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NDS Group (NNDS)

F1Q07 Earnings Call

October 31, 2006 10:00 am ET

Executives:

Abe Peled, Chairman and Chief Executive Officer

Alex Gersh, Chief Financial Officer

Analysts:

Alan Gould, Natexis Bleichroeder

Mehrdad Torbati, Deutsche Bank

Conrad Verner, Morgan Stanley

Daniel Meron, RBC Capital Markets

Todd Mitchell, Kaufman Brothers

Tim Boddy, Goldman Sachs

Ari Bensinger, Standard & Poor

Alan Bezoza, Oppenheimer

Luke Mertens, BNP Paribas

Todd Chanko, Jupiter Research

Robert Bovo, XI Asset Management

Operator

Thanks for standing by and welcome to the NDS First Quarter Results Conference Call. At this time all participants are in a listen-only mode. There will be a presentation followed by a question and answer session, at which time if you’d like to ask a question you’ll need to press * and 1 on your telephone keypad. I must advise you the conference is being recorded today, the 31st of October t 2006.

On this call we will make certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on management's views and assumptions regarding future events and business performance as of the time the statements are made. Actual results may differ materially from these expectations due to the changes in global, economic, business, competitive market, and regulatory factors. More detailed information about these and other factors that could affect future results is contained in our filings with the Securities and Exchange Commission. The forward-looking statements included in this call are made only as of the date of this call and we do not have any obligation to publicly update any forward-looking statements to reflect subsequent events or circumstances except as required by law.

I would now like to hand the conference over to your speaker today, Dr. Abe Peled, Chairman and CEO of NDS. Please go ahead.

Abe Peled, Chairman and Chief Executive Officer

Welcome to the NDS Q1FY07 conference call. I’m here with Alex Gersh our CFO, and we would like to take you briefly through our results for the quarter and then opening it up for questions.

I hope that most of you have had the chance to see our press release; NDS has enjoyed a strong quarter. Some of the improvement in this quarter I should hasten to add has to do with the fact that Tata-Sky, which did not happen in the fourth quarter of our last fiscal year and led to some questions from some of you, has of course happened in this quarter, and that has as Alex will explain obviously driven up a bit our margin, which you should not take as an indication for the margin for the rest of the year. But, we are pleased. Speaking about Tata-Sky, they were off to a really great start in the beginning of September having reported over 100,000 subscribers, and they are going quite strong. So, we’re very pleased with the reception of the system in India, and we obviously are a bit more confident that indeed it will be a rapid build up.

This quarter also we have been able to announce a number of new deals in our traditional businesses like Get, the Norwegian cable operation. While not a very large platform, I would say that it is significant because again it’s an old NDS technology -- middleware, DVR, EPG, high definition -- and NDS won it against a strong competition from various middleware and conditional access platforms, and I think it signifies the fact that NDS has been able to focus and improve our offerings for smaller customers, which we are now winning in Eastern Europe, obviously we’ve been doing for sometime in other areas.

Also significant is we have announced earlier this year our middleware solution for CineMedia Metro. In the past, we partnered with other people on middleware, but as we saw increasingly that the solutions being provided are not up to the standards of digital television, we came up with our own middleware, derived obviously from our own regular middleware, which already can deal with broadcast, and therefore it is suitable not only for pure IP systems but also for hybrid systems.

SES AMERICOM, which is going to use our CineMedia solution in its IP Prime Service being launched in the United States, has also announced that they are going to pick our Metro IPTV middleware, and we view that as quite interesting. Another small system is Romtelecom, and we have a number of other smaller systems in the pipeline.

NDS at the International Broadcasting Convention in Amsterdam, which is the biggest show that we do in the year, has really unveiled a whole range of solutions that not only articulate division that NDS has in PowerPoint slides and so on, but literally was working systems demonstrating our ability to secure and enable content anywhere, anytime, on any device. We just marked the introduction of our first product to secure content on the personal computer, our VideoGuard DRM Key solution, which we are particularly excited, and we think that it has a strong long-term potential, not only as an extension for the pay-TV operators that we already work with; as they transition from being simply an operator on a vertical platform but extending their proposition and their relationship with the customer to offer entertainment and content to their customers wherever they are, whether on the road, through broadband, on mobile, and of course into their set-top boxes.

So, the VideoGuard DRM Key, which I think has been received very well both by our traditional customers but with some interest also from some of the newer players that expect to deliver content to personal computers, has been quite interesting. Of course also the VideoGuard Key is a portable storage device in its own right in addition to having that security and allows convenient transfer of content between the different devices, whether it’s a set-top box DVR, a PC or a mobile to a portable mobile player, to a mobile phone, and other USB type devices.

To really enhance that, we’ve also shown that the connection to the PC once the hybrid box in the home is connected to broadband, it is of course connected to the same broadband through the home gateway router to the personal computers in the home, and our XTend solution allows convenient access to entertainment content, whether they are your personal photo albums or music or perhaps favorite video clips that reside on the PC to be accessible in a very nice way onto your set-top box on your television so you can share it with friends and family.

