Techwell, Inc. Q3 2008 Earnings Call Transcript

Techwell, Inc. (TWLL)

Q3 2008 Earnings Call Transcript

October 29, 2008, 5:15 pm ET

Executives

Beverly Twing – IR, Shelton Group

Mark Voll – VP of Finance & Administration and CFO

Hiro Kozato – President and CEO

Analysts

Heidi Poon – Thomas Weisel

Gary Mobley – Piper Jaffray

Christian Schwab – Craig-Hallum Capital Group

Chris Chaney – Stanford Group

J.D. Paget – Boston Co.

Steve Wortman – Lord Abbett

Presentation

Operator

Good afternoon ladies and gentlemen and welcome to Techwell’s third quarter 2008 financial results conference call for the period ended September 30, 2008. At this time all participants are in listen-only mode. (Operator instructions) I will now like to turn the call over to Beverly Twing of Shelton Group Investor Relations. Beverly, please go ahead.

Beverly Twing

Thank you and good afternoon everyone. Welcome to Techwell’s third quarter 2008 financial results conference call. The press release and financial tables associated with today’s conference call were distributed after the close of the market today. If you do not have a copy you may find them on the company’s website at www.techwellinc.com. This call is being broadcast live over the internet and may be accessed in the Investor Relations section of Techwell’s website.

Before management begins the discussion of the third quarter’s results, I would like to remind you that this conference call will contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 which include without limitation statements that relate to future events and include but are not limited to the company’s belief that demand for its products will continue to grow, the company’s ability to better address customer requirements, leverage technology capabilities and integrate additional functionality and achieve greater market share, the timing, anticipated benefits and acceptance of new products, statements relating to future opportunities, continued growth and its anticipated revenue, gross margin, operating expenses and tax rate for the fourth quarter of 2008 and anticipated trends and growth in the company’s business and end markets in which it operates.

Any forward-looking statements made during this call are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Additional information concerning factors that could cause actual results to differ materially from any forward-looking statements made during this call are contained in the company’s quarterly report on Form 10-Q filed with the Securities and Exchange Commission on August 8, 2008.

Techwell undertakes no obligation to publicly update any forward-looking statements for any reasons except as required by law, even as new information becomes available or other events occur in the future.

Thank you for your time and attention. I will now turn the call over to Mark Voll, Techwell’s Chief Financial Officer. Mark, please go ahead.

Mark Voll

Thanks, Beverly. Good afternoon everyone and welcome to our third quarter financial results conference call. With me today is our President and Chief Executive Officer, Hiro Kozato. I will begin today’s call with the review of our quarterly financial results and conclude with our outlook for the fourth quarter of 2008. Following my remarks, Hiro will provide an update on our business. We will then open the call for a question-and-answer session.

Please keep in mind that all reported financial results, unless otherwise noted, are presented on a GAAP basis. For the third quarter ended September 30, 2008 we reported total revenue of $18.5 million which was the mid point of our revenue guidance range of $18 million to $19 million.

Revenue for the third quarter compares to $15.1 million in the same period a year ago representing year-over-year growth of 22%. Revenue in the third quarter for each of our product lines consisted of security surveillance revenue of $14.4 million representing 78% of revenue, LCD display revenue of $2 million or 11% of revenue, video decoder revenue of $2.1 million or 11% of revenue and other revenue of approximately $16,000.

Security surveillance revenue grew 41% year-over-year and increased 12% sequentially. LCD display revenue increased 54% year-over-year and 2% sequentially. Video decoder revenue declined 37% year-over-year and 2% sequentially. In the third quarter we had two customers that each represented more than 10% of total revenue.

Sales to our largest distributor in China represented 37% of total revenue in the quarter which included shipments to multiple end customers and we had another customer that represented 11% of total revenue. Combined, our 10 largest customers represented 80% of total revenue in the third quarter of which nine of these customers are distributors.

Gross margin for the quarter was 63% and continues to exceed our long-term target of 55%. This compares to gross margin of 60% in the third quarter of 2007 and 62% in the prior quarter. Our third quarter gross margin was positively impacted by our transition of new products to the 0.18 micron manufacturing process. During the quarter, 65% of our total net revenue came from products fabricate in 0.18 micron. In the next several quarters we expect to realize full benefits from the cost reduction associated with this transition.

