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PortalPlayer Inc. (PLAY)

Q4 2005 Earnings Conference Call

January 26th 2006, 5:30 PM.

Executives:

Kristine Mozes, Investor Relations

Gary Johnson, Chief Executive Officer, President

Olav Carlsen, Chief Financial Officer

Analysts:

Randy Abrams, Credit Suisse First Boston

Peter Kirzres, CItigroup

Jason Pflaum, Thomas Weisel Partners

Quinn Bolton, Needham & Co.

Adam Benjamin, Jefferies & Co.

Daniel Ernst, Hudson Square Research

Craig Berger, Wedbush Morgan

Shawn Slayton, SG Cowen

Jason Paraschac, Kaufman Brothers

Presentation

Operator

Welcome to the PortalPlayer, Inc. fourth quarter and year-end 2005 earnings call. Operator Instructions At this time, for opening remarks and introductions I would like to turn the call over to Kristine Mozes, Investor Relations for PortalPlayer. Please go ahead, ma'am.

Kristine Mozes, Investor Relations

Thank you. And thank you for joining us today. In addition to this call being recalled by phone replay it's being broadcast live via the Investor Relations page of PortalPlayer's web site at www.PortalPlayer.com. Earlier today, we issued our earnings press release and filed it with the SEC. The press release is also available on PortalPlayer's web site. That press release contains certain non-GAAP financial measures, which we will discuss during today's call, together with the most directly comparable financial measures calculated in accordance with GAAP and reconciliations of the differences between these measures.

With me today is Gary Johnson, President and CEO of PortalPlayer, and Olav Carlsen, PortalPlayer's Chief Financial Officer. I will begin this call by reading our Safe Harbor statement. The statements on today's call, which are not historical facts, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act. These forward-looking statements include, but are not limited to, statements as to our future plans and growth, development efforts, features, benefits and introductions of products and technology, entrance into new markets, our plans to hire additional resources, our and our customers' market positions, our revenue growth, including revenue from the Flash market and timing thereof, market trends and demands for high capacity players and anticipated growth of this market, market trends and demand for differentiated notebooks and anticipated growth of this market, availability of Microsoft Vista side show technology, market trends and demand for products with wireless connectivity and anticipated growth of this market, potential acquisitions, demands for our product and future financial results, GAAP, and non-GAAP, including revenue, net income, expenses, gross margins, ASPs, stock-based compensation charges, tax rates, cash flow, weighted average shares outstanding, and operating expenses included but not limited to future R&D spending and selling, general and administrative expenses.

These forward-looking statements are subject to a number of risks and uncertainties that can cause actual results to differ materially from those discussed in these forward-looking statements. Please refer to today's earnings release, our Form 10-K for the year ended December 31 2004, and our Form 10-Q for the quarter ended September 30th, 2005, as filed with the SEC, and from time to time in our other SEC reports. For information on risk factors that can cause actual results to differ materially from those discussed in these forward-looking statements. These forward-looking statements speak only as of the date hereof, PortalPlayer disclaims any intent or obligation to update these forward-looking statements.

Additionally, this conference call is the property of PortalPlayer, and may not be recorded or rebroadcast without specific written permission from the company. Now, I would like to turn the call over to Gary for his introductory remarks. Gary?

Gary Johnson, Chief Executive Officer, President

Thank you and welcome, everyone. 2005 was certainly an outstanding year for PortalPlayer. On the financial side, we grew our annual revenue from $93 million in 2004, to $225 million in 2005. We also increased our profitability significantly year-over-year, and have impressive shipment activities throughout the entire quarter, including the last three weeks, which we recognize as deferred revenue. We are very proud of these results and believe that there's significant opportunity for growth in our current market of personal media players. And that we also have many opportunities ahead of us to leverage our technology to other fast-growing portable multimedia markets. We are really looking forward to the future.

To help support this growth in 2005, we organized the business into three product divisions: Each focusing on a different market opportunity, personal media players, personal media displays, and personal wireless entertainment. In the personal media space, we achieved very impressive results this year. We introduced innovative new technologies, such as our PP 5022 family which tripled the battery life of media players and features our MPEG 4 and motion JPEG capabilities, and our 5024, which is our first device to integrate the media processor along with the audio power management and battery charging features in a single package.

In September the iPod Nano, the first Flash-based media player using our technology was introduced into the market with great success. As a result, we extended our leadership position in the personal media player market to include Flash and hard drive-based storage. We also worked very aggressively on new technologies in 2005, we can't share details of all the projects we are focusing on just yet, but one result of our hard work was the successful launch at CES of our new PortalPlayer Preface technology. The implementation of which, garnered much attention and media attention during the show.

We believe the new technology will expand into a major market segment, personal media displays, a new, exciting feature for notebook computers in 2006 and beyond. We'll talk more about that market in a few minutes. In addition to working on these new opportunities, we are also looking at ways we can incorporate wireless connectivity into new multimedia devices. We were proud to see the Sirius Satellite Radio, the first wireless customer shipping the revolutionary Sirius S50, a CES Innovation 2006 Award honoree in the portable audio category. In addition, our newly created personal wireless entertainment division has been working very hard on next generation wireless technologies.

In a few minutes I will go into more detail on each of these initiatives but first I will turn the all over to Olav would will take you through the details of our fourth quarter and year-end financials.

Olav Carlsen, Chief Financial Officer

Thank you, Gary and welcome, everyone. This fourth quarter of '05 was again another record quarter in many ways. We proud to announce that revenue was a record $78.2 million which is a 75% increase from the $44.7 million in the same period a year ago. And 35% higher than the revenue of $57.9 million we recorded in the third quarter of 2005. This is above our guidance range of 65 to $75 million due to the fact that we met stronger than expected demand, especially in the second half of the quarter.

