ESS Technology Q4 2005 Earnings Conference Call Transcript (ESST)

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ESS Technology (ESST)

Q4 2005 Earnings Conference Call

February 1st 2006, 5:00 PM.

Executives

Fred Chan, Chairman of the Board

Robert L. Blair, President & CEO

James B. Boyd, CFO

Peter Cohn, Sec

Rebecca Mack, Investor Relations

Analysts

David Cannon, Point Capital

Jason Pflaum, Thomas Weisel Partners

Tayyib Shah, Longbow Research

Vanessa Jacob, Needham & Company

Adam Benjamin, Jefferies & company

Brain Harry, Equity Management Group

Steve Beau, Harbors Asset Management

Operator

Good afternoon, my name is Zamira, and I will be your conference facilitator today. At this time I would like to welcome everyone to the Fourth Quarter Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question and answer session. If you would like to ask a question during this time simply press “*” then the number “1” on the telephone keypad. If you would like to withdraw your question press “*” then the number “2” on your telephone keypad. Thank you. Ms. Mack, you may begin your conference.

Rebecca Mack, Investor Relations

Thank you. Good afternoon everyone and thank you for joining the fourth quarter 2005 conference call for ESS Technology. By now you should have received the copy of the news release that was faxed within the past hour. If you have not yet received the release or cannot access it from our website, please call Wendy Chafer at 510-492-1180 and she will send you one immediately. During this course of this teleconference we may projections or other forward-looking statements regarding future events or the future financial performance of the company.

We wish to caution you that these statements are only predictions and that the actual events or results may differ materially. We therefore would direct and encourage you to refer to our Safe Harbor statement in the company’s press release issued earlier today. The press release is available at the company’s website. As well we encourage you to refer to the documents that company’s files from time to time with the Securities and Exchange Commission, which contain and identify important risk factors that could cause the actual result to differ materially from those contained in our projections of forward-looking statements.

In addition this teleconference may contain information that is deemed to be a non-GAAP measure under SEC Regulation G. A reconciliation of these measures to the most directly comparable GAAP measures is contained in the Company's press release issued earlier today. The press release is available at the company’s website.

Joining me today is Fred Chan, ESS’s Chairman of the Board; Robert Blair, President and Chief Executive Officer; and James Boyd, Chief financial officer. Now I would like to turn the call over to Jim Boyd who will provide us financial review of the recently completed quarter. Jim.

James Boyd, Chief financial officer

Thank you, Rebecca, and good afternoon everyone. Today ESS reported net revenue for the quarter ended December 31st, 2005, of $44.1 million. Revenue was up $1 million compared to $43.1 million in the fourth quarter of 2004, and down $4.5 million from $48.6 million in the third quarter of 2005. DVD revenues during the quarter were approximately 56% of total revenue. While VCD revenue was 16% followed by Digital Imaging at 13%, recordables at 1%, other at 3% and royalties at 11%. On a GAAP basis, net loss for the quarter was $52.8 million or a loss of $1.32 per diluted share, which compares to a net loss of $20.9 million or $0.53 per diluted share for the fourth quarter of 2004, and a net loss of $11.1 million or $0.28 per diluted share for the third quarter of 2005.

Our GAAP numbers include $42.7 million in operating expense from our previously announced write-off of goodwill and intangibles, which we have taken out of our non-GAAP numbers for comparison purposes. As required by FAS 142, a goodwill impairment task was performed in the fourth quarter, and the results indicated that the fair value of the company was below book value of our assets, and therefore, goodwill was impaired.

On a non-cash basis, ESS had a fourth quarter net loss of $10 million, or $0.25 per diluted share which compares to fourth quarter 2004, non-GAAP net loss of $19.7 million or $0.50 per diluted share.

Third quarter 2005 non-GAAP net loss was $10.5 million or $0.26 per diluted share. ESS defines non-GAAP net loss as excluding amortization of intangible assets, impairment of goodwill and intangibles and the related tax effects. On a GAAP basis, there was a gross profit for the fourth quarter of 2005 of $7 million. This represents the gross margin of 15.9%, which compares to a gross margin of negative 10.5% in the fourth quarter of 2004 and a gross margin of 11.4% in the third quarter of 2005.

On a non-GAAP basis gross profit for the fourth quarter of 2005 was $7.7 million. This represents a non-GAAP gross margin of 17.5%, which compares to a negative 8.9% gross margin in the fourth quarter of 2004 and a gross margin of 12.8% in the third quarter of 2005. During the quarter we took a one-time charge to gross margin related to the towns in litigation settlement of approximately $700,000. This settlement relates to a patent rights dispute concerning our old modem technology and has been ongoing for several years. The Company no longer actively market these modem products, thus the settlement practically speaking has no impact on forward margin projections. Also non-GAAP gross profit excludes the effect of amortization of intangibles in the calculation of cost of goods sold.