Total operating expenses were $8 million in the third quarter representing approximately 43% of total revenue. This compares to operating expenses of $6.6 million or 44% of revenue in the same quarter last year and $8 million or 47% of revenue in the second quarter of 2008.

Of the $8 million of operating expenses in the quarter, research and development expenses totaled $4.4 million which included approximately $600,000 of tape out expenses related to new product development. Operating expenses also included approximately $1.7 million of pre-tax stock based compensation expenses under SFAS 123(R).

Net income for the third quarter totaled $2.5 million or $0.11 earnings per diluted share. Net income includes pre-tax stock based compensation expenses of approximately $1.8 million equating to an $0.08 per diluted share charge.

Full diluted earnings per share for the quarter were calculated using 22,083,000 shares. Earnings per diluted share of $0.11 in the third quarter compares to $0.25 in the third quarter of 2007. Net income for the third quarter of 2007 included a tax benefit recorded in the quarter of $2.2 million. We believe a more appropriate analysis of this quarter’s result to last year is comparison of income before taxes.

Income before taxes for the third quarter of 2008 was $4.2 million compares to $3.3 million in the third quarter of 2007, an increased of 27%. Our third quarter net income was impacted by a decrease compared to the same quarter year ago of $300,000 and non-operating income as we recorded $507,000 of interest income in the third quarter of 2008 compared to $819,000 of interest income in the same quarter last year. The reduction in non-operating income reflects lower interest rates available on cash, cash equivalents and investments.

Third quarter net income of $2.5 million or 14% of total revenue compares to approximately $5.4 million for the third quarter of 2007 or 36% of total revenue. As I had stated earlier, the third quarter of 2007 included tax benefit record in the quarter of $2.2 million. Our non-GAAP tax provision for the third quarter was $2.1 million.

Our tax rate for the third quarter was 39%. This was slightly higher than our guidance as we were not able to claim any tax benefit for the Federal Research and Development Tax Credit during the quarter. With the recently past legislation renewing the Research and Development tax credits through 2009, we will be able to realize all our R&D tax credits for 2008 in the fourth quarter.

Now, turning to the balance sheet; accounts receivable were approximately $2.4 million at the end of the third quarter compared to $2.5 million at the end of the second quarter of this year. Historically, we have sold on credit terms only to OEM customers and as a result our accounts receivable balances have been low in comparison to overall revenues. In the third quarter, revenue from direct sales to OEMs represented 21% of revenue; our sales to distributors represented 79% of total revenue.

Net inventory as of September 30 was $6 million, an increase of approximately $800,000 from the close of the second quarter. The rise in inventories was to support the increased level sale activity as well several new products going into volume production, including our TW8827 and TW6805.

Our cash, cash equivalents and both short and long-term investment balance as of September 30, 2008 was approximately $77.3 million compared to approximately $73.8 million as of June 30, 2008 and $68.4 million as of December 31, 2007. At the end of the third quarter we had 158 employees, 72 of which are in research and development.

In terms of guidance for the fourth quarter of 2008 we will continue to see revenue growth in our securities surveillance around business. As a result, we expect revenue to be in the range of $18.5 million to $19.5 million. The midpoint of our guidance range represents year-over-year growth of 15% and sequential growth 3%.

We anticipate gross margins in the fourth quarter will remain comparable to the third quarter results. We expect total operating expenses to be slightly higher than the third quarter and range between $6.25 million to $6.75 million excluding stock based compensation expenses.

The increase in operating expenses in the fourth quarter reflects higher tape-out expenses that we expect to incurred in the fourth quarter. We estimate tape-out cost to be approximately 800,000 dollars for the quarter. We expect the tax rate in the fourth quarter to be 30% which reflects the newly enacted legislation and renews the Federal Research and Development Tax Credits.

This concludes my prepared remarks. Now I will hand the call to Hiro for additional comment.

Hiro Kozato

Thanks, Mark; good afternoon everyone. Thank you for joining us. As we have discussed in our previous quarterly conference calls, we believe the combination of a healthy end market for the surveillance equipment and our regions security surveillance IC product portfolio is the main drive of our current success.

