Sonic Solutions F3Q08 (Qtr End 12/31/07) Earnings Call Transcript

Sonic Solutions (SNIC)

F3Q08 Earnings Call

February 26, 2008 4:30 pm ET

Executives

Nils Erdman – Vice President, Investor Relations

Dave Habiger – President and Chief Executive Officer

Paul Norris – Executive Vice President, Interim Chief Financial Officer and General Council

Clay Leighton – Chief Operating Officer

Mark Ely – Executive Vice President of Strategy

Analysts

Mike Olson – Piper Jaffray

Paul Coster – JP Morgan

Steven Frankel – Canaccord Adams

Ralph Schackart – William Blair

Alan Davis – D.A. Davidson.

Jeff Osher – Harvest Small Cap Partners

Presentation

Operator

Welcome to the Sonic Solutions fiscal year 2008 third quarter earnings release conference call. (Operator Instructions) I would like to turn the conference over to Nils Erdman, Vice President of Investor Relations.

Nils Erdman

Thank you for joining Sonic Solutions' third fiscal quarter 2008 earnings conference call. With me on today's call are Dave Habiger, President and Chief Executive Officer; Paul Norris, EVP, Interim Chief Financial Officer and General Counsel; Clay Leighton, Chief Operating Officer; Mark Ely, EVP and Head of Strategy; and Bob Doris, Chairman of the Board.

Before I hand the call over to Dave I will review our Safe Harbor statement. During the course of this call, we will make forward-looking statements within the meaning of the Federal Securities Laws.

All statements, other than those of historical fact, are statements that could be deemed forward-looking statements, including those regarding growth and financial performance, financial outlook, strategic and operational plans, target markets and strategic opportunities, potential benefits of Sonic's partnerships, Sonic's ability to strengthen relationships with end-users, the opportunities and benefits achieved for the evolution of and opportunities for Sonic arriving from next-generation high-definition formats and channels, the download and burn business model, views regarding the status and conclusions of Sonic's review of its historical and current stock option grant practices and related accounting, the expected impact and consequences of this review, including the expected restatement of Sonic's historical financial statements, and the time for completion of the process.

All forward-looking statements are based on current information and expectations and are inherently subject to change. Actual results may differ materially and adversely to those in our forward-looking statements due to various factors.

Now I would like to turn the call over to Dave Habiger.

Dave Habiger

Today we are reporting financial results for the third fiscal quarter of 2008. As we indicated in our press release, because of the continuation of our voluntary stock option review, we are reporting only preliminary and selected financial results.

As you may have noticed, we just filed our fiscal third quarter 2007 10-Q and our fiscal 2007 10-K, which had been delayed pending the completion of our voluntary review of stock option accounting. In order to be fully compliant, we still have to file quarterly reports for the first three quarters of fiscal 2008 and hold required shareholder meetings, but we anticipate these remaining steps will be completed within a matter of weeks.

You will have also noticed our 8-K filing announcing changes to our management team that coincided with our 10-Q and 10-K filings. Paul Norris, who is our General Counsel, has assumed the additional title of Interim CFO. He joins us today on the call along with Clay Leighton, who will now be our COO and who will help Paul throughout the transition.

The changes in Clay's and Paul's positions were made because our Board thought it better to transfer the responsibility for financial reporting and compliance to someone who had not been involved with stock option accounting during the review period, making clear to everyone the independence of the review and the reporting process.

Clay's new role as COO will permit Sonic to profit from Clay's long experience with the company at a time when our operations are expanding. Both Clay and Paul will provide more information regarding the status of the ongoing review and the preliminary selected financial results.

We ended our December quarter with $35.6 million in revenue, which was ahead of our prior guidance of $33 million to $35 million. Retail sales came in stronger than predicted and combined in-store and e-tail sales were up 8% from September and up 12% from December quarter of last year.

On the high def front, last week's announcement by Toshiba that it would discontinue support of HD DVD signaled the end of the format war. With all six major Hollywood studios now committed to Blu-ray, we believe the benefits of the new HD format over standard-def will pave the way for broad scale consumer adoption.

In 2008 we expect hardware manufacturers to align behind Blu-ray and prepare multiple products for market. As they scale production of Blu-ray devices, price points will continue to decline and we expect an increase in sell-through, signaling the major distribution studios that the format is reaching critical mass.

