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Creative Technology Ltd. (OTCPK:CREAF)

F4Q07 Earnings Call

August 7, 2007 8:00 pm ET

Executives

Phil O'Shaughnessy - Senior Director of Corporate Communications

Craig McHugh - President, Creative Labs

Analysts

Ken Hock Lim - Credit Suisse

Patrick Yao - McQuarrie

Carey Wong - OCBC Investment Research

Presentation

Operator

Good day. My name is Mark and I will be your conference operator. At this time, I would like to welcome everyone to the Creative Technology Limited fourth quarter fiscal year 2007 earnings release conference call. (Operator Instructions) Mr. O'Shaughnessy, you may begin your conference.

Phil O'Shaughnessy

Thank you. Good morning to those of you joining us in Singapore and good evening to everyone in the U.S. Thank you for joining us today. I’m Phil O'Shaughnessy, Creative’s Senior Director of Corporate Communications, and I would like to welcome you to Creative Technology's fourth quarter and fiscal year 2007 earnings release conference call.

The press release can be downloaded from our website, creative.com. We are also offering a webcast of today’s call, which you can access through the investor relations page on creative.com.

Today’s call will be hosted by Craig McHugh, President of Creative Labs. Craig will be joined on the call by Sim Wong Hoo, Creative’s Chairman and Chief Executive Officer, and Ng Keh Long, our Chief Financial Officer.

During our call today, Craig and the other participants who may be speaking on the call will, with the exception of historical information, be making forward-looking statements, including statements relating to gross margins, operating expenses, inventory, profitability and the market potential for our products. These forward-looking statements are based on the information that is available to us as of today and reflect management’s current analysis, beliefs, or expectations. Actual results could materially differ for a number of reasons, including those detailed in today’s press release and in our filings with the Securities and Exchange Commission over the last 12 months.

You are urged to review the risk factors set forth in our press release and in our SEC filings, including our annual report on Form 20-F.

Also, please note that Creative undertakes no obligation to update any forward-looking statement made in today’s conference call or in our press release to reflect events or circumstances that occur after today.

For today’s call, all results are stated in U.S. dollars. We will begin today with Craig McHugh providing a review of the results of the fourth quarter of our 2007 fiscal year. We will then open up the call for questions and answers.

At this time, I would like to turn the call over to Craig McHugh, President of Creative Labs. Craig.

Craig McHugh

Thank you, Phil. Good morning to those of you joining us in Singapore, good afternoon to those of you in the U.S. I would like to begin by a review of the financials. Revenues for the fourth quarter were $165.2 million, compared to revenues of $230.9 million for the same quarter last year. Revenues for the 2007 fiscal year were $914.9 million, compared to revenues of $1.1 billion for the previous fiscal year.

Net loss for the fourth quarter was $19.3 million, with a loss per share of $0.23, including restructuring charges of $2.4 million. This compares to a net loss of $12.7 million with a loss per share of $0.15 for the same period last year, including a $10 million tax credit.

Net income for the 2007 fiscal year was $28.2 million, with earnings per share of $0.34, including a $100 million paid up license for Apple for its use of the Zen patent in its products. This compares to a net loss of $118.2 million, with a loss per share of $1.42 for the previous fiscal year.

The paid up license from Apple for use of the Zen patent in its products was previously included in our revenues for the second quarter of fiscal year 2007, which ended December 31, 2006. However, taking into consideration recent comments that we received from the United States Securities and Exchange Commission, we have now classified the entire $100 million as non-operating other income in the cumulative 12 months consolidated statement of operations.

Now let’s take a look at the fourth quarter results in more detail. Sales for our personal digital entertainment, or PDE category, which includes our MP3 players and web cameras, contributed 57% of total sales in the period. This compares to 52% of revenues last quarter and 65% of revenues from PDE in the same quarter of last year.

