FOOL CONFERENCE CALL
By Dale Wettlaufer (MF Raleigh)
ALEXANDRIA, VA., (March 27, 1997) /FOOLWIRE/ -- On March 20, 1997, Broderbund Software reported fiscal 1997 second quarter results. On a conference call to discuss those results were Mike Shannahan, Vice President and CFO; Joe Durrett, CEO; and Bill McDonagh, Director, President and COO.
MIKE SHANNAHAN -- FINANCIAL REVIEW. "We reported a decline in revenue of nine percent, to about $44.3 million. Net income for the quarter was $3.2 million, which excludes a charge for the acquisition of Living Books. Including the charge, the net loss for the quarter was $3.5 million." Earnings per share (before the charge) declined to $0.15. Including the charge, EPS was a loss of $0.17. Revenues for the first six months were down 11%, to about $106 million. Net income declined, as well, to $12 million (excluding the one-time charge). Including the one-time charge, earnings were $5.4 million. EPS for the first six months of 1997 were $0.57 (excluding the charge).
During the quarter, Broderbund completed the acquisition of Random House's 50% interest in the Living Books joint-venture. The acquisition was accounted for using the purchase method and was accomplished with a combination of cash and the issuance of restricted stock. In connection with this acquisition, a portion of the excess purchase price [above book value] was allocated to in-process technology and was charged to operations at the time of the acquisition. The balance of the purchase price is included in "purchased technology" on the balance sheet and, consistent with other acquisitions, will amortized over a three-year period.
Also during the quarter, Broderbund repurchased 400,000 of common stock in the open market.
Productivity during the second quarter was down two percent and represented 51% of sales. Entertainment was down 33% and comprised 15% of sales. Education was up 22% and represented 25% of sales. Affiliated labels was down 34% in the quarter and represented nine percent of sales. On a year-to-date basis, productivity was up 11% and represented 51% of sales; entertainment was down 45% and made up 14% of sales; education was up 14% and comprised 22% of sales; affiliated label turned down 42% and represented 13% of sales.
Productivity revenues declined though unit volume grew 30%. "I think a lot of this had to do with the impact of dealing with issuing the Deluxe III and our Ensemble III version in the Print Shop line. Entertainment was down, but during the quarter, out unit volume increased 18%, which reflects the strong unit movement of Myst. Education was favorably impacted because of the acquisition of the Living Books joint-venture took effect on January 1, and so Living Books sales for two months of the quarter, as well as its expenses, were included in results. Affiliated labels declined primarily due to the decline in the number of entertainment products that we had in the first half of the year last year compared to this year."
Although gross margin was higher than historical levels, this quarter's gross margin on core products was down 6.5 percentage points from last quarter, which can be attributed to pricing decisions the company made going into the Christmas season. From the first quarter, gross margin was down two percentage points. For the balance of fiscal 1997, the company believes gross margin will be in the 70% range, based on pricing and on the mix of published titles to affiliates, which the company believes will remain low in the overall sales mix. Operating expenses for the quarter were $25.4 million, including Living Books expenses, which were down from $25.8 million in Q1, but up significantly from the same quarter in FY 1996. Those increases are due primarily to sales and marketing, where the company is providing additional funding into the channel, as well as increases in R&D, which (in addition to Living Books) has also increased due to the number of products in development.
Looking forward for the balance of 1997, the company expects its operating expenses to remain about the same as the Q2 level, rather than following the normal seasonal decline, due not only to the addition of Living Books, but to the number of releases Broderbund has scheduled for the remaining half of the year.
Non-operating income was $1.5 million during the quarter, due somewhat to a decline in cash balances. In the past, Broderbund has had equity and earnings of Living Books on the balance sheet and in non-operating income line of the income statement. Income tax rate was 19.8%, due to accounting for the acquisition and the write-off the in-process technology. Excluding the write-off, the tax rate was 38.5%. That tax rate was consistent with the first quarter and should remain at that level through the balance of the year. That rate is somewhat lower than last year because of higher tax-exempt income as a percentage of pre-tax earnings.
Cash at the end of the quarter was $144.5 million, down $4.6 from Q1. However, included in the quarter was the repurchase of 400,000 shares as well as the cash portion of the Living Books acquisition. Accounts receivable at the end of the quarter was $13.1 million, down from $33.7 million at the end of Q1, reflecting seasonally strong collections. Days-sales-outstanding are still less than 27 days.
