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China Digital TV Holding Co., Ltd. (NYSE:STV)

Q2 2008 Earnings Call Transcript

August 6, 2008 8:00 pm ET

Executives

Eric Yuan – Senior Manager of IR

Jianhua Zhu – CEO

Mason Xu – CFO

Jian Han – Chief Technology Officer

Analysts

Wallace Cheung – Credit Suisse

Richard Ji – Morgan Stanley

Adele Mao – Susquehanna International

Michael Olson – Piper Jaffray

Joe Parks – Oppenheimer

Greg Mesniaeff – Needham & Company

Operator

Good evening and thank you for participating for the China Digital TV second fiscal quarter 2008 earnings conference call. At this time, all participants are in listen-only mode. After managements prepared remarks, there will be a question-and-answer session. Today’s conference is being recorded, if you have any objections you may disconnect at this time. I would now like to turn the meeting over to your host for today’s conference, Mr. Eric Yuan, the China Digital TV, Manager of Investor Relationships.

Eric Yuan

Hello, everyone and welcome to China Digital second quarter 2008 earnings conference call. The company’s second quarter earnings results were released earlier today, and are available on the company’s IR website and ir.chinadtv.cn, as well as on newswire services. Today you will hear from Mr. Jianhua Zhu, China Digital Chief Executive Officer who will talk about the company’s strategy and business operations and Mr. Mason Xu, Chief Financial Officer who will discuss financial results and give guidance.

After their prepared remarks, Mr. Zhu, Mr. Xu and Dr. Zengxiang Lu, Chairman and Chief Strategy Officers will be available to answer questions. Before we continue, please note that the discussion today will contain certain forward-looking statements made under the Safe Harbor provision of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risks and uncertainties. As such, our results may be materially different from the views expressed today.

Further information regarding these and other risks and uncertainties is included in our registration statement on Form 20-F and other documents filed with the U.S. Securities and Exchange Commission. China Digital TV does not assume any obligation to update any forward-looking statements except as required under applicable law. As a reminder, this conference is being recorded. In addition, a webcast of this conference call will be available on China Digital TV’s Investor Relations website.

I will now turn the call over to our CEO Mr. Zhu.

Jianhua Zhu

Thank you, Eric. Hello, everyone and thank you for joining us today. I am pleased to report another solid quarter for China Digital TV. Our cooperate industries recorded a very impressive year-over-year growth, with 74% increase in net revenue. Likewise, our operating income and net income also saw strong year-over-year growth at 70% under 85% respectively.

In the second quarter we shift 2.69 million smart cards, the highest quarterly number in our company’s history. We are executing our growth plan in a number of ways. First our core CA business remained extremely strong over the quarter, we won 10 out of 16 available CA contract throughout China. We also gained a full house in province entering into a contract with the operator, servicing over 6.6 million customers. Their desire to work with us shows the strength of our brand and our competitive position. We will also choosing by that Hubei Chutian Digital TV Technology Corporation fro service which is more than 2 million households in Hubei province.

China Digital TV continues to lead in the market in securities, technologies and customer service. As we have discussed in the past the development and implementation of value-added services is the key components of out long-term strategy, expanding our VAS products and the capabilities allow us to leverage the solid customer relationships which our built over, throughout China. We are also announced to brining in additional recurring revenue stream. This quarter we took the first concreted step forward in our VAS trend by signing joint venture agreements with VAS partners in Guangzhou and the Dongguan.

Guangzhou host went of China’s best economy and the Dongguan is one of the richest TV’s in China. Through these and other initiatives in the pipeline we will develop and the market ability of value-added services, such as Digital TV based advertising and brand new TV programming including pay-per view, broadcasting. However, even with all our success over the quarter, it is clear that there are some pressures on the company that may impact us in the short terms.

As you are all aware there was a earthquake in Sichuan province in central China in May after careful evaluation of that effect of the earthquake on our business we found that our short-term cost human will indeed be affecting to us both equally. This is mainly because all the customers in that region will focused on the recovering efforts and not on television and the technology upgrade.

The other micro issue affecting us has been the 2008 Beijing Olympic Games. In the past we were discussing the Beijing Games with that there would have probably proved to be as nature factor in relation to our business operations.

As certain operators would likely wait until after the Olympics to make any changes to their system. However, we also believed this due to the government initiative to digitize some operators would make the change before the games. In fact in the second quarter we found that a great number of operators decided to wait until after games to make any technical changes ensuring that all current systems are functioning properly during the very important time.

