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China Digital TV Holding Co. Ltd. (NYSE:STV)

Q4 2010 Earnings Call

March 1, 2011 7:00 PM ET

Executives

Henry Fraser – Brunswick Group

Eric Yuan – IR Officer

Dong Li – President and Chief Marketing Officer

Zhenwen Liang – CFO

Analysts

Philip Wan – Morgan Stanley

Jie Liu – Auriga

Michael Olson – Piper Jaffray

Operator

(Operator comments)

Henry Fraser

Hello everyone and welcome to China Digital TV’s fourth quarter and full year 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 Mr. Dong Li, China Digital TV’s president, who will give an overview of the quarter, followed by the Company’s head of investor relations, Mr. Eric Yuan, who will discuss the financial results. After their prepared remarks, they will be joined by China Digital TV’s chief financial officer, Mr. Zhenwen Liang, 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 president, Mr. Li.

Dong Li

Thank you, Henry. Hello everyone.

We are pleased to report that our CA business continued to see strong growth in the fourth quarter. Smart card shipment reached 6.1 million units and revenues were 32.8 million US dollars. Both are new records for the Company. This stellar growth, continuing a trend which started in the second quarter of 2010, was largely supported by industry players’ response to government policies encouraging three network convergence and provincial level cable network consolidation, which were announced in early 2010. We saw that particularly in the fourth quarter, which is typically the busiest season in our industry, a large number of our carrier customers increased their investment in transitioning to digital TV, especially in lower tier cities, and this led to a big increase in demand for smart cards.

In addition to benefiting from market trends, I’m pleased to say that China Digital TV outpaced the market with over 80% growth in card shipments and nearly 60% growth in revenues over 2010. Leveraging our broad and diversified customer base and effective execution, we closed the year with an even stronger market leading position. According to data from Analysys International, a Beijing-based market research agency, the number of households with digital cable TV service in China increased by 29 million to just over 92 million by the end of 2010 and the level of digital TV penetration increased to over 50%. Currently, most households subscribing to digital TV service only have one set-top box at homes. In the next few years, we believe having multiple set-top boxes per household will become more common, leading to additional demand for smart cards.

Looking at 2011, we believe our customers will continue to invest in digitalization projects actively and we have seen a healthy volume of orders coming in to date. However, we do not expect to repeat the same growth rate we had in 2010 because the base number is much bigger and cable operators will make investment at a more stable pace after the rush in 2010. We believe it is likely that smart card shipment in 2011 will remain at least as strong as the 2010 level, although of course there are uncertainties related to ongoing industry consolidation. Looking further into the future of China’s digital TV market, we are cautiously optimistic about potential developments.

On the one hand, clear trends toward high definition TV and web-capable TV will likely lead to increased demand for content protection and other technological solutions as operators increasingly introduce value added services and create new revenue sources. However, at the same time, securing funds for upgrading infrastructure and successful commercialization of new products will be big challenges. So, we see the next two to three years as a transitional period for the market, as well as for China Digital TV, as we work to enhance our product offering and continue to explore new business models. I would now like to turn to operational developments. During the fourth quarter, average selling price for smart cards increased slightly over the third quarter of 2010 due to lower priced cards accounting for a smaller proportion of total sales.

Meanwhile, the unit cost for smart cards decreased quarter-over-quarter -- leading to a higher gross margin. For 2010 as a whole, ASP decreased by 8.1%, inline with our previous forecast. In 2011, we expect to see a decline in ASP of around 5% compared with the level in 2010. Revenue from our integrated chip product remained small in the fourth quarter. Having said that, based on positive customer feedback, we are confident that this product should take off starting in the second half of 2011, and we believe it will contribute several million dollars to 2011 revenue. Our overseas business is still in the market cultivation phase and in 2011 we will continue to seek opportunities in Latin America, South East and Central Asia. Combined, the integrated chip and overseas CA business should account for 4-6% of revenue in 2011.

On the R&D front, we continued to explore next generation products and services because, as we said earlier, we believe that in the next few years, which is a transitional period for China’s TV market, new products and services will need to emerge to service the needs of TV viewers and create new business models. To conclude, we believe that as the undisputable market leader and with a broad customer base, deep industry expertise and advanced content protection technologies, China Digital TV is well positioned to seize the opportunities presented in this transitional period. I will now hand the call over to Eric Yuan, our head of investor relations to discuss our financial management.

