Identiv Inc (INVE) 2003 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the SCM Microsystems third-quarter earnings conference call. (OPERATOR INSTRUCTIONS). As a reminder, this conference is being recorded Wednesday, October 29, 2003. I would now like to turn the conference over to Ms. Darby Dye, Investor Relations with SCM Microsystems.

Thank you. Hello, everyone, and thank you for joining us today as we discuss the results of SCM's third quarter 2003. Speaking on today's call are Steve Moore, Chief Financial Officer, who will provide financial analysis of SCM's recent quarter and forward-looking financial guidance, and Robert Schneider, Chief Executive Officer, who will provide an overview of SCM's market environment and business strategy.

As we begin today's call, let me remind you that during the course of this conference call, management will make certain forward-looking statements regarding future events or the future financial performance of the Company. We caution you that such statements involve risk and uncertainty, and that actually events or results may differ materially. We refer you to the Company's 10-K, filed March 27th, or 10-Q for the quarter ended June 30th, 2003, and other recent SEC filings which explain important factors that could cause actual results to differ from those contained in any projections or forward-looking statements. Any forward-looking statements made on this call are based on information that is currently available to us and which is likely to change over time. Although our projections will likely change, we do not plan to update them. SCM will provide our analysts and investors with information and forward-looking guidance in our quarterly financial news releases and conference calls. We will not provide any further guidance during the quarter unless done through a news release, conference call or SEC filing in accordance with Regulation Fair Disclosure. Please also note that on today's call, we will provide you with several financial metrics determined on a non-GAAP or pro forma basis. These items, together with the corresponding GAAP numbers and reconciliation to GAAP were practicable, are contained in today's earning press release, which we have posted on our Web site at www.SCMmicro.com, and filed with the SEC on Form 8-K.

Now I would like to introduce Steve Moore.

Hello, everyone, and thank you for joining us today. To begin today's call, I'd like to give you a quick update on the status of our major organizational developments of the third quarter. First, we completed the sale of the consumer digital media and video business, which we first announced on June 30, and which closed on July 25th. SCM is now focused on the OEM market for secure digital access solutions. In addition, we are now free to sell the stock consideration we received from Pinnacle Systems, and expect to receive $20 million in proceeds for the sale of this stock and future cash payments over the next two quarters.

A second accomplishment in Q3 was the restructuring of our organization around functional, rather than divisional, lines. With our retail division now gone, SCM now has the business model that is primarily OEM. We therefore felt it was critical to realign our business functions to better support our OEM customer base. This reorganization has already resulted in tangible improvements and our ability to leverage communication and coordination between various functional areas to address the needs of our customers.

Now let's look at the results of the third quarter. As a reminder, our financial results in the third quarter and going forward include financial performance for the Company's continuing security operations only. Financial results for the disposed digital media and video business are being treated as discontinued operations. Revenues from continuing operations were $15.9 million in Q3 within management's guidance of 15 million to $20 million for the quarter. Revenues were down approximately 15 percent, from the $18.7 million recorded in the third quarter 2002, and were sequentially down 18 percent from revenues of $19.3 million in Q2 of 2003. Beginning with Q3, and going forward, we will provide revenue data from our three main product line segments. Sales of our digital TV security modules were $8.1 million in Q3, which represented 51 percent of total revenues. These security modules are used in conjunction with open platform set-top boxes to protect digital pay-TV broadcast and enable legitimate subscribers to decrypt broadcast content. Sales of our smart card readers and related products used to provide secure access to PCs and computer networks totaled $5.1 million in Q3, which represented 32 percent of revenues. And sales of Flash media interface products were $2.7 million in the quarter or 17 percent of revenue.

Looking now at revenues split by geography, Europe represented 63 percent, the United States 24 percent, and Asia-Pacific, 13 percent of total Q3 revenues. Revenue levels in the third quarter reflect continued weakness in sales of our digital TV security modules in Europe, due primarily to poor economic conditions, but also resulting from new competition from gray market modules coming into the market in the last few months. Q3 revenues also reflect a low-level of orders for smart card readers from the U.S. government, which has mostly completed its large common access card program, but has not yet ramped for new projects being planned. We are aggressively addressing the competitive issue in our digital TV business, with new products coming out in Q4. Over time, we believe this will have a significant positive effect on the (indiscernible) of our digital TV business. However, given the economic and customer budgetary challenges facing us, we expect that the sale of our digital TV modules will continue to be under pressure in the near to medium-term. Given our field experience and the working relationships we have developed with major government contractors, we believe that we will able to garner a healthy share of the smart card reader business from new government projects once they begin. However, in the near term, we expect the sale of our smart card readers will continue to be soft as IT budgets remain on hold, and because of the timing of new government projects that remain uncertain.

