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DTS, Inc. (NASDAQ:DTSI)

Q2 2008 Earnings Call

August 7, 2008 5:00 pm ET

Executives

Ann McGuinness - Investor Relations

Jon E. Kirchner - President, Chief Executive Officer

Melvin L. Flanigan - Chief Financial Officer

Analysts

Ralph Schackart - William Blair & Company, L.L.C.

Brian Thackray - Deutsche Bank Securities

Barbara Coffey - Kaufman Bros.

Lloyd Walmsley - Thomas Weisel Partners

Operator

Welcome to the DTS second quarter 2008 conference call. (Operator Instructions) I would now like to turn the conference over to Ann McGuinness of Investor Relations.

Ann McGuinness

Joining me on the call today are Jon Kirchner, President and CEO, and Mel Flanigan, CFO of DTS.

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

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

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

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

Again this quarter the company is reporting the results of its Consumer business as continuing operations and reporting the activities of its Digital Cinema and Images businesses as discontinued operations. Income or loss from discontinued operations net of tax will appear as a single item below income from continuing operations on the company's statement of operations. Because the Digital Cinema and Images businesses were sold during the quarter, all assets and liabilities related to those businesses has been removed from the consolidated balance sheet as of June 30, 2008.

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

Now I will turn this over to Jon.

Jon E. Kirchner

We posted solid revenue again this quarter. Revenue for the second quarter was $12.8 million and earnings per diluted share were $0.07. Blu-ray products accounted for 11% of our revenue in the second quarter, down from 21% in the first quarter of 2008 and down slightly from the 12% in the second quarter of 2007.

As we mentioned on last quarter's call, some manufacturers are moving to upgrade their Blu-ray products to either add features or reduce costs or both. These upgrades are important as manufacturers now need to produce feature-rich products and at competitive prices. These product transitions resulted in relatively light player production at certain manufacturers. For the first half of the year, though, Blu-ray and HD-DVD products still accounted for over 16% of our revenue, essentially in line with our expectations for the year.

We are now beginning to see increased player availability at retail, with some at prices below $300 and as low as $339 for major name brands. We are also starting to see some Blu-ray Disc Profile 2.0 or BD-Live Interactive capable players, with DTS 7.1 Master Audio selling for less than $400. In June, WalMart ran a special promotion, a $100 gift card with the purchase of a Blu-ray player, making the purchase price effectively $199 for some models. We are also seeing advertisements for high-def TV and Blu-ray player bundles.

On the content side, retailers are increasing their in-store footprint available for Blu-ray titles and have also begun to increase promotional activities to support the Blu-ray format. There are currently more than 600 Blu-ray titles available.

Across the board we have seen an increasing number of movie titles available in the Blu-ray format and at better price points, with new releases available at prices as low as $15.99 and older titles as low as $9.99. Declining prices and greater title availability should help stimulate further demand.

In the PC space, the adoption of Blu-ray by some PC manufacturers is progressing more quickly than had been anticipated, in part because prices have continued to decline for Blu-ray drive components. We understand that the price to implement a Blu-ray drive into PCs has now dropped to below $100. Today there are more than 12 different Blu-ray drives available and more than 40 PC models with Blu-ray capability. Supporting the increasing number of product options is a growing amount of PC advertising featuring Blu-ray, along with declining end-user prices. For example, you can now purchase a Dell desktop PC equipped with Blu-ray drive and integrated DTS 7.1 Master Audio for under $800.

So while still a relatively small contributor to our total revenue, the news from the PC segment is encouraging. We expect to see a more significant revenue contribution from this segment in 2009.

In summary, according to recent reports, more than 80 Blu-ray related devices are expected to be on the market by the end of the year, which should dramatically improve the range of choice, pricing and availability of products for consumers ready to enhance their home entertainment experience. We see these developments as very positive for the long-term potential for the format and will continue to watch closely to see how things unfold in the coming months in preparation for the holiday season.

