Techwell Q3 2007 Earnings Call Transcript

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 |  About: Techwell, Inc. (TWLL)
by: SA Transcripts

Techwell,Inc. (TWLL) Q3 2007 Earnings Call October 29, 2007 5:15 PM ET

Executives

Beverly Twing - IR of SheltonGroup

Mark Voll - CFO

Hiro Kozato - President and CEO

Analysts

C.J. Muse - Lehman Brothers

Jay Srivatsa - Roth Capital Partners

Quinn Bolton - Needham

Chris Longiaru - Sidoti

Eric Rasmussen - Montgomery & Company

Heidi Poon - Thomas Weisel Partners

Greg Weaver - Kern Capital

Operator

Good day ladies and gentlemen,and welcome to the Techwell's Third Quarter 2007 Financial Results ConferenceCall for the period ended September 30, 2007. My name is Candice and I'll beyour coordinator for today. At this time, all participants are in a listen-onlymode. We will be facilitating a question-and-answer session towards the end oftoday's conference. (Operator Instructions).

I would now like to turn thepresentation over to your host for today's conference, Ms. Beverly Twing ofShelton Group, Investor Relations. Ma'am, you may proceed.

Beverly Twing

Thank you and good afternoon.Welcome to Techwell's third quarter 2007 financial results conference call. Thepress release and financial tables associated with today's conference call weredistributed after the close of the market today. If you do not have a copy, youmay find them on the company's website at www.techwellinc.com. This call isbeing broadcast live over the Internet, and may be accessed in the InvestorRelations section of Techwell's website.

Before management begins thediscussion of the third quarter's results, I would like to remind you that thisconference call will contain forward-looking statements within the meaning ofthe Private Securities Litigation Reform Act of 1995, which include but are notlimited to the company's belief that the demand for its products will continueto grow; the company's ability to better address customer requirements,leverage technology capabilities and integrate additional functionality andachieve greater market share; its anticipated revenue, growth margins, andoperating expenses for the fourth quarter of 2007; its anticipated tax rate forthe fourth quarter of 2007 and full year 2008; anticipated new productannouncements and anticipated trends and growth in the company's business andend markets in which it operates.

Any forward-looking statementsmade during this call are subject to risks and uncertainties that could causeactual results to differ materially from those projected. Additionalinformation concerning factors that could cause actual results to differmaterially from any forward-looking statements made during this call arecontained in the company's quarterly report on Form 10-Q filed with theSecurities and Exchange Commission on August 9, 2007. Techwell undertakes noobligation to publicly update any forward-looking statement for any reason,except as required by law, even as new information becomes available or otherevents occur in the future.

Thank you for your time andattention. I will now turn the call over to Mark Voll, Techwell's ChiefFinancial Officer. Mark, please go ahead.

Mark Voll

Thanks, Beverly. Good afternooneveryone, and welcome to our third quarter financial results conference call.

With me today is our Presidentand Chief Executive Officer, Hiro Kozato. I will begin today's call with a reviewof our quarterly financial results and conclude with an outlook for the fourthquarter of 2007. Following my remarks, Hiro will provide an overview of ourbusiness. We will then open the call for a question-and-answer session.

Please keep in mind that allreported financial results, unless otherwise noted, are presented on a GAAPbasis.

For the third quarter endedSeptember 30, 2007, we reported total net revenue of $15.1 million. Revenue forthe quarter was within our revenue guidance range of $14.5 million to $15.5million.

Total net revenue for the thirdquarter compares to $15.1 million in the same period a year ago and $14.7million last quarter.

Total net revenue in the thirdquarter for each of our product lines consisted of security surveillancerevenue of $10.2 million, representing 68% of total net revenues, LCD displayrevenue of $1.3 million, or 9% of total net revenues, video decoder revenue of$3.3 million or 22% of total net revenues, and other revenue of approximately$262,000, representing 2% of total net revenues.

