Xperi Holding Corporation
Q3 2017 Earnings Call Transcript

Published: 2 Nov 2017

[Operator:]

Good day, ladies and gentlemen and thank you for standing by and welcome to the Xperi Third Quarter Fiscal Year 2017 Earnings Conference Call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the call will be opened for questions. I would now like to turn the call over to Geri Weinfeld, Senior Director of Investor Relations for Xperi. Geri, please go ahead.

[Geri Weinfeld:]

Good afternoon, everyone. Thanks for joining us as we report our third quarter of fiscal year 2017 financial results. With me on the call today are Jon Kirchner, CEO; and Robert Anderson, CFO. Before we begin, I would like to provide two reminders. First, today's discussion contains forward-looking statements that are predictions, projections, or other statements about future events, which are based on management's current expectation and beliefs and therefore subject to risks, uncertainties and changes in circumstances. Please refer to the Risk Factors section in our SEC filings, including our most recent Forms 10-K and 10-Q for more information on the risks and uncertainties that could cause our actual results to differ materially from what we discuss today. Please note that the company does not intend to update or alter these forward-looking statements to reflect events or circumstances arising after this call. Second, we refer to certain non-GAAP financial measures, which exclude discontinued operations, restructuring and other exit costs, acquisition and related expenses, acquired intangible asset amortization, charges for acquired in-process research and development, stock-based compensation expense, expense reductions from insurance recoveries and imputing an estimated 31.5% effective tax rate on the non-GAAP pretax earnings of the Company. We have provided reconciliations of these non-GAAP measures to the most directly comparable GAAP measures in the earnings release and on the Investor Relations section of our website. A recording of this conference call will be available on our Investor Relations website at www.xperi.com and unauthorized recording of this webcast is not permitted. I'll now turn the call over to Jon Kirchner?

[Jon E. Kirchner:]

Thanks Geri and thanks to everyone for joining us. I want to open by acknowledging that we are currently experiencing and working through some short-term challenges in our business. Several customer, market specific and timing factors are impacting our results. Despite the near-term challenges we believe the fundamentals and industry trends supporting our business and opportunities set remains strong over the long-term. The challenge of timing and the resolution of our outstanding licensing matters is still uncertain though we believe that a strong catalyst exists on our Broadcom discussions before year-end. The other challenges stem from specific customer issues, market competition on the low-end of the mobile market, and time shifts and expected execution of certain new licenses. We believe all of these matters can ultimately be resolved and that the fundamentals of our business remains sound. This summer shortly after I became CEO I began a comprehensive process of reviewing each market and technology segment that our company addresses. This process which is essential to advancing our long-term strategy has already led to a narrowing of focus on fewer priorities, a deeper assessment of our competitive dynamics and other changes. One of the key aspects of that review has been the recognition that in some of our markets especially imaging we are experiencing increasing internal customer competition on low-end products. Our future direction is to innovate through advanced integrated hardware, software, and embedded solutions which is far harder to replicate by competitors. An integrated Xperi solution will deliver a far more magical and intelligent experience than is offered today. We believe that a strategy based on building advanced integrated solutions can deliver not only strong profitability and cash flow but long-term growth. With our new structure as a combined company we will take bold steps toward this vision. After my review process comes to a close this year we will provide to investors a multi-year roadmap for the business during the first half of 2018. As you've seen from our press release today we've lowered our full year guidance to a range of $330 million to $385 million down from $370 million to $445 million. The high-end of the updated range includes the potential resolution of the Broadcom matter. Note the guidance range excludes approximately 52 million in cash receipts which we are unable to recognize as revenue under purchase accounting related to the DTS transaction. We're obviously disappointed in this revised outlook though we are working through our temporary issues to generate growth as we look forward into 2018 and beyond. Let me provide a bridge between our prior full year guidance and the new guidance we provided today. The mix of moving pieces have impacted our outlook for the year. At a high level we've removed Samsung IP licensing from the range after the filing of litigation and subsequent discussions. We remain in dialogue and we are confident we will ultimately reach a favorable outcome. However, given the uncertainty around the timing of resolution at this point we believe it's appropriate to remove it from this year's guidance. We remain confident about a favorable resolution of the Broadcom matter. Resolution will in a large part determine where we fall within the annual guidance range. In addition there are four primary reasons we have adjusted our annual range which aggregate to a potential impact of approximately $35 million to $40 million. First, the probability of recognizing revenue from Echo, a significant mobile customer for audio technologies has progressively declined. In addition the TV business within Echo which largely had been isolated from mobile challenges now appears to be impacted by their financial difficulties. For the year this one customer impacted the revenue outlook by approximately $10 million. Second, we regularly review licensee production reports and based on those reviews we believe at least $10 million of forecasted revenue has been under reported. Our compliance team is aggressively engaging with these customers, however, resolution likely will shift this revenue into 2018. Third, expectations for our imaging business are more than $10 million lower than our original forecast. This changes in part due to delays associated with an expected shift in a major customers product mix, design losses to competition on low-end models, and delays in the release of certain new products incorporating our technology. And lastly, approximately $5 million in expected revenue from Invensas licensees has shifted into 2018. The shift is a result of elongated timeframes associated with completion of our customer's internal testing. Now let's move on to the quarter. I'll begin with some further perspective on the IP licensing business following that I will provide an update on Q3 and the progress we've made in each of our markets. Robert will then finish the call with a discussion of our Q3 financials, our outlook for the remainder of the year, and touch on the revenue recognition rule changes coming in 2018. Beginning with some perspective on the IP licensing business, it is important to note that our IP strategy is to maximize the total value of our IP portfolio for shareholders by not rushing into deals to generate near-term results at the expense of long-term value creation. Litigation and IP licensing are highly dynamic environments. Timelines as we have witnessed this year can shift despite our significant efforts to anticipate when key events will occur. Having said that there is no question that our IP portfolio has significant value. We believe the activities we have underway will improve our ability to realize a sizable opportunity representing hundreds of millions of dollars over time. We recognize the investor visibility challenge and are also working to improve communication around these highly complex and dynamic matters. One key development is our recent addition of Murali Dharan as President of the IP licensing business. This position previously existed at Tessera and Murali joins us after a search process that began more than a year ago. Importantly his 30 plus years of high technology and IP licensing experience will further enhance our capabilities. Given the opportunities we see, additional leadership and focus should accelerate our long-term growth. Now I will give more specifics on each of our significant litigation matters. As we announced, we initiated legal proceedings against Samsung on September 28th for patent infringement. This was not our preferred approach but unfortunately we were not able to reach a mutually acceptable relicensing agreement and we believe this was necessary step to protect our rights. We filed a total of 10 legal proceedings in six jurisdictions alleging infringement of 24 patents. We conducted extensive due diligence prior to filing these proceedings and we are confident that they will result in a positive outcome for the company. On October 31st the International Trade Commission or ITC instituted its investigation with respect to this matter to be filed against Samsung on two of our wafer level packaging patents. These proceedings are just getting started and we do not anticipate any material developments over the next quarter. Turning to Broadcom, the ITC is reviewing the Administrative Law Judge's initial determination and is scheduled to issue its final determination on December 1st. We remain confident that the ALJ's well reasoned decision will be upheld by the Commission and we have been taking steps to prepare for full enforcement of any orders that the Commission may issue with its final determination. In the meantime Broadcom and one of its key suppliers took certain 11th hour actions that we believe signal their understanding of the strength of our ITC case. First, Broadcom filed complaints in the ITC and Federal District Court alleging that our Play-Fi product infringes a Broadcom patent. The initial determination in this matter is scheduled for September 2018. Notably Broadcom did not engage in licensing discussions with us on this patent prior to filing suit. We view this case as a retaliatory negotiating tactic and we believe it has no merit. We have filed a petition for inter partes review with the U.S. Patent Office seeking a determination that Broadcom's patent is unpatentable. Our petition is currently under review. In addition Broadcom supplier TSMC has filed litigation and a motion for preliminary injunction asking a California Federal Court to block us from enforcing our rights in the ITC for Broadcom products made by TSMC. We also believe this action has no merit and represents a very late, improper attempt to circumvent the ITCs lawful authority and jurisdiction. We will make our legal responses to these filings in due course. The hearing on the motion for preliminary injunction is now scheduled for December 21st. In Germany where the Mannheim District Court found Broadcom to have infringed another one of our patents, the Federal Patent Court issued a tentative opinion giving its preliminary view that the patent may be invalid. This is not a final decision but is intended to guide the party's arguments in advance of the January 2018 hearing. We believe the tentative opinion is incorrect and we look forward to explaining why in further briefings and at the oral argument in January. In the Netherlands we have a bench trial scheduled to take place tomorrow Nov 3rd. Although this is a Dutch designation of the same patent issue in Germany, the Dutch court will make its own independent judgments on the merits and will not be bound by any decisions of the German courts. We expect a decision from the Dutch court in the first half of next year. Importantly the Play-Fi TSMC German and Dutch proceedings will all be decided after the ITC's scheduled final determination. Therefore we currently view the ITC's final determination is the primary catalyst in our discussions with Broadcom. Moving to the product licensing business, while year-to-date performance has been mixed we've made some significant strides in laying the groundwork to achieve our long-term targets. I want to first highlight some progress within the product licensing business this year. Our automotive business is up 21% year-to-date driven by continued penetration of our HD Radio technology. The roadmap for this business has never been stronger and we think the technology we have today and the innovation we're focused on for the car will continue to drive future growth. The home market has seen strong interest in our latest audio technology offerings including Virtual

[Robert Andersen:]

Thanks Jon. I will go into more detail on our third quarter results and the trends we're seeing in the business and then I will discuss the upcoming changes to revenue recognition standards that occur in 2018. And lastly I will provide additional details on our financial expectations for the remainder of the year. Before I do that let me make a quick comment on business integration. This year we worked successfully -- we have successfully worked our way through a large list of integration tasks. We are tracking to achieve or exceed our annualized expense synergy target of $15 million. Turning now to results, please note that with all of my comments I will begin with GAAP and then provide the comparable non-GAAP figure. Our GAAP to non-GAAP reconciliations can be found on our website and in the earnings release. As a reminder in Q3 we recognize the full cost of DTS operations. However, due to purchase accounting rules $7 million of revenue is not reflected in the income statement although we have already received cash from the contracts. It is also important to note that the purchase accounting rules impact both GAAP and non-GAAP results. Revenue for the third quarter grew 42% year-over-year due to the acquisition of DTS. Revenue was slightly below the low-end of our outlook range due to lower than expected royalty report from a large IP licensing customer which has now triggered an audit and a settlement from an IP licensing customer that slipped into Q4. In addition the product mix shift from a large imaging customer hasn't happened at the rate we expected. We closely managed the expenses during the quarter and thus earnings was in the range we provided. As expected GAAP and non-GAAP operating expenses for the quarter were up significantly year-over-year given that we now have additional expenses associated with our audio business. Operating expense was $97 million compared with $28 million for the third quarter of 2016. The year-over-year operating expense increase was primarily due to the addition of DTS expenses, higher amortization and stock based compensation associated with the acquisition, and increased litigation expense. R&D expense for the quarter was $25.8 million, an increase of $17 million from the third quarter of 2016. Note that R&D expense includes engineering and commercialization expenses associated with integrating our product and technology solutions in customer products. SG&A expense for the second quarter was -- for the third quarter rather was $34 million, an increase of $21.5 million from the prior year. The difference is largely due to the acquisition of DTS which brings with it a substantial sales and marketing organization. Litigation expense for the quarter was $9.2 million, an increase of $8.6 million from the prior year primarily due to a $5 million benefit from an insurance settlement that offset litigation expense last year. Litigation expense also increased year-over-year due to the initiation of the Samsung matters. Non-GAAP operating expense was $57 million for the third quarter. Q3 interest expense was $7.4 million. GAAP net loss for the third quarter was $12.1 million or a loss of $0.24 per share. Non-GAAP net income for the third quarter was $15.9 million or $0.30 per share. For the quarter our basic shares outstanding were 49.3 million and diluted shares outstanding were 50.3 million. Moving to the balance sheet we finished the quarter with $157 million in cash, cash equivalents, restricted cash and investments, an increase of 20.9 million from the prior quarter. We generated $40 million in operating cash flow during the quarter including a significant customer payment that was delayed from Q2. This brings year-to-date operating cash flow to $86 million. Given a decline in our share price we amended our approach to capital allocation during the third quarter to include share buybacks and subsequently repurchase 385,000 shares of a common stock for $10 million, at an average price of just under $26. As of September 30, 2017 we had a total of $148.2 million available for repurchase under our stock repurchase program. We think the repurchase program is not only good balance sheet management but an important signal to our confidence in the business going forward. In addition on October 25, 2017 the Board of Directors approved of regular quarterly dividend of $0.20 per share of common stock payable on December 13th to shareholders of record on November 22nd. Let me now turn to the topic of revenue accounting, as disclosed in our 10-Q filings over the course of the year we required to adopt the new standard ASC 606 that impacts revenue recognition rules beginning in 2018. The standard itself has been in development by the FASB and the IIFC over many years and has broad reaching impact to companies that report under U.S. GAAP. Earlier this year I talked to financial officer in a variety of industries along with senior partners at the Big 4 and it seems the two areas that are most affected by the standard change are software and licensing. But the actual impact to a company can vary widely depending on the facts and circumstances of each situation. There are two areas of the accounting change that impact both our product and IP licensing segments. Recording for royalty based contracts and the accounting for fixed fee on minimum guaranteed contracts. Currently we report royalty based revenue on a one quarter lag basis which is when we receive the World Report [ph] from our customer. Under the new standard we will need to estimate the royalty amount within the quarter and true up in the following quarter as necessary when the royalty reports are ultimately received. We currently recognize fixed fee for a minimum guarantee contracts over the term of the arrangement which is often over several years with revenue generally matching the cash collection. Under the new standard it is likely that such arrangements will need to be taken at the start of the license period depending on the level of performance obligations that occur over the term of the contract. We are working with our auditors to evaluate the impact of implementing the new standard on our business and I will communicate additional details on subsequent calls. One thing we have communicated in our filings is we will utilize the modified retrospective method of adoption which means that we will not restate accounting periods prior to 2018 but will rather report revenue under the new standard and provide disclosure in our financial statement that reconciles to what the revenue would have been under the current standard. I believe this approach will provide useful information to investors in a way that compare year-over-year business trends on an apples-to-apples basis. Importantly while nothing about the economics of our business will change, I expect this accounting adoption to have a significant impact on how we report revenue with potentially higher volatility on a quarterly basis due to the upfront recognition of the new minimum guarantee in fixed fee contracts along with occasional quarterly true ups on royalty based contracts. Consequently we were considering the best measures by which investors can evaluate the progress of our business and whether are moved to only annual guidance makes the most sense. Metrics like operating cash are not affected by the new rules and therefore will be a key focus of our communication going forward. Let me now turn to outlook. We are moving our annual revenue range down to $330 million to $385 million with the wide range reflecting the significance of key items that can occur during the quarter. This revenue range corresponds to a revised operating cash flow estimate for the year of between $110 million and $155 million. As a reminder our revenue outlook for 2017 excludes approximately $52 million in contributions from DTS due to the impact of purchase accounting. Please refer to slide 22 and our Q3 Investor Deck for additional detail. For the fourth quarter of 2017 we expect total revenue to be between $83 million and $138 million. This includes the impact of approximately $6 million through purchase accounting. The expected GAAP, income per share for the quarter between a loss of $.30 and earnings of $0.33 and non-GAAP income per share between $0.29 and $0.78. That concludes our prepared remarks. Now we will open the call to your questions.

[Operator:]

[Operator Instructions]. And we will go to Gary Mobley with Benchmark.

[Gary Mobley:]

Hi guys, hi Geri. I will start with a question about the wide range of revenue guide for Q4, I think you mostly explained it by talking about how Broadcom remains the wildcard for the fourth quarter. And so I'm just curious why you even included with the uncertainty around the December 1 date and how would any sort of resolution to the matter show up in the fourth quarter with respect to the mix of catch up payment, a continuation or some continued quarterly restructure payments or royalty payments?

[Jon E. Kirchner:]

Yeah, it is a fair question Gary. We are including in our guidance range because I think it would almost be conspicuous by its absence. It is obviously a significant part of the range that we're providing for the fourth quarter. And I can't break out exactly all of the different pieces which I'm sure you can appreciate. And I think that we have a degree of confidence that we described in the call in terms of resolution but obviously it's part of the range for that very reason.

[Robert Andersen:]

And Gary I would add two things. One is as we said a while ago and still believe, we believe that the progress in our position vis-à-vis some of the activities that are happening this fall in particular are scheduled to happen on December 1st we think are a very large catalyst and the chances are better than not that we get something done. That being said certainly our experience over the last quarter or two as time lines have moved around has stopped us short of saying it's absolutely going to or that it's absolutely not going to happen. And so what we've done is we've laid it out in a way where I think people can understand based on a series of factors how we end up in this range depending on what transpires in the short term.

[Gary Mobley:]

Okay, outside of the discussion of ACS 606 and the impact it's going to have on your revenue recognition for 2018 when will the purchase accounting stop impacting your quarterly revenue results from the DTSI acquisition?

[Robert Andersen:]

It starts to wane going into next year. The number that we have put in the slides that were posted this quarter is about 14 million, just over that for 2018. So we're down from 52 million to 14 million next year and they will continue to go on. So much less of an issue in 2018.

[Gary Mobley:]

Okay, and I appreciate the labeling of the different factors that influence your revised 2017 guide because could you talk about specifically in the third quarter what was -- was there a single factor that mostly influence the reported revenue falling below the guidance range?

[Robert Andersen:]

Well it's -- for the guidance range for Q3 there were a couple of things that I mentioned in the remarks which is really a late deal that pushed slightly out into this quarter and then a royalty report that was significantly lower than we expected which triggered or not. That was probably the two main things that had us under our range for the quarter.

[Gary Mobley:]

Okay, alright, I appreciate the commentary. I will hop in the queue. Thanks guys.

[Operator:]

[Operator Instructions]. And we will next go to Richard Shannon with Craig-Hallum.

[Richard Shannon:]

Well, hi guys, thanks for taking my questions as well. I guess my first question maybe I didn't understand Jon based on your early part of your prepared remarks here, but to try to bridge the prior yearly guidance range specifically the low end numbers to the new one here as we're talking about a difference of $40 million, what is all the aspect of that, was there Samsung revenue built into that change or not, it wasn't clear to me?

[Jon E. Kirchner:]

No, Samsung we took off -- Samsung IP licensing we had excluded from that bridge.

[Richard Shannon:]

Okay, thank you that's helpful. I guess when you talked about Invensas being some revenue being pushed out of 2018, is that specifically related to ZiBond or there were other -- was there some other impact there, since you've been talking mostly about that I thought it was from ZiBond but just wanted to be clear on that one?

[Jon E. Kirchner:]

We're engaged in a number of discussions with partners on both DBI and ZiBond. And as I mentioned we've got engagements that are progressing extremely well but we're also subject to their own internal testing cycles. And unfortunately while you do your best to move them along at the end of the day until they complete their own internal qualification processes they typically are not prepared to engage in the production license execution and based on some things that have transpired more of late, we believe some of these things are more likely to push into 2018 than close out in 2017. And thus kind of the conservative approach on eliminating those things from guidance.

[Richard Shannon:]

Okay, that's fair enough. Maybe if I can talk about your product licensing business and I guess this question may not be as useful given some of the discussion you had about Echo [ph] and perhaps others here but would you kind of review on the growth rates within your three major product categories within product licensing as you look into next year?

[Jon E. Kirchner:]

What I would say is that we expect the product technology licensing business to grow in 2018. We've got a number of design wins, we are seeing continuing momentum in different places, we also have some new programs that will roll in the next quarter or two that I think will provide additional support for the notion of growth. In terms of relative growth rates I think the best way to think about it is on a blended basis. You're probably looking at something we do more typically in kind of the mid single-digits to the low teens and I think that'll be determined in part based on some of the information we get over time. Now the growth rates within the different markets is something will handicap as we get closer into the year. And obviously you got different -- you've got very quite different bases in terms of the size of the respective markets. So stay tuned for more specifics on that.

[Richard Shannon:]

Okay, I look forward to doing that. I think I would jump back in the queue here, might jump back in if I have some follow-up as I ponder some of this but I will hold the seats for now. But thanks for taking my questions guys.

[Jon E. Kirchner:]

Sure, thanks Richard.

[Operator:]

And we will next go to Matthew Galinko with Sidoti.

[Matthew Galinko:]

Hey good afternoon, can you talk a little bit more about the competition you're seeing that blow into the phone market for FotoNation and I guess what specifically are doing to curtail that, I mean are you just focusing on the high-end of the market or do you think you can compete effectively at the low-end?

[Jon E. Kirchner:]

Sure, I think one of the things to understand obviously is that the good news and the bad news in some ways about imaging is that imaging is becoming a central application in a wide range of consumer devices. I mean it's arguable today as you look at the mobile phone market as to whether they're in the phone business or they're really in the camera business. And as a result people see a large market opportunity and particularly in software based solutions what you're finding where the barrier to entry is lower you're finding more competition not only amongst smaller competitive entrants but also with in-house competition where they can look at what they've licensed. And previously and to a certain extent on lower less sophisticated applications tried to come up with a substitute that may not be as good but in many cases it might be deemed adequate. So similar to the audio business of many of years ago as we looked at different types of point solutions, what we believe is the answer to this competitively is building integrated and more advanced solutions that require a lot more expertise and sophistication to build in many cases moving them into hardware software combinations that are deeply embedded within the actual device or the software stack. Because you end up with improved performance, advanced capabilities, etcetera, etcetera. And so, notably even as some of the legacy imaging solutions we've sold and in some cases really provided for a fair amount of growth over the last five years in the imaging business, a lot of that stuff has been older and we're pivoting the business towards this more advanced stuff. And so we're doubling down and really trying to focus the teams on this notion of building integrated embedded solutions where the demand is clear. Huawei Mate 10 is their flagship phone, it's an example that we are getting design wins at certainly at the high end and ultimately we believe that will trickle down into the mid-end and higher volume. So you've really got to kind of pick where you want to compete as opposed to chasing let's call it low-end phones where either price competition or performance differentiation is harder to accomplish particularly where it involves the practice or the know how that has now become much more common as the world has ramped up trying to focus on how do they also build competitive imaging solutions, does that help.

[Matthew Galinko:]

It does, I appreciate that.

[Operator:]

Thank you. And that concludes our question-and-answer session and I will now turn the call over to Jon Kirchner for any additional or closing remarks.

[Jon E. Kirchner:]

Thanks operator. As we work through our near-term challenges we continue to remain focused on further building a diversified, attractive, and highly cash flow generative business. We are excited about what lies ahead as we deliberate advanced, smart, and personalized experiences to consumers in their home, in their car, and on their mobile devices. Thank you for joining us today. We look forward to speaking with you in the future. Operator this concludes today's call.

[Operator:]

Thank you. Thank you for everyone for participating. You may now disconnect.