We expect that as the installed base of Blu-ray players surpasses the $2 million mark, studios will commit a broader number of catalog titles to production and Sonic will be ideally positioned to capitalize on this opportunity.

Sonic's professional tools are the gold standard for Blu-ray production and our professional products group has already focused its resources on the creation of a new application exclusively for Blu-ray titles. As the studios open up their catalogs for Blu-ray, demand for these professional tools will increase, especially as titles for holiday 2008 going to production.

With the pending tidal wave of content, PC and consumer electronics makers are being spurred to offer products with full Blu-ray functionality in their drives, devices and applications, igniting demand for software from Sonic's Advanced Technology Group.

Following on the announcements that Sony, Adobe and Broadcom are standardizing on Sonic software, we expect other customers to follow, resulting in increased per-unit royalties and other revenue ramping in anticipation of a "Blu Christmas".

Our consumer software business showed an uptick in the December quarter, with revenue exceeding expectations. Our key OEMs are now incorporating Creator 10 into their products, and we expect adoption across the majority of OEMs to be completed by the end of the current quarter.

On the retail front, Roxio continued to outshine competitors in 2007. According to NPD Group, which tracks retail sell-through in North America, Roxio applications increased their market share over the previous year, and led the category with 42% of the revenue.

On the Windows platform, Easy Media Creator more than doubled the revenue share of its next closest competitor. On the Mac platform, Toast increased unit sales by 49% year-over-year and secured more than 90% of revenues in the category. Roxio-branded applications are available in 15,000 stores worldwide and maintain key placement in leading retail and e-tail outlets, including Best Buy, Wal-Mart, Costco and Apple retail stores.

It's important to note that while the trend of overall retail software sales shows a decline from last year, Roxio-branded products are growing market share. Retailers looking to devote less shelf space to software products are consolidating their offerings and opting to stock only one or two SKUs, with Roxio-branded products the software of choice.

Roxio has over 315 million installed users, 4 million of whom connect to our sites each week, and one of our key goals for calendar 2008 is to foster a greater connection between Sonic's products and our consumers through mobile and online service offerings. We see an exciting growth opportunity to seamlessly interconnect our desktop applications with these services.

Current examples of this are Roxio's Back on Track and Mobile Media Manager applications. In partnership with Carbonite, Back on Track automatically and continuously protects personal data and digital files through an Internet-based backup service.

With Mobile Media Manager we have an arrangement with Research in Motion to bundle Roxio's software as a PC companion product to the Blackberry Curve and other smartphone devices. In mid-February we demoed the Mobile Media Manager at the Mobile World Congress in Barcelona on a number of different mobile devices, and the reception was phenomenal. We expect announcements with new devices manufacturers as early as this spring.

I would now like to discuss Qflix, our DVD on demand initiative. Our objectives in this emerging space have been: one, to license the IP for Qflix to chip, media and drive manufacturers and provide the software and infrastructure for our partners to get up and running quickly; two, to enable as many households as possible; and three, to drive adoption of the Qflix model across all brick and mortar and online retail sellers of DVDs.

We crossed a number of milestones in each of these categories in the December quarter and we continue to build on that momentum.

We licensed the Qflix technology IP to three of the world's largest optical media manufacturers, CMC Magnetics, Ritek and Verbatim. We received a licensing fee on all Qflix-certified optical media, though until the demand for download and burn increases, the near-term effect on our revenues for these partnerships will be minimal.

Currently we estimate that 62.2 billion blank DVDs are purchased annually for non-commercial use, and when Qflix becomes a standard feature on optical media, we stand to benefit significantly from the adoption of download and burn.

We progressed in our second objective by licensing Qflix technology to PLDS, one of the world's leading drive manufacturers, and the largest OEM of PC makers. Currently, over 100 million optical drives are shipped annually by PC and hardware manufacturers worldwide. Our intention for Qflix technology is for CSS encrypted DVD burning to become a standard feature on all optical drives and media.

We are also actively pursuing partnerships with other major drive manufacturers and expect to have similar licensing deals in place within the next few months. Near-term, we do not anticipate significant licensing revenues from this or other partnerships with drive manufacturers until we see volume-related revenue which we calculate for late calendar 2008.

As Qflix-enabled PLDS drives are also available to vendors providing custom DVD manufacturing services to Internet retailers, this partnership advances our third objective, to drive adoption at brick and mortar and e-tail stores.

