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DTS, Inc. (DTSI)

Q4 2006 Earnings Call

February 20, 2007 5:00 pm ET

Executives

Erica Abrams - IR

Jon Kirchner - President and CEO

Mel Flanigan – CFO

Analysts

Robert Stone – Cowen and Company

Ralph Schackart - William Blair

Murray Arenson - Ferris, Baker Watts

Alan Davis – DA Davidson

Barbara Coffey – Kaufman Brothers

Mike Altman – Piper Jaffray

J.D. Padgett - The Boston Company

Gordon Hodge – Thomas Weisel Partners

Steve Granchy – Granchy and Capital Management

Doug Benton – Uriah Global

Presentation

Operator

Welcome and thank you for standing by. Welcome to the DTS fourth quarter and fiscal year 2006 conference call. During today's presentation all parties will be in a listen only mode. Following the presentation the conference will be open for questions. If you have a question please press "star-one" on your touch tone phone. If you'll like to withdraw your question, press the "star" followed by the "two". If you're using speaker equipment, we ask that you lift the handset before making your selection.

This conference is being recorded today, Tuesday, February 20th, 2007. I would now like to turn the conference over to Erica Abrams. Please go ahead, ma'am.

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Erica Abrams

Thank you. Good afternoon ladies and gentleman. Thanks for joining us as we report fourth quarter and fiscal 2006 financial results for DTS. Joining me on the call today are Jon Kirchner, president and CEO and Mel Flanigan, CFO of DTS.

Before we begin, let me remind you that during this conference call management may make forward looking statements within the meanings of the private security's litigation reformat of 995. Such statements are subject to known and unknown risks, uncertainties or other factors that may cause the company's actual results to be materially different from historical reports or any results expressed or implied during this call.

The potential risks and uncertainties that could cause actual results to differ materially include, but are not limited to, the timing costs and attention attended to the divestiture to our non-consumer business, the transition to the next generation optical drive and consumer adoption of such technology, the rapidly changing and competitive nature of digital audio and images, including the transition to digital cinema, consumer electronics in the entertainment market, the company's inclusion and/or exclusion from governmental or industry standards, acceptance of the company's technology products, services, and pricing, risks related to the ownership and enforcement of intellectual property, the continued release and availability of entertainment content containing DTS audio sound tracks and risks related to integrating acquisitions and changes in domestic and international markets and political conditions.

The information in this conference call related to projections or other forward looking statements is based on current expectations. The company does not intend to update its forward looking statements should circumstances change.

Management’s discussion on this conference call also includes financial measures for non-GAAP, net income, and earnings per share that are not calculated in accordance with generally accepted accounting principles.

The company believes that non-GAAP net income and earnings per share, which exclude stock based compensation expenses, separation and restricting costs, and the impact of a consolidation of the results of Abaca Technology Corporation enhance investors ability to evaluate the company’s operating results, and compare current operating results with historical operating results.

Reconciliation between non-GAAP and GAAP measures can be found in the tables that accompany the press release that were issued earlier this afternoon, and which is posted on the investor section of the company’s website at www.dts.com, or on Yahoo! Finance.

Now I will turn the call over to Jon Kirchner, President and CEO of DTS. Jon, please go ahead.

Jon Kirchner

Thanks to all of you for joining us today. As you know from today’s press release, our board of directors has approved a plan to sell our cinema and digital images business now known as DTS Digital Cinema. I will briefly discuss this decision and the status of our respective businesses at the end of 2006.

Following my comments, Mel will provide a more detailed view into our 2006 financial performance and discuss our expectations for the coming year. I will wrap up with comments about our future outlook.

In recent months, we have been evaluating how best to separate our businesses and have spent a lot of time working through business and financial plans, preparing separate financial statements, and taking important steps to better position each business for a more successful future.

This has been a time consuming process, especially considering that it took us 14 years to build an integrated global business. Our decision to sell the digital cinema business comes from our belief that in order to better serve our customers and compete in two different highly dynamic markets, each business needs a singular focus.

DTS will continue as a business purely focused on licensing intellectual property and branded technologies to consumer electronics integrated circuit and content providers. We believe this business is highly attractive due to its potential for great scalability and high margins.

As you know, the consumer industry is in the midst of a major shift to high definition delivery formats which presents a major growth opportunity for our business.

During the fourth quarter we took important steps to position the consumer business for greater growth and long term profitability. First, we restricted our international licensing operations and took steps to establish a new headquarters in Ireland. This entity will enable us to take advantage of a skilled international talent base, EU supported economic development initiatives, and better serve our international customers. Over the long term, we will also benefit from lower overall operating costs.

In addition, we concluded a deal with a partner to buy out a commission agreement relating to licensing our intellectual property in China. Which, while resulting in a fourth quarter charge, paves the way for greater profitability and improved operating control going forwards.

And finally, we redirected the primary focus of our DTS entertainment group away from the production and sale of DVD discs towards supporting content providers in their adoption of DTS technologies.

Throughout 2006 we worked tirelessly with studies and distributors around the world to support the role-out of HDDVD and Blue Ray content, the wide availability of which is a critical factor in accelerating the launch of the formats.

To date, we have already seen approximately 150 releases of HDDVD or Blue Ray titles with DTS capability.

As we close the year, the number of consumer electronics manufacturers shipping hardware player models and hardware support models, is expected to go online in the first half of 2007. Notably, one manufacturer, LG Electronics, has announced a multi-format player.

In the PC market, we began to see revenue from PC manufacturers who are releasing HDDVD and Blue Ray laptops.