In the fourth quarter of 2005 approximately $700,000 of acquisition related amortization was included in cost of goods sold for our Digital Imaging and encoding businesses. However in Q4 along with the goodwill write-off, we also wrote-off the intangible assets associated with the acquisition in 2003 of our encoding business.

That amount was included in the previously mentioned $42.7 million of other operating expenses. What that means is that in future GAAP projections we will include approximately $300 in amortization of intangibles in our cost of goods sold, down from our previous estimates of $700,000 per quarter. We did retain the intangible assets associated with the acquisition also in 2003 of our Digital Imaging business which is represented by the $300,000 of forecast amortization expense included in our Q1 projections today.

Included in GAAP at non-GAAP net revenue and gross profit in Q4 2005 was $5 million of royalty income from Mediatech. Q4 2005 is the last payment we will receive from Mediatech. Operating expenses on a GAAP basis for the quarter were $59.2 million, up $41.2 million from $80 million in the fourth quarter of 2004, and up $42 million from $17.2 million in Q3 2005. As previously mentioned our GAAP operating expenses included on a separate line titled other expense of $42.7 million write-off of goodwill and intangibles which we have excluded from our non-GAAP results for comparison purposes. Without that expense non-GAAP operating expenses were approximately $16.5 million, down $1.5 million from $18 million in the fourth quarter of 2004.

R&D expenses were $8.6 million for the fourth quarter of 2005, compared to $8.6 million for the fourth quarter of 2004 and $8.7 million for Q3 2005. SG&A expenses were $7.8 million in the fourth quarter of 2005, compared to $9.4 million for the fourth quarter of 2004 and $8.5 million for Q3 2005. The decrease in Q4 SG&A over Q3 was mainly due to lower inside and outside commissions offset partially by an increase in bonus, travel and audit expense and approximately a $700,000 gain on the sale of an office building in Hong Kong.

Non-Operating income was $170,000 in the fourth quarter of 2005 versus $451,000 in Q3 of 2005. The decrease was mainly due to the write-off of a small equity investment in Asia. Our provision for income tax in Q4 2005 was $805,000 compared to a tax benefit of $106,000 in Q3 2005. The effective tax rate for the current quarter is lower than the statutory federal rate primarily due to the lower foreign tax rate on earnings from our foreign subsidiaries, which are considered to be permanently reinvested. In our tax guidance today we have included approximately $350,000 tax benefit for Q1 2006 in anticipation of a pretax loss.

Now turning to our balance sheet. As of December 31st, 2005 the company had $99.7 million in cash and short-term investments, a decrease of $7.2 million from our September 30th balance of $106.9 million and a decrease of $27 million from the December 31st, 2004 balance of $126.7 million.

Throughout 2005 the company has the average just under $7 million per quarter in usage refunds. Accounts receivable net of allowance for doubtful accounts in Q4 2005 was $20.8 million compared to $28.4 million at September 30th, 2005, a decrease to $7.6 million. DSO was 33 days in Q4 2005 versus 52 days in Q3 2005. As of December 31st, 2005 net inventories were $12.5 million, an increase of $1.3 million from the September 30th, 2005 level of $11.2 million.

We would expect to see a modest increase in inventory levels over the next few quarters as we consider our current year inventory levels to be a bit too low at this time. This inventory bill will probably result in an increased uses of cash compared to our previous quarterly averages. As of December 31st, 2005 accounts payable and accrued expenses was $35.9 million, a decrease of $5.4 million from $41.3 million as of September 30th, 2005.

Income tax payable and deferred income taxes have increased by approximately $600,000, a $42.6 million in Q4 from $42 million in Q3 2005. Our fully diluted shares outstanding were $39.8 million for the quarter ended December 31st, 2005 the same as the quarter ended September 30th, 2005. In developing our Q4 2005 or Q1 2006 guidance for the day we used $39.1 million fully diluted shares outstanding in our EPS calculation.

During the quarter ESS repurchased $329,000 shares of its common stock. As of today ESS has Board authority do repurchase up to 4.4 million shares of its common stock at market conditions at being favorable. And now I would like to turn the call over to Bob Blair, our CEO who will review the business during the quarter and give the guidance for the upcoming quarter.

Robert Blair, CEO

Thank you Jim. Our fourth quarter results came in a little better than expected primarily because of stronger than anticipated DVD selling prices. Our revenues were $44.1 million for the GAAP gross margin of 15.9% and a non-GAAP gross margin of 17.5%. As Jim discussed, during December we wrote-off $42.7 million for goodwill and intangible assets. Therefore our fully diluted GAAP earnings per share for the fourth quarter was a loss of a $1.33. Non-GAAP earnings per share which exclude the effects of amortization to write-off a goodwill and intangible assets and the related tax effects was a loss of $0.25.