Q3, 2008 results were no exception. We saw security revenue grow more than 12% quarter-over-quarter and more than 40% year-over-year. We continued to see strong demand from China along with steady performance from our other regions. In addition, we continue to maintain healthy margin across the security product line due to our significant product differentiation.

Despite a very challenging macroeconomic environment the gross prospects for our surveillance business remain attractive as we look in to Q4 and next year. There are two main reasons for this; first, we believe several of the major end markets upped by security surveillance equipment are more solid from economic downturn than other technology end market and will continue to spend increasingly more dollars on surveillance. Second our robust product will not include many products we significantly high levels of integration, which we believe will allow us to end market share over the next several years.

Let me discuss the end markets first. As you know, the markets for security surveillance highly fragmented with the six key segments including transportation, industrial, government, financials, retail and education. It is difficult for us to quantify the exact impact of the downturn because of our position in the supply chain and our lack of visibility into the specific end markets. We believe the government, transportations and education end markets will remain robust.

Sub-segments in government, include public safety, presents, critical infrastructure, military, public facilities and government office and complexes. Sub-segments in transportation include airports, seaports, trends, light ware and buses. Budgets are set by local, state and central government and normally extend over several years. As a result, we suspect the economic downturn would have best impact on these segments.

Turning to the security product road map, I have to say we are entering a very exciting time for Techwell. As many of you know, we have a robust set of new products that’s been multi channel video decoders, multiplexers, display processes and CODECs that are set to launch over the three months.

Many of these products are more highly integrated and possess more features that will allow us to drive higher ASPs and address more of the severance IC market opportunity. In fact, we will be announcing our TW2880 HT display controller in time for the China Public Security show in early December. This product is designed in a 90 nanometer [ph] process and integrates multiple functions physically performed across several stand along basics at PGS and DSP. I look forward to reporting more information on the TW2880 after the launch in December.

Let me now spend a few minutes on our automotive and consumer and PC businesses. On the automotive front, I think everyone is aware of the challenges facing the automotive manufacturers. With this in mind, I would like to highlight that we maintained our automotive display business despite terrible market conditions. I think this is a testament to our design win momentums with the automotive system suppliers. In fact, wire market volumes for existing projects remained depressed and mass production schedules of our current design have not slipped.

As a result we think the long term prospects for our automotive business are quite favorable, but in the near term it is reasonable to expect our automotive growth will be constraint by the difficult market conditions within the industry.

In terms of our consumer and PC business, our video decoder sales held roughly flat with Q1 and Q2. We would expect continued pressure on this business given the anticipated impact of the macro economic environment under consumer and PC end market and a continued product mix shift to lower ASP decoders. That said, we think there will only be marginal declines as we look into the fourth quarter.

Finally, let me conclude by highlighting that Techwell remains focused on pursuing profitable growth opportunities with high returns of investment. The result is on operating profit margin excluding stock based compensation expenses approaching 30% in the third quarter and annualized EBITDA based on the third quarter results of approximately $22 million.

That concludes my prepared remarks. Operator we’ll now open the call for questions.

Question-and-answer session

Operator

(Operator instructions) Your first question comes from the line of Heidi Poon with Thomas Weisel. Please proceed with your question.

Heidi Poon – Thomas Weisel

Thanks, a strong execution guys. I just wanted to get a little bit of color on your comments regarding the China market. Given a lot of expectation with slower growth in that region, we understand that security surveillance is typically more insulated, but could you give us a sense of the comments that you’re getting from your customers about the build out plans there, maybe specific cities, projects and also the share gain that you mentioned in your press release?

Hiro Kozato

Sorry your voice was too low and I didn’t quite get the answer. This is Hiro.

Heidi Poon – Thomas Weisel

Let me repeat my question. I would like to get more color on your comments about the China end market. Could you share with us the commentary from you customers regarding their build out plans and also if you could elaborate on the share gains that you are achieving in that region; that will be great? Thanks.

