摩托羅拉 (MSI) 2006 Q2 法說會逐字稿

Good morning, my name is Judy and I will be your conference operator today.

At this time I would like to welcome everyone to the Tut Systems second-quarter financial results conference call with your host Sal D'Auria, Chairman of the Board, President and CEO, and Scott Spangenberg, Chief Financial Officer.

All lines have been placed on mute to prevent any background noise.

After the speakers' remarks there will be a question-and-answer session. (OPERATOR INSTRUCTIONS).

Mr. Spangenberg, you may begin your conference.

Good morning and thank you for joining our conference call to report our second-quarter 2006 business and financial results.

My name is Scott Spangenberg and I am the CFO of the Company.

Before I turn the call over to Sal D'Auria, our Chairman, President and CEO, I'd like to remind you that today's conversation will contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Specifically without limitation our expectations about our revenues, cash flows, introduction of new products and performance of our various product lines, gross margin, total operating expenses, net interest expense, earnings per share, cash balances and restructuring activities are forward-looking statements within the meaning of the Safe Harbor.

Forward-looking statements are based on management's current expectations and beliefs and are subject to risks and uncertainties.

Actual results may differ materially from the forward-looking statements contained herein.

Risks that relate to these forward-looking statements include the risk inherent in new and developing technologies in markets such as the IP TV market, risks that competitors will introduce rival technologies and products, and the risk that the expected financial benefits of new technology deployments will not be achieved as a result of unforeseen costs or events.

Further detailed information about risk factors that may impact our business is set forth in our periodic filings with the Securities and Exchange Commission.

We expressly disclaim any obligation to update or alter our forward-looking statements whether as a result of new information, future events or otherwise.

Now I'd like to turn the call over to Sal for his opening remarks.

Welcome, everyone, to our early morning conference call.

While revenue in the first half of '06 was 17% ahead of revenue in the first half of '05, Q2 2006 revenue was below our expectations and was a frustrating quarter for Tut.

While the interest in IP TV continues to grow we experienced a pause in the decision-making process of new IOC and PTT customers.

While our current customer base has very high interest in HD high-definition upgrades, we were unable to fulfill that need in Q1.

While the customer trials are going very well with our new PBN products, we sold all the products we had manufactured by our contract manufacturers in the quarter but we were short of our goals.

While we are making real progress with various Tier 1 opportunities we are unsure of the exact timing.

We do believe that we will return to growth mode in Q3 and we are optimistic that we'll begin to see those opportunities stalled and our now larger funnel begin to increase their momentum starting in Q3 and becoming even stronger in Q4.

I'd like to turn it over to Scott to go through the detailed numbers and I'll give you some more insight into each of those opportunities.

Thanks, Sal.

First of all I'd like to review our operating results.

Our total revenue for the second quarter ended and six months ended June 30, 2006 was $8.1 and $19.6 million respectively compared with $9.7 million and $16.7 million for the same periods ended June 30, 2005.

Our Q2 2006 revenue represents a year-over-year decrease of 16.3% from Q2 2005 and a sequential quarter decrease of 29.7% from Q1 2006.

Our revenue for the first six months of 2006 represents an increase of 17.3% when compared with the first six months of 2005.

Our revenue from video processing systems products was $6.8 million, a decrease of $0.1 million or 1.3% compared with the second quarter ended June 30, 2005 and a decrease of $3.7 million or a 35% decrease compared with the first-quarter 2006 revenue of $10.5 million.

The sequential and year-over-year decrease in second-quarter video processing systems revenue was primarily due to potential new IOC and PTT customers extending their purchase decisions.

Sales of video processing systems products increased from $12.8 million in the six months ended June 30, 2005 to $17.3 million for the six months ended June 30, 2006.

Revenue from our private broadband network products in the second quarter of 2006 was $1.2 million.

This was an increase of 8.6% from the second quarter -- excuse me, a decrease of 8.6% from the second quarter 2005 revenue of $1.3 million and a 15.2% increase from last quarter's revenue of $1.0 million.