We ended the fourth quarter with approximately $100 million in cash in short-term investments compared with $107 million at the end of the September quarter. I would now like to provide you with some overall information about the quarter starting with our video business. Last quarter, we saw the VCD market demand slow slightly from third quarter levels. The fourth quarter for VCD is normally up slightly over Q3 but this year during the fourth quarter we shift the audio events in third quarter. We expect our VCD volumes to continue to decline as low cost price DVD players takeover part of this market, I will discuss this market in more depth in a moment.

Fourth quarter demand for our DVD products was up from the third quarter. Our MPEG-4 DivX products saw strong demands from our branded customers in Japan, Korea and Europe, and we believe our current shipments keep ESS as the market leader of MPEG-4 and DivX chips. The significant achievement during that quarter, was that our new phoenix line of DVD products begin shipping to major customers during last quarter. We believe that all of our major customers have committed to switch to this new product line, so these new products provide our customers with the highest level of integration available today with the most features including 8-HI performance audio decks both in Class C Amplifier Controllers, hi-definition Jpeg, 6-HI definition video decks, USB and another new features. Additionally these products have a lower cost than our current products. Our new Phoenix chips are currently being designed into all of our major OEM’s in addition to customers from China.

We’ve planned to continue to ramp production shipments this quarter and these chips are expected to be in the majority of our DVD shipments by the third quarter of this year. We continue to gain new design wins worldwide in the automotive market. Today ESS has designs for most of the major automotive DVD manufacturers worldwide. This manufacturers includes Philips, Fujitsu – Ten a join venture between Fujitsu and Toyota for product Sanyo, Alpine, Clarion, Kenwood, Panasonic, Sony, EBFO’s, Signori in Power.

Our products have been chosen by these customers because we were able to provide full-featured DVD products with extensive build-in audio capabilities. In the future we expect this part of our DVD business to grow as more customers begin to use the new full-featured Phoenix chips. Well I’ll give you an update on our quarter for product line. During the fourth quarter we shipped about $250,000 for those product line. We believe this market is growing more slowly than previous market forecast had anticipated and didn’t anticipate growth in this business in the first quarter and we will not breakout the segments separately in the future.

And for some more details about our DVD and our VCD business. For our VCD products we saw 6% decrease in overall selling prices compared to the 5% to 8% decrease forecast for last quarter. In the first quarter we expect VCD decoder selling prices to be approximately 10% to 15%, reflecting softness in the market after Chinese New Year. Overall DVD competition remains aggressive so we expect increase prices or pressure on prices in gross margin over the longer term. As a result of the continued price pressure and the fact the VCD market is shrinking as low cost DVD players capitalize the portion of this market. It will become increasingly difficult to maintain positive gross margins for those product line in the future.

Accordingly as I announced that our last conference call ESS has licensed the marketing rights of our VCD product lines to Ceylon and fiber semiconductor company headquartered in China. Ceylon manufactures of VCD chips used by many of our customers and we will bundle this chips with MPEG decoder for the VCD market. ESS will continue to sell our decoder products for Ceylon and Tolly to introduce – the integrated product using our combined technologies.

ESS will receive a share in the gross margins with a guaranteed minimum for those business. We believe this partnership is in the best interest to continue to ensure positive gross margins from those product line.

In our DVD business the selling prices for DVD chips decreased only 3% during this quarter compared to our guidance of 10% decrease. This was primarily because the mix with MPEG 4 and DivX products in a larger percentage of our overall DVD revenue. Going forward because of aggressive competition and the end of busy holidays season, we expect ESS’s DVD chip selling prices to decline an additional 10% to 15% in the first quarter.

Now I’ll give you an update on our camera phone business. Our Digital Imaging business had revenues of approximately $5.4 million in the fourth quarter inline with our estimates. These revenues came primarily from shipments of 1.3 Megapixel launches for Samsung and 1.3 mega pixel chips sales to LG Electronics. We continue to move our business model away from selling modules to selling silicon chips only. Our major customers are inline with this strategy and we were working with several margin manufacturers worldwide.

Today we have camera designs in many different handsets worldwide. Many of these new designs come from Korea both from Samsung and LG as we mentioned previously towards all kind of manufactures in the world. We also planned an additional higher performance lower cost integrated image sensor and image processor systems on a chips in the next several months. These chips will utilize advance 40 and shared 40 pixel technologies. We demonstrated a new 41.3 Megapixel system on chip at the CES show this year and we will sample this product this month.