As Gary mentioned earlier, we had a very high level of shipping activity throughout the entire quarter. Our Q1 guidance of $70 to $80 million reflects the strong late quarter activity, as well as some expected seasonal decline for Q1, but less of a decline that you would expect after a very strong holiday quarter. Revenue from our largest customer represented about 95% of our total revenue, as market share shifted again in favor of this customer's very popular new model, which features innovative form factors and revolutionary capabilities. Having said that, in Q4, revenue from our other customers increased to about $3.9 million, and we're certainly are very proud about our new design wins at Sirius Satellite Radio, Phillips and SanDisk and more about this in a few moments.

Our fourth quarter gross margin of 46.2% continued to be above our operating target margin of 41 to 44%, and I want to remind everyone again, that our financial forecast is based on a 41 to 44% growth margin range. Net income for the fourth quarter was $23.8 million, compared with a net income of $10.5 million in the same period a year ago. This fourth quarter 2005 net income resulted in an income of $0.92 per diluted share, based on $25.8 million weighted average shares outstanding, compared to a net income of $0.50 per diluted share based on approximately $21.1 million weighted average shares outstanding in the same quarter a year ago.

The significant difference in share count between these two quarters is, of course, due to the fact that we went public in the middle of the fourth quarter a year ago, and the newly issued IPO shares were partially included in last Q4's share count, using the required weighted average method. Net income in the third quarter of 2005 was $10.3 million or $0.40 per diluted share, based on 25.5 million weighted average shares. In terms of taxes, we saw a one-time benefit this quarter, which impacted our results by $8.6 million or $0.33 per diluted share.

Based on our recent strong financial performance in our financial forecast, we evaluated our deferred tax asset position and adjusted our valuation allowances accordingly. In doing this, we anticipated in the fourth quarter the favorable effect of some remaining tax NOLs. Now that we have used in 2005 most of the favorable effects from our pre-IPO losses, our effective tax rate for Q1 is expected to be at 35%, which is about the same as we had predicted in the past. When comparing year-over-year results in the future, it will be important to keep the difference in tax rates between '05 and 2006 in mind.

Now, excluding stock-based compensation charges of $664,000, and the one-time tax benefit non-GAAP net income for the fourth quarter of '05 was $15.9 million or $0.62 per diluted share. This, compared with a non-GAAP net income in the fourth quarter of '04, of approximately $11.2 million, or $0.53 per diluted share and non-GAAP net income for the third quarter of '05 was $11 million or $0.43 per diluted share. We provided the detailed reconciliation between GAAP numbers and the non-GAAP numbers, which detailed the stock compensation charges for each quarter, as well as the one-time tax adjustment.

Now here's some other details on this quarter's P&L. In Q4, our ASPs and costs were in line with our expectations, since we began shipping our 5022 family about a year ago, ASPs for the SKU have decreased by 20% which is the low end of our financial forecast, of an ASP decline of 20 to 25% on individual SKU basis. Operating expenses were about $18.8 million for R&D, and SG&A in the fourth quarter, $1.8 million above our guidance, and as we experienced strong revenue growth, we increased our spending level accordingly, with our financial operating model in mind and so operating expenses again, like in previous quarters came in at our target level of about 24% of our revenues. $12.7million of this, or 16.3% of our revenue was allocated to our R&D activities as we continue to successfully accelerate some of our important R&D milestones.

We were able, again, to attract many strategically important new employees, mostly in engineering areas here in the U.S. and in India. Going forward, in Q1, we expect to continue to manage our R&D spending to about 17% of our revenues, or about $13 million. SG&A expenses in the fourth quarter were $6 million, which is a $2 million increase from the previous quarter, and is within our long-term operating model. This increase is mostly driven by additional costs associated with our Sarbanes-Oxley compliance and one-time expenses related to the filing of our S-1 in October of 2005. In Q1 we expect SG&A to remain within our long-term operating model n of about 7% of revenue, or about $5.2 million, $800,000 below our Q4 spending level.

Our stock-based compensation charge of $664,000 included, as always, elements of amortization of deferred compensation, some variable charges, and a charge for amortizing the expense of restricted share grants that we began issuing in 2005. Going forward, we will record stock-based compensation in accordance with FAS 123-R, and will find the elements of these charges in the gross margin, and R&D and SG&A operating expenses, as well as the benefit from these expenses in our tax provision.

For Q1, we expect our total compensation charge under FAS 123R to be about $2.4 million or about $1.8 million net of certain tax effects. Now let's turn to the balance sheet. Our inventory balance at December 31st was $7.2 million, most of which is finished goods. This represents 10 to 11 days of inventory, once again, below our targeted goal of 30 days, reflecting the very strong activity level we saw at the end of the quarter. And accordingly, I will defer to income position, which represents the gross margin for shipments in the last three weeks of the quarter, was again at a very high level of $10.9 million. Head count at the end of the quarter was about 284, during the fourth quarter we added 34 very talented employees to our ranks, most of them in R&D. For the full year, we added a total of 103 new employees. As in previous quarters approximately 80% of our overall head count was focused on our current or strategic R&D activities and, again, about half of our overall head count was based in Hyderabad, in India.

And now turning briefly from the fourth quarter to fiscal 2005 results, net revenue for fiscal 2005 was $225.2 million, up 143% from the $92.6 million in revenue for fiscal 2004. Net income for the year was $48.2 million or an income of $1.90 per diluted share based on 25.4 million weighted average shares outstanding. This compares with a net income of $10.4 million, or $0.57 per diluted share based on about 18.1 million weighted average shares outstanding in 2004.