Meanwhile, the launch of the PS3 finally got underway, and we believe that the game console market will contribute significantly to our growth over the next two years, given that DTS is a mandatory technology in the PS3 and the X-Box 2 HDDVD drive accessory.

In the broadcast market we announced the first customer who will deploy DTS technology as part of their broadcast solution. Using a combined DTS encoding technology solution, HDTV service provider, Euro 1080 will implement and deliver multi-channel audio over satellite to next generation set-top boxes for HDTV in households across Europe.

We continue to support other prospective customers in their evaluations and we expect to expand our progress. We continued to support other prospective customers and their evaluations and we expect to expand our progress in this market later this year.

Turning towards the discussion of our cinema and digital images business, over the past year we've made great strides in shifting our operational focus toward the accelerating opportunity in D-cinema digital-content delivery. Early in 2006, we took the first step in preparing and expanding our back-end capabilities with the acquisition of digital booking systems, which will be used on more than 1,700 screens globally by the end of the first quarter.

Later in 2006, we expanded our digital product and technology platform by concluding a deal with Abaca, which helped to accelerate our entry into digital cinema. With this licensing arrangement behind us, we aggressively restructured our engineering and development efforts to focus on completing an end-to-end solution for our content and exhibitor customers, based on a robust platform of hardware, software, and services.

While it is still early, the results of these efforts are encouraging. We recently announced an agreement with DCL to install and manage a trial deployment of 25 D-Cinema systems in Ireland.

Within weeks, we'd installed the systems in theaters, and within 45 days exhibitors were showing digital cinema content to paying customers; content that had been digitally enhanced, encoded, packaged, and delivered by our digital images and content-services group, in a DCI compliant form.

This is an important milestone for DTS digital cinema because we were able to showcase our many strengths. The breadth of our capabilities, the depth of our knowledge of the cinema environment, and our ability to respond very quickly to customer needs.

In the digital-images business we've also made significant progress. Over the past two years we've worked aggressively to modify the cost structure of this business and enhance the technology platform. As a result, during 2006 we were able to complete more than three times the number of projects than in 2005, increase revenue by 50% over the prior year, improve growth margins, and gain access to newer and faster-growing markets like pre-compression processing and D-Cinema content preparation.

With a semi-fixed cost base, these opportunities should deliver higher margins over time, positioning this business to be a meaningful, profitable, and strategic contributor to DTS digital cinema.

We believe that with these steps behind us, we have positioned the digital-cinema business for growth and future profitability. We have started to market this business to strategic and financial buyers. As expected, we have received solid interest given the broad awareness of the major opportunity represented by the global conversion of the motion-picture industry infrastructure. From this point forward, we expect to account for DTS digital cinema as a discontinued operation until the sale is completed, which is expected later this year.

In many respects, 2006 was a challenging year due to the delays and roll-out of HDDVD, Blue Ray disks, and the PS3. This impacted our original outlook and caused us to moderate our expectations several times during the year.

Despite this, we believe it was a productive and strategically important year for DTS. We laid the groundwork for a different and compelling future as the launch towards high-definition delivery begins to take shape. We look forward to telling you more about our plans in the upcoming months.

Now I'll turn the call over to Mel for a detailed financial review.

Mel Flanigan

Thanks, Jon.

Hello, and thank you all for joining us this afternoon. For fiscal year 2006 we reported total revenue of $78.3 million. Cap-net income for the year was $3 million, or $0.16 per diluted share, including $3.6 million in stock-based compensation charges under FASB123R, $3 million in restructuring costs to buy out a commission agreement for licensing-out our technologies in China, $800,000 in inventory and other asset write-offs relating to the restructuring activities of our DTS entertainment label, and $1.1 million in costs related to the separation of the business.

Also included in the results for 2006 was approximately $300,000 in expenses related to the consolidation of Abaca with our results. I'll talk about the Abaca accounting in a moment.

Excluding these items, our non-GAAP net income for the year would have been $10 million, or $0.54 per diluted share. We wrapped up 2006 with a softer-than-expected fourth quarter, reporting revenue of $17.5 million. This shortfall was primarily related to ongoing in the market for standard-definition DVD products, in front of the expected ramp-up in high-definition technologies

GAAP net loss for the quarter was $5 million, or $0.28 per share, including $3.8 million in restructuring costs, $1 million in stock-based compensation expense, $700,000 in separation costs, and the $300,000 in Abaca expenses.

Excluding those charges, non-GAAP net income would have been $100,000, or below the outlook we provided last quarter.

Let me address a couple of housekeeping issues before getting into some more detail on our results.

First, included in our 2006 results and on our December 31st, 2006 balance sheet, is the impact of consolidating results in financial position of Abaca. Our license agreement with Abaca can be interpreted to give DTS control over their activities and income streams. And this must be consolidated under GAAP.

The effect of Abaca in our statements is to increase our assets by $3.6 million, liabilities by $3.9 million and to increase expenses by about $300,000. It's worth noting that while we present Abaca’s liabilities on our balance sheet we have no obligation to fund the payment of those liabilities.

Also as you know from our press release, beginning in the first quarter of 2007, we expect to start reporting the DTS digital cinema business as discontinued operations. As a result, you will see the net-loss of the digital cinema business reported in one line on our P&L. We will also provide information relating to income and earnings per share from continuing operations and income and earnings per share on a consolidated basis.

Overall stock base compensation in 2006 was $3.6 million or approximately $1 million per quarter. Because we'll be in the second year of adoption of 123R in 2007, we don't intend to continue our non-GAAP presentation for these costs. We expect to continue to see about $1 million in stock base compensation cost per quarter next year based on options currently outstanding.

