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Comtech Group, Inc. (COGO)

Q3 2007 Earnings Call

November 08, 2007 4:30 pm ET

Executives

Jeffrey Kang - President, Chairman and CEO

Hope Ni - CFO

Analysts

Charles John - Piper Jaffray

Brian White - Jefferies

Quinn Bolton - Needham & Company

Amir Rozwadowski - Lehman Brothers

Adele Mao - Susquehanna

Ramesh Misra - Collins Stewart

Mark Tobin - Roth Capital

Jeff Kvaal - Lehman Brothers

Brian White - Jefferies

Operator

Good afternoon. My name is [Zunou], and I will be your conference operator today. At this time, I would like to welcome everyone to the Comtech Group Third Quarter 2007 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. (Operator Instruction).

Thank you. It is now my pleasure to turn the floor over to your host, Hope Ni, CFO of Comtech Group. Ma'am, you may begin.

Hope Ni

Thank you, [Zunou], and good afternoon to everyone. I am Hope Ni, Chief Financial Officer of Comtech. And we would like to thank you for joining us today for this call to discuss the quarterly earnings for Comtech Group.

After the bell today, the company issued a press release reporting its financial results for the three month period ending September 30, 2007. This release can be accessed in the Investor Relations section of our website at www.comtech.com.cn, or on most other financial websites.

Our earning call today will be hosted by Jeffrey Kang, Chairman, President and CEO of Comtech, along with me, the Company's Chief Financial Officer. The earning call is being recorded; the webcast and playback of this call can also be accessed from Investor Relation section of our website at www.comtech.com.cn.

Before we begin, I would like to remind you that we may discuss some non-GAAP measures when we talk about our company performance. You can find the reconciliation of those measures to the near comparable GAAP measures in the press release issued today.

In addition, I would like to take a few moments to run through forward-looking statements. The call today may contain forward-looking statements regarding future events and the future financial performance of the company. We wish to caution you that any such statements are just the prediction, and actual results may differ materially as a result of risks and uncertainties that pertain to the company's business.

We refer you to the documents that the company files periodically with SEC, specifically, the company's Form S-1 and S-3, the most recent file at 10-K and 10-Q, as well as the Safe Harbor statement in the press release that was issued today. These documents contain important risk factors that could cause actual results to differ materially from those contained in the company's projections in the forward-looking statements. And Comtech assumes no obligation to revise any forward-looking statements contained in today's call.

At this time, I will turn the call over to Jeffrey Kang, President, Chairman and CEO of Comtech Group. Jeffrey, the floor is yours.

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Jeffrey Kang

Thank you, Hope. And thanks to everyone for joining this earnings call. I am pleased to report that we have achieved another record this quarter. We delivered both the highest quarterly revenue and profit in the company's history. We have also continued to improve the gross margins of our business.

Thirteen quarters have been passed since we became a public company, and our track record has demonstrated our commitments to building a sustainable high-growth company for the long run. This quarter, our revenue grew by 30% year-over-year, and the pro forma EPS about $0.18, representing a growth of more than 28% from last year.

Later on, Hope will provide a more details on the financial performance, and give you an updated guidance for '07. Now, let me provide some highlights from this quarter, and the business avenues for the rest of the year. We continue to experience the robust revenue growth which is above expectation performances overall of our key business areas during the quarter.

Let me start it away with the digital media business. During the quarter, our digital media business grew by over 37% year-over-year, contributing more than 24% of our total revenue. With the opening of the Beijing Olympics, less than 10 months away, we expect continuous growth accelerating in the digital media market, which is driven by strong economic performance and the consumer spending optimism in China.

In addition to the mid and low-end solutions, our high definition standard set-top box solutions with the Broadcom [to acknowledge] had become introduced this quarter. We expect to start a shipment in the end of this year, demand for the new applications, such as the GPS and auto entertainment and solutions had already ramped up. Our partnership with Microsoft continues to generate revenue through our GPS and other digital media solutions.

In addition to strong growth in the digital and IPTV set-top box and the home gateway business, we continuing to capture opportunities and expand into new digital media applications development. This quarter, we have entered into a faster growing education technology market, with a customized module solution for learning devices.

With Comtech's proven capabilities in identifying new emerging growth market in China and providing technology solutions to enable our manufacturer customers to mid market demand quickly, we are confident that we will continue to see meaningful revenue in the digital media business. Overall, we feel very confident about the growth we are experiencing in the near-term through 2008.

Now, let's shift our focus across Comtech's traditional markets, mobile handset, and telecom equipment. We are very pleased with the better-than-expected results in our mobile handset business.

Revenue in this area grew by over 40% year-over-year, contributed over 40% of our total revenue in the third quarter. Chinese handset market continued to experience stronger-than-expected growth this year, driven by strong domestic demand.

Industrial experts estimated annual Chinese domestic market demand this year spent at over 200 million new mobile phones, which excludes those made in China and are sold overseas. Recently, we announced additional $10 million worth of the new Comtech's for providing customized module solutions of GPS, and a touch panel to leading Chinese mobile phone manufacturers.

