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PortalPlayer, Inc. (PLAY)

Q3 2006 Earnings Call

October 26, 2006 5:30 pm ET

Executives

Kristine Mozes - IR

Gary Johnson - President and CEO

Olav Carlsen - VP and CFO

Analysts

Peter Trigarszky - Citigroup

[Amit Rao] - Credit Suisse

Alex Kim - Thomas Wiesel Partners

Adam Benjamin - Jefferies

Daniel Ernst - Hudson Square Research

Craig Berger - Wedbush Morgan Security

Quinn Bolton - Needham & Company

Presentation

Operator

Welcome to the PortalPlayer Inc. Third Quarter Fiscal 2006 Earnings Conference Call. Today’s call is being recorded and will be available for playback beginning two hours after the completion of the call. To access the replay, please dial 719-457-0820 with the passcode 8563431.

And at this time for opening remarks and introductions, I would like to turn the call over to Ms. Kristine Mozes, Investor Relations for PortalPlayer. Please go ahead, ma'am.

Kristine Mozes

Thank you for joining us today. In addition to this call being available by phone replay, it is being broadcast live via the Investor Relations page of PortalPlayer's website at www.portalplayer.com.

Earlier today, we issued our press release and filed it with the SEC. The press release is also available on PortalPlayer's website. That press release contains certain non-GAAP financial measures, which we will discuss during today's call, together with the most directly comparable financial measures calculated in accordance with GAAP and reconciliations of the differences between these measures.

With me today is Gary Johnson, President and CEO of PortalPlayer, and Olav Carlsen, PortalPlayer's Chief Financial Officer.

I will begin this call by reading our Safe Harbor statement.

The statements on today's call that are not historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act. These forward-looking statements include, but are not limited to, statements as to our core competencies, our ability to execute on our product roadmap and overall diversification strategies, our future plans and growth, development efforts, features, benefits and introductions of products and technology, our entrance into new markets, anticipated customer demand, our ability to execute our product roadmap, our revenue growth, market trends and demand for the benefits of the feature-rich segment of the personal media players market, and anticipated growth of this market; market trends and demand for PCs, notebooks and consumer devices that incorporate secondary display technology, and anticipated growth of this market, expected revenue from sales into this market, availability of the Microsoft Vista SideShow technology, our ability to incorporate new video technologies into our platforms, benefits from a new manufacturing flow, investments and facilities in India, demand for our products, our projected fourth quarter and future spending levels, and future financial results; GAAP and non-GAAP financial result including revenue, net income, expenses, gross margins, ASPs, stock-based compensation charges, tax rate, cash flow, and operating expenses including but not limited to future R&D spending and selling, general and administrative expense.

These forward-looking statements are subject to a number of risks and uncertainties that could cause the actual results to differ materially from those discussed in these forward-looking statements.

Please refer to today's earnings release, our Form 10-Q for the period ending June 30, 2006, as filed with the SEC and from time-to-time in our other SEC reports, for information on risk factors that could cause actual results to differ materially from those discussed in these forward-looking statements. These forward-looking statements speak only as of the date hereof. PortalPlayer disclaims any intent or obligation to update these forward-looking statements.

Additionally, this conference call is the property of PortalPlayer, and may not be recorded or rebroadcast without specific written permission from the company.

PortalPlayer reports earnings per share and net income in accordance with GAAP and additionally on a non-GAAP basis. PortalPlayer uses non-GAAP additional measures to exclude certain expenses it believes appropriate to enhance an overall understanding of its past financial performance and also its prospects for the future. PortalPlayer believes that providing these non-GAAP financial measures is useful to both its management and investors, because they provide a consistent basis for comparison of the company's financial condition and results of operations between quarters, which comparison is not influenced by stock-based charges, the amortization of purchased intangible assets and the related tax effects on these items.

The full reconciliation of the GAAP to non-GAAP financial data can be found in our earnings release issued earlier today, and we ask that you review in conjunction with this call.

Now, I would like to turn the call over to Gary for his introductory remarks. Gary?

Gary Johnson

Thank you and welcome, everyone. As you saw from our press release, Q3 revenue was inline with our guidance and was -- and we generated cash from operations to end the third quarter with a $195.5 million in cash and short-term investments, an all time high. We were able to further reduce our spending, as expected, while continuing to focus on our strategic programs.

Our projected fourth quarter spending level before stock and amortization charges is now expected to be about 40% less than it was in the fourth quarter a year ago. Also in Q3, we executed well on our strategic technology roadmap to achieve a more diversified business structure.

In our personal media player business, we continued to ship products to our largest customer, for its new video-enabled model. We expanded our relationship with SanDisk to include its c200 series of media players, and continued to market our technology to a broader customer base.

We expect revenue from our Preface product line to ramp in 2007 as manufacturers introduce their innovative designs throughout the year. Also during the quarter, we successfully taped out technology for our next generation family of products. For the first time, we used a 'customer owned tooling' manufacturing model, and are planning to sample the new chipset during the fourth quarter of this year, ahead of the January Consumer Electronics Show in Las Vegas.

In early October, we acquired AVCCore Inc., an early stage entrepreneur-funded company engaged in the development of high definition or HD video capabilities that we believe fit well within our technology roadmap. The total acquisition price for AVCcore was $2.5 million. We plan to use cash for this transaction with about half being paid in Q4 and the rest is expected to be paid over a three-year time period.

