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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 - LehmanBrothers
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 towelcome everyone to the Comtech Group Third Quarter 2007 Earnings Call. Alllines have been placed on mute to prevent any background noise. After thespeakers' remarks, there will be a question-and-answer period. (OperatorInstruction).
Thank you. It is now my pleasureto turn the floor over to your host, Hope Ni, CFO of Comtech Group. Ma'am, youmay begin.
Hope Ni
Thank you, [Zunou], and goodafternoon to everyone. I am Hope Ni, Chief Financial Officer of Comtech. And wewould like to thank you for joining us today for this call to discuss thequarterly earnings for Comtech Group.
After the bell today, the companyissued a press release reporting its financial results for the three monthperiod ending September 30, 2007. This release can be accessed in the InvestorRelations section of our website at www.comtech.com.cn, or on most otherfinancial websites.
Our earning call today will behosted 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 webcastand playback of this call can also be accessed from Investor Relation sectionof our website at www.comtech.com.cn.
Before we begin, I would like toremind you that we may discuss some non-GAAP measures when we talk about ourcompany performance. You can find the reconciliation of those measures to thenear comparable GAAP measures in the press release issued today.
In addition, I would like to takea few moments to run through forward-looking statements. The call today maycontain forward-looking statements regarding future events and the futurefinancial performance of the company. We wish to caution you that any suchstatements are just the prediction, and actual results may differ materially asa result of risks and uncertainties that pertain to the company's business.
We refer you to the documentsthat the company files periodically with SEC, specifically, the company's FormS-1 and S-3, the most recent file at 10-K and 10-Q, as well as the Safe Harborstatement in the press release that was issued today. These documents containimportant risk factors that could cause actual results to differ materiallyfrom those contained in the company's projections in the forward-lookingstatements. And Comtech assumes no obligation to revise any forward-lookingstatements contained in today's call.
At this time, I will turn thecall over to Jeffrey Kang, President, Chairman and CEO of Comtech Group.Jeffrey, the floor is yours.
Jeffrey Kang
Thank you, Hope. And thanks toeveryone for joining this earnings call. I am pleased to report that we haveachieved another record this quarter. We delivered both the highest quarterly revenueand profit in the company's history. We have also continued to improve thegross margins of our business.
Thirteen quarters have beenpassed since we became a public company, and our track record has demonstratedour 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 amore 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 avenuesfor the rest of the year. We continue to experience the robust revenue growth whichis above expectation performances overall of our key business areas during thequarter.
Let me start it away with the digitalmedia business. During the quarter, our digital media business grew by over 37%year-over-year, contributing more than 24% of our total revenue. With theopening of the Beijing Olympics, less than 10 months away, we expect continuousgrowth accelerating in the digital media market, which is driven by strongeconomic performance and the consumer spending optimism in China.
In addition to the mid andlow-end solutions, our high definition standard set-top box solutions with theBroadcom [to acknowledge] had become introduced this quarter. We expect tostart a shipment in the end of this year, demand for the new applications, suchas the GPS and auto entertainment and solutions had already ramped up. Ourpartnership with Microsoft continues to generate revenue through our GPS andother digital media solutions.
In addition to strong growth inthe digital and IPTV set-top box and the home gateway business, we continuingto capture opportunities and expand into new digital media applicationsdevelopment. This quarter, we have entered into a faster growing educationtechnology market, with a customized module solution for learning devices.
With Comtech's proven capabilitiesin identifying new emerging growth market in China and providing technology solutionsto enable our manufacturer customers to mid market demand quickly, we areconfident that we will continue to see meaningful revenue in the digital mediabusiness. Overall, we feel very confident about the growth we are experiencingin the near-term through 2008.
Now, let's shift our focus acrossComtech's traditional markets, mobile handset, and telecom equipment. We arevery pleased with the better-than-expected results in our mobile handsetbusiness.
Revenue in this area grew by over40% year-over-year, contributed over 40% of our total revenue in the thirdquarter. Chinese handset market continued to experience stronger-than-expectedgrowth this year, driven by strong domestic demand.
Industrial experts estimatedannual Chinese domestic market demand this year spent at over 200 million newmobile phones, which excludes those made in China and are sold overseas.Recently, we announced additional $10 million worth of the new Comtech's forproviding customized module solutions of GPS, and a touch panel to leadingChinese mobile phone manufacturers.
We believe this handset willfurther boost our mobile handset results for the rest of this year. Althoughthere are certain components, supply shortage may slightly impact somecustomers in the fourth quarter.