We believe this handset will further boost our mobile handset results for the rest of this year. Although there are certain components, supply shortage may slightly impact some customers in the fourth quarter.

Our projections actually already factored a set impact, and we are still seeing the demand better than our expectation and positive about the market often due in this sector for the rest of '07 and through '08.

Let’s turn to our telecom equipment business. Revenue from this business line increased by over 10% year-over-year, as we benefited from the growth of some of our major telecom customers, such as Huawei and ZTE, both of which are gaining a global market share.

I would also like to take this time to give you an update on a 3G situation in China. Though we are lot counting on this deal in the calendar year, a research indicated that the CapEx spending for the TD-SCDMA networks will be around RMB 30 billion in 2007, mostly infrastructure equipment-related business.

As you know, some of our customers, like ZTE, Huawei and [Starcom] have already announced a 3G contract wins and are playing very important roles in the development of the TD-SCDMA networks.

We believe Comtech is well positioned for the 3G opportunities in China. Our strong relationships with other major telecom OEMs, and our broad library of the functional module offerings, will allow us to grow alongside with these companies. We have already generated some small 3G-related revenue since this quarter, with a number of design wins in this space. We expect more meaningful revenue in the near-term, as the development continues.

We expect our telecom equipment sales to continually experience stable growth through '07. As always, fourth quarter is our traditionally strongest season of the year. We are optimistic about this sector for the rest of the year.

Next, turning to our service segment, we generated service revenue of total US $2.9 million, representing an increase of more than 56% year-over-year. We continue to be confident that this will be a high-growth, high-margin proportion for Comtech.

As we are seeing a strong demand from our Chinese customers, who have been requesting a total solution, including not only the technology products, but also implementation, maintenance and related service. Total expense as a one-stop service shop. This business model perfectly fits into our customers’ need. We believe there is a significant potential for COGO in this segment.

Finally, let's turn to our M&A development. During the third quarter, we have completed the acquisition of KA, a company specialized in design and engineering of display panel technology, in China. The management team is happy to see the [trainers] effect taken place during and after the merger.

We have started to introduce the new product and its service offering to our existing customers, and received positive feedbacks. We aim to expand KA's customer base from just a few T-cell phone customers to a much broader potential customer base with COGO having now.

We have already seen the revenue from this new business and expect more incremental revenue coming in the rest of the year. KA is the first acquisition after our recent offering, and we expect more accretive acquisition like this in future.

In addition to organic expansion, we are also considering using acquisition to grow our business faster in this emerging, plus growing, but still fragmented market, such as auto electronics, Medicare equipment, [Green Energy] as well as the education technology market. The company will continue to use both organic development and acquisitions to drive our sustainable growth over the coming five years.

With that remark, I would like to turn the call over to Ms. Hope Ni, our Chief Financial Officer, to discuss in detail the results for the third quarter. Hope?

Hope Ni

Thank you, Jeffrey. Good afternoon, everyone. For our clarity, all the figures I am discussing here, unless otherwise noted, will be in U.S. dollars. As Jeffrey mentioned earlier, we achieved another record quarter in our company history. We delivered 30% growth in revenue or 48% growth in non-GAAP net income, 29% growth in non-GAAP EPS. We have also further improved the gross margin and non-GAAP operating margin.

Now, let me go through each major line item. Revenue for the third quarter was $56.1 million, an increase of 30% compared to $43.2 million reported for the third quarter last year.

The revenue breakdown is; $13.6 million, or 24% of total sales for digital media products, representing a strong year-on-year increase of 37.6%; $23.1 million, or 41% of total sales for mobile handsets, representing a year-on-year increase of 40%; and $16.5 million, or 29% of total sales for our telecommunication equipment, representing a year-on-year increase of 10%.

The company's services contributed $2.9 million in revenue for the third quarter, and accounted for approximately 5.2% total sales, representing a year-on-year increase of 56%.

Cost of goods, which includes the aggregate purchase of components from the suppliers and direct cost of services, was $45.2 million compared to $35.1 million, representing a year-on-year increase of 28.8%.

Gross profit for the third quarter was $10.9 million, up 35% compared to $8.1 million, during the third quarter of last year. The gross margin for the third quarter was 19.5%, increased from 18.7%, reported during the third quarter of '06, and also increased slightly from 19.3% reported during the second quarter of '07.

Selling, general and admin expenses for the quarter totaled $4.6 million, up 30.8% compared to $3.5 million reported for the third quarter of last year. The increase was attributable to increase in stock-based compensation expenses resulted from increasing employee headcount, and other sales-related expenses to support our ongoing growing business.

Research and development expenses increased by 39% to $1.4 million compared to $1 million in the third quarter of '06. Research expenses were mainly related to investments in developing new business.

Income from operations was $4.9 million, increased 37% compared to $3.6 million for the third quarter of last year.

The operating margin for the third quarter was 8.8% versus 8.4% for the same period of last year. However, excluding the effects of the stock-based compensation and amortization of purchased intangible assets; the operating margin would have been 11.8%.

