Getty Reports Record Revenue For Q2 2006

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July 27, 2006

Getty Images reported record revenue for Q2 2006 of $204.8 million compared to $185.3 million for Q2 2005 and $200.9 million for Q1 2006. Excluding the effects of changes in currency exchange rates, revenue grew 12.8 percent. As a percentage of revenue, cost of revenue improved to 24.8 percent compared to 26.7 percent in the prior year.

Despite record revenues driven by growth in every region and every product line, for the third quarter in a row, the market punished the stock and drove it down to $45.12, an 18% drop, by the end of the first business day after the announcement. This is a more than 50% below the stock's high in November 2005. The stock hasn't been this low since December 2003.

Revenue grew 10.5 percent over Q2 of 2005. and 17 percent on a currency-neutral basis. As a percentage of revenue, cost of revenue improved to 24.8 percent compared to 26.7 percent in the prior year.

Income from operations was $39.7 million, compared to $55.5 million in the second quarter of 2005. Excluding $22.5 million for stock-based compensation and a non-cash loss on subleased property in New York, income from operations increased 11.3% to $62.2 million in the second quarter of 2006, or 30.4 percent of revenue, compared to $55.9 million or 30.1 percent of revenue in the same quarter last year.

Earnings per diluted share were $0.35. Excluding stock-based compensation, the losses on subleased property in New York and on the sale of short-term investments, earnings per diluted share were $0.64.

Net income for the second quarter was $22.3 million. Excluding $17.9 million for stock-based compensation, the non-cash loss on subleased property in New York and the loss on the sale of short-term investments, net income was $40.2 million or $0.64 per share. Excluding $3.5 million for the accelerated amortization of debt issuance costs and stock-based compensation, net income was $37.5 million or $0.58 in the second quarter of 2005. Excluding these items, net income grew 7.2 percent and earnings per diluted share grew 10.3 percent. The loss on subleased property in New York and the losses on sale of
short-term investments were announced by the company on May 23, 2006.

Net cash provided by operating activities was $121.4 million and the acquisition of property and equipment totaled $35.1 million in the first six months of 2006.

Cash and short-term investment balances were $259.5 million at June 30, 2006, down from $522.5 million at March 31, 2006. Net cash spent on acquisitions of businesses and share repurchases was $307.3 million during the second quarter of 2006.

Share Repurchase

During the second quarter, the company repurchased 2.5 million shares for a total of $161.4 million, representing approximately four percent of outstanding shares. Subsequent to the end of the quarter, the company repurchased an additional 214,000 shares for a total of $13.6 million leaving $75 million remaining under the $250 million share repurchase authorization.

Business Outlook

For the third quarter of 2006, the company expects to report revenue in the range of $205 million to $210 million and diluted earnings per share of $0.64 to $0.66. Third quarter diluted earnings per share guidance excludes approximately $0.04 related to expected stock-based compensation.

For all of 2006, the company dropped its estimates given in the previous quarter from $830 million to $850 million to a range of $820 million to $830 million, and diluted earnings per share of $2.63 to $2.70 (See Story 827). Full year earnings per share guidance excludes approximately $0.16 per share for stock-based compensation, and a total of approximately $0.25 per share for the loss on subleased property in New York, and loss on the sale of short-term investments.

Company guidance assumes approximately 60.7 million fully diluted shares in the third quarter and 61.7 million fully diluted shares for the full year.

Revenue Breakdown

The above percentages translate into the following dollar figures for the last nine quarters (in millions of dollars).

Stock Revenue As Percentage of Total Revenue

Image Used Chart

** Note: In order to determine the revenue generated by single image RF sales, it is necessary to deduct the amount of RF revenue generated by CDs, DVDs, Virtual CDs, Subscription and Micropayment sales. The numbers in this column reflect total revenue for single image sales. The revenue from "Other RF" (not single image licenses) was 16.2% of total RF sales in the quarter.

**** Note: The average price per image data is global as of Q1 2004. Prior to Q1 2004, the PPI data reflects the total Americas and EMEA only

What's Happening to Royalty Free?

In the conference call Jonathan Klein, co-founder and chief executive officer said , "At the beginning of the year we set ourselves high expectations for 2006 and these stretch goals are not being achieved largely due to the under performance in one area of our business" (Royalty Free). He further explained, "the company's most important challenge is Royalty Free volumes in the United States."

In the first quarter RF volumes were down 6% in the U.S. versus the prior year, but the second quarter was much better with volumes essentially flat compared to Q2 last year. According to my calculations Q2 2005 RF worldwide volumes were 264,622, but there is no way to break out the U.S. portion of that. In the last two quarters worldwide volumes dropped 8% from their previous high in Q3 2005, but this quarter those volumes rebounded 11% reaching a new high.