In the period, we introduced our tiny lightweight Zen Stone MP3 player, creating an exciting new market opportunity by offering a 1-gigabyte player in six different colors for less than $40. The media favorably compared the Zen Stone to the iPod shuffle, which has the same 250 song capacity but the Zen Stone is just half the price of the shuffle.

The Zen Stone receives an Editor’s Choice award from PC Gamer Magazine and a Best Mobile Buys award from Laptop Magazine, and also received very good ratings from CNET and PC Magazine.

Also in the period, we introduced the Zen Stone Plus MP3 player, which adds a screen, FM radio, clock and stopwatch with double the memory to 2-gigabytes, and is priced under $70. CNET also gave the Zen Stone Plus a very good rating. Available in the same six cool colors as the Zen Stone, the Zen Stone Plus began shipping to retailers this month.

We saw a very successful launch of the Zen Stone in the fourth quarter, with strong consumer demand. The strong sales of our Zen Stone and Zen V Plus flash-based players helped to increase our overall unit sales of MP3 players in the period.

During the quarter, we began the transition of our MP3 business from being both hard drive and flash-based to primarily flash-based, with focus on our Zen V, Zen V Plus, Zen Stone, and Zen Stone Plus flash players.

We are focusing on our flash-based players for among other reasons, they offer a higher gross margin opportunity than do our hard drive based players. And with the lower prices of our flash-based players, we believe we can increase our unit volume and improve our market position.

Our audio category contributed 15% of total sales for the period. This compares to 17% of sales last quarter and 13% for the same quarter last year. In the current quarter, we will being shipping our Xdock for iPod audio system to select Apple retail stores. The Xdock for iPod provides an X-Fi docking station for an iPod. Our X-Fi crystallizer technology in the Xdock for iPod dramatically improves the quality of iTunes music playback. The Xdock for iPod also allows the user to play music from an iPod wirelessly throughout the entire home with Xdock’s wireless receivers.

The Xdock for iPod has a suggested retail price of $200 and each X-Fi wireless receiver is priced at $100. The Xdock for iPod will be available at select Apple stores beginning this week.

Our speaker business contributed 18% of revenues in the fourth quarter, compared to 21% of revenues last quarter and 13% of revenues for the same period last year. We are very pleased to note that our award-winning GigaWorks T20 speakers have been chosen by Apple for select Apple retail stores and are going on sale this week in store.

We just introduced the new travel sound Zen Stone, the portable speaker system for the Zen Stone and the Zen Stone Plus, and it is priced at less than $40. This sleek, ultra-portable travel sound Zen Stone speaker looks and sounds great and it easily fits into a bag or backpack to take wherever you go.

Revenues from all other products accounted for 10% of total sales for the period.

Looking at the breakdown of revenue by specific geographic regions, the Americas represented 30% of total sales in the fourth quarter, compared to 46% for the same period last year and 32% for last quarter. Europe contributed 47% of total sales compared to 37% for the same period last year and 49% last quarter. Asia contributed 23% of revenues compared to 17% for the same period last year and 19% last quarter.

Our gross margin for the fourth quarter was 20% compared to 14% for the same period last year and to 21% last year.

Operating expenses for the period of $51.3 million, including approximately $2 million of restructuring charges, were down approximately 18% from the previous quarter’s operating expenses of $62.6 million, which included approximately $3 million in restructuring charges.

Moving on to the balance sheet, we ended the quarter with $250 million in cash, this even after a payment of $75 million toward our long-term debt in the period. This compares to $293 million in cash last quarter and $214 million for the same quarter last year.

In the fourth quarter, we further reduced our inventory level by 12%, coming in at $135 million compared to an inventory level of $153 million from last quarter and $235 million for the same period last year.

Day sales outstanding at the end of the fourth quarter were 60 days compared to 58 days last quarter and 52 days for the same period last year.

Now looking forward, key areas of our focus include the successful introduction of several new important products leading up to the holiday season; bringing our operating expenses below $50 million in the current quarter; further improvement in our supply chain and procurement processes; and coming closer to break-even in the current quarter and returning to profitability by the end of the calendar year and moving forward.