Hiro Kozato

First of all, we think we have more than 80% market share. So, we are not really seeing any new market share gain and at the same time we don’t think we’re losing market share, but one thing negative is as I said earlier we’re getting some hit from the macro economy impact and we believe that the gross rate in the security surveillance market is slowing down. We used to see 25% to 35% annual growth rate in this market, but now we’re seeing maybe – well actually its difficult to quantify at this movement, but I believe it’s more like 10% to 20% in Q4 and also into early next year.

Anyway, we haven’t seen any design loss and at the same time we don’t have any new market share gain, but we believe that with our new products scheduled to deliver in Q4 this year. We think we will gain some more market share with higher ASP. So, overall I will say yes, the revenue gross rate is slowing in China security surveillance market, but we still think it’s a very healthy growth for us next year. Did I answer your question right?

Heidi Poon – Thomas Weisel

Yes, that’s very helpful. Also regarding the automotive infotainment you mentioned that the new production schedule remains on track. So, I guess last time you mentioned that there is new product for us scheduled to be going into production in Q1, is that what you’ve referring to?

Hiro Kozato

Yes, at this movement, it’s still on schedule and those are the design wins, we had one year ago in Japan basically two major customers, two major auto makers and yes they are schedule to go in to production late Q1 or early Q2 as well as know?

Heidi Poon – Thomas Weisel

Right, thank you.

Hiro Kozato

Welcome.

Operator

Your next question comes from Gary Mobley with Piper Jaffray; please proceed with your question.

Gary Mobley – Piper Jaffray

Hi guys. The distributor that you alluded to in China that was 37% of revenue and that regard make as customer. I’m curious is that the only add new through which you’re selling to China or are there distributors in China or direct customers in China?

Mark Voll

There are other distributors, but they are the main distributor that we distribute to.

Gary Mobley – Piper Jaffray

Okay so, I guess doing the map that equates to the factor, I guess what happen in revenues now for video surveillance are tied to the Chinese marketplace or?

Mark Voll

I’m sorry. I didn’t hear the question.

Gary Mobley – Piper Jaffray

Is it true then that about half your video surveillance revenue is basically derived in China and if so is that the true end destination for these video surveillance systems?

Mark Voll

I would say that approximately 40% of our security surveillance revenue is in the China market.

Gary Mobley – Piper Jaffray

Okay and you mentioned in your prepared remarks that the gross margins have been creeping up because of more and more production on 180 nanometer process note. Just maybe you can give us some apples-to-apples comparison, how do your gross margins on the products or a 180 nanometer note compared to where they were on a different note one year ago?

Mark Voll

I would say that generally what we see is by the 20% cost savings on 0.18 versus 0.25, which is the older generation products that we have.

Gary Mobley – Piper Jaffray

Okay and last for me, the R&D tax credit with it being passed now, can we now assume your long-term tax rate will be roughly 30%?

Mark Voll

Will be 35%. So, we’ll see the pickup in Q3, which we’ll see the tax rate would be about 30% for the quarter and then now that the R&D tax credits in effect that should be approximately 35% throughout each quarter of ’09.

Operator

Your next question comes from Christian Schwab with Craig-Hallum Capital Group; please proceed with your question.

Christian Schwab – Craig-Hallum Capital Group

Mark when you’re doing 30% tax rate for the December quarter, you’re referring to GAAP, is that correct?

Mark Voll

It would be both GAAP and non-GAAP would be that rate also?

Christian Schwab – Craig-Hallum Capital Group

Perfect, that’s it. Okay, great. The brand new products that they are coming not only at positive gross margins, but don’t they also come with a significantly higher ASP?

Hiro Kozato

Yes.

Christian Schwab – Craig-Hallum Capital Group

Can you kind of quantify that and walk us through that?

Hiro Kozato

It’s still very difficult to quantify, because we don’t have design wins yet and also this new device would also replace our current devices, but its not 100% new higher ASP product, its higher ASP for 16 channel market and then also a replacement for current four channel markets.

Christian Schwab – Craig-Hallum Capital Group

Right so, I guess another way of asking what I’m trying to get to is, if the industry is going to slowdown to 10% to 20% next year until the macro environment improves from 25% to 35%; what do you believe you can grow at with market share gains and towards the second half of the year ramping on higher ASP products on a blended basis, than you may have actually in this year?

