NDS Group F2Q06 (Qtr Ending Dec 31, 2005) Earnings Conference Call Transcript (NNDS)

NDS Group (NNDS)
Q2 2006 Earnings Conference Call
January 31st 2006, 9:00 PM.

Executives:

Abraham Peled, Chairman and Chief Executive Officer
Alexander Gersh, Chief Financial Officer

Analysts:

Can Elbi, Chevreaux
Daniel Meron, RBC Capital Markets
Alan Gould, Natexis Bleichroeder
Ari Bensinger, Standard & Poor's
Roni Biron, Oscar Gruss
Jason Mauricio, Arete
Anuj Mutreja, Morgan Stanley
Murray Arenson, Ferris Baker Watts
Todd Mitchell, Kaufman Brothers
Mehrdad Torbati, Deutsche Bank
Tim Boddy, Goldman Sachs

Presentation

Operator

Thank you for standing by and welcome to the NDS Second Quarter Results Conference Call. At this time, all participants are in listen-only mode. There will be a presentation followed by a question-and-answer session, at that time if you would like to ask a question, you need to press '*' '1' on your telephone keypad. I must advise you the conference is be recorded today on January 31, 2006.

On this call we will make certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on management's views and assumptions regarding future events and business performance as of the time the statements are made. Actual results may differ materially from these expectations due to changes in global economic business competitive market regulatory factors. For more detailed information about these and other factors that could affect feature results is contained in our filings with the Securities and Exchange Commission. Forward-looking statements included in this call are made only as of the date of this call and do not have any obligation to publicly update any forward-looking statements to reflect subsequent events and circumstances except as required by law.

I would now like to hand the call over to your Chairman and CEO, Dr. Abe Peled. Please go ahead.

Abraham Peled, Chairman and Chief Executive Officer

Good morning, good afternoon, and welcome to the NDS Q2 FY '06 Conference Call. We are pleased to report another good quarter in NDS. And I would say that the principal business affecting NDS these days is our need to scale up to meet the demands from our customers for our advanced technologies worldwide. As you know, the competition in the pay TV market is intensifying with cable companies reacting to the inroads made by satellite companies worldwide and now with telecom companies joining into the fray with the offer and the promises of offering video through broadband IP networks. The result is increasing demand for an accelerated deployment of NDS technologies by our customers, whether they are our DVR technology, our working on the high-definition set-top boxes, high-definition DVRs, and also our satellite customers increasingly will require hybrid set-top boxes that include both satellite reception as well as IP broadband connectivity which we have introduced through our xSpace concept. So you will see that we added quite a few people over the last year and I have to say that we are continuing to hire to meet the demands for the business and the opportunities that we have in front of us.

Some of the key developments this quarter, as you know we now published a number of key metrics that track our performance, smartcard delivery 6.1 million in the quarter, authorized net additions 2.9 million bringing the total to 61.4, and the two new metrics that now was in track which obviously affect our financial performance in particular profitability is middleware deployments and DVR deployments. Middleware deployments this quarter were 7.4 million. That includes some additional catch-up on the DIRECTV but also obviously includes all boxes now are shipped with NDS middleware regular boxes. And bringing the cumulative to 34.1, well on our way to really become a market share leader in the middleware arena as well.

Speaking of middleware, we are continuing to make progress on our MediaHighway middleware, those both with our DIRECTV but also with some of the customers like a Sogecable where we launched our new MediaHighway advanced box that includes also emulation of the old Hancock version and the new agreements with Canal Plus, and Astro, which are already our MediaHighway customers. So we are continuing to see very good demand for middleware. Also DVR deployments 300,000 in the quarter. We do not include in that number any DVRs shipped by DIRECTV because obviously that only started quite late in the quarter and we do not have yet an accurate report that can be used for revenue recognition. But it brings the cumulative number of DVRs deployed worldwide with XTV technology to 2 million.

In terms of additional significant developments this quarter, the DIRECTV Plus based on XTV technology was launched in November and has been received quite well. In addition also in this quarter, My Sky and Sky Italia was launched, which is again a DVR using XTV technology. VIASAT launched their DVR using NDS technology and HOT, the cable company in Israel, launched HOT Magic, which is a DVR using NDS technology. So clearly DVR deployments are starting to take off.

In terms of growth of the subscriber base, I am also pleased to say that we started in the last two quarters to see real significant deployments in China in the city of Shenzhen where by the Chinese New Year; they will have finished the conversion of the whole subscriber base to digital. And one interesting fact that came up when I met the CEO of Shenzhen is that approximately 30% of the households have taken a second digital box, which really comes to confirm what we have talked about as the trend for multiple set-top boxes per household.

Additional factors are the SkyLife, which continues to do well with 1.8 million subscribers have selected NDS's XTV technology and expect to launch a DVR service in mid 2006. Tata Sky has signed a contract with NDS. They now have all the necessary approvals and are on an aggressive path to launch. Interestingly enough, as you may know, we also have a cable customer in India, Hathaway, and as I mentioned in the beginning of my remarks, a cable company now while the digital deployment in cable was mired in this conditional access law and various governmental issues, now that satellite is scheduled to be launched and Hathaway are starting to deploy aggressively digital boxes in order to preempt possibly the competitive impact from the satellite.

We also signed a new contract with our VideoGuard Express, which as you may recall is an offering that is aimed primarily for small- and mid-sized customers especially in Eastern Europe where a number of those and we have signed two of those contracts. One is with Serbia Broadband to the cable system and another one with the DTH Television Group in Romania for a satellite system. Also Comcor launched a cable service in Moscow under the AKADO name.