Speaking about hybrid, I’m also pleased to the say that NDS in Israel, which is really the farthest in deploying hybrid set-top boxes, has received regulatory approval to start trial on that and so far it’s going quite well. Also, our IP hybrid set-top boxes, as you may recall will be launching at Premiere over the next few weeks.

NDS also made a small acquisition in this quarter really enhancing our capabilities in games technologies that we already have in Denmark through the Visionik brand, now NDS Denmark. It’s a small company also based in Copenhagen which happens to be in the heart of gaming technologies. They have the 3D capability as well as having experience on consoles as well as live television with their “Hugo the Troll” animated character.

So, all in all, we are really pleased with the way the year has started for us and I would like to turn it over to our CFO, Alex Gersh, to take you in a bit more detail through the numbers. Alex…

Alex Gersh, Chief Financial Officer

Thank you, Abe. Good morning and good afternoon everybody. Just a quick highlight first and then some more detail. As you could see from our press release, as Abe had mentioned, total revenue for the quarter is $164 million, which is an increase of 14% over the first quarter ’06. Operating income is $44.6 million, an increase of 25% over the first quarter ‘06. Operating income margin is significantly improved to 27.2% versus 24.7% in '06. But again, as Abe had mentioned, clearly Tata-Sky revenue recognition for integration, for which majority of course were recognized last year, as well as a new R&D tax credit in France, which again I’ll talk about a little bit later, both have given us significant margin improvements for the quarter, and as Abe has said that certainly is not an indication of the kind of margin we would expect throughout the year.

Net income for the quarter, as you could see, is $35.1 million, a 29% improvement, and the diluted earnings per share for the quarter as $0.61 a share versus $0.47 a share in the first quarter of ’06.

Some detail in terms of some of the revenue components as well as the cost obviously – conditional access revenue increased by 12% to $93 million approximately. We’ve shipped 6.7 million cards in this quarter versus 5.5 million in the first quarter of last year. Security fee of course increased as a result of a larger number of authorized cards. We currently have 85% of our customer base that are active cards paying us the monthly fee. On the integration development and support line that increased by 33%; clearly Tata-Sky is the major reason for the increase as the system went live in August, and we’ve recognized the integration revenue this quarter.

License fees and royalties decreased by 1% to $24 million. Now, clearly Tata-Sky has increased as part of the integration. We have recognized revenue on some license fees and royalties relating to the head-end software that we deploy in the system. However, in the first quarter of last year, we have recognized some revenue on download and middleware to DirecTV for the boxes that DirecTV already had in use in prior periods, and we highlighted at that time that as a one-off event. So, while we have an increase in license fees and royalties in this quarter for Tata-Sky, we clearly did not have another one of these one-offs when it comes to DirecTV, and therefore those two items basically offset each other, and so you’ve got a license fee and royalty decrease of roughly 1%.

As of the end of the September, we estimate a cumulative number of 44.7 million set-top boxes now that contain NDS middleware, which have been shipped. New technologies increased by 32%. Again, we keep talking about DVR PVR as the driver; it continues to be the driver. While we see the increase in the number of DVRs shipped and the royalty received from the DVR shipments, we also see continuing increase in integration and development work that NDS does to support rapid advanced DVR deployments.

We’ve added 700,000 DVR-enabled set-top boxes in the quarter, and as of September we now estimate 4.2 million DVR-enabled set-top boxes which have been shipped, and of course we always talk about the number of customers we already won and the potential market we already see, so we continue to see and look forward to an improvement and increase in the rollout of the DVRs.

Again, making sure that we highlight — and we’ve highlighted it in the foreign exchange — as we said and as I’ve said now for a few quarters, 45% of our revenue is Pound and Euro denominated, and certainly due to the strengths in the U.S. Dollar, if you compare the first quarter of this year versus the first quarter of last year, we had a favorable impact of 2% on revenue, which is roughly $3.3 million. Total revenue from related parties, which are the news affiliated companies, spent $132 million for the quarter, we consider Tata-Sky of course a related party as well, and that’s one of the bigger reasons for an increase.

We see an improvement in gross margin from 58.6% to 62.1%. While the cost of sales increased by about 4% as a consequence of adding additional staff and additional facilities, we were able to continue to focus on the smart card costs and therefore overall see an improvement in the gross margin percentage. Of course, again, some of the revenues that we have recognized this quarter like Tata-Sky, as I’ve talked about before, has a very, very high gross margin because the costs of course were recognized last year, most of the costs.

Operating expenses increased by 17% to $57 million, again R&D increased by 15% due to of course higher employees and infrastructure costs. We’ve add roughly 450 employees for the 12-month period if you look at the first quarter versus the first quarter of this year. However, the costs have been offset by a $5.5 million grant from the French government relating to the R&D activities in France that we’ve recorded this quarter. If you recall, last year in the first quarter, we recorded a grant of $5.3 million. We have intensified work over the first of this year on the development of the new generation of middleware for NDS. A lot of this work is done in France and therefore we were able to again have a credit from the French government of about $5.5 million in the quarter.