And getting back to the fourth quarter in 2006. Revenue from technology and film licensing was $59.1 million for the year up 4% from 2005 primarily due to our car and PC activities.

In 2006, we saw strong growth in revenue from both the car and PC markets. The car market was particularly strong posting a growth rate of nearly 90% for the fourth quarter over 2004 and 2005 and over 80% for the year. The PC market was also solid posting growth of over 23% for both the fourth quarter and fiscal year.

Combined, these two markets now represent nearly 20% of our overall licensing revenues. We expect continued growth in both of these markets, although we would expect to see the car market growth rates to moderate somewhat and the PC market to accelerate in 2007.

Our core home AV business was essentially flat for the year, in part driven by softer than expected results from our domestic China operations. Film licensing posted 2% annual growth over the prior year coming in pretty much as we had expected. Product and other revenue for fiscal year 2006 was $19.3 million, up 5% over the prior year.

Growth in our digital images business more than offset declines in both our cinema hardware and DTS entertainment businesses during the year. As expected, our digital image business posted 50% revenue growth for the year as a result of a number of operational and process improvements that were implemented over the past 18 months.

For the fourth quarter product revenue was $4.7 million, down slightly from the prior year, driven primarily by lower sales of the cinema hardware as the US exhibition community has slow purchasing decisions while they evaluate these cinema alternatives.

SG&A expenses increased 23% over the prior year including $3 million in stock based compensation under status 123R. Excluding these, our basis SG&A increased 14% over the prior year, primarily related to targeted staffing increases to support our expected growth in both the consumer and digital cinema businesses.

R&D expenses in 2006 increased 25% over last year primarily to support our broadening product development agenda and the ongoing support of the roll out of Blue Ray disks and HDDVD. In addition about 5 percentage points of that increase was stock based compensation under status 123R.

Going forward, we expect to revisit and fine tune our operating infrastructure to support a highly competitive global company focused on IP licensing. As we plan for and ultimately execute the sale of the digital cinema business we are simultaneously working to identify infrastructure GAAP, needing investment as well as opportunities to gain operational efficiencies and create further leverage as our revenue grows.

Turning to the balance sheet, we close with cash equivalent and short term investment of $111 million, essentially unchanged from a year ago. Accounts receivable totaled $7.5 million and inventory ended at $3.2 million. Overall the balance sheet remains very strong.

To help put some context around our businesses and their future opportunity, it's useful to look at each business unit's performance for the year 2006 versus 2005. Total revenues in our consumer business were $50 million, up slightly over 2005 due to growth in some of our key markets, including car and PC as I mentioned earlier.

Growth margins were strong at 97%. Our cinema business contributed revenue of $20.3 million in 2006, down 7% from the prior year due to the decline in sales of cinema hardware. Gross margins in the cinema business were 49%, mostly unchanged from the prior year. Our digital images business reported revenue of $8 million up nicely from $5.3 million in 2005. Gross profit from this business was slightly negative for the year. 11% in the fourth quarter, as we began to realize the benefits of our cost reduction efforts and process improvement in that business.

Now turning to our outlook for 2007.

We'll provide an outlook solely for the consumer business going forward and with the uncertainties around the timing of our separation process and the very ability inherent in the consumer licensing business, we'll only provide a full year outlook at this time.

As you know from our press release we expect revenue for the consumer business to be in the range of $53-58 million. As we begin to see acceleration and long term growth cycles for the high definition optical media format, year-over-year royalty recoveries are expected to decline by more than $7 million to $4 million in 2007.

Excluding royalty recoveries, licensing growth would be in the range of 26-38% in 2007. To support the growth in our revenue stream we intend to continue to invest in R&D to remain competitive. In addition once the digital cinema sale is complete our SG&A costs will be entirely born by a smaller public company and will initially weigh heavily on our operating results.

Over time we expect to realize certain operating efficiencies and cost savings due to the reduced complexity of operating a single business. For 2007 we're assuming the consumer business will post gross margins of 97-98% and operating margins of approximately 20%. We expect to see significant leverage in our cost structure and expect operating margins at or about 50% within the next five years.

From an EPS standpoint we expect $0.40-0.47 from continuing operations in 2006, on our assumed share account of $18.5 million and a tax rate of 40%.

With that, I'll turn it back over to Jon for his closing remarks. Jon?

Jon Kirchner

Thanks, Mel. As we look forward in 2007 and complete the separation of our business, Mel and I and other members of our senior management team will devote our full time efforts to growing a highly attractive scalable consumer licensing business.

We will focus on the markets for HD players, home audio, PCs, game consoles and broadcast, and expect these opportunities to drive significant revenue and profitability over the next five years.

In the high definition player market, equipment is already shipping. We expect more than 2 million players to ship globally in 2007 with the long term opportunities significantly higher than that.

To put some perspective on this, in the last DVD cycle more than 200 million players were sold in the US alone. In the home AV space, increasing sales of high definition displays are driving consumer interest in higher quality equipment and coupled with the introduction of new audio and interface technologies it should lead to upgrades in audio systems.

In the PC market we expect HD capable drives to substantially replace DVD drives just as DVD has replaced CD-ROM. Global market opportunities for consumer PC optical drive is projected at more than 100 million units annually.

In game consoles, DTS is a mandatory technology in the PS3 and X-BOX2 HDDVD drive accessory and unlike the prior console cycle where we generated no revenue, manufacturers are expected to ship more than 15 million DTS capable game consoles during 2007.

And the broadcast space, we're beginning to monetize our efforts with broadcasters like Euro 1080 and we expect other opportunities to follow from current consumer evaluations, excuse me, current customer evaluations.

