Sounding the Alarm on DTS Inc.

DTS Inc. (DTSI) is a provider of digital multi-channel audio, or surround sound, to the consumer electronics market and Hollywood. The market is a duopoly for audio codecs, with Dolby (DLB) dominating the market. The “duopoly” is more like a monopoly with a second standard for the sake of competition (think Intel (INTC) and AMD (AMD)).

The bull case, as the stock has risen from the mid-teens to as high as the low thirties over the past two years, has focused on a consumer licensing earnings power story, once high definition gains mass adoption. This licensing story gained momentum in early 2007 (January), when DTS announced they intended to IPO or sell their digital cinema business, creating a pure play licensing model. The story has been promoted by the sellside with an emphasis on DTS’ inclusion as a standard spec for HD (the sellside fails point out that DTS was included in 92% of all standard def DVD players/HTIB’s and their numbers stunk. So will the incremental 8% TAM make a difference?).

A closer look at the historic numbers, management’s inability to forecast what should be a highly predictable financial model, questionable accounting around their discontinued operations, a heavy reliance on interest income, and a broad exposure to a CE (consumer electronics) slowdown, paints a very bleak story for a company that trades has generated only $7.2M of operating income (which is overstated) and has an EV of $390M.

Aggressive Accounting or Something More Sinister?

On August 9th, 2006, DTS announced they would separate into two companies, a licensing business and their digital cinema business. In January 2007, DTS announced its plans to sell or IPO its digital cinema business, which would make it a pure play licensing business. Digital cinema, which sells services to Hollywood and theater operators, comprised roughly 1/3 of revenues, yet carried lower margins based upon a heavy hardware focus and manual human intensive element of direct sales. DTS management recognized that Wall Street paid a much, much higher multiple for a pure IP licensing story, so they decided to sell Digital Cinema. In August, the company stated that:

In response to changing market conditions, including tightening in the credit markets, the Company reevaluated its sales strategy in an effort to maximize shareholder value, and it has modified its sale approach to offer the assets of the Cinema and Digital Images businesses together or individually.

This announcement was made in conjunction with the decision to account for digital cinema as discontinued operations. However, they assured the market on their conference call (Q2’07 and again Q3’07) that digital cinema would still get divested by the end of the year and the disc ops line would cease to exist….

…. Here we are February 28th, 2008, and judgment day draws near. This is a problem for the company because it seems that based upon the reported disc ops from their Q’s that either a) the digital cinema business is a collapsing asset, or b) they are overstating their consumer licensing margins and arbitrarily jamming costs into digital cinema.

First, the company has dispelled (a) in their 10Q for the third quarter:

The Company engaged a valuation firm during the third quarter of 2007 to perform an interim evaluation of goodwill, per SFAS No. 142, "Goodwill and Other Intangible Assets," in order to determine whether the changing market conditions represent impairment indicators for the goodwill classified as held for sale. The results from this interim evaluation were important factors in the Company's determination that impairment did not exist at September 30, 2007, as the valuation of the businesses or assets comprising the DTS Digital Cinema business exceeds the carrying value of the net assets held for sale.

Due to the changing market conditions and the decision to offer the assets of the Cinema and Digital Images businesses together or individually, the Company reevaluated SFAS No. 144 during the third quarter of 2007 and determined that the businesses or assets comprising the DTS Digital Cinema business and the related operations still meet the criteria for the held for sale and discontinued operations classifications, respectively.

So given the fact they ran a litmus test a few months ago, it seems they believe the business is still worth $28.8M (net assets of disc ops).

So, that leaves option (b). When examining the financials, one has to question the catastrophic collapse in digital cinema profitability, at the same time consumer licensing margins have slowly improved (again, the SBU the Street cares more about). In the first 9 months of 2006, Dig Cinema did $21.1M of revenue with a pretax loss of $5.83M. During that same period in 2007 (first 9 months), Digital Cinema did $15.9M of revenue (down $5.2M YoY), yet the pretax loss ballooned to $12.5M (down $6.7M YoY). This suggests that digital cinema had negative contribution margins of 129%!

These are actually understated as the company discloses in its filings that the 9 months of 2007 exclude $2.2M of D&A for digital cinema because the assets were held for sale. So apples to apples, the company actually lost $14.7M on $15.9M of sales, or an EBT margin of NEGATIVE 92.4%, compared to a negative EBT margin of negative 27.6%. It begs the question: If the $5.2M of revenue decline year-over-year were 100% margin, then what caused the incremental $3.7M of the loss in a segment that was being harvested for a sale?

The most likely answer is that DTS management has been tucking away personnel and overhead costs in the SBU which they couldn’t IPO, haven’t been able to sell, and will likely write-off when they report Q4’07. This would be disastrous for shareholders if this is true and shows up in higher opex for 2008 once disc ops gets removed. In light of the fact, the CFO Mel Flanigan said on their Q4’06 conference call:

I think the challenge that we face from a purely from a profitability standpoint in 2007, is just the fact that as a -- in the first year of being -- of reporting as a separate company, the reality is that we have to absorb all of the corporate infrastructure costs that would have been allocated among three different divisions or three different business units, up through 2006. So, there will be certainly some of the cost structure will be pulled out and go with the digital cinema group, but there is still a fairly large chunk that stays with DTS.