While the near-term outlook remains challenging, we remain optimistic about longer-term opportunities for growth in the future access market, and about SCM's ability to capitalize on those opportunities to fuel our own revenue and earnings growth.

Gross margins for the continuing security business in Q3 were 42 percent, significantly above our targeted gross margins for the quarter of 35 percent to 39 percent. This resulted primarily from a favorable mix of higher margin products sold in the quarter.

By product line, gross margins for digital TV products were 38 percent; gross margin for our PC security projects was 39 percent; and gross margin for our Flash media interface products was 57 percent.

As reported under GAAP, operating expenses in the third quarter were $7.4 million, which included a credit of $300,000 related to completion of an engineering project; amortization of intangibles is $300,000; as well as a credit to restructuring costs of $600,000. This restructuring credit resulted primarily from changes in management estimates (ph) related to facility closures. Excluding amortization and the restructuring credit, underlying operating expenses for the continuing security business were $7.8 million. Operating loss for the quarter in accordance with GAAP was $800,000. A further word on amortization of intangibles. We expect the quarterly amortization expenses will remain around $300,000 in the fourth quarter.

Continuing down the income statement, we recorded a gain on investments of $400,000 in the third quarter resulting from the liquidation of our holdings in Active Card (ph). (Indiscernible), interest and other stood at a gain of $75,000, resulting from interest and other income offset by a loss on foreign exchange. We recorded a tax benefit of $1.5 million in Q3, resulting from a U.S. tax refund of $2.1 million for prior years, offset by a required tax provisions in non-U.S. tax jurisdictions.

Net income from continuing operations for the third quarter, as reported in accordance with GAAP, was $1.1 million or 7 cents per share. This compares with a then as reported net loss of $6.3 million or 40 cents per share for the third quarter of 2002.

Looking now at discontinued operations, with the disposition of the consumer digital media and video business, we now have two line items on our income statement related to that disposition. Loss from discontinued operations represents the entire P&L for the digital media and video business condensed into one line. And for Q3 2003, the result is a loss of $4.1 million. Loss on the sale of discontinued operations represents costs associated with severance, facility closures, and legal and professional costs associated with the transaction, as well as the write-down of the assets of the digital media and video businesses. That is, the book value of the digital media and video business less the estimated proceeds from selling those assets. The loss on sale of discontinued operations was recorded at $5.9 million for Q3.

I would now like to talk about management's outlook for the next few quarters, and provide some specific guidance on what we expect. For the fourth quarter of 2003, we expect revenue to be in the range of 14 to $17 million. This reflects continued pressure on sales of our security modules to the digital TV market as well as continuing pressure on sales of our smart card reader products due to the uncertainty of timing on new government smart card projects. We expect gross margins to be in the range of 39 percent to 42 percent. Within this range of revenue and gross margin performance, we expect to record an operating loss from our continuing security operations in the fourth quarter.

To update guidance on charges, as you recall, at the end of our second quarter, we anticipated that we would record charges of between 35 million and $45 million in fiscal 2003 related to discontinued operations and the restructuring of our continuing security operations. Based on current estimates, we now believe this figure will be around the low end of this range.

Looking farther ahead, based on the availability of new products to address competition in the digital TV space in Europe, and our projection to begin initial volume shipments of digital TV modules to Korea and smart card readers to various U.S. and European programs, we expect to see modest improvement in sales levels in the first quarter of next year with more substantial increases in Q2. We expect the demand for volume shipments to address Korean digital TV, U.S. government smart card and other programs, to be underway in the second half of next year. And this should have a positive effect on SCM's ability to grow revenues in fiscal 2004.

To wrap up, I'd like to turn to the balance sheet. Cash and investments were $39.4 million at the end of Q3 as compared with $38.6 million at the end of Q2. Over the next two (ph) quarters, we expect to receive more than $20 million in cash proceeds from the sale of Pinnacle stock and future cash payments relating to the disposal of our consumer digital media and video business. Of course over the same two quarters, we expect to see cash outflows related to discontinued operations and restructuring to offset some of these cash inflows. At the end of Q2, we indicated that the sale of our digital media and video business would be cash neutral to slightly cash positive for SCM. Today, we believe that the transaction will have a positive effect on our cash position.