Non-GAAP net income for fiscal 2005 was $41.8 million, or $1.65 per diluted share, which excludes the fourth quarter tax benefit, and non-cash compensation charges. This compared with a non-GAAP net income of $16.2 million, or $0.89 per diluted share in fiscal 2004, excluding non-cash compensation charges. And before I turn the call back over to Gary, let me summarize our guidance for the first quarter.

Revenue is expected to come in between 70 and $80 million, total OpEx before stock charges is expected to be about 24% of revenue or about $18.2 million, stock-based compensation charges are expected to come in at $1.8 million, net of tax, GAAP net income per diluted share is expected to be between $0.28 and $0.38 based on approximately 26.5 million weighted average shares outstanding, and excluding the net effect of our stock compensation charges, non-GAAP net income per diluted share is expected to be between $0.35 and $0.45.

And at this time, I would like to turn the call back over to Gary for his comments. Gary?

Gary Johnson, Chief Executive Officer, President

Thank you, Olav. Thank you. All around another great quarter, and a great year for PortalPlayer, Financially, operationally, and technically. I would like to thank the entire PortalPlayer team here in the U.S., in India, Taiwan, Korea and Japan for continuing to execute impeccably on business plan, follow our road map and in supporting our world-class customers. As I mentioned earlier, we organized the business into three product divisions last year focusing on personal media players, personal media displays and personal wireless entertainment.

First, let's talk about our personal media player division. In the fourth quarter, we focused a lot of our attention on our operational execution. Supporting our customers as they significantly ramp their newly introduced products in the holiday season and getting new customers ready to introduce their products. Our largest customer had an excellent quarter, as for other customers, we recently announced that our technology is in the new SanDisk sensor, E200 series of mp3 players and the Phillips Go Gear HDD 6330 and 1630 personal media players. SanDisk E200 series, which features music playback, photo and video capabilities, is the first media player to use our 5024 device, and it comes in two, four and six gigabyte Flash models.

SanDisk just introduced these players at CES few weeks ago and they already received rave reviews. The Phillips go models offer customers access to music, photos, FM radio, and voice recordings with an intuitive sensory touch pad and are available in 30 gig and 6 gigabytes HDD models. Phillips is one of the world's most recognizable customer brands and we are proud to be working again with them on these new personal media players. These new models, together with Apple's iPod, and iPod Nano, are examples of products in which we call, in what we call the feature rich segment of the personal media player market.

Products in this feature rich segment include color displays, sophisticated features such as photo, video and gaming capabilities, in addition to playing music and large storage capabilities. In the future, we believe that this feature rich segment of the personal media player market will see very strong growth rates. We estimate that this portion of the market will almost double from about 35 million units in 2005, to about 64 million units in 2006. We intend to continue to be the leader in this segment. In contrast to the feature rich segment, personal media players that have no display or simple or single or double line displays, limited storage capacity, and only play music, we call the value portion of the market. These products are typically characterized by little opportunity for product differentiation, and low barriers to entry.

We want to lead in the space where features, functionality and innovation are key. We believe that there are several significant drivers that are going to fuel demand for higher capacity media players, with additional functionality. Including the availability of video content, satellite radio services, PBR capabilities, subscription services, podcasts and wireless connectivity.

Now let's talk about our personal media display division. This new product division leverages our current leadership in the personal media player market into other markets That can benefit from low power multimedia displays. The first new market addressed by this division is the secondary displays for notebook computers. These displays, an anticipated new feature in notebooks will be located on the outsides of the lid of the notebook, and allow the consumers to access key data, application, music, photos, and video content without having to turn on and boot up the notebook. In order to enable the best customer experience for this new feature, it should be tightly integrated with the operating system and applications on the notebook.

With this in mind the personal media display division has been working very closely with Microsoft, to enable this capability in Microsoft's slide show technology, which is part of the Microsoft Vista operating system. We recently launched our solutions to in market under the name Preface and in a book, the preface is the first thing you read and from this case the Preface-enabled display is the first thing you will look at on your notebook. In addition to eliminating the need to boot the computer to access the notebook content, a process that can take between two and four minutes, the low-powered nature of the Preface technology platform can enable up to 500 hours of music playback on the notebook. The low powered capabilities of the Preface platform also enabled access to certain notebook content for tens of hours, even if the battery is depleted to the point where the notebook can no longer boot up.

Initially notebooks that incorporate this technology will have access to data such as music, picture slide shows, Outlook calendar, e-mail, contact information, alarms, clocks, battery meters, and so forth. In addition, Microsoft is making this an open platform so third-party developers will be able to write their own applications, known as gadgets, allowing users access to many kinds of data stored on the notebook. In addition to Microsoft, we have also been working with partners such as Altura, Authentec, and Symantec to offer a variety of interfaces for these personal media displays.

According to Gartner, notebooks are the fastest growing segment in the PC market and we believe that manufacturers are looking for ways to differentiate their products. The PortalPlayer Preface technology enables visible differentiation to the design and the use of notebooks, which really have not changed since they were first introduced in the 1990s. We expect notebooks and secondary displays using Windows Vista to begin shipping in the second half of 2006. This year, we believe that total available market for this technology could be as high as 6 million units, growing to 16 million units next year and about 48 million units or almost half of the entire notebook market by 2008. Our targeted customers to Preface will be the top 10 OEM and ODM notebook manufacturers. In fact at CES we showed prototype designs from Quanta, and Asustec, which together make up a substantial portion of entire notebook market.