Security surveillance revenue of$10.2 million this quarter represented a 40% increase over the third quarter of2006. LCD revenue was $1.3 million, represented a 35% decrease from the samequarter last year. Video decoder revenue of $3.3 million represented a decreaseof 41%, compared to the same quarter last year.

In the third quarter, we hadthree customers, two of which are distributors that each represented more than10% of total net revenues, with the largest customers representing 24%, 12% and11% of total net revenues. Although our largest customer this quarter was ourdistributor in China, that customer is shipping to several end-customers.Combined, our 10 largest customers represented 84% of total net revenues in thethird quarter, of which five of these customers are distributors.

Gross margin continues to exceedour long-term target of 60% for the quarter. This compares to gross margins of58% in the third quarter of 2006 and 59% in the prior quarter. Third quarter2007 gross margins were positively impacted by the favorable product mixcomposing of our revenues as security surveillance's revenue was 68% ofrevenues.

Additionally, during the quarter,we continued our transition of new products to the 0.18-micron manufacturingprocess, which will provide us additional cost savings. For the third quarter,40% of total net revenues were earned from products fabricated in 0.18-micron.

Total operating expenses wereapproximately $6.6 million in the third quarter, representing approximately 44%of total net revenues. This compares to operating expenses of $4.4 million or29% of revenues in the same quarter last year and $5.7 million or 39% ofrevenues last quarter.

Third quarter results containedexpenses for research and development of $3.5 million, which includes more than$825,000 of tape-out expenses related to new product development.

Tape-out costs for the thirdquarter includes approximately $300,000, we had targeted to incur in the fourthquarter. Operating expenses also included approximately $1.3 million of pre-taxstock-based compensation expenses under SFAS 123R.

Net income for the third quartertotaled $5.4 million or $0.25 earnings per diluted share, which includes a $2.2million tax credit in the quarter or $0.10 earnings per diluted share.

The tax credit is due to $5.1million non-cash tax benefit from the release of valuation allowance on thecompany's deferred tax assets. The release of the valuation allowance wasnecessary under Statement of Financial Accounting Standards No. 109 as a resultof our continued profitability.

Net income for the quarter alsoincludes pre-tax stock-based compensation expenses equating to $0.06 per sharecharge. Fully diluted earnings per share for the quarter were calculated using21,768,000 shares.

Now turning to the balance sheet,accounts receivable were $1.9 million at the end of the third quarter, comparedto $2.4 million at the end of last quarter. Historically, we have sold oncredit terms only to OEM customers, and as a result, our accounts receivablebalances had been low in comparison to overall revenues.

In the third quarter, revenuesfrom direct sales to OEMs represented 36% of our revenues, while sales todistributors represented 64% of total net revenues.

Net inventory as of September 30,2007 was $4.5 million, decreasing from $4.8 million we recorded at the end ofthe second quarter of 2007. Our cash, cash equivalents in both short andlong-term investment balance as of September 30, 2007 was approximately $65.4million, compared to approximately $60.9 million as of June 30, 2007 and $54.5million as of December 31, 2006.

The increase in cash, cashequivalents in both short and long-term investments for the second quarter of2007 is a result of approximately $4.5 million in cash provided from operationsin the third quarter.

At the end of the third quarter,we had 125 employees, up from 108 employees at the end of last quarter with amajority of the new hires in research and development, which increased to 50employees.

In terms of guidance for thefourth quarter of 2007, we expect to see growth in our security surveillanceproduct line. As a result, we expect fourth quarter revenues to be in the rangeof $16 million to $16.5 million.

Gross margin for the quarter isexpected to continue to run above the long-term target of 55%. Total operatingexpenses will be down slightly because tape-out expenses will decrease toapproximately $250,000 in the fourth quarter and as a result, will remain inthe range of $5.0 million to $5.5 million, excluding stock-based compensationexpenses.