Our projections actually already factoreda set impact, and we are still seeing the demand better than our expectationand positive about the market often due in this sector for the rest of '07 andthrough '08.
Let’s turn to our telecomequipment business. Revenue from this business line increased by over 10%year-over-year, as we benefited from the growth of some of our major telecomcustomers, such as Huawei and ZTE, both of which are gaining a global market share.
I would also like to take thistime to give you an update on a 3G situation in China. Though we are lot countingon this deal in the calendar year, a research indicated that the CapEx spendingfor the TD-SCDMA networks will be around RMB 30 billion in 2007, mostlyinfrastructure equipment-related business.
As you know, some of ourcustomers, like ZTE, Huawei and [Starcom] have already announced a 3G contractwins and are playing very important roles in the development of the TD-SCDMAnetworks.
We believe Comtech is wellpositioned for the 3G opportunities in China. Our strong relationshipswith other major telecom OEMs, and our broad library of the functional moduleofferings, will allow us to grow alongside with these companies. We have alreadygenerated some small 3G-related revenue since this quarter, with a number ofdesign wins in this space. We expect more meaningful revenue in the near-term,as the development continues.
We expect our telecom equipmentsales to continually experience stable growth through '07. As always, fourthquarter is our traditionally strongest season of the year. We are optimisticabout this sector for the rest of the year.
Next, turning to our servicesegment, we generated service revenue of total US $2.9 million, representing anincrease of more than 56% year-over-year. We continue to be confident that thiswill be a high-growth, high-margin proportion for Comtech.
As we are seeing a strong demandfrom our Chinese customers, who have been requesting a total solution, includingnot only the technology products, but also implementation, maintenance andrelated service. Total expense as a one-stop service shop. This business modelperfectly fits into our customers’ need. We believe there is a significantpotential for COGO in this segment.
Finally, let's turn to ourM&A development. During the third quarter, we have completed theacquisition of KA, a company specialized in design and engineering of displaypanel technology, in China.The management team is happy to see the [trainers] effect taken place duringand after the merger.
We have started to introduce thenew product and its service offering to our existing customers, and receivedpositive feedbacks. We aim to expand KA's customer base from just a few T-cellphone customers to a much broader potential customer base with COGO having now.
We have already seen the revenuefrom this new business and expect more incremental revenue coming in the restof the year. KA is the first acquisition after our recent offering, and weexpect more accretive acquisition like this in future.
In addition to organic expansion,we are also considering using acquisition to grow our business faster in thisemerging, plus growing, but still fragmented market, such as auto electronics, Medicareequipment, [Green Energy] as well as the education technology market. Thecompany will continue to use both organic development and acquisitions to driveour sustainable growth over the coming five years.
With that remark, I would like toturn the call over to Ms. Hope Ni, our Chief Financial Officer, to discuss indetail the results for the third quarter. Hope?
Hope Ni
Thank you, Jeffrey. Goodafternoon, 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-GAAPEPS. We have also further improved the gross margin and non-GAAP operatingmargin.
Now, let me go through each majorline 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; $13.6million, or 24% of total sales for digital media products, representing a strongyear-on-year increase of 37.6%; $23.1 million, or 41% of total sales for mobilehandsets, representing a year-on-year increase of 40%; and $16.5 million, or29% of total sales for our telecommunication equipment, representing ayear-on-year increase of 10%.
The company's servicescontributed $2.9 million in revenue for the third quarter, and accounted forapproximately 5.2% total sales, representing a year-on-year increase of 56%.
Cost of goods, which includes theaggregate purchase of components from the suppliers and direct cost ofservices, was $45.2 million compared to $35.1 million, representing ayear-on-year increase of 28.8%.
Gross profit for the thirdquarter was $10.9 million, up 35% compared to $8.1 million, during the thirdquarter 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 alsoincreased slightly from 19.3% reported during the second quarter of '07.
Selling, general and adminexpenses for the quarter totaled $4.6 million, up 30.8% compared to $3.5million reported for the third quarter of last year. The increase wasattributable to increase in stock-based compensation expenses resulted fromincreasing employee headcount, and other sales-related expenses to support ourongoing growing business.
Research and development expensesincreased 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 newbusiness.
Income from operations was $4.9million, increased 37% compared to $3.6 million for the third quarter of lastyear.
The operating margin for thethird 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 ofpurchased intangible assets; the operating margin would have been 11.8%.
The effective tax rate for thethird 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 of132,000 over the same period last year, mainly due to our several notwholly-owned subsidiary now become our wholly-owned subsidiary this year.
