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Executives

Michael Curran - Integrated Corporate Relations

Matt Frost – Interim Chief Executive Officer, Chief Operating Officer

Tony Principe – Chief Financial Officer

Analysts

Karan Kumar – Private Investor

Bill Jones – Private Investor

Mike Aiu – Private Investor

Dick Voss – Private Investor

John Rohm – Private Investor

Bruce Felto – Private Investor

Scott Kosas – Private Investor

Frank Signia – Private Investor

ON2 Technologies, Inc. (ONT) Q2 2008 Earnings Call August 14, 2008 5:00 PM ET

Operator

Welcome to the ON2 Technologies second quarter 2008 results conference call. (Operator Instructions) It is now my pleasure to introduce your host, Michael Curran.

Michael Curran

Welcome to ON2 Technologies conference call for the second quarter 2008. This is Michael Curran with Integrated Corporate Relations. With me on the call today are Matt Frost, ON2 Technologies Interim Chief Executive Officer and Chief Operating Officer and Tony Principe, ON2's Chief Financial Officer.

Before we begin today's call I'd like to remind participants that this conference call may contain statements that constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements relating to ON2's future financial condition and business prospects. These forward-looking statements are subject to the safe harbor provisions of the aforementioned sections and the Private Securities Litigation Reform Act of 1995. Investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve potential risks and uncertainties including those described in our filings with the SEC and that the actual results or developments may differ materially from those in the forward-looking statements as a result of various factors. We have based these forward-looking statements on information currently available and disclaim any intention or obligation to update or revise any forward-looking statements.

Now let me turn the call over to Matt Frost, Interim Chief Executive Officer of ON2 Technologies.

Matt Frost

As you know, we had to delay our earnings release and conference call until our new auditors had a chance to complete their quarterly review process. Unfortunately, there was a delay in getting the working files from our old auditors to our new auditors and we postponed the call when it became clear that the transfer would not happen in time. We certainly share the frustration with this delay and we apologize for any inconvenience that postponing our release and results may have caused and appreciate [inaudible] patience and understanding.

ON2 reported revenue of $3.3 million in the second quarter, up 38% year over year, but down 27% from Q1. As we've discussed in the past, our quarterly license revenue can fluctuate on a quarter to quarter basis, depending on the timing of deals in the quarter. Our GAAP net loss was $7.2 million or $0.04 per share compared to a net loss of $3 million or $0.03 per share in the second quarter of 2007. Q2 expenses included $1.8 million in non-recurring legal audit and other fees. Excluding these non-recurring expenses, our net loss would have been $5.4 million or $0.03 per share.

We continue to feel good about our prospects and have a healthy deal pipeline, and at the same time, we're focusing on containing costs without constraining growth. As we've discussed previously, ON2's licensing arrangements generally give rise to two primary payment schemes to contribute to ON2's revenue; upfront license fees and back end royalties. In addition arrangements also generally provide for the payment of annual support fees.

ON2's license fees vary significantly in amounts, but ON2 regularly enters into a handful of large transactions, each of which can have a very significant impact on quarterly revenue. The size and complexity of these deals make for prolonged negotiations that frequently span multiple quarters, making it difficult for us to forecast precisely when they will hit, or orchestrate them so that they impact a certain quarter. These deals can skew periodic revenue, making quarter to quarter comparisons difficult, and Q2 was an example of this.

Furthermore with the acquisition of Hantro in Q4, our average overall sales cycle should lengthen as the average deal size has grown. As of today, we've already closed some six figure transactions in this quarter involving both ON2 and Hantro products, and our overall revenue trends continue to improve.

Early revenue in the second quarter was $677,000 or 21% of revenue. Noted as always, royalties were reported as one quarter in arrears. Q2 royalties were up 76% from the second quarter of 2007. They're down 29% from Q1 royalties, which included some catch up payments from at least one customer who shipped products and trades prior to Q1.

These catch up payments are a reality of our business, and we may continue to see them from time to time. Additionally, some customer agreements provide for annual or semi-annual rather than quarterly royalty payments, and these royalty payments can also impact reported royalty revenue for a given quarter.

ON2's royalty trends are encouraging as we see royalties become an increasingly significant revenue contributor. We're optimistic that an increase in basis recurring revenue will mitigate some of the effects on quarterly revenue of large one time license fees and multi-period royalty payments by diluting revenue concentration. Our business model from its up-front license fee and back end royalty components should generate near term revenue as well as providing long term annuity streams that follow, after our customers are implemented and begin distributing ON2's base products. It's also important to note that in the sometimes fickle world of consumer electronics and the internet, not all of the customers products are a hit, and therefore not every royalty bearing license agreement that we've signed turns into a future royalty stream.

