Avid Technology Inc (AVID) 2003 Q2 法說會逐字稿

Good day, everyone and thank you for holding. Welcome to today’s Avid Technology’s second quarter earnings results conference call. Today’s call is being recorded. For opening remarks and introductions I would like to turn the call over to the President and CEO, Mr. David Krall. Please go ahead, David.

Thank you and good afternoon. I’m David Krall, President and CEO of Avid Technology. I would like to welcome you to our second quarter 2003 results conference call. In a moment I will turn the call over to Paul Milbury, our CFO, who will provide a detailed discussion of this quarter’s financial results. Then, I will discuss some of the highlights from the quarter including the first customer shipment of our new flagship product, Media Composer Adrenaline. Finally, Paul will come back and provide you with our financial outlook for the third quarter and balance of 2003. Following our prepared remarks, we will be happy to take your questions.

Before we begin, please note that the information discussed today is current as of July 17th, 2003. Remarks made on this call may include forward-looking statements including statements about new product releases and functionality; projected growth of existing or new markets and anticipated results of operations during 2003. There are a number of factors that could cause actual events or results to differ materially from those indicated by such statements, such as delays in product shipments; the competitive markets in which Avid operates; market acceptance of Avid’s existing and new products and other factors set forth under the caption ‘certain factors that may affect future results’ in the company’s quarterly report on form 10Q for the quarter ended March 31st, 2003 as well as other documents filed with the Securities and Exchange Commission.

In addition, any forward-looking statements in our remarks represent our estimates only as of today and should not be replied upon as representing our estimates as of any subsequent dates. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our estimates change and therefore you should not rely on these forward-looking statements as representing our views as of any date subsequent to today.

During this call, we will be referring to non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with generally accepted accounting principles. The most directly comparable financial measures calculated in accordance with GAAP are contained in a press release available in the investors relations section at our website at www.avid.com under the heading, “audio archives”. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures will be provided during the call and will also be available on our website.

For the three months ended June 30, 2003, we are pleased to report revenues of $113.3m versus $106.1m in the corresponding quarter in 2002. At the bottom line, net income was $7.8m or 25 cents per diluted share, compared to net income of $152,000 or 1 cent per share for the corresponding quarter in 2002.

For the six months ended June 30, 2003, revenues were $225.5m compared to $198.1m for the first half of 2002. Net income for the six month period in 2003 was $13.3m or 43 cents per diluted share, compared to a net loss of $3.5m or 14 cents per share for the same period in 2002. Paul will now review these results in more detail.

Thank you, David, and good afternoon, everyone. We achieved our plan in Q2 and delivered another solid quarter. Entering the quarter, we recognized that it was going to be a transitional quarter for the video business. We started shipping Media Composer Adrenaline at the end of May and we delivered systems in line with our expectations. David will have more to say about Adrenaline in his comments shortly.

The transition to our new video product line up continues this quarter with first customer shipments of Avid DS Nitris, Avid Express Pro and Avid Mojo which are expected towards the end of the third quarter. Revenue increased sequentially to $113.3m from Q2. Video revenue was $77.4m. Digidesign equalled its historic high with revenue of $35.9m for the quarter.

Favourably impacting the top line was currency, which added approximately $1.5m to the top line sequentially, but this benefit was more than offset by an almost $3m decline in our Asian business, largely due to the impact SARS had in the region. Travel plans for our sales and engineering personnel were severely limited, and Beijing was essentially closed for business for a couple of months.

Additionally, travel to NAB by customers from the area was limited, and the Broadcast Asia trade show in Singapore, which is an important event for the Southeast Asia market was cancelled. The good news is it appears that commerce is beginning to return to normal in the region.

Gross margins came in about planned at 55.3 percent, up almost two full points from Q1 and up nearly five points from the second quarter of last year. By far the largest single factor in the sequential improvement in gross margin is related to the favourable Media Composer Adrenaline impact on product mix. Roughly half of the five point year-over-year improvement is related to product mix, while the other half is currency related.

Operating expenses, excluding $341,000 of amortization, were in line with our expectations rising sequentially to $54.8m, primarily reflecting costs associated with our participation in the NAB trade show. Operating income was $7.9m, or 7 percent of revenue.

As in the first quarter, both the video and audio segments were profitable. Net income, excluding amortization, was $8.1m, or 26 cents per diluted share. Including amortization expense, net income was $7.8m, or 25 cents per share.

We added $29m to our cash balance during the quarter, with approximately $11m coming from operations and the balance from stock option exercises. This brought our cash balance to $135m, up over $46m since the end of 2002. Over the past five quarters, we have increased our cash by $81.5m, $44.5m from operations and $37m from employee stock programs.

DSO has declined slightly from Q1 to 53 days, and capital spending was about $1m for the quarter, while depreciation was approximately $3m. I will be back shortly to update the guidance for the balance of 2003, but now I would like to turn the call back to David for discussion on the highlights from this past quarter.