Now, before we turn over to Q&A, I would like to note that during the quarter, we announced that we will voluntarily de-list Creative ordinary shares from the NASDAQ global market with August 31, 2007 as the last day of trading on NASDAQ. After August 31st, our current primary listing on the Singapore Exchange Securities Trading Limited, SGXST, will become our sole exchange listing. Our de-listing from NASDAQ will not affect the status of Creative’s shares on the SGXST.

A press release providing details about our voluntary de-listing from NASDAQ are available at creative.com in the investor relations section.

At this time, I would like to open up the call to questions and answers. Operator, if you could please open the call up.

Question-and-Answer Session

Operator

(Operator Instructions) You do have a question from the line of [Ken Hock Lim] with Credit Suisse.

Ken Hock Lim - Credit Suisse

Could you just elaborate on your sales in the U.S.? What is happening such that the sales in the U.S. is actually so weak? Do you expect any change in the geographical mix actually going forward?

Craig McHugh

Thank you for the question. As we noted today, the sales from the U.S. were down as a percentage year over year. I also commented in our press release today that our revenues were lower because of lower sales in the U.S. market, particularly in our retail segment.

There are several factors that have impacted sales in the U.S., premiere among those that I would note is related to what I shared today in my presentation with regard to our focus on flash-based MP3 players. We are beginning the transition of our MP3 product line away from our hard drive players into flash-based. As we’ve talked over previous quarters, we believe that the low price of flash allows us to be very competitive in the market while also being able to achieve target margins.

Although our hard drive based players have always done very well in the marketplace, they’ve been our lowest margin products, and as such, even as they offer the higher capacities, we’ve decided to move away to and focus primarily on our flash-based players, the new Zen Stone and Zen Stone Plus, and our very successful Zen V Plus in the marketplace.

Those products, although they offer us greater opportunity for gross margins, do go at a lower selling price so our overall, our average selling price for MP3 in the period dipped and that impacted our overall revenues in the U.S. marketplace.

At the same time, it was a very difficult market in the quarter for us in U.S. retail. Several of our largest customers noted that this particular segment was down for them. Circuit City particularly, one of our largest customers in the Americas, noted that they actually encountered double-digit percentage store decreases in the portable audio categories, and in some of the other categories that we serve in the peripherals and electronics.

I think their highlighting that in particular was witness to what many of our customers faced, particularly in the first two months of the quarter with some rebound in June. It was a very difficult segment.

So the very difficult retail market for us, particularly in the portable audio area in that period, the lower ASPs combined to impact us. And that’s two quarters where our revenues have been down in the U.S. We do look, I should say, we expect to return to profitability by the end of the year. We are looking to a very strong holiday quarter and we are getting very positive feedback from our current products as well as our planned products that we are going to introduce.

As I noted today, we are going to be introducing several key new product en route to the holiday season, so I believe we will be able to buoy our sales in the Americas, particularly in the U.S. retail market and have a stronger holiday period.

But the past two quarters have been difficult for us in U.S. retail. Conversely, I think you would have noted we’ve been exceptionally strong in Europe. We continue in many of the key geographic markets in Europe to be a very strong number two in MP3 and in very specific markets we have market leadership, specifically in flash-based players.

So although the U.S., particularly in the hard drive market, is -- we are seeing greater competition for the higher capacity hard drive players, in Europe we’ve been very, very strong with our MP3 business. I think you can see, as evidenced by the numbers over the past two quarters, we’ve had a very significant return from our efforts in Europe in retail in many of the key countries.

I think you are going to see continued strength in our European market throughout the holiday period. At the same time, Asia as a percentage has increased year over year, I think showing that the breadth of our product line and the breadth of our market penetration is allowing us to continue strong revenues there.

So a key focus for us going into the holiday will improving the U.S. revenues, and the downturn in U.S. revenues have impacted the overall corporate revenues, primarily for some of the reasons I stated.

