NDS Group Plc (ADR) Q3 2006 Earnings Conference Call Transcript (NNDS

NDS Group Plc (ADR), (NNDS)
Q3 2006 Earnings Conference Call
May 8, 2006, 9:00 a.m. EST

Executives:

Dr. Abraham Peled, Executive Director, Chairman, and CEO
Alex Gersh, Chief Financial Officer

Analysts:

Ari Bensinger, Standard & Poor’s
Daniel Meron, RBC
Mehrdad Torbati, Deutsche Bank
Jason Mauricio, Arete Research
Can Elbi, Cheuvreux
Alan Gould, Natexis Bleichroeder Inc.
Anuj Mutreja, Morgan Stanley
Todd Mitchell, Kaufman Brothers
Michael Walter, Goldman Sachs
Roni Biron, Oscar Gruss
Murray Arenson, Ferris Baker Watts

Presentation

Operator

Hi and welcome to the NDS First Quarter Results Conference Call. At this time, all participants are in a listen only mode. There will be a presentation followed by a question and answer session, at which time, if you wish to ask a question, you will need to press * 1 on your telephone. I must advise you that the conference is being recorded today, Monday, the 8th of May 2006. On this call, we will make certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on the management’s views and assumptions regarding future events of business performance to make. Actual results may differ materially from those expectations due to changes in global economic business competitive markets and regulatory factors. More detailed information about these and other factors that could affect future results if contained enough findings with and exchange commission. Forward-looking statements included in this call are made only of the date of this call and we do not have any obligation to publicly update any forward-looking statements to reflect subsequent to that in all circumstances, except as required by law. I will now hand the conference over to your speaker today, Dr. Abraham Peled, please go ahead sir.

Dr. Abraham Peled, Executive Director, Chairman, and CEO

Welcome to the NDS First Quarter FY06 Result Conference Call on the results. I’m pleased to say that we another very solid quarter in which we have seen strong demands across the world from our various customers. We have signed up some new accounts and we continue to invest in people and infrastructure to meet the demands of our customers for more rapid introduction of new technologies. We see the pay-TV markets getting more competitive in many places around the world with enclave of telecoms with recovery of cable and that drives our customers with a satellite with a cable or in some cases where we have made inroads into the market to deploy new technology from a faster schedule. The new technology that are key to competitiveness are DVR, high definition, and broadband, whether it’s broadband as a delivery mechanism as in the case of Telcoast, broadband to augment the delivery of satellite and what we refer to as hybrid system. So, if we look at our results, they authorize some pace as they reached $64 million with good growth on all platforms. I think we’re also pleased to see that we’ve now entered really into middleware shipments at a clip of $4.3 million middleware this quarter, which puts us around $13 million per year. I think we see still some room for growth in that area as we penetrate additional customers and also particularly we see the DVR growth really picking up 700 this quarter.

I’d like to make a note about DVR. If you look at our ability to sell the DVR technology, those among our existing conditional access customers as well as media highway customers that do not use our conditional access like Canal+ or Astro, and I’m pleased to say that in each of those cases where a operator has made a decision on a DVR, they take NDS DVR technology. If you look at the number of households that all of these DVR projects represent, it is really over 43 million DVR households presently. So, that doesn’t include any growth obviously at these platforms. It’s our view that DVR being such a fantastic technology that will penetrate over time the whole base depending obviously on economic conditions, price of DVR coming down, and that represents a great opportunity for NDS.

We also are pleased with some of the new wins this quarter. I think in particular we’re looking to Tata Sky. Tata Sky is now on schedule to launch this summer. We think that India can be a tremendous market for a good BPV package. They have a lot of good programming and I think are very ambitious in their medium term goals.

Another important one I think as we see China really toward 2008, getting more serious about the deployment of Digital. Currently, the Shenzhen Province with close to a million set of boxes deployed within the SCA, the largest digital deployment of any city or province in China and is being used as an example.

We’re please to have won another contract in the same province, the Guangdong Province, which is a more industrialized province behind Hong Kong, and Guangzhou which is a similar sized system to the Shenzhen system.

Another one that is of the two considered media contractors announced, one is with SES Americom which has a package called IP-Prime. That they plan to offer to Telcos in the United States and it’s really a turn key package, it’s like heads in the Sky System that delivers the package directly to smaller medium-sized Telcos or in some cases larger Telcos may decide to pick it up and it supports it as a turn key system.

Another system that’s launched is the one in Telekom Austria, aonDigital. And again, while I think NDS continues to remain cautious about the total number of IPTV subscribers, it is critical for us to have the technology of delivery by broadband because we also believe in the important of the mixed satellite and broadband systems and indeed our YES Satellite operator in Israel owned by the local, 51% by the local telephone company Bezek, has launched the initial hybrid broadband system last month in Israel on a pilot basis allowing one seamless experience between broadcast TV and broadband access.