Eric Yuan

Thank you, Mr. Li. Hello everyone.

As Mr. Li said, we’ve had a strong year in 2010, and we are reasonably confident about our business outlook in 2011. Now, let’s look at our financial highlights for the fourth quarter and full year 2010. Before I proceed, please note that, unless stated otherwise, all amounts are in US dollars. In Q4-2010, China Digital TV shipped approximately 6.10 million smart cards, compared to 2.36 million in Q4-09 and 3.95 million in Q3-2010. During the full year, we shipped 16.23 million smart cards, compared to 8.83 million in 2009. Net revenues in Q4 were 32.8 million, up 140% from last year, and 55.5% from last quarter, primarily due to increase in smart card sales. Revenues from our top five customers accounted for 23.6% of total revenues, compared to 27.1% in Q3-2010.

Gross profit in Q4-2010 was 26.5 million, an increase of 153% annually and 61% sequentially. Gross margin was 80.8% in Q4, compared to 76.5% in the same quarter of last year and 78.0% last quarter. The annual and sequential increases were primarily due to changes in product mix, reflecting improvements in higher margin businesses, principally sales of smart cards. ASP of smart cards in Q4-2010 increased by 3.7% compared to the quarter before, while the unit cost decreased by 13.3%. In 2010, the ASP of smart cards decreased by 8.1% compared to 2009. The unit cost of smart cards decreased by 15.2%, mainly due to the decline in chip and production costs.

Operating expenses in Q4-2010 were 7.4 million, an increase of 25.1% from the same period in 2009 and an increase of 19.2% compared to the third quarter of 2010. Operating income was 19.2 million in Q4-2010, a 317.6% annual increase and an 86.1% sequential increase. Operating margin was 58.4%, compared to 33.6% in Q4-09 and 48.8% in Q3-2010. Non-GAAP net income, defined as net income excluding certain one-time non-cash charges and withholding tax effect related to a special cash dividend, was US$19.6 million, and diluted non-GAAP earnings per ADS, in the fourth quarter of 2010 were 33 cents, compared to 11 cents in the same period in 2009. Income tax expenses in the fourth quarter of 2010 were 6.7 million, compared to 1.5 million in the third quarter of 2010 and nil in the same period of 2009. Of that 6.7 million, 1.3 million was related to income from operations, and 5.4 million was a withholding tax imposed by Chinese tax authority for our PRC subsidiary repatriating cash offshore for the special cash dividend declared in November 2010.

Some of you may know that China Digital TV is a minority shareholder in an online video content provider named OpenV. This company has been involved in a copyright related investigation and its online video service has been suspended for about five months. To our knowledge, OpenV’s executive officers are still in police custody. As a result, we believe our investment in OpenV may be materially impaired. So we have decided to make an impairment of the entire amount of our original 5 million dollar investment in OpenV. We do not expect any further impairment related to the OpenV investment to be incurred in the future. Net income in Q4 was 8.8 million, compared to 6.0 million in the same period in 2009 and 10.1 million in the third quarter of 2010, translating to earnings per share of 15 cents on diluted basis.

Turning to our balance sheet... As of December 31, 2010, China Digital TV had cash and cash equivalents, restricted cash and short-term investments totaling 217.6 million. In the fourth quarter of 2010, cash flow generated from operations was approximately 7.9 million. Now, let me provide our business outlook. Based on information available on March 1, 2011, China Digital TV expects smart card shipments for the first quarter of 2011 to be in the range of 3.50 million to 3.70 million. Net revenues for the first quarter of 2011 are expected to be in the range of US$19.22million to US$20.24 million, representing a year-over-year increase in the range of 37% to 44%.

Thank you for listening; we will now take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Philip Wan of Morgan Stanley. Please proceed.

Philip Wan – Morgan Stanley

Hi, good morning, Mr. Li, Mr. Liang and Eric. Congrats on a very strong quarter. I have three questions, first of all could you please help us to understand the big gap between the guidance and actual smart card shipment in the fourth quarter and also for the first quarter, could you share with us that what percentage of your smart card shipment guidance has been shipped up-to-date? Thank you.

Eric Yuan

Okay. Thank you, Philip. I’ll ask our President Mr. Li to answer your question.