Our sales and promotion efforts for the preface platform were kicked off earlier this month at the Consumer Electronics Show in Las Vegas, where we were able to show the Preface technology to a wide variety of press, analysts and potential notebook OEM customers. The response from the wide ranging audience was enthusiastic interest in the technology, and interest for the notebook OEMs to incorporate the technology in the 2006 and the 2007 models. And also an energetic display of the preface technology Walt Mossberg on CNBC. We are very excited about this market and the opportunity gives us in leveraging our existing technology into an entirely new space, targeting a new customer base. Revenue from this new major market could potentially reach 10% of our overall revenue in 2006.

Our personal wireless entertainment product division has also been hard at work, behind the scenes here at PortalPlayer. The group is focused both on the technology aspects of wireless, as well as understanding the ecosystem required to deliver compelling user experience on wirelessly connected devices. In addition, they are exploring opportunities to address the shortcomings in battery life and usability seen in many of the wireless devices already in the market today.

Looking forward into 2006, we will continue efforts in the wireless space, by working with strategic customers, wireless technology partners, as well as considerating strategic wireless acquisitions as they make sense. In summary, we are extremely pleased with our accomplishment in 2005, and believe that 2006 will be even more exciting. We believe that the feature rich segment of the personal media player market could almost double year-over-year in 2006, offering us a great opportunity for continued growth in our core market. With the expected emergence of the personal media display market in the latter half of the year, this will allow us to further increase the market opportunities available to us, and diversify our customer and revenue base as well. We continue to invest in wireless technology, as we believe that this wireless connectivity will become an integral part of the overall consumer electronics landscape.

We are now happy to open up the call to take your questions about our business. I want to remind everyone that it is our policy not to comment on specific customer products or road map. Operator, we are ready for questions.

Questions & Answers

Operator

Thank you, sir. Operator Instructions. We'll pause for just a moment to assemble our roster. We'll take our first question from Randy Abrams with Credit Suisse First Boston.

Q - Randy Abrams

Yes, Thanks a lot. I wanted to start off, you mentioned the Phillips and SanDisk products and maybe talk about your outlook for diversification over the next couple of quarters, even more in the media division, as three customers ramp up.

A - Gary Johnson

Well, as you know, Randy, CES is a very busy time for us, for us to bring new designs and to bring new life to our potential customers. The designs that analysts and other folks saw at CES are a good preview for the first half, but I as I said, the ones we've announced so far are focused on the Phillips and SanDisk devices. The SanDisk device, I think brings some new innovations to the market, the capacity of the device is very nice, the user interface, but beyond, beyond the SanDisk and Phillips devices we will not disclose new customer wins until our customers announce them.

Q - Randy Abrams

Okay. And Olav, I want to see if you could clarify, the ASP a unit year-over-year trends. I think you mentioned that 20%, was that a total company ASP for year-over-year?

A - Olav Carlsen

Well, it almost turned into total company because we shipped, most of our product we shipped basically, especially in the last three quarters of the year were the 5022 and so I only referenced the ASP decline for the 5022, which was a 20% year-over-year decline.

Q - Randy Abrams

Okay. And do you have the total year-over-year?

A - Olav Carlsen

The total year-over-year for the portfolio, is that what you are asking?

Q - Randy Abrams

Yes.

A - Olav Carlsen

It's below that. It's between 15 and 20%.

Q - Randy Abrams

Okay. And then turning over to Preface, could you talk about, I think you mentioned that displays is the first application. Maybe talk about some of the other applications where this technology starts to make sense.

A - Gary Johnson

Yes, the, the other applications again reinvolvele around multimedia displays and what Mossberg got excited about on CNBC, we had example prototypes at CES that showed this in intelligent remote controls, the ability to have rich display with lots of content on the remote controls, also, for example, front panels, for example, in media centers as media center PCs become more intelligent, you could well see a more intelligent user interface and panel for that market. Longer term, this type of application, I can see this moving to many markets, including automotive, but I would say, beyond notebooks, remote controls and media center PCs are that we have already demonstrated at CES.

Q - Randy Abrams

Okay. And maybe one final question, just on the gross margin. Maybe talk about the trends that drove the upside in gross margins and then as you move into the notebook application, is there any prospect with that mix shift that it will carry a higher margin?

A - Olav Carlsen

So the second part of your question, I don't believe that there's a shift. I think we feel very comfortable in the 41 to 44% target model that we are operating in longer term. So I see with the diversification of our business in the second half of the year, I don't see that margin model change. The, the first part of your question was about the trends or the uptrend to the 46, or about 46% gross margin in Q4, again, I need to remind you, our long-term model is 41 to 44%. That's our target model. If because of customer mix, or cost developments specifically the development on the cost side, if we can have a specific quarter or even two quarters we are happy about that.

Q - Randy Abrams

Okay. Thanks a lot, guys.

A - Gary Johnson

Thank you.

Operator

We'll take our next question from Glen Yeung with Citigroup.

Q - Peter Kirzres

Hi, this is Peter Kirzres (ph) with Glen Yeung. I wanted to ask going forward into the first quarter, your guidance is better than normal, seasonal decline. If we get a feel for how much of that would be coming from new customers, versus how much of that is coming from your existing customers, or, I guess your largest customer. And also if there's any benefit in pricing, as well.

A - Olav Carlsen

So, Peter we don't break out our revenue guidance by customer, it's a matter of policy. We do give you data on past quarters but not in terms of guidance. We are very proud of the designs that are shipping from Phillips and Sirius and we are excited about SanDisk. Ultimately consumers will decide how much they like the products. They are certainly cool products out there. It's too early to break it up at this time. Can you remind me of the second part of your question?