Net accounts receivables totaled $11.3 million at the end of Q3 compared with $13.2 million at the end of Q2. Both quarters' numbers include receivables related to the discontinued operations, because receivables for digital media and video businesses were not sold as part of the divestiture. Digital media and video receivables have been reserved for collectibility, and the P&L effect of those reserves has been reflected in the loss from discontinued operations for Q3.

Inventory levels were at $7.7 million, which represents the fair value of inventory for security products only, as the inventory for discontinued digital media and video divisions are classified as an asset held for sale.

With that, I'd like to now turn the call over to Robert.

Thank you, Steve. As you've heard from Steve, the economic and market environment was very challenging for SCM in the third quarter, and we expect these challenges to continue in Q4. However, we will remain confident about SCM's long-term outlook for revenue and earnings growth for three reasons.

First, the market potential is significant. There has been tremendous increase in new digital systems to support electronic commerce information sharing and entertainment. These new systems are generating large quantities of digital data in the form of new content and services. To protect the privacy and security value of this data, access to it must be restricted. So there is a unique opportunity for companies that can provide secure access to digital content and services.

Second, SCM is uniquely positioned to capitalize on this opportunity. Over many years, we've built a portfolio of standards, based on (indiscernible) experience in the field, and close industry relationships to address the need of secure digital access. We hold leading market share in several emerging markets, and will remain actively involved in industry organizations to further promote market developments.

Third, we have the financial means to persevere during these difficult months as we wait for market growth to return. We expect to further enhance our cash position over the next few quarters with proceeds from the sale of Pinnacle stock, as Steve just explained. We believe that very few companies of SCM's size are in as (indiscernible) a position as we are to leverage such tremendous market potential.

I would like now to share with you the details of some specific opportunities which are part of SCM's business forecast for the next 12 to 24 months. As you've heard from Steve, about half of SCM's revenue currently comes from sales of our digital TV security modules. This is primarily business from small pay-TV operators in Europe, whom SCM has been working with for many years. We believe that this is a relatively stable base of revenues, and it will continue at current levels for the foreseeable future. Expansion of our digital TV module business will come from three areas. The first is penetration of new markets, such as Korea. As we've discussed on previous calls, the Korean government has required that subscribers use removable security modules to secure broadcasts as part of the country's conversion to digital television technology. They have adopted the U.S. OpenCable standard for digital broadcast, and they expect to roll out digital TV to between five and eight million households over a period of five years.

SCM has been working very closely with partners, such as NDS, Niagara (ph), CANAL + (ph) and Eadetor (ph). Those four companies hold about 85 percent of the world's digital TV security business. And in this case, for Korea, we've worked with them to develop, jointly, the end user infrastructure and the new digital broadcasting system. In addition to ensuring that our new security modules are compatible with our partners' software and hardware products, we have also provided the test scenarios and test tools used by all (ph) suppliers to certify compatibility and compliance with OpenCable specifications. This is (indiscernible) U.S. OpenCable and Korea has adopted it.

A month ago, we announced a successful cooperation with Samsung in Korea to demonstrate the first two-way communication security module for the Korean digital TV market. SCM's security model is, today, the only module that is compliant with the specific requirements of the Korean government. We expect that we will begin to see initial volumes of security modules in Korea in mid 2004 and sustained volumes in 2005.

As we have discussed in the past, the opportunity in the U.S. market is also significant but heavily dependent on how strongly the FCC, the Federal Communication Commission, enforces the mandate to create an OpenSystem environment in a market which is currently dominated by two suppliers. We do expect that there will be a small opportunity at least to sell the first security modules used in the U.S. for cable TV decryption (ph) around the end of this year for testing purposes, and when the first (indiscernible) of digital TV sets are delivered to the market.

We were successful in working with conditional access provider, NDS, to develop a security module for the U.S. market, which was qualified by CableNet this summer. With our ability to leverage partnerships with European access providers, and our certified OpenCable U.S. OpenCable modules, SCM expects to participate in this small but important first deployment in the U.S. digital TV industry.

The second area where we expect to increase sales of our digital TV products is with the large operators in Europe. During the third quarter, we announced a significant cooperation with CANAL + Technologies, the largest operator in Europe, to sell their MediaGuard (ph) conditional access software for use with our security modules. We are the only company to have signed such an agreement. The broadcasting of our CANAL + (indiscernible) will have 10 million analog subscribers (indiscernible) for digital services over the next few years. SCM is in the process of forging relationships with each local operator and broadcaster to take advantage of this opportunity. We've already begun this (indiscernible) in agreement with Canard Digital in the Netherlands, to provide security modules using the CANAL + MediaGuard system. We expect to see initial sales of our modules carrying the MediaGuard security system in 2004.