We’re also pleased with the progress that we are making with Orbis, our gaming subsidiary. As you may recall, we’ve acquired a small company NT Media that develops broadband games, fixed-odds games. That allows us and sends the acquisition to win for new customers including Victor Chandler and we now have one central bed in Australia bringing our second bed which is the largest U.K. gaming operation for fixed-odds games. Again, we see this to be a rapidly advancing area and the lab process just introduced a multiplayer backgammon game developed by Orbis and NT Media. Many people feel that backgammon can become — really it has a big following and has tournaments like poker and we are quite excited about that launch.

So, I think all in all we feel it has been a very good quarter. We continue to make progress on our strategy of supporting out customers, introducing new services that help them be more competitive, winning new business and were appropriate strategic alliance like the one we’ve done in the area of security chips and the one we’ve announced with Intel recently on solutions for security in Wymax, mobile with Pantex, and so on. I think NDS has continued as you will see from the numbers, has continued to hire people at a healthy clip. And it’s really to feel with the demands from our customers for more and more new technology. I think as Alex will mention in a few minutes that we have more people now working on customer specific projects than with ever had before and we see that demands continuing. I’d like to now to turn it over to Alex who will take you through some of the numbers and after that we will be answering questions, Alex.

Alex Gersh, Chief Financial Officer

Thank you Abe. Good afternoon, good morning everybody. Just a few words on the third quarter numbers. Total revenue for third quarter of 2006 was $149 million, an increase of 18% over third quarter last year and we’ll talk about some of the specific increases. Operating income is $35 million, an increase of 57% over same period in fiscal 2005. Operating income margin for the quarter is at 24% versus 18% in the third quarter of 2005. Net income for the quarter is $28 million, a 72% improvement over last year, and fully diluted earnings per share of $0.49 in the quarter versus $0.29 in the third quarter 2005. Now a few words specifically about some of the revenue lines. Conditional access revenue increased by 34% to $89.5 million and we have delivered $6.8 million from our card store customers versus $5.1 million in the third quarter 2005 and a number of authorized cards now stands at $64 million versus $54.7 million in March 2005. The increase in Smart card sales is primarily due to our customers in the U.S. DIRECTV, Cablevision, and as Ab talked about our customers in China.

Integration, development, and support revenue decreased y 25% at $10.4 million. We always talk about this being a kind of a lumpy portion of our revenue. In current year, the revenue relates to delivery of various enhancements to our customers and the development related to middlware. Revenue in prior, however, included revenue related to Sky Italia migration to NDS traditional access. Licensees and royalties increased by 4%. The increase is really due to the middleware increase, deployment of middleware and as Ab said, we have this quarter delivered 4.3 million boxes with our middleware enabled versus 400,000 in the third quarter of last year. However, the increase was offset by again the Sky Italia migration revenue recognized last year. And again as Ab said, as of March, we estimated a cumulative number of 38.4 million set-top boxes containing our middleware have been deployed.

New technologies, and if you remember our new technologies include basically our DVR deployment, our Synamedia, our interactive application, as well as our Orbis subsidiary, and all of our gaming applications that Ab was talking about as well. And again, the new technologies have increased by 12% in the third quarter this year to $29 million. DVR is one the main reasons why there’s been an increase. We’ve shipped 500,000, 700,000 sorry, 700,000 DVR set-top boxes versus is 100,000 third quarter last year. And as of March, we estimate a cumulative number of $2.7 million DVRs that we have shipped. Synamedia is another area of increased revenue. We continue to perform service to quite a number of our customers.

Gross margin is at 61% versus 62% in the third quarter of last year. And again, I think one of the issues that Ab had mentioned is that as we have more and more employees working on customer specific projects, more and more of their time, and more and more of their cost appears in the cost of sale line rather than the R&D line and that is brought about by the next line. If we look at operating expense, R&D cost decreased 11%. Again if you look at third quarter this year versus third quarter of last year, the decrease is due to more and more of time and cost of the employees being chard and cost of sales, and that decrease was offset by obviously the increased head count. As Ab said, we continue to increase our head count, we increase it by roughly about 530 people from March to March, and that obviously has a cost impact. So, the marketing cost increased by about 10%. Again, increased activity in new areas of business, principally in Asia and Europe.

G&A expenses increased what looks like significantly but really what you have to remember is in the third quarter last year, we reversed $8 million provision for used space at Heathrowe Airport. So, that effectively impacted the number. If you take that out, G&A has been relatively flat. And as I said the company has now increased by about 530 people.

Our effective tax rate is 29% as I talked about net income was $28.5 million or $0.49 per diluted share compared to $16.6 million or $0.29 per share on the diluted basis the last year. A very good cash flow our DSL continues to be very very good for those 60 days and we continue to generate cash at a very healthy course.

Capital expenditures are higher this year for nine months versus last year and again we talked about investment in new facilities in the U.K, India, and the U.S. this year and we’ve received $17 million from the exercise of employee stock options, 1.2 million shares were actually sized in the last month of this year by our employees. As of March, we have 4 million share stock options outstanding with 2.5 million invested as of March 31.