Looking at our business activity in Q2, we had over 60 new customers excluding online sales. Major customers continue to represent a significant portion of revenue with nine transactions of $50,000 or more each. Since the end of the second quarter, we have announced that CCTV.com is partnered with us to deliver video coverage of the Beijing Olympics which began August 8 over the web. For those of you who are unfamiliar with CCTV, it is a Chinese State owned broadcasting service that is roughly comparable to the British BBC, which is a large scale deployment of ON2's Flix engine using VP6 which should enable CCTV.com to reduce its bandwidth requirements by as much as 40% while still providing high quality video on demand.

Looking at our product lines, our Flix consumer products counted for 32% of revenue in Q2. Our True Motion VP6 and VP7 products continue to perform well, and we've incorporated some of the features and benefits that will be in our forthcoming VP8 release which we anticipate by the end of the year. Our Hantro product line made up 40% of the revenue in the second quarter.

Looking at revenue geographically, in Q2, 32% of our revenue was from Asia, including Asia Pacific countries, 42% from the Americas, 17% from Europe and 9% from the rest of the world. Those figures include support and web sales and those results remain consistent with recent trends.

On our Q1 conference call last month, I indicated that the company is focused on managing our expenses to improve our bottom line results. As part of this initiative, we've reduced head count by an excess of 10%. As most of you know, we did not re-staff at Hantro after November 2007 acquisition and a significant percentage of those actions represented delayed post acquisition rights sizing.

Among other steps, we've also taken measures that we hope will reduce discretionary SG&A expenses which we found to be higher than we believe necessary to support our business. We've also significantly reduced travel and travel related expenses. It's important to recognize that these measures are cost containment tactics and have been targeted to have a minimal impact on our ability to innovate and to develop and to deliver new products.

The current weakness of the dollar against the Euro has also had a negative effect on earnings, impacting both our expenses since most of our costs are in Euro's and revenue, since most of our revenue over the last two quarters has been in dollars. We are identifying ways to intelligently mitigate risks rising from currency fluctuations and hope that we will be able to reduce the impacts of those fluctuations going forward. We expect to see the benefits of some of these actions in our third quarter results and as we work our way towards earnings per share positive results.

In Q2, our cost of revenue was $1.2 million or 36% of revenue, resulting in a gross margin of $2.1 million or 64%. Gross margin was down from 84% in the second quarter of 2007 and can vary with our quarter to quarter revenue fluctuations.

Looking at our operating costs, R&D was $3 million in line with Q1 but up year over year with the additional of the personnel at Hantro. Sales and marketing expense was $1.2 million, and was also up year over year due to the Hantro acquisition last year. General and administrative expenses of $3.9 million were up on a year over year and sequential basis and included several non-recurring charges in the quarter. Among those, were $1.8 million in legal, audit and other costs relating to our internal investigation and lease statement.

Our net operating loss carried forward remains over $130 million. Our second quarter GAAP net loss was $7.2 million or $0.04 per share.

Looking briefly at our balance sheet, we ended the second quarter with cash and equivalents of $8.1 million, a decrease from $12.8 million at the end of Q1 due to our cash outflows in the quarter which were exacerbated by the non-recurring expenses we incurred in the quarter.

We remain comfortable with our cash levels and anticipate improving revenues coupled with aggressive cost containment will allow us to return to a positive operating cash flow position over the next several quarters.

Looking beyond our financial results, we've been busy with a number of business initiatives that you should be hearing more about in the future. We've made great progress with VP8 and are very pleased with our results. We are also working hard on some new business models such as building service offerings for some of our products, developing more video solutions with the intention of moving higher up the value chain.

Finally, we're continuing the integration of ON2 and Hantro and exporting the synergies that our combination has provided. We expect to continue to refine the organizational structure over the coming weeks and are enthusiastic about the effects that will have on our ability to produce and sell products.

Lastly, as you know, we've been conducting a CEO search. We're making progress on this front. We don't have anything specific to announce at this time, but you should know we are carefully considering a number of highly qualified candidates and expect to start narrowing down the list in short order.

