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Creative Technology Ltd. (OTCPK:CREAF)

F1Q07 Earnings Call

October 30, 2006 7:00 pm ET

Executives

Phil O'Shaughnessy - Senior Director of Corporate Communications

Craig McHugh - President of Creative Labs

Sim Wong Hoo - Chairman and CEO

Ng Keh Long - CFO

Analysts

Horng Han Low - Citigroup

Patrick Yau - Macquarie

Lim Keng - Credit Suisse

Gregory Yap - Kim Eng

Brian Young - BNP Singapore

Jim Renck - Renck Capital Management

Presentation

Operator

Good day. My name is Matthew and I will be your conference operator today. At this time, I would like to welcome everyone to the Creative Technology First Quarter Fiscal Year 2007 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions). Thank you.

I would now like to turn the call over to Mr. Phil O'Shaughnessy, Senior Director of Corporate Communications. Phil, you may begin.

Phil O'Shaughnessy

Thank you. Good morning to those of you joining us in Singapore, and good afternoon and evening to everyone in the US. Thank you for joining us today. I am Phil O'Shaughnessy, Creative's Senior Director of Corporate Communication, and I would like to welcome you to Creative Technology's first quarter 2007 fiscal year earnings release conference call.

The press release can be downloaded from our website, which is www.creative.com. We're also offering a webcast of today's call, which you can access through the Investor Relations page on creative.com.

Today's call will be hosted by Craig McHugh, President of Creative Labs. Craig will be joined on the call by Sim Wong Hoo, Creative's Chairman and Chief Executive Officer, and Ng Keh Long, our Chief Financial Officer.

During our call today, Craig and the other participants who may be speaking on the call, will, with the exception of historical information, be making forward-looking statements, including statements relating to operating expenses, gross margin, profitability, and the market potential for our products. These forward-looking statements are based upon the information that is available to us as of today, and reflect management's current analysis, belief or expectations. Actual results could materially differ for a number of reasons, including those detailed in today's press release, and in our filings with the Securities and Exchange Commission over the last 12 months. You are urged to review the risk factors set forth in our press release and in our SEC filings, including our annual report on Form 20-F. Also, please note that Creative undertakes no obligation to update any forward-looking statement made in today's conference call or in our press release to reflect events or circumstances that occur after today.

For today's call, all results are stated in US dollars.

We will begin today with Craig McHugh providing a review of the results of the first quarter of our 2007 fiscal year. We will then open up the call for questions and answers.

At this time, I would like to turn the call over to Craig McHugh, President of Creative Labs. Craig.

Craig McHugh

Thank you, Phil. Sales for the first quarter were $241.5 million, which compared to sales of $280.2 million for the same quarter last year. Net loss for the first quarter was $21 million compared to net income of $0.7 million for the same period last year. Loss per share was $0.25 compared to earnings per share of $0.01 for the same period last year.

On August 24, we announced our broad settlement with Apple, and our expectations that the one-time licensing payment of $100 million from Apple to Creative would contribute approximately $0.85 per share. We received a payment from Apple on October 6, and we will account for the license payment in the current quarter. We are very pleased that the license payment is subject to a lower-than-expected effective tax rate, so we will recognize an even larger after-tax profit of $82 million with EPS of $0.98 from the payment in the current quarter.

Now that we have completed our license agreement with Apple and have received the $100 million license payment for their use of the ZEN patent, we are initiating our licensing business. We intent to aggressively pursue licensing agreements with each of the companies that currently use the ZEN patent in their products in the US or wish to use it in the future. The ZEN patent is currently found in many of the MP3 cell phones and many of the portable media players in the US.

We believe that our licensing business can be an integral part of our overall strategy moving forward. While we are not in a position to discuss any specific customers at this time, we have begun discussions with potential licensees.

We believe that the strength of the ZEN patent is underscored by our license with Apple. We are very pleased that our ongoing investment in research and development that has resulted in so many innovative products and technologies and a solid patent portfolio including the ZEN patent can now provide us with a major licensing opportunity going forward.

In the first quarter, although we incurred an operating loss as a result of our gross margins coming in at just 15%, we continue to progress on our plans to return to profitability in our current second quarter. Specifically, we are targeting to increase our gross margins to 20% or above in this quarter. We are projecting improved gross margins from our flash-based MP3 business particularly from the ZEN V and the ZEN V Plus. These improved gross margins in our flash-based MP3 business will be the primary factor in achieving gross margins at 20% or above in this quarter. In addition, we are working on bringing our operating expenses in line with our gross margins, and we are actively transitioning out of business areas that we believe do not have acceptable growth and profit potential.