Despite this lag of our full year smart card shipment volume will still meet our original estimates set earlier at around 11 million, the cost of our expanding and extremely loyal client base, many of the planed. Third quarter orders will be diverted to their fourth quarter of (inaudible) the first quarter of 2009 and later, but we are quite sure that this sales are delayed rather than lost.

Digital migration is changing the television in China and we at the forefront and a primary beneficiary of developments taking place. We have every reason to believe synchronizations will maintain strong momentum in the future. At the end of the second quarter, it is estimated that 36 minutes Chinese household were able to receive digital television. Approximately 100 cable network operators are schedule to go ditto over the next few years. We continue to benefit from very strong governmental support for synchronization and expansion.

We maintain very close relationship with our customers and continue to be recognizing it for our adaptable technology, excellence customer services and extensive in industry partnerships leads in-turn leads to very positive vote of milestone and excellent brand reputation. Out of which benefits our long-term position in fee system as well as our new VAS business.

I will now turn the call over to our Chief Financial Officer Mr. Mason Xu.

Mason Xu

Thank you, Mr. Zhu. Hello everyone. As mentioned, our financial results were released earlier today in on our website as well as online news services. Unless I note otherwise all the figures I mentioned today are in US dollars.

Net revenue in the second quarter was $19.4 million, an increase of 74.2% from the corresponding period in 2007 and an increase of the 12.5% from the first quarter of 2008. Operating income was $11.2 million, an increase of 70.1% year-over-year and 9.4% sequentially. Reflecting our ability to deliver profit growth, taking advantage of the economy of scale of our business model while subsidizing our VAS subsidiary as per our long-term growth strategy.

Net income for the second quarter was $11.2 million, up from $6 million in the same period of 2007 and a decrease of 1.2% from $11.4 million in the first quarter of 2008. The slight quarter-over-quarter decrease reflects the decline of interest income, which was impacted by the decrease of interest rates in the U.S. and a RMB2 million in special donations to earthquake affected regions in Sichuan, China.

Basic earnings per share in the second quarter were $0.20, compared to $0.14 in the same period of 2007 and $0.20 in the first quarter of 2008. China Digital TV sold a record $2.69 million smart cards during the second quarter, an increase of 75.8% from the corresponding period in 2007 and an increase of 16.8% from the first quarter of 2008.

In the second quarter of our 180 existing customers, a 142 purchased smart cards from the company, compared to 135 in the first quarter. In the second quarter, revenue from our top five customers accounted for 31% of total revenue compared to 48% in the first quarter. Only one customer contributed more than 10% of total revenue.

Gross margin was stable at 79.8% for the second quarter of 2008, compared to 80.3% in the same period in 2007 and 80.9% in the first quarter of 2008. This speaks to our ability to keep our cost down. Operating margins defined as income from operations divided by net revenue for the second quarter of 2008 was 57.6%, compared to 58.9% for the same period of 2007 and 59.1% for the first quarter of 2008.

During the quarter ASP eroded by 3.6% in US dollar term. Previously, we predicted ASP erosion in RMB terms of 5% to 10% for the full-year 2008. Due to quicken depreciation of the US dollar and the resulting ability of international competitors to sell at lower RMB prices, we expect ASP erosions in 2008 could increase more than previously predicted. ASP erosion is expected to be in a range of 0% to 5% in US dollar terms for 2008.

During the quarter unit cost decreased by 5.5%, the slight decrease in overall gross margin mainly reflects a decline in gross margin of the system integration business. Based on the information we have at this time, despite pricing pressure we consist to be encounter. We still expect gross margin for the full-year 2008 to be somewhere between 78% to 80%

Operating expenses for second quarter were $4.3 million, an increase of 80.5% from $2.1 million in same period of 2007, an increase of 14.1% from $3.8 million in the first quarter of 2008. The company added 23 employees in the second quarter, bringing the total number of employees to 462. Our total headcount increased 38% year-over-year. The pace of headcount exaction remains steady. Day’s sales outstanding in the second quarter were reduced to 43-days from 44-days in the first quarter and our base inventory outstanding decreased from 70-days in Q1 to 69-days in Q2.

Income tax expense in second quarter of 2008 was $1.5 million, an increase of 126.1% year-over-year and 11.1% sequentially. As we mentioned in last quarter, the year-over-year increase was due to extending profits and new Enterprise Income Tax Law of the PRC, which took it back in January 2008. This new tax law dictates that we use a 12.5% in income tax rate, until we have received official approval as a new and high technology enterprise.

