DTS, Inc. Q1 2006 Earnings Conference Call Transcript (DTSI)

Executives

Jon Kirchner, President and CEO

Mel Flanigan, Chief Financial Officer, DTS

Vanessa Lehr, Investor Relations

Analysts

Ralph Schackart - William Blair & Company

Gene Munster - Piper Jaffray

Paul Coster - J.P. Morgan

Robert Stone - SG Cowen & Company

Gordon Hodge - Thomas Weisel Partners

James Padgett - Founders Asset Management

DTS, Inc. (DTSI) Q1 2006 Earnings Conference Call May 8, 2006 6:00 PM ET

Operator

Good afternoon ladies and gentlemen and welcome to the DTS First Quarter 2006 Conference Call. At this time all participants are in a listen-only mode. Following today’s presentation, instructions will be given for the question and answer session. (Operator Instructions). As a reminder this conference is being recorded today Monday May 08, 2006. I would now like to turn the conference over to Vanessa Lehr with the Blueshirt Group. Please go ahead ma’am.

Vanessa Lehr

Good afternoon and thanks for joining us, as we report first quarter of fiscal 2006 financial results for DTS. Joining me on the call today are Jon Kirchner, President and CEO; and Mel Flanigan, CFO of DTS. Before we begin, let me remind you that during this conference call, management may make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to known and unknown risks. Uncertainties or other factors that may cause the company’s actual results to be materially different from historical reports or any results expressed or implied during this call. The potential risks and uncertainties that could cause the actual results, growth in results to differ materially include, but are not limited to the rapidly changing and competitive nature of the digital audio consumer electronics and entertainment market. The company’s inclusion in and/or exclusion from governmental or industry standards, acceptance of the company’s technology products, services and pricing, risk-related to the ownership and enforcement of intellectual property that continued release and availability of entertainment content containing DTS audio soundtrack, risks relating to integrating acquisitions and changes in domestic and international market and political conditions. The information in this conference call, related to projections or other forward-looking statements is based on current expectations. The company expressly disclaims any responsibility to update forward-looking statements, certain circumstances change.

Managerial discussion on this conference call also includes financial measures for non-GAAP net income and earnings per share. They cannot be calculated in accordance with generally expected accounting principle. The company believed that non-GAAP net income and earnings per share which includes stock-based compensation expenses, enhances investor’s ability to evaluate the company’s operating results and compare current operating results with historical operating results prior to the adoption of FAS 123R. A reconciliation between non-GAAP and GAAP measures can be found in the table that accompany the company press release that was issued earlier this afternoon and which is also posted on the Investor Relations section of the company’s website at www.dts.com or on Yahoo Finance. Now, I will turn the call over to Jon Kirchner, President and CEO of DTS. Jon, please go ahead.

Jon Kirchner

Thanks to all of you for joining us today as we report our first quarter performance. As you know from our press release, we reported strong financial results. Revenue increased 30% over the prior year to $28.7 million. Earnings per share were $0.38 and non-GAAP earnings per share were $0.40. Non-GAAP EPS excludes targets associated with FAS 123R. Revenue on EPS were both well above the outlook we provided last quarter. We had good execution across our businesses and are pleased to report a strong start to 2006. On our consumer business, we posted 25% year-over-year growth due to strength and royalty recoveries as well as good growth in the auto and PC markets.

In royalty recoveries, much of our work over the past year has been focused on improving complaints in the IC supply chain which we believe will result in improved revenue realization and should have a positive impact on our growth. This is especially important as we transition to the high definition formats where DTS has included as a mandatory standard. For those of you that are not familiar with the standards, DTS technology as a mandatory requirement in both the HD DVD and Blu-ray drive specifications. As the next generation products come to market, we expect to receive revenue for every PC, auto, game console, player and receiver that is shipped with an HD or BD drive.

In the PC market in the first quarter, we further expanded our licensee base and increased the number of products that are now offered with our technologies. Our outlook for growth in the PC segment is positive in the near-term based on this increased activity. For the long-term, with our mandatory inclusion in the next generation standards we expect even greater growth opportunities.

In the Car market, the industry is increasingly including our technology as a standard feature in in-dash video systems which along with allowing for easier installations, is helping to broaden adoption of DTS Technologies. Additionally, we are seeing growth in the OEM channel as major manufacturers release more vehicles with DTS as a standard feature or a factory sound upgrade option.

