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Zoran Corporation, (ZRAN)

Q1 2006 Earnings Conference Call

April 24, 2006, 5:00 p.m. EST

Executives:

Dr. Levy Gerzberg, President and CEO

Karl Schneider, Senior Vice President and CFO

Dr. Isaac Shenberg, Senior Vice President, Business Development

Analysts:

Richard Faust, C.E. Unterberg, Towbin

Sameer Doctor, JP Morgan

Jason Pflaum, Thomas Weisel Partners

Brian Alger, Pacific Growth Equities

Craig Berger, Wedbush Morgan Securities

Jennifer West, Merriman Curhan Ford & Co.

Tayyib Shah, Longbow Research

Heidi Poon, Piper Jaffray

Dan Morris, CIBC World Markets

Quinn Bolton, Needham & Company

Vernon Essi, Janney Montgomery Scott LLC

Dan Scovel, Tokeneke Research

Operator

Good day ladies and gentlemen, thank you for standing by and welcome to Zoran’s First Quarter Earnings Conference Call. My name is Carlo and I’ll be your coordinator for today’s presentation. At this time, all of our participants are in listen-only mode. We will be facilitating a question and answer session towards the end of today’s prepared remarks, at which time if you would like to ask a question feel free to press “*” and “1” on your touchtone telephone. If at any time during this call you require audio assistance, feel free to press “*” and “0” and a conference coordinator will be happy to assist you. I would now like to turn the presentation over to your host for today’s conference, Bonnie McBride. Please proceed mam.

Bonnie McBride, Director of Investor Relations

Thank you. Good afternoon everyone and thank you for joining us today to discuss Zoran’s First 2006 results. By now, you should have each received a copy of today’s earnings release. Joining us today from Zoran’s management team are Dr. Levy Gerzberg, President and CEO; Mr. Karl Schneider, Zoran’s Senior Vice President and Chief Financial Office; and Dr. Isaac Shenberg, Senior Vice President, Business Development.

Now, before we begin, I would like to recommend that during the course of this conference call we may make forward-looking statements regarding the market for the company’s products, revenue projections, the outlook for our manufacturing capacities and new product development, and certain trends affecting gross margins and operating expenses for future quarters. I would caution that such statements, expectations, and actual results or events may differ materially, and also the documents the company files from the time to time with the SEC. These documents contain important factors that could cause the company’s actual results to defer materially from those contained in our forward-looking statements. I will now turn the call over to Levy, please go ahead.

Dr. Levy Gerzberg, President and CEO

Thank you Bonnie and good afternoon everyone. The first quarter marks the beginning of what we believe will be a very successful year for Zoran. Our DTV business was particularly strong growing 37% sequentially while our digital camera business also grew during what is normally its seasonally weakest period. Our business model has never been stronger with increasing profitability, a well-diversified revenue base, and an exceptionally solid balance sheet. We continue to solidify our provision in each of our core markets by securing multiple design wins across all our product lines with manufacturers around the world. Zoran is poised for a very exciting year.

Now, on an update of our business. In digital cameras, we once again achieved record revenues for the quarter and design activity remains very strong. The on growing strength in demand for COACH solutions as top tier manufacturers enabled us to grow revenues and we are confident we will increase marketshare. Current market forecast estimates a 10% annual increase in this market and based on our performance during the first quarter, we believe we will continue to outpace the market growth rate. More than half of our digital camera revenues came from our COACH 8 Processor, which went into production with over 10 different customers including Pentax, Samsung, and others. In addition, we continue to gain ground in the Japanese captive market, securing major wins as a tier 1 manufacturer. The COACH 9, which was introduced at PMA in February, is being very well received by customers who are particularly attracted to its enhanced image quality and blur reduction feature. We are already in various stages of new product designs with customers using the COACH 9 and expect to see first models in the second half of the year.

Pricing in the digital camera market continues to decline somewhat as market matures. This in turn drives further erosion in the captive market as manufacturers seek to replace expensive captive ICs with more cost-effective, high-performance solutions from Zoran. We expect this trend to continue and to enable further marketshare gain for Zoran.

In our multimedia phone market segment, our focus remains on securing design wins for APPROACH 5C, a highly innovative multimedia processor which offers a wide range of features while maintaining its cost effectiveness. This makes it very well suited to larger OEM providers who have to create multiple feature phone models quickly for a reasonable cost. This product was launched at the 3GSM show in February receiving excellent feedback. We expect multiple design wins to finalize throughout the year.

In imaging, revenues declined somewhat from the fourth quarter as a result of unfavorable marketshare in product mixes among manufacturers in the Inkjet all in one segment. We remain focussed on broadening our customer base in order to reduce dependence on anyone OEM customer. We are also investing in the emerging color label segments with our recently announced Quatro 4230 Digital Processor.

The color label segment is expected to represent the most dramatic shift in the printer market over the next five years and OEMs are working aggressively to develop products that offer a higher print speed with a wider variety of features while maintaining affordable price levels. The 4230 is the only single chip solution that embeds the high performance CPU for processing page description language that supports complete color MSP functionality for products with speeds up to 20 color pages per minute, a level previously achieved only with multi-chip solutions. Customers began developing products with the new 4230 solution in the first quarter and we anticipate first deployment in the beginning of next year.

In addition, Panasonic introduced a new monochrome laser MSP based on our Quatro during the quarter. The continued growth of digital photography is driving increasing demand for snapshot photo printers and photo capable all in one printers with OEMs aggressively pursuing features such as Bluetooth Wireless Printing, an automatic Red Eye removal which Zoran’s enables. In the Inkjet all in one segment, we are pursuing a strategy to increase integration. First customer deployments with our Quatro 4050 and 4200 are starting to be introduced including Inkjet all in one and dye-sub snapshot printers from top tier customers.

In the enterprise or office segment market, new products based on our IPS-7 software were introduced during the quarter including models from Canon and HP as well as several other top tier manufacturers, and we expect to see many more throughout 2006. Our next-generation IPS product, which will be available later this year, includes our new interpreter from Microsoft new document formant XPS to be included in the next major release of the Windows Operating System VISTA due out in early 2007.

