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Entropic Communications Inc. (NASDAQ:ENTR)

Q1 2008 Earnings Call

April 28, 2008 5:00 pm ET

Executives

Debra Hart - Director of IR

Patrick Henry - Chairman and CEO

David Lyle - CFO

Analysts

Daniel Amir - Lazard Capital Markets

Sandy Harrison - Signal Hill Investments

John Pitzer - Credit Suisse

Gary Mobley - Piper Jaffray

Tim Luke - Lehman Brothers

Krishna Shankar - JMP Securities

Jay Srivatsa - Roth Capital Partners

Tore Svanberg - Thomas Weisel Partners

Operator

Ladies and gentlemen, good afternoon. At this time, I'd like to welcome everyone to the Entropic Communications conference call. During the presentation, all participants will be in a listen-only mode. A question-and-answer session will follow the company's formal remark. (Operator Instructions). As a reminder, today's conference is being recorded.

Now I'd like to turn the conference over to Debra Hart, Director of Investor Relations for Entropic Communications. Please go ahead, ma'am.

Debra Hart

Good afternoon, everyone, and welcome to Entropic Communications first quarter 2008 conference call. Leading the call today are Patrick Henry, Chairman and CEO and David Lyle, our Chief Financial Officer.

Before we begin, I would like to remind you that various remarks that we make on this call, including those about our future financial results, including revenue, gross margin, operating expense, design wins, product plans, our competitive situation, partnerships, goals and prospects, market trends, integration of acquired companies and our anticipated growth and profitability, all constitute forward-looking statements for the purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act.

These forward-looking statements and all other statements that may be made on this call that are not historical facts are subject to a number of risks and uncertainties that may cause actual results to differ materially.

We refer you to our Form 10-K for the fiscal year ended December 31, 2007 and in particular to the section entitled "Risk Factors" and to other reports that we may file from time to time with the SEC for additional information on factors that could cause actual results to differ materially from our current expectations. These forward-looking statements speak only as of the date hereof and we undertake no obligation to update these forward-looking statements.

In addition, Entropic reports gross margin and net income and basic and diluted net income per share in accordance with GAAP and additionally on a non-GAAP basis. Management believes the non-GAAP information is useful because it can enhance the understanding of the company's ongoing economic performance and Entropic therefore uses non-GAAP reporting internally to evaluate and manage the company's operations.

Entropic has chosen to provide this information to investors to enable them to perform comparisons of operating results in a manner similar to how the company analyzes its own operating results. The full reconciliation of the GAAP to non-GAAP financial data can be found in our earnings release issued earlier today and we ask that you review it in conjunction with this call. We have posted a GAAP to non-GAAP reconciliation on our website for your convenience.

Now I'll turn the call over to Patrick Henry. Patrick?

Patrick Henry

Thank you, Debbie, and thanks to everyone for joining the call today. We are very happy to report record revenue of $42 million and non-GAAP net income of $3.2 million, or $0.04 per diluted share. We are pleased with our progress to date across all our product lines.

Dave will take you through the numbers in greater detail and discuss guidance for the second quarter later on the call, but first I'd like to recap the quarter's highlights.

In Q1, Entropic not only achieved strong financial results, but we also made significant progress towards our planned growth. The following are some of the key events, which occurred since our last quarterly conference call.

DIRECTV and Time Warner Cable both recently joined the Multimedia over Coax Alliance, or MoCA, as contributing members, further validating MoCA as the de facto standard for connected home entertainment. We shipped our MoCA 1.1 compliance solutions to major customers. We began to ramp our channel stacking switch solutions at DIRECTV.

We expanded both our partnerships and the penetration of our c.LINK Access broadband solutions in China. We announced design wins for our DVB-C silicon TV tuners into tuner modules and set-top boxes. We consolidated our San Diego facilities and opened our new corporate headquarters.

And in April, we completed the acquisition of Vativ Technologies, expanding our product and IP portfolio and adding key complementary technical talent to our team and our focused market of connected home entertainment.

Specifically, Vativ brings complementary product lines including HDMI 1.3 receiver chips, advanced digital signal processing technology building blocks to augment Entropic's existing capabilities, and an innovative engineering team with deep core competencies in video communications, systems and chips.

I'll discuss these highlights in more depth as I review our product line quarterly accomplishments. Entropic has four product lines addressing the connected home entertainment market, home networking solutions, direct broadcast satellite outdoor unit solutions, high speed broadband access solutions, and the newly named TV tuner and interconnect solutions product line.

I'll start with our home networking product line. Our flagship MoCA home networking product line continued to thrive during Q1. Entropic remains the only high volume supplier of MoCA compliant silicon products and we continue to work with service providers and our direct OEM customers to deliver solutions which will meet their current and future needs.

During the quarter, we saw tremendous momentum in the support of the MoCA standard. The Multimedia over Coax Alliance currently has 57 members. Recently, DIRECTV and Time Warner Cable both joined MoCA as contributing members.

This is a significant development as contributing members actively participate in the advancement and definition of the MoCA technical specification and certification process and they help to drive MoCA's marketing activities.

MoCA now has six tier one U.S. service providers who are either MoCA promoter board members or MoCA contributor members, including Comcast, Cox Communications, DIRECTV, EchoStar Communications, Time Warner Cable and Verizon. In addition, AT&T is a MoCA associate member.

As of the end of 2007, on a combined basis, the six tier one U.S. service providers that are either promoter or contributor members had over 74 million pay TV subscribers, nearly 33 million broadband subs and nearly 35 million residential wireline phone subs, representing a huge potential opportunity for future MoCA deployments. In fact, the 74 million pay TV subscribers represented by this group account for about 75% of the total pay TV homes in the U.S. and about 67% of all TV homes in the U.S.

In addition, the vast majority of DVR homes and HDTV homes in the U.S. are also pay TV homes. This is significant to Entropic because multi-room DVR, including HD video, is the killer app for deployment of MoCA technology.