In addition in our interactive area, we have also seen quite good progress with Bell ExpressVu launching a suite of interactive applications. Sesame Street games have launched on Cablevision. These are interactive learning games for preschoolers that use a lot of audio feedback for kids. We are particularly pleased because obviously Sesame Street Productions is a very high-quality and a leading producer. Working with them I think we have been able to come up with really leading games.

Also NDS has been selected by Turner Broadcasting as its exclusive television games and application provider in the Asia-Pacific network regions and further deployment will be on Cartoon Network. I might also at the our Extreme Play, which is a new kind of gaming technology that allows the superposition of graphics on top of pre-random content, was launched on this platform in Israel. We also see a lot of activity in the broadband IP and we are busy working on a number of these systems. VIASAT has launched our Synamedia Systems on the Swedish IP-TV network and Telekom Austria has selected NDS Synamedia for deployment.

In addition, NDS had a very successful presence at the consumer electronics show, highlighting some of our advanced technologies that we feel we need to prepare for the future. While we don't expect to see significant revenue from mobile in the near-term, we feel that it is an area that NDS has to be strong in and has to have a presence. We have implemented OMA, open mobile alliance digital rights management. We have demonstrated that. We have demonstrated the DVBH deployment into a handset that has both a DVBH receiver and is a regular 3G phone with a EPG in this stand up in the NDS system. Also together with Samsung and Broadcom. We have demonstrated Spintar home server, high-definition able to connect to broadband IP whether it is in your home or broadband over the Internet, capable of connecting to the Samsung digital camera, Samsung printer, and being able to exchange contents through some disk secure flash memories.

We also demonstrated our hybrid set-top box, xSpace, showing the reception on the one hand of satellite content, on the other hand broadband Internet content from Akimbo, from Foxport, and from IGN Entertainment allowing you to seamlessly really move between broadcast television and broadband entertainment. And by the way including those selected sites in the electronic program and also linking them in real-time between the broadcast television and the broadband entertainment site which could be a source of new revenue for satellite operators. Finally our MediaHighway OCAP was demonstrated on a Thomson and Broadcom box.

So all in all we are very busy working on a large number of projects and we feel that over the medium term NDS will continue to benefit from strong demand for new technologies as our customers try to accelerate introduction of that to offer more competitive products and more entertaining products and we will see accelerated deployment of multiroom penetration, PVR/DVR penetration, I just want to make a comment. The personal video recorder is known in the U.S. as a digital video recorder, so given that we now report in the U.S. we are going to start referring to it as the DVR, so for our European colleagues and others, we will now start referring to DVR.

So DVR deployments that are gaining momentum, a high-definition that is going to start coming in quite strong in all of the platforms, all of the major platforms we're working on. We are working on high-definition middleware and DVRs and I believe the hybrid IP set-top boxes will be a critical need for our customers and will again drive replacement cycle for set-top boxes as well as considerable introduction of new services.

In addition, we're focused on content protection with our secure video processor initiative. We're focused on the future opportunities in mobile and as well as in broadband stand-alone systems, not only hybrid systems. So having said that, I would like to turn it over now to Alex Gersh, our CFO, who will take you through some of the results in somewhat more detail.

Alexander Gersh, Chief Financial Officer

Thank you, Abe. Good morning and good afternoon, everybody. First thing I want to say is that one of the things that we have been trying to do in terms of improving our reporting is to accelerate our 10-Q filing as close as possible to the date of this earnings announcement. Obviously Q has a lot more disclosures in it, but we expect to file our Q today. So on the same day of our earnings announcement. We will try to continue to do this on a quarterly basis.

In terms of the total revenue for this quarter, it stands at $152 million, an increase of 7% over Q2 fiscal '05. Operating income $34 million, an increase of 42% over fiscal 2004. Operating income margin stands at 22.5% versus 17% in Q2 '05. That obviously has to do with the mix of revenue we receive as well as our continuing focus on efficiencies. Net income for the quarter was $26 million, a 45% improvement over the Q2 of 2005.

Now some detail on some expenses and some revenues. Starting out of course as always with conditional access. Conditional access revenue increased by 1% to $87.6 million. We have delivered, as Abe said, 6.1 million smartcards in the quarter versus 8.1 million in the second quarter of 2004. However the authorized smartcards again as Abe said, stands now at 61.4 million versus 51.8 billion as of December 2004. So the lower volume of cards shipped, the revenue is more than offset by a monthly fee that is now being paid by 88% of our customers, 88% of our subscriber cards of our active cards pay us the monthly fee, and so that offsets any decline in terms of the card shipments for the quarter.

The decrease in card sales is really primarily due to a decrease in DIRECTV, and Sky Italia if you remember in the second quarter of 2004, Sky Italia was 2005, Sky Italia was in the process is of migrating to NDS technology so we had additional card shipments in that quarter. Integration, development and support revenue decreased by about 18% to $13.8 million. There has not been any big projects for this quarter in terms of deliberate and unconditional access for NDS. And revenue in the current year basically relates to the delivery of enhancement to our customers and some development revenue for DIRECTV middleware.

License fees and royalties increased by 43% to $26.9 million and that is really, we've talked about and Abe has talked about middleware, downloads of middleware to DIRECTV both some legacy revenue that we've recognized as well as legacy downloads as well as all the new boxes that are going out with our middleware. And as we disclosed, we have recognize revenue on 7.4 million additional set-top box downloads with our middleware in the quarter. As of September, we estimate that a cumulative number, as of December, we estimate that 34.1 million set-top boxes contain NDS middleware have been shipped.

New technologies increased by 7% for the second quarter of 2006. Revenues include as always our advanced DVR deployment, interactive application gaming, and initial revenue from some Synamedia contracts. Gross margin is 59.4% versus 61.6% in Q2 of 2005. The decrease in margin as we discussed last quarter is due to an increase in the number of our employees working on integration, development and support activities undertaking under specific customer contract and therefore shown in the cost of sales rather than in the R&D expense line.