The tax rate in the fourthquarter will be zero as we will complete the tax benefit from the release ofour evaluation allowance. We are expecting our tax rate for 2008 to be 35%.

This concludes my preparedremarks. Now, I will hand the call to Hiro for additional comments.

Hiro Kozato

Thanks Mark. Good afternoon,everyone. Thank you for joining us today. Today, I would like to provide youwith greater detail on the results of the past quarter and greater insight intoour business.

During the quarter, as Mark hasmentioned, revenue from our security surveillance business again accounted forthe majority of our overall revenue. The market for security surveillanceequipment continues to be very strong with growth coming from all marketsegments and geographic locations.

In particular, China is showingsignificant growth. Recently I was able to spend several days meeting andtalking to customers in China. For the first time, these customers haveindicated to me that they are beginning to see significant purchase orders forproducts to be delivered under the China Safe City initiative.

We believe this is providingadded momentum to an already healthy market environment. I will be returning toChina this week as Techwell will be exhibiting at the China Public SecurityExpo on November 1st through the 4th in Shenzhen. At the show, we willdemonstrate our four line of security surveillance ICs including our marketleading four in one video decoders, integrated multiplexers, our motion JPEG[turnkey] solutions and our PCI, DVR Card solution designed especially for thesecurity surveillance market.

We also plan to have a number ofproduct and customer announcements that will take place during the Expo.

In products, this will include anext generation four in one video decoder solution, and a next generation PCIDVR Card solution. We produce new products such as these will continue to help,maintain and draw our leading market position in 2008 and beyond.

Now, I would like to turn to ourLCD display units. Similar to the previous quarter, our customers continue totell us that North American SUV and minivan manufacturers are continuing towork through inventory issues. We believe this is impacting the sales ofrear-seat entertainment displays that integrate our ICs.

As a result, we continue to seeweak order volumes for our LCD display product in the third quarter and weexpect this to continue into fourth quarter. However, we have reasons to beoptimistic about our LCD display business of 2008.

We expect this inventory issuesto be mitigated by the end of this year. We also have significant design winmomentum at Tier 1 OEMs and ODMs, automotive infotainment suppliers that weexpect to start generating revenues in 2008.

In addition, we expect toannounce a series of new LCD display product at the CES show in January 2008that would include highly integrated solutions of the automotive infotainmentmarket segment as well as for advance TV applications.

As a result, we believe we arepositioned significantly through our LCD display business in 2008 compared to2007.

Let me now discuss about ourvideo decoder business. We saw our video decoder business decline in the thirdquarter. We believe there are two main reasons for this decline. First;Techwell has migrated most video decoder customer in the security market tomore highly integrated Techwell security IC solutions. This revenue waspreviously recorded as video decoder revenue and has now shifted to securitysurveillance revenue as we are now providing applications to specific productsfor this market.

Second, our delay in releasingour integrated audio/video decoder has caused us to lose market share at somekey consumer electronics customers. As a result, we expect video decoderrevenues to decline in the fourth quarter. However, we do expect our videodecoder business to stabilize in 2008. Markets for standalone video decodersremain across multiple consumer application and we believe we are winning asignificant portion of these market.

In addition, we plan to formallyannounce our audio/video decoder product at CES and we are continuing to workwith all of our customers to generate design wins that we believe will lead toincreasing revenues for this product line in 2008.

In the first three quarters ofthis year, we have continued to aggressively invest in research anddevelopment, and we will continue to increase these activities until we havesignificantly ramped new product development.

In the third quarter, we added 10new engineers to our research and development group and we also taped out fournew products. We believe the investments we make in research and development in2007 to expand our new product offering in each of our product line willproduce results for Techwell for the next several years.

That concludes my preparedremarks. Operator, we will now open the call for questions.

Question-and-Answer Session

Operator

(Operator Instruction). Our firstquestion will come from the line of C.J. Muse of Lehman Brothers. Pleaseproceed.

