": "Okay."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "You had success obviously with Upper Zakum, I am not familiar with the geology for whatyou are looking at. Are these carbonates?"
},
{
"speaker": "Henry Hubble",
"text": "They are heavy oil deposits. I amnot familiar with the specifics of the field there."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Okay. And then revisiting WestAfrica again, you probably won’t want to do this, but could you perhaps breakdown the entitlement effects by EG, Angolaand Nigeria,or not possible?"
},
{
"speaker": "Henry Hubble",
"text": "I don’t think it’s appropriate tobreak those down."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "All right. That's fine. Iappreciate it, thank you."
},
{
"speaker": "Operator",
"text": "We will take our next questionfrom Paul Cheng with Lehmann Brothers. Please go ahead."
},
{
"speaker": "Paul Cheng - Lehmann Brothers",
"text": "Hey Henry, good morning. I haveto apologize first because I came in late so you may have already covered inyour prepared remarks. Did you break down what is the FX tax on inventory orasset sales gains or loss on those items in the third quarter versus the secondquarter?"
},
{
"speaker": "Henry Hubble",
"text": "No I haven’t. But the Foreximpact. If you look at the net impact for the third quarter they were prettysmall. Like $14 million something in that range, quite small. We are kind ofnaturally hedged. We see some negative impacts in the Upstream. We see positiveimpacts in Downstream in chemicals that basically offset that."
},
{
"speaker": "Paul Cheng - Lehmann Brothers",
"text": "All right. Can you break down bydivision and force?"
},
{
"speaker": "Henry Hubble",
"text": "Upstream is about, as I mentionedabout 80 negative and then the bulk of the offsetting was in chemicals."
},
{
"speaker": "Paul Cheng - Lehmann Brothers",
"text": "Right. I am talking aboutsequentially from the second quarter level. Is the 80 still a good number? Ithought"
},
{
"speaker": "Henry Hubble",
"text": "Yes, that's pretty close. And thesame, the net effect for total there, when you look at it sequentially therewas less offset. Not much offset from the Downstream chemicals part ofbusiness. So that kind of carried through to the bottom line."
},
{
"speaker": "Paul Cheng - Lehmann Brothers",
"text": "So, it’s about 80 million that'ssequentially? Right?"
},
{
"speaker": "Henry Hubble",
"text": "That’s correct in total."
},
{
"speaker": "Paul Cheng - Lehmann Brothers",
"text": "In total?"
},
{
"speaker": "Henry Hubble",
"text": "Right."
},
{
"speaker": "Paul Cheng - Lehmann Brothers",
"text": "How about any tax adjustment? Orinventory gain or loss? Market sales?"
},
{
"speaker": "Henry Hubble",
"text": "We are in a LIFO basis, and wedon't take any, have any inventory effects during the year."
},
{
"speaker": "Paul Cheng - Lehmann Brothers",
"text": "How about price finalization?"
},
{
"speaker": "Henry Hubble",
"text": "Price finalization, if you lookat an absolute basis we had about 50 million. Now you look, again? Talkingsequential?"
},
{
"speaker": "Paul Cheng - Lehmann Brothers",
"text": "Yes."
},
{
"speaker": "Henry Hubble",
"text": "Yes, so about 50 million in the US onan absolute basis, 65 total and then if you look at the Delta it was like 30 intotal."
},
{
"speaker": "Paul Cheng - Lehmann Brothers",
"text": "I presume that, that is apositive, right?"
},
{
"speaker": "Henry Hubble",
"text": "Excuse me, I’m sorry. In thethird quarter of '07 the absolute level is all negative. So, it is about 65million negative. If you look at the change it was positive relative to theprior, to the second quarter, but quite small."
},
{
"speaker": "Paul Cheng - Lehmann Brothers",
"text": "Right. And do you indicate thatone of the reason about your perhaps a little but lower unit profitability interms of the capture rate comparing to the third quarter of last year, is thatyou have lesser after-sales gain. So, how big is the asset sales gain and on anabsolute level?"
},
{
"speaker": "Henry Hubble",
"text": "I don’t have a breakdown. The twobig factors we had in the absence of sales was associated with the Carson Creekin Canada and then we hadsome sales in Francelast year that were, but I don't have a total for you there. Those were the twothat were kind of the absence of those two. And basically mature areas."
},
{
"speaker": "Paul Cheng - Lehmann Brothers",
"text": "I understand about last year I amtalking about in this year third quarter?"
},
{
"speaker": "Henry Hubble",
"text": "Right. In this third quarter, wedidn’t have a whole lot in there that was a little bit we had in the south North Sea sale, associated with gas. And that was it."
},
{
"speaker": "Paul Cheng - Lehmann Brothers",
"text": "And the second question would bethe Piceance basis?"
},
{
"speaker": "Henry Hubble",
"text": "Paul, well maybe you ought tocome back at the end I think that is more than two."
},
{
"speaker": "Operator",
"text": "(Operator Instructions). And wewill take our next question from Mark Gilman with The Benchmark Company."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Hi, Henry good morning."
},
{
"speaker": "Henry Hubble",
"text": "Hi Mark, how are you?"
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Good thank you I hope you are aswell. I wanted to ask about the Statfjord Late Life and the Offshore project.My assumption on these projects, Henry, is that we will not see volumesactually rising as a result of these projects. But rather in both cases theyrepresent the ability to forego what would otherwise be declines. Marimbavis-à-vis Kizomba A and Statfjord obviously facilities and fields currently inproduction, is that an accurate assumption in both cases?"
},
{
"speaker": "Henry Hubble",
"text": "Pretty much. You're basicallytrying to maintain the capacity of full utilization of the facilities that youhave there so that's what you see from those developments for the most part."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Okay and one other one, if I could,just, one more whack at this entitlement issue from a different angle."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Henry, there are basically twokinds of entitlement issues, that impact on reported production. One is just asimple and rather straightforward cost recovery issue. The other is a morepermanent, in terms of life of field. Change in splits associated either withcumulative returns or cumulative production thresholds and/or cost recoveryfactors. I’m assuming that what we are dealing with here is primarily thelatter. And is therefore not something that in a difference price environmentis likely to change as we go forward. Is that assumption accurate?"
},
{
"speaker": "Henry Hubble",
"text": "Well, I’m not going to break outthe split for you here. You have both effects, but they are both in acontinuing basis. And again it’s going to depend on how crude prices evolvefrom here."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Okay. Thank you, Henry."
},
{
"speaker": "Operator",
"text": "And we’ll take our next questionfrom Paul Sankey with Deutsche Bank. Please go ahead."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Hi, Henry. I had a three part Middle East question, but I’m not going to go there onQA. So, let’s move on to Upper Zakum. You’vegot pretty significant downtime I believe right now. Could you just quantifyhow long that’s going to be out for, and what sort of impact that will have onQ4?"
},
{
"speaker": "Henry Hubble",
"text": "I don’t have anything right atthe tips of my fingers. Let’s see if I can get you something on that. I reallydon’t have any specific data on that at this point."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "But you didn’t turn around there?"
},
{
"speaker": "Henry Hubble",
"text": "You probably ought to ask Zadcoon that."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Okay. I’ll leave it on that onethen, obviously. The second part was about start-ups in Qatar nextyear. Can you just update us on when do you expect those two major projects tobe delivering?"
},
{
"speaker": "Henry Hubble",
"text": "As we had laid out in our earlierplans. We’re expecting those, the start-up of the Qatargas II Train 4 in 2008,and the RasGas Train 6 also scheduled for start-up in 2008, expecting one aboutmid-year, and the other closer to the end of the year; the end of the year.It’s the same as the F&O."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Okay, that answers that one. Wehad a couple of slightly non-answers there upfront. What final one, I’ll throwin one final one. Can you quantify the extent to which disposable impacted yourDownstream numbers. It’s noticeable particularly in Europe, but also to anextent in Asia, you had lower throughputs andsales in both those regions. Thanks."
},
{
"speaker": "Henry Hubble",
"text": "Yeah. The big impact in Europe is Inglestadt, and both on a year-on-yearcomparisons that you have there. And then, there’s ongoing on the part sales.We have ongoing high grating that we’ve got going on pretty much around theworld. Big piece of that happened in Africa, some of South America, but there’s also high grating that’s going on in theother portfolios, as well. And then, Can, you also have impacts that areassociated with turnarounds that are also impacting some of the numbers."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Any barrel numbers you can giveme on that?"
},
{
"speaker": "Henry Hubble",
"text": "If you look at, let me just lookif I have something here. If you look at the totals, or the Downstream, we’redown on the petroleum product sales as you know, about 1%, and that basically,if you look at, you’ve got, well, I don’t have a breakdown. Basically, US, ifyou look on a third quarter '06 versus third quarter '07, throughput wise,which we were up. And basically that’s improved reliability, and that wasalmost all that. Then if you look at theturnaround impact in Asia Pacific, that was Singapore,and Japan,the total of that was about the level you see, the 116 that’s in the numbers.So those were the two impacts there."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "That’s on the throughput, then wejust take Inglestadt out of the Europe number."
},
{
"speaker": "Henry Hubble",
"text": "That’s right."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "And on the product sales?"
},
{
"speaker": "Henry Hubble",
"text": "And on the product sales, thatagain, is I was talking about the divestments, that’s the big piece of, I amjust trying to look, we have I think that's bullet said it is the basically thebest months, the bulk of it is the best men in chief of those investments ineach of these areas, the same story. You kind of see it reflected in thenumbers in the US,basically down the same direction, and the overall total sales down about thesame direction from the throughput. It’s about down equally."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "So, the underlying market wasflat, is what you’re telling me?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah, I mean, if you’re trying toget back to what was the product demand, what we’re seeing on a worldwidebasis, is that we continue to see growth overall, about, not much down at allfrom what we have historically seen, on a total global demand basis, most ofthat growth occurring, though, in the Asia Pac area. US is near flat, up alittle bit. And we’re seeing, there’s nothing there that we can really point toas a global demand response. Again, you don’t know how high itwould be if crude prices weren’t this high, but we’re not seeing big declines.We’re still seeing year on year growth, and we’re not seeing big declines inthat rate of growth on a worldwide basis."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Sounds like you’re predicting$100 oil then, Henry?"
},
{
"speaker": "Henry Hubble",
"text": "I don’t know. I can’t tell youwhy it’s ninety-something today."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Okay, thanks."
},
{
"speaker": "Operator",
"text": "We’ll take our next question fromMark Flannery with Credit Suisse."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Hi, Henry. I have more of a localquestion, about ethanol blending in the US; specifically, in the Southeast.Are you guys getting ready to blend more ethanol into product in the Southeast,I’m thinking in Floridaparticularly; from next year? Are you making the necessary infrastructure andterminal end sort of investments right now, or are you holding back a littlebit?"
},
{
"speaker": "Henry Hubble",
"text": "Well, as you know, we are a majorblender of ethanol. There are incentives to blend ethanol currently. We are maximizingthat, but I’m not going to get into specific regional thoughts that we mighthave. But we’re basically meeting the Federal requirements. We’ve blendedbefore it was required because we saw economic opportunities there, and wecontinue to do that. So, we’ll take advantage of the incentives that are thereto blend ethanol. But again, I’m not going to get into specific investmentplans."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Right. Just a quick follow-up onthe refining side; when you think about ethanol blending and how it might go inthis country, just for the sake of it say, the donation goes to E-10 at someunspecified time in the future. Does that impact the way you think aboutinvestments in the domestic refining base?"
},
{
"speaker": "Henry Hubble",
"text": "Well, if you look at ourlong-term outlook for demand in the US, and actually in OECD ingeneral, our longer term outlook is that it is basically flat. And what you seethere is ongoing efficiencies that continue to come in, basically offsettingwhatever modest growth there may be in miles driven and vehicle use. So as we go forward, we are notseeing a lot of growth in our outlook, so we continue to focus on economicallycreeping our capacities, de-bottlenecking, low cost conversions ads. That’sbeen part of our base improvement, continuous improvement of our refiningfacilities. So, we’re constantly adding capacity through those kinds ofmechanisms, but we’re not seeing a lot of need for grass roots kinds ofinvestments in these mature markets. Now, on contrast, though, whenyou move out to Asia Pacific, China,some of these other areas. Our Fujianproject is a prime example there, where we’re investing to meet that growingdemand, which is substantially about what you can meet throughde-bottlenecking. And of course, in the base where we’re running our conversioncapacity full in all of the regions and there is incentive to continue tode-bottleneck that."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Great, thank you very much."
},
{
"speaker": "Operator",
"text": "And we’re taking follow-upquestion from Mark Gilman with the Benchmark Company. Please go ahead."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Henry, I noticed that the volumemix bar in your Upstream year-over-year earning experience is essentially zero,like the fact that the production is down. Was the lifting position in thisrecently completed quarter more favorable than production, and that explainsthe bar in the chart, or was there an adverse lifting position in the year-agoperiod. Can you shed some light on that?"
},
{
"speaker": "Henry Hubble",
"text": "Basically, what you are seeingthere is a mix effect, as you point out. There is a positive effect associatedwith the Sakhalin project, where we have theexport facilities now. And so you have higher realizations associated withthat."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Okay. One other if I could.Marimba on offshore Angola,is that ringed fence with [Kiz-A] in the same PSC, or is it a separate PSC?"
},
{
"speaker": "Henry Hubble",
"text": "It’s ring fence."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "We’ll take a follow-up questionfrom Paul Cheng with Lehman Brothers. Please go ahead."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Hey Henry, Nigeria,the government, as a contact, you guys about change in the region or there isjust noise?"
},
{
"speaker": "Henry Hubble",
"text": "No. We have not had any contactswith them at this point."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Final one, Piceance basin, whereare you in terms of production at this point? And what kind of rate program doyou have?"
},
{
"speaker": "Henry Hubble",
"text": "The latest numbers I have about50 million cubic feet per day. And of course, we have our phase one projectthat we’re working for. We’ve gotten the finding of no significant impactassociated with that, so we’re basically moving ahead with our developmentplans there. And expecting, that’s out in our ‘08/’09 time frame, basically."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Are we still looking at 400million cubic feet per day kind of production by the 2010/2011, even undertoday’s gas price?"
},
{
"speaker": "Henry Hubble",
"text": "Well, when you look at the total,we have multiple phases that give out, it’s in the '06 F&O. But basically,those future phases take us out to 2011 or so, something in that, beyond,basically get us to up to that full potential."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "So the current price structure inthe natural gas did not alter your view or your program?"
},
{
"speaker": "Henry Hubble",
"text": "Well, there’s infrastructurethat’s being added there to get the gas out of the region, so that is ashort-term phenomenon that you’re seeing there."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Okay very good. Thank you."
},
{
"speaker": "Operator",
"text": "This will conclude today'squestion-and-answer session. Mr. Hubble, I will turn the conference back overto you for closing comments."
},
{
"speaker": "Henry Hubble",
"text": "Well, I just want to say thanksto everybody for your questions, and for listening in. I look forward to seeingit on the road."
},
{
"speaker": "Operator",
"text": "Ladies and Gentlemen, this willconclude ExxonMobil Corporation’s 2007 conference call. We thank you for yourparticipation, and you may disconnect at this time."
}
] | null | null |
XOM | 2 | 2,007 | 2007-07-26 11:00:00 | TRANSCRIPT SPONSOR :
Executives: Henry Hubble - VP IR & Secretary
Analysts: Doug Terreson - Morgan Stanley Robert Kessler - Simmons & Company Nikki Decker - Bear Stearns & Company Paul Sankey - Deutsche Bank Doug Leggate - Citigroup Mark Gilman - The Benchmark Company Daniel Barcelo - Banc of America Securities Paul Cheng - Lehman Brothers Kate Lucas - JPMorgan Chase & Company John Herrlin - Merrill Lynch Neil McMahon - Sanford C. Bernstein
Operator: Good day, everyone, and welcome to this ExxonMobil Corporation Second Quarter 2007 Earnings Conference Call. Today's call is being recorded. And at this time for opening remarks, I am pleased to turn the conference over to Vice President of Investor Relations and Secretary, Mr. Henry Hubble. Mr. Hubble, you may begin, sir.
Henry Hubble: Thank you. Good morning, and welcome to ExxonMobil's teleconference and webcast on our second quarter 2007 financial and operating results. As you are aware from this mornings press release, our integrated business model delivered another strong quarter including record second quarter earnings for our downstream and chemical businesses. The fundamentals of our business are strong and we saw continued good operational performance in the quarter. We also continued our disciplined approach to prudently invest and meet long term demand growth. Before we go further, I'd like to draw your attention to our cautionary statement. Please note that estimates, plans, and projections are forward-looking statements. Actual results including resource recoveries, volume growth, and project outcomes could differ materially due to factors I discuss and factors noted in our SEC filings. Please see factors affecting future results on the Form 8K we furnished this morning which are available through the investor information section of our website. Please also see the frequently used terms, the supplements to this mornings press release, and the 2006 financial and operating review on our website. This material defines key terms I will use today, shows ExxonMobil's net interest in specific projects, and includes our SEC Regulation G disclosure. Now I'm pleased to turn your attention to the second quarter results. ExxonMobil's second quarter earnings were $10.3 billion, down slightly from the 2006 record second quarter. Earnings per share, however, were up markedly from last year at $1.83 reflecting the strong earnings and the continuing benefits of our ongoing share purchase program. Before I discuss the specific business results, I'd like to share some of our recently achieved milestones. In the quarter, we saw first production from our interest in the deepwater Rosa project in Angola Block 17. Rosa's recoverable resources are estimated at 370 million barrels and production capacity is expected to be approximately 150,000 barrels per day. SOX exploration Angola has a 20% interest in the project. On July 19, ExxonMobil majority owned affiliate, Imperial Oil and ExxonMobil Canada announced success in acquiring exploration rights for a large block in the Canadian Beaufort Sea. Imperial and ExxonMobil Canada were awarded the exploration license after bidding a work program of $585 million Canadian. The block is over 2,000 square kilometers and is located approximately 120 kilometers offshore in water depths ranging from 60 to 1,200 meters. An ExxonMobil subsidiary has also recently awarded an offshore block in New Zealand's latest exploration acreage release. The block which comprises approximately 20,000 square kilometers is located in the great South Basin off the southeastern coast of New Zealand. Water depths in the area range from 500 to 1,000 meters. The successful capture of acreage in the Beaufort Sea and offshore New Zealand demonstrates ExxonMobil's global approach to the identification and pursuit of quality hydrocarbon resources and exploration opportunities. We look forward to exploring these attractive and technically challenging areas with the full suite of ExxonMobil capabilities. During the quarter several new exploration discoveries were reported in ExxonMobil interest Blocks 31 and 32 offshore Angola. These continued successes attest to the resource potential of these blocks and the development options continue to be progressed. In the downstream, we continued our feed diversification activities running 29 crudes which were new to individual refineries. Additionally, we implemented projects during the quarter to further enhance feed flexibility. ExxonMobil's ability to rapidly assess and optimally process feedstocks utilizing our proprietary molecular management technology is a key competitive advantage which enables us to maximize the value of a broad range of feedstocks. We also completed the start up of new low sulfur gas facilities in Japan. These facilities allow more efficient production of low sulfur gasoline while improving operational flexibility. These projects were completed in line with budget and on or ahead of schedule. In June, we announced the worldwide introduction of Mobil Pegasus 1005, a high performance lubricant with advanced additive technology. This new lubricant provides exceptional levels of protection for today's high output, low emissions, natural gas engines. In our chemicals business, we announced the planned expansion of hydrocarbon fluids capacity at our Antwerp and Singapore facilities. The hydrocarbon fluids business includes differentiated products used in a broad range of applications and industrial processes. Antwerp capacity will increase -- be increased by about 10% to 700,000 tons per year, with expected completion by the end of this year. In Singapore, the expansion will add 130,000 tons per year bringing production capacity to over 500,000 tons per year. These investments reinforce our commitment to meet customer requirements for differentiated products. During the quarter ExxonMobil chemical also announced the development of technology to support the growing drive for improved automobile fuel efficiency. In Japan, an ExxonMobil affiliate is now producing innovative microporous films for hybrid and electric vehicle lithium ion batteries. In the U.S. we announced the planned construction of a facility to manufacture new specialty elastomer compounds that can improve the durability and reduce the weight of tires resulting in improved fuel economy. And finally, ExxonMobil Chemical also earned awards for energy efficiency from the American Chemistry Council and from the Industrial Energy Technology Conference hosted by the Energy Systems Laboratory of the Texas A&M university system. This is the 10th consecutive year that the ExxonMobil chemicals has received ACC energy efficiency awards. Turning now to the business line results. Upstream earnings in the second quarter were $6 billion. This represents a decrease of $1.2 billion versus the second quarter of 2006, primarily due to reduced worldwide natural gas realizations, lower gains from asset sales, tax effects including the absence of positive tax impacts in 2006, and increased expenses primarily due to new project developments. These negative effects were partially offset by positive sales mix impacts. Worldwide crude realizations were $65.11 per barrel, up $0.21 per barrel from second quarter 2006. Upstream after-tax unit earnings in the second quarter of 2007 remain strong at $15.88 per barrel. In total, oil equivalent volumes were down 1% from 2006. However, excluding the impact of entitlement, OPEC quota and divestment effects, second quarter production was actually up almost 4%. That increase was driven by increased volumes for major project ramp ups in Russia, West Africa, and Qatar, which more than offset natural field decline and lower European natural gas demand. Turning to liquids production. Although increased volumes from the recent project start-ups in Russia, West Africa, and Qatar more than offset natural field decline, liquids production fell by 34,000 barrels per day, or 1% from the same quarter last year due to entitlement and OPEC quota effects in Africa. Gas volumes were essentially unchanged from last year, with lower demand in Europe due to warmer weather and natural field decline offsetting higher production in Qatar. Now turning to the sequential comparison. Versus the first quarter of 2007, upstream earnings decreased about $90 million with seasonally lower natural gas volumes, reduced earnings from asset sales, and negative tax effects more than offsetting higher realizations. Liquids production decreased 3%, including the impact of entitlement and quota effects in Africa and plant field maintenance in the U.S. and Europe. Natural gas production was down 14%, primarily due to seasonally lower demand in Europe. Oil equivalent volumes were down 7% from the first quarter. Finally, in the upstream, as you're aware ExxonMobil's affiliate in Venezuela was not able to reach the agreement on the formation of a mixed enterprise and on June 27, 2007, the government took over our interest in the Serene rural project. ExxonMobil's net investment and Serene rural producing assets is about $750 million. Discussions with the Venezuelan authorities over the compensation to be paid to ExxonMobil have not yet been completed. At this time, the net impact of this matter on the corporations consolidated financial results cannot be reasonably estimated. However, we do not expect the resolution to have a material effect on the corporations, operations or financial condition. For further data on regional volumes, please refer to the press release and IR supplement. Now let's turn to the downstream results. Downstream earnings were a quarterly record at $3.4 billion, up approximately $910 million from the second quarter last year as the quality of our integrated downstream portfolio allowed us to benefit from the robust industry conditions. Margins improved across the downstream business functions, increasing earnings by $430 million. Volume mix effects were positive $190 million, reflecting feedstock flexibility and product optimization programs. These effects more than offset lower refinery throughput associated with the divestment of the Ingolstadt refinery in Germany and higher planned maintenance activity in the U.S. Despite lower U.S. refinery throughput during the quarter, our supply and operating flexibility allowed us to maintain U.S. gasoline production and in fact our year-to-date gasoline production in the U.S. is up 5% versus last year. Other factors increased earnings by $290 million, primarily due to asset sales, including the Ingolstadt refinery divestment. Sequentially, second quarter earnings increased by $1.5 billion, reflecting improved global refining margins. Volume mix effects were positive $110 million, as refinery optimization and other volume effects more than offset the impact of planned maintenance activities. Other factors benefited earnings by $110 million, including the positive effects from asset divestments partially offset by higher maintenance costs and foreign exchange effects. Chemical earnings were a record for the second quarter at $1 billion, up nearly $175 million versus the second quarter of 2006. Higher margins improved earnings by $215 million reflecting increased realizations partly offset by higher feedstock costs. Sequentially, second quarter chemical earnings were down by $225 million from a strong first quarter, driven by lower worldwide margins. Turning now to our corporate and financing segment. The Corporation recorded second quarter expenses of $99 million in the corporate and financing segment, unchanged from the second quarter of 2006. The effective tax rate for the second quarter was 44%. The Corporation distributed a total of $9 billion to shareholders in the second quarter through dividends and share purchases to reduce shares outstanding, up 14% from the second quarter of 2006. During the quarter, ExxonMobil purchased $7 billion of shares in excess of dilution, reducing the number of shares outstanding by 1.5%, and further demonstrating our ongoing commitment to return cash to our shareholders. CapEx in the second quarter was $5 billion. At the end of the second quarter, our cash balance was $33.6 billion and debt was $8.8 billion. In summary, these results highlight the fundamental strength of our business, our ability to deliver superior operational performance, and continue to grow our integrated capabilities while continuing to position ourselves for future demand growth and create value for our shareholders. That concludes my prepared remarks, and I'd now be happy to take your questions.
Operator: (Operator Instructions) We'll go first to Doug Terreson with Morgan Stanley.
Doug Terreson - Morgan Stanley: How are you?
Henry Hubble: Hi, Doug.
Doug Terreson - Morgan Stanley: In international refining and marketing, your refining production outside of Europe during the first half was higher by almost 5% in relation to the year ago period, which is obviously a good number, but marketing output seemed to be lower versus the same period. And so my question regards why these two figures might be diverging, which I believe represented a feature of the results during the past couple of quarters as well. And so divergence and refining and marketing first half outside of Europe is the question.
Henry Hubble: Outside of Europe?
Doug Terreson - Morgan Stanley: Outside of Europe, yes. Asia and other, basically.
Henry Hubble: Okay. Let me just look at what we've got here. There's no real big story here. Most of that, it's turnaround timing and it's going to fluctuate with timing, but I can't really point to a seasonal impact there that's going on either.
Doug Terreson - Morgan Stanley: Okay. Okay. Well, let me ask you another question. At the analyst meeting, Rex talked about the proficiency of the project management system as being one of the explanations why Exxon's actual and funded capital expenditures have been so close in recent years and at 2007 appears to be heading in the same direction.
Henry Hubble: Yes.
Doug Terreson - Morgan Stanley: Which is also good news too. And so on this point, I wanted to see if you could provide an update on some of the inflation trends that the Company is experiencing, because it appears as if you have taken them into consideration in an appropriate way in your operations, and Henry if you have an aggregate or by the major functions, that would be great.
Henry Hubble: Yes, I mean, if you just look at overall operating expenses for the Company, there's -- and you look at what we're able to do just -- of course we track this on a regular basis in terms of the various effects, and then how we're able to offset those. If you look at the inflationary effects, basically we've been able for a long period of time to offset inflationary effects with efficiency.
Doug Terreson - Morgan Stanley: Yes.
Henry Hubble: The general drive though that you see in rising costs, there are some associated with new projects and non -- noncash costs associated with new projects. You also have a 4X effect that's in here.
Doug Terreson - Morgan Stanley: Sure.
Henry Hubble: But obviously we're not immune to the impacts of higher costs and we work very hard to offset those. So when you look at the projects, especially in the CapEx area, there's an awful lot of work that goes on in the front end. In fact, that's a big piece of our focus, is to make sure that we have really got the concept of development right, that we've got the execution plans well thought through, the contracting is in place, and then we got to execute according to those plans. And we work very hard. It's not that things don't go wrong, but we have very -- because of the global functional approach that we have to be able to solve problems, we're able to get the right people there very quickly and get those resolved to help us keep on track.
Doug Terreson - Morgan Stanley: Sure.
Henry Hubble: And all of these things end up helping to manage those costs, but they're not silver bullets. It's a lot of hard work by a lot of people. The other thing I would say is technology plays a big factor here too, and many of the things that we have been able to deliver in even in the recent times, whether it's the technology we have around Fast Drill that has allowed us to improve the efficiency and effectiveness of our drilling efforts. That has taken anywhere from 15% to 30% out of the cost of wells, which is -- goes a big ways to offset the cost of inflation on drill rigs and other things. So all of that to say, there's just a lot of things that are going on, a lot of people working this very hard, but I'll tell you the other thing that's real key here, in any cost controlling effort, is that you don't start with the goal of reducing cost. You start with a goal to improve things like reliability or efficiency or productivity, and you put in systems that allow you to deliver those. You just don't go cut budgets or you won't get the results you're looking for. Generally, we find improved reliability and improved maintenance practices delivers lower costs and improved throughput.
Doug Terreson - Morgan Stanley: Well, the system is working. Thanks a lot.
Henry Hubble: Yes. Thanks.
Operator: Next we'll go to Robert Kessler at Simmons & Company.
Robert Kessler - Simmons & Company: Hi, Henry.
Henry Hubble: Hi.
Robert Kessler - Simmons & Company: Looking at your upstream variant sequentially, the other bucket, over $1 billion, can you just give a little bit more granularity as to the components there?
Henry Hubble: Yes. Just stepping back, in both of the comparative periods, we had a large other impact, and if you look into what's behind that, as we highlighted last year and it really is -- we also discussed in the first quarter, we saw a positive earnings impacts associated with asset sales in 2006, including the second quarter. It's really the absence of those sales or reduced number of sales that you see this negative variance and then we also had some positive tax impacts, largely in Canada, that we also got last year in the second quarter. So that -- those -- that combination of those two ends up being about 60% of that $1 billion variance in the other column.
Robert Kessler - Simmons & Company: Reading that different, Henry, do we just call the current quarter fairly clean then in that regard?
Henry Hubble: Yes, that's right. It's -- you had variations, but there's nothing in the current quarter that's a big negative to these results. I mean, we do see as I mentioned earlier, we do see some expense increases and those expense increases associated largely with new project startups. You also saw some in our exploration activity that reflected in the period, but I would tell you there's nothing there in the way of a significant other variance.
Robert Kessler - Simmons & Company: Sure. I appreciate with respect in Venezuela that the full financial impact is not yet estimable. Can you tell us though of the $750 million of PP&E exposure you had to Venezuela previously, how much is still on your books ?
Henry Hubble: Well, the $750 million is an all-in effect. So that's I think that's a way to look at that. That's basically all-in what we have on Venezuela from the Serenegro production.
Robert Kessler - Simmons & Company: And you have yet to really write-off any of that in the interim?
Henry Hubble: No, because we're still in the middle of discussions here , and you're predicting how that's going to turn out and what the net of this issue will be, or effect will be, is -- really can't be determined at this point. So I think it's premature to do anything in that
Robert Kessler - Simmons & Company: Okay. Last one for me. This is a quick one but looking at your cash flow from operations of $11.3 billion for the quarter, can you quantify any positive or negative working capital effects buried in there?
Henry Hubble: Yes, if you look at cash flow, normally in the comparisons that we have, especially in the first quarter or second quarter, you always have the impacts of -- you have more tax expense, or, excuse me, less tax expense than you have cash payments in the second quarter, because you end up -- we have that opposite effect we talk about in the first quarter when the taxes aren't due until April 15th. So you end up with essentially a double payment in the second quarter and that's the biggest piece of that. You'll see other variations that occur just with variations in pricing that goes on. I think there is a bit in here that may be associated with product receivables but the big impact was on the tax side.
Robert Kessler - Simmons & Company: But I'm sorry, in aggregate, last year, second quarter, you had about a $3 billion working capital use of cash. Is that about the same in this year's second quarter?
Henry Hubble: Let's see, if I look, the year comparison year on year, it's really almost nothing in there. It's -- they were almost identical.
Robert Kessler - Simmons & Company: Right.
Henry Hubble: Or had very similar effects.
Robert Kessler - Simmons & Company: Fair enough. Thanks, Henry.
Henry Hubble: Yes, okay.
Operator: Our next question will come from Nikki Decker at Bear Stearns.
Nikki Decker - Bear Stearns & Company: Hi, Henry.
Henry Hubble: Hi, Nikki.
Nikki Decker - Bear Stearns & Company: I wanted to ask you about U.S. liquids production. It's lower both sequentially and year-over-year.
Henry Hubble: Yes.
Nikki Decker - Bear Stearns & Company: Is something going on there?
Henry Hubble: Well, no, I would say we tend to look at the liquids in North America, or that's the way I'd generally look at this, and we're down about 4% on the year on year comparisons second quarter '07 to 06, and I would just say there's -- we feel very good about the work programs and overall, the things are on track there. There's -- I mean obviously there's actual field decline and mature areas, but we've been able to partially offset that with actually some pretty strong work programs during the period.
Nikki Decker - Bear Stearns & Company: Do the -- liquids production would reflect the natural declines?
Henry Hubble: Yes, Oh, yes.
Nikki Decker - Bear Stearns & Company: Okay. Secondly, Henry, I think last quarter, you provided a breakdown between refining and marketing on the margin contribution on your earnings comparison. I was wondering if you could do the same.
Henry Hubble: Yes. If you just -- if you look, it's about 75% marketing in the margin side, 75% marketing, 25% refining. And just back on your other question about the North America volumes, there are some asset management effects in there too. They aren't real big, but there are some of those that are in that same time frame.
Nikki Decker - Bear Stearns & Company: Okay, thanks. Just on your response on the margin question, is that sequentially or year-over-year?
Henry Hubble: That was year-over-year.
Nikki Decker - Bear Stearns & Company: Would you have it sequentially as well?
Henry Hubble: Sequentially, it's all refining. There's basically nothing in there on marketing.
Nikki Decker - Bear Stearns & Company: Thanks, Henry.
Henry Hubble: Yes.
Operator: We'll go to Paul Sankey at Deutsche.
Paul Sankey - Deutsche Bank: Hi, Henry.
Henry Hubble: Hi, Paul.
Paul Sankey - Deutsche Bank: How are you?
Henry Hubble: Good.
Paul Sankey - Deutsche Bank: Henry, I was given what you think about project start ups , it's notable that your African oil volumes are down quite heavily year on year. Could you speak specifically to that, and extend it to just break out the -- what were the components, divestments, and so on of the volume differential that you're talking about between the decline and what would have been a 4%
Henry Hubble: Right, yes. Well if you look at the number, when I was talking about the 4% increase I was really referring to the oil equivalent comparison in the year on year quarter comparison. Now, the bulk of that as I pointed out was for titlement effects, those were in Africa, associated with the projects that we have there, and it's components, as you know with the PSC's that we have there, we have impacts as we -- or cumulative price effects associated with those entitlement effects over those, and then we also have price impacts. But that was if you looked at it, that was if I just jump down to the total oil equivalent impact, we had -- we were 1% down year on year, and it was about 3% of that that impact associated with entitlements. There was a 1% impact that was associated with quota, and again the big piece of that quota effect was in Africa, and then there were divestment impacts, but they are obviously outside of Africa in the U.S. and non-U.S. And ended up being about another .5%, but that's where -- how you get to the 4%. And if you look at the Africa volumes themselves, and it's basically, again, it's the entitlement effects and the quota effects there, which were the big pieces of that. And that was offset by the new project volumes that we brought on that ended up partially offset by the new volumes we brought on.
Paul Sankey - Deutsche Bank: And is that situation in Africa particularly with the cutbacks on OPEC changing, Henry? Are you producing more now or is it still ratcheted back?
Henry Hubble: Well, I don't know. To current day, yes, but if you look at what the impact will be on the quarter, it's hard to say what's going to evolve from here on that front.
Paul Sankey - Deutsche Bank: But basically back at a similar level of cut back right now that we saw in the Q2?
Henry Hubble: It would be less currently today.
Paul Sankey - Deutsche Bank: That's interesting, thank you. The second question if I could, we were surprised by your realizations in European gas. We know about the seasonal volume effect obviously, but it's interesting that there was a really significant step down on the realization side. Could you talk about that?
Henry Hubble: Well, you see just with the warm weather in Europe, we did see downward pressures on realizations there, and if you look at the natural gas, if you look at like the -- you don't really have the equivalent of markers, but if you look at the UK net balancing point, it was down sharply across the time frame, and we saw some of that roll through into impacts in Europe in particular. So you kind of have an issue here where, in the U.S, natural gas actually increased during the period, about 11%, and over there we saw a 14% decline in our realizations, and really reflecting warmer weather and in fact there were even periods where there were arbitrage opens going across, so we did see weakness in the European gas pricing.
Paul Sankey - Deutsche Bank: Okay, so it was essentially just related to the headline -- the marker being down. It was nothing like no special items in there that would cause it to be unusually low?
Henry Hubble: No, other than we had, there was less demand associated with the warm weather.
Paul Sankey - Deutsche Bank: Sure.
Henry Hubble: And however that rolls back through into price, yes. That was there, but nothing else, no.
Paul Sankey - Deutsche Bank: Right, and finally for me, U.S. refining, it seems to me you got an 82% utilization rate in Q -- the first half. Is that going to improve do you think in the second half, and you mentioned it was related to plant turnarounds? It seems like an awfully low number or very high level of turnaround. Was there some additional issues there? Thank you.
Henry Hubble: Well, if you look at the turnaround impacts and the throughput impacts that we had in the quarterly comparison, we're down about 128 I think in North America or in the U.S, And that was essentially all turnaround, both Beaumont and Baytown. And they were pipe turnarounds, so you see that in throughput but we were actually because we didn't have as much conversion capacity down, we had more of our CAT units and other conversion units up and running, we were actually able to increase our gasoline production in this time frame. So what we've done is buy feedstocks to be able to keep those units full and we're able to maintain our production.
Paul Sankey - Deutsche Bank: Right, and your '06 number U.S. utilization was 90%. Is that what we can expect to see in the second half?
Henry Hubble: We'll have less turnaround activity scheduled in the second half.
Paul Sankey - Deutsche Bank: Thanks, Henry.
Henry Hubble: Yes.
Operator: We'll go next to Doug Leggate with Citigroup.
Doug Leggate - Citigroup: Thank you. Good morning, Henry.
Henry Hubble: Hi, Doug.
Doug Leggate - Citigroup: International downstream, notwithstanding the sequential and year-over-year comparisons that you've given us, if you look at the realized earnings in that segment and adjust for the gain, I guess, coming from the refinery disposal that the counter rates still look pretty impressive. Can you just talk around that and has there been anything specific going on? Have you changed to feedstock, or is there something unusual there that has pushed your earnings up?
Henry Hubble: Nothing that I can really point to. There's obviously in all of these periods a lot of emphasis on selecting the right raw materials and getting them into the refineries, and we do a lot as we talked about to get advantage feedstocks or advantage crudes into those refineries. And one of the things that we find is gives us an advantage in that is, we have with our molecule management technology, we're able to quickly assess the value of new raw materials and assess those values into our facilities. And that helps with our optimization, but there's nothing else I can really point to, other than kind of the normal good operations and good reliability that we've had in the period.
Doug Leggate - Citigroup: Can you break out the absolute contribution from the English stock disposal?
Henry Hubble: I don't have a specific number associated, but about 3 -- about 3 -- $300,000 -- $300 million.
Doug Leggate - Citigroup: Okay, and the only other one for me is if I could just jump back to Venezuela very quickly, obviously your -- one of your competitors took a fairly sizeable write-off in Venezuela yesterday. You folks have decided not to do that, but arguably, it's difficult to know how it's going to play out. But I'm just curious when you think about it from a prudent standpoint, why have you opted not yet to take that hit, given that it's relatively modest in any case?
Henry Hubble: Well, the -- I think both argue for not -- it's modest and overall sense, it's important, but we're in the middle of discussions and until you can estimate it, reasonably estimate what the impact is, if you follow, we follow GAAP rules and frankly, our view is you can't really estimate it until we're a little further down the road on these negotiations. And so we just don't think that it's appropriate timing to do that.
Doug Leggate - Citigroup: Okay, great. Thanks, Henry.
Henry Hubble: Yes.
Operator: (Operator Instructions) We'll move to Mark Gilman at Benchmark.
Mark Gilman - The Benchmark Company: Henry, good morning.
Henry Hubble: Hi, Mark, how are you?
Mark Gilman - The Benchmark Company: Good, thank you. Quick update on quality, if you can?
Henry Hubble: Update on --
Mark Gilman - The Benchmark Company: The following --
Henry Hubble: Oh, sorry. Yes. Basically, we had a fire at our -- you may have obviously heard about it, on the Cogent facility there, where we lost steam and some of the power production, basically ended upbringing the facility down. Right now, we're working on the plans and in fact the plans have been developed for restart and we're expecting that to happen over the next several days. So it's one of those -- you had a down time, but no long lasting damage as we've assessed it.
Mark Gilman - The Benchmark Company: Okay, do you have a hard number for your next Serenegro production in the second quarter?
Henry Hubble: I don't have a -- it's about 30%, because we had quota effects, we had some quota effects in there, so actually I think it's a little less than that, 20%, about 20%.
Mark Gilman - The Benchmark Company: About 20%?
Henry Hubble: Yes.
Mark Gilman - The Benchmark Company: Yes, I notice that in your variance analysis on the upstream. The volume is indicated to be a modest plus in the year-over-year comparison, whereas production was down. Does that mean that there were favorable lifting variances in this years second quarter?
Henry Hubble: Well, what you see there is really the effects of the positive -- we had a positive impact associated with new volumes that we're bringing on in the Middle East, as well as in Russia associated with the ramp up production there, and being able to export those volumes. So we had some positive mix effects associated with that.
Mark Gilman - The Benchmark Company: Okay, and final one for me, there's reference in the release to Canadian gas production and project that ramped that up a little bit. Wasn't aware of anything in that regard. Could you be a bit more specific?
Henry Hubble: Oh, that's associated with Sabel.
Mark Gilman - The Benchmark Company: Oh, okay.
Henry Hubble: Bringing that. Yes.
Mark Gilman - The Benchmark Company: Okay, thanks, Henry.
Henry Hubble: Yes, yes, no problem.
Operator: Next we'll take a question from Dan Barcelo with Banc of America.
Daniel Barcelo - Banc of America Securities: Hi, good morning, Henry.
Henry Hubble: Hi, Dan.
Daniel Barcelo - Banc of America Securities: Just a clarification regarding upstream.
Henry Hubble: Yes.
Daniel Barcelo - Banc of America Securities: Q2 versus Q1, and it related to two aspects. First U.S. realization seemed to be really light compared to Henry Hub benchmarks. Does that have to do with rocky differentials or things like that? And the second part is related to an earlier question, if you could give some color on the $620 million swing in other, related again from Q2 to Q1 in the upstream.
Henry Hubble: Yes. When you look at the other impacts, as I mentioned, you do have -- there's a whole bunch of items in there, but they are basically all going in the same direction again in this time frame. So we have a number of effects. Basically, again, it's the absence of some positive impacts from the first quarter including the asset sales and some positive tax impacts. And there were also some higher activity related to exploration, and we also had some -- a little additional in there in operating expenses and 4X impacts. But nothing else that I really can highlight. And then the other piece of the question was around --
Daniel Barcelo - Banc of America Securities: Henry Hub differential -- Henry Hub change 1Q to 2Q versus your realization, you were broadly flat. I think the benchmark went up to about $0.78. Is that related more to differentials and your position --
Henry Hubble: It's going to be related to the specific contracts. Typically we track pretty close. There isn't anything I can point to that was a specific issue there, so it's -- we've generally tracked that reasonably close. If you look at I think we had Henry Hub was our average would show $7.55 in the quarter and versus last or sequential quarter, $6.77 and we were at $6 versus, excuse me, U.S. we were $6.94 versus the $6.85. So I guess that's, it is a variance there, but I really can't point to anything specific.
Daniel Barcelo - Banc of America Securities: Okay, and then second one if I could was just maybe a broader comment on your deepwater U.S. Gulf strategy, both in the context of maybe lease expirations, upcoming lease sales. But it's also interesting because I understand you're bringing a rig down from Canada that was at Walker Ridge. And then last year you did something interesting with Statoil and AMI and Walker Ridge.
Henry Hubble: Right. Yes. We've got, if you look at the lower tertiary, we've got a number of -- we already drilled the Julia well as you're no doubt aware. We're bringing the rod down from -- or it's actually down I guess now, to drill the North Braun in fact it's drilling now, and then we'll be using it also to drill Hal later in the year, and then we also have Chuck that is being drilled in the time frame. So all has impacted is it's being drilled now as well so there's a fair bit of activity and those are prospects -- the best prospects that we see. There is some acreage that will be released in that area and we'll be evaluating what we want to do there.
Daniel Barcelo - Banc of America Securities: Okay, thank you.
Henry Hubble: Yes.
Operator: We'll go to Paul Cheng at Lehman -- Lehman Brothers, rather. Sorry.
Paul Cheng - Lehman Brothers: Hi, Henry. Good morning.
Henry Hubble: Hi, Paul.
Paul Cheng - Lehman Brothers: Two quick questions. I think based on what you just described earlier, that in this particular quarter we do not have any major impact one way or the other from inventory gain tax adjustment or foreign exchange?
Henry Hubble: Yes. We have foreign exchange is kind of minor impacts, but if I look at just the total, you end up in the second quarter, the year on year comparison, second quarter to second quarter, there's a positive $77 million of that in chemicals and then if you look at sequentially, it's a negative impact of about $50 million, but pretty small across the businesses. And that's from a 4X standpoint.
Paul Cheng - Lehman Brothers: Yes, how about in terms of inventory gain on laws or tax --
Henry Hubble: No, the only we really you don't see, we don't see any inventory effects other than at year-end associated with LIFO.
Paul Cheng - Lehman Brothers: Yes. Okay. And cats, what kind of impact are you guys -- and also can you talk about what is the asset sales gain for the German refinery?
Henry Hubble: I don't have a quick number off the top on the cats impact. I can -- we can get something for you on that, but it's relatively small.
Paul Cheng - Lehman Brothers: Relatively small?
Henry Hubble: Yes.
Paul Cheng - Lehman Brothers: And then how about in terms of the asset sales gain you record --
Henry Hubble: What was that again?
Paul Cheng - Lehman Brothers: The asset sales gain you record for the German refinery you sold?
Henry Hubble: Oh, yes, that was Ingolstadt of about $300 million.
Paul Cheng - Lehman Brothers: $300 million?
Henry Hubble: $300 million, yes, and the cats impact is about 40 million.
Paul Cheng - Lehman Brothers: 40,000 or 40 million cubic feet?
Henry Hubble: 40 million cubic feet.
Paul Cheng - Lehman Brothers: Wow, only?
Henry Hubble: Yes.
Paul Cheng - Lehman Brothers: You guys are in good shape.
Henry Hubble: Yes.
Paul Cheng - Lehman Brothers: Okay, thank you.
Henry Hubble: Yes.
Operator: And we'll take a question from Kate Lucas at JPMorgan.
Kate Lucas - JPMorgan Chase & Company: Hi, good morning.
Henry Hubble: Hi, Kate.
Kate Lucas - JPMorgan Chase & Company: Hi. Just a quick question on your chemical segment. We've seen pretty strong results over the last several quarters and you've had -- you've got some organic growth projects. But I just wanted to know if you might be giving any consideration to expanding the weighting of chemicals in your overall portfolio, maybe beyond the organic projects that you've approved for project start-up?
Henry Hubble: Well, as you -- well, we have a number of projects that are aimed at growing, basically aimed at the Asia Pacific market. So we have a project in Fujian that we're executing now. We're working on the Singapore parallel train and looking forward to bringing that one not too far down the road, and of course we also have the project in joint venture project in Wusavec and Saudi Arabia, and then we're working with Qatar, all of these will be world class facilities. So, yes, we're growing this business, and it's one where -- as we look at it, it grows about 2%, or better than 2% above GDP growth, and it's really driven because of the continuing substitution into automobile parts and textiles, and other things. So we see a strong demand growth there, and really, in that Asia Pacific area is the big piece. So, yes, we're working that and then also, of course our big focus in this in how we approach it is with a strong integration to our downstream businesses or to advantage feedstocks and with our upstream assets. So, yes, we're positioning ourselves to grow and meet the organic or the larger growth that's coming.
Kate Lucas - JPMorgan Chase & Company: Thank you.
Henry Hubble: Yes.
Operator: Next we'll go to John Herrlin with Merrill Lynch.
John Herrlin - Merrill Lynch: Yes, Henry, European gas sales were weak. You mentioned that the cast line would be out for a little bit volume wise in the prior question.
Henry Hubble: Yes.
John Herrlin - Merrill Lynch: What kind of sequential recovery are you seeing with respect to gas or should we expect more weakness in the third quarter in Europe?
Henry Hubble: Well, the big piece in sequential comparison is just the normal seasonal demand. So it typically, we see in the third quarter, it's not all that different than what we typically have in the second quarter, and then it starts picking up fourth quarter and first quarter. So I would -- it's going to be dominated by those seasonal impacts and I would expect it to be not all that different.
John Herrlin - Merrill Lynch: Okay. Next one for me is on chemicals, we've been getting a lot of weak economic data. Are your folks seeing any issues with respect to product demand on your chemical business?
Henry Hubble: Not really. We're running utilizations, we're running our plants full, so that's been strong. We've seen strong solid demand globally. The areas in our aeromatics have been strong in the period and we've seen good. So basically, strength through the business and don't really see that changing quickly here. It's in a good position, as long as we see good global demand growth --
John Herrlin - Merrill Lynch: Thank you.
Henry Hubble: All right
Operator: Next we'll take a follow-up from Mark Gilman.
Henry Hubble: All right
Mark Gilman - The Benchmark Company: Henry, I know there's rate of return thresholds in the PSC 's for Kizamba A and B. I was wondering whether Kiz B has hit that threshold which would result in a reduction in the profit split?
Henry Hubble: Well, there -- as you know, we don't get into the specifics of the contracts on those things. There are, as you know, there's a couple of components of PSC's, those that are affected with cumulative entitlement effects that are associated with cost recovery, and those associated with the profit-sharing, and their -- both of those effects are in those entitlement numbers you're seeing there.
Mark Gilman - The Benchmark Company: Let me try it differently. All things being equal, is there another step down further down in the life of either Kiz A or Kiz B that we should be aware of going forward?
Henry Hubble: Well, these projects they have a more traditional offshore profile for production and they have -- they do have effects associated with them as you basically go to different tranches in the cost recovery. So -- yes, that will mean -- there will be some future impacts.
Mark Gilman - The Benchmark Company: Okay, thanks, Henry.
Operator: Yes. And we'll go next to Neil McMahon at Sanford Bernstein.
Neil McMahon - Sanford C. Bernstein: Hi, I've got a few questions. The first, maybe Henry, just a quick, if you've got the number, idea of the earnings impact from all divestments, not just Ingolstadt, like you said a number of things like $300 million, just wondering what the overall number is. And then I've got a few questions on exploration.
Henry Hubble: Yes. And I'll -- let me look and see what I've got here. If you look at Ingolstadt, it really wasn't a whole lot outside that was significant. You ended up -- so I really don't have anything else to kind of point at there. That was the biggest single piece.
Neil McMahon - Sanford C. Bernstein: Okay. Maybe just the exploration questions. Your exploration expense on top of it from the first quarter and it sort of is running along the lines of fourth quarter numbers when it tends to be sort of back-end loaded. Geographically, was that Gulf of Mexico, North America or international where you were seeing that?
Henry Hubble: Well, I mean, a lot of it is what you see is it's a timing of big wells and specific timing of the recognition of some -- whatever dry holes were in the period. So I really couldn't point to -- I mean we have a broad slate of activity going on around the globe, as you know, and it was really not a specific area that was the big chunk of that. So you got some seismic activity in there, you've got drilling and dry hole expenses that were reflected in the period. But I guess just stepping back from it all, I mean, we do have a very active exploration program, and it's -- if you look around the globe, with Columbia, things we have going on in Brazil, Orphan, the -- now work on the Beaufort Sea, Gulf of Mexico, Tertiary, Piance, Ireland, Norway, UK North Sea high, activities in Africa, AP. So there's just a lot of activity going on around the world. And so a lot of these, there will be expenses associated with those.
Neil McMahon - Sanford C. Bernstein: Just on that actually, I think the big wells you've got coming up have more to do in the Orphan next year.
Henry Hubble: Yes.
Neil McMahon - Sanford C. Bernstein: But you've got Columbia. Has the Columbia well started drilling yet offshore?
Henry Hubble: No, not yet.
Neil McMahon - Sanford C. Bernstein: And then I think you've got Madagascar next year?
Henry Hubble: Yes. Columbia will be later this year.
Neil McMahon - Sanford C. Bernstein: My question is mainly, I saw you got into New Zealand.
Henry Hubble: Yes, yes.
Neil McMahon - Sanford C. Bernstein: Through the quarter. Where does that, since this is as you've probably the most remote wild cat you're going to drill ever, why does that rank up there with the big opportunities in Madagascar and the Beaufort Sea, and in terms of the way you're looking at new basins?
Henry Hubble: Well, we're going to be going through obviously to get the seismic first, so we've got basically planning under way to get the 2D and whatever 3D seismic data there. And then what it's going to take from there we'll make the decision after that. It's like a lot of these, they tend to be, they're plays that we think have high potential but they high risk or technically challenging in many of these areas. So I wouldn't want to put it in the characterization versus some of these others. It's obviously one that we think there's -- we have interest in and want to pursue.
Neil McMahon - Sanford C. Bernstein: So basically for our models running forward we might want to assume a bit higher exploration expense in the current rig rate environment, and the riskiness of some of these big high reward, high risk --
Henry Hubble: Yes, it's going to be variable, and we've -- we update that on kind of on a yearly basis, and we'll be reflecting what our best view of that is as we come up to the next round.
Neil McMahon - Sanford C. Bernstein: Great. Thanks a lot.
Henry Hubble: All right, very good.
Operator: And there are no further questions at this time. Mr. Hubble, I'll turn it back to you for any additional or closing remarks.
Henry Hubble: I just would like to thank everybody for joining us today and appreciate the questions. If you have any others or areas that you would like to pursue, please don't hesitate to give us a call. Thanks.
Operator: This does conclude today's teleconference. We thank you all for your participation. You may now disconnect your lines. | [
{
"speaker": "TRANSCRIPT SPONSOR",
"text": ""
},
{
"speaker": "Executives",
"text": "Henry Hubble - VP IR & Secretary"
},
{
"speaker": "Analysts",
"text": "Doug Terreson - Morgan Stanley Robert Kessler - Simmons & Company Nikki Decker - Bear Stearns & Company Paul Sankey - Deutsche Bank Doug Leggate - Citigroup Mark Gilman - The Benchmark Company Daniel Barcelo - Banc of America Securities Paul Cheng - Lehman Brothers Kate Lucas - JPMorgan Chase & Company John Herrlin - Merrill Lynch Neil McMahon - Sanford C. Bernstein"
},
{
"speaker": "Operator",
"text": "Good day, everyone, and welcome to this ExxonMobil Corporation Second Quarter 2007 Earnings Conference Call. Today's call is being recorded. And at this time for opening remarks, I am pleased to turn the conference over to Vice President of Investor Relations and Secretary, Mr. Henry Hubble. Mr. Hubble, you may begin, sir."
},
{
"speaker": "Henry Hubble",
"text": "Thank you. Good morning, and welcome to ExxonMobil's teleconference and webcast on our second quarter 2007 financial and operating results. As you are aware from this mornings press release, our integrated business model delivered another strong quarter including record second quarter earnings for our downstream and chemical businesses. The fundamentals of our business are strong and we saw continued good operational performance in the quarter. We also continued our disciplined approach to prudently invest and meet long term demand growth. Before we go further, I'd like to draw your attention to our cautionary statement. Please note that estimates, plans, and projections are forward-looking statements. Actual results including resource recoveries, volume growth, and project outcomes could differ materially due to factors I discuss and factors noted in our SEC filings. Please see factors affecting future results on the Form 8K we furnished this morning which are available through the investor information section of our website. Please also see the frequently used terms, the supplements to this mornings press release, and the 2006 financial and operating review on our website. This material defines key terms I will use today, shows ExxonMobil's net interest in specific projects, and includes our SEC Regulation G disclosure. Now I'm pleased to turn your attention to the second quarter results. ExxonMobil's second quarter earnings were $10.3 billion, down slightly from the 2006 record second quarter. Earnings per share, however, were up markedly from last year at $1.83 reflecting the strong earnings and the continuing benefits of our ongoing share purchase program. Before I discuss the specific business results, I'd like to share some of our recently achieved milestones. In the quarter, we saw first production from our interest in the deepwater Rosa project in Angola Block 17. Rosa's recoverable resources are estimated at 370 million barrels and production capacity is expected to be approximately 150,000 barrels per day. SOX exploration Angola has a 20% interest in the project. On July 19, ExxonMobil majority owned affiliate, Imperial Oil and ExxonMobil Canada announced success in acquiring exploration rights for a large block in the Canadian Beaufort Sea. Imperial and ExxonMobil Canada were awarded the exploration license after bidding a work program of $585 million Canadian. The block is over 2,000 square kilometers and is located approximately 120 kilometers offshore in water depths ranging from 60 to 1,200 meters. An ExxonMobil subsidiary has also recently awarded an offshore block in New Zealand's latest exploration acreage release. The block which comprises approximately 20,000 square kilometers is located in the great South Basin off the southeastern coast of New Zealand. Water depths in the area range from 500 to 1,000 meters. The successful capture of acreage in the Beaufort Sea and offshore New Zealand demonstrates ExxonMobil's global approach to the identification and pursuit of quality hydrocarbon resources and exploration opportunities. We look forward to exploring these attractive and technically challenging areas with the full suite of ExxonMobil capabilities. During the quarter several new exploration discoveries were reported in ExxonMobil interest Blocks 31 and 32 offshore Angola. These continued successes attest to the resource potential of these blocks and the development options continue to be progressed. In the downstream, we continued our feed diversification activities running 29 crudes which were new to individual refineries. Additionally, we implemented projects during the quarter to further enhance feed flexibility. ExxonMobil's ability to rapidly assess and optimally process feedstocks utilizing our proprietary molecular management technology is a key competitive advantage which enables us to maximize the value of a broad range of feedstocks. We also completed the start up of new low sulfur gas facilities in Japan. These facilities allow more efficient production of low sulfur gasoline while improving operational flexibility. These projects were completed in line with budget and on or ahead of schedule. In June, we announced the worldwide introduction of Mobil Pegasus 1005, a high performance lubricant with advanced additive technology. This new lubricant provides exceptional levels of protection for today's high output, low emissions, natural gas engines. In our chemicals business, we announced the planned expansion of hydrocarbon fluids capacity at our Antwerp and Singapore facilities. The hydrocarbon fluids business includes differentiated products used in a broad range of applications and industrial processes. Antwerp capacity will increase -- be increased by about 10% to 700,000 tons per year, with expected completion by the end of this year. In Singapore, the expansion will add 130,000 tons per year bringing production capacity to over 500,000 tons per year. These investments reinforce our commitment to meet customer requirements for differentiated products. During the quarter ExxonMobil chemical also announced the development of technology to support the growing drive for improved automobile fuel efficiency. In Japan, an ExxonMobil affiliate is now producing innovative microporous films for hybrid and electric vehicle lithium ion batteries. In the U.S. we announced the planned construction of a facility to manufacture new specialty elastomer compounds that can improve the durability and reduce the weight of tires resulting in improved fuel economy. And finally, ExxonMobil Chemical also earned awards for energy efficiency from the American Chemistry Council and from the Industrial Energy Technology Conference hosted by the Energy Systems Laboratory of the Texas A&M university system. This is the 10th consecutive year that the ExxonMobil chemicals has received ACC energy efficiency awards. Turning now to the business line results. Upstream earnings in the second quarter were $6 billion. This represents a decrease of $1.2 billion versus the second quarter of 2006, primarily due to reduced worldwide natural gas realizations, lower gains from asset sales, tax effects including the absence of positive tax impacts in 2006, and increased expenses primarily due to new project developments. These negative effects were partially offset by positive sales mix impacts. Worldwide crude realizations were $65.11 per barrel, up $0.21 per barrel from second quarter 2006. Upstream after-tax unit earnings in the second quarter of 2007 remain strong at $15.88 per barrel. In total, oil equivalent volumes were down 1% from 2006. However, excluding the impact of entitlement, OPEC quota and divestment effects, second quarter production was actually up almost 4%. That increase was driven by increased volumes for major project ramp ups in Russia, West Africa, and Qatar, which more than offset natural field decline and lower European natural gas demand. Turning to liquids production. Although increased volumes from the recent project start-ups in Russia, West Africa, and Qatar more than offset natural field decline, liquids production fell by 34,000 barrels per day, or 1% from the same quarter last year due to entitlement and OPEC quota effects in Africa. Gas volumes were essentially unchanged from last year, with lower demand in Europe due to warmer weather and natural field decline offsetting higher production in Qatar. Now turning to the sequential comparison. Versus the first quarter of 2007, upstream earnings decreased about $90 million with seasonally lower natural gas volumes, reduced earnings from asset sales, and negative tax effects more than offsetting higher realizations. Liquids production decreased 3%, including the impact of entitlement and quota effects in Africa and plant field maintenance in the U.S. and Europe. Natural gas production was down 14%, primarily due to seasonally lower demand in Europe. Oil equivalent volumes were down 7% from the first quarter. Finally, in the upstream, as you're aware ExxonMobil's affiliate in Venezuela was not able to reach the agreement on the formation of a mixed enterprise and on June 27, 2007, the government took over our interest in the Serene rural project. ExxonMobil's net investment and Serene rural producing assets is about $750 million. Discussions with the Venezuelan authorities over the compensation to be paid to ExxonMobil have not yet been completed. At this time, the net impact of this matter on the corporations consolidated financial results cannot be reasonably estimated. However, we do not expect the resolution to have a material effect on the corporations, operations or financial condition. For further data on regional volumes, please refer to the press release and IR supplement. Now let's turn to the downstream results. Downstream earnings were a quarterly record at $3.4 billion, up approximately $910 million from the second quarter last year as the quality of our integrated downstream portfolio allowed us to benefit from the robust industry conditions. Margins improved across the downstream business functions, increasing earnings by $430 million. Volume mix effects were positive $190 million, reflecting feedstock flexibility and product optimization programs. These effects more than offset lower refinery throughput associated with the divestment of the Ingolstadt refinery in Germany and higher planned maintenance activity in the U.S. Despite lower U.S. refinery throughput during the quarter, our supply and operating flexibility allowed us to maintain U.S. gasoline production and in fact our year-to-date gasoline production in the U.S. is up 5% versus last year. Other factors increased earnings by $290 million, primarily due to asset sales, including the Ingolstadt refinery divestment. Sequentially, second quarter earnings increased by $1.5 billion, reflecting improved global refining margins. Volume mix effects were positive $110 million, as refinery optimization and other volume effects more than offset the impact of planned maintenance activities. Other factors benefited earnings by $110 million, including the positive effects from asset divestments partially offset by higher maintenance costs and foreign exchange effects. Chemical earnings were a record for the second quarter at $1 billion, up nearly $175 million versus the second quarter of 2006. Higher margins improved earnings by $215 million reflecting increased realizations partly offset by higher feedstock costs. Sequentially, second quarter chemical earnings were down by $225 million from a strong first quarter, driven by lower worldwide margins. Turning now to our corporate and financing segment. The Corporation recorded second quarter expenses of $99 million in the corporate and financing segment, unchanged from the second quarter of 2006. The effective tax rate for the second quarter was 44%. The Corporation distributed a total of $9 billion to shareholders in the second quarter through dividends and share purchases to reduce shares outstanding, up 14% from the second quarter of 2006. During the quarter, ExxonMobil purchased $7 billion of shares in excess of dilution, reducing the number of shares outstanding by 1.5%, and further demonstrating our ongoing commitment to return cash to our shareholders. CapEx in the second quarter was $5 billion. At the end of the second quarter, our cash balance was $33.6 billion and debt was $8.8 billion. In summary, these results highlight the fundamental strength of our business, our ability to deliver superior operational performance, and continue to grow our integrated capabilities while continuing to position ourselves for future demand growth and create value for our shareholders. That concludes my prepared remarks, and I'd now be happy to take your questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) We'll go first to Doug Terreson with Morgan Stanley."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "How are you?"
},
{
"speaker": "Henry Hubble",
"text": "Hi, Doug."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "In international refining and marketing, your refining production outside of Europe during the first half was higher by almost 5% in relation to the year ago period, which is obviously a good number, but marketing output seemed to be lower versus the same period. And so my question regards why these two figures might be diverging, which I believe represented a feature of the results during the past couple of quarters as well. And so divergence and refining and marketing first half outside of Europe is the question."
},
{
"speaker": "Henry Hubble",
"text": "Outside of Europe?"
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Outside of Europe, yes. Asia and other, basically."
},
{
"speaker": "Henry Hubble",
"text": "Okay. Let me just look at what we've got here. There's no real big story here. Most of that, it's turnaround timing and it's going to fluctuate with timing, but I can't really point to a seasonal impact there that's going on either."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Okay. Okay. Well, let me ask you another question. At the analyst meeting, Rex talked about the proficiency of the project management system as being one of the explanations why Exxon's actual and funded capital expenditures have been so close in recent years and at 2007 appears to be heading in the same direction."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Which is also good news too. And so on this point, I wanted to see if you could provide an update on some of the inflation trends that the Company is experiencing, because it appears as if you have taken them into consideration in an appropriate way in your operations, and Henry if you have an aggregate or by the major functions, that would be great."
},
{
"speaker": "Henry Hubble",
"text": "Yes, I mean, if you just look at overall operating expenses for the Company, there's -- and you look at what we're able to do just -- of course we track this on a regular basis in terms of the various effects, and then how we're able to offset those. If you look at the inflationary effects, basically we've been able for a long period of time to offset inflationary effects with efficiency."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Yes."
},
{
"speaker": "Henry Hubble",
"text": "The general drive though that you see in rising costs, there are some associated with new projects and non -- noncash costs associated with new projects. You also have a 4X effect that's in here."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Sure."
},
{
"speaker": "Henry Hubble",
"text": "But obviously we're not immune to the impacts of higher costs and we work very hard to offset those. So when you look at the projects, especially in the CapEx area, there's an awful lot of work that goes on in the front end. In fact, that's a big piece of our focus, is to make sure that we have really got the concept of development right, that we've got the execution plans well thought through, the contracting is in place, and then we got to execute according to those plans. And we work very hard. It's not that things don't go wrong, but we have very -- because of the global functional approach that we have to be able to solve problems, we're able to get the right people there very quickly and get those resolved to help us keep on track."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Sure."
},
{
"speaker": "Henry Hubble",
"text": "And all of these things end up helping to manage those costs, but they're not silver bullets. It's a lot of hard work by a lot of people. The other thing I would say is technology plays a big factor here too, and many of the things that we have been able to deliver in even in the recent times, whether it's the technology we have around Fast Drill that has allowed us to improve the efficiency and effectiveness of our drilling efforts. That has taken anywhere from 15% to 30% out of the cost of wells, which is -- goes a big ways to offset the cost of inflation on drill rigs and other things. So all of that to say, there's just a lot of things that are going on, a lot of people working this very hard, but I'll tell you the other thing that's real key here, in any cost controlling effort, is that you don't start with the goal of reducing cost. You start with a goal to improve things like reliability or efficiency or productivity, and you put in systems that allow you to deliver those. You just don't go cut budgets or you won't get the results you're looking for. Generally, we find improved reliability and improved maintenance practices delivers lower costs and improved throughput."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Well, the system is working. Thanks a lot."
},
{
"speaker": "Henry Hubble",
"text": "Yes. Thanks."
},
{
"speaker": "Operator",
"text": "Next we'll go to Robert Kessler at Simmons & Company."
},
{
"speaker": "Robert Kessler - Simmons & Company",
"text": "Hi, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Hi."
},
{
"speaker": "Robert Kessler - Simmons & Company",
"text": "Looking at your upstream variant sequentially, the other bucket, over $1 billion, can you just give a little bit more granularity as to the components there?"
},
{
"speaker": "Henry Hubble",
"text": "Yes. Just stepping back, in both of the comparative periods, we had a large other impact, and if you look into what's behind that, as we highlighted last year and it really is -- we also discussed in the first quarter, we saw a positive earnings impacts associated with asset sales in 2006, including the second quarter. It's really the absence of those sales or reduced number of sales that you see this negative variance and then we also had some positive tax impacts, largely in Canada, that we also got last year in the second quarter. So that -- those -- that combination of those two ends up being about 60% of that $1 billion variance in the other column."
},
{
"speaker": "Robert Kessler - Simmons & Company",
"text": "Reading that different, Henry, do we just call the current quarter fairly clean then in that regard?"
},
{
"speaker": "Henry Hubble",
"text": "Yes, that's right. It's -- you had variations, but there's nothing in the current quarter that's a big negative to these results. I mean, we do see as I mentioned earlier, we do see some expense increases and those expense increases associated largely with new project startups. You also saw some in our exploration activity that reflected in the period, but I would tell you there's nothing there in the way of a significant other variance."
},
{
"speaker": "Robert Kessler - Simmons & Company",
"text": "Sure. I appreciate with respect in Venezuela that the full financial impact is not yet estimable. Can you tell us though of the $750 million of PP&E exposure you had to Venezuela previously, how much is still on your books ?"
},
{
"speaker": "Henry Hubble",
"text": "Well, the $750 million is an all-in effect. So that's I think that's a way to look at that. That's basically all-in what we have on Venezuela from the Serenegro production."
},
{
"speaker": "Robert Kessler - Simmons & Company",
"text": "And you have yet to really write-off any of that in the interim?"
},
{
"speaker": "Henry Hubble",
"text": "No, because we're still in the middle of discussions here , and you're predicting how that's going to turn out and what the net of this issue will be, or effect will be, is -- really can't be determined at this point. So I think it's premature to do anything in that"
},
{
"speaker": "Robert Kessler - Simmons & Company",
"text": "Okay. Last one for me. This is a quick one but looking at your cash flow from operations of $11.3 billion for the quarter, can you quantify any positive or negative working capital effects buried in there?"
},
{
"speaker": "Henry Hubble",
"text": "Yes, if you look at cash flow, normally in the comparisons that we have, especially in the first quarter or second quarter, you always have the impacts of -- you have more tax expense, or, excuse me, less tax expense than you have cash payments in the second quarter, because you end up -- we have that opposite effect we talk about in the first quarter when the taxes aren't due until April 15th. So you end up with essentially a double payment in the second quarter and that's the biggest piece of that. You'll see other variations that occur just with variations in pricing that goes on. I think there is a bit in here that may be associated with product receivables but the big impact was on the tax side."
},
{
"speaker": "Robert Kessler - Simmons & Company",
"text": "But I'm sorry, in aggregate, last year, second quarter, you had about a $3 billion working capital use of cash. Is that about the same in this year's second quarter?"
},
{
"speaker": "Henry Hubble",
"text": "Let's see, if I look, the year comparison year on year, it's really almost nothing in there. It's -- they were almost identical."
},
{
"speaker": "Robert Kessler - Simmons & Company",
"text": "Right."
},
{
"speaker": "Henry Hubble",
"text": "Or had very similar effects."
},
{
"speaker": "Robert Kessler - Simmons & Company",
"text": "Fair enough. Thanks, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Yes, okay."
},
{
"speaker": "Operator",
"text": "Our next question will come from Nikki Decker at Bear Stearns."
},
{
"speaker": "Nikki Decker - Bear Stearns & Company",
"text": "Hi, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Hi, Nikki."
},
{
"speaker": "Nikki Decker - Bear Stearns & Company",
"text": "I wanted to ask you about U.S. liquids production. It's lower both sequentially and year-over-year."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Nikki Decker - Bear Stearns & Company",
"text": "Is something going on there?"
},
{
"speaker": "Henry Hubble",
"text": "Well, no, I would say we tend to look at the liquids in North America, or that's the way I'd generally look at this, and we're down about 4% on the year on year comparisons second quarter '07 to 06, and I would just say there's -- we feel very good about the work programs and overall, the things are on track there. There's -- I mean obviously there's actual field decline and mature areas, but we've been able to partially offset that with actually some pretty strong work programs during the period."
},
{
"speaker": "Nikki Decker - Bear Stearns & Company",
"text": "Do the -- liquids production would reflect the natural declines?"
},
{
"speaker": "Henry Hubble",
"text": "Yes, Oh, yes."
},
{
"speaker": "Nikki Decker - Bear Stearns & Company",
"text": "Okay. Secondly, Henry, I think last quarter, you provided a breakdown between refining and marketing on the margin contribution on your earnings comparison. I was wondering if you could do the same."
},
{
"speaker": "Henry Hubble",
"text": "Yes. If you just -- if you look, it's about 75% marketing in the margin side, 75% marketing, 25% refining. And just back on your other question about the North America volumes, there are some asset management effects in there too. They aren't real big, but there are some of those that are in that same time frame."
},
{
"speaker": "Nikki Decker - Bear Stearns & Company",
"text": "Okay, thanks. Just on your response on the margin question, is that sequentially or year-over-year?"
},
{
"speaker": "Henry Hubble",
"text": "That was year-over-year."
},
{
"speaker": "Nikki Decker - Bear Stearns & Company",
"text": "Would you have it sequentially as well?"
},
{
"speaker": "Henry Hubble",
"text": "Sequentially, it's all refining. There's basically nothing in there on marketing."
},
{
"speaker": "Nikki Decker - Bear Stearns & Company",
"text": "Thanks, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "We'll go to Paul Sankey at Deutsche."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Hi, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Hi, Paul."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "How are you?"
},
{
"speaker": "Henry Hubble",
"text": "Good."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Henry, I was given what you think about project start ups , it's notable that your African oil volumes are down quite heavily year on year. Could you speak specifically to that, and extend it to just break out the -- what were the components, divestments, and so on of the volume differential that you're talking about between the decline and what would have been a 4%"
},
{
"speaker": "Henry Hubble",
"text": "Right, yes. Well if you look at the number, when I was talking about the 4% increase I was really referring to the oil equivalent comparison in the year on year quarter comparison. Now, the bulk of that as I pointed out was for titlement effects, those were in Africa, associated with the projects that we have there, and it's components, as you know with the PSC's that we have there, we have impacts as we -- or cumulative price effects associated with those entitlement effects over those, and then we also have price impacts. But that was if you looked at it, that was if I just jump down to the total oil equivalent impact, we had -- we were 1% down year on year, and it was about 3% of that that impact associated with entitlements. There was a 1% impact that was associated with quota, and again the big piece of that quota effect was in Africa, and then there were divestment impacts, but they are obviously outside of Africa in the U.S. and non-U.S. And ended up being about another .5%, but that's where -- how you get to the 4%. And if you look at the Africa volumes themselves, and it's basically, again, it's the entitlement effects and the quota effects there, which were the big pieces of that. And that was offset by the new project volumes that we brought on that ended up partially offset by the new volumes we brought on."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "And is that situation in Africa particularly with the cutbacks on OPEC changing, Henry? Are you producing more now or is it still ratcheted back?"
},
{
"speaker": "Henry Hubble",
"text": "Well, I don't know. To current day, yes, but if you look at what the impact will be on the quarter, it's hard to say what's going to evolve from here on that front."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "But basically back at a similar level of cut back right now that we saw in the Q2?"
},
{
"speaker": "Henry Hubble",
"text": "It would be less currently today."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "That's interesting, thank you. The second question if I could, we were surprised by your realizations in European gas. We know about the seasonal volume effect obviously, but it's interesting that there was a really significant step down on the realization side. Could you talk about that?"
},
{
"speaker": "Henry Hubble",
"text": "Well, you see just with the warm weather in Europe, we did see downward pressures on realizations there, and if you look at the natural gas, if you look at like the -- you don't really have the equivalent of markers, but if you look at the UK net balancing point, it was down sharply across the time frame, and we saw some of that roll through into impacts in Europe in particular. So you kind of have an issue here where, in the U.S, natural gas actually increased during the period, about 11%, and over there we saw a 14% decline in our realizations, and really reflecting warmer weather and in fact there were even periods where there were arbitrage opens going across, so we did see weakness in the European gas pricing."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Okay, so it was essentially just related to the headline -- the marker being down. It was nothing like no special items in there that would cause it to be unusually low?"
},
{
"speaker": "Henry Hubble",
"text": "No, other than we had, there was less demand associated with the warm weather."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Sure."
},
{
"speaker": "Henry Hubble",
"text": "And however that rolls back through into price, yes. That was there, but nothing else, no."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Right, and finally for me, U.S. refining, it seems to me you got an 82% utilization rate in Q -- the first half. Is that going to improve do you think in the second half, and you mentioned it was related to plant turnarounds? It seems like an awfully low number or very high level of turnaround. Was there some additional issues there? Thank you."
},
{
"speaker": "Henry Hubble",
"text": "Well, if you look at the turnaround impacts and the throughput impacts that we had in the quarterly comparison, we're down about 128 I think in North America or in the U.S, And that was essentially all turnaround, both Beaumont and Baytown. And they were pipe turnarounds, so you see that in throughput but we were actually because we didn't have as much conversion capacity down, we had more of our CAT units and other conversion units up and running, we were actually able to increase our gasoline production in this time frame. So what we've done is buy feedstocks to be able to keep those units full and we're able to maintain our production."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Right, and your '06 number U.S. utilization was 90%. Is that what we can expect to see in the second half?"
},
{
"speaker": "Henry Hubble",
"text": "We'll have less turnaround activity scheduled in the second half."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Thanks, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "We'll go next to Doug Leggate with Citigroup."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Thank you. Good morning, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Hi, Doug."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "International downstream, notwithstanding the sequential and year-over-year comparisons that you've given us, if you look at the realized earnings in that segment and adjust for the gain, I guess, coming from the refinery disposal that the counter rates still look pretty impressive. Can you just talk around that and has there been anything specific going on? Have you changed to feedstock, or is there something unusual there that has pushed your earnings up?"
},
{
"speaker": "Henry Hubble",
"text": "Nothing that I can really point to. There's obviously in all of these periods a lot of emphasis on selecting the right raw materials and getting them into the refineries, and we do a lot as we talked about to get advantage feedstocks or advantage crudes into those refineries. And one of the things that we find is gives us an advantage in that is, we have with our molecule management technology, we're able to quickly assess the value of new raw materials and assess those values into our facilities. And that helps with our optimization, but there's nothing else I can really point to, other than kind of the normal good operations and good reliability that we've had in the period."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Can you break out the absolute contribution from the English stock disposal?"
},
{
"speaker": "Henry Hubble",
"text": "I don't have a specific number associated, but about 3 -- about 3 -- $300,000 -- $300 million."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Okay, and the only other one for me is if I could just jump back to Venezuela very quickly, obviously your -- one of your competitors took a fairly sizeable write-off in Venezuela yesterday. You folks have decided not to do that, but arguably, it's difficult to know how it's going to play out. But I'm just curious when you think about it from a prudent standpoint, why have you opted not yet to take that hit, given that it's relatively modest in any case?"
},
{
"speaker": "Henry Hubble",
"text": "Well, the -- I think both argue for not -- it's modest and overall sense, it's important, but we're in the middle of discussions and until you can estimate it, reasonably estimate what the impact is, if you follow, we follow GAAP rules and frankly, our view is you can't really estimate it until we're a little further down the road on these negotiations. And so we just don't think that it's appropriate timing to do that."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Okay, great. Thanks, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) We'll move to Mark Gilman at Benchmark."
},
{
"speaker": "Mark Gilman - The Benchmark Company",
"text": "Henry, good morning."
},
{
"speaker": "Henry Hubble",
"text": "Hi, Mark, how are you?"
},
{
"speaker": "Mark Gilman - The Benchmark Company",
"text": "Good, thank you. Quick update on quality, if you can?"
},
{
"speaker": "Henry Hubble",
"text": "Update on --"
},
{
"speaker": "Mark Gilman - The Benchmark Company",
"text": "The following --"
},
{
"speaker": "Henry Hubble",
"text": "Oh, sorry. Yes. Basically, we had a fire at our -- you may have obviously heard about it, on the Cogent facility there, where we lost steam and some of the power production, basically ended upbringing the facility down. Right now, we're working on the plans and in fact the plans have been developed for restart and we're expecting that to happen over the next several days. So it's one of those -- you had a down time, but no long lasting damage as we've assessed it."
},
{
"speaker": "Mark Gilman - The Benchmark Company",
"text": "Okay, do you have a hard number for your next Serenegro production in the second quarter?"
},
{
"speaker": "Henry Hubble",
"text": "I don't have a -- it's about 30%, because we had quota effects, we had some quota effects in there, so actually I think it's a little less than that, 20%, about 20%."
},
{
"speaker": "Mark Gilman - The Benchmark Company",
"text": "About 20%?"
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Mark Gilman - The Benchmark Company",
"text": "Yes, I notice that in your variance analysis on the upstream. The volume is indicated to be a modest plus in the year-over-year comparison, whereas production was down. Does that mean that there were favorable lifting variances in this years second quarter?"
},
{
"speaker": "Henry Hubble",
"text": "Well, what you see there is really the effects of the positive -- we had a positive impact associated with new volumes that we're bringing on in the Middle East, as well as in Russia associated with the ramp up production there, and being able to export those volumes. So we had some positive mix effects associated with that."
},
{
"speaker": "Mark Gilman - The Benchmark Company",
"text": "Okay, and final one for me, there's reference in the release to Canadian gas production and project that ramped that up a little bit. Wasn't aware of anything in that regard. Could you be a bit more specific?"
},
{
"speaker": "Henry Hubble",
"text": "Oh, that's associated with Sabel."
},
{
"speaker": "Mark Gilman - The Benchmark Company",
"text": "Oh, okay."
},
{
"speaker": "Henry Hubble",
"text": "Bringing that. Yes."
},
{
"speaker": "Mark Gilman - The Benchmark Company",
"text": "Okay, thanks, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Yes, yes, no problem."
},
{
"speaker": "Operator",
"text": "Next we'll take a question from Dan Barcelo with Banc of America."
},
{
"speaker": "Daniel Barcelo - Banc of America Securities",
"text": "Hi, good morning, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Hi, Dan."
},
{
"speaker": "Daniel Barcelo - Banc of America Securities",
"text": "Just a clarification regarding upstream."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Daniel Barcelo - Banc of America Securities",
"text": "Q2 versus Q1, and it related to two aspects. First U.S. realization seemed to be really light compared to Henry Hub benchmarks. Does that have to do with rocky differentials or things like that? And the second part is related to an earlier question, if you could give some color on the $620 million swing in other, related again from Q2 to Q1 in the upstream."
},
{
"speaker": "Henry Hubble",
"text": "Yes. When you look at the other impacts, as I mentioned, you do have -- there's a whole bunch of items in there, but they are basically all going in the same direction again in this time frame. So we have a number of effects. Basically, again, it's the absence of some positive impacts from the first quarter including the asset sales and some positive tax impacts. And there were also some higher activity related to exploration, and we also had some -- a little additional in there in operating expenses and 4X impacts. But nothing else that I really can highlight. And then the other piece of the question was around --"
},
{
"speaker": "Daniel Barcelo - Banc of America Securities",
"text": "Henry Hub differential -- Henry Hub change 1Q to 2Q versus your realization, you were broadly flat. I think the benchmark went up to about $0.78. Is that related more to differentials and your position --"
},
{
"speaker": "Henry Hubble",
"text": "It's going to be related to the specific contracts. Typically we track pretty close. There isn't anything I can point to that was a specific issue there, so it's -- we've generally tracked that reasonably close. If you look at I think we had Henry Hub was our average would show $7.55 in the quarter and versus last or sequential quarter, $6.77 and we were at $6 versus, excuse me, U.S. we were $6.94 versus the $6.85. So I guess that's, it is a variance there, but I really can't point to anything specific."
},
{
"speaker": "Daniel Barcelo - Banc of America Securities",
"text": "Okay, and then second one if I could was just maybe a broader comment on your deepwater U.S. Gulf strategy, both in the context of maybe lease expirations, upcoming lease sales. But it's also interesting because I understand you're bringing a rig down from Canada that was at Walker Ridge. And then last year you did something interesting with Statoil and AMI and Walker Ridge."
},
{
"speaker": "Henry Hubble",
"text": "Right. Yes. We've got, if you look at the lower tertiary, we've got a number of -- we already drilled the Julia well as you're no doubt aware. We're bringing the rod down from -- or it's actually down I guess now, to drill the North Braun in fact it's drilling now, and then we'll be using it also to drill Hal later in the year, and then we also have Chuck that is being drilled in the time frame. So all has impacted is it's being drilled now as well so there's a fair bit of activity and those are prospects -- the best prospects that we see. There is some acreage that will be released in that area and we'll be evaluating what we want to do there."
},
{
"speaker": "Daniel Barcelo - Banc of America Securities",
"text": "Okay, thank you."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "We'll go to Paul Cheng at Lehman -- Lehman Brothers, rather. Sorry."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Hi, Henry. Good morning."
},
{
"speaker": "Henry Hubble",
"text": "Hi, Paul."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Two quick questions. I think based on what you just described earlier, that in this particular quarter we do not have any major impact one way or the other from inventory gain tax adjustment or foreign exchange?"
},
{
"speaker": "Henry Hubble",
"text": "Yes. We have foreign exchange is kind of minor impacts, but if I look at just the total, you end up in the second quarter, the year on year comparison, second quarter to second quarter, there's a positive $77 million of that in chemicals and then if you look at sequentially, it's a negative impact of about $50 million, but pretty small across the businesses. And that's from a 4X standpoint."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Yes, how about in terms of inventory gain on laws or tax --"
},
{
"speaker": "Henry Hubble",
"text": "No, the only we really you don't see, we don't see any inventory effects other than at year-end associated with LIFO."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Yes. Okay. And cats, what kind of impact are you guys -- and also can you talk about what is the asset sales gain for the German refinery?"
},
{
"speaker": "Henry Hubble",
"text": "I don't have a quick number off the top on the cats impact. I can -- we can get something for you on that, but it's relatively small."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Relatively small?"
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "And then how about in terms of the asset sales gain you record --"
},
{
"speaker": "Henry Hubble",
"text": "What was that again?"
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "The asset sales gain you record for the German refinery you sold?"
},
{
"speaker": "Henry Hubble",
"text": "Oh, yes, that was Ingolstadt of about $300 million."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "$300 million?"
},
{
"speaker": "Henry Hubble",
"text": "$300 million, yes, and the cats impact is about 40 million."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "40,000 or 40 million cubic feet?"
},
{
"speaker": "Henry Hubble",
"text": "40 million cubic feet."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Wow, only?"
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "You guys are in good shape."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Okay, thank you."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "And we'll take a question from Kate Lucas at JPMorgan."
},
{
"speaker": "Kate Lucas - JPMorgan Chase & Company",
"text": "Hi, good morning."
},
{
"speaker": "Henry Hubble",
"text": "Hi, Kate."
},
{
"speaker": "Kate Lucas - JPMorgan Chase & Company",
"text": "Hi. Just a quick question on your chemical segment. We've seen pretty strong results over the last several quarters and you've had -- you've got some organic growth projects. But I just wanted to know if you might be giving any consideration to expanding the weighting of chemicals in your overall portfolio, maybe beyond the organic projects that you've approved for project start-up?"
},
{
"speaker": "Henry Hubble",
"text": "Well, as you -- well, we have a number of projects that are aimed at growing, basically aimed at the Asia Pacific market. So we have a project in Fujian that we're executing now. We're working on the Singapore parallel train and looking forward to bringing that one not too far down the road, and of course we also have the project in joint venture project in Wusavec and Saudi Arabia, and then we're working with Qatar, all of these will be world class facilities. So, yes, we're growing this business, and it's one where -- as we look at it, it grows about 2%, or better than 2% above GDP growth, and it's really driven because of the continuing substitution into automobile parts and textiles, and other things. So we see a strong demand growth there, and really, in that Asia Pacific area is the big piece. So, yes, we're working that and then also, of course our big focus in this in how we approach it is with a strong integration to our downstream businesses or to advantage feedstocks and with our upstream assets. So, yes, we're positioning ourselves to grow and meet the organic or the larger growth that's coming."
},
{
"speaker": "Kate Lucas - JPMorgan Chase & Company",
"text": "Thank you."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "Next we'll go to John Herrlin with Merrill Lynch."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Yes, Henry, European gas sales were weak. You mentioned that the cast line would be out for a little bit volume wise in the prior question."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "What kind of sequential recovery are you seeing with respect to gas or should we expect more weakness in the third quarter in Europe?"
},
{
"speaker": "Henry Hubble",
"text": "Well, the big piece in sequential comparison is just the normal seasonal demand. So it typically, we see in the third quarter, it's not all that different than what we typically have in the second quarter, and then it starts picking up fourth quarter and first quarter. So I would -- it's going to be dominated by those seasonal impacts and I would expect it to be not all that different."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Okay. Next one for me is on chemicals, we've been getting a lot of weak economic data. Are your folks seeing any issues with respect to product demand on your chemical business?"
},
{
"speaker": "Henry Hubble",
"text": "Not really. We're running utilizations, we're running our plants full, so that's been strong. We've seen strong solid demand globally. The areas in our aeromatics have been strong in the period and we've seen good. So basically, strength through the business and don't really see that changing quickly here. It's in a good position, as long as we see good global demand growth --"
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Thank you."
},
{
"speaker": "Henry Hubble",
"text": "All right"
},
{
"speaker": "Operator",
"text": "Next we'll take a follow-up from Mark Gilman."
},
{
"speaker": "Henry Hubble",
"text": "All right"
},
{
"speaker": "Mark Gilman - The Benchmark Company",
"text": "Henry, I know there's rate of return thresholds in the PSC 's for Kizamba A and B. I was wondering whether Kiz B has hit that threshold which would result in a reduction in the profit split?"
},
{
"speaker": "Henry Hubble",
"text": "Well, there -- as you know, we don't get into the specifics of the contracts on those things. There are, as you know, there's a couple of components of PSC's, those that are affected with cumulative entitlement effects that are associated with cost recovery, and those associated with the profit-sharing, and their -- both of those effects are in those entitlement numbers you're seeing there."
},
{
"speaker": "Mark Gilman - The Benchmark Company",
"text": "Let me try it differently. All things being equal, is there another step down further down in the life of either Kiz A or Kiz B that we should be aware of going forward?"
},
{
"speaker": "Henry Hubble",
"text": "Well, these projects they have a more traditional offshore profile for production and they have -- they do have effects associated with them as you basically go to different tranches in the cost recovery. So -- yes, that will mean -- there will be some future impacts."
},
{
"speaker": "Mark Gilman - The Benchmark Company",
"text": "Okay, thanks, Henry."
},
{
"speaker": "Operator",
"text": "Yes. And we'll go next to Neil McMahon at Sanford Bernstein."
},
{
"speaker": "Neil McMahon - Sanford C. Bernstein",
"text": "Hi, I've got a few questions. The first, maybe Henry, just a quick, if you've got the number, idea of the earnings impact from all divestments, not just Ingolstadt, like you said a number of things like $300 million, just wondering what the overall number is. And then I've got a few questions on exploration."
},
{
"speaker": "Henry Hubble",
"text": "Yes. And I'll -- let me look and see what I've got here. If you look at Ingolstadt, it really wasn't a whole lot outside that was significant. You ended up -- so I really don't have anything else to kind of point at there. That was the biggest single piece."
},
{
"speaker": "Neil McMahon - Sanford C. Bernstein",
"text": "Okay. Maybe just the exploration questions. Your exploration expense on top of it from the first quarter and it sort of is running along the lines of fourth quarter numbers when it tends to be sort of back-end loaded. Geographically, was that Gulf of Mexico, North America or international where you were seeing that?"
},
{
"speaker": "Henry Hubble",
"text": "Well, I mean, a lot of it is what you see is it's a timing of big wells and specific timing of the recognition of some -- whatever dry holes were in the period. So I really couldn't point to -- I mean we have a broad slate of activity going on around the globe, as you know, and it was really not a specific area that was the big chunk of that. So you got some seismic activity in there, you've got drilling and dry hole expenses that were reflected in the period. But I guess just stepping back from it all, I mean, we do have a very active exploration program, and it's -- if you look around the globe, with Columbia, things we have going on in Brazil, Orphan, the -- now work on the Beaufort Sea, Gulf of Mexico, Tertiary, Piance, Ireland, Norway, UK North Sea high, activities in Africa, AP. So there's just a lot of activity going on around the world. And so a lot of these, there will be expenses associated with those."
},
{
"speaker": "Neil McMahon - Sanford C. Bernstein",
"text": "Just on that actually, I think the big wells you've got coming up have more to do in the Orphan next year."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Neil McMahon - Sanford C. Bernstein",
"text": "But you've got Columbia. Has the Columbia well started drilling yet offshore?"
},
{
"speaker": "Henry Hubble",
"text": "No, not yet."
},
{
"speaker": "Neil McMahon - Sanford C. Bernstein",
"text": "And then I think you've got Madagascar next year?"
},
{
"speaker": "Henry Hubble",
"text": "Yes. Columbia will be later this year."
},
{
"speaker": "Neil McMahon - Sanford C. Bernstein",
"text": "My question is mainly, I saw you got into New Zealand."
},
{
"speaker": "Henry Hubble",
"text": "Yes, yes."
},
{
"speaker": "Neil McMahon - Sanford C. Bernstein",
"text": "Through the quarter. Where does that, since this is as you've probably the most remote wild cat you're going to drill ever, why does that rank up there with the big opportunities in Madagascar and the Beaufort Sea, and in terms of the way you're looking at new basins?"
},
{
"speaker": "Henry Hubble",
"text": "Well, we're going to be going through obviously to get the seismic first, so we've got basically planning under way to get the 2D and whatever 3D seismic data there. And then what it's going to take from there we'll make the decision after that. It's like a lot of these, they tend to be, they're plays that we think have high potential but they high risk or technically challenging in many of these areas. So I wouldn't want to put it in the characterization versus some of these others. It's obviously one that we think there's -- we have interest in and want to pursue."
},
{
"speaker": "Neil McMahon - Sanford C. Bernstein",
"text": "So basically for our models running forward we might want to assume a bit higher exploration expense in the current rig rate environment, and the riskiness of some of these big high reward, high risk --"
},
{
"speaker": "Henry Hubble",
"text": "Yes, it's going to be variable, and we've -- we update that on kind of on a yearly basis, and we'll be reflecting what our best view of that is as we come up to the next round."
},
{
"speaker": "Neil McMahon - Sanford C. Bernstein",
"text": "Great. Thanks a lot."
},
{
"speaker": "Henry Hubble",
"text": "All right, very good."
},
{
"speaker": "Operator",
"text": "And there are no further questions at this time. Mr. Hubble, I'll turn it back to you for any additional or closing remarks."
},
{
"speaker": "Henry Hubble",
"text": "I just would like to thank everybody for joining us today and appreciate the questions. If you have any others or areas that you would like to pursue, please don't hesitate to give us a call. Thanks."
},
{
"speaker": "Operator",
"text": "This does conclude today's teleconference. We thank you all for your participation. You may now disconnect your lines."
}
] | null | null |
XOM | 1 | 2,007 | 2007-04-26 16:30:00 |
Executives | [] | null | null |
XOM | 4 | 2,008 | 2009-01-30 11:00:00 | Executives: David Rosenthal – VP of IR & Secretary
Analysts: Christina Chen – Barclays Capital Shin Kim [ph] – Merrill Lynch Neil McMahon – Sanford Bernstein Ryan Todd – Deutsche Bank Doug Leggate – Howard Weil William Ferer – W. H. Reaves & Co.
Operator: Good day, everyone and welcome to this ExxonMobil Corporation fourth quarter 2008 earnings conference call. Today's call is being recorded. At this time for opening remarks, I would like to turn the call over to your Vice President of Investor Relations and Secretary, David Rosenthal. Please go ahead, sir.
David Rosenthal: Thank you. Good morning. And welcome to ExxonMobil's teleconference and webcast on our fourth quarter and full year 2008 financial and operating results. As you are aware from this morning's press release, ExxonMobil's fourth quarter earnings performance was strong. Our results reflect the strength of our business model during a period of global economic weakness and significant decline in commodity prices. The current environment has created challenging business conditions for many industries and has also affected millions of consumers worldwide. Despite these challenges, ExxonMobil remains well positioned for the future as a direct result of our financial strength, long-term focus, effective approach to risk management, and capital discipline. Before we go further, I would like to draw your attention to our cautionary statement. Please note that estimates, plans and expectations are forward-looking statements. Actual results, including resource recovery, volume growth and project outcome could differ materially due to factors I discuss and factors noted in our SEC filing. Please see factors affecting future results and the Form 8-K we furnished this morning, which are available through the investor section of our Web site. Please also see the frequently used terms, the supplements to this morning's press release and the 2007 financial and operating review on our Web site. This material defines key terms I will use today, shows ExxonMobil's net interest in specific projects and includes our SEC Regulation G disclosure. Now, I am pleased to turn your attention to the fourth quarter results. ExxonMobil's fourth quarter 2008 normalized earnings and net income was $7.8 billion, a reduction of $3.8 billion from the fourth quarter of 2007, versus the third quarter of 2008, normalized earnings were down $5.6 billion and net income decreased $7 billion. Both comparisons reflect the recent sharp reduction in commodity prices. Normalized earnings per share were $1.55, down $0.58 from a year ago. During the fourth quarter of 2008, ExxonMobil distributed a total of $10 billion to shareholders, including dividends of $2 billion and share purchases to reduce shares outstanding of $8 billion. ExxonMobil's full year 2008 net income was $45.2 billion, up $4.6 billion from 2007 and a record for the Corporation, with strong results in each of our upstream, downstream, and chemical businesses. Normalized earnings for 2008 were also a record at $44.1 billion, up $3.5 billion from 2007. I would now like to share some of the milestones we have achieved since the last earnings call. In December, the Thunder Horse Project in the Gulf of Mexico achieved a production rate of over 200,000 oil equivalent barrels per day. The project at peak is expected to produce 250,000 barrels per day of crude oil and 200 million cubic feet per day of natural gas. Including Thunder Horse, Volve in Norway, Starling in the U.K. sector of the North Sea, Kizomba C Mondo, and Saxi Batuque in Angola, East Area and Natural Gas Liquids in Nigeria, Journey B in Malaysia and ACG Phase Three in Azerbaijan, we completed eight major project start-ups during 2008. Also, during the fourth quarter, we started up the offshore facilities for the Qatargas II Train 4 project in Qatar. We are completing commissioning activities onshore and we anticipate first LNG from the project during the first quarter of 2009. The South Hook LNG terminal in the U.K. is also in the process of completing commissioning and we expect initial LNG receipt and processing during the fist quarter. When full operational capacity is reached, the terminal will have the capability to supply 2 billion cubic feet of natural gas per day to the U.K. market. The fourth quarter also saw the completion of four new Q-Max class LNG carriers, the first of their kind. The Q-Max carriers are the largest LNG carriers in the world and can transport about 80% more cargo than a standard carrier. These vessels mark a step change in LNG shipping by lowering unit transportation cost while improving energy efficiency and reducing emissions. These groundbreaking improvements were made possible by applying the latest LNG shipping technology developed by ExxonMobil and our partner Qatar Petroleum. In December, the Sakhalin-1 project earned the excellence in project integration award from the committees and sponsoring societies of the International Petroleum Technology Conference or IPTC held in Kuala Lumpur. The award is a testament to ExxonMobil’s achievements in successfully executing the project in one of the most challenging Arctic environments in the world, in a safe and environmentally responsible manner. These major projects demonstrate our ongoing commitment to bring new supplies to market and deliver value to our shareholders. In exploration, we added to our global portfolio of outstanding deepwater opportunities. ExxonMobil entered into an agreement with Turkish national oil company, TPAO to explore two large deepwater blocks in the Black Sea offshore Turkey. These blocks cover total area of 7 million acres. We're awaiting final government approval of this agreement. ExxonMobil also signed an agreement with the Romanian oil and gas company Petron to cooperate on a 3D seismic acquisition and evaluation program of the Black Sea Neptune block covering approximately two million acres. This agreement helps strengthen our position in this new exploration play. In Brazil, the deepwater drilling rig, West Polaris is currently drilling the Azula well in Block BM-S-22. Plans for additional drilling on the block are underway with a second well to follow upon completion of the first. ExxonMobil is pleased to be participating in this new subsalt play and will leverage all of our global experience and industry-leading technologies in the exploration program. We also continue to progress our high potential unconventional natural gas opportunities around the world. In the Lower Saxony Basin in Germany, we have drilled three exploration wells in the promising shale gas play there and are preparing to commence testing operations. In the Mako Trough in southeast Hungary, we are now drilling our second and third evaluation wells. Testing operations will begin once we have completed the first set of wells. In the Horn River Basin, in northeastern British Columbia, Canada, we also commenced a four well winter drilling and testing program on our extensive shale gas acreage during the fourth quarter. Moving now to the downstream, during the quarter, we announced our plans to invest more than $1 billion in our Baton Rouge, Louisiana; Baytown, Texas, and Antwerp Belgium refineries to increase the supply of cleaner burning diesel. These projects include the construction of additional process units and modifications to existing facilities, which will allow us to increase diesel production by 6 million gallons per day at these sites. This increase in production is equivalent to the diesel produced from about four average sized refineries. Building on our commitment to technology, ExxonMobil announced in October that we are collaborating with Pratt & Whitney Rocketdyne to develop next generation gasification technology to convert coal, coke or biomass to synthesis gas. One of the potential uses of this technology would be to facilitate carbon capture and storage, reducing green house gas emissions from power generation. The collaboration takes advantage of ExxonMobil's technology leadership in the energy sector and Pratt & Whitney Rocketdyne experienced in rocket engine development, with the goal of making significant progress in gasification technology. Also in refining, we continued our activities to reduce raw material cost by managing our crude flexibility. This quarter, ExxonMobil ran 36 crudes that were new to individual refineries and four that were new to ExxonMobil. Turning now to our chemical business, in October, ExxonMobil 1, the 2008 ICIS Chemical Business award for best product innovation for our new battery separator film technology. During the fourth quarter, we also began construction on a new battery separator film manufacturing facility in Gumi, South Korea. The facility will have the capacity to produce over 30 million square meters of film per year with opportunity for future significant expansion. This ExxonMobil film technology is expected to help improve the efficiency and performance of lithium ion batteries and may lead to future applications in new, hybrid and electric vehicles. This investment will significantly enhance our capability to supply customers in this fast growing market. Also during the fourth quarter, we signed heads of agreement with Saudi Basic Industries to progress detailed studies for a new elastomers project at our petro chemical joint ventures located in Kemya and Yanpet, Saudi Arabia. The new facilities will supply a combined volume of over 400,000 tons per year of chemical products including synthetic rubber, thermal plastic specialty polymers and other products. This project is part of ExxonMobil's commitment to invest in advantaged, chemical growth projects in the Middle East and Asia-Pacific to meet long-term demand. Now turning to the business line results, upstream earnings in the fourth quarter were $5.6 billion, down $2.6 billion from the fourth quarter of 2007. Upstream after-tax unit earnings in the fourth quarter of 2008 were just under $15 per barrel. Lower realizations reduced earnings by $2.7 billion, driven by lower crude oil prices which were down $34 per barrel to just under $51 per barrel in the quarter. Natural gas realizations were up $1.46 per kcf from the fourth quarter of 2007, reflecting higher prices in Europe and the Middle East, partly offset by lower realizations in North America. Lower volumes reduced earnings by $240 million. Other effects increased earnings by $320 million due primarily to positive foreign exchange effects, higher gains from asset sales and lower taxes, partly offset by increased operating expenses. In total, oil equivalent volumes decreased to 3% from the fourth quarter of last year. Entitlement volume effects including price and spend impacts and PSC net interest reductions, reduced volumes by 47,000 barrels per day. Excluding the impact of lower entitlement volumes, quotas and divestments, production was down 1%, driven by lower European natural gas demand. Natural fuel decline was largely offset by a major project ramp ups in West Africa, the North Sea and Kazakhstan. Liquids production decreased 45,000 barrels per day or 2% from the fourth quarter of last year. Excluding impacts related to lower entitlement volumes, quotas and divestments, production was up just over 1%. Major project ramp ups in West Africa, Kazakhstan and the North Sea and lower maintenance activity more than offset natural fuel decline. Gas volumes decreased 565 million cubic feet per day from the fourth quarter of 2007. New project volumes in the North Sea, Qatar and Malaysia were more than offset by natural decline and lower demand in Europe. Turning now to the sequential comparison versus the third quarter of 2008, upstream earnings decreased $3.7 billion, primarily due to lower crude oil realizations, which were down $60 per barrel in the quarter. Higher crude oil and natural gas volumes increased earnings by $850 million. Other effects benefited earnings by $350 million primarily from higher gains on asset sales. Liquids production increased 8% reflecting the impact of new project volumes and the completion of maintenance programs. Natural gas production was up nearly 26% driven by seasonally higher demand in Europe. Oil equivalent volumes were up 14% from the third quarter. Looking now at the full year results, 2008 upstream earnings excluding special items were a record $33.8 billion, an increase of $7.3 billion over 2007. Improved realizations increased earnings by $11.8 billion. Crude oil prices were up, over $24 per barrel and natural gas realization increased in all major producing regions. Lower crude oil and natural gas volumes reduced earnings by $3.7 billion. Other factors reduced earnings by $800 million with higher expenses, including the impact of new project start-ups and negative tax effects partly offset by positive foreign exchange impacts and higher gains on asset sales. Full year oil equivalent volumes were down 6% versus 2007. Liquids volumes were down 8% while natural gas volumes were down 3%. Excluding entitlement volume effects, the Venezuela expropriation and divestments, production was down just under 3%. About half of that reduction was due to higher maintenance activity and the effects of the hurricanes in the U.S., with the balance reflecting natural fuel decline, offset by new project volumes in West Africa, the North Sea, Kazakhstan and Malaysia. For further detail on regional volumes, please refer to the press release and IR supplement. Turning now to the downstream results, earnings in the fourth quarter were $2.4 billion, up $150 million from the fourth quarter of 2007. Higher margins increased earnings by $890 million, with stronger marketing and industry refining margins and positive price finalization effects partly offset by impacts due to temporary inventory changes. Volume and mix effects reduced earnings by $230 million, driven primarily by lower sales volume. Other effects reduced earnings by $510 million, reflecting adverse foreign exchange impacts and higher operating expenses including hurricane related repair costs. Sequentially, fourth quarter earnings decreased by $600 million. Lower margins reduced earnings by $980 million, driven by weaker refining margins including negative impacts due to temporary inventory changes partly offset by improved marketing margins. Volume and mix effects increased earnings by $40 million with margin improvement activities more than offsetting lower sales volumes. Other factors increased earnings by $340 million including $190 million of positive LIFO effects and higher earnings from asset sales. Full year 2008 downstream earnings were $8.2 billion, down $1.4 billion from record earnings in 2007. Lower margins reduced earnings by $910 million due to weaker refining margins which more than offset improved marketing margins. Volume and mix effects increased earnings by $560 million, primarily due to positive margin improvement activities. Other factors reduced earnings by $1.1 billion reflecting higher operating expenses and negative foreign exchange effects. Now turning to our chemical results, fourth quarter chemical earnings were $155 million, down $960 million from the fourth quarter of 2007. Weaker margins reduced earnings by $270 million reflecting lower realizations while volume effects reduced earnings by $360 million due to lower demand and the impact of the hurricanes in the U.S. Other effects reduced earnings by $330 million, including hurricane related repair costs and negative foreign exchange effects, partially offset by positive LIFO impacts. Sequentially, fourth quarter chemical earnings decreased by $930 million. Weaker margins reduced earnings by $240 million and lower volumes decreased earnings by $370 million, both reflecting impacts of the economic slowdown. Other effects were negative, $320 million with adverse foreign exchange effects and hurricane related repair cost partly offset by positive LIFO effects. Full year 2008 chemical earnings were just under $3 billion, down 1.6 billion from record earnings in 2007. Weaker margins reduced earnings by $1.2 billion while lower volumes decreased earnings by $530 million. Turning now to our corporate and financing segment, corporate and financing expenses during the quarter were $383 million versus earnings of $77 million in the fourth quarter last year. The increase reflects the absence of positive tax effects and reduced interest income due to lower interest rates. Full year 2008 expenses were $830 million, up from $23 million in 2007, reflecting negative tax effect and lower interest income. The effective tax rate for the fourth quarter was 46%. And for the full year 2008, the effective tax rate was 47%. At the end of the fourth quarter, our cash balance was $31 billion and debt was $9 billion. The corporation distributed $10 billion to shareholders in the fourth quarter through dividends and share purchases to reduce shares outstanding. Of that total, $8 billion was distributed to purchase shares in excess of dilution, reducing the number of shares outstanding by 2.2%. For the full year 2008, we distributed a total of $40 billion to shareholders including $32 billion to purchase shares in excess of dilution, which reduced shares outstanding by 7.5% further demonstrating our commitment to return cash to our shareholders. Share purchases to reduce shares outstanding are expected to be $7 billion in the first quarter of 2009. CapEx in the fourth quarter was $6.8 billion, an increase of 11% from fourth quarter 2007 and brings 2008 full year CapEx to $26.1 billion. This is in line with our previous guidance and it increased a $5 billion from 2007. We continue to invest at record level in robust projects to help meet global demand for crude oil, natural gas and finished products. In summary, these results reflect the strength of ExxonMobil's business model. The volatile business conditions in 2008 demonstrate that our long-term commitment to the integrity of our operations, disciplined investment approach and integrated business model continue to deliver superior results. Finally, I would like to mention two upcoming events. First, in mid-February, we will be releasing our 2008 reserves performance data. And second, as many of you who already have seen, our analyst meeting this year will take place on Thursday, March 5th. This will include a live audio webcast beginning at 9:00 a.m. Eastern, 8:00 a.m. Central Time. ExxonMobil's presenters will be led by Chairman and CEO Rex Tillerson. That concludes my prepared remarks. I would now be happy to take your questions.
Operator: Thank you, Mr. Rosenthal. (Operator instructions). We'll take our first question from Christina Chen with Barclays Capital.
Christina Chen - Barclays Capital: Hi, good morning. I just had a quick question. Were there any asset sales gains in the quarter and can you break down the effects in the inventory gains?
David Rosenthal: Yes. Good morning, Christina.
Christina Chen - Barclays Capital: Good morning.
David Rosenthal: Yes. In the other bar, we do have some asset sales. In total, fourth quarter of '08 reflects a positive earnings of impacts from Brazil, Spain and Portugal affiliate sales. And in the downstream, we had a number of minor asset sales as well. Christina, did you have another question?
Christina Chen - Barclays Capital: Actually, is it possible to give out the actual number for that?
David Rosenthal: No. We don't typically disclose the actual earnings effects from our asset sales.
Christina Chen - Barclays Capital: Okay. And then were there any other effects in inventory effects?
David Rosenthal: We did have some LIFO effects in the quarter in the downstream. They were fairly minor if you're looking fourth quarter versus the fourth quarter '08 that is, versus the fourth quarter of '07. It was just under $100 million of negative LIFO effects.
Christina Chen - Barclays Capital: Okay. Thank you.
David Rosenthal: Alright. Thank you.
Operator: (Operator instructions). We'll take our next question from Shin Kim [ph] with Merrill Lynch.
Shin Kim - Merrill Lynch: Hi, actually I think the question was answered. Thank you.
David Rosenthal: Okay. Thank you.
Operator: We'll take our next question from Neil McMahon with Sanford Bernstein.
Neil McMahon - Sanford Bernstein: Hi, I was wondering if you could go through some of the new projects both in Brazil and in Hungary. I know its sort of early days, but you did go through or at least fit through to the Brazilian authorities that you had discovered oil in block 22. I was wondering if you could give us some more details there and indeed the quality of the oil or oil traces that were discovered?
David Rosenthal: Yes, of course. We are drilling the Azula well in the ExxonMobil operated BMS-22 block. We continue to drill ahead in that block. We did file a discovery notice on January 16th with the Brazilian authorities. But this is a notice just that we had encountered hydrocarbons, but that is the extent of the notice.
Neil McMahon - Sanford Bernstein: Okay. So you're not going any further than that?
David Rosenthal: No, at this time, we really don't have any other comments to make on Brazil other than we are drilling ahead and progressing with that well. Neil, I think you also asked a question about Hungary.
Neil McMahon - Sanford Bernstein: Yes.
David Rosenthal: As you recall, last year, we did announce that we had signed an agreement to begin phase work program in the Mako Trough in Hungary on about 184,000 acres. The first two of those wells have spud last year and the second well spud in December and we continue to explore and work on that prospect.
Neil McMahon - Sanford Bernstein: And just a very final one, maybe it's a quick one. In terms of the LNG coming to South Hook, are you planning to take it from Qatar with some of the new boats or could it be any sort of boat just to start up the regas facility?
David Rosenthal: No. We would be using our new Q-Max ships for that purpose, and the Q-Max and the Q flag ships.
Neil McMahon - Sanford Bernstein: Great. And then just a very final one to squeeze it in, in terms of your buyback, the run rate is dropping going to 7 billion, which is still pretty impressive. Are we to presume that over the course of the year that you're going to manage the buyback rate as you’ve said over time and still maintain your dividend group of policy?
David Rosenthal: Well, without providing any specific guidance on the buyback as we've talked about in the past, they are flexible. They are the fly wheel for the use of our cash after funding our robust investment program and our dividend. I really don't have any guidance to give today going forward other than what I stated. We do expect to spend $7 billion in the first quarter of this year.
Neil McMahon - Sanford Bernstein: Great. Thank you.
David Rosenthal: Thank you.
Operator: (Operator instructions). We'll go next to Ryan Todd with Deutsche Bank.
Ryan Todd - Deutsche Bank: Hi, good morning.
David Rosenthal: Good morning. How are you?
Ryan Todd - Deutsche Bank: Good. Thanks. I have a quick question on, if you can help me out at all on U.S. refining or just refining numbers in general. There is tremendous volatility. I’m bit surprised that you lost money in the U.S. downstream and made so much money in the international downstream. Can you -- especially given the performance of some of your peers throughout this week, can you help us out at all to understand kind of the refining dynamics that are going on and maybe a little bit of guidance for what we should expect going forward?
David Rosenthal: I'd like to certainly talk about the fourth quarter. If we look at the fourth quarter '08 versus the fourth quarter '07, in total, the margin effect as I mentioned was a positive about $890 million. And this was driven by stronger non-U.S. margins with improvements both in non-U.S. refining and marketing margins. Overall, U.S. margins were actually down and that was driven by weaker refining margins across the quarter. And that was the primary driver. If you look at the earnings particularly in the U.S., note at the bottom of our chart, that change in earnings across the quarter again was driven by significantly lower refining margins.
Ryan Todd - Deutsche Bank: Okay. So there is nothing from a quarter-on-quarter basis that in terms of just volatility in the numbers from rapid price movements, is there anything else that we should be aware of?
David Rosenthal: Well, yes, there are some effects included in there as you know. Changes in prices over time can have some price finalization impacts as well as impacts due to temporary changes in inventory across the year. But it is driven by overall again lower refining margins. Going forward, we really don't have any guidance going forward. A lot of factors are weighing on both demand and margins on downstream products and we'll be monitoring those as the next several months progress.
Ryan Todd - Deutsche Bank: While we're talking refining, can I actually check in as well on any potential exposure that you might have to the strike down in the Gulf Coast or that potential strike down on the Gulf Coast are you exposed?
David Rosenthal: We have a total of four refineries that have United Steel Workers and International Brotherhood of Electrical Workers Agreement. And in these four refineries, they expire at the end of the month. These refineries are Beaumont, Chalmette, Torrence and Billings. And if you look at the status of the discussions, ExxonMobil is currently engaged in active negotiations with the union. I really wouldn't consider it appropriate to discuss any specifics of the proposal other than the negotiations are ongoing.
Ryan Todd - Deutsche Bank: That's great. Thanks. And if I could just sneak in one more, Neil asked you about the gas prospects over there in Hungary and you mentioned as well drilling in Germany. Would it be possible to -- from the wells you’ve drilled so far to make any comparisons to gas assets that we see here in the U.S. in terms of reserve, flow rates or just how you view those assets versus gas assets here in the U.S.?
David Rosenthal: No. I wouldn't want to make any direct comparisons other than to say that although it's a little early, we do view the prospects that we have in Germany as potentially world class resources, but we're still evaluating and testing programs are underway, and we'll be testing the wells that we drilled and determining the extent of that resource.
Ryan Todd - Deutsche Bank: Great. Thanks. I appreciate it.
David Rosenthal: Thank you.
Operator: We'll take our next question from Doug Leggate with Howard Weil.
David Rosenthal: Good morning, Doug.
Doug Leggate - Howard Weil: Can you hear me?
David Rosenthal: Yes, good morning, Doug.
Doug Leggate - Howard Weil: Hi, how are you guys doing?
David Rosenthal: And welcome back.
Doug Leggate - Howard Weil: Thanks. I think you might have a little bit of competition this morning. So, David, I've got a couple of things. I don't know if you broke out in your prepared remarks, but it looks like you recaptured quite a bit of volume from production sharing contracts and some of your PSC centered areas. And obviously, all prices have come down a little below the average for the quarter again (inaudible) so far in Q1. Can you just give us an update on your sensitivity to volume recapture (inaudible) expression on from PSCs and I've got an unrelated follow-up?
David Rosenthal: Okay, sure. If we look at our volumes first, fourth quarter '08 versus fourth quarter '07, we did still see about 47,000 barrels a day overall negative from PSC effects. Most of that in net interest reductions and a little on the price and spend as we noted. I will say as we look at that sequential increase that we saw in volumes from the third quarter to the fourth quarter. As you would expect with prices declining, we did get a little help on the price and spend side of that equation and really didn't see any net interest reductions. But in that sequential increase we did see the impact of the lower prices on the price and spend component as you would have expected.
Doug Leggate - Howard Weil: (inaudible). Excluding the (inaudible) effects of those entitlements, is the actual price of the cost recovery element, the price sensitivity, if you like, is that largely washed through now or do you still have a little more that you'd like to see come back again in Q1?
David Rosenthal: On an ongoing basis in any quarter on the price and spend impacts, that will be determined on both the pricing at the time as well as our spend levels, but that again that will be variable. But I would expect the first quarter given if the prices stay the same would be about similar.
Doug Leggate - Howard Weil: Okay. Great. And my follow-up, David, is, is this really just an observation? I'm trying to understand the mechanics of what's going on with your costs. Because like everyone you've talked about how costs have been going up and so on. But if you look at the average oil price in the quarter, we will leave realization to decide for a second and look at the same the last time we had an average oil price all of that level was under that Q1 '07. Your net income on a per barrel basis is almost exactly the same which kind of suggests that either there has been a mixed change in improvement or that you've been able to recapture or go back some of the cost increases. Can you just talk about what's going on in the cost side and how those earnings would remain so resilient over the last couple of years?
David Rosenthal: Yes, let's talk about the cost side for just a minute. As you're well aware, the industry has seen significant upward pressure over the last couple of years in a fairly heated market for supplies and services, and we've not been immune to that, of course. But we have been able to mitigate a great deal of that through our global procurement organization, our focus on operations excellence and efficiency in our operations. So while we've seen the impact of those increases, we don't think it's been as big as it has perhaps on others. I would also offer that one of the things we're seeing here is the benefit of some of our technology advantages across some of our processes -- and the other piece of it would just simply be the mix of where the production is or isn't between any quarter. But I wouldn't have any other specific observation other than to say, they're coming in about as we expected and reflect a lot of the things that we think give us competitive advantages in the industry.
Doug Leggate - Howard Weil: Would you be prepared to give us some indication as to year-over-year what your costs look like in a percentage basis?
David Rosenthal: I don't think I have a direct comparison on a percentage basis, Doug, but I would say if you look at just our earnings impacts on a period to period earnings recs we do see some of the cost increases that we're talking about in there. But again, in terms of significance in any particular quarter, not that significant. Obviously, across the whole year, you'd see a little bigger effect on a business our size. But I really don't have a percentage increase in particular for any segment of the business or the company in whole.
Doug Leggate - Howard Weil: Great. I'll leave it there, David. Thanks again.
David Rosenthal: Okay, thank you.
Operator: We'll take our last question from William Ferer with W. H. Reaves & Co.
William Ferer - W. H. Reaves & Co.: Good morning.
David Rosenthal: Good morning.
William Ferer - W. H. Reaves & Co.: Thank you. Last is not always least. Just a couple the Imperial announced the proceeding on Kearl Lake wondering if the Exxon Corp is opposed to Imperial will participate in the program and if so, equal proportion how that might be. And I noticed in your fourth quarter exploration expense down from a year ago, and it leads to maybe two questions. Part A is were you just more successful or was it just a mix effect? And Part B, you mentioned earlier about economic factors, I'm wondering if the economic conditions perhaps in some oil producing nations would open up more opportunities for Exxon to perhaps participate more aggressively than they might have been given an opportunity where price is much higher, economy is much stronger.
David Rosenthal: Thank you. Let me see if I can take those in order. Let's start out with Kearl. As you know Kearl is a significant high quality oil sands resource. And that project continues to be progressed. Detailed design and engineering is underway. Long lead time procurement items are being advanced. Site activities are underway. And again, the project is progressing. And that is a project with ExxonMobil affiliates and NIOL. If we take a look I believe the next question related exploration expense. It's down, but it's really timing of activities and expenditures. I don't think we draw any other conclusions related to the market. Overall, our activity is higher as reflective of the portfolio that we have and the activity that we have under way to work on that portfolio, but the absolute timing of the expenditures as they're booked really relates to the activity and nothing special there quarter-to-quarter. If we look at the economic factors, I think, in particular, you were talking about more opportunities. Let me back up and actually take the economic factors that we're seeing in the business in two perspectives. One of which is the impact on prices of goods and services in our projects as we progress, our portfolio of investment opportunities. As you're well aware, commodity prices have dropped significantly in a number of areas and people are starting to see a little downturn perhaps in some expenses and services. And we're -- although it's a little early to tell the extent that those might provide us, we are actively pursuing for our global procurement and global project development organizations putting pressure on the system to really get the lag out and start to bring those cost reductions to the bottom-line as quickly as possible. The other aspect of the current economic environment as you mentioned is the impact it has on resource holders and producing nations. And without being anything particular or specific --
William Ferer - W. H. Reaves & Co.: Give real specific, will you?
David Rosenthal: I can't give real specific, but I would tell you certainly we are open and always exploring and chasing new opportunities to add value in all of the economic conditions. But it's a little early to tell what impact that's going to have in various scenarios or draw any conclusions other than I can assure you that we are well positioned both from a financial strength standpoint and organization capability standpoint to take advantage of any opportunity that might present itself for whatever reason that might come along. So thanks for the question.
William Ferer - W. H. Reaves & Co.: Thank you.
Operator: With that we have no further questions left in the queue. I'll turn the call back over to Mr. Rosenthal for any additional or closing remarks.
David Rosenthal: Thank you very much. I appreciate everybody joining the call and your questions. I would like to say, in closing, that despite the challenging economic environment, we remain confident that our long-term perspective, financial strength and disciplined investment approach will continue to deliver superior differentiated results and positions us well for the future.
Operator: Ladies and gentlemen, that does conclude today's conference. Thank you for your participation. You may now disconnect your lines. | [
{
"speaker": "Executives",
"text": "David Rosenthal – VP of IR & Secretary"
},
{
"speaker": "Analysts",
"text": "Christina Chen – Barclays Capital Shin Kim [ph] – Merrill Lynch Neil McMahon – Sanford Bernstein Ryan Todd – Deutsche Bank Doug Leggate – Howard Weil William Ferer – W. H. Reaves & Co."
},
{
"speaker": "Operator",
"text": "Good day, everyone and welcome to this ExxonMobil Corporation fourth quarter 2008 earnings conference call. Today's call is being recorded. At this time for opening remarks, I would like to turn the call over to your Vice President of Investor Relations and Secretary, David Rosenthal. Please go ahead, sir."
},
{
"speaker": "David Rosenthal",
"text": "Thank you. Good morning. And welcome to ExxonMobil's teleconference and webcast on our fourth quarter and full year 2008 financial and operating results. As you are aware from this morning's press release, ExxonMobil's fourth quarter earnings performance was strong. Our results reflect the strength of our business model during a period of global economic weakness and significant decline in commodity prices. The current environment has created challenging business conditions for many industries and has also affected millions of consumers worldwide. Despite these challenges, ExxonMobil remains well positioned for the future as a direct result of our financial strength, long-term focus, effective approach to risk management, and capital discipline. Before we go further, I would like to draw your attention to our cautionary statement. Please note that estimates, plans and expectations are forward-looking statements. Actual results, including resource recovery, volume growth and project outcome could differ materially due to factors I discuss and factors noted in our SEC filing. Please see factors affecting future results and the Form 8-K we furnished this morning, which are available through the investor section of our Web site. Please also see the frequently used terms, the supplements to this morning's press release and the 2007 financial and operating review on our Web site. This material defines key terms I will use today, shows ExxonMobil's net interest in specific projects and includes our SEC Regulation G disclosure. Now, I am pleased to turn your attention to the fourth quarter results. ExxonMobil's fourth quarter 2008 normalized earnings and net income was $7.8 billion, a reduction of $3.8 billion from the fourth quarter of 2007, versus the third quarter of 2008, normalized earnings were down $5.6 billion and net income decreased $7 billion. Both comparisons reflect the recent sharp reduction in commodity prices. Normalized earnings per share were $1.55, down $0.58 from a year ago. During the fourth quarter of 2008, ExxonMobil distributed a total of $10 billion to shareholders, including dividends of $2 billion and share purchases to reduce shares outstanding of $8 billion. ExxonMobil's full year 2008 net income was $45.2 billion, up $4.6 billion from 2007 and a record for the Corporation, with strong results in each of our upstream, downstream, and chemical businesses. Normalized earnings for 2008 were also a record at $44.1 billion, up $3.5 billion from 2007. I would now like to share some of the milestones we have achieved since the last earnings call. In December, the Thunder Horse Project in the Gulf of Mexico achieved a production rate of over 200,000 oil equivalent barrels per day. The project at peak is expected to produce 250,000 barrels per day of crude oil and 200 million cubic feet per day of natural gas. Including Thunder Horse, Volve in Norway, Starling in the U.K. sector of the North Sea, Kizomba C Mondo, and Saxi Batuque in Angola, East Area and Natural Gas Liquids in Nigeria, Journey B in Malaysia and ACG Phase Three in Azerbaijan, we completed eight major project start-ups during 2008. Also, during the fourth quarter, we started up the offshore facilities for the Qatargas II Train 4 project in Qatar. We are completing commissioning activities onshore and we anticipate first LNG from the project during the first quarter of 2009. The South Hook LNG terminal in the U.K. is also in the process of completing commissioning and we expect initial LNG receipt and processing during the fist quarter. When full operational capacity is reached, the terminal will have the capability to supply 2 billion cubic feet of natural gas per day to the U.K. market. The fourth quarter also saw the completion of four new Q-Max class LNG carriers, the first of their kind. The Q-Max carriers are the largest LNG carriers in the world and can transport about 80% more cargo than a standard carrier. These vessels mark a step change in LNG shipping by lowering unit transportation cost while improving energy efficiency and reducing emissions. These groundbreaking improvements were made possible by applying the latest LNG shipping technology developed by ExxonMobil and our partner Qatar Petroleum. In December, the Sakhalin-1 project earned the excellence in project integration award from the committees and sponsoring societies of the International Petroleum Technology Conference or IPTC held in Kuala Lumpur. The award is a testament to ExxonMobil’s achievements in successfully executing the project in one of the most challenging Arctic environments in the world, in a safe and environmentally responsible manner. These major projects demonstrate our ongoing commitment to bring new supplies to market and deliver value to our shareholders. In exploration, we added to our global portfolio of outstanding deepwater opportunities. ExxonMobil entered into an agreement with Turkish national oil company, TPAO to explore two large deepwater blocks in the Black Sea offshore Turkey. These blocks cover total area of 7 million acres. We're awaiting final government approval of this agreement. ExxonMobil also signed an agreement with the Romanian oil and gas company Petron to cooperate on a 3D seismic acquisition and evaluation program of the Black Sea Neptune block covering approximately two million acres. This agreement helps strengthen our position in this new exploration play. In Brazil, the deepwater drilling rig, West Polaris is currently drilling the Azula well in Block BM-S-22. Plans for additional drilling on the block are underway with a second well to follow upon completion of the first. ExxonMobil is pleased to be participating in this new subsalt play and will leverage all of our global experience and industry-leading technologies in the exploration program. We also continue to progress our high potential unconventional natural gas opportunities around the world. In the Lower Saxony Basin in Germany, we have drilled three exploration wells in the promising shale gas play there and are preparing to commence testing operations. In the Mako Trough in southeast Hungary, we are now drilling our second and third evaluation wells. Testing operations will begin once we have completed the first set of wells. In the Horn River Basin, in northeastern British Columbia, Canada, we also commenced a four well winter drilling and testing program on our extensive shale gas acreage during the fourth quarter. Moving now to the downstream, during the quarter, we announced our plans to invest more than $1 billion in our Baton Rouge, Louisiana; Baytown, Texas, and Antwerp Belgium refineries to increase the supply of cleaner burning diesel. These projects include the construction of additional process units and modifications to existing facilities, which will allow us to increase diesel production by 6 million gallons per day at these sites. This increase in production is equivalent to the diesel produced from about four average sized refineries. Building on our commitment to technology, ExxonMobil announced in October that we are collaborating with Pratt & Whitney Rocketdyne to develop next generation gasification technology to convert coal, coke or biomass to synthesis gas. One of the potential uses of this technology would be to facilitate carbon capture and storage, reducing green house gas emissions from power generation. The collaboration takes advantage of ExxonMobil's technology leadership in the energy sector and Pratt & Whitney Rocketdyne experienced in rocket engine development, with the goal of making significant progress in gasification technology. Also in refining, we continued our activities to reduce raw material cost by managing our crude flexibility. This quarter, ExxonMobil ran 36 crudes that were new to individual refineries and four that were new to ExxonMobil. Turning now to our chemical business, in October, ExxonMobil 1, the 2008 ICIS Chemical Business award for best product innovation for our new battery separator film technology. During the fourth quarter, we also began construction on a new battery separator film manufacturing facility in Gumi, South Korea. The facility will have the capacity to produce over 30 million square meters of film per year with opportunity for future significant expansion. This ExxonMobil film technology is expected to help improve the efficiency and performance of lithium ion batteries and may lead to future applications in new, hybrid and electric vehicles. This investment will significantly enhance our capability to supply customers in this fast growing market. Also during the fourth quarter, we signed heads of agreement with Saudi Basic Industries to progress detailed studies for a new elastomers project at our petro chemical joint ventures located in Kemya and Yanpet, Saudi Arabia. The new facilities will supply a combined volume of over 400,000 tons per year of chemical products including synthetic rubber, thermal plastic specialty polymers and other products. This project is part of ExxonMobil's commitment to invest in advantaged, chemical growth projects in the Middle East and Asia-Pacific to meet long-term demand. Now turning to the business line results, upstream earnings in the fourth quarter were $5.6 billion, down $2.6 billion from the fourth quarter of 2007. Upstream after-tax unit earnings in the fourth quarter of 2008 were just under $15 per barrel. Lower realizations reduced earnings by $2.7 billion, driven by lower crude oil prices which were down $34 per barrel to just under $51 per barrel in the quarter. Natural gas realizations were up $1.46 per kcf from the fourth quarter of 2007, reflecting higher prices in Europe and the Middle East, partly offset by lower realizations in North America. Lower volumes reduced earnings by $240 million. Other effects increased earnings by $320 million due primarily to positive foreign exchange effects, higher gains from asset sales and lower taxes, partly offset by increased operating expenses. In total, oil equivalent volumes decreased to 3% from the fourth quarter of last year. Entitlement volume effects including price and spend impacts and PSC net interest reductions, reduced volumes by 47,000 barrels per day. Excluding the impact of lower entitlement volumes, quotas and divestments, production was down 1%, driven by lower European natural gas demand. Natural fuel decline was largely offset by a major project ramp ups in West Africa, the North Sea and Kazakhstan. Liquids production decreased 45,000 barrels per day or 2% from the fourth quarter of last year. Excluding impacts related to lower entitlement volumes, quotas and divestments, production was up just over 1%. Major project ramp ups in West Africa, Kazakhstan and the North Sea and lower maintenance activity more than offset natural fuel decline. Gas volumes decreased 565 million cubic feet per day from the fourth quarter of 2007. New project volumes in the North Sea, Qatar and Malaysia were more than offset by natural decline and lower demand in Europe. Turning now to the sequential comparison versus the third quarter of 2008, upstream earnings decreased $3.7 billion, primarily due to lower crude oil realizations, which were down $60 per barrel in the quarter. Higher crude oil and natural gas volumes increased earnings by $850 million. Other effects benefited earnings by $350 million primarily from higher gains on asset sales. Liquids production increased 8% reflecting the impact of new project volumes and the completion of maintenance programs. Natural gas production was up nearly 26% driven by seasonally higher demand in Europe. Oil equivalent volumes were up 14% from the third quarter. Looking now at the full year results, 2008 upstream earnings excluding special items were a record $33.8 billion, an increase of $7.3 billion over 2007. Improved realizations increased earnings by $11.8 billion. Crude oil prices were up, over $24 per barrel and natural gas realization increased in all major producing regions. Lower crude oil and natural gas volumes reduced earnings by $3.7 billion. Other factors reduced earnings by $800 million with higher expenses, including the impact of new project start-ups and negative tax effects partly offset by positive foreign exchange impacts and higher gains on asset sales. Full year oil equivalent volumes were down 6% versus 2007. Liquids volumes were down 8% while natural gas volumes were down 3%. Excluding entitlement volume effects, the Venezuela expropriation and divestments, production was down just under 3%. About half of that reduction was due to higher maintenance activity and the effects of the hurricanes in the U.S., with the balance reflecting natural fuel decline, offset by new project volumes in West Africa, the North Sea, Kazakhstan and Malaysia. For further detail on regional volumes, please refer to the press release and IR supplement. Turning now to the downstream results, earnings in the fourth quarter were $2.4 billion, up $150 million from the fourth quarter of 2007. Higher margins increased earnings by $890 million, with stronger marketing and industry refining margins and positive price finalization effects partly offset by impacts due to temporary inventory changes. Volume and mix effects reduced earnings by $230 million, driven primarily by lower sales volume. Other effects reduced earnings by $510 million, reflecting adverse foreign exchange impacts and higher operating expenses including hurricane related repair costs. Sequentially, fourth quarter earnings decreased by $600 million. Lower margins reduced earnings by $980 million, driven by weaker refining margins including negative impacts due to temporary inventory changes partly offset by improved marketing margins. Volume and mix effects increased earnings by $40 million with margin improvement activities more than offsetting lower sales volumes. Other factors increased earnings by $340 million including $190 million of positive LIFO effects and higher earnings from asset sales. Full year 2008 downstream earnings were $8.2 billion, down $1.4 billion from record earnings in 2007. Lower margins reduced earnings by $910 million due to weaker refining margins which more than offset improved marketing margins. Volume and mix effects increased earnings by $560 million, primarily due to positive margin improvement activities. Other factors reduced earnings by $1.1 billion reflecting higher operating expenses and negative foreign exchange effects. Now turning to our chemical results, fourth quarter chemical earnings were $155 million, down $960 million from the fourth quarter of 2007. Weaker margins reduced earnings by $270 million reflecting lower realizations while volume effects reduced earnings by $360 million due to lower demand and the impact of the hurricanes in the U.S. Other effects reduced earnings by $330 million, including hurricane related repair costs and negative foreign exchange effects, partially offset by positive LIFO impacts. Sequentially, fourth quarter chemical earnings decreased by $930 million. Weaker margins reduced earnings by $240 million and lower volumes decreased earnings by $370 million, both reflecting impacts of the economic slowdown. Other effects were negative, $320 million with adverse foreign exchange effects and hurricane related repair cost partly offset by positive LIFO effects. Full year 2008 chemical earnings were just under $3 billion, down 1.6 billion from record earnings in 2007. Weaker margins reduced earnings by $1.2 billion while lower volumes decreased earnings by $530 million. Turning now to our corporate and financing segment, corporate and financing expenses during the quarter were $383 million versus earnings of $77 million in the fourth quarter last year. The increase reflects the absence of positive tax effects and reduced interest income due to lower interest rates. Full year 2008 expenses were $830 million, up from $23 million in 2007, reflecting negative tax effect and lower interest income. The effective tax rate for the fourth quarter was 46%. And for the full year 2008, the effective tax rate was 47%. At the end of the fourth quarter, our cash balance was $31 billion and debt was $9 billion. The corporation distributed $10 billion to shareholders in the fourth quarter through dividends and share purchases to reduce shares outstanding. Of that total, $8 billion was distributed to purchase shares in excess of dilution, reducing the number of shares outstanding by 2.2%. For the full year 2008, we distributed a total of $40 billion to shareholders including $32 billion to purchase shares in excess of dilution, which reduced shares outstanding by 7.5% further demonstrating our commitment to return cash to our shareholders. Share purchases to reduce shares outstanding are expected to be $7 billion in the first quarter of 2009. CapEx in the fourth quarter was $6.8 billion, an increase of 11% from fourth quarter 2007 and brings 2008 full year CapEx to $26.1 billion. This is in line with our previous guidance and it increased a $5 billion from 2007. We continue to invest at record level in robust projects to help meet global demand for crude oil, natural gas and finished products. In summary, these results reflect the strength of ExxonMobil's business model. The volatile business conditions in 2008 demonstrate that our long-term commitment to the integrity of our operations, disciplined investment approach and integrated business model continue to deliver superior results. Finally, I would like to mention two upcoming events. First, in mid-February, we will be releasing our 2008 reserves performance data. And second, as many of you who already have seen, our analyst meeting this year will take place on Thursday, March 5th. This will include a live audio webcast beginning at 9:00 a.m. Eastern, 8:00 a.m. Central Time. ExxonMobil's presenters will be led by Chairman and CEO Rex Tillerson. That concludes my prepared remarks. I would now be happy to take your questions."
},
{
"speaker": "Operator",
"text": "Thank you, Mr. Rosenthal. (Operator instructions). We'll take our first question from Christina Chen with Barclays Capital."
},
{
"speaker": "Christina Chen - Barclays Capital",
"text": "Hi, good morning. I just had a quick question. Were there any asset sales gains in the quarter and can you break down the effects in the inventory gains?"
},
{
"speaker": "David Rosenthal",
"text": "Yes. Good morning, Christina."
},
{
"speaker": "Christina Chen - Barclays Capital",
"text": "Good morning."
},
{
"speaker": "David Rosenthal",
"text": "Yes. In the other bar, we do have some asset sales. In total, fourth quarter of '08 reflects a positive earnings of impacts from Brazil, Spain and Portugal affiliate sales. And in the downstream, we had a number of minor asset sales as well. Christina, did you have another question?"
},
{
"speaker": "Christina Chen - Barclays Capital",
"text": "Actually, is it possible to give out the actual number for that?"
},
{
"speaker": "David Rosenthal",
"text": "No. We don't typically disclose the actual earnings effects from our asset sales."
},
{
"speaker": "Christina Chen - Barclays Capital",
"text": "Okay. And then were there any other effects in inventory effects?"
},
{
"speaker": "David Rosenthal",
"text": "We did have some LIFO effects in the quarter in the downstream. They were fairly minor if you're looking fourth quarter versus the fourth quarter '08 that is, versus the fourth quarter of '07. It was just under $100 million of negative LIFO effects."
},
{
"speaker": "Christina Chen - Barclays Capital",
"text": "Okay. Thank you."
},
{
"speaker": "David Rosenthal",
"text": "Alright. Thank you."
},
{
"speaker": "Operator",
"text": "(Operator instructions). We'll take our next question from Shin Kim [ph] with Merrill Lynch."
},
{
"speaker": "Shin Kim - Merrill Lynch",
"text": "Hi, actually I think the question was answered. Thank you."
},
{
"speaker": "David Rosenthal",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Neil McMahon with Sanford Bernstein."
},
{
"speaker": "Neil McMahon - Sanford Bernstein",
"text": "Hi, I was wondering if you could go through some of the new projects both in Brazil and in Hungary. I know its sort of early days, but you did go through or at least fit through to the Brazilian authorities that you had discovered oil in block 22. I was wondering if you could give us some more details there and indeed the quality of the oil or oil traces that were discovered?"
},
{
"speaker": "David Rosenthal",
"text": "Yes, of course. We are drilling the Azula well in the ExxonMobil operated BMS-22 block. We continue to drill ahead in that block. We did file a discovery notice on January 16th with the Brazilian authorities. But this is a notice just that we had encountered hydrocarbons, but that is the extent of the notice."
},
{
"speaker": "Neil McMahon - Sanford Bernstein",
"text": "Okay. So you're not going any further than that?"
},
{
"speaker": "David Rosenthal",
"text": "No, at this time, we really don't have any other comments to make on Brazil other than we are drilling ahead and progressing with that well. Neil, I think you also asked a question about Hungary."
},
{
"speaker": "Neil McMahon - Sanford Bernstein",
"text": "Yes."
},
{
"speaker": "David Rosenthal",
"text": "As you recall, last year, we did announce that we had signed an agreement to begin phase work program in the Mako Trough in Hungary on about 184,000 acres. The first two of those wells have spud last year and the second well spud in December and we continue to explore and work on that prospect."
},
{
"speaker": "Neil McMahon - Sanford Bernstein",
"text": "And just a very final one, maybe it's a quick one. In terms of the LNG coming to South Hook, are you planning to take it from Qatar with some of the new boats or could it be any sort of boat just to start up the regas facility?"
},
{
"speaker": "David Rosenthal",
"text": "No. We would be using our new Q-Max ships for that purpose, and the Q-Max and the Q flag ships."
},
{
"speaker": "Neil McMahon - Sanford Bernstein",
"text": "Great. And then just a very final one to squeeze it in, in terms of your buyback, the run rate is dropping going to 7 billion, which is still pretty impressive. Are we to presume that over the course of the year that you're going to manage the buyback rate as you’ve said over time and still maintain your dividend group of policy?"
},
{
"speaker": "David Rosenthal",
"text": "Well, without providing any specific guidance on the buyback as we've talked about in the past, they are flexible. They are the fly wheel for the use of our cash after funding our robust investment program and our dividend. I really don't have any guidance to give today going forward other than what I stated. We do expect to spend $7 billion in the first quarter of this year."
},
{
"speaker": "Neil McMahon - Sanford Bernstein",
"text": "Great. Thank you."
},
{
"speaker": "David Rosenthal",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "(Operator instructions). We'll go next to Ryan Todd with Deutsche Bank."
},
{
"speaker": "Ryan Todd - Deutsche Bank",
"text": "Hi, good morning."
},
{
"speaker": "David Rosenthal",
"text": "Good morning. How are you?"
},
{
"speaker": "Ryan Todd - Deutsche Bank",
"text": "Good. Thanks. I have a quick question on, if you can help me out at all on U.S. refining or just refining numbers in general. There is tremendous volatility. I’m bit surprised that you lost money in the U.S. downstream and made so much money in the international downstream. Can you -- especially given the performance of some of your peers throughout this week, can you help us out at all to understand kind of the refining dynamics that are going on and maybe a little bit of guidance for what we should expect going forward?"
},
{
"speaker": "David Rosenthal",
"text": "I'd like to certainly talk about the fourth quarter. If we look at the fourth quarter '08 versus the fourth quarter '07, in total, the margin effect as I mentioned was a positive about $890 million. And this was driven by stronger non-U.S. margins with improvements both in non-U.S. refining and marketing margins. Overall, U.S. margins were actually down and that was driven by weaker refining margins across the quarter. And that was the primary driver. If you look at the earnings particularly in the U.S., note at the bottom of our chart, that change in earnings across the quarter again was driven by significantly lower refining margins."
},
{
"speaker": "Ryan Todd - Deutsche Bank",
"text": "Okay. So there is nothing from a quarter-on-quarter basis that in terms of just volatility in the numbers from rapid price movements, is there anything else that we should be aware of?"
},
{
"speaker": "David Rosenthal",
"text": "Well, yes, there are some effects included in there as you know. Changes in prices over time can have some price finalization impacts as well as impacts due to temporary changes in inventory across the year. But it is driven by overall again lower refining margins. Going forward, we really don't have any guidance going forward. A lot of factors are weighing on both demand and margins on downstream products and we'll be monitoring those as the next several months progress."
},
{
"speaker": "Ryan Todd - Deutsche Bank",
"text": "While we're talking refining, can I actually check in as well on any potential exposure that you might have to the strike down in the Gulf Coast or that potential strike down on the Gulf Coast are you exposed?"
},
{
"speaker": "David Rosenthal",
"text": "We have a total of four refineries that have United Steel Workers and International Brotherhood of Electrical Workers Agreement. And in these four refineries, they expire at the end of the month. These refineries are Beaumont, Chalmette, Torrence and Billings. And if you look at the status of the discussions, ExxonMobil is currently engaged in active negotiations with the union. I really wouldn't consider it appropriate to discuss any specifics of the proposal other than the negotiations are ongoing."
},
{
"speaker": "Ryan Todd - Deutsche Bank",
"text": "That's great. Thanks. And if I could just sneak in one more, Neil asked you about the gas prospects over there in Hungary and you mentioned as well drilling in Germany. Would it be possible to -- from the wells you’ve drilled so far to make any comparisons to gas assets that we see here in the U.S. in terms of reserve, flow rates or just how you view those assets versus gas assets here in the U.S.?"
},
{
"speaker": "David Rosenthal",
"text": "No. I wouldn't want to make any direct comparisons other than to say that although it's a little early, we do view the prospects that we have in Germany as potentially world class resources, but we're still evaluating and testing programs are underway, and we'll be testing the wells that we drilled and determining the extent of that resource."
},
{
"speaker": "Ryan Todd - Deutsche Bank",
"text": "Great. Thanks. I appreciate it."
},
{
"speaker": "David Rosenthal",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Doug Leggate with Howard Weil."
},
{
"speaker": "David Rosenthal",
"text": "Good morning, Doug."
},
{
"speaker": "Doug Leggate - Howard Weil",
"text": "Can you hear me?"
},
{
"speaker": "David Rosenthal",
"text": "Yes, good morning, Doug."
},
{
"speaker": "Doug Leggate - Howard Weil",
"text": "Hi, how are you guys doing?"
},
{
"speaker": "David Rosenthal",
"text": "And welcome back."
},
{
"speaker": "Doug Leggate - Howard Weil",
"text": "Thanks. I think you might have a little bit of competition this morning. So, David, I've got a couple of things. I don't know if you broke out in your prepared remarks, but it looks like you recaptured quite a bit of volume from production sharing contracts and some of your PSC centered areas. And obviously, all prices have come down a little below the average for the quarter again (inaudible) so far in Q1. Can you just give us an update on your sensitivity to volume recapture (inaudible) expression on from PSCs and I've got an unrelated follow-up?"
},
{
"speaker": "David Rosenthal",
"text": "Okay, sure. If we look at our volumes first, fourth quarter '08 versus fourth quarter '07, we did still see about 47,000 barrels a day overall negative from PSC effects. Most of that in net interest reductions and a little on the price and spend as we noted. I will say as we look at that sequential increase that we saw in volumes from the third quarter to the fourth quarter. As you would expect with prices declining, we did get a little help on the price and spend side of that equation and really didn't see any net interest reductions. But in that sequential increase we did see the impact of the lower prices on the price and spend component as you would have expected."
},
{
"speaker": "Doug Leggate - Howard Weil",
"text": "(inaudible). Excluding the (inaudible) effects of those entitlements, is the actual price of the cost recovery element, the price sensitivity, if you like, is that largely washed through now or do you still have a little more that you'd like to see come back again in Q1?"
},
{
"speaker": "David Rosenthal",
"text": "On an ongoing basis in any quarter on the price and spend impacts, that will be determined on both the pricing at the time as well as our spend levels, but that again that will be variable. But I would expect the first quarter given if the prices stay the same would be about similar."
},
{
"speaker": "Doug Leggate - Howard Weil",
"text": "Okay. Great. And my follow-up, David, is, is this really just an observation? I'm trying to understand the mechanics of what's going on with your costs. Because like everyone you've talked about how costs have been going up and so on. But if you look at the average oil price in the quarter, we will leave realization to decide for a second and look at the same the last time we had an average oil price all of that level was under that Q1 '07. Your net income on a per barrel basis is almost exactly the same which kind of suggests that either there has been a mixed change in improvement or that you've been able to recapture or go back some of the cost increases. Can you just talk about what's going on in the cost side and how those earnings would remain so resilient over the last couple of years?"
},
{
"speaker": "David Rosenthal",
"text": "Yes, let's talk about the cost side for just a minute. As you're well aware, the industry has seen significant upward pressure over the last couple of years in a fairly heated market for supplies and services, and we've not been immune to that, of course. But we have been able to mitigate a great deal of that through our global procurement organization, our focus on operations excellence and efficiency in our operations. So while we've seen the impact of those increases, we don't think it's been as big as it has perhaps on others. I would also offer that one of the things we're seeing here is the benefit of some of our technology advantages across some of our processes -- and the other piece of it would just simply be the mix of where the production is or isn't between any quarter. But I wouldn't have any other specific observation other than to say, they're coming in about as we expected and reflect a lot of the things that we think give us competitive advantages in the industry."
},
{
"speaker": "Doug Leggate - Howard Weil",
"text": "Would you be prepared to give us some indication as to year-over-year what your costs look like in a percentage basis?"
},
{
"speaker": "David Rosenthal",
"text": "I don't think I have a direct comparison on a percentage basis, Doug, but I would say if you look at just our earnings impacts on a period to period earnings recs we do see some of the cost increases that we're talking about in there. But again, in terms of significance in any particular quarter, not that significant. Obviously, across the whole year, you'd see a little bigger effect on a business our size. But I really don't have a percentage increase in particular for any segment of the business or the company in whole."
},
{
"speaker": "Doug Leggate - Howard Weil",
"text": "Great. I'll leave it there, David. Thanks again."
},
{
"speaker": "David Rosenthal",
"text": "Okay, thank you."
},
{
"speaker": "Operator",
"text": "We'll take our last question from William Ferer with W. H. Reaves & Co."
},
{
"speaker": "William Ferer - W. H. Reaves & Co.",
"text": "Good morning."
},
{
"speaker": "David Rosenthal",
"text": "Good morning."
},
{
"speaker": "William Ferer - W. H. Reaves & Co.",
"text": "Thank you. Last is not always least. Just a couple the Imperial announced the proceeding on Kearl Lake wondering if the Exxon Corp is opposed to Imperial will participate in the program and if so, equal proportion how that might be. And I noticed in your fourth quarter exploration expense down from a year ago, and it leads to maybe two questions. Part A is were you just more successful or was it just a mix effect? And Part B, you mentioned earlier about economic factors, I'm wondering if the economic conditions perhaps in some oil producing nations would open up more opportunities for Exxon to perhaps participate more aggressively than they might have been given an opportunity where price is much higher, economy is much stronger."
},
{
"speaker": "David Rosenthal",
"text": "Thank you. Let me see if I can take those in order. Let's start out with Kearl. As you know Kearl is a significant high quality oil sands resource. And that project continues to be progressed. Detailed design and engineering is underway. Long lead time procurement items are being advanced. Site activities are underway. And again, the project is progressing. And that is a project with ExxonMobil affiliates and NIOL. If we take a look I believe the next question related exploration expense. It's down, but it's really timing of activities and expenditures. I don't think we draw any other conclusions related to the market. Overall, our activity is higher as reflective of the portfolio that we have and the activity that we have under way to work on that portfolio, but the absolute timing of the expenditures as they're booked really relates to the activity and nothing special there quarter-to-quarter. If we look at the economic factors, I think, in particular, you were talking about more opportunities. Let me back up and actually take the economic factors that we're seeing in the business in two perspectives. One of which is the impact on prices of goods and services in our projects as we progress, our portfolio of investment opportunities. As you're well aware, commodity prices have dropped significantly in a number of areas and people are starting to see a little downturn perhaps in some expenses and services. And we're -- although it's a little early to tell the extent that those might provide us, we are actively pursuing for our global procurement and global project development organizations putting pressure on the system to really get the lag out and start to bring those cost reductions to the bottom-line as quickly as possible. The other aspect of the current economic environment as you mentioned is the impact it has on resource holders and producing nations. And without being anything particular or specific --"
},
{
"speaker": "William Ferer - W. H. Reaves & Co.",
"text": "Give real specific, will you?"
},
{
"speaker": "David Rosenthal",
"text": "I can't give real specific, but I would tell you certainly we are open and always exploring and chasing new opportunities to add value in all of the economic conditions. But it's a little early to tell what impact that's going to have in various scenarios or draw any conclusions other than I can assure you that we are well positioned both from a financial strength standpoint and organization capability standpoint to take advantage of any opportunity that might present itself for whatever reason that might come along. So thanks for the question."
},
{
"speaker": "William Ferer - W. H. Reaves & Co.",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "With that we have no further questions left in the queue. I'll turn the call back over to Mr. Rosenthal for any additional or closing remarks."
},
{
"speaker": "David Rosenthal",
"text": "Thank you very much. I appreciate everybody joining the call and your questions. I would like to say, in closing, that despite the challenging economic environment, we remain confident that our long-term perspective, financial strength and disciplined investment approach will continue to deliver superior differentiated results and positions us well for the future."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, that does conclude today's conference. Thank you for your participation. You may now disconnect your lines."
}
] | null | null |
XOM | 3 | 2,008 | 2008-10-30 11:00:00 | Executives: David Rosenthal – Vice President of Investor Relations, Secretary
Analysts: Paul Sankey – Deutsche Bank Neil McMahon – Sanford C. Bernstein & Company, Inc.
– :
– : Jason Gammel – Macquarie Research Equities [Paul Cheng – Barclays Company] Robert Kessler – Simmons & Company International
Operator: Good day everyone and welcome to the Exxon Mobil corporation third quarter 2008 earnings conference call. Today’s call is being recorded. At this time for opening remarks and introductions, I’d like to turn the call over to the Vice President of Investor Relations and Secretary, Mr. David Rosenthal. Please go ahead sir.
David Rosenthal: Good morning and welcome to Exxon Mobil’s teleconference and webcast on our third quarter 2008 financial and operating results. As you are aware from this morning’s press release Exxon Mobil’s net income in the third quarter was a record for the corporation. Our integrated business portfolio, strong operational performance, and financial discipline continue to allow us to capture the benefits of the commodity price environment. Despite recent volatility in the financial, commodity, and credit markets the fundamentals at Exxon Mobil’s business remain strong and we continue to invest are record levels to bring new supplies to market. Before we go further I would like to draw your attention to our cautionary statement. Please note that estimates, plans, and expectations are forward-looking statements. Actual results, including resource recoveries, volume growth, and project outcomes could differ materially due to factors I discuss and factors noted in our SEC filings. Please see factors affecting future results and the Form 8-K we furnished this morning, which are available through the Investors section of our website. Please also see the frequently used terms, the supplements to this morning's press release, and the 2007 financial and operating review on our website. This material defines key terms I will use today, shows Exxon Mobil's net interest in specific projects, and includes our SEC Regulation G disclosure. Now, I'm pleased to turn your attention to the third quarter results. Exxon Mobil's third quarter 2008 net income was $14.8 billion, an increase of $5.4 billion from the third quarter of 2007. Third quarter 2008 net income included a $1.6 billion gain on the sale of our German gas transportation business which we commented on in our second quarter earnings teleconference and a special charge of $170 million for interest related to the Valdez punitive damages award. Third quarter normalized earnings, excluding special items, were $13.4 billion, up almost 4 billion from the third quarter of 2007. Normalized earnings per share were $2.59 per share, up 52% from a year ago, reflecting the strong earnings performance and the benefits of our share purchase program. During the third quarter of 2008, Exxon Mobil distributed a total of 10.1 billion to shareholders, including dividends of 2.1 billion and share purchased to reduce shares outstanding of $8 billion. Before I discuss our specific business results in more detail, I would like to make a few comments on the impact of the hurricanes which hit the Gulf Coast of Texas and Louisiana in September. Hurricanes Gustav and Ike were significant events for our employees, their families, and many communities across the Gulf Coast. Our top priority was the safety of our employees and the communities in which we operate. Our response plan and the diligence of our employees ensured the safe shutdown of platforms, refineries, and chemical plants in the path of the hurricanes. As part of our preparation and activities we worked diligently to bring additional fuel supply to our customers. For example we sourced gasoline from oversees and also purchased volumes in the U.S. to supplement our own production. In addition, Exxon Mobil has provided a total of $6.8 million in relief to help communities directly affected by the hurricanes. The majority of our upstream production operations and downstream refineries are now back online or completing the final stages of startup. However, the Beaumont chemical plant experienced more extensive water damage than our other facilities. And we continue to progress repairs and develop our restar plans. As a result of the hurricanes third quarter upstream volumes were down 24,000 oil equivalent barrels per day and costs were higher by $50 million before tax. Looking forward we expect damage repairs and lower volumes across all business lines associated with the hurricanes to reduce earnings by about $500 million in the fourth quarter. I would now like to share some of the milestones we have achieved since the last earnings call. Following the startup of the Mondo field in January this year we successfully started up the Saxi and Batuque fields in the third quarter, completing the second Kizomba C FPSO startup in Block 15 offshore Angola. The three fields comprising the Kizomba C development, Mondo, Saxi, and Batuque are now producing at a combined rate of 200,000 barrels per day and are expected to recover approximately 600 million barrels of oil. Daily production from the Exxon Mobil operated Block 15 developments in Angola has now reached approximately 700,000 barrels per day. In Malaysia natural gas production commenced from the offshore Journa (ph 00:06:12) B platform. The platform was fully designed and constructed in Malaysia. At its peak, this development should produce 150 million cubic feet per day bringing expected total production for the Journa field to 600 million cubic feet per day. Including Volvay (ph 00:06:33) in Norway, Starling in the U.K. sector of the North Sea, Kizomba C Mondo in Angola, East Area Natural Gas Liquids II offshore Nigeria, and ACG Phase III in Azerbaijan we have completed seven major project startups to date in 2008. In addition to these startups, a major expansion was completed in the third quarter at the Tengiz field in Kazakhstan with the full startup at the sour gas injection second generation plant. This expansion increased Tengiz’s production capacity by 235,000 barrels per day, nearly doubling production capacity to 540,000 barrels per day. These major projects demonstrate our ongoing commitment to bring new supplies to market and deliver value to our shareholders. Also in the third quarter we announced that the Adriatic LNG terminal left its construction site in Spain and arrived in Italy successfully. Following a period of commissioning and testing, the terminal should reach full operational capacity in 2009. Once operational the terminal will have a regassification capacity of 8 billion cubic meters per year, equal to approximately 10% of Italy’s national natural gas consumption, and about 10% of installed LNG regassification capacity in Europe. In exploration we added to our global portfolio of outstanding deepwater exploration opportunities. In the recent Gulf of Mexico lease sale 207, we were the high bidder for 130 blocks totaling 83,000 acres and water depths ranging from 2,100 feet to almost 10,000 feet. In Brazil the deepwater drilling rig West Polaris arrived in Brazilian waters in late September and after concluding the required inspections and clearances has begun drilling the Azula well (ph 00:08:46) in Block BM-S-22. Plans to drill a second well on the block are underway and will follow immediately upon completion of the first well. Exxon Mobil is pleased to be participating in this exciting new subsalt play and will leverage all of our global experience and industry leading technologies in the exploration program. Also in exploration we continue to progress our high potential unconventional natural gas opportunities in Europe and North America. In both the lower Saxony Basin in Germany and the Mako Trough in southeast Hungary we began drilling operations and will conduct production tests over the next several months. In the Horn River Basin in Northeastern British Columbia, Canada we captured an additional 21,000 acres in the area bringing our total to 136,000 acres. Drilling in the Horn River area will commence during the fourth quarter. Moving now to the downstream, in refining we continue our activities to reduce raw material costs by managing our crude flexibility. This quarter Exxon Mobil ran 44 crudes that were new to individual refineries and eight that were new to the corporation. Also during the quarter in our lubricants business, we introduced our new aviation hydraulic fluid Hijet-5. Hijet-5 is the only product of its type with the highest grade approvals from Airbus and Boeing and demonstrates our commitment to develop technologically advanced products for our customers. In our chemical business we started up facilities at our plant in Pensacola, Florida to manufacture a revolutionary new tire material excore dynamically vulcanized alloy or DVA. Excore DVA achieved 7 to 10 times better air permeability than existing halibutal tire inter-liner materials. This allows for improved tire durability and better air pressure retention which improves vehicle fuel economy. Building on the strength of our integrated facilities and demonstrating our disciplined investment approach, we also started up facilities in our plant in Singapore to increase EXOL hydrocarbon fluid’s production. These facilities will increase capacity at the site by 130,000 tons per year to more than 500,000 tons per year, allowing us to meet growing demand for differentiated hydrocarbon fluid products in Asia Pacific. This expansion reinforces Singapore’s status as a world class hydrocarbon fluid’s complex along with Exxon Mobil’s facilities in Baytown, Texas and Antwerp, Belgium. Now turning to the business line results, upstream earnings in the third quarter excluding special items were $9.4 billion, up 3.1 billion from the third quarter of 2007. We continue to capture the benefit of strong industry conditions during the quarter, generating upstream after tax unit earnings of $28.27 per barrel. Crude oil and natural gas realizations increased earnings by $4.4 billion. Worldwide crude oil realizations were up more than $40 per barrel to just over $111 per barrel in the quarter. Natural gas realizations were up $3.82 per KCF from third quarter 2007 reflecting higher prices in all major producing regions. Lower crude oil and natural gas volumes reduced earnings by $1.3 billion. Other effects reduced earnings by $50 million primarily due to increased operating expense and higher taxes partly offset by positive foreign exchange effects and higher gains from asset sales. In total oil equivalent volumes decreased 8% from the third quarter of last year. Entitlement volume effects including price and spend impacts and PSC net interest reductions reduced volumes by 110,000 barrels per day. Excluding the impacts of lower entitlement volumes and also the hurricane impacts in the U.S. production was down 4.8%. This reduction includes the impact of higher maintenance activity and downtime which reduced volumes by just under 3%. Natural field decline in mature areas was largely offset by major project ramp-ups in West Africa and the North Sea. Liquids production decreased approximately 250,000 barrels per day, or 10% from the third quarter of last year. Excluding impacts related to lower entitlement volumes and hurricane impacts in the U.S. production was down about 5%. This reduction includes the impact of higher maintenance activity and natural field decline in mature areas largely offset by major project ramp-ups in West Africa and the North Sea. Gas volumes decreased 460 million cubic feet per day from the third quarter 2007. Natural field decline in mature areas along with increased maintenance activity and entitlement effects were partly offset by new project volumes. Turning now to the sequential comparison, versus the second quarter of 2008 upstream earning decreased $660 million due to lower crude oil realizations and higher expenses partly offset by increased gains from asset sales and positive foreign exchange effects. Liquids production decreased 4% due to entitlement volume effects, natural field decline, and hurricane impacts in the U.S. partly offset by new project volumes. Natural gas production was down nearly 8% driven by seasonally lower demand in Europe, higher maintenance activity, hurricane impacts in the U.S., and natural field decline. Oil equivalent volumes were down 5.5% from the second quarter. For further data on regional volumes please refer to the press release and IR supplement. Turning now to the downstream results, earnings in the third quarter were $3 billion, up $1 billion from the third quarter of 2007. Higher margins increased margins by $1.1 billion driven by stronger refining and marketing margins including positive price finalization effects of just over $700 million. Volume and mix effects increased earnings by $210 million as margin improvement activities more than offset lower sales volumes. Other effects reduced earnings by $270 million primarily due to negative foreign exchange effects. Sequentially third quarter earnings increased by $1.5 billion reflecting stronger refining and marketing margins including positive price finalization effects of just over $1 billion. Volume and mix effects increased earnings by $90 million including the impact of ongoing margin improvement activities. Other factors reduced earnings by $450 million largely due to adverse foreign exchange impacts and lower gains from asset sales. Focusing now on our chemical results, third quarter chemical earnings of $1.1 billion were $115 million lower than the third quarter of 2007. Lower margins reduced earnings by 55 million while lower volumes reduced earnings by $200 million, reflecting hurricane impacts in the U.S. and lower demand. Other impacts increased earnings by $140 million, reflecting positive foreign exchange and tax effects. Sequentially third quarter chemical earnings increased by $400 million. Higher margins reflecting increased realizations improved earnings by $630 million. This was partly offset by lower volumes which reduced earnings by $280 million. Turning now to our corporate and financing segment, corporate and financing expenses were $71 million excluding the Valdez interest charge down 21 million from a year ago primarily due to positive tax effects. The effective tax rate for the third quarter was 45%. Our cash balance was $37 billion and debt was $10 billion at the end of the third quarter. Exxon Mobil made share purchases in excess of dilution of $8 billion during the quarter, reducing the number of shares outstanding by 2.1%, again demonstrating our commitment to return cash to our shareholders. CAPEX in the third quarter was $6.9 billion, an increase of $1.4 billion, or 26% from the third quarter of 2007. We continue to invest actively in robust projects to help meet global demand for crude oil, natural gas, and finished products. In summary, this quarter’s results highlight the quality of our integrated business model and disciplined investment approach. In the upstream our outstanding portfolio of producing assets is performing well. While volumes were impacted by the price environment and higher maintenance activity, operational performance was solid and we delivered strong earnings in the quarter. In downstream and chemical, Exxon Mobil’s integrated operations and continued focus on efficiency improvement and optimization allowed us to deliver differentiated results. That concludes my prepared remarks. I would now be happy to take your questions.
Operator: Thank you sir. (Operator Instructions) We will go first to Paul Sankey of Deutsche Bank.
Paul Sankey – Deutsche Bank: Hi, good morning everybody.
David Rosenthal: Good morning Paul.
Paul Sankey – Deutsche Bank: Looking at these volumes, just a very high level question first of all, at the analyst meeting you said that you would be essentially down very mildly. That was the projection in 2008. And then there would be growth in 2009 all at a level of about 4 million barrels a day. I guess if we add back in the incitement volumes and the hurricanes and the maintenance and so on effectively you’re down about 2%. Should we expect growth from that lower level in 2009 or can you give us some sort of indication of how much flight volumes have been permanently impaired by what’s happened over the past few months relative to what you thought in March? Thanks.
David Rosenthal: Well Paul, as you pointed out, if we look at where we are so far this year and you exclude the price related effects and the hurricane impacts and the maintenance we would be down about 2% and that is consistent with the volume outlook that we tabled at the March analyst meeting. I would point out that the PSC effects, while they do improve – do impact volumes, the high price environment on those PSCs has generated substantial returns and we are very pleased with the results out of those PSCs. As we move forward into 2009 we will be providing another update at our March analyst meeting. But I would say the projects that we have that are underpinning the volume chart that we showed before are on track and progressing as planned.
Paul Sankey – Deutsche Bank: So would you –
David Rosenthal: We do expect – let me just follow-up on one comment – we do expect growth in ’09 of course related to the startup of our large cutter LNG trains.
Paul Sankey – Deutsche Bank: So we should expect growth – should we take the new level to be the down 2% and growth from there and disregard the March outlook?
David Rosenthal: No, I think what would be more appropriate would be to look at what we tabled in March of this year for the long-term projection and volumes. And again we’ll provide an update to that at the next analyst meeting in March.
Paul Sankey – Deutsche Bank: Just breaking down into the PSC effects I guess some of those lower volumes have gone forever but some of them are price related and will come back. Can you give us a sense of the breakdown of how much the PSC effects were? Even if you could that regionally it would be very helpful as well just so that we can get a sense of how big that number will be on a trailing and going forward basis.
David Rosenthal: Sure. If we look at the volumes of third quarter ’08 versus third quarter of ’07 we mentioned that the total impact is about 110,000 barrels per day. And about 57,000 barrels per day does represent net interest reductions which are permanent and the other 53 do represent the price and spend impacts which of course as you know are related to the price of oil at the time we recover those barrels to cover our costs and those will vary with crude prices.
Paul Sankey – Deutsche Bank: Okay.
David Rosenthal: And if I just follow up on your last question. About 40% of the total was in the Russia Caspian area, about a third in West Africa and little across the rest of our portfolio.
Paul Sankey – Deutsche Bank: And the prices would just stay flat from here. How would we model back in the line for what you just said about the permanent reduction? How would we model back in the (inaudible 00:16:29) on the sensitive side of that.
David Rosenthal: Well, the - of course the net interest reductions are permanent and won’t be impacted by the prices going forward whether they go up or down.
Paul Sankey – Deutsche Bank: Right.
David Rosenthal : And then of course, the price and spend impacts will depend on both the level of our costs and spend patterns as well as the price of oil at the time. But again, those are variable both from what our spending profile looks like as well as the absolute value of the oil.
Paul Sankey – Deutsche Bank: So you can’t give me a sense, say for example, if we held that 665 or whatever we’re at today. If we held that level can you give me a sense of - for where we’d be?
David Rosenthal: I really wouldn’t want to try to give us a sense cause again, that’s dependent on both the price of the oil and our level of spend. But directionally lower prices, you know would yield more barrels at the same level of spending but I really wouldn’t want to try to table a number going forward.
Paul Sankey – Deutsche Bank: On the maintenance activity and down time, that’s kind of a special item that recurs. Is there a pattern here that we do see high levels of maintenance and we should, in many ways, consider those, for example North Sea issues to be a permanent feature of life in a mature world of oil going forward?
David Rosenthal: Well, as you know, historically maintenance is higher in the second and third quarters. And as you know, we have a very robust and disciplined system of doing our maintenance and that does, as I mentioned, tend to be higher in the second and third quarter. We had maintenance which was particular higher in the third quarter of this year primarily in Nigeria. But going forward, you know, I would expect those volumes to come back as we get the majority of that maintenance work behind us heading into the fourth quarter.
Paul Sankey – Deutsche Bank: Okay. So finally, for me, could you just split out how much was Nigeria and how much was North Sea? How much was, I guess, Tanges (ph 00:18:37) was also down as well?
David Rosenthal: The bulk of it was in the North Sea and Nigeria with small effects elsewhere but I really wouldn’t want to go into more detail but the bulk of it was in Nigeria and the North Sea and as you know, as we come out of the third quarter the North Sea maintenance for both liquids and gas will be behind us and we’re making progress in Nigeria as well.
Paul Sankey – Deutsche Bank: Okay. I’ll leave it there. Thank you.
David Rosenthal: Thank you.
Operator: Our next question comes from Neil McMahon of Sanford Bernstein.
David Rosenthal: Good morning, Neil.
Neil McMahon – Sanford C. Bernstein & Company, Inc.: Good morning or even afternoon this side. A few questions. The first one is could you give us an update on a few of your longer term potential operations that are what is, as far as I can tell, sort of legal disputes at the minute such as Natuna and on Point Thompson? And then I’ve got a second question.
David Rosenthal: All right. If we look first at Natuna we are continuing to progress that project and you know, we continue to discuss with the government our ongoing project development there and those negotiations are continuing but - and we have certainly communicated to the Indonesian government a willingness to seek a mutually acceptable solution. And we would expect to continue to work on that over the course of the quarter but I do want to say that there really is no legal dispute at this time for Natuna. Our contract remains valid and we continue discussions with the government. If we move on to Point Thompson, ExxonMobil and the other Point Thompson working interest owners are proceeding with the project while we seek to resolve the dispute with the state over the Point Thompson unit and leases. We have completed many activities in field operations at the Point Thompson site in preparation for the multi-well drilling program. We’ve got several of the permits to do that program and we’re awaiting additional approvals from the state regulatory agencies that are necessary to allow drilling activities to continue.
Neil McMahon – Sanford C. Bernstein & Company, Inc.: I think that just on Point Thompson, I think there was meant to be some resolution by October 15th. So I was just wondering if there was any update on that. And secondly on Natuna, should we then expect Natuna to reappear in your Asono (ph 00:21:22) document on your (inaudible 00:21:26) document in terms of the major projects, start ups for the next decade.
David Rosenthal: Well, let me hit Point Thompson first. I’m not aware of any specific October 15th deadline but as I mentioned earlier, we are in ongoing discussions with the state of Alaska on bringing that project forward. As opposed to Natuna, you know as I mentioned we are looking to progress in Natuna and the outcome of the negotiations that are underway will determine our reporting going forward.
Neil McMahon – Sanford C. Bernstein & Company, Inc.: Just a second question looking at - obviously, your balance sheet is probably one of the best in the world if not the best in the world.
David Rosenthal: Thank you.
Neil McMahon – Sanford C. Bernstein & Company, Inc.: And it’s hardly extreme to say so given the size of it. And just looking at the amount of cash, you’ve got nearly $37 billion on the balance sheet. What should we be thinking about your buy back level going forward? Neither the value of the stock has fallen and also how do you think about acquisitions given current prices for stocks which have fallen dramatically the last few months?
David Rosenthal: Well, let’s talk about the cash that we have on the balance sheet and let me just step back a second and say, of course, the utilization of that cash in whatever avenue is designed to increase shareholder value over the long-term. As we look forward, of course our first priority is to fund our very robust investment program and as we’ve mentioned we expect to spend in the league of $25 to $35 billion a year in CapEx over the next five years. And we have no change to those plans at this time. The projects are progressing as we expected. The next thing we fund, of course, is the dividend and we have a history of growing the dividend. And that is, of course, one of the avenues of distributing cash to the shareholders. The last means of distributing cash to the shareholders is through the share buyback but I would -- we do that ratably over a long period of time and we don’t speculate on the price. We’re buying everyday across the time and you know, that program has continued.
Neil McMahon – Sanford C. Bernstein & Company, Inc.: Okay, thank you.
David Rosenthal: If we just come back to your follow up question related to M&A activity. I’d like to say that, of course M&A activity, our opportunities are just one of many opportunities that we look at on a continuing basis. I’ll tell you that was true at $140 a barrel and it’s true at $70 a barrel. We are monitoring what’s going on in the market but again, M&A is just one opportunity amongst many that we have and in particular, on a global basis that we’re monitoring and looking at it and evaluating on a constant basis.
Neil McMahon – Sanford C. Bernstein & Company, Inc.: Great, thank you.
Operator: Our next question comes from Mark Gilman of Benchmark Company.
David Rosenthal: Good morning, Mark.
Mark Gilman – The Benchmark Company: David, good morning. I had a couple of things I wanted to go over. Of the net interest reductions cited in your production chart, did any occur in the third quarter precisely? Looks to me as if that’s just the carry over affect from impacts earlier in the year given that it’s a reduction from a 90 something number in 2Q same basis.
David Rosenthal: A lot of it is carry over as you suggested but specifically in the third quarter we did see some impacts from net interest deductions. Although they were small across a number of areas, nothing I would single out individually.
Mark Gilman – The Benchmark Company: Okay. Can you identify in a $60, $70 a barrel world, where going forward such might be anticipated?
David Rosenthal:
–:
Mark Gilman – The Benchmark Company: In interest reductions.
David Rosenthal: Oh, the permanent net interest reduction?
Mark Gilman – The Benchmark Company: Yeah.
David Rosenthal: Well, Mark, as you know only about 20% of our production portfolio is under PSEs and going forward, on a particular bice (ph 00:26:00) basis I couldn’t really offer any specifics. You know, but again there’s the net interest reductions and the price and spend impacts as we go forward.
Mark Gilman – The Benchmark Company: Okay. Let me try something else. It looks to me as if there was a massive net working capital increase in the third quarter which given the drop in prices is, to say the least, a bit counterintuitive. Is that accurate and why did it occur?
David Rosenthal: If you’re talking about our working capital change sequentially or quarter on quarter?
Mark Gilman – The Benchmark Company: Well, I’m just looking at the third quarter specifically, David, and in order to get to that cash flow from operations number indicated in your press release. About the only way for that to happen would be if there was a significant increase in working capital which I say in a lower, in a falling price environment is counterintuitive.
David Rosenthal: Well, we did see fairly significant changes in our working capital in the third quarter but those were related to a number of items both on the payable side and the receivable side given the change in the prices.
Mark Gilman – The Benchmark Company: Okay, but there was an increase?
David Rosenthal: Yes. Yeah, we did see an increase in the quarter.
Mark Gilman – The Benchmark Company: Okay. Could you - you mentioned in going through the variances in the segments on several occasions the impact of asset sales. Can you quantify, you know in reasonably specific terms, what the asset sales benefits were? Or if it’s a negative number, I doubt that, in the third quarter in the various segments.
David Rosenthal: Well, Mark as we look across the segments in the third quarter. Basically we had some of our just usual ongoing business. Don’t have anything specific to highlight in any of these segments with the exception, perhaps, we divest our Barnett Shell business in the upstream as you’re aware of. The really significant asset sale, of course, was the sale of our upstream gas transportation business in Germany which we did highlight as a special item. But other than the event I would characterize the rest of our asset sales across the segment as business as usual.
Mark Gilman – The Benchmark Company: Okay. One final one for me, David. The $500 million figure cited in the press release, you know in terms of the earnings impact of damage repairs and lower volumes in the fourth quarter. That just sounds like an awfully large kind of number. Can you put some color on that in terms of its pieces? You know particularly given your comment that most of the activity with respect to Beaumont chemical facility, you know, was really back on line.
David Rosenthal: Well, let me answer the last part of your question first and I’ll come back to the first part. If we look across our footprint in the Gulf of all of our assets, most of them are back up or will soon be back up. The one exception is the Beaumont chemical plant where we did sustain a fair amount of damage and that plant is not up. And we are continuing to progress repairs at those facilities. If we look back at the $500 million number mentioned in the press release. That’s split about evenly between loss volumes and also repair costs as we move into the quarter but yeah, it’s about 50/50 on repair costs and volume effects.
Mark Gilman – The Benchmark Company: Was the volume effect primarily on the chemical side?
David Rosenthal: It somewhat in the chemical side but also on the upstream side. We would expect it as we mentioned we had about 24 KBD down in the third quarter, most of that late in the quarter. As we move into the fourth quarter on those volumes, while most of our producing facilities are back online, in many cases we are awaiting third party facilities to be up and running. So our best guess, if we look quarter to quarter, average across the quarter, we’ll be down about the same 24,000 barrels a day. So the upstream volumes and some of the other volumes, again about half that $500 million with the balance being repair expense for the facilities that were damaged in the hurricane.
Mark Gilman – The Benchmark Company: Thank you, David.
David Rosenthal: Thank you.
Operator: Our next question comes from Erik Mielke of Merrill Lynch.
David Rosenthal: Good morning, Erik.
Erik Mielke – Merrill Lynch: Yeah, good morning. I apologize I have a bit of a sore throat so if I sound a bit funny that’s the reason for that.
David Rosenthal: Okay.
Erik Mielke – Merrill Lynch: Could you give us an update on the Catare (ph 00:31:08) projects specifically on timing and completion? You previously mentioned that train four should be ramping up in the fourth quarter and train six should be sometime early in 2009.
David Rosenthal: Sure, I’d be happy to provide an update. The train four commissioning is proceeding well and we expect to be producing L&G from train four in the winter, of this winter 2008/2009. Train five, of course, will start up in 2009 and train six, (inaudible 00:31:40) train six will begin commissioning in late 2008 with first L&G production expected in the first part of 2009. And finally train seven, of course, is projected to start up later in 2009. But let me also comment overall on the status of these projects. As you know, these are the largest L&G trains in the world. These are great projects for us and they are all progressing as planned, as expected and we expect the production from those to come on as we expected.
Erik Mielke – Merrill Lynch: Should we expect a meaningful contribution to volumes in the fourth quarter?
David Rosenthal: No, I would not expect a meaningful contribution in the fourth quarter but you’ll start to see the ramp up as we head into the first quarter of ’09.
Erik Mielke – Merrill Lynch: And the amount in those volumes, are you limited to Italy, the U.K. and the U.S.?
David Rosenthal: Well, I don’t want to really comment on any specific destination of the specific shipments. We do have some flexibility and of course, the volumes are going to individual markets at any point and time will depend on the conditions and the contractual arrangements in place but other than that, I really wouldn’t want to comment on any specifics of the commercial arrangements.
Erik Mielke – Merrill Lynch: Okay and can I ask a very quick extra question on oil sands.
David Rosenthal: Sure.
Erik Mielke – Merrill Lynch: We’ve seen some of your peers announce delays to various oil sands projects. Can you just confirm that you’re still happy with your (inaudible 00:33:24) project?
David Rosenthal: I’d be happy to confirm that because we are happy with the Coral (ph 00:33:30) project. We’re committed. Continue to be committed. As you know the Coral project is an advantaged resource in the oil sands province mainly because of the quality of that resource and the scale of it. As we looked at Coral from the beginning we did evaluate those economics over a broad range of prices as we do all of our investment opportunities. And as we look at the economics of Coral going forward, it continues to look like a robust project for us. In fact, as you mentioned, some of the other oil sands projects may be slowing down or whatever. That could actually provide some benefit to us in respect to lower costs of both raw materials and services given what’s going in some of the major commodity products but again, we are progressing. The detail designed engineering is underway and long lead procurement items are being advanced. And we would expect to be in a position to reach a final investment decision sometime in 2009.
Erik Mielke – Merrill Lynch: Very good, thank you.
David Rosenthal: Thank you.
Operator: Our next question comes from Jason Gammel of Macquarie.
David Rosenthal: Good morning, Jason.
Jason Gammel - Macquarie Research Equities: Good morning, David. How are you?
David Rosenthal: I’m fine, thank you.
Jason Gammel – Macquarie Research Equities: I wanted to ask a question about defined product sales. Year over year they were down about 6% in the quarter. It seemed to be essentially across all regions. Would you be able to talk about how much of that was related to maybe divestitures, effects of hurricanes, etc. versus just what you’re seeing in terms of weak demand?
David Rosenthal: Well, we’re seeing the impact of all of those factors that you mentioned. Demand is, of course, a piece of that particularly in the OECD countries. Although, we do still see a little growth in the non-OEC countries but we also, of course, have the effect of the hurricane and we do have some effect of divestments but I wouldn’t want to give any specifics on any of those individually. It’s a mixture of all of them but I’d say overall, you know, there’s an impact on demand in the OECD countries as well as the other effects we mentioned but pretty much across the board.
Jason Gammel – Macquarie Research Equities: Great, thanks. If I could ask one more on the effect of tax rate, it was down about four percentage points versus what we saw in the first half of the year. Is that really just primarily a reflection of the relatively higher contribution of down-stream or are there some adjustments and accrual factors we should know about?
David Rosenthal: Well, it’s clearly, (inaudible 00:36:24) you hit the nail on the head there. It is a function to some extent of the higher proportion of down-stream earnings. The other impact that we have in there relates to our Germany asset sale. That did carry a low tax rate and so those are the two primary factors in the quarter-to-quarter decrease in our effected tax rate.
Jason Gammel – Macquarie Research Equities: Thank you, David.
David Rosenthal: Thank you.
Operator: Our next question comes from Paul Cheng of Barclays Company.
David Rosenthal: Good morning, Paul.
[Paul Cheng – Barclays Company]: Hey, good morning. Dave, two simple questions, one, you’re talking about the share buy-back (inaudible 00:37:02) third quarter excluding the (inaudible 00:37:07) effect, you’re buying about eight billion. Can you tell us what is the run rate for the fourth quarter? Secondly, I want to see if you can make any comment in terms of overall cost pressure in the industry over the last (inaudible 00:37:23) year have been phenomenal, have you seen any visible signs, you start to crack and coming down?
David Rosenthal: Let me hit share buy-back question first. I really don’t want to provide a forward statement on what are expected share buy-back program will look like in the fourth quarter. As we look at the cost structure, yes, commodity prices are coming down. For example, steel, concrete, cooper, and other commodities and while it is a little early to tell the extent and timing effect of those prices on our business and our projects in particular, I can tell you that we are actively chasing the lag out of that process and working hard to realize and deliver any cost savings that the market may generate as quickly as possible and as I mentioned earlier, particular on some of our major projects that are just now getting underway, we’ll be working very hard to ensure that the lower cost we’re seeing in some of these goods and services does translate directly into lower costs of those projects to the extent possible.
[Paul Cheng – Barclays Company]: Dave, if I could, just follow-up on that. On the drilling rate on the deep-water, I think in the past that, if I recall correctly, you only have a commitment up to 2010 so that means that in the event that the (inaudible 00:38:54) rates start to come down, you should be able to take advantage on that. Is that a true statement or do you actually have commitment beyond 2010 already?
David Rosenthal: Well, rather then picking any particular year, what I would say overall is we are only committed to the extent that we have firm obligations. For example, we’ve just taken delivery of two new rigs and one of them, as I mentioned, is drilling the well in Brazil as we speak. What happens going forward with rig rates and other expenses, you know, we’ll just have to see how that shakes out going forward. But, I think what you’ll see is a lot of our commitment wells over the next couple of years are going to covered by the two new rigs that we’ve just taken delivery on as we continue to actively explore some of the outstanding exploration prospects that we have underway.
[Paul Cheng – Barclays Company]: Dave, final one, go back to your earlier question, you don’t want to give a number for the fourth quarter, understandable for the share buy-back. Can you tell us what is your (inaudible 00:40:10) in October?
David Rosenthal: No, I really don’t want to give any kind of a run rate. While we mentioned what the total purchases were in the third quarter and I’ll probably just leave at that.
[Paul Cheng – Barclays Company]: Okay, thanks.
David Rosenthal: Thank you.
Operator: And as a reminder it’s star 1 if you would like to signal for a question. We’ll go next to Robert Kessler of Simmons & Company.
Robert Kessler – Simmons & Company International: Good morning, David.
David Rosenthal: Good morning Robert, how are you?
Robert Kessler – Simmons & Company International: Good. This might be more of a nuance question but you mentioned a couple of times now that the inflationary trends that you’re seeing in the capital investment side of things and then you’ve reiterated this $25 to $30 billion per year spending for the next five years. I’m assuming that was calibrated giving consideration to the inflationary environment we witnessing at the time. So, just as you think about that program in the new environment, should we expect you to perhaps to spend less with the same activity to the extend deflation occurs or would you sort of pick up your activity to take advantage of the lower costs and then fill the gap and spend the same amount?
David Rosenthal: Well, that’s a good question and if you look at our major projects that are underway or in the early stages, these are very long-term large scale projects. And as I mentioned earlier, when we’re analyzing and evaluating those projects, we do look at them over a fairly broad range of prices and they are robust again across that range. As we look out into the future, we’re just going to need to just see what the impact is of these costs and how quickly they come through and what impact they have on the projects. But I would like to say overall, that we pursue investment opportunities, we don’t have spend target, if we mention the $25 to $30 billion a year going forward, that’s not a target that’s an outcome or an expectation that’s generated from the project portfolio that we’re pursuing. And as we continue to pursue that portfolio of projects, whatever impact, or help we get on prices will be realized in that. But again, we will be pursing all investment opportunities that we view as being robust and generate long term shareholder value.
Robert Kessler – Simmons & Company International: Makes sense, thanks, David.
David Rosenthal: Thank you.
Operator: And we’ll go back to Neil McMahon of Sanford Bernstein.
Neil McMahon – Sanford C. Bernstein & Company, Inc.: Hi, I’ve just got a follow-up call on the timing of any Brazil announcements. Have you got any guess estimate on roughly when the well will finish drilling? I think the idea was around the end of the year, start of next year?
David Rosenthal: Yes, as I mentioned the well has spudded and we would expect that well to be down by the end of the year, first of next year.
Neil McMahon – Sanford C. Bernstein & Company, Inc.: And I know you’re last vocal any many of your peers especially the smaller NP companies, would you be making any announcements around about that time?
David Rosenthal: You know I wouldn’t want to speculate on exactly when we’ll make an announcement but as soon as we’re ready and have information to provide, we’ll make that announcement.
Neil McMahon – Sanford C. Bernstein & Company, Inc.: Great, thanks.
David Rosenthal: Thank you.
Operator: We’ll go next to Paul Sankey, Deutsche Bank.
David Rosenthal: Yes, Paul.
Operator: (Operator instructions)
Paul Sankey – Deutsche Bank: My question was answered, I beg your pardon.
David Rosenthal: Thank you.
Operator: Not a problem, we’ll go back to Mark Gilman of Benchmark and Company.
Mark Gilman – The Benchmark Company: David, can you quantify the Nigerian maintenance impact on the third quarter, volume (inaudible 00:43:53}?
David Rosenthal: If we look at the total maintenance effect that we mentioned, about 3% of the decline, I would tell you again that the two largest components there were the North Sea and Nigeria. And while Nigeria was a major factor, I wouldn’t really want to single it out and give a specific number. But just to say that of that 100,000 barrels that we talked about, the two biggest impacts were your normal third quarter North Sea maintenance and Nigeria, but I think the key thing for us is that maintenance work has been successful and as we go forward we’d be expecting to see those volumes coming back.
Mark Gilman – The Benchmark Company: Okay, could you provide absolute price finalization numbers for the third quarter split US and foreign?
David Rosenthal: Sure, I’d be happy to provide that for you. If we look at the absolute values for the price finalization in the third quarter of 08, we were about $600 million in total, about two thirds of that U.S. and about a third of that non-U.S.
Mark Gilman – The Benchmark Company: Thank you, David.
David Rosenthal: Okay, thank you.
Operator: (Operator instructions) We’ll go back to Jason Gammel of Macquarie.
Jason Gammel – Macquarie Research Equities: David, I just wanted to complete the loop on the LNG infrastructure progress, can you talk about Golden Pass, where you’re at in terms of construction and when you expect to have first cargos in that facility?
David Rosenthal: Sure, as you know, Golden Pass is our larger LNG regasication (misspelled? 00:45:42) project in the U.S. It’s progressing along on schedule. We did have some hurricane impacts on the project and we’re assessing the impact of that and determining what restorative work will be needed. But I have to say we are still in the assessment stage and not prepared to give any specific indications on cost impact or schedule. We’re working through all of that and we’ll provide an update as we have more information.
Jason Gammel – Macquarie Research Equities: Thanks and if I could just one more on Golden Path, should we think of that as a terminal that will essentially have very steady (inaudible 00:46:28) volumes or will this be a facility that just takes advantage of price arbitrage in the North American market versus the other markets that you serve?
David Rosenthal: Well, I wouldn’t want to make a prediction on any type of a short-term basis. As you know, all of our LNG investments across the value chain are long-term in nature and are not subject to short-term variations in prices or supply demand balances. We do expect some volumes will come into the Golden Pass terminal, but I wouldn’t want to try to give a specific profile especially near-term. Again, if we think longer term the U.S. is going to need more LNG and we feel like we’re well positioned to meet that need from a number of standpoints including LNG out of cutter into our Golden Path terminal. But again, it’s a very long-term project meeting a very long-term need for gas into the U.S.
Jason Gammel – Macquarie Research Equities: Okay, appreciate it that, David, thanks.
David Rosenthal: Thank you.
Operator: That’s all the time we have for questions, I’d like to turn the call back over to Mr. Rosenthal for any additional or closing remarks.
David Rosenthal: Thank you very much. I’d like to close by commenting in a current volatile commodity and credit environments, we remain confident in our ability to deliver industry leading projects and grow shareholder value. Our financial strength, discipline investment approach, commitment to operational excellence and technology development continue to serve as well. I thank all of you for your time and your questions this morning.
Operator: And again ladies and gentlemen this does conclude today’s conference. We thank you for your participation, you may disconnect at this time. | [
{
"speaker": "Executives",
"text": "David Rosenthal – Vice President of Investor Relations, Secretary"
},
{
"speaker": "Analysts",
"text": "Paul Sankey – Deutsche Bank Neil McMahon – Sanford C. Bernstein & Company, Inc."
},
{
"speaker": "–",
"text": ""
},
{
"speaker": "–",
"text": "Jason Gammel – Macquarie Research Equities [Paul Cheng – Barclays Company] Robert Kessler – Simmons & Company International"
},
{
"speaker": "Operator",
"text": "Good day everyone and welcome to the Exxon Mobil corporation third quarter 2008 earnings conference call. Today’s call is being recorded. At this time for opening remarks and introductions, I’d like to turn the call over to the Vice President of Investor Relations and Secretary, Mr. David Rosenthal. Please go ahead sir."
},
{
"speaker": "David Rosenthal",
"text": "Good morning and welcome to Exxon Mobil’s teleconference and webcast on our third quarter 2008 financial and operating results. As you are aware from this morning’s press release Exxon Mobil’s net income in the third quarter was a record for the corporation. Our integrated business portfolio, strong operational performance, and financial discipline continue to allow us to capture the benefits of the commodity price environment. Despite recent volatility in the financial, commodity, and credit markets the fundamentals at Exxon Mobil’s business remain strong and we continue to invest are record levels to bring new supplies to market. Before we go further I would like to draw your attention to our cautionary statement. Please note that estimates, plans, and expectations are forward-looking statements. Actual results, including resource recoveries, volume growth, and project outcomes could differ materially due to factors I discuss and factors noted in our SEC filings. Please see factors affecting future results and the Form 8-K we furnished this morning, which are available through the Investors section of our website. Please also see the frequently used terms, the supplements to this morning's press release, and the 2007 financial and operating review on our website. This material defines key terms I will use today, shows Exxon Mobil's net interest in specific projects, and includes our SEC Regulation G disclosure. Now, I'm pleased to turn your attention to the third quarter results. Exxon Mobil's third quarter 2008 net income was $14.8 billion, an increase of $5.4 billion from the third quarter of 2007. Third quarter 2008 net income included a $1.6 billion gain on the sale of our German gas transportation business which we commented on in our second quarter earnings teleconference and a special charge of $170 million for interest related to the Valdez punitive damages award. Third quarter normalized earnings, excluding special items, were $13.4 billion, up almost 4 billion from the third quarter of 2007. Normalized earnings per share were $2.59 per share, up 52% from a year ago, reflecting the strong earnings performance and the benefits of our share purchase program. During the third quarter of 2008, Exxon Mobil distributed a total of 10.1 billion to shareholders, including dividends of 2.1 billion and share purchased to reduce shares outstanding of $8 billion. Before I discuss our specific business results in more detail, I would like to make a few comments on the impact of the hurricanes which hit the Gulf Coast of Texas and Louisiana in September. Hurricanes Gustav and Ike were significant events for our employees, their families, and many communities across the Gulf Coast. Our top priority was the safety of our employees and the communities in which we operate. Our response plan and the diligence of our employees ensured the safe shutdown of platforms, refineries, and chemical plants in the path of the hurricanes. As part of our preparation and activities we worked diligently to bring additional fuel supply to our customers. For example we sourced gasoline from oversees and also purchased volumes in the U.S. to supplement our own production. In addition, Exxon Mobil has provided a total of $6.8 million in relief to help communities directly affected by the hurricanes. The majority of our upstream production operations and downstream refineries are now back online or completing the final stages of startup. However, the Beaumont chemical plant experienced more extensive water damage than our other facilities. And we continue to progress repairs and develop our restar plans. As a result of the hurricanes third quarter upstream volumes were down 24,000 oil equivalent barrels per day and costs were higher by $50 million before tax. Looking forward we expect damage repairs and lower volumes across all business lines associated with the hurricanes to reduce earnings by about $500 million in the fourth quarter. I would now like to share some of the milestones we have achieved since the last earnings call. Following the startup of the Mondo field in January this year we successfully started up the Saxi and Batuque fields in the third quarter, completing the second Kizomba C FPSO startup in Block 15 offshore Angola. The three fields comprising the Kizomba C development, Mondo, Saxi, and Batuque are now producing at a combined rate of 200,000 barrels per day and are expected to recover approximately 600 million barrels of oil. Daily production from the Exxon Mobil operated Block 15 developments in Angola has now reached approximately 700,000 barrels per day. In Malaysia natural gas production commenced from the offshore Journa (ph 00:06:12) B platform. The platform was fully designed and constructed in Malaysia. At its peak, this development should produce 150 million cubic feet per day bringing expected total production for the Journa field to 600 million cubic feet per day. Including Volvay (ph 00:06:33) in Norway, Starling in the U.K. sector of the North Sea, Kizomba C Mondo in Angola, East Area Natural Gas Liquids II offshore Nigeria, and ACG Phase III in Azerbaijan we have completed seven major project startups to date in 2008. In addition to these startups, a major expansion was completed in the third quarter at the Tengiz field in Kazakhstan with the full startup at the sour gas injection second generation plant. This expansion increased Tengiz’s production capacity by 235,000 barrels per day, nearly doubling production capacity to 540,000 barrels per day. These major projects demonstrate our ongoing commitment to bring new supplies to market and deliver value to our shareholders. Also in the third quarter we announced that the Adriatic LNG terminal left its construction site in Spain and arrived in Italy successfully. Following a period of commissioning and testing, the terminal should reach full operational capacity in 2009. Once operational the terminal will have a regassification capacity of 8 billion cubic meters per year, equal to approximately 10% of Italy’s national natural gas consumption, and about 10% of installed LNG regassification capacity in Europe. In exploration we added to our global portfolio of outstanding deepwater exploration opportunities. In the recent Gulf of Mexico lease sale 207, we were the high bidder for 130 blocks totaling 83,000 acres and water depths ranging from 2,100 feet to almost 10,000 feet. In Brazil the deepwater drilling rig West Polaris arrived in Brazilian waters in late September and after concluding the required inspections and clearances has begun drilling the Azula well (ph 00:08:46) in Block BM-S-22. Plans to drill a second well on the block are underway and will follow immediately upon completion of the first well. Exxon Mobil is pleased to be participating in this exciting new subsalt play and will leverage all of our global experience and industry leading technologies in the exploration program. Also in exploration we continue to progress our high potential unconventional natural gas opportunities in Europe and North America. In both the lower Saxony Basin in Germany and the Mako Trough in southeast Hungary we began drilling operations and will conduct production tests over the next several months. In the Horn River Basin in Northeastern British Columbia, Canada we captured an additional 21,000 acres in the area bringing our total to 136,000 acres. Drilling in the Horn River area will commence during the fourth quarter. Moving now to the downstream, in refining we continue our activities to reduce raw material costs by managing our crude flexibility. This quarter Exxon Mobil ran 44 crudes that were new to individual refineries and eight that were new to the corporation. Also during the quarter in our lubricants business, we introduced our new aviation hydraulic fluid Hijet-5. Hijet-5 is the only product of its type with the highest grade approvals from Airbus and Boeing and demonstrates our commitment to develop technologically advanced products for our customers. In our chemical business we started up facilities at our plant in Pensacola, Florida to manufacture a revolutionary new tire material excore dynamically vulcanized alloy or DVA. Excore DVA achieved 7 to 10 times better air permeability than existing halibutal tire inter-liner materials. This allows for improved tire durability and better air pressure retention which improves vehicle fuel economy. Building on the strength of our integrated facilities and demonstrating our disciplined investment approach, we also started up facilities in our plant in Singapore to increase EXOL hydrocarbon fluid’s production. These facilities will increase capacity at the site by 130,000 tons per year to more than 500,000 tons per year, allowing us to meet growing demand for differentiated hydrocarbon fluid products in Asia Pacific. This expansion reinforces Singapore’s status as a world class hydrocarbon fluid’s complex along with Exxon Mobil’s facilities in Baytown, Texas and Antwerp, Belgium. Now turning to the business line results, upstream earnings in the third quarter excluding special items were $9.4 billion, up 3.1 billion from the third quarter of 2007. We continue to capture the benefit of strong industry conditions during the quarter, generating upstream after tax unit earnings of $28.27 per barrel. Crude oil and natural gas realizations increased earnings by $4.4 billion. Worldwide crude oil realizations were up more than $40 per barrel to just over $111 per barrel in the quarter. Natural gas realizations were up $3.82 per KCF from third quarter 2007 reflecting higher prices in all major producing regions. Lower crude oil and natural gas volumes reduced earnings by $1.3 billion. Other effects reduced earnings by $50 million primarily due to increased operating expense and higher taxes partly offset by positive foreign exchange effects and higher gains from asset sales. In total oil equivalent volumes decreased 8% from the third quarter of last year. Entitlement volume effects including price and spend impacts and PSC net interest reductions reduced volumes by 110,000 barrels per day. Excluding the impacts of lower entitlement volumes and also the hurricane impacts in the U.S. production was down 4.8%. This reduction includes the impact of higher maintenance activity and downtime which reduced volumes by just under 3%. Natural field decline in mature areas was largely offset by major project ramp-ups in West Africa and the North Sea. Liquids production decreased approximately 250,000 barrels per day, or 10% from the third quarter of last year. Excluding impacts related to lower entitlement volumes and hurricane impacts in the U.S. production was down about 5%. This reduction includes the impact of higher maintenance activity and natural field decline in mature areas largely offset by major project ramp-ups in West Africa and the North Sea. Gas volumes decreased 460 million cubic feet per day from the third quarter 2007. Natural field decline in mature areas along with increased maintenance activity and entitlement effects were partly offset by new project volumes. Turning now to the sequential comparison, versus the second quarter of 2008 upstream earning decreased $660 million due to lower crude oil realizations and higher expenses partly offset by increased gains from asset sales and positive foreign exchange effects. Liquids production decreased 4% due to entitlement volume effects, natural field decline, and hurricane impacts in the U.S. partly offset by new project volumes. Natural gas production was down nearly 8% driven by seasonally lower demand in Europe, higher maintenance activity, hurricane impacts in the U.S., and natural field decline. Oil equivalent volumes were down 5.5% from the second quarter. For further data on regional volumes please refer to the press release and IR supplement. Turning now to the downstream results, earnings in the third quarter were $3 billion, up $1 billion from the third quarter of 2007. Higher margins increased margins by $1.1 billion driven by stronger refining and marketing margins including positive price finalization effects of just over $700 million. Volume and mix effects increased earnings by $210 million as margin improvement activities more than offset lower sales volumes. Other effects reduced earnings by $270 million primarily due to negative foreign exchange effects. Sequentially third quarter earnings increased by $1.5 billion reflecting stronger refining and marketing margins including positive price finalization effects of just over $1 billion. Volume and mix effects increased earnings by $90 million including the impact of ongoing margin improvement activities. Other factors reduced earnings by $450 million largely due to adverse foreign exchange impacts and lower gains from asset sales. Focusing now on our chemical results, third quarter chemical earnings of $1.1 billion were $115 million lower than the third quarter of 2007. Lower margins reduced earnings by 55 million while lower volumes reduced earnings by $200 million, reflecting hurricane impacts in the U.S. and lower demand. Other impacts increased earnings by $140 million, reflecting positive foreign exchange and tax effects. Sequentially third quarter chemical earnings increased by $400 million. Higher margins reflecting increased realizations improved earnings by $630 million. This was partly offset by lower volumes which reduced earnings by $280 million. Turning now to our corporate and financing segment, corporate and financing expenses were $71 million excluding the Valdez interest charge down 21 million from a year ago primarily due to positive tax effects. The effective tax rate for the third quarter was 45%. Our cash balance was $37 billion and debt was $10 billion at the end of the third quarter. Exxon Mobil made share purchases in excess of dilution of $8 billion during the quarter, reducing the number of shares outstanding by 2.1%, again demonstrating our commitment to return cash to our shareholders. CAPEX in the third quarter was $6.9 billion, an increase of $1.4 billion, or 26% from the third quarter of 2007. We continue to invest actively in robust projects to help meet global demand for crude oil, natural gas, and finished products. In summary, this quarter’s results highlight the quality of our integrated business model and disciplined investment approach. In the upstream our outstanding portfolio of producing assets is performing well. While volumes were impacted by the price environment and higher maintenance activity, operational performance was solid and we delivered strong earnings in the quarter. In downstream and chemical, Exxon Mobil’s integrated operations and continued focus on efficiency improvement and optimization allowed us to deliver differentiated results. That concludes my prepared remarks. I would now be happy to take your questions."
},
{
"speaker": "Operator",
"text": "Thank you sir. (Operator Instructions) We will go first to Paul Sankey of Deutsche Bank."
},
{
"speaker": "Paul Sankey – Deutsche Bank",
"text": "Hi, good morning everybody."
},
{
"speaker": "David Rosenthal",
"text": "Good morning Paul."
},
{
"speaker": "Paul Sankey – Deutsche Bank",
"text": "Looking at these volumes, just a very high level question first of all, at the analyst meeting you said that you would be essentially down very mildly. That was the projection in 2008. And then there would be growth in 2009 all at a level of about 4 million barrels a day. I guess if we add back in the incitement volumes and the hurricanes and the maintenance and so on effectively you’re down about 2%. Should we expect growth from that lower level in 2009 or can you give us some sort of indication of how much flight volumes have been permanently impaired by what’s happened over the past few months relative to what you thought in March? Thanks."
},
{
"speaker": "David Rosenthal",
"text": "Well Paul, as you pointed out, if we look at where we are so far this year and you exclude the price related effects and the hurricane impacts and the maintenance we would be down about 2% and that is consistent with the volume outlook that we tabled at the March analyst meeting. I would point out that the PSC effects, while they do improve – do impact volumes, the high price environment on those PSCs has generated substantial returns and we are very pleased with the results out of those PSCs. As we move forward into 2009 we will be providing another update at our March analyst meeting. But I would say the projects that we have that are underpinning the volume chart that we showed before are on track and progressing as planned."
},
{
"speaker": "Paul Sankey – Deutsche Bank",
"text": "So would you –"
},
{
"speaker": "David Rosenthal",
"text": "We do expect – let me just follow-up on one comment – we do expect growth in ’09 of course related to the startup of our large cutter LNG trains."
},
{
"speaker": "Paul Sankey – Deutsche Bank",
"text": "So we should expect growth – should we take the new level to be the down 2% and growth from there and disregard the March outlook?"
},
{
"speaker": "David Rosenthal",
"text": "No, I think what would be more appropriate would be to look at what we tabled in March of this year for the long-term projection and volumes. And again we’ll provide an update to that at the next analyst meeting in March."
},
{
"speaker": "Paul Sankey – Deutsche Bank",
"text": "Just breaking down into the PSC effects I guess some of those lower volumes have gone forever but some of them are price related and will come back. Can you give us a sense of the breakdown of how much the PSC effects were? Even if you could that regionally it would be very helpful as well just so that we can get a sense of how big that number will be on a trailing and going forward basis."
},
{
"speaker": "David Rosenthal",
"text": "Sure. If we look at the volumes of third quarter ’08 versus third quarter of ’07 we mentioned that the total impact is about 110,000 barrels per day. And about 57,000 barrels per day does represent net interest reductions which are permanent and the other 53 do represent the price and spend impacts which of course as you know are related to the price of oil at the time we recover those barrels to cover our costs and those will vary with crude prices."
},
{
"speaker": "Paul Sankey – Deutsche Bank",
"text": "Okay."
},
{
"speaker": "David Rosenthal",
"text": "And if I just follow up on your last question. About 40% of the total was in the Russia Caspian area, about a third in West Africa and little across the rest of our portfolio."
},
{
"speaker": "Paul Sankey – Deutsche Bank",
"text": "And the prices would just stay flat from here. How would we model back in the line for what you just said about the permanent reduction? How would we model back in the (inaudible 00:16:29) on the sensitive side of that."
},
{
"speaker": "David Rosenthal",
"text": "Well, the - of course the net interest reductions are permanent and won’t be impacted by the prices going forward whether they go up or down."
},
{
"speaker": "Paul Sankey – Deutsche Bank",
"text": "Right."
},
{
"speaker": "David Rosenthal",
"text": "And then of course, the price and spend impacts will depend on both the level of our costs and spend patterns as well as the price of oil at the time. But again, those are variable both from what our spending profile looks like as well as the absolute value of the oil."
},
{
"speaker": "Paul Sankey – Deutsche Bank",
"text": "So you can’t give me a sense, say for example, if we held that 665 or whatever we’re at today. If we held that level can you give me a sense of - for where we’d be?"
},
{
"speaker": "David Rosenthal",
"text": "I really wouldn’t want to try to give us a sense cause again, that’s dependent on both the price of the oil and our level of spend. But directionally lower prices, you know would yield more barrels at the same level of spending but I really wouldn’t want to try to table a number going forward."
},
{
"speaker": "Paul Sankey – Deutsche Bank",
"text": "On the maintenance activity and down time, that’s kind of a special item that recurs. Is there a pattern here that we do see high levels of maintenance and we should, in many ways, consider those, for example North Sea issues to be a permanent feature of life in a mature world of oil going forward?"
},
{
"speaker": "David Rosenthal",
"text": "Well, as you know, historically maintenance is higher in the second and third quarters. And as you know, we have a very robust and disciplined system of doing our maintenance and that does, as I mentioned, tend to be higher in the second and third quarter. We had maintenance which was particular higher in the third quarter of this year primarily in Nigeria. But going forward, you know, I would expect those volumes to come back as we get the majority of that maintenance work behind us heading into the fourth quarter."
},
{
"speaker": "Paul Sankey – Deutsche Bank",
"text": "Okay. So finally, for me, could you just split out how much was Nigeria and how much was North Sea? How much was, I guess, Tanges (ph 00:18:37) was also down as well?"
},
{
"speaker": "David Rosenthal",
"text": "The bulk of it was in the North Sea and Nigeria with small effects elsewhere but I really wouldn’t want to go into more detail but the bulk of it was in Nigeria and the North Sea and as you know, as we come out of the third quarter the North Sea maintenance for both liquids and gas will be behind us and we’re making progress in Nigeria as well."
},
{
"speaker": "Paul Sankey – Deutsche Bank",
"text": "Okay. I’ll leave it there. Thank you."
},
{
"speaker": "David Rosenthal",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Neil McMahon of Sanford Bernstein."
},
{
"speaker": "David Rosenthal",
"text": "Good morning, Neil."
},
{
"speaker": "Neil McMahon – Sanford C. Bernstein & Company, Inc.",
"text": "Good morning or even afternoon this side. A few questions. The first one is could you give us an update on a few of your longer term potential operations that are what is, as far as I can tell, sort of legal disputes at the minute such as Natuna and on Point Thompson? And then I’ve got a second question."
},
{
"speaker": "David Rosenthal",
"text": "All right. If we look first at Natuna we are continuing to progress that project and you know, we continue to discuss with the government our ongoing project development there and those negotiations are continuing but - and we have certainly communicated to the Indonesian government a willingness to seek a mutually acceptable solution. And we would expect to continue to work on that over the course of the quarter but I do want to say that there really is no legal dispute at this time for Natuna. Our contract remains valid and we continue discussions with the government. If we move on to Point Thompson, ExxonMobil and the other Point Thompson working interest owners are proceeding with the project while we seek to resolve the dispute with the state over the Point Thompson unit and leases. We have completed many activities in field operations at the Point Thompson site in preparation for the multi-well drilling program. We’ve got several of the permits to do that program and we’re awaiting additional approvals from the state regulatory agencies that are necessary to allow drilling activities to continue."
},
{
"speaker": "Neil McMahon – Sanford C. Bernstein & Company, Inc.",
"text": "I think that just on Point Thompson, I think there was meant to be some resolution by October 15th. So I was just wondering if there was any update on that. And secondly on Natuna, should we then expect Natuna to reappear in your Asono (ph 00:21:22) document on your (inaudible 00:21:26) document in terms of the major projects, start ups for the next decade."
},
{
"speaker": "David Rosenthal",
"text": "Well, let me hit Point Thompson first. I’m not aware of any specific October 15th deadline but as I mentioned earlier, we are in ongoing discussions with the state of Alaska on bringing that project forward. As opposed to Natuna, you know as I mentioned we are looking to progress in Natuna and the outcome of the negotiations that are underway will determine our reporting going forward."
},
{
"speaker": "Neil McMahon – Sanford C. Bernstein & Company, Inc.",
"text": "Just a second question looking at - obviously, your balance sheet is probably one of the best in the world if not the best in the world."
},
{
"speaker": "David Rosenthal",
"text": "Thank you."
},
{
"speaker": "Neil McMahon – Sanford C. Bernstein & Company, Inc.",
"text": "And it’s hardly extreme to say so given the size of it. And just looking at the amount of cash, you’ve got nearly $37 billion on the balance sheet. What should we be thinking about your buy back level going forward? Neither the value of the stock has fallen and also how do you think about acquisitions given current prices for stocks which have fallen dramatically the last few months?"
},
{
"speaker": "David Rosenthal",
"text": "Well, let’s talk about the cash that we have on the balance sheet and let me just step back a second and say, of course, the utilization of that cash in whatever avenue is designed to increase shareholder value over the long-term. As we look forward, of course our first priority is to fund our very robust investment program and as we’ve mentioned we expect to spend in the league of $25 to $35 billion a year in CapEx over the next five years. And we have no change to those plans at this time. The projects are progressing as we expected. The next thing we fund, of course, is the dividend and we have a history of growing the dividend. And that is, of course, one of the avenues of distributing cash to the shareholders. The last means of distributing cash to the shareholders is through the share buyback but I would -- we do that ratably over a long period of time and we don’t speculate on the price. We’re buying everyday across the time and you know, that program has continued."
},
{
"speaker": "Neil McMahon – Sanford C. Bernstein & Company, Inc.",
"text": "Okay, thank you."
},
{
"speaker": "David Rosenthal",
"text": "If we just come back to your follow up question related to M&A activity. I’d like to say that, of course M&A activity, our opportunities are just one of many opportunities that we look at on a continuing basis. I’ll tell you that was true at $140 a barrel and it’s true at $70 a barrel. We are monitoring what’s going on in the market but again, M&A is just one opportunity amongst many that we have and in particular, on a global basis that we’re monitoring and looking at it and evaluating on a constant basis."
},
{
"speaker": "Neil McMahon – Sanford C. Bernstein & Company, Inc.",
"text": "Great, thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Mark Gilman of Benchmark Company."
},
{
"speaker": "David Rosenthal",
"text": "Good morning, Mark."
},
{
"speaker": "Mark Gilman – The Benchmark Company",
"text": "David, good morning. I had a couple of things I wanted to go over. Of the net interest reductions cited in your production chart, did any occur in the third quarter precisely? Looks to me as if that’s just the carry over affect from impacts earlier in the year given that it’s a reduction from a 90 something number in 2Q same basis."
},
{
"speaker": "David Rosenthal",
"text": "A lot of it is carry over as you suggested but specifically in the third quarter we did see some impacts from net interest deductions. Although they were small across a number of areas, nothing I would single out individually."
},
{
"speaker": "Mark Gilman – The Benchmark Company",
"text": "Okay. Can you identify in a $60, $70 a barrel world, where going forward such might be anticipated?"
},
{
"speaker": "David Rosenthal",
"text": ""
},
{
"speaker": "–",
"text": ""
},
{
"speaker": "Mark Gilman – The Benchmark Company",
"text": "In interest reductions."
},
{
"speaker": "David Rosenthal",
"text": "Oh, the permanent net interest reduction?"
},
{
"speaker": "Mark Gilman – The Benchmark Company",
"text": "Yeah."
},
{
"speaker": "David Rosenthal",
"text": "Well, Mark, as you know only about 20% of our production portfolio is under PSEs and going forward, on a particular bice (ph 00:26:00) basis I couldn’t really offer any specifics. You know, but again there’s the net interest reductions and the price and spend impacts as we go forward."
},
{
"speaker": "Mark Gilman – The Benchmark Company",
"text": "Okay. Let me try something else. It looks to me as if there was a massive net working capital increase in the third quarter which given the drop in prices is, to say the least, a bit counterintuitive. Is that accurate and why did it occur?"
},
{
"speaker": "David Rosenthal",
"text": "If you’re talking about our working capital change sequentially or quarter on quarter?"
},
{
"speaker": "Mark Gilman – The Benchmark Company",
"text": "Well, I’m just looking at the third quarter specifically, David, and in order to get to that cash flow from operations number indicated in your press release. About the only way for that to happen would be if there was a significant increase in working capital which I say in a lower, in a falling price environment is counterintuitive."
},
{
"speaker": "David Rosenthal",
"text": "Well, we did see fairly significant changes in our working capital in the third quarter but those were related to a number of items both on the payable side and the receivable side given the change in the prices."
},
{
"speaker": "Mark Gilman – The Benchmark Company",
"text": "Okay, but there was an increase?"
},
{
"speaker": "David Rosenthal",
"text": "Yes. Yeah, we did see an increase in the quarter."
},
{
"speaker": "Mark Gilman – The Benchmark Company",
"text": "Okay. Could you - you mentioned in going through the variances in the segments on several occasions the impact of asset sales. Can you quantify, you know in reasonably specific terms, what the asset sales benefits were? Or if it’s a negative number, I doubt that, in the third quarter in the various segments."
},
{
"speaker": "David Rosenthal",
"text": "Well, Mark as we look across the segments in the third quarter. Basically we had some of our just usual ongoing business. Don’t have anything specific to highlight in any of these segments with the exception, perhaps, we divest our Barnett Shell business in the upstream as you’re aware of. The really significant asset sale, of course, was the sale of our upstream gas transportation business in Germany which we did highlight as a special item. But other than the event I would characterize the rest of our asset sales across the segment as business as usual."
},
{
"speaker": "Mark Gilman – The Benchmark Company",
"text": "Okay. One final one for me, David. The $500 million figure cited in the press release, you know in terms of the earnings impact of damage repairs and lower volumes in the fourth quarter. That just sounds like an awfully large kind of number. Can you put some color on that in terms of its pieces? You know particularly given your comment that most of the activity with respect to Beaumont chemical facility, you know, was really back on line."
},
{
"speaker": "David Rosenthal",
"text": "Well, let me answer the last part of your question first and I’ll come back to the first part. If we look across our footprint in the Gulf of all of our assets, most of them are back up or will soon be back up. The one exception is the Beaumont chemical plant where we did sustain a fair amount of damage and that plant is not up. And we are continuing to progress repairs at those facilities. If we look back at the $500 million number mentioned in the press release. That’s split about evenly between loss volumes and also repair costs as we move into the quarter but yeah, it’s about 50/50 on repair costs and volume effects."
},
{
"speaker": "Mark Gilman – The Benchmark Company",
"text": "Was the volume effect primarily on the chemical side?"
},
{
"speaker": "David Rosenthal",
"text": "It somewhat in the chemical side but also on the upstream side. We would expect it as we mentioned we had about 24 KBD down in the third quarter, most of that late in the quarter. As we move into the fourth quarter on those volumes, while most of our producing facilities are back online, in many cases we are awaiting third party facilities to be up and running. So our best guess, if we look quarter to quarter, average across the quarter, we’ll be down about the same 24,000 barrels a day. So the upstream volumes and some of the other volumes, again about half that $500 million with the balance being repair expense for the facilities that were damaged in the hurricane."
},
{
"speaker": "Mark Gilman – The Benchmark Company",
"text": "Thank you, David."
},
{
"speaker": "David Rosenthal",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Erik Mielke of Merrill Lynch."
},
{
"speaker": "David Rosenthal",
"text": "Good morning, Erik."
},
{
"speaker": "Erik Mielke – Merrill Lynch",
"text": "Yeah, good morning. I apologize I have a bit of a sore throat so if I sound a bit funny that’s the reason for that."
},
{
"speaker": "David Rosenthal",
"text": "Okay."
},
{
"speaker": "Erik Mielke – Merrill Lynch",
"text": "Could you give us an update on the Catare (ph 00:31:08) projects specifically on timing and completion? You previously mentioned that train four should be ramping up in the fourth quarter and train six should be sometime early in 2009."
},
{
"speaker": "David Rosenthal",
"text": "Sure, I’d be happy to provide an update. The train four commissioning is proceeding well and we expect to be producing L&G from train four in the winter, of this winter 2008/2009. Train five, of course, will start up in 2009 and train six, (inaudible 00:31:40) train six will begin commissioning in late 2008 with first L&G production expected in the first part of 2009. And finally train seven, of course, is projected to start up later in 2009. But let me also comment overall on the status of these projects. As you know, these are the largest L&G trains in the world. These are great projects for us and they are all progressing as planned, as expected and we expect the production from those to come on as we expected."
},
{
"speaker": "Erik Mielke – Merrill Lynch",
"text": "Should we expect a meaningful contribution to volumes in the fourth quarter?"
},
{
"speaker": "David Rosenthal",
"text": "No, I would not expect a meaningful contribution in the fourth quarter but you’ll start to see the ramp up as we head into the first quarter of ’09."
},
{
"speaker": "Erik Mielke – Merrill Lynch",
"text": "And the amount in those volumes, are you limited to Italy, the U.K. and the U.S.?"
},
{
"speaker": "David Rosenthal",
"text": "Well, I don’t want to really comment on any specific destination of the specific shipments. We do have some flexibility and of course, the volumes are going to individual markets at any point and time will depend on the conditions and the contractual arrangements in place but other than that, I really wouldn’t want to comment on any specifics of the commercial arrangements."
},
{
"speaker": "Erik Mielke – Merrill Lynch",
"text": "Okay and can I ask a very quick extra question on oil sands."
},
{
"speaker": "David Rosenthal",
"text": "Sure."
},
{
"speaker": "Erik Mielke – Merrill Lynch",
"text": "We’ve seen some of your peers announce delays to various oil sands projects. Can you just confirm that you’re still happy with your (inaudible 00:33:24) project?"
},
{
"speaker": "David Rosenthal",
"text": "I’d be happy to confirm that because we are happy with the Coral (ph 00:33:30) project. We’re committed. Continue to be committed. As you know the Coral project is an advantaged resource in the oil sands province mainly because of the quality of that resource and the scale of it. As we looked at Coral from the beginning we did evaluate those economics over a broad range of prices as we do all of our investment opportunities. And as we look at the economics of Coral going forward, it continues to look like a robust project for us. In fact, as you mentioned, some of the other oil sands projects may be slowing down or whatever. That could actually provide some benefit to us in respect to lower costs of both raw materials and services given what’s going in some of the major commodity products but again, we are progressing. The detail designed engineering is underway and long lead procurement items are being advanced. And we would expect to be in a position to reach a final investment decision sometime in 2009."
},
{
"speaker": "Erik Mielke – Merrill Lynch",
"text": "Very good, thank you."
},
{
"speaker": "David Rosenthal",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jason Gammel of Macquarie."
},
{
"speaker": "David Rosenthal",
"text": "Good morning, Jason."
},
{
"speaker": "Jason Gammel - Macquarie Research Equities",
"text": "Good morning, David. How are you?"
},
{
"speaker": "David Rosenthal",
"text": "I’m fine, thank you."
},
{
"speaker": "Jason Gammel – Macquarie Research Equities",
"text": "I wanted to ask a question about defined product sales. Year over year they were down about 6% in the quarter. It seemed to be essentially across all regions. Would you be able to talk about how much of that was related to maybe divestitures, effects of hurricanes, etc. versus just what you’re seeing in terms of weak demand?"
},
{
"speaker": "David Rosenthal",
"text": "Well, we’re seeing the impact of all of those factors that you mentioned. Demand is, of course, a piece of that particularly in the OECD countries. Although, we do still see a little growth in the non-OEC countries but we also, of course, have the effect of the hurricane and we do have some effect of divestments but I wouldn’t want to give any specifics on any of those individually. It’s a mixture of all of them but I’d say overall, you know, there’s an impact on demand in the OECD countries as well as the other effects we mentioned but pretty much across the board."
},
{
"speaker": "Jason Gammel – Macquarie Research Equities",
"text": "Great, thanks. If I could ask one more on the effect of tax rate, it was down about four percentage points versus what we saw in the first half of the year. Is that really just primarily a reflection of the relatively higher contribution of down-stream or are there some adjustments and accrual factors we should know about?"
},
{
"speaker": "David Rosenthal",
"text": "Well, it’s clearly, (inaudible 00:36:24) you hit the nail on the head there. It is a function to some extent of the higher proportion of down-stream earnings. The other impact that we have in there relates to our Germany asset sale. That did carry a low tax rate and so those are the two primary factors in the quarter-to-quarter decrease in our effected tax rate."
},
{
"speaker": "Jason Gammel – Macquarie Research Equities",
"text": "Thank you, David."
},
{
"speaker": "David Rosenthal",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Paul Cheng of Barclays Company."
},
{
"speaker": "David Rosenthal",
"text": "Good morning, Paul."
},
{
"speaker": "[Paul Cheng – Barclays Company]",
"text": "Hey, good morning. Dave, two simple questions, one, you’re talking about the share buy-back (inaudible 00:37:02) third quarter excluding the (inaudible 00:37:07) effect, you’re buying about eight billion. Can you tell us what is the run rate for the fourth quarter? Secondly, I want to see if you can make any comment in terms of overall cost pressure in the industry over the last (inaudible 00:37:23) year have been phenomenal, have you seen any visible signs, you start to crack and coming down?"
},
{
"speaker": "David Rosenthal",
"text": "Let me hit share buy-back question first. I really don’t want to provide a forward statement on what are expected share buy-back program will look like in the fourth quarter. As we look at the cost structure, yes, commodity prices are coming down. For example, steel, concrete, cooper, and other commodities and while it is a little early to tell the extent and timing effect of those prices on our business and our projects in particular, I can tell you that we are actively chasing the lag out of that process and working hard to realize and deliver any cost savings that the market may generate as quickly as possible and as I mentioned earlier, particular on some of our major projects that are just now getting underway, we’ll be working very hard to ensure that the lower cost we’re seeing in some of these goods and services does translate directly into lower costs of those projects to the extent possible."
},
{
"speaker": "[Paul Cheng – Barclays Company]",
"text": "Dave, if I could, just follow-up on that. On the drilling rate on the deep-water, I think in the past that, if I recall correctly, you only have a commitment up to 2010 so that means that in the event that the (inaudible 00:38:54) rates start to come down, you should be able to take advantage on that. Is that a true statement or do you actually have commitment beyond 2010 already?"
},
{
"speaker": "David Rosenthal",
"text": "Well, rather then picking any particular year, what I would say overall is we are only committed to the extent that we have firm obligations. For example, we’ve just taken delivery of two new rigs and one of them, as I mentioned, is drilling the well in Brazil as we speak. What happens going forward with rig rates and other expenses, you know, we’ll just have to see how that shakes out going forward. But, I think what you’ll see is a lot of our commitment wells over the next couple of years are going to covered by the two new rigs that we’ve just taken delivery on as we continue to actively explore some of the outstanding exploration prospects that we have underway."
},
{
"speaker": "[Paul Cheng – Barclays Company]",
"text": "Dave, final one, go back to your earlier question, you don’t want to give a number for the fourth quarter, understandable for the share buy-back. Can you tell us what is your (inaudible 00:40:10) in October?"
},
{
"speaker": "David Rosenthal",
"text": "No, I really don’t want to give any kind of a run rate. While we mentioned what the total purchases were in the third quarter and I’ll probably just leave at that."
},
{
"speaker": "[Paul Cheng – Barclays Company]",
"text": "Okay, thanks."
},
{
"speaker": "David Rosenthal",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And as a reminder it’s star 1 if you would like to signal for a question. We’ll go next to Robert Kessler of Simmons & Company."
},
{
"speaker": "Robert Kessler – Simmons & Company International",
"text": "Good morning, David."
},
{
"speaker": "David Rosenthal",
"text": "Good morning Robert, how are you?"
},
{
"speaker": "Robert Kessler – Simmons & Company International",
"text": "Good. This might be more of a nuance question but you mentioned a couple of times now that the inflationary trends that you’re seeing in the capital investment side of things and then you’ve reiterated this $25 to $30 billion per year spending for the next five years. I’m assuming that was calibrated giving consideration to the inflationary environment we witnessing at the time. So, just as you think about that program in the new environment, should we expect you to perhaps to spend less with the same activity to the extend deflation occurs or would you sort of pick up your activity to take advantage of the lower costs and then fill the gap and spend the same amount?"
},
{
"speaker": "David Rosenthal",
"text": "Well, that’s a good question and if you look at our major projects that are underway or in the early stages, these are very long-term large scale projects. And as I mentioned earlier, when we’re analyzing and evaluating those projects, we do look at them over a fairly broad range of prices and they are robust again across that range. As we look out into the future, we’re just going to need to just see what the impact is of these costs and how quickly they come through and what impact they have on the projects. But I would like to say overall, that we pursue investment opportunities, we don’t have spend target, if we mention the $25 to $30 billion a year going forward, that’s not a target that’s an outcome or an expectation that’s generated from the project portfolio that we’re pursuing. And as we continue to pursue that portfolio of projects, whatever impact, or help we get on prices will be realized in that. But again, we will be pursing all investment opportunities that we view as being robust and generate long term shareholder value."
},
{
"speaker": "Robert Kessler – Simmons & Company International",
"text": "Makes sense, thanks, David."
},
{
"speaker": "David Rosenthal",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And we’ll go back to Neil McMahon of Sanford Bernstein."
},
{
"speaker": "Neil McMahon – Sanford C. Bernstein & Company, Inc.",
"text": "Hi, I’ve just got a follow-up call on the timing of any Brazil announcements. Have you got any guess estimate on roughly when the well will finish drilling? I think the idea was around the end of the year, start of next year?"
},
{
"speaker": "David Rosenthal",
"text": "Yes, as I mentioned the well has spudded and we would expect that well to be down by the end of the year, first of next year."
},
{
"speaker": "Neil McMahon – Sanford C. Bernstein & Company, Inc.",
"text": "And I know you’re last vocal any many of your peers especially the smaller NP companies, would you be making any announcements around about that time?"
},
{
"speaker": "David Rosenthal",
"text": "You know I wouldn’t want to speculate on exactly when we’ll make an announcement but as soon as we’re ready and have information to provide, we’ll make that announcement."
},
{
"speaker": "Neil McMahon – Sanford C. Bernstein & Company, Inc.",
"text": "Great, thanks."
},
{
"speaker": "David Rosenthal",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "We’ll go next to Paul Sankey, Deutsche Bank."
},
{
"speaker": "David Rosenthal",
"text": "Yes, Paul."
},
{
"speaker": "Operator",
"text": "(Operator instructions)"
},
{
"speaker": "Paul Sankey – Deutsche Bank",
"text": "My question was answered, I beg your pardon."
},
{
"speaker": "David Rosenthal",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Not a problem, we’ll go back to Mark Gilman of Benchmark and Company."
},
{
"speaker": "Mark Gilman – The Benchmark Company",
"text": "David, can you quantify the Nigerian maintenance impact on the third quarter, volume (inaudible 00:43:53}?"
},
{
"speaker": "David Rosenthal",
"text": "If we look at the total maintenance effect that we mentioned, about 3% of the decline, I would tell you again that the two largest components there were the North Sea and Nigeria. And while Nigeria was a major factor, I wouldn’t really want to single it out and give a specific number. But just to say that of that 100,000 barrels that we talked about, the two biggest impacts were your normal third quarter North Sea maintenance and Nigeria, but I think the key thing for us is that maintenance work has been successful and as we go forward we’d be expecting to see those volumes coming back."
},
{
"speaker": "Mark Gilman – The Benchmark Company",
"text": "Okay, could you provide absolute price finalization numbers for the third quarter split US and foreign?"
},
{
"speaker": "David Rosenthal",
"text": "Sure, I’d be happy to provide that for you. If we look at the absolute values for the price finalization in the third quarter of 08, we were about $600 million in total, about two thirds of that U.S. and about a third of that non-U.S."
},
{
"speaker": "Mark Gilman – The Benchmark Company",
"text": "Thank you, David."
},
{
"speaker": "David Rosenthal",
"text": "Okay, thank you."
},
{
"speaker": "Operator",
"text": "(Operator instructions) We’ll go back to Jason Gammel of Macquarie."
},
{
"speaker": "Jason Gammel – Macquarie Research Equities",
"text": "David, I just wanted to complete the loop on the LNG infrastructure progress, can you talk about Golden Pass, where you’re at in terms of construction and when you expect to have first cargos in that facility?"
},
{
"speaker": "David Rosenthal",
"text": "Sure, as you know, Golden Pass is our larger LNG regasication (misspelled? 00:45:42) project in the U.S. It’s progressing along on schedule. We did have some hurricane impacts on the project and we’re assessing the impact of that and determining what restorative work will be needed. But I have to say we are still in the assessment stage and not prepared to give any specific indications on cost impact or schedule. We’re working through all of that and we’ll provide an update as we have more information."
},
{
"speaker": "Jason Gammel – Macquarie Research Equities",
"text": "Thanks and if I could just one more on Golden Path, should we think of that as a terminal that will essentially have very steady (inaudible 00:46:28) volumes or will this be a facility that just takes advantage of price arbitrage in the North American market versus the other markets that you serve?"
},
{
"speaker": "David Rosenthal",
"text": "Well, I wouldn’t want to make a prediction on any type of a short-term basis. As you know, all of our LNG investments across the value chain are long-term in nature and are not subject to short-term variations in prices or supply demand balances. We do expect some volumes will come into the Golden Pass terminal, but I wouldn’t want to try to give a specific profile especially near-term. Again, if we think longer term the U.S. is going to need more LNG and we feel like we’re well positioned to meet that need from a number of standpoints including LNG out of cutter into our Golden Path terminal. But again, it’s a very long-term project meeting a very long-term need for gas into the U.S."
},
{
"speaker": "Jason Gammel – Macquarie Research Equities",
"text": "Okay, appreciate it that, David, thanks."
},
{
"speaker": "David Rosenthal",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "That’s all the time we have for questions, I’d like to turn the call back over to Mr. Rosenthal for any additional or closing remarks."
},
{
"speaker": "David Rosenthal",
"text": "Thank you very much. I’d like to close by commenting in a current volatile commodity and credit environments, we remain confident in our ability to deliver industry leading projects and grow shareholder value. Our financial strength, discipline investment approach, commitment to operational excellence and technology development continue to serve as well. I thank all of you for your time and your questions this morning."
},
{
"speaker": "Operator",
"text": "And again ladies and gentlemen this does conclude today’s conference. We thank you for your participation, you may disconnect at this time."
}
] | null | null |
XOM | 2 | 2,008 | 2008-07-31 17:00:00 | Operator: Welcome to the ExxonMobil Corporation's Second Quarter 2008 Earnings Conference Call. Today's conference is being recorded. Now at this time, I would like to turn the conference over to the Vice President of Investor Relations and Secretary, Henry Hubble. Mr. Hubble, please go ahead.
Henry H. Hubble: Thank you. Good morning and welcome to ExxonMobil's teleconference and webcast on our second quarter 2008 financial and operating results. As you are aware from this mornings press release, ExxonMobil's net income in the second quarter was a record for the corporation. Our integrated business portfolio and strong operational performance have allowed us to capture the benefits of the commodity price environment. The fundamentals of our business remain strong and we continue to invest at record levels to bring new supplies to the market. Before we go further, I'd like to draw your attention to our cautionary statement. Please note that estimates, plans and expectations are forward-looking statements. Actual results, including resource recoveries, volume growth, and project outcomes, could differ materially due to factors I discuss and factors noted in our SEC filings. Please see factors affecting future results and the Form 8-K we furnished this morning, which are available through the Investors section of our website. Please also see the frequently used terms, the supplements to this morning's press release, and the 2007 financial and operating review on our website. This material defines key terms I will use today, shows ExxonMobil's net interest in specific projects and includes our SEC Regulation G disclosure. Now, I'm pleased to turn your attention to the second quarter results. Exxon Mobil's second quarter 2008 net income was $11.7 billion, an increase of $1.4 billion from the second quarter of 2007. Second quarter 2008 net income included a special charge of $290 million related to the Valdez litigation. Second quarter normalized earnings, excluding the Valdez litigation charge, were nearly $12 billion, up $1.7 billion from the second quarter of 2007. Normalized earnings per share were $2.27 per share, up 24% from a year ago, reflecting strong earnings performance and the benefits of our share purchase program. During the second quarter of 2008, ExxonMobil distributed a total of $10.1 billion to shareholders, including dividends of $2.1 billion and share purchased to reduce shares outstanding of $8 billion. Before I discuss specific business results, I'd like to share some of the milestones we achieved since the last earnings call. In the second quarter, we started up production from the East Area Natural Gas Liquids II project, offshore Nigeria, three months ahead of schedule. The project will recover more than 275,000 million barrels of natural gas liquids from several east areas fields, which will help monetize gas resources and significantly, reduce layering. At peak, the project is expected to produce 50,000 barrels per day of natural gas liquids. In the second quarter, production also started from the Deepwater Gunashli platform in Azerbaijan. The startup of the Gunashli complex completes the third phase of development of the Azeri-Chirag-Gunashli or ACG field in the Azerbaijan sector of the Caspian Sea. At peak, phase 3 production is expected to reach almost 300,000 barrels per day. These startups bring the total number of major project startups to-date in 2008 to five, demonstrating our commitment to bring new supplies to market. Also in the second quarter, ExxonMobil announced that the joint venture participants and the PNG state have formerly signed and executed a gas agreement with the PNG LNG project. The agreement establishes the physical regime and legal framework by which a project will be regulated. It sets the terms and mechanisms for state equity participation and allows the FEED stage of the project to begin. In exploration, we had several notable milestones. We began shooting seismic in the Porcupine Basin of the southwest coast of Ireland, to improve the understanding of the geology and hydrocarbon bearing potential of our significant exploration acreage holdings, totaling about 760,000 gross acres in the area. In Columbia, ExxonMobil was awarded a technical evaluation agreement or block CPE3 [ph] covering 6.4 million acres in the onshore Yannos heavy oil [ph]. ExxonMobil has significant expertise and technological capabilities in heavy oil resources, and we look forward to assisting in the exploration and possible development of this potential resource. ExxonMobil continues to lead the industry in our long-term commitment to technology development. In May, we announced the decision to invest over $100 million to build a commercial demonstration plant near LaBarge, Wyoming or ExxonMobil's Controlled Freeze Zone technology to significantly reduce the cost of our moving and sequestering carbon dioxide and hydrogen sulfide for natural gas. This CFZ technology will assist in the development of additional natural gas resources to meet the world's growing demand for energy and facilitate the application of carbon capture and storage to reduce green house gas emissions. Finally on July 1st, ExxonMobil announced the completion of the sale of its interest in the natural gas transport business in Northern Germany. The positive after tax earnings of this transaction of approximately $1.6 billion will be reported in the third quarter 2008 results. This transaction does not effect the exploration, production and natural gas sales and storage activities conducted by ExxonMobil affiliates in Germany. Moving now to the downstream. In refining, we continue to identify and to implement projects which maximize the performance of existing facilities. At our Fawley refinery in the UK, we recently completed deign changes on distillation units to improve yields of jet and diesel fuel, as well as increased feed to our catalytic cracking unit. Additionally, at Baytown, Texas refinery, we started up new facilities to increase the capacity of our crude distillation and delay coking units. We also continue to utilize our proprietary molecule management technology to rapidly assess and optimally process feedstocks. During the second quarter, we ran 36 crudes that were new to individual refineries, six of which were new ExxonMobil. Our selective investments and ongoing optimization activities allow us to maximize the capture of available margin and achieve advantage returns even at the bottom of the business cycle. During the second quarter, our flagship engine oil, Mobil 1 was selected as the recommended service-fill oil for the smart fortwo car in the U.S. market. Additionally, Mobil 1, turbo diesel truck, 5W-40 has been reformulated to meet EPA emission standards mandated for new on-highway diesel trucks. Our continued focus on proprietary research and formulation upgrades allows Mobil 1 to remain the world's leading synthetic motor oil brand. In our Chemical business, we started up facilities at our plant in Baytown, Texas which will increase the bromobutyl rubber production capacity at the site by 60%, allowing us to meet growing global demand for halobutyl rubber. ExxonMobil Chemical is the largest supplier of halobutyl rubber to the global tire industry, and we have expanded our capacity to produce this polymer by 80% in the last decade. During the quarter, the American Chemistry Council granted ExxonMobil Chemical a total of 13 energy efficiency awards. This is the 11th consecutive year that ExxonMobil Chemical has been recognized by the ACC for energy efficiency. Now turning to the business line results. Upstream earnings in the second quarter were record at $10 billion, up nearly $4.1 billion from the second quarter of 2007. We continue to capture the benefit of strong industry conditions this quarter with upstream after tax unit earnings of $29 per barrel. Record crude oil and natural gas realization increased earnings by $6.1 billion. Worldwide crude realizations were up $54.17 per barrel to $119.29 in the quarter. Natural gas realizations were up $3.78 per kcf from second quarter 2007, reflecting higher prices in all major producing regions. Lower crude oil and natural gas volumes decreased earnings by $1.7 billion. Other effects reduced earnings by $330 million, primarily due to increased operating expenses including the effect of new field startups and higher taxes. In total, oil equivalent volume has decreased about 8% from the second quarter of last year. Entitlement volume effects including price and spend impacts and PSC net interest reductions reduced volumes by 160,000 barrels per day. Excluding the impacts of lower entitlement volumes, the Venezuela expropriation and the Nigeria labor strike, production was down 2.5%. The reduction principally reflects the impact of higher maintenance activity. As major project ramp ups in the North Sea and West Africa, an increased European natural gas demand largely offset natural field decline in mature areas. Liquids production decreased about 275,000 barrels per day, or 10% from the second quarter of last year. Excluding impacts related to the Valdez... Venezuela expropriation, Nigeria labor strike and lower entitlement volumes, production was down 2.5%. The reduction principally reflects impact of higher maintenance activity, as major project ramp ups in West Africa and North Sea largely offset natural field decline in mature areas. Gas volumes decreased approximately 285 million cubic feet per day from the second quarter of 2007. Natural field decline in mature areas, increased maintenance activity and asset management effects were partly offset by higher demand due to colder weather in Europe and new project volumes. New project volumes were below expectations due to slower than anticipated volume ramp up in the North Sea. Turning now to the sequential comparison. Versus the first quarter of 2008, upstream earnings increased $1.2 billion, due to higher crude oil and natural gas realizations, partly offset by lower volumes, primarily due to seasonally lower natural gas demand in Europe. Liquids production decreased 3%, due to scheduled maintenance activities in Canada, entitlement volume effects and the labor strike in Nigeria. Natural gas production was down 17%, driven by seasonally lower demand in Europe. Oil equivalent volumes were down about 9% from the first quarter. For further data on regional volumes, please refer to the press release and IR supplement. Turning now to the downstream results. Earnings in the second quarter were $1.6 billion, down $1.8 billion from the second quarter of 2007. Lower margins reduced earnings by $1.9 billion, driven by significantly lower refining margins. Volume and mix effects increased earnings by $230 million, as margin improvement activities more than offset lower sales volumes. Other effects reduced earnings by $180 million, primarily due to higher operating expenses. Sequentially, second quarter earnings increased by $390 million, reflecting stronger refining margins, partially offset by negative price finalization effects. Other factors increased earnings by $40 million, including higher gains of asset sales, offset by higher operating expenses and foreign exchange effects. Focusing now on our Chemical results. Second quarter chemical earnings of $687 million were 325 million lower than the second quarter of 2007. Lower margins reduced earnings by $480 million, as higher feedstock costs more than offset increased product realizations. Other impacts increased earnings by 130 million, reflecting positive foreign exchange and tax effects. Sequentially, second quarter Chemical earnings decreased by $340 million, driven by lower margins as continued increases in feedstock costs more than offset higher realizations. Turning now to the corporate and financing segments. Corporate and financing expenses excluding special items were $287 million in the second quarter of 2008, an increase of 188 million from the same period a year ago, primarily driven by tax items and lower interest income. The effective tax rate for the second quarter was 49%. Our cash balance was $39 billion and debt was $9.6 billion at the end of the second quarter. ExxonMobil made share purchases in excess of dilution of $8 billion during the second quarter, reducing the number of shares outstanding by 1.7%, and again demonstrating our commitment to return cash to our shareholders. CapEx in the second quarter totaled nearly $7 billion, an increase of $1.9 billion or 38% from the second quarter of 2007. Spending increased across all business lines as we continue to invest actively in projects to meet global demand for crude oil, natural gas and finished products. In summary, this quarter's results highlight the quality of our integrated business model, and disciplined investment approach. In the upstream, our outstanding portfolio of producing assets is performing well. While volumes were impacted by the high price environment, operational performance was solid and we delivered record earnings in the quarter. In the downstream and chemical, ExxonMobil's disciplined integrated operations and continued focus on efficiency improvements and optimization allow us to deliver a differentiated results in a period of lower industry margins. That concludes my prepared remarks and now I'll be happy to take your questions. Question And Answer
Operator: Thank you, Mr. Hubble. [Operator Instructions]. Our first will be from Michael LaMotte with J.P. Morgan.