Revenue from private broadband network products decreased by $0.2 million from $2.4 million in the six months ended June 30, 2005 to $2.2 million in the six months ended June 30, 2006.

The year-over-year decrease in our private broadband network product revenue is primarily the result of the transition from products at the end of the product lifecycle to our next generation products.

The sequential quarter revenue increase includes revenue from our new T2 productline.

Based on the level of customer interest we are experiencing for our new T2 productline and as we resolve production related issues, we expect revenue from our private broadband network products to increase in future orders.

International revenue was $0.8 million or 10.4% of our total revenue for the second quarter of 2006 compared with $1.5 million or 15.6% in the second quarter of 2005.

On a year-to-date basis international revenue was $3.1 million or 15.5% compared with $2.8 million or 16.6% for the same period last year.

One customer, Iowa Network Services Inc., accounted for 13% and 10% respectively of our revenue for the three and six months ended June 30, 2006.

One customer, FTC Management Inc., accounted for 15% of our revenue for the six months ended June 30, 2005.

No customers accounted for greater than 10% of our revenue during the second quarter 2005.

For the quarter ended June 30, 2006 our cost of goods sold was $5.7 million compared with $6.2 million for the second quarter of 2005.

Cost of goods sold in the first quarter of 2006 was $7.6 million.

The year-over-year decrease in second-quarter cost of goods sold of $0.5 million was due to a $0.5 million charge recorded during the second quarter of 2005 for the amortization of backlog associated with the Copper Mountain merger.

Amortization of intangibles included in cost of goods sold was $0.4 million for the quarters ended June 30, 2006 and 2005.

Our gross profit for the second quarter of 2006 was $2.4 million compared with $3.5 million for the second quarter of 2005 and $4.0 million for the first quarter of 2006.

Our gross margin was 29.6% for the quarter ended June 30, 2006 compared with 36% for the same period in 2005.

When compared to our first-quarter 2006 gross margin of 34.3% our second-quarter 2006 gross margin decreased by 4.7 percentage points.

The sequential quarterly decrease was primarily the result of our fixed cost and overhead representing a higher percentage of cost of goods sold.

Operating expenses were $6.7 million for the quarter ended June 30, 2006 excluding a $0.4 million restructuring charge.

Compared with the first-quarter 2006 operating expenses of $7.1 million, our second-quarter operating expenses declined by $0.4 million.

Cost of outside services and travel decreased by $0.3 million and $0.1 million, respectively.

The decrease in operating expenses was mainly the result of our restructuring actions and cost saving initiatives.

Included in our operating expenses was $0.3 million of stock compensation expense associated with the adoption of SFAS 123R.

As a reminder, we began expensing the cost associated with share based compensation at the beginning of this year.

Previously these non-cash expenses were not charged to operations but were footnoted in our financial statements.

The net loss for the quarter was $4.6 million.

After taking out non-cash charges of $1.2 million for stock compensation expense, depreciation and amortization and interest expense our EBITDA for the quarter was a negative $3.4 million.

Our net loss for the second quarter of 2005 was $4.5 million.

On a basic and diluted per share basis our loss was $0.14 in 2006 compared with a loss of $0.17 in 2005.

Our year-to-date net loss was $7.8 million and $0.23 per share compared with $7.8 million and $0.31 per share for the same period in 2005.

Now regarding our balance sheet and cash flows, cash and cash equivalents totaled $7.4 million at June 30, 2006, a decrease of $3 million from June 30, 2005.

Accounts receivable and unbilled revenue increased by $2.9 million from $11.0 million at June 30, 2005 to $13.9 million at June 30, 2006.

The increase in accounts receivable and unbilled revenue resulted primarily from longer digital head end system implementation timelines attributable to the availability of third-party MPEG-4 set-top boxes and related third-party middleware integration.

Excluding the unbilled revenue DSO's or days sales outstanding were 114 days at quarter end compared with 79 days last quarter and 77 days at June 30, 2005.

Since the end of the second quarter our cash collections totaled $3.6 million.

