DTS' CEO Discusses Q4 2013 Results - Earnings Call Transcript

| About: DTS, Inc. (DTSI)


Q4 2013 Earnings Conference Call

March 17, 2014 4:30 pm ET


Geri Weinfeld - Director, IR

Jon Kirchner - Chairman and CEO

Mel Flanigan - EVP, Finance and CFO


Andy Hargreaves - Pacific Crest Securities

Rob Stone - Cowen & Company

Steve Frankel - Dougherty & Company


Good day, ladies and gentlemen. Thank you for standing by. Welcome to the DTS Fourth Quarter and Fiscal Year 2013 Earnings Conference Call. During today's presentation, all parties would be in a listen-only mode. Following the presentation, the call will be open for questions. (Operator Instructions) This call is being recorded today, Monday, March 17, 2014. I would now like to turn the call over to Geri Weinfeld of DTS Investor Relations. Please go ahead.

Geri Weinfeld

Good afternoon, everyone. Thanks for joining us as we report fourth quarter and fiscal year 2013 financial results. With me on the call today are Jon Kirchner, Chairman and CEO; Mel Flanigan, CFO; and Brian Towne, President, Asia-Pacific. Before we begin, I would like to provide two reminders.

First, today's discussion contains forward-looking statements that are predictions, projections or other statements about future events which are based on management's current expectations and beliefs, and therefore subject to risks, uncertainties and changes in circumstances. Please refer to the Risk Factors section in our SEC filings, including our most recent Forms 10-K and 10-Q for more information on the risks and uncertainties that could cause our actual results to differ materially from what we discuss today. Please note that the Company does not intend to update or alter these forward-looking statements to reflect events or circumstances arising after this call.

Second, we refer to certain non-GAAP financial measures which generally exclude charges for stock-based compensation, amortization of intangibles and certain acquisition and integration-related expenses and the related tax effects, if any, and impute an expected 30% effective tax rate on the pre-tax earnings of the Company. We have provided reconciliations of these non-GAAP measures to the most directly comparable GAAP measures in the earnings release and on the Investor Relations section of our Web-site. The recording of this conference call will be available on our Investor Relations Web-site at www.dts.com, and unauthorized recording of this webcast is not permitted.

Now, I will turn the call over to Jon.

Jon Kirchner

Thanks, Geri, and a warm welcome to our team as our new Director of Investor Relations. Geri's strong IR background and experience will be an asset to our team as we work to build our business and strengthen communication and relationships with the investment community.

Hopefully, you've all had an opportunity to take a look at our fourth quarter and full year 2013 financial results issued this afternoon. I'll come back and talk after Mel goes through the results, as I normally do, but first I want to take a minute right up front to give you our perspective on the fourth quarter and the year.

In short, we are pleased to have delivered strong GAAP and non-GAAP net income results for the year but we are not entirely satisfied with our top line performance during the quarter or year overall. Top line growth in 2013 was 24%, a solid number but below our expectations. Q4 revenue was primarily impacted by two factors.

First, the manufacture of certain customer products did not match our timing expectations, especially in the mobile and game console categories. Second, our legacy Home AV market, home theater-in-a-box and DVD in particular, declined more than we had anticipated. It is worth noting that as we move into 2014, our exposure to these legacy markets is negligible as we forecast these DVD-based products to represent less than 2% of our business.

Most importantly, we are excited about the significant progress we made in 2013 in continuing to transition the business to address the connected on-the-go consumer lifestyle. 2013 was a productive year in terms of extending our long-term strategy and our shift into the commercialization phase for key new products, with revenues from these products beginning later this year and accelerating in 2015.

Looking ahead into 2014, we're focused on four key drivers to lead the cycle of continued growth, Headphone X, Play-Fi, streaming and UHD. I'll discuss these in more detail later in the call. Now I'll turn the call over to Mel to discuss the financial results.

Mel Flanigan

Thanks, Jon, and good afternoon everyone. We continue to be pleased with the performance or our network-connected business which grew 24% in the fourth quarter on a year-over-year basis. Consistent with our expectation, network-connected was the largest contributor to total revenue for the quarter. On a full year basis, network-connected was up 94% over 2012 and represented more than 45% of total revenue, compared to less than 30% a year ago. Within the network-connected segment, connected TVs was the primary driver as we continue to make progress in this space. TVs were up 41% year-over-year in the quarter and 116% for the year.