The initial feedback from our customers with the quality of the pictures taken with this chip is very nice, is very good and we believe it will be well received by the market. We believe these new products puts forth the base for future growth for the camera phone business. And I will get detailed guidance for ESS business in the first quarter of 2006.

I’ll be breaking down our first quarter business based on the following categories: DVD, VCD, Digital Imaging products and other products. Other products include our Digital Media player or DMP chips which targets the dividend TV market and our customer audio products. Start with the numbers. First quarter is normally lower than the fourth quarter due to seasonality, accordingly the cost of Mediatech royalty payments of $5 million and the continued weakness of VCD products combined with the transition of our DVD products through the Phoenix. We are projecting first quarter revenues up $26 to $30 million were down about 30% from the fourth quarter. We project the following ranges for the percent of revenue in our respective product launch for the first quarter.

We forecasted our DVD products will be in the 72% to 77% of total revenue, our VCD products are expected to be in the 11% to 12% range. Our Digital Imaging products will be in the 5% to 8% range of total revenue and our other product category will be in the 8% range of revenue. Because of strong DVD pricing pressure and most of our DVD shipments in the first quarter still coming from our older higher cost products will project our overall non-GAAP gross margins to be in the 3% to 8% range for this quarter.

R&D drives future revenues and ESS continues to increase our R&D resources primarily in our Asian facilities to reduce our overall R&D expenses. We now have R&D facilities in China, Taiwan and Canada in addition to the United States. We project that R&D expenses from the first quarter will be up slightly from the fourth quarter because of increased expenses and with the forecast revenues R&D expenses are expected to be 32% to 36% of total revenues. SG&A is expected to be down from the fourth quarter and expected to be 25% to 28% of revenues. Our long-term objective is to continue to reduce non-R&D operating expenses. Stock option expensing begins in the first quarter of 2006 for ESS and we forecast this expense to be in the 5% to 6% range of revenues.

Overall despite increasing R&D expenses by about $1 million for quarter this year, we have reduced SG&A expenses and have enabled to lower our total operating expenses to a run rate of $16 million to $17 million per quarter. We expect to further reduce this amount by the end of the first half of this year. Because we have an operating loss, our effective tax is projected to be a credit of $350,000 for the first quarter. For the first quarter of the year we are using $39.1 billion shares for EPS calculations and therefore we project the first quarter earnings per share to be in the following ranges. On a GAAP basis we are projecting a loss of $0.41 to $0.43 and on a non-GAAP basis we are projecting a loss of $0.36 to $0.38. And non-GAAP exclusively effects for amortization of intangible assets, stock options expensing and related tax affects of these items. That concludes our guidance for the first quarter.

Looking forward with the introduction of our new 41.3 Megapixel system on a chip this month we expect to begin to grow revenues in our Digital Imaging business in the second half of 2006. And we expect our DVD revenues to grow in 2006 as our new Phoenix products ramp into full production. We believe future growth will be driven by both our video and our camera-phone products. This guidance will be posted tomorrow on the ESS website that will be available for the next two weeks. I’d now like to open the call up for questions.

Questions-and-Answer Session

Operator

Operator Instructions Your first question comes from the line of David Cannon with Point Capital

Q - David Canon

Hi Rob, can you tell me when do you guys expect to breakeven or turn profitable?

A - Robert Blair

Oh that’s a tough question David, first of all ESS doesn’t give guidance beyond one quarter, so let me make a few comments but understand that this is not intended as guidance. I believe that is possible but unlikely for ESS to breakeven in the later half of 2006, but there are really too many variables in that for sure. For example we need to get a new phoenix DVD chips into full production quickly and then we got too in the manufacturing process, so we can get high yields and that will cost the company high yields. That doesn’t happen overnight and it could actually take several quarters. Also with the competitive DVD market it’s impossible to forecast what selling prices are going to do, especially if we start taking market share from the competition, I don’t think they are just going to send ideally and that is take their market. So DVD selling prices are big in number. In addition I think our 4T camera phone products need to be excepted by the market and designed in the cell phones for manufacturer in the second half of this year, if we are going to have any chance of breaking even, so there are just too many unknowns in practice outside of our control to know for sure if that breakeven will occur but David believe me we are all working hard on all these issues and a lot of other ones to ensure that we get this company back to profitability just as soon as possible.

Q - David Canon

Bob, what would as far as the revenue number what do you think would be the breakeven point would it around 50 million?

A - Robert Blair

I think its probably a little north of than 50 million, and its somewhere between 50 and 60, it depends on the gross margin we were seeing once again that’s not a normal thing, if the gross margin is 28% and its above 60 and if its 30% its between 50 and 60 so I, it's in that range someplace but it depends completely under gross margin percentage which we kept our forecast right now.