Inventories were $11.4 million at June 30, 2006 compared to $4.8 million a year ago.

Inventories increased to support anticipated higher revenue.

Our line of credit was $7.7 million at the end of the quarter and $5.0 million at June 30, 2005.

Accounts payable and accrued liabilities were $11.3 million at June 30, 2006 and $9 million at June 30, 2005.

The increase in accounts payable and accrued liabilities was primarily due to increased inventory purchases in the second quarter of 2006.

Regarding cash flow, cash used in operating activities reduced to $7.0 million for the six months ended June 30, 2006 compared with $7.6 million for the same period in 2005.

Sources of cash from operating activities for the six months ended June 30, 2006 include accounts payable and accrued liabilities of $2.4 million, accounts receivable of $1.0 million, and non-cash expenses such as depreciation, amortization and non-cash compensation of $2.1 million.

Uses of cash in operating activities for the same period include inventories of $4.7 million and prepaid expenses of $0.1 million.

Cash provided by investing activities was $1.1 million for the six months ended June 30, 2006 compared with $0.4 million for the same period in 2005.

During the six months ended June 30, 2006 cash provided by investing activities included proceeds of $1.7 million from short-term investments.

Partially offsetting this were additions to property and equipment of $0.6 million.

Cash from financing activities was $1.1 million for the six months ended June 30, 2006 compared with $5.1 million for the six months ended June 30, 2005.

The cash from financing activities in 2006 included proceeds from our bank line of credit of $0.6 million and net proceeds from the issuance of common stock of $0.5 million.

Let me now turn to our forward-looking guidance.

Remember that the forward-looking statements that I am about to make are subject to many risks and uncertainties as described at the beginning of this call.

Further, because of the high-cost per unit of our head end systems, if we were to sell even one less system than our forecasted number of head end sales per quarter, such a decrease in sales volume would have a material and adverse impact on our revenue for that quarter.

We're providing the following guidance for the third quarter of 2006.

We expect third-quarter revenue to be approximately 8.2 to $8.5 million.

This forecast does not include any revenue from Tier 1 opportunities that we are pursuing.

We estimate that our gross margin percentage, including amortization of intangibles of $0.4 million, will be approximately 30% with possible moderate growth for the quarter.

We estimate that our third-quarter operating expenses will drop to approximately $6.4 million.

We expect net interest expense for the third quarter to be approximately $0.2 million, and we expect the weighted average number of shares outstanding to be approximately 33.8 million shares for the third quarter.

This concludes my financial comments and guidance.

I would also like to remind everyone that we will not be reviewing or commenting on financial models or providing additional details to our expectations after this call or during the quarter.

We also wish to remind you that our actual financial results may vary materially from the guidance due to factors that are unforeseen or whose results are unpredictable at this time.

Now I'd like to turn the call back over to Sal for further comments.

Thank you, Scott.

You may remember that we point to four growth areas for our business -- one, the new IOC PTT customers; two, the upgrade cycle with our existing customers; three, the new activities from our PBN private broadband division; and last but not least, the Tier 1 opportunities that we've been pursuing for some time.

I'd like to make some further comments on each of these.

As we look at our new IOC and PTT business we believe that we will see increased new customer activity in Q3, but don't expect the pause to completely pass until approximately Q4 given the IP TV market conditions.

We do believe that we will be increasing new customers in that period.

Number two, relative to our current customer base upgrades to MPEG-4 HD will begin to be meaningful in Q3 and will become even more significant in Q4 as the set-top box, middleware conditional access options improve and reach a more full availability position.

Relative to our PBN division, our private broadband network division, mT2 trials of new product and initial deployments with hotel service providers and even some hotel chains directly are going very well around the world.

Manufacturing will increase in our Q3 time frame and the new XLP product, which is in beta, is getting very positive feedback from our trials from around the world.

Relative to Tier 1, as we announced earlier this week in a webcast conference, we are making meaningful progress with the Tier 1 activities we're pursuing.

We were notified in recent days that we have made the shortlist for a very large opportunity.

We are very excited about getting to this step in the progress after more than a year of very diligent work.

