ESS Technology, Inc. Q1 2006 Earnings Conference Call Transcript (ESST)

| About: ESS Technology (ESST)

ESS Technology, Inc. (ESST)

Q1 2006 Earnings Conference Call

April 26th 2006, 5:00 PM.


Rebecca Mack, Investor Relations

James Boyd, CFO, Principal Accounting Officer, Sr. VP and Asst. Secy.

Robert Blair, President, Chief Executive Officer


Alberto Mann, Thomas Weisel Partners


Good afternoon, my name is Tammy, and I will be your conference operator today. At this time, I would like to welcome everyone to the ESS Technology First Quarter Results Conference Call. Operator Instructions Thank you. Ms. Mack, you may begin your conference.

Rebecca Mack, Investor Relations

Thank you. Good afternoon everyone, and thank you for joining the first quarter 2006 conference call for ESS Technology. By now, you should have received a 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 the course of this teleconference, we may make 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 the company files from time-to-time with the Securities and Exchange Commission, which contain and identify important risk factors that could cause the actual results 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. Our 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 also available at the company's website.

Joining me today is Bob Blair, President and Chief Executive Officer, and Jim Boyd, Chief Financial Officer. Now, I would like to turn the call over to Jim Boyd, ESS Technology's Chief Financial Officer, who will provide a financial review of the recently completed quarter.

James Boyd, Chief Financial Officer, Principal Accounting Officer, Senior VP and Assistant Secretary

Thank you Rebecca, and good afternoon, everyone. Today, ESS reported net revenue for the quarter ended March 31, 2006 of $26.9 million. Revenue was down $15.9 million compared to $42.8 million in the first quarter of 2005, and down $17.2 million from $44.1 million in the fourth quarter of 2005.

DVD revenues during the quarter were approximately 63% of total revenue while VCD revenues were 21%, followed by Digital Imaging at 9%, recordables at 2%, and other at 5%. On a GAAP basis, net loss for the quarter was $14.1 million, or a loss of $0.36 per diluted share, which compares to a net loss of $24 million, or loss of $0.60 per diluted share for the first quarter of 2005, and a net loss of $52.8 million, or a loss of $1.33 per diluted share for the fourth quarter of 2005.

Our GAAP numbers include a total of $1.4 million in both cost of goods sold and operating expenses for the stock-based compensation expense under FAS 123R. On a non-GAAP basis, ESS had a first quarter net loss of $12.4 million, or a loss of $0.32 per diluted share, which compares to first quarter 2005 non-GAAP net loss of $23.3 million, or a loss of $0.59 per diluted share.

Fourth quarter 2005, non-GAAP net loss was $10 million, or a loss of $0.25 per diluted share. ESS defines non-GAAP net loss as excluding amortization of intangibles -- intangible assets, write-off of goodwill and intangible assets, stock-based compensation expense, and the related tax effects.

On a GAAP basis, there was a gross profit for the first quarter of 2006 of $2.4 million. This represents a gross margin of 8.8%, which compares to a negative gross margin of 13.6% in the first quarter of 2005, and a positive gross margin of 15.9% in the fourth quarter of 2005.

On a non-GAAP basis, gross profit for the first quarter of 2006 was $2.7 million. This represents a non-GAAP gross margin of 10.2%, which compares to a negative gross margin of 11.9% in the first quarter of 2005, and a positive gross margin of 17.5% in the fourth quarter of 2005.

Non-GAAP gross profit excludes the effect of amortization of intangible assets and stock-based compensation expense in the calculation of cost of goods sold.

In the first quarter of 2006, approximately $300,000 of acquisition-related amortization was included in the cost of goods sold for our digital imaging business, and also, $73,000 for stock-based compensation expense.

In our Q2 2006 GAAP projections today, we included approximately $230,000 for amortization of intangibles, and $60,000 for stock-based compensation expense in our cost of goods sold.

Not included in the GAAP and non-GAAP net revenue and gross profit figures for Q1, but in the comparable Q1 and Q4, 2005 figures, is a quarterly payment of $5 million in royalty income from MediaTek. The fourth quarter of 2005 payment completed the amounts owed under the terms of the copyright infringement settlement agreement with MediaTek.

On a GAAP basis, total operating expenses for the quarter were 17.6 million, up $200,000 from 17.4 million in the first quarter of 2006, and down $41.6 million from $59.2 million in the fourth quarter of 2005. The fourth quarter 2005 results included an one-time charge for the write-off of goodwill and intangibles of $42.7 million.

Our GAAP operating expenses in Q1, 2006, included a $1.3 million in stock option-based compensation expense, which is excluded from the non-GAAP results. Without the stock-based compensation expense, our operating expenses in Q1, 2006 were approximately $16.3 million, down $200,000, compared to $16.5 million without the write-off of goodwill and intangible assets in the fourth quarter of 2005.