Michael LaMotte: Thanks. Good morning, Henry.
Henry H. Hubble: Hi, Michael.
Michael LaMotte: I was struck by the comments... number of comments actually in the press release about mature field decline and I know that this is an area a focus for a lot of the NOCs today and increasingly focus of your IOC peers. Can you maybe talk about things that are doing differently to address decline maybe acceleration of the EOR activities, application of technology, those types of things?
Henry H. Hubble: Yeah. That's... we have an active work program that basically is designed to offset declines and have a lot of technology and experience in enhanced oil recovery. But even with the application of those technologies and techniques and the active program that we have we still see in mature areas declines. Nothing that frankly as a surprise, but where we were in or were expecting in the period as we've talked in the past, when we look at our overall decline rates, we've estimated that in the 5 to 6% range and of course we are investing to offset that.
Michael LaMotte: So, no deceleration of 5 to 6% range then it's really just feeling the impact on the portfolio size broadly?
Henry H. Hubble: Yeah, that's right. I mean if you look at our overall on average declines, they really have not changed. I mean, but in... and obviously in mature areas, it's somewhat higher and in other areas lower. You know, and as we talked about before it's... the programs that we have and if you looked at the just in general at the volumes projection that we have for this year, we were expecting what we shared at the analyst meeting, we to be down slightly versus 2007. And as we talked before, that's basically a reflection of the back-end loading of the projects that we have in our pipeline. The biggest change that you see versus our outlook, is associated with the price impacts from this... from the price environment on entitlements.
Michael LaMotte: Yeah, clearly.
Henry H. Hubble: And that's what you are seeing flow through in the big changes relative to what we have in that outlook.
Michael LaMotte: Okay.
Henry H. Hubble: Obviously, we are capturing value as reflexive, we are capturing value early in those projects, and the economics of them actually are better than originally anticipated. But it has been the major effect.
Michael LaMotte: Okay. That's helpful color. Thank you.
Henry H. Hubble: Alright.
Michael LaMotte: For my second question, maybe you could... I know you all have a very, very large acreage position, here in the Lower 48. But it has been interesting to watch a couple of the European majors move more aggressively into the North American gas market through acquisition and JV. Can you maybe talk about sort of the strategic... Exxon's strategic views on North American unconventional gas and whether you are thinking beyond the Piceance at this point?
Henry H. Hubble: Yeah. Well, I mean as we talked last quarter, of course Piceance is one of our major opportunities within the Lower 48, but we also have large acreage position in other areas as well, where Arkoma, we also picked up acreage position in Canada but the Horn River Basin and then and of course because we look at this on a global basis, we are looking also at those opportunities around the globe and you've seen us pickup the acreage positions then in Hungary as well as in Germany both unconventional gas plays, large unconventional gas plays. So between, we're quite active in this area and frankly we're looking at a lot of these different opportunities and so.
Michael LaMotte: How should we think about the rate of change on exploitation of that acreage second half '09 first half, sorry, second half '08, first half '09 versus where we've been in the first half of '08?
Henry H. Hubble: Well, if you look at... I mean, most of these... we're in the early days, the Piceance is producing as we talked about 55 million cubic feet per day, but most of these other acreage positions that we have, basically we're going through evaluation phases and then as we look at the next phase of Piceance of course we have 250 or another 200 that will bring on as part of that first phase with an ultimate capability of getting up nearly a billion.
Michael LaMotte: Okay. So no real change in the timetable relative to what you laid out at the beginning of the year?
Henry H. Hubble: No, these are long-term projects.
Michael LaMotte: Yes.
Henry H. Hubble: You will see as in... we are going to make sure we execute them very efficiently and that our cost, we focus a lot of attention on getting this cost of development right. And so the opportunities that you see us going after are really focused on areas where we can get significant acreage positions, and then we're going to approach it with a very disciplined development approach to maintain a low cost of development or banded cost development.
Michael LaMotte: Thanks, Henry.
Henry H. Hubble: Yeah.
Operator: We'll next go to Paul Sankey with Deutsche Bank.
Paul Sankey: Yeah. Hi, Henry. For my first question, I could just go back to the volumes sort of high level part specific, on the high level view at the analyst meeting outlined as you said a slight fall in '08?
Henry H. Hubble: Yeah.
Paul Sankey: Followed by slight rise in '09. Now that we've had something of a sharp fall in '08. Do we work off this lower base assuming flat oil prices from here or do we expect to see a fairly short comeback as over the course of 2009? And the follow-up to that naturally becomes, could you update us on the specific projects and when you expect them to start up now for the second half or first half of '09?
Henry H. Hubble: Yeah.
Paul Sankey: Thanks.
Henry H. Hubble: If you look at... we provided in the supplement material a bridge on the volumes, recognizing this was going to be an area and tried to put in some of the notable effects versus where we were last year and today. And if you look at that, you know that we talked already about the 160 kbd associated with PSC or entitlement effects. 95 of that is net interest reductions and those that is interest reductions are basically tranche changes that are permanent. So they roll through in, and each year when we update in our March analyst meeting we're basically reflecting updates to that as well as course updates for the various project outlooks. But you ought to think about that as rolling forward. And then as you look at the price spend effects, that's basically a reflection of crude prices and spend levels. And if crude is at $100 and you spend the $100, you get one barrel, if it drops to 50, we'll get two. So it really coming back to your guess at and my guess at what the future price of oil is going to be, but if you're looking at you assume the same kind of prices that we've had these effects could be at the same level going forward if the price maintains to that same level. And then if you look at the other effects in the bridge relative to last quarter there was 29 a day associated with Venezuela, there is 29 of Nigerian strike that was highlighted in there, those are the Nigerian piece is basically a one-time effect. And then the balance this 104 or 2.5% that we talked about Exo's effects is if you look through it, it's largely maintenance. The... if you look at net interest, I mean the decline rates, no surprises there. The projects that we have coming on and the growth in European demand basically they offset each other, and so the impact that you're left with this is maintenance, primarily maintenance.
Paul Sankey: That's great. Henry, thanks. It is really very helpful indeed. If I could jut follow up on two brief things; first, how much are you down in Nigeria right now. And secondly, could you give us an idea of the sensitivity of that PSC price spend element, let's say for a dollar change how much should we expect that price spend effect to be?
Henry H. Hubble: Yeah I don't really a rule of thumb to give you, you know because these things are... you hit these different tranches, you have a whole series of different contracts, different tranches, the price spend effect you can kind of look at as... I know as we talked about in terms of impact. But basically, if you see prices, crude prices maintaining at these same kind of levels, we see similar kind of impacts going forward. And based or slightly higher if we maintain at these price levels into the second half. And if you look at what the Nigerian strike impact and the maintenance that we had that is above the original plans here. I mean even excluding the price effects, we're slightly behind our outlook and it's going to be a challenge to catch that up during the year. So that maybe about as much as I can give you going forward in terms... and we'll be updating obviously again in March when we come back to you through the analyst meeting.
Paul Sankey: Okay, Henry, thanks a lot. Could I just ask a follow up and then call up my second question on the downstream.
Henry H. Hubble: Yes, yeah.
Paul Sankey: Its notable, you don't separate it out. You got the regional demand and then you got the byproduct demand, but it's notable that gasoline demand in your numbers is down 9% and distillate up 5%.
Henry H. Hubble: Yes.
Paul Sankey: Is there any additional noise in that or is that just a mega trend and I'll leave it at that. Thanks.
Henry H. Hubble: What you're seeing in the gasoline, I mean it basically reflecting... there's some divestments in that. It's a significant piece of it as we've been going through this process. But the other piece there is, we did have higher conversion unit, planned maintenance that largely impact gasoline production and so affects that. We are seeing if you look at the U.S., we'd say, we are down 1%, 1.5% or 2 or it's hard to actually determine in a short period of time, what that demand is. And you'll see those numbers were biased over time, that we would say, we are seeing something in that kind of range 1 to 2%.
Paul Sankey: So is that gasoline or oil product?
Henry H. Hubble: Gasoline, well, actually it's... you kind of see it rolling though in that. I would say it's in the total demand, but gasoline is a piece of that, the bigger piece of that in the U.S. In the distillates we are seeing growth year-on-year. And so there's actually been from a production standpoint a shift to try to maximize the distillate production, diesel production and so you see us emphasizing that. That's why you see some of the growth there. The Mo gas has been well supplied inventories as you know are pretty high. And so that's been the push in the demand there.
Paul Sankey: Thanks, Henry. I will let someone else have a go. Thank you.
Henry H. Hubble: Alright, very good.
Operator: Our next question then is from Erik Mielke with Merrill Lynch.
Erik Mielke: Yeah. Hi, Henry.
Henry H. Hubble: Hi, Erik.
Erik Mielke: In the upstream, I think we are getting better forecasting volumes with production more or less we expected. But the contribution coming through from, I think from international E&P was lower than what we had?
Henry H. Hubble: Yeah.
Erik Mielke: despite volumes and realized prices been aligned. It's obvious; the high tax is part of the answer. But it also seems that the cash flow is significant during the quarter. Can you help us understand what's your place with custom taxes and how we should think about that going forward with any new tax thresholds that you hit because of the high oil price in the quarter, any significant exponential expense and so forth?
Henry H. Hubble: Yeah. I mean the bridge, if you look at the bridge from the second quarter '08 to last year, I mean we have this 330 impact in other, you know that basically OpEx and tax effects were the two big components there. It's always made up of a number of different factors that are offset, but those were the two big that contributed to the increase. If you look at that, about a third of that was taxes, some of that, the biggest chunk of that was the Alaska tax effects. So that's really what's going on there. Then on the OpEx side, we continue to see inflationary effects in our OpEx, we also are seeing higher non-cash kinds of cost associated with new projects start ups and the capital investments that we are making. So that is reflecting through. And you know... but we have a very active program to be able to offset a lot of the escalation that we see. We are just not able in this environment to offset all of it.
Erik Mielke: Okay, thanks. And I think Paul asked this before, I'm not sure you gave a complete answer on the outlook for production in the second half in some of the key projects?
Henry H. Hubble: Oh yeah, I'm sorry.
Erik Mielke: Particularly on Kizomba [ph], Tengiz and Thunder Horse and so forth?
Henry H. Hubble: Yeah. If you look you know on the... in our outlook for the year, we had 12 major projects that we were planning on, was getting up during the year. Five of those have started up as I mentioned in the call, we still have the Malaysia, Jerneh B Kizomba C, Saxi/Batuque, those we should be hearing or announcing some things shortly and those. Thunder Horse, I think you know the status so that it's up initial oil and we'll be ramping that up as we go through the year, rest of the year. And then Qatar Gas Train 2, the first of the 7.8 Qatar Gas 2 Train 4, the first of the 7.8 million ton per annum trains; that will be starting up in basically supplying into the demand for the winter of '08. So we'll be giving that up in the fourth quarter. RasGas Train 6, basically we will be starting the commissioning of that at the end of the year and it will start contributing in the first quarter. So that's the big production startups and then of course we also have the terminals that are moving along on schedule.
Erik Mielke: And is there a lot of pickup from the second quarter, particularly from places like Nigeria and so forth where you lost some volumes and...
Henry H. Hubble: Yeah. Well, we did... of course we had the strike there and then we've had maintenance. Basically most of that maintenance, we talked a little bit about it previously but is in the JV area, it's about a little over 50 a day impact as we're going through that now. Some of that will continue into the third quarter. Basically, we have an ongoing and active maintenance program and we're upgrading our facilities associated with that. But we will have in addition of course the absence of the strike, but still some ramp up associated with the well sort of come back on.
Erik Mielke: Thanks, Henry.
Henry H. Hubble: And then the only other thing I might mention is, of course, this is... I mentioned the first two of those trains, we do have the last two of the 7.8 million ton per annum trains will also be starting up in 2009.
Erik Mielke: That's great, thank you.
Henry H. Hubble: Alright.
Operator: Our next question is from Neil McMahon with Sanford Bernstein.
Neil McMahon: Hi, Henry.
Henry H. Hubble: Hi, Neil.
Neil McMahon: Just a few questions.
Henry H. Hubble: Sure.
Neil McMahon: First of all, I am scratching my head to try and think of you at times before in the past when second quarter U.S. refining and marketing was down on first quarter, as you reported, maybe you could just give us a bit more detail on that and maybe... ?
Henry H. Hubble: Yes. One of the things that you see, whenever you see a real rapid run up in crude prices like we saw, there is always some compression that goes on and that generally will have a negative impact in the margins that we are able to capture. One of the other impacts that we also see, is a more of an accounting one, is on price finalization. And if you look at the price finalization impact in the first quarter... I mean, in the second quarter here, in total it was about $300 million, the vast majority of it in the U.S. So that was a larger impact that I think may not have been picked up.
Neil McMahon: And just generally on demand in the U.S. and worldwide, normally it's a something you are not as exposed to as others given the diversified nature of the business and the different product lines. Has that changed much this time around from last quarter?
Henry H. Hubble: We do a... when we look at our own demands, we're pretty much surrogate for the industry global demands picture. And when we look at the global demand, in the past... if you look at the 10 year average growth rate for petroleum liquids demand, it's been about 1.4 million barrels a day per year growth. We and others, as we've been looking at this and the impact of the economic activity as well as prices on the demand, we're now projecting that somewhere around 0.7 million barrels a day. So about half... still growing, but about half the rate that we would have seen in the past. And if we look around to where that's happening, the bulk of it is in the developing parts of the world, Middle East; Asia-Pac, and we actually see demand declining in the U.S. and in the OECD areas during this year.
Neil McMahon: Okay. Just a quick second question, something that's been quite noticeable, especially looking at your year-to-date share price performance is really the lack of impact of the buyback program on your share price. I know it's something that you definitely have a strategy to stick with. When do you think the buybacks will catch up with the liquidity in the market? When do you... have you done any work to suggest that if you take enough shares it will actually start to impact liquidity for your stock and therefore potentially see a price rise?
Henry H. Hubble: If you look at... I mean the way we think about the buyback, it's a distribution, and we view it as nothing more than a distribution. So we don't time it based on price, we don't... we buy ratably and we buy continuously in the market. And so we view it just as a distribution. So we are not really focusing as an investment or timing based on price. But if you look it from a liquidity standpoint, it's such a small percent of the volume overall and the shares outstanding for our company were over 5 billion shares with a lot of trading on a daily basis. We are not concerned about from a liquidity standpoint.
Neil McMahon: I was just thinking more from the fact that given your very large retail shareholder base and therefore... and on top of that adding in lots of family funds and things that have owned Standard Oil stock maybe, way-way back. That at some point, the actual overall share count may not fully reflect the liquidity of what's effectively in the market.
Henry H. Hubble: Yeah, I mean, we do have, as you point out, a strong retail shareholding. But I wouldn't... they participate in the market like the institutions and we see that. So, I wouldn't consider that as basically effective reduction of shares outstanding. They're loyal. We do have some long-term shareholders, but it's not a big impact in the liquidity end of the equation.
Neil McMahon: Great, thanks, Henry.
Henry H. Hubble: Yeah.
Operator: Our next will be from Mark Gilman with Benchmark Capital.
Mark Gilman: Henry, good morning
Henry H. Hubble: Hi, Mark. How are you?
Mark Gilman: Good, thanks. Hey, thanks very for much for what you call the production bridge, very helpful. If I could just follow up on that for a SEC.
Henry H. Hubble: Yes
Mark Gilman: The net interest reductions indicated on the chart.
Henry H. Hubble: Yes
Mark Gilman: Little smaller than, frankly, what I would have thought it was. Could you identify where those were hit and potentially talk a little bit about where you anticipate encountering similar effects in a price environment, let's say, equal to where we are today?
Henry H. Hubble: Well, I could tell you the... if you look at that 95 of net interest hit, about half of that's in Africa. And then there is a little less than half actually in the Russian Caspian area and that's basically associated with Azerbaijan. And those were the two big areas. So in the piece in Africa, as we've talked before, the East project is ring fenced in the Africa projects. So you are seeing different tranches hitting at different points for different projects. And to be honest with you, I can't give you a feel for it. We've moved through... if you look at some of our overall projects, we have moved through a lot of those tranches, but there is still some out there. And just to put into some perspective, I think, there is about 20% of our overall production that has these... has the potential for these kinds of impacts. They are in a PSC kind of arrangement.
Mark Gilman: 20% of your PSC production or your global production?
Henry H. Hubble: No, no, no, 20% of the total production is... has PSC type contracts.
Mark Gilman: Well, not all of those have net interest reduction elements to them. Do they.
Henry H. Hubble: No, no, absolutely, there are a lot of different terms for those, they have a lot of different... some of them don't have much price effect at all in them. Right, you are right.
Mark Gilman: Okay. If I could just for a second question, tax-oriented. The effective tax rate for the quarter for the corporation was essentially equal to the first quarter.
Henry H. Hubble: Yes, yeah.
Mark Gilman: Yet from a mix... from an earnings mix standpoint...
Henry H. Hubble: Yeah.
Mark Gilman: Taking into consideration the higher price environment and also some of the commentary as you went through your quarterly review regarding the impact of tax effects, particularly in the corporate segment, I would have expected it be a higher effective rate. Was there an offset somewhere?
Henry H. Hubble: No, actually there aren't... it's a pretty clean number that you are looking at there. And so there weren't a lot of effect... or very little in the way of one-time effects that are in this. So it just basically you do see a reflection on the mix of earnings, we have had... we have and a big piece of that is mix of earnings between upstream and downstream chemicals, as well as, of course, then in the mix of our upstream, where the upstream earnings are occurring. So it's a pretty clean number, but there is nothing really major in there that's a factor as a one-time effect.
Mark Gilman: Okay, Henry. Thanks a lot.
Henry H. Hubble: Yeah, no problem.
Operator: Our next question is from Jason Gammel with Macquarie.
Jason Gammel: Thank you. Hi, Henry.
Henry H. Hubble: Hi, Jason, how are you?
Jason Gammel: Good, thanks. You've done a pretty job. I am pretty far down in my question list here. Maybe you could talk a little bit about chemical margins. This is one of the lower quarters in quite some time in terms of chemical earnings?
Henry H. Hubble: Yeah.
Jason Gammel: Are you seeing any changes to margin activity right now or does it look like the next quarter or two is going to be fairly similar?
Henry H. Hubble: Well, I mean, if you look at margins, they have been under pressure just like we see in the refining side of the business. I mean, as you have these very rapid run ups in feedstock costs and so on, that's rolled through. But you also... I mean, we have seen this in the past too where there... what we'd almost called mini-cycles in the business where people see prices running up and they back off on purchases. So you will see swings in sales associated with that. We continue... if you look at long-term in this business, as we've talked many times, we see the chemical business as a growing business. It grows a couple of percent above GDP, it's had a long-term profile, we don't see that really changing. There are in the current environment though an impact associated with this very rapid run up in prices and we are seeing some of that really reflecting through in specific projects, I mean, in product areas, Aromatics in particular was hit relative to last quarter.
Jason Gammel: Yes, that makes sense.
Henry H. Hubble: But overall, I mean, it's robust given the environment. If you look at the benefits we have in this area, we feel pretty good about the way our chemicals business has been performing.
Jason Gammel: Okay, thanks, and that's helpful. And if I could ask a second one. On the PNG/LNG project, now that you have the fiscal regime and the regulatory regime pretty much firmed up with the governments, are there any other hurdles to reaching final investment decision or do you think that's something that could occur fairly quickly?
Henry H. Hubble: Well, we're working through the FEED at this point. So... I mean, there's always things you learn in that process. So, we'll be taking it through that stage and basically of course we have to get the necessary permits and the licenses and then of course also sales agreements that we're working. But I would say overall we feel very good about the project and are moving it ahead. So.
Jason Gammel: Okay, that's terrific. Thanks a lot, Henry.
Henry H. Hubble: Yeah.
Operator: Next question is from Paul Cheng with Lehman Brothers.
Paul Cheng: Hi, good morning.
Henry H. Hubble: Hey, Paul. How are you?
Paul Cheng: Very good. Henry, you talked about the PSC impact on the production.
Henry H. Hubble: Yes.
Paul Cheng: But you got to have a corresponding impact on your unit expense rate, unit costs, as well as the tax rate. Can you quantify on those two item?
Henry H. Hubble: Well, I mean...
Paul Cheng: Because I mean, when you string your production, but you still have to show that the full costs, I mean, your unit costs go up. Wondering that is there any number that you can share that, how big is the impact in the second quarter?
Henry H. Hubble: I mean. when you... if you look at the... probably the best way to look at that though is if you look at our net income per barrel and we have... you can develop and most of guys have correlation looking back at capture rate relative to crude price. You will see... I mean, we are pretty much on that correlation, we are capturing. So, there is not a big shift there. That wasn't a big factor. I mean, there some, as you see, just more moving overseas or higher percentage overseas, but it really... that hasn't been a big shift for us. And we recover those costs in the PSC kinds of projects and of course we recover those costs directly through barrels that we are incurring.
Paul Cheng: And Henry, you mentioned earlier that Alaska, the tax increase and that's from last year, obviously the rise in oil price that we have significant. How big is the incremental tax in Alaska in hitting you sequentially from first to second quarter?
Henry H. Hubble: First to second, I don't think there was... I don't know, I don't have a figure on it. If you look at the... I know that's not your question. If you look at from the second quarter year-on-year, it was about 100 million. But I don't know what it is sequentially, it wasn't a big factor, for sure.
Paul Cheng: It shouldn't or it should be?
Henry H. Hubble: It is not, it is not. No.
Paul Cheng: Oil price-wise, quite substantially in the second quarter.
Henry H. Hubble: I mean, there is some incremental effects. But it's not a major impact, and not in the reconciliation here.
Paul Cheng: I see. Can I just ask a quick one? Do you have any number in terms of the inventory gain or loss in the quarter, any meaningful number, any trading, commercial trading or hedging losses or --?
Henry H. Hubble: We don't have... we really just don't have anything there. I mean, it's... we don't... we basically... our trading is basically for physical movements. So we are not doing a lots of... in fact, we do very, very, very little derivatives kinds of trading.
Paul Cheng: Okay. FX, any big impact this quarter?
Henry H. Hubble: FoxEx, yeah, it's... if you look across the total business, it was like $50 million or something that range. The upstream negative, downstream had about a 100 negative, upstream about 25 negative, chemicals was actually positive about 80 something.
Paul Cheng: Is it year-over-year or sequential, this number?
Henry H. Hubble: That's a year-over-year.
Paul Cheng: Do you have a sequential number?
Henry H. Hubble: Yes and there it's about 60 for the total corporation, about 100 positive for upstream, about 200 negative for downstream and those were the big effects.
Paul Cheng: Very good, thank you.
Henry H. Hubble: Yes.
Operator: [Operator Instructions]. We'll go to Robert Kessler with Simmons & Company.
Robert Kessler: Henry.
Henry H. Hubble: Hi, Robert. How are you?
Robert Kessler: Not bad. A couple of quick project updates, if I might. Can I ask what current production is at deepwater Gunashli noting a startup in the quarter? And then secondly just for an update on Sakhalin. Where is production today at that development?.
Henry H. Hubble: Yeah. Let's see if I have. I don't have something right on my finger tips here. Actually it would be about 80 on Gunashli.
Robert Kessler: Okay.
Henry H. Hubble: Sorry, that's ACG total. Yeah, that's ACG total. Our net, that's our --
Robert Kessler: That's your net in ACG total.
Henry H. Hubble: No, that's... I'm sorry, that's gross. And then we have an 8% interest in that.
Robert Kessler: That's gross for Gunashli then, right?
Henry H. Hubble: Yes. And then Sack is about 200.
Robert Kessler: 200 today. And where would you expect kind of managed decline on Sakhalin going forward, what kind of rate per year?
Henry H. Hubble: It's not... we don't really have a number that I can... that I have available on our go forward field by field. We don't typically get into that. But we do... we are working, of course, the next phases, but it's not one that's fallen off cliffs here.
Robert Kessler: Okay, fair enough. Thanks, Henry.
Henry H. Hubble: Yeah.
Operator: And with that, there are no further questions. I'd like to turn the conference back for any additional or closing comments.
Henry H. Hubble: I'd just like to thank everybody for participating and for the questions this morning. | [
{
"speaker": "Operator",
"text": "Welcome to the ExxonMobil Corporation's Second Quarter 2008 Earnings Conference Call. Today's conference is being recorded. Now at this time, I would like to turn the conference over to the Vice President of Investor Relations and Secretary, Henry Hubble. Mr. Hubble, please go ahead."
},
{
"speaker": "Henry H. Hubble",
"text": "Thank you. Good morning and welcome to ExxonMobil's teleconference and webcast on our second quarter 2008 financial and operating results. As you are aware from this mornings press release, ExxonMobil's net income in the second quarter was a record for the corporation. Our integrated business portfolio and strong operational performance have allowed us to capture the benefits of the commodity price environment. The fundamentals of our business remain strong and we continue to invest at record levels to bring new supplies to the market. Before we go further, I'd like to draw your attention to our cautionary statement. Please note that estimates, plans and expectations are forward-looking statements. Actual results, including resource recoveries, volume growth, and project outcomes, could differ materially due to factors I discuss and factors noted in our SEC filings. Please see factors affecting future results and the Form 8-K we furnished this morning, which are available through the Investors section of our website. Please also see the frequently used terms, the supplements to this morning's press release, and the 2007 financial and operating review on our website. This material defines key terms I will use today, shows ExxonMobil's net interest in specific projects and includes our SEC Regulation G disclosure. Now, I'm pleased to turn your attention to the second quarter results. Exxon Mobil's second quarter 2008 net income was $11.7 billion, an increase of $1.4 billion from the second quarter of 2007. Second quarter 2008 net income included a special charge of $290 million related to the Valdez litigation. Second quarter normalized earnings, excluding the Valdez litigation charge, were nearly $12 billion, up $1.7 billion from the second quarter of 2007. Normalized earnings per share were $2.27 per share, up 24% from a year ago, reflecting strong earnings performance and the benefits of our share purchase program. During the second quarter of 2008, ExxonMobil distributed a total of $10.1 billion to shareholders, including dividends of $2.1 billion and share purchased to reduce shares outstanding of $8 billion. Before I discuss specific business results, I'd like to share some of the milestones we achieved since the last earnings call. In the second quarter, we started up production from the East Area Natural Gas Liquids II project, offshore Nigeria, three months ahead of schedule. The project will recover more than 275,000 million barrels of natural gas liquids from several east areas fields, which will help monetize gas resources and significantly, reduce layering. At peak, the project is expected to produce 50,000 barrels per day of natural gas liquids. In the second quarter, production also started from the Deepwater Gunashli platform in Azerbaijan. The startup of the Gunashli complex completes the third phase of development of the Azeri-Chirag-Gunashli or ACG field in the Azerbaijan sector of the Caspian Sea. At peak, phase 3 production is expected to reach almost 300,000 barrels per day. These startups bring the total number of major project startups to-date in 2008 to five, demonstrating our commitment to bring new supplies to market. Also in the second quarter, ExxonMobil announced that the joint venture participants and the PNG state have formerly signed and executed a gas agreement with the PNG LNG project. The agreement establishes the physical regime and legal framework by which a project will be regulated. It sets the terms and mechanisms for state equity participation and allows the FEED stage of the project to begin. In exploration, we had several notable milestones. We began shooting seismic in the Porcupine Basin of the southwest coast of Ireland, to improve the understanding of the geology and hydrocarbon bearing potential of our significant exploration acreage holdings, totaling about 760,000 gross acres in the area. In Columbia, ExxonMobil was awarded a technical evaluation agreement or block CPE3 [ph] covering 6.4 million acres in the onshore Yannos heavy oil [ph]. ExxonMobil has significant expertise and technological capabilities in heavy oil resources, and we look forward to assisting in the exploration and possible development of this potential resource. ExxonMobil continues to lead the industry in our long-term commitment to technology development. In May, we announced the decision to invest over $100 million to build a commercial demonstration plant near LaBarge, Wyoming or ExxonMobil's Controlled Freeze Zone technology to significantly reduce the cost of our moving and sequestering carbon dioxide and hydrogen sulfide for natural gas. This CFZ technology will assist in the development of additional natural gas resources to meet the world's growing demand for energy and facilitate the application of carbon capture and storage to reduce green house gas emissions. Finally on July 1st, ExxonMobil announced the completion of the sale of its interest in the natural gas transport business in Northern Germany. The positive after tax earnings of this transaction of approximately $1.6 billion will be reported in the third quarter 2008 results. This transaction does not effect the exploration, production and natural gas sales and storage activities conducted by ExxonMobil affiliates in Germany. Moving now to the downstream. In refining, we continue to identify and to implement projects which maximize the performance of existing facilities. At our Fawley refinery in the UK, we recently completed deign changes on distillation units to improve yields of jet and diesel fuel, as well as increased feed to our catalytic cracking unit. Additionally, at Baytown, Texas refinery, we started up new facilities to increase the capacity of our crude distillation and delay coking units. We also continue to utilize our proprietary molecule management technology to rapidly assess and optimally process feedstocks. During the second quarter, we ran 36 crudes that were new to individual refineries, six of which were new ExxonMobil. Our selective investments and ongoing optimization activities allow us to maximize the capture of available margin and achieve advantage returns even at the bottom of the business cycle. During the second quarter, our flagship engine oil, Mobil 1 was selected as the recommended service-fill oil for the smart fortwo car in the U.S. market. Additionally, Mobil 1, turbo diesel truck, 5W-40 has been reformulated to meet EPA emission standards mandated for new on-highway diesel trucks. Our continued focus on proprietary research and formulation upgrades allows Mobil 1 to remain the world's leading synthetic motor oil brand. In our Chemical business, we started up facilities at our plant in Baytown, Texas which will increase the bromobutyl rubber production capacity at the site by 60%, allowing us to meet growing global demand for halobutyl rubber. ExxonMobil Chemical is the largest supplier of halobutyl rubber to the global tire industry, and we have expanded our capacity to produce this polymer by 80% in the last decade. During the quarter, the American Chemistry Council granted ExxonMobil Chemical a total of 13 energy efficiency awards. This is the 11th consecutive year that ExxonMobil Chemical has been recognized by the ACC for energy efficiency. Now turning to the business line results. Upstream earnings in the second quarter were record at $10 billion, up nearly $4.1 billion from the second quarter of 2007. We continue to capture the benefit of strong industry conditions this quarter with upstream after tax unit earnings of $29 per barrel. Record crude oil and natural gas realization increased earnings by $6.1 billion. Worldwide crude realizations were up $54.17 per barrel to $119.29 in the quarter. Natural gas realizations were up $3.78 per kcf from second quarter 2007, reflecting higher prices in all major producing regions. Lower crude oil and natural gas volumes decreased earnings by $1.7 billion. Other effects reduced earnings by $330 million, primarily due to increased operating expenses including the effect of new field startups and higher taxes. In total, oil equivalent volume has decreased about 8% from the second quarter of last year. Entitlement volume effects including price and spend impacts and PSC net interest reductions reduced volumes by 160,000 barrels per day. Excluding the impacts of lower entitlement volumes, the Venezuela expropriation and the Nigeria labor strike, production was down 2.5%. The reduction principally reflects the impact of higher maintenance activity. As major project ramp ups in the North Sea and West Africa, an increased European natural gas demand largely offset natural field decline in mature areas. Liquids production decreased about 275,000 barrels per day, or 10% from the second quarter of last year. Excluding impacts related to the Valdez... Venezuela expropriation, Nigeria labor strike and lower entitlement volumes, production was down 2.5%. The reduction principally reflects impact of higher maintenance activity, as major project ramp ups in West Africa and North Sea largely offset natural field decline in mature areas. Gas volumes decreased approximately 285 million cubic feet per day from the second quarter of 2007. Natural field decline in mature areas, increased maintenance activity and asset management effects were partly offset by higher demand due to colder weather in Europe and new project volumes. New project volumes were below expectations due to slower than anticipated volume ramp up in the North Sea. Turning now to the sequential comparison. Versus the first quarter of 2008, upstream earnings increased $1.2 billion, due to higher crude oil and natural gas realizations, partly offset by lower volumes, primarily due to seasonally lower natural gas demand in Europe. Liquids production decreased 3%, due to scheduled maintenance activities in Canada, entitlement volume effects and the labor strike in Nigeria. Natural gas production was down 17%, driven by seasonally lower demand in Europe. Oil equivalent volumes were down about 9% from the first quarter. For further data on regional volumes, please refer to the press release and IR supplement. Turning now to the downstream results. Earnings in the second quarter were $1.6 billion, down $1.8 billion from the second quarter of 2007. Lower margins reduced earnings by $1.9 billion, driven by significantly lower refining margins. Volume and mix effects increased earnings by $230 million, as margin improvement activities more than offset lower sales volumes. Other effects reduced earnings by $180 million, primarily due to higher operating expenses. Sequentially, second quarter earnings increased by $390 million, reflecting stronger refining margins, partially offset by negative price finalization effects. Other factors increased earnings by $40 million, including higher gains of asset sales, offset by higher operating expenses and foreign exchange effects. Focusing now on our Chemical results. Second quarter chemical earnings of $687 million were 325 million lower than the second quarter of 2007. Lower margins reduced earnings by $480 million, as higher feedstock costs more than offset increased product realizations. Other impacts increased earnings by 130 million, reflecting positive foreign exchange and tax effects. Sequentially, second quarter Chemical earnings decreased by $340 million, driven by lower margins as continued increases in feedstock costs more than offset higher realizations. Turning now to the corporate and financing segments. Corporate and financing expenses excluding special items were $287 million in the second quarter of 2008, an increase of 188 million from the same period a year ago, primarily driven by tax items and lower interest income. The effective tax rate for the second quarter was 49%. Our cash balance was $39 billion and debt was $9.6 billion at the end of the second quarter. ExxonMobil made share purchases in excess of dilution of $8 billion during the second quarter, reducing the number of shares outstanding by 1.7%, and again demonstrating our commitment to return cash to our shareholders. CapEx in the second quarter totaled nearly $7 billion, an increase of $1.9 billion or 38% from the second quarter of 2007. Spending increased across all business lines as we continue to invest actively in projects to meet global demand for crude oil, natural gas and finished products. In summary, this quarter's results highlight the quality of our integrated business model, and disciplined investment approach. In the upstream, our outstanding portfolio of producing assets is performing well. While volumes were impacted by the high price environment, operational performance was solid and we delivered record earnings in the quarter. In the downstream and chemical, ExxonMobil's disciplined integrated operations and continued focus on efficiency improvements and optimization allow us to deliver a differentiated results in a period of lower industry margins. That concludes my prepared remarks and now I'll be happy to take your questions. Question And Answer"
},
{
"speaker": "Operator",
"text": "Thank you, Mr. Hubble. [Operator Instructions]. Our first will be from Michael LaMotte with J.P. Morgan."
},
{
"speaker": "Michael LaMotte",
"text": "Thanks. Good morning, Henry."
},
{
"speaker": "Henry H. Hubble",
"text": "Hi, Michael."
},
{
"speaker": "Michael LaMotte",
"text": "I was struck by the comments... number of comments actually in the press release about mature field decline and I know that this is an area a focus for a lot of the NOCs today and increasingly focus of your IOC peers. Can you maybe talk about things that are doing differently to address decline maybe acceleration of the EOR activities, application of technology, those types of things?"
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah. That's... we have an active work program that basically is designed to offset declines and have a lot of technology and experience in enhanced oil recovery. But even with the application of those technologies and techniques and the active program that we have we still see in mature areas declines. Nothing that frankly as a surprise, but where we were in or were expecting in the period as we've talked in the past, when we look at our overall decline rates, we've estimated that in the 5 to 6% range and of course we are investing to offset that."
},
{
"speaker": "Michael LaMotte",
"text": "So, no deceleration of 5 to 6% range then it's really just feeling the impact on the portfolio size broadly?"
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah, that's right. I mean if you look at our overall on average declines, they really have not changed. I mean, but in... and obviously in mature areas, it's somewhat higher and in other areas lower. You know, and as we talked about before it's... the programs that we have and if you looked at the just in general at the volumes projection that we have for this year, we were expecting what we shared at the analyst meeting, we to be down slightly versus 2007. And as we talked before, that's basically a reflection of the back-end loading of the projects that we have in our pipeline. The biggest change that you see versus our outlook, is associated with the price impacts from this... from the price environment on entitlements."
},
{
"speaker": "Michael LaMotte",
"text": "Yeah, clearly."
},
{
"speaker": "Henry H. Hubble",
"text": "And that's what you are seeing flow through in the big changes relative to what we have in that outlook."
},
{
"speaker": "Michael LaMotte",
"text": "Okay."
},
{
"speaker": "Henry H. Hubble",
"text": "Obviously, we are capturing value as reflexive, we are capturing value early in those projects, and the economics of them actually are better than originally anticipated. But it has been the major effect."
},
{
"speaker": "Michael LaMotte",
"text": "Okay. That's helpful color. Thank you."
},
{
"speaker": "Henry H. Hubble",
"text": "Alright."
},
{
"speaker": "Michael LaMotte",
"text": "For my second question, maybe you could... I know you all have a very, very large acreage position, here in the Lower 48. But it has been interesting to watch a couple of the European majors move more aggressively into the North American gas market through acquisition and JV. Can you maybe talk about sort of the strategic... Exxon's strategic views on North American unconventional gas and whether you are thinking beyond the Piceance at this point?"
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah. Well, I mean as we talked last quarter, of course Piceance is one of our major opportunities within the Lower 48, but we also have large acreage position in other areas as well, where Arkoma, we also picked up acreage position in Canada but the Horn River Basin and then and of course because we look at this on a global basis, we are looking also at those opportunities around the globe and you've seen us pickup the acreage positions then in Hungary as well as in Germany both unconventional gas plays, large unconventional gas plays. So between, we're quite active in this area and frankly we're looking at a lot of these different opportunities and so."
},
{
"speaker": "Michael LaMotte",
"text": "How should we think about the rate of change on exploitation of that acreage second half '09 first half, sorry, second half '08, first half '09 versus where we've been in the first half of '08?"
},
{
"speaker": "Henry H. Hubble",
"text": "Well, if you look at... I mean, most of these... we're in the early days, the Piceance is producing as we talked about 55 million cubic feet per day, but most of these other acreage positions that we have, basically we're going through evaluation phases and then as we look at the next phase of Piceance of course we have 250 or another 200 that will bring on as part of that first phase with an ultimate capability of getting up nearly a billion."
},
{
"speaker": "Michael LaMotte",
"text": "Okay. So no real change in the timetable relative to what you laid out at the beginning of the year?"
},
{
"speaker": "Henry H. Hubble",
"text": "No, these are long-term projects."
},
{
"speaker": "Michael LaMotte",
"text": "Yes."
},
{
"speaker": "Henry H. Hubble",
"text": "You will see as in... we are going to make sure we execute them very efficiently and that our cost, we focus a lot of attention on getting this cost of development right. And so the opportunities that you see us going after are really focused on areas where we can get significant acreage positions, and then we're going to approach it with a very disciplined development approach to maintain a low cost of development or banded cost development."
},
{
"speaker": "Michael LaMotte",
"text": "Thanks, Henry."
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah."
},
{
"speaker": "Operator",
"text": "We'll next go to Paul Sankey with Deutsche Bank."
},
{
"speaker": "Paul Sankey",
"text": "Yeah. Hi, Henry. For my first question, I could just go back to the volumes sort of high level part specific, on the high level view at the analyst meeting outlined as you said a slight fall in '08?"
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah."
},
{
"speaker": "Paul Sankey",
"text": "Followed by slight rise in '09. Now that we've had something of a sharp fall in '08. Do we work off this lower base assuming flat oil prices from here or do we expect to see a fairly short comeback as over the course of 2009? And the follow-up to that naturally becomes, could you update us on the specific projects and when you expect them to start up now for the second half or first half of '09?"
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah."
},
{
"speaker": "Paul Sankey",
"text": "Thanks."
},
{
"speaker": "Henry H. Hubble",
"text": "If you look at... we provided in the supplement material a bridge on the volumes, recognizing this was going to be an area and tried to put in some of the notable effects versus where we were last year and today. And if you look at that, you know that we talked already about the 160 kbd associated with PSC or entitlement effects. 95 of that is net interest reductions and those that is interest reductions are basically tranche changes that are permanent. So they roll through in, and each year when we update in our March analyst meeting we're basically reflecting updates to that as well as course updates for the various project outlooks. But you ought to think about that as rolling forward. And then as you look at the price spend effects, that's basically a reflection of crude prices and spend levels. And if crude is at $100 and you spend the $100, you get one barrel, if it drops to 50, we'll get two. So it really coming back to your guess at and my guess at what the future price of oil is going to be, but if you're looking at you assume the same kind of prices that we've had these effects could be at the same level going forward if the price maintains to that same level. And then if you look at the other effects in the bridge relative to last quarter there was 29 a day associated with Venezuela, there is 29 of Nigerian strike that was highlighted in there, those are the Nigerian piece is basically a one-time effect. And then the balance this 104 or 2.5% that we talked about Exo's effects is if you look through it, it's largely maintenance. The... if you look at net interest, I mean the decline rates, no surprises there. The projects that we have coming on and the growth in European demand basically they offset each other, and so the impact that you're left with this is maintenance, primarily maintenance."
},
{
"speaker": "Paul Sankey",
"text": "That's great. Henry, thanks. It is really very helpful indeed. If I could jut follow up on two brief things; first, how much are you down in Nigeria right now. And secondly, could you give us an idea of the sensitivity of that PSC price spend element, let's say for a dollar change how much should we expect that price spend effect to be?"
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah I don't really a rule of thumb to give you, you know because these things are... you hit these different tranches, you have a whole series of different contracts, different tranches, the price spend effect you can kind of look at as... I know as we talked about in terms of impact. But basically, if you see prices, crude prices maintaining at these same kind of levels, we see similar kind of impacts going forward. And based or slightly higher if we maintain at these price levels into the second half. And if you look at what the Nigerian strike impact and the maintenance that we had that is above the original plans here. I mean even excluding the price effects, we're slightly behind our outlook and it's going to be a challenge to catch that up during the year. So that maybe about as much as I can give you going forward in terms... and we'll be updating obviously again in March when we come back to you through the analyst meeting."
},
{
"speaker": "Paul Sankey",
"text": "Okay, Henry, thanks a lot. Could I just ask a follow up and then call up my second question on the downstream."
},
{
"speaker": "Henry H. Hubble",
"text": "Yes, yeah."
},
{
"speaker": "Paul Sankey",
"text": "Its notable, you don't separate it out. You got the regional demand and then you got the byproduct demand, but it's notable that gasoline demand in your numbers is down 9% and distillate up 5%."
},
{
"speaker": "Henry H. Hubble",
"text": "Yes."
},
{
"speaker": "Paul Sankey",
"text": "Is there any additional noise in that or is that just a mega trend and I'll leave it at that. Thanks."
},
{
"speaker": "Henry H. Hubble",
"text": "What you're seeing in the gasoline, I mean it basically reflecting... there's some divestments in that. It's a significant piece of it as we've been going through this process. But the other piece there is, we did have higher conversion unit, planned maintenance that largely impact gasoline production and so affects that. We are seeing if you look at the U.S., we'd say, we are down 1%, 1.5% or 2 or it's hard to actually determine in a short period of time, what that demand is. And you'll see those numbers were biased over time, that we would say, we are seeing something in that kind of range 1 to 2%."
},
{
"speaker": "Paul Sankey",
"text": "So is that gasoline or oil product?"
},
{
"speaker": "Henry H. Hubble",
"text": "Gasoline, well, actually it's... you kind of see it rolling though in that. I would say it's in the total demand, but gasoline is a piece of that, the bigger piece of that in the U.S. In the distillates we are seeing growth year-on-year. And so there's actually been from a production standpoint a shift to try to maximize the distillate production, diesel production and so you see us emphasizing that. That's why you see some of the growth there. The Mo gas has been well supplied inventories as you know are pretty high. And so that's been the push in the demand there."
},
{
"speaker": "Paul Sankey",
"text": "Thanks, Henry. I will let someone else have a go. Thank you."
},
{
"speaker": "Henry H. Hubble",
"text": "Alright, very good."
},
{
"speaker": "Operator",
"text": "Our next question then is from Erik Mielke with Merrill Lynch."
},
{
"speaker": "Erik Mielke",
"text": "Yeah. Hi, Henry."
},
{
"speaker": "Henry H. Hubble",
"text": "Hi, Erik."
},
{
"speaker": "Erik Mielke",
"text": "In the upstream, I think we are getting better forecasting volumes with production more or less we expected. But the contribution coming through from, I think from international E&P was lower than what we had?"
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah."
},
{
"speaker": "Erik Mielke",
"text": "despite volumes and realized prices been aligned. It's obvious; the high tax is part of the answer. But it also seems that the cash flow is significant during the quarter. Can you help us understand what's your place with custom taxes and how we should think about that going forward with any new tax thresholds that you hit because of the high oil price in the quarter, any significant exponential expense and so forth?"
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah. I mean the bridge, if you look at the bridge from the second quarter '08 to last year, I mean we have this 330 impact in other, you know that basically OpEx and tax effects were the two big components there. It's always made up of a number of different factors that are offset, but those were the two big that contributed to the increase. If you look at that, about a third of that was taxes, some of that, the biggest chunk of that was the Alaska tax effects. So that's really what's going on there. Then on the OpEx side, we continue to see inflationary effects in our OpEx, we also are seeing higher non-cash kinds of cost associated with new projects start ups and the capital investments that we are making. So that is reflecting through. And you know... but we have a very active program to be able to offset a lot of the escalation that we see. We are just not able in this environment to offset all of it."
},
{
"speaker": "Erik Mielke",
"text": "Okay, thanks. And I think Paul asked this before, I'm not sure you gave a complete answer on the outlook for production in the second half in some of the key projects?"
},
{
"speaker": "Henry H. Hubble",
"text": "Oh yeah, I'm sorry."
},
{
"speaker": "Erik Mielke",
"text": "Particularly on Kizomba [ph], Tengiz and Thunder Horse and so forth?"
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah. If you look you know on the... in our outlook for the year, we had 12 major projects that we were planning on, was getting up during the year. Five of those have started up as I mentioned in the call, we still have the Malaysia, Jerneh B Kizomba C, Saxi/Batuque, those we should be hearing or announcing some things shortly and those. Thunder Horse, I think you know the status so that it's up initial oil and we'll be ramping that up as we go through the year, rest of the year. And then Qatar Gas Train 2, the first of the 7.8 Qatar Gas 2 Train 4, the first of the 7.8 million ton per annum trains; that will be starting up in basically supplying into the demand for the winter of '08. So we'll be giving that up in the fourth quarter. RasGas Train 6, basically we will be starting the commissioning of that at the end of the year and it will start contributing in the first quarter. So that's the big production startups and then of course we also have the terminals that are moving along on schedule."
},
{
"speaker": "Erik Mielke",
"text": "And is there a lot of pickup from the second quarter, particularly from places like Nigeria and so forth where you lost some volumes and..."
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah. Well, we did... of course we had the strike there and then we've had maintenance. Basically most of that maintenance, we talked a little bit about it previously but is in the JV area, it's about a little over 50 a day impact as we're going through that now. Some of that will continue into the third quarter. Basically, we have an ongoing and active maintenance program and we're upgrading our facilities associated with that. But we will have in addition of course the absence of the strike, but still some ramp up associated with the well sort of come back on."
},
{
"speaker": "Erik Mielke",
"text": "Thanks, Henry."
},
{
"speaker": "Henry H. Hubble",
"text": "And then the only other thing I might mention is, of course, this is... I mentioned the first two of those trains, we do have the last two of the 7.8 million ton per annum trains will also be starting up in 2009."
},
{
"speaker": "Erik Mielke",
"text": "That's great, thank you."
},
{
"speaker": "Henry H. Hubble",
"text": "Alright."
},
{
"speaker": "Operator",
"text": "Our next question is from Neil McMahon with Sanford Bernstein."
},
{
"speaker": "Neil McMahon",
"text": "Hi, Henry."
},
{
"speaker": "Henry H. Hubble",
"text": "Hi, Neil."
},
{
"speaker": "Neil McMahon",
"text": "Just a few questions."
},
{
"speaker": "Henry H. Hubble",
"text": "Sure."
},
{
"speaker": "Neil McMahon",
"text": "First of all, I am scratching my head to try and think of you at times before in the past when second quarter U.S. refining and marketing was down on first quarter, as you reported, maybe you could just give us a bit more detail on that and maybe... ?"
},
{
"speaker": "Henry H. Hubble",
"text": "Yes. One of the things that you see, whenever you see a real rapid run up in crude prices like we saw, there is always some compression that goes on and that generally will have a negative impact in the margins that we are able to capture. One of the other impacts that we also see, is a more of an accounting one, is on price finalization. And if you look at the price finalization impact in the first quarter... I mean, in the second quarter here, in total it was about $300 million, the vast majority of it in the U.S. So that was a larger impact that I think may not have been picked up."
},
{
"speaker": "Neil McMahon",
"text": "And just generally on demand in the U.S. and worldwide, normally it's a something you are not as exposed to as others given the diversified nature of the business and the different product lines. Has that changed much this time around from last quarter?"
},
{
"speaker": "Henry H. Hubble",
"text": "We do a... when we look at our own demands, we're pretty much surrogate for the industry global demands picture. And when we look at the global demand, in the past... if you look at the 10 year average growth rate for petroleum liquids demand, it's been about 1.4 million barrels a day per year growth. We and others, as we've been looking at this and the impact of the economic activity as well as prices on the demand, we're now projecting that somewhere around 0.7 million barrels a day. So about half... still growing, but about half the rate that we would have seen in the past. And if we look around to where that's happening, the bulk of it is in the developing parts of the world, Middle East; Asia-Pac, and we actually see demand declining in the U.S. and in the OECD areas during this year."
},
{
"speaker": "Neil McMahon",
"text": "Okay. Just a quick second question, something that's been quite noticeable, especially looking at your year-to-date share price performance is really the lack of impact of the buyback program on your share price. I know it's something that you definitely have a strategy to stick with. When do you think the buybacks will catch up with the liquidity in the market? When do you... have you done any work to suggest that if you take enough shares it will actually start to impact liquidity for your stock and therefore potentially see a price rise?"
},
{
"speaker": "Henry H. Hubble",
"text": "If you look at... I mean the way we think about the buyback, it's a distribution, and we view it as nothing more than a distribution. So we don't time it based on price, we don't... we buy ratably and we buy continuously in the market. And so we view it just as a distribution. So we are not really focusing as an investment or timing based on price. But if you look it from a liquidity standpoint, it's such a small percent of the volume overall and the shares outstanding for our company were over 5 billion shares with a lot of trading on a daily basis. We are not concerned about from a liquidity standpoint."
},
{
"speaker": "Neil McMahon",
"text": "I was just thinking more from the fact that given your very large retail shareholder base and therefore... and on top of that adding in lots of family funds and things that have owned Standard Oil stock maybe, way-way back. That at some point, the actual overall share count may not fully reflect the liquidity of what's effectively in the market."
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah, I mean, we do have, as you point out, a strong retail shareholding. But I wouldn't... they participate in the market like the institutions and we see that. So, I wouldn't consider that as basically effective reduction of shares outstanding. They're loyal. We do have some long-term shareholders, but it's not a big impact in the liquidity end of the equation."
},
{
"speaker": "Neil McMahon",
"text": "Great, thanks, Henry."
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah."
},
{
"speaker": "Operator",
"text": "Our next will be from Mark Gilman with Benchmark Capital."
},
{
"speaker": "Mark Gilman",
"text": "Henry, good morning"
},
{
"speaker": "Henry H. Hubble",
"text": "Hi, Mark. How are you?"
},
{
"speaker": "Mark Gilman",
"text": "Good, thanks. Hey, thanks very for much for what you call the production bridge, very helpful. If I could just follow up on that for a SEC."
},
{
"speaker": "Henry H. Hubble",
"text": "Yes"
},
{
"speaker": "Mark Gilman",
"text": "The net interest reductions indicated on the chart."
},
{
"speaker": "Henry H. Hubble",
"text": "Yes"
},
{
"speaker": "Mark Gilman",
"text": "Little smaller than, frankly, what I would have thought it was. Could you identify where those were hit and potentially talk a little bit about where you anticipate encountering similar effects in a price environment, let's say, equal to where we are today?"
},
{
"speaker": "Henry H. Hubble",
"text": "Well, I could tell you the... if you look at that 95 of net interest hit, about half of that's in Africa. And then there is a little less than half actually in the Russian Caspian area and that's basically associated with Azerbaijan. And those were the two big areas. So in the piece in Africa, as we've talked before, the East project is ring fenced in the Africa projects. So you are seeing different tranches hitting at different points for different projects. And to be honest with you, I can't give you a feel for it. We've moved through... if you look at some of our overall projects, we have moved through a lot of those tranches, but there is still some out there. And just to put into some perspective, I think, there is about 20% of our overall production that has these... has the potential for these kinds of impacts. They are in a PSC kind of arrangement."
},
{
"speaker": "Mark Gilman",
"text": "20% of your PSC production or your global production?"
},
{
"speaker": "Henry H. Hubble",
"text": "No, no, no, 20% of the total production is... has PSC type contracts."
},
{
"speaker": "Mark Gilman",
"text": "Well, not all of those have net interest reduction elements to them. Do they."
},
{
"speaker": "Henry H. Hubble",
"text": "No, no, absolutely, there are a lot of different terms for those, they have a lot of different... some of them don't have much price effect at all in them. Right, you are right."
},
{
"speaker": "Mark Gilman",
"text": "Okay. If I could just for a second question, tax-oriented. The effective tax rate for the quarter for the corporation was essentially equal to the first quarter."
},
{
"speaker": "Henry H. Hubble",
"text": "Yes, yeah."
},
{
"speaker": "Mark Gilman",
"text": "Yet from a mix... from an earnings mix standpoint..."
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah."
},
{
"speaker": "Mark Gilman",
"text": "Taking into consideration the higher price environment and also some of the commentary as you went through your quarterly review regarding the impact of tax effects, particularly in the corporate segment, I would have expected it be a higher effective rate. Was there an offset somewhere?"
},
{
"speaker": "Henry H. Hubble",
"text": "No, actually there aren't... it's a pretty clean number that you are looking at there. And so there weren't a lot of effect... or very little in the way of one-time effects that are in this. So it just basically you do see a reflection on the mix of earnings, we have had... we have and a big piece of that is mix of earnings between upstream and downstream chemicals, as well as, of course, then in the mix of our upstream, where the upstream earnings are occurring. So it's a pretty clean number, but there is nothing really major in there that's a factor as a one-time effect."
},
{
"speaker": "Mark Gilman",
"text": "Okay, Henry. Thanks a lot."
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah, no problem."
},
{
"speaker": "Operator",
"text": "Our next question is from Jason Gammel with Macquarie."
},
{
"speaker": "Jason Gammel",
"text": "Thank you. Hi, Henry."
},
{
"speaker": "Henry H. Hubble",
"text": "Hi, Jason, how are you?"
},
{
"speaker": "Jason Gammel",
"text": "Good, thanks. You've done a pretty job. I am pretty far down in my question list here. Maybe you could talk a little bit about chemical margins. This is one of the lower quarters in quite some time in terms of chemical earnings?"
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah."
},
{
"speaker": "Jason Gammel",
"text": "Are you seeing any changes to margin activity right now or does it look like the next quarter or two is going to be fairly similar?"
},
{
"speaker": "Henry H. Hubble",
"text": "Well, I mean, if you look at margins, they have been under pressure just like we see in the refining side of the business. I mean, as you have these very rapid run ups in feedstock costs and so on, that's rolled through. But you also... I mean, we have seen this in the past too where there... what we'd almost called mini-cycles in the business where people see prices running up and they back off on purchases. So you will see swings in sales associated with that. We continue... if you look at long-term in this business, as we've talked many times, we see the chemical business as a growing business. It grows a couple of percent above GDP, it's had a long-term profile, we don't see that really changing. There are in the current environment though an impact associated with this very rapid run up in prices and we are seeing some of that really reflecting through in specific projects, I mean, in product areas, Aromatics in particular was hit relative to last quarter."
},
{
"speaker": "Jason Gammel",
"text": "Yes, that makes sense."
},
{
"speaker": "Henry H. Hubble",
"text": "But overall, I mean, it's robust given the environment. If you look at the benefits we have in this area, we feel pretty good about the way our chemicals business has been performing."
},
{
"speaker": "Jason Gammel",
"text": "Okay, thanks, and that's helpful. And if I could ask a second one. On the PNG/LNG project, now that you have the fiscal regime and the regulatory regime pretty much firmed up with the governments, are there any other hurdles to reaching final investment decision or do you think that's something that could occur fairly quickly?"
},
{
"speaker": "Henry H. Hubble",
"text": "Well, we're working through the FEED at this point. So... I mean, there's always things you learn in that process. So, we'll be taking it through that stage and basically of course we have to get the necessary permits and the licenses and then of course also sales agreements that we're working. But I would say overall we feel very good about the project and are moving it ahead. So."
},
{
"speaker": "Jason Gammel",
"text": "Okay, that's terrific. Thanks a lot, Henry."
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah."
},
{
"speaker": "Operator",
"text": "Next question is from Paul Cheng with Lehman Brothers."
},
{
"speaker": "Paul Cheng",
"text": "Hi, good morning."
},
{
"speaker": "Henry H. Hubble",
"text": "Hey, Paul. How are you?"
},
{
"speaker": "Paul Cheng",
"text": "Very good. Henry, you talked about the PSC impact on the production."
},
{
"speaker": "Henry H. Hubble",
"text": "Yes."
},
{
"speaker": "Paul Cheng",
"text": "But you got to have a corresponding impact on your unit expense rate, unit costs, as well as the tax rate. Can you quantify on those two item?"
},
{
"speaker": "Henry H. Hubble",
"text": "Well, I mean..."
},
{
"speaker": "Paul Cheng",
"text": "Because I mean, when you string your production, but you still have to show that the full costs, I mean, your unit costs go up. Wondering that is there any number that you can share that, how big is the impact in the second quarter?"
},
{
"speaker": "Henry H. Hubble",
"text": "I mean. when you... if you look at the... probably the best way to look at that though is if you look at our net income per barrel and we have... you can develop and most of guys have correlation looking back at capture rate relative to crude price. You will see... I mean, we are pretty much on that correlation, we are capturing. So, there is not a big shift there. That wasn't a big factor. I mean, there some, as you see, just more moving overseas or higher percentage overseas, but it really... that hasn't been a big shift for us. And we recover those costs in the PSC kinds of projects and of course we recover those costs directly through barrels that we are incurring."
},
{
"speaker": "Paul Cheng",
"text": "And Henry, you mentioned earlier that Alaska, the tax increase and that's from last year, obviously the rise in oil price that we have significant. How big is the incremental tax in Alaska in hitting you sequentially from first to second quarter?"
},
{
"speaker": "Henry H. Hubble",
"text": "First to second, I don't think there was... I don't know, I don't have a figure on it. If you look at the... I know that's not your question. If you look at from the second quarter year-on-year, it was about 100 million. But I don't know what it is sequentially, it wasn't a big factor, for sure."
},
{
"speaker": "Paul Cheng",
"text": "It shouldn't or it should be?"
},
{
"speaker": "Henry H. Hubble",
"text": "It is not, it is not. No."
},
{
"speaker": "Paul Cheng",
"text": "Oil price-wise, quite substantially in the second quarter."
},
{
"speaker": "Henry H. Hubble",
"text": "I mean, there is some incremental effects. But it's not a major impact, and not in the reconciliation here."
},
{
"speaker": "Paul Cheng",
"text": "I see. Can I just ask a quick one? Do you have any number in terms of the inventory gain or loss in the quarter, any meaningful number, any trading, commercial trading or hedging losses or --?"
},
{
"speaker": "Henry H. Hubble",
"text": "We don't have... we really just don't have anything there. I mean, it's... we don't... we basically... our trading is basically for physical movements. So we are not doing a lots of... in fact, we do very, very, very little derivatives kinds of trading."
},
{
"speaker": "Paul Cheng",
"text": "Okay. FX, any big impact this quarter?"
},
{
"speaker": "Henry H. Hubble",
"text": "FoxEx, yeah, it's... if you look across the total business, it was like $50 million or something that range. The upstream negative, downstream had about a 100 negative, upstream about 25 negative, chemicals was actually positive about 80 something."
},
{
"speaker": "Paul Cheng",
"text": "Is it year-over-year or sequential, this number?"
},
{
"speaker": "Henry H. Hubble",
"text": "That's a year-over-year."
},
{
"speaker": "Paul Cheng",
"text": "Do you have a sequential number?"
},
{
"speaker": "Henry H. Hubble",
"text": "Yes and there it's about 60 for the total corporation, about 100 positive for upstream, about 200 negative for downstream and those were the big effects."
},
{
"speaker": "Paul Cheng",
"text": "Very good, thank you."
},
{
"speaker": "Henry H. Hubble",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. We'll go to Robert Kessler with Simmons & Company."
},
{
"speaker": "Robert Kessler",
"text": "Henry."
},
{
"speaker": "Henry H. Hubble",
"text": "Hi, Robert. How are you?"
},
{
"speaker": "Robert Kessler",
"text": "Not bad. A couple of quick project updates, if I might. Can I ask what current production is at deepwater Gunashli noting a startup in the quarter? And then secondly just for an update on Sakhalin. Where is production today at that development?."
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah. Let's see if I have. I don't have something right on my finger tips here. Actually it would be about 80 on Gunashli."
},
{
"speaker": "Robert Kessler",
"text": "Okay."
},
{
"speaker": "Henry H. Hubble",
"text": "Sorry, that's ACG total. Yeah, that's ACG total. Our net, that's our --"
},
{
"speaker": "Robert Kessler",
"text": "That's your net in ACG total."
},
{
"speaker": "Henry H. Hubble",
"text": "No, that's... I'm sorry, that's gross. And then we have an 8% interest in that."
},
{
"speaker": "Robert Kessler",
"text": "That's gross for Gunashli then, right?"
},
{
"speaker": "Henry H. Hubble",
"text": "Yes. And then Sack is about 200."
},
{
"speaker": "Robert Kessler",
"text": "200 today. And where would you expect kind of managed decline on Sakhalin going forward, what kind of rate per year?"
},
{
"speaker": "Henry H. Hubble",
"text": "It's not... we don't really have a number that I can... that I have available on our go forward field by field. We don't typically get into that. But we do... we are working, of course, the next phases, but it's not one that's fallen off cliffs here."
},
{
"speaker": "Robert Kessler",
"text": "Okay, fair enough. Thanks, Henry."
},
{
"speaker": "Henry H. Hubble",
"text": "Yeah."
},
{
"speaker": "Operator",
"text": "And with that, there are no further questions. I'd like to turn the conference back for any additional or closing comments."
},
{
"speaker": "Henry H. Hubble",
"text": "I'd just like to thank everybody for participating and for the questions this morning."
}
] | null | null |
XOM | 1 | 2,008 | 2008-05-01 11:00:00 | Executives: Henry Hubble - VP of IR, Secretary
Analysts: Douglas Terreson - Morgan Stanley Mark Flannery - Credit Suisse Neil McMahon - Bernstein Michael LaMotte - J.P. Morgan Arjun Murti - Goldman Sachs Paul Sankey - Deutsche Bank Doug Leggate - Citigroup Paul Cheng - Lehman Brothers Robert Kessler - Simmons & Company Mark Gilman - Benchmark
Operator: Good day everyone and welcome to this Exxon Mobil Corporation First Quarter 2008 Earnings Conference Call. Today's call is being recorded. At this time, for opening remarks, I would like to turn the call over to the Vice President of Investor Relations and Secretary, Mr. Henry Hubble. Please go ahead, sir.
Henry Hubble - Vice President of Investor Relations, Secretary: Thank you. Good morning and welcome to Exxon Mobil's teleconference and webcast on our first quarter 2008 financial and operating results. As you are aware from this morning's press release, Exxon Mobil continues to deliver strong earnings performance. In an environment of high commodity prices, Exxon Mobil's outstanding portfolio of integrated businesses performed well allowing us to deliver record first-quarter results. Before we go further, I would like to draw your attention to our cautionary statement. Please note that estimates, plans and expectations are forward-looking statements. Actual results including resource recoveries, volume growth and project outcomes could differ materially due to factors I discuss and factors noted in our SEC filings. Please see factors affecting future results and the form 8-K we furnished this morning, which are available through the investor section of our website. Please also see the frequently used terms, the supplements to this morning's press release. And the 2007 financial and operating review on our website. This material defines key terms I will use today; shows Exxon Mobil's net interest in specific projects and includes our SEC regulations G disclosure. Now I'm pleased to turn your attention to our first quarter results. Exxon Mobil's first quarter 2008 normalized earnings and net income were $10.9 billion, an increase of $1.6 billion from the first quarter of 2007. Earnings per share were $2.03, up 25% from a year ago. Driven by the strong earnings and also the continuing benefits of our share repurchase program. In the first quarter of 2008, we increased our quarterly share repurchases to reduce shares outstanding from $7 billion to $8 billion, demonstrating our commitment to return cash to our shareholders. Before I discuss specific business line results, I would like to share some of the milestones we achieved since the last earnings call. During the first quarter start-up was achieved at the Bulba field [ph] located at 120 miles off the coast of Norway in the southern section of the Norwegian Continental Shelf. At its peak, this development is expected to produce 50,000 barrels of oil and 30 million cubic feet of natural gas per day. Further demonstrating the quality of our North Sea portfolio, in the first quarter we also announced the start-up of production from the Starling field in the U.K. sector of the North Sea. At peak production, the field is expected to deliver 110 million cubic feet of natural gas per day to the U.K. market. Following the January start-up of the Exxon Mobil operated Mondo field in the field in the Kizomba C development offshore Angola, Starling are the second and third major upstream start-ups for Exxon Mobil this year. In total, we anticipate 12 major upstream project start-ups in 2008, including the first two 7.8 million ton per annum LNG trains in Qatar, in the second half of the year. Also in the first quarter, Exxon Mobil signed the main principles agreement for a new 25-year production-sharing contract with the Malaysian National Oil Company, Petronas. Through the new PSC, we expect to invest in significant enhanced oil recovery and conventional oil development activities in Malaysia, utilizing our proprietary technologies and industry leading project execution capabilities. Exxon Mobil's advantage technologies continue to deliver competitive differentiation and maximize the profitability of our upstream producing assets. In the first quarter, we broke our own world record for extended reach drilling total depth, with the completion of the Z-12 well at our Sakhalin I project in Russia. The well was drilled from land and reached its target depth more than seven miles offshore. Through the implementation of Exxon Mobil leading edge technologies, we've improved drilling performance at Sakhalin by over 50% since the project began. Also, in the first quarter we added to our global portfolio of outstanding deepwater exploration opportunities. In the recent Gulf of Mexico lease sale, we were the high bidder for 15 blocks totaling 85,000 acres. Additionally, we were awarded 13 full and partial blocks totaling 760,000 gross acres in the Porcupine basin, offshore Ireland. Exxon Mobil continues to make significant progress in the capture of high potential, unconventional exploration opportunities around the globe. In April, we announced two new agreements related to unconventional gas and liquids opportunities in Hungary. The first is a joint exploration program covering a 387,000 gross acres in the Mako Trough area of southeast Hungary. The second is a production and development agreement covering a further 185,000 gross acres on an adjacent block. Our work programs in Hungary including wells, production tests and reservoir evaluation studies are getting underway this year. Exxon Mobil, along with majority owned affiliate, Imperial Oil Limited, further enhanced our portfolio of unconventional exploration opportunities, with the recently announced capture of about 115,000 acres in the Horn River Basin in the Northeastern British Columbia, Canada. Plans to evaluate the shale gas play potential, includes seismic acquisition and exploration drilling in late 2000 and beyond. Exxon Mobil brings industry leading technical expertise to all of these opportunities, including our fast drill process and our tight gas development capability. Exxon Mobil continues to pursue and capture a wide variety of opportunities to develop hydrocarbon resources to help meet growing energy demand. Now, moving to the downstream. In refining, we continue to improve our... the profitability of our operations through crude diversification. In the first quarter, we ran 35 crude new to individual refineries, nine of which were new to Exxon Mobil. We also continue to identify and implement projects to improve performance at our refineries by applying new technologies, which further enhance operations reliability, and margin capture. In our Lubricants and Specialties business, we launched the Mobil 1, advanced fuel economy synthetic motor oils in the U.S. In addition to providing outstanding engine protection, these advanced products can improve fuel efficiency in modern gasoline engines by up to 2% compared to traditional engine oils. In our Chemical Segment, Exxon Mobil launched a new methyllysine polyethylene platform called Enable mPE in the first quarter. This new product generates films with exceptional performance and also delivers energy savings in the production process. Our commitment to technology leadership and innovation continues to deliver breakthrough chemical products to meet the needs of our customers. During the quarter, Exxon Mobil's polyolefin plant in Baton Rouge was awarded the distinguished safety award from the National Petrochemical and Refiners Association for an unprecedented sixth consecutive year. This honor is a reflection of our fundamental and ongoing commitment to safety in all aspects of our operations. Now turning to the business line results. Upstream earnings in the first quarter were a record at $8.8 billion up $2.7 billion from the first quarter of 2007. We continue to capture the benefit of strong industry conditions this quarter with upstream after-tax unit earnings of just over $23 per barrel. Record crude oil and natural gas realizations increased earnings by $4.4 billion. Worldwide crude oil realizations were up $38.50 per barrel, and natural gas realizations were up $2.43 per Kcf from the first quarter of 2007. Volume and mix effects reduced earnings, as increased natural gas volumes were more than offset by lower crude oil volumes. Other effects reduced earnings by $900 million. Just over a third of that reduction was due to higher taxes; about 250 million reflects the impact of increased operating expenses including the effect of new field start-ups and increased exploration activity. And the balance was primarily lower earnings from asset sales. As anticipated in our outlook for 2008, volumes were lower in the first quarter than a year ago. Oil equivalent volumes decreased about 5.5% from the first quarter of last year. Excluding the Venezuela expropriation, divestments, coders and pricing spend impacts volumes were down 3%. The decrease was primarily due to PSC net interest reductions of approximately 80,000 barrels per day and the impact of maintenance activities in West Africa. Major project ramp ups in the North Sea and West Africa and increased European natural gas demand, offset fuel decline in mature areas. Our 2008, volume profile which we shared at our recent march Analyst Meeting, is back-end loaded due to the timing of major field start-ups, including the two large LNG trains in Qatar, [inaudible] SGP build facilities in Kazakhstan, and Thunder Horse in the Gulf of Mexico in the third and fourth quarters of this year. Liquid's production decreased about 270,000 barrels per day or 10% from the first quarter of last year. Excluding the Venezuela expropriation, divestments, quotas and price and spend impacts on volumes, production was down 6%. Major project ramp ups in West Africa and the North Sea were more than offset by natural fuel decline in matured areas, PSC net interest reductions and the impact of maintenance activities in West Africa. Gas volumes increased approximately 130 million cubic feet per day from the first quarter of 2007. New product volumes and higher demand due to colder weather in Europe were partly offset by natural fuel decline in mature areas. Turning now to the sequential comparison. Versus the fourth quarter of 2007. upstream earnings increased $580 million due to higher crude oil and natural gas realizations, partly offset by lower volumes and other effects primarily lower earnings from asset sales. Liquid's production decreased 2% due to the maintenance activities in West Africa and also price and spend impact. Natural gas production was also lower primarily due to natural fuel decline in mature areas. Oil equivalent volumes were down 2% from the fourth quarter. For further data on regional volumes, please refer to the press release and IR supplement. Turning now to the downstream results. Earnings in the first quarter were $1.2 billion, down nearly $750 million from the first quarter of 2007. Refining margins were markedly lower, compressed by rising crude prices, which reduced earnings by $1 billion. Volume and mix affects increased earnings by $350 million primarily due to refinery optimization activities. Other effects reduced earnings by $90 million, reflecting higher operating expenses including increased U.S. turnaround activity, partly offset by positive foreign exchange effects. Sequentially, first quarter earnings were $1.1 billion, below fourth quarter 2007. Lower margins reduced earnings by $360 million, while volume and mix effects decreased earnings by $80 million, primarily due to increased turnaround activity in the U.S. Other factors reduced earnings by $660 million, including the absence of positive LIFO inventory effects of about $250 million and approximately $400 million in lower earnings associated from asset sales. Focusing now on our chemical earnings. First quarter chemical earnings of $1 billion were $210 million lower than the first quarter of 2007. Lower margins reduced earnings by $350 million, as higher feedstock costs, more than offset increased product realizations. Other impacts increased earnings by $140 million, reflecting favorable foreign exchange and tax effects. Sequentially, first quarter chemical earnings decreased by $85 million. Higher margins increased earnings by $40 million as increased realizations more than offset higher feedstock cost. Lower volumes reduced earnings by $30 million, while other factors including the absence of positive tax and LIFO effects reduced earnings by $90 million. Turning now to our corporate and financing segment. Corporate and financing expenses in the first quarter were $90 million, versus earnings of $90 million in the same period a year ago, including the impact of higher corporate costs and the absence of positive tax effects. The effective tax rate for the first quarter was 49%. Our cash balance was $41 billion and debt was $10 billion at the end of the first quarter. The corporation distributed a total of nearly $10 billion to shareholders in the first quarter through dividends and share purchases to reduce shares outstanding, an increase of $1.1 billion or 13% versus the first quarter of 2007. During the first quarter, Exxon Mobil made share purchases in excess of dilution of $8 billion, reducing the number of shares outstanding by 1.8% and further demonstrating our ongoing commitment to return cash to our shareholders. Yesterday, our Board announced an increase in the quarterly dividend, of just over 14% to $0.40 per share. Exxon Mobil has paid a dividend each year for more than a century. And has increased its annual dividend payment for 26 consecutive years. CapEx in the first quarter was $5.5 billion, up almost $1.3 billion or 30% from the first quarter of 2007, and consistent with our outlook for 2008. In summary, this quarter's results again highlight the quality of our integrated business model and disciplined investment approach allowing us to leverage, robust industry conditions and deliver superior results for our shareholders. That concludes my prepared remarks, and I'd now be happy to take your questions. Question and Answer
Operator: Thank you Mr. Hubble. The question and answer session will be conducted electronically. [Operator Instructions]. And we'll go first to Doug Terreson with Morgan Stanley.
Douglas Terreson - Morgan Stanley: Good morning Henry.
Henry Hubble - Vice President of Investor Relations, Secretary: Hi Doug.
Douglas Terreson - Morgan Stanley: In U.S. refining and marketing, specifically Shell, my question in regard whether the economic effect of the switch, away from Venezuelan and feedstock was significant in the period and if so any quantification on that factor would be appreciated?
Henry Hubble - Vice President of Investor Relations, Secretary: It was not a major factor in the results. The primary issue associated with the margins that you saw really they're kind of across the Board, if you look around the globe.
Douglas Terreson - Morgan Stanley: Sure.
Henry Hubble - Vice President of Investor Relations, Secretary: When you look at the composite worldwide margin, it was down about 245 a barrel and it was really kind of shared throughout the system. And so, I wouldn't point to anything specific at Shell [ph].
Douglas Terreson - Morgan Stanley: And also, did you say that the $660 million of other item that unfavorably affected the down stream was related to LIFO mix effects and if I missed that, what was that negative delta related to?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes. We had about $250 million of LIFO effect in the fourth quarter, you may recall, and then there was also lower gains from asset sales. We had a number of asset sales that were in that period and it was the absence of about 400... a little $400 million worth of asset sales that were not in the period. So, what you're seeing here is pretty clean in terms of overall other impacts.
Douglas Terreson - Morgan Stanley: Okay. Okay, thanks a lot.
Operator: And we will go next to Mark Flannery with Credit Suisse.
Mark Flannery - Credit Suisse: Hi, I've got a couple of questions, one is can you tell us what's happening with units production costs and unit DD&A in international E&P. Are we still seeing both of those numbers rise, and would you expect maybe to see them bend down a little bit in the second half of the year, as you get some of that in your production on? Then, I've a second one.
Henry Hubble - Vice President of Investor Relations, Secretary: Well, if you look kind of, you are going to have impacts, non-cash impacts associated with new projects that we're bringing on, and you are seeing those continuing impacts as we are basically spending… the CapEx spending to bring on those new projects. But, I guess, if I step back from in terms of, inflationary effects, we have a consistent program of working to offset those things and if you look at... when we look kind of across the Board around the globe, we're pretty well able to offset the normal inflation effects, now there is some areas of our business, where we are seeing higher rates of inflation that we're not able to fully offset, but we've been able to get two-thirds of that essentially in the past. And we're just not immune to those cost impacts, but I think from the upstream perspective, the real focus I would point to is, if you look at the net income per barrel, you will find that the capture rate of earnings that we have on our per barrel basis, continues to be quite strong, and that's a reflection of being able to manage all of these impacts overall in a positive way.
Mark Flannery - Credit Suisse: Okay, thanks. Can I just switch my second one over to European refinery run rate, which at least against old model, a little bit light in the first quarter, how would you characterize your maintenance activities there?
Henry Hubble - Vice President of Investor Relations, Secretary: Well, in the throughput area, if you look at, the biggest impact in Europe was the Englestock refinery sale, that we had in the period that took out over 90 a day of capacity. So, that was the big and we did have a turnaround that fall in the period as well. But, if you're looking at general, we did see some… we did see some lower demand and as well but that was... those were the big impact in the period.
Mark Flannery - Credit Suisse: Right. And just around that question, on US refining, are you faring any downstream capacity right now, particularly think about SGCS or other gasoline units?
Henry Hubble - Vice President of Investor Relations, Secretary: No we are... all of our conversion capacity is running full, has been running full, and we did have some turnaround activity in parallel basically doing essential maintenance that we have to do and we tend to be a little in the outside of the gasoline season, we tend to take more of those turnarounds. So we end up about, if you look around the globe about 30% of our turnarounds in the first quarter. But in the US in particular, basically we are running conversion capacity full out.
Mark Flannery - Credit Suisse: Great.
Henry Hubble - Vice President of Investor Relations, Secretary: And overall when you look at the market supply, because as you know the gasoline inventories are... have been quite high, we have been really aiming to maximize distillate production in the period as well.
Mark Flannery - Credit Suisse: Great. Thank you.
Operator: We will go next to Neil McMahon at Bernstein.
Neil McMahon - Bernstein: Hi, Henry.
Henry Hubble - Vice President of Investor Relations, Secretary: Hi Neil?
Neil McMahon - Bernstein: Just a few questions. The first is really on your increase in exploration expense, I think this must be going to the Tayrona block in Colombia and it looks like that a dry well was drilled there, and that was done using your R3M electromagnetic technology and it is sort of follows, I think a separate news reports correctly sort of disappointing results from Northern basin last year as well. Am I right in thinking this because that sort of raise questions about some of that technology?
Henry Hubble - Vice President of Investor Relations, Secretary: Well, what you see in the numbers, the increased cost is really… have been associated with seismic activity. When you look at the number of places that we have acquired acreage positions and we are now out basically shooting seismic to evaluate those in both Libya and New Zealand and others. Now when you get back to the comment on the R3M technology, we are utilizing that broadly. It is not a silver bullet though, I mean it's a technology that helps reduce risk, it helps improve our valuation of these, but it doesn't give you 100% indication. So the way we utilize it helps to de-risk these plays, but whenever you are dealing with a wildcat exploration well, you are going to have still have, even with R3M significant risk associated with those. But obviously these are prospects that we think have potential and we are evaluating the data from both the open wells and Tayrona wells that we drilled and looking at next steps.
Neil McMahon - Bernstein: But you are still planning Madagascar and Southern Basin off shore in New Zealand and little sort of exploration well, there is still a part of the whole well count risk awarded program?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes, I mean yes. I mean all of those things, and we continue to utilize the R3M as part of our data collection efforts in these new areas, because we do think it's delivering value in our ability to assess the prospects.
Neil McMahon - Bernstein: Okay. Second question was really on, as you mentioned the production sharing agreements, in West Africa, what's… certainly it looks like Kizomba A and B went form cost oil to profit oil last year. What, was there anything and addition for that may be on your interest in block 17, that did that in this quarter, that brought volumes down or was there just a general West African effect, that’s all from me.
Henry Hubble - Vice President of Investor Relations, Secretary: Well, you have a combination, I mean when you have, when you do on a year-on-year comparison, I mean the tranche effects that we saw during last year, you're still seeing those in the year-on-year comparison, you're going to continue to see those year-on-year comparisons. Now, there are multiple tranches, different projects came on at different points, so you are different places and different ones, but the other PSC effect that we talked a about a little bit was continue to have pricing spend impacts associated with them and that's basically variable reflecting the current price of crude, and the relative spend that is going on in the given period. So, we see both of those effects, but, all of that when you come back and look at it on the grand scheme of things, we've been gathering significant early value, these projects, they're performing very well and both from the original project development but also in their continuing operations. But, we are getting into some lower tranches in the number of these deals.
Neil McMahon - Bernstein: Great. Thanks a lot.
Henry Hubble - Vice President of Investor Relations, Secretary: Yes.
Operator: And to next to Michael LaMotte at JP Morgan.
Michael LaMotte - J.P. Morgan: Hi Henry.
Henry Hubble - Vice President of Investor Relations, Secretary: Hi.
Michael LaMotte - J.P. Morgan: Pretty quickly on the Hungary, maybe if I can ask you to do a little bit of comparing contrast, particularly given a news flow around Hansfield [ph], Marcellus and some of the shale plays and unconventional plays in lower 48, that's in Horn River Basin in Canada, obviously but, I'm wondering if you're taking a look at those lower 48 plays at all, and see something in Hungry, that's truly unique, can you give provide a little bit more color on that? Maybe in contrast with some relative opportunities here?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes. Well, I'm not, I can't give you a relative comparison, what I can tell you is we are… we got a pretty wide approach on what we're looking at. We look at a lot of prospects and we have a global program that allows us to look and sets opportunities around the globe. And what we try to do is identify the best resources of type wherever they are and having that global capability is one of the advantages that we have. And these are some of the areas that we think have potential but it is still early days. We're going to be going through evaluation of the Hungary, Horn River and others.
Unidentified Company Representative: When you come down to, why do we see advantage in some of these areas, we bring some technology frankly that makes that we think... provides us with some unique advantages in this kinds of developments with the multi zone stimulation technology that we have with the fast drill technologies that we have. All of those are really important in these kinds of developments. We're going to be drilling a lot of wells in there in tight gas kind of place.
Michael LaMotte - J.P. Morgan: Is it geology or end market or both that sort of pushes you into an area like Hungary?
Henry Hubble - Vice President of Investor Relations, Secretary: All of the above.
Michael LaMotte - J.P. Morgan: And is there anything in particular in the resource that you can talk about today that would lead you to build such a big position, almost 600,000 acres.
Henry Hubble - Vice President of Investor Relations, Secretary: As I say, we basically being able to take advantage of our global understanding of these potential basins and to get in there early and work with the folks and being able to evaluate these prospects. Again we are going through an evaluation phase, we are going to be doing seismic and other delineation activities to understand what we have there.
Michael LaMotte - J.P. Morgan: Okay. Maybe to assume back on global sales quickly, just in terms of seismic activity. How do you see that unfolding over the next few quarters? Or you still sort of in expansion mode there, or is it a steady state, or is it going to be winding down over the next few quarters?
Henry Hubble - Vice President of Investor Relations, Secretary: We have been watching our acreage pickup. We have a number of areas that we are going to be taking a look at. So I'd say, I can't give you a direct figure but directionally up.
Michael LaMotte - J.P. Morgan: Okay. That is helpful. And then lastly, thoughts on the Alaska pipeline?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes. Well as... we continue to look for ways to move that forward, have been evaluating the various proposals and discussions around those various proposals. And basically looking for the most effective way to… the one, get the maximum value for the State of Alaska or ourselves, production and to move that ahead. But, what we're trying do is, basically evaluate the various options that are there are now and what our next steps are to be?
Michael LaMotte - J.P. Morgan: Okay. How should be think about the current proposal with the DP and Conoco going forward?
Henry Hubble - Vice President of Investor Relations, Secretary: We're in the, from our own prospective, I think probably I want to talk to those guys about that in particular. But from our own prospective, we're evaluating that. We've been asked to participate, and we're looking at it.
Michael LaMotte - J.P. Morgan: Okay. Thank you.
Operator: And next over to Arjun Murti of Goldman Sachs.
Arjun Murti - Goldman Sachs: Thank you Henry. A follow-up to some of the comments on the West African oil production, you mentioned maintenance activity hurt volumes in the first quarter?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes.
Arjun Murti - Goldman Sachs: Would it be possible to quantify the rough magnitude of that?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes. I mean it was in… about 40 a day of impact there.
Henry Hubble - Vice President of Investor Relations, Secretary: 40 a day. Got you. So, then that sort of get this stock towards the 3Q and 4Q production was and the profit shared?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes. When you look at the PSC net interest changes, and the price spend impacts because we did see even higher prices in this period. You've got about in total the combination of those in West Africa is about 120.
Arjun Murti - Goldman Sachs: The combination of maintenance and PSC effects?
Henry Hubble - Vice President of Investor Relations, Secretary: No, actually the combination of PSC net interest changes and price spend impacts.
Arjun Murti - Goldman Sachs: I'm sorry, price spends impact. Got you, that's 120?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes, correct. And then maintenance was on top of that.
Arjun Murti - Goldman Sachs: Yes, that then starts making more sense, I guess we've thought South Africa overall is a growing region, So your net volumes can be what they are, but the gross volumes we thought are probably increasing, it sounds like that would get us closer.
Henry Hubble - Vice President of Investor Relations, Secretary: Well, when you're looking at gross production in the area, yes it is a growing area.
Arjun Murti - Goldman Sachs: Absolutely. Henry any update on the timing of some of the Qatar LNG products that are scheduled to start up this year, are they still slated for second half of this year?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes, As I mentioned, are both of them we expect to have on this year. One we basically looking at the [inaudible] in 2008 and then [inaudible] in 2008. But, they will be back-end loaded as we mentioned.
Arjun Murti - Goldman Sachs: Back-end loaded and then presumably some ramp up period as well?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes. Well, they've come on pretty fast, but… once they start-up, but basically you're going to see part year effects from the start-ups.
Arjun Murti - Goldman Sachs: That's great. And then just a final one on the Alaskan gas. Some of the controversy that's right word over Point Thomson field, your participation or not in the Alaska pipeline, potentially tied to what ultimately happens to Point Thomson resource?
Henry Hubble - Vice President of Investor Relations, Secretary: Well, Point Thomson is going to be, as important to the Alaska pipeline, it's hard to make sense out of that pipeline without Point Thomson being developed, so there, you need both. And our view on Point Thomson, I mean, we were frankly surprised and disappointed by the Department of Natural Resources decisions there, and we will be pursuing our rights in that area and we're appealing or asking for rehearing on that, but we laid out commitments there to bring that production on, and develop that production. So, frankly we were surprised to see how that turned down at this point and we'll be pursuing for rehearing and our rights to further in that regard.
Arjun Murti - Goldman Sachs: Got you. That's great, thank you very much Henry.
Henry Hubble - Vice President of Investor Relations, Secretary: No problem.
Operator: And next to Paul Sankey at Deutsche Bank.
Paul Sankey - Deutsche Bank: Hi, good morning Henry.
Henry Hubble - Vice President of Investor Relations, Secretary: Good morning.
Paul Sankey - Deutsche Bank: Henry, if you don't want to, just like to keep reaching around in the volumes a bit here. Firstly, just to go through the lines, on the U.S, I'm assuming that its just all natural fuel decline, the 10% overall decline, you got there is related to that, or whether some issues with maintenance and down time there?
Henry Hubble - Vice President of Investor Relations, Secretary: The big chunk of that is, decline, it's a mature area and the bulk of what you have is decline. When we talk about our global decline rates, we've been talking about high 5% to 6% in that level. So, this is mature area and its… that's what you're seeing there.
Paul Sankey - Deutsche Bank: Great. Thanks and then, kind of the South America, I know there was some issues in Canada. Could you strip out what was Canada, what was Venezuela for us?
Henry Hubble - Vice President of Investor Relations, Secretary: Venezuela is essentially all of it that you're looking out there. When you get down into the gas, the big change there, I mean that's basically was a bulk of that was blow down, we had that at the… it's the absence of having blow down versus last year.
Paul Sankey - Deutsche Bank: Okay. And you've gone through Africa in some detail. The one question of course is Nigeria. Now is reportedly had a 800,000 barrel a day outage, and its right? Could you comment on that for the quarter, this quarter?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes. Well, what you heard, you know we had, on April 24th, the local chapter of the Senior Oil Workers Union there in Nigeria, halted collective bargaining discussions that we had and withdrew their services there. The union subsequently shut in those facilities. What we have heard this morning is that the union has directed the employees to return to facilities and so we are anticipating that will to move things ahead there.
Paul Sankey - Deutsche Bank: So this should be about 10 day, I guess outage for the quarter?
Henry Hubble - Vice President of Investor Relations, Secretary: That implies a start-up or ramp up and I really can't, I don't know what that is going to be. So more to come on that, there are still some discussions going on. I mean they have agreed basically direct the people back to work but we still have some discussions going on there.
Paul Sankey - Deutsche Bank: And the last one on this kind of granularity on the volumes, Europe obviously we can see the jump with the gas season, but I was wondering on the oil, if there is anything you could strip out there between the various effects on the decline?
Henry Hubble - Vice President of Investor Relations, Secretary: No. I mean there is some downtime in there but the big piece of that again is, it's a mature area and mostly decline.
Paul Sankey - Deutsche Bank: Got you Sales, Henry of product over the world wide down 5% US down 8%, Asia Pacific down 6%, could you just walk us through, I'm assuming that is not the market collapsing, if you could just walk us through the effects there, that would be great on petroleum product sales?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes. I mean if you look at by region the impacts... I mean it is actually US markets... essentially what we are seeing is in the mature markets we are seeing some softening of demand. But if we look at global growth overall, we are still seeing on a overall net basis, petroleum product growth, lower rates of growth versus our 10 year average, but still growth. Most of that occurring in the developing parts of the world and in the price controlled areas. Now the... our specific results, the bulk of our reductions are actually associated with the portfolio of high grading and the divestment activities about 60% of that is associated with that. The balance is due to a number of factors including as we talked lower refinery throughput but also demand softening of the demand and those are really the major impacts in the decrease in overall product sales.
Paul Sankey - Deutsche Bank: Great. I appreciate that. And then the final one on this line and I have got one very brief follow up, is just chemicals, it's notable that your US volumes are, the sales volumes are sharply down.
Henry Hubble - Vice President of Investor Relations, Secretary: There is some of that is... there was a piece of that that we are… mostly in commodities, and you saw that both in the US and Europe but some of that is basically associated with turnarounds as well. In the chemicals business we talk about many cycles within the business and frequently when you see rapidly rising crude prices and feed stock costs, there will be pre-buying and then people holding off, so you will see some swings in volumes associated with that basically trying to manage the price impacts.
Paul Sankey - Deutsche Bank: Okay, so we should go back to expecting more like 2.7 million tons in the US, and what's the potential for growth?
Henry Hubble - Vice President of Investor Relations, Secretary: Well, I mean, we will see how it develops but I mean, I don't have any better basis to tell you at this point and the quality of the business obviously is very good. And that's a growing business and we continue to see it growing couple of GDP above... a couple of percent above worldwide GDP growth, so it's a growing. But most of that again has been Asia-Pac area. So that's where we are making the investments.
Paul Sankey - Deutsche Bank: Yes. And then the very last... final one from me briefly is the tax rate of 49%, can you just talk more about whether or not that a sustainable, the ongoing level?
Henry Hubble - Vice President of Investor Relations, Secretary: Well. I mean, when you look at the tax rates increase there, essentially part of that, the biggest piece of it as you look year-on-year is associated with it's... essentially mix of earnings. You have more upstream earnings, less in the downstream areas and also the mix around the globe as to where we are getting those earnings. So that was a big piece of that. And then we did have some lower one-time tax items that was, that was also in there. So those are the... those were the two big things and it's going to be very dependent on that mix of earnings for the future. So it's hard to predict, we've seen them moving around here a bit more likely because of the volatility in prices. So it's hard to predict exactly how that's going to be going forward.
Paul Sankey - Deutsche Bank: Thanks Henry, I leave it there. Thank you.
Henry Hubble - Vice President of Investor Relations, Secretary: All right. Very good
Operator: And we'll go next to Doug Leggate at Citigroup.
Doug Leggate – Citigroup: Thanks. Hi, Henry.
Henry Hubble - Vice President of Investor Relations, Secretary: Hi Doug.
Doug Leggate – Citigroup: Couple of things. I guess also some housekeeping questions. The cash flow, operating cash flow is very high this quarter.
Henry Hubble - Vice President of Investor Relations, Secretary: Yes.
Doug Leggate – Citigroup: Can you... is that just timing of tax payments or can you help understand a little bit what's going on there?
Henry Hubble - Vice President of Investor Relations, Secretary: You've got a piece of it. The timing of tax payments we typically see that in the first quarter where both Norway and US we have more tax expense and we have actual payments in the period. And then the other, but the bigger factor actually was associated with crude payables. And as you saw the rapid ran up in or the higher crude prices, we have basically close through into the higher crude payables, and that was the bigger impact. Of course we also had some net income increased that also impacted that as well. But the biggest factors were in the working capital changes.
Doug Leggate – Citigroup: Can you give a total working capital move in the quarter?
Henry Hubble - Vice President of Investor Relations, Secretary: Well, I mean if you come back to... it will come out in the Q, but there is the bulk of that is basically associated with the crude payables, and if you look at that delta, it's the biggest piece of the unexplained portion as the DD&A is about the same.
Doug Leggate – Citigroup: Second one is to jump back to Paul's question about the tax rate, just to get a... may be a little bit of a breakdown, can you possibly give us what we quantify rather what was one-time tax items were, so we can get the underlying tax rate for the quarter?
Henry Hubble - Vice President of Investor Relations, Secretary: It was a smaller piece of the delta, if you look at it; it's about 20 about a third of the delta that you saw between the period.
Doug Leggate – Citigroup: Will it be reasonable, let’s assume we were in a similar environment over the balance of this year we'd expect that kind of rate going forward.
Henry Hubble - Vice President of Investor Relations, Secretary: Well. As I said, it's going depend very must on how the margins and the mix of earnings play out. It get identical may be it never has been identical.
Doug Leggate – Citigroup: All right. Thanks Henry.
Henry Hubble - Vice President of Investor Relations, Secretary: All right, very good.
Operator: We will go next to Paul Cheng at Lehman Brothers.
Paul Cheng - Lehman Brothers: Hi Henry, how are you doing?
Henry Hubble - Vice President of Investor Relations, Secretary: Hi Paul, very good.
Paul Cheng - Lehman Brothers: Number of quick ones, just want to clarify. I think you were talking about the lack of foreign exchange gain on inventory in the number of your comment. So could we assume that this is a thin quarter that really no major, on the absolute term, no major foreign exchange or loess or inventory gain or loss and [inaudible]?
Henry Hubble - Vice President of Investor Relations, Secretary: That's correct. The inventory impacts as you see in our results generally and you seen in the fourth quarter associated with LIFO.
Paul Cheng - Lehman Brothers: Right. So that, this quarter if we on the project forward that is a pretty clean quarter to use?
Henry Hubble - Vice President of Investor Relations, Secretary: That's correct. It did have some FOREX impact in the small though overall.
Paul Cheng - Lehman Brothers: And what is the magnitude on... you said some FOREX impact, you said 50 million or 100, 200?
Henry Hubble - Vice President of Investor Relations, Secretary: No, less than $100 million.
Paul Cheng - Lehman Brothers: Less than a hundred?
Henry Hubble - Vice President of Investor Relations, Secretary: For total, yes.
Paul Cheng - Lehman Brothers: Okay, in Alaska after the acquisition [ph], the higher tax rate or the… whatever you call production tax I guess. Can you quantify what's that in the first quarter with the higher oil price that what's that incremental hit on you guys?
Henry Hubble - Vice President of Investor Relations, Secretary: I don't really have a delta quarter-on-quarter on that.
Paul Cheng - Lehman Brothers: May be, I try another one. Henry, when I looked at the European gas sales volume, certainly that you have a nice pickup typically they always do in the first quarter, that's for quite some time I think the message is that, you have substantially more excess capacity as a function of the demand, if the demand is there you can sell far more gas. So, I thought that the gas volume given how robust the market there will be even higher. So, is that now that the sort of like we've been on a swing by the production capacity in Europe, that and most you can do is about 5.1, 5.2 to be unless that you'll bring on new gas?
Henry Hubble - Vice President of Investor Relations, Secretary: No. I mean we have... we're basically meeting demand there and as you know [inaudible] operations, service a bit of the swing, our European swing and it was not tapped out. And it basically, its reflecting the cooler weather, that's what and you're meeting demand there.
Paul Cheng - Lehman Brothers: No. I mean the weather is pretty cold over there, so I thought that would be higher demand in that. So, you're saying that you actually spilled even in the first quarter, have excess capacity and production capacity than if you, if there is a demand that you can actually increase that?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes, that's correct.
Paul Cheng - Lehman Brothers: Okay. What is your capacity over there now, any rough idea?
Henry Hubble - Vice President of Investor Relations, Secretary: I don't have that off the top here.
Paul Cheng - Lehman Brothers: Okay. A final question over the last 18 months, I think lot of your smaller kind of pause has been pretty optimistic above some of the non-conventional pay in U.S. and obviously Exxon is very optimistic about and beyond. But, we haven't heard much about Bakken or the Barnett Shale or the other one. Wondering that how Exxon looking at in the lower 48 non-conventional play outside Pean [ph] is that those is too small economic enough that for you guys to be interest or that is an area that you guys may be interested also?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes. We're doing, we're constantly evaluating and we basically are looking for what we do is, we look for the best opportunities on a global basis and as I mentioned earlier that's one of the benefits we have with that global approach and we're targeting what we feel are the best opportunities with that we see out there.
Paul Cheng - Lehman Brothers: So, in another words, that seems you guys have not made any significant attempt into the other non conventional, is that in your global portfolio, those that just not going high up.
Henry Hubble - Vice President of Investor Relations, Secretary: Well, I mean we don't talk about everything we are looking at. So maybe more to come, who knows.
Paul Cheng - Lehman Brothers: Very good. Thank you.
Operator: We'll go next to Robert Kessler with Simmons & Company.
Robert Kessler- Simmons & Company: I have some fairly quick, but granular questions on production. One, do you have a stat for what Mondo would have produced on average in the quarter of what it's producing today. And then secondly on Piceance, where are you at in terms of total production there now?
Henry Hubble - Vice President of Investor Relations, Secretary: Piceance is still above 55 million cubic feet per day.
Robert Kessler- Simmons & Company: Is that what you are running, say a year ago, isn't it?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes. I mean, basically the expansion has not come on at this point. We are working on that direction but that has not come on. So that's... and Mondo it is about 100?
Robert Kessler- Simmons & Company: About 100 on average for the quarter or today?
Henry Hubble - Vice President of Investor Relations, Secretary: That's down a day.
Robert Kessler- Simmons & Company: 100 a day, great. And just in terms of the follow-up on the Piceance, I mean I would have thought this is just a fairly well intensive development, and I'd have expected a bit more ratable production growth there? Is it going to be more lumpy or what should we really…
Henry Hubble - Vice President of Investor Relations, Secretary: It requires gas processing and that's... some of those facilities, basically the facilities are full, just waiting for those increments of gas processing.
Robert Kessler- Simmons & Company: Okay. Thank you.
Henry Hubble - Vice President of Investor Relations, Secretary: Yes.
Operator: And next to Mark Gilman at Benchmark.
Mark Gilman – Benchmark: Henry, good morning.
Henry Hubble - Vice President of Investor Relations, Secretary: Hi, Mark.
Mark Gilman – Benchmark: I noticed in conjunction with your entry into the Horn River Basin, this is not a second thing I guess I can point to where you and Imperial have interested side by side. Is it mandated that in Canada to the extent Exxon Mobil does anything, it has to be along with Imperial's participation?
Henry Hubble - Vice President of Investor Relations, Secretary: No.
Mark Gilman – Benchmark: It is not?
Henry Hubble - Vice President of Investor Relations, Secretary: No.
Mark Gilman – Benchmark: Okay.
Henry Hubble - Vice President of Investor Relations, Secretary: We work with them obviously very closely.
Mark Gilman – Benchmark: I mean, I guess I just kind of wonder if.... similar kind of structure is... and why it is, all things considered that you wouldn't do it on 100% basis as oppose to necessarily involving Imperial at all?
Henry Hubble - Vice President of Investor Relations, Secretary: Well I mean, we basically enter into these arrangements with what we think who is going to deliver the most overall value to our shareholders and the structure is aligned with that.
Mark Gilman – Benchmark: Secondly, you made reference in your opening comments to the new Malaysian PSC. You have been the industry's leading producer in that country for a number of years operating under an existing PSC. I'm wondering does this new PSC essentially extend the existing one and/or the terms more on risk?
Henry Hubble - Vice President of Investor Relations, Secretary: Well. It's basically an extension of the existing arrangements that we have there, but it does anticipate more enhanced oil recovery. And it's basically a PSC... extension of that PSC arrangement.
Mark Gilman – Benchmark: But the physical terms the same?
Henry Hubble - Vice President of Investor Relations, Secretary: We don't get into the specifics on that.
Mark Gilman – Benchmark: Okay. Final one, in your discussion of the E&P variances, you referred to tax factors in the other category and I'm wondering whether that was rate oriented or nearly total dollar oriented that was at the root of your comment?
Henry Hubble - Vice President of Investor Relations, Secretary: It's a mix of different things; I really wouldn't point to one in particular. It's a bit of both as to what you have there, but they are onetime effects.
Mark Gilman – Benchmark: They are one time?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes. Most of them.
Mark Gilman – Benchmark: So therefore it's not a rate item?
Henry Hubble - Vice President of Investor Relations, Secretary: Well, I mean it's rate in a period.
Mark Gilman – Benchmark: Well, yes, but not a statutory rate change or something...
Henry Hubble - Vice President of Investor Relations, Secretary: That's right, that's right.
Mark Gilman – Benchmark: Okay. Just one final volume question on Asia-Pacific, Middle Eastern gas volumes, sort of little bit lower than what I would thought they would be, is that a PSC effect at all? I mean Alkelege [ph] has that kind of structure I believe?
Henry Hubble - Vice President of Investor Relations, Secretary: I mean basically the decrease is largely lower demand in Qatar and then you also some in Australia as well. So you've seen a combined effect. We did have some plant maintenance in Qatar and that's really was the big impact.
Mark Gilman – Benchmark: Okay. Thanks a lot, Henry.
Operator: And we will go next to Eric Milky [ph] at Merrill Lynch.
Unidentified Analyst: Hi, good morning, Henry.
Henry Hubble - Vice President of Investor Relations, Secretary: Hi, Eric.
Unidentified Analyst: Couple of quick ones from me. Just want to make sure I understand the maintenance impact in West Africa in the first quarter correctly. Could you quantify the sequential impact and if we should expect those volumes to be back on in the second quarter?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes. Sequentially it is about 30 in that range.
Unidentified Analyst: And then they should be back on for Q2?
Henry Hubble - Vice President of Investor Relations, Secretary: I'm looking to what I have on schedule. I think, that's good to some.
Unidentified Analyst: Okay. And on the production sharing contract impact on production, is there a seasonal; impact, is there a quarterly impact that you've more cost recovery at the beginning of the year, and therefore you have great entitlement in the earlier quarters. What do you accrue for that, so just be doing the entitlement process?
Henry Hubble - Vice President of Investor Relations, Secretary: It's not accrual. Basically, as spending occurs, it's reimbursed.
Unidentified Analyst: Okay. And on TMS 22 [ph] in Brazil, are you able to give us an update on where you have the rig?
Henry Hubble - Vice President of Investor Relations, Secretary: Well, we had scheduled basically looking to do that in the third quarter of this year, and as you know, we're bringing in sea drill rigs to do that work, and we have no change for that plan, and basically we've done in the second half.
Unidentified Analyst: Then you see rig effect, when do you expect delivery of that?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes, I mean basically in the summer, but I don't know the exact date on it.
Unidentified Analyst: Okay. And for Sakhalin 1 production in Russia, and peak was 250. You are kind of running at about 225. Do you expect to maintain 225?
Henry Hubble - Vice President of Investor Relations, Secretary: Yes. It is going to be in that range with may be some decline, but that's pretty close.
Unidentified Analyst: But not the 10% type decline that we saw year-on-year?
Henry Hubble - Vice President of Investor Relations, Secretary: No, I really don't have a field specific data that I can throw out there for you. But...
Unidentified Analyst: All right. And since the Investor Day that you had back in March, it's been some Ko [ph] project, can you tell what how that if that influences your timing of Ko, in terms of the water permit?
Henry Hubble - Vice President of Investor Relations, Secretary: As you know, we were disappointed with water permit issue. We're basically proceeding with the work that can go on outside of that, so we're doing tranche work and that kind of thing. And then, in terms of the timing of the project, though we're optimistic we're going to get this… the permit was valid and we'll get that result there. So, we are not identifying any significant impacts in the schedule and we will be updating that as we move forward.
Henry Hubble - Vice President of Investor Relations, Secretary: No.
Unidentified Analyst: Okay. That's all for me. Thanks.
Henry Hubble - Vice President of Investor Relations, Secretary: Yes.
Operator: This does conclude the mean time that we have set aside for questions, and at this time I'd like to turn the conference back for any the closing or additional comments.
Henry Hubble - Vice President of Investor Relations, Secretary: I would just like to thank everybody for the time and questions and look forward to next quarter. Thank you.
Operator: This does conclude today's conference. We do thank you for your participation. You may disconnect at this time. THE INFORMATION CONTAINED IN EVENT TRANSCRIPTS IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE CONFERENCE CALLS. AS SUCH, WE DO NOT WARRANT, ENDORSE OR GUARANTEE THE COMPLETENESS, ACCURACY, INTEGRITY, OR TIMELINESS OF THE INFORMATION. YOU MUST EVALUATE, AND BEAR ALL RISKS ASSOCIATED WITH, THE USE OF ANY INFORMATION PROVIDED HEREUNDER, INCLUDING ANY RELIANCE ON THE ACCURACY, COMPLETENESS, SAFETY OR USEFULNESS OF SUCH INFORMATION. THIS INFORMATION IS NOT INTENDED TO BE USED AS THE PRIMARY BASIS OF INVESTMENT DECISIONS. IT SHOULD NOT BE CONSTRUED AS ADVICE DESIGNED TO MEET THE PARTICULAR INVESTMENT NEEDS OF ANY INVESTOR. THIS REPORT IS PUBLISHED SOLELY FOR INFORMATION PURPOSES, AND IS NOT TO BE CONSTRUED AS FINANCIAL OR OTHER ADVICE OR AS AN OFFER TO SELL OR THE SOLICITATION OF AN OFFER TO BUY ANY SECURITY IN ANY STATE WHERE SUCH AN OFFER OR SOLICITATION WOULD BE ILLEGAL. ANY INFORMATION EXPRESSED HEREIN ON THIS DATE IS SUBJECT TO CHANGE WITHOUT NOTICE. ANY OPINIONS OR ASSERTIONS CONTAINED IN THIS INFORMATION DO NOT REPRESENT THE OPINIONS OR BELIEFS OF GRIDSTONE RESEARCH. GRIDSTONE RESEARCH, ONE OR MORE OF ITS EMPLOYEES OR BUSINESS ASSOCIATES, INCLUDING THE WRITER OF THIS TRANSCRIPT, MAY HAVE A POSITION IN ANY OF THE SECURITIES DISCUSSED HEREIN. THE INFORMATION PROVIDED TO YOU HEREUNDER IS PROVIDED "AS IS," AND TO THE MAXIMUM EXTENT PERMITTED BY APPLICABLE LAW, GRIDSTONE RESEARCH AND ITS LICENSORS, BUSINESS ASSOCIATES AND SUPPLIERS DISCLAIM ALL WARRANTIES WITH RESPECT TO THE SAME, EXPRESS, IMPLIED AND STATUTORY, INCLUDING WITHOUT LIMITATION ANY IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE, ACCURACY, COMPLETENESS, AND NONINFRINGEMENT. TO THE MAXIMUM EXTENT PERMITTED BY APPLICABLE LAW, NEITHER GRIDSTONE RESEARCH NOR ITS OFFICERS, MEMBERS, DIRECTORS, PARTNERS, AFFILIATES, BUSINESS ASSOCIATES, LICENSORS OR SUPPLIERS WILL BE LIABLE FOR ANY INDIRECT, INCIDENTAL, SPECIAL, CONSEQUENTIAL OR PUNITIVE DAMAGES, INCLUDING WITHOUT LIMITATION DAMAGES FOR LOST PROFITS OR REVENUES, GOODWILL, WORK STOPPAGE, SECURITY BREACHES, VIRUSES, COMPUTER FAILURE OR MALFUNCTION, USE, DATA OR OTHER INTANGIBLE LOSSES OR COMMERCIAL DAMAGES, EVEN IF ANY OF SUCH PARTIES IS ADVISED OF THE POSSIBILITY OF SUCH LOSSES, ARISING UNDER OR IN CONNECTION WITH THE INFORMATION PROVIDED HEREIN OR ANY OTHER SUBJECT MATTER HEREOF. THE CONTENTS AND APPEARANCE OF THIS REPORT ARE COPYRIGHTED GRIDSTONE RESEARCH, 2006. “GRIDSTONE” AND “GRIDSTONE RESEARCH” ARE TRADEMARKS OF PERPUTO, INC. ALL OTHER TRADEMARKS MENTIONED ARE TRADEMARKS OF THEIR RESPECTIVE COMPANIES. ALL RIGHTS RESERVED. | [
{
"speaker": "Executives",
"text": "Henry Hubble - VP of IR, Secretary"
},
{
"speaker": "Analysts",
"text": "Douglas Terreson - Morgan Stanley Mark Flannery - Credit Suisse Neil McMahon - Bernstein Michael LaMotte - J.P. Morgan Arjun Murti - Goldman Sachs Paul Sankey - Deutsche Bank Doug Leggate - Citigroup Paul Cheng - Lehman Brothers Robert Kessler - Simmons & Company Mark Gilman - Benchmark"
},
{
"speaker": "Operator",
"text": "Good day everyone and welcome to this Exxon Mobil Corporation First Quarter 2008 Earnings Conference Call. Today's call is being recorded. At this time, for opening remarks, I would like to turn the call over to the Vice President of Investor Relations and Secretary, Mr. Henry Hubble. Please go ahead, sir."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Thank you. Good morning and welcome to Exxon Mobil's teleconference and webcast on our first quarter 2008 financial and operating results. As you are aware from this morning's press release, Exxon Mobil continues to deliver strong earnings performance. In an environment of high commodity prices, Exxon Mobil's outstanding portfolio of integrated businesses performed well allowing us to deliver record first-quarter results. Before we go further, I would like to draw your attention to our cautionary statement. Please note that estimates, plans and expectations are forward-looking statements. Actual results including resource recoveries, volume growth and project outcomes could differ materially due to factors I discuss and factors noted in our SEC filings. Please see factors affecting future results and the form 8-K we furnished this morning, which are available through the investor section of our website. Please also see the frequently used terms, the supplements to this morning's press release. And the 2007 financial and operating review on our website. This material defines key terms I will use today; shows Exxon Mobil's net interest in specific projects and includes our SEC regulations G disclosure. Now I'm pleased to turn your attention to our first quarter results. Exxon Mobil's first quarter 2008 normalized earnings and net income were $10.9 billion, an increase of $1.6 billion from the first quarter of 2007. Earnings per share were $2.03, up 25% from a year ago. Driven by the strong earnings and also the continuing benefits of our share repurchase program. In the first quarter of 2008, we increased our quarterly share repurchases to reduce shares outstanding from $7 billion to $8 billion, demonstrating our commitment to return cash to our shareholders. Before I discuss specific business line results, I would like to share some of the milestones we achieved since the last earnings call. During the first quarter start-up was achieved at the Bulba field [ph] located at 120 miles off the coast of Norway in the southern section of the Norwegian Continental Shelf. At its peak, this development is expected to produce 50,000 barrels of oil and 30 million cubic feet of natural gas per day. Further demonstrating the quality of our North Sea portfolio, in the first quarter we also announced the start-up of production from the Starling field in the U.K. sector of the North Sea. At peak production, the field is expected to deliver 110 million cubic feet of natural gas per day to the U.K. market. Following the January start-up of the Exxon Mobil operated Mondo field in the field in the Kizomba C development offshore Angola, Starling are the second and third major upstream start-ups for Exxon Mobil this year. In total, we anticipate 12 major upstream project start-ups in 2008, including the first two 7.8 million ton per annum LNG trains in Qatar, in the second half of the year. Also in the first quarter, Exxon Mobil signed the main principles agreement for a new 25-year production-sharing contract with the Malaysian National Oil Company, Petronas. Through the new PSC, we expect to invest in significant enhanced oil recovery and conventional oil development activities in Malaysia, utilizing our proprietary technologies and industry leading project execution capabilities. Exxon Mobil's advantage technologies continue to deliver competitive differentiation and maximize the profitability of our upstream producing assets. In the first quarter, we broke our own world record for extended reach drilling total depth, with the completion of the Z-12 well at our Sakhalin I project in Russia. The well was drilled from land and reached its target depth more than seven miles offshore. Through the implementation of Exxon Mobil leading edge technologies, we've improved drilling performance at Sakhalin by over 50% since the project began. Also, in the first quarter we added to our global portfolio of outstanding deepwater exploration opportunities. In the recent Gulf of Mexico lease sale, we were the high bidder for 15 blocks totaling 85,000 acres. Additionally, we were awarded 13 full and partial blocks totaling 760,000 gross acres in the Porcupine basin, offshore Ireland. Exxon Mobil continues to make significant progress in the capture of high potential, unconventional exploration opportunities around the globe. In April, we announced two new agreements related to unconventional gas and liquids opportunities in Hungary. The first is a joint exploration program covering a 387,000 gross acres in the Mako Trough area of southeast Hungary. The second is a production and development agreement covering a further 185,000 gross acres on an adjacent block. Our work programs in Hungary including wells, production tests and reservoir evaluation studies are getting underway this year. Exxon Mobil, along with majority owned affiliate, Imperial Oil Limited, further enhanced our portfolio of unconventional exploration opportunities, with the recently announced capture of about 115,000 acres in the Horn River Basin in the Northeastern British Columbia, Canada. Plans to evaluate the shale gas play potential, includes seismic acquisition and exploration drilling in late 2000 and beyond. Exxon Mobil brings industry leading technical expertise to all of these opportunities, including our fast drill process and our tight gas development capability. Exxon Mobil continues to pursue and capture a wide variety of opportunities to develop hydrocarbon resources to help meet growing energy demand. Now, moving to the downstream. In refining, we continue to improve our... the profitability of our operations through crude diversification. In the first quarter, we ran 35 crude new to individual refineries, nine of which were new to Exxon Mobil. We also continue to identify and implement projects to improve performance at our refineries by applying new technologies, which further enhance operations reliability, and margin capture. In our Lubricants and Specialties business, we launched the Mobil 1, advanced fuel economy synthetic motor oils in the U.S. In addition to providing outstanding engine protection, these advanced products can improve fuel efficiency in modern gasoline engines by up to 2% compared to traditional engine oils. In our Chemical Segment, Exxon Mobil launched a new methyllysine polyethylene platform called Enable mPE in the first quarter. This new product generates films with exceptional performance and also delivers energy savings in the production process. Our commitment to technology leadership and innovation continues to deliver breakthrough chemical products to meet the needs of our customers. During the quarter, Exxon Mobil's polyolefin plant in Baton Rouge was awarded the distinguished safety award from the National Petrochemical and Refiners Association for an unprecedented sixth consecutive year. This honor is a reflection of our fundamental and ongoing commitment to safety in all aspects of our operations. Now turning to the business line results. Upstream earnings in the first quarter were a record at $8.8 billion up $2.7 billion from the first quarter of 2007. We continue to capture the benefit of strong industry conditions this quarter with upstream after-tax unit earnings of just over $23 per barrel. Record crude oil and natural gas realizations increased earnings by $4.4 billion. Worldwide crude oil realizations were up $38.50 per barrel, and natural gas realizations were up $2.43 per Kcf from the first quarter of 2007. Volume and mix effects reduced earnings, as increased natural gas volumes were more than offset by lower crude oil volumes. Other effects reduced earnings by $900 million. Just over a third of that reduction was due to higher taxes; about 250 million reflects the impact of increased operating expenses including the effect of new field start-ups and increased exploration activity. And the balance was primarily lower earnings from asset sales. As anticipated in our outlook for 2008, volumes were lower in the first quarter than a year ago. Oil equivalent volumes decreased about 5.5% from the first quarter of last year. Excluding the Venezuela expropriation, divestments, coders and pricing spend impacts volumes were down 3%. The decrease was primarily due to PSC net interest reductions of approximately 80,000 barrels per day and the impact of maintenance activities in West Africa. Major project ramp ups in the North Sea and West Africa and increased European natural gas demand, offset fuel decline in mature areas. Our 2008, volume profile which we shared at our recent march Analyst Meeting, is back-end loaded due to the timing of major field start-ups, including the two large LNG trains in Qatar, [inaudible] SGP build facilities in Kazakhstan, and Thunder Horse in the Gulf of Mexico in the third and fourth quarters of this year. Liquid's production decreased about 270,000 barrels per day or 10% from the first quarter of last year. Excluding the Venezuela expropriation, divestments, quotas and price and spend impacts on volumes, production was down 6%. Major project ramp ups in West Africa and the North Sea were more than offset by natural fuel decline in matured areas, PSC net interest reductions and the impact of maintenance activities in West Africa. Gas volumes increased approximately 130 million cubic feet per day from the first quarter of 2007. New product volumes and higher demand due to colder weather in Europe were partly offset by natural fuel decline in mature areas. Turning now to the sequential comparison. Versus the fourth quarter of 2007. upstream earnings increased $580 million due to higher crude oil and natural gas realizations, partly offset by lower volumes and other effects primarily lower earnings from asset sales. Liquid's production decreased 2% due to the maintenance activities in West Africa and also price and spend impact. Natural gas production was also lower primarily due to natural fuel decline in mature areas. Oil equivalent volumes were down 2% from the fourth quarter. For further data on regional volumes, please refer to the press release and IR supplement. Turning now to the downstream results. Earnings in the first quarter were $1.2 billion, down nearly $750 million from the first quarter of 2007. Refining margins were markedly lower, compressed by rising crude prices, which reduced earnings by $1 billion. Volume and mix affects increased earnings by $350 million primarily due to refinery optimization activities. Other effects reduced earnings by $90 million, reflecting higher operating expenses including increased U.S. turnaround activity, partly offset by positive foreign exchange effects. Sequentially, first quarter earnings were $1.1 billion, below fourth quarter 2007. Lower margins reduced earnings by $360 million, while volume and mix effects decreased earnings by $80 million, primarily due to increased turnaround activity in the U.S. Other factors reduced earnings by $660 million, including the absence of positive LIFO inventory effects of about $250 million and approximately $400 million in lower earnings associated from asset sales. Focusing now on our chemical earnings. First quarter chemical earnings of $1 billion were $210 million lower than the first quarter of 2007. Lower margins reduced earnings by $350 million, as higher feedstock costs, more than offset increased product realizations. Other impacts increased earnings by $140 million, reflecting favorable foreign exchange and tax effects. Sequentially, first quarter chemical earnings decreased by $85 million. Higher margins increased earnings by $40 million as increased realizations more than offset higher feedstock cost. Lower volumes reduced earnings by $30 million, while other factors including the absence of positive tax and LIFO effects reduced earnings by $90 million. Turning now to our corporate and financing segment. Corporate and financing expenses in the first quarter were $90 million, versus earnings of $90 million in the same period a year ago, including the impact of higher corporate costs and the absence of positive tax effects. The effective tax rate for the first quarter was 49%. Our cash balance was $41 billion and debt was $10 billion at the end of the first quarter. The corporation distributed a total of nearly $10 billion to shareholders in the first quarter through dividends and share purchases to reduce shares outstanding, an increase of $1.1 billion or 13% versus the first quarter of 2007. During the first quarter, Exxon Mobil made share purchases in excess of dilution of $8 billion, reducing the number of shares outstanding by 1.8% and further demonstrating our ongoing commitment to return cash to our shareholders. Yesterday, our Board announced an increase in the quarterly dividend, of just over 14% to $0.40 per share. Exxon Mobil has paid a dividend each year for more than a century. And has increased its annual dividend payment for 26 consecutive years. CapEx in the first quarter was $5.5 billion, up almost $1.3 billion or 30% from the first quarter of 2007, and consistent with our outlook for 2008. In summary, this quarter's results again highlight the quality of our integrated business model and disciplined investment approach allowing us to leverage, robust industry conditions and deliver superior results for our shareholders. That concludes my prepared remarks, and I'd now be happy to take your questions. Question and Answer"
},
{
"speaker": "Operator",
"text": "Thank you Mr. Hubble. The question and answer session will be conducted electronically. [Operator Instructions]. And we'll go first to Doug Terreson with Morgan Stanley."
},
{
"speaker": "Douglas Terreson - Morgan Stanley",
"text": "Good morning Henry."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Hi Doug."
},
{
"speaker": "Douglas Terreson - Morgan Stanley",
"text": "In U.S. refining and marketing, specifically Shell, my question in regard whether the economic effect of the switch, away from Venezuelan and feedstock was significant in the period and if so any quantification on that factor would be appreciated?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "It was not a major factor in the results. The primary issue associated with the margins that you saw really they're kind of across the Board, if you look around the globe."
},
{
"speaker": "Douglas Terreson - Morgan Stanley",
"text": "Sure."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "When you look at the composite worldwide margin, it was down about 245 a barrel and it was really kind of shared throughout the system. And so, I wouldn't point to anything specific at Shell [ph]."
},
{
"speaker": "Douglas Terreson - Morgan Stanley",
"text": "And also, did you say that the $660 million of other item that unfavorably affected the down stream was related to LIFO mix effects and if I missed that, what was that negative delta related to?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes. We had about $250 million of LIFO effect in the fourth quarter, you may recall, and then there was also lower gains from asset sales. We had a number of asset sales that were in that period and it was the absence of about 400... a little $400 million worth of asset sales that were not in the period. So, what you're seeing here is pretty clean in terms of overall other impacts."
},
{
"speaker": "Douglas Terreson - Morgan Stanley",
"text": "Okay. Okay, thanks a lot."
},
{
"speaker": "Operator",
"text": "And we will go next to Mark Flannery with Credit Suisse."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Hi, I've got a couple of questions, one is can you tell us what's happening with units production costs and unit DD&A in international E&P. Are we still seeing both of those numbers rise, and would you expect maybe to see them bend down a little bit in the second half of the year, as you get some of that in your production on? Then, I've a second one."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Well, if you look kind of, you are going to have impacts, non-cash impacts associated with new projects that we're bringing on, and you are seeing those continuing impacts as we are basically spending… the CapEx spending to bring on those new projects. But, I guess, if I step back from in terms of, inflationary effects, we have a consistent program of working to offset those things and if you look at... when we look kind of across the Board around the globe, we're pretty well able to offset the normal inflation effects, now there is some areas of our business, where we are seeing higher rates of inflation that we're not able to fully offset, but we've been able to get two-thirds of that essentially in the past. And we're just not immune to those cost impacts, but I think from the upstream perspective, the real focus I would point to is, if you look at the net income per barrel, you will find that the capture rate of earnings that we have on our per barrel basis, continues to be quite strong, and that's a reflection of being able to manage all of these impacts overall in a positive way."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Okay, thanks. Can I just switch my second one over to European refinery run rate, which at least against old model, a little bit light in the first quarter, how would you characterize your maintenance activities there?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Well, in the throughput area, if you look at, the biggest impact in Europe was the Englestock refinery sale, that we had in the period that took out over 90 a day of capacity. So, that was the big and we did have a turnaround that fall in the period as well. But, if you're looking at general, we did see some… we did see some lower demand and as well but that was... those were the big impact in the period."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Right. And just around that question, on US refining, are you faring any downstream capacity right now, particularly think about SGCS or other gasoline units?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "No we are... all of our conversion capacity is running full, has been running full, and we did have some turnaround activity in parallel basically doing essential maintenance that we have to do and we tend to be a little in the outside of the gasoline season, we tend to take more of those turnarounds. So we end up about, if you look around the globe about 30% of our turnarounds in the first quarter. But in the US in particular, basically we are running conversion capacity full out."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Great."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "And overall when you look at the market supply, because as you know the gasoline inventories are... have been quite high, we have been really aiming to maximize distillate production in the period as well."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "We will go next to Neil McMahon at Bernstein."
},
{
"speaker": "Neil McMahon - Bernstein",
"text": "Hi, Henry."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Hi Neil?"
},
{
"speaker": "Neil McMahon - Bernstein",
"text": "Just a few questions. The first is really on your increase in exploration expense, I think this must be going to the Tayrona block in Colombia and it looks like that a dry well was drilled there, and that was done using your R3M electromagnetic technology and it is sort of follows, I think a separate news reports correctly sort of disappointing results from Northern basin last year as well. Am I right in thinking this because that sort of raise questions about some of that technology?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Well, what you see in the numbers, the increased cost is really… have been associated with seismic activity. When you look at the number of places that we have acquired acreage positions and we are now out basically shooting seismic to evaluate those in both Libya and New Zealand and others. Now when you get back to the comment on the R3M technology, we are utilizing that broadly. It is not a silver bullet though, I mean it's a technology that helps reduce risk, it helps improve our valuation of these, but it doesn't give you 100% indication. So the way we utilize it helps to de-risk these plays, but whenever you are dealing with a wildcat exploration well, you are going to have still have, even with R3M significant risk associated with those. But obviously these are prospects that we think have potential and we are evaluating the data from both the open wells and Tayrona wells that we drilled and looking at next steps."
},
{
"speaker": "Neil McMahon - Bernstein",
"text": "But you are still planning Madagascar and Southern Basin off shore in New Zealand and little sort of exploration well, there is still a part of the whole well count risk awarded program?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes, I mean yes. I mean all of those things, and we continue to utilize the R3M as part of our data collection efforts in these new areas, because we do think it's delivering value in our ability to assess the prospects."
},
{
"speaker": "Neil McMahon - Bernstein",
"text": "Okay. Second question was really on, as you mentioned the production sharing agreements, in West Africa, what's… certainly it looks like Kizomba A and B went form cost oil to profit oil last year. What, was there anything and addition for that may be on your interest in block 17, that did that in this quarter, that brought volumes down or was there just a general West African effect, that’s all from me."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Well, you have a combination, I mean when you have, when you do on a year-on-year comparison, I mean the tranche effects that we saw during last year, you're still seeing those in the year-on-year comparison, you're going to continue to see those year-on-year comparisons. Now, there are multiple tranches, different projects came on at different points, so you are different places and different ones, but the other PSC effect that we talked a about a little bit was continue to have pricing spend impacts associated with them and that's basically variable reflecting the current price of crude, and the relative spend that is going on in the given period. So, we see both of those effects, but, all of that when you come back and look at it on the grand scheme of things, we've been gathering significant early value, these projects, they're performing very well and both from the original project development but also in their continuing operations. But, we are getting into some lower tranches in the number of these deals."
},
{
"speaker": "Neil McMahon - Bernstein",
"text": "Great. Thanks a lot."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "And to next to Michael LaMotte at JP Morgan."
},
{
"speaker": "Michael LaMotte - J.P. Morgan",
"text": "Hi Henry."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Hi."
},
{
"speaker": "Michael LaMotte - J.P. Morgan",
"text": "Pretty quickly on the Hungary, maybe if I can ask you to do a little bit of comparing contrast, particularly given a news flow around Hansfield [ph], Marcellus and some of the shale plays and unconventional plays in lower 48, that's in Horn River Basin in Canada, obviously but, I'm wondering if you're taking a look at those lower 48 plays at all, and see something in Hungry, that's truly unique, can you give provide a little bit more color on that? Maybe in contrast with some relative opportunities here?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes. Well, I'm not, I can't give you a relative comparison, what I can tell you is we are… we got a pretty wide approach on what we're looking at. We look at a lot of prospects and we have a global program that allows us to look and sets opportunities around the globe. And what we try to do is identify the best resources of type wherever they are and having that global capability is one of the advantages that we have. And these are some of the areas that we think have potential but it is still early days. We're going to be going through evaluation of the Hungary, Horn River and others."
},
{
"speaker": "Unidentified Company Representative",
"text": "When you come down to, why do we see advantage in some of these areas, we bring some technology frankly that makes that we think... provides us with some unique advantages in this kinds of developments with the multi zone stimulation technology that we have with the fast drill technologies that we have. All of those are really important in these kinds of developments. We're going to be drilling a lot of wells in there in tight gas kind of place."
},
{
"speaker": "Michael LaMotte - J.P. Morgan",
"text": "Is it geology or end market or both that sort of pushes you into an area like Hungary?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "All of the above."
},
{
"speaker": "Michael LaMotte - J.P. Morgan",
"text": "And is there anything in particular in the resource that you can talk about today that would lead you to build such a big position, almost 600,000 acres."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "As I say, we basically being able to take advantage of our global understanding of these potential basins and to get in there early and work with the folks and being able to evaluate these prospects. Again we are going through an evaluation phase, we are going to be doing seismic and other delineation activities to understand what we have there."
},
{
"speaker": "Michael LaMotte - J.P. Morgan",
"text": "Okay. Maybe to assume back on global sales quickly, just in terms of seismic activity. How do you see that unfolding over the next few quarters? Or you still sort of in expansion mode there, or is it a steady state, or is it going to be winding down over the next few quarters?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "We have been watching our acreage pickup. We have a number of areas that we are going to be taking a look at. So I'd say, I can't give you a direct figure but directionally up."
},
{
"speaker": "Michael LaMotte - J.P. Morgan",
"text": "Okay. That is helpful. And then lastly, thoughts on the Alaska pipeline?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes. Well as... we continue to look for ways to move that forward, have been evaluating the various proposals and discussions around those various proposals. And basically looking for the most effective way to… the one, get the maximum value for the State of Alaska or ourselves, production and to move that ahead. But, what we're trying do is, basically evaluate the various options that are there are now and what our next steps are to be?"
},
{
"speaker": "Michael LaMotte - J.P. Morgan",
"text": "Okay. How should be think about the current proposal with the DP and Conoco going forward?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "We're in the, from our own prospective, I think probably I want to talk to those guys about that in particular. But from our own prospective, we're evaluating that. We've been asked to participate, and we're looking at it."
},
{
"speaker": "Michael LaMotte - J.P. Morgan",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "And next over to Arjun Murti of Goldman Sachs."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "Thank you Henry. A follow-up to some of the comments on the West African oil production, you mentioned maintenance activity hurt volumes in the first quarter?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "Would it be possible to quantify the rough magnitude of that?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes. I mean it was in… about 40 a day of impact there."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "40 a day. Got you. So, then that sort of get this stock towards the 3Q and 4Q production was and the profit shared?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes. When you look at the PSC net interest changes, and the price spend impacts because we did see even higher prices in this period. You've got about in total the combination of those in West Africa is about 120."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "The combination of maintenance and PSC effects?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "No, actually the combination of PSC net interest changes and price spend impacts."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "I'm sorry, price spends impact. Got you, that's 120?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes, correct. And then maintenance was on top of that."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "Yes, that then starts making more sense, I guess we've thought South Africa overall is a growing region, So your net volumes can be what they are, but the gross volumes we thought are probably increasing, it sounds like that would get us closer."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Well, when you're looking at gross production in the area, yes it is a growing area."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "Absolutely. Henry any update on the timing of some of the Qatar LNG products that are scheduled to start up this year, are they still slated for second half of this year?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes, As I mentioned, are both of them we expect to have on this year. One we basically looking at the [inaudible] in 2008 and then [inaudible] in 2008. But, they will be back-end loaded as we mentioned."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "Back-end loaded and then presumably some ramp up period as well?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes. Well, they've come on pretty fast, but… once they start-up, but basically you're going to see part year effects from the start-ups."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "That's great. And then just a final one on the Alaskan gas. Some of the controversy that's right word over Point Thomson field, your participation or not in the Alaska pipeline, potentially tied to what ultimately happens to Point Thomson resource?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Well, Point Thomson is going to be, as important to the Alaska pipeline, it's hard to make sense out of that pipeline without Point Thomson being developed, so there, you need both. And our view on Point Thomson, I mean, we were frankly surprised and disappointed by the Department of Natural Resources decisions there, and we will be pursuing our rights in that area and we're appealing or asking for rehearing on that, but we laid out commitments there to bring that production on, and develop that production. So, frankly we were surprised to see how that turned down at this point and we'll be pursuing for rehearing and our rights to further in that regard."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "Got you. That's great, thank you very much Henry."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "No problem."
},
{
"speaker": "Operator",
"text": "And next to Paul Sankey at Deutsche Bank."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Hi, good morning Henry."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Good morning."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Henry, if you don't want to, just like to keep reaching around in the volumes a bit here. Firstly, just to go through the lines, on the U.S, I'm assuming that its just all natural fuel decline, the 10% overall decline, you got there is related to that, or whether some issues with maintenance and down time there?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "The big chunk of that is, decline, it's a mature area and the bulk of what you have is decline. When we talk about our global decline rates, we've been talking about high 5% to 6% in that level. So, this is mature area and its… that's what you're seeing there."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Great. Thanks and then, kind of the South America, I know there was some issues in Canada. Could you strip out what was Canada, what was Venezuela for us?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Venezuela is essentially all of it that you're looking out there. When you get down into the gas, the big change there, I mean that's basically was a bulk of that was blow down, we had that at the… it's the absence of having blow down versus last year."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Okay. And you've gone through Africa in some detail. The one question of course is Nigeria. Now is reportedly had a 800,000 barrel a day outage, and its right? Could you comment on that for the quarter, this quarter?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes. Well, what you heard, you know we had, on April 24th, the local chapter of the Senior Oil Workers Union there in Nigeria, halted collective bargaining discussions that we had and withdrew their services there. The union subsequently shut in those facilities. What we have heard this morning is that the union has directed the employees to return to facilities and so we are anticipating that will to move things ahead there."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "So this should be about 10 day, I guess outage for the quarter?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "That implies a start-up or ramp up and I really can't, I don't know what that is going to be. So more to come on that, there are still some discussions going on. I mean they have agreed basically direct the people back to work but we still have some discussions going on there."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "And the last one on this kind of granularity on the volumes, Europe obviously we can see the jump with the gas season, but I was wondering on the oil, if there is anything you could strip out there between the various effects on the decline?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "No. I mean there is some downtime in there but the big piece of that again is, it's a mature area and mostly decline."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Got you Sales, Henry of product over the world wide down 5% US down 8%, Asia Pacific down 6%, could you just walk us through, I'm assuming that is not the market collapsing, if you could just walk us through the effects there, that would be great on petroleum product sales?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes. I mean if you look at by region the impacts... I mean it is actually US markets... essentially what we are seeing is in the mature markets we are seeing some softening of demand. But if we look at global growth overall, we are still seeing on a overall net basis, petroleum product growth, lower rates of growth versus our 10 year average, but still growth. Most of that occurring in the developing parts of the world and in the price controlled areas. Now the... our specific results, the bulk of our reductions are actually associated with the portfolio of high grading and the divestment activities about 60% of that is associated with that. The balance is due to a number of factors including as we talked lower refinery throughput but also demand softening of the demand and those are really the major impacts in the decrease in overall product sales."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Great. I appreciate that. And then the final one on this line and I have got one very brief follow up, is just chemicals, it's notable that your US volumes are, the sales volumes are sharply down."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "There is some of that is... there was a piece of that that we are… mostly in commodities, and you saw that both in the US and Europe but some of that is basically associated with turnarounds as well. In the chemicals business we talk about many cycles within the business and frequently when you see rapidly rising crude prices and feed stock costs, there will be pre-buying and then people holding off, so you will see some swings in volumes associated with that basically trying to manage the price impacts."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Okay, so we should go back to expecting more like 2.7 million tons in the US, and what's the potential for growth?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Well, I mean, we will see how it develops but I mean, I don't have any better basis to tell you at this point and the quality of the business obviously is very good. And that's a growing business and we continue to see it growing couple of GDP above... a couple of percent above worldwide GDP growth, so it's a growing. But most of that again has been Asia-Pac area. So that's where we are making the investments."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Yes. And then the very last... final one from me briefly is the tax rate of 49%, can you just talk more about whether or not that a sustainable, the ongoing level?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Well. I mean, when you look at the tax rates increase there, essentially part of that, the biggest piece of it as you look year-on-year is associated with it's... essentially mix of earnings. You have more upstream earnings, less in the downstream areas and also the mix around the globe as to where we are getting those earnings. So that was a big piece of that. And then we did have some lower one-time tax items that was, that was also in there. So those are the... those were the two big things and it's going to be very dependent on that mix of earnings for the future. So it's hard to predict, we've seen them moving around here a bit more likely because of the volatility in prices. So it's hard to predict exactly how that's going to be going forward."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Thanks Henry, I leave it there. Thank you."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "All right. Very good"
},
{
"speaker": "Operator",
"text": "And we'll go next to Doug Leggate at Citigroup."
},
{
"speaker": "Doug Leggate – Citigroup",
"text": "Thanks. Hi, Henry."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Hi Doug."
},
{
"speaker": "Doug Leggate – Citigroup",
"text": "Couple of things. I guess also some housekeeping questions. The cash flow, operating cash flow is very high this quarter."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes."
},
{
"speaker": "Doug Leggate – Citigroup",
"text": "Can you... is that just timing of tax payments or can you help understand a little bit what's going on there?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "You've got a piece of it. The timing of tax payments we typically see that in the first quarter where both Norway and US we have more tax expense and we have actual payments in the period. And then the other, but the bigger factor actually was associated with crude payables. And as you saw the rapid ran up in or the higher crude prices, we have basically close through into the higher crude payables, and that was the bigger impact. Of course we also had some net income increased that also impacted that as well. But the biggest factors were in the working capital changes."
},
{
"speaker": "Doug Leggate – Citigroup",
"text": "Can you give a total working capital move in the quarter?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Well, I mean if you come back to... it will come out in the Q, but there is the bulk of that is basically associated with the crude payables, and if you look at that delta, it's the biggest piece of the unexplained portion as the DD&A is about the same."
},
{
"speaker": "Doug Leggate – Citigroup",
"text": "Second one is to jump back to Paul's question about the tax rate, just to get a... may be a little bit of a breakdown, can you possibly give us what we quantify rather what was one-time tax items were, so we can get the underlying tax rate for the quarter?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "It was a smaller piece of the delta, if you look at it; it's about 20 about a third of the delta that you saw between the period."
},
{
"speaker": "Doug Leggate – Citigroup",
"text": "Will it be reasonable, let’s assume we were in a similar environment over the balance of this year we'd expect that kind of rate going forward."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Well. As I said, it's going depend very must on how the margins and the mix of earnings play out. It get identical may be it never has been identical."
},
{
"speaker": "Doug Leggate – Citigroup",
"text": "All right. Thanks Henry."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "All right, very good."
},
{
"speaker": "Operator",
"text": "We will go next to Paul Cheng at Lehman Brothers."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Hi Henry, how are you doing?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Hi Paul, very good."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Number of quick ones, just want to clarify. I think you were talking about the lack of foreign exchange gain on inventory in the number of your comment. So could we assume that this is a thin quarter that really no major, on the absolute term, no major foreign exchange or loess or inventory gain or loss and [inaudible]?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "That's correct. The inventory impacts as you see in our results generally and you seen in the fourth quarter associated with LIFO."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Right. So that, this quarter if we on the project forward that is a pretty clean quarter to use?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "That's correct. It did have some FOREX impact in the small though overall."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "And what is the magnitude on... you said some FOREX impact, you said 50 million or 100, 200?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "No, less than $100 million."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Less than a hundred?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "For total, yes."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Okay, in Alaska after the acquisition [ph], the higher tax rate or the… whatever you call production tax I guess. Can you quantify what's that in the first quarter with the higher oil price that what's that incremental hit on you guys?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "I don't really have a delta quarter-on-quarter on that."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "May be, I try another one. Henry, when I looked at the European gas sales volume, certainly that you have a nice pickup typically they always do in the first quarter, that's for quite some time I think the message is that, you have substantially more excess capacity as a function of the demand, if the demand is there you can sell far more gas. So, I thought that the gas volume given how robust the market there will be even higher. So, is that now that the sort of like we've been on a swing by the production capacity in Europe, that and most you can do is about 5.1, 5.2 to be unless that you'll bring on new gas?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "No. I mean we have... we're basically meeting demand there and as you know [inaudible] operations, service a bit of the swing, our European swing and it was not tapped out. And it basically, its reflecting the cooler weather, that's what and you're meeting demand there."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "No. I mean the weather is pretty cold over there, so I thought that would be higher demand in that. So, you're saying that you actually spilled even in the first quarter, have excess capacity and production capacity than if you, if there is a demand that you can actually increase that?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes, that's correct."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Okay. What is your capacity over there now, any rough idea?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "I don't have that off the top here."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Okay. A final question over the last 18 months, I think lot of your smaller kind of pause has been pretty optimistic above some of the non-conventional pay in U.S. and obviously Exxon is very optimistic about and beyond. But, we haven't heard much about Bakken or the Barnett Shale or the other one. Wondering that how Exxon looking at in the lower 48 non-conventional play outside Pean [ph] is that those is too small economic enough that for you guys to be interest or that is an area that you guys may be interested also?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes. We're doing, we're constantly evaluating and we basically are looking for what we do is, we look for the best opportunities on a global basis and as I mentioned earlier that's one of the benefits we have with that global approach and we're targeting what we feel are the best opportunities with that we see out there."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "So, in another words, that seems you guys have not made any significant attempt into the other non conventional, is that in your global portfolio, those that just not going high up."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Well, I mean we don't talk about everything we are looking at. So maybe more to come, who knows."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Very good. Thank you."
},
{
"speaker": "Operator",
"text": "We'll go next to Robert Kessler with Simmons & Company."
},
{
"speaker": "Robert Kessler- Simmons & Company",
"text": "I have some fairly quick, but granular questions on production. One, do you have a stat for what Mondo would have produced on average in the quarter of what it's producing today. And then secondly on Piceance, where are you at in terms of total production there now?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Piceance is still above 55 million cubic feet per day."
},
{
"speaker": "Robert Kessler- Simmons & Company",
"text": "Is that what you are running, say a year ago, isn't it?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes. I mean, basically the expansion has not come on at this point. We are working on that direction but that has not come on. So that's... and Mondo it is about 100?"
},
{
"speaker": "Robert Kessler- Simmons & Company",
"text": "About 100 on average for the quarter or today?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "That's down a day."
},
{
"speaker": "Robert Kessler- Simmons & Company",
"text": "100 a day, great. And just in terms of the follow-up on the Piceance, I mean I would have thought this is just a fairly well intensive development, and I'd have expected a bit more ratable production growth there? Is it going to be more lumpy or what should we really…"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "It requires gas processing and that's... some of those facilities, basically the facilities are full, just waiting for those increments of gas processing."
},
{
"speaker": "Robert Kessler- Simmons & Company",
"text": "Okay. Thank you."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "And next to Mark Gilman at Benchmark."
},
{
"speaker": "Mark Gilman – Benchmark",
"text": "Henry, good morning."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Hi, Mark."
},
{
"speaker": "Mark Gilman – Benchmark",
"text": "I noticed in conjunction with your entry into the Horn River Basin, this is not a second thing I guess I can point to where you and Imperial have interested side by side. Is it mandated that in Canada to the extent Exxon Mobil does anything, it has to be along with Imperial's participation?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "No."
},
{
"speaker": "Mark Gilman – Benchmark",
"text": "It is not?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "No."
},
{
"speaker": "Mark Gilman – Benchmark",
"text": "Okay."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "We work with them obviously very closely."
},
{
"speaker": "Mark Gilman – Benchmark",
"text": "I mean, I guess I just kind of wonder if.... similar kind of structure is... and why it is, all things considered that you wouldn't do it on 100% basis as oppose to necessarily involving Imperial at all?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Well I mean, we basically enter into these arrangements with what we think who is going to deliver the most overall value to our shareholders and the structure is aligned with that."
},
{
"speaker": "Mark Gilman – Benchmark",
"text": "Secondly, you made reference in your opening comments to the new Malaysian PSC. You have been the industry's leading producer in that country for a number of years operating under an existing PSC. I'm wondering does this new PSC essentially extend the existing one and/or the terms more on risk?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Well. It's basically an extension of the existing arrangements that we have there, but it does anticipate more enhanced oil recovery. And it's basically a PSC... extension of that PSC arrangement."
},
{
"speaker": "Mark Gilman – Benchmark",
"text": "But the physical terms the same?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "We don't get into the specifics on that."
},
{
"speaker": "Mark Gilman – Benchmark",
"text": "Okay. Final one, in your discussion of the E&P variances, you referred to tax factors in the other category and I'm wondering whether that was rate oriented or nearly total dollar oriented that was at the root of your comment?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "It's a mix of different things; I really wouldn't point to one in particular. It's a bit of both as to what you have there, but they are onetime effects."
},
{
"speaker": "Mark Gilman – Benchmark",
"text": "They are one time?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes. Most of them."
},
{
"speaker": "Mark Gilman – Benchmark",
"text": "So therefore it's not a rate item?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Well, I mean it's rate in a period."
},
{
"speaker": "Mark Gilman – Benchmark",
"text": "Well, yes, but not a statutory rate change or something..."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "That's right, that's right."
},
{
"speaker": "Mark Gilman – Benchmark",
"text": "Okay. Just one final volume question on Asia-Pacific, Middle Eastern gas volumes, sort of little bit lower than what I would thought they would be, is that a PSC effect at all? I mean Alkelege [ph] has that kind of structure I believe?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "I mean basically the decrease is largely lower demand in Qatar and then you also some in Australia as well. So you've seen a combined effect. We did have some plant maintenance in Qatar and that's really was the big impact."
},
{
"speaker": "Mark Gilman – Benchmark",
"text": "Okay. Thanks a lot, Henry."
},
{
"speaker": "Operator",
"text": "And we will go next to Eric Milky [ph] at Merrill Lynch."
},
{
"speaker": "Unidentified Analyst",
"text": "Hi, good morning, Henry."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Hi, Eric."
},
{
"speaker": "Unidentified Analyst",
"text": "Couple of quick ones from me. Just want to make sure I understand the maintenance impact in West Africa in the first quarter correctly. Could you quantify the sequential impact and if we should expect those volumes to be back on in the second quarter?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes. Sequentially it is about 30 in that range."
},
{
"speaker": "Unidentified Analyst",
"text": "And then they should be back on for Q2?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "I'm looking to what I have on schedule. I think, that's good to some."
},
{
"speaker": "Unidentified Analyst",
"text": "Okay. And on the production sharing contract impact on production, is there a seasonal; impact, is there a quarterly impact that you've more cost recovery at the beginning of the year, and therefore you have great entitlement in the earlier quarters. What do you accrue for that, so just be doing the entitlement process?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "It's not accrual. Basically, as spending occurs, it's reimbursed."
},
{
"speaker": "Unidentified Analyst",
"text": "Okay. And on TMS 22 [ph] in Brazil, are you able to give us an update on where you have the rig?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Well, we had scheduled basically looking to do that in the third quarter of this year, and as you know, we're bringing in sea drill rigs to do that work, and we have no change for that plan, and basically we've done in the second half."
},
{
"speaker": "Unidentified Analyst",
"text": "Then you see rig effect, when do you expect delivery of that?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes, I mean basically in the summer, but I don't know the exact date on it."
},
{
"speaker": "Unidentified Analyst",
"text": "Okay. And for Sakhalin 1 production in Russia, and peak was 250. You are kind of running at about 225. Do you expect to maintain 225?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes. It is going to be in that range with may be some decline, but that's pretty close."
},
{
"speaker": "Unidentified Analyst",
"text": "But not the 10% type decline that we saw year-on-year?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "No, I really don't have a field specific data that I can throw out there for you. But..."
},
{
"speaker": "Unidentified Analyst",
"text": "All right. And since the Investor Day that you had back in March, it's been some Ko [ph] project, can you tell what how that if that influences your timing of Ko, in terms of the water permit?"
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "As you know, we were disappointed with water permit issue. We're basically proceeding with the work that can go on outside of that, so we're doing tranche work and that kind of thing. And then, in terms of the timing of the project, though we're optimistic we're going to get this… the permit was valid and we'll get that result there. So, we are not identifying any significant impacts in the schedule and we will be updating that as we move forward."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "No."
},
{
"speaker": "Unidentified Analyst",
"text": "Okay. That's all for me. Thanks."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "This does conclude the mean time that we have set aside for questions, and at this time I'd like to turn the conference back for any the closing or additional comments."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations, Secretary",
"text": "I would just like to thank everybody for the time and questions and look forward to next quarter. Thank you."
},
{
"speaker": "Operator",
"text": "This does conclude today's conference. We do thank you for your participation. You may disconnect at this time. THE INFORMATION CONTAINED IN EVENT TRANSCRIPTS IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE CONFERENCE CALLS. AS SUCH, WE DO NOT WARRANT, ENDORSE OR GUARANTEE THE COMPLETENESS, ACCURACY, INTEGRITY, OR TIMELINESS OF THE INFORMATION. YOU MUST EVALUATE, AND BEAR ALL RISKS ASSOCIATED WITH, THE USE OF ANY INFORMATION PROVIDED HEREUNDER, INCLUDING ANY RELIANCE ON THE ACCURACY, COMPLETENESS, SAFETY OR USEFULNESS OF SUCH INFORMATION. THIS INFORMATION IS NOT INTENDED TO BE USED AS THE PRIMARY BASIS OF INVESTMENT DECISIONS. IT SHOULD NOT BE CONSTRUED AS ADVICE DESIGNED TO MEET THE PARTICULAR INVESTMENT NEEDS OF ANY INVESTOR. THIS REPORT IS PUBLISHED SOLELY FOR INFORMATION PURPOSES, AND IS NOT TO BE CONSTRUED AS FINANCIAL OR OTHER ADVICE OR AS AN OFFER TO SELL OR THE SOLICITATION OF AN OFFER TO BUY ANY SECURITY IN ANY STATE WHERE SUCH AN OFFER OR SOLICITATION WOULD BE ILLEGAL. ANY INFORMATION EXPRESSED HEREIN ON THIS DATE IS SUBJECT TO CHANGE WITHOUT NOTICE. ANY OPINIONS OR ASSERTIONS CONTAINED IN THIS INFORMATION DO NOT REPRESENT THE OPINIONS OR BELIEFS OF GRIDSTONE RESEARCH. GRIDSTONE RESEARCH, ONE OR MORE OF ITS EMPLOYEES OR BUSINESS ASSOCIATES, INCLUDING THE WRITER OF THIS TRANSCRIPT, MAY HAVE A POSITION IN ANY OF THE SECURITIES DISCUSSED HEREIN. THE INFORMATION PROVIDED TO YOU HEREUNDER IS PROVIDED \"AS IS,\" AND TO THE MAXIMUM EXTENT PERMITTED BY APPLICABLE LAW, GRIDSTONE RESEARCH AND ITS LICENSORS, BUSINESS ASSOCIATES AND SUPPLIERS DISCLAIM ALL WARRANTIES WITH RESPECT TO THE SAME, EXPRESS, IMPLIED AND STATUTORY, INCLUDING WITHOUT LIMITATION ANY IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE, ACCURACY, COMPLETENESS, AND NONINFRINGEMENT. TO THE MAXIMUM EXTENT PERMITTED BY APPLICABLE LAW, NEITHER GRIDSTONE RESEARCH NOR ITS OFFICERS, MEMBERS, DIRECTORS, PARTNERS, AFFILIATES, BUSINESS ASSOCIATES, LICENSORS OR SUPPLIERS WILL BE LIABLE FOR ANY INDIRECT, INCIDENTAL, SPECIAL, CONSEQUENTIAL OR PUNITIVE DAMAGES, INCLUDING WITHOUT LIMITATION DAMAGES FOR LOST PROFITS OR REVENUES, GOODWILL, WORK STOPPAGE, SECURITY BREACHES, VIRUSES, COMPUTER FAILURE OR MALFUNCTION, USE, DATA OR OTHER INTANGIBLE LOSSES OR COMMERCIAL DAMAGES, EVEN IF ANY OF SUCH PARTIES IS ADVISED OF THE POSSIBILITY OF SUCH LOSSES, ARISING UNDER OR IN CONNECTION WITH THE INFORMATION PROVIDED HEREIN OR ANY OTHER SUBJECT MATTER HEREOF. THE CONTENTS AND APPEARANCE OF THIS REPORT ARE COPYRIGHTED GRIDSTONE RESEARCH, 2006. “GRIDSTONE” AND “GRIDSTONE RESEARCH” ARE TRADEMARKS OF PERPUTO, INC. ALL OTHER TRADEMARKS MENTIONED ARE TRADEMARKS OF THEIR RESPECTIVE COMPANIES. ALL RIGHTS RESERVED."
}
] | null | null |
XOM | 4 | 2,006 | 2007-02-01 11:00:00 | TRANSCRIPT SPONSOR :
Executives: Henry Hubble - VP of IR & Secretary
Analysts: Doug Terreson - Morgan Stanley Doug Leggate - Citigroup Arjun Murti - Goldman Sachs Nicki Decker - Bear Stearns Paul Cheng - Lehman Brothers Dan Barcelo - Banc of America Paul Sankey - Deutsche Bank Mark Gilman - The Benchmark Company Mark Flannery - Credit Suisse Oxy Oswald Clint - Sanford Bernstein John Herrlin - Merrill Lynch
Operator: Good day and welcome to this Exxon Mobil Corporation fourth quarter 2006 earnings conference call. Today's call is being recorded. At this time, for opening remarks, I would like to turn the call over to the Vice President of Investor Relations and Secretary, Mr. Henry Hubble. Please go ahead, sir.
Henry Hubble: Thank you. Good morning and welcome to Exxon Mobil's teleconference and webcast on our fourth quarter and full-year 2006 financial and operating results. As you are aware from this morning's press release, we had another strong quarter as our longstanding commitments to the integrity of our operations, disciplined investment and our integrated business model continued to deliver superior results. At this time, I would like to draw your attention to our cautionary statement. Please note that estimates, plans and projections are forward-looking statements. Actual results, including resource recoveries, volume growth and project plans and outcomes could differ materially due to factors I'll discuss and factors noted in our SEC filings. Please see "Factors Affecting Future Results" in the Form 8-K we furnished this morning which are available through the investor information section of our website. Please also see the frequently used terms, the supplement to this morning's 8-K and the 2005 financial and operating review on our website. This material defines certain financial and operating terms I will use today, shows Exxon Mobil's net interest in specific projects and includes information required by SEC Regulation G. Now I'm pleased to turn your attention to the specific results. Exxon Mobil's fourth quarter net income was $10.3 billion, or $1.76 per share. These results included a $410 million one-time gain from the recognition of tax benefits related to historical investments in non-US assets. Excluding this gain, normalized earnings were $9.8 billion or $1.69 per share. This represents a decrease of $480 million versus last year's record fourth quarter. While absolute earnings were lower, normalized earnings per share were up from last year, due to the reduction in shares outstanding associated with our share purchase program. For the full year 2006, net income of $39.5 billion was a record, and increased $3.4 billion from 2005. Normalized earnings were also a record at $39.1 billion, up $5.2 billion from 2005. Before I discuss the specific business results, I would like to share some of the milestones achieved since the last earnings call. In the upstream, production commenced from the Dalia field in Angola Block 17, located in water depths of over 1,200 meters, 135 kilometers offshore. Dalia is estimated to contain close to 1 billion barrels of recoverable reserves and is expected to reach peak production of about 225,000 barrels of oil per day during the first quarter of this year. Also starting up in the fourth quarter was the Fram East field in the Troll area of the Norwegian North Sea. We anticipate the recovery of approximately 60 million barrels of oil and 70 billion cubic feet of natural gas from the field. Fram East is expected to reach peak production of about 45,000 barrels of oil per day and 45 million cubic feet of natural gas per day in 2008. Another milestone during the quarter was the early processing of LNG at RasGas Train 5 in Qatar. Start-up of the liquefaction train was only 29 months after contract award, a significant achievement for such a large facility and testament to the success of our design one, build many approach and outstanding project execution of the Qatar Petroleum and Exxon Mobil joint venture. Offshore facilities that will supply the natural gas to the train on a long-term basis should be complete by the end of the first quarter. RasGas Train 5 is designed to produce 4.7 million tons per year of LNG for anticipated delivery to market in Asia and Europe. Also in the quarter, we continued to ramp up crude oil production at our Sakhalin 1development in Russia producing over 200,000 barrels a day at year end. Production is expected to reach 250,000 barrels per day by the end of the first quarter. Exxon Mobil also expanded its exploration opportunities during the quarter with new agreements for exploration in the deepwater [Sanakin] Basin southwest of the Philippine Islands. In the downstream, the British Safety Council awarded the prestigious 2006 Sword of Honor to our US and UK-based marine transportation affiliates. The award was recognition of our commitment to workplace safety and health, high operating standards and disciplined management systems. As a multi-year recipient of this award, we continue to emphasize consistent and disciplined safety, health and environmental management in all aspects of our operations. In our lubes business, we announced that Exxon Mobil will become the title sponsor for the Porsche One Mobil 1 Super Cup, further progressing 10 years of close commercial and technical global collaboration with Porsche. Porsche exclusively recommends Mobil 1 and every new Porsche engine leaves the assembly line filled with Mobil 1 oil. During the quarter, our refining and supply business continued to grow profitability through crude diversification, running 41 crudes new to individual refineries, 16 of which were new to Exxon Mobil. In December, we completed a de-bottleneck of our Antwerp, Belgium refinery. This project increased distillation and conversion capacity at a fraction of grassroots costs and enhanced our ability to process advantage crudes. Our worldwide refinery capacity growth rate is equivalent to building a new refinery every three years but at significantly lower cost than new built. Turning to the chemicals business. During the quarter, we announced the progression of a feasibility study with the Saudi Basic Industries Corporation, to expand the [Yenta] and [Kemya] petrochemical joint ventures in Saudi Arabia. The project will include expansion of capacity for carbon black, butyl rubber and thermolplastic specialty polymers for international and emerging local markets. Start-up is anticipated in the 2011 through 2012 timeframe. In November, we announced an expansion of halobutyl rubber capacity at our Baytown, Texas plant that will increase production by 60%. This expansion, part of the Company's commitment to meet the strong global halobutyl rubber demand growth, follows an expansion that quadrupled capacity at Baytown in 2002. Targeted for completion during the second quarter of 2008, this project builds on Exxon Mobil's 70 years of experience in butyl rubber research and development, services and customer application. Turning now to the business results. Upstream earnings in the fourth quarter were $6.2 billion, down $820 million from 2005, which was our highest fourth quarter on record. Lower natural gas realizations reduced gas volumes and net other items were the primary drivers for the earnings change, partly offset by improved crude realizations. We continued to capture the benefit of strong industry conditions with upstream after-tax unit earnings of $15.99 per barrel for the quarter. Oil-equivalent volumes declined slightly versus the same quarter last year, driven by lower gas demand in Europe. Excluding entitlement effects and divestments, oil-equivalent volumes were up 2%. Liquids production increased about 50,000 barrels per day or 2% versus the same quarter last year as the impact of project start-ups and increased Middle East volumes more than offset mature field declines and entitlement effects. Gas volumes decreased 520 million cubic feet per day or about 5% versus the fourth quarter of 2005, due to the impact on demand of warmer weather in Europe. New project volumes and better up time, including the absence of hurricane effects in the US, offset natural field declines. Turning now to the sequential comparison. Versus the third quarter of 2006, upstream earnings decreased by $270 million as lower realizations driven by an almost $10 per barrel decrease in crude prices reduced earnings by $820 million. However, this impact was largely offset by the increased volumes -- by increased volumes. Oil-equivalent volumes were up nearly 6% from the third quarter. Liquids production increased 1% sequentially as we concluded to ramp up production at Sakhalin 1, while natural gas production was up 14%, due to seasonal demand increases in Europe. Now looking at the full year results. Excluding special items, full year 2006 upstream earnings were a record $26.2 billion, an increase of $3.5 billion or 15% over 2005. The most significant factor driving that increase was markedly higher crude and natural gas realizations partly offset by production mix effects and net other items. Full year equivalent production was up 4% versus 2005 with increased volumes in Africa and the Middle East. Liquids volumes were up 6% from 2005, while natural gas volumes were up 1%. Excluding divestments and entitlement effects, oil-equivalent volumes were up 6.6%. For further data on regional volumes, please refer to the press release and IR supplement. Now let's turn to the downstream results. Downstream normalized earnings in the fourth quarter were nearly $2 billion, down $430 million from the fourth quarter last year. Lower margins reduced earnings by $820 million with markedly lower fuels refining and marketing margins partially offset by stronger lubes earnings. Other factors included positive LIFO and BorEx effect. Sequentially, fourth quarter earnings decreased by $780 million. The primary drivers were lower refining and marketing margins, while reduced earnings -- which reduced earnings by $790 million. Improved refining operations more than offset seasonally lower fuels, marketing and lube sales. Other factors included positive LIFO impacts offset by higher planned maintenance and turnaround expenses. Full year 2006 downstream normalized earnings were a record at just under $8.5 billion. Earnings increased $570 million from 2005, primarily due to stronger fuels and lubes marketing margins. Volume mix effects reduced earnings by $480 million reflecting higher planned turnaround activity, partially offset by self-help margin enhancement items, including raw material optimization and product upgrades. Other earnings effects improved earnings by $300 million, primarily positive BorEx and LIFO impacts. Focusing now on our chemical results. Fourth quarter normalized earnings of $1.2 billion were up about $400 million versus the fourth quarter of 2005, reflecting higher margins, stronger volumes and positive LIFO effects partially offset by costs associated with turnaround activity. Sequentially, fourth quarter chemical earnings decreased by $110 million, reflecting seasonal volume mix and other effects partially offset by positive LIFO impacts. Full year 2006 normalized chemical earnings were at a record, almost $4.4 billion, $980 million higher than full year 2005. Stronger margins in our integrated polyolefins and specialties businesses and higher volumes were the largest contributors to the improvement. Full year chemical prime product sales increased by about 2%, reflecting higher volumes across most business lines. Our record 2006 earnings confirmed that our unique portfolio of chemical product lines, broad geographic coverage and integration with our downstream and upstream facilities provides us with a competitive advantage and delivers industry leading performance. Turning now to the corporate and financing segment. As I mentioned earlier, we had a special tax item in the corporate and financing segment this quarter. Excluding that special item, the Corporation recorded fourth quarter earnings of $420 million in the segment, up about $360 million from the fourth quarter of 2005, primarily due to favorable tax items and increased interest income. Excluding special items, full year 2006 corporate and financing earnings of $24 million were up by approximately $180 million from 2005, primarily due to higher interest income. The effective tax rate for the fourth quarter was 37%. For full year 2006, the effective tax rate was 43%. The Corporation distributed a total of almost $8.9 billion to shareholders in the fourth quarter through dividends and share purchases to reduce shares outstanding. That's up almost $2.1 billion from the fourth quarter of 2005. Included in the $8.9 billion of fourth quarter distributions was $7 billion to purchase shares in excess of dilution. These purchases reduced the number of shares outstanding by 1.8%. For the full year 2006, we purchased $25 billion of shares in excess of dilution and reduced shares outstanding by 6.6%, further demonstrating our ongoing commitment to return cash to our shareholders. CapEx in the fourth quarter was $5.1 billion. That takes full year CapEx to $19.9 billion, in line with our previous guidance, and an increase of approximately $2.2 billion from 2005, reflecting increased upstream investments. Fourth quarter cash flow from operations and asset sales was $9.6 billion, including $2.4 billion in contributions to the US pension plan. At the end of the year, our cash balance was $32.8 billion and debt was $8.3 billion. Finally, I would like to mention two upcoming events. First in mid-February, we'll be releasing our 2006 reserves performance data. And second, as many of you will have already seen, our analyst meeting this year will take place on March 7th, including a live audio webcast beginning at 9 a.m. Eastern, 8 a.m. Central Time. The meeting will include an update of our forward business plans. Exxon Mobil's presenters will be led by Chairman and CEO Rex Tillerson. That concludes my prepared remarks and I would now be happy to take your questions.
TRANSCRIPT SPONSOR :
Operator: [Operator Instructions] We'll take our first question from Doug Terreson from Morgan Stanley. Please go ahead, sir.
Doug Terreson - Morgan Stanley: Congratulations on solid numbers, Henry.
Henry Hubble: Thanks, Doug.
Doug Terreson - Morgan Stanley: In the upstream, you mentioned that weather effects were significant for European natural gas sales in relation to the year ago period.
Henry Hubble: Yes.
Doug Terreson - Morgan Stanley: And on this point, can we attribute the year-over-year decline in product sales in Europe and Asia Pacific to the same factor? And if not, could you comment on the other major factors that were at work in the period?
Henry Hubble: Well, when you look at the product volume sales, I mean, there are some impacts associated with weather -- and overall demand on obviously, heating oil sales in the area. But if you look at the weather effects, when we saw Europe was about 18% warmer than last year. The United States was about 22% warmer as measured in degree days. And then if you look at the actual volumes that were down about 145 fourth quarter versus fourth quarter '05, there's a piece of that that is retail divestments. It's part of our ongoing divestment programs in the retail marketing area. You also saw -- that was offset some by higher INW and then we also had lower throughput in Europe and we saw some of that show up in fuel oil sales, associated with the Antwerp refinery being down in that time frame.
Doug Terreson - Morgan Stanley: Sure.
Henry Hubble: So those were the primary impacts.
Doug Terreson - Morgan Stanley: Okay. And also in A&P, I just wanted to get an update on project status and specifically on a couple of projects and specifically how you guys view your position on Point Thompson in Alaska, [Natuna] in Indonesia and Papua, New Guinea gas and kind of the brief next steps on those three projects.
Henry Hubble: Well, if you start with Point Thompson, basically there -- we've had an indication from -- or the state basically has taken away the -- or modified or did not approve our modified development plan there and revoked the leases, and we are currently in the process of pursuing that with them. We filed a couple of cases, as you may know. We asked for reconsideration of that -- those lease cancellations, which was denied. We're asking that to be reconsidered by the Superior Court and then we'll go -- we'll take it from there. We are also pursuing damages associated with the cancellation of those leases.
Doug Terreson - Morgan Stanley: Sure.
Henry Hubble: When you look at Natuna, basically we are engaged in discussions there. Obviously, we'd like to move that forward. We're working with the Indonesian government on it. It's a challenging project. As you know, very high CO2 contents, and so we're basically working to have an amicable procedure going forward.
Doug Terreson - Morgan Stanley: Okay.
Henry Hubble: And then Papua, New Guinea, basically we continue to look at different options there on how we'll progress that project, and right now, it looks like LNG has a possibility but we are basically going through -- still at the concept stage there.
Doug Terreson - Morgan Stanley: Okay. Thanks a lot. Henry, thanks.
Henry Hubble: Yes.
Operator: We'll take our next question come from Doug Leggate with Citigroup. Please go ahead, sir.
Doug Leggate - Citigroup: Thank you. Good morning, Henry.
Henry Hubble: Hi, Doug.
Doug Leggate - Citigroup: Couple of things, Henry. I guess on the numbers really to help us reconcile things a bit. Could you walk us through the LIFO impacts and actually quantify them? On the downstream, just a follow-up, could you break out for me, please, the marketing and refining deltas both sequentially and year-over-year?
Henry Hubble: Yes, okay. Just starting with LIFO, if you look at the total impact of LIFO, there was about $400 million, and this is really a reflection of our ongoing efforts to optimize inventories and improving the efficiency of our entire supply chain, essentially. And so, if you look at those splits, there was about $280 million associated with downstream in 2006, most of that in the non-US. And then in chemical, we had $120 million positive, and that was split a little higher percentage in the US, about $70 in the US and the balance in non-US operations. And then if you are doing a comparison year-on-year, it was about $183 million above last year because this is something that we've had ongoing, -- as you know, ongoing effects as we continue to be able to optimize our inventory performance.
Doug Leggate - Citigroup: Great.
Henry Hubble: And then your other question was around the -- just the marketing breakdowns. Looking at the fourth quarter, comparisons there.
Doug Leggate - Citigroup: Yes. It looked like your capture rates were much better. I think the LIFO impacts account for a large part of it, so maybe it's not as critical as I thought it was.
Henry Hubble: Yes, if you look at -- if you just look at the fourth quarter versus fourth quarter comparison, most of the marketing -- I mean, most of the margin effects were in refining. And then that was -- and that was the big piece, small bit in marketing.
Doug Leggate - Citigroup: Okay. Great. I don't know if that counts as two questions but let me try just squeezing in another one real quick. Your cash balance declined for, I guess, for the first time in quite a while. Any impact on your buyback plans going forward?
Henry Hubble: We haven't -- we're not announcing any change there.
Doug Leggate - Citigroup: Okay. Great. Thanks, sir. Thanks a lot.
Operator: We'll take our next question from Arjun Murti from Goldman Sachs. Please go ahead.
Arjun Murti - Goldman Sachs: Thank you. Henry, I recognize you have your analyst meeting coming up next month and you'll certainly make more comments on this front there, but your ENT capital spending has grown at a kind of a solid double digit clip over the last five years as you have spent on all of these major developments.
Henry Hubble: Yes.
Arjun Murti - Goldman Sachs: You still have a big queue of developments to come.
Henry Hubble: Yes.
Arjun Murti - Goldman Sachs: There's been industry inflation. You've done better than industry, but there is still industry inflation. Is there any reason to think your ENT capital spending doesn't continue to grow at a double digit rate or have there been some recent one-off factors in the last year or two that might slow the growth rate in the ENT capital spending going forward?
Henry Hubble: Well, I mean, it's really -- the growth that you see in our -- is really a reflection of the projects that we have in the queue and we have a good pipeline of projects. We are continuing to advance those. So last year -- we'll be updating this as we get together in March, but last year, basically, we were showing ourselves close to $20 billion going out in the future time frame. We'll be updating that basically reflecting the projects and the status of those projects and we'll talk more about it at the meeting.
Arjun Murti - Goldman Sachs: That's great, and I guess in terms of my second question, obviously Angola has joined OPEC. This has been a major source of your West African growth. I know it is very hard to predict what countries will do or say in terms of limiting or controlling growth going forward but do you all think of Angola any differently now that it's part of OPEC? Do you sit there and say maybe we slow down future projects in that country? Is there any change in your outlook for Angola as a result of it?
Henry Hubble: No, we are very pleased with our Angolan developments and as you have no doubt seen, the exploration is going on in Block 31, 32. We have been pleased with progress there. But those projects will have to -- I mean, they are looking at how to bring those together to have a successful development. But we're still very encouraged with Angola, and don't really see this as a change from our perspective.
Arjun Murti - Goldman Sachs: That's great. Thank you very much.
Henry Hubble: Yes.
Operator: And we'll take our next question come from Nicki Decker from Bear Stearns. Please go ahead.
Nicki Decker - Bear Stearns: Good morning, Henry.
Henry Hubble: Hi, Nicki.
Nicki Decker - Bear Stearns: So just specifically on the production volumes, can you talk about what happened in Africa? The Africa liquids production was a little bit lower than we had expected. And then for my second question, as we look into next year, and all of the factors that are affecting production, other than organic growth of sales and PSC effects and OPEC issues, is there any reason to believe that your production might vary from your targeted 3% to 4% growth next year? I'm sorry, in 2007. That would be this year?
Henry Hubble: Yes, right. Just starting with the Africa piece of this. The African volumes are primarily driven by lower Angola volumes due to the entitlement effects and we have been seeing those going on a continuing basis. Some of that production comes from -- in fact, all of it is production sharing contract related. And those PSCs, they have -- that entitlement is reduced when the cumulative production or cumulative profitability thresholds are reached so there's been continuing impacts there as we have seen higher prices, all of which basically has made those projects more attractive and really we're very pleased with their performance. If you look at the other impact in that time frame, we did have some unscheduled downtime in Nigeria that also impacted in the period that may have been part of the miss that you had.
Nicki Decker - Bear Stearns: Okay. So can you talk about the impact in Nigeria, Henry?
Henry Hubble: I mean, it was basically associated with -- I will have to get some specifics about what that -- what that was. Yes, let me come back to you on that, because I don't have anything right at the tip of my fingers here.
Nicki Decker - Bear Stearns: Okay.
Henry Hubble: When we look at -- when we look at the production, we don't really -- I don't really have a product target going forward. The 3% that we have talked about, when you look at -- that's an outcome of the projects that we have in the plans, and as we said, it will be lumpy depending on how projects come on, and it was a reflection of those projects over a longer period of time. So you see -- you are going to see some positive peaks when you have more projects coming on and dips in that, and we really haven't tried to get into year by year kind of outlook on that.
Nicki Decker - Bear Stearns: Thanks, Henry.
Henry Hubble: Yes. Well, I guess the bulk -- from what I'm looking here, maybe the bulk of that Nigerian piece is associated with declines. And I just don't have any specifics on the outages at this point.
Nicki Decker - Bear Stearns: Okay. Great. Thank you.
Operator: And we'll take our next question from Paul Cheng from Lehman Brothers. Please go ahead.
Paul Cheng - Lehman Brothers: Hi, good morning. Henry, on the -- if we are looking at over the next four months if I look at, say, from a collective basis for the quarter is going to reach the payoff period, what may be a job in your production related debt?
Henry Hubble: And you're talking about Angola or --?
Paul Cheng - Lehman Brothers: No, I mean on your global portfolio. I mean, you must have some project that you are bringing on a lot of project over the last three years with the high prices. I presume that some of them over the next 12 months will reach the payoff period and it's such that your report production will see a reduction. Any kind of --?
Henry Hubble: Yes, I --
Paul Cheng - Lehman Brothers: -- rough number you can share that the impact may be for next year, for 2007?
Henry Hubble: Right. No. I don't have -- we'll talk about our production profile, which we'll take into those -- into account those kinds of effects when -- as we are doing that forward projection. But again, it's going to depend on the price. It depends on specific contracts. There are a lot of individual production and they're -- depending on when they started up and the time frame that they have been running, how they have been performing, all of those things will impact that, and it will be incorporated into that forward projection, but I don't have anything that I can give you in terms of a forward, forward look on that.
Paul Cheng - Lehman Brothers: Okay. If I could, I want to sneak in two more questions in here.
Henry Hubble: Yes.
Paul Cheng - Lehman Brothers: One, if you can give us an update where is the [Kitachee] project for you? I mean with the rapid rise in the cost, is the project still a go or that you guys having some second thought? And also I think during the -- your recovery (inaudible), you had indicate some of the foreign exchange gain or loss, I think in both chemical and the O&M, I don't know whether you have that in the upstream, if you can break it down for us versus the third quarter, what is the impact?
Henry Hubble: Yes, I sure can. If you look at the BorEx effects in the third -- versus the third quarter, they were almost nothing. I think for the total corporation, it was under $30 million. So there's nothing in there on BorEx in the sequential comparison. Back on the Qatar question with the GTL project, I mean the technical work continues there. There are cost pressures, no question about that. We are working very hard on the concept of development with the Qatarries and what we have found in all of these projects is the real focus -- you have to get that development concept right or you lose it. And so that -- we're spending the time to get that concept right, and so when we're ready to go forward from there, we will let you know, but we are still optimistic about it. We are working on that development concept.
Paul Cheng - Lehman Brothers: So I assume that I think initially, there were some expectations by 2011, 2012. That time frame probably is too aggressive?
Henry Hubble: We will be updating whatever on those kind of things at the analyst meeting.
Paul Cheng - Lehman Brothers: Okay. Thank you.
Henry Hubble: Right.
Operator: We'll take our next question from Dan Barcelo from Banc of America. Please go ahead.
Dan Barcelo - Banc of America: Hi, good morning. Regarding the downstream, it seems a lot of your competitors are really looking to sell a lot more refining assets. In particular, these values seem to be a little bit below replacement costs, especially when you compare it to Middle Eastern type new building costs.
Henry Hubble: Yes.
Dan Barcelo - Banc of America: I don't know if you could just comment rather broadly on Exxon's view of, in particular, downstream, in particular in terms of divestments or additions.
Henry Hubble: Yes. I mean, we're not going to -- I'm not going to speculate on specific divestments. We are always looking at our portfolio. So -- and looking at what is -- why there's more value to somebody else than there is to us, and we'll market things, and you did see us -- I mean we sold our -- our Englestock refinery. So -- but I would tell you that overall, when we look at the refining business, we feel very good about the refining business. We work hard on integration with our chemicals business and because we have those integrated operations with chemicals, with our lubes businesses, it makes them more resilient. The other things, the technologies that we employ in molecule management and other techniques that we have and improving reliability, operations, integrity, we've had very good returns in this business and what we do is -- every one of our refineries has a forward looking plan, a five-year plan, and they are basically planning to stay ahead of whatever that long-term margin trend is, which you have heard us talk about before. If you look at the long-term trend, it is down. We make sure we are staying ahead of that curve. So we feel good about the assets that we have there, but I don't rule out that there might be specific pieces that will be more valuable to somebody else than us, and we'll let you know if those things occur.
Dan Barcelo - Banc of America: Perfect. Thanks very much.
Operator: And we'll take our next question from Paul Sankey from Deutsche Bank. Please go ahead.
Paul Sankey - Deutsche Bank: Hi, Henry. Forgive me if you have answered this question. I know the word capital is being bandied about but my understanding is that you've got some issues there with the LNG trains. Could you just fill us in? I think they are shut down as far as I understand it or at least some of them. Could you just fill us in on the latest news there?
Henry Hubble: Yes. Well, what you were hearing about, we had some hydrate problems in the pipelines coming in. And basically, those facilities are essentially back up at this point. But it did impact us during the month of January. And what happened, we saw some rising pressure. Our monitoring equipment caught it. So we saw the pressure drop, increasing there, and then basically we are going through a process of clearing that out, which takes a little bit of time. So there was some -- we work with customers because there were some customers we had to restrict volumes on. And they are basically back up now.
Paul Sankey - Deutsche Bank: Okay. So the story was -- I think it was Train 4 -- was it 3, 4, and 5 were down, but basically what you are saying is they were only out for, what, I guess a matter of three weeks, two-three weeks?
Henry Hubble: Yes, and the impact varies -- it's not -- basically, it makes sure that we're cleaning the lines up and so you ended up with less than full impact as you went through this time frame. And then, of course, we are going through a very thorough investigation to understand what variables changed and what caused the problems that we had there so that it won't happen again.
Paul Sankey - Deutsche Bank: Right. And for my second question, I'm going to ask you a double question as part of it. Firstly, could you just comment on what your turnaround schedule or downtime will look like in terms of turning around refineries, if there's anything unusual in the US and internationally this quarter and this year? And a follow-on is that it is notable, following up on Doug's question, that volumes are down if we look at the whole year of '06 from '05. Was that disposals or was it -- was there some other reason why your sales of product, petroleum products was quite sharply down compared to global demand? Thanks.
Henry Hubble: Yes, okay. First off, I mean, just looking at the turnaround schedule, this year was a little bit heavier than typical and we are seeing it being similar next year, so in the same kind of -- in the same kind of range. And that is the primary impact on volumes. The other, again, is divestments, and there's hydrating in our portfolio. It's lower refinery throughputs and then you see that roll through in things like fuel oil sales. You'll see some in the specialty product sales because we had more pull to chemicals and of course, Englestock came out of that -- those numbers as well. So those are -- those were the big impacts.
Paul Sankey - Deutsche Bank: Right. And if we look at -- if you look at what the real oil market is doing, I guess it was up by what percent in '06 would you say on your numbers, and what do you expect in '07 and I will leave it there?
Henry Hubble: In terms of overall liquid demand?
Paul Sankey - Deutsche Bank: Yes.
Henry Hubble: Yes, I mean and that's probably the best way to look at it. We do the global balances and what are projected in our original projections would have been higher than how it's turned out this year. And we'd see overall demand worldwide somewhere in the million barrel a day increase, something maybe a little less than that when you took a total global balance. And that really reflects -- when we start looking behind it as to what impacted that, we think weather was a significant factor in there. If you look at the demands in the first quarter of last -- '06 and fourth quarter of '06, also if you look at some of the -- just the pricing between fuel oil and natural gas, there was fuel switching that was going on. So we think those were some of the things that were driving demands a little bit more than overall economics because when we look at the comparisons of -- for the long haul, it really correlates best with economic growth and we really haven't seen any slowdowns in economic growth and that's really what drives it overall in the longer term.
Paul Sankey - Deutsche Bank: Thanks, Henry.
Henry Hubble: Yes.
Operator: And we'll take our next question come from Mark Gilman from The Benchmark Company. Please go ahead.
Mark Gilman - The Benchmark Company: Henry, good morning. I had two questions. First one relates to Nigeria. It is my understanding that you have opted not to proceed with a grassroots LNG project in Nigeria and I was wondering if you could confirm that and discuss briefly the reasons for that decision. My second question relates to tax rate. If I quickly to through the arithmetic and make the adjustment for the special item, the tax rate gets up to about 39% effective basis for the quarter if I'm doing the math right. Given business mix and things of that sort, where we were in this regard in the first three quarters of '06, a rate in the 42% to 44% range would have seemed to have been where it should have been. I wonder if you comment on, perhaps, some of the factors that are responsible for that difference, and whether they are sustainable going forward.
Henry Hubble: Yes, right. Well, if you look at the first stuff on the Nigerian LNG project. I mean it's really premature for me to comment on that. We're still in the working phase on that to look at that project so there hasn't been any final decisions made one way or the other there. When you look at the tax impact, the special item was one piece that impacted our overall tax in the period but then as I mentioned also, there were some other items in our corp. and fin that increased -- that were positive to earnings. Those were -- and the reason -- the one was broken out as a special because it was large and it was non-recurring so it was identified as a special. The others -- we have always seen a certain number of tax effects, as you know, just because of the size of the Company, all the different jurisdictions we are involved in, but in the period, there were a number of return finalizations that occurred that basically went all in the same direction so it was a combination of those impacts that ended up. If you look at our longer term projection on tax, we would still guide in the 40%, 45% range and probably toward the higher end of that so typical of what we saw earlier in the year is, I think, the best way to look at it.
Mark Gilman - The Benchmark Company: Thanks, Henry.
Henry Hubble: Yes.
Operator: And we'll take our next question from Mark Flannery from Credit Suisse. Please, go ahead, sir.
Mark Flannery - Credit Suisse: Hi, Henry.
Henry Hubble: Hi, Mark.
Mark Flannery - Credit Suisse: Could you comment a little bit on what is going on in Asian R&M? We have seen some fairly weak numbers out of the Japanese market recently. You have a big business there. I'm just wondering how weak was that in the fourth quarter and is there any sign that margins or earnings or sales are going to get a bit better up there?
Henry Hubble: Yes, if you look at the margins in refining, out in the Asia Pacific, they were off. It got pretty weak during the fourth quarter of '06, actually, ex-Japan. It was outside of Japan. Japan had actually strengthened some in the period. And then if you look at -- on the marketing side, it varies but basically we were up. The marketing margins were up in Asia Pacific and Japan, comparing the -- if you go fourth quarter versus fourth quarter. So, most the negative impact on marketing margins or refining margins were US and Europe in those periods -- in the comparative period.
Mark Flannery - Credit Suisse: And what about sales volumes, specifically in Japan I'm thinking. Are you seeing any weakness there or --?
Henry Hubble: Well, I don't know if I've got a breakdown on Japanese demand.
Mark Flannery - Credit Suisse: Maybe you can talk about Asia in general, maybe.
Henry Hubble: Yes. If I look at Asia Pacific, it was down about -- quarter-on-quarter, it was down about 5%, and that really -- it was essentially mostly associated with lower runs and then we see the continuing growth in our chemicals business. We did have more transfers to chemicals so that's the other thing that goes on that's impacted some of those sales. It was basically a positive story there. And those were the bigger impacts.
Mark Flannery - Credit Suisse: Okay. Thanks a lot.
Henry Hubble: Yes.
Operator: And we'll take our next question from Neil McMahon from Sanford Bernstein. Please go ahead.
Oxy Oswald Clint - Sanford Bernstein: Hi, good morning. Hi, it's Oxy Oswald Clint here on behalf of Neil who is at the Shell presentation. Just two questions --
Henry Hubble: Okay.
Oxy Oswald Clint - Sanford Bernstein: Could you give us an update, please, on your decline rifts across the portfolio in 2006 versus 2005? And secondly, you mentioned Dalia in your press update this morning. Can you confirm any spending or the rumors that it's actually progressing well ahead of expectations?
Henry Hubble: Yes. I mean, as far as I know, Dalia is coming up and ramping up. We're expecting to get up to full rates by the end of the -- I think it's the first quarter, targeted at 225. So I mean, it's come on well, but it's probably better to focus that back at the operator. And then if you look at our declines, there really aren't any big surprises there. We look at the year -- obviously we monitor this very closely, field by field. You do have more decline in the maturer markets but if you look at our overall target, or guidance that we have had, we have said 4% to 6%, closer to the higher end of that range, and we have seen nothing that's really taken us out of there, nothing unusual in that at all.
Oxy Oswald Clint - Sanford Bernstein: Okay. That's great. Thank you.
Henry Hubble: Yes
Operator: [Operator Instructions] We'll take our next question from John Herrlin from Merrill Lynch. Please go ahead, sir.
John Herrlin - Merrill Lynch: Yes, hi. Henry, I know that later on this month, you are going to announce your reserve additions.
Henry Hubble: Yes.
John Herrlin - Merrill Lynch: But given Aira, Kizomba, Qatar, Obrizagam, would it be fair to say that your production replacement for 2006 would be better than 2005?
Henry Hubble: I'm not really not going to get -- we'll have it out here shortly. The thing that you have to remember in all of these things, though, is the timing of when a project comes on and when it's funded. That's -- mostly it's decisions and recognition of reserves or actually when you have a full funding decision and you are proceeding forward. So there's often a skewing between when something is funded and when it comes online that those reserves are often recognized at different periods. But we'll update you here shortly.
John Herrlin - Merrill Lynch: I thought it was worth a shot. Thanks anyway.
Henry Hubble: Yes, okay.
John Herrlin - Merrill Lynch: Next question is on Venezuela. Even though it's not a large part of your business, lots of headline risks these days. Have you heard from them? When will you hear from them or how are things going there?
Henry Hubble: Well, it's -- I mean, the discussions continue. We don't really have anything new to report there. Our affiliate has been informed that they would like to migrate to mixed enterprise, and basically the ball is a bit in Venezuela's court right now. So we'll see. We'd like to get an amicable resolution, obviously. We are looking to maintain the shareholder value from the projects that we invested in there and so hopefully we can work out something that will allow us to do all of that.
John Herrlin - Merrill Lynch: Great. Last one from me. US production decline rates, just normal field declines?
Henry Hubble: Yes. There was a little bit in there associated with Prudhoe Bay loadings that impacted in the period, but that's the biggest thing.
John Herrlin - Merrill Lynch: Thanks, Henry.
Henry Hubble: Yes.
Operator: [Operator Instructions] We'll take our next question from Mark Gilman from The Benchmark Company. Please go ahead.
Mark Gilman - The Benchmark Company: Henry, I guess I get a second shot! My two this time. There was reference to a large pension contribution --
Henry Hubble: Yes.
Mark Gilman - The Benchmark Company: -- in your comments and I'm wondering whether we should expect a similar level contribution for this year.
Henry Hubble: No. I wouldn't -- we evaluate these things on an ongoing basis. I can't really tell you yes or no on that. We constantly are looking at that and deciding when it makes sense to. We saw an opportunity here and -- for funding that we went ahead and exercised this year but I wouldn't read anything into that on a forward basis.
Mark Gilman - The Benchmark Company: Okay, and secondly, can you give us in absolute terms the price finalization impacts on the refining area split US and foreign in the fourth quarter?
Henry Hubble: Yes, if you look on an absolute basis for price finalization, it was a total of $120 million positive, $60 of that -- 50/50 split, $60 US, $60 non-US.
Mark Gilman - The Benchmark Company: Thank you, Henry.
Operator: This will conclude today's question-and-answer session. I would like to turn the conference back over to Mr. Hubble for any additional or closing remarks.
Henry Hubble: I would just like to thank everybody for your time and questions this morning. We certainly look forward to sharing more details on our record 2006 performance and forward business plans at the analysts meeting in March. Hope to see you there. Thanks.
Operator: Once again, ladies and gentlemen, this will conclude today's conference. We thank you for your participation. You may now disconnect.
TRANSCRIPT SPONSOR : | [
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"speaker": "TRANSCRIPT SPONSOR",
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"speaker": "Executives",
"text": "Henry Hubble - VP of IR & Secretary"
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"speaker": "Analysts",
"text": "Doug Terreson - Morgan Stanley Doug Leggate - Citigroup Arjun Murti - Goldman Sachs Nicki Decker - Bear Stearns Paul Cheng - Lehman Brothers Dan Barcelo - Banc of America Paul Sankey - Deutsche Bank Mark Gilman - The Benchmark Company Mark Flannery - Credit Suisse Oxy Oswald Clint - Sanford Bernstein John Herrlin - Merrill Lynch"
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"speaker": "Operator",
"text": "Good day and welcome to this Exxon Mobil Corporation fourth quarter 2006 earnings conference call. Today's call is being recorded. At this time, for opening remarks, I would like to turn the call over to the Vice President of Investor Relations and Secretary, Mr. Henry Hubble. Please go ahead, sir."
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"speaker": "Henry Hubble",
"text": "Thank you. Good morning and welcome to Exxon Mobil's teleconference and webcast on our fourth quarter and full-year 2006 financial and operating results. As you are aware from this morning's press release, we had another strong quarter as our longstanding commitments to the integrity of our operations, disciplined investment and our integrated business model continued to deliver superior results. At this time, I would like to draw your attention to our cautionary statement. Please note that estimates, plans and projections are forward-looking statements. Actual results, including resource recoveries, volume growth and project plans and outcomes could differ materially due to factors I'll discuss and factors noted in our SEC filings. Please see \"Factors Affecting Future Results\" in the Form 8-K we furnished this morning which are available through the investor information section of our website. Please also see the frequently used terms, the supplement to this morning's 8-K and the 2005 financial and operating review on our website. This material defines certain financial and operating terms I will use today, shows Exxon Mobil's net interest in specific projects and includes information required by SEC Regulation G. Now I'm pleased to turn your attention to the specific results. Exxon Mobil's fourth quarter net income was $10.3 billion, or $1.76 per share. These results included a $410 million one-time gain from the recognition of tax benefits related to historical investments in non-US assets. Excluding this gain, normalized earnings were $9.8 billion or $1.69 per share. This represents a decrease of $480 million versus last year's record fourth quarter. While absolute earnings were lower, normalized earnings per share were up from last year, due to the reduction in shares outstanding associated with our share purchase program. For the full year 2006, net income of $39.5 billion was a record, and increased $3.4 billion from 2005. Normalized earnings were also a record at $39.1 billion, up $5.2 billion from 2005. Before I discuss the specific business results, I would like to share some of the milestones achieved since the last earnings call. In the upstream, production commenced from the Dalia field in Angola Block 17, located in water depths of over 1,200 meters, 135 kilometers offshore. Dalia is estimated to contain close to 1 billion barrels of recoverable reserves and is expected to reach peak production of about 225,000 barrels of oil per day during the first quarter of this year. Also starting up in the fourth quarter was the Fram East field in the Troll area of the Norwegian North Sea. We anticipate the recovery of approximately 60 million barrels of oil and 70 billion cubic feet of natural gas from the field. Fram East is expected to reach peak production of about 45,000 barrels of oil per day and 45 million cubic feet of natural gas per day in 2008. Another milestone during the quarter was the early processing of LNG at RasGas Train 5 in Qatar. Start-up of the liquefaction train was only 29 months after contract award, a significant achievement for such a large facility and testament to the success of our design one, build many approach and outstanding project execution of the Qatar Petroleum and Exxon Mobil joint venture. Offshore facilities that will supply the natural gas to the train on a long-term basis should be complete by the end of the first quarter. RasGas Train 5 is designed to produce 4.7 million tons per year of LNG for anticipated delivery to market in Asia and Europe. Also in the quarter, we continued to ramp up crude oil production at our Sakhalin 1development in Russia producing over 200,000 barrels a day at year end. Production is expected to reach 250,000 barrels per day by the end of the first quarter. Exxon Mobil also expanded its exploration opportunities during the quarter with new agreements for exploration in the deepwater [Sanakin] Basin southwest of the Philippine Islands. In the downstream, the British Safety Council awarded the prestigious 2006 Sword of Honor to our US and UK-based marine transportation affiliates. The award was recognition of our commitment to workplace safety and health, high operating standards and disciplined management systems. As a multi-year recipient of this award, we continue to emphasize consistent and disciplined safety, health and environmental management in all aspects of our operations. In our lubes business, we announced that Exxon Mobil will become the title sponsor for the Porsche One Mobil 1 Super Cup, further progressing 10 years of close commercial and technical global collaboration with Porsche. Porsche exclusively recommends Mobil 1 and every new Porsche engine leaves the assembly line filled with Mobil 1 oil. During the quarter, our refining and supply business continued to grow profitability through crude diversification, running 41 crudes new to individual refineries, 16 of which were new to Exxon Mobil. In December, we completed a de-bottleneck of our Antwerp, Belgium refinery. This project increased distillation and conversion capacity at a fraction of grassroots costs and enhanced our ability to process advantage crudes. Our worldwide refinery capacity growth rate is equivalent to building a new refinery every three years but at significantly lower cost than new built. Turning to the chemicals business. During the quarter, we announced the progression of a feasibility study with the Saudi Basic Industries Corporation, to expand the [Yenta] and [Kemya] petrochemical joint ventures in Saudi Arabia. The project will include expansion of capacity for carbon black, butyl rubber and thermolplastic specialty polymers for international and emerging local markets. Start-up is anticipated in the 2011 through 2012 timeframe. In November, we announced an expansion of halobutyl rubber capacity at our Baytown, Texas plant that will increase production by 60%. This expansion, part of the Company's commitment to meet the strong global halobutyl rubber demand growth, follows an expansion that quadrupled capacity at Baytown in 2002. Targeted for completion during the second quarter of 2008, this project builds on Exxon Mobil's 70 years of experience in butyl rubber research and development, services and customer application. Turning now to the business results. Upstream earnings in the fourth quarter were $6.2 billion, down $820 million from 2005, which was our highest fourth quarter on record. Lower natural gas realizations reduced gas volumes and net other items were the primary drivers for the earnings change, partly offset by improved crude realizations. We continued to capture the benefit of strong industry conditions with upstream after-tax unit earnings of $15.99 per barrel for the quarter. Oil-equivalent volumes declined slightly versus the same quarter last year, driven by lower gas demand in Europe. Excluding entitlement effects and divestments, oil-equivalent volumes were up 2%. Liquids production increased about 50,000 barrels per day or 2% versus the same quarter last year as the impact of project start-ups and increased Middle East volumes more than offset mature field declines and entitlement effects. Gas volumes decreased 520 million cubic feet per day or about 5% versus the fourth quarter of 2005, due to the impact on demand of warmer weather in Europe. New project volumes and better up time, including the absence of hurricane effects in the US, offset natural field declines. Turning now to the sequential comparison. Versus the third quarter of 2006, upstream earnings decreased by $270 million as lower realizations driven by an almost $10 per barrel decrease in crude prices reduced earnings by $820 million. However, this impact was largely offset by the increased volumes -- by increased volumes. Oil-equivalent volumes were up nearly 6% from the third quarter. Liquids production increased 1% sequentially as we concluded to ramp up production at Sakhalin 1, while natural gas production was up 14%, due to seasonal demand increases in Europe. Now looking at the full year results. Excluding special items, full year 2006 upstream earnings were a record $26.2 billion, an increase of $3.5 billion or 15% over 2005. The most significant factor driving that increase was markedly higher crude and natural gas realizations partly offset by production mix effects and net other items. Full year equivalent production was up 4% versus 2005 with increased volumes in Africa and the Middle East. Liquids volumes were up 6% from 2005, while natural gas volumes were up 1%. Excluding divestments and entitlement effects, oil-equivalent volumes were up 6.6%. For further data on regional volumes, please refer to the press release and IR supplement. Now let's turn to the downstream results. Downstream normalized earnings in the fourth quarter were nearly $2 billion, down $430 million from the fourth quarter last year. Lower margins reduced earnings by $820 million with markedly lower fuels refining and marketing margins partially offset by stronger lubes earnings. Other factors included positive LIFO and BorEx effect. Sequentially, fourth quarter earnings decreased by $780 million. The primary drivers were lower refining and marketing margins, while reduced earnings -- which reduced earnings by $790 million. Improved refining operations more than offset seasonally lower fuels, marketing and lube sales. Other factors included positive LIFO impacts offset by higher planned maintenance and turnaround expenses. Full year 2006 downstream normalized earnings were a record at just under $8.5 billion. Earnings increased $570 million from 2005, primarily due to stronger fuels and lubes marketing margins. Volume mix effects reduced earnings by $480 million reflecting higher planned turnaround activity, partially offset by self-help margin enhancement items, including raw material optimization and product upgrades. Other earnings effects improved earnings by $300 million, primarily positive BorEx and LIFO impacts. Focusing now on our chemical results. Fourth quarter normalized earnings of $1.2 billion were up about $400 million versus the fourth quarter of 2005, reflecting higher margins, stronger volumes and positive LIFO effects partially offset by costs associated with turnaround activity. Sequentially, fourth quarter chemical earnings decreased by $110 million, reflecting seasonal volume mix and other effects partially offset by positive LIFO impacts. Full year 2006 normalized chemical earnings were at a record, almost $4.4 billion, $980 million higher than full year 2005. Stronger margins in our integrated polyolefins and specialties businesses and higher volumes were the largest contributors to the improvement. Full year chemical prime product sales increased by about 2%, reflecting higher volumes across most business lines. Our record 2006 earnings confirmed that our unique portfolio of chemical product lines, broad geographic coverage and integration with our downstream and upstream facilities provides us with a competitive advantage and delivers industry leading performance. Turning now to the corporate and financing segment. As I mentioned earlier, we had a special tax item in the corporate and financing segment this quarter. Excluding that special item, the Corporation recorded fourth quarter earnings of $420 million in the segment, up about $360 million from the fourth quarter of 2005, primarily due to favorable tax items and increased interest income. Excluding special items, full year 2006 corporate and financing earnings of $24 million were up by approximately $180 million from 2005, primarily due to higher interest income. The effective tax rate for the fourth quarter was 37%. For full year 2006, the effective tax rate was 43%. The Corporation distributed a total of almost $8.9 billion to shareholders in the fourth quarter through dividends and share purchases to reduce shares outstanding. That's up almost $2.1 billion from the fourth quarter of 2005. Included in the $8.9 billion of fourth quarter distributions was $7 billion to purchase shares in excess of dilution. These purchases reduced the number of shares outstanding by 1.8%. For the full year 2006, we purchased $25 billion of shares in excess of dilution and reduced shares outstanding by 6.6%, further demonstrating our ongoing commitment to return cash to our shareholders. CapEx in the fourth quarter was $5.1 billion. That takes full year CapEx to $19.9 billion, in line with our previous guidance, and an increase of approximately $2.2 billion from 2005, reflecting increased upstream investments. Fourth quarter cash flow from operations and asset sales was $9.6 billion, including $2.4 billion in contributions to the US pension plan. At the end of the year, our cash balance was $32.8 billion and debt was $8.3 billion. Finally, I would like to mention two upcoming events. First in mid-February, we'll be releasing our 2006 reserves performance data. And second, as many of you will have already seen, our analyst meeting this year will take place on March 7th, including a live audio webcast beginning at 9 a.m. Eastern, 8 a.m. Central Time. The meeting will include an update of our forward business plans. Exxon Mobil's presenters will be led by Chairman and CEO Rex Tillerson. That concludes my prepared remarks and I would now be happy to take your questions."
},
{
"speaker": "TRANSCRIPT SPONSOR",
"text": ""
},
{
"speaker": "Operator",
"text": "[Operator Instructions] We'll take our first question from Doug Terreson from Morgan Stanley. Please go ahead, sir."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Congratulations on solid numbers, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Thanks, Doug."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "In the upstream, you mentioned that weather effects were significant for European natural gas sales in relation to the year ago period."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "And on this point, can we attribute the year-over-year decline in product sales in Europe and Asia Pacific to the same factor? And if not, could you comment on the other major factors that were at work in the period?"
},
{
"speaker": "Henry Hubble",
"text": "Well, when you look at the product volume sales, I mean, there are some impacts associated with weather -- and overall demand on obviously, heating oil sales in the area. But if you look at the weather effects, when we saw Europe was about 18% warmer than last year. The United States was about 22% warmer as measured in degree days. And then if you look at the actual volumes that were down about 145 fourth quarter versus fourth quarter '05, there's a piece of that that is retail divestments. It's part of our ongoing divestment programs in the retail marketing area. You also saw -- that was offset some by higher INW and then we also had lower throughput in Europe and we saw some of that show up in fuel oil sales, associated with the Antwerp refinery being down in that time frame."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Sure."
},
{
"speaker": "Henry Hubble",
"text": "So those were the primary impacts."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Okay. And also in A&P, I just wanted to get an update on project status and specifically on a couple of projects and specifically how you guys view your position on Point Thompson in Alaska, [Natuna] in Indonesia and Papua, New Guinea gas and kind of the brief next steps on those three projects."
},
{
"speaker": "Henry Hubble",
"text": "Well, if you start with Point Thompson, basically there -- we've had an indication from -- or the state basically has taken away the -- or modified or did not approve our modified development plan there and revoked the leases, and we are currently in the process of pursuing that with them. We filed a couple of cases, as you may know. We asked for reconsideration of that -- those lease cancellations, which was denied. We're asking that to be reconsidered by the Superior Court and then we'll go -- we'll take it from there. We are also pursuing damages associated with the cancellation of those leases."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Sure."
},
{
"speaker": "Henry Hubble",
"text": "When you look at Natuna, basically we are engaged in discussions there. Obviously, we'd like to move that forward. We're working with the Indonesian government on it. It's a challenging project. As you know, very high CO2 contents, and so we're basically working to have an amicable procedure going forward."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Okay."
},
{
"speaker": "Henry Hubble",
"text": "And then Papua, New Guinea, basically we continue to look at different options there on how we'll progress that project, and right now, it looks like LNG has a possibility but we are basically going through -- still at the concept stage there."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Okay. Thanks a lot. Henry, thanks."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "We'll take our next question come from Doug Leggate with Citigroup. Please go ahead, sir."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Thank you. Good morning, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Hi, Doug."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Couple of things, Henry. I guess on the numbers really to help us reconcile things a bit. Could you walk us through the LIFO impacts and actually quantify them? On the downstream, just a follow-up, could you break out for me, please, the marketing and refining deltas both sequentially and year-over-year?"
},
{
"speaker": "Henry Hubble",
"text": "Yes, okay. Just starting with LIFO, if you look at the total impact of LIFO, there was about $400 million, and this is really a reflection of our ongoing efforts to optimize inventories and improving the efficiency of our entire supply chain, essentially. And so, if you look at those splits, there was about $280 million associated with downstream in 2006, most of that in the non-US. And then in chemical, we had $120 million positive, and that was split a little higher percentage in the US, about $70 in the US and the balance in non-US operations. And then if you are doing a comparison year-on-year, it was about $183 million above last year because this is something that we've had ongoing, -- as you know, ongoing effects as we continue to be able to optimize our inventory performance."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Great."
},
{
"speaker": "Henry Hubble",
"text": "And then your other question was around the -- just the marketing breakdowns. Looking at the fourth quarter, comparisons there."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Yes. It looked like your capture rates were much better. I think the LIFO impacts account for a large part of it, so maybe it's not as critical as I thought it was."
},
{
"speaker": "Henry Hubble",
"text": "Yes, if you look at -- if you just look at the fourth quarter versus fourth quarter comparison, most of the marketing -- I mean, most of the margin effects were in refining. And then that was -- and that was the big piece, small bit in marketing."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Okay. Great. I don't know if that counts as two questions but let me try just squeezing in another one real quick. Your cash balance declined for, I guess, for the first time in quite a while. Any impact on your buyback plans going forward?"
},
{
"speaker": "Henry Hubble",
"text": "We haven't -- we're not announcing any change there."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Okay. Great. Thanks, sir. Thanks a lot."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Arjun Murti from Goldman Sachs. Please go ahead."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "Thank you. Henry, I recognize you have your analyst meeting coming up next month and you'll certainly make more comments on this front there, but your ENT capital spending has grown at a kind of a solid double digit clip over the last five years as you have spent on all of these major developments."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "You still have a big queue of developments to come."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "There's been industry inflation. You've done better than industry, but there is still industry inflation. Is there any reason to think your ENT capital spending doesn't continue to grow at a double digit rate or have there been some recent one-off factors in the last year or two that might slow the growth rate in the ENT capital spending going forward?"
},
{
"speaker": "Henry Hubble",
"text": "Well, I mean, it's really -- the growth that you see in our -- is really a reflection of the projects that we have in the queue and we have a good pipeline of projects. We are continuing to advance those. So last year -- we'll be updating this as we get together in March, but last year, basically, we were showing ourselves close to $20 billion going out in the future time frame. We'll be updating that basically reflecting the projects and the status of those projects and we'll talk more about it at the meeting."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "That's great, and I guess in terms of my second question, obviously Angola has joined OPEC. This has been a major source of your West African growth. I know it is very hard to predict what countries will do or say in terms of limiting or controlling growth going forward but do you all think of Angola any differently now that it's part of OPEC? Do you sit there and say maybe we slow down future projects in that country? Is there any change in your outlook for Angola as a result of it?"
},
{
"speaker": "Henry Hubble",
"text": "No, we are very pleased with our Angolan developments and as you have no doubt seen, the exploration is going on in Block 31, 32. We have been pleased with progress there. But those projects will have to -- I mean, they are looking at how to bring those together to have a successful development. But we're still very encouraged with Angola, and don't really see this as a change from our perspective."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "That's great. Thank you very much."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "And we'll take our next question come from Nicki Decker from Bear Stearns. Please go ahead."
},
{
"speaker": "Nicki Decker - Bear Stearns",
"text": "Good morning, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Hi, Nicki."
},
{
"speaker": "Nicki Decker - Bear Stearns",
"text": "So just specifically on the production volumes, can you talk about what happened in Africa? The Africa liquids production was a little bit lower than we had expected. And then for my second question, as we look into next year, and all of the factors that are affecting production, other than organic growth of sales and PSC effects and OPEC issues, is there any reason to believe that your production might vary from your targeted 3% to 4% growth next year? I'm sorry, in 2007. That would be this year?"
},
{
"speaker": "Henry Hubble",
"text": "Yes, right. Just starting with the Africa piece of this. The African volumes are primarily driven by lower Angola volumes due to the entitlement effects and we have been seeing those going on a continuing basis. Some of that production comes from -- in fact, all of it is production sharing contract related. And those PSCs, they have -- that entitlement is reduced when the cumulative production or cumulative profitability thresholds are reached so there's been continuing impacts there as we have seen higher prices, all of which basically has made those projects more attractive and really we're very pleased with their performance. If you look at the other impact in that time frame, we did have some unscheduled downtime in Nigeria that also impacted in the period that may have been part of the miss that you had."
},
{
"speaker": "Nicki Decker - Bear Stearns",
"text": "Okay. So can you talk about the impact in Nigeria, Henry?"
},
{
"speaker": "Henry Hubble",
"text": "I mean, it was basically associated with -- I will have to get some specifics about what that -- what that was. Yes, let me come back to you on that, because I don't have anything right at the tip of my fingers here."
},
{
"speaker": "Nicki Decker - Bear Stearns",
"text": "Okay."
},
{
"speaker": "Henry Hubble",
"text": "When we look at -- when we look at the production, we don't really -- I don't really have a product target going forward. The 3% that we have talked about, when you look at -- that's an outcome of the projects that we have in the plans, and as we said, it will be lumpy depending on how projects come on, and it was a reflection of those projects over a longer period of time. So you see -- you are going to see some positive peaks when you have more projects coming on and dips in that, and we really haven't tried to get into year by year kind of outlook on that."
},
{
"speaker": "Nicki Decker - Bear Stearns",
"text": "Thanks, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Yes. Well, I guess the bulk -- from what I'm looking here, maybe the bulk of that Nigerian piece is associated with declines. And I just don't have any specifics on the outages at this point."
},
{
"speaker": "Nicki Decker - Bear Stearns",
"text": "Okay. Great. Thank you."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Paul Cheng from Lehman Brothers. Please go ahead."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Hi, good morning. Henry, on the -- if we are looking at over the next four months if I look at, say, from a collective basis for the quarter is going to reach the payoff period, what may be a job in your production related debt?"
},
{
"speaker": "Henry Hubble",
"text": "And you're talking about Angola or --?"
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "No, I mean on your global portfolio. I mean, you must have some project that you are bringing on a lot of project over the last three years with the high prices. I presume that some of them over the next 12 months will reach the payoff period and it's such that your report production will see a reduction. Any kind of --?"
},
{
"speaker": "Henry Hubble",
"text": "Yes, I --"
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "-- rough number you can share that the impact may be for next year, for 2007?"
},
{
"speaker": "Henry Hubble",
"text": "Right. No. I don't have -- we'll talk about our production profile, which we'll take into those -- into account those kinds of effects when -- as we are doing that forward projection. But again, it's going to depend on the price. It depends on specific contracts. There are a lot of individual production and they're -- depending on when they started up and the time frame that they have been running, how they have been performing, all of those things will impact that, and it will be incorporated into that forward projection, but I don't have anything that I can give you in terms of a forward, forward look on that."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Okay. If I could, I want to sneak in two more questions in here."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "One, if you can give us an update where is the [Kitachee] project for you? I mean with the rapid rise in the cost, is the project still a go or that you guys having some second thought? And also I think during the -- your recovery (inaudible), you had indicate some of the foreign exchange gain or loss, I think in both chemical and the O&M, I don't know whether you have that in the upstream, if you can break it down for us versus the third quarter, what is the impact?"
},
{
"speaker": "Henry Hubble",
"text": "Yes, I sure can. If you look at the BorEx effects in the third -- versus the third quarter, they were almost nothing. I think for the total corporation, it was under $30 million. So there's nothing in there on BorEx in the sequential comparison. Back on the Qatar question with the GTL project, I mean the technical work continues there. There are cost pressures, no question about that. We are working very hard on the concept of development with the Qatarries and what we have found in all of these projects is the real focus -- you have to get that development concept right or you lose it. And so that -- we're spending the time to get that concept right, and so when we're ready to go forward from there, we will let you know, but we are still optimistic about it. We are working on that development concept."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "So I assume that I think initially, there were some expectations by 2011, 2012. That time frame probably is too aggressive?"
},
{
"speaker": "Henry Hubble",
"text": "We will be updating whatever on those kind of things at the analyst meeting."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Okay. Thank you."
},
{
"speaker": "Henry Hubble",
"text": "Right."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Dan Barcelo from Banc of America. Please go ahead."
},
{
"speaker": "Dan Barcelo - Banc of America",
"text": "Hi, good morning. Regarding the downstream, it seems a lot of your competitors are really looking to sell a lot more refining assets. In particular, these values seem to be a little bit below replacement costs, especially when you compare it to Middle Eastern type new building costs."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Dan Barcelo - Banc of America",
"text": "I don't know if you could just comment rather broadly on Exxon's view of, in particular, downstream, in particular in terms of divestments or additions."
},
{
"speaker": "Henry Hubble",
"text": "Yes. I mean, we're not going to -- I'm not going to speculate on specific divestments. We are always looking at our portfolio. So -- and looking at what is -- why there's more value to somebody else than there is to us, and we'll market things, and you did see us -- I mean we sold our -- our Englestock refinery. So -- but I would tell you that overall, when we look at the refining business, we feel very good about the refining business. We work hard on integration with our chemicals business and because we have those integrated operations with chemicals, with our lubes businesses, it makes them more resilient. The other things, the technologies that we employ in molecule management and other techniques that we have and improving reliability, operations, integrity, we've had very good returns in this business and what we do is -- every one of our refineries has a forward looking plan, a five-year plan, and they are basically planning to stay ahead of whatever that long-term margin trend is, which you have heard us talk about before. If you look at the long-term trend, it is down. We make sure we are staying ahead of that curve. So we feel good about the assets that we have there, but I don't rule out that there might be specific pieces that will be more valuable to somebody else than us, and we'll let you know if those things occur."
},
{
"speaker": "Dan Barcelo - Banc of America",
"text": "Perfect. Thanks very much."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Paul Sankey from Deutsche Bank. Please go ahead."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Hi, Henry. Forgive me if you have answered this question. I know the word capital is being bandied about but my understanding is that you've got some issues there with the LNG trains. Could you just fill us in? I think they are shut down as far as I understand it or at least some of them. Could you just fill us in on the latest news there?"
},
{
"speaker": "Henry Hubble",
"text": "Yes. Well, what you were hearing about, we had some hydrate problems in the pipelines coming in. And basically, those facilities are essentially back up at this point. But it did impact us during the month of January. And what happened, we saw some rising pressure. Our monitoring equipment caught it. So we saw the pressure drop, increasing there, and then basically we are going through a process of clearing that out, which takes a little bit of time. So there was some -- we work with customers because there were some customers we had to restrict volumes on. And they are basically back up now."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Okay. So the story was -- I think it was Train 4 -- was it 3, 4, and 5 were down, but basically what you are saying is they were only out for, what, I guess a matter of three weeks, two-three weeks?"
},
{
"speaker": "Henry Hubble",
"text": "Yes, and the impact varies -- it's not -- basically, it makes sure that we're cleaning the lines up and so you ended up with less than full impact as you went through this time frame. And then, of course, we are going through a very thorough investigation to understand what variables changed and what caused the problems that we had there so that it won't happen again."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Right. And for my second question, I'm going to ask you a double question as part of it. Firstly, could you just comment on what your turnaround schedule or downtime will look like in terms of turning around refineries, if there's anything unusual in the US and internationally this quarter and this year? And a follow-on is that it is notable, following up on Doug's question, that volumes are down if we look at the whole year of '06 from '05. Was that disposals or was it -- was there some other reason why your sales of product, petroleum products was quite sharply down compared to global demand? Thanks."
},
{
"speaker": "Henry Hubble",
"text": "Yes, okay. First off, I mean, just looking at the turnaround schedule, this year was a little bit heavier than typical and we are seeing it being similar next year, so in the same kind of -- in the same kind of range. And that is the primary impact on volumes. The other, again, is divestments, and there's hydrating in our portfolio. It's lower refinery throughputs and then you see that roll through in things like fuel oil sales. You'll see some in the specialty product sales because we had more pull to chemicals and of course, Englestock came out of that -- those numbers as well. So those are -- those were the big impacts."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Right. And if we look at -- if you look at what the real oil market is doing, I guess it was up by what percent in '06 would you say on your numbers, and what do you expect in '07 and I will leave it there?"
},
{
"speaker": "Henry Hubble",
"text": "In terms of overall liquid demand?"
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Yes."
},
{
"speaker": "Henry Hubble",
"text": "Yes, I mean and that's probably the best way to look at it. We do the global balances and what are projected in our original projections would have been higher than how it's turned out this year. And we'd see overall demand worldwide somewhere in the million barrel a day increase, something maybe a little less than that when you took a total global balance. And that really reflects -- when we start looking behind it as to what impacted that, we think weather was a significant factor in there. If you look at the demands in the first quarter of last -- '06 and fourth quarter of '06, also if you look at some of the -- just the pricing between fuel oil and natural gas, there was fuel switching that was going on. So we think those were some of the things that were driving demands a little bit more than overall economics because when we look at the comparisons of -- for the long haul, it really correlates best with economic growth and we really haven't seen any slowdowns in economic growth and that's really what drives it overall in the longer term."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Thanks, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "And we'll take our next question come from Mark Gilman from The Benchmark Company. Please go ahead."
},
{
"speaker": "Mark Gilman - The Benchmark Company",
"text": "Henry, good morning. I had two questions. First one relates to Nigeria. It is my understanding that you have opted not to proceed with a grassroots LNG project in Nigeria and I was wondering if you could confirm that and discuss briefly the reasons for that decision. My second question relates to tax rate. If I quickly to through the arithmetic and make the adjustment for the special item, the tax rate gets up to about 39% effective basis for the quarter if I'm doing the math right. Given business mix and things of that sort, where we were in this regard in the first three quarters of '06, a rate in the 42% to 44% range would have seemed to have been where it should have been. I wonder if you comment on, perhaps, some of the factors that are responsible for that difference, and whether they are sustainable going forward."
},
{
"speaker": "Henry Hubble",
"text": "Yes, right. Well, if you look at the first stuff on the Nigerian LNG project. I mean it's really premature for me to comment on that. We're still in the working phase on that to look at that project so there hasn't been any final decisions made one way or the other there. When you look at the tax impact, the special item was one piece that impacted our overall tax in the period but then as I mentioned also, there were some other items in our corp. and fin that increased -- that were positive to earnings. Those were -- and the reason -- the one was broken out as a special because it was large and it was non-recurring so it was identified as a special. The others -- we have always seen a certain number of tax effects, as you know, just because of the size of the Company, all the different jurisdictions we are involved in, but in the period, there were a number of return finalizations that occurred that basically went all in the same direction so it was a combination of those impacts that ended up. If you look at our longer term projection on tax, we would still guide in the 40%, 45% range and probably toward the higher end of that so typical of what we saw earlier in the year is, I think, the best way to look at it."
},
{
"speaker": "Mark Gilman - The Benchmark Company",
"text": "Thanks, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Mark Flannery from Credit Suisse. Please, go ahead, sir."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Hi, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Hi, Mark."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Could you comment a little bit on what is going on in Asian R&M? We have seen some fairly weak numbers out of the Japanese market recently. You have a big business there. I'm just wondering how weak was that in the fourth quarter and is there any sign that margins or earnings or sales are going to get a bit better up there?"
},
{
"speaker": "Henry Hubble",
"text": "Yes, if you look at the margins in refining, out in the Asia Pacific, they were off. It got pretty weak during the fourth quarter of '06, actually, ex-Japan. It was outside of Japan. Japan had actually strengthened some in the period. And then if you look at -- on the marketing side, it varies but basically we were up. The marketing margins were up in Asia Pacific and Japan, comparing the -- if you go fourth quarter versus fourth quarter. So, most the negative impact on marketing margins or refining margins were US and Europe in those periods -- in the comparative period."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "And what about sales volumes, specifically in Japan I'm thinking. Are you seeing any weakness there or --?"
},
{
"speaker": "Henry Hubble",
"text": "Well, I don't know if I've got a breakdown on Japanese demand."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Maybe you can talk about Asia in general, maybe."
},
{
"speaker": "Henry Hubble",
"text": "Yes. If I look at Asia Pacific, it was down about -- quarter-on-quarter, it was down about 5%, and that really -- it was essentially mostly associated with lower runs and then we see the continuing growth in our chemicals business. We did have more transfers to chemicals so that's the other thing that goes on that's impacted some of those sales. It was basically a positive story there. And those were the bigger impacts."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Okay. Thanks a lot."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Neil McMahon from Sanford Bernstein. Please go ahead."
},
{
"speaker": "Oxy Oswald Clint - Sanford Bernstein",
"text": "Hi, good morning. Hi, it's Oxy Oswald Clint here on behalf of Neil who is at the Shell presentation. Just two questions --"
},
{
"speaker": "Henry Hubble",
"text": "Okay."
},
{
"speaker": "Oxy Oswald Clint - Sanford Bernstein",
"text": "Could you give us an update, please, on your decline rifts across the portfolio in 2006 versus 2005? And secondly, you mentioned Dalia in your press update this morning. Can you confirm any spending or the rumors that it's actually progressing well ahead of expectations?"
},
{
"speaker": "Henry Hubble",
"text": "Yes. I mean, as far as I know, Dalia is coming up and ramping up. We're expecting to get up to full rates by the end of the -- I think it's the first quarter, targeted at 225. So I mean, it's come on well, but it's probably better to focus that back at the operator. And then if you look at our declines, there really aren't any big surprises there. We look at the year -- obviously we monitor this very closely, field by field. You do have more decline in the maturer markets but if you look at our overall target, or guidance that we have had, we have said 4% to 6%, closer to the higher end of that range, and we have seen nothing that's really taken us out of there, nothing unusual in that at all."
},
{
"speaker": "Oxy Oswald Clint - Sanford Bernstein",
"text": "Okay. That's great. Thank you."
},
{
"speaker": "Henry Hubble",
"text": "Yes"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] We'll take our next question from John Herrlin from Merrill Lynch. Please go ahead, sir."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Yes, hi. Henry, I know that later on this month, you are going to announce your reserve additions."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "But given Aira, Kizomba, Qatar, Obrizagam, would it be fair to say that your production replacement for 2006 would be better than 2005?"
},
{
"speaker": "Henry Hubble",
"text": "I'm not really not going to get -- we'll have it out here shortly. The thing that you have to remember in all of these things, though, is the timing of when a project comes on and when it's funded. That's -- mostly it's decisions and recognition of reserves or actually when you have a full funding decision and you are proceeding forward. So there's often a skewing between when something is funded and when it comes online that those reserves are often recognized at different periods. But we'll update you here shortly."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "I thought it was worth a shot. Thanks anyway."
},
{
"speaker": "Henry Hubble",
"text": "Yes, okay."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Next question is on Venezuela. Even though it's not a large part of your business, lots of headline risks these days. Have you heard from them? When will you hear from them or how are things going there?"
},
{
"speaker": "Henry Hubble",
"text": "Well, it's -- I mean, the discussions continue. We don't really have anything new to report there. Our affiliate has been informed that they would like to migrate to mixed enterprise, and basically the ball is a bit in Venezuela's court right now. So we'll see. We'd like to get an amicable resolution, obviously. We are looking to maintain the shareholder value from the projects that we invested in there and so hopefully we can work out something that will allow us to do all of that."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Great. Last one from me. US production decline rates, just normal field declines?"
},
{
"speaker": "Henry Hubble",
"text": "Yes. There was a little bit in there associated with Prudhoe Bay loadings that impacted in the period, but that's the biggest thing."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Thanks, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] We'll take our next question from Mark Gilman from The Benchmark Company. Please go ahead."
},
{
"speaker": "Mark Gilman - The Benchmark Company",
"text": "Henry, I guess I get a second shot! My two this time. There was reference to a large pension contribution --"
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Mark Gilman - The Benchmark Company",
"text": "-- in your comments and I'm wondering whether we should expect a similar level contribution for this year."
},
{
"speaker": "Henry Hubble",
"text": "No. I wouldn't -- we evaluate these things on an ongoing basis. I can't really tell you yes or no on that. We constantly are looking at that and deciding when it makes sense to. We saw an opportunity here and -- for funding that we went ahead and exercised this year but I wouldn't read anything into that on a forward basis."
},
{
"speaker": "Mark Gilman - The Benchmark Company",
"text": "Okay, and secondly, can you give us in absolute terms the price finalization impacts on the refining area split US and foreign in the fourth quarter?"
},
{
"speaker": "Henry Hubble",
"text": "Yes, if you look on an absolute basis for price finalization, it was a total of $120 million positive, $60 of that -- 50/50 split, $60 US, $60 non-US."
},
{
"speaker": "Mark Gilman - The Benchmark Company",
"text": "Thank you, Henry."
},
{
"speaker": "Operator",
"text": "This will conclude today's question-and-answer session. I would like to turn the conference back over to Mr. Hubble for any additional or closing remarks."
},
{
"speaker": "Henry Hubble",
"text": "I would just like to thank everybody for your time and questions this morning. We certainly look forward to sharing more details on our record 2006 performance and forward business plans at the analysts meeting in March. Hope to see you there. Thanks."
},
{
"speaker": "Operator",
"text": "Once again, ladies and gentlemen, this will conclude today's conference. We thank you for your participation. You may now disconnect."
},
{
"speaker": "TRANSCRIPT SPONSOR",
"text": ""
}
] | null | null |
XOM | 3 | 2,006 | 2006-10-26 11:00:00 | Executives: Henry Hubble - Vice President of Investor Relations
Analysts: Doug Terreson - Morgan Stanley Mark Flannery - Credit Suisse Jennifer Rowland - JP Morgan Paul Sankey - Deutsche Bank Doug Leggate – Citigroup Neil McMahon – Bernstein Nikki Decker - Bear Stearns John Herrlin - Merrill Lynch Paul Cheng - Lehman Brothers Mark Gilman - Benchmark Company Daniel Barcelo - Banc of America Securities Paul Sankey - Deutsche Bank
Operator: Good day and welcome to the ExxonMobile Corporation Third Quarter 2006 Earnings Conference Call. Today's call is being recorded. At this time for opening remarks I would like to turn the call over to the Vice President of Investor Relations and Secretary, Mr. Henry Hubble. Please go ahead, sir.
Henry Hubble - Vice President of Investor Relations: Thank you. Good morning and welcome to ExxonMobile's teleconference and Webcast on our third quarter 2006 financial and operating results. As you are aware from this mornings press release, we had another strong quarter as our long standing commitments to the integrity of our operations, disciplined investment approach, and our integrated business model continued to position the Company to benefit from robust industry conditions. At this time I'd like to draw your attention to our cautionary statement. Please note the estimates, plans, and projections are forward-looking statements. Actual results including resource recoveries, volume growth, and project plans and outcomes could differ materially due to factors I'll discuss and factors noted in our SEC files. Please see factors affecting future results and the Form 8-K we furnished this morning which are available through the investor information section of our website. Please also see the frequently used terms. The supplement to this morning’s 8-K and the 2005 financial and operating review on our website. This material defines certain financial and operating terms I'll use today, shows ExxonMobile's net interest in specific projects, and includes information required by SEC Regulation G. Now I'm pleased to turn your attention to the specific results. ExxonMobile's third quarter net income and normalized earnings were $10.5 billion, or $1.77 per share. This was a record quarter for normalized earnings, and represents an increase of $2.2 billion over the third quarter 2005 on the same basis. Normalized earnings per share increased by 34% over the third quarter last year reflecting the strong earnings performance and also the benefits of the share repurchase program. Before I discuss the specific business results, I'd like to highlight some of the significant milestones we achieved since our last earnings call. Many of which are helping to bring new supply to the market. In the upstream we commissioned the export system and completed loading of first oil from the multi phase Sakhalin-1 project at the newly constructed De-Kastri terminal. Oil production should ramp up to an estimated peek rate of approximately 250,000 barrels a day around the end of the year following line out of the onshore processing facility and additional well tie-ins. We continue to be pleased with the phase one project performance and are pursuing future phases. In another recent milestone, we started production at Erha North, a deepwater development located offshore Nigeria. This is a satellite to the Erha development which came online earlier this year. Erha North started production within 30 months of discovery, setting a Nigeria deepwater record. Both Erha and Erha North facilities were constructed within budget and further demonstrate ExxonMobile's operational excellence, project execution, and deepwater expertise. Current production from the combined facilities is above expectations at 220,000 barrels a day. Also during this quarter, Golden Pass LNG LLC awarded a contract to begin engineering procurement and construction of the facilities near Sabine Pass, Texas. These facilities have capacity to process 15.6 million tons per year of LNG and are part of the multibillion dollar supply chain necessary to deliver LNG from Qatar to the United States. It's expected that the Ras Laffan 3 and Qatargas III projects which will produce and process natural gas from Qatar's offshore North field will provide the primary supply for the terminal. Construction of the Golden Pass terminal is another important step in supplying natural gas to customers along the Gulf Coast and other U.S. Markets. During the quarter, drilling began in one of our Orphan basin exploration blocks. The well is located about 250 miles off the coast of St. John's new found land in 8,000 feet of water. This is the first well to be drilled in the basin and carries significant risk and reward potential. Operations are expected to carry through until year-end. In the downstream, we successfully completed the transition of our facilities to meet new, U.S, Ultra low sulfur diesel requirement which reduce on road diesel sulfur by 97%. In addition to near term benefits, this ultra low sulfur fuel allows for the use of advanced emissions reduction technologies, which will lead to a significant reduction in diesel vehicle emissions as the fleet turns over. ExxonMobile's worldwide effort to reduce sulfur content of diesel and gasoline fuels represents a total investment of $3.5 billion and is an important part of our continuing efforts to reduce vehicle emissions. We were pleased to announce in August that our high performing synthetic oil, Mobil 1, was elected as the factory and service fuel motor oil for the new 2007 Acura RDX Luxury SUV. Mobil 1 received the highest rating of all oils tested, including other synthetics, and was selected on it's ability to meet the demands of a high performance turbo charge engine. Mobil 1 continues to lead the industry with over 30 automotive manufacture endorsements. Our advanced technology allows us to consistently meet customer requirements for high quality products and provides a competitive advantage. In keeping with our process of continuously and rigorously assessing our global portfolio of businesses, we recently announced the sale of a number of our fuels and lubes business in Africa. These transactions include a network of about 300 service stations and the associated supply and distribution facilities. These transactions are subject to the approval of relevant authorities in multiple countries, therefore completion time will vary from one country to another. I'd now like to comment on two significant chemical milestones. Earlier this month, we announced the signing of a heads of agreement with Qatar Petroleum to progress feasibility studies for a proposed $3 billion world scale petrochemical complex in Ras Laffan industrial city. The project would use feedstock from gas development projects in Qatar's North field and utilize ExxonMobile proprietary steam cracking furnace and polyethylene technologies to create premier products for customers in Asia and Europe. The successful partnership between ExxonMobile and Qatar Petroleum continues with this proposed project as we further expand the use of North field gas. Start up of the proposed petrochemical complex is estimated in 2012. In September, we announced plans to build a new chemical facility at our Baton Rouge, Louisiana complex, to produce specialty compounded products. This plant will be able to produce a broad spectrum of commercial compounded products, including ExxonMobile chemicals, performance polyolefin grades, Santoprene thermoplastic elastomers and other specialty elastomers. The new facility is expected to start up in mid 2007 and is part of a Company's global strategy and commitment to provide engineered thermoplastic materials to the automotive and consumer products industries. Turning now to the business line results. I'd ask you to also please refer to the earnings reconciliation in the IR supplement. Upstream normalized earnings in the third quarter were $6.5 billion. This represents an increase of about $760 million versus the third quarter of 2005. Upstream earnings per barrel were also strong at $17.61 per barrel. Higher realizations and volumes accounted for the increase in earnings from the third quarter of 2005. Net other items were essentially unchanged. Worldwide crude sales realizations were $65.14 per barrel, up $7.12 from the third quarter of 2005. Worldwide natural gas realizations were also improved. Oil equivalent volumes increased 7% with increases in Africa and the Middle East more than offsetting natural field declines in North America and Europe. Excluding the impact of divestments and entitlement effects, production increased by about 10%. Liquids production increased nearly 200,000 barrels per day or 8% versus the same quarter last year. Excluding the impact of divestments and entitlement effects, liquids production increased by 12%. The Erha, Bonga, East Area and Kizomba B start ups as well as the addition of Upper Zakum were the bigger sources of the additional liquids volumes. Gas volumes increased by approximately 450 million cubic feet per day or about 6% versus the third quarter of 2005. Higher production from the 2005 start ups of Ross Gas Train 4 and Al Khaleej in Qatar and the absence of 2005 hurricane impacts was partly offset by natural field decline in North America and Europe. Turning to the sequential comparison, upstream earnings decreased by about $640 million versus the second quarter of 2006. Lower realizations, normal seasonal declines in natural gas sales, lower asset sales, and negative tax effects were the primary reasons for the decrease. Liquids production was down 2% from the second quarter of 2006, including the impact of unplanned down time at Prudhoe Bay. Natural gas production was down about 7% due to normal seasonal declines in Europe. For further data on regional volumes, please refer to the press release and IR supplement. Now, turning to the downstream. Third Quarter downstream normalized earnings were a record $2.7 billion, up $610 million over the third quarter of 2005. The increase was driven by stronger marketing margins, partially offset by lower refining margins. The volume mix effect was a negative 240 million primarily due to higher refinery turnaround and maintenance activity partially offset by the absence of hurricane impacts. Other factors, increased earnings by $140 million primarily due to positive tax effects. Sequentially, downstream earnings increased by approximately $250 million with increased refinery throughput and other effects more than offsetting lower refinery margins. In total, margin impacts reduced earnings by $240 million compared to the second quarter. Refining margins were lower by $800 million; however this impact was largely offset by improved marketing margins. Volume mix effects were positive $210 million due to lower refining turnaround activity. Other factors improved earnings by $285 million with lower operating costs consistent with the reduction in refining turnaround activity combined with positive tax effects. Turning now to the chemical results. Third quarter normalized earnings were $1.35 billion, up $880 million versus the third quarter of 2005. Strong margins across all major business lines improved earnings by $820 million with higher realizations, out pacing increased feedstock cost. Volumes were slightly lower reflecting short-term demand effects. Year-to-date volumes are essentially flat with 2005. Earnings also benefited from positive tax effects. Sequentially, chemical earnings increased by about $510 million driven by higher margins. The impact of slightly reduced volumes following a robust second quarter was partially offset by lower operating costs. We continue to see strengthen our chemical business, as our diverse portfolio, broad geographic coverage, and integration capabilities result in strong competitive advantage and industry leading performance. Turning now to the corporate and financing segment. Corporate and financing expenses of about $100 million were up from the third quarter of 2005, primarily due to tax impacts partially offset by higher interest income. The effective tax rate for the third quarter was 44%. Our cash balance was $37 billion and debt was $8.6 billion at the end of the third quarter. The corporation distributed a total of $8.9 billion to shareholders in the third quarter through dividends and share repurchases to reduce shares outstanding, an increase of 30% or $2.1 billion versus the third quarter of 2005. During the third quarter, ExxonMobile purchased $7 billion of shares in excess of dilution. There by reducing the number of shares outstanding by 1.9%. Since the beginning of 2005 our quarterly share repurchase program has increased almost threefold which further demonstrates our ongoing commitment to return cash to shareholders. CapEx in the third quarter was $5.1 billion up almost $650 million from the third quarter of 2005, primarily due to planned upstream activity. Our year-to-date CapEx was $14.8 billion, approximately $2.4 billion higher than through the third quarter of 2005. Our full year outlook for CapEx remains unchanged at approximately $28 billion. That concludes my prepared remarks and I'd now be happy to take your questions.
Operator: Thank you, Mr. Hubble. [Operator Instructions] And we'll take our first question from Doug Terreson of Morgan Stanley.
Doug Terreson - Morgan Stanley: Good morning and congratulations on your results.
Henry Hubble: Thanks, Doug.
Doug Terreson - Morgan Stanley: In the downstream, both refinery throughput and petroleum product sales seem to be flat or down in relation to the year ago period both for Q3 and the first nine months of the year, and on this point I wanted to see if there were a few specific factors that helped to explain these trends and if not, any additional color on the turnaround and maintenance items that you highlighted would be appreciated.
Henry Hubble: Yeah. I mean, if you look at just the overall volumes, the throughput in the period, we were down from -- let me just pull the number here -- yeah, we were essentially flat across the period, and then what you saw in the volume effect that's there, basically that's turnarounds and that's essentially a mix of turnarounds because what you see in the throughput numbers is basically a distillation, we were tracking distillation there. And that was primarily crude, well or crude is down in the third quarter of last year and what you're seeing now in the relative comparison is more upgrading units.
Doug Terreson - Morgan Stanley: Okay.
Henry Hubble: So that was impact there.
Doug Terreson - Morgan Stanley: Okay that makes sense, and also, in the upstream in Alaska and Indonesia on Point Thompson and Natuna, there have been a decent amount of commentary in the press regarding possible changes in your position in those areas, and so I wanted to see if there was an update on the status of those two developments?
Henry Hubble: Well, if you look at Cepu, we continue to work with, work on basically with the government there to look to accelerate the project, and so we're continuing to work with them on the development plan there, and then if you look at Natuna, we're committed to develop Natuna. Obviously, it's a challenging resource.
Doug Terreson - Morgan Stanley: Sure.
Henry Hubble: Very high CO2 contents there, but you have been hearing a lot in the press, and all I would say is we're working to meet all of our obligations and we assume and expect that the government will be doing the same thing, and frankly, we're engaged in a discussion with the government right now to resolve those issues around the PSA.
Doug Terreson - Morgan Stanley: Great. Thanks a lot.
Operator: Thank you. We'll go next to Mark Flannery of Credit Suisse.
Mark Flannery - Credit Suisse: Yeah, hi, Henry. I have a question on drilling rig coverage.
Henry Hubble: Yes.
Mark Flannery - Credit Suisse: We've been picking up some news in the last few days that you guys have been involved and in fact have chartered the West Polaris drilling rig for delivery in the second quarter 2008. I wondered, does this represent anything of a change in your approach to rig coverage? I noticed McGill earlier this year was talking about how you were happy to be at a relatively low level of offshore rig coverage for ‘08 and ‘09. Are you changing your mind on this?
Henry Hubble: No. We continue to, we have a mix of coverage that we line up. There's really no change in our views in the rig situation, but as we move forward, we're going to continue to cover a specific requirements. We've got adequate coverage on our projects and basically, we've got rigs for the firm prospects that we have.
Mark Flannery - Credit Suisse: And could you maybe give us an idea of what kind of percentage coverage you have in ‘08 and ‘09 already for just for offshore rigs?
Henry Hubble: No. That gets into a little more competitive information than I want to get out here.
Mark Flannery - Credit Suisse: Okay. Thank you.
Henry Hubble: Yup.
Operator: Thank you. We'll go next to Jennifer Rowland of JP Morgan.
Jennifer Rowland - JP Morgan: Thanks. I was wondering if you could break out a little bit the refining versus the marketing on a sequential and also year-over-year basis?
Henry Hubble: Yeah. If you look at the big effects there were in margins in the sequential and the year-over-year, and if you look at -- first the sequential numbers, refining margins were down about $800 million and the marketing margins partially offset that to bring us to the 240, and what that reflects, you saw a big impact on refining margins in the period or the period comparison basically as inventories built and there was softness in those refining margins and that sequential comparison. Then if you look at the year-on-year, there was some, there we saw even larger impact or increase on the marketing margins so it was almost, in fact it was all of that increase that we saw, and there, you have again when you comparing the last quarter, we had the hurricane impacts in that period, so you saw actually decrease in the marketing margins during that timeframe and in this period with some of the lag effects that we see as crude prices and commodity prices drop, we had higher margins in this period.
Jennifer Rowland - JP Morgan: Okay, and then you mentioned there was some tax effects in both --
Henry Hubble: Yeah.
Jennifer Rowland - JP Morgan: Upstream and downstream on a sequential basis. Can you just break that out from the other bar?
Henry Hubble: Yeah. Let me just step back for just a little bit more on the margins because I'll mention, in the refining side, part of the reason we didn't see as much downturn in the third quarter margins on refining is also related to our integration with lubes. We have a lot of lubes refining capacity and that actually was positive year-on-year, so it was, so that was something else that helped improve our results there, and then on the tax side, there really, if you look at that other column, there really isn't a significant story there. There's a lot of minor changes up and down, but the ones I mentioned were the biggest effects and they are basically non-U.S. Tax items like Europe and Asia Pacific.
Jennifer Rowland - JP Morgan: Okay, great. Thank you.
Henry Hubble: Yup.
Operator: Thank you. We'll go next to Paul Sankey of Deutsche Bank.
Paul Sankey - Deutsche Bank: Hi, Henry.
Henry Hubble: Hi, Paul.
Paul Sankey - Deutsche Bank: If we could continue on the same theme, Henry, firstly on the downstream, the 800 down in refining margin and the 600 up in marketing, could you break that out regionally or at least between the U.S. and non-U.S?
Henry Hubble: Yeah. If you look at the refining margins in the U.S, They were down about 500 million overseas about 300.
Paul Sankey - Deutsche Bank: Great. That answers it. On the volume side if we revert to that now, those look a bit weak but you referenced I think some seasonal impacts on the chemical side. If I could slightly switch to my downstream chemicals but also in the oil markets you said that -- I think the disposals were a key reason for weakness in volumes on that?
Henry Hubble: Well, on the marketing margins, yeah. And we had divestments there that were the biggest impact on our product, our drop off in product sales --
Paul Sankey - Deutsche Bank: Do you have a number on that, Henry? And where? It wasn't U.S. I guess, was it?
Henry Hubble: Yeah. Let me, well the biggest, we have U.S, we continue to high grade the network there and of course we have the Africa piece, but that's going on around the circuit, you've got some in Africa, you’ve got some in Europe so we're high grading around in our network continually.
Paul Sankey - Deutsche Bank: You've broken out what your volumes would have been upstream if it hadn't been for disposal. Could you give us a guess of how good volumes or what kind of demand strength you would have seen had it not been for the sales you had done in the petroleum product side?
Henry Hubble: Yeah. You would have been up a percent or so.
