DTS Q1 2008 Earnings Call Transcript

DTS Inc. (DTSI)

Q1 2008 Earnings Call

May 12, 2008 5:00 pm ET

Executives

Ann McGuinness - Investor Relations

Jon E. Kirchner - President, Chief Executive Officer, Director

Melvin L. Flanigan - Chief Financial Officer, Executive Vice President - Finance

Analysts

Ralph Schackart - William Blair

Brian Thackray - Deutsche Bank

Rob Stone - Cowen & Company

Alan Davis - D.A. Davidson & Company

Barbara Coffey - Kaufman Brothers

Michael Olson - Piper Jaffray

Lloyd Walmsley - Thomas Weisel Partners

Presentation

Operator

Good afternoon, ladies and gentlemen, and thank you for standing by. Welcome to the DTS first quarter 2008 conference call. (Operator Instructions) I would now like to turn the conference over to Ann McGuinness of DTS Incorporated. Please go ahead.

Ann McGuinness

Good afternoon, ladies and gentlemen. Thanks for joining us as we report first quarter 2008 financial results for DTS. Joining me on the call today are Jon Kirchner, President and CEO; and Mel Flanigan, CFO of DTS.

Before we begin, let me remind you that during this conference call, management may make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that involves risks, uncertainties, assumptions, and other factors which, if they do not materialize or prove correct, could cause DTS' results to differ materially from historical results or those expressed or implied by such forward-looking statements.

All statements other than statements of historical fact are statements that could be deemed forward-looking statements, including statements containing the words plans, expects, believes, strategy, opportunity, anticipates, and similar words. These statements may include among others plans, strategies, and objectives of management for future operations, any statements regarding proposed new products, services, or developments, any statements regarding future economic conditions or financial or operating performance, statements of belief and any statements of assumptions underlying any of the foregoing.

The potential risks and uncertainties that could cause actual growth and results to differ materially include, but are not limited to, the timing, costs and attention attendant to the divesture of the non-consumer business, the transition to the next generation optical drives and consumer adoption of such technology, the rapidly changing and competitive nature of the digital audio, consumer electronics and entertainment markets, the company’s inclusion in or exclusion from governmental and industry standards, customer acceptance of the company’s technology, products, services and pricing, risks related to ownership and enforcement of intellectual property, the continued release and availability of entertainment content containing DTS audio soundtracks, changes in domestic and international market and political conditions, risks related to integrating acquisitions and other risks and uncertainties more fully described in DTS’ public filings with the Securities and Exchange Commission, available at www.sec.gov.

The information in this conference call related to projections or other forward-looking statements is based on current expectations. The company does not intend to update its forward-looking statements to reflect the events or circumstances arising after the date on which made.

Again this quarter, the company is reporting the results of its consumer business as continuing operations and reporting the activities of its digital cinema and images business as discontinued operations. Income or loss from discontinued operations net of tax will appear as a single item below income from continuing operations on the company’s statement of operations.

All financial results discussed in this call will reflect continuing operations, unless otherwise noted.

Now I will turn the call over to Jon. Please go ahead, Jon.

Jon E. Kirchner

Thanks, Ann and thanks to all of you for joining us today as we report first quarter 2008 financial results. As a reminder, today we will be discussing results from continuing operations unless otherwise noted.

We posted solid revenue again this quarter. Revenue for the first quarter was $15.2 million, up 21% over the first quarter of 2007. Earnings per diluted share were $0.18. Operating income was $4.4 million, or 29% of revenue compared to $2.7 million or 21% of revenue in the same period last year. This year-over-year improvement demonstrates the potential leverage in our business model as revenue scales upward.

Before I provide more details about the first quarter, I would like to touch on the sale of our digital cinema and digital images businesses. As you know, we sold the digital images business in early April and today we announced the sale of our digital cinema business. The D-cinema business was acquired by Beaufort California Inc., a member of Beaufort International Group PLC in England. In this transaction, we received approximately $3.3 million in cash and the buy assumed certain liabilities of the business. Further, we could receive up to $11.7 million in additional consideration over the next few years.

We truly appreciate the dedication of the management teams and employees who have continued to build these businesses throughout the sales processes. We wish both teams a very successful future.

