Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)
TRANSCRIPT SPONSOR
Better Than AdSense

Silicon Image, Inc. (NASDAQ:SIMG)

Q4 2006 Earnings Call

February 8, 2007 5:00 pm ET

Executives

David Allen - Director of IR

Bob Freeman - CFO

Steve Tirado - President and CEO

Ed Lopez - Chief Legal Officer

Analysts

Mahesh Sanganeria - RBC Capital Markets

Jason Pflaum - Thomas Weisel Partners

Quinn Bolton - Needham and Company

Daniel Gelbtuch - CIBC Worlds Markets

Tayyib Shah - Longbow Research

Jeff Schreiner - American Technology Research

Aalok Shah - D.A. Davidson

Adam Benjamin - Jefferies and Company

Presentation

Operator

Good day everyone and welcome to Silicon Image’s Fourth Quarter 2006 Financial Results Conference Call. Please note that today’s call is a question and answer session and is being recorded.

At this time, I would like to turn the call over to Mr. David Allen, for opening remarks, please go ahead.

David Allen

Thank you, operator. Good afternoon and welcome to Silicon Image’s Fourth Quarter 2006 Financial Results Conference Call. I am Dave Allen, Silicon Images, Director of Investor Relations. Joining me today are Steve Tirado, Silicon Image's, President and CEO and Bob Freeman our Chief Financial Officer. We would like to extend our apologies for the delay in starting the call. Our press release is now across the wire and we are prepared to start the call.

Before I turn the call over to Steve, let me remind the listeners that we will be making forward-looking statements during the call regarding our future performance based on our current expectation. These remarks may include stock buyback activities, financial targets, expected sales growth, anticipated royalty payments from Genesis and other companies, operating results, planned inventory reduction or other cost reduction activities, integration of sci-worx and IP from Sunplus, product introductions, product ramps, as well as announcements relative to standard and technology adoption rate.

Actual Company and marketplace results may differ materially differ materially from what are described in these and other forward-looking comments. We encourage you to familiarize yourself with our various SEC filings, including but not limited to the forward-looking statements in today's press release, and along with our most recent Form 10-K and Form 10-Q filed with the SEC. These documents describe relative risk factors that could affect future results. Additionally during this call we may highlight other factors that could impact projections or other forward-looking statements. Silicon Image assumes no obligation to update such forward-looking statement.

I also want to mention before we proceed, that all financial numbers are prepared unless otherwise noted in accordance with GAAP or Generally Accepted Accounting Principle. We have also used certain non-GAAP financial information. A reconciliation of non-GAAP financial information to the most directly comparable GAAP information is included in our fourth quarter and full-year fiscal statements, which were issued with today's press release. Today's press release can be found on our website in the Investor Relation section of siliconimage.com. We believe that certain non-GAAP financial information is useful to investors, because it may enhance their understanding of the results and trends in our business. We also use certain non-GAAP financial information internally to evaluate and manage our operation. As a note non-GAAP financial information we use may differ from that used by other companies. These non-GAAP measures should be considered in addition to and not as a substitute for the results prepared in accordance with GAAP.

For those who have not seen today's press release and again we apologize for the delay of having it across the wire, let me quickly recap the fourth quarter results. Total revenues for the quarter were $87 million. GAAP gross margins were 61.6%. Non-GAAP gross margins were 57.3%. GAAP net income and EPS were $26.3 million or $0.29 per share on a diluted basis respectfully. Non-GAAP net income was $18.3 million or $0.21 per share on a diluted basis. Bob will provide more details on our financial results later in the call. I will now turn the call over to Steve for a review of 2006 and some commentary on the business looking into 2007 and beyond. Steve?

TRANSCRIPT SPONSOR

Better Than AdSense

What if there was a way to promote your company to a perfectly targeted group of potential customers, partners, acquirers and investors? What if you could tailor your pitch to them at the moment of maximum interest? And what if you could do this for a no-brainer price?

This is exactly what Seeking Alpha is offering with transcript sponsorships.

Seven types of companies are sponsoring earnings transcripts on Seeking Alpha:

1. Company sponsors its own earnings call transcript (example).

2. Company sponsors partner's transcript (example).

3. Company sponsors competitor's transcript (example).

4. Issuer-sponsored research firm sponsors client's transcript (example).

5. Investment newsletter sponsors transcripts of successful stock picks (example).

6. IR firm sponsors transcript of micro-cap company (example).

7. Consulting company sponsors company's transcript in sector of interest (example).

Your company's name and promotion could have been on this transcript! Learn more, or email Zack Miller for details.

Steve Tirado

Thank you, Dave and good afternoon everyone. Before I begin I want the listeners to know that I'll be speaking about our financial results excluding the one-time effect of the Genesis settlement. I'm pleased to report on another record year for Silicon Image. 2006 was characterized by record revenue, record operating margins, and a well managed expense plan.

Top-line revenue grew over 35% from $212 million to $287 million. Non-GAAP net income before taxes grew over 53% from $47.5 to $73.1 million demonstrating improved leverage in the business and cash with short-term investments grew $99.1 million from $151.6 million at the end of '05 to $250.6 million at the end of '06. All-in-all, an excellent financial year for Silicon Image and a credit to the hard work of our management team and employees.

I would now like to review seven key highlights for 2006. Number one, it is clear that the consumer electronics market has fully embraced the HDMI standard. According to In-Stat's most recent forecast for HDMI shipments it was estimated at over 63 million devices shipped in 2006 and an estimated 130 million devices are expected to be shipped in 2007. By 2010, it is expected that approximately 325 million units we will be shipping per year.

Number two, companies adopting the HDMI standard has now passed the 540 mark and continues to grow with over 20% of these companies coming from China. The Consumer Electronics Association awarded the HDMI licensing LLC on behalf of the HDMI founders, its International CES innovations 2007 Design and Engineering Awards Honoree for the HDMI 1.3 specification.

Products considered for this prestigious award are judged by a preeminent panel of independent industrial designers, engineers and members of the trade press to honor outstanding design and engineering in cutting-edge CE products. It was unusual to see a specification win this kind of recognition, but it's an indicator of the significance of the benefits expected from implementing HDMI 1.3.

Number three, many new devices emerge for HDMI like new high-definition camcoders, digital cameras, HDMI enabled TV adapters like Apple's iTV and HP's Media Center, as well as an increasing number of DVD and A/V receiver products. These products represent the tip of the iceberg in terms of what we believe will happen in the next 12 to 24 months as a whole new generation of video capable mobile devices emerge that will store and output high quality movie content. These devices will range for music and video devices to smart mobile phone.

Number four, product execution was also excellent. We introduced a new series of integrated high-definition TV input processors, the Silicon Image 9153 and 9155, which support multiple HDMI 1.3 ports and high speed analog inputs with video resolutions up to, supporting video resolutions up to 1080p at 60Hz and 36-bit per pixel color depth. These two input processors also support the new losses compress digital audio format available in Dolby TrueHD and DTS-HD Master Audio as well as all the other HDMI supported audio formats including high-bandwidth uncompressed digital audio and compressed format such as Dolby Digital, DTS and Super Audio CD.

We introduced a new family of HDMI 1.3 switches, including the Silicon Image 9181 and 9185. These new cost-effective HDMI 1.3 switches enable multiple HDMI source devices to connect to HDTVs with frequency of operation up to 225 megahertz, allowing consumers to enjoy Deep Color content. We introduced a new mid-range HDMI 1.2 transmitter solution. The new Silicon Image 9034, extend Silicon Image's broad line of advanced HDMI transmitters that includes the world's best-selling HDMI transmitter, the 9030. It also complements the high-end Deep Color9134. The 9034 is intended for use in set-top boxes, DVD recorders and DVD players, which are increasing viewing HDMI-the-must-have technology.

For the PC market we introduced the VastLane 1392 and the 1932, which offer blazing fast performance up to 340 megahertz or 10.2 gigabits per second, allowing these products to support monitor resolutions up to WQXGA 2560 by 1600 pixels or HDTV resolutions up to 1440p. Additionally, the introduction of Microsoft's new operating system in January of '07, Vista, with its content digital rights management requirement has generated increased interest by PC manufacturers in HDMI connectivity. More than 50 HDMI PC products are currently available, including nearly two dozen desktop and notebook PCs, families of HDMI PC monitors for major manufacturers and a broad range of motherboards and graphics cards with HDMI output many enabled by a Silicon Image chip solution.