To summarize, while our financial results are not optically appealing due to the normal quarter to quarter lumpiness, our pipeline of deals and opportunities is large and active. We've already closed significant business in Q3 and we believe that new business, coupled with the cost reductions we are implementing should have a positive impact on earnings in Q3. We are committed to generating positive cash flow and net income and are confident that we are moving in the right direction. Thank you for your interest in ON2 and your interest in our presentation today.

We will now take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from Karan Kumar – Private Investor.

Karan Kumar – Private Investor

It's sad that we have such a great technology but every two years we come into this huge expense where the lawyers and accountants make more money your hard work.

Matt Frost

That is certainly a sentiment that we share. It's absolutely true. It is a pity and it's certainly something that we're very keen to avoid and very much focused on avoiding, and management spent a lot of time over the last six months trying to make sure that it doesn't happen again and certainly it's one of the factors that's weighing very heavily on everybody's minds during the recruitment process.

Karan Kumar – Private Investor

Do you think the Board should take responsibility for what's going on over the last three years? The Board members remain the same. Do you feel strong about the Board? I don't know if you're going to be able to honestly answer that question.

Matt Frost

I can honestly answer that question. The Board does take responsibility. I think that like management, a lot of the evidence of the Board's responsibility is in the great deal of time that they devote on to On2's affairs, and with what we've been through during the past six months, it's required a lot of time of these Board members, all whom have other jobs, all of whom are busy doing other things, and nevertheless make time for meetings on weekends, and over Memorial Day and late at night. And so I think we have a very involved Board.

I think we have a very broad range of abilities on the Board and personally, I think that they're very committed to the company. They have been very involved in the assessment of what has happened in ON2 and how to avoid the pitfalls that tripped us up last time. So I think that the shareholders should be comfortable that this company is in good hands with the Board of Directors that it has and really should feel confident that they are guiding this company well.

Operator

Our next question comes from Bill Jones – Private Investor.

Bill Jones – Private Investor

The amount of shares have been building up over the last four or five years and there was talk of a reverse split this time last year. For some reason it didn't go through and I'm wondering as you move forward with your cash situation, do you consider the possibility of another reverse split as time goes on?

Matt Frost

I'm sure there are a number of shareholders who are listening to you on the call and I'm cursing because reverse splits have not been the most popular topic at ON2. When we undertook it and concentrated it last year, one of the things that was driving it was the talk that perhaps we'd move on to the NASDAQ which has a minimum share value as a precondition for being on the NASDAQ. Another thing that we were focused on was trying to increase institutional ownership and some institutions have break line rules that they won't invest in companies who are trading at below a certain dollar value.

Things worked out in such a way last year that there was some downward pressure on the stock at the time that we would have gone through with the reverse spread and it seemed at the time that it wasn't necessarily the right move for ON2. There are two schools of thought on reverse spreads. There's one which a number of our shareholders subscribe to which is that no company does a reverse spread ever recovers its market capitalization to pre-split levels. There's another that says that companies that are doing well that have a good story behind their reverse spread, do do well.

And so I don't think that it's something that we're currently contemplating, but it's always a possibility, but right now what we're really focusing on is just driving the business. Thinking about reverse splits now is something that's maybe a little bit of a luxury because we have to just buckle down and focus on closing deals and controlling costs.

Operator

Our next question comes from Mike Aiu – Private Investor.

Mike Aiu – Private Investor

My concern is your royalties and your expenses. I'm looking at royalties that either stay flat, go up, come down, and I personally run a royalty based business and royalties just do not work in this manner. Last quarter you reported 21% on $4.1 million which came in at over $900,000.This quarter you report 21% on $3.3 million which comes in under $700,000, and it just seems to be all over the place. You guys keep claiming that lumpiness comes in from big deals and royalties should help alleviate that.

Your expenses, you reported last quarter that your expenses should be $2.9 million if I recall correctly, and from I'm looking at, you came in at about $1.8 million over expenses. How come you guys can't get that straight? I mean, when you through a number out there to investors of 2.3 by month which is 6.9 per quarter then you come in somewhere around 8.7. It just doesn't make much sense. It doesn't give confidence to us investors out here as to what you guys are doing out there.

Matt Frost

I guess I'm a little confused on exactly what you're talking about the expense number. That doesn't jive.

Mike Aiu – Private Investor

Last quarter in your report you reported that ON2 needs $2.3 million per month in operating expenses which comes down to $6.9 million. That was in your release. Now excluding the one time charge for attorneys you came in at about $8.7 million which is $1.8 million above what you claimed that you needed. That's one, and also the royalty question if you would.