We inquired about the timing of the decision -- the final decision in this opportunity -- we did not get a very clear answer.

We expect to get further visibility into the timing of this opportunity in the coming weeks.

This is a very large opportunity.

And by the way, as Scott mentioned, we have not factored Tier 1 business into our Q3 business.

Relative to our balance sheet, we are confident that we have a variety of responsible options to enhance our balance sheet if we choose to.

We will not lose a Tier 1 or a Tier 1 partner relationship over our balance sheet.

We will continue to analyze this very closely and only take the most pragmatic actions.

In summary, we believe that we are quickly seeing a stabilization of our core business and will return to growth in Q3.

Given the macro factors we are being very conservative on the growth projections for Q3, as Scott has talked about.

While there is upside, we think it is appropriate to be extra cautious given the market's response to our disappointing Q2.

Q4 may be a very interesting quarter for us as the IP TV market settles down, Tier 1 business becomes clear, and opportunities to open our funnel increase in their momentum.

Again, we think that we're very quickly coming back to a stable environment with our core business, we'll see that growth and, again, Q4 could be significant growth beyond that.

With that I'll open up for questions.

(OPERATOR INSTRUCTIONS).

Anton Wahlman, ThinkEquity. [Brian Wilkinson], Lewis Asset Management.

Quick question about the balance sheet and the options you mentioned that you may have to make sure that you don't miss these opportunities.

Can you just expand on that?

I think that the key thing, Brian, is to understand that we are watching this very, very closely.

We are in an interesting time particularly with Tier 1 opportunities, and again, I stress Tier 1 partner relationships.

And again, we've been offered many different opportunities and as appropriate we'll balance the timing of Tier 1 activities with that, again, what I would call pragmatic action associated with that.

Again, this is something that we're watching very, very closely and we will take the appropriate actions as appropriate.

Okay.

How much capacity do you have to borrow?

Our total line is $10 million.

As you know, it's a revolver with Silicon Valley Bank and it's as a percentage of receivables.

All of our borrowing on the revolver is off of a formula with receivables.

And what's outstanding on that currently?

Scott?

Well, at quarter end we were at $7.7 million.

But you mentioned that the Tier 1 activity you expect to find something out within this quarter ideally.

It seems like things are sort of coming to a head pretty soon here.

We believe that we are nearing the end of that very long and arduous cycle and we're very happy about what we're hearing.

We are still a bit frustrated about the timing, but we do believe that in Q3 it will become much clearer and, as appropriate -- back to your earlier question -- we'll deal with any balance sheet issues that we may have.

Thank you.

(OPERATOR INSTRUCTIONS). [Jay Albany], Callisto Capital.

Sal, could you give just us a little more color on why you're comfortable with the balance sheet and kind of give us a little more commentary on why we should be comfortable with that going forward?

Sure, Jay;

I'll do my best to do that.

Again, we're not being theoretical about opportunities that are out there.

We know we have a lot of good investors in the Company and we've been contacted by many investors and have come to the conclusion that we have some very clear options if we so choose.

Again, this is not a theoretical comment as much as a comment about resources that we know we have in the wings if necessary.

Great, thanks very much.

(OPERATOR INSTRUCTIONS).

At this time there are no further questions.

I will now turn the call back over to Mr. D'Auria.

I would give people a few more moments here.

I suspect we have some people out there with some additional questions.

And sometimes in these early morning conference calls people are a bit shy in asking their questions.

Michael [Zeldin], Brill Securities.

Hi, guys.

Can you give us a little more color on the set-top box shortage and any insights there as to what exactly happened and how it might be prevented going forward?

That's something that we've been spending a lot of time on.

In fact, it was just two days ago that I woke to a CEO of a set-top box manufacturer to get a very recent update on where things are.

I guess the thing I'd like to make sure everyone understands is that there are set-top boxes out there today -- I'm talking about MPEG-4 set-top boxes -- they're out there today.

They are what I would call first generation.

They are primarily based on DSPs.

They have I'd say appropriate first generation technology -- many of them only provide the decoding for standard definition.

