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DTS Inc. (DTSI - Snapshot Report) reported second quarter 2011 earnings (excluding amortization but including stock-based compensation) of 16 cents per share, which came in line with the Zacks Consensus Estimate. The reported earnings per share (EPS) increased 60.0% from the previous-year quarter. Strong quarterly growth in revenues helped boost the earnings.

Operational Performance

Operating income (excluding amortization but including stock-based compensation) increased 66.7% year over year to $4.7 million. The operating margin expanded 660 basis points (bps) in the reported quarter to 22.7% from the prior-year quarter. The expansion in margins was driven by a 120-bp expansion of the gross margin to 99.8%.

Strong gross margin expansion fully offset higher selling, general and administrative expense (up 10.1% year over year) and research and development expense (up 10.6.0% year over year).

Net income was $2.8 million, up 55.5% year over year. This excludes $0.3 million related to amortization and $0.1 million related to tax impact, but includes stock-based compensation charges of $2.4 million. Net margin expanded 330 bps in the quarter to 13.6%, due to higher operating margin.

Revenue

Though revenue increased 17.9% year over year to $20.6 million, it fell short of Zacks Consensus Estimate of $22.0 million. The year-on-year growth was primarily driven by strong contributions from the Blu-ray, network-connected and automotive markets.

However, low recovery payments and weaker game console revenues acted as headwinds during the quarter.

Balance Sheet

As of June 30, 2011, cash and short-term investments were $91.2 million compared with $102.0 million at the end of March 31, 2011. The company had no long-term debt at the end of the second quarter. Cash flow from operations was $6.7 million compared with $3.9 million in the previous quarter.

Outlook

For fiscal 2011, DTS has revised its estimates downward due to concerns in the macro-economic environment and cautious consumer spending. The company reduced its revenue expectation from $100.0 million-$105.0 million to $95.0 million-$100.0 million, below the Zacks Consensus Estimate of $104.0 million.

The company expects operating margins in the low-40’s range (40.0%-43.0%). DTS Inc. has lowered its EPS estimate from $1.40-$1.49 to $1.30-$1.42. The Zacks Consensus Estimate is pegged at $1.13 per share, still well below the guided range.

Recommendation

We maintain our Neutral rating on a long-term basis (6-12 months). We believe DTS Inc. will gain significant market share, riding on its strong product portfolio, increasing online availability and accelerated expansion of the DTS technology into new markets, such as smartphones, portable devices and digital media players.

Moreover, the company’s partnerships with LG in selling DTS-enabled smart TVs and the incorporation of DTS technology into LG’s flagship 3D phone platform will be incrementally beneficial for DTS Inc. in the long run.

Additionally, the company is likely to gain traction in the tablet market after the release of the DTS-enabled tablet, Vega N5, from Pantech.

However, DTS Inc. continues to face stiff competition from Dolby Laboratories Inc. (DLB - Snapshot Report), Sony Corp. (SNE - Snapshot Report) and privately held THX limited.

Currently, DTS Inc. has a Zacks #3 Rank, which implies a Hold rating on a short-term basis (1-3 months).

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