Operating expenses decreased by 11%. R&D expenses decreased by 10% again due to higher proportion of our technical activities being involved in specific customer projects and therefore classified as cost of goods sold. Offset by an increased headcount for the year as Abe talked about, we have increased our headcount. We have increased it by about 490 people. However, it is worthwhile mentioning that over 200 of those people have been hired in India. Sales and marketing activities have increased by 11% of really results from increased activity particularly in Asia and Europe.

G&A expenses decreased from the Q2 of last year and that really primarily has to do with a 3 million provision for Heathrow Space which we had in Q2 of 2005 which, as you know, we subsequently reversed and clearly don't have this year. So that is, the 3 million of it is really due to that.

Income tax, our effective tax rate stands at 31%. Net income is $26 million, $0.45 per share on a diluted basis, compared to $17.9 million or $0.32 per share on a diluted basis in Q2 of 2005, fiscal 2005. Just a few words on the cash flow. As you can see, cash stands at 380 million as of the end of December. Cash from operating activities has increased and it reflects lower payment for smartcards and taxes offset by some higher expenses. From the receivables perspective, it is probably worth to comment that our accounts receivable balance has, if you compare it to the June numbers has gone up significantly from June. Really that has to do with some additional billings that were done in December and so it is simply a timing issue. These billings will have been paid and collected in January by the company. Our DSO continues to stay at below 60 days.

Cash from investing activities, we have a higher capital expenditure than last year and as we talked about this particularly has to do with the new facilities that we moved into in UK, India and the U.S. We have also acquired during the six month's period, NT Media $3.1 million and during the six months we received around $9 million of cash from the exercise of the employee stock options, which equates to about 800,000 shares. As of December 31, 2005, NDS has 3.5 million shares of stock options outstanding with 2.7 million vested.

Now a few words about the guidance. We continue to as we do every quarter review our guidance. When we looked at our revenue guidance, we continue to see foreign exchange as a key uncertainty for the year and therefore we maintain our guidance on revenue in a range of 600 to 625 million. However when we look at our operating income and we look at the performance of the business, we continue to see improvement in our performance and therefore we are once again upgrading our operating profit guidance from what it was last quarter, which was 107 to 115 million to now 115 million to 120 million range.

Another thing that is worth mentioning is that the yesterday at the Board meeting, our Board has approved a new stock option grant for fiscal 2006 that the impact or the full annual impact of that grant is roughly in the range between $6.5 million to $7.5 million will be for full year, for full 12 months. When our upgrade of our operating income to $115 million to $120 million, now includes effect of this option grant for this year.

That is all that I wanted to touch on and I am going to turn it over to Abe.

Abraham Peled, Chairman & Chief Executive Officer

Okay, thank you very much, Alexander Gersh. We would like to now, operator, open it up for questions.

Questions & Answers

Operator

Operator Instructions Your first question comes from Can Elbi from Cheuvreux. please go ahead.

Q - Can Elbi

Hi, a couple of questions. First on the DIRECTV Plus revenue recognition on the royalty side, am I correct to assume that all the shipments post November will be recognized in fiscal Q3?

A - Alexander Gersh

Yes.

Q - Can Elbi

In terms of the XTV royalties, should we be assuming that the royalty number there is probably twice what you get on the conditional access royalty? Per box?

A - Abraham Peled

Well, since we haven't disclosed the conditional access royalty, and we haven't disclosed the royalty on the PVR, you can assume any number you want.

Q - Can Elbi

Okay, if I have to put numbers out then, should I be assuming that the XTV royalty is around $10 to $15?

A - Abraham Peled

No, we have said that the XTV royalties for our customers is in the range of $6 to $15 depending on volume. So clearly once the volume of those becomes large, then it would be towards the lower end of that number.

Q - Can Elbi

Okay. Moving onto India, in terms of this contract with Tata Sky, obviously the Hathaway contract which was announced I think in 2003 has not really gone your way because of the conditional access, the tax regulation in India being mired in political aspects. So I guess in Tata Sky is going to be different as you strikly pointed out I guess. But in terms of the potential of Tata Sky can you help us with certain numbers in terms of where you, what you see the potential especially in the next two to three years?

A - Abraham Peled

Tata Sky I think I said publicly that they have an ambition to reach 5 million customers in the three- to five-year period and I think they have quite aggressive early targets. But I think it will be really very attractive service from a programming point of view, from a service point of view, a quality point of view, and based on my visits to India, I think that there was a genuine demand for such a service because the cable service typically is very low quality from the signal, the frequent interruptions and really lack of service. So I think they are quite optimistic and we will track it as it starts. Clearly we will recognize revenue from that only in the next fiscal year.

Q - Can Elbi

Maybe lastly just in terms of the conditional access line and potential growth going forward, you talked about Shenzhen, so in terms of the Chinese cable market as we get closer to the 2008 Olympics, should we be looking for an acceleration in the deployment there? Maybe a follow up on that in terms of basically your close cooperation with CCTV, is that still a major advantage or are the barriers to entry lower in the CA market for the CA market in China?

A - Abraham Peled

I think first of all everybody we talk to in China as I visited there in November is clearly very focused on what they call the Ping Ye initiative. The reason Shenzhen was the first city to really move rapidly is that the local public equivalent of the public utilities committee of the city approved an increase in monthly fees for the cable service from 16 RMB which is $2.00 to 28 R&B, which is $3.50. That extra $1.50 goes to recover the cost of the set-top box and the installation and they get a very attractive loan from the China Industrial Bank if they can show a return of investment in seven years. So really the gate to massive and rapid deployment is getting that approval. Two cities that are currently trying to get that approval are Shanghai and Chungking, both of which where we have a strong presence and we expect to see a number of other provinces follow the Shenzhen example. But it is a clearly a very political issue. So the pressure from the government as they get closer to the Olympics increases on the local government to approve these rate increases to get on with it.