The effective tax rate for the third quarter of '07 was 8.7%, compared to 7.1% for the same period in 2006. Minority interest income share was 97,000 as compared to a share income of 132,000 over the same period last year, mainly due to our several not wholly-owned subsidiary now become our wholly-owned subsidiary this year.

Net income for the third quarter was $5.5 million representing EPS diluted $0.14 on a US GAAP basis, compared to a net income of $4.1 million, or EPS diluted of $0.12 in the third quarter last year. Included in the third quarter '07 net income were amount of $1.4 million for stock-based compensation expenses, and $300,000 for amortization of purchased intangible assets.

Excluding the share-based compensation cost and amortization of purchased intangible assets, the company would have reported non-GAAP net income of $7.1 million, or $0.18 diluted earnings per share for this quarter. Our weighted average number of shares used in the calculation of the EPS was $39.5 million, compared to 33.8 million shares in the third quarter of last year. The increase in the share count mainly due to issued on the recent secondary public offering.

Now, let's turn to our balance sheet items. We have maintained a positive balance sheet. Company completed the quarter with $114.7 million in cash. Write-downs from $128 million as of June 30, 2007. Namely attributable to payment related to recent acquisition.

Company has a very low bank borrowings, which is only $0.9 million, down 65% from $2.7 million from the previous quarter. It continues to be in a strong financial position, with the current ratio 0.2 to 1. Inventory turnover days has remained stable at 33 days during the third quarter of 2007.

Day sale receivables was 101 days, which is within our normal range and slightly on the high end of our normal range. The main reason is, this quarter we had a very strong revenue from our large customers, such us ZTE. Some of our largest customers usually has a better payment terms as well. But overall, it's within our normal range, and we do not see any risks in terms of receivable collections.

Cash flow was slightly negative this quarter, because businesses in this quarter with a few large customers, like ZTE, which had the longer payment; and another reason is, we had shortage in certain components, such as the power amplifier, and we few great quarter to satisfy our large customers first. So, in comparison to the other quarter, our previous quarters, our large customers, like ZTE, has a much bigger percentage this quarter, therefore, increased our payment term.

Now, let's discuss our future outlook. In terms of guidance for the year of 2007, based on the current guidance, management is increasing 2007 full-year guidance to $221 million in revenue from the previous guidance $220 million, provided in the last quarter and a pro forma EPS, excluding share-based compensation expense and amortization of intangible, relate to acquisition of $0.70 for the full-year of 2007 from the previous guidance $0.69 pro forma earnings per share.

We achieved better than expected results in Q3 2007. We remain very confident about the strong performance in the rest of 2007, which enable us to further raise our guidance. Our original guidance in the beginning of the year was only $200 million to $210 million, and $0.65 pro forma EPS. But now, we have provided to raise the guidance up to $220 million in revenue, and $0.70 pro forma EPS.

We will continue to deliver strong performance, and deliver value to our shareholders. This concludes my remarks and now I'll turn the call back to Jeffrey. Jeffrey?

Jeffrey Kang

Thank you, Hope. We have been a probably the company for 13 quarters, and our management is fully committed to achieving and maintaining a sustainable high growth. As we head into the fourth quarter, which is traditionally the biggest season of the year, we continue to see better-than-expected end of market demand in our mobile handset and the digital media business, while our telecom business is in line with our projections. We believe that we possess a strong visibility for the rest of '07.

Now, I would like to turn the floor over to questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions). Our first question is coming from Mike Walkley of Piper Jaffray.

Charles John - Piper Jaffray

Hello, Jeffrey and Hope, this is [Charles John] sitting in for Mike Walkley.

Jeffrey Kang

Hi John.

Charles John - Piper Jaffray

Hi, congratulations on the good numbers and thanks for taking my questions. Firstly it looks like the mobile handset division has come in a bit stronger than expected. Could you provide some color on what segment in the handset you are seeing this growth and I know you’ve given guidance for 2007, but would be really helpful, if you we could get some perspective on what we should expect for 2008, in terms of growth in both mobile and the telecom division.

Jeffrey Kang

I think for our mobile handset business as I just mentioned, our business is mainly driven by the Chinese domestic consumer spending. So, in other words most of our -- in the market of our mobile handset business and it goes into the Chinese domestic market. Even though some of them goes to also -- and it goes to the international market along with our customer like Huawei and ZTE.

So it's a strong party and I think fundamental raising is the Chinese economies are so strong Chinese consumer spending part is increasing, so that stuff very sold foundation for our in the mobile handset business' growth. So in terms of all, I think we are already half a way into the fourth quarter. We are seeing the better net expected demand from end market in this mobile handset business.

And with still, even though there are some components shortages in the market. But I think we've already factor that impact. So we still expect better than expected mobile handset business result for us in the fourth quarter.