We estimate the DTS decoders are now in nearly 60% of connected TVs. When we include the additional TVs with only DTS audio processing, we estimate a 47% share of the total TV market. We now have some form of DTS audio processing technology supported by all of the top 15 TV manufacturers and DTS codec support from all of the top 12 connected TV manufacturers globally.

The mobile segment was particularly challenged by the timing of DTS technology availability on certain IC platforms being later than expected. As a result, mobile was flat for the quarter, but overall our mobile performance was strong, up 82% on a year. With the significant investment phase now behind us, we're entering the investment return cycle around Headphone:X and Play-Fi, as market penetration and unit volumes begin to grow within the mobile market. Overall, we're bullish about our mobile strategy. In fact, we've already seen several key developments this year which Jon will discuss momentarily.

PC was also flat for the quarter despite declines in the overall PC industry. We expect our PC business to grow in 2014 due to recent design wins. For the year, PC was up 173%, primarily on the strength of our audio processing offerings in this space.

Blu-ray revenue was heavily impacted by timing of new game console production and continued softness in both stand-alone players and PC adoption. Blu-ray was down slightly in the fourth quarter and down 14% for the year, which was more than expected due to the delayed production of game consoles for the new cycle. We expect Blu-ray game consoles in particular to show modest growth throughout 2014.

Home AV was down approximately 18% and 15% for the fourth quarter and full year respectively and represented less than 15% of total revenue for both periods. In this market, we saw higher than expected decline in home theater-in-a-box systems as consumer trends continue to shift towards on-the-go entertainment devices.

In the automotive business, we saw relatively modest declines for both the quarter and the year, with auto contributing just over 10% of total revenue in each period. In 2014, we expect this segment to be essentially flat compared to 2013. Our automotive business has been a strong contributor to both revenues and profits over the years, and as we work to bring our newest technologies into the automotive space, we expect this business to resume growth in future years.

Total revenues in the fourth quarter were $37.1 million, up 25% year-over-year. Full-year revenues were $125.1 million, up 24%. As a reminder, in 2013, we implemented an ongoing comprehensive royalty audit program which is already positively impacting revenues by incrementally improving realization in any given year from manufacturing activity within that year. As expected, revenues from this program were strong in the fourth quarter at $5.6 million. For the year, revenue from royalty audits totaled $6.3 million.

On a non-GAAP basis, gross margin for the quarter and year fell slightly but remained high at 99%. Non-GAAP operating expenses for the quarter were $24.7 million, up from $22 million in last year's fourth quarter. On a GAAP basis, operating expenses totaled $28 million for the quarter, which included $3 million in stock-based compensation expense and $213,000 in amortization of intangibles.

Non-GAAP SG&A was $17.3 million, up 14% from $15.2 million in the fourth quarter of 2012. Growth in SG&A is primarily sales and marketing expenses targeted at driving future growth in the network-connected markets. Non-GAAP R&D was $7.4 million in Q4, up 9% from $6.8 million in the prior year's fourth quarter, as we continue to invest in commercializing our recent product launches and developing innovative next-generation technologies.

On a non-GAAP basis, operating income was $11.9 million, up 55% from $7.7 million in last year's fourth quarter. Non-GAAP operating margin in the fourth quarter of 2013 was 32%, up from 26% in the fourth quarter of 2012. GAAP operating profit for the fourth quarter of 2013 was $6.5 million compared to a GAAP operating loss of $2 million in the fourth quarter of 2012. On the bottom line, non-GAAP net income for the fourth quarter of 2013 was $8.3 million or $0.46 per diluted share, up 45% from $5.7 million or $0.31 per diluted share a year ago.

In the fourth quarter of 2013, GAAP net income was $7.3 million or $0.96 per diluted share, compared to GAAP net loss of $102,000 or $0.01 per diluted share in the fourth quarter of 2012. GAAP net income for the fourth quarter of 2013 includes $0.12 per diluted share, net of tax, in stock-based compensation expense, and $0.09 per diluted share, net of tax, in amortization of intangibles.

There's a lot to talk about with respect to income taxes this quarter. First, we were able to resolve certain long-running audits with both the IRS and the California Franchise Tax Board, and we're pleased to have achieved positive outcomes in all cases. We also implemented a complex restructuring of our IP portfolio and legal structure around the end of the year. This will lead to several significant benefits going forward, including lower global effective tax rate, improved profitability in the U.S., and significantly greater cash flow into the U.S.

In addition, based in part on the restructuring, we released the valuation allowance on certain deferred tax assets that had negatively impacted our tax rates during 2013. The net result of all this on our 2013 GAAP tax results was a tax rate of negative 121% for the year, driven by a $7.9 million credit related to the valuation allowance release.

Looking forward, there's one final piece of the puzzle that was completed in early 2014. We effected an IP transfer through a dividend of certain IP rights from a foreign subsidiary to the U.S. parent. The financial statement impact of this repatriation will be reflected in the Company's income tax provision for the quarter ending March 31, 2014 as a tax expense net of certain foreign tax credits. This was offset by the establishment of the deferred tax asset related to future tax deductions under Internal Revenue Code Section 197. The net result of these items is expected to be a reduction in the Company's 2014 tax expense of approximately $3 million.

With our international structure now optimized between Ireland and the U.S., we expect both our GAAP and non-GAAP effective rates to be 30% or lower in 2014, dependent upon the final magnitude of the net credit from the IP rights transfer. Looking ahead, we expect this optimized structure to enable further improvement and less volatility in our tax rate in future years.

Turning to the balance sheet, we generated $21.4 million in cash flow from operations during 2013, up 45% from $14.8 million in 2012. We closed the year with cash and investments totaling $71 million and $30 million of long-term debt. During the quarter, we repurchased 780,000 shares of DTS common stock for a total of $16.4 million, completing our previous 2 million share repurchase program.

To provide some perspective on our buyback program, since we initiated buybacks in 2007, we've repurchased a total of 6 million shares and returned more than $145 million to shareholders. In addition, we're pleased to announce that our Board authorized another 2 million share tranche at a recent meeting. This reflects our perspective on current market valuation metrics and our confidence in the Company's growth trajectory in the network-connected space.

Moving on to our outlook, the current market environment is quite dynamic as we work to launch groundbreaking new technologies. In addition, customer product timing delays relative to our forecast has impacted revenue growth ability. Accordingly, we've made a number of changes to our guidance model for 2014, which include employing significant caution and utilizing additional pipeline management tools.

Our 2014 guidance incorporates a cautious revenue outlook and focused expense management to deliver significant profit and earnings growth in 2014. This strategy is designed to yield greater earnings leverage as revenue growth accelerates over time, while still providing for appropriate levels of investment in key growth areas.

Now for the 2014 numbers; at this point we expect revenue in the range of $132 million to $138 million. Our primary growth drivers will continue to come from the network-connected markets, particularly from TVs, PCs and mobile devices. We expect network-connected markets to grow to more than 50% of revenue. We expect Blu-ray to be nearly 20% of revenue as we begin to meaningfully realize revenue from the new game console cycle. We expect the automotive market to be a little more than 10% of revenue and Home AV to be less than 15% of revenue.

We expect non-GAAP operating margin in the mid-20s and non-GAAP EPS in the range of $1.20 to $1.40 per diluted share. We expect stock-based compensation expense to be in the range of $0.41 to $0.47 per diluted share, net of tax, and amortization of intangibles to be in the range of $0.41 to $0.45. On a GAAP basis, we expect operating profit of approximately 7% to 10% and EPS in the range of $0.38 to $0.48 on an estimated 18 million weighted average shares outstanding.

Lastly, let me address the Form 12b-25 that we filed this afternoon. Few issues slowed the process of closing our books for 2013. First, in our business we can recognize either royalty recoveries or royalty audit findings at any time. If this information relates to current or prior period, we're required to include them in current period results. In this case, we received certain royalty information very late in our close process, the accounting for which impacted multiple aspects of the year-end close and independent audit process.

Second, our IP restructuring involves some complex accounting. Our goal was to get it right, even if it took a long time and the expertise of several major accounting firms to sort through. We expect to file our Form 10-K well within the 15 day period allowed as we work to complete all of the documentation and filing process steps necessary.

With that, I'll turn the call back over to Jon.

Jon Kirchner

Thanks Mel. 2013 was a year of strategic progress for DTS. After a lot of work, we are moving out of the show phase and into the shipment phase for some exciting new products, and the feedback continues to be very encouraging. As most of you know, one of the products we and our customers are most excited about is Headphone X. We previewed Headphone:X at CES early last year and it became available in mid-December 2013 on the leading mobile chip platform in the industry, the Qualcomm Snapdragon. Days after the software became available on the platform, we announced our first design win, the Vivo Xplay 3S, one of the world's most advanced smartphones.

For those of you less familiar with the China market, Vivo is a leading smartphone brand in the mid to high-end of the market. The Xplay 3S phone is expected to ship later this month, and as you may have seen this morning, we are pleased to announce that the Xplay 3S will come with the first OTT content service in China to bring high-quality DTS discrete audio to match the high-quality video on the phone. We expect to see other design wins and shipments as we move throughout the year and into 2015. Notably, China is the fastest growing smartphone market in the world and we are seeing significant interest in our technology there.

If you attended CES this year and came to our booth, you may have seen some of the production prototypes running Headphone:X demonstrations. As part of the Headphone:X platform, we are now showcasing two integrated and highly unique aspects of the product, headphone tuning and personalization. Tuning allows product manufacturers or content creators to tune their audio experience to match their desired intent, whether it would be the sound of a particular headphone connected to a device or within an application, for instance a game or a movie soundtrack. This uniquely allows content, device or headphone makers to ensure that a consumer's experience is exactly as intended.

The second aspect is personalization. Personalization gives consumers the power to control or personalize their audio experience. By creating a personal sound profile, users are able to uniquely store personal hearing characteristics and listening preferences that inform a device how to render the optimal listening experience for each individual user, enhancing value for product makers and consumers alike.

To further support the ecosystem around Headphone:X technology, you may have seen at CES that we signed agreements with several of the industry's Tier 1 headphone providers, including Skullcandy, Panasonic and Republic of Frends, which are participating in our Headphone:X Partner Tuning Program. A number of additional headphone manufacturers are expected to join this program throughout the year.

Under the program, headphone manufacturers work with us, tune and store their headphone attributes in our Headphone:X cloud service, which allows consumers to easily access and optimize their DTS Headphone:X experience across multiple devices regardless of the audio content source.

In addition, we recently completed some groundbreaking neuroscience research around the impact of Headphone:X audio on consumer enjoyment of content on mobile devices. The first of its kind, the study was conducted by Neuro-Insight and compared the impact of higher quality audio to changes in video resolution. Interestingly, the study showed an overall increase in enjoyment of 42% across all video resolutions when DTS Headphone:X audio was added.

The biggest spike was seen when adding Headphone:X to medium quality video where consumer enjoyment increased by 66%. In contrast, increases in the quality of video resolution with standard audio had little to no impact. These findings were shared with more than 1,000 attendees during the presentation at Mobile World Congress and are of significant interest to OTT content providers and device manufacturers.

Now let me turn to another significant product commercialization effort, Play-Fi. Play-Fi is the only wireless audio technology available today that is licensable, open, multi-zone and commercially proven. Play-Fi is attracting the interest of speaker, PC, AV and mobile manufacturers. We've had numerous design wins for Play-Fi this past year, including leading brands such as Polk and Definitive Technology. We are pleased to share that a number of these products are expected to come to market by Q3 of 2014.

To further accelerate our progress with Play-Fi, we also announced the expansion of our Play-Fi ecosystem to include eight of the leading audio ODMs in the industry. These prequalified, world-class manufacturers enable brands to quickly and cost-effectively create and ship products incorporating Play-Fi technology. To provide content to Play-Fi enabled speakers, we are also pleased to inform you that we've signed an agreement with a top five PC manufacturer to support Play-Fi drivers on upcoming platforms. This enables consumers to push any content on their device to Play-Fi enabled speakers.

We expect additional announcements like this later this year, including one from another top five PC manufacturer. Based on the content, speaker and mobile device support wins over the past few quarters, we believe Play-Fi is quickly gaining momentum as a leading open Wi-Fi multi-zone audio ecosystem.

Overall, our mission continues to focus on laying the groundwork for an ecosystem based on Play-Fi and Headphone:X that meets the consumer demand for a next-generation audio experience, on-the-go or in-the-home, playable seamlessly across different brands of phones, tablets, PCs, AV equipment speakers and headphones. We are making exciting progress on these initiatives, and as a result, increasingly consumers will be able to enjoy higher quality entertainment anywhere, anytime, in a simple intuitive way.

In a third example of progress, let me turn to the connected TV space. We ended the year with our penetration of connected TVs approaching 60% of the smart TV market. We also closed the year with contracts with all of the top 12 connected TV manufacturers, which we believe continues to build an attractive device footprint for content providers increasingly seeking to deliver higher quality experiences to their customers. We expect to further our penetration into this market over the course of 2014.

On the content front, we continue to make strides. Recently we announced several key strategic partnerships with various service providers, including IVA, a leading aggregator and distributor of movie trailers to mobile devices; AUPEO!, Panasonic's leading audio streaming platform for in-car experiences; and Songza, an integrated free streaming music service which is being integrated into our Play-Fi platform. Songza joins an ever-growing number of services integrated and supported by the Play-Fi ecosystem, ensuring consumers can enjoy a wide range of content on their compatible devices.

Lastly, we continue to make progress on another key program initiative, bringing to market a next-generation audio solution that supports object-based mixing, playback and interactivity. Our program has two parts; MDA or multi-dimensional audio, which is an open, interoperable, industry-supported mixing, storage and playback specification for digital cinema and professional markets; and DTS UHD, which is an audio codec solution that supports MDA and object-based file delivery and playback on a wide range of consumer electronics and broadcast devices. MDA and DTS UHD are generating excitement in the production, cinema and consumer electronics communities.

In early January, we demonstrated with a number of partners the power and flexibility of MDA in an AMC theater in Burbank. Our demonstration showed the film industry how object-based files mixed in MDA can playback across a range of speaker configurations. MDA-enabled theaters can embrace and benefit from the new format without having to commit to significant and expensive theater upgrades to provide their customers a next-generation audio experience. MDA also allows the film mixer to ensure the film will be played back properly, regardless of the speaker configuration in the cinema or via DTS UHD in a home theater. Response has been tremendous and we are quickly moving toward commercialization with a number of industry partners.

Also in January we demonstrated DTS UHD running on a Cirrus Logic VSP, which is a precursor to integration on AV receivers and sound bars in the next product cycle. The demand and interest among various CE manufacturers has been strong.

As you know, over the past few calls, we have consistently highlighted a key theme, progress. Our overall performance in Q4 continues this theme and demonstrates increase in strategic momentum. Importantly, we expect to begin capitalizing on this momentum in 2014, while also seeing significant gains and profitability. While there remains plenty to do, I feel good about how our Company is increasingly better positioned to drive attractive long-term growth in an ever more connected world.

On behalf of the Board and the rest of the management team, I'd like to take this opportunity to personally thank our entire team here at DTS for another year of great effort and strategic accomplishment. We would not be here today without their hard work and continued dedication to our Company and our mission to make the world sound better. We look forward to sharing more news with you over the course of the quarter and throughout 2014.

With that, I'll turn the call over to the operator for questions.

Question-and-Answer Session


(Operator Instructions) Our first question is from the line of Andy Hargreaves with Pacific Crest Securities. Please go ahead.

Andy Hargreaves - Pacific Crest Securities

Just a quick clarification. What was the catch-up commentary, does that mean there was $5.6 million recognized in the quarter or $6.3 million?

Mel Flanigan

Yes, it was $5.6 million for the quarter and $6.3 million for the entire year.

Andy Hargreaves - Pacific Crest Securities

Okay. And can you give us any indication of how many console units were recognized in the quarter? And then just following up on that, Blu-ray has declined now for a couple of years. I know the focus is on Home AV, but it's been like you're expecting Blu-ray to rebound. Is that totally related to the consoles or is there something else that's driving that expectation?

Mel Flanigan

So on the quarter side, I don't have the exact number of consoles recognized in the quarter, but we did see some of the PS4 very limited quantities in Q4. Production started later than we had anticipated and we didn't see any of the Xbox One in Q4. So as we look into 2014, we'd expect – you've seen all the reports about how well the consoles are selling and it seems like they are sort of now starting to jockey back and forth in the lead, but we do expect to see the full benefit of the new game console cycle impacting Blu-ray in 2014. That said, we don't expect to see huge changes on the stand-alone player side, and PC continues to be fairly soft with respect to Blu-ray adoption.

Jon Kirchner

Andy, just one other note. If you look at the software side of Blu-ray, there continues to be a solid growth in software sales related to Blu-ray. So I think in our view over the long-term, as Mel said, it's not that you're going to see a whole lot of growth here but it certainly is likely to be flattish to slightly up as we see some of these dynamics change in the near term.


Thank you. Our next question is from the line of Rob Stone with Cowen & Company. Please go ahead.

Rob Stone - Cowen & Company

Given the updated 2014 revenue outlook, can you comment a little bit on how we should think about seasonality in the normal quarterly pattern? I guess you probably will see a meaningful bump from the start of the console cycle in the March quarter. Is Q2 as usual going to be the low quarter for the year?

Mel Flanigan

Rob, we do expect to see a little bit of new console revenue, especially in Q1. Q2 should be slightly down from Q1, but I think overall we'd still expect 2014 to be a little bit more heavily backend weighted kind of like we saw this year.

Rob Stone - Cowen & Company

Okay. And with respect to managing expenses for more profitability, is that something where there's a significant step-function in a quarter, or how should we think about driving down the expense ratio during the year?

Mel Flanigan

So Q1 tends to be a bit high from an expense standpoint anyway because we've got a couple of large tradeshows, CES of course is the largest we attend, all year long, and then Mobile World Congress is another big one for us. So you'd expect to see it trending down a bit in Q2 anyway. I think if you look at the goal for 2014, it's basically to keep, hold expenses relatively flat, so think $23 million to $25 million a quarter on a non-GAAP basis as sort of where we end up.


(Operator Instructions) Our next question is from the line of Steven Frankel with Dougherty & Company. Please go ahead.

Steve Frankel - Dougherty & Company

Mel, I missed the breakout in terms of network-connected PC and Blu-ray as percentage of revenue. Could we start with that?

Mel Flanigan

Sure. So for the 2014?

Steve Frankel - Dougherty & Company

For the quarter.

Mel Flanigan

Okay, so network-connected I think we ended up at about – for the quarter, network-connected was a little under 45% of total revenues, Blu-ray was around, it was a little under 25%, Home AV was under 15% for the quarter.

Steve Frankel - Dougherty & Company

And PC?

Mel Flanigan

PC is sort of included. There's two elements of PC. We don't generally break it out separately. One of them is part of our network-connected space. So as we think about things like putting PC into – or putting technologies like Play-Fi into PC, that will be part of the network-connected category going forward. We also have Blu-ray PC, which of course has continued to be on the soft side.

Steve Frankel - Dougherty & Company

Okay. And then you made some comments in the release about mobile platforms being delivered later than you thought, but I just heard you say that the Snapdragon stuff is available now. So, is there another platform we're waiting for or it's just that these products are going to ramp in the back half versus the prior forecast that you might get some of this in H1?

Jon Kirchner

Steve, I think we expect to see some products shipped in the first half, but one of the challenges as you think about the mobile space is, you've got a lot of product models turning over fairly fast, and so you've got to intersect the availability of your solution with the various planning cycles. So because of some of the later than expected availability of the code, there's some stuff that basically got pushed out of 2013 and we basically had to pick up new product cycles in 2014 around it, but we do continue to expect growth, particularly as we get in the back half of the year around some of these solutions in mobile.


(Operator Instructions) And this does conclude the Q&A session. Thank you for your participation in the call today. As a reminder, a replay of this call will be available on the Investor Relations section of the Company's corporate Web-site at www.dts.com. Thank you for your participation. You may now disconnect.

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