The third area of possible expansion in our digital TV business is the development of a new product and for new market opportunities. As an example, in August at EFAB (ph), that's the world's largest consumer electronics show in Berlin, we introduced the world's first mobile terrestrial digital TV receiver in a PC card (indiscernible) sector (ph). This was a project supported by Target (ph) Telecom and a public broadcaster in Germany. The receiver enables subscribers to receive digital terrestrial port cards TV programs in use while (indiscernible) data services, including Internet access on a laptop or PDA. To-date, we've received thousands of requests for (indiscernible) of this product from operators and broadcasters. We will be working with these potential customers over the next several months to help develop applications based on this technology.

Our second product segment, PC security, consists of smart card readers and other solutions used to enable security applications for the government, enterprise and financial markets. In recent quarters, this business has contributed about 30 percent of revenues. Sales of our PC security products are associated with specific customer projects other than distribution channel. So revenue levels can fluctuate significantly based on the timing of those projects. Currently, the volume of orders we are receiving from PC security products (ph) is at the low point of the cycle, limited IT budgets have continued to slow new technology implementations in the corporate environment. A lack of both a common infrastructure and compelling applications has stalled a whole lot of smart cards and of course smart card readers in the financial sector. Hence, the U.S. government, being so far our major marketplace, is between switch and major programs, having completed its costs of work for the Common Access Card Program, but not yet ramping up on other programs.

Growth in our current PC security revenue base will come both from new opportunities and the ability to respond quickly to shift in technology requirements in the current market environment. In all cases, relationships are key. SCM has strong relations with both prime and sub-prime contractors working on smart card projects with the U.S. government. We have (indiscernible) supplier relationships with PC and other hardware manufactures to leverage corporate security program rollouts. And we have long-standing relationships with key European banks, which are now starting to utilize smart cards to benefit their customers and enhance their own security programs.

Specific opportunities for SCM over the next 12 to 24 months will primarily leverage current customers. First, the U.S. government has announced it is planning to implement new programs for both military and federal workers to utilize smart cards and readers to identify and authenticate personal cards; they will continue to be used for logical access -- that is, to log on to PC or a PC network.

The U.S. government has also announced plans to implement highly secure access systems for physical entry points for both its transportation workers and for all federal buildings. Smart card readers for those entry points must be highly secure and offer PINpad as well as both contact and contact-less smart card interfaces.

We estimate the market opportunity for physical access to be over the next three years -- next three to five years -- in the range of $40 million. SCM is in the final stages of development of a range of physical access readers for these applications, which offer a different shade of mechanism for securing sensitive locations. Our strong relationship with government (indiscernible) give us confidence that we will be able to secure a significant portion of this opportunity. Based on our core technology and contact-less PINpad and biometric interface, and drawing from our deep experience in the logical access market, we have been developing new products to address the opportunity in the physical access market for over a year now. We expect to be shipping physical (ph) access reader prototypes in Q4, with pilot installations beginning in early 2004. It is possible that the U.S. government demand for these products could result in volume shipments as early as the middle of next year.

Outside the government sector, we anticipate many corporations would like to implement smart card-based systems for their employees for building access, PC network log-on and other purposes. As increased budgets become available, this should result in new opportunities in the market. In addition, we are in the early stages developing or implementing new programs for secure home banking with a number of European banks, including Deutsche Bank.

Our third product segment consists of ASICS hardware -- software for Flash media and Flash card interface, which accounts for about 15 percent of our quarterly revenue. This business produces a healthy gross margin, and we have a strong intellectual property position in this area. We expect this revenue contribution to be sustainable at current levels. But also, this Flash card interface technology will help us to offer new products for digital TV applications.

As you can see, the target programs we have identified-- the conversion to digital TV in Korea, leveraging major commercial (ph) access provider relationships in Europe, providing physical access technology to the U.S. government, and others. Those provide significant opportunities for SCM's growth. Our leadership in secure access technology and our strong relationships with key industry partners, because our target markets will provide fuel for this growth. Given our size and our OEM business model, it isn't expected that we will continue to be exposed to fluctuations in our revenues on our quarterly basis until we can achieve greater scale. However, our solid financial condition and our clear strategy to leverage those opportunities gives us the confidence that we will be able to continue to operate our business and invest as required to support our long term goals.

Now I would like to turn the call over to the operator for questions and answers.