In terms of on '08, I think on the fourth, but currently from my business perspective what I can say is that '08 could be better. So the growth rate is they will be going to accelerate it and reason is very simple next year '08 is the busy earnings peaks. So, usually better will drive the consumer spending optimism. So usually that will result in even stronger end of market demand in the Chinese market. So that's my brief summary, about your question.

Charles John - Piper Jaffray

Okay, great. Just coming back to the components shortage you mentioned where you -- how have you been able to factor that into your model, were you able to increase your inventory ahead of time and how long do you expect this tightness to last in the market?

Jeffrey Kang

Usually in the fourth quarter certain -- usually there are certain components shortage while we are another and this year and we are seeing in the mobile handset a couple of components like a power amplifier and like LCD panel or actually are in a service in shortage. So that the reason why when we think about the fourth quarter that kind of our projection usually are internally we do the candle stuff, relatively a conservative deal. Well we cannot we don’t think the supply usually is able to meet 100% of end of market demand. So in other words we are seeing end of market demanding or demand is a bigger than the market or what market can suppliers can supply. So that's how we already know what we think about our fourth quarter as a business, we've already factored this into our business. Well overall what I can say that even though half way we are still seeing the better than expected result coming for us in the fourth quarter.

Charles John - Piper Jaffray

Okay. Great. One last quick question for Hope: Can you provide the breakout of the stock-based compensation by line items for your OpEx?

Hope Ni

Yes.

Charles John - Piper Jaffray

Both R&D and SG&A?

Hope Ni

Right. Again the percentage will be between backend.

Charles John - Piper Jaffray

Sure.

Hope Ni

They will be approximately 30% in the R&D and 70% in selling, general admin.

Charles John - Piper Jaffray

Okay, great. Thanks a lot guys and good luck.

Operator

Thank you. Our next question is coming from Brian White of Jefferies.

Brian White - Jefferies

Yes. Jeffrey, I am wondering if you could talk a little bit about or remind us your exposure to the U.S. market, the China market and elsewhere around the world? And then, I guess people are just curious, with various tech companies experiencing softness to the unwinding of the credit bubble here in the U.S.: If you could just remind us where you're generating your sales and you are these sales consumed?

Jeffrey Kang

Yes. Thanks, Brain. As we mentioned to our investor many times COGO, our business has mainly driven by the Chinese domestic consumer spending. So, in terms of our end of market, 70% of our end of market goes to the Chinese domestic market, now that 30% usually in international exporting related business, but mostly it's a telecom equipment related exporting business, which usually the Chinese customer Huawei, ZTE that produce that equipment in China, but it sells through the international market, mostly is a non-U.S. market Latino, Middle East, Asia and South Africa all those are growing emerging markets.

So that's why we don't think our business has too much impact connection with the U.S. economy, most of the Chinese domestic economy, or Chinese GDP, continues to grow strongly. We certainly will benefit from that. So it does not matter if the U.S. economy is similar next term, or if it will continue at a strong pace, we will deliver a very strong growth in the next couple of years.

Brian White - Jefferies

Okay, and Jeffrey, just give me some color on 2008 in terms of the big markets that will be the drivers and then maybe some of the interesting technologies or product examples that you expect to take off next year. You have talked a lot about GPS for example and the digital media segment. If you can just give us more color what is driving the growth in 2008?

Jeffrey Kang

Let's start with the second segment, one is in the mobile handset, as you know Chinese market this year delivered better than expected result or showed better than expected demand to the investors. So, we are seeing next year, this year we believe there are over 200 million units of cell phones has been sold us through, inside the Chinese market. So, we still believe this number will continue to grow in another 15% and 20% in 2008.

In terms of the feature embedded into the mobile handsets, we believe, features like the GPS or iPhone and similar touch panels solutions as well as the mobile TV. So, that we are seeing embedded into the cell phone will become the hot feature next year. This will drive the Chinese consumer replace their current cell phone. As you know, the Chinese consumers are replacing their cell phone very quickly in every 6 to 9 months. So, this kind of drives the significant end of market demand for the new features of the cell phone in the market. That will result in stronger demand for the cell phone from the cell phone vendors, which will benefit our business.

In the digital media business, as you know, this also benefited from the strong consumer spending like we are seeing demand for GPS, high definition IPTV set-top box, or auto electronics. All of this is going to indicate to us the strong driver for us in 2008. So that's what makes me believe, next year I believe the market, even though the U.S. might come to slightly slowing down in terms of the U.S. economy. But we are seeing the demand in China and business in China still will show very strong growth pace, and even, I believe, stronger than this year.

Brian White - Jefferies & Company

Okay. And Hope, do you have the breakout in terms customers over 10% in the quarter?

Hope Ni

This quarter it’s a little bit unusual. Normally we do not have over 10% customers, but this quarter for the reason is going earlier we do have one, which is ZTE is approximately over 20%. The reason is ZTE is in all our major segments. ZTE is our customer [line] mobile and digital media as well as in telecom. And as I explained earlier for certain component shortage such as the power amplifier we have been trying to give orders and satisfy our largest customers need. So relatively ZTE's as a percentage has been quite large this quarter. We still expect the annualized as a whole year though I think ZTE is still going to be around 10%.