However, once the decision was made to separate d-cinema into disc ops, this swelling of opex did NOT occur in DTS core, only in disc ops! What happens to those costs that just maybe were being allocated to digital cinema to artificially prop up consumer licensing margins? My bet is that a high percentage of those costs will roll back into licensing, demonstrating that DTS is a small, marginal player in a market dominated by Dolby. The scary element? Most shareholders own DTS for the consumer licensing business, which despite stuffing costs in disc ops, has still seen its EBIT margin decline from 29% to 20% (first 9 months of ’07 vs. ’06). That decline in a robust period for consumer spending begs the question: What happens to EBIT margins if the demand for consumer electronics slows AND they are forced to fully expense headcount that was split between the two SBU’s that loses an expense outlet when digital cinema vanishes?

History of DTS “Hopes” and “Statements” About D-Cinema

Q3’07 (11/8/07)

Before closing, I'd like to give you an update on the sale of our D-cinema businesses. In response to the current economic environment and feedback from potential buyers, we have modified our sales approach to offer the assets of the cinema and digital images businesses together or individually. We are pleased with the response to our change in approach and are working actively to complete a sale over the coming months.

I think we're clearly trying to move as fast as we can, as we sit here today I'd -- I cannot say with 100% confidence that it will be by yearend, but I am encouraged, as I said, by -- we've had good interest, and the process is moving along. So it's really a question of how -- how far and how fast we can get through rounds of bids as well as finishing documentation.

Q2’07 (8/9/07)

This brings me to an update on our D cinema business. Our team is making important progress in positioning our product line and business for the coming transition to digital cinema, recently completing a strong showing in Cinema Expo, and announcing the availability of a JPEG 2000 capable digital cinema server. In conjunction with these efforts, we remain focused on working toward a sale by the end of the year.

Q1’07 (5/10/07)

Turning to the status of the sale of our digital cinema business, we have now completed a number of management presentations and are narrowing our discussions to a select group of interested strategic and financial buyers. The next phase of the due diligence process will take some time. And we expect to report on our progress in the next earnings call. At this point, we believe we are still on track to complete the sale in the second half of 2007.

Q4’06 (2/20/07)

As a result, during 2006, we were able to complete more than three times the number of projects than in 2005, increase revenue by 50% over the prior year, improve gross margins and gain access to newer and faster growing markets like precompression processing and D Cinema content preparation. With the semi-fixed cost base these opportunities should deliver higher margins over time, positioning this business to be a meaningful, profitable and strategic contributor to DTS Digital Cinema.

We believe with these steps behind us we have positioned the digital cinema business for growth and future profitability. We have started to market this business to strategic and financial buyers. As expected, we have received solid interest given the broad awareness of the major opportunity represented by the global conversion of the motion picture industry infrastructure. From this point forward we expect to account for DTS Digital Cinema as discontinued operation until the sale is completed which is expected later this year.

We've reorganized the business in a way that really is focused on delivering end to end solution and solutions essentially for content providers all the way through exhibitors, and that necessarily necessitates having front end, as well as if you will, downstream capability. It is our intent, and we have certainly packaged the businesses together, because we've essentially spent the better part of the last year integrating them in a way that we believe adds strategic value over time. So, it's our clear intent to sell DTS Digital Cinema as one entity and thus far we've gotten solid interest from a number of areas, and obviously if that changes we'll make that decision, if and when that time comes. (well, they reversed this thought 4 months later)

Interest Income Saveth…. Interest Income Hurteth

DTS’s greatest asset is its balance sheet with $87M of cash ($4.78 per share) and no debt. Through the first 9 months of 2007, the company “earned” $2.1M from interest income, which was 23% of its pretax pro forma income. With the Fed aggressively cutting rates, and a 2008 average risk free rate likely to be anywhere from 1/3rd to ½ the risk free rate in 2007, DTS will likely see its interest income decline by a commensurate amount. Analyst models currently forecast a flat interest income line in 2008. If DTS “earns” $2.8M (annualizing first 9 mo’s) in 2007, and that falls by 1/3rd to $1.88M in 2008, the company will need to make up nearly $0.04 after tax (lower 35% tax rate next year) in the lost interest income – which is 6% of analyst estimates. Management actually discloses in their 10Q for the third quarter that they expect interest rates to remain flattish.

In this same segment they disclose a MATERIAL error that was never discussed in sellside reports or earnings calls relating to an overstatement of 2005 and 2006 interest income. They claim this error was not material, despite the fact it was $0.03 after tax! This is a significant concern given the potential accounting issues around their disc ops.