Our home AV business posted modest growth in the quarter, in line with our expectations and in line with industry trends. This market has been slowing as DVD penetration rates increase globally and more recently as consumers wait for next generation optical media formats. To that end, we have seen the first shipment of HD DVD players which sold quickly and are now on back order. This marks the beginning of DTS’s revenue cycle from these next generation products. With regard to the Blue-ray disk format, player shipments are scheduled to begin in June.

On the content side, content providers are expected to announce more active release plans to support these new player formats as we enter the summer months.

In game consoles, Sony has announced the launch of the PS3 in time for the holiday season. You may recall that the PS3 has been reported to include a Blue-ray drive which means it will carry DTS capabilities. In addition, Xbox has now announced that it will support HD-DVD drives marking an additional opportunity for DTS in the game console market.

Turning to the broadcast market, during the quarter we worked together with Linear Acoustic to develop and demonstrate hardware and codec products that enable high quality audio for broadcasts. In addition, with our partner coding technologies, we recently gave you the solution for highly efficient 5.1 multi channel sound for HDTV broadcasting. These solutions will deliver a complete feature set to address the contribution, distribution and emission of digital audio in broadcast environments.

Market interest has been positive and we continue to work with costumers that demonstrate and test our products. In summary, in the consumer business, we are encouraged by what we believe is increasing momentum in the high definition cycle which we expect will drive significant growth in our business over the long-term. For fiscal year 2006, we are forecasting a modest revenue contribution from the new high definition formats.

In our Digital Images business, we completed the bulk of the James Bond project which covered 20 titles. The substantial amount of our capacity has been occupied by this project since we closed the acquisition over 1 year ago. In the first quarter, we recognized $2.6 billion in Digital Images revenue including approximately $1.4 million in revenue from the Bond project. With the Bond project now behind us we have freight capacity to pursue higher margin work and film restoration and image processing.

In our Cinema business, we had better than expected film licensing activity due to a strong release slate in the quarter. In addition, we continued to post solid performance in sales of our XD10 Cinema Media Players and completed the pre-show project for Cinecom in Switzerland. The completion of the Cinecom project marks a major milestone. There is now nationwide digital pre-show network in operation with more than 400 DTS XD10 units providing an enhanced feature set for premium quality digital content delivery.

At Show West in the first quarter, we had 3 significant product announcements which strategically position us for the coming age of digital cinema. First, we released the DTS Cinema Media network, a complete network system including software and hardware for managing delivery of high definition video content and DTS surround sound. This network enables the automotive scheduling delivery and screening of pre-show advertising and alternative content for digital presentation. The system includes centralized network operating centers or NOCs to ingest and transmit content to DTS cinema servers located at various theatre sites. From our cinema servers, the content is distributed for play out to each screen on XD10 Cinema Media Player. Exhibitors who already operate the XD10 for feature soundtrack presentations, will only require a low cost upgrade to enable their existing XD10s to be connected to the DTS Cinema Media Network.

The DTS Cinema Media Network offers both, distributors and exhibitors alike, the opportunity to save cost by optimizing our DTS playback equipment for multipurpose use, supplying audio captions or subtitles for film presentations while also screening pre-show and alternative content digitally eliminating the need to prior distribute 35 millimeter film. Second, we introduced the advanced JPEG 2000 DTS digital cinema encoder, which we discussed with you last quarter. This product will be licensed to post production facilities around the world. The DTS digital cinema encoder utilizes JPEG 2000 image compression with DTS variable bit rate encoding so produced the highest quality images for D-Cinema.

As digital cinema exhibition expands duplication time and distribution cost will become an important factor in its commercial success. And our DTS digital cinema encoder provides constant quality encoding reducing file sizes by 30% to 50%. Another important step in readying our business for digital cinema was our acquisition of the digital booking systems technology which closed in mid April. This is an important ingredient of the suite of digital solutions which we intend to develop and introduce for our customers. DTS digital booking technology will allow exhibitors and distributors to conduct their business online, accelerating the process of booking deploy dates scheduling show times, programming trailers, tracking data and facilitating rental payments for both film and digital releases.

In summary, the first quarter was the strong start for 2006. We are optimistic about the acceleration in our business that is expected with the HD and Blu-ray drives and content. We are also optimistic about the opportunities in our cinema and digital images businesses over time, as the industry evolves towards the development, delivery and consumption of high-definition digital content. I’d like to thank our partners, customers and employees for their support and continued efforts to make DTS more successful. Now, I’ll turn the call over to Mel for a financial review.