R&D expenses were $9.6 million for the first quarter of 2006, compared to $7.8 million for the first quarter of 2005, and $8.6 million for the fourth quarter of 2005. R&D expenses in Q1, 2006, without the stock-based compensation expense were approximately $8.9 million, up $300,000 compared to Q4, 2005. The increase was mainly due to an increase in non-recurring engineering charges and engineering cash fund expenses, offset partially by a reduction in salary.

SG&A expenses were $8 million in the first quarter of 2006, compared to $9.7 million for the fourth quarter of 2005, and $7.8 million for Q4 of 2005. SG&A expenses for the quarter included $600,000 of stock-based compensation expense under 123R. Without those expenses, Q1, 2006 SG&A was approximately $7.4 million, down $400,000 from Q4, 2005, and down $2.3 million from Q1 of last year.

Non-operating income was $476,000 in the first quarter of 2006, versus a loss of $112,000 in Q1 of 2005, and an income of $170,000 in Q4, 2005. The increase in Q1 2006, compared to Q4 2005, was mainly due to a write-off in Q4 of 2005 of a small equity investment.

In our provision for income tax in Q1, 2006, was a tax benefit of $700,000, compared to a tax expense of $800,000 in Q4 of 2005. The effective tax rate for the current quarter is lower than the statutory federal rate, primarily due to the lower tax -- foreign tax rate on earnings from our foreign subsidiaries, which are considered to be permanently re-invested. In our guidance today, we have included approximately $500,000 in tax benefits for Q2, 2006, in anticipation of a pre-tax loss.

Now, if you turn to our balance sheet, on March 31, 2006, the company had $77.8 million in cash and short-term investments, a decrease of $21.9 million from our December 31, 2005 balance of $99.7 million.

Our cash usage was up substantially from prior quarters, but not unexpectedly. During the quarter, we had a pro forma operating loss of $3.4 million, and we built inventory of $8.6 million. Our inventory build is especially burdensome right now because we are building inventory in our Vibratto 2 family of products for the end of life orders, and we are building our Phoenix family of products in advance of sales because those products are starting to ramp.

We also made a $2.3 million tax payment during the quarter related to the refiguration of international cash, and spent 1.6 million on repurchase of shares. We expect to use cash next quarter without a reduced rate from this quarter.

Accounts receivable, net of allowance for doubtful accounts for Q1 2006 was $17.2 million, compared to $20.8 million at December 31, 2005, a decrease of $3.5 million.

As of March 31, 2006, net inventories were $21.1 million, an increase of $8.6 million from December 31, 2005 level of $12.5 million. We expect to continue to build inventory levels due to the previously mentioned inventory builds in both our Vibratto 2 and our Phoenix family of DVD products, but at reduced rate than we did in Q1.

As of March 31, 2006, accounts payable and accrued expenses were $33.5 million, a decrease of $2.4 million, from $35.9 million as of December 31, 2005. Income tax payable and deferred income tax had decreased approximately $3 million to $39.6 million in Q1, 2006, from $42.6 million in Q4, 2005.

Our fully diluted shares outstanding were 39.1 million shares for the quarter ended March 31, 2006, compared to $39.8 million, or 8 million shares for the quarter ended December 31, 2005. In developing our Q2 2006 guidance for today, we used 39.2 million fully diluted shares in our EPS calculation.

During the quarter, ESS repurchased 473,000 shares of its common stock at a cost of $1.6 million. As of today, ESS has board authority to repurchase up to 4.4 million shares of its common stock at market conditions if deemed 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 our upcoming quarter.

Robert Blair, President, Chief Executive Officer

Thank you Jim. Overall, our first quarter results came in pretty much as expected. Our revenues were $26.9 million with a GAAP gross margin of 8.8%, and non-GAAP gross margin of 10.2%. Our fully diluted GAAP earnings per share for the first quarter was a loss of $0.36. Non-GAAP earnings per share, which exclude 123R stock option expenses, the effects of amortization, the write-off of goodwill and intangible assets, and the related tax effects, was a loss of $0.32.

We ended the first quarter with approximately $78 million in cash and short-term investments, compared with just under $100 million at the end of the December quarter. As Jim has discussed, the use of cash was inline with our previous estimates, primarily because the rebuilding of our DVD inventory levels and our first quarter operating loss.

Now, I would like to provide you with some overall information about the quarter, starting with our video business.

Last quarter, we saw the VCD unit demand grow slightly from the fourth quarter levels. The first quarter for VCD is normally up slightly over Q4, and this year, we shipped slightly more units than we did in the fourth quarter. We expect our VCD volumes to continue to decline, though going forward, as low-price DVD products take over part of this market. I will discuss this product line in more detail in a moment.