Now let's take a look at the first quarter results in more detail. Sales for our personal digital entertainment or PDE category which includes our MP3 players and web cameras contributed 70% of total sales in the period. This compares to 65% of revenues last quarter and 66% of revenues from PDE in the same quarter of last year. In the PDE category in the first quarter we introduced the ZEN Vision W, our widescreen video, photo and music player. Featuring a high resolution, 4.3 inch wide screen and capacity for up to 240 hours of video, the ZEN Vision W has a huge amount of video content available to users from Amazon.com. Amazon's new Unbox service offers thousands of TV shows, movies, and other video content from more than 30 studios and networks. New releases from major studios including 20th Century Fox, Paramount Universal and Warner Brothers, and TV shows from A&E, MTV, FOX, PBS, and many more networks can be easily downloaded for use with the ZEN Vision W. In addition to the great selection of video content from Amazon Unbox, the ZEN Vision W supports a variety of video formats, music subscription and download services. It also features a built-in compact flashlight so you can take your memory card from your digital camera and offload pictures directly to the player. It's perfect for any vacation or long trip where you want all your favorite videos with you and some place to offload your pictures from your digital camera.

Our audio category contributed 10% of sales for the period compared to 13% for the same quarter last year and 13% of sales last quarter. On October 2, we introduced the Xmod. Based upon our X-Fi Xtreme Fidelity audio platform, the Xmod is a small device, just about the size of a candy bar that improves music playback for MP3, WMA, iTunes or AAC songs to beyond their original CD quality. The Xmod connects between stereo speakers or headphones in either a PC, a Mac, iPod or ZEN or any MP3 player and it dramatically improves the listening experience by up converting the music during playback to the X-Fi Xtreme Fidelity standard, which is very high quality 24-bit surround audio. Without requiring installation of any software it takes just seconds to connect an Xmod to a PC or MAC. You can even connect your Zen, iPod or any MP3 or CD players to the Xmod with an optional line-in and AC power adapter. Priced at only US $79.99 with good gross margins, the Xmod opens up a very exciting new market opportunity for us. Targeting at more than 100 million people who listen to MP3, WMA, or AAC music on their PCs, Macs or ZEN or iPod players. Just connecting the Creative Xmod enables Mac users to experience award-winning X-Fi Xtreme Fidelity audio for the first time. And PC users can now enjoy for the first time on their notebooks. Xmod doesn't require cumbersome or time-consuming conversion of files; it literally connects in seconds to playback existing music files in real-time with X-Fi Xtreme Fidelity. And with our recent settlement with Apple, we can bring the X-Fi family of products including the Xmod to Apple's Mac and iPod users. We're very excited about this opportunity with Xmod and we can also develop speaker systems for MAC and iPod users for the Made for iPod program.

Our speaker business contributed 13% of revenues in the first quarter compared to 13% of revenues for the same period last year and 13% of revenues last quarter. Revenues from all other products accounted for 7% of total sales for the period.

Looking at the breakdown of revenue by specific geographic regions, the Americas represented 47% of sales compared to 46% for last quarter and 41% for the same period last year. Europe contributed 38% of total sales compared to 37% last quarter and 39% for the same period last year. Asia contributed 15% of revenues compared to 17% last quarter and 20% for the same period last year. Our gross margin for the first quarter was 15% as compared to 14% last quarter. As noted earlier, we are targeting to achieve gross margins at or above 20% by the end of the current quarter.

Operating expenses for the period came in at $57.7 million. This compares to last quarter's operating expenses of $58.4 million.

We will continue to focus on reducing operating expenses as we streamline our product lines and transition out of any of our product areas that we do not believe have acceptable growth and profit potentials.

We will continue working to reduce operating expenses to bring them in line with our revenue and targeted gross margin to achieve profitability by the end of this quarter.

Let's move on to the balance sheet. We ended the quarter with $190 million in cash compared to $214 million last quarter and $172 million for the same quarter last year.

Our net inventory level for the first quarter was $269 million, which represents 26% reduction from our inventory level of $365 million for the same period last year.

Days sales outstanding at the end of the first quarter was 62 days compared to 52 days last quarter and 54 days for the same period last year. The value of our investment portfolio as of September 30 was $71.7 million. Of this total, approximately $60.5 million is in listed investments, including $16.9 million of unrealized gains.

During the first quarter, we did not purchase any shares from our share buyback program.

As noted in today's press release, over the past months, we've been exploring strategic alternatives for streamlining and improving our operations. As a part of that process, we've determined that our best course of action was to sell a majority interest in control of our CUBIC manufacturing operations in Malaysia. We felt this will provide us many significant benefits. These benefits include reducing our manufacturing overhead, reducing our working capital requirements, reducing our inventory levels, and reducing our product costs. In addition, it allows our teams to increase our focus on product development, sales and marketing.

We have agreed to terms of a sale of 80.1% of our interest in CUBIC with a venture-backed group led by the current management of the facility. We expect to receive approximately $40 million in cash for the sale and repayment of inter-company balances and recognized the profit of approximately $5 million from the sale upon completion of the transaction. We anticipate a transition period for the operation, and then we will outsource some product productions of the operation going forward as a term of the sale agreement. We're very pleased by this agreement as we have a high level of confidence and trust in the management and the quality of production from the CUBIC operation. We expect the transaction to close in approximately three months.