Multi-room DVR is the ability to access all the stored movie and TV programming stored on the DVR in one room in the house at other TVs and other rooms in the house with full time shifting capability. We continue to expect two additional tier one U.S. service provider deployments of MoCA-enabled products by the end of this year.

In addition to DIRECTV and Time Warner Cable, Aris, a global leader in communications technology joined MoCA as a contributing member in Q1. And TATA Alexi, the technology arm of the TATA Group, India's largest business conglomerate became an associate member, further expanding MoCA's global reach. We view all these memberships as a very positive indicator and further validation of MoCA becoming the de facto standard for home networking of digital entertainment.

Last fall the Multimedia over Coax Alliance ratified the MoCA 1.1 specification offering higher throughput performance, expanded coax outlet coverage support, enhanced quality of service, or QOS, and remote diagnostic features.

Today Entropic is shipping our EN2210 MoCA 1.1 enabled silicon in volume to our customers to help them future proof their products. These upgraded features easily and cost effectively distribute multiple streams of HD video throughout the connected home of today and tomorrow.

In particular, the enhanced QOS features in MoCA 1.1 allow for easy addition of retail MoCA devices to a pay TV service provider installed MoCA home network while ensuring the QOS of pay TV services, including things like video-on-demand services.

Earlier this quarter, Motorola, our largest direct customer of our MoCA home networking products, announced their DCX family of set-top boxes, including DVRs. The DCX product suite integrates our MoCA 1.1 compliant EN2210 across the DCX platform, ensuring future access to MoCA functionality for their U.S. cable customers.

Currently, Verizon's FiOS Triple Play service offering is our largest service provider based deployment. FiOS continues to gain popularity and is attracting new subscribers. Earlier today, Verizon announced that they added 263,000 net new FiOS TV customers and 262,000 net new FiOS Internet customers in the first quarter of 2008.

As of March 31, 2008, there are over 1.8 million total FiOS subscribers and over 1.2 million FiOS TV subs. In the FiOS deployment, Entropic provides three MoCA chips for every FiOS Internet installation and on average an additional three MoCA chips for every FiOS TV customer.

Next, we'll discuss our DBS outdoor unit product family. This product line consists of our first generation band translation switch, or BTS, and our second generation channel stacking switch, or CSS. This product line continued to gain design momentum in Q1.

Our DBS outdoor unit solutions are currently deployed through EchoStar by Dish Network and by DIRECTV. These two DBS service providers combined serve a total of 31 million pay TV subscribers in the U.S.

Our BTS solutions were initially used to support Dish Network's mass deployment of their award winning DVR set-top box products and they have now become the standard DBS outdoor unit install for Dish Network. Through Q1, we have shipped nearly 15 million BTS chips since initial deployment of this product in 2004, and the business continues to be a solid contributor to Entropic's revenue.

Earlier this quarter, we announced that DIRECTV is deploying our CSS chips in their MFH2 product line for multi-dwelling units. We are at an early stage of ramping volume to Sprint's application and expect to increase our penetration of DIRECTV over 2008 and 2009.

Dish Network and DIRECTV reported a combined 1.8 million gross ads in the fourth quarter of 2007 and a total of 7.3 million gross ads in the full year for 2007. Our DBS outdoor unit solutions can be deployed for new subscribers and in satellite TV upgrade situations.

For example, when satellite TV customers upgrade from standard def to high def service or upgrade to a DVR service, there is potential for new DBS outdoor unit equipment that may use Entropic technology. The strong trend in consumer option of HDTV and DVRs make this an attractive opportunity for us.

Entropic's DBS outdoor unit solutions simplify satellite TV service installation and offer the potential to reduce install time and install costs, thus reducing subscriber acquisition cost for the DBS service provider. The use of Entropic's DBS outdoor unit solutions can also improve the cable wiring aesthetics for the consumer.

Moving to our high speed broadband access product line, we continue to make progress on the international front. Our c.LINK Access solutions are sold in the geographies where fiber optic cabling is terminated within one kilometer of the customer's premises and coax cable can be used as the last kilometer broadband access delivery medium.

We see initial opportunities in Asia, with intermediate term opportunities in Europe and longer-term opportunities for expanding into North America. During Q1, we announced strategic partnerships and design wins with both Browan Communications and Actioncable, further expanding our c.LINK Access opportunity into the large and growing mainline China market.

As of the end of 2007, China had nearly 140 million cable TV subscribers but less than two million cable modem subs. In total, only about 15% of the households in China have any form of broadband access and most have slower speed ADSL.

Entropic's c.LINK Access solutions provide a cost effective means for delivering high speed broadband access and advanced video, voice and data services to the customer premise. We continue to focus on building strategic relationships in China as well as supporting the rollout of c.LINK Access in Korea and greater Asia.

Our final product line, previously called silicon TV tuners, has been renamed TV tuners and interconnect solutions, which reflects our recent acquisition of Vativ Technologies. Vativ was an innovator and provider of advanced DSP-based technologies for digital TV and data communications.

We acquired Vativ in early April as an asset purchase for $5.9 million in cash and the assumption of $1 million in liabilities. The Vativ acquisition brings Entropic a highly experienced and innovative team of 17 employees, including 15 engineers, with core competencies in physical layer, digital signal processing, communications systems and mixed signal. The Vativ team is filling some key positions and our hiring plan and Vativ's products, core technology and patents are enhancing our intellectual property portfolio.

Vativ's DSP based adaptive equalization capabilities provides us with a new key building block technology that is applicable to a variety of future applications. And finally, Vativ's HDMI 1.3 receiver product is complementary to our tuner product line.

Entropic's HDMI receivers use Vativ's patent pending vivid reach adaptive equalization technology which allows our products to far exceed HDMI specification requirements.

This performance enables the TV set manufacturer to position HDMI input anywhere in the TV set without the need for external equalizers, repeaters or switches and without the use of more expensive cabling.