Mel Flanigan

Thanks Jon. Hello and thank you all for joining us this afternoon. We were quite pleased with our financial performance in the first quarter. Total revenue was $28.7 million, up 30% over the first quarter of 2005. Revenue in the quarter includes approximately $10 million in royalty recovery payments compared to approximately $6.4 million in such payments in the first quarter of 2005. Adjusting for these payments, revenue growth in the quarter was 19%. GAAP net income for the first quarter improved to $7 million or $0.38 per diluted share, compared to GAAP net income of 3.6 million or $0.19 per diluted share reported in the first quarter of last year. GAAP results in the first quarter of 2006 include $619,000 pre tax or $0.02 per share net of tax and charges associated with the implementation of FAS 123R. First quarter 2005 results included a charge of $2.6 million or $0.09 per share net of tax associated with the acquisition of our Digital Images business.

On a non-GAAP basis, net income for the first was $7.4 million or $0.40 per diluted share above the outlook we provided last quarter. Technology and film licensing was $22.8 million, up 24% over the prior year’s first quarter. Consumer licensing posted growth of 26% and film licensing was up 6% for the quarter. Consumer licensing strength was driven by continuing success with royalty recoveries and strength in the PC and automotive market. PC and automotive markets increased 32% and 63% respectively over the prior year’s first quarter. Adjusting for the $3.6 million increase in royalty recoveries, consumer licensing would have increased 7% over the prior year.

Products and other revenue increased 63% over the prior year to $5.9 million driven primarily by growth in our Digital Images division. In addition, our cinema division recognized approximately $700,000 in deferred revenues from the Cinecom transaction as we complete the delivery and accept milestone on all aspects of that arrangement. From the segment perspective, total revenues in the consumer division for the first quarter were $20.7 million, up 25% over the prior year. Gross profits in the consumer business rose 27% over the prior year and the division’s growth margin was strong in 98%. The cinema division contributed revenue of $5.4 million in the quarter, up 13% over the strong first quarter of 2005.

Gross margins in the cinema division were 43%, down slightly from the prior year primarily because we’ve recognized revenue on the Cinecom transaction. Our Digital Images division reported revenue of $2.6 million, up nicely from $720,000 reported in the first quarter of 2005. As Jon discussed, we completed a substantial portion of the Bond work and recognized much of the revenue from those projects. However, the cost structure in this business tends to have a high fix cost component, in the most recent quarter while we completed the Bond work, the release of the deferred cost accumulated over an extended period of time combined with the 6 overhead and amortization of acquired intangibles, once gain resulted in a negative gross margin.

In the future, our objective is to improve unit volumes and pursue more profitable projects and we expect to see margin improvements throughout the year. In Q2, we expect gross margins in the Digital Images division to be about breakeven. We both have strong income from operations and operating margins of 35% in the first quarter of 2006 compared to 23% in the prior year and 5% in the prior quarter. In the first quarter, we recognized $619,000 in stock-based compensation under FAS 123R. Of this amount, $18,000 was charged to cost-of-goods sold, $496,000 to SG&A and $105,000 to R&D. For the remainder of 2006, we expect stock-based employee compensation charges of between $600,000 and $800,000 per quarter based on brands outstanding as far.

Turning to the balance sheet, we finished the quarter with cash, cash equivalents and short-term investment of $119 million, up from $111 million at the end of the fourth quarter. Accounts receivable decreased to $6.3 million from $7.3 million in the prior quarter and inventory ended essentially flat at $3.2 million. Overall, the balance sheet remains very strong with the current ratio of over 14:1 and no long-term debt.

In summary, we continue to be optimistic about our business opportunities and outlook. With our outstanding performance in Q1, we now expect revenue in a range of $14 million to $16 million and to be approximately breakeven on the bottom line for the second quarter, our seasonally slowest quarter. This of course was quite inline with our expectations for the first half of the year. As the result, we are maintaining our 2006 outlook revenue in the range of $83 million to $86 million, an EPS of approximately $0.55 excluding the impact of FAS 123R. We will continue to monitor market conditions involving the transition to the new high-definition format. As Jon discussed, we are not planning for major contributions from HD DVD or Blu-ray format at this time, but expect acceleration in these markets in 2007 and beyond. With that, I will thank you turn the call back over to Jon for closing remarks.