Now looking forward based on the progress we are making and our outlook for the market potential for our products, we maintain our outlook for returning to profitability by the end of this calendar year and continuation of profitability going forward. Our key areas of focus for the company are; one, returning our gross margins to about 20% by the end of this calendar year. Two, examining each of our product categories to determine how we could best achieve their revenue growth potential and transitioning out of any product or business area that we believe does not have acceptable growth and profit potential. We want to establish a licensing program pursuing royalty opportunities with those companies currently using the ZEN Patent in the US or those that wish to use the Zen Patent including cell phone manufacturers that make MP3-enabled cell phones and portable media players for the US market; working to reduce our operating expenses to bring them in line with our revenue and targeted gross margins to achieve profitability in the current quarter; and growing our audio business by expanding the market for X-Fi and Xtreme Fidelity in the consumer electronics space and having a successful launch of our new Xmod.

At this time, I would like to open up the call to questions and answers, operator please.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Horng Han Low with Citigroup.

Horng Han Low - Citigroup

Okay, hi. Good morning everyone. I would just like to understand in regards to the CUBIC manufacturing operations in Malaysia. Can you just let us know, how much that the operation account for your total production?

Craig McHugh

We haven’t broken out the specific percentages by our factories. We have two primary facilities, one in Malaysia and our facility in China. And we had the first production of our speakers and our web cameras as we shared historically. Going forward, we continue to evaluate strategic alternatives for each of our manufacturing facilities. In long-term, we would like to move to a complete outsourced model, and we believe we can gain the further benefits I already discussed today including reducing our working capital requirements, reducing our inventory, of key importance reducing our product costs, and allowing our teams to focus on the core areas of research, development, product development, sales and marketing. So, longer term you will see us move to an outsourced model.

Horng Han Low - Citigroup

Okay. So, I can probably as steady assume CUBIC would be -- then would account for majority of production in Malaysia itself. Will that be a right to think on this line?

Craig McHugh

We have -- CUBIC is our one facility that we do have in Malaysia, and they do a significant portion of our current manufacturing that we do in-house.

Horng Han Low - Citigroup

Okay. And my second question is, I would like to -- with regards your gross margin guidance of 20% in the next quarter itself; can you help us get an insight with regards to how much of the increase is due to your decision to outsource or could it be because of your shift in product mix going to the next quarter?

Craig McHugh

As I said today, we expect several months of transitioning. We won't complete the transaction for, we said, for approximately three months. So, the current quarter we won't be able to realize the reductions and product costs and inventories, that’s longer term. So, when we look at the margin, as I highlighted today, we are beginning to see improved gross margins in our Flash-based MP3 business. We expect to see that continue through the quarter, particularly in our newest product lines, in ZEN V and the ZEN V Plus, which were doing very well worldwide. We’re pleased with the margins there. So, the primary factor in increase of margins moving from 15% to a target of 20% or above is primarily result of improved margins in that Flash-based MP3 business.

Horng Han Low - Citigroup

Okay, thank you very much.

Craig McHugh

You're welcome, thank you.

Sim Wong Hoo

Thank you.

Operator

Our next question is from Patrick Yau with Macquarie.

Patrick Yau - Macquarie

Hi, good morning, Sim and Craig. I just have a quick question in terms of the level of manufacturing that you still have in-house, post the divestment of CUBIC?

Craig McHugh

Yes, that is right, I tried to highlight that. We've announced our plans for CUBIC, and longer term we will be moving to a complete outsourced model. But that is longer-term. So, I think you can look to us to continue to evaluate the strategic alternatives for our remaining facilities.

Patrick Yau - Macquarie

Would it be fair to assume that at any point in time CUBIC probably represents about half of your manufacturing effort?

Craig McHugh

Approximately.

Patrick Yau - Macquarie

Okay. Thank you.

Craig McHugh

Thank you.

Operator

(Operators Instructions). Our next question is from [Lim Keng] with Credit Suisse.

Lim Keng - Credit Suisse

Hi Craig. You spoke about streamlining the less profitable products, just wondering if any tangible steps have been taken, and roughly about where are the areas where you think you can streamline further?

Craig McHugh

The most visible we took earlier this year and that is as we transitioned our 3D Graphics business, and we issued press release. We talked about that in prior calls. Currently, we are working on each of the other business areas, where even within some of our audio areas and some of the product lines we have diversified offerings. Specifically some of the areas we are looking at is in our high-end professional music equipment, under our E-MU operation. There we support multiple product lines and we believe we can become much more efficient, improve the profitability and improve our competitive position by focusing on our most profitable highest revenue products, so that is an area of specific focus.