The laptop box market is expected to grow more than 100 million units in the next five years, and we believe this opportunity represents an important long-term growth driver for DTS.

DTS is also working on a number of new technology initiatives focused on enhancing the PC and portable entertainment experience, which we believe are strategically important over the next five years.

In short we are very optimistic about our future as a focused IP licensing business. This is an exciting time as our company undergoes the final stages of a major transition and our end markets are entering a new cycle of acceleration.

This has also been a time of great commitment and effort from our employees who are working hard to position our businesses for a more successful future, thanks to all of you.

Now operator, please go ahead with questions.

Question-and-Answer Session

Operator

Thank you sir. Ladies and gentlemen, we will now begin the question and answer session. As a reminder, if you have a question please press the * followed by the 1 on your touchtone phone. If you would like to withdraw a question, press the * followed by the 2.

If you are using speaker equipment you will need to lift up the handset before making your selection.

Our first question is from Rob Stone from Cowen and Company, please go ahead.

Robert Stone – Cowen and Company

Hi guys, a couple of questions.

First, could you provide a little more color on what happened in China? What drove the decision to change to a direct relationship there? And where do you see the opportunity in China versus other markets.

Jon Kirchner

Sure Rob, over the past few years, obviously China has continued to be more strategically and critically important both from an export as well as a domestic market prospective.

We have not been entirely pleased with our results out of China, and we felt after a series of ongoing discussions that the right thing to do is to take complete control over our future, and we’re confident that this agreement really paves the way for us to improve our operating performance on the ground and ultimately of course, our financial performance going forward.

Robert Stone – Cowen and Company

Is there a relationship between that change and the fact that you’re calling for smaller royalty recoveries this year? Are you expecting higher compliance, and therefore lower recovery payments? What drives the lower recovery?

Mel Flanigan

Hey Rob, its Mel, it actually has very little to do with the changes that we’re making in China. I think when we thought about forecasting royalty recoveries for this year, the last couple of years we’ve have very strong numbers in the royalty recovery arena, and I think the reality is we’ve really picked a lot of low hanging fruit there.

At this point I think we’re sort of moving into more of a normalized cycle if you will, and want to be relatively conservative in how much we’re anticipating from recoveries.

There’s actually still a fair amount of projects we have in the pipeline that relates to evaluating opportunities to recover additional royalty monies, but none of the larger ones are at the point that we’d feel comfortable projecting that they’re going to come to closure in ’07.

Robert Stone - Cowen and Company

A question for you Mel, related to setting up shop in Ireland. Would that eventually have implications for your tax rate? Because I noticed your guiding for a continuing operation assumes a 40% rate this year.

Mel Flanigan

Sure, we’ve been working for several years now actually to sort of manage our global tax exposure and tax rates. I think it’s certainly safe to say over time, as our IP is more focused in the Ireland operation, that that’s clearly going to have potentially significant tax benefits in the years to come.

Robert Stone - Cowen and Company

There’s nothing you can foresee in the next year or two?

Mel Flanigan

Well I don’t think we’re going to see anything in 2007…there’s tradeoffs. As we conduct more of our research out of a foreign location you sort of lose the deductibility in the U.S., which has the opposite effect. We think that as the European headquarters operation begins to collect more and more, or realize more and more of the benefits of our technology which could happen as early as 2008, we should start seeing some positive rate benefit associated with that activity.

Robert Stone - Cowen and Company

A final question, can you give us a sense roughly of how the assets are divided between the continuing and discontinued operations at this point?

Mel Flanigan

I’m sorry?

Robert Stone - Cowen and Company

If I look at the total assets shown on your year-end 2006 balance sheet, after you sell the digital cinema business, what are we going to be left with in terms of assets roughly?

Mel Flanigan

Ok, sorry Rob. Obviously the majority of our asset balance. We’ve got $158 million on the balance sheet of which $111 million is sitting in cash which goes with DTS. But I think as it relates to the remainder of the assets, we’re working through separating those balances out and we’ll report that beginning in Q1 of this year.

Robert Stone - Cowen and Company

But the way you’re foreseeing the sale at this point, the cash stays with DTS?

Mel Flanigan

Certainly in the case of the sale, yeah.

Robert Stone - Cowen and Company

Ok, that’s extremely helpful, thank you.

Mel Flanigan

Thank you.

Operator

Our next question comes from Ralph Schackart from William Blair, please go ahead.

Ralph Schackart - William Blair

Good afternoon, a couple of questions. First on the ’07 outlook, Mel, can you sort of give us a rough order of magnitude what percent of the revenue stream will be attached to HD? And I guess the remaining would come from standard def products. And additionally, two, your guidance of EPS of $0.40-0.47, is that a GAAP number or pro forma number?

Mel Flanigan

Ok, with respect to the HD, I don’t have the specifics off the top of my head, but my guess is that it’ll be certainly less than 20% of our revenues coming from the HD space in 2007.

And then in terms of the guidance, I think I mentioned on the call, we’re actually trying to get away from the non-GAAP presentation to the extent that we can. So now that we’re in the second year of FAS123 reporting, that is a number net of, or including the costs associated with stock based compensation.

Ralph Schackart - William Blair

Ok great, and then Jon, in terms of the asset I guess you’re calling it sale now. Is it fair to assume a spin out, which I think at one point you were discussing on calls is not an option you’re exploring? And should we look to some sort of a sale, whether it could be to a financial or strategic buyer?

Jon Kirchner

Yes, it’s our intent, and as I said, the board has approved a plan to sell the business and obviously financial and strategic buyers are the universe that we are currently in discussions with.