C.J. Muse - Lehman Brothers

Yeah. Good afternoon. Thank youfor taking my question. Couple quick ones here on my end. I guess first on, canyou provide an update on the TW9930 audio/video decoder? I know sampling isunderway, if you could talk about how you are progressing there and I guess inparticular with the [current]?

Hiro Kozato

Yes. This is Hiro. We are nowsampling the first version of our TW9930 and currently, we have a couple of customersworking on the design wins with our chip. But we still need to re-spin anotherversion, which fits in a minor performance issue.

C.J. Muse - Lehman Brothers

And when do you expect that to betaped out?

Hiro Kozato

Yes. We have to tape it out byend of this year. But currently, customers are laying out the report with ourcurrent samples. Only one minor issues remains.

C.J. Muse - Lehman Brothers

Okay. And I guess, Mark, aquestion for you. If we pull out the excess 250 tape out that was pulled intothe September quarter, it looks like your operating margin is running about 18%and R&D nevertheless still up a little bit. Can you talk a little bit, howwe should think about OpEx going forward into 2008 and what kind of operatingmargin model we should be looking for?

Mark Voll

Well, we have said that ourtarget model is on a non-GAAP basis to be -- have operating margins 25% to 30%.And we believe that we can accomplish that. But we have and we believe that wewill continue to do that into 2008.

C.J. Muse - Lehman Brothers

Okay. And one last question fromme. Not to be too nitpicky here but you guys got it to $16 million to $16.5million revenues for Q4, but then $59 million to $59.5 million for the fullyear and that $59 million to $59.5 million implies $15.6 million to $16.1million in revenues for Q4. So I guess, the question is, which one should we belooking at?

Mark Voll

The quarterly guidance of whichwe said $16 million to $16.5 million.

C.J. Muse - Lehman Brothers

Okay. Great. Thanks.

Operator

Our next question will come fromthe line of Jay Srivatsa of Roth Capital Partners. Please proceed.

Jay Srivatsa - Roth Capital Partners

Yeah. Thanks for taking myquestion. Couple of questions, if I may, could you tell us what percentage ofyour revenues was in China?

Mark Voll

Past quarter, it was 28%.

Jay Srivatsa - Roth Capital Partners

Looking ahead, do you expect thatpercentage to continue to grow given the strength that you are seeing there inthat security and surveillance segment?

Mark Voll

Yes. We do.

Jay Srivatsa - Roth Capital Partners

Okay. In terms of penetration inother countries, are you seeing any exposure in Japan and what is the situationthere?

Hiro Kozato

Yes. We will start seeing morecustomers in Japan now for the new design wins. And as we mentioned in the lastearning call, starting from second half next year, we will see more revenuesfrom car TVs from the current design wins.

Jay Srivatsa - Roth Capital Partners

Okay. Hiro, last quarter youtalked about some display panel shortages in the automotive segment. What's thesituation now?

Hiro Kozato

I think this is still continuing,probably, to end of this year.

Jay Srivatsa - Roth Capital Partners

Okay. So, it's both display paneland inventories, you expect that problem to continue till the end of the year?

Hiro Kozato

Yes. We believe so.

Jay Srivatsa - Roth Capital Partners

Okay. Looking ahead, till nextyear, is there any seasonality you expect in the March quarter or does thisbumps backs from the automotive side elevate that?

Hiro Kozato

We think starting from Q1 theautomotive business will come back. I think our customers are consuming theinventory this year. But early next year, we think we should see more revenuesfrom car TVs.

Jay Srivatsa - Roth Capital Partners

Okay. I might have to take itthat you don't expect too much seasonality then in the March quarter?

Hiro Kozato

Seasonality, not really from carTVs.

Jay Srivatsa - Roth Capital Partners

Okay. From an overall revenuestandpoint?

Hiro Kozato

Yes. Q1 usually is lower and Q2usually it's a better quarter for security surveillance market.