Another area for us is within Cambridge SoundWorks. We have there as you know, we have some of the finest home speakers and we have among the highest quality tabletop radios, specific as we look at some of the new areas in radio for high definition in the US and some of the digital areas in Europe. Again, there we have a very diverse product offering within Cambridge SoundWorks and we feel that we can hone our focus, be able to streamline the product lines, improve the efficiency of our development and our sales and marketing efforts.

So, focusing on some of the smaller operations right now that have very diverse product portfolios and trying to streamline those, we think we can get benefit as far as improved sales, reduce our operating overhead, reduce our operating expenses, and at the same time reduce some of our inventories and exposures in some of the lower growth areas. So, it's a couple of key areas of focus. But as I shared today, we are actually looking at all segments of our business, just as we did with the operations, as we believe we can improve productivity. A key area of focus for us, [taking out] besides the product area is how we approve in our worldwide distribution and logistics. We believe we can improve our cost, especially now with high cost of air freight and sea freight, with the price of oil, we believe there is some benefit there. So, we are really examining every part of our business, with specific focus on those areas I just mentioned.

Lim Keng - Credit Suisse

All right. And separately I think, just wondering when we can expect your products for the Made For iPod program to be launched?

Craig McHugh

We've shared in the past that we wanted to have our first products available, to be able to ship before the end of the year. I feel that we will be able to make that. We are hoping to have several key announcements at the Consumer Electronic Show in January, and also the Mac road show. We made great progress in our product development for the Made For iPod program, and I think if you can bear with us as far as watch for some of the product announcements over next few weeks, we are really excited about some of the progress we are making. Key areas that we kind of hinted out today, we expect to be in the Made For iPod with some of our speakers, especially our docking speakers, and a great excitement for us in what we are doing with Xmod. The Xmod is our first product that works both with the PC as well as the Mac, and the Xmod has great opportunity for sound improvement for all of the iPod users. That’s one of the areas we focus today, anybody with an iPod can connect it to the Xmod and have a dramatic improvement in their music, in their listening experience. So this is the first product you will see coming from us and we will have a host of others in that January timeframe.

Lim Keng - Credit Suisse

Right. And I think lastly, I am not sure if have missed this, but what are your sales expectation for the following quarter? I mean do you see the same sort of seasonality that you used to enjoy in the past for the upcoming quarter?

Craig McHugh

With the exception of the guidance we have given for the gross margin because that’s critical for our return to profitability, we are not breaking out specific guidance for our revenues going forward. We do expect to have a strong holiday season based on the sell-throughs that we are seeing in the retailers to date. But they are only going to specific guidance for that part of the quarter with the exception of the gross margins at or above 20% and returning to profitability this quarter, okay.

Lim Keng - Credit Suisse

Right. Thank you, Craig.

Craig McHugh

Thank you very much.

Operator

Our next question is from Gregory Yap with Kim Eng.

Gregory Yap - Kim Eng

Hi guys. [Keng Hock] really asked the first part of my question, but I just want to follow up with the question on how closely Apple controls the Made for iPod program i.e., do you have to work closely with them to come up with the product that you are targeting or is it something that you control completely?

Craig McHugh

The terms of the program of course are confidential to Apple that the products that we are developing for meet those specifications and we've said we are going to participate in the program all the products that we would bring into that program will meet each of the Apple's requirements. There is many companies that do have products in that program; we believe we are going to focus both on the performance and the quality, but also and it would be very competitively in priced, and you will see as I'd mentioned some of those products appear before the holiday and some in January. So we'll have quite a few products that qualify for the Made for iPod program.

Gregory Yap - Kim Eng

Okay, thanks.

Craig McHugh

Thank you.

Operator

(Operator Instructions). Our next question is from [Brian Young with BNP Singapore].

Brian Young - BNP Singapore

Hi. I’m just wondering your audio sales has actually dropped about 19.5% in the first quarter '07, can you explain why that has happened? Thanks.