In July 2008, the National Tax Authority issued Circular 362, outlining implementation guidelines for categorizing new and high-tech enterprises. However at present, the Tax Authorities are not yet setup to begin receiving applications for changes in tax setup of this nature. We are actively making preparation for applications for changes in tax data of this nature. We are actively making preparations for applications and we’ll apply as soon as the system is fully in place. Overall, we are focused on a tight financial control and wise use of money. We have a very experienced team of U.S. GAAP expert on Board and the company is on track to become a well governed company.

Let me now to go over the guidance for the third quarter and full year 2008. Based on information available on August 6, 2008, China Digital TV expects net revenue for the third quarter of 2008 to be in the range of $15.5 million to $16.5 million, representing year-over-year growth in the range of 8% to 15%.

As Mr. Zhu explained earlier we expect the earthquake and the Olympic Games will impact our third quarter results because certain operators have decided or may decide to delay upgrading to digital system until the fourth quarter of 2008 or first quarter of 2009.

Based on information available on August 6, 2008 China Digital TV is able to give a more precise full year guidance. We have narrowed our expectation of net revenue for the full year 2008 to be in the range of $80 million to $83 million, representing year-over-year growth in the range of 44% to 50%.

We will now open the call up to your questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Mr. Wallace Cheung from Credit Suisse; please proceed.

Wallace Cheung – Credit Suisse

Hi, good morning Zengxiang and Mason. I think the simple question is first regarding third quarter guidance, what is the expect number of SS card shipment and the second question will be also regarding the third quarter guidance. You mentioned that the Q-and-Q decline is partially related to earthquake. So can you quantify the amount of revenue that you have generated from each one and profits in the second quarter? Thank you.

Mason Xu

Wallace, could you kindly repeat the first question? Would you repeat that?

Wallace Cheung – Credit Suisse

First question is very simple. What is the expected number of conditional SS card shipment in the third quarter? Thank you.

Mason Xu

The number of contracts that are expected to be shipped in Q3 right.

Wallace Cheung – Credit Suisse

Yes.

Mason Xu

Okay, for the first question, we expect to ship between $2 million and $2.1 million smart cards in Q3 and for the second question according to our own calculation approximately $0.5 million smart cards were delayed by certain customers in the third party. Does this answer your questions?

Wallace Cheung – Credit Suisse

Yes, but say in the second quarter, what is the percentage of revenue generates from Sichuan province, roughly?

Mason Xu

Roughly, it just used, $6.6 time, $0.5 million that’s between $3 million and $3.5 million of revenue.

Wallace Cheung – Credit Suisse

Okay, thank you.

Operator

Next question comes from the line of Richard Ji from Morgan Stanley; please proceed.

Richard Ji – Morgan Stanley

Hi, Mr. Lu and Mason, good morning and I have two questions and the first question is regarding your outlook and obviously you guided for a relatively soft 3Q sales and you also maintained your full year sales guidance and I just wanted to get a sense of how much of assurance you have for all the cable operators in terms of they making up your 3Q deferred orders in 4Q, and what is their current feedback?

Mason Xu

What confidence level we have in that information in that guidance right?

Richard Ji – Morgan Stanley

Especially based on the feedback you collected from your cable workers.

Mason Xu

Right to answer your question, basically what the company did was we ask our sales folks to call the 180 customer one by one twice in the past month. We collected their feedback each time and we keep those information together and that’s how we came up with this Q3 and Q4 guidance.

Richard Ji – Morgan Stanley

Thanks Mason. My second question is regarding your ASP and the average selling price have declined two quarters in a row and obviously the to contrast the decline you also managed to cut back or scale back the unit cost of this smart card and I just want to have a sense of going forward what do you expect of the room of go further cost of cut in terms of smart card cost per unit? Thank you.

Mason Xu

Okay. Thanks for the question. As you might be aware about 40% to 45% of our cost of goods sold is on the computer chips. So, on the one hand the US dollar factor, the anticipated depreciation it is impacting our top-line, it is also helping us to reduce our costs because we purchased smart cards from intentional vendors like (inaudible) and Infineon and these contract are actually denominated in US dollars. So that’s how we were able to maintain our cost of goods sold at a pretty stable level.

On the other hand, on the non direct material parts of cost of goods sold. We were also able to leverage on our scale and further benefit from the economies of scale and as for how much we believe all our depreciation is benefiting from the direct material parts and we can’t predict how much the US dollar is going to depreciate against, R&D in the next few quarters, but that’s incentive principles we’re applying and as for the non direct material part, we think that there is a limit to which we could further reduce the cost of goods sold.

Richard Ji – Morgan Stanley

All right. Thank you, Mason.

Mason Xu

Thank you, Richard.

Operator

Your next question comes from the line of Adele Mao from Susquehanna International; please proceed.