Ken Hock Lim - Credit Suisse

Could you just give us an idea within the U.S. sales, what is the mix between hard drive and flash? How do you see each part actually -- do you expect the hard drive portion to continue falling?

Craig McHugh

I think falling is not the correct term there. We are transitioning away and focusing on our flash players. Our most recent introductions, of course, the Zen V Plus a couple of quarters ago and this quarter with the Zen Stone and the Zen Stone Plus, are flash-based. I think you are seeing a commitment to us to driving innovation in flash-based players, because we can achieve very exciting price points with the very low price of flash. Now we can increase the capacities and have a very compelling offering.

We will continue at the very high end with our Zen Vision W, the widescreen, to offer the high end hard drive players but we are transitioning away from our hard drive based players today. So that did, the transition also is one of the factors I noted affected our revenues. But it is an intentional transition from us so we can move to where we see is a greater margin opportunity in flash.

We did have a very successful launch of the Zen Stone, followed by the Zen Stone Plus. I think you will see, as we did last quarter, we had an increase in unit volume. We introduced the Zen Stone speaker, which I highlighted today because that supports the Zen Stone. With the strong volumes we achieve, we also see I believe stronger opportunities in the past for our accessory business.

You will see a continued shift in this case going forward, you’ll see primarily revenues primarily composed of flash-based products.

Ken Hock Lim - Credit Suisse

One question is actually on the margins. Despite moving to the more profitable flash product, and despite the prices of NAND coming off so much, your gross margin actually has not changed much compared to last quarter. Could you just give more explanation on that?

Craig McHugh

I think key factors that impacted the margins, one is on the lower revenues. The lower revenues, some of the fixed costs that we have in the operations area, both our local costs as well as some of the manufacturing costs, on the lower revenue base, they have a higher percentage so that impacts margins.

The transition away from our hard drive players and our efforts to be able to move those players through the market with good velocity so we can make a successful transition also impacted our revenues, particularly in the U.S. market. Because of some of the lagging sales in U.S. retail across the board, there was pressure by retailers to do market incentives, including rebates and others that would affect the margin. And supporting our retailers in the U.S. market and helping them be able to increase their sales, we did participate in some programs that adversely affected the margins in the period.

So the transition to what I believe is a higher margin product lines, our flash, is in the quarters ahead, so we worked through the majority of our transition. I mentioned the retail pressure as far as some of the aggressive marketing programs to help stimulate retail sales impacted the margins in the period.

Ken Hock Lim - Credit Suisse

Thank you.

Operator

Your next question is from the line of Patrick Yao with McQuarrie.

Patrick Yao - McQuarrie

Can you hear me?

Craig McHugh

Yes, Patrick. Go ahead. You’re clear.

Patrick Yao - McQuarrie

Could I just ask a question in terms of the differences between the European and American sales? I think I heard you explain a little the American sales are weak because there was a transition away from the hard drive based models.

Craig McHugh

In Europe, we have an exceptionally strong presence with our MP3 players, particularly flash in very specific markets. We are exceptionally strong in the Scandinavian markets, some of the southern markets in Spain, Italy, Portugal. Our business continues to grow and flourish for MP3 in our Eastern European markets. And there, the various products, the Zen Stone and Zen Stone Plus had exceptionally strong receptions in the marketplace.

In Europe, we haven’t had the competition from Microsoft. Microsoft has been affecting the market in the U.S. They’ve dropped price to try and clear their stocks because of what was seen as very disappointing sales of their products, and their price moves and pricing programs have affected sales in the U.S., where it hasn’t had the impact in the European market.

The European market, as it becomes much more centralized as far as in the largest retailers, within countries but there is many different retailers throughout Europe, and being very diversified as far as the markets, our strong presence has allowed us to build exceptionally strong relationships, as I mentioned, in the different countries.