I will now turn back to our consumer business. Due to the holiday promotions of Blu-Ray and HD DVD products, revenue from the high definition formats accounted for 21% of our revenue in the first quarter, ahead of our expected pace for the year. This compares to just 5% of our total revenue in the first quarter of 2007.

Unit volumes from PS3 game consoles and standalone players accounted for the growth in the high definition related revenue in the first quarter. Resolution of the format war, declining player prices and availability of more players and content appear to be spurring increasing interest in the Blu-Ray format.

A few manufacturers have also announced new combo players, such as high definition TVs with integrated Blu-Ray players, and we expect to see more announcements like this in the coming months.

In the PC space, we are seeing more advertisements for Blu-Ray drive upgrades, especially from Dell, HP, and Acer. Some PCs are available with a Blu-Ray drive for under $1,000. With declining prices on Blu-Ray drives, we expect to see more PCs shipping with Blu-Ray capability towards the end of the year, with more significant volumes available in 2009.

There is no question that Blu-Ray is gaining momentum. We remain cautious, however, about the pace of adoption given weakness in the broader economy and several near-term market specific conditions. Due to the unanticipated end of the format war in the quarter, many manufacturers’ production plans were not able to keep up with the demand for Blu-Ray products. In addition, some manufacturers are again working to upgrade their Blu-Ray products to add features or to reduce costs, or both, which has lowered certain production activity in recent months. These factors impact our very near-term outlook.

However, we believe the second half of the year will see very good growth. We will continue to watch closely to see how things further develop in the coming months.

Turning to our standard definition business, in the home AV market, revenue was relatively flat sequentially, on track with our expectations. The car market again had a solid quarter, essentially flat from last quarter and in line with our expectations.

In the PC market, we saw modest revenue growth and made important progress during the quarter working with customers to expand the use of DTS technologies. We announced a strategic agreement with motherboard manufacturer Foxconn to integrate DTS technologies into their upcoming PC motherboards. Foxconn is one of the largest suppliers of motherboards to major brand name consumer PC manufacturers.

Additionally, ArcSoft, a leader in the Blu-Ray soft player segment for PCs, has just received DTS HD master audio certification. DTS HD master audio enables the best possible audio experience for PC users. We expect other PC software companies to complete their DTS HD certifications in the coming months.

In April, we released an update for the DTS HD master audio suite toolset for Blu-Ray disc and DVD production. DTS HD MAS version 1.6 allows content creators greater freedom and flexibility to create picture-in-picture, alternate tracks, director commentaries, and other interactive features for Blu-Ray disc. We are proud to be the leader in enabling audio interactivity for this format.

We are also pleased to announce that DTS surround sensation has been well-received by tier one PC OEMs like Foxconn. We will be able to bring rich, DTS surround audio to the global PC market seamlessly, regardless of whether it is in a two-channel or a multi-channel system environment.

DTS surround sensation is also gaining traction in the home AV market. Onkyo just launched the industry’s first product to incorporate this technology. We expect to see additional products featuring DTS surround sensation from a number of manufacturers over the next 12 months.

Turning to the broadcast market, we continued to support the ongoing deployment of DTS technology in Norway and we completed certification and licensing agreements for a number of new set-top boxes. We continue to execute on our broadcast plans and still anticipate revenue, although immaterial to our results this year, to begin in the latter part of 2008.

In summary, we are excited about our long-term prospects as the high definition transition and other parts of our business continue to build momentum. With that, I’ll turn the call over to Mel for a financial review.

Melvin L. Flanigan

Thanks, Jon. Revenue for the first quarter was solid at $15.2 million, up 21% from the $12.6 million reported in last year’s first quarter. Operating income came in at $4.4 million, or 29% of revenue compared to $2.7 million, or 21% in the same period last year. Net income for the first quarter was $3.3 million, or $0.18 per diluted share, up from $2 million or $0.11 per diluted share we reported in the first quarter of 2007.

We did not see any royalty recovery payments this quarter compared to about $900,000 in last year’s first quarter. Excluding royalty recoveries, year-over-year revenue growth was about 30%.

Following our call in February, several of you requested that we continue to provide stock-based compensation numbers, so we will provide this information each quarter. In the first quarter of 2008, stock-based compensation expense was $1.1 million, or $0.04 per diluted share net of tax, compared to about $700,000, or $0.02 per diluted share net of tax in the first quarter last year.