Thank you, Paul. I would like to take the next few minutes to highlight some of our results this quarter and comment on trends that we see driving the industry forward in a number of areas. Regarding our performance for the quarter, Paul mentioned how we’ve continued to strengthen our balance sheet with a cash balance that is up $46m so far this year.

Our increased revenue this quarter, combined with substantial improvements in gross margins year over year resulted in our highest level of quarterly net income in five years.

From a product standpoint, we began shipping the first of our new Avid DNA solutions in Q2, Media Composer Adrenaline and Newscutter Adrenaline F/X systems. Though these products weren’t available until May 29th, or two months into the quarter, we received orders for over 900 Adrenaline units and we shipped over 800 to customers. We are extremely pleased with demand for Media Composer Adrenaline and are looking forward to the future this product will have in the marketplace.

As our next generation workhorse editing system, it continues to integrate seamlessly into a wide variety of post production environments, with the Avid Unity family of media asset management solutions, as well as offering tight, conforming capabilities with our DS line of finishing and compositing products. Whether it is today’s Avid DS and DSHD systems, or the new Avid DS Nitris family, which I will talk about more in a moment.

In addition, we built Media Composer Adrenaline with the ability to expand in the future to work with 10-bit high definition media. This is an added benefit for customers who recognized the steadily increasing value of HD post production and want to plan accordingly.

It also provides us with a significant opportunity down the road to upgrade any Media Composer Adrenaline customer to an HD solution. Continuing on the theme of HD, Avid DS Nitris, our flagship HD solution that has been designed to offer guaranteed real time multi-stream professional quality processing of high definition media, is expected to ship during the third quarter. As HD is gaining momentum in a number of geographies and markets, our objective is to have our tools be the standard for HD post production, just as our current products have set the standard for standard definition post production today.

As we look at the adoption rate of HD in the industry, it appears that competitive forces rather than regulatory mandates are a main driver. A number of terrestrial broadcasters, cable operators and satellite companies have been announcing their plans to increase the level of content they broadcast in HD. For example, last month, Fox announced that it plans to transmit at least 50 percent of it’s prime time scheduling in HDTV by fall, 2004. NBC has begun to demonstrate its commitment to HD by launching Bravo HD Plus, it’s first high definition cable channel scheduled to go live at the end of this month.

Just this week, HD Net, the first national television network to broadcast all of its programming in 10 ADI HD announced a long-term agreement to license the television rights to 58 feature films from New Line Television, all of which will appear on the HD Net and HD Movies Networks which are carried via satellite and cable.

And, according to a report issued by the national Cable and Telecommunications Association, as of June 1st cable TV operators in 112 of the 210 U.S. markets, including 78 of the top 100 now offer some sort of HDTV programming.

Now I’d like to talk about some of the marketing efforts we have underway to promote our new product introductions. While the annual NAB trade show is one of our most important venues to introduce new products, we recognize that not all of our customers and prospects can attend. Therefore, to help spread the word about the new Avid DNA family we introduced at NAB, we kicked off road show tours around the globe. In North America the tour is called, “Experience Avid” and includes corporate events in nine major cities, as well as more than 40 local and regional events.

The tour, which began in Dallas on May 13th and concludes next Tuesday in Toronto gives customers the opportunity to discuss industry trends, learn new tips and tricks and get a free, in-depth look into our new products.

At the same time, we’ve got a show on the road in Europe. So far we’ve completed nine events, visiting cities like Munich, Amsterdam, Madrid, Paris and London and the tour will be continuing through the balance of the year, crisscrossing Europe and informing customers about Avid and the new Avid DNA family of products. So far nearly 10,000 customers world-wide have registered for these events, and this total does not even include attendees at the many smaller events hosted by local resellers.

Understandably, much of the attention by the investment community since NAB has been on our new line up of post production products. However, our broadcast news business also continues to gain momentum in the marketplace. The pipeline of potential deals is growing as increasing numbers of broadcasters are investigating our end to end digital newsroom solution. Helping fuel the increased interest is an overall improvement in the financial outlook of many broadcasters. Reports are that the upfront ad market was particularly strong, and forecasts for ad spending for the balance of 2003 are encouraging. TNS Media Intelligence/CMR is forecasting an increase of 4.3 percent in U.S. ad spending this year, with particular strength in Spanish language television, syndicated television and cable network television.

Order activity for our end-to-end news solution continues to accelerate. During the quarter we received orders for 23 more end-to-end news solutions, bringing our cumulative total to 110 systems sold or installed over the past two-and-a-half years. With each successive quarter, we have been widening our lead as the provider of choice for digital newsroom solutions.