JOE DURRETT. "First, let me give you a little bit of context.... Last spring and summer, Broderbund assessed its situation and the company reached several key conclusions: 1. It concluded that at its then-current pricing, it would have a difficult time maintaining, and muss less building, market share on a unit or a physical basis." While revenues may have benefited from holding prices up in the short-term, "over the long-term, it was decided that it would be a poor choice as much of the company's strength depended on what we call evergreen products -- Print Shop, Family Tree Maker, 3-D Home Architect, or Carmen San Diego. These are products which enjoy substantial volume and profit from consumers' willingness to purchase the upgrades and revisions to these titles. Thus, it was decided to take significant reductions in pricing, as well as to introduce some additional sizes of the existing titles, which gave consumers some less-expensive entry points into our core product segment. 2. Broderbund recognized that significant fluctuations in the company's business over the year and the prior year have been a result of the successful Myst launch, which was difficult to replicate. Thus, the company reached the decision that, while maximum effort would [go into] assuring that the Myst sequel would be published in plenty of time for merchandising for the Christmas 1997 season, the company would also set out on an ambitious plan to field a number of potential games successes for the late summer and early fall of 1997. These would supplement the Myst sequel and provide a broader revenue base in this largest segment of the consumer software market, which, if successful, would lessen our dependence on Myst."
"3. With reduction in revenue due to the planned price decreases, we needed to make certain that our product flow was strong in every other area and that our overall offering was advantaged vs. competition in key core categories from a standpoint of product features. 4. The company knew it needed to change it culture. We knew we needed to move toward a culture of greater time urgency, consumer awareness, and a stronger work ethic, so that the demand for the timely and excellent product flow that we needed would be met. We also knew that we needed to do this in a way that would achieve change quickly but would not scare employees into concluding that they could not adapt to the new demands of Broderbund."
"Against these four conclusions, our point of view is that Broderbund has actually executed very well -- in fact, surprisingly well. If you did not know that we had recorded disappointing financial results for the second quarter, and if you were inside our offices and you were aware of the daily progress we were making in meeting our goals, you might conclude that we were clearly achieving the business improvement that we had sought. We see that as the correct conclusion -- we are achieving significant improvement in the fundamental health of our business. We are achieving the product development milestones and we are changing our culture to one of greater and faster accomplishments. So then, how can we say we are on target to execute a significant business improvement if we just missed the second quarter financial goals? Isn't the second quarter disappointment an indication that the business turnaround could be failing? I don't think so, and let me talk some more to let me tell you how I'm feeling about that."
THE RETAIL CHANNEL. "Let's look at the results of the second quarter. I'd like to focus on the consumer sell-through for the period of November through January, 1997. During this period, Broderbund executed its pricing reductions and introduced each of its planned new product launches and sold record-breaking numbers of its products in each of its core segments. In our education segment, Broderbund titles increased unit volume by 44%. Entertainment, despite Myst being in the fourth holiday season, unit volume sell-through advanced 12%. In the productivity area, unit volume advanced 68%. In total, Broderbund reversed over nine months of declining trends and built unit share during this seasonally important three-month period. We believe this achieved our first goal of growing our user base, which is so important to the long-term vitality of our type of business."
PRICING. "Many of the press reports on Broderbund in recent weeks have cited competitive pricing as being the driver behind our disappointing second quarter financial performance. While that is true, that could imply that competitive prices limited our unit sales, and that's note the case. As we said earlier, our unit volume moving to the consumer has been very strong. We think that the proper distinction is that Broderbund probably took its prices down more than it needed to in order to achieve the goal of holding its unit volume share, and the unit volume growth of the last quarter bears that out. To a significant degree, then, much of our disappointing financial performance of the last quarter was somewhat self-inflicted... The average selling price during the November-January 1997 period for all titles -- no matter what type -- in the consumer software industry, was $32.83," down 1% from last year. Broderbund's average selling price during that period was $32.12, a 33% decrease from a year ago, "...despite our premium quality positioning...." "While a higher price could have depressed unit volume some, our judgment is that we could have had a higher price, still maintained unit share, and probably achieved better financial performance.... Pricing in an industry that is as new as software is far from an exact science, and without better knowledge, we would probably take the same step again today since we wanted to achieve that all-important goal of protecting that business consumer preference for titles."
"Our job now is to achieve a better balance of unit movement and profit achievement. This is not going to be easy. Many of the key retail merchants are going to fight our efforts to restore prices. On some titles, we are going to have to wait until a revision comes out or we have an upgrade or we have a sequel that is an opportunity to add price-points. This fact will have an important effect on delaying the financial aspects of our business turnaround. So while we believe that we're on target with nearly every other aspect and milestone of our mission to get Broderbund back into a healthy growth stripe, our low retail prices and the resistance of the retail trade to upward movement on those prices will be a financial drag in the coming months."