Paul Sankey - Deutsche Bank: Okay, great. And on the chemical side, I think you said was it seasonal effects?
Henry Hubble: Yeah, well, on the chemical side, you have some of these what we almost call mini cycles in the chemicals business and it has a lot to do, the volumes that you see there have a lot to do with peoples expectation on where prices are going, so what you see is when prices, the feedstock prices start dropping rapidly, people will V-stock and slowdown their purchases waiting for that to be reflected into product prices, and so you'll see that whenever you have a big change in the commodity price.
Paul Sankey - Deutsche Bank: Okay, great. And if I could have one more, please, on taxes, you had, sorry, upstream taxes, you had said last quarter that the North Sea impact would be around $0.01 to $0.02 I believe?
Henry Hubble: That's right.
Paul Sankey - Deutsche Bank: And is that, I mean does that actually happened dare I ask and secondly could you quantify Alaska and any other impacts globally on the upstream side that might be within these numbers?
Henry Hubble: Well you’ve got the big ones. Those were the big impacts and the UK increase, it came in about where we thought it would, about in the middle of that range, so and then Alaska was a bit less than that.
Paul Sankey - Deutsche Bank: Okay. Henry, I'll leave it there. Thank you.
Henry Hubble: Very good.
Operator: Thank you. We'll go next to Doug Leggate of Citigroup.
Doug Leggate – Citigroup: Thank you, good morning Henry. I guess this is going to be something of a theme. The tax situation, if you look at your tax rate, it looked to be a little low or something, lower than recent quarters. Was that just the mix effect because of the heavier downstream contribution?
Henry Hubble: Well, the tax rate actually was about flat. I mean it was 44%, I think it was the same thing versus second quarter and actually up some versus last year.
Doug Leggate – Citigroup: Yeah, I'm talking sequentially.
Henry Hubble: Yeah, so it was flat. It was basically flat.
Doug Leggate – Citigroup: I guess -- my question is that some of your competitors only reported included some data charges for the first half of the year both UK, Alaska and one or two other things. Are you able to quantify if you did the same thing and to what extent it was?
Henry Hubble: Well, I mean, we report the effects, and these are net effects that we're reporting here, so in the UK, that's a net effect, and it's complex and I can't really get into all of the forward and backward pieces on it but they are net effects.
Doug Leggate – Citigroup: Okay and my second question is really just on production. There's actually two parts of this if you don't mind both very simple I'm afraid.
Henry Hubble: Yeah.
Doug Leggate – Citigroup: In terms of the pricing effects I just wanted to make sure my understanding is right on this. The average oil price in Q3 last year was about $7 below what it was this year.
Henry Hubble: Yes.
Doug Leggate – Citigroup: So are you saying if we hit the (inaudible) for $63 level for talking sake that your volumes would go up by around 3%?
Henry Hubble: Well, no. I mean, what we have said when we've looked at the entitlement effects has been more like a 1% kind of a number.
Doug Leggate – Citigroup: That balances disposals?
Henry Hubble: Yeah, and then you look there's disposals in there but if you look at the overall volume, volume impacts, it's about the balance was entitlements, almost 2% there.
Doug Leggate – Citigroup: Okay and I guess the second part very simply to that question is obviously OPEC cuts, have you seen anything in terms of requests and so on just in your business?
Henry Hubble: Yeah. I mean, the OPEC effects for us will be small. Now, we do see, we do see on a production side, but you do see things in supply as crude is being cut back, we are seeing changes in mix, generally comes out of heavy grades and so we see some of that.
Doug Leggate – Citigroup: Okay, that's great. Thank you.
Operator: Thank you. We'll go next to Neil McMahon of Bernstein.
Neil McMahon – Bernstein: Two questions. One is when you look at the sort of basic data you've given us for cash flow and your earnings press release, you've got $800 million for sales of subsidiaries investments and plant property and equipment. I wonder if you could break that down into how much of that was actual divestments and where they were in terms of upstream, downstream chemicals, other?
Henry Hubble: Yeah. I mean the biggest piece was Carson Creek, you know, we did have some upstream sales but we’re really -- I can't get into the break down of each of these things. I can tell you though, if you look at the quarter-on-quarter comparison though and for the upstream earnings, I mean, they netted out. We didn't really have any other effects and that was basically the impacts that I described on the tax side with UK and Alaska tax offsetting some higher asset sales in the biggest piece of that was Carson Creek.
Neil McMahon – Bernstein: But you would say that $800 million in your cash flow statement would be divestments?
Henry Hubble: Different divestments, yes. I mean, it's upstream and downstream mix.
Neil McMahon – Bernstein: Great. Just a second question on U.S. gas, you had a decline in volumes sequentially. Two parts: One, just wondering if that was due to divestments alone and secondly, are you seeing any changes in activity in the Piceance basin in terms of rig availability or indeed are you taking any actions yourself to change activities given where the natural gas price has been this year?
Henry Hubble: Yeah. As you're looking at the year-on-year gas production for the upstream?
Neil McMahon – Bernstein: I believe so.
Henry Hubble: Yeah, okay, so I mean one of the big impacts there is just the absence of the hurricanes, so that probably the biggest single impact to decrease that number and of course we're continuing to move Piceance forward and it's moving ahead according to plans there, but in terms of actual volume contribution at this point it's relatively small.
Neil McMahon – Bernstein: Okay, but you're not changing any of your activities going forward?
Henry Hubble: In terms of from a price outlook?
Neil McMahon – Bernstein: Yup.
Henry Hubble: No, our plans are based on long term outlooks and the competitiveness of the projects that we have and so it's not impacted by near term price.
Neil McMahon – Bernstein: Okay. Thanks.
Operator: Thank you. We'll go next to Nikki Decker of Bear Stearns.
Nikki Decker - Bear Stearns: Good morning, Henry.
Henry Hubble: Hi, Nikki.
Nikki Decker - Bear Stearns: Two questions on Saco if I could. First of all, I think you were due to start an inspection process by the natural resources ministry. Just wondering what we might expect and if there was anything potentially significant that could come out of that and secondly, we seen some press reports that you've reached a preliminary agreement on gas sales. Maybe you could comment on that.
Henry Hubble: Yeah, I guess first on the Saco in piece, the inspection hasn't started but there's been ongoing interactions with government officials all the way through this, so it's not like there's a lot of things, or still it's going to be more closing things out and we're not expecting any real issues and as you see, we started up the facilities and have made the first exports and in fact I think the next vessel is due to arrive either today or tomorrow. So, that continues to move ahead. And we're pleased with the progress.
Nikki Decker - Bear Stearns: And on gas sales agreement?
Henry Hubble: Yeah. Well, we basically signed an HOA with CNPC and that basically, you know, our intent is to work forward to an agreement there and there are also discussions as you might guess with gas prom about how to export that.
Nikki Decker - Bear Stearns: Okay, can you give us any color on the term size, anything?
Henry Hubble: No. We haven't -- all of that is to be defined yet in terms of the specific agreement.
Nikki Decker - Bear Stearns: Thank you, Henry.
Henry Hubble: Yup.
Operator: Thank you. We'll go next to John Herrlin of Merrill Lynch.
John Herrlin - Merrill Lynch: Yeah, hi Henry. Last quarter, Erha was running above boiler plate and now you put it in the satellite facility. Is this going to be constrained, is it going to be flowing at pretty high rates for a long time?
Henry Hubble: Well, as I said, it's up at the 220,000 barrels a day now and that's above what we were originally expecting, and so we'll see, but these do decline overtime and most of these fields have, they will maintain a peak for a certain period and then you'll see declines, but we feel real good about that project. It's done very, very well.
John Herrlin - Merrill Lynch: Understood. I was just trying to get a sense of how the satellite was.
Henry Hubble: I really can't give you anything right now. It's performing consistent and above our expectations.
John Herrlin - Merrill Lynch: Super. Next one for me with golden pass, when do you expect to receive LNG?
Henry Hubble: Well, in the completion date, I don't know if I have that right at my finger tips here. It's 2008.
John Herrlin - Merrill Lynch: Okay, and then lastly for me, with the Orphan basin you said you'll TD this one at the end of the year. Does that then mean a pause, should we expect an announcement, or what will you do?
Henry Hubble: Let me just back up on the completion of that looking around the 2009 is for the -- is when we'll have the first receipts there.
John Herrlin - Merrill Lynch: End of 2009 or middle?
Henry Hubble: No. I don't have anything more specific than that. And then Orphan, it's a tight hole so I don't have any data. I can share it's drilling and then obviously, it's one that's high risk and potentially high reward but we have a number of those kinds of prospects that we're working on.
John Herrlin - Merrill Lynch: Thanks, Henry.
Operator: Thank you. We'll go next to Paul Cheng of Lehman Brothers.
Paul Cheng - Lehman Brothers: Hi, Henry.
Henry Hubble: Hi, Paul. How are you?
Paul Cheng - Lehman Brothers: Very good. Sorry to have to bug you on this one. On the tax and office sales, let me try to understand a little bit better. In your supplemental presentation, you indicated that other sequentially that lead to 190 million lower earnings. If I recall correctly, in the second quarter, you have asset sales gain of about $340 million and the benefit from the Canadian tax law change of $200 million. So that's about $540 million and that the higher UK tax in Alaska based on what you just mentioned is roughly about 170 to 180 million, so that means that if this item, the $190 million lower earnings is assumed that mainly related to asset sales and tax changes, so does that mean that on the absolute dollar term, your third quarter, you have a benefit on those two items to the tune of about $5 to $600 million?
Henry Hubble: I'm not following. I think we're going to have to take that one off line because I'm not sure, I can't follow all of the numbers you were going through there, Paul.
Paul Cheng - Lehman Brothers: Okay.
Henry Hubble: I think we would be better off to take that offline.
Paul Cheng - Lehman Brothers: I will do so. Second question, wondering if you have been informed or by order by either your suppliers such as Saudi Arabia to have a lower location or that the shipment to you for November or by Nigeria that saying that you need to trim your production already?
Henry Hubble: Well, Saudi Arabia, that's a supply, my comments there were on a supply side and so and then for anything else, it's basically a dialogue with those countries on what they are going to actually do and that's ongoing, so there's nothing I have to report there at this point. Like I said on the supply side, we have contracts and they will ship the great mix and that kind of stuff.
Paul Cheng - Lehman Brothers: I understand, but Henry, I guess my question is that did they officially inform you guys of trimming your location?
Henry Hubble: Yeah. I mean, right now, there's plenty of crude supply out there. I'm not sure what you're going at in terms of we don't really have any, as I mentioned, there's no indication on limitation on the amount of oil. There's plenty of oil out there so we've got all of our, we're a big buyer of crude. We don't have any trouble covering that, and so – and then as I said before, in terms of our production side of it, it's very small, if anything.
Paul Cheng - Lehman Brothers: Okay. That's fine. Can I have just one final quick question? I think clearly, several weeks ago, the news come out saying that (inaudible) indicated that 2007 kept your spending would be roughly flat at $20 billion. Wondering if you can confirm whether he has said that or not.
Henry Hubble: Well, yeah. I mean and I think those are round figures and we'll be updating specifically the outlook at the Analyst meeting as we always do and you'll get more detail there, but I would take that as a round figure.
Paul Cheng - Lehman Brothers: Okay very good. Thank you.
Operator: Thank you. We'll go next to Mark Gilman with the Benchmark Company.
Mark Gilman - Benchmark Company: Hi, Henry, how are you?
Henry Hubble: Very good, Mark.
Mark Gilman - Benchmark Company: Two questions. Exploratory expenses are running considerably higher this year both in the quarter you reported today as well as the first half and I was wondering if you could shed a little light on the factors contributing to that and in particular, the extent to which it is an activity induced increase as opposed to any changes in success rates.
Henry Hubble: No. I mean, it does, we do have higher levels of activity and it reflects, but it does reflect and you'll see it as different prospects, there are some dry holes in here too because we do have activity in that but it also covers of course all of our seismic and other work that's in that category, and we did have well costs that are in there in this time frame.
Mark Gilman - Benchmark Company: Would you say activity increases is the primary driver?
Henry Hubble: No. I would say it's as much, I mean, it's activity on wells and then you have a certain number of them that are show up in those costs when they are non-economic, and so I guess when you say is it activity? Yeah, I mean, we do have higher activity on wells that are being drilled and some of those are showing up in this category.
Mark Gilman - Benchmark Company: Okay one other one if I could. In light of what you said about Erha and it's performance, the African liquids number in the third quarter was lower than the second. Could you perhaps shed a little light on that apparent discrepancy?
Henry Hubble: It's basically timing entitlements I guess is the biggest issue.
Mark Gilman - Benchmark Company: I'm not sure what you mean.
Henry Hubble: Well as prices rise, you have entitlement effects associated with that.
Mark Gilman - Benchmark Company: Price was flat, Henry, quarter to quarter.
Henry Hubble: Well, if I look at the Africa, that is the biggest impact is entitlement costs or entitlement effects.
Mark Gilman - Benchmark Company: Okay, thank you.
Operator: Thank you. We'll go now to Daniel Barcelo with Banc of America Securities.
Daniel Barcelo - Banc of America Securities: Hi, good morning. I wanted to know if you could just comment more conceptually about how Exxon views minority interest and certainly investments and in general, given some actions I guess with shell Canada in particular, how does Exxon view participation or ability to control capital spending or corporate government within some of it's subsidiaries there and if it has types of plans as well to look toward incorporating more of those minorities?
Henry Hubble: I'm sorry, I missed the front end of that?
Daniel Barcelo - Banc of America Securities: Regarding investments where you don't own 100% in your minority investments?
Henry Hubble: Yes.
Daniel Barcelo - Banc of America Securities: What is Exxon's strategy in order to essentially control say capital spending program, corporate governance --
Henry Hubble: Yeah, I mean, well, obviously, we're an active partner in anything where we're involved, and we go through in fact if you look at the upstream activities, we have a lot of ours are OBO arrangements there and of course we look at the risks involved and we'll offer our help in areas where the operator is seeking it, and we're active in those projects.
Daniel Barcelo - Banc of America Securities: You don't feel necessarily disadvantaged owning smaller stakes in that structure then?
Henry Hubble: No. Well, I mean, the whole reason you're in a project is because you're trying to get access to best resources and so we look at the resource quality. That's the first indicator and then we're working with them to make sure that it's as successful as possible and so we'll work with them on areas where we may have technical expertise or where we see a particular risk where we have some help to offer, we'll participate in that. But it's selective because there, the operator is the one that's running that.
Daniel Barcelo - Banc of America Securities: Okay, thank you.
Operator: Thank you. We'll go now to Paul Sankey of Deutsche Bank.
Henry Hubble: Hi, Paul.
Operator: Mr. Sankey, your line is open. Please go ahead.
Paul Sankey - Deutsche Bank: Hi, sorry, you surprised me by (inaudible). The one I had for you is the buyback. You made a forward-looking statement actually last quarter for the first time in my knowledge about the buyback levels but unless I missed it, you haven't made one about the outlook for this coming quarter and beyond, thanks.
Henry Hubble: No. Yeah, we didn't have any change there to make.
Paul Sankey - Deutsche Bank: Okay so just work on the idea that it's a $7 billion quarter with an additional amount of anti-dilution?
Henry Hubble: Well, yeah. I'm not giving any forward guidance but you know we're relatively stable.
Paul Sankey - Deutsche Bank: That's it. Thanks.
Operator: Thank you. That will conclude today's question and answer session. At this time I'd like to turn the conference back over to Mr. Hubble for any additional or closing remarks.
Henry Hubble - Vice President of Investor Relations: Thanks. Before we end the call, I'd just like to summarize a few points. Obviously, we had a very strong quarter and have been continually able to bring additional supply to the market, and ExxonMobile remains committed to managing our operations and providing high quality product to the market safely, reliably, efficiently, and responsibly, and as you can see from the results that we've announced today, we're delivering on those commitments. Thanks for listening.
Operator: Thank you for your participation. That does conclude today's conference. You may disconnect at this time. | [
{
"speaker": "Executives",
"text": "Henry Hubble - Vice President of Investor Relations"
},
{
"speaker": "Analysts",
"text": "Doug Terreson - Morgan Stanley Mark Flannery - Credit Suisse Jennifer Rowland - JP Morgan Paul Sankey - Deutsche Bank Doug Leggate – Citigroup Neil McMahon – Bernstein Nikki Decker - Bear Stearns John Herrlin - Merrill Lynch Paul Cheng - Lehman Brothers Mark Gilman - Benchmark Company Daniel Barcelo - Banc of America Securities Paul Sankey - Deutsche Bank"
},
{
"speaker": "Operator",
"text": "Good day and welcome to the ExxonMobile Corporation Third Quarter 2006 Earnings Conference Call. Today's call is being recorded. At this time for opening remarks I would like to turn the call over to the Vice President of Investor Relations and Secretary, Mr. Henry Hubble. Please go ahead, sir."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations",
"text": "Thank you. Good morning and welcome to ExxonMobile's teleconference and Webcast on our third quarter 2006 financial and operating results. As you are aware from this mornings press release, we had another strong quarter as our long standing commitments to the integrity of our operations, disciplined investment approach, and our integrated business model continued to position the Company to benefit from robust industry conditions. At this time I'd like to draw your attention to our cautionary statement. Please note the estimates, plans, and projections are forward-looking statements. Actual results including resource recoveries, volume growth, and project plans and outcomes could differ materially due to factors I'll discuss and factors noted in our SEC files. Please see factors affecting future results and the Form 8-K we furnished this morning which are available through the investor information section of our website. Please also see the frequently used terms. The supplement to this morning’s 8-K and the 2005 financial and operating review on our website. This material defines certain financial and operating terms I'll use today, shows ExxonMobile's net interest in specific projects, and includes information required by SEC Regulation G. Now I'm pleased to turn your attention to the specific results. ExxonMobile's third quarter net income and normalized earnings were $10.5 billion, or $1.77 per share. This was a record quarter for normalized earnings, and represents an increase of $2.2 billion over the third quarter 2005 on the same basis. Normalized earnings per share increased by 34% over the third quarter last year reflecting the strong earnings performance and also the benefits of the share repurchase program. Before I discuss the specific business results, I'd like to highlight some of the significant milestones we achieved since our last earnings call. Many of which are helping to bring new supply to the market. In the upstream we commissioned the export system and completed loading of first oil from the multi phase Sakhalin-1 project at the newly constructed De-Kastri terminal. Oil production should ramp up to an estimated peek rate of approximately 250,000 barrels a day around the end of the year following line out of the onshore processing facility and additional well tie-ins. We continue to be pleased with the phase one project performance and are pursuing future phases. In another recent milestone, we started production at Erha North, a deepwater development located offshore Nigeria. This is a satellite to the Erha development which came online earlier this year. Erha North started production within 30 months of discovery, setting a Nigeria deepwater record. Both Erha and Erha North facilities were constructed within budget and further demonstrate ExxonMobile's operational excellence, project execution, and deepwater expertise. Current production from the combined facilities is above expectations at 220,000 barrels a day. Also during this quarter, Golden Pass LNG LLC awarded a contract to begin engineering procurement and construction of the facilities near Sabine Pass, Texas. These facilities have capacity to process 15.6 million tons per year of LNG and are part of the multibillion dollar supply chain necessary to deliver LNG from Qatar to the United States. It's expected that the Ras Laffan 3 and Qatargas III projects which will produce and process natural gas from Qatar's offshore North field will provide the primary supply for the terminal. Construction of the Golden Pass terminal is another important step in supplying natural gas to customers along the Gulf Coast and other U.S. Markets. During the quarter, drilling began in one of our Orphan basin exploration blocks. The well is located about 250 miles off the coast of St. John's new found land in 8,000 feet of water. This is the first well to be drilled in the basin and carries significant risk and reward potential. Operations are expected to carry through until year-end. In the downstream, we successfully completed the transition of our facilities to meet new, U.S, Ultra low sulfur diesel requirement which reduce on road diesel sulfur by 97%. In addition to near term benefits, this ultra low sulfur fuel allows for the use of advanced emissions reduction technologies, which will lead to a significant reduction in diesel vehicle emissions as the fleet turns over. ExxonMobile's worldwide effort to reduce sulfur content of diesel and gasoline fuels represents a total investment of $3.5 billion and is an important part of our continuing efforts to reduce vehicle emissions. We were pleased to announce in August that our high performing synthetic oil, Mobil 1, was elected as the factory and service fuel motor oil for the new 2007 Acura RDX Luxury SUV. Mobil 1 received the highest rating of all oils tested, including other synthetics, and was selected on it's ability to meet the demands of a high performance turbo charge engine. Mobil 1 continues to lead the industry with over 30 automotive manufacture endorsements. Our advanced technology allows us to consistently meet customer requirements for high quality products and provides a competitive advantage. In keeping with our process of continuously and rigorously assessing our global portfolio of businesses, we recently announced the sale of a number of our fuels and lubes business in Africa. These transactions include a network of about 300 service stations and the associated supply and distribution facilities. These transactions are subject to the approval of relevant authorities in multiple countries, therefore completion time will vary from one country to another. I'd now like to comment on two significant chemical milestones. Earlier this month, we announced the signing of a heads of agreement with Qatar Petroleum to progress feasibility studies for a proposed $3 billion world scale petrochemical complex in Ras Laffan industrial city. The project would use feedstock from gas development projects in Qatar's North field and utilize ExxonMobile proprietary steam cracking furnace and polyethylene technologies to create premier products for customers in Asia and Europe. The successful partnership between ExxonMobile and Qatar Petroleum continues with this proposed project as we further expand the use of North field gas. Start up of the proposed petrochemical complex is estimated in 2012. In September, we announced plans to build a new chemical facility at our Baton Rouge, Louisiana complex, to produce specialty compounded products. This plant will be able to produce a broad spectrum of commercial compounded products, including ExxonMobile chemicals, performance polyolefin grades, Santoprene thermoplastic elastomers and other specialty elastomers. The new facility is expected to start up in mid 2007 and is part of a Company's global strategy and commitment to provide engineered thermoplastic materials to the automotive and consumer products industries. Turning now to the business line results. I'd ask you to also please refer to the earnings reconciliation in the IR supplement. Upstream normalized earnings in the third quarter were $6.5 billion. This represents an increase of about $760 million versus the third quarter of 2005. Upstream earnings per barrel were also strong at $17.61 per barrel. Higher realizations and volumes accounted for the increase in earnings from the third quarter of 2005. Net other items were essentially unchanged. Worldwide crude sales realizations were $65.14 per barrel, up $7.12 from the third quarter of 2005. Worldwide natural gas realizations were also improved. Oil equivalent volumes increased 7% with increases in Africa and the Middle East more than offsetting natural field declines in North America and Europe. Excluding the impact of divestments and entitlement effects, production increased by about 10%. Liquids production increased nearly 200,000 barrels per day or 8% versus the same quarter last year. Excluding the impact of divestments and entitlement effects, liquids production increased by 12%. The Erha, Bonga, East Area and Kizomba B start ups as well as the addition of Upper Zakum were the bigger sources of the additional liquids volumes. Gas volumes increased by approximately 450 million cubic feet per day or about 6% versus the third quarter of 2005. Higher production from the 2005 start ups of Ross Gas Train 4 and Al Khaleej in Qatar and the absence of 2005 hurricane impacts was partly offset by natural field decline in North America and Europe. Turning to the sequential comparison, upstream earnings decreased by about $640 million versus the second quarter of 2006. Lower realizations, normal seasonal declines in natural gas sales, lower asset sales, and negative tax effects were the primary reasons for the decrease. Liquids production was down 2% from the second quarter of 2006, including the impact of unplanned down time at Prudhoe Bay. Natural gas production was down about 7% due to normal seasonal declines in Europe. For further data on regional volumes, please refer to the press release and IR supplement. Now, turning to the downstream. Third Quarter downstream normalized earnings were a record $2.7 billion, up $610 million over the third quarter of 2005. The increase was driven by stronger marketing margins, partially offset by lower refining margins. The volume mix effect was a negative 240 million primarily due to higher refinery turnaround and maintenance activity partially offset by the absence of hurricane impacts. Other factors, increased earnings by $140 million primarily due to positive tax effects. Sequentially, downstream earnings increased by approximately $250 million with increased refinery throughput and other effects more than offsetting lower refinery margins. In total, margin impacts reduced earnings by $240 million compared to the second quarter. Refining margins were lower by $800 million; however this impact was largely offset by improved marketing margins. Volume mix effects were positive $210 million due to lower refining turnaround activity. Other factors improved earnings by $285 million with lower operating costs consistent with the reduction in refining turnaround activity combined with positive tax effects. Turning now to the chemical results. Third quarter normalized earnings were $1.35 billion, up $880 million versus the third quarter of 2005. Strong margins across all major business lines improved earnings by $820 million with higher realizations, out pacing increased feedstock cost. Volumes were slightly lower reflecting short-term demand effects. Year-to-date volumes are essentially flat with 2005. Earnings also benefited from positive tax effects. Sequentially, chemical earnings increased by about $510 million driven by higher margins. The impact of slightly reduced volumes following a robust second quarter was partially offset by lower operating costs. We continue to see strengthen our chemical business, as our diverse portfolio, broad geographic coverage, and integration capabilities result in strong competitive advantage and industry leading performance. Turning now to the corporate and financing segment. Corporate and financing expenses of about $100 million were up from the third quarter of 2005, primarily due to tax impacts partially offset by higher interest income. The effective tax rate for the third quarter was 44%. Our cash balance was $37 billion and debt was $8.6 billion at the end of the third quarter. The corporation distributed a total of $8.9 billion to shareholders in the third quarter through dividends and share repurchases to reduce shares outstanding, an increase of 30% or $2.1 billion versus the third quarter of 2005. During the third quarter, ExxonMobile purchased $7 billion of shares in excess of dilution. There by reducing the number of shares outstanding by 1.9%. Since the beginning of 2005 our quarterly share repurchase program has increased almost threefold which further demonstrates our ongoing commitment to return cash to shareholders. CapEx in the third quarter was $5.1 billion up almost $650 million from the third quarter of 2005, primarily due to planned upstream activity. Our year-to-date CapEx was $14.8 billion, approximately $2.4 billion higher than through the third quarter of 2005. Our full year outlook for CapEx remains unchanged at approximately $28 billion. That concludes my prepared remarks and I'd now be happy to take your questions."
},
{
"speaker": "Operator",
"text": "Thank you, Mr. Hubble. [Operator Instructions] And we'll take our first question from Doug Terreson of Morgan Stanley."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Good morning and congratulations on your results."
},
{
"speaker": "Henry Hubble",
"text": "Thanks, Doug."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "In the downstream, both refinery throughput and petroleum product sales seem to be flat or down in relation to the year ago period both for Q3 and the first nine months of the year, and on this point I wanted to see if there were a few specific factors that helped to explain these trends and if not, any additional color on the turnaround and maintenance items that you highlighted would be appreciated."
},
{
"speaker": "Henry Hubble",
"text": "Yeah. I mean, if you look at just the overall volumes, the throughput in the period, we were down from -- let me just pull the number here -- yeah, we were essentially flat across the period, and then what you saw in the volume effect that's there, basically that's turnarounds and that's essentially a mix of turnarounds because what you see in the throughput numbers is basically a distillation, we were tracking distillation there. And that was primarily crude, well or crude is down in the third quarter of last year and what you're seeing now in the relative comparison is more upgrading units."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Okay."
},
{
"speaker": "Henry Hubble",
"text": "So that was impact there."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Okay that makes sense, and also, in the upstream in Alaska and Indonesia on Point Thompson and Natuna, there have been a decent amount of commentary in the press regarding possible changes in your position in those areas, and so I wanted to see if there was an update on the status of those two developments?"
},
{
"speaker": "Henry Hubble",
"text": "Well, if you look at Cepu, we continue to work with, work on basically with the government there to look to accelerate the project, and so we're continuing to work with them on the development plan there, and then if you look at Natuna, we're committed to develop Natuna. Obviously, it's a challenging resource."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Sure."
},
{
"speaker": "Henry Hubble",
"text": "Very high CO2 contents there, but you have been hearing a lot in the press, and all I would say is we're working to meet all of our obligations and we assume and expect that the government will be doing the same thing, and frankly, we're engaged in a discussion with the government right now to resolve those issues around the PSA."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Great. Thanks a lot."
},
{
"speaker": "Operator",
"text": "Thank you. We'll go next to Mark Flannery of Credit Suisse."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Yeah, hi, Henry. I have a question on drilling rig coverage."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "We've been picking up some news in the last few days that you guys have been involved and in fact have chartered the West Polaris drilling rig for delivery in the second quarter 2008. I wondered, does this represent anything of a change in your approach to rig coverage? I noticed McGill earlier this year was talking about how you were happy to be at a relatively low level of offshore rig coverage for ‘08 and ‘09. Are you changing your mind on this?"
},
{
"speaker": "Henry Hubble",
"text": "No. We continue to, we have a mix of coverage that we line up. There's really no change in our views in the rig situation, but as we move forward, we're going to continue to cover a specific requirements. We've got adequate coverage on our projects and basically, we've got rigs for the firm prospects that we have."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "And could you maybe give us an idea of what kind of percentage coverage you have in ‘08 and ‘09 already for just for offshore rigs?"
},
{
"speaker": "Henry Hubble",
"text": "No. That gets into a little more competitive information than I want to get out here."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Okay. Thank you."
},
{
"speaker": "Henry Hubble",
"text": "Yup."
},
{
"speaker": "Operator",
"text": "Thank you. We'll go next to Jennifer Rowland of JP Morgan."
},
{
"speaker": "Jennifer Rowland - JP Morgan",
"text": "Thanks. I was wondering if you could break out a little bit the refining versus the marketing on a sequential and also year-over-year basis?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah. If you look at the big effects there were in margins in the sequential and the year-over-year, and if you look at -- first the sequential numbers, refining margins were down about $800 million and the marketing margins partially offset that to bring us to the 240, and what that reflects, you saw a big impact on refining margins in the period or the period comparison basically as inventories built and there was softness in those refining margins and that sequential comparison. Then if you look at the year-on-year, there was some, there we saw even larger impact or increase on the marketing margins so it was almost, in fact it was all of that increase that we saw, and there, you have again when you comparing the last quarter, we had the hurricane impacts in that period, so you saw actually decrease in the marketing margins during that timeframe and in this period with some of the lag effects that we see as crude prices and commodity prices drop, we had higher margins in this period."
},
{
"speaker": "Jennifer Rowland - JP Morgan",
"text": "Okay, and then you mentioned there was some tax effects in both --"
},
{
"speaker": "Henry Hubble",
"text": "Yeah."
},
{
"speaker": "Jennifer Rowland - JP Morgan",
"text": "Upstream and downstream on a sequential basis. Can you just break that out from the other bar?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah. Let me just step back for just a little bit more on the margins because I'll mention, in the refining side, part of the reason we didn't see as much downturn in the third quarter margins on refining is also related to our integration with lubes. We have a lot of lubes refining capacity and that actually was positive year-on-year, so it was, so that was something else that helped improve our results there, and then on the tax side, there really, if you look at that other column, there really isn't a significant story there. There's a lot of minor changes up and down, but the ones I mentioned were the biggest effects and they are basically non-U.S. Tax items like Europe and Asia Pacific."
},
{
"speaker": "Jennifer Rowland - JP Morgan",
"text": "Okay, great. Thank you."
},
{
"speaker": "Henry Hubble",
"text": "Yup."
},
{
"speaker": "Operator",
"text": "Thank you. We'll go next to Paul Sankey of Deutsche Bank."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Hi, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Hi, Paul."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "If we could continue on the same theme, Henry, firstly on the downstream, the 800 down in refining margin and the 600 up in marketing, could you break that out regionally or at least between the U.S. and non-U.S?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah. If you look at the refining margins in the U.S, They were down about 500 million overseas about 300."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Great. That answers it. On the volume side if we revert to that now, those look a bit weak but you referenced I think some seasonal impacts on the chemical side. If I could slightly switch to my downstream chemicals but also in the oil markets you said that -- I think the disposals were a key reason for weakness in volumes on that?"
},
{
"speaker": "Henry Hubble",
"text": "Well, on the marketing margins, yeah. And we had divestments there that were the biggest impact on our product, our drop off in product sales --"
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Do you have a number on that, Henry? And where? It wasn't U.S. I guess, was it?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah. Let me, well the biggest, we have U.S, we continue to high grade the network there and of course we have the Africa piece, but that's going on around the circuit, you've got some in Africa, you’ve got some in Europe so we're high grading around in our network continually."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "You've broken out what your volumes would have been upstream if it hadn't been for disposal. Could you give us a guess of how good volumes or what kind of demand strength you would have seen had it not been for the sales you had done in the petroleum product side?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah. You would have been up a percent or so."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Okay, great. And on the chemical side, I think you said was it seasonal effects?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah, well, on the chemical side, you have some of these what we almost call mini cycles in the chemicals business and it has a lot to do, the volumes that you see there have a lot to do with peoples expectation on where prices are going, so what you see is when prices, the feedstock prices start dropping rapidly, people will V-stock and slowdown their purchases waiting for that to be reflected into product prices, and so you'll see that whenever you have a big change in the commodity price."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Okay, great. And if I could have one more, please, on taxes, you had, sorry, upstream taxes, you had said last quarter that the North Sea impact would be around $0.01 to $0.02 I believe?"
},
{
"speaker": "Henry Hubble",
"text": "That's right."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "And is that, I mean does that actually happened dare I ask and secondly could you quantify Alaska and any other impacts globally on the upstream side that might be within these numbers?"
},
{
"speaker": "Henry Hubble",
"text": "Well you’ve got the big ones. Those were the big impacts and the UK increase, it came in about where we thought it would, about in the middle of that range, so and then Alaska was a bit less than that."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Okay. Henry, I'll leave it there. Thank you."
},
{
"speaker": "Henry Hubble",
"text": "Very good."
},
{
"speaker": "Operator",
"text": "Thank you. We'll go next to Doug Leggate of Citigroup."
},
{
"speaker": "Doug Leggate – Citigroup",
"text": "Thank you, good morning Henry. I guess this is going to be something of a theme. The tax situation, if you look at your tax rate, it looked to be a little low or something, lower than recent quarters. Was that just the mix effect because of the heavier downstream contribution?"
},
{
"speaker": "Henry Hubble",
"text": "Well, the tax rate actually was about flat. I mean it was 44%, I think it was the same thing versus second quarter and actually up some versus last year."
},
{
"speaker": "Doug Leggate – Citigroup",
"text": "Yeah, I'm talking sequentially."
},
{
"speaker": "Henry Hubble",
"text": "Yeah, so it was flat. It was basically flat."
},
{
"speaker": "Doug Leggate – Citigroup",
"text": "I guess -- my question is that some of your competitors only reported included some data charges for the first half of the year both UK, Alaska and one or two other things. Are you able to quantify if you did the same thing and to what extent it was?"
},
{
"speaker": "Henry Hubble",
"text": "Well, I mean, we report the effects, and these are net effects that we're reporting here, so in the UK, that's a net effect, and it's complex and I can't really get into all of the forward and backward pieces on it but they are net effects."
},
{
"speaker": "Doug Leggate – Citigroup",
"text": "Okay and my second question is really just on production. There's actually two parts of this if you don't mind both very simple I'm afraid."
},
{
"speaker": "Henry Hubble",
"text": "Yeah."
},
{
"speaker": "Doug Leggate – Citigroup",
"text": "In terms of the pricing effects I just wanted to make sure my understanding is right on this. The average oil price in Q3 last year was about $7 below what it was this year."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Doug Leggate – Citigroup",
"text": "So are you saying if we hit the (inaudible) for $63 level for talking sake that your volumes would go up by around 3%?"
},
{
"speaker": "Henry Hubble",
"text": "Well, no. I mean, what we have said when we've looked at the entitlement effects has been more like a 1% kind of a number."
},
{
"speaker": "Doug Leggate – Citigroup",
"text": "That balances disposals?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah, and then you look there's disposals in there but if you look at the overall volume, volume impacts, it's about the balance was entitlements, almost 2% there."
},
{
"speaker": "Doug Leggate – Citigroup",
"text": "Okay and I guess the second part very simply to that question is obviously OPEC cuts, have you seen anything in terms of requests and so on just in your business?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah. I mean, the OPEC effects for us will be small. Now, we do see, we do see on a production side, but you do see things in supply as crude is being cut back, we are seeing changes in mix, generally comes out of heavy grades and so we see some of that."
},
{
"speaker": "Doug Leggate – Citigroup",
"text": "Okay, that's great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. We'll go next to Neil McMahon of Bernstein."
},
{
"speaker": "Neil McMahon – Bernstein",
"text": "Two questions. One is when you look at the sort of basic data you've given us for cash flow and your earnings press release, you've got $800 million for sales of subsidiaries investments and plant property and equipment. I wonder if you could break that down into how much of that was actual divestments and where they were in terms of upstream, downstream chemicals, other?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah. I mean the biggest piece was Carson Creek, you know, we did have some upstream sales but we’re really -- I can't get into the break down of each of these things. I can tell you though, if you look at the quarter-on-quarter comparison though and for the upstream earnings, I mean, they netted out. We didn't really have any other effects and that was basically the impacts that I described on the tax side with UK and Alaska tax offsetting some higher asset sales in the biggest piece of that was Carson Creek."
},
{
"speaker": "Neil McMahon – Bernstein",
"text": "But you would say that $800 million in your cash flow statement would be divestments?"
},
{
"speaker": "Henry Hubble",
"text": "Different divestments, yes. I mean, it's upstream and downstream mix."
},
{
"speaker": "Neil McMahon – Bernstein",
"text": "Great. Just a second question on U.S. gas, you had a decline in volumes sequentially. Two parts: One, just wondering if that was due to divestments alone and secondly, are you seeing any changes in activity in the Piceance basin in terms of rig availability or indeed are you taking any actions yourself to change activities given where the natural gas price has been this year?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah. As you're looking at the year-on-year gas production for the upstream?"
},
{
"speaker": "Neil McMahon – Bernstein",
"text": "I believe so."
},
{
"speaker": "Henry Hubble",
"text": "Yeah, okay, so I mean one of the big impacts there is just the absence of the hurricanes, so that probably the biggest single impact to decrease that number and of course we're continuing to move Piceance forward and it's moving ahead according to plans there, but in terms of actual volume contribution at this point it's relatively small."
},
{
"speaker": "Neil McMahon – Bernstein",
"text": "Okay, but you're not changing any of your activities going forward?"
},
{
"speaker": "Henry Hubble",
"text": "In terms of from a price outlook?"
},
{
"speaker": "Neil McMahon – Bernstein",
"text": "Yup."
},
{
"speaker": "Henry Hubble",
"text": "No, our plans are based on long term outlooks and the competitiveness of the projects that we have and so it's not impacted by near term price."
},
{
"speaker": "Neil McMahon – Bernstein",
"text": "Okay. Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. We'll go next to Nikki Decker of Bear Stearns."
},
{
"speaker": "Nikki Decker - Bear Stearns",
"text": "Good morning, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Hi, Nikki."
},
{
"speaker": "Nikki Decker - Bear Stearns",
"text": "Two questions on Saco if I could. First of all, I think you were due to start an inspection process by the natural resources ministry. Just wondering what we might expect and if there was anything potentially significant that could come out of that and secondly, we seen some press reports that you've reached a preliminary agreement on gas sales. Maybe you could comment on that."
},
{
"speaker": "Henry Hubble",
"text": "Yeah, I guess first on the Saco in piece, the inspection hasn't started but there's been ongoing interactions with government officials all the way through this, so it's not like there's a lot of things, or still it's going to be more closing things out and we're not expecting any real issues and as you see, we started up the facilities and have made the first exports and in fact I think the next vessel is due to arrive either today or tomorrow. So, that continues to move ahead. And we're pleased with the progress."
},
{
"speaker": "Nikki Decker - Bear Stearns",
"text": "And on gas sales agreement?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah. Well, we basically signed an HOA with CNPC and that basically, you know, our intent is to work forward to an agreement there and there are also discussions as you might guess with gas prom about how to export that."
},
{
"speaker": "Nikki Decker - Bear Stearns",
"text": "Okay, can you give us any color on the term size, anything?"
},
{
"speaker": "Henry Hubble",
"text": "No. We haven't -- all of that is to be defined yet in terms of the specific agreement."
},
{
"speaker": "Nikki Decker - Bear Stearns",
"text": "Thank you, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Yup."
},
{
"speaker": "Operator",
"text": "Thank you. We'll go next to John Herrlin of Merrill Lynch."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Yeah, hi Henry. Last quarter, Erha was running above boiler plate and now you put it in the satellite facility. Is this going to be constrained, is it going to be flowing at pretty high rates for a long time?"
},
{
"speaker": "Henry Hubble",
"text": "Well, as I said, it's up at the 220,000 barrels a day now and that's above what we were originally expecting, and so we'll see, but these do decline overtime and most of these fields have, they will maintain a peak for a certain period and then you'll see declines, but we feel real good about that project. It's done very, very well."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Understood. I was just trying to get a sense of how the satellite was."
},
{
"speaker": "Henry Hubble",
"text": "I really can't give you anything right now. It's performing consistent and above our expectations."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Super. Next one for me with golden pass, when do you expect to receive LNG?"
},
{
"speaker": "Henry Hubble",
"text": "Well, in the completion date, I don't know if I have that right at my finger tips here. It's 2008."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Okay, and then lastly for me, with the Orphan basin you said you'll TD this one at the end of the year. Does that then mean a pause, should we expect an announcement, or what will you do?"
},
{
"speaker": "Henry Hubble",
"text": "Let me just back up on the completion of that looking around the 2009 is for the -- is when we'll have the first receipts there."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "End of 2009 or middle?"
},
{
"speaker": "Henry Hubble",
"text": "No. I don't have anything more specific than that. And then Orphan, it's a tight hole so I don't have any data. I can share it's drilling and then obviously, it's one that's high risk and potentially high reward but we have a number of those kinds of prospects that we're working on."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Thanks, Henry."
},
{
"speaker": "Operator",
"text": "Thank you. We'll go next to Paul Cheng of Lehman Brothers."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Hi, Henry."
},
{
"speaker": "Henry Hubble",
"text": "Hi, Paul. How are you?"
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Very good. Sorry to have to bug you on this one. On the tax and office sales, let me try to understand a little bit better. In your supplemental presentation, you indicated that other sequentially that lead to 190 million lower earnings. If I recall correctly, in the second quarter, you have asset sales gain of about $340 million and the benefit from the Canadian tax law change of $200 million. So that's about $540 million and that the higher UK tax in Alaska based on what you just mentioned is roughly about 170 to 180 million, so that means that if this item, the $190 million lower earnings is assumed that mainly related to asset sales and tax changes, so does that mean that on the absolute dollar term, your third quarter, you have a benefit on those two items to the tune of about $5 to $600 million?"
},
{
"speaker": "Henry Hubble",
"text": "I'm not following. I think we're going to have to take that one off line because I'm not sure, I can't follow all of the numbers you were going through there, Paul."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Okay."
},
{
"speaker": "Henry Hubble",
"text": "I think we would be better off to take that offline."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "I will do so. Second question, wondering if you have been informed or by order by either your suppliers such as Saudi Arabia to have a lower location or that the shipment to you for November or by Nigeria that saying that you need to trim your production already?"
},
{
"speaker": "Henry Hubble",
"text": "Well, Saudi Arabia, that's a supply, my comments there were on a supply side and so and then for anything else, it's basically a dialogue with those countries on what they are going to actually do and that's ongoing, so there's nothing I have to report there at this point. Like I said on the supply side, we have contracts and they will ship the great mix and that kind of stuff."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "I understand, but Henry, I guess my question is that did they officially inform you guys of trimming your location?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah. I mean, right now, there's plenty of crude supply out there. I'm not sure what you're going at in terms of we don't really have any, as I mentioned, there's no indication on limitation on the amount of oil. There's plenty of oil out there so we've got all of our, we're a big buyer of crude. We don't have any trouble covering that, and so – and then as I said before, in terms of our production side of it, it's very small, if anything."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Okay. That's fine. Can I have just one final quick question? I think clearly, several weeks ago, the news come out saying that (inaudible) indicated that 2007 kept your spending would be roughly flat at $20 billion. Wondering if you can confirm whether he has said that or not."
},
{
"speaker": "Henry Hubble",
"text": "Well, yeah. I mean and I think those are round figures and we'll be updating specifically the outlook at the Analyst meeting as we always do and you'll get more detail there, but I would take that as a round figure."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Okay very good. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. We'll go next to Mark Gilman with the Benchmark Company."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Hi, Henry, how are you?"
},
{
"speaker": "Henry Hubble",
"text": "Very good, Mark."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Two questions. Exploratory expenses are running considerably higher this year both in the quarter you reported today as well as the first half and I was wondering if you could shed a little light on the factors contributing to that and in particular, the extent to which it is an activity induced increase as opposed to any changes in success rates."
},
{
"speaker": "Henry Hubble",
"text": "No. I mean, it does, we do have higher levels of activity and it reflects, but it does reflect and you'll see it as different prospects, there are some dry holes in here too because we do have activity in that but it also covers of course all of our seismic and other work that's in that category, and we did have well costs that are in there in this time frame."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Would you say activity increases is the primary driver?"
},
{
"speaker": "Henry Hubble",
"text": "No. I would say it's as much, I mean, it's activity on wells and then you have a certain number of them that are show up in those costs when they are non-economic, and so I guess when you say is it activity? Yeah, I mean, we do have higher activity on wells that are being drilled and some of those are showing up in this category."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Okay one other one if I could. In light of what you said about Erha and it's performance, the African liquids number in the third quarter was lower than the second. Could you perhaps shed a little light on that apparent discrepancy?"
},
{
"speaker": "Henry Hubble",
"text": "It's basically timing entitlements I guess is the biggest issue."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "I'm not sure what you mean."
},
{
"speaker": "Henry Hubble",
"text": "Well as prices rise, you have entitlement effects associated with that."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Price was flat, Henry, quarter to quarter."
},
{
"speaker": "Henry Hubble",
"text": "Well, if I look at the Africa, that is the biggest impact is entitlement costs or entitlement effects."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Okay, thank you."
},
{
"speaker": "Operator",
"text": "Thank you. We'll go now to Daniel Barcelo with Banc of America Securities."
},
{
"speaker": "Daniel Barcelo - Banc of America Securities",
"text": "Hi, good morning. I wanted to know if you could just comment more conceptually about how Exxon views minority interest and certainly investments and in general, given some actions I guess with shell Canada in particular, how does Exxon view participation or ability to control capital spending or corporate government within some of it's subsidiaries there and if it has types of plans as well to look toward incorporating more of those minorities?"
},
{
"speaker": "Henry Hubble",
"text": "I'm sorry, I missed the front end of that?"
},
{
"speaker": "Daniel Barcelo - Banc of America Securities",
"text": "Regarding investments where you don't own 100% in your minority investments?"
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Daniel Barcelo - Banc of America Securities",
"text": "What is Exxon's strategy in order to essentially control say capital spending program, corporate governance --"
},
{
"speaker": "Henry Hubble",
"text": "Yeah, I mean, well, obviously, we're an active partner in anything where we're involved, and we go through in fact if you look at the upstream activities, we have a lot of ours are OBO arrangements there and of course we look at the risks involved and we'll offer our help in areas where the operator is seeking it, and we're active in those projects."
},
{
"speaker": "Daniel Barcelo - Banc of America Securities",
"text": "You don't feel necessarily disadvantaged owning smaller stakes in that structure then?"
},
{
"speaker": "Henry Hubble",
"text": "No. Well, I mean, the whole reason you're in a project is because you're trying to get access to best resources and so we look at the resource quality. That's the first indicator and then we're working with them to make sure that it's as successful as possible and so we'll work with them on areas where we may have technical expertise or where we see a particular risk where we have some help to offer, we'll participate in that. But it's selective because there, the operator is the one that's running that."
},
{
"speaker": "Daniel Barcelo - Banc of America Securities",
"text": "Okay, thank you."
},
{
"speaker": "Operator",
"text": "Thank you. We'll go now to Paul Sankey of Deutsche Bank."
},
{
"speaker": "Henry Hubble",
"text": "Hi, Paul."
},
{
"speaker": "Operator",
"text": "Mr. Sankey, your line is open. Please go ahead."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Hi, sorry, you surprised me by (inaudible). The one I had for you is the buyback. You made a forward-looking statement actually last quarter for the first time in my knowledge about the buyback levels but unless I missed it, you haven't made one about the outlook for this coming quarter and beyond, thanks."
},
{
"speaker": "Henry Hubble",
"text": "No. Yeah, we didn't have any change there to make."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Okay so just work on the idea that it's a $7 billion quarter with an additional amount of anti-dilution?"
},
{
"speaker": "Henry Hubble",
"text": "Well, yeah. I'm not giving any forward guidance but you know we're relatively stable."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "That's it. Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. That will conclude today's question and answer session. At this time I'd like to turn the conference back over to Mr. Hubble for any additional or closing remarks."
},
{
"speaker": "Henry Hubble - Vice President of Investor Relations",
"text": "Thanks. Before we end the call, I'd just like to summarize a few points. Obviously, we had a very strong quarter and have been continually able to bring additional supply to the market, and ExxonMobile remains committed to managing our operations and providing high quality product to the market safely, reliably, efficiently, and responsibly, and as you can see from the results that we've announced today, we're delivering on those commitments. Thanks for listening."
},
{
"speaker": "Operator",
"text": "Thank you for your participation. That does conclude today's conference. You may disconnect at this time."
}
] | null | null |
XOM | 2 | 2,006 | 2006-07-27 19:15:00 | Executives: Henry Hubble - Vice President, Investor Relations and Secretary
Analysts: Douglas Terreson - Morgan Stanley Dean Witter Doug Leggate - Citigroup Bruce Lanni - A.G. Edwards & Sons, Inc. Robert Kessler - Simmons & Company International Mark Flannery - Credit Suisse First Boston Jennifer Rowland - JPMorgan Chase & Co. Arjun Narayana Murti - Goldman Sachs Nicole Decker - Bear, Stearns & Co. Neil McMahon - Sanford C. Bernstein & Company, Inc. Paul Sankey - Deutsche Bank Paul Cheng - Lehman Brothers Daniel Barcelo - Banc of America Securities Mark Gilman - Benchmark Capital John Herrlin - Merrill Lynch
Operator: Good day and welcome to this Exxon Mobil Corporation second quarter 2006 earnings conference call. Today’s call is being recorded. At this time for opening remarks, I would like to turn the call over to the Vice President of Investor Relations and Secretary, Mr. Henry Hubble. Please go ahead, sir.
Henry Hubble: Thank you, and welcome, everybody, to Exxon Mobil's teleconference and webcast on our second quarter 2006 financial and operating results. As you are aware from this morning's press release, we have had another strong quarter as we continue to benefit from the performance of our world-class investments through good operations, production growth, and strong industry conditions. Although our company benefits from these conditions, we do recognize the impact today's high energy prices have on consumers and family budgets. Therefore, before I begin and comment on the business line results, I will share with you some of the milestones that include work we have done that will bring more product to the market and ease supply pressure. At this point, I would like to draw your attention to our cautionary statement. Please note that estimates, plans and projections are forward-looking statements. Actual results, including resource recoveries, volume growth and product outcomes could differ materially due to factors I will discuss and factors noted in our SEC filings. Please see the factors affecting future results in the Form 8-K we furnished this morning, which are available through the Investor Information section of our website. Please also see the frequently used terms, the supplement to this morning's 8-K, and the 2005 financial and operating review on our website. This material defines certain financial and operating terms I will use today, shows Exxon Mobil's net interest in specific projects, and includes information required by SEC regulation G. I am pleased to turn your attention to the specific results. Exxon Mobil's second quarter net income and normalized earnings were $10.4 billion, or $1.72 per share. This was a record second quarter, and represents an increase of $2.5 billion, or 32% versus second quarter 2005 normalized earnings. This performance was driven by strong crude prices and refining margins, as well as by continued focus on operational excellence and cost-containment. Before discussing the business line details, I will highlight some of the key milestones that occurred since our last earnings call. Within the up-stream, we started operations at the Guntong E gas compression platform in the South China Sea to help meet increasing gas demands in Malaysia. The platform is the first phase of the Guntong hub development and when combined with the existing Guntong D production and compression platforms, will have gas handling capacity of more than 800 million cubic feet of gas per day, to process production from current and future gas developments offshore peninsular Malaysia. The Guntong E platform is located approximately 130 miles off the East Coast of peninsular Malaysia, in water depths of 210 feet, and is operated by Exxon Mobil Exploration and Production Malaysia, Incorporated. In July, Exxon Mobil, the State of Qatar and Qatar Petroleum announced the launch of the Al Khaleej Gas Phase-2 project. AKG-2 is being developed to supply natural gas to domestic markets while recovering associated condensate and natural gas liquids for export. Phase-2 start-up is scheduled for late 2009. Phase-1 of Al Khaleej Gas, with a capacity of 750 million cubic feet per day of gas, began production in November, 2005. Exxon Mobil has 100% interest in the project. The East Area Additional Oil Recovery Project, located 17 miles offshore Nigeria, started up in June. Mobil Producing Nigeria is the operator and has a 40% interest. The project involves the re-injection of natural gas to mitigate production decline in East Area reservoirs and increase ultimate oil recovery. It is expected that the project will produce 530 million gross barrels of additional oil reserves and provide a peak volume of 120,000 barrels a day of oil. The development will also further reduce routine flaring at the facilities. In the down-stream, we completed the transition of our facilities to meet ethanol blending requirements in the U.S. The transition was completed smoothly without any supply disruptions. Similarly, we are pleased with the progress to meet ultra-low sulfur diesel requirements. We completed terminal and pipeline construction projects, and began producing ultra-low sulfur diesel from our refineries in the U.S. and Canada. Our plans are on track to meet regulatory deadlines and we do not anticipate any supply disruptions associated with the transition of our remaining facilities. In July, we announced plans to construct a new co-generation unit at the Antwerp integrated refining and chemical complex in Belgium. This unit will have the capability to produce 130 megawatts of power, or the equivalent of electricity to supply 300,000 Belgian households. It will also decrease carbon dioxide emissions by approximately 200,000 tons per year, or the equivalent of taking about 90,000 cars off the road. Co-generation, the simultaneous production of electricity and heat or steam, has been a significant factor in improving energy efficiency at Exxon Mobil facilities around the world while reducing air emissions. Exxon Mobil now has interest in 85 co-generation facilities in more than 30 locations worldwide. We have previously discussed our process of continuously and rigorously assessing our global portfolio of businesses and their opportunities for growth, restructuring, or divestment. In July, we announced plans to divest the Ingolstadt Refinery, the Bavarian industrial wholesale business, and Esso Bayern, which primarily runs the home heating oil direct business. The change of ownership is expected to be complete by early 2007, pending approval from authorities. In chemical, there are two milestones I will comment on now. We introduced a line of compounded polypropylene that is used in external and internal automobile applications, such as bumpers and internal trim. These new products complement our existing polypropylene production lines, providing customers with a complete line of products for automotive interior, exterior, and under-the-hood applications. Our ongoing investment in technology and compounding expertise provides us competitive advantage and highlights our commitment to the global automotive market. Regarding the Singapore chemical project, we continue to make good progress on our detailed study for a potential world-scale steam cracking complex that would be located at our existing Singapore refining and chemical site. In June, we announced the award of front-end engineering and design contracts for derivative units associated with the project, including polyethylene, polypropylene, aromatics extraction, oxo alcohol and specialty elastomers. Over the next 10 years, we expect over 50% of key commodity petrochemical demand growth to occur in Asia, with over a third in China alone. Exxon Mobil's established world-scale, fully-integrated refining and chemical facilities in Singapore and Saudi Arabia are well-positioned to supply these demands and this potential second steam cracker complex would further strengthen our advantage in supplying these growing markets. Turning now to the business line results, please refer to the earnings reconciliation in the IR supplement. Upstream normalized earnings in the first quarter were $7.1 billion. This represents an increase of $2.2 billion versus the second quarter of 2005. After tax, upstream unit earnings were also strong at $18.84 per barrel. Worldwide crude realizations were $64.93 per barrel, up $17.77 from second quarter 2005. The higher realizations were responsible for $2.1 billion of the increase in earnings from the second quarter of 2005. Other items, primarily higher property sales, more than offset an unfavorable change in volume mix. Oil equivalent volumes increased 6% versus the same quarter last year, with increases in Africa and the Middle East more than offsetting natural field declines and divestments in North America and Europe. Excluding the impact of divestments and entitlements, production increased 9%. Liquids production increased 230,000 barrels per day, or over 9% versus the same quarter last year. Excluding entitlements and divestments, liquids production increased 14%. The Kizomba B and Erha start-ups and the addition of Upper Zakum were the biggest sources of the additional liquids volumes. Gas volumes increased 60 million cubic feet per day, or about 1% versus the second quarter of 2005. Higher production in Qatar was offset by natural field decline and planned maintenance in North America and Europe. Turning to the sequential comparison, upstream earnings increased by $750 million versus the first quarter of 2006. Improved realizations were essentially offset by normal seasonal declines in natural gas sales. Other factors, including higher property sales, Canadian tax changes, and lower litigation expenses increased sequential earnings. Liquids production was essentially unchanged from the first quarter of 2006, while gas production was down about 20% due to normal seasonal variations. For further data on regional volumes, please refer to the press release and IR supplement. Turning to the downstream. Overall, second quarter downstream normalized earnings of nearly $2.5 billion were up approximately $260 million over the second quarter of 2005. Industry margins accounted for $790 million of the increase, as higher worldwide refining margins more than offset lower marketing margins. The volume mix effect was a negative $350 million, due to lower refinery throughput primarily associated with increased turnaround activity. Other factors, primarily higher turnaround related operating costs and the absence of asset sales, further reduced earnings by $180 million. Sequentially, downstream earnings increased by approximately $1.2 billion, primarily due to higher refining margins. Volume mix effects reduced earnings by $110 million, mainly as a result of additional turnaround work that resulted in lower throughput. Other factors reduced earnings by $90 million, as higher operating costs, consistent with the additional planned workload, were partially offset by favorable for-ex. Turning to chemical results. Second quarter normalized earnings were $840 million, up slightly versus the second quarter of 2005. Higher feedstock costs resulted in lower margins that reduced earnings by $160 million but were more than offset by the impact of higher volumes, lower operating costs, and the absence of unfavorable tax items. Sequentially, chemical earnings decreased by about $110 million. Lower margins reduced earnings by $290 million but were partially offset by favorable mix effect, for-ex, and the absence of unfavorable tax items. Our near-term and long-term outlooks for the chemical business remain strong. We believe our unique business approach, underpinned by our technology leadership, continues to deliver a competitive advantage in this growing business. Turning now to the corporate and financing segment. Corporate and financing expenses of approximately $100 million were essentially flat with the second quarter of 2005. The effective tax rate for the second quarter was 44%. Our cash balance was $36.7 billion, and debt was $8.4 billion at the end of the second quarter. The corporation distributed a total of $7.9 billion to shareholders in the second quarter, through dividends and share purchases, to reduce shares outstanding, an increase of 48%, or $2.6 billion versus the second quarter of 2005. During the second quarter, Exxon Mobil purchased $6 billion of shares in excess of dilution, thereby reducing the number of shares outstanding by 1.7%. As of the end of the second quarter, our share repurchase program had reduced shares outstanding by 15% since they were started in 2000. As a result of our ongoing financial strength, purchases of shares to reduce shares outstanding will be increased to $7 billion in the third quarter, further demonstrating our commitment to return cash to shareholders. Cap-ex in the second quarter was $4.9 billion, up $360 million from the second quarter of 2005, primarily due to planned upstream activity. Our year-to-date cap-ex is $9.7 billion. Our full-year outlook for cap-ex has been increased by $1 billion to $20 billion, reflecting increased drilling and development activity, primarily in Africa, Europe, and the United States. Before we begin the question-and-answer portion of the call, I will summarize a few key factors underpinning our second quarter performance. The record results that we have reported today are the outcome of the strategies we have shared with you in the past. Our upstream is focused on maximizing profitable production and capturing and investing in projects that deliver superior returns. Our downstream objectives are to maintain best-in-class operations, to provide quality, value, products and services to our customers, while selectively investing to grow returns. The chemical business draws on the synergies available through access to advantage feedstocks and integration across Exxon Mobil operations, while selectively investing in growth opportunities. Our strong financial position continues to allow to us pursue an unparalleled capital program, while also providing significant shareholder distributions. That concludes my prepared remarks, but before we begin the questions, I would like to address some apparent confusion about the revenue numbers. There has been a U.S. financial accounting standard change which changed a longstanding industry practice of reporting related party buy-sell transactions. The accounting is now being reported on a net basis, with no impact on earnings. The change shows up as a reduction in both revenues and total costs. I would now be happy to take your questions.
Operator: Thank you, Mr. Hubble. (Operator Instructions) We will take our first question from Doug Terreson with Morgan Stanley.
Douglas Terreson - Morgan Stanley Dean Witter: In E&P, the other factor in relation to the first quarter of 2006 was $710 million, I believe, and that is a number that is even relevant for Exxon Mobil. I wanted to see if you could provide some color and maybe some quantification on the primary components of that figure?
Henry Hubble: Yes, you are looking at the sequential comparison?
Douglas Terreson - Morgan Stanley Dean Witter: I am.
Henry Hubble: Yes, the biggest piece, as I mentioned, is associated with property sales, and there were various sales in there. It included Four Corners and some others. If you would like more detail on that, we can follow up with you. There was also a favorable tax impact in Canada, about $200 million, and then there is the absence of litigation we had in the first quarter associated with the Grefer case, and that was about $160 million.
Douglas Terreson - Morgan Stanley Dean Witter: One more question, in E&P, it appears that the Gorgon Project in Australia may be faced with rising estimates for capital investment and environmental issues. To my knowledge, Exxon has not announced any sales agreement on that project either. I wanted to see if you could provide an update on the status of that project, as well as any new timetables that may have materialized, if any new timetables have, as it relates to commercialization of that project?
Henry Hubble: We continue to work with the operator -- and as you know, Chevron is operating that one -- to progress an environmentally and economically-sound project. There was some advice that we are disappointed with from the EPA to the government, and we are appealing that recommendation. Further questions, I really cannot get into the specifics. It is probably better to address that back to the operator.
Operator: We will take our next question from Doug Leggate from Citigroup.
Doug Leggate - Citigroup: A couple of things on the -- it seems much more exhausting than it really is. A couple of questions on the downstream, please. First of all, the utilization rate on refining was a little lower than I was expecting. Can you quantify the planned versus [inaudible] down-time, and maybe give an outlook for the back-half of the year?
Henry Hubble: If you look at the bulk of the impact on the throughputs, it was basically turnaround related. Most of that input, 299-plus, was associated with turnaround. The turnaround workload normally is higher in the first-half of the year, and this year was a little higher than normal. Some of it associated with the ultra-low sulfur diesel implementations. If you look at the turnaround workload, it is about 75% complete for this year, so we have seen the bulk of it is behind us.
Doug Leggate - Citigroup: That is very helpful. The only follow-up I have is marketing. Can you give us some idea of the marketing delta sequentially and year-over-year, if that is possible?
Henry Hubble: If you are looking at the delta…are you talking volumes or…
Doug Leggate - Citigroup: No, just the earnings impact would be fine.
Henry Hubble: As we talked about, the bulk of the marketing impact in the year-to-year numbers is about -- on a sequential basis, it was about $60 million in margins, and then quarter on quarter, it was about 150, a little more, in margins, down -- down. [Multiple Speakers]
Henry Hubble: I beg your pardon?
Doug Leggate - Citigroup: Were U.S. and international still positive for the quarter?
Henry Hubble: In terms of absolute earnings? We do not really get into the specifics on that, but if you looked -- margins in general were down across the world, and really that reflects the lag effect you see from rising crude prices and subsequent feedstocks through the refinery. That is what most of that is -- compression due to the rising crude prices.
Operator: We will now take our next question from Bruce Lanni with A.G. Edwards.
Bruce Lanni - A.G. Edwards & Sons, Inc.: Actually a question that piggybacks on what Doug was asking on the downstream, basically I was wondering -- could you give some further clarification on the refined product sales numbers? Obviously they were down year over year, and I was looking, the throughputs were down too. Was most of the decline in product sales due to the lower throughputs year over year?
Henry Hubble: Yes.
Bruce Lanni - A.G. Edwards & Sons, Inc.: Was it primarily in distillates rather than gasoline? I am trying to get a fix on what you are seeing on the gasoline side.
Henry Hubble: If I look at the overall petroleum product sales, we were down about 2% in total, and if you look at the actual -- I am talking sequentially now, first quarter versus second quarter -- we were down about 2% overall. The bulk of that associated with the turnaround activities. If you look at mix, we were actually up some on gasoline, down some on diesel, across that timeframe. That is normal, seasonal kind of stuff. If you looked at it on a year-to-year basis, we were down about equally -- gasoline and heating oil, again reflecting the turnaround effects.
Bruce Lanni - A.G. Edwards & Sons, Inc.: In the U.S. then in particular, what are you witnessing right now as far as the gasoline sales go? Anecdotally, are you seeing relatively strong sales in…
Henry Hubble: If you look -- a general question about demands, it is really hard to get behind what is going on on a short-term basis, because there is a lot of moving around on consumption numbers. We continue to see demand grow year on year. We are running our capacity full. We are selling everything we can make. When we step back from it, normally it correlates best with GDP growth, and we see economies are still performing well around the world. You see the strong margins, which is basically being driven by clean products demand growth. That is what we are really seeing here.
Operator: Our next question will come from Robert Kessler with Simmons & Company.
Robert Kessler - Simmons & Company International: You have no doubt seen the announcement on Shell's Pearl GTL project this morning and the revised implied cost there. I was wondering if you might provide us with any update you could on your preliminary $7 billion estimate for your own GTL project in that country.
Henry Hubble: We signed the Heads of Agreement in July of 2004, as you probably know. Our project is about 154 KBD plant and we are working with Qatar Petroleum to finalize the DIPSA associated with it, and to complete the other commercial agreements associated with the project. We still have some appraisal well activities that we have to do on that. We will be updating the costs as we get closer, but this project, the technology we have here is a bit unique too, in that the yields that we get are a lot higher in terms of the distillate yield or the [LU-base] stock yield, which is one of things that advantages the project that we are looking at.
Robert Kessler - Simmons & Company International: I appreciate you still have some more fine-tuning then on the cost estimates, but roughly speaking -- above or below two times the $7 billion?
Henry Hubble: We are still in the mode of updating that and I do not have a number to offer you at this time. Just in general, obviously everybody is seeing cost pressures. We are working cost pressures, we work these things hard -- we do a lot to offset them, but we are really just not in a position to come back with a number at this point.
Operator: We will now move to Mark Flannery with Credit Suisse.
Mark Flannery - Credit Suisse First Boston: Two unrelated questions, the first is about the increase in cap-ex. You seemed to indicate in your prepared remarks that was all or substantially due to higher activity. Is any of it due to higher costs or not?
Henry Hubble: We have cost pressures just like everybody else has cost pressures, when you look at the pressure on op-ex and other things. When you look at those, the primary piece, the bulk of that is associated with drilling activity in Nigeria -- we are accelerating. We have worked through some of the issues on Kizomba C and have been able to accelerate that. We also have increased drilling in Europe and the U.S., so when you look at the overall numbers, there are still some cost inflation associated with that, but it would be less than a third of what we are seeing there.
Mark Flannery - Credit Suisse First Boston: The second question is about renewables. There have been various announcements from industry participants about their interest in getting into renewables, be that in a corn-based ethanol in the States or bio-diesel in Europe. Do you have position on that? Are you looking at anything? What is your general take on those?
Henry Hubble: Most of the bio-fuels that are out there, in fact, there are very few that are economic without subsidies. The current generation of technology has limitations due to their costs, when you look at fertilizer requirements, land-use impacts, so our focus has really been that you are going to have to do things to reduce those costs, so we are investing in breakthrough technologies to find transportation fuel options that would successfully meet the supply requirements and demand challenges for the future. Right now, the technology that is out there basically requires subsidies for the long-haul. We do not think that makes sense to invest in at this point. We are a major buyer and blender of ethanol, so we are using those products. We also blend bio-diesel in Europe.
Operator: We will now move to Jennifer Rowland with JP Morgan.
Jennifer Rowland - JPMorgan Chase & Co.: I have a question on the share buyback program. I know you had said you planned on doing $7 billion in the next quarter. Can you just provide some guidance going forward as far as how we should think about the pace of your share buyback program? I know you are obviously committed to increasing it, but I did not know if there were any targets that you have as far as either a percentage of cash flow or a goal as far as reducing the amount of shares outstanding -- anything you could provide to help us.
Henry Hubble: We do not have a target on that. We do not really provide forward guidance on that. We will update you as we are changing it, as we have been. If you step back and look at how we think about it, we are distributing cash to shareholders through dividends and the share repurchases. We tend to think about the dividends in the longer-term, and think of that more as a payout that we want to be able to increase steadily over time. We have had a 10% increase this year. Then, on the share buyback, it really is the more flexible component. Of course, the growth in it that you have seen is a reflection of the strong cash generation that we continue to deliver.
Jennifer Rowland - JPMorgan Chase & Co.: Great. Lastly, on the cap-ex, any change to your outlook for 2007 to 2010 guidance, given that you plan on spending $20 billion now in 2006?
Henry Hubble: Not at this point. We will be updating that, normally in our analyst meeting. There is a range, of course, in there even with those numbers, because you are going to look at what advances or changes there are to those projects, but we will be updating that in the March timeframe.
Operator: We will now move to Arjun Murti from Goldman Sachs
Arjun Narayana Murti - Goldman Sachs: Thank you. Henry, just a question on your ultra deep shelf drilling in the Gulf of Mexico, just wondering if you have any update related to either Blackbeard West, which has been drilling, or any future drilling plans in that area of the world.
Henry Hubble: Our Blackbeard project is continuing to drill. It is a tight hole, so we do not really have any information that I can provide you on it at this point, and...
Arjun Narayana Murti - Goldman Sachs: Do you have follow-up drilling plans? Maybe not on that prospect, but for other prospects that are firm? Or is it contingent on the outcome of that well?
Henry Hubble: That is the activity that we have there -- no other plans at this point. That is it.
Operator: We will now move to Nicole Decker with Bear Stearns.
Nicole Decker - Bear, Stearns & Co.: Your capture rate on your U.S. crude realizations, relative to the benchmark, seems to be higher this quarter than it has in the past. Would that be a reflection of the geographic mix, or maybe changes in your portfolio? Could you comment on that?
Henry Hubble: If you look at the totals, with the numbers I quoted in the $18.84 per barrel, that really reflects, similar to the correlations that are based on the rise in the commodity prices. We are seeing that on the overall portfolio, staying about in line with the things we provided in the past. In the U.S., I am not aware of anything that would have shifted that. Again, we look at it on a portfolio basis. There is not anything I can point to for you there.
Nicole Decker - Bear, Stearns & Co.: Secondly, what did Erha contribute to second quarter production?
Henry Hubble: I do not know if I have that. We may want to take that off-line. I do not really have it. It is currently running about 200,000 barrels a day, but I do not know what the actual delta was for the quarter.
Nicole Decker - Bear, Stearns & Co.: Which day did that start, Henry?
Henry Hubble: The date of start-up?
Nicole Decker - Bear, Stearns & Co.: Yes.
Henry Hubble: Again, we can get you that detail off-line, if you want to come back.
Nicole Decker - Bear, Stearns & Co.: That is fine. Thank you.
Operator: We will now take our next question from Neil McMahon with Bernstein.
Neil McMahon - Sanford C. Bernstein & Company, Inc.: Two things -- could you offer some guidance on the U.K. tax rates that I presume you are going to be taking in the third quarter? Seems that some of your competitors have been doing that just to help with earnings. Secondly, maybe you could give an update on when you think wells will be drilled in the wildcat exploration wells in the Orphan Basin and offshore Caribbean/Columbia. I am presuming Madagascar is an '07 well.
Henry Hubble: If you look at U.K. effects, we are still finalizing calculations there, but we estimate that we will take a one-time charge in the third quarter of $0.01 to $0.02 per share. On the drilling, Orphan will be in the fourth quarter of '06. I would have to get back to you on some of the other specifics. Madagascar I believe is '07, but I would have to get you -- it is ’07.
Neil McMahon - Sanford C. Bernstein & Company, Inc.: Columbia, is that '07 as well?
Henry Hubble: No, off the top of my head, I do not know. I would have to get that you.
Operator: We will now move to our next question from Paul Sankey with Deutsche Bank.
Paul Sankey - Deutsche Bank: Henry, with these kind of profits, you are going to attract negative attention from Washington, D.C. Could you comment generally on the risks that you face from lawmakers, particularly in this election year? Could you comment specifically on the potential impact of two pieces of legislation that are out there, firstly on price gouging and secondly on LIFO, FIFO? Thank you.
Henry Hubble: The real focus of helping to reduce the pressure that is in the market today is to get additional supplies. So we look at things, windfall profits and some of the other ideas that have been kicked around that basically are going to reduce the funds available for increasing supplies. Again, we are sharing the impacts of the investments that we have been making here to bring supplies on line, which is really going to be the key. There were investigations around price gouging, and really nothing that was -- for one, it is hard to define what that means -- but there was nothing they could come back to that really pointed at any issues that certainly we were involved with. The LIFO, FIFO, it has been one of those ideas out there. Certainly it has been a longstanding practice, a LIFO industry practice, and it is not just an impact on the oil industry. Again, that is one that I do not know where it is going to go, but we do not think it is a very good idea.
Paul Sankey - Deutsche Bank: Are you -- you are not taking any provisions for these risks, I guess? You must be feeling that the likelihood of actual action is quite slim.
Henry Hubble: You have to be able to estimate what they are in order to take them and we cannot do that.
Operator: We will take our next question from Paul Cheng with Lehman Brothers.
Paul Cheng - Lehman Brothers : Two questions -- one, sequentially from the first to the second quarter, is there any big-time impact due to the price finalization, inventory gain or loss, or FX change?
Henry Hubble: If you look at the price finalization impacts, the absolute numbers in the second quarter, basically we had $95 million overall, and that was split about 50/50 between U.S. and non-U.S. on an absolute. If you look at the comparison, quarter on quarter, it was about $50 million negative, with most of that in non-US.
Paul Cheng - Lehman Brothers : How about inventory, and also FX?
Henry Hubble: The only adjustment we have on inventory comes at the end of the year, so there is no LIFO effects in these kinds of numbers. If you look at the for-ex, we had, quarter versus quarter, it was about $41 million positive…
Paul Cheng - Lehman Brothers : Hello?
Henry Hubble: Yes? Sorry, there was somebody else on the line. It was $41 million positive overall…
Paul Cheng - Lehman Brothers : Hello?
Henry Hubble: Hello? Yes, somehow we have some interference on the call here. It sounds like we have a crossed line.
Paul Cheng - Lehman Brothers : I guess we should just continue.
Henry Hubble: Yes, right. Anyway, $41 million in total, 73 of that positive in the downstream and about $50 million negative in the upstream.
Paul Cheng - Lehman Brothers : Perfect. The second question is that we have heard, some of your competitors were talking about they have seen signs of a slowdown in the cost pressure for the upstream area in [inaudible] and other area. I am wondering if you have anything you can share with us. Have you guys seen a slowdown in the cost pressure or are they still as [ripe] as they have been?
Henry Hubble: As you know, this is an area where we work very hard, through existing contracting strategies and other things, technology, to reduce the impacts. We do an awful lot to offset these pressures. Things are still high and the pressures are still out there, but we have been successful in offsetting, and continue -- if I look at overall op-ex, we have self-help kinds of improvements, other things that have allowed us to offset inflation. In our project management, we are doing a lot of things to mitigate the cost pressures here. Rate of acceleration or deceleration, it is hard to say. It may be moderating a bit.
Operator: We will now move to our next question from Daniel Barcelo of Banc of America.
Daniel Barcelo - Banc of America Securities : A question on gasoline, if I could. You mentioned you are one of the larger handlers of ethanol. There are a lot of expectations for supply to increase almost by 30% over the next year or so. How an advantaged position are you in logistically to take advantage of that arbitrage, if indeed the ethanol price is advantageous to gasoline? Also as it relates to gasoline, [inaudible] sulfur credits are also kind of running out. How advantaged are you in that position also to take effect of that?
Henry Hubble: We are generally buying on a delivered basis for the ethanol, and we are one of the largest blenders of it. We have had a long history, actually, of blending ethanol when it has been advantaged. So we end up taking advantage of that as it presents itself. I do not see any particular advantage that I would say we have over industry. We are in good shape on gasoline sulfur and we are in good shape on the ultra-low sulfur diesel that is coming. I do not see any issues on that front.
Daniel Barcelo - Banc of America Securities : Then if I could on production, it was very strong, even if you exclude Upper Zakum year-over-year. In terms of the start-ups, I do not know if you could provide any sort of update from the February meeting. I know you had seven to eight scheduled for this year. How is rig cover for this year and next, and going forward? Do you have any color on that?
Henry Hubble: If you look at the project start-ups, it has been a very good list of [inaudible]. We are still benefiting, of course, year on year with Kizomba B, AKG-1, Ross Gas Train 4, Erha start up this year, Bonga, Yoho, ACG benefits coming in, [Socklan 1] -- so we have a very strong set of projects that are all contributing. If we look ahead, we have a great portfolio. The only one that we have right now that has slipped some is on Thunder Horse, and I think you have heard something about that already. It is probably best to talk to the operator about it.
Operator: Our next question will come from Mark Gilman with the Benchmark Company.
Mark Gilman - Benchmark Capital: A couple of things, if I could. Should I infer from your prior comments that the asset sale gains on an absolute basis in the second quarter were $350 million or more, and primarily U.S. E&P?
Henry Hubble: I was just giving some pieces of the total. There are up’s and down’s and other factors.
Mark Gilman - Benchmark Capital: Let me ask specifically -- what were the asset sale gains in the second quarter and where were they located segment-wise?
Henry Hubble: Just looking for the data, you can call us for some details on that, if you would like to go through the specifics. The big piece, as I said, was we had a number of various sales in U.S. and other, outside the U.S., and Four Corners was one of the big pieces. We can get you more specifics. There were a number of them.
Mark Gilman - Benchmark Capital: Okay, I will follow-up off-line. Secondly, tax rate dropped down to 44.2%. I assume part of that was the Canadian deferred tax adjustment, which I would appreciate if you could quantify. Is there anything else other than change-in-mix effects that is responsible for moving it down to the 44.2%?
Henry Hubble: It is kind of in line with the guidance we provided. There are a lot of factors that affect the tax rate and it is difficult to project exactly what those impacts will be going into the quarter. I had mentioned that Canadian was about $200 million, and that is a piece of it. But it is in line with the guidance. We are expecting about this same level going forward.
Mark Gilman - Benchmark Capital: Of 44%?
Henry Hubble: Yes, about.
Mark Gilman - Benchmark Capital: The $200 million on Canada, you said was an upstream number, I believe. Is there not a downstream piece also?
Henry Hubble: The bulk of it is upstream, but that it about the total on it.
Mark Gilman - Benchmark Capital: In the release, you talk about new project contributions of 243,000 a day in the second quarter. That relates to projects over what period of time, Henry?
Henry Hubble: That is a net number. You have declines in there, you have maintenance in there, you have a number of different factors. That is a net positive that comes from all of that. Again, we can go through the bridge with you off-line, but that is the net.
Mark Gilman - Benchmark Capital: Just one final one for me. If there were a front-end payment on the Upper Zakum entry, would that be included in either your prior or your upward revised capital budget estimate?
Henry Hubble: It is in our capital expenditures, yes.
Mark Gilman - Benchmark Capital: Thank you.
Operator: We will go next to John Herrlin with Merrill Lynch.
John Herrlin - Merrill Lynch: Just two quick upstream ones -- could you repeat the current production on Erha again? It sounded like you said 200,000 barrels a day, Henry, but I thought it was only supposed to be producing 190.
Henry Hubble: That is about what it is at right now. It is actually above the expected volumes.
John Herrlin - Merrill Lynch: Does that include the north satellite?
Henry Hubble: No. It has been performing very well. We are real pleased.
John Herrlin - Merrill Lynch: Next one for me is on U.K. gas. Even for seasonality and maintenance, it looked a little bit lower than in past years, so is that normal field declines, asset rationalization -- what is going on there?
Henry Hubble: There was some demand impact associated, weather-related impacts quarter on quarter for the two years. Of course, you also have planned maintenance that is a little higher than it was last year right now, or in the second quarter.
John Herrlin - Merrill Lynch: Last one for me, no issues getting equipment or anything for your upstream projects?
Henry Hubble: We continue to work that, and we have not had to delay anything that I can point to because of lack of availability, but it does impact forward schedules as you are trying to get access. That is really how we are working it through, but I cannot point to anything that is moving out of our schedule because of those issues.
Operator: Mr. Hubble, at this time there are no further questions. I will turn it back over to you for any closing remarks.
Henry Hubble: Thank you. Just before we end the call, I would like to summarize a few main points. Exxon Mobil remains committed to providing product to the market safely, reliably, efficiently and responsibly. As you can see from the results announced today, we are delivering on the commitments to our shareholders, customers, employees, and the communities in which we operate. We understand this is an important role entrusted to us by millions of people around the globe who rely on this supply every day, and we believe that our strategies and strengths will help us continue to deliver on that promise. I would like to thank you for participating in the call.
Operator: That does conclude the conference for today. Thank you for your participation, and have a great day. | [
{
"speaker": "Executives",
"text": "Henry Hubble - Vice President, Investor Relations and Secretary"
},
{
"speaker": "Analysts",
"text": "Douglas Terreson - Morgan Stanley Dean Witter Doug Leggate - Citigroup Bruce Lanni - A.G. Edwards & Sons, Inc. Robert Kessler - Simmons & Company International Mark Flannery - Credit Suisse First Boston Jennifer Rowland - JPMorgan Chase & Co. Arjun Narayana Murti - Goldman Sachs Nicole Decker - Bear, Stearns & Co. Neil McMahon - Sanford C. Bernstein & Company, Inc. Paul Sankey - Deutsche Bank Paul Cheng - Lehman Brothers Daniel Barcelo - Banc of America Securities Mark Gilman - Benchmark Capital John Herrlin - Merrill Lynch"
},
{
"speaker": "Operator",
"text": "Good day and welcome to this Exxon Mobil Corporation second quarter 2006 earnings conference call. Today’s call is being recorded. At this time for opening remarks, I would like to turn the call over to the Vice President of Investor Relations and Secretary, Mr. Henry Hubble. Please go ahead, sir."
},
{
"speaker": "Henry Hubble",
"text": "Thank you, and welcome, everybody, to Exxon Mobil's teleconference and webcast on our second quarter 2006 financial and operating results. As you are aware from this morning's press release, we have had another strong quarter as we continue to benefit from the performance of our world-class investments through good operations, production growth, and strong industry conditions. Although our company benefits from these conditions, we do recognize the impact today's high energy prices have on consumers and family budgets. Therefore, before I begin and comment on the business line results, I will share with you some of the milestones that include work we have done that will bring more product to the market and ease supply pressure. At this point, I would like to draw your attention to our cautionary statement. Please note that estimates, plans and projections are forward-looking statements. Actual results, including resource recoveries, volume growth and product outcomes could differ materially due to factors I will discuss and factors noted in our SEC filings. Please see the factors affecting future results in the Form 8-K we furnished this morning, which are available through the Investor Information section of our website. Please also see the frequently used terms, the supplement to this morning's 8-K, and the 2005 financial and operating review on our website. This material defines certain financial and operating terms I will use today, shows Exxon Mobil's net interest in specific projects, and includes information required by SEC regulation G. I am pleased to turn your attention to the specific results. Exxon Mobil's second quarter net income and normalized earnings were $10.4 billion, or $1.72 per share. This was a record second quarter, and represents an increase of $2.5 billion, or 32% versus second quarter 2005 normalized earnings. This performance was driven by strong crude prices and refining margins, as well as by continued focus on operational excellence and cost-containment. Before discussing the business line details, I will highlight some of the key milestones that occurred since our last earnings call. Within the up-stream, we started operations at the Guntong E gas compression platform in the South China Sea to help meet increasing gas demands in Malaysia. The platform is the first phase of the Guntong hub development and when combined with the existing Guntong D production and compression platforms, will have gas handling capacity of more than 800 million cubic feet of gas per day, to process production from current and future gas developments offshore peninsular Malaysia. The Guntong E platform is located approximately 130 miles off the East Coast of peninsular Malaysia, in water depths of 210 feet, and is operated by Exxon Mobil Exploration and Production Malaysia, Incorporated. In July, Exxon Mobil, the State of Qatar and Qatar Petroleum announced the launch of the Al Khaleej Gas Phase-2 project. AKG-2 is being developed to supply natural gas to domestic markets while recovering associated condensate and natural gas liquids for export. Phase-2 start-up is scheduled for late 2009. Phase-1 of Al Khaleej Gas, with a capacity of 750 million cubic feet per day of gas, began production in November, 2005. Exxon Mobil has 100% interest in the project. The East Area Additional Oil Recovery Project, located 17 miles offshore Nigeria, started up in June. Mobil Producing Nigeria is the operator and has a 40% interest. The project involves the re-injection of natural gas to mitigate production decline in East Area reservoirs and increase ultimate oil recovery. It is expected that the project will produce 530 million gross barrels of additional oil reserves and provide a peak volume of 120,000 barrels a day of oil. The development will also further reduce routine flaring at the facilities. In the down-stream, we completed the transition of our facilities to meet ethanol blending requirements in the U.S. The transition was completed smoothly without any supply disruptions. Similarly, we are pleased with the progress to meet ultra-low sulfur diesel requirements. We completed terminal and pipeline construction projects, and began producing ultra-low sulfur diesel from our refineries in the U.S. and Canada. Our plans are on track to meet regulatory deadlines and we do not anticipate any supply disruptions associated with the transition of our remaining facilities. In July, we announced plans to construct a new co-generation unit at the Antwerp integrated refining and chemical complex in Belgium. This unit will have the capability to produce 130 megawatts of power, or the equivalent of electricity to supply 300,000 Belgian households. It will also decrease carbon dioxide emissions by approximately 200,000 tons per year, or the equivalent of taking about 90,000 cars off the road. Co-generation, the simultaneous production of electricity and heat or steam, has been a significant factor in improving energy efficiency at Exxon Mobil facilities around the world while reducing air emissions. Exxon Mobil now has interest in 85 co-generation facilities in more than 30 locations worldwide. We have previously discussed our process of continuously and rigorously assessing our global portfolio of businesses and their opportunities for growth, restructuring, or divestment. In July, we announced plans to divest the Ingolstadt Refinery, the Bavarian industrial wholesale business, and Esso Bayern, which primarily runs the home heating oil direct business. The change of ownership is expected to be complete by early 2007, pending approval from authorities. In chemical, there are two milestones I will comment on now. We introduced a line of compounded polypropylene that is used in external and internal automobile applications, such as bumpers and internal trim. These new products complement our existing polypropylene production lines, providing customers with a complete line of products for automotive interior, exterior, and under-the-hood applications. Our ongoing investment in technology and compounding expertise provides us competitive advantage and highlights our commitment to the global automotive market. Regarding the Singapore chemical project, we continue to make good progress on our detailed study for a potential world-scale steam cracking complex that would be located at our existing Singapore refining and chemical site. In June, we announced the award of front-end engineering and design contracts for derivative units associated with the project, including polyethylene, polypropylene, aromatics extraction, oxo alcohol and specialty elastomers. Over the next 10 years, we expect over 50% of key commodity petrochemical demand growth to occur in Asia, with over a third in China alone. Exxon Mobil's established world-scale, fully-integrated refining and chemical facilities in Singapore and Saudi Arabia are well-positioned to supply these demands and this potential second steam cracker complex would further strengthen our advantage in supplying these growing markets. Turning now to the business line results, please refer to the earnings reconciliation in the IR supplement. Upstream normalized earnings in the first quarter were $7.1 billion. This represents an increase of $2.2 billion versus the second quarter of 2005. After tax, upstream unit earnings were also strong at $18.84 per barrel. Worldwide crude realizations were $64.93 per barrel, up $17.77 from second quarter 2005. The higher realizations were responsible for $2.1 billion of the increase in earnings from the second quarter of 2005. Other items, primarily higher property sales, more than offset an unfavorable change in volume mix. Oil equivalent volumes increased 6% versus the same quarter last year, with increases in Africa and the Middle East more than offsetting natural field declines and divestments in North America and Europe. Excluding the impact of divestments and entitlements, production increased 9%. Liquids production increased 230,000 barrels per day, or over 9% versus the same quarter last year. Excluding entitlements and divestments, liquids production increased 14%. The Kizomba B and Erha start-ups and the addition of Upper Zakum were the biggest sources of the additional liquids volumes. Gas volumes increased 60 million cubic feet per day, or about 1% versus the second quarter of 2005. Higher production in Qatar was offset by natural field decline and planned maintenance in North America and Europe. Turning to the sequential comparison, upstream earnings increased by $750 million versus the first quarter of 2006. Improved realizations were essentially offset by normal seasonal declines in natural gas sales. Other factors, including higher property sales, Canadian tax changes, and lower litigation expenses increased sequential earnings. Liquids production was essentially unchanged from the first quarter of 2006, while gas production was down about 20% due to normal seasonal variations. For further data on regional volumes, please refer to the press release and IR supplement. Turning to the downstream. Overall, second quarter downstream normalized earnings of nearly $2.5 billion were up approximately $260 million over the second quarter of 2005. Industry margins accounted for $790 million of the increase, as higher worldwide refining margins more than offset lower marketing margins. The volume mix effect was a negative $350 million, due to lower refinery throughput primarily associated with increased turnaround activity. Other factors, primarily higher turnaround related operating costs and the absence of asset sales, further reduced earnings by $180 million. Sequentially, downstream earnings increased by approximately $1.2 billion, primarily due to higher refining margins. Volume mix effects reduced earnings by $110 million, mainly as a result of additional turnaround work that resulted in lower throughput. Other factors reduced earnings by $90 million, as higher operating costs, consistent with the additional planned workload, were partially offset by favorable for-ex. Turning to chemical results. Second quarter normalized earnings were $840 million, up slightly versus the second quarter of 2005. Higher feedstock costs resulted in lower margins that reduced earnings by $160 million but were more than offset by the impact of higher volumes, lower operating costs, and the absence of unfavorable tax items. Sequentially, chemical earnings decreased by about $110 million. Lower margins reduced earnings by $290 million but were partially offset by favorable mix effect, for-ex, and the absence of unfavorable tax items. Our near-term and long-term outlooks for the chemical business remain strong. We believe our unique business approach, underpinned by our technology leadership, continues to deliver a competitive advantage in this growing business. Turning now to the corporate and financing segment. Corporate and financing expenses of approximately $100 million were essentially flat with the second quarter of 2005. The effective tax rate for the second quarter was 44%. Our cash balance was $36.7 billion, and debt was $8.4 billion at the end of the second quarter. The corporation distributed a total of $7.9 billion to shareholders in the second quarter, through dividends and share purchases, to reduce shares outstanding, an increase of 48%, or $2.6 billion versus the second quarter of 2005. During the second quarter, Exxon Mobil purchased $6 billion of shares in excess of dilution, thereby reducing the number of shares outstanding by 1.7%. As of the end of the second quarter, our share repurchase program had reduced shares outstanding by 15% since they were started in 2000. As a result of our ongoing financial strength, purchases of shares to reduce shares outstanding will be increased to $7 billion in the third quarter, further demonstrating our commitment to return cash to shareholders. Cap-ex in the second quarter was $4.9 billion, up $360 million from the second quarter of 2005, primarily due to planned upstream activity. Our year-to-date cap-ex is $9.7 billion. Our full-year outlook for cap-ex has been increased by $1 billion to $20 billion, reflecting increased drilling and development activity, primarily in Africa, Europe, and the United States. Before we begin the question-and-answer portion of the call, I will summarize a few key factors underpinning our second quarter performance. The record results that we have reported today are the outcome of the strategies we have shared with you in the past. Our upstream is focused on maximizing profitable production and capturing and investing in projects that deliver superior returns. Our downstream objectives are to maintain best-in-class operations, to provide quality, value, products and services to our customers, while selectively investing to grow returns. The chemical business draws on the synergies available through access to advantage feedstocks and integration across Exxon Mobil operations, while selectively investing in growth opportunities. Our strong financial position continues to allow to us pursue an unparalleled capital program, while also providing significant shareholder distributions. That concludes my prepared remarks, but before we begin the questions, I would like to address some apparent confusion about the revenue numbers. There has been a U.S. financial accounting standard change which changed a longstanding industry practice of reporting related party buy-sell transactions. The accounting is now being reported on a net basis, with no impact on earnings. The change shows up as a reduction in both revenues and total costs. I would now be happy to take your questions."
},
{
"speaker": "Operator",
"text": "Thank you, Mr. Hubble. (Operator Instructions) We will take our first question from Doug Terreson with Morgan Stanley."
},
{
"speaker": "Douglas Terreson - Morgan Stanley Dean Witter",
"text": "In E&P, the other factor in relation to the first quarter of 2006 was $710 million, I believe, and that is a number that is even relevant for Exxon Mobil. I wanted to see if you could provide some color and maybe some quantification on the primary components of that figure?"
},
{
"speaker": "Henry Hubble",
"text": "Yes, you are looking at the sequential comparison?"
},
{
"speaker": "Douglas Terreson - Morgan Stanley Dean Witter",
"text": "I am."
},
{
"speaker": "Henry Hubble",
"text": "Yes, the biggest piece, as I mentioned, is associated with property sales, and there were various sales in there. It included Four Corners and some others. If you would like more detail on that, we can follow up with you. There was also a favorable tax impact in Canada, about $200 million, and then there is the absence of litigation we had in the first quarter associated with the Grefer case, and that was about $160 million."
},
{
"speaker": "Douglas Terreson - Morgan Stanley Dean Witter",
"text": "One more question, in E&P, it appears that the Gorgon Project in Australia may be faced with rising estimates for capital investment and environmental issues. To my knowledge, Exxon has not announced any sales agreement on that project either. I wanted to see if you could provide an update on the status of that project, as well as any new timetables that may have materialized, if any new timetables have, as it relates to commercialization of that project?"
},
{
"speaker": "Henry Hubble",
"text": "We continue to work with the operator -- and as you know, Chevron is operating that one -- to progress an environmentally and economically-sound project. There was some advice that we are disappointed with from the EPA to the government, and we are appealing that recommendation. Further questions, I really cannot get into the specifics. It is probably better to address that back to the operator."
},
{
"speaker": "Operator",
"text": "We will take our next question from Doug Leggate from Citigroup."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "A couple of things on the -- it seems much more exhausting than it really is. A couple of questions on the downstream, please. First of all, the utilization rate on refining was a little lower than I was expecting. Can you quantify the planned versus [inaudible] down-time, and maybe give an outlook for the back-half of the year?"
},
{
"speaker": "Henry Hubble",
"text": "If you look at the bulk of the impact on the throughputs, it was basically turnaround related. Most of that input, 299-plus, was associated with turnaround. The turnaround workload normally is higher in the first-half of the year, and this year was a little higher than normal. Some of it associated with the ultra-low sulfur diesel implementations. If you look at the turnaround workload, it is about 75% complete for this year, so we have seen the bulk of it is behind us."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "That is very helpful. The only follow-up I have is marketing. Can you give us some idea of the marketing delta sequentially and year-over-year, if that is possible?"
},
{
"speaker": "Henry Hubble",
"text": "If you are looking at the delta…are you talking volumes or…"
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "No, just the earnings impact would be fine."
},
{
"speaker": "Henry Hubble",
"text": "As we talked about, the bulk of the marketing impact in the year-to-year numbers is about -- on a sequential basis, it was about $60 million in margins, and then quarter on quarter, it was about 150, a little more, in margins, down -- down. [Multiple Speakers]"
},
{
"speaker": "Henry Hubble",
"text": "I beg your pardon?"
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Were U.S. and international still positive for the quarter?"
},
{
"speaker": "Henry Hubble",
"text": "In terms of absolute earnings? We do not really get into the specifics on that, but if you looked -- margins in general were down across the world, and really that reflects the lag effect you see from rising crude prices and subsequent feedstocks through the refinery. That is what most of that is -- compression due to the rising crude prices."
},
{
"speaker": "Operator",
"text": "We will now take our next question from Bruce Lanni with A.G. Edwards."
},
{
"speaker": "Bruce Lanni - A.G. Edwards & Sons, Inc.",
"text": "Actually a question that piggybacks on what Doug was asking on the downstream, basically I was wondering -- could you give some further clarification on the refined product sales numbers? Obviously they were down year over year, and I was looking, the throughputs were down too. Was most of the decline in product sales due to the lower throughputs year over year?"
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Bruce Lanni - A.G. Edwards & Sons, Inc.",
"text": "Was it primarily in distillates rather than gasoline? I am trying to get a fix on what you are seeing on the gasoline side."
},
{
"speaker": "Henry Hubble",
"text": "If I look at the overall petroleum product sales, we were down about 2% in total, and if you look at the actual -- I am talking sequentially now, first quarter versus second quarter -- we were down about 2% overall. The bulk of that associated with the turnaround activities. If you look at mix, we were actually up some on gasoline, down some on diesel, across that timeframe. That is normal, seasonal kind of stuff. If you looked at it on a year-to-year basis, we were down about equally -- gasoline and heating oil, again reflecting the turnaround effects."
},
{
"speaker": "Bruce Lanni - A.G. Edwards & Sons, Inc.",
"text": "In the U.S. then in particular, what are you witnessing right now as far as the gasoline sales go? Anecdotally, are you seeing relatively strong sales in…"
},
{
"speaker": "Henry Hubble",
"text": "If you look -- a general question about demands, it is really hard to get behind what is going on on a short-term basis, because there is a lot of moving around on consumption numbers. We continue to see demand grow year on year. We are running our capacity full. We are selling everything we can make. When we step back from it, normally it correlates best with GDP growth, and we see economies are still performing well around the world. You see the strong margins, which is basically being driven by clean products demand growth. That is what we are really seeing here."
},
{
"speaker": "Operator",
"text": "Our next question will come from Robert Kessler with Simmons & Company."
},
{
"speaker": "Robert Kessler - Simmons & Company International",
"text": "You have no doubt seen the announcement on Shell's Pearl GTL project this morning and the revised implied cost there. I was wondering if you might provide us with any update you could on your preliminary $7 billion estimate for your own GTL project in that country."
},
{
"speaker": "Henry Hubble",
"text": "We signed the Heads of Agreement in July of 2004, as you probably know. Our project is about 154 KBD plant and we are working with Qatar Petroleum to finalize the DIPSA associated with it, and to complete the other commercial agreements associated with the project. We still have some appraisal well activities that we have to do on that. We will be updating the costs as we get closer, but this project, the technology we have here is a bit unique too, in that the yields that we get are a lot higher in terms of the distillate yield or the [LU-base] stock yield, which is one of things that advantages the project that we are looking at."
},
{
"speaker": "Robert Kessler - Simmons & Company International",
"text": "I appreciate you still have some more fine-tuning then on the cost estimates, but roughly speaking -- above or below two times the $7 billion?"
},
{
"speaker": "Henry Hubble",
"text": "We are still in the mode of updating that and I do not have a number to offer you at this time. Just in general, obviously everybody is seeing cost pressures. We are working cost pressures, we work these things hard -- we do a lot to offset them, but we are really just not in a position to come back with a number at this point."
},
{
"speaker": "Operator",
"text": "We will now move to Mark Flannery with Credit Suisse."
},
{
"speaker": "Mark Flannery - Credit Suisse First Boston",
"text": "Two unrelated questions, the first is about the increase in cap-ex. You seemed to indicate in your prepared remarks that was all or substantially due to higher activity. Is any of it due to higher costs or not?"
},
{
"speaker": "Henry Hubble",
"text": "We have cost pressures just like everybody else has cost pressures, when you look at the pressure on op-ex and other things. When you look at those, the primary piece, the bulk of that is associated with drilling activity in Nigeria -- we are accelerating. We have worked through some of the issues on Kizomba C and have been able to accelerate that. We also have increased drilling in Europe and the U.S., so when you look at the overall numbers, there are still some cost inflation associated with that, but it would be less than a third of what we are seeing there."
},
{
"speaker": "Mark Flannery - Credit Suisse First Boston",
"text": "The second question is about renewables. There have been various announcements from industry participants about their interest in getting into renewables, be that in a corn-based ethanol in the States or bio-diesel in Europe. Do you have position on that? Are you looking at anything? What is your general take on those?"
},
{
"speaker": "Henry Hubble",
"text": "Most of the bio-fuels that are out there, in fact, there are very few that are economic without subsidies. The current generation of technology has limitations due to their costs, when you look at fertilizer requirements, land-use impacts, so our focus has really been that you are going to have to do things to reduce those costs, so we are investing in breakthrough technologies to find transportation fuel options that would successfully meet the supply requirements and demand challenges for the future. Right now, the technology that is out there basically requires subsidies for the long-haul. We do not think that makes sense to invest in at this point. We are a major buyer and blender of ethanol, so we are using those products. We also blend bio-diesel in Europe."
},
{
"speaker": "Operator",
"text": "We will now move to Jennifer Rowland with JP Morgan."
},
{
"speaker": "Jennifer Rowland - JPMorgan Chase & Co.",
"text": "I have a question on the share buyback program. I know you had said you planned on doing $7 billion in the next quarter. Can you just provide some guidance going forward as far as how we should think about the pace of your share buyback program? I know you are obviously committed to increasing it, but I did not know if there were any targets that you have as far as either a percentage of cash flow or a goal as far as reducing the amount of shares outstanding -- anything you could provide to help us."
},
{
"speaker": "Henry Hubble",
"text": "We do not have a target on that. We do not really provide forward guidance on that. We will update you as we are changing it, as we have been. If you step back and look at how we think about it, we are distributing cash to shareholders through dividends and the share repurchases. We tend to think about the dividends in the longer-term, and think of that more as a payout that we want to be able to increase steadily over time. We have had a 10% increase this year. Then, on the share buyback, it really is the more flexible component. Of course, the growth in it that you have seen is a reflection of the strong cash generation that we continue to deliver."
},
{
"speaker": "Jennifer Rowland - JPMorgan Chase & Co.",
"text": "Great. Lastly, on the cap-ex, any change to your outlook for 2007 to 2010 guidance, given that you plan on spending $20 billion now in 2006?"
},
{
"speaker": "Henry Hubble",
"text": "Not at this point. We will be updating that, normally in our analyst meeting. There is a range, of course, in there even with those numbers, because you are going to look at what advances or changes there are to those projects, but we will be updating that in the March timeframe."
},
{
"speaker": "Operator",
"text": "We will now move to Arjun Murti from Goldman Sachs"
},
{
"speaker": "Arjun Narayana Murti - Goldman Sachs",
"text": "Thank you. Henry, just a question on your ultra deep shelf drilling in the Gulf of Mexico, just wondering if you have any update related to either Blackbeard West, which has been drilling, or any future drilling plans in that area of the world."
},
{
"speaker": "Henry Hubble",
"text": "Our Blackbeard project is continuing to drill. It is a tight hole, so we do not really have any information that I can provide you on it at this point, and..."
},
{
"speaker": "Arjun Narayana Murti - Goldman Sachs",
"text": "Do you have follow-up drilling plans? Maybe not on that prospect, but for other prospects that are firm? Or is it contingent on the outcome of that well?"
},
{
"speaker": "Henry Hubble",
"text": "That is the activity that we have there -- no other plans at this point. That is it."
},
{
"speaker": "Operator",
"text": "We will now move to Nicole Decker with Bear Stearns."
},
{
"speaker": "Nicole Decker - Bear, Stearns & Co.",
"text": "Your capture rate on your U.S. crude realizations, relative to the benchmark, seems to be higher this quarter than it has in the past. Would that be a reflection of the geographic mix, or maybe changes in your portfolio? Could you comment on that?"
},
{
"speaker": "Henry Hubble",
"text": "If you look at the totals, with the numbers I quoted in the $18.84 per barrel, that really reflects, similar to the correlations that are based on the rise in the commodity prices. We are seeing that on the overall portfolio, staying about in line with the things we provided in the past. In the U.S., I am not aware of anything that would have shifted that. Again, we look at it on a portfolio basis. There is not anything I can point to for you there."
},
{
"speaker": "Nicole Decker - Bear, Stearns & Co.",
"text": "Secondly, what did Erha contribute to second quarter production?"
},
{
"speaker": "Henry Hubble",
"text": "I do not know if I have that. We may want to take that off-line. I do not really have it. It is currently running about 200,000 barrels a day, but I do not know what the actual delta was for the quarter."
},
{
"speaker": "Nicole Decker - Bear, Stearns & Co.",
"text": "Which day did that start, Henry?"
},
{
"speaker": "Henry Hubble",
"text": "The date of start-up?"
},
{
"speaker": "Nicole Decker - Bear, Stearns & Co.",
"text": "Yes."
},
{
"speaker": "Henry Hubble",
"text": "Again, we can get you that detail off-line, if you want to come back."
},
{
"speaker": "Nicole Decker - Bear, Stearns & Co.",
"text": "That is fine. Thank you."
},
{
"speaker": "Operator",
"text": "We will now take our next question from Neil McMahon with Bernstein."
},
{
"speaker": "Neil McMahon - Sanford C. Bernstein & Company, Inc.",
"text": "Two things -- could you offer some guidance on the U.K. tax rates that I presume you are going to be taking in the third quarter? Seems that some of your competitors have been doing that just to help with earnings. Secondly, maybe you could give an update on when you think wells will be drilled in the wildcat exploration wells in the Orphan Basin and offshore Caribbean/Columbia. I am presuming Madagascar is an '07 well."
},
{
"speaker": "Henry Hubble",
"text": "If you look at U.K. effects, we are still finalizing calculations there, but we estimate that we will take a one-time charge in the third quarter of $0.01 to $0.02 per share. On the drilling, Orphan will be in the fourth quarter of '06. I would have to get back to you on some of the other specifics. Madagascar I believe is '07, but I would have to get you -- it is ’07."
},
{
"speaker": "Neil McMahon - Sanford C. Bernstein & Company, Inc.",
"text": "Columbia, is that '07 as well?"
},
{
"speaker": "Henry Hubble",
"text": "No, off the top of my head, I do not know. I would have to get that you."
},
{
"speaker": "Operator",
"text": "We will now move to our next question from Paul Sankey with Deutsche Bank."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Henry, with these kind of profits, you are going to attract negative attention from Washington, D.C. Could you comment generally on the risks that you face from lawmakers, particularly in this election year? Could you comment specifically on the potential impact of two pieces of legislation that are out there, firstly on price gouging and secondly on LIFO, FIFO? Thank you."
},
{
"speaker": "Henry Hubble",
"text": "The real focus of helping to reduce the pressure that is in the market today is to get additional supplies. So we look at things, windfall profits and some of the other ideas that have been kicked around that basically are going to reduce the funds available for increasing supplies. Again, we are sharing the impacts of the investments that we have been making here to bring supplies on line, which is really going to be the key. There were investigations around price gouging, and really nothing that was -- for one, it is hard to define what that means -- but there was nothing they could come back to that really pointed at any issues that certainly we were involved with. The LIFO, FIFO, it has been one of those ideas out there. Certainly it has been a longstanding practice, a LIFO industry practice, and it is not just an impact on the oil industry. Again, that is one that I do not know where it is going to go, but we do not think it is a very good idea."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Are you -- you are not taking any provisions for these risks, I guess? You must be feeling that the likelihood of actual action is quite slim."
},
{
"speaker": "Henry Hubble",
"text": "You have to be able to estimate what they are in order to take them and we cannot do that."
},
{
"speaker": "Operator",
"text": "We will take our next question from Paul Cheng with Lehman Brothers."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Two questions -- one, sequentially from the first to the second quarter, is there any big-time impact due to the price finalization, inventory gain or loss, or FX change?"
},
{
"speaker": "Henry Hubble",
"text": "If you look at the price finalization impacts, the absolute numbers in the second quarter, basically we had $95 million overall, and that was split about 50/50 between U.S. and non-U.S. on an absolute. If you look at the comparison, quarter on quarter, it was about $50 million negative, with most of that in non-US."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "How about inventory, and also FX?"
},
{
"speaker": "Henry Hubble",
"text": "The only adjustment we have on inventory comes at the end of the year, so there is no LIFO effects in these kinds of numbers. If you look at the for-ex, we had, quarter versus quarter, it was about $41 million positive…"
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Hello?"
},
{
"speaker": "Henry Hubble",
"text": "Yes? Sorry, there was somebody else on the line. It was $41 million positive overall…"
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Hello?"
},
{
"speaker": "Henry Hubble",
"text": "Hello? Yes, somehow we have some interference on the call here. It sounds like we have a crossed line."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "I guess we should just continue."
},
{
"speaker": "Henry Hubble",
"text": "Yes, right. Anyway, $41 million in total, 73 of that positive in the downstream and about $50 million negative in the upstream."
},
{
"speaker": "Paul Cheng - Lehman Brothers",
"text": "Perfect. The second question is that we have heard, some of your competitors were talking about they have seen signs of a slowdown in the cost pressure for the upstream area in [inaudible] and other area. I am wondering if you have anything you can share with us. Have you guys seen a slowdown in the cost pressure or are they still as [ripe] as they have been?"
},
{
"speaker": "Henry Hubble",
"text": "As you know, this is an area where we work very hard, through existing contracting strategies and other things, technology, to reduce the impacts. We do an awful lot to offset these pressures. Things are still high and the pressures are still out there, but we have been successful in offsetting, and continue -- if I look at overall op-ex, we have self-help kinds of improvements, other things that have allowed us to offset inflation. In our project management, we are doing a lot of things to mitigate the cost pressures here. Rate of acceleration or deceleration, it is hard to say. It may be moderating a bit."
},
{
"speaker": "Operator",
"text": "We will now move to our next question from Daniel Barcelo of Banc of America."
},
{
"speaker": "Daniel Barcelo - Banc of America Securities",
"text": "A question on gasoline, if I could. You mentioned you are one of the larger handlers of ethanol. There are a lot of expectations for supply to increase almost by 30% over the next year or so. How an advantaged position are you in logistically to take advantage of that arbitrage, if indeed the ethanol price is advantageous to gasoline? Also as it relates to gasoline, [inaudible] sulfur credits are also kind of running out. How advantaged are you in that position also to take effect of that?"
},
{
"speaker": "Henry Hubble",
"text": "We are generally buying on a delivered basis for the ethanol, and we are one of the largest blenders of it. We have had a long history, actually, of blending ethanol when it has been advantaged. So we end up taking advantage of that as it presents itself. I do not see any particular advantage that I would say we have over industry. We are in good shape on gasoline sulfur and we are in good shape on the ultra-low sulfur diesel that is coming. I do not see any issues on that front."
},
{
"speaker": "Daniel Barcelo - Banc of America Securities",
"text": "Then if I could on production, it was very strong, even if you exclude Upper Zakum year-over-year. In terms of the start-ups, I do not know if you could provide any sort of update from the February meeting. I know you had seven to eight scheduled for this year. How is rig cover for this year and next, and going forward? Do you have any color on that?"
},
{
"speaker": "Henry Hubble",
"text": "If you look at the project start-ups, it has been a very good list of [inaudible]. We are still benefiting, of course, year on year with Kizomba B, AKG-1, Ross Gas Train 4, Erha start up this year, Bonga, Yoho, ACG benefits coming in, [Socklan 1] -- so we have a very strong set of projects that are all contributing. If we look ahead, we have a great portfolio. The only one that we have right now that has slipped some is on Thunder Horse, and I think you have heard something about that already. It is probably best to talk to the operator about it."
},
{
"speaker": "Operator",
"text": "Our next question will come from Mark Gilman with the Benchmark Company."
},
{
"speaker": "Mark Gilman - Benchmark Capital",
"text": "A couple of things, if I could. Should I infer from your prior comments that the asset sale gains on an absolute basis in the second quarter were $350 million or more, and primarily U.S. E&P?"
},
{
"speaker": "Henry Hubble",
"text": "I was just giving some pieces of the total. There are up’s and down’s and other factors."
},
{
"speaker": "Mark Gilman - Benchmark Capital",
"text": "Let me ask specifically -- what were the asset sale gains in the second quarter and where were they located segment-wise?"
},
{
"speaker": "Henry Hubble",
"text": "Just looking for the data, you can call us for some details on that, if you would like to go through the specifics. The big piece, as I said, was we had a number of various sales in U.S. and other, outside the U.S., and Four Corners was one of the big pieces. We can get you more specifics. There were a number of them."
},
{
"speaker": "Mark Gilman - Benchmark Capital",
"text": "Okay, I will follow-up off-line. Secondly, tax rate dropped down to 44.2%. I assume part of that was the Canadian deferred tax adjustment, which I would appreciate if you could quantify. Is there anything else other than change-in-mix effects that is responsible for moving it down to the 44.2%?"
},
{
"speaker": "Henry Hubble",
"text": "It is kind of in line with the guidance we provided. There are a lot of factors that affect the tax rate and it is difficult to project exactly what those impacts will be going into the quarter. I had mentioned that Canadian was about $200 million, and that is a piece of it. But it is in line with the guidance. We are expecting about this same level going forward."
},
{
"speaker": "Mark Gilman - Benchmark Capital",
"text": "Of 44%?"
},
{
"speaker": "Henry Hubble",
"text": "Yes, about."
},
{
"speaker": "Mark Gilman - Benchmark Capital",
"text": "The $200 million on Canada, you said was an upstream number, I believe. Is there not a downstream piece also?"
},
{
"speaker": "Henry Hubble",
"text": "The bulk of it is upstream, but that it about the total on it."
},
{
"speaker": "Mark Gilman - Benchmark Capital",
"text": "In the release, you talk about new project contributions of 243,000 a day in the second quarter. That relates to projects over what period of time, Henry?"
},
{
"speaker": "Henry Hubble",
"text": "That is a net number. You have declines in there, you have maintenance in there, you have a number of different factors. That is a net positive that comes from all of that. Again, we can go through the bridge with you off-line, but that is the net."
},
{
"speaker": "Mark Gilman - Benchmark Capital",
"text": "Just one final one for me. If there were a front-end payment on the Upper Zakum entry, would that be included in either your prior or your upward revised capital budget estimate?"
},
{
"speaker": "Henry Hubble",
"text": "It is in our capital expenditures, yes."
},
{
"speaker": "Mark Gilman - Benchmark Capital",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "We will go next to John Herrlin with Merrill Lynch."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Just two quick upstream ones -- could you repeat the current production on Erha again? It sounded like you said 200,000 barrels a day, Henry, but I thought it was only supposed to be producing 190."
},
{
"speaker": "Henry Hubble",
"text": "That is about what it is at right now. It is actually above the expected volumes."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Does that include the north satellite?"
},
{
"speaker": "Henry Hubble",
"text": "No. It has been performing very well. We are real pleased."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Next one for me is on U.K. gas. Even for seasonality and maintenance, it looked a little bit lower than in past years, so is that normal field declines, asset rationalization -- what is going on there?"
},
{
"speaker": "Henry Hubble",
"text": "There was some demand impact associated, weather-related impacts quarter on quarter for the two years. Of course, you also have planned maintenance that is a little higher than it was last year right now, or in the second quarter."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Last one for me, no issues getting equipment or anything for your upstream projects?"
},
{
"speaker": "Henry Hubble",
"text": "We continue to work that, and we have not had to delay anything that I can point to because of lack of availability, but it does impact forward schedules as you are trying to get access. That is really how we are working it through, but I cannot point to anything that is moving out of our schedule because of those issues."
},
{
"speaker": "Operator",
"text": "Mr. Hubble, at this time there are no further questions. I will turn it back over to you for any closing remarks."
},
{
"speaker": "Henry Hubble",
"text": "Thank you. Just before we end the call, I would like to summarize a few main points. Exxon Mobil remains committed to providing product to the market safely, reliably, efficiently and responsibly. As you can see from the results announced today, we are delivering on the commitments to our shareholders, customers, employees, and the communities in which we operate. We understand this is an important role entrusted to us by millions of people around the globe who rely on this supply every day, and we believe that our strategies and strengths will help us continue to deliver on that promise. I would like to thank you for participating in the call."
},
{
"speaker": "Operator",
"text": "That does conclude the conference for today. Thank you for your participation, and have a great day."
}
] | null | null |
XOM | 1 | 2,006 | 2006-04-27 11:00:00 | Executives: Henry H. Hubble, Vice President of Investor Relations and Secretary
Analysts: Robert Kessler - Simmons & Company Doug Terreson - Morgan Stanley Neil McMahon - Bernstein Doug Leggate - Citigroup Arjun Murti - Goldman Sachs Paul Sankey - Deutsche Bank Mark Flannery - Credit Suisse Mark Gilman - Benchmark Company John Herrlin - Merrill Lynch Jennifer Rowland - JP Morgan Bruce Lanni - AG Edwards
Operator: Good day and welcome to this ExxonMobil Corporation First Quarter 2006 Earnings Conference Call. Today’s call is being recorded. At this time, for opening remarks, I would like to turn the conference over to the Vice President of Investor Relations and Secretary, Mr. Henry Hubble. Please go ahead sir.
Henry Hubble: Good morning. Welcome to ExxonMobil’s teleconference and webcast on our first quarter 2006 financial operating results. As you’re aware from this morning’s press release, we’ve had a strong quarter. Our portfolio of businesses have performed well and we’ve captured the benefits of the strong industry conditions. Before we go further, I would like to draw your attention to our cautionary statement. Please note that estimates, plans and projections are forward-looking statements. Actual results, including resource recoveries, volume growth, and project outcomes could differ materially due to factors I discuss and factors noted in our SEC filings. Please see Factors Affecting Future Results and the Form 8-K we furnished this morning, which are available through the investor information section of our website. Please also see the frequently used terms, the supplement to this morning’s 8-K, and the 2005 financial and operating review on our website. This material defines certain financial and operating terms I will use today, shows ExxonMobil’s net interest in specific projects, and includes information required by SEC Regulation G. Now I’m pleased to turn your attention to the specific results. ExxonMobil’s first quarter net income and normalized earnings were $8.4 billion, or $1.37 per share. This was a record first quarter and represents an increase of $1 billion versus the first quarter of 2005 normalized earnings. Industry conditions remain robust in our three core businesses. Before discussing the business details, I’d like to highlight some of the key milestones that occurred in the first quarter. Since our last earnings discussion, we’ve achieved a number of significant milestones in each of our business units. In late March, production started up from the world class Erha deepwater development, located approximately 60 miles offshore Nigeria, in 3900 feet of water. Erha production is expected to ramp up to 150,000 barrels of oil per day, by the third quarter. Erha North, a satellite development is expected to begin production in third quarter 2006 and will contribute an additional 40,000 barrels per day by yearend. These developments demonstrate ExxonMobil’s global project execution capability and deep water technology expertise. Erha is the second major facility startup for ExxonMobil affiliates in Nigeria this year. In February, Mobil Producing Nigeria started production from the full fuel facilities of the Yoho development project, following a successful early production system deployment. With estimated recoverable resources of 440 million barrels of oil, Yoho is currently producing about 160,000 barrels of oil, a day. ExxonMobil signed agreements with the Abu Dhabi National Oil Company to acquire a 28% undivided interest in the Upper Zakum Oil Field, offshore Abu Dhabi. Upper Zakum is one of the world’s largest oil fields and has potential for substantial production growth. The joint venture plans to increase production in this field by 50% from approximately 500,000 barrels of oil per day currently to 750,000. ExxonMobil signed a joint operating agreement with P.T. Pertamina for the Cepu Contract Area in Indonesia. The signing of the JOA enables some parties to begin the activities required to develop the discovered recourses and further explore the block during the 30-year contract period. The Banyu Urip field has that has already been discovered in the Cepu Contract Area is estimated to contain more than 250 million barrels of oil. At peak production, the field is expected to reach a rate of 165,000 barrels of oil per day. Recently, it was announced that ExxonMobil was selected as a recipient of two awards from the US department of the Interior Minerals Management Service. We are honored to receive the 2005 the Safe Operations and Accurate Reporting Award, in recognition of the company’s outstanding safety and physical management and reporting practices. We are also pleased to have received the Mineral’s Revenues Stewardship Award, in recognition of our performance in accurately reporting production volumes and paying the royalties as well as our cooperation with compliance request. These awards reflect the high standard of care that is applied to all aspects of our business. Exxon Mobil Pipeline Company commissioned their Canadian crude pipeline reversal project that provides access for Western Canadian crude oil to Gulf Coast refining markets, and expands sources of crude oil to the United States. This project has consistent with our refining initiatives to increase raw material flexibility and run more difficult to process crudes that our discounted in the marketplace. Challenge crude runs to our refineries are up over 60% since 2000. Also, in the downstream we are actively progressing plans to meet ethanol blending requirements, in the US by the end of April. We are pleased with the progress to-date and do not anticipate supply disruptions associated with the transition of our facilities. Our approach to operational excellence commits our organization to operating our assets to the highest standards of safety, reliability, efficiency and integrity. During the quarter, two of our downstream chemical plants were recognized; downstream and chemical plants were recognized for outstanding safety performance. The Baton Rouge Polyolefins plants earn the National Petrochemical and Refiners Association distinguished safety award for the fourth consecutive year. No other company has won this award for four years in a row. The Port Allen lubricant blend plant was awarded star status in the US Occupational Safety and Health Administrations voluntary protection program. The OSHA recognition certifies the comprehensive successful safety and health management system are implemented and the site has achieved injury and illness rates below industry national average. 16 of our facilities in the US have now received star certification and participate in OSHA’s voluntary protection program. The discipline commitment and effective day-to-day focus require to achieve highest level of safety performance are the same factors that lead to overall excellence in operations. Improved energy efficiency remains a core focus to lowering operating cost. In April, the US environmental protection agency and the US department of energy recognized ExxonMobil’s Baytown complex with the 2006 energy star combined heat and power award for the site’s cogeneration facilities. The facilities included 160 megawatt gas turbine generator coupled with the heat recover unit that can produce 560,000 pounds-per hour of steam for use and manufacturing processes. Using the most efficient technology available today, this cogeneration unit produces both steam and electricity at an efficiency of about twice that of producing electricity and steam separately. ExxonMobil has more than 85 cogeneration units located around the world that produce nearly 3,700 megawatts of electricity. Our cogeneration capacity is now enough to power nearly 3 million US homes. In chemical, we introduce new santoprene thermoplastic vulcanizate weatherseal grades for the automotive industry. Santoprene TPV’s have improved and effective in a wide range of automotive applications, such as weatherseals, interiors, exteriors and under the hood. These products can help reduce cost, speed up product development, improve performance and increased recycle ability. ExxonMobil is world’s leading supplier of TPVs to automotive industry. This is another example of how our ability to develop and apply leading edge technology, differentiates our performance. Turing now to the business line results. Please refer to the earnings reconciliation in the IR supplement. Upstream normalized earnings in the first quarter were $6.4 billion. This represents an increase of $1.3 billion versus the first quarter of 2005. Higher realizations of $2.2 billion were partially offset by a number of factors which include at a less favorable volume mix and charges associated with litigation and several pack provisions. Upstream after-tax unit earnings were strong in the first quarter of 2006. Worldwide crude sales realizations were $56.95 per barrel, up more than $14.35 from first quarter 2005. Oil equivalent volumes increased 5% versus the same quarter last year, with increases in Africa and the Middle East more than offsetting natural field declines and investments in North America and Europe. Excluding the effects of entitlements and asset sales production increased 7%. Liquids production increased to 152,000 barrels per day or 6% versus the same quarter last year with Kizomba B and the recently acquired interest in Upper Zakum being the lot biggest sources of the additional liquids volumes. Gas volumes increased 414 million cubic feet per day, or about 4% versus the first quarter of 2005. Our production in Qatar from the fourth quarter of 2005 RasGas train 4 and Al Khaleej start-ups and higher demand in Europe due to colder weather were mainly responsible for the increase. Turning to the sequential comparison versus the fourth quarter of 2005; upstream earnings decreased about $655 million due to lower asset sales and charges related to litigation and taxes referenced earlier, realizations were essentially flat as strong oil prices were offset by lower natural gas prices. Liquids production increased 3% due to higher volumes from Middle East while natural gas production was up 14% primarily due to colder weather in Europe. For further data on regional volumes please refer to the press release and IR supplement. Turning now to the downstream; overall first quarter downstream normalized earnings of $1.3 billion were up approximately $130 million over the first quarter of 2005. Higher industry margins accounted for $60 million as stronger US refining and marketing margins were partially offset by lower international margins. The volume mix effect was a positive $50 million. Our ongoing self help improvements to increase production of high-value products and lower raw material cost coupled with strong first quarter loop sales more than offset lower or primary throughput, primarily associated with increased turnaround activity. We set 26 new monthly unit rate or production records during the quarter and ran 4 new crudes to ExxonMobil and 34 new to individual refineries. We continue our long-term focus on improving our raw material flexibility as well as increasing our refining capacity to improve reliability and selective capital investments. Sequentially, downstream earnings decreased by about $1.1 billion due primarily to lower worldwide refining and marketing margins. The volume mix effect reduced earnings by $70 million as lower refinery throughput, primarily associated with increased turnaround activity was partially offset by the absence of hurricane impacts. Now turning to Chemical results; our chemical business had another good quarter underpinned by strong manufacturing performance and market conditions. First quarter normalized earnings of $915 million were strong as sales volumes returned to pre-hurricane levels. When compared with the record first quarter 2005, earnings were down approximately $330 million due to lower margins, total volumes were similar quarter-on-quarter, but favorable mix effects partially offset the margin impact. Sequentially, first quarter chemical earnings increased by about $110 million, a 10% increase in sales volumes accounted for 160 million positive effects, as first quarter volumes were strong, while fourth quarter volumes were lower primarily due to the hurricanes. Lower first quarter margins partially offset the higher sales volume. Turning now to the corporate and financing segment; corporate and financing expenses of approximately $200 million were up about $120 million from the first quarter of 2005, primarily due to several tax items. The effective tax rate for the first quarter was 47%, our guidance for the long-term tax rate remains unchanged in the 40% to 45% range, although it may trend for the upper end of this range. Our cash balance was $36.5 billion and debt was $8 billion at the end of the first quarter. The corporation distributed a total of $7 billion to shareholders in the first quarter through dividends and share repurchases to reduce shares outstanding, an increase of 67% or $2.8 billion versus the first quarter 2005. During the first quarter, ExxonMobil purchased $5 billion of shares to reduce shares outstanding. As a result of our ongoing financial strength purchases the shares to reduce shares outstanding will be increased to $6 billion in the second quarter. Within the last year alone, the quarterly share repurchase program has nearly doubled, which further demonstrates our ongoing commitment to return cash to shareholders. CapEx in the first quarter was $4.8 billion, up $1.4 billion from the first quarter of 2005, primarily due to planned upstream activity. Our full year outlook is approximately $119 billion, consistent with the outlook presented at our March analyst meeting. Before we move to the Q&A, I would like this take a moment to summarize the key messages from this morning’s call. Our strong first quarter results reflects the strong commodity prices and our fundamental business model that is disciplined, straight forward and focused on generating value while managing risk. We are extremely pleased to have the opportunity to participate in the Upper Zakum Field. We look forward to assisting the already strong Zakum development company in increasing production and cooperating closely with the Abu Dhabi National Oil Company. Our selection by ADNOC is an honor and demonstrates the strength of our technical capabilities. Our superior project management skill continues to be displayed by delivery of our operated startups, on time and on budget. Our broad and diverse portfolio projects create ongoing opportunities to continue to bring new resources online and helps supply the world’s growing need for energy. That concludes my prepared remarks and I would now be happy to take your questions.
Operator: Thank you Mr. Hubble. The question and answer session will be conducted electronically. (Operator Instructions). And our first question comes from Robert Kessler with Simmons & Company.
Robert Kessler - Simmons & Company: Good morning Henry. How are you?
Henry Hubble: Hi Robert, how are you?
Robert Kessler - Simmons & Company: Doing well, thank you.
Henry Hubble: Good.
Robert Kessler - Simmons & Company: I’d like to see, if you might take in a little bit deeper into the tax rate change over the course of the quarter and in particular what might be happening in the UK as so whether or not you’ve going ahead and booked the expected change in the tax rate there?
Henry Hubble: Just in, in answer to the UK question now, we have in at this point but, if you just step back from, kind of our broader perspective and look at what went on in the first quarter, these results obviously are a record and we’re particularly strong in that, they accrued over $450 million, or about $0.07 per share in charges associated with litigation and several tax items that you just mentioned.
Robert Kessler - Simmons & Company: Okay.
Henry Hubble: Items, items that are one-time items, that won’t be a recurring during the year. The tax items, overall, totaled about $300 million. They’re comprised of several different items including charges for both, US and state, the US state and federal income taxes and also the absence of some positive impacts in prior period. And they, they really are affecting all of the segments of the business but primarily the US upstream.
Robert Kessler - Simmons & Company: If we look at the other variance and upstream sequentially the $605 million, how much of that relates specifically to these tax items?
Henry Hubble: On the, you’re looking at the sequential?
Robert Kessler - Simmons & Company: Right, I look at the $605 million variance drops $0.10 a share, pretty significant, just wondering how much of that is related to these tax items?
Henry Hubble: Well, you also, yeah, the state, the tax items are about $100 million to $115 million or something in that range and that in the upstream.
Robert Kessler - Simmons & Company: Okay.
Henry Hubble: But if you look at, the litigation items that are also in that 605, which about 160 and then there was some asset management effects about 200 million.
Robert Kessler - Simmons & Company: Just to think more conceptually here for a second. You historically have gotten a pretty good correlation between your earnings per barrel and oil prices. And, clearly oil prices increased a bit sequentially and yet earnings per barrel declined. Any general thoughts on whether or not higher government take is beginning to eat into your ability to out capture the incremental profits there?
Henry Hubble: Well, if you look, what we’ve done in course, we’ve provided data on the net income per barrel in the upstream. In the quarter its $15.55 per barrel for the first quarter here, but that’s up from $12.94 in the first quarter of 2005. And really just reflecting the higher commodity prices and of course, the ongoing focus we have on cost control and maximizing the recovery for the fields. But if you plot that on those, on that graph that we have, provided in the past the net income per barrel versus the markers, it’s pretty much on the line. So it’s a not a model as we vision it.
Robert Kessler - Simmons & Company: Okay.
Operator: Thank you. We’ll move to our next question from Doug Terreson with Morgan Stanley.
Doug Terreson - Morgan Stanley: Congratulations Henry on these results.
Henry Hubble: Thanks.
Doug Terreson - Morgan Stanley: Okay, so just back to the previous question, the $200 million asset management, not to make that clear but, what it does really refer to? From the $605 million sequential comparison that you guys are talking about?
Henry Hubble: Yeah, when we go back and look at the specific items in asset management, I mean most of that was associated with, some Canadian properties as number properties but Canadian properties were a piece of that. And then, that was the biggest single piece.
Doug Terreson - Morgan Stanley: Okay thanks. Okay, and also on Upper Zakum, I wanted to see…
Henry Hubble: Oh yeah, and there, just a look back up. There is the absence of some fourth quarter effects as well.
Doug Terreson - Morgan Stanley: Okay, okay.
Henry Hubble: Possible fourth quarter effects.
Doug Terreson - Morgan Stanley: Good point. Okay, also in Abu Dhabi, I want to see if you could provide some color on the format of the agreement that you guys have reached meaning, those are traditionally, fixed margin arrangement and in this case, is it something else and if you can provide any details, I would appreciate it.
Henry Hubble: Well, the specific commercial terms are confidential.
Doug Terreson - Morgan Stanley: Okay.
Henry Hubble: But, it’s, as I mentioned in the remarks, I mean, its, its one of the world’s largest oil fields, in our vision, like we’re very, very pleased to be involved in it.
Doug Terreson - Morgan Stanley: Sure.
Henry Hubble: And of course, we valued all these things on the same kind of basis that we do our other investments.
Doug Terreson - Morgan Stanley: I understand, thanks a lot.
Henry Hubble: Yep, thanks.
Operator: Thank you. We’ll move to next to Neil McMahon with Bernstein.
Neil McMahon - Bernstein: Hi good morning.
Henry Hubble: Hi Neil.
Neil McMahon - Bernstein: Hi got two questions. First of all, just going for the, your US Gas production, just looking at it sequentially, its looking pretty strong again, I’m just wondering how much of that is coming out of the Pions base and what you’re doing there and what we should be projecting in terms of our growth rate for your US Gas production. And then maybe if you’d just comment on some of your project timings for the rest of this year and in terms of startups in West Africa? Thanks.
Henry Hubble: Yeah, if you look at the Gas trade affect, that it would, I tend to look at it on the North America basis but it was down about 8% but their impacts and they’re associated with, divestments and hurricanes, which end up about, would ahead us of down, about 5% without that, The Peons is 55 KBD right now and then they were going to be base, I mean, excuse me, 1 million cubic feet per day and we’ll be ramping that up, steady over the next 3 to 7 years, so, we’re going to expect kind of ratable increase there.
Neil McMahon - Bernstein: And there is, like they’re really to get a sense of that, the difference over fourth quarter ’05, was that the Pions that was providing that? Or was there any of that area, was there return of hurricane affects or…
Henry Hubble: Yeah, when you look at, when you look at, it’s really a return of the hurricane that’s, that’s largest single factor and it actually was, when you look at our quarter-to-quarter basis that was up, sequentially up 5%. And then if you look at the, if you look at the delta versus, versus fourth quarter, on hurricanes we were up about 142 Mcf per day.
Neil McMahon - Bernstein: Okay and then, then the second question was really looking at your West African project timings coming on this year, really out there, like just wonder if you give a look three all the ones or one we should be expecting towards the end of the year and where they are versus schedule?
Henry Hubble: The projects that we have, basically have been coming on as schedule and what we are seeing in the effects after this point is largely the carry on of, of, of the projects that we have, that we brought on, some of them on late fourth quarter, so we are seeing, we are seeing the full year OpEx as we bring those projects on, of course, we have seen, we’ve seen the affects such as the RasGas, Train-4 and Al Khaleej, the Bonga project, Yoho and then the Erha and then if we look ahead, the, the East Area its, its schedule for third quarter, its on schedule, we’re also looking at the Erha North, they are becoming up in, and also in third quarter, by ramping up by yearend and then Dalia is still on schedule for fourth quarter, those with me and I was in and, we have further detail in the, in the FNL but at this point no, no real changes to that outlook.
Neil McMahon - Bernstein: Great thank you very much.
Henry Hubble: Very good.
Operator: Thank you we will move next to Doug Leggate with Citigroup.
Doug Leggate - Citigroup: Nice, good morning Henry.
Henry Hubble: Hi, Doug.
Doug Leggate - Citigroup: Couple of things Henry, package impacts the tax rate very quickly if I heard you like $300 million was the, the tax impacts of the visible one of items, is that the right number?
Henry Hubble: Yeah that’s right.
Doug Leggate - Citigroup: So first of that, your underlying tax rate would be running around 45% might be top end of your, of your range?
Henry Hubble: We have saved 40%, 44%, 45%, yeah.
Doug Leggate - Citigroup: So, I guess my question is that, if fuel prices remain like say in the, I mean, they’re obviously, fairly inflated levels, but…
Henry Hubble: Yes.
Doug Leggate - Citigroup: If all the prices that could prove by, would you expect that tax rate just would watch in terms of the impact of the international new, new dollars coming on to so on?
Henry Hubble: Well I, I don’t think so, I mean what you got is, you got some, you got the impacts of the mix basically, and some of the higher, its reflecting the higher production fields or the higher production coming on from the overseas fields.
Doug Leggate - Citigroup: Okay.
Henry Hubble: But we would look; we would look, for guidance going forward, this and during the period, towards the upper end of that range.
Doug Leggate - Citigroup: Okay. When, when the enact of UK tax charge comes through, that numbers, is it going to move higher or do you expect it to stay in that range?
Henry Hubble: It’s going to be consistent with that guidance its, it’s a smaller fact for us.
Doug Leggate - Citigroup: Okay. And then related question, I guess, jump into the retention very quickly.
Henry Hubble: Yes.
Doug Leggate - Citigroup: Could you give an indication of the, the delta on the marketing earnings, between a quarter sequentially and year-over-year?
Henry Hubble: For the, for the marketing piece that was, if you look at the, when your are looking at total, with total delta and marketing earnings.
Doug Leggate - Citigroup: Yeah.
Henry Hubble: So, if I, if I look across, its up, margins were up about, about 60 million in the quarter-to-quarter on a comparison and about 15 million in, in mix, I mean in volume mix affects.
Doug Leggate - Citigroup: Okay so that’s, that’s Q4 to Q1?
Henry Hubble: Excuse me no that was one year, first quarter of ’05 versus first quarter ’06. If you look at, if you look at the fourth quarter versus first quarter marketing margins were down about 400 million and we’re almost and then the volume affect were negligible.
Doug Leggate - Citigroup: Okay that’s the number I was looking for. Thanks Henry.
Henry Hubble: Sorry, yeah.
Operator: We will move now to Arjun Murti with Goldman Sachs.
Arjun Murti - Goldman Sachs: Well, can you hear me?
Henry Hubble: Yes, got you.
Arjun Murti - Goldman Sachs: Okay fine. How much did the Upper Zakum field contribute to 1Q and, really was it in for the full quarter or will there be another kind of volume uplift effect in the second quarter?
Henry Hubble: From the volume metrics standpoint they are in.
Arjun Murti - Goldman Sachs: Yeah, from the new Abu Dhabi field.
Henry Hubble: Yeah, and they are in about a 140 KBD.
Arjun Murti - Goldman Sachs: For the first quarter?
Henry Hubble: That’s correct.
Arjun Murti - Goldman Sachs: And would the impact be similar in the second quarter or would it be a higher number?
Henry Hubble: No it would be about the same.
Arjun Murti - Goldman Sachs: About the same, terrific, I just don’t understand the volume mix graph correctly from 1Q'06 versus 1Q'05?
Henry Hubble: Yes.
Arjun Murti - Goldman Sachs: I mean, you are not saying that you would have been better off not producing the 5 extra percent are you?
Henry Hubble: No, no, I mean what you are seeing there, I mean, it’s mix effects that are associated with changes in the volumes from, if you look at the additional volumes that are coming on in Africa, Middle East demand in Europe and then we are, we are seeing natural field decline and the divestments that is still affecting our North America and Europe volumes. And so it’s really in that total mix that you are seeing the impact.
Arjun Murti - Goldman Sachs: Yeah, okay, that’s great thank you very much.
Henry Hubble: Yep.
Operator: Thank you. We’ll go next to Paul Sankey with Deutsche Bank.
Paul Sankey - Deutsche Bank: Good afternoon guys.
Henry Hubble: Hi, Paul.
Paul Sankey - Deutsche Bank: We’ll go with what we should say. The, out, just back to your Upper Zakum and Cepu….
Henry Hubble: Yeah.
Paul Sankey - Deutsche Bank: Your outlook for 5 million barrels based production by 2010, do I assume those 2 projects are included within that outlook that you gave at the analyst meeting?
Henry Hubble: Yes they were.
Paul Sankey - Deutsche Bank: Great thanks, and on the refining side you spoken about, if we, adding the equivalents of the refinery over the past, I think 3 years.
Henry Hubble: Yes, yes.
Paul Sankey - Deutsche Bank: As far as efficiency gains, the throughput numbers you’ve got, kind of show the opposite that is to say it stepped down by about the size of the refinery in the past year. Should we be looking if you can bounce back to a higher level of refinery throughput than what we see here?
Henry Hubble: Yes.
Paul Sankey - Deutsche Bank: At that space, I guess they got some very, very high level to downtime in Q1?
Henry Hubble: Yeah, that’s exactly what it is, I mean we had a, as we mentioned earlier, we were expecting a higher turnaround load this year and the timing of the turnaround is largely in the first quarter or, well, first quarter and second quarter tend to be the highest period. That’s the real effect that you are seeing there is, is turnarounds. They were, and they were kind of across to board, we had turn around to US, Europe and overseas in Singapore in our other operations.
Paul Sankey - Deutsche Bank: But we can expect to bounce back over the course of the year to more than, let say 5.8 million a day of refining throughput?
Henry Hubble: Well I mean, the numbers that we quoted, they, we are going to expect to continue to see progress in that and, that was kind of a longer term, but, as we go and increase projects from capacity creep and other things, but we expect to see that on an ongoing basis. But its not, comes in lumps and basically, generally time with the turnarounds, so you see we are adding capacity with the turnarounds and some of our capital expenditures are actually up in the first quarter reflecting some of that work.
Paul Sankey - Deutsche Bank: Right, but would the low point of downtime for the year would be Q1 then?
Henry Hubble: I would say generally yes, but I’d, I don’t, I’d have to look back at the data to say that.
Paul Sankey - Deutsche Bank: Great thanks and then finally from the…
Henry Hubble: First half is lower for sure.
Paul Sankey - Deutsche Bank: Sorry?
Henry Hubble: First half is lower for sure.
Paul Sankey - Deutsche Bank: That’s right thanks, okay great thanks. And finally from the sales, trying to plot at sales, 2 of each down…
Henry Hubble: Yes.
Paul Sankey - Deutsche Bank: US and internationally and globally for that matter, 4% year-on-year…
Henry Hubble: Yeah
Paul Sankey - Deutsche Bank: Can you talk little bit about that?
Henry Hubble: Yeah, that I mean again it reflects of the turnaround are the first biggest piece of that and, and that reflects back in, supply sales and those patrolling product sales that you see there. So that you are seeing that effect, that’s the biggest one, there are also some divestments in there and, we had the divestments in Africa that we talked about before and we’ve also had, continuing high grading in Europe and in the US, but that’s, we are not really seeing something that would point to as our overall demand issue.
Paul Sankey - Deutsche Bank: Right, so if we would say talk about a life, like that comparison and you should be thinking about demand rising 1% year-on-year something?
Henry Hubble: That, that’s our longer term projection again, it’s going to be dependent really more on how economies develop and, but it ties very closely with GDP or, has the best, that’s a best correlation we have is back to GDP and we haven’t really seen anything to let’s say that’s changed in a significant way.
Paul Sankey - Deutsche Bank: Okay I’ll leave it there, thanks.
Henry Hubble: All right very good.
Operator: Thank you we will go next to Mark Flannery with Credit Suisse.
Mark Flannery - Credit Suisse: Hi Henry.
Henry Hubble: Hi Mark.
Mark Flannery - Credit Suisse: I just back on, Upper Zakum…
Henry Hubble: Yes.
Mark Flannery - Credit Suisse: Mostly on the topic today, yeah I know you didn’t really answer Doug’s question about the terms, but I was wishing, to have any details on the commercials. So can you characterize the contract for us, I mean can you give us an idea what type of contract it is, and, for modeling purposes or?
Henry Hubble: Well, as I say, I mean we have a 28% undivided interest that was in the enhancement but I really can’t get into any of the contractual terms associated with that.
Mark Flannery - Credit Suisse: Okay, I mean one thing may be is it sensitive to oil prices in same way that the rest of the portfolio is something that?
Henry Hubble: As I said, I really can’t get into the terms.
Mark Flannery - Credit Suisse: So, I’ll stop asking that question.
Henry Hubble: All right.
Mark Flannery - Credit Suisse: Just very quickly in Asia, can you give us an update about what’s happening in China on refining on that project?
Henry Hubble: On the Fujian project?
Mark Flannery - Credit Suisse: Yeah.
Henry Hubble: Yeah I mean we are being basically working that forward on, front end engineering work progressing that and as we talked at the analyst meeting, our aim is to have that ready for decision, later this year, but its progressing as planned, and frankly it’s, as we’ve talk before, it’s the only integrated project that’s out there, I mean, with refining fuels marketing and chemicals operations. So, we are continued to move that ahead, and hope that as a decision later this year.
Mark Flannery - Credit Suisse: Great thank you very much.
Henry Hubble: Thank you.
Operator: Thank you we will move now to Mark Gilman with Benchmark Company
Mark Gilman - Benchmark Company: Henry, good morning.
Henry Hubble: Hey Mark, how are you?
Mark Gilman - Benchmark Company: Good thanks. I got a couple of other volume-related questions; I’m puzzled by the drop between 4Q and 1Q, in both African volumes as well as the newly segregated Russia and Caspian categories? Could you comment on those two and the extent towards entitlement effects were responsible there or whether it’s something else. I would just note that it seems that, one of your partners with respect to a particular West African block seems to exhibiting same king of thing. Wondering whether this a lip tick issue here?
Henry Hubble: Well, we do have higher entitlements in the area and that’s basically the major impact. So, isn’t really is much else to say there on that one.
Mark Gilman - Benchmark Company: Henry, in Russia and the Caspian, you got another leg of the very sure of this came on and I would assume that your Zakum project is building if the numbers were down versus?
Henry Hubble: Well, I was talking on the, on the Africa volumes. Then if you look at Russia, I mean that’s basically, associated with some on schedule downtime that was between the first quarter and fourth quarter and basically, there was some turnaround activity going on there.
Mark Gilman - Benchmark Company: But in the African piece, the primary towards of the decline is entitlements?
Henry Hubble: That’s correct.
Mark Gilman - Benchmark Company: You referenced in your milestone comments the startup of the full field facilities at Yoho, how much of a production increase that we are talking about versus the early production system that was in place?
Henry Hubble: Well, it basically replaced the early production that we have there. So it’s as a relatively small effect about 15 KBD.
Mark Gilman - Benchmark Company: Okay. Were there any mark-to-market effects with respect to US Gas contract, UK Gas contracts in the quarter?
Henry Hubble: Very small, nothing really to highlight there.
Mark Gilman - Benchmark Company: All right and just one more vis-à-vis the tax rate issue. Is this primarily and I’m speaking more I guess in terms of the change in guidance about to this 44, 45 range. We are talking about mix issues here or whether particular statutory rate changes to the response for ’04 for moving it up.
Henry Hubble: For the rates going forward, it’s really more of the mix associated with growth in, with the growth the higher portion of our profits coming from overseas locations.
Mark Gilman - Benchmark Company: Okay but no significant statutory rate increases that you might call our attention to.
Henry H. Hubble: No, no.
Mark Gilman - Benchmark Company: Okay, I want just one other thing. I am a little bit confused by the relationships between the reference in the release to these litigation in tax effects are being over $0.04 a share and your comment previously that it’s a $450 million…
Henry Hubble: Yeah.
Mark Gilman - Benchmark Company: Is that $450 a delta number?
Henry Hubble: No the $450 million is, is the, the $0.04 that’s in the press release was associated with the upstream. And as I mentioned, the tax effects really went across the entire, total business. So, $300 million associated with the tax across the entire business and $160 million associated with the litigation that was in the upstream. So, that’s the bridge.
Mark Gilman - Benchmark Company: I see, so the $450 million is not at delta at all.
Henry Hubble: No.
Mark Gilman - Benchmark Company: Absolute. Very good thanks Henry.
Henry Hubble: Yup. Very good.
Operator: We’ll move next to John Herrlin, Merrill Lynch.
John Herrlin - Merrill Lynch: I guess each of those all guys had to count Henry, adequate not to be the dead horse here, on Zakum but can you give us a sense of timing to the portal and also once you set your portal rate how long can you keep it at the target of 750 a day?
Henry Hubble: Well Upper Zakum is a very, very large field and we expect that will, it will take a several years to get to the 750 but then our expectation is, that will have a long, long, long pattern, great as very high following resources you know.
John Herrlin - Merrill Lynch: Yes great, with Indonesia with the Cepu development what’s the timing on that to hit your target there could you give us a sense of the capital you will be committing?
Henry Hubble: Well, on Cepu.
John Herrlin - Merrill Lynch: Yes.
Henry Hubble: We really are in the developing of production plant there I am working that through, so its shown in our 2009 floods category and they definitely, really have to changed that outlook, I will be getting more information as we basically move through the production planning process.
John Herrlin - Merrill Lynch: Okay last one from here on the downstream side, you said things where fine with ethanol how about on the ultra low sulfur diesel side?
Henry Hubble: Yeah, good shape there and ready for ready for brining it on later this year.
John Herrlin - Merrill Lynch: Great thanks.
Henry Hubble: Yep.
Operator: Thank you, we’ll move now to Jennifer Rowland with JP Morgan.
Jennifer Rowland - JP Morgan: Thanks, two questions, one, can you give us any color on the potential discovery at Sao Tome? And second, if you just give us an up down more things down with Nigeria?
Henry Hubble: Yeah on the Sao Tome that is really one that share rounds of evaluating the well data there and that will now set some layer points. I really can’t give you any thing further on it. And in Nigeria, if you look at if you look at our operations they continue, normal at our facilities obviously, we are concerned and are been working the safety aspects and making sure that but we really can’t get into this specific that we are taking there. But basically, at this point operations are normal and we are just on a state of a higher alert.
Jennifer Rowland - JP Morgan: Okay thank you.
Henry Hubble: Yup.
Operator: We’ll go now to Bruce Lanni, AG Edwards.
Bruce Lanni - AG Edwards: Yeah. Good morning Henry, congratulations on the quarter.
Henry Hubble: Well, thank you.
Bruce Lanni - AG Edwards: Listen, I kind of didn’t follow up, I may have missed part of it, but in respect to, on the downstream, this is more general question, but in respect to the, the changeover from the fuel specs and ethanol…
Henry Hubble: Yeah.
Bruce Lanni - AG Edwards: About couple of things, first of all, where are you in the process specifically like on a percentage basis for both of them. And then secondly, if the regulations change as they been proposed to for the spring period, would that have any impact on your preceding forward with the new fuel specs or will that change anything in the dynamics of the market in your opinion?
Henry Hubble: Well I mean when you look at where we are in the conversion, we are out of MTBE and we baton basically converting facilities over to the ethanol blends. And basically, I have that done by the month here so, I mean we are very, very close, 90 something plus percent, so we are not anticipating promise now, there may be specific service stations that will have an issue as you are cleaning tanks in that kind of stuff but that’s going to be worn off, kinds of the impacts, not anticipating any significant problem.
Bruce Lanni - AG Edwards: Yeah but, I assume, there is discussions about the EPA is slackening the regulations going into the spring to allow that over fuel specs to be used, I mean, if that was to happen, do you see from an industry standpoint having any material impact on the markets. Or do you think?
Henry Hubble: I mean because, what you make to switchover is, you have things basically set up for in the pipelines moving into the tanks, I would be surprised that if they’re gone very much, much opportunities switched a lot at this point. Now the imports may benefit from, from that kind of a change but, but I don’t expect to see much impact in the domestic supplies.
Bruce Lanni - AG Edwards: Okay fair enough. That’s what I was looking for. Thanks.
Henry Hubble: Alright.
Operator: Thank you and our last question in the queue comes from Paul Sankey with Deutsche Bank.
Paul Sankey - Deutsche Bank: It’s the horrible one Henry, but the liquid one of the charge look quite high, given the cash balance I would have expected it somewhat lower, can you say anything about that and can you give us guidance for Pion? Thanks.
Henry Hubble: Yeah, it’s I mean where, the guidance we are still looking to 50 to 100 in that range, but what you see here is again a continuation of the tax impacts that we talked about before and that reflects into 4% as well, and that’s really is a big delta, the book of the delta.
Paul Sankey - Deutsche Bank: Okay, that’s what I had been, finally just on the tax rate side you said, I mean you’ve been over this quite a bit. But are you expecting then the tax rate for next quarter to go back down to that 45% range?
Henry Hubble: Our guidance for the period is in that upper 40% or 45%.
Paul Sankey - Deutsche Bank: Okay, you’ve stepped straight back down.
Henry Hubble: Yeah.
Paul Sankey - Deutsche Bank: Okay great thanks.
Henry Hubble: Okay.
Operator: Thank you, we’ll go now, excuse me; we’ll go now to Mark Gilman with Benchmark Company.
Mark Gilman - Benchmark: Henry just two quick ones and I will try to learn how to count a little bit.
Henry Hubble: Okay.
Mark Gilman - Benchmark: What something I haven’t done well for a longtime and longed many. Pipe finalization effect in the quarter both US and foreign downstream if you could?
Henry Hubble: Yeah, in pipe finalization, if you look on absolute basis, about $60 million in the first quarter absolute and that’s split well even between US and non US…
Mark Gilman - Benchmark: Negative.
Henry Hubble: That’s correct.
Mark Gilman - Benchmark: Okay and there is reference in the release to negative foreign exchange effects in particular in the foreign upstream?
Henry Hubble: Yeah.
Mark Gilman - Benchmark: You help us quantify it?
Henry Hubble: It’s about 100 in total and a most and in fact all of that in industry low 100 million in the upstream about negative.
Mark Gilman - Benchmark: Is that translational or transactional?
Henry Hubble: I have to look at the split; clearly both, I don’t know what the exact split is.
Mark Gilman - Benchmark: Yeah, maybe when you call it just give me a call.
Henry Hubble: Yeah we can do that.
Mark Gilman - Benchmark: Great thanks very much.
Henry Hubble: All right very good
Operator: And that’s all the time we have for questions today, I’d like to turn the conference back over to Mr. Hubble if any additional or closing remarks.
Henry H. Hubble, Vice President of Investor Relations and Secretary: Yeah, just want to say, first of all, just let me thank everybody for taking the time to join us this morning. And before I end here, I’d like to leave you with the couple of key points. First, our technology leadership and commitment coupled with our operational excellence continuous to distinguish ExxonMobil. The upstream projects that have been completed without delays, add-in volumes that we have expected at cost on budget or below. Our results reflect the same business model and disciplined investment process that we had for years and we will continue to have and we look through the volatility of the commodity cycles, we consistently focus on delivering superior results to meet the energy challenges this quarter and beyond. And I just like to thank all you for spending the time with us. Thanks.
Operator: That concludes today’s teleconference. Thank you all for your participation. | [
{
"speaker": "Executives",
"text": "Henry H. Hubble, Vice President of Investor Relations and Secretary"
},
{
"speaker": "Analysts",
"text": "Robert Kessler - Simmons & Company Doug Terreson - Morgan Stanley Neil McMahon - Bernstein Doug Leggate - Citigroup Arjun Murti - Goldman Sachs Paul Sankey - Deutsche Bank Mark Flannery - Credit Suisse Mark Gilman - Benchmark Company John Herrlin - Merrill Lynch Jennifer Rowland - JP Morgan Bruce Lanni - AG Edwards"
},
{
"speaker": "Operator",
"text": "Good day and welcome to this ExxonMobil Corporation First Quarter 2006 Earnings Conference Call. Today’s call is being recorded. At this time, for opening remarks, I would like to turn the conference over to the Vice President of Investor Relations and Secretary, Mr. Henry Hubble. Please go ahead sir."
},
{
"speaker": "Henry Hubble",
"text": "Good morning. Welcome to ExxonMobil’s teleconference and webcast on our first quarter 2006 financial operating results. As you’re aware from this morning’s press release, we’ve had a strong quarter. Our portfolio of businesses have performed well and we’ve captured the benefits of the strong industry conditions. Before we go further, I would like to draw your attention to our cautionary statement. Please note that estimates, plans and projections are forward-looking statements. Actual results, including resource recoveries, volume growth, and project outcomes could differ materially due to factors I discuss and factors noted in our SEC filings. Please see Factors Affecting Future Results and the Form 8-K we furnished this morning, which are available through the investor information section of our website. Please also see the frequently used terms, the supplement to this morning’s 8-K, and the 2005 financial and operating review on our website. This material defines certain financial and operating terms I will use today, shows ExxonMobil’s net interest in specific projects, and includes information required by SEC Regulation G. Now I’m pleased to turn your attention to the specific results. ExxonMobil’s first quarter net income and normalized earnings were $8.4 billion, or $1.37 per share. This was a record first quarter and represents an increase of $1 billion versus the first quarter of 2005 normalized earnings. Industry conditions remain robust in our three core businesses. Before discussing the business details, I’d like to highlight some of the key milestones that occurred in the first quarter. Since our last earnings discussion, we’ve achieved a number of significant milestones in each of our business units. In late March, production started up from the world class Erha deepwater development, located approximately 60 miles offshore Nigeria, in 3900 feet of water. Erha production is expected to ramp up to 150,000 barrels of oil per day, by the third quarter. Erha North, a satellite development is expected to begin production in third quarter 2006 and will contribute an additional 40,000 barrels per day by yearend. These developments demonstrate ExxonMobil’s global project execution capability and deep water technology expertise. Erha is the second major facility startup for ExxonMobil affiliates in Nigeria this year. In February, Mobil Producing Nigeria started production from the full fuel facilities of the Yoho development project, following a successful early production system deployment. With estimated recoverable resources of 440 million barrels of oil, Yoho is currently producing about 160,000 barrels of oil, a day. ExxonMobil signed agreements with the Abu Dhabi National Oil Company to acquire a 28% undivided interest in the Upper Zakum Oil Field, offshore Abu Dhabi. Upper Zakum is one of the world’s largest oil fields and has potential for substantial production growth. The joint venture plans to increase production in this field by 50% from approximately 500,000 barrels of oil per day currently to 750,000. ExxonMobil signed a joint operating agreement with P.T. Pertamina for the Cepu Contract Area in Indonesia. The signing of the JOA enables some parties to begin the activities required to develop the discovered recourses and further explore the block during the 30-year contract period. The Banyu Urip field has that has already been discovered in the Cepu Contract Area is estimated to contain more than 250 million barrels of oil. At peak production, the field is expected to reach a rate of 165,000 barrels of oil per day. Recently, it was announced that ExxonMobil was selected as a recipient of two awards from the US department of the Interior Minerals Management Service. We are honored to receive the 2005 the Safe Operations and Accurate Reporting Award, in recognition of the company’s outstanding safety and physical management and reporting practices. We are also pleased to have received the Mineral’s Revenues Stewardship Award, in recognition of our performance in accurately reporting production volumes and paying the royalties as well as our cooperation with compliance request. These awards reflect the high standard of care that is applied to all aspects of our business. Exxon Mobil Pipeline Company commissioned their Canadian crude pipeline reversal project that provides access for Western Canadian crude oil to Gulf Coast refining markets, and expands sources of crude oil to the United States. This project has consistent with our refining initiatives to increase raw material flexibility and run more difficult to process crudes that our discounted in the marketplace. Challenge crude runs to our refineries are up over 60% since 2000. Also, in the downstream we are actively progressing plans to meet ethanol blending requirements, in the US by the end of April. We are pleased with the progress to-date and do not anticipate supply disruptions associated with the transition of our facilities. Our approach to operational excellence commits our organization to operating our assets to the highest standards of safety, reliability, efficiency and integrity. During the quarter, two of our downstream chemical plants were recognized; downstream and chemical plants were recognized for outstanding safety performance. The Baton Rouge Polyolefins plants earn the National Petrochemical and Refiners Association distinguished safety award for the fourth consecutive year. No other company has won this award for four years in a row. The Port Allen lubricant blend plant was awarded star status in the US Occupational Safety and Health Administrations voluntary protection program. The OSHA recognition certifies the comprehensive successful safety and health management system are implemented and the site has achieved injury and illness rates below industry national average. 16 of our facilities in the US have now received star certification and participate in OSHA’s voluntary protection program. The discipline commitment and effective day-to-day focus require to achieve highest level of safety performance are the same factors that lead to overall excellence in operations. Improved energy efficiency remains a core focus to lowering operating cost. In April, the US environmental protection agency and the US department of energy recognized ExxonMobil’s Baytown complex with the 2006 energy star combined heat and power award for the site’s cogeneration facilities. The facilities included 160 megawatt gas turbine generator coupled with the heat recover unit that can produce 560,000 pounds-per hour of steam for use and manufacturing processes. Using the most efficient technology available today, this cogeneration unit produces both steam and electricity at an efficiency of about twice that of producing electricity and steam separately. ExxonMobil has more than 85 cogeneration units located around the world that produce nearly 3,700 megawatts of electricity. Our cogeneration capacity is now enough to power nearly 3 million US homes. In chemical, we introduce new santoprene thermoplastic vulcanizate weatherseal grades for the automotive industry. Santoprene TPV’s have improved and effective in a wide range of automotive applications, such as weatherseals, interiors, exteriors and under the hood. These products can help reduce cost, speed up product development, improve performance and increased recycle ability. ExxonMobil is world’s leading supplier of TPVs to automotive industry. This is another example of how our ability to develop and apply leading edge technology, differentiates our performance. Turing now to the business line results. Please refer to the earnings reconciliation in the IR supplement. Upstream normalized earnings in the first quarter were $6.4 billion. This represents an increase of $1.3 billion versus the first quarter of 2005. Higher realizations of $2.2 billion were partially offset by a number of factors which include at a less favorable volume mix and charges associated with litigation and several pack provisions. Upstream after-tax unit earnings were strong in the first quarter of 2006. Worldwide crude sales realizations were $56.95 per barrel, up more than $14.35 from first quarter 2005. Oil equivalent volumes increased 5% versus the same quarter last year, with increases in Africa and the Middle East more than offsetting natural field declines and investments in North America and Europe. Excluding the effects of entitlements and asset sales production increased 7%. Liquids production increased to 152,000 barrels per day or 6% versus the same quarter last year with Kizomba B and the recently acquired interest in Upper Zakum being the lot biggest sources of the additional liquids volumes. Gas volumes increased 414 million cubic feet per day, or about 4% versus the first quarter of 2005. Our production in Qatar from the fourth quarter of 2005 RasGas train 4 and Al Khaleej start-ups and higher demand in Europe due to colder weather were mainly responsible for the increase. Turning to the sequential comparison versus the fourth quarter of 2005; upstream earnings decreased about $655 million due to lower asset sales and charges related to litigation and taxes referenced earlier, realizations were essentially flat as strong oil prices were offset by lower natural gas prices. Liquids production increased 3% due to higher volumes from Middle East while natural gas production was up 14% primarily due to colder weather in Europe. For further data on regional volumes please refer to the press release and IR supplement. Turning now to the downstream; overall first quarter downstream normalized earnings of $1.3 billion were up approximately $130 million over the first quarter of 2005. Higher industry margins accounted for $60 million as stronger US refining and marketing margins were partially offset by lower international margins. The volume mix effect was a positive $50 million. Our ongoing self help improvements to increase production of high-value products and lower raw material cost coupled with strong first quarter loop sales more than offset lower or primary throughput, primarily associated with increased turnaround activity. We set 26 new monthly unit rate or production records during the quarter and ran 4 new crudes to ExxonMobil and 34 new to individual refineries. We continue our long-term focus on improving our raw material flexibility as well as increasing our refining capacity to improve reliability and selective capital investments. Sequentially, downstream earnings decreased by about $1.1 billion due primarily to lower worldwide refining and marketing margins. The volume mix effect reduced earnings by $70 million as lower refinery throughput, primarily associated with increased turnaround activity was partially offset by the absence of hurricane impacts. Now turning to Chemical results; our chemical business had another good quarter underpinned by strong manufacturing performance and market conditions. First quarter normalized earnings of $915 million were strong as sales volumes returned to pre-hurricane levels. When compared with the record first quarter 2005, earnings were down approximately $330 million due to lower margins, total volumes were similar quarter-on-quarter, but favorable mix effects partially offset the margin impact. Sequentially, first quarter chemical earnings increased by about $110 million, a 10% increase in sales volumes accounted for 160 million positive effects, as first quarter volumes were strong, while fourth quarter volumes were lower primarily due to the hurricanes. Lower first quarter margins partially offset the higher sales volume. Turning now to the corporate and financing segment; corporate and financing expenses of approximately $200 million were up about $120 million from the first quarter of 2005, primarily due to several tax items. The effective tax rate for the first quarter was 47%, our guidance for the long-term tax rate remains unchanged in the 40% to 45% range, although it may trend for the upper end of this range. Our cash balance was $36.5 billion and debt was $8 billion at the end of the first quarter. The corporation distributed a total of $7 billion to shareholders in the first quarter through dividends and share repurchases to reduce shares outstanding, an increase of 67% or $2.8 billion versus the first quarter 2005. During the first quarter, ExxonMobil purchased $5 billion of shares to reduce shares outstanding. As a result of our ongoing financial strength purchases the shares to reduce shares outstanding will be increased to $6 billion in the second quarter. Within the last year alone, the quarterly share repurchase program has nearly doubled, which further demonstrates our ongoing commitment to return cash to shareholders. CapEx in the first quarter was $4.8 billion, up $1.4 billion from the first quarter of 2005, primarily due to planned upstream activity. Our full year outlook is approximately $119 billion, consistent with the outlook presented at our March analyst meeting. Before we move to the Q&A, I would like this take a moment to summarize the key messages from this morning’s call. Our strong first quarter results reflects the strong commodity prices and our fundamental business model that is disciplined, straight forward and focused on generating value while managing risk. We are extremely pleased to have the opportunity to participate in the Upper Zakum Field. We look forward to assisting the already strong Zakum development company in increasing production and cooperating closely with the Abu Dhabi National Oil Company. Our selection by ADNOC is an honor and demonstrates the strength of our technical capabilities. Our superior project management skill continues to be displayed by delivery of our operated startups, on time and on budget. Our broad and diverse portfolio projects create ongoing opportunities to continue to bring new resources online and helps supply the world’s growing need for energy. That concludes my prepared remarks and I would now be happy to take your questions."
},
{
"speaker": "Operator",
"text": "Thank you Mr. Hubble. The question and answer session will be conducted electronically. (Operator Instructions). And our first question comes from Robert Kessler with Simmons & Company."
},
{
"speaker": "Robert Kessler - Simmons & Company",
"text": "Good morning Henry. How are you?"
},
{
"speaker": "Henry Hubble",
"text": "Hi Robert, how are you?"
},
{
"speaker": "Robert Kessler - Simmons & Company",
"text": "Doing well, thank you."
},
{
"speaker": "Henry Hubble",
"text": "Good."
},
{
"speaker": "Robert Kessler - Simmons & Company",
"text": "I’d like to see, if you might take in a little bit deeper into the tax rate change over the course of the quarter and in particular what might be happening in the UK as so whether or not you’ve going ahead and booked the expected change in the tax rate there?"
},
{
"speaker": "Henry Hubble",
"text": "Just in, in answer to the UK question now, we have in at this point but, if you just step back from, kind of our broader perspective and look at what went on in the first quarter, these results obviously are a record and we’re particularly strong in that, they accrued over $450 million, or about $0.07 per share in charges associated with litigation and several tax items that you just mentioned."
},
{
"speaker": "Robert Kessler - Simmons & Company",
"text": "Okay."
},
{
"speaker": "Henry Hubble",
"text": "Items, items that are one-time items, that won’t be a recurring during the year. The tax items, overall, totaled about $300 million. They’re comprised of several different items including charges for both, US and state, the US state and federal income taxes and also the absence of some positive impacts in prior period. And they, they really are affecting all of the segments of the business but primarily the US upstream."
},
{
"speaker": "Robert Kessler - Simmons & Company",
"text": "If we look at the other variance and upstream sequentially the $605 million, how much of that relates specifically to these tax items?"
},
{
"speaker": "Henry Hubble",
"text": "On the, you’re looking at the sequential?"
},
{
"speaker": "Robert Kessler - Simmons & Company",
"text": "Right, I look at the $605 million variance drops $0.10 a share, pretty significant, just wondering how much of that is related to these tax items?"
},
{
"speaker": "Henry Hubble",
"text": "Well, you also, yeah, the state, the tax items are about $100 million to $115 million or something in that range and that in the upstream."
},
{
"speaker": "Robert Kessler - Simmons & Company",
"text": "Okay."
},
{
"speaker": "Henry Hubble",
"text": "But if you look at, the litigation items that are also in that 605, which about 160 and then there was some asset management effects about 200 million."
},
{
"speaker": "Robert Kessler - Simmons & Company",
"text": "Just to think more conceptually here for a second. You historically have gotten a pretty good correlation between your earnings per barrel and oil prices. And, clearly oil prices increased a bit sequentially and yet earnings per barrel declined. Any general thoughts on whether or not higher government take is beginning to eat into your ability to out capture the incremental profits there?"
},
{
"speaker": "Henry Hubble",
"text": "Well, if you look, what we’ve done in course, we’ve provided data on the net income per barrel in the upstream. In the quarter its $15.55 per barrel for the first quarter here, but that’s up from $12.94 in the first quarter of 2005. And really just reflecting the higher commodity prices and of course, the ongoing focus we have on cost control and maximizing the recovery for the fields. But if you plot that on those, on that graph that we have, provided in the past the net income per barrel versus the markers, it’s pretty much on the line. So it’s a not a model as we vision it."
},
{
"speaker": "Robert Kessler - Simmons & Company",
"text": "Okay."
},
{
"speaker": "Operator",
"text": "Thank you. We’ll move to our next question from Doug Terreson with Morgan Stanley."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Congratulations Henry on these results."
},
{
"speaker": "Henry Hubble",
"text": "Thanks."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Okay, so just back to the previous question, the $200 million asset management, not to make that clear but, what it does really refer to? From the $605 million sequential comparison that you guys are talking about?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah, when we go back and look at the specific items in asset management, I mean most of that was associated with, some Canadian properties as number properties but Canadian properties were a piece of that. And then, that was the biggest single piece."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Okay thanks. Okay, and also on Upper Zakum, I wanted to see…"
},
{
"speaker": "Henry Hubble",
"text": "Oh yeah, and there, just a look back up. There is the absence of some fourth quarter effects as well."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Okay, okay."
},
{
"speaker": "Henry Hubble",
"text": "Possible fourth quarter effects."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Good point. Okay, also in Abu Dhabi, I want to see if you could provide some color on the format of the agreement that you guys have reached meaning, those are traditionally, fixed margin arrangement and in this case, is it something else and if you can provide any details, I would appreciate it."
},
{
"speaker": "Henry Hubble",
"text": "Well, the specific commercial terms are confidential."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Okay."
},
{
"speaker": "Henry Hubble",
"text": "But, it’s, as I mentioned in the remarks, I mean, its, its one of the world’s largest oil fields, in our vision, like we’re very, very pleased to be involved in it."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "Sure."
},
{
"speaker": "Henry Hubble",
"text": "And of course, we valued all these things on the same kind of basis that we do our other investments."
},
{
"speaker": "Doug Terreson - Morgan Stanley",
"text": "I understand, thanks a lot."
},
{
"speaker": "Henry Hubble",
"text": "Yep, thanks."
},
{
"speaker": "Operator",
"text": "Thank you. We’ll move to next to Neil McMahon with Bernstein."
},
{
"speaker": "Neil McMahon - Bernstein",
"text": "Hi good morning."
},
{
"speaker": "Henry Hubble",
"text": "Hi Neil."
},
{
"speaker": "Neil McMahon - Bernstein",
"text": "Hi got two questions. First of all, just going for the, your US Gas production, just looking at it sequentially, its looking pretty strong again, I’m just wondering how much of that is coming out of the Pions base and what you’re doing there and what we should be projecting in terms of our growth rate for your US Gas production. And then maybe if you’d just comment on some of your project timings for the rest of this year and in terms of startups in West Africa? Thanks."
},
{
"speaker": "Henry Hubble",
"text": "Yeah, if you look at the Gas trade affect, that it would, I tend to look at it on the North America basis but it was down about 8% but their impacts and they’re associated with, divestments and hurricanes, which end up about, would ahead us of down, about 5% without that, The Peons is 55 KBD right now and then they were going to be base, I mean, excuse me, 1 million cubic feet per day and we’ll be ramping that up, steady over the next 3 to 7 years, so, we’re going to expect kind of ratable increase there."
},
{
"speaker": "Neil McMahon - Bernstein",
"text": "And there is, like they’re really to get a sense of that, the difference over fourth quarter ’05, was that the Pions that was providing that? Or was there any of that area, was there return of hurricane affects or…"
},
{
"speaker": "Henry Hubble",
"text": "Yeah, when you look at, when you look at, it’s really a return of the hurricane that’s, that’s largest single factor and it actually was, when you look at our quarter-to-quarter basis that was up, sequentially up 5%. And then if you look at the, if you look at the delta versus, versus fourth quarter, on hurricanes we were up about 142 Mcf per day."
},
{
"speaker": "Neil McMahon - Bernstein",
"text": "Okay and then, then the second question was really looking at your West African project timings coming on this year, really out there, like just wonder if you give a look three all the ones or one we should be expecting towards the end of the year and where they are versus schedule?"
},
{
"speaker": "Henry Hubble",
"text": "The projects that we have, basically have been coming on as schedule and what we are seeing in the effects after this point is largely the carry on of, of, of the projects that we have, that we brought on, some of them on late fourth quarter, so we are seeing, we are seeing the full year OpEx as we bring those projects on, of course, we have seen, we’ve seen the affects such as the RasGas, Train-4 and Al Khaleej, the Bonga project, Yoho and then the Erha and then if we look ahead, the, the East Area its, its schedule for third quarter, its on schedule, we’re also looking at the Erha North, they are becoming up in, and also in third quarter, by ramping up by yearend and then Dalia is still on schedule for fourth quarter, those with me and I was in and, we have further detail in the, in the FNL but at this point no, no real changes to that outlook."
},
{
"speaker": "Neil McMahon - Bernstein",
"text": "Great thank you very much."
},
{
"speaker": "Henry Hubble",
"text": "Very good."
},
{
"speaker": "Operator",
"text": "Thank you we will move next to Doug Leggate with Citigroup."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Nice, good morning Henry."
},
{
"speaker": "Henry Hubble",
"text": "Hi, Doug."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Couple of things Henry, package impacts the tax rate very quickly if I heard you like $300 million was the, the tax impacts of the visible one of items, is that the right number?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah that’s right."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "So first of that, your underlying tax rate would be running around 45% might be top end of your, of your range?"
},
{
"speaker": "Henry Hubble",
"text": "We have saved 40%, 44%, 45%, yeah."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "So, I guess my question is that, if fuel prices remain like say in the, I mean, they’re obviously, fairly inflated levels, but…"
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "If all the prices that could prove by, would you expect that tax rate just would watch in terms of the impact of the international new, new dollars coming on to so on?"
},
{
"speaker": "Henry Hubble",
"text": "Well I, I don’t think so, I mean what you got is, you got some, you got the impacts of the mix basically, and some of the higher, its reflecting the higher production fields or the higher production coming on from the overseas fields."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Okay."
},
{
"speaker": "Henry Hubble",
"text": "But we would look; we would look, for guidance going forward, this and during the period, towards the upper end of that range."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Okay. When, when the enact of UK tax charge comes through, that numbers, is it going to move higher or do you expect it to stay in that range?"
},
{
"speaker": "Henry Hubble",
"text": "It’s going to be consistent with that guidance its, it’s a smaller fact for us."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Okay. And then related question, I guess, jump into the retention very quickly."
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Could you give an indication of the, the delta on the marketing earnings, between a quarter sequentially and year-over-year?"
},
{
"speaker": "Henry Hubble",
"text": "For the, for the marketing piece that was, if you look at the, when your are looking at total, with total delta and marketing earnings."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Yeah."
},
{
"speaker": "Henry Hubble",
"text": "So, if I, if I look across, its up, margins were up about, about 60 million in the quarter-to-quarter on a comparison and about 15 million in, in mix, I mean in volume mix affects."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Okay so that’s, that’s Q4 to Q1?"
},
{
"speaker": "Henry Hubble",
"text": "Excuse me no that was one year, first quarter of ’05 versus first quarter ’06. If you look at, if you look at the fourth quarter versus first quarter marketing margins were down about 400 million and we’re almost and then the volume affect were negligible."
},
{
"speaker": "Doug Leggate - Citigroup",
"text": "Okay that’s the number I was looking for. Thanks Henry."
},
{
"speaker": "Henry Hubble",
"text": "Sorry, yeah."
},
{
"speaker": "Operator",
"text": "We will move now to Arjun Murti with Goldman Sachs."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "Well, can you hear me?"
},
{
"speaker": "Henry Hubble",
"text": "Yes, got you."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "Okay fine. How much did the Upper Zakum field contribute to 1Q and, really was it in for the full quarter or will there be another kind of volume uplift effect in the second quarter?"
},
{
"speaker": "Henry Hubble",
"text": "From the volume metrics standpoint they are in."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "Yeah, from the new Abu Dhabi field."
},
{
"speaker": "Henry Hubble",
"text": "Yeah, and they are in about a 140 KBD."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "For the first quarter?"
},
{
"speaker": "Henry Hubble",
"text": "That’s correct."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "And would the impact be similar in the second quarter or would it be a higher number?"
},
{
"speaker": "Henry Hubble",
"text": "No it would be about the same."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "About the same, terrific, I just don’t understand the volume mix graph correctly from 1Q'06 versus 1Q'05?"
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "I mean, you are not saying that you would have been better off not producing the 5 extra percent are you?"
},
{
"speaker": "Henry Hubble",
"text": "No, no, I mean what you are seeing there, I mean, it’s mix effects that are associated with changes in the volumes from, if you look at the additional volumes that are coming on in Africa, Middle East demand in Europe and then we are, we are seeing natural field decline and the divestments that is still affecting our North America and Europe volumes. And so it’s really in that total mix that you are seeing the impact."
},
{
"speaker": "Arjun Murti - Goldman Sachs",
"text": "Yeah, okay, that’s great thank you very much."
},
{
"speaker": "Henry Hubble",
"text": "Yep."
},
{
"speaker": "Operator",
"text": "Thank you. We’ll go next to Paul Sankey with Deutsche Bank."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Good afternoon guys."
},
{
"speaker": "Henry Hubble",
"text": "Hi, Paul."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "We’ll go with what we should say. The, out, just back to your Upper Zakum and Cepu…."
},
{
"speaker": "Henry Hubble",
"text": "Yeah."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Your outlook for 5 million barrels based production by 2010, do I assume those 2 projects are included within that outlook that you gave at the analyst meeting?"
},
{
"speaker": "Henry Hubble",
"text": "Yes they were."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Great thanks, and on the refining side you spoken about, if we, adding the equivalents of the refinery over the past, I think 3 years."
},
{
"speaker": "Henry Hubble",
"text": "Yes, yes."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "As far as efficiency gains, the throughput numbers you’ve got, kind of show the opposite that is to say it stepped down by about the size of the refinery in the past year. Should we be looking if you can bounce back to a higher level of refinery throughput than what we see here?"
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "At that space, I guess they got some very, very high level to downtime in Q1?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah, that’s exactly what it is, I mean we had a, as we mentioned earlier, we were expecting a higher turnaround load this year and the timing of the turnaround is largely in the first quarter or, well, first quarter and second quarter tend to be the highest period. That’s the real effect that you are seeing there is, is turnarounds. They were, and they were kind of across to board, we had turn around to US, Europe and overseas in Singapore in our other operations."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "But we can expect to bounce back over the course of the year to more than, let say 5.8 million a day of refining throughput?"
},
{
"speaker": "Henry Hubble",
"text": "Well I mean, the numbers that we quoted, they, we are going to expect to continue to see progress in that and, that was kind of a longer term, but, as we go and increase projects from capacity creep and other things, but we expect to see that on an ongoing basis. But its not, comes in lumps and basically, generally time with the turnarounds, so you see we are adding capacity with the turnarounds and some of our capital expenditures are actually up in the first quarter reflecting some of that work."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Right, but would the low point of downtime for the year would be Q1 then?"
},
{
"speaker": "Henry Hubble",
"text": "I would say generally yes, but I’d, I don’t, I’d have to look back at the data to say that."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Great thanks and then finally from the…"
},
{
"speaker": "Henry Hubble",
"text": "First half is lower for sure."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Sorry?"
},
{
"speaker": "Henry Hubble",
"text": "First half is lower for sure."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "That’s right thanks, okay great thanks. And finally from the sales, trying to plot at sales, 2 of each down…"
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "US and internationally and globally for that matter, 4% year-on-year…"
},
{
"speaker": "Henry Hubble",
"text": "Yeah"
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Can you talk little bit about that?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah, that I mean again it reflects of the turnaround are the first biggest piece of that and, and that reflects back in, supply sales and those patrolling product sales that you see there. So that you are seeing that effect, that’s the biggest one, there are also some divestments in there and, we had the divestments in Africa that we talked about before and we’ve also had, continuing high grading in Europe and in the US, but that’s, we are not really seeing something that would point to as our overall demand issue."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Right, so if we would say talk about a life, like that comparison and you should be thinking about demand rising 1% year-on-year something?"
},
{
"speaker": "Henry Hubble",
"text": "That, that’s our longer term projection again, it’s going to be dependent really more on how economies develop and, but it ties very closely with GDP or, has the best, that’s a best correlation we have is back to GDP and we haven’t really seen anything to let’s say that’s changed in a significant way."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Okay I’ll leave it there, thanks."
},
{
"speaker": "Henry Hubble",
"text": "All right very good."
},
{
"speaker": "Operator",
"text": "Thank you we will go next to Mark Flannery with Credit Suisse."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Hi Henry."
},
{
"speaker": "Henry Hubble",
"text": "Hi Mark."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "I just back on, Upper Zakum…"
},
{
"speaker": "Henry Hubble",
"text": "Yes."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Mostly on the topic today, yeah I know you didn’t really answer Doug’s question about the terms, but I was wishing, to have any details on the commercials. So can you characterize the contract for us, I mean can you give us an idea what type of contract it is, and, for modeling purposes or?"
},
{
"speaker": "Henry Hubble",
"text": "Well, as I say, I mean we have a 28% undivided interest that was in the enhancement but I really can’t get into any of the contractual terms associated with that."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Okay, I mean one thing may be is it sensitive to oil prices in same way that the rest of the portfolio is something that?"
},
{
"speaker": "Henry Hubble",
"text": "As I said, I really can’t get into the terms."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "So, I’ll stop asking that question."
},
{
"speaker": "Henry Hubble",
"text": "All right."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Just very quickly in Asia, can you give us an update about what’s happening in China on refining on that project?"
},
{
"speaker": "Henry Hubble",
"text": "On the Fujian project?"
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Yeah."
},
{
"speaker": "Henry Hubble",
"text": "Yeah I mean we are being basically working that forward on, front end engineering work progressing that and as we talked at the analyst meeting, our aim is to have that ready for decision, later this year, but its progressing as planned, and frankly it’s, as we’ve talk before, it’s the only integrated project that’s out there, I mean, with refining fuels marketing and chemicals operations. So, we are continued to move that ahead, and hope that as a decision later this year."
},
{
"speaker": "Mark Flannery - Credit Suisse",
"text": "Great thank you very much."
},
{
"speaker": "Henry Hubble",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you we will move now to Mark Gilman with Benchmark Company"
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Henry, good morning."
},
{
"speaker": "Henry Hubble",
"text": "Hey Mark, how are you?"
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Good thanks. I got a couple of other volume-related questions; I’m puzzled by the drop between 4Q and 1Q, in both African volumes as well as the newly segregated Russia and Caspian categories? Could you comment on those two and the extent towards entitlement effects were responsible there or whether it’s something else. I would just note that it seems that, one of your partners with respect to a particular West African block seems to exhibiting same king of thing. Wondering whether this a lip tick issue here?"
},
{
"speaker": "Henry Hubble",
"text": "Well, we do have higher entitlements in the area and that’s basically the major impact. So, isn’t really is much else to say there on that one."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Henry, in Russia and the Caspian, you got another leg of the very sure of this came on and I would assume that your Zakum project is building if the numbers were down versus?"
},
{
"speaker": "Henry Hubble",
"text": "Well, I was talking on the, on the Africa volumes. Then if you look at Russia, I mean that’s basically, associated with some on schedule downtime that was between the first quarter and fourth quarter and basically, there was some turnaround activity going on there."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "But in the African piece, the primary towards of the decline is entitlements?"
},
{
"speaker": "Henry Hubble",
"text": "That’s correct."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "You referenced in your milestone comments the startup of the full field facilities at Yoho, how much of a production increase that we are talking about versus the early production system that was in place?"
},
{
"speaker": "Henry Hubble",
"text": "Well, it basically replaced the early production that we have there. So it’s as a relatively small effect about 15 KBD."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Okay. Were there any mark-to-market effects with respect to US Gas contract, UK Gas contracts in the quarter?"
},
{
"speaker": "Henry Hubble",
"text": "Very small, nothing really to highlight there."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "All right and just one more vis-à-vis the tax rate issue. Is this primarily and I’m speaking more I guess in terms of the change in guidance about to this 44, 45 range. We are talking about mix issues here or whether particular statutory rate changes to the response for ’04 for moving it up."
},
{
"speaker": "Henry Hubble",
"text": "For the rates going forward, it’s really more of the mix associated with growth in, with the growth the higher portion of our profits coming from overseas locations."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Okay but no significant statutory rate increases that you might call our attention to."
},
{
"speaker": "Henry H. Hubble",
"text": "No, no."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Okay, I want just one other thing. I am a little bit confused by the relationships between the reference in the release to these litigation in tax effects are being over $0.04 a share and your comment previously that it’s a $450 million…"
},
{
"speaker": "Henry Hubble",
"text": "Yeah."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Is that $450 a delta number?"
},
{
"speaker": "Henry Hubble",
"text": "No the $450 million is, is the, the $0.04 that’s in the press release was associated with the upstream. And as I mentioned, the tax effects really went across the entire, total business. So, $300 million associated with the tax across the entire business and $160 million associated with the litigation that was in the upstream. So, that’s the bridge."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "I see, so the $450 million is not at delta at all."
},
{
"speaker": "Henry Hubble",
"text": "No."
},
{
"speaker": "Mark Gilman - Benchmark Company",
"text": "Absolute. Very good thanks Henry."
},
{
"speaker": "Henry Hubble",
"text": "Yup. Very good."
},
{
"speaker": "Operator",
"text": "We’ll move next to John Herrlin, Merrill Lynch."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "I guess each of those all guys had to count Henry, adequate not to be the dead horse here, on Zakum but can you give us a sense of timing to the portal and also once you set your portal rate how long can you keep it at the target of 750 a day?"
},
{
"speaker": "Henry Hubble",
"text": "Well Upper Zakum is a very, very large field and we expect that will, it will take a several years to get to the 750 but then our expectation is, that will have a long, long, long pattern, great as very high following resources you know."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Yes great, with Indonesia with the Cepu development what’s the timing on that to hit your target there could you give us a sense of the capital you will be committing?"
},
{
"speaker": "Henry Hubble",
"text": "Well, on Cepu."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Yes."
},
{
"speaker": "Henry Hubble",
"text": "We really are in the developing of production plant there I am working that through, so its shown in our 2009 floods category and they definitely, really have to changed that outlook, I will be getting more information as we basically move through the production planning process."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Okay last one from here on the downstream side, you said things where fine with ethanol how about on the ultra low sulfur diesel side?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah, good shape there and ready for ready for brining it on later this year."
},
{
"speaker": "John Herrlin - Merrill Lynch",
"text": "Great thanks."
},
{
"speaker": "Henry Hubble",
"text": "Yep."
},
{
"speaker": "Operator",
"text": "Thank you, we’ll move now to Jennifer Rowland with JP Morgan."
},
{
"speaker": "Jennifer Rowland - JP Morgan",
"text": "Thanks, two questions, one, can you give us any color on the potential discovery at Sao Tome? And second, if you just give us an up down more things down with Nigeria?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah on the Sao Tome that is really one that share rounds of evaluating the well data there and that will now set some layer points. I really can’t give you any thing further on it. And in Nigeria, if you look at if you look at our operations they continue, normal at our facilities obviously, we are concerned and are been working the safety aspects and making sure that but we really can’t get into this specific that we are taking there. But basically, at this point operations are normal and we are just on a state of a higher alert."
},
{
"speaker": "Jennifer Rowland - JP Morgan",
"text": "Okay thank you."
},
{
"speaker": "Henry Hubble",
"text": "Yup."
},
{
"speaker": "Operator",
"text": "We’ll go now to Bruce Lanni, AG Edwards."
},
{
"speaker": "Bruce Lanni - AG Edwards",
"text": "Yeah. Good morning Henry, congratulations on the quarter."
},
{
"speaker": "Henry Hubble",
"text": "Well, thank you."
},
{
"speaker": "Bruce Lanni - AG Edwards",
"text": "Listen, I kind of didn’t follow up, I may have missed part of it, but in respect to, on the downstream, this is more general question, but in respect to the, the changeover from the fuel specs and ethanol…"
},
{
"speaker": "Henry Hubble",
"text": "Yeah."
},
{
"speaker": "Bruce Lanni - AG Edwards",
"text": "About couple of things, first of all, where are you in the process specifically like on a percentage basis for both of them. And then secondly, if the regulations change as they been proposed to for the spring period, would that have any impact on your preceding forward with the new fuel specs or will that change anything in the dynamics of the market in your opinion?"
},
{
"speaker": "Henry Hubble",
"text": "Well I mean when you look at where we are in the conversion, we are out of MTBE and we baton basically converting facilities over to the ethanol blends. And basically, I have that done by the month here so, I mean we are very, very close, 90 something plus percent, so we are not anticipating promise now, there may be specific service stations that will have an issue as you are cleaning tanks in that kind of stuff but that’s going to be worn off, kinds of the impacts, not anticipating any significant problem."
},
{
"speaker": "Bruce Lanni - AG Edwards",
"text": "Yeah but, I assume, there is discussions about the EPA is slackening the regulations going into the spring to allow that over fuel specs to be used, I mean, if that was to happen, do you see from an industry standpoint having any material impact on the markets. Or do you think?"
},
{
"speaker": "Henry Hubble",
"text": "I mean because, what you make to switchover is, you have things basically set up for in the pipelines moving into the tanks, I would be surprised that if they’re gone very much, much opportunities switched a lot at this point. Now the imports may benefit from, from that kind of a change but, but I don’t expect to see much impact in the domestic supplies."
},
{
"speaker": "Bruce Lanni - AG Edwards",
"text": "Okay fair enough. That’s what I was looking for. Thanks."
},
{
"speaker": "Henry Hubble",
"text": "Alright."
},
{
"speaker": "Operator",
"text": "Thank you and our last question in the queue comes from Paul Sankey with Deutsche Bank."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "It’s the horrible one Henry, but the liquid one of the charge look quite high, given the cash balance I would have expected it somewhat lower, can you say anything about that and can you give us guidance for Pion? Thanks."
},
{
"speaker": "Henry Hubble",
"text": "Yeah, it’s I mean where, the guidance we are still looking to 50 to 100 in that range, but what you see here is again a continuation of the tax impacts that we talked about before and that reflects into 4% as well, and that’s really is a big delta, the book of the delta."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Okay, that’s what I had been, finally just on the tax rate side you said, I mean you’ve been over this quite a bit. But are you expecting then the tax rate for next quarter to go back down to that 45% range?"
},
{
"speaker": "Henry Hubble",
"text": "Our guidance for the period is in that upper 40% or 45%."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Okay, you’ve stepped straight back down."
},
{
"speaker": "Henry Hubble",
"text": "Yeah."
},
{
"speaker": "Paul Sankey - Deutsche Bank",
"text": "Okay great thanks."
},
{
"speaker": "Henry Hubble",
"text": "Okay."
},
{
"speaker": "Operator",
"text": "Thank you, we’ll go now, excuse me; we’ll go now to Mark Gilman with Benchmark Company."
},
{
"speaker": "Mark Gilman - Benchmark",
"text": "Henry just two quick ones and I will try to learn how to count a little bit."
},
{
"speaker": "Henry Hubble",
"text": "Okay."
},
{
"speaker": "Mark Gilman - Benchmark",
"text": "What something I haven’t done well for a longtime and longed many. Pipe finalization effect in the quarter both US and foreign downstream if you could?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah, in pipe finalization, if you look on absolute basis, about $60 million in the first quarter absolute and that’s split well even between US and non US…"
},
{
"speaker": "Mark Gilman - Benchmark",
"text": "Negative."
},
{
"speaker": "Henry Hubble",
"text": "That’s correct."
},
{
"speaker": "Mark Gilman - Benchmark",
"text": "Okay and there is reference in the release to negative foreign exchange effects in particular in the foreign upstream?"
},
{
"speaker": "Henry Hubble",
"text": "Yeah."
},
{
"speaker": "Mark Gilman - Benchmark",
"text": "You help us quantify it?"
},
{
"speaker": "Henry Hubble",
"text": "It’s about 100 in total and a most and in fact all of that in industry low 100 million in the upstream about negative."
},
{
"speaker": "Mark Gilman - Benchmark",
"text": "Is that translational or transactional?"
},
{
"speaker": "Henry Hubble",
"text": "I have to look at the split; clearly both, I don’t know what the exact split is."
},
{
"speaker": "Mark Gilman - Benchmark",
"text": "Yeah, maybe when you call it just give me a call."
},
{
"speaker": "Henry Hubble",
"text": "Yeah we can do that."
},
{
"speaker": "Mark Gilman - Benchmark",
"text": "Great thanks very much."
},
{
"speaker": "Henry Hubble",
"text": "All right very good"
},
{
"speaker": "Operator",
"text": "And that’s all the time we have for questions today, I’d like to turn the conference back over to Mr. Hubble if any additional or closing remarks."
},
{
"speaker": "Henry H. Hubble, Vice President of Investor Relations and Secretary",
"text": "Yeah, just want to say, first of all, just let me thank everybody for taking the time to join us this morning. And before I end here, I’d like to leave you with the couple of key points. First, our technology leadership and commitment coupled with our operational excellence continuous to distinguish ExxonMobil. The upstream projects that have been completed without delays, add-in volumes that we have expected at cost on budget or below. Our results reflect the same business model and disciplined investment process that we had for years and we will continue to have and we look through the volatility of the commodity cycles, we consistently focus on delivering superior results to meet the energy challenges this quarter and beyond. And I just like to thank all you for spending the time with us. Thanks."
},
{
"speaker": "Operator",
"text": "That concludes today’s teleconference. Thank you all for your participation."
}
] | null | null |
PARA | 4 | 2,006 | 2007-02-27 08:30:00 | TRANSCRIPT SPONSOR :
Executives: Marty Shea - IR Sumner Redstone - Executive Chairman, Founder Les Moonves - President, CEO Fred Reynolds - CFO
Analysts: Victor Miller - Bear Stearns Jessica Reif-Cohen - Merrill Lynch Lucas Binder - UBS Investments Kathy Styponias - Prudential John Klim - Credit Suisse Doug Mitchelson - Deutsche Bank Anthony Diclemente - Lehman Brothers Kit Spring - Stifel David Miller - Sanders Morris Harris Benjamin Swinburne - Morgan Stanley
Operator: Good day, everyone, and welcome to the CBS Corporation fourth quarter 2006 earnings release teleconference. Today's call is being recorded. At this time I would like to turn the call over to the Executive Vice President of Investor Relations, Mr. Marty Shea.
Marty Shea: Good morning, everyone. Thank you for taking the time to join us for our fourth quarter and full year 2006 earnings call. Joining me for today's call are Sumner Redstone, our Chairman; Leslie Moonves, President and CEO; and Fred Reynolds, our Executive Vice President and CFO. Sumner will have some opening remarks and will then turn the call over to Les and Fred for strategic and financial issues. We will then open up the call to questions. Let me note that statements on this conference call relating to matters which are not historical facts are forward-looking statements which involve risks and uncertainties that could cause actual results to differ. Risks and uncertainties are disclosed in CBS Corporation's news releases and security filings. A summary of CBS Corporation's fourth quarter and full year 2006 results should have been sent to all of you. If you did not receive the results, please contact Punam Visay at 975-3667 and she will get it to you. A webcast of the call, the earnings release and any other information related to the presentation can be found on CBS Corporation's corporate website at the address CBSCorporation.com. Now I'll turn the call over to Sumner.
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Sumner Redstone: Thanks, Marty. Good morning, everyone. I really thank you for being with us today. When we look at our terrific fourth quarter and full year 2006 results, one thing is very clear: what a success the new CBS Corporation has become in its very first year. We have done a phenomenal job operating our core business, adjusting our asset portfolio and positioning the company to compete in the interactive space. Our vibrant businesses continue to throw off huge amounts of cash and we have made good on our commitment to return value to investors in the form of dividends. I am really enthusiastic about the future of the CBS Corporation. I have unequivocal full confidence that Les and his team will continue to lead this company with success and indeed, with distinction. We have a couple of really important announcements to make today and for them and more I turn this over to you, Les.
Les Moonves: Thank you very much, Sumner, and good morning to everyone. It's good to be here with you, as always. This time last year we told you all the things we were planning to grow and strengthen the CBS Corporation. Well, we've gotten a lot done and we're just getting started. Today the CBS Corporation has a successful profitable platform to build upon. We've got a proven ability to generate cash and the discipline and vision to leverage that cash effectively for the long-term benefit of our shareholders. Nowhere is this more evident than in our fourth quarter and full year 2006 results. By now you've probably seen our press release. As you can tell, the fourth quarter was a terrific cap on a great first year. Strong fourth quarter operating results in television, outdoor and publishing helped us surpass our key financial targets for 2006. In terms of profits, we adjusted fourth quarter results to provide a meaningful comparison with the previous year. Last year we had a $9.5 billion impairment charge in the fourth quarter; we took that out. We've also adjusted for tax benefits and stock-based compensation. Even with all that adjustment, operating income was up 14% to $759 million. Net earnings from continuing operations were up 44% to $464 million. Adjusted fourth quarter EPS from continuing operations was up 43% to $0.60 per diluted share; clearly, way above expectations. This is all on top of a 2% revenue increase for the quarter which shows we continue to have great success leveraging top line growth. For the full year 2006, also adjusted, EPS from continuing operations was up 19% to $1.85 and free cash flow was up 8% to $1.6 billion. These kind of results have been achieved by running our core businesses at the forefront of their respective industries. But there is so much opportunity out there to position these businesses for even better growth and in order to do that we are pursuing a three pillar strategy: The first pillar is something we've been saying we were going to do since day 1: get paid retransmission fees for our content. Late last week we announced that we've reached retransmission consent agreements with nine separate cable operators covering more than 1 million subscribers nationally. Several of these deals are with MSOs from the top 25. Clearly there's a new paradigm in the marketplace, one which bodes very well for us going forward as future retrans deals are renegotiated. The second pillar of our strategy is to reshape our portfolio into better margin, higher growth businesses. We started down this path early in 2006 by divesting Paramount Parks. We then followed up by putting 39 radio stations in slower growth markets on the block. The stations were sold at highly attractive multiples, reflecting the value of our portfolio and the strength of the broadcasting businesses we operate. We've closed on 12 of these properties to date and we expect to close on the rest by the end of next quarter. In keeping with this strategy, earlier this month we announced the sale of seven of our owned and operated television stations for $185 million. A week later we've entered into an agreement with Liberty Media to acquire 7.6 million shares of CBS stock that they own in exchange for our television station in Green Bay, Wisconsin and approximately $170 million in cash. This particular deal gave us the unique opportunity to fine tune our portfolio of assets while at the same time reducing the number of shares outstanding. The third pillar of our strategy has been to take our world-class content and to extend it into new interactive platforms. The end goal, of course, is to reach even larger audiences, to achieve wider margins on our first run content, and to create incremental revenue streams while getting paid for our content through every single means possible. We recently formed a new unit, CBS Interactive, headed by Quincy Smith to lead this charge. Quincy has moved quickly to position all of our businesses to capitalize on numerous interactive opportunities. For example, as you may recall last year we transitioned our March Madness on demand service to a free ad-supported model. Our out of market online game coverage turned out to be a huge hit. So this year, we've sold it much more aggressively and project to double our revenues and increase our profits sixfold. This is a trend that we expect to continue as this medium grows. We have also formed a new unit called CBS Mobile to help us adapt our content to the cell phone; a platform that some experts believe has even greater promise than the Internet. We continue to broker deals with carriers that pay us significant license fees for our content. Beyond the cell phone we continue to extend our hit content to interactive platforms everywhere including iTunes, Comcast, Yahoo!, YouTube and others. We have also set up an investment fund and are investing in a variety of companies that will lead us into this space as well. There has been so much activity on the Internet front already it's hard to believe that this is just the beginning. So before I say much more about the future let me briefly update you on the major headlines coming from each of our businesses. In television the CBS Television Network continues to be America's most-watched television network in primetime. Currently, season to date, we're number 1 in every major category, households adult 25-to-54 and 18-to-49. These numbers were also true before the Super Bowl; we were number 1 in all these categories and obviously all these numbers increased after the game. With more than 93 million viewers, CBS' coverage of Super Bowl 41 gathered the third-biggest audience in broadcast history behind the finale of Mash and Super Bowl 30. According to Nielson, about 140 million people watched all or part of that game -- 140 million people; that's close to half of the U.S. population. It also achieved record advertising pricing as well. Remember, there is simply no other medium that can deliver that many eyeballs in one fell swoop and create that kind of passionate community. We're thrilled with the success of Super Bowl 41. What's more, our broadcast of the Grammies on February 11th delivered the award program's largest audience and highest ratings in adults 18-to-49 and adults 25-to-54 since 2004. While we love having the mega events, our real strength lies in the depth and consistency of our successful shows. We have nine of the top 20 shows, more than any other network. Also in television, our production company, CBS Paramount Network Television, continues to provide top programs to the broadcast and cable markets and now produces seven of the top 20 primetime series on network television. On the distribution side, we combined CBS Paramount Television, King World and CBS Paramount International during the fourth quarter to form CBS Television Distribution, the biggest syndication powerhouse in the business. Rachael Ray was the most successful new series of 2006 and with renewals through 2010, it's a franchise in the making. Most importantly overall our strength in syndication remains solid and on most weeks we have nine of the top 10 shows in syndication. Our cable operations are thriving as well. Showtime had a terrific quarter and year, both in programming and subscriber growth. Dexter quickly became the network's highest-rated show and along with Weeds continues to generate great critical and industry acclaim. In April we're looking forward to the premiere of our next big original series, The Tudors. Over at CSTV we're enjoying the immediate benefit of recent multi-year programming agreements with DirecTV that has put CSTV in nearly 21 million homes. That's a 50% increase since we acquired it last year. Our television station group also had an extremely strong fourth quarter and a great 2006 overall, primarily driven by political dollars and the success of the CBS Television Network. We've seen local news ratings growth in key markets, particularly in New York and L.A. where most of the money is made. There's indication that 2008 political dollars could creep well into 2007, particularly in major states across the country where the primaries are being moved up. Moving to radio, clearly in 2006 for radio it was a challenging year. We're not satisfied with this performance and we continue to aggressively seek ways to engage listeners with the programming that they want to hear in the ways they want to hear it. Certain formats such as JACK and FREE FM have shown positive momentum and we continue to leverage interactive opportunities and capitalize upon HD radio and streaming, plus the use of online video streaming and other technologies are already helping radio become more personalized and community-oriented. Throughout the year, as I noted, we sharpened our major market focus in radio which will now enable us to deploy our resources where they matter most. Let's not forget that we achieved multiples in mid-teens for our slower growing markets. This only underscores the values of the operations we have elected to keep. With the sales of many of our stations at high multiples, with the improvement in many formats and with all the new digital initiatives we are ahead of the curve in our transformation of this important business. In outdoor, our outdoor division continues to show exceptional growth. Revenues were up double-digits for the quarter driven by strong performances in the U.S., Mexico and Canada. In North America and in our international operations, we have continued to acquire multiple display spaces while ramping up our digital media offerings. We love outdoor and expect the strong growth to keep going as digital technologies continue to make out-of-home ads more compelling, targeted, timely and cost effective for advertisers. Over at our publishing business, Simon & Schuster finished 2006 with 111 New York Times bestsellers, the most in company history. Fourth quarter sales were very strong and have carried over well into the first quarter. So that's a brief look at where CBS is today. We had a great first year and our fourth quarter was our strongest quarter of the year, giving us great momentum going into 2007. We continue to produce strong free cash flow quarter in and quarter out, maintaining a healthy balance sheet. We have substantially repositioned our portfolio from parks to significant broadcasting properties, which will put us in a strong financial position for 2007 and beyond. When comparing 2007 to 2006 on an as-reported basis, several factors including higher expense for stock-based compensation, the sale of those 39 radio stations and nine television stations as well as the shutdown of UPN, will result in revenue and operating income that will be comparable to that of '06. For the long term, the company is poised to deliver rates of growth as follows: low single-digit growth in revenues, mid single-digit growth in operating income and high single-digit growth in earnings per share. This future outlook underlies our strong fundamentals across the company. It is this solid base and our belief in the future of these businesses that enables us to make two important announcements today. First, I am pleased to announce this morning that our board of directors has approved an increase of 10% in our quarterly dividend raising it from $0.20 to $0.22. We continue to believe that a healthy dividend is the best way to return value to our shareholders. This is now the fourth increase in the last 14 months from $0.14 to $0.16, from $0.16 to $0.18, $0.18 to $0.20 and now from $0.20 to $0.22. This represents a total increase of nearly 60% since we became a standalone company last year. A second shareholder initiative is one we discussed on our last earnings call: a potential share repurchase program. I'm pleased to tell you that in addition to the dividend increase, our board has approved a $1.5 billion share repurchase program. We plan to buy back up to 6% of the company's outstanding common stock, or roughly 47 million shares at current values. If you include the shares we acquired in the Liberty swap it is actually 7%. Fred will discuss the particulars a little bit later. The approval of the dividend increase and share buyback program is a direct reflection of our complete confidence in our ongoing ability to generate strong, healthy free cash flow. We strongly believe in our businesses and have a proven ability to deliver on our commitments. We are doing everything we can to ensure this principle will continue for many years to come. We have demonstrated once again how important our shareholders are to us. As you can tell, we've made great strides in 2006 and have positioned the company for future success in '07 and beyond. Once again we are positively determined to continue to receive compensation for our content through retransmission, reshape our portfolio into better margin, higher growth businesses, take our world-class content and to extend it to new interactive platforms and, as underscored by our two announcements this morning, return value to our investors. Thank you and now let's hear from our CFO Fred Reynolds.
Fred Reynolds: Thank you, Leslie and good morning to all of you. As Leslie just discussed our fourth quarter and full year 2006 highlights, let me add some additional information on our fourth quarter operating performance, cash flow and balance sheet. Then I'll brief you on our $1.5 billion share buyback plan and finally provide you with some comments on our expectations for 2007. Revenues for the fourth quarter of 2006 totaled $3.9 billion. That was up 2% over the fourth quarter of last year. Now as we have mentioned in previous quarters, two items reduced our reported revenue growth when compared to 2005: first was the absence of the UPN network in the fourth quarter of 2006 due to its shutdown at the end of September. Second, we now record our DVD revenues net of cost as we now use a third-party distributor. These two items reduced our total revenue growth in the fourth quarter by 3.6 percentage points. Television, outdoor and Simon & Schuster led our fourth quarter revenue growth with television up 3% versus year ago fourth quarter. Again, the absence of UPN and recording DVD's net reduced the television segment's revenue growth by 5.5 percentage points. TV stations lead the segment's revenue growth with revenues up 14.6%, driven by very strong political ad spending in the fourth quarter of 2006. Turning to OIBDA, as you will note, in our earnings release we report profits with and without the non-cash impairment charges which had a very, very significant negative impact on earnings in the fourth quarter of 2005. So OIBDA, excluding the impairment charges for the fourth quarter of 2006, was $860 million, up 11% over last year's fourth quarter. Included in the fourth quarter's OIBDA was $13 million of stock-based compensation expense versus only $5 million in the previous year's quarter. Again, the television segment led our OIBDA growth in the fourth quarter, up 20% over the fourth quarter of last year. Outdoors' OIBDA was up 13% versus year ago. We are very pleased, very pleased to report that all of our segments improved their profit margins in the fourth quarter. Overall our adjusted OIBDA margin for the company was 22.5% in the fourth quarter of 2006, up almost 2 percentage points over the fourth quarter of 2005. As you can tell, with the portfolio moves that we have made that margins are going up as we get rid of businesses that were not as profitable as the total company. Subsequent to the year end 2006 we made a couple announcements on the sale of nine television stations. These stations were sold at an after-tax multiple of about 15X cash flow. However, due to high allocated goodwill and intangibles associated with this transaction we did recognize a $65 million non-cash impairment charge in the fourth quarter of 2006. We expect to close on the sale of these TV stations early in the second half of 2007, at which time the gain on the sale will be recognized. Operating income for the fourth quarter totaled $759 million on an adjusted basis, up 14% over the fourth quarter year ago. In other items net you'll notice that there's a profit of $13 million in the fourth quarter. Recorded in other items net is the gain on the sale of the five Buffalo radio stations which closed in December of 2006. As we have noted in the earnings release, subsequent to year end ten radio stations in three markets -- Kansas City, Columbus and Greensboro -- have closed. Those gains on those sales will be recorded in the first quarter of 2007. The remaining 24 radio stations in six markets will close during the balance of the first and second quarters. Our provision for income tax, including the impact of impairment charges for the fourth quarter, came in at a 33% rate, quite a bit lower than the fourth quarter 2005's rate of 45%. The drop in the tax rate is due largely to truing up the tax provision for the federal, state and local returns which were filed at the end of 2006. Going forward, we expect our tax provision to be at a rate of approximately 14%. Also during the fourth quarter 2006 we took a non-cash charge to reduce the carrying value of one of our equity investments due to the fact that, in our opinion, the investment's stock price decline in 2006 was other than temporary. This non-cash charge of $156 million pre-tax and $94 million after-tax is reflected in equity losses in affiliated companies. As Leslie noted, net earnings for the fourth quarter was at $335 million, or $0.43 a share on an as-reported basis. On an adjusted basis, excluding the impairment charges, stock-based compensation asset sales and the one-time tax benefit that was referred to, earnings per share was $0.60 for the fourth quarter of '06, up 43% over year ago. Free cash flow for the fourth quarter was a use of cash of about $14.7 million. However, included in free cash flow in the fourth quarter was our discretionary pre-funding of our qualified pension plan of $200 million. As we have mentioned previously, we believe the mid-teens after-tax internal rate of return on funding the pension plan, in essence reducing debt and getting a tax deduction for it, was a real good use of our excess cash. Taking into account this pension pre-funding we produced very strong free cash flow in the fourth quarter 2006. Strong earnings coupled with high accounts receivable collections drove cash flow in the fourth quarter offset somewhat by a $66 million increase in capital spending. The jump in capital spending was driven by a $49 million increase in the television segment relating to new TV station facilities in Los Angeles and Chicago. As you'll recall, we previously sold the L.A. and Chicago buildings and these are their replacement facilities. CapEx was also up about $30 million at outdoor, driven by spending for new and additional displays for our London Underground contract which has been extended for another eight years and new boards including digital in the U.S. Turning to the balance sheet. At 12/31/06 cash totaled $3.1 billion and gross debt was $7 billion. Sale of assets such as Paramount Parks plus full year free cash flow of over $1.6 billion, which you should note includes $250 million of the discretionary pension pre-funding for the full year, greatly improved our already very strong balance sheet. Our leverage ratio using gross debt of the $7 billion was 2.2:1 for the year ended 2006. Now let's turn to 2007. As Leslie mentioned, several factors will affect our revenue and profit growth on an as-reported basis in 2007 versus 2006. Most of these factors which affect 2007 involve actions we had taken to reshape our portfolio, to improve our growth prospects, increase margins and along the way, as Leslie said, get terrific exit values. Here are the key items which will affect revenue and profit comparisons in 2007 versus 2006: First, as you'll recall, we signed agreements in 2006 to sell 39 radio stations for $669 million, or over 14X their 2006 OIBDA. These stations have either closed or will close shortly and their absence will affect the comparability with 2006. Next, we also announced the sale of the nine TV stations for about $250 million or 15X their 2006 OIBDA. The sale of these stations will affect comparability again in 2007 versus 2006 when these transactions close later this year. Third, for the nine months UPN was still broadcasting in 2006, it produced revenues of over $175 million which will affect our 2007 revenue growth comparisons as now UPN has been shut down. Next, off-network syndication in 2007 will largely consist of the syndication of NCIS which will likely occur in the fourth quarter of 2007. In 2006, as we reported on, we syndicated the second cycles of Frasier, Star Trek Voyager and the first cycles of CSI Miami and Without a Trace. As we look to 2008 and 2009 the number of programs we have available for syndication increases dramatically. Finally, stock-based compensation expense will likely increase by $40 million to $50 million in 2007 versus 2006, assuming the same level of equity grants are issued in 2007 as were issued last year. As you know, we vest the equity grants pro rata over four years, so the 2006 grants will have roughly 25% of their expense reflected in 2007 thereby driving up our incremental stock-based compensation expense in 2007. Taking all these items into account, revenues and operating income on an as reported basis would be comparable to 2006. However, on an underlying growth basis, stripping out all these non-comparable items we expect our businesses in 2007 will deliver another solid operating performance and strong cash flow. Finally, as Leslie announced at the start of today's call, we'll raise our dividend by $0.02 to $0.22 a quarter and that's payable April 1st to shareholders of record as of March 7th. Also we will initiate a one-time $1.5 billion share buyback program utilizing an accelerated share repurchase program or ASR. Our ASR program will involve us buying $1.5 billion of CBS shares, or roughly 47 million shares, from a financial institution immediately reducing the number of shares outstanding. We believe an ASR program will efficiently and effectively utilize our excess cash and ensure the share buyback is accomplished at a very attractive cost to us. We expect to complete the share buyback program by the end of this first quarter. With that I thank you and we'd like to open the telephone lines for your questions. Connie, if you could open the lines that would be great.
Operator: (Operator Instructions) Your first question comes from Victor Miller - Bear Stearns.
Victor Miller - Bear Stearns: Fred, I have a question for you and one for Leslie. In terms of the 39 radio stations and nine TV stations at UPN, the net political dollars that you had last year versus what you anticipate this year, syndication revenues you talked about, can you give us a sense when you wrap that all together, Fred, what does that mean in terms of the revenue drag potentially for this year versus last year and in the sense of the EBITDA associated with that bucket of pieces? Leslie, in terms of the radio business you have been able to sell your radio stations at about a 14.1X multiple overall. I'm wondering two things philosophically. One, is there any more to do in terms of paring back that portfolio? Secondly, if you look at a lot of the radio growth that Clear Channel just reported, one could argue that it comes from Premier, which is its network business. As you know, Citadel is now buying ABC's network business along with its station so there's, again, an integrated radio network presence. There are two of those in the marketplace, Westwood is kind of a separate entity and you own an 18% stake in it. Does it make any sense to have in your case those two together? Thanks.
Les Moonves: In terms of paring it down, right now we're pretty satisfied. We did an analysis at the beginning of the year of what we felt were the smaller markets least likely to grow stations. When you're able to get the multiples that we got, we did that. It's not to say that we won't look at it and potentially pare down further, but at the moment we're pretty happy with the hand that we're dealt. We do have a relationship obviously with Westwood One where we own a decent percentage of the company. There are no plans right now to bring that in-house. One could argue about the value of the networks. We still think Westwood is a very valuable asset, but we have no plans to bring it in-house and combines it with our radio stations.
Fred Reynolds: Victor, on the radio stations, their sales for '06 were about $125 million,$130 million. I give you a little bit of a range because some of them when into an LMA in the fourth quarter. But their run rate for that probably is about $125 million. The nine TV stations are probably around $75 million to $80 million in revenue. So that's what will come out and as we've committed before, we'll do the reports on a same-station basis so you can see the comparability, but that is going to be a drag. Finally, I think your question was about political. Clearly '06 was a great political year, it set all records. As Leslie alluded to, every year, even on odd years we have political but nowhere at the level that you have an election year. The question is will some of the '08 political dollars come into this year? That is hard to tell at this point. But political was very strong in '06. Obviously we had the Super Bowl this year, so on a revenue standpoint the revenue won't change that much except the profitability is clearly different from selling a normal ad versus a sports ad.
Les Moonves: Clearly the political race is heating up a lot faster than everybody thought it would. I think there's more attention, considering that we are almost two years away from the next election the fireworks that are out there bodes well for us. Obviously a lot of people are raising a lot of money and so I think it bodes well. I think, as Fred said, there's a real possibility there could be more leakage from '08 into '07 of political dollars.
Operator: Your next question comes from Jessica Reif-Cohen – Merrill Lynch.
Jessica Reif-Cohen - Merrill Lynch: Les, as you reshape your assets over the next three to five years, how different will the revenue and cash flow mix be? Do you need to make acquisitions? Where do you stop with the dispositions? Could you just give us a little guidance on how much you plan on spending for digital boards in outdoor in '07 and '08?
Les Moonves: Jessica, the first question is a tough one. Obviously we are investing in a rather small way in a variety of new media assets. We do believe in their long-term growth and that that's where a lot of our revenue is going to come from in the future. It's really hard to assess where that is. As it stands now we still believe in the blocking and tackling of our basic assets which are television, radio and outdoor and they're still great businesses. There will be obviously revenue and profit migrating into new media assets and we intend to be there in quite a large way. We didn't have any great intention to sell our television stations, these nine stations, but at the multiples that we were offered they were very, very high prices and we had to look at that. The same thing with our radio stations. On one hand people say, gee, radio is slowing down. At these multiples it certainly doesn't look that way. So we're pretty pleased with the way we ended up and we would always listen to a reasonable offer.
Fred Reynolds: Jessica, on the outdoor, one of the big jumps in the fourth quarter of '06 was in outdoor, about $29 million to $30 million. Most of that was with the London Underground and a lot of that is digital. We were looking to expand our capital spending in '07 in outdoor by about $40 million to $50 million, and I would say a good share of that, the lion's share of that, is probably for digital outdoor in the UK. Just to give you a perspective on where we are. At the end of '07 we expect to have in the U.S. about 300 digital boards installed. That is up from about 160 where we are now. In Europe because of the London Underground, we are going to have thousands of boards, but they're going to be more the display boards. We could end '07 with about 3,000 display boards with the lion's share in the London Underground. So I think you can kind of plan on $30 million to $40 million a year in the expansion of our boards. Most of it will be in the digital area.
Operator: Your next question comes from Lucas Binder - UBS Investments.
Lucas Binder - UBS Investments : On retransmission, obviously it is good direction, the announcement last week with regard to the nine cable companies, MSOs. What is the timeline for the next step and what can we look out for as far as additional negotiations ahead of the big MSOs in 2009? Fred, you mentioned on a gross basis you are about 2.2X leverage. Do you see opportunity to increase that, and potentially following on how the share buyback goes you'll look to do additional buybacks in the future?
Les Moonves: On the retrans, obviously we are extremely pleased by the nine MSOs that have jumped on board. You're going to see more and more of these smaller operators and some of the not so small operators coming around. And as I said, there's a shift, there's a new paradigm. As I've said before, MSOs are already paying for networks. You can disguise it under other things as everybody has done. I've said this before, if you're paying $3 for ESPN, you're really paying $2.50 for ESPN and $0.50 for ABC. We are now a stand-alone. We see more and more of the MSOs getting on board. As you noticed, these nine MSO deals were done without a whole a lot of noise. There weren't big newspaper ads, there weren't big fights, there wasn't anything pulled off the air. So I think the MSOs are realizing that it's better to get along than to fight. Yes, the big ones are up in '09 and '10, but you'll see us do a number of deals before then.
Fred Reynolds: The leverage ratio, as we said before, is really at the low end of what we targeted. We have some debt maturities that come due in '07, about $700 million in May, we plan to extend those out with ten and 30-year money depending on how the market looks. So there's no desire to reduce our debt or leverage. Listen, we think paying dividends and increasing it is the best way. If you look at where we are, we'll spend about $675 million on dividend payouts at the $0.22 a quarter. That's before the share buyback. So we buyback 47 million shares so that drops to maybe $640 million. That's a very significant call on cash. As you know, it's far greater than our interest cost. So I think we have to weigh that. I think the inclination of Sumner and Leslie and myself is that dividends would be the preferred method. But hopefully we've proven to you that when we have a windfall on some of these asset sales that we're going to return to shareholders if we can't redeploy it effectively at greater than our cost of capital in our existing business. That is our goal thought, we would love to keep redeploying this cash in our businesses and accelerate both the revenue, profit and returns growth. But absent that we'll return it to you. The preference really is dividends because we think it is a little bit stickier, if I could use that term.
Operator: Your next question comes from Kathy Styponias - Prudential.
Kathy Styponias - Prudential: Les, I was wondering if you can reconcile for us in light of your retransmission consent deal, your decision to sell TV stations albeit in smaller markets, in light of the fact that it's at the TV station level that you're actually capturing the cash for retrans consent, why are you selling stations and what should we expect from you with respect to further TV station sales? Fred, I was wondering if you can give us any sort of color on what the value that you're extracting for retransmission consent for the CBS signal? Thanks.
Les Moonves: Kathy, in terms of that, obviously we weighed that. These are really small market stations that we sold. We weren't going out there looking for them, but when you get the opportunity to sell them at those phenomenal multiples, you figure in what retrans potentially could be and the economics still made much, much better sense to do a sale. Having said that, there would be little chance that any major station would be sold because the future is extremely bright for what they will get per sub. So we factored that in and it all worked out in our favor. I'm not going to let Fred tell you what we're getting per sub.
Fred Reynolds: Kathy, obviously Leslie has stated that the value of our content and I guess you can be assured that we're going to be fairly compensated for that in these deals. I would echo what Leslie says about these businesses. When you get a 15X after-tax multiple, Kathy, as you know, on businesses like Austin we could have baked in almost ESPN kind of retrans and not gotten those multiples.
Operator: Your next question comes from John Klim - Credit Suisse.
John Klim - Credit Suisse: Have you seen any material impact or could you talk about any impact on the ratings of the shows that you've highlighted on YouTube? Could you update us on how you feel about further developing your relationship with YouTube or its parent company, Google? Thanks.
Les Moonves: Sure. Our deal with YouTube where we supply certain entertainment news and sports content is primarily promotional at this point in time. Certainly with the entertainment stuff we have seen certain cause and effect from some of our research. It's rather early to say, but in terms of the number of hits that our promos get on YouTube, arguably our content is promoted so heavily because of the number of people. In addition, it's bringing in a younger demographic. We think it is fairly significant. It's hard to do an absolute cause and effect, but we know it absolutely is helping. We are looking at every single outlet there is for our content. We are talking to everybody. As you've seen, we've done deals with just about everybody and it's something that all the companies are looking at and how do we maximize our content in the future either through advertising sales or through promotion.
Operator: Your next question comes from Doug Mitchelson - Deutsche Bank.
Doug Mitchelson - Deutsche Bank: Les, one of your most under-monetized assets when you look across your company remains your TV library, maybe even current TV production. So cable operators are sitting there with plenty of servers at their head ends, waiting for the green light to offer as much TV content and demand as you will give them. What's holding you back right now from offering more or all of your content on demand? I know that you're doing some, but it's tiny relative to the totality of your TV library and current production. Maybe along a similar vein, what happened in the Google negotiations that made you uncomfortable that you didn't want to give them broad distribution of your TV content at this time? Was it monetization, was it rights? What was it?
Les Moonves: No, it's a very valid point. Our TV library is unbelievably valuable and it is relatively undermined. We have not put a lot of properties out there. The main reason -- this sort of ties into your second question -- is we want to get paid appropriately for it. We will eventually have our library out there, it will be on demand either through advertising, subscription or pay per view, some way shape or form, we just value it very highly and very dearly. We obviously get paid through syndication and DVDs. It is inevitable that our library is going to be out on the Internet and downloaded and we will be making deals for this content. The good news for us as we go forward is, you're right, it is undermined and there's a great future ahead with this library and with our current production. So look for more things in the fairly near future.
Doug Mitchelson - Deutsche Bank: I'm not sure if there's a specific answer you can give, but as you think about the things that are holding you back right now, is it the size of Google's audience, is it the cable operators, are they not able to monetize through advertising the content to the level you'd like to see? What's stopping it from happening?
Les Moonves: In general terms without getting into the specifics, we want to make sure that, look, there is a cause and effect. Obviously putting it out there, we want our content and I genuinely believe everybody is going to be able to get our content whenever they want it, wherever they want it, it's just getting the right price at the right time for it. There are a lot of factors that weigh in. Obviously we have an important DVD library that might be affected, we have the syndication thing that might be affected and that will all be well and good and we think that the Internet will be additive to that, it's just that we just have to be appropriately paid for it. We discuss this all the time and it's one of the things that we deal with greatly but we have to get the right deal.
Operator: Your next question comes from Anthony Diclemente - Lehman Brothers.
Anthony Diclemente - Lehman Brothers: Fred, if you take the free cash flow that you reported in this release for '06 and you add back the $250 million in pension contribution, which I think most people would agree is discretionary, you get to about $2.40 a share of free cash flow. My question is, as we move forward into '07 you're looking for comparable EBITDA. Is there any reason that the free cash flow number shouldn't move in somewhat lockstep with EBITDA? Is there any change in working capital or change in CapEx that's dramatic that we should know about? Is there any chance that the retransmission deals that you have in place with the larger cable operators, that being Comcast and Time Warner Cable, are renegotiated prior to the '08/'09 time period when those contracts are up? Given the shift that you discuss in the balance is there any chance that you would preempt the existing time horizon on those existing contracts? Thank you.
Fred Reynolds: As you know, we don't forecast or give guidance on cash flow. But let me give you a couple comments because I think it might be helpful. In '06 we spent a little under $400 million, $394 million in capital spending. Our expectations, which you'll see in our K that gets filed probably tomorrow or the next day, we are going to give a range of estimates of $450 million to $475 million in capital spending. I personally think we'll be at the low end of that at the $450 million. So we are going to step up capital spending again. The lion's share of it is going to go into outdoor, so that is going to be a change. The one thing I think, as we noted I think it was in the second and third quarter, that we had the settlement of a number of previous audits of taxes with the IRS from 2000 to 2003. We also had a fairly large overpayment in 2005 that we applied to 2006. So our cash taxes will go up. Everything else you say, working capital probably will be the same; we won't use a lot of working capital. As you know, with only one major syndication versus four that we will have no use of net assets, you guys call it working capital, it's really changed to net assets because the receivable won't get ballooned as much.
Anthony Diclemente - Lehman Brothers: And then presumably your interest expense comes down I would think?
Fred Reynolds: Sure, interest on $1.5 billion, we earn a measly 5.25% on that. So on $1.5 billion that's going to come down by $75 million or so. Again, I don't want to give a forecast. I would point out that capital spending will go up, everything else should stay the same except cash taxes will go up in '07 because we won't enjoy the roughly $150 million overpayment that we got to enjoy in '06.
Les Moonves: Anthony, on your second question, certainly it's possible that we would enter into early discussions with these people. Our relationships with Comcast are terrific. We do a lot of business with them. We have a VOD deal with them and we talk to them all the time. The same thing with Time Warner obviously. We have a lot of business with Time Warner, we co-own the CW with them, they have a lot of programming on CBS so we are open to dialogue, Showtime is negotiating with them all the time as is CSTV. We are certainly open and willing to talk with them at any point in time. I guess it's very possible that negotiations could begin much earlier than when the contracts are up.
Operator: Your next question comes from Kit Spring - Stifel.
Kit Spring - Stifel: A number of your affiliates are being successful with retrans fees. Do you expect to change the relationships with your affiliate so that you garner some of those economics? I think that's been changing over the past five or ten years. Do you see affiliate comp turning to reverse comp and how big of an opportunity is that?
Les Moonves: You know, Kit, our relationship with our affiliates has evolved over a period of time. When I first got here we were paying out hundreds of millions of dollars which is virtually down to zero right now. There are a lot of deals that we do with them. Our relationships with our affiliates are great. They like the idea getting paid for retrans as do we. So it's an ongoing dialogue in terms of the content we supply them as well as our relationship with them. So without getting specific it will be an ongoing dialogue and, once again, it continues to evolve.
Operator: Your next question comes from David Miller - Sanders Morris Harris.
David Miller - Sanders Morris Harris: Outdoor revenue growth plus 10%, that's obviously model growth in the quarter generally comparable to your competitors. I would think, however, that that would be leverageable into at least mid-teens to high teens EBITDA growth. You came in with plus 13% growth. It looks like you got hit by foreign exchange a little bit. Was there something else going on in the quarter expense wise that you could flesh out for us? Also, at your analyst day about a year ago today or a year ago this week or so you had mentioned that the publishing business was also non-core to operations, very similar to the Paramount Parks. What is the status of the sale of that asset? Thanks very much.
Les Moonves: David, thank you. I'll deal with the publishing question and I'll flip it to Fred to give you the color on the outdoor business. In terms of publishing, yes, I mean arguably Simon & Schuster is not a core business; however, they are showing a tremendous ability to generate terrific revenues and profits and we love having them with us. We think it's a great asset. As I said, they not only had their best year last year creatively, but financially they're doing far better than people expected. So we love having it and we find no need to sell it, it's going to be a part of our businesses for a long time to come.
Fred Reynolds: On outdoor, a couple things in the fourth quarter. Again, I would cite that in U.S. the billboard business was up 12%, and some of it had to do with the revenue growth. As you may know, some of the contracts that were sort of marginal for us we're no longer participating in, which plays into what we booked as far as expenses in the fourth quarter. We did have severance costs to lay off 110 people that related to the New York MTA and also the New York street furniture businesses that we no longer have. Again, those were marginal at best contracts for us, so the revenue will come down in all of '07, but the profits will not be that affected. But we did recognize the exit cost to get out of that including, again, layoffs of 110 people. We did renew the New York subway and we did renew the London Underground, both of which had significant increases in fees in the fourth quarter because both of those new contracts started in the fourth quarter. What I would tell you, there's a little bit of a lag. Obviously the municipalities want their fees early. They have with the increased license fees came increased availability of inventory, a lot of it, as we discussed earlier on the call, going to digital. So we're building out, we're adding the new display, that's why we're spending more on capital there, but the revenue, we haven't monetized all the displays yet. I would expect to '07 us being able to hike off and more than offset the increase in the transit franchise fees or license fees in the New York subway and London Underground. We had some other renewals, but I think those are the big items that sort of were a drag on the fourth quarter and why I've said I think we can go 2X revenues up at 1% in the U.S. and profits should be up 2%. Those were the drags that pulled us down, but again, I think almost all of them are just transitional and that we will have more inventory to sell even though the franchise fee went up.
Operator: Your final question comes from Benjamin Swinburne - Morgan Stanley.
Benjamin Swinburne - Morgan Stanley: Let me ask you a question on the DVR side. Can you give us an update on your thoughts on Live Plus, what the ad buyers are saying along those lines and any expectation for monetization of recorded viewing in 2007 in your guidance?
Les Moonves: Yes, the advertisers got away with just getting Live last May. That won't happen this year. Number one, there are much more sophisticated ways of measurement through the commercial ratings, more Live Plus Same Day, Live Plus Three. It's now going to become a significant number and we need to get paid for that, we will get paid for that. I think all the networks feel like that is a necessity and that it's going to happen which bodes very well for this upfront period. So we're very excited about it.
Marty Shea: Thank you, everyone for joining us. I will be available for the rest of the day. Have a great day.
TRANSCRIPT SPONSOR :
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"speaker": "Executives",
"text": "Marty Shea - IR Sumner Redstone - Executive Chairman, Founder Les Moonves - President, CEO Fred Reynolds - CFO"
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"speaker": "Analysts",
"text": "Victor Miller - Bear Stearns Jessica Reif-Cohen - Merrill Lynch Lucas Binder - UBS Investments Kathy Styponias - Prudential John Klim - Credit Suisse Doug Mitchelson - Deutsche Bank Anthony Diclemente - Lehman Brothers Kit Spring - Stifel David Miller - Sanders Morris Harris Benjamin Swinburne - Morgan Stanley"
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"speaker": "Operator",
"text": "Good day, everyone, and welcome to the CBS Corporation fourth quarter 2006 earnings release teleconference. Today's call is being recorded. At this time I would like to turn the call over to the Executive Vice President of Investor Relations, Mr. Marty Shea."
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"speaker": "Marty Shea",
"text": "Good morning, everyone. Thank you for taking the time to join us for our fourth quarter and full year 2006 earnings call. Joining me for today's call are Sumner Redstone, our Chairman; Leslie Moonves, President and CEO; and Fred Reynolds, our Executive Vice President and CFO. Sumner will have some opening remarks and will then turn the call over to Les and Fred for strategic and financial issues. We will then open up the call to questions. Let me note that statements on this conference call relating to matters which are not historical facts are forward-looking statements which involve risks and uncertainties that could cause actual results to differ. Risks and uncertainties are disclosed in CBS Corporation's news releases and security filings. A summary of CBS Corporation's fourth quarter and full year 2006 results should have been sent to all of you. If you did not receive the results, please contact Punam Visay at 975-3667 and she will get it to you. A webcast of the call, the earnings release and any other information related to the presentation can be found on CBS Corporation's corporate website at the address CBSCorporation.com. Now I'll turn the call over to Sumner."
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"speaker": "Sumner Redstone",
"text": "Thanks, Marty. Good morning, everyone. I really thank you for being with us today. When we look at our terrific fourth quarter and full year 2006 results, one thing is very clear: what a success the new CBS Corporation has become in its very first year. We have done a phenomenal job operating our core business, adjusting our asset portfolio and positioning the company to compete in the interactive space. Our vibrant businesses continue to throw off huge amounts of cash and we have made good on our commitment to return value to investors in the form of dividends. I am really enthusiastic about the future of the CBS Corporation. I have unequivocal full confidence that Les and his team will continue to lead this company with success and indeed, with distinction. We have a couple of really important announcements to make today and for them and more I turn this over to you, Les."
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"speaker": "Les Moonves",
"text": "Thank you very much, Sumner, and good morning to everyone. It's good to be here with you, as always. This time last year we told you all the things we were planning to grow and strengthen the CBS Corporation. Well, we've gotten a lot done and we're just getting started. Today the CBS Corporation has a successful profitable platform to build upon. We've got a proven ability to generate cash and the discipline and vision to leverage that cash effectively for the long-term benefit of our shareholders. Nowhere is this more evident than in our fourth quarter and full year 2006 results. By now you've probably seen our press release. As you can tell, the fourth quarter was a terrific cap on a great first year. Strong fourth quarter operating results in television, outdoor and publishing helped us surpass our key financial targets for 2006. In terms of profits, we adjusted fourth quarter results to provide a meaningful comparison with the previous year. Last year we had a $9.5 billion impairment charge in the fourth quarter; we took that out. We've also adjusted for tax benefits and stock-based compensation. Even with all that adjustment, operating income was up 14% to $759 million. Net earnings from continuing operations were up 44% to $464 million. Adjusted fourth quarter EPS from continuing operations was up 43% to $0.60 per diluted share; clearly, way above expectations. This is all on top of a 2% revenue increase for the quarter which shows we continue to have great success leveraging top line growth. For the full year 2006, also adjusted, EPS from continuing operations was up 19% to $1.85 and free cash flow was up 8% to $1.6 billion. These kind of results have been achieved by running our core businesses at the forefront of their respective industries. But there is so much opportunity out there to position these businesses for even better growth and in order to do that we are pursuing a three pillar strategy: The first pillar is something we've been saying we were going to do since day 1: get paid retransmission fees for our content. Late last week we announced that we've reached retransmission consent agreements with nine separate cable operators covering more than 1 million subscribers nationally. Several of these deals are with MSOs from the top 25. Clearly there's a new paradigm in the marketplace, one which bodes very well for us going forward as future retrans deals are renegotiated. The second pillar of our strategy is to reshape our portfolio into better margin, higher growth businesses. We started down this path early in 2006 by divesting Paramount Parks. We then followed up by putting 39 radio stations in slower growth markets on the block. The stations were sold at highly attractive multiples, reflecting the value of our portfolio and the strength of the broadcasting businesses we operate. We've closed on 12 of these properties to date and we expect to close on the rest by the end of next quarter. In keeping with this strategy, earlier this month we announced the sale of seven of our owned and operated television stations for $185 million. A week later we've entered into an agreement with Liberty Media to acquire 7.6 million shares of CBS stock that they own in exchange for our television station in Green Bay, Wisconsin and approximately $170 million in cash. This particular deal gave us the unique opportunity to fine tune our portfolio of assets while at the same time reducing the number of shares outstanding. The third pillar of our strategy has been to take our world-class content and to extend it into new interactive platforms. The end goal, of course, is to reach even larger audiences, to achieve wider margins on our first run content, and to create incremental revenue streams while getting paid for our content through every single means possible. We recently formed a new unit, CBS Interactive, headed by Quincy Smith to lead this charge. Quincy has moved quickly to position all of our businesses to capitalize on numerous interactive opportunities. For example, as you may recall last year we transitioned our March Madness on demand service to a free ad-supported model. Our out of market online game coverage turned out to be a huge hit. So this year, we've sold it much more aggressively and project to double our revenues and increase our profits sixfold. This is a trend that we expect to continue as this medium grows. We have also formed a new unit called CBS Mobile to help us adapt our content to the cell phone; a platform that some experts believe has even greater promise than the Internet. We continue to broker deals with carriers that pay us significant license fees for our content. Beyond the cell phone we continue to extend our hit content to interactive platforms everywhere including iTunes, Comcast, Yahoo!, YouTube and others. We have also set up an investment fund and are investing in a variety of companies that will lead us into this space as well. There has been so much activity on the Internet front already it's hard to believe that this is just the beginning. So before I say much more about the future let me briefly update you on the major headlines coming from each of our businesses. In television the CBS Television Network continues to be America's most-watched television network in primetime. Currently, season to date, we're number 1 in every major category, households adult 25-to-54 and 18-to-49. These numbers were also true before the Super Bowl; we were number 1 in all these categories and obviously all these numbers increased after the game. With more than 93 million viewers, CBS' coverage of Super Bowl 41 gathered the third-biggest audience in broadcast history behind the finale of Mash and Super Bowl 30. According to Nielson, about 140 million people watched all or part of that game -- 140 million people; that's close to half of the U.S. population. It also achieved record advertising pricing as well. Remember, there is simply no other medium that can deliver that many eyeballs in one fell swoop and create that kind of passionate community. We're thrilled with the success of Super Bowl 41. What's more, our broadcast of the Grammies on February 11th delivered the award program's largest audience and highest ratings in adults 18-to-49 and adults 25-to-54 since 2004. While we love having the mega events, our real strength lies in the depth and consistency of our successful shows. We have nine of the top 20 shows, more than any other network. Also in television, our production company, CBS Paramount Network Television, continues to provide top programs to the broadcast and cable markets and now produces seven of the top 20 primetime series on network television. On the distribution side, we combined CBS Paramount Television, King World and CBS Paramount International during the fourth quarter to form CBS Television Distribution, the biggest syndication powerhouse in the business. Rachael Ray was the most successful new series of 2006 and with renewals through 2010, it's a franchise in the making. Most importantly overall our strength in syndication remains solid and on most weeks we have nine of the top 10 shows in syndication. Our cable operations are thriving as well. Showtime had a terrific quarter and year, both in programming and subscriber growth. Dexter quickly became the network's highest-rated show and along with Weeds continues to generate great critical and industry acclaim. In April we're looking forward to the premiere of our next big original series, The Tudors. Over at CSTV we're enjoying the immediate benefit of recent multi-year programming agreements with DirecTV that has put CSTV in nearly 21 million homes. That's a 50% increase since we acquired it last year. Our television station group also had an extremely strong fourth quarter and a great 2006 overall, primarily driven by political dollars and the success of the CBS Television Network. We've seen local news ratings growth in key markets, particularly in New York and L.A. where most of the money is made. There's indication that 2008 political dollars could creep well into 2007, particularly in major states across the country where the primaries are being moved up. Moving to radio, clearly in 2006 for radio it was a challenging year. We're not satisfied with this performance and we continue to aggressively seek ways to engage listeners with the programming that they want to hear in the ways they want to hear it. Certain formats such as JACK and FREE FM have shown positive momentum and we continue to leverage interactive opportunities and capitalize upon HD radio and streaming, plus the use of online video streaming and other technologies are already helping radio become more personalized and community-oriented. Throughout the year, as I noted, we sharpened our major market focus in radio which will now enable us to deploy our resources where they matter most. Let's not forget that we achieved multiples in mid-teens for our slower growing markets. This only underscores the values of the operations we have elected to keep. With the sales of many of our stations at high multiples, with the improvement in many formats and with all the new digital initiatives we are ahead of the curve in our transformation of this important business. In outdoor, our outdoor division continues to show exceptional growth. Revenues were up double-digits for the quarter driven by strong performances in the U.S., Mexico and Canada. In North America and in our international operations, we have continued to acquire multiple display spaces while ramping up our digital media offerings. We love outdoor and expect the strong growth to keep going as digital technologies continue to make out-of-home ads more compelling, targeted, timely and cost effective for advertisers. Over at our publishing business, Simon & Schuster finished 2006 with 111 New York Times bestsellers, the most in company history. Fourth quarter sales were very strong and have carried over well into the first quarter. So that's a brief look at where CBS is today. We had a great first year and our fourth quarter was our strongest quarter of the year, giving us great momentum going into 2007. We continue to produce strong free cash flow quarter in and quarter out, maintaining a healthy balance sheet. We have substantially repositioned our portfolio from parks to significant broadcasting properties, which will put us in a strong financial position for 2007 and beyond. When comparing 2007 to 2006 on an as-reported basis, several factors including higher expense for stock-based compensation, the sale of those 39 radio stations and nine television stations as well as the shutdown of UPN, will result in revenue and operating income that will be comparable to that of '06. For the long term, the company is poised to deliver rates of growth as follows: low single-digit growth in revenues, mid single-digit growth in operating income and high single-digit growth in earnings per share. This future outlook underlies our strong fundamentals across the company. It is this solid base and our belief in the future of these businesses that enables us to make two important announcements today. First, I am pleased to announce this morning that our board of directors has approved an increase of 10% in our quarterly dividend raising it from $0.20 to $0.22. We continue to believe that a healthy dividend is the best way to return value to our shareholders. This is now the fourth increase in the last 14 months from $0.14 to $0.16, from $0.16 to $0.18, $0.18 to $0.20 and now from $0.20 to $0.22. This represents a total increase of nearly 60% since we became a standalone company last year. A second shareholder initiative is one we discussed on our last earnings call: a potential share repurchase program. I'm pleased to tell you that in addition to the dividend increase, our board has approved a $1.5 billion share repurchase program. We plan to buy back up to 6% of the company's outstanding common stock, or roughly 47 million shares at current values. If you include the shares we acquired in the Liberty swap it is actually 7%. Fred will discuss the particulars a little bit later. The approval of the dividend increase and share buyback program is a direct reflection of our complete confidence in our ongoing ability to generate strong, healthy free cash flow. We strongly believe in our businesses and have a proven ability to deliver on our commitments. We are doing everything we can to ensure this principle will continue for many years to come. We have demonstrated once again how important our shareholders are to us. As you can tell, we've made great strides in 2006 and have positioned the company for future success in '07 and beyond. Once again we are positively determined to continue to receive compensation for our content through retransmission, reshape our portfolio into better margin, higher growth businesses, take our world-class content and to extend it to new interactive platforms and, as underscored by our two announcements this morning, return value to our investors. Thank you and now let's hear from our CFO Fred Reynolds."