Revenue from the car market was $2 million, essentially flat sequentially and up 18% year over year. We continue to expect our car business to remain at about 15% of total revenue for 2008. Gross margin in the first quarter was 98%, essentially unchanged from the same period last year.

SG&A expenses for the quarter were $8.8 million and R&D expenses were $1.8 million, in line with our expectations and our guidance of $10 million to $12 million in total per quarter.

First quarter operating income at $4.4 million was 29% of revenue compared to 21% in the first quarter of 2007 and represented a growth rate of nearly 63% year over year. Our tax rate for the quarter was approximately 38%, a little higher than we previously anticipated as a result of revised expectations for the geographic mix of revenue and earnings.

Looking forward, we expect our basic tax rate for 2008 to remain at 38% and to see the rate trend slightly downward over the next few years. One of the main factors that can cause our rate to vary over time is the mix of the countries from which our royalty payments originate. A shift to countries that have relatively high withholding rates can cause our effective rate to exceed our current expectations while a shift to countries with low or no withholding taxes would have a beneficial impact. We’ll keep you posted on our tax rate expectations in future calls.

Turning to the balance sheet, we closed the quarter with overall cash, cash equivalents, short and long-term investments of $86 million, which includes $28 million in long-term investments. On March 31st, we continued to hold about $24 million in auction rate securities. We anticipate that these instruments will be refinanced and called by the issuers within the next 12 to 24 months and as a result, classified these securities to long-term investments during the quarter.

At this time, we have not recognized any realized or unrealized losses on our auction rate securities portfolio as we expect the securities to settle at par.

In summary, we are pleased with our solid performance in the first quarter and the increase in high definition related revenue. For the reasons Jon described earlier, however, we remain cautious about our near-term expectations, especially as we enter the seasonally soft second quarter. We continue to plan for full year revenue of $55 million to $59 million, including approximately $4 million in royalty recoveries. At these revenue levels, we expect operating profit margins to be in the low to mid-20s and EPS in the range of $0.52 to $0.58 per diluted share for the full year on $18.8 million shares outstanding.

With that, I will turn it back over to Jon for his closing remarks.

Jon E. Kirchner

Thanks for the detail, Mel. In summary, we are pleased with our strong start to 2008. We will watch closely as the market for Blu-Ray continues to unfold. We are also working hard to diversify our business in the virtual and broadcast markets and to expand the use of DTS technology across all applications. We will update you on our progress and on the market as our visibility improves. We look forward to meeting with some of you at upcoming conferences and investor meetings.

Before I conclude, I’d like to thank our partners, customers, and employees for their continued support and commitment to DTS. That concludes our prepared remarks. I’ll now turn the call back over the Operator so we can take your questions. Operator, please go ahead.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from Ralph Schackart with William Blair. Go ahead, please.

Ralph Schackart - William Blair

Good afternoon. Nice clean quarter, guys. A couple of questions; first, Jon, sort of big picture, have you seen any material changes, both positive or things that you weren’t expecting since the last call -- has the cycle, is it rolling out any differently than we talked about on the last quarter?

Jon E. Kirchner

No, not really, Ralph. When we last spoke, we expected things to take a little time to develop this year and I think they are.

Ralph Schackart - William Blair

Great, and then in terms of -- if you could pull out your crystal ball, hardware pricing by the holidays I would assume that it would be lower than current price points. Do you have anything factored into your models, sort of big picture, sort of a rate of change on the price declines year-over-year or where we are from today?

Jon E. Kirchner

At this point, Ralph, I think the question of product pricing is best left to the manufacturers, but I will say that we’ve done a lot of work on various industry forecasts and I think the expected price of certainly players and associated products will certainly decline over the course of the year as you get into Christmas but just how much, not in a position to say.

Ralph Schackart - William Blair

Great and one last one, if I could; in terms of the buy-back activity, were you active at all during the quarter?

Jon E. Kirchner

We were blacked out essentially pretty much the entire quarter, so no.

Ralph Schackart - William Blair

Great. Thanks, guys.