Now, just a few words about the 2006 guidance. As you know, we continue to review guidance on a quarterly basis. Based on our review while we will maintain the revenue guidance range of $600 million to $625 million which was a range we had throughout the year. I would like to mention, I do like to mention that we believe that the revenue will come in at the low end of the guidance. In terms, however, we continue to see very positive operation performance of our business and therefore we are upgrading our profit guidance from $115 million to $120 million which was our range last quarter, when we talk to now a new range of $128 million to $135 million. We are still in the process of finalizing our 2007 budget and therefore on this call, I will not be giving preliminary guidance for next year, however, we will communicate the guidance at our next call full year’s results announcement, and that’s all I have, thank you.

Dr. Abraham Peled, Executive Director, Chairman, and CEO

Okay, thank you Alex. And now operator if you could please open the conference call to questions.

Operator

Thank you. We will now begin the question and answer session. If you wish to ask a question, please press “*1” on your telephone and wait for your name to be announced next. Your first question comes from Harry Bensinger of Standard & Poor’s. Please ask your question.

Ari Bensinger, Standard & Poor’s

Yes thank you. I was hoping to get more color in the gross margin improvement sequentially. Can you maybe go through your segments and talk about how they range in terms of gross margin and how a shift in products mix would help that possibility of the company.

Alex Gersh, Chief Financial Officer

Well, I think two things about our, our gross margin is really effected by a couple of things. Obviously the product mix has an effect and if you look at our software type of products, clearly they have a higher margin than for instance cards themselves. So, as the business moves towards, revenues shifts from cards to software type of products and services as well as our monthly fee, with our conditional access, becomes a bigger component of the conditional access revenue, the improvement in margin is effected. I think in terms of the cost, clearly there are a couple of things that effect our margin. First, in the cost of cards itself, obviously what we see is, the cost of cards is very dependent on the mix of what customers are actually being supplied card and that mix would effect your margin as well as obviously our continuing focus on trying to reduce the cost of card. In terms of the other part of the margin which has to do with the operations side of the business, that is really the course of our employees that support the existing contracts and as we said, as you look at more and more of our employees working on specific revenue generating contracts and what you specifically support our customers, you will see an additional shift of the cost of those employees into the cost of sales line which would obviously effect your margin in a negative way. So, those are the four or five components that effect our margin.

Ari Bensinger, Standard & Poor’s

Okay and another quick model question. So, just looking as a percentage of sales for G&A, should we expect this type of level going forward in terms of how relative the sales goes?

Alex Gersh, Chief Financial Officer

This year, if you look at the third quarter G&A number, there are some specific — one of the things in there, we have some additional cost of stock compliant and we have some additional personnel costs. I think if you look at kind of the second quarter and third quarter number in the average, that’s probably, and then apply a single digit, low single digit percentage growth to it, that’s probably how you should look at the G&A.

Ari Bensinger, Standard & Poor’s

Thank you.

Operator

Your next question comes from Daniel Meron at RBC, please ask your question.

Daniel Meron, RBC

Hi Alex and Ab and congratulations on the growth and execution on your part. Can you provide us with the guidelines of how we should think about NDS, any change or deviation from the revenue growth going forward and also what do you expect as far as operating margin expansion.

Dr. Abraham Peled, Executive Director, Chairman, and CEO

Well, I think that there are several issues that we will have to deal with as we prepare for providing guidance going forward, one is obviously as we have explained in the past, currency has an impact on our dollar results. If you look at the guidance that we gave in May of last year, the dollar was, pound was 192 or so to the dollar. It has gone through a low, it’s now back up. It has less of an impact in profit because we have, we’re fairly well balanced in terms of revenue and expenses. But perhaps another critical thing that we should highlight that as you know, we take the, part of the monthly subscriber fee, we take it into deferred income and if you look at the deferred income on our balance sheet, there’s over $100 million roughly and that is revenue that will come in once we do card replacement. So, a impact would be for example, 2007 whether any card replacement cycles that start for larger customers obviously would have an impact on revenue growth and that’s why we’d like to talk about multi year rather than any one individual year because these kind of effects do have — it needs to be smoothed out on a multi-year basis. Also, one should remember that this year, we had the benefit of two one-time events in our operating income. One is the download of middleware and existing DIRECTV set-top boxes rather than new ones that go on in a ongoing basis. Also, a tax and R&D credit in France and Alex will comment maybe on the exact number, but in the order of $50 million was more of a one-time event. So, when you look at next year, I think you’ll have to smooth it out. Having said all that, we do believe that in our current business model and what we see the market going forward, we can do a multi-year revenue growth of 10 to 15% and an operating profit growth that’s faster than that on the order of 20, perhaps 25% and we would expect to get to a 25% operating margin within the next three years, three to four years perhaps. Alex, you want to add anything?

Alex Gersh, Chief Financial Officer

Yeah, just one thing Ab, I mean the other thing which is really important particularly to our margin is the deployment of the PVR, the DVR and the speed of that deployment. As Ab had mentioned the potential of 43 million households out there clearly could have a significant access, but again it could take in terms of the length of time that it takes for the DVR to reach adoption level is obviously will effect our annual result, which is another reason why you’d like to talk about this multi-year average because clearly that’s an unknown for us.

Daniel Meron, RBC

How is it that, you mentioned card dropouts, which customers specifically are you thinking of when you how is that Sky deployment impact your revenue or model mixture one way or another, thanks?