Jay Srivatsa - Roth Capital Partners

Okay. In terms of the transitionto 0.1-micron, you had a healthy growth to 40%. Do you expect the Decemberquarter to contribute more with 0.18-micron?

Mark Voll

Yes, we do.

Jay Srivatsa - Roth Capital Partners

Okay. Maybe a last question, thenI'll step out of the queue, comparatively in the security surveillance segment,what are the things out here? Could you set the landscape for us?

Hiro Kozato

We are still seeing the samecompetitors and we are still leading the market share. But competitors aretrying to under [call] us in price. So, we are seeing some price pressure butnothing unusual at this moment.

Jay Srivatsa - Roth Capital Partners

Thank you very much. Goodquarter.

Hiro Kozato

You are welcome. Thank you.

Operator

Our next question will come fromthe line Quinn Bolton of Needham, please proceed.

Quinn Bolton - Needham

Hey, guys. Just wanted to followup Hiro on that last comment around tracing. Can you be a little bit morespecific, what you saw especially in the security business in Q3 and whetheryou are seeing continuing price pressure in Q4?

Hiro Kozato

The price DSP was quite flat andQ4, I think it will stay quite flat.

Quinn Bolton - Needham

Okay. So, it looks like in Q4,you are going to have flat pricing, a mix shift towards security products,because you commented earlier on the call that video or the video decoder theconsumer business would be down and auto it sounds like it's still weak. So,why wouldn't the gross margin actually trend up with that mix shift towardssecurity in a stable pricing environment?

Mark Voll

We think that the environmentwill be quite favorable for gross margins. What we don't know is what will bethe exact mix of product within security surveillance itself as we would havedifferent products that have different gross margins. Overall, we think thatthe environment just like Q3 would be quite favorable for us. Yeah.

Quinn Bolton - Needham

Okay. So, if you have a good mixof security, it's not out of the question that gross margin could actuallyincrease quarter-on-quarter?

Mark Voll

I don't know if I can go thatfar, but we think it's a pretty favorable environment where we believe we willcontinue to get some cost savings and we think pricing would be stable.

Quinn Bolton - Needham

Okay. And then for Hiro, I thinklast quarter, there might have been some product transitions around a newDaVinci Platform and H.264 decoding. Can you just talk about whether you thinkthe market is now mostly through that DaVinci Platform change?

Hiro Kozato

Actually, I don't think we simplychange yet. I think the only thing that we would see is where we have got areference design with TI where our 2835 or 2835 business was quite strong in Q3different from Q2.

Quinn Bolton - Needham

Okay. But I guess you haven'tseen any adverse impact on security business now because of any platformchanges on the DSP.

Hiro Kozato

Not yet.

Quinn Bolton - Needham

Okay.

Hiro Kozato

Usually, the design cycle, thequalification cycle is very long in security.

Quinn Bolton - Needham

Okay. And then for Mark, youtalked about reverse in evaluation, reserve against deferred tax assets, itlooks like that results in a slightly higher tax rate for next year. Is thereanything you can do or you are looking at any strategies to try and move someof the IT offshore, to try and lower that 35% tax rate beyond 2008?

Mark Voll

We are looking at deferredscenarios, but we won't be able to have any benefit for 2008.

Quinn Bolton - Needham

Okay. Great. Thank you.

Operator

Our next question will come fromthe line of Chris Longiaru of Sidoti. Please proceed.

Chris Longiaru - Sidoti

Hi, gentlemen.

Hiro Kozato

Hi.

Chris Longiaru - Sidoti

My first question is, you weretalking about the addition of two new LCD display customers last quarter. Arethose still online for I guess the first half of '08, is what you guided to?

Hiro Kozato

We think it's second half of '08.

Chris Longiaru - Sidoti

Second half of '08.

Hiro Kozato

Is it first or --?

Mark Voll

No, second half.

Chris Longiaru - Sidoti

Second half of '08.

