Good evening and thank you for standing by for China Digital TV's first quarter 2010 earnings conference call. At this time, all participants are in listen-only mode. After management's prepared remarks, there will be a question-and-answer session. Today's conference is being recorded. If you have any objections you may disconnect at this time. I would now like to turn the meeting over to your host for today's conference, Mr. Eric Yuan, China Digital TV's Senior Manager of Investor Relations.
Hello everyone and welcome to China Digital TV's first quarter 2010 earnings conference call. The company's earnings results were released earlier today, and are available on the company's IR website at ir.chinadtv.cn, as well as on newswire services.
Today, you will hear from our chief executive officer, Mr. Jianhua Zhu, who will give an overview of the quarter, followed by our president Mr. Dong Li who will talk about company strategy and business updates, and finally from Mr. Mason Xu, our chief financial officer, who will discuss financial results and business outlook. After their prepared remarks, they will be available to answer your questions.
Before we continue, please note that the discussion today will contain certain forward-looking statements made under the "safe harbor" provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risks and uncertainties. As such, our results may be materially different from the views expressed today.
Further information regarding these and other risks and uncertainties is included in our registration statement on Form 20-F and other documents filed with the U.S. Securities and Exchange Commission. China Digital TV does not assume any obligation to update any forward-looking statements except as required under applicable law.
As a reminder, this conference is being recorded. In addition, a webcast of this conference call will be available on China Digital TV's investor relations website. I will now turn the call over to China Digital TV's CEO, Mr. Zhu.
Thank you, Eric. Hello everyone.
We are pleased to deliver results above our expectations for the first quarter. Net revenues were US$14 million, exceeding our high-end guidance of US$12.5 million led by a recovery in smart card shipments.
We believe three factors contributed to the pick-up in smart card shipments for the first quarter. First, signals from the government to advance the development of China's digital TV industry are very clear. Related policies on three-network convergence and cable network consolidation timeline serve as additional confidence builders for industry players. Second, some cable operators increased their investments in mass migration and two-way network upgrade projects in light of movements toward three-network convergence, and the anticipation of more direct competition from telecom operators. Also, I would like to extend special recognition to our sales and customer support teams. It is through their relentless efforts that we achieved 54% market share and were able to win 7 out of 10 new contracts granted during the quarter, helping to solidify our No. 1 market leader position.
We believe the momentum in smart card shipment growth should continue into the second quarter. But at the same time, we remain cautious as we anticipate that some cable operators may alter smart card purchase plans during the course of provincial network consolidation.
Despite these uncertainties, we believe that our industry is moving toward a higher level of commercialization and that today China Digital TV has more-focused strategies to build upon our market leadership. For the rest of 2010, we will continue to enhance our core CA offering, explore opportunities to expand our CA business to overseas markets, and invest in value-added services. These initiatives are critical in establishing our long-term competitive advantages in the digital TV value chain.
I will now hand the call to our president, Dong Li, who will discuss industry and operational developments in detail.
Thank you, Mr. Zhu. Hello everyone.
We were excited to see smart card shipments exceed our expectations. In addition to the three factors contributing to a strong quarter that Mr. Zhu went over just now, we also saw ASP stabilize at just 2% below Q4-09 levels in the first quarter. Competition from domestic CA providers may continue to put pressure on smart card prices in 2010, but we feel the level of decrease should be contained within 10% below 2009 levels.
Lately, we have received many inquiries from investors about three-network convergence, so I would like to spend some time talking about what this policy means for China Digital TV. We believe three-network convergence will bring more opportunities for us as cable and telecom operators demand higher quality products and solutions to support the development of their converged services. To prepare, we are enhancing our efforts in R&D for our core CA business and speeding up the commercialization of our technologies. For example, our newly created digital rights management department is preparing to offer content protection solutions for two-way cable and IPTV networks.
At the same time, we will continue our expansion into set-top box related terminal-end technologies, an area in which we have been making progress with a number of projects. These include an "all-in-one" single-chip solution which combines encoding, encryption and other key modules in one chip to effectively reduce set-top box production costs. We have signed on one operator for this solution and expect to attract more cable operators who value the cost saving as well as TV manufacturers as they develop TV sets with built-in STB features. We have also signed several contracts for a software solution for set-top boxes which will allow cable operators to offer applications such as video-on-demand, time shifting and TV gaming under a unified interface. It will also allow operators to uniformly expand and upgrade services on their networks regardless of STB models or compatibility. We will continue our active marketing efforts to promote this exciting solution.
In parallel, we are continuing our R&D efforts in value-added services and exploring relevant business models including HD content delivery, video-on-demand, TV gaming, as well as other applications, some of which are based on cloud computing.
We are also making headways in expanding our CA business to international markets. We hope to secure a number of contracts during 2010 and will keep you posted on major developments.
Lastly, I would like to give an update on our investment in OpenV. OpenV is a leading provider of copyrighted online video content in China. The purpose of this investment is in line with our long-term strategy to create and market products that allow consumers to conveniently access high quality content anywhere, anytime. We are pleased to report that OpenV is on track to achieve its financial targets for the year.