Dr. Abraham Peled, Executive Director, Chairman, and CEO

First of all, we can’t comment on card replacement cycles of our customers. Sorry, I cannot help you on that. In terms of Tata, you know, they are supposed to launch this summer. I think there is still — whether we recognize the launch and it’s integration development revenue next quarter or the following quarter really depends on an acceptance status and very detailed timing. I think we’re still, you know it’s very hard to be sure of it and we don’t really try to manage it. It happens when it happens. In terms of the rate of deployment, I think they said that they would like to get a few millions within three to four years. So, they are preparing for a very strong ground.

Daniel Meron, RBC

Okay, that’s fair enough. Also, can you maybe elaborate on how you feel your positioning is within the IPTV market; one way or another is it acting — you mentioned obviously speeding out the decision process in competition in this way positively, but do you see yourselves losing share or gaining share in the IPTV market on a stand-alone basis?

Dr. Abraham Peled, Executive Director, Chairman, and CEO

First of all, I think obviously our major competitor in the IPTV market is Microsoft and their kind of solution. I do believe that NDS has a better solution. First it works and is scalable and second we believe it’s significantly more secure and once IPTV becomes a major deployed platform and we’ll be under attack, we feel that our solution is more secure. Having said that, there’s a lot of discussion about IPTV, but if you look at the 2.2 roughly million IPTV set-top boxes in stores worldwide, over 1 million doesn’t have any CA. It really is used whether its Fast Web or Free in France of PCCW, the Premium TV Services on it are only incidental and account for a very tiny fraction of the revenue. So, the really broadband was on cable TV thrown in and perhaps tens of thousands of premium subscription. How that ended — it has happened a lot slower than people expected a year ago. You look at that number, NDS probably of the remaining million or so in terms of deployed, our largest instillation is in Japan, which has close to 150,000 now. Then, a major European telecom that has deployed which we haven’t formally announced has tens of thousands, as Telekom Austria seems to be going and so on. NDS probably has around 250,000 all together in the IPTV which is certainly a higher market sales than Microsoft that has almost nothing deployed at this point. Now, how this whole thing will develop you know remains to be seen and we continue to be active in offering our solution.

I again want to emphasize that I think it will all together not be very large number of subscribers compared to a continuing growth in our store based whether it’s on cable or satellite, we added this year than — if you look at the March 2005 to Mach 2006, 10 million increase in store set-top boxes. IPTV will take a while to get under that kind of range of number.

Daniel Meron, RBC

Thank you Ab and Alex, good luck going forward.

Operator

Your next question comes from Murray Arenson of Ferris Baker Watts, please ask your question.

Murray Arenson, Ferris Baker Watts

First, I wondered if you could help quantify the foreign exchange impact for this past quarter, for the March quarter?

Alex Gersh, Chief Financial Officer

I think what we said, when you look at our, we haven’t really looked at it on a quarterly basis. I think in a quarter we make a significant, I think what we said it’s about 3% impact on our revenues on the quarterly basis and roughly the same 3% impact on a cost going the other way. So, the impact on the operating income is really nonexistent.

Murray Arenson, Ferris Baker Watts

I looked at the operating income, if I remember right from what you said last quarter, you were looking for the operating income margins to be down in the second half versus the first half, clearly that’s not the case that you are of to at least for starters, can you just kind of explain to us what went well and what surprised to get to this point?

Alex Gersh, Chief Financial Officer

I think a couple of things obviously went well. As we said, you know our operator here, if you look at our gross margin and I talked about the things that effect our gross margin and whether it’s a monthly fee and additional number subscribers, whether it’s the software components of our business have gone well. I think again if you look at our costs, again whether it’s because of the mix of the customers that we are shipping on cards too as well as the good job we’ve done in terms of cost of the cards, we see that has also gone well. And I think in general, we continue to be in terms of the overall cost line we have found, as we said, that we have resources, we have a significant proportion in India which continues to help us as well as just overall focus on operating efficiencies. Some of these things have gone as we expected and some of the things have gone on better than we expected, which is were we wound up.

Murray Arenson, Ferris Baker Watts

Okay, great. Last question on the middleware side, I’m not sure if I caught your complex correctly Ab, I mean it looks to me like what you did for this quarter in terms of middleware versus the run rate you’re talking about, like you’re ahead of your run rate for this particular quarter; can you just kind of give us a sense of where that’s at and what we should expect?

Dr. Abraham Peled, Executive Director, Chairman, and CEO

I think that we were saying we think we could do a $12 million run rate. We really would like to get to $15 million run rate as you, as we are getting new customers and we started shipping into some of the whether it’s Canal+ as well as with the DIRECTV DVR, that of course has the middleware as well, as well as the DVR technology. I think $40 million is probably at this point a reasonable run rate. We hope that next year it will go off based on some new wins as well as some more aggressive deployments on some of the platforms in Europe.

Murray Arenson, Ferris Baker Watts

Great, okay, thank you very much.

Operator

Your next question comes from Roni Biron or Oscar Gruss, please ask your question.