Further to this objective, we are now entering the go-to-market phase and have a number of partners that are beta testing the Qflix technology. All of our partnerships have revenue-generating potential from licensing fees, in addition to software and services that enable premium burning on demand, such as websites, kiosks or manufacturing on demand models for retail. We would expect to begin to see meaningful contributions from these sources in the latter part of calendar 2008.

Of the 2 billion DVDs replicated annually, we estimate that more than 10% are returned as damaged or unsold, which are reported as returns for content owners and wind up in landfills.

The Qflix solution has the potential to have a dramatic financial and environmental impact for studios and retailers, dramatically reducing distribution costs and eliminating millions of pounds of waste. We believe that Qflix has tremendous potential for Sonic, and we'll be focusing a number of our efforts and devoting key personnel to ramping up in this area of our business.

With that I would like to introduce Paul Norris, our new interim CFO, who will review the financials for our third quarter of fiscal 2008.

Paul Norris

As Dave mentioned earlier because we still have not fully caught up with our filings, we are reporting results and giving guidance today on a preliminary basis and without taking into account any adjustments that may be required in connection with any restatement.

Also please note that unless otherwise indicated, we are reporting costs on a non-GAAP basis, excluding equity compensation charges, the amortization of acquired intangibles and costs associated with our voluntary review of stock option accounting.

For the December quarter, total revenue was $35.6 million and exceeded our prior guidance range of $33 to $35 million. We recognized $1.6 million in professional product revenue during the quarter. This is up slightly from the September quarter total of $1.4 million and in line with our expectations.

As a reminder, in 2007, we announced a change in the way we recognize revenue related to professional system sales. We now recognize revenue from new software licenses over the term of the maintenance contract, usually one year, rather than at the time of shipment. Due to this change, as professional system sales increased during fiscal year 2009, PPG revenue should grow at a steady rate.

Consumer revenue was $34 million in the December quarter, up 10% from $30.9 million in the September quarter. Our e-tail and retail revenue was up over 8% compared to the September quarter.

Technology licensing revenue from our ATG Group, which we include in our consumer revenue, totaled approximately $2.5 million in the December quarter, up from $2.1 million in the September quarter.

We forecast that revenue will remain between $2 million and $2.5 million in March quarter. We believe that licensing revenue will increase during fiscal year 2009 as PC and CE manufacturers ramp up use of our technology tools in order to incorporate Blu-ray compatibility into their drives, devices, and applications.

Cost of revenue for the quarter, excluding stock based compensation and amortization of intangibles, was $7.1 million or 20% of revenue, which was $500,000 less than the $7.6 million reported in the September quarter.

Our September quarter cost of revenue was higher primarily due to costs associated with the retail launch of Creator 10. The amortization of intangibles was approximately $1.2 million in the December quarter similar to the September quarter. During the quarter, operating expenses were $24.6 million split as follows: sales and marketing, $9 million; research and development, $10.7 million; and general and administrative, $4.9 million.

This is a $1 million decrease from operating expenses of $25.6 million in the September quarter and slightly below our last forecast. The full benefit of the closure of our facility in Richmond Hill, Canada, will not be realized until the March quarter.

In addition to the operating expenses just mentioned, we incurred $5.9 million in one-time charges, including $3 million in costs related to the stock option review and $2.9 million in restructuring charges, primarily from the closing of our Richmond Hill office. These charges were previously announced and are in line with our expectations.

Other income for the quarter, consisting primarily of net interest income, was $290,000. In the December quarter we had approximately 26.3 million basic shares outstanding and 27.2 million shares outstanding on a fully diluted basis.

Given our accounting review, we are not releasing a complete balance sheet at this time. However we will provide some information related to our cash position.

Cash, cash equivalents and short-term investments ended the quarter at $65.2 million, down $2.3 million from the $67.5 million at September 30, 2007. The decrease is primarily due to the one-time expenses that I mentioned a minute ago.

Accounts receivable DSOs were approximately 27 days as of September 31 versus 33 days at September 30. These DSO calculations have been made on a simple basis and are at their lowest historical level. Our bank debt outstanding at December 31 was $20 million, unchanged from September 30.

I'd like to take a moment to discuss our fiscal year 2007 Form 10-K that we just filed. At a very broad level, the 10-K reflects the following financial implications of our stock option review.