Through this acquisition, we add HD video expertise to our design teams in India and in the United States. The acquisition also brings us HD video related intellectual property that would assist us in developing our next generation high definition technologies.

In a few minutes, I'll go into more details about each of our target markets and the milestones we've achieved. But first, I'll turn the call over the Olav, who will go through the quarterly financials. Olav?

Olav Carlsen

Thank you, Gary and welcome everyone. The third quarter financial results we are reporting today are once again inline with our previous guidance, with revenue of $34.8 million. In the third quarter, more than 10% of this came from what we've termed other customers and we expect revenue from other customers to increase. On an absolute dollar basis, as well as a percentage of overall revenue to an all-time record level in the December quarter. Our third quarter gross margins of about 43% was better than we expected and was about 80 basis points higher than in the previous quarter.

As we discussed with you last quarter, we still expect margin pressure in the fourth quarter. This is of course due to the fact that our largest customer did not transition to our follow-on product to the 5021 device, while at the same time we continue to experience a decline in ASPs for the 5021. As a result, we expect our fourth quarter gross margin to be below our long-term model of 41% to 44%. But the overall gross margin for the full year of '06 is expected to be around the low-end of this model.

From the technology perspective, the third quarter marked a very important milestone. As Gary mentioned earlier, we successfully taped-out our new product family, not only did we tape-out what we expect to be very impressive technology; but we also did this for the first time in a consumer -- I am sorry customer owned tooling or COT manufacturing flow. We expect this move to positively impact our gross margins in '07. Once we start selling our new SoC's that will be manufactured using this more direct manufacturing flow.

The third quarter also marked another positive milestone for us; we added another revenue flow to our business model. For the first time, we have begun to license our silicon and software; as a result, we recorded royalty income in the third quarter and expect income from royalty and licensing to increase over the coming quarters. This new revenue flow was designed specifically to enable us to extend the life of our mature, feature-rich technology or broadening our available market to include products typically dominated by lower cost technology providers.

We are very excited to implement this model for the first time to help bring high-end product features to media players priced under $100, and Gary will share more details with you in a minute.

Net income for the third quarter was $1.5 million compared with a net income of $10.3 million in the same period a year ago. The third quarter 2006 net income resulted in an income of $0.06 per diluted share based on 25.4 million weighted average shares outstanding compared with a net income of $0.40 per diluted share based on approximately 25.5 million weighted average shares outstanding in the same quarter a year ago.

Net income in the second quarter of '06 was $1.4 million or $0.05 per diluted share based on 25.3 million weighted average shares. This included not only stock-based compensation charges, but also the amortization of intangibles and the tax effects of those items. Remember that in the second quarter of '06, we also booked the net tax benefit of about $1 million to our P&L even though we were profitable.

Now, excluding stock-based compensation charges of $2.8 million in accordance with FAS 123R also excluding the $340,000 of amortization of intangibles assets as well as the tax effects associated with these charges non-GAAP net income for the third quarter of '06 increased quarter-over-quarter to $3.4 million or to $0.13 per diluted shares based on 25.4 million weighted average shares outstanding.

The non-GAAP effective tax rate was at 34% which is 1 percent point lower than our previous guidance, and this compared with a non-GAAP net income in the third quarter of '05 of approximately $11 million or $0.43 per diluted share. Non-GAAP net income for the second quarter of '06 which in addition to excluding stock-based compensation also excludes the amortization of intangibles, as well as the tax effect of those items was $1.9 million or $0.08 per diluted share.

And in our earnings release, we provided a detailed reconciliation between GAAP numbers and the non-GAAP numbers, which details the stock compensation charges, the charges resulting from the amortization of intangibles together with their tax effects for Q3 of '06, Q3 of '05 and the year-to-date information from both years, as well as the effect associated with the adjustment of our effective GAAP's tax-rate. Excluding stock compensation and the amortization of intangibles, our operating expenses were about $12.4 million for R&D and SG&A in the third quarter, which was about $1.3 million lower than our Q2 spending. This shows again, how flexibly and swiftly we can react to changes in our business. We planned to be very cautious with our spending to achieve a balance between investing widely, so we can successfully execute on our technology roadmap and providing a financial model that supports our current transition to much more diversified business model.

We expect our Q4 operating expenses to be about $11.5 million, which then will be almost 40% less than the fourth quarter a year ago. We continue to expect as in the third quarter to be cash positive in the December quarter and get close to a $200 million cash level by year-end.

Our stock-based compensation charge of $2.8 million this quarter was for stock-based compensation in accordance with FAS 123R including expenses related to our restricted share grants that we began issuing in '05, elements of amortization of deferred compensation and some variable charges. For Q4, we expect our total compensation charge on the FAS 123R to be about $2.7 million before the effects of taxes.

And now let's turn to the balance sheet. In the third quarter, we continued to successfully manage our inventory level with the quarter end balance of only $2.9 million. Our deferred income position which represents the gross margin for shipments in the last two to three weeks of the quarter was $4.5 million.

Headcount at the end of the quarter was 266 with about 60% of our employees based in India and our other locations in Asia, and about 40% in the U.S. About 90% of our overall headcount are technical employees. I also want to give you a brief update on the new facility that we’re building in Hyderabad, India. We have now completed the building shell, and expect it to be completed by year end. We expect this to be a worthwhile investment from the recruiting, development, and financial standpoint.