Net income for the third quarterwas $5.5 million representing EPS diluted $0.14 on a US GAAP basis, compared toa net income of $4.1 million, or EPS diluted of $0.12 in the third quarter lastyear. Included in the third quarter '07 net income were amount of $1.4 millionfor stock-based compensation expenses, and $300,000 for amortization ofpurchased intangible assets.
Excluding the share-basedcompensation cost and amortization of purchased intangible assets, the companywould have reported non-GAAP net income of $7.1 million, or $0.18 dilutedearnings per share for this quarter. Our weighted average number of shares usedin the calculation of the EPS was $39.5 million, compared to 33.8 millionshares in the third quarter of last year. The increase in the share countmainly due to issued on the recent secondary public offering.
Now, let's turn to our balancesheet items. We have maintained a positive balance sheet. Company completed thequarter 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 bankborrowings, which is only $0.9 million, down 65% from $2.7 million from theprevious quarter. It continues to be in a strong financial position, with the currentratio 0.2 to 1. Inventory turnover days has remained stable at 33 days duringthe third quarter of 2007.
Day sale receivables was 101days, which is within our normal range and slightly on the high end of ournormal range. The main reason is, this quarter we had a very strong revenuefrom our large customers, such us ZTE. Some of our largest customers usually hasa better payment terms as well. But overall, it's within our normal range, andwe do not see any risks in terms of receivable collections.
Cash flow was slightly negativethis quarter, because businesses in this quarter with a few large customers,like ZTE, which had the longer payment; and another reason is, we had shortagein certain components, such as the power amplifier, and we few great quarter tosatisfy our large customers first. So, in comparison to the other quarter, ourprevious quarters, our large customers, like ZTE, has a much bigger percentagethis quarter, therefore, increased our payment term.
Now, let's discuss our futureoutlook. 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 revenuefrom the previous guidance $220 million, provided in the last quarter and a proforma EPS, excluding share-based compensation expense and amortization ofintangible, relate to acquisition of $0.70 for the full-year of 2007 from theprevious guidance $0.69 pro forma earnings per share.
We achieved better than expectedresults in Q3 2007. We remain very confident about the strong performance inthe rest of 2007, which enable us to further raise our guidance. Our originalguidance 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 $220million in revenue, and $0.70 pro forma EPS.
We will continue to deliverstrong performance, and deliver value to our shareholders. This concludes myremarks and now I'll turn the call back to Jeffrey. Jeffrey?
Jeffrey Kang
Thank you, Hope. We have been a probablythe company for 13 quarters, and our management is fully committed to achievingand maintaining a sustainable high growth. As we head into the fourth quarter,which is traditionally the biggest season of the year, we continue to seebetter-than-expected end of market demand in our mobile handset and the digitalmedia business, while our telecom business is in line with our projections. Webelieve that we possess a strong visibility for the rest of '07.
Now, I would like to turn thefloor over to questions. Operator?
Question-and-AnswerSession
Operator
(Operator Instructions). Our first question is coming fromMike Walkley of Piper Jaffray.
Charles John - PiperJaffray
Hello, Jeffrey and Hope, this is [Charles John] sitting infor Mike Walkley.
Jeffrey Kang
Hi John.
Charles John - PiperJaffray
Hi, congratulations on the good numbers and thanks fortaking my questions. Firstly it looks like the mobile handset division has comein a bit stronger than expected. Could you provide some color on what segmentin the handset you are seeing this growth and I know you’ve given guidance for2007, but would be really helpful, if you we could get some perspective on whatwe should expect for 2008, in terms of growth in both mobile and the telecomdivision.
Jeffrey Kang
I think for our mobile handsetbusiness as I just mentioned, our business is mainly driven by the Chinesedomestic consumer spending. So, in other words most of our -- in the market ofour mobile handset business and it goes into the Chinese domestic market. Eventhough some of them goes to also -- and it goes to the international marketalong with our customer like Huawei and ZTE.
So it's a strong party and Ithink fundamental raising is the Chinese economies are so strong Chineseconsumer spending part is increasing, so that stuff very sold foundation forour in the mobile handset business' growth. So in terms of all, I think we arealready half a way into the fourth quarter. We are seeing the better netexpected demand from end market in this mobile handset business.
And with still, even though thereare some components shortages in the market. But I think we've already factorthat impact. So we still expect better than expected mobile handset businessresult for us in the fourth quarter.
In terms of on '08, I think onthe 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 itand reason is very simple next year '08 is the busy earnings peaks. So, usuallybetter will drive the consumer spending optimism. So usually that will resultin even stronger end of market demand in the Chinese market. So that's my briefsummary, about your question.