Matt Frost

I guess turning to the expense question first because that's clearly a subject that's on everybody's mind. As we said last quarter, the expenses that we've been incurring over the last several quarters have in our opinion been higher than are necessary to support a business of this size, and part of that has to do as we discussed, the one time expenses that we've incurred, that I referred to in the first question, the one time expense that we incurred in connection with the investigation and the restatement. And those are expenses that we hope are basically capped in Q2. There may be a very small amount of those expenses in Q3, but those should be disappearing. And we need to control those expenses by making sure that we have controls in place that prevent the occurrence of the problems that we had over last two quarters and into last year.

But as well, our core operating expenses are high and as I said, as we committed to doing in the last earnings call and as we have been doing since the last earnings call, we have spent a lot of time identifying cost containment measures. We've made a number of very difficult decisions including decisions to let go a number of employees that both on the ON2 and Hantro side and to eliminate a number of positions at both organizations.

In addition we focused on some of the discretionary SG&A expenses. We've significantly reduced some of our discretionary marketing budget and we believe that when fully implemented this should result in savings of approximately $1.2 million from our budget in cost amounts. Now I should note that some of these costs, as anyone who's done this knows, it takes awhile to get the benefit of these cost reductions. When you say we're going to reduce travel expenses by 75% or 50%, or whatever the number is, that's a number that you can influence immediately. But when you talk about things like eliminating leases and terminating employees, that's something where there's severance payments and it can take a little longer for it to kick in.

And so with that we expect to see really to reap the full benefit of that probably two quarters out, meaning six months out, so not in the first quarter of 2009, but really fully in the second quarter of 2009.

Mike Aiu – Private Investor

What about the royalty issue?

Matt Frost

We have a number of different products that bring in royalties on both sides of the business; on the Hantro side and the ON2 side, and they can vary from royalties on PC based products, on products that enabled with faction coders where the royalty amounts that we get very much are dependent upon sales of consumer products or sales to businesses of those products. We have royalties that are on individual video devises so multi-media devices and mobile type devices. Those react slightly differently to market demands and those are obviously at a different royalty level.

On the Hantro side the royalties come in, in most cases on the deployment of consumer electronics and mobile electronics which of course is Hantro's main business. So to the extent that you were saying the growth isn't where you've expected, as we've said numerous times I think, it's a very long cycle from our actually closing a deal with a customer to implementation of our technology and a customers products. And if we're talking about ON2's True Motion technology, even if it's a software based solution that gets implemented, say for instance when Macromedia put in Flash, that was a deal where it took 15 months for it be put in, for it to be fully implemented and rolled out.

On the Hantro side there's hardware IP and RTO designs. Its three years before the product licensed by a chip company, grows to a tape out that is produced in silicone, then gets integrated by an OEM into a handset which then gets put on the shelf or taken by a carrier and sent out to customers. So it takes a long time for us to go from deal to starting to count the money that's rolling in on royalty reports.

Operator

Our next question comes from Dick Voss – Private Investor.

Dick Voss – Private Investor

My question is regarding the challenges that are being faced from the adoption of the H264, and I'm just curious about how is VP8 going to address those challenges, specifically regarding performance, new generation hardware from a performance and efficiency perspective. Can you enlighten us a little bit on that?

Matt Frost

H.264 poses a challenge on a number of different fronts. In reality we have space in the Flash ecosystem. It's a competitor to VP7, and when VP8 rolls out it will be a competitor to VP8. But I think that we believe that there are a number of reasons with all those products. I guess VP7 and VP8 can sort of be lumped together as the latest generation codex. But there are a number of reasons that we feel that our products will remain competitive.

With respect to VP6, which pre-dates me at ON2 so it's at least five or six years old, remains very competitive with H.264 and in many situations exceeds H.264 in our PS&R tests which are the tests that we run to determine differences in qualities between competitive codex. In addition, one thing that our codex of all generations have going for them is efficiency in coding which means that they're very well coded. The algorithm are well designed and they operate more efficiently on CPU's, DSP's, than an H.264 does.

And then there's the general commercial benefits from licensing of ON2 which is, when you go to ON2, you're not just licensing IP which is what you get when you go to the MPEG licensing association from which you get license rates for H.264, so if you go to MPEG LA, all you're getting is the right to operate under some patents. For that you're going to pay per unit royalties and you're subject to restrictions and potential additional royalties for commercial streaming.