And before I turn the call back over to Gary, let me summarize our guidance for the fourth quarter. We expect revenue to be about the same as in the third quarter with a range of $31 million to $38 million. Total OpEx, before stock and amortization charges is expected to be about $11.5 million. Stock-based compensation charges are expected to come in at about $2.7 million, before the effect of tax. GAAP net income or loss per diluted share is expected to be between a loss of $0.03 to income of $0.05, based on approximately 25.7 million weighted average shares outstanding. Excluding the stock compensation charges, $340,000 of amortization related to our purchased intangibles, and the related tax effects non-GAAP net income per diluted share, is expected to be between $0.05 and $0.14.

And on top of this, there might be an additional charge for a one time write-off of in-process R&D from the acquisition of AVCcore in the fourth quarter. However, we expect it to be limited of course by the relatively small amount of cash we paid so far for this acquisition. The exact amount will be determined in evaluation analysis undertaken in the fourth quarter. And at this time, I would like to turn the call back over to Gary for his comments. Garry?

Gary Johnson

Thank you, Olav. Now, let's take a closer look at the milestones we achieved in our target markets. First, the personal media player market; we were very pleased that our largest customers introduced refreshed versions of its video enabled media players last month, all of which use our technology. As we announced in our press release today, we also expanded our relationship with SanDisk. SanDisk Sansa e200 audio players which use our technology began shipping in the spring and have been very well received; helping SanDisk to become the second largest brand of Flash-based media players in the United States, according to MPT Group's Retail Track. Now SanDisk has designed our technology into its new Sansa c200 series of audio players.

These players will use silicon based on our proven technology, with a color display, media card slot, and 2 gigabyte memory capacity for under $100, the Sansa 200 is expected to be a volume seller in SanDisk's expanding lineup of media players.

As Olav mentioned earlier, we are licensing the silicon and software [hardware] mature technology to cost effectively migrate our feature rich technologies into the sub $100 market. This is a new approach for us, and has enabled us to win additional business for mid-range personal media players that address customer demands for feature rich functionality at lower price points.

This plays to a PortalPlayer's strengths while helping customers to break the $100 barrier. We plan to selectively use this business model in the future to win additional business with customers, where we can extend the life of our technology, or address markets that are typically supplied by our competitors.

Looking ahead, we believe 2007 will be a very innovative year for the personal media player market. On a content side, we expect to see content distribution sites with new business models that could spur demands for additional content including HD. New media players are likely be introduced to the variety of wireless capabilities, enhanced video and other new features.

Now let's talk about our personal media display business. When we launched our Preface Technologies with Microsoft last January, we envisaged an innovative, simple, inlet display of notebook computers through which users could access all kinds of data, without having to boot the computer, and with 100s of hours of battery life. What we found in working through the design opportunities of our customers is that the potential applications are in fact much broader than that.

PC manufacturers are interested in the technology to finally to be able to differentiate their products. And they are designing new ways to implement the technology. For example, the secondary display can be used to extend the value of the always on experienced to portable devices that are associated with the PC. Many are looking at form factors that enable the secondary display to function as media center remote control. Personal media player and Bluetooth enabled VoIP handsets among others.

We believe this potentially expands our overall target market because the manufacturers are thinking about using Preface for other products, not just with notebook computers. Supporting that effort, we recently hired new team members for this business unit, including a new divisional Chief Technology Officer, [Dean Skelton], who was most recently at Intel for nine years. Reasonable innovative designs are possible because of the flexibility in features, available in PortalPlayer's Preface platform. With the designs being more complex and with the concepts of side show and gadgets being used, it has resulted in longer design cycles associated with these new designs. Therefore, assuming an on time launch of Vista, we do expect unit volumes to start off modestly in January with customers that plan to synchronize their introduction with the Vista launch. We expect initial Preface orders that would have come in towards the end of this year for those customers. We expect volumes to increase throughout 2007, as additional manufacturers ship that product with more enhanced secondary display applications. We are excited about this market and the opportunity gives us in leveraging our existing technology to an entirely new space. Having a new customer base and significantly expanding our target market.

Now let's take a look at our wireless initiatives. We believe our highly integrated wireless solutions will be the foundation of future platforms, in all of our target markets. And we are very pleased that after 18 months of development, we have successfully taped out over next generation of what would be a family of products.

Within our labs, we have passed critical milestones of demonstrating and testing wireless connectivity and multiple operating system support, entry silicon development environments. We plan to sample the new chipset during the fourth quarter and believe we are on track to have some exciting technologies to show customers, at the Consumer Electronics Show in January and at 3GSM in February.

Our focus now is to deliver the chipset and fill that platform to our target customers in order to achieve additional design wins, which could result in initial customer product shipments in the second half of 2007. In addition, we are continuing our business development and sales effort to target new customer designs for the late 2007 and 2008 timeframe.

Now let me share with you another strategic initiative that we are aggressively working to develop. We have recently seen a dramatic increase in amount of high-definition or HD content available both by broadcast TV and through Internet downloads.

The availability of this content is driving customer demand for flat panel displays, with HD capabilities. In fact flat panel TVs are expected to out sale traditional TV's in Untied States in 2007. As consumers become more accustomed to having this HD content available in the home, they will soon demand portable devices that allow them to take their HD quality content with them wherever they go. This trend ties together four key concepts that we believe all play into our value proposition.