Craig McHugh

In the quarter, we were completing the transitions of some of our new products that we will have in the marketplace for this holiday. And we are also conservative in the Xmod shipments early on. We wanted to have the product at a significant worldwide launch. So we wanted to have all of our regions and localizations ready for the launch period. We had originally anticipated shipping in the quarter, because I'd mentioned today, we only announced it on October 2. And the Xmod is really our premier product for the holiday season. So we didn't have a significant revenue contribution from the Xmod, and we are transitioning some of the audio products in the period. Having said that we were disappointed by performance from the audio area, and we believe going forward as we look out into 2007, we have significant opportunity with the focus on the Xmod family of Xmod-related products and the penetration with X-Fi, and we have significant opportunities for expansion of our audio business. Over the past couple of years, we've focused primarily on the gaming and the PC, audio business has contracted. But I think it's very important to note that our focus going forward is on in the consumer electronics space. The Xmod and all future products in that Xmod family are truly focused on everyone who listens to MP3, AAC or iTunes music. We are targeting all the PC and Mac users and these are very simple-to-use products. So I tried to highlight with the Xmod today, Bryan, this is a product that just literally installs in seconds. You connect it up to a PC or Mac or to your iPOD or to your ZEN, there is tens and millions of customers we can target that out. You don't have to open up your PC to install a card any longer. So this is just the first in whole family of products. At CES you'll see a complete, I believe, evolution in our marketing approach. These products so dramatically improves the listening experience anybody who listens to MP3 music, anyone who listens to an iPOD or a ZEN has great benefit from using one of these products. So in the past we have been, I think, underscoring how exciting our audio business is. Going forward it's going to be a main thrust of our marketing. I invite you to come to CES show and see the huge emphasis we are placing on the Xmod and the new audio products we will be releasing in January. There is going to be a major emphasis throughout the company in I/O going forward. I mentioned today the Xmod has -- it's only 79.99 but it has great margins for us and it has very good margins for the retailers. We have wonderful positioning going forward. So although the audio business has contracted over the past several quarters, we do see great opportunity going ahead for marketing, market penetration and we are really gratified to see the Xmod being actually positioned in several parts of the retail stores.

Some of our retail customers are using them to improve their speakers and their speaker displays, some companies are displaying them with their portable section, and many of them are displaying them with their MP3 players both the ZEN and the iPOD. So you are seeing penetration in retail of our audio production, the way we haven’t seen in many years. So I think there is great opportunity going forward. So I do appreciate you highlighting the audio business for us. As I mentioned there is a depth going forward as you look at 2007, the calendar year, please look for some of the exciting product announcements, I think there is going to be just really superb opportunities for us to increase our audio business going forward.

Brian Young - BNP Singapore

Okay. Thanks.

Craig McHugh

Thank you.

Operator

Our next question is from Jim Renck with Renck Capital Management.

Jim Renck - Renck Capital Management

Yes. Good evening gentlemen. Listen, operating expenses are very much under the control of management and maybe you could explain something to me if I just don’t get it. In the March 2005 quarter, which is the quarter when you had problem with Apple's aggressive price cuts with three weeks left in the quarter and you ended up with bloated inventory for the rest of the year. Your operating expenses as a percentage of revenue were 21%. In current quarter, even though you have made progress cutting operating expenses on an absolute basis, still almost 24% of sales, now is it that -- what’s the explanation, may be Keh Long could tell us or any of you; the explanation for that, is it inability to accurately forecast sales, track sales, is it an inability to make aggressive cuts in the operating expenses, just what it is -- what’s the problem, and is there an actual target that you guys have or that you can share with us? You talked about reaching gross margins to 20%, but where would you like the operating expenses to be as a percentage of sales?

Craig McHugh

Okay. Jim, shall we break the question into a few parts. You're correct that operating expenses in the period were approximately 24% versus 21% in prior periods and 20% for Q2, a holiday quarter of last year. At 24%, clearly our operating expenses are too high to achieve our goal of being profitable in the second quarter in an ongoing basis. As we shared beginning in the March quarter of this year, our goal is to be able to reduce operating expenses and be able to do so in a thoughtful manner. What I mean by thoughtful is, we -- we have so many great new products in areas coming out from the Xmod to our new Made for iPod products in the speaker side and some very significant introductions we are going to be making in the speaker area.

At the same, we continue a very strong number two position worldwide in MP3, and as you may know, the number one player, Apple, has a huge marketing budget and advertising budget. We wish our number two position had a Samsung and Sony, everyone else with a very modest advertising budget this last year. So although, we have a goal of trying to reduce operating costs, we also have to be able to market and bring the excitement with our products that they deserve. So, we are always looking at a kind of dual-edged sword, one is the need to reduce expenses, but the other is the need to be able to be promote and drive and launch these products. So part of the solution is to reduce operating expenses as we shared today to bring them in line with our gross margins, but at the same time to significantly increase gross margin. If we achieve our target in the current quarter going from 15 to 20 points, that's a 33% increase in gross margin, it's just single quarter based on the improvement of margins in our flash area.

So if we just do wholesale cutting of the expenses at the time we have fantastic products and market opportunities, I think you are going to sell the company short and long-term. So we are tying to do in a thoughtful way and at the same time, we are making strategic moves at each quarter. As you may know early in the year, we reduced the operating expense significantly by transitioning our 3D graphics business. We just made a significant move that we announced today that we hope to close in the next three months and as we're improving our product costs by selling the majority or 80.1% of our facility in Malaysia. I know that we’re looking at two of our divisions right now. We’re already in the mode of transitioning what we’re doing with E-MU and Cambridge SoundWorks. We’re really focusing on reducing those costs in areas that don’t provide the highest level of profit and growth opportunities, but at the same time continue to invest and driving those businesses forward with areas we do have strong growth.