Hiro Kozato

Yes, at this movement, it is still difficult to quantify. As I said earlier, we don’t have any new designs wins yet with the new devices, but according to our own schedule, we think we would start shipping that shift in Q3 next year and meant more back end office in Q4. So, we think we can almost offset the drop of the gross rate, not quite exactly the sense, but we think we’ll get close to that drop.

Christian Schwab – Craig-Hallum Capital Group

Great, a couple of other companies have mentioned that they may enter this marketplace, are you seeing any new competition?

Hiro Kozato

No, we don’t, we still are seeing TI as our major competitor and NetChip from Korea and Rich Next in Taiwan and other smaller competitors.

Christian Schwab – Craig-Hallum Capital Group

Great, thank you.

Hiro Kozato

Welcome.

Operator

Your next question comes from the line of Chris Chaney with Stanford. Please proceed with your question.

Chris Chaney – Stanford Group

Thanks, I just have a couple of questions here; first on the automotive sector. A couple of quarters ago you guys thought that growth is based on the new designing wins, it could be something like 8% or better on a year-over-year for ’08 versus ’07 and then I think it was changed to something like 50% year-over-year as of last quarter and I’m wondering with the continuing impact of the economy here, do you expect to see that’s something like 30% or so this year in terms of growth for automotive and next year would you still expect to see mid, let’s say 20% to 30% growth in that area next year? What are your thoughts on automotive next year?

Hiro Kozato

We think the gross ratio to be at least same as the one from last year, because next year we will start shipping for the front consult instead of the rear seat entertainment unit, which is an option. So, we think that the gross rate will stay at least the same or higher shipping to the navigator.

Chris Chaney – Stanford Group

Now, have the shipments looked in the rear view mirror like that and is that continuing?

Hiro Kozato

Yes, that revenue we’ll see that revenue in Q4 next year, on the rear view mirror and back up cameras.

Chris Chaney – Stanford Group

And I think I recalled you saying that there really had been no changes to the shipments schedules by the auto manufactures, the 10 or 12 new ones that you’re adding. Is that correct?

Hiro Kozato

Correct, except volume is still so small. We haven’t really started to shipping to front consult, yet that’s why the volume is small.

Chris Chaney – Stanford Group

But when we look at the automotive segment, those margins I understand are quite a bit lower than the security surveillance market. So, I guess changes in revenue there are going to be as impacted on the bottom line. Correct?

Hiro Kozato

That’s correct.

Chris Chaney – Stanford Group

Okay. On the foundry, I have some questions about your foundries; we’re hearing that GMC and GSMC and other foundries out there, are just really dying for business right now. Their utilization rates are extremely low and wafer pricing is coming down. Can you talk about sort of your wafer pricing, how it’s changed and whether or not you are having the pass through the differences to your customers?

Mark Voll

We don’t have any gain from the wafer prices yet, but definitely we’ll keep working on that wafer prices.

Chris Chaney – Stanford Group

Do you have any price aspects yet?

Mark Voll

Not yet.

Chris Chaney – Stanford Group

Okay, and then Mark you alluded something about realizing the full impact of the transition of 0.18 micron in the next few quarters. Does that suggest that maybe it will see gross margin remain flattish or potentially even go up from here as the full impact is realized?

Mark Voll

Well, it will certainly see lower costs, the unit costs as more and more product goes to 0.18 and more likely that will allow us to maintain gross margins as APSs decline, so that will off set that ASP decline on the margin itself.

Chris Chaney – Stanford Group

Last question here; on the PC consumer market, I think you guys were looking at in business new products maybe late next year for 2010 sales. I’m wondering if the economic slowdown has changed the way you’re thinking about your R&D expenses going into next year and whether or not transfer that products that are still planned for 2010.

Hiro Kozato

Yes, we still have the present plan and schedule.

Chris Chaney – Stanford Group

All right. Thanks very much.

Hiro Kozato

Welcome

Operator

(Operator instructions) Your next question comes from J.D. Paget with the Boston Company; please proceed with your question.

J.D. Paget – Boston Co.

Hi guys, a nice set of results. The one question I had was what’s the timeline for new product introductions that we know about in securities base or any other of the segments that we’re talking about?