Sales and marketing increased by 10%, again that’s just a general increase due to the increased sales and trade show activities. G&A increased by 35% and that’s really the result of the higher facilities’ cost and particularly when it relates to our headquarters at Heathrow Airport where we now have a full quarter of costs of that building, which we did not have in the first quarter of last year, and the cost of that building, because this is an administrative facility, is all part of G&A.

Also, the stock options that were granted last January to our employees, the cost of those options has affected us and increased our overall option cost, obviously when you compare the first quarter of last year to the first quarter of this year. As I said, the total head count increased by about 450 employees than September ’05.

Again, in terms of the foreign exchange, approximately 49% of our expenses are Euro and Pound denominated, and due to the weaker U.S. Dollar we estimate an adverse impact on the cost of our business of about 2% or roughly $2.5 million.

Income tax expenses are 30.7% versus 29.8% in the first quarter of last year, really just due to the effect of retired tax rates in some of the non-U.K. operations. Net income, as I said, is $35.1 million or $0.61 per diluted share, compares to $27.1 million or $0.47 per diluted share in the first quarter of last year.

From the cash flow perspective, just a few words on the cash flow – cash and short-term investments together are about $507 million. Cash from operating activities decreased basically reflecting higher payments for smart cards, higher expenses due increased number of people as well as these new facilities we talked about, higher taxes as we’re becoming more profitable offset by higher receipts from our customers, as we continue to drive the revenue increases up.

In terms of cash from investing activities, we spent $4 million on capital expenditures. That’s lower than the first quarter of last year. In the first quarter of last year, we spent a lot of money on U.K., India, and U.S. facilities. That has not repeated itself obviously in the first quarter of this year. And as I’ve mentioned, on September 29th, we acquired Interactive Television Entertainment Company in Copenhagen for $1.8 million in cash. We assumed approximately $1.2 million of debt. All that debt has been paid in October, so in the second quarter that’s all been paid. And in addition in the quarter, we’ve paid $1.8 million additional consideration for NT Media acquisition relating to delivery of a full casino suite, which was one of the conditions for this payment when we purchased the company, and the money has actually been paid this quarter.

As of September 30th, NDS has 3.6 million shares stock option outstanding with 2.1 million divested, and our employees exercised roughly 32,000 shares in the quarter for about $600,000 of cash that NDS received.

Just a few words in terms of the guidance – we are not changing the guidance as of the first quarter. We are maintaining our guidance as we have given it to you when we did our annual results at the end of 2006, and just to reiterate the revenue range is $660 million to $680 million and operating income range of $150 million to $160 million. We still expect to spend about $25 million on capital expenditures for the year. which is exactly what we told you again the last time we spoke.

The biggest thing in terms of our guidance and in terms of going forward for us is continuing to see obviously the development of our customers’ DVR deployments and the pace of DVR deployments. We continue to watch of course foreign currency while it has a significant effect on revenue and expense fluctuations.

So that’s kind of the summary of the results for the quarter. Thank you very much.

Abe Peled, Chairman and Chief Executive Officer

Thank you, Alex. Operator, we would like now to open the call for questions.

Question-and-Answer Session

Operator

If you would like to ask a question, please press * and 1 on your telephone keypad and wait for your name to be announced. If you wish to cancel your request please press the # key. The first question comes from Alan Gould from Bleichroeder, please go ahead.

Alan Gould, Natexis Bleichroeder

Thank you and good morning. First question is with respect to the cash. I was wondering if you and the board have had any more thoughts of possibly instituting a dividend.

Abe Peled, Chairman and Chief Executive Officer

We have as I said considered it at our board meeting in fact yesterday, and given that we are currently actively looking at a number of acquisitions to enhance our position both in the converging world of broadband IP and broadcast as well in the area of mobile, the board felt it prudent at this point to retain our cash position to give us the flexibility needed in the future.

Alan Gould, Natexis Bleichroeder

Abe, what’s the largest acquisition you’ve done in dollars?

Abe Peled, Chairman and Chief Executive Officer

The largest acquisition in dollars probably is $120 million or so, and the acquisitions we’re looking at are in these types of ranges. I mean there maybe bigger ones later, but the ones that we’re actively under considerations are in these types of ranges.

Alan Gould, Natexis Bleichroeder

Okay, there’s a change in the control of Open TV, Kudelski your competitor buying Liberty stake, does that help you or have any impact on you particularly where Open TV is the middleware, BSkyB and some of the other news corp related platforms?

Abe Peled, Chairman and Chief Executive Officer

First of all, we have been facing a very strong alliance of Open TV and Kudelski for the last year and a half in a number of accounts, most recently Get but also in Première where they are already the conditional access supplier, and I believe in each of the cases that we’ve faced with this alliance, with the exception of the Liberty Media property at the time of UPC in Holland, we’ve won the business. I think the fact that Kudelski only acquired the controlling share in the minority economic interest in Open TV will limit their ability if they indeed observe and respect the rights of the rest of the shareholders in Open TV, to flexibly bundle middleware and conditional access in a way that they talked actually even in their conference call, because it may disadvantage Open TV shareholders. So, I think also the ability to invest and really combine the things in a way that does not damage the interest of the shareholders would be quite tricky in my opinion, and I believe that the experience that the Kudelski Group has with running a U.S. NASDAQ traded, Sarbanes-Oxley company is quite limited, and I hope that they will step up to it. But more to the point, as I have seen in the past, our new-generation middleware fusion is aimed straight at being able to replace Open TV not only in the big news corp accounts that we have like BSkyB or Foxtel or Sky Italia; I mean I’d like to say obviously that this is still a challenge to be able to do that, but from the NDS point of view our strategy is to develop the middleware that is more capable in the whole hybrid arena. We believe that our MediaHighway Advanced Middleware has years of investment behind it that make it quite powerful in this area, which is the reason we have won against Open TV in the past, and I think it will only accelerate. So, I frankly think that it’s either neutral or even beneficial to NDS given the additional complexity in having to put together such an alliance.