To help facilitate broadcaster’s transition from analog and tape based production to digital, non-linear news production environments, we recently formed our professional services group within Avid. This cross-functional team offers a comprehensive set of services including presales support, consulting, installation, training and post-installation support. We believe there is a significant opportunity to provide these services to broadcasters and expect that they will be a growing part of our broadcast business.

There has been a great deal of news recently about the FCC’s decision in early June to raise the audio reach ceiling to 45 percent from 35 percent, thus allowing a further consolidation of media ownership. It is clear the issue is far from settled, as just earlier this week the House Appropriations Committee passed a proposal that would roll back the FCC’s decision.

Nevertheless, I would like to spend a few minutes talking about the impact further consolidation could have on our business. Such consolidation of the television industry could prove to offer unique benefits to Avid as many station groups may be able to cast a wider net with respect to the number of stations they are permitted to own.

As we have discussed in the past, we believe that station groups are a key market opportunity for Avid, where many broadcasters test the water, so to speak, with one end-to-end digital news room production environment from Avid and then convert their remaining stations based on the efficiencies they’ve experienced with the first station.

With the potential for increased consolidation among broadcasters, our penetration at station groups and media conglomerates could expand as a result of station acquisition in the broadcast market.

However, regardless of the final outcome on this consolidation issue, we intend to continue to execute against our plan to capitalize on this substantial broadcast market opportunity.

Now, switching to our audio division, Digidesign, the second quarter saw the release of Pro Tools Version 6.1. This version represents the first release of Pro Tools software offering a unified feature set across Windows XP and Mac OSX systems. This is particularly important to the entry level of the audio market which tends to be more PC based.

In addition, version 6.1 has a new streamlined user interface and tighter interoperability with the Avid video editing solutions. Digi also began shipping the Digi 002 rack, the newest member of the Pro Tools LE product line. This is the first rack mountable fire wire based Pro Tools product from Digidesign and it fills an important niche in the entry level of the audio market.

At Softimage, the quarter was highlighted by the release of Softimage XSI Version 3.5 and Behavior Version 1.1. These products will be on display at [SigRaft] July 28 and July 31st. [SigRaft] is the major trade show for the animation industry. At the show, Softimage will be highlighting customer experiences with XSI focusing mostly on how it has enabled users to meet the increasing visual sophistication requirements of films and games while delivering substantial increases in productivity.

For example, Hybrid, the animation and effects company producing Spy Kids 3 was able to complete their work three weeks ahead of schedule using an all Softimage pipeline. As you can imagine, case studies like this resonate with the film industry.

Well, I hope we have given you a good snapshot of our progress throughout the quarter as well as a sense of the development and the trends that are shaping future opportunities for Avid’s business. With only a couple of our Avid DNA-based products out of the gate so far, we are off to a strong start in 2003 and we are looking forward to shipping the remainder of what we announced at NAB in the months ahead. I would now like to hand it back to Paul to discuss our outlook for the balance of 2003.

Thanks, David. Let me start with an update to our full year 2003 revenue and EPS guidance. With respect to revenue, we are increasing the range to $460m to $465m from our previous range of $450 to $460m. We are also increasing our EPS guidance from 97 cents to $1.20 for the full year, before acquisition related amortization and restructuring and other costs.

The $1.20 per share assumes revenue at the midpoint of our revenue range, so of course there is a range of potential EPS around the $1.20. Including amortization, restructuring and other costs would reduce the full year EPS by approximately 10 cents per share.

The third quarter generally has some seasonal weakness related to our audio business, and we do expect our audio revenues to decline several million from Q2 to Q3. Overall, we currently expect total company revenue to be in the range of $114m to $117m for Q3. Although there are a number of risk factors that could impact our revenue results, the biggest risk factor is related to shipping our new products in this quarter; Avid DS Nitris and Avid Express Pro are currently expected to ship in the second half of September. This means we cannot plan for significant revenue from these products this quarter, and the low end of our range does not include any revenue from these new products.

Gross margins are expected to remain strong at around 55 percent for the balance of the year, resulting in full year gross margins of approximately 54.7 percent. Operating expenses, excluding acquisition related amortization, which is expected to be in the range of $350,000 or 1 cent per share in each of Q3 and Q4 are expected to decline to about $54m in Q3 and then rise slightly to about $54.5m in the fourth quarter.

For the third quarter, using the midpoint of our $114m to $117m range, we would expect operating profit, excluding amortization, to be approximately $9m or 8 percent of revenue. For the fourth quarter, we would expect to achieve an operating profit of more than 10 percent of revenue, a level of profitability we have not achieved in almost five years.

Other income should be approximately $500,000 per quarter for Q3 and Q4 and tax expense should be approximately $300,000 per quarter for Q3 and Q4. Fully diluted shares outstanding are expected to be approximately $32.5m for both the third and fourth quarters. Cash from operations is expected to be in the area of $10m for Q3 and $15m in Q4, which would increase our cash position from $135m today to $145m at the end of Q3, and $160m at the end of the year.