Q - Peter Kirzres

That actually takes care of it. But I will ask you this then, on a separate subject, for wireless, as you are working through your wireless division, have you zeroed in or do you have any more clarity on what type of assets you might need to take in to, as you bring the products to market? Or before you bring products to market?

A - Gary Johnson

Well, yes, we have honed in on the type of assets but they are not for discussion at this point. The technologies that obviously interest us most are technologies that can really add to our portfolio of low power technologies. When we look at wireless, in terms of a hand held device, we really want to focus around applications that will start to push you both in multimedia aspect and the low power aspects. So, we could use acquisitions as part of the methodology to acquire technology, and expertise there but we also, as you indicated have had a very active in internal development now during 2005. The short answer is it's too early to tip our hat, but we are narrowing in on what we think will be very important capabilities on the next generation platforms.

Q - Peter Kirzres

Great. Thank you.

Operator

And we'll take our next question from Jason Pflaum of Thomas Weisel Partners.

Q - Jason Pflaum

Yes, good afternoon. Congratulations.

A - Olav Carlsen

Thanks.

Q - Jason Pflaum

Just to touch on the guidance, again, I guess looking at the deferred income line. It looks I can you have a third of your revenue guidance, I guess in the deferred income line heading into the quarter. What type of seasonality or linearity are you expecting in the quarter? Is it typically a back-end loaded quarter, maybe some color as far as that?

A - Olav Carlsen

Are you suggesting that, are you asking whether the first quarter is a back end specifically or the fourth?

Q - Jason Pflaum

The first quarter, I'm interested in.

A - Olav Carlsen

I don't think that the first quarter is a back-end loaded quarter. Number one, our guidance reflects everything that we know at this time, and most current business inputs. And to your question on the deferred revenue, yes, we have extremely busy three weeks activity there in the last three weeks. It is right that as a central portion of the revenue that we guide to, is already in that deferred portion. So that we realize in the Q1, it's certainly, we have to do some math and I can help with you that, how much of the deferred revenue is already sold through our customers in the fourth quarter and how much of that is going to be sold through by our customers in the first quarter.

Q - Jason Pflaum

All right. Okay. And then just again on the gross margin. I think your guidance, or you are implying that you would fall back within that 41 to 44% range in Q1. Can you talk about what the drivers of that would be, perhaps more pricing or maybe just a level of conservatism?

A - Olav Carlsen

It's just a matter of consistency. This is our target model, 41 to 44. This is the model around which we model a very highly successful company of in financial terms so we would like to remind everyone about it. What could drive, the gross margin from 46 back to 44, 43, pricing and cost? And as new products will be introduced throughout the year, as costs, the manufacturers cost shed, it's easy to get a 2% change in your gross margin up and down, so we like to remind everyone about that target model of 41 to 44%.

Q - Jason Pflaum

Okay. And then last question, just circling back on a missed opportunity. When you look into the design window, can you just talk generally about where you stand today as far as your interaction with customers? Have you locked in any design wins yet, just kind of talk about what gives you confidence in kind of your 10% revenue target by year end.

A - Gary Johnson

Let me describe, let me set the landscape, first of all. As you know, a good deal of the features and the benefits come in lock stead with Vista. And so we, when we look, that clearly looks towards a policy and second half opportunity for us. The notebook OEMs and ODMs all have different cycles. There are some OEMs and ODMs, for example, that already have plastics and cases designed into the, you know the earlier '07 time period, but there are many others who have cycles throughout the year, and they are the ones that will be targeting as we look at the second half '06 opportunity. Again, we will be relying on the VISTA rollouts, but, again, by having the technology and having the technology demonstrated, frankly with two leaders at CES we believe the platform is stable, and it's now ready to be incorporated by the notebook OEMs and ODMs and we feel very encouraged by the feedback we are getting.

Q - Jason Pflaum

Okay. Very well. Thank you very much. Good luck.

A - Gary Johnson

Thank you.

Operator

And we'll take our next question from Quinn Bolton with Needham & Company.

Q - Quinn Bolton

Hello. Nice job on the quarter, guys.

A - Gary Johnson

Thanks.

Q - Quinn Bolton

You reorganized now into three divisions. I'm just kind of wondering looking forward maybe in '07, I mean is this something you think over time you start to report revenue by division, just to give us a flavor as to what was the traditional personal media player, what was Preface or personal media displays and PWE on a good forward basis? Again that might not make sense until later this year. Do you envision going in that direction when talking about revenues.

A - Gary Johnson

We have not made that decision yet. It's sort of premature but, you know, we'll certainly take input in that makes sense, we'll certainly look at that That but we have made no decisions on that at this point.

Q - Quinn Bolton

And then following up on Jason's question about the timing of the launch. It seems the Computex trade show in early June is one big trade show where you see a lot of the second half systems. Would you think that you have at least prototype systems or your customers might have prototype systems on the show floor sort of for display, in that time frame?

A - Gary Johnson

I don't want to be that specific, frankly, in tying down sort of future design wins, that level of granularity. You are absolutely right, Computex is an important time of the year, and we, frankly, are, from an investment point of view, investing quite significant resources now in our Taiwan office in terms of development expertise. So we are very focused on that. As you pointed out, that would be, an important time of year for us but I don't want to go any further, in preannouncing customer design wins. As you know, the style base, we do that for all of our customers and we let our customers announce first and then generally we announce post their announcements. You are absolutely right, Computex will be a busy time.

Q - Quinn Bolton

Okay. Maybe one for Olav, I know you haven't introduced, formally introduced the new silicon platform, as you look at, you talked about a 20 to 25% sort of per SKU price decline, what do you have on the road map in terms of process technology shrinks, either down to say, 0.11 or 90-nanometer is that something that we can expect to help you further reduce costs either on existing platforms or new platforms?