},
{
"speaker": "Fred Reynolds",
"text": "Thank you, Leslie and good morning to all of you. As Leslie just discussed our fourth quarter and full year 2006 highlights, let me add some additional information on our fourth quarter operating performance, cash flow and balance sheet. Then I'll brief you on our $1.5 billion share buyback plan and finally provide you with some comments on our expectations for 2007. Revenues for the fourth quarter of 2006 totaled $3.9 billion. That was up 2% over the fourth quarter of last year. Now as we have mentioned in previous quarters, two items reduced our reported revenue growth when compared to 2005: first was the absence of the UPN network in the fourth quarter of 2006 due to its shutdown at the end of September. Second, we now record our DVD revenues net of cost as we now use a third-party distributor. These two items reduced our total revenue growth in the fourth quarter by 3.6 percentage points. Television, outdoor and Simon & Schuster led our fourth quarter revenue growth with television up 3% versus year ago fourth quarter. Again, the absence of UPN and recording DVD's net reduced the television segment's revenue growth by 5.5 percentage points. TV stations lead the segment's revenue growth with revenues up 14.6%, driven by very strong political ad spending in the fourth quarter of 2006. Turning to OIBDA, as you will note, in our earnings release we report profits with and without the non-cash impairment charges which had a very, very significant negative impact on earnings in the fourth quarter of 2005. So OIBDA, excluding the impairment charges for the fourth quarter of 2006, was $860 million, up 11% over last year's fourth quarter. Included in the fourth quarter's OIBDA was $13 million of stock-based compensation expense versus only $5 million in the previous year's quarter. Again, the television segment led our OIBDA growth in the fourth quarter, up 20% over the fourth quarter of last year. Outdoors' OIBDA was up 13% versus year ago. We are very pleased, very pleased to report that all of our segments improved their profit margins in the fourth quarter. Overall our adjusted OIBDA margin for the company was 22.5% in the fourth quarter of 2006, up almost 2 percentage points over the fourth quarter of 2005. As you can tell, with the portfolio moves that we have made that margins are going up as we get rid of businesses that were not as profitable as the total company. Subsequent to the year end 2006 we made a couple announcements on the sale of nine television stations. These stations were sold at an after-tax multiple of about 15X cash flow. However, due to high allocated goodwill and intangibles associated with this transaction we did recognize a $65 million non-cash impairment charge in the fourth quarter of 2006. We expect to close on the sale of these TV stations early in the second half of 2007, at which time the gain on the sale will be recognized. Operating income for the fourth quarter totaled $759 million on an adjusted basis, up 14% over the fourth quarter year ago. In other items net you'll notice that there's a profit of $13 million in the fourth quarter. Recorded in other items net is the gain on the sale of the five Buffalo radio stations which closed in December of 2006. As we have noted in the earnings release, subsequent to year end ten radio stations in three markets -- Kansas City, Columbus and Greensboro -- have closed. Those gains on those sales will be recorded in the first quarter of 2007. The remaining 24 radio stations in six markets will close during the balance of the first and second quarters. Our provision for income tax, including the impact of impairment charges for the fourth quarter, came in at a 33% rate, quite a bit lower than the fourth quarter 2005's rate of 45%. The drop in the tax rate is due largely to truing up the tax provision for the federal, state and local returns which were filed at the end of 2006. Going forward, we expect our tax provision to be at a rate of approximately 14%. Also during the fourth quarter 2006 we took a non-cash charge to reduce the carrying value of one of our equity investments due to the fact that, in our opinion, the investment's stock price decline in 2006 was other than temporary. This non-cash charge of $156 million pre-tax and $94 million after-tax is reflected in equity losses in affiliated companies. As Leslie noted, net earnings for the fourth quarter was at $335 million, or $0.43 a share on an as-reported basis. On an adjusted basis, excluding the impairment charges, stock-based compensation asset sales and the one-time tax benefit that was referred to, earnings per share was $0.60 for the fourth quarter of '06, up 43% over year ago. Free cash flow for the fourth quarter was a use of cash of about $14.7 million. However, included in free cash flow in the fourth quarter was our discretionary pre-funding of our qualified pension plan of $200 million. As we have mentioned previously, we believe the mid-teens after-tax internal rate of return on funding the pension plan, in essence reducing debt and getting a tax deduction for it, was a real good use of our excess cash. Taking into account this pension pre-funding we produced very strong free cash flow in the fourth quarter 2006. Strong earnings coupled with high accounts receivable collections drove cash flow in the fourth quarter offset somewhat by a $66 million increase in capital spending. The jump in capital spending was driven by a $49 million increase in the television segment relating to new TV station facilities in Los Angeles and Chicago. As you'll recall, we previously sold the L.A. and Chicago buildings and these are their replacement facilities. CapEx was also up about $30 million at outdoor, driven by spending for new and additional displays for our London Underground contract which has been extended for another eight years and new boards including digital in the U.S. Turning to the balance sheet. At 12/31/06 cash totaled $3.1 billion and gross debt was $7 billion. Sale of assets such as Paramount Parks plus full year free cash flow of over $1.6 billion, which you should note includes $250 million of the discretionary pension pre-funding for the full year, greatly improved our already very strong balance sheet. Our leverage ratio using gross debt of the $7 billion was 2.2:1 for the year ended 2006. Now let's turn to 2007. As Leslie mentioned, several factors will affect our revenue and profit growth on an as-reported basis in 2007 versus 2006. Most of these factors which affect 2007 involve actions we had taken to reshape our portfolio, to improve our growth prospects, increase margins and along the way, as Leslie said, get terrific exit values. Here are the key items which will affect revenue and profit comparisons in 2007 versus 2006: First, as you'll recall, we signed agreements in 2006 to sell 39 radio stations for $669 million, or over 14X their 2006 OIBDA. These stations have either closed or will close shortly and their absence will affect the comparability with 2006. Next, we also announced the sale of the nine TV stations for about $250 million or 15X their 2006 OIBDA. The sale of these stations will affect comparability again in 2007 versus 2006 when these transactions close later this year. Third, for the nine months UPN was still broadcasting in 2006, it produced revenues of over $175 million which will affect our 2007 revenue growth comparisons as now UPN has been shut down. Next, off-network syndication in 2007 will largely consist of the syndication of NCIS which will likely occur in the fourth quarter of 2007. In 2006, as we reported on, we syndicated the second cycles of Frasier, Star Trek Voyager and the first cycles of CSI Miami and Without a Trace. As we look to 2008 and 2009 the number of programs we have available for syndication increases dramatically. Finally, stock-based compensation expense will likely increase by $40 million to $50 million in 2007 versus 2006, assuming the same level of equity grants are issued in 2007 as were issued last year. As you know, we vest the equity grants pro rata over four years, so the 2006 grants will have roughly 25% of their expense reflected in 2007 thereby driving up our incremental stock-based compensation expense in 2007. Taking all these items into account, revenues and operating income on an as reported basis would be comparable to 2006. However, on an underlying growth basis, stripping out all these non-comparable items we expect our businesses in 2007 will deliver another solid operating performance and strong cash flow. Finally, as Leslie announced at the start of today's call, we'll raise our dividend by $0.02 to $0.22 a quarter and that's payable April 1st to shareholders of record as of March 7th. Also we will initiate a one-time $1.5 billion share buyback program utilizing an accelerated share repurchase program or ASR. Our ASR program will involve us buying $1.5 billion of CBS shares, or roughly 47 million shares, from a financial institution immediately reducing the number of shares outstanding. We believe an ASR program will efficiently and effectively utilize our excess cash and ensure the share buyback is accomplished at a very attractive cost to us. We expect to complete the share buyback program by the end of this first quarter. With that I thank you and we'd like to open the telephone lines for your questions. Connie, if you could open the lines that would be great."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Victor Miller - Bear Stearns."
},
{
"speaker": "Victor Miller - Bear Stearns",
"text": "Fred, I have a question for you and one for Leslie. In terms of the 39 radio stations and nine TV stations at UPN, the net political dollars that you had last year versus what you anticipate this year, syndication revenues you talked about, can you give us a sense when you wrap that all together, Fred, what does that mean in terms of the revenue drag potentially for this year versus last year and in the sense of the EBITDA associated with that bucket of pieces? Leslie, in terms of the radio business you have been able to sell your radio stations at about a 14.1X multiple overall. I'm wondering two things philosophically. One, is there any more to do in terms of paring back that portfolio? Secondly, if you look at a lot of the radio growth that Clear Channel just reported, one could argue that it comes from Premier, which is its network business. As you know, Citadel is now buying ABC's network business along with its station so there's, again, an integrated radio network presence. There are two of those in the marketplace, Westwood is kind of a separate entity and you own an 18% stake in it. Does it make any sense to have in your case those two together? Thanks."
},
{
"speaker": "Les Moonves",
"text": "In terms of paring it down, right now we're pretty satisfied. We did an analysis at the beginning of the year of what we felt were the smaller markets least likely to grow stations. When you're able to get the multiples that we got, we did that. It's not to say that we won't look at it and potentially pare down further, but at the moment we're pretty happy with the hand that we're dealt. We do have a relationship obviously with Westwood One where we own a decent percentage of the company. There are no plans right now to bring that in-house. One could argue about the value of the networks. We still think Westwood is a very valuable asset, but we have no plans to bring it in-house and combines it with our radio stations."
},
{
"speaker": "Fred Reynolds",
"text": "Victor, on the radio stations, their sales for '06 were about $125 million,$130 million. I give you a little bit of a range because some of them when into an LMA in the fourth quarter. But their run rate for that probably is about $125 million. The nine TV stations are probably around $75 million to $80 million in revenue. So that's what will come out and as we've committed before, we'll do the reports on a same-station basis so you can see the comparability, but that is going to be a drag. Finally, I think your question was about political. Clearly '06 was a great political year, it set all records. As Leslie alluded to, every year, even on odd years we have political but nowhere at the level that you have an election year. The question is will some of the '08 political dollars come into this year? That is hard to tell at this point. But political was very strong in '06. Obviously we had the Super Bowl this year, so on a revenue standpoint the revenue won't change that much except the profitability is clearly different from selling a normal ad versus a sports ad."
},
{
"speaker": "Les Moonves",
"text": "Clearly the political race is heating up a lot faster than everybody thought it would. I think there's more attention, considering that we are almost two years away from the next election the fireworks that are out there bodes well for us. Obviously a lot of people are raising a lot of money and so I think it bodes well. I think, as Fred said, there's a real possibility there could be more leakage from '08 into '07 of political dollars."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jessica Reif-Cohen – Merrill Lynch."
},
{
"speaker": "Jessica Reif-Cohen - Merrill Lynch",
"text": "Les, as you reshape your assets over the next three to five years, how different will the revenue and cash flow mix be? Do you need to make acquisitions? Where do you stop with the dispositions? Could you just give us a little guidance on how much you plan on spending for digital boards in outdoor in '07 and '08?"
},
{
"speaker": "Les Moonves",
"text": "Jessica, the first question is a tough one. Obviously we are investing in a rather small way in a variety of new media assets. We do believe in their long-term growth and that that's where a lot of our revenue is going to come from in the future. It's really hard to assess where that is. As it stands now we still believe in the blocking and tackling of our basic assets which are television, radio and outdoor and they're still great businesses. There will be obviously revenue and profit migrating into new media assets and we intend to be there in quite a large way. We didn't have any great intention to sell our television stations, these nine stations, but at the multiples that we were offered they were very, very high prices and we had to look at that. The same thing with our radio stations. On one hand people say, gee, radio is slowing down. At these multiples it certainly doesn't look that way. So we're pretty pleased with the way we ended up and we would always listen to a reasonable offer."
},
{
"speaker": "Fred Reynolds",
"text": "Jessica, on the outdoor, one of the big jumps in the fourth quarter of '06 was in outdoor, about $29 million to $30 million. Most of that was with the London Underground and a lot of that is digital. We were looking to expand our capital spending in '07 in outdoor by about $40 million to $50 million, and I would say a good share of that, the lion's share of that, is probably for digital outdoor in the UK. Just to give you a perspective on where we are. At the end of '07 we expect to have in the U.S. about 300 digital boards installed. That is up from about 160 where we are now. In Europe because of the London Underground, we are going to have thousands of boards, but they're going to be more the display boards. We could end '07 with about 3,000 display boards with the lion's share in the London Underground. So I think you can kind of plan on $30 million to $40 million a year in the expansion of our boards. Most of it will be in the digital area."
},
{
"speaker": "Operator",
"text": "Your next question comes from Lucas Binder - UBS Investments."
},
{
"speaker": "Lucas Binder - UBS Investments",
"text": "On retransmission, obviously it is good direction, the announcement last week with regard to the nine cable companies, MSOs. What is the timeline for the next step and what can we look out for as far as additional negotiations ahead of the big MSOs in 2009? Fred, you mentioned on a gross basis you are about 2.2X leverage. Do you see opportunity to increase that, and potentially following on how the share buyback goes you'll look to do additional buybacks in the future?"
},
{
"speaker": "Les Moonves",
"text": "On the retrans, obviously we are extremely pleased by the nine MSOs that have jumped on board. You're going to see more and more of these smaller operators and some of the not so small operators coming around. And as I said, there's a shift, there's a new paradigm. As I've said before, MSOs are already paying for networks. You can disguise it under other things as everybody has done. I've said this before, if you're paying $3 for ESPN, you're really paying $2.50 for ESPN and $0.50 for ABC. We are now a stand-alone. We see more and more of the MSOs getting on board. As you noticed, these nine MSO deals were done without a whole a lot of noise. There weren't big newspaper ads, there weren't big fights, there wasn't anything pulled off the air. So I think the MSOs are realizing that it's better to get along than to fight. Yes, the big ones are up in '09 and '10, but you'll see us do a number of deals before then."
},
{
"speaker": "Fred Reynolds",
"text": "The leverage ratio, as we said before, is really at the low end of what we targeted. We have some debt maturities that come due in '07, about $700 million in May, we plan to extend those out with ten and 30-year money depending on how the market looks. So there's no desire to reduce our debt or leverage. Listen, we think paying dividends and increasing it is the best way. If you look at where we are, we'll spend about $675 million on dividend payouts at the $0.22 a quarter. That's before the share buyback. So we buyback 47 million shares so that drops to maybe $640 million. That's a very significant call on cash. As you know, it's far greater than our interest cost. So I think we have to weigh that. I think the inclination of Sumner and Leslie and myself is that dividends would be the preferred method. But hopefully we've proven to you that when we have a windfall on some of these asset sales that we're going to return to shareholders if we can't redeploy it effectively at greater than our cost of capital in our existing business. That is our goal thought, we would love to keep redeploying this cash in our businesses and accelerate both the revenue, profit and returns growth. But absent that we'll return it to you. The preference really is dividends because we think it is a little bit stickier, if I could use that term."
},
{
"speaker": "Operator",
"text": "Your next question comes from Kathy Styponias - Prudential."
},
{
"speaker": "Kathy Styponias - Prudential",
"text": "Les, I was wondering if you can reconcile for us in light of your retransmission consent deal, your decision to sell TV stations albeit in smaller markets, in light of the fact that it's at the TV station level that you're actually capturing the cash for retrans consent, why are you selling stations and what should we expect from you with respect to further TV station sales? Fred, I was wondering if you can give us any sort of color on what the value that you're extracting for retransmission consent for the CBS signal? Thanks."
},
{
"speaker": "Les Moonves",
"text": "Kathy, in terms of that, obviously we weighed that. These are really small market stations that we sold. We weren't going out there looking for them, but when you get the opportunity to sell them at those phenomenal multiples, you figure in what retrans potentially could be and the economics still made much, much better sense to do a sale. Having said that, there would be little chance that any major station would be sold because the future is extremely bright for what they will get per sub. So we factored that in and it all worked out in our favor. I'm not going to let Fred tell you what we're getting per sub."
},
{
"speaker": "Fred Reynolds",
"text": "Kathy, obviously Leslie has stated that the value of our content and I guess you can be assured that we're going to be fairly compensated for that in these deals. I would echo what Leslie says about these businesses. When you get a 15X after-tax multiple, Kathy, as you know, on businesses like Austin we could have baked in almost ESPN kind of retrans and not gotten those multiples."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Klim - Credit Suisse."
},
{
"speaker": "John Klim - Credit Suisse",
"text": "Have you seen any material impact or could you talk about any impact on the ratings of the shows that you've highlighted on YouTube? Could you update us on how you feel about further developing your relationship with YouTube or its parent company, Google? Thanks."
},
{
"speaker": "Les Moonves",
"text": "Sure. Our deal with YouTube where we supply certain entertainment news and sports content is primarily promotional at this point in time. Certainly with the entertainment stuff we have seen certain cause and effect from some of our research. It's rather early to say, but in terms of the number of hits that our promos get on YouTube, arguably our content is promoted so heavily because of the number of people. In addition, it's bringing in a younger demographic. We think it is fairly significant. It's hard to do an absolute cause and effect, but we know it absolutely is helping. We are looking at every single outlet there is for our content. We are talking to everybody. As you've seen, we've done deals with just about everybody and it's something that all the companies are looking at and how do we maximize our content in the future either through advertising sales or through promotion."
},
{
"speaker": "Operator",
"text": "Your next question comes from Doug Mitchelson - Deutsche Bank."
},
{
"speaker": "Doug Mitchelson - Deutsche Bank",
"text": "Les, one of your most under-monetized assets when you look across your company remains your TV library, maybe even current TV production. So cable operators are sitting there with plenty of servers at their head ends, waiting for the green light to offer as much TV content and demand as you will give them. What's holding you back right now from offering more or all of your content on demand? I know that you're doing some, but it's tiny relative to the totality of your TV library and current production. Maybe along a similar vein, what happened in the Google negotiations that made you uncomfortable that you didn't want to give them broad distribution of your TV content at this time? Was it monetization, was it rights? What was it?"
},
{
"speaker": "Les Moonves",
"text": "No, it's a very valid point. Our TV library is unbelievably valuable and it is relatively undermined. We have not put a lot of properties out there. The main reason -- this sort of ties into your second question -- is we want to get paid appropriately for it. We will eventually have our library out there, it will be on demand either through advertising, subscription or pay per view, some way shape or form, we just value it very highly and very dearly. We obviously get paid through syndication and DVDs. It is inevitable that our library is going to be out on the Internet and downloaded and we will be making deals for this content. The good news for us as we go forward is, you're right, it is undermined and there's a great future ahead with this library and with our current production. So look for more things in the fairly near future."
},
{
"speaker": "Doug Mitchelson - Deutsche Bank",
"text": "I'm not sure if there's a specific answer you can give, but as you think about the things that are holding you back right now, is it the size of Google's audience, is it the cable operators, are they not able to monetize through advertising the content to the level you'd like to see? What's stopping it from happening?"
},
{
"speaker": "Les Moonves",
"text": "In general terms without getting into the specifics, we want to make sure that, look, there is a cause and effect. Obviously putting it out there, we want our content and I genuinely believe everybody is going to be able to get our content whenever they want it, wherever they want it, it's just getting the right price at the right time for it. There are a lot of factors that weigh in. Obviously we have an important DVD library that might be affected, we have the syndication thing that might be affected and that will all be well and good and we think that the Internet will be additive to that, it's just that we just have to be appropriately paid for it. We discuss this all the time and it's one of the things that we deal with greatly but we have to get the right deal."
},
{
"speaker": "Operator",
"text": "Your next question comes from Anthony Diclemente - Lehman Brothers."
},
{
"speaker": "Anthony Diclemente - Lehman Brothers",
"text": "Fred, if you take the free cash flow that you reported in this release for '06 and you add back the $250 million in pension contribution, which I think most people would agree is discretionary, you get to about $2.40 a share of free cash flow. My question is, as we move forward into '07 you're looking for comparable EBITDA. Is there any reason that the free cash flow number shouldn't move in somewhat lockstep with EBITDA? Is there any change in working capital or change in CapEx that's dramatic that we should know about? Is there any chance that the retransmission deals that you have in place with the larger cable operators, that being Comcast and Time Warner Cable, are renegotiated prior to the '08/'09 time period when those contracts are up? Given the shift that you discuss in the balance is there any chance that you would preempt the existing time horizon on those existing contracts? Thank you."
},
{
"speaker": "Fred Reynolds",
"text": "As you know, we don't forecast or give guidance on cash flow. But let me give you a couple comments because I think it might be helpful. In '06 we spent a little under $400 million, $394 million in capital spending. Our expectations, which you'll see in our K that gets filed probably tomorrow or the next day, we are going to give a range of estimates of $450 million to $475 million in capital spending. I personally think we'll be at the low end of that at the $450 million. So we are going to step up capital spending again. The lion's share of it is going to go into outdoor, so that is going to be a change. The one thing I think, as we noted I think it was in the second and third quarter, that we had the settlement of a number of previous audits of taxes with the IRS from 2000 to 2003. We also had a fairly large overpayment in 2005 that we applied to 2006. So our cash taxes will go up. Everything else you say, working capital probably will be the same; we won't use a lot of working capital. As you know, with only one major syndication versus four that we will have no use of net assets, you guys call it working capital, it's really changed to net assets because the receivable won't get ballooned as much."
},
{
"speaker": "Anthony Diclemente - Lehman Brothers",
"text": "And then presumably your interest expense comes down I would think?"
},
{
"speaker": "Fred Reynolds",
"text": "Sure, interest on $1.5 billion, we earn a measly 5.25% on that. So on $1.5 billion that's going to come down by $75 million or so. Again, I don't want to give a forecast. I would point out that capital spending will go up, everything else should stay the same except cash taxes will go up in '07 because we won't enjoy the roughly $150 million overpayment that we got to enjoy in '06."
},
{
"speaker": "Les Moonves",
"text": "Anthony, on your second question, certainly it's possible that we would enter into early discussions with these people. Our relationships with Comcast are terrific. We do a lot of business with them. We have a VOD deal with them and we talk to them all the time. The same thing with Time Warner obviously. We have a lot of business with Time Warner, we co-own the CW with them, they have a lot of programming on CBS so we are open to dialogue, Showtime is negotiating with them all the time as is CSTV. We are certainly open and willing to talk with them at any point in time. I guess it's very possible that negotiations could begin much earlier than when the contracts are up."
},
{
"speaker": "Operator",
"text": "Your next question comes from Kit Spring - Stifel."
},
{
"speaker": "Kit Spring - Stifel",
"text": "A number of your affiliates are being successful with retrans fees. Do you expect to change the relationships with your affiliate so that you garner some of those economics? I think that's been changing over the past five or ten years. Do you see affiliate comp turning to reverse comp and how big of an opportunity is that?"
},
{
"speaker": "Les Moonves",
"text": "You know, Kit, our relationship with our affiliates has evolved over a period of time. When I first got here we were paying out hundreds of millions of dollars which is virtually down to zero right now. There are a lot of deals that we do with them. Our relationships with our affiliates are great. They like the idea getting paid for retrans as do we. So it's an ongoing dialogue in terms of the content we supply them as well as our relationship with them. So without getting specific it will be an ongoing dialogue and, once again, it continues to evolve."
},
{
"speaker": "Operator",
"text": "Your next question comes from David Miller - Sanders Morris Harris."
},
{
"speaker": "David Miller - Sanders Morris Harris",
"text": "Outdoor revenue growth plus 10%, that's obviously model growth in the quarter generally comparable to your competitors. I would think, however, that that would be leverageable into at least mid-teens to high teens EBITDA growth. You came in with plus 13% growth. It looks like you got hit by foreign exchange a little bit. Was there something else going on in the quarter expense wise that you could flesh out for us? Also, at your analyst day about a year ago today or a year ago this week or so you had mentioned that the publishing business was also non-core to operations, very similar to the Paramount Parks. What is the status of the sale of that asset? Thanks very much."
},
{
"speaker": "Les Moonves",
"text": "David, thank you. I'll deal with the publishing question and I'll flip it to Fred to give you the color on the outdoor business. In terms of publishing, yes, I mean arguably Simon & Schuster is not a core business; however, they are showing a tremendous ability to generate terrific revenues and profits and we love having them with us. We think it's a great asset. As I said, they not only had their best year last year creatively, but financially they're doing far better than people expected. So we love having it and we find no need to sell it, it's going to be a part of our businesses for a long time to come."
},
{
"speaker": "Fred Reynolds",
"text": "On outdoor, a couple things in the fourth quarter. Again, I would cite that in U.S. the billboard business was up 12%, and some of it had to do with the revenue growth. As you may know, some of the contracts that were sort of marginal for us we're no longer participating in, which plays into what we booked as far as expenses in the fourth quarter. We did have severance costs to lay off 110 people that related to the New York MTA and also the New York street furniture businesses that we no longer have. Again, those were marginal at best contracts for us, so the revenue will come down in all of '07, but the profits will not be that affected. But we did recognize the exit cost to get out of that including, again, layoffs of 110 people. We did renew the New York subway and we did renew the London Underground, both of which had significant increases in fees in the fourth quarter because both of those new contracts started in the fourth quarter. What I would tell you, there's a little bit of a lag. Obviously the municipalities want their fees early. They have with the increased license fees came increased availability of inventory, a lot of it, as we discussed earlier on the call, going to digital. So we're building out, we're adding the new display, that's why we're spending more on capital there, but the revenue, we haven't monetized all the displays yet. I would expect to '07 us being able to hike off and more than offset the increase in the transit franchise fees or license fees in the New York subway and London Underground. We had some other renewals, but I think those are the big items that sort of were a drag on the fourth quarter and why I've said I think we can go 2X revenues up at 1% in the U.S. and profits should be up 2%. Those were the drags that pulled us down, but again, I think almost all of them are just transitional and that we will have more inventory to sell even though the franchise fee went up."
},
{
"speaker": "Operator",
"text": "Your final question comes from Benjamin Swinburne - Morgan Stanley."
},
{
"speaker": "Benjamin Swinburne - Morgan Stanley",
"text": "Let me ask you a question on the DVR side. Can you give us an update on your thoughts on Live Plus, what the ad buyers are saying along those lines and any expectation for monetization of recorded viewing in 2007 in your guidance?"
},
{
"speaker": "Les Moonves",
"text": "Yes, the advertisers got away with just getting Live last May. That won't happen this year. Number one, there are much more sophisticated ways of measurement through the commercial ratings, more Live Plus Same Day, Live Plus Three. It's now going to become a significant number and we need to get paid for that, we will get paid for that. I think all the networks feel like that is a necessity and that it's going to happen which bodes very well for this upfront period. So we're very excited about it."
},
{
"speaker": "Marty Shea",
"text": "Thank you, everyone for joining us. I will be available for the rest of the day. Have a great day."
},
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PARA | 3 | 2,006 | 2006-11-02 08:30:00 | Executives: Sumner Redstone - Executive Chairman Leslie Moonves - President and CEO Fred Reynolds – EVP and CFO Marty Shea – IR
Analysts: Jessica Reif Cohen - Merrill Lynch Doug Mitchelson - Deutsche Bank William Drewry - Credit Suisse Victor Miller - Bear Stearns Kathy Styponias – Prudential John Blackledge – JP Morgan Anthony DiClemente - Lehman Brothers Andrew Baker - Cathay Financial Anthony Noto - Goldman Sachs Michael Nathanson – Bernstein David Miller - Sanders Morris Harris
Operator: Good day, everyone and welcome to the CBS Corporation third quarter 2006 earnings release teleconference. Today's call is being recorded. At this time I would like to turn the call over to the Senior Vice President of Investor Relations, Mr. Marty Shea.
Marty Shea: Good morning, everyone and thank you for taking the time to join us for our third quarter 2006 earnings call. Joining me for today's discussion are Sumner Redstone, our Executive Chairman; Leslie Moonves, our President and CEO; and Fred Reynolds, Executive Vice President and CFO. Sumner will have some opening remarks, and then we will turn the call over to Les and Fred for strategic and financial issues. We will then open up the call for questions. Let me note that statements on this conference call relating to matters which are not historical facts are forward-looking statements which involve risks and uncertainties that could cause actual results to differ. Risks and uncertainties are disclosed in CBS's Corporation's news releases and security filings. A summary of CBS Corporation's third quarter 2006 results should have been sent to all of you. If you did not receive the results, please contact Punam Visay at 212-975-3667 and she will get it to you. A webcast of the call, the earnings release, and any other information related to this presentation can be found on CBS Corporation's corporate website at the address of cbscorporation.com. Now, let me turn the call over to Sumner.
Sumner Redstone: Thanks, Marty and good morning, everyone and thank you for joining us. We now have three quarters on the books and I couldn’t be more pleased with everything that Les and his team have achieved. Over the past ten months, we have delivered on the promises CBS made at the beginning of the year. We have driven growth in every important measure: revenue, profits, free cash flow, and of great importance to our shareholders, dividends. By the way, think about it -- free cash flow up 65%. Our core businesses continue to be among the strongest in the industry and at the same time, Les and his team are executing our strategy of bringing our world-class content to emerging digital platforms. I must tell you, I am more enthusiastic than ever about what Les and his team are doing at CBS and everything the future holds for this great Company, and by the way, for this great executive. I have said it before, I want to say it to you again: in Les we have the best executive in the media industry. To tell you more about it, here is our great executive, Les.
Leslie Moonves: Thank you, Sumner. I'm overwhelmed by your comments; I really am. I appreciate it. Good morning, everyone. Thank you for joining us. I am very happy to be here to talk about the CBS Corporation's third quarter results. It continues to be a very exciting time at CBS. We are pleased with the performance of our core businesses. Many of the digital opportunities we have seen on the horizon are now becoming reality. This morning, I will give you an overview of our third quarter results, along with some key operational highlights. After that, our CFO Fred Reynolds will provide a more detailed look at our financial position, and then we will open up the call for your questions. We started the third quarter by raising the dividend 11% from $0.18 to $0.20 per share. It was the third time we increased the dividend since the start of the year, adding up to a total increase of 43%. Once again, these increases demonstrate that we are confident in where we are and where we are headed and importantly, we are committed to delivering on our promise to continually return value to you, our shareholders. Now, let's take a look at our other third quarter financial highlights. Revenues of $3.4 billion were very slightly ahead of the same quarter last year. OIBDA was up 3% to $756 million. Operating income rose 4% to $646 million. However, excluding stock-based compensation and adjusting for the separation, OIBDA for the third quarter was up 6% and operating income was up 7%. Meanwhile, net earnings from continuing operations were up 26% to $324 million. Diluted EPS was up 27% to $0.42 per diluted share. Free cash flow, which reflects net cash flow from continuing operations minus capital expenditures, was up 65% to $432 million. Looking a bit closer at revenues, we had 9% growth in outdoor, offset by a 6% decline in radio. TV revenues were essentially flat, again affected by certain one-time events such as the switch from self-distribution to third-party distribution of our DVD business and the shutdown of the UPN Television Network. Overall, there is no doubt that are core businesses are very healthy and continue to throw off lots of cash. Now, we know you have a lot of questions about what we plan to do with all that cash. Some preliminary thoughts: I want to reiterate what I have said before, we have no plans to make any large acquisitions. That means we are not buying a movie studio. But rather, we will continue to look for smaller tuck-in opportunities that complement the businesses we are already in. Just this week, we announced an equity investment in Spot Runner, a unique start-up that helps small businesses promote their brands with high quality, local television ads. We believe Spot Runner has great potential and clearly fits well with our core businesses, making it a smart strategic investment in our future. I will say more later about the balance sheet, particularly as it pertains to future plans for use of our cash. But first, I would like to take you through some of the operational highlights at the businesses, starting with television. At the CBS Television Network, we started the 2006-2007 season strong and have been holding our lead over the other networks ever since. Through the first five weeks of the season, we continue to be number one in households, number one in viewers, number one in 25 to 54, a very competitive number two in adults 18 to 49, just a tenth of a point behind ABC. We have the number one sitcom, Two and a Half Men; the number one news magazine, 60 Minutes; the number one new drama, Shark. Through Sunday, we have grown CBS viewers year-over-year and we are up double-digit in viewers 25 to 54 and 18 to 49 on three nights of the week. It is not just CBS who is doing well. Looking at the big four networks year-over-year, viewers are up 7%, 25 to 54 is up, 18 to 49 is up. Once again, the so-called death of network television has been greatly exaggerated, even by some of the other networks. On the highly competitive Thursday night, much has been written. We have stood up very well to counter programming from ABC. CSI is neck-in-neck with Grey's Anatomy in viewers and is the number two show overall on television. Plus, our shows repeat extremely well. When the rebroadcast of CSI aired against a rebroadcast of Grey's Anatomy last Thursday night, we topped Grey's by 38% in viewers and 11% in 18 to 49. Meanwhile, DVR and Internet streaming are only adding viewers. New technologies and platforms make it easy for people to enjoy both programs that air during these highly competitive time periods. We are already getting paid for this incremental viewing on the Internet, and we expect to get paid for DVR viewing next year. Over at the news division, we're very pleased with the progress we're making at the new Evening News with Katie Couric. While the overall ratings have returned to Earth since Katie's debut week, the show has picked up traction in key, younger demos. Season to-date, it is up 24% in adults 25 to 54, which is where the vast majority of news business is sold. As a result, we have been able to attract millions more in advertising dollars. Our TV stations have also gotten a lift. They are up 33% in the demo since Katie's debut. By the way, we are the only network whose evening news ratings are up. All the others are down. We're also serving up record numbers of users and viewers with CBS News online and the Evening News on demand. Not only does this reflect improved penetration with younger demos, it also positions CBS News as a trusted information source for younger audiences as they form primary media consumption habits online. We're really happy with everything that Katie has achieved since September 5th and are confident that in the years to come the wisdom of the decision to bring her to CBS will be even more evident at CBS. Over at CBS Sports, we're having our third-best season since reclaiming the NFL in 1998. We expect to do even better in the coming weeks. In the NFL Today our pre-game show with James Brown is doing terrific. Season to-date, we are edging closer to Fox and are up 8% compared with last year, while Fox is flat. As you know, in less than 100 days, we will have the Super Bowl back on CBS. Ad spots are selling briskly, with rates now coming in north of $2.5 million per 30 seconds. I guess network television is still pretty good. In golf, we recently signed three times Masters winner Nick Faldo to be our new 18th tower guy, bolstering what already is the best golf announcing team in sports. Our TV stations also had a very strong quarter thanks in large part to political and CBS network ratings. As I have said before, success at the TV stations tends to follow the success of the network. We're now seeing the positive impact of that success. In television production and syndication, we announced the formation of the CBS Television Distribution Group. The new powerhouse combines the syndication giant King World and CBS Paramount TV, both domestic and international. Collectively, our syndication group has nine of the ten top shows in syndication and the leadership position in every single program genre. The move of reorganizing will help us consolidate and streamline our operations, focusing on marketing resources, and realize significant cost savings. Meanwhile, as we anticipated, Rachael Ray is a big hit. It is the number one new syndicated show this season by a wide margin, delivering the highest rated new show since Dr. Phil premiered in 2002. At cable, Showtime continues to build its impressive portfolio of premium quality original programming. New shows like Dexter and Brotherhood, and returning hits such as Weeds and The L Word, are raising Showtime's profile. As a result, ratings and subscribers are up. Several Showtime programs have also found wider audiences on iTunes, where Weeds continues to be one of the most popular programs. Over at CSTV we launched a new broadband platform in August that will cover over 10,000 live collegiate athletic events during the school year. In September, we began broadcasting the new Mountain West Regional Sports Network in partnership with Comcast. We're also happy with the launch of the new CW network, our 50-50 joint venture with Warner Brothers Entertainment. America's Next Top Model is winning its time period in women 18 to 34 and is just barely behind ABC in adults 18 to 34. The network as a whole is tracking ahead of the WB's ratings last year in both of these valuable demos. It is an impressive feat considering that CW viewers had to find their shows on new channels in much of the country. Our CW television stations are also performing very well. Now turning to radio. As you know, back in May we announced our intention to sell some of our stations in ten smaller markets. We had a busy quarter in this regard. In August, we sold 17 stations in five markets. In September and October we sold 12 stations in three markets. Overall, we have entered into agreements to sell 29 stations in eight markets for a total of $570 million, with two more markets to go, Fresno and Greensboro. We are expecting excellent exit values for these stations, roughly 14X OIBDA and now we will be able to sharpen our focus in those markets where we see greater opportunity to grow. We are encouraged by the revenue growth we have had in key formats during the third quarter. Spanish formats on our two major market stations were up 66%, and JACK FM on 12 stations was up 18%. In terms of pacing, if you exclude the smaller market stations that we have recently agreed to sell, October will finish up 3% in markets where we did not have loss of key morning programming from last year. We believe that the right format, be it music, language or talk, we can grow radio's revenues. We are determined to keep finding the format that the largest audiences want to listen to. We're also beginning to see the result of new talent hires. After only five months on the air, Opie & Anthony are a force to be reckoned with during the morning drive. According to newly released summer ratings, they are number one in men aged 18 to 49 in New York City, up 150% since their arrival. They are up in other major cities as well: 100% in Boston, 104% in Philadelphia, 84% in DC, 155% in Cleveland. We are extending radio to new media through podcasting and streaming. We now have over 90 stations broadcasting in HD. By the end of the year, we expect radio to bring in to close to $14 million in digital revenues. Over in outdoor, we continue to see terrific growth both in revenues, which were up 9%, and OIBDA, which was up 20%. By the way, that growth is continuing into the fourth quarter, where revenues are pacing up 8%. Here in New York, we're forging ahead with our New York City subways deal. As you know we won the NYC subways contract for ten years starting in the first quarter of '07. We have begun installing the first 80 new urban LCD digital screens and expect to have them completed this month. Over at our international operations, in the UK we're working on the London Underground and Victoria Coach Station contract. In France we have closed a deal to acquire Stower's billboard businesses which includes roughly 2,200 facings. Across all of our operations in Europe and Asia we're in the process of re-branding from Viacom Outdoor to CBS Outdoor. We look forward to having all of our outdoor businesses united under the CBS Corporation brand. In publishing, Bob Woodward's State of Denial continues to fly off the shelf. It has been at the top of The New York Times bestseller list since its debut four weeks ago and already has close to 1 million copies in print. State of Denial is projected to be one of the most successful non-fiction titles of '06 and has already generated over $14 million in revenue. We also had robust sales from a sleeper hit, the Thirteenth Tale, a first novel by Diane Setterfield which jumped to the top of the New York Times list after just one week on sale. Also this fall, we have just published Steven King's latest blockbuster, Lisey's Story, and the highly anticipated 75th anniversary of that much beloved American icon, which I use all the time, The Joy of Cooking. Last, but certainly not least, I want to talk about our efforts in the digital space. New media is a huge opportunity that cuts across all of our businesses and affects everything we do as a premier content company. You guys are always asking us when we're going to start making money here. While it is still too soon to quantify the impact, I can tell you we expect to generate hundreds of millions in digital revenues in '07. We made a number of very significant moves over the quarter to extend the reach of our television programming online. In October we partnered with YouTube to begin offering short form video streams that include content from the CBS Television Network, Showtime, and CSTV. Meanwhile as I mentioned earlier, we continue to find new platforms to stream our hit content. We're already offering many of our shows on Google Video, Apple iTunes, Amazon.com, and AOL. Plus we began offering free next-day streaming of 12 primetime series on Innertube, our own entertainment website. We have streamed more than 2 million episodes of our show so far this season and over 3 million related videos. These numbers continue to grow week over week. It is not just TV that is benefiting. The digital opportunity extends to all of our businesses. As I noted, we're getting streaming revenues in radio and at outdoor we are installing LCD digital screens in the New York City subways and all over the country. At publishing, Simon & Schuster recently partnered with Sony for the launch of its new eBook reader device. S&S is offering nearly 3,000 titles for sale at Sony's online store. Finally, as I mentioned earlier, I want to take you through our priorities for how we intend to use our free cash. First, we will opportunistically pre-fund our qualified pension plan in the range of $150 million to $200 million. Second, we will continue to return cash to our shareholders in the form of a dividend. As I said earlier, our dividend has increased 43% from $0.14 a quarter to $0.20 a quarter already this year. We expect dividends to continue to be the primary vehicle for returning cash to our shareholders each year. Going forward, we intend to increase our dividend in line with earnings growth and cash flow. Finally, based on our current business trends, we intend to recommend to our board a stock buyback to the order of $1 billion to $1.5 billion in the early part of '07. This level of buyback would return to shareholders a significant portion of the strong after-tax gains we received on the sale of Paramount Parks and some of our radio stations. The form, exact amount, and timing of the buyback will be decided over the next few months as we discuss alternatives with our Board of Directors. Above all, we will stay focused on long-term value creation and returning that value to you, our shareholders, both today and for many years to come. Thank you. And with that, I will turn it over to Fred.
Fred Reynolds: Thanks, Leslie and good morning. Leslie just provided you with the highlights to the third quarter 2006. Let me now provide you with additional information on our third quarter operating performance, cash flow and balance sheet, and our full-year outlook. Revenues for the third quarter of 2006 of about $3.4 billion were up slightly over the third quarter of '05. Two items in the third quarter reduced our revenue growth when compared to the third quarter last year. The first item, as Leslie mentioned, was revenues from our DVD sales. which were considerably lower again this quarter versus year ago, as we are required to record DVD revenues on a net versus gross basis this year. Also, our broadcast network revenues were lower due to the shutdown of the UPN Network in mid-September. These two items combined to reduce our revenues for the total company in the third quarter of '06 as compared to last year's third quarter by approximately $50 million. These two items lowered our revenue growth in the third quarter by 1.5 percentage points. Also, our revenue growth in the third quarter of '06 continued to be slowed by our radio segment sales decline versus last year. TV stations, outdoor, and Showtime all had solid revenue increases in the third quarter of '06 versus '05. Operating profit before depreciation and amortization for the third quarter was $756 million, up 3.4% over last year's third quarter. Excluding stock-based compensation expense from both years, OIBDA would have increased 6.3%. Our OIBDA margins for the third quarter of '06 were 22.4%, up from 21.7% in the third quarter last year. Operating income for the third quarter totaled $646 million, up 4% from year ago. Again, excluding the stock-based compensation expense, operating income would have increased by 7.3%. Our television and outdoor segments drove our profit growth in the third quarter, more than offsetting the profit decline at radio. Let me highlight a few other items in the P&L. Interest expense was $140 million for the third quarter, down dramatically from the third quarter last year. Once again, the special dividend of $5.4 billion we received at the very end of 2005 reduced our bank debt and interest expense when compared to last year. In addition, interest income was up in the third quarter of '06 to $41 million versus $5 million at this time last year, due to the after-tax proceeds from selling Paramount Parks of approximately $1 billion, plus strong year-to-date cash flow from operations drove our interest income. Our tax provision for the third quarter was 38.7%, down considerably from 45.5% in last year's third quarter. Approximately 5 percentage points of the drop in the tax rate versus the third quarter '05 had to do with lower state and local tax rates, lower foreign taxes due to tax planning strategies that we have developed, and the balance of the drop in the tax rates are due to the benefits from the resolution of prior-year federal and state tax returns. Net earnings from continuing operations for the third quarter '06 totaled $324 million or $0.42 a diluted share, up almost 26% over the third quarter of '05 and up 27% on an earnings per share basis. Solid operating income growth plus lower interest expense, lower income taxes, and fewer shares outstanding compared to 2005 third quarter drove the jump in our net earnings and earnings per share. Turning to cash flow. Free cash flow for the third quarter totaled $432 million, up 65% over last year's third quarter. The big jump in free cash flow for the quarter was driven by higher operating income before depreciation and amortization, and excluding stock-based compensation expense; plus lower interest expense, lower cash taxes due to a federal tax overpayment in 2005, which we were able to apply to offset 2006 cash tax. Of course, we had strong accounts receivable collections as we continue to focus on increasing our asset turnover. Capital spending was up $11 million to $82 million for the third quarter of '06, primarily due to the higher spending at our outdoor segment, driven by our strategy to expand our inventory in the United States and the United Kingdom. Let's turn briefly to our segments. The television segment's revenues of $2.2 billion were down slightly from the third quarter of '05. As we mentioned earlier, DVD revenues were down due to the recording of DVD sales net of cost versus gross. While recording DVD revenues net affects sales, there is zero, zero impact on profits. Of course, the shutdown of UPN gave us only partial sales for UPN during the month of September. Both of these items, as I mentioned, combined for a $50 million reduction from year ago. Our time period sales at the CBS networks were down about $30 million versus last year's third quarter, with over half of that drop in time period sales due to the absence of airing the Primetime Emmys in the third quarter of last year. The balance of the decline was due to softer scatter pricing in July and August versus year ago. TV station revenues were up 5.3% in the third quarter of '06 versus year ago. While the third quarter has experienced record political ad revenue at our owned and operated stations, as you may recall the third quarter of '05 had very strong political ad spending in our New York market, with last year's mayoral and New Jersey gubernatorial races. Year-to-date, 2006 political ad revenue by our owned and operated stations has smashed all previous records. This strong political ad spending continues into the fourth quarter of 2006. Currently, our TV stations' revenues are pacing up 14% over the fourth quarter of '05. OIBDA for the television segment in the third quarter was $457 million, up 9% over the same period last year. Revenue growth from TV station Showtime along with better mix of revenue at CBS Paramount and the network, coupled with lower programming costs, drove the strong OIBDA growth of 8.6%. Excluding stock-based compensation expense, OIBDA would have been up 10.4% at the television segment. Radio revenues for the third quarter were down 6.3% versus year ago. This drop in revenue was caused primarily by the 27 radio stations which had a significant change in their drivetime programming at the start of this year. The remaining 152 stations revenues were down 1.3% versus the third quarter of '05 on a comparable basis. Radio's OIBDA for the third quarter totaled $210 million, down about 10% to a year ago. Excluding stock-based compensation expense, we would have been down about 8% in the quarter versus year ago. During the third quarter, as Leslie mentioned, we have announced the sale of eight of our markets. As we go forward, we will provide radio revenue and OIBDA growth on a same-station basis to you, in addition to as-reported results. None of the divestitures of the radio stations in the third quarter had any impact on our results. Radio sales overall are pacing minus 2% in the fourth quarter. But if you exclude those 27 radio stations, which had the significant programming changes at the start of the year, the remaining stations for the whole fourth quarter are actually pacing up plus 1%. Radio stations' fourth-quarter loss will be negatively impacted as we dropped a number of NFL radio contracts. They were the Dallas Cowboys, the Washington Redskins, the Baltimore Ravens. While sales growth will be held down due to the absence in the fourth quarter of these sports revenues, profits will actually be up at these radio stations, as these sports rights contracts were very, very costly. Turning to outdoor, revenues for the third quarter were $536 million, up 9% over the third quarter last year. Excluding the impact of foreign exchange, revenues would have been up about 7%. The U.S. market was up 9%, with U.S. billboards leading the way at plus 13% over a year ago. UK market was up 16% in dollars and up 11% in local currency. The OIBDA for outdoor in the third quarter totaled $142 million, up 20% over the third quarter last year. Again excluding stock-based compensation expense, OIBDA for the third quarter would have been up 21%. Outdoor's sales for the fourth quarter are pacing up 8% over last year's fourth quarter, with the U.S. market up 10% and the UK up 14% in dollars and 9% in local currency. Corporate G&A for the third quarter totaled $41 million, which was $5 million higher than third quarter last year. However, on a pro forma basis, as if the CBS was a stand-alone company at the start of 2005, and excluding stock-based compensation expense, corporate G&A in the third quarter of '06 would have been $36 million versus last year’s $40 million or a drop of $5 million dollars in G&A. As you know, residual costs relate to our divested businesses' pension and OPEB costs. For the third quarter residual costs were $35 million, $5 million higher than last year, due to changes in our pension assumptions, partially offset by favorable trends in lowering our retiree medical costs. Turning to the full year outlook, we expect to deliver revenue growth in the low single-digits, grow operating income mid single-digits; and grow earnings per share in the high single-digits for 2006 versus 2005. Finally, turning to our balance sheet, Leslie just mentioned our near-time priorities of utilizing our cash. Let me provide you with additional information. As of September 30 we had about $3.2 billion of cash on our balance sheet. Of this amount, about $900 million of our cash was held internationally. Bringing home our international cash at this point in time would trigger negative tax consequences. We're developing various tax strategies which may enable us to bring some or all of the international cash back to the U.S. with far less costly tax consequences. Our priorities for the domestic cash is based on driving the highest after-tax return to our shareholders. As Leslie mentioned we have an opportunity to do another discretionary -- and I emphasize discretionary – pre-funding of our qualified pension plan of $150 million to $200 million before the end of this year. As you may recall, in the first quarter of 2006 we pre-funded $50 million to our qualified pension plan. The after-tax internal rate of return on adding funds to the qualified pension plan is north of a 14.5% return. So that is the kind of return we would expect for these kind of opportunistic investments. We will continue to look for opportunities to drive solid after-tax return and continue to focus on increasing the speed at which our assets turn over, so that we drive higher cash flow growth. Thank you. Operator, with that we will open the telephone lines to take your questions.
Operator: Your first question comes from Jessica Reif Cohen - Merrill Lynch.
Jessica Reif Cohen - Merrill Lynch: Thank you. Just to go back to the balance sheet, I know you talked a lot about it. But what is your comfort level with leverage? Given the more than $3 billion of cash on the balance sheet, you can fund all three goals that Les went through: the pension liabilities, dividends, and buybacks. So could you discuss acquisitions, maybe in a little bit more detail? What type of acquisitions, what size? How much of cash, or how much are you willing to leverage up? How much will you spend on development, on midseason, and into the '07/ '08 season?
Leslie Moonves: Let me deal with a little bit of it, and then I will turn it over to Fred. In terms of acquisitions, Jessica, obviously new media. There are a lot of new media assets that are out there that may potentially fit with the businesses we are currently in; and we are exploring those. But once again there is not going to be any major acquisitions. We're happy with the hand that we are dealt. We do want to expand new media. We're having success in that area with the amount of revenue that is starting to come in there. We want those platforms. You know, as we have said before, we're not going to buy YouTube, but it is not a bad idea to buy the next YouTube. We are looking at that and we're doing a lot of exploration in that area. In terms of midseason, in terms of what we are doing, the good news for us is 21 out of 22 hours of our schedule is working. We only had to cancel one show, and we're putting a new show in, in a couple of weeks. The rest of our schedule is unbelievably solid. Night after night we are performing extremely well, and I am very happy with how we are performing. The CBS network, once again, there are very few highs but there are never any lows. So as a result, you can bet on us this year. You can bet on us last year. And you can bet on us next year. In terms of development costs, once again, we are going to develop like we always do, but there is not going to be any major expenditure nor is there any desperation on the part of this network because as we look forward to next May, there is going to be very little we're going to need. So I am very confident of where we are in the schedule.
Fred Reynolds: Jessica, our current leverage ratio, using the rating agencies' method, is about 2.3X. So yes, we have capacity. Where we have focused, as you know, is expanding outdoor because that has a pretty high return. We have a lot of opportunities to do tuck-in acquisitions, and that is what where you will continue to see us add acquisitions in addition to on the content side that Leslie just talked about. I would also emphasize again that we have about $625 million a year that we will spend currently at the dividend rate we have today. That is a huge commitment. I always have to make sure that we have enough fuel in the tank to take us where Leslie and Sumner want us to go. So I like where the balance sheet is today. I think we can return a lot of value to the shareholders. I think we continue to grow these businesses and do the right tuck-in acquisitions and add to our content and outdoor.
Jessica Reif Cohen - Merrill Lynch: Thank you.
Operator: Your next question comes from Doug Mitchelson - Deutsche Bank.
Doug Mitchelson - Deutsche Bank: Thanks. For Leslie, I know this is always a question that is difficult to answer, but you never know, so here goes. You have got, in my mind, the best radio station group pound for pound, given its large market concentration; the best management team in radio running at Clear Channel. Now with private bids for radio assets that are likely to come in much higher than where CBS is trading. You have got the best outdoor plan in the U.S.; and Lamar is out there trading at 16X EBITDA, which if I'm doing the math right is a little bit above where you are trading. Have the recent events in these sectors, radio and outdoor, caused you to rethink at all the strategic rationale of keeping all these different media under one roof? Thank you very much.
Leslie Moonves: Well, we like all the businesses we're in. I mean, when we did the split from Viacom, we felt that the assets that we have would cause us to be able to focus on these assets. I agree with you, we have world-class assets in television, in radio, in outdoor, and publishing. The great news is right now we are able to focus on all four of them extremely well. So once again, we have trimmed down radio, we are building outdoor and we like where we are.
Doug Mitchelson - Deutsche Bank: Okay, thanks.
Operator: Your next question comes from William Drewry - Credit Suisse.
William Drewry - Credit Suisse: Thank you. I just wonder if you could give, Les, maybe a little bit more color on the scatter market trends. Just wondering if you think, given how the upfront was a bit weak but the scatter markets broadly seemed to be stronger, if there is a decisive move by advertisers to shift their spending patterns? If you think that is the case, what that might mean for us as we go into 2007?
Leslie Moonves: It's a very good question. Yes, scatter is stronger than the upfront was. We're pleased with what we were seeing. It is still rather early, we're only a few weeks into the season. But we like what we're seeing. Johnson & Johnson clearly was a major advertiser that stayed out of the upfront market and is now jumping back in, in a rather large way in the scatter market. We like what we are seeing there. Frankly, we are ready to go either way. The solidarity of our schedule enables us, and we have played this game for five years now. We're not going to sell below the prices we want to get in the upfront. That is not to say we won't deal with the irregularities of what the upfront market is. But having said that, we are always confident that our network is going to perform as we have proven time and time again. So whenever there is a scatter, we are always there in a very, very big way. So the improvements we are seeing in scatter are proving very beneficial for the year. We are, right now, right on track or beyond where we want to be for the fourth quarter in terms of scatter market and dollars. We are ready to go either way. I don't necessarily see a larger trend in the upfront being reduced and scatter growing. But if that happens, it is fine for us.
William Drewry - Credit Suisse: Thank you.
Operator: Your next question comes from Victor Miller - Bear Stearns.
Victor Miller - Bear Stearns: Thank you for taking the questions and thanks for all of the comments on the use of cash. First of all, may I ask --
Leslie Moonves: Can you talk a little louder, please?
Victor Miller - Bear Stearns: Sure. Can I ask you to give us what you think the impact will be on two Nielsen changes: one, obviously the commercial ratings which are happening this month; and then apparently the college viewing that they will measure in January?
Leslie Moonves: Sure, we are viewing both these things as very positive for us. Number one, in the commercial ratings, if you have noticed cable has vehemently opposed this. That is because our studies show that broadcast commercials are watched with a lot more attention than perhaps cable is. So we think the more people are aware of what the ratings are in the commercials on our television shows, the better off we are going to be. We like ratings, we like precise ratings because we feel like our product is very strong and it will continue to be very strong. In terms of the colleges, when you think about our long-term goal, our long-term deal with the NCA Basketball Tournament and the fact that we have not gotten credit for one single viewer on a college campus all this time, says to us that when they start getting college numbers we are going to be way up. Same for Letterman. We are going to get a lot more dollars out of that marketplace. So the more and more Nielsen grows, the better it is for us, and we are encouraged by both these things.
Victor Miller - Bear Stearns: Thank you.
Operator: Your next question comes from Kathy Styponias - Prudential.
Kathy Styponias - Prudential: Hi, thanks. Two questions. Les, it sounds like the schedule for CBS has done extremely well. But I was wondering if you can give us a little bit of color of what you have promised in terms of upfront with respect to ratings in general, overall on the schedule? Then the second question was regarding a comment you made about DVR and getting paid for it next year. Could you clarify what you mean by that? Thanks.
Leslie Moonves: You know, in terms of schedule, we are fine. That is all I want to tell you. We don't tell you what we have sold to the advertisers. But we're not in the make-goods business, put that way. Let me leave it as simple as that, and we're very pleased with that. In terms of DVR we think it is inevitable that they are going to have to start counting DVR usage as part of ratings. I think everybody in the world, even the advertising community, is acknowledging that. This year they were able to exclude it; but next year there is no way that that is going to happen. So once again, we think as technology advances, as Nielsen advances, as recordings advances, these strong broadcast networks are going to be even stronger.
Kathy Styponias - Prudential: Thank you.
Operator: Your next question comes from Anthony DiClemente - Lehman Brothers.
Anthony DiClemente - Lehman Brothers: Two quick questions for Fred. Fred, at year-to-date $1.6 billion of free cash flow, most analysts are looking for $1.4 billion for the full year. So that would imply fourth quarter $200 million free cash flow loss. Is that possible? I understand it is not linear and you have not been in production the first part of the year. But with the production costs in the 4Q, is it possible that it would lead to a $200 million loss? The second question is, if you would help me quantify in the quarter how much dollars revenue, EBITDA, whatever you can give us on a CSI syndication sales and/or CS Television impact in the quarter. Thanks, Fred.
Fred Reynolds: Okay, Anthony. As you know, we don't give forward-looking guidance on cash flow. So I won't be specific. But clearly, we tend to have good cash flow in the fourth quarter, particularly this year with so much political coming in, that is cash on delivery. We actually have no receivables. So I am not going to opine about whether people are $1.4 billion or whatever they are going to be, or negative. But that is not our history if you look back over time. You will see that most times the fourth quarter does deliver. We don't breakout CSI. We got a really good deal, it went to A&E, so we had a really good price on CSI Miami for going to A&E with a number of episodes. So that did help in the third quarter. However, I would tell you last year in the quarter, we had a lot of library sales. As good as CSI is, library product that is 30 and 40 years old and has like a 95% gross margin. So we did well. But the gross margin on library tends to be much higher. But we are really pleased with the CSI sales to A&E.
Leslie Moonves: But we love that $2 million from McHale's Navy for those of you old enough to remember that show.
Anthony DiClemente - Lehman Brothers: Thanks. Any color on the CSTV? Anything you can give us to quantify that in the quarter?
Fred Reynolds: I'm sorry, I apologize. CSTV continues. We are in about 14 million households on the cable side. They're continuing to do really well with the online business, particularly at the college level with the ecommerce they have there. We're looking for more carriage. We continue to have opportunity to expand carriage. Brian Bedol and the team are in the process of doing that. But we think they have got a great product. The combination with our sports, the NCAA, and CSTV, and also with SportsLine is really why Leslie and the guys all fell in love with this company. CSTV is going to do well for us.
Anthony DiClemente - Lehman Brothers: Thank you very much.
Operator: Your next question comes from John Blackledge – JP Morgan.
John Blackledge – JP Morgan: Thanks for taking the question. As you talked about in the past, most of your output deals for Showtime are up at the end of '07, I believe. You talked about investing a couple hundred million in feature film production with films going to Showtime in the premium window. We have estimated that return on assets for the major film studios over the past few years averaged about 7% to 8%. What type of returns would CBS be targeting? Also just wondering where you are at in the process. Have you hired anyone? Have you guys looked at scripts? I know that it is kind of early.
Leslie Moonves: Fair enough. Right now, the CBS film studio is me. So I have hired no one. By the way, we never stated that we would spend $200 million; let me clarify on that. We talked about that we would start, and our output deals are up in the near future with our three output deals. That does not mean we aren’t considering some sort of deals with them. We're still putting together our fact-finding sheet regarding a film company which we want to start in a small way. But I would doubt we would spend the kind of money you are talking about. It is still very, very preliminary.
John Blackledge – JP Morgan: Thank you.
Operator: Your next question comes from Andrew Baker - Cathay Financial.
Andrew Baker - Cathay Financial : Thank you very much. A question to try to clarify the two explanations of your TV business. Leslie, you keep talking about how strong things are, how viewers are up here and there. Then we hear time sales are down. So I guess the question is, is the industry so weak that even your strong performance has a hard time overcoming that? Then a second question for Fred. Are there limitations on pre-funding the pension? It seems to me if you can get that kind of return and you've got the cash, you could possibly go even bigger. So I was wondering if you could just flesh that out for us a little bit.
Leslie Moonves: By the way, time sales are not down. You know, I don't know where that came from. Look, the upfront was not quite as strong as anybody would have liked. We would have liked them to be up 3% or 4% and they weren’t, by and large. But I think once again, if you look at the ratings overall for network television, it is up. It is solid. CPMs are doing extremely well, and we are very pleased with them.
Fred Reynolds: Leslie, let me just add. On the time period sales that I referred to was in the third quarter as I mentioned, in July and August, which was the old season. I think that had a lot to do with it, and the fact that you get probably four times the amount per spot on the Emmys as you would on a rerun in July and August. So I think what Leslie is saying is right. As we are going forward, time period sales are up, but in that last quarter of the broadcast year you get a little softness as you have reruns, particularly you are running over Emmys from a year ago. Andrew, on your comment about pre-funding, yes, there are limits that you can pre-fund by the IRS rules, where you would not get a tax deduction above that. We are well within that limit. I would also say that we have to look at what is the true under-funding. Because I don't look at when interest rates or discount rates are at 0.5% and 0.75% it seems like a little bit low, and so that drives the obligation up. So I think we take an economic view to it and we also take the tax view on it. That is why we are comfortable for the year we will have pre-funded the first $50 million and anywhere from $150 million to another $200 million we think is appropriate at this time. But we will always relook at it.
Andrew Baker - Cathay Financial : Thanks a lot, and thanks for clarifying the time sales.
Operator: Your next question comes from Anthony Noto - Goldman Sachs.
Anthony Noto - Goldman Sachs : Thank you very much. Given all the debate on the CBS broadcast network, I was wondering if you could clarify for us what the year-over-year growth or decline in September may have been? As we look at season to-date ratings, adults 18 to 49 during primetime are down about 6.9% and adults 25 to 54, using the same measurement a year ago, are down about 4.7%. So it would lead me to believe that September, backing out any other factors, was down on a year-over-year basis.
Leslie Moonves: Anthony, those numbers are not correct since the season began. 25 to 54 we are flat.
Fred Reynolds: Anthony, this is Fred. As you know, September has two-and-a-half weeks of reruns. The new season starts the third week of the year. So I am not sure that is a good comparison.
Anthony Noto - Goldman Sachs : Yes, we are just quoting Nielsen.
Leslie Moonves: Quoting Nielsen but not since the beginning of the season. I have these numbers in front of me, Anthony, I study them daily. We are down a little bit in 18 to 49 and we are flat in 25 to 54.
Anthony Noto - Goldman Sachs : Okay, so what are the year-over-year sales for CBS broadcast network in September? Are they up or down is the real question I am asking?
Fred Reynolds: We don't really break that out.
Leslie Moonves: They are probably down because last September we had the Emmy Awards.
Fred Reynolds: Again, but I would also say you're not looking at broadcast seasons. You're splitting them. You're looking at the last two-and-a-half weeks of the old season and one-and-a-half weeks of the new season.
Anthony Noto - Goldman Sachs : Which was the same a year ago, so it's not like the time period has changed on a year-over-year basis. There would have been the same comparison.
Leslie Moonves: But the counts --.
Anthony Noto - Goldman Sachs : I understand the point on the Emmys. I guess the second question would be, if you look at your growth rate on a year-to-date basis, adding back the impairment charge in '05 of $19 million, and then backing out the radio sale this year in this quarter, it would look like your fourth quarter would have to grow 12% to 13% in EBIT, based on your definitions, to get to your guidance for EBIT for the full year. Is that something that you're still comfortable with?
Fred Reynolds: Well, as I said at the outset, that we are comfortable with our guidance on operating income of mid single-digits. I think your numbers are off. What we need to grow in the fourth quarter is not that high. But I would tell you that we are very comfortable. We are now in November 2. We have a lot a good visibility through most of this quarter and we are comfortable with the guidance that we said at the outset and what is in the earnings release.
Anthony Noto - Goldman Sachs : What would the number have to be then, based on your definition? I want to make sure we know what we are getting wrong.
Fred Reynolds: I'm not sure I understand your question. What would what have to be?
Anthony Noto - Goldman Sachs : You said that 12% to 13% is too high for the fourth quarter. I'm using the definitions that you provided in your press release.
Fred Reynolds: Operating income, it would have to be up in the high single-digits. As you know, operating income excludes stock-based compensation and in the third quarter grew 7.3%. We will be several ticks above that in the fourth quarter on the outlook that we have today on operating income, again excluding stock-based compensation and all the one-times that you reiterated. So again, I don’t understand your math. But I think we laid out pretty well in the back of the earnings release, if you have a chance to look at it. It is on the last two pages.
Anthony Noto - Goldman Sachs : Right, we will have to talk about it off-line. Thank you.
Operator: Your next question comes from Michael Nathanson - Bernstein.
Michael Nathanson – Bernstein: Thanks. I have two, they are both for Fred. One is on outdoor. When I looked at outdoor this quarter and I back out the hurricane charges from last year, it looks like outdoor posted very little operating leverage. For the most part of this year you have great leverage in outdoor. So I wondered what happened in the quarter? Was there any cost assisted with the new contract wins? Did some markets show margin declines? Then I have one on TV.
Fred Reynolds: Okay, so on outdoor, yes, we did have some of the hurricane items from last year. But again I think the issues were more of we are not going to always be able to go up four and five times leverage. But we do believe outdoor will grow. If the revenue grows X, we should be able to get more than 2X in profit growth. I think the third quarter sort of indicates that, or better. But earlier in the year, because we had so many rolling over money-losing contracts from prior years, we were getting an exponential increase in that. But I don't think that is the normal route. Our fixed costs are fairly fixed. A lot of our costs in outdoor are variable as you know. So therefore, I would say for every percentage increase in revenue we ought to get 2X that in operating income.
Michael Nathanson – Bernstein: There is no near-term startup costs that would hurt that the next couple quarters in New York or London?
Fred Reynolds: No. Well, London will have higher fees, but we also have more inventory. So you know, I think, overall, our expectation for the outdoor business is to grow, as I said. If we get revenue growth, we will get more than that, and we will continue to have margin.
Michael Nathanson – Bernstein: Okay, then following on TV, following on Anthony's question, I just wanted to just clarify. You said you were down $30 million in the quarter. What would that be on a percentage basis at CBS? If you were down $30 million, was that 2% to 3%?
Fred Reynolds: Yes, because it was all CBS. We broke out separately the time period sales related to UPN as that separate item that I mentioned.
Michael Nathanson – Bernstein: This is the second quarter in a row that the network was down in revenues. I wondered, given how strong you believe the schedule is and how good the market is, should we expect fourth quarter revenues to start turning positive at the CBS line?
Leslie Moonves: I think there is no question about it. Look, most of the last two quarters involved summer programming. Post-summer programming. Somehow or another we look at the seasons, they begin September 21. We don't combine the first two weeks in September with the last nine days in September. It starts then and we are looking forward to revenue growth in the fourth quarter.
Michael Nathanson – Bernstein: At CBS?
Leslie Moonves: Yes.
Michael Nathanson – Bernstein: Thanks.
Operator: Your final question comes from David Miller - Sanders Morris Harris.
David Miller - Sanders Morris Harris : Hi, thanks for taking the question. Les, just a brief question on the network television business. Correct me if I am wrong: you guys had four new shows on the air this year; one has been canceled; the other three I don't believe are top five shows as measured by Nielsen. I think the top five new shows are all on ABC or NBC with Heroes. What is your sort of patience quotient with the new shows? Do you believe that is just simply too early? Do you believe that the new shows still just need to find an audience? Or are you quick to cancel these series the way NewsCorp does if they just fall below their ratings guarantee? Thank you very much.
Leslie Moonves: Well, in 18 to 49 we do have one of the top five new shows in Jericho. In total viewers, we have the number one or number two new show in Shark. I have two shows that I am extremely pleased with. Jericho has improved the time period, Wednesday at 8:00, by about 27%. Now to me that is a pretty good number. In addition, Shark is doing extremely well Thursday night at 10. So those two are absolute keepers. The Class, which is our other new show, is a show 8:30 on Monday that is finding itself; and we are not sure of what the eventual fate is of that show. We canceled Smith after three weeks. So as I said, as far as I'm concerned, I have 21 out of 22 hours working. Maybe 20.5 if you say Class is on the fence. I feel we are as solid as any other network. There may be a couple more home runs, but in terms of what the world considers, there are two hits of Heroes and Ugly Betty, and right below that is Jericho. So we are very pleased with how we started the new season.
David Miller - Sanders Morris Harris : Okay, great. Thanks very much.
Marty Shea: Thank you very much, and we will talk to you all later.
Operator: That does conclude today's conference call. | [
{
"speaker": "Executives",
"text": "Sumner Redstone - Executive Chairman Leslie Moonves - President and CEO Fred Reynolds – EVP and CFO Marty Shea – IR"
},
{
"speaker": "Analysts",
"text": "Jessica Reif Cohen - Merrill Lynch Doug Mitchelson - Deutsche Bank William Drewry - Credit Suisse Victor Miller - Bear Stearns Kathy Styponias – Prudential John Blackledge – JP Morgan Anthony DiClemente - Lehman Brothers Andrew Baker - Cathay Financial Anthony Noto - Goldman Sachs Michael Nathanson – Bernstein David Miller - Sanders Morris Harris"
},
{
"speaker": "Operator",
"text": "Good day, everyone and welcome to the CBS Corporation third quarter 2006 earnings release teleconference. Today's call is being recorded. At this time I would like to turn the call over to the Senior Vice President of Investor Relations, Mr. Marty Shea."
},
{
"speaker": "Marty Shea",
"text": "Good morning, everyone and thank you for taking the time to join us for our third quarter 2006 earnings call. Joining me for today's discussion are Sumner Redstone, our Executive Chairman; Leslie Moonves, our President and CEO; and Fred Reynolds, Executive Vice President and CFO. Sumner will have some opening remarks, and then we will turn the call over to Les and Fred for strategic and financial issues. We will then open up the call for questions. Let me note that statements on this conference call relating to matters which are not historical facts are forward-looking statements which involve risks and uncertainties that could cause actual results to differ. Risks and uncertainties are disclosed in CBS's Corporation's news releases and security filings. A summary of CBS Corporation's third quarter 2006 results should have been sent to all of you. If you did not receive the results, please contact Punam Visay at 212-975-3667 and she will get it to you. A webcast of the call, the earnings release, and any other information related to this presentation can be found on CBS Corporation's corporate website at the address of cbscorporation.com. Now, let me turn the call over to Sumner."
},
{
"speaker": "Sumner Redstone",
"text": "Thanks, Marty and good morning, everyone and thank you for joining us. We now have three quarters on the books and I couldn’t be more pleased with everything that Les and his team have achieved. Over the past ten months, we have delivered on the promises CBS made at the beginning of the year. We have driven growth in every important measure: revenue, profits, free cash flow, and of great importance to our shareholders, dividends. By the way, think about it -- free cash flow up 65%. Our core businesses continue to be among the strongest in the industry and at the same time, Les and his team are executing our strategy of bringing our world-class content to emerging digital platforms. I must tell you, I am more enthusiastic than ever about what Les and his team are doing at CBS and everything the future holds for this great Company, and by the way, for this great executive. I have said it before, I want to say it to you again: in Les we have the best executive in the media industry. To tell you more about it, here is our great executive, Les."
},
{
"speaker": "Leslie Moonves",
"text": "Thank you, Sumner. I'm overwhelmed by your comments; I really am. I appreciate it. Good morning, everyone. Thank you for joining us. I am very happy to be here to talk about the CBS Corporation's third quarter results. It continues to be a very exciting time at CBS. We are pleased with the performance of our core businesses. Many of the digital opportunities we have seen on the horizon are now becoming reality. This morning, I will give you an overview of our third quarter results, along with some key operational highlights. After that, our CFO Fred Reynolds will provide a more detailed look at our financial position, and then we will open up the call for your questions. We started the third quarter by raising the dividend 11% from $0.18 to $0.20 per share. It was the third time we increased the dividend since the start of the year, adding up to a total increase of 43%. Once again, these increases demonstrate that we are confident in where we are and where we are headed and importantly, we are committed to delivering on our promise to continually return value to you, our shareholders. Now, let's take a look at our other third quarter financial highlights. Revenues of $3.4 billion were very slightly ahead of the same quarter last year. OIBDA was up 3% to $756 million. Operating income rose 4% to $646 million. However, excluding stock-based compensation and adjusting for the separation, OIBDA for the third quarter was up 6% and operating income was up 7%. Meanwhile, net earnings from continuing operations were up 26% to $324 million. Diluted EPS was up 27% to $0.42 per diluted share. Free cash flow, which reflects net cash flow from continuing operations minus capital expenditures, was up 65% to $432 million. Looking a bit closer at revenues, we had 9% growth in outdoor, offset by a 6% decline in radio. TV revenues were essentially flat, again affected by certain one-time events such as the switch from self-distribution to third-party distribution of our DVD business and the shutdown of the UPN Television Network. Overall, there is no doubt that are core businesses are very healthy and continue to throw off lots of cash. Now, we know you have a lot of questions about what we plan to do with all that cash. Some preliminary thoughts: I want to reiterate what I have said before, we have no plans to make any large acquisitions. That means we are not buying a movie studio. But rather, we will continue to look for smaller tuck-in opportunities that complement the businesses we are already in. Just this week, we announced an equity investment in Spot Runner, a unique start-up that helps small businesses promote their brands with high quality, local television ads. We believe Spot Runner has great potential and clearly fits well with our core businesses, making it a smart strategic investment in our future. I will say more later about the balance sheet, particularly as it pertains to future plans for use of our cash. But first, I would like to take you through some of the operational highlights at the businesses, starting with television. At the CBS Television Network, we started the 2006-2007 season strong and have been holding our lead over the other networks ever since. Through the first five weeks of the season, we continue to be number one in households, number one in viewers, number one in 25 to 54, a very competitive number two in adults 18 to 49, just a tenth of a point behind ABC. We have the number one sitcom, Two and a Half Men; the number one news magazine, 60 Minutes; the number one new drama, Shark. Through Sunday, we have grown CBS viewers year-over-year and we are up double-digit in viewers 25 to 54 and 18 to 49 on three nights of the week. It is not just CBS who is doing well. Looking at the big four networks year-over-year, viewers are up 7%, 25 to 54 is up, 18 to 49 is up. Once again, the so-called death of network television has been greatly exaggerated, even by some of the other networks. On the highly competitive Thursday night, much has been written. We have stood up very well to counter programming from ABC. CSI is neck-in-neck with Grey's Anatomy in viewers and is the number two show overall on television. Plus, our shows repeat extremely well. When the rebroadcast of CSI aired against a rebroadcast of Grey's Anatomy last Thursday night, we topped Grey's by 38% in viewers and 11% in 18 to 49. Meanwhile, DVR and Internet streaming are only adding viewers. New technologies and platforms make it easy for people to enjoy both programs that air during these highly competitive time periods. We are already getting paid for this incremental viewing on the Internet, and we expect to get paid for DVR viewing next year. Over at the news division, we're very pleased with the progress we're making at the new Evening News with Katie Couric. While the overall ratings have returned to Earth since Katie's debut week, the show has picked up traction in key, younger demos. Season to-date, it is up 24% in adults 25 to 54, which is where the vast majority of news business is sold. As a result, we have been able to attract millions more in advertising dollars. Our TV stations have also gotten a lift. They are up 33% in the demo since Katie's debut. By the way, we are the only network whose evening news ratings are up. All the others are down. We're also serving up record numbers of users and viewers with CBS News online and the Evening News on demand. Not only does this reflect improved penetration with younger demos, it also positions CBS News as a trusted information source for younger audiences as they form primary media consumption habits online. We're really happy with everything that Katie has achieved since September 5th and are confident that in the years to come the wisdom of the decision to bring her to CBS will be even more evident at CBS. Over at CBS Sports, we're having our third-best season since reclaiming the NFL in 1998. We expect to do even better in the coming weeks. In the NFL Today our pre-game show with James Brown is doing terrific. Season to-date, we are edging closer to Fox and are up 8% compared with last year, while Fox is flat. As you know, in less than 100 days, we will have the Super Bowl back on CBS. Ad spots are selling briskly, with rates now coming in north of $2.5 million per 30 seconds. I guess network television is still pretty good. In golf, we recently signed three times Masters winner Nick Faldo to be our new 18th tower guy, bolstering what already is the best golf announcing team in sports. Our TV stations also had a very strong quarter thanks in large part to political and CBS network ratings. As I have said before, success at the TV stations tends to follow the success of the network. We're now seeing the positive impact of that success. In television production and syndication, we announced the formation of the CBS Television Distribution Group. The new powerhouse combines the syndication giant King World and CBS Paramount TV, both domestic and international. Collectively, our syndication group has nine of the ten top shows in syndication and the leadership position in every single program genre. The move of reorganizing will help us consolidate and streamline our operations, focusing on marketing resources, and realize significant cost savings. Meanwhile, as we anticipated, Rachael Ray is a big hit. It is the number one new syndicated show this season by a wide margin, delivering the highest rated new show since Dr. Phil premiered in 2002. At cable, Showtime continues to build its impressive portfolio of premium quality original programming. New shows like Dexter and Brotherhood, and returning hits such as Weeds and The L Word, are raising Showtime's profile. As a result, ratings and subscribers are up. Several Showtime programs have also found wider audiences on iTunes, where Weeds continues to be one of the most popular programs. Over at CSTV we launched a new broadband platform in August that will cover over 10,000 live collegiate athletic events during the school year. In September, we began broadcasting the new Mountain West Regional Sports Network in partnership with Comcast. We're also happy with the launch of the new CW network, our 50-50 joint venture with Warner Brothers Entertainment. America's Next Top Model is winning its time period in women 18 to 34 and is just barely behind ABC in adults 18 to 34. The network as a whole is tracking ahead of the WB's ratings last year in both of these valuable demos. It is an impressive feat considering that CW viewers had to find their shows on new channels in much of the country. Our CW television stations are also performing very well. Now turning to radio. As you know, back in May we announced our intention to sell some of our stations in ten smaller markets. We had a busy quarter in this regard. In August, we sold 17 stations in five markets. In September and October we sold 12 stations in three markets. Overall, we have entered into agreements to sell 29 stations in eight markets for a total of $570 million, with two more markets to go, Fresno and Greensboro. We are expecting excellent exit values for these stations, roughly 14X OIBDA and now we will be able to sharpen our focus in those markets where we see greater opportunity to grow. We are encouraged by the revenue growth we have had in key formats during the third quarter. Spanish formats on our two major market stations were up 66%, and JACK FM on 12 stations was up 18%. In terms of pacing, if you exclude the smaller market stations that we have recently agreed to sell, October will finish up 3% in markets where we did not have loss of key morning programming from last year. We believe that the right format, be it music, language or talk, we can grow radio's revenues. We are determined to keep finding the format that the largest audiences want to listen to. We're also beginning to see the result of new talent hires. After only five months on the air, Opie & Anthony are a force to be reckoned with during the morning drive. According to newly released summer ratings, they are number one in men aged 18 to 49 in New York City, up 150% since their arrival. They are up in other major cities as well: 100% in Boston, 104% in Philadelphia, 84% in DC, 155% in Cleveland. We are extending radio to new media through podcasting and streaming. We now have over 90 stations broadcasting in HD. By the end of the year, we expect radio to bring in to close to $14 million in digital revenues. Over in outdoor, we continue to see terrific growth both in revenues, which were up 9%, and OIBDA, which was up 20%. By the way, that growth is continuing into the fourth quarter, where revenues are pacing up 8%. Here in New York, we're forging ahead with our New York City subways deal. As you know we won the NYC subways contract for ten years starting in the first quarter of '07. We have begun installing the first 80 new urban LCD digital screens and expect to have them completed this month. Over at our international operations, in the UK we're working on the London Underground and Victoria Coach Station contract. In France we have closed a deal to acquire Stower's billboard businesses which includes roughly 2,200 facings. Across all of our operations in Europe and Asia we're in the process of re-branding from Viacom Outdoor to CBS Outdoor. We look forward to having all of our outdoor businesses united under the CBS Corporation brand. In publishing, Bob Woodward's State of Denial continues to fly off the shelf. It has been at the top of The New York Times bestseller list since its debut four weeks ago and already has close to 1 million copies in print. State of Denial is projected to be one of the most successful non-fiction titles of '06 and has already generated over $14 million in revenue. We also had robust sales from a sleeper hit, the Thirteenth Tale, a first novel by Diane Setterfield which jumped to the top of the New York Times list after just one week on sale. Also this fall, we have just published Steven King's latest blockbuster, Lisey's Story, and the highly anticipated 75th anniversary of that much beloved American icon, which I use all the time, The Joy of Cooking. Last, but certainly not least, I want to talk about our efforts in the digital space. New media is a huge opportunity that cuts across all of our businesses and affects everything we do as a premier content company. You guys are always asking us when we're going to start making money here. While it is still too soon to quantify the impact, I can tell you we expect to generate hundreds of millions in digital revenues in '07. We made a number of very significant moves over the quarter to extend the reach of our television programming online. In October we partnered with YouTube to begin offering short form video streams that include content from the CBS Television Network, Showtime, and CSTV. Meanwhile as I mentioned earlier, we continue to find new platforms to stream our hit content. We're already offering many of our shows on Google Video, Apple iTunes, Amazon.com, and AOL. Plus we began offering free next-day streaming of 12 primetime series on Innertube, our own entertainment website. We have streamed more than 2 million episodes of our show so far this season and over 3 million related videos. These numbers continue to grow week over week. It is not just TV that is benefiting. The digital opportunity extends to all of our businesses. As I noted, we're getting streaming revenues in radio and at outdoor we are installing LCD digital screens in the New York City subways and all over the country. At publishing, Simon & Schuster recently partnered with Sony for the launch of its new eBook reader device. S&S is offering nearly 3,000 titles for sale at Sony's online store. Finally, as I mentioned earlier, I want to take you through our priorities for how we intend to use our free cash. First, we will opportunistically pre-fund our qualified pension plan in the range of $150 million to $200 million. Second, we will continue to return cash to our shareholders in the form of a dividend. As I said earlier, our dividend has increased 43% from $0.14 a quarter to $0.20 a quarter already this year. We expect dividends to continue to be the primary vehicle for returning cash to our shareholders each year. Going forward, we intend to increase our dividend in line with earnings growth and cash flow. Finally, based on our current business trends, we intend to recommend to our board a stock buyback to the order of $1 billion to $1.5 billion in the early part of '07. This level of buyback would return to shareholders a significant portion of the strong after-tax gains we received on the sale of Paramount Parks and some of our radio stations. The form, exact amount, and timing of the buyback will be decided over the next few months as we discuss alternatives with our Board of Directors. Above all, we will stay focused on long-term value creation and returning that value to you, our shareholders, both today and for many years to come. Thank you. And with that, I will turn it over to Fred."
},
{
"speaker": "Fred Reynolds",
"text": "Thanks, Leslie and good morning. Leslie just provided you with the highlights to the third quarter 2006. Let me now provide you with additional information on our third quarter operating performance, cash flow and balance sheet, and our full-year outlook. Revenues for the third quarter of 2006 of about $3.4 billion were up slightly over the third quarter of '05. Two items in the third quarter reduced our revenue growth when compared to the third quarter last year. The first item, as Leslie mentioned, was revenues from our DVD sales. which were considerably lower again this quarter versus year ago, as we are required to record DVD revenues on a net versus gross basis this year. Also, our broadcast network revenues were lower due to the shutdown of the UPN Network in mid-September. These two items combined to reduce our revenues for the total company in the third quarter of '06 as compared to last year's third quarter by approximately $50 million. These two items lowered our revenue growth in the third quarter by 1.5 percentage points. Also, our revenue growth in the third quarter of '06 continued to be slowed by our radio segment sales decline versus last year. TV stations, outdoor, and Showtime all had solid revenue increases in the third quarter of '06 versus '05. Operating profit before depreciation and amortization for the third quarter was $756 million, up 3.4% over last year's third quarter. Excluding stock-based compensation expense from both years, OIBDA would have increased 6.3%. Our OIBDA margins for the third quarter of '06 were 22.4%, up from 21.7% in the third quarter last year. Operating income for the third quarter totaled $646 million, up 4% from year ago. Again, excluding the stock-based compensation expense, operating income would have increased by 7.3%. Our television and outdoor segments drove our profit growth in the third quarter, more than offsetting the profit decline at radio. Let me highlight a few other items in the P&L. Interest expense was $140 million for the third quarter, down dramatically from the third quarter last year. Once again, the special dividend of $5.4 billion we received at the very end of 2005 reduced our bank debt and interest expense when compared to last year. In addition, interest income was up in the third quarter of '06 to $41 million versus $5 million at this time last year, due to the after-tax proceeds from selling Paramount Parks of approximately $1 billion, plus strong year-to-date cash flow from operations drove our interest income. Our tax provision for the third quarter was 38.7%, down considerably from 45.5% in last year's third quarter. Approximately 5 percentage points of the drop in the tax rate versus the third quarter '05 had to do with lower state and local tax rates, lower foreign taxes due to tax planning strategies that we have developed, and the balance of the drop in the tax rates are due to the benefits from the resolution of prior-year federal and state tax returns. Net earnings from continuing operations for the third quarter '06 totaled $324 million or $0.42 a diluted share, up almost 26% over the third quarter of '05 and up 27% on an earnings per share basis. Solid operating income growth plus lower interest expense, lower income taxes, and fewer shares outstanding compared to 2005 third quarter drove the jump in our net earnings and earnings per share. Turning to cash flow. Free cash flow for the third quarter totaled $432 million, up 65% over last year's third quarter. The big jump in free cash flow for the quarter was driven by higher operating income before depreciation and amortization, and excluding stock-based compensation expense; plus lower interest expense, lower cash taxes due to a federal tax overpayment in 2005, which we were able to apply to offset 2006 cash tax. Of course, we had strong accounts receivable collections as we continue to focus on increasing our asset turnover. Capital spending was up $11 million to $82 million for the third quarter of '06, primarily due to the higher spending at our outdoor segment, driven by our strategy to expand our inventory in the United States and the United Kingdom. Let's turn briefly to our segments. The television segment's revenues of $2.2 billion were down slightly from the third quarter of '05. As we mentioned earlier, DVD revenues were down due to the recording of DVD sales net of cost versus gross. While recording DVD revenues net affects sales, there is zero, zero impact on profits. Of course, the shutdown of UPN gave us only partial sales for UPN during the month of September. Both of these items, as I mentioned, combined for a $50 million reduction from year ago. Our time period sales at the CBS networks were down about $30 million versus last year's third quarter, with over half of that drop in time period sales due to the absence of airing the Primetime Emmys in the third quarter of last year. The balance of the decline was due to softer scatter pricing in July and August versus year ago. TV station revenues were up 5.3% in the third quarter of '06 versus year ago. While the third quarter has experienced record political ad revenue at our owned and operated stations, as you may recall the third quarter of '05 had very strong political ad spending in our New York market, with last year's mayoral and New Jersey gubernatorial races. Year-to-date, 2006 political ad revenue by our owned and operated stations has smashed all previous records. This strong political ad spending continues into the fourth quarter of 2006. Currently, our TV stations' revenues are pacing up 14% over the fourth quarter of '05. OIBDA for the television segment in the third quarter was $457 million, up 9% over the same period last year. Revenue growth from TV station Showtime along with better mix of revenue at CBS Paramount and the network, coupled with lower programming costs, drove the strong OIBDA growth of 8.6%. Excluding stock-based compensation expense, OIBDA would have been up 10.4% at the television segment. Radio revenues for the third quarter were down 6.3% versus year ago. This drop in revenue was caused primarily by the 27 radio stations which had a significant change in their drivetime programming at the start of this year. The remaining 152 stations revenues were down 1.3% versus the third quarter of '05 on a comparable basis. Radio's OIBDA for the third quarter totaled $210 million, down about 10% to a year ago. Excluding stock-based compensation expense, we would have been down about 8% in the quarter versus year ago. During the third quarter, as Leslie mentioned, we have announced the sale of eight of our markets. As we go forward, we will provide radio revenue and OIBDA growth on a same-station basis to you, in addition to as-reported results. None of the divestitures of the radio stations in the third quarter had any impact on our results. Radio sales overall are pacing minus 2% in the fourth quarter. But if you exclude those 27 radio stations, which had the significant programming changes at the start of the year, the remaining stations for the whole fourth quarter are actually pacing up plus 1%. Radio stations' fourth-quarter loss will be negatively impacted as we dropped a number of NFL radio contracts. They were the Dallas Cowboys, the Washington Redskins, the Baltimore Ravens. While sales growth will be held down due to the absence in the fourth quarter of these sports revenues, profits will actually be up at these radio stations, as these sports rights contracts were very, very costly. Turning to outdoor, revenues for the third quarter were $536 million, up 9% over the third quarter last year. Excluding the impact of foreign exchange, revenues would have been up about 7%. The U.S. market was up 9%, with U.S. billboards leading the way at plus 13% over a year ago. UK market was up 16% in dollars and up 11% in local currency. The OIBDA for outdoor in the third quarter totaled $142 million, up 20% over the third quarter last year. Again excluding stock-based compensation expense, OIBDA for the third quarter would have been up 21%. Outdoor's sales for the fourth quarter are pacing up 8% over last year's fourth quarter, with the U.S. market up 10% and the UK up 14% in dollars and 9% in local currency. Corporate G&A for the third quarter totaled $41 million, which was $5 million higher than third quarter last year. However, on a pro forma basis, as if the CBS was a stand-alone company at the start of 2005, and excluding stock-based compensation expense, corporate G&A in the third quarter of '06 would have been $36 million versus last year’s $40 million or a drop of $5 million dollars in G&A. As you know, residual costs relate to our divested businesses' pension and OPEB costs. For the third quarter residual costs were $35 million, $5 million higher than last year, due to changes in our pension assumptions, partially offset by favorable trends in lowering our retiree medical costs. Turning to the full year outlook, we expect to deliver revenue growth in the low single-digits, grow operating income mid single-digits; and grow earnings per share in the high single-digits for 2006 versus 2005. Finally, turning to our balance sheet, Leslie just mentioned our near-time priorities of utilizing our cash. Let me provide you with additional information. As of September 30 we had about $3.2 billion of cash on our balance sheet. Of this amount, about $900 million of our cash was held internationally. Bringing home our international cash at this point in time would trigger negative tax consequences. We're developing various tax strategies which may enable us to bring some or all of the international cash back to the U.S. with far less costly tax consequences. Our priorities for the domestic cash is based on driving the highest after-tax return to our shareholders. As Leslie mentioned we have an opportunity to do another discretionary -- and I emphasize discretionary – pre-funding of our qualified pension plan of $150 million to $200 million before the end of this year. As you may recall, in the first quarter of 2006 we pre-funded $50 million to our qualified pension plan. The after-tax internal rate of return on adding funds to the qualified pension plan is north of a 14.5% return. So that is the kind of return we would expect for these kind of opportunistic investments. We will continue to look for opportunities to drive solid after-tax return and continue to focus on increasing the speed at which our assets turn over, so that we drive higher cash flow growth. Thank you. Operator, with that we will open the telephone lines to take your questions."
},
{
"speaker": "Operator",
"text": "Your first question comes from Jessica Reif Cohen - Merrill Lynch."
},
{
"speaker": "Jessica Reif Cohen - Merrill Lynch",
"text": "Thank you. Just to go back to the balance sheet, I know you talked a lot about it. But what is your comfort level with leverage? Given the more than $3 billion of cash on the balance sheet, you can fund all three goals that Les went through: the pension liabilities, dividends, and buybacks. So could you discuss acquisitions, maybe in a little bit more detail? What type of acquisitions, what size? How much of cash, or how much are you willing to leverage up? How much will you spend on development, on midseason, and into the '07/ '08 season?"
},
{
"speaker": "Leslie Moonves",
"text": "Let me deal with a little bit of it, and then I will turn it over to Fred. In terms of acquisitions, Jessica, obviously new media. There are a lot of new media assets that are out there that may potentially fit with the businesses we are currently in; and we are exploring those. But once again there is not going to be any major acquisitions. We're happy with the hand that we are dealt. We do want to expand new media. We're having success in that area with the amount of revenue that is starting to come in there. We want those platforms. You know, as we have said before, we're not going to buy YouTube, but it is not a bad idea to buy the next YouTube. We are looking at that and we're doing a lot of exploration in that area. In terms of midseason, in terms of what we are doing, the good news for us is 21 out of 22 hours of our schedule is working. We only had to cancel one show, and we're putting a new show in, in a couple of weeks. The rest of our schedule is unbelievably solid. Night after night we are performing extremely well, and I am very happy with how we are performing. The CBS network, once again, there are very few highs but there are never any lows. So as a result, you can bet on us this year. You can bet on us last year. And you can bet on us next year. In terms of development costs, once again, we are going to develop like we always do, but there is not going to be any major expenditure nor is there any desperation on the part of this network because as we look forward to next May, there is going to be very little we're going to need. So I am very confident of where we are in the schedule."
},
{
"speaker": "Fred Reynolds",
"text": "Jessica, our current leverage ratio, using the rating agencies' method, is about 2.3X. So yes, we have capacity. Where we have focused, as you know, is expanding outdoor because that has a pretty high return. We have a lot of opportunities to do tuck-in acquisitions, and that is what where you will continue to see us add acquisitions in addition to on the content side that Leslie just talked about. I would also emphasize again that we have about $625 million a year that we will spend currently at the dividend rate we have today. That is a huge commitment. I always have to make sure that we have enough fuel in the tank to take us where Leslie and Sumner want us to go. So I like where the balance sheet is today. I think we can return a lot of value to the shareholders. I think we continue to grow these businesses and do the right tuck-in acquisitions and add to our content and outdoor."
},
{
"speaker": "Jessica Reif Cohen - Merrill Lynch",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Doug Mitchelson - Deutsche Bank."
},
{
"speaker": "Doug Mitchelson - Deutsche Bank",
"text": "Thanks. For Leslie, I know this is always a question that is difficult to answer, but you never know, so here goes. You have got, in my mind, the best radio station group pound for pound, given its large market concentration; the best management team in radio running at Clear Channel. Now with private bids for radio assets that are likely to come in much higher than where CBS is trading. You have got the best outdoor plan in the U.S.; and Lamar is out there trading at 16X EBITDA, which if I'm doing the math right is a little bit above where you are trading. Have the recent events in these sectors, radio and outdoor, caused you to rethink at all the strategic rationale of keeping all these different media under one roof? Thank you very much."
},
{
"speaker": "Leslie Moonves",
"text": "Well, we like all the businesses we're in. I mean, when we did the split from Viacom, we felt that the assets that we have would cause us to be able to focus on these assets. I agree with you, we have world-class assets in television, in radio, in outdoor, and publishing. The great news is right now we are able to focus on all four of them extremely well. So once again, we have trimmed down radio, we are building outdoor and we like where we are."
},
{
"speaker": "Doug Mitchelson - Deutsche Bank",
"text": "Okay, thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from William Drewry - Credit Suisse."
},
{
"speaker": "William Drewry - Credit Suisse",
"text": "Thank you. I just wonder if you could give, Les, maybe a little bit more color on the scatter market trends. Just wondering if you think, given how the upfront was a bit weak but the scatter markets broadly seemed to be stronger, if there is a decisive move by advertisers to shift their spending patterns? If you think that is the case, what that might mean for us as we go into 2007?"
},
{
"speaker": "Leslie Moonves",
"text": "It's a very good question. Yes, scatter is stronger than the upfront was. We're pleased with what we were seeing. It is still rather early, we're only a few weeks into the season. But we like what we're seeing. Johnson & Johnson clearly was a major advertiser that stayed out of the upfront market and is now jumping back in, in a rather large way in the scatter market. We like what we are seeing there. Frankly, we are ready to go either way. The solidarity of our schedule enables us, and we have played this game for five years now. We're not going to sell below the prices we want to get in the upfront. That is not to say we won't deal with the irregularities of what the upfront market is. But having said that, we are always confident that our network is going to perform as we have proven time and time again. So whenever there is a scatter, we are always there in a very, very big way. So the improvements we are seeing in scatter are proving very beneficial for the year. We are, right now, right on track or beyond where we want to be for the fourth quarter in terms of scatter market and dollars. We are ready to go either way. I don't necessarily see a larger trend in the upfront being reduced and scatter growing. But if that happens, it is fine for us."
},
{
"speaker": "William Drewry - Credit Suisse",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Victor Miller - Bear Stearns."
},
{
"speaker": "Victor Miller - Bear Stearns",
"text": "Thank you for taking the questions and thanks for all of the comments on the use of cash. First of all, may I ask --"
},
{
"speaker": "Leslie Moonves",
"text": "Can you talk a little louder, please?"
},
{
"speaker": "Victor Miller - Bear Stearns",
"text": "Sure. Can I ask you to give us what you think the impact will be on two Nielsen changes: one, obviously the commercial ratings which are happening this month; and then apparently the college viewing that they will measure in January?"
},
{
"speaker": "Leslie Moonves",
"text": "Sure, we are viewing both these things as very positive for us. Number one, in the commercial ratings, if you have noticed cable has vehemently opposed this. That is because our studies show that broadcast commercials are watched with a lot more attention than perhaps cable is. So we think the more people are aware of what the ratings are in the commercials on our television shows, the better off we are going to be. We like ratings, we like precise ratings because we feel like our product is very strong and it will continue to be very strong. In terms of the colleges, when you think about our long-term goal, our long-term deal with the NCA Basketball Tournament and the fact that we have not gotten credit for one single viewer on a college campus all this time, says to us that when they start getting college numbers we are going to be way up. Same for Letterman. We are going to get a lot more dollars out of that marketplace. So the more and more Nielsen grows, the better it is for us, and we are encouraged by both these things."
},
{
"speaker": "Victor Miller - Bear Stearns",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Kathy Styponias - Prudential."
},
{
"speaker": "Kathy Styponias - Prudential",
"text": "Hi, thanks. Two questions. Les, it sounds like the schedule for CBS has done extremely well. But I was wondering if you can give us a little bit of color of what you have promised in terms of upfront with respect to ratings in general, overall on the schedule? Then the second question was regarding a comment you made about DVR and getting paid for it next year. Could you clarify what you mean by that? Thanks."
},
{
"speaker": "Leslie Moonves",
"text": "You know, in terms of schedule, we are fine. That is all I want to tell you. We don't tell you what we have sold to the advertisers. But we're not in the make-goods business, put that way. Let me leave it as simple as that, and we're very pleased with that. In terms of DVR we think it is inevitable that they are going to have to start counting DVR usage as part of ratings. I think everybody in the world, even the advertising community, is acknowledging that. This year they were able to exclude it; but next year there is no way that that is going to happen. So once again, we think as technology advances, as Nielsen advances, as recordings advances, these strong broadcast networks are going to be even stronger."
},
{
"speaker": "Kathy Styponias - Prudential",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Anthony DiClemente - Lehman Brothers."
},
{
"speaker": "Anthony DiClemente - Lehman Brothers",
"text": "Two quick questions for Fred. Fred, at year-to-date $1.6 billion of free cash flow, most analysts are looking for $1.4 billion for the full year. So that would imply fourth quarter $200 million free cash flow loss. Is that possible? I understand it is not linear and you have not been in production the first part of the year. But with the production costs in the 4Q, is it possible that it would lead to a $200 million loss? The second question is, if you would help me quantify in the quarter how much dollars revenue, EBITDA, whatever you can give us on a CSI syndication sales and/or CS Television impact in the quarter. Thanks, Fred."
},
{
"speaker": "Fred Reynolds",
"text": "Okay, Anthony. As you know, we don't give forward-looking guidance on cash flow. So I won't be specific. But clearly, we tend to have good cash flow in the fourth quarter, particularly this year with so much political coming in, that is cash on delivery. We actually have no receivables. So I am not going to opine about whether people are $1.4 billion or whatever they are going to be, or negative. But that is not our history if you look back over time. You will see that most times the fourth quarter does deliver. We don't breakout CSI. We got a really good deal, it went to A&E, so we had a really good price on CSI Miami for going to A&E with a number of episodes. So that did help in the third quarter. However, I would tell you last year in the quarter, we had a lot of library sales. As good as CSI is, library product that is 30 and 40 years old and has like a 95% gross margin. So we did well. But the gross margin on library tends to be much higher. But we are really pleased with the CSI sales to A&E."
},
{
"speaker": "Leslie Moonves",
"text": "But we love that $2 million from McHale's Navy for those of you old enough to remember that show."
},
{
"speaker": "Anthony DiClemente - Lehman Brothers",
"text": "Thanks. Any color on the CSTV? Anything you can give us to quantify that in the quarter?"
},
{
"speaker": "Fred Reynolds",
"text": "I'm sorry, I apologize. CSTV continues. We are in about 14 million households on the cable side. They're continuing to do really well with the online business, particularly at the college level with the ecommerce they have there. We're looking for more carriage. We continue to have opportunity to expand carriage. Brian Bedol and the team are in the process of doing that. But we think they have got a great product. The combination with our sports, the NCAA, and CSTV, and also with SportsLine is really why Leslie and the guys all fell in love with this company. CSTV is going to do well for us."
},
{
"speaker": "Anthony DiClemente - Lehman Brothers",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Blackledge – JP Morgan."
},
{
"speaker": "John Blackledge – JP Morgan",
"text": "Thanks for taking the question. As you talked about in the past, most of your output deals for Showtime are up at the end of '07, I believe. You talked about investing a couple hundred million in feature film production with films going to Showtime in the premium window. We have estimated that return on assets for the major film studios over the past few years averaged about 7% to 8%. What type of returns would CBS be targeting? Also just wondering where you are at in the process. Have you hired anyone? Have you guys looked at scripts? I know that it is kind of early."
},
{
"speaker": "Leslie Moonves",
"text": "Fair enough. Right now, the CBS film studio is me. So I have hired no one. By the way, we never stated that we would spend $200 million; let me clarify on that. We talked about that we would start, and our output deals are up in the near future with our three output deals. That does not mean we aren’t considering some sort of deals with them. We're still putting together our fact-finding sheet regarding a film company which we want to start in a small way. But I would doubt we would spend the kind of money you are talking about. It is still very, very preliminary."
},
{
"speaker": "John Blackledge – JP Morgan",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Andrew Baker - Cathay Financial."
},
{
"speaker": "Andrew Baker - Cathay Financial",
"text": "Thank you very much. A question to try to clarify the two explanations of your TV business. Leslie, you keep talking about how strong things are, how viewers are up here and there. Then we hear time sales are down. So I guess the question is, is the industry so weak that even your strong performance has a hard time overcoming that? Then a second question for Fred. Are there limitations on pre-funding the pension? It seems to me if you can get that kind of return and you've got the cash, you could possibly go even bigger. So I was wondering if you could just flesh that out for us a little bit."
},
{
"speaker": "Leslie Moonves",
"text": "By the way, time sales are not down. You know, I don't know where that came from. Look, the upfront was not quite as strong as anybody would have liked. We would have liked them to be up 3% or 4% and they weren’t, by and large. But I think once again, if you look at the ratings overall for network television, it is up. It is solid. CPMs are doing extremely well, and we are very pleased with them."
},
{
"speaker": "Fred Reynolds",
"text": "Leslie, let me just add. On the time period sales that I referred to was in the third quarter as I mentioned, in July and August, which was the old season. I think that had a lot to do with it, and the fact that you get probably four times the amount per spot on the Emmys as you would on a rerun in July and August. So I think what Leslie is saying is right. As we are going forward, time period sales are up, but in that last quarter of the broadcast year you get a little softness as you have reruns, particularly you are running over Emmys from a year ago. Andrew, on your comment about pre-funding, yes, there are limits that you can pre-fund by the IRS rules, where you would not get a tax deduction above that. We are well within that limit. I would also say that we have to look at what is the true under-funding. Because I don't look at when interest rates or discount rates are at 0.5% and 0.75% it seems like a little bit low, and so that drives the obligation up. So I think we take an economic view to it and we also take the tax view on it. That is why we are comfortable for the year we will have pre-funded the first $50 million and anywhere from $150 million to another $200 million we think is appropriate at this time. But we will always relook at it."
},
{
"speaker": "Andrew Baker - Cathay Financial",
"text": "Thanks a lot, and thanks for clarifying the time sales."
},
{
"speaker": "Operator",
"text": "Your next question comes from Anthony Noto - Goldman Sachs."
},
{
"speaker": "Anthony Noto - Goldman Sachs",
"text": "Thank you very much. Given all the debate on the CBS broadcast network, I was wondering if you could clarify for us what the year-over-year growth or decline in September may have been? As we look at season to-date ratings, adults 18 to 49 during primetime are down about 6.9% and adults 25 to 54, using the same measurement a year ago, are down about 4.7%. So it would lead me to believe that September, backing out any other factors, was down on a year-over-year basis."
},
{
"speaker": "Leslie Moonves",
"text": "Anthony, those numbers are not correct since the season began. 25 to 54 we are flat."
},
{
"speaker": "Fred Reynolds",
"text": "Anthony, this is Fred. As you know, September has two-and-a-half weeks of reruns. The new season starts the third week of the year. So I am not sure that is a good comparison."
},
{
"speaker": "Anthony Noto - Goldman Sachs",
"text": "Yes, we are just quoting Nielsen."
},
{
"speaker": "Leslie Moonves",
"text": "Quoting Nielsen but not since the beginning of the season. I have these numbers in front of me, Anthony, I study them daily. We are down a little bit in 18 to 49 and we are flat in 25 to 54."
},
{
"speaker": "Anthony Noto - Goldman Sachs",
"text": "Okay, so what are the year-over-year sales for CBS broadcast network in September? Are they up or down is the real question I am asking?"
},
{
"speaker": "Fred Reynolds",
"text": "We don't really break that out."
},
{
"speaker": "Leslie Moonves",
"text": "They are probably down because last September we had the Emmy Awards."
},
{
"speaker": "Fred Reynolds",
"text": "Again, but I would also say you're not looking at broadcast seasons. You're splitting them. You're looking at the last two-and-a-half weeks of the old season and one-and-a-half weeks of the new season."
},
{
"speaker": "Anthony Noto - Goldman Sachs",
"text": "Which was the same a year ago, so it's not like the time period has changed on a year-over-year basis. There would have been the same comparison."
},
{
"speaker": "Leslie Moonves",
"text": "But the counts --."
},
{
"speaker": "Anthony Noto - Goldman Sachs",
"text": "I understand the point on the Emmys. I guess the second question would be, if you look at your growth rate on a year-to-date basis, adding back the impairment charge in '05 of $19 million, and then backing out the radio sale this year in this quarter, it would look like your fourth quarter would have to grow 12% to 13% in EBIT, based on your definitions, to get to your guidance for EBIT for the full year. Is that something that you're still comfortable with?"
},
{
"speaker": "Fred Reynolds",
"text": "Well, as I said at the outset, that we are comfortable with our guidance on operating income of mid single-digits. I think your numbers are off. What we need to grow in the fourth quarter is not that high. But I would tell you that we are very comfortable. We are now in November 2. We have a lot a good visibility through most of this quarter and we are comfortable with the guidance that we said at the outset and what is in the earnings release."
},
{
"speaker": "Anthony Noto - Goldman Sachs",
"text": "What would the number have to be then, based on your definition? I want to make sure we know what we are getting wrong."
},
{
"speaker": "Fred Reynolds",
"text": "I'm not sure I understand your question. What would what have to be?"
},
{
"speaker": "Anthony Noto - Goldman Sachs",
"text": "You said that 12% to 13% is too high for the fourth quarter. I'm using the definitions that you provided in your press release."
},
{
"speaker": "Fred Reynolds",
"text": "Operating income, it would have to be up in the high single-digits. As you know, operating income excludes stock-based compensation and in the third quarter grew 7.3%. We will be several ticks above that in the fourth quarter on the outlook that we have today on operating income, again excluding stock-based compensation and all the one-times that you reiterated. So again, I don’t understand your math. But I think we laid out pretty well in the back of the earnings release, if you have a chance to look at it. It is on the last two pages."
},
{
"speaker": "Anthony Noto - Goldman Sachs",
"text": "Right, we will have to talk about it off-line. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Michael Nathanson - Bernstein."
},
{
"speaker": "Michael Nathanson – Bernstein",
"text": "Thanks. I have two, they are both for Fred. One is on outdoor. When I looked at outdoor this quarter and I back out the hurricane charges from last year, it looks like outdoor posted very little operating leverage. For the most part of this year you have great leverage in outdoor. So I wondered what happened in the quarter? Was there any cost assisted with the new contract wins? Did some markets show margin declines? Then I have one on TV."
},
{
"speaker": "Fred Reynolds",
"text": "Okay, so on outdoor, yes, we did have some of the hurricane items from last year. But again I think the issues were more of we are not going to always be able to go up four and five times leverage. But we do believe outdoor will grow. If the revenue grows X, we should be able to get more than 2X in profit growth. I think the third quarter sort of indicates that, or better. But earlier in the year, because we had so many rolling over money-losing contracts from prior years, we were getting an exponential increase in that. But I don't think that is the normal route. Our fixed costs are fairly fixed. A lot of our costs in outdoor are variable as you know. So therefore, I would say for every percentage increase in revenue we ought to get 2X that in operating income."
},
{
"speaker": "Michael Nathanson – Bernstein",
"text": "There is no near-term startup costs that would hurt that the next couple quarters in New York or London?"
},
{
"speaker": "Fred Reynolds",
"text": "No. Well, London will have higher fees, but we also have more inventory. So you know, I think, overall, our expectation for the outdoor business is to grow, as I said. If we get revenue growth, we will get more than that, and we will continue to have margin."
},
{
"speaker": "Michael Nathanson – Bernstein",
"text": "Okay, then following on TV, following on Anthony's question, I just wanted to just clarify. You said you were down $30 million in the quarter. What would that be on a percentage basis at CBS? If you were down $30 million, was that 2% to 3%?"
},
{
"speaker": "Fred Reynolds",
"text": "Yes, because it was all CBS. We broke out separately the time period sales related to UPN as that separate item that I mentioned."
},
{
"speaker": "Michael Nathanson – Bernstein",
"text": "This is the second quarter in a row that the network was down in revenues. I wondered, given how strong you believe the schedule is and how good the market is, should we expect fourth quarter revenues to start turning positive at the CBS line?"
},
{
"speaker": "Leslie Moonves",
"text": "I think there is no question about it. Look, most of the last two quarters involved summer programming. Post-summer programming. Somehow or another we look at the seasons, they begin September 21. We don't combine the first two weeks in September with the last nine days in September. It starts then and we are looking forward to revenue growth in the fourth quarter."
},
{
"speaker": "Michael Nathanson – Bernstein",
"text": "At CBS?"
},
{
"speaker": "Leslie Moonves",
"text": "Yes."
},
{
"speaker": "Michael Nathanson – Bernstein",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Your final question comes from David Miller - Sanders Morris Harris."
},
{
"speaker": "David Miller - Sanders Morris Harris",
"text": "Hi, thanks for taking the question. Les, just a brief question on the network television business. Correct me if I am wrong: you guys had four new shows on the air this year; one has been canceled; the other three I don't believe are top five shows as measured by Nielsen. I think the top five new shows are all on ABC or NBC with Heroes. What is your sort of patience quotient with the new shows? Do you believe that is just simply too early? Do you believe that the new shows still just need to find an audience? Or are you quick to cancel these series the way NewsCorp does if they just fall below their ratings guarantee? Thank you very much."
},
{
"speaker": "Leslie Moonves",
"text": "Well, in 18 to 49 we do have one of the top five new shows in Jericho. In total viewers, we have the number one or number two new show in Shark. I have two shows that I am extremely pleased with. Jericho has improved the time period, Wednesday at 8:00, by about 27%. Now to me that is a pretty good number. In addition, Shark is doing extremely well Thursday night at 10. So those two are absolute keepers. The Class, which is our other new show, is a show 8:30 on Monday that is finding itself; and we are not sure of what the eventual fate is of that show. We canceled Smith after three weeks. So as I said, as far as I'm concerned, I have 21 out of 22 hours working. Maybe 20.5 if you say Class is on the fence. I feel we are as solid as any other network. There may be a couple more home runs, but in terms of what the world considers, there are two hits of Heroes and Ugly Betty, and right below that is Jericho. So we are very pleased with how we started the new season."
},
{
"speaker": "David Miller - Sanders Morris Harris",
"text": "Okay, great. Thanks very much."
},
{
"speaker": "Marty Shea",
"text": "Thank you very much, and we will talk to you all later."
},
{
"speaker": "Operator",
"text": "That does conclude today's conference call."
}
] | null | null |
PARA | 2 | 2,006 | 2006-08-03 13:45:00 | Executives:
Analysts: Victor Miller - Bear Stearns Jessica Reif Cohen - Merrill Lynch Doug Mitchelson - Deutsche Bank Anthony DiClemente - Lehman Brothers Kathy Styponias - Prudential John Blackledge - JP Morgan Anthony Noto - Goldman Sachs Andrew Baker - Cathay Financial David Miller - Sanders Morris Harris Michael Nathanson - Sanford Bernstein
Operator: Welcome to the CBS Corporation second quarter 2006 earnings release teleconference. Today's call is being recorded. At this time I would like to turn the conference over to the Senior Vice President of Investor Relations, Mr. Marty Shea. Please go ahead, sir.
Marty Shea: Good morning everyone and thank you for joining us for our second quarter earnings call. Joining me for today's discussion are Sumner Redstone, our Executive Chairman; Leslie Moonves, our President and CEO; and Fred Reynolds, Executive Vice President and CFO. Sumner will have a few opening remarks and then we will turn the call over to Les and Fred for strategic and financial issues. We will then open the call to questions. Let me note that statements on this conference call relating to matters which are not historical facts are forward-looking statements which involves risks and uncertainties that could cause actual results to differ. Risks and uncertainties are disclosed in CBS Corporation's news releases and security filings. A summary of CBS Corporation's second quarter 2006 results should have been sent to all of you. If you did not receive the results please contact Punamb Dusai at 212-975-3667 and she will get a copy to you. A webcast of the call, the earnings release and other information related to the presentation can be found on CBS Corporation's corporate website at the address of cbscorporation.com. Now I will turn the call over to Sumner.
Sumner Redstone: Thanks, Marty. Although I am required, actually required to be here in California instead of there in the room with Les and his team, I must assure you that neither the distance nor the early hour of the day diminishes my enthusiasm for CBS Corporation and for Les and his team. In just six short months, Les and his team have shown great progress in fulfilling the long-term promise we envision. Of course to tell you all about it, here is Les.
Leslie Moonves: Thank you, Sumner. Good morning everybody. I'm very pleased to be here to talk about our second quarter results. We now have two quarters under our belt as a stand-alone Company and we are growing our businesses and strengthening our balance sheet every day. This morning I'm going to share our second quarter results with you and provide highlights on our business operations and then I'll turn it over to Fred Reynolds who will provide a more detailed look at our segment results and free cash flow before we open up the call for your questions. You may remember when we had our first earnings call of the year we said that CBS is a Company on the move. While that description still holds; I'll take it a step further now and say we're a Company in motion. We're doing the things we said we would do. We're delivering on the promises we made to you. In short, we are executing on our strategy. For example, we promised we'd raise the dividend and we have -- twice. On May 25, we announced a 12.5% increase on our quarterly dividend from $0.16 to $0.18 per share. It was the second increase since the start of the Company and a 29% increase since the start of the year. So I think you can see that we are committed to making good on our promises by returning value to shareholders. You can also see that we are very confident in the near future and the many years to come. Now let's take a look at what we did overall in the second quarter. The main headlines were as follows: Net earnings from continuing operations were up 29%; diluted EPS from continuing operations were up 36% to $0.64 per diluted share; and free cash flow of $546.2 million was up 2%; and, we had fantastic growth at CBS Outdoor where operating income was up 32%. During the quarter we were able to resolve prior year tax audits which allowed us to lower our tax provision in the second quarter by approximately $125 million. I'm particularly pleased with our growth in free cash flow, the foundation of future dividend growth. I'd like to point out that with the exception of radio, which is still not delivering the results we expect, our core operations are firing on all cylinders. Revenues of $3.48 billion were down 1% from the same quarter last year. Though our TV stations were up 5%, the television segment was off 1% overall. Outdoor and publishing both showed growth but we were affected by an 8% drop in revenue at radio. The radio marketplace is tough right now and we face year-to-year operating issues related to the loss of key programming. However, we swiftly made changes in 2006 and are encouraged by the early results. The crucial East Coast morning drive time numbers are trending up. More on that soon when we get into the segments. Operating income before depreciation and amortization decreased 6% to $859 million and operating income was off 7% to $750 million. Both of these declines were largely due to the impact of stock-based compensation expenses as well as $24 million of expenses relating to the shutdown of UPN Television Network. A significant event during the quarter was the sale of Paramount Parks to Cedar Fair for $1.24 billion in cash which amounted to a gain of $292 million. We are extremely pleased with the price we received for this business. Looking at the first half, revenues were up 2% from the same prior year period, diluted EPS from continuing operations was up 24% and free cash flow was up 7%. Overall it was a good first half and we expect to deliver on our business outlook for the full year. Before I turn things over to Fred, I'd like to update you on some of the key events and accomplishments at our Company since our last earnings call and let you know what's going on in each of our businesses. Starting with television, in May we rounded out the 2005/2006 television season and for the fourth consecutive year, CBS won in viewers and households. Plus for the third consecutive season, the network took the top spot for the 25 to 54 demo, and it was a close race in the 18 to 49 with only fractions of a point separating the top three. We have six shows returning from last year's freshman class and with only four new shows to promote this fall, all of which are getting great buzz, we're confident we can deliver again starting this September. Of course on September 5, we have the first broadcast of the CBS Evening News with Katy Couric. While you all know that moving network news ratings is a long and gradual process, we believe this represents a major step forward for our entire news organization. Plus, we recently announced an evening news content will be available cross platform to anyone, anywhere, anytime on TV, the radio, the Internet and wireless. Katy's reports will be sent out via broadcast, podcast and will feature supplementary and sometimes simultaneous reporting and previews on VCast Wireless, CBS Radio News and Katy's own interactive daily blog on cbsnews.com. We are making the very most of every single opportunity out there to give consumers the content when they want it, how they want it. In the process, we will grow interest and demand for our evening news broadcasts. Meanwhile, our TV station group is also benefiting from the continued success of the CBS Network. TV station revenues were up 5% during the quarter. Everywhere but New York, political spending is exceeding expectations and we anticipate even bigger gains as we move closer to the November elections. Early advertising sales indicate that our CW stations are also quite strong which should lift the station groups even higher. In syndication, King World will debut Rachael Ray beginning in September. This is a highly anticipated daily first-run talk show that's cleared in 97% of the country. Without overselling Rachael Ray, we believe this is a great addition to our stable of syndicated hits which already includes eight of the top 10 syndicated shows on television. Turning to cable. At Showtime, subscribers and subscriber fees are both up and we're very happy with the momentum so far this year. We hope to build on that later this month with the return of Weeds which won five Emmys in its first season and Showtime's new drama, Brotherhood, has been getting a great reception as well. We recently aired the pilot episode on the CBS network to broaden the show's exposure. This is just one example of how Showtime is benefiting from being a part of the CBS family. Showtime intends to be the best and producing the best content is the surest way to get us where we want to be. At CSTV, our college sports cable network, we're teaming up with Comcast to launch the Mountain Sports Network focusing on Mountain West Conference athletics. The Mountain will initially premiere on Comcast systems in Utah, Colorado and Mexico. This is yet another wonderful addition to our portfolio of local sports assets and will make an excellent play on both cable and the Internet. CW, our 50-50 joint venture with Warner Brothers, will begin broadcasting in late September. Distribution for the new network now covers more than 90% of the country and having stations that do exceed what the former WB and UPN ever did on their own. Plus we had a very successful upfront and interest in this new network and its attractive young demos is quite high. Moving onto radio, where we continue to seek an aggressive turnaround. To climb back into the growth position we need to offer the programming that listeners want to here and we're making progress. Several of our new formats are doing terrific. Spanish formats are up over 50% year-to-date and in the second quarter of 2006, Jack FM was up 13% and talk radio was up 9%. Plus, the spring Arbitron ratings released last month showed big gains for our stations in major markets, particularly during morning drive. New York, Philadelphia and Boston improved dramatically. The returning of Opie and Anthony to New York had a huge impact on our listenership in the men 25 to 54 demo. We've jumped from fifteenth to second, or 140% since the show began broadcasting on April 26. Overall this show in most of our markets has done exceedingly well. We're getting the ratings back and we're beginning to monetize them already. At the same time, we’re looking to sharpen our focus in higher growth markets by getting out of smaller, slower growth areas. On May 23rd, we announced that we're exploring the divestiture of radio stations in ten of our smaller markets. Since then we have received literally dozens of offers that we're in the process of reviewing. The good news is these offers have been very, very attractive. We expect to have an announcement on the sale soon. Additionally, after the close of the second quarter we announced a headcount reductions of over 100 staff positions at CBS radio. Reducing radio's cost structure is another way we can help maximize the performance of the larger operation and we remain absolutely committed to doing that. Moving to Outdoor, a really incredible story. As I said earlier, operating income was up a remarkable 32% here. We love Outdoor and lately so does everyone else. We all know that reaching consumers is becoming increasingly difficult in today's fragmented media marketplace. So it's not surprising that outdoor advertising is having a renaissance. Experts are predicting Outdoor will become a $10 billion business within the next five years and CBS Outdoor will get a bigger piece of that rapidly expanding pie in North America as well as overseas. In May, we won an eight-and-a-half year contract to sell advertising in the London Underground; the deal is believed to be the largest [out of home] contract anywhere in the world. When it starts later this month, advertisers will be able to use digital technology to target consumers more effectively. We're also looking forward to offering them some great opportunities when the 2010 Olympics are held in London. The impact of improving digital technology in the Outdoor arena will soon be felt here in New York starting next month, a network of 80 high-definition local LCD panels will be installed in the city transit system. Displays will be visible above subway entrances, at street level in high traffic areas across Manhattan. We continue to look for new opportunities to grow this exciting business. In publishing, second quarter revenues were up 1% to $176 million where OIBDA and operating income were up 7% and 5% respectively. Top-selling titles in the quarter include Chill Factor by Sandra Brown and Looking for Peyton Place by Barbara Delinsky. We're looking forward to the fall book-selling season with the 75th anniversary edition of The Joy of Cooking and Stephen King's, Lisey's Story. Finally, let's take a quick look at new media which spreads across all of our operations. We continue to see tremendous proof that big brands are driving new media as they have driven establish media. For that reason we made CSI and Survivor, our best-known franchises, available for downloads on iTunes. Also during the quarter we partnered with Amazon.com to make the archived CBS Evening News material available on 90-minute customized DVDs. CBS Radio has begun streaming sports content to mobile phones and when we introduced text message voting to Big Brother, the trial effort garnered to 14 million votes. We've also launched two new web sites, Innertube and Showbuzz. Innertube is our new advertiser supported broadband channel offering free original entertainment programming expressly for Internet users. Showbuzz is a one-stop online destination for entertainment news and pop culture. These are brand new offerings and we'll keep you posted on how they shape up. At the same time we're pursuing web strategies in all our local properties including television and radio. These opportunities are very important to advertisers and with our tremendous local broadcasting presence, we have a huge leg up in reaching local customers on the web. Clearly across all of our platforms, both local and national, this will continue to grow significantly in the future. Our content will be everywhere and provide increasing revenues in the new media space across the board. In conclusion, we are on track to deliver on our business outlook for the full year. Our businesses are well-positioned, our team is second to none and we continue to produce lots of cash. We've repeatedly demonstrated that we return value to our shareholders and we intend to continue doing so. Thank you and with that, I will turn it over to Fred.
Fred Reynolds: Thank you, Leslie and good morning. What I'd like to do this morning is provide highlights for the second quarter of 2006 and give you additional information about our second quarter operating performance, cash flow and our full year outlook. Now as Leslie just mentioned for the second quarter of '06, revenues were almost $3.5 billion, down about nine-tenths of a percent from the second quarter of '05. The primary reasons for the slight decline in revenues were lower ad sales at our radio stations and lower home entertainment or DVD revenues. We will discuss radio results in a few minutes, but first our DVD sales for the second quarter of 2006, which are primarily from our large CBS Paramount Library, are now distributed by a third party. In prior years we distributed our own DVDs. Now at CBS our practice is to record revenues from the sale of our DVDs by third-party distributors, net of their costs and fees. While this accounting treatment had zero impact on profits, it did impact revenues. Our revenues for the quarter were down $50 million versus a year ago. So if you exclude the effect of the DVD revenues overall, the Company's revenues would have been 1.4% higher and the television segment revenues would have been 2.2 percentage points higher than what has been reported. Now for the second half of the year, we expect to see the DVD Home Entertainment net sales increase versus a year ago. TV stations Showtime and Outdoor all had solid revenue growth in the second quarter of '06 versus a year ago and revenues at our international businesses led by the United Kingdom, Canada and Mexico were up about 5% over the second quarter of '05. Operating income before depreciation or amortization for the second quarter of '06 was $860 million, down about 6% to a year ago. Operating income also declined to $750 million, a drop of about 7%. Two items in particular I would highlight which mask our underlying profit performance in the second quarter of '06. First, as Leslie mentioned, was the $24 million of costs which we incurred to shut down the UPN Network which we recognized in this quarter. In addition, in the second quarter of '06 we had incremental stock-based compensation of about $13 million higher than last year. The weak performance from our radio stations versus year ago also pulled down our profit performance. Radio's results suffered in comparison to the second quarter of 2005 not only from lower station revenues but also due to a $15 million gain we recognized in the second quarter of 2005 from the sale of a radio station. No radio station sales have taken place in the second quarter of this year. Now turning to interest expense, it was $141 million for the quarter, $35 million lower than it was last year at this time as our debt outstanding is down considerably due to the $5.4 billion dividend we received at the end of last year in anticipation of the separation of new Viacom. Lower debt at the start of 2006 coupled with strong first half cash flow from operations significantly lowered our borrowings and interest expense versus year ago. The proceeds from the sale of Paramount Parks of $1.24 billion had no impact on our interest expense in the second quarter as the Parks' proceeds were received on the last day of the quarter on June 30 2006. Interest income is up considerably over 2005 second quarter due to our strong cash generation. Now during the quarter we did retire $50 million of our 2011 6 5/8 debt which resulted in the $2 million loss on early extinguishment that you will see in our P&L. Our tax provision for the second quarter of 2006 of $118 million is down over $120 million from a year ago. The tax provision rate was 19.3% versus last year's second quarter of 39.1%. The significant drop in our tax rate was due largely to the resolution of prior year's federal tax returns. Excluding the benefit of resolving these prior year tax matters, the tax provision rate would have been 40.4% in the second quarter of 2006, up slightly over 2005 due to a higher mix of U.S. taxable income this year which is taxed at a higher rate than our foreign operations. Net earnings from continuing operations totaled $490 million or $0.64 a diluted share. The tax benefit, as you will note, added $0.17 per share to our 2006 EPS. Now if you exclude the tax benefit, the shutdown of the UPN and the stock-based compensation, the earnings per share for the second quarter of 2006 was $0.50 a share versus $0.47 a share in 2005. The gain on the sale of Paramount Parks nets us $292 million after tax or a pre-tax gain of $455 million which is an additional $0.38 per diluted share, giving us total earnings for the second quarter of '06 of $782 million or $1.02 per share. Free cash flow for the quarter was $546 million up 2% over the second quarter of '05. Strong receivable collections dropped our days sales outstanding across all of our businesses, coupled with lower programming inventory helped to drive our very, very strong cash flow for the second quarter. As you may have noted, during the second quarter we reduced the number of stock options outstanding by exchanging approximately 7.2 million restricted shares for 64 million stock options that were outstanding. The restricted shares vest pro rata over three years. We believe the exchange significantly reduced the stock option overhang that CBS Corporation had at the start of the year. Now let's turn briefly to our segments. Leslie discussed the performance of each of our segments but let me add a couple of other highlights. As Leslie noted, television segment revenues were down 1% versus '05 as our growth at TV stations were plus 5%, Showtime plus 8% and CST added to our growth but it was offset largely by the drop in the DVD revenues that I just discussed. OIBDA for the television segment of $535 million was down 2% to the second quarter of '05 but again if you exclude stock-based compensation expense, the incremental amount, and the $24 million of the UPN shutdown costs, the second quarter 2006 OIBDA for television segment would have been up 3% over a year ago. Turning to radio. Radio's revenues for the quarter were down 8%. Now the 152 stations which did not suffer from the program changes were down about 3% versus a year ago. In the second quarter of this year, inventory avails at our radio stations were down 2% from a year ago, as we selectively reduced the number of commercials. I would also add on the process of selling the 10 markets not only have the quantity and quality of the buyers have been impressive but the indicative values look very strong and hopefully again, as Leslie mentioned, we expect to conclude the sales process in the next several weeks. Turning to outdoor, revenues were up 7%, with the U.S. up 7.4%; Mexico up 15.3%; and Canada in local currency up 5%; and in dollar terms, Canada was up 17% as the Canadian dollar strengthened against the U.S. The UK was up 7.4% both in local currency and in dollars. Outdoor's operating profit before depreciation and amortization of $160 million was up 19% over last year's second quarter and operating income was up 32% to $108 million. As you will note, corporate expenses were roughly $40 million for the second quarter, and are up over last year's $27 million expense. Now the second quarter of '05 number is an as reported amount which does not reflect CBS as a stand-alone company. So on a pro forma basis, as if CBS was freestanding as of January 1, 2005, corporate expenses in the second quarter of '06 would be up about $5 million higher than a year ago. The increase relates primarily to transition costs which we expect will ease in the second half of 2006 and costs associated with the voluntary exchange program that I just mentioned to bring in the options that were outstanding. Year-to-date on a pro forma basis, corporate expenses were also up about the same $5 million over last year's 2005 year-to-date. Residual costs, which consist of pension and retiring medical expenses of our divested businesses from the past, was $35 million for the second quarter of '06, up about $5 million from the second quarter of '05. Costs are largely due to pension assumption changes, offset somewhat by lower retiree medical costs. As you will note in our earnings release, we have highlighted our stock-based compensation expense in total and by segment. We expect our full year stock-based compensation expense to total approximately $80 million for 2006. So as Leslie mentioned, turning to our full year outlook, we are on track to deliver low single-digit revenue growth and mid single-digit operating income and earnings per share growth. Now finally as you will note from our balance sheet, we have accumulated over $3 billion of cash as of the end of June. A little over $1 billion of this cash amount relates to proceeds we received from the sale of Paramount Parks net of the expected income taxes on the gain. As we have indicated previously, we would certainly consider returning the excess proceeds from the sale of the Parks business to shareholders if we could not invest that cash in a disciplined manner. As you may know, we constantly review numerous investment opportunities to redeploy our strong cash flow and we will continue to pursue looking at investment opportunities that may arise. However, I think we can all assure you that we would have to be very confident that any investment would result in accelerating our revenue, earnings and cash flow growth and also provide a strong return to our shareholders. The hurdle any investment would have to achieve is that it would need to be superior -- superior -- to returning capital to shareholders. The timing on our decision is also dependent on what is the best way to return excess cash to shareholders. That is either in the form of increased dividends which has been the path that we have followed so far, or a share buyback program, or a combination. In addition and related to the timing of our decision, some of the offers we have received to buy the radio stations we are selling involve acquisition structures which could be very, very tax efficient for CBS. We have not come to any conclusions on whether these offers optimize our overall value. However, should we elect such an acquisition structure that would be tax efficient for us, it would curtail our ability to buy back shares while the sale transaction was underway. We know you are keenly, keenly interested in this matter and we hope to have much more clarity on the matter in the very near future. So thank you very much for taking the time to listen to our second quarter. Now, operator, if you would, we could open the lines for questions.
Operator: (Operator Instructions) Our first question comes from Victor Miller - Bear Stearns.
Victor Miller - Bear Stearns: Good morning, thank you for taking the question. First of all, Fred, what you just talked about on returning capital, there's a certain expectation. You've probably seen it written in several analyst notes, articles, that there's a $1 billion plus expected return on capital. Maybe you can talk about what is your dimension is in terms of potential acquisitions relative to that dollar? Also, the reality is that your net debt now is below $4 billion, which is extremely ahead of what anybody had expected here. Even if you ended today you'd be at 1.2 times leverage. So regardless of whether you did something with that cash other than returning that $1 billion from the Parks to the shareholders, wouldn't the balance sheet allow a very substantial repurchase/special dividend/tender regardless? For Les and Fred, I don't know if you can answer this right now, but on the radio side obviously you've made some cuts. Obviously you've decided not to renew the Redskins, the Ravens and the Cowboys. We've got the NFL season coming on right now, it's obviously a lot of revenue generated from those three teams. Can you talk about what impact those two events may have on the revenue and the expense of the radio group in the second half? Thanks.
Fred Reynolds: Victor, wow, that was like three paragraphs, but thank you. I think certainly we understand the focus on the cash. One, we're very pleased to be in this position to have the cash. I think Leslie has been very clear that we would not do any acquisitions that wouldn't be very, very good returns to us. We've said in the past we want to focus on content acquisitions that makes sense. We have a lot of outdoor small tuck-in acquisitions which wouldn't use anywhere near the kind of cash we're talking about. I would say we're probably more in the CSTV kind of level. But there has been, as you know and has been well reported, about opportunities that come along all the time. But I would say to you that Leslie, myself and the team are very, very disciplined in our approach. We don't chase after acquisitions. There's nothing we need to have. But clearly we would like to keep growing the businesses and have a higher growth rate. So again, we can talk about that more as we unfold. We are clearly focused on trying to do the best amount we can on the sale of those radio stations and get the best amount of value to shareholders and some of the structures would allow that. Yes, our debt is low and you will not hear us talk about debt pay down as a priority for our free cash flow. Our free cash flow priorities will be, if they make sense, and they could truly be a great return -- better than just giving the return of capital to our shareholders – then acquisitions would be a priority. Returning capital to shareholders is the other priority. There really aren't other priorities that I would speak of. I'll answer the question on radio and then turn it over to Leslie for your other questions about the direction. Clearly our revenue is suffering. We don't have some of the baseball teams we had last year and also radio doesn't have the Redskins, as you mentioned. So costs will be down but so will revenue be down. As we focused mostly on the revenue growth that is a dampener more so in the third and fourth quarter than so far to date.
Leslie Moonves: Victor, I just want to say, those are indicative of obviously we're paying a lot of attention to the radio business. We're being very careful about every single deal we make in terms of talent, in terms of all those renewals of the football deals that you referred to. Every deal we make will be studied at great length. In terms of specifics how much that will change the equation, we don't know but we're treading with great caution. I think we're going to be able to make a significant difference as we did with the 100-person layoff as well as the ending of some of these bad contracts.
Victor Miller - Bear Stearns: Thank you, Les. Thank you, Fred.
Operator: Our next question comes from Jessica Reif Cohen - Merrill Lynch.
Jessica Reif Cohen - Merrill Lynch: Hi, two questions. This is sort of acquisition-related, one of them. Given the anemic upfront market for both broadcasting and cable, money is obviously going elsewhere; the Internet, product placement. What is your plan to recapture this money? Do you need to acquire some property, some web-based property or something else or will you go purely the organic route? Secondly, can you flush out your film strategy? Is the plan to make theatrical films, made for TV movies, how will you finance that?
Leslie Moonves: First of all, Jessica, I might disagree with you on the anemic upfront. We didn't view it as anemic. I think three of the four networks did very well -- or should I say, four of the five networks did very well. CW did well, CBS obviously, we had low CPM increases. Our volume was up and we were actually quite encouraged by it. When you look at how much money is shifting to the Internet obviously we're there. We've made a number of deals across the board. Along with our network deals and our syndication deals, there were web properties that got a piece of the upfront. Having said that, the percentage of that was rather small. We did make some cross-platforming deals with a lot of our new shows and a lot of the Internet is there as part of it, but the amount of money is rather small and frankly we were not disappointed with the upfront. The CW did extremely well at the upfront as well, taking in more money than either one of the other two networks and increased from where the WB was, and we view that as a very significant event. We were, at the end of the day, pleased with the upfront. In terms of our film strategy, let me clarify because a lot has been written about it. We have a very valuable asset called Showtime which right now pays hundreds of millions of dollars to three studios for film output deals. These deals end in 18 months. When you look at that as a basis and then you add in the television network and you add in DVDs and you add in international television, we look at being able to get into the film business, and I'm talking about in a rather small way with four to six movies per year and movies that range from $10 million to $40 million to $50 million tops. We have figured out a way where we can get into the movie business literally risk-free. I'm talking about zero risk. Whereby our piece of the movie, we will be out before a dollar is achieved in box office. So it's an interesting way to look at the film business and one as we head toward the future, we have always said content is a very, very important thing to us. So if we do six movies a year and a couple of them are hits, we guarantee we will make money. Then at the end of five years if you have a library of 30 to 40 pictures, that is also going to be worth quite a bit of money and can be used in a lot of different ways. So we look at it as a positive. But once again, let me assure you, we're not going to get into it in a big way. We're not going to have a large studio overhead. We're going to do it in a very cautious manner. In terms of movies of the week, we are not doing them for the network obviously. We have some output deals with some foreign companies so we are producing some with CBS Paramount and they are mostly for cable.
Operator: Our next question comes from Doug Mitchelson - Deutsche Bank.
Doug Mitchelson - Deutsche Bank: Thank you very much. Les, given your long list of digital initiatives on this call, can you just give us a sense of the amount of digital revenue you expect for full year '06 and what you might see in '07? Maybe as an alternative, what percentage of revenue in each of those two years you think all these initiatives might add up to? Fred, I'm curious based on your DVD commentary, what was the DVD revenue year-to-year change when looking at net this year and net last year in 2Q and maybe year-to-date? Do the new terms of the London Underground contract deliver lower EBITDA at the beginning of the contract that then you earn out in the later years? Thanks.
Leslie Moonves: Doug, I'm going to be evasive. All I can tell you is the revenue from the new media stuff is growing a great deal. It's going to grow more than 100% in '06 from '05. We expect that kind of growth even more significant in '07. In terms of giving a specific number, it is very hard because these initiatives are coming in every single day. It will be in the hundreds of millions of dollars though. Sports Line clearly is our number one area for that and that is growing in leaps and bounds and so there is a lot that is out there, rather difficult to quantify right now but it is all very exciting.
Fred Reynolds: Doug, this is Fred. On the DVD, if I understand your question, year-to-date last year we had about $100 million more in DVDs revenues than we have this year. So if you're looking at our year-to-date revenue numbers, last year was benefited. Again I went to emphasize zero, zero impact on profits. It's just a matter of gross versus net. The profits are the same, our gross margin whatever you want to call it, but the fact that we don't record it gross but we record it net is the only difference. But last year benefited. So if you are looking at the health of our revenue growth, last year had $100 million because we self distributed versus third party this year.
Doug Mitchelson - Deutsche Bank: So net to net is flat then?
Fred Reynolds: Pretty much, yes. It is down slightly but it's not significant and we expect to make that up in the second half of the year. The profits should be stronger in the second half or gross margins stronger in the second half on DVD sales than last year. The change in OIBDA is negligible year-to-year. On the London Underground, we do start off with a lower margin than we end it with a caveat; we also have more inventory. So if you just looked at the same inventory or same boards year-to-year, we'd probably have a lower margin. We have more inventory that we're going to be granted. So if we can make more revenue off of that our margins should be equal to. But we are not saying that's in the cards yet. Certainly we have more inventory and it's for us to get more value for.
Doug Mitchelson - Deutsche Bank: Thanks.
Operator: Our next question comes from Anthony DiClemente - Lehman Brothers.
Anthony DiClemente - Lehman Brothers: Hi, thanks for taking the questions. I have two quick questions for Fred. For the leverage ratio, if you layer in your pension liabilities, isn't the leverage ratio as of the end of the 2Q closer to 2.0 times? Do you have a target long-term leverage ratio that you can share with us? Second question is if I look at your recurring free cash flow through the first half, that's excluding the one-time tax benefit, you're at about an even $1 billion and we're only halfway through the year. Most of the analysts are looking for $1.3 billion of free cash for the full year. So that would imply a dramatic use of working capital in the second half. Does that sound plausible or are all of our free cash flow numbers just too low? Thanks.
Fred Reynolds: Okay, thanks, Anthony. On the leverage ratio, I think the way we look at it is the way the rating agencies do. So they tax affect our non-interest-bearing obligations which would be pension and retiree medical and so they tax affect that because on the balance sheet it is pre-tax. So it would be around a 2. As you know, I look at our dividend as a fixed cost or a fixed commitment. So I sort of layer that in. But let me be clear, we are very, very comfortable with our leverage ratio. Again, I think we would certainly be comfortable in the 2.5 range if it was used to acquire something that would grow our businesses faster. As I mentioned at the outset, we see paying down debt as not a priority because we think our debt is terrific where it is. On free cash flow, as you know, the first half of the year in our businesses is where we do produce a lot of free cash flow, the first and second quarters. Because largely we're not in production out in Hollywood. Starting this month or the end of this month, we start really upping production for all the fall series and we have the NFL contracts and NCAA contracts. It has never been and it won't be linear this year, that each quarter you can multiply by four. So we are on the same cycle we always are. Cash flow will not be as strong in the third quarter which it typically isn't as it is in the first half. We don't forecast the full year free cash flow for you but obviously we are very pleased where we are and the businesses throw off a lot of cash.
Anthony DiClemente - Lehman Brothers: Okay, thank you Fred.
Operator: Our next question comes from Kathy Styponias - Prudential.
Kathy Styponias - Prudential: Thanks. A couple of questions for you, Les. With respect to Showtime and your movie strategy, to the extent that you mentioned that some of your output deals are coming up for renewal in 18 months, to what degree is the movie strategy looking to replace some of the content that you might lose? Would making five to six movies on your own be enough to kind of continue to sustain Showtime because I imagine the deals that are coming up for expiration provide you with a lot more movies than that? If you're going to make it up on original programming, aren't Showtime's costs going to up? The second question is, could you discuss the programming costs for the CBS Network in light of the fact that you only have four shows to promote in the fall? What kind of growth rates should we expect at the network level for the 06/07 season? Thanks.
Leslie Moonves: Regarding Showtime, you are absolutely right, six movies will not be enough. That is not to say that we're going to preclude from doing other deals. I think right now the cable networks have an advantage in that they don't have to do the large output deals that they have done in the past whereby you have to buy every single movie from the studio. So there is lots of cash that is paid to the studios for these output deals. Obviously we will be making some deals in the future. But if we think the deals will be more advantageous from Showtime than they have in the past, we still plan on doing that. In terms of original programming, right now we do intend to increase production somewhat. Probably the balance will change somewhat from renting movies from the studios and doing more original programming that we do in fact own, or in fact, license from other people. But that should not change the balance of the cost for Showtime. As a matter affect, we think it will be reduced, the cost of Showtime in the future. We think once again their profits should be going up in future years and we like how that looks. It also does give us the advantage of owning some of these movies as opposed to renting from other studios. In terms of programming costs at CBS by and large they were up rather small amounts. We have always been rather smart. Number one, we own most of the programming on our network so we've been able to control the costs that have been there. So it's impossible to predict what the growth rate will be if the network. I think we are keeping with a guidance that we've had for the year. But we've had great discipline and we've been very successful in negotiating appropriate contracts on all our programming, so that continue in the future with rather minimal growth to programming costs.
Kathy Styponias - Prudential: Thank you.
Operator: Our next question comes from John Blackledge – JP Morgan.
John Blackledge - JP Morgan: Thanks for taking the question. A couple of things on outdoor. If you look at the Company, outdoor should be the highest growth segment within the Company over the next several years. When you look at it, CapEx of sales of CBS Outdoor versus some of its peers CapEx sales about 4% for CBS Outdoor versus CTO at about 7%, the margin around 11% to 12%. In order to sustain a certain level of growth over time, do you need to ramp up investment at CBS Outdoor? Then if you could just outline your current digital strategy? Thank you.
Leslie Moonves: Fred, why don't you talk outdoor and I'll talk about digital.
Fred Reynolds: On outdoor, yes, I think it should be one of our fastest growing. I'm not sure we would see it be the fastest but I think it will be one of the fastest-growing. I think on capital you have to look at where our businesses are different. We are keen on expanding the digital platforms that we have in outdoor. We think it is a truly one of the great technological revolutions there. So we are keen on investing in it, but we're going to invest smart. We want to get a good return on it. Because we are largely a billboard business, we tend to have lower capital spending than some others that have a different mix. We don't have the street furniture business. As we got out of some of the transit contracts which had a heavier capital spend commitment as part of the contract, that is lower. But Leslie is certainly not shy about having the outdoor guys accelerate their growth. We do lots of acquisitions. They are not big. They are $2 million to $10 million, sometimes $20 million. We buy lots of boards. We want to keep buying boards particularly in North America, the United States, Canada, Mexico. But we would love to press the accelerator faster on outdoor, but it has to be a good return.
Leslie Moonves: Yes, I'm assuming you meant digital strategy regarding outdoor. As a Fred said, we're picking our spots. Obviously we're increasing our digital position in cities like New York, San Francisco, Chicago. London is fairly significant but once again, we're weighing the costs of this versus what our return is. Once again, the cost of the digital boards is coming down significantly. Dealing with volume and we view it like plasma televisions where they used to cost $10,000 apiece and now they are $899. So I think that's going to be part of our strategy and costs will be down and hopefully revenues will be up significantly.
John Blackledge - JP Morgan: Thank you.
Operator: Our next question comes from Anthony Noto - Goldman Sachs.
Anthony Noto - Goldman Sachs: Thank you very much. Fred and Les, I was wondering if you could comment on second half growth. You had mentioned you still feel comfortable with operating income growth excluding stock-based comp of mid single digits. Looking at the growth in the first half of the year and backing out Parks a year ago, it looks like it was down 2% year-to-year -- correct me if I am wrong -- which should imply you would need high single-digit to low double-digit growth in the back half of the year. Is that true? If so, could you give us a more detail on how you think you get there given the trends we've seen so far? Could you also comment on TV advertising excluding CSTV? Thanks.
Fred Reynolds: Anthony, this is Fred. Let me start off. As we look at the way we have said the growth would be over '05 stripping out non-cash, non comparable items or other non-comparable items, we're probably about flat. We're not down 2% at the halfway mark here. As you know, our third and fourth quarters are a lot stronger particularly this year, with it being a political year we will have more strength. So we are confident that we will get to a guidance of mid single-digit operating income and EPS growth. Clearly we weren't going to take credit for the tax benefit we had in that and we noted that we excluded that also. At the halfway point right now, if you take out the stock-based compensation and the write down at UPN, we are about flat to where we were last year. We should be able to deliver. again barring some catastrophic situation in the economy, we should be able to be there.
Leslie Moonves: Yes, and regarding TV advertising. I just want to reiterate what Fred just said. We are going to be there, we are fairly confident that our numbers for the year, our guidance for the year is right on target and we are confident that we are going to hit that. In terms of television advertising, there's a myth out there that the upfront was down. You have to remember we went from a universe of six networks to five networks. So if you exclude some of the money that was taken in by that last network, basically the numbers appear to be flat for the upfront. We're seeing also in syndication the upfront is up low single-digits but we're very pleased with the return and once again, having such great syndicated product, we're encouraged by the upfront for the syndicated shows. It was a soft second quarter in scatter. Political as I said in my earlier remarks is going to exceed budget with the exception of New York and it is heating up. We are looking forward at the station level to hitting our numbers if not exceeding them in the second half of the year.
Anthony Noto - Goldman Sachs: Fred, could you give us a growth rate number for the second quarter for television without CSTV?
Fred Reynolds: On revenues?
Anthony Noto - Goldman Sachs: Yes.
Fred Reynolds: Again, I think revenues would have been about flat for television segments. It is down about 2% if you take out that DVDs. If you leave the DVDs in, we're going to be fairly down. But if you take out the non-comparable, the television segment was about flat if you take out CSTV and the DVD accounting change.
Anthony Noto - Goldman Sachs: Thank you.
Fred Reynolds: Anthony, if you have our earnings release -- I don't know if you have the same page numbers -- you'll see were where we reconciled, page 17 shows you how '06 year-to-date is versus last year's '05 year-to-date. They are within $400,000 to $600,000 of each other year-to-date. So we are about flat.
Anthony Noto - Goldman Sachs: Thank you.
Operator: Our next question comes from Andrew Baker - Cathay Financial.
Andrew Baker - Cathay Financial: Thank you very much. When you went through the numbers on TV, I didn't hear you go through CBS Network. I was wondering if you can tell us how the CBS Network did in Q2? And then any indication you can give how scatter pricing is doing in Q3? Thank you.
Fred Reynolds: Okay, on revenue if you look at the time period sales, we were down a little bit in time period sales second quarter of '06 versus second quarter of '05 we were down about 1.5% in revenue. About three-quarters of that was because we had some very significant finales at the end of the '05, May '05 with the Raymond finale which was being priced at an ungodly amount. We also had the JAG and the Amy finales which were smaller along with the big Survivor finale. So about three-quarters of the drop we just had a significant ending of a nine-year run of Raymond and we got a lot of money for it. The other part of it was the scatter market was softer than we would have liked in the second quarter. I think certainly Leslie has said that and we've communicated that. I don't always want to say why things are up or down because probably next May we will have huge finales. But that is one reason why, or the major reason why we were down.
Leslie Moonves: The good news is you know on that, yes, we didn't have the major finales, but the good news is we didn't lose any major shows this year. We go into next year with a fairly pat hand with only four new shows and that bodes very well for the stability of the CBS network as we go forward.
Marty Shea: We will have time for one more question.
Operator: Our next question comes from David Miller - Sanders Morris Harris.
David Miller - Sanders Morris Harris: Marty, you stumped me. All of my questions have been answered. So you guys can move on and take one more question. Thanks very much for taking the question though.
Leslie Moonves: Thank you, David.
Operator: Our final question comes from Michael Nathanson - Sanford Bernstein.
Michael Nathanson - Sanford Bernstein: Okay, thanks. I have one for Fred and then one for Les. Fred, in the past, you talked about what the revenue growth was in the Howard Stern stations. Can you tell us what that was? Was there any inventory cuts out of those stations? For Les, as a firm we try not to focus too much on the upfront, but as you say, there was low pricing this upfront as people drove volume. So historically CPM pricing has been up in the upfront, it's been strong. So why do you think low pricing occurred this year? Is this beginning of a new trend going forward?
Leslie Moonves: I will go first with the upfront question. Number one, you took out, Johnson & Johnson didn't participate in the upfront this year which was rather unusual. It was have a different strategy where they are going to buy in August and September. If there is any softening in volume, and we didn't have it by the way, that only bodes well we think for scatter pricing. As I said, our volume was up. We were able to take a significant amount of money from other networks and where different advertisers may be looking at the upfront in different ways than they had before. Once again, for the networks that are doing well, the upfront is not necessarily the best way of doing things. It is the system that we have now and we're playing by those rules. But by and large with the exception of possibly second quarter this year, scatter pricing for us has been significantly up. So we don't mind a game change and we think we're going to take a significant part of the J&J money although it may come in somewhat later.
Fred Reynolds: Michael, this is Fred. On the question on the 27 stations that had the programming change. Clearly they are down significantly, as we said, for the full year, we thought they would probably be down about $50 million and you can sort of say each quarter is going to be some percentage of that. So, yes, they are pacing down significantly. The good news is, as Leslie said before, we're starting to get some traction with the Opie and Anthony show here in New York. We're seeing that as we look out to the third quarter which we only have really good visibility out through September, it's starting to pick up pace nicely each week. It is still down, but we are encouraged that it's going to come back. All it takes is a New York and a couple of markets and we should start turning that around. But it is down we said about $50 million for the year, on these 27 stations. So each quarter it would probably be down somewhere pro rata of that $50 million.
Michael Nathanson - Sanford Bernstein: Okay, thanks.
Marty Shea: Thank you very, very much everyone and we will continue to be around for your further questions during the day.
Operator: That does conclude today's conference call. We thank you for your participation. You may disconnect at this time. | [
{
"speaker": "Executives",
"text": ""
},
{
"speaker": "Analysts",
"text": "Victor Miller - Bear Stearns Jessica Reif Cohen - Merrill Lynch Doug Mitchelson - Deutsche Bank Anthony DiClemente - Lehman Brothers Kathy Styponias - Prudential John Blackledge - JP Morgan Anthony Noto - Goldman Sachs Andrew Baker - Cathay Financial David Miller - Sanders Morris Harris Michael Nathanson - Sanford Bernstein"
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{
"speaker": "Operator",
"text": "Welcome to the CBS Corporation second quarter 2006 earnings release teleconference. Today's call is being recorded. At this time I would like to turn the conference over to the Senior Vice President of Investor Relations, Mr. Marty Shea. Please go ahead, sir."
},
{
"speaker": "Marty Shea",
"text": "Good morning everyone and thank you for joining us for our second quarter earnings call. Joining me for today's discussion are Sumner Redstone, our Executive Chairman; Leslie Moonves, our President and CEO; and Fred Reynolds, Executive Vice President and CFO. Sumner will have a few opening remarks and then we will turn the call over to Les and Fred for strategic and financial issues. We will then open the call to questions. Let me note that statements on this conference call relating to matters which are not historical facts are forward-looking statements which involves risks and uncertainties that could cause actual results to differ. Risks and uncertainties are disclosed in CBS Corporation's news releases and security filings. A summary of CBS Corporation's second quarter 2006 results should have been sent to all of you. If you did not receive the results please contact Punamb Dusai at 212-975-3667 and she will get a copy to you. A webcast of the call, the earnings release and other information related to the presentation can be found on CBS Corporation's corporate website at the address of cbscorporation.com. Now I will turn the call over to Sumner."
},
{
"speaker": "Sumner Redstone",
"text": "Thanks, Marty. Although I am required, actually required to be here in California instead of there in the room with Les and his team, I must assure you that neither the distance nor the early hour of the day diminishes my enthusiasm for CBS Corporation and for Les and his team. In just six short months, Les and his team have shown great progress in fulfilling the long-term promise we envision. Of course to tell you all about it, here is Les."
},
{
"speaker": "Leslie Moonves",
"text": "Thank you, Sumner. Good morning everybody. I'm very pleased to be here to talk about our second quarter results. We now have two quarters under our belt as a stand-alone Company and we are growing our businesses and strengthening our balance sheet every day. This morning I'm going to share our second quarter results with you and provide highlights on our business operations and then I'll turn it over to Fred Reynolds who will provide a more detailed look at our segment results and free cash flow before we open up the call for your questions. You may remember when we had our first earnings call of the year we said that CBS is a Company on the move. While that description still holds; I'll take it a step further now and say we're a Company in motion. We're doing the things we said we would do. We're delivering on the promises we made to you. In short, we are executing on our strategy. For example, we promised we'd raise the dividend and we have -- twice. On May 25, we announced a 12.5% increase on our quarterly dividend from $0.16 to $0.18 per share. It was the second increase since the start of the Company and a 29% increase since the start of the year. So I think you can see that we are committed to making good on our promises by returning value to shareholders. You can also see that we are very confident in the near future and the many years to come. Now let's take a look at what we did overall in the second quarter. The main headlines were as follows: Net earnings from continuing operations were up 29%; diluted EPS from continuing operations were up 36% to $0.64 per diluted share; and free cash flow of $546.2 million was up 2%; and, we had fantastic growth at CBS Outdoor where operating income was up 32%. During the quarter we were able to resolve prior year tax audits which allowed us to lower our tax provision in the second quarter by approximately $125 million. I'm particularly pleased with our growth in free cash flow, the foundation of future dividend growth. I'd like to point out that with the exception of radio, which is still not delivering the results we expect, our core operations are firing on all cylinders. Revenues of $3.48 billion were down 1% from the same quarter last year. Though our TV stations were up 5%, the television segment was off 1% overall. Outdoor and publishing both showed growth but we were affected by an 8% drop in revenue at radio. The radio marketplace is tough right now and we face year-to-year operating issues related to the loss of key programming. However, we swiftly made changes in 2006 and are encouraged by the early results. The crucial East Coast morning drive time numbers are trending up. More on that soon when we get into the segments. Operating income before depreciation and amortization decreased 6% to $859 million and operating income was off 7% to $750 million. Both of these declines were largely due to the impact of stock-based compensation expenses as well as $24 million of expenses relating to the shutdown of UPN Television Network. A significant event during the quarter was the sale of Paramount Parks to Cedar Fair for $1.24 billion in cash which amounted to a gain of $292 million. We are extremely pleased with the price we received for this business. Looking at the first half, revenues were up 2% from the same prior year period, diluted EPS from continuing operations was up 24% and free cash flow was up 7%. Overall it was a good first half and we expect to deliver on our business outlook for the full year. Before I turn things over to Fred, I'd like to update you on some of the key events and accomplishments at our Company since our last earnings call and let you know what's going on in each of our businesses. Starting with television, in May we rounded out the 2005/2006 television season and for the fourth consecutive year, CBS won in viewers and households. Plus for the third consecutive season, the network took the top spot for the 25 to 54 demo, and it was a close race in the 18 to 49 with only fractions of a point separating the top three. We have six shows returning from last year's freshman class and with only four new shows to promote this fall, all of which are getting great buzz, we're confident we can deliver again starting this September. Of course on September 5, we have the first broadcast of the CBS Evening News with Katy Couric. While you all know that moving network news ratings is a long and gradual process, we believe this represents a major step forward for our entire news organization. Plus, we recently announced an evening news content will be available cross platform to anyone, anywhere, anytime on TV, the radio, the Internet and wireless. Katy's reports will be sent out via broadcast, podcast and will feature supplementary and sometimes simultaneous reporting and previews on VCast Wireless, CBS Radio News and Katy's own interactive daily blog on cbsnews.com. We are making the very most of every single opportunity out there to give consumers the content when they want it, how they want it. In the process, we will grow interest and demand for our evening news broadcasts. Meanwhile, our TV station group is also benefiting from the continued success of the CBS Network. TV station revenues were up 5% during the quarter. Everywhere but New York, political spending is exceeding expectations and we anticipate even bigger gains as we move closer to the November elections. Early advertising sales indicate that our CW stations are also quite strong which should lift the station groups even higher. In syndication, King World will debut Rachael Ray beginning in September. This is a highly anticipated daily first-run talk show that's cleared in 97% of the country. Without overselling Rachael Ray, we believe this is a great addition to our stable of syndicated hits which already includes eight of the top 10 syndicated shows on television. Turning to cable. At Showtime, subscribers and subscriber fees are both up and we're very happy with the momentum so far this year. We hope to build on that later this month with the return of Weeds which won five Emmys in its first season and Showtime's new drama, Brotherhood, has been getting a great reception as well. We recently aired the pilot episode on the CBS network to broaden the show's exposure. This is just one example of how Showtime is benefiting from being a part of the CBS family. Showtime intends to be the best and producing the best content is the surest way to get us where we want to be. At CSTV, our college sports cable network, we're teaming up with Comcast to launch the Mountain Sports Network focusing on Mountain West Conference athletics. The Mountain will initially premiere on Comcast systems in Utah, Colorado and Mexico. This is yet another wonderful addition to our portfolio of local sports assets and will make an excellent play on both cable and the Internet. CW, our 50-50 joint venture with Warner Brothers, will begin broadcasting in late September. Distribution for the new network now covers more than 90% of the country and having stations that do exceed what the former WB and UPN ever did on their own. Plus we had a very successful upfront and interest in this new network and its attractive young demos is quite high. Moving onto radio, where we continue to seek an aggressive turnaround. To climb back into the growth position we need to offer the programming that listeners want to here and we're making progress. Several of our new formats are doing terrific. Spanish formats are up over 50% year-to-date and in the second quarter of 2006, Jack FM was up 13% and talk radio was up 9%. Plus, the spring Arbitron ratings released last month showed big gains for our stations in major markets, particularly during morning drive. New York, Philadelphia and Boston improved dramatically. The returning of Opie and Anthony to New York had a huge impact on our listenership in the men 25 to 54 demo. We've jumped from fifteenth to second, or 140% since the show began broadcasting on April 26. Overall this show in most of our markets has done exceedingly well. We're getting the ratings back and we're beginning to monetize them already. At the same time, we’re looking to sharpen our focus in higher growth markets by getting out of smaller, slower growth areas. On May 23rd, we announced that we're exploring the divestiture of radio stations in ten of our smaller markets. Since then we have received literally dozens of offers that we're in the process of reviewing. The good news is these offers have been very, very attractive. We expect to have an announcement on the sale soon. Additionally, after the close of the second quarter we announced a headcount reductions of over 100 staff positions at CBS radio. Reducing radio's cost structure is another way we can help maximize the performance of the larger operation and we remain absolutely committed to doing that. Moving to Outdoor, a really incredible story. As I said earlier, operating income was up a remarkable 32% here. We love Outdoor and lately so does everyone else. We all know that reaching consumers is becoming increasingly difficult in today's fragmented media marketplace. So it's not surprising that outdoor advertising is having a renaissance. Experts are predicting Outdoor will become a $10 billion business within the next five years and CBS Outdoor will get a bigger piece of that rapidly expanding pie in North America as well as overseas. In May, we won an eight-and-a-half year contract to sell advertising in the London Underground; the deal is believed to be the largest [out of home] contract anywhere in the world. When it starts later this month, advertisers will be able to use digital technology to target consumers more effectively. We're also looking forward to offering them some great opportunities when the 2010 Olympics are held in London. The impact of improving digital technology in the Outdoor arena will soon be felt here in New York starting next month, a network of 80 high-definition local LCD panels will be installed in the city transit system. Displays will be visible above subway entrances, at street level in high traffic areas across Manhattan. We continue to look for new opportunities to grow this exciting business. In publishing, second quarter revenues were up 1% to $176 million where OIBDA and operating income were up 7% and 5% respectively. Top-selling titles in the quarter include Chill Factor by Sandra Brown and Looking for Peyton Place by Barbara Delinsky. We're looking forward to the fall book-selling season with the 75th anniversary edition of The Joy of Cooking and Stephen King's, Lisey's Story. Finally, let's take a quick look at new media which spreads across all of our operations. We continue to see tremendous proof that big brands are driving new media as they have driven establish media. For that reason we made CSI and Survivor, our best-known franchises, available for downloads on iTunes. Also during the quarter we partnered with Amazon.com to make the archived CBS Evening News material available on 90-minute customized DVDs. CBS Radio has begun streaming sports content to mobile phones and when we introduced text message voting to Big Brother, the trial effort garnered to 14 million votes. We've also launched two new web sites, Innertube and Showbuzz. Innertube is our new advertiser supported broadband channel offering free original entertainment programming expressly for Internet users. Showbuzz is a one-stop online destination for entertainment news and pop culture. These are brand new offerings and we'll keep you posted on how they shape up. At the same time we're pursuing web strategies in all our local properties including television and radio. These opportunities are very important to advertisers and with our tremendous local broadcasting presence, we have a huge leg up in reaching local customers on the web. Clearly across all of our platforms, both local and national, this will continue to grow significantly in the future. Our content will be everywhere and provide increasing revenues in the new media space across the board. In conclusion, we are on track to deliver on our business outlook for the full year. Our businesses are well-positioned, our team is second to none and we continue to produce lots of cash. We've repeatedly demonstrated that we return value to our shareholders and we intend to continue doing so. Thank you and with that, I will turn it over to Fred."
},
{
"speaker": "Fred Reynolds",
"text": "Thank you, Leslie and good morning. What I'd like to do this morning is provide highlights for the second quarter of 2006 and give you additional information about our second quarter operating performance, cash flow and our full year outlook. Now as Leslie just mentioned for the second quarter of '06, revenues were almost $3.5 billion, down about nine-tenths of a percent from the second quarter of '05. The primary reasons for the slight decline in revenues were lower ad sales at our radio stations and lower home entertainment or DVD revenues. We will discuss radio results in a few minutes, but first our DVD sales for the second quarter of 2006, which are primarily from our large CBS Paramount Library, are now distributed by a third party. In prior years we distributed our own DVDs. Now at CBS our practice is to record revenues from the sale of our DVDs by third-party distributors, net of their costs and fees. While this accounting treatment had zero impact on profits, it did impact revenues. Our revenues for the quarter were down $50 million versus a year ago. So if you exclude the effect of the DVD revenues overall, the Company's revenues would have been 1.4% higher and the television segment revenues would have been 2.2 percentage points higher than what has been reported. Now for the second half of the year, we expect to see the DVD Home Entertainment net sales increase versus a year ago. TV stations Showtime and Outdoor all had solid revenue growth in the second quarter of '06 versus a year ago and revenues at our international businesses led by the United Kingdom, Canada and Mexico were up about 5% over the second quarter of '05. Operating income before depreciation or amortization for the second quarter of '06 was $860 million, down about 6% to a year ago. Operating income also declined to $750 million, a drop of about 7%. Two items in particular I would highlight which mask our underlying profit performance in the second quarter of '06. First, as Leslie mentioned, was the $24 million of costs which we incurred to shut down the UPN Network which we recognized in this quarter. In addition, in the second quarter of '06 we had incremental stock-based compensation of about $13 million higher than last year. The weak performance from our radio stations versus year ago also pulled down our profit performance. Radio's results suffered in comparison to the second quarter of 2005 not only from lower station revenues but also due to a $15 million gain we recognized in the second quarter of 2005 from the sale of a radio station. No radio station sales have taken place in the second quarter of this year. Now turning to interest expense, it was $141 million for the quarter, $35 million lower than it was last year at this time as our debt outstanding is down considerably due to the $5.4 billion dividend we received at the end of last year in anticipation of the separation of new Viacom. Lower debt at the start of 2006 coupled with strong first half cash flow from operations significantly lowered our borrowings and interest expense versus year ago. The proceeds from the sale of Paramount Parks of $1.24 billion had no impact on our interest expense in the second quarter as the Parks' proceeds were received on the last day of the quarter on June 30 2006. Interest income is up considerably over 2005 second quarter due to our strong cash generation. Now during the quarter we did retire $50 million of our 2011 6 5/8 debt which resulted in the $2 million loss on early extinguishment that you will see in our P&L. Our tax provision for the second quarter of 2006 of $118 million is down over $120 million from a year ago. The tax provision rate was 19.3% versus last year's second quarter of 39.1%. The significant drop in our tax rate was due largely to the resolution of prior year's federal tax returns. Excluding the benefit of resolving these prior year tax matters, the tax provision rate would have been 40.4% in the second quarter of 2006, up slightly over 2005 due to a higher mix of U.S. taxable income this year which is taxed at a higher rate than our foreign operations. Net earnings from continuing operations totaled $490 million or $0.64 a diluted share. The tax benefit, as you will note, added $0.17 per share to our 2006 EPS. Now if you exclude the tax benefit, the shutdown of the UPN and the stock-based compensation, the earnings per share for the second quarter of 2006 was $0.50 a share versus $0.47 a share in 2005. The gain on the sale of Paramount Parks nets us $292 million after tax or a pre-tax gain of $455 million which is an additional $0.38 per diluted share, giving us total earnings for the second quarter of '06 of $782 million or $1.02 per share. Free cash flow for the quarter was $546 million up 2% over the second quarter of '05. Strong receivable collections dropped our days sales outstanding across all of our businesses, coupled with lower programming inventory helped to drive our very, very strong cash flow for the second quarter. As you may have noted, during the second quarter we reduced the number of stock options outstanding by exchanging approximately 7.2 million restricted shares for 64 million stock options that were outstanding. The restricted shares vest pro rata over three years. We believe the exchange significantly reduced the stock option overhang that CBS Corporation had at the start of the year. Now let's turn briefly to our segments. Leslie discussed the performance of each of our segments but let me add a couple of other highlights. As Leslie noted, television segment revenues were down 1% versus '05 as our growth at TV stations were plus 5%, Showtime plus 8% and CST added to our growth but it was offset largely by the drop in the DVD revenues that I just discussed. OIBDA for the television segment of $535 million was down 2% to the second quarter of '05 but again if you exclude stock-based compensation expense, the incremental amount, and the $24 million of the UPN shutdown costs, the second quarter 2006 OIBDA for television segment would have been up 3% over a year ago. Turning to radio. Radio's revenues for the quarter were down 8%. Now the 152 stations which did not suffer from the program changes were down about 3% versus a year ago. In the second quarter of this year, inventory avails at our radio stations were down 2% from a year ago, as we selectively reduced the number of commercials. I would also add on the process of selling the 10 markets not only have the quantity and quality of the buyers have been impressive but the indicative values look very strong and hopefully again, as Leslie mentioned, we expect to conclude the sales process in the next several weeks. Turning to outdoor, revenues were up 7%, with the U.S. up 7.4%; Mexico up 15.3%; and Canada in local currency up 5%; and in dollar terms, Canada was up 17% as the Canadian dollar strengthened against the U.S. The UK was up 7.4% both in local currency and in dollars. Outdoor's operating profit before depreciation and amortization of $160 million was up 19% over last year's second quarter and operating income was up 32% to $108 million. As you will note, corporate expenses were roughly $40 million for the second quarter, and are up over last year's $27 million expense. Now the second quarter of '05 number is an as reported amount which does not reflect CBS as a stand-alone company. So on a pro forma basis, as if CBS was freestanding as of January 1, 2005, corporate expenses in the second quarter of '06 would be up about $5 million higher than a year ago. The increase relates primarily to transition costs which we expect will ease in the second half of 2006 and costs associated with the voluntary exchange program that I just mentioned to bring in the options that were outstanding. Year-to-date on a pro forma basis, corporate expenses were also up about the same $5 million over last year's 2005 year-to-date. Residual costs, which consist of pension and retiring medical expenses of our divested businesses from the past, was $35 million for the second quarter of '06, up about $5 million from the second quarter of '05. Costs are largely due to pension assumption changes, offset somewhat by lower retiree medical costs. As you will note in our earnings release, we have highlighted our stock-based compensation expense in total and by segment. We expect our full year stock-based compensation expense to total approximately $80 million for 2006. So as Leslie mentioned, turning to our full year outlook, we are on track to deliver low single-digit revenue growth and mid single-digit operating income and earnings per share growth. Now finally as you will note from our balance sheet, we have accumulated over $3 billion of cash as of the end of June. A little over $1 billion of this cash amount relates to proceeds we received from the sale of Paramount Parks net of the expected income taxes on the gain. As we have indicated previously, we would certainly consider returning the excess proceeds from the sale of the Parks business to shareholders if we could not invest that cash in a disciplined manner. As you may know, we constantly review numerous investment opportunities to redeploy our strong cash flow and we will continue to pursue looking at investment opportunities that may arise. However, I think we can all assure you that we would have to be very confident that any investment would result in accelerating our revenue, earnings and cash flow growth and also provide a strong return to our shareholders. The hurdle any investment would have to achieve is that it would need to be superior -- superior -- to returning capital to shareholders. The timing on our decision is also dependent on what is the best way to return excess cash to shareholders. That is either in the form of increased dividends which has been the path that we have followed so far, or a share buyback program, or a combination. In addition and related to the timing of our decision, some of the offers we have received to buy the radio stations we are selling involve acquisition structures which could be very, very tax efficient for CBS. We have not come to any conclusions on whether these offers optimize our overall value. However, should we elect such an acquisition structure that would be tax efficient for us, it would curtail our ability to buy back shares while the sale transaction was underway. We know you are keenly, keenly interested in this matter and we hope to have much more clarity on the matter in the very near future. So thank you very much for taking the time to listen to our second quarter. Now, operator, if you would, we could open the lines for questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Our first question comes from Victor Miller - Bear Stearns."
},
{
"speaker": "Victor Miller - Bear Stearns",
"text": "Good morning, thank you for taking the question. First of all, Fred, what you just talked about on returning capital, there's a certain expectation. You've probably seen it written in several analyst notes, articles, that there's a $1 billion plus expected return on capital. Maybe you can talk about what is your dimension is in terms of potential acquisitions relative to that dollar? Also, the reality is that your net debt now is below $4 billion, which is extremely ahead of what anybody had expected here. Even if you ended today you'd be at 1.2 times leverage. So regardless of whether you did something with that cash other than returning that $1 billion from the Parks to the shareholders, wouldn't the balance sheet allow a very substantial repurchase/special dividend/tender regardless? For Les and Fred, I don't know if you can answer this right now, but on the radio side obviously you've made some cuts. Obviously you've decided not to renew the Redskins, the Ravens and the Cowboys. We've got the NFL season coming on right now, it's obviously a lot of revenue generated from those three teams. Can you talk about what impact those two events may have on the revenue and the expense of the radio group in the second half? Thanks."
},
{
"speaker": "Fred Reynolds",
"text": "Victor, wow, that was like three paragraphs, but thank you. I think certainly we understand the focus on the cash. One, we're very pleased to be in this position to have the cash. I think Leslie has been very clear that we would not do any acquisitions that wouldn't be very, very good returns to us. We've said in the past we want to focus on content acquisitions that makes sense. We have a lot of outdoor small tuck-in acquisitions which wouldn't use anywhere near the kind of cash we're talking about. I would say we're probably more in the CSTV kind of level. But there has been, as you know and has been well reported, about opportunities that come along all the time. But I would say to you that Leslie, myself and the team are very, very disciplined in our approach. We don't chase after acquisitions. There's nothing we need to have. But clearly we would like to keep growing the businesses and have a higher growth rate. So again, we can talk about that more as we unfold. We are clearly focused on trying to do the best amount we can on the sale of those radio stations and get the best amount of value to shareholders and some of the structures would allow that. Yes, our debt is low and you will not hear us talk about debt pay down as a priority for our free cash flow. Our free cash flow priorities will be, if they make sense, and they could truly be a great return -- better than just giving the return of capital to our shareholders – then acquisitions would be a priority. Returning capital to shareholders is the other priority. There really aren't other priorities that I would speak of. I'll answer the question on radio and then turn it over to Leslie for your other questions about the direction. Clearly our revenue is suffering. We don't have some of the baseball teams we had last year and also radio doesn't have the Redskins, as you mentioned. So costs will be down but so will revenue be down. As we focused mostly on the revenue growth that is a dampener more so in the third and fourth quarter than so far to date."
},
{
"speaker": "Leslie Moonves",
"text": "Victor, I just want to say, those are indicative of obviously we're paying a lot of attention to the radio business. We're being very careful about every single deal we make in terms of talent, in terms of all those renewals of the football deals that you referred to. Every deal we make will be studied at great length. In terms of specifics how much that will change the equation, we don't know but we're treading with great caution. I think we're going to be able to make a significant difference as we did with the 100-person layoff as well as the ending of some of these bad contracts."
},
{
"speaker": "Victor Miller - Bear Stearns",
"text": "Thank you, Les. Thank you, Fred."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jessica Reif Cohen - Merrill Lynch."
},
{
"speaker": "Jessica Reif Cohen - Merrill Lynch",
"text": "Hi, two questions. This is sort of acquisition-related, one of them. Given the anemic upfront market for both broadcasting and cable, money is obviously going elsewhere; the Internet, product placement. What is your plan to recapture this money? Do you need to acquire some property, some web-based property or something else or will you go purely the organic route? Secondly, can you flush out your film strategy? Is the plan to make theatrical films, made for TV movies, how will you finance that?"
},
{
"speaker": "Leslie Moonves",
"text": "First of all, Jessica, I might disagree with you on the anemic upfront. We didn't view it as anemic. I think three of the four networks did very well -- or should I say, four of the five networks did very well. CW did well, CBS obviously, we had low CPM increases. Our volume was up and we were actually quite encouraged by it. When you look at how much money is shifting to the Internet obviously we're there. We've made a number of deals across the board. Along with our network deals and our syndication deals, there were web properties that got a piece of the upfront. Having said that, the percentage of that was rather small. We did make some cross-platforming deals with a lot of our new shows and a lot of the Internet is there as part of it, but the amount of money is rather small and frankly we were not disappointed with the upfront. The CW did extremely well at the upfront as well, taking in more money than either one of the other two networks and increased from where the WB was, and we view that as a very significant event. We were, at the end of the day, pleased with the upfront. In terms of our film strategy, let me clarify because a lot has been written about it. We have a very valuable asset called Showtime which right now pays hundreds of millions of dollars to three studios for film output deals. These deals end in 18 months. When you look at that as a basis and then you add in the television network and you add in DVDs and you add in international television, we look at being able to get into the film business, and I'm talking about in a rather small way with four to six movies per year and movies that range from $10 million to $40 million to $50 million tops. We have figured out a way where we can get into the movie business literally risk-free. I'm talking about zero risk. Whereby our piece of the movie, we will be out before a dollar is achieved in box office. So it's an interesting way to look at the film business and one as we head toward the future, we have always said content is a very, very important thing to us. So if we do six movies a year and a couple of them are hits, we guarantee we will make money. Then at the end of five years if you have a library of 30 to 40 pictures, that is also going to be worth quite a bit of money and can be used in a lot of different ways. So we look at it as a positive. But once again, let me assure you, we're not going to get into it in a big way. We're not going to have a large studio overhead. We're going to do it in a very cautious manner. In terms of movies of the week, we are not doing them for the network obviously. We have some output deals with some foreign companies so we are producing some with CBS Paramount and they are mostly for cable."
},
{
"speaker": "Operator",
"text": "Our next question comes from Doug Mitchelson - Deutsche Bank."
},
{
"speaker": "Doug Mitchelson - Deutsche Bank",
"text": "Thank you very much. Les, given your long list of digital initiatives on this call, can you just give us a sense of the amount of digital revenue you expect for full year '06 and what you might see in '07? Maybe as an alternative, what percentage of revenue in each of those two years you think all these initiatives might add up to? Fred, I'm curious based on your DVD commentary, what was the DVD revenue year-to-year change when looking at net this year and net last year in 2Q and maybe year-to-date? Do the new terms of the London Underground contract deliver lower EBITDA at the beginning of the contract that then you earn out in the later years? Thanks."
},
{
"speaker": "Leslie Moonves",
"text": "Doug, I'm going to be evasive. All I can tell you is the revenue from the new media stuff is growing a great deal. It's going to grow more than 100% in '06 from '05. We expect that kind of growth even more significant in '07. In terms of giving a specific number, it is very hard because these initiatives are coming in every single day. It will be in the hundreds of millions of dollars though. Sports Line clearly is our number one area for that and that is growing in leaps and bounds and so there is a lot that is out there, rather difficult to quantify right now but it is all very exciting."
},
{
"speaker": "Fred Reynolds",
"text": "Doug, this is Fred. On the DVD, if I understand your question, year-to-date last year we had about $100 million more in DVDs revenues than we have this year. So if you're looking at our year-to-date revenue numbers, last year was benefited. Again I went to emphasize zero, zero impact on profits. It's just a matter of gross versus net. The profits are the same, our gross margin whatever you want to call it, but the fact that we don't record it gross but we record it net is the only difference. But last year benefited. So if you are looking at the health of our revenue growth, last year had $100 million because we self distributed versus third party this year."
},
{
"speaker": "Doug Mitchelson - Deutsche Bank",
"text": "So net to net is flat then?"
},
{
"speaker": "Fred Reynolds",
"text": "Pretty much, yes. It is down slightly but it's not significant and we expect to make that up in the second half of the year. The profits should be stronger in the second half or gross margins stronger in the second half on DVD sales than last year. The change in OIBDA is negligible year-to-year. On the London Underground, we do start off with a lower margin than we end it with a caveat; we also have more inventory. So if you just looked at the same inventory or same boards year-to-year, we'd probably have a lower margin. We have more inventory that we're going to be granted. So if we can make more revenue off of that our margins should be equal to. But we are not saying that's in the cards yet. Certainly we have more inventory and it's for us to get more value for."
},
{
"speaker": "Doug Mitchelson - Deutsche Bank",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Our next question comes from Anthony DiClemente - Lehman Brothers."
},
{
"speaker": "Anthony DiClemente - Lehman Brothers",
"text": "Hi, thanks for taking the questions. I have two quick questions for Fred. For the leverage ratio, if you layer in your pension liabilities, isn't the leverage ratio as of the end of the 2Q closer to 2.0 times? Do you have a target long-term leverage ratio that you can share with us? Second question is if I look at your recurring free cash flow through the first half, that's excluding the one-time tax benefit, you're at about an even $1 billion and we're only halfway through the year. Most of the analysts are looking for $1.3 billion of free cash for the full year. So that would imply a dramatic use of working capital in the second half. Does that sound plausible or are all of our free cash flow numbers just too low? Thanks."
},
{
"speaker": "Fred Reynolds",
"text": "Okay, thanks, Anthony. On the leverage ratio, I think the way we look at it is the way the rating agencies do. So they tax affect our non-interest-bearing obligations which would be pension and retiree medical and so they tax affect that because on the balance sheet it is pre-tax. So it would be around a 2. As you know, I look at our dividend as a fixed cost or a fixed commitment. So I sort of layer that in. But let me be clear, we are very, very comfortable with our leverage ratio. Again, I think we would certainly be comfortable in the 2.5 range if it was used to acquire something that would grow our businesses faster. As I mentioned at the outset, we see paying down debt as not a priority because we think our debt is terrific where it is. On free cash flow, as you know, the first half of the year in our businesses is where we do produce a lot of free cash flow, the first and second quarters. Because largely we're not in production out in Hollywood. Starting this month or the end of this month, we start really upping production for all the fall series and we have the NFL contracts and NCAA contracts. It has never been and it won't be linear this year, that each quarter you can multiply by four. So we are on the same cycle we always are. Cash flow will not be as strong in the third quarter which it typically isn't as it is in the first half. We don't forecast the full year free cash flow for you but obviously we are very pleased where we are and the businesses throw off a lot of cash."
},
{
"speaker": "Anthony DiClemente - Lehman Brothers",
"text": "Okay, thank you Fred."
},
{
"speaker": "Operator",
"text": "Our next question comes from Kathy Styponias - Prudential."
},
{
"speaker": "Kathy Styponias - Prudential",
"text": "Thanks. A couple of questions for you, Les. With respect to Showtime and your movie strategy, to the extent that you mentioned that some of your output deals are coming up for renewal in 18 months, to what degree is the movie strategy looking to replace some of the content that you might lose? Would making five to six movies on your own be enough to kind of continue to sustain Showtime because I imagine the deals that are coming up for expiration provide you with a lot more movies than that? If you're going to make it up on original programming, aren't Showtime's costs going to up? The second question is, could you discuss the programming costs for the CBS Network in light of the fact that you only have four shows to promote in the fall? What kind of growth rates should we expect at the network level for the 06/07 season? Thanks."
},
{
"speaker": "Leslie Moonves",
"text": "Regarding Showtime, you are absolutely right, six movies will not be enough. That is not to say that we're going to preclude from doing other deals. I think right now the cable networks have an advantage in that they don't have to do the large output deals that they have done in the past whereby you have to buy every single movie from the studio. So there is lots of cash that is paid to the studios for these output deals. Obviously we will be making some deals in the future. But if we think the deals will be more advantageous from Showtime than they have in the past, we still plan on doing that. In terms of original programming, right now we do intend to increase production somewhat. Probably the balance will change somewhat from renting movies from the studios and doing more original programming that we do in fact own, or in fact, license from other people. But that should not change the balance of the cost for Showtime. As a matter affect, we think it will be reduced, the cost of Showtime in the future. We think once again their profits should be going up in future years and we like how that looks. It also does give us the advantage of owning some of these movies as opposed to renting from other studios. In terms of programming costs at CBS by and large they were up rather small amounts. We have always been rather smart. Number one, we own most of the programming on our network so we've been able to control the costs that have been there. So it's impossible to predict what the growth rate will be if the network. I think we are keeping with a guidance that we've had for the year. But we've had great discipline and we've been very successful in negotiating appropriate contracts on all our programming, so that continue in the future with rather minimal growth to programming costs."
},
{
"speaker": "Kathy Styponias - Prudential",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from John Blackledge – JP Morgan."
},
{
"speaker": "John Blackledge - JP Morgan",
"text": "Thanks for taking the question. A couple of things on outdoor. If you look at the Company, outdoor should be the highest growth segment within the Company over the next several years. When you look at it, CapEx of sales of CBS Outdoor versus some of its peers CapEx sales about 4% for CBS Outdoor versus CTO at about 7%, the margin around 11% to 12%. In order to sustain a certain level of growth over time, do you need to ramp up investment at CBS Outdoor? Then if you could just outline your current digital strategy? Thank you."
},
{
"speaker": "Leslie Moonves",
"text": "Fred, why don't you talk outdoor and I'll talk about digital."
},
{
"speaker": "Fred Reynolds",
"text": "On outdoor, yes, I think it should be one of our fastest growing. I'm not sure we would see it be the fastest but I think it will be one of the fastest-growing. I think on capital you have to look at where our businesses are different. We are keen on expanding the digital platforms that we have in outdoor. We think it is a truly one of the great technological revolutions there. So we are keen on investing in it, but we're going to invest smart. We want to get a good return on it. Because we are largely a billboard business, we tend to have lower capital spending than some others that have a different mix. We don't have the street furniture business. As we got out of some of the transit contracts which had a heavier capital spend commitment as part of the contract, that is lower. But Leslie is certainly not shy about having the outdoor guys accelerate their growth. We do lots of acquisitions. They are not big. They are $2 million to $10 million, sometimes $20 million. We buy lots of boards. We want to keep buying boards particularly in North America, the United States, Canada, Mexico. But we would love to press the accelerator faster on outdoor, but it has to be a good return."
},
{
"speaker": "Leslie Moonves",
"text": "Yes, I'm assuming you meant digital strategy regarding outdoor. As a Fred said, we're picking our spots. Obviously we're increasing our digital position in cities like New York, San Francisco, Chicago. London is fairly significant but once again, we're weighing the costs of this versus what our return is. Once again, the cost of the digital boards is coming down significantly. Dealing with volume and we view it like plasma televisions where they used to cost $10,000 apiece and now they are $899. So I think that's going to be part of our strategy and costs will be down and hopefully revenues will be up significantly."
},
{
"speaker": "John Blackledge - JP Morgan",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Anthony Noto - Goldman Sachs."
},
{
"speaker": "Anthony Noto - Goldman Sachs",
"text": "Thank you very much. Fred and Les, I was wondering if you could comment on second half growth. You had mentioned you still feel comfortable with operating income growth excluding stock-based comp of mid single digits. Looking at the growth in the first half of the year and backing out Parks a year ago, it looks like it was down 2% year-to-year -- correct me if I am wrong -- which should imply you would need high single-digit to low double-digit growth in the back half of the year. Is that true? If so, could you give us a more detail on how you think you get there given the trends we've seen so far? Could you also comment on TV advertising excluding CSTV? Thanks."
},
{
"speaker": "Fred Reynolds",
"text": "Anthony, this is Fred. Let me start off. As we look at the way we have said the growth would be over '05 stripping out non-cash, non comparable items or other non-comparable items, we're probably about flat. We're not down 2% at the halfway mark here. As you know, our third and fourth quarters are a lot stronger particularly this year, with it being a political year we will have more strength. So we are confident that we will get to a guidance of mid single-digit operating income and EPS growth. Clearly we weren't going to take credit for the tax benefit we had in that and we noted that we excluded that also. At the halfway point right now, if you take out the stock-based compensation and the write down at UPN, we are about flat to where we were last year. We should be able to deliver. again barring some catastrophic situation in the economy, we should be able to be there."
},
{
"speaker": "Leslie Moonves",
"text": "Yes, and regarding TV advertising. I just want to reiterate what Fred just said. We are going to be there, we are fairly confident that our numbers for the year, our guidance for the year is right on target and we are confident that we are going to hit that. In terms of television advertising, there's a myth out there that the upfront was down. You have to remember we went from a universe of six networks to five networks. So if you exclude some of the money that was taken in by that last network, basically the numbers appear to be flat for the upfront. We're seeing also in syndication the upfront is up low single-digits but we're very pleased with the return and once again, having such great syndicated product, we're encouraged by the upfront for the syndicated shows. It was a soft second quarter in scatter. Political as I said in my earlier remarks is going to exceed budget with the exception of New York and it is heating up. We are looking forward at the station level to hitting our numbers if not exceeding them in the second half of the year."
},
{
"speaker": "Anthony Noto - Goldman Sachs",
"text": "Fred, could you give us a growth rate number for the second quarter for television without CSTV?"
},
{
"speaker": "Fred Reynolds",
"text": "On revenues?"
},
{
"speaker": "Anthony Noto - Goldman Sachs",
"text": "Yes."
},
{
"speaker": "Fred Reynolds",
"text": "Again, I think revenues would have been about flat for television segments. It is down about 2% if you take out that DVDs. If you leave the DVDs in, we're going to be fairly down. But if you take out the non-comparable, the television segment was about flat if you take out CSTV and the DVD accounting change."
},
{
"speaker": "Anthony Noto - Goldman Sachs",
"text": "Thank you."
},
{
"speaker": "Fred Reynolds",
"text": "Anthony, if you have our earnings release -- I don't know if you have the same page numbers -- you'll see were where we reconciled, page 17 shows you how '06 year-to-date is versus last year's '05 year-to-date. They are within $400,000 to $600,000 of each other year-to-date. So we are about flat."
},
{
"speaker": "Anthony Noto - Goldman Sachs",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Andrew Baker - Cathay Financial."
},
{
"speaker": "Andrew Baker - Cathay Financial",
"text": "Thank you very much. When you went through the numbers on TV, I didn't hear you go through CBS Network. I was wondering if you can tell us how the CBS Network did in Q2? And then any indication you can give how scatter pricing is doing in Q3? Thank you."
},
{
"speaker": "Fred Reynolds",
"text": "Okay, on revenue if you look at the time period sales, we were down a little bit in time period sales second quarter of '06 versus second quarter of '05 we were down about 1.5% in revenue. About three-quarters of that was because we had some very significant finales at the end of the '05, May '05 with the Raymond finale which was being priced at an ungodly amount. We also had the JAG and the Amy finales which were smaller along with the big Survivor finale. So about three-quarters of the drop we just had a significant ending of a nine-year run of Raymond and we got a lot of money for it. The other part of it was the scatter market was softer than we would have liked in the second quarter. I think certainly Leslie has said that and we've communicated that. I don't always want to say why things are up or down because probably next May we will have huge finales. But that is one reason why, or the major reason why we were down."
},
{
"speaker": "Leslie Moonves",
"text": "The good news is you know on that, yes, we didn't have the major finales, but the good news is we didn't lose any major shows this year. We go into next year with a fairly pat hand with only four new shows and that bodes very well for the stability of the CBS network as we go forward."
},
{
"speaker": "Marty Shea",
"text": "We will have time for one more question."
},
{
"speaker": "Operator",
"text": "Our next question comes from David Miller - Sanders Morris Harris."
},
{
"speaker": "David Miller - Sanders Morris Harris",
"text": "Marty, you stumped me. All of my questions have been answered. So you guys can move on and take one more question. Thanks very much for taking the question though."
},
{
"speaker": "Leslie Moonves",
"text": "Thank you, David."
},
{
"speaker": "Operator",
"text": "Our final question comes from Michael Nathanson - Sanford Bernstein."
},
{
"speaker": "Michael Nathanson - Sanford Bernstein",
"text": "Okay, thanks. I have one for Fred and then one for Les. Fred, in the past, you talked about what the revenue growth was in the Howard Stern stations. Can you tell us what that was? Was there any inventory cuts out of those stations? For Les, as a firm we try not to focus too much on the upfront, but as you say, there was low pricing this upfront as people drove volume. So historically CPM pricing has been up in the upfront, it's been strong. So why do you think low pricing occurred this year? Is this beginning of a new trend going forward?"
},
{
"speaker": "Leslie Moonves",
"text": "I will go first with the upfront question. Number one, you took out, Johnson & Johnson didn't participate in the upfront this year which was rather unusual. It was have a different strategy where they are going to buy in August and September. If there is any softening in volume, and we didn't have it by the way, that only bodes well we think for scatter pricing. As I said, our volume was up. We were able to take a significant amount of money from other networks and where different advertisers may be looking at the upfront in different ways than they had before. Once again, for the networks that are doing well, the upfront is not necessarily the best way of doing things. It is the system that we have now and we're playing by those rules. But by and large with the exception of possibly second quarter this year, scatter pricing for us has been significantly up. So we don't mind a game change and we think we're going to take a significant part of the J&J money although it may come in somewhat later."
},
{
"speaker": "Fred Reynolds",
"text": "Michael, this is Fred. On the question on the 27 stations that had the programming change. Clearly they are down significantly, as we said, for the full year, we thought they would probably be down about $50 million and you can sort of say each quarter is going to be some percentage of that. So, yes, they are pacing down significantly. The good news is, as Leslie said before, we're starting to get some traction with the Opie and Anthony show here in New York. We're seeing that as we look out to the third quarter which we only have really good visibility out through September, it's starting to pick up pace nicely each week. It is still down, but we are encouraged that it's going to come back. All it takes is a New York and a couple of markets and we should start turning that around. But it is down we said about $50 million for the year, on these 27 stations. So each quarter it would probably be down somewhere pro rata of that $50 million."
},
{
"speaker": "Michael Nathanson - Sanford Bernstein",
"text": "Okay, thanks."
},
{
"speaker": "Marty Shea",
"text": "Thank you very, very much everyone and we will continue to be around for your further questions during the day."
},
{
"speaker": "Operator",
"text": "That does conclude today's conference call. We thank you for your participation. You may disconnect at this time."
}
] | null | null |
PARA | 1 | 2,006 | 2006-04-26 16:00:00 | Executives: Marty Shea, Executive VP, Investor Relations Sumner Redstone, Executive Chairman Les Moonves, President and CEO Fred Reynolds, Executive VP and CFO
Analysts: Victor Miller, Bear Stearns Jessica Reif Cohen, Merrill Lynch Kathy Styponias, Prudential Securities Doug Mitchelson, Deutsche Bank John Blackledge, JP Morgan Michael Nathanson, Sanford Bernstein Andy Baker, Cathay Financial Anthony DeClemente. Lehman Brothers Alan Gould, Blythe Schroeder
Operator: Good day everybody and welcome to the CBS Q1 2006 Earnings Conference call. Today’s call is being recorded. At this time for opening remarks and introductions I would like to turn the call over to Executive Vice President of Investor Relations, Mr. Marty Shea, please go ahead sir.
Marty Shea, Executive VP, Investor Relations: Good morning everyone and thank you for taking time to join us for our first quarter 2006 earnings call. Joining me for today’s discussion are Sumner Redstone, our Executive Chairman, Leslie Moonves, President and CEO and Fred Reynolds, our Executive VP and CFO. Sumner will have some opening remarks and then turn the call over to Les and Fred for strategic and financial issues. We will then open up the call to questions. Let me note that statements on this conference call relating to matters which are not historical facts are considered forward looking statements, which involve risks and uncertainties that could cause actual results to differ. Risks and uncertainties are disclosed in CBS Corporation’s news releases and securities filings. A summary of CBS Corporation’s first quarter results should have been sent to al of you. If you did not receive these results, please contact Punam Desai at 975-3557 and she will get it to you. A webcast of the call, the earning release and other information related to the presentation can be found on CBS Operations corporate website at the address cbscorporation.com. Now I’ll turn the call over to Sumner.
Sumner Redstone, Executive Chairman : Thanks Marty. Good morning everyone; thank you for joining us. I couldn’t be happier with CBS’s performance since it became a stand alone company. As you see the results today, this is a company on the move. It’s clear that Les and his team are determined to grow, are demonstrating the ability to grow revenue, to grow profit and indeed to increase value per shareholders. The new CBS is completely focused on this strategy.—to maximize the strong prospects of our existing businesses while using world class content to fuel new media platforms. From its leading broadcast networks to its television production factories to its powerful TV and radio stations, CBS Corporation is leveraging its reach of popularity to capture new opportunities across the board. With a host of strategic moves already underway and our debut in 2006 with very solid first quarter results, we see excellent momentum moving toward the long term goals that we have set. The fact is we are off to a terrific start and I am truly excited about what the future holds for CBS and with that, I’ll pass it over to Les.
Les Moonves, President and CEO: Thank you very much. Good morning everyone. It is a pleasure to be here to talk about a very good quarter. As you know, this is our first full quarter of results as the new CBS Corporation. I’m pleased to report that our fundamental growth pattern is working; we are absolutely achieving the results we expected from our core businesses. From revenues to operating income to earnings per share to free cash flow, we are well positioned for long-term stable growth. The headlines are as follows: Revenues were up 4% to $3.6 billion compared with the first quarter of 2005. Free cash flow was up a very strong 12% to $585 million, strong double digit free cash flow growth off of mid- single digit revenue growth is something we’re particularly pleased with. And on a pro forma basis, diluted earnings per share came in at $.30, up 11%. As you see from these results, our core business is producing the kind of performance we expect and demand. In a few minutes, Fred Reynolds, our CFO will discuss our results in greater detail. But first I want to walk you through each of our operating units and also briefly highlight how they are using the new media opportunities to make more money off of the things they are already doing. So first let’s start with our largest segment, television. We remain the number 1 most watched television network. The top network in advertising billings, according to broadcasting and cable; and our prime time lineup was number 1 for the fourth consecutive year. Plus, we’ve just announced large scale renewals and have successfully launched both of our mid-season hits – Old Christine and the Unit. With the breadth and depth of our hit dramas, comedies and reality shows, we have unparalleled strength across the board with successful shows every night of the week. And our hit shows are also quite young in their lifecycles. In fact, we expect with strong development this year that the CBS Television Network will extend its lead. Plus, our revenue growth for the first quarter was achieved in spite of the tough competition from the Olympics. While many of the other networks aired original programming, we saved most of our new episodes to air in the second quarter to maximize our audience and optimize revenues. And since our last earnings call in February, we took a major step forward in our news division. As I’m sure all of you know Katie Couric will become the anchor and Managing Editor of the Evening News and our newest contributor to 60 Minutes. Katie’s arrival is just further proof that CBS is the place to be for the most talented professionals out there. And, I am extremely proud to welcome her to our News Division and our Company. With Katie on board we see significant upsides to the evening news, where a single ratings point translates into tens of millions of dollars for us. Katie’s switch also changes the entire landscape of the morning news. This is a move that will boost the overall performance and profitability of the news division across the board. As always, the first quarter was a big one to CBS Sports, with the NCAA Tournament and, as I’ll tell you in a moment, this year we added an on-line component to that valuable asset that broke records. Also in the television segment, we had significant revenue growth in syndication; mostly from the second cycle sales of Frasier at CBS Paramount Television, in pay cable from higher fees and increasing subscribers at Showtime, and in the television stations group which also had a terrific quarter. As we’ve said before, success in local television tends to trail success with the network. Our very profitable stations are starting to pull ahead and they’ll benefit from a great deal of political advertising later in the year with a number of key competitive races about to unfold throughout the Country. Radio, turning to radio. Our toughest story. We’re clearly not yet achieving the level of growth we look for, but these are extremely valuable assets which we believe will again become a significant contributor to our growth profile very soon. We’re already on our way with changes in programming and we continue to strategically invest in that programming and we’re pleased with the early signs. For instance, the new Jacked and Spanish formats have shown success in many major markets and this week’s return of Opie and Anthony is a good example of the flexibility of the radio business. We made a quick mid course change and brought in proven talent who we believe should greatly improve the revenue and profit performance of our nation’s largest east coast markets. These guys were number 1 in their day part when they were last on our air in 2002, and we look forward to the new excitement they will bring to the morning beginning with their first broadcast with us, which happened today. We are also looking at seriously adjusting our portfolio. We’re in more than 40 markets and will continue to focus on those that are large and fast growing. Where these criteria aren’t met, we will consider selling some stations if it makes sense. The process has begun and is on going. We’re encouraged by the very strong exit values that radio stations have realized recently. Turning around radio and making it the revenue and profit contributor that it can be, is one of our top priorities. In Outdoor we have a really terrific story. OIBDA surged 43%, and operating income, nearly tripled. The stellar performance was due largely from double digit top line growth in North America and to our decision to exit low margin transit contracts toward the end of the year. And the Hispanic market has also been booming for us. We’ve been growing this key demographic at a pace of 100% per year for the past three years in the US. We continue to lock in attractive deals such as the New York City subway contract. Plus we are evaluating several tuck-in acquisition opportunities in the US, Europe, China and in Mexico. And as we’ve said, digital technology offers great potential for what is already our fastest growing segment. Digital technology brings lower operating costs at significant upside to advertising revenue. We expect to see a great deal more from this business in the future. Last but not least, our Parks and Publishing Division had a great quarter. Parks is off to an excellent start with strong attendance this year. As you know, we plan to sell the Parks business and you can expect an announcement on that in the second half of 2006. Our Publishing segment also did very well in the strength of first quarter titles including, Two Little Girls in Blue by Mary Higgins Clarke, and Cell by Stephen King. Simon & Schuster is extremely active in the growing business of downloading its content and we believe that here as elsewhere in our company digital distribution holds great promise for all of our divisions. This brings us to the new media announcements we made over the quarter that highlight our strategy of getting new revenue streams from already existing content. For instance, this was our 25th year broadcasting the NCAA Men’s Basketball Tournament. And, this spring we offered internet streaming of out-of-market-games. With over 19 million screens served, it was the biggest live sporting event in the history of the internet. Ratings for the simultaneous broadcast games weren’t affected; so, all of the web hits were incremental as was the revenue produced. That business is clearly on the rise. The revenue was considerable and we will clearly increase greatly every year for the future years of the tournament. We’ve also made advances in our effort to get paid for our programming by content distributors. Last month we announced a pure retransmission consent agreement with Verizon. With each subscriber that Verizon’s fiber optic TV ads, CBS will directly benefit. The days of retransmission consent for broadcast networks are here. And last month we announced a partnership with Yahoo to bring 60 Minutes video content and robust news packages to Yahoo’s media properties. Downloads of our shows, our entertainment shows from numerous platforms including, Google, iTunes, Comcast on demand and our own CBS.com continue to grow. We look forward to what the future holds. With every new distribution outlet comes a new way to generate revenues. Also the Verizon V Cast deal which lets V Cast subscribers view CBS content on their cell phones will bring in some $3 million in incremental revenue through subscription dollars this year alone. $3 million, that’s genuine growth in what will be a real business for us going forward. And it all goes directly to the bottom line. I think you can see that our ability to monetize content in new ways is rapidly increasing and there will be many, many more of these opportunities for us in the future. In conclusion, it’s been a terrific start for us these past few months. This is just the first quarter of our new company and we’re right on track. Looking forward, I’m confident with the guidance we have given in our business outlook for the full year. We continue to produce lots of cash. We believe there are no better businesses we can invest in today than our own. We investing in our businesses and returning capital to our shareholders are the best uses of our free cash flow going forward. Plus our strong balance sheet and the upcoming sale of our Parks Division will give the opportunity to review a possible dividend increase and other ways to return capital to shareholders in 2006 and beyond. In three months of our new company we’ve delivered on all of our major promises to our investors. We said we’d raise the dividend and we did. We said we’d get paid for retransmission of our content, and we are, with more to come in the future. We said we’d stay on top at our TV network and we are. We said we’d get paid in many different ways on new platforms and we did. We said we would grow revenues and we did that too. When we say we’re going to do something, we do it. You can count on us to keep our commitment to be the best at all of our businesses and to translate our success into shareholder value over the long term. It’s been a terrific quarter, we’re very proud of that and with that I will now turn it over to our CFO, Fred Reynolds.
Fred Reynolds, Executive VP and CFO: Thank you Leslie and good morning. What I’d like to do this morning is briefly take you through the highlights of our first quarter 2006 performance. So let’s start with revenues. As Leslie mentions we’re up 4% to $3.6 billion over the first quarter of 2005, led by 5% growth at the Television segment and 5.4% growth at Outdoor. Our operating profit before depreciation and amortization or OIBDA was $634 million, up 1.1% over the first quarter of 2005. Now, included in our results for the first quarter 2006 was $8.5 million of stock option expense. On a pro forma basis, assuming that the separation had occurred as of January 1, 2005 and excluding the $8.5 million of stock option expense (OIBDA) in the first quarter 2006 would have increased by approximately 4% over the first quarter of 2005. On an as reported basis, operating income was $511 million, up 1%. Now again, on a pro forma basis, and excluding stock option expense, operating income would have increased by 4%. So let’s move down to P&O. You will note that other items net is down significantly by $42 million from the first quarter of 2005. In last year’s first quarter we recognized the significant net gain of $38 million pre-tax or about $.028 a share after tax primarily from the sale of our interest in Market Watch. Interest expense, was $144 million for the quarter and it’s down from $175 million in the first quarter a year ago. This drop in interest expense reflects our lower debt as a result of the $5.4 billion year end dividend we received at the time of separation. Also during the quarter we retired $52 million of our 7.7% coupon bonds which were due in 2010 which resulted in an early extinguishment loss of $4 million. Our tax rate for the first quarter of 2006 was 40.8%, slightly below the tax rate from the year ago. The reduction in tax rate is a result of numerous initiatives that we have taken at the state and local level. Our tax rate was dropped from over 42% in 2005. Based on these and other initiatives at the state and local level, we currently project our tax rate for 2006 to be at or slightly below 41%. Earnings per share on a fully diluted basis was $.30 for the first quarter of 2006, up 7.6% on an as reported basis. Now on a pro forma basis, and again excluding stock option expense, earnings per share would have been up 11% over the first quarter a year ago As Leslie mentioned, free cash flow for the first quarter totaled $585 million, up approximately 12% over the first quarter of 2005. Included in free cash flow was the pre funding of $50 million which we contributed to our qualified pension plans. Adding back this $50 million which is a discretionary, a discretionary use of free cash flow, free cash flow for the first quarter 2006 would have increased by over 20% from year ago. This is driven by strong accounts receivable collections, lower cash interest, lower cash taxes and a modest increase in capital spending. Our capital spending was up $4 million over the first quarter 2005 to $62 million in the first quarter of this year. So, strong cash into receivable, lower interest cost, lower cash taxes and a modest increase in CapEx drove our strong free cash flow performance. On a per share basis, our first quarter’s free cash flow was $.76 per share. Now if you add that $50 million which was the discretionary use of cash to put into the pension plan, that $.76 would have risen to $.83 and this compares to $.64 a share in the first quarter of 05. Let’s briefly turn to the business segments. Our television segment revenues of $2.5 billion were up 5% over the first quarter a year ago. CBS Paramount lead the way with growth of revenues over 20% and as Leslie mentioned driven by the syndication of the second cycle of Frasier in this first quarter. TV station revenues were up 2.5% over last year’s first quarter lead by good growth in our top market. Operating profit before depreciation amortization was $424 million, up 3% over the first quarter a year ago. Again, excluding stock option expense our first quarter 2006 operating profits before depreciation amortization would have bee up 4%. Radio’s revenue for the first quarter was $434 million down 6% from last year. As you know, 27 or our 179 radio stations had a significant change in programming with the loss of the Howard Stern Show. The 152 stations not experiencing a change in programming fared significantly better from a revenue standpoint with sales declining 1.5% from year ago. Radio’s operating profit before depreciation amortization was $171 million, down 14% from the first quarter 05. And as Leslie mentioned, Outdoor had a terrific quarter. Just a terrific quarter with revenues up 5.4%, but that masks really the strength of outdoor. North America’s revenues were up over 10% lead by double digit growth in revenues in the US billboard business. Europe’s revenues in dollar terms were down 3.8%. However, revenues in Europe in local currency were up 5%. Outdoors’ operating profit before depreciation amortization was $99 million, up 43% over the first quarter of 05. This terrific performance driven by higher revenue particularly the United States and the rest of North America and as Leslie mentioned, the absence of unprofitable contracts which had been entered into in prior years. Next is corporate expenses for the first quarter. Total $28 million on a pro forma basis, excluding stock option expense, corporate expense for the first quarter 2006 increased by just $700,000 for the first quarter of last year. We expect corporate expense to be relatively flat on a pro forma basis and again, excluding stock option expense for the full year 2006 compared to 2005. Residual costs which consists primarily of pension and retiree medical expenses are related to our divested business, was $35 million for the first quarter, up from $30 million in the first quarter last year. This increase in costs related primarily to our pension expense as we updated our mortality assumption. The increase in pension expense was somewhat offset by lower retiree medical expenses as we are benefiting from lower prescription and drug costs due to the Medicare Part D subsidy. And finally, during the first quarter as you know, we increased our dividend from $.14 a share per quarter to $.16 a share per quarter, a 14% increase. So to wrap up. As Leslie and Sumner just mentioned, we’re off to a very, very good start to 2006. Thank you for taking the time and with that we’ll now open the telephone lines for your questions. Operator.
Operator: Thank you Mr. Reynolds. The question and answer session will be conducted electronically. If you would like to ask a question, you may do so by pressing the star key followed by the digit 1 on your telephone. Keep in mind that if you are using a speaker phone, to depress your mute function to allow your signal to reach our equipment. Again, that’s star 1 if you have a question or comment. We’ll pause for just a moment to assemble the queue. Our first question will come from Victor Miller with Bear Stearns.
Victor Miller : Good morning, thanks for taking the call. What I’m struck by the significant decrease in debt since you’re on almost $429 million, as you look to predict net debt by the end of the year 06, could you update us on the Viacom special dividend, what you expect in the net proceeds of Parks, what kind of proceeds you like to do ultimately in radio? Could you be levered at under 1.25 times by year end? If that’s the case, how would you look at prioritizing share repurchase dividends and pension? And then last of course, with three weeks away, the up front, could you tell us what you expect from CBS and CW?
Fred Reynolds: Well Victor, let me take the first part. Yes, as you know we’ve ended 05 in better shape from a debt standpoint and we added to that in the first quarter of 06. We have no desire to have our leverage fall below where it is now. So as Leslie alluded to and we are considering certainly as we monetize the Parks business, and no Victor, I’m not going to give you the value of what we think we’ll get our Park. I can tell you though, we have an extremely interested group of bidder, and numerous people have been through. We expect to again know in the next 6 weeks or 8 weeks we’ll have a good idea where we are on Parks, but everything we see is very encouraging. And it couldn’t be better than they’re off to just a terrific start. Attendance is up, per caps are up at the Parks, so everything is one the right wave there. You can kind of expect as Leslie said we’re going to look at raising dividend at some point this year. We’d like to wait to the second half, third quarter. And my guess is as Leslie said, our best investment is our own businesses, but you know our businesses don’t use a lot of capital, so we would probably look at one of the options that we all are focusing on, is shrinking some of the equity base, which would be a share buy back. We’re not committed to it yet; give us a little more time. Let’s get the Parks monetized, let’s get through the second quarter and I think we can certainly if we can stay on the track we’re on, I think we’ll all be pleased with the recommendations we’ll come up with.
Les Moonves: Victor, on the question regarding the up front, in about 3 weeks when the up front comes, we’re very excited about it. I think network television has had an extraordinary year across the board. I think three out of four of the major networks have done exceedingly well. And, as you know we’ve renewed a great deal of our programming. We have very strong development. The bar is going to be set extremely high for CBS. Scatter is proving to be exceedingly good in second quarter and post Olympics we’re just sailing into the up front. We’re very bullish about it. Regarding CW, once again, the marketplace has now gone from 6 networks to 5. When you add the programming from the two networks together, once again we had an extremely solid schedule there. We’re reorganizing. Our team is in place. We’ve gotten the best of development from UPN and from the WB and once again the bar’s going to be very high there. We expect to have distribution in over 90% of the Country by the time the up front comes, which will be stronger than the distribution of either UPN or CW so we expect CPM’s to be up there as well and as I mentioned before, we expect the CW to be profitable from day 1, which not only helps us in owning half the network but also 11 of it’s TV stations for us to become much stronger. So, we’re looking forward with a great deal of excitement to be up front.
Victor Miller: Thank you.
Operator: Our next question will come from Jessica Reif Cohen with Merrill Lynch
Jessica Reif Cohen: Hi, two questions. With the announcement that you made on radio, could you talk about the number of markets you ultimately expect to be in and how soon you would expect a sale to occur? And then, on the potential for acquisitions, you guys continually get mentioned as a potential bidder for Univision, so could you just elaborate on your current views on something like that?
Fred Reynolds: In terms of radio, Jessica, as you know we are a big market company primarily. So, without giving specific numbers, we want to stay in the bigger markets and some of the smaller markets that are fast to grow we’re going to do that. We’re already exploring a number of radio stations at this point in time in the smaller non-rapidly growing markets. You know we’re already getting some interest. We were very pleased with what ABC radio was able to sell their stations for, so without quantifying a number, we’re being quite aggressive about it. Regarding Univision. Univision is a wonderful company. As you know there are major, major FCC obstacles for us. We’re very happy with the hand we’re playing now. We’re not looking for an acquisition of that size.
Jessica Reif Cohen: Thank you.
Operator: Our next question goes to Kathy Styponias, Prudential Securities.
Kathy Styponias: Hi. Thank you. I have two questions as well. Les, first can you talk about how much you’re currently earning in revenues from new platforms and where you expect that to be over the next three to five year? And then the second question is for Fred. Fred your free cash flow growth in the quarter was very impressive, when you talked about free cash flow for the year for 2006, you’ve alluded to the fact that it should be lower for various reasons than 2005, but looking at what you’ve done with the tax rate, could you articulate, could you give us an update on that, whether or not that might prove to be conservative and to the extent that you can tell us how we should expect, whether we should expect more pre-funding on your pension costs. Thanks.
Les Moonves: Kathy, regarding new media it’s sort of a tough question. As I mentioned, where this year alone the V Cast was rising and we’re going to make over $3 million. We took in north of $4 million in revenue from the NCAA basketball tournament on the webcast as well. The downloads -- we’re still gathering information on that. These experiments just began in January. They’re really brand new, but each month is growing in leaps and bounds. Our news site is up about 300%. Now, granted, the base is rather low, but as years go by we expect to shortly be in the 10’s of millions of dollars and that’s really as specific as I can get right now, but every month they’re growing and we are very excited about what’s happening out there. Fred
Fred Reynolds: Les, I’d just add on the new media, Kathy is we have a pretty big base with something called Sportslink, it’s doing really well and growing very rapidly as it’s now integrated for the first time this year because we got it last year at one point in the year. So, that is growing very quickly in and of itself. Now whether you count that as new media? We sort of do, because it’s internet and it’s doing great. On your point on the free cash flow. We’re very pleased with the first quarter and as you can tell, the first quarter is always very strong for us. It was strong last year. We obviously did better this year because we had higher revenues, higher profits and a lower tax rate. As I was trying to say in my comments, I expected tax rates to be lower than what we had guided to before. I think we guided to a 42% tax revision and we feel pretty good at 41%, maybe a tick below that slightly, but I would count on 41%. So that would be a driver for increasing the free cash flow for the full year. On the pension pre funding, again, I think conservatively, we put that in free cash flow. I think that economically, it’s a discretionary decision. We’ll only do it if it gives us a great return. We believe it’s a 13% internal rate of return after tax to do that. Will we do more? Likely, unless there’s something else we can do that will give us a better return. But it won’t impact the effect that we’ll have on free cash flow to do things such as raise dividends or if we decided to buy back shares at the end of this year. You know, we want to return the capital in an efficient way. We know we have a one-time event with the Parks monetization. That is not in our free cash flows as you would guess. That’s just a one-time event. My guess is that we would want to return that to shareholders the most efficient way. Whether that’s raising the dividend higher one time or share buy back – we’re still sorting that out. I guess you’re hearing from Leslie, me and Sumner, we feel really good about the year started. First quarter, very important to get off to a strong start in cash flow. Really pleased with the way our DSO’s our Day Sales are going. We managed that as you know, Kathy, every single day. We look at the cash, we drive that number down, or get the cash in as fast as we can. So, yes, we were conservative on free cash flow. I don’t think we gave specific guidance on it, but for sure you can count on tax rate being lower than what we had first communicated.
Kathy Styponias: Thank you.
Operator: Thank you. Doug Mitchelson with Deutsche Bank has our next question.
Doug Mitchelson: Thanks. Just one around pacings. It looks like CBS Network grew about 3% revenue in the first quarter. Is that right? Do you have a sense of what the impact from competing with the Olympics was during the quarter? And give us a sense of TV and radio station and TV network scatter pacings in 2Q and then, if I could just also ask, Les you talked a little bit about the up front – on the fourth quarter call you talked about a 4% up front growth being what your guys thought it might come out at. Has anything changed in your outlook there?
Les Moonves: I’ll ask the last question first, and then I’ll turn it over to Fred. Nothing has really changed. You know in the fourth quarter we talked about it this was pre CW, which I think potentially tightens inventory and I think it makes it even more valuable. In addition, I think network television as a whole, I even made mention some of the other networks with American Idol, doing what it’s doing and Lost doing what it’s doing, and CSI continuing to be very strong. I think network television has probably never been stronger. So I see nothing to change that number that I said, maybe I’m being a little conservative.
Fred Reynolds: Let me jump in on the television segment. It’s always a little confusing when you have a big syndicated show that hits in the quarter and the second cycle of Frasier, very profitable, good for us. Last year’s first quarter, we didn’t have as much revenue, but we sold a lot of product out of the library that has very, very, very high gross margins on it. Andy Griffith, G-d bless him, still produces a lot of money. The other is Beverly Hills 90210 774 whatever it was. And so those are very profitable. So it sort of hues good profits on Frasier, extremely gross profits on the others. We also had very good cost controls at the network. Again, we’re still riding the lack of the Raymond cost, the Jag cost and Judging Amy cost, so our costs at the network are actually down in programming. So we had a lot of different pieces. The stations as we said did well. Showtime did well. Across the board, the divisions within the television segment, everyone was up in the quarter, but again, we got a little bit skewed because when we have a big first run or I’m sorry, second cycle of Frasier.
Les Moonves: Regarding the Olympics. We’re very pleased with the results. Because we sort of hung low during the Olympics and had mostly repeats on. As a result, post Olympics we’ve been running almost originals across the board through the end of the year. So, our product is very, very strong and we’re seeing the benefit of a lot of good scatter market and some of the networks don’t have quite as much as we do. So we’re very pleased.
Doug Mitchelson: And then just 2 Q scatter or 2 Q pacings if you can?
Les Moonves: It’s hard to give that right now.
Fred Raymond: I would just say that like in the first quarter, right now we’re up. Our businesses are up, but it tends to build in the quarter. It did in the first quarter. We got much stronger after the Olympics. We see May and June looking a lot stronger than April, but April was still up. So we’re not going to get into specific pacings by group, but I see intensity building and of course now we’re starting to see as Leslie said in his opening remarks, the political starting to kick came much in May and June.
Les Moonves: Yes, the later you get, the more politicals coming in, we’re seeing that snowball starting to come down the hill and there’s a lot of moneys beginning to come in for May and June.
Doug Mitchelson: Thank you very much.
Operator: We’ll go next to John Blackledge with JP Morgan.
John Blackledge: Hi. Thanks for taking my question. With the current growth prospects and evaluation for pure play outdoor companies, just wondered if you’d consider selling the Outdoor business or spinning some of it off to investors as a way to tap into the inherent value that CBS may not be getting credit for at the current moment? Thanks.
Fred Reynolds: We believe we are going to get credit for it. We love the outdoor business. You can see these results are sensational. There is no intent whatsoever to sell off Outdoor. We love it. We love the business. We’re going to get paid appropriately for our stock, we know we are.
John Blackledge: Thank you.
Operator: Thank you. We’ll go next to Michael Nathanson, Sanford Bernstein
Michael Nathanson: I have three, the first two will be for Fred, the third will be for Les. Fred, on CBS I guess the question was in the quarter, what was revenue growth for the network in the quarter because as someone suggested it was 3%, I just wanted to confirm that?
Fred Reynolds: I missed the last part of your comment, sorry.
Michael Nathanson: The question was, what was the revenue growth for CBS network in the quarter?
Fred Reynolds: It was up 1%
Michael Nathanson: Okay. Secondly, last time we talked there was a guidance without options expense. I wondered, as the Board met and gave a better idea of what we can expect from options expense in the quarter?
Fred Reynolds: Michael, for the year, the Board has not met to grant the 2006 equity compensation yet. We do have a Board meeting in May. I believe Leslie you can confirm that. I think that’s when they’ll meet. But at this point we don’t have any more information than we did at the start of the year which is they have not been granted yet.
Michael Nathanson: Okay. And for Les, the Opie & Anthony move was a very bold move to try to get back some audience. Given that you’re suing Howard Stern for promoting Sirius on the air, are you concerned at all that this could benefit satellite radio by having people tune in to Opie & Anthony and then move on to satellite?
Les Moonves: No, we’re really not. They’re terrific talent. We were very happy to be able to make the deal with XM. We think it benefits us. It can benefit down, we don’t think it hurts us on iota and our ratings are going to go up considerably. So, I’m not at all concerned.
Michael Nathanson: Do you have protection that they’re not going to promote anything that you have in the contract?
Les Moonves: No. As a matter of fact, they’re allowed to mention XM on the air. We look forward to dealing with XM and they were XM property. So, you know we are fine with that.
Michael Nathanson: Okay. Thanks.
Operator: Our next question is from Andy Baker with Cathay Financial.
Andy Baker: Thanks a lot. A couple of questions. One on Radio, one on Outdoor. Can you talk about the improvement in Outdoor coming from trends? Was that correct that it was already started? I thought they were going to be sort of later in the second half of 06 and if so, how much of this improvement did come from that versus how much is just fundamental improvement? And secondly on Radio, do you have any sense of in the Howard Stern market, how those markets performed. In other words, how much of your loss in this market was Howard Stern related and how much was just organic market decline?
Fred Reynolds: This is Fred. If I can ask you to clarify your first part, you said something about Outdoor? Was it about the Transit contract?
Andy Baker: Yes. Are you already getting out of those transit contracts. I thought that was a second half of the year event.
Fred Reynolds: Most of them, the bad contracts are gone. There are only one or two left. We will be out of those. But the bigger ones are gone.
Andy Baker: The margin we’re looking at now for this quarter is sort of a stand alone margin going forward we should be looking at?
Fred Reynolds: Actually Andy, it should get better. Because again, while getting out of the unprofitable contracts was good, the biggest driver and I was trying to allude to that is the strength of the billboard business. It’s our highest margin segment within Outdoor and it’s growing double digit. The revenue growth is terrific and almost all flows through because our costs are very, very fixed. The Transit contracts are great, billboard growth was a more powerful driver and will continue, but to Leslie’s point those all were down to one bad contract, not bad, just not what we’d like it to be. The rest are gone.
Les Moonves: And regarding radio. Obviously we we’ve said this before, Howard was a loss, but it was very funny we were looking at who could make up for that loss. Once again we kept coming back to the guys that can do it are Opie & Anthony. This is something we’ve been working on for awhile. The fact that we were able to get them, we think that is the best solution to this problem and when you look at I mentioned, their ratings when they were on the air with us in 2002, in the afternoon (which is a far worse period of time), putting them on in the morning, without Howard there, you know we think we’re going to see marked improvement. We’re very excited about it.
Andy Baker: Great. Thanks a lot. And one last question. You had mentioned earlier given the radio multiple hits in the market right now, it seems it might be attractive to someone of your slower going stations; can you quantify what multiples you’ve seen in the market?
Les Moonves: I think the ABC, were close to14, the ABC station sale just a few months ago were about 14 times, so that’s pretty attractive.
Andy Baker: Thanks a lot.
Operator: Thank you. Lehman Brothers with Anthony DeClemente has our next question.
Anthony DeClemente: Good morning. Thanks for taking my question. A couple for Fred. First off, on the Frasier syndication sales, can you give us the dollar amount of that? And then, did you receive the cash for that in the 1Q or just book it on the P&L? Secondly, can you give us I think Victor had asked this question earlier, an update on the adjustment on the special dividend that was mentioned in the K the $460 million, Fred can you just let us know what’s the timing and resolution of that and your expectation of at least what portion of that can come through, and finally, Do you expect free cash flow to grow in the 2Q. Thanks.
Fred Reynolds: Anthony, on the Frasier sale, I don’t think I will. We sold it to Lifetime and I’m not sure whether we have any confidentially agreement. We got a very good value per episode of Frasier and no we didn’t monetize it yet through our securitization program. So it did grow our receivables both current and non current receivables which again, is one more reason why I’m really pleased with our receivables. Our trade receivables actually went down so it didn’t cause much of a blip. So we didn’t monetize that. We will get that cash in over the next window which I think is 36 months. On the special dividends, I really don’t have much of an update from where we last were. I think as of Friday of this week or maybe Monday, I just don’t recall, is the date that we will get the response back from new Viacom and again, we believe nothing has come to light in our review of the submission that we made that would change our point of view. So I have nothing new. Again, hopefully in the next couple of weeks we will be able to understand more if there are any issues and I don’t know if there will be any issues. So on that, I guess it’s going to be a second quarter to maybe early third quarter before the mechanics of it get resolved. We are owed a response. I believe it’s on Friday of this week to what we submitted. On free cash flow growing in the second quarter, I’ll give you my standard response – we don’t forecast free cash flow by quarter.
Anthony DeClemente: I knew that was coming.
Fred Reynolds: I know you appreciate it. You like the consistency.
Operator: Thank you. We’ll go next to Alan Gould with Blythe Schroeder.
Alan Gould: Thank you. Most of my questions have been answered but are there any more major syndication availabilities coming up this year?
Les Moonves: We’re discussing Numbers becomes available, Medium becomes available and you know there’s a lot of activity going on. There are new cycles of Raymond that we will be sharing in and we’re sharing in King of Queens, which is out there right now; so there are a number of shows. What we are clearly doing now that we’re in control of the majority, this amount of product is to eliminate the rollercoaster effect from syndication sales. So, we’re going to be very strong.
Fred Reynolds: I’d just add Leslie, we have Star Trek Voyager, second cycle and we will have the first cable cycle for CSI Miami, so those will happen probably fourth quarter, maybe we’ll pull them into third, but I don’t think it will happen in the second. So, those will be the big ones in addition to going to library products too, but it will be second cycle of Star Trek Voyager and first run on cable for Miami – CSI Miami.
Alan Gould: Thank you.
Marty Shea: A last question, please.
Operator: That will come from Tuma Ahmaby with Standard & Poors Equity Group
Tuma Ahmaby: Thank you very much for taking the question. I’ve got a couple. The first one is, on the CW, my understanding is that right now you have approximately mid 80’s percentage of reach with affiliate signage and
Fred Reynolds: We’re at 85 right now and before the up front which will be in about 3 weeks, I expect to be in the low 90’s.
Tuma Ahmaby: Now, Les, of that percentage how many are currently signed up to pay reverse compensation as you would call them programming fees? And that’s question number 1. And question number 2 is what kind of new media rights are you signing up with these agreements? Do these agreements can come past the rights to new media with the affiliates, and another question is to clarify that the 10’s of millions of dollars from the upside potential for new media rights, does that include radio, radio you know the things that you’re doing, pod casting, on-line stream and so on? And finally, on the up front, if you could comment on your possible change in strategy this year given ABC’s lead off last year. It seemed like kind of capped the CPM group there. Are you going to be more aggressive this year and how do you see the new DVR ratings from Neilsen factoring into your negotiations?
Les Moonves: Tuma, you just asked 17 questions. If you have to ask 17 questions, I’ll try to do them briefly. The CW there are stations that are paying reverse comp. I’m not allowed nor will I get into which ones specifically, but there is reverse comp being paid to the network. New media rights, yes they are being encompassed in all of our new deals and with our affiliates that they are part of it. It’s an on-going conversation with our affiliates both on the CBS side and the CW side. We are very satisfied with how that’s going. And everybody is going to share and everybody is gong to be happy. The 10’s of millions of dollars is just a number I threw out there. And no, it didn’t include anything for radio or their pod casting numbers which are unquantifiable at this time. And the up front strategy, our strategy has always been the same. If you say more aggressive, those of you who know me, think it’s impossible for me to be more aggressive. You know we’re expecting a very good up front as is ABC as is Fox as is the CW. I think it’s going to be a very strong year. ABC has had a lot of hits. We are strong throughout the week. Every night we have hits. The advertising community is very pleased with our performance. They’re buying scatter, they’re going to buy at the up front. So I think that covered your 17 questions in 17 seconds.
Tuma Ahmaby: Thank you very much
Marty Shea: Thank you and everyone, thank you. Deborah and I will be around for more questions. Again, thank you very much.
Operator: Thank you that does conclude our call today. We would like to thank everybody for their participation, have a great day.
| [
{
"speaker": "Executives",
"text": "Marty Shea, Executive VP, Investor Relations Sumner Redstone, Executive Chairman Les Moonves, President and CEO Fred Reynolds, Executive VP and CFO"
},
{
"speaker": "Analysts",
"text": "Victor Miller, Bear Stearns Jessica Reif Cohen, Merrill Lynch Kathy Styponias, Prudential Securities Doug Mitchelson, Deutsche Bank John Blackledge, JP Morgan Michael Nathanson, Sanford Bernstein Andy Baker, Cathay Financial Anthony DeClemente. Lehman Brothers Alan Gould, Blythe Schroeder"
},
{
"speaker": "Operator",
"text": "Good day everybody and welcome to the CBS Q1 2006 Earnings Conference call. Today’s call is being recorded. At this time for opening remarks and introductions I would like to turn the call over to Executive Vice President of Investor Relations, Mr. Marty Shea, please go ahead sir."
},
{
"speaker": "Marty Shea, Executive VP, Investor Relations",
"text": "Good morning everyone and thank you for taking time to join us for our first quarter 2006 earnings call. Joining me for today’s discussion are Sumner Redstone, our Executive Chairman, Leslie Moonves, President and CEO and Fred Reynolds, our Executive VP and CFO. Sumner will have some opening remarks and then turn the call over to Les and Fred for strategic and financial issues. We will then open up the call to questions. Let me note that statements on this conference call relating to matters which are not historical facts are considered forward looking statements, which involve risks and uncertainties that could cause actual results to differ. Risks and uncertainties are disclosed in CBS Corporation’s news releases and securities filings. A summary of CBS Corporation’s first quarter results should have been sent to al of you. If you did not receive these results, please contact Punam Desai at 975-3557 and she will get it to you. A webcast of the call, the earning release and other information related to the presentation can be found on CBS Operations corporate website at the address cbscorporation.com. Now I’ll turn the call over to Sumner."
},
{
"speaker": "Sumner Redstone, Executive Chairman",
"text": "Thanks Marty. Good morning everyone; thank you for joining us. I couldn’t be happier with CBS’s performance since it became a stand alone company. As you see the results today, this is a company on the move. It’s clear that Les and his team are determined to grow, are demonstrating the ability to grow revenue, to grow profit and indeed to increase value per shareholders. The new CBS is completely focused on this strategy.—to maximize the strong prospects of our existing businesses while using world class content to fuel new media platforms. From its leading broadcast networks to its television production factories to its powerful TV and radio stations, CBS Corporation is leveraging its reach of popularity to capture new opportunities across the board. With a host of strategic moves already underway and our debut in 2006 with very solid first quarter results, we see excellent momentum moving toward the long term goals that we have set. The fact is we are off to a terrific start and I am truly excited about what the future holds for CBS and with that, I’ll pass it over to Les."
},
{
"speaker": "Les Moonves, President and CEO",
"text": "Thank you very much. Good morning everyone. It is a pleasure to be here to talk about a very good quarter. As you know, this is our first full quarter of results as the new CBS Corporation. I’m pleased to report that our fundamental growth pattern is working; we are absolutely achieving the results we expected from our core businesses. From revenues to operating income to earnings per share to free cash flow, we are well positioned for long-term stable growth. The headlines are as follows: Revenues were up 4% to $3.6 billion compared with the first quarter of 2005. Free cash flow was up a very strong 12% to $585 million, strong double digit free cash flow growth off of mid- single digit revenue growth is something we’re particularly pleased with. And on a pro forma basis, diluted earnings per share came in at $.30, up 11%. As you see from these results, our core business is producing the kind of performance we expect and demand. In a few minutes, Fred Reynolds, our CFO will discuss our results in greater detail. But first I want to walk you through each of our operating units and also briefly highlight how they are using the new media opportunities to make more money off of the things they are already doing. So first let’s start with our largest segment, television. We remain the number 1 most watched television network. The top network in advertising billings, according to broadcasting and cable; and our prime time lineup was number 1 for the fourth consecutive year. Plus, we’ve just announced large scale renewals and have successfully launched both of our mid-season hits – Old Christine and the Unit. With the breadth and depth of our hit dramas, comedies and reality shows, we have unparalleled strength across the board with successful shows every night of the week. And our hit shows are also quite young in their lifecycles. In fact, we expect with strong development this year that the CBS Television Network will extend its lead. Plus, our revenue growth for the first quarter was achieved in spite of the tough competition from the Olympics. While many of the other networks aired original programming, we saved most of our new episodes to air in the second quarter to maximize our audience and optimize revenues. And since our last earnings call in February, we took a major step forward in our news division. As I’m sure all of you know Katie Couric will become the anchor and Managing Editor of the Evening News and our newest contributor to 60 Minutes. Katie’s arrival is just further proof that CBS is the place to be for the most talented professionals out there. And, I am extremely proud to welcome her to our News Division and our Company. With Katie on board we see significant upsides to the evening news, where a single ratings point translates into tens of millions of dollars for us. Katie’s switch also changes the entire landscape of the morning news. This is a move that will boost the overall performance and profitability of the news division across the board. As always, the first quarter was a big one to CBS Sports, with the NCAA Tournament and, as I’ll tell you in a moment, this year we added an on-line component to that valuable asset that broke records. Also in the television segment, we had significant revenue growth in syndication; mostly from the second cycle sales of Frasier at CBS Paramount Television, in pay cable from higher fees and increasing subscribers at Showtime, and in the television stations group which also had a terrific quarter. As we’ve said before, success in local television tends to trail success with the network. Our very profitable stations are starting to pull ahead and they’ll benefit from a great deal of political advertising later in the year with a number of key competitive races about to unfold throughout the Country. Radio, turning to radio. Our toughest story. We’re clearly not yet achieving the level of growth we look for, but these are extremely valuable assets which we believe will again become a significant contributor to our growth profile very soon. We’re already on our way with changes in programming and we continue to strategically invest in that programming and we’re pleased with the early signs. For instance, the new Jacked and Spanish formats have shown success in many major markets and this week’s return of Opie and Anthony is a good example of the flexibility of the radio business. We made a quick mid course change and brought in proven talent who we believe should greatly improve the revenue and profit performance of our nation’s largest east coast markets. These guys were number 1 in their day part when they were last on our air in 2002, and we look forward to the new excitement they will bring to the morning beginning with their first broadcast with us, which happened today. We are also looking at seriously adjusting our portfolio. We’re in more than 40 markets and will continue to focus on those that are large and fast growing. Where these criteria aren’t met, we will consider selling some stations if it makes sense. The process has begun and is on going. We’re encouraged by the very strong exit values that radio stations have realized recently. Turning around radio and making it the revenue and profit contributor that it can be, is one of our top priorities. In Outdoor we have a really terrific story. OIBDA surged 43%, and operating income, nearly tripled. The stellar performance was due largely from double digit top line growth in North America and to our decision to exit low margin transit contracts toward the end of the year. And the Hispanic market has also been booming for us. We’ve been growing this key demographic at a pace of 100% per year for the past three years in the US. We continue to lock in attractive deals such as the New York City subway contract. Plus we are evaluating several tuck-in acquisition opportunities in the US, Europe, China and in Mexico. And as we’ve said, digital technology offers great potential for what is already our fastest growing segment. Digital technology brings lower operating costs at significant upside to advertising revenue. We expect to see a great deal more from this business in the future. Last but not least, our Parks and Publishing Division had a great quarter. Parks is off to an excellent start with strong attendance this year. As you know, we plan to sell the Parks business and you can expect an announcement on that in the second half of 2006. Our Publishing segment also did very well in the strength of first quarter titles including, Two Little Girls in Blue by Mary Higgins Clarke, and Cell by Stephen King. Simon & Schuster is extremely active in the growing business of downloading its content and we believe that here as elsewhere in our company digital distribution holds great promise for all of our divisions. This brings us to the new media announcements we made over the quarter that highlight our strategy of getting new revenue streams from already existing content. For instance, this was our 25th year broadcasting the NCAA Men’s Basketball Tournament. And, this spring we offered internet streaming of out-of-market-games. With over 19 million screens served, it was the biggest live sporting event in the history of the internet. Ratings for the simultaneous broadcast games weren’t affected; so, all of the web hits were incremental as was the revenue produced. That business is clearly on the rise. The revenue was considerable and we will clearly increase greatly every year for the future years of the tournament. We’ve also made advances in our effort to get paid for our programming by content distributors. Last month we announced a pure retransmission consent agreement with Verizon. With each subscriber that Verizon’s fiber optic TV ads, CBS will directly benefit. The days of retransmission consent for broadcast networks are here. And last month we announced a partnership with Yahoo to bring 60 Minutes video content and robust news packages to Yahoo’s media properties. Downloads of our shows, our entertainment shows from numerous platforms including, Google, iTunes, Comcast on demand and our own CBS.com continue to grow. We look forward to what the future holds. With every new distribution outlet comes a new way to generate revenues. Also the Verizon V Cast deal which lets V Cast subscribers view CBS content on their cell phones will bring in some $3 million in incremental revenue through subscription dollars this year alone. $3 million, that’s genuine growth in what will be a real business for us going forward. And it all goes directly to the bottom line. I think you can see that our ability to monetize content in new ways is rapidly increasing and there will be many, many more of these opportunities for us in the future. In conclusion, it’s been a terrific start for us these past few months. This is just the first quarter of our new company and we’re right on track. Looking forward, I’m confident with the guidance we have given in our business outlook for the full year. We continue to produce lots of cash. We believe there are no better businesses we can invest in today than our own. We investing in our businesses and returning capital to our shareholders are the best uses of our free cash flow going forward. Plus our strong balance sheet and the upcoming sale of our Parks Division will give the opportunity to review a possible dividend increase and other ways to return capital to shareholders in 2006 and beyond. In three months of our new company we’ve delivered on all of our major promises to our investors. We said we’d raise the dividend and we did. We said we’d get paid for retransmission of our content, and we are, with more to come in the future. We said we’d stay on top at our TV network and we are. We said we’d get paid in many different ways on new platforms and we did. We said we would grow revenues and we did that too. When we say we’re going to do something, we do it. You can count on us to keep our commitment to be the best at all of our businesses and to translate our success into shareholder value over the long term. It’s been a terrific quarter, we’re very proud of that and with that I will now turn it over to our CFO, Fred Reynolds."
},
{
"speaker": "Fred Reynolds, Executive VP and CFO",
"text": "Thank you Leslie and good morning. What I’d like to do this morning is briefly take you through the highlights of our first quarter 2006 performance. So let’s start with revenues. As Leslie mentions we’re up 4% to $3.6 billion over the first quarter of 2005, led by 5% growth at the Television segment and 5.4% growth at Outdoor. Our operating profit before depreciation and amortization or OIBDA was $634 million, up 1.1% over the first quarter of 2005. Now, included in our results for the first quarter 2006 was $8.5 million of stock option expense. On a pro forma basis, assuming that the separation had occurred as of January 1, 2005 and excluding the $8.5 million of stock option expense (OIBDA) in the first quarter 2006 would have increased by approximately 4% over the first quarter of 2005. On an as reported basis, operating income was $511 million, up 1%. Now again, on a pro forma basis, and excluding stock option expense, operating income would have increased by 4%. So let’s move down to P&O. You will note that other items net is down significantly by $42 million from the first quarter of 2005. In last year’s first quarter we recognized the significant net gain of $38 million pre-tax or about $.028 a share after tax primarily from the sale of our interest in Market Watch. Interest expense, was $144 million for the quarter and it’s down from $175 million in the first quarter a year ago. This drop in interest expense reflects our lower debt as a result of the $5.4 billion year end dividend we received at the time of separation. Also during the quarter we retired $52 million of our 7.7% coupon bonds which were due in 2010 which resulted in an early extinguishment loss of $4 million. Our tax rate for the first quarter of 2006 was 40.8%, slightly below the tax rate from the year ago. The reduction in tax rate is a result of numerous initiatives that we have taken at the state and local level. Our tax rate was dropped from over 42% in 2005. Based on these and other initiatives at the state and local level, we currently project our tax rate for 2006 to be at or slightly below 41%. Earnings per share on a fully diluted basis was $.30 for the first quarter of 2006, up 7.6% on an as reported basis. Now on a pro forma basis, and again excluding stock option expense, earnings per share would have been up 11% over the first quarter a year ago As Leslie mentioned, free cash flow for the first quarter totaled $585 million, up approximately 12% over the first quarter of 2005. Included in free cash flow was the pre funding of $50 million which we contributed to our qualified pension plans. Adding back this $50 million which is a discretionary, a discretionary use of free cash flow, free cash flow for the first quarter 2006 would have increased by over 20% from year ago. This is driven by strong accounts receivable collections, lower cash interest, lower cash taxes and a modest increase in capital spending. Our capital spending was up $4 million over the first quarter 2005 to $62 million in the first quarter of this year. So, strong cash into receivable, lower interest cost, lower cash taxes and a modest increase in CapEx drove our strong free cash flow performance. On a per share basis, our first quarter’s free cash flow was $.76 per share. Now if you add that $50 million which was the discretionary use of cash to put into the pension plan, that $.76 would have risen to $.83 and this compares to $.64 a share in the first quarter of 05. Let’s briefly turn to the business segments. Our television segment revenues of $2.5 billion were up 5% over the first quarter a year ago. CBS Paramount lead the way with growth of revenues over 20% and as Leslie mentioned driven by the syndication of the second cycle of Frasier in this first quarter. TV station revenues were up 2.5% over last year’s first quarter lead by good growth in our top market. Operating profit before depreciation amortization was $424 million, up 3% over the first quarter a year ago. Again, excluding stock option expense our first quarter 2006 operating profits before depreciation amortization would have bee up 4%. Radio’s revenue for the first quarter was $434 million down 6% from last year. As you know, 27 or our 179 radio stations had a significant change in programming with the loss of the Howard Stern Show. The 152 stations not experiencing a change in programming fared significantly better from a revenue standpoint with sales declining 1.5% from year ago. Radio’s operating profit before depreciation amortization was $171 million, down 14% from the first quarter 05. And as Leslie mentioned, Outdoor had a terrific quarter. Just a terrific quarter with revenues up 5.4%, but that masks really the strength of outdoor. North America’s revenues were up over 10% lead by double digit growth in revenues in the US billboard business. Europe’s revenues in dollar terms were down 3.8%. However, revenues in Europe in local currency were up 5%. Outdoors’ operating profit before depreciation amortization was $99 million, up 43% over the first quarter of 05. This terrific performance driven by higher revenue particularly the United States and the rest of North America and as Leslie mentioned, the absence of unprofitable contracts which had been entered into in prior years. Next is corporate expenses for the first quarter. Total $28 million on a pro forma basis, excluding stock option expense, corporate expense for the first quarter 2006 increased by just $700,000 for the first quarter of last year. We expect corporate expense to be relatively flat on a pro forma basis and again, excluding stock option expense for the full year 2006 compared to 2005. Residual costs which consists primarily of pension and retiree medical expenses are related to our divested business, was $35 million for the first quarter, up from $30 million in the first quarter last year. This increase in costs related primarily to our pension expense as we updated our mortality assumption. The increase in pension expense was somewhat offset by lower retiree medical expenses as we are benefiting from lower prescription and drug costs due to the Medicare Part D subsidy. And finally, during the first quarter as you know, we increased our dividend from $.14 a share per quarter to $.16 a share per quarter, a 14% increase. So to wrap up. As Leslie and Sumner just mentioned, we’re off to a very, very good start to 2006. Thank you for taking the time and with that we’ll now open the telephone lines for your questions. Operator."