In the Storage area we added this SteelVine -- most recently added the SteelVine 5733. The first storage processor with content security enabled -- I am sorry with content security enabled by automatic drive locking. 5733 gives HDTV digital video recorders, set-top box, and PC motherboard manufacturers a cost effective storage solution that is simple, scalable, reliable, and secure. And of course doesn't require any software, software drivers or special user knowledge to deploy. It really confirms to our idea of designing technology with a CE centered point of view meaning devices are simple and they just work in predictable consistent ways.

Number five, two negotiations started in 2006, and recently closed. That represents very important part of our long-term product and business strategy for the next several years. First, in January of 2007, we completed an acquisition for net of $13.6 million in an all cash transaction from Infineon Technologies, of sci-worx GmbH, now referred to as Silicon Image Germany. A leading intellectual property and design service provider, specializing in multimedia communications and networking application. Silicon Image Germany has approximately 172 employees more than 80% of them are engineers.

Secondly, another negotiation started in '06 resulting in Silicon Image signing a cross-license agreement -- just recently with Sunplus Technology for license to use up and the right to further develop advanced IP for video processors and DTV products at a cost of $40 million cash paid over the next 18 months. The Sunplus IP along with the engineering talent and IP recently acquired in the sci-worx transaction is expected to further enhance and accelerate Silicon Image's ability to provide top tier consumer electronics customers with a full line of products ranging from our industry-leading discrete HDMI chip, new integrated front-end DTV input processors and fully integrated System-on-a-Chip DTV products that advance a new architecture for premium High-Definition content access throughout the home and mobile environment.

Number six. It is our belief that an increasingly larger number of retailers and manufacturers will demand a guarantee of interoperability in this new all digital device world. Simplay Labs, a wholly-owned subsidiary of Silicon Image was created to give the consumer industry a rigorous testing suite and setup services to give substance to the desire for strong interoperability. The program has now authorized more than 125 products to use the Simplay HD logo, indicating that these products have undergone our testing. Initially, Simplay Lab opened its first European test center providing local support to European CE manufactures and this compliments the Simplay Lab's test centers already in operation in North America and Asia.

And number seven, finally, as we mentioned in today's press release, we are looking forward to 2007 being another good year in terms of revenue, profitability and cash flow. With this in mind, the Board of Directors offered us the stock buyback program of up to $100 million over the next three years.

All in all, I am very pleased with our products toward increasing the capability of the Silicon Image to offer a broader product line with more highly integrated products, especially in the DTV space. The IP license from Sunplus represents several hundred man-years of proven technology from the DVD and DTV processor market and as intellectual property will provide most of the necessary building blocks for us to offer compelling DTV solutions differentiated by connectivity innovation, we plan to introduce early next year.

Our business is a design-win driven business. As we look into 2007, we believe we can grow revenue to between $340 million to $360 million while maintaining our non-GAAP operating margins in the 20% range for the full year through strong execution and tight expense control. Our confidence is based on our bottoms up analysis for business and represents our best estimate at this time. We have won significant HDMI 1.3 design with almost every major OEM in the market and continue to see good momentum for these products. We have an aggressive development plan with programs in 2007 that will feed our 2008 revenue. The Sunplus IP and sci-worx IP and engineering team will allow Silicon Image to move forward in completing its vision for the connected digital home in the digital television market.

I will now turn the call over to Bob for a detailed review of our Q4 and full year 2006 financial results as well as our Q1 '07 guidance and revenue expectations for 2007. Bob?

Bob Freeman

Thank you, Steve, and afternoon. Let me start with the income statement. Total revenue for our fourth quarter was a record $87 million, an increase of 41.7% from the fourth quarter of 2005 an 11% improvement over the prior quarter. For the fourth quarter, our product revenue totaled $66.3 million or 76.2% of total revenue. Our licensing revenue totaled $20.7 million or 23.8% of total fourth quarter revenue. Included in the $20.7 million of licensing revenue was approximately $11.8 million of royalty revenue associated with the previously announced settlement and licensing agreement with Genesis. Of this amount, approximately $10.6 million of royalty revenue was related to periods prior to the fourth quarter of 2006. I would also like to point out that our acquisition of sci-worx from Infineon occurred in January. Therefore there was no revenue contribution from sci-worx reflected in our fourth quarter results.

For the fourth quarter on a GAAP basis, consumer electronics revenue including licensing was up 4.8% compared to the third quarter of 2006 and accounted for $56.8 million or 65.4% of our total revenue in the fourth quarter. PC revenue including licensing increased 43.8% compared to the third quarter of 2006, and represented $20.8 million or 23.9% of our total revenue in the period. I would like to point out that the increase in PC revenue in the fourth quarter was attributable to the royalty revenue we recognized from the previously announced Genesis settlement. Storage revenue including licensing declined approximately $300,000 in the fourth quarter compared to the third quarter of 2006 and accounted for $9.3 million or 11% of the total fourth quarter revenue.

After adjusting for the non-current portion of Genesis revenue in the fourth quarter, we achieved $76.4 million in revenue, which was a sequential decline of 2.5% or slightly better than the 3% to 5% decline we indicated in our guidance coming in to the fourth quarter. CE revenue including licensing but excluding Genesis royalties earned in the prior period was down 3.1% compared to the third quarter of 2006, and accounted for $52.6 million or 68% of our revenue in the fourth quarter. The decline was mainly due to normal seasonal pattern that we have seen over the past few years in consumer electronics where our customers do most of their orderings in the second and third quarter with leveling off or some decline in the fourth quarter. PC revenue including licensing but excluding Genesis royalties was down approximately 0.1% compared to the third quarter of 2006 and contributed $14.5 million or 16.6% of our revenue in the third -- in the period. The decline, we believe was due in part to the impact of the notebook battery recalls and the timing of the release of Microsoft Vista operating system.

Storage revenue, including licensing declined 3% in the fourth quarter, compared to the third quarter of 2006 and accounted for $9.3 million or 12.1% of the fourth quarter revenue. The decline was due in part to the end of life of certain products.

For the full year under GAAP, we had a record $295 million in revenue, an increase of 38.9% over 2005, led by a 64.2% growth in our consumer electronics business. After adjusting for the Genesis royalties we also had a record year of $287.9 million in sales, up 35.6%. On a year-over-year basis product revenue was $66.3 million in the fourth quarter of 2006, up 19.7% from the same quarter of 2005, but down as expected 4.2% from the seasonally strong third quarter of 2006.

Fourth quarter 2006 unit shipments grew 5.4% over the third quarter of 2006, while ASPs declined 9% sequentially. Storage ASPs declined at greater rate than either CE or PC products and was largely driven by product mix changes. CE declines were largely impacted by planned ASP reductions associated with volume increases for certain transmitters. PC price declines were modest.

For the full year, unit shipments across all product lines increased 58.2% over 2005 unit shipments. In 2006, ASPs declined at a rate consistent with expectations on an average of 4% to 5% per quarter on an annualized basis, with the largest decline occurring in the fourth and first quarter, when customers typically work off inventories before new programs begin to move into volume ramps.

Overall in 2006, ASPs were down in Q1, slightly up in Q2 and down in Q3 and Q4. Overall, the decline in ASPs has been due to a combination of lower selling prices and product mix. Based on current visibility, we expect to see a similar pattern in the first half of 2007.

Distributor revenue, which we generally record on a sell-through basis, was $38.1 million, an increase of $1.6 million in the fourth quarter compared to third quarter of 2006. Distributor revenue accounts for 43.8% of our fourth quarter product revenue. Direct sales account for $28.2 million in the fourth quarter.

Fourth quarter IP licensing revenues, including licensing, development, royalties and testing revenue was $20.7 million or 23% of total revenue. Aided by the recording of $11.8 million in royalty revenue from the settlement with Genesis, licensing revenues increased $14.7 million from the $6 million of licensing revenue we recorded in the fourth quarter of 2005. And our licensing revenue in the fourth quarter of 2006 was up sharply from the prior quarter's $9.2 million level.

After adjusting for Genesis royalty revenue, IP licensing revenues were $10.1 million or 13.2% of total fourth quarter revenues.

Now, let's turn to our overall products gross margins in the fourth quarter. Our overall gross margins on a GAAP basis were 61.6% for the fourth quarter. In comparison, our overall GAAP gross margins were 58% for the same period in 2005 and 58.2% for the third quarter of 2006. Gross margins for the fourth quarter of 2006 on adjusted for the $10.6 million of Genesis royalties were 57.3% compared to 58.1% in the fourth quarter of 2005 and 59.2% in the prior quarter.