It is getting harder and harder to calculate growth in volumes and revenue in the Royalty Free sector. On the face of it $78.23 million was a significant increase from the previous quarter of $73.53 and $70.6 million a year ago, but in the past year micro payment and Subscription (MP&S) have been added to the RF mix. And Getty has acquired two major Royalty Free brands - Digital Vision and Stockbyte - which should have pushed volumes up somewhat.

In Q4 2005 13% of the RF revenue came from CD's and Virtual CD's and the rest from single image sales. Then in Q1 2006 the company included Subscription and Micro Payment in the gross number and the percentage of non-single-image sales jumped nicely. If we assume that the CD revenue remained at about 13% of the total, that would make the total for Q2 2006 $10.l6 million. The total non-single-image revenue was actually $12.67 million leaving $2.51 million for the MP&S revenue.

The problem with this number is that one investment analysts has reported that Getty has said iStockphoto had the potential of licensing 10 million images this year at an average price of $2.00 each or $20 million in total revenue. The $2.51 for a quarter is only about half of what might have been expected from iStockphoto. One explanation for this could be that the revenue for CD's was under $8 million instead of over $10 million. That would also be understandable given the 20% discount in price that Getty offered across much of the market for the entire quarter. In fact, if all CD's of the Getty owned image brands were 20% cheaper than they were the previous quarter selling roughly the same number would explain a $2 million loss in revenue.

It also seems likely that most of the discounting was on CD's, not single images because the average single image price dropped only 5% to $241 per image and Getty sold significantly more units.

(It should be noted that average price-per-image is based on revenue from single images licensed through company owned offices and distributors, excluding imagery licensed through delegates. As a result when I divide the price-per-image into the total global single image revenue my number of images licensed will always be slightly low due to the fact that Getty's PPI data is calculated on revenue excluding delegates.)

In the past Getty might have solved the problem of relatively flat RF sales by raising unit prices, but this time that doesn't seem to be an option. Recently, Piper Jaffray & Company conducted a survey of 197 image buyers and the results indicated that Getty's high pricing is alienating some customers. Before the only alternative a customers had was to look for RM and try to negotiate the price down. Now they have the MP&S options and Getty certainly doesn't want to push more customers to consider that option.

Normally, Getty has announced price increases in January and July. After a modest price increase in January they announced that there would be no price increase in July. And they have had a four month 20% off sales in certain segments of the market. It looks like RF may be priced about as high as it can go.

It is also worth noting that an almost a full quarter of Stockbyte and a full three months of iStockphoto (as compared with the two months in Q1) only added $4.7 million to the RF bottom line. Getty is certainly getting very little bump in revenue for the $185 million it spent to acquire Stockbyte and iStockphoto.

Are Micropayments The Problem?

There is concern in the investment community as to what is causing this slight decline, and more to the point why the expected growth is not continuing. Many question whether micro payment and subscription options are beginning to cannibalize traditional RF.

Klein acknowledges that micro payments "has and will continue to impact some portion of our business." But, he pointed out that, "Only 8% of the iStock customers are Getty Images customers." While this number is interesting, there are several other important things to consider to really understand what this 8% might mean.

Who are these customers and how many images do they use both from Getty and from iStockphoto in an average year? How many customers does the 8% represent? (It is easy to understand why for competitive reasons Mr. Klein does not provide this degree of granularity.)

If the 8% is made up to a large extent of Getty's major customers the actual numbers of images they license could be much higher than 8% of iStockphoto's totals. If these customers currently use a significant number of traditional RF images then they might learn in a short period of time that images from the micro payment sites could satisfy a large percentage of their RF image needs.

On the other hand if each of those customers happens to only buy one or two RF images a year from Getty Images then the fall out if they switch is likely to be very minimal. In the short term whether or not the 8% rises may be less important than how the buying habits of the 8% change.

For example, I know one web developer who is buying about 150 images per year from iStockphoto. If he represents the average user (and only Getty and iStockphoto know) then iStockphoto would have about 66,000 customers. 8% of that would be 5,280 and Alan Meckler says it is generally agreed that there are 4,000 major customers in the world. Are all those 4,000 included in the 8%?

But also consider this web developer's options. If he were to get all his images from the cheapest RF brand on the Getty site it would cost him $55 each or $8,250 for the year. With some brands the smallest resolution file costs $160 each. If he gets 150 images from iStockphoto, or one of the other micro payment sites, his costs would be $150 per year. That's a significant savings on stock photography and there is a good chance all of it will end up as part of the web developer's profits. Such users are not likely to be converted to a higher priced product and web developers are the fastest growing segment of stock photo users and the ones who need the smallest file sizes.