Hiro Kozato

We have one major drawback coming in, as you said late November to early December this year and another one in late Q1 to early Q2 next year; those two are for security surveillance market that has very high level of integration, high ASP.

J.D. Paget – Boston Co.

So one of them is the 16 channel product?

Hiro Kozato

Yes, one of them is 16 channel, the other one is 4 channel. So, we try to address from low to mid-end to high-end.

J.D. Paget – Boston Co.

So, the one is more integrated has a support for height or depth or something?

Hiro Kozato

Yes, the one we would deliver in Q4 this year.

J.D. Paget – Boston Co.

So that’s the higher level of integration or is there even more content that you integrate into those chips versus what you’ve done historically?

Hiro Kozato

Actually both has almost the same level integration, both has VGA, deinterlacer scalers and many other features, but one is for 16 channel use and the other is for 4 channel use.

J.D. Paget – Boston Co.

Okay and then are there other products throughout next year where you’re increasing your level of integration and bringing a new content?

Hiro Kozato

Yes, we also have a couple of new products for Car TVs with higher level of integration.

J.D. Paget – Boston Co.

Okay, thank you.

Operator

The question comes from Steve Wortman with Lord Abbett; please proceed with your question.

Steve Wortman – Lord Abbett

Good afternoon. Congratulations on the revenue and the gross margins, the trends there have been very strong for couple of years, but just kind of wanted to focus a little bit on the expense side. It just seems that basically all the line items are a little bit higher than we would we like them to see and also the share count continues to prepare as well. So, maybe if you can tie it to what you are doing to reign in expenses a little bit and also maybe entertainment factored given your balance sheet maybe a more aggressive buyback to kind of spend the share creep? Thanks.

Mark Voll

Well, the operate expense has been pretty remarkably stable this year. The only increases that are noticeable there are tape-out expenses due to new products and we think that’s key to future revenue growth. So, again this current quarter we had about $600,000 of our expenses related to tape-out expenses on new products; it will be about $800,000 in Q4. So, these two quarters have been pretty high as far as new product development costs are concerned and to review that how that goes into 2009, but we would expect for the most part other than the tape-out expenses are other operating expenses has been remarkably stable and flat.

Steve Wortman – Lord Abbett

I mean that the comp expense, that continues to go up. The GAAP between non-GAAP and GAAP seems pretty high in the stock continues of fallback a little bit. I’m just curious, why that’s transpiring?

Mark Voll

Well, that actually again Q3 was lower than Q2, so we’re at $1.9 million in Q2, $1.8 million in Q3. So, again that’s another expense where we think that we’ll remain stable, we’re not hiring a lot of new employees. So, all those expenses related to stock-based comps are related to options that were issued to employees as they became employees of the company.

Steve Wortman – Lord Abbett

So, if we looked at for a ’09, I mean just how much in ‘08 would you indicate that your spending on new products is over your steady state?

Mark Voll

I will say 90% for the new products.

Steve Wortman – Lord Abbett

And you’re introducing more products in ’08 and you typically have done in the past?

Hiro Kozato

No, it’s about the same, except we are now using 90 nano process, which is much more expensive than the 0.25, 0.18.

Mark Voll

So for example, it would be; if our costs that we incurred last year were a little over $2 million, in the second-half of this year alone it will be $1.4 million.

Steve Wortman – Lord Abbett

Have you guys thought about getting more aggressively with the cash to buyback stock given where it is?

Mark Voll

We prefer to look at other opportunities that we could grow our business, be it acquiring companies or technologies that will allow us to grow the top line.

Steve Wortman – Lord Abbett

Okay, Thanks a lot.

Operator

There are now further questions in queue. I would now like to turn the call back over to Mr. Voll for closing remarks.

Mark Voll

We encourage you to visit our website at www.techwellinc.com to view our latest announcements as well as our calendar of events. This quarter, we will be presenting at financial industry conferences including the AEA Financial Classic Conference in Santiago on November 3 and 4, and at the UBS Global Technology and Services Conference in New York on November 20. Additionally if you have any questions or would like more information, please contact Shelton Group or me directly. Thank you for joining us today. Operator, we may now disconnect.

Operator

Thank you for your participation in today’s conference call. This concludes the presentation. Have a good day.

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