Fourth quarter GAAP product gross margins were 50.3%, down from approximately 50.5% in the fourth quarter of last year and 53.1% in the prior quarter. This is largely due to the ASP declines I previously noted. Fourth quarter product gross margins after adjusting for stock compensation was 51% down from approximately 53.5% in the fourth quarter of last year and 53.1% last quarter.

Turning to operating expenses. Our GAAP operating expense for the fourth quarter of 2006 totaled $28.9 million or 37.9% of total revenue in the fourth quarter compared to $24 million or 39.1% of total revenue in the fourth quarter of 2005 and $34.4 million or 43.9% of total revenue in the prior quarter. The GAAP operating expenses in the fourth quarter of 2006 included expense recoveries associated with the Genesis settlement. Offset by certain related legal expenses and incentives.

Excluding $4.3 million for stock compensation expense and $78,000 for acquisition related expenses, the net one-time expense impact of the Genesis settlement on our non-GAAP operating expenses for the fourth quarter of 2006 totaled $28.1 million or 36.8% of revenue. In comparison, non-GAAP operating expenses for the fourth quarter of 2005 were $22.8 million or 37.2% of total revenue. And non-GAAP expenses for the third quarter of 2006 were $26.5 million or 33.8% of total revenue. For the fourth quarter, our operating margin of $24.6 million on a GAAP basis increased by 111.9% over the fourth quarter of 2005 and 120.2% over the prior quarter. On a non-GAAP basis and after adjusting for certain Genesis settlement proceeds, our operating margin of $15.7 million increased by 21.9% over the fourth quarter of 2005, but declined 21.3% from the prior quarter, due to lower revenue and higher operating expenses and incentives.

Now let me take a few minutes to talk about our tax provision in the fourth quarter. During the first three quarters of the year, our GAAP tax provision was 41.7%. Our tax provision for the fourth quarter was impacted by the release of our reserves against our deferred tax assets offset by our increased investments outside the United States, and technology and headcount in line with our relationships with our foreign customers and suppliers. The net effect of these items resulted in a year-to-date tax provision of approximately 25% for 2006. And an unusually low GAAP tax provision of only 5% in the fourth quarter.

For the full year on a GAAP basis, pretax earnings in 2006 were $56.5 million compared with $56.3 million in 2005. GAAP net income in 2006 was $42.5 million or $0.49 per diluted share. In comparison, GAAP net income in 2005 was $49.5 million or $0.59 per diluted share. For a full year on non-GAAP basis pretax earnings in 2006 was $73.1 million compared to $47.6 million in 2005. Non-GAAP net income in 2006 was $68.9 million or $0.79 per diluted share. In comparison, non-GAAP income in 2005 was $46.2 million or $0.55 per diluted share.

I will now make a few comments on the balance sheet and cash flow statements. Our cash and short-term investments continue to grow and totaled $250.6 million or $2.81 per diluted share at the end of the fourth quarter of 2006. In comparison, cash and short-term investments were $151.6 million or $1.80 per share at the end of 2005 and $235.8 million or $2.70 per share at the end of the prior quarter.

As in the slide, after the fourth quarter ended in early January 2007, we paid a net $13.6 million to acquire sci-worx and received $5.4 million in reimbursement of litigation costs related to the Genesis settlement and licensing agreement. Accounts receivable net at the end of the fourth quarter of 2006 was $39.9 million up from $30.1 million at the end of the year 2005 and up from $32 million in the prior quarter. The sequential increase resulted in a DSO of 41 days compared to 44 days in December of 2005 and 37 days from the prior quarter.

Inventory, rose $20 million to $28.3 million at the end of fourth quarter of 2006 compared to $17.1 million at the end of 2005 and $19.6 million from the prior quarter. The increased inventory levels combined with the reduced product sales resulted in our inventory turns slowing to 4.7 times for the fourth quarter of 2006, compared to six times at the end of last year and 6.7 times at the end of the prior quarter.

More than three quarters of our inventory build in the fourth quarter was at the wafer stage. Due to some inefficiencies in our material planning processes, that are now being addressed, we were unable to adjust our material ordering and build plans quickly enough match our customers, as they adjust to their product requirement for several high-volume product.

Based on our current forecast and the corrective action steps already taken, we expect and are committed to reducing our inventories to a more appropriate level for anticipated needs [related] in the end of the June quarter.

Based upon our outlook however, we believe the right level will be approximately $25 million, not far from our levels at the end of 2006.

Depreciation and amortization expense for the property, plant and equipment and intangible assets, were $1.7 million in the fourth quarter of 2006, compared to $1.5 million in the fourth quarter of 2005, and $1.9 million in the prior quarter.

I will now turn to the outlook for the March quarter, and several data points for the full year. As we announced last month, we continue to expect our full-year revenue for 2007 to range between $340 million and $360 million, a 15% to 22% increase over our record $295 million of revenue in 2006, driven by new products, broader and deeper HDMI penetration across more product lines and higher licensing.

Based on our current customer demand visibility, expected product mix and the timing of an anticipated channel inventory correction, we expect our total revenue in the first quarter of 2007, which is seasonally the weakest quarter for CE component supplier like Silicon Image, to range between $68 million and $72 million, a decrease of approximately 6% to 11%, compared with the fourth quarter of 2006, after adjusting for the Genesis settlement.

We expect our non-GAAP gross margins for the March quarter to be approximately 53% to 55%. The lower guidance range for the gross margin for the March quarter reflects the impact of our January 2007 acquisition of sci-worx, now Silicon Image Germany and the fact that a portion of their existing design services activity and other customer programs are charged against cost of goods and services. This is expected to result in about a 2% to 3% impact on our gross margin.

While we expect to continue to honor and support sci-worx's existing contract obligations, overtime Silicon Image Germany's engineering resources, will be increasingly focused on advancing our products and technology roadmap. As this process unfolds, and as our new products increasingly ramp, we expect to see our gross margins improve and our research and development expense to increase.

We also expect our non-GAAP operating expenses for the first quarter to range between $30 million and $32 million in part due to Silicon Image's increased level of R&D activities and its recent acquisition of Silicon Image Germany. Excluding the impact of acquisition related expenses, such as in process R&D charges that may occur.

Also we expect our non-GAAP tax provision to be approximately 55% to 60% in 2007. The increased rate is a result of unbenefitted losses from our increased investment outside the United States in technology and headcount in line with our relationships with our foreign customers and suppliers. The rate will be affected by how quickly we can implement our global tax strategy.

Before opening up the Q&A period, I want to emphasize that management is committed to keeping a tight control on expenses and reducing our inventories to levels appropriate for the business. As we indicated in our press release, we expect inventories to match our anticipated needs by the end of the June quarter, if not sooner. We also announced as Steve said earlier, a stock buyback, which after satisfying Silicon Images' IP and engineering resource constraints and evaluating our future cash flows, we felt it appropriate at this point in time to enter into such a buyback agreement, which represents about 10% of our current market value.

This concludes our prepared remarks and we would like to open up the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions). We go first to Mahesh Sanganeria.

Mahesh Sanganeria - RBC Capital Markets

Hello. Steve, there's too many numbers, so I think I am going to be confused with the numbers. So, I am going to ask you on a strategy question, on your DTV strategy. The question is basically two-part. One is, why do you want to get into a DTV market? And the second is why are you choosing the path you are choosing? So, to elaborate more on that, it's well known that DTV market is pretty crowded and you are coming in pretty late. Why take a chance on that and enter this high risk market, whereas you could probably find better markets to expand your revenues? And on the question of mine, why are you going with the buying -- paying $40 million to Sunplus, you had been working with them for about three years now and you know what they have. And if I look at the display search market share data, they don't appear in top ten. The tenth guy is like less than 1%. So, what I don't understand is, why are paying $40 million and I would like to how are you are going to expense that? Is it going to go in the R&D or it's going to be one-time charge?

Steve Tirado

Okay. Let's parse the question here because your underlying assumption is that we are going to answer the market in the same way you see video processor guys are competing today. Is that correct?

Mahesh Sanganeria - RBC Capital Markets

Yes.