In terms of CCTV, CCTV have announced that they are going to launch a DTH service in addition to obviously their distribution to cable, which we work with them on. The satellite will be launched by China Aerospace late this summer and we are currently engaged in discussions with CCTV obviously with they being quite interested in winning that DTH business. They again have very high ambitions for reaching a significant number by 2008. Having said all that from our own planning purposes we maintain, we continue to maintain a cautious stand in China and I would say we ourselves are looking at anywhere from the 3 million to 5 million over the next 3 to 5 years. So we have not, while Shenzhen is very encouraging, we still have to see that happening in other places and really gathering real momentum.

Q - Can Elbi

Just maybe one last, in China are you still operating on a stand-alone basis or do you have a local partner there?

A - Abraham Peled

We operate, we have a strong NDS presence in China. We have about 40 people in development. We work together with the local operators to help them develop applications, and we don't have, you know, so we don't use agents or third parties.

Q - Can Elbi

Okay, thanks a lot.

Operator

Your next question comes from Daniel Meron from RBC Capital, please go ahead.

Q - Daniel Meron

Hi, congrats on the continued execution. A couple questions here. First can you give us a sense on what is the ramp up post the initial revenue recognition in the March quarter? And maybe relating to that, what makes you, can you maybe give us a bit more color on what makes you so cautious with revenue guidance at this point given that you are halfway through based on the first half of fiscal '06 in meeting the high end of the range?

A - Abraham Peled

And if you just take 296 and multiply it by 2, you only get to 600. I'm not sure what is your, the reason we are cautious is, as I indicated in previous calls, the impact of the strong dollar translates our sterling and Euro into less revenue, obviously, while it doesn't have a similar impact on our profits. I think Alex has said in previous conference calls that compared to when we first issued the guidance, just the impact of revenues on the order of $22 million to $23 million. And so maintaining that guidance really we feel is the appropriate posture. Also higher middleware shipments or higher PVR shipments, while they have a big impact on profitability, have a much smaller impact on revenues. And other million kind of middleware deployment can be anywhere from $2 million to $4 million in revenue, which is not much on 600, but it is still $2 million to $4 million on operating profit. So that is really, and that really confirms what we have said, that NDS is committed to improve our operating margin. We had had our original target for this year was on the order of 18.5%, up from 16.5%. I think we may get to obviously a higher operating margin, reaching our 20% operating margin target a year earlier than we have said many years ago.

Q - Daniel Meron

Okay. Thank you, Abe. Alex, maybe can you give us a bit more color or how to think about the gross margins in the next few quarters, especially given the replacement cycle that you mentioned?

A - Alexander Gersh

Given what, I'm sorry?

Q - Daniel Meron

You said that sometime down the road, you may have a replacement cycle going on.

A - Alexander Gersh

The replacement cycle, if you're talking about a card replacement cycle, that does not really have any effect on the gross margin per se, in terms of the gross margin percentage. Because, obviously, as we have explained before, our deferral of the portion of the security fee, we defer the price of the security fee and, therefore, assuming the margin. So when we have a replacement of cards, there is going to be an increase in revenue, but the margin percentage should stay relatively the same as it is or should not be affected by the changeover cards. In terms of the, our gross margin percentage is affected, as I said, last quarter by the resources that are spent, our technical resources that are spent working on a specific customer-related project versus the more what we call at-risk type of technical resources, which we classify as R&D. Our expectations are that we will be able to improve our margin from now through the end of the year, basically because as we've always said, we continue, the revenue mix will change away from perhaps, the revenue mix will continue to change towards the software elements, as well as continuing to try to get to leverage our technical base.

Q - Daniel Meron

So can I interpret that……?

A - Alexander Gersh

I'm sorry, just one more thing. On the negative side, obviously, if you look at the number of cards we shipped in the first six months of the year, we expect higher number of smartcard shipments in the second half of the year. So that would have effectively a negative effect on the gross margin.

Q - Daniel Meron

So the net-net, would that mean that gross margins should stay flat here at 59% or so, or could they trend lower in the second half of '06?

A - Alexander Gersh

My expectation is that they will trend slightly higher, very slightly higher; flat to very slightly higher.

Q - Daniel Meron

Okay. So any change in the OpEx then?

A - Alexander Gersh

If we talk about operating margin, we are now, as Abe said, we are certainly, in our latest guidance we're envisioning our operating margin at anywhere between 19.7% to 20%. So clearly we continue to, while the margin is not going to be as strong as it was in the first six months of the year mainly for two reasons. One is on the revenue side you know we've recognized the downloads, the legacy download from the middleware for DIRECTV. Also on the operating cost side if you remember in the first six months of the year we recorded this credit the R&D research credit from their French government of approximately 5 million, right? So we expect, those things will not continue in the second six months of the year, so we expect the margin to be lower obviously, the operating margin to be lower for the next six months of the year, giving us for the full year around anywhere between 19.5% to 20% margin.

Q - Daniel Meron

Okay. Thanks, Alexander Gersh. Thanks, Abe.

Operator

Your next question comes from Alan Gould from Natexis.

Q - Alan Gould

First for Alex. Alex, deferred income keeps increasing. I realize a lot of that is just smartcard replacement cycle. At a certain point do you ever release some of those reserves?