According to the research from n-Stat, the HDMI device market is expected to grow from an estimated 144 million units shipped in 2007 to 485 million units in 2011, a 36% compound annual growth rate, which makes HDMI an attractive market for us.

This acquisition reflects our corporate strategy to address adjacent market opportunities within the large and rapidly growing market for HD video and connected home entertainment.

Our customer interactions following the close of the Vativ deal have been very positive and we are encouraged about the prospects with the Vativ product line. However, we do not expect significant revenue contribution from this product line in 2008.

In Q1, we announced design wins in our silicon TV tuner product line with Earda Electronics and with Jiuzhou Electronics in the China market with our DVB-C cable tuner. As China's broadcasters rapidly upgrade their infrastructure from analog to digital, there is a need for high performance digital TV tuners that can deliver digital programming to subscribers. Entropic's RF4800 offers high performance and integration, which is helping customers meet demand and shorten product development cycles.

The conversion from analog to digital TV tuners is accelerating and according to IMS Research, n-Stat and Informatics, the total available market for digital tuners was approximately 173 million units in 2007, growing to 374 million units by 2011, representing a compound annual growth rate of 21%.

In addition, in 2007 less than 20% of the digital tuner market was serviced by silicon IC tuners and the silicon IC tuner market is expected to grow even faster than the overall digital TV tuner market over the next several years. Entropic is still at an early stage in this market and we expect our tuner products to reach significant volume production levels in 2009.

So in summary, Q1 was an exciting and productive quarter for Entropic. We made significant progress across all our product lines and we delivered strong financial results.

I'd like to turn the call over to David Lyle, our Chief Financial Officer, who'll provide the details of our first quarter performance and our second quarter guidance. Then I'll provide some closing remarks and we'll open the call for your questions. Dave?

David Lyle

Great. Thanks, Patrick. As Patrick just described, Q1 was a very good quarter for Entropic. First quarter revenue of $42 million was up $1.8 million or 4.5% sequentially from $40.2 million in Q4.

Top-line revenue growth was driven primarily by upside from our MoCA deployment with Verizon as well as rising penetration rates of our channel stacking switch product in DIRECTV satellite dish installations.

Non-GAAP gross margin for the quarter was 48.7%. We enjoyed revenue upside in our home networking business and typical seasonal softness from our DBS outdoor unit product line. Non-GAAP gross margin excludes $1.2 million of amortization of purchased intangibles associated with prior acquisitions.

Non-GAAP operating expense of $17.4 million was up by approximately $300,000, or less than 2% from $17.1 million in Q4. Q1 total headcount of 281 employees worldwide remained unchanged from the fourth quarter.

Our Q1 non-GAAP results exclude $3.6 million in stock-based compensation expense and approximately $600,000 in amortization of purchased intangibles from prior acquisitions as well as $1.1 million of restructuring charges in connection with the relocation of our corporate headquarters into a larger building.

With respect to income taxes, due to our net operating loss carry-forwards that we expect to use this year, our effective tax rate was 4.6% of non-GAAP income, or approximately $200,000 of expense, primarily an accrual for AMT purposes.

Non-GAAP net income was $3.2 million in Q1, flat with Q4 non-GAAP net income. Non-GAAP net income excludes approximately $500,000 of debt issuance costs, written off in connection with the early payoff of debt. Non-GAAP earnings per share was $0.04 per share based on diluted weighted average common share count of approximately 73.6 million shares.

Moving to our balance sheet, we ended the quarter with $35 million in cash and marketable securities and no bank debt. Our cash and marketable securities balance was down from $54.5 million in December. There are a few reasons for the decrease in cash.

We paid down approximately $9 million in debt obligations in January. We also had approximately $2 million in capital expenditures attributable to the move of our headquarters in the quarter.

In addition, our cash balance was impacted by significant billings that occurred in the latter half of the quarter, which resulted in a large increase in accounts receivable at quarter end.

Higher accounts receivable resulted in an increase in DSOs from 56 days in Q4 to 81 days in Q1. The higher DSOs was a result of in-quarter sales timing, not an aging issue. Our inventory turns improved from 5.1 times in Q4 to 6.1 times in Q1 on a non-GAAP basis.

Now I'd like to provide our guidance for the second quarter of 2008.

In Q2, we expect top-line revenue to be in the range of $43 million to $44 million. This revenue growth will be driven by our home networking, DBS outdoor units and broadband access product lines.

We believe non-GAAP gross margin in Q2 will be 48.5% to 49.5% and like Q1, will depend on product mix. We believe non-GAAP operating expense will grow in Q2 by approximately 16% to 17% sequentially.

In Q1, we were running behind our net hiring plan, which kept operating expense relatively flat over Q4. In Q2, we will catch up to our hiring targets as we've been able to successfully sign on new talent in April, including the addition of 17 employees from our acquisition of Vativ Technologies.

Also please note that we will exclude from our non-GAAP operating expense approximately $800,000 of amortization of purchased intangibles from prior acquisitions.

Moving to income tax expense, we anticipate using net operating loss carry-forwards this year to offset income tax expense. However, we expect to record approximately $200,000 of income tax expense primarily related to AMT in Q2. We expect to approach our long-term target effective tax rate of approximately 20% after Q2 when we formally begin to realize our new international structure.

We estimate that our non-GAAP diluted weighted average share count will be approximately 74 million shares in Q2. Our ending cash balance for Q2 will be approximately $30 million after the cash payment associated with the Vativ acquisition.

Excluding cash paid for that acquisition, we expect to be a positive net generator of cash in Q2. We expect DSOs to improve to the mid-60s in Q2 and inventory turns to remain solid.

And finally, we have some preliminary estimates regarding our purchased accounting for the Vativ acquisition. We expect to record a one-time charge for purchased in-process R&D of approximately $700,000 and approximately $300,000 of amortization of purchased intangibles and cost of goods sold.