Operator

Thank you. Our next question comes from Brian Thackray with Deutsche Bank. Go ahead, please.

Brian Thackray - Deutsche Bank

Good quarter. First question, the 21% of revenue compared to was it 7% last quarter, can you give a sense for a little bit more granularity, how much of that was coming from gaming and how much of that came from Blu-Ray and how much came from HD DVD?

Melvin L. Flanigan

I think about -- I want to say about half of it was related to the gaming business and the other half was split between -- it’s probably more like 60-40 between Blu-Ray and HD DVD. HD DVD made up in the neighborhood of $0.5 million or so in Q1.

Brian Thackray - Deutsche Bank

Okay, and any sense -- I understand the changes on the standalone player side, but do you expect any change on the gaming side in terms of manufacturing and production schedules?

Melvin L. Flanigan

Nothing I think we can talk publicly about but I think one of the things we are concerned about, or simply that we’ve heard, is that obviously people are preparing for a big push in the back-half of the year and they are trying to get their product sets just right in terms of feature sets and bill of materials, so probably best to continue to ask some of the manufacturers about that.

Brian Thackray - Deutsche Bank

Okay, and if I look at the HDMA announcements you guys had this past quarter, could you talk a little bit about the significant of that and also how that changes the economics at all around that agreement?

Jon E. Kirchner

Sure. I think in general, it really doesn’t change the economics at all but it is a -- it’s a significant event in that there are a large number of people that use their PS3s to enjoy filmed entertainment and we have had requests, both from studios as well as consumers, to work with Sony naturally to make lossless 7.1 capable DTS master audio available on the PS3 format and essentially we just completed that effort and announced it here just a bit ago. So in essence, it just opens up a chance for consumers to leverage that device even further for high quality entertainment.

Brian Thackray - Deutsche Bank

Okay, and last question following up on Ralph’s on the share repurchase program, can you talk about just philosophy, how aggressive you expect to be now that you are out of the blackout period, or soon to be out of the blackout period?

Jon E. Kirchner

It’s a constant discussion with the board of directors and I think it’s best left to that. You know, philosophically naturally we’re looking to deploy our assets in ways that will enhance shareholder value, whether it be through organic investment in development, share repurchases, or M&A type transactions but it is something we look at on a quarter to quarter basis and based on what happens in the marketplace and our upcoming discussion at the board level, we’ll determine how we want to approach it. But nothing I’d like to comment on specifically.

Brian Thackray - Deutsche Bank

Okay. Guys, thanks for the insight.

Operator

Thank you. Our next question comes from Rob Stone with S.G. Cowen. Go ahead, please.

Rob Stone - Cowen & Company

Actually, it’s just Cowen & Company. What conditions would be connected to the potential pay-out of more money on the [inaudible]?

Jon E. Kirchner

Rob, there are a couple of factors built into that agreement. There are some financing related milestones and there are some performance based milestones that if achieved may result in further consideration in that deal but at this point, we’ve taken the conservative position obviously, basing how we booked the transaction on the cash up front and the transaction of $3.3 million.

Rob Stone - Cowen & Company

Okay. In terms of the catch-up, you I guess had no catch-up revenue in this quarter. Can you say whether activity in terms of pursuing those things is different now as a result of the transition in the market? I know you basically had $4 million a year as your expected total for each of the last several years but it’s dropped to zero this time, so can you give us a sense of what you [may encounter] for the level of activity?

Melvin L. Flanigan

Sure, Rob. I think we are still pretty confident that we can get to $4 million or better this year. It’s not unusual that we’ll have a quarter with little or no royalty recovery activity. We’ve talked in the past about the fact that it can be somewhat lumpy. I think in terms of whether the end of the format wars has changed the dynamic, I don’t think so. I think we’ve been working several different issues, or a number of different issues, for some period of time now and we’ll just continue to work them as we go forward and hope to get the closed as quickly as possible.

Rob Stone - Cowen & Company

You are working out some situations at this point?

Melvin L. Flanigan

Oh, yeah, we’ve had several of them that are in process as we speak.

Rob Stone - Cowen & Company

Can you comment at all, either of you, Jon or Mel, on pricing, whether you’ve seen a change in how licensees are looking at unit pricing now that the war is over and the focus is on volume up and price down for the end products?