Adele Mao – Susquehanna International

Hi, it’s Adele Mao from Susquehanna.

Mason Xu

Hi, Adele.

Adele Mao – Susquehanna International

Hi, my first question is about the delay impacted by Olympics. I was just wondering if the delay is industry wide or is more profound with your geographic exposure.

Mason Xu

I’m going to invite our Chief Marketing Officer to answer this question.

Dong Li

(Interpreted) We believe this is an industry wide phenomenon. Basically, our conversation with the other players on the team told us that they are experiencing the same month issues.

Adele Mao – Susquehanna International

Okay, so the delay should impact your competitors to the same degree and should not negatively impact your market share for the quarter; would you agree with that?

Dong Li

(Interpreted) The Olympic event will not impact our market share.

Adele Mao – Susquehanna International

Okay, great. Mason, you mentioned earlier that you were looking at 0% to 5% ASP decline for the year in US dollar term, correct?

Mason Xu

Right, that’s correct.

Adele Mao – Susquehanna International

So, what was the exchange rate assumption that you factor in for the rest of the year.

Mason Xu

Basically, our thinking process is as we said earlier, basically the US dollar depreciation is allowing the international competitors to sell their product in China at a cheaper price and now we are giving the guidance in US dollar and hope that – I don’t think investors could use the 0% to 5% US dollar depreciations in the price erosions plus, whatever percentage that’s going to come from the US dollar depreciation to kind of aggregate the effect of the total price erosion in R&D, but obviously that’s the worst case scenario. So, the worst case is, if you had a 0% or 5% with (inaudible) of US dollar depreciation for the year 2008.

Adele Mao – Susquehanna International

Okay and your full-year guidance is fast growing and the R&D continued appreciation through the rest of the year right.

Mason Xu

Right correct.

Adele Mao – Susquehanna International

My other question is that you have a lot of cash on your balance sheet that would you consider a share buyback at current level or what do you guys think is the best use of your cash at this moment?

Mason Xu

Okay, I’m to invite our CEO Mr. Zhu to answer this question.

Jianhua Zhu

(Interpreted) The board has had some preliminary discussion on this topic and the company is doing homework on the potential ways and the potential impact by the share back and we are also inviting certain investing banks to do to research together with us.

Adele Mao – Susquehanna International

Okay great, that’s helpful and just the last question for me. In term of value-added service, do you still expect some revenue contribution from that in 2008?

Mason Xu

Let me invite our head of new business, Mr. Jian Han, to answer at this question.

Jian Han

(Interpreted) We still expect value-added services to contribute some revenue to our top-line, but we don’t think it’s going to be material for the full-year 2008.

Adele Mao – Susquehanna International

Okay, would you quantify that?

Jian Han

(Interpreted) We maintain our guidance on the $2 million revenue contribution from value-added services for the full-year 2008.

Adele Mao – Susquehanna International

Great, thank you, that’s all I have.

Mason Xu

Thank you, Adele.

Operator

Your next question comes from the line of Michael Olson from Piper Jaffray; please proceed.

Michael Olson – Piper Jaffray

Hi, thanks and good morning. Just wondering based on the new guidance, what are your smart cards shipment assumptions for Q4 and can you remind us how that would compare to smart card shipments that you did last Q4?

Mason Xu

Thank you Michael for the questions. We expect to be able to ship more than 4 million smart cards in Q4 of 2008 and as a reminder in that Q4; we shipped 2.6 million smart cards.

Michael Olson – Piper Jaffray

Okay and then just one another question on the tax rate. So, should we assume a 12.5% tax rate for the remainder of ’08 and then going down to like a 7.5% tax in 2009; what assumptions should we make for the tax rate?

Mason Xu

I think at this moment based on the information we have, at this movement, we believe a 12.5% tax rate should be a reasonable assumption for the full-year in 2008. We are still waiting for the government, for the tax authority to setup a facility or a certain department to receive applications from companies like us and we expect this to happen as soon as Q4 and it could be as late as Q1, 2009.

Michael Olson – Piper Jaffray

Okay, but when that change is made, you’ll be back to that 7.5% rate?

Mason Xu

If we get approved as a high and new technology enterprise, that’s going to impact our 2009 bottom line.

Michael Olson – Piper Jaffray

Okay, thank you very much.

Mason Xu

Thank you, Michael.

Operator

Your next question comes from the line of Mr. Joe Parks from Oppenheimer; please proceed.

Joe Parks – Oppenheimer

Hi, just a quick questions here regarding some of your OpEx spending plans given in fact that you are seeing some macro headwinds here in the second half of the year; how do you guys plan to kind of rationalize at your spending for the second half?