Alan Gould, Natexis Bleichroeder

Okay, my last question is for Alex. Alex, this French R&D credit we thought was a one-time thing last year – one, should I assume that’s recurring, and two, has that already been factored into your guidance that you gave us last quarter?

Abe Peled, Chairman and Chief Executive Officer

First of all, we never said it was one time. What we said was that last year it was a multi-year credit, because last year was the first time. So clearly, we did not expect the credit to be quite as large this quarter. So, to answer your question, we will apply every single year to the French government to receive the credit. How much we receive is a different issue. No, we did not expect $5.5 million when we gave the guidance, so it was slightly less than that, and certainly when we’re looking at the future it’s very, very difficult to predict. So, the only thing that I can tell you is that we have not raised our guidance, so we clearly did expect a large proportion of it this year. And going forward, we do expect to apply on an annual basis. How much we’re actually going to receive, it really depends on the nature of the R&D done in France.

Alan Gould, Natexis Bleichroeder

Okay, thank you very much.

Operator

Your next question comes from Mehrdad Torbati from Deutsche Bank, please go ahead.

Mehrdad Torbati, Deutsche Bank

Hi, Abe and Alex, congratulations. I have a question regarding your cost base going forward this year, do you think the run rate you’re having in terms of underlying cost in the first quarter is sustainable for the rest of the year? Are you currently in a hiring phase, are we going to see the same number of employees you added last year that are going to be added this year to your platform as well, can you give us a bit of guidance there? My question pertains to the DVR deployment, are you happy with 700,000 DVRs deployed in the first quarter, is it the type of run rate your expect for the rest of the year, are there any campaigns out there which is beyond your control but would facilitate further penetration of PVR into some of the major accounts you have, can you shed some light on that as well?

Alex Gersh, Chief Financial Officer

Let me comment on the costs first. What I can say is that in the first quarter barring the R&D credit of $5.5 million, which will not repeat itself certainly by the end of the year, we don’t have any other what I would call one-off activities. So clearly, our costs will continue to be dependent on the number of employees we hire and on any new facilities that we may need to employ to make sure the employees are productive. And I can tell you that, as we continue to ramp up in India and continue to increase our presence in India, there is certainly a very good possibility that we may have to look at new facilities in India this year. So, that’s what I can say in terms of the cost base trajectory. From the point of view of head count, certainly I’ve learned not to predict head count. We’ve done it a few times and obviously you could see our revenues continue to increase as the new project arrives and as I have certainly mentioned many, many times, they continue to arise all the time where we may need to add people and continue to add people. So, we’re not looking at anymore of the kind of the target number of people, because projects do tend to arise. However, I do want to point out that we continue to predict the expansion in our operating margin, which obviously assumes that our costs are going to go at a lower, slower pace than our revenue, and that is something that we’ve been very, very consistent on and will continue to be very, very consistent on. In terms of the DVR penetration, we certainly see acceleration, and it is clear that as HD is becoming more important we see acceleration in both the SD and PVR and we see some starting movements in terms of the HD PVRs. So clearly, we do expect acceleration of it this year and then acceleration going forward. As we’ve commented a number of times, DVR is something that depends on the aggressive promotions of the operator. We see the operators and really understand the value that a lot of the features that our DVRs give them and the opportunities that they give them, so therefore as they become more aggressive and continue to become more aggressive, we certainly expect the acceleration in the DVR deployment.

Mehrdad Torbati, Deutsche Bank

Last question if I may, and more on a strategic level based on the comments you made earlier, with one of the criteria for acquisitions in the past I remember you saying that you would consider perhaps an interest in technology which would bring you also closer to U.S. Cable somehow in terms of a technology provider cost relationship point of view, and now that we see Kudelski taking over a controlling stake in Open TV, and Open TV being a technology provider somewhat close to the U.S. Cable, is it going to undermine your position in front of U.S. Cable in the future assuming at some point of time in the future we would see maybe downloadable conditional access being a reality if at all, or are they having a better competitive positioning in front of U.S. Cable compared to you, putting Cablevision aside where you’re the active player, more thinking about Time Warner in these accounts?