Charles John - PiperJaffray
Okay, great. Just coming back tothe components shortage you mentioned where you -- how have you been able tofactor that into your model, were you able to increase your inventory ahead oftime and how long do you expect this tightness to last in the market?
Jeffrey Kang
Usually in the fourth quartercertain -- usually there are certain components shortage while we are anotherand this year and we are seeing in the mobile handset a couple of componentslike a power amplifier and like LCD panel or actually are in a service inshortage. So that the reason why when we think about the fourth quarter thatkind of our projection usually are internally we do the candle stuff,relatively a conservative deal. Well we cannot we don’t think the supplyusually is able to meet 100% of end of market demand. So in other words we areseeing end of market demanding or demand is a bigger than the market or whatmarket can suppliers can supply. So that's how we already know what we thinkabout 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 thebetter than expected result coming for us in the fourth quarter.
Charles John - PiperJaffray
Okay. Great. One last quickquestion for Hope: Can you provide the breakout of the stock-based compensationby line items for your OpEx?
Hope Ni
Yes.
Charles John - PiperJaffray
Both R&D and SG&A?
Hope Ni
Right. Again the percentage willbe between backend.
Charles John - PiperJaffray
Sure.
Hope Ni
They will be approximately 30% inthe R&D and 70% in selling, general admin.
Charles John - PiperJaffray
Okay, great. Thanks a lot guysand good luck.
Operator
Thank you. Our next question iscoming from Brian White of Jefferies.
Brian White - Jefferies
Yes. Jeffrey, I am wondering ifyou could talk a little bit about or remind us your exposure to the U.S. market, the China market and elsewhere aroundthe world? And then, I guess people are just curious, with various techcompanies experiencing softness to the unwinding of the credit bubble here inthe U.S.:If you could just remind us where you're generating your sales and you arethese sales consumed?
Jeffrey Kang
Yes. Thanks, Brain. As wementioned to our investor many times COGO, our business has mainly driven bythe 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% usuallyin international exporting related business, but mostly it's a telecomequipment related exporting business, which usually the Chinese customer Huawei,ZTE that produce that equipment in China, but it sells through theinternational market, mostly is a non-U.S. market Latino, Middle East, Asia andSouth Africa all those are growing emerging markets.
So that's why we don't think ourbusiness has too much impact connection with the U.S. economy, most of the Chinesedomestic economy, or Chinese GDP, continues to grow strongly. We certainly willbenefit 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 growthin the next couple of years.
Brian White - Jefferies
Okay, and Jeffrey, just give mesome color on 2008 in terms of the big markets that will be the drivers andthen maybe some of the interesting technologies or product examples that youexpect to take off next year. You have talked a lot about GPS for example andthe digital media segment. If you can just give us more color what is drivingthe growth in 2008?
Jeffrey Kang
Let's start with the secondsegment, one is in the mobile handset, as you know Chinese market this yeardelivered better than expected result or showed better than expected demand tothe investors. So, we are seeing next year, this year we believe there are over200 million units of cell phones has been sold us through, inside the Chinesemarket. So, we still believe this number will continue to grow in another 15%and 20% in 2008.
In terms of the feature embeddedinto the mobile handsets, we believe, features like the GPS or iPhone andsimilar touch panels solutions as well as the mobile TV. So, that we are seeingembedded into the cell phone will become the hot feature next year. This willdrive the Chinese consumer replace their current cell phone. As you know, theChinese consumers are replacing their cell phone very quickly in every 6 to 9months. So, this kind of drives the significant end of market demand for thenew features of the cell phone in the market. That will result in strongerdemand for the cell phone from the cell phone vendors, which will benefit ourbusiness.
In the digital media business, as you know, this alsobenefited 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 toindicate to us the strong driver for us in 2008. So that's what makes mebelieve, next year I believe the market, even though the U.S. might come toslightly slowing down in terms of the U.S. economy. But we are seeing thedemand in China and businessin Chinastill will show very strong growth pace, and even, I believe, stronger thanthis year.
Brian White -Jefferies & Company
Okay. And Hope, do you have the breakout in terms customersover 10% in the quarter?