Mason Xu

Okay, I don’t think I got the question. So, are you trying to get a sense of the G&A sales and marketing and R&D expenses?

Joe Parks – Oppenheimer

Yes, I just wanted to get some more color there and how you guys think about it strategically given the macro headwinds, if you guys need to pullback a little bit or if you guys I think this is and more of an opportune time to push needles here?

Mason Xu

Right, in the next few quarters we expect our R&D expenses to be in the range of 8% to 9% of net revenue. In the past quarter we hired 23 new employees and most of which are still in the R&D area and going forward we are going to keep doing that and R&D expense is going to be proportional to net revenue going forward.

Sales and marketing wise, we expect the spending to be in the range of 6% to 7% and as for G&A in the past few quarters we have hired quite a few experienced financial and accounting staffs from outside of company and also personal on the internal control department and we believe in last few quarters G&A expense is going to be steady around 7% of that revenue.

Joe Parks – Oppenheimer

Okay, that’s very helpful and then kind of looking at the bigger picture, you mentioned that there were the 100 cable customers I believe that were planning on transitioning to digital VCR, is that correct?

Mason Xu

That’s next year

Joe Parks – Oppenheimer

Next year, okay. So is that the most critical gross driver you are looking out into 2009 or is there something else we should be thinking about as well?

Mason Xu

The conversion to digital is a gradual process. It could take somewhere between half a year to three years. So, the 100 new customers are actually incremental customers we should be expecting in 2009 and we think the bulk of the revenue is still going to be coming from the existing customers. We currently have 180 customers so far and the bulk of the revenue is still coming from the older customers.

We expect the new customers to be signed in 2009; I mean industry wide the average size of these 100 customers in terms of the portal number of subscribers they have should be slower than the existing customer base. Don’t forget that out of the 80 million total potential subscriber base we only shipped around to 18 million to that customer base. So, even if we stop signing new contracts, we are still in the good position to enjoy high growth in that few quarter and the next few years.

Joe Parks – Oppenheimer

Okay, thank you very much.

Mason Xu

Thank you, Joe.

Operator

Your next question comes from the line of Mr. Greg Mesniaeff from Needham & Company; please proceed.

Greg Mesniaeff – Needham & Company

Yes, thank you. Mason, I was wondering if you can give us some roadmap as to what China Digital was planning in terms of any new product launches or enhancements to its conditional access system.

Mason Xu

Sure, I’m going to invite our CEO to answer this question.

Jianhua Zhu

(Interpreted) We are developing our CA product in a vertical and a horizontal way. Horizontal way, we are expanding our conditional access platform from a cable to mobile TV, ICTV, satellite TV and we are trying to store enough technology to be ready and when these new platform takeoff in China, we should be in a position to capture that growth.

Vertical wise we are developing; our conditional access technology has new demand come into play; for example we have come up with the two way solution for conditional access as more and more operators are converting their network into two way and also we are developing on conditional access based on Bluetooth communication, enhance the memory of our conditional access and also to enhance our encryption technology and make the technology even more robust. Greg, does that answer to your question.

Greg Mesniaeff – Needham & Company

Yes, thank you, that’s very helpful. My other question is, as far as the push out or delays of some orders in light of the Olympic Games. I’m wondering, whether your assumption of a rebound after those games is just kind of a normal assumption your management has made or is this based on feedback and backlog in orders that you visibility on from your customers.

Mason Xu

Thank you Greg and this is a good question. Basically, what we did in the past month was we actually asked our sales folks to call each and every of the 180 customers we had so far and we get their feedback on their time table in Q3 and Q4 and then we key sourcing information together to form the big picture and we actually did that twice in the past months. So, this assumption should be very solid.

Greg Mesniaeff – Needham & Company

Thank you

Mason Xu

Thank you Greg

Operator

(Operator instructions) Your next question comes from the line of Mr. Wallace Cheung from Credit Suisse; please proceed.

Wallace Cheung – Credit Suisse

Hi, Jianhua and Mason.

Mason Xu

Hi, Wallace

Operator

(Operator instructions)

Mason Xu

Hello, Wallace

Operator

Mr. Wallace, your phone maybe on mute. Please press your unmute feature or please star one to queue back into the call. There are no further questions in queue.

Eric Yuan

Okay again, thank you for joining us today. If you have any further questions, please do not hesitate to contact our IR team at 8610-8279-0021, or by sending an email to ir@ novel-supertv.com. Thank you and good bye.

Operator

Thank you for your participation on today’s conference. This concludes your presentation. You may disconnect. Good day.

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