Ralph Schackart - William Blair

Ok great, and this is one follow up if I could. Jon if you look out over the horizon 3-4 years, the thrusts of the cycles, this is a type of business that could generate in excess of $100 million, or perhaps $200 million in revenues. And if that’s the case is that still a business that would generate 50% operating margins?

Jon Kirchner

I think there’s no question Ralph as we look forward to full acceleration of the HD cycle, we think it’s going to look a lot like the current DVD cycle and based on our information at this point, that would clearly put our revenues certainly well north of $100 million.

And I think one of our objectives is to build an infrastructure that not only will successfully support that ramp, but ultimately generate a lot of leverage as revenue increases, and so I think it’s clearly possible that we will continue to see really attractive operating margins.

And as we said, we’re looking to at least 50% in the next five years. And part of that is a function of the fact that you get ever greater leverage as revenues increase. And part of that is also a reflection on the fact that we spend a lot of time building infrastructure over the past couple of years to support what we believe will be a large and very attractive business.

Ralph Schackart - William Blair

Ok thanks.

Operator

Thank you, and our next question comes from Murray Arenson from Ferris, Baker Watts, please go ahead.

Murray Arenson - Ferris, Baker Watts

Thanks, good afternoon guys. One follow-up on what Ralph was just asking you as far as the growth outlook when you put out the 50% operating margin target. Can you maybe put alongside that what you think your annual growth outlook rate might look like to get to that point?

Jon Kirchner

Well, I think when we're sitting at the front end of the high definition cycle, that is, there's still a paramount of uncertainty as to the timing and the flop of the ramp.

You know when we do our projections, we’re I think fairly conservative, but we're assuming that the revenue streams are going to grow at around 20% per year. We'd obviously like to see that much faster then that, in which case we get to the higher profitability levels much more rapidly.

But if, given sort of just the nature of technologies rollouts and certainly what's happened with the high definition cycle thus far, I think to sit here today and assume that it's going to go much much more quickly then that, it's just kind of risky.

So, you know, our expectation is that, like I said, we think that it's about 20% per year. We will certainly be keeping our eyes on it and if we see greater adoption towards the back half of this year then that could change things going into 2008.

Murray Arenson - Ferris, Baker Watts

Ok great, that's helpful.

I can back into some numbers a little bit but I figured I'd just ask you straight out. If I'm looking at next quarter, can the operating expenses on a continuing bases…what remains, what the business is, what you’re selling off, can you give us some sort of guidance here?

Jon Kirchner

Well, I think at this point the guidance that we've given of about 20% operating margins is probably the best level of details to build models off of. You know, the challenge of course isn't in the next six months or so, we're sort of in the heat of this operation process, which is going to have its own, costs associated with it. So, you know, I guess we would tend to budget fairly conservatively in the first half of the year.

Murray Arenson - Ferris, Baker Watts

Ok. And as you take a look at the potential buyers for the business that you're selling, can you guess whether or not you expect to sell the cinema and the images business together or likely that you're going to have to split those up, or just, can you give us a sense of what that universe looks like?

Jon Kirchner

We've reorganized the business in a way that really is focused on delivering end to end solutions, essentially for content provided all the way through exhibitors and that essentially necessitates having front end as well as if you will downstream capabilities.

So it's our intent, and we have certainly packaged the business together because we've essentially spent the better part of the last year integrating them in a way that we believe had strategic value over time.

So it's our clear intent to sell DTS digital cinema as one entity and thus far we've gotten solid interest from a number of areas and obviously if that changes, we'll make that decision if and when that time comes.

Murray Arenson - Ferris, Baker Watts

Ok. Thanks very much

Operator

Thank you and our next question comes from Alan Davis from DA Davidson, please go ahead.

Alan Davis – DA Davidson

Just a couple of questions here.

First, Mel, it looks like something went not right, the EPS number you gave suggest a cash balance of about $70 millions, if you add in the correct income by interest income, is that it?

Mel Flanigan

Roughly, in the range. Well no, I think that we have $111 million or so today, and we certainly don't plan on burning through them. In fact, you know, they conserve our business' and is part of the cash flow positive going forward.

You know, generally speaking, when we're doing our budgeting for…especially if it relates to something below the line like interest income, you know, we tend to be very conservative.

Alan Davis – DA Davidson

Ok. So all that cash will stay in the company?

Mel Flanigan

Yeah.

Alan Davis – DA Davidson

Ok. Sorry.

And was curious, in terms of your outlook…longer term in the broadcast market, maybe you can characterize your expectations there as will that become a significant portion of the revenues over the next few years?

Mel Flanigan

I think in the short term we've got modest expectations on the basis that we've been working on for hours with customers for some time. I think what's notable is what the (inaudible) announcement, as well as some other things we're working on completing think that this year will see the first acquisition of our efforts and it should accelerate over the coming years.

I think when you look in the long term, broadcast is a very attractive and its a very important market as you know you increasingly are seeing the world converge for contents being delivered through a lot of different mediums and nationally of course, the border will space, and wireless delivery is a critical element as well.

Alan Davis – DA Davidson

OK. And then, last thing Mel, I was wondering if you were willing to break out in rough terms the components or line items of the operating expenses in (inaudible)?

Mel Flanigan

For ‘07?

Not at this point, I think that what we said so far is that we think that the operating profit is going to be in the 20% range.

You know, I don't think I'd anticipate large shifts between ST&A and R&D.

Obviously we're going to continue to invest in R&D moving forward and I don’t know that the rates are all that different, you know, for the consumer business than they are for the business as a whole.