Whereas with ON2 you come to the guys who invented the technology and you get both an implementation of the technology as well as the right to operate under out IP.

With the VP7 and VP8, you're talking about newer generation products. Just even VP7 which are in most cases superior to H.264, particularly in live streaming applications. Again, they don't come with a lot of the burdens and patent restrictions that you see from MPEG LA, and we have licensing flexibility that the MPEG LA doesn't. If you want to license H.264, there's one licensing model and if you try to negotiate for a different licensing model, you're not going to get it.

With ON2, we are partnered with many different people using video applications and we're very open to different licensing structures with them, and it's something that many of our biggest customers have found particularly attractive about us.

Finally, I think there's some concern from some that there's this slow move toward H.264 which is inevitable. It's a perception. You look at our customers from Skype to Mood Networks to Adobe to Sun, and they're clearly customers out there who don't just want plain Vanilla video. They want the latest and the greatest and they want video that's going to make their application more competitive than those people who are out there using the standard space technology. And we are a company that can innovate much more rapidly than our competitors and that time and time again have come out with new generation codex that surpass anything are available in the market.

So H.264 is a reality of our business and there are some deals that are going to go to H.264 for reasons that have nothing to do with the quality of the video but simply there's existing content in each H.264. There are other technical reasons to go to H.264. But one other thing that's very much worth mentioning is, we have a very vibrant H.264 business on the Hantro side and to the extent the customers are looking for H.264 that's going to drive our TL sales and embedded software sales on the hardware side. We've got H.264 support in a number of our Flix products.

So we certainly have a door into what to expect with H.264 business but for our core codex business I think we absolutely will remain competitive. We are competitive with VP6 and VP7 and I think our shareholders will be very, very pleased when we come out with VP8, because I think we'll be even more competitive with VP8.

Operator

Our next question comes from John Rohm – Private Investor.

John Rohm – Private Investor

I had a question about the progression of revenue. I'm looking at 2006 and early 2007 there seemed to be a fairly steady progression of revenue since the company launch of Flash 8 and it sort of peaked in the core revenues about the first quarter of '07 and since then things have been sort of very volatile and actually this year fairly down. As a matter of fact, you quoted up 38% from the second quarter of '07 in the release but when you look at the combined company, the total revenues are down quite significantly for Hantro plus ON2. Is that correct?

Matt Frost

On a quarter by quarter basis, that's correct if you look at Q2 versus Q1. I think something that we've said on previous calls and will continue to say is that we have very lumpy revenues. Taking Hantro alone for instance, you look at Hantro's performance a year ago in Q1 '07, they did something like E500,000 to E600,000 in business and yet by the end of 2007 they were producing $4 million in revenue. So that number may be wrong.

Hantro has business that changes significantly from quarter to quarter depending on when the revenue falls and so I think you have to step back and take a look at a broader period when you're looking at the revenue of the combined companies.

John Rohm – Private Investor

I'm talking about the year over year revenue from the first half of '07 versus '08. But my question is, seeing that the core of ON2 and non Hantro revenues have declined since that peak in the first quarter of '07, how much do you think has been the impact of Flash incorporating it's H.264 to affect those revenues in terms of an alternative?

Matt Frost

I think it's a little premature to say. I think there's been some impact in that there's some free tools out there which some customers who are not interested in support can go and use to produce Flash with H.264. But having said that, we support H.264 in many of our Fliks products and we think we have more robust products than our competitors do and certainly than the free tools that are out there.

I think some of it is, you do expect to see a slight plateauing of revenues from products like Fliks as you see some saturation in the market. And that's one of the reasons that it is incumbent upon us to innovate within our Fliks product line and it's one of the reasons that our product manager in Fliks is devoting a lot of time in thinking about how to improve the product, how to improve our engine product which is still a significant driver of revenue.

But I think also, as we've said in the past that you're witnessing a little bit of a shift in ON2's business in that we saw an increase in the encoder business and then coming along we see a slow increase in royalties from devices as we start to enable the Flash ecosystem with VP6 video on devices. The same thing holds true on the Hantro side where we're seeing Hantro royalty revenue coming in.

So there's no denying that there's been a slight slowing of the Flix business, but I don't think it has any of us wringing our hands. I think it's some of it's to be expected and some of it we can influence with continued improvements to products, pricing variation. So even with H.264, we support H.264 but there are people who are buying our Flix products not simply because we put VP6 into it but because it's a very good Flash encoding and transcoding product, and the same engineering genius which brought you our codex bring you excellent transcoding product. And so in that case, H.264, the addition of H.264, they've only been driving additional sales for Flix.