Roni Biron, Oscar Gruss

Hi Ab and Alex, congratulations on the quarter and a couple of questions from me. First, in terms of DVR revenues from what customers did you recognize DVR revenue this quarter for the first time and how do you expect this line of business to run in the coming quarters?

Dr. Abraham Peled, Executive Director, Chairman, and CEO

Well, we don’t usually provide breakdowns by customers, but clearly we now have DIRECTV DVR, we have Sky Italia DVR that’s probably for the first time, Alex correct me if I’m wrong.

Alex Gersh, Chief Financial Officer

No, you’re right.

Dr. Abraham Peled, Executive Director, Chairman, and CEO

And Sky that reported number, you know rate continues to be very strong. I think Sky in the U.K. reported under 40,000 DVRs this quarter, 49 actually. So, I think that’s really where the DVR numbers started coming from.

Roni Biron, Oscar Gruss

For the next coming quarters, do you see a significant ramp up into your business or similar levels?

Dr. Abraham Peled, Executive Director, Chairman, and CEO

Well, I think there is a variation depending on promotion. I think that Sky HD DVR will launch the World Cup. It seems to be reasonable sense of demand. It really has a lot more to do with the marketing and sales promotions that our customers run and we can control it. So, typically last quarter of the year, around Christmas, they do more promotions and people tend to buy this, get this as they think. But I do believe that both HD and DVR will start playing more significantly next year.

Roni Biron, Oscar Gruss

Now, in terms of gross margin, as it was probably mentioned a few times in this call, it was better than I expected. How sustainable do you see this level and do you expect it to continue and improve when the DVR shows ramp up?

Dr. Abraham Peled, Executive Director, Chairman, and CEO

I just want to, and Alex will answer, I love to know how some people to the gross margin that we have is really to be frank, the people that we have working on specific projects on the cost of the card. People working specific projects will fluctuate. We typically, as a management team focus, on the operating margin because that consumes it too. We are combatively improving the operating margin. This year, it came in higher because, as I said, for some one-time factors, but we want to get to 25%, Alex.

Alex Gersh, Chief Financial Officer

Nothing really else to add, I think you really answered the question Ab.

Roni Biron, Oscar Gruss

Okay, just in general, do you assume any revenues contribution from that in your full year guidance?

Dr. Abraham Peled, Executive Director, Chairman, and CEO

We can’t go into that.

Roni Biron, Oscar Gruss

Okay, in regards to you agreement with Intel, if you can talk about it, the potential here and when do you expect it to materialize into significant revenues.

Dr. Abraham Peled, Executive Director, Chairman, and CEO

I think it’s way premature to talk about revenues. We are committed to integrate our security hardware elements into as many standard chips as possible that is the now strategy. So, it’s like MDS insight, which is a double insight that’s MDS Intel insight — it’s Intel insight or MDS insight whatever, and we’ve done it to collect them all of these different applications as to, and now, what extent that will happen quickly and will it be used to distribute broadband entertainment and other, is certainly, we’re talking two to three years out for it to be of any significant scale. You know, when you deal with chips, you have to be there to be used, and I think that, and you almost think of it as design wins in some respect and to materialize.

Roni Biron, Oscar Gruss

Finally, Alex, could you repeat what was the number of the diluted shares this quarter?

Alex Gersh, Chief Financial Officer

I’m sorry what?

Roni Biron, Oscar Gruss

The number of diluted shares this quarter?

Alex Gersh, Chief Financial Officer

The EPS number?

Roni Biron, Oscar Gruss

Yeah. You specified the EPS but not the diluted number of shares.

Alex Gersh, Chief Financial Officer

You’ll see it in the Q when it comes out today. I think it’s something around $56 million or something like that. We said it’s $0.49 per diluted share, which was our net income per share…

Dr. Abraham Peled, Executive Director, Chairman, and CEO

28 million divided by 49.

Roni Biron, Oscar Gruss

Okay, so thank you very much.

Operator

You’re next question comes from Michael Walter at Goldman Sachs, please ask your question.

Michael Walter, Goldman Sachs

Hi Ab and Alex. I have a couple of questions if I may, and the first one is on profitability. As far as I can understand, your average revenue per active customer either in the rental mode or the monthly fee mode or the standard mode, seems to have decreased somewhat this quarter versus the previous quarter, maybe you can either confirm it or explain it what was the cause. I’m also interested if the current cost per card that you sustainable? Thank you.

Alex Gersh, Chief Financial Officer

I’m sorry I did not understand the first part of the average revenue question, I couldn’t, but could you repeat it please?

Michael Walter, Goldman Sachs

Yes, absolutely, it looks in my model that you’re average revenue per, either you would or the card ESP have decreased this quarter versus the previous, is that something that could be due because of the mixed shift or is it, has it actually happened?

Alex Gersh, Chief Financial Officer

I’m not exactly sure, but I think that maybe we need to, at some point, to just look at your models, because I don’t think that’s true. Certainly Ab, our average revenue per subscriber I do not believe that’s decreased.

Michael Walter, Goldman Sachs

And then going down to your Smart card cost, is the current level something that is sustainable.

