Identiv Inc (INVE) 2004 Q2 法說會逐字稿

Good morning. My name is Judy, and I will be your conference facilitator. At this time, I would like to welcome everyone to the SCM Microsystems, Inc. second-quarter results conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer period. (OPERATOR INSTRUCTIONS).

Thank you. Ms. Dye, you may begin your conference.

Hello, everyone, and thank you for joining us today as we discussed the results of SCM's second quarter of 2004. 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 risks and uncertainty, and that actual events or results may differ materially. We refer you to the Company's 10-K for fiscal 2003, filed March 12, 2004, and other SEC filings which explain important factors that could cause actual results to differ from those contained in any projection or forward-looking statement. Any forward-looking statements made on this call are based on information that is currently available 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.

Now, I would like to introduce Steve Moore.

Hello, everyone, and thank you for joining us today. The second quarter of 2004 was a very disappointing one, as the rapid deterioration of our traditional digital TV small operator business significantly widened the gap between our revenue and expense levels. To address this gap, and to position the Company for profitability, SCM's management has adopted a strategy to reduce expenses by approximately 25 percent over the next six months. To accomplish this, we intend to reduce headcount-related costs by 20 to 25 percent, and are evaluating additional areas for reduction throughout all functions of the organization. We anticipate recording restructuring charges of between 1 million and 2 million to effect these changes. These charges will be incurred over the next three quarters, but predominantly in Q4. Robert will provide details on the market opportunities that form the base for our strategy to grow revenues in a few moments. Let me begin with a discussion of Q2 performance.

Revenues from continuing operations in the second quarter were $11.5 million, below management guidance of $13 million to $15 million for the quarter. Year-over-year revenues were down approximately 40 percent from the $19.3 million reported in the second quarter 2003, and sequentially down 13 percent from revenues of $13.2 million in the first quarter of 2004.

Looking at revenues by product line, sales of our digital TV security modules were $4.4 million in Q2, which represented 39 percent of total revenues. These modules are used in conjunction with open architecture set-top boxes to protect digital pay TV broadcasts and enable legitimate subscribers to decrypt broadcast content. Sales of our smartcard readers and related products used to provide secure access to PCs and computer networks totaled $4.3 million in Q2, which represented 37 percent of revenues. Sales of flash media card readers were $2.8 million in the quarter, or 24 percent of revenues.

The geographic split of revenues in the second quarter included 45 percent of sales from Europe, 34 percent from the United States and 21 percent from the Asia-Pacific region. The revenue shortfall in the second quarter was primarily due to the result of a sharp decline in sales of digital TV security modules to our traditional small-operator customer base in Europe. Over the last several quarters, aggressive new competition from nonlicensed modules has threatened our business, but up until the last several weeks, we believed we could address this competition with new product offerings. However, technical issues with these new products, much of which had to do with third-party technology and services and not with SCM, soured the market at a critical time, and these products did not prove to be an effective countermeasure to competition.

As a result, it is now clear that the small-operator revenue stream, which has been an important component of SCM's business for several years, is now significantly reduced and unlikely to be fully regained. Based on this assessment, we wrote down the value of digital TV product and component inventory in the second quarter by $2.9 million. This resulted in gross margins of 15 percent. Without this write-down, gross margin would have been 40 percent, within the range of guidance for the quarter of 40 to 42 percent. By product line, we recorded a loss in gross margin of 31 percent for our digital TV products in Q2, due to inventory write-downs, and gross margin for our PC security products is 46 percent. Gross margin for our flash media interface products was 40 percent of revenue.

As reported under generally accepted accounting principles, operating expenses in the first quarter were $8.9 million, which included amortization of intangibles of approximately $290,000 as well as a credit to restructuring and other charges of $149,000, which resulted from tax adjustments to other charges taken in prior periods. Operating loss for the quarter was $7.2 million.

Q2 interest and other income stood at a gain of $374,000, resulting from interest income from cash investments, as well as a gain on foreign exchange. Loss from continuing operations for the second quarter was $6.9 million, or 44 cents per diluted share, as reported in accordance with GAAP. This compares with an as-reported loss from continuing operations of $5 million or 33 cents per share in the second quarter of 2003.