But at this point, we're just going to do it at the operating profit line.

Alan Davis – DA Davidson

OK, was the cash of royalties in the fourth quarter about $1 million?

Mel Flanigan

No, we didn't actually mention any cash of royalty in the fourth quarter of 2006.

What I said about cash of royalties is that we're just expecting it to be down by about $7+ million from 2006 to 2007.

We had a real strong collection here in ‘06 and we're sort of anticipating, you know, going into 07' that it will be sort of a normalized year at $1 million a quarter.

Alan Davis – DA Davidson

Ok, but it will break out for the fourth quarter of ’06?

Mel Flanigan

Yeah, and you know that generally means that there was nothing large that would have changed our operating results significantly.

Alan Davis – DA Davidson

OK great, thank you.

Operator

And our next question comes from Gordon Hodge from Thomas Weisel Partners, please go ahead.

Gordon Hodge – Thomas Weisel Partners

Ok, good afternoon. Just a couple questions. I guess the encoding business on the cinema side, is that…that's pretty high margin business and I'm curious, is that not in some way intricately involved in your old method consumer business, in other words, is that a part of the business that would make sense to keep or is that something you would license to whomever bought your cinema business?

We can take that offline if it's too complex of a question, but just be curious about that.

And also, noticed that the differed revenue is next to nothing. I assume that it's just the completion of the MGM business at LDI, does that therefore also suggest that there's not a lot of backlog there on the imaging side?

And then what I would ask, just a question on the cinema business. If you should get a 20% margin on consumers I assume that the cinema business is losing money right now. Maybe you should comment on that?

Thanks.

Jon Kirchner

The cinema business is, well the combined cinema, what we now call the EPS digital cinema for the combination of cinema and digital images, has been loosing money, and if you go back to our (inaudible) for the last couple of years, you can see that that's been the case.

With respect to DDI backlog, the change or the decline in differed revenue, certainly did at one point…the Bond series was a big chunk of that, and depending on the time, every once in a while there will be a large project that sort of spans quarter to quarter and therefore we end up with some additional differed revenue.

It so happens that at the end of 2006, we had pushed through most of the projects and there weren't any very large projects that were sort of hanging over into the following quarter.

I don't think that the magnitude of differed revenue is really not an indicator of backlog. I think the interesting thing…I think that we've changed over the last year or so is the nature of the projects that we're doing in the digital images business.

And I think the reality is that some of these process improvements that we've made has allowed us to take on smaller projects that tend to actually be more profitable, but they take less time, they're lower revenue per share and you just end up with fewer projects sort-of crossing over from one quarter to the next.

Gordon Hodge – Thomas Weisel Partners

Okay, and now on the encoding part?

Jon Kirchner

Right, and then, Gordon, on the encoding side of things, what we've done is, essentially we've organized the two businesses really around their primary customer base, as well as making sure that all the capabilities that need to exist in one business or another to support those revenue streams are really there.

And so, when you think about the digital cinema business, the licensing that goes on with respect to film soundtracks is really dealing with a set of customers that is, in part, different from that which our consumer business serves. We deal in the consumer business primarily with home video elements of the studios and other distributors.

And while in some cases naturally they sit within the same company, they in fact really have different support requirements, and the decision-making process is, in some cases, a bit independent. So, we don't necessarily have a need, if you will, to license technology out of the consumer business for use in the digital cinema business for use for Filmwise and so forth.

That being said, when the sale occurs, there is some core technology that the consumer business will continue to own, that will be utilized in the product platform in the cinema side of the business, and you know, at this point it's too early to tell exactly how that plays out.

But naturally, it's our intent to make sure that entity has what it needs to go off and build a successful business, and obviously that which is needed to create a successful transaction for our continuing consumer shareholders.

Gordon Hodge – Thomas Weisel Partners

Great, thank you.

Operator

Thank you, and your next question comes from Barbara Coffey from Kaufman Brothers. Please go ahead.

Barbara Coffey – Kaufman Brothers

Yes, good afternoon. As we're looking forward to seeing not only Blue Ray and HD, but also the potentially combined players versus different potential disks, how does this affect your sort-of licensing revenue from these different kinds of players?

And do you see this potentially stalling the market even further? Or is there some sort of catalyst to point to that shows that we get to some sort of level of HD-DVD consumption at the home?

Jon Kirchner

Barbara, I think broadly speaking, the fact that people are working on building multi-format players isn't expected to, I think from where we sit, result in, if you will, additional revenue per unit given that common chip sets in many cases are going to be powering the devices.

Obviously, I can't necessarily say that that would be the case in every case. But I think, broadly speaking, that's my understanding.

So, I think one of the things that multi-format players do for the market, is they remove one barrier potentially to consumers moving forward with enjoying the benefits that high-definition delivery brings.

And so, I think there are number of factors: content availability, more player models, the price points that these models are being sold at, and retailer support.

And think over the course of the next twelve months, we're going to see a lot of that move forward in a meaningful way that will, I think, give us all a better feel for what does the ramp look like, and how fast will we be moving in the nearer term.

I don't think we have any more of a crystal ball than anybody else, as far as at this point, sitting and saying that we expect it to be faster or slower. Except to say that with regard to our forecast for the year, as we're prone to do, I think we've taken a reasonable and conservative view of what may happen in the market. But definitely expect there to be acceleration as we get into 2008 and beyond.

Barbara Coffey – Kaufman Brothers

Thank you.

Operator

Thank you, and our next question comes from Gene Munster from Piper Jaffray. Please go ahead.

Mike Altman – Piper Jaffray

Hey guys, sorry for the background noise. This is Mike Altman for Gene.