We will exclude these charges from our non-GAAP results for Q2. Excluding these charges, we expect the Vativ acquisition will be neutral to earnings in the near-term and accretive within two quarters.

So now I'll turn it back to Patrick to finish up.

Patrick Henry

Thank you, Dave. To summarize, we had a great quarter. We continued to expand revenue and we delivered our third consecutive quarter of non-GAAP net income. We also increased momentum in all of our served markets.

Our technology and competitive leadership is evident in our results. We are very encouraged by the rapid growth of our target markets and the growing acceptance of our technology solutions.

We believe MoCA is becoming the de facto standard for home networking of digital entertainment and there are strong signs in the market supporting this view, such as the additional members and the MoCA consortium, including DIRECTV and Time Warner Cable joining MoCA as contributor members. Our DBS outdoor unit products continue to gain traction and we are laying the groundwork for further diversification with our high speed broadband access and TV tuners and interconnect products.

Finally, I think it's important to note that Entropic's common stock lockup will expire on June 4th, so we anticipate our share liquidity will improve in the coming months.

With that said, David and I will now be happy to answer any questions that you may have.

Question-and-Answer Session

Operator

Thank you.

(Operator Instructions) We'll take our first question today from Daniel Amir, Lazard Capital Markets.

Daniel Amir - Lazard Capital Markets

Hi. Good afternoon and congratulations on the good results.

David Lyle

Thanks, Daniel.

Daniel Amir - Lazard Capital Markets

A couple of questions here. First of all, I guess can you expand a bit more on, I guess the cable trend towards MoCA here? Looks like Time Warner has joined. You talked about in the past that a couple of more service providers should ramp up. Can you expand a bit where they stand? What should we expect here? And is there an expectation basically that all the cable guys will be rolling out MoCA-enabled products here in the near-term?

Patrick Henry

Yes, Daniel, it's Patrick. Thanks a lot for the nice comments. With respect to future deployments of MoCA with the major tier one U.S. service providers, we really can't comment further than what we talked about in the prepared remarks on the call.

Up to this point, Verizon is the only tier one service provider that has announced that they've launched MoCA based products. But we do see great momentum with the MoCA standard with additional major service providers, including DIRECTV and Time Warner Cable joining the alliance.

Daniel Amir - Lazard Capital Markets

Okay. And on the tuner business, I guess, can you a bit expand kind of what the opportunity is here now that I guess you have the Vativ acquisition? It looks like it's not contributing the revenues here this year, but what markets are we going after in terms of what's the opportunity here and kind of in the future here in terms of diversification of your revenue base?

Patrick Henry

Yes, so in the tuner market, our primary success to-date has really been in the China and kind of greater Asia market, including some of the [silicon] tuner manufacturers that are looking to move from discreet tuner modules to integrated silicon tuner modules, so we have design activities underway there with DVB-T as well as with DVB-C.

On the HTMI product lines, Vativ did have some design commits from some major Japanese and Korean consumer electronics companies and part of the job in Entropic is to convert those design commits to design wins and then eventually to production. So that's a focus of our sales team.

I think one of the challenges that Vativ had, which is a smaller company, it wasn't perceived as necessarily a stable platform that some of the major consumer electronics companies would like to see. Entropic immediately resolved that problem and we really see the Vativ products as something we're bolting additional products under our existing channels.

So up to this point, we haven't really said that there'd be any significant revenue contribution from either tuners or HDMI in 2008. For our tuner products, we do see the design wins that we're winning today will start to more materially contribute to revenues in 2009 and we're a little bit early on HDMI, but the early indicators are that we have some good prospects there for 2009 as well.

Daniel Amir - Lazard Capital Markets

Okay, thanks. And the last question is any update on the competitive front this quarter? Anything changed in terms of players or visibility?

Patrick Henry

Yes, we haven't really heard much new from either customers or any kind of press releases coming out of our competitors, so we still expect at some point to see Broadcom and probably Conexant in the market. But we're encouraged by the progress we continue to make on new design wins with our key customers.

Daniel Amir - Lazard Capital Markets

Okay, thanks a lot.

Patrick Henry

Sure. Thanks, Daniel.

Operator

Next, we'll hear from Sandy Harrison, Signal Hill Investments.

Sandy Harrison - Signal Hill Investments

Thanks. Good afternoon, guys.

Patrick Henry

Hi, Sandy.

Sandy Harrison - Signal Hill Investments

Hey, just to finish off or start on the question you just finished off. I mean how much competitive advantage do you think the fact that you're now shipping your MoCA 1.1 chip versus some of the others haven't shipped the MoCA 1.0? What sort of advantage does that give, you think, on a window?

Patrick Henry

Well, I think it's created a moving target. I think that the customers, since they're primarily service providers, really want to have a solution that can coexist with retail aftermarket products while ensuring quality of service of video services like video-on-demand. So I think with Verizon, they definitely have a desire to have those capabilities. I think that's something they've stated publicly as well as the other major operators that we're working with that haven't been announced, they do like those features.

So I think it makes it a requirement that any new silicon provider out of the gate really provide MoCA 1.1 capabilities as being a key element of any product offering that they have.

Sandy Harrison - Signal Hill Investments

Got you. And if you look at sort of your experience, I can respect your not having the luxury of being able to talk about future service provider deployments. But if you were to just look at your experience with Verizon and how long it took from when they actually joined the MoCA alliance and contributed to when they started actually deploying the technology, what was the time frame that it typically took for them? And if you were to draw that map kind of to some of the folks that have joined today, what sort of window of time do you think that creates?

Patrick Henry

Well, I think there's a variety. You've got operators like Comcast that were one of the founding members of MoCA that still haven't made any public announcements of deploying. Verizon, I don't remember the specific timetable but I think it was probably within, like, a nine-month window from the time that they joined MoCA to the time that they launched their initial service.