Abe Peled, Chairman and Chief Executive Officer

Well, let me take that. First of all, our competitors’ position in conditional access I would say is extremely good, given the piracy that Kudelski is experiencing and the fact that several of Kudelski’s large customers are getting quite impatient and are talking to us. I think in terms of U.S. Cable, NDS has continued to be active in open cable and in downloadable CA, and having Open TV which has at best a very marginal position, certainly nothing really deployed in U.S. Cable, I don’t think that improves Kudelski’s access to U.S. Cable compared to our strong security record and much stronger U.S. presence and so forth. So, I’m not worried about that, although I will again say that in my own view U.S. Cable is currently focused on telephony, on many other things other than necessarily changing their television proposition, and therefore I don’t see it as a short-term or even medium-term prospect for anyone, not only NDS. I think from an acquisition point of view, we are as I said more focused on, I would say, IP world and mobile world where we think a lot of exciting new developments are happening and may happen, and technologies that provide us better access to those would be interesting and useful.

Mehrdad Torbati, Deutsche Bank

Okay, thank you.

Operator

Your next question comes from Conrad Verner from Morgan Stanley, please go ahead.

Conrad Verner, Morgan Stanley

Hi there, thanks. First, the question on the potential M&A, I mean there’s been a lot of R&D investments done in the company, and at your last meeting in Heathrow we were able to see the fruits of those efforts and there are some very impressive products both that are available today and set to come down the pipe. So, in terms of acquisitions that you would consider, can you be basically buying companies where you can leverage some of the work that you’ve already done internally or do you really need to make a big investment in something to really expand your internal IP in areas where you have nothing basically, to get a better feeling for that? And then second question, just on the cash flow for the quarter, it looks like inventories ate up a lot of cash this quarter and the accounts payable did as well, certainly in comparison with what we saw in the first quarter last year, is that something that evens itself out over the course of the year, is it just a kind of quirk in terms of the timing or is there something else going on? Thanks.

Abe Peled, Chairman and Chief Executive Officer

Let me take the first one and I’ll get Alex to answer the cash flow; but just so you are relaxed, we will generate cash along the lines that we said we will generate. In terms of acquisitions, I think when we look at those technologies that we haven’t focused on that are pure for the IP world or mobile, but also as you correctly point out will allow us to leverage through market access some of the technologies we’ve been developing in-house. So, if you look at some of the things we are considering, they have this property that they have markets in their own rights in either telco or mobile with technologies that we don’t necessarily have in-house. On the other hand, they can provide a platform to leverage both ways, technology that these companies have developed and that would be applied to our market place as it embraces broadband as well as technologies that we have developed in-house that could be applied broader to some of that market segment. Alex…

Alex Gersh, Chief Financial Officer

Thank you. In terms of the questions on cash flow, let me take the inventory question. Yes you are correct, we have been accumulating an inventory in anticipation of the possible changeover, and that’s as much as I can say in terms of that. That is certainly not an ongoing situation; it is something that’s just happening now. In terms of payables, there is certainly nothing in terms of accounts payable, there are no issues in terms of the accounts payable. Now, if you look at the liabilities altogether and you look at the total payroll cost there, you see a big decline, and that clearly is a reflection of the payment of the bonuses to our employees in the first quarter of this year for the partial bonus for the fiscal ’06, and that’s the big variation in the liability side.

Conrad Verner, Morgan Stanley

Okay, so we can basically assume a similar kind of working capital profile as last year, is that correct?

Alex Gersh, Chief Financial Officer

That’s correct. We continue to say that we expect to generate cash roughly equal to our operating income, and we stand by that statement. And if you look at our last year’s result, as you correctly say, you see a big negative in working capital movement in the first quarter and then it sorts itself out in the second quarter or third quarter and so on, so you should expect the same profile.

Conrad Verner, Morgan Stanley

Thanks Alex, and just one other question. When do you then roughly expect the changeover shipments this year, is it possible to give us a sense of timing next quarter or more towards the end of the year or is it even…

Alex Gersh, Chief Financial Officer

No, as you know, the only thing that I can tell you is when you look at our changeover you could see that we have a deferred liability relating to changeover of roughly $145 million of which $5 million is classified as current, which by definition means within the next 12 months. That you’ll see in our 10-Q and that’s as much as I can tell you.

Conrad Verner, Morgan Stanley

Thank you.

Operator

Your next question comes from Daniel Meron from RBC Capital Markets, please go ahead.

Daniel Meron, RBC Capital Markets

Thank you, congrats Abe and Alex on the solid quarter. Can you give us a sense on where you’re seeing competition, has it really changed now, what are your customers telling you, just following up on the comments you made on Open TV and Kudelski and from other competitors in the market place that you have performed some recent acquisitions and mergers specifically between Irdeto and Philips there? Thank you.