Turning to our Standard Definition business, in the home AV market revenue was up modestly year-over-year but down slightly sequentially, in line with our expectations. The car market was again solid this quarter, with revenue in excess of $2 million. In the PC market, revenue was up modestly year-over-year; however we made great progress with PC OEMs and motherboard manufacturers. For example, a major PC OEM will shop DTS Surround Sensation this quarter. We expect to see the results of these and other efforts translate into higher growth in the PC segment in 2009.

In the broadcast market the deployment of DTS technology in Norway has begun and the solution is now operational. We saw a small amount of revenue related to this deployment in the second quarter. We have now certified more than 10 DTS capable set-top boxes and continue to work potential broadcast partners.

In another example of our progress in the broadcast market, through our relationship with Linear Acoustic, DTS Neo:6 technology will be used by NBC during the coverage of the Beijing Olympics, offering audiences a more immersive audio and viewing experience. This represents an excellent opportunity for DTS to create exposure for our technologies in the broadcast space and highlight some of the benefits we can offer broadcast customers. Overall, we view our Broadcast business as a longer-term strategic opportunity and will keep you abreast as we conclude deals in the space.

Let me now turn over the call to Mel for a financial review.

Melvin L. Flanigan

Revenue for the quarter was solid at $12.8 million and income from continuing operations was $1.4 million or $0.07 per diluted share. This compares to revenue of $12.9 million and income from continuing operations of $2.4 million or $0.13 per diluted share reported in the second quarter of 2007.

Revenue in the second quarter included $1.8 million in royalty recovery payments, essentially flat with the same period of 2007.

In the second quarter of 2008, stock-based compensation expense was $1.1 million or $0.03 per diluted share net of tax compared to about $800,000 or $0.03 per share in the second quarter last year.

Revenue for the six-month period was $28 million and income from continuing operations was $4.6 million or $0.25 per diluted share. This compares to revenue of $25.5 million and income from continuing operations of $4.3 million or $0.23 per diluted share recorded in the first six months of 2007.

Included in our 2008 results were approximately $1.8 million in royalty recoveries compared to $2.7 million in the same period last year. Also included in 2008 results were $2.2 million or $0.07 per diluted share net of tax in stock-based compensation compared to $1.5 million or $0.05 per share in the first half of 2007.

Revenue from the car market exceeded $2 million in the second quarter of 2008. We continue to expect our Car business to remain at about 15% of total revenue for the year.

Gross margin in the second quarter was about 98%, essentially unchanged from the same period last year.

SG&A expenses for the quarter were $8.8 million and R&D expenses were $1.9 million, in line with our expectations and our guidance of $10 to $12 million in total per quarter.

Operating expenses for the quarter were up 9% over the prior year's second quarter, primarily due to increases in employee-related expenses such as stock-based compensation and expanded foreign operations and increased expenses in support DTS HD and our broadening product development agenda.

Our tax rate for the quarter was approximately 40%, slightly above expectations, primarily due to the effects of geographic mix of revenue. Looking forward, we expect our effective tax rate for 2008 to be approximately 39% and to see the rate trend slightly downward over the next several years.

Turning to the balance sheet, we closed the quarter with overall cash, cash equivalents, short and long-term investments of $108 million, up $23 million thus far this year. On June 30th we continued to hold about $21.5 million in auction rate securities and have further reduced that number to $16.8 million as of today. We anticipate that the remaining auction rate instruments will be called by the issuers or sold within the next 15 to 18 months and as a result have classified these securities as long-term investments. At this time, we have not recognized any realized or unrealized losses on our auction rate securities portfolio as we expect these investments to settle at par.

In summary, we are pleased with our solid performance in the second quarter and with the pace of growth in high-definition related revenue. Looking forward, we have to remain cautious about our near-term expectations given the ongoing uncertainty in the economic environment. Today, no one can predict the impact on the consumer electronics sector if the situation worsens, so everyone in this industry will be watching closely as the holiday season approaches. As a result, we continue to plan for full year revenue of $55 to $59 million, including at least $4 million in royalty recoveries. At these revenue levels, we expect operating profit margins in the low to mid 20s and EPS in the range of $0.52 to $0.58 per diluted share for the full year on 18.5 million shares outstanding.