Now Verizon and Cox and Comcast all joined at a time when we were still kind of finalizing MoCA specification, certification process, things like that. So we're much further along in terms of the maturity of the alliance at this stage. We already have a ratified specification for MoCA 1.1. So I think that that's a positive sign in terms of potential for how quickly somebody could get into deployment out of today's world versus a couple of years ago.

Sandy Harrison - Signal Hill Investments

Got you. And I've heard a couple of folks talking about adaptive equalization technology and different respects and you guys mentioned it with your Vativ acquisition. I mean, just how important is that technology? Because I continue to hear it being thrown around in these circles.

Patrick Henry

I think where it becomes important is in applications where you have longer cables or cable situations where the quality of the cables aren't necessarily as good. So getting an improved signal than noise by kind of cleaning things up from a digital equalization technology helps in those types of applications. So in the HDMI application where they use this technology today, it allows for us to sit anywhere and the chip can sit anywhere inside of a TV set.

And as an example, if they wanted to put one HDMI jack on the front of the TV and two on the back of the TV, then we would be able to do that without using more expensive cables or adding more expense to the bill of materials to enable that capability. So that's the example that we're using today but that basic capability has potential applicability for other products in the future.

Sandy Harrison - Signal Hill Investments

So basically it makes it cheaper deployment for the carriers who don't have to upgrade or potentially upgrade their infrastructure.

Patrick Henry

Right. It provides that type of potential, especially in either geographies where you might have older infrastructure or in situations where it's going inside the box and you want to use less expensive cable or not add to the bill of materials.

Sandy Harrison - Signal Hill Investments

Great. Thanks for taking my questions.

Patrick Henry

Sure. Thanks, Sandy.

Operator

Next from Credit Suisse, John Pitzer.

John Pitzer - Credit Suisse

Yeah. Good afternoon, guys. Congratulations. Just a couple of questions. First, when you look at the lack of linearity in billings in the quarter, could you just dive into a little bit more detail of what you thought was going on to cause that?

Patrick Henry

So I will comment on and Dave can jump in with any kind of details he wants to provide. We have pretty good visibility going into a quarter and kind of reasonable visibility kind of one quarter out. As we were in the Q1 situation, we had the typical seasonal softness we see in our DBS outdoor unit products, which usually results in a little bit additional non-linearity that you would get versus normal quarters. And we're not totally linear within a quarter. I mean, it's backend loaded.

What we've talked about historically is we're not doing 90% of our revenues in the last two weeks of the quarter like a software company. So we have a little bit of non-linearity naturally and I think combination of some seasonal softness with DBS ODU and some upside opportunities that we were servicing late in the quarter and our MoCA products were what kind of exacerbated this for Q1. Dave, you have any additional color you want to add?

David Lyle

No, that actually covers it pretty well.

John Pitzer - Credit Suisse

Patrick, just to help quantify, just so I understand, if normal linearity is, say, 30, 30, 40, did you guys experience kind of a 20, 20, 60? Or help me understand as you run through the month what kind of backend linearity you kind of saw?

Patrick Henry

Yes, we're really not going to break it out to that level of detail. I think in a normal situation it's like 20, 30, 50, but it was more backend loaded than that.

John Pitzer - Credit Suisse

And then just relative to the guidance for DSOs in the second quarter, why can't you bring them back down to sort of what we saw at the end of the Q4? I think, David, you said maybe mid-60s at the end of the quarter. Any reason we can do better than that?

David Lyle

Yes. We think over time we're going to get closer to our long-term target, which is kind of in the 45 to 50 days range. But we think it's going to take a little bit of time to get there. And I think part of the reason is we don't have as broad a mix as we will in the future. As we branch smaller and even new, bigger customers, we're going to see the DSOs come down pretty quickly towards model.

John Pitzer - Credit Suisse

And then guys relative to the acquisition, you made the comment that it was neutral to earnings. I'm just trying to figure out, no revenue in '08 but you have expenses going up 16% to 17% quarter-on-quarter in Q2. How much of that is related to the acquisition versus just organic growth of the business?

Patrick Henry

So Vativ actually does have some modest revenue, which was just not a significant amount of revenue related to our overall business. So there is some revenue there. The 17 employees that came over from Vativ primarily sold open [rex]. I mean we had a pretty aggressive hiring plan in Q1.

We were able to successfully hire in Q1 but we had some attrition as well. The combination of the Vativ employees plus some organic hiring that we're doing will be the total mix of the expense increase in Q2. Dave, you want to provide a little additional color on that?

David Lyle

Yes. And I think the running under on our hiring plan actually creates a much, obviously, higher sequential growth rate. But as of today, in April we caught back up to our operating plan.

John Pitzer - Credit Suisse

And then, guys, by June, are we looking at sort of an expense structure that then grows more in line with revenue growth? Or is there more sort of expenses sequentially in the back half of the year?

David Lyle

Yes, exactly. You'll see it more in line with revenue growth.

John Pitzer - Credit Suisse

And then, Patrick, last question from me. Two new MoCA customers expected by the end of the calendar year. Just help me understand relative to sort of the timing of those new customers versus your competitive position with those customers, there's a lot of concern that as the year kind of carries on, the risk of a new entrant coming in. I guess my question to you is if these two new customers come in the back half of the year or late this year, how much of a monopoly position will you have before we have to start worrying about sort of second sources relative to deployment?

Patrick Henry

Entropic definitely doesn't have a monopoly position. MoCA is a standard and we're the first mover so we're in a sole source position today. But we do expect competition. As far as design win cycles and deployment cycles, anything that gets deployed in the second half of this year has to already be in production by definition. So I think that our confidence level of very solid market share in 2008 is very high. In fact, it's significantly high even in 2009.

If you look at once somebody gets a sample of a MoCA chip, they have to go through certification, in or out, they have to get designed into an OEM's product and then they have to go through a deployment cycle with a major service provider. So I think we have a significant first mover advantage and I would say it's probably in the 12 to 18 month range. So we're feeling pretty good about that definitely for initial operator deployments beyond Verizon.