Hope Ni
This quarter it’s a little bit unusual. Normally we do nothave over 10% customers, but this quarter for the reason is going earlier we dohave one, which is ZTE is approximately over 20%. The reason is ZTE is in allour major segments. ZTE is our customer [line] mobile and digital media as wellas in telecom. And as I explained earlier for certain component shortage suchas the power amplifier we have been trying to give orders and satisfy ourlargest customers need. So relatively ZTE's as a percentage has been quitelarge this quarter. We still expect the annualized as a whole year though Ithink 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 theyservice 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 ofNeedham & Company
Quinn Bolton - Needham & Company
Hi Jeff and Hope. Want to see if you might be able toquantify? How much business you may have lost on the table due to the componentshortages here in the third quarter? I mean: is that something that you thinkthere is a material amount of business that was affected because you couldn'tget the power amplifiers or the small screens [first]?
Jeffrey Kang
I think the reason why the PA is in shortage. As I believe isthat the end market demand is much bigger than all of the PA vendors as previouslyanticipation. So that's the reason of course, but the near term shortage of thepower amplifier. I believe this filtration copy which obviously makes us comeout. So it’s probably before next January. Having seen that, I think this is ahappy problem. So the reason is that end market demand is much bigger thanpreviously and we have what everybody anticipated. So that's the reason why thecomponent shortage in the market is probably over since middle of September. Sowe feel as, but preparing in another way. So even without this shortage so weare 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 soundslike you probably could have had higher revenues for the third and the fourthquarter based on how strong demand is? You didn't say some of these componentshortages?
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 apositive impact to our business. But having said that, you don't have thisusually, usually in the fourth quarter we anticipate some of the componentshortages. Its one way or another let me remind the power amplifier, nothingprobably that's the memory. So every year we anticipate some component shortagein the fourth quarter and so that's why we don't think it's usually, nobody canwalk on the percent with the market demand in the fourth quarter.
Quinn Bolton - Needham & Company
Okay, great. Then Jeffrey looking into next year, it soundslike the strength that you're seeing here in the third quarter and fourthquarter is really all year in 2007 in the China market really came from theolder GPRS or edge markets. Just wondering: if you could sort of talk about howdo you see the market in 2008? Is that still going to be mostly GPRS? Does thatplay a bigger role? And when do you think you start to seeing meaningfulTD-SCDMA revenue on the handset side?
Jeffrey Kang
We again, this year, in the very beginning, I told youlastly we don’t come of TD 3G business in this year. Even for the next year wedon't -- that will come on the TD 3G business. Even though we are veryconfident and Chinese government will push for this new technology rolling offin next year. But I’ll say it to you again, if we don't, we will not be put offtoo much. Our future is betting on some of the uncertainly. We still believeour growth drivers will be coming from the two area digital media and a mobilehandset. Digital media business, we get into not only just the IPTV set-top boxbusiness. Our GPS revenues just started to just ramp up, we spent a lot ofmoney developing the technology or introducing the new solutions. The businessjust started generating revenue in essence this quarter.
So that is why we anticipate next year will be the hardestyear for us, that will be our whole investment. On the other hand, because ofwhat we are seeing, we are also moving into the new territory like educationtechnology devices, which is, I know, and we're seeing a very huge demand fromthe end market. We already are getting into that business. We already generatedrevenue this year. So we still anticipate a deeper penetration rate for us inthat market. And also we expect the mobile handset business will continue thestrong growth, like our panel business. Well also we acquiring in the KA that aPanel Company. They just started to give some more contribution. And we believeall the bigger contribution will come in next year in the 2008. So that's whywe are so confident to believe our 2008 business out of the look should it bebrighter for us.
Quinn Bolton - Needham & Company
Okay, good. Its sounds like the 15% to 20% handset unitforecast that you talked about in 2008. That may sound like that was fullydriven by the 2, 2.5 [KA] market that's really not baking in any forecastassumptions on the TD market. Is that right?
Jeffrey Kang
Yes correct. As I said this isactually if the TD really jumped up. Usually I believe in the next year all theTD cell phone they are kind of a combining module is covering both the 2G andthe 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 still2.5 denominated.
Quinn Bolton - Needham& Company
Okay. Great. And then just twoquick questions on the digital media business, first: ahead of that ChinaOlympics, are you seeing any of the cable companies working to deploy highdefinition services over the cable network and if so is that an opportunitythat you are focused in the cable set-top box? And then second: on the GPStechnologies, are you working with any chip suppliers in particular to rolloutthe GPS or is that more of a software based solution? Thanks.
Jeffrey Kang
For HD, high-definition standard,Chinadoesn't have the HD standard yet. So, I believe, next year the mainstream willstill 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 theyhave 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 twomarkets: one is tucked in the international market, like the market that is inEurope and in Hong Kong and some developedcountries. Another is the Chinese domestic market.
So, we believe the highdefinition next year -- well starting year and we are going to see work grow ata very fast pace in the next couple of years.