NEW TITLES. The company's second goal is to develop a successful line of entertainment titles to accompany the Myst sequel and build a stronger entertainment division. "We are on target. We're in the numbers, where we want to be. Our products have been issued on time, and any milestones for those that haven't yet been shipped are being met. Next month, we'll be shipping 'The Last Express,' a new title, to American stores, and this week, we're holding a major introduction of 'The Last Express' in Paris, France for the European trade. Sell-in is strong, reviews are good, and we expect solid business performance. Additional entertainment titles will be shipped later this summer and early fall, and each is, so far, on time. Because there have been no production delays, we may consider purposefully delaying one of our titles this fall to January to help balance our launch activities..." The sequel to Myst -- Riven -- is also on time. The company is planning extensive launch marketing for the sequel. The ship date is targeted for August, the final month of the fiscal year. There is nothing that the company knows of that will present a problem for the launch and marketing push for the 1997 holiday season. Major retailers are reserving time and space for this release to make it "their consumer software focus this fall." For internal planning purposes, Broderbund assuming Riven ships in the first quarter of 1998, which begins in September.
As for the third goal of overall product flow and competitiveness in overall product offerings, "we are on target with our plans. This first we introduced the revised version of 'Where in the USA is Carmen San Diego?,' which accompanied the earlier summer launch of 'Where in the World is Carmen San Diego?' Both titles were well merchandised and have reinvigorated this line. We also introduced last quarter the 'Williams Sonoma Guide to Cooking,' which quickly became the leading cooking title. Six additional 'Family Tree Maker' were launched, and Living Books...placed 'Stellaluna' and 'Dr. Suess's Green Eggs and Ham' on the store shelves."
"In the coming months, we are going to bring out additional titles beyond the previously-mentioned 'Last Express.' There will be stronger production from Living Books -- we have additional Carmen San Diego titles scheduled which will take advantage of this consumer franchise in some new subject areas, something we're very proud of. An interior decorating title will be on shelves to accompany our exterior architecture title, which will itself be revised for new features. Family Tree Maker will issue a major upgrade. Print Shop has been, and should continue to be, very aggressive. We are right now shipping a new Print Shop product called 'Press Writer,' which helps our customer base produce new fliers and brochures. Unlike more complicated products such as the Microsoft Publisher, our 'Press Writer' has the same simple kind-of easy look and feel that has made Press Shop the leader in the consumer desktop publishing business.... We have redefined our Print Shop arena to better respond to the overall graphic and electronic communications needs of our customer base, who have learned to trust us for easy-to-use, no surprises way of doing things. We clearly have strong anticipations for our Print Shop line in the months to come."
BRODERBUND CULTURE. "On changing the Broderbund culture to one of greater performance without unnecessarily scaring the employees: We think we're on the right track here, but probably the only way you will know is to judge us by the steady and timely stream of product development milestones and by listening to what we say. Here's what I can tell you: Management is more involved than ever in the daily workings of this business. We have changed our organization structure to move to focused, product-oriented business units so that there will be better focus on the consumer, greater coordination between marketing and product development on the product quality and consumer targeting, and enhanced responsibility for the commercial consequences and the daily allocation of resources." All employees receive options, but "we are focusing on meritocracy, in that only the best-performing employees will receive annual increments. Next week, we will have our first in recent history all-company meetings so that the entire organization will be together under one roof to better understand our strategies and their roles and our goals. We think we're doing the right things here."
OTHER INITIATIVES. "In addition to this report on where we are, I believe that there at least two other subjects which we judge you will want to be aware of when you assess Broderbund. One is the subject of our vision for new business in the future. The other is the more close-in guidance you will want for your assessments of our short-term financial prospects.... 1. We are attacking Internet opportunities like never before. In each of our established segments, we are succeeding with formulas which make sense, and in the next six months, you will see active Internet offerings in our entertainment segment, for our Print Shop line of products, and for our Family Tree Maker geneology products. 2. As you might know, we also established last year an online venture fund so that we could become closer to Internet opportunities. This venture fund has paid off, not only in teaching us about investment opportunities, but it's also paid off in spurring us import our learnings into our established businesses. We are spending substantial time in developing better alliances with other companies where we believe that those associations can help us strengthen our core business. Some of these alliances may ultimately involve financial linkages -- others will not. We should be announcing some of these in the months ahead. 3. We have established a small group of managers, who are very clearly focused on identifying good commercial opportunities for us in clearly new businesses, which will most often take advantage of some existing Broderbund expertise, but will also allow a new field of opportunity. Once again, we are making good progress and we will be announcing some of those new directions in the months ahead.