In addition to the cash from operations, I would expect proceeds from employee stock option exercises and the employee stock purchase plan to add to that balance. These conclude my remarks. David and I would now be pleased to take your questions.

(Operator instructions) We will move first to Richard Ingrassia from Roth Capital.

Good afternoon, everyone.

Hi, Rich.

On the broadcast for this quarter, can you give us an idea of what the geographical mix was? International versus North America?

Yes, we can actually give you the specific numbers there. We had 16 domestic and then the rest –

Roughly two-thirds to one-third.

Do you see that pattern continuing for the near future?

Actually no, not really. If we count our total target market we had said that there were 2,700 total broadcasters that we are going after and approximately 1,100 of those are in the U.S., so that would actually put the majority overseas longer term. However, it probably is the case that the U.S. has been the first to do a conversion.

But that mix could shift fairly significantly from quarter to quarter.

And do we have a sense from the resellers on the makeup of the customers so far on Adrenaline? Are we talking mostly about upgrades to current Avid seats, or new customers, or are they replacing other equipment? Do we have any idea there?

Well these have been new seats as opposed to upgrades, and in terms of what the end user uses have been for the system we haven’t really consolidated that input yet.

Do you have any indication of how it is tracking so far for July?

We do, but we are not going to disclose it. It is pretty early in the quarter for us.

Thanks a lot.

We will move to Gene Munster with Piper Jaffray.

Hi guys. Congratulations and thanks for the details. Going back through the unit shipments, you said you had 900 orders and 800 units shipped, and is a fair EPS, what is the revenue per box? Any sort of colour on what that might be?

We don’t disclose the level of reseller discount. The list price is $24,995. So the pricing was pretty solid, probably a little bit better than what we were thinking about.

Okay, let’s say it is maybe $20,000. That gets you to $16m in Adrenaline for the quarter –

Actually I should qualify that a little bit, because we received over 900 orders. We shipped out the door to customers over 800, but not all of those shipments out the door were for revenue this quarter. Some of those are deferred and tied up in deals that haven’t been recognized. So it was lower than that.

You think of it as, we took revenue for over 700, not 800. 900 orders, 800 shipped, 700 revenue.

So 700 recognized. So assuming 700 at 20 a pop is $14m, which seems very strong for basically five weeks of sales. Any sort of feel in terms of what the linearity of that is? I know you probably have no idea how that is going to track out for next quarter, but what is your general sense of the speed at which the resellers are placing orders pretty consistent today versus when they initially got the product, or any thoughts on that? I assume it probably has tailed off just naturally after a new product ships.

We are not going to make any specific product-by-product projections going forward.

Okay. Can you talk a little bit about, aside from Adrenaline, just the health of the rest of the business? It seems like that is pretty stable. Any sort of trends you are seeing within that? Is this just kind of, get us to the point where we get these other three products shipping as far as the rest of the video business?

I’ll comment on the video business. As you know, this has been a huge product transition for Avid, starting with the biggest new product release in our history that we first introduced at NAB, and the adrenaline product is really the first one to make that transition, so we’ve successfully gone through that gate.

During that time though, since we have introduced our new products, we’ve had a slight decline in revenue and our other video products as our customers are anticipating the release of the successors to all of those products. So this makes this a bit of a transitional quarter for us, but obviously a lot of strength in Adrenaline, a lot of strength in Avid Unity. In fact, our revenue from Unity was up 25 percent quarter over quarter and over 60 percent year over year. We are finding that the Unity systems that we are selling are larger and larger in terms of higher ASPs and much higher storage associated with it. We also obviously had a lot of strength in our broadcast business. So a number of areas doing very, very well and then other areas that are anticipating the transition to the remainder of the DNA family.

Would some of those Adrenaline’s be accounted for as broadcast revenue?

Yes. Some of them, the units that we gave out were for total adrenaline units which included Media Composer Adrenaline as well as the Newscutter Adrenaline F/X systems.

Are there – maybe I just missed this, but did you give kind of a simple number in terms of what the growth in the overall broadcast business was sequentially?

We didn’t give it out, but it actually was a very strong quarter for us in broadcast. We don’t breakout those individually because actually for us our unity revenue ends up crossing the categories of broadcast as well as post-production.

What were your original expectations for Adrenaline in that first quarter?

This has been in line with our expectations, maybe even a little bit above.

Lastly, before I turn it over, in terms of the Digi revenue, surprised to see that. Any sort of other thoughts on – you had mentioned that you expect that to kind of pull back a little bit here, but were you surprised by that strength? Any thoughts on that strength?

Not really surprised by it. I think that Q2 is historically a strong quarter for Digi and Q3 is historically a seasonally weaker quarter for Digi, so they did a great job in Q2 and we are expecting a slight seasonal pull back in Q3.

Excellent. Thanks, guys.

Steve Frankel, Adams, Harkness and Hill.