I think if you look at Creative over the past two years, conversely we've been -- to sum up your points, we've done a phenomenal job of being able to reduce operating expenses in the past to keep them in line with our margins. With a short drop in margins this year, as we mentioned, starting in March, we had the significant price chop in flash. We tried to increase margins and went from negative margins beginning of the year to 10% at the end of the June quarter to right now we're at 15%. So, we've gone from negative to 10 to 14 to 15%, as they were showing a very aggressive target of getting past 20%. So, we are reducing operating expenses. We’re going to continue to do it, and we’re being actually quite aggressive as the way we transition our businesses. 24% is unacceptably high, even as we increase gross margins. So, I don’t want to break out specific long-term target with the exception that we will have it in line with our gross margins, so we can achieve profitability and keep it going forward.

Operating expenses remain a key strategic factors I shared, of the five factors I shared with you today, and our goal is to be able to do it in such a way that we can continue to maintain and grow our number two worldwide market share in MP3, bring us into the consumer electronics space with Xmod, and Jim I can't stress enough the importance of what we’re doing in the audio space. Xmod is a magnificent product in technology. It has wonderful benefits to every MP3, or iTunes listener, but it is one that we have to promote aggressively. Our old methods of selling and marketing may not work in this new market. So, we do have to invest in promotion, especially types of in store and people could hear the product. So, you will see Sim very active in what we are doing in marketing and merchandising these new products. So, we are going to have to be very cautious and I think careful and very deliberate in our operating expenses. That's why we are not saying a specific target now, we are not making wholesale cuts, because we are positioned extremely well. And I would close on this point, but actually look at the product areas.

What we have today is, MP3 and web cameras represent 70% of sales. The webcam market is fantastic right now. You see what's going on with YouTube and others. The emphasis on video is extremely strong, we are very well positioned. Even with the introduction by Microsoft of web cameras about six months ago, we are maintaining our number two worldwide position of web cameras and we are going introduce a whole new family in January. That is a great market with huge expansion opportunity.

What we are doing to speakers, now that we have the Made For iPod program, we [also have docking speakers. It is a terrific space, is a very high growth space, and that is where our competitors have benefited over the past year and half by growth in area we do not participate in. Now, we will be there with great products. So, I am actually pleased, consider you have to carefully weigh the opportunities that we see with the needs to reduce operating expenses. In this past quarter, we had a very small reduction in operating expenses, sequentially quarter-over-quarter, but dramatic year-over-over, and will continue to be able to make considered reductions going forward.

Jim Renck - Renck Capital Management

Actually I have a follow-up question. You mentioned your number two worldwide market share behind Apple?

Craig McHugh

Yes.

Jim Renck - Renck Capital Management

In the US alone, SanDisk has certainly taken the number two market share position. I know you said worldwide. Microsoft, of course, is no secret there, about to enter the marketplace. Is there any reason why Creative should remain in the MP3 business? Last one for Sim.

Craig McHugh

I'll take it first and then, of course, rest of the team can enter. But again I will break your question down into elements. The reporting that we were referring to for the US is based on statistics from a source called MPD.

Jim Renck - Renck Capital Management

Correct

Craig McHugh

And MPD has a, what we consider to be a limited view of the US market. It doesn’t have all of the retailers, specifically not some of the largest retailers in the US, and probably not the largest retailer in the US, we have exceptionally strong position in. So, many of our competitors try and quote statistics from MPD, because they like the way it makes them look. The US market represents only about a third of the global market. As you know, MP3 is very significant in Asia and Flash is huge in Europe. Europe we have a very strong hold on number two. I would ask you to look at the US market where the statistics don't truly reveal the market case, but if you look at our overall revenues for the past year, I think if you took SanDisk and you add the number three competitor together, we may be larger to those combined. So, we are very confident in our position. I think worldwide is the only way to look at it, because US is a portion of the market and some of the largest customer aren’t even included in the statistics that you quote.

When you look at why we want to stay in this business, to be able to achieve number two against Sony, Samsung, LG, Phillips and all of the others is striking, and we've been able to do it at a very difficult year, when there has been huge fluctuations in memory pricing, specifically this year, there was a precipitous drop in price at the beginning of the year. So, there I would ask you to look at, as the price of Flash memory now has come down to a very low level, there has been a slight increase about 20% over the past two months. At these very low levels we are exceptionally competitive really for the first time in three years against what we believe is Apple pricing, companies like SanDisk, iRiver, companies that have had an advantage on memory pricing over us for some time.

But as the price -- the spot market price and the contract price for Flash is at very low levels for one and two, even four gigabytes, we are wonderfully positioned. That's why we are bold enough, Jim, to make the statement that we expect the margins to improve sharply this quarter in Flash. We haven't said that in a long time. This has actually been the most troublesome area for us. Though with the web cameras and our MP3 players representing 70% of revenues and we can get a significant improvement in margins of our flash-based business along with their huge volumes, that's a very strong reason to be in this space.