Steve Tirado

And so, this probably required more discussion, but just kind of on a -- first of all, our vision for where to go in DTV is very different than what we are seeing in the video processor market today and that's because, we have a fundamental belief that the architecture in television that these top-tier OEMs are going to be putting out, is going to change. It's going to change in the following way. It's going to have, in many cases, a highly integrated input processor, talking to a backend shift as produced by that top-tier customer. So, when you talk to a Sony or Samsung or Panasonic any of these guys out there, it is very clear to us that their desire is to continue to control the backend image quality because that's what differentiates their brand. So in other words, they are not looking to have, if you will, an Intel Inside like program, because then they will be an undifferentiated product in the marketplace.

So, we believe that the input processor that we've just -- the two products we have just announced are going to be very key parts of a re-architecting of the TV in the marketplace. Additionally, we believe that connectivity for the TV is going to get increasingly important as more and more input sources become available. And here, I am not talking about more new kinds of DVDs and all that, but I am talking about content being sold over broadband connection, content coming in over mobile devices. You're going to see just an explosion of devices all windily connect up and display their content on a television or in a home network, whether that's wired, wireless, power line, you name it, right.

So, our vision for how the market will develop over time, it's very different than what we are seeing in the marketplace today. Now having said that, why did we go by $40 million worth of IP that is primarily DTV related? The answer is, it is critical for us to understand the total architecture and to have all the IP blocks necessary for us to continue on with some of the innovations that we want to go pursue in the marketplace. And so now, you are going to look at the market and say, well geez, I don't see that in the marketplace today and we know that you don't see that today. What we are telling you is we believe there's going to be a significant shift in the market and we are preparing for that by getting the IP.

Now let me get to the second part of your question which is, why $40 million? When we went out to look at the intellectual property blocks, we thought they were important for us to own and also understand, because remember here what we are doing is, yes, we are working in partnership with Sunplus and by the way, we will continue to do other programs with them. We are not going to stop that. What we want it to be able to do is begin to implement a different vision for the way the TV gets constructed. And we think only in the IP is going to be very important for that. But with respect to the -- there's a value of the IP. It is one thing to go and buy all the pieces; it's another thing to have a technology that's proven. And I think anybody will tell you in the market, when you come out with a piece of technology, until it has been banged on by all the other marginal devices out there, you don't work all the kinks out. You don't get your firmware clean, you don't get your processing blocks clean, you don't get your software clean. So, we really look for something that was already built, fully integrated, that we understood really well. And again, precisely because we have had a longstanding relationship with Simplay, we really understand a lot of what we were getting into and we think it's very good technology and its technology that we will take and develop into new products over the next several years.

So, I know it's kind of a long answer; but part of this has to do with understanding what our vision is for the way the television architecture is going to change overtime. Would we produce, for example, a video processor chip like [it has been] in the marketplace today. I think that when we get there -- in other words, do our own products outside of the Sunplus relationship, our products are going to look very different.

Mahesh Sanganeria - RBC Capital Markets

Okay. I don't think I still understood, I think I will have to have an offline discussion with you on this.

Steve Tirado

Yeah. No problem. We are a company that tends to be out there on the edge with some of these things. But, this is very much driven by our very close relationships with some of these top tier customers. We are building these input processor products, because we've been asked to do so.

Mahesh Sanganeria - RBC Capital Markets

So, on the -- how does this $40 million flow through the income statements?

Steve Tirado

I'll let Bob talk about that.

Bob Freeman

Yeah. First of all the $40 million payment is going to be spread over milestone deliverables that are spread over about a year and half. So, it's not $40 million upfront. And then secondly, what we will do is we will fair value the IP under the purchase accounting rules and then we will basically amortize that off over the useful likes of the IP as we determine that. And to some extent, there could be some in-process R&D that we have to address and write-off. But, we will get into that as we go up through our fair valuation.

Mahesh Sanganeria - RBC Capital Markets

So pretty much its -- a pro formal income statement is not going to see this number, although you are going to spend the cash?

Bob Freeman

Well, you will see it as it hits amortization on a GAAP basis but -- on EBITDA --

Mahesh Sanganeria - RBC Capital Markets

But you took the amortization out of the pro forma numbers right?

Bob Freeman

Yeah. That amortization must be essentially a non-GAAP adjustment.

Mahesh Sanganeria - RBC Capital Markets

Then what is the tax treatment since you are paying cash? Do you realize the tax gain? Is it an expense in the tax as you pay the cash to Sunplus?

Bob Freeman

I haven't gone through the tax analysis of that yet. So I don't have a quick answer for you.

Mahesh Sanganeria - RBC Capital Markets

Okay. I'll just ask one last question and I'll cut. The inventory went up 40% and you talked about that. Can you provide us more color, exactly what happened? Because, if I remember in the Q3 conference call, you said the slowdown -- you were not surprised with the slowdown and this was all in the expectation and now your inventory goes up 40%. What was the -- can you give us more color on that?

Bob Freeman

On the inventory level?

Mahesh Sanganeria - RBC Capital Markets

Yes.

Bob Freeman

Yeah. I think basically in terms of looking at our planning systems, we had a disconnect, in terms of several of our products related to our sales forecasts versus our inventory build. But, what we try and do is we try and carry our inventory -- a good percentage of our inventory now at the wafer bank level. So without taking it all the way to the product level, so that we can react quickly to customer demand for products. As it typically, otherwise, would be about a 12 week cycle to get product out of the door. So, we have been increasing our inventory levels to meet that, we just had a breakdown in terms of some of our processes that we were using to forecast our demand. But, we've taken the steps to fix that.

Steve Tirado

Yeah, one of the comments we also made though, is our level do have to rise based on our view of the business. So, that's why we mentioned that we are probably going to get up around $25 million as the appropriate level for at least this first half.

Bob Freeman

And we will have some buildup of inventories for new products that we -- that we're introducing in Q1, Q2 --

Steve Tirado

Yes. Some of our customers require us do quite a buildup in anticipation of their requirement. So that's part of it as well.

Mahesh Sanganeria - RBC Capital Markets

Thank you very much.

Steve Tirado

You are welcome.

Operator

We go next to Jason Pflaum.

Jason Pflaum - Thomas Weisel Partners

Yeah. Good afternoon guys, couple of quick questions here. Just to follow-up on the inventory question, I guess first. Can you talk -- and is there something that -- perhaps there were some customer forecast revisions, maybe you can just give us a sense for what segments those might have been in. And also give us a flavor for how much of this inventory build is really in the new products, maybe the 1.3 product. That would be helpful, thanks.

Bob Freeman

Well, I would say lot of the buildup have to do with the introduction of the 1.3 products and the fact that, that there was a tremendous amount of demand to try and get those into products, early in 2007 from our customers, that's actually the 1.3 products. So, we were making decisions to get started on the inventory buildup, based upon the projections that we were getting from our sales group. In summary, to meet the demand of the customer before we even get a purchase order sometimes we basically have to make a decision that, yes in fact we need to get started.

Steve Tirado

You have to kind of also really the context, we were struggling all year with up demands every quarter, so our operations guys were really running around trying to make sure we had enough supply and the -- some of the customers were actually even saying they wanted to have a certain size buffer et cetera. But, when we take risks like this we tend to go along on new products not on existing products or products we think are going out of production and so, obviously we have been through this.

Bob Freeman

Yeah, we think this thing can be corrected over the next couple of quarters.

Jason Pflaum - Thomas Weisel Partners

Okay, and then maybe just to follow-on with the 1.3, I think in your commentary you mentioned that you are seeing pretty significant traction among the TV OEM's out there. Maybe you can give us some little bit more color there. How deep are you seeing the TV guys push this technology will it be mainstream, maybe give us a shot at where you think the penetration levels perhaps --

Steve Tirado

So, I am not going to tell you too much different than I have in the past, I mean really all of the design wins that I know about are pretty much in the high end. I think there are a couple of companies out there who have very good supplies for the extended panel and I think they may use that as a way of really pushing differentiation. But you think about it, if you brought two TV's and maybe the price difference is 500 to 600 bucks, but you needed that extra money is going to really have you ready for the future, you might want to buy that to pay that difference. So, I don't know exactly what the marketing programs are going to look like, but I think they are going to be pretty aggressive with using that as a differentiator. So, the good news is we got a lot design wins, we know that our product is deployable across many of the TV's that they have because they way they typically design is in by a little card, so they can really decide when they want to decide, where are they going to put us? So, all I can say is we are feeling good about our design win progress and its kind of probably going to get down to how much supply is going to be out there of these new panels. Now having said that we also have a lot of the source device world, one at HDMI 1.3 Chips for the audio. So, they wouldn’t even care about the deep color but they wanted the new audio stuff. So that actually was a nice surprise for us.