Before I address guidance for the third quarter, I'd like to give you a quick update on the status of the demand letter we talked about in our preliminary release on July 9. In the release we disclosed that we received a letter from a significant European customer demanding payment for damages that the customer claims were caused by the poor performance of one of our new digital TV products. While we believe that we resolved all technical issues related to our own technology in a timely fashion, and that remaining issues and responsibility of third-party technology and service providers, it is possible that this demand letter may result in legal action against the Company. Clearly, the outcome of any such legal action is impossible to predict. Since July 9, there has been no change in this situation, and so we have no new information to give you at this time.

I'd now like to talk about management's outlook over the near term, and provide some specific guidance for the third quarter of 2004. We expect revenue to be in the range of $8 to $12 million and gross margins to be in the range of 38 to 41 percent. Within this range of revenue and gross margin performance, we expect to record an operating loss from our continuing operations in the third quarter.

To wrap up, I'd like to turn to the balance sheet. As a result of the gap between revenues and expenses in the second quarter, cash and investments fell to $50.1 million at the end of Q2, compared with $56.2 million at the end of Q1. Net accounts receivable were $7.2 million at the end of Q2, compared with $8.4 million at the end of Q1, due both to lower revenues in the quarter and to effect of collections. Inventory levels were at 10.9 million at the end of Q2, compared with 12.4 million at the end of Q1. Excluding the write-down of digital TV components and finished goods, inventory grew in the quarter, as we continued to receive long leadtime components that had been ordered earlier in anticipation of higher digital TV product demand in the quarter.

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

Thank you, Steve. As you have heard, the market scenario for our traditional core small European operator business was very difficult in Q2. Unlicensed digital security modules have been infiltrating this market for some time (indiscernible) compacting hacker modules (ph) in the large operator space, and have obtained in court injunctions against several hacker companies within Germany. However, we were not able to stop the supply of those nonlicensed modules.

Also, competition among the small broadcasters and operators has been increasing. The small operators are getting very aggressive. New entry points are possible for this market, and therefore there is a major change happening in this market segment.

This has put a lot of pressure on hardware and software prices, as well. So even where we were able to compete against unlicensed modules, it may not make sense for us to compete at current pricing levels. This market situation accelerated early Q2, and we have been working to develop new opportunities with larger operators for our digital TV products for many months now. We continue to believe that these new market opportunities will result in significant revenue potential for SCM over the next several years, and of course SCM is in the strongest position to lever these (ph) opportunities.

The larger European operator market is opening up slowly for removable digital TV security modules. SCM remains the only provider of licensed modules today, and the only partner of the major conditional access for wireless (ph). As a result, we have signed contracts over the last 12 months with major regional operators such as Premiere, the pay TV company in Germany; Canal Digitaal, the pay TV operator in the Netherlands; the start (ph) of Europe's largest pay TV operator, CANAL+; and, in the most recent quarter, DigiTurk, the leading pay TV operator in Turkey; as well as a new startup for pay TV in the UK called Top Up TV. We believe that this segment will continue to be a stable source of sales, and potentially a source for us (ph) over time.

In Asia and specifically in Korea, SCM has announced the second major contract that provides the government-mandated digital TV security modules for cable TV decryption. In Q1, we signed the BSI cable operator in Korea, and a week ago, we announced the contract with CJ CableNet. These are two of Korea's largest operators, and SCM is currently the only company supplying modules into the Korean market. We expect to begin volume shipments into Q3 2004.

Certainly, with the arrival of the integrated digital TV sets and high-end set-top boxes such as PVRs -- personal video recorders -- the common interface slot for digital TV security modules will become a standard feature. In a recent European publication of all IDTVs -- integrated digital TV sets -- there is currently 14 of them including Sony, Panasonic and all the leading players. All of those digital TV sets have slots for our digital TV security modules.

In the US cable markets, integrated digital TV sets will start selling by end of this year, and again, all of these TVs have a slot for digital TV security modules. 70 million (ph) of IDTVs are projected to be sold worldwide by 2007, with the number rising to 116 million by 2015. At that time, most Western (ph) governments will have switched off the analog transmission for TV, and there is only digital TV transmission available.

Each of these TVs will require a security module in case of pay TV contacts. SCM is the leading supplier of the controller chip to create the module interface for the clocks (ph), and we are more experienced than any other company in the world in developing the security modules for these slots. So we are, indeed, in a strong position, a unique position to be in the module business in the emerging digital TV market.