Q - David Canon

Okay, what percent of revenue this quarter was camera phone business and why is it down, I know last quarter I think it was like at least 5 million, no, no maybe in the north than hereof, and then this you’re forecasting, as you’ve said 5% to 8% so implicitly, probably $2 million bucks, is that – can you just tell me what’s going on there?

A - Robert Blair

You know, what's going on in the camera phone is since that we had some couple of really nice designs that customers use phones were featured by, actually for the Christmas season they were very special, since entering the third quarter and then somewhat into the fourth quarter we have large volumes since they were supporting the Christmas sales. Those models are now being faced out and new models to be faced in and the reality is since we been behind the camera phone business because we've been using the 3T pixels and our the largest competitions as we move forward into 4T pixels so our products were actually non competitive from a cost and price point of view. Our new 4T since that we have just demonstrated with CEOs I think starts correcting that and like to skip back into the game much closer that even playing field. We have a lot of work to do in the camera phone business, we need to continue to develop 4T shared pixels and drive towards lower cost and higher resolution with 3 Megapixel and much, much smaller VGA and 1.3 Megapixel since its going through the rest of this year, but I think the 4T our products that we have, that we are introducing this number actually I think is the first big step along that but its going to take till the second half of this year before you start seeing that our role into real production numbers and forecast numbers from us.

Q - David Canon

Do you think that the camera phone business by the end of the year could be 10% of revenue or is that too optimistic?

A - Robert Blair

Well I think its too far out to say things like that, we don’t get guidance that far out. Of course its eminently possible just because how successful we are in selling the product and getting the new product sale. But I don’t want to try to guide, it’s going to be 10%

Q - David Canon

The new 4T pixels chip have been designed into any phones as of yet or its just something that you featuring at standpoint?

A - Robert Blair

Its brand new we’ve just showed for the first time at the CES show three weeks ago and we have a two of our largest customers are evaluating right now but it is not currently designed in

Q - David Canon

Is that some thing that you would disclose, as you had design wins, would you announce that, or it’s just something that you wanted to find out through conference calls?

A - Robert Blair

We would probably, announce through the conference calls rather than doing your press release or something that we typically don’t do press release – because once we typically just discuss, some of our customers and designs on the conference call.

Q - David Canon

Okay so in light of the fact that you know the market has moved to 40 pixel, any revenues you do get on the image sensors side should be nominal at this point until the second half of the year, is that safe to assume?

A - Robert Blair

That’s probably a fair way to put it.

Q - David Canon

Okay. And then on the Phoenix line that you just started shipping, you said that you expect the majority of your DVD revenues by Q3 to come from Phoenix so, does that mean a little more than 50% or we talking like 80% to 90%?

A - Robert Blair

Well it’s simply cutting those numbers.

Q - David Canon

Okay that’s good enough, and then, the gross margins on that, what percent of your DVD revenues this quarter came from Phoenix, can you point out?

A - Robert Blair

For the fourth quarter?

Q - David Canon

Yes

A - Robert Blair

It was very small, I would say that it was in the order of 1% type of numbers. It seems very small, it is insignificant.

Q - David Canon

I see, okay so. And where the gross margins be, I know you, you know back in the heyday when you are in the 40's that’s probably not a realistic target in light of the commoditization and the market has gone to do but, do you think that you can at least get into the mid 30's for that particular product line, is that reasonable?

A - Robert Blair

David, like I mentioned earlier about the breakeven question, the selling price is not knowable right now, if you can tell me what the selling prices are going to be I can give you an answer to your question, but I think that we have started gaining some market share in the China market, I don’t think that our competition is going to stand by and the volume level just continue to take our market shares, so I think this going to be some selling price reduction. Well I can hope that we are going to get into the mid 30's on the gross margins, I can’t possibly guarantee your guide to that, because its not global at this point. It’s probably very unlikely that can never happen again, with the competition the amount of commoditization in the strong competition. So that’s probably that’s not impossible it’s maybe extremely unlikely.

Q - David Canon

Extremely unlikely if we get, you mean in the 40's or mid 30's?

A - Robert Blair

I’d say, it would probably unlikely given in the mid 30's, it maybe very, very difficult just to get the whole margin up to 30%. Depending on what happens to selling prices it could be even lower than that. There is a lot of commoditization and when you can go down to the store and buy a 1995 Power DVD you know that the prices all over, don’t know where it is right now, it’s a new product line but others get a quarter or two to it and then ask me this question again.

Q - David Canon

Okay thanks for the update good luck.

A - Robert Blair

Thank you David.

Operator

Your next question comes from the line of Jason Pflaum with Thomas Weisel Partners.

Q - Jason Pflaum

Hi guys good afternoon, can you hear me okay?