At the same time, in the European market in the last quarter, they didn’t experience the downturn in retail that we saw in the U.S. and our particular sectors, and they didn’t come under some of the pricing pressures and marketing programs that did suffer in the U.S., which affect both revenues as well as margins.

So I think Europe didn’t have the downturn we saw in the U.S. and its various markets. We continue to see it strong and as we hope and believe the U.S. will recover, we hope that all the regions will have a strong holiday period.

Patrick Yao - McQuarrie

Thank you.

Operator

(Operator Instructions) You have a follow-up question from the line of Ken Hock Lim with Credit Suisse.

Ken Hock Lim - Credit Suisse

You mentioned some marketing rebates to move the hard drive product. Is this more like a one-off kind of event which you don’t expect to recur going forward? If so, are you able to quantify roughly how big were those rebates?

Craig McHugh

It is difficult to quantify the full impact of the rebates, but for example some of our largest retailers were offering 10% to 20% off on some of our hard drive players in the form of mail-in rebates or marketing incentives. Those of course at that level would affect the revenues as well as the margins. So typically we saw 10% to 20% off in the period and supported our retailers with that.

That allows us to make the transition also to help the retailers stimulate their sales and we want to be supportive of our key retail partners in the U.S., and in so doing it did impact the quarter. The transitions to our new product lines in MP3 are substantially complete. We are continuing with moving some of the hard drive players this quarter but they are moving through at a very good rate right now, as I mentioned. We saw improvements in June in the marketplace.

As I highlighted in the previous call, we didn’t do those types of incentives in Europe, so Europe had a stronger revenue performance and they didn’t see the need for some of the rebates that we did here. And those we offered pretty much throughout the U.S. and Canada, which are our primary markets in the Americas for the hard drive players.

So going forward, we wouldn’t see those types of strong marketing programs. The flash-based players, the Zen Stone which I mentioned at $39.99, came out with a very aggressive price point, yet at the same time we are able to maintain good margins on that product. I think we will even buoy the margins as we are able to get some of our accessories in the field, like the speaker and others to support that Zen Stone family.

So the transition was a difficult one in the period and as we are moving forward right now, I think you will see that all of our product lines are aggressively priced in the beginning. At the same time, since they are flash-based, it allows us to have very good margins compared to what we’ve seen historically in hard drive.

Ken Hock Lim - Credit Suisse

Could you also elaborate on what kind of new product introductions we can expect in the coming two quarters?

Craig McHugh

I can’t go into specific detail right now. Perhaps -- why don’t I elaborate on a couple of the key products, but as I hinted last quarter, we are going to introduce a couple of key MP3 players. We did that with the Zen Stone and Zen Stone Plus, which were very well-received not just by the press but exceptionally well-received by the consumer.

We are going to be introducing two very important products in our speaker, in our headset business. We will be introducing those over the next month so I don’t want to go into too much information on those right now. And you are going to see a very important product for us in our Made for iPod program in our speaker area.

So the products we are focusing on introducing are higher ASP products than you may have seen from us in the past, providing both good margin but very exciting feature sets. Hopefully the ones in the Made for iPod program will be appealing not just to the U.S. market but you’ll see those have a global impact on our business. So we are really focused on several products in each of our categories at the higher end, so I think we’ll have an opportunity for us to drive some very exciting marketing programs. At the same time, be able to contribute to our margins and revenues in the holiday period.

Ken Hock Lim - Credit Suisse

The other question is with regard to inventory. You have done a fairly good job in bringing inventory down. Would this kind of lower inventory level be sustainable?

Craig McHugh

I think we are very pleased with the progress we made in inventory, and we are also pleased that the balance of the inventory is very good, supporting our products and preparing for some of the new product launches.

As we are going into the holiday season, I mentioned we are anticipating a strengthening of the U.S. market and continued strength in our European and Asian markets, so as we go into the holiday period, historically we do have to increase our inventory levels to support the holiday period. Openly, we do ship quite a bit of the holiday goods starting at the end of this quarter as well as early next quarter, so our factories and our inventories do need to be able to begin to build to support the increased revenue levels.