In the PC security side, we also see several areas of significant new opportunities in our smartcard reader business. Smartcard has become the matter (ph) of choice for identification, for many applications including digital citizens' cards or ID cards, for health (ph) applications for banking applications. While there are many large organs (ph) planned around the world, to date there have been only a few high-volume deployments of cards involving with smartcard readers. As a result, our business in Q2 continues to come from multiple smaller shipments, as it has already been the case for the last several quarters. We believe these this will change slowly, as large planned (ph) programs in banking and government roll out over the next few years.

One of the significant opportunities we see in smartcard reader space is for physical access control base (ph) on smartcard. Currently the US government is putting together a program to add physical access capabilities to their common access card (ph), which has already been issued for 4 million military personnel for the last couple of years for providing secure physical identification and authentication for PC network logon. As part of US homeland security, the US government plans to install thousands of physical access readers within facilities around the country.

SCM has been developing a new physical access terminal to address the US government's requirements for over a year now. We were the primary source for smartcard readers for the common access card program, and delivered over 1.5 million readers through 2002. We have strong relationships with major system integrators involved with this new homeland security programs, and believe that we will be able to leverage our experience and new product offerings to gain share of this market opportunity. In addition, we plan to leverage our development in physical access technology to work with emerging markets for security also in Europe and within the European government programs.

Another major area of opportunity for SCM in the PC smartcard readers is in e-commerce and home banking. In Western Europe, the deadline for compliance with EMV's requirements -- that stands for Europay, MasterCard and Visa -- driving the rollout of chips for smartcard-based cards for replacing the magnetic stripes on credit and debit cards. The use of EMV smartcard is intended to eliminate credit card fraud, especially for PC Internet transactions. Smartcard also makes it possible to securely perform transactions online that the user can be securely authenticated and sensitive data protected. The use of the home PC for secure authorization is a major goal for MasterCard and the banks. In particular, many banks are beginning to promote a new MasterCard mobile smartcard reader that provides contactless authentication for online or foreign transactions. This is a very convenient and secure way for consumers to access financial records and services.

In the last several months, SCM has launched two new mobile smartcard reader devices, the EasyTAN and myEMV. We are seeing requests for information, for proposals, from banks across the world, with some (ph) in the UK, Canada and Brazil. And we already in programs with banks in Germany, as well as some pilots in Asia that distribute mobile readers to bank plans (ph).

The second major opportunity for us is the increasing use of smartcards as personal identifiers. Many countries worldwide are moving into smartcard identity programs. National ID cards are being planned or discussed in North America, Asia and Europe, and in some cases, such as Hong Kong, have already been proven as effective identifications teams (ph) for border identification, e-government and numerous other applications. Many countries are also scheduled to begin issuing electronic passports as early as this fall.

National health cards may be the first widespread application for personal ID smartcards. Many countries in Europe already use magstripe or simple laminated (ph) cards to identify cardholders for healthcare services. Smartcards are expected to eventually replace all these cards, in order to cut down the administrative costs for -- or most especially (ph) (indiscernible). Smartcards can store information on the chip, so that healthcare (indiscernible) prescription data is available. Already new operated (ph) smartcard programs are planned in France, Germany, Austria and Slovenia. In Germany, a new smartcard will replace the 10 -- the 12-year-old chip card system by January 2006. The German government has decided to move ahead and start implementing those projects in that timeframe.

This is the key reason for this desire to eliminate the default (ph), according to the healthcare system. Germany plans to roll out 18 (ph) million cards, which will identify individuals rather than families, and personal information and medical data that will help ensure that the card is not used by anyone other than the qualified citizen. Cards like this will require a new generation of smartcard readers that then can support the higher security and other requirements on the card. This technology is something which fits very well SCM's capabilities, and we expect to participate in those programs.

We still have an unchallenged position in the market for smartcard readers. As the (indiscernible) recent market results, we are the leader in this market segment, together with Gemplus. We have strong relationships with card manufacturers, application providers, system integrators and industry leaders across the government, banking and enterprise segments.

Finally, SCM has a strong market position as a manufacturer for secure access products. Our Singapore manufacturing facility just recently received certification through the international BS 7799 standard, which (indiscernible) secure information management. BS 7799 is the highest standard recognized in security environment, and SCM is among the elite group of manufacturers who have been qualified for this.

