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NDS Group (NNDS)

F2Q07 Earnings Call

January 30, 2007 09:00 am ET

Executives:

Abe Peled, Chairman and Chief Executive Officer

Alex Gersh, Chief Financial Officer

Analysts:

Alan Gould - Natexis Bleichroeder

Ari Bensinger - Standard & Poors

Alan Bezoza - Oppenheimer

Roni Biron, Oscar Gruss

Murray Arenson - Ferris, Baker Watts

Daniel Meron - RBC Capital Markets

Michael Walter - Goldman Sachs

Raja Janakiraman - Morgan Stanley

Jason Mauricio - Arete Research

Gordon Tomasin [ph] - Aco Capital[ph]

Marty Hyman[ph] - Kooga Trading[ph]

Todd Chanko - Jupiter Research

Barry Flynn - Informa

Presentation

Operator

Thank you for standing by and welcome to the NDS Q2 results conference call. Operator instructions.

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 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, sir.

Abe Peled, Chairman and Chief Executive Officer

Welcome to our Q2 FY07 conference call. I’m pleased to say we’ve had another successful quarter. At the consumer electronics show we really showed a wide range of new products that position NDS for the changing distribution of media scenario that we see gradually evolving as we move into the future, with broadband becoming more ubiquitous. Not only did we show obviously our hybrid capabilities with the regular hybrid box, xSpace, the ability to connect on the home network to the PCs or extend, and our X-Share[?} technology allowing the ability of DVR that our broadband connected to participate in peer to peer exchanges of programs, but we also introduced the VG DRM Key which we had first shown at IBC.

Again it was a very good result and variations of that as well as various solutions for mobile. Together with the acquisition of Jungo, which does middleware for residential gateway, I think this puts NDS really in a very strong position to capitalize on the emerging convergence between broadcast and broadband delivery of rich media – video, movies and other rich media that are rapidly appearing all over websites all over the world.

You know, we think that that is really quite important. Having said that, I hasten to say that the rollout of all of these things will be gradual, as indeed broadband becomes more ubiquitous and more present in the various markets in which we operate, and the set top boxes with these capabilities enabled rollout and adequate critical mass to justify the deployment of applications on top of them.

Meantime, our current business continues to perform well with the key trends that we have identified before driving a lot of the growth of the business. In developing markets, the introduction of new technologies as well as additional set top boxes in the household have driven some of the growth. DVR deployments continue to gain momentum with 5.3 million cumulative DVRs and the launch of the SkyLive[?] DVR in Korea.

The second factor, of course is developing markets where the technology is now sufficiently inexpensive to justify digital deployment in low ARPU markets. Probably the fastest ramp up has been in India where Tata-Sky got off to a fantastic start. It has over 400,000 subscribers as of the opening of our office in Mumbai, which was in mid-December.

In addition, some of the other developing markets – whether it’s Eastern Europe, China – a strong part of our growth in conditional access smart card shipments has been in that area. As Alex will mention, some of the royalties on Tata-Sky will be initially lagging behind due to the fact that we still have to accurately estimate and get reports on the number of boxes actually deployed.

Also in the area of new wins, we are particularly excited by the win with Dogan Media. Dogan Media is about to launch a service. It has been already made available to a limited group of people. It contains the whole range of NVS technologies and I think the model in which NVS technology is built in. The principle offering is initially free to air, but with an increasingly rich offering of pay in a variety of modes which is a new area for us. We’re very fortunate to have Dogan Media, Turkey’s leading media group, as a partner in this with a lot of programming capability, and marketing know-how. In addition, obviously, Turkey is a fairly large market with 17 million households, which is under-penetrated in pay TV and with a rising economic standard of living.

The additional contracts that we are currently in discussions with people are again leading us to be confident on our overall view that the market in these developing markets is expected to continue and the increase in NVS will do well in penetration of those markets.

In summary, I think the quarter was quite a good quarter, with very solid financial results, and in addition it has unveiled some of our strategy of positioning ourselves for future growth. So I would like to turn it over now to Alex, who will take you through the numbers and some of the color behind them. Alex?

Alex Gersh, Chief Financial Officer

Thank you, Abe. Good morning and good afternoon everybody. Again, starting from the top as Abe had said, it has been a good quarter. The total revenue for the quarter is $165 million, 8% higher than Q2 of last year. The main drivers for growth, again as Abe said are conditional access, which continues to perform well as well as DVR. Both deployment and integration, operating income is $37.4 million, an increase of 9% over Q2 of last year. Operating income margin of 22.5% in the quarter of 2006. Net income for the quarter was $30.3 million, a 17% increase over Q2 of last year and the diluted EPS were $0.52 versus $0.45 in Q2 2006.