But I think you will see a heavy focus from Creative both on minimizing the inventory, even though it will be at a higher level potentially, but at the same time really focused on the quality of the inventory mix.

So you may see an increase in the short-term while we prepare for the holiday season.

Ken Hock Lim - Credit Suisse

Thank you.

Operator

(Operator Instructions) You have a question from the line of Carey Wong with OCBC Investment Research.

Carey Wong - OCBC Investment Research

Good morning, Craig. I’m just wondering about your audio segment. I noticed it is down both year on year and Q-on-Q. Can we get an update on your audio business as far as the X-Fi licensing?

Craig McHugh

Let me break that down into parts. You may recall last quarter we were up year over year and we anticipated being able to grow the business again this quarter. We were disappointed that we didn’t begin shipping our new Xdock in the period, and the Xdock is what we talked about today that will be premiering in select Apple stores this week. So some of the audio revenue that we hoped to gain last quarter by initial shipments of both our Xdock and another related product called X-mod, as these are very high-end products but with very compelling feature sets for enhancing MP3 music or iTunes music, those were delayed and will begin shipping in the current quarter.

At the same time last quarter, we had two negative impacts and the conversion of the operating systems to Vista. One of our largest OEMs had delayed some of our key audio purchases from us as they converted their lines over to Vista, and so we lost about two months of shipping revenue in the OEM space. So our OEM revenues in audio were light, as well as some of the product introductions we had planned were delayed.

Now with stabilization of our OEM business, and with the shipping of these products, we are optimistic that we will be able to once again be able to have positive results in our audio business as we did last quarter. But as you note, this last quarter was down and we -- our goal would be to bring that back up as we head towards the holiday season.

So the key, what’s driving us for audio is our X-Fi everywhere platform. Recently we introduced or announced in a press release that we for the first time were selling our X-Fi audio platform to other audio soundcard manufacturers, as well as motherboard manufacturers. We believe that they will be able to penetrate new markets for us, some niche markets but at the same time the motherboard guys will be able to bring X-Fi out into the mainstream, so anticipate that as a further revenue stream for us.

We have the design wins and those will be coming to fruition over the upcoming quarters. There is, of course, a design delay in those before they reach the market.

At the same time, with X-Fi, now that we have X-Fi being able to be pushed into the Apple stores, one of the other key announcements that I mentioned in our headphone speaker area will also be heavily focused on X-Fi, and that’s a product that we expect to be widely distributed throughout the U.S. and Europe and key markets within Asia.

So we’ll be able for the first time to have X-Fi docking systems with the Xdock, there will be X-Fi audio boards, there will be X-Fi motherboards, and then soon we will be able to have them in headsets and as well as in speakers. So we will be able to have all aspects of audio covered.

But we recently invested in our infrastructure for our OEM and systems business. We brought in a new vice president for our OEM business based here in the U.S., to be able to outreach the companies, potentially integrating X-Fi into set-top type boxes and home electronics.

So our first platform, having it through all the Creative products, will be starting to be complete by this holiday, and our outreach program to new OEMs and platform manufacturers is beginning to kick off now, and is evidenced by the recent press release for the first motherboard manufacturer and soundcard manufacturer.

All those avenues we hope will come to fruition, allowing us to turn around the negative trend that we talked about a moment ago in audio.

Carey Wong - OCBC Investment Research

Okay. Thanks a lot, Craig.

Operator

(Operator Instructions)

Craig McHugh

If there are no more questions --

Operator

Yes, sir, there are no further questions at this time.

Craig McHugh

Okay. On behalf of Creative Technology in Singapore, Creative Labs in the U.S. and all of our team members, we want to thank you very much for joining our call today. Thank you very much, everyone, for the questions and good night in the U.S. and have a great day in Singapore. Thank you very much.

Operator

This concludes today’s conference call. You may now disconnect.

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