Alex Gersh, Chief Financial Officer

Well, you know, I think there are two, as I said before, I there are two things that are important could cost of SmartCard. One is clearly the mix of customers that we are shipping cards to out. Different customers obviously have cards that have different costs, but overall I mean you can make a statement that as we continued to increase our customer base as we continue to ship more and more card and as Ab said, we’ve got 10 million active subscribers out there, clearly it would give us the opportunity for continuing to work on any kind of volume discount that we would get. So, those two things need to be taken together. One is, you know, the view to the customers and two is as we continue ship more and more cards, we certainly have the opportunity to perhaps look at the additional volume discount.

Michael Walter, Goldman Sachs

Finally, usually you say what percent of your total number of cards that are in the rental mode, I’m wondering if that’s something you could expand upon.

Dr. Abraham Peled, Executive Director, Chairman, and CEO

We don’t have a rental mode, just to clarify it.

Michael Walter, Goldman Sachs

Sorry, monthly fee mode?

Alex Gersh, Chief Financial Officer

About 87% of our base is paid as a monthly fee.

Michael Walter, Goldman Sachs

Okay, thank you very much.

Operator

Your next question comes from Todd Mitchell of Kaufman Brothers, please ask your question.

Todd Mitchell, Kaufman Brothers

Good morning. I feel we’re way in on the impressive margin leverage, however, if I could nickpick on one thing. It seems to me that revenues were slightly lower than people were looking for and specifically compared to my model, it came in the new technologies line. Can you sort of flush out what might be going on there, I know we have DIRECTV make some comments on it earnings call last week that their stock was about $10 to $15 and it had to do with some execution issues on boxes going out and having being reshipped back; is there anything going on there and is it fair to assume what we’re seeing in this quarter is the margin new technology line doesn’t reflect as full on an annualized basis, the quarterly run rate that we will see out of DIRECTV going forward for DVR?

Dr. Abraham Peled, Executive Director, Chairman, and CEO

We, I think that as you said, DIRECTV have said that there has been updates with the DVR software which have occurred since shipment and with every new product there is a ramp up period in getting everybody across the line both in knowing and understanding the product from the stores to the operators in the call centers as well as once you have it out there, you discover things you wished you had and certain effects that you can think about, and all of these have been updated over the first quarter of this year. So I don’t think that, your question has to do, is that the kind of volume per quarter that would be shipped on a regular basis, you know I really can’t tell because that depends on how aggressively DIRECTV is promoting it and how much retail there is, the seasonality, and that’s why we refrain from making shorter predictions on would be this many that quarter. We think that over a medium time frame, the DVR will become the main set-top box in their home with everyone of our major developed customers.

Todd Mitchell, Kaufman Brothers

Okay, can you just on a quality — in this business, the way that your revenues are generated from DIRECTV, is there because you’re in the process of — downloads that are going on in the site; is there a component of booked in milestones, booked on ASTs. And is that, you see what I’m saying is there an issue there where there could have been milestones that could be booked later?

Dr. Abraham Peled, Executive Director, Chairman, and CEO

No, it has nothing to do with them.

Todd Mitchell, Kaufman Brothers

Okay, thank you very much.

Operator

Your next question comes from Anuj Mutreja of Morgan Stanley, pleas ask your question.

Anuj Mutreja, Morgan Stanley

Thank you, Hi Alex and Ab. Most of my done earlier on but if I could just pick up one thing and get a bit of color and I want to ask you on EBIT margin basis, on a like-for-like basis, what has been the growth lets say between last year and this year in terms of your fact cost and maybe specifically the pricing cost that are attributed to R&D, just if I can understand what’s going on in a basic level. I understand that you have to transfer it between cost and consults, but if we just look at it as operating costs in total, do you have that number?

Alex Gersh, Chief Financial Officer

If you basically take your operations in support and add it to an R&D line, you will get that. I mean the increase has been the head cont increase. So, the 530 people we have mentioned was the increase.

Anuj Mutreja, Morgan Stanley

Okay, that’s fine,

Alex Gersh, Chief Financial Officer

Fundamentally all.

Anuj Mutreja, Morgan Stanley

Yeah that’s what I was looking for, thank you.

Operator

Your next question comes from Alan Gould at Natexis, please ask your question.

Alan Gould, Natexis Bleichroeder Inc.

Thank you, a couple of questions. Alex first, what was the $2.2 million of other in the quarter?

Alex Gersh, Chief Financial Officer

$2.2 million of other expenses?

Alan Gould, Natexis Bleichroeder Inc.

Yeah, it came as a positive $2.2 million in the other expenses.

Alex Gersh, Chief Financial Officer

That’s the foreign exchange impact.

Alan Gould, Natexis Bleichroeder Inc.

Okay, and what tax rates do we use for the year about 30%?

Alex Gersh, Chief Financial Officer

Yeah, our tax rate is very much accepted by various jurisdictions where the taxable income is coming from. So, sometimes we can do better, but we generally talk about 30%.

Alan Gould, Natexis Bleichroeder Inc.

Yeah ok. Is that normalized or should that go up next year would one think?

Alex Gersh, Chief Financial Officer

We don’t expect it go up, no.