Jason Pflaum - Thomas Weisel Partners

And so, can you just talk about how you envision this rollout? Do you get much contribution in Q1 from the TV guys pull in 1.3 or is it, is the build really more of a Q2-Q3?

Steve Tirado

Yeah, it's merely Q2-Q3 where we are going to see it, but we have to start obviously building it up in Q1 and we are already seeing evidence in our order rates that this is coming.

Jason Pflaum - Thomas Weisel Partners

Okay. Then the last question is on the gross margin. Can you just repeat, I think I may have missed that the guidance there and how you see that trending over the next couple of quarters? Thanks guys.

Bob Freeman

Okay. On the gross margin we said it was going to be down for the first quarter. And so around 53% to 55% and a significant portion of that is related to the acquisition of Silicon Image, Germany. In the sense that they do custom work for their customers and as a result a lot of their development costs are taken to cost to sales, whereas most of our engineering work resides in R&D expense. So, we expected that to have kind of a 2% to 3% impact on our gross margins, in the first quarter. Our intent is to eventually, while we are going to continue to support their existing contractual obligations, our intent and the purpose of the acquisition is to focus those engineering resources on advancing our products and technology. So, overtime we would expect to see that impact change.

Jason Pflaum - Thomas Weisel Partners

Okay, so besides I guess normalizing and if you take that out you are still seeing some pressure on the gross margin, maybe you could just talk about what you are seeing from the core business, is it coming more from pricing is it license or royalties?

Bob Freeman

Yeah, I would say more from time scenarios, pricing pressure and typically the first quarter as I mentioned, fourth quarter and first quarter is where we experience the greatest pressure on the pricing until we see some of our new products shipping.

Steve Tirado

I don’t know if you heard this, Jason, we actually characterized the way the ASP's went last year and we think that we look at our data it's sort of traditional. So, in another words where we tend to go down some in Q4 and Q1, last year we were slightly up in Q2, and just kind of moderates a little bit in Q3 and it starts to go down again in Q4, Q1, as we sell off the older products. So that’s kind of the way that we see the business.

Jason Pflaum - Thomas Weisel Partners

Okay. That’s helpful, thanks guys.

Bob Freeman

Okay, thank you.

Operator

We go next to Quinn Bolton from Needham and Company.

Quinn Bolton - Needham and Company

Hi, guys just a few questions. First, can you quantify what the Skyworks revenues will be in the March quarter, because I don't think you had any in the December quarter?

Steve Tirado

We don’t breakout our revenue that way. I know a lot of the analysts that have been asking about this. We are trying to keep people focused, especially as it relates to the licensing stuff and just the total number. I think Bob actually did make some statements about back when we did the announcement about what the general range was, but additionally, what happened was the expenses associated with the operation are roughly covered by the revenues and based on what we said it was just going to be profit neutral.

Bob Freeman

And we expect also, I mean -- they have a lot of IP that hasn't really been exploited and that we are going to be working with them and work our customer base to look at different opportunities.

Steve Tirado

You know our goal with them is really -- the motivation for their doing IP licensing, which is very different than ours. The way we approach the IP business is it is an outgrowth of our chip strategy. So, as we build products in the market, we then look at markets we are not going to serve and then we will make our IP available for complimentary uses. They were a company that was -- that was now in spite the designing services is a part of their business, but they lived -- they really were a true IP company. We are not going to -- over time we will phase out some of their IP developments and only those that are absolutely relevant to our products strategy will continue, and it is those programs that will probably then get licensed out in the marketplace. So, for example, they've got a really a state-of-the-art multi-format video decoder if it does -- BC180C is a very nice piece of technology. We will incorporate that into products and we'll very likely continue to license that in the market, but they had a lot of other pieces that are just not aligned with strategy. So that's kind of what we are saying is we really acquired sci-worx to bring an engineering team with the appropriate skill sets and knowledge in the product areas where we are interested in and we weren't as much interested in the business they had.

Quinn Bolton - Needham and Company

Okay. And then just looking at the annual guidance for 2007, any sense you can give us as to what percent of the product revenue you think may come from 1.3?

Steve Tirado

I stated my goal is to get to about 30 to 50% of the HDMI stuff, last time I think I was at -- I told people we're -- we think we're going to get to at least the lower end of that number. I just don't have enough visibility yet. The orders are starting to come in, when we get in the Q2 and such, I will have a better idea, but that's all I can tell you at this point.

Quinn Bolton - Needham and Company

What was it -- sorry, was that an exit rate or was that for the full year?

Steve Tirado

That wasn’t the exit rate.

Quinn Bolton - Needham and Company

Okay. Okay, great. And then on the -- you said a lot of time at the beginning of the Q&A, you were just talking about the Sunplus IP, sounds like you're not going to come to market with a fully integrated input processor, video processor, single-chip, like many of your competitors that you'll pursue different avenues with that intellectual property?

Steve Tirado

Well the input processor, we are all -- we've already announced--

Quinn Bolton - Needham and Company

Right.

Steve Tirado

--that we're going to really develop that. Now, what is an input processor? An input processor is something that manages all the IOs into the television, the analog, the VGA, the digital provides the switching, and there is a little bit of work that's being done in that front0-end chip. And then it delivers one or two digital streams to the back-end that does all the pretty picture color manipulation, et cetera.

So the input processor market we're very committed to, it's a very core part of our strategy. The input processor in the future may include things like the video decode as well as the MPEG decode. So a lot of the blocks that we've obtained are going to go into that front-end input processor. Now, having said that, we -- I've mentioned this earlier it's important for us to understand the total chip architecture or the total architecture of the television, I understand those back-end processes, then we will develop blocks that can do the back-end, and we probably will, at least inside the company, have these single-chips solutions and at the appropriate time will go to the market. But we don't want to go until we got a really differentiated answer for DTVs, which means that a lot of the work we are working to advance connectivity will be a part of that.

Quinn Bolton - Needham and Company

Okay, so, I mean but the blocks, you think, will reside and the Tier-1 OEMs will be more the scaling generally seen in color processing blocks, you will focus more on the connectivity at the front-end?

Steve Tirado

Pretty much, that’s basically how we think it will go.

Quinn Bolton - Needham and Company

Okay. And then just a last one for Bob, can you just reiterate what the tax rate guidance was I think you said -- you gave us guidance on a non-GAAP basis? I just want to make sure I heard that right.

Bob Freeman

Yeah, that -- we expected that for a while, we are going to see a tax rate in the 55-60% range. And this is a result of us not getting the benefit for some of our expenses that we previously received because of the fact that we increased our investment in offshore activities. And so, we don't have those deductions to offset our US income. So, but what has to happen is we have to transition our revenue and other activities offshore into foreign entities that would flow through and get the benefit of the lower tax jurisdiction. There were in the process of implementing this year.

Steve Tirado

This is a multi-year strategy that actually it takes several years to get to.

Bob Freeman

What we are doing is, what a lot of companies have done ahead of us. And now that we have reached the point, where we are paying taxes and we have to pay attention to this. We are implementing this global tax strategy for the company. And it makes sense for us because about 75% of our revenue is coming from foreign sources. And a good high -- just as high a percentage or more is of our operation and production activity is generated offshore.

Quinn Bolton - Needham and Company

Okay, great. Thank you.

Bob Freeman

Okay.

Operator

We go next to Daniel Gelbtuch from CIBC World Markets.

Daniel Gelbtuch - CIBC Worlds Markets

Hey, guys. Few questions, just a follow up on our tax question. So, we should be essentially dialing in a 55% to 60% tax rate for the full year here?

Bob Freeman

Yeah, I would say that that's probably -- we released our provision, our reserve. We are going to be paying taxes. And going forward over the next two to three years or so, we are going to be looking at a higher tax rate. How quickly we can implement all the other activities to take advantage of the lower tax jurisdictions. That's -- we are going to grow into that.

Daniel Gelbtuch - CIBC Worlds Markets

Do you think for at least a year, if not two, if not more, we should be at 55% to 60%?

Bob Freeman

Yeah. We don't know how quickly we can absorb all of that, but you can go two ways. You can either accelerate it or you kind of level it out or probably level it down. If I take it three years or, so that -- before we get there.

Daniel Gelbtuch - CIBC Worlds Markets

I got you. And as far as -- I am not familiar with the provision, the size of provision. What kind of provision have you taken against this?

Bob Freeman

In terms of how big is the provision, the -- I don't understand the question. You want to repeat that?