},
{
"speaker": "Operator",
"text": "Thank you Mr. Reynolds. The question and answer session will be conducted electronically. If you would like to ask a question, you may do so by pressing the star key followed by the digit 1 on your telephone. Keep in mind that if you are using a speaker phone, to depress your mute function to allow your signal to reach our equipment. Again, that’s star 1 if you have a question or comment. We’ll pause for just a moment to assemble the queue. Our first question will come from Victor Miller with Bear Stearns."
},
{
"speaker": "Victor Miller",
"text": "Good morning, thanks for taking the call. What I’m struck by the significant decrease in debt since you’re on almost $429 million, as you look to predict net debt by the end of the year 06, could you update us on the Viacom special dividend, what you expect in the net proceeds of Parks, what kind of proceeds you like to do ultimately in radio? Could you be levered at under 1.25 times by year end? If that’s the case, how would you look at prioritizing share repurchase dividends and pension? And then last of course, with three weeks away, the up front, could you tell us what you expect from CBS and CW?"
},
{
"speaker": "Fred Reynolds",
"text": "Well Victor, let me take the first part. Yes, as you know we’ve ended 05 in better shape from a debt standpoint and we added to that in the first quarter of 06. We have no desire to have our leverage fall below where it is now. So as Leslie alluded to and we are considering certainly as we monetize the Parks business, and no Victor, I’m not going to give you the value of what we think we’ll get our Park. I can tell you though, we have an extremely interested group of bidder, and numerous people have been through. We expect to again know in the next 6 weeks or 8 weeks we’ll have a good idea where we are on Parks, but everything we see is very encouraging. And it couldn’t be better than they’re off to just a terrific start. Attendance is up, per caps are up at the Parks, so everything is one the right wave there. You can kind of expect as Leslie said we’re going to look at raising dividend at some point this year. We’d like to wait to the second half, third quarter. And my guess is as Leslie said, our best investment is our own businesses, but you know our businesses don’t use a lot of capital, so we would probably look at one of the options that we all are focusing on, is shrinking some of the equity base, which would be a share buy back. We’re not committed to it yet; give us a little more time. Let’s get the Parks monetized, let’s get through the second quarter and I think we can certainly if we can stay on the track we’re on, I think we’ll all be pleased with the recommendations we’ll come up with."
},
{
"speaker": "Les Moonves",
"text": "Victor, on the question regarding the up front, in about 3 weeks when the up front comes, we’re very excited about it. I think network television has had an extraordinary year across the board. I think three out of four of the major networks have done exceedingly well. And, as you know we’ve renewed a great deal of our programming. We have very strong development. The bar is going to be set extremely high for CBS. Scatter is proving to be exceedingly good in second quarter and post Olympics we’re just sailing into the up front. We’re very bullish about it. Regarding CW, once again, the marketplace has now gone from 6 networks to 5. When you add the programming from the two networks together, once again we had an extremely solid schedule there. We’re reorganizing. Our team is in place. We’ve gotten the best of development from UPN and from the WB and once again the bar’s going to be very high there. We expect to have distribution in over 90% of the Country by the time the up front comes, which will be stronger than the distribution of either UPN or CW so we expect CPM’s to be up there as well and as I mentioned before, we expect the CW to be profitable from day 1, which not only helps us in owning half the network but also 11 of it’s TV stations for us to become much stronger. So, we’re looking forward with a great deal of excitement to be up front."
},
{
"speaker": "Victor Miller",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question will come from Jessica Reif Cohen with Merrill Lynch"
},
{
"speaker": "Jessica Reif Cohen",
"text": "Hi, two questions. With the announcement that you made on radio, could you talk about the number of markets you ultimately expect to be in and how soon you would expect a sale to occur? And then, on the potential for acquisitions, you guys continually get mentioned as a potential bidder for Univision, so could you just elaborate on your current views on something like that?"
},
{
"speaker": "Fred Reynolds",
"text": "In terms of radio, Jessica, as you know we are a big market company primarily. So, without giving specific numbers, we want to stay in the bigger markets and some of the smaller markets that are fast to grow we’re going to do that. We’re already exploring a number of radio stations at this point in time in the smaller non-rapidly growing markets. You know we’re already getting some interest. We were very pleased with what ABC radio was able to sell their stations for, so without quantifying a number, we’re being quite aggressive about it. Regarding Univision. Univision is a wonderful company. As you know there are major, major FCC obstacles for us. We’re very happy with the hand we’re playing now. We’re not looking for an acquisition of that size."
},
{
"speaker": "Jessica Reif Cohen",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question goes to Kathy Styponias, Prudential Securities."
},
{
"speaker": "Kathy Styponias",
"text": "Hi. Thank you. I have two questions as well. Les, first can you talk about how much you’re currently earning in revenues from new platforms and where you expect that to be over the next three to five year? And then the second question is for Fred. Fred your free cash flow growth in the quarter was very impressive, when you talked about free cash flow for the year for 2006, you’ve alluded to the fact that it should be lower for various reasons than 2005, but looking at what you’ve done with the tax rate, could you articulate, could you give us an update on that, whether or not that might prove to be conservative and to the extent that you can tell us how we should expect, whether we should expect more pre-funding on your pension costs. Thanks."
},
{
"speaker": "Les Moonves",
"text": "Kathy, regarding new media it’s sort of a tough question. As I mentioned, where this year alone the V Cast was rising and we’re going to make over $3 million. We took in north of $4 million in revenue from the NCAA basketball tournament on the webcast as well. The downloads -- we’re still gathering information on that. These experiments just began in January. They’re really brand new, but each month is growing in leaps and bounds. Our news site is up about 300%. Now, granted, the base is rather low, but as years go by we expect to shortly be in the 10’s of millions of dollars and that’s really as specific as I can get right now, but every month they’re growing and we are very excited about what’s happening out there. Fred"
},
{
"speaker": "Fred Reynolds",
"text": "Les, I’d just add on the new media, Kathy is we have a pretty big base with something called Sportslink, it’s doing really well and growing very rapidly as it’s now integrated for the first time this year because we got it last year at one point in the year. So, that is growing very quickly in and of itself. Now whether you count that as new media? We sort of do, because it’s internet and it’s doing great. On your point on the free cash flow. We’re very pleased with the first quarter and as you can tell, the first quarter is always very strong for us. It was strong last year. We obviously did better this year because we had higher revenues, higher profits and a lower tax rate. As I was trying to say in my comments, I expected tax rates to be lower than what we had guided to before. I think we guided to a 42% tax revision and we feel pretty good at 41%, maybe a tick below that slightly, but I would count on 41%. So that would be a driver for increasing the free cash flow for the full year. On the pension pre funding, again, I think conservatively, we put that in free cash flow. I think that economically, it’s a discretionary decision. We’ll only do it if it gives us a great return. We believe it’s a 13% internal rate of return after tax to do that. Will we do more? Likely, unless there’s something else we can do that will give us a better return. But it won’t impact the effect that we’ll have on free cash flow to do things such as raise dividends or if we decided to buy back shares at the end of this year. You know, we want to return the capital in an efficient way. We know we have a one-time event with the Parks monetization. That is not in our free cash flows as you would guess. That’s just a one-time event. My guess is that we would want to return that to shareholders the most efficient way. Whether that’s raising the dividend higher one time or share buy back – we’re still sorting that out. I guess you’re hearing from Leslie, me and Sumner, we feel really good about the year started. First quarter, very important to get off to a strong start in cash flow. Really pleased with the way our DSO’s our Day Sales are going. We managed that as you know, Kathy, every single day. We look at the cash, we drive that number down, or get the cash in as fast as we can. So, yes, we were conservative on free cash flow. I don’t think we gave specific guidance on it, but for sure you can count on tax rate being lower than what we had first communicated."
},
{
"speaker": "Kathy Styponias",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Doug Mitchelson with Deutsche Bank has our next question."
},
{
"speaker": "Doug Mitchelson",
"text": "Thanks. Just one around pacings. It looks like CBS Network grew about 3% revenue in the first quarter. Is that right? Do you have a sense of what the impact from competing with the Olympics was during the quarter? And give us a sense of TV and radio station and TV network scatter pacings in 2Q and then, if I could just also ask, Les you talked a little bit about the up front – on the fourth quarter call you talked about a 4% up front growth being what your guys thought it might come out at. Has anything changed in your outlook there?"
},
{
"speaker": "Les Moonves",
"text": "I’ll ask the last question first, and then I’ll turn it over to Fred. Nothing has really changed. You know in the fourth quarter we talked about it this was pre CW, which I think potentially tightens inventory and I think it makes it even more valuable. In addition, I think network television as a whole, I even made mention some of the other networks with American Idol, doing what it’s doing and Lost doing what it’s doing, and CSI continuing to be very strong. I think network television has probably never been stronger. So I see nothing to change that number that I said, maybe I’m being a little conservative."
},
{
"speaker": "Fred Reynolds",
"text": "Let me jump in on the television segment. It’s always a little confusing when you have a big syndicated show that hits in the quarter and the second cycle of Frasier, very profitable, good for us. Last year’s first quarter, we didn’t have as much revenue, but we sold a lot of product out of the library that has very, very, very high gross margins on it. Andy Griffith, G-d bless him, still produces a lot of money. The other is Beverly Hills 90210 774 whatever it was. And so those are very profitable. So it sort of hues good profits on Frasier, extremely gross profits on the others. We also had very good cost controls at the network. Again, we’re still riding the lack of the Raymond cost, the Jag cost and Judging Amy cost, so our costs at the network are actually down in programming. So we had a lot of different pieces. The stations as we said did well. Showtime did well. Across the board, the divisions within the television segment, everyone was up in the quarter, but again, we got a little bit skewed because when we have a big first run or I’m sorry, second cycle of Frasier."
},
{
"speaker": "Les Moonves",
"text": "Regarding the Olympics. We’re very pleased with the results. Because we sort of hung low during the Olympics and had mostly repeats on. As a result, post Olympics we’ve been running almost originals across the board through the end of the year. So, our product is very, very strong and we’re seeing the benefit of a lot of good scatter market and some of the networks don’t have quite as much as we do. So we’re very pleased."
},
{
"speaker": "Doug Mitchelson",
"text": "And then just 2 Q scatter or 2 Q pacings if you can?"
},
{
"speaker": "Les Moonves",
"text": "It’s hard to give that right now."
},
{
"speaker": "Fred Raymond",
"text": "I would just say that like in the first quarter, right now we’re up. Our businesses are up, but it tends to build in the quarter. It did in the first quarter. We got much stronger after the Olympics. We see May and June looking a lot stronger than April, but April was still up. So we’re not going to get into specific pacings by group, but I see intensity building and of course now we’re starting to see as Leslie said in his opening remarks, the political starting to kick came much in May and June."
},
{
"speaker": "Les Moonves",
"text": "Yes, the later you get, the more politicals coming in, we’re seeing that snowball starting to come down the hill and there’s a lot of moneys beginning to come in for May and June."
},
{
"speaker": "Doug Mitchelson",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "We’ll go next to John Blackledge with JP Morgan."
},
{
"speaker": "John Blackledge",
"text": "Hi. Thanks for taking my question. With the current growth prospects and evaluation for pure play outdoor companies, just wondered if you’d consider selling the Outdoor business or spinning some of it off to investors as a way to tap into the inherent value that CBS may not be getting credit for at the current moment? Thanks."
},
{
"speaker": "Fred Reynolds",
"text": "We believe we are going to get credit for it. We love the outdoor business. You can see these results are sensational. There is no intent whatsoever to sell off Outdoor. We love it. We love the business. We’re going to get paid appropriately for our stock, we know we are."
},
{
"speaker": "John Blackledge",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. We’ll go next to Michael Nathanson, Sanford Bernstein"
},
{
"speaker": "Michael Nathanson",
"text": "I have three, the first two will be for Fred, the third will be for Les. Fred, on CBS I guess the question was in the quarter, what was revenue growth for the network in the quarter because as someone suggested it was 3%, I just wanted to confirm that?"
},
{
"speaker": "Fred Reynolds",
"text": "I missed the last part of your comment, sorry."
},
{
"speaker": "Michael Nathanson",
"text": "The question was, what was the revenue growth for CBS network in the quarter?"
},
{
"speaker": "Fred Reynolds",
"text": "It was up 1%"
},
{
"speaker": "Michael Nathanson",
"text": "Okay. Secondly, last time we talked there was a guidance without options expense. I wondered, as the Board met and gave a better idea of what we can expect from options expense in the quarter?"
},
{
"speaker": "Fred Reynolds",
"text": "Michael, for the year, the Board has not met to grant the 2006 equity compensation yet. We do have a Board meeting in May. I believe Leslie you can confirm that. I think that’s when they’ll meet. But at this point we don’t have any more information than we did at the start of the year which is they have not been granted yet."
},
{
"speaker": "Michael Nathanson",
"text": "Okay. And for Les, the Opie & Anthony move was a very bold move to try to get back some audience. Given that you’re suing Howard Stern for promoting Sirius on the air, are you concerned at all that this could benefit satellite radio by having people tune in to Opie & Anthony and then move on to satellite?"
},
{
"speaker": "Les Moonves",
"text": "No, we’re really not. They’re terrific talent. We were very happy to be able to make the deal with XM. We think it benefits us. It can benefit down, we don’t think it hurts us on iota and our ratings are going to go up considerably. So, I’m not at all concerned."
},
{
"speaker": "Michael Nathanson",
"text": "Do you have protection that they’re not going to promote anything that you have in the contract?"
},
{
"speaker": "Les Moonves",
"text": "No. As a matter of fact, they’re allowed to mention XM on the air. We look forward to dealing with XM and they were XM property. So, you know we are fine with that."
},
{
"speaker": "Michael Nathanson",
"text": "Okay. Thanks."
},
{
"speaker": "Operator",
"text": "Our next question is from Andy Baker with Cathay Financial."
},
{
"speaker": "Andy Baker",
"text": "Thanks a lot. A couple of questions. One on Radio, one on Outdoor. Can you talk about the improvement in Outdoor coming from trends? Was that correct that it was already started? I thought they were going to be sort of later in the second half of 06 and if so, how much of this improvement did come from that versus how much is just fundamental improvement? And secondly on Radio, do you have any sense of in the Howard Stern market, how those markets performed. In other words, how much of your loss in this market was Howard Stern related and how much was just organic market decline?"
},
{
"speaker": "Fred Reynolds",
"text": "This is Fred. If I can ask you to clarify your first part, you said something about Outdoor? Was it about the Transit contract?"
},
{
"speaker": "Andy Baker",
"text": "Yes. Are you already getting out of those transit contracts. I thought that was a second half of the year event."
},
{
"speaker": "Fred Reynolds",
"text": "Most of them, the bad contracts are gone. There are only one or two left. We will be out of those. But the bigger ones are gone."
},
{
"speaker": "Andy Baker",
"text": "The margin we’re looking at now for this quarter is sort of a stand alone margin going forward we should be looking at?"
},
{
"speaker": "Fred Reynolds",
"text": "Actually Andy, it should get better. Because again, while getting out of the unprofitable contracts was good, the biggest driver and I was trying to allude to that is the strength of the billboard business. It’s our highest margin segment within Outdoor and it’s growing double digit. The revenue growth is terrific and almost all flows through because our costs are very, very fixed. The Transit contracts are great, billboard growth was a more powerful driver and will continue, but to Leslie’s point those all were down to one bad contract, not bad, just not what we’d like it to be. The rest are gone."
},
{
"speaker": "Les Moonves",
"text": "And regarding radio. Obviously we we’ve said this before, Howard was a loss, but it was very funny we were looking at who could make up for that loss. Once again we kept coming back to the guys that can do it are Opie & Anthony. This is something we’ve been working on for awhile. The fact that we were able to get them, we think that is the best solution to this problem and when you look at I mentioned, their ratings when they were on the air with us in 2002, in the afternoon (which is a far worse period of time), putting them on in the morning, without Howard there, you know we think we’re going to see marked improvement. We’re very excited about it."
},
{
"speaker": "Andy Baker",
"text": "Great. Thanks a lot. And one last question. You had mentioned earlier given the radio multiple hits in the market right now, it seems it might be attractive to someone of your slower going stations; can you quantify what multiples you’ve seen in the market?"
},
{
"speaker": "Les Moonves",
"text": "I think the ABC, were close to14, the ABC station sale just a few months ago were about 14 times, so that’s pretty attractive."
},
{
"speaker": "Andy Baker",
"text": "Thanks a lot."
},
{
"speaker": "Operator",
"text": "Thank you. Lehman Brothers with Anthony DeClemente has our next question."
},
{
"speaker": "Anthony DeClemente",
"text": "Good morning. Thanks for taking my question. A couple for Fred. First off, on the Frasier syndication sales, can you give us the dollar amount of that? And then, did you receive the cash for that in the 1Q or just book it on the P&L? Secondly, can you give us I think Victor had asked this question earlier, an update on the adjustment on the special dividend that was mentioned in the K the $460 million, Fred can you just let us know what’s the timing and resolution of that and your expectation of at least what portion of that can come through, and finally, Do you expect free cash flow to grow in the 2Q. Thanks."
},
{
"speaker": "Fred Reynolds",
"text": "Anthony, on the Frasier sale, I don’t think I will. We sold it to Lifetime and I’m not sure whether we have any confidentially agreement. We got a very good value per episode of Frasier and no we didn’t monetize it yet through our securitization program. So it did grow our receivables both current and non current receivables which again, is one more reason why I’m really pleased with our receivables. Our trade receivables actually went down so it didn’t cause much of a blip. So we didn’t monetize that. We will get that cash in over the next window which I think is 36 months. On the special dividends, I really don’t have much of an update from where we last were. I think as of Friday of this week or maybe Monday, I just don’t recall, is the date that we will get the response back from new Viacom and again, we believe nothing has come to light in our review of the submission that we made that would change our point of view. So I have nothing new. Again, hopefully in the next couple of weeks we will be able to understand more if there are any issues and I don’t know if there will be any issues. So on that, I guess it’s going to be a second quarter to maybe early third quarter before the mechanics of it get resolved. We are owed a response. I believe it’s on Friday of this week to what we submitted. On free cash flow growing in the second quarter, I’ll give you my standard response – we don’t forecast free cash flow by quarter."
},
{
"speaker": "Anthony DeClemente",
"text": "I knew that was coming."
},
{
"speaker": "Fred Reynolds",
"text": "I know you appreciate it. You like the consistency."
},
{
"speaker": "Operator",
"text": "Thank you. We’ll go next to Alan Gould with Blythe Schroeder."
},
{
"speaker": "Alan Gould",
"text": "Thank you. Most of my questions have been answered but are there any more major syndication availabilities coming up this year?"
},
{
"speaker": "Les Moonves",
"text": "We’re discussing Numbers becomes available, Medium becomes available and you know there’s a lot of activity going on. There are new cycles of Raymond that we will be sharing in and we’re sharing in King of Queens, which is out there right now; so there are a number of shows. What we are clearly doing now that we’re in control of the majority, this amount of product is to eliminate the rollercoaster effect from syndication sales. So, we’re going to be very strong."
},
{
"speaker": "Fred Reynolds",
"text": "I’d just add Leslie, we have Star Trek Voyager, second cycle and we will have the first cable cycle for CSI Miami, so those will happen probably fourth quarter, maybe we’ll pull them into third, but I don’t think it will happen in the second. So, those will be the big ones in addition to going to library products too, but it will be second cycle of Star Trek Voyager and first run on cable for Miami – CSI Miami."
},
{
"speaker": "Alan Gould",
"text": "Thank you."
},
{
"speaker": "Marty Shea",
"text": "A last question, please."
},
{
"speaker": "Operator",
"text": "That will come from Tuma Ahmaby with Standard & Poors Equity Group"
},
{
"speaker": "Tuma Ahmaby",
"text": "Thank you very much for taking the question. I’ve got a couple. The first one is, on the CW, my understanding is that right now you have approximately mid 80’s percentage of reach with affiliate signage and"
},
{
"speaker": "Fred Reynolds",
"text": "We’re at 85 right now and before the up front which will be in about 3 weeks, I expect to be in the low 90’s."
},
{
"speaker": "Tuma Ahmaby",
"text": "Now, Les, of that percentage how many are currently signed up to pay reverse compensation as you would call them programming fees? And that’s question number 1. And question number 2 is what kind of new media rights are you signing up with these agreements? Do these agreements can come past the rights to new media with the affiliates, and another question is to clarify that the 10’s of millions of dollars from the upside potential for new media rights, does that include radio, radio you know the things that you’re doing, pod casting, on-line stream and so on? And finally, on the up front, if you could comment on your possible change in strategy this year given ABC’s lead off last year. It seemed like kind of capped the CPM group there. Are you going to be more aggressive this year and how do you see the new DVR ratings from Neilsen factoring into your negotiations?"
},
{
"speaker": "Les Moonves",
"text": "Tuma, you just asked 17 questions. If you have to ask 17 questions, I’ll try to do them briefly. The CW there are stations that are paying reverse comp. I’m not allowed nor will I get into which ones specifically, but there is reverse comp being paid to the network. New media rights, yes they are being encompassed in all of our new deals and with our affiliates that they are part of it. It’s an on-going conversation with our affiliates both on the CBS side and the CW side. We are very satisfied with how that’s going. And everybody is going to share and everybody is gong to be happy. The 10’s of millions of dollars is just a number I threw out there. And no, it didn’t include anything for radio or their pod casting numbers which are unquantifiable at this time. And the up front strategy, our strategy has always been the same. If you say more aggressive, those of you who know me, think it’s impossible for me to be more aggressive. You know we’re expecting a very good up front as is ABC as is Fox as is the CW. I think it’s going to be a very strong year. ABC has had a lot of hits. We are strong throughout the week. Every night we have hits. The advertising community is very pleased with our performance. They’re buying scatter, they’re going to buy at the up front. So I think that covered your 17 questions in 17 seconds."
},
{
"speaker": "Tuma Ahmaby",
"text": "Thank you very much"
},
{
"speaker": "Marty Shea",
"text": "Thank you and everyone, thank you. Deborah and I will be around for more questions. Again, thank you very much."
},
{
"speaker": "Operator",
"text": "Thank you that does conclude our call today. We would like to thank everybody for their participation, have a great day."
}
] | null | null |
PEG | 4 | 2,006 | 2007-01-31 11:00:00 | TRANSCRIPT SPONSOR :
Executives: Kathleen Lally - VP, IR Ralph Izzo - President and COO Tom O'Flynn - CFO
Analysts: Ashar Khan - SAC Capital Paul Ridzon - Keybanc Capital Markets Andrew Levy - Frankfort Advisors Paul Patterson - Glenrock Associates Zachary Schreiber - Duquesne Capital Danielle Seitz - Dahlman Rose & Company Viswanath Khaitan - Deutsche Investment Management Clark Orsky - KDP Investment Advisors
Operator: Ladies and gentlemen, thank you for standing by. Welcome to the Public Service Enterprise Group Fourth Quarter 2006 Earnings Call and web cast. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session for members of the financial community. (Operator Instructions). As a reminder, this conference is being recorded Wednesday, January 31st, 2007 and will be available for telephone replay for 48 hours beginning at 1 pm Eastern Time today until 1 pm Eastern Time on February 2, 2007. It will also be available as audio webcast on PSEG's corporate website at www.pseg.com. I would now like to turn the conference over to Kathleen Lally. Please go ahead.
Kathleen Lally: Thank you very much, and good morning to everyone. We appreciate your listening in today either by telephone or over our website. I will be turning the call over to Ralph Izzo, PSEG's President and Chief Operating Officer for comments on the company’s results and outlook. Also participating in today's call will be Tom O'Flynn, PSEG's Chief Financial Officer. Tom will provide a more detailed view of the company's operating and financial results and the forecast for 2007. Before we begin, however, I just need to make a few points. We issued our earnings release this morning. In case you have not seen it, a copy is posted on our website. We expect to file our Form 10-K with the SEC at the end of February. In today's webcast, we will discuss our future outlook and I must refer you to our forward-looking disclaimer. Although we believe our forecasts are based on reasonable assumptions, we can give you no assurance that they will be achieved. The results or events forecast in our statements today may differ materially from actual results or events. The last word on any of our businesses is contained in the various reports we file with the SEC. As a reminder, our guidance speaks as of the date it is issued. Any confirmation or update in guidance will only be done in a public manner, generally in the form of a press release or webcast such as this. PSEG may or may not confirm or update guidance with every press release. As a matter of policy, we will not comment on guidance during any one-on-one meeting or individual phone calls. In the body of our earnings release we provided a table that reconciled net income to operating earnings. We've adopted this format to improve the readability of the release and to provide the required reconciliation between the GAAP terms “net income” and "income from continuing operations" to the non-GAAP term “operating earnings”. The attachments for the press release provide the reconciliation to each of our major businesses. Operating earnings exclude merger-related costs and the net impact of certain asset sales during the period presented. Operating earnings is our standard for comparing 2006 results to 2005 for all of our businesses. We exclude such costs so that we can better compare our current period results with prior or future periods. Finally, at the end of the prepared remarks Ralph and Tom will take your questions. I would now like to turn the call over to Ralph.
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Ralph Izzo: Thank you, Kathleen, and good morning. I too appreciate the time you've taken today in listening to our call and I hope you've been able to review the earnings release distributed this morning. I am pleased with the results we reported in that release. As you can see, our operating earnings of $3.71 a share came in at the upper end of guidance for the year. Although we spent much of the year working to complete the merger with Exelon, we kept a close eye on maintaining strong go-it-alone capabilities. As a result, we not only ended the year with operating earnings at the high end of our guidance but also with our strongest outlook in sometime. PSEG has been a successful company for over a hundred years through many changes in markets and in the industry, and we are equally upbeat about our future. Operational excellence is the foundation for success in our business and in 2006 we demonstrated excellence across the Board. This is a tribute to the hard work of our talented and dedicated employees. Our Salem and Hope Creek nuclear stations generated more electricity than in any single year prior to 2006, and the Fossil component of the PSEG Power also had its best year of electric production. Strong nuclear and fossil operations enabled us to benefit more fully from a favorable energy pricing environment and enabled PSEG Power to achieve a record level of operating earnings. PSE&G, our New Jersey energy delivery business continued to operate with best-in-class reliability. Both electric and gas operations have never been stronger. PSE&G also received an important measure of rate relief in November of 2006 that will help its long term financial picture. In addition, to providing a fair return for investors the rate relief provided the resources needed to support our ability to provide safe reliable service. PSEG Energy Holdings had its most profitable year due in large measure to outstanding performance from its two Texas generating stations. We also reduced international exposure by selling investments in Poland and Brazil in keeping with our long-term strategy for that business. I am pleased to report that the remaining assets are performing on a more predictable basis. As for the future, we have a positive earnings trajectory based on a combination of strong operations, the prices we've contracted for our anticipated energy supply, and an improving picture for energy capacity markets. Tom will provide more details on this in a moment. In addition to the results I just described, we've made progress with our most important near-term objective. I already mentioned the rate relief that we received towards the end of the year that will clearly be helpful. We've also completed the redesign of our organization and have most of the senior management team now in place. We're continuing to address staffing needs while working to preserve many of the efficiency savings achieved during the merger process. We anticipate hiring back only 60% of the staff loss during the merger review process. This is exactly the stretch goal we had set for ourselves. We have also taken steps to make sure our nuclear progress continues, as you probably know, we'll resume direct management of the Salem and Hope Creek facilities before the exploration of our nuclear operating services agreement with Exelon. The three cheerleaders managing Salem and Hope Creek are now employees of PSEG. We have great confidence in them, the stations and the future of our nuclear assets. I would be greatly [remised] however, if I did not recognize and extend out some serious thanks to John Rowe, Jack Skolds, Chris Crane, and the entire Exelon team for their co-operation and support during this process. I cannot say enough positive things about the support being provided by Exelon management during this transition. We look forward to continuing the improvements and excellence in operations that they started at our sites and with Bill Levis, Tom Joyce and George Barnes' leadership, we are confident about their future success. Over the past year, you also saw the continued reshaping of our portfolio of assets. The changes made during the year were designed to improve our returns, strength in the balance sheet and sharpen our focus on core operating areas. We remained committed to improving the balance sheet by further reducing debts and as our financial strength improves, we'll be able to pursue options for future growth. The actions taken over the past year, coupled with higher energy prices, support our forecast improvement in 2007 operating earnings, to a $4.60 to $5 per share, with growth in 2008 in excess of 10%. Power prices have declined since we made this forecast in the fall of 2006, but significant forward head ratios, the sale of Lawrenceburg and a reduction in financing costs continue to provide us with confidence in our forecast. We are in the process of developing our long run business growth strategy and we will provide you with an update on March 26, when we host the meeting for the financial community, at [Philadelphia Storey] in New York. Now Tom will review the fourth quarter and our outlook for 2007.
Tom O'Flynn: Thanks Ralph. Good morning. Let me first extend our welcome to Kathleen Lally, our new Vice President of Investor Relations. We know Kathleen from her former roles and you will be happy to know she continues to have a lot of tough questions for us and keep us on our toes. PSEG reported operating earnings for the fourth quarter of $174 million or $0.69 per share, versus $233 million or $0.94 per share for the 2005 fourth quarter. The strong results for the recent quarter overcame a charge of $0.10 per share, Power, related to impairment of turbines to be sold in 2007. And I also want to remind you that last year's results include a gain of $0.18 from the sale of the Seminole lease. The year, PSEG reported operating earnings of $938 million or $3.71 per share compared to 2005 amounts of $918 million or $3.77 per share. The results for '06 are based on 252 million shares outstanding, a 3.3% increase over 2005. PSEGs results for the quarter and the year are defined in large parts by strong performance from our generation fleet and higher power prices, offset by warmer weather. For the fourth quarter, Power reported operating earnings of $102 million or $0.40 and 11% decline in the 113 million or $0.45 from a year ago. As you know, a number of our strategic activities were reviewed in a different context during the merger process. Shortly after the termination of the merger, Power took a close at two assets in its portfolio that had uncertain long-term value for us. Namely Lawrenceburg and 4EA Turbines. Lawrenceburg is a 1100 megawatt combined cycle gas unit in Indiana that did not integrate well into our PJM eastern based portfolio. During 2006, it produced an operating loss of over $0.10 and although we anticipated improvements in the future, we believe that the unit may be worth more in the hands of another owner. Early in January, we announced the sale to American Electric Power recorded an after-tax loss of $210 million and the unit was moved to discontinued operations in the fourth quarter. With our completion of the sale, we expect to receive approximately $425 million of after-tax cash flow. As for the turbines, Power has no immediate use for these units and with the passage of time. Our evaluation is that newer technology proved be more flexible and efficient in new projects. This analysis coupled with interest by a number of potential buyers caused us to decide to monetize these assets and recognize an impairment of $44 million or $0.10 in the fourth quarter. This loss is included in our operating earnings for the quarter and the year. For the year, Power reported record operating earnings of $515 million worth $2.04 per share, an 11% improvement over '05's operating earnings of $446 million worth $1.83 per share. Power saw an improving margin during the quarter and the year as a result of higher prices for our contracted output and other market hedging activities. Given our strategy of contracting for a few years into the future, we generally experience market prices on a lag basis. Higher pricing added $0.22 to earnings for the quarter and $0.84 to the year. The continuation of strong operations via nuclear fleet also supported margins for the quarter. Nuclear units operated at a capacity factor of 96% in the fourth quarter resulting in a full year capacity factor also of 96%, which included a record refueling outage at Salem 2 of under 22 days. This performance added $0.02 per share to Power's earnings for the quarter. Earnings were improved by $0.20 per share for the full year as a result of the fleet's year-over-year improvement. Higher prices and increased output more than offset the effective higher depreciation expense in 2006. The operation of new assets and the absence of Nuclear Decommissioning Trust Fund gains of $0.05 per share recognized in last year's fourth quarter. Power's fourth quarter earnings for the BGSS were also down $0.11 versus an unusually strong fourth quarter 2005 that benefited from very high post-hurricane gas prices in normal weather. In contrast, fourth quarter '06 was hurt by warm weather and a lingering effect in the inventory costs of last year's gas price run up. This $0.11 impact during the quarter brought the full year impact to $0.22 per share lower than we saw in 2005. Looking forward to 2007, our inventory position is better balanced and with some more normal weather, we would expect the BGSS contribution to improve in 2007 by approximately $0.10 to $0.15 over 2006. Operating earnings for Power in 2007 are expected to be in the range of $770 million to $850 million. The midpoint of this range represents a $295 million increase, a greater than 50% improvement over our '06 operating earnings. The key drivers to this increase are the higher prices for our nuclear in Poland output that are realized because of the rolling nature of our forward hedge positions. The exploration of our contract with United Illuminating in Connecticut, the sale at Lawrenceburg, and our projected improvements in margins on serving the BGSS contract. In addition to the improvement in energy markets the redesign of capacity markets will also provide reasonable signals for reliability and is expected to enhance Power's margins. There were positive steps in December related to capacity design. First, the transitional period began for the forward capacity market in New England. Capacity prices in New England are approximately $3 per kilowatt [a month]. Second, the FERC approved reliability pricing model for PJM with implementation in June of 2007. Those market changes are expected to be accretive to Power and are forecasted at approximately $100 million to $115 million Power's 2007 margins. Overall, our gross margin per megawatt hour has increased from approximately $33 per megawatt hour in 2005 to approximately $38 per megawatt hour in '06 and is forecasted to expand in '07 by approximately another $10 per megawatt hour. As you recall, we are pleased to announce during the fourth quarter that we received approval to extend the in-service date of pollution control facilities at Hudson Unit 2 for four years beyond 2006 under an agreement with Federal and State Environmental Authorities. The agreement requires PSEG fossils undertaking number of plant modifications and operating changes to meet targeted reductions in the missions of NOx, SO2, particulate matter and mercury. We also need to notify the authorities by the end of 2007 when we will install the additional pollution controls the Hudson Unit 2 by the end of 2010 or plan for the early shutdown of the unit. We are in the midst of concluding detailed engineering work and updating our projection of our environmental capital cost for our 2006 Form 10-K. As many of you are aware, the markets for major environmental and construction projects are tight. We may see some increase in our current estimate of environmental capital cost of $400 million to $500 million for Hudson and $300 million to $450 million for Mercer. PSE&G, our electric and gas utility company reported operating earnings for the quarter of $64 million or $0.25 per share compared with $66 million or $0.26 per share from a year ago. The challenge with PSE&G in the quarter and for the year has been weather and extended delay in receiving rate relief. For the fourth quarter, warmer than normal weather reduced PSE&G's earnings by $0.06 per share versus prior results, and also, versus normal. For the full year, warmer than normal weather reduced PSE&G's earnings by $0.12 per share versus normal and by $0.19 per share versus 2005 reported earnings. Higher transmission revenues, reduction in operating expenses, and true up of taxes in the quarter allowed PSE&G to almost offset the negative effect of weather. For the year, PSE&G reported operating earnings of $262 million or $1.04 per share, a 27% decline over '05's operating earnings of $347 million or $1.42. Decline reflects the abnormal weather conditions and the delayed rate relief. Operating earnings for PSE&G are forecasted to improve in 2007 to $330 million to $350 million, and accordingly this range represents a 30% improvement over '06's operating results. The full year effect of the gas and electric rate agreements approved in November, coupled with more normal weather are the primary drivers behind this forecasted improvement. PSEG Energy Holdings reported earnings for the fourth quarter of $24 million or $0.10 per share compared to $72 million or $0.30 per share from the fourth quarter of '05. The quarter-over-quarter results primarily reflect the absence of $0.18 per share gain at resources from the sale of the Seminole lease and some other items as illustrated in the attachment 7. For the year, Holdings reported operating earnings of $227 million or $0.89 per share, a 10% improvement over '05's operating earnings of $196 million or $0.81 per share. These results for '06 include a mark-to market gain of $0.11 per share. Holdings 2006 earnings are noteworthy considering Global has reduced the invested capital in its portfolio by over $500 million over the past three years, as shown in attachment 9. This decrease was driven by over $900 million of sales of non-strategic international investments, and an after-tax gain of $50 million over this timeframe. As a result, over 90% of Global's portfolio consists of its investments in Chile and Peru, primarily stable distribution companies and our US generation business. The sale of assets and reduction in recourse debt by Holdings [throughout] the subsidiary, contributed $95 million to PSEG in the fourth quarter. Operating earnings for Holdings have forecasted a decline '07 to $130 million to $145 million. The largest reduction from '06 to '07 is our Texas assets. Due to a variety of factors, including the absence of '06's mark-to-market gain. A large decrease in spark spreads year-over-year and additional plant maintenance outages. We also anticipate that the implementation of the new accounting standard for uncertain tax positions, FIN-48, will reduce Holding's earnings, particularly with respect with some leases at resources. Finally, I'd like to make some comments regarding our consolidated cash flow and liquidity. In 2006, cash flow from operations was very strong, generating $1.9 billion. This represents improvement than the $925 million from last year. The improvement was largely due to reduced cash collateral postings by Power and approved receivables. [Absent] changes in working capital, cash from operations improved by $100 million year-over-year. In addition to meaningful excess cash from operations during 2006, the after-tax cash proceeds from the sale of assets and Holdings contributed more than $600 million of additional cash flow. This primarily reflects the sale of our interest in RGE and two generating facilities in Poland. In total, excess cash to pay down recourse debt was about $950 million. We have available liquidity at yearend 2006 exceeding $3 billion. In the fourth quarter, we refinanced $3.2 billion of credit facilities, (inaudible) Enterprise grew $1 billion, Power for $1.6 billion and Utility for $600 million. All three Power facilities mature in 2011. Debt reduction has materially strengthened our balance sheet, in conjunction with refinancing our credit facilities, our covenant calculations were relaxed by our lenders. Normalizing for changes to our covenant calculations, we reduced our financial leverage by about 4 percentage points during 2006. 00:17 15th file pro forma -- with the anticipated proceed from the sale of Lawrenceburg, we will have reduced our leverage to about 50%. This reduction leverage is expected to reduce operating expenses at the Holding Company level, to a range of $50 million to $60 million in '07 versus $66 million. In summary, we are pleased with our performance for 2006 and believe we are well positioned for 2007. Highlights include, as Ralph went through, earnings are expected to grow by one-third from $4.60 to $5 per share. Our capital structure is improving, operating risk has been reduced, improved operations, strong forward hedge portfolio and reduced international risk. Now Ralph and I would be pleased to take questions.
Kathleen Lally: Operator?
Operator: Ladies and Gentlemen we will now begin the question-and-answer session for members of the financial community. (Operator Instructions). And the first question is coming from the line of Ashar Khan with SAC Capital. Please proceed.
Ashar Khan - SAC Capital: Good morning. Tom, could you just go over what the hedges are? Could you update your hedge information, the last information I had was that EEI, could you update what the hedges stand currently for '07, '08 and '09?
Tom O'Flynn: Sure. Those are generally still reasonable numbers, still reasonable ranges for those folks who don't have the information there at the EEI presentation we said in '07, we are about 85% to 95% hedged, '08 was 65% to 80%, and '09 was 10% to 40%. Those are still reasonable ranges. When we talk about hedge ratios, we generally talk about our forward nuclear and coal as that represents about 85% of our megawatt hours, a higher percentage of our margin. We also would expect to update those in the K to the extent there is any material changes.
Ashar Khan - SAC Capital: Okay. I guess this PJM auction will move those hedges upwards, is that a fair assumption?
Tom O'Flynn: The BGS auction does commence next week. As you probably know, we are not able to comment on that even to the extent that we are participating in it, just for confidentiality reason. So, yes, there is BGS auction next week. Yes, it does allow all generators an opportunity including ourselves if they participate to move those hedges up.
Ashar Khan - SAC Capital: Okay. And if I can just end up, could you just give us what is -- I know you mentioned a $10 margin improvement in '07 gross margin, could you tell us roughly what it would be in '08, which is an excess of 10% the guidance?
Tom O'Flynn: Yeah, we are still -- and also this is your last first question. It would not be as -- we would still see margin improvement from '07 to '08. It would not be in the magnitude of 10 bucks per megawatt hour, but it would support an overall earnings increase for PSEG of 10% and more from '07 to '08.
Ashar Khan - SAC Capital: Okay. Thank you.
Operator: The next question is from Paul Ridzon with Keybanc Capital Markets. Please proceed.
Paul Ridzon - Keybanc Capital Markets: Ralph, is your strategic review of Holdings complete or could we see some more divestitures?
Ralph Izzo: Paul, that's still a work in progress. We were looking at the whole portfolio there and we may be able to say modestly more things in the March timeframe at the analyst conference, but right now I just simply leave it at that.
Paul Ridzon - Keybanc Capital Markets: And Tom, just more granularity around the $4.60 to $5, has the pullback towards the top end of that pretty much out of range at this point?
Tom O'Flynn: We generally, Paul, don't comment on ranges within ranges. I'd say since the EEI prices have come down a little bit 2 to 4 bucks depending upon where you are in the curve. At the same time, there have been some offsets. I think we mentioned that Lawrenceburg had been an operating drag. That won't be there in '07, so we're still very comfortable with our $4.60 to $5 range.
Paul Ridzon - Keybanc Capital Markets: But the previous -- the $4.60 to $5 had about a 10% loss from Lawrenceburg?
Tom O'Flynn: Yes.
Paul Ridzon - Keybanc Capital Markets: Thank you very much.
Tom O'Flynn: Right there, yeah.
Operator: Your next question is coming from the line of Andrew Levy with [Frankfort Advisors]. Please proceed with your question.
Andrew Levy - Frankfort Advisors: Hey, guys.
Tom O'Flynn: Hi.
Andrew Levy - Frankfort Advisors: Hiring Kathleen is like letting the fox in the henhouse, but congratulations. Hey, Kathleen.
Tom O'Flynn: Well, I would rather hear for (inaudible).
Andrew Levy - Frankfort Advisors: No, it's a smart fox, a very smart fox. So, it works so well. Hey, just a quick question. Is there any political pressure that you guys are seeing just relating to electric rates?
Ralph Izzo: I think that there is always political pressure to keep electric rates under control, Andrew. But the reality is, if you look at the retail rates that New Jersians are seeing and how they have moved relative to other states nearby, it's a real tribute to the intelligence of the design of the BGS auction. So it's been a -- I think it's been a regulatory success here.
Andrew Levy - Frankfort Advisors: Thanks.
Operator: Your next question comes from Paul Patterson with Glenrock Associates. Please proceed.
Paul Patterson - Glenrock Associates: Good morning guys.
Ralph Izzo: Good morning.
Paul Patterson - Glenrock Associates: Just the Energy Holdings, it would be -- I guess you guys are not expecting mark-to-market gain and that sort of explains about a third of the decrease that you are expecting for ’07. How does the other, the new accounting standard and the spark spreads breakout after that?
Tom O'Flynn: I think in general, if we take Texas, first of all, Paul, this year our net income after tax contribution in Texas was about $80 million to $85 million. As you see in one of the attachments, almost $30 million of that was mark-to-market, I think the number is 28 to 29. So, you it kind of back into a mid 50s -- a mid 50s type of number excluding the mark-to-market, we are not anticipating mark-to-market this year. And we expect Texas to be down about $20 million, probably the biggest piece that is sparks coming from last year realized sparks were 19 to 20. We've got no forecast right now, but 15 to 16. And then -- so that brings you down about two-thirds of that decrement and then the other piece would be some maintenance outage as we do expense those as they come along. So that's the biggest -- that's kind of the waterfall if you will, on Texas.
Ralph Izzo: With respect to FIN-48 caution ate that we are (inaudible 00:13 19 file) units, it's a very detailed and a cumbersome thing to work through. We have been talking about this for a few months. I think in general, our guidance would contemplate a FIN-48 headwind if you will, a reduction to earnings in the mid-20s.
Paul Patterson - Glenrock Associates: Okay. And then just on the nuclear capacity factor for '07 and '08. I think you said it was 96% for the year in '06? What do you guys think it's going to be with refueling and everything, the schedule on just to --, your expectation for '07 and '08 going forward?
Tom O'Flynn: I think 96% was a good number, we certainly wouldn't count that, but it would be a number in low 90's.
Paul Patterson - Glenrock Associates: Low 90's.
Tom O'Flynn: Yeah.
Paul Patterson - Glenrock Associates: Okay. Thanks a lot.
Tom O'Flynn: 90 to 92, something that kind of range.
Operator: Your next question is from Zachary Schreiber with Duquesne Capital. Please proceed with your question.
Zachary Schreiber - Duquesne Capital: Hi its Zach Schreiber from Duquesne. Congratulations Kathleen.
Kathleen Lally: Thank you, Zach.
Zachary Schreiber - Duquesne Capital: Just say a quick question, Tom, on the RPM, the $100 million to $150 million. Is that a year-over-year number or is that an absolute number?
Tom O'Flynn: No, it is a year-over-year. It is in '06 versus '07. Consistent Zach, I think we talked about November, at the EEI. The PJM-RPM as you all know has generally come through as anticipated.
Zachary Schreiber - Duquesne Capital: Okay.
Tom O'Flynn: The '06 is obviously smaller, so you would expect another increase from '07 to '08, even if the dollars per kilowatt year don't change, just because the PJM-RPM, we really don't get a lot for the first five months of '07.
Zachary Schreiber - Duquesne Capital: Okay. And then on the CapEx, on the environmental side, is there anything you can just sort of put some parameters around the digit. Since I got from your comments was, may be its a little bit higher, but not a huge amount, but can you just cooperate if it is higher, how much higher and just put some parameters around that?
Tom O'Flynn: Yeah I [advise], stay away from that. We are, as I said doing detail engineering estimates, and we are also in the middle of some negations, discussions with some outsiders. It will be in the K. I'd say -- Zach, we generally see it as a manageable number, but I think the purpose was to just remind people as you are probably seeing from other folks in the sector.
Zachary Schreiber - Duquesne Capital: Yeah
Tom O'Flynn: That there was some pressure and you may see some movement. It's a manageable amount, but its certainly enough, that's -- we are working our best to manage it.
Zachary Schreiber - Duquesne Capital: Okay. Can you just remind us on the number of megawatts that you would be scrubbing and rest of the things, so we would just have some benchmark whether its -- you are assuming $300 a kilowatt, or $200 a kilowatt or $600, so we shouldn't know what kind of --?
Tom O'Flynn: Yeah, Hudson is six, in Mercer is the same.
Zachary Schreiber - Duquesne Capital: Hudson is six.
Tom O'Flynn: So you get it. Yeah.
Zachary Schreiber - Duquesne Capital: Okay.
Tom O'Flynn: So the other dam -- Hudson you can -- adjust about the simple number, we talked about four to five, which is moving. You can still see that they (inaudible) 600 megawatts of coal, Hudson is located in a very attractive place, almost constrained area of load pocket, to stop the [ballasting skyway] from driving in your city. And it's steadily -- and attractive facility in a very key location.
Zachary Schreiber - Duquesne Capital: Okay. And on this Connecticut lawsuit -- is there -- to us, it doesn’t seem like the Attorney General would have any way to do what he is proposing to do and [singling] on the FERC Regulation and EWG and [Federal Fund] Rate Adoption is that the proper way to think about this or is there any way that there is some sort of wrinkle in which that Connecticut can try and impose its regulatory jurisdiction over apparently deregulated generation?
Tom O'Flynn: Yes Zach, we don't think we will be giving legal views over the -- on the wire (inaudible) --currently, there has been some press up there, I'd just say that there was certainly a sale out there that was fully competitive with the plants. There is a good competitive market, that energy prices, SCM in there. I think from our own standpoint, if you just look at the total (inaudible) acts, we expect to do well in '07, but we did not do well. So in '06 and '05, if you look at the full package, just given that we signed a three year contract with UI in late 2003, if you look at the full package of our profitability in that period, it has actually been quite marginal until the last couple of weeks. But any way we think all the pieces that bill into market make sense, but there is no detailed piece available of legislation we are going to look at right now, it's really more a thing throughout the press.
Zachary Schreiber - Duquesne Capital: Last question, on the coal cost, are you guys getting helped by lower coal costs?
Tom O'Flynn: May be two of them, (inaudible) we tend to hedge pretty far forward. So that if we did it, it would really be more out in the '09-'10 timeframe.
Zachary Schreiber - Duquesne Capital: Got it.
Tom O'Flynn: Our coal buy tends to be equal to or may be even a shade longer than our forward hedging.
Zachary Schreiber - Duquesne Capital: Got it. Thanks so much guys and congratulations, Kathleen.
Kathleen Lally: Thank you, Zach.
Operator: (Operator Instructions). Your next question is from Danielle Seitz with Dahlman Rose & Company. Please proceed with your question.
Danielle Seitz - Dahlman Rose & Company: Thank you. I just wanted to clarify the $100 to $150 million is just for RPM or is it includes also New England?
Tom O'Flynn: That would be all capacity.
Danielle Seitz - Dahlman Rose & Company: Okay. And it includes New England as well?
Tom O'Flynn: It includes New England and it also includes New York to the extent that our best line energy facility gets something.
Danielle Seitz - Dahlman Rose & Company: Okay, okay. And may I ask, do you feel that you have pretty much done with the assets sales you wanted to do at Holdings?
Tom O'Flynn: Danielle, I'll go back to Ralph's question -- I mean response that I think we've…
Danielle Seitz - Dahlman Rose & Company: I mean you seems to be reaching a steady state there?
Tom O'Flynn: Yeah, I think we've sold the assets that are the largest in an area that we don't have a regional mass of assets. Certainly the U.S. assets have a lot of fit towards its Texas and then some smaller IPPs in California plants that are all consistent with our strategy. There are lot of assets in Latin America. I think as Ralph said, we are doing some reassessment of those, nothing at this point to report we may have some more discussion of those at our analyst session in late March. But sorry, I think we just say that consistent with what we've done in last couple of years from time to time with those opportunistic things for us to pursue, but nothing specific at this time.
Danielle Seitz - Dahlman Rose & Company: Great. Thanks.
Operator: Your next question is from Viswanath Khaitan with Deutsche Investment Management. Please proceed with your question.
Viswanath Khaitan - Deutsche Investment Management: Hello and thank you. Nobody has said Vishwanath before, so I am glad to here somebody say that. Bigger question for Ralph or Tom, strategic question that '07, '08 may be catch-up years for you as you show some improvement in earnings, so when do you see the normalization of earnings? Is it at the end of '08 or do you think there are more drivers in '09 and beyond to grow beyond the normal growth rate?
Tom O'Flynn: We'll achieve that after '08.
Kathleen Lally: You are asking --
Viswanath Khaitan - Deutsche Investment Management: What I am asking is that, when do you reach the normalized earnings level, is it in '08 or there are other drivers in '09 or '10 to continue to grow beyond normal growth rate?
Tom O'Flynn: Yeah, -- [breaking] channel, I would say we've talked about some growth from '07 to '08. As you look out after '08, very much of it gets into the markets driven by Power and PSE&G and Holdings are relatively stable. PSE&G is, if you think about in '07 has got to a normalized earnings level. Holdings businesses are reasonably stable. So, the growth to come from Power, as we said, it takes a couple of years for us -- couple of few years for us to lag into the forward curve that's happening over '07, '08. We do have one meaningful contract that drops off at the end of '08. That’s a primary megawatt around a clock sale. That's a number of years old, but for last of our older contracts. So, that will be a nice embedded pop form '08 to '09. But after that, it's in -- it's looking at the forward capacity and energy curves, and also with some growth initiatives that we are thinking to at this time.
Ralph Izzo: And Vish, clearly just to follow-up on what Tom said, I mean the whole reason for positioning the balance would be to take advantage of opportunities that will exist 18 to 24 months from now, and just being able to play in that market, fulfill it forcefully, and with growth in mind.
Viswanath Khaitan - Deutsche Investment Management: Right. And what about the carbon legislation, will that also give you some kickers?
Ralph Izzo: Yeah, we are part of the Clean Energy Group. We have supported several of the proposals discussed in Washington, clearly carbon constraint future is a positive future for our shareholders. So, no doubt which position we will be speaking out in that arena.
Viswanath Khaitan - Deutsche Investment Management: Right. Okay. Thank you.
Tom O'Flynn: Thanks Vish.
Operator: Your next question is from Clark Orsky with KDP Investment Advisors. Please proceed.
Clark Orsky - KDP Investment Advisors: Yeah, I had a couple more on Holdings. Can you tell me what cash at Holdings was at the end of the year and what cash flow from operations was there in the fourth quarter?
Tom O'Flynn: You're saying cash flow from operations or cash on hand?
Clark Orsky - KDP Investment Advisors: Both.
Tom O'Flynn: Cash on hand I think was reasonably modest, because I think I said that we paid $95 to $90 dividend in December and [our complete] cash is in $30 million range at the end of the year.
Clark Orsky - KDP Investment Advisors: Okay
Tom O'Flynn: And cash from operations for the year was in the 150 million range.
Clark Orsky - KDP Investment Advisors: Okay. And was debt pretty much the same, as it was at 930, at that level of Holdings?
Tom O'Flynn: Yes, George, there was no material. Holdings we have a bank line that we use very-very frequently. It's a $150 million $200 million line. But there was 1.15 billion of Holdings bonds outstanding and those were still outstanding.
Clark Orsky - KDP Investment Advisors: Okay
Tom O'Flynn: Yeah we made purchases on those obviously over the last couple of years, but 930 to 1230, [we had] no change.
Clark Orsky - KDP Investment Advisors: Okay. And then, just a couple on the guidance for Holdings, is there a tax rate we can use for Holdings for next year?
Tom O'Flynn: We have to get back to you with more details, it does move around a little bit, especially some of the tax rate is a function of consolidation, especially with some of the resource leases.
Clark Orsky - KDP Investment Advisors: Right.
Tom O'Flynn: In general the US business is -- our tax before rate 40% or so international businesses, we book at lower rates. So may be number is in the 20s.
Clark Orsky - KDP Investment Advisors: Okay and I guess -- I was just wondering about equity and earnings next year and sort of what's baked into the -- your forecast?
Ralph Izzo: For Holdings?
Clark Orsky - KDP Investment Advisors: Yeah. Sort of similar to this year, I think it was about 120 for the year or something?
Ralph Izzo: Well, we said 125 to 140 is that line of release. I think the way to think about it is that the business is down and Chile and Peru are quite stable. The Texas, I think I went through that with an earlier caller. Okay. That we see coming down both the mark-to-market and at about $20 million after-tax and net income for sparks and some maintenance. And then the other businesses are smaller contributors. And on the other piece, it's a non-cash piece, but its book [accrual] is under FIN-48 and its related FAS-132, for leases, its in the mid-20s. There is a drain.
Clark Orsky - KDP Investment Advisors: Okay. Okay I appreciate it.
Operator: Mr. Izzo, Mr. O'Flynn, there are no further questions at this time. Please continue with your presentation or closing remarks.
Kathleen Lally: Okay, thank you very much. I would again like to thank you all for participating in the call and if you have any further questions, please feel free to call us. I can be reached on 973-430-6565 and I would myself or any member of the IR team will be happy to help. Thank you.
Operator: Ladies and gentlemen, that does conclude your conference call for today. You may disconnect and thank you for participating.
TRANSCRIPT SPONSOR :
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"speaker": "TRANSCRIPT SPONSOR",
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"speaker": "Executives",
"text": "Kathleen Lally - VP, IR Ralph Izzo - President and COO Tom O'Flynn - CFO"
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"speaker": "Analysts",
"text": "Ashar Khan - SAC Capital Paul Ridzon - Keybanc Capital Markets Andrew Levy - Frankfort Advisors Paul Patterson - Glenrock Associates Zachary Schreiber - Duquesne Capital Danielle Seitz - Dahlman Rose & Company Viswanath Khaitan - Deutsche Investment Management Clark Orsky - KDP Investment Advisors"
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{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by. Welcome to the Public Service Enterprise Group Fourth Quarter 2006 Earnings Call and web cast. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session for members of the financial community. (Operator Instructions). As a reminder, this conference is being recorded Wednesday, January 31st, 2007 and will be available for telephone replay for 48 hours beginning at 1 pm Eastern Time today until 1 pm Eastern Time on February 2, 2007. It will also be available as audio webcast on PSEG's corporate website at www.pseg.com. I would now like to turn the conference over to Kathleen Lally. Please go ahead."
},
{
"speaker": "Kathleen Lally",
"text": "Thank you very much, and good morning to everyone. We appreciate your listening in today either by telephone or over our website. I will be turning the call over to Ralph Izzo, PSEG's President and Chief Operating Officer for comments on the company’s results and outlook. Also participating in today's call will be Tom O'Flynn, PSEG's Chief Financial Officer. Tom will provide a more detailed view of the company's operating and financial results and the forecast for 2007. Before we begin, however, I just need to make a few points. We issued our earnings release this morning. In case you have not seen it, a copy is posted on our website. We expect to file our Form 10-K with the SEC at the end of February. In today's webcast, we will discuss our future outlook and I must refer you to our forward-looking disclaimer. Although we believe our forecasts are based on reasonable assumptions, we can give you no assurance that they will be achieved. The results or events forecast in our statements today may differ materially from actual results or events. The last word on any of our businesses is contained in the various reports we file with the SEC. As a reminder, our guidance speaks as of the date it is issued. Any confirmation or update in guidance will only be done in a public manner, generally in the form of a press release or webcast such as this. PSEG may or may not confirm or update guidance with every press release. As a matter of policy, we will not comment on guidance during any one-on-one meeting or individual phone calls. In the body of our earnings release we provided a table that reconciled net income to operating earnings. We've adopted this format to improve the readability of the release and to provide the required reconciliation between the GAAP terms “net income” and \"income from continuing operations\" to the non-GAAP term “operating earnings”. The attachments for the press release provide the reconciliation to each of our major businesses. Operating earnings exclude merger-related costs and the net impact of certain asset sales during the period presented. Operating earnings is our standard for comparing 2006 results to 2005 for all of our businesses. We exclude such costs so that we can better compare our current period results with prior or future periods. Finally, at the end of the prepared remarks Ralph and Tom will take your questions. I would now like to turn the call over to Ralph."
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"speaker": "Ralph Izzo",
"text": "Thank you, Kathleen, and good morning. I too appreciate the time you've taken today in listening to our call and I hope you've been able to review the earnings release distributed this morning. I am pleased with the results we reported in that release. As you can see, our operating earnings of $3.71 a share came in at the upper end of guidance for the year. Although we spent much of the year working to complete the merger with Exelon, we kept a close eye on maintaining strong go-it-alone capabilities. As a result, we not only ended the year with operating earnings at the high end of our guidance but also with our strongest outlook in sometime. PSEG has been a successful company for over a hundred years through many changes in markets and in the industry, and we are equally upbeat about our future. Operational excellence is the foundation for success in our business and in 2006 we demonstrated excellence across the Board. This is a tribute to the hard work of our talented and dedicated employees. Our Salem and Hope Creek nuclear stations generated more electricity than in any single year prior to 2006, and the Fossil component of the PSEG Power also had its best year of electric production. Strong nuclear and fossil operations enabled us to benefit more fully from a favorable energy pricing environment and enabled PSEG Power to achieve a record level of operating earnings. PSE&G, our New Jersey energy delivery business continued to operate with best-in-class reliability. Both electric and gas operations have never been stronger. PSE&G also received an important measure of rate relief in November of 2006 that will help its long term financial picture. In addition, to providing a fair return for investors the rate relief provided the resources needed to support our ability to provide safe reliable service. PSEG Energy Holdings had its most profitable year due in large measure to outstanding performance from its two Texas generating stations. We also reduced international exposure by selling investments in Poland and Brazil in keeping with our long-term strategy for that business. I am pleased to report that the remaining assets are performing on a more predictable basis. As for the future, we have a positive earnings trajectory based on a combination of strong operations, the prices we've contracted for our anticipated energy supply, and an improving picture for energy capacity markets. Tom will provide more details on this in a moment. In addition to the results I just described, we've made progress with our most important near-term objective. I already mentioned the rate relief that we received towards the end of the year that will clearly be helpful. We've also completed the redesign of our organization and have most of the senior management team now in place. We're continuing to address staffing needs while working to preserve many of the efficiency savings achieved during the merger process. We anticipate hiring back only 60% of the staff loss during the merger review process. This is exactly the stretch goal we had set for ourselves. We have also taken steps to make sure our nuclear progress continues, as you probably know, we'll resume direct management of the Salem and Hope Creek facilities before the exploration of our nuclear operating services agreement with Exelon. The three cheerleaders managing Salem and Hope Creek are now employees of PSEG. We have great confidence in them, the stations and the future of our nuclear assets. I would be greatly [remised] however, if I did not recognize and extend out some serious thanks to John Rowe, Jack Skolds, Chris Crane, and the entire Exelon team for their co-operation and support during this process. I cannot say enough positive things about the support being provided by Exelon management during this transition. We look forward to continuing the improvements and excellence in operations that they started at our sites and with Bill Levis, Tom Joyce and George Barnes' leadership, we are confident about their future success. Over the past year, you also saw the continued reshaping of our portfolio of assets. The changes made during the year were designed to improve our returns, strength in the balance sheet and sharpen our focus on core operating areas. We remained committed to improving the balance sheet by further reducing debts and as our financial strength improves, we'll be able to pursue options for future growth. The actions taken over the past year, coupled with higher energy prices, support our forecast improvement in 2007 operating earnings, to a $4.60 to $5 per share, with growth in 2008 in excess of 10%. Power prices have declined since we made this forecast in the fall of 2006, but significant forward head ratios, the sale of Lawrenceburg and a reduction in financing costs continue to provide us with confidence in our forecast. We are in the process of developing our long run business growth strategy and we will provide you with an update on March 26, when we host the meeting for the financial community, at [Philadelphia Storey] in New York. Now Tom will review the fourth quarter and our outlook for 2007."
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"speaker": "Tom O'Flynn",
"text": "Thanks Ralph. Good morning. Let me first extend our welcome to Kathleen Lally, our new Vice President of Investor Relations. We know Kathleen from her former roles and you will be happy to know she continues to have a lot of tough questions for us and keep us on our toes. PSEG reported operating earnings for the fourth quarter of $174 million or $0.69 per share, versus $233 million or $0.94 per share for the 2005 fourth quarter. The strong results for the recent quarter overcame a charge of $0.10 per share, Power, related to impairment of turbines to be sold in 2007. And I also want to remind you that last year's results include a gain of $0.18 from the sale of the Seminole lease. The year, PSEG reported operating earnings of $938 million or $3.71 per share compared to 2005 amounts of $918 million or $3.77 per share. The results for '06 are based on 252 million shares outstanding, a 3.3% increase over 2005. PSEGs results for the quarter and the year are defined in large parts by strong performance from our generation fleet and higher power prices, offset by warmer weather. For the fourth quarter, Power reported operating earnings of $102 million or $0.40 and 11% decline in the 113 million or $0.45 from a year ago. As you know, a number of our strategic activities were reviewed in a different context during the merger process. Shortly after the termination of the merger, Power took a close at two assets in its portfolio that had uncertain long-term value for us. Namely Lawrenceburg and 4EA Turbines. Lawrenceburg is a 1100 megawatt combined cycle gas unit in Indiana that did not integrate well into our PJM eastern based portfolio. During 2006, it produced an operating loss of over $0.10 and although we anticipated improvements in the future, we believe that the unit may be worth more in the hands of another owner. Early in January, we announced the sale to American Electric Power recorded an after-tax loss of $210 million and the unit was moved to discontinued operations in the fourth quarter. With our completion of the sale, we expect to receive approximately $425 million of after-tax cash flow. As for the turbines, Power has no immediate use for these units and with the passage of time. Our evaluation is that newer technology proved be more flexible and efficient in new projects. This analysis coupled with interest by a number of potential buyers caused us to decide to monetize these assets and recognize an impairment of $44 million or $0.10 in the fourth quarter. This loss is included in our operating earnings for the quarter and the year. For the year, Power reported record operating earnings of $515 million worth $2.04 per share, an 11% improvement over '05's operating earnings of $446 million worth $1.83 per share. Power saw an improving margin during the quarter and the year as a result of higher prices for our contracted output and other market hedging activities. Given our strategy of contracting for a few years into the future, we generally experience market prices on a lag basis. Higher pricing added $0.22 to earnings for the quarter and $0.84 to the year. The continuation of strong operations via nuclear fleet also supported margins for the quarter. Nuclear units operated at a capacity factor of 96% in the fourth quarter resulting in a full year capacity factor also of 96%, which included a record refueling outage at Salem 2 of under 22 days. This performance added $0.02 per share to Power's earnings for the quarter. Earnings were improved by $0.20 per share for the full year as a result of the fleet's year-over-year improvement. Higher prices and increased output more than offset the effective higher depreciation expense in 2006. The operation of new assets and the absence of Nuclear Decommissioning Trust Fund gains of $0.05 per share recognized in last year's fourth quarter. Power's fourth quarter earnings for the BGSS were also down $0.11 versus an unusually strong fourth quarter 2005 that benefited from very high post-hurricane gas prices in normal weather. In contrast, fourth quarter '06 was hurt by warm weather and a lingering effect in the inventory costs of last year's gas price run up. This $0.11 impact during the quarter brought the full year impact to $0.22 per share lower than we saw in 2005. Looking forward to 2007, our inventory position is better balanced and with some more normal weather, we would expect the BGSS contribution to improve in 2007 by approximately $0.10 to $0.15 over 2006. Operating earnings for Power in 2007 are expected to be in the range of $770 million to $850 million. The midpoint of this range represents a $295 million increase, a greater than 50% improvement over our '06 operating earnings. The key drivers to this increase are the higher prices for our nuclear in Poland output that are realized because of the rolling nature of our forward hedge positions. The exploration of our contract with United Illuminating in Connecticut, the sale at Lawrenceburg, and our projected improvements in margins on serving the BGSS contract. In addition to the improvement in energy markets the redesign of capacity markets will also provide reasonable signals for reliability and is expected to enhance Power's margins. There were positive steps in December related to capacity design. First, the transitional period began for the forward capacity market in New England. Capacity prices in New England are approximately $3 per kilowatt [a month]. Second, the FERC approved reliability pricing model for PJM with implementation in June of 2007. Those market changes are expected to be accretive to Power and are forecasted at approximately $100 million to $115 million Power's 2007 margins. Overall, our gross margin per megawatt hour has increased from approximately $33 per megawatt hour in 2005 to approximately $38 per megawatt hour in '06 and is forecasted to expand in '07 by approximately another $10 per megawatt hour. As you recall, we are pleased to announce during the fourth quarter that we received approval to extend the in-service date of pollution control facilities at Hudson Unit 2 for four years beyond 2006 under an agreement with Federal and State Environmental Authorities. The agreement requires PSEG fossils undertaking number of plant modifications and operating changes to meet targeted reductions in the missions of NOx, SO2, particulate matter and mercury. We also need to notify the authorities by the end of 2007 when we will install the additional pollution controls the Hudson Unit 2 by the end of 2010 or plan for the early shutdown of the unit. We are in the midst of concluding detailed engineering work and updating our projection of our environmental capital cost for our 2006 Form 10-K. As many of you are aware, the markets for major environmental and construction projects are tight. We may see some increase in our current estimate of environmental capital cost of $400 million to $500 million for Hudson and $300 million to $450 million for Mercer. PSE&G, our electric and gas utility company reported operating earnings for the quarter of $64 million or $0.25 per share compared with $66 million or $0.26 per share from a year ago. The challenge with PSE&G in the quarter and for the year has been weather and extended delay in receiving rate relief. For the fourth quarter, warmer than normal weather reduced PSE&G's earnings by $0.06 per share versus prior results, and also, versus normal. For the full year, warmer than normal weather reduced PSE&G's earnings by $0.12 per share versus normal and by $0.19 per share versus 2005 reported earnings. Higher transmission revenues, reduction in operating expenses, and true up of taxes in the quarter allowed PSE&G to almost offset the negative effect of weather. For the year, PSE&G reported operating earnings of $262 million or $1.04 per share, a 27% decline over '05's operating earnings of $347 million or $1.42. Decline reflects the abnormal weather conditions and the delayed rate relief. Operating earnings for PSE&G are forecasted to improve in 2007 to $330 million to $350 million, and accordingly this range represents a 30% improvement over '06's operating results. The full year effect of the gas and electric rate agreements approved in November, coupled with more normal weather are the primary drivers behind this forecasted improvement. PSEG Energy Holdings reported earnings for the fourth quarter of $24 million or $0.10 per share compared to $72 million or $0.30 per share from the fourth quarter of '05. The quarter-over-quarter results primarily reflect the absence of $0.18 per share gain at resources from the sale of the Seminole lease and some other items as illustrated in the attachment 7. For the year, Holdings reported operating earnings of $227 million or $0.89 per share, a 10% improvement over '05's operating earnings of $196 million or $0.81 per share. These results for '06 include a mark-to market gain of $0.11 per share. Holdings 2006 earnings are noteworthy considering Global has reduced the invested capital in its portfolio by over $500 million over the past three years, as shown in attachment 9. This decrease was driven by over $900 million of sales of non-strategic international investments, and an after-tax gain of $50 million over this timeframe. As a result, over 90% of Global's portfolio consists of its investments in Chile and Peru, primarily stable distribution companies and our US generation business. The sale of assets and reduction in recourse debt by Holdings [throughout] the subsidiary, contributed $95 million to PSEG in the fourth quarter. Operating earnings for Holdings have forecasted a decline '07 to $130 million to $145 million. The largest reduction from '06 to '07 is our Texas assets. Due to a variety of factors, including the absence of '06's mark-to-market gain. A large decrease in spark spreads year-over-year and additional plant maintenance outages. We also anticipate that the implementation of the new accounting standard for uncertain tax positions, FIN-48, will reduce Holding's earnings, particularly with respect with some leases at resources. Finally, I'd like to make some comments regarding our consolidated cash flow and liquidity. In 2006, cash flow from operations was very strong, generating $1.9 billion. This represents improvement than the $925 million from last year. The improvement was largely due to reduced cash collateral postings by Power and approved receivables. [Absent] changes in working capital, cash from operations improved by $100 million year-over-year. In addition to meaningful excess cash from operations during 2006, the after-tax cash proceeds from the sale of assets and Holdings contributed more than $600 million of additional cash flow. This primarily reflects the sale of our interest in RGE and two generating facilities in Poland. In total, excess cash to pay down recourse debt was about $950 million. We have available liquidity at yearend 2006 exceeding $3 billion. In the fourth quarter, we refinanced $3.2 billion of credit facilities, (inaudible) Enterprise grew $1 billion, Power for $1.6 billion and Utility for $600 million. All three Power facilities mature in 2011. Debt reduction has materially strengthened our balance sheet, in conjunction with refinancing our credit facilities, our covenant calculations were relaxed by our lenders. Normalizing for changes to our covenant calculations, we reduced our financial leverage by about 4 percentage points during 2006. 00:17 15th file pro forma -- with the anticipated proceed from the sale of Lawrenceburg, we will have reduced our leverage to about 50%. This reduction leverage is expected to reduce operating expenses at the Holding Company level, to a range of $50 million to $60 million in '07 versus $66 million. In summary, we are pleased with our performance for 2006 and believe we are well positioned for 2007. Highlights include, as Ralph went through, earnings are expected to grow by one-third from $4.60 to $5 per share. Our capital structure is improving, operating risk has been reduced, improved operations, strong forward hedge portfolio and reduced international risk. Now Ralph and I would be pleased to take questions."
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"speaker": "Kathleen Lally",
"text": "Operator?"
},
{
"speaker": "Operator",
"text": "Ladies and Gentlemen we will now begin the question-and-answer session for members of the financial community. (Operator Instructions). And the first question is coming from the line of Ashar Khan with SAC Capital. Please proceed."
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{
"speaker": "Ashar Khan - SAC Capital",
"text": "Good morning. Tom, could you just go over what the hedges are? Could you update your hedge information, the last information I had was that EEI, could you update what the hedges stand currently for '07, '08 and '09?"
},
{
"speaker": "Tom O'Flynn",
"text": "Sure. Those are generally still reasonable numbers, still reasonable ranges for those folks who don't have the information there at the EEI presentation we said in '07, we are about 85% to 95% hedged, '08 was 65% to 80%, and '09 was 10% to 40%. Those are still reasonable ranges. When we talk about hedge ratios, we generally talk about our forward nuclear and coal as that represents about 85% of our megawatt hours, a higher percentage of our margin. We also would expect to update those in the K to the extent there is any material changes."
},
{
"speaker": "Ashar Khan - SAC Capital",
"text": "Okay. I guess this PJM auction will move those hedges upwards, is that a fair assumption?"
},
{
"speaker": "Tom O'Flynn",
"text": "The BGS auction does commence next week. As you probably know, we are not able to comment on that even to the extent that we are participating in it, just for confidentiality reason. So, yes, there is BGS auction next week. Yes, it does allow all generators an opportunity including ourselves if they participate to move those hedges up."
},
{
"speaker": "Ashar Khan - SAC Capital",
"text": "Okay. And if I can just end up, could you just give us what is -- I know you mentioned a $10 margin improvement in '07 gross margin, could you tell us roughly what it would be in '08, which is an excess of 10% the guidance?"
},
{
"speaker": "Tom O'Flynn",
"text": "Yeah, we are still -- and also this is your last first question. It would not be as -- we would still see margin improvement from '07 to '08. It would not be in the magnitude of 10 bucks per megawatt hour, but it would support an overall earnings increase for PSEG of 10% and more from '07 to '08."
},
{
"speaker": "Ashar Khan - SAC Capital",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "The next question is from Paul Ridzon with Keybanc Capital Markets. Please proceed."
},
{
"speaker": "Paul Ridzon - Keybanc Capital Markets",
"text": "Ralph, is your strategic review of Holdings complete or could we see some more divestitures?"
},
{
"speaker": "Ralph Izzo",
"text": "Paul, that's still a work in progress. We were looking at the whole portfolio there and we may be able to say modestly more things in the March timeframe at the analyst conference, but right now I just simply leave it at that."
},
{
"speaker": "Paul Ridzon - Keybanc Capital Markets",
"text": "And Tom, just more granularity around the $4.60 to $5, has the pullback towards the top end of that pretty much out of range at this point?"
},
{
"speaker": "Tom O'Flynn",
"text": "We generally, Paul, don't comment on ranges within ranges. I'd say since the EEI prices have come down a little bit 2 to 4 bucks depending upon where you are in the curve. At the same time, there have been some offsets. I think we mentioned that Lawrenceburg had been an operating drag. That won't be there in '07, so we're still very comfortable with our $4.60 to $5 range."
},
{
"speaker": "Paul Ridzon - Keybanc Capital Markets",
"text": "But the previous -- the $4.60 to $5 had about a 10% loss from Lawrenceburg?"
},
{
"speaker": "Tom O'Flynn",
"text": "Yes."
},
{
"speaker": "Paul Ridzon - Keybanc Capital Markets",
"text": "Thank you very much."
},
{
"speaker": "Tom O'Flynn",
"text": "Right there, yeah."
},
{
"speaker": "Operator",
"text": "Your next question is coming from the line of Andrew Levy with [Frankfort Advisors]. Please proceed with your question."
},
{
"speaker": "Andrew Levy - Frankfort Advisors",
"text": "Hey, guys."
},
{
"speaker": "Tom O'Flynn",
"text": "Hi."
},
{
"speaker": "Andrew Levy - Frankfort Advisors",
"text": "Hiring Kathleen is like letting the fox in the henhouse, but congratulations. Hey, Kathleen."
},
{
"speaker": "Tom O'Flynn",
"text": "Well, I would rather hear for (inaudible)."
},
{
"speaker": "Andrew Levy - Frankfort Advisors",
"text": "No, it's a smart fox, a very smart fox. So, it works so well. Hey, just a quick question. Is there any political pressure that you guys are seeing just relating to electric rates?"
},
{
"speaker": "Ralph Izzo",
"text": "I think that there is always political pressure to keep electric rates under control, Andrew. But the reality is, if you look at the retail rates that New Jersians are seeing and how they have moved relative to other states nearby, it's a real tribute to the intelligence of the design of the BGS auction. So it's been a -- I think it's been a regulatory success here."
},
{
"speaker": "Andrew Levy - Frankfort Advisors",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from Paul Patterson with Glenrock Associates. Please proceed."
},
{
"speaker": "Paul Patterson - Glenrock Associates",
"text": "Good morning guys."
},
{
"speaker": "Ralph Izzo",
"text": "Good morning."
},
{
"speaker": "Paul Patterson - Glenrock Associates",
"text": "Just the Energy Holdings, it would be -- I guess you guys are not expecting mark-to-market gain and that sort of explains about a third of the decrease that you are expecting for ’07. How does the other, the new accounting standard and the spark spreads breakout after that?"
},
{
"speaker": "Tom O'Flynn",
"text": "I think in general, if we take Texas, first of all, Paul, this year our net income after tax contribution in Texas was about $80 million to $85 million. As you see in one of the attachments, almost $30 million of that was mark-to-market, I think the number is 28 to 29. So, you it kind of back into a mid 50s -- a mid 50s type of number excluding the mark-to-market, we are not anticipating mark-to-market this year. And we expect Texas to be down about $20 million, probably the biggest piece that is sparks coming from last year realized sparks were 19 to 20. We've got no forecast right now, but 15 to 16. And then -- so that brings you down about two-thirds of that decrement and then the other piece would be some maintenance outage as we do expense those as they come along. So that's the biggest -- that's kind of the waterfall if you will, on Texas."
},
{
"speaker": "Ralph Izzo",
"text": "With respect to FIN-48 caution ate that we are (inaudible 00:13 19 file) units, it's a very detailed and a cumbersome thing to work through. We have been talking about this for a few months. I think in general, our guidance would contemplate a FIN-48 headwind if you will, a reduction to earnings in the mid-20s."
},
{
"speaker": "Paul Patterson - Glenrock Associates",
"text": "Okay. And then just on the nuclear capacity factor for '07 and '08. I think you said it was 96% for the year in '06? What do you guys think it's going to be with refueling and everything, the schedule on just to --, your expectation for '07 and '08 going forward?"
},
{
"speaker": "Tom O'Flynn",
"text": "I think 96% was a good number, we certainly wouldn't count that, but it would be a number in low 90's."
},
{
"speaker": "Paul Patterson - Glenrock Associates",
"text": "Low 90's."
},
{
"speaker": "Tom O'Flynn",
"text": "Yeah."
},
{
"speaker": "Paul Patterson - Glenrock Associates",
"text": "Okay. Thanks a lot."
},
{
"speaker": "Tom O'Flynn",
"text": "90 to 92, something that kind of range."
},
{
"speaker": "Operator",
"text": "Your next question is from Zachary Schreiber with Duquesne Capital. Please proceed with your question."
},
{
"speaker": "Zachary Schreiber - Duquesne Capital",
"text": "Hi its Zach Schreiber from Duquesne. Congratulations Kathleen."
},
{
"speaker": "Kathleen Lally",
"text": "Thank you, Zach."
},
{
"speaker": "Zachary Schreiber - Duquesne Capital",
"text": "Just say a quick question, Tom, on the RPM, the $100 million to $150 million. Is that a year-over-year number or is that an absolute number?"
},
{
"speaker": "Tom O'Flynn",
"text": "No, it is a year-over-year. It is in '06 versus '07. Consistent Zach, I think we talked about November, at the EEI. The PJM-RPM as you all know has generally come through as anticipated."
},
{
"speaker": "Zachary Schreiber - Duquesne Capital",
"text": "Okay."
},
{
"speaker": "Tom O'Flynn",
"text": "The '06 is obviously smaller, so you would expect another increase from '07 to '08, even if the dollars per kilowatt year don't change, just because the PJM-RPM, we really don't get a lot for the first five months of '07."
},
{
"speaker": "Zachary Schreiber - Duquesne Capital",
"text": "Okay. And then on the CapEx, on the environmental side, is there anything you can just sort of put some parameters around the digit. Since I got from your comments was, may be its a little bit higher, but not a huge amount, but can you just cooperate if it is higher, how much higher and just put some parameters around that?"
},
{
"speaker": "Tom O'Flynn",
"text": "Yeah I [advise], stay away from that. We are, as I said doing detail engineering estimates, and we are also in the middle of some negations, discussions with some outsiders. It will be in the K. I'd say -- Zach, we generally see it as a manageable number, but I think the purpose was to just remind people as you are probably seeing from other folks in the sector."
},
{
"speaker": "Zachary Schreiber - Duquesne Capital",
"text": "Yeah"
},
{
"speaker": "Tom O'Flynn",
"text": "That there was some pressure and you may see some movement. It's a manageable amount, but its certainly enough, that's -- we are working our best to manage it."
},
{
"speaker": "Zachary Schreiber - Duquesne Capital",
"text": "Okay. Can you just remind us on the number of megawatts that you would be scrubbing and rest of the things, so we would just have some benchmark whether its -- you are assuming $300 a kilowatt, or $200 a kilowatt or $600, so we shouldn't know what kind of --?"
},
{
"speaker": "Tom O'Flynn",
"text": "Yeah, Hudson is six, in Mercer is the same."
},
{
"speaker": "Zachary Schreiber - Duquesne Capital",
"text": "Hudson is six."
},
{
"speaker": "Tom O'Flynn",
"text": "So you get it. Yeah."
},
{
"speaker": "Zachary Schreiber - Duquesne Capital",
"text": "Okay."
},
{
"speaker": "Tom O'Flynn",
"text": "So the other dam -- Hudson you can -- adjust about the simple number, we talked about four to five, which is moving. You can still see that they (inaudible) 600 megawatts of coal, Hudson is located in a very attractive place, almost constrained area of load pocket, to stop the [ballasting skyway] from driving in your city. And it's steadily -- and attractive facility in a very key location."
},
{
"speaker": "Zachary Schreiber - Duquesne Capital",
"text": "Okay. And on this Connecticut lawsuit -- is there -- to us, it doesn’t seem like the Attorney General would have any way to do what he is proposing to do and [singling] on the FERC Regulation and EWG and [Federal Fund] Rate Adoption is that the proper way to think about this or is there any way that there is some sort of wrinkle in which that Connecticut can try and impose its regulatory jurisdiction over apparently deregulated generation?"
},
{
"speaker": "Tom O'Flynn",
"text": "Yes Zach, we don't think we will be giving legal views over the -- on the wire (inaudible) --currently, there has been some press up there, I'd just say that there was certainly a sale out there that was fully competitive with the plants. There is a good competitive market, that energy prices, SCM in there. I think from our own standpoint, if you just look at the total (inaudible) acts, we expect to do well in '07, but we did not do well. So in '06 and '05, if you look at the full package, just given that we signed a three year contract with UI in late 2003, if you look at the full package of our profitability in that period, it has actually been quite marginal until the last couple of weeks. But any way we think all the pieces that bill into market make sense, but there is no detailed piece available of legislation we are going to look at right now, it's really more a thing throughout the press."
},
{
"speaker": "Zachary Schreiber - Duquesne Capital",
"text": "Last question, on the coal cost, are you guys getting helped by lower coal costs?"
},
{
"speaker": "Tom O'Flynn",
"text": "May be two of them, (inaudible) we tend to hedge pretty far forward. So that if we did it, it would really be more out in the '09-'10 timeframe."
},
{
"speaker": "Zachary Schreiber - Duquesne Capital",
"text": "Got it."
},
{
"speaker": "Tom O'Flynn",
"text": "Our coal buy tends to be equal to or may be even a shade longer than our forward hedging."
},
{
"speaker": "Zachary Schreiber - Duquesne Capital",
"text": "Got it. Thanks so much guys and congratulations, Kathleen."
},
{
"speaker": "Kathleen Lally",
"text": "Thank you, Zach."
},
{
"speaker": "Operator",
"text": "(Operator Instructions). Your next question is from Danielle Seitz with Dahlman Rose & Company. Please proceed with your question."
},
{
"speaker": "Danielle Seitz - Dahlman Rose & Company",
"text": "Thank you. I just wanted to clarify the $100 to $150 million is just for RPM or is it includes also New England?"
},
{
"speaker": "Tom O'Flynn",
"text": "That would be all capacity."
},
{
"speaker": "Danielle Seitz - Dahlman Rose & Company",
"text": "Okay. And it includes New England as well?"
},
{
"speaker": "Tom O'Flynn",
"text": "It includes New England and it also includes New York to the extent that our best line energy facility gets something."
},
{
"speaker": "Danielle Seitz - Dahlman Rose & Company",
"text": "Okay, okay. And may I ask, do you feel that you have pretty much done with the assets sales you wanted to do at Holdings?"
},
{
"speaker": "Tom O'Flynn",
"text": "Danielle, I'll go back to Ralph's question -- I mean response that I think we've…"
},
{
"speaker": "Danielle Seitz - Dahlman Rose & Company",
"text": "I mean you seems to be reaching a steady state there?"
},
{
"speaker": "Tom O'Flynn",
"text": "Yeah, I think we've sold the assets that are the largest in an area that we don't have a regional mass of assets. Certainly the U.S. assets have a lot of fit towards its Texas and then some smaller IPPs in California plants that are all consistent with our strategy. There are lot of assets in Latin America. I think as Ralph said, we are doing some reassessment of those, nothing at this point to report we may have some more discussion of those at our analyst session in late March. But sorry, I think we just say that consistent with what we've done in last couple of years from time to time with those opportunistic things for us to pursue, but nothing specific at this time."
},
{
"speaker": "Danielle Seitz - Dahlman Rose & Company",
"text": "Great. Thanks."
},
{
"speaker": "Operator",
"text": "Your next question is from Viswanath Khaitan with Deutsche Investment Management. Please proceed with your question."
},
{
"speaker": "Viswanath Khaitan - Deutsche Investment Management",
"text": "Hello and thank you. Nobody has said Vishwanath before, so I am glad to here somebody say that. Bigger question for Ralph or Tom, strategic question that '07, '08 may be catch-up years for you as you show some improvement in earnings, so when do you see the normalization of earnings? Is it at the end of '08 or do you think there are more drivers in '09 and beyond to grow beyond the normal growth rate?"
},
{
"speaker": "Tom O'Flynn",
"text": "We'll achieve that after '08."
},
{
"speaker": "Kathleen Lally",
"text": "You are asking --"
},
{
"speaker": "Viswanath Khaitan - Deutsche Investment Management",
"text": "What I am asking is that, when do you reach the normalized earnings level, is it in '08 or there are other drivers in '09 or '10 to continue to grow beyond normal growth rate?"
},
{
"speaker": "Tom O'Flynn",
"text": "Yeah, -- [breaking] channel, I would say we've talked about some growth from '07 to '08. As you look out after '08, very much of it gets into the markets driven by Power and PSE&G and Holdings are relatively stable. PSE&G is, if you think about in '07 has got to a normalized earnings level. Holdings businesses are reasonably stable. So, the growth to come from Power, as we said, it takes a couple of years for us -- couple of few years for us to lag into the forward curve that's happening over '07, '08. We do have one meaningful contract that drops off at the end of '08. That’s a primary megawatt around a clock sale. That's a number of years old, but for last of our older contracts. So, that will be a nice embedded pop form '08 to '09. But after that, it's in -- it's looking at the forward capacity and energy curves, and also with some growth initiatives that we are thinking to at this time."
},
{
"speaker": "Ralph Izzo",
"text": "And Vish, clearly just to follow-up on what Tom said, I mean the whole reason for positioning the balance would be to take advantage of opportunities that will exist 18 to 24 months from now, and just being able to play in that market, fulfill it forcefully, and with growth in mind."
},
{
"speaker": "Viswanath Khaitan - Deutsche Investment Management",
"text": "Right. And what about the carbon legislation, will that also give you some kickers?"
},
{
"speaker": "Ralph Izzo",
"text": "Yeah, we are part of the Clean Energy Group. We have supported several of the proposals discussed in Washington, clearly carbon constraint future is a positive future for our shareholders. So, no doubt which position we will be speaking out in that arena."
},
{
"speaker": "Viswanath Khaitan - Deutsche Investment Management",
"text": "Right. Okay. Thank you."
},
{
"speaker": "Tom O'Flynn",
"text": "Thanks Vish."
},
{
"speaker": "Operator",
"text": "Your next question is from Clark Orsky with KDP Investment Advisors. Please proceed."
},
{
"speaker": "Clark Orsky - KDP Investment Advisors",
"text": "Yeah, I had a couple more on Holdings. Can you tell me what cash at Holdings was at the end of the year and what cash flow from operations was there in the fourth quarter?"
},
{
"speaker": "Tom O'Flynn",
"text": "You're saying cash flow from operations or cash on hand?"
},
{
"speaker": "Clark Orsky - KDP Investment Advisors",
"text": "Both."
},
{
"speaker": "Tom O'Flynn",
"text": "Cash on hand I think was reasonably modest, because I think I said that we paid $95 to $90 dividend in December and [our complete] cash is in $30 million range at the end of the year."
},
{
"speaker": "Clark Orsky - KDP Investment Advisors",
"text": "Okay"
},
{
"speaker": "Tom O'Flynn",
"text": "And cash from operations for the year was in the 150 million range."
},
{
"speaker": "Clark Orsky - KDP Investment Advisors",
"text": "Okay. And was debt pretty much the same, as it was at 930, at that level of Holdings?"
},
{
"speaker": "Tom O'Flynn",
"text": "Yes, George, there was no material. Holdings we have a bank line that we use very-very frequently. It's a $150 million $200 million line. But there was 1.15 billion of Holdings bonds outstanding and those were still outstanding."
},
{
"speaker": "Clark Orsky - KDP Investment Advisors",
"text": "Okay"
},
{
"speaker": "Tom O'Flynn",
"text": "Yeah we made purchases on those obviously over the last couple of years, but 930 to 1230, [we had] no change."
},
{
"speaker": "Clark Orsky - KDP Investment Advisors",
"text": "Okay. And then, just a couple on the guidance for Holdings, is there a tax rate we can use for Holdings for next year?"
},
{
"speaker": "Tom O'Flynn",
"text": "We have to get back to you with more details, it does move around a little bit, especially some of the tax rate is a function of consolidation, especially with some of the resource leases."
},
{
"speaker": "Clark Orsky - KDP Investment Advisors",
"text": "Right."
},
{
"speaker": "Tom O'Flynn",
"text": "In general the US business is -- our tax before rate 40% or so international businesses, we book at lower rates. So may be number is in the 20s."
},
{
"speaker": "Clark Orsky - KDP Investment Advisors",
"text": "Okay and I guess -- I was just wondering about equity and earnings next year and sort of what's baked into the -- your forecast?"
},
{
"speaker": "Ralph Izzo",
"text": "For Holdings?"
},
{
"speaker": "Clark Orsky - KDP Investment Advisors",
"text": "Yeah. Sort of similar to this year, I think it was about 120 for the year or something?"
},
{
"speaker": "Ralph Izzo",
"text": "Well, we said 125 to 140 is that line of release. I think the way to think about it is that the business is down and Chile and Peru are quite stable. The Texas, I think I went through that with an earlier caller. Okay. That we see coming down both the mark-to-market and at about $20 million after-tax and net income for sparks and some maintenance. And then the other businesses are smaller contributors. And on the other piece, it's a non-cash piece, but its book [accrual] is under FIN-48 and its related FAS-132, for leases, its in the mid-20s. There is a drain."
},
{
"speaker": "Clark Orsky - KDP Investment Advisors",
"text": "Okay. Okay I appreciate it."
},
{
"speaker": "Operator",
"text": "Mr. Izzo, Mr. O'Flynn, there are no further questions at this time. Please continue with your presentation or closing remarks."
},
{
"speaker": "Kathleen Lally",
"text": "Okay, thank you very much. I would again like to thank you all for participating in the call and if you have any further questions, please feel free to call us. I can be reached on 973-430-6565 and I would myself or any member of the IR team will be happy to help. Thank you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, that does conclude your conference call for today. You may disconnect and thank you for participating."
},
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] | null | null |
PEG | 3 | 2,006 | 2006-11-01 11:00:00 | Executives: Mort Plawner - IR Tom O'Flynn - CFO Ralph Izzo - CEO
Analysts: Paul Patterson – Glenrock Associates Ashar Khan - SAC Capital Management Analyst for Gerald Chung - Banc of America Securities Michael Goldenberg – Loomis Management David Frank – Piqua Capital Management Steven Huang - Citadel Investment Group Andrew Levy – Bear Wagner Specialists
Operator: Welcome to the Public Service Enterprise Group third quarter 2006 earnings conference call and webcast. (Operator Instructions) I would now like to turn the conference over to Mort Plawner. Please go ahead, sir.
Mort Plawner: Thank you and good morning. We appreciate your listening in today, either by telephone or over our website. I will be turning the call over to Tom O'Flynn, PSEG's CFO, for a review of our third quarter results. First, I need to make a few points. We issued our earnings release this morning. In case you have not seen it, a copy is posted on our website. We expect to file our 10-Q with the SEC later today, which will contain additional information. In today's webcast, Tom will discuss our future outlook and so I must refer you to our forward-looking disclaimer. Although we believe our forecasts are based on reasonable assumptions, we can give no assurance that they will be achieved. The results or events forecast in our statements today may differ materially from actual results or events. The last word on any of our businesses is contained in the various reports we file with the SEC. As a reminder, our guidance speaks as of the date it is issued. Any confirmation or update in guidance will only be done in a public manner, generally in the form of a press release or webcast such as this. PSEG may or may not confirm or update guidance with every press release. As a matter of policy, we will not comment on guidance during any one-on-one meeting or individual phone call. In the body of our earnings release we provided a table that reconciled net income to operating earnings. We've adopted this format to improve the readability of the release and to provide the required reconciliation between the GAAP term “net income” and the non-GAAP term “operating earnings”. The attachments to the press release provide a reconciliation for each of our major businesses. Operating earnings exclude the merger-related costs and the net impact of certain asset sales during the period presented. Operating earnings is our standard for comparing 2006 results to 2005 for all our businesses. We exclude such costs so that we can better compare our current period results with prior or future periods. Finally, Tom will take your questions at the conclusion of the prepared remarks. Please limit yourself to one question and one follow-up. Thank you, I will now turn the call over to Tom.
Tom O'Flynn: Thanks, Mort. Good morning, everyone. Thanks for joining us. I hope you've had a chance to review the release we put out this morning. On this call, I will briefly go over our results for the third quarter, and discuss some of the major issues. Briefly, operating earnings for PSEG were $372 million for the quarter, an increase of $93 million or $0.34 from the third quarter of last year. Can you just make sure the mic is on mute, please? We've got a little bit of speaker interference or listener interference. Operator, if you're still there?
Operator: Yes, sir.
Tom O'Flynn: Can you make sure all the phones are on mute with the exception of mine?
Operator: All lines are muted, sir.
Tom O'Flynn: As I said, the operating earnings for PSEG were $372 million for the quarter, an increase of $93 million, or $0.34 from the third quarter of last year. Third quarter results were strong for power and holdings and slightly off for utility. At Power, higher prices for generation output and strong operations boosted margins for the quarter. However, high depreciation and the absence of an NDT restructuring gain in the same quarter last year somewhat dampened the quarter over quarter impact. PSEG results reflect the delay of rate relief caused by merger-related issues. However, we are pleased that earlier this week we reached an agreement to settle the outstanding gas and electric cases, which will allow us the opportunity to earn a fair rate of return. I'll provide more details in a moment. For holdings, our two Texas plants provided a significant uplift in our earnings for the quarter, both in terms of cash earnings as well as mark-to-market gains. Our overall results continue to support our 2006 operating earnings guidance of $3.45 to $3.75 a share, as well as our guidance for 2007, which is $4.60 to $5 per share. Power reported operating earnings of $203 million or $0.81 per share for the quarter, $67 million or $0.26 per share above '05 results. ESEG reported operating earnings of $86 million, or $0.34 for the quarter, lower than last year's results of $115 million or $0.47 per share. Finally, holdings reported operating earnings of $101 million or $0.40 per share for the quarter, an increase of $53 million or $0.20 over last year. As I go through the three major businesses, I'll provide more insight into the changes from last year, using earnings per share as the measure. I should note that PSEG had on average about 8 million more shares outstanding for the quarter compared to last year, a result of our prior mandatory convertible security. Full quarter-to-quarter reconciliation of our operating company's results can be found on attachment 6 of the press release. Starting with PSEG Power, we continue to benefit from strong operations throughout our generation fleet, and in particular, continued improvements at our nuclear operations. During the critical summer months, our New Jersey units at Hope Creek and Salem ran at a capacity factor of nearly 100%, coupled with the strong performance at Peak’s Bottom, our nuclear operations added about $0.03 per share from the same quarter of last year. For the quarter, our nuclear operations have shown tremendous improvement. Our New Jersey units ran at a capacity factor of 95% versus 86% for the first nine months of 2005. Our five-unit fleet has a year-to-date capacity factor of 96%, a 6% improvement over last year's results of 90%. I'm also very pleased to report that Salem Unit 2 synched to the grid earlier this morning after a successful refueling outage completed in just under 21 days 10 hours, a record time for that site. Congratulations to Bill Levis, Tom Joyce and our entire team for continued good work. As you're aware, our Salem and Hope Creek units are currently run under nuclear operating services contracts with Exelon. PSEG has provided notice to Exelon that it is electing to continue the contract for two years, during which times the companies will move into a transition phase. At the same time, PSEG continues to consider a number of long-term alternatives and we expect to define our long-term strategy well before the two-year period is completed. Alternatives range from rebuilding our standalone nuclear capabilities to long-term Exelon operations that could also be accompanied by a swap in nuclear capacity. PSEG also retains the right to extend the transition phase of the contract for an additional year if it so elects. Power also saw large margin improvements as a result of higher contract prices and other market hedging activities. Given our strategy of contracting for a few years into the future, we generally see market prices impacting us on a lag basis. Higher realized prices from our forward sales contracts added $0.34 to Power's earnings for the quarter versus last year's results. One driver to this increase is the recognition of a full quarter of the 2006 BGS auction results. This auction cleared, as you know, at $102 per megawatt hour and replaced a three--year-old BGS contract that rolled off at $55 per megawatt hour. This added $0.17 per share to the third quarter results, including the seasonal effect of pricing. Year-to-date, our margins have improved by over $6 per megawatt hour versus the same period last year, an increase we expect to sustain through year end. The impact of Power's Linden generation station, which was placed in service in May of this year, resulted in a reduction of $0.06 over the third quarter of 2005. This impact predominantly reflects higher interest and depreciation costs. Also the third quarter of this year overcame the absence of nuclear decommissioning trust fund gains of $38 million that were recognized in the third quarter of last year. These prior-year gains were the result of fund restructuring and asset rebalancing. We continue to make constructive progress on an environmental resolution regarding our 600 megawatt Hudson coal-fired generation facility in Northern New Jersey. The company has been in negotiations with the EPA and the NJDEP on a proposed alternate pollution reduction plan. The plan would achieve similar emission reductions to those contemplated in a 2002 agreement and allow for the Hudson unit to continue operating on coal beyond the current December 2006 deadline. Such agreement would allow investments in pollution control facilities of approximately $400 million to $500 million to be made over the next several years. While these negotiations are ongoing, Power is hopeful that a settlement can be reached in the near future. In anticipation of such a settlement, Power has increased its environmental reserves in the third quarter by approximately $15 million or $0.06 per share to cover costs expected as a result of this potential agreement. Now turning to PSEG, for the quarter the utility was down $29 million or $0.13 per share compared to the third quarter of 2005. The absence of rate relief to offset the expiration of the excess depreciation credit was responsible for $0.04 of this decline. Weather, while above normal, was below last year's record-setting levels and resulted in a $0.03 reduction quarter over quarter. Third quarter 2006 was 9.6% above normal, while third quarter '05 was 29.8% above normal. Moderately lower usage further reduced earnings about $0.02 per share. Although PSEG was challenged during the quarter with six major summer storms with record heat that pushed electric demand to an all-time peak, it continues to perform in the top quartile in national peer panels for frequency of customer interruptions, average customer restoration time and a number of other variables. Also the quarter was affected by higher depreciation and amortization and increased O&M totaling $0.03 per share. On the regulatory front, we have reached a settlement agreement with the BPU staff and public advocate and other intervening parties on both the gas base rate case and electric distribution financial review. We caution these settlements are not final until acted upon by the BPU. We anticipate the approval and implementation of the new rates shortly. Our original gas petition was for $133 million. The settlement provides a $40 million increase in rates and a $39 million reduction in depreciation and amortization expenses resulting in $79 million of incremental margin. On the electric side, we sought to eliminate the $64 million rate credit authorized in August of 2003. The continuation of the rate credit has put pressure on PSEG's earnings this year. The settlement eliminates most of that rate credit which, with volume growth, represents additional revenues of $47 million. PSEG has agreed that these base rates would remain in effect until November of 2009. We also settled the BGSS filing that would lower residential gas bills by 6%, reflecting the lower commodity costs. Of course changes in the BGSS rates have no earnings impact to PSEG. Overall, we're pleased that we were able to lower gas residential bills by 4.4% and only increase electric bills by less than 1%. These settlements are fair, and give us the opportunity to earn an ROE of 10%, but more importantly, they reflect a regulatory climate in New Jersey that recognizes the importance of outstanding utility service to its customers while providing a fair return to investors. We're pleased that the BPU staff and the public advocate have been able to focus on these traditional issues so quickly after the demanding merger proceedings. Now finally onto Energy Holdings. As you recall, earlier this year Holdings was very successful in selling its interest in two coal-fired plants in Poland and its interest in RGE, a Brazilian electric company. These sales resulted in net proceeds of approximately $612 million, a net after-tax gain of approximately $51 million and improve the equity of Holdings by $240 million. These sales, coupled with operating cash flows, resulted in Holdings accumulating over $750 million of funds which it invested on a short-term basis with PSEG. In September, Holdings utilized these funds, returning $425 million of capital to PSEG and calling $300 million of debt for early retirement. Operating earnings for the third quarter of '06 were up sharply from the comparable period last year. The results were largely driven by our Texas generation business as the improvement in spark spreads in the Texas market continued into the third quarter. Our 2,000 megawatt plants have operated very well, able to benefit from high spark spreads available in the market. The margins achieved this year will be difficult to repeat in '07, as a result of projected lower spark spreads, planned maintenance outage and more normal weather. A recent drop in prices at the end of the third quarter led to a sizable unrealized gain for certain of our fixed price contracts that are required to be mark-to-market to earnings under the accounting rules. We have a number of contracts for delivery over the balance of the year, a portion for 2007 and one longer-term contract that runs through 2010. As prices declined at the end of the third quarter, these fixed price contracts became more valuable, leading to an unrealized gain. Holdings also reported continued lower interest expense for the quarter, driven by the redemption of debt in January and a short-term investment of cash in the asset sales for PSEG. The cost associated with the call of $300 million of notes in September totaled approximately $0.03 and were included in third quarter results. Also, Holdings had lower income taxes this quarter relative to last year, contributing approximately $0.09, largely driven by the absence of tax expenses incurred in the third quarter of 2005 in connection with the repatriation of funds under the Jobs Act. The balance of holdings businesses including resources leasing businesses, global South American distribution investments and domestic contracted generation plants, are meeting this year's expectations. That concludes my review of the business segments. I would now like to summarize the mark-to-markets earnings impact. We have experienced some meaningful mark-to-market impacts and have added schedule 11 to the earnings release which indicates that the third quarter impact to PSEG is $0.17, $0.05 and $0.12 for Power and Holdings respectively. As specified in this attachment, year-to-date PSEG has realized a benefit of $0.16 and we currently expect about one-third of that to reverse over the fourth quarter. Finally I would like to make some comments regarding our consolidated cash flow and liquidity. Through September, cash flow from operations has been very strong, generating more than $1.4 billion from operations. This represents more than $500 million of an increase versus the same period last year, which is largely driven by increased earnings at Power and reduced collateral requirements. In addition to meaningful excess cash from ops, the after-tax proceeds from the sales of assets at Holdings contributed an incremental $600 million of cash for 2006. Consistent with these factors, combined PSEG and Power have available liquidity of almost $3 billion. From a financing perspective, in April of this year we hit a maturity of $500 million at Power, and maturities totally $322 million earlier at PSEG. Through September, strong cash flow has allowed us not to refinance these maturities. From a balance sheet perspective, we have made significant improvements. At the end of 2005, our debt to capitalization as defined by our lenders was about 60%. As of September, this ratio had fallen to 53%, driven by strong earnings, collateral reductions and other equity improvements. That concludes my remarks. Just my last comment before we take questions is that we are looking forward to seeing everybody at the EI. I'm pleased to say that Ralph Izzo will be joining us for the duration of the conference and giving us his assessment of the company’s current position and prospects. As you know, Ralph has recently been promoted to President and COO of PSEG after serving as President of PSE&G for the past three years. Operator, and we can now open it up for questions.
Paul Patterson – Glenrock Associates: Good morning, guys. The mark-to-market gains, how do we model that going forward? What is the expectation in the 2007 numbers for any mark-to-market adjustments? Do you expect any of those to reverse out? What is the expectation for that, since it was a big of a driver this quarter?
Ralph Izzo: It was a bit of a driver this quarter. It does move around, I think over the long run it is expected to be zero, to be honest. If you just go back, even in the first couple of quarters, the first quarter of this year it was down $0.07; the second quarter it was positive $0.06 so halfway through the year we are basically at zero. We were $0.17 up this year, the biggest part of that was Texas. It is one of the few contracts we mark-to-market. As I said, about one-third of that is based on quarter end forward prices we expect to reverse.
Tom O'Flynn: Just in terms of our contracts, really the majority of our activities are either hedge accounting, which is not mark-to-market, or get normal purchase and sale. That is for the majority of our contracts at Power and most of our contracts at Holdings. The one major exception we have is a long-term contract we’ve got for 250 megawatts for four-and-a-half more years at Texas.
Ralph Izzo: In the long run, Paul, I think it is going to move around quarter to quarter, but as we think about our business going forward, it is a net neutral.
Paul Patterson – Glenrock Associates: Weather versus normal, you had mentioned what it was versus the year-over-year, but what is it versus normal? Do you have a rough idea of the last nine months how much weather has contributed?
Tom O'Flynn: The last nine months were below normal by about $0.12. About two-thirds of that is gas.
Paul Patterson – Glenrock Associates: So about $0.12 a share is lower than what normal weather would have brought in?
Tom O'Flynn: Yes, and that is largely gas from January/February.
Paul Patterson – Glenrock Associates: Finally, when is the settlement effective? I know you probably mentioned it, but somehow I got distracted when you were talking about it. When does the settlement become effective after the BPU rules on it?
Tom O'Flynn: The settlement has to be reviewed by the BPU, we're hopeful that can be done in the near term. We are hopeful that upon it being approved, rates would be effective very shortly thereafter. We are obviously especially sensitive and optimistic that they will become effective before the winter heating season.
Paul Patterson – Glenrock Associates: Was this expected in your 2007 guidance? Was this anticipated or something similar to this?
Tom O'Flynn: We generally anticipated getting a fair resolution of this, though this is within the range of expectations.
Paul Patterson – Glenrock Associates: Thanks a lot.
Operator: Your next question comes from Ashar Khan - SAC Capital Management.
Ashar Khan - SAC Capital Management : Good morning, Tom. Could you just go back, you had mentioned reaching debt targets at September. I was going back to the call a month ago. At what point, based on your outlook for next year, do you start having excess cash or capital return to shareholders? Where does that happen in your forecast?
Tom O'Flynn: Sure, Ashar. Just to review our debt to cap is 53%; there are different ways to look at it, but the one we look at the most consistently is how our lenders define it. We expect to have continued improvements to that. In terms of when excess cash can be used to grow the business as opposed to retire debt, if that's what you're getting to, I think that's really an ’08 question. We still want to use cash fourth quarter in '07 to continue to improve our credit profile. And as you know, it's a mixture of cash flow coverage, cash flow to debt, as well as debt to cap. So as we look at the majority of those, I think it's realistically '08 before we would have cash flow that could be used for discretionary growth of the business. That's outside. We clearly feel comfortable we have the cash flow to run the business, including some CapEx and other fundamental business requirements, but in terms of cash for additional investments or share repurchase, things like that, in my mind that's an '08 question.
Ashar Khan - SAC Capital Management: Tom, can you just mention, I don't know if could you update us on what your hedging is for the next couple of years? Where you are?
Tom O'Flynn: It's pretty consistent, at least the ranges are still within where we are. We've shown this slide before. For 2006, we're at over 95% for the remaining couple of months. For '07 we're 85% to 95%, for ‘08 we're in the 65% to 80% range. '09 would be less than 50% is probably how I would characterize it right now. As we characterize those percentages, the denominator is really our base load nuke and coal. That's the majority of our margin, that's the easiest to project. As you know, looking forward your gas generation (a) it’s less profitable and (b) the volume is a little harder to measure because it’s based on regional prices, weather and all sorts of things.
Ashar Khan - SAC Capital Management : Just going to, I don't know if Ralph or you could address it, as earnings grow huge, the next couple of years, how do you look at the dividend in respect to earnings in terms of payout? If could you give some indication as to how you would look at it?
Tom O'Flynn: Ashar, this will be the last question and then we have to move on. I think in general, we’ve shown the dividend over the last couple of years, to grow through the dividend. Clearly our financial picture is better so as we assess the dividend in conjunction with our year end financial planning process, we will look to whether we have the ability to continue our growth and whether we can do better. But other than that, it's going to be hard for us to comment. Those are things that we do in conjunction with our year end financial and business planning process that culminates in our December board meeting. Next question, please.
Operator: Your next question comes from Gerald Chung - Banc of America Securities.
Analyst for Gerald Chung - Banc of America Securities: Can you give us an update on the supply contract you have in Connecticut? I think it's supposed to reprice in '07?
Tom O'Flynn: Yes. Our contract with the utility up in Connecticut does end at the end of this year. We would, if it was signed three years ago at this time, I think I've said before, it looked like a good contract then, but it is materially below market. So as we go forward in '07 we would expect materially better profitability out of our Connecticut unit, even for its 375 megawatt coal plant, New Haven is largely RMR, that's not going to change as much. We've done some forward hedging as you might expect, but we would expect to get prices running through our income statement in January more reflective of the market.
Analyst for Gerald Chung - Banc of America Securities: Okay. So, going forward, we should expect a bit of an upside from the current Connecticut contract?
Tom O'Flynn: Yes, only because we'd expect to be earning margins that are reflective of current market conditions as opposed to very old market conditions.
Analyst for Gerald Chung - Banc of America Securities: Okay. Just one more question. Holdings has been monetizing assets quite a bit. Going forward, how should we be thinking about Holdings as a part of PSEG? Is this something that you guys are continuing to fold completely in the long term? Or is this something that we should see as a part of PSEG in the long term?
Tom O'Flynn: I think we'll continue to look for opportunities to monetize assets. I think we've shown a couple this year that have been quite beneficial for debt holders and for PSEG equity holders. That's been out there for a while. I think as we look forward, as we’ve done before, we'll assess markets, assess the fit. But we'd likely continue to seek opportunities to monetize assets. No material change in the pace of those. That's one of the things we'll look at going forward.
Analyst for Gerald Chung - Banc of America Securities: Thanks.
Operator: Your next question comes from Michael Goldenberg – Loomis Management.
Michael Goldenberg – Loomis Management: Good morning, gentlemen. I think I missed a couple of things I just wanted to confirm. Did you say on the Hudson plant capital expenditures of $400 million to $500 million?
Tom O'Flynn: Yes, That would be the environmental CapEx that I think we had in our Q last quarter, and we'll have it again.
Michael Goldenberg – Loomis Management: Has that been updated? I'm just trying to understand if it's a view that hasn’t been changed or it has been updated and you still believe it's $400 million to $500 million.
Tom O'Flynn: We still believe it. It is consistent with the number that we'll have in our Q that we expect to file later today. It was in our Q -- at least the prior Q, maybe going back a year or so -- it might have been $50 million less.
Michael Goldenberg – Loomis Management: Should a settlement not be reached, you do not plan to shut the plant off on December 31st, right? Or in fact would PJM just not allow you to?
Tom O'Flynn: That's hard to forecast. I think as I said, we are hopeful of a constructive resolution. The fact that we took a reserve of $15 million, though being a negative this quarter would be consistent with us having a reasonable expectation of getting a constructive resolution. We have just for technical reasons, we did put PJM on notice that we do not have a final resolution and, therefore, that could cause an issue in January. But that was more of a technical filing. At this point, it's hard to get into other “what ifs”.
Michael Goldenberg – Loomis Management: My other question deals with the current rate settlement you've reached -- and congrats on doing that. I wanted to ask you, you mentioned there was a depreciation credit that will come into effect or shall I say non-cash adjustments that will not affect customers that should flow through the income statement. Could you outline them?
Tom O'Flynn: The major pieces, part of our increase on the gas side of 133 requested an increase in depreciation. I think it was about $50 million. What we ended up doing was getting an increase of $40 million that would flow through and impact customers' rates. We actually decreased the depreciation or extended the useful life of the plants. The depreciation rate is less than 2%, which would suggest a fairly long life, which is certainly consistent with how we use our gas facilities. Pipes in the ground last a long time.
Michael Goldenberg – Loomis Management: So besides the $87 million increase from increase in customer rates, how much of that is going to be additional benefit from change in the depreciation?
Tom O'Flynn: There's another $39 million of non-cash expense reduction, if you will. So the total impact to our EBIT would be the $87 million plus the $39 million.
Michael Goldenberg – Loomis Management: If can you comment in general about how the rate settlement compares to expectations. Can you talk about implied earned ROE or anything in that regard?
Tom O'Flynn: No, I think what I'd say is the gas, that was a full rate case so that does contemplate a 10% ROE with the capital structure we've got, 47.5%, 48% equity so it's very consistent with our expectations, with our balance sheet. The 10% I believe is what we got in our last cash rate case which was early '02. Those are reasonable numbers. The electric, we keep on calling it a distribution financial review, it was not a full rate case. So the prior ROE of 9.75% back from August of '03 is still part of that. We were able to get 47 of the 69, I think. Our sense is there is certainly reason that we could ask for more, but it seemed like a reasonable result consistent with our general expectation of having being treated fairly over the last 100 years. We are appreciative that after a very extensive, exhaustive merger proceeding, folks were able to diligently tackle this quite promptly.
Michael Goldenberg – Loomis Management: Just so I understand, if I'm not mistaken, following the merger break-up, you said you were expecting a 10% net income growth at PSE&G into '07? And correct me if I'm wrong on that number. Is that number expected now to be the same, higher or lower?
Tom O'Flynn: It's in that range.
Michael Goldenberg – Loomis Management: But 10% is the correct number?
Tom O'Flynn: Yes. It's generally in that range. We haven't updated specifically subsidiary guidance. We’ve obviously got '07 guidance, got a growth from '07 to '08. We may, probably more towards the end of the year, update specific subsidiary guidance.
Michael Goldenberg – Loomis Management: But the rate settlement doesn't change that?
Tom O'Flynn: Correct. It's consistent with our prior expectations.
Michael Goldenberg – Loomis Management: And you are expecting the new rates to be in effect January 1st?
Tom O'Flynn: I think as I said earlier, we would hope that the BPU would be able to look at this in the near future, it's not formally docketed but we would expect it to be looked at shortly and reviewed. If approved by the BPU, we would be hopeful that rates would go into effect quite promptly. Particularly, we would like them to go into effect for gas prior to the heating season, which as I was trick-or-treating last night in my shorts, it wasn't in effect last night. But we're hoping the heating season does start soon in New Jersey.
Michael Goldenberg – Loomis Management: Thank you very much for taking the time once again, thanks.
Operator: Your next question comes from David Frank – Piqua Capital Management.
David Frank – Piqua Capital Management: Good morning. Maybe I was a little confused before. The total mark-to-market for the quarter was $0.17 or was that for the nine months?
Tom O'Flynn: That is for the quarter. For the nine months it's $0.16. It's on the attachment to the press release.
David Frank – Piqua Capital Management: So the 148 has $0.17 of end-to-end gains in there.
Tom O'Flynn: Correct.
David Frank – Piqua Capital Management: Texas spark spreads, could you tell us what the realized spark spread was for you guys in the third quarter? The average?
Tom O'Flynn: I've got it year-to-date. Generally year-to-date it's in the 19, 20 range.
David Frank – Piqua Capital Management: And in the quarter, it was something significantly higher than that, I would imagine?
Tom O'Flynn: It was, because I'm thinking year-to-date in June it was 16, 17. So it did average up during the quarter. Expectations for the year, the average in the fall it will be in the 18 range and next year, I think the forwards are in the 14, 15 range, last I saw.
David Frank – Piqua Capital Management: Thank you.
Operator: Your next question comes from Steven Huang - Citadel Investment Group.
Steven Huang - Citadel Investment Group: I wanted to just follow up with your lease portfolio. Has there been any new developments in that regard with the IRS?
Tom O'Flynn: No, there have not been any developments. We will update the rolling exposure we have in our Q, but no, there have not been any meaningful developments.
Steven Huang - Citadel Investment Group: And it continues to be something that you can't easily unwind, right? If you wanted to, to help generate some cash proceeds?
Tom O'Flynn: I'd say in general, the leasing portfolio is one we expect to be in for a long period of time. Most of the time the leases do have tax recapture if there's sale or exits at an early time. That being said, there have been some leases we bought in the secondary market that are coming to the latter part of their lives and we have had some gains. But those are generally exceptions, rather than expectations. Just as examples we had the Seminole deal that we sold and had a nice gain at the end of '05. Prior, about a year-and-a-half ago, we did have a lease out in the Midwest with one of the generation companies, that they bought us out of.
Steven Huang - Citadel Investment Group: Tom, do you have any other leases that are close to the end where the counterparty may look to buy out the leases again?
Tom O'Flynn: Some pieces here and there, there is a lease out in the Northwest that we expect to file. It will be in our Q. We expect to buy out in the mid $20 million range, something like that. It's out about two years, 08/09. But nothing, certainly on the Seminole side.
Steven Huang - Citadel Investment Group: On your Connecticut plants, following up on a previous question, when you said that you are now looking to re-contract, does that mean you do not win the latest auction?
Tom O'Flynn: I'm not sure for confidentiality we're not allowed to comment on what we did and didn't win. I would say that there's no material contract that we won such that we would feel an obligation to report it, put it that way. There's obviously forward hedging that we do but nothing of a material size that we feel it was reasonable or meaningful to an investor to report a specific contract.
Steven Huang - Citadel Investment Group: Can you remind us again under the hypothetical situation of you guys looking to split your regulated and unregulated, would you need New Jersey BPU approval?
Ralph Izzo: We generally don't believe that we do. That being said, I want to be cautious to not be providing detailed legal opinions, but we generally provide that the current structure would allow for a separation. I think we've said that is something that we would think about over the longer term but certainly it is not on the near-term action list.
Steven Huang - Citadel Investment Group: Great, thank you.
Tom O'Flynn: The near-term action list is very much in the meat and potatoes – and Ralph will address this when he is out there for a couple days -- very much meat and potatoes, getting our feet on the ground, getting fair rate for PSE&G which we seem to be close to doing; getting the operations running well which certainly Salem with their return to ops is super; and other blocking and tackling.
Steven Huang - Citadel Investment Group: Tom, one last thing. In your analyst day coming up in December, what should we be expecting for that, other than segment details? Are you guys going to help us out with longer-term guidance? What are you guys thinking about?
Tom O'Flynn: We may touch on that a little bit at the EI. We'll hopefully give folks a good update. As I said, I'll be out there, Ralph will be out there for the duration for two-and-a-half days. I'm looking forward to showing him that there's not a lot of fun and games, not a lot of time at the gambling table at these things. So we hope to give people a detailed update. We want to circle shortly after that and just make sure that the December 4th date is the right time to have our investor conference. We just had a discussion over the last couple of days as to whether that may be too close to the EI such that it might be some of the same commentary, but we'll get back to you out there.
Steven Huang - Citadel Investment Group: Okay. So at EI, you will give us the longer-term drivers?
Tom O'Flynn: Yes. At EI, we'll speak to some of the longer-term drivers and then we want to come back and add a half-day investor conference that's currently scheduled for December. We just want to think about whether if we push that off until the first couple of months of '07, whether that wouldn't just allow us to have more time between EI and provide more depth to the story. We'll update you next week.
Steven Huang - Citadel Investment Group: Okay. Sounds good.
Operator: Your next question comes from Andrew Levy – Bear Wagner Specialists.
Andrew Levy – Bear Wagner Specialists : What do you mean no gambling?
Tom O'Flynn: I can't stay up that late.
Andrew Levy – Bear Wagner Specialists : Most of my questions have been asked. But just to understand, your comments from before, I guess after the conference call that you did after the merger ended, there was probably a little bit more emotion. So it sounds like on the conference call you seemed a little bit more hot and heavy back then about possibly taking a look at breaking yourselves up. But I guess for the time being, which is probably the wise thing, is just really get the house back in order, focus on the regulatory environment, get that back in order and go from there. Is that kind of where we're at?
Ralph Izzo: I think that’s right. I think it was a combination that we perhaps discussed it more and then I think some of the subsequent reports in the press may have picked it up as suggesting it might have been more imminent. Clearly it's something that we and other companies like ourselves need to assess. But I think it's something we would look at over a longer-term basis. Certainly not an imminent question.
Andrew Levy – Bear Wagner Specialists : Just real quick, you're not 100% sure whether you would need regulatory approval from the State of New Jersey, is that up in the air? Or is that something you're pretty certain that if you wanted to do some type of transaction a year or two down the line, it would be fairly easy to do, as far as the regulatory aspect of it?
Ralph Izzo: I'd stay with where we are, Andy. We don't expect that we would need it, but I'm not in a position of giving definitive legal opinions. We think that there's the route for us to do it if we go like that.
Andrew Levy – Bear Wagner Specialists : Great. Thanks.
Tom O'Flynn: And your rates are going down, Andy both at gas and only up a little on electric. I don’t want to see any customer letter.
Andrew Levy – Bear Wagner Specialists : I hear you. Have fun this weekend.
Operator: I have no further questions at this time.
Tom O'Flynn: Okay. Thanks very much. Thanks for joining. We look forward to seeing everybody, Ralph, I and the team look forward to seeing everybody and are certainly pleased with the quarter. Earnings up, we appear poised to have a settlement at PSE&G, which is really one of our key action items coming in. We continue to have a good ops story, congrats once again to Bill Levis, Tom Joyce and the Island team for a 20 day, 10 hour refueling. See you next week.
Operator: Ladies and gentlemen, that does conclude your conference call for today. | [
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{
"speaker": "Operator",
"text": "Welcome to the Public Service Enterprise Group third quarter 2006 earnings conference call and webcast. (Operator Instructions) I would now like to turn the conference over to Mort Plawner. Please go ahead, sir."
},
{
"speaker": "Mort Plawner",
"text": "Thank you and good morning. We appreciate your listening in today, either by telephone or over our website. I will be turning the call over to Tom O'Flynn, PSEG's CFO, for a review of our third quarter results. First, I need to make a few points. We issued our earnings release this morning. In case you have not seen it, a copy is posted on our website. We expect to file our 10-Q with the SEC later today, which will contain additional information. In today's webcast, Tom will discuss our future outlook and so I must refer you to our forward-looking disclaimer. Although we believe our forecasts are based on reasonable assumptions, we can give no assurance that they will be achieved. The results or events forecast in our statements today may differ materially from actual results or events. The last word on any of our businesses is contained in the various reports we file with the SEC. As a reminder, our guidance speaks as of the date it is issued. Any confirmation or update in guidance will only be done in a public manner, generally in the form of a press release or webcast such as this. PSEG may or may not confirm or update guidance with every press release. As a matter of policy, we will not comment on guidance during any one-on-one meeting or individual phone call. In the body of our earnings release we provided a table that reconciled net income to operating earnings. We've adopted this format to improve the readability of the release and to provide the required reconciliation between the GAAP term “net income” and the non-GAAP term “operating earnings”. The attachments to the press release provide a reconciliation for each of our major businesses. Operating earnings exclude the merger-related costs and the net impact of certain asset sales during the period presented. Operating earnings is our standard for comparing 2006 results to 2005 for all our businesses. We exclude such costs so that we can better compare our current period results with prior or future periods. Finally, Tom will take your questions at the conclusion of the prepared remarks. Please limit yourself to one question and one follow-up. Thank you, I will now turn the call over to Tom."
},
{
"speaker": "Tom O'Flynn",
"text": "Thanks, Mort. Good morning, everyone. Thanks for joining us. I hope you've had a chance to review the release we put out this morning. On this call, I will briefly go over our results for the third quarter, and discuss some of the major issues. Briefly, operating earnings for PSEG were $372 million for the quarter, an increase of $93 million or $0.34 from the third quarter of last year. Can you just make sure the mic is on mute, please? We've got a little bit of speaker interference or listener interference. Operator, if you're still there?"
},
{
"speaker": "Operator",
"text": "Yes, sir."
},
{
"speaker": "Tom O'Flynn",
"text": "Can you make sure all the phones are on mute with the exception of mine?"
},
{
"speaker": "Operator",
"text": "All lines are muted, sir."
},
{
"speaker": "Tom O'Flynn",
"text": "As I said, the operating earnings for PSEG were $372 million for the quarter, an increase of $93 million, or $0.34 from the third quarter of last year. Third quarter results were strong for power and holdings and slightly off for utility. At Power, higher prices for generation output and strong operations boosted margins for the quarter. However, high depreciation and the absence of an NDT restructuring gain in the same quarter last year somewhat dampened the quarter over quarter impact. PSEG results reflect the delay of rate relief caused by merger-related issues. However, we are pleased that earlier this week we reached an agreement to settle the outstanding gas and electric cases, which will allow us the opportunity to earn a fair rate of return. I'll provide more details in a moment. For holdings, our two Texas plants provided a significant uplift in our earnings for the quarter, both in terms of cash earnings as well as mark-to-market gains. Our overall results continue to support our 2006 operating earnings guidance of $3.45 to $3.75 a share, as well as our guidance for 2007, which is $4.60 to $5 per share. Power reported operating earnings of $203 million or $0.81 per share for the quarter, $67 million or $0.26 per share above '05 results. ESEG reported operating earnings of $86 million, or $0.34 for the quarter, lower than last year's results of $115 million or $0.47 per share. Finally, holdings reported operating earnings of $101 million or $0.40 per share for the quarter, an increase of $53 million or $0.20 over last year. As I go through the three major businesses, I'll provide more insight into the changes from last year, using earnings per share as the measure. I should note that PSEG had on average about 8 million more shares outstanding for the quarter compared to last year, a result of our prior mandatory convertible security. Full quarter-to-quarter reconciliation of our operating company's results can be found on attachment 6 of the press release. Starting with PSEG Power, we continue to benefit from strong operations throughout our generation fleet, and in particular, continued improvements at our nuclear operations. During the critical summer months, our New Jersey units at Hope Creek and Salem ran at a capacity factor of nearly 100%, coupled with the strong performance at Peak’s Bottom, our nuclear operations added about $0.03 per share from the same quarter of last year. For the quarter, our nuclear operations have shown tremendous improvement. Our New Jersey units ran at a capacity factor of 95% versus 86% for the first nine months of 2005. Our five-unit fleet has a year-to-date capacity factor of 96%, a 6% improvement over last year's results of 90%. I'm also very pleased to report that Salem Unit 2 synched to the grid earlier this morning after a successful refueling outage completed in just under 21 days 10 hours, a record time for that site. Congratulations to Bill Levis, Tom Joyce and our entire team for continued good work. As you're aware, our Salem and Hope Creek units are currently run under nuclear operating services contracts with Exelon. PSEG has provided notice to Exelon that it is electing to continue the contract for two years, during which times the companies will move into a transition phase. At the same time, PSEG continues to consider a number of long-term alternatives and we expect to define our long-term strategy well before the two-year period is completed. Alternatives range from rebuilding our standalone nuclear capabilities to long-term Exelon operations that could also be accompanied by a swap in nuclear capacity. PSEG also retains the right to extend the transition phase of the contract for an additional year if it so elects. Power also saw large margin improvements as a result of higher contract prices and other market hedging activities. Given our strategy of contracting for a few years into the future, we generally see market prices impacting us on a lag basis. Higher realized prices from our forward sales contracts added $0.34 to Power's earnings for the quarter versus last year's results. One driver to this increase is the recognition of a full quarter of the 2006 BGS auction results. This auction cleared, as you know, at $102 per megawatt hour and replaced a three--year-old BGS contract that rolled off at $55 per megawatt hour. This added $0.17 per share to the third quarter results, including the seasonal effect of pricing. Year-to-date, our margins have improved by over $6 per megawatt hour versus the same period last year, an increase we expect to sustain through year end. The impact of Power's Linden generation station, which was placed in service in May of this year, resulted in a reduction of $0.06 over the third quarter of 2005. This impact predominantly reflects higher interest and depreciation costs. Also the third quarter of this year overcame the absence of nuclear decommissioning trust fund gains of $38 million that were recognized in the third quarter of last year. These prior-year gains were the result of fund restructuring and asset rebalancing. We continue to make constructive progress on an environmental resolution regarding our 600 megawatt Hudson coal-fired generation facility in Northern New Jersey. The company has been in negotiations with the EPA and the NJDEP on a proposed alternate pollution reduction plan. The plan would achieve similar emission reductions to those contemplated in a 2002 agreement and allow for the Hudson unit to continue operating on coal beyond the current December 2006 deadline. Such agreement would allow investments in pollution control facilities of approximately $400 million to $500 million to be made over the next several years. While these negotiations are ongoing, Power is hopeful that a settlement can be reached in the near future. In anticipation of such a settlement, Power has increased its environmental reserves in the third quarter by approximately $15 million or $0.06 per share to cover costs expected as a result of this potential agreement. Now turning to PSEG, for the quarter the utility was down $29 million or $0.13 per share compared to the third quarter of 2005. The absence of rate relief to offset the expiration of the excess depreciation credit was responsible for $0.04 of this decline. Weather, while above normal, was below last year's record-setting levels and resulted in a $0.03 reduction quarter over quarter. Third quarter 2006 was 9.6% above normal, while third quarter '05 was 29.8% above normal. Moderately lower usage further reduced earnings about $0.02 per share. Although PSEG was challenged during the quarter with six major summer storms with record heat that pushed electric demand to an all-time peak, it continues to perform in the top quartile in national peer panels for frequency of customer interruptions, average customer restoration time and a number of other variables. Also the quarter was affected by higher depreciation and amortization and increased O&M totaling $0.03 per share. On the regulatory front, we have reached a settlement agreement with the BPU staff and public advocate and other intervening parties on both the gas base rate case and electric distribution financial review. We caution these settlements are not final until acted upon by the BPU. We anticipate the approval and implementation of the new rates shortly. Our original gas petition was for $133 million. The settlement provides a $40 million increase in rates and a $39 million reduction in depreciation and amortization expenses resulting in $79 million of incremental margin. On the electric side, we sought to eliminate the $64 million rate credit authorized in August of 2003. The continuation of the rate credit has put pressure on PSEG's earnings this year. The settlement eliminates most of that rate credit which, with volume growth, represents additional revenues of $47 million. PSEG has agreed that these base rates would remain in effect until November of 2009. We also settled the BGSS filing that would lower residential gas bills by 6%, reflecting the lower commodity costs. Of course changes in the BGSS rates have no earnings impact to PSEG. Overall, we're pleased that we were able to lower gas residential bills by 4.4% and only increase electric bills by less than 1%. These settlements are fair, and give us the opportunity to earn an ROE of 10%, but more importantly, they reflect a regulatory climate in New Jersey that recognizes the importance of outstanding utility service to its customers while providing a fair return to investors. We're pleased that the BPU staff and the public advocate have been able to focus on these traditional issues so quickly after the demanding merger proceedings. Now finally onto Energy Holdings. As you recall, earlier this year Holdings was very successful in selling its interest in two coal-fired plants in Poland and its interest in RGE, a Brazilian electric company. These sales resulted in net proceeds of approximately $612 million, a net after-tax gain of approximately $51 million and improve the equity of Holdings by $240 million. These sales, coupled with operating cash flows, resulted in Holdings accumulating over $750 million of funds which it invested on a short-term basis with PSEG. In September, Holdings utilized these funds, returning $425 million of capital to PSEG and calling $300 million of debt for early retirement. Operating earnings for the third quarter of '06 were up sharply from the comparable period last year. The results were largely driven by our Texas generation business as the improvement in spark spreads in the Texas market continued into the third quarter. Our 2,000 megawatt plants have operated very well, able to benefit from high spark spreads available in the market. The margins achieved this year will be difficult to repeat in '07, as a result of projected lower spark spreads, planned maintenance outage and more normal weather. A recent drop in prices at the end of the third quarter led to a sizable unrealized gain for certain of our fixed price contracts that are required to be mark-to-market to earnings under the accounting rules. We have a number of contracts for delivery over the balance of the year, a portion for 2007 and one longer-term contract that runs through 2010. As prices declined at the end of the third quarter, these fixed price contracts became more valuable, leading to an unrealized gain. Holdings also reported continued lower interest expense for the quarter, driven by the redemption of debt in January and a short-term investment of cash in the asset sales for PSEG. The cost associated with the call of $300 million of notes in September totaled approximately $0.03 and were included in third quarter results. Also, Holdings had lower income taxes this quarter relative to last year, contributing approximately $0.09, largely driven by the absence of tax expenses incurred in the third quarter of 2005 in connection with the repatriation of funds under the Jobs Act. The balance of holdings businesses including resources leasing businesses, global South American distribution investments and domestic contracted generation plants, are meeting this year's expectations. That concludes my review of the business segments. I would now like to summarize the mark-to-markets earnings impact. We have experienced some meaningful mark-to-market impacts and have added schedule 11 to the earnings release which indicates that the third quarter impact to PSEG is $0.17, $0.05 and $0.12 for Power and Holdings respectively. As specified in this attachment, year-to-date PSEG has realized a benefit of $0.16 and we currently expect about one-third of that to reverse over the fourth quarter. Finally I would like to make some comments regarding our consolidated cash flow and liquidity. Through September, cash flow from operations has been very strong, generating more than $1.4 billion from operations. This represents more than $500 million of an increase versus the same period last year, which is largely driven by increased earnings at Power and reduced collateral requirements. In addition to meaningful excess cash from ops, the after-tax proceeds from the sales of assets at Holdings contributed an incremental $600 million of cash for 2006. Consistent with these factors, combined PSEG and Power have available liquidity of almost $3 billion. From a financing perspective, in April of this year we hit a maturity of $500 million at Power, and maturities totally $322 million earlier at PSEG. Through September, strong cash flow has allowed us not to refinance these maturities. From a balance sheet perspective, we have made significant improvements. At the end of 2005, our debt to capitalization as defined by our lenders was about 60%. As of September, this ratio had fallen to 53%, driven by strong earnings, collateral reductions and other equity improvements. That concludes my remarks. Just my last comment before we take questions is that we are looking forward to seeing everybody at the EI. I'm pleased to say that Ralph Izzo will be joining us for the duration of the conference and giving us his assessment of the company’s current position and prospects. As you know, Ralph has recently been promoted to President and COO of PSEG after serving as President of PSE&G for the past three years. Operator, and we can now open it up for questions."
},
{
"speaker": "Paul Patterson – Glenrock Associates",
"text": "Good morning, guys. The mark-to-market gains, how do we model that going forward? What is the expectation in the 2007 numbers for any mark-to-market adjustments? Do you expect any of those to reverse out? What is the expectation for that, since it was a big of a driver this quarter?"
},
{
"speaker": "Ralph Izzo",
"text": "It was a bit of a driver this quarter. It does move around, I think over the long run it is expected to be zero, to be honest. If you just go back, even in the first couple of quarters, the first quarter of this year it was down $0.07; the second quarter it was positive $0.06 so halfway through the year we are basically at zero. We were $0.17 up this year, the biggest part of that was Texas. It is one of the few contracts we mark-to-market. As I said, about one-third of that is based on quarter end forward prices we expect to reverse."
},
{
"speaker": "Tom O'Flynn",
"text": "Just in terms of our contracts, really the majority of our activities are either hedge accounting, which is not mark-to-market, or get normal purchase and sale. That is for the majority of our contracts at Power and most of our contracts at Holdings. The one major exception we have is a long-term contract we’ve got for 250 megawatts for four-and-a-half more years at Texas."
},
{
"speaker": "Ralph Izzo",
"text": "In the long run, Paul, I think it is going to move around quarter to quarter, but as we think about our business going forward, it is a net neutral."
},
{
"speaker": "Paul Patterson – Glenrock Associates",
"text": "Weather versus normal, you had mentioned what it was versus the year-over-year, but what is it versus normal? Do you have a rough idea of the last nine months how much weather has contributed?"
},
{
"speaker": "Tom O'Flynn",
"text": "The last nine months were below normal by about $0.12. About two-thirds of that is gas."
},
{
"speaker": "Paul Patterson – Glenrock Associates",
"text": "So about $0.12 a share is lower than what normal weather would have brought in?"
},
{
"speaker": "Tom O'Flynn",
"text": "Yes, and that is largely gas from January/February."
},
{
"speaker": "Paul Patterson – Glenrock Associates",
"text": "Finally, when is the settlement effective? I know you probably mentioned it, but somehow I got distracted when you were talking about it. When does the settlement become effective after the BPU rules on it?"
},
{
"speaker": "Tom O'Flynn",
"text": "The settlement has to be reviewed by the BPU, we're hopeful that can be done in the near term. We are hopeful that upon it being approved, rates would be effective very shortly thereafter. We are obviously especially sensitive and optimistic that they will become effective before the winter heating season."
},
{
"speaker": "Paul Patterson – Glenrock Associates",
"text": "Was this expected in your 2007 guidance? Was this anticipated or something similar to this?"
},
{
"speaker": "Tom O'Flynn",
"text": "We generally anticipated getting a fair resolution of this, though this is within the range of expectations."
},
{
"speaker": "Paul Patterson – Glenrock Associates",
"text": "Thanks a lot."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ashar Khan - SAC Capital Management."
},
{
"speaker": "Ashar Khan - SAC Capital Management",
"text": "Good morning, Tom. Could you just go back, you had mentioned reaching debt targets at September. I was going back to the call a month ago. At what point, based on your outlook for next year, do you start having excess cash or capital return to shareholders? Where does that happen in your forecast?"
},
{
"speaker": "Tom O'Flynn",
"text": "Sure, Ashar. Just to review our debt to cap is 53%; there are different ways to look at it, but the one we look at the most consistently is how our lenders define it. We expect to have continued improvements to that. In terms of when excess cash can be used to grow the business as opposed to retire debt, if that's what you're getting to, I think that's really an ’08 question. We still want to use cash fourth quarter in '07 to continue to improve our credit profile. And as you know, it's a mixture of cash flow coverage, cash flow to debt, as well as debt to cap. So as we look at the majority of those, I think it's realistically '08 before we would have cash flow that could be used for discretionary growth of the business. That's outside. We clearly feel comfortable we have the cash flow to run the business, including some CapEx and other fundamental business requirements, but in terms of cash for additional investments or share repurchase, things like that, in my mind that's an '08 question."
},
{
"speaker": "Ashar Khan - SAC Capital Management",
"text": "Tom, can you just mention, I don't know if could you update us on what your hedging is for the next couple of years? Where you are?"
},
{
"speaker": "Tom O'Flynn",
"text": "It's pretty consistent, at least the ranges are still within where we are. We've shown this slide before. For 2006, we're at over 95% for the remaining couple of months. For '07 we're 85% to 95%, for ‘08 we're in the 65% to 80% range. '09 would be less than 50% is probably how I would characterize it right now. As we characterize those percentages, the denominator is really our base load nuke and coal. That's the majority of our margin, that's the easiest to project. As you know, looking forward your gas generation (a) it’s less profitable and (b) the volume is a little harder to measure because it’s based on regional prices, weather and all sorts of things."
},
{
"speaker": "Ashar Khan - SAC Capital Management",
"text": "Just going to, I don't know if Ralph or you could address it, as earnings grow huge, the next couple of years, how do you look at the dividend in respect to earnings in terms of payout? If could you give some indication as to how you would look at it?"
},
{
"speaker": "Tom O'Flynn",
"text": "Ashar, this will be the last question and then we have to move on. I think in general, we’ve shown the dividend over the last couple of years, to grow through the dividend. Clearly our financial picture is better so as we assess the dividend in conjunction with our year end financial planning process, we will look to whether we have the ability to continue our growth and whether we can do better. But other than that, it's going to be hard for us to comment. Those are things that we do in conjunction with our year end financial and business planning process that culminates in our December board meeting. Next question, please."
},
{
"speaker": "Operator",
"text": "Your next question comes from Gerald Chung - Banc of America Securities."
},
{
"speaker": "Analyst for Gerald Chung - Banc of America Securities",
"text": "Can you give us an update on the supply contract you have in Connecticut? I think it's supposed to reprice in '07?"
},
{
"speaker": "Tom O'Flynn",
"text": "Yes. Our contract with the utility up in Connecticut does end at the end of this year. We would, if it was signed three years ago at this time, I think I've said before, it looked like a good contract then, but it is materially below market. So as we go forward in '07 we would expect materially better profitability out of our Connecticut unit, even for its 375 megawatt coal plant, New Haven is largely RMR, that's not going to change as much. We've done some forward hedging as you might expect, but we would expect to get prices running through our income statement in January more reflective of the market."
},
{
"speaker": "Analyst for Gerald Chung - Banc of America Securities",
"text": "Okay. So, going forward, we should expect a bit of an upside from the current Connecticut contract?"
},
{
"speaker": "Tom O'Flynn",
"text": "Yes, only because we'd expect to be earning margins that are reflective of current market conditions as opposed to very old market conditions."
},
{
"speaker": "Analyst for Gerald Chung - Banc of America Securities",
"text": "Okay. Just one more question. Holdings has been monetizing assets quite a bit. Going forward, how should we be thinking about Holdings as a part of PSEG? Is this something that you guys are continuing to fold completely in the long term? Or is this something that we should see as a part of PSEG in the long term?"
},
{
"speaker": "Tom O'Flynn",
"text": "I think we'll continue to look for opportunities to monetize assets. I think we've shown a couple this year that have been quite beneficial for debt holders and for PSEG equity holders. That's been out there for a while. I think as we look forward, as we’ve done before, we'll assess markets, assess the fit. But we'd likely continue to seek opportunities to monetize assets. No material change in the pace of those. That's one of the things we'll look at going forward."
},
{
"speaker": "Analyst for Gerald Chung - Banc of America Securities",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from Michael Goldenberg – Loomis Management."
},
{
"speaker": "Michael Goldenberg – Loomis Management",
"text": "Good morning, gentlemen. I think I missed a couple of things I just wanted to confirm. Did you say on the Hudson plant capital expenditures of $400 million to $500 million?"
},
{
"speaker": "Tom O'Flynn",
"text": "Yes, That would be the environmental CapEx that I think we had in our Q last quarter, and we'll have it again."
},
{
"speaker": "Michael Goldenberg – Loomis Management",
"text": "Has that been updated? I'm just trying to understand if it's a view that hasn’t been changed or it has been updated and you still believe it's $400 million to $500 million."
},
{
"speaker": "Tom O'Flynn",
"text": "We still believe it. It is consistent with the number that we'll have in our Q that we expect to file later today. It was in our Q -- at least the prior Q, maybe going back a year or so -- it might have been $50 million less."
},
{
"speaker": "Michael Goldenberg – Loomis Management",
"text": "Should a settlement not be reached, you do not plan to shut the plant off on December 31st, right? Or in fact would PJM just not allow you to?"
},
{
"speaker": "Tom O'Flynn",
"text": "That's hard to forecast. I think as I said, we are hopeful of a constructive resolution. The fact that we took a reserve of $15 million, though being a negative this quarter would be consistent with us having a reasonable expectation of getting a constructive resolution. We have just for technical reasons, we did put PJM on notice that we do not have a final resolution and, therefore, that could cause an issue in January. But that was more of a technical filing. At this point, it's hard to get into other “what ifs”."
},
{
"speaker": "Michael Goldenberg – Loomis Management",
"text": "My other question deals with the current rate settlement you've reached -- and congrats on doing that. I wanted to ask you, you mentioned there was a depreciation credit that will come into effect or shall I say non-cash adjustments that will not affect customers that should flow through the income statement. Could you outline them?"
},
{
"speaker": "Tom O'Flynn",
"text": "The major pieces, part of our increase on the gas side of 133 requested an increase in depreciation. I think it was about $50 million. What we ended up doing was getting an increase of $40 million that would flow through and impact customers' rates. We actually decreased the depreciation or extended the useful life of the plants. The depreciation rate is less than 2%, which would suggest a fairly long life, which is certainly consistent with how we use our gas facilities. Pipes in the ground last a long time."
},
{
"speaker": "Michael Goldenberg – Loomis Management",
"text": "So besides the $87 million increase from increase in customer rates, how much of that is going to be additional benefit from change in the depreciation?"
},
{
"speaker": "Tom O'Flynn",
"text": "There's another $39 million of non-cash expense reduction, if you will. So the total impact to our EBIT would be the $87 million plus the $39 million."
},
{
"speaker": "Michael Goldenberg – Loomis Management",
"text": "If can you comment in general about how the rate settlement compares to expectations. Can you talk about implied earned ROE or anything in that regard?"
},
{
"speaker": "Tom O'Flynn",
"text": "No, I think what I'd say is the gas, that was a full rate case so that does contemplate a 10% ROE with the capital structure we've got, 47.5%, 48% equity so it's very consistent with our expectations, with our balance sheet. The 10% I believe is what we got in our last cash rate case which was early '02. Those are reasonable numbers. The electric, we keep on calling it a distribution financial review, it was not a full rate case. So the prior ROE of 9.75% back from August of '03 is still part of that. We were able to get 47 of the 69, I think. Our sense is there is certainly reason that we could ask for more, but it seemed like a reasonable result consistent with our general expectation of having being treated fairly over the last 100 years. We are appreciative that after a very extensive, exhaustive merger proceeding, folks were able to diligently tackle this quite promptly."
},
{
"speaker": "Michael Goldenberg – Loomis Management",
"text": "Just so I understand, if I'm not mistaken, following the merger break-up, you said you were expecting a 10% net income growth at PSE&G into '07? And correct me if I'm wrong on that number. Is that number expected now to be the same, higher or lower?"
},
{
"speaker": "Tom O'Flynn",
"text": "It's in that range."
},
{
"speaker": "Michael Goldenberg – Loomis Management",
"text": "But 10% is the correct number?"
},
{
"speaker": "Tom O'Flynn",
"text": "Yes. It's generally in that range. We haven't updated specifically subsidiary guidance. We’ve obviously got '07 guidance, got a growth from '07 to '08. We may, probably more towards the end of the year, update specific subsidiary guidance."
},
{
"speaker": "Michael Goldenberg – Loomis Management",
"text": "But the rate settlement doesn't change that?"
},
{
"speaker": "Tom O'Flynn",
"text": "Correct. It's consistent with our prior expectations."
},
{
"speaker": "Michael Goldenberg – Loomis Management",
"text": "And you are expecting the new rates to be in effect January 1st?"
},
{
"speaker": "Tom O'Flynn",
"text": "I think as I said earlier, we would hope that the BPU would be able to look at this in the near future, it's not formally docketed but we would expect it to be looked at shortly and reviewed. If approved by the BPU, we would be hopeful that rates would go into effect quite promptly. Particularly, we would like them to go into effect for gas prior to the heating season, which as I was trick-or-treating last night in my shorts, it wasn't in effect last night. But we're hoping the heating season does start soon in New Jersey."
},
{
"speaker": "Michael Goldenberg – Loomis Management",
"text": "Thank you very much for taking the time once again, thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from David Frank – Piqua Capital Management."
},
{
"speaker": "David Frank – Piqua Capital Management",
"text": "Good morning. Maybe I was a little confused before. The total mark-to-market for the quarter was $0.17 or was that for the nine months?"
},
{
"speaker": "Tom O'Flynn",
"text": "That is for the quarter. For the nine months it's $0.16. It's on the attachment to the press release."
},
{
"speaker": "David Frank – Piqua Capital Management",
"text": "So the 148 has $0.17 of end-to-end gains in there."
},
{
"speaker": "Tom O'Flynn",
"text": "Correct."
},
{
"speaker": "David Frank – Piqua Capital Management",
"text": "Texas spark spreads, could you tell us what the realized spark spread was for you guys in the third quarter? The average?"
},
{
"speaker": "Tom O'Flynn",
"text": "I've got it year-to-date. Generally year-to-date it's in the 19, 20 range."
},
{
"speaker": "David Frank – Piqua Capital Management",
"text": "And in the quarter, it was something significantly higher than that, I would imagine?"
},
{
"speaker": "Tom O'Flynn",
"text": "It was, because I'm thinking year-to-date in June it was 16, 17. So it did average up during the quarter. Expectations for the year, the average in the fall it will be in the 18 range and next year, I think the forwards are in the 14, 15 range, last I saw."
},
{
"speaker": "David Frank – Piqua Capital Management",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Steven Huang - Citadel Investment Group."
},
{
"speaker": "Steven Huang - Citadel Investment Group",
"text": "I wanted to just follow up with your lease portfolio. Has there been any new developments in that regard with the IRS?"
},
{
"speaker": "Tom O'Flynn",
"text": "No, there have not been any developments. We will update the rolling exposure we have in our Q, but no, there have not been any meaningful developments."
},
{
"speaker": "Steven Huang - Citadel Investment Group",
"text": "And it continues to be something that you can't easily unwind, right? If you wanted to, to help generate some cash proceeds?"
},
{
"speaker": "Tom O'Flynn",
"text": "I'd say in general, the leasing portfolio is one we expect to be in for a long period of time. Most of the time the leases do have tax recapture if there's sale or exits at an early time. That being said, there have been some leases we bought in the secondary market that are coming to the latter part of their lives and we have had some gains. But those are generally exceptions, rather than expectations. Just as examples we had the Seminole deal that we sold and had a nice gain at the end of '05. Prior, about a year-and-a-half ago, we did have a lease out in the Midwest with one of the generation companies, that they bought us out of."
},
{
"speaker": "Steven Huang - Citadel Investment Group",
"text": "Tom, do you have any other leases that are close to the end where the counterparty may look to buy out the leases again?"
},
{
"speaker": "Tom O'Flynn",
"text": "Some pieces here and there, there is a lease out in the Northwest that we expect to file. It will be in our Q. We expect to buy out in the mid $20 million range, something like that. It's out about two years, 08/09. But nothing, certainly on the Seminole side."
},
{
"speaker": "Steven Huang - Citadel Investment Group",
"text": "On your Connecticut plants, following up on a previous question, when you said that you are now looking to re-contract, does that mean you do not win the latest auction?"
},
{
"speaker": "Tom O'Flynn",
"text": "I'm not sure for confidentiality we're not allowed to comment on what we did and didn't win. I would say that there's no material contract that we won such that we would feel an obligation to report it, put it that way. There's obviously forward hedging that we do but nothing of a material size that we feel it was reasonable or meaningful to an investor to report a specific contract."
},
{
"speaker": "Steven Huang - Citadel Investment Group",
"text": "Can you remind us again under the hypothetical situation of you guys looking to split your regulated and unregulated, would you need New Jersey BPU approval?"
},
{
"speaker": "Ralph Izzo",
"text": "We generally don't believe that we do. That being said, I want to be cautious to not be providing detailed legal opinions, but we generally provide that the current structure would allow for a separation. I think we've said that is something that we would think about over the longer term but certainly it is not on the near-term action list."
},
{
"speaker": "Steven Huang - Citadel Investment Group",
"text": "Great, thank you."
},
{
"speaker": "Tom O'Flynn",
"text": "The near-term action list is very much in the meat and potatoes – and Ralph will address this when he is out there for a couple days -- very much meat and potatoes, getting our feet on the ground, getting fair rate for PSE&G which we seem to be close to doing; getting the operations running well which certainly Salem with their return to ops is super; and other blocking and tackling."
},
{
"speaker": "Steven Huang - Citadel Investment Group",
"text": "Tom, one last thing. In your analyst day coming up in December, what should we be expecting for that, other than segment details? Are you guys going to help us out with longer-term guidance? What are you guys thinking about?"
},
{
"speaker": "Tom O'Flynn",
"text": "We may touch on that a little bit at the EI. We'll hopefully give folks a good update. As I said, I'll be out there, Ralph will be out there for the duration for two-and-a-half days. I'm looking forward to showing him that there's not a lot of fun and games, not a lot of time at the gambling table at these things. So we hope to give people a detailed update. We want to circle shortly after that and just make sure that the December 4th date is the right time to have our investor conference. We just had a discussion over the last couple of days as to whether that may be too close to the EI such that it might be some of the same commentary, but we'll get back to you out there."
},
{
"speaker": "Steven Huang - Citadel Investment Group",
"text": "Okay. So at EI, you will give us the longer-term drivers?"
},
{
"speaker": "Tom O'Flynn",
"text": "Yes. At EI, we'll speak to some of the longer-term drivers and then we want to come back and add a half-day investor conference that's currently scheduled for December. We just want to think about whether if we push that off until the first couple of months of '07, whether that wouldn't just allow us to have more time between EI and provide more depth to the story. We'll update you next week."
},
{
"speaker": "Steven Huang - Citadel Investment Group",
"text": "Okay. Sounds good."
},
{
"speaker": "Operator",
"text": "Your next question comes from Andrew Levy – Bear Wagner Specialists."
},
{
"speaker": "Andrew Levy – Bear Wagner Specialists",
"text": "What do you mean no gambling?"
},
{
"speaker": "Tom O'Flynn",
"text": "I can't stay up that late."
},
{
"speaker": "Andrew Levy – Bear Wagner Specialists",
"text": "Most of my questions have been asked. But just to understand, your comments from before, I guess after the conference call that you did after the merger ended, there was probably a little bit more emotion. So it sounds like on the conference call you seemed a little bit more hot and heavy back then about possibly taking a look at breaking yourselves up. But I guess for the time being, which is probably the wise thing, is just really get the house back in order, focus on the regulatory environment, get that back in order and go from there. Is that kind of where we're at?"
},
{
"speaker": "Ralph Izzo",
"text": "I think that’s right. I think it was a combination that we perhaps discussed it more and then I think some of the subsequent reports in the press may have picked it up as suggesting it might have been more imminent. Clearly it's something that we and other companies like ourselves need to assess. But I think it's something we would look at over a longer-term basis. Certainly not an imminent question."
},
{
"speaker": "Andrew Levy – Bear Wagner Specialists",
"text": "Just real quick, you're not 100% sure whether you would need regulatory approval from the State of New Jersey, is that up in the air? Or is that something you're pretty certain that if you wanted to do some type of transaction a year or two down the line, it would be fairly easy to do, as far as the regulatory aspect of it?"
},
{
"speaker": "Ralph Izzo",
"text": "I'd stay with where we are, Andy. We don't expect that we would need it, but I'm not in a position of giving definitive legal opinions. We think that there's the route for us to do it if we go like that."
},
{
"speaker": "Andrew Levy – Bear Wagner Specialists",
"text": "Great. Thanks."
},
{
"speaker": "Tom O'Flynn",
"text": "And your rates are going down, Andy both at gas and only up a little on electric. I don’t want to see any customer letter."
},
{
"speaker": "Andrew Levy – Bear Wagner Specialists",
"text": "I hear you. Have fun this weekend."
},
{
"speaker": "Operator",
"text": "I have no further questions at this time."
},
{
"speaker": "Tom O'Flynn",
"text": "Okay. Thanks very much. Thanks for joining. We look forward to seeing everybody, Ralph, I and the team look forward to seeing everybody and are certainly pleased with the quarter. Earnings up, we appear poised to have a settlement at PSE&G, which is really one of our key action items coming in. We continue to have a good ops story, congrats once again to Bill Levis, Tom Joyce and the Island team for a 20 day, 10 hour refueling. See you next week."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, that does conclude your conference call for today."
}
] | null | null |
PEG | 2 | 2,006 | 2006-08-01 09:45:00 | Executives: Sue Carson - IR Tom O'Flynn - CFO Jim Ferland - CEO
Analysts: Paul Fremont - Jeffries & Co. Ed Kressler - Angelo Gordon & Company Louis Sarkes - Chesapeake Partners Ashar Khan - SAC Capital Clark Orsky - KDP Investments
Operator: Ladies and gentlemen, thank you for standing by. Welcome to the Public Service Enterprise Group second quarter 2006 earnings call. (Operator Instructions). I would now like to turn the conference over to Sue Carson, Director of Investor Relations. Please go ahead, ma'am.
Sue Carson: Thank you and good morning. We appreciate your listening in today either by telephone or over our website. I will be turning the call over to Tom O'Flynn, PSEG's Chief Financial Officer, for a review of our second quarter 2006 results. Jim Ferland will then join us to discuss the status of our pending merger with Exelon. But first, I need to make a few quick points. We issued our earnings release this morning. In case you have not seen it, a copy is posted on our website, www.pseg.com. We expect to file our 10-Q with the Securities and Exchange Commission shortly, which will contain additional information. In today's webcast, Tom will discuss our future outlook in his remarks and so I must refer you to our forward-looking disclaimer. Although we believe that our expectations are based on reasonable assumptions, we can give no assurance they will be achieved. The results or events forecast in our statements may differ materially from actual results or events. The last word on any of our businesses is contained in the various reports that we file with the SEC. As a reminder, our guidance speaks as of the data it is issued. Any confirmation or update in guidance will only be done in a public manner, generally in the form of a press release, a webcast such as this or an 8-K or other SEC filing. PSEG may or may not confirm or update guidance with every press release. As a matter of corporate policy, we do not comment on questions regarding guidance during one-on-one meetings or individual phone calls. In the body of our earnings release, we've provided a table that reconciles net income to operating earnings. We have adopted this format to improve the readability of the release and provide the required reconciliation between the GAAP term “net income” and the non-GAAP term “operating earnings”. The attachments to the press release provide the required reconciliation for each of our major businesses. Operating earnings exclude merger-related costs and the net impact of our various asset sales during the period presented. Operating earnings is our standard for comparing 2006 results to 2005 for all of our businesses. We exclude such costs so that we can better compare our current period results with future and prior periods. By excluding the merger-related costs, our results in the guidance are consistent with the way Exelon is treating their merger-related costs. Finally, Tom and Jim will take your questions at the conclusion of the prepared remarks. In order to accomplish this call effectively, we would appreciate it if you'd limit yourself to one question and one follow up. Thank you, and I will now turn it over to Tom.
Tom O’Flynn: Thanks, Sue. Good morning everyone, thanks for joining us today. I hope you have had a chance to review our release of this morning. On this call, I will briefly go over our results for the second quarter, review our expectations for the remainder of the year and then I'll turn it over to Jim Ferland to discuss the current status of our pending merger with Exelon. Briefly, operating earnings for PSEG were $166 million for the quarter, an increase of $62 million or $0.23 from the second quarter of last year. Results for the second quarter exclude $3 million of after-tax merger-related costs, a net gain of $51 million from the sales of Global’s assets in Poland and Brazil, and $5 million of losses from operations in Poland. Second quarter results were mixed for our three operating companies: Our overall results continue to support our 2006 operating earnings guidance of $3.45 to $3.75 a share. As always, our guidance does not contemplate the impact of mark-to-market accounting, asset sales and related costs or merger costs. We've updated our expectations for PSE&G and Energy Holdings, which offset each other. I will walk through the details as I go through each company's results. Just a reminder that the full year 2006 guidance for PSEG is unchanged. While on the expected closing of our merger with Exelon, all results would obviously be integrated into Exelon Electric & Gas. Jim will have additional comments on the merger in a few minutes. PSE&G, our regulated utility, reported operating earnings of $34 million or $0.13 for the quarter over 30% lower than last year’s result of $48 million or $0.20 per share. Power reported operating earnings of $78 million, or $0.31 per share for the quarter, $15 million or $0.05 per share above 2005 results. Finally, Holdings reported operating earnings of $72 million, or $0.29 per share for the quarter, an increase of $61 million, or $0.24 over last year. As I go through the three major businesses, I will provide more insight into the changes from last year using earnings per share as the metric. As an aside, PSEG had an average of about 9 million more shares outstanding for the quarter as compared to last year, the result of our prior convertible security. Starting now with PSE&G, for the quarter, the utility was down $14 million, or $0.07 per share compared to second quarter of '05. The absence of rate relief to offset the expiration for the excess depreciation credit was responsible for $0.04 of this decline. Mild weather resulted in a $0.03 reduction year-over-year. Increased transmission revenues, result of higher peak usage in 2005, added another of another $0.02 to earnings. Transmission tariffs are set based on the highest peak load during the prior calendar year, so we will continue to see some benefit from the 2005 peak all year. Offsetting the benefit of the higher transmission revenues was higher O&M expenses of $0.02. The increase is related mostly to higher labor and benefit costs, something we expect to see over the remainder of the year. We continue to work with the BPU on our gas base rate filing we made last September supporting a 3.8% increase in the gas distribution rate. The earnings are scheduled to end in mid-August and we expect to file briefs and begin settlement discussions shortly thereafter. We're moving on a schedule that would allow for rate relief late in the year or early next year. This is clearly subject to change based on our merger settlement discussions. We continued to experience disappointing returns from our gas business and we clearly need this rate relief. Some of the reduced earnings have been due to mild weather earlier this year, but we've also seen reduced usage stemming from customers' price sensitivity. Our trailing 12-month return on equity for the gas business is less than 4%, far below the 10% allowed in our last rate case. Continuing on the regulatory front, as part of the settlement of our 2003 electric base rate case, $64 million excess depreciation credit was established. This credit expired on December 31, 2005. PSE&G has made all the filings required by the settlement and provided requested updates. Year-to-date, this has reduced PSE&G's after-tax earnings by almost $20 million compared to 2005. As Jim will outline, this case is now part of our merger settlement discussions. As a result of these delays, we are reducing our 2006 operating earnings range for PSE&G by another $20 million. As you may recall, we reduced the range by $45 million when we reported first quarter results. The revised range for the utility is $250 million to $270 million for 2006. By way of comparison, 2005 earnings for PSE&G were $347 million. A summary of the various impacts of PSE&G that resulted in a $0.07 decline in earnings for the quarter can be found in attachment 6 of the release. For PSEG Power, we continue to see operational improvements for both our fossil and nuclear fleets. Hope Creek entered a refueling outage on April 7 and returned to service 29 days later on May 6. This was a significant accomplishment in light of the considerable outage scope that was planned. In addition to the standard refueling process, the team at Hope Creek replaced a large number of control rod drive mechanisms, the B recirc pump shaft and motor and inspected the high-pressure turbine. All these activities, as well as many others, are focused on improving the material condition of the plant were done while setting site records in multiple areas, including safety. For the quarter, the three New Jersey units had a capacity factor of 90%, including the scheduled Hope Creek refueling outage. This compares to a capacity factor of 79% last year, which included the sale on two refueling and vessel head replacements. Without the Hope Creek outage, all units ran at 100% for the quarter. For the full five unit fleets, the quarterly capacity factor was 90% versus 86% for the second quarter of last year. The ongoing improvements at our nuclear operations continue to benefit the financial results for Power. This second quarter, the increased nuclear output added about $0.04 in margin compared to last year. In addition to the strong performance of the nuclear fleet, we continue to see improved performance in the operations of our fossil fleet. Both quarterly and year-to-date output is higher for the fleet, while the forced outage rate for the core fleet was 20% below the three-year average. The increased output from our fossil and nuclear fleet yielded incremental margins for Power. In addition, we realized higher prices from forward sales contracts and spot market sales compared to our older, lower-priced positions. Overall, better plant performance and market activities increased margins by $0.18 over comparable results for the second quarter of last year. The majority of this benefit, about two-thirds, resulted from general portfolio management activities in the forward markets and the remainder came from the improved pricing of the new BGS tranches. For the balance of the year, we expect to continue to see benefits from these improved margins. O&M expenses at Power for the quarter were $0.06 higher than last year; $0.04 from nuclear, $0.02 from fossil, both of which were expected. Last year when Salem 2 had the refueling outage and replaced the reactor vessel head, Power bore only 57% of the total cost because of our co-ownership of the unit with Exelon. This year, the Hope Creek outage was top both in terms of duration and cost. However, our costs were borne Power, accounting for the majority of the quarter-over-quarter increase in nuclear O&M. For the fossil fleet, incremental O&M was primarily the result of scheduled maintenance at Bergen and our peaking fleet. The incremental fixed costs related to our new assets, the Bethlehem Energy Center in Albany, which went commercial last summer, and the Linden plant in early May, reduced quarter-over-quarter results by $0.08. Most of this impact was the result of higher interest costs and the depreciation associated with the new plants. Around the other discussion of the variances for the quarter, mark-to-market impacts were flat at Power compared with a $0.02 loss reported last year for the second quarter. In addition, we also reported a $0.02 loss on the BGSS, the early spring impact of the gas prices that we talked about last quarter. A summary of the $0.05 improvement quarter-over-quarter for Power can be found in attachment 6 of the release. Now onto Holdings. As part of our ongoing program of opportunistically monetizing our international assets, in May, Global completed the sale of its ownership interest in two generating facilities in Poland and in June, completed the sale of Global's 32% interest in Rio Grande Energia, RGE, an electric distribution company in Brazil. Combined, the two asset sales provided gross proceeds of $654 million, approximately $612 million after-tax. Holdings is evaluating use of proceeds, including potential debt redemption in loans and/or dividends to PSEG. As part of this evaluation, PSEG and Energy Holdings will review liquidity needs of their respective businesses and the targeted financial profile for Energy Holdings. Operating earnings for the second quarter of 2006 were up sharply from the comparable period last year. Operationally, the second quarter was very strong for Holdings. Our Texas plants continued to achieve significant benefits in an attractive market and reflected a $0.07 improvement compared to the second quarter of last year. Part of the relative improvement was due to a major maintenance outage last year. The larger improvement came as a result of increased spark spreads in Texas. For the quarter, spark spreads were about $20, or 40% higher than last year. We had 75% of our peak output sold forward, leaving the remaining 25% to sell into a very attractive day-ahead market during the quarter. For the fall, we've locked in the majority of our expected margins. The continued strength in the Texas market is expected to increase Holdings' '06 operating earnings by an additional $20 million for the year. This is in addition to the $10 million increase we announced on our first quarter call. The current estimate of Holdings' operating earnings for 2006 is $185 million to $205 million, of which $50 million to $60 million is expected to come from Texas. With that, I will now turn it over to Jim Ferland.
Jim Ferland: Thanks, Tom. Good morning, everyone. I'm going to make the assumption that most of you probably listened to the Exelon conference call yesterday, and to the extent some of you didn't and you would like additional details, I will try and deal with that in the Q&A section. I would like to give our view of this thing and maybe with some special emphasis on how we think the proposal we have put forth would benefit the state since it's really the BPU and the BPU staff that is one of the most important players moving head. Just quickly, some of the components that John described in some detail yesterday. The enhanced offer that we've put forth provides $600 million of cash for any number of customer benefits. That could be for conservation, the economic development, lowering bills. So the $600 million cash is pretty easy to understand from the standpoint of the benefits to the state. Additionally, the proposal would have us deferring our electric rate case, which we have had under consideration for sometime, for an additional four years. It will have us also completing a settlement of our gas case at a substantial reduction from its filed level. Just delaying those rate cases for some period of time into the future we think clearly has a value to the state. Somebody could easily get to $200 million or $250 million over the next three or four-year time period. So that's another significant benefit to the state. I think in addition to those more obvious factors are a couple of others that really provide significant benefits to the state which we really haven't elaborated on a lot. One is that, after the merger and as a result of the merger, the state is going to benefit, we estimate between $150 million and $200 million in additional tax revenues over the next three to four years, and that comes about for a couple of reasons. One is, it has to do with certain loss carryforwards that we have currently. They're going to disappear when you put the companies together. The second contributor, you've heard John Young talk about this in a different context. John was talking about some of the painful aspects of selling many of these fossil generation assets and the fact that we're going to realize capital gains on those and that's a cost obviously to the combined companies. Well, it turns out the state is a beneficiary of many of those additional tax revenues. So there's another $150 million or $200 million here over the next several years. I think the one that's probably most overlooked but is of incredible value, it's the performance of our nuclear plants. I think it's readily apparent to everyone that trying to run three plants, which is what we have been doing for some period of time, as opposed to having those three plants being part of a 20 nuclear unit fleet which we hope to achieve after the merger, we're not going to get the same results as a large fleet operator can create. As a result of that, the benefits, one of the additional benefits of the merger is that there will be increased nuclear output. Now it's easy to convert that and to understand how that provides a benefit to the Company and to our new generation company because we have more nuclear megawatt hours to sell. But there's a secondary effect that provides very substantial benefit to the customers really at no additional cost to the Company. That is that, everyday these nuclear plants run where they wouldn't have otherwise or they run at a higher capacity factor than they would have otherwise, that puts downward pressure on the wholesale power markets, which customers will benefit from. There has been a lot of analysis done in the rate case proceedings about the quantification of that. We believe it's a number between $100 million and $120 million per year effects in the form of benefits to the customers of New Jersey as a result of lower wholesale prices that go along with higher nuclear performance. So in the aggregate, you roll up those numbers, there's $600 million of cash, there's $200 million to $250 million associated with deferred rate cases, there's $150 million to $200 million associated with taxes which the state otherwise would not get, and there's something on the order of $450 million in nuclear benefits over a four-year time period. So I personally view this as a benefit of something approaching $1.5 billion in benefits to the state over the next four years. So if we look at our situation today and the decision-making process, the standard of the BPU is to apply a positive benefits test: is this thing, in the aggregate, good for the state, its customers and so forth. I think just on its face, it would seem to me it would be hard to argue that the state is not a clear beneficiary of this merger, and that it clearly would demonstrate satisfactorily meeting any positive benefits test. The issue gets to be, when does someone reach a conclusion like that? I would say at this time and you got some of this from John I know yesterday, time is our biggest enemy here. It's really a schedule issue at this point, because we have been waiting now 18-20 months and one can argue, there may be a lot of good reasons for that. But it's easy to understand from Exelon's side how they could be somewhat frustrated and feeling like, hey guys, we have to get this done or not, and I think John clearly stated that the other day and I know that the view of his Board as well. Schedule is not unimportant to our company, particularly on the recruitment and retention of employees. Our employees have, since we announced this transaction on December 20, 2004, there has been uncertainty associated with how this is going to work out and what the impact will be on their jobs. That has affected our ability to hold onto and attract additional people. We still have adequate people here to run the company and run a stand-alone business, if that's necessary. But this cannot go on much longer. So our Board is, while they have not given me a near-term deadline, they really, they share the vision of the Exelon Board generally, that we need to get this transaction done, or in the absence of the ability to do that, get about our businesses in general. So that's where we are and it's a schedule issue and how fast we can get some agreements on these broad parameters that we've described. Now with regard to when do you close a transaction like this, even if we had an agreement with the various parties -- and I should say that, even in the short time period we have put out this new offer, we have made considerable progress with many important parties in this proceeding. The parties that are most important that we still haven't gotten there yet and that's the BPU staff in working out some sort of an agreement with them within this broad framework. We are aware that, even if we had such an agreement today, which we don't, it's going to take some period of time to get this thing closed. This deal is a closing issue. We know that even after you have an agreement, you have to develop a very detailed stipulation, and currently, that document has been circulating back and forth, but it's 50 or 60 pages of material and we've made good progress on a lot of it, but there's still some things to nail down. Even after we have that, it's got to go to the administrative law judge. The judge has to rule on it, and then it goes to the BPU for final approval. So the point I'm making on closing schedule is that, even if all of this stuff falls out and we can reach an agreement here relatively quickly, it could still pass the September 30 date that we've been talking about, could find its way into the fourth quarter. A final thing I would say is, obviously, our Board like the Exelon Board is reserving the right to look at this transaction when it's all done and all the various aspects have been identified. As I see transaction now, the transaction continues to make very good sense for our Company and it provides many of the strategic benefits that led us into the transaction in the first place. With that, I will stop talking and I think Tom and I would be pleased to address questions you may have.
Sue Carson: Operator, can you please provide the instructions for the Q&A?
Operator: (Operator Instructions) Our first question comes from Paul Fremont - Jeffries & Co.
Paul Fremont - Jeffries & Co.: Thank you. Yesterday, we heard John Rowe indicate that he was hoping to get a response from the other intervener parties in the negotiations over a period that sounded to be one or two weeks. Can you indicate whether the other parties seem willing to negotiate on an expedited time schedule, or have you been able to gauge any type of reaction to the deadline that was put forward by John Rowe?
Tom O’Flynn: Well, clearly, some of these parties are willing to negotiate on these type of terms because we've made significant progress with certain of them. The group that we just don't know currently where they are and probably the most important single group we have to deal with Paul, is the BPU staff. And at this time, we're continuing to have discussions with them. We just don't know at this time, we can't be certain what their willingness to accommodate that kind of a deadline is.
Paul Fremont - Jeffries & Co.: Thank you.
Operator: Our next question comes from Ed Kressler - Angelo Gordon & Co.
Ed Kressler - Angelo Gordon & Co. : Thank you. Just a quick question on the up offering. What period of time expired between when you actually made the up offer to the BPU staff and the decision to go public? The only thing that was disturbing yesterday about Mr. Rowe's comments and about yours today are that, why are we even hearing this? Why isn't this just going on kind of behind the scenes? Are things that bad at the BPU staff?
Tom O’Flynn: I think that in part, first of all, I don't know how long, I guess ten days or something, a week, something like a week, that has been available. It appeared that -- there are many parties to this proceeding and a lot of people got copies of this material. It appeared to us that this stuff was leaking out from somewhere and the information was finding its way selectively into the financial community. We felt that we had to say something about that. We don't like the situation, but if some of this stuff is getting out, we felt that from a fair disclosure consideration, we had to get the information out. So that's why it came out and the timing was driven largely by when it appeared, elements of this were showing up in the financial community.
Ed Kressler - Angelo Gordon & Company: Thank you.
Operator: Our next question comes from Louis Sarkes - Chesapeake Partners.
Louis Sarkes - Chesapeake Partners: Thank you. Are there ongoing discussions this week with the staff? Is it a question of really no response from them, or is it an issue of they have rejected? Because this offer as you describe it, at least from what we had seen and heard, what New Jersey wanted, it seems to either meet or exceed the outlines of what they wanted. So is it a question of them just getting that and then refusing it, or is it just a question of just no response?
Tom O’Flynn: It's not either. Nobody has refused anything yet, and we do have ongoing discussions with them.
Louis Sarkes - Chesapeake Partners: Okay. But just to characterize it, is my characterization a correct one? I heard a rumor that the ask, I guess, from the state was something on the order of $1.2 billion or so, and you had a much smaller reported offer out there. Is this something that you believe responds to what they described as they wanted?
Tom O’Flynn: First on the $1.2 billion number, I have heard all kinds of numbers, but nobody has come to us with a proposal that says we need $1.2 billion. That's just not there. I have described this proposal to you. It's beyond me how someone could look at this and say -- keep in mind, there's standards that they're judging this thing against, are there positive benefits for the state for customers? How somebody can look at that collection of data and information and reach a conclusion that there is not is beyond me.
Louis Sarkes - Chesapeake Partners: Thank you.
Operator: (Operator Instructions). Our next question comes from Ashar Khan - SAC Capital.
Ashar Khan - SAC Capital: Jim, can I just ask you, I am assuming is the market power issue totally resolved, so it's all about the number right now? What is a satisfactory number, which is it coming down to?
Jim Ferland: I would like to think it's there, but I'm not sure that the Commission would fully agree. As you know, FERC is done with this thing, they have signed off on it. DOJ is done with it, they've signed off on it after looking at it for over a year. The BPU staff has surfaced a couple additional questions to the market monitor, Joe Bowring at PJM, and they've indicated they would like to have us address a few of these things. It looks like any remaining concerns, I don't think they are legitimate, but it doesn't matter. If somebody thinks they are, we need to deal with them. It looks like any additional concerns could be dealt with the behavioral changes of changing bidding practices and so forth in a way which would not affect the economics of the transaction.
Ashar Khan - SAC Capital: Can I ask you, with your offer which is pretty generous, what is the response? We will take our time and come back to you? Is that what the response was you got? I'm just trying to understand what the other side's response was when you presented your new revised offer?
Jim Ferland: With regard to the timing issue, I don't think they've gotten back to us. They haven't said anything yet about it being acceptable or not. That is the issue here. That's what we're dealing with. We've put a proposal out there and we know that some of the fine details in a 60 to 70 page stipulation is going to take some time to work out. But frankly, the framework of this offer that we've put on the table, they can move parts around inside of it and the rest, but the economic effects on the Company cannot be any greater than that. Frankly, unless we can get some kind of assurances that we're working within that envelope, it doesn't make any sense to continue pursuing this because if a month from now or two months from now, they're going to conclude, well, we cannot settle this within these boundaries, all we've done is waste another couple of months.
Ashar Khan - SAC Capital: I agree. Are there any further meetings scheduled in the next week or two weeks where we move forward towards?
Jim Ferland: The meetings never stop. The meetings have been going on hour by hour, day after day. This is nothing that somebody is dealing with from time to time, there are people dealing with this every minute of the day.
Ashar Khan - SAC Capital: Okay, I appreciate it.
Operator: Our next question comes from Clark Orsky - KDP Investments.
Clark Orsky - KDP Investments: Can I just ask a question about holdings? I think you said the decision about dividends or debt repayment would be based on some sort of financial parameters for holdings. Can you tell us what those goals are?
Jim Ferland: Sure. We've generally talked about FFO to interest coverage at the holdings being three times or greater. It's a target that we've had in place for some period of time. As you look at our performance over the last number of years, we have generally been there or exceeded that. That's generally a guideline, but we look at other credit ratios. As we monetize assets and get cash and obviously reduce the asset size of the business, we generally look to maintain the credit quality of holdings as we determine use of proceeds. On a short term, we may use that within PSEG as we're doing now. Actually, Holdings is loaning some money out to PSEG. But on a longer-term basis, we obviously look to Holdings' longer-term debt and potential dividends from Holdings up.
Clark Orsky - KDP Investments: Can you tell me what the debt is at the end of the quarter at Holdings?
Jim Ferland: I think it's $1.4 billion.
Clark Orsky - KDP Investments: $1.4 billion?
Jim Ferland: Yes. I will remind you that we bought back 310, something like that, the first month of this year. The end the year was 175 or something. I think 1450, something in that ballpark.
Clark Orsky - KDP Investments: Thanks.
Jim Ferland: That's on a gross. On a net debt basis, it would be cash that Holdings got, that number would be under $1 billion.
Clark Orsky - KDP Investments: Okay, thank you.
Operator: (Operator Instructions). Mr. O'Flynn, there are no further questions at this time.
Tom O’Flynn: Okay, well thanks all for joining us. Just in summary, I think we've had a good quarter. Jim has is obviously told you what we know about the merger and we'll provide updates as they go forward. But our base businesses continue to do well, Power is a very good operation, super on the nuclear side. The rolling nature of our escalating prices that we realize in Power, we're realizing that with good margin improvements. Holdings is generating cash, enjoying benefits of Texas and stability in our other businesses. PSE&G continues to operate very well, safely, reliably and has a couple of rate cases stuck with the broader merger proceedings. But other than that, the broad business is doing well. So thanks all for joining us today.
Operator: Ladies and gentlemen, that does conclude your conference call for today. You may disconnect and thank you for your participation. | [
{
"speaker": "Executives",
"text": "Sue Carson - IR Tom O'Flynn - CFO Jim Ferland - CEO"
},
{
"speaker": "Analysts",
"text": "Paul Fremont - Jeffries & Co. Ed Kressler - Angelo Gordon & Company Louis Sarkes - Chesapeake Partners Ashar Khan - SAC Capital Clark Orsky - KDP Investments"
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by. Welcome to the Public Service Enterprise Group second quarter 2006 earnings call. (Operator Instructions). I would now like to turn the conference over to Sue Carson, Director of Investor Relations. Please go ahead, ma'am."
},
{
"speaker": "Sue Carson",
"text": "Thank you and good morning. We appreciate your listening in today either by telephone or over our website. I will be turning the call over to Tom O'Flynn, PSEG's Chief Financial Officer, for a review of our second quarter 2006 results. Jim Ferland will then join us to discuss the status of our pending merger with Exelon. But first, I need to make a few quick points. We issued our earnings release this morning. In case you have not seen it, a copy is posted on our website, www.pseg.com. We expect to file our 10-Q with the Securities and Exchange Commission shortly, which will contain additional information. In today's webcast, Tom will discuss our future outlook in his remarks and so I must refer you to our forward-looking disclaimer. Although we believe that our expectations are based on reasonable assumptions, we can give no assurance they will be achieved. The results or events forecast in our statements may differ materially from actual results or events. The last word on any of our businesses is contained in the various reports that we file with the SEC. As a reminder, our guidance speaks as of the data it is issued. Any confirmation or update in guidance will only be done in a public manner, generally in the form of a press release, a webcast such as this or an 8-K or other SEC filing. PSEG may or may not confirm or update guidance with every press release. As a matter of corporate policy, we do not comment on questions regarding guidance during one-on-one meetings or individual phone calls. In the body of our earnings release, we've provided a table that reconciles net income to operating earnings. We have adopted this format to improve the readability of the release and provide the required reconciliation between the GAAP term “net income” and the non-GAAP term “operating earnings”. The attachments to the press release provide the required reconciliation for each of our major businesses. Operating earnings exclude merger-related costs and the net impact of our various asset sales during the period presented. Operating earnings is our standard for comparing 2006 results to 2005 for all of our businesses. We exclude such costs so that we can better compare our current period results with future and prior periods. By excluding the merger-related costs, our results in the guidance are consistent with the way Exelon is treating their merger-related costs. Finally, Tom and Jim will take your questions at the conclusion of the prepared remarks. In order to accomplish this call effectively, we would appreciate it if you'd limit yourself to one question and one follow up. Thank you, and I will now turn it over to Tom."
},
{
"speaker": "Tom O’Flynn",
"text": "Thanks, Sue. Good morning everyone, thanks for joining us today. I hope you have had a chance to review our release of this morning. On this call, I will briefly go over our results for the second quarter, review our expectations for the remainder of the year and then I'll turn it over to Jim Ferland to discuss the current status of our pending merger with Exelon. Briefly, operating earnings for PSEG were $166 million for the quarter, an increase of $62 million or $0.23 from the second quarter of last year. Results for the second quarter exclude $3 million of after-tax merger-related costs, a net gain of $51 million from the sales of Global’s assets in Poland and Brazil, and $5 million of losses from operations in Poland. Second quarter results were mixed for our three operating companies: Our overall results continue to support our 2006 operating earnings guidance of $3.45 to $3.75 a share. As always, our guidance does not contemplate the impact of mark-to-market accounting, asset sales and related costs or merger costs. We've updated our expectations for PSE&G and Energy Holdings, which offset each other. I will walk through the details as I go through each company's results. Just a reminder that the full year 2006 guidance for PSEG is unchanged. While on the expected closing of our merger with Exelon, all results would obviously be integrated into Exelon Electric & Gas. Jim will have additional comments on the merger in a few minutes. PSE&G, our regulated utility, reported operating earnings of $34 million or $0.13 for the quarter over 30% lower than last year’s result of $48 million or $0.20 per share. Power reported operating earnings of $78 million, or $0.31 per share for the quarter, $15 million or $0.05 per share above 2005 results. Finally, Holdings reported operating earnings of $72 million, or $0.29 per share for the quarter, an increase of $61 million, or $0.24 over last year. As I go through the three major businesses, I will provide more insight into the changes from last year using earnings per share as the metric. As an aside, PSEG had an average of about 9 million more shares outstanding for the quarter as compared to last year, the result of our prior convertible security. Starting now with PSE&G, for the quarter, the utility was down $14 million, or $0.07 per share compared to second quarter of '05. The absence of rate relief to offset the expiration for the excess depreciation credit was responsible for $0.04 of this decline. Mild weather resulted in a $0.03 reduction year-over-year. Increased transmission revenues, result of higher peak usage in 2005, added another of another $0.02 to earnings. Transmission tariffs are set based on the highest peak load during the prior calendar year, so we will continue to see some benefit from the 2005 peak all year. Offsetting the benefit of the higher transmission revenues was higher O&M expenses of $0.02. The increase is related mostly to higher labor and benefit costs, something we expect to see over the remainder of the year. We continue to work with the BPU on our gas base rate filing we made last September supporting a 3.8% increase in the gas distribution rate. The earnings are scheduled to end in mid-August and we expect to file briefs and begin settlement discussions shortly thereafter. We're moving on a schedule that would allow for rate relief late in the year or early next year. This is clearly subject to change based on our merger settlement discussions. We continued to experience disappointing returns from our gas business and we clearly need this rate relief. Some of the reduced earnings have been due to mild weather earlier this year, but we've also seen reduced usage stemming from customers' price sensitivity. Our trailing 12-month return on equity for the gas business is less than 4%, far below the 10% allowed in our last rate case. Continuing on the regulatory front, as part of the settlement of our 2003 electric base rate case, $64 million excess depreciation credit was established. This credit expired on December 31, 2005. PSE&G has made all the filings required by the settlement and provided requested updates. Year-to-date, this has reduced PSE&G's after-tax earnings by almost $20 million compared to 2005. As Jim will outline, this case is now part of our merger settlement discussions. As a result of these delays, we are reducing our 2006 operating earnings range for PSE&G by another $20 million. As you may recall, we reduced the range by $45 million when we reported first quarter results. The revised range for the utility is $250 million to $270 million for 2006. By way of comparison, 2005 earnings for PSE&G were $347 million. A summary of the various impacts of PSE&G that resulted in a $0.07 decline in earnings for the quarter can be found in attachment 6 of the release. For PSEG Power, we continue to see operational improvements for both our fossil and nuclear fleets. Hope Creek entered a refueling outage on April 7 and returned to service 29 days later on May 6. This was a significant accomplishment in light of the considerable outage scope that was planned. In addition to the standard refueling process, the team at Hope Creek replaced a large number of control rod drive mechanisms, the B recirc pump shaft and motor and inspected the high-pressure turbine. All these activities, as well as many others, are focused on improving the material condition of the plant were done while setting site records in multiple areas, including safety. For the quarter, the three New Jersey units had a capacity factor of 90%, including the scheduled Hope Creek refueling outage. This compares to a capacity factor of 79% last year, which included the sale on two refueling and vessel head replacements. Without the Hope Creek outage, all units ran at 100% for the quarter. For the full five unit fleets, the quarterly capacity factor was 90% versus 86% for the second quarter of last year. The ongoing improvements at our nuclear operations continue to benefit the financial results for Power. This second quarter, the increased nuclear output added about $0.04 in margin compared to last year. In addition to the strong performance of the nuclear fleet, we continue to see improved performance in the operations of our fossil fleet. Both quarterly and year-to-date output is higher for the fleet, while the forced outage rate for the core fleet was 20% below the three-year average. The increased output from our fossil and nuclear fleet yielded incremental margins for Power. In addition, we realized higher prices from forward sales contracts and spot market sales compared to our older, lower-priced positions. Overall, better plant performance and market activities increased margins by $0.18 over comparable results for the second quarter of last year. The majority of this benefit, about two-thirds, resulted from general portfolio management activities in the forward markets and the remainder came from the improved pricing of the new BGS tranches. For the balance of the year, we expect to continue to see benefits from these improved margins. O&M expenses at Power for the quarter were $0.06 higher than last year; $0.04 from nuclear, $0.02 from fossil, both of which were expected. Last year when Salem 2 had the refueling outage and replaced the reactor vessel head, Power bore only 57% of the total cost because of our co-ownership of the unit with Exelon. This year, the Hope Creek outage was top both in terms of duration and cost. However, our costs were borne Power, accounting for the majority of the quarter-over-quarter increase in nuclear O&M. For the fossil fleet, incremental O&M was primarily the result of scheduled maintenance at Bergen and our peaking fleet. The incremental fixed costs related to our new assets, the Bethlehem Energy Center in Albany, which went commercial last summer, and the Linden plant in early May, reduced quarter-over-quarter results by $0.08. Most of this impact was the result of higher interest costs and the depreciation associated with the new plants. Around the other discussion of the variances for the quarter, mark-to-market impacts were flat at Power compared with a $0.02 loss reported last year for the second quarter. In addition, we also reported a $0.02 loss on the BGSS, the early spring impact of the gas prices that we talked about last quarter. A summary of the $0.05 improvement quarter-over-quarter for Power can be found in attachment 6 of the release. Now onto Holdings. As part of our ongoing program of opportunistically monetizing our international assets, in May, Global completed the sale of its ownership interest in two generating facilities in Poland and in June, completed the sale of Global's 32% interest in Rio Grande Energia, RGE, an electric distribution company in Brazil. Combined, the two asset sales provided gross proceeds of $654 million, approximately $612 million after-tax. Holdings is evaluating use of proceeds, including potential debt redemption in loans and/or dividends to PSEG. As part of this evaluation, PSEG and Energy Holdings will review liquidity needs of their respective businesses and the targeted financial profile for Energy Holdings. Operating earnings for the second quarter of 2006 were up sharply from the comparable period last year. Operationally, the second quarter was very strong for Holdings. Our Texas plants continued to achieve significant benefits in an attractive market and reflected a $0.07 improvement compared to the second quarter of last year. Part of the relative improvement was due to a major maintenance outage last year. The larger improvement came as a result of increased spark spreads in Texas. For the quarter, spark spreads were about $20, or 40% higher than last year. We had 75% of our peak output sold forward, leaving the remaining 25% to sell into a very attractive day-ahead market during the quarter. For the fall, we've locked in the majority of our expected margins. The continued strength in the Texas market is expected to increase Holdings' '06 operating earnings by an additional $20 million for the year. This is in addition to the $10 million increase we announced on our first quarter call. The current estimate of Holdings' operating earnings for 2006 is $185 million to $205 million, of which $50 million to $60 million is expected to come from Texas. With that, I will now turn it over to Jim Ferland."
},
{
"speaker": "Jim Ferland",
"text": "Thanks, Tom. Good morning, everyone. I'm going to make the assumption that most of you probably listened to the Exelon conference call yesterday, and to the extent some of you didn't and you would like additional details, I will try and deal with that in the Q&A section. I would like to give our view of this thing and maybe with some special emphasis on how we think the proposal we have put forth would benefit the state since it's really the BPU and the BPU staff that is one of the most important players moving head. Just quickly, some of the components that John described in some detail yesterday. The enhanced offer that we've put forth provides $600 million of cash for any number of customer benefits. That could be for conservation, the economic development, lowering bills. So the $600 million cash is pretty easy to understand from the standpoint of the benefits to the state. Additionally, the proposal would have us deferring our electric rate case, which we have had under consideration for sometime, for an additional four years. It will have us also completing a settlement of our gas case at a substantial reduction from its filed level. Just delaying those rate cases for some period of time into the future we think clearly has a value to the state. Somebody could easily get to $200 million or $250 million over the next three or four-year time period. So that's another significant benefit to the state. I think in addition to those more obvious factors are a couple of others that really provide significant benefits to the state which we really haven't elaborated on a lot. One is that, after the merger and as a result of the merger, the state is going to benefit, we estimate between $150 million and $200 million in additional tax revenues over the next three to four years, and that comes about for a couple of reasons. One is, it has to do with certain loss carryforwards that we have currently. They're going to disappear when you put the companies together. The second contributor, you've heard John Young talk about this in a different context. John was talking about some of the painful aspects of selling many of these fossil generation assets and the fact that we're going to realize capital gains on those and that's a cost obviously to the combined companies. Well, it turns out the state is a beneficiary of many of those additional tax revenues. So there's another $150 million or $200 million here over the next several years. I think the one that's probably most overlooked but is of incredible value, it's the performance of our nuclear plants. I think it's readily apparent to everyone that trying to run three plants, which is what we have been doing for some period of time, as opposed to having those three plants being part of a 20 nuclear unit fleet which we hope to achieve after the merger, we're not going to get the same results as a large fleet operator can create. As a result of that, the benefits, one of the additional benefits of the merger is that there will be increased nuclear output. Now it's easy to convert that and to understand how that provides a benefit to the Company and to our new generation company because we have more nuclear megawatt hours to sell. But there's a secondary effect that provides very substantial benefit to the customers really at no additional cost to the Company. That is that, everyday these nuclear plants run where they wouldn't have otherwise or they run at a higher capacity factor than they would have otherwise, that puts downward pressure on the wholesale power markets, which customers will benefit from. There has been a lot of analysis done in the rate case proceedings about the quantification of that. We believe it's a number between $100 million and $120 million per year effects in the form of benefits to the customers of New Jersey as a result of lower wholesale prices that go along with higher nuclear performance. So in the aggregate, you roll up those numbers, there's $600 million of cash, there's $200 million to $250 million associated with deferred rate cases, there's $150 million to $200 million associated with taxes which the state otherwise would not get, and there's something on the order of $450 million in nuclear benefits over a four-year time period. So I personally view this as a benefit of something approaching $1.5 billion in benefits to the state over the next four years. So if we look at our situation today and the decision-making process, the standard of the BPU is to apply a positive benefits test: is this thing, in the aggregate, good for the state, its customers and so forth. I think just on its face, it would seem to me it would be hard to argue that the state is not a clear beneficiary of this merger, and that it clearly would demonstrate satisfactorily meeting any positive benefits test. The issue gets to be, when does someone reach a conclusion like that? I would say at this time and you got some of this from John I know yesterday, time is our biggest enemy here. It's really a schedule issue at this point, because we have been waiting now 18-20 months and one can argue, there may be a lot of good reasons for that. But it's easy to understand from Exelon's side how they could be somewhat frustrated and feeling like, hey guys, we have to get this done or not, and I think John clearly stated that the other day and I know that the view of his Board as well. Schedule is not unimportant to our company, particularly on the recruitment and retention of employees. Our employees have, since we announced this transaction on December 20, 2004, there has been uncertainty associated with how this is going to work out and what the impact will be on their jobs. That has affected our ability to hold onto and attract additional people. We still have adequate people here to run the company and run a stand-alone business, if that's necessary. But this cannot go on much longer. So our Board is, while they have not given me a near-term deadline, they really, they share the vision of the Exelon Board generally, that we need to get this transaction done, or in the absence of the ability to do that, get about our businesses in general. So that's where we are and it's a schedule issue and how fast we can get some agreements on these broad parameters that we've described. Now with regard to when do you close a transaction like this, even if we had an agreement with the various parties -- and I should say that, even in the short time period we have put out this new offer, we have made considerable progress with many important parties in this proceeding. The parties that are most important that we still haven't gotten there yet and that's the BPU staff in working out some sort of an agreement with them within this broad framework. We are aware that, even if we had such an agreement today, which we don't, it's going to take some period of time to get this thing closed. This deal is a closing issue. We know that even after you have an agreement, you have to develop a very detailed stipulation, and currently, that document has been circulating back and forth, but it's 50 or 60 pages of material and we've made good progress on a lot of it, but there's still some things to nail down. Even after we have that, it's got to go to the administrative law judge. The judge has to rule on it, and then it goes to the BPU for final approval. So the point I'm making on closing schedule is that, even if all of this stuff falls out and we can reach an agreement here relatively quickly, it could still pass the September 30 date that we've been talking about, could find its way into the fourth quarter. A final thing I would say is, obviously, our Board like the Exelon Board is reserving the right to look at this transaction when it's all done and all the various aspects have been identified. As I see transaction now, the transaction continues to make very good sense for our Company and it provides many of the strategic benefits that led us into the transaction in the first place. With that, I will stop talking and I think Tom and I would be pleased to address questions you may have."
},
{
"speaker": "Sue Carson",
"text": "Operator, can you please provide the instructions for the Q&A?"
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Our first question comes from Paul Fremont - Jeffries & Co."
},
{
"speaker": "Paul Fremont - Jeffries & Co.",
"text": "Thank you. Yesterday, we heard John Rowe indicate that he was hoping to get a response from the other intervener parties in the negotiations over a period that sounded to be one or two weeks. Can you indicate whether the other parties seem willing to negotiate on an expedited time schedule, or have you been able to gauge any type of reaction to the deadline that was put forward by John Rowe?"
},
{
"speaker": "Tom O’Flynn",
"text": "Well, clearly, some of these parties are willing to negotiate on these type of terms because we've made significant progress with certain of them. The group that we just don't know currently where they are and probably the most important single group we have to deal with Paul, is the BPU staff. And at this time, we're continuing to have discussions with them. We just don't know at this time, we can't be certain what their willingness to accommodate that kind of a deadline is."
},
{
"speaker": "Paul Fremont - Jeffries & Co.",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Ed Kressler - Angelo Gordon & Co."
},
{
"speaker": "Ed Kressler - Angelo Gordon & Co.",
"text": "Thank you. Just a quick question on the up offering. What period of time expired between when you actually made the up offer to the BPU staff and the decision to go public? The only thing that was disturbing yesterday about Mr. Rowe's comments and about yours today are that, why are we even hearing this? Why isn't this just going on kind of behind the scenes? Are things that bad at the BPU staff?"
},
{
"speaker": "Tom O’Flynn",
"text": "I think that in part, first of all, I don't know how long, I guess ten days or something, a week, something like a week, that has been available. It appeared that -- there are many parties to this proceeding and a lot of people got copies of this material. It appeared to us that this stuff was leaking out from somewhere and the information was finding its way selectively into the financial community. We felt that we had to say something about that. We don't like the situation, but if some of this stuff is getting out, we felt that from a fair disclosure consideration, we had to get the information out. So that's why it came out and the timing was driven largely by when it appeared, elements of this were showing up in the financial community."
},
{
"speaker": "Ed Kressler - Angelo Gordon & Company",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Louis Sarkes - Chesapeake Partners."
},
{
"speaker": "Louis Sarkes - Chesapeake Partners",
"text": "Thank you. Are there ongoing discussions this week with the staff? Is it a question of really no response from them, or is it an issue of they have rejected? Because this offer as you describe it, at least from what we had seen and heard, what New Jersey wanted, it seems to either meet or exceed the outlines of what they wanted. So is it a question of them just getting that and then refusing it, or is it just a question of just no response?"
},
{
"speaker": "Tom O’Flynn",
"text": "It's not either. Nobody has refused anything yet, and we do have ongoing discussions with them."
},
{
"speaker": "Louis Sarkes - Chesapeake Partners",
"text": "Okay. But just to characterize it, is my characterization a correct one? I heard a rumor that the ask, I guess, from the state was something on the order of $1.2 billion or so, and you had a much smaller reported offer out there. Is this something that you believe responds to what they described as they wanted?"
},
{
"speaker": "Tom O’Flynn",
"text": "First on the $1.2 billion number, I have heard all kinds of numbers, but nobody has come to us with a proposal that says we need $1.2 billion. That's just not there. I have described this proposal to you. It's beyond me how someone could look at this and say -- keep in mind, there's standards that they're judging this thing against, are there positive benefits for the state for customers? How somebody can look at that collection of data and information and reach a conclusion that there is not is beyond me."
},
{
"speaker": "Louis Sarkes - Chesapeake Partners",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "(Operator Instructions). Our next question comes from Ashar Khan - SAC Capital."
},
{
"speaker": "Ashar Khan - SAC Capital",
"text": "Jim, can I just ask you, I am assuming is the market power issue totally resolved, so it's all about the number right now? What is a satisfactory number, which is it coming down to?"
},
{
"speaker": "Jim Ferland",
"text": "I would like to think it's there, but I'm not sure that the Commission would fully agree. As you know, FERC is done with this thing, they have signed off on it. DOJ is done with it, they've signed off on it after looking at it for over a year. The BPU staff has surfaced a couple additional questions to the market monitor, Joe Bowring at PJM, and they've indicated they would like to have us address a few of these things. It looks like any remaining concerns, I don't think they are legitimate, but it doesn't matter. If somebody thinks they are, we need to deal with them. It looks like any additional concerns could be dealt with the behavioral changes of changing bidding practices and so forth in a way which would not affect the economics of the transaction."
},
{
"speaker": "Ashar Khan - SAC Capital",
"text": "Can I ask you, with your offer which is pretty generous, what is the response? We will take our time and come back to you? Is that what the response was you got? I'm just trying to understand what the other side's response was when you presented your new revised offer?"
},
{
"speaker": "Jim Ferland",
"text": "With regard to the timing issue, I don't think they've gotten back to us. They haven't said anything yet about it being acceptable or not. That is the issue here. That's what we're dealing with. We've put a proposal out there and we know that some of the fine details in a 60 to 70 page stipulation is going to take some time to work out. But frankly, the framework of this offer that we've put on the table, they can move parts around inside of it and the rest, but the economic effects on the Company cannot be any greater than that. Frankly, unless we can get some kind of assurances that we're working within that envelope, it doesn't make any sense to continue pursuing this because if a month from now or two months from now, they're going to conclude, well, we cannot settle this within these boundaries, all we've done is waste another couple of months."
},
{
"speaker": "Ashar Khan - SAC Capital",
"text": "I agree. Are there any further meetings scheduled in the next week or two weeks where we move forward towards?"
},
{
"speaker": "Jim Ferland",
"text": "The meetings never stop. The meetings have been going on hour by hour, day after day. This is nothing that somebody is dealing with from time to time, there are people dealing with this every minute of the day."
},
{
"speaker": "Ashar Khan - SAC Capital",
"text": "Okay, I appreciate it."
},
{
"speaker": "Operator",
"text": "Our next question comes from Clark Orsky - KDP Investments."
},
{
"speaker": "Clark Orsky - KDP Investments",
"text": "Can I just ask a question about holdings? I think you said the decision about dividends or debt repayment would be based on some sort of financial parameters for holdings. Can you tell us what those goals are?"
},
{
"speaker": "Jim Ferland",
"text": "Sure. We've generally talked about FFO to interest coverage at the holdings being three times or greater. It's a target that we've had in place for some period of time. As you look at our performance over the last number of years, we have generally been there or exceeded that. That's generally a guideline, but we look at other credit ratios. As we monetize assets and get cash and obviously reduce the asset size of the business, we generally look to maintain the credit quality of holdings as we determine use of proceeds. On a short term, we may use that within PSEG as we're doing now. Actually, Holdings is loaning some money out to PSEG. But on a longer-term basis, we obviously look to Holdings' longer-term debt and potential dividends from Holdings up."
},
{
"speaker": "Clark Orsky - KDP Investments",
"text": "Can you tell me what the debt is at the end of the quarter at Holdings?"
},
{
"speaker": "Jim Ferland",
"text": "I think it's $1.4 billion."
},
{
"speaker": "Clark Orsky - KDP Investments",
"text": "$1.4 billion?"
},
{
"speaker": "Jim Ferland",
"text": "Yes. I will remind you that we bought back 310, something like that, the first month of this year. The end the year was 175 or something. I think 1450, something in that ballpark."
},
{
"speaker": "Clark Orsky - KDP Investments",
"text": "Thanks."
},
{
"speaker": "Jim Ferland",
"text": "That's on a gross. On a net debt basis, it would be cash that Holdings got, that number would be under $1 billion."
},
{
"speaker": "Clark Orsky - KDP Investments",
"text": "Okay, thank you."
},
{
"speaker": "Operator",
"text": "(Operator Instructions). Mr. O'Flynn, there are no further questions at this time."
},
{
"speaker": "Tom O’Flynn",
"text": "Okay, well thanks all for joining us. Just in summary, I think we've had a good quarter. Jim has is obviously told you what we know about the merger and we'll provide updates as they go forward. But our base businesses continue to do well, Power is a very good operation, super on the nuclear side. The rolling nature of our escalating prices that we realize in Power, we're realizing that with good margin improvements. Holdings is generating cash, enjoying benefits of Texas and stability in our other businesses. PSE&G continues to operate very well, safely, reliably and has a couple of rate cases stuck with the broader merger proceedings. But other than that, the broad business is doing well. So thanks all for joining us today."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, that does conclude your conference call for today. You may disconnect and thank you for your participation."
}
] | null | null |
PEG | 1 | 2,006 | 2006-05-01 11:00:00 | Executives: Sue Carson, Director of Investor Relations Thomas O’ Flynn, Chief Financial Officer
Analysts: Gregory Gordon - Citigroup Investment Research Paul Patterson - Glenrock Association Andy Lewis Leslie Rich - Columbia Management Ashar Khan - SAC Capital Paul Ridzon - Key Banc Capital Markets John Ali - Zimmer Lucas Partners Daniele Seitz - Dahlman Rose and Company Unidentified Speaker - Deutsche Investment Management
Operator: Ladies and gentlemen, thank you for standing by. Welcome to the Public Service Enterprise Group First Quarter 2006 Earnings Conference Call and Webcast. (Operator Instructions). As a reminder, this conference is being recorded, Monday May 1, 2006 and will be available for telephone replay for 48 hours, beginning at 1 PM Eastern Time today until 1 PM Eastern Time on May 1, 2006. It will also be available as an audio webcast on PSEG’s corporate website at www.pseg.com. I would now like to turn the conference over to Sue Carson. Please go ahead.
Sue Carson: Thank you and good morning. We appreciate your listening in today either by telephone or over our website. I’ll be turning the call over to Tom O’ Flynn, PSEG’s Chief Financial Officer for review of our first quarter 2006 results. Jim Ferland, PSEG’s Chairman and Chief Executive Officer will also join us this morning to discuss our pending merger with Exelon and other key events. But first, I need to make a few quick points. We issued our earnings release this morning, incase you have not seen it; the copy is posted on our website, www.pseg.com. We expect to file our 10-Q with the Securities and Exchange Commission later today, which will contain additional information. In today’s webcast Tom and Jim will discuss our future outlook in their remarks and so I must refer you to our forward-looking disclaimer. Although we believe that our expectations are based on reasonable assumptions, we can give no assurance they will be achieved. The results or events forecast in our statements today may differ materially from actual results or events. The last word on any of our businesses is contained in the various reports that we filed with the SEC. As a reminder, our guidance speaks as of the date it is issued, any confirmation or update in guidance will only be done in a public manner, generally in a form of a press release, a webcast such as this, or an 8-K or other SEC filings. PSEG may or may not confirm or update guidance with every press release. As a matter of corporate policy, we will not comment on questions regarding guidance during one-on-one meetings or individual phone calls. In the body of our earnings release, we provided tables that reconciled net income to operating earnings. We’ve adopted this format to improve the readability of the release and provide the required reconciliation’s between the GAAP terms, net income, and income from continuing operations to the non-GAAP term operating earnings. Operating earnings exclude merger-related costs. Operating earnings is our standard for comparing 2006 results to 2005 for all of our businesses. The exclusive merger-related costs that we can better compare our current period results with prior and future periods. By excluding the merger-related costs, our results and guidance are consistent with the way Exelon is treating their merger-related costs. Attachments to the press release provide the required reconciliation between the GAAP terms, net income and income from continuing operations to the non-GAAP term operating earnings for each of our major businesses. Finally, Tom and Jim will take your questions at the conclusions of the prepared remarks. In order to accomplish this effectively, we would appreciate it, if you limit yourselves to one question and one follow-up. Thank you and I’ll now turn the call over to Tom.
Thomas O’ Flynn: Thanks Sue, good morning everyone and thanks for joining. I hope you’ve had a chance review our release of this morning. On this call, I’ll briefly go over our results for the first quarter and review our expectations for the remainder of the year. Then I’ll turn it over to Jim, to discuss the current status of our pending merger with Exelon. Briefly, operating earnings for PSEG were $204 million for the quarter. We expect it excludes $5 million of after-tax merger-related costs, a decrease of $79 million or $0.36 per share from the first quarter of last year. Although these early results were disappointing, they continue to support our 2006 operating earnings guidance of $3.45 to $3.75 per share. As always our guidance does not contemplate the impact of any new mark-to-market accounting issues, positive or negative, or the impact of any asset sales. We’ve updated our expectations for each of our operating subsidiaries, which all made out to zero. I’ll walk through the details as I go through each company’s results. Just a remainder that the guidance for PSEG is for the full year 2006, we continue to expect to close our merger with Exelon in the third quarter and such results post quarter-some would obviously be integrated into Exelon electric and gas. Power reported operating earnings of $112 million, or $0.45 per share for the quarter, just slightly below their 2005 results of $116 million of $0.48 per share. PSE&G, our utility reported operating earnings of $78 million or $0.31 for the quarter, about 33% lower than last year’s result of $117 million or $0.49 per share. Finally, Energy Holdings reported operating earnings of 28 million or $0.11 per share for the quarter, a decrease of $37 million or $0.15 per share from last year. As I go through our three major businesses, I’ll provide more insight into the changes from last year using earnings per share as the measure. As in aside, PSEG had, on average about 10 million more shares outstanding for the quarter compared to last year which will impact the comparable per share results. The PSEG Power, we continued to see improvements from both our fossil and nuclear fleets. As you know, our three nuclear units in New Jersey are currently being operated by Exelon under the Nuclear Operating Services Agreement. For the quarter, these units had a capacity factor of 101%, using the summer rating. This compares to capacity factor of just over 89% last year when Hope Creek was offline for most of January. After a very successful 214 day run, Hope Creek entered a refueling outage on April 7th. The unit is currently in a final stage of this outage and we expect it to return to service shortly. The improvements on our nuclear operations had a direct impact on the financial results for power during the first quarter, with the absence of the replacement power cost incurred last year for Hope Creek adding $0.12 to earnings for the quarter. Recontracting our positions at higher prices in spot market sales added another $0.13 over comparable results for the first quarter of last year. By a way of comparison, the average realized margins on our portfolio during the first quarter were about $5 per megawatt-hour higher than the first quarter of 2005. We anticipate enjoying a similar margin differential for the balance of this year. We also anticipate further expansion of margin in future years is more of our older lower price contracts well-off. Offsetting the benefits, the improved operations for mark-to-market losses are $0.04 for the quarter, when compared to the $0.05 gain reported in the first quarter of last year, the quarter-over-quarter swing is a net reduction of $0.09. We expect the $0.04 loss on the current positions to reverse before the end of the year, this transaction’s under-term. In our release, we mentioned briefly the negative impact moderating gas prices we had on Power’s results for the quarter. Power supplies all of PSE&G’s gas customers under the PGSS contract is in combination of physical storage, pipeline capacity and forward hedges. For residential customers, power passes through the inventory cost for the gas commodity, the PSE&G. Any difference between the tariff and the inventory cost for residential customers is differed on the utilities books for future recovery or refund. For commercial and industrial customers or C&I customers, a tariff structure is applied that is adjusted monthly based on the current NYMEX prices. Power results were compensative services such as the carrying cost of the gas. The PGSS contract, including the C&I component has generally provided a steady source of margin to power. During the first quarter, market prices were declining while the cost of gas and inventory was relatively stable. The increase in Power’s margin, the mild weather also contributed to decline in earnings as volumes were lower for our customers. The combined impact for the first quarter of 2006 was about $0.11 per share for the first quarter 2005 which was, was by contrast a very strong quarter. O&M expenses of power was slightly higher than last year during the first quarter, the net result of higher maintenance cost including labor and benefits partially offset by reduced cost at our nuclear site. Nuclear savings had the result of the headcount reduction and other efficiencies have taken place as part of the Nuclear Operating Services Agreement. As summary, the $0.03 decline quarter-over-quarter power can be found as attachment here at the press release. As the result of the higher prices for recontracted nuclear and coal output partially offset by the lower than expected PGSS margins, we’re increasing our 2006 operating earnings expectations for power by $25 million. The revised range is $500 million to $550 million, a significant increase over 2005 actual result of $480 million. Finally for Power, today we announced commercial operation of our 1220 megawatt Linden facility. This is sufficient to combine cycle gas plant will provide much needed capacity to the eastern region of PJM, the unit replaces 430 megawatts of coal fire capacity at the site. Now turning to PSE&G, for the quarter the utility was down over $39 million or $0.18 per share compared to the first quarter of 2005. Weather was a single largest contributor to this decline with degree days 20% warmer than the first quarter of ’05. This mild weather reduced margins by $0.07 per share. In addition to the weather impact, residential customers continue to curtail the usage of natural gas, further reducing PSE&G’s earnings on the distribution of natural gas. For the quarter this impact was about $0.02 per share. As you continue to see reductions in customer usage for gas, absent weather impacts, timely, regularly becomes even more important. Our current rates are insufficient to recover cost increases and infrastructure improvements approved in our 2002 rate case. As you know, we fall for a 3.8% increase in the gas distribution rates last September to recover cost incurred since 2002. We continue to respond to interrogatories from the BPU staff in this case; however the schedule for decision of this case was moved from October to December of this year, further reducing our earnings expectations for 2006. Continuing on the regulatory front, as part of the settlement of our 2003 electric base rate case, a $64 million excess depreciation credit was established. This credit expired on December 31, 2005. As part of this settlement, PSE&G either financial filing at the BPU in November of 2005 to compensate the elimination of this credit. We made that filing in early February, the BPU denied our request and suggested we file when our first quarter results were available. We will be making that filing shortly. However, it appears that until the merger is resolved with the BPU, decisions on such filings maybe difficult to achieve. For the first quarter, the resulting increase in depreciation expense reduced PSE&G’s earnings by $0.04 per share. Finally, higher wage and benefit cost increased quarter-over-quarter O&M expense by $0.02 per share. As summary, the various impacts with PSE&G could be found also in attachment file. As a result of the regulatory delays in the electric and gas distribution businesses of PSE&G as well as the unfavorable first quarter weather, we are reducing our operating earnings range for PSE&G by $45 million. The revised range for the utility is $270 million to $290 million for 2006. By a way of comparison, 2005 earnings for PSE&G was $347 million. Now the Energy Holdings, operating earnings for the first quarter of ’06 were down sharply from a comparable period last year. Firstly all the decline, gains on asset sales took place during the first quarter of 2005. In January 2005, we received the final payment of $36 million on, our withdrawal from Eagle Point contract. We also reported modest gains on sales of two investments, MPC in China and semis (ph) in California. The absence of gains from asset sales, reduce holdings comparative results by $0.13 per share. Higher tax rate on the overall earnings of PSEG Global, negatively impacted holdings for the quarter by $0.05. With a larger portion of the earnings coming from domestic sources, the result of higher Texas earnings and International asset monetizations, the full US tax rate is applied to the earnings. Operationally, the first quarter was very strong for holdings. Our Texas Plant continues to achieve significant benefits from attractive market, saw $0.04 improvement compared to the first quarter of last year. However, although margins taxes have increased which is, it improves our business outlook; our forward sales, contracts that hedge a portion of our output result in an unrealized mark-to-market losses for the quarter of $0.02 per share. We expect that happened to $0.02 to reverse during current year. The strength in Texas market as well as improvements in some of our South American operations should increase the expected operating earnings and holdings by about $10 million for the year. As a result, we are increasing the range for holdings to $165 million to $185 million for 2006. That pretty much sums up the quarter; I’ll now turn it over to Jim Ferland.
James Ferland: Hey thanks Tom and good morning everyone. Before getting to the, on the merger front, I’d like to say just a couple of things about nuclear operations. Tom has already discussed the performance Salem and Hope Creek in terms of plant output and the financial effects of improved operations which are obviously very important. I’d like to report to you that those are not the only indicators we’ve got and well, how things are going down at nuclear. Now without exception, the feedback with the Nuclear Regulatory Commission, INPO (Institute of Nuclear Power Operations) special review team we’ve employed our own internal quality assurance folks, all now are meaningful improvements across all aspects of our nuclear operations. But we’re not, not the earnings perfectly and these reports don’t say that, but all of us have work to do. Power from the trends are extremely positive and they made me feel real good about, we can, are being able to look forward to some very strong performance from these facilities in the upcoming years. I may hope out now to the, to the merger for a little bit. I suspect many, if not most of you participated in the Exelon teleconference last Wednesday. And as you heard from John and the Exelon folks were the two key remaining regulatory proceedings, we have to deal with, The Department of Justice and then here in New Jersey, the BPU. The Jury hearings concluded sometime ago, now at the end of March, the initial briefs were all filed last Wednesday and the final briefs, I’ll do by May 10th, that’s next Wednesday. So we’re reaching the end of that process. And we feel very good about it, (indiscernible) established and we believe that our arguments that will be persuaded. I suspect many of you, but maybe not all of you are aware that end of juristic cases, this nature of almost all was settled as suppose to litigate it to a final decision. And I suspect that will be the case of here as well. But it is likely that the settlement demands will be greater than the $120 million in rate credits that we have on the table. We’re currently having discussions with New Jersey and The Department of Justice to resolve these proceeding as quickly as we possibly can. Now this morning for example, PSE&G is trying to establish a million with BPU, trying to sort out, and reach agreement on reliability and customer service issues. Now we got a, a lot of issues to queue with here in New Jersey and well its always hard to know for sure that I really can’t predict these things, not expect by the timely guess at the end of this month May we’ll, we should have sorted out pretty well what the outcomes going to look like, what we’d be able to workout in the way of a settlement, here in this state. At the same time, we’re actively engaged with the Department of Justice, to try to make us all come together at roughly the same time hopefully this month. Obviously, we are not going to be discussing the status of our settlement discussions in either at jurisdiction, I wouldn’t say that they, they are ongoing. While the pace and the length of the BPU and DOJ processes had been to long than expected. We are now finally actively engaged to discussions with both parties. While the, standard nature these proceedings have been, have been frustrating hardly and so that probably extremely frustrating, the developments would have taken place over the time period when we signed as merger agreement back in December of ’04. Today I have strongly reinforced our judgments regarding our strategic value of this transaction of both companies. Over this period, since our signing in a merger agreement both natural gas and electricity absolute prices and volatility have significantly increased with frequent and substantial swings in forward market prices, first in the east and then go back to the west and then they swing back again, highlighting the risk reduction benefits of a large geographic footprint which encompasses numerous power markets, the importance of scale is called our retention everyday becomes more obvious as our competitors continue to grow through mergers and acquisitions and on the legislative and regulatory front, there are lot of action going on in a variety of states including states which including states in which our companies operate. And that highlights again the benefits of the diversification of such risks across multiple jurisdictions. And the strategic benefits are combining under nuclear operations we’ve already produced a very remarkable results and the improvement of plant Salem and Hope Creek. Developments such as these have served to strengthen our result to complete this transaction as soon as possible. This is not the sale-over that we are insensitive for the outcome of the Department of Justice and the BPU proceedings. They are obviously very important. We remain firmly committed for these transactions and continue to expect to bring it to a successful closure with reasonable outcomes at the Department of Justice and the BPU; we continue to feel that it should occur in the third quarter. I agree totally with the John Rowe in his assessment of resulting new company should be extremely well-positioned to be an industrial leader. Final comments, some of you may have noticed in the April 17th issue of Fortune Magazine, they put about the business of rating companies on a variety of parameters and on electric and gas utilities and on the parameter of total return over a 10-year time period of compound a quick return, PSEG illustrates second excellent with the title, a little company down of south outselling company, with a compound rate of return over the 10 years of 14%. It turns out a little higher up in the performance levels; Exelon was #1 with the 10-year return 18%. Both of these companies have a long history of doing well for investors and I feel very good about what we are going to be able to do on a combined basis. That concludes my prepared remarks, Tom and I would be pleased to take questions.
Sue Carson: Operator, can you provide the instructions for the Q&A?
Operator: Thank you. Ladies and Gentlemen we will now begin the question and answer session for the members of the financial community. (Operator Instructions). One moment please, for the first question. The first question is from Gregory Gordon from Citigroup Investment Research, please proceed.
Gregory Gordon - Citigroup Investment Research: Thanks, I’ve got a couple of much in both questions on the quarter and then a larger question on the merger. First on the, on the new guidance for the utility the $270 million to $290 million operating earnings guidance, what type of ROEs at the electric and gas business does that infer?
Thomas O’ Flynn: Greg its Tom, we usually don’t give specific ROEs for each of our segment which are electric gas and of course, our transmission business. I’d say the gas business is materially under earning to 10% it got in this last case of 2002. It’s in the, it’s materially under earning it’s in the, it’s currently in the 6% to 7% ROE kind of range. So we certainly need a rate increase. The electric has been earning on historical basis somewhat higher than the 975 it got back in its August ’03 case. So on a rolling basis, we will over the next quarter or so, come down to that level and ultimately below that level and I feel to get the kind of credit recognition that that we need in the transmission business to go better.
Gregory Gordon - Citigroup Investment Research: Yeah and then the other question before I get to the larger is, strategic issues is on the, that transmission the PGSS, it appears that you guys are well aware that there is a structural mismatch there that can happen because the pricing is based on NYMEX but you obviously take positions in terms of storage for gas. So I would like to, I want to understand how you wouldn’t hedge some of that financial risk, sort of near-term fluctuations in NYMEX versus the gas that you have in storage, the NYMEX is a liquid financial product, to lose $0.11 because the gas price is falling sort of month-to-month versus the basis you had in storage is sort of, doesn’t make any sense to me that you wouldn’t somehow try to hedge that risk?
Thomas O’ Flynn: Yeah it’s a fair point Greg. Let me just put in context the $0.11 was versus first quarter of last year which is the very strong quarter versus that normalized year was about $0.07 below that. So, of the $0.11 but $0.04 was, comparing to a strong quarter last year and then $0.07 was a more was versus expectations of our internal plan. Of this $0.07, about a four of that number is just plain volumes. There is a general volume based kind of number, so we’re talking about $0.04 or $0.05. Historically, this has been very solid stable business frankly we talk about a lot because it’s quite solid and reliable. And generally, we find some, in a normal, continual as I guess you call it curved, it has upward sloping curve generally our inventory cost compared reasonably favorably with our cost during the season. This year as you know prices were quite high, quite high and then sell-off dramatically over a very short period of time, we do, do some hedging. It varies from period-to-period, we do, do some hedging of course we can’t hedge, everything as you know always volumes are going to be. This year volumes were down materially but we did do some hedging this year, in hind side, we probably wished we would have hedged a little more back in fall, but I would say over time, over the last number of years we’ve done very well. In fact the first quarter of ’05 we would be testament to that.
Gregory Gordon - Citigroup Investment Research: Great thank you. And then the larger question is for Jim. Its sounds like your confidence as you are making headway now on both fronts both at the DOJ and then the New Jersey BPU, I guess my question for you is, is the June 20th, date in the merger document, after which either company come to the unilaterally choose to no longer pursue the merger, a significant deadline in your mind in terms of getting these agreements done or not? And can you say in terms of that a little bit?
James Ferland: Yeah the short answer for your last question is no. But let me elaborate on it, a little bit. First of all, as for as engagement, it has been frustrating to get everybody engaged but at this time, the source and the process was Department of Justice, they worked on this for but something like north of a year and until they were completing with all their work and they are now simply are not willing to tell us anything. And that was frustrating, for such an extended period of time, well now they are willing to start to say some ideas and thoughts and they are willing to share those with us and we are actively engaged with them and the same thing now at the BPU. On the June 20th, let me comeback for that after a minute. No, I don’t view that is a particularly important date at this time for a variety of reasons first just to remind everyone, what avails when we sign this merger agreement back in 2004, we didn’t want the merger agreement to be outstanding forever so we have, let’s take a data out there somewhere where if we can get all the approvals, we can walk away and I can remember thinking, its time, My God! That could never be as late as you know June of 2006, what as I know, as an effort that date was created for and it does give the parties the ability to walk away. The reason I don’t like that’s going to be, of any particular relevance is, I suspect, by the time they get to the end of this month, we’re going to have a pretty good idea about what this transaction will look like and what we are going to be achieve at both Justice and with the, and with the BPU. Now, half of that time before we can reach a settlement with either of these parties, both are respected companies, they’re have to agree that these agreements and settlements make sense. Now if we reach agreements with those parties and they make sense to both companies, the June date becomes not, no particular relevant it is like the, either that we can successfully reach settlement agreements with these two organizations, the papering of those in a various approvals could extend and will past the June 20th day and John and I has talk about that, and if we think it was beneficial of that time, we’d probably just move it ahead.
Gregory Gordon - Citigroup Investment Research: Okay thanks guys.
Sue Carson: Thank you. Just to remind everyone, we’ve got a number of calls queued up so please limit yourself to one question. Thank you. Let’s go to next question please.
Operator: Our next question comes from Paul Patterson of Glenrock Association. Please proceed with your question.
Paul Patterson - Glenrock Association: Good morning guys.
Thomas O’ Flynn: Hi Paul.
Paul Patterson - Glenrock Association: Just the follow up here, I am not sure, I completely understood the answer to the, to the electric ROE that you guys expected to get this year. Could you just elaborate a little bit on that and also on the weather versus normal, I think you said it was $0.07 on the gas side versus 2005, what would have been normal. And was there any impact on electric at all?
James Ferland: Yeah Paul, let me try to do this one at a time, the gas number I think I said was in the 6 or 5, close to the 5% range. The electric and I am comparing these two what our latest allowed was, the electric the latest slab was 9.75 which is in summer 2003, we’re currently a point or two, above that on a rolling historical basis, the request for making an offset to depreciation credit on a look forward basis as well as historical basis. And as the year progresses, we’re going to fall at or through that 9.75% range without the credit.
Paul Patterson - Glenrock Association: You fall below the 9.75
James Ferland: Yes.
Paul Patterson - Glenrock Association: Okay that’s nice go ahead.
James Ferland: Towards, towards, towards end of the year, yes. So in another words, we, that’s something we mainly and we think it’s appropriate to be getting. Just on, on the rate impacts, PSE&G was down for the quarter-to-quarter about $0.07, the 90% of that was gas, that’s the PSE&G. And the PGSS, it’s the contract between Power and PSE&G for gas supply that was half about $0.07 versus a normal year, our expectations result $0.11 versus last year which was an unusually strong year, strong quarter.
Paul Patterson - Glenrock Association: Okay but the, but the $0.07 of PSE&G versus normal would have been, would have been what, I mean, if you look at the first quarter, it says weather is $0.07 that’s gas is at the same as what, what it would have been versus the, versus the normal year?
James Ferland: Actually, the, yeah the seven is versus a strong year last year. So versus normal, it’s about 5.
Paul Patterson - Glenrock Association: Okay thanks.
James Ferland: It was a, it is a cold winter first quarter 2005, which help both PSE&G and the PGSS. The PSE&G is half about $0.07 versus first quarter about 5 versus normal and the PSEG Powers is half about $0.07 versus normal about an 11 versus last year.
Paul Patterson - Glenrock Association: Great thank you.
Operator: The next question is from (indiscernible). Please proceed with your question.
Andy Lewis: Hi actually it’s Andy Lewis, how you doing? I guess only got one question. Let me go with this one, can you just comment on John Rowe’s, (indiscernible) Exelon’s press release are related to earnings and just your comment or their phase of using economic sense…
James Ferland: Yeah Jim Ferland here I’m in.
Andy Lewis: What you’re thinking…
James Ferland: I think that’s, I could make that chain comment. See, the figure remaining uncertainties in this issue and in this, in this combination, what we are going to have to give up if any thing at The Department of Justice and the BPU and obviously those are important outcomes and if we give away too much then we could bow away the economics of the transaction. And that’s going to be a very important to both of us. And we are both going to be looking at that. But the, we’ve got away, we’re pulling that, we are going to be forced to be over that in reaching settlements with these various organizations. So we’ll, once we’ve done that, we’ll obviously, we won’t get in to those agreements unless they produce a satisfactory outcome.
Andy Lewis: Are you two both on the same page, with the two companies or is there a little differing of opinion on…
James Ferland: I don’t confuse it; I don’t think there is a inch of space between John and I. We are talking all the time; we know what’s going on. Frankly, people ask how do guys get along in this kind of thing frankly, we could be a better person or made do be doing this transaction with, then John Rowe I don’t know where you will find him. This guy has been incredibly flexible, reasonable; we are communicating all the time and I don’t think there is a space at all between the two of us when it is to how we look this transaction.
Andy Lewis: I received that’s a bit of extra question but yeah you both good guys I agree thank you.
James Ferland: Yeah.
Operator: The next question is from Leslie Rich of Columbia Management Advisors please proceed.
Leslie Rich - Columbia Management: Hi I wondered if I could just ask some question on attachment for which is your cash flow statement. You have a big positive swing in sort of, other cash flow come Ops with no breakdown I assume, about $200 million of that its depreciation just wondered what else or causing a $500 million positive swing? And then also in financing activities negative $750 million approximately I thought you paid down from debt I just wondered what else was, sort of the big drivers in those two buckets?
Thomas O’ Flynn: Okay Leslie, we are filing our Q, we expect by the terms of business today so obviously the full cash flow statements in it. The biggest up was really margining as prices came up somewhat and I think we said in our K, that our margin-posted, collateral-posted came down by about which got basically in half during February and we did continue to see that now some of that’s in letters of credit some of that’s in cash. Those were the, those are the biggest pieces, there were some other pieces in terms of pension in some other pieces but there was no collateral and, collateral was the largest. In terms of debt coming down, the biggest piece is Power had a maturity, I think it was a five year from initial deal that was done, $500 million maturity we paid that up with short-term debt.
Leslie Rich - Columbia Management: Okay thank you.
Operator: The next question is from Ashar Khan, SAC Capital. Please proceed with your question.
Ashar Khan - SAC Capital: Just with two short question how much did the PGSS make last year and how much are you expecting to make on that this year?
Thomas O’ Flynn: Yeah, I’m sorry rather we don’t report that as a separate segment. And I think in the past we’ve shown some large numbers for over all ER&T numbers, I’d rather get away from specific numbers that’s what I talked all about it all in terms of differentials.
Ashar Khan - SAC Capital: Okay but Tom, is it fair to say that for the rest of the year are you expecting further negative variance or the negative variance is the only one in the first quarter?
Thomas O’ Flynn: Well PGSS just like our PSE&G gas business is largely pretty 4-month season. And certainly January and February are the biggest piece and that’s probably about, first quarters’ by 50% of our send out the rest would be Novembers some on close December.
Ashar Khan, SAC Capital: Okay if I can just end up, you mentioned end of May on both agreements I can rely to New Jersey but can I just ask why would it take the end of May at Department of Justice just trying to get a sense of the timing your anticipated timing?
James Ferland: Well I would like to think it wouldn’t take that long but it, but it may obviously, we are going to make this time further short as we possibly can. And I can say that all are taken the Department of Justice so long time that it’d be willing to talk towards they have been very forth-coming and very responsive since they have provided their first feedback to us.
Ashar Khan, SAC Capital: Jim, can I just ask you when that first feedback was provided?
James Ferland: I don’t remember the exact day but that was a not longer, maybe of a week or two.
Ashar Khan, SAC Capital: Okay, thank you.
Operator: The next question is Paul Ridzon of Key Banc Capital Markets. Please proceed.
Paul Ridzon - Key Banc Capital Markets: Good morning, throughout the balance of the year, is it tax rate that holdings are going to be a headwind or it was, was just a particularly owners quarter?
Thomas O’ Flynn: This is a, a little more honest but, but we should have somewhat of our higher tax rate during the years we said, some of that is just an increase percentage of US based contribution. But that’s all cooked into the guidance that we gave you.
Paul Ridzon - Key Banc Capital Markets: Can you, just back on this PGSS because it is initially the kind of the first time referred about it. Is there kind of a sense to stay in the course and kind of try to almost outcast the market or do you want to put more maybe you can just ride the market more?
Thomas O’ Flynn: Yeah I just, this is been a very good business for us. It continues to be good business, it is doing something we’ve done for many and many years which is procure gas on behalf of customers for PSE&G. Obviously, it, the residential costs are pass through. I think it was in our third quarter earnings call, where we talked about the inventory costs that the PGSS had based upon our ADBs or sell store generates about 30% below the market. So that’s, its obviously doing good things for customers. This is one year when there was a dramatic decline of prices and that and that took about $0.04 or $0.05 off of the margins just on that price to decline if you will, keep in mind also when we look at this, we look at this in the context, the Powers overall risk return relative to gaps, it just because we’re we have to look at this is part of the overall portfolio. So we don’t want to suggest that we will only expose to Gas, there were some hedges on, difficult for hedge given volumes with complete certainty, but also we look at this on a portfolio basis for Power.
Paul Ridzon - Key Banc Capital Markets: Given the uncertainty on volumes is this inventory mark-to-market or it is or do you, is it you think qualifies hedge counting.
Thomas O’ Flynn: It’s largely normal. Anyway, next question.
Sue Carson: Okay Paul.
Operator: The next question comes from John Ali of Zimmer Lucas Partners. Please proceed with your question.
John Ali - Zimmer Lucas Partners: Good morning and just a quick question on the utility guidance. You said weather it’s about $0.07 which is like $17 million over that $45 million. How much you’re now including in guidance of the $64 million depreciation credit? And then, how much of any of the gas rate increase?
Thomas O’ Flynn: I don’t want to go into these specifics on outcome of rate increases, I think on the gas side we’ve said that decision has been put off until December so obviously we are not.
John Ali - Zimmer Lucas Partners: Okay.
Thomas O’ Flynn: That’s the humble expectation, the 64 which is ruining out 68 technically on the electric side, we expect to get that during the year. But obviously, we were, we didn’t get a last quarter but we think as the year goes along, we should get some reasonable piece of that.
John Ali - Zimmer Lucas Partners: Okay great, thank you very much.
Operator: The next question is from Daniele Seitz of Dahlman Rose and company. Please proceed with your question.
Daniele Seitz - Dahlman Rose and Company: Actually it’s just a follow up on one before. I was wondering you kind of really covered that $0.04. So, whatever the cost of the delay, it’s going to be on the depreciation issue.
James Ferland: That’s right Daniele, it is fine to us.
Daniele Seitz - Dahlman Rose and Company: Okay, so and okay I’ll speak to that question, I’ll come back later.
Sue Carson: Next question.
Operator: Our next question comes from the line of (indiscernible) from Deutsche Investment Management. Please proceed.
Unidentified Speaker - Deutsche Investment Management: Well, thank you, a question for Jim regarding the two discussions you are having with New Jersey and DOJ. But is the public benefit, is the primary criteria for department for the New Jersey as well as how does the DOJ defer from first review of the same issues?
Jim Ferland: Well, it was a great question on New Jersey, the BPU they have separate area that describes the one of that is supposed to consider when they look at a merge like this is a product yet demonstrates pulses of benefits to the state of New Jersey and the customers and then you’ve got a group a lot of parties and that going to held at least been different that cant stop any losses in those significant number of those. On the, with regard to the DOJ, I think maybe some people might have thought at one time that DOJ would simply differ up to further on these issue, some scrap leads to conclusion quite soon and they, and they choose not to, and they have been working this issue and enormous detail for an extended period of time, in the last numbers I’ve saw, we have produced something in the order 10 million documents for their review and dozens and dozens of interviews in sale-force and I really went after this is a very, very federal way and they are obviously not simply going to take whatever, whatever, whatever friction, so we’re kind of, workout with them and we know we can work something out here as we work our way to the rest of this month.
Unidentified Speaker - Deutsche Investment Management: Okay thank you.
Operator: That will conclude the Q&A session. Mr. O’ Flynn I will turn the call back to you. Please continue.
Thomas O’ Flynn, Chief Financial Officer: I think just one thing Leslie, I was really confused on the debt maturity the one we had was after the quarter. The biggest piece of the fiber of the large debt decrease was the call we enhanced a few days before the end of 2005 were holdings for about $309 million, $310 million and then so the other meets our demand, so that’s was, that was the biggest chance that therefore let PSE&G (indiscernible). But the, the Power maturity half in the first, a few weeks to second quarter, I think right, folks thanks all for joining. We will start the quarter we expect it would continue to, see yourselves getting the guidance and see some good improvements especially in the latter part of the year at Power. Again we continue to like our business model; I think we’ve got a good balance of earnings growth and prudent risk management and thanks all again for joining.
Operator: Ladies and gentlemen, that does conclude your conference call for today; you may disconnect and thank you for participating. | [
{
"speaker": "Executives",
"text": "Sue Carson, Director of Investor Relations Thomas O’ Flynn, Chief Financial Officer"
},
{
"speaker": "Analysts",
"text": "Gregory Gordon - Citigroup Investment Research Paul Patterson - Glenrock Association Andy Lewis Leslie Rich - Columbia Management Ashar Khan - SAC Capital Paul Ridzon - Key Banc Capital Markets John Ali - Zimmer Lucas Partners Daniele Seitz - Dahlman Rose and Company Unidentified Speaker - Deutsche Investment Management"
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by. Welcome to the Public Service Enterprise Group First Quarter 2006 Earnings Conference Call and Webcast. (Operator Instructions). As a reminder, this conference is being recorded, Monday May 1, 2006 and will be available for telephone replay for 48 hours, beginning at 1 PM Eastern Time today until 1 PM Eastern Time on May 1, 2006. It will also be available as an audio webcast on PSEG’s corporate website at www.pseg.com. I would now like to turn the conference over to Sue Carson. Please go ahead."
},
{
"speaker": "Sue Carson",
"text": "Thank you and good morning. We appreciate your listening in today either by telephone or over our website. I’ll be turning the call over to Tom O’ Flynn, PSEG’s Chief Financial Officer for review of our first quarter 2006 results. Jim Ferland, PSEG’s Chairman and Chief Executive Officer will also join us this morning to discuss our pending merger with Exelon and other key events. But first, I need to make a few quick points. We issued our earnings release this morning, incase you have not seen it; the copy is posted on our website, www.pseg.com. We expect to file our 10-Q with the Securities and Exchange Commission later today, which will contain additional information. In today’s webcast Tom and Jim will discuss our future outlook in their remarks and so I must refer you to our forward-looking disclaimer. Although we believe that our expectations are based on reasonable assumptions, we can give no assurance they will be achieved. The results or events forecast in our statements today may differ materially from actual results or events. The last word on any of our businesses is contained in the various reports that we filed with the SEC. As a reminder, our guidance speaks as of the date it is issued, any confirmation or update in guidance will only be done in a public manner, generally in a form of a press release, a webcast such as this, or an 8-K or other SEC filings. PSEG may or may not confirm or update guidance with every press release. As a matter of corporate policy, we will not comment on questions regarding guidance during one-on-one meetings or individual phone calls. In the body of our earnings release, we provided tables that reconciled net income to operating earnings. We’ve adopted this format to improve the readability of the release and provide the required reconciliation’s between the GAAP terms, net income, and income from continuing operations to the non-GAAP term operating earnings. Operating earnings exclude merger-related costs. Operating earnings is our standard for comparing 2006 results to 2005 for all of our businesses. The exclusive merger-related costs that we can better compare our current period results with prior and future periods. By excluding the merger-related costs, our results and guidance are consistent with the way Exelon is treating their merger-related costs. Attachments to the press release provide the required reconciliation between the GAAP terms, net income and income from continuing operations to the non-GAAP term operating earnings for each of our major businesses. Finally, Tom and Jim will take your questions at the conclusions of the prepared remarks. In order to accomplish this effectively, we would appreciate it, if you limit yourselves to one question and one follow-up. Thank you and I’ll now turn the call over to Tom."