A - Alexander Gersh

No, no, no. We have got two types of deferred income, clearly. None of it really can be talked about as reserves. There is a deferred income that is released all the time as we complete projects and complete milestones and we release that income under the U.S. GAAP rules under SOP 97-2, which is the pronouncement that governs revenue recognition under U.S. GAAP. And as you can see right now you can see that in our current liability deferred income that is something that is built up and released as we complete various projects and milestones. Now in our long-term liabilities there is about $112 million of deferred income relating to the changeover of cards. That will only be released when the changeover actually occurs.

Q - Alan Gould

If you get to the point though where the technology, the encryption is not broken and you don't have to changeover the cards as quickly as you had reserved for or planned for, would you be able to reverse some of that into income?

A - Alexander Gersh

What happens is we constantly talk to our customers with regard to these changeovers and constantly work with them on understanding when changeovers are likely to occur. When there is a realization that, and this is done with a mutual agreement with a customer, then the changeover could be delayed, obviously we will defer it less of revenue because we will have a longer time to effectively defer the necessary revenue. So we will defer less on a monthly basis.

Q - Alan Gould

Is that occurring?

A - Alexander Gersh

It is something that we don't disclose obviously a discussion with the customers, but it is not out of the realm of possibility. These discussions occur all the time and we evaluate the deferred revenue on the quarterly basis, so it is not out of the realm of possibility that those discussions could occur.

Q - Alan Gould

Okay. Abe, can you tell us a little bit about some of the platform consolidation we are seeing in Israel and France and what the opportunities might be for NDS there?

A - Abraham Peled

Well, in France, which is Canal Plus and TPS combining, we certainly will do our best to get the business for the combined platform. TPS uses OpenTV, so that is a middleware opportunity. I think our record in Spain where Sogecable combined Via Digital, Sogecable, we were able to win against OpenTV and I would expect we would be able to win on the Canal Plus platform. We currently have been able to really provide very good service to Canal Plus, satisfying their demands for a hybrid satellite set-top box, doing IP boxes and Canal Plus would really be in charge of the combined platform. So that has a potential of about going forward really but it adds another 1.5 million or so subscribers to Canal Plus and in general I would say it will improve Canal Plus's chances of more rapid growth and we have seen an acceleration demand from them. In Israel there are three cable companies that have been in the process of combining for the last couple of years. And have been constantly held up in the various regulatory and financial hurdles. One of them uses Kudelski conditional access, Golden-Channels, and the other two use NDS conditional access. The brand-name for the combined platform is called HOT. It has about 1.2 million, 1 million or so digital set-top boxes. I think the good news is that our new HOT DVR known as HOT Magic has been released to work not only on the old Matav and Tevel platform but also in similar crypt mode on the Golden-Channel platform. And it is a product they are quite happy with and they are pushing extensively. I hope that once they decide to consolidate on one conditional access we will be able to win it. On the other hand, as I have said many times before, we are not going to enter into a price war with Kudelski to lead to unprofitable business.

Q - Alan Gould

Okay, thank you.

Operator

Your next question comes from Ari Bensinger from Standard & Poor's.

Q - Ari Bensinger

Congratulations on a strong quarter. I believe that when you look at the smart cards, the net additions to the authorized subscriber base compared to the shipments is increasing as a percentage and I am wondering what factors are playing into that and what the trend going forward, what do you see the trend going forward?

A - Abraham Peled

I don't know. I assume you have researched it over many quarters?

Q - Ari Bensinger

Just over the last couple quarters.

A - Abraham Peled

I think you really can't conclude too much from that because the cards shipped in any particular quarter will vary depending on inventory levels and just bunching of orders to meet minimum quantities and to get etc. So I would not, so I don't know. I myself have not researched it. The only thing that I can say that would support your assertion possibly is that we are seeing an increase in replacement cycle in set-top boxes. So some of the set-top boxes on DIRECTV have now been around for close to 10 years and I think Chase Carey on one of his conference calls has said that they have seen roughly one million replacement boxes in over a period of a year. We see that on some of the other platforms like Sky obviously, which has now boxes that come off to the six and seven years as well as another. Those boxes obviously would report as smart card chips shipments but would not report a net increase in subscribers. So I think as the large customers installed base gets kind of older and the replacement cycle accelerates like some of these switching out an old SD box for a new HD box, you would see a new smart card ship but that not an increase in the installed base.

Q - Ari Bensinger

Being that sort of your recurring revenue base is becoming a bigger part of conditional access sales, can you talk about the trend for not putting a particular price on it for the average monthly security fees going forward?

A - Abraham Peled

Well, I think that the trend in terms of have we seen the pricing declines or……..?

Q - Ari Bensinger

Is the price, I think should probably trend upward as DIRECTV sort of ramps down from its big deployment, right?

A - Alexander Gersh

Our monthly fee is obviously part of our long-term contracts and as we've said many times, our contracts with our customers run for six years and the monthly fee is contractual. We'd don't certainly expect the fee to trend up. I'm not sure but at the same time we provide a very significant value both from the operational security and from other aspects of the security for our fee and we believe that in terms of it will continue to be stable.

Q - Ari Bensinger

Okay, and then last question, middleware sales were pretty higher than we were forecasting them. I'm just wondering sort of excluding the downloads to DIRECTV, what type of normalized number is reasonable going forward in terms of shipments?

A - Alexander Gersh

I think if you look at last year where we didn't have any downloads to DIRECTV, I'm mean, I am not sure whether that would give an indication of normalized number or whatever that means going forward, but if you wanted a number without the DIRECTV, you would be looking at last year's numbers.

A - Abraham Peled

Well, I think that if you want to include DIRECTV we have said that we expect middleware shipments kind of excluding the onetime makeup of the DIRECTV download to be on the order of 12 million to 14 million units per year, the big number coming from DIRECTV. And then we have obviously middleware and a lot of other platforms, all the Canal Plus platforms, Astro, Sogecable, and we're seeing, starting to see good growth in some of those. As well as in our Tata Sky will use our middleware and in China in some cases our middleware is used, etc.