Abe Peled, Chairman and Chief Executive Officer

Well, I’ve heard the comment on Kudelski and Open TV, so I don’t think there is much more than I can comment. I do believe that in Irdeto they’ve kind of been more active in Europe…they used to be active primarily in China, but they have become a bit more active in Europe. Again, for NDS it’s more as in the past winning business with an adequate margin rather than just winning business at any cost, and again of worthwhile customers, and we’re continuing to focus on that. I would say in our traditional business of cable, satellite, and so on, I think we’re in an extremely strong competitive position subject to what I said before that we focus on customers that are serious and will spend money and we will get an adequate return on our business. I think the competition that we are more focused on and looking forward is the competition in these new emerging markets, which are the distribution over IP, distribution over broadband, distribution over mobile, where while we do have a starting position that is quite good, we certainly don’t have yet, as the market hasn’t yet developed, a position that is as strong as I would like, and we have introduced some of the VideoGuard DRM expansions. That’s why we’re also looking at strengthening our overall positions of market not only on the security side but by offering a broader array of services. So, in summary, I would say the competition hasn’t really changed significantly in our traditional markets, but certainly we are very focused on maintaining our market share as the means of distribution broaden and may encompass other than the traditional modes of distribution. Again, I hate to add, we’re not going to be big in the next couple of years, but obviously NDS is looking forward over the medium and long period to ensure that we are in a very strong competitive position which ever way these developments go.

Daniel Meron, RBC Capital Markets

Thanks, Abe. Maybe you mentioned this before, but where do you stand as far as HD DVR deployments with your various customers these days, did you already start shipping, and if so were there any revenues recognized?

Abe Peled, Chairman and Chief Executive Officer

The largest shipments in actuals have been with Sky HD DVR, and I believe Sky will provide a number when they produce their reports. DirecTV DVR revenues have still been quite small, and I think the revenue recognition in this quarter from HD is quite small.

Daniel Meron, RBC Capital Markets

Okay, thank you Abe and good luck going forward.

Operator

Your next question comes from Todd Mitchell from Kaufman Brothers, please go ahead.

Todd Mitchell, Kaufman Brothers

Thank you. I have a question about the middleware numbers. You reported 3.1 million net adds, can you characterize that in terms of boxes shipped versus downloaded upgrades? What I’m trying to get at is this a good number for a runrate going forward? And then I have a followup on that.

Abe Peled, Chairman and Chief Executive Officer

I believe that we have pretty much done the middleware upgrades. There is a catchup that may happen in the next quarter on HD boxes and DirecTV, which don’t have interactive middleware downloaded, but in this quarter there was no catchup. I think in terms of runrate, which could be over 12 million, that’s probably not a bad number although it maybe anywhere from 12-13 million depending on…it maybe higher because the Premiere is only starting in this quarter, and that may increase the numbers. So, it’s probably a little bit low as a runrate now that I take into account these two things, but the runrate should be in the order of 13 and perhaps higher.

Todd Mitchell, Kaufman Brothers

Okay, and as a followup on to that, can you characterize the percentage of middleware net adds that are also conditional access customers? And I guess what I’m getting to with this part of the question is, in terms of sort of the overall footprint of NDS’ touch, is the middleware becoming a better proxy than perhaps the conditional access for the size of your overall footprint?

Abe Peled, Chairman and Chief Executive Officer

No, because we still have very large platforms -- BSkyB, Sky Italia, Foxtel, and VIASAT, all of which still use Open TV middleware. And to that end we have middleware customers like Canal Plus, Astro which incidentally started shipping our DVR this quarter, MediaHighway Advanced DVR, which used MediaHighway Middleware, so it’s not yet a good proxy.

Todd Mitchell, Kaufman Brothers

Okay, thank you very much.

Operator

Your next question comes from Tim Boddy from Goldman Sachs, please go ahead.

Tim Boddy, Goldman Sachs

Yes, just a couple of questions. First of all, just any update on the situation at DirecTV in the U.S., obviously difficult to comment, but what implications would a change of ownership or change of control of that customer have for NDS, and indeed where are we to see DirecTV’s largest pair of EchoStar merge with AT&T, how would see DirecTV’s competitive position in that market? And then I’ve got a followup question about the VideoGuard Key.

Abe Peled, Chairman and Chief Executive Officer

Well, I really can’t comment on the change of ownership for DirecTV. In terms of impact on NDS, as I’ve said in the past, NDS technologies are deeply embedded in DirecTV. It’s performing very well and it’s extremely competitive in both our pricing and for sure in our performance. So, we would expect no change, also our contract runs up to 2010.

Tim Boddy, Goldman Sachs

Okay. And in terms of the VideoGuard Key, it seems from the analyst day this was perhaps a product which we could see significant revenue traction, probably the soonest of all the new products which obviously look forward to the medium term for the most part, is there any update in terms of when we might see revenues from that and potentially what sort of number of customers would you hope to win in the next 12 months?

Abe Peled, Chairman and Chief Executive Officer

Well, we already have two customers that have either expressed a strong interest or formally actually committed to starting deploying it. I would say that revenues probably are a 2008 kind of number given that it takes time to deploy it, and then the extent to which it’s deployed is really a little bit hard to guess, because it depends on the competitive environment that these people face. I think it will be used more as a competitive element. I’m sorry I neglected to answer your question over the DirecTV AT&T-EchoStar situation. Obviously should the scenario of AT&T and EchoStar get together, which I think in general it makes sense for telcos and phone companies to get together to fight cable rather than having three people fight each other out both technologically and commercially, it certainly would hasten the need of the other major telcos like Verizon or others to get closer to DirecTV in terms of both commercial bundles and perhaps technological bundles, especially if it turns out as it seems to be the case that the deployment of their standalone video propositions is slower than expected and perhaps more expensive than expected. So, I wouldn’t foresee deterioration in the competitive position, because people will do what they need to do to be competitive, both on the telephone side and on the satellite side.