So, we have been able to manage through some incredibly difficult quarters, where we had some inventory problems, we had the drop in price of flash, but now we see flash pricing as its at a very low level, it levels the playing field against all those players I mentioned. So, this may be the exact best time for us to make strides going forward, and I think I will close by that. In some countries when you look at, like, Scandinavia, which is huge for MP3, we are number one. In the major markets in Europe like France, UK, Canada, we are solid number two. So, I'd ask you to consider all the competitors in that space and there are other markets we are not going to be number two, we might be number three because this is a huge market.

Most of the industry analysts say that the market is over a 100 million players a year. There is room for a number two, number three and a four player, to all do exceptionally large volumes. And I think Apple with their huge marketing budget and their position in the US often gets credit for far more share than they have. So I ask you not to discount what we have, I ask you to pay close attention to what we may do this next quarter in margin. I think those are contributing to the reason we are in this space. Okay?

Jim Renck - Renck Capital Management

Craig, I wasn’t sure if someone was going to add anything to that, but let me ask. What efforts are you taking to grow the MP3 business in China and/or Japan, if I can ask specifically about countries?

Craig McHugh

In Japan specifically, in addition to our retail strategy we will focus very heavily on online direct-to-consumer strategy. We've really -- we can improve our margins and our competitive positioning in the market in Japan. So our new product introduction the ZEN V Plus just recently introduced in Japan. We have two new products. The new Neon and one additional product that is being designed specific for the market in Japan. So there I think we have room to improve our results. And in China Sim I'd ask you to potentially talk about the China market.

Sim Wong Hoo

Yeah. This is Sim. Hi Jim.

Jim Renck - Renck Capital Management

Hi Sim.

Sim Wong Hoo

I think just on the first part of the question, I think the number two position that we are in is a very hot end position and this is in the largest market. I mean we can see how Apple had benefited from it. We are in this number two position, we are two -- the strong number two in this area. And to just walk away from it right now I think that will be the most foolish thing to do. So there are many ways to skin the cat so to say. So first of all we've got this ZEN patent established and it was not that in this MP3 area early enough. Although we did, we were not -- that the ZEN patent, it would not be in the current position that we are in. So we run through some difficult periods because of various reasons which we had explained flash, (inaudible) and those kinds of things. We've already addressed all these problems and that again is very hard and a lot of hard work, a lot of heartache. So we have very good relation with the flash suppliers and also the [hard disks] all the problems then that we have faced. So it's now actually time to really streamline the business and make profit out of it. So I think Craig has mentioned the return to 20% gross margin that's because of lot of the hard work.

So I think, this number two position in this actually are very important space. If you look at Microsoft coming in, in a big way, I think it actually emphasize the importance of this, and of course we would want to be smarter this time to avoid any direct clash with whatever Microsoft is going to do. Of course, we always have a ZEN patent to have those set out here and there. And by focusing on the flash area, which actually today we have very strong position, strong insight, I think we can actually make a good business sense of this whole thing. So I think the market especially in Asia we are very strong. Great probably in Japan. In China, we are actually going into establish a new marketing effort to go into China again. And so I think that Apple is going on right now. In fact, we are now looking at India, India is starting to boom. So India we have very good brand name for our speakers in the past and I think we can leverage on the boom right now to go into India. So actually if you look at Asia, we actually overall has a very strong position and we are going to leverage on that and make benefit out of it. So I think it is an important market that we are doing this part of a way from that. On the cost side going forward we will not be like what in the past trying to say big, small but we are trying to tackle every segment on market. We try to focus; we will be focusing on the profitable part of the market and the market has consolidated which is good. And therefore I think with the technology that we have, we still have a lot new technology in this MP3 areas that we can introduce in going forward which if we don't do any kind of R&D in this space or our phone market in this space, we would not be able to benefit from the technologies that we have invented. So I think going forward, we are going to look at overall MP3 market that, yes, that will be a path where we will do the sales of the products, and so we should learn to be more careful more focused on other technology part which we can go out for licensing or go out to what we partners, where we actually can make a better profit in those space. So I think, we have done a lot, we've invested a lot in this space and it is near harvesting time, so I think it's not a wise move to just slog way.

Jim Renck - Renck Capital Management

Okay. Thank you.

Operator

Our next question is from [Lim Keng with Credit Suisse].

Lim Keng - Credit Suisse

Hi. Craig, just looking at your inventory level, I mean going back just two years ago, the inventory level was about 150 million on a very similar run rate for sales, just wondering, with the disposal of CUBIC could you bring your inventory back down to those levels again?