Due to our adjustments of stock option measurement dates, we recorded additional charges totaling approximately $38 million less $13 million in tax benefits or $25 million on an after-tax basis for the restated period through September of 2006. Most of the charges are non-cash except for the payroll tax related amounts, and most of the tax benefits will be realized as tax savings.

Expenses associated with conducting the review totaled approximately $7 million through December 31, 2007. We anticipate that we will spend an additional $3 million to complete the review and filings.

In addition we have made a few other miscellaneous adjustments. As many of you are aware, we changed our method of accounting for royalties received from OEMs for bundled versions of our consumer software. This change involves implementing an end of calendar quarter cut off for OEM royalty reports.

This revised methodology was applied back to our revenue results for fiscal years 2006 and 2007. In addition, we made some adjustments related to goodwill and income taxes of a Canadian subsidiary we acquired as part of the Roxio acquisition, and made a revenue adjustment relating to a sales transaction during the first fiscal quarter of 2007.

In terms of the impact of the review on Sonic from the tax perspective, we have increased our tax loss carryforward and do not anticipate that Sonic will be paying significant cash income taxes through at least fiscal year 2009. However, we estimate we will record book taxes at statutory rates of approximately 40%.

Now I'd like to discuss guidance for the remainder of fiscal 2008 and looking ahead to 2009. For the March quarter, we anticipate revenues of at least $34 million. In general, we anticipate our third and fourth quarters to be relatively comparable on a top-line basis. This will bring our annual revenues for fiscal 2008 to at least $132 million.

We anticipate that our cost of goods sold, excluding amortization of intangibles and any stock based compensation, will be approximately 20% of revenue in the March quarter. Our ongoing operating expenses should continue to benefit from the impact of our restructuring in December.

We forecast that operating expenses, excluding stock based compensation and any one-time charges associated with the stock option review and the restructuring charges will be $24 million in the March quarter.

Our target continues to be to achieve a 20% pro forma operating margin in fiscal year 2009, and to generate roughly $30 million in EBITDA per year under favorable scenarios.

As we begin to benefit from the adoption of the Blu-ray format, and assuming that our Qflix initiatives begin to gain traction in the market, we would expect to have a growth trajectory in fiscal year 2009 that puts us back on course to produce high single digit to low double-digit growth year-over-year, exclusive of acquisitions.

Dave Habiger

Looking ahead to 2008 we have a great deal to be excited about, both with Sonic and the industry as a whole. We consider the potential for Qflix and DVD on demand to be a terrific opportunity for us and to help maximize our success in this initiative we've appointed Mark Ely, our EVP of Strategy, to take on additional responsibility as general manager of our newly created Qflix division.

Matt DiMaria, our SVP of Marketing, will assume Mark's role as General Manager of the Roxio division and we expect him to usher in a new era of online and mobile initiatives, while strengthening the dominant position of our Roxio products.

We are similarly encouraged by movements taking place within the industry. The format war is at an end and Blu-ray is poised for growth. Qflix and the download and burn model are gaining major traction with manufacturers and retailers, consumers are buying more CE and PC devices and are interacting with more digital media on a daily basis.

Having successfully navigated a particularly difficult period in Sonic's history, we see tremendous opportunity in calendar 2008 to fuel revenue growth, improve operating margins and deliver meaningful returns to shareholders.

Though I mention it every conference call, I would sincerely like to thank our employees for their dedication and their continued efforts.

At this point we will take questions from the group.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mike Olson - Piper Jaffray.

Mike Olson – Piper Jaffray

If the studios are going to be getting their libraries ready for Blu-ray, when do you think you are going to start to see an uptick in the Pro authoring systems? Is it in the June quarter or is it more in the September and December quarters? Do you have any thoughts on the potential total opportunity for the Pro business as we go through that cycle?

Dave Habiger

We are already starting to feel a slight impact. Obviously the trend is heading in the right direction and I think, as we mentioned in the call, the wide scale adoption of players by the market will be the next catalyst. And we are seeing that already take place.

Specifically we are starting to feel the effects already and obviously those will be amplified as we move into the Christmas holiday season. And certainly in the end of summer and fall when there are going to be clearly a lot of studios wanting to get titles out in time for the holidays.

Paul Norris

I wanted to add as I mentioned in the prepared remarks that we will probably see revenues increases on a gradual basis over time due to the new way that we are recognizing revenue on the Pro systems. In other words we are recognizing that over the term of the annual maintenance contract rather than at the time of the initial license sale.