Dong Li

[Interpreted] Okay, Philip, there are two – a couple of reasons to expand the gap between our guidance in the fourth quarter and the fourth quarter of 2010. The main reason is seasonality factor; normally the fourth quarter is better season in the industry. While the fourth quarter is actually the slowest season in the industry because of the Chinese New Year factor and also in March there is a big industry show which also will distract some attention from operators.

Now, the second reason is the December of last year is deadline of setting up a province level cable company and each province ordered by the Central Government, Chinese Central Government. So, smaller cable operator in that period, in the fourth quarter who were aggressive increasing their spending on convergence project to position themselves better in the further in a possible consolidation.

So, that factor lead to some unexpected surge in the market demand. So, we do not think that we can repeat that growth rate in the 2011. But if you look at our guidance for Q1, on year-over-year basis we will see that we can still achieve more than 35%, actually increase in that revenue. We think it is also still a very healthy signal.

I don’t know if we answered your question, Philip.

Philip Wan – Morgan Stanley

Sorry, I think I was in – my question was I would like to understand the gap between your guidance in the fourth quarter, I mean the last, just on guidance terms, 3.7% at the end of the fiscal year?

Unidentified Company Representative

Sure.

Dong Li

[Interpreted] So, Philip we make, the China Digital TV is making its guidance based on the information we collect from our customer by summing up their own budget expectation, but actually in the fourth quarter a lot of our customers, their actual investment in those projects even in the past that their own expectation at the quarter beginning so that’s why we said that with various unexpected search in the marketing. I don’t know if that answers your question.

Philip Wan – Morgan Stanley

Okay, that’s helpful, thank you. And then my second question is about your integrated chip business. Looks like it is going to be a new book riser for your company in 2011 and you mentioned that it will contribute around 46% of your total revenue and just want to get some color from you, what is your expectation in terms of revenue contribution in the first quarter and also your expectations in terms of shipment volume for ASP and even if you can share with us your expected margin compared with smart card business going forward? It will be very helpful, Thank you.

Eric Yuan

Sure. Okay. I will also let our President to answer this question.

Dong Li

[Interpreted] The first quarter shipment will be relatively more.

For the full year of 2011 we expect the card shipment to be in the range of 500,000 to 600,000 and but the [inaudible] will be we think will the momentum will start from the second half.

Okay. For the standard definition format chip, we expect the average selling price will be between RMB90 to RMB100 and for the format of the high definition, we expect we can have higher FD margins.

Okay. So, the gross margin will be lower than that of smart cards. We expect it could be about 50%. Thanks.

Philip Wan – Morgan Stanley

Thank you.

Dong Li

Thank you.

Eric Yuan

Operator next question please.

Operator

Please proceed, caller with your question from Globus Capital.

Henry Fraser

Hello, anybody have any questions?

Operator

We have one question from the line of Jie Liu of Auriga, USA. Please proceed, ma’am.

Jie Liu – Auriga

Okay. I am a guy, by the way. Hi, good morning everybody, a very good quarter and very good guidance. A few questions, the first one is yield for your ship in the guidance for 2011, did you include any international shipments and does the guidance include your chip solutions also?

Eric Yuan

Okay. Thank you, Jie. First of all we do not actually issue any formal guidance for the full year 2011. And in our earnings release, we’ve said we made the shipments in line with 2010 level that’s our actually preliminary forecast, but that’s another formal guidance. But anyway, I would let Mr. Li to give you some more color on [inaudible] rates.

Dong Li

[Foreign Language]

Eric Yuan

Yes. It is already included.

Jie Liu – Auriga

Okay. In that case, could you give us a ballpark estimate of your international shipments in 2011?

Dong Li

[Interpreted] But it will between 300,000 to 400,000 of overseas shipments.

Jie Liu – Auriga

Okay. All right, so for your smart card business, how should we think about the average selling prices? On the call you guys said in 2010, the ASP decreased like an 8.1% year-over-year, so how should we think about that in 2011?

Dong Li

Okay. I will let our CFO. [Foreign Language]

Zhenwen Liang

[Interpreted] So, we think the ASP- we think will decline, but have old milder rates, will be around 5% compared with 2010 level.

Jie Liu – Auriga

Okay. So, the ASP of your international shipments should be similar to that of your domestic shipments, right?

Dong Li

Okay. [Interpreted] Yes, it’s a similar.

Jie Liu – Auriga

Okay. So just one more question. Maybe you guys could give us an update on your value-added services business?