Mark Voll

Right.

Chris Longiaru - Sidoti

Okay. And beyond that, just toget an idea here, the inventory situation, you've got pressure bailing startingin '08 and then kind of building out or it that kind of start in the firstquarter and that's gone by second quarter? How do you see that playing out?

Hiro Kozato

You mean inventory in car TV?

Chris Longiaru - Sidoti

Right. In LCD in the cars.

Hiro Kozato

Sorry. Would you repeat thequestion again?

Chris Longiaru - Sidoti

How do you see the inventory? Yousaid that you expect that -- I guess you have signs that point to thisinventory situation amongst your customers, kind of working ourselves out andstarting to -- I guess you should start to feel some relief in the beginning of'08. How do you see that playing out? Is there going to be something that allof a sudden that just going to hits in Q1 or is that going to kind of ease?

Hiro Kozato

I think that'll provide upsidefor us in Q1.

Chris Longiaru - Sidoti

In Q1, okay. Anyway, I think thatI missed was, you said the video surveillance market was up year-over-year.What was the percentage again?

Mark Voll

About 40%.

Chris Longiaru - Sidoti

40%?

Mark Voll

Yes. That's correct.

Chris Longiaru - Sidoti

Okay. All right, thank you guys.

Mark Voll

Welcome.

Operator

Our next question will come fromthe line of Eric Rasmussen of Montgomery & Company. Please proceed.

Eric Rasmussen - Montgomery & Company

Hi, guys. Thanks for taking thequestions. Just a follow up from Jay's comment earlier, you talked about0.18-micron around 40% this quarter. Are you still looking at that targeting at50% by year-end or somewhere close to there?

Mark Voll

That will be close. We see itincreasing. Yes. So, we should be close to that.

Eric Rasmussen - Montgomery & Company

Okay, great. And the competitivelandscape in the past, you talked about Texas, TI and Philips, any change inyour relationships there in terms of any dynamics happening that might increasethe competitive landscape there?

Hiro Kozato

Actually, I think ourrelationship with TI and Philips is getting better.

Eric Rasmussen - Montgomery & Company

Okay, great. And just one otherfinal question. Any possibility, you said that the inventory correction shouldbe mitigated by year end. But what's giving you the confidence with that rightnow as you see the business heading into the end of the year?

Hiro Kozato

The system providers are tellingus that they should be able to finish up the inventory soon. We don't knowexactly when, but we guess if it's starting from Q1, they will probably startordering new inventory.

Eric Rasmussen - Montgomery & Company

Okay, great. Thanks gentlemen.

Hiro Kozato

Welcome.

Mark Voll

You are welcome.

Operator

Our next question is a follow upquestion from the line of C.J. Muse of Lehman Brothers. Please proceed.

C.J. Muse - Lehman Brothers

Yes, thank you. Just a quickfollow up, I guess to seasonality of security surveillance. I guess with SafeCity potentially driving inner strength there, do you think that we could seebetter than typical seasonality in Q1 for that segment of your business?

Mark Voll

It's possible, yes.

C.J. Muse - Lehman Brothers

Okay. So, I guess '07 Q1 was down8% sequentially, so better than that you can give in regards?

Mark Voll

'07 was down about 15% from '06.

C.J. Muse - Lehman Brothers

At 8.9% versus 9.7%?

Mark Voll

No. And we were at 15.5% from16.1%, yeah.

C.J. Muse - Lehman Brothers

No, just for securitysurveillance, sorry.

Mark Voll

For security. We were down from10% to 9% I believe. 10% in Q4 and 9% in Q1. So, about 10% down.

C.J. Muse - Lehman Brothers

So, down 8% to 10% is what weshould expect without [steady] potentially shown better?

Hiro Kozato

I think it would be better.