One, the ability to manage very high quality DRM-protected content; two, the need for increased storage, in excess of 100 gigabytes of HDD or hard drives, and tens of gigabytes of flash memory; three, the need to wirelessly connect these portable devices, for the acquisition and enjoyment of various HD content, and four, the display of this content on both portable devices and external flat panel screens.

Most of you have probably seen HD quality and can agree that is the driving force of the future and we are excited to be working on the technology to bring HD, to portable devices. We are now happy to open the calls to take your questions about our business. But I want to remind everyone that it is our policy not to comment on specific customers' products or roadmaps. Operator, we are ready for questions.

Question-and-Answer Session

Operator

Thank you. Today's question-and-answer session will be conducted electronically. (Operator Instructions). And our first question today is from Glen Yeung from Citigroup.

Peter Trigarszky - Citigroup

Hi, this is Peter Trigarszky for Glen Yeung. I am curious that you talked a bit about Preface initial shipments starting in January and ramping through the year. Can you give us an idea of how many OEMs you are working with and how you see, I mean, describe the ramp a bit better. Maybe just give us a sense of how large an opportunity that’s going to be by year-end. I think you have described it in terms of -- relative to the size of the notebook market previously.

Gary Johnson

Sure. Let me start off, but I think because the underlining -- one of the threads that really came out of hopefully this conference call and our work in the Preface environment is eventually evolution beyond, as you talked about just the pure lid association in the notebook. We have been pleasantly surprised how our customers have taken that and broaden that into other areas. Now, having said that that does take design time, so those I think will take some time to develop through the ’07 timeframe. So, our early adoptions are certainly moving along as we expected and as we say, assuming [just the launching] time, which we still believe and hope it does indeed. We think those early adoptions will be dividing that early volume and as we go through the year, we think some of these new additional applications, I think have already given us the chance to broaden our application with Preface. So, we think that has a broad future of us in '07.

Peter Trigarszky - Citigroup

So, you are saying that some designs will actually be shipping for revenue in '07, so next '07 holiday season?

Gary Johnson

Well, that -- lets be careful '07 holiday season is -- absolutely, you mean, Christmas '07. Yes, I mean we are expecting that our Preface technology is in fact going to be synchronizing with the Vista launch in Q1 of '07. So absolutely by the Christmas '07, we will certainly hope to see more of these innovative designs in a broader base than just a pure notebook application, yes.

Peter Trigarszky - Citigroup

Okay. And then again, could you -- can you give us a sense of how many -- so you are launching with Vista, I assume that’s at least that part of it is with PC OEMs. Can you give us a sense of how many are potentially coming to market and may be how they -- how that number increases through the year or give us some way to think about sizing that?

Gary Johnson

Again, as you know from a purely American point of view, we were very careful to focus only on the next quarter. But we believe that this could be millions of units in '07. The Preface product line, as you said, will start modestly as we talked about around the Vista launch. I think that gives you some color.

Peter Trigarszky - Citigroup

Great. And then you talked some about, I think it was flexible licensing as you are moving into the sub-$100 MP3 products? Can you just help us understand how you manage your own internal ASPs and then -- or your ASPs into those products? And previously with Apple you did a lot of software and systems design. I am guessing that you are potentially moving out to a broader customer set, is that right or are you still going to keep it as just larger MP3 manufacturers that you are working with?

Gary Johnson

Again the -- from a -- starting at the top-level there, we are approaching -- our approach as you said is in general to focus more on targeted larger customers that works well for the model. So, as we said, the c200 is the first model that has utilize that. I am not going to give you specific financial details for all that model today, but what I will say is that the underpinning of this is two-fold. One, it allows more direct access for those customers to the silicon foundry, and then two, as you indicated, a licensing of the firmware platform. The beauty of that is, it allows the combination of extending the value of our mature technology, but it allows us get to sub-100 price points. So, it’s a really a new revenue model incorporating both silicon and licensing of the firmware platform.

Olav Carlsen

So, also Peter to your question, are we going to take it to the market maybe with smaller customers. We have started this in the true PortalPlayer fashion with the big guys and we are exploiting basically now for '07 for the quarters to come. We can benefit the company from taking it maybe through a broader range of customers. So for now, we are extending life of matured technology with big guys. That’s -- as we have done business in the past. But that doesn’t mean that we can't open up to a much broader market in the future.

Peter Trigarszky - Citigroup

And does that change your revenue recognition at all, as far as the licensing versus the device sale?

Olav Carlsen

Sure. That’s a different revenue recognition model. So, but it doesn’t cannibalize one thing, right. It's an addition. It’s a totally -- it’s a new market, its new customers, its new products. The chip model remains the same. That’s the same revenue recognition model that you are already used to for so many quarters now.

Peter Trigarszky - Citigroup

Right.

Olav Carlsen

And then recognizing revenue on license and royalty has its own rules. I mean, you have royalty income, you have license income. Royalty income is sort of volume-based. License income is time-based. So too complex to go into detail now, but yeah, it does change certainly to some degree. It's a 100% margin model too.

Peter Trigarszky - Citigroup

All right, great. Thank you.

Gary Johnson

Thanks Peter.

Operator

And we will go next to Michael Masdea from Credit Suisse.