A - Olav Carlsen

There's nothing that we can talk about today in terms of reducing it to 90-nanometer or anything. I think it's pretty logical that over time, you will look at this, we are an engineering and fab company so we have people look at this all the time and it's not just for not starting today only. So will it help us on costs? Absolutely. These reductions when you get over the first hump, maybe the first quarter or two and as you ram in significant production, yes, you should see a benefit at a time when you move from 0.13 to 90 nanometer, as we have experienced when we moved from 0.18 to 0.13. Having said all of this, you know, we haven't made any announcements at this time. We want to remind you of that.

A - Gary Johnson

I want to add a little color of that. A good part of our business, it's still one where innovation counts and it's the speed of innovation and bringing out new product cycles as we are doing and adding new features. In general as you said, as you implied you can have the cost reduction cycles. At the moment this market is adding features at such a rate that we are generally focusing much more on the next cycle of innovation, that necessarily focusing on a cost reduction path. We have lots of new technology to integrate in.

Q - Quinn Bolton

It's likely having some type of process technology shrink, but, you haven't announced the details yet. Just last question on the personal wireless entertainment, is the Sirius design win is that grouped into that division, or is that still part of the traditional PNP business?

A - Gary Johnson

That really came out of the 2005 efforts, the formation of this business unit came as we transitioned from '05 to '06 and as you said, it could be viewed in sort of either case. What was probably and frankly more important than where it all sits in the business is the learnings we got in being an applications processor, certainly is applicable to that division's work and we've got some, again that with other significant efforts going on is building, we think, some good internal mention on our own technology capability.

Q - Quinn Bolton

Great, thanks again, guys.

A - Gary Johnson

Thank you.

Operator

We'll take our next question from Adam Benjamin with Jefferies & Company.

Q - Adam Benjamin

Thanks, guys. Great quarter.

A - Gary Johnson

Thanks.

Q - Adam Benjamin

With respect to the gross margin, your guidance does seem to indicate or imply about 41% or so coming down from the 46% range. Can you give us any view, is that a shift due to maybe from the 5022 to the 5024?

A - Gary Johnson

There's some, can you hear me all right, Adam? There's some disturbance there on the audio here.

Q - Adam Benjamin

Yeah, I can hear you.

A - Olav Carlsen

Okay. Don't take what I said as a guidance. For any particular part. I would just like to remind you that what our long-term model is and I, we do not guide to the next quarter's margin. So having said that I mean, is there then another question that is, anything else that you,

Q - Adam Benjamin

Well, I guess what I was trying to get at is it does appear as Q1 comes down to the bottom end of that 41 to 44% range, is that something we can expect to come back up in Q2?

A - Olav Carlsen

So as I haven't guided to the bottom range or the upper range, you know I can't answer your question, really, and bringing, just taking, I constantly remind everyone of the 41 to 44, this is not new. I have done this in the past fourth quarter. We present the 41 to 44% gross margin model everywhere and so it hasn't changed. This is not new. This is consistent with the past. Don't take that as a specific guidance for the first quarter.

Q - Adam Benjamin

Back to wireless connectivity I know you have been beating around the bush on this. People have been talking about PNPs having wireless LAN and Bluetooth built in. Can you give us some better view as to what that group could look at?

A - Gary Johnson

Well, one way of giving it some color on that is actually CES where you have a technology demonstration there, where, for example, we were starting to point towards the capabilities, for example, of Wi-Fi. That is now pervasive enough that you've got hot spots. You have home networks. You have office networks. You've got streaming. But Wi-Fi is prevalent. That certainly could be a useful addition to a pnp capability. In the area of Bluetooth, we think that's more likely to be signed, for example to work on wireless headsets and frankly, we demonstrated that a year before last at CES So you are right, in that the wireless technologies typically take longer to rollout. They have to have an infrastructure in place. You have to really generate, good insertability, but Wi-Fi, for one, does look an attractive solution, now that we have, you know, access points everywhere, you have got low-cost o r no-cost services. So we feel quite bullish on Wi-Fi.

Q - Adam Benjamin

One last question. With respect to the cell phone market, there's, there has been some debate as to whether the MP3 capability will be run off the base then or there will be a multimedia processor and that would put you in direct competition against a TIs, or others. How are you seeing that market and is that a market you can expect to play in, in maybe late '06 or if not '07/08?

A - Gary Johnson

You are right, there's various architectures being proposed and emerging in the cell phone space. The simple low cost coprocessor to give you sort of simple polyphonic tones and MP3 playback have gone as the first generation of phones in that they haven't really got, they haven't got great user acceptance. They are in the phones but that simple co-processor is not one that's particularly attractive to us. But moving forward, though as you describe the co-processor has proved to be a popular business model for adding new multimedia features to the phone. And so that clearly would offer interest to us as we look at focusing really on the features and the battery life and performance as differentiation. So that the co-processor model has proved itself to be popular and that could be a vehicle we could use to bring, you know, high quality, low power multimedia type features to that type of market.

Q - Adam Benjamin

Are you currently seeing design activity there?

A - Gary Johnson

Well, as we talk about for all of our product lines, we won't be disclosing design wins or customer wins ahead of time. We have been very active with work in that space now for a period of time, but these cycles , typically the wireless space, are more extended than you would have in a traditional market, solidification cycles, working with these platforms, do take longer. So there's nothing that we would announce at this time.

Q - Adam Benjamin

All right, great. Thanks a lot.

A - Gary Johnson

Thank you.

A - Olav Carlsen

Sure.