There is a new wave of set-top boxes that are coming out that include not only standard definition but high-definition and we are hearing that they are imminent in their ability.

This CEO -- the call I had with him the other day, he promised that he would be shipping his first set-top boxes by the end of August, beginning of September.

But there's another factor here that I think is important for everyone to understand is that this ecosystem is more complicated than just having the set-top box available.

There's also a middleware component and a conditional access component which all come from different vendors.

And there needs to be the appropriate integration and combination of the set-top box middleware and conditional access.

And there are many, many permutations of this.

When it comes to the customer, the customer likes to choose what they like to choose and they may say, well, I like this set-top box, I like this conditional access, I like this middleware, I like this set-top box that has DVR capability, or whatever it might be.

So again, to give you a perspective on exactly where we are there again are some set-top boxes available, they are mostly only SD; there are some SD/HD combinations that will be available beginning the end of this month.

And as we go through the rest of Q3 and Q4 you'll see more and more of these combinations available.

As I mentioned, we're starting to see increased momentum in our business and predicting that for Q3, but we're realistic in understanding that not all the combinations of set-top boxes and middleware conditional access will be available in Q3 and some of those that some of the customers will be waiting for will be available in Q4.

Therefore we are predicting that Q4 could be a very interesting quarter for us because of the increased activity level or increased option level on the set-top box side.

And again, this is not theoretical; this is speaking directly to the senior executive at a company that makes their business around set-top boxes.

So as you hear about set-top boxes, again, be very diligent in understanding how complicated it is and where it puts the customers.

Again, we do believe that things are every day getting better and meaningfully better.

There are a number of customers that we know of that are waiting for some of those products to come out in August.

Right.

Is this a problem -- I mean that you could have foreseen?

Or is it sort of an evolving problem that you'll be able to see in the future if something like this were to happen?

I think a couple of things.

I think that we will see, as we go through the Q3 and Q4 time frame -- turn into what I would call a steady-state availability of a broad range of options.

Back to what we can foresee and not.

I think that not just us, but I think the industry has been surprised at how long it's taken for some of these set-top boxes to be available.

And I think the ecosystem goes back before the set-top boxes and includes the ASICs, the chip set that are made for these things.

And one last comment there is that this is impacting all set-top box manufacturers.

And while some are being done sooner than others, it isn't like it's just the small guys that are behind, everyone is a bit behind.

But again, I think that we're seeing some of these things and that's why we're predicting growth in Q3 and potentially significant growth in Q4.

Right.

Obviously we're all looking forward to whatever potential contracts you may ultimately get with Tier 1's, but I think most shareholders are concerned about feeling that you're stable in your core business and I'm trying to address that.

So I appreciate your comments.

And again, I think hopefully -- and I'm losing my voice today, so I'm sorry if I didn't make -- I curtailed my comments in the opening part.

But we see that our core business is stabilizing and we are very excited about the progress on Tier 1's.

We've been working very, very hard on that.

And by the way, the Tier 1 opportunities that I've talked about are not being held up by set-top boxes.

And that's (multiple speakers)

Just to clarify that point.

And that shouldn't be an issue should you get a large Tier 1?

They're not dependent upon the availability of a set-top box.

It is not being held up for that reason in any way.

Okay, thanks.

That's all I have.

Jay Albany, Callisto Capital.

I just was hoping you could -- just to kind of follow-up on the balance sheet question -- if you could maybe kind of give a little more detail or clarify some of the options you're referring to or what kinds of financing you might (technical difficulty) if you were to have to draw?

I think that it's hard to give any more detail -- hard to give any more detail other than to say that we have numerous paths that are not theoretical and we live to match those with the need that we have and we very much connect the Tier 1 opportunities and balance sheet very closely together.

So again, it's hard to be appropriate and give you more detail other than to say the keyword is we have confidence that there are real opportunities that are in the wings if we so choose to do that.

And I'd say that -- when I say in the wings that they're there for us in a very short period of time if we push the green go button on any of those things.