},
{
"speaker": "Thomas O’ Flynn",
"text": "Thanks Sue, good morning everyone and thanks for joining. I hope you’ve had a chance review our release of this morning. On this call, I’ll briefly go over our results for the first quarter and review our expectations for the remainder of the year. Then I’ll turn it over to Jim, to discuss the current status of our pending merger with Exelon. Briefly, operating earnings for PSEG were $204 million for the quarter. We expect it excludes $5 million of after-tax merger-related costs, a decrease of $79 million or $0.36 per share from the first quarter of last year. Although these early results were disappointing, they continue to support our 2006 operating earnings guidance of $3.45 to $3.75 per share. As always our guidance does not contemplate the impact of any new mark-to-market accounting issues, positive or negative, or the impact of any asset sales. We’ve updated our expectations for each of our operating subsidiaries, which all made out to zero. I’ll walk through the details as I go through each company’s results. Just a remainder that the guidance for PSEG is for the full year 2006, we continue to expect to close our merger with Exelon in the third quarter and such results post quarter-some would obviously be integrated into Exelon electric and gas. Power reported operating earnings of $112 million, or $0.45 per share for the quarter, just slightly below their 2005 results of $116 million of $0.48 per share. PSE&G, our utility reported operating earnings of $78 million or $0.31 for the quarter, about 33% lower than last year’s result of $117 million or $0.49 per share. Finally, Energy Holdings reported operating earnings of 28 million or $0.11 per share for the quarter, a decrease of $37 million or $0.15 per share from last year. As I go through our three major businesses, I’ll provide more insight into the changes from last year using earnings per share as the measure. As in aside, PSEG had, on average about 10 million more shares outstanding for the quarter compared to last year which will impact the comparable per share results. The PSEG Power, we continued to see improvements from both our fossil and nuclear fleets. As you know, our three nuclear units in New Jersey are currently being operated by Exelon under the Nuclear Operating Services Agreement. For the quarter, these units had a capacity factor of 101%, using the summer rating. This compares to capacity factor of just over 89% last year when Hope Creek was offline for most of January. After a very successful 214 day run, Hope Creek entered a refueling outage on April 7th. The unit is currently in a final stage of this outage and we expect it to return to service shortly. The improvements on our nuclear operations had a direct impact on the financial results for power during the first quarter, with the absence of the replacement power cost incurred last year for Hope Creek adding $0.12 to earnings for the quarter. Recontracting our positions at higher prices in spot market sales added another $0.13 over comparable results for the first quarter of last year. By a way of comparison, the average realized margins on our portfolio during the first quarter were about $5 per megawatt-hour higher than the first quarter of 2005. We anticipate enjoying a similar margin differential for the balance of this year. We also anticipate further expansion of margin in future years is more of our older lower price contracts well-off. Offsetting the benefits, the improved operations for mark-to-market losses are $0.04 for the quarter, when compared to the $0.05 gain reported in the first quarter of last year, the quarter-over-quarter swing is a net reduction of $0.09. We expect the $0.04 loss on the current positions to reverse before the end of the year, this transaction’s under-term. In our release, we mentioned briefly the negative impact moderating gas prices we had on Power’s results for the quarter. Power supplies all of PSE&G’s gas customers under the PGSS contract is in combination of physical storage, pipeline capacity and forward hedges. For residential customers, power passes through the inventory cost for the gas commodity, the PSE&G. Any difference between the tariff and the inventory cost for residential customers is differed on the utilities books for future recovery or refund. For commercial and industrial customers or C&I customers, a tariff structure is applied that is adjusted monthly based on the current NYMEX prices. Power results were compensative services such as the carrying cost of the gas. The PGSS contract, including the C&I component has generally provided a steady source of margin to power. During the first quarter, market prices were declining while the cost of gas and inventory was relatively stable. The increase in Power’s margin, the mild weather also contributed to decline in earnings as volumes were lower for our customers. The combined impact for the first quarter of 2006 was about $0.11 per share for the first quarter 2005 which was, was by contrast a very strong quarter. O&M expenses of power was slightly higher than last year during the first quarter, the net result of higher maintenance cost including labor and benefits partially offset by reduced cost at our nuclear site. Nuclear savings had the result of the headcount reduction and other efficiencies have taken place as part of the Nuclear Operating Services Agreement. As summary, the $0.03 decline quarter-over-quarter power can be found as attachment here at the press release. As the result of the higher prices for recontracted nuclear and coal output partially offset by the lower than expected PGSS margins, we’re increasing our 2006 operating earnings expectations for power by $25 million. The revised range is $500 million to $550 million, a significant increase over 2005 actual result of $480 million. Finally for Power, today we announced commercial operation of our 1220 megawatt Linden facility. This is sufficient to combine cycle gas plant will provide much needed capacity to the eastern region of PJM, the unit replaces 430 megawatts of coal fire capacity at the site. Now turning to PSE&G, for the quarter the utility was down over $39 million or $0.18 per share compared to the first quarter of 2005. Weather was a single largest contributor to this decline with degree days 20% warmer than the first quarter of ’05. This mild weather reduced margins by $0.07 per share. In addition to the weather impact, residential customers continue to curtail the usage of natural gas, further reducing PSE&G’s earnings on the distribution of natural gas. For the quarter this impact was about $0.02 per share. As you continue to see reductions in customer usage for gas, absent weather impacts, timely, regularly becomes even more important. Our current rates are insufficient to recover cost increases and infrastructure improvements approved in our 2002 rate case. As you know, we fall for a 3.8% increase in the gas distribution rates last September to recover cost incurred since 2002. We continue to respond to interrogatories from the BPU staff in this case; however the schedule for decision of this case was moved from October to December of this year, further reducing our earnings expectations for 2006. Continuing on the regulatory front, as part of the settlement of our 2003 electric base rate case, a $64 million excess depreciation credit was established. This credit expired on December 31, 2005. As part of this settlement, PSE&G either financial filing at the BPU in November of 2005 to compensate the elimination of this credit. We made that filing in early February, the BPU denied our request and suggested we file when our first quarter results were available. We will be making that filing shortly. However, it appears that until the merger is resolved with the BPU, decisions on such filings maybe difficult to achieve. For the first quarter, the resulting increase in depreciation expense reduced PSE&G’s earnings by $0.04 per share. Finally, higher wage and benefit cost increased quarter-over-quarter O&M expense by $0.02 per share. As summary, the various impacts with PSE&G could be found also in attachment file. As a result of the regulatory delays in the electric and gas distribution businesses of PSE&G as well as the unfavorable first quarter weather, we are reducing our operating earnings range for PSE&G by $45 million. The revised range for the utility is $270 million to $290 million for 2006. By a way of comparison, 2005 earnings for PSE&G was $347 million. Now the Energy Holdings, operating earnings for the first quarter of ’06 were down sharply from a comparable period last year. Firstly all the decline, gains on asset sales took place during the first quarter of 2005. In January 2005, we received the final payment of $36 million on, our withdrawal from Eagle Point contract. We also reported modest gains on sales of two investments, MPC in China and semis (ph) in California. The absence of gains from asset sales, reduce holdings comparative results by $0.13 per share. Higher tax rate on the overall earnings of PSEG Global, negatively impacted holdings for the quarter by $0.05. With a larger portion of the earnings coming from domestic sources, the result of higher Texas earnings and International asset monetizations, the full US tax rate is applied to the earnings. Operationally, the first quarter was very strong for holdings. Our Texas Plant continues to achieve significant benefits from attractive market, saw $0.04 improvement compared to the first quarter of last year. However, although margins taxes have increased which is, it improves our business outlook; our forward sales, contracts that hedge a portion of our output result in an unrealized mark-to-market losses for the quarter of $0.02 per share. We expect that happened to $0.02 to reverse during current year. The strength in Texas market as well as improvements in some of our South American operations should increase the expected operating earnings and holdings by about $10 million for the year. As a result, we are increasing the range for holdings to $165 million to $185 million for 2006. That pretty much sums up the quarter; I’ll now turn it over to Jim Ferland."
},
{
"speaker": "James Ferland",
"text": "Hey thanks Tom and good morning everyone. Before getting to the, on the merger front, I’d like to say just a couple of things about nuclear operations. Tom has already discussed the performance Salem and Hope Creek in terms of plant output and the financial effects of improved operations which are obviously very important. I’d like to report to you that those are not the only indicators we’ve got and well, how things are going down at nuclear. Now without exception, the feedback with the Nuclear Regulatory Commission, INPO (Institute of Nuclear Power Operations) special review team we’ve employed our own internal quality assurance folks, all now are meaningful improvements across all aspects of our nuclear operations. But we’re not, not the earnings perfectly and these reports don’t say that, but all of us have work to do. Power from the trends are extremely positive and they made me feel real good about, we can, are being able to look forward to some very strong performance from these facilities in the upcoming years. I may hope out now to the, to the merger for a little bit. I suspect many, if not most of you participated in the Exelon teleconference last Wednesday. And as you heard from John and the Exelon folks were the two key remaining regulatory proceedings, we have to deal with, The Department of Justice and then here in New Jersey, the BPU. The Jury hearings concluded sometime ago, now at the end of March, the initial briefs were all filed last Wednesday and the final briefs, I’ll do by May 10th, that’s next Wednesday. So we’re reaching the end of that process. And we feel very good about it, (indiscernible) established and we believe that our arguments that will be persuaded. I suspect many of you, but maybe not all of you are aware that end of juristic cases, this nature of almost all was settled as suppose to litigate it to a final decision. And I suspect that will be the case of here as well. But it is likely that the settlement demands will be greater than the $120 million in rate credits that we have on the table. We’re currently having discussions with New Jersey and The Department of Justice to resolve these proceeding as quickly as we possibly can. Now this morning for example, PSE&G is trying to establish a million with BPU, trying to sort out, and reach agreement on reliability and customer service issues. Now we got a, a lot of issues to queue with here in New Jersey and well its always hard to know for sure that I really can’t predict these things, not expect by the timely guess at the end of this month May we’ll, we should have sorted out pretty well what the outcomes going to look like, what we’d be able to workout in the way of a settlement, here in this state. At the same time, we’re actively engaged with the Department of Justice, to try to make us all come together at roughly the same time hopefully this month. Obviously, we are not going to be discussing the status of our settlement discussions in either at jurisdiction, I wouldn’t say that they, they are ongoing. While the pace and the length of the BPU and DOJ processes had been to long than expected. We are now finally actively engaged to discussions with both parties. While the, standard nature these proceedings have been, have been frustrating hardly and so that probably extremely frustrating, the developments would have taken place over the time period when we signed as merger agreement back in December of ’04. Today I have strongly reinforced our judgments regarding our strategic value of this transaction of both companies. Over this period, since our signing in a merger agreement both natural gas and electricity absolute prices and volatility have significantly increased with frequent and substantial swings in forward market prices, first in the east and then go back to the west and then they swing back again, highlighting the risk reduction benefits of a large geographic footprint which encompasses numerous power markets, the importance of scale is called our retention everyday becomes more obvious as our competitors continue to grow through mergers and acquisitions and on the legislative and regulatory front, there are lot of action going on in a variety of states including states which including states in which our companies operate. And that highlights again the benefits of the diversification of such risks across multiple jurisdictions. And the strategic benefits are combining under nuclear operations we’ve already produced a very remarkable results and the improvement of plant Salem and Hope Creek. Developments such as these have served to strengthen our result to complete this transaction as soon as possible. This is not the sale-over that we are insensitive for the outcome of the Department of Justice and the BPU proceedings. They are obviously very important. We remain firmly committed for these transactions and continue to expect to bring it to a successful closure with reasonable outcomes at the Department of Justice and the BPU; we continue to feel that it should occur in the third quarter. I agree totally with the John Rowe in his assessment of resulting new company should be extremely well-positioned to be an industrial leader. Final comments, some of you may have noticed in the April 17th issue of Fortune Magazine, they put about the business of rating companies on a variety of parameters and on electric and gas utilities and on the parameter of total return over a 10-year time period of compound a quick return, PSEG illustrates second excellent with the title, a little company down of south outselling company, with a compound rate of return over the 10 years of 14%. It turns out a little higher up in the performance levels; Exelon was #1 with the 10-year return 18%. Both of these companies have a long history of doing well for investors and I feel very good about what we are going to be able to do on a combined basis. That concludes my prepared remarks, Tom and I would be pleased to take questions."
},
{
"speaker": "Sue Carson",
"text": "Operator, can you provide the instructions for the Q&A?"
},
{
"speaker": "Operator",
"text": "Thank you. Ladies and Gentlemen we will now begin the question and answer session for the members of the financial community. (Operator Instructions). One moment please, for the first question. The first question is from Gregory Gordon from Citigroup Investment Research, please proceed."
},
{
"speaker": "Gregory Gordon - Citigroup Investment Research",
"text": "Thanks, I’ve got a couple of much in both questions on the quarter and then a larger question on the merger. First on the, on the new guidance for the utility the $270 million to $290 million operating earnings guidance, what type of ROEs at the electric and gas business does that infer?"
},
{
"speaker": "Thomas O’ Flynn",
"text": "Greg its Tom, we usually don’t give specific ROEs for each of our segment which are electric gas and of course, our transmission business. I’d say the gas business is materially under earning to 10% it got in this last case of 2002. It’s in the, it’s materially under earning it’s in the, it’s currently in the 6% to 7% ROE kind of range. So we certainly need a rate increase. The electric has been earning on historical basis somewhat higher than the 975 it got back in its August ’03 case. So on a rolling basis, we will over the next quarter or so, come down to that level and ultimately below that level and I feel to get the kind of credit recognition that that we need in the transmission business to go better."
},
{
"speaker": "Gregory Gordon - Citigroup Investment Research",
"text": "Yeah and then the other question before I get to the larger is, strategic issues is on the, that transmission the PGSS, it appears that you guys are well aware that there is a structural mismatch there that can happen because the pricing is based on NYMEX but you obviously take positions in terms of storage for gas. So I would like to, I want to understand how you wouldn’t hedge some of that financial risk, sort of near-term fluctuations in NYMEX versus the gas that you have in storage, the NYMEX is a liquid financial product, to lose $0.11 because the gas price is falling sort of month-to-month versus the basis you had in storage is sort of, doesn’t make any sense to me that you wouldn’t somehow try to hedge that risk?"
},
{
"speaker": "Thomas O’ Flynn",
"text": "Yeah it’s a fair point Greg. Let me just put in context the $0.11 was versus first quarter of last year which is the very strong quarter versus that normalized year was about $0.07 below that. So, of the $0.11 but $0.04 was, comparing to a strong quarter last year and then $0.07 was a more was versus expectations of our internal plan. Of this $0.07, about a four of that number is just plain volumes. There is a general volume based kind of number, so we’re talking about $0.04 or $0.05. Historically, this has been very solid stable business frankly we talk about a lot because it’s quite solid and reliable. And generally, we find some, in a normal, continual as I guess you call it curved, it has upward sloping curve generally our inventory cost compared reasonably favorably with our cost during the season. This year as you know prices were quite high, quite high and then sell-off dramatically over a very short period of time, we do, do some hedging. It varies from period-to-period, we do, do some hedging of course we can’t hedge, everything as you know always volumes are going to be. This year volumes were down materially but we did do some hedging this year, in hind side, we probably wished we would have hedged a little more back in fall, but I would say over time, over the last number of years we’ve done very well. In fact the first quarter of ’05 we would be testament to that."
},
{
"speaker": "Gregory Gordon - Citigroup Investment Research",
"text": "Great thank you. And then the larger question is for Jim. Its sounds like your confidence as you are making headway now on both fronts both at the DOJ and then the New Jersey BPU, I guess my question for you is, is the June 20th, date in the merger document, after which either company come to the unilaterally choose to no longer pursue the merger, a significant deadline in your mind in terms of getting these agreements done or not? And can you say in terms of that a little bit?"
},
{
"speaker": "James Ferland",
"text": "Yeah the short answer for your last question is no. But let me elaborate on it, a little bit. First of all, as for as engagement, it has been frustrating to get everybody engaged but at this time, the source and the process was Department of Justice, they worked on this for but something like north of a year and until they were completing with all their work and they are now simply are not willing to tell us anything. And that was frustrating, for such an extended period of time, well now they are willing to start to say some ideas and thoughts and they are willing to share those with us and we are actively engaged with them and the same thing now at the BPU. On the June 20th, let me comeback for that after a minute. No, I don’t view that is a particularly important date at this time for a variety of reasons first just to remind everyone, what avails when we sign this merger agreement back in 2004, we didn’t want the merger agreement to be outstanding forever so we have, let’s take a data out there somewhere where if we can get all the approvals, we can walk away and I can remember thinking, its time, My God! That could never be as late as you know June of 2006, what as I know, as an effort that date was created for and it does give the parties the ability to walk away. The reason I don’t like that’s going to be, of any particular relevance is, I suspect, by the time they get to the end of this month, we’re going to have a pretty good idea about what this transaction will look like and what we are going to be achieve at both Justice and with the, and with the BPU. Now, half of that time before we can reach a settlement with either of these parties, both are respected companies, they’re have to agree that these agreements and settlements make sense. Now if we reach agreements with those parties and they make sense to both companies, the June date becomes not, no particular relevant it is like the, either that we can successfully reach settlement agreements with these two organizations, the papering of those in a various approvals could extend and will past the June 20th day and John and I has talk about that, and if we think it was beneficial of that time, we’d probably just move it ahead."
},
{
"speaker": "Gregory Gordon - Citigroup Investment Research",
"text": "Okay thanks guys."
},
{
"speaker": "Sue Carson",
"text": "Thank you. Just to remind everyone, we’ve got a number of calls queued up so please limit yourself to one question. Thank you. Let’s go to next question please."
},
{
"speaker": "Operator",
"text": "Our next question comes from Paul Patterson of Glenrock Association. Please proceed with your question."
},
{
"speaker": "Paul Patterson - Glenrock Association",
"text": "Good morning guys."
},
{
"speaker": "Thomas O’ Flynn",
"text": "Hi Paul."
},
{
"speaker": "Paul Patterson - Glenrock Association",
"text": "Just the follow up here, I am not sure, I completely understood the answer to the, to the electric ROE that you guys expected to get this year. Could you just elaborate a little bit on that and also on the weather versus normal, I think you said it was $0.07 on the gas side versus 2005, what would have been normal. And was there any impact on electric at all?"
},
{
"speaker": "James Ferland",
"text": "Yeah Paul, let me try to do this one at a time, the gas number I think I said was in the 6 or 5, close to the 5% range. The electric and I am comparing these two what our latest allowed was, the electric the latest slab was 9.75 which is in summer 2003, we’re currently a point or two, above that on a rolling historical basis, the request for making an offset to depreciation credit on a look forward basis as well as historical basis. And as the year progresses, we’re going to fall at or through that 9.75% range without the credit."
},
{
"speaker": "Paul Patterson - Glenrock Association",
"text": "You fall below the 9.75"
},
{
"speaker": "James Ferland",
"text": "Yes."
},
{
"speaker": "Paul Patterson - Glenrock Association",
"text": "Okay that’s nice go ahead."
},
{
"speaker": "James Ferland",
"text": "Towards, towards, towards end of the year, yes. So in another words, we, that’s something we mainly and we think it’s appropriate to be getting. Just on, on the rate impacts, PSE&G was down for the quarter-to-quarter about $0.07, the 90% of that was gas, that’s the PSE&G. And the PGSS, it’s the contract between Power and PSE&G for gas supply that was half about $0.07 versus a normal year, our expectations result $0.11 versus last year which was an unusually strong year, strong quarter."
},
{
"speaker": "Paul Patterson - Glenrock Association",
"text": "Okay but the, but the $0.07 of PSE&G versus normal would have been, would have been what, I mean, if you look at the first quarter, it says weather is $0.07 that’s gas is at the same as what, what it would have been versus the, versus the normal year?"
},
{
"speaker": "James Ferland",
"text": "Actually, the, yeah the seven is versus a strong year last year. So versus normal, it’s about 5."
},
{
"speaker": "Paul Patterson - Glenrock Association",
"text": "Okay thanks."
},
{
"speaker": "James Ferland",
"text": "It was a, it is a cold winter first quarter 2005, which help both PSE&G and the PGSS. The PSE&G is half about $0.07 versus first quarter about 5 versus normal and the PSEG Powers is half about $0.07 versus normal about an 11 versus last year."
},
{
"speaker": "Paul Patterson - Glenrock Association",
"text": "Great thank you."
},
{
"speaker": "Operator",
"text": "The next question is from (indiscernible). Please proceed with your question."
},
{
"speaker": "Andy Lewis",
"text": "Hi actually it’s Andy Lewis, how you doing? I guess only got one question. Let me go with this one, can you just comment on John Rowe’s, (indiscernible) Exelon’s press release are related to earnings and just your comment or their phase of using economic sense…"
},
{
"speaker": "James Ferland",
"text": "Yeah Jim Ferland here I’m in."
},
{
"speaker": "Andy Lewis",
"text": "What you’re thinking…"
},
{
"speaker": "James Ferland",
"text": "I think that’s, I could make that chain comment. See, the figure remaining uncertainties in this issue and in this, in this combination, what we are going to have to give up if any thing at The Department of Justice and the BPU and obviously those are important outcomes and if we give away too much then we could bow away the economics of the transaction. And that’s going to be a very important to both of us. And we are both going to be looking at that. But the, we’ve got away, we’re pulling that, we are going to be forced to be over that in reaching settlements with these various organizations. So we’ll, once we’ve done that, we’ll obviously, we won’t get in to those agreements unless they produce a satisfactory outcome."
},
{
"speaker": "Andy Lewis",
"text": "Are you two both on the same page, with the two companies or is there a little differing of opinion on…"
},
{
"speaker": "James Ferland",
"text": "I don’t confuse it; I don’t think there is a inch of space between John and I. We are talking all the time; we know what’s going on. Frankly, people ask how do guys get along in this kind of thing frankly, we could be a better person or made do be doing this transaction with, then John Rowe I don’t know where you will find him. This guy has been incredibly flexible, reasonable; we are communicating all the time and I don’t think there is a space at all between the two of us when it is to how we look this transaction."
},
{
"speaker": "Andy Lewis",
"text": "I received that’s a bit of extra question but yeah you both good guys I agree thank you."
},
{
"speaker": "James Ferland",
"text": "Yeah."
},
{
"speaker": "Operator",
"text": "The next question is from Leslie Rich of Columbia Management Advisors please proceed."
},
{
"speaker": "Leslie Rich - Columbia Management",
"text": "Hi I wondered if I could just ask some question on attachment for which is your cash flow statement. You have a big positive swing in sort of, other cash flow come Ops with no breakdown I assume, about $200 million of that its depreciation just wondered what else or causing a $500 million positive swing? And then also in financing activities negative $750 million approximately I thought you paid down from debt I just wondered what else was, sort of the big drivers in those two buckets?"
},
{
"speaker": "Thomas O’ Flynn",
"text": "Okay Leslie, we are filing our Q, we expect by the terms of business today so obviously the full cash flow statements in it. The biggest up was really margining as prices came up somewhat and I think we said in our K, that our margin-posted, collateral-posted came down by about which got basically in half during February and we did continue to see that now some of that’s in letters of credit some of that’s in cash. Those were the, those are the biggest pieces, there were some other pieces in terms of pension in some other pieces but there was no collateral and, collateral was the largest. In terms of debt coming down, the biggest piece is Power had a maturity, I think it was a five year from initial deal that was done, $500 million maturity we paid that up with short-term debt."
},
{
"speaker": "Leslie Rich - Columbia Management",
"text": "Okay thank you."
},
{
"speaker": "Operator",
"text": "The next question is from Ashar Khan, SAC Capital. Please proceed with your question."
},
{
"speaker": "Ashar Khan - SAC Capital",
"text": "Just with two short question how much did the PGSS make last year and how much are you expecting to make on that this year?"
},
{
"speaker": "Thomas O’ Flynn",
"text": "Yeah, I’m sorry rather we don’t report that as a separate segment. And I think in the past we’ve shown some large numbers for over all ER&T numbers, I’d rather get away from specific numbers that’s what I talked all about it all in terms of differentials."
},
{
"speaker": "Ashar Khan - SAC Capital",
"text": "Okay but Tom, is it fair to say that for the rest of the year are you expecting further negative variance or the negative variance is the only one in the first quarter?"
},
{
"speaker": "Thomas O’ Flynn",
"text": "Well PGSS just like our PSE&G gas business is largely pretty 4-month season. And certainly January and February are the biggest piece and that’s probably about, first quarters’ by 50% of our send out the rest would be Novembers some on close December."
},
{
"speaker": "Ashar Khan, SAC Capital",
"text": "Okay if I can just end up, you mentioned end of May on both agreements I can rely to New Jersey but can I just ask why would it take the end of May at Department of Justice just trying to get a sense of the timing your anticipated timing?"
},
{
"speaker": "James Ferland",
"text": "Well I would like to think it wouldn’t take that long but it, but it may obviously, we are going to make this time further short as we possibly can. And I can say that all are taken the Department of Justice so long time that it’d be willing to talk towards they have been very forth-coming and very responsive since they have provided their first feedback to us."
},
{
"speaker": "Ashar Khan, SAC Capital",
"text": "Jim, can I just ask you when that first feedback was provided?"
},
{
"speaker": "James Ferland",
"text": "I don’t remember the exact day but that was a not longer, maybe of a week or two."
},
{
"speaker": "Ashar Khan, SAC Capital",
"text": "Okay, thank you."
},
{
"speaker": "Operator",
"text": "The next question is Paul Ridzon of Key Banc Capital Markets. Please proceed."
},
{
"speaker": "Paul Ridzon - Key Banc Capital Markets",
"text": "Good morning, throughout the balance of the year, is it tax rate that holdings are going to be a headwind or it was, was just a particularly owners quarter?"
},
{
"speaker": "Thomas O’ Flynn",
"text": "This is a, a little more honest but, but we should have somewhat of our higher tax rate during the years we said, some of that is just an increase percentage of US based contribution. But that’s all cooked into the guidance that we gave you."
},
{
"speaker": "Paul Ridzon - Key Banc Capital Markets",
"text": "Can you, just back on this PGSS because it is initially the kind of the first time referred about it. Is there kind of a sense to stay in the course and kind of try to almost outcast the market or do you want to put more maybe you can just ride the market more?"
},
{
"speaker": "Thomas O’ Flynn",
"text": "Yeah I just, this is been a very good business for us. It continues to be good business, it is doing something we’ve done for many and many years which is procure gas on behalf of customers for PSE&G. Obviously, it, the residential costs are pass through. I think it was in our third quarter earnings call, where we talked about the inventory costs that the PGSS had based upon our ADBs or sell store generates about 30% below the market. So that’s, its obviously doing good things for customers. This is one year when there was a dramatic decline of prices and that and that took about $0.04 or $0.05 off of the margins just on that price to decline if you will, keep in mind also when we look at this, we look at this in the context, the Powers overall risk return relative to gaps, it just because we’re we have to look at this is part of the overall portfolio. So we don’t want to suggest that we will only expose to Gas, there were some hedges on, difficult for hedge given volumes with complete certainty, but also we look at this on a portfolio basis for Power."
},
{
"speaker": "Paul Ridzon - Key Banc Capital Markets",
"text": "Given the uncertainty on volumes is this inventory mark-to-market or it is or do you, is it you think qualifies hedge counting."
},
{
"speaker": "Thomas O’ Flynn",
"text": "It’s largely normal. Anyway, next question."
},
{
"speaker": "Sue Carson",
"text": "Okay Paul."
},
{
"speaker": "Operator",
"text": "The next question comes from John Ali of Zimmer Lucas Partners. Please proceed with your question."
},
{
"speaker": "John Ali - Zimmer Lucas Partners",
"text": "Good morning and just a quick question on the utility guidance. You said weather it’s about $0.07 which is like $17 million over that $45 million. How much you’re now including in guidance of the $64 million depreciation credit? And then, how much of any of the gas rate increase?"
},
{
"speaker": "Thomas O’ Flynn",
"text": "I don’t want to go into these specifics on outcome of rate increases, I think on the gas side we’ve said that decision has been put off until December so obviously we are not."
},
{
"speaker": "John Ali - Zimmer Lucas Partners",
"text": "Okay."
},
{
"speaker": "Thomas O’ Flynn",
"text": "That’s the humble expectation, the 64 which is ruining out 68 technically on the electric side, we expect to get that during the year. But obviously, we were, we didn’t get a last quarter but we think as the year goes along, we should get some reasonable piece of that."
},
{
"speaker": "John Ali - Zimmer Lucas Partners",
"text": "Okay great, thank you very much."
},
{
"speaker": "Operator",
"text": "The next question is from Daniele Seitz of Dahlman Rose and company. Please proceed with your question."
},
{
"speaker": "Daniele Seitz - Dahlman Rose and Company",
"text": "Actually it’s just a follow up on one before. I was wondering you kind of really covered that $0.04. So, whatever the cost of the delay, it’s going to be on the depreciation issue."
},
{
"speaker": "James Ferland",
"text": "That’s right Daniele, it is fine to us."
},
{
"speaker": "Daniele Seitz - Dahlman Rose and Company",
"text": "Okay, so and okay I’ll speak to that question, I’ll come back later."
},
{
"speaker": "Sue Carson",
"text": "Next question."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of (indiscernible) from Deutsche Investment Management. Please proceed."
},
{
"speaker": "Unidentified Speaker - Deutsche Investment Management",
"text": "Well, thank you, a question for Jim regarding the two discussions you are having with New Jersey and DOJ. But is the public benefit, is the primary criteria for department for the New Jersey as well as how does the DOJ defer from first review of the same issues?"
},
{
"speaker": "Jim Ferland",
"text": "Well, it was a great question on New Jersey, the BPU they have separate area that describes the one of that is supposed to consider when they look at a merge like this is a product yet demonstrates pulses of benefits to the state of New Jersey and the customers and then you’ve got a group a lot of parties and that going to held at least been different that cant stop any losses in those significant number of those. On the, with regard to the DOJ, I think maybe some people might have thought at one time that DOJ would simply differ up to further on these issue, some scrap leads to conclusion quite soon and they, and they choose not to, and they have been working this issue and enormous detail for an extended period of time, in the last numbers I’ve saw, we have produced something in the order 10 million documents for their review and dozens and dozens of interviews in sale-force and I really went after this is a very, very federal way and they are obviously not simply going to take whatever, whatever, whatever friction, so we’re kind of, workout with them and we know we can work something out here as we work our way to the rest of this month."
},
{
"speaker": "Unidentified Speaker - Deutsche Investment Management",
"text": "Okay thank you."
},
{
"speaker": "Operator",
"text": "That will conclude the Q&A session. Mr. O’ Flynn I will turn the call back to you. Please continue."
},
{
"speaker": "Thomas O’ Flynn, Chief Financial Officer",
"text": "I think just one thing Leslie, I was really confused on the debt maturity the one we had was after the quarter. The biggest piece of the fiber of the large debt decrease was the call we enhanced a few days before the end of 2005 were holdings for about $309 million, $310 million and then so the other meets our demand, so that’s was, that was the biggest chance that therefore let PSE&G (indiscernible). But the, the Power maturity half in the first, a few weeks to second quarter, I think right, folks thanks all for joining. We will start the quarter we expect it would continue to, see yourselves getting the guidance and see some good improvements especially in the latter part of the year at Power. Again we continue to like our business model; I think we’ve got a good balance of earnings growth and prudent risk management and thanks all again for joining."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, that does conclude your conference call for today; you may disconnect and thank you for participating."
}
] | null | null |
QCOM | 4 | 2,006 | 2006-11-02 19:00:00 | Executives: Paul Jacobs - CEO Steve Altman - President Sanjay Jha - President of CDMA Technologies Group Bill Keitel - CFO Lou Lupin - General Counsel Bill Davidson - IR
Analysts: Paul Sagawa - Bernstein John Bucher - BMO Capital Markets Mike Ounjian - Credit Suisse Steve O’Toole - Lehman Brothers Ehud Gelblum – JP Morgan Mike Walkley - Piper Jaffray Inderbir Singh - Prudential Equity Group Brian Modoff - Deutsche Bank Hasan Imam - Thomas Weisel Partners Daryl Armstrong - Citigroup Tim Long - Banc of America Matt Hoffman - Cowen & Co.
Operator: Welcome to the QUALCOMM fourth quarter conference call. (Operator Instructions) I would now like to turn the call over to Bill Davidson, Vice President of Global Marketing and Investor Relations. Bill, please go ahead, sir.
Bill Davidson: Thank you and good afternoon. Today's call will include prepared remarks by Dr. Paul Jacobs, Steve Altman, Dr. Sanjay Jha and Bill Keitel. An Internet presentation and audio broadcast accompanies this call, and you can access it by visiting www.QUALCOMM.com. During this conference call, if we use any non-GAAP financial measures as defined by the SEC in Regulation G, you can find the required reconciliations to GAAP on our website. I would also direct you to our 10-K and earnings release which were filed and furnished respectively with the SEC today and are available on our website. We may make forward-looking statements relating to our expectations and other future events that may differ materially from QUALCOMM's actual results. Please review our SEC filings for a detailed presentation of each of our businesses and associated risks and other important factors that may cause our actual results to differ from these forward-looking statements. Pro forma revenues were $2 billion in the fourth fiscal quarter, up 28% year over year and 2% sequentially. Fourth fiscal quarter pro forma net income was $705 million, up 30% year over year and down 3% sequentially. Pro forma diluted earnings per share were $0.42, up 31% year over year and even sequentially. Fourth fiscal quarter pro forma free cash flow, defined as net cash from operating activities less capital expenditures, was $907 million, up 8% year over year and was 45% of revenue. Before I turn the call over to Dr. Paul Jacobs, I would like to mention that we are hosting an analyst meeting on November 13 in London. The meeting will be simulcast on our website with audio and slide presentations. Questions from our webcast participants can be submitted prior to the meeting by going to QUALCOMM's Investor Relations website at www.QUALCOMM.com and following the links to our London webcast. Now it is my pleasure to introduce QUALCOMM's CEO, Dr. Paul Jacobs.
Paul Jacobs: Thank you, Bill and good afternoon, everyone. Let me begin by thanking the employees of QUALCOMM for delivering another spectacular year. Despite the numerous challenges by a few companies to our business model this year, as an organization we have remained focused by continuing to both innovate and execute, and I am delighted to report that this effort has resulted in some excellent financial and operational results. Let me first comment on our financial results. Our pro forma earnings per share were up 41% year over year to $1.64. We were able to significantly outperform our original FY '06 guidance of $1.43 to $1.47 because we, with our partners and licensees, enabled stronger than predicted growth in handset shipments across all forms of 3G CDMA and because average selling prices of phones stabilized due to customer adoption of higher end features and a more rapid transition of 2G subscribers to 3G. These trends drove record pro forma fiscal year revenue, generating $7.53 billion, up 33% year over year, and pro forma net income of $2.8 billion in FY 2006, up 42% year over year. Now let me spend a few minutes going through some of the key achievements for our business in fiscal 2006. In QCT, each quarter of fiscal 2006 represented a new record for shipments, that obviously resulted in a record for the entire year. This outstanding performance included a total of 207 million chips shipped this year as compared to 151 million in fiscal 2005 and 137 million in fiscal 2004. QCT continues to demonstrate the benefits of our fabless business model and its ability to scale to our increasing volumes. Our growth also continued in QTL where we signed 22 new 3G CDMA licenses. Other significant licensing milestones included granting our first-ever licenses for single mode OFDM, OFDMA, a license for a manufacturer in India and one for a third-party FLO chipset manufacturer. In QIS we now have 69 BREW operator partners in 31 countries with BREW developer payments surpassing a cumulative $700 million. The launch of uiOne on the Pantech Ice handset in September highlights our successful acquisition of Trigenix, and other European operators are in the process of deploying BREW uiOne. In addition to also deploying uiOne, Sprint extended our relationship on QChat and announced that they will be deploying it as their solution for Push-To-Talk as they begin migrating their iDEN subscriber base to CDMA DO Revision A. In QSI we announced Verizon as our launch partner for media flow and are looking forward to deploying this revolutionary technology early next year. In addition, the FLO Air Interface standard was ratified by TIA, dispelling the misinformation that FLO is a closed technology. We were very pleased with the unanimous FCC ruling released in response to a petition for a declaratory ruling filed by QUALCOMM in January of 2005. This ruling greatly expands the number of markets in which MediaFLO USA can operate prior to the digital TV transition date of February 17, 2009. I would once again like to express our appreciation to Chairman Martin, the other commissioners and the FCC staff for their support for the new services that MediaFLO will enable. As I look forward to fiscal 2007, our challenge is clear. It is critically important that we help our customers grow their market share, and we continue to enable the operators' data businesses to be successful. Our R&D spending in fiscal 2007 is tracking to our long-term plan. Our R&D investments are targeted at both near and long-term projects, and the amount dedicated to longer-term projects is greater than it has been at any other point in our history. The industry move from commodity voice services to differentiated data services provides us with many opportunities to create new technologies and future revenue streams. The competitive advantages in cost, size, power and performance of QCT chipsets are clearly being leveraged in CDMA2000. There are 85 EV-DO deployments in more than 50 countries worldwide, and Sprint Nextel recently announced that they were the first operator to deploy EV-DO Revision A. San Diego is the first of 21 markets where Sprint will roll out EV-DO Revision A this year with coverage expected to reach more than 40 million people by year end. Additionally other forward-looking CDMA2000 operators such as Verizon, KDDI, Leap Wireless and Telecom New Zealand and LG Telecom already have aggressive plans for their evolution to EV-DO Rev A. For the WCDMA market, HSDPA is in its initial rollout stage. CDMA has been primarily a voice market to date since the data capability within the initial WCDMA specification was not a significant improvement over Edge or GPRS. Up until now in Europe specifically, there has been minimal distinction between 2G and 3G handsets, and consumers have continued to purchase largely based on form factor and known brands as opposed to functionality. But similar to the way the CDMA market matured over time, we have seen the number of manufactures increase in the WCDMA market. QCT alone has more than 30 customers with 267 designs available or coming to market. QCT will work to increase its share of the WCDMA chipset by assisting their existing partners or gaining new ones. In an example which highlights the power of the QUALCOMM business model to foster competition and support wireless operators' initiatives, Huawei and Vodafone recently announced the commercial availability of the first Vodafone-branded handset, the V710 manufactured by Huawei. In February the two companies entered into a strategic relationship in which Huawei will supply exclusive Vodafone-branded handsets in 21 countries over the next five years. As a result of the increased competition, prices have come down dramatically for WCDMA handsets, while volumes have increased. Using Yankee Group estimates for total market shipments and our own royalty reports for WCDMA unit shipments, WCDMA handset sales represented 41% of total sales in Western Europe, up from 30% in the March quarter and 25% in the December quarter of 2005. Competition is a far more important piece in driving down price in the handset market than any other single factor. I would also like to comment on recent speculation concerning the health of the CDMA2000 market based on a small number of emerging market operators considering GSM overlays to their CDMA2000 network. CDMA2000 continues to pace the migration from 2G to 3G and strengthens its market position. Close to 80% of the entire 3G subscriber base uses CDMA2000 devices and services. According to the CDMA Development Group, nearly 200 CDMA2000 networks are in operation worldwide as compared to 127 at this point last year. Now turning to WCDMA, according to the Global Mobile Suppliers Association, the GSA, more than 120 operators around the world have deployed WCDMA as of October 10, 2006. The vast majority of these deployments have been as overlays to GSM networks. Gartner Dataquest forecasted 54% of all spending this year as going to CDMA2000 and WCDMA infrastructure. By 2007 the firm expects spending to jump to 61% for 3G infrastructure, as spending on 2G technologies like GSM continues to decline. Strategy Analytics also predicts that more than half of the global spending for 3G wireless infrastructure will go to CDMA2000 and WCDMA during 2006 and that 2G technology investments will continue to decline. The continued deployment of HSDPA and ultimately HSUPA will be an important component of this infrastructure spending. HSDPA was introduced in November 2005 and is now commercial with 65 operators in 33 countries with 21 others in deployment. There are 51 commercial devices on the market from 16 suppliers that support HSDPA. The next evolution of this wireless broadband technology, HSUPA, is expected to be available in 2007 and will offer higher data throughput speeds in the uplink and other enhancements to improve the economics and performance of the 3G network. QCT was first to market with a HSDPA chipset solution, and we are pleased that our chipset customers have been the first device manufacturers to support HSDPA launches. QCT was also first to market with an HSUPA chipset, and we have design wins with ten manufacturers for that device. We are now working to make the broadband capabilities of HSDPA technology accessible to broader audiences. We sampled our MSM 6260 chipset ahead of schedule, which leverages the cost efficiencies of 65 nanometer process technology to accelerate the availability of HSDPA handsets to the mass market. Our leadership in HSDPA and in 1xEV-DO and DO Rev A has created the opportunity for us to build close relationships with laptop manufacturers. As a result, our HSDPA and DO chipsets are now being used in 73 commercial notebooks from nine manufacturers on 11 wireless operators' networks. As this industry evolves, you can be sure that QUALCOMM will design and deploy the highest performance air links for a broad array of applications. Beyond that, we will work with our partners to turn these into services that consumers and enterprises will demand. In closing, I am exceedingly proud of our accomplishments this year and remain steadfast in my belief that our business model has and will continue to be a positive force in the industry. Our philosophy is simple. Manufacturers should be able to compete in an open market, not a closed market controlled by a limited number of manufacturers using their intellectual property to stifle competition. By QUALCOMM acting as an aggregator of R&D for the industry, all participants in the value chain get the benefit of equal access to technology, enabling the best products to win in the market. I'm excited about the future for QUALCOMM. Our vision and execution in R&D programs, as well as the development of products and services by our partners, puts us in an enviable position to take advantage of the many opportunities ahead. I would now like to turn the call over to Steve Altman.
Steve Altman: Thanks, Paul, and good afternoon, everyone. I would like to first update you on the status of some of the legal proceedings that we are involved in. Let me start first with the complaints that were filed in Europe by six companies that have been referred to as Project Stockholm. There has recently been some confusing media reports issued about the expected next step in the process, and so I would like to clear up the confusion. The next step in the process is for the EC to decide whether or not to continue its informal investigation. Although we expect that the EC will shortly make a decision to continue its informal investigation, such a decision means only that the EC will continue to do what it has been doing. That is gathering and evaluating information in order to fully understand the complaints. Such a decision would not signal that the investigation has become formal or intensified as some media reports have mistakenly suggested. The decision to continue the informal investigation is not the equivalent of a statement of objections which would signal a more formal phase, nor does it indicate one way or the other whether a statement of objections will ultimately be issued. We have been advised that in complex cases it can sometimes take years -- in some cases as long as five to six years -- for the commission to reach the next milestone, namely a determination whether to either reject the complaints or initiate formal proceedings and issue a statement of objections or negotiate proposals to close the case. Because we feel that our agreements and actions have been lawful, we remain optimistic that the commission will ultimately decide not to issue a statement of objection. We have seen several positive developments in our litigation with Broadcom in the past few months. Broadcom's antitrust complaint against QUALCOMM was dismissed in federal court on September 1. Essentially the judge determined that even if she accepted as true everything that Broadcom alleged in its complaint, QUALCOMM has not violated any U.S. antitrust laws. This was a very significant and favorable ruling for us, and although it is certainly not binding upon the determination of similar issues that have been raised by the Project Stockholm group in the EC, we believe that it will be carefully reviewed and considered by the European Commission. Broadcom has appealed the ruling, and the appeals process will likely take a year-and-a-half or more to conclude. In the Broadcom International Trade Commission matter, on October 10 a judge determined that QUALCOMM did not infringe two of the three patents asserted by Broadcom. Although the judge determined there was infringement of certain claims of the third patent, he recommended that no downstream remedies, including no injunctions be implemented against the wireless handsets of third parties that incorporate QUALCOMM chips and software. We maintain that this third patent, which does not apply to CDMA technology but rather deals with transitioning the handset to a power saving mode when out of a service area, is invalid and not infringed, and we will ask the full commission to reject the judge's recommendations on these issues. In any case, we are exploring designs to replace the features accused of infringement with superior functionality. During the course of our litigation with Broadcom, we discovered that Broadcom had engaged in a successful multi-year effort to improperly acquire thousands of pages of our confidential business and technical information, including source code related to our WCDMA chip development. We also recently announced that the federal court in San Diego has enjoined Broadcom from any further solicitation, use or dissemination of QUALCOMM's WCDMA trade secrets, including source code. A copy of the injunction order is available for your review on our website. If we are later able to demonstrate that Broadcom is using any of our misappropriated trade secret information, Broadcom will be in violation of the injunction which could result in a finding of contempt. In April we identified Nokia as a company whose CDMA agreement needs to be extended. In the event that after April 9, 2007 the existing agreement is not extended or a new agreement is not signed, Nokia's rights to sell handsets under most of our patents and, therefore, Nokia's obligation to pay royalties to us, will both cease under the terms of the current agreement. And our rights to sell integrated circuits under Nokia's patents will likewise cease under the terms of the current agreement. Although we regularly meet with Nokia to discuss the terms of such an extension, given, among other things, Nokia's recent public statements and the little progress we have made to date, our negotiating team is not optimistic that we will conclude the extension by April 2007. Changing topics, we see continued signs of strong 3G growth in virtually every market around the globe. In Japan, as of the end of September, approximately 62% of Japan's nearly 94 million cellular users now subscribe to 3G services. In anticipation of local number portability, DoCoMo, KDDI and Soft Bank all introduced a wide variety of new handsets to the Japanese market, which we expect will continue to help grow that market. The U.S. market continues to experience rapid growth in the use of data. Verizon recently noted that their customers exchanged 232 million picture and video messages and completed 55 million downloads of games, ring tones and other content in the September quarter. Verizon’s VCast music service now has a 1.3 million song library, and the September quarter represented the first quarter when data revenue exceeded $1 billion, up 84% year over year. Sprint noted that its data service revenue is up 74% year over year, driven by increased usage of its 1xEV-DO PowerVision Network. Interestingly, Sprint noted that the monthly average data ARPU for CDMA subscribers is $10, twice that of the average for their iDEN subscribers. In developing markets, CDMA 450 is gaining significant traction around the world. CDMA 450 provides an extremely efficient wireless telecommunications solution by offering wide coverage and the ability to provide superior voice quality and high-speed data services and therefore has great potential for future growth. According to the CDMA Development Group, CDMA 450 networks are now deployed in 35 countries around the world, including China, Pakistan, Russia, Romania, Indonesia, Cambodia and Vietnam. In China, we have seen the continued expansion of CDMA2000. In the first nine months of calendar 2006, China Unicom introduced more than 60 devices and sold more than 5 million units. We continue to be very excited about the prospects in China, especially when the 3G licenses are issued. However, given the highly speculative nature of when the 3G licenses will actually be issued, we have not included the potential growth from 3G licenses in our '07 forecast. Turning to India, the CDMA market experienced strong growth with average monthly net additions of more than 1.7 million subscribers in the third quarter of 2006. India now has a cumulative base of over 38 million subscribers with Reliance and TADA surpassing 23 million and 12 million subscribers respectively. This quarter the Telecom Regulatory Authority of India has permitted CDMA operators to bid for 3G mobile phone services in 800 megahertz spectrum which they already use for their current services. We are pleased with this outcome as it enables easy expansion to existing networks and lays the foundation for the potential deployment of EV-DO in India. In Western Europe, we continue to see increasing 3G adoption across the region as next generation devices continue to decrease in cost and improve in form factor and battery life. The deployment of HSPA and the proliferation of new devices are becoming catalysts for operators’ 3G focus. The number of 3G capable handsets has accelerated rapidly in the past 12 months with over 60 new WCDMA handsets launched in the first half of 2006. As we look towards next year and beyond, we see a global market that will continue growing very rapidly due to a variety of factors, including a wide range of attractive and affordable devices combined with the improved network performance and the introduction of compelling new applications and services. We take pride in knowing that our broad licensing program, our engineering expertise and our continued investments in R&D are an important contributor to the industry's growth. Although our success and the success of our partners has resulted in challenges to our business model by some of our competitors, we remain confident that we will overcome these challenges. We feel very strongly that we have well-established the fair and reasonable value of our patent portfolio through bilateral arms-length negotiations with over 130 companies, and we will make our decisions considering the long-term best interests of QUALCOMM and its shareholders. I would now like to turn the call over to Sanjay Jha.
Sanjay Jha: Thank you, Steve. Good afternoon. I would like to review some key highlights for QCT. In the fourth quarter of fiscal 2006, QCT continued to set new milestones for financial performance. We set records for MSM chipset shipments, for revenue and for CSM channels. By shipping approximately 56 million MSMs, QCT established a record for the fifth straight quarter. This compares to approximately 55 million MSMs shipped in the third quarter of fiscal 2006 and 40 million in the fourth quarter of fiscal 2005. Year over year, this represents a 40% increase. For the full 2006 fiscal year, QCT shipped approximately 2007 million MSMs compared to approximately 151 million in fiscal 2005 for a 37% annual increase. For the fourth quarter of fiscal 2006, QCT achieved record revenues of over $1.1 billion. This amount is marginally higher than the third quarter but represents a 26% increase year over year. Our fiscal 2006 annual revenue of over $4.3 billion is a 32% increase over fiscal 2005. This represents a compound annual growth rate over the last four years of 28%. While QCT's annual operating profit of 26% in fiscal 2006 remains consistent with 2005, our operating profit increased 33% to greater than $1.1 billion for this fiscal year. As chip shipments and revenues accelerate, we are seeing the results of our technology innovation in the form of wireless devices launching throughout the world. QCT tripled our shipment of EV-DO chipsets in fiscal 2006, a fact that can be partially attributed to strong market acceptance of mobile broadband services. Both PC cards and mobile handsets supporting the next evolution of EV-DO networks, EV-DO Revision A, will be commercially launched before the end of the year. We remain committed to emerging markets, and this past quarter introduced that QSC 1100 single chip solution that will enable CDMA2000 handsets to break new price barriers. In addition to bringing wireless communication to new users in emerging marketplaces, the QSC 1100 is also designed to double talk time compared to CDMA2000 handsets on the market today and improve network capacity by up to 100%. Even as we continue to build our technology leadership in CDMA2000, we are continuing to increase our technology leadership in UMTS. This past quarter QCT completed successful test calls delivering 2 Mbps on the uplink with HSUPA and performed HSUPA inter-op testing with multiple leading infrastructure vendors. HSUPA is the next evolution of wideband CDMA technology that together with HSDPA delivers wireless broadband capability on the uplink as well as the downlink. Our HSDPA and wideband CDMA chipsets continue to gain traction, and we're enabling hundreds of models with our wideband CDMA chipset. We continue to invest into future technology and this past quarter acquired Qualphone, a San Diego-based provider of IP-based multimedia subsystems or IMS embedded client software solutions. Qualphone's IMS product and interoperability testing resources will enable QCT to accelerate our delivery of more feature-rich devices to global marketplaces as HSDPA and HSUPA, as well as DO Revision A get deployed. Our GPS1 assisted GPS technology has reached a new milestone with 200 million GPS1-enabled handsets now shipped around the world. GPS1 powers the majority of location services that are currently available at over 50 networks around the world. These applications bring enhanced functionality to consumer, business and personal safety markets at significantly lower costs and oftentimes with better capability than stand-alone GPS devices. In order to keep pace with growing demand for QCT products, we have announced a strategic agreement with Semiconductor Manufacturing International Corporation in China. As part of our ongoing commitment to China industry, our agreement with SMIC will help us streamline our operation, accelerate time to market and focus on our core technology strengths. I will now turn this call over to Bill Keitel for an overview of our financial results.
Bill Keitel: Thank you, Sanjay and good afternoon, everyone. We are very pleased to report another year of record revenues, earnings per share and operating cash flow. GAAP earnings for fiscal 2006 were a record $1.44 per fully diluted share. Share-based compensation was an estimated $0.19 per share. QSI was a $0.02 loss per share, net tax benefits related to prior years were $0.02 per share, and acquired in-process R&D expense was $0.01 per share. Excluding these items, our pro forma earnings for fiscal 2006 were a record $1.64 per fully diluted share. Pro forma revenues increased 33% yea –over year to $7.53 billion, and pro forma net income increased 42% to $2.8 billion. Our businesses continued to generate strong cash flows. Operating cash flow for fiscal 2006 was $3.25 billion, up 21% year over year and was a healthy 43% of revenue. During the year, we returned approximately $2.2 billion in capital to our shareholders through a combination of stock repurchases and our growing dividend program. This includes cash dividends paid of $698 million, or $0.42 per share, and 34 million shares repurchased for $1.5 billion. Although our share repurchases were reduced in the fourth fiscal quarter as compared to the third fiscal quarter, we continue to believe that our stock is undervalued. From time to time, however, we make judgments that due to the tendency of potentially significant events -- for example, earnings announcements, litigations, major contracts or acquisitions -- that it would be inappropriate for us to be in the market for our stock until such events had been concluded and then subsequently disclosed. Fortunately, we have a lot of exciting things happening at QUALCOMM. Unfortunately, from time to time that impedes our ability to execute on the stock buyback program at the pace we would otherwise choose. QCT shipped a record 207 million MSMs in fiscal 2006. QCT's operating margin ended the fiscal year at 26% as volume ramped, driven by increased shipments of EV-DO, WCDMA and low tier MSMs. QTL continues to be positively impacted by the growing adoption of CDMA around the world. WCDMA royalties from handsets shipped during the June quarter grew to approximately 49% of third-party royalties reported by licensees in the fourth fiscal quarter. Of $705 million in QTL revenues for the fourth quarter, $44 million represented inter-company royalties, $13 million were license fees and $648 million were royalties from third-party licensees. QTL's operating margin was 91% for fiscal 2006 and 90% for the fiscal fourth quarter. In our last quarter conference call, we advised of a larger than normal channel inventory build for China and India. We had adjusted our guidance accordingly, and we forecasted a correction in the channel to occur by the end of the calendar year. I'm pleased to report that we see the correction has occurred largely as we anticipated. We believe channel inventory levels are now comfortably within a normal 15 to 20-week band and will increase during the current quarter to a seasonally normal upper end of the band. R&D investment remained a strategic priority this year as we continue to invest in our WCDMA chip development, multimedia functionality and enhancements to the CDMA2000 technology roadmap. We also continue to increase our investment in longer-term business opportunities and technology innovations, including MediaFLO, OFDMA and display technologies. Pro forma R&D increased 28% year over year, and we expect this will maintain our leadership position with exciting and innovative products and services, and their associated intellectual property. Based on royalty reports from licensees, worldwide CDMA-based handsets shipped in the June quarter were approximately 70 million units, up from 66 million units shipped in the March quarter, driven primarily by sequential growth in shipments of WCDMA handsets in Europe. The average selling price of CDMA-based handsets was approximately $223 for the June quarter and $215 for the fiscal year. I will now highlight our forward guidance. For the calendar 2006 CDMA market, we now expect approximately 290 million to 298 million CDMA-based handsets to be shipped, including approximately 98 million WCDMA handsets. Based on the 294 million midpoint of our estimate, worldwide CDMA handset shipments for calendar 2006 are anticipated to grow approximately 40% year over year. We estimate the calendar 2007 CDMA phone market will increase approximately 25% to 32% over 2006 with shipments of approximately 368 million to 388 million units. Last year we refrained from estimating when the Chinese authorities would issue 3G licensees. We are including such estimates in our financial guidance, and we're continuing that practice this year. Based on the 378 million midpoint of our 2007 estimate, we anticipate shipments of approximately 203 million CDMA2000 units and approximately 175 million WCDMA units as 2G to 3G migration accelerates in many regions around the world. Based on the current business outlook, we anticipate fiscal 2007 revenues to be in the range of approximately $8.1 billion to $8.6 billion, an increase of 8% to 14% over fiscal 2006. We anticipate pro forma diluted earnings per share to be in the range of $1.76 to $1.81, an increase of 7% to 10% year over year. We estimate average selling prices for CDMA2000 and WCDMA phones combined to decrease approximately 5% in fiscal 2007 to approximately $205, and this of course compares to $215 in fiscal 2006. We anticipate pro forma R&D and SG&A expenses combined to increase approximately 16% for fiscal 2007. This increase is driven primarily by the full-year effect in fiscal 2007 of the growth in our employee base during fiscal 2006, as well as we’re planning for further increases in our legal expenses. QCT continues to invest meaningfully to grow our WCDMA chip share, and at this point, our guidance reflects a modest growth in share for fiscal 2007 over fiscal 2006. We anticipate our pro forma tax rate in fiscal 2007 to be approximately 26%. unchanged versus fiscal 2006. We estimate our GAAP diluted earnings per share will be approximately $1.45 to $1.50 for fiscal 2007. This estimate includes an estimated loss of approximately $0.11 per share attributable to QSI, as well as approximately $0.20 per share attributable to estimated share-based compensation. Turning to the first quarter of fiscal 2007, we estimate revenues will be in the range of approximately $1.98 billion to $2.08 billion, an increase of 14% to 19% year over year. We estimate first quarter pro forma diluted earnings per share to be in the range of approximately $0.42 to $0.44, an increase of 8% to 13% year over year. This estimate assumes shipments of approximately 55 million to 58 million MSM phone chips during the December quarter and an estimate of approximately 74 million to 76 million CDMA-based handsets shipped in the September quarter at an average selling price of approximately $209. We expect QCT operating margins to be lower sequentially and total company pro forma R&D and SG&A expenses combined to increase approximately 5% to 8%. Our full year fiscal '07 earnings estimate assumed the renewal of Nokia's license agreement prior to April 2007. If we're unable to resolve licensing issues with Nokia and Nokia refuses to pay for its use of our patents, we estimate a possible impact to our earnings of $0.04 to $0.06 per diluted share in fiscal 2007. This estimate is based on our current expectations for June 2007 quarter handset shipments, average selling prices and market share. And, of course, those numbers will be recorded in our fiscal fourth quarter. At this time, we expect a seasonal decline in MSM shipments in the second fiscal quarter of 2007 as channel inventories are reduced post the Christmas season. Our second fiscal quarter royalty revenues will reflect licensee shipments from the typically seasonally strong December quarter, and our operating expenses also tend to increase in the second fiscal quarter for seasonal reasons. In combination, we expect pro forma second fiscal quarter earnings to be in the range of our first quarter guidance. The QUALCOMM Investor Relations website includes an extensive slide presentation on the many data points included in this conference call. I look forward to sharing with you additional data points regarding our fiscal 2007 guidance, including regional handset shipment estimates, at our London analyst meeting on November 13. This meeting will be webcast for those of you not able to attend. That concludes our remarks, and I will now hand the call back over to Bill Davidson.
Bill Davidson: Before we go into our question-and-answer session, I would like to remind our participants that our goal is to address as many as possible before we run out of time. Therefore, I’d like to ask you to limit your questions to one per caller. Operator, we are ready to accept questions.
Operator: (Operator Instructions) Your first question comes from Paul Sagawa - Bernstein.
Paul Sagawa - Bernstein : Hi. So if I'm looking ahead into 2007 and the next quarter, I think a lot of folks in the market have been a little bit spooked by comments from Nokia and Texas Instruments about WCDMA demand in the near term, particularly out of European carriers. Your guidance for 2007, $175 million, upbeat and I must say I agree with it, but it is a little bit counter to some of that more cautious commentary. Can you talk a little bit about what you're seeing with regard to demand for WCDMA handsets in Europe that leads to a more optimistic view? Also, is this some indication that you believe that your chipset customers may be taking market share in the near term in WCDMA?
Bill Keitel: Hi Paul. With regard to our WCDMA estimates for next year, we are expecting very substantial growth for the European market. We will get into the details of that in London. But I have heard some concerns by some of the parties you have mentioned more focused on the near term. I have heard that a bit in Europe, with reference to Europe. I would say that we are expecting, based on our information and forecasts that a lot of our licensees have shared with us, we expect an increased number shipments into the European market in the September quarter relative to the June quarter, and I expect the same continuing into the December quarter. Where I have seen some statements that sync with ours, I would note that in the Japan market as strong as things are there, I think people have stocked up on inventory in anticipation of local number portability, and we have a modest decline estimated for our shipments of product in Japan in the September quarter, although picking back up in the December quarter. So I think that did sync with a number of other comments from other people. But overall for WCDMA in Europe, I would say that we see HSDPA being deployed at an increasing rate, and I think that data ARPU is going to be the compelling point there. As well as the ASPs I think will continue to improve and make it even more enticing for operators to be pushing WCDMA.
Paul Jacobs: Thank you. We are also heartened by the price competition that is happening, and in particular this Huawei phone that I talked about earlier is coming in at a significantly lower price that allows WCDMA phones to enter a different tier in the pricing. So we hope to see that as a significant driver of volume as well.
Sanjay Jha: Paul, you had a question about how I see our wideband CDMA chipset demand going forward. We have seen a fairly substantial increase in demand for wideband CDMA chipsets for the December quarter over September quarter, so I have to say September quarter was, for wideband CDMA, not as strong for us as we had initially hoped. But there is a fairly substantial uptick in demand in the December quarter. Consistent with what Bill and Paul said, we see significant strengths in the wideband CDMA marketplace and our guidance reflects that. I should make one additional point. One of our competitors who indicated the Japan market is weak for them has a particularly large exposure to DoCoMo's high-end OMAP kind of marketplace. As you have seen with number portability, both Soft Bank and KDDI appear to be doing rather well. I could certainly see that that could be the case.
Paul Sagawa - Bernstein : Great, thanks.
Operator: Your next question comes from John Bucher - BMO Capital Markets.
John Bucher - BMO Capital Markets: Thank you. A question on your fiscal 2007 outlook. Bill, I guess this would be for you. You indicated R&D and SG&A would be up 16%, so that would explain why pro forma EPS will grow at a slower rate than the revenue outlook. I am wondering how much you are factoring in there – and the employee base stuff I understand, you probably have a pretty good idea on that – but how much variable expense might be there, just all depending on a variety of the legal contingencies and how they play out? Could there be, perhaps a range that the R&D and SG&A would be up, the 16% perhaps being a midpoint? What is the standard deviation if things go well on the legal front? Thank you.
Bill Keitel: Sure, John. A couple of points. On that 16% year over year estimate, it isn’t a midpoint. First, I would say that the majority of that is what I call carryover from fiscal 2006. We have ramped our employee base, particularly our engineering base, significantly in fiscal 2006. Now we will see a full year effect of that in fiscal 2007. We do expect to reduce quite substantially the rate of new hiring into fiscal 2007 relative to the past three or four years. So the majority of that increase I think is the carryover from a full year effect of the hiring we put in place this year, number one. Number two, I did also mention it is also legal fees. The numbers are quite substantial, and we're planning at this time in our estimates to increase our spending on legal for fiscal 2007. We will have to see how that proceeds, but if you put a band around that 16%, I would say it is a plus, minus 4% or so, like a 12% to 20% kind of band.
John Bucher - BMO Capital Markets: Thank you very much.
Operator: Your next question comes from Mike Ounjian - Credit Suisse.
Mike Ounjian - Credit Suisse : Great, thank you. Also looking at the '07 guidance but for the handset shipments, particularly on the CDMA side. As you mentioned, there has been a lot of focus on a few operators in the developing regions who are looking at GSM. Could you talk about some of the factors that are driving the overall number to be up and in particular what regions you really see growth coming from next year?
Bill Keitel: I will take a stab at that. So for CDMA2000 the calendar '07 versus calendar '06 guidance that we just shared with you, I think it's about a 4% year-over-year increase for CDMA2000. We will give a regional breakdown consistent with how we define our regions today and breakdown our global estimates, but I'm pretty confident when you see that, we will show you a growth in all markets. Our expectation is good growth in all markets with the exception of Latin America. Take Latin America out of our CDMA2000 estimates and I think our forecast for CDMA2000 growth is closer to about 9%. So we think there's a good market ahead for CDMA2000 in most all regions around the world.
Mike Ounjian - Credit Suisse: Thank you.
Operator: Your next question comes from Steve O’Toole - Lehman Brothers.
Steve O’Toole - Lehman Brothers: With respect to the framework you outlined for Nokia and the pending issues there, you said there was little progress to-date, so you would expect it to go beyond the April timeline. You mentioned that you would be looking to pursue or entertain injunctions. When you think about that as a framework, should we be thinking that is a dispute that you would anticipate going through several quarters, perhaps then, of the fiscal '08 given the way you see it now? I am sure Bill you may be reluctant to share some of the assumptions behind $0.04 to $0.06, that is quite a precise range that you're suggesting would be the impact from Nokia in September. Perhaps you might be able to give some framework for how you think that might develop going forward, or should we going forward and just use that as a reasonably steady-state rate? Lastly, maybe just directionally in terms of the regions, while you're going to give detail at the Analyst Day, should we think about Brazil and India -- given the issues there -- as growing next year, or how should we think about that?
Steve Altman: It is Steve. Let me just real quickly respond to your question regarding Nokia. I think it is very difficult to forecast how long or short these negotiations will go. It is certainly very possible that it could go for several quarters or even beyond as the courts systems are used and so forth. So it is a possibility, and like we said, we have discussions with them regularly. We will continue to have those discussions, and if progress is made, we will let you know.
Steve O’Toole - Lehman Brothers: But you, in terms of expectations, look for a fairly lengthy and drawn out process?
Steve Altman: Let's say it this way that we plan accordingly to that, but we are hopeful that it does not go as long as it could.
Bill Keitel: On the $0.04 to $0.06 estimate for Nokia, I have been through that a few different times in the last few months or more. It has been a stable forecast. It is a good forecast. At this point I would say I would be surprised if it fell outside that band. Then on India, again, we will share the regional guidance in London, but we are looking for a healthy growth year over year for CDMA2000 in India, albeit it is a low-end market. So as I have said in the past, it is an important market for us, but in terms of bottom line contribution, it is more of a business development than anything else.
Operator: Your next question comes from Ehud Gelblum – JP Morgan.
Ehud Gelblum – JP Morgan: Thank you very much. First, a quick clarification and then a question. The clarification, did you mention ASP on the 3G phones that you had in prior quarters? If not, can you give us some sense as to what it looked like and how it has trended over the last couple of quarters? That would be great. As you look forward to the EPS guidance ranges that you gave for the first quarter and for the fiscal year '07, they seem to be a little lighter than the optimism on the top line and the $175 million WCDMA handsets for '07 would suggest, which I think are both very strong numbers.
Bill Keitel: I will take a stab at your answers here. On the ASP, the trend here has been for the quarter we just reported, average ASP was $223, it was $213 in the prior quarter, $208 in the quarter before that. We averaged $215 for the fiscal year. We have not disclosed the WCDMA versus CDMA2000 breakout of that here this quarter. But suffice it to say, WCDMA remains at a fairly significant premium, although the range of handset prices available in WCDMA is very broad. In terms of your point on mix of royalty payments, I would say it is more, Ehud, that you get variability in terms of the mix of handset royalties and infrastructure royalties. Of course, there are a lot of changes OEM to OEM and what they are selling quarter to quarter, and then region by region. But other than that, no, I don't think there's anything really of note that I would point out. We will get into a little more detail in London on margins and profitability, et cetera.
Operator: Your next question comes from Mike Walkley - Piper Jaffray.
Mike Walkley - Piper Jaffray: Great, thanks. Just another question on the fiscal '07 guidance. I think on your QCT division, you mentioned a 25% to 32% rate with a big ramp in R&D again this year. Would it fall below that rate maybe in '07 and go back to that range into '08? With the price of GSM phones continuing to fall, I think Nokia said in their conference call north of 40% of their volume was below EUR50, maybe you can talk about the single chip solution and how that is progressing and how you are closing the gap on pricing between CDMA and GSM on the entry markets?
Sanjay Jha: I will take that. Yes, you're right. I have guided you to 25% to 32% of the range that we drive the business to. This year we were at 26%, as we were last year. My expectation is that we will come in below 25% for overall operating profit for QCT for '07. But obviously we see this right now as the kind of investment that we need to make while there is ongoing consolidation in UMTS industry. We see our ability to invest as a core competitive advantage, and it is a conscious decision that we are taking to continue to make that investment, not only in reducing cost of our chipsets but also investing in the next generation of HSPA, sometimes often called HSPA+, to further improve the capabilities of HSPA technology. I think that we have made a conscious decision, and yes, for the first time, we are falling outside the long-term range that we have guided you to. Secondly, on single chip solutions, I expect that there will be launch of handsets based on our single chip solution this year in various parts of the world. Of course, you recognize that Ron Garriques (Motorola, President, Mobile Devices) in his analyst call said that he will deliver. I expect that there is a chance that one other handset manufacturer might deliver a handset based on single chip solutions this year, and there is a possibility that they may not, and they cannot do it in January/February. But there are 18 handsets being designed based on single chip solutions, so I think that we will see healthy competition in the low end, and we really think that we will drive the price of low-end handsets to be very, very competitive with GSM. Again, I'm cautious in saying that we will be exactly the same price, but we will get closer and closer. We have shown that combined with very cost effective, low-end handsets the capacity increases that we are offering makes this quite compelling for our carriers. I think that those were the two parts of your question.
Operator: Your next question comes from Inderbir Singh - Prudential Equity Group.
Inderbir Singh - Prudential Equity Group : Thanks very much. I wanted to just come back to the comments that you made in the press release about in the event that the Nokia agreement is not signed in time, obviously you have indicated there would be some legal options you might pursue. In the past, Paul or Steve, I think you've also addressed the possibility of business actions you might take, business restructuring perhaps. Could you maybe bring us up-to-date on where you are on your thought process on that?
Steve Altman: I guess all I would say is that we are keeping our options open and looking at what the best thing to do is to enhance or maintain shareholder value. I would not say that I have any specific new initiatives to announce along those lines. Just to say that it is a possible response to these negotiations.
Operator: Your next question comes from Brian Modoff - Deutsche Bank.
Brian Modoff - Deutsche Bank : On page 6 of the press release, you talk about your inability to use self-integrator circuits under Nokia's patents. Do you see any issues getting around those patents, or do you see them having potentially leverage on your chipsets from that? Also, talking about low-cost CDMA, are you working on a single chip WCDMA type product, and could we see something like that for next year? What are the carriers you're seeing in Europe saying to you around their promotion plans for WCDMA? Christmas clearly Vodafone with 77% of their phones WCDMA, has some plans there. We are also hearing from Orange similar plans around that. Can you kind of comment on that, please?
Sanjay Jha: I will take the latter two questions. First, on single chip solution, Brian, clearly after having established the technology for CDMA, we have the ability to go deliver that in wideband CDMA, and we look forward to announcing that at the appropriate stage in the near future. On the second part of the question about the carriers' plans, we actually see fairly aggressive plans from the carriers. If you look at the Vodafone UMTS lineup, it is actually a really compelling lineup. We think that looking from a broader wideband CDMA perspective Nokia has some good devices. Motorola has some good devices, and there are lots of devices based on our solution on Vodafone's lineup, which I think will be very compelling for consumers. As you say, Orange is also becoming more aggressive. We see Cingular in the U.S. with their rollout of HSDPA and UMTS becoming more aggressive. And the M&P competition that is now raging in Japan, also driving more sales of both CDMA and UMTS devices in Japan. So I think that it is fair to say that we are cautiously bullish on what happens in the December quarter.
Lou Lupin: I will answer the first part of your question. We have never believed that Nokia's patents are applicable to our products. As you probably know, our current rates for Nokia are royalty-free. So there has been never any tacit acknowledgment of their applicability to our products. Having said that, we believe that if we are unable to resolve the current impasse in the negotiations before April that there is likely to be litigation going both ways. I'm sure Nokia is going to take a different position, and that question, if not resolved through some kind of amicable arrangement, will get sorted out in the courts and various other bodies that have the responsibility for deciding patent matters.
Operator: Your next question comes from Hasan Imam - Thomas Weisel Partners.
Hasan Imam - Thomas Weisel Partners : My question has to do with actually the December quarter guidance. Last year's seasonality and WCDMA ramp had contributed to pretty strong sequential growth, and this year it appears to be more flat lining, despite your positive comments on the WCDMA handset segment and the India inventory overhang clearing up. So I am just wondering why we don't see more of an acceleration? Is that primarily the trade out between unit growth and ASP declines? Thank you.
Bill Keitel: In terms of unit growth, I think that as I said, we always expected the channel inventory excesses we were concerned about for China and India to work itself out by the end of the calendar year, and we see that happening. So we're very encouraged by that. It is consistent with our prior estimates, but we do think that is happening as we speak, and part of that in this current December quarter. So that would be part of the effect, number one. Number two, you have quite a ramp I think that occurred in Japan in anticipation of a L&P, so I think that was also a factor that adjusted a bit what you might otherwise have seen in a quarterly profile. In terms of ASPs, I think our forecasts in the past have been pretty accurate on ASPs. I hope they will be again. We certainly have put the same effort into them, so we are expecting a modest decline in the ASPs, but other than that I think it is pretty much business as usual.
Hasan Imam - Thomas Weisel Partners : As a follow-up to that, if we continue to see the WCDMA ramp in December quarter, does that indicate because of your revenue recognition, a stronger first half '07?
Bill Keitel: As phones ramped in the December quarter, that will positively affect our royalty revenues in the March quarter. So to the extent our forecast of units is correct for the December quarter, I have tried to size that in my March estimates, and I gave you some indications of guidance for the second fiscal quarter.
Hasan Imam - Thomas Weisel Partners: Great, thank you.
Operator: Your next question comes from Daryl Armstrong - Citigroup.
Daryl Armstrong - Citigroup : Thank you very much. I have a question for Lou. You talked about the litigation that will likely extend from QUALCOMM to Nokia and Nokia back to QUALCOMM post the April deadline. Do you think that litigation exposure also extends to your chipset customers if they accept your chips after that deadline? Do you anticipate that QUALCOMM would indemnify those customers if there is some exposure there?
Lou Lupin: The litigation could in theory extend to those customers who don't independently have rights from Nokia. Having said that, I think it is unlikely that Nokia wants to involve most of our customers in this because they are going to again get a similar reaction from the customers. That is, the customers will assert patents back against Nokia, as well as the patents that we would be asserting. So I think it is unlikely that they would want to draw in our customers. I don't really want to comment on the terms and conditions of our supply agreements between us and our customers. So I think I will leave it at that.
Operator: Your next question comes from Tal Liani - Merrill Lynch.
Tal Liani - Merrill Lynch : I had just one clarification on the prior answer and then one question. Nokia on their conference call discussed specifically about pass-through rights and said that they are not getting pass-through rights. Probably you're not going to answer on a specific question on Nokia, but would you mind to clarify the issue of pass-through rights, how does it work? What kind of rights do you have in general that you pass through your customers? My question is something very specific on Japan. Can you discuss on any potential inventories at NTT for WCDMA phones?
Steve Altman: This is Steve. On the pass-through rights, it probably would take longer than we should give it here on this conference call. But let me just say at the analyst conference in London, I will go into more detail on pass-through rights, how they work and so forth. If you can bear with us until then, I think you will get a better understanding.
Tal Liani - Merrill Lynch : About inventories at NTT since TI made a comment about some inventories in Japan?
Sanjay Jha: Tal, we do have some handsets at NTT DoCoMo, but I think we don't have enough visibility for the entity DoCoMo to comment in detail except to say, as Bill said, there was some buildup of inventory in anticipation of mobile number portability. So far, we see Soft Bank and KDDI being disproportionate winners out of that transition. So I think beyond those data points, I couldn’t point to anything else.
Operator: Your next question comes from Tim Long - Banc of America.
Tim Long - Banc of America : Bill, if I could just ask you a question on the September quarter QTL line. I was a little surprised to see it up only 3% sequentially. If you could just explain if there was anything funny in the quarter there? Because if you look back at the June numbers, you had a pretty good spike in ASP, up 4% or 5%, and unit shipments looked like they were up about 6%. So I am just curious as to why the royalty line with the quarter lag, it seems like the license revenues were about stable, why we didn't see a bigger sequential jump in that line? Has there been any change in overall rate or anything else in the quarter?
Bill Keitel: Tim, no change in rates for licensees. Those rates stay constant. So again, it comes back to a different mix of infrastructural royalties versus test equipment royalties versus phone royalties. And then there are small amounts of special credits that sometime folded into the QTL segment. I think we had a modest amount of those in the September quarter.
Tim Long - Banc of America : Okay. Well, Bill, should I think of it as the prior quarter was helped out on the high side or the June quarter or the September quarter was hurt on the low side? Which was a more normal number would you say?
Bill Keitel: Tim, I will go into a little more specifics for 2007. I think that is the key is 2007, and we will go into a bit more specifics in London.
Steve Altman: Let me just clarify. When we talk about credits or so forth, what we're really talking about is time to time with special programs with carriers, we will provide incentives to carriers to sell more product or focus more on certain applications and so forth. Those types of expenses get allocated to QTL in terms of growing the overall CDMA business. So that impacts the amount.
Operator: Your final question comes from Matt Hoffman - Cowen & Co.
Matt Hoffman - Cowen & Co. : Thanks. Another question on the term changes in the negotiations with Nokia. Steve, Nokia discussed a four-part test for an injunction post April 9 and thought QUALCOMM would not be able to meet the standards for that test. Could you discuss both the test and QUALCOMM's ability to prove the company is entitled to an injunction if no agreement with Nokia is reached. Thanks.
Lou Lupin: I will take that one. We think we will have utterly no problem meeting the four-part test. You're talking about a situation of a company that had a license that has been paying royalties, acknowledges the applicability of our patents in the most sincere way by paying large amounts of money for them, and then declines to renew and deliberately infringes. I think under those circumstances we are going to have very little difficulty in getting an injunction in meeting the test. I would be happy to expand upon the legal specifics of that test at a later time. I think it would take more time than we have now. I'm planning on being in London as well. So either Steve or I would be happy to address that there.
Operator: Dr. Jacobs, do you have any closing remarks?
Paul Jacobs: I would just like to say that for the first full year of our new management team, I'm extremely pleased by the results that we were able to deliver. You know, there were obviously a few companies that decided to attack us and certainly have attempted to flood the market with a lot of misinformation. I guess I had hoped that we would have built a stronger working relationship with some of those companies, and I still remain hopeful that that will happen in the future. But I definitely want to highlight the fact that we are working extremely well with a large number of partners, and we are creating many new partnerships both inside and outside of the wireless industry. So despite these attacks, we really have remained extremely focused on innovation, execution and partnerships, and I think that you will see that we have many new products, new technologies and news services that we will bring to market in the next fiscal year. So thanks, everybody for joining us. I will look forward to seeing some of you in London.
Operator: This concludes the QUALCOMM fourth quarter conference call. | [
{
"speaker": "Executives",
"text": "Paul Jacobs - CEO Steve Altman - President Sanjay Jha - President of CDMA Technologies Group Bill Keitel - CFO Lou Lupin - General Counsel Bill Davidson - IR"
},
{
"speaker": "Analysts",
"text": "Paul Sagawa - Bernstein John Bucher - BMO Capital Markets Mike Ounjian - Credit Suisse Steve O’Toole - Lehman Brothers Ehud Gelblum – JP Morgan Mike Walkley - Piper Jaffray Inderbir Singh - Prudential Equity Group Brian Modoff - Deutsche Bank Hasan Imam - Thomas Weisel Partners Daryl Armstrong - Citigroup Tim Long - Banc of America Matt Hoffman - Cowen & Co."
},
{
"speaker": "Operator",
"text": "Welcome to the QUALCOMM fourth quarter conference call. (Operator Instructions) I would now like to turn the call over to Bill Davidson, Vice President of Global Marketing and Investor Relations. Bill, please go ahead, sir."
},
{
"speaker": "Bill Davidson",
"text": "Thank you and good afternoon. Today's call will include prepared remarks by Dr. Paul Jacobs, Steve Altman, Dr. Sanjay Jha and Bill Keitel. An Internet presentation and audio broadcast accompanies this call, and you can access it by visiting www.QUALCOMM.com. During this conference call, if we use any non-GAAP financial measures as defined by the SEC in Regulation G, you can find the required reconciliations to GAAP on our website. I would also direct you to our 10-K and earnings release which were filed and furnished respectively with the SEC today and are available on our website. We may make forward-looking statements relating to our expectations and other future events that may differ materially from QUALCOMM's actual results. Please review our SEC filings for a detailed presentation of each of our businesses and associated risks and other important factors that may cause our actual results to differ from these forward-looking statements. Pro forma revenues were $2 billion in the fourth fiscal quarter, up 28% year over year and 2% sequentially. Fourth fiscal quarter pro forma net income was $705 million, up 30% year over year and down 3% sequentially. Pro forma diluted earnings per share were $0.42, up 31% year over year and even sequentially. Fourth fiscal quarter pro forma free cash flow, defined as net cash from operating activities less capital expenditures, was $907 million, up 8% year over year and was 45% of revenue. Before I turn the call over to Dr. Paul Jacobs, I would like to mention that we are hosting an analyst meeting on November 13 in London. The meeting will be simulcast on our website with audio and slide presentations. Questions from our webcast participants can be submitted prior to the meeting by going to QUALCOMM's Investor Relations website at www.QUALCOMM.com and following the links to our London webcast. Now it is my pleasure to introduce QUALCOMM's CEO, Dr. Paul Jacobs."
},
{
"speaker": "Paul Jacobs",
"text": "Thank you, Bill and good afternoon, everyone. Let me begin by thanking the employees of QUALCOMM for delivering another spectacular year. Despite the numerous challenges by a few companies to our business model this year, as an organization we have remained focused by continuing to both innovate and execute, and I am delighted to report that this effort has resulted in some excellent financial and operational results. Let me first comment on our financial results. Our pro forma earnings per share were up 41% year over year to $1.64. We were able to significantly outperform our original FY '06 guidance of $1.43 to $1.47 because we, with our partners and licensees, enabled stronger than predicted growth in handset shipments across all forms of 3G CDMA and because average selling prices of phones stabilized due to customer adoption of higher end features and a more rapid transition of 2G subscribers to 3G. These trends drove record pro forma fiscal year revenue, generating $7.53 billion, up 33% year over year, and pro forma net income of $2.8 billion in FY 2006, up 42% year over year. Now let me spend a few minutes going through some of the key achievements for our business in fiscal 2006. In QCT, each quarter of fiscal 2006 represented a new record for shipments, that obviously resulted in a record for the entire year. This outstanding performance included a total of 207 million chips shipped this year as compared to 151 million in fiscal 2005 and 137 million in fiscal 2004. QCT continues to demonstrate the benefits of our fabless business model and its ability to scale to our increasing volumes. Our growth also continued in QTL where we signed 22 new 3G CDMA licenses. Other significant licensing milestones included granting our first-ever licenses for single mode OFDM, OFDMA, a license for a manufacturer in India and one for a third-party FLO chipset manufacturer. In QIS we now have 69 BREW operator partners in 31 countries with BREW developer payments surpassing a cumulative $700 million. The launch of uiOne on the Pantech Ice handset in September highlights our successful acquisition of Trigenix, and other European operators are in the process of deploying BREW uiOne. In addition to also deploying uiOne, Sprint extended our relationship on QChat and announced that they will be deploying it as their solution for Push-To-Talk as they begin migrating their iDEN subscriber base to CDMA DO Revision A. In QSI we announced Verizon as our launch partner for media flow and are looking forward to deploying this revolutionary technology early next year. In addition, the FLO Air Interface standard was ratified by TIA, dispelling the misinformation that FLO is a closed technology. We were very pleased with the unanimous FCC ruling released in response to a petition for a declaratory ruling filed by QUALCOMM in January of 2005. This ruling greatly expands the number of markets in which MediaFLO USA can operate prior to the digital TV transition date of February 17, 2009. I would once again like to express our appreciation to Chairman Martin, the other commissioners and the FCC staff for their support for the new services that MediaFLO will enable. As I look forward to fiscal 2007, our challenge is clear. It is critically important that we help our customers grow their market share, and we continue to enable the operators' data businesses to be successful. Our R&D spending in fiscal 2007 is tracking to our long-term plan. Our R&D investments are targeted at both near and long-term projects, and the amount dedicated to longer-term projects is greater than it has been at any other point in our history. The industry move from commodity voice services to differentiated data services provides us with many opportunities to create new technologies and future revenue streams. The competitive advantages in cost, size, power and performance of QCT chipsets are clearly being leveraged in CDMA2000. There are 85 EV-DO deployments in more than 50 countries worldwide, and Sprint Nextel recently announced that they were the first operator to deploy EV-DO Revision A. San Diego is the first of 21 markets where Sprint will roll out EV-DO Revision A this year with coverage expected to reach more than 40 million people by year end. Additionally other forward-looking CDMA2000 operators such as Verizon, KDDI, Leap Wireless and Telecom New Zealand and LG Telecom already have aggressive plans for their evolution to EV-DO Rev A. For the WCDMA market, HSDPA is in its initial rollout stage. CDMA has been primarily a voice market to date since the data capability within the initial WCDMA specification was not a significant improvement over Edge or GPRS. Up until now in Europe specifically, there has been minimal distinction between 2G and 3G handsets, and consumers have continued to purchase largely based on form factor and known brands as opposed to functionality. But similar to the way the CDMA market matured over time, we have seen the number of manufactures increase in the WCDMA market. QCT alone has more than 30 customers with 267 designs available or coming to market. QCT will work to increase its share of the WCDMA chipset by assisting their existing partners or gaining new ones. In an example which highlights the power of the QUALCOMM business model to foster competition and support wireless operators' initiatives, Huawei and Vodafone recently announced the commercial availability of the first Vodafone-branded handset, the V710 manufactured by Huawei. In February the two companies entered into a strategic relationship in which Huawei will supply exclusive Vodafone-branded handsets in 21 countries over the next five years. As a result of the increased competition, prices have come down dramatically for WCDMA handsets, while volumes have increased. Using Yankee Group estimates for total market shipments and our own royalty reports for WCDMA unit shipments, WCDMA handset sales represented 41% of total sales in Western Europe, up from 30% in the March quarter and 25% in the December quarter of 2005. Competition is a far more important piece in driving down price in the handset market than any other single factor. I would also like to comment on recent speculation concerning the health of the CDMA2000 market based on a small number of emerging market operators considering GSM overlays to their CDMA2000 network. CDMA2000 continues to pace the migration from 2G to 3G and strengthens its market position. Close to 80% of the entire 3G subscriber base uses CDMA2000 devices and services. According to the CDMA Development Group, nearly 200 CDMA2000 networks are in operation worldwide as compared to 127 at this point last year. Now turning to WCDMA, according to the Global Mobile Suppliers Association, the GSA, more than 120 operators around the world have deployed WCDMA as of October 10, 2006. The vast majority of these deployments have been as overlays to GSM networks. Gartner Dataquest forecasted 54% of all spending this year as going to CDMA2000 and WCDMA infrastructure. By 2007 the firm expects spending to jump to 61% for 3G infrastructure, as spending on 2G technologies like GSM continues to decline. Strategy Analytics also predicts that more than half of the global spending for 3G wireless infrastructure will go to CDMA2000 and WCDMA during 2006 and that 2G technology investments will continue to decline. The continued deployment of HSDPA and ultimately HSUPA will be an important component of this infrastructure spending. HSDPA was introduced in November 2005 and is now commercial with 65 operators in 33 countries with 21 others in deployment. There are 51 commercial devices on the market from 16 suppliers that support HSDPA. The next evolution of this wireless broadband technology, HSUPA, is expected to be available in 2007 and will offer higher data throughput speeds in the uplink and other enhancements to improve the economics and performance of the 3G network. QCT was first to market with a HSDPA chipset solution, and we are pleased that our chipset customers have been the first device manufacturers to support HSDPA launches. QCT was also first to market with an HSUPA chipset, and we have design wins with ten manufacturers for that device. We are now working to make the broadband capabilities of HSDPA technology accessible to broader audiences. We sampled our MSM 6260 chipset ahead of schedule, which leverages the cost efficiencies of 65 nanometer process technology to accelerate the availability of HSDPA handsets to the mass market. Our leadership in HSDPA and in 1xEV-DO and DO Rev A has created the opportunity for us to build close relationships with laptop manufacturers. As a result, our HSDPA and DO chipsets are now being used in 73 commercial notebooks from nine manufacturers on 11 wireless operators' networks. As this industry evolves, you can be sure that QUALCOMM will design and deploy the highest performance air links for a broad array of applications. Beyond that, we will work with our partners to turn these into services that consumers and enterprises will demand. In closing, I am exceedingly proud of our accomplishments this year and remain steadfast in my belief that our business model has and will continue to be a positive force in the industry. Our philosophy is simple. Manufacturers should be able to compete in an open market, not a closed market controlled by a limited number of manufacturers using their intellectual property to stifle competition. By QUALCOMM acting as an aggregator of R&D for the industry, all participants in the value chain get the benefit of equal access to technology, enabling the best products to win in the market. I'm excited about the future for QUALCOMM. Our vision and execution in R&D programs, as well as the development of products and services by our partners, puts us in an enviable position to take advantage of the many opportunities ahead. I would now like to turn the call over to Steve Altman."
},
{
"speaker": "Steve Altman",
"text": "Thanks, Paul, and good afternoon, everyone. I would like to first update you on the status of some of the legal proceedings that we are involved in. Let me start first with the complaints that were filed in Europe by six companies that have been referred to as Project Stockholm. There has recently been some confusing media reports issued about the expected next step in the process, and so I would like to clear up the confusion. The next step in the process is for the EC to decide whether or not to continue its informal investigation. Although we expect that the EC will shortly make a decision to continue its informal investigation, such a decision means only that the EC will continue to do what it has been doing. That is gathering and evaluating information in order to fully understand the complaints. Such a decision would not signal that the investigation has become formal or intensified as some media reports have mistakenly suggested. The decision to continue the informal investigation is not the equivalent of a statement of objections which would signal a more formal phase, nor does it indicate one way or the other whether a statement of objections will ultimately be issued. We have been advised that in complex cases it can sometimes take years -- in some cases as long as five to six years -- for the commission to reach the next milestone, namely a determination whether to either reject the complaints or initiate formal proceedings and issue a statement of objections or negotiate proposals to close the case. Because we feel that our agreements and actions have been lawful, we remain optimistic that the commission will ultimately decide not to issue a statement of objection. We have seen several positive developments in our litigation with Broadcom in the past few months. Broadcom's antitrust complaint against QUALCOMM was dismissed in federal court on September 1. Essentially the judge determined that even if she accepted as true everything that Broadcom alleged in its complaint, QUALCOMM has not violated any U.S. antitrust laws. This was a very significant and favorable ruling for us, and although it is certainly not binding upon the determination of similar issues that have been raised by the Project Stockholm group in the EC, we believe that it will be carefully reviewed and considered by the European Commission. Broadcom has appealed the ruling, and the appeals process will likely take a year-and-a-half or more to conclude. In the Broadcom International Trade Commission matter, on October 10 a judge determined that QUALCOMM did not infringe two of the three patents asserted by Broadcom. Although the judge determined there was infringement of certain claims of the third patent, he recommended that no downstream remedies, including no injunctions be implemented against the wireless handsets of third parties that incorporate QUALCOMM chips and software. We maintain that this third patent, which does not apply to CDMA technology but rather deals with transitioning the handset to a power saving mode when out of a service area, is invalid and not infringed, and we will ask the full commission to reject the judge's recommendations on these issues. In any case, we are exploring designs to replace the features accused of infringement with superior functionality. During the course of our litigation with Broadcom, we discovered that Broadcom had engaged in a successful multi-year effort to improperly acquire thousands of pages of our confidential business and technical information, including source code related to our WCDMA chip development. We also recently announced that the federal court in San Diego has enjoined Broadcom from any further solicitation, use or dissemination of QUALCOMM's WCDMA trade secrets, including source code. A copy of the injunction order is available for your review on our website. If we are later able to demonstrate that Broadcom is using any of our misappropriated trade secret information, Broadcom will be in violation of the injunction which could result in a finding of contempt. In April we identified Nokia as a company whose CDMA agreement needs to be extended. In the event that after April 9, 2007 the existing agreement is not extended or a new agreement is not signed, Nokia's rights to sell handsets under most of our patents and, therefore, Nokia's obligation to pay royalties to us, will both cease under the terms of the current agreement. And our rights to sell integrated circuits under Nokia's patents will likewise cease under the terms of the current agreement. Although we regularly meet with Nokia to discuss the terms of such an extension, given, among other things, Nokia's recent public statements and the little progress we have made to date, our negotiating team is not optimistic that we will conclude the extension by April 2007. Changing topics, we see continued signs of strong 3G growth in virtually every market around the globe. In Japan, as of the end of September, approximately 62% of Japan's nearly 94 million cellular users now subscribe to 3G services. In anticipation of local number portability, DoCoMo, KDDI and Soft Bank all introduced a wide variety of new handsets to the Japanese market, which we expect will continue to help grow that market. The U.S. market continues to experience rapid growth in the use of data. Verizon recently noted that their customers exchanged 232 million picture and video messages and completed 55 million downloads of games, ring tones and other content in the September quarter. Verizon’s VCast music service now has a 1.3 million song library, and the September quarter represented the first quarter when data revenue exceeded $1 billion, up 84% year over year. Sprint noted that its data service revenue is up 74% year over year, driven by increased usage of its 1xEV-DO PowerVision Network. Interestingly, Sprint noted that the monthly average data ARPU for CDMA subscribers is $10, twice that of the average for their iDEN subscribers. In developing markets, CDMA 450 is gaining significant traction around the world. CDMA 450 provides an extremely efficient wireless telecommunications solution by offering wide coverage and the ability to provide superior voice quality and high-speed data services and therefore has great potential for future growth. According to the CDMA Development Group, CDMA 450 networks are now deployed in 35 countries around the world, including China, Pakistan, Russia, Romania, Indonesia, Cambodia and Vietnam. In China, we have seen the continued expansion of CDMA2000. In the first nine months of calendar 2006, China Unicom introduced more than 60 devices and sold more than 5 million units. We continue to be very excited about the prospects in China, especially when the 3G licenses are issued. However, given the highly speculative nature of when the 3G licenses will actually be issued, we have not included the potential growth from 3G licenses in our '07 forecast. Turning to India, the CDMA market experienced strong growth with average monthly net additions of more than 1.7 million subscribers in the third quarter of 2006. India now has a cumulative base of over 38 million subscribers with Reliance and TADA surpassing 23 million and 12 million subscribers respectively. This quarter the Telecom Regulatory Authority of India has permitted CDMA operators to bid for 3G mobile phone services in 800 megahertz spectrum which they already use for their current services. We are pleased with this outcome as it enables easy expansion to existing networks and lays the foundation for the potential deployment of EV-DO in India. In Western Europe, we continue to see increasing 3G adoption across the region as next generation devices continue to decrease in cost and improve in form factor and battery life. The deployment of HSPA and the proliferation of new devices are becoming catalysts for operators’ 3G focus. The number of 3G capable handsets has accelerated rapidly in the past 12 months with over 60 new WCDMA handsets launched in the first half of 2006. As we look towards next year and beyond, we see a global market that will continue growing very rapidly due to a variety of factors, including a wide range of attractive and affordable devices combined with the improved network performance and the introduction of compelling new applications and services. We take pride in knowing that our broad licensing program, our engineering expertise and our continued investments in R&D are an important contributor to the industry's growth. Although our success and the success of our partners has resulted in challenges to our business model by some of our competitors, we remain confident that we will overcome these challenges. We feel very strongly that we have well-established the fair and reasonable value of our patent portfolio through bilateral arms-length negotiations with over 130 companies, and we will make our decisions considering the long-term best interests of QUALCOMM and its shareholders. I would now like to turn the call over to Sanjay Jha."
},
{
"speaker": "Sanjay Jha",
"text": "Thank you, Steve. Good afternoon. I would like to review some key highlights for QCT. In the fourth quarter of fiscal 2006, QCT continued to set new milestones for financial performance. We set records for MSM chipset shipments, for revenue and for CSM channels. By shipping approximately 56 million MSMs, QCT established a record for the fifth straight quarter. This compares to approximately 55 million MSMs shipped in the third quarter of fiscal 2006 and 40 million in the fourth quarter of fiscal 2005. Year over year, this represents a 40% increase. For the full 2006 fiscal year, QCT shipped approximately 2007 million MSMs compared to approximately 151 million in fiscal 2005 for a 37% annual increase. For the fourth quarter of fiscal 2006, QCT achieved record revenues of over $1.1 billion. This amount is marginally higher than the third quarter but represents a 26% increase year over year. Our fiscal 2006 annual revenue of over $4.3 billion is a 32% increase over fiscal 2005. This represents a compound annual growth rate over the last four years of 28%. While QCT's annual operating profit of 26% in fiscal 2006 remains consistent with 2005, our operating profit increased 33% to greater than $1.1 billion for this fiscal year. As chip shipments and revenues accelerate, we are seeing the results of our technology innovation in the form of wireless devices launching throughout the world. QCT tripled our shipment of EV-DO chipsets in fiscal 2006, a fact that can be partially attributed to strong market acceptance of mobile broadband services. Both PC cards and mobile handsets supporting the next evolution of EV-DO networks, EV-DO Revision A, will be commercially launched before the end of the year. We remain committed to emerging markets, and this past quarter introduced that QSC 1100 single chip solution that will enable CDMA2000 handsets to break new price barriers. In addition to bringing wireless communication to new users in emerging marketplaces, the QSC 1100 is also designed to double talk time compared to CDMA2000 handsets on the market today and improve network capacity by up to 100%. Even as we continue to build our technology leadership in CDMA2000, we are continuing to increase our technology leadership in UMTS. This past quarter QCT completed successful test calls delivering 2 Mbps on the uplink with HSUPA and performed HSUPA inter-op testing with multiple leading infrastructure vendors. HSUPA is the next evolution of wideband CDMA technology that together with HSDPA delivers wireless broadband capability on the uplink as well as the downlink. Our HSDPA and wideband CDMA chipsets continue to gain traction, and we're enabling hundreds of models with our wideband CDMA chipset. We continue to invest into future technology and this past quarter acquired Qualphone, a San Diego-based provider of IP-based multimedia subsystems or IMS embedded client software solutions. Qualphone's IMS product and interoperability testing resources will enable QCT to accelerate our delivery of more feature-rich devices to global marketplaces as HSDPA and HSUPA, as well as DO Revision A get deployed. Our GPS1 assisted GPS technology has reached a new milestone with 200 million GPS1-enabled handsets now shipped around the world. GPS1 powers the majority of location services that are currently available at over 50 networks around the world. These applications bring enhanced functionality to consumer, business and personal safety markets at significantly lower costs and oftentimes with better capability than stand-alone GPS devices. In order to keep pace with growing demand for QCT products, we have announced a strategic agreement with Semiconductor Manufacturing International Corporation in China. As part of our ongoing commitment to China industry, our agreement with SMIC will help us streamline our operation, accelerate time to market and focus on our core technology strengths. I will now turn this call over to Bill Keitel for an overview of our financial results."
},
{
"speaker": "Bill Keitel",
"text": "Thank you, Sanjay and good afternoon, everyone. We are very pleased to report another year of record revenues, earnings per share and operating cash flow. GAAP earnings for fiscal 2006 were a record $1.44 per fully diluted share. Share-based compensation was an estimated $0.19 per share. QSI was a $0.02 loss per share, net tax benefits related to prior years were $0.02 per share, and acquired in-process R&D expense was $0.01 per share. Excluding these items, our pro forma earnings for fiscal 2006 were a record $1.64 per fully diluted share. Pro forma revenues increased 33% yea –over year to $7.53 billion, and pro forma net income increased 42% to $2.8 billion. Our businesses continued to generate strong cash flows. Operating cash flow for fiscal 2006 was $3.25 billion, up 21% year over year and was a healthy 43% of revenue. During the year, we returned approximately $2.2 billion in capital to our shareholders through a combination of stock repurchases and our growing dividend program. This includes cash dividends paid of $698 million, or $0.42 per share, and 34 million shares repurchased for $1.5 billion. Although our share repurchases were reduced in the fourth fiscal quarter as compared to the third fiscal quarter, we continue to believe that our stock is undervalued. From time to time, however, we make judgments that due to the tendency of potentially significant events -- for example, earnings announcements, litigations, major contracts or acquisitions -- that it would be inappropriate for us to be in the market for our stock until such events had been concluded and then subsequently disclosed. Fortunately, we have a lot of exciting things happening at QUALCOMM. Unfortunately, from time to time that impedes our ability to execute on the stock buyback program at the pace we would otherwise choose. QCT shipped a record 207 million MSMs in fiscal 2006. QCT's operating margin ended the fiscal year at 26% as volume ramped, driven by increased shipments of EV-DO, WCDMA and low tier MSMs. QTL continues to be positively impacted by the growing adoption of CDMA around the world. WCDMA royalties from handsets shipped during the June quarter grew to approximately 49% of third-party royalties reported by licensees in the fourth fiscal quarter. Of $705 million in QTL revenues for the fourth quarter, $44 million represented inter-company royalties, $13 million were license fees and $648 million were royalties from third-party licensees. QTL's operating margin was 91% for fiscal 2006 and 90% for the fiscal fourth quarter. In our last quarter conference call, we advised of a larger than normal channel inventory build for China and India. We had adjusted our guidance accordingly, and we forecasted a correction in the channel to occur by the end of the calendar year. I'm pleased to report that we see the correction has occurred largely as we anticipated. We believe channel inventory levels are now comfortably within a normal 15 to 20-week band and will increase during the current quarter to a seasonally normal upper end of the band. R&D investment remained a strategic priority this year as we continue to invest in our WCDMA chip development, multimedia functionality and enhancements to the CDMA2000 technology roadmap. We also continue to increase our investment in longer-term business opportunities and technology innovations, including MediaFLO, OFDMA and display technologies. Pro forma R&D increased 28% year over year, and we expect this will maintain our leadership position with exciting and innovative products and services, and their associated intellectual property. Based on royalty reports from licensees, worldwide CDMA-based handsets shipped in the June quarter were approximately 70 million units, up from 66 million units shipped in the March quarter, driven primarily by sequential growth in shipments of WCDMA handsets in Europe. The average selling price of CDMA-based handsets was approximately $223 for the June quarter and $215 for the fiscal year. I will now highlight our forward guidance. For the calendar 2006 CDMA market, we now expect approximately 290 million to 298 million CDMA-based handsets to be shipped, including approximately 98 million WCDMA handsets. Based on the 294 million midpoint of our estimate, worldwide CDMA handset shipments for calendar 2006 are anticipated to grow approximately 40% year over year. We estimate the calendar 2007 CDMA phone market will increase approximately 25% to 32% over 2006 with shipments of approximately 368 million to 388 million units. Last year we refrained from estimating when the Chinese authorities would issue 3G licensees. We are including such estimates in our financial guidance, and we're continuing that practice this year. Based on the 378 million midpoint of our 2007 estimate, we anticipate shipments of approximately 203 million CDMA2000 units and approximately 175 million WCDMA units as 2G to 3G migration accelerates in many regions around the world. Based on the current business outlook, we anticipate fiscal 2007 revenues to be in the range of approximately $8.1 billion to $8.6 billion, an increase of 8% to 14% over fiscal 2006. We anticipate pro forma diluted earnings per share to be in the range of $1.76 to $1.81, an increase of 7% to 10% year over year. We estimate average selling prices for CDMA2000 and WCDMA phones combined to decrease approximately 5% in fiscal 2007 to approximately $205, and this of course compares to $215 in fiscal 2006. We anticipate pro forma R&D and SG&A expenses combined to increase approximately 16% for fiscal 2007. This increase is driven primarily by the full-year effect in fiscal 2007 of the growth in our employee base during fiscal 2006, as well as we’re planning for further increases in our legal expenses. QCT continues to invest meaningfully to grow our WCDMA chip share, and at this point, our guidance reflects a modest growth in share for fiscal 2007 over fiscal 2006. We anticipate our pro forma tax rate in fiscal 2007 to be approximately 26%. unchanged versus fiscal 2006. We estimate our GAAP diluted earnings per share will be approximately $1.45 to $1.50 for fiscal 2007. This estimate includes an estimated loss of approximately $0.11 per share attributable to QSI, as well as approximately $0.20 per share attributable to estimated share-based compensation. Turning to the first quarter of fiscal 2007, we estimate revenues will be in the range of approximately $1.98 billion to $2.08 billion, an increase of 14% to 19% year over year. We estimate first quarter pro forma diluted earnings per share to be in the range of approximately $0.42 to $0.44, an increase of 8% to 13% year over year. This estimate assumes shipments of approximately 55 million to 58 million MSM phone chips during the December quarter and an estimate of approximately 74 million to 76 million CDMA-based handsets shipped in the September quarter at an average selling price of approximately $209. We expect QCT operating margins to be lower sequentially and total company pro forma R&D and SG&A expenses combined to increase approximately 5% to 8%. Our full year fiscal '07 earnings estimate assumed the renewal of Nokia's license agreement prior to April 2007. If we're unable to resolve licensing issues with Nokia and Nokia refuses to pay for its use of our patents, we estimate a possible impact to our earnings of $0.04 to $0.06 per diluted share in fiscal 2007. This estimate is based on our current expectations for June 2007 quarter handset shipments, average selling prices and market share. And, of course, those numbers will be recorded in our fiscal fourth quarter. At this time, we expect a seasonal decline in MSM shipments in the second fiscal quarter of 2007 as channel inventories are reduced post the Christmas season. Our second fiscal quarter royalty revenues will reflect licensee shipments from the typically seasonally strong December quarter, and our operating expenses also tend to increase in the second fiscal quarter for seasonal reasons. In combination, we expect pro forma second fiscal quarter earnings to be in the range of our first quarter guidance. The QUALCOMM Investor Relations website includes an extensive slide presentation on the many data points included in this conference call. I look forward to sharing with you additional data points regarding our fiscal 2007 guidance, including regional handset shipment estimates, at our London analyst meeting on November 13. This meeting will be webcast for those of you not able to attend. That concludes our remarks, and I will now hand the call back over to Bill Davidson."
},
{
"speaker": "Bill Davidson",
"text": "Before we go into our question-and-answer session, I would like to remind our participants that our goal is to address as many as possible before we run out of time. Therefore, I’d like to ask you to limit your questions to one per caller. Operator, we are ready to accept questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Paul Sagawa - Bernstein."
},
{
"speaker": "Paul Sagawa - Bernstein",
"text": "Hi. So if I'm looking ahead into 2007 and the next quarter, I think a lot of folks in the market have been a little bit spooked by comments from Nokia and Texas Instruments about WCDMA demand in the near term, particularly out of European carriers. Your guidance for 2007, $175 million, upbeat and I must say I agree with it, but it is a little bit counter to some of that more cautious commentary. Can you talk a little bit about what you're seeing with regard to demand for WCDMA handsets in Europe that leads to a more optimistic view? Also, is this some indication that you believe that your chipset customers may be taking market share in the near term in WCDMA?"
},
{
"speaker": "Bill Keitel",
"text": "Hi Paul. With regard to our WCDMA estimates for next year, we are expecting very substantial growth for the European market. We will get into the details of that in London. But I have heard some concerns by some of the parties you have mentioned more focused on the near term. I have heard that a bit in Europe, with reference to Europe. I would say that we are expecting, based on our information and forecasts that a lot of our licensees have shared with us, we expect an increased number shipments into the European market in the September quarter relative to the June quarter, and I expect the same continuing into the December quarter. Where I have seen some statements that sync with ours, I would note that in the Japan market as strong as things are there, I think people have stocked up on inventory in anticipation of local number portability, and we have a modest decline estimated for our shipments of product in Japan in the September quarter, although picking back up in the December quarter. So I think that did sync with a number of other comments from other people. But overall for WCDMA in Europe, I would say that we see HSDPA being deployed at an increasing rate, and I think that data ARPU is going to be the compelling point there. As well as the ASPs I think will continue to improve and make it even more enticing for operators to be pushing WCDMA."
},
{
"speaker": "Paul Jacobs",
"text": "Thank you. We are also heartened by the price competition that is happening, and in particular this Huawei phone that I talked about earlier is coming in at a significantly lower price that allows WCDMA phones to enter a different tier in the pricing. So we hope to see that as a significant driver of volume as well."
},
{
"speaker": "Sanjay Jha",
"text": "Paul, you had a question about how I see our wideband CDMA chipset demand going forward. We have seen a fairly substantial increase in demand for wideband CDMA chipsets for the December quarter over September quarter, so I have to say September quarter was, for wideband CDMA, not as strong for us as we had initially hoped. But there is a fairly substantial uptick in demand in the December quarter. Consistent with what Bill and Paul said, we see significant strengths in the wideband CDMA marketplace and our guidance reflects that. I should make one additional point. One of our competitors who indicated the Japan market is weak for them has a particularly large exposure to DoCoMo's high-end OMAP kind of marketplace. As you have seen with number portability, both Soft Bank and KDDI appear to be doing rather well. I could certainly see that that could be the case."
},
{
"speaker": "Paul Sagawa - Bernstein",
"text": "Great, thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Bucher - BMO Capital Markets."
},
{
"speaker": "John Bucher - BMO Capital Markets",
"text": "Thank you. A question on your fiscal 2007 outlook. Bill, I guess this would be for you. You indicated R&D and SG&A would be up 16%, so that would explain why pro forma EPS will grow at a slower rate than the revenue outlook. I am wondering how much you are factoring in there – and the employee base stuff I understand, you probably have a pretty good idea on that – but how much variable expense might be there, just all depending on a variety of the legal contingencies and how they play out? Could there be, perhaps a range that the R&D and SG&A would be up, the 16% perhaps being a midpoint? What is the standard deviation if things go well on the legal front? Thank you."
},
{
"speaker": "Bill Keitel",
"text": "Sure, John. A couple of points. On that 16% year over year estimate, it isn’t a midpoint. First, I would say that the majority of that is what I call carryover from fiscal 2006. We have ramped our employee base, particularly our engineering base, significantly in fiscal 2006. Now we will see a full year effect of that in fiscal 2007. We do expect to reduce quite substantially the rate of new hiring into fiscal 2007 relative to the past three or four years. So the majority of that increase I think is the carryover from a full year effect of the hiring we put in place this year, number one. Number two, I did also mention it is also legal fees. The numbers are quite substantial, and we're planning at this time in our estimates to increase our spending on legal for fiscal 2007. We will have to see how that proceeds, but if you put a band around that 16%, I would say it is a plus, minus 4% or so, like a 12% to 20% kind of band."
},
{
"speaker": "John Bucher - BMO Capital Markets",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mike Ounjian - Credit Suisse."
},
{
"speaker": "Mike Ounjian - Credit Suisse",
"text": "Great, thank you. Also looking at the '07 guidance but for the handset shipments, particularly on the CDMA side. As you mentioned, there has been a lot of focus on a few operators in the developing regions who are looking at GSM. Could you talk about some of the factors that are driving the overall number to be up and in particular what regions you really see growth coming from next year?"
},
{
"speaker": "Bill Keitel",
"text": "I will take a stab at that. So for CDMA2000 the calendar '07 versus calendar '06 guidance that we just shared with you, I think it's about a 4% year-over-year increase for CDMA2000. We will give a regional breakdown consistent with how we define our regions today and breakdown our global estimates, but I'm pretty confident when you see that, we will show you a growth in all markets. Our expectation is good growth in all markets with the exception of Latin America. Take Latin America out of our CDMA2000 estimates and I think our forecast for CDMA2000 growth is closer to about 9%. So we think there's a good market ahead for CDMA2000 in most all regions around the world."
},
{
"speaker": "Mike Ounjian - Credit Suisse",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Steve O’Toole - Lehman Brothers."
},
{
"speaker": "Steve O’Toole - Lehman Brothers",
"text": "With respect to the framework you outlined for Nokia and the pending issues there, you said there was little progress to-date, so you would expect it to go beyond the April timeline. You mentioned that you would be looking to pursue or entertain injunctions. When you think about that as a framework, should we be thinking that is a dispute that you would anticipate going through several quarters, perhaps then, of the fiscal '08 given the way you see it now? I am sure Bill you may be reluctant to share some of the assumptions behind $0.04 to $0.06, that is quite a precise range that you're suggesting would be the impact from Nokia in September. Perhaps you might be able to give some framework for how you think that might develop going forward, or should we going forward and just use that as a reasonably steady-state rate? Lastly, maybe just directionally in terms of the regions, while you're going to give detail at the Analyst Day, should we think about Brazil and India -- given the issues there -- as growing next year, or how should we think about that?"
},
{
"speaker": "Steve Altman",
"text": "It is Steve. Let me just real quickly respond to your question regarding Nokia. I think it is very difficult to forecast how long or short these negotiations will go. It is certainly very possible that it could go for several quarters or even beyond as the courts systems are used and so forth. So it is a possibility, and like we said, we have discussions with them regularly. We will continue to have those discussions, and if progress is made, we will let you know."
},
{
"speaker": "Steve O’Toole - Lehman Brothers",
"text": "But you, in terms of expectations, look for a fairly lengthy and drawn out process?"
},
{
"speaker": "Steve Altman",
"text": "Let's say it this way that we plan accordingly to that, but we are hopeful that it does not go as long as it could."
},
{
"speaker": "Bill Keitel",
"text": "On the $0.04 to $0.06 estimate for Nokia, I have been through that a few different times in the last few months or more. It has been a stable forecast. It is a good forecast. At this point I would say I would be surprised if it fell outside that band. Then on India, again, we will share the regional guidance in London, but we are looking for a healthy growth year over year for CDMA2000 in India, albeit it is a low-end market. So as I have said in the past, it is an important market for us, but in terms of bottom line contribution, it is more of a business development than anything else."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ehud Gelblum – JP Morgan."
},
{
"speaker": "Ehud Gelblum – JP Morgan",
"text": "Thank you very much. First, a quick clarification and then a question. The clarification, did you mention ASP on the 3G phones that you had in prior quarters? If not, can you give us some sense as to what it looked like and how it has trended over the last couple of quarters? That would be great. As you look forward to the EPS guidance ranges that you gave for the first quarter and for the fiscal year '07, they seem to be a little lighter than the optimism on the top line and the $175 million WCDMA handsets for '07 would suggest, which I think are both very strong numbers."
},
{
"speaker": "Bill Keitel",
"text": "I will take a stab at your answers here. On the ASP, the trend here has been for the quarter we just reported, average ASP was $223, it was $213 in the prior quarter, $208 in the quarter before that. We averaged $215 for the fiscal year. We have not disclosed the WCDMA versus CDMA2000 breakout of that here this quarter. But suffice it to say, WCDMA remains at a fairly significant premium, although the range of handset prices available in WCDMA is very broad. In terms of your point on mix of royalty payments, I would say it is more, Ehud, that you get variability in terms of the mix of handset royalties and infrastructure royalties. Of course, there are a lot of changes OEM to OEM and what they are selling quarter to quarter, and then region by region. But other than that, no, I don't think there's anything really of note that I would point out. We will get into a little more detail in London on margins and profitability, et cetera."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mike Walkley - Piper Jaffray."
},
{
"speaker": "Mike Walkley - Piper Jaffray",
"text": "Great, thanks. Just another question on the fiscal '07 guidance. I think on your QCT division, you mentioned a 25% to 32% rate with a big ramp in R&D again this year. Would it fall below that rate maybe in '07 and go back to that range into '08? With the price of GSM phones continuing to fall, I think Nokia said in their conference call north of 40% of their volume was below EUR50, maybe you can talk about the single chip solution and how that is progressing and how you are closing the gap on pricing between CDMA and GSM on the entry markets?"
},
{
"speaker": "Sanjay Jha",
"text": "I will take that. Yes, you're right. I have guided you to 25% to 32% of the range that we drive the business to. This year we were at 26%, as we were last year. My expectation is that we will come in below 25% for overall operating profit for QCT for '07. But obviously we see this right now as the kind of investment that we need to make while there is ongoing consolidation in UMTS industry. We see our ability to invest as a core competitive advantage, and it is a conscious decision that we are taking to continue to make that investment, not only in reducing cost of our chipsets but also investing in the next generation of HSPA, sometimes often called HSPA+, to further improve the capabilities of HSPA technology. I think that we have made a conscious decision, and yes, for the first time, we are falling outside the long-term range that we have guided you to. Secondly, on single chip solutions, I expect that there will be launch of handsets based on our single chip solution this year in various parts of the world. Of course, you recognize that Ron Garriques (Motorola, President, Mobile Devices) in his analyst call said that he will deliver. I expect that there is a chance that one other handset manufacturer might deliver a handset based on single chip solutions this year, and there is a possibility that they may not, and they cannot do it in January/February. But there are 18 handsets being designed based on single chip solutions, so I think that we will see healthy competition in the low end, and we really think that we will drive the price of low-end handsets to be very, very competitive with GSM. Again, I'm cautious in saying that we will be exactly the same price, but we will get closer and closer. We have shown that combined with very cost effective, low-end handsets the capacity increases that we are offering makes this quite compelling for our carriers. I think that those were the two parts of your question."
},
{
"speaker": "Operator",
"text": "Your next question comes from Inderbir Singh - Prudential Equity Group."
},
{
"speaker": "Inderbir Singh - Prudential Equity Group",
"text": "Thanks very much. I wanted to just come back to the comments that you made in the press release about in the event that the Nokia agreement is not signed in time, obviously you have indicated there would be some legal options you might pursue. In the past, Paul or Steve, I think you've also addressed the possibility of business actions you might take, business restructuring perhaps. Could you maybe bring us up-to-date on where you are on your thought process on that?"
},
{
"speaker": "Steve Altman",
"text": "I guess all I would say is that we are keeping our options open and looking at what the best thing to do is to enhance or maintain shareholder value. I would not say that I have any specific new initiatives to announce along those lines. Just to say that it is a possible response to these negotiations."
},
{
"speaker": "Operator",
"text": "Your next question comes from Brian Modoff - Deutsche Bank."
},
{
"speaker": "Brian Modoff - Deutsche Bank",
"text": "On page 6 of the press release, you talk about your inability to use self-integrator circuits under Nokia's patents. Do you see any issues getting around those patents, or do you see them having potentially leverage on your chipsets from that? Also, talking about low-cost CDMA, are you working on a single chip WCDMA type product, and could we see something like that for next year? What are the carriers you're seeing in Europe saying to you around their promotion plans for WCDMA? Christmas clearly Vodafone with 77% of their phones WCDMA, has some plans there. We are also hearing from Orange similar plans around that. Can you kind of comment on that, please?"
},
{
"speaker": "Sanjay Jha",
"text": "I will take the latter two questions. First, on single chip solution, Brian, clearly after having established the technology for CDMA, we have the ability to go deliver that in wideband CDMA, and we look forward to announcing that at the appropriate stage in the near future. On the second part of the question about the carriers' plans, we actually see fairly aggressive plans from the carriers. If you look at the Vodafone UMTS lineup, it is actually a really compelling lineup. We think that looking from a broader wideband CDMA perspective Nokia has some good devices. Motorola has some good devices, and there are lots of devices based on our solution on Vodafone's lineup, which I think will be very compelling for consumers. As you say, Orange is also becoming more aggressive. We see Cingular in the U.S. with their rollout of HSDPA and UMTS becoming more aggressive. And the M&P competition that is now raging in Japan, also driving more sales of both CDMA and UMTS devices in Japan. So I think that it is fair to say that we are cautiously bullish on what happens in the December quarter."
},
{
"speaker": "Lou Lupin",
"text": "I will answer the first part of your question. We have never believed that Nokia's patents are applicable to our products. As you probably know, our current rates for Nokia are royalty-free. So there has been never any tacit acknowledgment of their applicability to our products. Having said that, we believe that if we are unable to resolve the current impasse in the negotiations before April that there is likely to be litigation going both ways. I'm sure Nokia is going to take a different position, and that question, if not resolved through some kind of amicable arrangement, will get sorted out in the courts and various other bodies that have the responsibility for deciding patent matters."
},
{
"speaker": "Operator",
"text": "Your next question comes from Hasan Imam - Thomas Weisel Partners."
},
{
"speaker": "Hasan Imam - Thomas Weisel Partners",
"text": "My question has to do with actually the December quarter guidance. Last year's seasonality and WCDMA ramp had contributed to pretty strong sequential growth, and this year it appears to be more flat lining, despite your positive comments on the WCDMA handset segment and the India inventory overhang clearing up. So I am just wondering why we don't see more of an acceleration? Is that primarily the trade out between unit growth and ASP declines? Thank you."
},
{
"speaker": "Bill Keitel",
"text": "In terms of unit growth, I think that as I said, we always expected the channel inventory excesses we were concerned about for China and India to work itself out by the end of the calendar year, and we see that happening. So we're very encouraged by that. It is consistent with our prior estimates, but we do think that is happening as we speak, and part of that in this current December quarter. So that would be part of the effect, number one. Number two, you have quite a ramp I think that occurred in Japan in anticipation of a L&P, so I think that was also a factor that adjusted a bit what you might otherwise have seen in a quarterly profile. In terms of ASPs, I think our forecasts in the past have been pretty accurate on ASPs. I hope they will be again. We certainly have put the same effort into them, so we are expecting a modest decline in the ASPs, but other than that I think it is pretty much business as usual."
},
{
"speaker": "Hasan Imam - Thomas Weisel Partners",
"text": "As a follow-up to that, if we continue to see the WCDMA ramp in December quarter, does that indicate because of your revenue recognition, a stronger first half '07?"
},
{
"speaker": "Bill Keitel",
"text": "As phones ramped in the December quarter, that will positively affect our royalty revenues in the March quarter. So to the extent our forecast of units is correct for the December quarter, I have tried to size that in my March estimates, and I gave you some indications of guidance for the second fiscal quarter."
},
{
"speaker": "Hasan Imam - Thomas Weisel Partners",
"text": "Great, thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Daryl Armstrong - Citigroup."
},
{
"speaker": "Daryl Armstrong - Citigroup",
"text": "Thank you very much. I have a question for Lou. You talked about the litigation that will likely extend from QUALCOMM to Nokia and Nokia back to QUALCOMM post the April deadline. Do you think that litigation exposure also extends to your chipset customers if they accept your chips after that deadline? Do you anticipate that QUALCOMM would indemnify those customers if there is some exposure there?"
},
{
"speaker": "Lou Lupin",
"text": "The litigation could in theory extend to those customers who don't independently have rights from Nokia. Having said that, I think it is unlikely that Nokia wants to involve most of our customers in this because they are going to again get a similar reaction from the customers. That is, the customers will assert patents back against Nokia, as well as the patents that we would be asserting. So I think it is unlikely that they would want to draw in our customers. I don't really want to comment on the terms and conditions of our supply agreements between us and our customers. So I think I will leave it at that."
},
{
"speaker": "Operator",
"text": "Your next question comes from Tal Liani - Merrill Lynch."
},
{
"speaker": "Tal Liani - Merrill Lynch",
"text": "I had just one clarification on the prior answer and then one question. Nokia on their conference call discussed specifically about pass-through rights and said that they are not getting pass-through rights. Probably you're not going to answer on a specific question on Nokia, but would you mind to clarify the issue of pass-through rights, how does it work? What kind of rights do you have in general that you pass through your customers? My question is something very specific on Japan. Can you discuss on any potential inventories at NTT for WCDMA phones?"
},
{
"speaker": "Steve Altman",
"text": "This is Steve. On the pass-through rights, it probably would take longer than we should give it here on this conference call. But let me just say at the analyst conference in London, I will go into more detail on pass-through rights, how they work and so forth. If you can bear with us until then, I think you will get a better understanding."
},
{
"speaker": "Tal Liani - Merrill Lynch",
"text": "About inventories at NTT since TI made a comment about some inventories in Japan?"
},
{
"speaker": "Sanjay Jha",
"text": "Tal, we do have some handsets at NTT DoCoMo, but I think we don't have enough visibility for the entity DoCoMo to comment in detail except to say, as Bill said, there was some buildup of inventory in anticipation of mobile number portability. So far, we see Soft Bank and KDDI being disproportionate winners out of that transition. So I think beyond those data points, I couldn’t point to anything else."
},
{
"speaker": "Operator",
"text": "Your next question comes from Tim Long - Banc of America."
},
{
"speaker": "Tim Long - Banc of America",
"text": "Bill, if I could just ask you a question on the September quarter QTL line. I was a little surprised to see it up only 3% sequentially. If you could just explain if there was anything funny in the quarter there? Because if you look back at the June numbers, you had a pretty good spike in ASP, up 4% or 5%, and unit shipments looked like they were up about 6%. So I am just curious as to why the royalty line with the quarter lag, it seems like the license revenues were about stable, why we didn't see a bigger sequential jump in that line? Has there been any change in overall rate or anything else in the quarter?"
},
{
"speaker": "Bill Keitel",
"text": "Tim, no change in rates for licensees. Those rates stay constant. So again, it comes back to a different mix of infrastructural royalties versus test equipment royalties versus phone royalties. And then there are small amounts of special credits that sometime folded into the QTL segment. I think we had a modest amount of those in the September quarter."
},
{
"speaker": "Tim Long - Banc of America",
"text": "Okay. Well, Bill, should I think of it as the prior quarter was helped out on the high side or the June quarter or the September quarter was hurt on the low side? Which was a more normal number would you say?"
},
{
"speaker": "Bill Keitel",
"text": "Tim, I will go into a little more specifics for 2007. I think that is the key is 2007, and we will go into a bit more specifics in London."
},
{
"speaker": "Steve Altman",
"text": "Let me just clarify. When we talk about credits or so forth, what we're really talking about is time to time with special programs with carriers, we will provide incentives to carriers to sell more product or focus more on certain applications and so forth. Those types of expenses get allocated to QTL in terms of growing the overall CDMA business. So that impacts the amount."
},
{
"speaker": "Operator",
"text": "Your final question comes from Matt Hoffman - Cowen & Co."
},
{
"speaker": "Matt Hoffman - Cowen & Co.",
"text": "Thanks. Another question on the term changes in the negotiations with Nokia. Steve, Nokia discussed a four-part test for an injunction post April 9 and thought QUALCOMM would not be able to meet the standards for that test. Could you discuss both the test and QUALCOMM's ability to prove the company is entitled to an injunction if no agreement with Nokia is reached. Thanks."
},
{
"speaker": "Lou Lupin",
"text": "I will take that one. We think we will have utterly no problem meeting the four-part test. You're talking about a situation of a company that had a license that has been paying royalties, acknowledges the applicability of our patents in the most sincere way by paying large amounts of money for them, and then declines to renew and deliberately infringes. I think under those circumstances we are going to have very little difficulty in getting an injunction in meeting the test. I would be happy to expand upon the legal specifics of that test at a later time. I think it would take more time than we have now. I'm planning on being in London as well. So either Steve or I would be happy to address that there."
},
{
"speaker": "Operator",
"text": "Dr. Jacobs, do you have any closing remarks?"
},
{
"speaker": "Paul Jacobs",
"text": "I would just like to say that for the first full year of our new management team, I'm extremely pleased by the results that we were able to deliver. You know, there were obviously a few companies that decided to attack us and certainly have attempted to flood the market with a lot of misinformation. I guess I had hoped that we would have built a stronger working relationship with some of those companies, and I still remain hopeful that that will happen in the future. But I definitely want to highlight the fact that we are working extremely well with a large number of partners, and we are creating many new partnerships both inside and outside of the wireless industry. So despite these attacks, we really have remained extremely focused on innovation, execution and partnerships, and I think that you will see that we have many new products, new technologies and news services that we will bring to market in the next fiscal year. So thanks, everybody for joining us. I will look forward to seeing some of you in London."
},
{
"speaker": "Operator",
"text": "This concludes the QUALCOMM fourth quarter conference call."
}
] | null | null |
QCOM | 3 | 2,006 | 2006-07-20 00:45:00 | Executives: Bill Davidson - VP IR Dr. Paul Jacobs - CEO Steve Altman - President Dr. Sanjay Jha - President of CDMA Technologies Group Bill Keitel - CFO
Analysts: Brian Modoff - Deutsche Bank John Bucher - Harris Nesbitt Gerard Paul Sagawa - Sanford C. Bernstein Avi Silver - Bear Stearns Tim Luke - Lehman Brothers Natalie for Brant Thompson - Goldman Sachs Jeff Walkenhorst - Banc of America Securities Christin Armacost - Lazard Freres & Co Matthew Hoffman - SG Cowen
Operator: Ladies and gentlemen, thank you for standing by. Welcome to the QUALCOMM third quarter conference call. (Operator Instructions) I would now like to turn the call over to Bill Davidson, Vice President of Investor Relations. Sir, please go ahead.
Bill Davidson: Thank you and good afternoon. Today's call will include prepared remarks by Dr. Paul Jacobs, Steve Altman, Dr. Sanjay Jha, and Bill Keitel. An Internet presentation and audio broadcast accompanies this call, and you can access it by visiting www.QUALCOMM.com. During this conference call, if we use any non-GAAP financial measures as defined by the SEC and Regulation G, you can find the required reconciliations to GAAP on our web site. I would also direct you to our 10-Q and earnings release, which were filed and furnished respectively with the SEC today and are available on our Web site. As a reminder, the QUALCOMM Investor Relations Web site includes a thorough presentation on the many data points included in this conference call. We may make forward-looking statements relating to our expectations and other future events that may differ materially from QUALCOMM's actual results. Please review our SEC filings for a detailed presentation of each of our businesses and associated risks and other important factors that may cause our actual results to differ from these forward-looking statements. Pro forma revenues were $1.95 billion in the third fiscal quarter, up 44% year-over-year and 6% sequentially. Third quarter fiscal pro forma net income was $726 million, up 56% year-over-year and 3% sequentially. Pro forma diluted earnings per share were $0.42, up 50% year-over-year and 2% sequentially. Third fiscal quarter pro forma free cash flow, defined as net cash from operating activities less capital expenditures, was $795 million, up 116% year-over-year, and was 41% of revenue. Now, it's my pleasure to introduce QUALCOMM's CEO, Dr. Paul Jacobs.
Paul Jacobs: Thank you, Bill, and good afternoon, everyone. In spite of the turmoil in the market, QUALCOMM has continued to focus and the execution of our business continues to be extremely strong. We had a fourth consecutive quarter of record revenues and chip shipments. Our revenue is up 44% year-over-year and our pro forma free cash flow is 41% of revenue and increased 116% year-over-year. I'm proud of these results and I thank our employees for their efforts and our customers for their support. The 2G to 3G migration is well underway worldwide. Our business is being driven by the growing adoption of 3G CDMA-based technologies in multiple regions around the world. As a result, we are once again raising our handset guidance for 2006 and increasing our revenue and earnings estimates for this fiscal year. We're focused on continuing to foster new and vigorous competition, bringing innovative products and lower prices to the rapidly growing 3G CDMA market. QUALCOMM and our licensees have been demonstrating to many audiences worldwide the consumer benefits of rapidly decreasing handset costs and the increasing variety of innovative devices resulting from our pro-competitive business model. During the quarter, we saw 3G subscribers grow to more than 324 million worldwide, including more than 33 million 1x EV-DO subscribers and more than 66 million WCDMA subscribers. We are quite happy with the continuing record of growth of 3G technologies worldwide. From March 2005 to March 2006, WCDMA handset shipments grew in Western Europe and comprised 30% of the handset shipments in the March quarter. In the same year, GSM handset shipments have declined by 14%. Our success in the competitive dynamics of the 3G CDMA market has caused a small number of companies to challenge our licensing business model. The challenges we are facing are not new to us and we remained steadfast in our strong belief that because of the pro-competitive business model we have established, we will overcome these challenges. The royalties we charge are a small part of the overall cost of handsets, represent a reasonable return to us for the value of the intellectual property that we license, the risks that we assumed in developing, marketing, and commercializing CDMA technologies, the investments we made and continue to make, the market and competition that we helped create and enable, and our ongoing innovation that provides new capabilities, services and revenue opportunities for all of those in the wireless value chain. QUALCOMM participates in and contributes significantly to many major standards processes. The majority of our technologies are standards-based. In this light, I'm pleased to note that the MediaFLO air interface has recently become a TIA standard through the work of the FLO Forum, a group of 46 partner companies. The best measure of the value of our contribution to standardized technologies is the 130 license agreements that were freely negotiated with manufacturers around the world, including the largest and most sophisticated companies in the wireless arena, beginning in 1990 and continuing today with five new licensees during the last fiscal quarter. However, as one indicator of the significance of our contributions to open standards, publicly available sources can be used for one objective measure of the value of essential patents in the WCDMA standard by examining how often patents essential to the WCDMA standard were cited as prior art in the patents of other inventors. While we do not believe that counting schemes of any kind are a reliable measure of the value and quality of patents, the frequency with which one’s patents are cited by others is obviously more of an indicator of the importance of a patent portfolio than simply counting essential patents in a standard. Looking at citations is a measure of significance somewhat analogous to the way Google ranks Web pages by examining the number of links to that page. When you factor out citations by a company of its own patents, QUALCOMM has 47% of the citation-weighted portfolio of essential patents for WCDMA, followed by Ericsson at 21%. Significantly, Nokia has only 3%, NEC 2%, Panasonic 1%, and TI and Broadcom have less than 1%. Of course, to reiterate, the best measure by far of the value of QUALCOMM's patent portfolio is the 130 arms-length license agreements that we've negotiated over 15 years with nearly every major supplier in the industry. Those agreements have established, confirmed and reconfirmed our patents portfolio's market value. We continue to believe that the operation of free market forces provides the only true indicator of patent value, but looking at citations provides another interesting indicator of innovative importance. There have been significant advances in the CDMA2000 roadmap. QCT shipped five times the number of EV-DO Rev A bay station chips than last quarter, setting a new record. It's clear that operators are aggressively migrating to EV-DO Rev A. The 170 different EV-DO device models have made it possible for operators to increase their data ARPUs. For example, in May, Verizon reported nearly an 80% year-over-year increase. In April, KDDI reported a 37% year-over-year increase, and Sprint reported a 55% year-over-year increase. In May, Vivo reported a 38% year-over-year increase. The move from commoditized voice to differentiated data services is generating revenue for the operators and therefore, they're willing to further invest in higher-speed networks. In addition to the ability to drive wireless data, we have demonstrated significant increases in voice capacity with Voice-over-IP, or VoIP, running on DO Rev A. Over the coming years, the technology roadmap enabled by VoIP will continue to provide CDMA2000 operators with the most cost-effective roadmap to increase capabilities. The deployment of DO Rev A Voice-over-IP devices will allow carriers to transition from circuit-switched networks to an all-packet, all-IP future. As subscribers transition from 1x to DO Rev A, operators will be able to bond together multiple channels using DO Rev B techniques to enable extremely high data rates. Combined with interference cancellation techniques implemented in our next generation CSMs, this roadmap provides the CDMA2000 operators with the most efficient and cost-effective solutions for wireless broadband in their existing spectrum. In the past quarter, there's been significant discussion surrounding some of the emerging market operators, in particular Vivo and Alliance and how they may move from 3G CDMA to 2G GSM. QUALCOMM royalties have been cited as a reason for this potential shift. In fact, the lowest CDMA2000 phones are below $40 in these emerging markets, and with net phone royalties under 5%, the royalty is a small amount in absolute dollars. We continue to invest significant effort and resources to drive the cost of the lowest MCDMA2000 phones down. Utilizing the advantages of CDMA, we have long believed that data services would be important not just to the high-end users but also the low-end subscribers. We are encouraged by recent reports from China and India that the lowest-end subscribers are making significant use of data services, thereby increasing operator revenues. In India, Tata is one of the top 10 operators worldwide for revenue downloads on BREW. Tata doubled the number of applications downloaded from its network between the months of May and June this year with two-thirds of the activity coming from users of the Kyocera Prisma low-cost phone. In order to free up capacity for increasing use of data services, we will nearly double the voice capacity of CDMA2000 systems using the new 4GV Vocoder, integrated receive diversity in both handset and base station interference cancellation. We see the use of CDMA2000 as the best way to bridge the digital divide in emerging markets. We made a conscious decision several quarters ago to accept very low margins to enable emerging markets with very low-end subscriber devices. We are encouraged by the increasing importance of data services for existing CDMA2000 and by the impending rollouts of WCDMA as a path to improved economics for GSM operators. To further address that market opportunity, we sampled three low-end WCDMA chip sets during the quarter with the MSN 6245 focused at the lowest end of the market. WCDMA continues to grow with WCDMA royalties accounting for 47% of overall royalties, up from 36% in the prior-year quarter. Turning to MediaFLO, MediaFLO USA continues to move towards the launch of commercial service. Its broadcast operations center and network operations center are now up and running at MediaFLO USA's headquarters in San Diego. Currently, MediaFLO USA's facilities are being used for service trials and preparing for Verizon Wireless' launch of MediaFLO. MediaFLO USA continues its discussions with many wireless operators on how to leverage a dedicated media delivery network that aggregates compelling content for their subscriber base and that will complement their existing 3G network. Outside of the United States, we continue to see tremendous interest in FLO technology. In May, QUALCOMM and British Sky Broadcasting signed a nonbinding letter of intent to conduct the first technical trials of MediaFLO technology in the UK. Beginning this summer, the trial will feature ten channels of BSkyB content and a small number of non-commercial devices provided by QUALCOMM. The BSkyB technical trial is the first of what we expect to be a number of FLO technology trials in Europe and in other parts of the world. In addition to our trial agreement with BSkyB, QUALCOMM and KDDI have formed a joint venture to explore the deployment of MediaFLO services in Japan. We took advantage of the recent decline in our stock price to repurchase 32 million shares of our common stock for $1.4 billion. Combined with our recently increased cash dividend, we provided a total return of capital to our shareholders of $1.6 billion since the end of the fiscal second quarter. Our balance sheet strength and unique business model continues to provide significant financial flexibility, allowing us to pursue strategic growth objectives, pay dividends, and repurchase shares in our continuous effort to enhance stockholder value. I'd now like to turn the call over to Steve Altman.
Steve Altman: Thanks, Paul and good afternoon. As we look at 3G deployments around the globe, we see continued signs of strong growth in virtually every market. Europe is witnessing an increase in the adoption of 3G, enabled by new handset form factors, improved battery life, and rapidly decreasing prices. Feature-rich 3G phones are becoming the must-have consumer gadgets, even in regions that do not have 3G networks. WCDMA handsets sales in Western Europe during the March quarter of '06 represented approximately 30% of the total handset sales in Western Europe, compared to approximately 25% of the total handset sales in the previous quarter. This enthusiasm for 3G is encouraging operators to expedite HSDPA deployment with commercial service now available in a growing number of countries. The initial targets for HSDPA-enabled mobile broadband services had been enterprise customers via data cards, and now the first HSDPA-enabled handsets are also beginning to reach the market. The India market had another strong quarter with average monthly net additions of 1.3 million in the second quarter of 2006, reaching a cumulative base of 33.6 million subscribers. Leading CDMA2000 operators Reliance and Tata have crossed 20 million and 10 million subscribers, respectively. BSNL, India's largest telecom company, sees significant opportunities in rural India, and has reiterated commitment for CDMA2000 technologies for its rural expansion. In a recent bid opened by state-owned service provider MTNL, more than one-third of the 2 million expansion planned is ear-marked for 3G mobile services, based on WCDMA. In North America, the 3G momentum continues with broad-based DO growth and expanding HSDPA coverage. Cingular now offers their Broadband Connect 3G service in 18 markets, including New York City. Verizon recently announced that Lucent and Nortel will provide DO Revision A technology into Verizon's nationwide network, enabling them to introduce a range of new services, including enhanced Push-to-Talk, messaging, and Voice-over-IP. Also of note, the FCC approved the first dual-mode CDMA2000 1x IDEN phone that Sprint previously reported it would launch later this year. The introduction of this dual-mode device will more readily allow Sprint Nextel to migrate its existing IDEN customers so they can experience the voice and data improvements that CDMA2000 provides before Sprint Nextel's DO REV A nationwide build out is complete. The Korean handset market is in line with expectations and well on track to reach 40 million subscribers by the end of the year. Of note, SKT broadened its base by announcing an investment in China Unicom, creating an opportunity for those companies to share their expertise in growing the CDMA2000 market in China. Despite, as Paul mentioned, the uncertainty of Vivo's rumored potential build out of a parallel GSM network, the Brazilian market has performed close to our expectations to-date. In Japan, the number of 3G subscribers continues to surpass the number of 2G subscribers. As of the end of June, approximately 57% of Japan's 93 million-plus cellular users now subscribe to 3G services, and we expect a vast majority of the remaining 2G subscribers to upgrade to 3G by 2008. Attractive handset models and the pending launch of mobile number portability have led to strong increases in new handset sales and replacement rates. 15 new handsets were launched in Japan in the month to June. KDDI unveiled seven new CDMA2000 handset models, six of which were EV-DO. DoCoMo introduced six new WCDMA handsets this quarter in the 3G FOMA 7 series. DoCoMo now has more than 51 million total subscribers, including an unmatched 26 million WCDMA subscribers. Let me turn now to Nokia's recent announcement that it will discontinue its CDMA2000 development and scale down its CDMA2000 business. As part of that announcement, Nokia also reported that it will continue to participate in some key CDMA2000 markets that it recognizes are too large to ignore, such as North America, through an ODM model. We were not surprised by this announcement. Unlike GSM where Nokia's business model has been successful and allowed it to capture and hold the dominant position, the CDMA2000 handset market is dynamic and highly competitive. Nokia has experienced difficulties competing against the large number of CDMA2000 suppliers, enabled by QUALCOMM's business model, and was never able to maintain a significant share in CDMA2000. For this reason, it is also not surprising that Nokia's announcements attempted to downplay the significance of the worldwide CDMA2000 market. We do not believe that Nokia's announced plans will negatively impact the growth and continued adoption of CDMA2000 products. In fact, with their announced departure from CDMA2000, we have already seen evidence of even stronger interest from competing handset manufacturers that view Nokia's departure as an excellent opportunity to not only grow their share in CDMA2000 but also grow their share in the overall wireless handset market. As to our license agreement, we remain in discussions with Nokia regarding an extension of their CDMA agreement. Although we're hopeful of being able to include such an extension before April, we continue to maintain our position that we have fairly valued our intellectual property portfolio and will take the necessary measures required to protect our business interests if we're not able to successfully conclude our extension by April. Our litigation with Broadcom is continuing. The case in the ITC concluded its remedies phase on July 12. There is no liability or remedies recommendation by the judge at this point. We expect the judge to issue a recommendation towards the end of August and not later than August 21. Verizon, Sprint, Motorola, Kyocera, Samsung and LG all intervened in the ITC action against Broadcom during the remedies phase to explain to the ITC why the remedies sought by Broadcom are inappropriate and insupportable. The growth of the 3G market and our leading position in it is why we are seeing this litigation and attacks from some of our competitors. Over the past year, we have seen increased media activity, threats, complaints and litigation against our business model. Some of the complaining companies criticize our business model because they incorrectly hope that this will cause us to lower the subscriber royalties that they agreed to pay us. Others challenge our business model because the competition that we have enabled through our technology innovation, our licensing program, and our advanced chipset and software processes threatens the success that these complaining parties have had in 2G GSM technologies. In all of these cases, we are very confident that our business practices are not only lawful, but promote healthy competition within the industry. I will now turn the call over to Sanjay Jha.
Sanjay Jha: Thanks, Steve. Good afternoon. I'd like to go over some key highlights for QCT business. QCT continues to set performance records. We shipped more than 55 million MSMs, compared to 49 million in the previous quarter, which is a 12% quarter-over-quarter increase. In comparison to the third quarter of last year in which QCT shipped 36 million MSMs, this represents a 53% year-over-year growth. Our revenue of $1.1 billion was also record-setting, up 11% from last quarter and 48% year-over-year. This quarter, we delivered record operating profit of $303 million, a 20% increase over the previous quarter. QCT's operating margin was 27% in the third quarter of fiscal 2006, compared to 24% in the third quarter of fiscal 2005. We can attribute this growth not only to greater MSM shipment but also to a trend towards higher-end solutions with more CDMA2000 1x EV-DO and wideband CDMA MSMs shipped this quarter than in the past. We also shipped a record number of CDMA2000 cell site-to-modem voice equivalent channel elements in the quarter. Historically, we have seen that CSM shipments are a strong, leading indicator of future demand and data usage and quantity of handsets. The CDMA market continues to grow at a strong rate and there are numerous indications that it will continue to do so. According to market research, 21 of the 34 sub-$50 designs in India are CDMA devices. Additionally, these handsets are available from ten suppliers, compared to five for GSM devices. Part of the driving force behind the growth of CDMA in the emerging market is that growing demand for functionality that only CDMA handsets can offer at the low tier, such as downloadable polyphonic ring tones. We have 11 customers designing handsets based on our QSC single-chip solutions with commercial products expected beginning at the end of this year. Overall, our growth in UMTS is strong with 34 device manufacturer customers and 267 wideband CDMA devices available or in design with our chipsets. Our UMTS MSM shipment increased by 24% from last quarter. To help expand the market, we demonstrated UMTS in 900 MHz, which will help network operators deploy the 3G technology in existing spectrum with up to 70% reduction in CapEx. Furthermore, ten device manufacturers are now using our HSUPA chipsets and have started HSUPA interoperability testing with multiple leading infrastructure providers. QCT is building on technology leadership we established with the industry's first HSDPA solution by making the broadband capabilities of HSDPA technology acceptable to a much larger segment of wireless users. We sampled our MSM 6260 chipset ahead of schedule, which leverages the cost efficiencies of 65-nanometer process technology to accelerate the availability of HSDPA handsets to mass market. QCT is helping drive the rapid growth of this technology around the world, as evidenced by the 34 live networks and 43 networks in process of deployment in just six months after the first was launched, according to Informa. Along with driving HSDPA into mass market, QTC is also making wideband CDMA devices more accessible with MSM 6245 and MSM 6255-A chipsets. Together with MSM 6260 chipsets, they are part of a family of PIN software and RF-compatible UMTS chipsets that deliver shortened design cycles and reduce development costs for device manufacturers. All three chipsets leverage 65-nanometer process technology and the highly integrated RTR 6275, RFCMOS, GSM, GPRS, UMTS transceiver to enable cost-efficient handsets. Embedded modules for 3G connectivity in laptop computers remain a priority for QCT. There are now nearly 50 laptops in design or commercially available that feature embedded connectivity to either EV-DO or HSDPA networks with a QUALCOMM chipset. This has been an extremely rapid growth area and we anticipate that it will continue to accelerate. We continue to make strong investments into IP-based multimedia subsystem or IMS technology, and are developing an air interface agnostic IMS device client solution that will be able to provide a consistent client environment to drive faster deployment of innovative IP-based applications. This translates to greater flexibility for operators in configuring and controlling services such as Voice-over-IP, video sharing, and Push-to-Talk with other applications planned for the future. We are seeing strong traction for our 7000 series converged platform chipset, which features the industry's leading integration to offer numerous consumer electronics features and mobile devices. There are currently 25 devices in design with our first commercial unit expected to be available by the end of this year. QCT also announced a collaboration with Microsoft to deliver integrated support for Windows Mobile on our 7000 series converged platform chipset. Our work with Microsoft will result in a wider range of slim, attractive and power efficient Smartphones, which we anticipate will be available by the end of this year and next year. I will now turn this call over to Bill Keitel for an overview of our financial results.
Bill Keitel: Thank you, Sanjay, and good afternoon, everyone. We are very pleased to report another quarter of record revenues, chip shipments, and earnings per share. GAAP earnings for the June quarter were $0.37 per diluted share and our pro forma earnings were $0.42 per diluted share, excluding $0.05 in estimated stock option expense. Revenues increased 44% year-over-year to $1.95 billion. Pro forma diluted earnings per share increased by 50% year-over-year. During the quarter, we returned $1.4 billion in capital to shareholders, including $202 million of cash dividends, or $0.12 per share, and $1.2 billion to repurchase our common stock. Shortly after the quarter end, we repurchased an additional $238 million of our stock. In the past two months, we have repurchased a total of $1.4 billion of our stock and looking forward, it will be accretive to earnings per share. Our business continues to generate strong cash flow. Operating cash flow was $816 million for the third fiscal quarter, up 56% year-over-year. Pro forma free cash flow was $795 million, up 116% year-over-year. Our pro forma estimated tax rate for fiscal 2006 is 26% as compared to our prior estimate of 27%. As Sanjay mentioned, QCT again had record MSM shipments during the quarter. QCT's third quarter revenues increased 48% year-over-year. MSMs shipped increased 53% year-over-year. QCT's operating margin increased to 27%. QCT earnings before tax increased 63% year-over-year. QTL earned record revenues of $683 million this quarter, up 52% year-over-year, as licensees reported approximately 66 million new handset units shipped with an average selling price of approximately $213 per handset. These shipments occurred in the March quarter and were awarded to us by our licensees in the June quarter. Of the $683 million in total QTL revenues, $43 million represented inter-segment royalties, $13 million were license fees, and $627 million were royalties from third-party licensees. WCDMA royalties were approximately 47% of third-party royalties reported this quarter, and QTL's operating margin was 90%. Based on our recent checks, we believe higher-than-normal channel inventory build has occurred for China and India, consistent with our prior expectations. For the rest of the world, we believe channel inventory levels are comfortably within the normal 15 to 20-week band. Before addressing our guidance, I will offer a little more perspective to Paul's comments on emerging markets and a couple of operators potentially moving to GSM. Although emerging markets are important to QUALCOMM, I want to be clear that financial contribution of significance from very low-end is a few years away. Although we dedicate significant support to emerging market operators and continue to invest in low-end solutions, today this business is appropriately characterized as business development in the context of bottom line profit. Turning to our guidance, we are increasing our estimate for the calendar year 2006 CDMA-based handset market. We now estimate shipments of approximately 285 million to 295 million units in calendar 2006, an increase of 36% to 40% over calendar 2005 shipments. Based on the 290 million midpoint of this estimate for calendar 2006, we now anticipate shipments of approximately 190 million CDMA2000 units and approximately 100 million WCDMA units. This increase to our calendar year estimates is driven primarily by strength of CDMA2000 in North America and India and WCDMA in Europe. A detailed regional breakdown of our increased market estimates is available on our Investor Relations web site. We are also increasing our guidance for fiscal 2006 revenue and earnings per share. We now expect fiscal 2006 revenues to be in the range of approximately $7.4 billion to $7.5 billion, an increase of 30% to 32% over fiscal 2005. We anticipate pro forma diluted earnings per share to be in the range of $1.61 to $1.63, an increase of 39% to 41% year-over-year. We now estimate the fiscal 2006 average selling price for CDMA2000 and WCDMA phones combined to decrease approximately 1% year-over-year to approximately $213. We continue to see a wide array of wholesale prices occurring with CDMA2000 devices and increasingly so with WCDMA devices. We expect a combination of pro forma R&D and SG&A expense for fiscal 2006 to increase approximately 28% to 29% year-over-year, driven by growth in R&D as we continue to invest in the evolution of CDMA2000 and WCDMA, multimedia functionality, single-chip low-cost solutions, and longer-term technology enhancements, including OFDMA. We estimate GAAP diluted earnings per share will be approximately $1.40 to $1.42 for fiscal 2006. This estimate includes a non-cash expense of approximately $0.20 per share for estimated share-based compensation, a loss of approximately $0.03 per share attributable to QSI, a gain of $0.03 attributable to tax benefits related to prior years, and a $0.01 loss attributable to in-process R&D from completed acquisitions. Turning to our guidance for the fourth fiscal quarter of 2006, we estimate revenues to be in the range of approximately $1.88 billion to $1.98 billion, a 21% to 27% increase year-over-year. We estimate fourth quarter pro forma diluted earnings per share to be approximately $0.39 to $0.41, a 22% to 28% increase year-over-year. This estimate includes shipments of approximately 53 million to 56 million MSM phone chips during the September quarter. We continue to see very strong demand across multiple product segments, including CDMA2000 EV-DO, WCDMA, and HSDPA. We estimate approximately 67 million to 70 million CDMA-based handsets shipped in the June quarter at an average selling price of approximately $215. Our unit forecast reflects sequential growth in multiple regions, including WCDMA in Europe and CDMA2000 in North America when compared to the March quarter, while the overall market reflects a 40% to 46% growth over the year-ago quarter June. We anticipate fourth fiscal quarter pro forma R&D and SG&A expenses combined to increase sequentially by approximately 3% to 6%, driven by our continued investment in new products and services to address the growing market. In closing, it has been another great quarter of record financial results and strong cash flow driven by the growing adoption of 3G CDMA technology around the world and continued strong execution in our business units. We are well-positioned for the significant opportunities in front of us, as we continue to invest and innovate. As well, we're pleased to be actively returning capital to our shareholders while maintaining financial flexibility to take advantage of new opportunities and to continue to grow our business at a high rate in the years ahead. That concludes my comments. I will now turn the call back to Bill Davidson.
Bill Davidson: Thank you, Bill. Before we go into our Q&A session, I'd like to remind our participants that our goal is to address as many questions as possible before we run out of time on the call. Therefore, I'd like to ask that our participants limit their questions to one per caller. Operator, we're ready to receive questions.
Operator: Our first question comes from Brian Modoff - Deutsche Bank.
Brian Modoff - Deutsche Bank: Good afternoon. Thanks for taking the question. You've raised your WCDMA forecast from 96 million to 100 million this quarter. Can you kind of give some granularity as to why you did that? And specifically, can you address the demand trends you're seeing in Western Europe? Thank you.
Bill Keitel: Our WCDMA estimates, we increased slightly our estimates for Europe from 51 million to 53 million units, and we increased our estimates for rest of world -- that being everything but Japan and Europe -- from 5 million units to 7 million units.
Brian Modoff - Deutsche Bank: Can you give some granularity behind what caused that? What kind of trends are you seeing in Europe? You know, what's driving this? Because we get mixed signals on Europe, so I'm curious what's driving this demand trend over there particularly.
Bill Keitel: What I see driving it, Brian, is now broadly across many operators is increasing attraction for buckets of minutes, packages and I think an increasing interest in HSDPA and the enhanced data capabilities, both quality to the consumer and cost for the operator, with the rollouts that are occurring now.
Brian Modoff - Deutsche Bank: All right, thank you.
Bill Keitel: Brian, I just want to add also that, in rest of world, we're seeing a lot of WCDMA handsets being sold onto GSM-only networks, so that was not an insignificant part of our estimate increase for rest of world.
Brian Modoff - Deutsche Bank: Thank you.
Operator: Our next question comes from John Bucher - Harris Nesbitt.
John Bucher - Harris Nesbitt: Thank you. There's been a lot of attention devoted to whether certain CDMA2000 carriers may go to GSM. Yet it would seem that with the substantial installed base of GSM carriers that could migrate to WCDMA, that you've got a huge opportunity there. With Sanjay mentioning the 900 MHz WCDMA chip sets being sampled, do you think that's the key tipping factor that might get some GSM carriers to move to WCDMA? Or are there political and regulatory factors that might open up this opportunity for you?
Paul Jacobs: We are definitely seeing a shift in the regulatory and political landscape towards enabling technology neutrality and the operators are clearly pressing on having that opportunity to lower their CapEx by moving to a WCDMA 900. That's certainly a tremendous opportunity for us. But we also see the opportunity, we talked about the fact that, in India, we're starting to see operators being interested in moving, so even in emerging markets, we see that as well. It seems to be happening worldwide. The fact that people are buying WCDMA handsets and running them on 3G networks is also not escaping the notice of the operators as well, so they see an opportunity to launch new services there as well. Sanjay, I don't know whether you want to add anything.
Sanjay Jha: Yes, John, I spent a little time in Europe in the last few weeks and actually the attraction of the UMTS 900 was one of the key things that struck me as a positive trend, certainly for QUALCOMM. Of course that means lower CapEx and better coverage, both indoors and in rural space for UMTS operators. I'm actually very, very positive and very excited about this opportunity, not the least because we have leadership in providing integrated RF solution for this band, so I see this as a very important development.
Operator: Our next question comes from Paul Sagawa - Sanford Bernstein.
Paul Sagawa - Sanford Bernstein: Thank you very much. So as we sail towards that April 9 date, obviously there's been a lots of noise in the marketplace, and it's those that would try to seek a better deal with you who put as much pressure as possible. I'm interested about those post-April 9, as we move into a timeframe when both companies, if they continue to ship, would be in likely violation of patent infringement. What actions are available to you? Obviously, you can file suit. There would be damages associated with that. We know that, in the United States, there are treble damages for willful infringement. If you could talk a little bit about what damages you think might be available in pursuing this here and in Europe? Also, the potential of getting injunctions in those markets. Then finally, are the carriers and distributors of phones that infringe upon your patents also at risk, or are they party to the infringement? Would they be potentially a pressure you could bring to bear on this circumstance, should it come to it?
Steve Altman: Part of that question you answered as well. Let me go through it. You're right. In the U.S., there would be treble damages as an opportunity. I think that once we get past April 9, if there's no agreement, they will be infringing our patents, so we will take all appropriate measures, which would be I think pretty obvious to you in terms of what steps we would have to take. In addition to damages, we would look and seek injunctions in a variety of markets where there are shipping certainly WCDMA at that time. In terms of carriers that would be subject to risk, while it would be true that a carrier who buys an unlicensed product that's infringing our patents from a company like Nokia after April 9 would also be infringing on those patents by using those products. We are very good partners with our carriers and we believe very strongly that the remedies that we would seek would be very applicable to the manufacturers, so I don't think that you will see us asserting these patents, I don't think we need to assert these patents against our carrier partners.
Paul Sagawa - Sanford Bernstein: Do you think the carriers would respect your patents with regard to an infringing product?
Steve Altman: I think that as the carriers decide what products that they're going to want to purchase and rely on in their product portfolio, I think it's widely recognized that licenses from QUALCOMM are necessary. So to the extent that they were to buy from somebody and include those products in their portfolio, they would do so knowing that they could be very abruptly removed from their portfolios. I think they would take that into consideration as they make their purchases.
Paul Sagawa - Sanford Bernstein: Thank you.
Operator: Our next question comes from Avi Silver - Bear Stearns.
Avi Silver - Bear Stearns: I had two questions. Is there anyone out there that is manufacturing the WCDMA or CDMA phone that doesn't currently have a license agreement with QUALCOMM? My second question is a follow-up on Sanjay's comment earlier. It seems like two major catalysts for 3G in Europe are 900 MHz and HSDPA. Can you talk about some of the timing regarding 900 MHz, whatever process that needs to go through to get approved and the potential timing for that, as well as commercialization of HSDPA? We see LG's phone now with Cingular in the U.S. When does that launch in Europe on a wider scale?
Steve Altman: Well, certainly we can say that there's nobody that is manufacturing and selling WCDMA of any significant volume that does not have a license. If you look back at QUALCOMM's historical practices, if there are companies that were proceeding with CDMA but we were in licensed negotiations and making what we perceived as reasonable progress, we don't rush into litigation if we think there's a good opportunity to resolve the issue. So there's nobody of any significant volume, and we are in discussions with new companies that would become WCDMA licensees.
Sanjay Jha: In terms of UMTS 900, let me just say that there has been a significant amount of regulatory discussion and most all of the European countries with the possible exception of one; the one company which is objecting, their motivation is not to stop UMTS 900 but to get some other concession in some other band. Most of the countries are supporting UMTS 900. There are one or two issues with respect to those carriers who have 3G spectrum but don't have access to 900 spectrum, and H3G comes to mind as one such carrier. Finding appropriate arrangements for sharing the benefits of 900 MHz spectrum, as that happens, I think that UMTS 900 will happen. In terms of timing, we will have commercial products available in the second half this year. There are at least two carriers who are going to mandate that every UMTS phone that they buy, starting June next year, that every phone they buy has 900 MHz support. So I think that 900 MHz is going to happen faster than perhaps some people anticipate, and the case for 900 is so overwhelmingly compelling that anyone who is capable of moving and freeing spectrum to support a 900 MHz band, that they will definitely migrate to UMTS. In terms of HSDPA, I think you have seen the CU500 from LGE being launched at Cingular. I expect you would see between one and ten phones being launched -- broad range I know, but I need to cover myself here -- being launched based on HSDPA. Every single data card starting from about July or August will be HSDPA. As I mentioned, a large number of laptops are coming onto market with embedded HSDPA modules. So I think those are the three things that I think will drive HSDPA. The number of networks being launched is accelerating not least because most of the networks are software upgradeable to HSDPA. So both 900 and HSDPA are big positive trends for QUALCOMM.
Paul Jacobs: To amplify Sanjay's comment, I was in Europe recently and the guys got me a very attractive laptop with embedded HSDPA and I was able to use it almost everywhere I went in HSDPA mode, so the networks are getting up and being launched. Now, I was in major metropolitan areas of course, but the experience was tremendous.
Avi Silver - Bear Stearns: Great, thank you.
Operator: Our next question comes from Tim Luke - Lehman Brothers.
Tim Luke - Lehman Brothers: Thank you. Just a clarification for Bill. Could you just give us a framework of what the inventory build is in India and China? You said it was 15 to 20 weeks elsewhere. How many weeks is it there or can you give us some framework for how we should think about that? Then for Paul, you were obviously just in India and talking to Reliance. Can you give us some sort of framework of what the issues are there? Do you think it's fairly likely that they will proceed with some GSM there or not, and how should we view that? Maybe if you could give us a similar framework for your expectations with respect to Brazil. Bill, you eluded to the fact that it's not insignificant in terms of the contribution. Maybe frame that, that might be helpful. Thank you.
Bill Keitel: On the inventory, as we said, outside of China and India, looking at the world as a whole, the channel is comfortably within a 15 to 20-week band. Last quarter, we mentioned that we are cautious; we've been cautious on India and China, in the context of thinking that OEMs were perhaps targeting to gain a little too much share from each other, or perhaps a little too optimistic on what the operator sell-through would be.
Tim Luke - Lehman Brothers: But the guidance implies that it will be done by the end of this quarter, in terms of cleaning out that inventory?
Bill Keitel: I think it's going to improve this quarter. I still see a steady flow of our product, but I think that channel would probably improve this coming quarter, and then right itself probably the quarter after that. In the context of total world inventory, the excess that we see for China in inventory is not inventory that we think is very likely transportable to other regions of the world, so to the extent it was bought for India or China, we think it will probably stay directed at those markets.
Tim Luke - Lehman Brothers: Thank you.
Paul Jacobs: This is Paul. On Reliance, I would say the issue started out, at least publicly, around royalty rates. I think we had pretty much a meeting of the minds that the issue is predominantly handset costs and that's what we need to focus on. We have done, I think, a very good job over the last year. I think the result was that through competition we got the handset prices at the very low end down by 25% in the last year. So we're going to continue to drive that. They are always focused on the cost differential between their lowest-cost phone and the lowest-cost phone available to the GSM operators, although on an average basis, the gap is extremely small in the sub-$50 range. Across the entire market, CDMA actually has lower average selling prices, although that has something to do with the strategy of focusing more in on the low end of the market. So we are discussing with them things like how to get a broader range of handsets, some higher-end handsets into that market as well. Clearly, the way the spectrum is being allocated in India and the relative lack of spectrum availability is playing into some of their concerns. They are a GSM operator in certain circles, so I would say it's still up in the air, what their decision-making process is going to be, and we are still in pretty deep discussions with them, not just us but also other partners. So, I think that's going to continue on and there's a lot of negotiating back and forth that's currently happening.
Tim Luke - Lehman Brothers: Will it be this calendar year? You would expect the decision to be made by the end of this calendar year with respect to their direction?
Paul Jacobs: They say things like that to us, so I would expect so, but we've been in discussion with them for a fairly long period of time, so we'll see how it goes. Like I said, the negotiations continue; the discussions continue. I should point out that while I was there, I also met with Tata and BSNL, both of whom seem to be very aggressive on their CDMA2000 plans, and met with some of the WCDMA operators. So India is turning out to be a very increasingly interesting and complicated market, and we will spend a fair time focusing on that. You know, with respect to Brazil, we've all heard the issues. There has clearly been some disagreement in the ownership of Vivo about the direction we've heard of, very aggressive offers being made by the GSM vendor community. So we continue to talk with them as well. Clearly having the low-end phone and having the range of phones -- I mean, it's a similar dynamic for these markets, although I would say that we've seen expansion of DO and the use of data services is probably higher in terms of DO and so forth in Brazil, so we'll see that discussion continue on.
Tim Luke - Lehman Brothers: But you would expect them to do GSM in the regions where they don't have Spectrum or Vivo?
Paul Jacobs: NanoTel has opened up consultations and it looks like there will be 1900 MHz spectrum available for them to cover. But it is an interesting point that in both of these situations we're talking about, there is spectrum availability and regulatory issues that are causing these operators to have some problems in terms of just having adequate capacity or adequate coverage, so we are actively working those issues, we have been trying to work those issues over an extended period of time. I think there are some breakthroughs in Brazil that are possible.
Tim Luke - Lehman Brothers: Thank you.
Steve Altman: In the context, Tim, of characterizing the very low end as more business development, I will just say that we think we are seeing $40 wholesale handset prices now occurring, and we think with our single-chip solution towards the end of this year, that's going to go down substantially further. To enable a sub-$40 wholesale handset price, obviously the chipset price is very low and the royalty we get off that is very low. As Paul said several quarters ago, we consciously made a decision to even accept lower margins on our sales of these very low-end devices to just further help these emerging markets. As I said, from a financial perspective, it's more of a business development area. The operators are very important to us and we dedicate a lot of time and resource to them. But the opportunity, the financial opportunity, is really some years ahead.
Tim Luke - Lehman Brothers: This is a framework for investor expectations, though, that you would acknowledge that you may see announcements about GSM or WCDMA deployments in that region in Brazil in the next several months, or you think that's an unlikely prospect? How should we think about that?
Paul Jacobs: I mean, the possibility exists, so we would certainly welcome the announcements of WCDMA.
Tim Luke - Lehman Brothers: Great. Thanks, Paul. Thanks, Bill.
Operator: Our next question comes from Brantley Thompson - Goldman Sachs.
Natalie for Brant Thompson - Goldman Sachs: This is Natalie in for Brant Thompson. Sanjay, you had talked a little bit about expectations over the next few quarters for the QCT margins seems to be coming in stronger, at least than we had expected. So any commentary around what we should look for going forward?
Sanjay Jha: Natalie, no update to the guidance that I've provided for long-term operating profit for our business, which is 25% to 32% is where we look for, so clearly, we are very happy about the quarter which is coming in slightly stronger driven by two things: a slightly richer mix and higher volume. Going forward, we are hopeful that we will maintain our performance.
Bill Keitel: I would just add to that, too, Sanjay, at the outset of the year said that he thought the year would end plus or minus about a 25% operating margin, and it looks like that's about where we're going to come in. He also said that, quarter-to-quarter, it's going to go up and down, and that truly has been the case, too. So we're going to have fluctuations quarter-to-quarter as the mix changes, but nonetheless, I think that business is operating extremely well.
Operator: Our next question comes from Tim Long - Banc of America.
Jeff Walkenhorst - Banc of America: Yes, it's Jeff Walkenhorst for Tim Long. Thanks for taking the question. I'm wondering if you can talk a little bit more on Nokia's decision to ramp down on CDMA? The first question would be more towards Sanjay. When do you think that the chipset business might see some share gains in some of the other vendors that may be clamoring for some of that share? I guess the flip side is, do you think that Nokia will be so aggressive that it might make it hard for CDMA to maintain relative market share to GSM? Thanks.
Sanjay Jha: Two things there: first of all, that I think, in the last earnings call I talked about how Nokia actually already had some phones based on our solutions, ODM phones based on our solution in the marketplace, both in the very low-end as well as DO devices. So as Nokia ramps down their effort, they are still shipping a considerable amount of products based on our solutions. That's one. Secondly, we already see that all the other manufacturers are very aggressive about going after and winning market share from Nokia worldwide, as well as in particular regions. India and U.S are particularly important, and as Paul mentioned, so as Latin America. So I expect that does lead to some positive gains for us. In terms of Nokia making it hard, Nokia has actually been very public about not playing even in GSM, in the absolute low end of the marketplace. In fact, I see them being quite aggressive right now in wideband CDMA, so I actually see Nokia's move as a net positive overall for QUALCOMM, certainly a net positive in CDMA2000 to the chipset business.
Jeff Walkenhorst - Banc of America: Okay, thanks. As far as the pricing differential in India and low-end markets, maybe it is around $4 or $5 at the absolute low end. What do you think that might be a year from now?
Sanjay Jha: It's very difficult to tell because it's a very dynamic marketplace. If you look at where that market has been, it has come down very dramatically. What both of us are chasing is really a pretty rapid curve down. I expect that our objective certainly is to get closer and closer to GSM price, and with a single-chip solution, I think we have the opportunity to get much closer.
Paul Jacobs: The other thing that we are absolutely trying to do in that low-end market, though, is to make use of the data capabilities of CDMA and the functionality that Sanjay's team is integrating into the chipsets, and that's why we are so happy to see these reports that the very low-end subscribers are actually generating a fair amount of data ARPU, more ARPU on data than through the tier just above them. That's a strategic insight that we've only recently gotten, and we are always focused on data for the low end, but now it's very clear that there's an opportunity for us there.
Jeff Walkenhorst - Banc of America: Great, thanks. Good luck, guys.
Operator: Our next question comes from Christin Armacost - Lazard.
Christin Armacost - Lazard Freres & Co.: Thank you. I wanted to ask you a question about the guidance and in particular, Bill, your comments about QCT margins. With so many metrics that you give us, there's very little for us to play around with in the September quarter estimate. Especially in QCT, QCT margins and the ASP for the MSM chipset. So what I'm trying to understand is, relative to your guidance and the metrics, are you anticipating a pretty significant decline in QCT margins to get to the EPS numbers or a significant decline in MSM ASPs?
Bill Keitel: I will offer my thoughts here and Sanjay can add to it if he sees anything. We are expecting a very modest decline in the ASP of our average chipset sales, consistent with our prior expectations and consistent with our trends. But in addition to that, we are continuing to increase our R&D spending and a good portion of that increase we expect to be in QCT. So yes, we are expecting a decrease in QCT operating margins in the September quarter.
Christin Armacost - Lazard Freres & Co.: Great, thank you.
Operator: Our next question comes from Matthew Hoffman - Cowen & Co.
Matthew Hoffman - Cowen & Co.: Bill, I hope we can continue with that line of thought real quick. To get to the new EPS guidance, you talked about the R&D and the QCT margins. But what about gross margins? They ticked down a little bit for this quarter. Should we assume that they are also going to tick down again next quarter? Then Sanjay, it seems like pretty good news on the CSM Rev A chips. Geographically, where should we assume those chips are headed? Are they going to base stations in Japan and the U.S. or any in emerging markets?
Sanjay Jha: Matt, let me take the second part of your question first. In terms of DO Revision A chips, actually the carriers who are driving are it -- Sprint, Verizon, KDDI -- are the three carriers who are driving the migration to DO Revision A very fast. I think that those three carriers are the key drivers of that growth, therefore Japan and U.S. being the drivers of that growth.
Operator: Ladies and gentlemen, we have reached the allotted time allowed for questions and answers. Dr. Jacobs, do you have anything further to add before adjourning the conference call?
Paul Jacobs: Yes, I'd like to thank everybody for joining us. I think, despite all the noise that is out there, the real events of this quarter demonstrate our values of innovation, execution and partnership, and I think that that has resulted in the absolutely outstanding financial performance that we turned in. The data capabilities and 3G are really leading to a better mix for us and all the core businesses. We remain focused on those opportunities that are ahead of us as 3G CDMA continues to be the key mainstream technology for enabling compelling new devices and services. If we just used the growing subscriber base worldwide, we can see that consumers are buying 3G. So we look forward to continuing to help drive that market. Thanks very much, everybody. Bye.
Operator: Ladies and gentlemen, this concludes the QUALCOMM third quarter conference call. Thank you for your participation. You may now disconnect. | [
{
"speaker": "Executives",
"text": "Bill Davidson - VP IR Dr. Paul Jacobs - CEO Steve Altman - President Dr. Sanjay Jha - President of CDMA Technologies Group Bill Keitel - CFO"
},
{
"speaker": "Analysts",
"text": "Brian Modoff - Deutsche Bank John Bucher - Harris Nesbitt Gerard Paul Sagawa - Sanford C. Bernstein Avi Silver - Bear Stearns Tim Luke - Lehman Brothers Natalie for Brant Thompson - Goldman Sachs Jeff Walkenhorst - Banc of America Securities Christin Armacost - Lazard Freres & Co Matthew Hoffman - SG Cowen"
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by. Welcome to the QUALCOMM third quarter conference call. (Operator Instructions) I would now like to turn the call over to Bill Davidson, Vice President of Investor Relations. Sir, please go ahead."
},
{
"speaker": "Bill Davidson",
"text": "Thank you and good afternoon. Today's call will include prepared remarks by Dr. Paul Jacobs, Steve Altman, Dr. Sanjay Jha, and Bill Keitel. An Internet presentation and audio broadcast accompanies this call, and you can access it by visiting www.QUALCOMM.com. During this conference call, if we use any non-GAAP financial measures as defined by the SEC and Regulation G, you can find the required reconciliations to GAAP on our web site. I would also direct you to our 10-Q and earnings release, which were filed and furnished respectively with the SEC today and are available on our Web site. As a reminder, the QUALCOMM Investor Relations Web site includes a thorough presentation on the many data points included in this conference call. We may make forward-looking statements relating to our expectations and other future events that may differ materially from QUALCOMM's actual results. Please review our SEC filings for a detailed presentation of each of our businesses and associated risks and other important factors that may cause our actual results to differ from these forward-looking statements. Pro forma revenues were $1.95 billion in the third fiscal quarter, up 44% year-over-year and 6% sequentially. Third quarter fiscal pro forma net income was $726 million, up 56% year-over-year and 3% sequentially. Pro forma diluted earnings per share were $0.42, up 50% year-over-year and 2% sequentially. Third fiscal quarter pro forma free cash flow, defined as net cash from operating activities less capital expenditures, was $795 million, up 116% year-over-year, and was 41% of revenue. Now, it's my pleasure to introduce QUALCOMM's CEO, Dr. Paul Jacobs."
},
{
"speaker": "Paul Jacobs",
"text": "Thank you, Bill, and good afternoon, everyone. In spite of the turmoil in the market, QUALCOMM has continued to focus and the execution of our business continues to be extremely strong. We had a fourth consecutive quarter of record revenues and chip shipments. Our revenue is up 44% year-over-year and our pro forma free cash flow is 41% of revenue and increased 116% year-over-year. I'm proud of these results and I thank our employees for their efforts and our customers for their support. The 2G to 3G migration is well underway worldwide. Our business is being driven by the growing adoption of 3G CDMA-based technologies in multiple regions around the world. As a result, we are once again raising our handset guidance for 2006 and increasing our revenue and earnings estimates for this fiscal year. We're focused on continuing to foster new and vigorous competition, bringing innovative products and lower prices to the rapidly growing 3G CDMA market. QUALCOMM and our licensees have been demonstrating to many audiences worldwide the consumer benefits of rapidly decreasing handset costs and the increasing variety of innovative devices resulting from our pro-competitive business model. During the quarter, we saw 3G subscribers grow to more than 324 million worldwide, including more than 33 million 1x EV-DO subscribers and more than 66 million WCDMA subscribers. We are quite happy with the continuing record of growth of 3G technologies worldwide. From March 2005 to March 2006, WCDMA handset shipments grew in Western Europe and comprised 30% of the handset shipments in the March quarter. In the same year, GSM handset shipments have declined by 14%. Our success in the competitive dynamics of the 3G CDMA market has caused a small number of companies to challenge our licensing business model. The challenges we are facing are not new to us and we remained steadfast in our strong belief that because of the pro-competitive business model we have established, we will overcome these challenges. The royalties we charge are a small part of the overall cost of handsets, represent a reasonable return to us for the value of the intellectual property that we license, the risks that we assumed in developing, marketing, and commercializing CDMA technologies, the investments we made and continue to make, the market and competition that we helped create and enable, and our ongoing innovation that provides new capabilities, services and revenue opportunities for all of those in the wireless value chain. QUALCOMM participates in and contributes significantly to many major standards processes. The majority of our technologies are standards-based. In this light, I'm pleased to note that the MediaFLO air interface has recently become a TIA standard through the work of the FLO Forum, a group of 46 partner companies. The best measure of the value of our contribution to standardized technologies is the 130 license agreements that were freely negotiated with manufacturers around the world, including the largest and most sophisticated companies in the wireless arena, beginning in 1990 and continuing today with five new licensees during the last fiscal quarter. However, as one indicator of the significance of our contributions to open standards, publicly available sources can be used for one objective measure of the value of essential patents in the WCDMA standard by examining how often patents essential to the WCDMA standard were cited as prior art in the patents of other inventors. While we do not believe that counting schemes of any kind are a reliable measure of the value and quality of patents, the frequency with which one’s patents are cited by others is obviously more of an indicator of the importance of a patent portfolio than simply counting essential patents in a standard. Looking at citations is a measure of significance somewhat analogous to the way Google ranks Web pages by examining the number of links to that page. When you factor out citations by a company of its own patents, QUALCOMM has 47% of the citation-weighted portfolio of essential patents for WCDMA, followed by Ericsson at 21%. Significantly, Nokia has only 3%, NEC 2%, Panasonic 1%, and TI and Broadcom have less than 1%. Of course, to reiterate, the best measure by far of the value of QUALCOMM's patent portfolio is the 130 arms-length license agreements that we've negotiated over 15 years with nearly every major supplier in the industry. Those agreements have established, confirmed and reconfirmed our patents portfolio's market value. We continue to believe that the operation of free market forces provides the only true indicator of patent value, but looking at citations provides another interesting indicator of innovative importance. There have been significant advances in the CDMA2000 roadmap. QCT shipped five times the number of EV-DO Rev A bay station chips than last quarter, setting a new record. It's clear that operators are aggressively migrating to EV-DO Rev A. The 170 different EV-DO device models have made it possible for operators to increase their data ARPUs. For example, in May, Verizon reported nearly an 80% year-over-year increase. In April, KDDI reported a 37% year-over-year increase, and Sprint reported a 55% year-over-year increase. In May, Vivo reported a 38% year-over-year increase. The move from commoditized voice to differentiated data services is generating revenue for the operators and therefore, they're willing to further invest in higher-speed networks. In addition to the ability to drive wireless data, we have demonstrated significant increases in voice capacity with Voice-over-IP, or VoIP, running on DO Rev A. Over the coming years, the technology roadmap enabled by VoIP will continue to provide CDMA2000 operators with the most cost-effective roadmap to increase capabilities. The deployment of DO Rev A Voice-over-IP devices will allow carriers to transition from circuit-switched networks to an all-packet, all-IP future. As subscribers transition from 1x to DO Rev A, operators will be able to bond together multiple channels using DO Rev B techniques to enable extremely high data rates. Combined with interference cancellation techniques implemented in our next generation CSMs, this roadmap provides the CDMA2000 operators with the most efficient and cost-effective solutions for wireless broadband in their existing spectrum. In the past quarter, there's been significant discussion surrounding some of the emerging market operators, in particular Vivo and Alliance and how they may move from 3G CDMA to 2G GSM. QUALCOMM royalties have been cited as a reason for this potential shift. In fact, the lowest CDMA2000 phones are below $40 in these emerging markets, and with net phone royalties under 5%, the royalty is a small amount in absolute dollars. We continue to invest significant effort and resources to drive the cost of the lowest MCDMA2000 phones down. Utilizing the advantages of CDMA, we have long believed that data services would be important not just to the high-end users but also the low-end subscribers. We are encouraged by recent reports from China and India that the lowest-end subscribers are making significant use of data services, thereby increasing operator revenues. In India, Tata is one of the top 10 operators worldwide for revenue downloads on BREW. Tata doubled the number of applications downloaded from its network between the months of May and June this year with two-thirds of the activity coming from users of the Kyocera Prisma low-cost phone. In order to free up capacity for increasing use of data services, we will nearly double the voice capacity of CDMA2000 systems using the new 4GV Vocoder, integrated receive diversity in both handset and base station interference cancellation. We see the use of CDMA2000 as the best way to bridge the digital divide in emerging markets. We made a conscious decision several quarters ago to accept very low margins to enable emerging markets with very low-end subscriber devices. We are encouraged by the increasing importance of data services for existing CDMA2000 and by the impending rollouts of WCDMA as a path to improved economics for GSM operators. To further address that market opportunity, we sampled three low-end WCDMA chip sets during the quarter with the MSN 6245 focused at the lowest end of the market. WCDMA continues to grow with WCDMA royalties accounting for 47% of overall royalties, up from 36% in the prior-year quarter. Turning to MediaFLO, MediaFLO USA continues to move towards the launch of commercial service. Its broadcast operations center and network operations center are now up and running at MediaFLO USA's headquarters in San Diego. Currently, MediaFLO USA's facilities are being used for service trials and preparing for Verizon Wireless' launch of MediaFLO. MediaFLO USA continues its discussions with many wireless operators on how to leverage a dedicated media delivery network that aggregates compelling content for their subscriber base and that will complement their existing 3G network. Outside of the United States, we continue to see tremendous interest in FLO technology. In May, QUALCOMM and British Sky Broadcasting signed a nonbinding letter of intent to conduct the first technical trials of MediaFLO technology in the UK. Beginning this summer, the trial will feature ten channels of BSkyB content and a small number of non-commercial devices provided by QUALCOMM. The BSkyB technical trial is the first of what we expect to be a number of FLO technology trials in Europe and in other parts of the world. In addition to our trial agreement with BSkyB, QUALCOMM and KDDI have formed a joint venture to explore the deployment of MediaFLO services in Japan. We took advantage of the recent decline in our stock price to repurchase 32 million shares of our common stock for $1.4 billion. Combined with our recently increased cash dividend, we provided a total return of capital to our shareholders of $1.6 billion since the end of the fiscal second quarter. Our balance sheet strength and unique business model continues to provide significant financial flexibility, allowing us to pursue strategic growth objectives, pay dividends, and repurchase shares in our continuous effort to enhance stockholder value. I'd now like to turn the call over to Steve Altman."
},
{
"speaker": "Steve Altman",
"text": "Thanks, Paul and good afternoon. As we look at 3G deployments around the globe, we see continued signs of strong growth in virtually every market. Europe is witnessing an increase in the adoption of 3G, enabled by new handset form factors, improved battery life, and rapidly decreasing prices. Feature-rich 3G phones are becoming the must-have consumer gadgets, even in regions that do not have 3G networks. WCDMA handsets sales in Western Europe during the March quarter of '06 represented approximately 30% of the total handset sales in Western Europe, compared to approximately 25% of the total handset sales in the previous quarter. This enthusiasm for 3G is encouraging operators to expedite HSDPA deployment with commercial service now available in a growing number of countries. The initial targets for HSDPA-enabled mobile broadband services had been enterprise customers via data cards, and now the first HSDPA-enabled handsets are also beginning to reach the market. The India market had another strong quarter with average monthly net additions of 1.3 million in the second quarter of 2006, reaching a cumulative base of 33.6 million subscribers. Leading CDMA2000 operators Reliance and Tata have crossed 20 million and 10 million subscribers, respectively. BSNL, India's largest telecom company, sees significant opportunities in rural India, and has reiterated commitment for CDMA2000 technologies for its rural expansion. In a recent bid opened by state-owned service provider MTNL, more than one-third of the 2 million expansion planned is ear-marked for 3G mobile services, based on WCDMA. In North America, the 3G momentum continues with broad-based DO growth and expanding HSDPA coverage. Cingular now offers their Broadband Connect 3G service in 18 markets, including New York City. Verizon recently announced that Lucent and Nortel will provide DO Revision A technology into Verizon's nationwide network, enabling them to introduce a range of new services, including enhanced Push-to-Talk, messaging, and Voice-over-IP. Also of note, the FCC approved the first dual-mode CDMA2000 1x IDEN phone that Sprint previously reported it would launch later this year. The introduction of this dual-mode device will more readily allow Sprint Nextel to migrate its existing IDEN customers so they can experience the voice and data improvements that CDMA2000 provides before Sprint Nextel's DO REV A nationwide build out is complete. The Korean handset market is in line with expectations and well on track to reach 40 million subscribers by the end of the year. Of note, SKT broadened its base by announcing an investment in China Unicom, creating an opportunity for those companies to share their expertise in growing the CDMA2000 market in China. Despite, as Paul mentioned, the uncertainty of Vivo's rumored potential build out of a parallel GSM network, the Brazilian market has performed close to our expectations to-date. In Japan, the number of 3G subscribers continues to surpass the number of 2G subscribers. As of the end of June, approximately 57% of Japan's 93 million-plus cellular users now subscribe to 3G services, and we expect a vast majority of the remaining 2G subscribers to upgrade to 3G by 2008. Attractive handset models and the pending launch of mobile number portability have led to strong increases in new handset sales and replacement rates. 15 new handsets were launched in Japan in the month to June. KDDI unveiled seven new CDMA2000 handset models, six of which were EV-DO. DoCoMo introduced six new WCDMA handsets this quarter in the 3G FOMA 7 series. DoCoMo now has more than 51 million total subscribers, including an unmatched 26 million WCDMA subscribers. Let me turn now to Nokia's recent announcement that it will discontinue its CDMA2000 development and scale down its CDMA2000 business. As part of that announcement, Nokia also reported that it will continue to participate in some key CDMA2000 markets that it recognizes are too large to ignore, such as North America, through an ODM model. We were not surprised by this announcement. Unlike GSM where Nokia's business model has been successful and allowed it to capture and hold the dominant position, the CDMA2000 handset market is dynamic and highly competitive. Nokia has experienced difficulties competing against the large number of CDMA2000 suppliers, enabled by QUALCOMM's business model, and was never able to maintain a significant share in CDMA2000. For this reason, it is also not surprising that Nokia's announcements attempted to downplay the significance of the worldwide CDMA2000 market. We do not believe that Nokia's announced plans will negatively impact the growth and continued adoption of CDMA2000 products. In fact, with their announced departure from CDMA2000, we have already seen evidence of even stronger interest from competing handset manufacturers that view Nokia's departure as an excellent opportunity to not only grow their share in CDMA2000 but also grow their share in the overall wireless handset market. As to our license agreement, we remain in discussions with Nokia regarding an extension of their CDMA agreement. Although we're hopeful of being able to include such an extension before April, we continue to maintain our position that we have fairly valued our intellectual property portfolio and will take the necessary measures required to protect our business interests if we're not able to successfully conclude our extension by April. Our litigation with Broadcom is continuing. The case in the ITC concluded its remedies phase on July 12. There is no liability or remedies recommendation by the judge at this point. We expect the judge to issue a recommendation towards the end of August and not later than August 21. Verizon, Sprint, Motorola, Kyocera, Samsung and LG all intervened in the ITC action against Broadcom during the remedies phase to explain to the ITC why the remedies sought by Broadcom are inappropriate and insupportable. The growth of the 3G market and our leading position in it is why we are seeing this litigation and attacks from some of our competitors. Over the past year, we have seen increased media activity, threats, complaints and litigation against our business model. Some of the complaining companies criticize our business model because they incorrectly hope that this will cause us to lower the subscriber royalties that they agreed to pay us. Others challenge our business model because the competition that we have enabled through our technology innovation, our licensing program, and our advanced chipset and software processes threatens the success that these complaining parties have had in 2G GSM technologies. In all of these cases, we are very confident that our business practices are not only lawful, but promote healthy competition within the industry. I will now turn the call over to Sanjay Jha."
},
{
"speaker": "Sanjay Jha",
"text": "Thanks, Steve. Good afternoon. I'd like to go over some key highlights for QCT business. QCT continues to set performance records. We shipped more than 55 million MSMs, compared to 49 million in the previous quarter, which is a 12% quarter-over-quarter increase. In comparison to the third quarter of last year in which QCT shipped 36 million MSMs, this represents a 53% year-over-year growth. Our revenue of $1.1 billion was also record-setting, up 11% from last quarter and 48% year-over-year. This quarter, we delivered record operating profit of $303 million, a 20% increase over the previous quarter. QCT's operating margin was 27% in the third quarter of fiscal 2006, compared to 24% in the third quarter of fiscal 2005. We can attribute this growth not only to greater MSM shipment but also to a trend towards higher-end solutions with more CDMA2000 1x EV-DO and wideband CDMA MSMs shipped this quarter than in the past. We also shipped a record number of CDMA2000 cell site-to-modem voice equivalent channel elements in the quarter. Historically, we have seen that CSM shipments are a strong, leading indicator of future demand and data usage and quantity of handsets. The CDMA market continues to grow at a strong rate and there are numerous indications that it will continue to do so. According to market research, 21 of the 34 sub-$50 designs in India are CDMA devices. Additionally, these handsets are available from ten suppliers, compared to five for GSM devices. Part of the driving force behind the growth of CDMA in the emerging market is that growing demand for functionality that only CDMA handsets can offer at the low tier, such as downloadable polyphonic ring tones. We have 11 customers designing handsets based on our QSC single-chip solutions with commercial products expected beginning at the end of this year. Overall, our growth in UMTS is strong with 34 device manufacturer customers and 267 wideband CDMA devices available or in design with our chipsets. Our UMTS MSM shipment increased by 24% from last quarter. To help expand the market, we demonstrated UMTS in 900 MHz, which will help network operators deploy the 3G technology in existing spectrum with up to 70% reduction in CapEx. Furthermore, ten device manufacturers are now using our HSUPA chipsets and have started HSUPA interoperability testing with multiple leading infrastructure providers. QCT is building on technology leadership we established with the industry's first HSDPA solution by making the broadband capabilities of HSDPA technology acceptable to a much larger segment of wireless users. We sampled our MSM 6260 chipset ahead of schedule, which leverages the cost efficiencies of 65-nanometer process technology to accelerate the availability of HSDPA handsets to mass market. QCT is helping drive the rapid growth of this technology around the world, as evidenced by the 34 live networks and 43 networks in process of deployment in just six months after the first was launched, according to Informa. Along with driving HSDPA into mass market, QTC is also making wideband CDMA devices more accessible with MSM 6245 and MSM 6255-A chipsets. Together with MSM 6260 chipsets, they are part of a family of PIN software and RF-compatible UMTS chipsets that deliver shortened design cycles and reduce development costs for device manufacturers. All three chipsets leverage 65-nanometer process technology and the highly integrated RTR 6275, RFCMOS, GSM, GPRS, UMTS transceiver to enable cost-efficient handsets. Embedded modules for 3G connectivity in laptop computers remain a priority for QCT. There are now nearly 50 laptops in design or commercially available that feature embedded connectivity to either EV-DO or HSDPA networks with a QUALCOMM chipset. This has been an extremely rapid growth area and we anticipate that it will continue to accelerate. We continue to make strong investments into IP-based multimedia subsystem or IMS technology, and are developing an air interface agnostic IMS device client solution that will be able to provide a consistent client environment to drive faster deployment of innovative IP-based applications. This translates to greater flexibility for operators in configuring and controlling services such as Voice-over-IP, video sharing, and Push-to-Talk with other applications planned for the future. We are seeing strong traction for our 7000 series converged platform chipset, which features the industry's leading integration to offer numerous consumer electronics features and mobile devices. There are currently 25 devices in design with our first commercial unit expected to be available by the end of this year. QCT also announced a collaboration with Microsoft to deliver integrated support for Windows Mobile on our 7000 series converged platform chipset. Our work with Microsoft will result in a wider range of slim, attractive and power efficient Smartphones, which we anticipate will be available by the end of this year and next year. I will now turn this call over to Bill Keitel for an overview of our financial results."
},
{
"speaker": "Bill Keitel",
"text": "Thank you, Sanjay, and good afternoon, everyone. We are very pleased to report another quarter of record revenues, chip shipments, and earnings per share. GAAP earnings for the June quarter were $0.37 per diluted share and our pro forma earnings were $0.42 per diluted share, excluding $0.05 in estimated stock option expense. Revenues increased 44% year-over-year to $1.95 billion. Pro forma diluted earnings per share increased by 50% year-over-year. During the quarter, we returned $1.4 billion in capital to shareholders, including $202 million of cash dividends, or $0.12 per share, and $1.2 billion to repurchase our common stock. Shortly after the quarter end, we repurchased an additional $238 million of our stock. In the past two months, we have repurchased a total of $1.4 billion of our stock and looking forward, it will be accretive to earnings per share. Our business continues to generate strong cash flow. Operating cash flow was $816 million for the third fiscal quarter, up 56% year-over-year. Pro forma free cash flow was $795 million, up 116% year-over-year. Our pro forma estimated tax rate for fiscal 2006 is 26% as compared to our prior estimate of 27%. As Sanjay mentioned, QCT again had record MSM shipments during the quarter. QCT's third quarter revenues increased 48% year-over-year. MSMs shipped increased 53% year-over-year. QCT's operating margin increased to 27%. QCT earnings before tax increased 63% year-over-year. QTL earned record revenues of $683 million this quarter, up 52% year-over-year, as licensees reported approximately 66 million new handset units shipped with an average selling price of approximately $213 per handset. These shipments occurred in the March quarter and were awarded to us by our licensees in the June quarter. Of the $683 million in total QTL revenues, $43 million represented inter-segment royalties, $13 million were license fees, and $627 million were royalties from third-party licensees. WCDMA royalties were approximately 47% of third-party royalties reported this quarter, and QTL's operating margin was 90%. Based on our recent checks, we believe higher-than-normal channel inventory build has occurred for China and India, consistent with our prior expectations. For the rest of the world, we believe channel inventory levels are comfortably within the normal 15 to 20-week band. Before addressing our guidance, I will offer a little more perspective to Paul's comments on emerging markets and a couple of operators potentially moving to GSM. Although emerging markets are important to QUALCOMM, I want to be clear that financial contribution of significance from very low-end is a few years away. Although we dedicate significant support to emerging market operators and continue to invest in low-end solutions, today this business is appropriately characterized as business development in the context of bottom line profit. Turning to our guidance, we are increasing our estimate for the calendar year 2006 CDMA-based handset market. We now estimate shipments of approximately 285 million to 295 million units in calendar 2006, an increase of 36% to 40% over calendar 2005 shipments. Based on the 290 million midpoint of this estimate for calendar 2006, we now anticipate shipments of approximately 190 million CDMA2000 units and approximately 100 million WCDMA units. This increase to our calendar year estimates is driven primarily by strength of CDMA2000 in North America and India and WCDMA in Europe. A detailed regional breakdown of our increased market estimates is available on our Investor Relations web site. We are also increasing our guidance for fiscal 2006 revenue and earnings per share. We now expect fiscal 2006 revenues to be in the range of approximately $7.4 billion to $7.5 billion, an increase of 30% to 32% over fiscal 2005. We anticipate pro forma diluted earnings per share to be in the range of $1.61 to $1.63, an increase of 39% to 41% year-over-year. We now estimate the fiscal 2006 average selling price for CDMA2000 and WCDMA phones combined to decrease approximately 1% year-over-year to approximately $213. We continue to see a wide array of wholesale prices occurring with CDMA2000 devices and increasingly so with WCDMA devices. We expect a combination of pro forma R&D and SG&A expense for fiscal 2006 to increase approximately 28% to 29% year-over-year, driven by growth in R&D as we continue to invest in the evolution of CDMA2000 and WCDMA, multimedia functionality, single-chip low-cost solutions, and longer-term technology enhancements, including OFDMA. We estimate GAAP diluted earnings per share will be approximately $1.40 to $1.42 for fiscal 2006. This estimate includes a non-cash expense of approximately $0.20 per share for estimated share-based compensation, a loss of approximately $0.03 per share attributable to QSI, a gain of $0.03 attributable to tax benefits related to prior years, and a $0.01 loss attributable to in-process R&D from completed acquisitions. Turning to our guidance for the fourth fiscal quarter of 2006, we estimate revenues to be in the range of approximately $1.88 billion to $1.98 billion, a 21% to 27% increase year-over-year. We estimate fourth quarter pro forma diluted earnings per share to be approximately $0.39 to $0.41, a 22% to 28% increase year-over-year. This estimate includes shipments of approximately 53 million to 56 million MSM phone chips during the September quarter. We continue to see very strong demand across multiple product segments, including CDMA2000 EV-DO, WCDMA, and HSDPA. We estimate approximately 67 million to 70 million CDMA-based handsets shipped in the June quarter at an average selling price of approximately $215. Our unit forecast reflects sequential growth in multiple regions, including WCDMA in Europe and CDMA2000 in North America when compared to the March quarter, while the overall market reflects a 40% to 46% growth over the year-ago quarter June. We anticipate fourth fiscal quarter pro forma R&D and SG&A expenses combined to increase sequentially by approximately 3% to 6%, driven by our continued investment in new products and services to address the growing market. In closing, it has been another great quarter of record financial results and strong cash flow driven by the growing adoption of 3G CDMA technology around the world and continued strong execution in our business units. We are well-positioned for the significant opportunities in front of us, as we continue to invest and innovate. As well, we're pleased to be actively returning capital to our shareholders while maintaining financial flexibility to take advantage of new opportunities and to continue to grow our business at a high rate in the years ahead. That concludes my comments. I will now turn the call back to Bill Davidson."
},
{
"speaker": "Bill Davidson",
"text": "Thank you, Bill. Before we go into our Q&A session, I'd like to remind our participants that our goal is to address as many questions as possible before we run out of time on the call. Therefore, I'd like to ask that our participants limit their questions to one per caller. Operator, we're ready to receive questions."
},
{
"speaker": "Operator",
"text": "Our first question comes from Brian Modoff - Deutsche Bank."
},
{
"speaker": "Brian Modoff - Deutsche Bank",
"text": "Good afternoon. Thanks for taking the question. You've raised your WCDMA forecast from 96 million to 100 million this quarter. Can you kind of give some granularity as to why you did that? And specifically, can you address the demand trends you're seeing in Western Europe? Thank you."
},
{
"speaker": "Bill Keitel",
"text": "Our WCDMA estimates, we increased slightly our estimates for Europe from 51 million to 53 million units, and we increased our estimates for rest of world -- that being everything but Japan and Europe -- from 5 million units to 7 million units."
},
{
"speaker": "Brian Modoff - Deutsche Bank",
"text": "Can you give some granularity behind what caused that? What kind of trends are you seeing in Europe? You know, what's driving this? Because we get mixed signals on Europe, so I'm curious what's driving this demand trend over there particularly."
},
{
"speaker": "Bill Keitel",
"text": "What I see driving it, Brian, is now broadly across many operators is increasing attraction for buckets of minutes, packages and I think an increasing interest in HSDPA and the enhanced data capabilities, both quality to the consumer and cost for the operator, with the rollouts that are occurring now."
},
{
"speaker": "Brian Modoff - Deutsche Bank",
"text": "All right, thank you."
},
{
"speaker": "Bill Keitel",
"text": "Brian, I just want to add also that, in rest of world, we're seeing a lot of WCDMA handsets being sold onto GSM-only networks, so that was not an insignificant part of our estimate increase for rest of world."
},
{
"speaker": "Brian Modoff - Deutsche Bank",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from John Bucher - Harris Nesbitt."
},
{
"speaker": "John Bucher - Harris Nesbitt",
"text": "Thank you. There's been a lot of attention devoted to whether certain CDMA2000 carriers may go to GSM. Yet it would seem that with the substantial installed base of GSM carriers that could migrate to WCDMA, that you've got a huge opportunity there. With Sanjay mentioning the 900 MHz WCDMA chip sets being sampled, do you think that's the key tipping factor that might get some GSM carriers to move to WCDMA? Or are there political and regulatory factors that might open up this opportunity for you?"
},
{
"speaker": "Paul Jacobs",
"text": "We are definitely seeing a shift in the regulatory and political landscape towards enabling technology neutrality and the operators are clearly pressing on having that opportunity to lower their CapEx by moving to a WCDMA 900. That's certainly a tremendous opportunity for us. But we also see the opportunity, we talked about the fact that, in India, we're starting to see operators being interested in moving, so even in emerging markets, we see that as well. It seems to be happening worldwide. The fact that people are buying WCDMA handsets and running them on 3G networks is also not escaping the notice of the operators as well, so they see an opportunity to launch new services there as well. Sanjay, I don't know whether you want to add anything."
},
{
"speaker": "Sanjay Jha",
"text": "Yes, John, I spent a little time in Europe in the last few weeks and actually the attraction of the UMTS 900 was one of the key things that struck me as a positive trend, certainly for QUALCOMM. Of course that means lower CapEx and better coverage, both indoors and in rural space for UMTS operators. I'm actually very, very positive and very excited about this opportunity, not the least because we have leadership in providing integrated RF solution for this band, so I see this as a very important development."
},
{
"speaker": "Operator",
"text": "Our next question comes from Paul Sagawa - Sanford Bernstein."
},
{
"speaker": "Paul Sagawa - Sanford Bernstein",
"text": "Thank you very much. So as we sail towards that April 9 date, obviously there's been a lots of noise in the marketplace, and it's those that would try to seek a better deal with you who put as much pressure as possible. I'm interested about those post-April 9, as we move into a timeframe when both companies, if they continue to ship, would be in likely violation of patent infringement. What actions are available to you? Obviously, you can file suit. There would be damages associated with that. We know that, in the United States, there are treble damages for willful infringement. If you could talk a little bit about what damages you think might be available in pursuing this here and in Europe? Also, the potential of getting injunctions in those markets. Then finally, are the carriers and distributors of phones that infringe upon your patents also at risk, or are they party to the infringement? Would they be potentially a pressure you could bring to bear on this circumstance, should it come to it?"
},
{
"speaker": "Steve Altman",
"text": "Part of that question you answered as well. Let me go through it. You're right. In the U.S., there would be treble damages as an opportunity. I think that once we get past April 9, if there's no agreement, they will be infringing our patents, so we will take all appropriate measures, which would be I think pretty obvious to you in terms of what steps we would have to take. In addition to damages, we would look and seek injunctions in a variety of markets where there are shipping certainly WCDMA at that time. In terms of carriers that would be subject to risk, while it would be true that a carrier who buys an unlicensed product that's infringing our patents from a company like Nokia after April 9 would also be infringing on those patents by using those products. We are very good partners with our carriers and we believe very strongly that the remedies that we would seek would be very applicable to the manufacturers, so I don't think that you will see us asserting these patents, I don't think we need to assert these patents against our carrier partners."
},
{
"speaker": "Paul Sagawa - Sanford Bernstein",
"text": "Do you think the carriers would respect your patents with regard to an infringing product?"
},
{
"speaker": "Steve Altman",
"text": "I think that as the carriers decide what products that they're going to want to purchase and rely on in their product portfolio, I think it's widely recognized that licenses from QUALCOMM are necessary. So to the extent that they were to buy from somebody and include those products in their portfolio, they would do so knowing that they could be very abruptly removed from their portfolios. I think they would take that into consideration as they make their purchases."
},
{
"speaker": "Paul Sagawa - Sanford Bernstein",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Avi Silver - Bear Stearns."
},
{
"speaker": "Avi Silver - Bear Stearns",
"text": "I had two questions. Is there anyone out there that is manufacturing the WCDMA or CDMA phone that doesn't currently have a license agreement with QUALCOMM? My second question is a follow-up on Sanjay's comment earlier. It seems like two major catalysts for 3G in Europe are 900 MHz and HSDPA. Can you talk about some of the timing regarding 900 MHz, whatever process that needs to go through to get approved and the potential timing for that, as well as commercialization of HSDPA? We see LG's phone now with Cingular in the U.S. When does that launch in Europe on a wider scale?"
},
{
"speaker": "Steve Altman",
"text": "Well, certainly we can say that there's nobody that is manufacturing and selling WCDMA of any significant volume that does not have a license. If you look back at QUALCOMM's historical practices, if there are companies that were proceeding with CDMA but we were in licensed negotiations and making what we perceived as reasonable progress, we don't rush into litigation if we think there's a good opportunity to resolve the issue. So there's nobody of any significant volume, and we are in discussions with new companies that would become WCDMA licensees."
},
{
"speaker": "Sanjay Jha",
"text": "In terms of UMTS 900, let me just say that there has been a significant amount of regulatory discussion and most all of the European countries with the possible exception of one; the one company which is objecting, their motivation is not to stop UMTS 900 but to get some other concession in some other band. Most of the countries are supporting UMTS 900. There are one or two issues with respect to those carriers who have 3G spectrum but don't have access to 900 spectrum, and H3G comes to mind as one such carrier. Finding appropriate arrangements for sharing the benefits of 900 MHz spectrum, as that happens, I think that UMTS 900 will happen. In terms of timing, we will have commercial products available in the second half this year. There are at least two carriers who are going to mandate that every UMTS phone that they buy, starting June next year, that every phone they buy has 900 MHz support. So I think that 900 MHz is going to happen faster than perhaps some people anticipate, and the case for 900 is so overwhelmingly compelling that anyone who is capable of moving and freeing spectrum to support a 900 MHz band, that they will definitely migrate to UMTS. In terms of HSDPA, I think you have seen the CU500 from LGE being launched at Cingular. I expect you would see between one and ten phones being launched -- broad range I know, but I need to cover myself here -- being launched based on HSDPA. Every single data card starting from about July or August will be HSDPA. As I mentioned, a large number of laptops are coming onto market with embedded HSDPA modules. So I think those are the three things that I think will drive HSDPA. The number of networks being launched is accelerating not least because most of the networks are software upgradeable to HSDPA. So both 900 and HSDPA are big positive trends for QUALCOMM."
},
{
"speaker": "Paul Jacobs",
"text": "To amplify Sanjay's comment, I was in Europe recently and the guys got me a very attractive laptop with embedded HSDPA and I was able to use it almost everywhere I went in HSDPA mode, so the networks are getting up and being launched. Now, I was in major metropolitan areas of course, but the experience was tremendous."
},
{
"speaker": "Avi Silver - Bear Stearns",
"text": "Great, thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Tim Luke - Lehman Brothers."
},
{
"speaker": "Tim Luke - Lehman Brothers",
"text": "Thank you. Just a clarification for Bill. Could you just give us a framework of what the inventory build is in India and China? You said it was 15 to 20 weeks elsewhere. How many weeks is it there or can you give us some framework for how we should think about that? Then for Paul, you were obviously just in India and talking to Reliance. Can you give us some sort of framework of what the issues are there? Do you think it's fairly likely that they will proceed with some GSM there or not, and how should we view that? Maybe if you could give us a similar framework for your expectations with respect to Brazil. Bill, you eluded to the fact that it's not insignificant in terms of the contribution. Maybe frame that, that might be helpful. Thank you."
},
{
"speaker": "Bill Keitel",
"text": "On the inventory, as we said, outside of China and India, looking at the world as a whole, the channel is comfortably within a 15 to 20-week band. Last quarter, we mentioned that we are cautious; we've been cautious on India and China, in the context of thinking that OEMs were perhaps targeting to gain a little too much share from each other, or perhaps a little too optimistic on what the operator sell-through would be."
},
{
"speaker": "Tim Luke - Lehman Brothers",
"text": "But the guidance implies that it will be done by the end of this quarter, in terms of cleaning out that inventory?"
},
{
"speaker": "Bill Keitel",
"text": "I think it's going to improve this quarter. I still see a steady flow of our product, but I think that channel would probably improve this coming quarter, and then right itself probably the quarter after that. In the context of total world inventory, the excess that we see for China in inventory is not inventory that we think is very likely transportable to other regions of the world, so to the extent it was bought for India or China, we think it will probably stay directed at those markets."
},
{
"speaker": "Tim Luke - Lehman Brothers",
"text": "Thank you."
},
{
"speaker": "Paul Jacobs",
"text": "This is Paul. On Reliance, I would say the issue started out, at least publicly, around royalty rates. I think we had pretty much a meeting of the minds that the issue is predominantly handset costs and that's what we need to focus on. We have done, I think, a very good job over the last year. I think the result was that through competition we got the handset prices at the very low end down by 25% in the last year. So we're going to continue to drive that. They are always focused on the cost differential between their lowest-cost phone and the lowest-cost phone available to the GSM operators, although on an average basis, the gap is extremely small in the sub-$50 range. Across the entire market, CDMA actually has lower average selling prices, although that has something to do with the strategy of focusing more in on the low end of the market. So we are discussing with them things like how to get a broader range of handsets, some higher-end handsets into that market as well. Clearly, the way the spectrum is being allocated in India and the relative lack of spectrum availability is playing into some of their concerns. They are a GSM operator in certain circles, so I would say it's still up in the air, what their decision-making process is going to be, and we are still in pretty deep discussions with them, not just us but also other partners. So, I think that's going to continue on and there's a lot of negotiating back and forth that's currently happening."
},
{
"speaker": "Tim Luke - Lehman Brothers",
"text": "Will it be this calendar year? You would expect the decision to be made by the end of this calendar year with respect to their direction?"
},
{
"speaker": "Paul Jacobs",
"text": "They say things like that to us, so I would expect so, but we've been in discussion with them for a fairly long period of time, so we'll see how it goes. Like I said, the negotiations continue; the discussions continue. I should point out that while I was there, I also met with Tata and BSNL, both of whom seem to be very aggressive on their CDMA2000 plans, and met with some of the WCDMA operators. So India is turning out to be a very increasingly interesting and complicated market, and we will spend a fair time focusing on that. You know, with respect to Brazil, we've all heard the issues. There has clearly been some disagreement in the ownership of Vivo about the direction we've heard of, very aggressive offers being made by the GSM vendor community. So we continue to talk with them as well. Clearly having the low-end phone and having the range of phones -- I mean, it's a similar dynamic for these markets, although I would say that we've seen expansion of DO and the use of data services is probably higher in terms of DO and so forth in Brazil, so we'll see that discussion continue on."
},
{
"speaker": "Tim Luke - Lehman Brothers",
"text": "But you would expect them to do GSM in the regions where they don't have Spectrum or Vivo?"
},
{
"speaker": "Paul Jacobs",
"text": "NanoTel has opened up consultations and it looks like there will be 1900 MHz spectrum available for them to cover. But it is an interesting point that in both of these situations we're talking about, there is spectrum availability and regulatory issues that are causing these operators to have some problems in terms of just having adequate capacity or adequate coverage, so we are actively working those issues, we have been trying to work those issues over an extended period of time. I think there are some breakthroughs in Brazil that are possible."
},
{
"speaker": "Tim Luke - Lehman Brothers",
"text": "Thank you."
},
{
"speaker": "Steve Altman",
"text": "In the context, Tim, of characterizing the very low end as more business development, I will just say that we think we are seeing $40 wholesale handset prices now occurring, and we think with our single-chip solution towards the end of this year, that's going to go down substantially further. To enable a sub-$40 wholesale handset price, obviously the chipset price is very low and the royalty we get off that is very low. As Paul said several quarters ago, we consciously made a decision to even accept lower margins on our sales of these very low-end devices to just further help these emerging markets. As I said, from a financial perspective, it's more of a business development area. The operators are very important to us and we dedicate a lot of time and resource to them. But the opportunity, the financial opportunity, is really some years ahead."
},
{
"speaker": "Tim Luke - Lehman Brothers",
"text": "This is a framework for investor expectations, though, that you would acknowledge that you may see announcements about GSM or WCDMA deployments in that region in Brazil in the next several months, or you think that's an unlikely prospect? How should we think about that?"
},
{
"speaker": "Paul Jacobs",
"text": "I mean, the possibility exists, so we would certainly welcome the announcements of WCDMA."
},
{
"speaker": "Tim Luke - Lehman Brothers",
"text": "Great. Thanks, Paul. Thanks, Bill."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brantley Thompson - Goldman Sachs."
},
{
"speaker": "Natalie for Brant Thompson - Goldman Sachs",
"text": "This is Natalie in for Brant Thompson. Sanjay, you had talked a little bit about expectations over the next few quarters for the QCT margins seems to be coming in stronger, at least than we had expected. So any commentary around what we should look for going forward?"
},
{
"speaker": "Sanjay Jha",
"text": "Natalie, no update to the guidance that I've provided for long-term operating profit for our business, which is 25% to 32% is where we look for, so clearly, we are very happy about the quarter which is coming in slightly stronger driven by two things: a slightly richer mix and higher volume. Going forward, we are hopeful that we will maintain our performance."
},
{
"speaker": "Bill Keitel",
"text": "I would just add to that, too, Sanjay, at the outset of the year said that he thought the year would end plus or minus about a 25% operating margin, and it looks like that's about where we're going to come in. He also said that, quarter-to-quarter, it's going to go up and down, and that truly has been the case, too. So we're going to have fluctuations quarter-to-quarter as the mix changes, but nonetheless, I think that business is operating extremely well."
},
{
"speaker": "Operator",
"text": "Our next question comes from Tim Long - Banc of America."
},
{
"speaker": "Jeff Walkenhorst - Banc of America",
"text": "Yes, it's Jeff Walkenhorst for Tim Long. Thanks for taking the question. I'm wondering if you can talk a little bit more on Nokia's decision to ramp down on CDMA? The first question would be more towards Sanjay. When do you think that the chipset business might see some share gains in some of the other vendors that may be clamoring for some of that share? I guess the flip side is, do you think that Nokia will be so aggressive that it might make it hard for CDMA to maintain relative market share to GSM? Thanks."
},
{
"speaker": "Sanjay Jha",
"text": "Two things there: first of all, that I think, in the last earnings call I talked about how Nokia actually already had some phones based on our solutions, ODM phones based on our solution in the marketplace, both in the very low-end as well as DO devices. So as Nokia ramps down their effort, they are still shipping a considerable amount of products based on our solutions. That's one. Secondly, we already see that all the other manufacturers are very aggressive about going after and winning market share from Nokia worldwide, as well as in particular regions. India and U.S are particularly important, and as Paul mentioned, so as Latin America. So I expect that does lead to some positive gains for us. In terms of Nokia making it hard, Nokia has actually been very public about not playing even in GSM, in the absolute low end of the marketplace. In fact, I see them being quite aggressive right now in wideband CDMA, so I actually see Nokia's move as a net positive overall for QUALCOMM, certainly a net positive in CDMA2000 to the chipset business."
},
{
"speaker": "Jeff Walkenhorst - Banc of America",
"text": "Okay, thanks. As far as the pricing differential in India and low-end markets, maybe it is around $4 or $5 at the absolute low end. What do you think that might be a year from now?"
},
{
"speaker": "Sanjay Jha",
"text": "It's very difficult to tell because it's a very dynamic marketplace. If you look at where that market has been, it has come down very dramatically. What both of us are chasing is really a pretty rapid curve down. I expect that our objective certainly is to get closer and closer to GSM price, and with a single-chip solution, I think we have the opportunity to get much closer."
},
{
"speaker": "Paul Jacobs",
"text": "The other thing that we are absolutely trying to do in that low-end market, though, is to make use of the data capabilities of CDMA and the functionality that Sanjay's team is integrating into the chipsets, and that's why we are so happy to see these reports that the very low-end subscribers are actually generating a fair amount of data ARPU, more ARPU on data than through the tier just above them. That's a strategic insight that we've only recently gotten, and we are always focused on data for the low end, but now it's very clear that there's an opportunity for us there."
},
{
"speaker": "Jeff Walkenhorst - Banc of America",
"text": "Great, thanks. Good luck, guys."
},
{
"speaker": "Operator",
"text": "Our next question comes from Christin Armacost - Lazard."
},
{
"speaker": "Christin Armacost - Lazard Freres & Co.",
"text": "Thank you. I wanted to ask you a question about the guidance and in particular, Bill, your comments about QCT margins. With so many metrics that you give us, there's very little for us to play around with in the September quarter estimate. Especially in QCT, QCT margins and the ASP for the MSM chipset. So what I'm trying to understand is, relative to your guidance and the metrics, are you anticipating a pretty significant decline in QCT margins to get to the EPS numbers or a significant decline in MSM ASPs?"
},
{
"speaker": "Bill Keitel",
"text": "I will offer my thoughts here and Sanjay can add to it if he sees anything. We are expecting a very modest decline in the ASP of our average chipset sales, consistent with our prior expectations and consistent with our trends. But in addition to that, we are continuing to increase our R&D spending and a good portion of that increase we expect to be in QCT. So yes, we are expecting a decrease in QCT operating margins in the September quarter."
},
{
"speaker": "Christin Armacost - Lazard Freres & Co.",
"text": "Great, thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Matthew Hoffman - Cowen & Co."
},
{
"speaker": "Matthew Hoffman - Cowen & Co.",
"text": "Bill, I hope we can continue with that line of thought real quick. To get to the new EPS guidance, you talked about the R&D and the QCT margins. But what about gross margins? They ticked down a little bit for this quarter. Should we assume that they are also going to tick down again next quarter? Then Sanjay, it seems like pretty good news on the CSM Rev A chips. Geographically, where should we assume those chips are headed? Are they going to base stations in Japan and the U.S. or any in emerging markets?"
},
{
"speaker": "Sanjay Jha",
"text": "Matt, let me take the second part of your question first. In terms of DO Revision A chips, actually the carriers who are driving are it -- Sprint, Verizon, KDDI -- are the three carriers who are driving the migration to DO Revision A very fast. I think that those three carriers are the key drivers of that growth, therefore Japan and U.S. being the drivers of that growth."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, we have reached the allotted time allowed for questions and answers. Dr. Jacobs, do you have anything further to add before adjourning the conference call?"
},
{
"speaker": "Paul Jacobs",
"text": "Yes, I'd like to thank everybody for joining us. I think, despite all the noise that is out there, the real events of this quarter demonstrate our values of innovation, execution and partnership, and I think that that has resulted in the absolutely outstanding financial performance that we turned in. The data capabilities and 3G are really leading to a better mix for us and all the core businesses. We remain focused on those opportunities that are ahead of us as 3G CDMA continues to be the key mainstream technology for enabling compelling new devices and services. If we just used the growing subscriber base worldwide, we can see that consumers are buying 3G. So we look forward to continuing to help drive that market. Thanks very much, everybody. Bye."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes the QUALCOMM third quarter conference call. Thank you for your participation. You may now disconnect."
}
] | null | null |
QCOM | 2 | 2,006 | 2006-04-20 16:45:00 | Executives: Bill Davidson - VP, IR Paul Jacobs - CEO Steve Altman - President Sanjay Jha - EVP, President-CDMA Technologies Group Bill Keitel - EVP, CFO Lou Lupin - SVP, General Counsel
Analysts: Tim Luke - Lehman Brothers Tal Liani - Merrill Lynch Daryl Armstrong - Smith Barney Citigroup Tim Long - Banc of America Mike Ounjian - Credit Suisse First Boston Louis Gerhardy - Morgan Stanley Matthew Hoffman - Cowen & Co. Mike Walkley - Piper Jaffray Ehud Gelblum - JP Morgan John Bucher - Harris Nesbitt Brian Modoff - Deutsche Bank
Operator: Welcome to the QUALCOMM second quarter conference call. (Operator Instructions) I would now like to turn the call over to Bill Davidson, Vice President of Investor Relations. Bill, please go ahead.
Bill Davidson: Thank you, and good afternoon. Today's call will include prepared remarks by Dr. Paul Jacobs, Steve Altman, Dr. Sanjay Jha, and Bill Keitel. In addition, Lou Lupin will join for the question-and-answer portion of the call. An Internet presentation and audio broadcast accompanies this call and you can access it by visiting www.qualcomm.com. During this conference call if we use any non-GAAP financial measures as defined by the SEC in Regulation G, you can find the required reconciliations to GAAP on our website. I would also direct you to our 10-Q and earnings release, which were filed and furnished respectively with the SEC today and are available on our website. As a reminder, the QUALCOMM Investor Relations website includes a thorough presentation on the many data points included in this conference call. We may make forward-looking statements relating to our expectations and other future events that may differ materially from QUALCOMM's actual results. Please review our SEC filings for a detailed presentation of each of our businesses and associated risks and other important factors that may cause our actual results to differ from these forward-looking statements. Pro forma revenues were $1.83 billion in the second fiscal quarter, up 34% year-over-year and 5% sequentially. Second fiscal quarter pro forma net income was $706 million, up 45% year-over-year and 6% sequentially. Pro forma diluted EPS were $0.41, up 41% year-over-year and 5% sequentially. Second quarter fiscal pro forma free cash flow, defined as net cash from operating activities less capital expenditures, was $947 million, up 28% year-over-year and was 52% of revenue. I'd like to mention that QUALCOMM is hosting an Analyst Meeting in New York City on May 4th with detailed presentations from our executive team. The meeting will be simulcast on our website with audio and slide presentations. Now, it's my pleasure to introduce QUALCOMM's CEO, Dr. Paul Jacobs.
Paul Jacobs: Thank you, Bill. Good afternoon, everyone. I'm pleased to report that QUALCOMM had a third consecutive quarter of record revenues in chip shipments, and phone shipments hit a new quarterly record, all driven by the growing adoption of CDMA-based technologies in multiple regions around the world. We have seen strong 3G CDMA growth continue around the world. At the conclusion of March 2006, there were more than 272 million reported 3G CDMA subscribers. As Bill Keitel will discuss in more detail we are raising our forecast for CDMA2000 and WCDMA handset shipments in 2006. Closing out calendar 2005 we saw record shipments of phones in the December quarter. Reports from our licensees in the March quarter showed that CDMA-based handset shipments to wireless operators during the December quarter totaled approximately 67 million units, at an ASP of approximately $208. Our markets continue to expand. The ratio of WCDMA reported royalties to total reported royalties grew to approximately 46% reported in the March quarter of 2006, from approximately 32% reported in the year-ago quarter. In the December quarter of 2005, approximately 25% of the total wireless handsets shipped into Europe were WCDMA, an increase from 18% in the prior quarter. This helped Europe pass Japan to become the second-largest market for 3G CDMA devices. Prices are declining due to increased competition. We reported last quarter that the worldwide average selling price of WCDMA handsets was $372. Based upon information reported by our licensees, this quarter we're happy to report that the average worldwide selling price declined 8% to $342 and the range of handsets continues to increase. We estimate that the average selling price for the lowest 10% of WCDMA handsets has decreased quarter-over-quarter from $228 to $197, a decrease of 14%. As WCDMA handset prices continue to rapidly decline, we expect to see a consistent trend of an increasing percentage of the total handsets being WCDMA as GSM share of the market declines. While we're having great success at the high-end with both CDMA2000 and WCDMA, we still face significant competition from GSM-based products in the low-end market. The low-end market is a tough battleground, but one that is definitely important. We expect growing demand for low-end phones to continue and have invested resources for single chip solutions, which combines the base band, radio frequency and power management chips into one package. We believe lower component counts and further integration will drive costs down and enable faster time to market to meet the increasing demand for low-end phones. We have excellent data points from both India and China for the low end. CDMA devices constituted 48% of the total device shipments into India and 49% in the sub $50 tier in the fourth calendar quarter of 2005. This growth has been helped by aggressive pricing by QUALCOMM and by handset manufacturers that in turn allows carriers to promote more aggressively. In a recent handset analysis provided by the Yankee Group the GAAP and average selling prices between CDMA and GSM in the sub $50 tier in India had narrowed to $3 in December of 2005. Another area where we've seen significant growth is in the use of CDMA 450 in China, which is driven by China Telecom and China Netcom's Universal Service Program aimed at providing telecom service to China's vast underserved rural areas in a cost-effective and efficient manner. Our two major Chinese licensees, Huawei and ZTE, are the suppliers of infrastructure as well as terminals for CDMA 450. QUALCOMM recently entered into agreements with Huawei and ZTE respectively for CDMA chipset supplies valued at $600 million, and such chipset supplies do include CDMA 450 chipsets. QCT's execution and integration strategy is redefining what a low-end handset can be by cost effectively enabling features like data capability and camera support. While it remains important to have an entry level price point in developing markets it is clear that consumers the world over will use advance networks and features provided that they can be delivered cost effectively. We believe that the strong growth in 3G CDMA is attributable to a number of factors including the availability of a wide variety of attractive handsets at lower prices, continued optimization and coverage of 3G networks, and an increased usage of 3G applications. Carriers are seeing the benefits of 3G technology through increased capacity in their networks and increased revenue from compelling applications such as, music and video downloads, location-based services, gaming and Internet connectivity. It's been reported that mobile music sales in Japan have exceeded $1 billion per year. KDDI has also seen 5.5 million e-Book downloads in 19 months. With more than 40 3D games available through VCast, Verizon Wireless has seen a 36% increase in gaming downloads since introducing premium 3D games as part of the V Cast service enabled by EVDO. In India, Tata has quickly risen to become one of the top 10 operators worldwide for revenue generating BREW downloads. We're very encouraged by the positive discussions we have had with European operators regarding their HSDPA rollout plans, many of which are expected to begin throughout the course of this year. I believe that we are well-positioned to take advantage of this market dynamic by virtue of our leadership position in chipsets for HSDPA. In QCT our execution on the R&D investments that we have made is clearly paying off. We have established first market technology leadership in EVDO, DO Revision A, HSDPA, and HSUPA. QCT's integration strategy combined with technology leadership is driving more features into handsets and enabling extremely compelling designs, like the Thin Phones that are now available in both CDMA2000 and WCDMA. Turning to MediaFLO, we provided citywide coverage of FLO Technology and conducted live over-the-air MediaFLO demonstrations at CTIA Wireless 2006 in Las Vegas. These included live video and audio on attractive phones from leading handset manufacturers. There were eight models from six manufacturers including Samsung, LG Electronics, Pantech, Kyocera, Motorola, and Sharp. These included a Samsung WCDMA phone with FLO integrated which concretely makes the point that FLO goes just as well with WCDMA as it does with CDMA2000. In addition to audio and video, we also showcased data casting with two BREW applications that interface to the FLO system to get continuous updates. One was from Major League Baseball's Advanced Media Game Day application showing stats and game progress for every major league game that was underway. The other was a stock portfolio tracker application which kept a continuously updated portfolio. I know a number of you saw these applications and the response we got from people who saw them confirms that the potential for the wireless multimedia user experience extends far beyond mobile television and video. The FLO Air Interface continues to make strides in the area of global standardization. In March the FLO Forum announced the ratification of several key technical specifications developed by its test and certification committee. The technical and performance requirements captured in the document assure interoperability and compatibility for FLO-based terrestrial mobile multimedia, multicast devices and transmitters. The specifications are companion documents to the previously ratified FLO Air Interface specification. The FLO Forum continues to grow as the floforum.org website now lists 37 companies as members. While we continue to work with individual broadcasters to clear Channel 55, the United States Congress approved a statutory definitive end date for the nation's television broadcasters to transition to digital television spectrum, which will clear significant spectrum in the 700-MHz band. This spectrum will then be used not only to enable new broadcast multimedia services like those offered by QUALCOMM's MediaFLO USA subsidiary, but also to support public safety communications and provide additional broadband wireless access to urban and rural areas. This spectrum provides us with new opportunities to innovate. The future holds many exciting opportunities for QUALCOMM and I'm confident that we are investing in the appropriate areas and at the appropriate levels to capitalize on these opportunities. QCT has established a leadership position in both CDMA2000 and WCDMA chipsets. Our business model in QTL of aggregating R&D for the wireless industry has fostered innovation and competition. Both businesses combine to drive growth in the 3G CDMA market. The addressable market for both businesses is substantial and is increasing as handset prices continue to decline rapidly. As we continue to execute across our different businesses the Company is positioned well for the future. This is reflected in our updated financial guidance as we are increasing our fiscal 2006 revenue and earnings estimates, as well as increasing our estimates for CDMA handset shipments in calendar 2006. I'd now like to turn the call over to Steve Altman.
Steve Altman: Thanks, Paul. Good afternoon, everyone. As we look at 3G deployments around the globe we see signs of strong 3G growth in virtually every market. In Japan during this last quarter, the number of 3G subscribers surpassed the number of 2G subscribers for the first time. 53% of Japan's over 91 million wireless users now subscribe to 3G services. WCDMA handsets shipped to Japan increased approximately 33% quarter-over-quarter. In February 2006, KDDI and NTT DoCoMo launched a combined 12 new handset models. Features on these new handsets include mobile wallet, a 4-gigabyte hard disk drive; mobile TV broadcast receiver; and a location-based service device focused on child safety. In the U.S., Verizon, Sprint, Nextel, and Cingular have deployed 3G CDMA systems, are actively promoting their high-speed networks, and are offering a wide variety of 3G handsets, as well as data cards for laptops. These carriers are actively selling phones with enhanced capabilities, including music and video downloads, games, position location, and other useful multimedia applications. We expect to see strong replacement sales in Korea, not only because of its rollout of broadcast mobile TV, but also because the Korean wireless operators are now permitted to offer subsidies to subscribers who have maintained their service with the same carrier longer than 18 months. We understand that operators can provide subsidies of up to $200, which in the past has resulted in an increasing percentage of higher-end phones being sold in the market. In India, network operators who offer CDMA-based services saw a dramatic growth in their subscriber bases with the number of CDMA subscribers growing by 65% in 2005 and reaching 25 million in December. With average monthly net additions of 1.4 million in the first calendar quarter of 2006, CDMA reached a cumulative base of 29.5 million subscribers in March 2006 with Reliance Infocom at 18.3 million and Tata at 8.5 million. Quarter-over-quarter WCDMA handsets shipped to Europe increased approximately 73% while average selling prices for WCDMA handsets in Europe declined at a rate of approximately 10%. The increased variety of attractive WCDMA handsets at reduced pricing is, as Paul pointed out, increasing the share of WCDMA versus GSM in Europe and is a trend that we expect to continue. In addition to the increased activity that we are seeing around CDMA 450 in China we are continuing to closely monitor the timing of China's 3G license issuance. We are encouraged to see recent public reports from the USTR on their agreement with the Chinese Government at the Joint Commission on Commerce and Trade Meeting in Washington, D.C., where the Chinese Government reconfirmed its commitment to adopt a policy of technology neutrality in connection with its issuance of 3G licenses and to allow Chinese operators freedom in choosing technology standards for their 3G services. As we have previously disclosed, our license agreements generally license certain patents of ours that were applied for during an agreed upon capture period. From time to time, we have needed to extend existing agreements to include patents that fall outside of the licensees capture period. We have entered into many extensions over time with a substantial number of licensees, who have needed access to our expanding patent portfolio and in each case we have done so without negatively impacting our licensing program in any material way. Many of you have approached us speculating whether Nokia will need an extension. Our policy is not to talk specifically about particular license agreements, and so we have neither confirmed nor denied this speculation. However, based on an agreement reached with Nokia, we have today disclosed information in our 10-Q to the following effect: QUALCOMM has a license with Nokia, which in part expires on April 9, 2007. QUALCOMM and Nokia have been in discussions to conclude an extension or a new license agreement beyond that time period and I expect discussions to continue. However, there is no certainty as to when the parties will be able to conclude an agreement or the terms of any such agreement. There is also a possibility that the parties will not be able to conclude a new or extended agreement by April 2007. In that event, after April 9, 2007 unless and until the existing agreement is extended or a new agreement is concluded, Nokia's right to sell subscriber products under most of QUALCOMM's patents, including many that we have declared as essential to CDMA, WCDMA, and other standards, and therefore, Nokia's obligation to pay QUALCOMM's royalties will both cease under the terms of the current agreement. Likewise, unless and until the existing agreement is extended or a new agreement is concluded QUALCOMM's rights to sell integrated circuits under Nokia's patents will cease on April 9, 2007 under the terms of the current agreement. By agreement with Nokia we are limiting our comments to the foregoing at this time. Please bear in mind, however, that any company that makes or sells products without a license under the applicable patents of another company would be exposed to a patent infringement litigation by such other company. I would also like to make clear that if we are unable to reach agreement with Nokia and they become unlicensed to sell subscriber products after April 2007 this will have no material impact under our other license agreements. I'd also like to talk about a release that was recently issued in Korea. Nextreaming Corporation, a Korean company, issued a press release announcing that it has filed a formal complaint against QUALCOMM with the Korean Fair Trade Commission. This is the same Korean company that QUALCOMM mentioned without identifying specifically in our April 5th press release regarding the Korean Fair Trade Commission's visit to the offices of QUALCOMM Korea and several other manufacturers. Nextreaming had been using the threat of a complaint to the KFTC in an attempt to extract inappropriate commercial concessions from QUALCOMM. We have refused to yield to Nextreaming's demands with the result that Nextreaming is apparently now filed its threatened complaint. Although we have not yet seen the complaint we believe that QUALCOMM's activities in Korea have been lawful and pro competitive and that Nextreaming's complaint has been filed for an improper purpose. I'd now like to turn the call over to Sanjay Jha.
Sanjay Jha: Good afternoon. I'd like to go over some key highlights for QCT's business. We shipped approximately 49 million MSMs in the second fiscal quarter. This was the third consecutive record quarter for MSM shipments and an all-time high booking quarter. In comparison, 47 million MSMs were shipped during the first quarter of fiscal 2006 and 37 million chips in the same quarter of fiscal 2005. The 32% increase year-over-year is driven by low-end shipment doubling due to strong CDMA demand in emerging markets. In addition, we saw a four-fold increase in our EVDO shipments, primarily driven by strong demand in the U.S. year-over-year. Our UMTS shipments increased fivefold compared to same quarter last year as well. This growth is also supported by continued diversification of our customer base worldwide. Our revenues again exceeded $1 billion for the quarter, in spite of this typically being a seasonally lower quarter. This compares to $746 million the second quarter of fiscal 2005, an increase of 36% year-over-year. Our operating profits increased nearly 60% versus this same quarter last year. While our average selling price was sequentially lower for the quarter driven by strong unit growth in CDMA2000 low-end products, this was partially offset by an increase in our mix of higher-end multimedia and enhanced multimedia chips as mentioned previously. This past quarter we made significant strides in broadening our product portfolio. QCT sampled the first generation of QUALCOMM Single-Chip, or QSC product, that enable more efficient, cost efficient and attractive CDMA handsets for emerging markets. We have enjoyed a very high level of interest in the QSC products with more than five leading manufacturers already receiving shipments. The first commercial handsets based on this solution are expected to launch by the end of 2006 calendar year. Demand for our existing EVDO portfolio continues to grow. There are now over 250 devices based on our chipsets either commercially launched or in design. This past quarter, QCT sampled MSM6800, our first EVDO Revision A solution and our first 65nm commercial chipset. A full two months ahead of schedule. We expect the first devices based on EVDO Revision A to be available before the end of 2006. Furthermore, we shared with the industry our expectation that commercial data card products based on EVDO Revision B will be available by the end of 2007. Revision B delivers up to 14.7 Mb on the downlink and 5 MHz bandwidth to enable ubiquitous broadband data experience. In UMTS, QCT is working with more than 30 manufacturing partners who collectively have launched or are designing over 120 devices based on our chipsets. QCT was first to market with an HSDPA solution and we continue to be a technology leader in the UMTS market with the first solution for HSUPA. At the end of March we sampled our MSM7200 chipset, which supports HSUPA and MBMS technologies for broadcasting over UMTS networks. Our global focus extends to cooperation with partners around the world and QCT has continued to build key relationships. Together with TechFaith of China, we established a new company, TechSoft, which will develop application software for our 3G CDMA devices. The long-term goal of TechSoft is to develop solutions that will enable handset manufacturers to dramatically reduce the time to market of a new fully featured 3G handsets. This is a continuation of the Company's commitment to supporting entrepreneurship and local innovation, as well as to the Chinese industry as an area of tremendous opportunity and growth. I will now turn this call over to Bill Keitel for an overview of our financial results.
Bill Keitel: Thank you, Sanjay. Good afternoon, everyone. We are pleased to report record revenues and earnings per share again this quarter driven by growth in CDMA-based products and services around the globe and continued strong execution by our business units. I'll highlight a number of key items in our second quarter fiscal 2006 results, which reflect the Flarion and Berkana acquisitions completed this quarter. First, GAAP earnings for the March quarter were $0.34 per share. Our pro forma earnings were $0.41 per share, excluding $0.05 in estimated stock option expense, $0.01 loss attributable to acquired in-process R&D, and $0.01 loss attributable to the QSI segment. Revenues increased 34% year-over-year to $1.8 billion. Our pro forma earnings per share increased 41% year-over-year. Second, our business continues to generate strong cash flow. Operating cash flow was $889 million for the second fiscal quarter, up 8% year-over-year. Pro forma free cash flow was $947 million, up 28% year-over-year. Cash flows are the primary driver of long-term shareholder value and are unchanged by the accounting for a theoretical stock option expense. During the quarter we paid $298 million in cash dividends and announced a 33% dividend increase from $0.09 to $0.12 per share effective for quarterly dividends payable after March 24, 2006. Third, our fiscal second quarter tax rates for total QUALCOMM and pro forma were 25% and 27% respectively. Our pro forma estimated tax rate for fiscal 2006 is now 27% as compared to our prior estimate of 26%. Fourth, QCT again had record MSM shipments during the quarter. QCT's second quarter revenues increased 36% year-over-year to $1.02 billion on the strength of 49 million MSM shipped, a 32% increase year-over-year. QCT's operating margin was 25%, an anticipated quarter-over-quarter decrease reflecting continued growth of R&D investments and new chip development and modest sequential chip ASP decrease. Fifth, QTL earned record revenues of $679 million this quarter as licensees reported a record high of approximately 67 million new handset units shipped with an ASP of approximately $208 per handset. These shipments occurred in the December quarter and were reported to us by our licensees in the March quarter. Licensee reports are the basis of our royalty revenue recognition. We are pleased to report that CDMA is experiencing strong growth around the world. Sequential growth was particularly strong for WCMA shipments in Europe and Japan, and CDMA2000 shipments in China, Latin America, India, and North America during the December quarter. The average ASP for all WCDMA handsets decreased approximately 8% from the prior quarter. Of the $679 million in total QTL revenues $40 million represented enter segment royalties, $12 million were amortized license fees, and $627 million were royalties from third-party licensees. WCDMA royalties were approximately 46% of third-party royalties reported this quarter and QTL's operating margin was 92%. For the calendar 2005 CDMA market, with the receipt of all licensee reports, we now estimate that CDMA handset shipments were approximately 210 million units, including approximately 160 million CDMA2000 units, and approximately 50 million WCDMA units. Lastly, we believe total CDMA channel inventories remain in the historically normal band of 15 to 20 weeks. Now turning to our guidance. We are increasing our estimate for the calendar year 2006 CDMA-based handset market. We now estimate shipments of approximately 275 to 290 million units in calendar 2006, an increase 31% to 38% over our estimate for calendar 2005. Based on the 283 million midpoint of this estimate for calendar 2006 we anticipate shipments of approximately 187 million CMA2000 units, and approximately 96 million WCDMA units. The regional breakdown of our market estimate is available on our website. We are also increasing our guidance for fiscal 2006 revenue and earnings per share. We now expect fiscal 2006 revenues to be in the range of approximately 7.1 to $7.4 billion. An increase of 25 to 30% over fiscal 2005. We anticipate pro forma diluted earnings per share to be in the range of $1.53 to $1.57, an increase of 32% to 35% year-over-year. We now estimate the average selling price for CDMA2000 and WCDMA phones combined will decrease approximately 4% in fiscal 2006 to approximately $207. We are particularly pleased with the ASP trends we are seeing for WCDMA handsets, which continue to decrease at a rapid pace consistent with our expectations and encouraging for future market growth. We expect the combination of pro forma R&D and SG&A expense for fiscal 2006 to increase approximately 26% to 29% year-over-year, driven by growth in R&D as we continue to invest in the evolution of CDMA2000 and WCDMA multimedia functionality, single chip low-cost solutions, and longer term technology enhancements including OFDMA. We estimate GAAP earnings per share will be approximately $1.31 to $1.35 for fiscal 2006. This estimate includes a loss of approximately $0.20 per share for estimated share-based compensation, a loss of approximately $0.04 per share attributable to QSI, a gain of $0.03 attributable to tax benefits related to prior years, and a $0.01 loss attributable to in-process R&D from completed acquisitions. Turning to our guidance for the fiscal third quarter of 2006, we estimate revenues to be in the range of approximately $1.77 to $1.87 billion, a 30 to 38% increase year-over-year. We estimate third quarter pro forma diluted earnings per share to be approximately $0.36 to $0.38, a 29 to 36% increase year-over-year. This estimate includes the shipments of approximately 50 to 53 million MSM phone chips during the June quarter reflecting growth across multiple product segments including CDMA2000 low-end, EV-DO, WCDMA, and HSDPA. We expect chip ASPs to decrease modestly as we continue to sell a greater proportion of low tier MSMs for emerging markets, in addition to planned price erosion across our broad product offerings. We estimate approximately 62 to 64 million CDMA-based handsets shipped in the March quarter at an average selling price of approximately $203. Our unit forecast reflects seasonally lower post-holiday shipments across most regions when compared to the strong December quarter, though still a very healthy 44% to 49% higher than the 43 million handsets reported by licensees for the March quarter last year. We anticipate the third fiscal quarter pro forma R&D and SG&A expenses combined to increase sequentially approximately 6 to 8% driven by our continued investment in new products and services. In closing, we are very pleased with how our Company is executing across all business groups. The growing adoption of CDMA-based 3G technology across many consumer segments and regions around the world continues to drive strong financial results for our stockholders. That concludes my comments. I will now turn the call back to Bill Davidson.
Bill Davidson: Thank you, Bill. Before we go into our question-and-answer session I'd like to remind our participants that our goal is to address as many questions as possible before we run out of time on the call. Therefore, I would like to ask our participants to limit their questions to one per caller. Operator, please go ahead.
Operator: (Operator Instructions) Your first question is from Tim Luke with Lehman Brothers. Please go ahead and ask your question, sir.
Tim Luke - Lehman Brothers: Thank you very much. Congratulations on the quarter. A clarification and a question. The clarification just relates to Steve's comments around your current and ongoing negotiations with Nokia. You seemed to comment on the situations that happen if you don't conclude an agreement by April the 9th. If you could provide any further clarity around what you said with respect to your chip business and your chip shipments if you haven't formalized anything? What are the implications with respect to their payments to you if they were to ship WCDMA phones without an extension of the royalty agreement? The question was simply, as you raised your guidance with respect to the phone market both for WCDMA and for CDMA for the full year, where is that upside as you move from 86 to 96 coming from in WCDMA regionally and similarly in the CDMA area? Thank you so much.
Steve Altman: So Tim, it's Steve. As for Nokia, if we do not conclude an agreement by April 9, 2007, then the rights under most of our patents for them to sell subscriber products they would not be licensed, and so they would be infringing on our patents. Likewise, at that point in time, we would have no rights to sell our chips under their patents. So we would be in a situation where we believe they would be infringing our patents and we would not have rights under their patents.
Tim Luke - Lehman Brothers: Okay. Thanks for clarifying that.
Bill Keitel: On the WCMA market, we raised our estimates in Europe from 40 million to 51 million, that's an increase of 11 million obviously. And we decreased just by a million a modest amount for what we call rest of world. So that's everything but Europe and Asia for WCDMA. So Europe is the increase.
Tim Luke - Lehman Brothers: The CDMA2000 side, you also increased that?
Bill Keitel: In CDMA2000 we raised our estimate for North America from 80 to 85. We increased China from 12 to 15. We increased India from 16 to 21. In the Americas, primarily Latin America, we decreased by one. The combination of Korea, Japan, Southeast Asia, rest of world, we decreased by one. There is a table on our website that gives those numbers as well.
Operator: Your next question comes from Tal Liani with Merrill Lynch.
Tal Liani - Merrill Lynch: Hi, guys. I have a question which has two parts but they are related. What happens if you do not get to an agreement with Nokia and you still sell the chips? Just hypothetically speaking, can Nokia go to Samsung let's say that buys your chip and say, "Okay, now you owe us royalty rate or royalty fee? What happens in this situation? Second, which is related to that, about five years ago you failed an S-1 to break off the chip business from the licensing business. I think you called it Spinco. Will a breakup of QUALCOMM into chips and licenses resolve this issue and will you consider this? Thank you.
Lou Lupin: I'll try to answer the first part of your question. Whether Nokia could approach Samsung or any other handset manufacturer would depend upon the existence or nonexistence of agreements between those companies. Each of the handset suppliers has the ability to enter into license arrangements and other arrangements with Nokia or with other third parties as it sees fit. So that really would be a matter for Nokia and Samsung.
Tal Liani - Merrill Lynch: Right, but right now there is a pass-through of the patents, right, which ends with the contract?
Lou Lupin: We have not commented specifically on pass-through rights with respect to particular companies and so I can't comment on the situation as it relates to Nokia or any other specific company with respect to pass-through rights.
Paul Jacobs: In terms of potentially restructuring the Company, we're willing to consider any option in order to maintain and enhance shareholder value. I would say that the particular structure that we considered in the past is probably not what we would do if we were going to do a restructuring. But some kind of restructuring to protect those two businesses is possible. We expect that we'll actually come to agreement before such thing would happen.
Operator: Your next question comes from Daryl Armstrong with Smith Barney Citigroup.
Daryl Armstrong - Smith Barney Citigroup: Thank you very much. Going back again relative to the Nokia patent issue, the question I have is that for a chipset you guys sell to your customers before the expiration of the royalty or the licensing agreement -- what happens to those chips if they're still in inventory at your customers? Can they still use them within their handsets or are they precluded from using them after April 9th? Thanks.
Steve Altman: Yes, this is Steve. The answer to your question really pertains to whether or not there's pass-through rights and as Lou mentioned we can't go into that. But what I can say is that with respect to our sales, their ability to assert their patents against us with respect to our sales prior to April 9th, that's covered under the agreement. So it would only be with respect to our sales after April 9th that they could assert their patents.
Operator: Your next question comes from Tim Long with Banc of America.
Tim Long - Banc of America: Thank you. Maybe if we could just switch over to the chipset business for a second. Sanjay, I don't know if you gave a number on ASP decline in the quarter, but if you could just clarify that. How do you think things are progressing on the WCDMA side? You said up fourfold year-over-year. What's your sense of your market share there and potential movements? Some of the customers have had pretty good quarters, some have had pretty poor quarters in WCDMA; so if you could just update us on your market share thinking there?