Turning to the GPS, we currentlyremain working with [Syntran] team nowis part of the [Acer] and we also offer Broadcom our major partners in thissegment after Broadcom acquiring a global locate, so we probably we will beworking with them and using their technology or chipset to develop the newsolutions for next year.
Quinn Bolton - Needham& Company
Okay. Great, thanks Jeffrey.Thanks Hope.
Operator
Thank you. Our next question iscoming from Amir Rozwadowski from Lehman Brothers.
Amir Rozwadowski - Lehman Brothers
Thank you very much Jeffrey andHope. Just quick clarification on the 3G opportunity on the infrastructure sideof the business, Jeffrey. Can you clarify the opportunity a bit in 3G on theinfrastructure side? It seems though you are taking a more positive stands fromprevious 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 inthe very beginning we just tell the investor that we are not accounting on ourown revenue from the 3G business in China in mid year probably run mostpart of the next year. Raising money, because we believe that the Chinesegovernment is very nice and kind of obligated to push off this in newertechnology across the country, and so raising the money is very simple. Theyalready, in a permits to the word they have -- they will support the Chinahome grown. So I think it's just a matter of time so the TD-SCDMA still will bea approximer in Chinabut haven't seen that as a company we cannot bet on -- we only bid on the 3Gopportunity. So that's why we are using a relatively conservative attitude todeal with it.
So, we put the 3G opportunity asan upside as a bonus to us, so we have order solutions surrounding thesubsidiary networks. So, for example this year lessening our 3G business iswritten mostly is that 3G equipment related in a business, because we are seeingthe first step, as a first step of investment is to build the national widealso some of the safety wide or province wide the TD infrastructure networks.
So not improving is correct andas our customer such as ZTE, Huawei already announced, they're wining thecontract from the Chinamobile to build the TD-SCDMA networks translated in China. So when they get a contractwe get our portion of their orders to support their TD equipment roll outs.
Next year, I think most of peopleare starting looking at the TD cell phone business. We see TD next year, the TDnetworking business will still be increasing. But in addition to this, we arestill going to see more in the TD cell phone business coming next year.
Amir Rozwadowski - Lehman Brothers
Okay. Thank you very much. That'svery helpful. And not just to hop on some of the component issues, but you mayhave answered this, so I apologies but when do you see sort of resolutionthere? And is that something that actually could be resolved in the fourthquarter 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 ofthe next February. Key in terms of the product, some of the certain key componentsof that power amplifier shortage, I think that the major issue is coming fromthe renaissance, because this year is resumed to customize this component. Soonce you design in using [managed tape]. It takes few months to replace withthe competitors products. So, even if it will benefit our customer, theycannot, even you replace this components which is in shortage. It takes anotherone or two months, or three months for them. So, that again totally inducedtype of window in the fourth quarter. So, that's why we are seeing, thissituation is little bit tight for the supply in the power amplifier, similar tothe business in the fourth quarter. But, I think the situation is going toeasily be resolved in next two months.
Hope Ni
One point is that, even thoughthere is shortage, overall our business is very healthy and robust. That's whywe upgraded our guidance further for this year. So, we don't foresee any riskin terms of our performance business.
Amir Rozwadowski - Lehman Brothers
Great, well thank you both, it'svery helpful.
Operator
Thank you. Our next question iscoming from Adele Mao of Susquehanna.
Adele Mao - Susquehanna
I have several questions, firstof all historically your gross margin formula has hence thus are typicallylower than your overall gross margin, with mobile handset business sort ofcontributing increasing percentage with total revenue. Where do you see youroverall gross margin trending lets say next quarter and are you stillcomfortable with margin improvement quarter-over-quarter?
Hope Ni
We still expect the margin improvegradually over time. I think the pattern is to be, we still expect the patternto be quite consistent with our historical tightness.
Adele Mao - Susquehanna
So, are you seeing mobile handsetsegment gross margin actually improving from 2004.
Hope Ni
I think mobile handset is stillwithin the range because the range is around 15% to 18%, so within this rangeso we still -- we don't see, we see fluctuation because it could be dependsthen coming into the different solutions, it could be ranges 15% to 18%. Butoverall we always continue to work on the higher margin solutions and thehigher margin new products. So margin year-over-year we definitely expectincrease.
Adele Mao - Susquehanna
Okay. The other question I havecould you share with us how much revenue do you expect KA to contribute in thefourth quarter and how should we look at KS' growth in to 2008.