Some details and some flavor in terms of the revenue and the revenue components: conditional access has increased by 12% to $98.2 million. Both the number of cards we shipped has increased, again comparing to Q2 of last year: 6.3 million cards were shipped this quarter versus 6.1 million in Q2 of last year. A higher security fee – there was an increase in authorized cards – also contributed to growth. 84% of our subscribers for active cards pay us this monthly fee.

Integration development and support revenue increased by 7% to $12.7 million. This was due to a delivery of many additional enhancements to a number of major customers of ours. License fees and royalties have decreased by 13% to $23.5 million. Again you will all remember that we have legacy downloads in Q1 and Q2 of last year onto the DirecTV boxes already in the field. Obviously that is not the case in this year. The total volume of the media middleware-enabled boxes in the quarter has increased to 7.4 million versus 5.5 million in Q2 of last year, total number of boxes shipped with our middleware.

As Abe said, we have commenced recognizing middleware on the Tata-Sky platform in India and this is the first quarter in which we’ve recognized the revenue. Obviously there is a slight lag until we get to the point where we are comfortable in terms of the accruals that can be made looking forward. As of December, we estimated the cumulative number of set top boxes with our middleware at 50.2 million that have been shipped.

In terms of new technologies, there has been an increase of 25% to $28.9 million. This increase is primarily due to higher revenue from our DVR technology, both integration as well as the shipments of DVRs. We have shipped 1.1 million DVR enabled set top boxes in the quarter versus 300,000 in Q2 2006. As of December, we estimate a cumulative total of 5.3 million DVR enabled set top boxes have been shipped.

As always on revenue, I like to remind people about the foreign exchange. 49% of our revenues roughly is pound and euro denominated, and due to the relative weakness of the US dollar, for the six month period in 2007, the positive impact on our revenue is roughly 3% of the total revenue.

Total revenue from related parties, which is something everybody always asks us about, is 74% in the quarter, versus 78% in Q2 2006. Cost of sales effectively remains substantially unchanged and gross margin increased from 59% to 63%, primarily due to the mix of revenue, which again is consistent with what we’ve been saying in terms of how we will continue to improve our operating margin performance.

Operating expenses increased by 19% to $66.5 million. R&D increased by 19% really due to higher employees and infrastructure costs. In terms of the sales and marketing, we had a significant sales and marketing increase of about 38% to $9.3 million, really as a result of increased activity at trade shows, travel as well as the increased headcount, primarily in the Asia region.

G&A increased by roughly 8% to $11.4 million as a result of higher facilities costs, higher stock option expenses, legal and business development activity. The company’s headcount from December of last year to December of this year increased by roughly 480 employees and just to let you know that out of our total costs, the staff costs represent about 58% of our total costs for the quarter. In terms of the foreign exchange, as I’ve talked about it, it affects us at the top line and it affects us on the cost line as well.

Approximately 71% of our expenses are euro, pound and shekel denominated and the weaker US dollar has increased the expenses overall by roughly 4% in total. Some of the expense increases I talked about before are attributable to the weaker US dollar. Income tax expense – the effective rate is roughly 31%.

A couple of things of note in this quarter on the balance sheet, first is although we have not completed the final valuation of certain assets and liabilities in relation to the Jungo acquisition, we have made a preliminary allocation on the balance sheet of the purchase price and purchase consideration, and our preliminary estimate is the $30 million of the purchase price has been allocated to the definite intangible assets, primarily intellectual property rights of course, and approximately $50 million has been allocated to goodwill. We are in the process of completing the allocation and obviously certainly by the end of next quarter, we’ll have the allocations finalized.

We have also, if you look at the balance sheet, increased the current portion of deferred income and decreased the non-current portion of deferred income in anticipation of a possible changeover that could occur over the next 12 months – or could begin over the next 12 months.

Cash flow: in terms of cash flow, just a few words. As of December, cash and short term investments were at $483 million. Cash from operating activities increased, reflecting higher customer receipts, higher interest receipts and offset by higher payments for smart cards and higher operating costs. Cash from investing activities: during the quarter as I said we’ve acquired Jungo for a consideration of $90.9 million, $77.5 million net of cash acquired.

As of September we acquired Interactive Television Entertainment, which we talked about before, and we have made in the quarter an additional payment for NT Media, related to the NT Media acquisition.

The overall capital expenditures for the six months actually decreased due to a slower spend on facilities in the US and in the US in the six month period. For the six months ending December 31, 2006, we issued roughly 320,000 shares to the employees upon the exercise of stock options. As of December 31, NDS has 3.3 million shares of stock options outstanding with 2.1 million vested.