Brian White, Jefferies & Company

Okay. So, if T&W had been well over 10% and I think they service ZTE and Huawei, but T&W was not 10% this quarter?

Hope Ni

No.

Brian White, Jefferies & Company

Okay. Thank you.

Operator

Thank you. Our next question is coming from Quinn Bolton of Needham & Company

Quinn Bolton - Needham & Company

Hi Jeff and Hope. Want to see if you might be able to quantify? How much business you may have lost on the table due to the component shortages here in the third quarter? I mean: is that something that you think there is a material amount of business that was affected because you couldn't get the power amplifiers or the small screens [first]?

Jeffrey Kang

I think the reason why the PA is in shortage. As I believe is that the end market demand is much bigger than all of the PA vendors as previously anticipation. So that's the reason of course, but the near term shortage of the power amplifier. I believe this filtration copy which obviously makes us come out. So it’s probably before next January. Having seen that, I think this is a happy problem. So the reason is that end market demand is much bigger than previously and we have what everybody anticipated. So that's the reason why the component shortage in the market is probably over since middle of September. So we feel as, but preparing in another way. So even without this shortage so we are going to see and the market demand is to be much brighter than it is today. But the actual situation is, even today, the situation is very good.

Quinn Bolton - Needham & Company

It sounds like, I'm just trying to get a sense, it sounds like you probably could have had higher revenues for the third and the fourth quarter based on how strong demand is? You didn't say some of these component shortages?

Jeffrey Kang

Yes, I think if we involve this power amplifier shortage, overall the market demand should it be bigger, so that certainly will have a positive impact to our business. But having said that, you don't have this usually, usually in the fourth quarter we anticipate some of the component shortages. Its one way or another let me remind the power amplifier, nothing probably that's the memory. So every year we anticipate some component shortage in the fourth quarter and so that's why we don't think it's usually, nobody can walk on the percent with the market demand in the fourth quarter.

Quinn Bolton - Needham & Company

Okay, great. Then Jeffrey looking into next year, it sounds like the strength that you're seeing here in the third quarter and fourth quarter is really all year in 2007 in the China market really came from the older GPRS or edge markets. Just wondering: if you could sort of talk about how do you see the market in 2008? Is that still going to be mostly GPRS? Does that play a bigger role? And when do you think you start to seeing meaningful TD-SCDMA revenue on the handset side?

Jeffrey Kang

We again, this year, in the very beginning, I told you lastly we don’t come of TD 3G business in this year. Even for the next year we don't -- that will come on the TD 3G business. Even though we are very confident and Chinese government will push for this new technology rolling off in next year. But I’ll say it to you again, if we don't, we will not be put off too much. Our future is betting on some of the uncertainly. We still believe our growth drivers will be coming from the two area digital media and a mobile handset. Digital media business, we get into not only just the IPTV set-top box business. Our GPS revenues just started to just ramp up, we spent a lot of money developing the technology or introducing the new solutions. The business just started generating revenue in essence this quarter.

So that is why we anticipate next year will be the hardest year for us, that will be our whole investment. On the other hand, because of what we are seeing, we are also moving into the new territory like education technology devices, which is, I know, and we're seeing a very huge demand from the end market. We already are getting into that business. We already generated revenue this year. So we still anticipate a deeper penetration rate for us in that market. And also we expect the mobile handset business will continue the strong growth, like our panel business. Well also we acquiring in the KA that a Panel Company. They just started to give some more contribution. And we believe all the bigger contribution will come in next year in the 2008. So that's why we are so confident to believe our 2008 business out of the look should it be brighter for us.

Quinn Bolton - Needham & Company

Okay, good. Its sounds like the 15% to 20% handset unit forecast that you talked about in 2008. That may sound like that was fully driven by the 2, 2.5 [KA] market that's really not baking in any forecast assumptions on the TD market. Is that right?

Jeffrey Kang

Yes correct. As I said this is actually if the TD really jumped up. Usually I believe in the next year all the TD cell phone they are kind of a combining module is covering both the 2G and the 3G. So for us because we are focusing on the peripheral functional modules, so for us we don't see any difference no matter TV is coming up or again still 2.5 denominated.

Quinn Bolton - Needham & Company

Okay. Great. And then just two quick questions on the digital media business, first: ahead of that China Olympics, are you seeing any of the cable companies working to deploy high definition services over the cable network and if so is that an opportunity that you are focused in the cable set-top box? And then second: on the GPS technologies, are you working with any chip suppliers in particular to rollout the GPS or is that more of a software based solution? Thanks.

Jeffrey Kang

For HD, high-definition standard, China doesn't have the HD standard yet. So, I believe, next year the mainstream will still be that in a standard definition solution in China and that will be, maybe, 95% of the total business. But I haven't seen that because some location like in Beijing or Shenzhen they have already started trying to roll-off some of the high definition business. So for us, where are we, -- for our HD set-top box business, we have the two markets: one is tucked in the international market, like the market that is in Europe and in Hong Kong and some developed countries. Another is the Chinese domestic market.