Just kind-of a follow-up on the last question there. It seems like obviously the business is now more dependent on high-def DVD than ever, which ultimately, is probably a good thing. But do you expect that, coming out of CES (inaudible) the team to continue here, do you think the dual-format player is going to be the way that this all goes down? Or how do you see it kind-of playing out?

Jon Kirchner

I think there are so many variables here that it's hard to point to one data point or one element that you can say ultimately carries the day. As I said, I think it's really all of the above. And I would argue anyway in one sense, the market isn't stagnating, obviously.

You've got about two million PS3s that have been shipped worldwide, which dramatically increases the number of HD-capable installed units. Of course, you're continuing to see sales of X-Box 2 units as well. And I believe Sony has come out at least and said publicly that some of their research indicates that people who are buying PS3 players have, or intend, to play movies on their players, which I think is something that matters deeply to the content-provider community.

And so I realize that's a limited set of data, and the HDVD group is also working on making progress on a couple of fronts. So, I think it is really best to try to keep your eye on multiple indicators and see how things evolve over the next six months.

But as prices come down, and as units become more widely available, that in turn will clearly stimulate content-provider support, all of which then begins to answer the question that everybody is really looking to have an answer for.

Mike Altman – Piper Jaffray

Okay. And then just one quick one on looking at consumer revenue growth '07. Should we just anticipate kind-of normal consumer revenue seasonality on a quarterly basis throughout the year?

Jon Kirchner

Yeah, I think so, Mike. There are a couple of things to consider when you look at seasonality of '07. One is that Q1 of 2006 was obviously a huge quarter because we brought in $10+ million in royalty recoveries in Q1 of last year, and we certainly don't expect that to repeat this year.

The other thing to keep in mind is that, as you looked at the back half of the year, we certainly expect to see the ramp-up in HD, relatively speaking, impacting the second half of the year much more heavily than it will the first half of the year. So, normal seasonality or typical seasonality in the CE industry, or at least for us, would be relatively strong Q1, a little bit softer in Q2. Q2 tends to be the low point each year. And then it builds in Q3 and Q4. Those core dynamics aren't any different. It's just that you're going to see a little bit of additional strength in Q3, and especially into Q4 this year.

Mike Altman – Piper Jaffray

Okay, thanks a lot, guys.

Jon Kirchner

Sure.

Operator

Thank you, and our next question comes from J.D. Padgett from the Boston Company. Please go ahead.

J.D. Padgett - The Boston Company

Yeah, hi guys. A couple of quick ones. One was with the change in China. Do you need to go out now and find new talent on the legal front? Or have you already identified those people?

Jon Kirchner

No, J.D. It actually has no impact on our legal or enforcement infrastructure whatsoever. We've long had most of those resources, if you will, on our side of the relationship. So, we will just continue more aggressively with the team that we have on the ground.

J.D. Padgett - The Boston Company

So what was the purpose of that middleman before? Just to kind-of collect and process?

Jon Kirchner

Well, I think China, as you can well appreciate, is a market where relationships mean a tremendous amount. And this relationship dates back to us getting started in China in the consumer business. And in the time and circumstance that we were in at that point, the other party had the ability to expedite our progress in the market.

But obviously, as we've built our own capabilities, you know, it made sense to take complete control of our opportunity going forward.

J.D. Padgett - The Boston Company

So this doesn't set you back at all?

Jon Kirchner

No.

J.D. Padgett - The Boston Company

Okay. The other question was, if we look at the operating expenses and all, I think it was about $14 million, kind-of on a recurring basis if you strip out all the one-time factors. But including stock-based comp, is the right way to think about that now, when you peel out of the cinema business, that that may falls off in Q1? And then, as you kind-of back-fill, some of the infrastructure begins to grow again through the rest of this year?

Because clearly not all that $14 million can be consumer business, right?

Jon Kirchner

Right, yeah. I think the challenge that we face, purely from a profitability standpoint in 2007 is just the fact that, as in a reporting of a separate company, the reality is we have to absorb all the corporate infrastructure costs that would have been allocated among three different divisions or three different business units up through 2006. So certainly some of the cost structure will be pulled and go with the digital cinema group. But there's still a fairly large chunk that stays with DTS.

That being said, you know, we will continue to increase our investment in very targeted areas this year. Things like on the development side. There are a number of new initiatives that we are continuing to pursue and there's expertise that we need to bring on board to sort of expedite that process of broadening our product portfolio. And so we'll continue to invest both on the SG&A side, especially sales marketing kind of positions, and in R&D.

J.D. Padgett - The Boston Company

Okay so there's not really anything that you need to back though because you'll keep all the same public company corporate resources that you have. You just have to bear the burden short term of allocation?

Jon Kirchner

Yeah and I think that maybe another point to get across that I think is important as we look forward, especially into '08 and beyond, and that is that 2006, and especially now going into 2007, there is a tremendous amount of effort going into the separation process and a few other large things that we have going on in the business.

But one of the primary expectations for this transition process is to reevaluate kind of from the ground up what a stand alone consumer business needs to operate in the various markets. And given the fact that we're a public company, we fully expect to completely sort of reevaluate our cost structure through the course of 2007 and position ourselves to take advantage of the increase or the ramp-up in revenues towards the back half of the year and into 2008.

So, you know, I think what I mentioned in the script is that all of these public company costs and the other cost of sort of consolidating into a smaller business weigh heavily. What I meant was they weigh heavily in the near term and we fully expect to see significant leverage in the couple of years ahead.

J.D. Padgett - The Boston Company

And can you give me the consumer theatrical (inaudible) rev's one more time?