Mike Olson – Piper Jaffray

One question about this stock option review, can you talk at all about when you expect to get the rest of everything filed?

Paul Norris

We are working very hard on it. We have gotten through the real hurdle here in terms of we have done the stock option restatement itself. Now all we have is to catch up on the three quarterly reports for our fiscal year 2008 and to hold our annual meetings for 2006 and 2007.

And we should be able to work through those pretty much as a matter of course, but it is going to take a number of weeks. Probably we are looking out a month or two before we are really fully caught up.

Mike Olson – Piper Jaffray

What you mentioned about recognizing the Pro revenue over the life of the contract, what is the typical period? Is that like a year-long revenue recognition period? Or what's the typical period for that?

Paul Norris

Yes, it's over the maintenance period and that is typically one year.

Mike Olson – Piper Jaffray

Can you go through the numbers again for what the retail business was up year-over-year? And what the breakdown was between consumers and Pro for the quarter?

Paul Norris

The breakdown between consumer and Pro for the quarter, the total consumer was $34 million and Pro was $1.6 million. I don't think we take year-over-year retail increase numbers.

Clay Leighton

In the prepared remarks that Dave had, I think it was 12% year-over-year for the December quarter, and then 8% on the December over September. And that retail, just to be clear, is a combination of both our e-tail and retail.

Operator

Your next question comes from Paul Coster - JPMorgan.

Paul Coster – JPMorgan

On the Mobility side, has it yet reached the level of materiality? If not, when?

Dave Habiger

It's always hard slicing the adjectives here. I think it is fair to say that the Mobile side is material and becoming material.

Paul Coster – JPMorgan

So it's approaching the 5% of licensing revenue, now, is it?

Dave Habiger

Well, here's where you get into splitting hairs. If you look at our consumer products, inside that bundle is a lot of mobile device support. So we got support for iPod and Rim products and all sorts of third party devices. That product is now starting to ship with people like Dell. It is shipping at retail.

For us it gets a little complicated when you'd ask me to say what percent of the value of that product is based on those features. So that's why I'm dancing a little bit here because that's obviously a very subjective number. I certainly know that we have a significant over whatever we talk about a deal like RIM you should assume it is seven figures or more and that is purely mobile business.

Inside of our current applications, our information tells us that people that are buying those products are buying for a lot of reasons. And one of the primary reasons is they read a good review. They hear it's a good product and they want to use it with their handheld device. And it's just hard for me to extrapolate how much of my retail business and my OEM business is driven by that behavior.

Paul Coster – JPMorgan

But on the RIM side you'll pay, that's probably a good deal less than the amount you are talking about here. But with respect to RIM you will get paid on a per unit basis? Is that correct or is it a fixed amount?

Dave Habiger

It's a hybrid. You can assume that we typically try to protect ourselves on the downside and take advantage of the upside in per unit.

Paul Coster – JPMorgan

Is there anything exclusive about that arrangement with RIM or when you go to new handsets will you be able to replicate the full functionality there?

Dave Habiger

Nothing exclusive and we fully expect to ship with other handset manufacturers.

Paul Coster – JPMorgan

Dave, but can you talk us through your sense of the sequence of events on Qflix that happen in 2008 and then 2009, and even if you care to look that far out, 2010. So we can start to get a sense of when the various revenue drivers kick in.

Dave Habiger

It's obviously been a long process. The sequence of events was marked by two important hurdles. The first hurdle was could we get the studios to even agree to this concept and the legal implications of creating a disk, a legal entity, a DVD disc on your PC or somewhere else besides a plant? That hurdle was bridged about a year ago, a year and a half ago, and the studio has actively helped push and promote this program.

The second hurdle was the CSS amendment which was passed and then it had to be ratified and the whole legal process because this ultimately has to do with legality of disks as opposed to encryption. We talked a lot about that in the past. That happened in October. Nothing can really substantively happen until that is out of the way. We are now at what I think is much less risk.

Frankly, those are the two things that one would look at and have concerns about if you'd looked at this business four years ago. We are now entering a stage where we are signing up third parties to produce the drives, invoke the IP, and ship the products. And that's going to be driven by companies much larger than us. Sonic is not large enough or influential enough to convince the market to embrace this new format.