A couple of questions. First of all it obviously was a great quarter, congratulations. Going into this transition, David, you talked about the old ABBV customers and how they had sat out the last round. What evidence do you have that they are lining up for Adrenaline at this point, or want to?

Well I don’t have statistical data for it, just simply because we haven’t tracked our Adrenaline unit sales down to individual customers to find out what the reasons were for the purchase and what their intended use is, but I can give you qualitative data based on the Avid experience tours that I attended.

I have talked to a number of customers who are still ABBV customers who came to the event and were very excited to hear the new Adrenaline system supports ABBV media resolutions. That has been a big roadblock for customers. We have approximately 13,000 ABBV customers who did not upgrade to any Meridian family member from Avid who are very excited about the new Adrenaline product. So we are encouraged by that kind of a result, but again, that is qualitative, not quantitative.

Well, can you give us any feedback on the DSHD promotion that you had talked about on the last conference call?

Yes. We have a $5,000 promotion, basically, that gives you a discount on the purchase of a DSHD toward a free upgrade to a Nitris system. I guess what I would say is that sales for DSHD were not particularly strong this quarter, mainly because we think that our customers are looking forward to actually seeing the system first-hand and using a Nitris system. So that is a pretty expected or typical response from customers when they are buying a high-end system. So as we get closer and closer to the ship date we are expecting that the demand will increase.

And you’d expect demo units to be out a couple of weeks before the actual customer availability, like it was with Adrenaline?

Yes, typically.

And what about the international rollout of Adrenaline? Is that fully rolled out at this point?

It is rolled out and we had very strong results internationally.

Great. Thank you very much.

We will move to Jim Ricchiuti of Needham & Co.

Thank you. David, I wonder if you can comment at all about just the industry environment. It seems like there is a better backdrop for the equipment spending cycle. How much is it, of the strength you are seeing in your video business, do you think is a result of that and how much is due to the new products? I mean, clearly the new products are having a big impact. I am just wondering about the general tone of industry demand out there.

Well, I split our industry on the video side into two segments; broadcast and post. I think that we are seeing some real strength in the broadcast industry. As I mentioned, a number of broadcasters have more positive outlooks based on the uptake in ad spending and that is helping to drive capital purchases, as well as traditionally election and Olympic years are strong years for broadcasters, and that is obviously coming up in 2004. So there are a number of things to look forward to if you are a broadcaster.

From the post-production side of things, I wouldn’t say that there is a real secular trend of strength in post production. I believe that actually our results there are more driven by the new product introductions than by any change in the industry environment, so obviously there is some upside to that as the post-production industry starts to pick up.

David, on the Unity product line, do you feel you are gaining share there or is there just a more rapid transition to this? What is your sense in that product line?

We actually think it is increased adoption of network-based systems, or integrated workflow. So one of the big efforts that Avid has had underway for the past three years is driving the industry movement from standalone systems to network systems based on shared storage, and we are seeing more and more adoption of an integrated, collaborative workflow.

In addition, the Unity sales, as I mentioned earlier, are driven by the increase in our broadcast sales because the Unity for News system lies at the heart, either Unity for News or a LAN shared F/X system lies at the heart of an integrated, end-to-end, newsroom solution. So there is strong growth on both sides in post as well as broadcast for Unity systems.

Okay. Paul, maybe this is one for you. I may have missed this, I don’t know if you commented on this, but the overall profitability of the video business in the quarter, can you speak to that?

The video business, as I said, both of the segments were profitable. The video business had operating profit of $2.7m or about 3.5 percent of sales. That should be clearly the lowest profitability quarter for video because of the cost of the need to absorb the cost of the NAB trade show in Q2. So its profitability as a segment should improve substantially in the third and fourth quarters.

Do you see any residual impact from SARS at all in this quarter or do you basically see that as out of the way?

This quarter?

Q3 is what you are referring to?

Q3.

I mentioned that things are beginning to get back to normal, but there is still a little bit of kind of a transition to normal that is going on as we speak, but clear signs of things getting better.

Okay, thanks very much. Congratulations on the quarter.

Sam Doctor, JP Morgan.

Congratulations. I have a question for you on the broadcast segment. You’ve done a total of 110 so far. Do you have a sense as to how many out of the total 2,700 have transitioned so far?

Yes. As of last quarter we had estimated that about a total of 135 had made the conversion which is roughly 5 percent of that 2,700 total so we haven’t gone through to do our estimates of what we think total market conversion has been over the past quarter, but it is going to be single digit percentage increase.

Okay. And of the 110 that you have shipped, how many of those are exclusively your solutions and how many would you be part of other solutions?

The systems that we are talking about, we are at the heart of. So going back to how we measure it, it is Avid Unity for new systems at it’s core, surrounded by editing systems, ingest and play out, et cetera. However, in a number of those systems they are heterogeneous environments, so we may be interfacing with other third party products for ingest or for play out, et cetera. So the total though is related to our Unity for News systems.