In DVD, we continue to see an overall improvement in growth margins driven by a favorable mix chip including strong sales of our higher margin Vaddis 8 processor in an increasingly wide range of products. In addition, the high level of integration in our Vaddis 8 enables our customers to realize a lower bill of materials for new DVD products being delivered to market this year.

Nearly all of our customers have transitioned to the Vaddis 8 with the exception of a few making very high end products using Vaddis 7 processor.

During the quarter, we saw strong demand for DVD player products for the growing portable market and for standalone players in emerging markets including South America, South East Asia, India, and China. Demand also came from Europe where retailers are planning promotions to coincide with the World Cup Soccer Championship in June.

Our recently introduced Vaddis 9 is being well received in several customers including Phillips, who went into mass production during first quarter. The Vaddis 9 addresses the full range of DVD applications and is specifically optimized for the growing portable market, and already two major DVD portable manufacturers are ready to go into mass production. We expect to transition customers to this new product during the year.

We continue to make progress in the DVD recorder market with our latest-generation Activa chipset, a solution designed to meet the demand of our customers to deliver DVD recording products at more affordable price levels. We are working closely with customers that are currently sampling the Activa to finalize those systems for production. We continue to lead the DVD combo market where demand for DVD, VCRs, and home theater in the box systems remain stable. We’re seeing increasing demand in particular for DVD portables where our marketshare is believed to be approximately 40%. We are the first to introduce a DVD SOC with an integrated SCD driver for portable players, which should enable us to increase our marketshare in portables. We are also first to introduce a DVD player SOC with an integrated App converter, an HVMI transmitter, which is helping us gain share in the high-definition television related markets across multiple geographies.

In DTV, our strategy to address the full market including CRP, flood panels, and set-top boxes with technology that serves high-end, mainstream, and high volume end-market is succeeding. In HDTV our SupraHD processor and Cascade2 demodulators dropped growth in the US where ATSC-compliant COT sales gained momentum. New models from Phillips, Magnavox, Sharp, and Sanyo started shipping in large volumes. Orion is also shipping new products under multiple brand names. As expected, this new compliance market created by the FCC is beginning to grow rapidly, and we are raising the entry barrier with our integrated product offering and customer base. We believe we can capture a large portion of the mandate compliance CoDTV market.

We’re extremely pleased with the market acceptance of the SupraHD 660 IC, which according to our customers offers the best integration in analog video processing and scaling. This produce is ideally suited to the fast growing sweet spot of LCD TVs up to 37 inches and 42-inch plasma display televisions. Sanyo and Xoceco have already begun shipping HD COT and flat panel TVs with additional models from these customers expected to be released throughout the year. This SOC is now also being designed into many TV products that are destined for the European DVBT market as it provides the most integrated solution available for LCD and plasma display TV products that require more both analog and digital reception. We also saw design activity in our SupraHD product in Taiwan, Korea, and China, and we’ll see new models on the tier 1 names in the coming quarter.

Zoran’s Cascade2 demodulator product line once again achieved significant growth. This IC family is shipped to many of our SupraHD customers as well as into the tuner network interface module market. Major supplies including Semco, Sharp, and Thomson are now in production.

Our SDTV product line continues to exceed our expectation. As many of our customers secured new export business for free-to-air set-top-boxes for markets in the UK, Spain, Italy, Germany, and other European countries. As new digital channels become available for the European DVBT standards, consumer demand is increasing. This product line continues to grow marketshare and revenue for Zoran as we supply to customers such as Acer, E-tek, Homecast, MECO, NPC, and Xoceco. Our fully field tested and qualified DVB systems, which covers literally all European countries, positions us well to compete in this growing market.

Before turning the call over to Karl, I want to reiterate our enthusiasm for Zoran’s achievements during the first quarter. We are executing on all of our key objectives, diversifying our business and revenue stream, growing marketshare, taking a leadership position in all of our target market and increasing profitability. Karl…

Karl Schneider, Senior Vice President and CFO

Thank you Levy and good afternoon everyone. Total revenues for the first quarter ended March 31, 2006, were $142.2 million, which includes $30.1 million in net payments received in connection with the settlement of litigation reached on January 26, 2006. These payments were net of amounts paid to a holder of rights pursuant to license agreements of certain patents associated with the litigation and legal expenses. Excluding these proceeds, revenues for the quarter would have been $112.1 million, an increase of 2.6% compared to the $109.3 million reported last quarter and a 51.7% increase from the $73.9 million in the first quarter of 2005.

Our GAAP net income for this period was $20.8 million or $0.43 per diluted share on 48.5 million common and equivalent shares. These results include charges of $12.7 million related to the amortization of acquisition related to purchase intangible assets, stock-based compensation expenses of $4.6 recorded as the result of the adoption of FAS 123R, and a provision of $6 million for income tax expense related to the proceeds received in connection with the litigation settlement. This compared to the net loss of $2.1 million or $0.05 per share for the previous quarter and a net loss of $18.8 million or $0.43 per share for the first quarter of last year.

On a non-GAAP basis, our net income for the first quarter was $13.9 million or $0.28 per diluted share, which excludes the proceeds from the litigation settlement and the related provision for income tax expense as well as acquisition-related charges and stock-based compensation. Non-GAAP net income for the first quarter includes the impact of a net gain on investment of $1 million or $0.02 per diluted share net of tax. This compares to non-GAAP net income of $10.9 million or $0.23 per diluted share for the previous quarter and a non-GAAP net loss of $5.9 million or $0.14 per share for the first quarter of 2005.

Hardware product revenues driven by DTV and digital camera increased sequentially by $3.7 million or 3.9% during the first quarter to $99.2 million. Software royalties licensing and other revenues decreased by nearly $1 million or 7% to $12.9 million during the same period. Revenue by product family for the first quarter of 2006 excluding license litigation settlement revenues was 32% DVD, 32% mobile, 19% DTV, and 17% imaging. This is clear evidence that our diversification strategy is working when compared to the same period last year, which was 44% DVD, 18% mobile, 10% DTV, and 28% imaging. Sales by geographic region during the first quarter were 35% in China, 24% Japan, 21% Taiwan, 12% US, Europe, and others, and 8% Korea.

Overall gross margin for the first quarter was 51.4%, which excludes revenues recorded as part of the litigation settlement. This compares with 54.5% last quarter and with 50% for the first quarter of 2005. The decline in our overall gross margin was primarily the result of lower licensing revenue, a mix shift towards DTV and slightly declining margins in our digital camera products, which we have previously indicated would come down throughout the year.

