DTS Even More Alarming After Q4 Earnings

I felt that it was important to address several of the issues that came from DTS Inc.’s (DTSI) Q4’07 call, in light of my article ("Sounding the Alarm on DTS Inc.") published yesterday. While the “optics” of the quarter appeared strong, the disastrous guidance is even more ominous when one peels back the onion of the quarter just reported. Below is an update from the quarter on several of the points discussed in my recent article that should be very concerning for shareholders:

The Quarter

DTS reported revenues of $16.8M, well above the expected $15.1M. They also reported earnings from “continuing” operations of $0.24, versus the $0.15 expected. Looks good. BUT, a deeper dive into the numbers is illustrative of the general quality problems with the company. First, the tax rate was 20% for the quarter. On their Q3’07 call, they guided the annual tax rate for 2007 (one quarter to go at that point) to 45%. Secondly, they had royalty recoveries of $4.7M, significantly above the $2M a quarter they had been anticipating (they only had $2.7M of recoveries in the first 9 months). If they had $2M of royalty recoveries (what was expected) in Q4’07, they would have done $14.8M of revenue, missing consensus by $300,000.

Further, had they not had the surprising royalty recoveries, and incurred the tax rate they guided to just three months earlier, they would have made $0.087 cents – far shy of the $0.15 consensus (EBT = 5,552 – 2,700 of royalty recovery over the $2M expected * (1-0.45)/18.1M shares out). While some sell side analysts will laud the company’s performance, it seems from our discussions that others are looking at the issues with the numbers. It is worth pointing out in black and white terms that the company had an operating profit of $4.99M – of which $4.7M came from royalty recoveries.

The Guidance

DTS guided 2008 revenues $55M to $59M and earnings $0.52 - $0.58, significantly below the Street’s expectations of $61.2M and $0.69 respectively (First Call estimates from FactSet). This suggests the third straight year of flattish revenues and earnings (’07 = 53.1M/0.54, ’06 = 50M/0.54). This must be terribly discouraging for the bulls given the expectations for a ramp from the Blue Ray HD cycle, a lower tax rate, and a history of the company setting estimates too high (see my article from yesterday on DTSI).

The Cash

Our article yesterday alluded to our suspicion that DTS had been trying to earn extra yield on its cash by playing in the auction rate market with its cash and equivalents. Indeed, the company confessed on its call that they had $29.5M of “cash” that was stuck in ARS assets (35% of their cash and equivalents!). While they said that they were not going to take a charge against their cash, we would not be surprised to see their auditors force them to reclassify the cash as long-term investments. One has to wonder, especially a bull, why DTS - an IP licensing business - is playing in the auction rate security market stretching for yield. While we like the management of DTS, there seems to be a lot of questions that their actions create.

Margins

DTS guided 2008 operating margins to the range of 20%-25%. One of our primary concerns with DTS in our article yesterday was surrounding our belief that opex may be residing in disc ops that is in fact shared by the licensing business. Their opex guidance seems to support our assertion. DTS exited Q4’07 with an operating margin of 30%. Further, the company had 2007 operating margins of 23% (12.21M op inc/53.1M revs), so the guidance implies no margin expansion despite a higher midpoint of the revenue guidance by nearly $4M over 2007. To top it off, SG&A jumped QoQ to $9.8M from $7.2M ($8M in Q2’07 and $8M in Q4’06). We think our concerns about disc ops hiding opex is more worrisome after Q4’07 than ever.

Disc Ops – Our Main Issue

As we had pointed out, we were highly skeptical of the carrying value of disc ops on DTS’s books. Indeed, they wrote down the carrying value in Q4’07 by $24.7M! However, they didn’t write it down completely, maintaining roughly $6M of carrying value on the balance sheet. This also allowed them to keep disc ops on the income statement. Again, they blamed “recent market and economic conditions” and highlighted the “credit markets” on their earnings call for their inability to dispose of the asset.

It seems very unusual that potential buyers of a $6M asset would need to obtain debt to finance the purchase. We wonder why the asset wasn’t written down in Q3’07 when they ran their fair value test as disclosed in the 10Q. What we are even more disturbed by is the fact they KEPT the disc ops line on the income statement. Why not write it off completely and free the income statement from the disc ops line? We continue to assert that this is problematic because opex that is shared by digital cinema and the licensing business is currently residing in the disc ops cost line. Had they written disc ops down completely, instead of 80% (strange), then they would have been forced to show in continuing operations a P&L with any expenses that are co-mingled between disc ops and DTS licensing. The company would not take buyside questions on the call, so we were unable to ask for an explanation of the delta between the write-down ($24.7M) and the reported disc ops loss of ($22.3M). The K has not been published, so there are many questions left unanswered.

The net-net is a hairy quarter, a big guidedown versus consensus, a third straight year of flat revenues and earnings – even as the HD cycle should be lifting, cash management problems, a disc ops line that continues to warp the true margin structure of the company, and a decision to write-down 80%, but not 100%, of a dying asset that was supposed to go away 18 months ago.

My Question to Shareholders

With the market crushing all genres of companies, why would you (barring end of month marks) choose to put marginal capital into DTS when you can buy many other names at great prices without all of the questions?

Disclosure: Author holds a short position in DTSI

Comments

[downdraft:]

Jackson,
What a mess. Thank you for the insight and the response to the comments from yesterday. Hopefully, we'll be hearing more from you on DTS and other stocks in the future.

2008 Feb 29 08:11 AM

[Bill Rimealio:]

I listened to the call as well. My question would be how the auditors can permit them to continue to make statements about the cinema business and then fail to deliver? Is there a time limit a company can have for a disc ops line?

2008 Feb 29 08:15 AM