From looking at the available numbers, I can't see much indication that micro payments have had much impact on the traditional RF market yet. Logic tells me that eventually they will, but the question is very open as to how much and how soon.

Klein says, "It would be wrong of me to say micro payments are not an issue. And it would be naïve to suggest that the 8% will not increase slightly over time. We feel very strongly that there is room for all these different models." He also indicated that soon Getty Image will be launching another pricing model that will add to all those that are already there.

He continued, "I remain more optimistic about our industry, the growth prospects for imagery and our place in the industry than ever before. I'm also yet to find anyone who disputes the simple assertion that the world will continue to consume more and more imagery in more and more places delivered as well as sourced in more and more ways."

While not disputing that position, just because there are more and more people using images, it does not necessarily follow that the gross revenue that will be generated will be greater. If iStockphoto is downloading 10 million images it is easy to see how the total micro payment industry might be downloading 30 million. That's a lot more than
Getty's 1.5 million a year. At an average $2.00 per image the 30 million downloads could represent $60 million. But if those who formerly bought RF images at $90 or more can find one-quarter of 1% of what they need on the micro payment sites the stock photo industry as a whole will lose money. It seems likely to me that customers will find a good deal more than one-quarter of 1% of what they need on the micro payment sites. Given the huge price differences more users, (more "eyeballs") doesn't necessarily mean more revenue.

Klein also tries to dismiss critics by pointing out that ten years ago when RF was introduced many were concerned as to whether RM would disappear as a licensing model. He says, "As you know, RM is thriving and continues to be an important part of the industry and our business. So over time it is clear that there will be some movement to micro stock but it is also clear that it will not be some sort of tsunami that drives away the other licensing model."

When RF came on the scene no one had any clear idea of how much revenue this industry was generating so no one can say whether the total industry revenue has declined or not. It is impossible tell whether the amount lost in RM revenue is greater than the amount gained in total RF revenue.

Also, when RF came on the scene it took several years before the majority of high end photo buyers accepted the idea that RF was a legitimate replacement for RM in many situations. Now they use RF some of the time. I fully expect that adoption to occur much more rapidly this time around because the leap or RF from one price point to RF at another is a much easier jump to make.

This time around, because so much of the industry is owned by three major companies, we have a much better idea of what total industry revenue might be. This time we should be able to tell whether more users actually results in more revenue.

Resetting The Bar On Future Growth Expectations

During the conference call Peter Appert of Goldman Sachs asked Jonathan Klein, "Have you given any thought to resetting the bar in terms of your long term growth expectations, specifically you talked about 15% top line and 25% bottom line. They seem like a bit of a stretch at this point.'

Klein answered, "At this point we are not specifically outlining growth expectations for 2007 and beyond. But, it would be naïve of me to suggest that those are still attainable in the short term. And if you look at the guidance you'll see that the EPS guidance for this year assumes currency neutral EPS growth of between 18% and 21% for the full year. There is no question that we have not achieved the 25% EPS growth that we had aimed for currency neutral in 2006. Last year EPS grew 33%."

"Conditions have got more difficult in one area in particular, business is extremely strong, but those very ambitious goals will take us a little longer to achieve."

Royalty Share

Almost the entire "Cost of Revenue" for the company is royalties paid out to image suppliers. Recently Getty decided to report this cost of revenue as a percentage of total revenue for each line of business. Below I have broken these percentages down into real numbers in millions and also provided an average total royalty in percent.

Photographers should recognize that in some cases this percent is being paid out to a third party provider and the amount the photographer receives will actually be much lower, minus that 3rd party partner's share. Also, some of the money that Getty reports comes from distributors and delegates. In those cases the distributors has taken a share of the gross sales off the top and the figure Getty reports is not the gross paid by the customer to use the image.

This quarter the percentage of total revenue paid out by Getty in royalties was 24%, down from 26% in the previous quarter. The improvement was driven by the recent acquisition of Stockbyte's wholly owned content and by the creation of other wholly owned content.
During the conference call Klein was asked about the overall costs of sales (royalties paid) for the company and he said, "I'm extremely bullish" about being able to cut the costs even further.

SG&A

Selling, general and administrative expenses (SG&A) were $77.9 million compared to $64.9 million in the second quarter of 2005. Excluding stock-based compensation of $3.9 million in the second quarter of 2006 and $0.4 million in the second quarter of 2005, SG&A was 36.1 percent of revenue in the second quarter of 2006 compared to 34.8 percent in the prior year.

Geographic Breakdown

The percentage of revenue from both EMEA (Europe, the Middle East and Africa), and Asia was up during the quarter while the percentage of revenues for the Americas was down. In real dollar terms total U.S. revenue was down more than $3 million. The rise in Europe was due mostly to currency exchange rates as the actual number of units licensed because so many people stopped working in June to watch the World Cup.