During the first quarter of 2006, the company adopted FAS 123R resulting in a charge for stock-based compensation expenses of $4.6 million as mentioned earlier. The allocation of this expense in our GAAP income statement is $145,000 to manufacturing overhead including cost of sales, $1.5 million in the R&D line, and $2.9 million in SG&A. Excluding these stock-based compensation expenses, research and development expenses declined approximately $1.5 million in the first quarter of 2006 to $22.6 million compared to the $24.1 million in the prior quarter. Compared with the same quarter of last year, R&D spending increased 12.4% from $20.1 million. This year-over-year increase in R&D spending can be primarily attributed to the acquisition of Oren Semiconductor. On a sequential basis, R&D spending tends to fluctuate from quarter to quarter based on the tightening of major engineering-related expenses such as tape outs which include mass sets and engineering wafers as evidenced in the decline in the first quarter of 2006 compared to the prior quarter. Excluding the impact of stock-based compensation charges, selling, general and administrative expenses decreased to $21.9 million in the first quarter from the $24.5 million reported last quarter. Compared to the same quarter last year, SG&A expenses declined by 5.6% from $23.2 million.

Other income and expense for the first quarter of 2006 increased to $2.8 million. Included in the $2.8 million was interest income of $1.6 million earned on increased cash balances at higher rates and a net gain on stock-based investment of $1 million.

Our current estimate of the company’s performance tax rate for the year 2006 is approximately 13% excluding the tax impact of the litigation settlement. Since the litigation settlement is US-based income, the incremental rate applied to those proceeds is 20%.

Moving over to the balance sheet, cash, cash equivalents, and short-term investments increased by $68.6 million to $217.9 million from $149.3 million reported last quarter. Cash generated from operations during the quarter was $52.7 million, which includes the litigation proceeds net of tax of $24.1 million. Accounts receivable at the end of the quarter were $62.4 million, a decrease of $7.8 million from $70.2 million last quarter with DSOs decreasing to 50 days versus 58 days in the previous quarter excluding the proceeds from the litigation settlement.

Inventory balances at the end of the quarter increased to $38.7 million from $32.6 million for the previous quarter. Inventory returns for the first quarter were approximately 5. The increase in inventory was associated with DTV and digital camera products and with a planned increase in light of the sales growth we are expecting in the coming quarters.

I will now address the company’s outlook for the second quarter of 2006. During the Q&A session that follows, you’re encouraged to ask any questions that may not be covered during the course of our comments as we do not anticipate having to provide any financial guidance after this call. Before we provide any forward-looking guidance, we want to remind you that any forward-looking statements related to revenue projections, gross margin expectations, and all other comments on the expected financial results for Zoran are just predictions; actual results may differ materially.

For the second quarter of 2006, we currently anticipate that revenues will range between $118 and $120 million, which excludes the expected one time receipt of $5.6 million related to the patent litigation settlement with overall gross margins ranging between 52% and 53%. Excluding any acquisition-related cost and stock-based compensation expense under FAS 123R, operating expenses are expected to range between $47.5 and $49 million. Acquisition-related costs are expected to be approximately $13 million. FAS 123R expenses are expected to range between $4.5 million and $5 million.

The GAAP net income for the quarter is expected to range between break even and $0.02 per share. Excluding acquisition-related costs, FAS 123R expense, and the final litigation settlement payments, which we do not consider part of our core operating expenses or income, non-GAAP earnings for the quarter are expected to range between $0.26 and $0.29 per share on approximately 50 million shares.

Before we open up the call for questions, I want to remind you that we will be hosting our first analyst day on May 25, 2006, following the JP Morgan Conference in San Francisco. The event will take place here at our Headquarters in Sunnyvale and will include guest speakers, presentation from senior management, as well as many new demonstrations of our latest technology. If you have not yet signed up for this event, please call Bonnie McBride at 415-388-1635 or e-mail her at bonnie.mcbride@zoran.com to register. With that, we’ll open up the call for questions. Operator, please go ahead.

Question-and-Answer Session

Operator

Thank you sir. Ladies and gentlemen at this time if you wish to ask a question, please key “*” and “1” on your touchtone telephone. If that question has been answered or you wish to remove yourself from the queue, you may then press “*” and “2;” again “*” and “1” at this time for any questions; one moment. Sir, your first question is from the line of Rick Faust with Unterberg.

Richard Faust, C.E. Unterberg, Towbin

Congratulations on a great quarter. Just to give us an idea, the digital TV that’s really started to move here, is this mostly CRT ATSC compliance that’s driving this in the near term or are you also seeing a certain amount of LCD and other form factors?

Dr. Levy Gerzberg, President and CEO

Well, Rick, we see it across the board, not only LCD but we also see it in plasma displays, we also see it in COTs. So, it’s actually across the board, as demonstrated by those customers that we mentioned earlier.

Richard Faust, C.E. Unterberg, Towbin

Is your super product being used for…obviously the HD decoding along with the Cascade for the demodulation in the tuning function, is the chip also being used as the main display processor in many of these applications or is it sitting besides someone else’s display processor?

Dr. Levy Gerzberg, President and CEO

Oh absolutely, we are driving the display in most of the systems that we are integrated in, in the majority of them. So, this is really an integrated solution.

Richard Faust, C.E. Unterberg, Towbin

Very good, excellent. And finally MediaTek is starting to pay you, I guess, $1.5 million a quarter royalty, is that included in this revenue guidance and outlook?

Karl Schneider, Senior Vice President and CFO

Rick, we’re going to be recognizing the payments from the litigation settlement on a cash basis. So, in the first quarter, there was no royalties which relate to the numbers you just mentioned. So, we’ll actually recognize the first payment in the second quarter, which will be approximately $1 million and then going forward it will be about $1.5 million net to Zoran on a quarterly basis.

Richard Faust, C.E. Unterberg, Towbin

Great, and what’s driving the improvement in gross margin into the upcoming quarter, is it mix, what is the driver there?

Karl Schneider, Senior Vice President and CFO

I would say it’s primarily mix issue in the quarter.

Richard Faust, C.E. Unterberg, Towbin

Okay, thanks a lot, I appreciate it.