Craig McHugh

As we go through the -- well, first we actually complete the transaction which we believe is about three months and we go through a transition period. We believe that that will help us significantly reduce our inventory levels going forward as we shift to the outsource model. The outsource folks have to take on the inventory burden, that’s one of our goals. The other is we did need to build up our inventory because of the number of new products in the audio area and some of the speaker areas and getting ready for the Made for iPod program. So the increase is about 15% sequentially although it's down 25% year-over-year, but we do anticipate as we get to the holiday that we will be able to bring that back down through our just the natural act of the peak holiday season at the same time as we begin transitioning the Malaysia facility.

Lim Keng - Credit Suisse

I am not sure, if you can disclose this, but the percentage of headcount under Creative which is related to CUBIC, I mean, would that be a significant proportion?

Craig McHugh

May I ask Keh Long, I don’t have the specific figures available on the headcount in that facility.

Ng Keh Long

CUBIC being a manufacturing facility the headcount varies there with seasonality. Right now, I believe it is about 2005 or so of headcount.

Lim Keng - Credit Suisse

Okay, and what would your total headcount for the group be now.

Ng Keh Long

2005, it will be probably be about one-third of the total headcount because this is mainly manufacturing operators.

Lim Keng - Credit Suisse

Right, okay. Thank you so much.

Craig McHugh

Thank you.

Operator

[Operator Instructions] And, our next question is from Gregory Yap with Kim Eng.

Gregory Yap - Kim Eng

Hi, I just have another question on the licensing program. I know you probably will not want to comment on when do you expect the first contributions, but having said that, are there any specific copies that you have in your slides that you are seeing a similar in market impact to Apple, bearing in mind that you are also looking beyond the MP3 space. And the second part of the question is, I would anticipate legal costs, what would you cap it at?

Craig McHugh

The first part of your question as I mentioned, we are not breaking out any specific companies that we’re talking to or working with you at this time. But we have begun discussions with some companies and our goal -- you mentioned the legal fees, our goal is to reach amiable solutions with those companies who are currently using the Zen Patent, and only if we are not able to reach an amiable solution, we have to look at other ways to protect our intellectual property, but our goal is to reach an amiable settlement or agreements with these companies, and that's what we target to do and hence the discussions.

Of course, Apple has a very large volume in the MP3 space, but as I shared today, it's a part of our media players and part of the digital players, but as well as MP3-enabled cell phones. Many of the MP3-enabled cell phones in the US today do use the Zen Patents in their players, so there are opportunities potentially because of the nature of the cell phone market, there could be volume opportunities, but those are some of things that we are looking at.

Gregory Yap - Kim Eng

How useful then do you expect the settlement with Apple to set a precedent for this to company to consider when you approach them?

Craig McHugh

As I highlighted today, as we believe that the Apple settlement underscores the strength of the Apple Patent, I think some of the quotes by Apple in our original press release talking about the settlement also underscore the significance, this is a very early Patent. We believe the strength in the Zen Patent is reflected in our broad settlement with Apple and being very early in this space, we've talked about our investment in R&D and being able to innovate and invent and the Zen Patent was a part of our overall invention very specifically which is an interface for part of the media players, right now just look at the number of products in the US market place that use the Zen Patent. It is a very strong patent, it's an early patent, and it's one that’s very important to being able to easily access large amount of data for such a player or a MP3 cell phone.

Gregory Yap - Kim Eng

Okay. Can you then expand a little bit on the fundamental platform for this patent? Because I would have thought that it's a very logical way to construct an interface of such sort, how is it then that you are able to obtain this patent even though -- from my knowledge of the patenting process, is it something that’s very basic, if there is no other way of doing it and normally it would not be patentable?

Craig McHugh

Well, it is about US patent. It was granted earlier in last year by the US Patent Office. Other companies at a much later timeframe tried to seek similar patent because how important this invention is, it truly is an invention. Other people had tried. There were other MP3 players in the market, including a hard drive player. But at that time, the interface of those was very clumsy, very difficult, and non-intuitive. Our invention clearly is detailed and this is in earlier press conference that the invention we have for being able to intuitively go through a higher [arc] as well interface to be able to access the data easily and rapidly, was truly the invention. So, the strength of the patent is strength of the invention, there isn't any question. And I believe -- to your earlier question, the size of our settlement and the broad settlement we have with Apple reflects the strength of it. And I think they would be very knowledgeable in the industry and they would be very knowledgeable on this particular patent. So, I think that speaks for itself, and that's as far as details, I can go into right now.

Gregory Yap - Kim Eng

Okay. Thank you.

Operator

Ladies and gentlemen, we have reached the end of the allotted time for question and answers. I would like to turn it back over to management for closing remarks.

Craig McHugh

Okay. On behalf of Mr. Sim and Keh Long and the Creative team worldwide, like to thank you very much for joining us today. Have a good evening in the US and good day in Singapore. Thank you and good bye.

Operator

This concludes today's teleconference. We thank you for your participation. You may now disconnect.

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Source: Creative Technology F1Q07 (Qtr End 9/30/06) Earnings Call Transcript
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