Jon Kirchner

Thanks Mel. Our industry is in a midst of the major market transition towards the creation, distribution and consumption of high-definition entertainment. This transition promises to bring strong financial benefits to DTS. DTS is well-positioned with proprietary technologies, service infrastructure, a growing well recognized brand and important industry relationships which will enable us to serve the market with value-added solutions. In particular, we are well positioned with regard to the transition to the next generation optical media formats. As part of our efforts and strategy, we will continue to develop and evaluate new technologies that meet the changing needs in the entertainment industry. We have big expectations for growth on our business and we will continue to take important while also prudent steps to increase our market and build our brand across the industry. With this strong start in 2006, we believe that we are on the path to accelerated growth in the years ahead. Now I would like to turn the call over to the operator for Q&A. Operator, please go ahead.

Question and Answer Session

Operator

Thank you, sir. Ladies and gentleman at this time we will begin the question and answer session. (Operator Instructions).

One moment please for the first question. Our first question is from Ralph Schackart with William Blair & Company.

Ralph Schackart - William Blair & Company

Good afternoon. Jon I was wondering if you could qualify how much HD revenues in your ‘06 guidance or perhaps you can give us a range, somewhere below 5%, 5% to 10% and additionally, Mel can you sort of give us little bit color on expenses where those go in 2006 with respect to revenue growth and how much you think about expenses in our long-term model? Thanks.

Jon Kirchner

Well, with regard to the high-definition formats the answer is less than 2% of our consumer revenue is in our guidance.

Ralph Schackart - William Blair & Company

Great thanks.

Jon Kirchner

Hi Ralph, this is Mel, and regarding the, the expense side I think, we did about $12.6 million in SG&A and R&D combined in Q1, I think Q1 tends to be a little bit stronger year because we got a couple of major trade shows in the quarter, so we would expect it to trend down in the Q2, I think overall, the goal for the year as we said in the, in the February call is to moderate expense growth and such that the, the overall profitability of the business should show improvement in the year and I think if you look at the guidance of $0.65 give or take, you, that definitely reflects an improvement in profitability.

Ralph Schackart - William Blair & Company

Great, and one more if I could, in terms of your outlook for growth in your traditional decoder and trademark licensing business, not incorporating the HD revenue stream. Can you give us a sense where that growth is now compared to your outlook that you provided at analyst day, and I will turn it over? Thanks.

Jon Kirchner

Ralph when we looked at the year and generally across the DVD product area, we basically expected it to grow in the middish single digits, we expected to be flat up, I think as expected we are seeing the DVD, the trademark side of the business, soften, which is offset in part by the HDTV market which is still growing from our perspective on a worldwide basis, in the upper single digits and I think, net-net-net we don’t expect at this point to be dramatically different and then what we had originally said which is essentially flat to slightly up for the year.

Ralph Schackart - William Blair & Company

Hey great thank you.

Operator

Thank you, our next question is from Gene Munster with Piper Jaffray.

Gene Munster - Piper Jaffray

Hey good afternoon, just to clarify I guess breakeven EPS gains for Q2, does that include or exclude stock, stock-based compensation?

Mel Flanigan

That’s excluding the stock-based comp.

Gene Munster - Piper Jaffray

Okay, excluding, so including in that would be loss essentially?

Mel Flanigan

Correct.

Gene Munster - Piper Jaffray

Thanks, and I guess just from the, you talked about 2% of the business would be high definition, you’ve talked about some general parameters about what the price on some of that high definition might be, if you remind us about some of those potential numbers about the, how’s the tax rate they are going to be 100%, could you remind us what the potential pricing could be?

Mel Flanigan

Sure, in terms of what we call the 2-channel or DTS stereo implementation, will be in the neighborhood of approximately $0.30 a unit.

Gene Munster - Piper Jaffray

Okay, is that something that potentially could change as we get closer to more of the ramp up of high debt or is that something that that, I guess you feel comfortable enough to say another call, its something that we can kind of put in their models.

Jon Kirchner

Its not, expected.

Gene Munster - Piper Jaffray

Okay, not expected a change.

Jon Kirchner

Correct.

Gene Munster - Piper Jaffray

Okay, and then one last question, any royalty recovery revenue assumed for June quarter gains?

Mel Flanigan

No with the, with a such a strong start to the year, at $10 million we actually do expect some additional royalty recovery monies to come in during the remainder of the year, but at this point its kind of difficult to anticipate the timing of any of those kind of activity. So, certainly we are in $1 million in the Q2 kind of numbers.

Gene Munster - Piper Jaffray

Okay great thank you.

Operator

Thank you, our next question is from Paul Coster with J.P. Morgan.