But as we look at the -- again, the buttons are in front of us and we're just making sure we have the right glasses on the opportunities.

Have you considered something equity based?

As you might imagine, we have looked at a variety of things from equity to debt to other lines of credit and have fully vetted the opportunities, the impact of the opportunities and most importantly the impact of those opportunities on our future business.

Okay.

Which, again, is a key driver and just understand that that's what we -- we'll take the appropriate actions to gain the appropriate position in business.

Thanks very much.

(OPERATOR INSTRUCTIONS).

Bill Morrison, Ryan Beck and Company.

I'm curious; do you have a backlog number on the private broadband business?

Actually even internally we don't track backlog on that business.

We do track our various trials given that there's a very leveraged model with the PBN business in the hotel space.

Given that we work with the service providers that service hotels, and what we do is we track their deployment possibilities and relate those trials which may be -- the trials or I would say initial property deployments with their overall deployment.

So we don't, again, even internally think of it as backlog as much as the activities with these service providers.

And I didn't mention it specifically on this call but I've mentioned recently in public that we have trial activities going on around the world with top tier hotels and I believe we now have I think three of the top tier service providers in that space either trialing or deploying some of our mT2 product today.

So don't underestimate the impact of the business over the next couple of quarters as we more fully roll out that productline around the world.

The second question is do you have any visibility into the HD transcode business?

Since it just came out late in the quarter is there any significant backlog or orderbook there?

Yes, so -- and I've also, again, recently commented in public webcast forums about this, but I think for this group I'll make sure that for those of you that haven't heard this.

We do have what I would characterize as millions of dollars between backlog and what I would call pent up demand in this space.

Our customers are very, very anxious to put HD channels in their service lineup.

We saw I would say minimal revenue in Q2.

It really was very, very limited in Q2.

That will increase and become meaningful in Q3.

And as we sort of map out the upgrade cycle we believe that Q4 will be significant in the revenue.

And the whole cycle given the demand, we don't think this is a two-year cycle as much as more like a nine-month and 12-month cycle.

And to remind everyone that today we have over 160 service providers out there I think it's fair to say that all of those -- or 99% of those are standard definition based.

They all are getting pressure from other alternative service providers -- cable and satellite.

They all need to stay competitive and, as I've mentioned recently in public, if you put magnitude on this, even if you think of 100 of these customers upgrading -- if you think that HD, for rough purposes imagine it's $30,000 a channel and you need a minimum of about 10 channels to make a competitive service offering, there's $300,000 from 100 customers that's about a $30 million opportunity set.

This is significant.

Make no mistake about the value of that upgrade potential with these customers.

And again, in Q3 it will become meaningful and in Q4 we believe that, again, consistent with some of those set-top box conditional access, middleware things we talked about earlier, that we believe that it will really begin hitting its stride and I think continue through the early midpart of '07.

So do not underestimate that part of our business.

Finally, on the short listed Tier 1, do they have any kind of -- did they communicate any budget for this year or next year.

And even though the timing is not yet clear, is there some kind of an indication of when they might start?

Again, the most frustrating part of it is the timing part.

The most exciting part about it -- actually there are two things that are exciting for us is that this is a very, very large opportunity.

This may be our largest opportunity there and to go to this very small group the next step is something that, again, we've worked very hard to get there.

And again, we're not done yet, but -- and they're not being very clear on their timing guidance, but we've heard no indication of it being any smaller an opportunity than we've previously been told which, as you might imagine, this is a -- well, it gets our interest because of the magnitude of the opportunity.

Okay, thanks, Sal.

Thank you, Bill.

Peter Conrad, Kopp Investment Advisors.

While you've focused your comments on the Tier 1 opportunity where you've been short listed, it's exciting to see some progress there.

Are you seeing any progress in any of the other Tier 1 opportunities in the funnel?

Are some decisions getting closer, are some dropping out?

Just some context as to where things are progressing?

We believe -- that's a good question.

Again, we do our best to give you those facts as we -- the definitive facts as we get them.

Again, moving on steps through a short list are definitive and easy to communicate.