Q - Ari Bensinger

Thank you, that's helpful.

Operator

Your next question comes from Roni Biron from Oscar Gruss, please go ahead.

Q - Roni Biron

Hi Abe and Alexander Gersh. Congratulations on the good quarter. A couple of questions. First can you elaborate on your PVR shipments to DIRECTV now that the service is commercially available? What do you see so far in terms of the service uptake as well as revenues contribution in the coming quarters?

A - Abraham Peled

Well, we really can't comment on that. I believe DIRECTV may provide some indication on the number of DVRs that they shipped in the last quarter, but some of those are obviously still TiVo DVR's and so I don't think you're going to be able to get the breakdown. We will provide again the total number. We can't separate DIRECTV or not. Having said that, if you look at the previous year's DIRECTV deployments around the order of 1 million to 1.5 million on an annual basis and I think they have said that they want to accelerate that significantly. Obviously they have reduced the price to zero and actually you get $1.00 back if you get the DVR and three boxes. So I would expect to see certainly a larger number. I have given it a medium term, which I said I expect over a three- to five-year period to see every household to have at least one DVR whether standard or high-definition.

Q - Roni Biron

And second question is in light of your recent wins in India, Eastern Europe, as well as high-definition TV and IP-TV opportunities, what kind of growth rates are you looking at for the coming years? Is it around the high teens or so?

A - Abraham Peled

I think we have always maintained that our business can provide a growth rate of 10% to 15% on the top line and a 20% or higher percent on the operating profit, as we obviously improve our 20% to 25% as we improve our operating margin. That is over an average of multiyears. Clearly in, any particular year currency account, onetime factors like last year we had some onetime effects that came from the Sky Italia and VIASAT deployments that could affect only one year, two year comparison. But when we look over the three- to five-years and we look at the trends that I just described, the multiroom penetration etc., we can from our main business and obviously not talking about potential upside in other areas where we can see a 10% to 15% revenue growth and a 20% to 25% operating profit growth.

Q - Roni Biron

That includes your estimate on high-definition TV, IP-TV, and mobile applications?

A - Abraham Peled

Not mobile. I don't know how to estimate mobile and I don't expect them to be very large, but IP-TV I think includes our estimate of a relatively slow deployment because obviously our revenue is highly impacted by the number of the end subscribers not total numbers of systems. So the fact that we now have 11 or so IP-TV systems between them, they still have a very small number of subscribers. So it doesn't make an impact on the revenue. And we expect the IP-TV numbers to be relatively small compared to the 60 million active smart cards and the growth in that that we have in our main line.

Q - Roni Biron

Do you expect HDTV to trigger a replacement cycle somewhere in 2007/2008? Or is it going to be more moderate?

A - Abraham Peled

I thought that the HDTV will get to a 30% or so penetration, maybe even 40% in the U.S. where it is becoming really a big thing and probably 20%, 25% in Europe and other places.

Q - Roni Biron

Okay. Finally can you repeat your targets for gross margin and operating margin in a couple of years from now?

A - Abraham Peled

We have not really issued, we had the target to get to 20% operating margin by our 2007 fiscal year. We expect to be able to get to that in this year roughly. And so probably we will set out new targets. But we would expect to be able to get to a 25% operating margin over the next three- to five-year period.

Q - Roni Biron

Thank you very much.

Operator

Your next question comes from Jason Mauricio from Arete.

Q - Jason Mauricio

Just a few quick questions. First of all, can you split out what the currency impact was this quarter?

A - Alexander Gersh

When you take a look at our Q, what we do disclose is just in percentage terms that from the second quarter of last year to the second quarter of this year the revenue impact was about 2% and we also talk about the costs. We also as Abe had mentioned and what I have said is that since we've issued the guidance based on the exchange rates until now if the same exchange rate that we see now persists through the end of the year for pound and euro, that would have, as Abe said, anywhere between 22 million to 24 million negative impact on our revenues.

Q - Jason Mauricio

Okay. Also, Alexander Gersh, in terms of the stock option charge, am I correct in assuming that that should appear in the quarter that we are currently in?

A - Alexander Gersh

Well, what you'll see is, I made it very clear, I was trying to make it clear to say that I am talking about an annual charge, so obviously these options have just been approved. So over the next, five months of the charge will hit us over the next, through the year end effectively and it will be prorated some for next quarter and some for the following quarter obviously. Plus of course let's not forget the expense that we are currently incurring for the six months of the year this year we have incurred 1.7 million stock option charge from prior grants as well. So that is what you should be seeing going forward.

Q - Jason Mauricio

I was a little confused in terms of how much you're talking about. Is this the 6.5 million? Is that the charge for the……..?

A - Alexander Gersh

What I said is the 2006 expense for total annual expense of the 2006 stock option grant is anywhere between $6.5 million to $7.5 million for a full year, because obviously the grant this year happened well into the year, we will not take a full charge for 6.5 million to 7.5 million for the year. Next year you will see the full charge for the 2006 stock option grant.

Q - Jason Mauricio

Great. Thanks for clarifying that. Maybe one for you, Abe. In China it seems like many Western vendors or technology companies trying to do business there are required to transfer technology in order to win deals. One, are you having to do that in some of the talks you are having in China? And what is NDS's overall policy on that?

A - Abraham Peled

So far we have not. With CCTV we are among the discussions are the possibility of engaging in a joint venture etc. We I think have always been quite cautious on what part of the technology we might transfer and limitations on that. But I am not excluding it. I do believe the Chinese, China is very much into being self-sufficient and our main consideration is that it could not be used to compete with us in markets outside of China. Second that that would only happen after a significant build up of revenue in the customer base rather than from day one.