Operator

Sir, your next question is from the Sameer Doctor with JP Morgan.

Sameer Doctor, JP Morgan

Thank you and congratulations. A couple of questions, first a housekeeping question for Karl, what was CapEx in the quarter.

Karl Schneider, Senior Vice President and CFO

What was guidance…

Sameer Doctor, JP Morgan

What was CapEx?

Karl Schneider, Senior Vice President and CFO

Oh CapEx, sorry. CapEx was probably around $4 million or $5 million I would guess.

Sameer Doctor, JP Morgan

And is it likely to be at the same level the next quarter?

Karl Schneider, Senior Vice President and CFO

That’s typically…actually sorry, it was about $1.5 million in the quarter.

Sameer Doctor, JP Morgan

Okay, and Levy you obviously seem to be gaining share, what’s driving the share gains especially in DTV but also on the DVD side, because you’ve seen some of your competition report numbers that are significantly lower than your growth, what are the drivers of share gains?

Dr. Levy Gerzberg, President and CEO

Well, I think in both markets, these are the new products that we have, certainly in DVD, as we introduced in the beginning of the year, we have a new solution with integrated HVMI and the LCD driver; this is becoming very popular. It’s not a simple function to integrate at an affordable cost. So, a number of our customers are now entering the production. There are other features in our DVD solutions that are very attractive across the globe and making the bill of materials more affordable, many enhanced the interfaces and features. This is in the DVD, exactly as we projected and planned for. In the DTV, a number of our customers reached production with both our Supra 660 and 640, and of course the mandate is driving the COT very nicely. There are a number of customers of Zoran that actually were depressed in the world to introduce the COT-based solutions to the market, actually starting in fourth quarter and gaining more momentum in first quarter, which will enable the consumer to receive HDTV broadcast and display it on a low cost analog TV. So, we were the first to drive this in the market and it’s creating a very nice momentum. And of course, the overall integration now integrates everything, our system on a chip including, as we mentioned earlier, the driver of the display. There is no need for a separate external chip. So, all of these are helping us gain marketshare.

Sameer Doctor, JP Morgan

So, you know in the DVD side, how much of a lead do you think you have over your competition? Do you think it’s like three months behind or six months behind, and if you are to quantify it how would you look at it?

Dr. Levy Gerzberg, President and CEO

Well, it’s difficult to quantify because some of these solutions require not just the chip, they require a complete solution and the software. This is very important to emphasize. When we’re selling a system and a chip, we are providing the entire system solution with the design which is production ready and a lot of software that goes with this. But all of this gives us the confidence that we open up the gap at least six months ahead of competition, in some cases even a year.

Sameer Doctor, JP Morgan

Okay, finally, on the digital TV side, can you give us a sense of what percentage of the revenues was driven by the CC mandate?

Dr. Levy Gerzberg, President and CEO

What percentage was driven by the mandate…it’s hard to come up with a specific number, but it’s probably more than half because it’s essentially of what our customers’ field. They believe that if they’re not going to come out now with mandate-compliant solutions they will be left out, and it’s very interesting to see how fast they’re moving. As mentioned even with COTs, they’re already out in the fourth quarter just before the holiday season and they’re pushing very hard in the first quarter, so it’s probably 50%. The LCD is driven by system cost and increasing demand, you know the prices of LCD are coming down, so everyone is trying to be compliant right now. So, our solution is very attractive in driving the volume.

Sameer Doctor, JP Morgan

All right, thank you and congratulations again.

Operator

Sir, our next question is from the line of Jason Pflaum with Thomas Weisel Partners.

Jason Pflaum, Thomas Weisel Partners

Yes good afternoon guys, just a quick followup to the last question, just trying to get a better sense of the composition of your DTV business. Can you give a sense of the split between set-top LCD and digital CRT?

Dr. Levy Gerzberg, President and CEO

Well, the CRT is really the majority and then comes the LCD mix and the set-top boxes. In HDTV, it’s primarily with Generation9 where a number of integrated solutions, but with the new SupraHD solutions, against COT, LCD, and then the set-top boxes. Now, the set-top boxes are strong as well.

Jason Pflaum, Thomas Weisel Partners

Okay, will that mix change as you move through the year?

Dr. Levy Gerzberg, President and CEO

It will probably change. There will be a shift more towards integrated TVs, more LCDs in particular, and plasma display.

Jason Pflaum, Thomas Weisel Partners

Okay, and then just as far as the outlook, can you just talk generally about the direction you think your business is moving in the second quarter -- DTV up, DVD a flak down, just wanting to give some color there please?

Karl Schneider, Senior Vice President and CFO

Jason, I think in the second quarter we can expect that with the exception of probably imaging all of our businesses will be up.

Jason Pflaum, Thomas Weisel Partners

Okay, great. Then just one clarification, Karl, that $1 million in MediaTek royalty is that included in the gross margin guidance?

Karl Schneider, Senior Vice President and CFO

The $1 million is included in the gross margin guidance.

Jason Pflaum, Thomas Weisel Partners

Finally, just to follow up on the…I think you have some outstanding litigation with MediaTek and UMC, if you can just give an update on that? That’s my last question, thank you.

Karl Schneider, Senior Vice President and CFO

Actually, Jason, there is no litigation outstanding anymore with UMC or MediaTek. It has been settled in its entirety.

Operator

Sir, our next question is from the line of Brian Alger with Pacific Growth Equities.

Brian Alger, Pacific Growth Equities

Well guys, nice quarter. Karl, you mentioned that your tax rate away from the licenses was about 13%. That’s considerable than what I think we’re looking at coming into the year, should we expect that 13% rate to continue?

Karl Schneider, Senior Vice President and CFO

Well right now the 13% rate is based on what we currently estimated the year to look like. If the company becomes more or less successful, then depending up on what geography we do that, that 13% is subject to change.

Brian Alger, Pacific Growth Equities

So, we should use 13% until notified otherwise?

Karl Schneider, Senior Vice President and CFO

Correct.

Brian Alger, Pacific Growth Equities

Okay, great. As we look at the year, historically we’ve kind of described Zoran’s business as seasonally having a 40/60 split, first half and second half. You’re off to a great start here, even backing out the settlement, DTV and digital still just ramping up dramatically, do you think this is a change in terms of how we should think of Zoran, in terms of the seasonal swings, or are we looking at it that big of a second half?

