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DTS Inc. (DTSI - Snapshot Report) reported third quarter 2011 earnings (excluding amortization but including stock-based compensation) of 15 cents per share, below the Zacks Consensus Estimate of 18 cents. On a year-over-year basis, earnings went down 16.7%.

Operational Performance

Gross Profit (excluding amortization but including stock-based compensation) for the quarter fell 2.0% from the year-ago quarter to $20.5 million. Gross margin was 99.9% versus 99.3% in the third quarter last year.

Operating income (excluding amortization but including stock-based compensation) decreased 24.1% year over year to $4.5 million. The operating margin contracted 630 basis points (bps) in the reported quarter to 22.0% from the prior-year quarter.

Operating margin was negatively impacted by a 6.7% rise in the operating expenses on year-over-year basis. Additionally, as a percentage of revenue, operating expense increased 660 bps on a yearly basis aided by higher general and administrative expense (up 4.1% year over year) and research and development expense (up 17.9% year over year).

Revenue

Revenues of $20.5 million for the reported quarter not only moved down 2.4% on a year-over-year basis, but fell short of the Zacks Consensus Estimate of $22.0 million. DTS Inc. benefited from royalty recoveries worth $1.1 million in the prior-year quarter. Excluding royalty recoveries, third quarter revenue increased 3.0% over 2010.

During the reported quarter, DTS Inc. witnessed strong growth in the network-connected markets. Also, given the diversification of the business, the company observed continued expansion of the Blu-ray PC and stand-alone player markets. However, third quarter auto and AV revenues reflected effects of Japan earthquake, which hampered production.

Balance Sheet

Exiting the third quarter, the company has cash and short-term investments of $85.8 million compared with $91.2 million at the end of second quarter 2011. The company had no long-term debt at the end of the third quarter. Cash flow from operations was $4.0 million compared with $6.7 million in the previous quarter.

Outlook

For fiscal 2011, the company reiterated its outlook. The company expects to earn revenues of $95.0 million-$100.0 million. The Zacks Consensus Estimate projects DTS Inc. to earn revenues of $98.0 million. The company expects 15.0% to 20.0% of the revenues to come from network connected markets and solid Blu-ray unit forecasts. However, management expects home AV, broadcast & car revenue to remain flat.

The company expects operating margins in the low-40’s range (40.0%-43.0%). DTS Inc. expects Non-GAAP earnings per share in range of $1.30-$1.42. The Zacks Consensus Estimate is pegged at $1.01 per share.

For fiscal 2011, management expects royalty recoveries to be in range of $1.0 million-$3.0 million.

The company expects fourth quarter results to be driven by continuing strength in Blu-ray and network-connected markets and expects rebound in the game console and automotive markets. Moreover, the company expects fourth quarter revenues to be positively impacted by closure of several royalty recovery matters.

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 partnerships with Adobe Systems Inc. (ADBE - Analyst Report), Rovi Corp. (ROVI - Snapshot Report), and Digital Rapids is expected to drive growth in the long run. Additionally, the company’s partnership 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.

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 #4 Rank, which implies a Sell rating on a short-term basis (1-3 months).

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