Jon E. Kirchner

Rob, are you talking about product pricing at retail or pricing with respect to our technology?

Rob Stone - Cowen & Company

Royalty per unit, so the price to DTS.

Jon E. Kirchner

We have not seen any changes in our pricing. We essentially signed volume-based contracts that essentially accounted for all the expectations and what will happen with the format, so as things evolve in the market, we don’t expect any major impact.

Rob Stone - Cowen & Company

So you’ve essentially had a schedule going in of -- you get to the next tier of higher volume, you get to the next tier of [lower price set, ordering costs]?

Jon E. Kirchner

Correct.

Rob Stone - Cowen & Company

Okay, and then just a housekeeping question -- how many shares remain authorized under the current buy-back program?

Melvin L. Flanigan

10 million shares.

Rob Stone - Cowen & Company

Okay. Thank you.

Operator

Thank you. Our next question comes from Alan Davis with D.A. Davidson. Go ahead, please.

Alan Davis - D.A. Davidson & Company

Just a couple of questions here; I guess first off, not that you gave quarterly guidance but given the quarter and again your comments, it sounds like this year could end up being more of a bracketed year I guess with the big first and fourth quarter than maybe you thought coming into the year. Is that fair?

Jon E. Kirchner

I think so. I think Q3 -- you know, our typical pattern is that Q2 will be very much the low point in a year and then it sort of builds in Q3 and Q4 would be stronger still. So we certainly expect to see that pattern this year.

Alan Davis - D.A. Davidson & Company

Okay, and any change in your expectations for standard definition DVD royalties this year?

Jon E. Kirchner

No, I think the market is sort of shaping up pretty much as we expected, relatively flat on the standard def side. You know, the one caveat I guess to that is that as we look at some of our PC applications and some of the new stuff we’re doing, we might see some upside in standard def DVD but not in the -- certainly not in the home AV space.

Alan Davis - D.A. Davidson & Company

Okay. As a chance that surround sensation becomes significant, is that kind of ’09, 2010? What are your expectations there?

Jon E. Kirchner

It certainly will be in ’09 and later.

Alan Davis - D.A. Davidson & Company

Okay. And I also had a question now with the sale of the digital cinema business. Any significant ties there in terms of the co-brand using the DTS brand and any other legal ties between the two companies?

Jon E. Kirchner

Yes, Beaufort will have the rights to use the DTS brand in connection with certain products for a period of up to five years, but they are essentially arms length contracts and how certain specific provisions and rights associated with them.

Alan Davis - D.A. Davidson & Company

Okay but you obviously won’t be working together at all, it’s arms length?

Jon E. Kirchner

Correct.

Alan Davis - D.A. Davidson & Company

Okay. All right and I just want a bookkeeping question -- total depreciation and amortization for the quarter?

Melvin L. Flanigan

It would add up to -- let me think about this here for a second.

Alan Davis - D.A. Davidson & Company

While you’re thinking, I’ll ask another one -- now that you’ve sold the two pieces of the pro business, possibility of seeing a restructuring, maybe a lower cost base -- what’s the outlook there?

Melvin L. Flanigan

Well, a couple of things; first of all, in terms of total amortization and depreciation, it’s around -- between $500,000 and $700,000 per quarter. In terms of the cost structure, don’t expect any major changes because as under discontinued ops accounting, you basically only put costs into disc ops that are going to be eliminated once the sales occur. So kind of by definition then, once we separate we should see the continuing ops continue forward pretty much as is.

Alan Davis - D.A. Davidson & Company

Okay. Thanks, gentlemen.

Operator

Thank you. Our next question comes from Barbara Coffey with Kaufman. Go ahead, please.

Barbara Coffey - Kaufman Brothers

Good afternoon. When I take a look at sort of Blu-Ray adoption, I probably have okay insight into the U.S. but can you speak a bit about how it’s being adopted internationally?

Jon E. Kirchner

I think there’s -- it varies by territory. Obviously there’s been a fair amount visibility forward in places like Japan, much less so in places like China. Europe was a bit behind us in the whole HD optical media battle and I would expect Europe to remain slightly behind us as they come up to speed as more content is developed in the BD format. So there is no question that we are leading the way in North America but I think a lot will happen over the next 12 or so months, 12 to 18 months as much greater amounts of content and much wider availability of players at lower price points become available in all the markets.