The people we work through in our OEMs are and they have run rates, ramps and business plans that they will launch and our roadmap hasn't changed much since our last several calls. We would anticipate that you'll start to see some evidence in the trial or something that you could look at in the spring timeframe, spring/summer timeframe to be safe.

We expect that assuming the market embraces this delivery mechanism, which we think they will, you'll start to see more meaningful launches, programs and shipments of drives, media, and services throughout the course of the year going into 2009. By 2010 and in 2009, our anticipation is that every one of our, certainly maybe by the end of 2008, we would be surprised if at least all of our major PC OEMs weren't shipping some type of Qflix device or technology.

In 2009, we would certainly expect broad adoption. And by 2010, I tend not to believe projections more than two years out in technology. So I'll probably punt on 2010.

Paul Coster – JPMorgan

From the kiosk, the bricks and mortar subset of that, when does that start to kick in and become material, do you think?

Dave Habiger

I think we would stick with our prepared remarks. I think material revenue is near the end of 2008. So I don't think you are not going to see us generating anything material in the near-term.

Paul Coster – JPMorgan

And no one else has emerged with competing technology in this narrow context?

Dave Habiger

I would anticipate in a phase like this, that if it is as large as we think it is and we think it's large, there are going to be some people that will try to either align themselves next to us or compete against us. We have not seen anything that poses any imminent threat.

And we believe that even in areas where Qflix as a brand is not used, our IP position is so strong and the people that are backing it and participating are bigger companies than Sonic, that we will still benefit even if a third party finds a way to somehow out-market or outsell us. We will certainly have an IP position that we feel is significant.

I think the real risk here is not some third party. We are now at the stage of whether or not consumers are comfortable using the Web for digital media. And we think consumers are increasingly going to be comfortable using the Web to consume digital media. And a good portion of those consumers will be comfortable putting it onto a disk so they can watch it in their living room.

Operator

Your next question comes from Steven Frankel - Canaccord Adams.

Steven Frankel – Canaccord Adams

Could you start with the customer concentration in the quarter?

Paul Norris

If we're talking about our 10% or larger customers, you've got Dell and I think you can also consider HP, Navarre, Digital River and Ingram maybe just about breaking into that area as well.

Steven Frankel – Canaccord Adams

And Dell and HP were each what percentage of sales?

Paul Norris

Dell was $8.6 million in the quarter and HP we haven't broken out.

Steven Frankel – Canaccord Adams

And it's under 5%?

Paul Norris

No. It's above that, but I don't have the exact percentage in front of me right now.

Steven Frankel – Canaccord Adams

Dave, Qflix always sounds very exciting, but I think the one thing that appears to have changed since when you started down this path, is that consumer-buying patterns have seemed to change more towards the subscription model.

So the Netflix and other type rental models have become very popular in DVD titles just start selling as much as possible. Is that a risk that might impact the demand for Qflix or is there something that the studios might do to encourage purchase rather than rental?

Dave Habiger

I think the DVDs will definitely be encouraging to purchase as opposed to rental. Our model doesn't necessarily exclude it, and I think the trend you are seeing, we would agree with. In fact when Qflix was conceived, we would have anticipated that the trend that you are referring to with others would have been farther along by now. I'm still surprised that it is such a very small amount of the population that is comfortable downloading and consuming content in different ways.

Qflix and our initiatives with Blu-ray are based and can only exist in a market where consumers are looking for content that goes on multiple devices, and in our case, the CD is just another device. Consumers shouldn't see a RIM handheld or an iPod any differently than a disk. It's that we are assuming and encouraging the adoption of digital media consumption through the PC.

And Qflix exploits it more than anything else I see. It's a $1 billion a year business and it may be flat, but it's still hundreds of thousands of times the size from a revenue perspective anything else out there. So we are fortunate that the studios want to protect it and we have an interesting hybrid approach to helping them protect it.

Steven Frankel – Canaccord Adams

So from the get go you would expect that these Qflix programs would allow portability? So I can download and burn to a disk, but I also might be able to play it on a RIM or some other portable device, same file, same cost?

Dave Habiger

Again we will leave it to the third party that is shipping and providing the service to decide what and how they want to provide functionality. But as we have said in the past, the CSS amendment allows for exactly what you've just described. It is the gateway to making a lot of that happen.