John Pitzer - Credit Suisse

And then, Patrick, last question from me. As you talk to these potential new adopters of the MoCA standard, how do they view the backer economic backdrop relative to their ramp plans? Is this something that disrupts the ramp plans or actually something that accelerates because they're looking to be more sticky with their customers with more sort of recurring revenue with their customers?

Patrick Henry

Yes, we're fortunate to be in a couple of businesses that are product cycle stories as opposed to things that are going to get massively affected by any kind of economics, broader macroeconomics. In the case of Verizon, everything they say in the press and everything they said to us and to their OEMs that are their suppliers and our direct customers is that they're continuing to move full force with deployment of FiOS so we expect to see a continued strong business there.

In the case of our satellite outdoor unit business, the deployment of our products there really helps to reduce subscriber acquisition costs, which is a big trigger item for the major satellite service providers. So we see those as also being product cycle stories that are somewhat immune to kind of the macroeconomics that are going on.

John Pitzer - Credit Suisse

And then, Patrick, if I can sneak one last one in, if I remember correctly, Q4 was somewhat impacted by some inventory issues at Motorola. Are those for the most part behind us and did we get any catch-up revenue in June from sort of the inventory cycle there?

Patrick Henry

So we talked about in both Q4 and Q1 that we would have a little bit of impact in terms of our entering into the supplier on inventory program with Motorola, their hubbing arrangement. So we're pretty much past that at this point and it's going to be more kind of business as usual. It wasn't really an inventory issue per se. It was more of a revenue timing thing because we moved from recognizing revenue as we shipped to Motorola, which is what we did prior to October 1 last year, and then we moved to a program that we're recognizing revenue as they pull from the hub.

So there was a lag in revenue recognition there that we had to work through. The top-line guidance that Dave provided in Q2 is what we feel comfortable with in the Q2 time frame.

John Pitzer - Credit Suisse

Great. Thanks, guys. Congratulations again.

Patrick Henry

Thanks, John.

David Lyle

Thanks, John.

Operator

(Operator Instructions) Next, we'll hear from Gary Mobley, Piper Jaffray.

Gary Mobley - Piper Jaffray

Hi. I had a question regarding revenue mix. Can you give us some detail on revenue mix by service provider type? If not an absolute number or percent, maybe you can give us some commentary on the directional change of each type of service provider?

Patrick Henry

Hi, Gary. We really don't break it out like at that level. Part of the challenge there is even by segment it's heavily concentrated within a couple of customers. It's possible sometime in the future when we get some additional customer diversification within segments that we'd be able to provide that type of color. What I can say is the last quarter that we kind of broke it out was Q3 last year where about 75% of our revenue was in the MoCA business, about 20% in the satellite outdoor unit business.

We definitely have started to see some initial diversification from the MoCA business and we're still on track with the initial guidance we provided on the road show, the IPO road show, where we'd expect about 50% of our overall revenue to come from the Verizon deployment kind of in the Q4 time frame.

So we definitely feel like we're executing on the other growth engines in the business, our broadband access business, our satellite outdoor unit business, and then later in the year we expect, as we talked about before, a couple of additional MoCA deployments. Although the revenue will be modest relative to Verizon in calendar '08, we'll start to see that ramping later this year.

Gary Mobley - Piper Jaffray

Okay. Any greater than 10% customers in the quarter?

David Lyle

Yes. Good question. We had Motorola at 36%, Actiontec at about 26% and [Jabal], which is a contract manufacturer for Tellabs at 12%.

Gary Mobley - Piper Jaffray

Okay. So that's about roughly 70% some-odd from -- 72% from Verizon. Is that right?

Patrick Henry

It's possible that Motorola could be shipping products to other operators beyond Verizon. We don't really break out the mix within Motorola. But the majority of Motorola is definitely to the Verizon deployment.

Gary Mobley - Piper Jaffray

Okay. And, Dave, could you give us some commentary on the gross margin trends in the RF Magic product line, the BTS and the CSS products? It's my understanding that they were fairly low marketing products in the past with a sharp ramp expected.

David Lyle

Yes, it's our policy not to break out these product lines in revenue or gross margin. Historically we have said, though, that the home networking product line was below our long-term model, which is 50% to 52% and that the old RF Magic legacy products were above that same range. But that's kind of the extent to which we can talk to.

In terms of gross margins, it's also important that you recall that we said in the past that non-GAAP gross margins will fluctuate quarter-to-quarter in and around our long-term model range as our product mix shifts and as demand grows at different rates because we're going to be launching new service providers at different times throughout each year.

Gary Mobley - Piper Jaffray

Okay. Are there any upcoming pricing thresholds triggered by some volume threshold that we should be aware of that might impact gross margin over the next few quarters?

Patrick Henry

I think it's all in the guidance. I mean, we're only guiding out one quarter, but if we look longer-term, we have long-term contract pricing that does have price erosion built into it. And we're continuing to lower prices as we need to continue to drive demand in these markets. We think that there is price elasticity of demand around both our major product lines as well as the broadband access product line. So we're proactively lowering prices to try to drive additional demand.

Gary Mobley - Piper Jaffray

All right, thank you.

Operator

Next, we'll hear from Tim Luke, Lehman Brothers.

Tim Luke - Lehman Brothers

Thanks, guys. I was wondering could you, David, perhaps give some greater clarity on the gross margin variables based on the first calendar quarter and how you see it developing in the second calendar quarter and for the second half of the year in terms of the variables? Thank you very much.

David Lyle

Thanks, Tim. Yes, we're not going to get into breaking out the product lines themselves. But kind of overall there's not much more to say probably about Q1 except that the change that we had at 48.7% was a product mix shift. And we're feeling pretty good about our guidance in Q2, which is 48.5% to 49.5%.