We do believe we're making progress on other opportunities as well.

Some of those may not have passed a definitive milestone as the one we mentioned, but we do believe that we are making progress.

And the thing that makes us feel good about that is that when we look at the competitive environment where certain opportunities we continue to be very, very confident about our product uniqueness and competitive position.

So yes, Peter, we are making progress in others, and as we hear clear definitive things, we will communicate those as appropriate.

Great, thank you.

Michael Zeldin.

Guys, do you have any new projections for when you will be cash flow positive?

Is there still a potential for it to be in the fourth quarter?

That is a good question.

Again, as looking to Q4, Q4 could be a very interesting quarter for us.

Remember, with our multiple set of opportunities which, by the way, in really Q2 was -- internally we called it the perfect storm where our four growth areas were -- none of the four were really producing, hitting their stride in Q2.

We believe that that begins to change in Q3, but if they all or even if the majority of them begin to produce as we expect them to in Q4, it could change our Q4 profile significantly.

I think everyone can understand that relative to a Tier 1, but I don't think appreciate that we don't need a Tier 1 to change our profile.

So we have not given quantitative guidance relative to Q4.

I have indicated that we are bullish on Q4, and you can extrapolate that to it's certainly -- it is possible that Q4 could be EBITDA positive.

It is unclear at this time as we are navigating this Q2 discontinuity.

So it is possible we are not guiding that that is the case at this time, but there are scenarios where our four growth pieces of our business cycle in a certain way to be very, very positive there.

But again, we are not guiding do that now.

But to be clear, we are guiding that Q3 will grow and there may be some upside in Q3, but we are being very cautious because of again the response that we have seen from the marketplace relative to Q2.

Okay, thanks.

(OPERATOR INSTRUCTIONS). [Richard Pugh], Richard Pugh Investment Co.

Good morning.

Sal, I enjoyed thoroughly your presentation in Boston, and I have a general question which may seem a bit naive.

But it seems to me that the telephone companies are in a position where they have to go after the TV business since the cable companies are going after the telephone business.

Am I missing something here?

No, not at all, you are absolutely right on to the major premise for the IP TV revolution.

This is why large companies and small, large telephone companies and small telephone companies, are all getting into the IP TV space.

There is no question in my mind; there is no question in I think a broad group of analysts out there that every telephone company needs to be a triple-play service provider, and they all are working to do that.

Unfortunately, I think that a lot of the, particularly the larger tier service providers, telephone companies, are a bit behind in their rollouts and their buildouts, which has sort of stretched out some of these things in the marketplace.

And I think that we saw somewhat of an impact of that in Q2, and they are not yet on track yet.

But it is absolutely imperative that they offer a triple-play service offering in the marketplace.

We believe that we are very well-positioned to take advantage of that, as we have seen.

Remember, before Q2 we had seven sequential quarters of growth.

And with Q3, we expect to get back on that trail and expect to bring IP TV to more and more service providers around the world.

I'd just like to make an observation.

It seems to me that you guys are standing in front of a tsunami of growth and you sound terribly conservative about your future compared to what seems to me to be an inevitable stream of very rapid growth in front of you.

We may seem a bit conservative today, but we do think the momentum is there.

And you're right, it's a giant wave of opportunity that we are very well-positioned for.

And I think that those people who've seen cycles, particularly in the Telecom area, know that sometimes there's a slight pause before the storm hits.

And we think that, again, we're well positioned and we think that these ecosystem elements that we've talked about will go from that earliest phase to really cross that chasm to the steady-state that enables that tsunami to happen.

One other question.

Once you've made the initial sale of equipment, are there follow on revenues, a service level of revenue or something that comes from the equipment once it's installed?

Actually there is -- I would say I'd characterize it as a small amount of service revenue, something that is a 5 to 10% type of a revenue stream from the customers on the service side.

More importantly, there are significant upgrades that our customers will make over time.

We have been -- back in 2005 and back to 2004, any period 30% of our business could be upgrade business with our customers.