[Amit Rao] - Credit Suisse

Good afternoon. This is [Amit Rao] calling in for Michael Masdea. PortalPlayer was traditionally focused on the high-end PMP market, now I have heard you talk a lot about sub-$100 market, and even HD or flat-panel displays. Can you discuss what's changing maybe that -- what changed or what's driving the change strategy to go at the lower-end PMP market, some of these broader markets?

Gary Johnson

Sure. Let's start with the lower-end market. Frankly it's -- I think a natural evolution of how technology moves down to price curve. I think the way you characterize here at PortalPlayer is we have really done extremely well in feature-rich personal media players. And as those features and as color display cost drive reduce, we can drive that with our customers into this sub-$100 price points. The way to look at this is essentially evolving high feature technology which we do extremely well into the sub-$100 price point, not chasing the low-end commodity market but leveraging our strengths, frankly through I think fairly creative model such as the licensing model, is to allow us to go after the $100 model below without distorting our existing traditional silicon based models. So the only reason we are going there is our technology with the reduced price of display, it allows us to target that, and I think we've chosen a very creative way of attacking that market without cannibalizing our existing silicon based business.

Amit Rao - Credit Suisse

Okay. And I’m assuming the ASP's at the lower end or in the licensing model are a lot lower than what PortalPlayer's traditionally seeing. Do you think there is going to be additional pressure on PortalPlayer's traditional ASP's that are still being sold into higher end PMP player?

Gary Johnson

No. I think there is pressure in general of course -- but that frankly comes more from a competitive environment. The direction we are seeing from our customers such SanDisk for example, is we have, in the E-series a traditional model and we've used this new revenue flow model in that C200. So, I think in effect, it allows us to actually in some effect sort of protect the pricing models and pricing targets for our traditional product line by moving to a much more flexible model on the licensing side. So, I think this is a protection mechanism not a weakening mechanism.

Amit Rao - Credit Suisse

Got it. And can you comment -- just one more thought. Can you comment on the acquisition and how do you see that product portfolio complimenting PortalPlayer's current product portfolio?

Gary Johnson

Sure, as I mentioned the team we've acquired is a very talented team that had done significant work in the area of video technologies, in particular high-definition technology. So, part of our vision here at PortalPlayer as you also mentioned in your commentary, as we focus on feature rich and high-end products, we think high-definition. Once we will see high-definition, they'll get it. It's one of those sort of light switches that go on and we think that in the future companies that can exploit that and bring that sort of enjoyment and aha viewing capability to portable devices, I think can do some very innovative products, and so that was the rationale for us to help accelerate that both with people and with intellectual property.

Amit Rao - Credit Suisse

Got it. And just the final, could you give any comment on the CEO transition plan? Is there any update or what is the -- say your timeline?

Gary Johnson

Sure. The Board is driving the process as you expect, and they are interviewing a pipeline of candidates.

Amit Rao - Credit Suisse

Got it. And say it comes to the end of the year; you plan on staying on until -- the currency yield plans staying on until, the new one is inevitably, even if it takes longer than expected?

Gary Johnson

Well, Mike my overall plans hasn't changed but I expect to have with us smooth and effective transition at the right time. So, I think that really just sums it up well.

Amit Rao - Credit Suisse

Okay. Thanks a lot. That’s all my questions.

Gary Johnson

Thank you.

Operator

We will take a question from Jason Pflaum, from Thomas Wiesel Partners.

Alex Kim - Thomas Wiesel Partners

Hi, this is actually Alex Kim, calling in for Jason. I guess where I would like to begin is just on the 10% as far as other customer revenue and I think the commentary is regarding and looking into December quarter, they would reach an all time high. I am just trying to get a sense of anyway to quantify that and then as far as looking into '07, how does that grow as well?

Olav Carlsen

I think the momentum is very clear. I don’t want to split-up our revenue guidance by customer, I have never done that, I don’t want to start it now. I gave a little more color because this is part of the executions of our strategy that we announced two quarters ago, focusing on other customers and helping them to bring great technology to market; and so Q4 is going to be an interesting quarter for us because we are going to see a record high in this and I can probably give you colors its not like just $100,000 more than the previous record, its really a lot of momentum behind this. And as you can imagine SanDisk is a big driver again, this is the focus of the company, we really support the guys that can do it and SanDisk has -- is doing very well. Now, '07 is I recently have some good numbers there but I can’t share them with you at this time.

Alex Kim - Thomas Wiesel Partners

Okay. That’s fair. And just a clarification question on Preface, are we going to see December quarter revenues with Preface, I think I was a little confused with some of the line in answering, but and I know that, I think one -- obviously in one Q we are expecting volume there. But I guess the question is, in your guidance are we reflecting Preface revenues?

Olav Carlsen

No, I don’t reflect any material revenue in the Q4 guidance. What we have said is, it's kind of like in line with what we said earlier when we say we might expect the little bit of revenue in Q4 to support the January launch. I think it is -- its better to say that we do expect the PLs to come in, if we ship them on the last day of the quarter that, okay and then there is some revenue but, it's not included in the guidance. We do however expect to see the first PLs now.

Alex Kim - Thomas Wiesel Partners

Okay. And just one final question on the general health of the MP3 Player market, are you seeing pockets with inventory or is sales coming in as far as expectations for the broader market in your view okay, just whatever commentary you can add with respect to the general health of the MP3 player market.