Daniel Gelbtuch - CIBC Worlds Markets

You said you released the provision, I am not sure, what --?

Bob Freeman

No, we released the reserve.

Daniel Gelbtuch - CIBC Worlds Markets

Oh, its reserve, I am sorry.

Bob Freeman

We released the reserve against the deferred tax assets and we did that this quarter. And we have been looking at it every quarter. We partially released some of the reserve in 2005. We have been releasing portions of the reserves throughout 2006. And we've got to the point in time based upon our profitability that we couldn't fully justify reserving it. So, we set up those deferred tax assets on the balance sheet by releasing the reserve.

Daniel Gelbtuch - CIBC Worlds Markets

How big is that right now, have you got the reserve?

Bob Freeman

Well, there's zero reserve right now gone from -- other than for selected amount. But at the beginning of the year, it was around some $50 million that we went into 2006 with and so that would be reduced by whatever we've absorbed through 2006.

Daniel Gelbtuch - CIBC Worlds Markets

I got you, okay. And as far as, going back to Sunplus, I am just little confused, what's the difference between the assets you got at sci-worx, the core competency of sci-worx versus Sunplus? I mean, from my understanding Sunplus is in the decode space more so than anything else and it sounds like sci-worx is more into decode as well but perhaps more in the next-gen Codecs. Does either one have any entrancing technology of node and what's the value add of Sunplus versus sci-worx?

Steve Tirado

Daniel, this is Steve. The real value is the fact, they have an integrated TV architecture and so, the real value of these things is stitching it all together and making it work in a high-performance, high-quality way. So, it's not just getting the block. I could have gone out and paid less for all the block if you added them all up. But then, I wouldn't have an architecture and I wouldn't have them all working together. So, part of what we are getting here is that.

The other thing is with respect to their DVD technology unlike sci-worx, it's proven. It's been beaten on by probably hundreds of thousands of product. So we know it's reliable and they can deal with the various implementations that you have out there that plug into your chip and don't work right. So, there is a -- for people in the business, there is a whole lot to be said for having proven technology that's been out in the marketplace long enough and it's field tested. The other thing is stitching it all together, there is real know-how and architecture that goes into putting these things together.

For us to be successful with our own products I really wanted to own the IP and I wanted to give our guys the chance to take something again complete and proven. And from there, we will add our innovations as we go into the marketplace. So, it's a subtle point but for anyone who's in the market and deals with these kinds of chips, they understand this point.

Daniel Gelbtuch - CIBC Worlds Markets

So, basically you're saying that sci-worx is more the team with the know-how and Sunplus, the assets, the proven assets, the field tested assets and field testing IP?

Steve Tirado

That is exactly right Daniel.

Daniel Gelbtuch - CIBC Worlds Markets

Alright, now just to go back to SteelVine, I know you coded the In-Stat numbers -- I'm sorry the HDMI 1.3 coded In-Stat numbers of 130 million. How much do you think is possible that it could be how much of those unit numbers could be HMDI 1.3? And then, as far as HDMI 1.3 currently in the market, is there any product that you see other than, I guess PlayStation 3 that has -- that supports that new standard?

Steve Tirado

Well, I know there are a lot of products coming out that I can't talk about both on the source and down the TV side that will come out supporting HDMI 1.3. I am reluctant to give you a percentage of the market at this point in time. What I can't say is that a lot of this has been on the higher-end product. So, to be higher-end DVD/AV receivers, it will be in the higher-end of the TV, probably the 40 inch and above segment. I mean, this is where you are going to see this stuff. And it depends on how aggressive they want to get and then what kind of panel availabilities are out there. So, I cannot be more specific then that, but at this point in time, as the quarter goes -- as the quarters go on I'll be able to give you a little bit more clarity on it, but it's still too early.

Daniel Gelbtuch - CIBC Worlds Markets

I got you now. As far as what's out there in terms of competition, obviously products that are going to ship in the second half of '07, whether it would be on the source or the receiver side. They probably had been designed already. And when you went to those break-offs did you see -- were there any other 1.3 Silicon alternatives in the market? And will -- do you think the competition is going to be more catered or more geared towards '08 or even '09?

Steve Tirado

Yeah, I mean, I would say those are all correct observation. We didn't see any competition for 1.3 in '06. It was zero. And, so, all of the top-tier guys were working with us around their 1.3 plan. If you look at competitor announcements, they've talked about having stuff available that start sampling like in the first quarter of '07. That's too late for '07. So, I think that they will be focusing on trying to battle in '07 for '08. And I think that's where we will see them. That is part of the reason, why we have moved aggressively to make sure we've got this integrated input processor line we think that will be an important part of our strategy going forward. And of course, we do expect to advance the HDMI standard this year primarily in the service of mobile devices coming on stream.

Daniel Gelbtuch - CIBC Worlds Markets

Okay, last question just -- I think you have much talked about the SteelVine business and your new cost reduced products come. Should we be expecting to see product in the market in the second half of '07 with these new SteelVine products?

Steve Tirado

Yeah. I mean, we announced one win with MSI, but we've got more coming. We -- yeah, and that stuff won't really start to scale until probably, getting into the second half of the year.

Daniel Gelbtuch - CIBC Worlds Markets

Okay. Thanks very much.

Steve Tirado

You're welcome.

Operator

We go next to Tayyib Shah from Longbow Research.

Tayyib Shah - Longbow Research

Hi guys. So, if I look at your 2007 guidance, it kind of indicates that they are going to be a pretty significant ramp from second quarter onwards. I just wanted to know what gives you confidence in that? Is this based on more of a bottom-up approach based on customer forecast or is this based on where -- on more, on a top down approach where you are a looking at where the HDMI market could be in 2007 and working down from there?

Steve Tirado

No, this is all bottoms-up. I mean when we look at the business, especially near-term, we know what sockets we want, and what platforms we are going to be on now. What we don't know is when they give us those forecast are they really accurate, right. Sometimes you add up all your customers and they add up some more from the market, so you know that they are assuming market share gains. So, we are careful to calibrate our numbers, especially from the standpoint of planning our builds and all that. But, this is based on our bottoms-up view of the business.

Tayyib Shah - Longbow Research

Okay and then with this Sunplus cross-licensing agreement, will Sunplus not be updating the IP going forward? Will you develop it on your own? And if so, where you do you stand in terms of having a design team that understands the TV processor IP design?

Steve Tirado

So, it is for a given point in time in terms of the IP. So, we will get -- basically we are starting the transfer process now. So, what we are getting is that state-of-the-art. What we are -- what we will get from them is we will get support and we will get bug fixes and those kinds of things. But, your observation is correct. This is not a -- every time they do a new thing that we're going to get that, if that’s not the case. The team that will absorb this IP is primarily going to be -- well, it's primarily the Silicon Image Germany operation. They are very comfortable with and familiar with pretty sophisticated highly integrated chip technology and so, they will be the ones who are primarily digesting this year.

Tayyib Shah - Longbow Research

Okay, and if I can just get back to the tax rate again. Bob, I mean the 55% to 60% tax rate, is that going to very similar to what you are going to record in 2008 maybe as well or do we start to come down to maybe 30% range or something like that in 2008?

Bob Freeman

No, I think it's going to be for a period of probably closer to three years, and it really depends on how quickly we can ramp up our offshore revenue, and flow that through basically our offshore tax jurisdiction. So, like I said we were a fine candidate for this, because a significant majority of our sales are overseas and essentially we just basically got to flow the activity but you are out of any existing commitments and stuffs like that. So that has to transition over.

Tayyib Shah - Longbow Research

So 55% to 60% is pretty similar to the cash tax expense that you'll be paying as well?

Bob Freeman

No, not really. I think you are using a -- you are using our federal tax rate of about 35% which you're not getting as much of the deductions that you would normally have because now they are offshore.

Tayyib Shah - Longbow Research

Okay.

Bob Freeman

So that’s what essentially is inflating on tax provision.

Tayyib Shah - Longbow Research

Okay. Thank you, guys.

Bob Freeman

Okay.

Operator

Thank you. At this time we go to Jeff Schreiner from American Tech Research.

Jeff Schreiner - American Technology Research

Hey, good afternoon guys.

Steve Tirado

Good afternoon.

Jeff Schreiner - American Technology Research

Steve, I was wondering if you could talk a little bit about the Analogics lawsuit. It seems a little bit unique in some of the assertions made by Silicon Image against Analogics. I wonder if you could maybe provide us with what the company sees is possible estimated damages incurred by the charges asserted. And does this damage trouble. Is this an infringement type suite -- [local] infringement type suite? Just looking for a little color there?