Q - Jason Mauricio

Got you. Just to clarify on the Tata agreement, that was for VideoGuard and the middleware? It was not for the XTV platform?

A - Abraham Peled

It was for VideoGuard, middleware, electronic program guide, head end, and system integration. Not the DVR yet.

Q - Jason Mauricio

Okay, thanks a lot.

Operator

Your next question comes from Anuj Mutreja from Morgan Stanley.

Q - Anuj Mutreja

Just a couple of quick ones actually. Could you just tell us a little bit about the India option? You have told that about 3 to 5 million potential subs. How do you think the revenue pans out, i.e., what does the platform look like and what are the relative pricing versus Western Europe or the U.S. even?

A - Abraham Peled

Well, I think that the first element is that there is no subscriber fee. There is a separate ala carte arrangement for the maintenance of security. Second, because it is a lower functionality system to begin with, the price on both smart card and set-top box royalties and middleware is somewhat lower then, say, a high function European customer or a U.S. customer. But having said that, I think it is still quite a reasonable number and I think hopefully will be made up by volume. And as I think they understand the market better and could introduce a higher appeal of functionality, the contract envisions an upgrade of the functionality for additional revenue.

Q - Anuj Mutreja

Okay, great. Thank you. My final question, Alexander Gersh, you talked about this deferred income where you do a constant reassessment of the changeover risk, if you will. I'm not asking you to disclose what you've discussed but has there been a delta with what you have historically done to what you're doing now?

A - Alexander Gersh

Is very, very hard to say. We do a constant reassessment and it depends on a lot of factors. It depends on what we see as a cost of the smart cards, the price of the smart cards in the future. It depends on a lot of different security elements. So it really is almost impossible to answer this question. As I said, the only thing I can say is that we do look at it very, very carefully every quarter and if things do change, and they do change, they do change whether it is the delay in the replacement cards or other factors do change, the churn in the customer, anything like this, all of those things do play a roll and that is why we need to assess them so carefully.

A - Abraham Peled

The only thing I want to add is clearly when it is kind of a smooth effect, so we don't see a, because we do it on a quarterly basis looking forward you don't see suddenly bumps up-and-down, but rather you may see less deferral going forward so that it is not, or in some instances, we may actually release some revenue. In general we're very proud of the fact that our security, NDS is experiencing zero piracy on all our platforms around the world, and that gives our customers the opportunity to assess to what extent it makes business sense for them and for us to delay that. I think in the last six years we have never had to accelerate a replacement and we did have a delay of at least a year in some of the platforms.

Q - Anuj Mutreja

Okay, that's fair enough. Good. Thank you very much.

Operator

Your next question comes from Murray Arenson from Ferris Baker Watts, please go ahead.

Q - Murray Arenson

You answered most of my questions. Just a couple of quick things. I know DIRECTV is implementing a leasing program on the boxes beginning in March. I wondered if that was in line with what you had originally expected and if there is any impact either in terms of magnitude or the dynamic there for you guys?

A - Abraham Peled

Well, first of all we're really neutral to whether they lease it or expense it. I think it will allow DIRECTV to be more aggressive in the accelerated deployment of DVRs without getting and having perhaps a better handle on churn.

Q - Murray Arenson

Okay. Can you talk about the SkyLife deal? You were talking about anticipated launch middle of this year. I wondered if you could just give us a little additional insight of what you're visibility is there and if we should be looking at any contribution this coming quarter or not?

A - Abraham Peled

No, no. I think obviously that would be revenue that we would recognize in 2007, fiscal 2007, because if they launch in the summer, then obviously it's beyond our current fiscal year. But you see currently you see the increased expense in integration, development and support as people work on that contract.

Q - Murray Arenson

Very good. Thank you.

Operator

Your next question comes from Todd Mitchell from Kaufman Brothers.

Q - Todd Mitchell

I have a question about potential deployment of your broadband IP product on your bigger customers, i.e. DIRECTV. If just sort of theoretically, if DIRECTV were to move ahead with an IP-TV offering, I am assuming a large number of their boxes already have broadband connections. So if that happens, does the business to NDS look like the middleware download or does it look like the DVR rollout in a sense that a large portion of those boxes could be upgraded immediately? And if so, do you have any idea or are you willing to share any idea what percentage of their set-top box base would be able to be upgraded and what the sort of relative ASP looks like vis-à-vis, say, your middleware or your DVR?

A - Abraham Peled

Well, the only thing I can tell you, the only boxes that can be upgraded by software to handle broadband connectivity are the DIRECTV Plus DVR, so……

Q - Todd Mitchell

None of the existing boxes that have broadband connections could be upgraded?

A - Abraham Peled

I don't believe they do.

Q - Todd Mitchell

Okay. I was talking to DIRECTV and they said a number of their boxes have broadband connections.

A - Abraham Peled

Possibly the HD boxes, so I stand corrected.

Q - Todd Mitchell

Those would be the old TiVo boxes, basically?

A - Abraham Peled

Yes, as well as the newer H20 boxes.

Q - Todd Mitchell

Okay, okay. Then I guess the last question here is in terms of DIRECTV's launch of DIRECTV 2 Go, is there a component of either at the set-top box or at the head end that would need a rollout of an incremental NDS technology to enable that offering?

A - Abraham Peled

Not in the DIRECTV 2 Go that was announced, which is a fairly straightforward transition.

Q - Todd Mitchell

Okay, thank you.

Operator

Your next question comes from Mehrdad Torbati from Deutsche Bank.