To conclude, we are staying focused on our strategies, which are to grow our CA business both domestically and internationally while exploring ways to provide value-added services to Chinese TV viewers. We have some near-term challenges to tackle but we are making progress through focused and relentless execution. We look forward to a strong second quarter but our focus is on the long-term.
I will now hand the call over to Mason Xu, our CFO to discuss our business initiatives from the financial management perspective.
Thank you, Mr. Li, and hello everyone.
To reiterate Mr. Zhu's and Mr. Li's points, we are excited about the near-term pick-up in smart card shipments but are fully prepared for the uncertainties associated with cable network consolidation at the provincial level. Our healthy gross and operating margins despite declining ASP and continued investments, speak to our ability to manage for profitable growth. For the rest of the year, you will see us continue to invest in research & development for value-added services and explore innovative business models while prudently managing costs.
In addition, we will strengthen our efforts in improving workforce quality and productivity in 2010 by implementing a more rigorous performance evaluation system this year. We will firmly execute on our policy to remove the bottom performers and reward the top performers. We believe this approach will result in a stronger workforce over time.
Now, let me take you quickly through financial highlights for the first quarter of 2010.
In Q1 this year, we shipped 2.56 million smart cards, compared to 2.38 million in Q109 and 2.36 million in Q409.
According to market data, in Q1 2010, we won 7 out of 10 new contracts to install CA systems in China.
Net revenues in Q1-10 were US$14.0 million, representing a 2.1% annual decrease and a 2.5% sequential increase.
Revenues from smart cards and related products were US$13.2 million in Q1-10, a decrease of 2.7% from Q109 and an increase of 6.0% from Q409. Sales of smart cards and related products accounted for 93.5% of total revenues for the quarter, slightly up from 90.0% in Q409, primarily due to the pick-up in smart card shipments.
In Q1-10, revenues from the Company's top five customers accounted for 27.1% of total revenues, compared to 22.7% in Q409.
Revenues from services were US$900,000 in Q1-10, an increase of 6.4% from Q109 and a decrease of 33.6% from Q409. The year-over-year increase was mainly a result of higher licensing income. The quarter-over-quarter decrease was primarily due to decreases in system integration and development revenues, royalty incomes and other services revenues. In particular, the decrease in other services revenues was due to the discontinuation of digital TV based advertising services, which had accounted for the majority of other services revenues in the fourth quarter of 2009.
Gross profit in Q1-10 was US$10.9 million, a decrease of 2.0% compared to Q109 and an increase of 3.7% from Q409. Gross margin was 77.5% in Q1-10, compared to 77.4% in Q109 and 76.5% in Q409. Gross margin remained stable y-o-y despite decreases in ASP, mainly due to effective cost control. The q-o-q improvement in gross margin was primarily due to the higher margin CA business contributing 93.5% of total revenues, compared to 90.0% in Q409.
In Q1-10, ASP for smart cards decreased by 2.3% compared to Q409, while the unit cost of smart cards decreased by 0.6% compared to Q409. For the rest of 2010, we expect to see ASP declines contained within 10%.
Operating expenses in Q1-10 were US$5.6 million, an increase of 16.6% from Q109 and a decrease of 4.5% from Q409.
Research and development expenses in Q1-10 were US$2.1 million, representing an 8.5% annual increase and a 16.8% sequential decrease. The y-o-y increase was mainly due to increases in both headcount and average salary. The q-o-q decrease was mainly due to a one-time US$0.3 million impairment loss of certain intangible assets in Q409.
Sales and marketing expenses in Q1-10 were US$1.9 million, representing a 22.0% annual increase and a 13.0% sequential decrease. The y-or-y increase was mainly due to increased traveling expenses and marketing activities while the q-o-q decrease was primarily due to reduced consulting fees relating to marketing and decreased traveling expenses.
General and administrative expenses in Q1-10 were US$1.7 million, an increase of 21.7% annually and an increase of 34.1% compared to Q409. The y-o-y and q-o-q increases were both mainly due to increased share-based compensation expenses relating to additional options granted to employees in Q1-10.
Operating income was US$5.2 million in Q1-10, a 16.3% annual decrease and a 14.3% sequential increase. Operating margin was 37.4%, compared to 43.8% in 09Q1 and 33.6% in Q409.
Income tax expenses in Q1-10 were $US900,000 compared to $US500,00 million in Q109 and zero in Q409. In 2010, the Company is subject to a 15% tax rate, compared to a 7.5% preferential tax rate in 2009.
Net income in Q1-10 was US$5.7 million, translating to diluted earnings per ADS of 10 cents US, and representing a 24.1% annual decrease and a 3.9% sequential decrease.
Moving on to discuss our balance sheet...
As of March 31, 2010, China Digital TV had cash and cash equivalents, restricted cash and deposits with maturity over three months totaling US$235.6 million. Operating cash flow in Q1-10 was approximately US$5.9 million.
Now, let me provide our business outlook.
Based on information available as of May 11, 2010, China Digital TV expects smart card shipments for the second quarter of 2010 to be in the range of 2.67 million to 2.87 million. Net revenues for the second quarter of 2010 are expected to be in the range of US$14.0 million to US$14.9 million, compared to US$14.6 million in the second quarter of 2009.
Thanks for listening and we will now take your questions.
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