Sanjay Jha: Tim, the ASP decline is approximately 5%, and really driven by incredible growth in our low-end business. As Paul mentioned in his commentary, we have taken a strategic decision to make sure that our carriers in emerging marketplaces are competitive in offering services and phones with their GSM counterparts. So we made a very good stride, I think, and as you would see, the difference between GSM and CDMA handsets are coming down dramatically. So that's really what drove it. The increase on the other hand that was offset by increase in DO shipments and, therefore, a slightly richer mix of higher-end handsets, but the growth in CDMA2000 low-end really has been pretty dramatic and that drove ASP. Thinking about wide band CDMA business, we feel pretty well-positioned, as I noted in my comments, 30 customers. A clear leadership in HSDPA. We believe that most of the handsets launching this year with Samsung, LG, Novatel, Sierra, Option, and other of our customers based on HSDPA will give us leadership. We also believe that we have leadership in the low-end. We have been working as you know with Huawei, and Huawei has been accepted by Vodafone for delivering handsets to them. Similarly, Amoi and ZTE have been successful, not just in producing CDMA handsets, but also exporting wideband CDMA handsets based on our solution. That has been a strong factor. Samsung I think has one of the best phone lineups in wideband CDMA today, so that gives us a great deal of confidence that they will continue to drive growth in wideband CDMA for our chipset shipment. LG has been very successful with U880 and then recently launched U890. At DoCoMo we just had launches from LG, from Sanyo the second phone was launched, and I expect that there will be two more phones launched on DoCoMo's network. So as I look going forward this year, I feel pretty comfortable with our position in wideband CDMA and as Bill has said we updated our guidance on wideband CDMA shipment from 86 million, I believe, to 96 million units. And as we do that that clearly increases the total volume that we think we can address.
Operator: Your next question comes from Mike Ounjian with Credit Suisse First Boston.
Mike Ounjian - Credit Suisse First Boston: Great, thank you. I just wanted to talk about a little bit about the increased guidance for CDMA handset shipments in China this year and just what's giving you the confidence there? Is CDMA 450 the primary driver of that increase of 3 million units or is there something beyond that that you are seeing with China Unicom? On the U.S. and the increase, just wanted to get a sense of what you are seeing in terms of the EVDO mix within the North America shipments?
Bill Keitel: In terms of China we do see China Unicom continuing at a good steady pace, but as Paul noted the CDMA 450 market appears to be pretty active, and the bigger part of that increase for China we think is CDMA 450. In terms of North America, the 5 million units for the calendar year, we think that the mix within that 85 million is shifting well to EVDO.
Operator: Your next question comes from Louis Gerhardy with Morgan Stanley.
Louis Gerhardy - Morgan Stanley: Yes, good afternoon. Just following up on the Nokia issue. First for Sanjay, how do you expect your customers to react if there's some uncertainty out there about the availability of chipsets? I'm just trying to get at why won't they build up some safety inventory? And then to Steve, just on the pass-through rights, why won't they change if your Nokia agreement expires? I just need a little help there. Thanks.
Sanjay Jha: Louis, in terms of how our customers would react, there have been, as Steve has noted, a number of times in the course of this industry where there has been uncertainty on those matters and I think we will work with our customers to try to find solutions for them as effectively as we can. It's important to note that the uncertainty will be there for not just our chipset shipment, but also Nokia's handset shipments. So I think that certainly both parties will be strongly motivated to resolve this issue in the interest of each of our shareholders, but also in the interest of the industry. So I see this as a disclosure that is right and appropriate for us to make, but I don't think that this is something that our customers are particularly concerned about at this stage.
Steve Altman: No, I would add to that that, again, we have done many extensions over the course of our licensing program. This is not a unique situation in terms of what we've had to do in the past and so I also expect that we'll eventually work things out. But having said that, in answer to your question on the pass-through rights again whether they'll change or not, that would require me to answer whether or not there are pass-through and as we said, we can't get into that detail.
Operator: Your next question comes from Matthew Hoffman with Cowen & Co.
Matthew Hoffman - Cowen & Co.: First, Sanjay, let's drill down on the earlier question on WCDMA chip share. You've seen a substantial increase in WCDMA handsets in Western Europe over the calendar fourth quarter. You've got a pretty substantial share of the chip market worldwide. What is your WCDMA chip share within Western Europe, and hoping you could give us some color on the progress you're making there? Thanks.
Sanjay Jha: Matthew, we've not broken out our chip share worldwide or for any particular region, so allow me to refrain on that. But I can give you color as to what progress we're making with each of the carriers. We have handsets at the moment in Europe I think Vodafone and H3G are two of the big drivers of growth in wideband CDMA shipments. We feel particularly well-positioned with both of these carriers in terms of handsets that they're shipping and the volume that they're shipping with Samsung being very well-positioned at Vodafone; Toshiba being positioned at Vodafone; Huawei being positioned at Vodafone; Novatel, Option, and Sierra being positioned at Vodafone. If I look at H3G then LG is a big driver of the growth in LG shipments. We feel that the best handset that H3G offered last year was U880 through the Christmas season. I think the update of that phone, U890 will drive some growth for us. We also see a number of other handset providers working pretty closely with H3G based on our solutions to offer chipsets there. We have worked with T-Mobile, with Telecom Italian Mobile, we believe that we are very well-positioned also. Samsung has a very good portfolio there. HTC actually is delivering some very compelling data devices now to Europe based on our solution right now in UMTS and very quickly based on HSDPA. So I think in terms of our positioning, in terms of launching handsets, we are very well-positioned. Now volume, the drivers will be a different matter. Now we have seen a thrust from Nokia at the low-end, and as you know they commented that they will have a very large market share. We see that driving growth in the UMTS marketplace and enabling our handset manufacturers to come in below where Nokia is in the pricing today. We're very motivated and very focused in enabling that through our chipset pricing, through enabling for these handset phones to launch, through enabling application software integration support, through testing support, through an inter-op testing support, so we think we're very well-positioned. As we say again we see growth towards the last two quarters of this year coming in wideband CDMA, and for that I think the number of handset launches we feel give us some confidence.
Operator: Your next question comes from Mike Walkley with Piper Jaffray.
Mike Walkley - Piper Jaffray: Great, thanks. Just another question on the chipset side. On the ASPs, I think you said they would be down a little bit sequentially, but how should we maybe think about the trajectory in the back half, should we start shipping better mix of HSDPA and with the recent pick up in the Korea market on the high-end phones falling subsidies? How should we maybe think about the trajectory of ASPs maybe into the back half of the calendar year?
Sanjay Jha: We have not provided any guidance but I expect that that would be flat. And depending on how that ticks up there's a possibility of some uptick. But I expect to the back half our ASP is likely to be flat.
Operator: Your next question comes from Ehud Gelblum with JP Morgan.
Ehud Gelblum - JP Morgan: Hi, can you hear me? Hello?
Sanjay Jha: Yes, we can hear you.
Ehud Gelblum - JP Morgan: Okay, great. Thank you. Two very quick questions. One is, I want to talk to you about your estimate on the ASP for handsets next quarter of $203, Bill. Last year in the June quarter you had a huge $231 ASP that was driven by a very strong Japan handset shipment quarter in March. Looking at the Japanese subscriber numbers in the past three months, basically January, February, March, you had a similar phenomena with Japan about the KDDI site, and the DoCoMo side being very, very strong. I'm a little surprised to see the guidance there for ASP down to $203. I would have thought it to be at least flat if not up. I understand that there's lower end things in there. Can you give a little color around that? Paul, if you can give us a little update on -- we know that Verizon on MediaFLO and some of the other types of technology that you're getting kind of more into; we know obviously Verizon's doing MediaFLO. What's the progress with perhaps Cingular or Sprint doing MediaFLO? Any update you can tell us about what Sprint might do with the their 2.5 GHz licenses and any part that you may plan that would be helpful too?
Bill Keitel: So Ehud on the 203 ASP forecast, and on your point specifically to Japan, we are expecting greater sequential shipments of phones in Japan, shipments in March, which of course would be June revenue relative to shipments in the December quarter. But likewise we're also expecting growth in the India market, in the China market, and in the Korea market. In Europe and Latin America and North America, we're expecting those three markets to be down slightly consistent with the seasonal effect that we've often seen in the past. So, now, if this forecast proves to be wrong and Japan does much better than we expect that would be positive on the ASP, but that's not my best expectation at this time.
Paul Jacobs: Sorry. In terms of discussions on MediaFLO, we continue to be in discussions with all of the major operators. I don't have any particular announcements to make at this point although I would highlight when you highlight Cingular that Samsung did show a WCDMA FLO phone at the CTIA, so I think that was positive at least in terms of our ability to address Cingular as a potential customer. In terms of Sprint in the 2.5GHz band we continue to be in discussions with them as well. We have a number of technologies that could be very good for that band including Rev B, Rev B with flex duplex which allows asymmetrical, downlink, and broadcast capabilities within the band. Also as you know Nextel had been looking at the Flash technology. We continue to discuss evolutions of that as well and the 802.20 and Rev C technology is out at 3GPP. So we've actually gone to them with a pretty broad technology road map, depending on the kinds of applications that they're interested in for that band. We think that we can provide them with very compelling solution along with a great ecosystem and along with the fact that when QUALCOMM says that they are going to bring out a technology we bring it out on time and we bring it out with very high performance. I think that's compelling to them as well.
Operator: And your next question comes from John Bucher with Harris Nesbitt.
John Bucher - Harris Nesbitt: Thank you. Question for Paul. Actually it's a nice segue. With looking beyond the current fiscal year, there's a lot of other spectrum besides Sprint and MDS band that's likely to get deployed, the air-to-ground auction, AWS, some of the ATC spectrum. I'm just wondering, Paul, whether you see a significant incremental opportunity for growth looking out beyond the fiscal year there or do you think that that's largely just going to be in-line with what normal cellular wireless equipment deployment would be? Thank you.
Paul Jacobs: I think it depends on who ends up with the spectrum. I'm sure there will be additional deployments. The question is, do those then turn into incremental device sells and subscribers because of increased competition? Air-to-ground I think is very interesting. We have nice technology for air-to-ground and we've been working with people on that segment for awhile. The AWS is also going to be interesting. I think getting that cleared, getting an option, action, getting it cleared and so forth certainly provides incremental opportunity, particularly when you think about the operators who really are looking for additional spectrum assets. ATC is also good for us in terms of the ability to innovate and integrate additional radio capabilities because there's the satellite segment that has to be satisfied there as well. One of the things that we've been looking at is how to build the right radio link so that you can integrate the satellite capability into a standard phone so that you get the ATC capability or the authority for ATC through the Safe Harbor that SEC set-up. So, yes, I believe there's a lot of opportunity both for innovation and for incremental device sales.
Operator: Your next question comes from Brian Modoff with Deutsche Bank.
Brian Modoff - Deutsche Bank: Hi, real quick, a couple of things, Sanjay, on HSDPA, what do you think your technology lead is right now in terms of your competitor's ability to start delivering HSDPA products? And what do you think your market share is in chipsets design or in terms of WCDMA phone design activity? In other words, what percent of the new designs do you think you have in the market? Finally, any estimate on how many MediaFLO chips, or phones you might ship this year with MediaFLO inside?
Sanjay Jha: Brian on HSDPA it's difficult for me to be precise on what an advantage we have, but I can tell you where we are and you can determine for yourself where the others are. We delivered the first sample of HSDPA in December of 2004 and we did interrupt testing with every single network and you saw Samsung produce a very, very slim forum factor commercial device, which they will start shipping in a couple of months. The HSDPA data cards have been available from three vendors based on our solution. So I think that we have seen with UMTS, with CDMA2000, and now with HSDPA making lab calls to producing and delivering commercial forum factor devices for high data speed terminals actually takes a significant amount of expertise and essentially time. I think that we have seen that figure to be around six months for sure, so I'm comfortable with that number. I believe that Nokia is not too far behind us and a few other people lining up behind that. But I do think that we have an advantage, certainly in chip vendors we have a pretty good advantage, and all of our customers realize that and are taking advantage of that. In terms of handset designs, again, it's difficult for me to say exactly what the overall design activity is that we don't have visibility to. But as we said we believe that around 120 phone designs based on our chipset have either already been launched or will be launched in short order. So that gives you the scale of activities that we are supporting with our application support. Our hope is that that leads to increased volume shipments for us.
Paul Jacobs: This is Paul. In terms of MediaFLO, we aren't even projecting a launch of the network this fiscal year. So the number of handset shipments would be relatively low. Also Verizon will make the final decision about the actual service launch date and they have not yet committed to a launch date. They have a lot of things that they have to do to get ready, including marketing and channel filling and all of those kinds of things. So it's a little bit indeterminate on the front end, but I think that once it comes out -- the demonstrations that we did showed that the application is extremely compelling to people and I think that it will be very successful.
Operator: And at this time I would like to turn the call back over to Dr. Jacobs. Sir, do you have anything further to add before adjourning the call?
Paul Jacobs: I'm very proud of the execution of the Company. I think with the record phone chip and revenue marks it's showing that the growth of 3G is really happening, and I think that as we look forward there's an awful lot of opportunities for us to innovate, to execute, and to partner with many companies in the wireless value chain. So I'm excited by the future. I think we've done well and it seems like it's only going to continue to get better. Thank you.
Operator: Ladies and gentlemen, we do appreciate your joining us today. This does conclude our QUALCOMM second quarter conference call. You may now disconnect. | [
{
"speaker": "Executives",
"text": "Bill Davidson - VP, IR Paul Jacobs - CEO Steve Altman - President Sanjay Jha - EVP, President-CDMA Technologies Group Bill Keitel - EVP, CFO Lou Lupin - SVP, General Counsel"
},
{
"speaker": "Analysts",
"text": "Tim Luke - Lehman Brothers Tal Liani - Merrill Lynch Daryl Armstrong - Smith Barney Citigroup Tim Long - Banc of America Mike Ounjian - Credit Suisse First Boston Louis Gerhardy - Morgan Stanley Matthew Hoffman - Cowen & Co. Mike Walkley - Piper Jaffray Ehud Gelblum - JP Morgan John Bucher - Harris Nesbitt Brian Modoff - Deutsche Bank"
},
{
"speaker": "Operator",
"text": "Welcome to the QUALCOMM second quarter conference call. (Operator Instructions) I would now like to turn the call over to Bill Davidson, Vice President of Investor Relations. Bill, please go ahead."
},
{
"speaker": "Bill Davidson",
"text": "Thank you, and good afternoon. Today's call will include prepared remarks by Dr. Paul Jacobs, Steve Altman, Dr. Sanjay Jha, and Bill Keitel. In addition, Lou Lupin will join for the question-and-answer portion of the call. An Internet presentation and audio broadcast accompanies this call and you can access it by visiting www.qualcomm.com. During this conference call if we use any non-GAAP financial measures as defined by the SEC in Regulation G, you can find the required reconciliations to GAAP on our website. I would also direct you to our 10-Q and earnings release, which were filed and furnished respectively with the SEC today and are available on our website. As a reminder, the QUALCOMM Investor Relations website includes a thorough presentation on the many data points included in this conference call. We may make forward-looking statements relating to our expectations and other future events that may differ materially from QUALCOMM's actual results. Please review our SEC filings for a detailed presentation of each of our businesses and associated risks and other important factors that may cause our actual results to differ from these forward-looking statements. Pro forma revenues were $1.83 billion in the second fiscal quarter, up 34% year-over-year and 5% sequentially. Second fiscal quarter pro forma net income was $706 million, up 45% year-over-year and 6% sequentially. Pro forma diluted EPS were $0.41, up 41% year-over-year and 5% sequentially. Second quarter fiscal pro forma free cash flow, defined as net cash from operating activities less capital expenditures, was $947 million, up 28% year-over-year and was 52% of revenue. I'd like to mention that QUALCOMM is hosting an Analyst Meeting in New York City on May 4th with detailed presentations from our executive team. The meeting will be simulcast on our website with audio and slide presentations. Now, it's my pleasure to introduce QUALCOMM's CEO, Dr. Paul Jacobs."
},
{
"speaker": "Paul Jacobs",
"text": "Thank you, Bill. Good afternoon, everyone. I'm pleased to report that QUALCOMM had a third consecutive quarter of record revenues in chip shipments, and phone shipments hit a new quarterly record, all driven by the growing adoption of CDMA-based technologies in multiple regions around the world. We have seen strong 3G CDMA growth continue around the world. At the conclusion of March 2006, there were more than 272 million reported 3G CDMA subscribers. As Bill Keitel will discuss in more detail we are raising our forecast for CDMA2000 and WCDMA handset shipments in 2006. Closing out calendar 2005 we saw record shipments of phones in the December quarter. Reports from our licensees in the March quarter showed that CDMA-based handset shipments to wireless operators during the December quarter totaled approximately 67 million units, at an ASP of approximately $208. Our markets continue to expand. The ratio of WCDMA reported royalties to total reported royalties grew to approximately 46% reported in the March quarter of 2006, from approximately 32% reported in the year-ago quarter. In the December quarter of 2005, approximately 25% of the total wireless handsets shipped into Europe were WCDMA, an increase from 18% in the prior quarter. This helped Europe pass Japan to become the second-largest market for 3G CDMA devices. Prices are declining due to increased competition. We reported last quarter that the worldwide average selling price of WCDMA handsets was $372. Based upon information reported by our licensees, this quarter we're happy to report that the average worldwide selling price declined 8% to $342 and the range of handsets continues to increase. We estimate that the average selling price for the lowest 10% of WCDMA handsets has decreased quarter-over-quarter from $228 to $197, a decrease of 14%. As WCDMA handset prices continue to rapidly decline, we expect to see a consistent trend of an increasing percentage of the total handsets being WCDMA as GSM share of the market declines. While we're having great success at the high-end with both CDMA2000 and WCDMA, we still face significant competition from GSM-based products in the low-end market. The low-end market is a tough battleground, but one that is definitely important. We expect growing demand for low-end phones to continue and have invested resources for single chip solutions, which combines the base band, radio frequency and power management chips into one package. We believe lower component counts and further integration will drive costs down and enable faster time to market to meet the increasing demand for low-end phones. We have excellent data points from both India and China for the low end. CDMA devices constituted 48% of the total device shipments into India and 49% in the sub $50 tier in the fourth calendar quarter of 2005. This growth has been helped by aggressive pricing by QUALCOMM and by handset manufacturers that in turn allows carriers to promote more aggressively. In a recent handset analysis provided by the Yankee Group the GAAP and average selling prices between CDMA and GSM in the sub $50 tier in India had narrowed to $3 in December of 2005. Another area where we've seen significant growth is in the use of CDMA 450 in China, which is driven by China Telecom and China Netcom's Universal Service Program aimed at providing telecom service to China's vast underserved rural areas in a cost-effective and efficient manner. Our two major Chinese licensees, Huawei and ZTE, are the suppliers of infrastructure as well as terminals for CDMA 450. QUALCOMM recently entered into agreements with Huawei and ZTE respectively for CDMA chipset supplies valued at $600 million, and such chipset supplies do include CDMA 450 chipsets. QCT's execution and integration strategy is redefining what a low-end handset can be by cost effectively enabling features like data capability and camera support. While it remains important to have an entry level price point in developing markets it is clear that consumers the world over will use advance networks and features provided that they can be delivered cost effectively. We believe that the strong growth in 3G CDMA is attributable to a number of factors including the availability of a wide variety of attractive handsets at lower prices, continued optimization and coverage of 3G networks, and an increased usage of 3G applications. Carriers are seeing the benefits of 3G technology through increased capacity in their networks and increased revenue from compelling applications such as, music and video downloads, location-based services, gaming and Internet connectivity. It's been reported that mobile music sales in Japan have exceeded $1 billion per year. KDDI has also seen 5.5 million e-Book downloads in 19 months. With more than 40 3D games available through VCast, Verizon Wireless has seen a 36% increase in gaming downloads since introducing premium 3D games as part of the V Cast service enabled by EVDO. In India, Tata has quickly risen to become one of the top 10 operators worldwide for revenue generating BREW downloads. We're very encouraged by the positive discussions we have had with European operators regarding their HSDPA rollout plans, many of which are expected to begin throughout the course of this year. I believe that we are well-positioned to take advantage of this market dynamic by virtue of our leadership position in chipsets for HSDPA. In QCT our execution on the R&D investments that we have made is clearly paying off. We have established first market technology leadership in EVDO, DO Revision A, HSDPA, and HSUPA. QCT's integration strategy combined with technology leadership is driving more features into handsets and enabling extremely compelling designs, like the Thin Phones that are now available in both CDMA2000 and WCDMA. Turning to MediaFLO, we provided citywide coverage of FLO Technology and conducted live over-the-air MediaFLO demonstrations at CTIA Wireless 2006 in Las Vegas. These included live video and audio on attractive phones from leading handset manufacturers. There were eight models from six manufacturers including Samsung, LG Electronics, Pantech, Kyocera, Motorola, and Sharp. These included a Samsung WCDMA phone with FLO integrated which concretely makes the point that FLO goes just as well with WCDMA as it does with CDMA2000. In addition to audio and video, we also showcased data casting with two BREW applications that interface to the FLO system to get continuous updates. One was from Major League Baseball's Advanced Media Game Day application showing stats and game progress for every major league game that was underway. The other was a stock portfolio tracker application which kept a continuously updated portfolio. I know a number of you saw these applications and the response we got from people who saw them confirms that the potential for the wireless multimedia user experience extends far beyond mobile television and video. The FLO Air Interface continues to make strides in the area of global standardization. In March the FLO Forum announced the ratification of several key technical specifications developed by its test and certification committee. The technical and performance requirements captured in the document assure interoperability and compatibility for FLO-based terrestrial mobile multimedia, multicast devices and transmitters. The specifications are companion documents to the previously ratified FLO Air Interface specification. The FLO Forum continues to grow as the floforum.org website now lists 37 companies as members. While we continue to work with individual broadcasters to clear Channel 55, the United States Congress approved a statutory definitive end date for the nation's television broadcasters to transition to digital television spectrum, which will clear significant spectrum in the 700-MHz band. This spectrum will then be used not only to enable new broadcast multimedia services like those offered by QUALCOMM's MediaFLO USA subsidiary, but also to support public safety communications and provide additional broadband wireless access to urban and rural areas. This spectrum provides us with new opportunities to innovate. The future holds many exciting opportunities for QUALCOMM and I'm confident that we are investing in the appropriate areas and at the appropriate levels to capitalize on these opportunities. QCT has established a leadership position in both CDMA2000 and WCDMA chipsets. Our business model in QTL of aggregating R&D for the wireless industry has fostered innovation and competition. Both businesses combine to drive growth in the 3G CDMA market. The addressable market for both businesses is substantial and is increasing as handset prices continue to decline rapidly. As we continue to execute across our different businesses the Company is positioned well for the future. This is reflected in our updated financial guidance as we are increasing our fiscal 2006 revenue and earnings estimates, as well as increasing our estimates for CDMA handset shipments in calendar 2006. I'd now like to turn the call over to Steve Altman."
},
{
"speaker": "Steve Altman",
"text": "Thanks, Paul. Good afternoon, everyone. As we look at 3G deployments around the globe we see signs of strong 3G growth in virtually every market. In Japan during this last quarter, the number of 3G subscribers surpassed the number of 2G subscribers for the first time. 53% of Japan's over 91 million wireless users now subscribe to 3G services. WCDMA handsets shipped to Japan increased approximately 33% quarter-over-quarter. In February 2006, KDDI and NTT DoCoMo launched a combined 12 new handset models. Features on these new handsets include mobile wallet, a 4-gigabyte hard disk drive; mobile TV broadcast receiver; and a location-based service device focused on child safety. In the U.S., Verizon, Sprint, Nextel, and Cingular have deployed 3G CDMA systems, are actively promoting their high-speed networks, and are offering a wide variety of 3G handsets, as well as data cards for laptops. These carriers are actively selling phones with enhanced capabilities, including music and video downloads, games, position location, and other useful multimedia applications. We expect to see strong replacement sales in Korea, not only because of its rollout of broadcast mobile TV, but also because the Korean wireless operators are now permitted to offer subsidies to subscribers who have maintained their service with the same carrier longer than 18 months. We understand that operators can provide subsidies of up to $200, which in the past has resulted in an increasing percentage of higher-end phones being sold in the market. In India, network operators who offer CDMA-based services saw a dramatic growth in their subscriber bases with the number of CDMA subscribers growing by 65% in 2005 and reaching 25 million in December. With average monthly net additions of 1.4 million in the first calendar quarter of 2006, CDMA reached a cumulative base of 29.5 million subscribers in March 2006 with Reliance Infocom at 18.3 million and Tata at 8.5 million. Quarter-over-quarter WCDMA handsets shipped to Europe increased approximately 73% while average selling prices for WCDMA handsets in Europe declined at a rate of approximately 10%. The increased variety of attractive WCDMA handsets at reduced pricing is, as Paul pointed out, increasing the share of WCDMA versus GSM in Europe and is a trend that we expect to continue. In addition to the increased activity that we are seeing around CDMA 450 in China we are continuing to closely monitor the timing of China's 3G license issuance. We are encouraged to see recent public reports from the USTR on their agreement with the Chinese Government at the Joint Commission on Commerce and Trade Meeting in Washington, D.C., where the Chinese Government reconfirmed its commitment to adopt a policy of technology neutrality in connection with its issuance of 3G licenses and to allow Chinese operators freedom in choosing technology standards for their 3G services. As we have previously disclosed, our license agreements generally license certain patents of ours that were applied for during an agreed upon capture period. From time to time, we have needed to extend existing agreements to include patents that fall outside of the licensees capture period. We have entered into many extensions over time with a substantial number of licensees, who have needed access to our expanding patent portfolio and in each case we have done so without negatively impacting our licensing program in any material way. Many of you have approached us speculating whether Nokia will need an extension. Our policy is not to talk specifically about particular license agreements, and so we have neither confirmed nor denied this speculation. However, based on an agreement reached with Nokia, we have today disclosed information in our 10-Q to the following effect: QUALCOMM has a license with Nokia, which in part expires on April 9, 2007. QUALCOMM and Nokia have been in discussions to conclude an extension or a new license agreement beyond that time period and I expect discussions to continue. However, there is no certainty as to when the parties will be able to conclude an agreement or the terms of any such agreement. There is also a possibility that the parties will not be able to conclude a new or extended agreement by April 2007. In that event, after April 9, 2007 unless and until the existing agreement is extended or a new agreement is concluded, Nokia's right to sell subscriber products under most of QUALCOMM's patents, including many that we have declared as essential to CDMA, WCDMA, and other standards, and therefore, Nokia's obligation to pay QUALCOMM's royalties will both cease under the terms of the current agreement. Likewise, unless and until the existing agreement is extended or a new agreement is concluded QUALCOMM's rights to sell integrated circuits under Nokia's patents will cease on April 9, 2007 under the terms of the current agreement. By agreement with Nokia we are limiting our comments to the foregoing at this time. Please bear in mind, however, that any company that makes or sells products without a license under the applicable patents of another company would be exposed to a patent infringement litigation by such other company. I would also like to make clear that if we are unable to reach agreement with Nokia and they become unlicensed to sell subscriber products after April 2007 this will have no material impact under our other license agreements. I'd also like to talk about a release that was recently issued in Korea. Nextreaming Corporation, a Korean company, issued a press release announcing that it has filed a formal complaint against QUALCOMM with the Korean Fair Trade Commission. This is the same Korean company that QUALCOMM mentioned without identifying specifically in our April 5th press release regarding the Korean Fair Trade Commission's visit to the offices of QUALCOMM Korea and several other manufacturers. Nextreaming had been using the threat of a complaint to the KFTC in an attempt to extract inappropriate commercial concessions from QUALCOMM. We have refused to yield to Nextreaming's demands with the result that Nextreaming is apparently now filed its threatened complaint. Although we have not yet seen the complaint we believe that QUALCOMM's activities in Korea have been lawful and pro competitive and that Nextreaming's complaint has been filed for an improper purpose. I'd now like to turn the call over to Sanjay Jha."
},
{
"speaker": "Sanjay Jha",
"text": "Good afternoon. I'd like to go over some key highlights for QCT's business. We shipped approximately 49 million MSMs in the second fiscal quarter. This was the third consecutive record quarter for MSM shipments and an all-time high booking quarter. In comparison, 47 million MSMs were shipped during the first quarter of fiscal 2006 and 37 million chips in the same quarter of fiscal 2005. The 32% increase year-over-year is driven by low-end shipment doubling due to strong CDMA demand in emerging markets. In addition, we saw a four-fold increase in our EVDO shipments, primarily driven by strong demand in the U.S. year-over-year. Our UMTS shipments increased fivefold compared to same quarter last year as well. This growth is also supported by continued diversification of our customer base worldwide. Our revenues again exceeded $1 billion for the quarter, in spite of this typically being a seasonally lower quarter. This compares to $746 million the second quarter of fiscal 2005, an increase of 36% year-over-year. Our operating profits increased nearly 60% versus this same quarter last year. While our average selling price was sequentially lower for the quarter driven by strong unit growth in CDMA2000 low-end products, this was partially offset by an increase in our mix of higher-end multimedia and enhanced multimedia chips as mentioned previously. This past quarter we made significant strides in broadening our product portfolio. QCT sampled the first generation of QUALCOMM Single-Chip, or QSC product, that enable more efficient, cost efficient and attractive CDMA handsets for emerging markets. We have enjoyed a very high level of interest in the QSC products with more than five leading manufacturers already receiving shipments. The first commercial handsets based on this solution are expected to launch by the end of 2006 calendar year. Demand for our existing EVDO portfolio continues to grow. There are now over 250 devices based on our chipsets either commercially launched or in design. This past quarter, QCT sampled MSM6800, our first EVDO Revision A solution and our first 65nm commercial chipset. A full two months ahead of schedule. We expect the first devices based on EVDO Revision A to be available before the end of 2006. Furthermore, we shared with the industry our expectation that commercial data card products based on EVDO Revision B will be available by the end of 2007. Revision B delivers up to 14.7 Mb on the downlink and 5 MHz bandwidth to enable ubiquitous broadband data experience. In UMTS, QCT is working with more than 30 manufacturing partners who collectively have launched or are designing over 120 devices based on our chipsets. QCT was first to market with an HSDPA solution and we continue to be a technology leader in the UMTS market with the first solution for HSUPA. At the end of March we sampled our MSM7200 chipset, which supports HSUPA and MBMS technologies for broadcasting over UMTS networks. Our global focus extends to cooperation with partners around the world and QCT has continued to build key relationships. Together with TechFaith of China, we established a new company, TechSoft, which will develop application software for our 3G CDMA devices. The long-term goal of TechSoft is to develop solutions that will enable handset manufacturers to dramatically reduce the time to market of a new fully featured 3G handsets. This is a continuation of the Company's commitment to supporting entrepreneurship and local innovation, as well as to the Chinese industry as an area of tremendous opportunity and growth. I will now turn this call over to Bill Keitel for an overview of our financial results."
},
{
"speaker": "Bill Keitel",
"text": "Thank you, Sanjay. Good afternoon, everyone. We are pleased to report record revenues and earnings per share again this quarter driven by growth in CDMA-based products and services around the globe and continued strong execution by our business units. I'll highlight a number of key items in our second quarter fiscal 2006 results, which reflect the Flarion and Berkana acquisitions completed this quarter. First, GAAP earnings for the March quarter were $0.34 per share. Our pro forma earnings were $0.41 per share, excluding $0.05 in estimated stock option expense, $0.01 loss attributable to acquired in-process R&D, and $0.01 loss attributable to the QSI segment. Revenues increased 34% year-over-year to $1.8 billion. Our pro forma earnings per share increased 41% year-over-year. Second, our business continues to generate strong cash flow. Operating cash flow was $889 million for the second fiscal quarter, up 8% year-over-year. Pro forma free cash flow was $947 million, up 28% year-over-year. Cash flows are the primary driver of long-term shareholder value and are unchanged by the accounting for a theoretical stock option expense. During the quarter we paid $298 million in cash dividends and announced a 33% dividend increase from $0.09 to $0.12 per share effective for quarterly dividends payable after March 24, 2006. Third, our fiscal second quarter tax rates for total QUALCOMM and pro forma were 25% and 27% respectively. Our pro forma estimated tax rate for fiscal 2006 is now 27% as compared to our prior estimate of 26%. Fourth, QCT again had record MSM shipments during the quarter. QCT's second quarter revenues increased 36% year-over-year to $1.02 billion on the strength of 49 million MSM shipped, a 32% increase year-over-year. QCT's operating margin was 25%, an anticipated quarter-over-quarter decrease reflecting continued growth of R&D investments and new chip development and modest sequential chip ASP decrease. Fifth, QTL earned record revenues of $679 million this quarter as licensees reported a record high of approximately 67 million new handset units shipped with an ASP of approximately $208 per handset. These shipments occurred in the December quarter and were reported to us by our licensees in the March quarter. Licensee reports are the basis of our royalty revenue recognition. We are pleased to report that CDMA is experiencing strong growth around the world. Sequential growth was particularly strong for WCMA shipments in Europe and Japan, and CDMA2000 shipments in China, Latin America, India, and North America during the December quarter. The average ASP for all WCDMA handsets decreased approximately 8% from the prior quarter. Of the $679 million in total QTL revenues $40 million represented enter segment royalties, $12 million were amortized license fees, and $627 million were royalties from third-party licensees. WCDMA royalties were approximately 46% of third-party royalties reported this quarter and QTL's operating margin was 92%. For the calendar 2005 CDMA market, with the receipt of all licensee reports, we now estimate that CDMA handset shipments were approximately 210 million units, including approximately 160 million CDMA2000 units, and approximately 50 million WCDMA units. Lastly, we believe total CDMA channel inventories remain in the historically normal band of 15 to 20 weeks. Now turning to our guidance. We are increasing our estimate for the calendar year 2006 CDMA-based handset market. We now estimate shipments of approximately 275 to 290 million units in calendar 2006, an increase 31% to 38% over our estimate for calendar 2005. Based on the 283 million midpoint of this estimate for calendar 2006 we anticipate shipments of approximately 187 million CMA2000 units, and approximately 96 million WCDMA units. The regional breakdown of our market estimate is available on our website. We are also increasing our guidance for fiscal 2006 revenue and earnings per share. We now expect fiscal 2006 revenues to be in the range of approximately 7.1 to $7.4 billion. An increase of 25 to 30% over fiscal 2005. We anticipate pro forma diluted earnings per share to be in the range of $1.53 to $1.57, an increase of 32% to 35% year-over-year. We now estimate the average selling price for CDMA2000 and WCDMA phones combined will decrease approximately 4% in fiscal 2006 to approximately $207. We are particularly pleased with the ASP trends we are seeing for WCDMA handsets, which continue to decrease at a rapid pace consistent with our expectations and encouraging for future market growth. We expect the combination of pro forma R&D and SG&A expense for fiscal 2006 to increase approximately 26% to 29% year-over-year, driven by growth in R&D as we continue to invest in the evolution of CDMA2000 and WCDMA multimedia functionality, single chip low-cost solutions, and longer term technology enhancements including OFDMA. We estimate GAAP earnings per share will be approximately $1.31 to $1.35 for fiscal 2006. This estimate includes a loss of approximately $0.20 per share for estimated share-based compensation, a loss of approximately $0.04 per share attributable to QSI, a gain of $0.03 attributable to tax benefits related to prior years, and a $0.01 loss attributable to in-process R&D from completed acquisitions. Turning to our guidance for the fiscal third quarter of 2006, we estimate revenues to be in the range of approximately $1.77 to $1.87 billion, a 30 to 38% increase year-over-year. We estimate third quarter pro forma diluted earnings per share to be approximately $0.36 to $0.38, a 29 to 36% increase year-over-year. This estimate includes the shipments of approximately 50 to 53 million MSM phone chips during the June quarter reflecting growth across multiple product segments including CDMA2000 low-end, EV-DO, WCDMA, and HSDPA. We expect chip ASPs to decrease modestly as we continue to sell a greater proportion of low tier MSMs for emerging markets, in addition to planned price erosion across our broad product offerings. We estimate approximately 62 to 64 million CDMA-based handsets shipped in the March quarter at an average selling price of approximately $203. Our unit forecast reflects seasonally lower post-holiday shipments across most regions when compared to the strong December quarter, though still a very healthy 44% to 49% higher than the 43 million handsets reported by licensees for the March quarter last year. We anticipate the third fiscal quarter pro forma R&D and SG&A expenses combined to increase sequentially approximately 6 to 8% driven by our continued investment in new products and services. In closing, we are very pleased with how our Company is executing across all business groups. The growing adoption of CDMA-based 3G technology across many consumer segments and regions around the world continues to drive strong financial results for our stockholders. That concludes my comments. I will now turn the call back to Bill Davidson."
},
{
"speaker": "Bill Davidson",
"text": "Thank you, Bill. Before we go into our question-and-answer session I'd like to remind our participants that our goal is to address as many questions as possible before we run out of time on the call. Therefore, I would like to ask our participants to limit their questions to one per caller. Operator, please go ahead."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question is from Tim Luke with Lehman Brothers. Please go ahead and ask your question, sir."
},
{
"speaker": "Tim Luke - Lehman Brothers",
"text": "Thank you very much. Congratulations on the quarter. A clarification and a question. The clarification just relates to Steve's comments around your current and ongoing negotiations with Nokia. You seemed to comment on the situations that happen if you don't conclude an agreement by April the 9th. If you could provide any further clarity around what you said with respect to your chip business and your chip shipments if you haven't formalized anything? What are the implications with respect to their payments to you if they were to ship WCDMA phones without an extension of the royalty agreement? The question was simply, as you raised your guidance with respect to the phone market both for WCDMA and for CDMA for the full year, where is that upside as you move from 86 to 96 coming from in WCDMA regionally and similarly in the CDMA area? Thank you so much."
},
{
"speaker": "Steve Altman",
"text": "So Tim, it's Steve. As for Nokia, if we do not conclude an agreement by April 9, 2007, then the rights under most of our patents for them to sell subscriber products they would not be licensed, and so they would be infringing on our patents. Likewise, at that point in time, we would have no rights to sell our chips under their patents. So we would be in a situation where we believe they would be infringing our patents and we would not have rights under their patents."
},
{
"speaker": "Tim Luke - Lehman Brothers",
"text": "Okay. Thanks for clarifying that."
},
{
"speaker": "Bill Keitel",
"text": "On the WCMA market, we raised our estimates in Europe from 40 million to 51 million, that's an increase of 11 million obviously. And we decreased just by a million a modest amount for what we call rest of world. So that's everything but Europe and Asia for WCDMA. So Europe is the increase."
},
{
"speaker": "Tim Luke - Lehman Brothers",
"text": "The CDMA2000 side, you also increased that?"
},
{
"speaker": "Bill Keitel",
"text": "In CDMA2000 we raised our estimate for North America from 80 to 85. We increased China from 12 to 15. We increased India from 16 to 21. In the Americas, primarily Latin America, we decreased by one. The combination of Korea, Japan, Southeast Asia, rest of world, we decreased by one. There is a table on our website that gives those numbers as well."
},
{
"speaker": "Operator",
"text": "Your next question comes from Tal Liani with Merrill Lynch."
},
{
"speaker": "Tal Liani - Merrill Lynch",
"text": "Hi, guys. I have a question which has two parts but they are related. What happens if you do not get to an agreement with Nokia and you still sell the chips? Just hypothetically speaking, can Nokia go to Samsung let's say that buys your chip and say, \"Okay, now you owe us royalty rate or royalty fee? What happens in this situation? Second, which is related to that, about five years ago you failed an S-1 to break off the chip business from the licensing business. I think you called it Spinco. Will a breakup of QUALCOMM into chips and licenses resolve this issue and will you consider this? Thank you."
},
{
"speaker": "Lou Lupin",
"text": "I'll try to answer the first part of your question. Whether Nokia could approach Samsung or any other handset manufacturer would depend upon the existence or nonexistence of agreements between those companies. Each of the handset suppliers has the ability to enter into license arrangements and other arrangements with Nokia or with other third parties as it sees fit. So that really would be a matter for Nokia and Samsung."
},
{
"speaker": "Tal Liani - Merrill Lynch",
"text": "Right, but right now there is a pass-through of the patents, right, which ends with the contract?"
},
{
"speaker": "Lou Lupin",
"text": "We have not commented specifically on pass-through rights with respect to particular companies and so I can't comment on the situation as it relates to Nokia or any other specific company with respect to pass-through rights."
},
{
"speaker": "Paul Jacobs",
"text": "In terms of potentially restructuring the Company, we're willing to consider any option in order to maintain and enhance shareholder value. I would say that the particular structure that we considered in the past is probably not what we would do if we were going to do a restructuring. But some kind of restructuring to protect those two businesses is possible. We expect that we'll actually come to agreement before such thing would happen."
},
{
"speaker": "Operator",
"text": "Your next question comes from Daryl Armstrong with Smith Barney Citigroup."
},
{
"speaker": "Daryl Armstrong - Smith Barney Citigroup",
"text": "Thank you very much. Going back again relative to the Nokia patent issue, the question I have is that for a chipset you guys sell to your customers before the expiration of the royalty or the licensing agreement -- what happens to those chips if they're still in inventory at your customers? Can they still use them within their handsets or are they precluded from using them after April 9th? Thanks."
},
{
"speaker": "Steve Altman",
"text": "Yes, this is Steve. The answer to your question really pertains to whether or not there's pass-through rights and as Lou mentioned we can't go into that. But what I can say is that with respect to our sales, their ability to assert their patents against us with respect to our sales prior to April 9th, that's covered under the agreement. So it would only be with respect to our sales after April 9th that they could assert their patents."
},
{
"speaker": "Operator",
"text": "Your next question comes from Tim Long with Banc of America."
},
{
"speaker": "Tim Long - Banc of America",
"text": "Thank you. Maybe if we could just switch over to the chipset business for a second. Sanjay, I don't know if you gave a number on ASP decline in the quarter, but if you could just clarify that. How do you think things are progressing on the WCDMA side? You said up fourfold year-over-year. What's your sense of your market share there and potential movements? Some of the customers have had pretty good quarters, some have had pretty poor quarters in WCDMA; so if you could just update us on your market share thinking there?"
},
{
"speaker": "Sanjay Jha",
"text": "Tim, the ASP decline is approximately 5%, and really driven by incredible growth in our low-end business. As Paul mentioned in his commentary, we have taken a strategic decision to make sure that our carriers in emerging marketplaces are competitive in offering services and phones with their GSM counterparts. So we made a very good stride, I think, and as you would see, the difference between GSM and CDMA handsets are coming down dramatically. So that's really what drove it. The increase on the other hand that was offset by increase in DO shipments and, therefore, a slightly richer mix of higher-end handsets, but the growth in CDMA2000 low-end really has been pretty dramatic and that drove ASP. Thinking about wide band CDMA business, we feel pretty well-positioned, as I noted in my comments, 30 customers. A clear leadership in HSDPA. We believe that most of the handsets launching this year with Samsung, LG, Novatel, Sierra, Option, and other of our customers based on HSDPA will give us leadership. We also believe that we have leadership in the low-end. We have been working as you know with Huawei, and Huawei has been accepted by Vodafone for delivering handsets to them. Similarly, Amoi and ZTE have been successful, not just in producing CDMA handsets, but also exporting wideband CDMA handsets based on our solution. That has been a strong factor. Samsung I think has one of the best phone lineups in wideband CDMA today, so that gives us a great deal of confidence that they will continue to drive growth in wideband CDMA for our chipset shipment. LG has been very successful with U880 and then recently launched U890. At DoCoMo we just had launches from LG, from Sanyo the second phone was launched, and I expect that there will be two more phones launched on DoCoMo's network. So as I look going forward this year, I feel pretty comfortable with our position in wideband CDMA and as Bill has said we updated our guidance on wideband CDMA shipment from 86 million, I believe, to 96 million units. And as we do that that clearly increases the total volume that we think we can address."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mike Ounjian with Credit Suisse First Boston."
},
{
"speaker": "Mike Ounjian - Credit Suisse First Boston",
"text": "Great, thank you. I just wanted to talk about a little bit about the increased guidance for CDMA handset shipments in China this year and just what's giving you the confidence there? Is CDMA 450 the primary driver of that increase of 3 million units or is there something beyond that that you are seeing with China Unicom? On the U.S. and the increase, just wanted to get a sense of what you are seeing in terms of the EVDO mix within the North America shipments?"
},
{
"speaker": "Bill Keitel",
"text": "In terms of China we do see China Unicom continuing at a good steady pace, but as Paul noted the CDMA 450 market appears to be pretty active, and the bigger part of that increase for China we think is CDMA 450. In terms of North America, the 5 million units for the calendar year, we think that the mix within that 85 million is shifting well to EVDO."
},
{
"speaker": "Operator",
"text": "Your next question comes from Louis Gerhardy with Morgan Stanley."
},
{
"speaker": "Louis Gerhardy - Morgan Stanley",
"text": "Yes, good afternoon. Just following up on the Nokia issue. First for Sanjay, how do you expect your customers to react if there's some uncertainty out there about the availability of chipsets? I'm just trying to get at why won't they build up some safety inventory? And then to Steve, just on the pass-through rights, why won't they change if your Nokia agreement expires? I just need a little help there. Thanks."
},
{
"speaker": "Sanjay Jha",
"text": "Louis, in terms of how our customers would react, there have been, as Steve has noted, a number of times in the course of this industry where there has been uncertainty on those matters and I think we will work with our customers to try to find solutions for them as effectively as we can. It's important to note that the uncertainty will be there for not just our chipset shipment, but also Nokia's handset shipments. So I think that certainly both parties will be strongly motivated to resolve this issue in the interest of each of our shareholders, but also in the interest of the industry. So I see this as a disclosure that is right and appropriate for us to make, but I don't think that this is something that our customers are particularly concerned about at this stage."
},
{
"speaker": "Steve Altman",
"text": "No, I would add to that that, again, we have done many extensions over the course of our licensing program. This is not a unique situation in terms of what we've had to do in the past and so I also expect that we'll eventually work things out. But having said that, in answer to your question on the pass-through rights again whether they'll change or not, that would require me to answer whether or not there are pass-through and as we said, we can't get into that detail."
},
{
"speaker": "Operator",
"text": "Your next question comes from Matthew Hoffman with Cowen & Co."
},
{
"speaker": "Matthew Hoffman - Cowen & Co.",
"text": "First, Sanjay, let's drill down on the earlier question on WCDMA chip share. You've seen a substantial increase in WCDMA handsets in Western Europe over the calendar fourth quarter. You've got a pretty substantial share of the chip market worldwide. What is your WCDMA chip share within Western Europe, and hoping you could give us some color on the progress you're making there? Thanks."
},
{
"speaker": "Sanjay Jha",
"text": "Matthew, we've not broken out our chip share worldwide or for any particular region, so allow me to refrain on that. But I can give you color as to what progress we're making with each of the carriers. We have handsets at the moment in Europe I think Vodafone and H3G are two of the big drivers of growth in wideband CDMA shipments. We feel particularly well-positioned with both of these carriers in terms of handsets that they're shipping and the volume that they're shipping with Samsung being very well-positioned at Vodafone; Toshiba being positioned at Vodafone; Huawei being positioned at Vodafone; Novatel, Option, and Sierra being positioned at Vodafone. If I look at H3G then LG is a big driver of the growth in LG shipments. We feel that the best handset that H3G offered last year was U880 through the Christmas season. I think the update of that phone, U890 will drive some growth for us. We also see a number of other handset providers working pretty closely with H3G based on our solutions to offer chipsets there. We have worked with T-Mobile, with Telecom Italian Mobile, we believe that we are very well-positioned also. Samsung has a very good portfolio there. HTC actually is delivering some very compelling data devices now to Europe based on our solution right now in UMTS and very quickly based on HSDPA. So I think in terms of our positioning, in terms of launching handsets, we are very well-positioned. Now volume, the drivers will be a different matter. Now we have seen a thrust from Nokia at the low-end, and as you know they commented that they will have a very large market share. We see that driving growth in the UMTS marketplace and enabling our handset manufacturers to come in below where Nokia is in the pricing today. We're very motivated and very focused in enabling that through our chipset pricing, through enabling for these handset phones to launch, through enabling application software integration support, through testing support, through an inter-op testing support, so we think we're very well-positioned. As we say again we see growth towards the last two quarters of this year coming in wideband CDMA, and for that I think the number of handset launches we feel give us some confidence."
},
{
"speaker": "Operator",
"text": "Your next question comes from Mike Walkley with Piper Jaffray."
},
{
"speaker": "Mike Walkley - Piper Jaffray",
"text": "Great, thanks. Just another question on the chipset side. On the ASPs, I think you said they would be down a little bit sequentially, but how should we maybe think about the trajectory in the back half, should we start shipping better mix of HSDPA and with the recent pick up in the Korea market on the high-end phones falling subsidies? How should we maybe think about the trajectory of ASPs maybe into the back half of the calendar year?"
},
{
"speaker": "Sanjay Jha",
"text": "We have not provided any guidance but I expect that that would be flat. And depending on how that ticks up there's a possibility of some uptick. But I expect to the back half our ASP is likely to be flat."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ehud Gelblum with JP Morgan."
},
{
"speaker": "Ehud Gelblum - JP Morgan",
"text": "Hi, can you hear me? Hello?"
},
{
"speaker": "Sanjay Jha",
"text": "Yes, we can hear you."
},
{
"speaker": "Ehud Gelblum - JP Morgan",
"text": "Okay, great. Thank you. Two very quick questions. One is, I want to talk to you about your estimate on the ASP for handsets next quarter of $203, Bill. Last year in the June quarter you had a huge $231 ASP that was driven by a very strong Japan handset shipment quarter in March. Looking at the Japanese subscriber numbers in the past three months, basically January, February, March, you had a similar phenomena with Japan about the KDDI site, and the DoCoMo side being very, very strong. I'm a little surprised to see the guidance there for ASP down to $203. I would have thought it to be at least flat if not up. I understand that there's lower end things in there. Can you give a little color around that? Paul, if you can give us a little update on -- we know that Verizon on MediaFLO and some of the other types of technology that you're getting kind of more into; we know obviously Verizon's doing MediaFLO. What's the progress with perhaps Cingular or Sprint doing MediaFLO? Any update you can tell us about what Sprint might do with the their 2.5 GHz licenses and any part that you may plan that would be helpful too?"
},
{
"speaker": "Bill Keitel",
"text": "So Ehud on the 203 ASP forecast, and on your point specifically to Japan, we are expecting greater sequential shipments of phones in Japan, shipments in March, which of course would be June revenue relative to shipments in the December quarter. But likewise we're also expecting growth in the India market, in the China market, and in the Korea market. In Europe and Latin America and North America, we're expecting those three markets to be down slightly consistent with the seasonal effect that we've often seen in the past. So, now, if this forecast proves to be wrong and Japan does much better than we expect that would be positive on the ASP, but that's not my best expectation at this time."
},
{
"speaker": "Paul Jacobs",
"text": "Sorry. In terms of discussions on MediaFLO, we continue to be in discussions with all of the major operators. I don't have any particular announcements to make at this point although I would highlight when you highlight Cingular that Samsung did show a WCDMA FLO phone at the CTIA, so I think that was positive at least in terms of our ability to address Cingular as a potential customer. In terms of Sprint in the 2.5GHz band we continue to be in discussions with them as well. We have a number of technologies that could be very good for that band including Rev B, Rev B with flex duplex which allows asymmetrical, downlink, and broadcast capabilities within the band. Also as you know Nextel had been looking at the Flash technology. We continue to discuss evolutions of that as well and the 802.20 and Rev C technology is out at 3GPP. So we've actually gone to them with a pretty broad technology road map, depending on the kinds of applications that they're interested in for that band. We think that we can provide them with very compelling solution along with a great ecosystem and along with the fact that when QUALCOMM says that they are going to bring out a technology we bring it out on time and we bring it out with very high performance. I think that's compelling to them as well."
},
{
"speaker": "Operator",
"text": "And your next question comes from John Bucher with Harris Nesbitt."
},
{
"speaker": "John Bucher - Harris Nesbitt",
"text": "Thank you. Question for Paul. Actually it's a nice segue. With looking beyond the current fiscal year, there's a lot of other spectrum besides Sprint and MDS band that's likely to get deployed, the air-to-ground auction, AWS, some of the ATC spectrum. I'm just wondering, Paul, whether you see a significant incremental opportunity for growth looking out beyond the fiscal year there or do you think that that's largely just going to be in-line with what normal cellular wireless equipment deployment would be? Thank you."
},
{
"speaker": "Paul Jacobs",
"text": "I think it depends on who ends up with the spectrum. I'm sure there will be additional deployments. The question is, do those then turn into incremental device sells and subscribers because of increased competition? Air-to-ground I think is very interesting. We have nice technology for air-to-ground and we've been working with people on that segment for awhile. The AWS is also going to be interesting. I think getting that cleared, getting an option, action, getting it cleared and so forth certainly provides incremental opportunity, particularly when you think about the operators who really are looking for additional spectrum assets. ATC is also good for us in terms of the ability to innovate and integrate additional radio capabilities because there's the satellite segment that has to be satisfied there as well. One of the things that we've been looking at is how to build the right radio link so that you can integrate the satellite capability into a standard phone so that you get the ATC capability or the authority for ATC through the Safe Harbor that SEC set-up. So, yes, I believe there's a lot of opportunity both for innovation and for incremental device sales."
},
{
"speaker": "Operator",
"text": "Your next question comes from Brian Modoff with Deutsche Bank."
},
{
"speaker": "Brian Modoff - Deutsche Bank",
"text": "Hi, real quick, a couple of things, Sanjay, on HSDPA, what do you think your technology lead is right now in terms of your competitor's ability to start delivering HSDPA products? And what do you think your market share is in chipsets design or in terms of WCDMA phone design activity? In other words, what percent of the new designs do you think you have in the market? Finally, any estimate on how many MediaFLO chips, or phones you might ship this year with MediaFLO inside?"
},
{
"speaker": "Sanjay Jha",
"text": "Brian on HSDPA it's difficult for me to be precise on what an advantage we have, but I can tell you where we are and you can determine for yourself where the others are. We delivered the first sample of HSDPA in December of 2004 and we did interrupt testing with every single network and you saw Samsung produce a very, very slim forum factor commercial device, which they will start shipping in a couple of months. The HSDPA data cards have been available from three vendors based on our solution. So I think that we have seen with UMTS, with CDMA2000, and now with HSDPA making lab calls to producing and delivering commercial forum factor devices for high data speed terminals actually takes a significant amount of expertise and essentially time. I think that we have seen that figure to be around six months for sure, so I'm comfortable with that number. I believe that Nokia is not too far behind us and a few other people lining up behind that. But I do think that we have an advantage, certainly in chip vendors we have a pretty good advantage, and all of our customers realize that and are taking advantage of that. In terms of handset designs, again, it's difficult for me to say exactly what the overall design activity is that we don't have visibility to. But as we said we believe that around 120 phone designs based on our chipset have either already been launched or will be launched in short order. So that gives you the scale of activities that we are supporting with our application support. Our hope is that that leads to increased volume shipments for us."
},
{
"speaker": "Paul Jacobs",
"text": "This is Paul. In terms of MediaFLO, we aren't even projecting a launch of the network this fiscal year. So the number of handset shipments would be relatively low. Also Verizon will make the final decision about the actual service launch date and they have not yet committed to a launch date. They have a lot of things that they have to do to get ready, including marketing and channel filling and all of those kinds of things. So it's a little bit indeterminate on the front end, but I think that once it comes out -- the demonstrations that we did showed that the application is extremely compelling to people and I think that it will be very successful."
},
{
"speaker": "Operator",
"text": "And at this time I would like to turn the call back over to Dr. Jacobs. Sir, do you have anything further to add before adjourning the call?"
},
{
"speaker": "Paul Jacobs",
"text": "I'm very proud of the execution of the Company. I think with the record phone chip and revenue marks it's showing that the growth of 3G is really happening, and I think that as we look forward there's an awful lot of opportunities for us to innovate, to execute, and to partner with many companies in the wireless value chain. So I'm excited by the future. I think we've done well and it seems like it's only going to continue to get better. Thank you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, we do appreciate your joining us today. This does conclude our QUALCOMM second quarter conference call. You may now disconnect."
}
] | null | null |
QCOM | 1 | 2,006 | 2006-01-27 05:45:00 | Executives: Bill Davidson, VP, IR Paul Jacobs, Chief Executive Officer Steve Altman, President Sanjay Jha, EVP, President, CDMA Technologies Group Bill Keitel, EVP, Chief Financial Officer
Analysts: Michael Ounjian, Credit Suisse First Boston Ittai Kidron, CIBC Christin Armacost, SG Cowen Hasan Imam, Thomas Weisel Partners Inder Singh, Prudential Securities Mark McCatchney (ph), Twin Peaks Capital Edward Snyder, Charter Equity Research Tim Long, Banc of America Securities Brian Modoff, Deutsche Bank Paul Sagawa, Sanford C. Bernstein Brantley Thompson, Goldman Sachs John Bucher, Harris Nesbitt
Operator: Thank you for standing by. Welcome to the QUALCOMM First Quarter Conference Call. At this time all participants are in a listen-only mode. Later we will conduct a question and answer session. If you have a question, you’ll need to press “*” “1” on your telephone keypad. As a reminder this conference is being recorded today, January 25, 2006. The playback number for today's call is 800-642-1687, international callers please dial 706-645-9291. The playback reservation number is 4046245. I would now like to turn the call over to Mr. Bill Davidson, Vice President of Investor Relations. Bill, please go ahead, sir.
Bill Davidson, VP, IR: Thank you and good afternoon. Today's call will include prepared remarks by Dr. Paul Jacobs, who is joining us remotely from the World Economic Forum; Steve Altman; Dr Sanjay Jha; and Bill Keitel. An Internet presentation and audio broadcast accompanies this call and you can access it by visiting www.qualcomm.com. During this conference call, if we use any non-GAAP financial measures as defined by the SEC in Regulation-G, you can find the required reconciliations to GAAP on our website. I would also direct you to our 10-Q and earnings release which were filed and furnished respectively with the SEC today and are available on our website. As a reminder the QUALCOMM Investor Relations website includes a thorough presentation on the many data points included in this conference call. We may make forward-looking statements relating to our expectations and other future events that may differ materially from QUALCOMM's actual results. Please review our SEC filings for a detailed presentation of each of our businesses and associated risks and other important factors that may cause our actual results to differ from these forward-looking statements. Pro forma revenues were $1.74 billion in the first fiscal quarter, up 25% year-over-year and 12% sequentially. First quarter pro forma net income was $667 million, up 41% year-over-year and 23% sequentially. Pro forma diluted earnings per share were $0.39, up 39% year-over-year and 22% sequentially. First fiscal quarter pro forma free cash flow defined as net cash from operating activities less capital expenditures was $531 million, up 93% year-over-year and was 30% of revenue. Now it's my pleasure to introduce QUALCOMM's CEO, Dr. Paul Jacobs.
Paul Jacobs, CEO: Thank you Bill, and good afternoon everyone. I am pleased to report that we started the new fiscal year with record first quarter revenue led by strong demand for our chips. We reaffirmed our fiscal 2006 guidance, which reflects an acceleration of the CDMA market, which in turn is driving our financial projections for the year. I've been spending a lot of time on the road talking to our operator and manufacturer partners. We've been discussing our business model and the positive impacts on the industry from the healthy and competitive worldwide wireless marketplace that our business model fosters. We work closely with many wireless equipment manufacturers in all parts of the world to promote the adoption of 3G, partially because of the large number and variety of companies that we've licensed that we enable with advanced and feature-rich chipsets and software, prices for handsets and other wireless devices continue to decrease while features and functionality continue to increase. We continue to invest significantly in R&D to drive this dynamic and to build a leadership position in the wireless industry. Our inventions enable new revenue streams for all our partners, enabling continuing investments throughout the wireless value chain. Our licensing model helps to limit royalty stacking on CDMA products, thereby reducing prices for the wireless consumer. For example, QUALCOMM has not increased its royalty rate as new technologies using QUALCOMM's patents are developed and commercialized. The cumulative number of QUALCOMM's inventions has grown substantially over the years but our royalty rate has remained the same. The resulting innovations are made available through our licensing agreement as unlike many other companies, we broadly license not only our essential patents but generally all of our patents. In addition, many of our license agreements include extremely valuable pass-through rights from which our customers of our QUALCOMM chipsets can benefit. In November, we announced DMMX, DO multicarrier, multilink extensions, our platform for driving the EV-DO roadmap through the end of the decade. Part of our DMMX strategy is to be the leader in supporting standards based enhancements to EV-DO technology, namely revision A and revision B. At the same time, we intend to be the leader in implementing other enhancements that significantly improve system performance but don't require changes to the standards. The revisions will open the door to mobile Voice over Internet Protocol services and very low latency applications such as push to talk via DMMX, phones will operate in a concurrent multilink manner with multiple radio technologies while simultaneously receiving at multiple frequencies. MediaFLO is a good example of DMMX because audio and video transmissions over EV-DO cellular networks are seamlessly combined with transmissions received using the FLO technology, which operates in separate spectrum. The goal is to enable operator partners to provide a superior multimedia experience at the lowest possible cost. Similarly, on the WCDMA side of 3G we're driving the roadmap via HMMX HSDPA multicarrier, multilink extensions. We continue to transfer what we learned on the CDMA2000 roadmap to support our WCDMA customers and partners, providing them with products that support higher data rates through our HSDPA and HSUPA solutions. Through these, operators are able to provide their customers enhanced multimedia and IP-based data capabilities including multicasting.
indiscernible: QCT continues to be unmatched in execution on their product roadmaps. The same strategies of integration, on-time delivery and technical leadership that we established in CDMA2000 are driving our success in WCDMA. Over the past quarter we announced a new entry level WCDMA chipset and we reinforced our leadership standing in HSDPA technology with the sampling of an HSDPA solution towards data rates of up to 7.2 megabits per second, surpassing the speeds of many wired broadband connections. We've worked closely with numerous industry partners to help lead the rollout of 3G UMTS networks and commercialization of devices. Our WCDMA roadmap now includes solution for all market tiers from low end to highly advanced, features the integration of multimedia capabilities and will help drive the adoption of 3G technology. Our integration strategy delivers significant benefits to device manufacturers and enables the slim form factors for WCDMA devices that are in great demand by wireless users. I also believe there's a strong growth opportunity in developing markets and we're focused on providing very low-end CDMA2000 solutions. We work closely with our partners to hit exceptionally competitive price points and bring the benefits of CDMA technology to the world's next billion wireless subscribers. We believe that CDMA technology provides significant advantages to emerging markets because subscribers can use their low-end handset for data services as well as voice calls and SMS, advantages that positively impact local economies and bridge digital divides. Our goal is to bring these benefits to all developing markets. In December 2005, we announced plans to work with Verizon wireless to bring its customers real-time mobile video over the MediaFLO multicasting network in the United States. Verizon wireless intends to be the first service provider to use the MediaFLO USA network to deliver mobile TV services once the network begins planned commercial operation. Specific timing of service launches will of course be determined by the wireless operators but we continue to make excellent progress towards commercialization of MediaFLO. In January 2006 we connected live over the air demonstrations of FLO technology with LG Electronics and Samsung Electronics during the 2006 International Consumer Electronics show in Las Vegas. The demonstrations were the first featuring FLO technology on handsets from major device manufacturers. Great strides have also been made in achieving the global standardization of FLO technology. This past quarter the FLO Forum, an organization of 25 member companies which is driving the standardization efforts of FLO technology ratified the FLO air interface specifications and submitted it as a contribution for standardization to the telecommunications industry and sub-committee ER-47.1. Last call I made the point that QUALCOMM is more than a CDMA company. MediaFLO is one aspect of our diversification. The recent closure of the Flarion acquisition enhances QUALCOMMs strong position in OFDMA and demonstrates our commitment to add to our intellectual property portfolio through both internal R&D and acquisitions. Intellectual property is available to our existing licensees for use in CDMA multimode equipment without an increase to standard CDMA royalty rates. While CDMA remains the optimal technology to provide broadband spectro efficient mobile wide area wireless networks for the foreseeable future, both DMAs low complexity at wide signal bandwidth makes it a potential alternative where large blocks of spectrum can be dedicated. Beyond the Flarion acquisition we've been working in the IEEE working group 802.20 traditionally confirmed a draft specification for the next generation of mobile broadband wireless access. This draft specification will now enter the 802.20 ballot process. 802.20 draft specifications consist of frequency division duplex and time division duplex components that can be deployed in bandwidths up to 20 megahertz. The bandwidth can flexibly be adjusted based on available spectrum. The draft specification leverages the technical strength of CDMA and OFDMA by using OFDMA on the forward link and a combination of CDMA and OFDMA on the reverse link. These techniques increase the coverage, capacity, and hope to maintain the quality of service for wireless systems. We believe that this solution significantly exceeds capabilities of other proposed systems. Turning to wireless LAN, IEEE or 802.11n confirmed to draft specification for the next generation of wireless LAN with QUALCOMM's active involvement. Our leading edge MIMO transmit beam forming and link adaptation technologies have been included in the draft specification. These technologies greatly improve the range, data rates, and performance stability of wireless LAN which we've demonstrated at QUALCOMMs research center in New England. The 802.11n standard should deliver nearly four times performance of existing 802.11g networks and will be instrumental in supporting the digital wireless home and office of the future. The announcement of our Scorpion processor at the end of last year supports the market's next generation of data centric devices based upon the proven ARM architecture. Scorpion's processing power enables mobile handsets to feature many of the capabilities only found on personal computers. This is done in combination with significantly reduced power demands in order to ensure adequate battery life for wireless devices. I'm very pleased that we are executing well financially and that our results for the first quarter ended a bit higher than we had originally guided at the outset of the quarter, and we continue to be excited by the opportunities ahead of us. I'd like to now turn the call over to Steve Altman.
Steve Altman, President: Thanks Paul and good afternoon everyone. I'm going to start by highlighting some important facts and trends that we're seeing in CDMA2000 and WCDMA around the world. Over the past decade QUALCOMMs licensees have commercialized more than 1,000 CDMA phone models. Today there are approximately 50 manufacturers supplying CDMA2000 devices at a wide variety of prices ranging from the very high end to the very low end. In the low end we now have at least three licensees that have supplied at manufacturer prices below $50. We're also aware of manufacturer prices being quoted for CDMA2000 handsets in the Indian market of approximately $40. We believe that all price tiers of handsets are important to help grow our business and we will therefore continue to work closely with our customers to help allow all of these different tiers to remain competitive. We also continue to see quite healthy growth in WCDMA. Based on royalty reports received in the December quarter of 2005 our shipments in the September quarter of 2005 there was 24% volume growth quarter-over-quarter in shipments of WCDMA units mainly due to 51% growth in Europe based on these reports the number of manufacturers selling WCDMA devices increased quarter-over-quarter to 17 from 13. And we are now seeing a wide range of competitive handsets being made available. As the WCDMA market grows, as increased price competition occurs, and as a wider variety of high, middle, and lower end handsets become available from more of our licensees entering the WCDMA market we have seen and expect to continue to see the rapid decline of the ASP for WCDMA devices as well as a broadening of the range between the highest and lowest prices. We now estimate that the world ASP, the worldwide ASP for WCDMA devices to be $372, which represents a decline of approximately 10% quarter-over-quarter. At our London analyst conference, we shared with you the lowest wholesale pricing, we have seen for WCDMA handsets in quantities of approximately 50,000 units. We now estimate that this WCDMA low end pricing dropped from $217 in the September quarter of 2005 to $141 for the December quarter. As I'm sure you noted we for the first time provided you with specific ASP information for WCDMA. Although I think you may find this information is interesting, it is important to understand that particularly at this early stage of WCDMA deployment a number of factors can significantly impact WCDMA ASPs, including the geographic mix of the sales, as well as the shifting market shares amongst the various manufacturers, because as you might expect some manufacturers are charging significantly higher prices for their WCDMA devices than other manufacturers. Now let me briefly discuss some of our other markets around the world. In India, the CDMA subscriber base reached 25.1 million units resulting in approximately 30% market share for CDMA. 32 CDMA based devices were launched in December quarter. We expect continued growth in this market with continued emphasis on the low cost handset. In China, you may have seen a number of articles surfacing recently related to third-generation wireless licenses. We no longer speculate on when these 3G licenses will be issued. Once these licenses are issued, however, we believe that China will rapidly deploy CDMA 3G products increasing overall volumes and decreasing ASPs, and we believe that our licensed Chinese manufacturers as well as other licensees will participate in a major way. In Europe we continue to be encouraged by the rollout of WCDMA services. Paul, Sanjay, and I have met with a number of the European operators. They all appear to be very committed to WCDMA and we expect volumes to continue to ramp as ASPs decrease and the number and variety of available handsets increase. We have allocated significant resources to Europe and have received a very warm reception from the operators. As we have and continue to do with CDMA2000 operators we are working with many of the European operators hand-in-hand to help them optimize their WCDMA networks and services. We remain committed to working closely with European operators during their ongoing WCDMA and HSDPA network deployments. In North America, Japan, and Korea, we continue to see increased demand for EV-DO products. Although neither Sprint, Nextel and Verizon have yet announced their results for the December quarter, Verizon wireless recently announced fourth quarter 2005 net wireless customer additions of two million – and industry record to-date. Verizon has also stated that they're continuing to see increased data ARPU and continue to achieve record low churn. Samsung, Kyocera, and Motorola as well as other manufacturers have announced new handsets supporting EV-DO networks in these regions. In the U.S Cingular, announced Cingular Broadband Connect based on HSDPA technology. We are extremely pleased that our chipset customers were able to support this launch as QCT was first to market with a solution for HSDPA. NTT DoCoMo reported strong 3G subscriber figures for December with net adds of 1 5 million up 53% month-over-month. KDDI also posted strong net adds in December and finished the year over 21.5 million subscribers, of which 6.75 million are DO. Turning to QTL, in the first quarter of 2006, three new licensees entered into CDMA subscriber equipment license agreements. One of the three agreements was with a WCDMA licensing in China bringing the total number of WCDMA agreements with Chinese manufacturers to 7 all at our standard worldwide royalty rates. Finally, let me briefly update you on the complaints that were filed against us by six companies with the European Commission. Of the six complaints that were filed we up to date received a redacted version of just one of the complaints. We continue to believe the allegations contained in the complaint are without merit. We have not yet received the other complaints. As to the investigation by the EC, its status is confidential and there's little further that we can say at this time. We have and we’ll continue to cooperate with the EC to explain and demonstrate that all of QUALCOMM's activities are lawful and in fact foster healthy competition. Although we see articles or press releases from time-to-time attempting to attribute the higher ASPs of WCDMA devices to QUALCOMM's licensing terms or alleging that WCDMA is rolling out slowly as a result of IPR costs we see no evidence of any of this being true, and in fact believe the opposite is true. Our licensing program has fostered healthy competition amongst the WCDMA handset suppliers leading to the rapid declines in ASPs mentioned earlier. Royalties paid to us by our licensees are very small component of the cost and price of the handset. As I mentioned earlier WCDMA handset ASPs are coming down rapidly, primarily driven by our chipset customers who benefit not only from our intellectual property licenses and past due rights, but also our competitive chipsets and software. For example, in Europe where a complaint has been filed alleging that QUALCOMM's activities are responsible for higher WCDMA handset ASPs we estimate that the ASP of WCDMA handsets sold by licensees using our chip is, are substantially lower than the ASP of WCDMA handsets sold by licensees that do not use our chip. We are seeing strong growth in volumes of WCDMA handsets and WCDMA handset ASPs will continue to decline as volumes continue to increase. I'd now like the turn the call over to Sanjay Jha.
Sanjay Jha, EVP, President: Good afternoon. I'd like to go over some key highlights of the QCT business. This was a record setting quarter for QCT in terms of shipments, revenues, and profit. We shipped approximately 47 million MSM to our customers around the world, had quarterly revenues of more than $1 billion and record operating profit of more than $300 million. In comparison, we shipped approximately 39 million MSM units in the first quarter of fiscal 2005 and 40 million units last quarter. In the first quarter of fiscal 2005 our quarterly revenues were $865 million and our operating profit was $242 million. ASP this quarter was down approximately 3% from the previous quarter, primarily due to normal price erosion combined with an increase in the shipment of our lower tier chipsets. As Steve and Paul mentioned we have been focused on meeting the needs of cost sensitive subscribers and enabling the growth of emerging CDMA markets like India, Latin America, Southeast Asia, and China. QCT has worked hard enabling our partners to be more competitive in cost sensitive markets with our 6000 -- MSM6000 and RF CMOS based handsets. We have hit highly aggressive price points driving volume and enabling competitive entry-level handsets in these emerging markets. As a result we saw a significant increase in the demand of our MSM6000 chipset as a growing number of subscriber select CDMA solutions to meet their communication needs and we anticipate that this trend will continue in following quarters. We have seen increasing traction of our EV-DO portfolio. We now count 154 devices commercially available with 56 of them having launched in the past quarter and an additional 65 handsets in design. All based on our multimedia rich MSM6500 and MSM 6550 solutions for EV-DO networks. We experienced 128% increase in shipment of these chipsets during the quarter compared to the same quarter last year. With more than 30 customers who have 120 handsets either in design or commercially available based on our UMTS and HSDPA products we've been actively contributing to wideband CDMA and HSDPA network deployments around the world. For example we supported the world's first HSDPA rollout launched by Cingular wireless by working with leading device manufacturers to develop and validate multiple mobile devices based on our MSM6275 chipset. QCT saw 48% growth in UMTS MSM shipment versus the previous quarter. This follows two successive quarters, which grew by 120 and 41% respectively in our UMTS chipset shipment. QCT is the first to market with solutions for HSDPA and we have continued to make great progress in this area. We sampled our second-generation MSM6280 HSDPA solution and we're the first to achieve data rates of 2.6 megabits per second using MSM6280 based terminals in cooperation with numerous industry partners. Data cards and embedded modules are an increasingly important segment of our business and we have seen significant success in this market. QCT has had several customers announcing the commercial launch of numerous data cards and embedded modules based on our MSM solutions over the past quarter. We are on track to sample the first 65-nanometer MSM6245 chipset for entry-level wideband CDMA markets in the second quarter of 2006. We are aggressively migrating our roadmap to 65-nanometer process technology to enable cost competitive ultra thin form factor handsets in demand by wireless users today. We're also on track to sample the convergence platform, MSM7200 for HSUPA and MBMS networks in this upcoming quarter, extending our leadership in the next evolution of UMTS. Our acquisition of Berkana Wireless, a fabulous semiconductor provider of CMOS RFICs expanded our RF capabilities and reinforces our leadership in this area. The addition of their RF CMOS IP design portfolio and engineering experience will help us bring new integrated advanced RF CMOS products to market faster. Thank you. I'll now turn the call over to Bill Keitel.
Bill Keitel, EVP, CFO: Thank you, Sanjay, and good afternoon, everyone. We are very pleased to report record revenues and earnings per share again this quarter driven by continued growth in demand for CDMA based products and services around the globe. Consistent with our prior practice we continue to provide both GAAP and pro forma financial results. Our pro forma results exclude the QUALCOMM Strategic Initiatives or QSI segment, tax gains related to prior years and with the advent of stock option expensing non-cash stock option expenses. We believe pro forma results provide investors with meaningful information about the Company's ongoing core operating businesses and are useful in evaluating performance on a basis that is consistent, comparable with prior periods. I'll now highlight a number of key items in our first quarter fiscal 2006 results. First, GAAP earnings for the first quarter fiscal 2006 were $0.36 per share, including $0.05 in estimated stock option expense, $0.03 in tax gains related to prior years, and $0.01 loss attributable to QSI. Revenues increased 25% year-over-year to $1.7 billion, and pro forma earnings per share increased 39% year-over-year $0.39 per share. Second. Our business model continues to generate strong cash flow. Operating cash flow was $596 million for the first fiscal quarter up 50% year-over-year. Pro forma free cash flow was $531 million, up 93% year-over-year. Cash flows are the primary driver of long-term shareholder value and are unchanged with the advent of a theoretical stock option expense. During the quarter we announced dividends totaling $148 million or $0.09 per share, which were paid on January 4, 2006. Third, our tax rate for total QUALCOMM was 16% for the quarter. Lower than our prior estimate as a result of tax audits completed during the quarter. Our pro forma tax rate for the quarter was 26% consistent with our estimated 2006 full year rate. Fourth, QCT had record revenues in MSM shipments during the quarter. Revenues increased 19% year-over-year to $1.03 billion on the strength of 47 million MSM shipped a 22% increase year-over-year. QCTs operating margin was 29% unchanged quarter-over-quarter as we continue to grow R&D investments in new chip development. Chip ASPs decreased sequentially driven by some product mix shift to lower tier MSMs in the quarter as well as planned price erosion. Fifth, QTL earned record revenues of $564 million this quarter as licensees reported approximately 52 million new handset units shipped with an average selling price of approximately $215 per handset. As you recall these shipments occurred in the September quarter and were reported to us by our licensees in the December quarter. The licensees reports are the basis of our royalty revenue recognition. Unit shipments of these new handsets appear to have been notably strong in North America, Europe, and Japan during the September quarter. WCDMA average wholesale handset prices continued to decrease at a rapid pace and the range of prices continues to increase. Consistent with our expectation and encouraging for future unit growth. ASPs for WCDMA handsets decreased approximately 10% from the prior quarter with wholesale price points as low as $120 for low-end models. Of the $564 million in total QTL revenue $39 million represented intersegment royalties $11 million were license fees and $514 million were royalties from third-party licensees. WCDMA royalties were approximately 40% of third party royalties reported this quarter and QTLs operating margin was 91%. Turning to our guidance, for the calendar 2005 CDMA market, we now estimate that shipments were approximately 202 to 204 million new handsets. Based on the 203 million midpoint of this estimate we anticipate approximately 158 million CDMA2000 units and 45 million WCDMA units were shipped worldwide in calendar 2005. Our estimate for the calendar year 2006 handset market has not changed. We continue to expect shipments of approximately 255 to 270 million units in calendar 2006, an increase of 26% to 33% over our midpoint estimate for calendar 2005. Based on the 262 million midpoint of this estimate for calendar 2006, we anticipate shipments of approximately 176 million CDMA2000 units and approximately 86 million WCDMA units. We are reaffirming our guidance for fiscal 2006 revenue and earnings per share. We expect fiscal 2006 revenues to be in the range of approximately $6.7 billion to $7.1 billion, an increase of 18% to 25% over fiscal 2005. Although we're seeing early signs of increased revenue strength in low-tier products, such strength is judged to be within our stated range of revenue estimates. We believe it is too early in the year to raise the midpoint of that revenue guidance. We anticipate pro forma diluted earnings per share to be in the range of $1.43 to $1.47, an increase of 23% to 27% year-over-year, inclusive of $0.02 dilution from the recent Berkana and Flarion acquisitions but excluding $0.01 of one-time in-process R&D charges related to these acquisitions. We estimate average selling prices for CDMA2000 and WCDMA phones combined will decrease 2% in fiscal 2006 to approximately $210 consistent with our prior guidance. We expect the combination of pro forma R&D and SG&A expense to increase approximately 22% to 27% year-over-year with the greater growth occurring in R&D as we continue to invest in the evolution of the CDMA2000 technology roadmap, WCDMA chip development, multimedia chip functionality, single chip low cost solutions, and longer-term technology enhancements including OFDMA. We anticipate our pro forma tax rate for fiscal 2006 to improve to approximately 26% compared to our prior estimate of 27%. Primarily as a result of increased foreign income taxed at lower rates. We estimate GAAP earnings per share will be approximately $1.19 to $1.23 for fiscal 2006. This estimate includes a loss of approximately $0.06 per share attributable to QSI, a loss of approximately $0. 20 per share for estimated non-cash share-based compensation, a gain of $0.03 per share attributable to tax benefits related to prior years, and a $0.01 loss attributable to in process R&D from completed acquisitions. Turning to the second quarter of 2006 we estimate revenues to be in the range of approximately $1.63 billion to $1.73 billion, a 19% to 27% increase year-over-year. We estimate second quarter pro forma diluted earnings per share to be approximately $0.35 to $0.37, a 21% to 28% increase year-over-year. This estimate includes shipments of approximately 44 million to 46 million MSM phone chips during the March quarter, a slight decrease sequentially, which is consistent with the seasonality we've often seen historically. We expect chip ASPs to decrease modestly as we sell proportionately more low-tier MSMs. We estimate that approximately 59 million to 61 million CDMA-based handsets shipped in the December quarter at an average selling price of approximately $209, driven by increased sequential shipments in multiple regions around the world notably WCDMA in Europe and Japan and CDMA2000 in the U.S and India. As of the end of December we estimate that channel inventories remain within the 15 to 20 week historical band. We anticipate second quarter pro forma R&D and SG&A expenses combined to increase sequentially approximately 10% to 13% driven by our continued investment in new products and service, the acquisitions of Flarion and Berkana, and second quarter seasonal expenses such as employee related payroll taxes. Our guidance for the fiscal year anticipates modestly lower earnings the second half as compared to the first half. Although we're at an early juncture of the fiscal year, at this time we anticipate continued R&D investment growth, including our acquisitions of Flarion and Berkana, and proportionately more growth in the low tier markets as CDMA continues to grow in lower income regions of the world. In closing, I see QUALCOMM and the broader CDMA market off to an excellent start for 2006. I'm pleased we've met or exceeded our fiscal first quarter guidance and reaffirmed our expectation for strong revenue and earnings growth in fiscal 2006 while continuing our growing investments to capture the significant opportunities we see ahead. That concludes my comments. I will now turn the call back over to Bill Davidson.
Bill Davidson, VP, IR: Thank you, Bill. Before we go into our question and answer session, I'd like to remind our participants that our goal is to address as many questions as possible before we run out of time on the call. Therefore I would like to ask our participants to limit their questions to one per caller. If you ask more than one question we will select the one to answer. Operator, we're ready for questions.
Operator: Ladies and gentleman, we will not begin the question and answer session. To queue a question press “*’ “1” to retract the question press “*” “2”, if you are using a speaker phone please pick up your handset before pressing the numbers, one moment please for the first question. Your first question comes from Mike Ounjian with Credit Suisse First Boston.
Q - Michael Ounjian: Great, thank you very much. Sanjay, could you, I know Bill said that MSM ASP should be down sequentially in the March quarter but could you speak a little more about what you -- we should expect in terms of trends? Is it similar to the 3% we saw this quarter? And if it's in that range, Bill, if you could expand on why we're seeing revenue guidance down as much as it is given a very small decrease in chipset shipments and a fairly healthy increase in handset shipments. Is there something else we're missing there in terms of the revenue guidance going into the March quarter?
A - Bill Keitel: Do you want me to go first, Sanjay. So, first on the revenue guidance, if you recall, we're expecting ASPs on worldwide phones to decrease to approximately $209. And then other than that, it's a sequential decline in MSM units as we typically see and a modest decline in the average ASP. Other than that there's nothing really abnormal, Mike.
A - Sanjay Jha: Mike, in terms of the ASP decline of the chipsets, there are two or three things going on. Typically, the first calendar quarter is seasonally the lowest quarter for our ASP over multiple previous years. Secondly, we have made a pretty dramatic move in our low end chipset pricing to drive the emerging marketplace, and that has had two effects. Clearly it affects ASP. And secondly, it's actually driven the demand quite dramatically higher in the MSM6000 RF CMOS chipset. So I think those are two factors that impact our ASP. In terms of the range, without being precise, it's a marginal decrease, single digit decrease in the ASP.
Operator: Your next question comes from the line of Ittai Kidron with CIBC.
Q - Ittai Kidron: Hi, guys, congratulations on a good quarter. Steve, can you give us a little bit more color and updates on where do you stand with royalty agreements with Chinese OEMs on TDS CDMA and with non-Chinese OEMs given that 3G is hopefully finally around the corner?
A - Steve Altman: Well, we have, I think we've announced previously we have a number of agreements with on the non-Chinese manufacture side with all the major manufacturers that cover TDS CDMA, cover WCDMA, cover CDMA2000. There are still agreements that will need to be entered into with respect to TDS CDMA and the Chinese manufacturers. Our position right now is we're continuing to kind of watch that market. It's not clear to us at this point how and when and to what extent TDS CDMA will be deployed in China although it certainly appears that it will have some share there. But at this point we do have TDS CDMA agreements. I think our portfolio has been recognized by many major manufacturers in that regard, but we still have some work to do on the TDS CDMA side with Chinese manufacturers.
Operator: Your next question comes from Christin Armacost with SG Cowen.
Q - Christin Armacost: I think you, Bill, I wanted to go back to your guidance about earnings in the second half of the year and wondered if there are any major changes well, first of all, why would the earnings in the second half of the year be lower than the first half? And are we looking at any changes in the assumptions for the QCT operating margins that were supposed to increase I think to a little over 30% exiting '06? Thank you.
A - Bill Keitel: Yes, first what the guidance back in November for QCT operating margin was in the mid 20 percentile, closer to 25% in fact. So that must have been an older data point, Christin. On second half what we're seeing at this early stage is we continue to expect to grow our resources here, primarily R&D resources. We'll have full quarter effects of the Flarion and Berkana acquisitions on board with their engineering teams, and then as well, we're expecting -- we are seeing a stronger, expecting a stronger shift proportionately to the lower tier markets as these you know the India's, the China's, et cetera, we expect to see some good growth into those markets.
Operator: Your next question comes from Hasan Imam with Thomas Weisel.
Q - Hasan Imam: Thank you. I just had basically a follow-up on Christin's question. I was wondering, Bill, if you could comment on the margin trajectory for '06? As you mentioned with 3G handset ASPs coming down, makeshift toward lower tier chipset are we likely to see gross margin pressures through the year, and then with OpEx up, operating margins are also likely to have a down trajectory, or will revenue growth be enough to compensate? Thanks.
A - Bill Keitel: Okay. Hasan, couple of perspectives there first, we are reiterating our guidance. We did a thorough, as usual, bottoms-up review, and we saw a few minor adjustments, as I said, some indications that revenue might be a little bit higher, but too early in the year to really count. And it was within our prior you know the revenue range we stated. So what I am seeing is a slightly lower tax rate, and a slightly lower gross margin relative to what I saw a couple months ago. But net-net, that's the view overall is holding well, our regional guidance you'll see is holding pretty much as we had previously stated it. So no surprise here on our end for what we're looking into the second half of the year just a bit proportionally more in the second half relative to the first half of the lower income regions of the world where the low end chipsets are more popular. As Steve indicated, we've got indications of $40 wholesale phones selling into India recently, and that chipset is lower revenue than and there's lower royalty than a phone that sells into at $300 wholesale into other areas of the world.
Operator: Your next question comes from Inder Singh with Prudential.
Q - Inder Singh: Yeah thanks very much. Bill, I just wanted to follow-up on that and ask about sort of how you view the price elasticity of WCDMA units and ASPs, particularly in some of the emerging markets where you're focusing and what that means for your revenue growth and your market share gains over the next year or two?
A - Bill Davidson: I'm very encouraged by that I think the elasticity will be strong. Hard to predict that elasticity quarter-to-quarter, but extend that out over a little longer period and I think that will be very favorable. It's been our strategy all along. We've certainly seen it in the CDMA2000 arena as well as, is very important, is the broad segmentation of handsets, so that operator has got the high, the mid, the low tier to sell into their customer base. So I'm very optimistic on that, and with these lower ASPs, I think it's going to quicken the interest of GSM operators elsewhere around the world to overlay a CDMA platform.
A - Paul Jacobs: As we bring the ASPs down, we also break into a new range of handset models. And so one of the things we're looking for is bringing the WCDMA pricing down so that the mid-tier phone is not a GSM only phone, but is actually a WCDMA/GSM phone and that will make a big difference in volumes.
Operator: Your next question comes from the line of Mark McCatchney with Twin Peaks Capital.
Q - Mark McCatchney: Great, thank you. Hopefully you can hear me, okay. I wanted to kind of just clarify your guidance for the second half of the year. Are you saying that EPS will be lower than the first half? Or are you saying that growth will be lower? Thank you.
A - Bill Keitel: We expect greater revenues in the second half of the year relative to the first half but with $0.39 pro forma first quarter, a midpoint estimate of $0.36 in the second quarter, that's $0.75. So if we execute on that, our full-year guidance is $1.43 to $1.47, is where one conclude that we're expecting a slightly lower second half earnings relative to the first half.
Operator: Your next question comes from Edward Snyder with Charter Equity.
Q - Edward Snyder: Thank you. In terms of wideband CDMA handsets worldwide you're seeing growth and I expect unit volumes are looking to double this year and we've heard Vodafone a couple of days ago talking about difficult competitive environment, prices are already dropping there, but it looks like they're having more difficulty than I guess they expected and seeing an uptake in the service. Is it just pricing that's going to be driving demand? Is that what your model looks for? Or is there some other metric like size or other features? Or what else can drive traction of handsets at this point?
A - Steve Altman: I think there's a couple of things that can do it. Clearly the price allows us to get into these other tiers as I talked about but we are starting to see the very slim style handsets coming out, so the fact that our advanced chipsets are enabling those kind of form factors I think will also cause consumers to move to 3G.
A - Paul Jacobs: I add to that, as we've always expected, that the operator economics are going to be very key to this, and thus far the reports we've been seeing from CDMA, WCDMA operators that are reporting it, we're seeing ARPU uplifts both on data and on voice. So long as they're getting that ARPU uplift I think it's going to be a very interesting market that they're going to want to push harder on. So that would be one and two is that, it's competition. It takes, doesn't take much more than one or two major operators in a given region of the world to see the success or the promise of that success push hard for it and then the others that may have been a little more hesitant will follow.
Operator: Your next question comes from Tim Long with Banc of America Securities.
Q - Tim Long: Thank you. Bill, if we could, I'd love to drill into that assumption of 59 million to 61 million phones in the quarter. I'd just love to get your sense of a confidence on that, understanding you guys changed from the accrual basis to the cash basis a few years ago, yet we still had two over the last three-quarters or so with a pretty big under-estimation. So my particular question relates to WCDMA where you don't have as high of market share as you do in CDMA. So if you could just give us a sense as to your confidence in that number and what type of swing factor could we see in it, what kind of royalty reports do you get, or monthly data do you get to that number, that would be helpful. Thanks.
A - Bill Keitel: Sure. So at this point, Tim, we have very few royalty reports we received, but there is quite an active exchange with our licensees as to what they've seen in the December quarter. Not all licensees but many of them. We've had that practice going on now for some time and we think we get pretty good visibility through that avenue. We like you are monitoring operator reports that they've been, generally been quite positive but we're a little cautious, as one operator reports a positive result that if there's another CDMA operator in that region, that hasn't yet reported, we'll tend to be a little cautious until we know what that other operator has reported so we have a better idea that it isn't just a share change. So a few more reports yet to come that I think are significant from operators around the world, and then in a couple months time we will have all the licensee reports in hand. But I would say at this point, Tim that the visibility on that 50 to 60, 59 million to 61 million is similar to where we were last quarter when we guided 52 to 53, I think was the number. With the one exception, it is a Christmas season, and so Christmas in some markets leads to a little more variability than otherwise I think at -- in that forecast. But all in all, I feel pretty good about it.
Operator: Your next question comes from Brian Modoff with Deutsche Bank.
Q - Brian Modoff: Yes, just one point of clarification and then a question on units. Isn't your guidance somewhat also a reflection of the fact that you had Christmas chip sales plus royalty collections in the front half of the year and you don't have those in the second half of the year? Then the question is, how many WCDMA units do you think shipped in the December quarter? Did we hit around that 44 million or 45 million unit number for the year? How comfortable are you with that?
A - Bill Keitel: Yes, Brian. Good point. On the royalty business, the royalty business for our fiscal year, it's a July through June period out in the market given our one quarter lag. To your point there, the seasonality of our royalty business is different than the seasonality in the chip business. On the WCDMA units, the reports we've seen thus far and estimates that licensees have shared with us, we feel pretty good about that 2005 WCDMA estimate of approximately 45 million units.
Operator: Your next question comes from Paul Sagawa with Sanford Bernstein.
Q - Paul Sagawa: Hi, it's really kind of a question for Sanjay. If I look at the WCDMA market going forward, a number of the biggest handset makers in the world seem to have sort of incumbent chipset suppliers and you are incumbent at a number of the major handset vendors as well. At this point how much likelihood is there for there to be share shifts with those big handset makers? What other switching costs are we looking at? What kind of discussions do you have with non customers, and how receptive are they to think about switching with any associated costs that come along with that? So as we think about going forward, what's the opportunity for that share shift to happen?
A - Sanjay Jha: Paul this is Sanjay. I think I've indicated a number of times that I believe that most non vertically integrated providers, and I would call Sony, Ericsson, and Nokia vertically integrated today. Most nonintegrated vertical handset providers are actually looking at multiple sources. We are quite entrenched I think today at Samsung and LG but I'm confident that they are evaluating all their options. But similarly I think that other handset manufacturers are also evaluating how to get second sources to get leverage. One on their primary source, but secondly to leverage any technology leadership that might exist elsewhere in the value chain. And I believe today, in HSDPA, in low cost, in HSUP and MBMS we have technology leadership so we feel comfortable that most folks are looking at our solution carefully and evaluating how they can take advantage of that. The second thing to think about in terms of our market share is, we certainly think that our customers today are growing their market share. If you look in fourth quarter, we had 48% quarter-over-quarter increase in our shipment, and I don't believe that overall markets grew by quite 48%. So we think in fourth quarter we increased our market share a little bit. When we have final numbers I think we'll have clarity on that, but I think with the customers that we have we're growing our market share, and I think with the technology leadership that we have we certainly make a very good argument to other OEMs to look at our solution carefully. We talk to all of them all of the time but nothing to report more specific than that at this point.
Operator: Your next question comes from Brantley Thompson with Goldman Sachs.
Q - Brantley Thompson: Hi. I was wondering if you could give us a little bit more color on the handset ASP forecast for fiscal year '06 or, you know, the sequential guidance you gave for 2.10. It was pretty much unchanged but at the same time there's a lot of rhetoric in the call about much bigger demand from the low-end phones and at the same time a lot of things that are very positive for 3G adoption could you just give -- those things seem incrementally new. Could you just talk about that in terms of that 3G versus low end balance and how we should think about how that might impact ASP going forward?
A - Bill Keitel: Sure. Brantley, it's Bill Keitel. I'll take a, maybe a stab here and then maybe some other people want to join in. At that 2.10, we do see the low end market accelerate at a good pace this year. But likewise, the feature content and the size of the mid to high-tier market we think is going to grow nicely. We're expecting continual growth each quarter here on WCDMA phones shipping as we progress through this year, and much a similar picture on the DO front. So with the North American market as an example, moving aggressively on to DO, HSDPA, one carrier is pushing pretty hard there, it's very robust market, I think, and the ARPUs are justifying it for the carriers. I think that there's good optimism. We'll start to see that in Europe this year, and certainly Japan is pushing very hard on that front, given how KDDI is doing so well on their DO platform. So I think it's a very robust high end market, and at the low end, yes, they are very feature-less phones, very voice centric, but I expect as we've seen in the last several years, as low end grows, the interest in more feature content, more capabilities in the phones has largely held the ASP on CDMA as a whole pretty constant.
A - Paul Jacobs: Even as we drive the low end phone, or the very low end phone, I should say, what a lot of the operators find is that that still isn't that huge a part of their market. They have to have that as a piece of the market, but then people tend to step up a bit to the next phone, so all of these initiatives that you've heard about on the GSM side at the very low end, the volumes really aren't as great as the rhetoric might make it appear. The other point is that, to amplify Bill, the high end prices can be as much as 10X, the very low end price. So as we see growth in these upper ends, that provides a nice trend for us on ASPs.
Operator: Your next question comes from the line of John Bucher with Harris Nesbitt.
Q - John Bucher: Thank you. A question for Paul, some of the comments he made on standards efforts, and seeing if there's any correlation with some of the EC complaints. I'm wondering if you're seeing any indication that QUALCOMM might be become less influential in some of these standardization efforts since you're dealing with so many different standards bodies that are not necessarily TOCO centric in trying to bring your innovations to market as you look at your long-term technology roadmap?
A - Paul Jacobs: Yes, I actually think the opposite is true. I think we're actually becoming more influential in a number of these other you know we talked about the IEEE standards bodies having a couple of nice milestones passed there. And I think it's because of this partnering strategy that we're on to reach out more broadly than just the telecommunications industry. So, for example, the IEEE 802.11n stuff was driven in large part by consumer electronics manufacturers who want to ship multimedia around the house, they want multiple HD streams of video, and they see that our enhancements made that possible. So I think it really is reaching out to a lot of partners more broadly, people who are outside of some of these, I don't know, battles that we're going through again. That's actually helping us have more influence. And then within the telecom industry, like I said, we really are doing a lot to lead the development of the follow-on generations on both the CDMA2000 and the WCDMA path. And I think the technical excellence is helping. And we're making our way into the community better. We have a guy on the SE Board now as an example so I actually think that's tending to improve over time.
A - Steve Altman: I would add to that, that we also have, I think, economic incentives from the standpoint as we pointed out, we have a well established CDMA licensing program, and as Paul clarified, when we, when additional technology that we contribute are added in the CDMA multimode environment, their license to our existing licensees at our standard rates. So there's no incremental royalty to those licensees by incorporating new technologies that we propose.
Operator: Ladies and gentlemen, we have reached the allotted time for questions and answers. Dr. Jacobs, do you have any closing remarks before we adjourn the call today?
Paul Jacobs, CEO: Yes, I'm very happy by the CDMA2000 growth that we're seeing, both at the high and mid-tier in the developed market and at the low end in the developing markets. I am also very happy to see WCDMA continues to grow, and Europe is doing very well, and that was an area where people had some question. We talked about a number of new technology initiatives. We're making great progress there. We're passing milestones, we're getting progress and standardization across those. So that's going well as well. And like I said, I've been doing a lot of visiting with customers, and I find that the reception of customers, to the contrary of what some of the rhetoric might make you think, the reception by our customers is very warm, and they see the benefits we bring. They're very excited to work with us to help us, or us to help them get their networks up and running, and optimize those networks and start to generate revenue. So I feel like our business model is working extremely well to drive 3G. We're excited about the opportunities ahead of us. And thanks, everybody, for joining us today.
Operator: Ladies and gentlemen, this does conclude our QUALCOMM First Quarter Conference Call. You may now disconnect. | [
{
"speaker": "Executives",
"text": "Bill Davidson, VP, IR Paul Jacobs, Chief Executive Officer Steve Altman, President Sanjay Jha, EVP, President, CDMA Technologies Group Bill Keitel, EVP, Chief Financial Officer"
},
{
"speaker": "Analysts",
"text": "Michael Ounjian, Credit Suisse First Boston Ittai Kidron, CIBC Christin Armacost, SG Cowen Hasan Imam, Thomas Weisel Partners Inder Singh, Prudential Securities Mark McCatchney (ph), Twin Peaks Capital Edward Snyder, Charter Equity Research Tim Long, Banc of America Securities Brian Modoff, Deutsche Bank Paul Sagawa, Sanford C. Bernstein Brantley Thompson, Goldman Sachs John Bucher, Harris Nesbitt"
},
{
"speaker": "Operator",
"text": "Thank you for standing by. Welcome to the QUALCOMM First Quarter Conference Call. At this time all participants are in a listen-only mode. Later we will conduct a question and answer session. If you have a question, you’ll need to press “*” “1” on your telephone keypad. As a reminder this conference is being recorded today, January 25, 2006. The playback number for today's call is 800-642-1687, international callers please dial 706-645-9291. The playback reservation number is 4046245. I would now like to turn the call over to Mr. Bill Davidson, Vice President of Investor Relations. Bill, please go ahead, sir."
},
{
"speaker": "Bill Davidson, VP, IR",
"text": "Thank you and good afternoon. Today's call will include prepared remarks by Dr. Paul Jacobs, who is joining us remotely from the World Economic Forum; Steve Altman; Dr Sanjay Jha; and Bill Keitel. An Internet presentation and audio broadcast accompanies this call and you can access it by visiting www.qualcomm.com. During this conference call, if we use any non-GAAP financial measures as defined by the SEC in Regulation-G, you can find the required reconciliations to GAAP on our website. I would also direct you to our 10-Q and earnings release which were filed and furnished respectively with the SEC today and are available on our website. As a reminder the QUALCOMM Investor Relations website includes a thorough presentation on the many data points included in this conference call. We may make forward-looking statements relating to our expectations and other future events that may differ materially from QUALCOMM's actual results. Please review our SEC filings for a detailed presentation of each of our businesses and associated risks and other important factors that may cause our actual results to differ from these forward-looking statements. Pro forma revenues were $1.74 billion in the first fiscal quarter, up 25% year-over-year and 12% sequentially. First quarter pro forma net income was $667 million, up 41% year-over-year and 23% sequentially. Pro forma diluted earnings per share were $0.39, up 39% year-over-year and 22% sequentially. First fiscal quarter pro forma free cash flow defined as net cash from operating activities less capital expenditures was $531 million, up 93% year-over-year and was 30% of revenue. Now it's my pleasure to introduce QUALCOMM's CEO, Dr. Paul Jacobs."
},
{
"speaker": "Paul Jacobs, CEO",
"text": "Thank you Bill, and good afternoon everyone. I am pleased to report that we started the new fiscal year with record first quarter revenue led by strong demand for our chips. We reaffirmed our fiscal 2006 guidance, which reflects an acceleration of the CDMA market, which in turn is driving our financial projections for the year. I've been spending a lot of time on the road talking to our operator and manufacturer partners. We've been discussing our business model and the positive impacts on the industry from the healthy and competitive worldwide wireless marketplace that our business model fosters. We work closely with many wireless equipment manufacturers in all parts of the world to promote the adoption of 3G, partially because of the large number and variety of companies that we've licensed that we enable with advanced and feature-rich chipsets and software, prices for handsets and other wireless devices continue to decrease while features and functionality continue to increase. We continue to invest significantly in R&D to drive this dynamic and to build a leadership position in the wireless industry. Our inventions enable new revenue streams for all our partners, enabling continuing investments throughout the wireless value chain. Our licensing model helps to limit royalty stacking on CDMA products, thereby reducing prices for the wireless consumer. For example, QUALCOMM has not increased its royalty rate as new technologies using QUALCOMM's patents are developed and commercialized. The cumulative number of QUALCOMM's inventions has grown substantially over the years but our royalty rate has remained the same. The resulting innovations are made available through our licensing agreement as unlike many other companies, we broadly license not only our essential patents but generally all of our patents. In addition, many of our license agreements include extremely valuable pass-through rights from which our customers of our QUALCOMM chipsets can benefit. In November, we announced DMMX, DO multicarrier, multilink extensions, our platform for driving the EV-DO roadmap through the end of the decade. Part of our DMMX strategy is to be the leader in supporting standards based enhancements to EV-DO technology, namely revision A and revision B. At the same time, we intend to be the leader in implementing other enhancements that significantly improve system performance but don't require changes to the standards. The revisions will open the door to mobile Voice over Internet Protocol services and very low latency applications such as push to talk via DMMX, phones will operate in a concurrent multilink manner with multiple radio technologies while simultaneously receiving at multiple frequencies. MediaFLO is a good example of DMMX because audio and video transmissions over EV-DO cellular networks are seamlessly combined with transmissions received using the FLO technology, which operates in separate spectrum. The goal is to enable operator partners to provide a superior multimedia experience at the lowest possible cost. Similarly, on the WCDMA side of 3G we're driving the roadmap via HMMX HSDPA multicarrier, multilink extensions. We continue to transfer what we learned on the CDMA2000 roadmap to support our WCDMA customers and partners, providing them with products that support higher data rates through our HSDPA and HSUPA solutions. Through these, operators are able to provide their customers enhanced multimedia and IP-based data capabilities including multicasting."
},
{
"speaker": "indiscernible",
"text": "QCT continues to be unmatched in execution on their product roadmaps. The same strategies of integration, on-time delivery and technical leadership that we established in CDMA2000 are driving our success in WCDMA. Over the past quarter we announced a new entry level WCDMA chipset and we reinforced our leadership standing in HSDPA technology with the sampling of an HSDPA solution towards data rates of up to 7.2 megabits per second, surpassing the speeds of many wired broadband connections. We've worked closely with numerous industry partners to help lead the rollout of 3G UMTS networks and commercialization of devices. Our WCDMA roadmap now includes solution for all market tiers from low end to highly advanced, features the integration of multimedia capabilities and will help drive the adoption of 3G technology. Our integration strategy delivers significant benefits to device manufacturers and enables the slim form factors for WCDMA devices that are in great demand by wireless users. I also believe there's a strong growth opportunity in developing markets and we're focused on providing very low-end CDMA2000 solutions. We work closely with our partners to hit exceptionally competitive price points and bring the benefits of CDMA technology to the world's next billion wireless subscribers. We believe that CDMA technology provides significant advantages to emerging markets because subscribers can use their low-end handset for data services as well as voice calls and SMS, advantages that positively impact local economies and bridge digital divides. Our goal is to bring these benefits to all developing markets. In December 2005, we announced plans to work with Verizon wireless to bring its customers real-time mobile video over the MediaFLO multicasting network in the United States. Verizon wireless intends to be the first service provider to use the MediaFLO USA network to deliver mobile TV services once the network begins planned commercial operation. Specific timing of service launches will of course be determined by the wireless operators but we continue to make excellent progress towards commercialization of MediaFLO. In January 2006 we connected live over the air demonstrations of FLO technology with LG Electronics and Samsung Electronics during the 2006 International Consumer Electronics show in Las Vegas. The demonstrations were the first featuring FLO technology on handsets from major device manufacturers. Great strides have also been made in achieving the global standardization of FLO technology. This past quarter the FLO Forum, an organization of 25 member companies which is driving the standardization efforts of FLO technology ratified the FLO air interface specifications and submitted it as a contribution for standardization to the telecommunications industry and sub-committee ER-47.1. Last call I made the point that QUALCOMM is more than a CDMA company. MediaFLO is one aspect of our diversification. The recent closure of the Flarion acquisition enhances QUALCOMMs strong position in OFDMA and demonstrates our commitment to add to our intellectual property portfolio through both internal R&D and acquisitions. Intellectual property is available to our existing licensees for use in CDMA multimode equipment without an increase to standard CDMA royalty rates. While CDMA remains the optimal technology to provide broadband spectro efficient mobile wide area wireless networks for the foreseeable future, both DMAs low complexity at wide signal bandwidth makes it a potential alternative where large blocks of spectrum can be dedicated. Beyond the Flarion acquisition we've been working in the IEEE working group 802.20 traditionally confirmed a draft specification for the next generation of mobile broadband wireless access. This draft specification will now enter the 802.20 ballot process. 802.20 draft specifications consist of frequency division duplex and time division duplex components that can be deployed in bandwidths up to 20 megahertz. The bandwidth can flexibly be adjusted based on available spectrum. The draft specification leverages the technical strength of CDMA and OFDMA by using OFDMA on the forward link and a combination of CDMA and OFDMA on the reverse link. These techniques increase the coverage, capacity, and hope to maintain the quality of service for wireless systems. We believe that this solution significantly exceeds capabilities of other proposed systems. Turning to wireless LAN, IEEE or 802.11n confirmed to draft specification for the next generation of wireless LAN with QUALCOMM's active involvement. Our leading edge MIMO transmit beam forming and link adaptation technologies have been included in the draft specification. These technologies greatly improve the range, data rates, and performance stability of wireless LAN which we've demonstrated at QUALCOMMs research center in New England. The 802.11n standard should deliver nearly four times performance of existing 802.11g networks and will be instrumental in supporting the digital wireless home and office of the future. The announcement of our Scorpion processor at the end of last year supports the market's next generation of data centric devices based upon the proven ARM architecture. Scorpion's processing power enables mobile handsets to feature many of the capabilities only found on personal computers. This is done in combination with significantly reduced power demands in order to ensure adequate battery life for wireless devices. I'm very pleased that we are executing well financially and that our results for the first quarter ended a bit higher than we had originally guided at the outset of the quarter, and we continue to be excited by the opportunities ahead of us. I'd like to now turn the call over to Steve Altman."
},
{
"speaker": "Steve Altman, President",
"text": "Thanks Paul and good afternoon everyone. I'm going to start by highlighting some important facts and trends that we're seeing in CDMA2000 and WCDMA around the world. Over the past decade QUALCOMMs licensees have commercialized more than 1,000 CDMA phone models. Today there are approximately 50 manufacturers supplying CDMA2000 devices at a wide variety of prices ranging from the very high end to the very low end. In the low end we now have at least three licensees that have supplied at manufacturer prices below $50. We're also aware of manufacturer prices being quoted for CDMA2000 handsets in the Indian market of approximately $40. We believe that all price tiers of handsets are important to help grow our business and we will therefore continue to work closely with our customers to help allow all of these different tiers to remain competitive. We also continue to see quite healthy growth in WCDMA. Based on royalty reports received in the December quarter of 2005 our shipments in the September quarter of 2005 there was 24% volume growth quarter-over-quarter in shipments of WCDMA units mainly due to 51% growth in Europe based on these reports the number of manufacturers selling WCDMA devices increased quarter-over-quarter to 17 from 13. And we are now seeing a wide range of competitive handsets being made available. As the WCDMA market grows, as increased price competition occurs, and as a wider variety of high, middle, and lower end handsets become available from more of our licensees entering the WCDMA market we have seen and expect to continue to see the rapid decline of the ASP for WCDMA devices as well as a broadening of the range between the highest and lowest prices. We now estimate that the world ASP, the worldwide ASP for WCDMA devices to be $372, which represents a decline of approximately 10% quarter-over-quarter. At our London analyst conference, we shared with you the lowest wholesale pricing, we have seen for WCDMA handsets in quantities of approximately 50,000 units. We now estimate that this WCDMA low end pricing dropped from $217 in the September quarter of 2005 to $141 for the December quarter. As I'm sure you noted we for the first time provided you with specific ASP information for WCDMA. Although I think you may find this information is interesting, it is important to understand that particularly at this early stage of WCDMA deployment a number of factors can significantly impact WCDMA ASPs, including the geographic mix of the sales, as well as the shifting market shares amongst the various manufacturers, because as you might expect some manufacturers are charging significantly higher prices for their WCDMA devices than other manufacturers. Now let me briefly discuss some of our other markets around the world. In India, the CDMA subscriber base reached 25.1 million units resulting in approximately 30% market share for CDMA. 32 CDMA based devices were launched in December quarter. We expect continued growth in this market with continued emphasis on the low cost handset. In China, you may have seen a number of articles surfacing recently related to third-generation wireless licenses. We no longer speculate on when these 3G licenses will be issued. Once these licenses are issued, however, we believe that China will rapidly deploy CDMA 3G products increasing overall volumes and decreasing ASPs, and we believe that our licensed Chinese manufacturers as well as other licensees will participate in a major way. In Europe we continue to be encouraged by the rollout of WCDMA services. Paul, Sanjay, and I have met with a number of the European operators. They all appear to be very committed to WCDMA and we expect volumes to continue to ramp as ASPs decrease and the number and variety of available handsets increase. We have allocated significant resources to Europe and have received a very warm reception from the operators. As we have and continue to do with CDMA2000 operators we are working with many of the European operators hand-in-hand to help them optimize their WCDMA networks and services. We remain committed to working closely with European operators during their ongoing WCDMA and HSDPA network deployments. In North America, Japan, and Korea, we continue to see increased demand for EV-DO products. Although neither Sprint, Nextel and Verizon have yet announced their results for the December quarter, Verizon wireless recently announced fourth quarter 2005 net wireless customer additions of two million – and industry record to-date. Verizon has also stated that they're continuing to see increased data ARPU and continue to achieve record low churn. Samsung, Kyocera, and Motorola as well as other manufacturers have announced new handsets supporting EV-DO networks in these regions. In the U.S Cingular, announced Cingular Broadband Connect based on HSDPA technology. We are extremely pleased that our chipset customers were able to support this launch as QCT was first to market with a solution for HSDPA. NTT DoCoMo reported strong 3G subscriber figures for December with net adds of 1 5 million up 53% month-over-month. KDDI also posted strong net adds in December and finished the year over 21.5 million subscribers, of which 6.75 million are DO. Turning to QTL, in the first quarter of 2006, three new licensees entered into CDMA subscriber equipment license agreements. One of the three agreements was with a WCDMA licensing in China bringing the total number of WCDMA agreements with Chinese manufacturers to 7 all at our standard worldwide royalty rates. Finally, let me briefly update you on the complaints that were filed against us by six companies with the European Commission. Of the six complaints that were filed we up to date received a redacted version of just one of the complaints. We continue to believe the allegations contained in the complaint are without merit. We have not yet received the other complaints. As to the investigation by the EC, its status is confidential and there's little further that we can say at this time. We have and we’ll continue to cooperate with the EC to explain and demonstrate that all of QUALCOMM's activities are lawful and in fact foster healthy competition. Although we see articles or press releases from time-to-time attempting to attribute the higher ASPs of WCDMA devices to QUALCOMM's licensing terms or alleging that WCDMA is rolling out slowly as a result of IPR costs we see no evidence of any of this being true, and in fact believe the opposite is true. Our licensing program has fostered healthy competition amongst the WCDMA handset suppliers leading to the rapid declines in ASPs mentioned earlier. Royalties paid to us by our licensees are very small component of the cost and price of the handset. As I mentioned earlier WCDMA handset ASPs are coming down rapidly, primarily driven by our chipset customers who benefit not only from our intellectual property licenses and past due rights, but also our competitive chipsets and software. For example, in Europe where a complaint has been filed alleging that QUALCOMM's activities are responsible for higher WCDMA handset ASPs we estimate that the ASP of WCDMA handsets sold by licensees using our chip is, are substantially lower than the ASP of WCDMA handsets sold by licensees that do not use our chip. We are seeing strong growth in volumes of WCDMA handsets and WCDMA handset ASPs will continue to decline as volumes continue to increase. I'd now like the turn the call over to Sanjay Jha."
},
{
"speaker": "Sanjay Jha, EVP, President",
"text": "Good afternoon. I'd like to go over some key highlights of the QCT business. This was a record setting quarter for QCT in terms of shipments, revenues, and profit. We shipped approximately 47 million MSM to our customers around the world, had quarterly revenues of more than $1 billion and record operating profit of more than $300 million. In comparison, we shipped approximately 39 million MSM units in the first quarter of fiscal 2005 and 40 million units last quarter. In the first quarter of fiscal 2005 our quarterly revenues were $865 million and our operating profit was $242 million. ASP this quarter was down approximately 3% from the previous quarter, primarily due to normal price erosion combined with an increase in the shipment of our lower tier chipsets. As Steve and Paul mentioned we have been focused on meeting the needs of cost sensitive subscribers and enabling the growth of emerging CDMA markets like India, Latin America, Southeast Asia, and China. QCT has worked hard enabling our partners to be more competitive in cost sensitive markets with our 6000 -- MSM6000 and RF CMOS based handsets. We have hit highly aggressive price points driving volume and enabling competitive entry-level handsets in these emerging markets. As a result we saw a significant increase in the demand of our MSM6000 chipset as a growing number of subscriber select CDMA solutions to meet their communication needs and we anticipate that this trend will continue in following quarters. We have seen increasing traction of our EV-DO portfolio. We now count 154 devices commercially available with 56 of them having launched in the past quarter and an additional 65 handsets in design. All based on our multimedia rich MSM6500 and MSM 6550 solutions for EV-DO networks. We experienced 128% increase in shipment of these chipsets during the quarter compared to the same quarter last year. With more than 30 customers who have 120 handsets either in design or commercially available based on our UMTS and HSDPA products we've been actively contributing to wideband CDMA and HSDPA network deployments around the world. For example we supported the world's first HSDPA rollout launched by Cingular wireless by working with leading device manufacturers to develop and validate multiple mobile devices based on our MSM6275 chipset. QCT saw 48% growth in UMTS MSM shipment versus the previous quarter. This follows two successive quarters, which grew by 120 and 41% respectively in our UMTS chipset shipment. QCT is the first to market with solutions for HSDPA and we have continued to make great progress in this area. We sampled our second-generation MSM6280 HSDPA solution and we're the first to achieve data rates of 2.6 megabits per second using MSM6280 based terminals in cooperation with numerous industry partners. Data cards and embedded modules are an increasingly important segment of our business and we have seen significant success in this market. QCT has had several customers announcing the commercial launch of numerous data cards and embedded modules based on our MSM solutions over the past quarter. We are on track to sample the first 65-nanometer MSM6245 chipset for entry-level wideband CDMA markets in the second quarter of 2006. We are aggressively migrating our roadmap to 65-nanometer process technology to enable cost competitive ultra thin form factor handsets in demand by wireless users today. We're also on track to sample the convergence platform, MSM7200 for HSUPA and MBMS networks in this upcoming quarter, extending our leadership in the next evolution of UMTS. Our acquisition of Berkana Wireless, a fabulous semiconductor provider of CMOS RFICs expanded our RF capabilities and reinforces our leadership in this area. The addition of their RF CMOS IP design portfolio and engineering experience will help us bring new integrated advanced RF CMOS products to market faster. Thank you. I'll now turn the call over to Bill Keitel."
},
{
"speaker": "Bill Keitel, EVP, CFO",
"text": "Thank you, Sanjay, and good afternoon, everyone. We are very pleased to report record revenues and earnings per share again this quarter driven by continued growth in demand for CDMA based products and services around the globe. Consistent with our prior practice we continue to provide both GAAP and pro forma financial results. Our pro forma results exclude the QUALCOMM Strategic Initiatives or QSI segment, tax gains related to prior years and with the advent of stock option expensing non-cash stock option expenses. We believe pro forma results provide investors with meaningful information about the Company's ongoing core operating businesses and are useful in evaluating performance on a basis that is consistent, comparable with prior periods. I'll now highlight a number of key items in our first quarter fiscal 2006 results. First, GAAP earnings for the first quarter fiscal 2006 were $0.36 per share, including $0.05 in estimated stock option expense, $0.03 in tax gains related to prior years, and $0.01 loss attributable to QSI. Revenues increased 25% year-over-year to $1.7 billion, and pro forma earnings per share increased 39% year-over-year $0.39 per share. Second. Our business model continues to generate strong cash flow. Operating cash flow was $596 million for the first fiscal quarter up 50% year-over-year. Pro forma free cash flow was $531 million, up 93% year-over-year. Cash flows are the primary driver of long-term shareholder value and are unchanged with the advent of a theoretical stock option expense. During the quarter we announced dividends totaling $148 million or $0.09 per share, which were paid on January 4, 2006. Third, our tax rate for total QUALCOMM was 16% for the quarter. Lower than our prior estimate as a result of tax audits completed during the quarter. Our pro forma tax rate for the quarter was 26% consistent with our estimated 2006 full year rate. Fourth, QCT had record revenues in MSM shipments during the quarter. Revenues increased 19% year-over-year to $1.03 billion on the strength of 47 million MSM shipped a 22% increase year-over-year. QCTs operating margin was 29% unchanged quarter-over-quarter as we continue to grow R&D investments in new chip development. Chip ASPs decreased sequentially driven by some product mix shift to lower tier MSMs in the quarter as well as planned price erosion. Fifth, QTL earned record revenues of $564 million this quarter as licensees reported approximately 52 million new handset units shipped with an average selling price of approximately $215 per handset. As you recall these shipments occurred in the September quarter and were reported to us by our licensees in the December quarter. The licensees reports are the basis of our royalty revenue recognition. Unit shipments of these new handsets appear to have been notably strong in North America, Europe, and Japan during the September quarter. WCDMA average wholesale handset prices continued to decrease at a rapid pace and the range of prices continues to increase. Consistent with our expectation and encouraging for future unit growth. ASPs for WCDMA handsets decreased approximately 10% from the prior quarter with wholesale price points as low as $120 for low-end models. Of the $564 million in total QTL revenue $39 million represented intersegment royalties $11 million were license fees and $514 million were royalties from third-party licensees. WCDMA royalties were approximately 40% of third party royalties reported this quarter and QTLs operating margin was 91%. Turning to our guidance, for the calendar 2005 CDMA market, we now estimate that shipments were approximately 202 to 204 million new handsets. Based on the 203 million midpoint of this estimate we anticipate approximately 158 million CDMA2000 units and 45 million WCDMA units were shipped worldwide in calendar 2005. Our estimate for the calendar year 2006 handset market has not changed. We continue to expect shipments of approximately 255 to 270 million units in calendar 2006, an increase of 26% to 33% over our midpoint estimate for calendar 2005. Based on the 262 million midpoint of this estimate for calendar 2006, we anticipate shipments of approximately 176 million CDMA2000 units and approximately 86 million WCDMA units. We are reaffirming our guidance for fiscal 2006 revenue and earnings per share. We expect fiscal 2006 revenues to be in the range of approximately $6.7 billion to $7.1 billion, an increase of 18% to 25% over fiscal 2005. Although we're seeing early signs of increased revenue strength in low-tier products, such strength is judged to be within our stated range of revenue estimates. We believe it is too early in the year to raise the midpoint of that revenue guidance. We anticipate pro forma diluted earnings per share to be in the range of $1.43 to $1.47, an increase of 23% to 27% year-over-year, inclusive of $0.02 dilution from the recent Berkana and Flarion acquisitions but excluding $0.01 of one-time in-process R&D charges related to these acquisitions. We estimate average selling prices for CDMA2000 and WCDMA phones combined will decrease 2% in fiscal 2006 to approximately $210 consistent with our prior guidance. We expect the combination of pro forma R&D and SG&A expense to increase approximately 22% to 27% year-over-year with the greater growth occurring in R&D as we continue to invest in the evolution of the CDMA2000 technology roadmap, WCDMA chip development, multimedia chip functionality, single chip low cost solutions, and longer-term technology enhancements including OFDMA. We anticipate our pro forma tax rate for fiscal 2006 to improve to approximately 26% compared to our prior estimate of 27%. Primarily as a result of increased foreign income taxed at lower rates. We estimate GAAP earnings per share will be approximately $1.19 to $1.23 for fiscal 2006. This estimate includes a loss of approximately $0.06 per share attributable to QSI, a loss of approximately $0. 20 per share for estimated non-cash share-based compensation, a gain of $0.03 per share attributable to tax benefits related to prior years, and a $0.01 loss attributable to in process R&D from completed acquisitions. Turning to the second quarter of 2006 we estimate revenues to be in the range of approximately $1.63 billion to $1.73 billion, a 19% to 27% increase year-over-year. We estimate second quarter pro forma diluted earnings per share to be approximately $0.35 to $0.37, a 21% to 28% increase year-over-year. This estimate includes shipments of approximately 44 million to 46 million MSM phone chips during the March quarter, a slight decrease sequentially, which is consistent with the seasonality we've often seen historically. We expect chip ASPs to decrease modestly as we sell proportionately more low-tier MSMs. We estimate that approximately 59 million to 61 million CDMA-based handsets shipped in the December quarter at an average selling price of approximately $209, driven by increased sequential shipments in multiple regions around the world notably WCDMA in Europe and Japan and CDMA2000 in the U.S and India. As of the end of December we estimate that channel inventories remain within the 15 to 20 week historical band. We anticipate second quarter pro forma R&D and SG&A expenses combined to increase sequentially approximately 10% to 13% driven by our continued investment in new products and service, the acquisitions of Flarion and Berkana, and second quarter seasonal expenses such as employee related payroll taxes. Our guidance for the fiscal year anticipates modestly lower earnings the second half as compared to the first half. Although we're at an early juncture of the fiscal year, at this time we anticipate continued R&D investment growth, including our acquisitions of Flarion and Berkana, and proportionately more growth in the low tier markets as CDMA continues to grow in lower income regions of the world. In closing, I see QUALCOMM and the broader CDMA market off to an excellent start for 2006. I'm pleased we've met or exceeded our fiscal first quarter guidance and reaffirmed our expectation for strong revenue and earnings growth in fiscal 2006 while continuing our growing investments to capture the significant opportunities we see ahead. That concludes my comments. I will now turn the call back over to Bill Davidson."
},
{
"speaker": "Bill Davidson, VP, IR",
"text": "Thank you, Bill. Before we go into our question and answer session, I'd like to remind our participants that our goal is to address as many questions as possible before we run out of time on the call. Therefore I would like to ask our participants to limit their questions to one per caller. If you ask more than one question we will select the one to answer. Operator, we're ready for questions."
},
{
"speaker": "Operator",
"text": "Ladies and gentleman, we will not begin the question and answer session. To queue a question press “*’ “1” to retract the question press “*” “2”, if you are using a speaker phone please pick up your handset before pressing the numbers, one moment please for the first question. Your first question comes from Mike Ounjian with Credit Suisse First Boston."
},
{
"speaker": "Q - Michael Ounjian",
"text": "Great, thank you very much. Sanjay, could you, I know Bill said that MSM ASP should be down sequentially in the March quarter but could you speak a little more about what you -- we should expect in terms of trends? Is it similar to the 3% we saw this quarter? And if it's in that range, Bill, if you could expand on why we're seeing revenue guidance down as much as it is given a very small decrease in chipset shipments and a fairly healthy increase in handset shipments. Is there something else we're missing there in terms of the revenue guidance going into the March quarter?"
},
{
"speaker": "A - Bill Keitel",
"text": "Do you want me to go first, Sanjay. So, first on the revenue guidance, if you recall, we're expecting ASPs on worldwide phones to decrease to approximately $209. And then other than that, it's a sequential decline in MSM units as we typically see and a modest decline in the average ASP. Other than that there's nothing really abnormal, Mike."
},
{
"speaker": "A - Sanjay Jha",
"text": "Mike, in terms of the ASP decline of the chipsets, there are two or three things going on. Typically, the first calendar quarter is seasonally the lowest quarter for our ASP over multiple previous years. Secondly, we have made a pretty dramatic move in our low end chipset pricing to drive the emerging marketplace, and that has had two effects. Clearly it affects ASP. And secondly, it's actually driven the demand quite dramatically higher in the MSM6000 RF CMOS chipset. So I think those are two factors that impact our ASP. In terms of the range, without being precise, it's a marginal decrease, single digit decrease in the ASP."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ittai Kidron with CIBC."
},
{
"speaker": "Q - Ittai Kidron",
"text": "Hi, guys, congratulations on a good quarter. Steve, can you give us a little bit more color and updates on where do you stand with royalty agreements with Chinese OEMs on TDS CDMA and with non-Chinese OEMs given that 3G is hopefully finally around the corner?"
},
{
"speaker": "A - Steve Altman",
"text": "Well, we have, I think we've announced previously we have a number of agreements with on the non-Chinese manufacture side with all the major manufacturers that cover TDS CDMA, cover WCDMA, cover CDMA2000. There are still agreements that will need to be entered into with respect to TDS CDMA and the Chinese manufacturers. Our position right now is we're continuing to kind of watch that market. It's not clear to us at this point how and when and to what extent TDS CDMA will be deployed in China although it certainly appears that it will have some share there. But at this point we do have TDS CDMA agreements. I think our portfolio has been recognized by many major manufacturers in that regard, but we still have some work to do on the TDS CDMA side with Chinese manufacturers."
},
{
"speaker": "Operator",
"text": "Your next question comes from Christin Armacost with SG Cowen."
},
{
"speaker": "Q - Christin Armacost",
"text": "I think you, Bill, I wanted to go back to your guidance about earnings in the second half of the year and wondered if there are any major changes well, first of all, why would the earnings in the second half of the year be lower than the first half? And are we looking at any changes in the assumptions for the QCT operating margins that were supposed to increase I think to a little over 30% exiting '06? Thank you."
},
{
"speaker": "A - Bill Keitel",
"text": "Yes, first what the guidance back in November for QCT operating margin was in the mid 20 percentile, closer to 25% in fact. So that must have been an older data point, Christin. On second half what we're seeing at this early stage is we continue to expect to grow our resources here, primarily R&D resources. We'll have full quarter effects of the Flarion and Berkana acquisitions on board with their engineering teams, and then as well, we're expecting -- we are seeing a stronger, expecting a stronger shift proportionately to the lower tier markets as these you know the India's, the China's, et cetera, we expect to see some good growth into those markets."
},
{
"speaker": "Operator",
"text": "Your next question comes from Hasan Imam with Thomas Weisel."
},
{
"speaker": "Q - Hasan Imam",
"text": "Thank you. I just had basically a follow-up on Christin's question. I was wondering, Bill, if you could comment on the margin trajectory for '06? As you mentioned with 3G handset ASPs coming down, makeshift toward lower tier chipset are we likely to see gross margin pressures through the year, and then with OpEx up, operating margins are also likely to have a down trajectory, or will revenue growth be enough to compensate? Thanks."
},
{
"speaker": "A - Bill Keitel",
"text": "Okay. Hasan, couple of perspectives there first, we are reiterating our guidance. We did a thorough, as usual, bottoms-up review, and we saw a few minor adjustments, as I said, some indications that revenue might be a little bit higher, but too early in the year to really count. And it was within our prior you know the revenue range we stated. So what I am seeing is a slightly lower tax rate, and a slightly lower gross margin relative to what I saw a couple months ago. But net-net, that's the view overall is holding well, our regional guidance you'll see is holding pretty much as we had previously stated it. So no surprise here on our end for what we're looking into the second half of the year just a bit proportionally more in the second half relative to the first half of the lower income regions of the world where the low end chipsets are more popular. As Steve indicated, we've got indications of $40 wholesale phones selling into India recently, and that chipset is lower revenue than and there's lower royalty than a phone that sells into at $300 wholesale into other areas of the world."
},
{
"speaker": "Operator",
"text": "Your next question comes from Inder Singh with Prudential."
},
{
"speaker": "Q - Inder Singh",
"text": "Yeah thanks very much. Bill, I just wanted to follow-up on that and ask about sort of how you view the price elasticity of WCDMA units and ASPs, particularly in some of the emerging markets where you're focusing and what that means for your revenue growth and your market share gains over the next year or two?"
},
{
"speaker": "A - Bill Davidson",
"text": "I'm very encouraged by that I think the elasticity will be strong. Hard to predict that elasticity quarter-to-quarter, but extend that out over a little longer period and I think that will be very favorable. It's been our strategy all along. We've certainly seen it in the CDMA2000 arena as well as, is very important, is the broad segmentation of handsets, so that operator has got the high, the mid, the low tier to sell into their customer base. So I'm very optimistic on that, and with these lower ASPs, I think it's going to quicken the interest of GSM operators elsewhere around the world to overlay a CDMA platform."
},
{
"speaker": "A - Paul Jacobs",
"text": "As we bring the ASPs down, we also break into a new range of handset models. And so one of the things we're looking for is bringing the WCDMA pricing down so that the mid-tier phone is not a GSM only phone, but is actually a WCDMA/GSM phone and that will make a big difference in volumes."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mark McCatchney with Twin Peaks Capital."
},
{
"speaker": "Q - Mark McCatchney",
"text": "Great, thank you. Hopefully you can hear me, okay. I wanted to kind of just clarify your guidance for the second half of the year. Are you saying that EPS will be lower than the first half? Or are you saying that growth will be lower? Thank you."
},
{
"speaker": "A - Bill Keitel",
"text": "We expect greater revenues in the second half of the year relative to the first half but with $0.39 pro forma first quarter, a midpoint estimate of $0.36 in the second quarter, that's $0.75. So if we execute on that, our full-year guidance is $1.43 to $1.47, is where one conclude that we're expecting a slightly lower second half earnings relative to the first half."
},
{
"speaker": "Operator",
"text": "Your next question comes from Edward Snyder with Charter Equity."
},
{
"speaker": "Q - Edward Snyder",
"text": "Thank you. In terms of wideband CDMA handsets worldwide you're seeing growth and I expect unit volumes are looking to double this year and we've heard Vodafone a couple of days ago talking about difficult competitive environment, prices are already dropping there, but it looks like they're having more difficulty than I guess they expected and seeing an uptake in the service. Is it just pricing that's going to be driving demand? Is that what your model looks for? Or is there some other metric like size or other features? Or what else can drive traction of handsets at this point?"
},
{
"speaker": "A - Steve Altman",
"text": "I think there's a couple of things that can do it. Clearly the price allows us to get into these other tiers as I talked about but we are starting to see the very slim style handsets coming out, so the fact that our advanced chipsets are enabling those kind of form factors I think will also cause consumers to move to 3G."
},
{
"speaker": "A - Paul Jacobs",
"text": "I add to that, as we've always expected, that the operator economics are going to be very key to this, and thus far the reports we've been seeing from CDMA, WCDMA operators that are reporting it, we're seeing ARPU uplifts both on data and on voice. So long as they're getting that ARPU uplift I think it's going to be a very interesting market that they're going to want to push harder on. So that would be one and two is that, it's competition. It takes, doesn't take much more than one or two major operators in a given region of the world to see the success or the promise of that success push hard for it and then the others that may have been a little more hesitant will follow."
},
{
"speaker": "Operator",
"text": "Your next question comes from Tim Long with Banc of America Securities."
},
{
"speaker": "Q - Tim Long",
"text": "Thank you. Bill, if we could, I'd love to drill into that assumption of 59 million to 61 million phones in the quarter. I'd just love to get your sense of a confidence on that, understanding you guys changed from the accrual basis to the cash basis a few years ago, yet we still had two over the last three-quarters or so with a pretty big under-estimation. So my particular question relates to WCDMA where you don't have as high of market share as you do in CDMA. So if you could just give us a sense as to your confidence in that number and what type of swing factor could we see in it, what kind of royalty reports do you get, or monthly data do you get to that number, that would be helpful. Thanks."
},
{
"speaker": "A - Bill Keitel",
"text": "Sure. So at this point, Tim, we have very few royalty reports we received, but there is quite an active exchange with our licensees as to what they've seen in the December quarter. Not all licensees but many of them. We've had that practice going on now for some time and we think we get pretty good visibility through that avenue. We like you are monitoring operator reports that they've been, generally been quite positive but we're a little cautious, as one operator reports a positive result that if there's another CDMA operator in that region, that hasn't yet reported, we'll tend to be a little cautious until we know what that other operator has reported so we have a better idea that it isn't just a share change. So a few more reports yet to come that I think are significant from operators around the world, and then in a couple months time we will have all the licensee reports in hand. But I would say at this point, Tim that the visibility on that 50 to 60, 59 million to 61 million is similar to where we were last quarter when we guided 52 to 53, I think was the number. With the one exception, it is a Christmas season, and so Christmas in some markets leads to a little more variability than otherwise I think at -- in that forecast. But all in all, I feel pretty good about it."
},
{
"speaker": "Operator",
"text": "Your next question comes from Brian Modoff with Deutsche Bank."
},
{
"speaker": "Q - Brian Modoff",
"text": "Yes, just one point of clarification and then a question on units. Isn't your guidance somewhat also a reflection of the fact that you had Christmas chip sales plus royalty collections in the front half of the year and you don't have those in the second half of the year? Then the question is, how many WCDMA units do you think shipped in the December quarter? Did we hit around that 44 million or 45 million unit number for the year? How comfortable are you with that?"
},
{
"speaker": "A - Bill Keitel",
"text": "Yes, Brian. Good point. On the royalty business, the royalty business for our fiscal year, it's a July through June period out in the market given our one quarter lag. To your point there, the seasonality of our royalty business is different than the seasonality in the chip business. On the WCDMA units, the reports we've seen thus far and estimates that licensees have shared with us, we feel pretty good about that 2005 WCDMA estimate of approximately 45 million units."
},
{
"speaker": "Operator",
"text": "Your next question comes from Paul Sagawa with Sanford Bernstein."
},
{
"speaker": "Q - Paul Sagawa",
"text": "Hi, it's really kind of a question for Sanjay. If I look at the WCDMA market going forward, a number of the biggest handset makers in the world seem to have sort of incumbent chipset suppliers and you are incumbent at a number of the major handset vendors as well. At this point how much likelihood is there for there to be share shifts with those big handset makers? What other switching costs are we looking at? What kind of discussions do you have with non customers, and how receptive are they to think about switching with any associated costs that come along with that? So as we think about going forward, what's the opportunity for that share shift to happen?"
},
{
"speaker": "A - Sanjay Jha",
"text": "Paul this is Sanjay. I think I've indicated a number of times that I believe that most non vertically integrated providers, and I would call Sony, Ericsson, and Nokia vertically integrated today. Most nonintegrated vertical handset providers are actually looking at multiple sources. We are quite entrenched I think today at Samsung and LG but I'm confident that they are evaluating all their options. But similarly I think that other handset manufacturers are also evaluating how to get second sources to get leverage. One on their primary source, but secondly to leverage any technology leadership that might exist elsewhere in the value chain. And I believe today, in HSDPA, in low cost, in HSUP and MBMS we have technology leadership so we feel comfortable that most folks are looking at our solution carefully and evaluating how they can take advantage of that. The second thing to think about in terms of our market share is, we certainly think that our customers today are growing their market share. If you look in fourth quarter, we had 48% quarter-over-quarter increase in our shipment, and I don't believe that overall markets grew by quite 48%. So we think in fourth quarter we increased our market share a little bit. When we have final numbers I think we'll have clarity on that, but I think with the customers that we have we're growing our market share, and I think with the technology leadership that we have we certainly make a very good argument to other OEMs to look at our solution carefully. We talk to all of them all of the time but nothing to report more specific than that at this point."
},
{
"speaker": "Operator",
"text": "Your next question comes from Brantley Thompson with Goldman Sachs."
},
{
"speaker": "Q - Brantley Thompson",
"text": "Hi. I was wondering if you could give us a little bit more color on the handset ASP forecast for fiscal year '06 or, you know, the sequential guidance you gave for 2.10. It was pretty much unchanged but at the same time there's a lot of rhetoric in the call about much bigger demand from the low-end phones and at the same time a lot of things that are very positive for 3G adoption could you just give -- those things seem incrementally new. Could you just talk about that in terms of that 3G versus low end balance and how we should think about how that might impact ASP going forward?"
},
{
"speaker": "A - Bill Keitel",
"text": "Sure. Brantley, it's Bill Keitel. I'll take a, maybe a stab here and then maybe some other people want to join in. At that 2.10, we do see the low end market accelerate at a good pace this year. But likewise, the feature content and the size of the mid to high-tier market we think is going to grow nicely. We're expecting continual growth each quarter here on WCDMA phones shipping as we progress through this year, and much a similar picture on the DO front. So with the North American market as an example, moving aggressively on to DO, HSDPA, one carrier is pushing pretty hard there, it's very robust market, I think, and the ARPUs are justifying it for the carriers. I think that there's good optimism. We'll start to see that in Europe this year, and certainly Japan is pushing very hard on that front, given how KDDI is doing so well on their DO platform. So I think it's a very robust high end market, and at the low end, yes, they are very feature-less phones, very voice centric, but I expect as we've seen in the last several years, as low end grows, the interest in more feature content, more capabilities in the phones has largely held the ASP on CDMA as a whole pretty constant."
},
{
"speaker": "A - Paul Jacobs",
"text": "Even as we drive the low end phone, or the very low end phone, I should say, what a lot of the operators find is that that still isn't that huge a part of their market. They have to have that as a piece of the market, but then people tend to step up a bit to the next phone, so all of these initiatives that you've heard about on the GSM side at the very low end, the volumes really aren't as great as the rhetoric might make it appear. The other point is that, to amplify Bill, the high end prices can be as much as 10X, the very low end price. So as we see growth in these upper ends, that provides a nice trend for us on ASPs."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of John Bucher with Harris Nesbitt."
},
{
"speaker": "Q - John Bucher",
"text": "Thank you. A question for Paul, some of the comments he made on standards efforts, and seeing if there's any correlation with some of the EC complaints. I'm wondering if you're seeing any indication that QUALCOMM might be become less influential in some of these standardization efforts since you're dealing with so many different standards bodies that are not necessarily TOCO centric in trying to bring your innovations to market as you look at your long-term technology roadmap?"
},
{
"speaker": "A - Paul Jacobs",
"text": "Yes, I actually think the opposite is true. I think we're actually becoming more influential in a number of these other you know we talked about the IEEE standards bodies having a couple of nice milestones passed there. And I think it's because of this partnering strategy that we're on to reach out more broadly than just the telecommunications industry. So, for example, the IEEE 802.11n stuff was driven in large part by consumer electronics manufacturers who want to ship multimedia around the house, they want multiple HD streams of video, and they see that our enhancements made that possible. So I think it really is reaching out to a lot of partners more broadly, people who are outside of some of these, I don't know, battles that we're going through again. That's actually helping us have more influence. And then within the telecom industry, like I said, we really are doing a lot to lead the development of the follow-on generations on both the CDMA2000 and the WCDMA path. And I think the technical excellence is helping. And we're making our way into the community better. We have a guy on the SE Board now as an example so I actually think that's tending to improve over time."
},
{
"speaker": "A - Steve Altman",
"text": "I would add to that, that we also have, I think, economic incentives from the standpoint as we pointed out, we have a well established CDMA licensing program, and as Paul clarified, when we, when additional technology that we contribute are added in the CDMA multimode environment, their license to our existing licensees at our standard rates. So there's no incremental royalty to those licensees by incorporating new technologies that we propose."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, we have reached the allotted time for questions and answers. Dr. Jacobs, do you have any closing remarks before we adjourn the call today?"
},
{
"speaker": "Paul Jacobs, CEO",
"text": "Yes, I'm very happy by the CDMA2000 growth that we're seeing, both at the high and mid-tier in the developed market and at the low end in the developing markets. I am also very happy to see WCDMA continues to grow, and Europe is doing very well, and that was an area where people had some question. We talked about a number of new technology initiatives. We're making great progress there. We're passing milestones, we're getting progress and standardization across those. So that's going well as well. And like I said, I've been doing a lot of visiting with customers, and I find that the reception of customers, to the contrary of what some of the rhetoric might make you think, the reception by our customers is very warm, and they see the benefits we bring. They're very excited to work with us to help us, or us to help them get their networks up and running, and optimize those networks and start to generate revenue. So I feel like our business model is working extremely well to drive 3G. We're excited about the opportunities ahead of us. And thanks, everybody, for joining us today."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this does conclude our QUALCOMM First Quarter Conference Call. You may now disconnect."
}
] | null | null |
SBUX | 4 | 2,006 | 2006-11-16 19:15:00 | Executives: JoAnn DeGrande - Director of Investor Relations Howard Schultz - Chairman Jim Donald - President and CEO Michael Casey - EVP and CFO
Analysts: John Glass - CIBC Jeffrey Bernstein - Lehman Brothers Joe Buckley - Bear Stearns Steven Kron - Goldman Sachs David Palmer - UBS Sharon Zackfia - William Blair Matt DiFrisco - Thomas Weisel Partners Glen Petraglia - Citigroup Dan Geiman - McAdams Wright Ragen
Operator: Good afternoon, my name is Richard and I will be your conference operator today. At this time, I would like to welcome everyone to the Starbucks Fourth Quarter Fiscal Year-end 2006 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer session. (Operator Instructions). Thank you. I would now like to turn the call over to Ms. JoAnn DeGrande. Please go ahead ma’am.
JoAnn DeGrande: Thank you, Richard and good afternoon ladies and gentlemen. This is JoAnn DeGrande, Director of Investor Relations with Starbucks Coffee Company. With me today are Howard Schultz, Chairman; Jim Donald, President and CEO; Michael Casey, Executive Vice President and CFO; and Mary Ekman, Vice President, Corporate Development and Investor Relations. During today’s call, Jim will review key results and accomplishments for the fourth quarter and the full year as well as provide some highlights from our US retail business, Howard will provide an update on our international business and our music and entertainment initiatives, and Michael will highlight the key drivers behind our fourth quarter and fiscal year 2006 results. We will limit today's call to one hour including Q&A. As a reminder to all listeners, this call is being broadcast live over the Internet. A replay will be available via telephone at 800-642-1687, reservation number 3728606 through 5:30 pm Pacific Time on Thursday, November 23rd, and on the Investor Relations page at starbucks.com through 5:00 pm Pacific Time on Thursday, December 14th. In addition, today’s remarks will be available on the Investor Relations portion of starbucks.com by the end of the day and will remain available through Thursday, December 14th. This conference call includes forward-looking statements such as trends and/or expectations regarding store openings, comparable store sales, net revenue and earnings per share results. These forward-looking statements are all based on currently available operating, financial and competitive information, and are subject to various risks and uncertainties. Additional information concerning factors that could cause actual results to differ materially from those in the statements are contained in the company’s filings with the Securities and Exchange Commission, including the risk factors section of Starbucks' Annual Report on Form 10-K for the fiscal year ended October 2, 2005. The company assumes no obligation to update any of these forward-looking statements. With that, I will turn the call over to Jim.
Jim Donald: Thank you, JoAnn, and good afternoon ladies and gentlemen. Fiscal 2006 was another strong year for Starbucks as we continued to do more of the very same, delivering solid consistent performance by surprising, delighting our customers every day with product innovations, retail locations in places where our customers want us and through the extension of the Starbucks brand outside our retail stores. We have achieved a number of accomplishments this year. So, let me begin with a quick review of our store development endeavors, followed by an overview of our fiscal year financial results, and then a few highlights from the fourth quarter. During fiscal 2006, we delivered a record number of store openings, 2,199 to be exact. This equates to an average of six new stores per day. When you compare fiscal 2006 store openings to fiscal 2005, it is clear that we continued the momentum with consistent execution as we opened over 30% more stores this year than last. Due to the strength in our store development capabilities paired with strong demand for Starbucks locations, we surpassed our regional store count target of 1,800 stores by nearly 400. And we continue to see tremendous opportunity in store openings both in the US and international markets. This year, we are targeting the opening of at least 2,400 locations worldwide. Of note, we have grown our store base by a compound annual growth rate of more than 21% over the past five years. Additionally, we believe we can ultimately have 40,000 locations worldwide with half of those locations outside the US. With so much development in growth, the natural question might be, how have these investments impacted Starbucks' financial health? Let me reassure you. We've achieved robust store expansion, delivered strong financial performance, increased our equity ownership in international markets and continue to foster innovation throughout our business around the world. Let me talk about some specifics. In fiscal year 2006, we served our customers more than 40 million times per week in 12,440 Starbucks locations in 37 countries. We delivered consolidated net revenues of $7.8 billion, increase of 22%, which exceeded our growth target comprised of solid increases in both retail and specialty revenues. We reported comparable store sales growth of 7% for the year including 5% transaction growth and 2% ticket growth. We delivered net earnings of $564 million compared to $494 million in fiscal 2005. And earnings per share for the year came at $0.73 compared to $0.61 per share in fiscal 2005 excluding the impact of new accounting requirement for asset retirement obligations, which Michael will review later in the call. We exited 2006 in a solid position, have set aggressive growth targets for our current fiscal year, and we look forward to continuing a positive momentum in fiscal 2007. Now, it's important to note that these results and the aggressive financial targets we have set for fiscal 2007, are all driven by the same consistent strategy to remain focused on delivering value to our culture of product innovation, serving premium quality products and continue investing in our passionate partners who provide legendary customer service, and the numbers speak for themselves. Our average unit volumes continue to increase. Fiscal 2006, average unit volumes for US company-operated stores grew to over $1 million. Additionally, first year sales in our fiscal 2006 new stores in the US have continued to perform well delivering an estimated $920,000. Now, let me recap some of the highlights specific to the fourth quarter. Consolidated net revenues grew by 21% to $2 billion, with net earnings of $117 million. Comparable store sales grew 5% for the quarter, 4% by transaction growth and 1% by higher ticket. As we grow our business, Starbucks Experience continues to be universally relevant and accepted. Let's review both the innovations and traditions Starbucks had and will deliver in order to continue this growth. During the quarter, we continue to build on what makes Starbucks unique. Product innovation, legendary service and execution and the focus clearly paid-off. During the fourth quarter, Starbucks US company-operated retail locations delivered $1.4 billion in revenues. Key drivers behind this quarter were innovations across our beverage menu, as well as our food offerings. Beverages introduced during the fourth quarter included our new Frappuccino Juice Blends, offered in two popular flavors, Pomegranate and Tangerine, and the return of one of our highly anticipated seasonal flavor Pumpkin Spice. The continued success of Pumpkin Spice provides an excellent trailer to the return of our popular holiday beverage trio, Peppermint Mocha, Gingerbread Latte and Eggnog Latte. Again during the fourth quarter and for the year, food was a strong contributor to sales in all three categories -- Bakery, Lunch and Warming. Food continues to be a growing part of our business, and fiscal 2006 demonstrated significant progress in capturing some of the potential opportunities we have identified. We've enhanced our offerings introducing additional reduced fat options in bakery and our new yogurt parfait. We've added new lunch items, we've expanded our grab-and-go lunches into new markets and to more stores, and we saw substantial expansion of our warm breakfast sandwich program, more than tripling the number of stores in which it is offered year-over-year. Let me first bring you up-to-date on expansion of lunch. At the end of our fiscal 2006, we had offerings in 21 markets, with the newest being Atlanta. Our customers now have the options to purchase lunch along with their favorite beverage in more than 4,150 locations within the US and Canada. This is in addition of nearly 1,000 locations during the year, an increase of 32% when compared to this time last year. Think about it this way, lunch is offered in 67% of our US company-operated locations and 70% of our company-operated locations in Canada. Now let's shift to one of our newest food innovation, the warm breakfast sandwiches. More and more of our customers around the US will be able to enjoy warm breakfast items as we aggressively expand the stores providing warming at fiscal 2007. In fact, by this time next year, we estimate that approximately 3,400 Starbucks stores will feature warm breakfast items and that’s compared to approximately 1,000 locations today, which includes our latest market launch in New York in early October. Not only just warming offer our customers a premium quality breakfast option, but also provides us a nice incremental revenue contribution, delivering approximately $35,000 in additional annual sales to those stores offering the products. Looking at what's in our stores today, last week marked the return of our popular holiday beverage including the Peppermint, Gingerbread and Eggnog beverage trio. Starbucks Christmas Blend whole bean coffee, returning seasonal food favorites and fantastic gift ideas, which we believe will strengthen our customer loyalty. We also brought back the perfect food pairings to accompany our holiday beverages, the Cranberry Bliss Bar and the gingerbread loaf, which offer a tasty indulgence. Additionally, a favorite customer lunch offering will also be featured again this year, Grandma's Turkey Sandwich, which is available in stores through out the holidays. Turning to merchandise, this year's holiday assortment is a wonderful mix of old favorites and new traditions, making Starbucks a convenient destination for our customers' holiday shopping. Again this year, we featured everything from stocking stuffers to holiday serveware to special holiday prices on our brewing equipment. A few of our merchandise items includes new holiday Barista Bears, Starbucks exclusive gift packs, two new seasonal Starbucks card designs, new Hear Music holiday CDs and audio books and a new ten-cup brewer that is exclusive to Starbucks. Before I close, I'd like to spend a little time discussing our ongoing commitment to preserving the core of our company and that’s coffee. In fiscal 2004, we formally introduced C.A.F.E. practices, which helps ensure Starbucks purchases coffee that is grown and processed in a sustainable manner. Additionally, C.A.F.E. practices help secure Starbucks coffee supply using environmental and social responsible practices. During the fiscal 2006, we set a goal of purchasing 150 million pounds of coffee through C.A.F.E. Practices. I am very pleased to report that we surpassed that goal and we'll continue our work in this area. Our new goal is to purchase 225 million pounds of C.A.F.E. Practices-verified coffee during fiscal 2007. This commitment to preserving our core coffee also extends to ongoing education around sustainable coffee practices and our tireless effort -- our tireless support and efforts of our coffee farmers. You may have recently seen Starbucks in the media with respect to Ethiopia and trademark issues. We support the recognition of the source of our coffees and have a deep appreciation of the farmers that grow them. In fact between 2002 and 2006, Starbucks increased its Ethiopian coffee purchases by nearly 400%. Starbucks has recently asked to support a licensing agreement and the trademark in names used for growing coffee in the coffee area in Ethiopia. Starbucks has never filed an opposition to Ethiopian government's trademark application. We have proposed certification as an alternative solution. We are committed to working collaboratively with key stakeholders to find a solution that supports Ethiopian coffee farmers. We stand true to our core and recognize that coffee is important to our continued growth. With that, I would like to turn the call over to Howard.
Howard Schultz: Thank you, Jim. My remarks today will focus on two areas, an overview of our international business and a look at recent developments in our music and entertainment strategy. Our international business continues to be a key focal point for the company. We have and will remain focused on building upon our solid foundation with a goal to continue to expand our store base through our entry into new markets. We also seek opportunities to further leverage the brand by introducing products outside Starbucks retail locations, something we have had great success with in the US. During fiscal 2006, we continued to focus on hiring and building strong teams throughout our international business, making relevant connections with local communities, providing legendary service to our customers around the world and increasing our equity stake in several key markets. Fiscal year 2006 results reflect the progress that we have made with total international net revenues increasing 32% to $1.4 billion, and operating income growing 33% to $115 million. Overall, we now have more than 3600 stores in 36 countries outside the US. We have opened a record number of locations during the year, 665 to be exact, and we achieved several significant milestones during the year. Canada now has more than 680 locations, Japan reached 650 stores, UK store count now exceeds 500 locations, and there are more than 430 stores throughout our greater China region. And, this is just the beginning. We have tremendous opportunities to continue growing in existing markets and now have worked diligently over the past year to ready ourselves for entry into several new and key markets within the coming year. Our solid financial performance during a time of rapid growth is truly exceptional and further encourages us to capitalize on the immense growth opportunities that lie ahead for Starbucks. Before I move on, I would like to highlight our recent launch of the Starbucks card in the U.K. Beginning this week, our customers in the United Kingdom are now able to purchase, reload, and register Starbucks cards at more than 500 Starbucks locations. The initial response was very, very strong on the first day. One enthusiastic customer purchased 30 cards in one transaction. This response suggests that the Starbucks card will be a very popular gift item in the U.K. and just as successful and well accepted as it has been in North America. In fact, we have already had to order more cards to supply for the strong demand in anticipation of the holiday season. Now, moving on to a discussion around the growth opportunities available to us, not only through entering new markets or opening new stores but also through opportunistically increasing our equity ownership where and when appropriate. During fiscal 2006, we took advantage of the opportunity to acquire the remaining 95% ownership of our operations of both Hawaii and Puerto Rico. These acquisitions provide us with greater influence over the Starbucks brand and will allow us to focus on continued operational efficiencies and growth in these markets. We began fiscal 2007 with the acquisition of a 90% interest in our Beijing operations. This represents our continued commitment to invest in what we believe could be the single largest market outside of the United States. This will allow us to leverage the infrastructure investments we've put in place over the last year to lead the greater China market in building a consistent operating platform and delivering the Starbucks experience to our customers in Beijing. Our increased equity ownership further demonstrates our commitment to China, and through this transaction, we hope to accelerate our expansions plans within this market. As the second largest city in China, boasting a population of more than 11 million people, Beijing is a key market for Starbucks. Now, let me highlight up coming new market entries. Later this month, we will open our first Starbucks store in Sao Paulo, Brazil's financial and industrial center. We recognize there is already a thriving coffee culture in Brazil, and we look to introduce the local Brazilian communities to our unique coffee experience. Brazil is an important market for Starbucks not only because it is a source for high quality arabica coffee beans but also because it's a market with many growth opportunities for the retail sector as a whole. We will also open our first Starbucks store in Cairo, Egypt by the end of the calendar year, which is another notable milestone, because this will be our first entry into Africa. Not only is Cairo the capital of Egypt and the largest city in the Middle East and in Africa, it also has a rich coffee history, coffee culture with consumers interested in the right mix of ambiance and products. We believe the Starbucks experience will provide just that to the people of Cairo. The Starbucks brand continues to attract more and more interest from communities around the world, which is a reflection of the power of the brand and it's relevancy to so many different cultures. It's the continued high level of community interest coupled with the strong financial performance we delivered today that gave us the confidence to raise our long-term international store count total to at least 20,000 locations in markets outside of the US. With more than 3,600 locations today, we have a tremendous runway for growth in international markets in the years ahead. Now, let me provide you with an update on the results of our initial project in the movie segment of our music and entertainment business, and then I will review more recent initiatives in the overall entertainment category. As you know, through unique marketing efforts in our retail stores, Starbucks was involved in the theatrical release of Akeelah and the Bee. And we were happy to report that following the film's release, we experienced great success with the sale of the DVD in our stores. In fact, Starbucks ranked among the top four brick and mortar retailers of selling Akeelah and the Bee. Our combined four-week market share for the end of the fiscal year was approximately 9%. Moving now to our entry into literature. You will recall that during the fourth quarter, we announced the next phase of our entertainment strategy, the integration of books into our overall entertainment offering. Our first selection was a novel by acclaimed author Mitch Albom titled "For One More Day". We began the nationwide promotion of the novel on October 3 with in-store appearances by Mitch in eight markets. Coinciding with that was the first-ever Starbucks Book Break where customers in 32 markets were able to share their thoughts and connect with one another through meaningful discussions of the universal themes of the book. Our role in the promotion of For One More Day was truly successful. Sales of the book in our stores have exceeded our expectations. The book has been a New York Times' Bestseller as well and as a result of the success and the continued demand on a national level for the book, we will continue to sell the book through the Christmas holiday. Reflecting on that success with both the book and the film, one point I would like to highlight to you that you are probably nor aware of, and that is that Starbucks in both cases of the DVD and in the book sold these products at full retail price at a time when these categories are being heavily discounted by other retailers. Yet, we were able to maintain full gross margin on these items, I think once again creating an opportunity for us, which our customers really do trust, the editorial voice of our company. Now, moving on to the music component of Starbucks Entertainment. Last month, we released a new CD from Ray Charles. That's right. You heard me correctly. A new CD from Ray Charles appeared in our stores last month. Starbucks Entertainment teamed up again with Concord Records to co-release and co-market Ray Sings, Basie Swings, a new album that marries never before released Ray Charles recordings with brand new performances by the Count Basie Orchestra. After a strong first week of sales at Starbucks and traditional retailers, this album debuted at number 23 on the Billboard Top 200 albums chart and has been -- and has remained there since its release. Starbucks locations account for more than one half of all copies of this album in America. Our newest initiative partners Hear Music with iTunes, an innovative partnership providing online access to our popular Hear Music titles; iTunes users now have the ability to preview, buy and download a wide variety of tunes from Hear Music's library. The Starbucks Entertainment area and iTunes marks the first time that Apple has allowed editorial guidance in content from another brand that has been developed by a partner to appear with the iTunes store. Bridging the gap between product in our stores and the digital consumer, we are now looking forward to such opportunities as marketing programs that link physical CDs sales in our stores to unique content online. This puts Starbucks in a great position to create true entertainment destination with the next stop in our digital strategy. We're excited to be working with Apple and iTunes on this innovative buying experience which will provide our customers the ability to take Starbucks Hear Music tunes with them wherever they go. The success we have had with music, film and literature and more recently our iTunes collaboration demonstrates that Starbucks has truly transformed the way our customers discover and acquire quality entertainment options providing an enriching experience to both them and our partners. Starbucks has a unique place in the daily lives of our customers and we highly value the trust our customers have placed in us. We embrace the opportunity to be part of their entertainment discovery and we are committed to selecting music, movie or literature projects that will represent the quality and substance reflective of the Starbucks brand and experience. This is the same approach we apply throughout our business, seeking products, channels and opportunities that enrich the daily lives of our customers. In closing, as I reflect on the ten years since we opened our first international store, we have worked diligently over that time, building a solid foundation for our international business, which will allow us to capitalize on the tremendous growth opportunities ahead of us. Just look at what we have accomplished. We have entered 36 countries outside the US. We have more than 3,600 stores in international markets at fiscal year end with nearly 50 more opened in the last month. Over that decade, we acquired full equity ownership in six markets and increased our equity ownership position in seven JV markets. While I am talking about expansion, let's not forget about store development. It was not that long ago following a great deal of planning and thoughtful review that we began speaking to you about extending our store development strategy to opening drive-thru locations in America. Now just a short time later, we have also expanded drive-thrus to several of our international markets, again demonstrating the strengths of the brand, which allowed us to extend a relatively new Starbucks concept to our global customers. We now have approximately 100 international drive-thru locations including stores in Canada, Japan, Mexico, Saudi Arabia, Puerto Rico, Jordon, Australia and Indonesia. In fact, just last month, a near record number of customers joined us for the opening of our newest drive-thru in Monterrey, Mexico. In a very short period of time, it has become the gathering place in the neighborhood. It's often packed from noon to closing in the late evening. It wasn’t that long ago, that we questioned whether or not we could extend the drive-thru strategy to international markets. Would drive-thrus appeal to customers outside of America? Today, we are extremely encouraged by the strong customer adoption of these stores, so early on, in the development of our international business. Also of note, within this decade, we have made significant inroads in extending the brand beyond our retail stores, by introducing ready-to-drink beverages in several Asia Pacific markets, and that is just one of the many opportunities to further leverage our strong brand equity and monetize the equity of Starbucks brand outside of our stores. Think about that, 10 years ago we had no presence outside in North America. Today, Starbucks has established a worldwide appeal not only for our coffee, but the physical environment we have created within our stores. I believe one would be hard for us to find another US based retailer that has accomplished this much and achieve this much in such a short period of time. The level of global acceptance, which Starbucks has achieved, is really, really significant. While this company has come a long away in a very short period of time, I truly believe we are still in the early stages of growth. We have a strong business model, which has continued to deliver strong returns to our shareholders and we have great confidence in the long-term global potential for Starbucks. With that Michael Casey.
Michael Casey: Thank you, Howard. This afternoon, I will provide highlights of our financial performance for the fourth quarter and the full fiscal year. However, before I get into the details, I think I should clarify and put into perspective what appears to be some confusion about with the initial reading of our press release today. There are several net income numbers reported, and I would like to line each of them up with how we look at. The bottom line for the fourth quarter was earnings per share of $0.15, but that included $0.02 per share of a new accounting principle FIN 47 for asset retirement liability. If you take that out or you back up above that, the earnings per share would have been $0.17 a share or about $134.5 million. That’s 18.7% growth over the previous year, but when we look at our business on an apples-to-apples basis, we also exclude the impact of SFAS 123R or the accounting for equity-based compensation. And if you added back the $0.02 per share related to that, our earnings per share would have been $0.19 per share and the net income would be $152 million or 22.8% above the previous year, which is the way we look at the business, from an operational point of view. For both the fourth quarter and the full year of fiscal 2006, our revenue growth continued to be very robust. Consolidated net revenues grew 21% for the quarter and 22% for the year. Company-operated retail revenues increased 22% for both the quarter and the full year, driven by the opening of 1,040 new company-owned retail stores in the last 12 months, and comparable store sales growth of 5% for the quarter and 7% for the full year. Specialty revenues grew 16% for the quarter and 23% for the year, primarily due to higher product sales and royalty revenues from the opening of 1,159 new licensed retail stores in the last 12 months. Before I move on to reviewing other financial highlights, let me mention three items that had an impact on our reported results in the fourth quarter: stock-based compensation expense, the adoption of new accounting guidance for asset retirement obligations, and the effect of certain tax items. As we have discussed in previous quarters the company adopted new expensing requirements for stock-based compensation at the beginning of 2006 with no restatement of prior period results. The pre-tax stock-based compensation expense recognized for the fourth quarter was $27 million or $17.5 million net of tax for an EPS impact of $0.02 per diluted share. For the full year of 2006, stock-based compensation was $69 million net of tax or $0.09 per share. Please refer to page 7 of the press release for a breakout of how this expense is allocated in our consolidated statement of earnings. Next, as we discussed last quarter, new accounting requirements from the FASB related to asset retirement obligations known as FIN 47 were adopted by the company at the end of fiscal 2006. For Starbucks as for other retailers with large numbers -- with a large number of leased store locations, these costs are for the estimated future expense of remodeling leasehold improvement at the termination of the lease. A cumulative effect of this accounting change was $17.2 million net of tax or $0.02 per diluted share. Beginning in fiscal 2007, this accounting requirement will be reflected in the company's financial statements and will not have a material impact on the company's results. Now turning to the tax items. As I have mentioned several times in the past, fluctuations in the effective tax rate are much more likely now than they used to be. For the fourth quarter, our effective tax rate was 33.2% compared to 38.1% for the same period in fiscal 2005. For the full year of 2006, the effective tax rate was 35.8% compared to 37.9% for 2005. The decline in the fourth quarter was due to recognition of the full-year benefit of a shift in the mix of expected profitability to lower tax international markets and increased effectiveness of the company's long-term tax planning strategies, as well as several favorable audit settlements, closures, and adjustments. In addition, there was a valuation allowance recorded in the fourth quarter of fiscal 2005, which resulted in a higher effective tax rate for that quarter. For the full year, the decrease in the effective tax rate was due to the items mentioned above as well as to the settlement reported in the third quarter of 2006 of a multi-year income tax audit in a foreign jurisdiction, for which Starbucks had established a contingent liability. Now, I would like to elaborate further on our operating results. Operating income was $198 million in the fourth quarter compared to $197 million in the prior year. As a percentage of net revenues, the operating margin declined to 9.9% from 11.8% in the prior period. Excluding $27 million of stock-based compensation expense recognition in the fourth quarter of this year, operating income increased by 14.3% to $225 million, and the operating margin was 11.2%. Beyond the impact of stock-based compensation in the -- is the cumulative impact of various rising costs that we incurred during the period, a significant portion of which related to higher labor costs in our US retail business, which I will review later in the US segment discussion. For the full year 2006, operating income increased to $894 million from $781 million in fiscal 2006, and the operating margin was 11.5% compared to a record 12.3% in fiscal 2005. For the full year, the company’s operating margin, excluding the impact of stock-based compensation, improved 0.5% of revenues to 12.8%. Beginning in fiscal 2007, reported amounts for the current and prior period will be comparable with respect to stock-based compensation. Fully diluted earnings per share were $0.17 for the fourth quarter of fiscal 2006 compared to $0.16 per share for the comparable period in fiscal 2005, excluding $0.02 cumulative effect of adopting FIN 47 in 2006. For the full year, diluted earnings per share were $0.73, excluding $0.02 for the accounting change compared to $0.61 per share for fiscal 2005. So, in summary, in fiscal 2006, we once again delivered strong financial performance exceeding our 20% revenue growth target, generating same-store sales growth at the high end of our 3% to 7% range and delivering EPS growth significantly above our original target of $0.63 to $0.65 per share. Turning now to the operating segment's results for the fourth quarter. Total net revenues for our United States operating segment increased by 18% to $1.6 billion for the fourth quarter of fiscal 2006. Company-operated retail revenues grew 18% to $1.4 billion, primarily due to the opening of 801 new company-operated stores in the last 12 months, and comparable store sales growth of 5% for the quarter. The increase in comparable stores sales growth was comprised of a 4% increase in the number of customer transactions combined with 1% increase in the average value per transaction. US specialty revenues grew by 14% to $247 million in the fourth quarter. Within specialty revenues, licensing revenues increased 20% to $168 million, primarily due to higher product sales and royalty revenues from the opening of 733 new licensed retail stores in the last 12 months, and to a lesser extent, growth in the licensed grocery and warehouse club businesses. Foodservice and other revenues increased 3% to $78 million, due mainly to the addition of new accounts in the U.S., bringing our total foodservice reach to approximately 15,000 accounts. The impact of the growth in foodservice revenues and other revenues was dampened by an unfavorable year-over-year comparison in other revenues, which included revenue from the sales of Ray Charles 'Genius Loves Company CD outside of Starbucks retail stores in the fourth quarter of 2005. U.S. store operating expenses as a percentage of related retail revenue increased to 43.2% in the fourth quarter of fiscal 2006 from 41.5% in the prior year. The increase was primarily related to higher payroll expenditures for our U.S. retail stores, due to higher than ideal store staffing levels, the addition of more assistant store managers, and regional support positions and an increase in training hours for store partners and future store leaders. With our continued aggressive growth in retail stores, the investment in our future store leaders is absolutely paramount. Accordingly, at the end of fiscal 2006 we had assistant store managers in 77% of our company-operated stores, compared to 68% at the end of fiscal 2005. We have taken proactive steps to help mitigate rising store operating costs through the additional management focus on more effective store labor deployment and with our recent beverage and whole bean price increase. You should also note that the recognition of stock-based compensation expense increased payroll related expenditures in fiscal 2006 versus 2005. U.S. operating income increased to $240 million during the quarter from $239 million during the same period in fiscal 2005. The operating margin decreased to 15.2% of related revenues for the fourth quarter of fiscal 2006 from 17.3% for the fourth quarter of fiscal 2005. The decrease was due primarily to the higher store operating expenses I just noted and to an increase in cost of goods sold, including occupancy costs. The cost of sales including occupancy costs increased primarily due to higher green coffee costs, a shift in retail sales mix to products with lower gross margins when compared with beverages as well as to higher utility and distribution costs, offset in part by favorable dairy costs. U.S. food revenues grew at a faster rate than overall revenue growth. Now moving to the international segment, international total revenues increased 36% to $381 million in the fourth quarter of fiscal 2006. International company-operated retail revenues increased 39% to $319 million in fiscal 2006, mainly due to the opening of 239 new company-operated retail stores in the last 12 months, comparable store sales growth of 8% for the quarter and the conversion of Hawaii from a licensed market to a company-operated market. The comparable store sales increase resulted from a 5% increase in the number of customer transactions, coupled with a 3% increase in average value per transaction. International specialty revenues for the quarter increased 24% to $62 million, primarily due to higher product sales and royalty revenues from opening 426 licensed retail stores in the last 12 months and due to sales of ready-to-drink products in Japan, Taiwan and Korea. Operating income for international operations decreased to $28 million in the fourth quarter of fiscal 2006 from $30 million in fiscal 2005. The operating margin decreased to 7.4% of related revenues from a record fourth quarter of 10.9% in fiscal 2005. This decrease was primarily due to lower reported income from the company's equity investees, higher store operating expenses, as well as higher other operating expenses, offset in part by lower cost of sales including occupancy. The decrease in equity investee income was primarily due to accounting corrections, totaling $4.1 million made in the fourth quarter of fiscal 2006 for two of our international joint venture markets. The increase in store operating expenses and other operating expenses was due to higher payroll expenditures for additional employees to support global expansion, particularly in our Asia-Pacific, China and EMEA markets and due to the recognition of stock-based compensation expense. Lower cost of sales, including occupancy, were due primarily to leverage gains from fixed costs distributed over an expanded revenue base as well as favorable dairy costs, offset in part by higher green coffee costs. It bears repeating past comments that our ongoing investment in our international infrastructure, including investments in emerging markets, will continue and can be expected to cause variability in future quarterly operating margins. Our overall business model is based on strong revenue growth and moderate margin improvement over the long term, an approach that requires initial infrastructure buildout. Returning now to the consolidated business, during the fourth quarter, the company repurchased 14.6 million shares of Starbucks' stock at a cost of approximately $474 million under authorized share repurchase programs. For the full year, 25.6 million shares were repurchased for a cost of $828 million. Since the inception of our share repurchase program in 2001, Starbucks has returned over $2.3 billion to shareholders through the repurchase of approximately 100 million shares through October 1, 2006. Our strong balance sheet, continued strong operating cash flows, and the borrowing capacity under our $1 billion revolver provide the company significant financial strength and flexibility. This allows us to continue to build and maintain our expanding store base, reinvest into the brand through equity ownership stakes in new markets, and equity contributions to existing JV markets, selectively invest in new growth opportunities, such as China, Brazil, Russia and India, and to repurchase shares. We also continue to improve our return on equity, which reached 25% in fiscal 2006 from 20% in fiscal 2005 and 17% in fiscal 2004. Let me wrap up by reminding you that Starbucks has a solid track record of delivering on its aggressive financial growth targets. We have a strong business model that consistently drives approximately 20% top-line revenue growth, primarily through retail revenue growth in our company-operated stores. Our track record of 15 years of 5% or greater same-store sales growth is clearly among the best-in-class for retailers. And our revenue growth is complemented by our specialty revenues, which are primarily driven by our licensed stores. We believe that our unique business model, global presence, and strong brand recognition are all key competitive advantages. Those factors, as well as the immense opportunities that lie ahead of us, provide us the confidence to set our sights on aggressive targets for 2007. These include opening 2400 new stores, approximately 20% top-line growth, same-store sales growth in the 3% to 7% range, and earnings per share growth of approximately 20% to 25%. As you all know, the first half of fiscal 2006 resulted in particularly strong earnings growth, so it is important to keep in mind quarterly comparisons in the first half will be more challenging than the second half of fiscal 2007. With that I would like to now ask the operator to queue up the first question. Please ask one question at a time, and re-queue for additional questions.
Operator: (Operator Instructions). We will pause for just a moment to compile the Q&A roster. Your first question comes from John Glass with CIBC.
John Glass - CIBC: Thanks. Michael, it sounded like maybe the higher store level labor in the U.S. was a surprise to you in the quarter. Is there any way to quantify how much margin pressure came from the growth spending rather than maybe just ambient cost pressures? Maybe you could just look forward, how much of the price increase will -- how much of that will be covered by the price increase as you go forward the next couple of quarters?
Michael Casey: I would say that less than half of the margin pressure in the store operating expenses or approximately half, to be conservative, was due to issues within the store and the other half was growth related. And we believe that we're taking the steps both with regard to labor deployment and as a benefit -- and with the benefits of the price increase to offset that part of the margin pressure.
John Glass - CIBC: Thank you.
Operator: Your next question comes from Jeffrey Bernstein with Lehman Brothers.
Jeffrey Bernstein - Lehman Brothers: Great. Thank you. I have a question on margins. I think you mentioned in your prepared remarks that the cost of sales negatively impacted by the shift in sales to products with low gross margins. Obviously, as you continue to grow your business in the areas other than coffee I would expect this trend to continue. Just wondering your thoughts on that and specifically how we should think about cost of sales as we look out to fiscal '07 for both U.S. and international. Thanks.
Michael Casey: I'll take that question. I think the important thing to remember is that I was talking about the cost of sales including occupancy line, when I made that comment. And so, the nature of the non-beverage products are that they have lower gross margins, but they have much less labor activity associated with them. So at the store level, we are equally profitable whether we sell an extra dollar of beverages or an extra dollar of either food or merchandise or entertainment products. So, the pressure is related to the gross margin line, not to the store contribution line. I think that’s the most important aspect of that. In the US, we expect -- for the total company, we are expecting approximately flat gross margins year-over-year, 2007 versus 2006. If you break it down by segment, we do expect to continue to see some improvement in the international segment as we get an increasing number of stores utilizing the infrastructure that has been built and is continuing to be built in the international market.
Jim Donald: And to repeat the plan for '07, the increase in warming and lunch is baked into our numbers that we are looking at going forward.
Jeffrey Bernstein - Lehman Brothers: Thank you.
Operator: Your next question comes from Joe Buckley with Bear Stearns.
Joe Buckley - Bear Stearns: Thank you. First is the clarification on the last one. Mike, did you say you expect the gross margins in the US to be flat or the store level margins?
Michael Casey: We think the -- we expect the gross margins year-over-year to be approximately flat in '07 versus '06.
Joe Buckley - Bear Stearns: Okay. And then just a question on G&A in the quarter and a question on the tax rate going forward, just a full year expectation, just the G&A in the quarter looked -- particularly on the US side, very well-contained, very low. There is a couple of things mentioned in the release, but can you just talk a little bit about that and what your thoughts are going forward on that line? And then again as I suggest your full-year tax expectations for '07?
Michael Casey: Over our 3 to 5 years strategic planning horizon, we expect the primary driver of total company margin improvement to be G&A leverage. We expect to maintain our operating margins, perhaps make some improvement, not talking about it on a particular quarter, but on a year-over-year basis, modest improvement in operating margins. But as the business grows to get more significant improvement in the G&A lines and to some extent in the depreciation and amortization line, so that we get growth in total -- in total company operating margin. Within these individual segments, we expect to continue to get operating margin improvement within international, but not so much so within our family of US businesses. The tax rate, as I mentioned leading to that, the tax rate used to be a lot easier to predict when it was done on a longer-term basis. The current requirements with regard to tax, is that every specific event that happens triggers a specific change in that period. So there are going to be more fluctuation in the tax rate. And, so we are still targeting the 38% effective tax rate that we've targeted in the past. But we are encouraged that some of our long-term tax planning activities and the increasing contribution to profit made by our international business over the long term will give us improvement in the effective tax rate. But it won't be every quarter and it won't be dramatic in the short term.
Joe Buckley - Bear Stearns: Thank you.
Operator: Your next question comes from Steven Kron with Goldman Sachs.
Steven Kron - Goldman Sachs: Great, thanks. Can I just quickly ask a follow-up on that G&A question? In the press release, Michael, as it talks about the lower provision for incentive compensation, just wondering if you can just put a little bit more color around that? And, then my question is more balance sheet related, I don’t think in the release there was balance sheet information, can you tell us how much cash you had at year-end and did you tap into the revolver during the quarter? Thanks.
Michael Casey: Well, I will answer to the cash question first. We reduced our -- I believe we reduced our borrowings during the quarter and we expect to further reduce our borrowings during the very strong operating first quarter in G&A. Well if you look at the operating results of our business, they weren’t as strong in the fourth quarter of this year as they were in the fourth quarter of last year, looking at strictly an operating point of view. And, so we have a performance-based incentive comp program and because the business wasn't quite as strong, we had a lower accrual for incentive compensation related to the business in the fourth quarter.
Steven Kron - Goldman Sachs: Okay. And do you have that cash balance as of year-end?
Michael Casey: We didn’t issue the balance sheet because we are still finalizing the details of FIN 47 as it related to the balance sheet but the cash and cash equivalents were about $313 million.
Steven Kron - Goldman Sachs: Okay, thanks.
Michael Casey: I'm sorry, to correct what I said before, the borrowings at the end of the year were $700 million versus about $300 million at the end of last year. But we have paid that down subsequent to the end of the quarter and would expect to continue so during the very strong first fiscal quarter of the year.
Steven Kron - Goldman Sachs: Thank you.
Michael Casey: You're welcome. Operator?
Operator: Your next question comes from David Palmer with UBS
David Palmer - UBS: Hey guys. You mentioned 3,500 stores, I think by next year with breakfast versus about 1,000 now. I think that's what you said and if that's true that would maybe 800 or more per quarter. Is the ramp up going to be smooth like that or is there going to be a ramp up in deployment? Could you perhaps give us a sense of the timetable? And separately, could you give us a sense of may be how breakfast is going in new markets where you deploy it? Are you seeing the same sort of 30,000 per store lift that you are seeing in some markets early on or are you perhaps seeing a bit better performance these days?
Jim Donald: On average, it is around the 30,000, may be a shade north of that. If you take -- if you dive down to the markets, each market has differently based upon the time it has been in the marketplace. But when we look at the launch, we have to -- it's no different than we launched this from the inception. We are taking a balanced approach on a quarter-by-quarter basis and putting again this all into our ’07 plan, the resources in place that we don't affect the in-store experience with the speed of service that the sandwich -- the warming sandwich that our customers get are up to our own and their expectations. So, this is something that we are doing over the course of the entire year on a balanced approach.
David Palmer - UBS: Thank you.
Operator: Your next question comes from Sharon Zackfia, with William Blair.
Sharon Zackfia - William Blair: Hi, good afternoon. Can you talk about the reaction of customers to the price increase you took here in the US and also in Japan? And where you think the effective price benefit will fall out or comp here in the US?
Howard Schultz: This is Howard. I will start Japan. I just came back from Japan. Our business there is quite good. It appeared that the price increase was relatively seamless in terms of the announcement and feel very comfortable on a go-forward basis.
Jim Donald: In the US, as I look across, all of our markets, all of our regions, we basically see the same -- are seeing the same thing, a seamless transition over to a small increase and customers continuing to frequent our stores on a same or a higher transaction comp basis.
Michael Casey: And the impact of the price increase is included in our 3% to 7% same store sales guidance.
Sharon Zackfia - William Blair: Thank you.
Operator: Your next question comes from Matt DiFrisco with Thomas Weisel Partners.
Matt DiFrisco - Thomas Weisel Partners: Thanks. With respect to margins and on the international side in the text of the release you say accounting corrections totaling 4.1 million were in part attributed to the margin contraction on the international side, how should we look at that going forward as far as the direction of margins internationally, especially the first half given the heady year-ago comparisons?
Michael Casey: You should not expect the accounting corrections to occur -- to reoccur. That has -- that was a one-time event that we don't expect to happen again. So, that part of it is not -- would not be repeated. I don't want to predict the youth -- the international market -- margins on a quarter-by-quarter basis, but as you want to reiterate that we expect over any sort of trailing 12 month period compared to previous trailing 12 month period that there would be noticeable improvement. But the rate at which we enter new markets, the activity within the various markets can cause some quarters to be up and some quarters to be down over the next several years as we move forward. Q1 last year was extraordinarily strong, and so that might be one that I wouldn't expect to surpass, but I don't want to get in the business of trying to predict segment margins on a quarter-by-quarter basis in a business that we know is going to be lumpy and it's going to be a challenge to balance the need to build the infrastructure for the tremendous opportunity that's ahead us versus the also-important need to continue to be increasingly profitable.
Matt DiFrisco - Thomas Weisel Partners: Okay, I guess also I had a clarification and want to make sure did you say that the price increase is going to in the US meet and offset the cost pressures that are causing some of the margin pressures and therefore hold restaurant level margin flat?
Michael Casey: Well I didn't go that far, I said that the price increase should have a beneficial effect on the labor pressure that we had in the fourth quarter. There are all kinds of other things that are going on in the business and I am not prepared to predict what the margins are going to be in the first quarter.
Matt DiFrisco - Thomas Weisel Partners: Okay. Thanks.
Operator: Your next question comes from Glen Petraglia with Citigroup.
Glen Petraglia - Citigroup: Thanks. Michael, if you could maybe give an outlook for green coffee prices as well as the company’s use of fixed price versus price to be fixed contract in 2007 and how that compares to 2006. That will be great. Thanks.
Michael Casey: Okay. Basically the last couple of years we have been seeing increasing green coffee prices and we have in the third quarter of this year and in the fourth quarter of this year we had approximately 10% higher green coffee costs in the current period than we did in the previous period. The good news -- well, sort of the bad news is that the near term and the near and the future contract prices in the market place have gone up in the last two or three weeks fairly noticeably. But the good news in that story is that we are basically bought 18 months ahead and that we have done essentially -- the vast majority, 90% of the purchasing that we need to do in this current 12-month period has been accomplished in the August, September, early October time frame. So, our purchases were ahead of the recent run up so I don’t expect any surprises whatsoever in green coffee. And I do expect our absolute costs to level over the next 12 months and the comparisons will get better as the prior year green coffee costs come up underneath the fairly flat level that we are going to experience for the next twelve months.
Glen Petraglia - Citigroup: Thanks.
Operator: Your final question comes from Dan Geiman with McAdams Wright Ragen.
Dan Geiman - McAdams Wright Ragen: Good afternoon. I guess, excluding like green coffee, which you just talked about, what are your assumptions as far as commodity prices and other inputs heading into the coming year? Where do you see the primary pressure points? Where do you see some areas of opportunities as well?
Michael Casey: We currently have seek favorability in the diary complex and the milk products that we buy, although I have caveat that with the fact that they can change rather rapidly and we are not hedged with regard to dairy, but currently we are getting favorable comparisons in dairy. I think the negative aspect will continue at least in the first half of this year related to energy. As we compare against periods when the energy costs were not quite so high in the first half of last year and when a number of our vendors, landlord, other business partners, had not fully passed through energy cost increases to us.
Dan Geiman - McAdams Wright Ragen: Thank you.
Michael Casey: Thank you.
Operator: That was our final question. Do you have any closing remarks?
JoAnn DeGrande: Yes, thank you. Thank you all for joining us for the earnings call today and we hope you will back with us for the webcast of our fiscal first quarter 2007 financial results on Wednesday, January 31, 2007. Thank you.
Operator: That concludes today's Starbucks fourth quarter fiscal year-end 2006 earnings conference call. You may now disconnect. | [
{
"speaker": "Executives",
"text": "JoAnn DeGrande - Director of Investor Relations Howard Schultz - Chairman Jim Donald - President and CEO Michael Casey - EVP and CFO"
},
{
"speaker": "Analysts",
"text": "John Glass - CIBC Jeffrey Bernstein - Lehman Brothers Joe Buckley - Bear Stearns Steven Kron - Goldman Sachs David Palmer - UBS Sharon Zackfia - William Blair Matt DiFrisco - Thomas Weisel Partners Glen Petraglia - Citigroup Dan Geiman - McAdams Wright Ragen"
},
{
"speaker": "Operator",
"text": "Good afternoon, my name is Richard and I will be your conference operator today. At this time, I would like to welcome everyone to the Starbucks Fourth Quarter Fiscal Year-end 2006 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer session. (Operator Instructions). Thank you. I would now like to turn the call over to Ms. JoAnn DeGrande. Please go ahead ma’am."
},
{
"speaker": "JoAnn DeGrande",
"text": "Thank you, Richard and good afternoon ladies and gentlemen. This is JoAnn DeGrande, Director of Investor Relations with Starbucks Coffee Company. With me today are Howard Schultz, Chairman; Jim Donald, President and CEO; Michael Casey, Executive Vice President and CFO; and Mary Ekman, Vice President, Corporate Development and Investor Relations. During today’s call, Jim will review key results and accomplishments for the fourth quarter and the full year as well as provide some highlights from our US retail business, Howard will provide an update on our international business and our music and entertainment initiatives, and Michael will highlight the key drivers behind our fourth quarter and fiscal year 2006 results. We will limit today's call to one hour including Q&A. As a reminder to all listeners, this call is being broadcast live over the Internet. A replay will be available via telephone at 800-642-1687, reservation number 3728606 through 5:30 pm Pacific Time on Thursday, November 23rd, and on the Investor Relations page at starbucks.com through 5:00 pm Pacific Time on Thursday, December 14th. In addition, today’s remarks will be available on the Investor Relations portion of starbucks.com by the end of the day and will remain available through Thursday, December 14th. This conference call includes forward-looking statements such as trends and/or expectations regarding store openings, comparable store sales, net revenue and earnings per share results. These forward-looking statements are all based on currently available operating, financial and competitive information, and are subject to various risks and uncertainties. Additional information concerning factors that could cause actual results to differ materially from those in the statements are contained in the company’s filings with the Securities and Exchange Commission, including the risk factors section of Starbucks' Annual Report on Form 10-K for the fiscal year ended October 2, 2005. The company assumes no obligation to update any of these forward-looking statements. With that, I will turn the call over to Jim."
},
{
"speaker": "Jim Donald",
"text": "Thank you, JoAnn, and good afternoon ladies and gentlemen. Fiscal 2006 was another strong year for Starbucks as we continued to do more of the very same, delivering solid consistent performance by surprising, delighting our customers every day with product innovations, retail locations in places where our customers want us and through the extension of the Starbucks brand outside our retail stores. We have achieved a number of accomplishments this year. So, let me begin with a quick review of our store development endeavors, followed by an overview of our fiscal year financial results, and then a few highlights from the fourth quarter. During fiscal 2006, we delivered a record number of store openings, 2,199 to be exact. This equates to an average of six new stores per day. When you compare fiscal 2006 store openings to fiscal 2005, it is clear that we continued the momentum with consistent execution as we opened over 30% more stores this year than last. Due to the strength in our store development capabilities paired with strong demand for Starbucks locations, we surpassed our regional store count target of 1,800 stores by nearly 400. And we continue to see tremendous opportunity in store openings both in the US and international markets. This year, we are targeting the opening of at least 2,400 locations worldwide. Of note, we have grown our store base by a compound annual growth rate of more than 21% over the past five years. Additionally, we believe we can ultimately have 40,000 locations worldwide with half of those locations outside the US. With so much development in growth, the natural question might be, how have these investments impacted Starbucks' financial health? Let me reassure you. We've achieved robust store expansion, delivered strong financial performance, increased our equity ownership in international markets and continue to foster innovation throughout our business around the world. Let me talk about some specifics. In fiscal year 2006, we served our customers more than 40 million times per week in 12,440 Starbucks locations in 37 countries. We delivered consolidated net revenues of $7.8 billion, increase of 22%, which exceeded our growth target comprised of solid increases in both retail and specialty revenues. We reported comparable store sales growth of 7% for the year including 5% transaction growth and 2% ticket growth. We delivered net earnings of $564 million compared to $494 million in fiscal 2005. And earnings per share for the year came at $0.73 compared to $0.61 per share in fiscal 2005 excluding the impact of new accounting requirement for asset retirement obligations, which Michael will review later in the call. We exited 2006 in a solid position, have set aggressive growth targets for our current fiscal year, and we look forward to continuing a positive momentum in fiscal 2007. Now, it's important to note that these results and the aggressive financial targets we have set for fiscal 2007, are all driven by the same consistent strategy to remain focused on delivering value to our culture of product innovation, serving premium quality products and continue investing in our passionate partners who provide legendary customer service, and the numbers speak for themselves. Our average unit volumes continue to increase. Fiscal 2006, average unit volumes for US company-operated stores grew to over $1 million. Additionally, first year sales in our fiscal 2006 new stores in the US have continued to perform well delivering an estimated $920,000. Now, let me recap some of the highlights specific to the fourth quarter. Consolidated net revenues grew by 21% to $2 billion, with net earnings of $117 million. Comparable store sales grew 5% for the quarter, 4% by transaction growth and 1% by higher ticket. As we grow our business, Starbucks Experience continues to be universally relevant and accepted. Let's review both the innovations and traditions Starbucks had and will deliver in order to continue this growth. During the quarter, we continue to build on what makes Starbucks unique. Product innovation, legendary service and execution and the focus clearly paid-off. During the fourth quarter, Starbucks US company-operated retail locations delivered $1.4 billion in revenues. Key drivers behind this quarter were innovations across our beverage menu, as well as our food offerings. Beverages introduced during the fourth quarter included our new Frappuccino Juice Blends, offered in two popular flavors, Pomegranate and Tangerine, and the return of one of our highly anticipated seasonal flavor Pumpkin Spice. The continued success of Pumpkin Spice provides an excellent trailer to the return of our popular holiday beverage trio, Peppermint Mocha, Gingerbread Latte and Eggnog Latte. Again during the fourth quarter and for the year, food was a strong contributor to sales in all three categories -- Bakery, Lunch and Warming. Food continues to be a growing part of our business, and fiscal 2006 demonstrated significant progress in capturing some of the potential opportunities we have identified. We've enhanced our offerings introducing additional reduced fat options in bakery and our new yogurt parfait. We've added new lunch items, we've expanded our grab-and-go lunches into new markets and to more stores, and we saw substantial expansion of our warm breakfast sandwich program, more than tripling the number of stores in which it is offered year-over-year. Let me first bring you up-to-date on expansion of lunch. At the end of our fiscal 2006, we had offerings in 21 markets, with the newest being Atlanta. Our customers now have the options to purchase lunch along with their favorite beverage in more than 4,150 locations within the US and Canada. This is in addition of nearly 1,000 locations during the year, an increase of 32% when compared to this time last year. Think about it this way, lunch is offered in 67% of our US company-operated locations and 70% of our company-operated locations in Canada. Now let's shift to one of our newest food innovation, the warm breakfast sandwiches. More and more of our customers around the US will be able to enjoy warm breakfast items as we aggressively expand the stores providing warming at fiscal 2007. In fact, by this time next year, we estimate that approximately 3,400 Starbucks stores will feature warm breakfast items and that’s compared to approximately 1,000 locations today, which includes our latest market launch in New York in early October. Not only just warming offer our customers a premium quality breakfast option, but also provides us a nice incremental revenue contribution, delivering approximately $35,000 in additional annual sales to those stores offering the products. Looking at what's in our stores today, last week marked the return of our popular holiday beverage including the Peppermint, Gingerbread and Eggnog beverage trio. Starbucks Christmas Blend whole bean coffee, returning seasonal food favorites and fantastic gift ideas, which we believe will strengthen our customer loyalty. We also brought back the perfect food pairings to accompany our holiday beverages, the Cranberry Bliss Bar and the gingerbread loaf, which offer a tasty indulgence. Additionally, a favorite customer lunch offering will also be featured again this year, Grandma's Turkey Sandwich, which is available in stores through out the holidays. Turning to merchandise, this year's holiday assortment is a wonderful mix of old favorites and new traditions, making Starbucks a convenient destination for our customers' holiday shopping. Again this year, we featured everything from stocking stuffers to holiday serveware to special holiday prices on our brewing equipment. A few of our merchandise items includes new holiday Barista Bears, Starbucks exclusive gift packs, two new seasonal Starbucks card designs, new Hear Music holiday CDs and audio books and a new ten-cup brewer that is exclusive to Starbucks. Before I close, I'd like to spend a little time discussing our ongoing commitment to preserving the core of our company and that’s coffee. In fiscal 2004, we formally introduced C.A.F.E. practices, which helps ensure Starbucks purchases coffee that is grown and processed in a sustainable manner. Additionally, C.A.F.E. practices help secure Starbucks coffee supply using environmental and social responsible practices. During the fiscal 2006, we set a goal of purchasing 150 million pounds of coffee through C.A.F.E. Practices. I am very pleased to report that we surpassed that goal and we'll continue our work in this area. Our new goal is to purchase 225 million pounds of C.A.F.E. Practices-verified coffee during fiscal 2007. This commitment to preserving our core coffee also extends to ongoing education around sustainable coffee practices and our tireless effort -- our tireless support and efforts of our coffee farmers. You may have recently seen Starbucks in the media with respect to Ethiopia and trademark issues. We support the recognition of the source of our coffees and have a deep appreciation of the farmers that grow them. In fact between 2002 and 2006, Starbucks increased its Ethiopian coffee purchases by nearly 400%. Starbucks has recently asked to support a licensing agreement and the trademark in names used for growing coffee in the coffee area in Ethiopia. Starbucks has never filed an opposition to Ethiopian government's trademark application. We have proposed certification as an alternative solution. We are committed to working collaboratively with key stakeholders to find a solution that supports Ethiopian coffee farmers. We stand true to our core and recognize that coffee is important to our continued growth. With that, I would like to turn the call over to Howard."
},
{
"speaker": "Howard Schultz",
"text": "Thank you, Jim. My remarks today will focus on two areas, an overview of our international business and a look at recent developments in our music and entertainment strategy. Our international business continues to be a key focal point for the company. We have and will remain focused on building upon our solid foundation with a goal to continue to expand our store base through our entry into new markets. We also seek opportunities to further leverage the brand by introducing products outside Starbucks retail locations, something we have had great success with in the US. During fiscal 2006, we continued to focus on hiring and building strong teams throughout our international business, making relevant connections with local communities, providing legendary service to our customers around the world and increasing our equity stake in several key markets. Fiscal year 2006 results reflect the progress that we have made with total international net revenues increasing 32% to $1.4 billion, and operating income growing 33% to $115 million. Overall, we now have more than 3600 stores in 36 countries outside the US. We have opened a record number of locations during the year, 665 to be exact, and we achieved several significant milestones during the year. Canada now has more than 680 locations, Japan reached 650 stores, UK store count now exceeds 500 locations, and there are more than 430 stores throughout our greater China region. And, this is just the beginning. We have tremendous opportunities to continue growing in existing markets and now have worked diligently over the past year to ready ourselves for entry into several new and key markets within the coming year. Our solid financial performance during a time of rapid growth is truly exceptional and further encourages us to capitalize on the immense growth opportunities that lie ahead for Starbucks. Before I move on, I would like to highlight our recent launch of the Starbucks card in the U.K. Beginning this week, our customers in the United Kingdom are now able to purchase, reload, and register Starbucks cards at more than 500 Starbucks locations. The initial response was very, very strong on the first day. One enthusiastic customer purchased 30 cards in one transaction. This response suggests that the Starbucks card will be a very popular gift item in the U.K. and just as successful and well accepted as it has been in North America. In fact, we have already had to order more cards to supply for the strong demand in anticipation of the holiday season. Now, moving on to a discussion around the growth opportunities available to us, not only through entering new markets or opening new stores but also through opportunistically increasing our equity ownership where and when appropriate. During fiscal 2006, we took advantage of the opportunity to acquire the remaining 95% ownership of our operations of both Hawaii and Puerto Rico. These acquisitions provide us with greater influence over the Starbucks brand and will allow us to focus on continued operational efficiencies and growth in these markets. We began fiscal 2007 with the acquisition of a 90% interest in our Beijing operations. This represents our continued commitment to invest in what we believe could be the single largest market outside of the United States. This will allow us to leverage the infrastructure investments we've put in place over the last year to lead the greater China market in building a consistent operating platform and delivering the Starbucks experience to our customers in Beijing. Our increased equity ownership further demonstrates our commitment to China, and through this transaction, we hope to accelerate our expansions plans within this market. As the second largest city in China, boasting a population of more than 11 million people, Beijing is a key market for Starbucks. Now, let me highlight up coming new market entries. Later this month, we will open our first Starbucks store in Sao Paulo, Brazil's financial and industrial center. We recognize there is already a thriving coffee culture in Brazil, and we look to introduce the local Brazilian communities to our unique coffee experience. Brazil is an important market for Starbucks not only because it is a source for high quality arabica coffee beans but also because it's a market with many growth opportunities for the retail sector as a whole. We will also open our first Starbucks store in Cairo, Egypt by the end of the calendar year, which is another notable milestone, because this will be our first entry into Africa. Not only is Cairo the capital of Egypt and the largest city in the Middle East and in Africa, it also has a rich coffee history, coffee culture with consumers interested in the right mix of ambiance and products. We believe the Starbucks experience will provide just that to the people of Cairo. The Starbucks brand continues to attract more and more interest from communities around the world, which is a reflection of the power of the brand and it's relevancy to so many different cultures. It's the continued high level of community interest coupled with the strong financial performance we delivered today that gave us the confidence to raise our long-term international store count total to at least 20,000 locations in markets outside of the US. With more than 3,600 locations today, we have a tremendous runway for growth in international markets in the years ahead. Now, let me provide you with an update on the results of our initial project in the movie segment of our music and entertainment business, and then I will review more recent initiatives in the overall entertainment category. As you know, through unique marketing efforts in our retail stores, Starbucks was involved in the theatrical release of Akeelah and the Bee. And we were happy to report that following the film's release, we experienced great success with the sale of the DVD in our stores. In fact, Starbucks ranked among the top four brick and mortar retailers of selling Akeelah and the Bee. Our combined four-week market share for the end of the fiscal year was approximately 9%. Moving now to our entry into literature. You will recall that during the fourth quarter, we announced the next phase of our entertainment strategy, the integration of books into our overall entertainment offering. Our first selection was a novel by acclaimed author Mitch Albom titled \"For One More Day\". We began the nationwide promotion of the novel on October 3 with in-store appearances by Mitch in eight markets. Coinciding with that was the first-ever Starbucks Book Break where customers in 32 markets were able to share their thoughts and connect with one another through meaningful discussions of the universal themes of the book. Our role in the promotion of For One More Day was truly successful. Sales of the book in our stores have exceeded our expectations. The book has been a New York Times' Bestseller as well and as a result of the success and the continued demand on a national level for the book, we will continue to sell the book through the Christmas holiday. Reflecting on that success with both the book and the film, one point I would like to highlight to you that you are probably nor aware of, and that is that Starbucks in both cases of the DVD and in the book sold these products at full retail price at a time when these categories are being heavily discounted by other retailers. Yet, we were able to maintain full gross margin on these items, I think once again creating an opportunity for us, which our customers really do trust, the editorial voice of our company. Now, moving on to the music component of Starbucks Entertainment. Last month, we released a new CD from Ray Charles. That's right. You heard me correctly. A new CD from Ray Charles appeared in our stores last month. Starbucks Entertainment teamed up again with Concord Records to co-release and co-market Ray Sings, Basie Swings, a new album that marries never before released Ray Charles recordings with brand new performances by the Count Basie Orchestra. After a strong first week of sales at Starbucks and traditional retailers, this album debuted at number 23 on the Billboard Top 200 albums chart and has been -- and has remained there since its release. Starbucks locations account for more than one half of all copies of this album in America. Our newest initiative partners Hear Music with iTunes, an innovative partnership providing online access to our popular Hear Music titles; iTunes users now have the ability to preview, buy and download a wide variety of tunes from Hear Music's library. The Starbucks Entertainment area and iTunes marks the first time that Apple has allowed editorial guidance in content from another brand that has been developed by a partner to appear with the iTunes store. Bridging the gap between product in our stores and the digital consumer, we are now looking forward to such opportunities as marketing programs that link physical CDs sales in our stores to unique content online. This puts Starbucks in a great position to create true entertainment destination with the next stop in our digital strategy. We're excited to be working with Apple and iTunes on this innovative buying experience which will provide our customers the ability to take Starbucks Hear Music tunes with them wherever they go. The success we have had with music, film and literature and more recently our iTunes collaboration demonstrates that Starbucks has truly transformed the way our customers discover and acquire quality entertainment options providing an enriching experience to both them and our partners. Starbucks has a unique place in the daily lives of our customers and we highly value the trust our customers have placed in us. We embrace the opportunity to be part of their entertainment discovery and we are committed to selecting music, movie or literature projects that will represent the quality and substance reflective of the Starbucks brand and experience. This is the same approach we apply throughout our business, seeking products, channels and opportunities that enrich the daily lives of our customers. In closing, as I reflect on the ten years since we opened our first international store, we have worked diligently over that time, building a solid foundation for our international business, which will allow us to capitalize on the tremendous growth opportunities ahead of us. Just look at what we have accomplished. We have entered 36 countries outside the US. We have more than 3,600 stores in international markets at fiscal year end with nearly 50 more opened in the last month. Over that decade, we acquired full equity ownership in six markets and increased our equity ownership position in seven JV markets. While I am talking about expansion, let's not forget about store development. It was not that long ago following a great deal of planning and thoughtful review that we began speaking to you about extending our store development strategy to opening drive-thru locations in America. Now just a short time later, we have also expanded drive-thrus to several of our international markets, again demonstrating the strengths of the brand, which allowed us to extend a relatively new Starbucks concept to our global customers. We now have approximately 100 international drive-thru locations including stores in Canada, Japan, Mexico, Saudi Arabia, Puerto Rico, Jordon, Australia and Indonesia. In fact, just last month, a near record number of customers joined us for the opening of our newest drive-thru in Monterrey, Mexico. In a very short period of time, it has become the gathering place in the neighborhood. It's often packed from noon to closing in the late evening. It wasn’t that long ago, that we questioned whether or not we could extend the drive-thru strategy to international markets. Would drive-thrus appeal to customers outside of America? Today, we are extremely encouraged by the strong customer adoption of these stores, so early on, in the development of our international business. Also of note, within this decade, we have made significant inroads in extending the brand beyond our retail stores, by introducing ready-to-drink beverages in several Asia Pacific markets, and that is just one of the many opportunities to further leverage our strong brand equity and monetize the equity of Starbucks brand outside of our stores. Think about that, 10 years ago we had no presence outside in North America. Today, Starbucks has established a worldwide appeal not only for our coffee, but the physical environment we have created within our stores. I believe one would be hard for us to find another US based retailer that has accomplished this much and achieve this much in such a short period of time. The level of global acceptance, which Starbucks has achieved, is really, really significant. While this company has come a long away in a very short period of time, I truly believe we are still in the early stages of growth. We have a strong business model, which has continued to deliver strong returns to our shareholders and we have great confidence in the long-term global potential for Starbucks. With that Michael Casey."
},
{
"speaker": "Michael Casey",
"text": "Thank you, Howard. This afternoon, I will provide highlights of our financial performance for the fourth quarter and the full fiscal year. However, before I get into the details, I think I should clarify and put into perspective what appears to be some confusion about with the initial reading of our press release today. There are several net income numbers reported, and I would like to line each of them up with how we look at. The bottom line for the fourth quarter was earnings per share of $0.15, but that included $0.02 per share of a new accounting principle FIN 47 for asset retirement liability. If you take that out or you back up above that, the earnings per share would have been $0.17 a share or about $134.5 million. That’s 18.7% growth over the previous year, but when we look at our business on an apples-to-apples basis, we also exclude the impact of SFAS 123R or the accounting for equity-based compensation. And if you added back the $0.02 per share related to that, our earnings per share would have been $0.19 per share and the net income would be $152 million or 22.8% above the previous year, which is the way we look at the business, from an operational point of view. For both the fourth quarter and the full year of fiscal 2006, our revenue growth continued to be very robust. Consolidated net revenues grew 21% for the quarter and 22% for the year. Company-operated retail revenues increased 22% for both the quarter and the full year, driven by the opening of 1,040 new company-owned retail stores in the last 12 months, and comparable store sales growth of 5% for the quarter and 7% for the full year. Specialty revenues grew 16% for the quarter and 23% for the year, primarily due to higher product sales and royalty revenues from the opening of 1,159 new licensed retail stores in the last 12 months. Before I move on to reviewing other financial highlights, let me mention three items that had an impact on our reported results in the fourth quarter: stock-based compensation expense, the adoption of new accounting guidance for asset retirement obligations, and the effect of certain tax items. As we have discussed in previous quarters the company adopted new expensing requirements for stock-based compensation at the beginning of 2006 with no restatement of prior period results. The pre-tax stock-based compensation expense recognized for the fourth quarter was $27 million or $17.5 million net of tax for an EPS impact of $0.02 per diluted share. For the full year of 2006, stock-based compensation was $69 million net of tax or $0.09 per share. Please refer to page 7 of the press release for a breakout of how this expense is allocated in our consolidated statement of earnings. Next, as we discussed last quarter, new accounting requirements from the FASB related to asset retirement obligations known as FIN 47 were adopted by the company at the end of fiscal 2006. For Starbucks as for other retailers with large numbers -- with a large number of leased store locations, these costs are for the estimated future expense of remodeling leasehold improvement at the termination of the lease. A cumulative effect of this accounting change was $17.2 million net of tax or $0.02 per diluted share. Beginning in fiscal 2007, this accounting requirement will be reflected in the company's financial statements and will not have a material impact on the company's results. Now turning to the tax items. As I have mentioned several times in the past, fluctuations in the effective tax rate are much more likely now than they used to be. For the fourth quarter, our effective tax rate was 33.2% compared to 38.1% for the same period in fiscal 2005. For the full year of 2006, the effective tax rate was 35.8% compared to 37.9% for 2005. The decline in the fourth quarter was due to recognition of the full-year benefit of a shift in the mix of expected profitability to lower tax international markets and increased effectiveness of the company's long-term tax planning strategies, as well as several favorable audit settlements, closures, and adjustments. In addition, there was a valuation allowance recorded in the fourth quarter of fiscal 2005, which resulted in a higher effective tax rate for that quarter. For the full year, the decrease in the effective tax rate was due to the items mentioned above as well as to the settlement reported in the third quarter of 2006 of a multi-year income tax audit in a foreign jurisdiction, for which Starbucks had established a contingent liability. Now, I would like to elaborate further on our operating results. Operating income was $198 million in the fourth quarter compared to $197 million in the prior year. As a percentage of net revenues, the operating margin declined to 9.9% from 11.8% in the prior period. Excluding $27 million of stock-based compensation expense recognition in the fourth quarter of this year, operating income increased by 14.3% to $225 million, and the operating margin was 11.2%. Beyond the impact of stock-based compensation in the -- is the cumulative impact of various rising costs that we incurred during the period, a significant portion of which related to higher labor costs in our US retail business, which I will review later in the US segment discussion. For the full year 2006, operating income increased to $894 million from $781 million in fiscal 2006, and the operating margin was 11.5% compared to a record 12.3% in fiscal 2005. For the full year, the company’s operating margin, excluding the impact of stock-based compensation, improved 0.5% of revenues to 12.8%. Beginning in fiscal 2007, reported amounts for the current and prior period will be comparable with respect to stock-based compensation. Fully diluted earnings per share were $0.17 for the fourth quarter of fiscal 2006 compared to $0.16 per share for the comparable period in fiscal 2005, excluding $0.02 cumulative effect of adopting FIN 47 in 2006. For the full year, diluted earnings per share were $0.73, excluding $0.02 for the accounting change compared to $0.61 per share for fiscal 2005. So, in summary, in fiscal 2006, we once again delivered strong financial performance exceeding our 20% revenue growth target, generating same-store sales growth at the high end of our 3% to 7% range and delivering EPS growth significantly above our original target of $0.63 to $0.65 per share. Turning now to the operating segment's results for the fourth quarter. Total net revenues for our United States operating segment increased by 18% to $1.6 billion for the fourth quarter of fiscal 2006. Company-operated retail revenues grew 18% to $1.4 billion, primarily due to the opening of 801 new company-operated stores in the last 12 months, and comparable store sales growth of 5% for the quarter. The increase in comparable stores sales growth was comprised of a 4% increase in the number of customer transactions combined with 1% increase in the average value per transaction. US specialty revenues grew by 14% to $247 million in the fourth quarter. Within specialty revenues, licensing revenues increased 20% to $168 million, primarily due to higher product sales and royalty revenues from the opening of 733 new licensed retail stores in the last 12 months, and to a lesser extent, growth in the licensed grocery and warehouse club businesses. Foodservice and other revenues increased 3% to $78 million, due mainly to the addition of new accounts in the U.S., bringing our total foodservice reach to approximately 15,000 accounts. The impact of the growth in foodservice revenues and other revenues was dampened by an unfavorable year-over-year comparison in other revenues, which included revenue from the sales of Ray Charles 'Genius Loves Company CD outside of Starbucks retail stores in the fourth quarter of 2005. U.S. store operating expenses as a percentage of related retail revenue increased to 43.2% in the fourth quarter of fiscal 2006 from 41.5% in the prior year. The increase was primarily related to higher payroll expenditures for our U.S. retail stores, due to higher than ideal store staffing levels, the addition of more assistant store managers, and regional support positions and an increase in training hours for store partners and future store leaders. With our continued aggressive growth in retail stores, the investment in our future store leaders is absolutely paramount. Accordingly, at the end of fiscal 2006 we had assistant store managers in 77% of our company-operated stores, compared to 68% at the end of fiscal 2005. We have taken proactive steps to help mitigate rising store operating costs through the additional management focus on more effective store labor deployment and with our recent beverage and whole bean price increase. You should also note that the recognition of stock-based compensation expense increased payroll related expenditures in fiscal 2006 versus 2005. U.S. operating income increased to $240 million during the quarter from $239 million during the same period in fiscal 2005. The operating margin decreased to 15.2% of related revenues for the fourth quarter of fiscal 2006 from 17.3% for the fourth quarter of fiscal 2005. The decrease was due primarily to the higher store operating expenses I just noted and to an increase in cost of goods sold, including occupancy costs. The cost of sales including occupancy costs increased primarily due to higher green coffee costs, a shift in retail sales mix to products with lower gross margins when compared with beverages as well as to higher utility and distribution costs, offset in part by favorable dairy costs. U.S. food revenues grew at a faster rate than overall revenue growth. Now moving to the international segment, international total revenues increased 36% to $381 million in the fourth quarter of fiscal 2006. International company-operated retail revenues increased 39% to $319 million in fiscal 2006, mainly due to the opening of 239 new company-operated retail stores in the last 12 months, comparable store sales growth of 8% for the quarter and the conversion of Hawaii from a licensed market to a company-operated market. The comparable store sales increase resulted from a 5% increase in the number of customer transactions, coupled with a 3% increase in average value per transaction. International specialty revenues for the quarter increased 24% to $62 million, primarily due to higher product sales and royalty revenues from opening 426 licensed retail stores in the last 12 months and due to sales of ready-to-drink products in Japan, Taiwan and Korea. Operating income for international operations decreased to $28 million in the fourth quarter of fiscal 2006 from $30 million in fiscal 2005. The operating margin decreased to 7.4% of related revenues from a record fourth quarter of 10.9% in fiscal 2005. This decrease was primarily due to lower reported income from the company's equity investees, higher store operating expenses, as well as higher other operating expenses, offset in part by lower cost of sales including occupancy. The decrease in equity investee income was primarily due to accounting corrections, totaling $4.1 million made in the fourth quarter of fiscal 2006 for two of our international joint venture markets. The increase in store operating expenses and other operating expenses was due to higher payroll expenditures for additional employees to support global expansion, particularly in our Asia-Pacific, China and EMEA markets and due to the recognition of stock-based compensation expense. Lower cost of sales, including occupancy, were due primarily to leverage gains from fixed costs distributed over an expanded revenue base as well as favorable dairy costs, offset in part by higher green coffee costs. It bears repeating past comments that our ongoing investment in our international infrastructure, including investments in emerging markets, will continue and can be expected to cause variability in future quarterly operating margins. Our overall business model is based on strong revenue growth and moderate margin improvement over the long term, an approach that requires initial infrastructure buildout. Returning now to the consolidated business, during the fourth quarter, the company repurchased 14.6 million shares of Starbucks' stock at a cost of approximately $474 million under authorized share repurchase programs. For the full year, 25.6 million shares were repurchased for a cost of $828 million. Since the inception of our share repurchase program in 2001, Starbucks has returned over $2.3 billion to shareholders through the repurchase of approximately 100 million shares through October 1, 2006. Our strong balance sheet, continued strong operating cash flows, and the borrowing capacity under our $1 billion revolver provide the company significant financial strength and flexibility. This allows us to continue to build and maintain our expanding store base, reinvest into the brand through equity ownership stakes in new markets, and equity contributions to existing JV markets, selectively invest in new growth opportunities, such as China, Brazil, Russia and India, and to repurchase shares. We also continue to improve our return on equity, which reached 25% in fiscal 2006 from 20% in fiscal 2005 and 17% in fiscal 2004. Let me wrap up by reminding you that Starbucks has a solid track record of delivering on its aggressive financial growth targets. We have a strong business model that consistently drives approximately 20% top-line revenue growth, primarily through retail revenue growth in our company-operated stores. Our track record of 15 years of 5% or greater same-store sales growth is clearly among the best-in-class for retailers. And our revenue growth is complemented by our specialty revenues, which are primarily driven by our licensed stores. We believe that our unique business model, global presence, and strong brand recognition are all key competitive advantages. Those factors, as well as the immense opportunities that lie ahead of us, provide us the confidence to set our sights on aggressive targets for 2007. These include opening 2400 new stores, approximately 20% top-line growth, same-store sales growth in the 3% to 7% range, and earnings per share growth of approximately 20% to 25%. As you all know, the first half of fiscal 2006 resulted in particularly strong earnings growth, so it is important to keep in mind quarterly comparisons in the first half will be more challenging than the second half of fiscal 2007. With that I would like to now ask the operator to queue up the first question. Please ask one question at a time, and re-queue for additional questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions). We will pause for just a moment to compile the Q&A roster. Your first question comes from John Glass with CIBC."
},
{
"speaker": "John Glass - CIBC",
"text": "Thanks. Michael, it sounded like maybe the higher store level labor in the U.S. was a surprise to you in the quarter. Is there any way to quantify how much margin pressure came from the growth spending rather than maybe just ambient cost pressures? Maybe you could just look forward, how much of the price increase will -- how much of that will be covered by the price increase as you go forward the next couple of quarters?"
},
{
"speaker": "Michael Casey",
"text": "I would say that less than half of the margin pressure in the store operating expenses or approximately half, to be conservative, was due to issues within the store and the other half was growth related. And we believe that we're taking the steps both with regard to labor deployment and as a benefit -- and with the benefits of the price increase to offset that part of the margin pressure."
},
{
"speaker": "John Glass - CIBC",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jeffrey Bernstein with Lehman Brothers."
},
{
"speaker": "Jeffrey Bernstein - Lehman Brothers",
"text": "Great. Thank you. I have a question on margins. I think you mentioned in your prepared remarks that the cost of sales negatively impacted by the shift in sales to products with low gross margins. Obviously, as you continue to grow your business in the areas other than coffee I would expect this trend to continue. Just wondering your thoughts on that and specifically how we should think about cost of sales as we look out to fiscal '07 for both U.S. and international. Thanks."
},
{
"speaker": "Michael Casey",
"text": "I'll take that question. I think the important thing to remember is that I was talking about the cost of sales including occupancy line, when I made that comment. And so, the nature of the non-beverage products are that they have lower gross margins, but they have much less labor activity associated with them. So at the store level, we are equally profitable whether we sell an extra dollar of beverages or an extra dollar of either food or merchandise or entertainment products. So, the pressure is related to the gross margin line, not to the store contribution line. I think that’s the most important aspect of that. In the US, we expect -- for the total company, we are expecting approximately flat gross margins year-over-year, 2007 versus 2006. If you break it down by segment, we do expect to continue to see some improvement in the international segment as we get an increasing number of stores utilizing the infrastructure that has been built and is continuing to be built in the international market."
},
{
"speaker": "Jim Donald",
"text": "And to repeat the plan for '07, the increase in warming and lunch is baked into our numbers that we are looking at going forward."
},
{
"speaker": "Jeffrey Bernstein - Lehman Brothers",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Joe Buckley with Bear Stearns."
},
{
"speaker": "Joe Buckley - Bear Stearns",
"text": "Thank you. First is the clarification on the last one. Mike, did you say you expect the gross margins in the US to be flat or the store level margins?"
},
{
"speaker": "Michael Casey",
"text": "We think the -- we expect the gross margins year-over-year to be approximately flat in '07 versus '06."
},
{
"speaker": "Joe Buckley - Bear Stearns",
"text": "Okay. And then just a question on G&A in the quarter and a question on the tax rate going forward, just a full year expectation, just the G&A in the quarter looked -- particularly on the US side, very well-contained, very low. There is a couple of things mentioned in the release, but can you just talk a little bit about that and what your thoughts are going forward on that line? And then again as I suggest your full-year tax expectations for '07?"
},
{
"speaker": "Michael Casey",
"text": "Over our 3 to 5 years strategic planning horizon, we expect the primary driver of total company margin improvement to be G&A leverage. We expect to maintain our operating margins, perhaps make some improvement, not talking about it on a particular quarter, but on a year-over-year basis, modest improvement in operating margins. But as the business grows to get more significant improvement in the G&A lines and to some extent in the depreciation and amortization line, so that we get growth in total -- in total company operating margin. Within these individual segments, we expect to continue to get operating margin improvement within international, but not so much so within our family of US businesses. The tax rate, as I mentioned leading to that, the tax rate used to be a lot easier to predict when it was done on a longer-term basis. The current requirements with regard to tax, is that every specific event that happens triggers a specific change in that period. So there are going to be more fluctuation in the tax rate. And, so we are still targeting the 38% effective tax rate that we've targeted in the past. But we are encouraged that some of our long-term tax planning activities and the increasing contribution to profit made by our international business over the long term will give us improvement in the effective tax rate. But it won't be every quarter and it won't be dramatic in the short term."
},
{
"speaker": "Joe Buckley - Bear Stearns",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Steven Kron with Goldman Sachs."
},
{
"speaker": "Steven Kron - Goldman Sachs",
"text": "Great, thanks. Can I just quickly ask a follow-up on that G&A question? In the press release, Michael, as it talks about the lower provision for incentive compensation, just wondering if you can just put a little bit more color around that? And, then my question is more balance sheet related, I don’t think in the release there was balance sheet information, can you tell us how much cash you had at year-end and did you tap into the revolver during the quarter? Thanks."
},
{
"speaker": "Michael Casey",
"text": "Well, I will answer to the cash question first. We reduced our -- I believe we reduced our borrowings during the quarter and we expect to further reduce our borrowings during the very strong operating first quarter in G&A. Well if you look at the operating results of our business, they weren’t as strong in the fourth quarter of this year as they were in the fourth quarter of last year, looking at strictly an operating point of view. And, so we have a performance-based incentive comp program and because the business wasn't quite as strong, we had a lower accrual for incentive compensation related to the business in the fourth quarter."
},
{
"speaker": "Steven Kron - Goldman Sachs",
"text": "Okay. And do you have that cash balance as of year-end?"
},
{
"speaker": "Michael Casey",
"text": "We didn’t issue the balance sheet because we are still finalizing the details of FIN 47 as it related to the balance sheet but the cash and cash equivalents were about $313 million."
},
{
"speaker": "Steven Kron - Goldman Sachs",
"text": "Okay, thanks."
},
{
"speaker": "Michael Casey",
"text": "I'm sorry, to correct what I said before, the borrowings at the end of the year were $700 million versus about $300 million at the end of last year. But we have paid that down subsequent to the end of the quarter and would expect to continue so during the very strong first fiscal quarter of the year."
},
{
"speaker": "Steven Kron - Goldman Sachs",
"text": "Thank you."
},
{
"speaker": "Michael Casey",
"text": "You're welcome. Operator?"
},
{
"speaker": "Operator",
"text": "Your next question comes from David Palmer with UBS"
},
{
"speaker": "David Palmer - UBS",
"text": "Hey guys. You mentioned 3,500 stores, I think by next year with breakfast versus about 1,000 now. I think that's what you said and if that's true that would maybe 800 or more per quarter. Is the ramp up going to be smooth like that or is there going to be a ramp up in deployment? Could you perhaps give us a sense of the timetable? And separately, could you give us a sense of may be how breakfast is going in new markets where you deploy it? Are you seeing the same sort of 30,000 per store lift that you are seeing in some markets early on or are you perhaps seeing a bit better performance these days?"
},
{
"speaker": "Jim Donald",
"text": "On average, it is around the 30,000, may be a shade north of that. If you take -- if you dive down to the markets, each market has differently based upon the time it has been in the marketplace. But when we look at the launch, we have to -- it's no different than we launched this from the inception. We are taking a balanced approach on a quarter-by-quarter basis and putting again this all into our ’07 plan, the resources in place that we don't affect the in-store experience with the speed of service that the sandwich -- the warming sandwich that our customers get are up to our own and their expectations. So, this is something that we are doing over the course of the entire year on a balanced approach."
},
{
"speaker": "David Palmer - UBS",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Sharon Zackfia, with William Blair."
},
{
"speaker": "Sharon Zackfia - William Blair",
"text": "Hi, good afternoon. Can you talk about the reaction of customers to the price increase you took here in the US and also in Japan? And where you think the effective price benefit will fall out or comp here in the US?"
},
{
"speaker": "Howard Schultz",
"text": "This is Howard. I will start Japan. I just came back from Japan. Our business there is quite good. It appeared that the price increase was relatively seamless in terms of the announcement and feel very comfortable on a go-forward basis."
},
{
"speaker": "Jim Donald",
"text": "In the US, as I look across, all of our markets, all of our regions, we basically see the same -- are seeing the same thing, a seamless transition over to a small increase and customers continuing to frequent our stores on a same or a higher transaction comp basis."
},
{
"speaker": "Michael Casey",
"text": "And the impact of the price increase is included in our 3% to 7% same store sales guidance."
},
{
"speaker": "Sharon Zackfia - William Blair",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Matt DiFrisco with Thomas Weisel Partners."
},
{
"speaker": "Matt DiFrisco - Thomas Weisel Partners",
"text": "Thanks. With respect to margins and on the international side in the text of the release you say accounting corrections totaling 4.1 million were in part attributed to the margin contraction on the international side, how should we look at that going forward as far as the direction of margins internationally, especially the first half given the heady year-ago comparisons?"
},
{
"speaker": "Michael Casey",
"text": "You should not expect the accounting corrections to occur -- to reoccur. That has -- that was a one-time event that we don't expect to happen again. So, that part of it is not -- would not be repeated. I don't want to predict the youth -- the international market -- margins on a quarter-by-quarter basis, but as you want to reiterate that we expect over any sort of trailing 12 month period compared to previous trailing 12 month period that there would be noticeable improvement. But the rate at which we enter new markets, the activity within the various markets can cause some quarters to be up and some quarters to be down over the next several years as we move forward. Q1 last year was extraordinarily strong, and so that might be one that I wouldn't expect to surpass, but I don't want to get in the business of trying to predict segment margins on a quarter-by-quarter basis in a business that we know is going to be lumpy and it's going to be a challenge to balance the need to build the infrastructure for the tremendous opportunity that's ahead us versus the also-important need to continue to be increasingly profitable."
},
{
"speaker": "Matt DiFrisco - Thomas Weisel Partners",
"text": "Okay, I guess also I had a clarification and want to make sure did you say that the price increase is going to in the US meet and offset the cost pressures that are causing some of the margin pressures and therefore hold restaurant level margin flat?"
},
{
"speaker": "Michael Casey",
"text": "Well I didn't go that far, I said that the price increase should have a beneficial effect on the labor pressure that we had in the fourth quarter. There are all kinds of other things that are going on in the business and I am not prepared to predict what the margins are going to be in the first quarter."
},
{
"speaker": "Matt DiFrisco - Thomas Weisel Partners",
"text": "Okay. Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from Glen Petraglia with Citigroup."
},
{
"speaker": "Glen Petraglia - Citigroup",
"text": "Thanks. Michael, if you could maybe give an outlook for green coffee prices as well as the company’s use of fixed price versus price to be fixed contract in 2007 and how that compares to 2006. That will be great. Thanks."
},
{
"speaker": "Michael Casey",
"text": "Okay. Basically the last couple of years we have been seeing increasing green coffee prices and we have in the third quarter of this year and in the fourth quarter of this year we had approximately 10% higher green coffee costs in the current period than we did in the previous period. The good news -- well, sort of the bad news is that the near term and the near and the future contract prices in the market place have gone up in the last two or three weeks fairly noticeably. But the good news in that story is that we are basically bought 18 months ahead and that we have done essentially -- the vast majority, 90% of the purchasing that we need to do in this current 12-month period has been accomplished in the August, September, early October time frame. So, our purchases were ahead of the recent run up so I don’t expect any surprises whatsoever in green coffee. And I do expect our absolute costs to level over the next 12 months and the comparisons will get better as the prior year green coffee costs come up underneath the fairly flat level that we are going to experience for the next twelve months."
},
{
"speaker": "Glen Petraglia - Citigroup",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Your final question comes from Dan Geiman with McAdams Wright Ragen."
},
{
"speaker": "Dan Geiman - McAdams Wright Ragen",
"text": "Good afternoon. I guess, excluding like green coffee, which you just talked about, what are your assumptions as far as commodity prices and other inputs heading into the coming year? Where do you see the primary pressure points? Where do you see some areas of opportunities as well?"
},
{
"speaker": "Michael Casey",
"text": "We currently have seek favorability in the diary complex and the milk products that we buy, although I have caveat that with the fact that they can change rather rapidly and we are not hedged with regard to dairy, but currently we are getting favorable comparisons in dairy. I think the negative aspect will continue at least in the first half of this year related to energy. As we compare against periods when the energy costs were not quite so high in the first half of last year and when a number of our vendors, landlord, other business partners, had not fully passed through energy cost increases to us."
},
{
"speaker": "Dan Geiman - McAdams Wright Ragen",
"text": "Thank you."
},
{
"speaker": "Michael Casey",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "That was our final question. Do you have any closing remarks?"
},
{
"speaker": "JoAnn DeGrande",
"text": "Yes, thank you. Thank you all for joining us for the earnings call today and we hope you will back with us for the webcast of our fiscal first quarter 2007 financial results on Wednesday, January 31, 2007. Thank you."
},
{
"speaker": "Operator",
"text": "That concludes today's Starbucks fourth quarter fiscal year-end 2006 earnings conference call. You may now disconnect."
}
] | null | null |
SBUX | 3 | 2,006 | 2006-08-02 22:15:00 | Executives: Howard Schultz - Chairman Jim Donald - President and Chief Executive Officer Michael Casey - Chief Financial Officer, Executive Vice President, Chief Administrative Officer Mary Ekman - Vice President of Corporate Development and Investor Relations JoAnn DeGrande - Director, Investor Relations
Analysts: Matthew Difrisco - Thomas Weisel Partners Joseph Buckley - Bear, Stearns & Co. John Glass - CIBC World Markets Jeffrey Bernstein - Lehman Brothers Steven Kron - Goldman Sachs David Palmer - UBS Sharon Zackfia - William Blair & Co. Glen Petraglia - Citigroup John Ivankoe - JPMorgan Chase & Co. Dan Geiman - McAdams Wright Ragen
Operator: Good afternoon, my name is Judy and I will be your conference operator today. At this time, I would like to welcome everyone to the Starbucks third quarter 2006 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer session. (Operator Instructions) I will now turn the call over to JoAnn DeGrande, Director, Investor Relations. Ma’am, you may begin your conference.
JoAnn DeGrande: Thank you. Good afternoon, ladies and gentlemen. This is JoAnn DeGrande, Director of Investor Relations with Starbucks Coffee Company. With me today are Howard Schultz, Chairman; Jim Donald, President and CEO, Michael Casey, Executive Vice President and CFO; and Mary Ekman, Vice President of Corporate Development and Investor Relations. During today’s call, Jim will review key results and accomplishments, as well as provide some highlights from our U.S. retail business. Howard will provide an update on our international business, and Michael will highlight the key drivers behind our third quarter results, comment on fiscal 2006 growth targets, and introduce our fiscal 2007 growth targets. We will limit today’s call to one hour, including Q&A. I would like to remind you that today we released our July revenues in conjunction with our fiscal third quarter results. As a reminder to all listeners, this call is being broadcast live over the Internet. A replay will be available by telephone at 800-642-1687, reservation number 3728558, by 5:30 Pacific time on Wednesday, August 9th; on the Internet and on the investor relations page at starbucks.com through 5:00 p.m. Pacific time on Wednesday, August 30th. In addition, today’s remarks will be available on the Investor Relations portion of starbucks.com by the end of the day today and will remain available through Wednesday, August 30th. This conference call includes forward-looking statements such as anticipated store openings, comparable stores sales expectations, trends in or expectations regarding the company’s net revenue, estimate stock-based compensation expense, expected capital expenditures, expected effective tax rate, and earnings per share results. These forward-looking statements are all based on currently available operating, financial and competitive information, and are subject to various risks and uncertainties. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements are contained in the company’s filings with the Securities and Exchange Commission, including the risk factors section of Starbucks Annual Report on Form 10-K for the fiscal year ended October 2, 2005. The company assumes no obligation to update any of these forward-looking statements. I will now turn the call over to Jim.
Jim Donald: Thank you, JoAnn, and good afternoon, ladies and gentlemen. Our third quarter financial results continue to demonstrate our dedicated focus on successful execution across all our business fronts. Let me begin with an overview of our solid third quarter financial results. Again this quarter, our partners successfully delivered the Starbucks Experience through product innovation and solid execution to more than 40 million customers around the world weekly, resulting in net revenue growth of 23% to $2 billion, net earnings of $145 million, and third quarter earnings per share of $0.18. For the quarter, Starbucks delivered strong comparable store sales of 6%, solidly within our 3% to 7% target range. Our robust store expansion continued with the opening of 559 new locations worldwide -- that is the highest level of store openings in a third-quarter period in the company’s history. Our store development partners demonstrated once again excellent dedication, drive, focus and skill by opening 395 stores in the United States and 164 locations in international markets. Speaking of international, a few of our international markets hit significant milestones recently: Starbucks Japan now has more than 600 locations; the U.K. opened its 500th store during the quarter; and I just recently participated in the opening celebration of our 100th store in the Philippines. What is notable about the 100th store opening in the Philippines is that when we initially opened that market, we anticipated a maximum of 50 Starbucks stores -- this again demonstrates the strength in Starbucks worldwide acceptance and the depth of our global store opportunity. Today, we also announced July results with a 20% increase in revenues for the month and comparable store sales growing 4% -- marking the 175th consecutive month of positive comparable store sales growth. I have yet to find another company in our peer universe that has delivered a similar record of positive comparable store sales growth over such a sustained period. During July, we added 162 new stores. There has been a lot of news in the past few months around fears of an economic slowdown. We are aware of softening retail sales and declines in traffic at many retail-oriented businesses, which have been attributed to overall economic conditions. While you may have drawn your own conclusions that Starbucks comparable store sales results are reflecting those macroeconomic factors, we believe our results are related more to a different set of factors and, as I will explain, we believe the opportunity for improvement remains in our control. Starbucks U.S. comparable store sales growth for the quarter was well within our target range of 3% to 7% -- but it would be remiss if we did not acknowledge that our July comp growth of 4% is below the level achieved for the first nine months of fiscal 2006. Unlike many retailers, to date, based on the best data available to us, we are not seeing any signs that macroeconomic trends are having a significant impact on Starbucks business. Yet, we do remain mindful and cautious about the external environment and we are aware of issues facing the consumer. We believe our recent slower comp growth, while still very healthy, reflects some internal challenges our stores are facing with meeting customer demand for cold blended beverages. Currently, we are experiencing stronger than expected -- it is actually unprecedented -- customer demand for blended beverages during morning peak hours. While we have made tremendous progress on our service with speed initiatives during our peak espresso periods, we still have work to do with service efficiencies around our Frappuccino blended beverage preparation. Last year we spoke to you about the growing popularity of our blended beverages. In fact, during our Spring and Summer 2006 promotional periods, we introduced a number of new and exciting blended beverage offerings which have been very well received. In light of the increasing demand for our blended beverages, we have recognized the opportunity to refine and improve our Cold Beverage Station to make drink preparation more efficient and improve service over time but, in retrospect, we did not move aggressively enough. Currently, we have deployed the Cold Beverage Station to 1,070 locations -- about 18% of our company-operated locations in the U.S. and Canada. This is one example of how we are beginning to make progress toward increasing service efficiencies in this category. What is key here is that blended beverage sales are showing strong growth, but we are experiencing the softest overall comparable transaction growth in stores with the highest blended sales. Because of this, we believe we are losing some espresso business due to longer than normal wait times, in both cafes and drive-thru’s during peak morning hours. It is also possible that we are not maximizing the blended beverage business due to this capacity constraint. We believe that our July comparable store sales growth is under pressure because we are challenged to meet customer demand for our Frappuccino beverages. Customers are embracing these cold blended beverages as a morning staple to a degree that we had not anticipated, and it is clear to us that the opportunity for improvement remains in our control. We recognize the opportunity ahead of us and we know what our challenge is. That is to take the efficiencies and learnings from stores providing the best service with speed during periods of peak customer demand for cold beverages and applying them broadly to our company-operated stores across the U.S. and Canada. These learnings include equipment improvements, ergonomic engineering, more effective labor deployment and partner training. We know it is not just our job to create customer demand through innovation, we also have to satisfy that demand and we are actively working to alleviate new capacity constraints that develop as our business grows. Now, let me take a step back and review the drivers behind the third quarter’s strong results. During the quarter, Starbucks company-operated retail locations in the U.S. delivered $1.4 billion in revenues, proving the positive effect of the variety and integration of beverage and food offerings, intended to keep our stores fresh, our partners engaged and our customers excited. The synchronized promotions across all in-store products created the perfect ambiance for the impending change from winter to spring and then to summer. Key drivers behind this quarter were innovations across our core beverage platforms as well as food. To kick-off our summer promotion, we literally went bananas and not just domestically but globally. Using fresh banana puree, the Banana Frappuccino Blended Beverage Platform included Banana Coconut Frappuccino Blended Coffee, made with the finest Latin American coffees, and Bananas & Crème Frappuccino Blended Crème, an indulgent treat for those seeking a non-coffee option. The promotion was accompanied by food offerings that complement our beverage innovations. The Reduced Fat Banana Chocolate Chip Coffee Cake and the Banana Crème Crunch Bar, they were immediate hits with our customers. It is important to note that our entire line-up of food offerings provides a meaningful contribution to our comparable store sales growth and to retail revenues. We talk a lot about innovation, not only how it touches nearly all aspects of our business but also as a driver to our success. During the final days of the third quarter, we took innovation to a new level by introducing Frappuccino Juice Blends in two popular flavors -- Tangerine and Pomegranate. The platform is off to a strong start, offering our customers a refreshing, juice-based option. These new beverages, made with freshly brewed Tazo tea and real fruit juices, are naturally cholesterol and fat free, low in calories and are non-dairy -- offering expanded choices for our customers. As with most of our new beverages, we introduced two food items that pair well with these beverages. The Pineapple Crumb Cake and the Caramel Nut Bar were introduced this quarter to accompany the Frappuccino Juice Blends. As I mentioned earlier, our food offerings continue to contribute to sales. Our lunch program is tracking extremely well, and during the third quarter, lunch offerings were added to 283 locations, including more than 80 stores in the Fresno, California area. Overall, we have increased the store count in our lunch program by 29% to 3,800 Starbucks stores when compared to the third quarter of fiscal 2005. Currently, lunch is offered in 64% of our company-operated locations in the U.S. and 72% of our company-operated locations in Canada. Another growing component of our food offerings is our Warming Program. During the quarter, we launched warming in both San Francisco and Chicago, adding 252 stores. In its first month, Chicago has proven to be one of our top new markets with volumes slightly exceeding our prior market entries. Over the last year, our first two markets that offered the Warming Program -- Seattle and Washington, D.C. have seen an incremental revenue contribution on average of approximately $35,000 annually. As of the end of the third quarter, nearly 600 stores offered customers the opportunity to order warmed breakfast sandwiches. Additionally, at the end of June, in order to refine our selection of offerings and provide a broader assortment to our customers, we began testing two new breakfast sandwiches in our first three warming markets -- that would be Seattle, Washington, D.C. and Portland. Those were the Virginia Ham Bagel and, just for a limited time, the Chicken Apple Sausage Bagel. Before I close, I would like to briefly mention the great selection of merchandise and music in our stores. Summer was not only evident in our expanded refreshing blended beverages, but also in our merchandising with fresh, colorful signage, serveware, our city-specific Bearista Bears, and summer travel games. Our selection of CDs included new titles from some of our favorite artists, such as Tony Bennett, Marvin Gaye and Bruce Springsteen, as well as new emerging artists like Sonya Kitchell, KT Tunstall and Corinne Bailey Rae. The third quarter’s consistent performance positions us well on the way to achieving our fiscal 2006 goals and towards pursuing Starbucks continued global opportunities as we look ahead to fiscal 2007. As of the end of the third quarter, we are on track to meet or exceed our original targets for store growth, revenue growth, comparable store sales growth and EPS. We know that our partners’ dedication, the drive, the focus and the execution set Starbucks apart. We, Starbucks, we are a unique company. It is a place that offers legendary service, providing customers with the human connection that is sometimes lost in the hustle and bustle of their busy daily lives. It is a place with strong focus on innovation and customization, providing customers with the offerings they truly desire, and it is a company that, at the end of the day, continues to grow aggressively, ultimately delivering value to our shareholders. This is what makes Starbucks unique and able to perform well in a tough economic environment. With that, I will turn the call over to Howard.
Howard Schultz: Thank you, Jim, and good afternoon, everyone. We are very pleased with the financial results our international segment delivered during the quarter, which positions us well as we enter the final quarter of fiscal 2006. During the third quarter, not only did our international segment deliver strong net revenue growth of 37% and operating income growth of 55%, we have also exceeded our company-operated store opening targets for the fiscal year. This demonstrates strong performance amidst tremendous growth and is especially significant, as we mark the 10th anniversary this month of our first market outside North America -- that was Japan. It was exactly 10 years ago today that we celebrated the opening of our first store in Tokyo. As Jim mentioned earlier, a decade later, Starbucks Japan now has more than 600 locations. Overall, we now have more than 3,400 stores in 36 countries outside the U.S., compared to nearly 2,800 stores in 34 countries a year ago. This is just the beginning. In addition to the great opportunity remaining to infill existing markets, as we have shared with you in the past, there are several new markets we intend to enter in the next few years. In fact, preparations are well underway to open our first store in Brazil later in the calendar year. We are now realizing the unique benefits of leveraging our enterprise capabilities in international store development. We will continue to focus on building out new and existing markets worldwide, as well as increasing equity ownership in existing markets where it makes business sense. We are pleased that Starbucks is seen as a strong community partner of choice, which is evident by the growing interest for our stores from communities and cities throughout the world. It was not that long ago that many of you asked “Will the Starbucks brand and experience be accepted globally?” Today, our stores are considered a great community gathering place and Starbucks is becoming an integral part of communities around the world. In fact, many communities are approaching us, seeking our presence because we are seen as a terrific partner in communities where we have an opportunity to really integral in the daily lives of the local population. This acceptance validates the strength of our brand, and that the Starbucks experience is translated in unique and rewarding ways across many different languages, communities and life styles worldwide. We have spoken many times about our excitement for the growth opportunities China presents, and you know of our investment in the infrastructure there to prepare for capturing those opportunities. At the end of the quarter, we had 246 stores in mainland China, including Hong Kong, and 177 locations in Taiwan, for a total of 423 stores in greater China. We are equally excited about two other major markets we intend to enter during 2007 -- India and Russia. You have heard us speak about these in the past, but it is important for you to know that the planning and research is well underway. We are in discussions with potential joint venture partners in each of these markets. Meanwhile, we are scouting locations, meeting with government officials -- all toward gaining additional market knowledge and building critical relationships to make our market entries a success. Specific to India, there has been a great deal of information and speculation around exciting expansion opportunities for U.S. companies. Undoubtedly you have all read the same articles we have been reading, which cite India as a land of opportunity and a competitive challenge to China. As the world’s second most populous country, with more than 1 billion people and growing at 6% per year, we see unique and great opportunity for bringing the Starbucks experience to this market. Much like China, India has traditionally been a tea culture, yet there is a growing coffee culture emerging, especially among the country’s young adults. Also like China, there is a growing interest in Western consumer brands and luxury products. U.S. companies continue to outsource more work to India’s labor force, providing increased job opportunities, often higher wages, and building increasing awareness of Western culture and products. All of this is very exciting and Starbucks plans to be part of India’s growing economy. We look forward to sharing more details with you closer to the store opening date. Let me talk a little bit about Russia. Russia also holds exciting opportunities for Starbucks. Similar to China and India, the people of Russia have enthusiastically embraced international brands, especially premium and luxury products. Not only has Russia realized a positive economic change over the last five years, resulting in an expanded middle and wealthy class, the country has been identified by an association of international retailers as one of the top two most attractive development markets for global retailers. A little more than a year ago, we brought the Starbucks brand to Russia for the first time through our Foodservice relationship with Marriott International. The Renaissance Moscow Hotel exclusively serves Starbucks coffee and espresso in its restaurants, coffee shops and catering business under the Starbucks “We Proudly Brew” brand. This relationship is the first step in building awareness of the Starbucks brand, as we see that market in advance of our retail expansion. Also paving the way for our entry into Russia was a recent trademark ruling in favor of Starbucks against a third party’s attempt to register a trademark using the Starbucks name and logo. As you know, we are dogmatic about protecting Starbucks intellectual property, and we are very pleased to now have full ownership of Starbucks trademarks in Russia. So we are well underway, laying the groundwork for our entry into Russia in fiscal 2007. We will be sure to update you on the progress as we move in closer to a store opening date. In summary, let me just echo, for our International business, some of what Jim said earlier about operations in the U.S. -- we will continue to focus on the basics: execution across all levels of the business, commitment to our partners and communities in which we operate and a continued focus on delivering our legendary service to more and more customers worldwide. Over the past several years, we have worked diligently to build a strong foundation for our international business to allow us to capture the significant opportunities that lie ahead. While we have made great progress, we know we are still in the early stages of our international growth. I truly believe that we are in a great position to achieve sustainable growth well into the future and I am truly excited about the opportunities that lie ahead. With more than 3,400 stores in 36 countries, we are clearly in the embryonic phase of our long-term goal of at least 15,000 stores outside the United States. I will now give the call to Michael Casey.