Steve Tirado

So, actually I got Ed Lopez, our Chief Legal Officer. I am going to let him comment on that.

Ed Lopez

Hi this is Ed Lopez. The claims that we filed are not patent claims. So, there maybe some well furnished aspect to it whether it results in trouble and damages and again its not a patent claim. What we are looking really in this litigation it's for damages of course, but also primarily when jumped it from these to prevent the unlawful conduct from continuing. As we are alleging the complains, basically we were alleging the copyright infringement, misappropriation of trade secrets and unlawful and unfair business practices.

Jeff Schreiner - American Technology Research

Okay. Bob, could you talk a little bit about the pricing and legacy HDMI right now. It seems like things are getting a little rough out there? Is it getting quite competitive in the legacy versions of HDMI right now within the marketplace?

Bob Freeman

What you do mean by legacy?

Jeff Schreiner - American Technology Research

I would say Versions 1.1 to 1.2?

Bob Freeman

Yes, so definitely there is more price competition in that area. One of the ways that we have continued to differentiate ourselves even in that area is due to what we are doing with Simplay Labs. So, the interoperability testing and the robustness of your solutions, especially as it relates to HDCP key management. So, we have this thing called triple key validation that is something that really gives our customers a lot of comfort in that. We have an excellent program, we shift over 100 million keys, so we know how to prevent things like corruptions and duplicates and selective authentications; that being when you plug to devices. Some times it works, some times it doesn’t. We can virtually guarantee to our customers, those who will never happen with us.

So, what we are finding is, yes the prices have gone down but there is an ability on our part to charge a premium, largely because people know the quality is there.

Jeff Schreiner - American Technology Research

Okay. And would you say Steve, that your competitors really haven't been able to catch up to Silicon Image and their technically know how related to interoperability and quality?

Bob Freeman

I would say that they, they do not yet know how complicated this gets and how big of an issue this is. We have seen it because we have shipped over 100 million keys and we got a very rock solid system, we work through all the budget, our top-tier customers. And by the way, they know how important this is as well. So, until you kind of get up there and you start really shipping a lot of products, its not so clear about what the potential issues might be. And to get back to my point earlier, that when we were discussing the IP and how we were looking for proven IP, what happens is you have to get in the market and have your products plug into a lot of other products to find out all the marginal things that go on out there, so that you can make your products robust and up to withstand that kind of marginality. And, so, I think that's really where we have an edge and why many of the top-tier guys are reluctant to opt us out. Now, having said that when a competitor comes in and says I am going to offer you a lower price, I can guarantee you my customer will come to me and say, I need a discount. And, so, you are seeing our prices fluctuate about 4% to 5% per quarter average on an existing product and I don't think that's going to change.

Jeff Schreiner - American Technology Research

Okay. One other question, I just wanted to ask you and then we will just wrap it up for the evening. I wonder how we should really look at the core business right now. You guys aren't really going to give us what sci-worx is going to do and we can always make assumptions, and soon if sci-worx in a long run may prove to be a very effective acquisition for Silicon Image. But in the short run it really seems that with the guidance provided for March, things within the core business, looking at, what is within December going into March had really slowed down and typically is your seasonally slow quarter. But will you be far [back off] base to say that the 6% to 11% that do reflect the core business at this point that you've guided to?

Steve Tirado

You should -- does not or does?

Jeff Schreiner - American Technology Research

Does not?

Steve Tirado

No, I would say that it is the main business that's driving this. I mean that is the vast majority of the revenue. Even if I were to break it out right, you would see that is the vast majority of the revenue and bear in mind, again, I'm not trying to be cute or anything. Our intention with sci-worx was always to rededicate those resources around a different business model that compliments our product strategy, which is why we don't want to put a lot of focus on what they were doing or how they were generating revenue because we're really going to shift them away from the model they were using before and make them consistent with ours.

Jeff Schreiner - American Technology Research

Okay. One quick question just to finish it up, I appreciate your time. 10-bit versus 12-bit within the digital television market, why did the customer need to move so quickly to version 1.3 this year if 10-bit seems to be the sweet spot currently by your end customers?

Steve Tirado

Well, so when you say 10-bit, what you're referring to I think is that the video processors today do 10-bit right?

Jeff Schreiner - American Technology Research

Correct.

Steve Tirado

The problem with that though is the pipeline from the source all the way to the glass is not 10-bit, and that's where the HDMI 1.3 opens up. The video processors all along have been able to do higher quality. They just can't get the bits in and they can't get the bits out. What we've done is we've opened the whole pipeline up, so that you can process up to 16-bit, if you want to go that fast. And so it's now -- the content is short in 10-bit, it's able to be sent in 10-bit, and they will be processed in 10-bit and then sent to the glass and the column drivers if you will. Literally the group inside of the LCD monitor can manage to get more colors above the screen. So it's enough just to say you video process 10-bit. You got to have a pipe from the -- the source has to be shot that way and you have to have a pipeline, all the way to the glass that allows that, and that's what HDMI 1.3 is all about, [and we are] enabling that pipeline for the content.

Jeff Schreiner - American Technology Research

Well, thank you gentlemen.

Steve Tirado

You're welcome.

Operator

Thank you. We'll now go to Aalok Shah from D.A. Davidson.

Aalok Shah - D.A. Davidson

Hi guys. A couple of quick questions and I'll probably take some more offline. But just in terms of the gross margin, I'm little confused Steve. You guys had said before, you expect to see some improvement in gross margin on the core business -- couple of quarters. I think you said that in Q3. And I'm surprised -- have you guys seen all of a sudden, an ASP pressure that you weren't aware of, or did something else happen along those lines? And then the second question is, how much of a premium is there for HDMI 1.3 right now for you guys, is there much of a premium, or should we expect that to be the same ASPs as your 1.1 or 1.2 products at this point?

Steve Tirado

Okay, let me part the question here. So the first one was related to -- now you are asking about the margin guidance or the current quarter's margin?

Aalok Shah - D.A. Davidson

Current quarter, Q4, I mean it was down quite a bit too. I mean, so its -- I guess some --?

Steve Tirado

When you say down quite a bit, you are saying 57.3.

Aalok Shah - D.A. Davidson

57.3 versus 59.2, down 200 basis points.

Steve Tirado

Yeah, but we had outlooked 56, I think the 58, right. No, we said -- or was it -- no, I think it was 57 to 59, which was the guidance, right?

Aalok Shah - D.A. Davidson

Right.

Steve Tirado

So we came in a little lighter than we would have liked. I don't know what to tell you, that's probably about as accurate as we get on something like that. But what it means is, there was a mix shift in some products that were little bit lower margin, than we had anticipated going into the quarter. What was the second part -- the second part of the question was --?

Aalok Shah - D.A. Davidson

I guess the HDMI 1.3 premium if there is one now?

Steve Tirado

Yeah. We probably get about a 25% to 30% premium over the pricing you'll see in the market today for what -- I know the gentleman was calling legacy HDMI, if there is such a thing. But if you look at 1.1, 1.2 silicon [assets] and you look at pricing. 1.3 chips are going to get about 25% to 30% premium over that.

Aalok Shah - D.A. Davidson

Okay. And do you expect that premium to probably exist until competitors enter the market, I am assuming?

Steve Tirado

Well, we will just see this goes. What we are doing at going upstream, we are going to be operating input processors at a much higher average selling price that will partially impact our business in '07 and dramatically impact it in '08.

Aalok Shah - D.A. Davidson

Okay. And then one point for -- is that still on the roadmap for this year, or is that more of an '08 story at this point?

Steve Tirado

Well, we are driving real hard to get 1.4 out. We may actually even do two releases. There is a short-term release we are looking at and we are considering doing, that could come out as soon as June. That wouldn't address probably the mobile stuff -- the mobile stuff probably would come till the end of the year. But there is some interest on the part of the founders to take a look in breaking some features to the standards that would address some issues for the PC market. What's happening is, we are just getting a lot of traction for HDMI in the PC space, and there is some things we can do, for example, allowing people to do -- basically implement the technology in a very small process geometries of variable voltage. So there is ways we can accommodate that within the standard. So we are looking at doing that shorter term before we started attacking some of the mobile issues.

Aalok Shah - D.A. Davidson

Okay. Great. Thank you.

Steve Tirado

You're welcome.