(indiscernible) is called by (ph) market transitions and the specific issues of the small European digital market (ph) is we believe we have significant emerging market opportunities, and that we are positioned as the leader in plug-and-play removable security for digital and PC platforms.

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

(OPERATOR INSTRUCTIONS). Thomas Becker, HSBC.

A couple of questions. First of all, I missed the amount of restructuring costs at the beginning, and probably you can tell us what amount is cash effective. Second point is, what is your current headcount, and what are you targeting at the end of the restructuring? Third question is who planned some provisions for a potential lawsuit concerning the claim from the major customer in Europe? And the last question is, what are your concrete action points, when you look at the digital TV access module business to stabilize that business in Europe?

The first question had to do with the restructuring charge, and the number that we quoted was between $1 million and $2 million to be expended or incurred, rather, over the next three quarters, but primarily in Q4.

I believe your second question was headcount?

Yes. Could you tell us what was cash effective of that? Or is it all cash effective?

It's primarily cash. We are not looking at disposing of a large quantity of assets. It's mostly related to -- the direct impact of the restructuring charges that I've quoted are mostly related to getting out of either contracts or headcount-related.

A current headcount?

The current headcount is approximately 370, including temporary and contract employees. And that total number is what we're quoting the percentages against.

And what is your target, let's say, in six or nine months' time at the end of the restructuring?

As we said, we're trying to stay between 20 and 25 percent of the costs related to that total headcount, including contractors and temporaries.

Regarding the third question, what we're doing about developing the digital TVs, the module business --

Yes, especially in Europe (multiple speakers).

We have enjoyed, over the last couple of years from this specific market segment, an excellent revenue stream and, of course, have always invested R&D and marketing in getting into the bigger operators. This has always been our top-level priority. We have succeeded from a market position. The top-level security companies of the world -- in Europe, there's only five. And the two largest ones have about 50 percent of the market share. They have, until three years ago, have clearly resisted against removeable security module technology. All of them, with all of them we have contracts. And they have worked with us on bringing (ph) the security conditional access (ph) on our modules. So (indiscernible) this is a head (ph) position, but it's also a big investment, because we need to apply R&D to that. It's a project; it needs marketing work. Now, in terms of deploying the modules for the operators like Germany and other major markets, that has been much lower than what we had hoped. We had an agreement with Premiere. We are starting to ship modules. But since Premiere is not too successful in getting new subscribers, that has caused some limitation there. And in addition, companies like Premiere are still pushing an embedded, proprietary boxes into the market. So there are some regulator (ph) recommendations, but the fact is that the operators are very slow in going for open systems. This, we are pretty sure, will change with the digital TV sets, because I think governments, regulators, but I think also the consumer technology industry would not have a couple of million digital TV sets, let's say, in Germany being deployed, more (ph) by the consumer, which has only a specific operator security system. So therefore, as I mentioned before, all the IDTV, digital TV sets, all of them have the slots for our security modules. And at that point, it becomes the lowest-cost way to add the security for the operator. So it's strategically extremely important that we have the slots go out in the market, ready to be used and upgraded for pay TV once the consumer buys a digital TV set, for example. So all this work has been done, and indeed this is quite an (ph) investment. We're working with the top-level security companies, we're working with the consumer industry. You need a 10- to 20-people team to make all those things happen. It's mostly an investment. So we are preparing for the future. We have done this investment. It is very unfortunate that, before this larger operator market is taking off, that the small broadcaster business is such -- in a difficult scenario to not licensed -- unlicensed or, one could say, hacker modules.

But we have done a lot, of course, to develop the big market opportunities. And it is growing; in fact, we have not only two Korean operators but we have one DigiTurk; we have one CANAL+ as a partner -- of course, they are not opening up for us in France. They only allow us to ship modules into the Netherlands as a start, and the second market might be Poland, where they have their own pay TV operator.

So it's making progress. We wish it would be much faster, but we have done a lot of investment to get into this large operator business.

Your other question related to the lawsuit?

Yes.

In fact, it is not a lawsuit; it's simply a claim letter that was received, and we have not reserved anything related to it at this time. Under US GAAP, that would be inappropriate, I think, anyway. But also, we believe we have very strong defenses, should this turn into a lawsuit, as well as potential counterclaims. However, I'd also emphasize that we continue in dialogue with the customer and with some of the other vendors within this product. And we certainly have some hope to arrive at a situation where everyone walks away happy, but at this point we feel we have to notify our shareholders of the existence of the claim.