A few words on guidance: with our acquisition of Jungo, we have reassessed our guidance and we are upgrading our top revenue guidance from the previous range of $660 million to $680 million to the new range of $670 million to $690 million. Operating income - we are upgrading the lower range from $150 million to $155 million but keeping the higher range the same at $160 million. The uncertainties like the PVR deployment and the foreign exchange components continue to be the reason why we’re increasing the bottom range, while keeping our top range the same.

In terms of the overall for the year, we expect capital expenditure to be at about a $25 million total level for the year. Those are the major highlights. Abe, back to you?

Abe Peled

Operator, we’re ready to take questions now.

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Questions-and-Answer Session

Operator

Operator instructions. Our first question comes from Alan Gould, Natexis Bleichroeder.

Q - Alan Gould, Natexis Bleichroeder

In the press release, you commented about the number of new customers won particularly in Europe. Are those all reflected in the current reporting and the current income statement, or are there some that you have had some wins for besides Dogan that we haven’t seen flow through? Secondly, in terms of – you say smart card costs continue to decline. They’re about $3.06 versus $3.78 a year ago and $4.02 two years ago. Will that continue to decrease prior to the card changeover?

A – Abe Peled

First of all, in terms of new wins, we have a number of people that we are in various stages of negotiation with. We don’t announce the win until we have a signed contract in place, so there are a number of operators in Europe with whom we are at an advanced stage, but we don’t have contracts yet. In terms of smart card costs, we continue to obviously advance the technology by moving to lower dimensions which reduces the area, and we’ve been aggressive in even present generation cards, moving them to a lower cost by rescaling them. I think also some effect is a result of the mix – perhaps simpler cards with sophisticated cards. I don’t think you can expect the same rate of decline going forward because obviously you know, I think we’ve gotten a lot out of it. We are looking at moving directly to fabs rather than – so doing more of the design and IT in house, which may yield further reductions, but that’s really a longer-term plan.

Operator

Your next question comes from Ari Bensinger, Standard & Poors.

Q - Ari Bensinger, Standard & Poors

You mentioned about some type of delay for Tata-Sky revenue recognition – I guess middleware related. I was just wondering what type of lag, if you could just give a little but more color on that?

A – Alex Gersh

What we recognized in this quarter is effectively the Q1 downloads. The reason why it works that way is because we don’t get the reports from the platform until the following quarter. Traditionally what we’ve done is as we get more and more history of the customer, we can then accrue what we believe to be the estimates, even without necessarily having the report. Obviously Tata-Sky being a new customer, we have not done that because we do not have the history to know exactly what the rollout would be and how to accrue. Right now, the revenue that we recognized is for Q1 middleware downloads and Q2 will be recognized next quarter.

A – Abe Peled

And Q1 was just the end of September so that was the early part of the rollout.

Q - Ari Bensinger, Standard & Poors

Got it. If I try to take the middle point of your guidance in terms of operating income and revenues, it comes out I think about a 23% operating margin. You know, that’s where you’re at now this quarter. I’m just wondering, is there any type of leverage that you expect to get on the operating expense line if we assume that this gross margin type of level is sustainable and maybe you know, get some leverage out of the operating expense line if your revenues continue to grow?

A – Abe Peled

We have guided to approximately 26% operating profit this year, with the objective of reaching 25% in a couple of years and I think this puts us well on track for that. At this point, you know, many of the expenses that we incur are ahead of revenues that will come and to be frank we actually have a lot of demand for people and we continue to ramp up people to be able to deal with the projects that are in our pipeline – you know, in preparation for our FY 2008 and FY 2009. I don’t think that we can give you any indication that we will be reducing operating expenses.

Q - Ari Bensinger, Standard & Poors

Last question – in terms of DVR, I know there’s a lot of uncertainties. Is there any run rate that you could point us to for the year?

A – Abe Peled

Well we have said that we expect to see something like 4 million DVR, that’s what we have assumed in our business but again, you know, given that it’s now on 14 different platforms, it’s highly dependent on local promotions that operators do, therefore it’s a really hard number to pin down.

Operator

Your next question comes from Alan Bezoza, Oppenheimer.

Q - Alan Bezoza, Oppenheimer

First, on the Korea Telecom win that you put out a couple of weeks ago, I just wanted to go over how you see the opportunities following through for telco opportunities now – you know, with continued problems with Microsoft. First, are the new opportunities that you’re pursuing – what does the competitive landscape look like? Is it Scientific Atlanta and Microsoft, so they’re clearly – do you have opportunities to maybe switch out some of the Microsoft wins that had already happened? I have one follow up after that.