Tim Boddy, Goldman Sachs

Okay, thank you.

Operator

Your next question comes from Ari Bensinger from Standard & Poor, please go ahead.

Ari Bensinger, Standard & Poor

Yes, thank you. My question is more on the modeling side. Integration and support revenue was up sequentially, roughly $8 million, and I’m wondering how much of that was attributable to the Tata-Sky revenue recognition?

Alex Gersh, Chief Financial Officer

We don’t disclose the specific numbers relating to any specific customers, but obviously as I said before, a significant amount of that number was attributable to Tata-Sky.

Ari Bensinger, Standard & Poor

And is there going to be a gradual stepdown going from the second quarter to third quarter or is that something that will fall off a little bit more drastically?

Alex Gersh, Chief Financial Officer

As we always said, our kind of ongoing integration development kind of activity without any major projects runs at around $11 million to $12 million a quarter roughly, so barring any new big projects which could happen, that’s the kind of ongoing business there.

Ari Bensinger, Standard & Poor

So, there shouldn’t be any spillover into the second quarter?

Alex Gersh, Chief Financial Officer

There shouldn’t be, sorry?

Ari Bensinger, Standard & Poor

Any spillover from Tata-Sky.

Alex Gersh, Chief Financial Officer

No, with Tata-Sky the system is live, integration, development, and license fee per head has all been recognized in the first quarter.

Ari Bensinger, Standard & Poor

Okay, thank you. For new technologies, DVR while growing pace I think still represents according to our estimates roughly 15% to 20% of segment sales, I’m just wondering if you could just comment on some of the other major components and how they’re doing year-to-year and sequentially?

Alex Gersh, Chief Financial Officer

It’s more than 15% to 20% of the segment sales, but I will also say that the other components are continuing to do well. However, one of the things that’s key to remember for instance in projects like Synamedia, you also have integration revenues. So, for projects like our IPTV, like Synamedia, new technologies encompasses any card shipment as well as integration as well as any license fees. So, if you complete integration project in one quarter and you recognize revenue and you don’t have it in another quarter that could create some lumpiness. In terms of our interactive technology as well as Orbis, our gambling and gaming subsidiary, the revenue will continue to increase and improve.

Ari Bensinger, Standard & Poor

Thank you, and just a clarification. This is the first time I’m really hearing about maybe a changeover starting, and I just wanted to clarify that your guidance as of currently does not incorporate any changeover related revenues, right?

Alex Gersh, Chief Financial Officer

That’s correct.

Ari Bensinger, Standard & Poor

Thank you.

Operator

Your next question comes from the Alan Bezoza from Oppenheimer, please go ahead.

Alan Bezoza, Oppenheimer

Yes, good morning. A couple of questions on cost; when you look at the smart card cost in the quarter, it’s a little bit higher than what was expected given the amount of shipments you’ve had, is there anything there that we can look into that? And then on the shipments side of the smart cards, can you characterize how much is coming from new customers whether it’s Sky Tata, Get, and now digital versus your more traditional customers gaining subscribers or multiple television outlets?

Alex Gersh, Chief Financial Officer

Let me make a comment on the cost of the cards. I presume you’re looking sequentially, fourth quarter to the first quarter?

Alan D’Souza, Oppenheimer

That’s right, yeah.

Alex Gersh, Chief Financial Officer

This is why I highlight very much the foreign exchange fluctuations, because clearly the Pound and the Euro, as I said the weakness of the U.S. Dollar has affected us on the cost side. Where it affects us the most are in two basic components of our cost: one is in any smart cards that are purchased in Euros or in Pounds, and we do have a significant number of our smart cards purchased in Euros, and two is of course on the cost of our people who work in the U.K. and France and so on. So, when you’re looking at the smart cards what you see is the foreign exchange effect of a weakening Dollar against the Euro.

Alan D’Souza, Oppenheimer

Just about the $2 million you said was P&L cost, the majority of that came from the smart card side?

Alex Gersh, Chief Financial Officer

Sorry, I thought your question was on the smart card cost…

Alan D’Souza, Oppenheimer

No, that’s right it has, so most of that difference is related to the foreign exchange. And then on the new customers, card shipments?

Abe Peled, Chairman and Chief Executive Officer

Well, we don’t obviously disclose individual shipments, but there is an increase in shipments to new customers as we ship a certain number of cards to Tata-Sky, to China, to other smaller systems. So proportionally, as Alex indicated, these people typically don’t pay a subscriber fee, so that’s why the percent of people paying subscriber fee went from 88 to 85 or something, which reflects a growing base of active cards which are in developing markets over developed markets.

Alan D’Souza, Oppenheimer

Okay, great, thanks a lot guys.

Operator

Your next question comes from Luke Mertens from BNP Paribas, please go ahead.