Dr. Levy Gerzberg, President and CEO

No, we believe the characteristics of the seasonality will continue as it was before. We believe that the second half will be strong as it always has been, towards the holiday season, and we started the year very strongly, because we have new products that are helping us gain momentum from the beginning. We worked on it very hard last year and now we start to see the fruits.

Brian Alger, Pacific Growth Equities

So, I guess that implies a rather large number then if we were to see the same 60/40 split? I guess what I’m hearing then, Levy, is that you think the share gains that you’re seeing here in the first quarter are going to be maintained through the backend of the year and show up as seasonal growth as we normally would expect then?

Karl Schneider, Senior Vice President and CFO

Brian, I think we didn’t guide super strong growth for the second quarter, because over the last couple of years it’s hard to say what’s seasonally normal given the condition that the DVD market was in over the last two years. However, we expect that the second half will be stronger than the first half. I’m not sure if we go as far as saying it is 60/40, but it’s going to be a strong in the second half.

Brian Alger, Pacific Growth Equities

And then just one last one, you talked about an OpEx excluding the various charges, pretty good growth there sequentially in the OpEx line, is that by design, is there something we should know about in there, and should we expect the company to continue to grow the OpEx to that degree as we look to the rest of the year?

Karl Schneider, Senior Vice President and CFO

No, I don’t think you can attribute the rate between the first quarter and the second quarter guidance to what’s going to happen in every quarter going forward. I think we do tape out and those kinds of things fluctuate and 90-nanometer is a very, very expensive engineering project, almost $1 million of tape out versus probably $300,000 or $400,000 at 0.18 to 0.16. So we’re coming out with a lot new products, a lot of new ICs, and so depending on the quarter we’re going to see it either jump up or come down depending on how many tape outs are scheduled in that quarter.

Brian Alger, Pacific Growth Equities

All right, thanks guys, nice quarter.

Operator

Sir our next question is from the line of Craig Berger with Wedbush Morgan.

Craig Berger, Wedbush Morgan Securities

Good afternoon and congrats on a good quarter. Can you comment on what you’re seeing out there in the DVD market with respect to demand, and I’m asking you because one of your competitors from Taiwan wasn’t sounding that great recently, I’m just curious what you guys are seeing?

Dr. Levy Gerzberg, President and CEO

Well, Craig, we see the demand growing for our products. You know, we cannot comment specifically on the competitors. All we can tell you is that we have new products in the market, the Vaddis 8, the Vaddis 9 which are in great demand. These are very good products. I wish we had more volumes to ship in the first quarter; the demand is good.

Craig Berger, Wedbush Morgan Securities

Do you see any inventories building up for customers or your customer’s customers?

Dr. Levy Gerzberg, President and CEO

We have not seen it from our customer’s side or from their customer’s.

Craig Berger, Wedbush Morgan Securities

What’s a decent bogey on DVD recorder for this year for you guys in terms of volumes?

Dr. Levy Gerzberg, President and CEO

Well, in general, what we see in the DVD recorder market is that the overall growth of the market is quite modest. There have been some recent reports that show this market is not growing as fast as expected. It is still a small portion of our DVD business. We are going to see growth, we are gaining momentum as we mentioned in our prepared remarks, and we expect towards the end of the year to start to see the adoption of our new Activa 200 product family. The growth that you see is mostly in Japan and Europe. We don’t see a major growth in the US. So, all in all, we expect that the overall market for DVD and DVR will show a small growth in general.

Craig Berger, Wedbush Morgan Securities

Do you think you might be able to ship a million units this year?

Dr. Levy Gerzberg, President and CEO

Oh yeah, more than that.

Karl Schneider, Senior Vice President and CFO

Craig, one other thing to this, we have to remember we’re in the first quarter of the year, the seasonally slowest quarter historically in DVD. So, the fact that people maybe overestimated the sub-segments that they were serving or whatever, we just have to keep that in mind, the high season is in front of us, not just behind us?

Craig Berger, Wedbush Morgan Securities

Right, on the DTV side, you guys did roughly $21 million this quarter. I know you’ve been talking about ramping to $100 million in light of this being the seasonally slow first quarter, it seems like $100 million is easily doable. Do you think you can do better than that or do you have an update for us on that front?

Dr. Levy Gerzberg, President and CEO

Craig, we are aiming as high as we can get, but we can’t comment on the rest of the year, but we are happy with the results in the first quarter and the momentum that we see going into the second quarter and beyond in the DTV markets, so all the good reasons that we have mentioned. So, we hope to experience a very nice growth this year.

Craig Berger, Wedbush Morgan Securities

One last question and then I’m done. Can you update us on the APPROACH handset Apps processor, sort of the design wins with the new product that you’re sampling?

Dr. Levy Gerzberg, President and CEO

Yeah, we are gaining a number of design wins. This product is not aimed at generating a lot of revenue this year, but the reception has been very, very positive at 3GSM. This is a very small device, the smallest we’ve seen in the market and yet providing very high performance including function MPEG4, H.264, graphics, GPS, and it’s also using the smallest size of memory externally, so it makes the overall system cost lower than any competing solution. So the interest is going. We are showing all kinds of demonstrations of system examples with this device, but this is aimed at production towards the end of the year and revenue generation early next year and beyond.

Operator

Sir our next question is from the line of Jennifer West with Merriman.

Jennifer West, Merriman Curhan Ford & Co

Congratulations on a good quarter. Going back to DVD and note of the share gains that you think you’ve won, can you update us on what you think your marketshare is in that marketplace?

Dr. Levy Gerzberg, President and CEO

Yeah, it’s hard at the beginning of the year to estimate exactly what the marketshare is, but certainly the market that we are addressing is growing and our marketshare is growing, and we’re looking at about 30% marketshare in those areas.

Jennifer West, Merriman Curhan Ford & Co

And do you have any expectation of where that could go towards the end of this year?

Dr. Levy Gerzberg, President and CEO

Well, we hope to increase it, but it’s very difficult to tell at this time. Again, we are focusing on some segments where we’ll see the markets growing, and our marketshare growing to probably another 5% on most of it.