Q - Mehrdad Torbati

My questions are almost all answered. Just a question on clarification on the legacy downloads of middleware at DIRECTV. Did you say that these legacy downloads are now all over with the end of second quarter? And I know we're going into the normal rollout with the additional subscribers DIRECTV will be having on the platform. Is that correct?

A - Abraham Peled

I think they are mostly over. It is very hard to tell. As you know, we don't know the exact number that are capable of, the loader I expect that there are certain, some additional models that we may still see in the third quarter of '06, but I think the great majority have already been downloaded.

Q - Mehrdad Torbati

Now that you have demonstrated xSpace, can you please give us a sense of about the business model behind it, revenue model, what we can expect in terms of fees or royalties coming out of this area?

A - Abraham Peled

I can't really add anything to that because we don't have specific agreements in place that I could comment on. But obviously the biggest driver would be replacement set-top boxes, set-top boxes that taking out old boxes, putting in new boxes that are capable of being a hybrid satellite and IP box.

Q - Mehrdad Torbati

When do you think that would what happen or when would we see hybrid boxes coming out at some of your major platforms?

A - Abraham Peled

Well, I would think that probably starting in fiscal 2007 as you know Sky obviously in the UK has bought Easynet, is going to be looking to do that. Yes, it is going to start in March. So I would say it will start in our fiscal '07 but probably gain real momentum in '08 and '09.

Q - Mehrdad Torbati

DIRECTV would be more like '08 and 09? Correct?

A - Abraham Peled

DIRECTV as you know the institution in the United States says that you can't do unbundling of the local loop and at the moment the phone companies are aiming to be a competitor. DIRECTV or News Corp have mentioned that they are looking into an option for another option for broadband potentially wireless. So that clearly would require new infrastructure and so that is not going to happen very quickly.

Q - Mehrdad Torbati

On the acquisition front, any news there? Are you progressing there?

A - Abraham Peled

Well, I think we have continuing activity, but obviously when we will have something that we are in a position to announce a definitive deal, we will do that.

Q - Mehrdad Torbati

You could last one or two years before you take any action regarding your underleveraged balance sheet?

A - Abraham Peled

Well, I would hope that it will be a little less, but we have to be pragmatic and not overpay and buy something that really fits within our strategy of enhancing our capability in broadband and IP in marketplace positioning.

Q - Mehrdad Torbati

Okay. Thank you very much.

Operator

Your next question comes from Tim Boddy from Goldman Sachs.

Q - Tim Boddy

Once again most of the questions have been asked. Maybe just a more general question. Looking at your customers and their share prices, by and large this has been a very difficult start to the year. Obviously investors worry about increasing competition from new platforms. In terms of NDS, clearly you stand to benefit in some ways from increased investment by your customers and we have been discussing that on this call. Could you maybe give us a sense of where we might see that benefit coming through in the P&L and indeed how quickly it could come?

A - Abraham Peled

Well, I think that our three types of benefits as we see. The first is the demand for the accelerated introduction of new technology, which results in more project and more NRE. And so that is first. And we have commented in the past that we now have dedicated teams to some of our leading customers working on introduction of new capabilities whether it is HD or DVR or new capabilities in the DVR on an accelerated schedule. That is number one. Number two is clearly the push to move that new technology in the field so that higher penetration of DVR, faster, higher penetration of the HD faster, which results in royalties obviously. And the third part of the benefit to NDS is that in many cases we supply both cable and satellite or in the case of Korea actually our first triple play country where we supply satellite to three major cable companies and Korea Telecom. So we see basically a benefit from being able to do more work for all of these platforms. I mentioned India for example where now Hathaway because Tata Sky will be launching is starting an accelerated deployment of their digital, which they had not done for the last three years because there was no competition. So I think these are some of the, in Israel for example, satellite and cable competing obviously they want to get DVR quicker and broadband and so on.

Q - Tim Boddy

In terms of the speed at which you might see these developments positively impacting the P&L?

A - Abraham Peled

Well, I think some of them have already positively impacted the P&L and some are part of what you see now is expense, more people working on these projects obviously. Once these projects are finished we're going to start seeing the revenue coming through.

A - Alexander Gersh

I think when we mentioned this 3 to 5 target of average 15% revenue growth and 20 to 20% operating income growth that has taken some of these benefits into consideration.

Q - Tim Boddy

Okay, that's very helpful. And your level of confidence that investors are also worried about the marketshare also obviously at the satellite operators. What is your level of confidence in those fares not materializing?

A - Abraham Peled

Well we're going to do our best to help our customers stay ahead, so I do feel that there is considerable technology advantage and in particular the ability to deploy rapidly nationwide which is a big advantage. So if you look at high-definition for example in the U.S., just to take that as an example, once DIRECTV will have all the local markets and high-definition. It makes a huge difference because that is what most of the people see most of the time is their local channels. And I think cable will have difficulties delivering high-definition on all of the local channels plus the same thing for the phone companies that are going to be struggling to deliver SD. So I do feel that satellite can continue to have the first mover advantage and offer the best possible package and entertainment experience to their customers. Now we're going to do our best to help them. In many cases we also as I said work with cable, in which case we help both to the best of our ability.

Q - Tim Boddy

Thank you very much.

A - Abraham Peled

Okay, well, there are no further questions I think we should wrap up. I want to thank everybody for participating in the call and we will see you. We will get together next quarter. Thank you.

A - Alexander Gersh

Thank you.

Operator

That does conclude our conference for today. Thank you for participating. You may all disconnect.

Copyright policy: All transcripts on this site are copyright Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and link to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY’S CONFERENCE CALL AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE CONFERENCE CALLS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY’S CONFERENCE CALL ITSELF AND THE APPLICABLE COMPANY’S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.