C.J. Muse - Lehman Brothers

Okay. And remarkably to drill Iguess still a little bit deeper on the gross margin leverage up 60 bits here inthe quarter. Can you just I guess talk about how much of that came from justbetter top line versus I guess the higher 180 mix?

Mark Voll

It's going to be coming from thecost savings. So, the pricing has been pretty stable. The one aspect that'simproved was with the cost savings, we have gotten from more and more productgoing to 0.18. And this quarter, the mix was pretty favorable with the highpercent of revenue coming from security surveillance products.

C.J. Muse - Lehman Brothers

Got you. And earlier you said 48%was what you are targeting exiting Q4?

Mark Voll

48% --

C.J. Muse - Lehman Brothers

Of 0.18-micron for the next?

Mark Voll

No. It should be greater than 40approaching 50 we believe.

C.J. Muse - Lehman Brothers

Okay. And what's the theoreticalmaths there giving where you see mix overall for the company from varioussegments and what you are driving down the 0.18?

Mark Voll

I would imagine as we get furtherinto next year, the vast majority of our revenues becoming 0.18. It's greaterthan 75%.

C.J. Muse - Lehman Brothers

Okay. So, this 0.18 story maystill have legs in terms of benefit to the gross margin line in first half of'08.

Mark Voll

Yes. We believe we would begetting cost savings from that, correct.

C.J. Muse - Lehman Brothers

All right. Thank you.

Mark Voll

You are welcome.

Operator

Our next question is a follow-upquestion from the line of Jay Srivatsa of Roth Capital Partners. Pleaseproceed. Jay your line is open.

Jay Srivatsa - Roth Capital Partners

Quick question. Sorry about that.Can you tell me what is the stock-based comp for the next quarter, Mark?

Mark Voll

It should be about same levelthat was obtained in Q3.

Jay Srivatsa - Roth Capital Partners

Okay.

Mark Voll

It should be flat.

Jay Srivatsa - Roth Capital Partners

Okay. Hiro, maybe you can help usunderstand the China business a little bit more. We are seeing a lot ofcontracts that China's security and surveillance is getting. Could you sharewith us, how does it roll out, meaning, what is the time lag between when Chinasecurity gets a contracts and when you start getting the orders and how theyget deployed?

Hiro Kozato

This is difficult question.Depends on what stage they are in. They can sign the contract today and deliverthe parts in six months or three quarter. So, I don't know exactly whatcontracts they've signed. But one of their subsidiary who is using 100% ourproduct is telling us that they are raising their forecast.

Jay Srivatsa - Roth Capital Partners

Okay. Well, if the securitybusiness is not going to have much seasonality and the automotive business isgoing to bounce back in Q1, why do you expect any seasonal impact in the Marchquarter?

Mark Voll

I think we are just approachingin general, where we see a seasonal chart in Q1. But this time, we are muchmore constant.

Hiro Kozato

May be it won't be as drastic asbeen in other years.

Mark Voll

Right.

Jay Srivatsa - Roth Capital Partners

Fair enough. Thank you very much.

Hiro Kozato

Okay.

Mark Voll

You are welcome.

Operator

Our next question will come fromthe line of Heidi Poon of Thomas Weisel Partners. Please proceed.

Heidi Poon - Thomas Weisel Partners

Hi, Hiro and Mark. I just want afollow up on the China opportunity. Do you actually have any feasibility as towhat you're customers are designed into, where in terms of cities or provincesdo you have a sense of the deployment? Or do you just basically get the ordersfrom your DVR customer and go from there?

Hiro Kozato

Case by case, depends on thecustomer too. Some customer will tell us, some customer won't tell us. Andunfortunately, I don't have order information for you today, but I am sure oursales team has more information.

Heidi Poon - Thomas Weisel Partners

So, so far your sense is that asthe deployment is concentrating in certain major cities or is there anysurprise cities where smaller cities are also deploying? I just want to get asense of is it really just rolling out in a very initial stage?

Mark Voll

I think it's in at the initialstage and I think it's more for the big cities at this moment.