We recorded an adjustment in the first quarter of 2007 to correct an error. In the first quarter of 2007, management identified an error in our accrued interest income balances related to 2005 and 2006 that was corrected during the first quarter of 2007. The correction had the effect of reducing short-term investments and decreasing interest income by $0.7 million. The correction has decreased income from continuing operations before income taxes by $0.7 million and income from continuing operations by $0.5 million for the nine months ended September 30, 2007. Although this correction was an out-of-period adjustment, management determined that the effect on previously filed reports was not material. Going forward, we expect interest income for the year to be in the range of $2.5 to $3.0 million, based on the current interest rate environment and current investment balances.

At the end of 2006, per their 10K (most recent available), DTS held $69 million in munis and another $9.3M in commercial paper. It would not be a surprise if they were forced to reclassify some of their short term investments because they were involved in auction rate securities that were unable to roll.

History of Earnings Misses and Lower Revisions

Any investor or analyst (yes they are not one in the same) that has followed DTS for more than a quarter will bemoan the long history of consistent misses and/or guidedowns. The company ranks up there with the best for their history of mismanaging financial expectations. In fact there are a plethora of examples where they have shown no grasp of their own business model, let alone their financial model (for instance stating in Q2’07 that HD was 12% of revenues and that would ramp to 15-185 in Q3/Q4. Despite the fact they were six weeks into Q3 when they gave that projection, Q3’07 HD revenue fell to 9% of total). There are many examples, but back to the financial task at hand. On 2/13/06, DTS projected revenues of $83-$86M and $0.65 of EPS for 2006. They ended up doing $78.3M and $0.40. On May 10, 2007, they projected 2007 revenue of $53M-$58M and $0.40- $0.47. Six months later, they lowered projections to $50M-$53M and $0.42-$0.45 (while even getting the benefit of 1M share eliminated and hiding costs in disc ops).

On April 1, 2007, consensus estimates for 2008 were $95M of revenue and $0.80 of EPS. Just nine months later, estimates have already fallen for this year to $61M of revenue and $0.67 (which is roughly $0.10 of interest income after tax based on management’s assumptions). Oh, and did I mention that the company guided the ’08 tax rate down 10 full percentage points from 45% to 35%? Had the tax rate been kept constant, then consensus would be looking for $0.57 for 2008.

If we assume for a second, that consensus is correct, directionally, yet DTS loses 1/3 of its interest income and has to “eat” just $3M of incremental opex once digital cinema is divested (Street modeling flattish opex for ’08 which seems absurd), then the $0.67 of earnings ($12.3M) becomes $0.55 per share. After two consecutive years (assuming they hit Q4 – which they should after the big guidedown following Q3’07) of lousy earnings ($0.40 and $0.43), a third year without the parabolic ramp may be enough to cause the long term shareholders to realize the out year may never come…..

At 10x EBIT plus the cash on hand, DTS would be valued at no more than $14.00, which is still 21x a 2008 consensus number that they’ll never hit….

Disclosure: Author has a short position in DTSI

Comments

[downdraft]

Jackson,
This is a very well written and insightful article. As a fellow short seller, I have to ask the question: Do you think that another miss and/or guidedown will be sufficient to cause the longs to throw in the towel. Stories like this usually come crashing down when the longs realize their story never occurs and they all run away at the same time. Thanks for the submission.

[valueman]

Very well-written idea, and my research supports your general thesis regarding cost-switching between units. However, if I was forced to construct a bull case, it would be that the fact that DTS is mandatory in Blu-Ray means that DTSI has pricing power and can grow revenue significantly. Can you help me understand the nitty-gritty of the negotiation between an equip manufacturer and DTSI. For example, what constrains the price DTSI charges? Is it that a manufacturer will simply not follow the Blu-Ray spec exactly and leave out the DTS? Or is it that the manufacturers will change the spec if DTS charges too much? Or is it that DTS agreed to a price already for the minimal 2-channel DTS decoding technology?

My fear is that the fact that DTS is required will give DTS tremendous pricing power even if nobody uses it.

Thanks in advance.

[Jackson America]

thanks for the comments. my understanding is that Blue Ray working group has a patent pool of which DTS has contributed IP. DTS gets ~ .30 per unit across platforms and that is SIMILAR to their standard def royalty rate. What bulls miss is that DTS has ~ 92% penetration rate in SD, so will the incremental 8% TAM make a significant difference? What if the HD cycle is weaker than the SD cycle? I'm going to write a follow up tonight that hopefully will be out tomorrow.

[moog_dog]

I think that the comment re: DTS in standard def DVD players maybe slightly incorrect. Yes, they were in the standard, but with respect to standard def DVD players, players were not required to have a decoder in the player itself, most did not, unlike 2/0 Dolby digital (which was mandatory), rather they just passed through the encoded bitstream.

DTS's primary source of licensing revenue comes from A/V receivers and theatre in a box systems, not standard def DVD players. I'll have to go back and check the BluRay standard and see if an on-board DTS 2ch decoder is mandatory for all players, but if it is, then that's an upside for them as it's (assuming anyone actually buys them) an additional source of revenue tied directly to unit sales of BluRay.

Regarding the accounting shens, I never looked that much into the numbers, your assessment is quite insightful.