Olav Carlsen

I think particularly this quarter, its interesting because this is sort of the second full year of MP3 player success. I think it's very well planned, I think all players that as we know have learned from last year and have put a lot of planning in. I don’t think there is a need from our perspective for big pockets of inventory but the question really is certainly for our customers to answer. From our perspective, I think that it's a very healthy market and well planned this time.

Alex Kim - Thomas Wiesel Partners

Great, thank you guys.

Olav Carlsen

Thanks Kim.

Operator

And we will take a question from Adam Benjamin from Jefferies.

Adam Benjamin - Jefferies

Thanks guys. With respect to the gross margin guidance its you don’t usually give gross margin guidance but your guidance seems to imply about 36% for December quarter and I know that you sited it being below your normal range due to the apple transition and ASP declines. I am just trying to reconcile that with the growing piece of the license which I would think would be a 100% gross margin, so that should offset some ASP declines. Can you talk a little bit about that?

Gary Johnson

Sure, last part of your question 100% yeah that's true, so the license or the royalty model, the 100% gross margin. Yeah you are right, I don’t give guidance on gross margin I started however last quarter with it and I sort of just reiterated what I said last quarter which is Q4 is under pressure to some degree because we are missing the follow-on technology, that we should be shipping by now and we don't and so I think these are the reason haven't changed, nothing has changed its in line with the expectation and how we discussed it on the last call. To your point what the gross margins I still can't give the exact number because there is a lot of variables in there we are a better than expected this quarter than we were before. The variables are always the customer mix and certainly for the success on reducing our manufacturing cost and in this case and you pointed it out it certainly also the royalty model and how much it's going affect its next quarter. So, I want to be -- I have to be little vague on exact numbers, it is below 41% we said that clearly it shouldn't surprise anybody because that's in line with what we said last quarter.

Adam Benjamin - Jefferies

Okay and then based on your internal targets, when do you think at the earliest, you can get back up into that -- what is it, 41%-44%, is there kind of given range?

Gary Johnson

I think 2007 that you it will start right in January, when we are going to see first success from Preface. It will go as we go through 2007, we're going to see success and that’s a significant impact in our margin, when we go into direct manufacturing flow the COT that we've been basically talking about for years and have chosen, really design-by-design, to not do it or do it. And this time the 2007 technology will be manufactured using that flow, that’s a significant impact on gross margin. The customer mix as we bring other customer up is going to have impact on this. And then -- you know the increased success of the royalty model, as we might take this to other customers, we will have a very positive impact on that too. So, I don’t want to be -- I am not going to tell you it's on February 10th or anything. But it's really starting in Q1 and it's going improve through the year.

Adam Benjamin - Jefferies

But, so, for the first -- for the full first quarter, you think you can get back to the target, it sounds like?

Gary Johnson

Yeah, I don’t know, I don’t want to say that Q1 is already within that target model of 41 to 44. But probably well on the way.

Adam Benjamin - Jefferies

Okay. And just to follow-up a little bit on the licensing strategy. You know, just trying to understand how that works and how the impact that you could see with your chip business. Just can you give us more color on the thought process of this licensing strategy. Obviously, it’s a lot more profitable but it does take away, the silicon business and that opportunity. So, just trying to understand the pros and cons of this and why you guys think that there are obviously more pros than cons.

Gary Johnson

Well yeah, well the first proposition is this, we absolutely -- and I have seen the result of that viewing as an additive revenue flow. You are quite right, we are not going to -- we weren't plan to take an existing design and convert that to royalty model. The royalty model allows us to stretch to price points where we don’t want to take out existing chip sets in terms of its ASP. So, rather than drag that down and -- down to that point, the first time it allows us now to attack devices below $100, you have never really seen us in those feature rich products below $100. We have typically been in the 149, 199 -- more typically 249 product range. So, I think it's actually opens up a new segments in the market that allow us to be very competitive and change the rules somewhat with how our competitors will deal with us, in that price band. And so it's not a traditional model of just dragging down -- you know your own chipset and trying to squeeze every penny out. It absolutely has allowed us to target an additional market segment and I think in creative way which makes it tough for the competition.

Olav Carlsen

I think under normal circumstances, just using the design that we announced today, the c200 would not have been our win. This would have been competitor's design and we are into this by doing what we explain under royalty license. So it's a great success for us.

Adam Benjamin - Jefferies

Are you guys going to give us any kind of potential target, we should be looking at, in terms of revenue potential we could see for this licensing line in 2007?

Olav Carlsen

Not at this point because we've started just with one guy right now and it's very fresh and we've been working on this for quite sometime, but now we see the benefits in Q4. And we want to exploit that, very carefully, as we move into the first quarter. I am pretty sure I can talk a little more about it on the first quarter -- I am sorry on the fourth quarter call in December and January.

Adam Benjamin - Jefferies

Just two quick ones, you usually give the ASP declines year-over-year. Can you provide that for September Olav?

Olav Carlsen

I can't, yeah it was exactly what it was in the past two quarters. We dropped quarter-over-quarter 8%.

Adam Benjamin - Jefferies

Okay. And what was the year-over-year?

Olav Carlsen

It's somewhere in the 30 -- 28% to 30% range.