With that I'll turn it back over to Jon for his closing remarks.

Jon E. Kirchner

In summary, we're pleased with our solid performance in the first six months of 2008. We believe we are on track to achieve our full year expectations and will continue to monitor events as the market for Blu-ray unfolds. Before I conclude I'd like to thank our partners, customers and employees for their continued support and commitment to DTS.

That concludes our prepared remarks.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Ralph Schackart - William Blair & Company, L.L.C.

Ralph Schackart - William Blair & Company, L.L.C.

On the consumer environment, were there any material changes versus your expectations from last call, either sort of positive, negative or sort of in line with what you were expecting?

Jon E. Kirchner

Generally in line with what we've been expecting.

Ralph Schackart - William Blair & Company, L.L.C.

And then on a go-forward basis, do you continue to feel that your guidance reflects some - I don't know if I'd call it conservatism but basically to reflect the current economic environment?

Melvin L. Flanigan

Yes. Yes.

Jon E. Kirchner

It obviously reflects some caution but, in light of where we are and what's going on around us, we've decided that what we've got is the most prudent course.

Ralph Schackart - William Blair & Company, L.L.C.

And then you seem very [bold] up on the Blu-ray cycle and some of the data points are starting to come together. On your competitor's call last week they had talked about some of the skews at this point for the holiday season, maybe undertracking their original expectations, so maybe it's just their expectations game. Can you sort of talk about the skews that you're licensing now for the holidays, '08 and '09, and if you're sort of happy with that throughput today?

Jon E. Kirchner

Well, we've certainly seen a significant increase in the number of players that have been coming through certification and we expect there to be a lot more product on the shelves as we get into the fourth quarter and the holiday season.

We also, based on the data we have, we expect to see a fair amount of more content. And I think there are definitely reports out on the Street about some softness, and I think it's everybody's trying to handicap what happens in the back half of the year. And I think our feeling is that there are a number of elements which, if they come together and the industry really pushes, as we expect they will, they will have some pretty good results for the holiday season.

Now whether they outperform probably depends on your perspective, but I think given where we are today and where we've been, we look forward to what we think will be a pretty solid holiday season, obviously subject to any cliff in the economy which may dramatically change things.

Ralph Schackart - William Blair & Company, L.L.C.

HD as a percentage of revenue was down slightly year-over-year. Can we attribute that to sort of the closeout of the original BD spec and prep of the BD-Live?

Jon E. Kirchner

The biggest difference year-to-year, Ralph, had to do with there was a significant unit volume in game consoles last year as somebody was pushing. And I think, clearly, as we've said, we've seen lighter production between player manufacturers and the end of the format wars. So I think that's the difference year-to-year as to why it's down slightly.

Operator

Your next question comes from Brian Thackray - Deutsche Bank Securities.

Brian Thackray - Deutsche Bank Securities

Getting back to the macro perspective for a second, obviously there's concerns and everyone has their own perspective; when you talk to your customers, the manufacturers on the Blu-ray side, are they concerned about it or are they kind of producing and manufacturing full steam right now in anticipation of the ramp in the back half of the year? Or do you see them pulling back on the manufacturing schedules?

Jon E. Kirchner

With respect to Blu-ray, I think the feedback we're getting in the conversations is that people are charging ahead and looking to make a real impact this holiday season.

Brian Thackray - Deutsche Bank Securities

And can you talk about, in terms of player certification, are you seeing some of the lower-cost players coming for certification from some of the Chinese manufacturers?

Jon E. Kirchner

Yes. We're seeing a growing number of what you might call Tier 2 manufacturers show up and ready product for the market.

Brian Thackray - Deutsche Bank Securities

Do you care to kind of put a guess out there in terms of what the price points would be and when you will expect to see them in the market?