Let me add one more. About the restructuring, what is the focused area? So is it everything save the marketing is the R&D, G&A, or is it production?

Every area will be looked at or, within the existing plan, be affected.

And if you take the Q2 number for operational costs, I think it's around 8.8 million US dollars. And is this the number you want to try to reduce around 25 percent; is that right?

Correct.

Adrian Powell (ph), DZ Bank.

Three or four questions, if I may. First of all, in the beginning, I'm quite sure you said something about working capital, but maybe I didn't get this correctly. But I was wondering, given your guidance for the current quarter, with sales again going down slightly, I've seen that the working capital has expanded. And I want to ask you if you could give us an explanation for this.

Next question is on capital expenditure. Could you give us the amount that you spent in the second quarter, and what you think will CapEx be at the end of the year?

Next question is on the cost-cutting. You said you wanted to cut 20 to 25 percent. I was wondering on which sales projection is this based, meaning I'd like to find an explanation if this cost-cutting measures is really enough to be profitable, let's say in the next year.

And the last question is on the ramp-up in South Korea. I was believing so far that you were going to ship significant volume starting in the second half of this year, but when I look at the safe guidance as well, then it's a little bit in jeopardy, in my eyes. So maybe you could give us just short comments on these.

Well, the first question had to do with working capital, and I think you're really specifically talking about our inventory. We continue to invest in inventory, primarily because of the long leadtime components that we ordered as much as six months ago that are not cancelable, but we ordered them based on a much higher level of digital TV sales expectations. So, even though we have dropped our digital television expectations, we continue to bring component product in. And therefore, that combination caused both a growth in inventory and a write-off of some of the components -- or not a write-off, but a write-down of some of those components.

The next question? CapEx -- I don't have an exact number from a net standpoint -- from a gross standpoint, rather. But from a net standpoint, we did not add capital to our balance sheet; we don't expect to do so, either, in the coming quarter. We expect to continue to depreciate at a higher level than we replace.

The next question was on cost-cutting. I was wondering just if the 20 to 25 percent was enough, and on which sales projection this is primarily based.

It's a percentage of our existing expenses, and clearly, our revenues will have to grow from the current $11 million level for us to be profitable even with the 25 percent decrease. I think -- was your last question about Korea, or was it the one in between?

No, there was basically the question. Coming back to cost-cutting, when you said your revenues have to grow, do you believe that it would be possible that you will reach, let's say, last year's level of sales, and that your business will be profitable then?

The reason for the cost-cutting is to arrive at a level of expenses that would allow us to be profitable at the levels of revenues that we are forecasting for early next year. I don't know that there's a whole lot to add there. We historically haven't given, and don't intend to at this point to give guidance for revenues beyond this quarter. But clearly, we believe that our revenues are going to grow beyond the $11 million range.

And then the last question was on South Korea.

In South Korea, part of the question -- we have orders for Korea. Honestly, they've come in a little behind what we had originally hoped, but I don't think we are unhappy with how we are progressing from a contracting standpoint there. We have delivered some product to Korean customers, and we expect a larger volume of product to be shipped in Q3 and then again larger in Q4. It should have a positive impact on our revenues in the year. Robert, do you want to add anything to that?

No; I think that's reflecting reality. We have two contracts in place of products ready to be shipped -- actually, produced. We only need to release from basically the trust center (ph) of Korea, and then we are ready to ship. So certifications are done, initial production is down. So deployment can start, and we expect initial shipments in Q3.

-- or initial volume shipments. We did ship, earlier, a small number of production units. But the full-fledged production shipments we did expect for this quarter.

At this time, there are no further questions. I will now turn the conference back over for any closing remarks.

Thank you. Certainly, as outlined here in much detail, we have a difficult revenue situation. We have a loss of market segment. We are winning good projects on larger operators, but nevertheless this will be a couple of million dollar revenues each quarter less than we originally planned. That is the reason we have embarked here on a large, reasonably large cost-cutting exercise. We need to do this, of course, without destroying our international market position. We are confident that the team can execute on this, and but still we are in investment mode. We think investments we did over the last couple of years in gaining access to large operator markets will pay off. And thank you for joining us today.

This concludes today's conference call. You may disconnect at this time.