A - James Boyd

Yes, I can hear you now Jason

Q - Jason Pflaum

Okay great, maybe just first on the DVD side, can you talk about the ASP differential between the Phoenix and the prior generation? If there is one, very close or?

A - James Boyd

It depends on the market, the Phoenix products and the branded products our branded customers is slightly below our old products, like our other two products, in the China market its significantly below because we didn’t really play much in the China market in the past, because our costs were too high so the selling price in China which is where we are gaining lot of market shares and is quite a bit lower than the overall running retail selling prices.

Q - Jason Pflaum

Okay so overall, it’s definitely below.

A - James Boyd

Yes

Q - Jason Pflaum

Okay, moving on to the imagining business can you talk to us generally what portion of your business today is marginal versus chip, could you give a kind of a general sense, how we kind of moved well beyond 50%?

A - James Boyd

Today the majority of our business I’m going to say something like 2/3rd of three quarters to silicon business, not modules.

Q - Jason Pflaum

Okay, so the sequential little decline in that business that you’re experiencing in Q1, that’s not so much a reflection of the shift to chips but more so of the actual business?

A - James Boyd

It’s combination of both.

Q - Jason Pflaum

Okay. Do you think we would be able to see any other top shares in your mix on your imaging business this year?

A - James Boyd

I would hope so, but I can’t guarantee that, that the mixed thing it’s not knowable.

Q - Jason Pflaum

You don’t have design wins yet with any additional, and as far as the number of customers beyond LG, Samsung, are we talking about just two or three, or there multiple second on this case?

A - James Boyd

China, and some assignments in Europe, so there are, more than 2 or 3 less than a couple of dozen.

Q - Jason Pflaum

Okay, and just kind of backward profitability in that business, what type of revenue run rate do you think can be head to breakeven in the sensor business?

A - James Boyd

Once again that’s going to depend on the success of moving people to the silicon and what gross margins which can get on silicon, silicon our camera phone gross margins we expect will be lower than our - probably in the 20% range, and so that means that we need something in the $15 million to $20 million order run rate to breakeven in that business.

Q - Jason Pflaum

Has that I guess gross margin target changed at all, do you recall in past quarters you’re thinking a little bit that north of that, is that because the pricing environment has changed or there are other factors?

A - James Boyd

Well, I think it’s primarily because there is a lot of competitive pressure in the camera phone just like the DVD business and, we are a new entrant and so we are not going to probably get that price and so we are going to have to, have not just the best picture or equally better picture or else going to have to be somewhat aggressive in selling prices so I think targeting anything above the 20% gross margin is not realistic at this point.

Q - Jason Pflaum

Okay. And then last question given your, rather depressed revenue levels here and cash burned, are they are any expectations for any type of OpEx, restructuring or can we expect to see any action, is there any obtain meaningful topline growth here near-term?

A - James Boyd

Well couple of things we’ve already taken several steps to reduce the operating expenses, we’ve taken the SG&A down by about several million dollars per quarter. We have actually increased the R&D expending because long-term we would like to have new products and grow the revenue line and we hope that as our Phoenix products get later in the year we should be able to show some growth there, but we will continue to be very, very diligent about reducing expenses in cutting cost wherever we can, and at the same time making sure that we don’t cut off our future by cutting off the R&D expenses that we need for future products.

Q - Jason Pflaum

Okay. So nothing major near-term here, and then just one more question if I may, on the VCD side, can you talk about when you expect the transition from chip sales to royalty still occur, is that kind of a Q2, Q3 type event?

A - James Boyd

I don’t think it will start happening in Q3, what be an overnight type of thing, but I think my guess right now, its some sort of historic in Q3 and will be pretty much probably over by Q1 of 2007.

Q - Jason Pflaum

Okay. But now do we see any of that in Q1, is that correct?

A - James Boyd

Of this quarter?

Q - Jason Pflaum

Yes.

A - James Boyd

In 2006?

Q - Jason Pflaum

Yes

A - James Boyd

No you got to see the revenue, because in total Ceylon has it’s own integrated product, they are going to be buying our products from us, and only when they have their own product which is into Italia where we move to the growth the only basis.

Q - Jason Pflaum

Okay. Great that’s all I had guys, good luck.

A - James Boyd

Thanks Jason

Operator

Your next question comes from the line of Tayyib Shah with Longbow Research.

Q - Tayyib Shah

Hi guys. I just was wondering if you can clarify where that DVD margins are right now, and if it’s realistic to expect something like something north of 20% in the next couple of quarters?

A - Robert Blair

Well, we never give up specific information like this saying so, right now, that we were shipping our older two products and they have a low margin, we have to ramp into the new products and get the Phoenix out there, and then see how is the competition, we added to their selling prices and it’s really just not removable, but even if I knew the answer I’d probably I wouldn’t give it Phoenix, we never talk about specific product line gross margins.