Alan Gould, Natexis Bleichroeder Inc.

Okay and when you have the card slop avenue, and you recognize that avenue, would that be that be a similar profit margin that you’re getting on your currently recognized revenue from the cards, higher or lower?

Alex Gersh, Chief Financial Officer

We differ the price of the card and so if you think about how it would work, once the slop out begins, the price of the card effect will go into revenue, we obviously need to provide a card, so the cost of the card comes into the cost. So, your gross margin should be the same as you see now — any assess on the gross margin if you’re looking at the cards.

Alan Gould, Natexis Bleichroeder Inc.

My last question, the range of $128-135 million on your new operating income guidance, is most of that differential as to whether or not Tata Sky launches in this fiscal year versus next fiscal year?

Alex Gersh, Chief Financial Officer

There are a number of things, as Ab said we don’t specifically talk about Tata Sky, but there are a number of things that make that number, some of it would have to do obviously recognizing the revenue as we complete projects for customers. Others have to do with some additional cost that we expect in the fourth quarter. As an example, I’ll give you an example, we expect to invest some money in the fourth quarter in the engineering as we develop the next generation of cards. So, that’s going to be one of the items in the fourth quarter and there’s a few other ones. There is a new facility that we have here in the U.K. that will have an effect. Obviously, the third quarter head count and the fourth quarter additional head count will have an effect and some one-time personnel cost that will have an effect.

Alan Gould, Natexis Bleichroeder Inc.

Okay, did the board authorize an option program?

Alex Gersh, Chief Financial Officer

The board authorized an option program.

Alan Gould, Natexis Bleichroeder Inc.

Okay, thank you.

Operator

Your next question comes from Can Elbi of Cheuvreux, pleas ask your question.

Can Elbi, Cheuvreux

Hi Alex, just two questions. First, is one of your major competitors that are going to some major policies right how, are you seeing that has any positive impact on NDS when you’re going through contract trends.

Dr. Abraham Peled, Executive Director, Chairman, and CEO

Well, I think it’s a double-edged sword. That major competitor is a result of the issues that we have, is even more aggressive on reducing its prices and as you know Can, NDS does not compete simply on price and we want to have only business with adequate returns. On the other hand we have, obviously more customers coming to NDS and saying perhaps saying what can you do to help us because our security is really improving itself and we enjoy 0 piracy around the world with cards that are now being deployed often three and four years.

Can Elbi, Cheuvreux

Okay, and Alex, on this $50 million R&D credit that we see in France…sorry, is it 5, okay. I thought you said that that was going to be an ongoing $5 million credit going forward and I guess Ab now said it’s only one off so…

Alex Gersh, Chief Financial Officer

No, we both said it was a one-off and there maybe some small credit in the next year, but this was basically a one-off large credit.

Can Elbi, Cheuvreux

Okay, was that mostly second quarter or is it second quarter and third quarter together, that $5 million?

Alex Gersh, Chief Financial Officer

Second quarter, all of it was in the second quarter.

Alex Gersh, Chief Financial Officer

Okay, thanks a lot.

Alex Gersh, Chief Financial Officer

It was actually first quarter, not second quarter, I’m sorry.

Operator

Your next question comes from Jason Mauricio of Arete Research, please ask your question.

Jason Mauricio, Arete Research

Hi there, three questions if I will. One, Ab, when you talk about 250,000 IPTV sub, is that mainly for positional access or would you include middleware in that? Then, turning to the middleware side of the business, if you would to maybe winning new business contenders which are on offer now, can you talk about the outlook on the middleware side and maybe any changes in business model to adopting a more recurring revenue type model. And then finally Alex, when you say that you’ll hit the lower end of the revenue guidance, when you’re making, when you’re planning for the guidance, what would have had to happen to get to the upside; I mean what’s not happening that is bringing you down to the lower end?

Dr. Abraham Peled, Executive Director, Chairman, and CEO

Okay, so IPTV at the moment in media offering is integrated with other people’s middleware in the case of Yahoo Broadband in Japan, it’s UT Starcom, in some other cases it’s Alcatel. So, the 250,000 are all smart card based ITPV set-top boxes was NDS. As well head on component.

Jason Mauricio, Arete Research

So, you don’t have any aware customers yet?

Dr. Abraham Peled, Executive Director, Chairman, and CEO

I would say the only exception is the deployment of media high way and where we don’t have our CA but Canal+ in France where it’s deployed through France Telecom lines as part of, I believe it’s called. We do have that middleware but from a deployed IPTV systems, it’s all other people’s middleware. Of course, we are looking at the opportunities in that area as well. In terms of middleware at best, I’m pleased to say that we have competed in four cases in the last year on middleware with some serious middleware players and have won in each of those cases. So, I think we feel fairly good about our ability to win with our media high way middleware and then particular on next generation middleware that we’ll start rolling our next year.

Jason Mauricio, Arete Research

Are there any particular large customers out there, potential customers that could be coming to tender in the next year or so?

Dr. Abraham Peled, Executive Director, Chairman, and CEO

At this moment, there are…

Jason Mauricio, Arete Research

Or rethinking their middleware strategy.