Adam Benjamin - Jefferies

Okay and then one last one and I'll go away. It's just that last quarter on the conference call, you mentioned a wireless opportunity that you expected to see in '07. Just, can you provide us an update there and let us know the timing of what we can expect on that? Thanks.

Gary Johnson

Sure but it was that the timing hasn’t changed for that. Again I think with our new technology taping out as we indicated and samples due back eminently. We are working incredibly hard in that segment with that customer. And so we see no change in that timing for that design.

Adam Benjamin - Jefferies

And any additional customers in that segment?

Gary Johnson

We have you know a number of active discussions on the way I’m not going to talk about specific opportunities at this point. But you should expect that our sales and marketing people are knocking on a wide variety of doors, at this point. Now, we have essentially a new platform coming that really changes, the type of applications we now can serve.

Adam Benjamin - Jefferies

Great thanks a lot guys.

Gary Johnson

Thank you.

Operator

And we will take a question from Daniel Ernst with Hudson Square Research.

Daniel Ernst - Hudson Square Research

Yes. Good evening. Thanks for taking the call. Three questions if I may. First of all in 2007 as you sit here now, that you expect to be still serving that customer with product. And then the second question in the same market in the personal media player market. Have you been able to secure any additional design wins that we just haven’t heard about yet? That are in your pocket, that there could be opportunities in '07, if they ramp? Are there any additional wins we just haven’t heard of yet? And then the last question on the wireless opportunity. You had mentioned that as being the driver in TMT or are you still seeing wireless as a separate product for the handset market? Thanks.

Olav Carlsen

Let me answer the last question first. I think as we talked about in today's call. I think our vision and belief is that wireless connectivity is [moving] integral part of essentially most handhelds in various forms, as we go through next years. So, I think the wireless investments we have been making over the last 18 months, will absolutely play themselves out in all the market segments we serve. So, I think you will see a broad push of that. In terms of the specific opportunities with particular customers, as we said we don’t talk about ahead of time those specific opportunities, but if there are customers that want to build the other feature rich portable multimedia devices and for that you should be expecting and ourselves the marketing guys are calling on us as we speak.

Daniel Ernst - Hudson Square Research

And then your existing customer, your largest customer, do you still expect it to be serving them in '07?

Olav Carlsen

Well the Video iPods was just refreshed and beyond that we don’t discuss the customers' roadmaps. It wouldn’t be surprised to see a continuing diversity across the whole PMP market of types of products that customers bring to market, but we don’t discuss specific customers' roadmaps, as you can expect.

Daniel Ernst - Hudson Square Research

Understood. Thank you.

Gary Johnson

Thank you.

Operator

And we will take a question from Craig Berger from Wedbush Morgan Security.

Craig Berger - Wedbush Morgan Security

Good afternoon. Thanks for taking my question. Just real quickly on the OpEx, just to say is just kind of the drop or is there any more spending reductions to come?

Olav Carlsen

I think that’s inline with the guidance we have given in the past six months. We sort of guided you guys to 12 million. So, we are little below that is -- we believe these are the resources that we need to execute well in our 2007 strategy.

Craig Berger - Wedbush Morgan Security

Right is there tape-out expending in Q3 that’s being diverted to other projects in Q4?

Olav Carlsen

There are tape-out expenses certainly as we guided in Q3, there is nothing that we have to discuss in Q4 for tape on. Tape was done.

Craig Berger - Wedbush Morgan Security

Okay.

Gary Johnson

But that’s particular point, there are additional -- there is always ongoing investments and this is not -- there isn’t one off deal is done, there are always continuing residual charges residual access to both technology and IP so. You will see a continuing tale to those types of investments.

Craig Berger - Wedbush Morgan Security

And I apologize if this has been asked, I got on a little bit late, but with respect to Preface, I know you guys said, you are planning up on starting to ship next year. Do you have any update with respect to what you think the magnitude of shipments could be throughout the course of the year, I know if you go back to see timeframe you guys put out some rough potential numbers out there, any updates to those numbers?

Gary Johnson

Hey again with the qualifier I gave earlier, that is we got good insight from some of the earlier adopters and through the year, with this new types of devices, it's harder to judge that. But we think it could be in the millions of units.

Craig Berger - Wedbush Morgan Security

In the millions of units. Okay, and then I know on the MP3 side Apple and SanDisk are both big customers. Who else are your larger MP3 customers?

Gary Johnson

The focused customers that we talk about are always SanDisk, you know Apple and then Philips is a customer. With some success in the market, we do have activity with some Taiwanese white box and I think these are -- there is not of I think has left, there in the market as you know.

Craig Berger - Wedbush Morgan Security

Right.

Gary Johnson

So, Phillips -- the bigger the name, that particularly as you look to the second half of this year has been a plan and have been continued investment in the space is that all has indicated, but there certainly is a consolidation occurring in the space here. So, again -- our approach in the past was continue to be is to target that the volume runners, menu as innovative business models to serve their different price points. So that’s why the licensing model has worked well in the sub-$100 model for example with SanDisk. And so we tend to exploit those types of creative ways to work with the large volume providers in this space.

Craig Berger - Wedbush Morgan Security

Okay, last question for me. And I know, you guys don’t talk about specific customers or programs, but just generally for investors. You know this kind of $30 million quarterly revenue run rate sustainable in '07? I am not asking for specific guidance, but in terms of directional magnitude. Should we be expecting a significant let down at any point in the future or as this kind of a reasonable base that which to then drive a normal seasonality in some other growth platforms?