Now I should say – you had said all the units we had shipped to customers. These are ones we’ve sold, total, but not necessarily all of these systems are installed or even necessarily shipped to customers at this point.

All right. Thank you.

You are welcome.

Randy Scherago with First Albany has the next question.

Hi guys. Just a couple of housekeeping questions. International as a percentage of total sales for the quarter?

U.S. sales were about 58 percent and international was 42 percent.

Is there a timing of the release of Nitris and Express Pro with Mojo? I know with Adrenaline there was a lot of the date for shipment slipped a bunch. Is there any hard date for the shipment of these two products?

Well these two products are not linked, so they are being developed by independent engineering teams so therefore their release dates are not correlated. In terms of the target dates they are both targeted for late this quarter, but as in any release, especially a complex and significant release there is always the possibility of movement on the ship date. So it is as good an estimate as we can give.

But in the guidance that Paul gave he anticipated the possibility of not incorporating any revenue from the Nitris product this quarter at all. So we’ve already calculated any movement of the ship date into our guidance.

Thanks, guys.

[Jacob Caldenbalm], Harvest Equity Research.

Hello, gentlemen, and congratulations on the quarter. I would be interested to hear you talk about the professional services side of your business, because I was wondering when that was going to start to show up, considering that you are moving into a lot of system sales, especially with regard to your Unity.

I was wondering if you could provide some more detail about your services business, how it’s built up so far and to the extent you can, what your expectations are for it going forward.

Well what we have so far, we had announced this quarter, earlier in Q2 that we had launched our professional services group, initially staffed with 12 people. The intent of that is to provide presales assessment, site analysis, the installation, the training and post-sales support of a sale. As these sales become increasingly complex and large and far-reaching for a customer’s enterprise, obviously this sort of service becomes more and more important for customers as well as for the overall success of our business.

So there is not an individual number that we will break out right now in terms of what we think the revenue is from that business, but we do think that it can become an important component of our revenue from the broadcast marketplace. So it is something that is very significant to us as we move forward.

Do you have a person who is leading the charge? Can you tell me what their background is? Do they have outside professional services experience? Are you planning on bringing someone like that in?

We obviously have staffed it with the people we think are the right ones for the job. The person we have directing this effort is a gentleman by the name of Joe [Vandenberg]. He is a broadcast industry veteran with about 20 years of experience in the industry. So broadcast is nothing new to him, and neither is the service business. It is something that we think is going to be able to jump start our efforts and get it off on the right foot.

Okay, great. To the extent – I think someone touched on this a little bit, but I want to ask the question a little differently. How much of the 800 units of Adrenaline that you shipped was pent up demand due to the knowledge of the product being launched? In other words, how much of it was deferred from the previous quarter, in your minds?

Well I will say one thing. That question, I don’t think I can answer the question accurately in the sense that we never really know when we introduce a new product to somebody if they’ve bought it based on pent-up demand or brand new demand. So it all depends on a case-by-case basis.

I will say though that we had had very strong upgrade of our customer base to our Meridian program for ABVB 2 Meridian upgrades and I think many of our customers in our install base had already done an upgrade. So for that reason, a lot of the demand for Adrenaline systems was new demand.

Great. And then I actually want to backtrack to the previous subject. I was curious what your sales look like, what an Avid storage sale looks like as related to the Unity. How much of that is direct, how much of that is indirect? At what level are you guys in the majority of your sales with regard to these deep systems that are going into the broadcast groups?

Well broadcast in the U.S. is primarily a direct business, with the exception of very small broadcasters who we can’t quite reach with our direct sales force. It tends to be also a business that we are taking more and more direct in Europe. In Asia the business tends to be indirect. So these are all things though that as we look at large broadcasters and these deals become larger and larger we are taking more of that business direct.

Great. Well congrats on the quarter again.

Thank you.

(Operator instructions) We have a follow up from Steve Frankel.

Just David, some qualitative comments from you on Softimage and how you think you are doing in penetrating new customers.

Well, Softimage as you know has released it’s new versions of XSI, so 3.5 and Behavior. We are finding very interesting applications for Softimage for some new markets in pre-visualization. That is actually where they do the staging of a production before actual production takes place.

What that allows you to do is get camera set ups, lighting, all of the placement of key features and actors before you do the shooting, which can save time and money. As we’ve talked about before, 90 percent of the expense of a film is in the production stage. Only 10 percent of the money is spent in post production. So any amount of money that you can save during the production phase is extremely valuable and important to the film effort.

So we are seeing increased use of SXI in that application. Interestingly, the Behavior product is being used very innovatively in large crowd simulations where somebody needs to be able to show a large number of characters, it could be human beings, it could be other characters as well, and I am just alluding to some upcoming movies that are going to be coming out that used Behavior extensively.