A – Abe Peled

I don’t think at this point that we see anything concrete on these Microsoft platforms. While they’re struggling, they’re so deep into it that we – they’re just very busy trying to make it work with Microsoft continuing to reassure them that it will all be fine. I cannot tell you that we are or have an imminent change that we can foresee. I think in terms of new platforms, a number of people we’re talking to in the United States, I still think with the launch of SES Americom, that we’ll be offering kind of a turnkey package through a lot of telcos. There may be some opportunity even with some of the large telcos for particular regions to take that package, if indeed they can show that it works and works well. So that will be rolling out before the summer, and that’s probably a good opportunity to show off our technology in North America, coupled with not only the video card at CA but also metro middleware, so that’s the status.

Q - Alan Bezoza, Oppenheimer

A question on the opex, now that you’ve taken in Jungo. Can you kind of give us some hint as to how the opex shapes up including the Jungo acquisition? Lastly, Alex, you mentioned the changeover in the next 12 months. Can you just give us a sense of the magnitude and timing? Qualitatively or quantitatively, any way you can do it.

A – Abe Peled

In terms of Jungo, you know I think the main point with Jungo is that we still have to get a feel for how they are – you know, they are obviously making money, but in terms of how much money they’ll be making versus our IPR amortization. At the moment we’ve assumed it’s neutral given that we don’t have yet a good enough feel for it. In terms of opex, they are continuing to ramp up and on people currently they are about 140 – we expect them to get to 170 by June. The changeover – I think we’re really limited on commenting on it because of the confidentiality agreements with customers, but maybe, Alex – I don’t know if you can say how much we moved from one category to the other?

A – Alex Gersh

In the quarter we moved roughly $17 million from long term to current. That gives you the idea of the magnitude of the possible expected changeover over the next 12 months.

Q - Alan Bezoza, Oppenheimer

That’s helpful. Then just on the Jungo side, how much the opex is, just to follow up on that. When you look at their business model, how much – can you give us a sense of their operating margin, just so we can model NDS going forward adding the initial opex?

A – Alex Gersh

Right now, obviously this year there are acquisition costs, there are – as Abe mentioned – very similar to this. We’re in the process of performing this final evaluation of the IPR, which will affect them. We’re in the process of doing all this now and once we have definitive answers, we’ll come back with some of these questions.

A – Abe Peled

The only thing I can add there is that in principle, their business model is very much volume related because it’s much more of a standard product than middleware and NDS, which has to be customized for almost every different customer. The residential gateway middleware is much more standard and as the volume of shipments increases, there is substantial leverage in that. It’s very much like a software product, if it gets volume then the margins are very, very good.

Operator

Your next question comes from Roni Biron, Oscar Gruss.

Q - Roni Biron, Oscar Gruss

In regard to the changeover, do you assume any contribution in your 2007 guidance?

A – Alex Gersh

No, we do not. Until we understand the pace of the changeover and how it will happen, we have assumed nothing in the guidance.

Q - Roni Biron, Oscar Gruss

My second question is regarding your gross margin, which went up by 90bps to 63% this quarter. Is it all related to a revenue mix and a higher software component, or does it also have anything to do with reclassification of R&D expenses? What should we be looking for, is it indicative for coming quarters?

A – Alex Gersh

No, it has nothing to do with the reclassification of R&D expenses. The proportion of our allocation between R&D and cost of sales has been constant since we’ve made that adjustment. It has to do with the mix, as we’ve said. First and foremost is has to do with the mix in revenue. The second is as Abe mentioned, because of the mix in revenue and the customers we are delivering cards to it has to do with the margins on the cards based on the customers that we’re shipping the cards to and on some of these other things that Abe has mentioned that we’ve done to minimize the card costs.

Q - Roni Biron, Oscar Gruss

So it could be indicative for coming quarters?

A – Alex Gersh

Yes. Unless – every quarter, we look at our allocation between R&D and our cost of sales. If we see a change, then I will certainly talk about that change, but f you assume that the next quarter will be like this quarter was, it should be an indication of what is to come.

Operator

Your next question comes from Murray Arenson - Ferris, Baker Watts.

Q - Murray Arenson - Ferris, Baker Watts

Most of my questions were answered. I wanted to ask you if there was anything incremental to say vis a vis option grants for the year versus what you’ve said in previous quarters?

A – Alex Gersh

Our board has not approved the new grant for 2007 yet, so there is nothing at all to say about that. We’ve talked about obviously last year’s grant. So no updates.

Q - Murray Arenson - Ferris, Baker Watts

Okay, but there should be some sort of news shortly, I’m assuming?

A – Alex Gersh

We’re working on it and we will bring it to the board’s approval hopefully shortly.

Q - Murray Arenson - Ferris, Baker Watts

Secondly, you talked specifically about uncertainties regarding PVR when you were discussing the operating income guidance, and I just wondered if you could give some additional color as to what the levers are there and what we should be looking for to try and gauge how that is going?

A – Abe Peled

As I mentioned, unfortunately none of the levers are ours. They all have to do with the degree of aggressiveness, the competitive situation in the individual market in which the different DVRs are deployed. Obviously the big markets are the UK and the US but we have DVRs that contribute significantly in 12 other markets and so hopefully that tends to even it out a little bit. I would say you know, UK for example have reached the 25% penetration that they mentioned some time ago. It will take until 2008, have already reached it and are now saying, you know, we’ll continue to grow. But unfortunately there is really no particular insight that we can give you on this, nor do we have other than by continuing to watch the trends. If you watch the trends this quarter, it was quite good.

Q - Murray Arenson - Ferris, Baker Watts

If I could ask you about the IPTV middleware market in particular, everybody’s always talking about Microsoft and obviously that’s an important player in the mix, but I wonder if you could just kind of give me your thoughts on the competitive framework there. There’s been consolidation in and around that space. If you expect some more, and how ripe do you see that opportunity as being right now, and how much shifting do you expect in the landscape over the next year or so?

A – Abe Peled

You know, when we went into IPTV middleware that was being offered by Alcatel at the time, there were a number of other players – small ones like ANT, like Myrio, they all including Microsoft usually are simply a browser in the IP box that goes back for everything to the server. As we work with more and more customers with different, I might add, middleware or what was called IPTV middleware, we recognize the fact that part of the reason for the difficulties in scaling it up or the performance had to do with this constant requirement to keep going back to the server – the fact that they were what we call thin clients. Today’s set top boxes can easily handle a more powerful client, like our satellite or cable boxes do, which do a lot more of the processing locally, so our metro middleware really takes a different approach in the sense that it uses software that is capable of doing a lot of the processing locally, like looking up whether you’re authorized to view the next channel, the guide being handled by a multi cast system information stream rather than having to go back constantly to the server. All of those I think can contribute to improving the performance and scalability of these IP systems without really affecting the cost of the IP set top boxes. That’s why we really introduced our middleware, and as it will start to roll out, hopefully we will be able to demonstrate these things, which may change. We have looked in terms of consolidation and there is really no technology or market access that we feel we need I this area that would be durable, because I think a lot of the early solutions may not prove durable, especially as people try to scale up these systems.

Operator

The next question comes from Daniel Meron, RBC Capital Markets.

Q - Daniel Meron, RBC Capital Markets

Congratulations on the continued executions. Can you give us a sense on what is the run rate that you expect from Jungo heading into FY 2008? What is the ramp up that you expect there? I realize that it is early in the game, but just give us a sense on the extent and the opportunity.

A – Alex Gersh

I think the only thing we could say is the longer term – today the only thing we can say is that the longer term target for NDS together with Jungo of 10-15% revenue growth and 20-25% operating income growth still stands. That’s probably – unfortunately I really cannot comment anything specifically on Jungo right now.

Q - Daniel Meron, RBC Capital Markets

Maybe give us a sense – on the press release, you mentioned that you’re going to retain the cash and use it for business development and corporate users. I assume that means that is towards other M&A. Can you give us a color on what areas you would look to expand into?

A – Abe Peled

I think as we’ve said in the past, we’re continuing to look at the IP and broadband world, including broadband wireless applications and perhaps mobile, particularly in the content management area for both broadband and mobile where we think there may be an opportunity to expand our end to end solutions and offer a better end to end system. That’s really the extent, and that hasn’t changed. I think Jungo fit very well within that definition of looking at the two strengths in our hands, both in market access and technology for these new markets.

Q - Daniel Meron, RBC Capital Markets

What is the timeframe for that? Would you take a breather here until it digests Jungo and then make the next move? Or are you looking to do something in the next few quarters?

A – Abe Peled

I think we’re continuing to look and you know, I believe we’re careful both in terms of the technological fit, the corporate culture and people fit and we have an active program looking for the right opportunities. I would hope that over the next year, we will be able to find some additional things.

Q - Daniel Meron, RBC Capital Markets

You featured the SAMSA[?] disc and then the Disney one – can you give us a sense – are we still talking about very low numbers for those digital rights management kind of solutions in other applications around that, or is it gaining more traction right now?

A – Abe Peled

I think the numbers of deployment of these things are sufficiently small and the revenue from them is sufficiently small that unless it becomes millions, obviously you’re not going to see it in our numbers. I think it’s essential for us to participate in this market as people experiment with different methods of distribution, different levels of security and as I said in my introductory remarks, I think the revenue and traction from these things will gradually start showing up over the next few years. But definitely not in FY 2007 or even FY 2008 in any meaningful, large way.

Q - Daniel Meron, RBC Capital Markets

Last one from me – on the balance sheet side, the inventories and also receivables have been edging higher for the last three or four quarters. Can you give us some color there? Is it more of a seasonal nature or is it related to moving into more emerging market regions? Is that the reason?

A – Alex Gersh

Well the inventory – we have been accumulating some cards in relation to – next generation cards, both for changeover as well as to roll out next generation cards. There has been an accumulation of inventory and when the new generation of cards start rolling out as well as when the changeover is initiated, you will see that relief. In terms of the receivables, there is nothing special on receivables. It’s simply sometimes at the end of the quarter, significant billings are being done so you see an increase in receivables. It works itself out as the revenue increases – the overall receivable balance can go up. There is no issues, nor is there anything really notable to speak of on receivables.

Operator

Your next question comes from Michael Walter – Goldman Sachs.

Q – Michael Walter, Goldman Sachs

I just wondered if you could give us some more color on opex drivers going forward, if there are any particular areas within R&D where you feel you need to spend more resources, or in sales and marketing in some of the new geographical regions where you think you need to be more active. Should we expect a similar opex pattern or seasonality this year as we saw last year?

A – Abe Peled

First of all, on R&D, we’re really not increasing a lot of increase – it doesn’t have to do with new areas, but it has to do with new projects that we are undertaking that may be will start getting revenue next year. Obviously some of the investment and the DRM Key but that’s not the majority of the increase. In terms of sales and marketing, we have opened a Mumbai office and we’re opening a Moscow office on February 8, so that’s a slight increase, but again we don’t expect to see – that’s business as usual, it’s not a massive increase. We’re just continuing to ramp up our ability to deliver more projects concurrently as we see more demand coming up.

A – Alex Gersh

Just to add, we just highlighted obviously the foreign exchange affected our costs for six months by roughly $10 million and a significant proportion of this was actually in Q2. All of the cost lines are also susceptible and while we’re okay on the operating income, they are susceptible to the changes in FX. Clearly I just want everybody to remember that in R&D in Q1, we have benefited from the R&D credit in France, which we also had in Q1 of last year, so if you’re looking at the Q1 to Q2 comparison, Q1 has a $5.3 million credit in the R&D line, which grew, and people just need to remember that.

Operator

Your next question comes from Raja Janakiraman of Morgan Stanley.

Q - Raja Janakiraman, Morgan Stanley

Just to confirm, the new guidance that you’ve given doesn’t include any contribution from Jungo, correct? Just to be clear on this?

A – Alex Gersh

That’s correct.

Q - Raja Janakiraman, Morgan Stanley

And the increase in the revenue line of the revenue number, is it because of the foreign exchange that we just spoke about, or is it because you have a bit more visibility in terms of some revenue streams?

A – Abe Peled

The revenue guidance increase is due to Jungo. We did not increase our operating income guidance as a result of Jungo, because of the factors that indicated that first of all there is the acquisition cost, second there is the amortization of IPR that is still uncertain, and you know, we’d like to get a better handle on the actual profits coming from Jungo. That’s the trouble – we haven’t increased it as a result of Jungo and the operating income, but did increase it on the revenue line.

Q - Raja Janakiraman, Morgan Stanley

Okay. One more question on the Q2 2007 margins – I think this was a point that Alex was just making now. You said that the bulk of the $10 million FX effect on costs came into Q2. So I think if we kind of include that in and make the same adjustment for revenues, you did see a sequential increase in operating margins after adjusting for the French credit in Q1 2007, is that right?

A – Alex Gersh

The operating margin in Q2 was not affected because of the cost and the revenues. The effect of FX was effectively the same on the cost and the revenues. If you adjust in Q1 for the margin in Q1, I’m not sure – I haven’t done the calculation.

A – Abe Peled

There is also Tata-Sky in Q1. We haven’t done the calculations.

A – Alex Gersh

Yes, I haven’t done the calculations to tell you what would happen if we adjusted Q1.

Q - Raja Janakiraman, Morgan Stanley

Okay. Apart from these two items in the revenues and the costs, was there any significant timing difference that you say in terms of either/or in the investments that you made? I know you mentioned the point on sales and marketing and the investments in trade shows, was there anything on the R&D line that kind of took you by surprise in Q2?

A – Alex Gersh

No.

Q - Raja Janakiraman, Morgan Stanley

Okay. The last question is on the head count that you will probably close at the end of the year without Jungo. You mentioned that Jungo would be about 170 employees. Can you give us a sense as to where exactly you see this for NDS at the end of the year? Just to get a feeling.

A – Alex Gersh

We have an estimate, but to be honest with you I certainly would be hesitating to give it to you, only because as Abe has indicated, our headcount is very much driven by projects that we see and anticipate and if those increase, we may increase the headcount. It’s very, very hard to give an estimate so I would prefer not to do that any more, just because the accuracy of those estimates sometimes wasn’t as good as I wanted it to be.

Operator

Thank you. Your next question is from Jason Mauricio, from Arete Research.

Q – Jason Mauricio - Arete Research

A few questions. Abe, I was wondering if you could give us your thoughts on the July 2007 mandate by the FCC and what that might do for NDS in terms of opportunity and how you think that might play out? Second, Abe, could you give us an update on the China market? We understand India is going pretty well, but China is still a mystery and they certainly are off their targets for the Olympics. Alex, I was wondering if you could give an update and maybe refresh our memory on how you account for changeovers in terms of the margins. Am I correct in assuming that margins from the changeover would be slightly dilutive to the corporate average?

A – Abe Peled

In terms of the FCC mandate on cable cards, it really is not a new opportunity for NDS, because in principle – on the Motorola system, you need a Motorola cable card, on the Scientific Atlanta system you need a Scientific Atlanta cable card, both of which are available, it’s really the issue of generating set top boxes that have the cable card interface and dealing with cards that can handle more than one stream for DVR, but really it does not represent a change of opportunity for NDS, because none of the major operators have invested or forced Motorola or Scientific Atlanta into similar situations that would allow perhaps new things. I think it’s neutral for NDS. In terms of China, we continue to see accelerated deployment partly driven by the desire to have enough digital for the Olympics but primarily driven by the overall initiative to convert to digital the analog cable, [the sting E initiative?]. We have said that we expect – last year we did a million cards in China and we said that this year we expect to do something like 3-4 million and at the current pace, we believe that we will come in within that range. We continue to pursue new accounts but they obviously wouldn’t impact this fiscal year.

A – Alex Gersh

On the margin, as you know, every quarter when we look at our deferral calculation, we adjust it if there’s a change in various circumstances. One of the circumstances is a margin so if we’re right in our estimates and our adjustments are right, the changeover should not have any dilutive effect on the margin. It’s only if the estimates turn out to be off a bit that it would have some kind of an effect.

Operator

Your next question comes from Gordon Tomasin [ph], Aco Capital[ph].

Q - Gordon Tomasin [ph] - Aco Capital[ph]

Two questions if I may. The first one would be a quick update on developments within your gaming technologies, and the second one if you could just talk a little bit more in detail about what exactly you’re doing with Dogan and how the offering goes from free to air into potentially Pay TV applications and whether or not this could be used in other areas that are under-penetrated from a Pay TV point of view?

A – Abe Peled

In terms of gaming, Orbis continues to do well. Our percentage of revenue in Orbis and increase in revenue in Orbis has been quite good this year, but the fraction that comes from revenue share is steadily increasing, you know, and with the launch of new games and I think a few new customers, we think that’s going quite well. In the regular games area again, I think that’s going quite well. Having said that, you know, they’re not quantum leaps in terms of revenue on the revenue that NDS already has, but I think represent a good income component.

Q - Gordon Tomasin [ph] - Aco Capital[ph]

And the possibility to maybe leverage some of these client relationships with acquisitions to accelerate growth in this area, how do you see that?

A – Abe Peled

We’ve been quite careful to restrict ourselves to technology and customers that don’t accept US debts and are strictly on the right side of the law and operate in regulated jurisdictions, so a lot of these things that you’re talking about for consolidation, there are people who have been actually operating with US debts. We are very careful in that area. Again I want to say that it’s an area that contributes to our ability to improve our margin and as a result our product mix. It’s very complementary in terms of helping us with access to new customers over time in areas like the UK with broadband enabled set top boxes, we believe that many of the things that are currently available only on the internet would also be available on television, perhaps combined with entertainment and that would be another area of growth.

Q - Gordon Tomasin [ph] - Aco Capital[ph]

And on Dogan?

A – Abe Peled

Dogan – as I said the model is that the set top boxes are rolled out already with the smart cards and conditional access and all our technology in them initially. They can be the motivation for people to get them, it’s to get a lot of the free to air channels and gradually Dogan Media expects to introduce particular programs that are for pay and full channels that are for pay and I think we’re interested in seeing how that will evolve. But in terms of is it applicable to us, obviously we will be looking in other areas for a similar opportunity.