Operator

We'll take our next question from Daniel Ernst with Hudson Square Research.

Q - Daniel Ernst

Yes, good evening. Thank you for taking the call. A couple, if I might. First, Olav your R&D spending, it fell a bit below your 17% target. So will your spending or your hiring in the quarter allow you to catch up to your target during the, during the first quarter or into the second? And then on your inventory level, being at 10 to 11 days, did you expect to be able to get into your target range over the course of the first quarter as well? And then just last question, on Java ME can you talk about that what that does to margins of a given platform, are you able to pass through the royalty of software costs on top of platform per unit, or do you actually get a little bit of upside on margin on Java and the ME enabled platforms?

A - Olav Carlsen

All right, the answer to the first two, it's simple, it's both yes. So even though R&D was below the 17%, we have increased it significantly as you see quarter over quarter and as revenue increased, even faster, we're below the 17%, but slightly, right, 16.3%. We are targeting and we keep targeting that is building to our very fleflible spending model of 17% R&D and the guidance that we have given is very clearly We are again hiring about $13 million of R&D for the first quarter. We will be hiring. We will be successful as we were in the last quarter. I have no doubt that we can attract very talented engineers to our group, with our new divisions. We have a lot of, you know with have a lot to sell here to these people. They are very interested in what we are doing.

I have no doubt that we can be a successful R&D spending company in Q1, within the target model. Inventory, 10 to 11 days that's kind of like what you have seen in the past. And, you know, when you calculate the inventory days you get a balance sheet snapshot. You don't see what we have during a quarter and when we have the high level of activity that certainly looks at the balance sheet. With doe have a 30-day goal. I would like to remind you, it's not just us holding inventory we have a powerful supply chain with our intermediaries. It is very easy for us to pull inventory out of the supply chain. We don't have to have it on the balance sheet. I'm very happy with the 10 to 11 days. I would like to see a little more inventory, but a balance sheet snap, but balance sheet snapshot, during the quarter might be different things sometimes. So I have no concern about our inventory level whatsoever. I will pass it on to Gary on your Java question.

A - Gary Johnson

Yeah, on the Java question, as with any of the new technologies that we are adding, for example, at CS, we were able to show the addition of things like gaming, the video, and of other advanced features. They generally offer us an opportunity, as you point out to do an upsale in terms of ASP price points. Not always the case but sometimes strategically we don't necessarily do that. For example in video, we purposefully have what we call a, one part of our strategy is what we call video-for-ree and C.S we showed MPEG 4 on our existing chip set and make video part of the main stream for that market for a zero uplift. But you're right in, general, when there's other licensed software we do aim to have an ASP uplift.

Q - Daniel Ernst

Do you expect to be able to generate some wins on the Java enabled platform during the year?

A - Gary Johnson

Well, the, we wouldn't have been, we wouldn't have made that investment and shown it at C.S, if we thought it was a zero sum game. We have significant interest from different times of customers that are interested in that. Again, it's, it's preannounced design wins but it is an important technology and one that actually can be applied, you know across different segments of our product divisions, as you think about it. So we think Java is an important extension technology for us, as well as we'll hope we turn into additional business this year.

Q - Daniel Ernst

Great. Thanks, Gary and thanks Olav. Look forward to seeing more of this.

Operator

And we'll take our next question from Craig Berger with Wedbush Morgan.

Q - Craig Berger

Good afternoon, gentlemen and nice job on the execution.

A - Olav Carlsen

Thank you.

Q - Craig Berger

A couple questions. One, on the, on your relationship with your manufacturing partner, are there any plans to change that? In the foreseeable future or do all things remain rosy on that front?

A - Gary Johnson

Well, the, I would say all things remain rosy. We enjoy I think very positive relationships, as you would expect in a growing business. I think the vector is clearly in the right direction for everyone as part of the bigger economy here. So in general, I think we're very happy with both intermediaries we used. So, no immediate changes on the horizon.

Q - Craig Berger

Okay.

A - Gary Johnson

And good relationships with all.

Q - Craig Berger

Have any of your customers complained about margins stacking or driving costs down further or it's not an issue at this point?

A - Gary Johnson

Our customers constantly complain about pricing, and it's part of their pricing negotiation discussion we typically have two or three times a year. Nothing that's out of the ordinary. Of course, customers find various reasons to complain about pricing, but as I said, we've had a very consistent 41 to 44% model that we've been working towards. We bring a great deal of value to our customers solutions, so, but, of course, customers find any reason to complain, but our 41 to 44% puts us in a good balance, and the right sweet spot we think with the value to our biggest customers.

Q - Craig Berger

Okay. With respect to the depressive engagement, can you talk about the competitive situation there? Who else do you know of is gunning for those sockets and potentially, do you know if they are as far along in their software development efforts as you are or whether or not your head start was exclusive with Microsoft?

A - Gary Johnson

We believe we have a very significant head start. We haven't seen other folks talking about this type of solution in the market. So we do, I think we do characterize it as having a significant lead in the market. Part of that, frankly, comes in developing this, working very closely with Microsoft, there was an enormous amount of work that went into this for the second half of '05. We do expect to see competitors emerge, but at the moment, from certainly the very strong response we are getting from the, the notebook OEM and ODMs, I think we have an opportunity to establish a real foothold here in the market as we go.

Q - Craig Berger

Is there a market share in that market that you would be happy with?

A - Gary Johnson

Well, of course, I would like a very large market share there, but, no, we are not going to make a public prediction of market share for this type of segment. We have been very fortunate working with leaders in the personal media class space and we have advantage in personal media displays and we hope to turn that into a long term relationship. To your point, we are playing this for long term, we think that '06 will give us really good momentum, but we really have to build and really keep our eye focused on the potential market of 16 million and 48 million units in the subsequent years. So time will tell, but we have a fresh move to start.