So, we believe the high definition next year -- well starting year and we are going to see work grow at a very fast pace in the next couple of years.

Turning to the GPS, we currently remain working with [Syntran] team now is part of the [Acer] and we also offer Broadcom our major partners in this segment after Broadcom acquiring a global locate, so we probably we will be working with them and using their technology or chipset to develop the new solutions for next year.

Quinn Bolton - Needham & Company

Okay. Great, thanks Jeffrey. Thanks Hope.

Operator

Thank you. Our next question is coming from Amir Rozwadowski from Lehman Brothers.

Amir Rozwadowski - Lehman Brothers

Thank you very much Jeffrey and Hope. Just quick clarification on the 3G opportunity on the infrastructure side of the business, Jeffrey. Can you clarify the opportunity a bit in 3G on the infrastructure side? It seems though you are taking a more positive stands from previous comments potentially on 2007 and 2008 revenue contribution there?

Jeffrey Kang

We are actually, we are actually, we always are very positive about the TDs and 3Gs option in long run. And in the very beginning we just tell the investor that we are not accounting on our own revenue from the 3G business in China in mid year probably run most part of the next year. Raising money, because we believe that the Chinese government is very nice and kind of obligated to push off this in newer technology across the country, and so raising the money is very simple. They already, in a permits to the word they have -- they will support the China home grown. So I think it's just a matter of time so the TD-SCDMA still will be a approximer in China but haven't seen that as a company we cannot bet on -- we only bid on the 3G opportunity. So that's why we are using a relatively conservative attitude to deal with it.

So, we put the 3G opportunity as an upside as a bonus to us, so we have order solutions surrounding the subsidiary networks. So, for example this year lessening our 3G business is written mostly is that 3G equipment related in a business, because we are seeing the first step, as a first step of investment is to build the national wide also some of the safety wide or province wide the TD infrastructure networks.

So not improving is correct and as our customer such as ZTE, Huawei already announced, they're wining the contract from the China mobile to build the TD-SCDMA networks translated in China. So when they get a contract we get our portion of their orders to support their TD equipment roll outs.

Next year, I think most of people are starting looking at the TD cell phone business. We see TD next year, the TD networking business will still be increasing. But in addition to this, we are still going to see more in the TD cell phone business coming next year.

Amir Rozwadowski - Lehman Brothers

Okay. Thank you very much. That's very helpful. And not just to hop on some of the component issues, but you may have answered this, so I apologies but when do you see sort of resolution there? And is that something that actually could be resolved in the fourth quarter or is it something that you see more first half of '08?

Jeffrey Kang

I think the first half of though -- first maybe before the Chinese New Year, end of the January or beginning of the next February. Key in terms of the product, some of the certain key components of that power amplifier shortage, I think that the major issue is coming from the renaissance, because this year is resumed to customize this component. So once you design in using [managed tape]. It takes few months to replace with the competitors products. So, even if it will benefit our customer, they cannot, even you replace this components which is in shortage. It takes another one or two months, or three months for them. So, that again totally induced type of window in the fourth quarter. So, that's why we are seeing, this situation is little bit tight for the supply in the power amplifier, similar to the business in the fourth quarter. But, I think the situation is going to easily be resolved in next two months.

Hope Ni

One point is that, even though there is shortage, overall our business is very healthy and robust. That's why we upgraded our guidance further for this year. So, we don't foresee any risk in terms of our performance business.

Amir Rozwadowski - Lehman Brothers

Great, well thank you both, it's very helpful.

Operator

Thank you. Our next question is coming from Adele Mao of Susquehanna.

Adele Mao - Susquehanna

I have several questions, first of all historically your gross margin formula has hence thus are typically lower than your overall gross margin, with mobile handset business sort of contributing increasing percentage with total revenue. Where do you see your overall gross margin trending lets say next quarter and are you still comfortable with margin improvement quarter-over-quarter?

Hope Ni

We still expect the margin improve gradually over time. I think the pattern is to be, we still expect the pattern to be quite consistent with our historical tightness.

Adele Mao - Susquehanna

So, are you seeing mobile handset segment gross margin actually improving from 2004.

Hope Ni

I think mobile handset is still within the range because the range is around 15% to 18%, so within this range so we still -- we don't see, we see fluctuation because it could be depends then coming into the different solutions, it could be ranges 15% to 18%. But overall we always continue to work on the higher margin solutions and the higher margin new products. So margin year-over-year we definitely expect increase.

Adele Mao - Susquehanna

Okay. The other question I have could you share with us how much revenue do you expect KA to contribute in the fourth quarter and how should we look at KS' growth in to 2008.

Jeffrey Kang

For the KS business, so break them into the two parts; one is they generate some revenue from their old customer, another, because of incremental revenue, because we are able to introduce their new solutions to our existing and broader customers in China. So, that's why internally we didn't just (inaudible) booking the KS revenue because KS revenue has been already embedded into our broad customer base and in China. But what we can say is that we believe this type of the technology KA related business will become around 10% of our business next year.