Operator

Our next question comes from Bruce Felto – Private Investor.

Bruce Felto – Private Investor

I'm calling to find out primarily a lot of people that are investing in the company have been looking to technologies move to devices and you're starting to see some of that with some of the major deals that ON2 signed last year but are somewhere in the pipeline. I guess my question is, I'm looking for some information, for example it was recently Apple – gets $50 per device for IP for device, just for device there's $50 worth of IP. Sorenson had a thing out for Spark that PR out for a product that was the optimization device for just the Spark Kodak, $0.20 per device.

Investors that are looking towards royalties and what they can be done down the road with some of the major deal, areas where those per unit royalties could be. I understand the need for you to have a flexible licensing scheme and how those terms are not revealed, and it's understandable. But at the same time I think investors need to know what kind of per unit royalties are capable of the video IP that we're selling and the designs that we're selling. Is it in the range of $0.20? Are some of them in the range of $0.50? Is somebody going for the all in one solution, is it around $1.00? How can you comment on that?

Matt Frost

My first comment would be to say it's very astute of you to say that you realize that there would be a competitive disadvantage for us to really reveal precisely what our pricing is, other than to say that we're in a business where there are other pricing models that are publicly available and we have to compete with that business. And so you can look around at video codex and MPEG 2, MPEG 4, H.264. You can look at the audio codex and sort of get a sense of what the range of pricing is.

The classic business model for us as we've spoken about, is an upfront license fee and a back end royalty. In that case, royalties meaning per unit royalties based on customer deployment of devices. Unlike MPEG LA, though, there are other pricing models for us and we have other ways of sharing in the success of customers on deployments, as so we don't adhere only to a per unit royalty model when there are other models that may work better with our customers monetization plans and that may allow us to reap the benefit of our customers success while giving our customers a model that scales better with their business.

So I know that's not going to be an entirely satisfactory answer other than to say you can look around and get a sense of what the model is that this industry adheres to and definitely we will say that's the sort of the same model we're focusing on.

Bruce Felto – Private Investor

What about device certification? Is ON2 [inaudible] Have you considered that?

Matt Frost

That is definitely something that we've considered. As we rolled out, I think more on the True Motion side, so our proprietary codex side, it's definitely something that we faced as we've had more and more manufacturers out there who are implementing VP6 and to a lesser extent VP7 on devices, and then they will come back to us and say, "Can we get some sort of certification that this is working?"

And for those of you who may not be familiar with this concept, I think a good example of this is Divix, although I think there are other independent third parties who have a test suite of dozens, hundreds, maybe even up to the thousand different clips or different tests that a video decoder for instance is run through to ensure that it is completely bit stream compliant and that it can decode any VP6 or VP7 content that's thrown at it. And for that, and for some sort of a certification that says to a manufacturer that's going to roll out potentially millions of products and wants to make sure that their investment is well spent and that they're not going to find that they have some sort of a bug in hardware or in software once they're rolled it out.

They're looking for some sort of seal of approval from ON2 and it's definitely something that we focused on. I can't guarantee that we're going to do it, but it's been very seriously bandied about here.

Operator

Our next question comes from Scott Kosas – Private Investor.

Scott Kosas – Private Investor

Last year Hantro was due to receive some bonus shares based on 2007 performance. Can you update the investors on where they were at in terms of meeting those bonus goals and how many shares they're set to receive or not receive and when that would eventually take effect with the filing that would increase the share count.

Matt Frost

What you're talking about is the earn out in connection with the Hantro acquisition, and that earn out was a provision in the acquisition agreement which basically awarded the Hantro shareholders additional shares if they met certain performance targets. And in this case, the performance targets were annual revenue numbers of an excess of E9 million and Hantro met that number and so automatically it became entitled to receive the additional earn out shares. And those earn out shares were payable. Unfortunately there was a delay associated with our closing of the books for 2007, the lease statements. But those shares have been paid out to the Hantro shareholders.

Scott Kosas – Private Investor

What is the current share count?

Matt Frost

I believe there's 11.1 million.

Scott Kosas – Private Investor

And what's the current total share count?

Matt Frost

It's in the 10Q. I think it's 171 million.