Jeffrey Kang
For the KS business, so breakthem into the two parts; one is they generate some revenue from their oldcustomer, another, because of incremental revenue, because we are able tointroduce their new solutions to our existing and broader customers in China.So, that's why internally we didn't just (inaudible) booking the KS revenuebecause KS revenue has been already embedded into our broad customer base andin China.But what we can say is that we believe this type of the technology KA relatedbusiness 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 pastI believe, you mentioned several certain growth areas that you are interestedin getting involved on acquisition front and did you sort of prioritize forthat and do you foresee an acquisition by the end of this year or it will be2008?
Jeffrey Kang
As we want to report in that, sowe always thinking this a new acquisition opportunities is actually we have aquite our few deals in our pipeline. And as you see COGO, well we have ourdiscipline in terms of acquisition. We have our principles. So we have to makesure every deal we have bound is a good deal, well it support our long-termgrowth strategy. So in terms of the specific area we focus on like the digitalmedia and auto and some of the newer territories and we believe there is acouple of gears coming in the next in this or next quarter.
Adele Mao - Susquehanna
Okay. Can you elaborate a littlebit on green energy you mentioned that statement?
Jeffrey Kang
As you know, because energytoday, more and more, attracts the people's attention in the market. I meanfrom a consumer or from the business perspective, for example, how to save theenergy if you have to acknowledge --electronics acknowledge to save energy to make electronics -- electrical powerused wisely intelligently, so that will help your customer save their cost. Soif you the solution that means that will help you customer they will buy yoursolutions or buy your service. So that's the area right now we are also lookingat. So we already have our feel right at top, and in my pipeline. So we mightuse acquisition to get into that business, even they can meet their conditionwe are looking at.
Adele Mao - Susquehanna
Okay, great. Thank you.
Operator
Thank you. Our next question iscoming from Ramesh Misra of Collins Stewart.
Ramesh Misra - Collins Stewart
Hi. Good morning Jeffrey andHope. And I hope you can here me?
Hope Ni
Hi Ramesh.
Ramesh Misra - Collins Stewart
Hi. My first question was inregards to the contract that you had announced at the end of September frommobile phone manufacturers for GPS and touch panel solutions. You had suggestedthat it might be incremental to Q4 revenues and I wanted to get a sense of whetherthat was also impacted by the component shortages?
Jeffrey Kang
You know, we announced this $10million the revenue even the end of the fourth quarter and what we can say ismost of it's GPS than a touch panel related business. I think some of them alreadyincluded in our previous guidance and some of them are outside to ourinvestors. So that's why we have room to increase our guidance in this quarter.
Answering to your question, sowhen we started to give the guidance to street we have already factored allthose (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, weare still able to deliver the better than expected results in the fourthquarter 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 ampand the LCD panels where there any other components that were impacted and alsorelated to that where there any change in pricing of these components?
Jeffrey Kang
We are just talking about what is happening now, forexample, the powered amplifier is in shortage, we're also seeing the panel isin shortage, we are also seeing that. Usually in the fourth quarter mostcomponent supplies are very tight. Now phase them, the memory, memory unitsales in this quarter is in shortage or like even some of the like that themobile TV chip is in shortage. In the telco related business, we are seeing inthe broadcast ADS so it should said as is actually in shortage.
You can say, usually in the fourth quarter, we are seeing isanother supply tight toughness comes as always. But we believe that this marketcame by judge and that this shortages situation and we believe the situationwill be resolved in the next two months.
Ramesh Misra -Collins Stewart
Okay. Finally, Jeffrey, in regards to your engineeringservices business, well congratulations on that year-on-year growth. Now in thepast you had expected engineering services to be contributing a more sizableamount of your revenues and also contributing positively to growth margins. AndI wanted to get a sense of where that is right now where do you see thattransitioning over in '08?
Jeffrey Kang
We still believe that service business will be on highmargin, mostly as a highest margin business. Again we slightly changed ourpolicy or strategy year. We want to focus not only just pursue the servicerevenue growing. We want to make is more quality revenue. So we are, but that'sthe reason why as you know last year even though we have in some -- in firsthalf of this year, even though we have the service revenue, but a betterrevenue also contribute to higher gross margin. But on our side it's been a lotof -- we invest a lot of money to build the platforms, operating expenses alsoa have a lot of expense to spend in the quarters in order to achieve thisservice revenue. Since the second half of this year we changed our strategy, wewanted to make sure audit service revenue not only just contributes to bettergross margin, but it still will help us increase our operating results. Sothat's why we are using control the service revenue growth and turn them intothe quantitative service revenue and cut our cost from the service revenueoperating expenses. So that will, today I believe even though -- I think ourservice revenue contributed much better quantitative revenue to us in terms ofthe 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 topin you down a little bit on your TD-SCDMA revenue. Can you say whether it wasaround $5 million or whether around $10 million ballpark, very rough ballparks?