Q - Tayyib Shah

Okay. And fair enough, and then did you, I’m sorry, I joined the call late, did you talk about the 2 Megapixel product in the image sensor area as well or is that on the roadmap?

A - Robert Blair

Is in our roadmap, we target to introduce that later this year we think that that’s the product we need to have, there is a three main products for revenue in the next year or two are going to be 1.3 Megapixel the 2 Megapixel, and obviously the VGA is still actually a very large seller, so those are the main products that are going to drive revenue in this business in this product line. So we are targeting to have all of them in our mix.

Q - Tayyib Shah

And then, the 4T design wins don’t come through, what’s the kind of the lifecycle for addressing the business, the existing model, are they going to be saved out completely by third quarters and by the holiday seasons?

A - Robert Blair

Very likely yes.

Q - Tayyib Shah

Okay and then, where are you most seeing interest for your Phoenix, I mean what kind of geographies are most interested in designing this product?

A - Robert Blair

Well, all of our existing products are the right amount of products which are primarily in Japan, Korea and Europe with just a couple in China, and all of them have switched to designing the new model for Phoenix product. In addition we are seeing a fair amount of activity in China on designs wins for Phoenix, now the caveat on that is that its routine for companies in China to design to model a DVD player with two or even three suppliers and want to confine a place in order they go out and negotiate the best price and so, the fact that we have a lot of activity in China design wins will result in some additional business but you don’t know how much, because you know, you’re not going to get all of it or even the bulk of it, even though you have the design wins but the new customers are pretty much all coming from China.

Q - Tayyib Shah

So on, and then Zoran just announced the Vaddis 9 that their lower cost version, do you think there is a race that even with the Phoenix you have, were you want them to be you might face further pressures or loss of market share in the DVD space?

A - Robert Blair

Well there is always price competition and cost pressure on the company, we have low cost other new DVD chips that we are working on that have lower cost also. Right now Phoenix is, I think is being accepted by the marketplace because its a full featured product that has more features and more capabilities that I think the competition has today but it does not address the very low end of the market, that I think that that line addresses. So again we are talking about two slightly different segments of the DVD market here.

Q - Tayyib Shah

And finally question for Jim, what’s the cash burn rate right now, where do you expect it to be greeting’06 and maybe if you can just give us a ballpark figure for where you expect the cash balance to be in greeting ’06?

A - James Boyd

For the last fourth quarters I think if you look back we averaged between $6 million and $8 million and I don’t see anything specific in changing in the future, you know and so we get back to profitability except for a slight increase inventory sales that all happened in Q1 and probably Q3.

Q - Tayyib Shah

Okay thank you guys.

A - James Boyd

Thank you

Operator

Your next question comes from the line of Vanessa Jacobs with Needham & Company.

Q - Vanessa Jacob

Hi guys, I just got down a few minutes. Can you just give me the revenues once again?

A - Robert Blair

Sure, we had DVD revenues in the quarter of 56%, VCD at 16%, Digital Imaging at 13%, recordables 1%, other at 3% and royalty at 11%.

Q - Vanessa Jacob

Okay thanks.

Operator

Your next question comes from the line of Adam Benjamin with Jefferies & company.

Q - Adam Benjamin

Thanks, this is Blain for Adam, I said, I just want to revisit the Digital Imaging, I mean when will the transition of chips be complete, I mean would it be in '06 or we can just put out?

A - James Boyd

Could you please repeat the question I am sorry?

Q - Adam Benjamin

The transition to chips from modules in Digital Imaging, will that be completed in '06?

A - James Boyd

Yes, I think it will be complete by probably, I would expect the end of the second quarter of this year.

Q - Adam Benjamin

Okay, and the other thing I was trying on handle on is the gross margin guidance I mean maybe I’m looking at the strong I've thought your DVD line had the better margins and I guess you are shifting in Q1 to a higher mix of DVD and less VCD. So just looking at maybe give a little color on to what's driving that the gross margin guidance?

A - James Boyd

Well that if you could look at the gross margin, if you look at our gross margin for Q4 and you say that, its roughly the non-GAAP gross margins it was 17.5% and that includes $5 million payments from Mediatech, it’s a 100% margin, so if you think that $5 million down that’s roughly 1.1% - I am sorry 11%, you can subtract the 11% from the 17.5% the real company wide gross margin for the fourth quarter was about 6.5% for the Mediatech. We don’t have a Mediatech payment coming in the first quarter and so the guidance I think 3% to 8% is roughly equivalent to the same guidance or to the actuals that we had in the fourth quarter. The reality is that our costs are by products is very high today, and we get a very low margin today on our DVD business, that’s why the transition to Phoenix is important for us to improve our good margins in the future.