Jennifer West, Merriman Curhan Ford & Co

And then the gross margins is kind of looking out more long term towards the second half of ’06, do you think the gross margins can be sustained about 50% or do you think those will kind of trend more towards your long-term model?

Karl Schneider, Senior Vice President and CFO

I think for the balance of this year, Jennifer, we can expect the gross margins will stay north of the 50% level, but not at the 54% level we experienced in the recent past, but somewhere in the 51%-52% range.

Jennifer West, Merriman Curhan Ford & Co

It’s being driven primarily because of your product mix towards TV or because of improvements in DVD or what’s going on there?

Karl Schneider, Senior Vice President and CFO

Well, I think it’s a number of things that you just mentioned. It’s product mix in any given quarter, it’s improvements in DVD, gross margins for example that we’re experiencing right now, so it’s all of the above including volume.

Dr. Levy Gerzberg, President and CEO

Jennifer, we’ll see a significant growth in volume this year and it goes with the market. So, as prices come down in the market, of course everything will scale, although we see the decline in our ASP is normally less than the decline in the system cost. But still, we are planning for a slight decline in margin as a result of it.

Jennifer West, Merriman Curhan Ford & Co

All right, thank you.

Operator

Sir, our next question is from the line of Tayyib Shah with Longbow Research.

Tayyib Shah, Longbow Research

Hi guys, congratulations on the quarter. Obviously DTV business is doing very well, can you take a stab at where you think your marketshare is in the flat panel space?

Dr. Levy Gerzberg, President and CEO

First of all, we are sure that our marketshare is increasing and we feel we’re starting to benefit actually across the board. Probably in the US it is somewhere around 12% or so, going up to 14% and hopefully higher than that in the US, and this is in the integrated TV market; this is our main target. We also see our marketshare in Japan growing, it is still small but this is an area of growth for us. We hope to grow in the European marketshare as well in this area with the good penetration that we see with our integrated solutions. So, all in all, we see a pretty good marketshare increase for us this year, and we think that our growth will outpace the market growth.

Tayyib Shah, Longbow Research

And then within the DTV space, who are you seeing as your main competitors right now, is it more the digital players like ATI and Broadcom or the original analog competition, Trident and Genesis?

Dr. Levy Gerzberg, President and CEO

Well, in order to really compare apples to apples, you need to look at companies that provide more integrated solutions, not just one function. Actually, with some competitors that you mentioned, there are systems that we provide the so called backend solution and their scale out is available in conjunction with our solution on the same system, and now many systems are transitioning to a single chip solution like ours. ATI probably is the more apples-to-apples competitor. The scaler companies that you mentioned, these companies will provide just the display functions to the best of our knowledge. They do not use fully integrated solutions with everything that goes with it, including the software and so on. So, right now, there are some captive solutions and our integrated solution and with CAPI, in some systems we see Broadcom more in legacy designs.

Tayyib Shah, Longbow Research

Again, Levy, I’m sorry if I missed this, but I didn’t hear Sony, Samsung or Sharp among your flat panel TV design wins, can you just give us a general idea of what is your traction with these top tier TV OEMs?

Dr. Levy Gerzberg, President and CEO

First of all, we cannot mention everyone, we’re not allowed sometimes to mention some of the designs; it is too early. But, we mentioned Philips, we mentioned Sanyo, and there are number of other companies…we mentioned TPV in the plasma display systems. There are other manufacturers that we mentioned that they are OEM providers to some of the top tier companies, and unfortunately we are not at liberty to tell you whom they are selling to yet, but you’ll hear about it.

Tayyib Shah, Longbow Research

So, in the second half, should we expect multiple models with Zoran’s chips inside them, with these top tier OEMs?

Dr. Levy Gerzberg, President and CEO

I don’t know about Trident, I can tell you we have many design wins in the pipe and we expect to be in more and more top tiers and high-volume manufactures from all over the world.

Tayyib Shah, Longbow Research

Okay, and then finally a question on your digital camera business, have you seen any competition lately from Sunplus this year, and then maybe if you can just give us a sense of what the design cycle is among the ODMs this year, when do you start to see decisions on designs that will go into production later this year, during Christmas and then back to school season?

Dr. Levy Gerzberg, President and CEO

Well there are some very low-cost cameras, the design win cycles for those are very quick, but these are very, very low cost cameras. Of course we see competition from various places. I’ll tell that the main competition that we’ve seen in the digital camera market is from the captive companies, although, because of much shorter time to market that we provide and very advanced roadmap with backward and forward compatibility of software, many of the first tier captive manufacturers are moving to Zoran, and this is one reason why our volume has been going up and marketshare has been growing up so nicely. Sunplus has been there for a long time. There are one or two other smaller companies in Taiwan. We have not seen them in big volumes yet, of course we’re watching them, and so far we’ve not seen the same platforms that we have. We demonstrated COACH 9. COACH 8 is a big volume high runner for us. COACH 9 is coming, of course we have on the drawing board COACH 10 and beyond with many applications, modules, software modules. So far we do not see any new competitors that have really demonstrated volume in stores, not just in press releases.

Tayyib Shah, Longbow Research

Thank you guys.

Operator

Sir, our next question is from the line of Tore Svanberg with Piper Jaffray.

Heidi Poon, Piper Jaffray

Hi this is Heidi Poon for Tore. Congratulations on a good quarter. Could you tell me what percentage was Gen9 in DTV revenue?

Dr. Levy Gerzberg, President and CEO

Gen9 was not a very large percentage of our revenues and we don’t break out by percentage by product lines. So, we do sales with Gen9, we are continuing to sell it to high-end systems, but the SupraHD and Momentum are really taking off now, and we think the percentage of the Gen9 will decline and the SupraHD will win more and more systems.

Heidi Poon, Piper Jaffray

So is Gen9 already below 30% relative to the DTV revenues then?

Dr. Levy Gerzberg, President and CEO

As I mentioned, it is small but we prefer not to provide specific breakdown in percentages.

Heidi Poon, Piper Jaffray

Okay fair enough. For digital cameras, given that you’re expecting to outpace the market growth, couple that with ASP erosion that you mentioned earlier in the year, what is your expectation for the year for this segment?

Karl Schneider, Senior Vice President and CFO

Our ASP erosion?

