William Blair: DTS’s Earning Power Should Steadily Increase in 2007 and Beyond (DTSI)

William Blair & Company analyst Ralph Schackart released a note to clients on the prospects for digital audio company DTS Inc. (DTSI) following recently hosted investor meetings. Key excerpts from the note follow:

We walked away increasingly more confident that the High Definition [HD] cycle is finally beginning and that DTS’s earnings power potential will begin to benefit in 2007 and beyond now that it is an HD standard (along with Dolby (DLB).

Management remains bullish about its HD-cycle growth potential now that it is a mandatory standard. Moreover, management continues to “feel comfortable” with its 2006 guidance of revenue between $83 million and $86 million, earnings per share (excluding option expense) of about $0.65, and 50% growth in DDI.

Stock remains attractive as a highly leveraged HD-cycle investment. Shares remain attractive at 11.1 and 9.8 times 2006 and 2007 EV/EBITDA, respectively, and 22.4 times and 20.4 times P/E (excluding cash), respectively, a 6.5% FCF yield, and about $6.50 per share in cash (in 2006), or roughly 35% of its market value.

We recommend purchase of the shares for growth investors. We believe an investment in DTS is a leveraged and diversified end-market (i.e., DVD, video game hardware, PCs, etc.) play on the HD cycle, as we estimate DTS can earn about $1.00 per share in 2008 -- and potentially more than $1.30 if our PC ASP forecast of $0.25 per unit proves too conservative...

Our PC revenue forecast and, in turn, our 2007 EPS estimate of $0.72, may be conservative.
We forecast DTS earns roughly $0.25 per PC shipped with either a Blu-ray or HD-DVD drive equipped with two-channel (i.e., left and right audio channels only) audio.

As efforts to turn PCs into media center devices continue, however, many will likely opt for 5.1-channel (i.e., surround sound) playback. We believe DTS can earn roughly $2 per PC equiped with 5.1 audio.

At present, DTS sells very few PCs with 5.1-channel audio (i.e., it only generates about $3 million in PC revenues, compared with Dolby’s estimated $75 million-plus PC revenues), because, unlike Dolby, it is not a mandated standard on current-generation DVDs. As a result, on PCs shipped with next-generation DVD players, we believe DTS has the chance to earn ASPs on par with Dolby's $0.70 average.

Using this Dolby PC ASP forecast of roughly $0.70 in our 2007 DTS model, instead of our current $0.25 ASP, yields a 2007 EPS opportunity of roughly $0.83, or up 15% from our estimate of $0.72...

That said, as the transition to the HD cycle is still in its early stages, we will maintain our $0.25
ASP estimate per PC shipped with a Blu-ray/HD-DVD drive in 2007 and 2008. We believe there is upside potential to our estimates if PCs begin to ship with 5.1 audio capabilities, however.

There is an increasing conviction in HD cycle potential to achieve 30% household penetration in three years — sooner than the last DVD cycle. Management believes HD household penetration rates of DVD players could achieve 30% penetration rates in three years -- considerably faster than the roughly five years it took current-generation DVD players.

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