Michael Casey: Thank you, Howard. This afternoon, I will provide highlights of our financial performance for the third quarter, both consolidated and by segment, and I will review our targets for the remainder of fiscal 2006, as well as introduce the company’s growth targets for fiscal 2007. Let me begin by emphasizing the continued broad-based strength of our revenue growth. Consolidated net revenues for the 13 weeks ended July 2, 2006 were a record $2.0 billion, up 23% compared to the same period in fiscal 2005, and above our 20% annual revenue growth target. Company-operated retail revenues increased 22% to $1.7 billion for the quarter, driven by the opening of 955 new company-operated retail stores in the last 12 months, and 6% comparable store sales growth for the quarter. Comparable store sales growth consisted of a 4% increase in the number of customer transactions, coupled with a 2% increase in the average value per transaction. Specialty revenues grew 23% to $303 million for the quarter. Within specialty revenues, licensing revenues grew 27% to $216 million for the quarter, driven by higher product sales and royalty revenues from the opening of 1,158 new licensed retail stores in the last 12 months. I would now like to spend a little time reviewing our financial highlights. Operating income increased 8% to $215 million in the quarter, from $200 million in the prior quarter. Excluding $27.4 million of stock-based compensation expense, operating income increased by 21.2%. As a percentage of total net revenues, the operating margin declined 153 basis points to 10.9% from a third quarter record high of 12.5% in the prior year. Of the reported 153 basis point decline, 139 basis points or 91% was due to the cost of stock-based compensation, which was not expensed last year. The remaining 14 basis point decline was the net result of a 29 basis points higher COGS and related occupancy due to green coffee costs, 47 basis points higher store operating expense due to payroll-related expenses, and 38 basis points higher other operating expenses due to marketing and payroll-related costs; offset by leverage on G&A, and depreciation, as well as growth in our income from equity investees. I do not often review income from equity investees, but with a 42% increase year over year, I felt it was appropriate for me to provide a few comments. This line item represents our proportionate share of equity investees’ earnings. The strong growth reflected in this period was primarily related to volume-driven results coming from the North American Coffee Partnership, which included contributions from the introduction of our new ready-to-drink iced coffee and two new line extensions in our bottled Frappuccino coffee drink and Starbucks DoubleShot espresso drink product offerings. Also contributing to the growth was improved results from our international investees, particularly Japan. As we have discussed in previous quarters, the company adopted the new expensing requirement for stock-based compensation this fiscal year, with no restatement of prior period results. The pre-tax stock-based compensation expense recognized for the third quarter was $27 million, or $18 million net of tax, for an EPS impact of $0.02 per share. For the three quarters of fiscal 2006, stock-based compensation was $51 million, net of tax, or $0.07 per share -- in line with our expectations. Our strong results in the first three quarters have tended to make this expense less visible than it might otherwise have been. As we previously disclosed, for the entire fiscal year, we expect stock-based compensation to reduce EPS by approximately $0.09 per share. Please refer to page 10 of the press release for a break-out of how this expense is allocated to our consolidated statement of earnings. For the quarter, the effective tax rate was 33.7% compared to 38.1% for the corresponding period in fiscal 2005. This decline in the rate was mainly due to the settlement of a multi-year income tax audit in a foreign jurisdiction, for which Starbucks had previously established a contingent liability. The settlement allowed us to release the contingent liability and amounted to a one-time benefit in earnings per share of $0.01 in the third quarter. Turning now to operating segment results for the third quarter. Total net revenues for the United States operating segment increased by 20% to $1.6 billion in the third quarter of fiscal 2006. Company-operated retail revenues grew 19% to $1.4 billion, primarily due to the opening of 727 new company-operated retail stores in the last 12 months and comparable store sales growth of 6% for the quarter. The increase in comparable store sales was comprised of a 5% increase in the number of customer transactions and a 1% increase in the average value per transaction. U.S. specialty revenues grew by 22% to $241 million in the third quarter. Within specialty revenues, licensing revenues increased 26% to $162 million, primarily due to higher product sales and royalty revenues from the opening of 730 new licensed retail stores in the last 12 months and, to a lesser extent, growth in the licensed grocery and warehouse businesses. U.S. store operating expenses as a percent of related retail revenues increased to 42.1% in the third quarter of fiscal 2006, from 40.7% in the prior year. The increase was primarily related to payroll-related expenditures due to the recognition of stock-based compensation expense and higher employee health benefit costs. In addition, regional leadership conferences for retail management employees were held during the third quarter this year compared to the second quarter in fiscal 2005. These increases were partially offset by lower marketing expenses. U.S. operating income increased 8% to $264 million during the quarter from $245 million during the same period in fiscal 2005. The operating margin decreased to 16.5% of related revenues for the third quarter from 18.3% for the third quarter of fiscal 2005. The decrease was primarily due to the higher store operating expenses I just noted, and to an increase in cost of sales, including occupancy costs from higher green coffee costs and higher distribution and utilities expenses, which were due in part to higher fuel costs. Now moving to the International segment. Our international total revenues increased 37% to $358 million in the third quarter of fiscal 2006. International company-operated retail revenues increased 38% to $297 million in fiscal 2006, mainly due to the opening of 228 new company-operated retail stores in the last 12 months, and comparable store sales growth of 7% for the quarter. The comparable store sales increase resulted from a 4% increase in the number of customer transactions combined with a 3% increase in the average value per transaction. International specialty revenues for the quarter increased 30% to $61 million, primarily due to higher product sales and royalty revenues from the opening of 428 licensed retail stores in the last 12 months, and to sales of ready-to-drink products introduced in Japan, Taiwan and Korea in the fall of last year. Operating income for international operations increased 55% to $29 million in the third quarter this year from $19 million in fiscal 2005, with the operating margin increasing to 8.2% of related revenues from 7.2% in fiscal 2005. The operating margin improvement is primarily driven by lower cost of sales, including occupancy costs from leverage gained on fixed rent, production, and distribution costs distributed over an expanded revenue base. Partially offsetting this improvement was an increase in other operating expenses for marketing and advertising related to the reintroduction of one of our ready-to-drink chilled coffee products in Japan, as well as increased payroll-related expenditures to support global expansion. Our ongoing investment in our international infrastructure, including investments in emerging markets such as China, will continue and can be expected to cause variability in future quarterly operating margins. During the third quarter, the company repurchased 4.9 million shares of Starbucks stock at a cost of approximately $176 million, under an authorized share repurchase program. Our repurchase activity continued through July and with only 3.4 million shares remaining available under the existing authorization, today we announced the Board’s authorization to repurchase up to an additional 25 million shares of the company’s common stock. Since the inception of our share repurchase program in 2001, Starbucks has returned approximately $2.1 billion to shareholders through the repurchase of 92.3 million shares through August 1, 2006. Before I discuss our targets for 2006 and 2007, I want to call your attention to an accounting change from the Financial Accounting Standards Board related to Asset Retirement Obligations, which we will adopt at the end of fiscal 2006. As we have been disclosing in our SEC filings, the FASB’s Interpretation Number 47 requires that an estimate of the cost of future asset retirements to be accrued in advance of their settlement. For Starbucks, as for other retailers with a large number of leased store locations, the primary amounts that will be accrued are for the costs of removing leasehold improvements at the termination of a lease. The initial impact of adopting these new requirements will be to record, at the end of the fourth quarter of 2006, the cumulative catch-up amount as a below-the-line, non-cash adjustment to earnings after income taxes. We are currently in the process of estimating the cumulative catch-up amount, but it is expected to total $0.05 per share or less. Beginning in fiscal 2007, this accounting change will be reflected in the company’s financial statements and will not have a material impact on the company’s results. I will turn now to an overview of our updated fiscal 2006 growth targets, based on our strong third quarter performance and our latest forecast for the balance of the year. We have made great progress in building up our store development capabilities and in leveraging strong relationships with licensed partners to support our continued, rapid retail store expansion. We now expect to open at least 2,000 net new stores on a global basis in fiscal 2006, an increase of 200 stores over our previous target of 1,800. In the United States, we plan to open approximately 750 company-operated locations and 650 licensed locations. In international markets, we plan to open approximately 200 company-operated stores and 400 licensed stores. Robust revenue growth is expected to continue in the fourth quarter, and we continue to target total net revenue growth of approximately 20% for the full year. Today we reported July comparable store sales growth of 4%, and we continue to expect comparable store sales growth in the range of 3% to 7%, with monthly anomalies, for the remainder of fiscal 2006. Based on our third quarter results and our continued positive outlook for the balance of the year, we are now targeting earnings per share in the range of $0.72 to $0.73 per share for fiscal 2006. Excluding the $0.01 per share one-time benefit in the third quarter, this new EPS target is unchanged from our previous target range of $0.71 to $0.72 per share. This target also does not include the cumulative impact expected in the fourth quarter upon the adoption of FIN 47, which I just mentioned. I want to remind listeners again that our fiscal 2006 earnings targets include stock-based compensation expense estimated at approximately $0.02 per share per quarter, and $0.09 per share for the full year, and as a result, EPS growth rates compared to fiscal 2005, are decreased due to this accounting change. Primarily driven by the acceleration in new store development, capital expenditures are now expected to be approximately $800 million in fiscal 2006, which is an increase over our previous target range of $750 million to $775 million. Let me now share a first look at our fiscal 2007 financial targets. Best-in-class store development capabilities and expanding a talented bench of partners to manage our stores is a core competitive advantage for Starbucks, and has allowed for continued acceleration of our store growth plans over the years. Accordingly, we are now planning to ramp up our net new store openings to approximately 2,400 new stores on a global basis in fiscal 2007, an increase of 400 stores compared to our newly raised fiscal 2006 target. In the United States, we plan to open approximately 1,000 company-operated locations and 700 licensed locations. In International markets, we plan to open approximately 300 company-operated locations and 400 licensed stores. We are targeting total net revenue growth of approximately 20% to continue in fiscal 2007, and we again expect comparable store sales growth in the range of 3% to 7%, with monthly anomalies. We are targeting earnings per share of $0.87 to $0.89 for fiscal 2007, which reflects growth of approximately 20% to 25% compared to our fiscal 2006 earnings per share target range of $0.72 to $0.73 per share, when adjusted to exclude the one-time tax benefit of $0.01 recorded in the fiscal 2006 third quarter. Please keep in mind that performance in the first half of fiscal 2006 was particularly strong, so year over year EPS growth comparisons will be more challenging for those periods. For fiscal 2007, we are targeting an effective tax rate of approximately 38%, with quarterly variations likely. Finally, capital expenditures are expected to be in the range of $950 million to $1 billion in fiscal 2007. These capital investments will go toward supporting the addition of at least 1,300 new company-operated stores next year, to maintenance of our existing growing retail store base, and to further building infrastructure to support our rapidly growing global business. With that, I would now like to ask the Operator to queue the first question. Please ask one question at a time, and re-queue for additional questions.
Operator: (Operator Instructions) Your first question comes from the line of Matt Difrisco from Thomas Weisel.
Matthew Difrisco - Thomas Weisel Partners: Can you hear me now? Just curious, when the guidance was given for the guidance range of 3% to 7%, with monthly anomalies -- is that also inclusive, then would you consider a below 3% as a monthly anomaly, but still being able to make the earnings target for one month?
Michael Casey: Yes, that would be a possibility. It is not something that we expect, but we are not predicting each and every month. We are talking about a range, and that range is 3% to 7%.
Jim Donald: I think that has been our range for -- I do not have the exact time, but at least more than five years, I would say. Could you correct me, Mary, do you know? How long has it been?
Mary Ekman: At least three years.
Jim Donald: At least three? Okay. At least three years. Thank you.
Operator: Your next question comes from Joe Buckley with Bear, Stearns.
Joseph Buckley - Bear, Stearns & Co.: Thank you. I just wanted to go with your comments on the July same-store sales number. First, do you think the increase in the cold blended beverages is seasonal? Is that something that will fade as we move into colder weather? I am curious how you measure or how you came to the conclusion of the bottleneck. Is that something you could measure in some way?
Jim Donald: Joe, we do measure and it is measured by region, actually. We have insight into our stores across the country. The way we got that information was just by seeing the results that I talked about. Actually, we get into it by city, by store, by district, and we can tell you by store what is happening with espresso, we can tell you what is happening with cold blended. When you look at cold blended, it too is a seasonal offerings that we come out with. I think what we are finding is that our innovative prowess has created some unbelievable opportunities for us in the Frappuccino juice blend, that quite frankly have done quite well and created some of this. On top of that, what I said earlier was that we were somewhat surprised that the need stage for this happened earlier in the day, in our a.m. business, when we were cranking out our espresso and our coffee drinks. We measure these transactions per half hour, and we measure these transactions per half hour versus a year ago, so we are able to see down to that transaction what that effect was.
Howard Schultz: We sort our stores by those that are in the warmer weather zones versus ones that are in colder weather zones, or less warm. We can see the growth in the blended beverage, the accelerated growth in the blended beverages in the warmer markets. We can see it spreading over into the earlier day-parts, particularly the morning, when we did not expect it. We can see in the colder markets that we are not getting quite that up-tick in blended beverage business, but we are maintaining a stronger transaction growth. So it is the comparison of those two that leads us to that conclusion.
Operator: Your next question comes from John Glass from CIBC.
John Glass - CIBC World Markets: I would like to actually just follow up on that. If your conclusion is correct about the blended beverage business slowing down comps, what are you going to do about it specifically? How soon can you do something about it? Could you also overlay that on the drive-thru -- is the drive-thru blended business slowing it down more specifically than non-drive-thru blended business?
Jim Donald: The drive-thru is actually part of the fix, because we are opening new drive-thru’s with separate stations, John, that we talked about before, and so that partner, the barista that is behind the drive-thru does not have to swim upstream while crossing over with some of our other partners behind the counter. We have already started to roll out more cold blended beverage stations. We are looking at a third barista mode at the automated espresso machines that we are putting in. We are looking at the engineering behind the blenders themselves creating more efficiency and reducing the amount of time that it takes to blend. We are also looking at deployment. Through each one of these areas, as we are rolling it out now past 1,070 stores, we are able to see that towards the end of the summer, we will be able to make a difference. Actually now, but for next year as we gear up again, we will be in much better shape.
Operator: Your next question comes from Jeffrey Bernstein with Lehman Brothers.
Jeffrey Bernstein - Lehman Brothers: Thank you. Actually, a question on the food business. As you continue to expand the lunch rollout, and breakfast seems to be meeting or exceeding expectations, I just wonder if you could provide a little bit more detail in terms of your thoughts for both segments, if we were to look out a few years from now. How do you see each business evolving? When we should expect either or both to be system wide, what type of contribution we should expect -- any thoughts on the direction of those businesses would be great. Thank you.
Jim Donald: We have taken a very pragmatic approach to warming and to lunch. We want to make sure we could execute, first and foremost, the warming as it is taking some of our partners' behind-the-counter functions more so in a manner than the ready-to-eat cold sandwiches. We see opportunities out in and amongst the areas that we have not launched yet, and we are we are still taking this pragmatic approach because it is not something that we have to do coast-to-coast and it is not something we would normally put in coast-to-coast, but we want to make sure we are in the right market. If the customer has that opportunity to participate in creating this, continuing to create the surprise and adding value to their trip, and roll that out as we see the areas being primed for this -- this is not something we pull the trigger and off it goes. We go into the area well in advance of the products, train our partners both on the deployment of the actual bringing the lunch and the warming sandwich into the flow of what they are doing now, and make sure they get that before we just punch the button. As we roll this out, we are continuing to look at the markets we know have a need for it right now, and not necessarily trying to put it coast to coast in all of our stores across the U.S. and Canada.
Howard Schultz: If I had to make a little bit of a projection, we are currently in the mid-60’s -- 60% of our stores have the lunch program. I would think that over the next year or two, we could get up into the mid-70’s, but not necessarily have a lunch program in all of our stores, because of a variety of traffic patterns, lease restrictions, et cetera. But the warming program, which is now doing even better than it was a year ago, I could see at some point in time, two or three years down the road, that we could have the warming program in all of the company-owned stores. It will take a while to get there, but I think that is the goal that we would probably shoot for, given the success that we have seen so far. As Jim says, we are not going to rush. We are going to continue to improve and continue to roll out on a market-by-market basis.
Jim Donald: The future of food in our stores is not necessarily one that we are looking to get in this business. We are looking to continue to add to the quality of our service, the quality of our beverage, and to have that be a complement to, and not necessarily reign at the end of the day.
Operator: Your next question comes from Steven Kron with Goldman Sachs.
Steven Kron - Goldman Sachs: I had two quick ones, if I might. First, you talked last call about back-half investments in infrastructure in the international business. I was a little surprised to see margins up 100 basis points. I would have thought there was going to be more of an offset. Did you pull back a little bit this quarter? Was there a reallocation of infrastructure investment? Secondly, real quickly, on the accelerated development, are there additional costs that we need to think about from a personnel or a training perspective that will affect margins?
Michael Casey: On your first question, we absolutely did not pull back on the international development at all. We have just been able to grow revenue at a faster rate than that infrastructure has grown. I think if you looked at the G&A, you probably saw year-over-year increase in the G&A and in the other operating expenses, is where you see some of that infrastructure build. We are not pulling back even a little bit on the international infrastructure. With regard to the accelerated store growth, I do not think you will see any difference on our P&L. We have been increasing our store count basically for as long as I can remember, and we have learned how to do it and how to build in advance for it. We have been building that capability by adding people, adding assistant store managers gradually. We are practically at the opening rate in this quarter that we are projecting for next year, so this has been gradual and I do not think you will see any difference in the P&L ratios.
Operator: Your next question comes from David Palmer with UBS.
David Palmer - UBS: Thank you. A big question on international and a quick one on warming. This is the third year in a row you have had great contributions from international in terms of profitability. I think it is contributing 20% to 25% of your profit growth each of the last three years. Assuming the fourth quarter has a decent margin, it looks like your margin for international will be approaching about 10%. That is obviously up from 0 in '03. My question is about the incremental profit contributions in the future. What should we expect here? You are going to be making a lot of investments for growth, going for big growth in China -- how should we think about the contribution of profit in China? Secondly, with regard to stores and the warming, I am curious to know, are you thinking -- and maybe even doing this already -- putting an effort in terms of lunch or even dinner day-part offerings there and getting any results since you have that warming equipment? Thank you.
Howard Schultz: Let me start on the international side, at first on the qualitative response to your question and then give it to Michael on the economic response. I think the big headline here, if you go back three years ago where we had not made money and where we are today, is the level of acceptance, and most specifically the relevancy, of the Starbucks experience in which we have been able to land so softly and so easily in so many different types of markets. When you look at the countries that we are in and the level of coffee education from a market as mature as France and Spain, and then you look at China and Malaysia and Singapore and even Japan, for that matter, it is really remarkable. That speaks to the fact that the third-place experience, Starbucks is a place between home and work, is as relevant in these countries as they have been in the U.S. That has given us the ability to ramp up and also create the kind of unit economics that, candidly, we did not expect. I think that, going away from this call, I know many of you will probably focus on 4% comps, but for me the headline is we have just announced an increase in stores for '06, an increase in stores for '07 and, most importantly, the fact that our international business is firing on all cylinders and we just announced the interest in Russia and India on top of the way in which we are being embraced all over the world, and specifically with now over 400 stores in greater China. With that, I will let Michael take the economic side, but we could not be more enthused and excited about what is happening internationally, which complements, obviously, the growth in development that we have had over the last 30 years in the U.S.
Michael Casey: I have received the question about the international margins pretty frequently, and I try to be very consistent with the answer. International margins are a difficult balancing act for us. We would like to get continuous improvement in the margins but we also recognize the tremendous opportunity the international marketplaces provide for us. If we were to be just looking at a steady state, I think I could predict pretty regular increases in the international margins in the direction of the U.S. margins, but not getting there for quite a while just because of the difference in scale. You have to layer on to that the fact that we see an opportunity for five or 10 times the number of stores in places like China that we have today. We want to build the type of organization and infrastructure that will support that. The bigger the opportunity, the more we are going to invest and we will also be layering in investments in some of the countries that Howard just mentioned that will not contribute any sales or profitability in the short term but will be laying the groundwork to be able to continue this high level of growth, not just in the next five years, but in 2012 through 2017. It is a balancing act between investment in great potential for the long-term and the fact that we do want to be mindful of short-term profitability. What I think I can say to quantify it a little bit is that if you look at any 12-month period compared to the 12-month period before that, I would expect the operating margins to improve. In other words, that there is a general upward bias in margins, but I would be hesitant to predict that every quarter the margins would show improvement quarter over quarter, because we are going to make the investments when we need to and to the extent that we think is appropriate for the opportunity.
Jim Donald: Was there a warming question?
Mary Ekman: Yes, whether or not it would expand lunch or dinner.
Jim Donald: In the U.S. or internationally?
Mary Ekman: Warming in general.
Jim Donald: Warming right now is being expected and continued to roll out in our morning day-parts only. However, we are testing and looking at, and even looking at some of the current sandwiches that we have in our stores as being applicable to warming. We have some markets that are looking at that. That is something that we are currently under review. We want the same quality that we have in warming to transfer over to our lunch operations, but we are currently in the stage of just testing and rolling it out in just very, very, very small markets and stores.
Operator: Your next question comes from Sharon Zackfia with William Blair.
Sharon Zackfia - William Blair & Co.: On the cold beverage bottleneck in the morning, can you help quantify for us how much Frappuccinos are actually up year over year in that day-part? As you measure that, how much you think that is dragging on your comps?
Jim Donald: I do not think we can quantify either one of those here on the call. We have looked at it on a market-by-market basis and we think it is putting downward pressure on same-store sales, but I would be hesitant to try to quantify it.
Sharon Zackfia - William Blair & Co.: Can I ask a follow-up question, since I did not get that one answered?
Jim Donald: Sure.
Sharon Zackfia - William Blair & Co.: On the domestic margins, on the gross margin side, in the past you have used price to defend your margins domestically. Is that something you are contemplating with green coffee working against you now?
Jim Donald: We always feel that given that situation in our stores, pricing is an alternative but it is not one that we are choosing to employ at the present time.
Operator: Your next question comes from Glenn Petraglia with Citigroup.
Glen Petraglia - Citigroup: Michael, if you could help me think about green coffee. I think you generally purchase 12 to 18 months ahead. What sort of headwind, or how long should we be thinking about the headwind from green coffee to last? I know prices are down from their peak last year but in your purchasing, are you hitting that peak at this point in time?
Michael Casey: I think we are at the point where the peak, the year-over-year differential between this year's green coffee and last year's green coffee is probably at its peak. On an absolute basis, we expect green coffee costs to continue to gradually increase through next year, through next fiscal year. We have taken that into account in setting our targets for next year. We have had great transparency for the increase this year, having talked about it a year ago in July, that we expected it and it is basically tracking exactly the way we expected it to be. Following or either late in 2007, or following in 2008, we would expect to start to get flattening or a turn in green coffee costs.
Operator: Your next question comes from John Ivankoe with JPMorgan.
John Ivankoe - JPMorgan Chase & Co.: Thank you. I am not sure anyone has ever opened 1,000 units in the United States on a company-owned basis in a given year. Certainly it is an impressive goal for you to do that and I am sure accomplish that. Could you just give us a sense, in terms of if anything changes about those units in '07 relative to '06 or previous years, whether on a location basis or through any new markets, drive-thru versus non-drive-thru? Finally, just slightly separately, if you expect any measurable cannibalization to increase, based on the units you have opened in '06 and '07? Thank you.
Jim Donald: We are looking at close to the same mix of drive-thru’s versus our regular stores as this year. I think currently we have 1400 drive-thru’s and we are looking at about a 50% portfolio going through forward with next year. Again, we have put a team in place to go out well ahead of where we currently were and identify these new stores, and it is not like we do not know where those stores are today. Those stores have been identified, so we are very comfortable that they will open. We are also very comfortable that the effect of cannibalization that we have had in the past will not be much different than it currently is today and going forward. We are not seeing that as something that we are putting any type of that cannibalization into our plan. Our comps for next year are 3% to 7% range, and we are very comfortable with that number for '07.
Howard Schultz: I would just add one thing that I think is a subtlety, and that is, I think three or four years ago, our ability to select the kind of locations that perhaps we are selecting today, we could not do with a level of confidence. Specifically, what I am thinking about or trying to explain, is the fact that our customer base is much, much broader today than it ever has been, which gives us great flexibility to achieve the kind of unit economics that we have in the past with a much broader set of the nation's population. That has been demonstrated over the last 12 to 18 months in significant ways, where our unit economics, in places that we probably could not have even thought of going three or four years, ago exist today and that opens up very, very big opportunities for us.
Jim Donald: We are still looking at a 2-to-1 sales-to-investment ratio for '07 as well.
Howard Schultz: I think you should repeat that, because not only do I not think there are many companies opening 1000 stores, but I am not sure there is anyone in our space that has that kind of sales-to-investment ratio.
Operator: At this time, we have time for one more question. That comes from Dan Geiman with McAdams Wright Ragen.
Dan Geiman - McAdams Wright Ragen : Good afternoon. Just going back to the cold beverages and the capacity constraints there, just trying to get a better feel for when you saw signs of those capacity constraints in prior months. Did you see them earlier this year, May and June? Last year, last summer? Or did they kind of sneak up on you?
Michael Casey: When we started to study it, we looked back and we can see evidence of the beginning of this trend as early as April. Quite honestly, we did not recognize it because we did not look hard enough, until we basically got into July and started to do the analysis which showed there was that variance. While we do not generally like to talk about weather as an impact on our business, the fact that it has been hotter this year than it has ever been before, and we have been so innovative with our blended beverages, that there was more of a shift from hot espresso beverages to cold Frappuccino-type beverages in the morning peak, which is the key, than we anticipated. Had we known, I think we could have done better training and better deployment to have avoided it, and we would have accelerated the rollout of the cold beverage stations. We wish we had the benefit of hindsight.
Jim Donald: It is interesting. This morning at 5:45 a.m., across the street in Seattle, I stood in line as a group of customers were buying our juice-blended Frappuccinos, six of them, at quarter-to-six in the morning. It was perfect timing for me to be a part of that.
Howard Schultz: Just to clarify one other thing, we think we are doing a pretty good job of speed of service within the Frappuccino beverages when we are focused on those, like the afternoon when we are expecting the business. The challenge becomes greater when the Frappuccino business shifts into the morning, when we are geared for espresso speed, and then the challenge is to manage both the Frappuccino at high speed and the blended -- and the espresso beverages at high speed simultaneously. That is the challenge.
Jim Donald: What is reassuring about this is we have seen it in our espresso beverage as we implemented basically the same tools, whether it was automated espresso, labor deployment -- we were able to see those lines come down and the transaction rates grow. We are confident we will able to do the same in cold blended.
Operator: This concludes today’s Q&A session. I will now turn the call back over for any closing remarks.
JoAnn DeGrande: Thank you. Thank you all for joining us for the earnings call today and we hope you will join us again for the webcast of our fourth-quarter and fiscal 2006 financial results. We will be back with you on Thursday, November 16, 2006. Thank you.
Operator: This concludes today's conference call. You may disconnect at this time. | [
{
"speaker": "Executives",
"text": "Howard Schultz - Chairman Jim Donald - President and Chief Executive Officer Michael Casey - Chief Financial Officer, Executive Vice President, Chief Administrative Officer Mary Ekman - Vice President of Corporate Development and Investor Relations JoAnn DeGrande - Director, Investor Relations"
},
{
"speaker": "Analysts",
"text": "Matthew Difrisco - Thomas Weisel Partners Joseph Buckley - Bear, Stearns & Co. John Glass - CIBC World Markets Jeffrey Bernstein - Lehman Brothers Steven Kron - Goldman Sachs David Palmer - UBS Sharon Zackfia - William Blair & Co. Glen Petraglia - Citigroup John Ivankoe - JPMorgan Chase & Co. Dan Geiman - McAdams Wright Ragen"
},
{
"speaker": "Operator",
"text": "Good afternoon, my name is Judy and I will be your conference operator today. At this time, I would like to welcome everyone to the Starbucks third quarter 2006 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer session. (Operator Instructions) I will now turn the call over to JoAnn DeGrande, Director, Investor Relations. Ma’am, you may begin your conference."
},
{
"speaker": "JoAnn DeGrande",
"text": "Thank you. Good afternoon, ladies and gentlemen. This is JoAnn DeGrande, Director of Investor Relations with Starbucks Coffee Company. With me today are Howard Schultz, Chairman; Jim Donald, President and CEO, Michael Casey, Executive Vice President and CFO; and Mary Ekman, Vice President of Corporate Development and Investor Relations. During today’s call, Jim will review key results and accomplishments, as well as provide some highlights from our U.S. retail business. Howard will provide an update on our international business, and Michael will highlight the key drivers behind our third quarter results, comment on fiscal 2006 growth targets, and introduce our fiscal 2007 growth targets. We will limit today’s call to one hour, including Q&A. I would like to remind you that today we released our July revenues in conjunction with our fiscal third quarter results. As a reminder to all listeners, this call is being broadcast live over the Internet. A replay will be available by telephone at 800-642-1687, reservation number 3728558, by 5:30 Pacific time on Wednesday, August 9th; on the Internet and on the investor relations page at starbucks.com through 5:00 p.m. Pacific time on Wednesday, August 30th. In addition, today’s remarks will be available on the Investor Relations portion of starbucks.com by the end of the day today and will remain available through Wednesday, August 30th. This conference call includes forward-looking statements such as anticipated store openings, comparable stores sales expectations, trends in or expectations regarding the company’s net revenue, estimate stock-based compensation expense, expected capital expenditures, expected effective tax rate, and earnings per share results. These forward-looking statements are all based on currently available operating, financial and competitive information, and are subject to various risks and uncertainties. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements are contained in the company’s filings with the Securities and Exchange Commission, including the risk factors section of Starbucks Annual Report on Form 10-K for the fiscal year ended October 2, 2005. The company assumes no obligation to update any of these forward-looking statements. I will now turn the call over to Jim."
},
{
"speaker": "Jim Donald",
"text": "Thank you, JoAnn, and good afternoon, ladies and gentlemen. Our third quarter financial results continue to demonstrate our dedicated focus on successful execution across all our business fronts. Let me begin with an overview of our solid third quarter financial results. Again this quarter, our partners successfully delivered the Starbucks Experience through product innovation and solid execution to more than 40 million customers around the world weekly, resulting in net revenue growth of 23% to $2 billion, net earnings of $145 million, and third quarter earnings per share of $0.18. For the quarter, Starbucks delivered strong comparable store sales of 6%, solidly within our 3% to 7% target range. Our robust store expansion continued with the opening of 559 new locations worldwide -- that is the highest level of store openings in a third-quarter period in the company’s history. Our store development partners demonstrated once again excellent dedication, drive, focus and skill by opening 395 stores in the United States and 164 locations in international markets. Speaking of international, a few of our international markets hit significant milestones recently: Starbucks Japan now has more than 600 locations; the U.K. opened its 500th store during the quarter; and I just recently participated in the opening celebration of our 100th store in the Philippines. What is notable about the 100th store opening in the Philippines is that when we initially opened that market, we anticipated a maximum of 50 Starbucks stores -- this again demonstrates the strength in Starbucks worldwide acceptance and the depth of our global store opportunity. Today, we also announced July results with a 20% increase in revenues for the month and comparable store sales growing 4% -- marking the 175th consecutive month of positive comparable store sales growth. I have yet to find another company in our peer universe that has delivered a similar record of positive comparable store sales growth over such a sustained period. During July, we added 162 new stores. There has been a lot of news in the past few months around fears of an economic slowdown. We are aware of softening retail sales and declines in traffic at many retail-oriented businesses, which have been attributed to overall economic conditions. While you may have drawn your own conclusions that Starbucks comparable store sales results are reflecting those macroeconomic factors, we believe our results are related more to a different set of factors and, as I will explain, we believe the opportunity for improvement remains in our control. Starbucks U.S. comparable store sales growth for the quarter was well within our target range of 3% to 7% -- but it would be remiss if we did not acknowledge that our July comp growth of 4% is below the level achieved for the first nine months of fiscal 2006. Unlike many retailers, to date, based on the best data available to us, we are not seeing any signs that macroeconomic trends are having a significant impact on Starbucks business. Yet, we do remain mindful and cautious about the external environment and we are aware of issues facing the consumer. We believe our recent slower comp growth, while still very healthy, reflects some internal challenges our stores are facing with meeting customer demand for cold blended beverages. Currently, we are experiencing stronger than expected -- it is actually unprecedented -- customer demand for blended beverages during morning peak hours. While we have made tremendous progress on our service with speed initiatives during our peak espresso periods, we still have work to do with service efficiencies around our Frappuccino blended beverage preparation. Last year we spoke to you about the growing popularity of our blended beverages. In fact, during our Spring and Summer 2006 promotional periods, we introduced a number of new and exciting blended beverage offerings which have been very well received. In light of the increasing demand for our blended beverages, we have recognized the opportunity to refine and improve our Cold Beverage Station to make drink preparation more efficient and improve service over time but, in retrospect, we did not move aggressively enough. Currently, we have deployed the Cold Beverage Station to 1,070 locations -- about 18% of our company-operated locations in the U.S. and Canada. This is one example of how we are beginning to make progress toward increasing service efficiencies in this category. What is key here is that blended beverage sales are showing strong growth, but we are experiencing the softest overall comparable transaction growth in stores with the highest blended sales. Because of this, we believe we are losing some espresso business due to longer than normal wait times, in both cafes and drive-thru’s during peak morning hours. It is also possible that we are not maximizing the blended beverage business due to this capacity constraint. We believe that our July comparable store sales growth is under pressure because we are challenged to meet customer demand for our Frappuccino beverages. Customers are embracing these cold blended beverages as a morning staple to a degree that we had not anticipated, and it is clear to us that the opportunity for improvement remains in our control. We recognize the opportunity ahead of us and we know what our challenge is. That is to take the efficiencies and learnings from stores providing the best service with speed during periods of peak customer demand for cold beverages and applying them broadly to our company-operated stores across the U.S. and Canada. These learnings include equipment improvements, ergonomic engineering, more effective labor deployment and partner training. We know it is not just our job to create customer demand through innovation, we also have to satisfy that demand and we are actively working to alleviate new capacity constraints that develop as our business grows. Now, let me take a step back and review the drivers behind the third quarter’s strong results. During the quarter, Starbucks company-operated retail locations in the U.S. delivered $1.4 billion in revenues, proving the positive effect of the variety and integration of beverage and food offerings, intended to keep our stores fresh, our partners engaged and our customers excited. The synchronized promotions across all in-store products created the perfect ambiance for the impending change from winter to spring and then to summer. Key drivers behind this quarter were innovations across our core beverage platforms as well as food. To kick-off our summer promotion, we literally went bananas and not just domestically but globally. Using fresh banana puree, the Banana Frappuccino Blended Beverage Platform included Banana Coconut Frappuccino Blended Coffee, made with the finest Latin American coffees, and Bananas & Crème Frappuccino Blended Crème, an indulgent treat for those seeking a non-coffee option. The promotion was accompanied by food offerings that complement our beverage innovations. The Reduced Fat Banana Chocolate Chip Coffee Cake and the Banana Crème Crunch Bar, they were immediate hits with our customers. It is important to note that our entire line-up of food offerings provides a meaningful contribution to our comparable store sales growth and to retail revenues. We talk a lot about innovation, not only how it touches nearly all aspects of our business but also as a driver to our success. During the final days of the third quarter, we took innovation to a new level by introducing Frappuccino Juice Blends in two popular flavors -- Tangerine and Pomegranate. The platform is off to a strong start, offering our customers a refreshing, juice-based option. These new beverages, made with freshly brewed Tazo tea and real fruit juices, are naturally cholesterol and fat free, low in calories and are non-dairy -- offering expanded choices for our customers. As with most of our new beverages, we introduced two food items that pair well with these beverages. The Pineapple Crumb Cake and the Caramel Nut Bar were introduced this quarter to accompany the Frappuccino Juice Blends. As I mentioned earlier, our food offerings continue to contribute to sales. Our lunch program is tracking extremely well, and during the third quarter, lunch offerings were added to 283 locations, including more than 80 stores in the Fresno, California area. Overall, we have increased the store count in our lunch program by 29% to 3,800 Starbucks stores when compared to the third quarter of fiscal 2005. Currently, lunch is offered in 64% of our company-operated locations in the U.S. and 72% of our company-operated locations in Canada. Another growing component of our food offerings is our Warming Program. During the quarter, we launched warming in both San Francisco and Chicago, adding 252 stores. In its first month, Chicago has proven to be one of our top new markets with volumes slightly exceeding our prior market entries. Over the last year, our first two markets that offered the Warming Program -- Seattle and Washington, D.C. have seen an incremental revenue contribution on average of approximately $35,000 annually. As of the end of the third quarter, nearly 600 stores offered customers the opportunity to order warmed breakfast sandwiches. Additionally, at the end of June, in order to refine our selection of offerings and provide a broader assortment to our customers, we began testing two new breakfast sandwiches in our first three warming markets -- that would be Seattle, Washington, D.C. and Portland. Those were the Virginia Ham Bagel and, just for a limited time, the Chicken Apple Sausage Bagel. Before I close, I would like to briefly mention the great selection of merchandise and music in our stores. Summer was not only evident in our expanded refreshing blended beverages, but also in our merchandising with fresh, colorful signage, serveware, our city-specific Bearista Bears, and summer travel games. Our selection of CDs included new titles from some of our favorite artists, such as Tony Bennett, Marvin Gaye and Bruce Springsteen, as well as new emerging artists like Sonya Kitchell, KT Tunstall and Corinne Bailey Rae. The third quarter’s consistent performance positions us well on the way to achieving our fiscal 2006 goals and towards pursuing Starbucks continued global opportunities as we look ahead to fiscal 2007. As of the end of the third quarter, we are on track to meet or exceed our original targets for store growth, revenue growth, comparable store sales growth and EPS. We know that our partners’ dedication, the drive, the focus and the execution set Starbucks apart. We, Starbucks, we are a unique company. It is a place that offers legendary service, providing customers with the human connection that is sometimes lost in the hustle and bustle of their busy daily lives. It is a place with strong focus on innovation and customization, providing customers with the offerings they truly desire, and it is a company that, at the end of the day, continues to grow aggressively, ultimately delivering value to our shareholders. This is what makes Starbucks unique and able to perform well in a tough economic environment. With that, I will turn the call over to Howard."
},
{
"speaker": "Howard Schultz",
"text": "Thank you, Jim, and good afternoon, everyone. We are very pleased with the financial results our international segment delivered during the quarter, which positions us well as we enter the final quarter of fiscal 2006. During the third quarter, not only did our international segment deliver strong net revenue growth of 37% and operating income growth of 55%, we have also exceeded our company-operated store opening targets for the fiscal year. This demonstrates strong performance amidst tremendous growth and is especially significant, as we mark the 10th anniversary this month of our first market outside North America -- that was Japan. It was exactly 10 years ago today that we celebrated the opening of our first store in Tokyo. As Jim mentioned earlier, a decade later, Starbucks Japan now has more than 600 locations. Overall, we now have more than 3,400 stores in 36 countries outside the U.S., compared to nearly 2,800 stores in 34 countries a year ago. This is just the beginning. In addition to the great opportunity remaining to infill existing markets, as we have shared with you in the past, there are several new markets we intend to enter in the next few years. In fact, preparations are well underway to open our first store in Brazil later in the calendar year. We are now realizing the unique benefits of leveraging our enterprise capabilities in international store development. We will continue to focus on building out new and existing markets worldwide, as well as increasing equity ownership in existing markets where it makes business sense. We are pleased that Starbucks is seen as a strong community partner of choice, which is evident by the growing interest for our stores from communities and cities throughout the world. It was not that long ago that many of you asked “Will the Starbucks brand and experience be accepted globally?” Today, our stores are considered a great community gathering place and Starbucks is becoming an integral part of communities around the world. In fact, many communities are approaching us, seeking our presence because we are seen as a terrific partner in communities where we have an opportunity to really integral in the daily lives of the local population. This acceptance validates the strength of our brand, and that the Starbucks experience is translated in unique and rewarding ways across many different languages, communities and life styles worldwide. We have spoken many times about our excitement for the growth opportunities China presents, and you know of our investment in the infrastructure there to prepare for capturing those opportunities. At the end of the quarter, we had 246 stores in mainland China, including Hong Kong, and 177 locations in Taiwan, for a total of 423 stores in greater China. We are equally excited about two other major markets we intend to enter during 2007 -- India and Russia. You have heard us speak about these in the past, but it is important for you to know that the planning and research is well underway. We are in discussions with potential joint venture partners in each of these markets. Meanwhile, we are scouting locations, meeting with government officials -- all toward gaining additional market knowledge and building critical relationships to make our market entries a success. Specific to India, there has been a great deal of information and speculation around exciting expansion opportunities for U.S. companies. Undoubtedly you have all read the same articles we have been reading, which cite India as a land of opportunity and a competitive challenge to China. As the world’s second most populous country, with more than 1 billion people and growing at 6% per year, we see unique and great opportunity for bringing the Starbucks experience to this market. Much like China, India has traditionally been a tea culture, yet there is a growing coffee culture emerging, especially among the country’s young adults. Also like China, there is a growing interest in Western consumer brands and luxury products. U.S. companies continue to outsource more work to India’s labor force, providing increased job opportunities, often higher wages, and building increasing awareness of Western culture and products. All of this is very exciting and Starbucks plans to be part of India’s growing economy. We look forward to sharing more details with you closer to the store opening date. Let me talk a little bit about Russia. Russia also holds exciting opportunities for Starbucks. Similar to China and India, the people of Russia have enthusiastically embraced international brands, especially premium and luxury products. Not only has Russia realized a positive economic change over the last five years, resulting in an expanded middle and wealthy class, the country has been identified by an association of international retailers as one of the top two most attractive development markets for global retailers. A little more than a year ago, we brought the Starbucks brand to Russia for the first time through our Foodservice relationship with Marriott International. The Renaissance Moscow Hotel exclusively serves Starbucks coffee and espresso in its restaurants, coffee shops and catering business under the Starbucks “We Proudly Brew” brand. This relationship is the first step in building awareness of the Starbucks brand, as we see that market in advance of our retail expansion. Also paving the way for our entry into Russia was a recent trademark ruling in favor of Starbucks against a third party’s attempt to register a trademark using the Starbucks name and logo. As you know, we are dogmatic about protecting Starbucks intellectual property, and we are very pleased to now have full ownership of Starbucks trademarks in Russia. So we are well underway, laying the groundwork for our entry into Russia in fiscal 2007. We will be sure to update you on the progress as we move in closer to a store opening date. In summary, let me just echo, for our International business, some of what Jim said earlier about operations in the U.S. -- we will continue to focus on the basics: execution across all levels of the business, commitment to our partners and communities in which we operate and a continued focus on delivering our legendary service to more and more customers worldwide. Over the past several years, we have worked diligently to build a strong foundation for our international business to allow us to capture the significant opportunities that lie ahead. While we have made great progress, we know we are still in the early stages of our international growth. I truly believe that we are in a great position to achieve sustainable growth well into the future and I am truly excited about the opportunities that lie ahead. With more than 3,400 stores in 36 countries, we are clearly in the embryonic phase of our long-term goal of at least 15,000 stores outside the United States. I will now give the call to Michael Casey."
},
{
"speaker": "Michael Casey",
"text": "Thank you, Howard. This afternoon, I will provide highlights of our financial performance for the third quarter, both consolidated and by segment, and I will review our targets for the remainder of fiscal 2006, as well as introduce the company’s growth targets for fiscal 2007. Let me begin by emphasizing the continued broad-based strength of our revenue growth. Consolidated net revenues for the 13 weeks ended July 2, 2006 were a record $2.0 billion, up 23% compared to the same period in fiscal 2005, and above our 20% annual revenue growth target. Company-operated retail revenues increased 22% to $1.7 billion for the quarter, driven by the opening of 955 new company-operated retail stores in the last 12 months, and 6% comparable store sales growth for the quarter. Comparable store sales growth consisted of a 4% increase in the number of customer transactions, coupled with a 2% increase in the average value per transaction. Specialty revenues grew 23% to $303 million for the quarter. Within specialty revenues, licensing revenues grew 27% to $216 million for the quarter, driven by higher product sales and royalty revenues from the opening of 1,158 new licensed retail stores in the last 12 months. I would now like to spend a little time reviewing our financial highlights. Operating income increased 8% to $215 million in the quarter, from $200 million in the prior quarter. Excluding $27.4 million of stock-based compensation expense, operating income increased by 21.2%. As a percentage of total net revenues, the operating margin declined 153 basis points to 10.9% from a third quarter record high of 12.5% in the prior year. Of the reported 153 basis point decline, 139 basis points or 91% was due to the cost of stock-based compensation, which was not expensed last year. The remaining 14 basis point decline was the net result of a 29 basis points higher COGS and related occupancy due to green coffee costs, 47 basis points higher store operating expense due to payroll-related expenses, and 38 basis points higher other operating expenses due to marketing and payroll-related costs; offset by leverage on G&A, and depreciation, as well as growth in our income from equity investees. I do not often review income from equity investees, but with a 42% increase year over year, I felt it was appropriate for me to provide a few comments. This line item represents our proportionate share of equity investees’ earnings. The strong growth reflected in this period was primarily related to volume-driven results coming from the North American Coffee Partnership, which included contributions from the introduction of our new ready-to-drink iced coffee and two new line extensions in our bottled Frappuccino coffee drink and Starbucks DoubleShot espresso drink product offerings. Also contributing to the growth was improved results from our international investees, particularly Japan. As we have discussed in previous quarters, the company adopted the new expensing requirement for stock-based compensation this fiscal year, with no restatement of prior period results. The pre-tax stock-based compensation expense recognized for the third quarter was $27 million, or $18 million net of tax, for an EPS impact of $0.02 per share. For the three quarters of fiscal 2006, stock-based compensation was $51 million, net of tax, or $0.07 per share -- in line with our expectations. Our strong results in the first three quarters have tended to make this expense less visible than it might otherwise have been. As we previously disclosed, for the entire fiscal year, we expect stock-based compensation to reduce EPS by approximately $0.09 per share. Please refer to page 10 of the press release for a break-out of how this expense is allocated to our consolidated statement of earnings. For the quarter, the effective tax rate was 33.7% compared to 38.1% for the corresponding period in fiscal 2005. This decline in the rate was mainly due to the settlement of a multi-year income tax audit in a foreign jurisdiction, for which Starbucks had previously established a contingent liability. The settlement allowed us to release the contingent liability and amounted to a one-time benefit in earnings per share of $0.01 in the third quarter. Turning now to operating segment results for the third quarter. Total net revenues for the United States operating segment increased by 20% to $1.6 billion in the third quarter of fiscal 2006. Company-operated retail revenues grew 19% to $1.4 billion, primarily due to the opening of 727 new company-operated retail stores in the last 12 months and comparable store sales growth of 6% for the quarter. The increase in comparable store sales was comprised of a 5% increase in the number of customer transactions and a 1% increase in the average value per transaction. U.S. specialty revenues grew by 22% to $241 million in the third quarter. Within specialty revenues, licensing revenues increased 26% to $162 million, primarily due to higher product sales and royalty revenues from the opening of 730 new licensed retail stores in the last 12 months and, to a lesser extent, growth in the licensed grocery and warehouse businesses. U.S. store operating expenses as a percent of related retail revenues increased to 42.1% in the third quarter of fiscal 2006, from 40.7% in the prior year. The increase was primarily related to payroll-related expenditures due to the recognition of stock-based compensation expense and higher employee health benefit costs. In addition, regional leadership conferences for retail management employees were held during the third quarter this year compared to the second quarter in fiscal 2005. These increases were partially offset by lower marketing expenses. U.S. operating income increased 8% to $264 million during the quarter from $245 million during the same period in fiscal 2005. The operating margin decreased to 16.5% of related revenues for the third quarter from 18.3% for the third quarter of fiscal 2005. The decrease was primarily due to the higher store operating expenses I just noted, and to an increase in cost of sales, including occupancy costs from higher green coffee costs and higher distribution and utilities expenses, which were due in part to higher fuel costs. Now moving to the International segment. Our international total revenues increased 37% to $358 million in the third quarter of fiscal 2006. International company-operated retail revenues increased 38% to $297 million in fiscal 2006, mainly due to the opening of 228 new company-operated retail stores in the last 12 months, and comparable store sales growth of 7% for the quarter. The comparable store sales increase resulted from a 4% increase in the number of customer transactions combined with a 3% increase in the average value per transaction. International specialty revenues for the quarter increased 30% to $61 million, primarily due to higher product sales and royalty revenues from the opening of 428 licensed retail stores in the last 12 months, and to sales of ready-to-drink products introduced in Japan, Taiwan and Korea in the fall of last year. Operating income for international operations increased 55% to $29 million in the third quarter this year from $19 million in fiscal 2005, with the operating margin increasing to 8.2% of related revenues from 7.2% in fiscal 2005. The operating margin improvement is primarily driven by lower cost of sales, including occupancy costs from leverage gained on fixed rent, production, and distribution costs distributed over an expanded revenue base. Partially offsetting this improvement was an increase in other operating expenses for marketing and advertising related to the reintroduction of one of our ready-to-drink chilled coffee products in Japan, as well as increased payroll-related expenditures to support global expansion. Our ongoing investment in our international infrastructure, including investments in emerging markets such as China, will continue and can be expected to cause variability in future quarterly operating margins. During the third quarter, the company repurchased 4.9 million shares of Starbucks stock at a cost of approximately $176 million, under an authorized share repurchase program. Our repurchase activity continued through July and with only 3.4 million shares remaining available under the existing authorization, today we announced the Board’s authorization to repurchase up to an additional 25 million shares of the company’s common stock. Since the inception of our share repurchase program in 2001, Starbucks has returned approximately $2.1 billion to shareholders through the repurchase of 92.3 million shares through August 1, 2006. Before I discuss our targets for 2006 and 2007, I want to call your attention to an accounting change from the Financial Accounting Standards Board related to Asset Retirement Obligations, which we will adopt at the end of fiscal 2006. As we have been disclosing in our SEC filings, the FASB’s Interpretation Number 47 requires that an estimate of the cost of future asset retirements to be accrued in advance of their settlement. For Starbucks, as for other retailers with a large number of leased store locations, the primary amounts that will be accrued are for the costs of removing leasehold improvements at the termination of a lease. The initial impact of adopting these new requirements will be to record, at the end of the fourth quarter of 2006, the cumulative catch-up amount as a below-the-line, non-cash adjustment to earnings after income taxes. We are currently in the process of estimating the cumulative catch-up amount, but it is expected to total $0.05 per share or less. Beginning in fiscal 2007, this accounting change will be reflected in the company’s financial statements and will not have a material impact on the company’s results. I will turn now to an overview of our updated fiscal 2006 growth targets, based on our strong third quarter performance and our latest forecast for the balance of the year. We have made great progress in building up our store development capabilities and in leveraging strong relationships with licensed partners to support our continued, rapid retail store expansion. We now expect to open at least 2,000 net new stores on a global basis in fiscal 2006, an increase of 200 stores over our previous target of 1,800. In the United States, we plan to open approximately 750 company-operated locations and 650 licensed locations. In international markets, we plan to open approximately 200 company-operated stores and 400 licensed stores. Robust revenue growth is expected to continue in the fourth quarter, and we continue to target total net revenue growth of approximately 20% for the full year. Today we reported July comparable store sales growth of 4%, and we continue to expect comparable store sales growth in the range of 3% to 7%, with monthly anomalies, for the remainder of fiscal 2006. Based on our third quarter results and our continued positive outlook for the balance of the year, we are now targeting earnings per share in the range of $0.72 to $0.73 per share for fiscal 2006. Excluding the $0.01 per share one-time benefit in the third quarter, this new EPS target is unchanged from our previous target range of $0.71 to $0.72 per share. This target also does not include the cumulative impact expected in the fourth quarter upon the adoption of FIN 47, which I just mentioned. I want to remind listeners again that our fiscal 2006 earnings targets include stock-based compensation expense estimated at approximately $0.02 per share per quarter, and $0.09 per share for the full year, and as a result, EPS growth rates compared to fiscal 2005, are decreased due to this accounting change. Primarily driven by the acceleration in new store development, capital expenditures are now expected to be approximately $800 million in fiscal 2006, which is an increase over our previous target range of $750 million to $775 million. Let me now share a first look at our fiscal 2007 financial targets. Best-in-class store development capabilities and expanding a talented bench of partners to manage our stores is a core competitive advantage for Starbucks, and has allowed for continued acceleration of our store growth plans over the years. Accordingly, we are now planning to ramp up our net new store openings to approximately 2,400 new stores on a global basis in fiscal 2007, an increase of 400 stores compared to our newly raised fiscal 2006 target. In the United States, we plan to open approximately 1,000 company-operated locations and 700 licensed locations. In International markets, we plan to open approximately 300 company-operated locations and 400 licensed stores. We are targeting total net revenue growth of approximately 20% to continue in fiscal 2007, and we again expect comparable store sales growth in the range of 3% to 7%, with monthly anomalies. We are targeting earnings per share of $0.87 to $0.89 for fiscal 2007, which reflects growth of approximately 20% to 25% compared to our fiscal 2006 earnings per share target range of $0.72 to $0.73 per share, when adjusted to exclude the one-time tax benefit of $0.01 recorded in the fiscal 2006 third quarter. Please keep in mind that performance in the first half of fiscal 2006 was particularly strong, so year over year EPS growth comparisons will be more challenging for those periods. For fiscal 2007, we are targeting an effective tax rate of approximately 38%, with quarterly variations likely. Finally, capital expenditures are expected to be in the range of $950 million to $1 billion in fiscal 2007. These capital investments will go toward supporting the addition of at least 1,300 new company-operated stores next year, to maintenance of our existing growing retail store base, and to further building infrastructure to support our rapidly growing global business. With that, I would now like to ask the Operator to queue the first question. Please ask one question at a time, and re-queue for additional questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from the line of Matt Difrisco from Thomas Weisel."
},
{
"speaker": "Matthew Difrisco - Thomas Weisel Partners",
"text": "Can you hear me now? Just curious, when the guidance was given for the guidance range of 3% to 7%, with monthly anomalies -- is that also inclusive, then would you consider a below 3% as a monthly anomaly, but still being able to make the earnings target for one month?"
},
{
"speaker": "Michael Casey",
"text": "Yes, that would be a possibility. It is not something that we expect, but we are not predicting each and every month. We are talking about a range, and that range is 3% to 7%."
},
{
"speaker": "Jim Donald",
"text": "I think that has been our range for -- I do not have the exact time, but at least more than five years, I would say. Could you correct me, Mary, do you know? How long has it been?"
},
{
"speaker": "Mary Ekman",
"text": "At least three years."
},
{
"speaker": "Jim Donald",
"text": "At least three? Okay. At least three years. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Joe Buckley with Bear, Stearns."
},
{
"speaker": "Joseph Buckley - Bear, Stearns & Co.",
"text": "Thank you. I just wanted to go with your comments on the July same-store sales number. First, do you think the increase in the cold blended beverages is seasonal? Is that something that will fade as we move into colder weather? I am curious how you measure or how you came to the conclusion of the bottleneck. Is that something you could measure in some way?"
},
{
"speaker": "Jim Donald",
"text": "Joe, we do measure and it is measured by region, actually. We have insight into our stores across the country. The way we got that information was just by seeing the results that I talked about. Actually, we get into it by city, by store, by district, and we can tell you by store what is happening with espresso, we can tell you what is happening with cold blended. When you look at cold blended, it too is a seasonal offerings that we come out with. I think what we are finding is that our innovative prowess has created some unbelievable opportunities for us in the Frappuccino juice blend, that quite frankly have done quite well and created some of this. On top of that, what I said earlier was that we were somewhat surprised that the need stage for this happened earlier in the day, in our a.m. business, when we were cranking out our espresso and our coffee drinks. We measure these transactions per half hour, and we measure these transactions per half hour versus a year ago, so we are able to see down to that transaction what that effect was."
},
{
"speaker": "Howard Schultz",
"text": "We sort our stores by those that are in the warmer weather zones versus ones that are in colder weather zones, or less warm. We can see the growth in the blended beverage, the accelerated growth in the blended beverages in the warmer markets. We can see it spreading over into the earlier day-parts, particularly the morning, when we did not expect it. We can see in the colder markets that we are not getting quite that up-tick in blended beverage business, but we are maintaining a stronger transaction growth. So it is the comparison of those two that leads us to that conclusion."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Glass from CIBC."
},
{
"speaker": "John Glass - CIBC World Markets",
"text": "I would like to actually just follow up on that. If your conclusion is correct about the blended beverage business slowing down comps, what are you going to do about it specifically? How soon can you do something about it? Could you also overlay that on the drive-thru -- is the drive-thru blended business slowing it down more specifically than non-drive-thru blended business?"
},
{
"speaker": "Jim Donald",
"text": "The drive-thru is actually part of the fix, because we are opening new drive-thru’s with separate stations, John, that we talked about before, and so that partner, the barista that is behind the drive-thru does not have to swim upstream while crossing over with some of our other partners behind the counter. We have already started to roll out more cold blended beverage stations. We are looking at a third barista mode at the automated espresso machines that we are putting in. We are looking at the engineering behind the blenders themselves creating more efficiency and reducing the amount of time that it takes to blend. We are also looking at deployment. Through each one of these areas, as we are rolling it out now past 1,070 stores, we are able to see that towards the end of the summer, we will be able to make a difference. Actually now, but for next year as we gear up again, we will be in much better shape."
},
{
"speaker": "Operator",
"text": "Your next question comes from Jeffrey Bernstein with Lehman Brothers."
},
{
"speaker": "Jeffrey Bernstein - Lehman Brothers",
"text": "Thank you. Actually, a question on the food business. As you continue to expand the lunch rollout, and breakfast seems to be meeting or exceeding expectations, I just wonder if you could provide a little bit more detail in terms of your thoughts for both segments, if we were to look out a few years from now. How do you see each business evolving? When we should expect either or both to be system wide, what type of contribution we should expect -- any thoughts on the direction of those businesses would be great. Thank you."
},
{
"speaker": "Jim Donald",
"text": "We have taken a very pragmatic approach to warming and to lunch. We want to make sure we could execute, first and foremost, the warming as it is taking some of our partners' behind-the-counter functions more so in a manner than the ready-to-eat cold sandwiches. We see opportunities out in and amongst the areas that we have not launched yet, and we are we are still taking this pragmatic approach because it is not something that we have to do coast-to-coast and it is not something we would normally put in coast-to-coast, but we want to make sure we are in the right market. If the customer has that opportunity to participate in creating this, continuing to create the surprise and adding value to their trip, and roll that out as we see the areas being primed for this -- this is not something we pull the trigger and off it goes. We go into the area well in advance of the products, train our partners both on the deployment of the actual bringing the lunch and the warming sandwich into the flow of what they are doing now, and make sure they get that before we just punch the button. As we roll this out, we are continuing to look at the markets we know have a need for it right now, and not necessarily trying to put it coast to coast in all of our stores across the U.S. and Canada."
},
{
"speaker": "Howard Schultz",
"text": "If I had to make a little bit of a projection, we are currently in the mid-60’s -- 60% of our stores have the lunch program. I would think that over the next year or two, we could get up into the mid-70’s, but not necessarily have a lunch program in all of our stores, because of a variety of traffic patterns, lease restrictions, et cetera. But the warming program, which is now doing even better than it was a year ago, I could see at some point in time, two or three years down the road, that we could have the warming program in all of the company-owned stores. It will take a while to get there, but I think that is the goal that we would probably shoot for, given the success that we have seen so far. As Jim says, we are not going to rush. We are going to continue to improve and continue to roll out on a market-by-market basis."
},
{
"speaker": "Jim Donald",
"text": "The future of food in our stores is not necessarily one that we are looking to get in this business. We are looking to continue to add to the quality of our service, the quality of our beverage, and to have that be a complement to, and not necessarily reign at the end of the day."
},
{
"speaker": "Operator",
"text": "Your next question comes from Steven Kron with Goldman Sachs."
},
{
"speaker": "Steven Kron - Goldman Sachs",
"text": "I had two quick ones, if I might. First, you talked last call about back-half investments in infrastructure in the international business. I was a little surprised to see margins up 100 basis points. I would have thought there was going to be more of an offset. Did you pull back a little bit this quarter? Was there a reallocation of infrastructure investment? Secondly, real quickly, on the accelerated development, are there additional costs that we need to think about from a personnel or a training perspective that will affect margins?"
},
{
"speaker": "Michael Casey",
"text": "On your first question, we absolutely did not pull back on the international development at all. We have just been able to grow revenue at a faster rate than that infrastructure has grown. I think if you looked at the G&A, you probably saw year-over-year increase in the G&A and in the other operating expenses, is where you see some of that infrastructure build. We are not pulling back even a little bit on the international infrastructure. With regard to the accelerated store growth, I do not think you will see any difference on our P&L. We have been increasing our store count basically for as long as I can remember, and we have learned how to do it and how to build in advance for it. We have been building that capability by adding people, adding assistant store managers gradually. We are practically at the opening rate in this quarter that we are projecting for next year, so this has been gradual and I do not think you will see any difference in the P&L ratios."
},
{
"speaker": "Operator",
"text": "Your next question comes from David Palmer with UBS."
},
{
"speaker": "David Palmer - UBS",
"text": "Thank you. A big question on international and a quick one on warming. This is the third year in a row you have had great contributions from international in terms of profitability. I think it is contributing 20% to 25% of your profit growth each of the last three years. Assuming the fourth quarter has a decent margin, it looks like your margin for international will be approaching about 10%. That is obviously up from 0 in '03. My question is about the incremental profit contributions in the future. What should we expect here? You are going to be making a lot of investments for growth, going for big growth in China -- how should we think about the contribution of profit in China? Secondly, with regard to stores and the warming, I am curious to know, are you thinking -- and maybe even doing this already -- putting an effort in terms of lunch or even dinner day-part offerings there and getting any results since you have that warming equipment? Thank you."
},
{
"speaker": "Howard Schultz",
"text": "Let me start on the international side, at first on the qualitative response to your question and then give it to Michael on the economic response. I think the big headline here, if you go back three years ago where we had not made money and where we are today, is the level of acceptance, and most specifically the relevancy, of the Starbucks experience in which we have been able to land so softly and so easily in so many different types of markets. When you look at the countries that we are in and the level of coffee education from a market as mature as France and Spain, and then you look at China and Malaysia and Singapore and even Japan, for that matter, it is really remarkable. That speaks to the fact that the third-place experience, Starbucks is a place between home and work, is as relevant in these countries as they have been in the U.S. That has given us the ability to ramp up and also create the kind of unit economics that, candidly, we did not expect. I think that, going away from this call, I know many of you will probably focus on 4% comps, but for me the headline is we have just announced an increase in stores for '06, an increase in stores for '07 and, most importantly, the fact that our international business is firing on all cylinders and we just announced the interest in Russia and India on top of the way in which we are being embraced all over the world, and specifically with now over 400 stores in greater China. With that, I will let Michael take the economic side, but we could not be more enthused and excited about what is happening internationally, which complements, obviously, the growth in development that we have had over the last 30 years in the U.S."
},
{
"speaker": "Michael Casey",
"text": "I have received the question about the international margins pretty frequently, and I try to be very consistent with the answer. International margins are a difficult balancing act for us. We would like to get continuous improvement in the margins but we also recognize the tremendous opportunity the international marketplaces provide for us. If we were to be just looking at a steady state, I think I could predict pretty regular increases in the international margins in the direction of the U.S. margins, but not getting there for quite a while just because of the difference in scale. You have to layer on to that the fact that we see an opportunity for five or 10 times the number of stores in places like China that we have today. We want to build the type of organization and infrastructure that will support that. The bigger the opportunity, the more we are going to invest and we will also be layering in investments in some of the countries that Howard just mentioned that will not contribute any sales or profitability in the short term but will be laying the groundwork to be able to continue this high level of growth, not just in the next five years, but in 2012 through 2017. It is a balancing act between investment in great potential for the long-term and the fact that we do want to be mindful of short-term profitability. What I think I can say to quantify it a little bit is that if you look at any 12-month period compared to the 12-month period before that, I would expect the operating margins to improve. In other words, that there is a general upward bias in margins, but I would be hesitant to predict that every quarter the margins would show improvement quarter over quarter, because we are going to make the investments when we need to and to the extent that we think is appropriate for the opportunity."
},
{
"speaker": "Jim Donald",
"text": "Was there a warming question?"
},
{
"speaker": "Mary Ekman",
"text": "Yes, whether or not it would expand lunch or dinner."
},
{
"speaker": "Jim Donald",
"text": "In the U.S. or internationally?"
},
{
"speaker": "Mary Ekman",
"text": "Warming in general."
},
{
"speaker": "Jim Donald",
"text": "Warming right now is being expected and continued to roll out in our morning day-parts only. However, we are testing and looking at, and even looking at some of the current sandwiches that we have in our stores as being applicable to warming. We have some markets that are looking at that. That is something that we are currently under review. We want the same quality that we have in warming to transfer over to our lunch operations, but we are currently in the stage of just testing and rolling it out in just very, very, very small markets and stores."
},
{
"speaker": "Operator",
"text": "Your next question comes from Sharon Zackfia with William Blair."
},
{
"speaker": "Sharon Zackfia - William Blair & Co.",
"text": "On the cold beverage bottleneck in the morning, can you help quantify for us how much Frappuccinos are actually up year over year in that day-part? As you measure that, how much you think that is dragging on your comps?"
},
{
"speaker": "Jim Donald",
"text": "I do not think we can quantify either one of those here on the call. We have looked at it on a market-by-market basis and we think it is putting downward pressure on same-store sales, but I would be hesitant to try to quantify it."
},
{
"speaker": "Sharon Zackfia - William Blair & Co.",
"text": "Can I ask a follow-up question, since I did not get that one answered?"
},
{
"speaker": "Jim Donald",
"text": "Sure."
},
{
"speaker": "Sharon Zackfia - William Blair & Co.",
"text": "On the domestic margins, on the gross margin side, in the past you have used price to defend your margins domestically. Is that something you are contemplating with green coffee working against you now?"
},
{
"speaker": "Jim Donald",
"text": "We always feel that given that situation in our stores, pricing is an alternative but it is not one that we are choosing to employ at the present time."
},
{
"speaker": "Operator",
"text": "Your next question comes from Glenn Petraglia with Citigroup."
},
{
"speaker": "Glen Petraglia - Citigroup",
"text": "Michael, if you could help me think about green coffee. I think you generally purchase 12 to 18 months ahead. What sort of headwind, or how long should we be thinking about the headwind from green coffee to last? I know prices are down from their peak last year but in your purchasing, are you hitting that peak at this point in time?"
},
{
"speaker": "Michael Casey",
"text": "I think we are at the point where the peak, the year-over-year differential between this year's green coffee and last year's green coffee is probably at its peak. On an absolute basis, we expect green coffee costs to continue to gradually increase through next year, through next fiscal year. We have taken that into account in setting our targets for next year. We have had great transparency for the increase this year, having talked about it a year ago in July, that we expected it and it is basically tracking exactly the way we expected it to be. Following or either late in 2007, or following in 2008, we would expect to start to get flattening or a turn in green coffee costs."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Ivankoe with JPMorgan."
},
{
"speaker": "John Ivankoe - JPMorgan Chase & Co.",
"text": "Thank you. I am not sure anyone has ever opened 1,000 units in the United States on a company-owned basis in a given year. Certainly it is an impressive goal for you to do that and I am sure accomplish that. Could you just give us a sense, in terms of if anything changes about those units in '07 relative to '06 or previous years, whether on a location basis or through any new markets, drive-thru versus non-drive-thru? Finally, just slightly separately, if you expect any measurable cannibalization to increase, based on the units you have opened in '06 and '07? Thank you."
},
{
"speaker": "Jim Donald",
"text": "We are looking at close to the same mix of drive-thru’s versus our regular stores as this year. I think currently we have 1400 drive-thru’s and we are looking at about a 50% portfolio going through forward with next year. Again, we have put a team in place to go out well ahead of where we currently were and identify these new stores, and it is not like we do not know where those stores are today. Those stores have been identified, so we are very comfortable that they will open. We are also very comfortable that the effect of cannibalization that we have had in the past will not be much different than it currently is today and going forward. We are not seeing that as something that we are putting any type of that cannibalization into our plan. Our comps for next year are 3% to 7% range, and we are very comfortable with that number for '07."
},
{
"speaker": "Howard Schultz",
"text": "I would just add one thing that I think is a subtlety, and that is, I think three or four years ago, our ability to select the kind of locations that perhaps we are selecting today, we could not do with a level of confidence. Specifically, what I am thinking about or trying to explain, is the fact that our customer base is much, much broader today than it ever has been, which gives us great flexibility to achieve the kind of unit economics that we have in the past with a much broader set of the nation's population. That has been demonstrated over the last 12 to 18 months in significant ways, where our unit economics, in places that we probably could not have even thought of going three or four years, ago exist today and that opens up very, very big opportunities for us."
},
{
"speaker": "Jim Donald",
"text": "We are still looking at a 2-to-1 sales-to-investment ratio for '07 as well."
},
{
"speaker": "Howard Schultz",
"text": "I think you should repeat that, because not only do I not think there are many companies opening 1000 stores, but I am not sure there is anyone in our space that has that kind of sales-to-investment ratio."
},
{
"speaker": "Operator",
"text": "At this time, we have time for one more question. That comes from Dan Geiman with McAdams Wright Ragen."
},
{
"speaker": "Dan Geiman - McAdams Wright Ragen",
"text": "Good afternoon. Just going back to the cold beverages and the capacity constraints there, just trying to get a better feel for when you saw signs of those capacity constraints in prior months. Did you see them earlier this year, May and June? Last year, last summer? Or did they kind of sneak up on you?"
},
{
"speaker": "Michael Casey",
"text": "When we started to study it, we looked back and we can see evidence of the beginning of this trend as early as April. Quite honestly, we did not recognize it because we did not look hard enough, until we basically got into July and started to do the analysis which showed there was that variance. While we do not generally like to talk about weather as an impact on our business, the fact that it has been hotter this year than it has ever been before, and we have been so innovative with our blended beverages, that there was more of a shift from hot espresso beverages to cold Frappuccino-type beverages in the morning peak, which is the key, than we anticipated. Had we known, I think we could have done better training and better deployment to have avoided it, and we would have accelerated the rollout of the cold beverage stations. We wish we had the benefit of hindsight."
},
{
"speaker": "Jim Donald",
"text": "It is interesting. This morning at 5:45 a.m., across the street in Seattle, I stood in line as a group of customers were buying our juice-blended Frappuccinos, six of them, at quarter-to-six in the morning. It was perfect timing for me to be a part of that."
},
{
"speaker": "Howard Schultz",
"text": "Just to clarify one other thing, we think we are doing a pretty good job of speed of service within the Frappuccino beverages when we are focused on those, like the afternoon when we are expecting the business. The challenge becomes greater when the Frappuccino business shifts into the morning, when we are geared for espresso speed, and then the challenge is to manage both the Frappuccino at high speed and the blended -- and the espresso beverages at high speed simultaneously. That is the challenge."
},
{
"speaker": "Jim Donald",
"text": "What is reassuring about this is we have seen it in our espresso beverage as we implemented basically the same tools, whether it was automated espresso, labor deployment -- we were able to see those lines come down and the transaction rates grow. We are confident we will able to do the same in cold blended."
},
{
"speaker": "Operator",
"text": "This concludes today’s Q&A session. I will now turn the call back over for any closing remarks."
},
{
"speaker": "JoAnn DeGrande",
"text": "Thank you. Thank you all for joining us for the earnings call today and we hope you will join us again for the webcast of our fourth-quarter and fiscal 2006 financial results. We will be back with you on Thursday, November 16, 2006. Thank you."
},
{
"speaker": "Operator",
"text": "This concludes today's conference call. You may disconnect at this time."
}
] | null | null |
SBUX | 2 | 2,006 | 2006-05-04 17:00:00 | Operator: Good afternoon ladies and gentlemen. My name is Myles and I will be your conference operator this afternoon. At this time, I would like to welcome everyone to the Starbucks Second Quarter 2006 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press star, then the number two. We respectfully request that you limit yourself to just one question at a time. Thank you. I will now turn the call over to Ms. JoAnn DeGrande, Director of Investor Relations. Please proceed, Madam.
JoAnn DeGrande: Thank you. Good afternoon, ladies and gentlemen. This is JoAnn DeGrande, Director of Investor Relations at Starbucks Coffee Company. With me today are Howard Schultz, Chairman; Jim Donald, President and CEO; Michael Casey, Executive Vice-President and CFO, and Mary Akman, Vice-President Corporate Development and Investor Relations. During today’s call, Jim will review key results and accomplishments on a consolidated basis, as well as provide some highlights from our U.S. business. Howard will provide an update on our latest music and entertainment initiative, and comment on our international business, and Michael will highlight the key drivers behind our second quarter results, as well as discuss fiscal 2006 growth targets. We will limit today’s call to one hour, including Q&A. Please note that today we released our April revenues in conjunction with our fiscal second quarter results. As a reminder to all listeners, this call is being broadcast live over the internet. A replay will be available via telephone at 800-642-1687, reservation number 3728538, through 5:30 p.m. Pacific time on Wednesday, May 10th, on the internet and on the investor relations page at starbucks.com through 5:00 p.m. Pacific time on Wednesday, May 31st. In addition, today’s remarks will be available on the investor relations portion of starbucks.com by the end of the day, and will remain available through Wednesday, the 31st of May. This conference call includes forward-looking statements such as anticipated store openings, comparable store sales expectations, trends in or expectations regarding the company’s revenue and expense growth, capital expenditures, effective tax rate and earnings per share results. These statements are all based on currently available operating, financial and competitive information and are subject to various risks and uncertainties. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements are contained in the company’s filings with the Securities and Exchange Commission, including the risk factor section of Starbucks’ annual report on form 10K for the fiscal year ended October 2, 2005. The company assume no obligations to update any of these forward-looking statements. Let me now turn the call over to Jim.
Jim Donald: Thank you, JoAnn, good afternoon ladies and gentlemen. Starbucks’ tremendous second quarter financial results reflected successful execution on all business fronts. Last year during this time, we spoke to you about investing in the business and building a solid foundation to support our aggressive future growth plans. A year later, we are pleased to report record revenues and earnings during the second quarter. This places us in a solid position as we enter the second half of fiscal 2006. Our robust second quarter delivered net revenue growth of 24% to $1.9 billion, net earnings growth of 27% to $127 million, and second quarter earnings per share of $0.16. A continued focus on store development resulted in 424 new store openings during the second quarter – that number surpasses any other second-quarter store opening pace in the Company’s history. Additionally, stores that have been open for at least 13 months delivered strong comparable store sales growth of 10%. We ended the quarter with 11,225 Starbucks locations in 37 countries, serving more than 40 million customers per week. More recently, April revenues grew 23% over the same period a year ago to $597 million, comparable store sales increased 6% and we added another 152 stores during the month. Starbucks product innovation pipeline is robust and extends out further into the future than at any other time in the Company’s history. We are well situated to achieve our aggressive financial targets for fiscal 2006 and to continue meeting our long-term growth goals. Now let’s review some of the key drivers behind our second quarter results. The quarter started off with a new beverage, Cinnamon Dolce Latte – which turned out to be a big hit with our customers. In fact, the Cinnamon Dolce Latte was one of the most successful new promotional beverage offerings in Starbucks history. This flavor profile provided a feeling of warmth and comfort during the cold of winter with sweet baked flavors reminiscent of a hot, buttery cinnamon pastry. The Cinnamon Dolce Latte, along with Starbucks Reduced Fat Coffee Cake trio, generated enthusiasm among both our customers and partners and contributed to our strong comparable store sales growth during this period. Our stores also featured a nostalgic treat for customers of all ages -- Starbucks Cupcake Originals. We featured two cupcake flavors nationwide, including Vanilla Sunshine and Chocolate Chocolate, which instantly became popular with our customers, often in the afternoon day part when they were seeking that special indulgence. We kicked off our 2006 Annual Brewing Event on March 14th, which provided our customers the opportunity to purchase best-in-class brewing equipment and accessories -- specially designed to prepare the best coffee at home -- at very attractive prices. The Brewing Event spanned the last three weeks of our second quarter and contributed positively to our quarterly results. Additionally, Starbucks hosted our first ever National Coffee Break. Through in-store signage, a press release and word-of-mouth, we invited customers into our stores for a complimentary cup of freshly brewed coffee. These two events raised awareness of our coffee expertise and provided an opportunity for our partners to share with our customers their passion for great coffee - while driving traffic into our stores. Adding to the new merchandise in our stores during the quarter we featured several CDs, including Back to Bedlam by James Blunt, 3121 by Prince, Timeless by Sergio Mendes and Starbucks Hear Music Opus collection -- Tony Bennett. Turning now to the food programs in our stores, we continued expansion of our lunch program during the second quarter, adding more than 200 additional locations throughout the U.S. and Canada. This brings the total to more than 3500 stores, or 62% of our North American Company-operated locations. While we continue to in-fill existing markets, we are also realizing operational efficiencies gained from our experience with this program. We have consolidated our lunch vendors, improved our order management and fine-tuned our selections for those core lunch offerings. We are seeing tremendous success with the lunch program, which reflects customer acceptance and solid execution by our store partners. Additionally, we continued the expansion of our Warming Program to new cities this year, which will provide more customers the option to enjoy warm, savory breakfast sandwiches along with their favorite Starbucks beverage. Last quarter, I reported on our expansion of Warming to more than 50 stores in Portland, Oregon, and since then we have received extremely positive feedback from our customers in that market. Building on that momentum, in early April, we introduced Warming in more than 100 stores in San Francisco, and the early results indicate strong customer acceptance in this market as well. Later this quarter we will introduce Warming to Chicago, which will bring us to our previously stated goal of 600 stores offering this program by the end of the fiscal year. Similar to our experience with the lunch program, we are pleased with sales and operational efficiencies gained as we have expanded the Warming program to additional markets. Now let’s take a look at what’s currently in our stores and what’s ahead. Inspired by the successful launch of our Green Tea Frappuccino blended crème last year, we have created two new green tea beverages -- one hot and one cold. The new Tazo Green Tea Latte is a delicious blend of lightly sweetened matcha green tea with a hint of tropical melon flavor and fresh steamed milk. The new Blackberry Green Tea Frappuccino Blended Crème adds a delicious twist to last year’s favorite by adding the fresh light taste of blackberry syrup made with real blackberry juice. Again this year, for those looking for a lower calorie, non-coffee option, we are also featuring Tazo Shaken Iced Green Tea and Tazo Shaken Green Tea Lemonade. These flavors blend perfectly to deliver the ultimate in summer refreshment. Customers will be able to choose from a large selection of serveware and Mother’s Day gift options in fresh spring colors and floral patterns. However, our merchandise offerings does not stop there -- customers can choose from a large selection of CD titles, including the soundtrack from our first entry into film, Akeelah and the Bee and Tony Bennett’s Through the Years. We are also excited to showcase our second CD in the Starbucks Hear Music Debut series -- Sonya Kitchell’s Words Came Back To Me. Summer is just around the corner, and quite frankly, I can hardly contain my excitement for the new offerings that we’ll be introducing during our two summer promotional phases; one’s launching in mid-May and the second in late June. Let me start by telling you about the new… no, I’m going to stop right there. I can’t go there. Since we are only 2 weeks away from the first phase, let me just say that these will be some of the freshest, most exciting new beverage introductions I’ve ever seen, inspired by colors and flavors of the world. So let the anticipation build. We will also offer a fresh new selection of merchandise, including serveware in bright summer colors, a new selection of CD titles and, late in the summer, the DVD of Akeelah and the Bee. While our retail stores continue to be the primary driver of our results, exciting things are also happening in our non-retail businesses. During the quarter, the North American Coffee Partnership, a joint venture between Starbucks Coffee Company and the Pepsi-Cola Company, introduced several new ready-to-drink beverages: Starbucks Iced Coffee, an entirely new canned coffee product, and two line extensions within our ready-to-drink platforms -- Starbucks DoubleShot Light espresso drink and Starbucks Strawberries & Crème Frappuccino crème beverage. At the end of April, these products were introduced into grocery and convenience stores nation-wide. Brand extensions such as these allow us to introduce innovative products and extend the Starbucks Experience to our customers at any place and any time they choose. The 95% U.S. market share we hold in this category is indicative of the broad acceptance of our ready-to-drink beverages. We have created a solid foundation that has positioned us well for growth; however, we understand that it is extremely important to always provide social, environmental and economic support for the communities in which we operate. With our purchase last year of Ethos Water, Starbucks has set a goal to support water projects around the world. As we’ve said before, five cents from the sale of each bottle of Ethos Water will support the goal of donating $10 million from 2005 through 2010 to non-profit organizations that are helping to alleviate the world water crisis. Starbucks participated in several events during the quarter which aligned with our efforts to bring clean water to children and communities who need the support. On March 22nd, Starbucks honored World Water Day through “Walks for Water,” an event established to build awareness of the 1.1 billion people worldwide who lack access to clean drinking water. Nearly 2,000 Starbucks partners and customers participated in the three-mile walk which took place in 11 cities around the U.S. In addition to participating in “Walks for Water,” we contributed to our previously stated goal of donating at least $10 million between 2005 and 2010 through two grants to water programs from the Ethos Water Fund of the Starbucks Foundation. These grants, which represented a total commitment of $2.1 million, will support programs in Western Ethiopia and four provinces in the Sumatra region of Indonesia. Starbucks is committed to positively contributing to the world we live in, and is dedicated to becoming a leader in helping to provide clean drinking water to children and their communities around the world. Starbucks is in a great position for both near-term and long-term growth, but at the same time that we are keeping a close eye on our performance and reaching our financial targets, we are always mindful of our social and environmental commitments. We understand that it’s important for us to earn our success every day -- not only through product innovation and delivering the Starbucks Experience, but also through focused efforts supporting Corporate Social Responsibility. These efforts extend throughout our business ensuring that we conduct ourselves in ways that provide social, environmental and economic benefits for the communities in which we operate. We firmly believe that our strong commitment to CSR not only benefits Starbucks, but also our customers, partners, suppliers and shareholders. Before I conclude my comments, I’d like to share with you my thoughts on recent developments in the Specialty Coffee Industry. Over the past couple of months, there has been a lot of buzz about other players entering the premium coffee space. And as we have said consistently over the years, we welcome the broadening field. As more competitors enter the premium quality coffee space, Starbucks benefits as well. Our company has played a pivotal role in the creation of the specialty coffee market, and as Starbucks and others continue to generate awareness for specialty coffee around the world, the category will continue to grow as consumer demand grows. We believe the combination of Starbucks’ highest quality coffee, unwavering focus on coffee education and the personal interaction between our customers and baristas -- what we call the Starbucks Experience -- demonstrates our coffee expertise, differentiates us from others and provides the foundation for future growth. Our opportunities are immense with this growing population of educated, aware specialty coffee consumers. We are extremely pleased with our second quarter results, and we enter the second half of the fiscal year with a continued focus on execution. Achieving exceptional results again this quarter is attributable to doing more of the same that we talked about last quarter -- the continued hard work and commitment of our partners, a keen focus on our coffee core, a robust pipeline of innovations and initiatives, and diligent execution at all levels of this business. This is true for the U.S. as well as our International markets. Howard will now share some International highlights after a brief update on our Entertainment initiatives. Howard.
Howard Schultz: Thank you, Jim, and nice job. Good afternoon, everyone. Before I discuss our International business, I’d like to take a minute to update you on our most recent Music and Entertainment initiative -- specifically, our entry into film. You will recall that last quarter I spoke to you about the transformative marketing and distribution partnership Starbucks embarked upon with Lionsgate Entertainment to introduce the new film, Akeelah and the Bee. During the second quarter, our retail stores launched a truly innovative and interactive in-store marketing campaign in advance of the film’s opening at the box office. Through unique in-store placements and techniques that have not really been used before, our customers had the opportunity to challenge themselves by expanding their vocabulary and spelling aptitude with complex, difficult-to-spell words printed on in-store items such as flash cards, magnets, coasters, and cup sleeves. In addition, the film’s soundtrack is available in our stores and the DVD of Akeelah and the Bee will be available late this summer. All these efforts are directed at raising our customers’ interest and to encourage them to see this very inspiring movie. Akeelah and the Bee opened in theatres last Friday following enthusiastic pre-opening reviews from popular movie critics Ebert & Roeper, along with a strong endorsement from Oprah Winfrey as well. We are pleased with the initial reception to the inspiring story that embraces the human spirit and we anticipate that word-of-mouth from this week’s first weekend audience will build additional interest. It’s important to remember that Starbucks invested no cash in the production of this film, and we will be an equity participant in the film’s success. We have no plans to invest capital in future movie projects as well. The unique economic partnership model we have forged clearly speaks to the power of the Starbucks brand and the value of our broad customer reach. The positive experience we have had in our first film venture -- invigorated by our customer’s enthusiastic response to our in-store marketing efforts -- led to the announcement earlier this week of the next step in our music and entertainment strategy. Starbucks has formed a unique relationship with the William Morris Agency, one of the world’s largest diversified talent and literary agencies, to leverage their skills and talent in identifying music, film and book projects for Starbucks to consider for marketing and distribution in our stores. Our entry into film has given us the confidence to seek other entertainment and literary opportunities in the future that are complementary to the Starbucks Experience and that share the same human values and relevant messaging that is core to our brand. After the initial announcement of our involvement with Akeelah and the Bee, Starbucks was deluged with material from film distributors interested in becoming our next movie partner. Our partnership with William Morris recognizes our need to align ourselves with a firm who has the expertise and capacity to manage this type of work. Starbucks has a unique place in the daily lives of our customers -- as a gathering place to share a sense of community and connection over a cup of coffee. This makes our stores an ideal channel to present them with relevant and complementary forms of entertainment. We highly value the trust our customers have placed in us and we embrace the opportunity to be part of their entertainment discovery. We are committed to selecting music, movie or literature projects that will represent the quality and substance reflective of the Starbucks brand. I look forward to updating you on our progress in the future. Turning to international, and now moving on to a global update. We continue to deliver excellent performance in our International business as we build out the platform for our future growth. Let me share with you some business updates, as well as my observations over the last quarter as I traveled through several cities in Asia-Pacific and the Middle East. Our global footprint continues expanding with the opening of 135 new stores in international markets during the quarter, which marks a second-quarter record for International store openings. We now have 3,275 locations outside the United States, and this broad base includes a combination of in-fill in our more mature markets such as Canada and Japan, as well as strong openings in China and Taiwan, where we have significant growth opportunities. The additional new stores and strong comparable store sales growth combined to deliver outstanding revenue growth in the international segment. It was an active quarter in our Asia Pacific region, so I will spend most of my discussion highlighting events and activities in that region. Beginning with China, I visited Beijing, Shanghai, Chongqing, and Chengdu during the quarter, and I have to say, my enthusiasm for the business, which has already been strong, continues to build. I must say that I think we have a really unique dynamic opportunity in many areas of our business. We have maintained our store expansion and now have more than 175 locations in Mainland China, 63 in Hong Kong and more than 170 in Taiwan. During the quarter we entered the province of Shenyang, a major industrial city known for transportation, technology, trade and culture. We have also further strengthened our leadership team in China by bringing on vice presidents of finance and marketing who held previous leadership roles in that market with industry leaders. They join Jinlong Wang, our recently-appointed president of China, forming a leadership team who not only boasts local market experience but also brings a broad range of depth and industry experience and expertise. Our business in China is performing well and we remain confident in the growth opportunities ahead. As many of you know, during his recent visit to the United States, the first stop for China’s President Hu was Seattle, Washington, and I was fortunate to have the opportunity to participate along with other local business leaders, dignitaries and elected officials in several events to honor his visit. Not only was this an incredible experience for me but it was also great exposure for Starbucks, as President Hu mentioned the company twice during two of his formal speeches. In addition to toasting the luncheon attendees with Starbucks coffee, President Hu commented -- which was just an unbelievable opportunity for all of us to witness, and I quote -- If I were not serving in this office, I would certainly prefer to go into one of the coffee shops run by Starbucks -- end quote. I think this is indicative of the way in which we have entered China and the respect that we have gained in a very short period of time. We are very appreciative of Starbucks acceptance in China and we embrace the opportunity before us in leading the emergence of a coffee culture in that country. This is yet another further confirmation that the Starbucks Experience translates well into other countries and cultures around the world. Asia Pacific ended the quarter with 1,597 locations, 21% growth from a year ago. The Europe and Middle East region -- which represents some of the broadest diversity in language, culture and landscape -- now totals nearly 900 stores, which represents 23% growth over the past twelve months. In March, the Middle East was the site of our third annual Global Advisory Council meeting -- a gathering of our Joint Venture Partners from the international markets in which we do business. The meeting, held in Dubai, was hosted by Mohammed Alshaya, CEO of the Alshaya Group, our partner for the Middle East and Turkey, and one of our longest standing JV partners. Joining me at this council meeting were nearly two dozen members of Starbucks’ senior management team, including Jim Donald, Michael Casey and Martin Coles, as well as the presidents of our international markets. The purpose of the two-day meeting was to discuss global growth plans, key business strategies and future opportunities for Starbucks -- but even more importantly was the sharing of best practices among all of us. I must admit I was overwhelmed with the enthusiasm of this group and the strategic alignment we all share. The passion and commitment for delivering the highest quality products and legendary service, as well as the appetite for continued store growth, was universal among all partners. This meeting truly demonstrated that Starbucks management team and JV partners are aligned in our commitment to the company’s international growth strategy and delivering the Starbucks Experience around the world. This gathering of our key partners also presented the ideal opportunity to acknowledge and celebrate the tremendous contribution to the company’s success by one particular leader, and that was Yuji Tsunoda, the CEO/COO and representative director of Starbucks Japan. Yuji is part of the original team that spurred Starbucks international growth and he has played an integral role in the development and success of Starbucks Japan. He embraced and infused Starbucks values in our partners and customers throughout Japan while building a profitable business with more than 600 stores in Japan today. We truly appreciate his hard work, commitment and dedication to our company. Thank you, Yuji! As Yuji transitions out of his role and retires as CEO and COO in June of this year, we welcome his successor, Mercy Corrales, whose operational expertise and deep knowledge of the retail industry will provide solid leadership as Starbucks Japan enters its second decade of operations later this year. With the well-planned leadership transition, we are confident Starbucks Japan will continue their successful efforts at further building the Starbucks brand, opening new stores, introducing innovative beverage and food offerings, and delivering the Starbucks Experience. These are very exciting times for all of us at Starbucks. Looking at where we are today, I am proud of the fact that we have built a company that recognizes the fiduciary responsibility of generating profits and building shareholder value, as we’ve done as a public company since 1992, while integrating a social conscience in everything that we do. Looking ahead, the ambition and the level of enthusiasm to continue to grow presents us with greater opportunity than ever before. With a long growth trajectory and so much opportunity ahead, we will strive to continue to provide the highest quality products and service and protect our brand and reputation as we innovate and grow into the future. I will now turn the call over to Michael Casey
Michael Casey: Thank you, Howard. This afternoon, I will provide highlights of our financial performance for the second quarter, both consolidated and by segment, give a brief update on the impact of stock-based compensation expense, and review our targets for the remainder of the year. Our continued attention to execution again produced outstanding top line and bottom line growth. Revenues were very strong in both company-operated and specialty businesses, and in our international and U.S. markets. Operating flow-through remained strong and we continued to make important investments in our future. Consolidated net revenues for the quarter were $1.9 billion, up 24% compared to the corresponding 13-week period in fiscal 2005 -- well above our 20% revenue growth target. Company-operated retail revenues increased 25% to $1.6 billion for the quarter, driven by the opening of 874 new company-operated retail stores in the last 12 months, and 10% comparable store sales growth for the quarter. Comparable stores sales were led by an 8% increase in the number of customer transactions coupled with a 2% increase in the average value per transaction. This marks Starbucks’ 57th consecutive quarter of publicly reported positive comparable store sales growth. Licensing revenues grew 25% to $202 million for the quarter, driven by higher product sales and revenues from the opening of 1,090 new licensed retail stores in the last 12 months, and continued growth in the licensed grocery and warehouse club businesses. Starbucks whole bean and ground coffee is now available in approximately 29,000 grocery and warehouse locations, and Seattle’s Best Coffee is available in almost 23,000 grocery and warehouse club locations. Operating income was up 28% to $202 million for the quarter, from $157 million in the prior year. As a percentage of total net revenues, operating margin increased to 10.7%, from 10.4% in the prior year, primarily due to lower cost of sales including occupancy costs, partially offset by higher corporate and international general and administrative expenses. Cost of sales including occupancy costs as a percentage of total net revenues decreased due to fixed rent costs in the current year being distributed over an expanded revenue base, as well as a favorable year-over-year comparison in occupancy costs resulting from intensified store maintenance activities in fiscal 2005. These favorable items, together with other lesser improvements, offset higher green coffee costs in the second quarter. General and administrative expenses increased due to higher payroll-related expenditures from stock-based compensation, additional employees to support continued global growth, and higher provisions for incentive compensation based on the company’s strong operating results in fiscal 2006. As we discussed last quarter, the company adopted the new expensing requirements for stock-based compensation this fiscal year, with no restatement of prior period results. Our broad-based equity compensation is a long-standing part of Starbucks culture and success, and options are granted to partners at all levels of the organization, including eligible part-time employees. Last November, the company granted options to nearly 58,000 partners. The pre-tax stock-based compensation expense recognized for the second quarter was $28 million, or $18 million net of tax, for an EPS impact of $0.02 per share. For the first half of fiscal 2006, stock-based compensation was $33 million, net of tax, or $0.04 per share -- in line with our expectations. Our strong results for the first half of the fiscal year have tended to make this expense less visible than it might otherwise have been. As we previously disclosed, for the entire fiscal year, we expect stock-based compensation to reduce EPS by approximately $0.09 per share. Please refer to page 9 of the press release for a break-out of how this expense is allocated to our consolidated statement of earnings. Turning now to operating segment results for the second quarter, total net revenues for our United States operating segment increased by 23% to $1.6 billion in the second quarter of fiscal 2006. Company-operated retail revenues grew 23% to $1.3 billion, primarily due to the opening of 660 new company-operated retail stores in the last 12 months and comparable store sales growth of 10% for the quarter. The increase in comparable store sales was comprised of an 8% increase in the number of customer transactions and a 2% increase in average value per transaction. U.S. specialty revenues grew by 21%, to $232 million in the second quarter. Within specialty revenues, licensing revenues increased 26% to $156 million, primarily due to higher product sales and royalty revenues from the opening of 685 new licensed retail stores in the last 12 months, and growth in the licensed and grocery warehouse club business. U.S. store operating expenses as a percentage of related retail revenues improved to 42.0% in the second quarter of fiscal 2006 from 42.1% in the prior year. This slight improvement was primarily due to higher costs in the prior year associated with the North American leadership conference, and leverage gained from higher retail revenues. These favorable variances were almost entirely offset by increased payroll-related expenditures from higher provisions for incentive compensation based on the company’s strong operating results in fiscal 2006 and recognition of stock-based compensation expense. Regional leadership conferences will be held during our third fiscal quarter in 2006, whereas in fiscal 2005, the leadership conference took place in the second fiscal quarter. In fiscal 2007, the leadership conference will shift back to the second quarter and will be held in an international location for the first time. U.S. operating income increased 36% to $266 million during the quarter. Operating margin expanded by 1.5 percentage points to 16.9% of related revenues for the second quarter of fiscal 2006. This improvement was primarily due to leverage gained from fixed costs, including occupancy, depreciation, and general and administrative expenses, distributed over an expanded revenue base in the current year period, and to higher costs in the prior year period for intensified store maintenance activities in company-operated retail stores. Now moving to our international segment. International total net revenues increased 30% to $315 million in the second quarter of fiscal 2006. International company-operated retail revenues increased 31%, to $262 million in fiscal 2006, primarily due to the opening of 214 new company-operated retail stores in the last 12 months and comparable store sales growth of 9% for the quarter. The increase in comparable store sales resulted from a 7% increase in the number of customer transactions coupled with a 2% increase in the average value per transaction. International specialty revenues for the quarter increased 24% to $54 million, primarily due to higher product sales and royalty revenues from opening 405 licensed retail stores in the last 12 months and expansion of our Canadian grocery and wholesale club business. Operating income for international operations increased 29% to $22 million in the second quarter of fiscal 2006 from $17 million in fiscal 2005. International operating margin decreased slightly to 7.1% of related revenues from 7.2% in fiscal 2005, primarily due to higher general and administrative expenses and an increase in other operating expenses for expanding infrastructure to support global growth, as well as increased retail store operating expenses due to higher provisions for incentive compensation. These items were partially offset by lower costs of sales including occupancy costs due primarily to leverage gained from fixed costs distributed over an expanded revenue base, as well as improvements in our food program. As our store base continues to increase rapidly, we continue to invest in our international infrastructure including investments in emerging markets, such as China. In addition to our excellent results in the second quarter of fiscal 2006, our year-to-date results are also noteworthy. Our consolidated operating income increased 25% to $482 million in the first half of this year from $384 million in the first half of last year, and the operating margin increased to 12.6% from 12.4% -- the highest operating margin ever reported by the company for the first six months of a fiscal year. Net earnings rose 23% and during the first half of the fiscal year, we opened 984 net new stores. We are very pleased with our strong financial performance in the first half, which positions us well as we enter the second half of the fiscal year. I will turn now to an overview of our updated fiscal 2006 growth targets, based on our very strong second quarter performance and our latest forecast for the balance of the fiscal year: Before I turn the call back over to the operator for the Q&A, I’d like to make one final comment. On a personal note, after more than ten exciting years as Starbucks’ chief financial officer, we have decided to initiate the process of identifying the next chief financial officer. We are going to consider both internal and external candidates with the goal of having someone in position by the end of the year, but we will take whatever time is required to find the right person and fully immerse him or her in the company’s business and culture. I will be actively involved in the transition and, beyond that, I will continue with my other executive responsibilities and new projects and initiatives as they come up. We are committed to making this transition as seamless and effective as our recent CEO transition proved to be. With that, I would like to ask the operator to queue the first question. Please ask one question at a time and re-queue for additional questions.
Operator: (Operator Instructions) Your first question comes from Jeffrey Bernstein with Lehman Brothers.
Jeffrey Bernstein: Great, thanks very much. I just had a question on the international margins. I know you gave some detail in your commentary, but just looking between the first quarter and the second quarter, obviously there was tremendous expansion in the first quarter, tougher second quarter. I’m just wondering if you could walk through some of the delta’s. Secondly, what would you expect for the back half of the year? I know you made some commentary that you’re going to be investing more for the back half of the year. I’m just wondering what your outlook would be. Thank you.
Michael Casey: We made tremendous progress over the last three years in our international business, both in growing the revenue base and improving the margins. I think the year, the quarter over quarter improvement in the first quarter was very strong, and we have always expected that this operating margin will improve gradually, but not necessarily up significantly every quarter. We don’t expect any backward movement in the operating margin in international business. We expect to continue to have improvement when you look at it over six or nine months at a time, but not necessarily each and every quarter. As I mentioned, we are primarily building our organization to support the tremendous opportunity that we foresee in China. We’ve been talking about that for the last several quarters, and we’ve been working diligently at that. We’re now starting to see some of the expense related to the people that we’ve hired. They came on payroll a little bit later than we had originally expected, but they’re up and running and we think forming a new base from which we will continue to grow the business with the team that’s currently in place. So we don’t call margins by quarter specifically, but looking over an extended period of time, we expect to see continued improvement in the operating margins.
Operator: Your next question comes from John Glass with CIBC.
John Glass: Thank you. My question has to do with the growth in the specialty line, especially the licensed line. Last quarter it grew at an exceptionally strong rate, somewhere above 30%. This quarter it’s a little bit more in the 20 range, so what is a normalized growth level? I guess if last quarter was exceptionally strong, why was it? Because the number of units didn’t grow faster last quarter than in prior quarters, or is this an anomaly from a low -- I’m trying to understand, I guess the one rate growth of that line, particularly in the U.S.
Michael Casey: We have the same business parameters in our licenses business as we do in our company-owned, and we had a particularly strong holiday season which carried over to our licensed stores as well as our company-owned stores. The number of stores that are open at the end of a period isn’t necessarily indicative of the sales weeks during that period, because the opening pace skewed, bowed and backed. But I think a growth rate in the 20% range is a reasonable target going forward. The 30% year over year growth in that line was unusual.
Operator: Your next question comes from Steven Kron with Goldman & Sachs.
Steven Kron: Good afternoon. I have a question, Howard, on the entertainment business and drilling down a little bit on the Akeelah and the Bee experience. Box-office receipts in the first weekend seemed to be disappointing to those that kind of look at that industry. It sounds like you had a pretty positive experience. I guess in your stores, how did the results from the experience of Akeelah kind of compare to your expectations? How are you from a big picture standpoint measuring the success on Starbucks’ ability to kind of build awareness in the entertainment industry?
Howard Schultz: I appreciate the question. I think going into this, all along, as we look at scripts and screen movies, which dates back almost 12 months before we made the decision on this movie, we were looking for a movie that really had a lot of hope attached to it, was inspirational and really was the kind of story that was compatible with what our customers and, most importantly, our people, would expect us to be part of. So although we clearly were interested in the box-office receipts, that was just one of a number of ways in which we were going to measure success. I would admit that the box-office receipts were less than perhaps Lionsgate or the industry had thought, but there were other competing factors. Lionsgate has a long history with movies that have a unique level of word of mouth, most specifically Crash, which opened in a similar fashion. I think this movie is going to have a long tail to it. I think on a go-forward basis, what we’re looking to do as we have done with music, as we now have done with a film, and we keep mentioning that we are also looking for the possibility of bringing a book into our store, we are looking for things that could add texture to the equity of the brand and the experience to bring value to our customers, and we think we are in a unique position. I think our customers have come to expect us to not only provide a great cup of coffee but we are an integral part of their life and their lifestyle, and we want to be able to, when we find interesting stories and interesting pieces of content, to bring it to the marketplace. As I said in the script, we do not see ourselves as becoming an entertainment company. We are very mindful that our core business is coffee and the coffee experience, but we all feel that this is highly complementary to who we are, what we do, and it ultimately will reinforce our position in the marketplace. So we feel really positive about the experience. We are learning a lot and we look forward to other projects.
Operator: Your next question comes from Matthew DiFrisco with Thomas Weisel Partners.
Matthew DiFrisco: Just looking at the income statement, it looks like there might have been a reclassification or something going on with the depreciation. If you could just clarify that for us, I might have missed something in the release. Then, if you could just comment on you’ve touched on also in your prepared remarks about the brewing sale or promotion having a positive benefit to Q1. Did it have an impact on the April comparable sales number released today as well?
Michael Casey: I’ll take the first one. There has been no reclassification or change in depreciation. The numbers are consistent with the growth in primarily company-owned stores, which raised that number.
Howard Schultz: The brewing event, the timing was such that most of the business last year came into this quarter this month that we just finished. I think it was a week off, maybe eight days. So when you look at what the value of that was, again we are pleased to see that we captured the bulk of that last month but still had a great month this year with our 60% comps.
Jim Donald: I’ll go a step further. We were very, very pleased with 60% comps, and if anyone on the call is disappointed, you’re off-base.
Operator: Your next question comes from Sharon Zackfia with William Blair.
Sharon Zackfia: Good afternoon. I have been -- or I continue to be impressed with your COGS performance. It keeps improving quarter after quarter. I’m just wondering how low can that go, and is there some sort of comp where you start to get leverage in all those six expenses that you are talking about in the text and the press release?
Michael Casey: I am not sure we can set a limit on how low the cost in related occupancy can go. The benefit we’ve been getting in the last several quarters is attributable primarily to the average unit volumes, particularly in our U.S. stores, which are now over $1 million, significantly noticeably over $1 million per store, and allows us to get leverage in a number of categories of the occupancy line, which is part of cost of goods sold. We believe in our North American business, we are getting leverage in G&A and I believe we would be getting leverage in G&A overall if it weren’t for the adoption of stock-based compensation expensing this year. We are also getting some benefit this year in cost of goods sold from favorable dairy costs, relative to a year ago. Those are the primary drivers. We continue to believe, absent some see-change in one of our basic commodities, that we can continue to do a better job than the COG occupancy line because we intend to continue to grow our average unit volumes and we think we can become more efficient in a number of the programs that we initiated the last two years, like drive-thru stores, lunch, warming -- those are places where we are still learning and continuing to get better.
Operator: Your next question comes from David Palmer with UBS.
David Palmer: Congratulations on the quarter, everybody. Michael, congratulations on I guess your CFO career. I guess it’s not your total career.
Michael Casey: Thank you. I do want to clarify. I am going to continue to be here doing many other things as we identify a new CFO.
David Palmer: I was going to ask about the COGS line, and one thing I was curious about too is the dairy inflation, how that might evolve, along with coffee inflation over the next twelve months, but I want to save my big question for perhaps warming, and if you have any sort of preliminary timetable about how you might roll that out, how many quarters and years it might take to get across the system. Thank you.
Michael Casey: We are going to take a similar approach to the approach that we took to Lunch. We are going to move slowly. We are going to continuously improve the selection of the products, the way we do procurement, the way we do distribution, the way we do training. It could easily take two or three years to roll it out completely. And we still haven’t made the final decision that we’re going to go everywhere with Warming. We have had great initial success in the markets that we have gone to. We are planning to do some additional markets yet to be identified next year, but beyond that, we are going to take it as it goes.
Jim Donald: Let me add to that one. There is no race to get this rolled out. Every market that we go into, we are actually five or six steps better from all the things that Michael has mentioned. We want to make sure though that we are continuing to enhance the customer’s experience when they come in in the morning to pick up their beverage and their sandwich, be it quality of the product and the speed with service. So as we take notes from every launch, we continue to raise the bar.
Operator: Your next question comes from Ashley Woodruff with Bears Stearns.
Ashley Woodruff: Thank you. I wonder if we could talk a little bit about pricing. The last time you took a price increase was October 2004, which was four years after your previous price increase, and I think at that time you began to think that perhaps you should take pricing a little more frequently, so your customer would get more accustomed to it. As you start to plan for 2007, can you talk about whether pricing plays a role in that?
Michael Casey: We do not currently have any plans to change our pricing structure, specifically in the United States. Occasionally in one of the international markets, there will be a price increase but it doesn’t affect the big picture in the normal course of business related to whatever is happening in that marketplace. But I assume your primary question is related to company-owned stores in the U.S., and we have no plans in the foreseeable future to take a price increase. Not this year, and not in our current thinking for 2007.
Operator: Your next question comes from Glen Petraglia with Citigroup.
Glen Petraglia: Good afternoon. My question is regarding the store target for this year. It would seem that the 1800 new store target is somewhat conservative, given that in the past, store openings have generally been a little more prevalent in the second half of the year. If you could comment on that, please.
Jim Donald: First of all, I have to say that the 1800 is probably one of our most ambitious goals that we have rolled out, and we are very pleased to see that as we have gone from quarter to quarter, we have been able to exceed our quarterly targets. We look at what has created that, it’s combining the partners in the areas of store development, in the areas of filling the bench to make sure that our partners are ready to take these stores as they come open. We will continue to keep with our 1800 store rollout and when we see the opportunities to accelerate that on a market-by-market basis, we will do that, provided that the store will be ready in its entirety and that the store partners will be ready to staff that store to deliver the Starbucks Experience.
Michael Casey: One of the things we have talked about frequently in this call and previously is execution, and that applies to lots of different areas, but one of the ways it applies to store development is we have become much more systematic. We are planning much better, so I do not think you will see an acceleration toward the end of the year to the same extent in the future that you have seen in the past, because we are just planning better, we are executing better. We are not getting behind and therefore we do not have to catch up. So I think you will see a pretty -- eventually I believe we will raise those store targets for future years, but I do not think 1800 is conservative by any measure.
Operator: Your next question comes from John Ivankoe with J.P. Morgan.
John Ivankoe: Thank you. A question for you, Howard. Could you talk about the special challenges in China as you see that might be structural in the market and what you have done differently with Starbucks and your organization there to allow you to achieve your goals?
Howard Schultz: I think that there are special challenges, and this is a very unique environment. I think, John, you and I spoke privately -- there is such a rush to China and I think a lot of companies will succeed and many will fail. I think that one of the things that we recognized early on, and that’s from the benefit of having very good JV partners and Chinese Starbucks people on the ground, was the importance of very high-level relationships with the government and the importance of interpersonal relationships with senior people from Starbucks. We have been to China many, many times this fiscal year and in years past, primarily to build relationships and to demonstrate a deep level of respect for not only the marketplace but the culture and the way the Chinese people perceive their business and outsiders. I think the work we have done this year in hiring very senior Chinese people who are leading our business, a dedicated Chinese team, coupled with a philanthropic effort that we put forth earlier in the year, in which we created a $5 million education fund for those young children, specifically girls in rural China that may not have a chance for education, really demonstrated to senior Chinese officials and business leaders that Starbucks was trying to build a business here the right way. We have a long way to go. I think we have built a very solid foundation. You have heard us say before that this potentially will be the largest market in the world for Starbucks outside of North America. I think we are off to a great start, and we are seeing real traction and acceptance. I think we have a lot of work to do, but we have done a lot of things right.
JoAnn DeGrande: Myles, that wraps up the call, please.
Operator: Okay, Madam.
JoAnn DeGrande: Thank you for listening to our earnings call today. We hope you will join the webcast of our third quarter fiscal 2006 financial results on August 2, 2006, and note that at that time we will release revenues for July as well. Thank you for joining us today.
Operator: Ladies and gentlemen, we do appreciate your joining us. This does conclude our Starbucks second quarter 2006 earnings conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good afternoon ladies and gentlemen. My name is Myles and I will be your conference operator this afternoon. At this time, I would like to welcome everyone to the Starbucks Second Quarter 2006 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press star, then the number two. We respectfully request that you limit yourself to just one question at a time. Thank you. I will now turn the call over to Ms. JoAnn DeGrande, Director of Investor Relations. Please proceed, Madam."
},
{
"speaker": "JoAnn DeGrande",
"text": "Thank you. Good afternoon, ladies and gentlemen. This is JoAnn DeGrande, Director of Investor Relations at Starbucks Coffee Company. With me today are Howard Schultz, Chairman; Jim Donald, President and CEO; Michael Casey, Executive Vice-President and CFO, and Mary Akman, Vice-President Corporate Development and Investor Relations. During today’s call, Jim will review key results and accomplishments on a consolidated basis, as well as provide some highlights from our U.S. business. Howard will provide an update on our latest music and entertainment initiative, and comment on our international business, and Michael will highlight the key drivers behind our second quarter results, as well as discuss fiscal 2006 growth targets. We will limit today’s call to one hour, including Q&A. Please note that today we released our April revenues in conjunction with our fiscal second quarter results. As a reminder to all listeners, this call is being broadcast live over the internet. A replay will be available via telephone at 800-642-1687, reservation number 3728538, through 5:30 p.m. Pacific time on Wednesday, May 10th, on the internet and on the investor relations page at starbucks.com through 5:00 p.m. Pacific time on Wednesday, May 31st. In addition, today’s remarks will be available on the investor relations portion of starbucks.com by the end of the day, and will remain available through Wednesday, the 31st of May. This conference call includes forward-looking statements such as anticipated store openings, comparable store sales expectations, trends in or expectations regarding the company’s revenue and expense growth, capital expenditures, effective tax rate and earnings per share results. These statements are all based on currently available operating, financial and competitive information and are subject to various risks and uncertainties. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements are contained in the company’s filings with the Securities and Exchange Commission, including the risk factor section of Starbucks’ annual report on form 10K for the fiscal year ended October 2, 2005. The company assume no obligations to update any of these forward-looking statements. Let me now turn the call over to Jim."
},
{
"speaker": "Jim Donald",
"text": "Thank you, JoAnn, good afternoon ladies and gentlemen. Starbucks’ tremendous second quarter financial results reflected successful execution on all business fronts. Last year during this time, we spoke to you about investing in the business and building a solid foundation to support our aggressive future growth plans. A year later, we are pleased to report record revenues and earnings during the second quarter. This places us in a solid position as we enter the second half of fiscal 2006. Our robust second quarter delivered net revenue growth of 24% to $1.9 billion, net earnings growth of 27% to $127 million, and second quarter earnings per share of $0.16. A continued focus on store development resulted in 424 new store openings during the second quarter – that number surpasses any other second-quarter store opening pace in the Company’s history. Additionally, stores that have been open for at least 13 months delivered strong comparable store sales growth of 10%. We ended the quarter with 11,225 Starbucks locations in 37 countries, serving more than 40 million customers per week. More recently, April revenues grew 23% over the same period a year ago to $597 million, comparable store sales increased 6% and we added another 152 stores during the month. Starbucks product innovation pipeline is robust and extends out further into the future than at any other time in the Company’s history. We are well situated to achieve our aggressive financial targets for fiscal 2006 and to continue meeting our long-term growth goals. Now let’s review some of the key drivers behind our second quarter results. The quarter started off with a new beverage, Cinnamon Dolce Latte – which turned out to be a big hit with our customers. In fact, the Cinnamon Dolce Latte was one of the most successful new promotional beverage offerings in Starbucks history. This flavor profile provided a feeling of warmth and comfort during the cold of winter with sweet baked flavors reminiscent of a hot, buttery cinnamon pastry. The Cinnamon Dolce Latte, along with Starbucks Reduced Fat Coffee Cake trio, generated enthusiasm among both our customers and partners and contributed to our strong comparable store sales growth during this period. Our stores also featured a nostalgic treat for customers of all ages -- Starbucks Cupcake Originals. We featured two cupcake flavors nationwide, including Vanilla Sunshine and Chocolate Chocolate, which instantly became popular with our customers, often in the afternoon day part when they were seeking that special indulgence. We kicked off our 2006 Annual Brewing Event on March 14th, which provided our customers the opportunity to purchase best-in-class brewing equipment and accessories -- specially designed to prepare the best coffee at home -- at very attractive prices. The Brewing Event spanned the last three weeks of our second quarter and contributed positively to our quarterly results. Additionally, Starbucks hosted our first ever National Coffee Break. Through in-store signage, a press release and word-of-mouth, we invited customers into our stores for a complimentary cup of freshly brewed coffee. These two events raised awareness of our coffee expertise and provided an opportunity for our partners to share with our customers their passion for great coffee - while driving traffic into our stores. Adding to the new merchandise in our stores during the quarter we featured several CDs, including Back to Bedlam by James Blunt, 3121 by Prince, Timeless by Sergio Mendes and Starbucks Hear Music Opus collection -- Tony Bennett. Turning now to the food programs in our stores, we continued expansion of our lunch program during the second quarter, adding more than 200 additional locations throughout the U.S. and Canada. This brings the total to more than 3500 stores, or 62% of our North American Company-operated locations. While we continue to in-fill existing markets, we are also realizing operational efficiencies gained from our experience with this program. We have consolidated our lunch vendors, improved our order management and fine-tuned our selections for those core lunch offerings. We are seeing tremendous success with the lunch program, which reflects customer acceptance and solid execution by our store partners. Additionally, we continued the expansion of our Warming Program to new cities this year, which will provide more customers the option to enjoy warm, savory breakfast sandwiches along with their favorite Starbucks beverage. Last quarter, I reported on our expansion of Warming to more than 50 stores in Portland, Oregon, and since then we have received extremely positive feedback from our customers in that market. Building on that momentum, in early April, we introduced Warming in more than 100 stores in San Francisco, and the early results indicate strong customer acceptance in this market as well. Later this quarter we will introduce Warming to Chicago, which will bring us to our previously stated goal of 600 stores offering this program by the end of the fiscal year. Similar to our experience with the lunch program, we are pleased with sales and operational efficiencies gained as we have expanded the Warming program to additional markets. Now let’s take a look at what’s currently in our stores and what’s ahead. Inspired by the successful launch of our Green Tea Frappuccino blended crème last year, we have created two new green tea beverages -- one hot and one cold. The new Tazo Green Tea Latte is a delicious blend of lightly sweetened matcha green tea with a hint of tropical melon flavor and fresh steamed milk. The new Blackberry Green Tea Frappuccino Blended Crème adds a delicious twist to last year’s favorite by adding the fresh light taste of blackberry syrup made with real blackberry juice. Again this year, for those looking for a lower calorie, non-coffee option, we are also featuring Tazo Shaken Iced Green Tea and Tazo Shaken Green Tea Lemonade. These flavors blend perfectly to deliver the ultimate in summer refreshment. Customers will be able to choose from a large selection of serveware and Mother’s Day gift options in fresh spring colors and floral patterns. However, our merchandise offerings does not stop there -- customers can choose from a large selection of CD titles, including the soundtrack from our first entry into film, Akeelah and the Bee and Tony Bennett’s Through the Years. We are also excited to showcase our second CD in the Starbucks Hear Music Debut series -- Sonya Kitchell’s Words Came Back To Me. Summer is just around the corner, and quite frankly, I can hardly contain my excitement for the new offerings that we’ll be introducing during our two summer promotional phases; one’s launching in mid-May and the second in late June. Let me start by telling you about the new… no, I’m going to stop right there. I can’t go there. Since we are only 2 weeks away from the first phase, let me just say that these will be some of the freshest, most exciting new beverage introductions I’ve ever seen, inspired by colors and flavors of the world. So let the anticipation build. We will also offer a fresh new selection of merchandise, including serveware in bright summer colors, a new selection of CD titles and, late in the summer, the DVD of Akeelah and the Bee. While our retail stores continue to be the primary driver of our results, exciting things are also happening in our non-retail businesses. During the quarter, the North American Coffee Partnership, a joint venture between Starbucks Coffee Company and the Pepsi-Cola Company, introduced several new ready-to-drink beverages: Starbucks Iced Coffee, an entirely new canned coffee product, and two line extensions within our ready-to-drink platforms -- Starbucks DoubleShot Light espresso drink and Starbucks Strawberries & Crème Frappuccino crème beverage. At the end of April, these products were introduced into grocery and convenience stores nation-wide. Brand extensions such as these allow us to introduce innovative products and extend the Starbucks Experience to our customers at any place and any time they choose. The 95% U.S. market share we hold in this category is indicative of the broad acceptance of our ready-to-drink beverages. We have created a solid foundation that has positioned us well for growth; however, we understand that it is extremely important to always provide social, environmental and economic support for the communities in which we operate. With our purchase last year of Ethos Water, Starbucks has set a goal to support water projects around the world. As we’ve said before, five cents from the sale of each bottle of Ethos Water will support the goal of donating $10 million from 2005 through 2010 to non-profit organizations that are helping to alleviate the world water crisis. Starbucks participated in several events during the quarter which aligned with our efforts to bring clean water to children and communities who need the support. On March 22nd, Starbucks honored World Water Day through “Walks for Water,” an event established to build awareness of the 1.1 billion people worldwide who lack access to clean drinking water. Nearly 2,000 Starbucks partners and customers participated in the three-mile walk which took place in 11 cities around the U.S. In addition to participating in “Walks for Water,” we contributed to our previously stated goal of donating at least $10 million between 2005 and 2010 through two grants to water programs from the Ethos Water Fund of the Starbucks Foundation. These grants, which represented a total commitment of $2.1 million, will support programs in Western Ethiopia and four provinces in the Sumatra region of Indonesia. Starbucks is committed to positively contributing to the world we live in, and is dedicated to becoming a leader in helping to provide clean drinking water to children and their communities around the world. Starbucks is in a great position for both near-term and long-term growth, but at the same time that we are keeping a close eye on our performance and reaching our financial targets, we are always mindful of our social and environmental commitments. We understand that it’s important for us to earn our success every day -- not only through product innovation and delivering the Starbucks Experience, but also through focused efforts supporting Corporate Social Responsibility. These efforts extend throughout our business ensuring that we conduct ourselves in ways that provide social, environmental and economic benefits for the communities in which we operate. We firmly believe that our strong commitment to CSR not only benefits Starbucks, but also our customers, partners, suppliers and shareholders. Before I conclude my comments, I’d like to share with you my thoughts on recent developments in the Specialty Coffee Industry. Over the past couple of months, there has been a lot of buzz about other players entering the premium coffee space. And as we have said consistently over the years, we welcome the broadening field. As more competitors enter the premium quality coffee space, Starbucks benefits as well. Our company has played a pivotal role in the creation of the specialty coffee market, and as Starbucks and others continue to generate awareness for specialty coffee around the world, the category will continue to grow as consumer demand grows. We believe the combination of Starbucks’ highest quality coffee, unwavering focus on coffee education and the personal interaction between our customers and baristas -- what we call the Starbucks Experience -- demonstrates our coffee expertise, differentiates us from others and provides the foundation for future growth. Our opportunities are immense with this growing population of educated, aware specialty coffee consumers. We are extremely pleased with our second quarter results, and we enter the second half of the fiscal year with a continued focus on execution. Achieving exceptional results again this quarter is attributable to doing more of the same that we talked about last quarter -- the continued hard work and commitment of our partners, a keen focus on our coffee core, a robust pipeline of innovations and initiatives, and diligent execution at all levels of this business. This is true for the U.S. as well as our International markets. Howard will now share some International highlights after a brief update on our Entertainment initiatives. Howard."
},
{
"speaker": "Howard Schultz",
"text": "Thank you, Jim, and nice job. Good afternoon, everyone. Before I discuss our International business, I’d like to take a minute to update you on our most recent Music and Entertainment initiative -- specifically, our entry into film. You will recall that last quarter I spoke to you about the transformative marketing and distribution partnership Starbucks embarked upon with Lionsgate Entertainment to introduce the new film, Akeelah and the Bee. During the second quarter, our retail stores launched a truly innovative and interactive in-store marketing campaign in advance of the film’s opening at the box office. Through unique in-store placements and techniques that have not really been used before, our customers had the opportunity to challenge themselves by expanding their vocabulary and spelling aptitude with complex, difficult-to-spell words printed on in-store items such as flash cards, magnets, coasters, and cup sleeves. In addition, the film’s soundtrack is available in our stores and the DVD of Akeelah and the Bee will be available late this summer. All these efforts are directed at raising our customers’ interest and to encourage them to see this very inspiring movie. Akeelah and the Bee opened in theatres last Friday following enthusiastic pre-opening reviews from popular movie critics Ebert & Roeper, along with a strong endorsement from Oprah Winfrey as well. We are pleased with the initial reception to the inspiring story that embraces the human spirit and we anticipate that word-of-mouth from this week’s first weekend audience will build additional interest. It’s important to remember that Starbucks invested no cash in the production of this film, and we will be an equity participant in the film’s success. We have no plans to invest capital in future movie projects as well. The unique economic partnership model we have forged clearly speaks to the power of the Starbucks brand and the value of our broad customer reach. The positive experience we have had in our first film venture -- invigorated by our customer’s enthusiastic response to our in-store marketing efforts -- led to the announcement earlier this week of the next step in our music and entertainment strategy. Starbucks has formed a unique relationship with the William Morris Agency, one of the world’s largest diversified talent and literary agencies, to leverage their skills and talent in identifying music, film and book projects for Starbucks to consider for marketing and distribution in our stores. Our entry into film has given us the confidence to seek other entertainment and literary opportunities in the future that are complementary to the Starbucks Experience and that share the same human values and relevant messaging that is core to our brand. After the initial announcement of our involvement with Akeelah and the Bee, Starbucks was deluged with material from film distributors interested in becoming our next movie partner. Our partnership with William Morris recognizes our need to align ourselves with a firm who has the expertise and capacity to manage this type of work. Starbucks has a unique place in the daily lives of our customers -- as a gathering place to share a sense of community and connection over a cup of coffee. This makes our stores an ideal channel to present them with relevant and complementary forms of entertainment. We highly value the trust our customers have placed in us and we embrace the opportunity to be part of their entertainment discovery. We are committed to selecting music, movie or literature projects that will represent the quality and substance reflective of the Starbucks brand. I look forward to updating you on our progress in the future. Turning to international, and now moving on to a global update. We continue to deliver excellent performance in our International business as we build out the platform for our future growth. Let me share with you some business updates, as well as my observations over the last quarter as I traveled through several cities in Asia-Pacific and the Middle East. Our global footprint continues expanding with the opening of 135 new stores in international markets during the quarter, which marks a second-quarter record for International store openings. We now have 3,275 locations outside the United States, and this broad base includes a combination of in-fill in our more mature markets such as Canada and Japan, as well as strong openings in China and Taiwan, where we have significant growth opportunities. The additional new stores and strong comparable store sales growth combined to deliver outstanding revenue growth in the international segment. It was an active quarter in our Asia Pacific region, so I will spend most of my discussion highlighting events and activities in that region. Beginning with China, I visited Beijing, Shanghai, Chongqing, and Chengdu during the quarter, and I have to say, my enthusiasm for the business, which has already been strong, continues to build. I must say that I think we have a really unique dynamic opportunity in many areas of our business. We have maintained our store expansion and now have more than 175 locations in Mainland China, 63 in Hong Kong and more than 170 in Taiwan. During the quarter we entered the province of Shenyang, a major industrial city known for transportation, technology, trade and culture. We have also further strengthened our leadership team in China by bringing on vice presidents of finance and marketing who held previous leadership roles in that market with industry leaders. They join Jinlong Wang, our recently-appointed president of China, forming a leadership team who not only boasts local market experience but also brings a broad range of depth and industry experience and expertise. Our business in China is performing well and we remain confident in the growth opportunities ahead. As many of you know, during his recent visit to the United States, the first stop for China’s President Hu was Seattle, Washington, and I was fortunate to have the opportunity to participate along with other local business leaders, dignitaries and elected officials in several events to honor his visit. Not only was this an incredible experience for me but it was also great exposure for Starbucks, as President Hu mentioned the company twice during two of his formal speeches. In addition to toasting the luncheon attendees with Starbucks coffee, President Hu commented -- which was just an unbelievable opportunity for all of us to witness, and I quote -- If I were not serving in this office, I would certainly prefer to go into one of the coffee shops run by Starbucks -- end quote. I think this is indicative of the way in which we have entered China and the respect that we have gained in a very short period of time. We are very appreciative of Starbucks acceptance in China and we embrace the opportunity before us in leading the emergence of a coffee culture in that country. This is yet another further confirmation that the Starbucks Experience translates well into other countries and cultures around the world. Asia Pacific ended the quarter with 1,597 locations, 21% growth from a year ago. The Europe and Middle East region -- which represents some of the broadest diversity in language, culture and landscape -- now totals nearly 900 stores, which represents 23% growth over the past twelve months. In March, the Middle East was the site of our third annual Global Advisory Council meeting -- a gathering of our Joint Venture Partners from the international markets in which we do business. The meeting, held in Dubai, was hosted by Mohammed Alshaya, CEO of the Alshaya Group, our partner for the Middle East and Turkey, and one of our longest standing JV partners. Joining me at this council meeting were nearly two dozen members of Starbucks’ senior management team, including Jim Donald, Michael Casey and Martin Coles, as well as the presidents of our international markets. The purpose of the two-day meeting was to discuss global growth plans, key business strategies and future opportunities for Starbucks -- but even more importantly was the sharing of best practices among all of us. I must admit I was overwhelmed with the enthusiasm of this group and the strategic alignment we all share. The passion and commitment for delivering the highest quality products and legendary service, as well as the appetite for continued store growth, was universal among all partners. This meeting truly demonstrated that Starbucks management team and JV partners are aligned in our commitment to the company’s international growth strategy and delivering the Starbucks Experience around the world. This gathering of our key partners also presented the ideal opportunity to acknowledge and celebrate the tremendous contribution to the company’s success by one particular leader, and that was Yuji Tsunoda, the CEO/COO and representative director of Starbucks Japan. Yuji is part of the original team that spurred Starbucks international growth and he has played an integral role in the development and success of Starbucks Japan. He embraced and infused Starbucks values in our partners and customers throughout Japan while building a profitable business with more than 600 stores in Japan today. We truly appreciate his hard work, commitment and dedication to our company. Thank you, Yuji! As Yuji transitions out of his role and retires as CEO and COO in June of this year, we welcome his successor, Mercy Corrales, whose operational expertise and deep knowledge of the retail industry will provide solid leadership as Starbucks Japan enters its second decade of operations later this year. With the well-planned leadership transition, we are confident Starbucks Japan will continue their successful efforts at further building the Starbucks brand, opening new stores, introducing innovative beverage and food offerings, and delivering the Starbucks Experience. These are very exciting times for all of us at Starbucks. Looking at where we are today, I am proud of the fact that we have built a company that recognizes the fiduciary responsibility of generating profits and building shareholder value, as we’ve done as a public company since 1992, while integrating a social conscience in everything that we do. Looking ahead, the ambition and the level of enthusiasm to continue to grow presents us with greater opportunity than ever before. With a long growth trajectory and so much opportunity ahead, we will strive to continue to provide the highest quality products and service and protect our brand and reputation as we innovate and grow into the future. I will now turn the call over to Michael Casey"
},
{
"speaker": "Michael Casey",
"text": "Thank you, Howard. This afternoon, I will provide highlights of our financial performance for the second quarter, both consolidated and by segment, give a brief update on the impact of stock-based compensation expense, and review our targets for the remainder of the year. Our continued attention to execution again produced outstanding top line and bottom line growth. Revenues were very strong in both company-operated and specialty businesses, and in our international and U.S. markets. Operating flow-through remained strong and we continued to make important investments in our future. Consolidated net revenues for the quarter were $1.9 billion, up 24% compared to the corresponding 13-week period in fiscal 2005 -- well above our 20% revenue growth target. Company-operated retail revenues increased 25% to $1.6 billion for the quarter, driven by the opening of 874 new company-operated retail stores in the last 12 months, and 10% comparable store sales growth for the quarter. Comparable stores sales were led by an 8% increase in the number of customer transactions coupled with a 2% increase in the average value per transaction. This marks Starbucks’ 57th consecutive quarter of publicly reported positive comparable store sales growth. Licensing revenues grew 25% to $202 million for the quarter, driven by higher product sales and revenues from the opening of 1,090 new licensed retail stores in the last 12 months, and continued growth in the licensed grocery and warehouse club businesses. Starbucks whole bean and ground coffee is now available in approximately 29,000 grocery and warehouse locations, and Seattle’s Best Coffee is available in almost 23,000 grocery and warehouse club locations. Operating income was up 28% to $202 million for the quarter, from $157 million in the prior year. As a percentage of total net revenues, operating margin increased to 10.7%, from 10.4% in the prior year, primarily due to lower cost of sales including occupancy costs, partially offset by higher corporate and international general and administrative expenses. Cost of sales including occupancy costs as a percentage of total net revenues decreased due to fixed rent costs in the current year being distributed over an expanded revenue base, as well as a favorable year-over-year comparison in occupancy costs resulting from intensified store maintenance activities in fiscal 2005. These favorable items, together with other lesser improvements, offset higher green coffee costs in the second quarter. General and administrative expenses increased due to higher payroll-related expenditures from stock-based compensation, additional employees to support continued global growth, and higher provisions for incentive compensation based on the company’s strong operating results in fiscal 2006. As we discussed last quarter, the company adopted the new expensing requirements for stock-based compensation this fiscal year, with no restatement of prior period results. Our broad-based equity compensation is a long-standing part of Starbucks culture and success, and options are granted to partners at all levels of the organization, including eligible part-time employees. Last November, the company granted options to nearly 58,000 partners. The pre-tax stock-based compensation expense recognized for the second quarter was $28 million, or $18 million net of tax, for an EPS impact of $0.02 per share. For the first half of fiscal 2006, stock-based compensation was $33 million, net of tax, or $0.04 per share -- in line with our expectations. Our strong results for the first half of the fiscal year have tended to make this expense less visible than it might otherwise have been. As we previously disclosed, for the entire fiscal year, we expect stock-based compensation to reduce EPS by approximately $0.09 per share. Please refer to page 9 of the press release for a break-out of how this expense is allocated to our consolidated statement of earnings. Turning now to operating segment results for the second quarter, total net revenues for our United States operating segment increased by 23% to $1.6 billion in the second quarter of fiscal 2006. Company-operated retail revenues grew 23% to $1.3 billion, primarily due to the opening of 660 new company-operated retail stores in the last 12 months and comparable store sales growth of 10% for the quarter. The increase in comparable store sales was comprised of an 8% increase in the number of customer transactions and a 2% increase in average value per transaction. U.S. specialty revenues grew by 21%, to $232 million in the second quarter. Within specialty revenues, licensing revenues increased 26% to $156 million, primarily due to higher product sales and royalty revenues from the opening of 685 new licensed retail stores in the last 12 months, and growth in the licensed and grocery warehouse club business. U.S. store operating expenses as a percentage of related retail revenues improved to 42.0% in the second quarter of fiscal 2006 from 42.1% in the prior year. This slight improvement was primarily due to higher costs in the prior year associated with the North American leadership conference, and leverage gained from higher retail revenues. These favorable variances were almost entirely offset by increased payroll-related expenditures from higher provisions for incentive compensation based on the company’s strong operating results in fiscal 2006 and recognition of stock-based compensation expense. Regional leadership conferences will be held during our third fiscal quarter in 2006, whereas in fiscal 2005, the leadership conference took place in the second fiscal quarter. In fiscal 2007, the leadership conference will shift back to the second quarter and will be held in an international location for the first time. U.S. operating income increased 36% to $266 million during the quarter. Operating margin expanded by 1.5 percentage points to 16.9% of related revenues for the second quarter of fiscal 2006. This improvement was primarily due to leverage gained from fixed costs, including occupancy, depreciation, and general and administrative expenses, distributed over an expanded revenue base in the current year period, and to higher costs in the prior year period for intensified store maintenance activities in company-operated retail stores. Now moving to our international segment. International total net revenues increased 30% to $315 million in the second quarter of fiscal 2006. International company-operated retail revenues increased 31%, to $262 million in fiscal 2006, primarily due to the opening of 214 new company-operated retail stores in the last 12 months and comparable store sales growth of 9% for the quarter. The increase in comparable store sales resulted from a 7% increase in the number of customer transactions coupled with a 2% increase in the average value per transaction. International specialty revenues for the quarter increased 24% to $54 million, primarily due to higher product sales and royalty revenues from opening 405 licensed retail stores in the last 12 months and expansion of our Canadian grocery and wholesale club business. Operating income for international operations increased 29% to $22 million in the second quarter of fiscal 2006 from $17 million in fiscal 2005. International operating margin decreased slightly to 7.1% of related revenues from 7.2% in fiscal 2005, primarily due to higher general and administrative expenses and an increase in other operating expenses for expanding infrastructure to support global growth, as well as increased retail store operating expenses due to higher provisions for incentive compensation. These items were partially offset by lower costs of sales including occupancy costs due primarily to leverage gained from fixed costs distributed over an expanded revenue base, as well as improvements in our food program. As our store base continues to increase rapidly, we continue to invest in our international infrastructure including investments in emerging markets, such as China. In addition to our excellent results in the second quarter of fiscal 2006, our year-to-date results are also noteworthy. Our consolidated operating income increased 25% to $482 million in the first half of this year from $384 million in the first half of last year, and the operating margin increased to 12.6% from 12.4% -- the highest operating margin ever reported by the company for the first six months of a fiscal year. Net earnings rose 23% and during the first half of the fiscal year, we opened 984 net new stores. We are very pleased with our strong financial performance in the first half, which positions us well as we enter the second half of the fiscal year. I will turn now to an overview of our updated fiscal 2006 growth targets, based on our very strong second quarter performance and our latest forecast for the balance of the fiscal year: Before I turn the call back over to the operator for the Q&A, I’d like to make one final comment. On a personal note, after more than ten exciting years as Starbucks’ chief financial officer, we have decided to initiate the process of identifying the next chief financial officer. We are going to consider both internal and external candidates with the goal of having someone in position by the end of the year, but we will take whatever time is required to find the right person and fully immerse him or her in the company’s business and culture. I will be actively involved in the transition and, beyond that, I will continue with my other executive responsibilities and new projects and initiatives as they come up. We are committed to making this transition as seamless and effective as our recent CEO transition proved to be. With that, I would like to ask the operator to queue the first question. Please ask one question at a time and re-queue for additional questions."
},
{
"speaker": "Operator",
"text": "(Operator Instructions) Your first question comes from Jeffrey Bernstein with Lehman Brothers."
},
{
"speaker": "Jeffrey Bernstein",
"text": "Great, thanks very much. I just had a question on the international margins. I know you gave some detail in your commentary, but just looking between the first quarter and the second quarter, obviously there was tremendous expansion in the first quarter, tougher second quarter. I’m just wondering if you could walk through some of the delta’s. Secondly, what would you expect for the back half of the year? I know you made some commentary that you’re going to be investing more for the back half of the year. I’m just wondering what your outlook would be. Thank you."
},
{
"speaker": "Michael Casey",
"text": "We made tremendous progress over the last three years in our international business, both in growing the revenue base and improving the margins. I think the year, the quarter over quarter improvement in the first quarter was very strong, and we have always expected that this operating margin will improve gradually, but not necessarily up significantly every quarter. We don’t expect any backward movement in the operating margin in international business. We expect to continue to have improvement when you look at it over six or nine months at a time, but not necessarily each and every quarter. As I mentioned, we are primarily building our organization to support the tremendous opportunity that we foresee in China. We’ve been talking about that for the last several quarters, and we’ve been working diligently at that. We’re now starting to see some of the expense related to the people that we’ve hired. They came on payroll a little bit later than we had originally expected, but they’re up and running and we think forming a new base from which we will continue to grow the business with the team that’s currently in place. So we don’t call margins by quarter specifically, but looking over an extended period of time, we expect to see continued improvement in the operating margins."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Glass with CIBC."
},
{
"speaker": "John Glass",
"text": "Thank you. My question has to do with the growth in the specialty line, especially the licensed line. Last quarter it grew at an exceptionally strong rate, somewhere above 30%. This quarter it’s a little bit more in the 20 range, so what is a normalized growth level? I guess if last quarter was exceptionally strong, why was it? Because the number of units didn’t grow faster last quarter than in prior quarters, or is this an anomaly from a low -- I’m trying to understand, I guess the one rate growth of that line, particularly in the U.S."
},
{
"speaker": "Michael Casey",
"text": "We have the same business parameters in our licenses business as we do in our company-owned, and we had a particularly strong holiday season which carried over to our licensed stores as well as our company-owned stores. The number of stores that are open at the end of a period isn’t necessarily indicative of the sales weeks during that period, because the opening pace skewed, bowed and backed. But I think a growth rate in the 20% range is a reasonable target going forward. The 30% year over year growth in that line was unusual."
},
{
"speaker": "Operator",
"text": "Your next question comes from Steven Kron with Goldman & Sachs."
},
{
"speaker": "Steven Kron",
"text": "Good afternoon. I have a question, Howard, on the entertainment business and drilling down a little bit on the Akeelah and the Bee experience. Box-office receipts in the first weekend seemed to be disappointing to those that kind of look at that industry. It sounds like you had a pretty positive experience. I guess in your stores, how did the results from the experience of Akeelah kind of compare to your expectations? How are you from a big picture standpoint measuring the success on Starbucks’ ability to kind of build awareness in the entertainment industry?"
},
{
"speaker": "Howard Schultz",
"text": "I appreciate the question. I think going into this, all along, as we look at scripts and screen movies, which dates back almost 12 months before we made the decision on this movie, we were looking for a movie that really had a lot of hope attached to it, was inspirational and really was the kind of story that was compatible with what our customers and, most importantly, our people, would expect us to be part of. So although we clearly were interested in the box-office receipts, that was just one of a number of ways in which we were going to measure success. I would admit that the box-office receipts were less than perhaps Lionsgate or the industry had thought, but there were other competing factors. Lionsgate has a long history with movies that have a unique level of word of mouth, most specifically Crash, which opened in a similar fashion. I think this movie is going to have a long tail to it. I think on a go-forward basis, what we’re looking to do as we have done with music, as we now have done with a film, and we keep mentioning that we are also looking for the possibility of bringing a book into our store, we are looking for things that could add texture to the equity of the brand and the experience to bring value to our customers, and we think we are in a unique position. I think our customers have come to expect us to not only provide a great cup of coffee but we are an integral part of their life and their lifestyle, and we want to be able to, when we find interesting stories and interesting pieces of content, to bring it to the marketplace. As I said in the script, we do not see ourselves as becoming an entertainment company. We are very mindful that our core business is coffee and the coffee experience, but we all feel that this is highly complementary to who we are, what we do, and it ultimately will reinforce our position in the marketplace. So we feel really positive about the experience. We are learning a lot and we look forward to other projects."
},
{
"speaker": "Operator",
"text": "Your next question comes from Matthew DiFrisco with Thomas Weisel Partners."
},
{
"speaker": "Matthew DiFrisco",
"text": "Just looking at the income statement, it looks like there might have been a reclassification or something going on with the depreciation. If you could just clarify that for us, I might have missed something in the release. Then, if you could just comment on you’ve touched on also in your prepared remarks about the brewing sale or promotion having a positive benefit to Q1. Did it have an impact on the April comparable sales number released today as well?"
},
{
"speaker": "Michael Casey",
"text": "I’ll take the first one. There has been no reclassification or change in depreciation. The numbers are consistent with the growth in primarily company-owned stores, which raised that number."
},
{
"speaker": "Howard Schultz",
"text": "The brewing event, the timing was such that most of the business last year came into this quarter this month that we just finished. I think it was a week off, maybe eight days. So when you look at what the value of that was, again we are pleased to see that we captured the bulk of that last month but still had a great month this year with our 60% comps."
},
{
"speaker": "Jim Donald",
"text": "I’ll go a step further. We were very, very pleased with 60% comps, and if anyone on the call is disappointed, you’re off-base."
},
{
"speaker": "Operator",
"text": "Your next question comes from Sharon Zackfia with William Blair."
},
{
"speaker": "Sharon Zackfia",
"text": "Good afternoon. I have been -- or I continue to be impressed with your COGS performance. It keeps improving quarter after quarter. I’m just wondering how low can that go, and is there some sort of comp where you start to get leverage in all those six expenses that you are talking about in the text and the press release?"
},
{
"speaker": "Michael Casey",
"text": "I am not sure we can set a limit on how low the cost in related occupancy can go. The benefit we’ve been getting in the last several quarters is attributable primarily to the average unit volumes, particularly in our U.S. stores, which are now over $1 million, significantly noticeably over $1 million per store, and allows us to get leverage in a number of categories of the occupancy line, which is part of cost of goods sold. We believe in our North American business, we are getting leverage in G&A and I believe we would be getting leverage in G&A overall if it weren’t for the adoption of stock-based compensation expensing this year. We are also getting some benefit this year in cost of goods sold from favorable dairy costs, relative to a year ago. Those are the primary drivers. We continue to believe, absent some see-change in one of our basic commodities, that we can continue to do a better job than the COG occupancy line because we intend to continue to grow our average unit volumes and we think we can become more efficient in a number of the programs that we initiated the last two years, like drive-thru stores, lunch, warming -- those are places where we are still learning and continuing to get better."
},
{
"speaker": "Operator",
"text": "Your next question comes from David Palmer with UBS."
},
{
"speaker": "David Palmer",
"text": "Congratulations on the quarter, everybody. Michael, congratulations on I guess your CFO career. I guess it’s not your total career."
},
{
"speaker": "Michael Casey",
"text": "Thank you. I do want to clarify. I am going to continue to be here doing many other things as we identify a new CFO."
},
{
"speaker": "David Palmer",
"text": "I was going to ask about the COGS line, and one thing I was curious about too is the dairy inflation, how that might evolve, along with coffee inflation over the next twelve months, but I want to save my big question for perhaps warming, and if you have any sort of preliminary timetable about how you might roll that out, how many quarters and years it might take to get across the system. Thank you."
},
{
"speaker": "Michael Casey",
"text": "We are going to take a similar approach to the approach that we took to Lunch. We are going to move slowly. We are going to continuously improve the selection of the products, the way we do procurement, the way we do distribution, the way we do training. It could easily take two or three years to roll it out completely. And we still haven’t made the final decision that we’re going to go everywhere with Warming. We have had great initial success in the markets that we have gone to. We are planning to do some additional markets yet to be identified next year, but beyond that, we are going to take it as it goes."
},
{
"speaker": "Jim Donald",
"text": "Let me add to that one. There is no race to get this rolled out. Every market that we go into, we are actually five or six steps better from all the things that Michael has mentioned. We want to make sure though that we are continuing to enhance the customer’s experience when they come in in the morning to pick up their beverage and their sandwich, be it quality of the product and the speed with service. So as we take notes from every launch, we continue to raise the bar."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ashley Woodruff with Bears Stearns."
},
{
"speaker": "Ashley Woodruff",
"text": "Thank you. I wonder if we could talk a little bit about pricing. The last time you took a price increase was October 2004, which was four years after your previous price increase, and I think at that time you began to think that perhaps you should take pricing a little more frequently, so your customer would get more accustomed to it. As you start to plan for 2007, can you talk about whether pricing plays a role in that?"
},
{
"speaker": "Michael Casey",
"text": "We do not currently have any plans to change our pricing structure, specifically in the United States. Occasionally in one of the international markets, there will be a price increase but it doesn’t affect the big picture in the normal course of business related to whatever is happening in that marketplace. But I assume your primary question is related to company-owned stores in the U.S., and we have no plans in the foreseeable future to take a price increase. Not this year, and not in our current thinking for 2007."
},
{
"speaker": "Operator",
"text": "Your next question comes from Glen Petraglia with Citigroup."
},
{
"speaker": "Glen Petraglia",
"text": "Good afternoon. My question is regarding the store target for this year. It would seem that the 1800 new store target is somewhat conservative, given that in the past, store openings have generally been a little more prevalent in the second half of the year. If you could comment on that, please."
},
{
"speaker": "Jim Donald",
"text": "First of all, I have to say that the 1800 is probably one of our most ambitious goals that we have rolled out, and we are very pleased to see that as we have gone from quarter to quarter, we have been able to exceed our quarterly targets. We look at what has created that, it’s combining the partners in the areas of store development, in the areas of filling the bench to make sure that our partners are ready to take these stores as they come open. We will continue to keep with our 1800 store rollout and when we see the opportunities to accelerate that on a market-by-market basis, we will do that, provided that the store will be ready in its entirety and that the store partners will be ready to staff that store to deliver the Starbucks Experience."
},
{
"speaker": "Michael Casey",
"text": "One of the things we have talked about frequently in this call and previously is execution, and that applies to lots of different areas, but one of the ways it applies to store development is we have become much more systematic. We are planning much better, so I do not think you will see an acceleration toward the end of the year to the same extent in the future that you have seen in the past, because we are just planning better, we are executing better. We are not getting behind and therefore we do not have to catch up. So I think you will see a pretty -- eventually I believe we will raise those store targets for future years, but I do not think 1800 is conservative by any measure."
},
{
"speaker": "Operator",
"text": "Your next question comes from John Ivankoe with J.P. Morgan."
},
{
"speaker": "John Ivankoe",
"text": "Thank you. A question for you, Howard. Could you talk about the special challenges in China as you see that might be structural in the market and what you have done differently with Starbucks and your organization there to allow you to achieve your goals?"
},
{
"speaker": "Howard Schultz",
"text": "I think that there are special challenges, and this is a very unique environment. I think, John, you and I spoke privately -- there is such a rush to China and I think a lot of companies will succeed and many will fail. I think that one of the things that we recognized early on, and that’s from the benefit of having very good JV partners and Chinese Starbucks people on the ground, was the importance of very high-level relationships with the government and the importance of interpersonal relationships with senior people from Starbucks. We have been to China many, many times this fiscal year and in years past, primarily to build relationships and to demonstrate a deep level of respect for not only the marketplace but the culture and the way the Chinese people perceive their business and outsiders. I think the work we have done this year in hiring very senior Chinese people who are leading our business, a dedicated Chinese team, coupled with a philanthropic effort that we put forth earlier in the year, in which we created a $5 million education fund for those young children, specifically girls in rural China that may not have a chance for education, really demonstrated to senior Chinese officials and business leaders that Starbucks was trying to build a business here the right way. We have a long way to go. I think we have built a very solid foundation. You have heard us say before that this potentially will be the largest market in the world for Starbucks outside of North America. I think we are off to a great start, and we are seeing real traction and acceptance. I think we have a lot of work to do, but we have done a lot of things right."
},
{
"speaker": "JoAnn DeGrande",
"text": "Myles, that wraps up the call, please."
},
{
"speaker": "Operator",
"text": "Okay, Madam."
},
{
"speaker": "JoAnn DeGrande",
"text": "Thank you for listening to our earnings call today. We hope you will join the webcast of our third quarter fiscal 2006 financial results on August 2, 2006, and note that at that time we will release revenues for July as well. Thank you for joining us today."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, we do appreciate your joining us. This does conclude our Starbucks second quarter 2006 earnings conference call. You may now disconnect."
}
] | null | null |
SBUX | 1 | 2,006 | 2006-02-02 12:45:00 | Executives: JoAnn DeGrande, Director of Investor Relations Jim Donald, president and Chief Executive Officer Howard Schultz, Chairman and Chief Global Strategist Michael Casey, Executive Vice President, Chief Financial Officer and Chief Administrative Officer Mary Ekman, Vice President Corporate Development and Investor Relation
Analysts: Jeffrey Bernstein, Lehman Brothers Larry Miller, Prudential John Glass, CIBC Dan Geiman, McAdams Wright Ragen Steve Kron, Goldman Sachs Matthew Difrisco, Thomas Weisel Partners Sharon Zackfia, William Blair David Palmer, UBS Ashley Woodruff, Bear Stearns John Ivankoe, J.P. Morgan
Operator: Good afternoon my name is Mild (ph), I will be your conference facilitator. At this time, I would like to welcome everyone to the Starbucks First Quarter 2006 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers remark, there will be a question and answer session. If you would like to ask a question during this time simply press “*” then the “1” on your telephone keypad. If you would like to withdraw your question, press “*” then the “2” on your telephone keypad. Thank you. Miss. DeGrande, you may proceed with the conference.
JoAnn DeGrande, Director of Investor Relations: Thank you, good afternoon ladies and gentlemen, this is JoAnn DeGrande, Director of Investor Relations to Starbucks Coffee Company. With me today are Howard Schultz, Chairman, Jim Donald, president and CEO, Michael Casey, Executive Vice President and CFO and Mary Ekman, Vice President Corporate Development and Investor Relations. During today’s call, Jim will review key results and accomplishments, Howard will provide an update on the next stage of our entertainment strategy and Michael will highlight the key drivers behind our first quarter results as well as discuss our fiscal 2006 growth targets. We will windup today’s call to one hour including Q&A. I would like to point out today for the first time along with our fiscal first quarter results we also release our January revenues. As a reminder to all listeners, this call is being broadcast live over the Internet. A replay will be available via telephone at 800-642-1687, reservation number 372-8089 through 5.30 PM Pacific Time on Wednesday February 8 and at the internet on the Investor Relations page at starbucks.com through 5 PM Pacific Time on Tuesday March 7. In addition, today’s remark will be available on the Investor Relations portions at starbucks.com by the end of the day and will remain available through Thursday March 2. This conference call includes forward-looking statements such as anticipated store openings, comparable store sales expectations, trends beyond our expectations regarding the company’s revenue and expense growth, capital expenditures, effective tax rate, net earnings and earnings per share results. These statements are all based on currently available operating, financial and competitive information and are subject to various risks and uncertainties. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements are contained in the company’s filings with the Securities Exchange Commission including the risk factors sections of Starbucks Annual Report on Form 10-K for the fiscal year ended October 2, 2005. The company assumes no obligation to update any of these forward-looking statements. With that, let me turn the call over to Jim.
James L. Donald, President and Chief Executive Officer: Thank you, JoAnn, and good afternoon ladies and gentlemen. Starbucks robust performance in the first quarter of fiscal 2006 sets the stage for the year and provides momentum for achieving our ambitious 2006 growth targets. Our success for first quarter including new as well as returning seasonal and holiday favors. Product launches in both our international and domestic markets and a keen focus on execution at all levels of the business. This led to net revenues growth of 22%, net earnings growth of 20% and first quarter earnings per share of $0.22. Great team work and flawless execution resulted in 560 new store openings, a record number for our fiscal first quarter. Our stores also delivered solid comparable store sales growth to 7% at the high end of our 3% to 7% target range. We end the quarter with 10,801 Starbucks locations in 37 countries serving more than 40 million customers per week. The strong momentum from yearend continued in the January as revenues grew 23%, 555 million and comparable store sales for the month increased 10% and we added 67stores during the period. Let us review some of the key drivers behind our first quarter results. First, I would like to highlight what is being happening in our retail stores, were our results are driven by superior operational execution at store level. Last year seasonal; and holiday favorites return this year beginning the fall of the Pumpkin Spice platform. The continued success of Pumpkin Spice provided an excellent play load during November return of our great anticipated holiday offering beverage trio, Peppermint, Gingerbread, and Eggnog. Based on the seasonal popularity of Eggnog this year, we added a Chai Eggnog Latte, which could be came a customer favorite. We kicked off the 2005 holiday season; with an innovative and unique marketing approach through several carefully august-rated efforts, which included the redcup.com as well as our first simultaneous promotional launch in one of US and Canadian retail stores. Between store closings on November 9 and opening on November 10 our partners transform our stores to holiday red in 9 excitements among our partners and customers and building energy around Starbucks holiday offerings. We provide a variety of coffee relevant merchandise in holiday treats, specifically designed to meet the gifting needs of our customers. I am pleased to report that the combination of the strong merchandise selection and affective inventory management led to robust product sales during the holidays as well as fewer mark downs, foreign season when compared to last year. Prior to the holiday rush, we completed the deployment of our new point of sales scanners in US and Canadian stores with resulted in more efficient merchandise transaction processing and faster service counter during this busy buying season. Once again, the Starbucks card was a very popular item, more than fours ago Starbucks was a market leader in introducing the store value card and many retails have since tried to replicate the idea for their own businesses based on our success. Yet despite the proliferation of the store value cards, we track you in the Starbucks brand along with convenience and the Starbucks expends that our partners deliver continues to differentiate the Starbucks card from others. The Starbucks card has created a loyal following among our existing customer base and continues to draw new customers. The strong growth of accounts the stickiness our card create with our customers and the frequency of usage, clearly separates us from other programs. During the season of giving and is for our ongoing community out reach, we continued one of our traditions, the Starbucks Holiday Angels Joy Drive. Thousands of seriously ill children received gifts through this joint effort by Starbucks partners, customers and the Starlight, Starbright Children’s Foundation. I am pleased to say that this year’s Toy Joy delivered more than 865, 000 gifts to pediatric patients across US surpassing our goal and more than 100,000 gifts. Now looking at the second quarter, I want a promotion provide this feeling of warmth and comfort during this cold winter days. We begin with our Cinnamon Dolce beverage platform highlighting sweet date notes that are lamination of our warm and buttery, Cinnamon pastry and in both feeling of the comfort and pleasure associated with walking in to your favorite bakery. Customers can choose between a variety of offers suite their needs, ranging from Cinnamon Dolce evocate the Cinnamon Dolce cream to a Cinnamon Dolce Frappuccino, or Frappuccino light blended coffee. This platform, this flavor platform highlights the handcrafted artistry performed by, by our breezes everyday in our stores and it’s something that truly sets us apart from our competitors. Nor that many of us begin the New Year with the result to make more healthy choices, we are also featuring Starbucks exclusive reduce that coffee cakes. This year our new flavor to reduce that model coffee cake joins two past flavors to reduce that Cinnamon to a coffee cake and reduce that Blueberry coffee cake. The new coffee cake presents a perfect compliment to assume both, cakes and chocolates as well as any of our other handcraft with special beverages. As we mentioned during the last conference call, we are expanding our warming program to senior cities this year, which will provide more customers the option to enjoy a one favorite breakfast sandwich along with your favorite Starbucks beverage. Begin today our customers in quadrant that will report in Oregon can visit on of our 54 stores which launched the warming program just this morning. We’ve also add warming to 37 more location within our Seattle market today. Looking ahead, we planned to introduce this program to both San Francisco and Chicago during this spring. We will provide more details as we get closer to those market reductions. Before I review international highlights I would briefly recap last week’s acquisition announcement. Starbucks acquired the remaining 95% ownership for the operations and Hawaii and Puerto Rico. This added, 67 stores to our company operated store portfolio and allows us greater influence over the brand and new attractive markets. This transaction also aligned with our long-term strategy to increase our equity position we’re appropriate. We’re energized about continued growth potential in both of these markets and see these acquisitions as an opportunity to more fully capture. Now let’s take a look at our international markets and the progress we are making. We opened 201 new stores in the international markets during the first quarter and today we have retail presence in 36 countries outside the United States. Financial results for international segment continues to strengthen field have rapid retail expansion healthy comparable store sales growth and improving profit margin in markets throughout the world. We see tremendous global opportunity for our brand ranging from ongoing presence in current markets to exploring, entering into new markets such as Brazil, Russia and eventually India. All this aligns with the work we are doing to build solid infrastructure that are to carry Starbucks global expansion to the future. Starbucks continues to offer a borderless community on a place for our customers to connect with one another and for our partners to build relationships within their communities. The success of this connection is evident in the robust results delivered by international segment this quarter. Starting with Japan, you may have recently seen the news that Starbucks Japan has appointed eminent CEO, COO designate, Mercy has, present international management background having held numerous senior management positions at Levi Strauss Company in a number of markets over a 31 year career with the company. She joined Starbucks Japan as they posed their sixth consecutive month of positive comparable store sales growth and operational expertise and diagnosed as a retail industry will provide strong leadership as the company enters its second decade of operations later this year. Continuing with the Asia-Pacific news, I’d like to update you on the success with discoveries, our new RTD products in Japan and Taiwan. The enthusiastic reception to Starbucks discoveries by consumers in those two markets far exceeded our expectations and gained live spread public awareness. The launch of this chilled cup coffee product featuring the high quality coffee customers expect from Starbucks clearly demonstrated powerful execution in collaboration between our US and Asia-Pacific consumer product teams. Turning to China, I just recently returned from a 5-day city trip and was accompanied by Michael and 5 other senior Starbucks leaders. The trip provided a wonderful occasion for us to meet with partners and our company operators and license doors and observed first hand the opportunities that await us in this important market. Our retail presence continues to grow nicely as we opened over 50 stores in China market over the last 12 months including more than doubling our store count, in new company operator markets to 26 stores to-date. In total, we entered the quarter with 221 stores in China and our business there is performing well. We’re seeing continued growth in market level comparable store sales and profitability in our older licensed markets such as Shanghai and Beijing and we are experiencing an enthusiastic reception in newer China markets without exception. Personally, this is my first trip to China and now I am even more confident in Starbucks future there strengthened by the gathering momentum of the lively coffee culture. So our interaction with the local partners, it was apparent that the Starbucks culture and passion, it was powerful as what we experienced among our partners in our US and other established markets. My insight has reinforced by these first hand observations that the Starbucks experience clearly travel. Let me just share a quick story. We opened our store in Chongqing, a couple from a neighboring province was working on a development project nearby and heard about the Starbucks store opening, they postponed their return flight by a day to personally experience the opening Chongqing’s first Starbucks location. What is special about this story is that they told us that they were already planning a trip back the following week to visit our store again which demonstrates the relevancy of the Starbucks brand and the connection we are making in the communities worldwide. Before wrap up my comments, I would like to share with you some special recognition that company received during the first quarter. First, Starbucks is recognized by the Financial Times as one of the world’s most respected companies. This is the first time, Starbucks made this prominent list determined by a survey performed by the Financial Times pulling more than 950 CEOs across 25 countries. The company was also recently recognized by brandchannel.com as one of the top 5 world’s most influential brands, a meaningful accomplishment ranking with such topper brands as Google and Apple. I’m also pleased to say that for the 8 years fortune magazine named Starbucks one of the 100 best companies to work for in 2005. And for a global retailer, with over 100,000 partners worldwide, this is a wonderful accomplishment and confirms that Starbucks can truly stage them all while we do think. And finally, I’m pleased to announce that Starbucks has been recognized in China as one of the top 10 employers in 2005. We were awarded this recognition by CCTV, China’s National Television Network. These accolades are very meaningful as it takes the collective effort of each and every partner to ensure that Starbucks is a great place to work. As that reflect on our first quarter results, I’m proud of success we have achieved thanks to the hard work and commitment of our partners. I’m looking forward to the year ahead with continued focus on a core and accelerating pipeline of innovations and initiatives and a very strong management team in place. I’m confident that further extending our brand executing at all levels of the of the business and providing our customers with the products and innovation they have come to expect will continue to prove successful throughout the balance of the year. I will now turn the call over to Howard.
Howard Schultz, Chairman and Chief Global Strategist: Thank you Jim, nice job, by the way and good afternoon everyone. Today, I’m going to focus my comments on a very exciting and evolving segment of our business, entertainment. Before I talk about where we are today, I would like to take a step back and revisit the road Starbucks has taken in our evolving music and entertainment strategy. As many of you know, music has always been an essential part of the coffee house culture. For Starbucks our musical journey began in 1995 when we first introduced CD sales into our stores, as a result of a very popular in-house music program created by one of our store partners. A natural extension from that was our 1999 acquisition of Hear Music, a San Francisco based music retailer known for the innovative way it helped consumers discover great music. This acquisition helped boost our in-store music selection and propelled us forward in creating the musical coffee house environment. Our role in music then moved beyond just the sale of CDs and extended to music programming at Starbucks stores worldwide. Music compilations, a 24-hour music channel with XM satellite radio, an innovative collaboration with music labels to produce, market and distribute both exclusive and non-exclusive music followed. From there, Starbucks has evolved to become a significant presence in the music industry. For example, collaborations with record companies such as Concord Records for the release of Ray Charles’ Genius Loves Company, the final recording by the gifted artist, went on to an Eight Grammy and subsequently hit the number one position on the BillBoard sales chart. More recently, Herbie Hancock’s Possibility CD which we co-released with Hancock Music and Vector Recordings has received Two Grammy nominations. Not only has Possibility drawn the attention of the recording academy, it has also been the most successful debut in Mr. Hancock’s career, selling more than 42,000 copies in the US alone in its first week of sales. Possibilities also debuted at No. 22 in the BillBoard 200 Albums Chart. In addition to offering music in our traditional stores, we also introduced Starbucks Hear Music Coffeehouse, a wonderful unique land of music store and coffeehouse which provides customers a venue to enjoy one of our hand crafted beverages while exploring a wide selection of CDs and digital music. Our flagship Santa Monica store was recently joined by second Starbucks Hear Music Coffeehouse, which opened in San Antonio, Texas in December of ’05. A third Starbucks Hear Music Coffeehouse will open in Miami Florida later this month. Each store offers a vast selection of more than 1 million digital tracks to sample; listen, burn and print, truly transforming the way consumers discover and acquire music. A sale of CDs at Starbucks locations has provided record labels with a broad new channel of distribution and a powerful cost-effective in innovative way to connect with an expanded untapped customer basis at Starbucks. Our approach today with music has been precisely executed changing how consumers discover great music while at the same time, generating a profitable revenue platform for the company. As we continue to seek and capitalize on emerging opportunities, we are taking our entertainment strategy to the next stage, films. As we have demonstrated over the last few years Starbucks has become a market maker in the music industry and now similar to music we are seeking to be an innovator in the marketing and distribution of film. Our strategy is to bring relevant and unique entertainment to the forefront utilizing our expansive retail footprint. Over the past several years, the film industry has experienced a decline in box office receives while also realizing a significant increase in the cost to market new films. Starbucks has prepared to break that paradigm and changed the model of how new films reached the public. We are confident that the strength of the Starbucks brand coupled with our broad national footprints and be a catalyst for the industry by engaging our customer base the opportunity is there to generate higher box office proceeds and lower marketing costs associated with the premier of a film in a powerful and cost effective way. What we intent to do is unlike any thing you have seen from other, Starbucks will not replicate the way in which fast food chains have co-opted their stores for the marketing of films, in order to sell more fast food. We are not entering into the venture with a sole purpose to sell more coffee, but instead to bring a inspirational uplifting story to our customers and to the public who may otherwise not have the opportunity to experience this particular film. I’m speaking about the recent announcement of a truly transformational partnership in which Starbucks will participate in all aspects of the marketing and distribution of Landscape Entertainment’s new film Akeelah and the Bee. This next step is simply the natural evolution of our entertainment strategy and one we have been, been researching and exploring for quite some time. In our first quarter into this medium, it was critical to find the right film that would resonate with our customers and honor the trust they have place in us. Akeelah and the Bee is especially relevant with its inspirational story of a young girl who despite many social and economic obstacles advances from the inner city the scripts national splendid. This film which will be released in theatres on April 28th has the content depth and inspiration we were seeking and conveys the human touch that for fact, personifies the Starbucks brand. I want to stop here for a moment and make it really clear that we are not investing in a movie and we are not getting into the movie business in a traditional way. What we are doing is leveraging our vast retail store footprint and the cultural relevancy of the Starbucks brand to bring film to the public in a new way during the time when the film industry has been challenged. Starbucks will participate in all aspects of the marketing and distribution of this year film, and we will be an equity participant in the film’s success, not only at the box office but through the sale of the sound track and the DVD in all retail outlooks including our stores. The soundtrack will be available in early April and we will carry the DVD along with other traditional retails, when it becomes available later in the year. Through this venture, we are creating an economic partnership with the film industry that mirrors the structure we created in music with the successful later trail CD. Through the power of the Starbucks brand, we will create awareness and drive new Movie Goers to the film, something movie producers could not do on their own. We will introduce the film through a truly innovative and interactive in store marketing campaigns, which will provide customers the opportunity to experience the fun and inspirational feeling of the movie. Many of our store partners will have a chance to view the film prior to its release and they along with strategic marketing materials with in the store will create enthusiasm in entries among our customers around the Akeelah and the Bee. Starbucks has become recognized by entertainment authorities has a significant force in the music industry. Lending our trusted editorial voice and raising awareness of this film through our partnerships, through our powerful distribution systems to translate into Starbucks achieving a similar role in the film industry. While our core remains unchanged, we recognize that we have an opportunity to provide much more then the best cup of coffee. We offer our community gathering place where people come together to connect, explore and make new discoveries. We value the trust that our customers have placed in us and we are committed to providing high quality and relevant offerings as we take our entertainment strategy to the next stage. Before I close I would like to share a quote with you, from a music reporter who seems to be as equally energized about Starbucks venture into entertainment as we are. According to Melinda Newman, the West Coast bureau chief for Billboard magazine, Starbucks and, Starbucks has become a power in the industry, they are forced to be recon with. If you are looking at Starbucks and saying, is this a project we will be best served by making a deal with Starbucks. It’s exiting to share with these developments in our entertainment strategy. We are creating a truly transformational entertainment experience by providing our customers the venue to discover music and movies from a brand that they have come to trust. It all gets back to the basic, the foundation upon which we have build our company, it’s around a human connection and our passion to innovate and grew with new offerings, new sound and new experiences. While seeking unique opportunities to monetize our assets and in doing so increase shareholder value. We look forward to providing you with future updates as we build on this exciting venture. I will now turn the call over to Michael.
Michael Casey, Executive Vice President, Chief Financial Officer and Chief Administrative Officer: Thank you, Howard. During today’s call I will highlight our financial performance for the first quarter that was consolidated in by segments, from provide a brief review of the impact of, adopting the new stock based compensation accounting role. Comments on our strong balance sheets and cash flow, and provide updated targets for the remainder of the year. I am pleased to report that we once again produced strong top line and bottom-line growth, sales was solid in both our company operated and specialty businesses and in our US and international segments. More specifically consolidated net revenues for the quarter ended January 1st 2006 were record 1.9 billion up 22% from the first quarter of fiscal 2005. Company operated retail revenues increased 20% for the quarter, driven by the opening of 803 new stores in the last 12 months and 7% comparable store sales growth for the quarter. Comparable store sales growth consisted of a 6% in the number of customers transactions coupled with a 1% point increase in the average value per transaction. The comparable store sales growth of 7% particularly satisfying given that in October we lost the October 2004 leverage price increase in our US and Canadian markets. Licensing revenues grew 39% for the quarter, driven by the opening of 1049 new licensed retail stores in the last 12 months and continued growth in the licensed grocery and warehouse club business. Food service and other revenues increased 18% for the quarter, primarily due to growth in new and existing US and International food services accounts. Operating income was up 23% to 280 million for the 13 weeks ended January 1, 2006, from 227 million in the prior year, as a percentage of total net revenues operating margin increased to a record 14.5% from 14.3% in the prior year, primarily due to lower cost of sales including occupancy cost. In-store operating expense has a percentage of total net revenues. Partially offset by higher corporate, general and administrative expenses. While store operating expenses has a percentage of related company operating retail revenues improved by only 10 basis points for the 13 weeks ended January 26th. As a percentage of total revenues, they improved by 50 basis points, this leverage was created by specialty revenues growing at a faster pace than retail revenues. General and administrative expenses increased due to higher payroll related expenditures for stock based compensation and higher provisions for incentive compensation based on the company’s strong operating results for the first fiscal quarter of 2006. As well as increased charitable contributions during the quarter. As we previously discussed in which we adopted the financial accounting standard boards, final stock based compensation guidance formerly known as FAS123R. As we ride under FAS123R we are adopting the new expensing requirements for the fiscal 2006, with no restatement of prior period results. The free cash stock based compensation expense recognized for the current quarter, was 23 million pre tax or 15 million net taxes for an EPS impact of $0.02 per share inline with our expectations. Please refer to page 8 of the pres release to view the numerous expense line items impacted by the adoptions of this accounting standard. Due to timing of our stock brands, which is generally concentrated in the middle of the first fiscal quarter, the current quarter’s pretax amount is slightly lower than what we would expect for subsequent quarters in 2006. However we will continue to impact quarterly earnings per share by approximately $0.02 per share for the remainder of the fiscal year. As $0.02 per share per quarter, I’ll make sure, I heard about that, for the remainder of the fiscal year. The total stock-based compensation expense was allocated to our 3 reporting segments as follows, US Segment 51%, International segment 10% and corporate 39%. Current quarter expense was approximately 33% due to options granted in this fiscal year, approximately 10% due to our employee stock purchase plan and the remaining 57% was due to options granted in prior years. I will now move on to first quarter results by operating segment, total net revenues for United States operating segment increased by 21% to 1.6 billion for the first quarter of 2006. Company operated retail revenues grew 19% to 1.4 billion primarily due to the opening of 634 new company operated retail stores in the last 12 months, and comparable store sales growth of 7%, US specialty revenues grew by 32% to 250 million for the first quarter. Within specialty revenues, licensing revenues increased by 40%, to 170 million. This is primarily due to higher product sales and royalty revenues from the opening of 650 new licensed retail stores in the last 12 months, which was 45% higher in store openings at this time a year ago. In additions we have strong operating level revenue performance. Both are contributing to the increasing and licensing revenues was the growth in the licensed Grocery and warehouse club business. Food service and other revenues increased 18% to 80 million, and there is a growth in both new and existing foodservice accounts. US operating income increased 28%to 339 million in the first quarter from 266 million in the fiscal 2005. Operating margin increased to 20.9% of related revenues for the first quarter of fiscal 2006, from 19.8% for the first quarter of fiscal 2005, with a 110 basis point improvement. This improvement in operating margin was primarily due to leverage from strong revenue growth as discussed above, and controlled spending in most areas of the business. First quarter is historically a best quarter of the year from a margin point of view. Now moving to the international segment, as Jim mentioned we recently spend a week together in China and following that trip I am more convinced than ever of a great opportunity that awaits us there. Either exciting times in our international business, our investments for the future, were also roofing the benefits of strong financial results due to a sharp focus consolidated execution in our current markets. International total revenues increased 25% to 314 million in the first quarter. International company operated retail revenue increased 23%, 267 million in fiscal 2006. Primarily due to the opening of 169 new company-operated retail stores in the last 12 months, and comparable store sales growth of 8% for the quarter. The increase in comparable store sales results from a 5% in customer transactions; couple with a 3% increase in average value per transaction. International specialty revenues for the quarter increased 35% to 56 million, primarily due to higher product sales in royalty revenues from opening 398 licensed stores in the last 12 months, which is a 45% higher, which is 45% higher than store openings a year ago. And to a lesser extent the recent launch of our new ready-to-drink coffee beverages in Japan and Taiwan, in the fourth quarter of fiscal 2005, and in Korea in the first quarter of 2006. Operating income from international operations increased an impressive 79% to 35 million in the first quarter from 20 million in fiscal 2005, international operating margin expanding to a 11.3% of related revenues from 7.9% fiscal 2005. This significant improvement was primarily due to lower cost of sales including occupancy cost and store operating expenses has a percentage of net revenues, also contributing to the margin expansion was an increase in income for nearly every equity investors, particular Japan and Korea. Due to an increase in that store base improved comparable store sales growth and strengthening store profitability. Partially offset in these improvements was an increase in other operating expense from marketing and advertising related to the recent launch of ready-to-drink coffee beverages in Japan, Taiwan and Korea. Our international store base continues to increase rapidly, and we are achieving a growing contribution from established areas of the business, our investing and emerging markets and channels. The balance between these 2 resulted significant margin improvement in the first quarter, but it is expected to shift back towards investment and therefore less margin improvement for the remainder of fiscal 2006. Moving briefly to the consolidated balance sheet, total cash, cash equivalents and other liquid investments increased 594 million at the end of the first quarter of 2006, from 368 million at the end of fiscal 2005, primarily due to strong operating cash flows. During the first quarter of fiscal 2006, Starbucks repurchased 4.3 million shares of common stock for total cost of 121 million and reduce the outstanding balance on our credit revolver by 172 million. Our solid balance sheet, continuing strong cash flows and our borrowing capacity allows to continue to fund our operations, opportunistic repurchase shares and selectively invest in new growth opportunities, such as our recently announced acquisitions of full ownership of Hawaii, Puerto Rico operations. Before we, moving on to our 2006 fiscal targets, let me add a little color on the Starbucks card activity. This was a contributor to the January revenues we reported today. During the first quarter customers activated a record 221 million on Starbucks products. Including a 165 million in December alone and an increase of 35% compared to the first quarter of fiscal 2005. At the end of the quarter, more than 293 million was loaded on to the Starbucks part waiting to do with in. A significant increase compared to 192 million at the end of the first quarter last year. During the month of January Starbucks redemptions reached an all time record of 93 million or 22% of company operated retail revenues in United States and Canada. I will now turn to an overview of a updated fiscal 2006 growth targets. Based on our very strong first quarter performance in our latest forecast for the balance of the year, we planned to open at least 800 new stores on a global basis in fiscal 2006. In United States we planned to open approximately 700 company operated locations and 600 licensed locations, in international markets we planned to open 150 company operating stores and 350 licensed stores. We anticipate robust revenue growth will continue and we are targeting a total net revenue growth of approximately 20% on a quarterly basis and for the full year. As we reported today, January comparable store sales growth exceeded our target range of 3% to 7%. We do not view that level of growth as sustainable, however and we continue to expect comparable store sales growth in the range of 3% to 7% it must be anomalous for the remainder of fiscal 2006. Starbucks annual leadership conference for all US, store managers, which was held during the fiscal second quarter last year, will be held during the third quarter this fiscal year. I mentioned this important store operating activity, for 2 reasons. First the cost of this event is significant enough that timing shifts do impact earnings growth rates for the affected quarters, and second it is worth noting very early on that we are planning our fiscal 2007 leadership conference, shift back to the 7th to the 2nd quarter, and to be held at an international location for the first time. In updating our plans for the remainder of the fiscal year, we bare in mind the important balance from strong comp performance and making investments from the future growth initiatives. This strategy has consistently generated long-term value for our shareholders. In the second half of fiscal 2006, a key area of increased investment for us will be infrastructure to support the significant opportunity we foresee in China. We have recently filled several leadership positions in China and we are close to filling several additional key positions and making other infrastructure investments for the market, which we expect to big impact in international segment expenses, and operating margin through out the remainder of fiscal 2006. Based on our excellent first quarter results and our continued positive outlook for the balance of the year, we have raised our earnings per share target range to $0.68 to $0.70 per share for fiscal 2006, an increase of $0.05 per share over our original target set last July. Based on January revenue with result and the revenue and expense outlook I just described, we now a somewhat stronger expectation for our second quarter results, by the time we set our original, targets. Well our goals for the last half of the year are generally unchanged. More specifically on a quarterly basis, we’re targeting earnings per share of $0.14 per share for Q2 and a range of $0.16 to $0.17 per share for each of Q3 and Q4. I want to remind listeners again that our fiscal 2006 earnings targets include stock option compensation expense estimated at approximately $0.02 per share per quarter and $0.09 per share for the full year. And as a result, EPS growth rates compared to fiscal 2005 have decreased due to this accounting change. The effective tax rate is expected to remain at approximately 38% in fiscal 2006 with quarterly variations and capital expenditures are expected to be in the range of 700 million to 725 million. With that, I would like to ask the operator to queue the first question. Please ask one question at a time and re-queue for additional questions, thank you.
Operator: And at this time, I would like to remind everyone, if you would like to ask a question, please press “*” then the number “1” on your telephone keypad, “*” “1” to ask a question. We will pause for just a moment to compile the Q&A roster. Your first question comes from the line of Jeffrey Bernstein with Lehman Brothers.
Q - Jeffrey Bernstein: Thank you very much. Actually just a question on the overall costing segment and there’s been a lot of chatter lately down to focus on improving their offerings to more in the service and growth in US is ramping up, just wondering if you could provide us with this year take on the competitive landscape, specifically I guess who would you categorize as your main competitor if any, and do you view the competitive landscape and healthy for the category? Thanks.
A - Howard Schultz: I think that’s an important question. First, we’ve always said that as a percentage of total coffee consumed in North America, we probably have less than 10% of the total coffee market. And in view of that, we’ve always had a very strong competitive list of people that were trying to capture the morning segment away from Starbucks, we viewed the recent activity by the companies you’ve mentioned as a positive influence on the category, the more education, the more advertising that people place on the category, on a macro level will have a greater effect I think on our ability to demonstrate the differentiation between not only Starbucks coffee but most importantly the experience that we create day-in and day-out. And as we’ve said in the past, although jumping on since on a wonderful job in the New England area, we sold our own against them consistently the spike the amount of money that they continued to spend in that market and on some levels we’ve seen the business spike up when they have placed for this proportion amount of money in advertising. So, we are mindful of the competitors but we think when all have said and done it’s a positive effect on the category we’ll benefit from it.
A - James L. Donald: Howard, I might add to this, this is Jim Donald that as we prepare for this, we’re also preparing for our partners to become experts in coffee and the taste of our coffee masters those of partners that have going through a train if you will on coffee countries of origin, and use coffee at home as actually outpace the comp that we’ve grown 50% in the last year going from 10,000 coffee masters to 15,000 coffee masters that’s both well for us.
Operator: Your next question comes from the line of Larry Miller with Prudential.
Q - Larry Miller: Yeah, hi, thanks very much. Just wanted to ask you that the margins that was impressive almost 21% and I think you’ve typically guided to, relatively flat margins and I was just trying to think it out how extending about the business going forward as you’re rolling out more food but doesn’t launch and if you could develop on how the entertainment strategy might look in that line as it starts to extend I would move reason an expanded use of thing?
A - Michael Casey: We had our best, this Michael, we had our best margin quarter in the history of the company in this first quarter so, we are very pleased about that, the first quarter is traditionally our best quarter for margins because it benefits from the gifting in the holiday sales, merchandize sales in addition to our everyday beverage business. So, we would expect this to be the strongest margin quarter of the year as it has been historically. Looking at our individual segments, we think that full year margins in our US retail business in a range around 19% is the right place for that business, it’s the right next between delivering value to the customers and delivering value to the shareholders. And so, we are very pleased to be managing our business on a full year basis in that range and when its, its in the high, when its at the high end of that around 19 range, obviously we’re pleased with that. We do expect if we continue to grow our US business with very steady margins that we will get leverage in other parts of the P&L particularly with the corporate G&A. In the international business, the margins are lower than in the US and over the long term we think the will move in the direction of the US margins but they’re not going to move in that direction quickly because as I tried to emphasize in my earlier remarks, while we are showing significant improvements in almost every market, almost every quarter we’re also identifying new growth opportunities whether it would be China or ultimately Brazil or Russia or some place else. So that the next role continues to change as older stores, older markets become more profitable and new markets that have command its opportunity come into the picture. So we do expect year-over-year improving margins in the international segment but not as fast as you might expect, if we weren’t pursuing the huge opportunities in the international. Now we do expect to get margin improvement consistently as a total company namely from G&A level.
Operator: Your next question comes from the line of John Glass with CIBC.
Q - John Glass: Thanks, good afternoon. My question is on the rate of international unit growth, as though sets if you hit your goals and obviously we need to say you will, it will actually be the first year in which the percentage growth rate of international units is lower than the US. And I am just wondering why given your success in improving profitability, why has that decelerated the growth rate and should we expect an inflation point in the pickup in unit growth, anytime soon, maybe not just in China but in other areas of the world where you’ve obviously been successful?
A - James L. Donald: John, we don’t look so much at percentages as we do it at the number of stores and we’re confident that we’re going to hit this year’s targets for stores and hopefully you feed them and then each subsequent year, open more stores in almost all of our markets could certainly in total, then we did the year before and continue to ramp that up, particularly in our concentrated markets like the UK, Japan, China as it comes on and then Europe as well.
A - Howard Schultz: But I would just say John, I wouldn’t look at it so much on the quarterly basis, it’s a timing issue on a lot of issues that relate to permitting a municipality, the long range plan as its said before, is at least 15,000 stores outside North America and we’ve been more infused or confident about the way in which we haven’t received and the ongoing profitability of the international business, so, I would be more mindful of it long term in quarter-to-quarter.
Q - John Glass: Thank you.
Operator: Your next question comes from Dan Geiman with McAdams Wright Ragen
Q - Dan Geiman: Hi good afternoon. Regarding roll out of the breakfast warming program how stores will it have expanded by the end of the fiscal year, do you anticipate and also do you anticipate the rate of expansion to accelerate in future years. Also any expectation and results on per-store basis are going to be comparable to what you’ve seen Seattle and Washington?
A - James L. Donald: Yeah, Jim Donald, we look for the results to be comparable to what we sold out and that’s between $25,000 and $30,000 a year annualized sales. We mentioned we’re rolling out Portland, Oregon today and they will have Chicago and San Francisco, so it rolls up to about 600 stores.
A - Howard Schultz: At fiscal yearend an additional 400 down…
A - James L. Donald: About 200 currently in Seattle and Washington.
Q - Dan Geiman: Okay great.
Operator: Your next question comes from Steve Kron with Goldman Sachs.
Q - Steven Kron: Thanks I had a question on speeder service initiatives, you mentioned Jim in your prepared remarks the point of sales scanner is introduced throughout the retail stores and improvement there, I was wondering if there was any way to kind of, quantify what effect that’s had on speeder service and on that topic, the expansion of breakfast and the role out that you discussed, we too assume that, in the current markets where you are testing breakfast, that it hasn’t been diluted to your service speeds. Thanks.
A - James L. Donald: Second, I will answer the second one first, and that is correct it is not diluted to, we are talking about the speeder service, we have worked into the model, how the deployment works in those particular areas. So we are looking at, that overall in the first quarter we probably in terms of speeder service, we are 6% faster, however when I look at the scanner, it’s just one piece of what we call speeder service, other area is behind the bar that we are reengineering to including driver to continue to increase that speeder service. And when we look at our transactions growth, we are finding that, as we said this in the past that as lines moves faster they tend to kind of keep same amount of people and because they know they can get through, in that timeframe that is life for us and life for them. So we continue to tweak it along with scanners, with other operations as well.
A - Howard Schultz: I would like to just add one thing from that previous question that, I didn’t get to the second half of, I think Larry Miller’s question about margins, as we add other things into out retail stores. The music the entertainment, the food products, don’t have this good gross margin, as it beverages the handcrafted beverages, but at the PC level at the store, they contribute strongly and they don’t have a negative impact on overall store markets. So it changes the composition a little bit, but overall it adds to the average check and increases the store product contribution proportion.
Operator: Your next question comes from Matthew Difrisco with Thomas Weisel Partners.
Q - Matthew Difrisco: Hi I also have a food question that relates right to the coffee company, but also wanted to have a food something that catching halt here. As far as incremental, looking at our incremental basis, what you’ve learned from the 200 or so stores that you are in now. If you can give subscription of how the bell curve looks percent of the sales that food presents on from those various markets that you’ve seen.
A - James L. Donald: The food is the percentage of our business, continuous to increase with our new products offerings and looking at what we are doing with special platforms like better for you. So we are seeing an overall increase in food as it is today. We are seeing an incremental increase when you add on the breakfast involving sandwiches to this food category. So it’s a combination of both, and I thought you are going to go to where, how is the one with sandwich has been accepted which has been very well. But it’s not necessarily driving the food increase by itself.
Q - Matthew Difrisco: Well I tried to get into is breakfast becoming incremental on top of food, or is kind of lies of in other foods so.
A - James L. Donald: No, no it is incremental to that.
Q - Matthew Difrisco: And what’s the high watermark that you’ve seen so far, best case scenario, best market that is gone to be as a percent of sale?
A - James L. Donald: Well I think, it bettered to take in terms of averages, and both the lunch program and the wine program, the benchmark is about $30,000 per store, per year.
Q - Matthew Difrisco: And that’s probably right that’s not only…
A - James L. Donald: With out any material weakness in terms of speeder services, or the qualitative aspect of the customer experience.
A - James L. Donald: And we look at that from a USD prospective to earnings per stores per day, and we find it, as we roll out if, from market to market that the executions gets better, the understanding of it gets better, we are sure to see that, just Michael said stay in that $30,000 year range.
Q - Matthew Difrisco: Each individually 30,000 incrementally?
A - James L. Donald: Yes each store, correct.
A - Howard Schultz: That’s lunch and wine.
Q - Matthew Difrisco: Got it absolutely thank you.
Operator: So your next question from Sharon Zackfia with William Blair.
Q - Sharon Zackfia: Hi good afternoon. A question on the holiday, focus here that you made this year, can you maybe give us some perspective on what you saw most effective that was less effective than, what you might see you replicate going forward?
A - James L. Donald: Well obviously we have, irons that just blow out, and we have irons that do, what we considered to beyond our performance, but if I had to breakdown, I would tell you that, the chances of our entire holiday program starting with the execution that we delivered on store by store basis across North America, and we can figure and say on November 10 that all stores were set for holidays, meaning that all that playing well and had a time and make sure that our product was there, point of sale material in store sides, that I think led to an excitement from our store partners that clearly carry today and carry the momentum are going through. By don’t you look at what that, that merchandise mix was made up from beverages to food to job merchandise that‘s breeze to bears is some of our gifting that flowing to Starbucks gift card was there. And I got to tell you Christmas blend coffee, set record levels as well. It was just we hit out the part when it comes to the execution of a holiday and it is well tiny parts of blends we can probably do better than that we are currently working on.
Q - Sharon Zackfia: Okay thank you.
Operator: Your next question comes from David Palmer with UBS.
Q - David Palmer: Hi guys, congratulations on that quarter.
A - James L. Donald: Thanks.
Q - David Palmer: Specialty revenue growth was, was pretty strong this quarter I thought and I would mistimed maybe tempted is the reasons why no craft noted in that very strong sales, at Seattle’s Best, Starbucks coffees and that its coffee sales for boosted, competitors having supply disruptions, I am just wondering if you think that this was unusually strong quarter for grocery roll out sales maybe because of some clear things like that and also I am wondering maybe even if your new discoveries ready to bring beverage in Japan was at any part of driver of that specially revenue line as well. Thanks.
A - James L. Donald: The primary driver in specialty revenues for us was our licensing a retail store licensing which is the, build out of both Starbucks and Seattle Best license stores that was the primary factor. We also had a strong contribution from our food service business which is been a, 10% to 15% growth in last few quarter that grew between 15% and 20% this quarter and I hope, the grocery was strong and it, undoubtedly it sets craft attributed some of the two I’m sure this is contributes to that, but that was a relatively small part of growth in all specialty revenue.
Q - David Palmer: Okay thank you.
A - James L. Donald: I saw that as one of the thing, I think underlying the success of the holiday Christmas retail season and what you just noted in the specialty business. Its something that we kind of goes unset but I think its work repeating and that is the, the equity of the Starbucks brand, the power of the Starbucks brand in the marketplace coupled with the relevancy of the third place the sensuous community and how people are using our stores. The attachment that people have to, the Starbucks experience travels well beyond their experience in the stores and I think we are seeing the connectivity of the Starbucks brand in other channels of distribution and how people are trusting the experience beyond their stores. And I think it’s very different in traditional consumer brand that are, that have been dealt to advertising and promotion where Starbucks has build the brand in a very enjoying way almost quick essentially by the experience. And that is, and we are seeing the, the ongoing relationship of the brand and other products and other channels, that are parallel in success of our retail business.
Q - David Palmer: Thank you.
Operator: Your next question comes from Ashley Woodruff with Bear Stearns.
Q - Ashley Woodruff: Hi thanks. Just significantly expanded the entertainment initiative over the past several years and as you said soon you will be testing movies and probably more. And then could you talk a bit about how you balance from a time allocation standpoint managing the course Starbucks coffee brand operations versus analyzing the new initiative like entrainment?
A - Michael Casey: Well every thing that we do though is core to, what we are calling our Starbucks Coffee house experience our store retail store experience. And we are not trying own house in there, they are not necessary; they don’t necessarily compliment the customers experience. And so we work when we work with our operating team, we work with our implementation team; roll it down to store level. We are making sure that the execution is all in one and it’s all wrapped around, that customer’s experience. So they are able to tie that experience, with understanding about coffee knowledge, understanding how to juggle new beverages that might come out in spring versus fall versus winter and we tie all into one package. So they are able to, to juggle these and they should be bring out to provision. Howard, do you have any thing to add to that with the entertainment?
A - Howard Schultz: I would only say that the, the ongoing success we had with music and the initiative of the movie all of the positions that we are making on the content side is made with the launch of making sure that the music and the movie is accretive to the experience our customers have come to expect from Starbucks. We don’t want to do anything that would dilute the trust that our customers have in our company. And I think the first wave of all of that is with our partners. We want our partners to be proud of the music that we are choosing, and the movie that we are going to share with the American audience. And I think it’s linked to making sure that everything we do matters and it supports the foundation of the company and that is, we are not an entertainment company, we are not a music company, we are coffee company, we are creating opportunities that will complement the coffee experience.
A - James L. Donald: And I want add to that, because of the excitement that was generated for the holiday said, by the execution that I’ve ever seen in retail, when we get our partners excited about it, they get tremendous buy and it keeps executed.
A - JoAnn DeGrande: Operator we have time for one more question please.
Operator: Thank you Ma’am and we now go to the line of John Ivankoe with J.P. Morgan.
Q - John Ivankoe: Hi thanks very much. You know Howard I was, just thinking about the entertainment initiatives and specifically movies and I will then follow up on a couple of questions, and presumably you have to pick and choose the movies, coming Lions Gate as both of them dictating the movies that you are going to promote, could you discuss, I guess that’s selection process and whether its, in the script stage or if its actually in the finished product stage, kind of you an elaborate a little bit on the financials behind it, I know you mentioned in your prepared remarks that you will be responsible for the marketing cost, but is there any capital commitment at all, for the movie, and if I may, I think this is one question, is that, so we just assume at least for the time being in the current year music is, and I guess sales, CD format that we currently see in the stores is being relatively static, I mean have you done with that, we should expect a significant continued involvement of that piece of the entertainment strategy thanks.
A - Howard Schultz: Okay, John it’s a lot of question.
Q - John Ivankoe: Well, its kind of, its actually short if you think about, for just you, walk thorough how you go through this movies, thanks.
A - Howard Schultz: Okay, let’s begin with, I think we believe that given the unique relationship we built with our customers around music, that we had built a level of trust that gave us the license to extend music to other forms of environments. So over the past 12 months, and maybe slightly longer, we have had ongoing conversations with multiple movie studios about trying to find a movie that would set with the aspirational story and the uplifting and a story that we felt needed to be told, and story that we thought we could get behind in a very natural seamless way. This particular movie was pretty much done when we saw it, we had screened many movies, we had read many scripts, this particular movie was almost completed. Lions Gate to their credit, although they are public company, it’s a more of an independent movie company, then say Warner Brothers they’ve great success this year past year with Crash, they understood the challenge of the movie industry in terms of box office problems, high marketing costs and saw right away, that Starbucks got involved in the movie that we could advance the rate at which people would go see it and potentially lower their marketing cost, what we wanted for that was something that mirrored what we did was Ray Charles, which was the template of our music initiatives. We wanted equity in the movie business, in the movie without investing any dollars in the movie itself. We agree that we would create a marketing campaign in store that was significantly less in dollars then we are going to get paid and we wanted to be able to participate not only in the front-end, but in the backend of the box-office received in all ancillary products if in fact the movie success is what we believe it to be. And this is a very important first step because, it sets the stage and the template by which other movie deals, assuming this will be successful will be judged. Since that time, we’ve many movie studios contact us wanting to be the next one, we are going to wait and see how we do with this, and as if fact, all the things that we hope to happen occurs. With regard to music this should not in anyway be a signal that we are done with music quite a contrary. Our music business continuous to be strong and healthy we have a new album coming out relatively soon with Surgio Mendes , we’ve got Tony Bennett coming out and we just had great success Dean Martin, believe or not during Valentine’s Day and we are full throttle on our ability to create a profitable stream of revenue for the company and a new channel distribution, what’s interesting about what we’ve done this year, as we also gave you are a market maker and discovering a group called Antigone Rising, they never had a record deal, they sold over a 100,000 units for Starbucks and we just picked to be the opening act of the balance of the Rolling Stones, that was attributable directly to the validation of Starbucks involvement. So we are a market maker, we’ve recognized the power of that, and also the responsibility we are going to look for ways in entertainment that are profitable, that are unique and add texture to the brand.
Q - John Ivankoe: Thanks very much Howard.
A - Howard Schultz: Thank you.
A - Howard Schultz: I guess that does.
JoAnn DeGrande, Director of Investor Relations: Thank you for listening into our earnings call today, we hope that you will join us for our webcast of our second quarter fiscal 2006 financial results, which will be on May 3rd, and note that at that time, that will be also include revenues figures along with Q2 results. Thanks again.
Operator: Ladies and gentlemen we appreciate your joining us today, this does conclude our Starbucks first quarter 2006 earnings conference call. You may now disconnect. | [
{
"speaker": "Executives",
"text": "JoAnn DeGrande, Director of Investor Relations Jim Donald, president and Chief Executive Officer Howard Schultz, Chairman and Chief Global Strategist Michael Casey, Executive Vice President, Chief Financial Officer and Chief Administrative Officer Mary Ekman, Vice President Corporate Development and Investor Relation"
},
{
"speaker": "Analysts",
"text": "Jeffrey Bernstein, Lehman Brothers Larry Miller, Prudential John Glass, CIBC Dan Geiman, McAdams Wright Ragen Steve Kron, Goldman Sachs Matthew Difrisco, Thomas Weisel Partners Sharon Zackfia, William Blair David Palmer, UBS Ashley Woodruff, Bear Stearns John Ivankoe, J.P. Morgan"
},
{
"speaker": "Operator",
"text": "Good afternoon my name is Mild (ph), I will be your conference facilitator. At this time, I would like to welcome everyone to the Starbucks First Quarter 2006 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers remark, there will be a question and answer session. If you would like to ask a question during this time simply press “*” then the “1” on your telephone keypad. If you would like to withdraw your question, press “*” then the “2” on your telephone keypad. Thank you. Miss. DeGrande, you may proceed with the conference."
},
{
"speaker": "JoAnn DeGrande, Director of Investor Relations",
"text": "Thank you, good afternoon ladies and gentlemen, this is JoAnn DeGrande, Director of Investor Relations to Starbucks Coffee Company. With me today are Howard Schultz, Chairman, Jim Donald, president and CEO, Michael Casey, Executive Vice President and CFO and Mary Ekman, Vice President Corporate Development and Investor Relations. During today’s call, Jim will review key results and accomplishments, Howard will provide an update on the next stage of our entertainment strategy and Michael will highlight the key drivers behind our first quarter results as well as discuss our fiscal 2006 growth targets. We will windup today’s call to one hour including Q&A. I would like to point out today for the first time along with our fiscal first quarter results we also release our January revenues. As a reminder to all listeners, this call is being broadcast live over the Internet. A replay will be available via telephone at 800-642-1687, reservation number 372-8089 through 5.30 PM Pacific Time on Wednesday February 8 and at the internet on the Investor Relations page at starbucks.com through 5 PM Pacific Time on Tuesday March 7. In addition, today’s remark will be available on the Investor Relations portions at starbucks.com by the end of the day and will remain available through Thursday March 2. This conference call includes forward-looking statements such as anticipated store openings, comparable store sales expectations, trends beyond our expectations regarding the company’s revenue and expense growth, capital expenditures, effective tax rate, net earnings and earnings per share results. These statements are all based on currently available operating, financial and competitive information and are subject to various risks and uncertainties. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements are contained in the company’s filings with the Securities Exchange Commission including the risk factors sections of Starbucks Annual Report on Form 10-K for the fiscal year ended October 2, 2005. The company assumes no obligation to update any of these forward-looking statements. With that, let me turn the call over to Jim."
},
{
"speaker": "James L. Donald, President and Chief Executive Officer",
"text": "Thank you, JoAnn, and good afternoon ladies and gentlemen. Starbucks robust performance in the first quarter of fiscal 2006 sets the stage for the year and provides momentum for achieving our ambitious 2006 growth targets. Our success for first quarter including new as well as returning seasonal and holiday favors. Product launches in both our international and domestic markets and a keen focus on execution at all levels of the business. This led to net revenues growth of 22%, net earnings growth of 20% and first quarter earnings per share of $0.22. Great team work and flawless execution resulted in 560 new store openings, a record number for our fiscal first quarter. Our stores also delivered solid comparable store sales growth to 7% at the high end of our 3% to 7% target range. We end the quarter with 10,801 Starbucks locations in 37 countries serving more than 40 million customers per week. The strong momentum from yearend continued in the January as revenues grew 23%, 555 million and comparable store sales for the month increased 10% and we added 67stores during the period. Let us review some of the key drivers behind our first quarter results. First, I would like to highlight what is being happening in our retail stores, were our results are driven by superior operational execution at store level. Last year seasonal; and holiday favorites return this year beginning the fall of the Pumpkin Spice platform. The continued success of Pumpkin Spice provided an excellent play load during November return of our great anticipated holiday offering beverage trio, Peppermint, Gingerbread, and Eggnog. Based on the seasonal popularity of Eggnog this year, we added a Chai Eggnog Latte, which could be came a customer favorite. We kicked off the 2005 holiday season; with an innovative and unique marketing approach through several carefully august-rated efforts, which included the redcup.com as well as our first simultaneous promotional launch in one of US and Canadian retail stores. Between store closings on November 9 and opening on November 10 our partners transform our stores to holiday red in 9 excitements among our partners and customers and building energy around Starbucks holiday offerings. We provide a variety of coffee relevant merchandise in holiday treats, specifically designed to meet the gifting needs of our customers. I am pleased to report that the combination of the strong merchandise selection and affective inventory management led to robust product sales during the holidays as well as fewer mark downs, foreign season when compared to last year. Prior to the holiday rush, we completed the deployment of our new point of sales scanners in US and Canadian stores with resulted in more efficient merchandise transaction processing and faster service counter during this busy buying season. Once again, the Starbucks card was a very popular item, more than fours ago Starbucks was a market leader in introducing the store value card and many retails have since tried to replicate the idea for their own businesses based on our success. Yet despite the proliferation of the store value cards, we track you in the Starbucks brand along with convenience and the Starbucks expends that our partners deliver continues to differentiate the Starbucks card from others. The Starbucks card has created a loyal following among our existing customer base and continues to draw new customers. The strong growth of accounts the stickiness our card create with our customers and the frequency of usage, clearly separates us from other programs. During the season of giving and is for our ongoing community out reach, we continued one of our traditions, the Starbucks Holiday Angels Joy Drive. Thousands of seriously ill children received gifts through this joint effort by Starbucks partners, customers and the Starlight, Starbright Children’s Foundation. I am pleased to say that this year’s Toy Joy delivered more than 865, 000 gifts to pediatric patients across US surpassing our goal and more than 100,000 gifts. Now looking at the second quarter, I want a promotion provide this feeling of warmth and comfort during this cold winter days. We begin with our Cinnamon Dolce beverage platform highlighting sweet date notes that are lamination of our warm and buttery, Cinnamon pastry and in both feeling of the comfort and pleasure associated with walking in to your favorite bakery. Customers can choose between a variety of offers suite their needs, ranging from Cinnamon Dolce evocate the Cinnamon Dolce cream to a Cinnamon Dolce Frappuccino, or Frappuccino light blended coffee. This platform, this flavor platform highlights the handcrafted artistry performed by, by our breezes everyday in our stores and it’s something that truly sets us apart from our competitors. Nor that many of us begin the New Year with the result to make more healthy choices, we are also featuring Starbucks exclusive reduce that coffee cakes. This year our new flavor to reduce that model coffee cake joins two past flavors to reduce that Cinnamon to a coffee cake and reduce that Blueberry coffee cake. The new coffee cake presents a perfect compliment to assume both, cakes and chocolates as well as any of our other handcraft with special beverages. As we mentioned during the last conference call, we are expanding our warming program to senior cities this year, which will provide more customers the option to enjoy a one favorite breakfast sandwich along with your favorite Starbucks beverage. Begin today our customers in quadrant that will report in Oregon can visit on of our 54 stores which launched the warming program just this morning. We’ve also add warming to 37 more location within our Seattle market today. Looking ahead, we planned to introduce this program to both San Francisco and Chicago during this spring. We will provide more details as we get closer to those market reductions. Before I review international highlights I would briefly recap last week’s acquisition announcement. Starbucks acquired the remaining 95% ownership for the operations and Hawaii and Puerto Rico. This added, 67 stores to our company operated store portfolio and allows us greater influence over the brand and new attractive markets. This transaction also aligned with our long-term strategy to increase our equity position we’re appropriate. We’re energized about continued growth potential in both of these markets and see these acquisitions as an opportunity to more fully capture. Now let’s take a look at our international markets and the progress we are making. We opened 201 new stores in the international markets during the first quarter and today we have retail presence in 36 countries outside the United States. Financial results for international segment continues to strengthen field have rapid retail expansion healthy comparable store sales growth and improving profit margin in markets throughout the world. We see tremendous global opportunity for our brand ranging from ongoing presence in current markets to exploring, entering into new markets such as Brazil, Russia and eventually India. All this aligns with the work we are doing to build solid infrastructure that are to carry Starbucks global expansion to the future. Starbucks continues to offer a borderless community on a place for our customers to connect with one another and for our partners to build relationships within their communities. The success of this connection is evident in the robust results delivered by international segment this quarter. Starting with Japan, you may have recently seen the news that Starbucks Japan has appointed eminent CEO, COO designate, Mercy has, present international management background having held numerous senior management positions at Levi Strauss Company in a number of markets over a 31 year career with the company. She joined Starbucks Japan as they posed their sixth consecutive month of positive comparable store sales growth and operational expertise and diagnosed as a retail industry will provide strong leadership as the company enters its second decade of operations later this year. Continuing with the Asia-Pacific news, I’d like to update you on the success with discoveries, our new RTD products in Japan and Taiwan. The enthusiastic reception to Starbucks discoveries by consumers in those two markets far exceeded our expectations and gained live spread public awareness. The launch of this chilled cup coffee product featuring the high quality coffee customers expect from Starbucks clearly demonstrated powerful execution in collaboration between our US and Asia-Pacific consumer product teams. Turning to China, I just recently returned from a 5-day city trip and was accompanied by Michael and 5 other senior Starbucks leaders. The trip provided a wonderful occasion for us to meet with partners and our company operators and license doors and observed first hand the opportunities that await us in this important market. Our retail presence continues to grow nicely as we opened over 50 stores in China market over the last 12 months including more than doubling our store count, in new company operator markets to 26 stores to-date. In total, we entered the quarter with 221 stores in China and our business there is performing well. We’re seeing continued growth in market level comparable store sales and profitability in our older licensed markets such as Shanghai and Beijing and we are experiencing an enthusiastic reception in newer China markets without exception. Personally, this is my first trip to China and now I am even more confident in Starbucks future there strengthened by the gathering momentum of the lively coffee culture. So our interaction with the local partners, it was apparent that the Starbucks culture and passion, it was powerful as what we experienced among our partners in our US and other established markets. My insight has reinforced by these first hand observations that the Starbucks experience clearly travel. Let me just share a quick story. We opened our store in Chongqing, a couple from a neighboring province was working on a development project nearby and heard about the Starbucks store opening, they postponed their return flight by a day to personally experience the opening Chongqing’s first Starbucks location. What is special about this story is that they told us that they were already planning a trip back the following week to visit our store again which demonstrates the relevancy of the Starbucks brand and the connection we are making in the communities worldwide. Before wrap up my comments, I would like to share with you some special recognition that company received during the first quarter. First, Starbucks is recognized by the Financial Times as one of the world’s most respected companies. This is the first time, Starbucks made this prominent list determined by a survey performed by the Financial Times pulling more than 950 CEOs across 25 countries. The company was also recently recognized by brandchannel.com as one of the top 5 world’s most influential brands, a meaningful accomplishment ranking with such topper brands as Google and Apple. I’m also pleased to say that for the 8 years fortune magazine named Starbucks one of the 100 best companies to work for in 2005. And for a global retailer, with over 100,000 partners worldwide, this is a wonderful accomplishment and confirms that Starbucks can truly stage them all while we do think. And finally, I’m pleased to announce that Starbucks has been recognized in China as one of the top 10 employers in 2005. We were awarded this recognition by CCTV, China’s National Television Network. These accolades are very meaningful as it takes the collective effort of each and every partner to ensure that Starbucks is a great place to work. As that reflect on our first quarter results, I’m proud of success we have achieved thanks to the hard work and commitment of our partners. I’m looking forward to the year ahead with continued focus on a core and accelerating pipeline of innovations and initiatives and a very strong management team in place. I’m confident that further extending our brand executing at all levels of the of the business and providing our customers with the products and innovation they have come to expect will continue to prove successful throughout the balance of the year. I will now turn the call over to Howard."
},
{
"speaker": "Howard Schultz, Chairman and Chief Global Strategist",
"text": "Thank you Jim, nice job, by the way and good afternoon everyone. Today, I’m going to focus my comments on a very exciting and evolving segment of our business, entertainment. Before I talk about where we are today, I would like to take a step back and revisit the road Starbucks has taken in our evolving music and entertainment strategy. As many of you know, music has always been an essential part of the coffee house culture. For Starbucks our musical journey began in 1995 when we first introduced CD sales into our stores, as a result of a very popular in-house music program created by one of our store partners. A natural extension from that was our 1999 acquisition of Hear Music, a San Francisco based music retailer known for the innovative way it helped consumers discover great music. This acquisition helped boost our in-store music selection and propelled us forward in creating the musical coffee house environment. Our role in music then moved beyond just the sale of CDs and extended to music programming at Starbucks stores worldwide. Music compilations, a 24-hour music channel with XM satellite radio, an innovative collaboration with music labels to produce, market and distribute both exclusive and non-exclusive music followed. From there, Starbucks has evolved to become a significant presence in the music industry. For example, collaborations with record companies such as Concord Records for the release of Ray Charles’ Genius Loves Company, the final recording by the gifted artist, went on to an Eight Grammy and subsequently hit the number one position on the BillBoard sales chart. More recently, Herbie Hancock’s Possibility CD which we co-released with Hancock Music and Vector Recordings has received Two Grammy nominations. Not only has Possibility drawn the attention of the recording academy, it has also been the most successful debut in Mr. Hancock’s career, selling more than 42,000 copies in the US alone in its first week of sales. Possibilities also debuted at No. 22 in the BillBoard 200 Albums Chart. In addition to offering music in our traditional stores, we also introduced Starbucks Hear Music Coffeehouse, a wonderful unique land of music store and coffeehouse which provides customers a venue to enjoy one of our hand crafted beverages while exploring a wide selection of CDs and digital music. Our flagship Santa Monica store was recently joined by second Starbucks Hear Music Coffeehouse, which opened in San Antonio, Texas in December of ’05. A third Starbucks Hear Music Coffeehouse will open in Miami Florida later this month. Each store offers a vast selection of more than 1 million digital tracks to sample; listen, burn and print, truly transforming the way consumers discover and acquire music. A sale of CDs at Starbucks locations has provided record labels with a broad new channel of distribution and a powerful cost-effective in innovative way to connect with an expanded untapped customer basis at Starbucks. Our approach today with music has been precisely executed changing how consumers discover great music while at the same time, generating a profitable revenue platform for the company. As we continue to seek and capitalize on emerging opportunities, we are taking our entertainment strategy to the next stage, films. As we have demonstrated over the last few years Starbucks has become a market maker in the music industry and now similar to music we are seeking to be an innovator in the marketing and distribution of film. Our strategy is to bring relevant and unique entertainment to the forefront utilizing our expansive retail footprint. Over the past several years, the film industry has experienced a decline in box office receives while also realizing a significant increase in the cost to market new films. Starbucks has prepared to break that paradigm and changed the model of how new films reached the public. We are confident that the strength of the Starbucks brand coupled with our broad national footprints and be a catalyst for the industry by engaging our customer base the opportunity is there to generate higher box office proceeds and lower marketing costs associated with the premier of a film in a powerful and cost effective way. What we intent to do is unlike any thing you have seen from other, Starbucks will not replicate the way in which fast food chains have co-opted their stores for the marketing of films, in order to sell more fast food. We are not entering into the venture with a sole purpose to sell more coffee, but instead to bring a inspirational uplifting story to our customers and to the public who may otherwise not have the opportunity to experience this particular film. I’m speaking about the recent announcement of a truly transformational partnership in which Starbucks will participate in all aspects of the marketing and distribution of Landscape Entertainment’s new film Akeelah and the Bee. This next step is simply the natural evolution of our entertainment strategy and one we have been, been researching and exploring for quite some time. In our first quarter into this medium, it was critical to find the right film that would resonate with our customers and honor the trust they have place in us. Akeelah and the Bee is especially relevant with its inspirational story of a young girl who despite many social and economic obstacles advances from the inner city the scripts national splendid. This film which will be released in theatres on April 28th has the content depth and inspiration we were seeking and conveys the human touch that for fact, personifies the Starbucks brand. I want to stop here for a moment and make it really clear that we are not investing in a movie and we are not getting into the movie business in a traditional way. What we are doing is leveraging our vast retail store footprint and the cultural relevancy of the Starbucks brand to bring film to the public in a new way during the time when the film industry has been challenged. Starbucks will participate in all aspects of the marketing and distribution of this year film, and we will be an equity participant in the film’s success, not only at the box office but through the sale of the sound track and the DVD in all retail outlooks including our stores. The soundtrack will be available in early April and we will carry the DVD along with other traditional retails, when it becomes available later in the year. Through this venture, we are creating an economic partnership with the film industry that mirrors the structure we created in music with the successful later trail CD. Through the power of the Starbucks brand, we will create awareness and drive new Movie Goers to the film, something movie producers could not do on their own. We will introduce the film through a truly innovative and interactive in store marketing campaigns, which will provide customers the opportunity to experience the fun and inspirational feeling of the movie. Many of our store partners will have a chance to view the film prior to its release and they along with strategic marketing materials with in the store will create enthusiasm in entries among our customers around the Akeelah and the Bee. Starbucks has become recognized by entertainment authorities has a significant force in the music industry. Lending our trusted editorial voice and raising awareness of this film through our partnerships, through our powerful distribution systems to translate into Starbucks achieving a similar role in the film industry. While our core remains unchanged, we recognize that we have an opportunity to provide much more then the best cup of coffee. We offer our community gathering place where people come together to connect, explore and make new discoveries. We value the trust that our customers have placed in us and we are committed to providing high quality and relevant offerings as we take our entertainment strategy to the next stage. Before I close I would like to share a quote with you, from a music reporter who seems to be as equally energized about Starbucks venture into entertainment as we are. According to Melinda Newman, the West Coast bureau chief for Billboard magazine, Starbucks and, Starbucks has become a power in the industry, they are forced to be recon with. If you are looking at Starbucks and saying, is this a project we will be best served by making a deal with Starbucks. It’s exiting to share with these developments in our entertainment strategy. We are creating a truly transformational entertainment experience by providing our customers the venue to discover music and movies from a brand that they have come to trust. It all gets back to the basic, the foundation upon which we have build our company, it’s around a human connection and our passion to innovate and grew with new offerings, new sound and new experiences. While seeking unique opportunities to monetize our assets and in doing so increase shareholder value. We look forward to providing you with future updates as we build on this exciting venture. I will now turn the call over to Michael."
},
{
"speaker": "Michael Casey, Executive Vice President, Chief Financial Officer and Chief Administrative Officer",
"text": "Thank you, Howard. During today’s call I will highlight our financial performance for the first quarter that was consolidated in by segments, from provide a brief review of the impact of, adopting the new stock based compensation accounting role. Comments on our strong balance sheets and cash flow, and provide updated targets for the remainder of the year. I am pleased to report that we once again produced strong top line and bottom-line growth, sales was solid in both our company operated and specialty businesses and in our US and international segments. More specifically consolidated net revenues for the quarter ended January 1st 2006 were record 1.9 billion up 22% from the first quarter of fiscal 2005. Company operated retail revenues increased 20% for the quarter, driven by the opening of 803 new stores in the last 12 months and 7% comparable store sales growth for the quarter. Comparable store sales growth consisted of a 6% in the number of customers transactions coupled with a 1% point increase in the average value per transaction. The comparable store sales growth of 7% particularly satisfying given that in October we lost the October 2004 leverage price increase in our US and Canadian markets. Licensing revenues grew 39% for the quarter, driven by the opening of 1049 new licensed retail stores in the last 12 months and continued growth in the licensed grocery and warehouse club business. Food service and other revenues increased 18% for the quarter, primarily due to growth in new and existing US and International food services accounts. Operating income was up 23% to 280 million for the 13 weeks ended January 1, 2006, from 227 million in the prior year, as a percentage of total net revenues operating margin increased to a record 14.5% from 14.3% in the prior year, primarily due to lower cost of sales including occupancy cost. In-store operating expense has a percentage of total net revenues. Partially offset by higher corporate, general and administrative expenses. While store operating expenses has a percentage of related company operating retail revenues improved by only 10 basis points for the 13 weeks ended January 26th. As a percentage of total revenues, they improved by 50 basis points, this leverage was created by specialty revenues growing at a faster pace than retail revenues. General and administrative expenses increased due to higher payroll related expenditures for stock based compensation and higher provisions for incentive compensation based on the company’s strong operating results for the first fiscal quarter of 2006. As well as increased charitable contributions during the quarter. As we previously discussed in which we adopted the financial accounting standard boards, final stock based compensation guidance formerly known as FAS123R. As we ride under FAS123R we are adopting the new expensing requirements for the fiscal 2006, with no restatement of prior period results. The free cash stock based compensation expense recognized for the current quarter, was 23 million pre tax or 15 million net taxes for an EPS impact of $0.02 per share inline with our expectations. Please refer to page 8 of the pres release to view the numerous expense line items impacted by the adoptions of this accounting standard. Due to timing of our stock brands, which is generally concentrated in the middle of the first fiscal quarter, the current quarter’s pretax amount is slightly lower than what we would expect for subsequent quarters in 2006. However we will continue to impact quarterly earnings per share by approximately $0.02 per share for the remainder of the fiscal year. As $0.02 per share per quarter, I’ll make sure, I heard about that, for the remainder of the fiscal year. The total stock-based compensation expense was allocated to our 3 reporting segments as follows, US Segment 51%, International segment 10% and corporate 39%. Current quarter expense was approximately 33% due to options granted in this fiscal year, approximately 10% due to our employee stock purchase plan and the remaining 57% was due to options granted in prior years. I will now move on to first quarter results by operating segment, total net revenues for United States operating segment increased by 21% to 1.6 billion for the first quarter of 2006. Company operated retail revenues grew 19% to 1.4 billion primarily due to the opening of 634 new company operated retail stores in the last 12 months, and comparable store sales growth of 7%, US specialty revenues grew by 32% to 250 million for the first quarter. Within specialty revenues, licensing revenues increased by 40%, to 170 million. This is primarily due to higher product sales and royalty revenues from the opening of 650 new licensed retail stores in the last 12 months, which was 45% higher in store openings at this time a year ago. In additions we have strong operating level revenue performance. Both are contributing to the increasing and licensing revenues was the growth in the licensed Grocery and warehouse club business. Food service and other revenues increased 18% to 80 million, and there is a growth in both new and existing foodservice accounts. US operating income increased 28%to 339 million in the first quarter from 266 million in the fiscal 2005. Operating margin increased to 20.9% of related revenues for the first quarter of fiscal 2006, from 19.8% for the first quarter of fiscal 2005, with a 110 basis point improvement. This improvement in operating margin was primarily due to leverage from strong revenue growth as discussed above, and controlled spending in most areas of the business. First quarter is historically a best quarter of the year from a margin point of view. Now moving to the international segment, as Jim mentioned we recently spend a week together in China and following that trip I am more convinced than ever of a great opportunity that awaits us there. Either exciting times in our international business, our investments for the future, were also roofing the benefits of strong financial results due to a sharp focus consolidated execution in our current markets. International total revenues increased 25% to 314 million in the first quarter. International company operated retail revenue increased 23%, 267 million in fiscal 2006. Primarily due to the opening of 169 new company-operated retail stores in the last 12 months, and comparable store sales growth of 8% for the quarter. The increase in comparable store sales results from a 5% in customer transactions; couple with a 3% increase in average value per transaction. International specialty revenues for the quarter increased 35% to 56 million, primarily due to higher product sales in royalty revenues from opening 398 licensed stores in the last 12 months, which is a 45% higher, which is 45% higher than store openings a year ago. And to a lesser extent the recent launch of our new ready-to-drink coffee beverages in Japan and Taiwan, in the fourth quarter of fiscal 2005, and in Korea in the first quarter of 2006. Operating income from international operations increased an impressive 79% to 35 million in the first quarter from 20 million in fiscal 2005, international operating margin expanding to a 11.3% of related revenues from 7.9% fiscal 2005. This significant improvement was primarily due to lower cost of sales including occupancy cost and store operating expenses has a percentage of net revenues, also contributing to the margin expansion was an increase in income for nearly every equity investors, particular Japan and Korea. Due to an increase in that store base improved comparable store sales growth and strengthening store profitability. Partially offset in these improvements was an increase in other operating expense from marketing and advertising related to the recent launch of ready-to-drink coffee beverages in Japan, Taiwan and Korea. Our international store base continues to increase rapidly, and we are achieving a growing contribution from established areas of the business, our investing and emerging markets and channels. The balance between these 2 resulted significant margin improvement in the first quarter, but it is expected to shift back towards investment and therefore less margin improvement for the remainder of fiscal 2006. Moving briefly to the consolidated balance sheet, total cash, cash equivalents and other liquid investments increased 594 million at the end of the first quarter of 2006, from 368 million at the end of fiscal 2005, primarily due to strong operating cash flows. During the first quarter of fiscal 2006, Starbucks repurchased 4.3 million shares of common stock for total cost of 121 million and reduce the outstanding balance on our credit revolver by 172 million. Our solid balance sheet, continuing strong cash flows and our borrowing capacity allows to continue to fund our operations, opportunistic repurchase shares and selectively invest in new growth opportunities, such as our recently announced acquisitions of full ownership of Hawaii, Puerto Rico operations. Before we, moving on to our 2006 fiscal targets, let me add a little color on the Starbucks card activity. This was a contributor to the January revenues we reported today. During the first quarter customers activated a record 221 million on Starbucks products. Including a 165 million in December alone and an increase of 35% compared to the first quarter of fiscal 2005. At the end of the quarter, more than 293 million was loaded on to the Starbucks part waiting to do with in. A significant increase compared to 192 million at the end of the first quarter last year. During the month of January Starbucks redemptions reached an all time record of 93 million or 22% of company operated retail revenues in United States and Canada. I will now turn to an overview of a updated fiscal 2006 growth targets. Based on our very strong first quarter performance in our latest forecast for the balance of the year, we planned to open at least 800 new stores on a global basis in fiscal 2006. In United States we planned to open approximately 700 company operated locations and 600 licensed locations, in international markets we planned to open 150 company operating stores and 350 licensed stores. We anticipate robust revenue growth will continue and we are targeting a total net revenue growth of approximately 20% on a quarterly basis and for the full year. As we reported today, January comparable store sales growth exceeded our target range of 3% to 7%. We do not view that level of growth as sustainable, however and we continue to expect comparable store sales growth in the range of 3% to 7% it must be anomalous for the remainder of fiscal 2006. Starbucks annual leadership conference for all US, store managers, which was held during the fiscal second quarter last year, will be held during the third quarter this fiscal year. I mentioned this important store operating activity, for 2 reasons. First the cost of this event is significant enough that timing shifts do impact earnings growth rates for the affected quarters, and second it is worth noting very early on that we are planning our fiscal 2007 leadership conference, shift back to the 7th to the 2nd quarter, and to be held at an international location for the first time. In updating our plans for the remainder of the fiscal year, we bare in mind the important balance from strong comp performance and making investments from the future growth initiatives. This strategy has consistently generated long-term value for our shareholders. In the second half of fiscal 2006, a key area of increased investment for us will be infrastructure to support the significant opportunity we foresee in China. We have recently filled several leadership positions in China and we are close to filling several additional key positions and making other infrastructure investments for the market, which we expect to big impact in international segment expenses, and operating margin through out the remainder of fiscal 2006. Based on our excellent first quarter results and our continued positive outlook for the balance of the year, we have raised our earnings per share target range to $0.68 to $0.70 per share for fiscal 2006, an increase of $0.05 per share over our original target set last July. Based on January revenue with result and the revenue and expense outlook I just described, we now a somewhat stronger expectation for our second quarter results, by the time we set our original, targets. Well our goals for the last half of the year are generally unchanged. More specifically on a quarterly basis, we’re targeting earnings per share of $0.14 per share for Q2 and a range of $0.16 to $0.17 per share for each of Q3 and Q4. I want to remind listeners again that our fiscal 2006 earnings targets include stock option compensation expense estimated at approximately $0.02 per share per quarter and $0.09 per share for the full year. And as a result, EPS growth rates compared to fiscal 2005 have decreased due to this accounting change. The effective tax rate is expected to remain at approximately 38% in fiscal 2006 with quarterly variations and capital expenditures are expected to be in the range of 700 million to 725 million. With that, I would like to ask the operator to queue the first question. Please ask one question at a time and re-queue for additional questions, thank you."
},
{
"speaker": "Operator",
"text": "And at this time, I would like to remind everyone, if you would like to ask a question, please press “*” then the number “1” on your telephone keypad, “*” “1” to ask a question. We will pause for just a moment to compile the Q&A roster. Your first question comes from the line of Jeffrey Bernstein with Lehman Brothers."
},
{
"speaker": "Q - Jeffrey Bernstein",
"text": "Thank you very much. Actually just a question on the overall costing segment and there’s been a lot of chatter lately down to focus on improving their offerings to more in the service and growth in US is ramping up, just wondering if you could provide us with this year take on the competitive landscape, specifically I guess who would you categorize as your main competitor if any, and do you view the competitive landscape and healthy for the category? Thanks."
},
{
"speaker": "A - Howard Schultz",
"text": "I think that’s an important question. First, we’ve always said that as a percentage of total coffee consumed in North America, we probably have less than 10% of the total coffee market. And in view of that, we’ve always had a very strong competitive list of people that were trying to capture the morning segment away from Starbucks, we viewed the recent activity by the companies you’ve mentioned as a positive influence on the category, the more education, the more advertising that people place on the category, on a macro level will have a greater effect I think on our ability to demonstrate the differentiation between not only Starbucks coffee but most importantly the experience that we create day-in and day-out. And as we’ve said in the past, although jumping on since on a wonderful job in the New England area, we sold our own against them consistently the spike the amount of money that they continued to spend in that market and on some levels we’ve seen the business spike up when they have placed for this proportion amount of money in advertising. So, we are mindful of the competitors but we think when all have said and done it’s a positive effect on the category we’ll benefit from it."
},
{
"speaker": "A - James L. Donald",
"text": "Howard, I might add to this, this is Jim Donald that as we prepare for this, we’re also preparing for our partners to become experts in coffee and the taste of our coffee masters those of partners that have going through a train if you will on coffee countries of origin, and use coffee at home as actually outpace the comp that we’ve grown 50% in the last year going from 10,000 coffee masters to 15,000 coffee masters that’s both well for us."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Larry Miller with Prudential."
},
{
"speaker": "Q - Larry Miller",
"text": "Yeah, hi, thanks very much. Just wanted to ask you that the margins that was impressive almost 21% and I think you’ve typically guided to, relatively flat margins and I was just trying to think it out how extending about the business going forward as you’re rolling out more food but doesn’t launch and if you could develop on how the entertainment strategy might look in that line as it starts to extend I would move reason an expanded use of thing?"
},
{
"speaker": "A - Michael Casey",
"text": "We had our best, this Michael, we had our best margin quarter in the history of the company in this first quarter so, we are very pleased about that, the first quarter is traditionally our best quarter for margins because it benefits from the gifting in the holiday sales, merchandize sales in addition to our everyday beverage business. So, we would expect this to be the strongest margin quarter of the year as it has been historically. Looking at our individual segments, we think that full year margins in our US retail business in a range around 19% is the right place for that business, it’s the right next between delivering value to the customers and delivering value to the shareholders. And so, we are very pleased to be managing our business on a full year basis in that range and when its, its in the high, when its at the high end of that around 19 range, obviously we’re pleased with that. We do expect if we continue to grow our US business with very steady margins that we will get leverage in other parts of the P&L particularly with the corporate G&A. In the international business, the margins are lower than in the US and over the long term we think the will move in the direction of the US margins but they’re not going to move in that direction quickly because as I tried to emphasize in my earlier remarks, while we are showing significant improvements in almost every market, almost every quarter we’re also identifying new growth opportunities whether it would be China or ultimately Brazil or Russia or some place else. So that the next role continues to change as older stores, older markets become more profitable and new markets that have command its opportunity come into the picture. So we do expect year-over-year improving margins in the international segment but not as fast as you might expect, if we weren’t pursuing the huge opportunities in the international. Now we do expect to get margin improvement consistently as a total company namely from G&A level."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of John Glass with CIBC."
},
{
"speaker": "Q - John Glass",
"text": "Thanks, good afternoon. My question is on the rate of international unit growth, as though sets if you hit your goals and obviously we need to say you will, it will actually be the first year in which the percentage growth rate of international units is lower than the US. And I am just wondering why given your success in improving profitability, why has that decelerated the growth rate and should we expect an inflation point in the pickup in unit growth, anytime soon, maybe not just in China but in other areas of the world where you’ve obviously been successful?"
},
{
"speaker": "A - James L. Donald",
"text": "John, we don’t look so much at percentages as we do it at the number of stores and we’re confident that we’re going to hit this year’s targets for stores and hopefully you feed them and then each subsequent year, open more stores in almost all of our markets could certainly in total, then we did the year before and continue to ramp that up, particularly in our concentrated markets like the UK, Japan, China as it comes on and then Europe as well."
},
{
"speaker": "A - Howard Schultz",
"text": "But I would just say John, I wouldn’t look at it so much on the quarterly basis, it’s a timing issue on a lot of issues that relate to permitting a municipality, the long range plan as its said before, is at least 15,000 stores outside North America and we’ve been more infused or confident about the way in which we haven’t received and the ongoing profitability of the international business, so, I would be more mindful of it long term in quarter-to-quarter."
},
{
"speaker": "Q - John Glass",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Dan Geiman with McAdams Wright Ragen"
},
{
"speaker": "Q - Dan Geiman",
"text": "Hi good afternoon. Regarding roll out of the breakfast warming program how stores will it have expanded by the end of the fiscal year, do you anticipate and also do you anticipate the rate of expansion to accelerate in future years. Also any expectation and results on per-store basis are going to be comparable to what you’ve seen Seattle and Washington?"
},
{
"speaker": "A - James L. Donald",
"text": "Yeah, Jim Donald, we look for the results to be comparable to what we sold out and that’s between $25,000 and $30,000 a year annualized sales. We mentioned we’re rolling out Portland, Oregon today and they will have Chicago and San Francisco, so it rolls up to about 600 stores."
},
{
"speaker": "A - Howard Schultz",
"text": "At fiscal yearend an additional 400 down…"
},
{
"speaker": "A - James L. Donald",
"text": "About 200 currently in Seattle and Washington."
},
{
"speaker": "Q - Dan Geiman",
"text": "Okay great."
},
{
"speaker": "Operator",
"text": "Your next question comes from Steve Kron with Goldman Sachs."
},
{
"speaker": "Q - Steven Kron",
"text": "Thanks I had a question on speeder service initiatives, you mentioned Jim in your prepared remarks the point of sales scanner is introduced throughout the retail stores and improvement there, I was wondering if there was any way to kind of, quantify what effect that’s had on speeder service and on that topic, the expansion of breakfast and the role out that you discussed, we too assume that, in the current markets where you are testing breakfast, that it hasn’t been diluted to your service speeds. Thanks."
},
{
"speaker": "A - James L. Donald",
"text": "Second, I will answer the second one first, and that is correct it is not diluted to, we are talking about the speeder service, we have worked into the model, how the deployment works in those particular areas. So we are looking at, that overall in the first quarter we probably in terms of speeder service, we are 6% faster, however when I look at the scanner, it’s just one piece of what we call speeder service, other area is behind the bar that we are reengineering to including driver to continue to increase that speeder service. And when we look at our transactions growth, we are finding that, as we said this in the past that as lines moves faster they tend to kind of keep same amount of people and because they know they can get through, in that timeframe that is life for us and life for them. So we continue to tweak it along with scanners, with other operations as well."
},
{
"speaker": "A - Howard Schultz",
"text": "I would like to just add one thing from that previous question that, I didn’t get to the second half of, I think Larry Miller’s question about margins, as we add other things into out retail stores. The music the entertainment, the food products, don’t have this good gross margin, as it beverages the handcrafted beverages, but at the PC level at the store, they contribute strongly and they don’t have a negative impact on overall store markets. So it changes the composition a little bit, but overall it adds to the average check and increases the store product contribution proportion."
},
{
"speaker": "Operator",
"text": "Your next question comes from Matthew Difrisco with Thomas Weisel Partners."
},
{
"speaker": "Q - Matthew Difrisco",
"text": "Hi I also have a food question that relates right to the coffee company, but also wanted to have a food something that catching halt here. As far as incremental, looking at our incremental basis, what you’ve learned from the 200 or so stores that you are in now. If you can give subscription of how the bell curve looks percent of the sales that food presents on from those various markets that you’ve seen."
},
{
"speaker": "A - James L. Donald",
"text": "The food is the percentage of our business, continuous to increase with our new products offerings and looking at what we are doing with special platforms like better for you. So we are seeing an overall increase in food as it is today. We are seeing an incremental increase when you add on the breakfast involving sandwiches to this food category. So it’s a combination of both, and I thought you are going to go to where, how is the one with sandwich has been accepted which has been very well. But it’s not necessarily driving the food increase by itself."
},
{
"speaker": "Q - Matthew Difrisco",
"text": "Well I tried to get into is breakfast becoming incremental on top of food, or is kind of lies of in other foods so."
},
{
"speaker": "A - James L. Donald",
"text": "No, no it is incremental to that."
},
{
"speaker": "Q - Matthew Difrisco",
"text": "And what’s the high watermark that you’ve seen so far, best case scenario, best market that is gone to be as a percent of sale?"
},
{
"speaker": "A - James L. Donald",
"text": "Well I think, it bettered to take in terms of averages, and both the lunch program and the wine program, the benchmark is about $30,000 per store, per year."
},
{
"speaker": "Q - Matthew Difrisco",
"text": "And that’s probably right that’s not only…"
},
{
"speaker": "A - James L. Donald",
"text": "With out any material weakness in terms of speeder services, or the qualitative aspect of the customer experience."
},
{
"speaker": "A - James L. Donald",
"text": "And we look at that from a USD prospective to earnings per stores per day, and we find it, as we roll out if, from market to market that the executions gets better, the understanding of it gets better, we are sure to see that, just Michael said stay in that $30,000 year range."
},
{
"speaker": "Q - Matthew Difrisco",
"text": "Each individually 30,000 incrementally?"
},
{
"speaker": "A - James L. Donald",
"text": "Yes each store, correct."
},
{
"speaker": "A - Howard Schultz",
"text": "That’s lunch and wine."
},
{
"speaker": "Q - Matthew Difrisco",
"text": "Got it absolutely thank you."
},
{
"speaker": "Operator",
"text": "So your next question from Sharon Zackfia with William Blair."
},
{
"speaker": "Q - Sharon Zackfia",
"text": "Hi good afternoon. A question on the holiday, focus here that you made this year, can you maybe give us some perspective on what you saw most effective that was less effective than, what you might see you replicate going forward?"
},
{
"speaker": "A - James L. Donald",
"text": "Well obviously we have, irons that just blow out, and we have irons that do, what we considered to beyond our performance, but if I had to breakdown, I would tell you that, the chances of our entire holiday program starting with the execution that we delivered on store by store basis across North America, and we can figure and say on November 10 that all stores were set for holidays, meaning that all that playing well and had a time and make sure that our product was there, point of sale material in store sides, that I think led to an excitement from our store partners that clearly carry today and carry the momentum are going through. By don’t you look at what that, that merchandise mix was made up from beverages to food to job merchandise that‘s breeze to bears is some of our gifting that flowing to Starbucks gift card was there. And I got to tell you Christmas blend coffee, set record levels as well. It was just we hit out the part when it comes to the execution of a holiday and it is well tiny parts of blends we can probably do better than that we are currently working on."
},
{
"speaker": "Q - Sharon Zackfia",
"text": "Okay thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from David Palmer with UBS."
},
{
"speaker": "Q - David Palmer",
"text": "Hi guys, congratulations on that quarter."
},
{
"speaker": "A - James L. Donald",
"text": "Thanks."
},
{
"speaker": "Q - David Palmer",
"text": "Specialty revenue growth was, was pretty strong this quarter I thought and I would mistimed maybe tempted is the reasons why no craft noted in that very strong sales, at Seattle’s Best, Starbucks coffees and that its coffee sales for boosted, competitors having supply disruptions, I am just wondering if you think that this was unusually strong quarter for grocery roll out sales maybe because of some clear things like that and also I am wondering maybe even if your new discoveries ready to bring beverage in Japan was at any part of driver of that specially revenue line as well. Thanks."
},
{
"speaker": "A - James L. Donald",
"text": "The primary driver in specialty revenues for us was our licensing a retail store licensing which is the, build out of both Starbucks and Seattle Best license stores that was the primary factor. We also had a strong contribution from our food service business which is been a, 10% to 15% growth in last few quarter that grew between 15% and 20% this quarter and I hope, the grocery was strong and it, undoubtedly it sets craft attributed some of the two I’m sure this is contributes to that, but that was a relatively small part of growth in all specialty revenue."
},
{
"speaker": "Q - David Palmer",
"text": "Okay thank you."
},
{
"speaker": "A - James L. Donald",
"text": "I saw that as one of the thing, I think underlying the success of the holiday Christmas retail season and what you just noted in the specialty business. Its something that we kind of goes unset but I think its work repeating and that is the, the equity of the Starbucks brand, the power of the Starbucks brand in the marketplace coupled with the relevancy of the third place the sensuous community and how people are using our stores. The attachment that people have to, the Starbucks experience travels well beyond their experience in the stores and I think we are seeing the connectivity of the Starbucks brand in other channels of distribution and how people are trusting the experience beyond their stores. And I think it’s very different in traditional consumer brand that are, that have been dealt to advertising and promotion where Starbucks has build the brand in a very enjoying way almost quick essentially by the experience. And that is, and we are seeing the, the ongoing relationship of the brand and other products and other channels, that are parallel in success of our retail business."
},
{
"speaker": "Q - David Palmer",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ashley Woodruff with Bear Stearns."
},
{
"speaker": "Q - Ashley Woodruff",
"text": "Hi thanks. Just significantly expanded the entertainment initiative over the past several years and as you said soon you will be testing movies and probably more. And then could you talk a bit about how you balance from a time allocation standpoint managing the course Starbucks coffee brand operations versus analyzing the new initiative like entrainment?"
},
{
"speaker": "A - Michael Casey",
"text": "Well every thing that we do though is core to, what we are calling our Starbucks Coffee house experience our store retail store experience. And we are not trying own house in there, they are not necessary; they don’t necessarily compliment the customers experience. And so we work when we work with our operating team, we work with our implementation team; roll it down to store level. We are making sure that the execution is all in one and it’s all wrapped around, that customer’s experience. So they are able to tie that experience, with understanding about coffee knowledge, understanding how to juggle new beverages that might come out in spring versus fall versus winter and we tie all into one package. So they are able to, to juggle these and they should be bring out to provision. Howard, do you have any thing to add to that with the entertainment?"
},
{
"speaker": "A - Howard Schultz",
"text": "I would only say that the, the ongoing success we had with music and the initiative of the movie all of the positions that we are making on the content side is made with the launch of making sure that the music and the movie is accretive to the experience our customers have come to expect from Starbucks. We don’t want to do anything that would dilute the trust that our customers have in our company. And I think the first wave of all of that is with our partners. We want our partners to be proud of the music that we are choosing, and the movie that we are going to share with the American audience. And I think it’s linked to making sure that everything we do matters and it supports the foundation of the company and that is, we are not an entertainment company, we are not a music company, we are coffee company, we are creating opportunities that will complement the coffee experience."
},
{
"speaker": "A - James L. Donald",
"text": "And I want add to that, because of the excitement that was generated for the holiday said, by the execution that I’ve ever seen in retail, when we get our partners excited about it, they get tremendous buy and it keeps executed."
},
{
"speaker": "A - JoAnn DeGrande",
"text": "Operator we have time for one more question please."
},
{
"speaker": "Operator",
"text": "Thank you Ma’am and we now go to the line of John Ivankoe with J.P. Morgan."
},
{
"speaker": "Q - John Ivankoe",
"text": "Hi thanks very much. You know Howard I was, just thinking about the entertainment initiatives and specifically movies and I will then follow up on a couple of questions, and presumably you have to pick and choose the movies, coming Lions Gate as both of them dictating the movies that you are going to promote, could you discuss, I guess that’s selection process and whether its, in the script stage or if its actually in the finished product stage, kind of you an elaborate a little bit on the financials behind it, I know you mentioned in your prepared remarks that you will be responsible for the marketing cost, but is there any capital commitment at all, for the movie, and if I may, I think this is one question, is that, so we just assume at least for the time being in the current year music is, and I guess sales, CD format that we currently see in the stores is being relatively static, I mean have you done with that, we should expect a significant continued involvement of that piece of the entertainment strategy thanks."
},
{
"speaker": "A - Howard Schultz",
"text": "Okay, John it’s a lot of question."
},
{
"speaker": "Q - John Ivankoe",
"text": "Well, its kind of, its actually short if you think about, for just you, walk thorough how you go through this movies, thanks."
},
{
"speaker": "A - Howard Schultz",
"text": "Okay, let’s begin with, I think we believe that given the unique relationship we built with our customers around music, that we had built a level of trust that gave us the license to extend music to other forms of environments. So over the past 12 months, and maybe slightly longer, we have had ongoing conversations with multiple movie studios about trying to find a movie that would set with the aspirational story and the uplifting and a story that we felt needed to be told, and story that we thought we could get behind in a very natural seamless way. This particular movie was pretty much done when we saw it, we had screened many movies, we had read many scripts, this particular movie was almost completed. Lions Gate to their credit, although they are public company, it’s a more of an independent movie company, then say Warner Brothers they’ve great success this year past year with Crash, they understood the challenge of the movie industry in terms of box office problems, high marketing costs and saw right away, that Starbucks got involved in the movie that we could advance the rate at which people would go see it and potentially lower their marketing cost, what we wanted for that was something that mirrored what we did was Ray Charles, which was the template of our music initiatives. We wanted equity in the movie business, in the movie without investing any dollars in the movie itself. We agree that we would create a marketing campaign in store that was significantly less in dollars then we are going to get paid and we wanted to be able to participate not only in the front-end, but in the backend of the box-office received in all ancillary products if in fact the movie success is what we believe it to be. And this is a very important first step because, it sets the stage and the template by which other movie deals, assuming this will be successful will be judged. Since that time, we’ve many movie studios contact us wanting to be the next one, we are going to wait and see how we do with this, and as if fact, all the things that we hope to happen occurs. With regard to music this should not in anyway be a signal that we are done with music quite a contrary. Our music business continuous to be strong and healthy we have a new album coming out relatively soon with Surgio Mendes , we’ve got Tony Bennett coming out and we just had great success Dean Martin, believe or not during Valentine’s Day and we are full throttle on our ability to create a profitable stream of revenue for the company and a new channel distribution, what’s interesting about what we’ve done this year, as we also gave you are a market maker and discovering a group called Antigone Rising, they never had a record deal, they sold over a 100,000 units for Starbucks and we just picked to be the opening act of the balance of the Rolling Stones, that was attributable directly to the validation of Starbucks involvement. So we are a market maker, we’ve recognized the power of that, and also the responsibility we are going to look for ways in entertainment that are profitable, that are unique and add texture to the brand."
},
{
"speaker": "Q - John Ivankoe",
"text": "Thanks very much Howard."
},
{
"speaker": "A - Howard Schultz",
"text": "Thank you."
},
{
"speaker": "A - Howard Schultz",
"text": "I guess that does."
},
{
"speaker": "JoAnn DeGrande, Director of Investor Relations",
"text": "Thank you for listening into our earnings call today, we hope that you will join us for our webcast of our second quarter fiscal 2006 financial results, which will be on May 3rd, and note that at that time, that will be also include revenues figures along with Q2 results. Thanks again."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen we appreciate your joining us today, this does conclude our Starbucks first quarter 2006 earnings conference call. You may now disconnect."
}
] | null | null |
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