Paul Coster - J.P. Morgan

Yes thank you, Mel couple of quick question if I may, in terms of the business mix, was there any sort of significant change in terms of geographies this quarter, or customer concentration?

Mel Flanigan

Well, with the Cinecom revenue being recognized obviously that’s swings about 700k, into the European region generically, but other than that there was nothing unusual I guess about the geographic mix between our revenues.

Paul Coster - J.P. Morgan

Does that also affect the customer concentration?

Mel Flanigan

Correct, for the sort of the normal ongoing business, yeah there was nothing unusual.

Paul Coster - J.P. Morgan

No, it’s same to same customers?

Mel Flanigan

Yeah correct.

Paul Coster - J.P. Morgan

All right and then in terms of businesses, the distribution technology that you are, you announced, so was, do you anticipate DTSI having to make any capital investments in order to support that business, will you for instance, receding in anyway by creating your own network operating census?

Jon Kirchner

Paul I think at this point, in times we are obviously looking at a number of different scenarios as to how best to ride the business, I think broadly speaking we don’t see our balance sheet as the best vehicle for funding any major rollout, we are obviously making sure that the systems we are developing can be deployed successfully which involve minor investments. But in general, we are looking to deploy our technology in our products in a way that essentially means they are being licensed, sold to third parties essentially to operate networks.

Paul Coster - J.P. Morgan

Okay. Thank you very much.

Operator

Thank you, our next question is from Robert Stone with Cowen & Company.

Robert Stone - SG Cowen & Company

Hi guys, I have couple of questions, now could, could I ask you to just repeat please the sub segment detail on automotive and PC segments, the percentages and give us some sense of where those are in dollar run-rate slightly?

Mel Flanigan

Yeah that the growth rates that we, that I mentioned where the PC was up 32% year-over-year in the automotive market, up 63% year-over-year, I think if we look at where we were a year ago with little under 10% for those and for this year we are expecting the combination of those markets to be in the 15% to 20% total consumer revenue range.

Robert Stone - SG Cowen & Company

Okay.

Mel Flanigan

So they are becoming a larger portion of the total now.

Robert Stone - SG Cowen & Company

And in terms of your full year outlook, you had about $3.7 million in upside versus where the street was for the first quarter, but your full year revenue guidance I mean we’ve seen, that essentially fall in royalty recoveries that you had expected to be more federal over the year is there something else that arrived early in 2006?

Jon Kirchner

Couple of factors I guess, one is the royalty recoveries are little bit stronger than we anticipated in our February call. I think, the other couple of points were the Cinecom transaction which we’ve anticipated, in terms of by the Q2 timeframe and similarly on the Bond side, we expected some of that to be, to occur in Q2 as well. So it’s kind of a pulling in of some of the revenue.

Robert Stone - SG Cowen & Company

I guess flip side we are looking at that is, nothing else you are getting softer at the start of the year just the timing of the several items.

Jon Kirchner

Yeah, I think when we look at it, just sort of pulling the first half together, we are pretty comfortable with the, we are heading in the right direction at this point.

Robert Stone - SG Cowen & Company

Great thank you.

Operator

Thank you, our next question is from Gordon Hodge with Thomas Weisel Partners.

Gordon Hodge - Thomas Weisel Partners

Yes, just something I think you discussed already posts which is some, can you shape out the trends in the decoder versus the trademark really it sounded like DVD trademark business was down exceeding royalty recoveries, but maybe just talk about the trends you are seeing in home theatre systems and other receiver business and sort of what do you expect going forward and also on Cinecom, are there more deliverables for more meaningful revenue, I mean the milestones that we should be looking forward.

Jon Kirchner

Gordon the Cinecom transaction is done.

Gordon Hodge - Thomas Weisel Partners

Yeah okay.

Jon Kirchner

We’ve delivered.

Gordon Hodge - Thomas Weisel Partners

Everything?

Jon Kirchner

And our software has been accepted, with regard to broader trends in the consumer business, as I said, we expect that the consumer business in the core DVD area to be flattish just slightly up, and that reflects both the softening DVD player trademark license on business and, a slightly up kind of decoder business looking broadly globally at the AV receiver market as well the HDAV market, as well as the fact that we expected to see some pretty significant growth in the PC and automotive area which is exactly what is happening. So, broadly speaking I think some things are coming as we had expected.

Gordon Hodge - Thomas Weisel Partners

Great thank you.

Operator

Thank you, our next question is from Jamie Padgett with Founders Asset Management.