I won't try and describe or put the studio's business into a single definition because they are a little bit different. But it's certainly fair to say that the studios have more flexibility when providing content under the CSS amendment for burns and other devices than in most other ways. So, yes we think that that you should anticipate a lot of our customers are going to use the CSS amendment and Qflix to empower plenty of devices, PCs, set-top boxes as well as the ability to burn.

Steven Frankel – Canaccord Adams

Looking at the operating expenses, is the March quarter guidance the run rate we should be thinking about in fiscal '09? Or are we going to be starting at a lower level?

Paul Norris

I think you can use that as a good benchmark.

Steven Frankel – Canaccord Adams

Have you fully begun to move the bodies to China that you were going to move and realize those savings already?

Clay Leighton

I think we already have achieved many of those savings and we are going to be continuing the process of looking at applying people efficiently there.

Steven Frankel – Canaccord Adams

Do you anticipate keeping '09 with the ability to hit a 20% up margin?

Dave Habiger

Yes.

Operator

Your next question comes from Ralph Schackart - William Blair

Ralph Schackart – William Blair

Dave, I was wondering on Qflix if you could walk us through what royalty stream will start to flow through the P&L first? Will it come from the drive manufacturers? Will it come from retail or MOD?

Dave Habiger

The short answer is, I'm not certain. A little bit of that is accounting treatment and, frankly, the other part that I think we are watching and monitoring is who is going to launch first. And that's something that we don't have a lot of control over.

So the things that we will help give us some clarity over time is who actually gets out in a meaningful way and launches first; and then what is the adoption rate and the consumer behavior, relative to that launch? And you can imagine that when you take those two variables and you apply a discount and an average to each, I can make an argument for any one of the three. And until we see it I'm probably not going to give any direction on which I think is first?

Ralph Schackart – William Blair

Specifically, as it relates to the drive manufacturers, your discussions with them right now. At what point do they have to start implementing the Qflix technology for delivery at some date in the future? Meaning have you already had these advanced discussions and do you have pretty good visibility into when they will be launching the drive?

Mark Ely

I think that on the royalty side we got a royalty structure associated with Qflix IT and specifications for driving the e-manufacturers. And then essentially as we signed up these drive manufacturers, we expect to see royalties from those devices and now as you go through the initial phases of Qflix delivery, some of the royalty that will come in at Sonic and we may use some of those to promote the Qflix program.

We will go back and market development funds, but you will begin to see that as soon as those devices begin to show. And at this point we already have a major manufacturer. It was PLDS putting the Qflix drive on the roadmap for both the full [high end] and the half [way] drives. And we expect to find additional drive manufacturers as well. So as those drives hit the market in the later part of this year in volume, then we will begin to see some of those royalties.

Ralph Schackart – William Blair

Fiscal '09 you talked about growth in the high single digits to low double digits, I believe. Was that on a year-over-year basis or was that a sequential growth rate?

Clay Leighton

I'm not sure I understand the differences. Year-over-year would be the general way that I would think about that.

Operator

Your next question comes from Alan Davis - D.A. Davidson

Alan Davis – D.A. Davidson

Could you give us a sense for the incremental upside above your guidance in the quarter? How much of that was driven by Creator 10 versus your other products?

Dave Habiger

As we mentioned in the prepared remarks, that certainly was retail-driven and that's a combination of e-tail and in-store sales. So that was up 8% from September and you'd probably want to think of if you had to point to a single spot, the OEM business was also still fairly strong last quarter.

And part of that was the shift in products used as well, people like Dell shipping more retail obviously helps our business. And it was a reasonably good holiday selling season and at least relative to our forecast. I know I've read plenty of things that say the PC space was struggling, but we didn't feel it.

Alan Davis – D.A. Davidson

And is there any significant cash tax liability related to the restatements and the stock options expense that you just finished?

Clay Leighton

Yes. If you look in our filing there is a payroll tax expense that we are in the process of working through with the IRS and so the total amount in the restatements as it's related to that payroll tax is slightly more than $6 million.

Alan Davis – D.A. Davidson

What are expectations in terms of the 621 patent and those royalties going forward and the timing of those and maybe potential ranges for those?

Dave Habiger

We can give exact ranges, but if you'll keep in mind 621 is tied to both Blu-ray and to the Qflix initiative. So more than likely you won't see us break that out as a line item. It will probably show up in other categories. But as we get closer and it's more clearly defined as a separate entity, we will pull it out and explain what it is. But we haven't broken that out as a separate line item.