Heidi Poon, Piper Jaffray

Your share gain that’s going to outpace the market coupled with the ASP erosions.

Dr. Levy Gerzberg, President and CEO

We believe that last year in 2005 we were very close to the 20% marketshare including everyone, including the captive solutions, and we believe that this year we’ll see a nice marketshare growth. This is based on the design win cycles, actually it’s related to the previous questions which have been answered completely. Some of these design wins take at least nine months, sometimes a year for high-quality cameras to come out. So based on this, we know what design wins we have already, but we believe that our marketshare in digital cameras will increase beyond the 20%. Related to your earlier question about Gen9, one thing I did not mention is that actually in Japan, in the Japan cable digital TV market, actually we have a significant marketshare with Gen9, so this will continue for a while.

Heidi Poon, Piper Jaffray

Well, I’m asking my question to understand whether Gen9 was contributing to the better-than-expected performance on the quarter…now higher ASPs though.

Dr. Levy Gerzberg, President and CEO

No, the better than expected quarter is a result of very good momentum with our product, the SupraHD and demodulator chip, both of them.

Operator

Sir our next question is from Rick Schafer with CIBC World Markets.

Dan Morris, CIBC World Markets

Hi guys this is Dan Morris actually calling in for Rick. Let me add my congratulations on the quarter. Just to follow up a little bit on the camera question, come out a little bit different way, in your first quarter, do you have any estimate on what the merchant captive split was and then maybe what it might be towards the end of the year?

Dr. Levy Gerzberg, President and CEO

Well, part of the merchant versus captive is increasing. The captive percentage of the market is going down, probably it’s going to remain mostly in SLR and higher end cameras, but we believe that this year it will probably approach the 40% or below 40% for captives, so 60% of the market or more than that towards the end of the year is going to be serviced by merchant semiconductor suppliers such as Zoran.

Dan Morris, CIBC World Markets

Okay, and you mentioned that the retail pricing has kind of opened up at those merchant sockets, and I’ve think you’ve also mentioned previously that’s going to have also have a little bit of impact on your margins. Can you just talk about if there was any impact this quarter and where margins might have ended up by the end of this year, if it’s going to be closer to corporate average?

Karl Schneider, Senior Vice President and CFO

Yeah, Dan, I think we’ve indicated all along that the margins in our digital camera COACH products would be coming down because they were quite high for a consumer product like that. So, our ASP declines are coming down, a couple of percent or so a quarter and that’s going to impact the market.

Dan Morris, CIBC World Markets

Okay great, thank you.

Operator

Sir, our next question is from the line of Quinn Bolton with Needham & Company.

Quinn Bolton, Needham & Company

Hi, just wanted Karl to sort of get to the gross margin drivers again. It looks like quarter to quarter you get maybe 100 basis points, so benefit from the MediaTek royalties starting to flow in and then the product gross margin probably about flat quarter over quarter, is that kind of the right way to look at it?

Karl Schneider, Senior Vice President and CFO

It’s close.

Quinn Bolton, Needham & Company

And then within the products, probably better margins, is that a safe bet, it’s a 9 ramp in DVD and slightly lower D-CAM?

Karl Schneider, Senior Vice President and CFO

That’s correct.

Quinn Bolton, Needham & Company

Okay, and then just a couple or product-related questions, can you give us an update on sort of your activities around your H.264 and VC-1 cores and when you think you have that core ready for your various DTV, digital DVD markets, etc.?

Dr. Levy Gerzberg, President and CEO

I’m sorry, can you repeat the question, what core are you talking about?

Quinn Bolton, Needham & Company

Just your H.264 and VC-1 core for say digital TV or digital DVD markets?

Dr. Levy Gerzberg, President and CEO

This is aimed sometime next year.

Quinn Bolton, Needham & Company

But will you have product sampling this year or do you think it’s for introduction next year?

Dr. Levy Gerzberg, President and CEO

It’s towards the end of the year, and actually we don’t like to give too much guidance about products that have not been announced, so I can tell you it’s in the development pipe and it will be there when the market really needs it, so stay tuned.

Quinn Bolton, Needham & Company

Okay, and then following up on the DTV question, it sounds like SupraHD and Cascade are now more than half of the business, and it sounds like Gen9 is a relatively small percentage now?

Karl Schneider, Senior Vice President and CFO

Well Gen9 has come down as a total percentage, Quinn, but we are ramping SupraHD and it will continue to ramp, and Gen9 will get smaller.

Quinn Bolton, Needham & Company

Okay, but no comments?

Karl Schneider, Senior Vice President and CFO

Not on the exact mix.

Quinn Bolton, Needham & Company

Okay, and then finally, can you give us an update just in terms of the tier 1 Japanese, how many have you penetrated to date and do you think that that increase is by the end of the year?

Karl Schneider, Senior Vice President and CFO

That’s in television?

Quinn Bolton, Needham & Company

Sorry, in the digital camera space.

Dr. Levy Gerzberg, President and CEO

Oh, digital camera space, we have a number of tier 1s. In the past, we talked about Pentax and we mentioned some designs with Olympus. They are coming, stay tuned. Some cameras are on the market and we are not at liberty to mention them, but at least there at least two more famous tier 1 camera makers in Japan that are now using our COACH solutions. So, hopefully we’ll be in a position to talk about it openly in the near future. You’re welcome to go to WolfCamera and Best Buy with a screwdriver, open some cameras, and you’ll see it.

Operator

Sir, our next question is from the line of Vernon Essi with Janney Montgomery Scott.

Vernon Essi, Janney Montgomery Scott LLC

Thanks for taking my question, mostly financial ones here. Karl, I wanted to just revisit the interest income and what guidance you would be giving us going forward. You had $1 million incrementally, should we just back that out and kind of run with it from here, or are there any other extraordinary items for that line?

Karl Schneider, Senior Vice President and CFO

I don’t think, Vernon, you can expect to see any of the extraordinary items like the gain on the stock-based investments, so interest income was somewhere in the neighborhood of $1.5 million and you can just kind of run with that based on cash bonds.

Vernon Essi, Janney Montgomery Scott LLC

Then, what was depreciation in the quarter?

Karl Schneider, Senior Vice President and CFO

Depreciation?

Vernon Essi, Janney Montgomery Scott LLC

Yes.