So we are seeing both those products applied in non-traditional markets that have a lot of growing room.

Thank you.

And we’ll take a follow up from Randy Scherago as well.

Hi guys. You guys have been spending a tremendous amount of money in R&D getting these new products out. When do you think R&D as a percentage of sales will start to come down? Also, being as Q2 was NAB and a big push for the Adrenaline product in the nationwide DNA tour, when do you think marketing and selling expenses will start to ramp down a little bit?

I would expect the company’s R&D expense as a percentage of revenue to start to decline this year, based on the fact that R&D spending is not growing as fast as revenue is growing. I would expect that to continue next year. Not based on absolute cuts in R&D spending, but containing the growth to a very low level while our revenue grows.

I don’t see our ongoing sales and marketing expenses declining, again in absolute dollars. Maybe not even as a percentage of sales. You know, we are investing in the launch of these new products. We are also investing in capturing the broadcast opportunity that we see in front of us.

Tom Leech, Bennett Lawrence.

Good afternoon, gentlemen. I am new to your company so I am going to ask a couple of housekeeping questions if I could. On your tax rate, it is obviously under normal rate, I guess you have net operating losses. How many dollars are there and how long does that go on?

When I lump together the remaining tax amortization for our Softimage acquisition and our NOLs and our R&D tax credit, there is well over $200m of U.S. taxable income that can be sheltered from those items.

In addition, stock option exercises also generate incremental tax deductions over and above that, so we’ve actually been adding to that amount recently. So we can shelter quite a bit of U.S. taxable income, well over $200m.

The next question, a simple question, the mix of your revenue between channel and direct.

It is roughly 70 percent channel and 30 percent direct on a worldwide basis. For the video business its 60 percent channel and 40 percent direct.

And the first numbers you gave me were total, right?

Total company. The audio business is 100 percent indirect.

And on revenue recognition when you go through the channel, sell in or sell out?

Revenue recognition on the video side of the business is based on sell into the channel. We in almost all cases have an end user customer identified on the reseller purchase order when we ship. In the audio business, which is a somewhat different business, actually they have a consumer part of their business. We recognize revenue on sell into the channel and then monitor the channels pretty closely.

On audio it is 100 percent channel, right?

Yes.

I see your deferred revenue dropped this quarter. Why is that?

It’s really related to the amount of cash payments that we get on our large broadcast deals. We don’t create any deferred revenue when we ship a large broadcast deal prior to recognizing it. In our case, deferred revenue is only created when a customer makes a cash deposit or a partial cash payment against an order, so it is really just a timing issue.

So it isn’t that there is a long revenue recognition time, it’s just a matter of whether you can get a cash deposit up front?

That’s right. That’s the only thing that generates deferred revenue in our case. Our backlog for the large broadcast deals, although we don’t disclose the specific amount, this quarter remains strong and rose from the previous quarter.

Did you guys talk about book to bill?

No.

And then your gross margin obviously was a surprise this quarter. I’ve talked to a number of your customers and things like that. Is there a big average selling price difference between Adrenaline and Meridian and the gross margin between those two different products?

It’s a question that I think I answered in the last call. When you look at Adrenaline with a list price of $25,000, you need to compare it against the Media Composer system that it is replacing but also the Media Composer upgrade business and the Media Composer Express business that we’ve done in the past. When you look at the blended ASP for those products being replaced by the Media Composer, the selling price is roughly 10 percent to 15 percent lower, but the gross margin dollars per unit for that Media Composer Adrenaline product are higher than the products it’s replacing.

We’ll move to Brian Gagnon, Gagnon Securities.

Hi guys. First, congratulations on managing a difficult transition. A few questions. First, with HD and the trend also to 5.1 in the audio business, are we going to see a kind of quantum leap in the need for storage over the next 18 to 24 months?

It all depends on what you call quantum leap. I guess if you listen to what we are hearing from people in the industry, for example I will say that I’ve heard from EMC directly that they believe that one of the biggest consumers of storage in the world is actually going to be the content creation industry. That is drive by the fact that media takes up a lot more space than data files. We find that when we sell a Unity system they tend to go out the door with more and more storage, often maxed out. So we are having customers bump up against our own upper limits. If we had more storage to sell them, they would take it.

Will you be working on upgrades to that, to be able to exceed your upper limits?

Absolutely. In fact, our historic numbers, this is about a quarter old but I don’t think the data has changed. The last time we looked at it, 80 percent of our Unity customers had upgraded their storage, so it is a pretty typical pattern for customers to increase the storage once they are a Unity customer. But we are also working on products that can expand the scalability of our storage in Unity because we are seeing that as a pretty significant customer need.

If you just look at the production of one HD film, the film and its components can consume over a terabyte of storage, so you can see that there is a fair amount of storage that can be consumed in the HD production of media.