Operator

Your next question comes from Marty Hyman[ph], Kooga Trading[ph].

Q - Marty Hyman[ph], Kooga Trading[ph]

A question about mobile TV and broadcast in terms of how you see that opportunity developing when and how big it could be?

A – Abe Peled

I think we obviously are quite active in the whole mobile TV area for DVDH, and other standards. I’m somewhat cautious on the rate at which this will be deployed, because the cost of deploying a very specialized infrastructure to support Mobile TV that has to be recovered from the subscription that is available on Mobile TV, if you look at these calculations, the numbers may not necessarily add up, especially in well served markets. I think also technologically there may be a competition from WiMax and WiFi hotspots delivered through IP streaming, like we’ve done in Korea with KT Telecom, the tote system which allows you to get Mobile TV on very nice screens, but in anywhere that you are within a hotspot or in the future wideband, they are going to have that on public transportation and so on. We obviously have technologies for both, but both of them I think, at some point may compete with each other and furthermore the rollout may be slower than people expect.

Q - Marty Hyman[ph], Kooga Trading[ph]

What about with respect to opportunity in broadcast?

A – Abe Peled

I’m talking about broadcast here. We are talking DVDH or this type of standards. That’s what I’m – I think the investment necessary to put the infrastructure in, whether it’s old terrestrial or even terrestrial augmented by satellite is quite large, and the type of money you get from just the broadcast package may not necessarily close that equation.

Operator

Your next question comes from Todd Chanko, Jupiter Research.

Q - Todd Chanko, Jupiter Research

Of course the past couple of days we’ve been hearing Bill Gates and the like tout the digital future for Microsoft with Vista. I wanted to know if you could comment on whether you think there are already opportunities for NDS in this so-called new Vista environment, or whether it represents some kind of competitive threat, or perhaps neither?

A – Abe Peled

I think Vista has gone to great lengths to close the PC for security purposes to enable it to become an entertainment device. It will be – you know, there are at this point significant debates raging on the various internet sites that specialize in this area – to what extent that will work and how it will actually impact the rest of the applications that are not necessarily entertainment related. The current Microsoft DRM is quite compromised. We believe that you know, hiding the encryption and decryption keys in software somewhere in the hardware memory of the PC and simply protecting it by trying to close down further drivers and access and producing revocation is not going to ultimately work. We believe that things like the VideoGuard DRM Key which is kept on an external USB device that has a smart card in it has to be the ultimate solution to providing a reasonable level of security. We see Microsoft clearly very focused on entering the entertainment distribution arena and becoming the new middle man, displacing Pay TV aggregators. As such as think they are a competitive element. On the other hand, we feel that the technology we provide will allow a better way to distribute, especially content that is valuable including to PCs, and that is the reason why we introduced the VG Key that can work equally in the existing population of PCs which is still the predominant – I don’t think that people will that rapidly - especially in homes – upgrade to Vista. So it is a part of the unfolding fight for the distribution of media in a secure way.

Operator

Your next question comes from Barry Flynn, Informa.

Q - Barry Flynn, Informa

How many of the 4 million PVRs that you’re forecasting might be personal portable PVRs like the ones you’ve been demonstrating at trade shows for a few years now?

A – Abe Peled

None.

Q - Barry Flynn, Informa

None? Why is that?

A – Abe Peled

Because they haven’t been launched yet by anybody on any reasonable scale.

Q - Barry Flynn, Informa

Why is that technology that you’ve demonstrated not attractive to Pay TV operators?

A – Abe Peled

I think first of all it’s expensive. These things are expensive and the focus of the Pay TV operators is really in proving – they’re always spending money on upgrading the DVRs to HD and so on, rather than investing considerable resources and being able to extend the DVR from home to the portable DVR. Probably we’ll wait for the prices of these things to come down some more before they can become a key focus item.

Operator

Thank you. There are no further questions at this time. Please continue.

Abe Peled

I would like to thank everybody for joining us on this call. We hope to see some of you at our analyst day tomorrow – as many as we can. Everybody else, we’ll see you on the next quarter call. Thank you.

Operator

That does conclude our conference for today. For those of you wishing to review this conference, the replay facility can be accessed by dialing within the UK on 0845 245 5205 or alternatively on country code +44 1452 55 00 00. The reservation number is 605 6657. Thank you for participating. You may all disconnect.

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Source: NDS Group F2Q07 (Qtr End 12/31/06) Earnings Call Transcript
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