Patrick Henry

I think the additional thing I would say there is we do feel very good about the prospects we have with DIRECTV with the channel stacking switch product line. So we think that's going to be a major growth driver for us as we get into the second half and then into 2009. And we'll also see some ramp of our broadband access product line in the second half.

Even with the additional two MoCA deployments that we're expecting to see later this year, the revenue contribution on those is going to be at an early ramp phase. So I think that when you put all that in the mix, we should see some improvements maybe not in a straight line, as Dave said, we're going to kind of vary in and around the range depending upon the product mix, but I think we will see progress over time towards that long-term range for the balance of 2008.

Tim Luke - Lehman Brothers

Could you just kind of highlight here; what was the mix just given the quarter that caused the lower gross margin?

David Lyle

Well, the lower end of the guidance that we gave in the last call was 49.5% and we did 48.7%, so it was a little lower than what we had guided. We saw some upside in our home networking product line which we had again historically said had gross margins below our long-term model of 50% to 52%.

Patrick Henry

One of the benefits about being a multi-product company with multiple lines of business, multiple operators, is that even though we saw a little bit more pronounced softness in one line of business, we had some additional upside opportunities in another line of business so we're still able to exceed our top-line revenue guidance based on that.

Tim Luke - Lehman Brothers

I would also be grateful if you have any color on the lockup for June 4th and how you perceive the new stock, sort of the stock blocks that may potentially become available in that time?

Patrick Henry

So, all our outstanding shares except 9.2 million shares that were sold in the IPO are subject to the lockup. So we had a total of about 68.7 million shares outstanding, that means about 59.5 million shares will be released from the lockup restrictions on June 4th.

I really can't speculate as what'll happen to our trading volume once the lockup comes off. As you know, lockup releases occur with every IPO and I'm not aware of any unique circumstances that would apply in our case.

Tim Luke - Lehman Brothers

With respect to the broadband business, just regionally are there any sort of new updates that we should be focusing on in terms of the back half of this year or the first half of next year that you think may be important?

Patrick Henry

I think they're pretty much in alignment with what we've historically talked about. We think that the major upside in broadband access, major growth in broadband access is really in the Asia-Pacific rim, really concentrated especially in mainland China and also in Korea. But we do have some opportunities in greater Asia as well.

We have some trial activities going on in Europe, kind of early discussions with some U.S. operators. But I wouldn't really expect to see anything in the U.S. even intermediate term. It's possible as we get into '09 there might be some European opportunities that would start to ramp in addition to the Asia stuff.

Tim Luke - Lehman Brothers

Thank you so much. Good luck, guys.

Patrick Henry

Thanks, Tim.

Operator

Next, we'll hear from Krishna Shankar, JMP Securities.

Krishna Shankar - JMP Securities

Yes, folks, congratulations on some good results there in Q1. And a couple of questions. Were there any production bottlenecks in Q1 either at the contract manufacturers or at some of the set-top box suppliers which constrained your growth in Q1? Were there any bottlenecks?

Patrick Henry

Yes, I don't if I would call it a production bottleneck, but I think it was reported in the Wall Street Journal that Verizon knew some HDTV promotions that they were running had potential upsides in Q1 that couldn't be fully serviced based on they were upside. So their supplier couldn't respond as quickly as Verizon would have liked. I think we've worked through most of those things, which is really an increase in forecast more than a production bottleneck per se.

So we think that part of the growth that we're going to experience from Q1 to Q2 will be based on continued ramp in our MoCA business and we're very excited about the continued growth prospects with Verizon. And we continue to work aggressively with some additional operators to get them to launch their deployments before the end of this year as well.

Krishna Shankar - JMP Securities

And all of the Verizon deployment now MoCA 1.1 chipsets?

Patrick Henry

We continue to ship some of the older generation product lines and some legacy set-top boxes that were not under the restriction of having separable security. So, all the new designs that Motorola has put into production from a set-top box standpoint are using the MoCA 1.1 capable silicon. All the new designs that we have going on in the ONT and BHR world are also MoCA 1.1 capable. And as we're designing into other set-top box manufacturers that could potentially service other operators, that's all MoCA 1.1 capable silicon as well.

Krishna Shankar - JMP Securities

Okay. And can you give us some sense on the gross margin outlook? Refresh us again on your process manufacturing technology and what transitions there can help you in terms of gross margin enhancement?

Patrick Henry

Yes, so we're continuing to progress on our product development efforts and as we talked about historically, we're really doing product development in three areas. One is kind of pure cost reductions. Another area is feature enhancement, higher levels of performance. And the third area is higher levels of integration.

So all three of those areas can help with gross margin, some by reducing cost on a pure basis, others by increasing value, which will allow us to mitigate some ASP erosion based on both integration and higher performance products. So our product development efforts are progressing nicely.

All new baseband oriented products that we have in development are on 65 nanometer. Our current production level products, the EN2210, which is the MoCA 1.1 compliant product that's in production and shipping to customers, is on 0.13 micron CMOS. To go into 65 nanometer is a pretty big step function there.

Krishna Shankar - JMP Securities

Perfect. And my final question is on the DIRECTV CSS ramp. You said that it was relatively early. Can you give us some sense of growth in the opportunity within that business, in DIRECTV?

Patrick Henry

I think it's still a little bit early to kind of talk about penetration rates. I think we ought to see how things go with Q2. But we're optimistic that previous guidance that we provided is in reach and we definitely see the DBS outdoor unit business in general as being one of the major growth engines for the company in the second half of this year and into '09.

Krishna Shankar - JMP Securities

Great. Thank you.

Patrick Henry

Thanks, Krishna.

Operator

Next from Roth Capital Partners, Jay Srivatsa.

Jay Srivatsa - Roth Capital Partners

Yes, thanks for taking my question. Patrick, in terms of your international exposure with MoCA, with the TATA Group jumping onboard, how do you see the opportunity for your chips outside of the U.S.?