Q - Adam Benjamin

Okay so I guess lets say fair to assume that the transition of Phoenix kind of offset your ASP decline, or to flat?

A - James Boyd

Well, we would hope that if does that and more but we have to wait and see what the ASPs would be.

Q - Adam Benjamin

Okay thank you.

Operator

Your next question comes from the line of Brain Harry with Equity Management Group.

Q - Brain Harry

All my questions been answered, thank you.

Operator

Again I would like to remind everyone if you would like to ask a question please press "*" then the number "1" on your telephone keypad. Your next question comes from the line of Steve Beaumont with Harbors Asset Management.

Q - Steve Beaumont

Good evening guys. Just wondering if you can talk quickly about your methodology of putting together guidance your attitude towards guidance, if I got my numbers right, you sort of significantly beat the top end of your revenue guidance, you show your last two quarters sort of been I guess 5% to 10% above the midpoint of your guidance and just wonder if that kind of reflects a significant amount of conservativism when you are forecasting your revenue?

A - Robert Blair

Well, that’s a good question, the reality is that the majority of our business is turns business during that we actually booked during the quarters somewhere between 70% to 90%, depending on the particular quarter, will not be on backlog that’s beginning of the quarter so it’s very, very difficult to forecast accurately what’s going to happen as a result in order to not the two optimistics and occasionally misguidance, we try to be realistic with our guidance since they what's the realistic number out here then we think we can meet and not disappoint Wall street. Necessarily those are probably more conservative then what is possible and so the last few quarters I think you've seen coming through our way but and the answer is that’s it's very, very risky and its not removable because so much of our businesses is transport business, and that we try to give the street numbers that we can hopefully we could at least need if they still come, come up where we would hope.

Q - Steve Beaumont

That’s helpful Bob, thanks very much. What is, what are the lead times right now?

A - Robert Blair

In terms of what we are talking about, you know a way for lead times, today there is about six weeks from the historical wafers but they are typically there is a two to three weeks queue before they get into the – typically talking 8 to 9 weeks for Feb, we have a week or so in its someway, a couple of weeks in past and the whole things adds up to typically 11 weeks to 13 weeks overall from the timing placed in order to the timing you can ship the product.

Q - Steve Beaumont

And do you guys quarter lead time to your customers at all between the time they, or you guys just eventually ready to ship?

A - Robert Blair

We try to be ready to ship, the customers, a lot of our customers basically will place an order but you really can't count that order as an order and totally put up a credit because we don’t give credit to all of our customers especially in China, so the net result is on, they put up a letter of credit, they expect it to ship immediately and so we have to try to manage their inventories and so we have enough to take care that you have enough so much that were we are so, that’s another tricky part of the business.

Q - Steve Beaumont

Sure, switching gears a little bit, the VCD business model change, is there going to be a lag between the time that some, that the integrated product that you shipped in when you guys are going to recognize revenue or are you essentially going to recognize revenue a quarter in over years on?

A - Robert Blair

Actually that’s a good question, I think that has to be transitioned out of selling the chips to Ceylon and they start selling their own, there will probably be a month slip, that we will be getting our shipment reports in royalty payments on a monthly basis and so there could be one month type of lag but I don’t think it would be anything more than that.

Q - Steve Beaumont

Okay it’s going to be monthly report instead of quarterly reports, so there won’t be a four quarters, okay and then finally for Jim, Jim, did I hear you slip in that you guys had brought back stock in the quarter?

A - James Boyd

Yeah, that’s what I said in there.

Q - Steve Beaumont

So you can just go over the details again it surprised me so I wasn’t able to write it down?

A - James Boyd

Yes, we purchase 329,000 shares actually must be at an average price of $3.54 during the quarter, total of $1.2 million.

Q - Steve Beaumont

Okay and you, how much was left on the authorization?

A - James Boyd

Well we have currently outstanding, we have $4.4 million left on the authorization, we also purchased about a $0.5 million shares during this quarter at an average price of about 340.

Q - Steve Beaumont

During the first quarter, this calendar quarter so far?

A - James Boyd

That’s correct

Q - Steve Beaumont

Okay and I am sorry the 4.4 million is shares or?

A - James Boyd

That’s the authorization from the Board that we have remaining

A – Robert Blair

That is shares?

Q - Steve Beaumont

And that is shares and not dollars. Okay thanks very much guys.

Operator

Again I will now like to remind everyone if you would like to ask a question please press "*" then the number "1" on your telephone keypad. We have no further questions at this time.

Robert Blair, Chief Executive Officer, Pres

Okay, well I like to thank you everybody for joining us on this call and for all of your questions had some bivalence, so this will conclude our conference call.

Operator

This concludes today's conference call, you may now disconnect.

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