Luke Mertens, BNP Paribas

Hi, good morning. Just a question which is in fact following the analyst day in London, do you now have a specific view on the Microsoft IPTV deployment, because it sounds to me with the announcement in October that the system is quelling up now with boxes from Motorola, Philips, and even Tatung if I understand well. Some of that is around the issue of video packet loss, so I’m wondering if you’ve got a bit of an update on that deployment in the U.S. market. And a more specific question, what part of your revenues at the moment is deriving from solutions in IPTV and phone applications, and what could we expect for the coming quarters, is that very much ramping up by year end or next year?

Abe Peled, Chairman and Chief Executive Officer

Well, I’m not sure where you get your information. Some of the customers that we work with that have in the past an alliance with Microsoft, here have continuing delays. I believe the latest information that I’ve seen in terms of the ability to scale at a reasonable cost by the way, which includes a number of B-Servers that had to be deployed haven’t been sold. So, they may have more set-top boxes but I don’t believe that some of the scalability or functionality issues have been solved. In terms of the percentage of our revenues that come from pure IP systems, it’s quite small and we don’t expect that to be a major ramp up in the next few quarters or even in the medium term. I don’t believe, as we have said, that standalone IPTV systems will be…I’m not taking for premium IPTV distribution, not kind of incidental television…compared to the 66 million active smart cards, to get that to be a big number will take quite a long time.

Luke Mertens, BNP Paribas

Okay, and just as a briefing out, if I could add, will you consider Siemen’s Myrio as a key player for this part of the business, or will you consider that mostly as a side liner?

Abe Peled, Chairman and Chief Executive Officer

Well, we are working with Myrio in a number of accounts, and one of the reasons we have introduced our IPTV Metro solution is because we believe that the middleware that some of these new players that come primarily from the IP side are not yet capable of dealing effectively with television and handling that in real-time, the ability to scale it, scale the guide other than it being just a browser and so on. So, I think Myrio may suffer from some of the same issues.

Luke Mertens, BNP Paribas

Okay, thank you very much.

Operator

Your next question comes from Todd Chanko from Jupiter Research, please go ahead.

Todd Chanko, Jupiter Research

Yes, good morning, about your XTend solution, are you looking into any kind of partnerships with ISPs particularly or would you do a wide cable version, are you looking to integrate it with any specific web content platforms?

Abe Peled, Chairman and Chief Executive Officer

So, the answer is yes, we are already working at least on a trial project with one major ISP that expects to start using something like that to distribute content. So, we are definitely looking with these solutions outside of our circle of traditional customers as I said in my introduction.

Todd Chanko, Jupiter Research

Thank you.

Operator

Your next question from Robert Bovo from XI Asset Management, please go ahead.

Robert Bovo, XI Asset Management

Thanks, my question was answered, I appreciate it.

Operator

You have a followup question from Daniel Meron from RBC Capital Markets, please go ahead.

Daniel Meron, RBC Capital Markets

Hi. Abe, I just wanted to get a bit of update on your progress in emerging markets, and also what is the kind of possibility you see…I understand that these are small projects but you introduced some more off-the-shelf kind of solutions there, I’m just wondering what’s the possibility on those projects and what do you expect from this region going forward say in the next two to three years? Thank you.

Abe Peled, Chairman and Chief Executive Officer

Well, we have introduced our VideoGuard Express package. We have further streamlined it, we now have the ability to have a reasonable standard product that is low cost of entry, and we differentiate between two kinds of small customers, customers that are small but have the potential to become big, so they start small but really have big potential, and then some customers that will never be very big, for example Get, which will never become 1 million subscribers or 2 million subscribers. But even for those, we believe that we can come up with a solution that will provide a really good margin given that we have to put in a lower investment and where we’re using a lot of our solutions.

Daniel Meron, RBC Capital Markets

And for the long-term prospects, when do you think your efforts in the emerging markets, China, India, Romania that you just announced in Eastern Europe and elsewhere in Asia will start really impacting your numbers.

Abe Peled, Chairman and Chief Executive Officer

Well, I would say China is already impacting our numbers. This year as I said we expect 2-3 million additional subscribers in China, and in India obviously we’ll be big both with Hathaway and Tata deploying very aggressively. Hathaway is actually over 3 million subscribers. So, I would expect in the next ’08 and ‘09 period some more significant numbers will come from these markets.

Daniel Meron, RBC Capital Markets

Great, last one, do you have an updates, I know you commented briefly on the inventory side but do you have any sense on the dynamics of the changeover?

Abe Peled, Chairman and Chief Executive Officer

We don’t have any changeover at this moment planned in this fiscal year.

Daniel Meron, RBC Capital Markets

Okay, thank you Abe and Alex.

Abe Peled, Chairman and Chief Executive Officer

Okay, if there are no further questions I would like to thank everybody for participating in our conference call, and we look forward to talking to you next quarter. Thank you everyone.

Alex Gersh, Chief Financial Officer

Thank you.

Operator

That does conclude our conference for today. For those of you wishing to access the replay facility the number if 0044 1452 550 000; for the U.K. callers 0845 245 5205, and for U.S. toll free 1-866-247-4222. The replay number is 8521439 followed by the # key. Thank you for participating, you may all disconnect.

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Source: NDS Group F1Q07 (Qtr End 09/30/06) Earnings Call Transcript
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