Paul Norris

The other thing is I think some of the negotiations over the Blu-ray patent pool rates are still ongoing. But we certainly would expect that as Blu-ray begins to take off, we would start to see some revenues attributable to the 621 on that front.

Operator

Your next question comes from Jeff Osher - Harvest Small Cap Partners.

Jeff Osher – Harvest Small Cap Partners

With regards to OpEx, so you were at $25.5 million in Q2 of cash OpEx. And I think you had said you'll get roughly $6 million. So that lines up with the $24 million on a quarterly basis. Are there other areas with regard to OpEx that you look out into fiscal '09 that can be right sized?

Clay Leighton

I think it's fair to say that we are going to review all our costs and are constantly looking at our budgets and thinking about that and trying to optimize our expenditures. Clearly, the new change in the formats and the elimination of HD DVD will cause us to rethink some of the expenses that we might have been thinking about in that area. So I think it's fair to say that we will be actively looking at and reviewing all of our expenses on a go forward basis.

Jeff Osher – Harvest Small Cap Partners

Mark, if we just try to think intuitively here, if Philips Lite-On is onboard from a competitive standpoint, is there any reason they would be a licensee of Qflix and the other drive manufacturers from a competitive standpoint and would choose not to have Qflix as a standard as well?

Mark Ely

I think that the key way to look at this is really how the major PC manufacturers source their products and of course most of the major PC OEMs, HP, Dell, DeNovo, and others always like to have two to three different drive partners.

And so at this point of course we are talking to every major drive manufacturer. And in fact all of the major ones are in the process of evaluating Qflix and essentially have some of the information from us in how to sign up and get going with it. So as I mentioned PLDS is first to sign up and commit with products on the roadmaps and we are actively working for the others.

And I agree with you, I think we hope it's the less competitive necessity to have Qflix as a key feature on any drive going forward, both standard def burners as well as Blu-ray combination burners.

Jeff Osher – Harvest Small Cap Partners

I think you said there's roughly $100 million burners is the potential PAM and if we assume between your Qflix royalty and then any Roxio apps, I presume the ASP will be in line to north given the fact you have the royalty with Qflix, the standard def cycle. Is that fair assuming at some point in '08, '09 you have the same penetration and market share you had in the last cycle?

Mark Ely

ASP for Creator as the application?

Jeff Osher – Harvest Small Cap Partners

Yes, because you'll get two, right? You'll get Qflix with the actual drive and then any up sell with an application?

Mark Ely

I think certainly the ways that we think about it is there's drive royalties. Now there are media royalties, but of course there are software application royalties we charge. And specifically around Qflix that might be an [ASP] royalty charge or if it's software that is going out with a major PC partner, there would be an application style royalty.

And so in some ways we think about this as independent whatever we are doing with Creator. Of course their technologies are tied together but we look at Qflix as one revenue screen and then Creator as an additional one.

Jeff Osher – Harvest Small Cap Partners

Right, but if we were to look at a per box absolute number that goes to Sonic, given the fact there, that in the last cycle you didn't have the Qflix royalty stream. I would presume on an apples-to-apples basis, when you layer in Qflix and the fact there is potential for you to have a significant market share of drive manufacturers, the ASP this cycle could be significantly higher or at least higher than standard.

Mark Ely

I think sure, yes, if you added up, that would certainly be our hope. If you look at it in terms of all, selling our Sonic licensee IT comes from the assistantship and yes.

Jeff Osher – Harvest Small Cap Partners

Once we do see Qflix revenue start to get recognized and I think you used the word material revenue potentially in the second half of calendar '08 or fiscal '09, is that going to unlock that ATG line so that it creeps higher from the $10-ish million run rate back to historically what was a mid teens run rate with a 100% margin?

Dave Habiger

It certainly will help and we obviously have other things in the works to help move us back in that direction.

Jeff Osher – Harvest Small Cap Partners

But directionally ATG, we should think about this $2 to $2.5 as a baseline that heads higher as we get in the back half of the year. Is that right?

Dave Habiger

Typically that's what we have seen. We've always said ATG is lumpy. And I think it's obvious that or we've also made it clear in these calls that at the moment we are in between formats, which certainly doesn't help ATG. And we are not happy with the current revenue rate inside that division and anticipate the growth.

Operator

That concludes all the questions we have at this time.

Dave Habiger

Thanks, everyone, for calling in and look forward to speaking with you in another quarter.

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