Adele Mao - Susquehanna

Okay. So 10% of your business, and that’s consistent on the second system with what you indicated in the past I believe, you mentioned several certain growth areas that you are interested in getting involved on acquisition front and did you sort of prioritize for that and do you foresee an acquisition by the end of this year or it will be 2008?

Jeffrey Kang

As we want to report in that, so we always thinking this a new acquisition opportunities is actually we have a quite our few deals in our pipeline. And as you see COGO, well we have our discipline in terms of acquisition. We have our principles. So we have to make sure every deal we have bound is a good deal, well it support our long-term growth strategy. So in terms of the specific area we focus on like the digital media and auto and some of the newer territories and we believe there is a couple of gears coming in the next in this or next quarter.

Adele Mao - Susquehanna

Okay. Can you elaborate a little bit on green energy you mentioned that statement?

Jeffrey Kang

As you know, because energy today, more and more, attracts the people's attention in the market. I mean from a consumer or from the business perspective, for example, how to save the energy if you have to acknowledge -- electronics acknowledge to save energy to make electronics -- electrical power used wisely intelligently, so that will help your customer save their cost. So if you the solution that means that will help you customer they will buy your solutions or buy your service. So that's the area right now we are also looking at. So we already have our feel right at top, and in my pipeline. So we might use acquisition to get into that business, even they can meet their condition we are looking at.

Adele Mao - Susquehanna

Okay, great. Thank you.

Operator

Thank you. Our next question is coming from Ramesh Misra of Collins Stewart.

Ramesh Misra - Collins Stewart

Hi. Good morning Jeffrey and Hope. And I hope you can here me?

Hope Ni

Hi Ramesh.

Ramesh Misra - Collins Stewart

Hi. My first question was in regards to the contract that you had announced at the end of September from mobile phone manufacturers for GPS and touch panel solutions. You had suggested that it might be incremental to Q4 revenues and I wanted to get a sense of whether that was also impacted by the component shortages?

Jeffrey Kang

You know, we announced this $10 million the revenue even the end of the fourth quarter and what we can say is most of it's GPS than a touch panel related business. I think some of them already included in our previous guidance and some of them are outside to our investors. So that's why we have room to increase our guidance in this quarter.

Answering to your question, so when we started to give the guidance to street we have already factored all those (inaudible) components, or shortage or some customer missed their number, we've already factored all this news. So that's why we are very confident, we are still able to deliver the better than expected results in the fourth quarter even though they have a base of that and a problem in the market.

Ramesh Misra - Collins Stewart

Got it, in regards to the components shortage you power amp and the LCD panels where there any other components that were impacted and also related to that where there any change in pricing of these components?

Jeffrey Kang

We are just talking about what is happening now, for example, the powered amplifier is in shortage, we're also seeing the panel is in shortage, we are also seeing that. Usually in the fourth quarter most component supplies are very tight. Now phase them, the memory, memory unit sales in this quarter is in shortage or like even some of the like that the mobile TV chip is in shortage. In the telco related business, we are seeing in the broadcast ADS so it should said as is actually in shortage.

You can say, usually in the fourth quarter, we are seeing is another supply tight toughness comes as always. But we believe that this market came by judge and that this shortages situation and we believe the situation will be resolved in the next two months.

Ramesh Misra - Collins Stewart

Okay. Finally, Jeffrey, in regards to your engineering services business, well congratulations on that year-on-year growth. Now in the past you had expected engineering services to be contributing a more sizable amount of your revenues and also contributing positively to growth margins. And I wanted to get a sense of where that is right now where do you see that transitioning over in '08?

Jeffrey Kang

We still believe that service business will be on high margin, mostly as a highest margin business. Again we slightly changed our policy or strategy year. We want to focus not only just pursue the service revenue growing. We want to make is more quality revenue. So we are, but that's the reason why as you know last year even though we have in some -- in first half of this year, even though we have the service revenue, but a better revenue also contribute to higher gross margin. But on our side it's been a lot of -- we invest a lot of money to build the platforms, operating expenses also a have a lot of expense to spend in the quarters in order to achieve this service revenue. Since the second half of this year we changed our strategy, we wanted to make sure audit service revenue not only just contributes to better gross margin, but it still will help us increase our operating results. So that's why we are using control the service revenue growth and turn them into the quantitative service revenue and cut our cost from the service revenue operating expenses. So that will, today I believe even though -- I think our service revenue contributed much better quantitative revenue to us in terms of the gross margin as well as the operating margins as well.

Ramesh Misra - Collins Stewart

Okay. That helps a lot Jeffery thanks. I am going to try to pin you down a little bit on your TD-SCDMA revenue. Can you say whether it was around $5 million or whether around $10 million ballpark, very rough ballparks?

Jeffery Kang

I think what we can see is a single digital, actually in that range of $5 million to $10 million next year.

Ramesh Misra - Collins Stewart

Okay. Thanks very much Jeffery and congratulations on the solid report.