As anticipated, first quarter demand for our first -- for our DVD products was down significantly from the fourth quarter as we are phasing out our older Vibratto 2 products, and our new Phoenix DVD products are not yet shipping to all of our customers.

Our MPEG-4 DivX products saw continued strong demand from the branded customers in Japan, Korea and Europe.

We believe that all of our major customers have committed to switch to the new Phoenix product family. These new products provide our customers with the highest level of integration available today, with the most features, including a high-performance audio decks, class D built-in amplifier controllers, HD JPEG, 6 high-definition video decks, USB, HDMI, and other new features. Additionally, these products have a lower cost than our old Vibratto 2 products.

Our new Phoenix chips are currently being designed into all of our major OEMs, and into additional new customers in China. We plan to continue to ramp production shipments during the June quarter, and these chips are expected to be the majority of our DVD shipments by the third quarter of this year.

The significant achievement during the first quarter was of the shipment of our new Phoenix line of DVD products grew to almost 1 million units. The large task to convert and customize the software for existing customers plus bringing up new designs for the new customers took longer than expected, otherwise, we could have shipped many more Phoenix products.

Now, I'll give you an update on our recordable product line. During the first quarter, we shipped about $400,000 for this product line. We believe this market is growing more slowly than previous market forecasts had anticipated, and we do not anticipate growth in the business during the second quarter.

Now, I'll give you some details about our DVD and VCD business and selling prices. For our VCD products, we saw an overall 30% decrease in overall ASPs compared to the 10% to 15% decrease forecasted last quarter. However, ASPs of the VCD decoder-only chips declined 18%, only slightly higher than our guidance. The difference in selling price drops is because our new VCD partner, Salon sells its home server companionship, and therefore, because of mix issues, our overall VCD family selling prices and revenue declined at a rate higher than the decoder business alone.

In the second quarter, we expect VCD decoder ASPs to decline approximately 10% to 12%, reflecting softness in the Chinese market up to the Chinese New Year. Overall, VCD competition remains aggressive, so we expect increased pressure on prices and gross margins 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 cannibalize a portion of this market, it will become increasingly difficult to maintain positive gross margins for this product in the future.

Accordingly, as previously discussed, ESS has licensed the marketing rights for our VCD product line to Salon, a fabulous company headquartered in China. Salon manufactures a VCD servo chip used by many of our customers, and bundles their servo chip with their own print decoder to the VCD market.

ESS will continue to sell our decoder products to Salon, until they have introduced and integrated products using our combined technologies. ESS will receive a share of this group for the gross margin, with a guaranteed minimum for this business. We believe this partnership is the best way to continue to ensure positive gross margins from this segment of our business.

For our DVD business, the selling prices for DVD chips were stronger than anticipated, and decreased only 2% during the quarter, compared with our guidance of 10% to 15% decrease. This was primarily because of the mix for MPEG-4 and DivX products became a large percentage of our overall DVD revenue, and because most of our shipments in the first quarter came from our end of life product: the Vibratto 2. Going forward, because of competition, we expect ESS's DVD selling prices to decline an additional 7% to 12% in the second quarter.

Now, I'll give you an update on our camera phone business. Our digital imaging business had revenues of approximately $2.5 million in the first quarter inline with our estimates. These revenues came primarily from shipments of our 1.3 megapixel chips to LG Electronics.

Today, we are currently sampling our new 4T 1.3 megapixel, system-on-chip to customers worldwide. We are also developing new higher-performance, lower-cost, integrated image sensor and image process system-on-a-chip, which we plan to introduce to the market later this year. These new chips will utilize events, share at 14 pixel technologies, and we believe these advanced 4T-shared products will provide ESS with the combination of high-performance and low-cost products that the camera phone market requires.

I'll now give the detailed guidance for ESS's business in the second quarter of this year. I'll be breaking down our second quarter business based on the following four categories: DVD, VCD, Digital Imaging products, and other products. Other products include our digital media player, or DMP chips, which target the digital TV market, and our consumer audio product.

Now, for the numbers. Despite the fact that the second quarter is normally slower than the first quarter due to seasonality, more of our new designs wins with Phoenix are ramping into production, and we are projecting Q2 revenues of 28 million to 32 million, an increase over the first quarter.

We project the following ranges for the percent of revenue in our respective product lines for Q2. We forecast that our DVD products will be in the 75% to 78% range of total revenue, our VCD products are expected to be on the 11% to 14% range, our digital imaging products will be in the 2% to 4% range; and our other product category will be in the 6% revenue.