(OPERATOR INSTRUCTIONS). Our first question comes from the line of Wolfgang Fickus (ph) from West LB. Please go ahead.

Yes, good afternoon. Wolfgang Fickus from West LB. Actually replacing Adrian Hopkinson, who cannot attend today. I have a question -- two questions. Firstly, concerning the gray market activities, you mentioned in the digital TV module market, maybe you can quantify how you want to limit that gray market activity and where it really hurts you and which regions. And secondly, maybe a question on the growth prospect in Korea; the subscriber growth of those platforms like SkyDive (ph) is pretty impressive already, running at well over 800,000 subscribers within a few months or a few quarters. Did you already see that in your digital TV security business? Or what is really the problem in that segment for you?

I'll answer that. The first question on this Korean topic, we're not addressing the satellite scenario. So we have been invited by the Korean Minister of Information and Communication along with security companies to demonstrate for their just starting cable conversion from analog to digital, to provide this removable security technology. So the federal (ph) (indiscernible) is not active in this. And federal I think has started on a digital order or a couple of years ago. And the government is not interfering there. See we are only addressing the new 8 million analog households today in Korea, which are being converted to digital.

Okay. The other question on the gray market scenario needs some explanations, of course. Now first, if you were in the security business, there is (indiscernible). And there is an estimate that in Europe, there is about 30 percent of the European pay-TV market is illegal. And of course, security is always a competition and always changing new security systems. Therefore, for example, an exchangeable security systems has an advantage. And of course, module technology is starting to penetrate the market; and we guess we have about 5 percent of the overall pay-TV market today with removable security. The hacker community is starting to address it. And now we have to defend it. We actually have been very successfully, and we're part of some European industry groups who fight those activities. And we had several court decisions, especially in Germany, where we have been able, by court, that the shipment of those illegal modules have been stopped. We had two different approaches; one was infringement of our intellectual property, which we secured in one case. And in two other cases, we succeeded drawing on European and of course also a German legislation or law, which forbids the shipment of equipment where you can circumvent a pay-TV content. It's like -- I think in the U.S., it would be the copyright law. So we are successful, and this is an ongoing fight. And we will invest some legal costs, of course, in continuing to fight it. We have to make sure that we stand on the legal side, which means that opens to us the big operator market and the big security players.

Okay. Mass two follow-on questions?

Sure.

Okay. Concerning the treatment of the receivables in the inventory equipment in your disposed digital media business, could you tell me once again how you treat that? I'm unfortunately not as good in accounting as I should be. Could you re-explain that maybe?

I'll pass this on to our CFO, Steve Moore.

Sure. It is confusing to some extent. The receivables are being collected, so they're not considered accounts for sale as part of the discontinuation. So they wind up -- the receivables for the digital media and video division that are still uncollected, on a gross basis, wind up in our receivable number. However, they have been reserved to reflect any collectibility issues that you might imagine for a division that some months ago, announced that was no longer going to be in the business. So the net number, although it does affect the net receivable number to some extent, is not overwhelming at this point. On the inventory side, however, the digital media and video inventories are being held for disposition and sale. They too have been heavily reserved because their salability is limited in the case of digital media readers to being sold through Zero Corporation, who we entered into an agreement with to liquidate those inventories. And you'll see them on one line on the balance sheet, the inventory side. Does that answer your question?

Yes. Maybe just as a follow-on to that question, so you don't see, in brief, any particular write-down potential for the coming quarters from that side until those receivables and inventories are really collected and/or sold?

No, I don't expect any major write-downs. We're still continuing, as planned, to have the discontinued operations' expenses in Q4, and to a much more modest extent into Q1. Likewise, we will continue to have restructuring charges related to the restructuring that we did going from divisional to functional in Q4, and again to a very modest extent in Q1.

Okay. And then maybe the very last question would be on the growth prospect for 2004. The topline growth prospects looks as though the year will be more geared towards the second half of the year, in terms of quarterly developments. But would it be reasonable to look at the double-digit topline growth numbers, as those you would comment on?

I think what we have said, perhaps not as explicitly as you might have wanted, is that we expect our total revenues to exceed 2003, for 2004. More clearly, perhaps, our 2004 total revenues are forecast or planned to be higher than our total 2003 revenues.

Okay. Thank you, very much.

I'm showing no further questions. Please continue with your presentation or any closing remarks.

Okay. In summary, we believe that SCM is uniquely positioned to capitalize on the long-term growth opportunities in the markets for security tool (ph) access, and financially strong enough to hold our costs at least (ph) as these markets develop. Thank you for joining us today.

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines.