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DTS, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements May Prove Inaccurate This quarterly report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Words such as "believes," "anticipates," "estimates," "expects," "intends," "projections," "may," "can," "will," "should," "potential," "plan," "continue" and similar expressions are intended to identify those assertions as forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this report. All statements, other than statements of historical fact, are statements that could be deemed forward-looking statements, including, but not limited to, statements regarding our future financial performance or position, future economic conditions, our business strategy, plans or expectations, our future effective tax rates, and our objectives for future operations, including relating to our products and services. Although forward-looking statements in this report reflect our good faith judgment, such statements are based on facts and factors currently known by us. We caution readers that forward-looking statements are not guarantees of future performance and our actual results and outcomes may be materially different from those expressed or implied by the forward-looking statements. Important factors that could cause or contribute to such differences in results and outcomes include, without limitation, those discussed under "Risk Factors" contained in Part II, Item 1A in this quarterly report on Form 10-Q and in other documents we file with the Securities and Exchange Commission (SEC). Readers are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We undertake no obligation to revise or update these forward-looking statements to reflect future events or circumstances, unless otherwise required by law. In Management's Discussion and Analysis of Financial Condition and Results of Operations, "we," "us" and "our" refer to DTS, Inc. and its consolidated subsidiaries. References to "Notes" are Notes included in our Notes to Consolidated Financial Statements. You should read the following discussion and analysis of our financial condition and results of operations in conjunction with the consolidated financial statements and the notes to those statements included elsewhere in this Form 10-Q, as well as the audited financial statements and notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2013 filed with the SEC on March 20, 2014. Overview We are a premier audio solutions provider for high-definition entertainment experiences-anytime, anywhere, on any device. We exist to make the world sound better. Our audio solutions are designed to enable recording, delivery and playback of simple, personalized, and immersive high-definition audio which are incorporated by hundreds of licensee customers around the world, into an array of consumer electronics devices, including televisions (TVs), personal computers (PCs), smartphones, tablets, digital media players, video game consoles, Blu-ray Disc players, audio/video receivers, wireless speakers, soundbars, DVD based products, automotive audio systems, set-top-boxes, and home theater systems. We derive revenues from licensing our audio technologies, copyrights, trademarks, and know-how under agreements with substantially all of the major consumer audio electronics manufacturers. Our business model typically provides for these manufacturers to pay us royalties for DTS-enabled products that they manufacture. We actively engage in intellectual property compliance and enforcement activities focused on identifying third parties who have either incorporated our technologies, copyrights, trademarks or know-how without a license or who have under-reported the amount of royalties owed under license agreements with us. We continue to invest in our compliance and enforcement infrastructure to support the value of our intellectual property to us and our licensees and to improve the long-term realization 14 -------------------------------------------------------------------------------- Table of Contents of revenues from our intellectual property. As a result of these activities, from time to time, we recognize royalty revenues that relate to consumer electronics manufacturing activities from prior periods. These royalty recoveries may cause revenues to be higher than expected during a particular reporting period and may not occur in subsequent periods. While we consider such revenues to be a part of our normal operations, we cannot predict such recoveries or the amount or timing of such revenues. Our cost of revenues consists primarily of amortization of acquired intangibles. It also includes costs for products and materials, as well as payments to third parties for copyrighted material. Our selling, general and administrative (SG&A) expenses consist primarily of salaries and related benefits and expenses for personnel engaged in sales and licensee support, as well as costs associated with promotional and other selling and licensing activities. SG&A expenses also include professional fees, facility-related expenses and other general corporate expenses, including salaries and related benefits and expenses for personnel engaged in corporate administration, finance, human resources, information systems and legal. Our research and development (R&D) costs consist primarily of salaries and related benefits and expenses for research and development personnel, engineering consulting expenses associated with new product and technology development and quality assurance and testing costs. R&D costs are expensed as incurred. Executive Summary Financial Highlights º • º Revenues increased $7.5 million and $20.6 million for the three and nine months ended September 30, 2014, respectively, compared to the same prior year periods. º • º Royalty recoveries from intellectual property compliance and enforcement activities increased $2.5 million and $9.9 million for the three and nine months ended September 30, 2014, respectively, compared to the same prior year periods. Trends, Opportunities, and Challenges Historically, our revenue was primarily dependent upon the DVD and Blu-ray Disc based home theater markets. Because we are a mandatory technology in the Blu-ray standard, our revenue stream from this market is closely tracking the sales trend of Blu-ray equipped players, game consoles and PCs. However, the market for optical disc based media players, in general, has slowed in favor of a growing trend toward network-based delivery of entertainment content to network-connected devices-what we call the network-connected markets. In response to this shift in entertainment delivery and consumption over the past several years, we have transitioned our primary focus to providing end-to-end audio solutions to the network-connected markets, and we believe that our mandatory position in the Blu-ray standard has given us the ability to extend the reach of our audio into the growing network-connected markets. We have signed agreements with a number of network-connected digital TV, mobile device and PC manufacturers to incorporate DTS audio solutions into their products. We have also pursued partnerships to expand the integration of our premium audio technologies into streaming and downloadable content. To date, our technologies have been integrated into thousands of titles, and we continue to work with numerous partners to expand our presence in streaming and downloadable content, including Deluxe Digital Distribution, CinemaNow, and Paramount Pictures. Additionally, we have maintained a strategy focused on increasing DTS support among providers of streaming and downloadable solutions and tools within the cloud-based content delivery ecosystem, working with 15 -------------------------------------------------------------------------------- Table of Contents partners such as Digital Rapids, Elemental Technologies, NexStreaming, VisualOn and castLabs in this area. One of the largest challenges we face is the growing consumer trend toward open platform, on-line entertainment consumption and the need to constantly and rapidly evolve our technologies to address the emerging consumer electronics markets. We believe that although the trend has begun, any transition to such open platform, on-line entertainment will take many years. Further, we believe that this trend demands that playback devices be capable of processing content originating in any form, whether optical disc based or on-line, which creates a substantial opportunity for our technologies to extend into network-connected products that may not have an optical disc drive. During the transition period, we expect that optical disc based media will continue to contribute meaningfully to our revenues, while on-line entertainment formats will continue to grow and thrive. Critical Accounting Policies and Estimates Management's Discussion and Analysis of Financial Condition and Results of Operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America and pursuant to the rules and regulations of the SEC. The preparation of our consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosures of contingent assets and liabilities. On an ongoing basis, estimates and judgments are evaluated, including those related to revenue recognition; valuations of goodwill, other intangible assets and long-lived assets; fair value of contingent consideration; stock-based compensation; and income taxes. These estimates and judgments are based on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, which form the basis for our judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. By their nature, estimates are subject to an inherent degree of uncertainty. Actual results may differ materially from these estimates. There has been no material change to our critical accounting policies and estimates from the information provided in our Annual Report on Form 10-K filed with the SEC on March 20, 2014. For information relating to accounting for performance-based restricted stock units, refer to Note 9, "Stock-Based Compensation". Results of Operations Revenues Change 2014 2013 $ % ($ in thousands) Three months ended September 30, $ 35,676 $ 28,159 $ 7,517 27 % Nine months ended September 30, $ 108,700 $ 88,075 $ 20,625 23 % Revenues for the three and nine months ended September 30, 2014 included $3.2 million and $10.7 million, respectively, of royalties recovered through intellectual property compliance and enforcement activities, which we characterize as "royalty recoveries". Revenues for the three and nine months ended September 30, 2013 included $0.7 million and $0.8 million, respectively, of royalty recoveries. While we believe royalty recoveries are a normal and ongoing aspect of our business, they may cause revenues to be higher than expected during a particular period and may not occur in subsequent periods. Therefore, unless otherwise noted, the impact of royalty recoveries has been excluded from our revenue discussions in order to provide a more comparable analysis. 16 -------------------------------------------------------------------------------- Table of Contents Three Months Ended September 30, 2014 Compared to Three Months Ended September 30, 2013 Excluding royalty recoveries, the increase in revenues was primarily attributable to increased royalties from network-connected markets, which in dollar terms, were up 48%. Network-connected royalties comprised over 50% of revenues in the third quarter of 2014. The increase in royalties from network-connected markets was primarily driven by increased royalties from connected TVs. The increase was also driven by growth in revenue from Play-Fi-enabled wireless speakers. These increases were partially offset by a decrease in royalties from Home AV markets, which in dollar terms, were down 8%, as network-connected devices become more mainstream. Nine Months Ended September 30, 2014 Compared to Nine Months Ended September 30, 2013 Excluding royalty recoveries, the increase in revenues was primarily attributable to increased royalties from network-connected markets, which experienced significant growth in network-connected TVs and PCs. In dollar terms, network-connected royalties were up 19%, and comprised almost 50% of revenues so far in 2014. The increase was also driven by growth in revenue from Play-Fi-enabled wireless speakers and increased Blu-ray related royalties, which were impacted by the continued success of the latest gaming cycle. In dollar terms, Blu-ray related royalties were up 24%, and comprised over 20% of revenues so far in 2014. These increases were partially offset by a decrease in royalties from Home AV markets, which in dollar terms, were down 12%, as network-connected devices become more mainstream. We expect to see continued growth from the network-connected markets as we expand our footprint in terms of both products and geographies served. Gross Profit Percentage point change 2014 % 2013 % in gross profit margin ($ in thousands) Three months ended September 30, $ 32,374 91% $ 25,726 91% 0% Nine months ended September 30, $ 100,607 93% $ 80,908 92% 1% Our gross profit percentage remained relatively consistent for both periods, compared to the prior year. Selling, General and Administrative (SG&A) Change 2014 2013 $ % ($ in thousands) Three months ended September 30, $ 18,712 $ 18,784 $ (72 ) 0 % % of Revenue 52% 67% Nine months ended September 30, $ 60,013 $ 59,223 $ 790 1 % % of Revenue 55% 67% SG&A dollars remained relatively consistent for the three month periods. The dollar increase in SG&A for the nine months was primarily due to an increase in employee related costs, largely due to increased accruals for estimated incentive compensation. 17 -------------------------------------------------------------------------------- Table of Contents Research and Development (R&D) Change 2014 2013 $ % ($ in thousands) Three months ended September 30, $ 9,092 $ 7,490 $ 1,602 21 % % of Revenue 25% 27% Nine months ended September 30, $ 27,098 $ 23,011 $ 4,087 18 % % of Revenue 25% 26% The dollar increase in R&D for both the three and nine month periods was primarily due to an increase in employee related costs, largely due to increased accruals for estimated incentive compensation and severance related costs, as well as consultant expenses to support our new programs and initiatives. Interest and Other Income (Expense), Net Change 2014 2013 $ % ($ in thousands) Three months ended September 30, $ (149 ) $ (27 ) $ (122 ) (452 )% Nine months ended September 30, $ (132 ) $ (446 ) $ 314 70 % Interest and other income (expense), net, for the three months ended September 30, 2014 was comprised mostly of interest expense associated with our debt and the effects of translation of foreign subsidiaries to the US dollar. Interest and other income (expense), net for the nine months ended September 30, 2014 also included a gain from the sale of certain other assets. Income Taxes 2014 2013 ($ in thousands) Three months ended September 30, $ 352 $ (83) Effective tax rate 8% (4)% Nine months ended September 30, $ (3,395) $ 2,279 Effective tax rate (26)% 322% Our effective quarterly tax rates are based in part upon projections of our annual pre-tax results. The tax rates differed from the US statutory rate of 35% in part due to varying foreign income tax rates and foreign withholding taxes, non-deductible stock-based compensation, the federal tax deduction for domestic production activities, and state research and development tax credits. Also, our rate for the three months ended September 30, 2014 was lower due to an increase in the amount of foreign tax credit available to offset the tax associated with a special one-time transfer of certain Japan and Taiwan intellectual property licensing rights transacted on January 1, 2014. Additionally, our rate for the nine months ended September 30, 2014 differed due to a net tax benefit associated with the transfer of intellectual property licensing rights and a tax benefit associated with the settlement of a federal tax audit. Our rate for the nine months ended September 30, 2013 also differed from the US statutory rate due to a change in the valuation allowance for federal deferred taxes, as realization of the deferred tax asset was deemed uncertain. As a result of the transfer of intellectual property licensing rights, based on our current forecasts, we expect that our annualized effective tax rate before discrete items will not vary significantly from the US federal statutory rate for the foreseeable future. 18 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources As of September 30, 2014, we had cash, cash equivalents and short-term investments of $86.5 million, compared to $71.0 million at December 31, 2013. As of September 30, 2014, $65.0 million of cash, cash equivalents, and short-term investments was held by our foreign subsidiaries. If these funds are needed for our operations in the US, they would be subject to US federal and state income taxes, less applicable foreign tax credits. However, our intent is to permanently reinvest funds outside of the US and our current plans do not demonstrate a need to repatriate them to fund our US operations. Net cash provided by operating activities was $25.8 million and $15.0 million for the nine months ended September 30, 2014 and 2013, respectively. Cash flows from operating activities during both periods were primarily impacted by net income (loss) adjusted for certain non-cash items, including stock-based compensation, depreciation and amortization and the effect of changes in working capital and other operating activities. The operating cash flows during the nine months ended September 30, 2014 were also impacted by the timing of cash receipts for certain receivables. We typically use cash in investing activities to purchase office equipment, fixtures, computer hardware and software, and engineering and certification equipment, for securing patent and trademark protection for our proprietary technology and brand names, and to purchase investments such as US government and agency securities. Net cash used in investing activities totaled $4.3 million for the nine months ended September 30, 2014. These cash flows were primarily driven by cash paid for business acquisitions and purchases of property and equipment, partially offset by the sale of certain other assets. Net cash provided by investing activities totaled $8.5 million for the nine months ended September 30, 2013, and were primarily impacted by investment maturities, partially offset by investment and property and equipment purchases. Net cash used in financing activities totaled $6.0 million and $7.8 million for the nine months ended September 30, 2014 and 2013, respectively. Net cash used for 2014 was primarily the result of purchases of treasury stock. We also received $30.0 million in proceeds from a new credit facility and repaid $30.0 million on our previously existing credit facility. Net cash used for 2013 was primarily the result of purchases of treasury stock and amounts used to satisfy statutory withholding requirements upon the vesting of restricted stock. Credit Facility On September 29, 2014, we entered into a Credit Agreement (the "Credit Agreement") with Wells Fargo Bank, National Association, together with the other lenders thereunder from time to time. The Credit Agreement provides us with (i) a $25.0 million secured revolving line of credit (the "Revolver"), with a $1.0 million sublimit for the issuance of letters of credit, and (ii) a $25.0 million secured term loan (the "Term Loan"). In connection with the Credit Agreement, we borrowed $25.0 million under the Term Loan and $5 million under the Revolver, and repaid the $30.0 million line of credit under the previously existing loan agreement with MUFG Union Bank, N.A. (formerly known as Union Bank, N.A.). The Revolver and Term Loan will be used to finance permitted acquisitions and for working capital and general corporate purposes. As of September 30, 2014, $30.0 million was outstanding under the Credit Agreement. All advances under the Revolver will become due and payable on September 29, 2017, or earlier in the event of a default. $5.0 million of the principal amount of the Term Loan will become due and payable on October 1, 2015, and $1.25 million of the principal amount of the Term Loan will be due and payable in quarterly installments thereafter, with the remaining balance due and payable on September 29, 2017. We anticipate that repayment of the Credit Agreement will be satisfied with our future available cash and cash equivalents and operating cash flows, by renewing the credit facility, or 19 -------------------------------------------------------------------------------- Table of Contents by entering into a new credit facility. As of and during the nine months ended September 30, 2014, we were in compliance with all loan covenants. Common Stock Repurchases In February 2014, our Board of Directors authorized, subject to certain business and market conditions, the purchase of up to 2.0 million shares of our common stock in the open market or in privately negotiated transactions. As of September 30, 2014, we had repurchased 0.4 million shares under this authorization for an aggregate of $7.5 million. All shares repurchased under this authorization were accounted for as treasury stock. Contingent Consideration In connection with the contingent consideration arrangement related to Phorus, we may be required to pay up to an additional $1.5 million in consideration subject to the achievement of certain revenue milestones. For additional information, refer to Note 4 and 7, "Fair Value Measurements" and "Commitments and Contingencies", respectively. Contractual Obligations There have been no material changes to our contractual obligations since December 31, 2013. As of September 30, 2014, our total amount of unrecognized tax benefits was $10.3 million. We are currently unable to make reasonably reliable estimates of the periods of cash settlements associated with these obligations. We believe that it is not estimable with any practicable degree of certainty that our unrecognized tax benefits will increase or decrease. Further, under certain existing contractual rights arrangements, we may be obligated to pay up to approximately $7.5 million over an estimated period of three years if certain milestones are achieved. Working Capital and Capital Expenditure Requirements We believe that our cash, cash equivalents, short-term investments, cash flows from operations and our credit facility will be sufficient to satisfy our working capital and capital expenditure requirements for at least the next twelve months. Changes in our operating plans, including lower than anticipated revenues, increased expenses, acquisitions of businesses, products or technologies or other events, including those described in "Risk Factors" included elsewhere herein and in other filings, may cause us to seek additional debt or equity financing on an accelerated basis. Financing may not be available on acceptable terms, or at all, particularly given recent economic conditions, including lack of confidence in the financial markets and limited availability of capital and demand for debt and equity securities. Our failure to raise capital when needed could negatively impact our growth plans and our financial condition and results of operations. Additional equity financing may be dilutive to the holders of our common stock and debt financing, if available, and may involve significant cash payment obligations and financial or operational covenants that restrict our ability to operate our business. Recently Issued Accounting Standards Refer to Note 2, "Recent Accounting Pronouncements". |