Because of strong DVD pricing pressure, and with many of our DVD shipments in Q2 still coming from our older, higher-cost products, we project our overall non-GAAP gross margins to be in the 10% to 15% 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 in the future. We now have R&D facilities in China, Taiwan, and Canada, in addition to the United States. We project that our R&D expenses in the second quarter will be up slightly from the first quarter because of increased pay-cut expenses, and with the forecasted revenues, R&D expenses are expected to be 33% to 37% of revenues.

SG&A is expected to be down from the first quarter, and is expected to be 22% to 25% of revenues. Our long-term objective is to continue to reduce non-R&D operating expenses.

Stock option expenses began in the first quarter, and we forecast this expense to be 3% to 4% of revenues in Q2. Overall, despite increasing R&D expenses by about $1 million per quarter throughout this year, we have reduced SG&A expenses and have been able to pull our total operating expenses to a run-rate of about $17 million per quarter without the 123R charges.

We will continue our efforts to reduce costs and expect to further reduce our SG&A and overall operating expenses throughout the balance of 2006.

Because we have an operating loss in the second quarter, our effective tax rate is projected to be a credit for $500,000 for the quarter. For the second quarter of this year, we are using 39.2 million shares from earnings per share calculations. Therefore, we are projecting the second quarter earnings per share to be in the following ranges. On a GAAP basis, we are expecting a loss of $0.32 to $0.36; and on a non-GAAP pro forma basis, which excludes the effects of amortization of intangible assets, stock option expenses, and the related tax effects, we are projecting a loss of $0.28 to $0.32. This concludes our guidance for the second quarter.

Looking forward, we expect our DVD revenues to continue to grow in 2006 as our new Phoenix products ramp into full production. This guidance will be posted tomorrow on the ESS website where it will be available for the next two weeks. I now would like to open up the call for questions.

Question-and-Answer Session


Operator Instructions. Your first question comes from the line of Jason Pflaum, Thomas Weisel.

Q - Alberto Mann

Hi, guys. This is actually Alberto Mann, calling in for Jason. First, maybe you could talk a little about your expectations for exiting 2006 for your product lines? Do you still see DVD at 75% to 78% exiting '06, or do you think your digital imaging business will pick up a little bit?

A - James Boyd

Current forecast shows that digital imaging will be picking up in the second half of the year, but I would still expect the DVD revenue to be the major percentage of our business.

Q - Alberto Mann

Okay. And, in terms of the VCD royalty revenues, or the licensing fees, when will we start seeing that? Will that be a '07 story, and how significant will that be the gross margin?

A - James Boyd

First of all, I think it will begin, I think it's in ’07 I think it's actually probably too late this year to be able to see that. What we have done is we have now negotiated with our customers, so we will be guaranteed a minimal gross profit on the VCD line, until the new integrated products come to market, so I think you'll start seeing a positive gross margin on the VCD not a large one, but it will be a positive for the rest of this year.

Q - Alberto Mann

Okay. And how much of the gross margin improvement for in the near-term hinges on the rollout of the Phoenix product, and how much of the Vibratto 2 do you still have left to get rid of in that inventory? In other words, how much of the inventory is Vibratto?

A - James Boyd

Okay. You asked two questions. The first one on the gross margin improvement, how much of it is going to be determined by the switch from Vibratto to Phoenix? It's going to be basically the vast majority because we are taking a product that’s selling low cost, to a product that has a positive gross margin, so when you replace Vibratto 2 with Phoenix sales, and then, those Phoenix sales have new designs, at new customers, and increase that, then the gross margin -- gross profit dollars make the major huge switch because of that change in -- from Vibratto 2 to Phoenix. And how much inventory do we have on the Vibratto 2? I don't know the absolute number -- I'm sorry, I don't have that -- but I believe that the majority of the inventory growth the last quarter in dollars, I believe, was in Vibratto 2, if not, it was a significant portion of the growth. We made an end-of-life buy, and our customers have placed orders for the end-of-life, for this product, but we needed to build the inventory and get it over this week.

Q - Alberto Mann

Okay. I guess my question is how much longer do you think you will be selling Vibratto 2, will that continue into September and December, or is that fading out?

A - James Boyd

It's reducing every quarter, but it actually -- the POs from our customers go through the early part of '07. The scheduled shipments go through '07, but it's at an ever-decreasing rate.

Q - Alberto Mann

Okay, all right. Thanks, guys.

A - James Boyd

Okay. Thanks, Alberto.


At this time, there are no further questions

James Boyd, Chief Financial Officer, Principal Accounting Officer, Senior VP and Assistant Secretary

All right. Well, if there are no further questions, I guess I would like to thank everybody for joining the conference call, and I look forward to talking to you at our next quarter, and giving you the new inputs then. So, this will conclude the call.


Thank you. This concludes today’s conference call. You may now disconnect.

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