Gary Johnson

Well I think it's going to be a mix. Yeah you are right. I don’t want to get too much into 2007, but this is not the policy to talk about. But in terms of what '07 means in business developments and for us, there is number one; certainly there will be seasonality. We do expect that for the first and second quarter, as always. Don’t know exactly what it is. It's too early. We only have like one year; we need to compare it to. But '07 overall, I think looks to be a very exciting year for us. I mean, we have -- we are bringing new customers up. We are adding the licensing model now. So, it's not just a revenue but certainly also a margin and margin contribution dollar question. We have new manufacturing models. We have a Preface ramp. So, contrast seasonalities, so to speak, there is a new business added, being added to our current revenue model. And I think we don’t really want to, well, if you ask, what I would say, I don’t want to talk about the further reduction of expenses, because I think we have found the level that we need for '07. So, it's hard for me to give you a revenue run rate because seasonality is the one big element that in our consumer electronics space, that makes it almost impossible to talk about a quarterly run rate. The focus is profitability, the focus is cash positive and the focus is to add exciting businesses in -- to our current business model in '07. I think we are on a good path there.

Craig Berger - Wedbush Morgan Security

And you never have said with the wireless technologies, you guys are pursuing on your chips. Is it cellular or Wi-Fi or Bluetooth or --?

Gary Johnson

For competitive reasons actually we haven’t been specific. We have -- our marketing guys keep kicking me and they want to unveil the product, when we actually launch our products. So, now we've been specifically vague around the technology their. In longer-term, and in the past, we have actually talked and demonstrated many of the technologies you described, but we haven't described the variance or the combination that will be associated with the new platform primarily for comparative reasons.

Craig Berger - Wedbush Morgan Security

Any hint, when you guys are going to come out with that?

Gary Johnson

Well, we have been -- so, I think a little stronger on the hint today, that we announced that we had successfully taped out the products. We will be receiving samples eminently. We intend to sample customers in Q4 this year, primarily to get us and them ready to be able to do exiting demonstrations, for example at CS in January, Las Vegas and also ready at 3GSM.

Craig Berger - Wedbush Morgan Security

Great thanks guys.

Gary Johnson

Thank you.

Operator

And our last question today is from Quinn Bolton from Needham & Company.

Quinn Bolton - Needham & Company

Let's say, I have jumped on -- guys, I apologize if (inaudible) has been hit. But, first of all could you just state again what you said about the pricing both quarter-over-quarter and yea-over-year?

Gary Johnson

I said inline with the previous two quarters, an 8% quarter-over-quarter drop in ASPs and about 28% to 30% year-over-year for the third quarter.

Quinn Bolton - Needham & Company

Okay, great. And the follow-up on Craig question on the wireless. I know you are not really giving a lot of details but can you say -- are you designing your platforms to work with standard chipsets or are you actually starting to build in either basebands and/or transceiver functionality into your system on a chip. Can you at least sort of say how you are approaching and I know you are not going to talk about what protocols you are looking at but are you building that actually into your chip regions building interfaces to work with standard chipsets from third-party suppliers?

Gary Johnson

No. I think you know it's fairly well. So I think the description that you can look towards is the way we describe this as a highly integrated platform. And we talked about the integration of wireless audio capabilities and video. And so you should expect this to be much more highly integrated than you would see from us in the past.

Quinn Bolton - Needham & Company

Perfect. Okay, great. And then just lastly on the licensing program, I wasn’t sure if you gave a lot of details there. But is there something whether licensing your software, they are licensing your hardware design, just wondering if you could go through sort of what exactly is the customer licensing for the sub $100 player market?

Gary Johnson

Well again. We will give you sort of the high level view there in two possible ways. One, obviously the firmware platform and the issued licensed, that's is an integral part of our platform; and essentially on the licensing model, we are allowing a more direct access to the silicon, silicon provider itself. If you know -- as you do you know -- manufacture flourish typically to intermediaries and so there is two elements. There is a licensing of the firmware platform and also elements associated with allowing more direct access to the silicon provider.

Quinn Bolton - Needham & Company

Is there any envision to sort of take the firmware and make -- say perhaps more applicable to the standard third-party base at our base line but ARM controller, does this strategy have application say in the so your handset or other non-portable media player markets?

Gary Johnson

Potentially, I think part of it as Olav indicated earlier, we are still have got toe in the water here with one large customer at air and who knows what it might develop to. We don’t envisage -- the way we look at the licensing model is over the additive way to extend the life of mature business. We've not set-up a separate business unit. This is not a main thrust of being in the licensing business; this is the way of us adding and extending life to more maturing products and allowing us to sort of reach down one more product level in the pyramid. It is not a transformation of the company into a licensing company with we wouldn't go through that, this is an additive flow to products that are in the maturing cycle of the business.

Quinn Bolton - Needham & Company

Gotcha. Thank you very much for taking my question.

Gary Johnson

Thanks a lot.

Operator

And that concludes our question and answer session. I would like to turn the call back over to Gary Johnson for any additional or closing remarks.

Gary Johnson

Well, thanks, everyone for joining us today. With that, we will conclude this conference call. Thank you.

Operator

And that does conclude today's conference call. Thank you for your participation, you may now disconnect.

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