Jon E. Kirchner

Well, I certainly think we're going to see product in the mid 2s in the holiday season for sure. The question is whether on promotion they drop perhaps, let's say, as low as the WalMart promotion went. That remains to be seen. But I don't think you're going to see what I'll call industrywide average prices, much lower than the mid 2s. But I do think you'll see some people getting aggressive about trying to incentivize consumers to take the leap into Blu-ray and to really - you're going to see them highlight the features more than you ever have before.

Brian Thackray - Deutsche Bank Securities

A million share stock repurchase, can you just update with your thoughts around that?

Melvin L. Flanigan

We haven't done any purchases as of June 30th and generally we'll update you guys as we actually execute against the repurchase plan.

Brian Thackray - Deutsche Bank Securities

Can you just talk maybe how you think about it in terms of either price points or timing?

Melvin L. Flanigan

Brian, in terms of timing, last year when we did our previous buyback, it took us about a year to effect the outcomes for obvious market reasons. We won't get into the specifics as to our approach, but suffice it to say we fully intend to execute on this buyback just as we did the last one.

Operator

Your next question comes from Barbara Coffey - Kaufman Bros.

Barbara Coffey - Kaufman Bros.

As you're looking at the devices, the 80 type - 80 devices that are going to be out, are most of these just straight players or are you considering sort of the different skews of PlayStation? How should we be sort of taking a look at this and milestones we should be watching for as the holidays approach?

Jon E. Kirchner

Well, I think we expect to see a range of Blu-ray products, obviously, that make up the back half of our year. PS3 has been and will continue to be an important category. I think you're going to see standard players or what are called set-top box players beginning to increase in volume. And I think the wild card for us is just what kind of unit volumes does the PC business do, but we're certainly encouraged by the breadth that is appearing with respect to Blu-ray penetration across a number of units, whether they be laptops or desktops.

Barbara Coffey - Kaufman Bros.

And you expect to start seeing the PC portion of this later this year or sort of more into next?

Jon E. Kirchner

I think we'll begin to certainly see it in the back half of the year. The question is how material it is relative to the rest of our business. I think in a broader sense we expect to see major acceleration in 2009.

Operator

Your next question comes from Lloyd Walmsley - Thomas Weisel Partners.

Lloyd Walmsley - Thomas Weisel Partners

I was wondering if you guys are still seeing ASPs' holdup in Blu-ray driven by the adoption of multi-channel licenses, and is there any reason to think that people would not adopt multi-channel licenses given the importance of high quality in a Blu-ray experience going forward?

Jon E. Kirchner

Well, the answer to your first question is no, we haven't seen any decline in ASPs. I think we're seeing a number of your early products, in fact, supporting 5.1 or more channels, some as many as 7.1 channels of decoding on the basis of the sales proposition being a completely feature-rich product with respect to video as well as audio.

So as we get into later stages a couple of years from now in terms of the market dynamics and the price is dropping, how that ultimately impacts what I'll call the average mix, hard to say, but at this point we've been encouraged by the number of people that are clearly putting a stake in the ground saying that they're offering products with 5.1 or more channels of decoding.

I think what we've said conservatively is obviously, from a modeling perspective, as we need to gather more data on ultimately what the average ASPs may turn out to be, you can obviously model it at the two-channel rate pretty conservatively, which is around $0.30.

Lloyd Walmsley - Thomas Weisel Partners

And then looking at the auto market, I would guess a lot of the auto sales are in the SUVs. Have you seen any impact - A, is that right, and B, have you seen any impact in the massive slowdown in SUV sales?

Jon E. Kirchner

We haven't yet seen any direct impact from SUV-related slowdowns. I mean, our Car business is actually performing pretty well, and our business is made up of a bunch of different elements - there's aftermarket, there's OEM components. There probably would be a lag before we would see any significant changes, but given the fact that we continue to see more models of vehicles putting in DTS capable sound systems, that net effect may wash out. We'll just have to see.

But as we've said, for the year we feel pretty good about the fact that Car will make up about 15% of our revenue.

Operator

There are no further questions in the queue.

Jon E. Kirchner

Thank you very much. We look forward to speaking to you next quarter. Have a good day.

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