Q - Craig Berger

One more and then I will drop off. Can you give us maybe who are your top two competitors in that market segment?

A - Gary Johnson

Again, they are not, there are no names that are being expressed to us in that segment as yet.

Q - Craig Berger

Okay.

A - Gary Johnson

Again,

Q - Craig Berger

Thank you.

Operator

We'll take our next question from Shawn Slayton with SG Cowen.

Q - Shawn Slayton

Good afternoon. When does OpEx cease to become a fixed percentage of sales for PortalPlayer? And I ask this, you know, because of the universe of fab companies so much of the earnings growth is derived from leverage off ever operating expenses.

A - Olav Carlsen

Well, not in the foreseeable future and when I say that, I don't plan to change the model over the next couple of quarters, but, yeah, you have a point. If at some point, this becomes a huge revenue company den aim I'm not pointing to this, I'm just theoretically discussing I'm pretty sure at some point in time, you will see the leverage and especially on our SG&A side, you will see some leverage, with 24% target model will not be 24 or 22 or something below. But I think it's too early to discuss at the time. We're fast ramping in not just one division anymore. We have like, two interesting divisions now. We are targeting business and customer diversification, which is very important for us, and for our investors, you, investors with, you know, the successful launch of our PMD division, the personal media division and the wireless is our next step. So we have, I think, you know, good incentive to keep spending at a certain level and limit it to that level so that you guys have an opportunity to look at our financials for the future and to model us for 2006. I give you the point that at some time later, develop to maybe look at that model again but not for the foreseeable future.

Q - Shawn Slayton

Okay. That's helpful. Thank you. And for Gary, you know, considering your extensive experience within the MP3 player industry, can you help us understand, you know, the significance relative underperformance of higher capacity window-based MP3 players as compared to the obvious alternative? I mean this cam subpoena certainly a very large, camp is certainly a very large opportunity for PortalPlayer and when does it take off in your estimation?

A - Olav Carlsen

Well, the, I'm not sure I have any particular insight other than it's obvious in the market. The present market leader is just firing on all cylinders across a broad range of strengths in both services and content and devices. They are doing everything right.

Q - Shawn Slayton

So I, for the other camp, is it an asset or marketing dollars or features? What will get that other camp moving?

A - Gary Johnson

I think to get the other camp moving, it is, there's going to have to be a maturity in the technology, the technology has progressed over the last two generations. That needs to be, I think, a shift maybe in the Tyne of business model in the way that the people want to enjoy content. The model from Microsoft, you know, starts to really focus in more on a subscription type of model, a more adaptable, purchase or view for 30 days or enjoy for 30 days model. And so, really, I think it may come down to, do people, well a segment of the population latch on to subscription services. And without that, you are right,-- the difference becomes very unclear.

Q - Shawn Slayton

Okay. Thanks guys, I appreciate it.

A - Gary Johnson

Thanks.

Operator

We'll go next to Jason Paraschac with Kaufman Brothers.

Q - Jason Paraschac

Hopefully two quick questions. One on the Preface product, that it's based on the 5024 platform. Going forward if you try to diversify, should we expect, these other product verticals that you need to be also based on the same chip platform that you are using in your core market.

A - Gary Johnson

Not necessarily. We took an opportunity for speed and also the actual factor that the display drove, display lid drove, which is a small physical size. 5024 was a perfect fit. But to your point in other verticals, we will develop, you know, specific leading edge solutions for those verticals, but, again, if we can leverage the technology and maintain the chip technology it's a great ROI for us. So the answer is that was probably an example of good adoption technology across the space, in general, as you know, we have previously discussed having three development teams and we certainly have the ability to develop specialized silicon for different market opportunities.

Q - Jason Paraschac

Okay. And then you talked about the feature rich MP3 market in terms of the unit volumes. I'm curious if you looked, to see how that will evolve this year. How much of that market could be addressed with the capabilities of the 5022 product today?

A - Gary Johnson

Certainly with the addition recently of the from CES, the capability of video, as you looked into '06, we think a lion's share of that market is available to that class of product. It really does address, you know, the audio, the photo, the video, and the gaming capabilities. So I think a lion's share of that market is developed for that class of product.

Q - Jason Paraschac

And the video spec on the 5022 that you were showing, I mean it was a little reduced from what's out there in the market. But, you know, do you think that is enough at least this year to, you know, most of the market out there?

A - Gary Johnson

Well, certainly the feedback that we got from our customers was not quite as negative as you first sort of posed it there? I didn't mean it to be negative.

Q - Jason Paraschac

No, that's fine. The example on the key metric that everyone, I think was impressed with was the 30 frames per second MPEG 4 functionality on the smaller screen. That technology, i.e. video for free, will not be on the larger display devices but for the main stream devices where the cost of the display is paramount, we think that could be a very compelling solution and, again, it's hard to be free. Great. Great quarter, guys. Thanks.

A - Gary Johnson

Thanks a lot. Well, operator.

Operator

That concludes our question-and-answers sir. I would like to turn it back to you for closing remarks..

Gary Johnson, Chief Executive Officer, President

Thank you very much for joining us today. We plan to meet with investors on February 8th in San Francisco at the Thomas Weisel Partners technology conference. We look forward to seeing many of you there, and with that, we'll conclude this conference call. Thank you.

Operator

Once again that does conclude today's conference. Thank you for your participation. You may disconnect at this time.

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Source: PortalPlayer Inc. Q4 2005 Earnings Conference Call Transcript (PLAY)
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