Scott Kosas – Private Investor

And the Hantro shares are included in that.

Matt Frost

Yes

Scott Kosas – Private Investor

Do you foresee any future dilution or authorization of any of the shares that were authorized via the voting of last year or would you put that to a shareholder vote if that was to happen?

Matt Frost

We don't have any immediate plans to issue additional shares in terms of a sale of shares or any acquisitions at present that would be paid for in part with shares. Certainly, there are certain transactions that if we had took and succeeded, and we were issuing shares in excess of some percentage of outstanding shares, I think the number may be 20% but that may be high, that we have to seek shareholder approval. And if that were the case, we would certainly do so.

With the exception of option grants or the likes, or ordinary course of business option grants, I don't think that there are any additional issuances that we see in the future.

Operator

Our next question comes from Frank Signia – Private Investor.

Frank Signia – Private Investor

It seems like in this part of the industry, Microsoft and Adobe seem to be facing off as the two major competitors in providing this type of video over the internet and to mobile devices. Our relationship with Adobe I feel is very important to us. Do they feel the same way and are they going to let us help them to stem off the undue shadow of Microsoft as per their Silverllight as they're doing with NBC during the Olympics?

Matt Frost

I think that's definitely an accurate depiction of the landscape. I think if you look at all of those big companies, Microsoft, Adobe, Apple, Google, Yahoo, even though they're not all in the same businesses, they nevertheless are all looking at one another and each of them are playing in a certain way and a business that overlaps with one another and they're all jockeying for position.

We were talking about this earlier today internally about Silverlight. Certainly Silverlight, it's a good product and it's made some noise and I think it was certainly cool for Microsoft that it got the deal with NBC. Having said that, flash adoption is just huge and it has a very, very big advantage. It absolutely is ubiquitous and when I went to look at the Olympics on NBC, I had to download a Silverlight player and even though downloads have gotten a lot quicker and players have gotten a lot smaller, it's still not the same as just pushing a button and watching the video.

So I don't know that the executives at Adobe need to lose a lot of sleep over Silverlight, but having said that we also base our business at ON2 on the assumption that there will always be another video player, that people are always looking for better video and that those people who are in the business of producing video, and rest on their old technology are going to lose to those people who are out there who are pushing for the best video, because that's what the market's really demanding.

With respect to your question about our relationship with Adobe, obviously we're sort of limited in what we say, although I have to say we have a long history with Adobe. We've worked closely with them. It is certainly ON2's aim to have a strong partnerships with all of their customers and I think that it's a testament to the strength of our engineers because really the people who sell ON2's products in many ways, are the engineers who go in and support customers as they're contemplating buying products and developing strong relationships at the engineer level or product manager levels that keep people coming back to ON2.

So as with all of our customers, we try to maintain a very strong relationship with Adobe and we have a lot of respect with what they've done with out technology and we look forward to a long and strong relationship with them.

Operator

We have a follow up question from Dick Blass – Private Investor.

Dick Voss – Private Investor

I'm encouraged by the Asian market penetration that you're starting to realize in ON2 and I'm wondering if you could expand a little on the scope of the CCTV deal especially on future revenues for the combined companies, Hantro, ON2 and maybe if you could provide us a few examples of the monetization that can be realized arising from that deal.

Matt Frost

First of all we share your enthusiasm about the Asian market. I think that the timing is right for us but I think we also benefit from having a very strong team in Asia. We've got a strong regional sales manager in John Fargiss and we picked up a very, very strong sales team from the Hantro side who has really caught the fever of ON2'a product. I think it's having a lot of success there.

The CCTV announcement was really a feather in our cap and we're very pleased to have been part of the CCTV's broadcast of the Beijing Olympics. So for a sale like that, everyone knows that's an engine sale, so Flix engine is our carrier grade video and transcoding products that sits on a customers servers and ingests video and transcodes it in this case into Flash 8 VP6 video.

That's a business which we make money off of through the sales of these servers and as adoption grows and as CCTV processes more and more video, they're going to need more and more servers and so we should see assuming growth in CCTV's use, we should see an increase in our revenue from that. Now having said that, we're selling servers, there's a limited number of servers, so while this is a real revenue producer for us, it's not where we are really seeing the future revenue coming from, from that deal.

For us, these deals, and frankly the entire experience with EGC video has been about developing content that drives use of ON2 decoders because what CCTV represents to us is the production of highly valuable, highly sought after content which people are going to want to view. And ultimately, that helps us as we go out and talk to chip manufacturers and talk to device manufacturers and mobile handset manufacturers about supporting VP6 on devices.