Dr. Abraham Peled, Executive Director, Chairman, and CEO

Yeah, I think obviously that’s an ongoing process. I can’t really comment on customers that we are talking to at this point.

Jason Mauricio, Arete Research

Okay.

Alex Gersh, Chief Financial Officer

On the revenue question, I think the short answer, as Ab alluded in his introduction remarks, foreign exchange fluctuations have effected us significantly during the year. About 50% of our revenue is found in Euro denominated and clearly if you look at Ab talked about, guidance, when we set the guidance originally and the race for the first nine months of the year, if you look at March, you will see probably an 8% or so, I’m sorry a 8% shrink of the dollar over that period. So, that has had a very, very significant effect on the guidance.

Jason Mauricio, Arete Research

Okay, thanks.

Operator

Your next question comes from Mehrdad Torbati from Deutsche Bank, please ask your question.

Mehrdad Torbati, Deutsche Bank

Hi Ab and Alex. I have a question regarding the last three months on the cash side. I’ve noticed that you have made over $100 million short-term investments, could you please tell us what kind of interests could we expect out of this investment and since you’re talking about cash, I know you have $460 million cash on hand, do you see opportunities out there at all, evaluations have increased in the meantime and we haven’t seen you making acquisitions for almost two years now, apart from a small one. So, where are you on that front, it there any opportunity to give cash back to shareholders in some form of the other? And I have a question regarding your employees, I mean you have added 500 employees over the last 12 months, is it the same rate we should expect you to add employees over the next 12 months, has this cycle of investment in HR coming down and we should expect slow down in your hiring? The final question is regarding the one-time impact on your office. You mentioned the credit from France one-time effect of $5 million in the first quarter. Could you comment on stock option expensing in the third quarter, what the impact was there and to date thank you?

Alex Gersh, Chief Financial Officer

Let me take a few of these questions and then let Ab review the acquisition question. In terms of the short-term investment, it’s nothing fancy, nothing complicated. All we’ve basically done is we’ve put some of our money into the six months bank deposits versus what we used to do which is a three months deposit. Once you’ve put it in the six months or more under the U.S. GAAP, you’ll have to quantify it as a short-term investment. Clearly, I mean in terms of rate, we don’t disclose the specific rate but obviously three months versus six months, the rate is not significantly better, I mean it’s slightly but nothing huge. In terms of the employee numbers, I think two things that I would say, it’s that It’s really difficult for us. We’ve tried last year to predict the number of employees we’re going to add and I think what we’ve learned is as the business evolved and there are more and more opportunities for us and more and more projects come on, we have to look at this and relook at this figure. So, I think certainly for me it’s hard to comment on the number of employees we’re going to add. It all depends on the revenue, it depends on the project, it depends on new developments that happen. I do want to point out though that if you look at the overall cost and you look at the number of employees, because of our significant expansion in India, the cost of the employees that we higher as not been an efficient way to make sure that the cost stay in line. In terms of the stock option expense, this year, for the whole year, the new stock option grant, you will see all the numbers in the 10-Q which will come out today, but the last stock option grant because it was approved to be at the middle of the year this year, it would have a roughly $3 million effect on the PML for this quarter and next quarter. So, $1.5 million or so a quarter and obviously next year it would have a full year impact of roughly around $6 million.

Dr. Abraham Peled, Executive Director, Chairman, and CEO

Okay, in terms of the acquisitions, I think Mehrdad, first of all, your absolutely right, evaluations are going up and they are getting a bit too rich for some of the things we’ve been looking at. We, I think, continue to believe that there are acquisitions that we can make to expand our coverage of the mobile IPTV, in particular hybrid TV market, but NDS has always been careful not to overpay, and it’s not like we’re in a hurry that we have to buy something. Therefore, we continue looking at. In the subject of returning money to shareholders, our board added annual — before the general shareholder’s meeting, consider the question of dividends and I’m sure that it will be considered again in our annual meeting this year.

Mehrdad Torbati, Deutsche Bank

Thank you.

Operator

There are no further questions at this time sir, please continue.

Dr. Abraham Peled, Executive Director, Chairman, and CEO

Okay, well I want to thank everybody for joining us on this conference call and as I said, NDS continues to enjoy healthy demand for its product and services. We see the market evolving quite rapidly. I think in the medium term the impact on NDS financial performance would be strongly affected by things like multi-room penetration and if you look at the results, for example, Sky show continues with multi-room penetration. DVR penetration which as I said we have 43 million households to go out of which only 2.7 million now have them and the High Definition and High Definition DVR which will drive a major replacement cycle and finally as the satellite operators will become more competitive, they’re looking to introduce to hybrid boxes and that again will drive a major replacement cycle. That in addition to new wins and more software and services will help us improve our margins. So, thank you very much and we will deal with you on our next call in August.

Operator

That concludes our conference call today. For those of you wishing to review this conference, the re-tape facility can be accessed by dialing the U.K. on country code 44-1452-55-0000 or 0845-245-5205. The U.S. free phone number is 1866-247-4222. The reservation number is 768-7585 followed by the “#” key. Thank you for participating, you may all disconnect.

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