Dong Li

[Interpreted] Okay. So we will continue to invest actively in the value-added services you know such as the video-on-demand solution, cloud service solution and TV gaming solution. However, we think in China in the near term, the pay-TV value chain has not being performed very well, so we don’t have a very high expectation that this new business has immoderate contribute our sizable revenue in 2011.

Jie Liu – Auriga

Okay. May be I’ll leave the floor now. I’ll come back if somebody else has a question. Okay. Well, congratulations again.

Eric Yuan

Thank you, Jie.

Operator

[Operator Instructions] A follow-up question from the line of Jie Liu of Auriga USA. Please proceed.

Jie Liu – Auriga

Okay. I’m back. Another question; do you guys have any industry statistics that indicate what percentage of the overall set-top box demand in China is from either the replacement set-top box or the second or third set-top box in the household?

Eric Yuan

I would ask Mr. Liang to answer this question.

[Foreign language]

Zhenwen Liang

[Interpreted] There is no very solid data that has explain what is exact percentage of set-top box which are maybe replace the box or the second or third box at home. But from our talk with industry insiders, maybe the percentage is around 10% that is second or third box similar to the household.

Jie Liu – Auriga

Okay, that’s great. Thank you, guys.

Eric Yuan

Thank you, Jie.

Operator

Our next question is a follow-up question from the line of Mike Olson from Piper Jaffray. Please proceed.

Michael Olson – Piper Jaffray

All right. Thanks. Good morning. Just a couple of quick questions. One thing on gross margin. I saw it was up almost 81% in Q4. Should we expect gross marginal change significantly from that level or I guess just what should we expect gross margin will look like in 2011?

Eric Yuan

Thank you, Mike. I’ll transfer Mr. Liang to answer this question.

[Foreign language]

Zhenwen Liang

[Interpreted] We expect that the gross margin for the full year of 2011 will be around 75%. There are a couple of reasons. One is that the average selling price of smart card will continue to decline either at a milder rate, while the unit cost look chip stable compared with 2010 level.

The second reason is due to the change in the product mix. As we said earlier, the new product lacks integrated chip solution will grow substantially compared with 2010 level, so which means in percentage wise the revenue from smart card will decrease, but the margin for those new product we will be in lower than the higher margin smart card business. That’s why we expect gross margin will be around 75%. Does that answer your questions, Mike?

Michael Olson – Piper Jaffray

It does; thank you very much. And you said – I just want to confirm you said ASPs will be down around 5% in 2011, is that correct?

Unidentified Company Representative

Yes, that’s correct.

Michael Olson – Piper Jaffray

Okay. And then I guess one other just kind of high level question; you guys mentioned that smart card shipments will be generally unchanged in 2011 compared to 2010. If that’s the case I realize there is obviously some new initiatives that will cost revenue growth, but what would be the biggest driver for revenue growth in 2011 given smart card shipments will be unchanged and ASPs will be coming down a little bit?

Unidentified Company Representative

Okay. I’ll let our President, Mr. Li Dong answer this question. [Foreign Language]

Dong Li

[Interpreted] Okay. There are several maybe potential positively surprising factor. One is related with industry consolidation. Right now the consolidation basically happened in the municipality level where there are hundreds of smaller operators in the country level and actually these operators have hundreds of thousands subscribers and their demand could make our actual fulfillment better than our forecast.

And the second part is in the new product settlement and with that about integrated chip unit and overseas sales and video on demand solutions. We already had – having investments in these few products. We hopefully these new products can bring out some surprise and good news.

Okay. Lastly is about our innovative solution, such as the cloud service solutions. Even the actual revenue contributions from these – those solutions that are not very big, but because now the Chinese government has heavily promoted domestic innovation in these new hi-tech solutions, it is likely that we can get some funding support of subsidiaries from the government. Does this answer your question?

Michael Olson – Piper Jaffray

Yes, it does. Thank you very much.

Eric Yuan

Thank you, Mike.

Operator

This concludes the Q&A portion of this call today. I’ll now like to turn the call back over to Mr. Henry Fraser for closing remarks. Thank you.

Henry Fraser

Again, thank you for joining us today. If you have any further questions please do not hesitate to contact our investor relations team by sending e-mail to ir@chinadtv.cn. Thank you.

Operator

Ladies and gentlemen, this concludes today’s conference. Thank you for your participation. You may now disconnect. Have a great day.

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