Karl Schneider, Senior Vice President and CFO

Let’s see depreciation was approximately about 2.5 or so.

Vernon Essi, Janney Montgomery Scott LLC

All right. Finally, in your non-GAAP adjustment tablet, I’m trying to reconcile the litigation settlement revenue that you back out, and in that number obviously it looks like your tax effecting that, I’m curious if there are another fees that go into that as well from a litigation standpoint, does the note reflect or it is mostly just taxes?

Karl Schneider, Senior Vice President and CFO

That is the net to Zoran, the $30.1 million we talked about, it’s the net received to Zoran before the tax effect, and the tax was about $6 million.

Vernon Essi, Janney Montgomery Scott LLC

Okay, and is there…just a curiosity question, why would that be tax effect at a different rate than the corporate rate?

Karl Schneider, Senior Vice President and CFO

Well what I tried to do is because…remember our corporate rate is a worldwide rate. On a worldwide basis, the rates without the litigation are about approximately 13%. But if you take the litigation settlement, which is all US-based income, our US rate in the US is 20%. So, that’s an incremental piece that you can use to come up with the EB impact on the litigation on our net.

Vernon Essi, Janney Montgomery Scott LLC

Then, going back to the OpEx question, going forward, what sort of litigation expenses should we be looking at, it seems like it’s obviously dropping dramatically or they have in the past, but it’s very nominal?

Karl Schneider, Senior Vice President and CFO

Yeah, I mean it’s just nominal. The only way that we can really judge that is if there’s new litigation that comes up, but right now the MediaTek litigation is over and there’s no more expenses to be expected from it.

Vernon Essi, Janney Montgomery Scott LLC

Okay, thank you.

Operator

Sir our next question is from the line of Dan Scovel with Tokeneke Research.

Dan Scovel, Tokeneke Research

Thanks, last quarter, it seemed be negative, I was wondering if you could elaborate on what’s going on in your imaging business?

Dr. Levy Gerzberg, President and CEO

Hello Dan, long time no hear.

Dan Scovel, Tokeneke Research

How are you Levy?

Dr. Levy Gerzberg, President and CEO

Good, thank you. The imaging business, as we mentioned, we experienced a slight decline in our business during the quarter, primarily because of the shift in the market between various suppliers, so at least one of our customers lost marketshare, but what we’ve been doing is we’ve been coming out with a number of new solutions, one of them we mentioned that will be aimed at the laser printer market, and also we’re learning that some of our customers are gaining very nice OEM positions with some of the larger manufacturers. So, we think in the second half of the year we’ll start to see growth and momentum in the business; this is for the hardware side. The software part of the business, the enterprise continues as we expected.

Dan Scovel, Tokeneke Research

Okay, so the software has continued to march along, it’s the hardware side where you’re seeing some variability there?

Dr. Levy Gerzberg, President and CEO

That’s right.

Dan Scovel, Tokeneke Research

Also, on the DVD side, could you talk a little bit about what’s going on in that market, is the market itself actually growing significantly, or is it more so that you’re gaining share and how is the HD disaster sort of playing into that?

Dr. Levy Gerzberg, President and CEO

The DVD market is growing somewhat, it’s not a huge growth, but we think that our volume is growing percentage wise more than the market growth, and this is really an indication of the marketshare growth. Certainly, in the areas that we mentioned -- the DTV connectors, DVD players -- we see a nice momentum there. DVD market in contrast to what some people thought is continuing to grow. There are new territories that we mentioned -- South America, Far East Asia, Eastern Europe. So, our marketshare is growing and we’re happy with the results so far. We will continue to provide better and better solutions. We’re obviously gaining momentum and we’ll continue to support it. Now, in terms of the HD DVD or BlueEye DVD, it’s not taking off yet. There’s no market yet. Here and there we’ve seen some solutions on the market. The quality of these solutions is not that impressive based on what we’ve seen. We’ve just looked at the commercial available system here in our theater. It will come, it’s not there yet. We believe this is at least a couple of years too early. However, we are working on our own solutions for this market and we will be format agnostic. We will be able to support all the various formats in this market, and when there will be market we’ll be there.

Dan Scovel, Tokeneke Research

How do you see your customers dealing with the format war?

Dr. Levy Gerzberg, President and CEO

Of course, there are several camps and our strategy has been to team up to support all of them, and our solutions which will be out early next year will address all of them. Some of our customers supporting Vaddis, the Toshiba camp will stay with HD DVD and some system manufacturers will support both, like Panasonic is saying it and some others. But anyhow, we are going to be universal. We’re going to provide the solution that will satisfy everyone, and you’ll hear from us early next year about it. We believe that the market itself is a 2008 market, not really before that, in terms of volume.

Dan Scovel, Tokeneke Research

And back to DVDs, is most of that growth occurring at the low end of the market?

Dr. Levy Gerzberg, President and CEO

Actually we have a local solution. We have several flavors of our solution. The Vaddis 9 could be a very nice solution for the lower cost market, but our focus is really the HD9 DVD where we see very nice demand and a nice growth, and we are going with it.

Dan Scovel, Tokeneke Research

Great, nice quarter, thank you.

Operator

Sir, we have a followup question from the line of Brian Alger.

Brian Alger, Pacific Growth Equities

Hi guys a couple of things…can we expect in terms of the numbers…

Karl Schneider, Senior Vice President and CFO

Brian you broke up there.

Dr. Levy Gerzberg, President and CEO

Brian, you are breaking up…operator I think we lost him.

Operator

With that, we have no further questions sir, back over to the group for any further remarks.

Dr. Levy Gerzberg, President and CEO

So, thank you again for joining us everyone, and once again we’re very pleased with the results of the first quarter of the year and we believe we are well positioned in each of our core markets for solid growth in 2006. We will be presenting several conferences in the coming months, all of which are posted on our website. So, please note them down and you can see where we will present. Also, I’d like to remind you again, please do not forget to register for our analyst day which will take place on May 25th. You can call Bonnie McBride at 415-388-1635 to register. We look forward to seeing you there. Thank you very much and goodbye.

Operator

Ladies and gentlemen, we do thank you for your participation in today’s conference. This concludes our presentation and you

may now disconnect.

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Source: Zoran Corporation Q1 2006 Earnings Conference Call Transcript (ZRAN)
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