Jeffery Kang

Thank you.

Operator

Thank you. Our next question is coming from Mark Tobin of Roth Capital.

Mark Tobin - Roth Capital

Good morning Jeffery and Hope.

Jeffery Kang

Hi Mark.

Mark Tobin - Roth Capital

Quick question going back to service revenue have you trimmed the staff there at all, I am trying to understand from a cost control standpoint, just getting a little more color?

Jeffrey Kang

Yes correct. We cannot, after over one years’ training and quantifying, so we cannot cut the service engineer head counts since the Q2 and Q3. So I think that we already, as you can say, after we cutting this head counts we didn’t see the revenue streams, because we are as and still getting more contract from our customer we, diversified our customer base and more importantly and so I think that moving forward, so didn’t expect too much of the head of account increasing in next year. So that will makes every bonus of service revenue can contribute as not only the gross margin, but also the operating result as well.

Mark Tobin - Roth Capital

Okay. And what kind of visibility does that business provide you are you entering into multi-year contracts within the service business?

Jeffrey Kang

We are more focused on our service business and along with our products offering. So in terms of the visibility, for example, just using the maintenance as a service revenue as an example. Even though the customer sometimes they give us a one year contract, some times they only gives us kind of indication and then they connect pay by use strategy. But overall because we know exactly what our customer is going to use the surveys, we know that exactly there is demand. So basically we still believe this is the service business, we have a very good visibility for us. We are still going to estimate that this is sort of fast growing and high gross margin business to us in next couple of years.

Mark Tobin - Roth Capital

Okay. And then one quick balance sheet question on the accrued expenses line that was up quite a bit quarter-over-quarter. Hope, can you provide some color behind that?

Hope Ni

Specifically, related to acquisition and then -- so that's why because what happens on few acquisitions and that the expenses is partially expenses is under the accrued expenses.

Mark Tobin - Roth Capital

Okay. Thank you.

Operator

Thank you. Our next question is coming from Jeff Kvaal of Lehman Brothers.

Jeff Kvaal - Lehman Brothers

Thanks Jeffrey and Hope. I was wondering if you could explain a little bit on your infrastructure comment, to what extent do you feel or like that in lineish market and forecast that you are talking about in structure. Does that extend to the, I mean how does that translate to overall revenue growth, so both for you guys and I guess to some extent this China market in particular? Thank you.

Jeffrey Kang

In terms of our infrastructure business, as you know this is our announced business. This is our first the business started 11 years ago, and we're seeing the robust revenue growth although from this business in last 10 years. But it comes to in this three years because telecom related revenue is roughly 25% to 30% of our total revenue. And in terms of the growth rate we are -- because for this telecom infrastructure related business, our growth mainly coming from few major customers in China like Huawei, ZTE and they grow their business not only in China but also in the international market.

Telecom business once you estimate this will be stable on a growing business for us in next couple of years. Even though they've already had a relatively bigger size to us, but we still expect at least a double-digit growth year-over-year in the next couple of years. So, the main driver is we are still confident above our key customer in its territory like Huawei, ZTE; they are gaining the international marketing shares.

Jeff Kvaal - Lehman Brothers

Okay and this is of course pre TD-SCDMA or any 3G at all.

Jeffrey Kang

No, this is a TD-SCDMA is rational portion of our infrastructure business. But mainly the infrastructure for us is still like for example (inaudible), broadband, like GSM, the GSm base station or type of the telecom infrastructure related business. A small portion may be just a few percent amount of total telecom infrastructure related business.

Jeff Kvaal - Lehman Brothers

Thanks Jeffery, very much.

Operator

Thank you. We have one follow-up question coming from Brian White of Jefferies.

Brian White - Jefferies

Hi, Hope. Do you have deprecation and CapEx for the quarter?

Hope Ni

For the nine month, CapEx, there is hold on. For the nine months its around [1 million].

Brian White - Jefferies

Okay.

Hope Ni

CapEx.

Brian White - Jefferies

And how about that depreciation.

Hope Ni

Depreciation is the 0.45 million, so $450,000.

Brian White - Jefferies

For the nine months.

Hope Ni

Yeah, nine months.

Brian White - Jefferies

Nine months, okay thank you.

Operator

Thank you. We have no further questions at this time. I would like to turn the floor back over to Mr. Kang.

Jeffrey Kang

Hi, thanks, I would like to take this opportunity to thank all COGO's believers; our employees, our customers, partners and long term short orders. Because of you COGO is able to deliver a robust and sustainable growth in that the full 13 quarters. We believe we are in the right industries, the growing market and we are in a good position to capture and characterize the China growth. The management team is fully committed to drive the sustainable high growth in the next five years to provide significant returns to our investors. Thanks again for joining this call and I look forward to talking with you soon in next time. Thank you, bye.

Hope Ni

Thank you. Bye bye.

Operator

Thank you this does conclude today's Comtech Group conference call. You may disconnect your lines and have a wonderful day.

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Source: Comtech Group Q3 2007 Earnings Call Transcript
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