Jeffery Kang
I think what we can see is a single digital, actually inthat range of $5 million to $10 million next year.
Ramesh Misra -Collins Stewart
Okay. Thanks very much Jeffery and congratulations on thesolid report.
Jeffery Kang
Thank you.
Operator
Thank you. Our next question is coming from Mark Tobin ofRoth Capital.
Mark Tobin - RothCapital
Good morning Jeffery and Hope.
Jeffery Kang
Hi Mark.
Mark Tobin - RothCapital
Quick question going back to service revenue have youtrimmed the staff there at all, I am trying to understand from a cost controlstandpoint, just getting a little more color?
Jeffrey Kang
Yes correct. We cannot, after over one years’ training andquantifying, so we cannot cut the service engineer head counts since the Q2 andQ3. So I think that we already, as you can say, after we cutting this headcounts we didn’t see the revenue streams, because we are as and still gettingmore contract from our customer we, diversified our customer base and moreimportantly and so I think that moving forward, so didn’t expect too much of thehead of account increasing in next year. So that will makes every bonus ofservice revenue can contribute as not only the gross margin, but also theoperating result as well.
Mark Tobin - RothCapital
Okay. And what kind of visibility does that business provideyou are you entering into multi-year contracts within the service business?
Jeffrey Kang
We are more focused on our service business and along withour products offering. So in terms of the visibility, for example, just usingthe maintenance as a service revenue as an example. Even though the customersometimes they give us a one year contract, some times they only gives us kindof indication and then they connect pay by use strategy. But overall because weknow exactly what our customer is going to use the surveys, we know thatexactly there is demand. So basically we still believe this is the servicebusiness, we have a very good visibility for us. We are still going to estimatethat this is sort of fast growing and high gross margin business to us in nextcouple of years.
Mark Tobin - RothCapital
Okay. And then one quick balance sheet question on theaccrued expenses line that was up quite a bit quarter-over-quarter. Hope, canyou provide some color behind that?
Hope Ni
Specifically, related to acquisition and then -- so that'swhy because what happens on few acquisitions and that the expenses is partiallyexpenses is under the accrued expenses.
Mark Tobin - RothCapital
Okay. Thank you.
Operator
Thank you. Our next question is coming from Jeff Kvaal of LehmanBrothers.
Jeff Kvaal - LehmanBrothers
Thanks Jeffrey and Hope. I was wondering if you couldexplain a little bit on your infrastructure comment, to what extent do you feelor like that in lineish market and forecast that you are talking about instructure. Does that extend to the, I mean how does that translate to overallrevenue growth, so both for you guys and I guess to some extent this Chinamarket in particular? Thank you.
Jeffrey Kang
In terms of our infrastructure business, as you know this isour 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 last10 years. But it comes to in this three years because telecom related revenueis roughly 25% to 30% of our total revenue. And in terms of the growth rate weare -- because for this telecom infrastructure related business, our growthmainly coming from few major customers in Chinalike Huawei, ZTE and they grow their business not only in China but also in the internationalmarket.
Telecom business once you estimate this will be stable on agrowing business for us in next couple of years. Even though they've alreadyhad a relatively bigger size to us, but we still expect at least a double-digitgrowth year-over-year in the next couple of years. So, the main driver is weare still confident above our key customer in its territory like Huawei, ZTE;they are gaining the international marketing shares.
Jeff Kvaal - LehmanBrothers
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 ourinfrastructure business. But mainly the infrastructure for us is still like forexample (inaudible), broadband, like GSM, the GSm base station or type of thetelecom infrastructure related business. A small portion may be just a fewpercent amount of total telecom infrastructure related business.
Jeff Kvaal - LehmanBrothers
Thanks Jeffery, very much.
Operator
Thank you. We have one follow-up question coming from BrianWhite 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 ninemonths 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. Iwould like to turn the floor back over to Mr. Kang.
Jeffrey Kang
Hi, thanks, I would like to take this opportunity to thankall COGO's believers; our employees, our customers, partners and long termshort orders. Because of you COGO is able to deliver a robust and sustainablegrowth 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 characterizethe Chinagrowth. The management team is fully committed to drive the sustainable highgrowth 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 soonin next time. Thank you, bye.
Hope Ni
Thank you. Bye bye.
Operator
Thank you this does conclude today's Comtech Groupconference call. You may disconnect your lines and have a wonderful day.
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