And ultimately, looking at the Hantro side of the business, that's going to drive sales of 81/90 when it had VP6 included in it and on the ON2 side, it should drive sales of our embedded software SDK. So it can arm SDK with an arm being the common processor in mobile hand sets. So the monetization is really two fold. Sales of engines to CCTV and then the bigger part which is why we're most excited about this deal is driving forward the consumption of VP6 based flash content and support for that on devices.

And then the side benefit of this is just as with any high profile adoption of ON2's technology, is that here we have this major network in China saying, "We looked at all the technology out there and we adopted ON2's Flix engine." And for the growing number of EGC section in China, we're very hopeful and I think some of the feedback that we've gotten is that this has been a meaningful decision because they're looking at this as a probably state owned agency, which clearly has very sophisticated IT department and has done their due diligence on our products, and they've sort of given the seal of approval to ON2 engine and to VP6, and we hope that that will drive further sales within the EGC market which in turn should produce more content, which should drive adoption on devices.

Operator

Our next follow up question comes from John Rohm – Private Investor.

John Rohm – Private Investor

You mentioned that the expense reduction that you're putting in place you believe will take effect by second quarter of '09. Did I hear that correctly?

Matt Frost

Yes, I think that's what I said.

John Rohm – Private Investor

Looking at your cash available, you had a cash burn last quarter approaching $5 million. You have about $8 million left. Do you see a need before that time in the next 12 months to go raise more capital?

Matt Frost

No, responding to the earlier caller who was asking about dilution. We don't currently foresee any need to raise capital. As part of this process of looking to reduce expenses and focusing on cost curtailment, obviously our number one concern was making sure that we had cash on hand to run the business, and we went through the process of evaluation using very, very conservative revenue numbers.

I'm really analyzing on a cash basis rather than a recognizable revenue basis and so we feel comfortable that we have enough cash to take us forward over the next 12 months and more over, that we have cash on hand to in the slim chance that we have to weather another bad quarter or two. So I think that we are able to make enough immediate impact on expenses to really have a significant impact in the next two quarters, just not as big an impact as we'd like to see ultimately. And then also we encouraged by our revenue trends and our deal pipeline and so we do feel that we'll have a revenue boost to take us through. But the long and short of it is, that we've been making these expense cuts very much with an eye towards ensuring that we have cash on hand to run this business without going out and raising additional capital because frankly, we think we should be required to run this business with the cash on hand, and to make it a self sustaining business.

Operator

Our final question comes from Bruce Felto – Private Investor.

Bruce Felto – Private Investor

You mentioned when you stated about service offerings and some more [inaudible] offerings that may be something that ON2 is looking at? VP8 was mentioned at one time it was going to be tied to a significant customer and that its deployment may be tied to that. Is that still the case?

Matt Frost

VP8, I don't think we can talk right now about potential customer deployment other than to say obviously we're very eager to get a big customer to adopt VP8 as early as possible and it's something that we've worked on with VP6 and VP7 and we'll certainly work on with VP8.

With respect to the new business models that we're focusing on again, I don't want to go into it in too much detail, but I can talk in general about what we're focusing and one product offering that we currently have that is an example of this.

I you take our True Mobile offering, that is really a solution rather than a development tool, and historically on the ON2 side, we've sold tools. We've sold source code which is a very low level tool or we've sold software development kits, STK's which are aimed at the developer market. So we've been in the business of selling baking soda rather than selling bread. And what we've been trying to do is get into the bread business a little bit, and doing that by focusing on showing more solutions where we can move up the value chain a little bit and start to get incremental increases in revenue for each of these pieces that we're adding. So it takes something like true mobile or true mobile solution. That can include a VP7 decoder, a true cast player, a true cast server, a ON2 comp encoder. We could as well integrate VP7 into Flix products and conceivably give somebody an entire UGS mobile solution.

So that's what we're really focusing on doing, mainly within our core competency which is video and mobile multi-media, starting to broaden a little bit and starting to produce some products which are more full productized, really ready for the end user which may be a Telco, in some instances it may a consumer, but it's on something that is ready to be run by the consumer rather than something that has to be integrated into a product.

Thank you again to all the listeners who participated in today's call. We look forward to speaking with you again in the future.

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Source: ON2 Technologies, Inc. Q2 2008 Earnings Call Transcript
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