Jon Kirchner

Consumer was $50 million. And the...

J.D. Padgett - The Boston Company

For the quarter. I'm sorry.

Jon Kirchner

Oh sorry. Okay let me...uh...real quick here....bear with me for one second. (papers scuffling)

Digital image was about $2 million, cinema was about $5.2 million and consumer was about $10.3 million.

J.D. Padgett - The Boston Company

Okay, thank you.

Jon Kirchner

Sure.

Operator

Thank you and our next question comes from Steve Granchy from Granchy and Capital Management. Please go ahead.

Steve Granchy – Granchy and Capital Management

Yeah, I have a couple of questions.

You know as I listen to your presentation and the Q&A, it certainly sounds you all are pretty confident of the future especially as you start at 2008. But having said that, if you take a look at what officer, director, and corporate actions are, you sort of wonder.

For example, you know, I've noticed that officers and directors continue to be sellers of the stock and, well, perhaps you haven't been able to be buyers of it for various reasons.

My first question is if you're that confident that you have $100 million business that could have $50 million in operating profits in the next five years, and you got all that cash in the company…why would officers and directors would be selling it?

And the second is a sort of corollary. You said in a response to one of the questions that you all expect to be cash flow positive during the year and you have over $110 million in equity. Could we assume that once perhaps you get by the sale or the divestiture that you have coming, that if the stock price were more or less this level that you would consider this stock as very attractable and you might consider utilizing some of that cash to repurchase shares?

Jon Kirchner

Sure. Let me start with your second question and then work backwards. At the board level, we're always having...we're in constant conversations about what will maximize value for the shareholders both in terms of resources needed to build the business as well as evaluating whether it will be share buy backs and dividends. The whole spectrum is something that remains on our mind.

I think one thing to be aware of that you may not be is the ordered adopted a share repurchase plan back last summer. And we decided to implement the plan via attend the five-one structured purchase plan and to date, the triggers in that plan, have not kicked in. So it may very well do so in the future but they have not yet been triggered so we have taken a step forward in terms of addressing the very issue that you raise.

I think also with respect to sales amongst management, we as a matter of routine have adopted 10B51 selling plans on an annual basis. So any selling that you've seen over the past, basically 11 months, is a result of decisions and plans that were adopted prior there to and generally has to do specifically related to just asset diversification.

And in terms of us being able to purchase shares, naturally, as you said, being able to buy shares in the open market in light of constant strategic discussions and being in and out of windows is not the easiest. But I think we are positive about the future. I think overtime, you know, exactly how well we can position this business going forward I think will really demonstrate the benefit of the decisions that we've made over the past two years and kind of positioning these businesses to independently move forward.

Operator

Thank you and our next question comes from Doug Benton from Uriah Global. Please go ahead.

Doug Benton – Uriah Global

Now quick question. You had $1.1 million of separation costs in Q4. Just based on your 20% operating margin guidance for 2007, what if any separation costs are factored into that guidance?

Mel Flanigan

Hi, Doug. Let me clarify first the...in 2004 the separation costs number was around $700,000 and the $1.1 million relates to the year-to-date number so it actually all began in August so it's Q3 and Q4.

As it relates to the guidance going forward, no doubt there will be some separation cost, but the bulk of those separation costs are actually going to be recorded in the discontinued Ops line. So we don't have a tremendous amount built in to the EPS guidance or the 20%.

Doug Benton – Uriah Global

Got it. Thank you.

Operator

Okay, ladies and gentleman, if there are any additional questions, please press the "star" followed by the "one" on your telephone keypad. As a reminder, if you're using speaker equipment, lift the handset before pressing your numbers.

Our next question is from Rob Stone from Cowen and Company. Please go ahead.

Robert Stone – Cowen and Company

Hi. Follow up question, Jon, regarding the film licensing business. If the IP for film licensing is going to stay with DTF, how does the value of that, that will be part of the cinema business, flow back to you? Is that going to be be a one time license for that application at the time of sale or some form of ongoing royalty. Or how are you thinking about it?

Jon Kirchner

Rob, slight misunderstanding perhaps.

The core technology that we license to film studios will in fact be moved over and as part of the asset base that's contemplated to go with the digital cinema business so the issue of licensing, and if you will, between DTS consumer and the digital cinema business isn't relevant.

There is some other technology however. Our core consumer technology, DTS coherent acoustics (inaudible).

Robert Stone – Cowen and Company

(inaudible) Is that necessary to somehow feed those changes in the encode/decode stream into the cinema front end as well? It's got to be on the soundtrack of a film before its interesting to play back on a consumer platform is it not?

Jon Kirchner

Well two things. I think to the extent that, depending on the deal that ultimately is struck in connection with the sale, I would imagine that developments that occur there or after really would be that type of relationship.

With regard to the notion of technology having to exist on, let's say, a theatrical release in order for it to follow through to say an HDDVD that actually is not the case because they're really two separate post production processes and encoding processes so there isn't a direct tie in between the two.

Robert Stone – Cowen and Company

But you can insert the changes to the encoding at the time when they go from the master to whatever form of home video distribution?

Jon Kirchner

Yes.

Robert Stone – Cowen and Company

Okay. That's helpful. Thanks.

Operator

Thank you and at this time we have no further questions in queue.

And ladies and gentleman that will conclude the conference for today for DTS Fourth Quarter Fiscal 2006 Conference Call.

We thank you again for your participation.

And if you would like to listen to a replay of today's conference you may dial 1-800-405-2236 or 303-590-3000. And use pass-code 11083460# to access the conference. Thank you again. You may now disconnect.

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