Just for a reference point, one terabyte for an HD film, what is it for a standard definition film?

The data rates associated with HD are roughly six times the data rates associated with standard definition media.

The second question is, on the Adrenaline systems, how many can you make?

If the world were all building them… Well I will put it this way. We have established a manufacturing pipeline that is going to allow us to outsource the manufacturing of our Adrenaline systems so we aren’t even touching them internally. We think we will be able to ramp that capacity significantly if necessary.

So initially we’ve been shipping those systems through our in-house manufacturing, but we’ve designed the manufacturing process so that it can be outsourced, including the calibration process. So we’ve got scalability around our ability to ship that product.

Okay. Then kind of in the same vein, by having this product be lower priced, and even though it is 10 percent to 15 percent lower cost, is the real cost savings to you guys by improving your gross margin the lack of having to have specific I/O cards and being able to use a straight fire wire cable?

Well the Adrenaline system as you know is a very different architecture than what we had on our prior generation system. It actually is allowing us to leverage the host processor and offload a lot of the basic computations to the host CPU purchased by the consumer. The big benefit of that is that the consumer gets to get better performance out of their Adrenaline system as they upgrade their host processor at some point in the future. So it is a system that offers tremendous future proofing for a customer’s investment.

In terms of our improved gross margins though, it is also significantly related to the fact that we designed the system with COGs in mind and we were very selective in building something that would allow us to have lowest COGs possible while at the same time delivering professional quality, in fact unsurpassed, image quality on ingest.

Thank you.

Thank you.

We will move to Gary Lenoff, Brie Kaloor.

David, if we can look past this quarter and even Q3 and Q4 into next year and talk a little bit about the audio opportunity. Can you just shed some light on what you guys are thinking in terms of product and introductions, what parts of that market do you find interesting now, and when might you be able to share specifically some of the plans that you have for 2004 in that space?

We have, I think what you are referencing is we have alluded to the fact that this year, 2003 for Digidesign has been a year of investing in some new product developments that will be unveiled to the marketplace in 2004. So in terms of what light we can shed on it, we are not yet in a position where we want to talk explicitly about what market opportunities Digi is pursuing other than to say that they are adjacent markets that are very well suited to the technologies that Digidesign has been building to serve it’s core markets today. We will talk about that at a future date as we are closer to shipping the product. I apologize for not being able to be more explicit than that on your first part of your question.

To talk about where we see market opportunities today with our existing products, there is still a very significant opportunity that is in front of Digidesign in mixing. The mixing marketplace is still, in large part, done in an analog fashion using older technology and Digidesign offers a very efficient, very cost-effective method for mixing and mastering media entirely in the digital domain. That is an opportunity that Digi is pursuing with its Pro Tools HD product as well as the mixing and control surfaces that it sells today. There is still a lot of room to grow in that existing market.

Okay. And I believe in the past you’ve alluded to a billion dollar market opportunity. Is that the size of the market that you are not currently addressing that you look to address in 2004 or can you clarify that for me? I am not sure I recall correctly what you were referring to.

It’s about a billion dollars, and historically we’ve talked about that market being a billion dollars. When we look at the recording, editing, mixing and mastering of digital media. That also includes a growing market segment for Digidesign which is in the home market. You’ve seen us introduce some very compelling new products. M-Box, the Digi 001, the Digi 002 for addressing the opportunity in the home market.

So traditionally we’ve talked about the billion dollar market being what the current markets were that we’re serving. We see the opportunity in these adjacent markets to be incremental to that.

Okay. I don’t want to create any controversy, but I’m struck by the positive tone as well as obviously the positive results that you are experiencing in the broadcast base, as contrasted to a bit more conservative or cautious tone that Pinnacle has taken in their comments in the past. Can you shed some light on, is there a competitive shift going on here or is it just – help me understand a little bit more why you seem to be a bit more optimistic and excited about the opportunities than Pinnacle has been when they’ve talked about it.

Well I actually don’t know what specific comments you are referring to on the Pinnacle side, I will just say from our point of view, we look at our own internal sales pipeline and we see the possibility for business in all geographies being very strong. As Paul said, we’ve increased our backlog in business quarter on quarter so we’ve got a pretty positive outlook. If you look at the systems that we sold this quarter, the 23 has us well on the way of achieving our year goal which we had established of selling 60 to 80 systems for the year.

We feel like we are on track, maybe even a little bit ahead of where we thought we would be at this point. So for us, we don’t have any reason not to feel optimistic.

Okay. Well congratulations on a great quarter. I appreciate it.

Thank you.

That does appear to be all the time we have for questions today. Did any of our speakers have any concluding comments?

I would like to thank everyone for joining us today. I would invite you, that should you have any further questions, please feel free to contact us directly. If not, we look forward to speaking with you all again next quarter. Thank you.

That will conclude today’s audio conference. Again, we do thank everyone for their participation.