Heidi Poon - Thomas Weisel Partners

And I know that you are[definancing] the major DVR companies, but do you think that there's any localcompetition or maybe the bigger guys like TI also trying to get into thismarket? Do you see them when you are trying to get into designs?

Hiro Kozato

Yes. We are competing with manypeople everyday. But at this moment, we don't see a big change.

Heidi Poon - Thomas Weisel Partners

Okay. And more on the grossmargin side, I remember in Q1, you usually negotiate contracts with some ofyour larger customers. So, do you think that we are going to see that in Q1that we might see some pressure because sort of a new pricing contract wouldtake effect?

Hiro Kozato

We think so. I think so. But wewill be offering the 0.18-micron product to negotiate the contract.

Heidi Poon - Thomas Weisel Partners

Okay. Do you expect that to helpyou at least maybe maintain the gross margin, potential or pricing?

Hiro Kozato

Right.

Heidi Poon - Thomas Weisel Partners

Okay, great. Thank you.

Hiro Kozato

Welcome.

Operator

Our next question comes from theline of Quinn Bolton of Needham. Please proceed

Quinn Bolton - Needham

Hey, guys. Just a quick follow upon the consumer business for the general purpose video decoder business. Youmentioned that, that was going to be down in the fourth quarter because of somemarket share loss. Any quantitative comments you can put around that? Is thatsomething we should think of down around 10%? I think you said it was $3.3million in September, but just trying to get a hand on, how big of a declineare you expecting in that business?

Hiro Kozato

I would say less than $1 millionin revenue.

Quinn Bolton - Needham

Okay. So, it sounds like it couldbe down 20%, 30%?

Hiro Kozato

From the video decoder?

Quinn Bolton - Needham

Yeah. The video decoder businessI think it was $3.3 million in September and I think you had made a commentearlier on the call that that would likely be down in the fourth quarter?

Hiro Kozato

Yeah.

Quinn Bolton - Needham

So, that could be down tosomewhere in the 2.3 to 2.5 range?

Mark Voll

I would tell you, we do expect itto be down about 10% to 20%.

Quinn Bolton - Needham

10% to 20%. Okay. Great. Thankyou.

Operator

At this time, we have time forone final question and that question will come from the line of Greg Weaver ofKern Capital.

Greg Weaver - Kern Capital

Hi. Just one more follow up onthe China thing here. Hiro, could you talk a little bit more about it here.Could you think of [hazard to guesses] the size of the opportunity for you nextyear or maybe even the year after?

Hiro Kozato

Yeah. Many people have been askingthis question, but it's very difficult to quantify. Yet, there in some cases,in some customers, customers are telling us, they would double their orders andsome customers, they think it's flat. Well, case-by-case, I would say, just arough idea, Overall, I think it's outgrowing the worldwide market growth which is 20% to 25% normally.China is definitely outgrowing and I am sorry, I don't know exactly what thepercentage would be, maybe 50%.

Greg Weaver - Kern Capital

No. I was just trying to get a handon the total dollar opportunity in terms of number of cameras or some metricthat you might have worked out yourself to try to access how big this could be?

Hiro Kozato

Well, let me put it in this way.We think we'll do something around $38 million to $40 million in securitybusiness this year and next year, we think we will do more than $50 million inrevenue worldwide.

Greg Weaver - Kern Capital

Okay. So, what about the [delta]coming from China?

Hiro Kozato

Yeah, more from China. Japaneseis increasing. The Korea still in flat and the China is outgrowing Japan andother territories.

Greg Weaver - Kern Capital

Okay. Thank you very much.

Hiro Kozato

You are welcome.

Operator

Ladies and gentlemen, thisconcludes the question-and-answer portion of today's conference. I will turn itback to Mr. Voll for any closing remarks. Sir?

Mark Voll

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Thank you foryour participation. You may now disconnect. Have a great day.

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