GUIDANCE. "At the risk of disappointing you, we may be unable to be too comfortable on this call. On one hand, we are very confident that we are going to have a solid business underway by the first quarter of next year -- nothing changed. On the other hand, we know that we will be less successful until then from a financial standpoint, primarily because we anticipate that we will have difficulty boosting our prices to target levels. We are also sufficiently excited about these new product plans we're putting together that we choose to re-invest some of our earnings in greater support for these new products. From a revenue standpoint, we can tell you that our target for the balance of the year will be moderately less than [some of analysts'] models, but we do not anticipate a significant departure. What we are purposefully being tentative about at this time is earnings. Very simply, we are looking at our plans for the forward months, and if we believe that Broderbund will be stronger throughout 1998 by a greater expense investment for the balance of this fiscal year, we are going to take that choice."
QUESTION & ANSWER SESSION. Gross margin of approximately takes into account a continued decline in affiliated labels as well as treating Living Books as a core product family. Operating expenses will be flat on a dollar basis for the next two quarters with Q2 levels, but not necessarily on a percentage basis.
Living Books should not be a drag on earnings, even with amortization. There is a still a facility that the company is evaluating, but the company believes it knows how to handle the product line, expenses, and how it will be incorporated into Broderbund operations.
The company believes maintaining new customers and retaining new customers is very important, hence the unit share and product strategy. The company was concerned that other companies would take market share just through pricing and that could impact Broderbund over the long-term. In the next fiscal year, the company believes it will be gaining on dollar share.
Expense levels are reaching a level that might be higher than planned. Seasonally, operating expense falls off in the second half of the year, but in order to maintain presence with mass merchants, Broderbund will continue to provide them with funding. It's not a foregone conclusion that operating margin will drop next year -- budgeting will be looked at from the standpoint of trying to maintain historical operating margin of 20%. A lot of that will depend on efforts to get pricing back to a premium to that market, but certainly not to there they were a few years ago when the market was less crowded.
The company expects to see an increase in entertainment and some improvement in education, with the impact being a reduction in productivity as a percentage of overall revenues. Living Books expenses are not terrible significant in the overall cost structure, though the company is working on reducing operating expenses in that area.
The company doesn't think the first two months of operations at Living Books is indicative of what will be seen in the third or fourth fiscal quarters.
Europe is a strong entertainment market -- that's one of the drivers in the company's strategy to expand there. Europe should start to show some significant growth with the strong Q4 and Q1 lineups.
The 400,000 share buyback was made in part to prevent dilution coming from the Living Books acquisition. The company is still looking at further share buybacks in future quarters.
The Riven publishing structure is the same as the Myst structure.
The reserve level this quarter is exactly the same as what it was last quarter, which did impact gross margin. Going into the last two quarters, the company said it would issue price protection in connection with its unit growth strategy. With the older Print Shop lines, those products will come back from the channel. There's nothing wrong with those products, which have been revised, and the company thinks it can find alternative markets for those. With a reserve level of $33 million, the company believes that it has sufficient reserves to protect against a write-down.
Competition in the channel remains "quite severe." -- competition for shelf space, mind-share, promotional dollars, end-caps, pallets, etc.. There are only half a dozen or so major channels of distribution that are moving the vast majority of software today. The company "is getting more than its fair share out there," but it's cost a little more than the company expected. The company doesn't have a single account that accounts for more than 10% of revenues.
Reference is an area that the company has looked at, but has not found anything yet, despite the potential of that market.
The company is somewhat insulated from employee competition being in Marin County and not in Silicon Valley, however, they experience this all the time with such a mobile workforce. The company has had a few defections in the last six months, which it would rather not discuss. For the most part, though, the company has a committed workforce, and turnover has not changed since the company started to experience competition.
Broderbund sees DVD as an opportunity, in the productivity area with the large content and with reference. With video games, the company may license, and with future titles, may think about that market more.
By the time the company completes the fiscal year, Living Books should be in-line and generating a similar return. For the balance of the fiscal year, the company expects to run the unit at break-even, including amortization, which will run about $425-450,000 per quarter.
* A Fool conference call synopsis represents an effort to highlight the salient points of a conference call and should not be taken as an authoritative accounting or transcription of the entire event. Note: Statements made by a company other than historical information may constitute forward-looking statements for which the company can claim protection under the Safe Harbor Act. Please consult the company's filings with the SEC for information on risk factors which might cause actual results to differ materially from the information contained in these forward-looking statements.