Operator

Thank you. We go next to Adam Benjamin from Jefferies.

Adam Benjamin - Jefferies and Company

Well, thanks. Couple of questions guys, just a follow-up on the gross margin again. It seems like the guidance implies about 400 basis point sequential decline. And it seems Bob, you indicated maybe about 100 basis points is due to ASPs decline and then another 300 has to do with this Skyworks acquisition. So, I am just as you look at Q1 and beyond that, the Skyworks acquisition this is the first quarter fully -- as a part of the company, we should expect that range to continue throughout '07?

Bob Freeman

No, I think it's as roughly you said as we are going to support their existing commitments and contracts for design work. But, their design work is not long-term projects. So, I think we are going to be transitioning a lot of the engineering effort to support our investment and direction to other video processor market. As Steve mentioned, a lot of their Sunplus IP that we have now got access to, we are going to be utilizing those people in Germany who understand that business to work on some of our particular products related to that.

Steve Tirado

My goal Adam, is that by the end of 2007, they are completely 100% aligned with the way we are doing business, which means that the way that we are accounting for those resources will go down to the R&D expense line and not the part of the cost of sale.

Adam Benjamin - Jefferies and Company

Okay, so asked a different way throughout '06, your gross margin trended basically between 58% and 59%, and now you are guiding at the mid point 54. So, it sounds like this transition needs to continue throughout the rest of '07 and we basically complete as we have finished the year. So, should we be thinking about resetting that base from the 58-59 range to the 54%-55% range?

Bob Freeman

I would say in the short-term and look when I give you the guidance on a quarterly basis that where we see that movement, but I think, now we are also seeing some decline in terms of our revenue guidance as well and our typical pressure on margins in the first quarter. But, I would say that the bulk of it is going to be just the additional. IP cost relative to the design work that sci-worx has done.

Steve Tirado

Yeah, so as Bob said earlier in the call. I don't know if you were able to get the whole thing but it's about a 2% to 3% hit.

Bob Freeman

Yeah.

Adam Benjamin - Jefferies and Company

Alright.

Steve Tirado

So, as we begin to shift the resources than that will come off of the margin there and so we should see an improvement.

Adam Benjamin - Jefferies and Company

Alright, Okay. Just moving over to the Analogics litigation just a follow-up on that. Didn't hear in kind in the marketplace that they have been gaining some share. I am assuming that you guys are pursuing a litigation strategy and spending money with lawyers there obviously because you feel as if they are a viable threat?

Steve Tirado

No I will let Ed answer that.

Ed Lopez

No, that's not the case. The case is only about the best of intellectual property, dis-appropriation of our intellectual property and then using non-intellectual property in their products, that's what this case was all about.

Adam Benjamin - Jefferies and Company

Okay. Can you quantify how much in legal expenses you guys are estimating kind of throughout the rest of this year or into '08 as this litigation progresses?

Ed Lopez

Well we can't comment on that at this point and since it's too early to tell. We've just filed the complaint, we won't be receiving -- we expect to receive a respond in next 30 days or so and then we'll see how that moves forward.

Steve Tirado

Yeah. We'll try to probably give you some sort of estimate may be next quarter.

Adam Benjamin - Jefferies and Company

Okay. I mean typical customer legal costs or some of these litigation impact, and infringement cases that I have seen in the past is like a million or two a quarter, is that kind of in the ballpark?

Ed Lopez

Again this is not a time for infringement case and we are talking about having infringement in those numbers, interim expense but it really is not a patent case. So, we have discovered at this point, what we expect the litigation to run against toward the (inaudible).

Adam Benjamin - Jefferies and Company

Okay and then just a follow up on display port. Genesis has talked publicly about how they see that moving, how the contortion has adopted display port and expect to see that continue to see some traction throughout '07 and into '08. I am just curious can you talk a little bit how that impacts your existing PC business?

Steve Tirado

I think in '07, it won't. I think that if the guess is going and there is no reason to think if they couldn't as long as their order is out there for product from OEMs like Dell, they are saying, hey, I want display port monitor or I want display port chip for the PC side. But, I don't really see it coming into play in '07, possibly in '08. We'll have to wait and see. We have been surprised at how much traction we are getting for HDMI on the PC. And even some of the customers who have talked about display port are now saying they are positioning HDMI as the replacement, for like S-Video and they are positioning display port as a replacement for VGA. But I would argue that I still think it's really extra cost, with no benefit. HDMI in my view really represents the thing to do and there is really no need for another digital interface.

Adam Benjamin - Jefferies and Company

Okay. Just two quick follow-ups. On the 1.3 Steve, can you comment as to what the ASP differential is versus 1.2?

Steve Tirado

Well, what I said earlier was that there is about a 25% to 30% premium for an HDMI 1.3 over maybe a 1.2 or a 1.1 shipped in the marketplace.

Adam Benjamin - Jefferies and Company

Okay. And then lastly, as you look at your full year guidance and historically it seems like consumer has been representing about 50%, going as high as almost 60% of total revenue. Do you see that composition changing much as you exit '07?

Steve Tirado

No. I think that just all of the strength is there. Actually I think our numbers are even closer to sometimes 65%. So, it's just the growth rate, the growth is there. Obviously, we are doing everything we can to push up our other businesses. But our primary engine these days is the CE business.

Adam Benjamin - Jefferies and Company

Okay. So based on your current guidance, you are not factoring in much growth from the other two businesses?

Steve Tirado

There is -- but yes, the primary engine of growth is CE.

Adam Benjamin - Jefferies and Company

Thanks guys.

Steve Tirado

Okay. Thank you.

Bob Freeman

Operator, I think we have time for maybe one more question and then we have some concluding remarks we would like to share with the people on the call.

Operator

Thank you. Our final question comes from Mahesh Sanganeria.

Mahesh Sanganeria - RBC Capital Markets

Yeah. Just two quick questions, one on gross margin and on tax. I just wanted to confirm that you said 55% to 60%, that's in non-GAAP tax?

Bob Freeman

Well, it's -- GAAP or a non-GAAP, it's going to be the same.

Mahesh Sanganeria - RBC Capital Markets

Okay.

Bob Freeman

Hello. Operator, did he get cut off?

Operator

(Operator Instructions).

Bob Freeman

It sounds like we lost him.

Operator

Sounds like we did.

Bob Freeman

Okay, we are going to wrap up. Thank you, operator. But before wrapping up the call, let me quickly recap several important points. Number one, HDMI continues to gain traction, industry analysts project that HDMI-enabled devices will more than double in '07 to over a 130 million devices.

Number two, Silicon Image is really well positioned with top tier customers who have committed designs to our Silicon for '07. These customers include Sony, Sharp, Samsung, LG, Mitsubishi, Dell, HP, Apple, ASUSTeK and Philips, as well as several others.

Number three, HDMI 1.3 will be viewing the future years as one of the most important HDMI releases for significantly improving audio and video quality for the HDTV device world and we will capture most of the 1.3 sales in 2007. And finally, we have significantly strengthened our IP portfolio, engineering resources, and SoC design capabilities through recent initiative including the acquisition of sci-worx and the IP agreement we announced early this week with Sunplus. We believe Silicon Image now has the IP development channel and product strategy, for sustained revenue growth, as we drive the architecture and implementation, the storage distribution and presentation of high-def content in the HD connected home and mobile environment.

We look forward to keeping you apprised of our progress. Once again thank you for participating in today's call, and for your interest in Silicon Image.

Operator

And that does conclude today's conference. Everyone have a great day.

TRANSCRIPT SPONSOR

Better Than AdSense

What if there was a way to promote your company to a perfectly targeted group of potential customers, partners, acquirers and investors? What if you could tailor your pitch to them at the moment of maximum interest? And what if you could do this for a no-brainer price?

This is exactly what Seeking Alpha is offering with transcript sponsorships.

Six types of companies are sponsoring earnings transcripts on Seeking Alpha:

1. Company sponsors its own earnings call transcript (example).

2. Company sponsors partner's transcript (example).

3. Company sponsors competitor's transcript (example).

4. Issuer-sponsored research firm sponsors client's transcript (example).

5. Investment newsletter sponsors transcripts of successful stock picks (example).

6. IR firm sponsors transcript of micro-cap company (example).

7. Consulting company sponsors company's transcript in sector of interest (example).

Your company's name and promotion could have been on this transcript! Learn more, or email Zack Miller for details.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Silicon Image Q4 2006 Earnings Call Transcript
This Transcript
All Transcripts