Barbara Coffey - Kaufman Brothers

Similarly, are you seeing international studios also have the push to have more Blu-Ray content?

Jon E. Kirchner

Absolutely. We are doing quite a bit of work overseas at the moment.

Barbara Coffey - Kaufman Brothers

Thank you.

Operator

Thank you. Our next question comes from Michael Olson with Piper Jaffray. Go ahead, please.

Michael Olson - Piper Jaffray

Thanks. Good afternoon. Mel, I just had a quick question about SG&A. It’s gone from kind of consistently being in the 60% plus as a percent of revenue range to now being in the high 50s the last couple of quarters. What do you think we should expect going forward? Is SG&A going to be up year over year in ’08 on an absolute basis or is it going to be flat or just any high level thoughts on that?

Melvin L. Flanigan

I think, as you are probably aware, I think last year we made a fairly public and conscious effort to begin adjusting the cost structure and so that’s part of what you are seeing, is that the SG&A as a percentage of revenues is going to decline. I think it’s going to decline further as revenues continue to accelerate as well, so yeah, I think we’ve talked in terms of total OpEx in the range of $10 million to $12 million this year and I think that’s certainly what we expect to see.

Michael Olson - Piper Jaffray

And then as far as just looking at what some of your competitors are up to doing some work on this volume consistency technology, are you guys doing anything on that front?

Jon E. Kirchner

Nothing we’re prepared to talk about at this point but Mike, as you can well appreciate, we’ve got all kinds of things happening in the lab and we are excited about our pipeline, so more news to follow.

Michael Olson - Piper Jaffray

Okay, and then just along those same lines, virtual surround, anything to talk about on that front?

Jon E. Kirchner

Well, I think as we touched on, Onkyo released their first product. We expect a number of more product announcements this year. We’re seeing some traction in the PC space and so I think we are -- our expectations have been exceeded, if you will, with the speed at which manufacturers are indicating they have a desire to incorporate the technology. That being said, we don’t expect it to be material this year but we look for good things next year and in 2010.

Michael Olson - Piper Jaffray

Okay. That’s it for me. Thanks.

Operator

(Operator Instructions) Our next question comes from Lloyd Walmsley with Thomas Weisel Partners. Go ahead, please.

Lloyd Walmsley - Thomas Weisel Partners

Great. I was wondering if you could remind us at the peak of the cycle in terms of your penetration of PCs in the -- I’m sorry, of DVD players in the standard def cycle, how penetrated were you all in players on a trademark basis? And then as you look at the Blu-Ray opportunity, to what extent do you think the majority of the opportunity lies in new channels like the game consoles and the PCs versus the opportunity for the standalone DVD players, given your mandatory standard?

Jon E. Kirchner

I think the opportunity is huge in all of the categories, essentially because obviously we didn’t participate in gaming revenue at all in the previous round of consoles. Our PC business today in standard def is very small and really consists of after-market soft DVD player upgrades as well as some working sound cards, but on a percentage basis, it’s tiny, well less than 10% of our revenues.

And with respect to players around your peak question, it’s a very difficult question to answer and so I’m not even going to guess, and the reason I say that is because in the trademark licensing business, there is always a fair amount of slippage in places like China where you are not exactly sure how much stuff actually has your name on it. You don’t have the ability to trace it or track it like you would with silicon where you are only selling chips to authorized parties and you have an audit trail. But I think it’s fair to say that at one point, clearly more than 50% of the unit volume had our logos on it and well north of 50, between 50 and 100 -- it’s hard to handicap today, significantly less than that does and I think there’s significant economic upside for us with respect to player related licensing as we’ll improve our per unit ASP and we will be including on 100% of the volume from the start, which is a big difference from where we were in the last go-round 10 years ago.

Lloyd Walmsley - Thomas Weisel Partners

Great. Thank you.

Operator

Ladies and gentlemen, this concludes the DTS first quarter 2008 conference call. If you’d like to listen to a replay of today’s conference, please dial 800-405-2236 or 303-590-3000 with the pass code 11113554, and the pound key. ACT would like to thank you for your participation and you may now disconnect.

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