Now, as I mentioned relative to the HD cycle, 99% of our customers are offering only SD standard definition television channels.

All of those guys talk about tsunami, all of those guys will respond to the tsunami of high-definition television.

And as I partially quantified earlier, this is in excess of a $30 million opportunity that we see with our customers out there.

So it's beyond the nominal 5 to 10% service revenue, beyond the normal I'd like to add a few more standard definition channels.

We are now entering the cycle of the HD upgrade which, by the way, is a very easy upgrade for our customers.

They can add a few more cards to their system -- not do a forklift upgrade, not to change the management system and begin to offer the HD channels alongside the SD channels in their lineup.

We make it very easy for them.

We are very much the natural path for them to do an upgrade and feel very well-positioned in those environments.

And one last thing, I mentioned this in one of the recent conferences as a quantitative example.

Our first HD customer that we had in Q2 we went out and visited, showed them the demonstration without a set-top box because there was no set-top box available.

But they were so impressed with the quality of our transcode solution that they put an order in within a number of days and they ordered something like $260,000 of HD.

But at the same time they added additional other elements to their purchase order and the total purchase order was in excess of $600,000 from this customer.

So we believe that that installed base is ripe for various upgrades and this HD upgrade is one of the, again, most immediate and largest.

Finally, you talked about financing and someone asked and I think alluded to that you might be issuing additional stock.

Is that in the -- do you see that as a possibility?

Like I said earlier, we've looked at the -- we know what all of the different mechanisms and, again, not just from the theoretical standpoint but from an actual opportunity standpoint, and we didn't say we'd be issuing more stock in doing this.

We said we have the opportunities and we'll be pragmatic about pushing the button if we need to.

That may take the form of equity, it may take the form of debt, it may take the form of other types of the vehicles.

I think that they are all options for us and we'll take the best option for our shareholders and the growth of our company.

Okay, thank you very much.

Thank you for your questions.

Michael Zeldin, Brill Securities.

Hope I'm not overstaying my welcome here.

Harmonic just came out with their new HD encoder and I was wondering if you could address everybody on your continued technological advantage over your competitors these days?

That's a good question, Mike.

Thanks for that question.

We've recently seen in the press an announcement about a new Harmonic product that is not available yet but I think will be some time in the next couple of months.

We have not seen the product up front or directly as, again, it's not in the marketplace.

We have not heard from any of our customers that they've seen it.

We have not lost in the U.S. to HD -- to Harmonic on the HD front or SD front.

From what we've gleaned from the information in the press, this is once again a pizza box approach.

This is not a chassis based product.

We can guess that it's -- our guess is that it's not a Telco grade product.

By not being a chassis it could have limited flexibility in its ability to process numbers of channels.

We know that most of our customers will significantly prefer to have a single box chassis solution.

And I think that the key thing is -- and someone asked earlier about our transcoding -- people need to understand that our transcoding solution for HD is a very efficient solution.

We believe that with the Harmonic product -- again from what we can glean from the press -- that they will need two separate boxes to do what we do in one box.

Again, on a transcode, which means taking MPEG-2 HD and turning it into MPEG-4 HD, further compressing it and putting it into the MPEG-4 format is a one step process, a one box process for us.

For others like Harmonic and like this new product we believe is they would have to put the MPEG-2 into a box and process it before they put it into their new box to turn it into MPEG-4.

So again, we think that we have an advantage from a single box chassis based Telco grade product and we think that we will continue to do well with our products against competitors like Harmonic and others.

Thanks again, guys.

There are no further questions at this time.

I will now turn the call back over to Mr. D'Auria.

Thank you all for joining us this morning.

I'm sorry I'm losing my voice here and I hope we've given you some insight about the issues we saw in Q2.

I hope you all understand that Q3 gets our core business back on track.

I hope you all understand that we do have some very interesting opportunities with Tier 1's and we very much look forward to getting back on track in a big way and we look forward to the potential upside in our business.

So again, thanks for joining us and thanks for your insightful questions.

This concludes today's Tut Systems second-quarter financial results conference call.

You may disconnect at this time.