Patrick Henry

Thanks, Jay. The major areas that we see opportunities outside the U.S. are Canada, northern Europe and then parts of Japan are the three major geographies we've really been focused on. However, there are other geographies where there's a lot of coax infrastructure, India, China and Korea. The reason why we hadn't focused MoCA in those particular geographies earlier was that most of those geographies typically only have one TV per household but they've got a lot of TV households.

We mentioned earlier that in mainland China there's 140 million cable subscribers. That's about two times the number of cable subscribers that we have in the United States. So even if some percentage of those have multiple TVs in the home and it's a cable TV deployment, there is potentially a MoCA opportunity there. So it's still early, but we're encouraged that there could be a follow-on market in some of those emerging economies for MoCA longer-term and India would be one example of that.

Jay Srivatsa - Roth Capital Partners

In terms of your discussions with those international service providers, are they looking at MoCA as the standard to go with or are they examining wireless or home plug and other standards? And what's your sense in terms of where they are in the decision process?

Patrick Henry

I think they're early in the decision process around home networking. We're making progress in some of those geographies with our broadband access product, which is from the fiber-to-the-building and then use the coax to actually get to the customer premise.

The decision process that some of these international operators are going through are the same ones that the U.S. operators went through a few years ago where people looked at WiFi, people looked at power line technologies, people looked at MoCA. And it really depends upon the application requirements.

If you have an application that is for whole house data and portability or maybe you're moving one standard def stream or maybe even one high def stream in a small house, maybe you could use wireless in that situation. Home plug AV is pretty good for moving one HD stream. And then if you need to move multiple HD streams or multiple SD streams, it depends upon the quality of SD streams, throughout the home to a number of different terminal devices, then MoCA is really the best solution, assuming you have good in-home coax.

The reason for that is really the medium, coax as a medium has gigabits of data rate capability on it and MoCA takes advantage of that available spectrum and then deals with all of the specific idiosyncrasies and challenges of the in-home coax as the communication medium. Because you don't have just a straight piece of cable, you have splitters in those homes and those are a particular communication challenge that MoCA works very well with.

Jay Srivatsa - Roth Capital Partners

Okay. Thanks for the very detailed answer there. David, in terms of the balance sheet, your DSOs went up quite a bit because of the AR. Do you expect it to drop back down to the previous levels or what's the typical DSO numbers you're looking at going forward?

David Lyle

Well I think I've guided in the past that our long-term model was 45 to 50 days and we think we'll get there over time. But in Q2, we've guided that we're going to be somewhere in the mid-60s for next quarter on our way down to our long-term target.

Jay Srivatsa - Roth Capital Partners

Okay, thank you. Nice quarter, guys.

Patrick Henry

Thanks, Jay.

David Lyle

Thanks.

Operator

And we have time for one more question and it will come from Tore Svanberg, Thomas Weisel Partners.

Tore Svanberg - Thomas Weisel Partners

Yes, thank you. Good quarter. First of all, it seems like you expect growth from all three businesses, home networking, DBS outdoor and broadband access. On a relative basis, are they all going to grow about the same?

Patrick Henry

We really aren't breaking out the mix there, but all three of them are good growth engines and they all kind of hit at different times. I mean we're growing off a smaller base with broadband access, so percentage growth there is going to be higher but dollar growth is going to be within the range of the other two lines of business.

The big opportunity in the second half for growth is really our satellite outdoor unit business. We think that that's going to grow both from a dollar basis and a percentage basis probably larger than the other opportunities that we have in '08. As we get into 2009, we think MoCA continues to, as we get additional deployments, start having some additional growth there as well.

We started the initial Verizon deployment in late 2005, so we had kind of very rapid growth for the first couple of years of deployment. We've had and will expect to continue to see more modest growth in that business for the balance of this year. So, really it's the next sort of operator deployments that drive kind of the next step function level of growth in the MoCA business.

Tore Svanberg - Thomas Weisel Partners

Great. And it seems that the 2210 is still a small percentage of revenue. As that grows faster and contributes more meaningfully, is that a gross margin event for you or is that product more just keeping up with the cost curve?

Patrick Henry

2210 is in pretty high volume production at this point. The 2010, which is our first generation MoCA baseband solution, we are still shipping that but at a more modest level versus 2210. So we've already passed on some significant price reductions that are along the lines of the price curves that we've outlined, which we expect price erosion to be kind of in the 20% per year range. So we've been able to benefit from that to some extent.

Kind of our next level of cost reduction really comes with the 65-nanometer products, which won't be in production until late this year, and then we would get the benefit of those in '09.

Tore Svanberg - Thomas Weisel Partners

Fair enough. And then finally on the Vativ acquisition and on HDMI specifically, is the strategy here to be a merchant supplier of HDMI or should we expect maybe more of an integration roadmap for that particular technology?

Patrick Henry

Short-term, it's really a merchant supplier type of business where we have an established set of customers that we're already in dialog with and selling to set-top box manufacturers as well as TV set manufacturers. So we're going to sell it as a merchant product, but it is another technology that we have in the portfolio in the event that integration does become important, that's something that we have available now.

Tore Svanberg - Thomas Weisel Partners

Great. Thank you very much.

Patrick Henry

Sure. Thanks, Tore.

Operator

That is all the time we have for questions. Ms. Hart, I'll turn the conference back over to you for any additional and closing comments.

Debra Hart

Thank you, Sara. We'd like to thank you all for your participation today. There will be an audio replay of this call available in the IR section of our website. You can also access the audio replay by dialing 719-457-0820 and entering the reservation number 2212423.

Please note that although this call will be available for replay, except for our historical results, all information in the call is as of today's date, April 28, 2008. We have undertaken no obligation or commitment to update any information presented today. Please feel free to call me if you have any additional questions. Again, thank you for your participation. Have a nice evening.

Operator

That does conclude today's Entropic Communications conference. We thank you all for joining us.

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Source: Entropic Communications Inc. Q1 2008 Earnings Call Transcript

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