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DTS Inc. (DTSI - Snapshot Report) reported mixed second quarter results. Earnings exceeded the Zacks Consensus Estimate by 8 cents (61.5%), while revenue was just short of the consensus mark.

Quarter Details

Revenue climbed 5.7% year over year to $21.8 million during the quarter. The year-over-year growth was driven by 81.0% annual surge in network-connected business (30% of total revenue). This strong growth fully offset an 11.0% year-over-year decline in the Blu-Ray business (25.0% of total revenue).

The Home AV business continued to remain weak, with revenue declining 3.0% year over year, due to the ongoing transition from DVD-based products to network connected business. Automotive business jumped 12.0% year over year in the reported quarter.

Gross profit (excluding amortization & acquisition cost but including stock-based compensation) for the quarter increased 5.8% year over year to $21.7 million. Gross margin expanded 10 basis points (bps) on a year-over-year basis to 99.9%.

Operating expenses soared 20.1% year over year to $19.1 million, primarily due to a 12.2% rise in selling, general & administrative expense (SG&A) and a 52.5% jump in research & development expense (R&D) related to continuing investments in network connected business in the quarter.

Higher operating expenses dragged down operating income (excluding amortization & acquisition cost but including stock-based compensation), which plunged 42.8% year over year to $2.7 million in the reported quarter. Operating margin for the quarter was 12.3% compared with 22.7% in the previous-year quarter.

Net income (excluding amortization, acquisition cost & stock-based compensation) was $3.5 million or 21 cents per share compared with $4.2 million or 24 cents in the year-ago quarter.

However, excluding amortization expense and acquisition cost but including stock-based compensation expense and related tax effect, net income was $1.01 million or 6 cents compared with $2.8 million or 16 cents in the year-ago quarter.

Exiting the second quarter, DTS had cash and short-term investments of $100.7 million compared with $79.0 million at the end of first quarter of 2012. Cash flow from operations was $3.8 million compared with $6.8 million in the previous quarter. DTS did not buy back any shares during the quarter.

Outlook

DTS expects full year 2012 revenue to be in the range of $110.0 million to $115.0 million (down from prior outlook of $112.0 million to $116.0 million). Operating margin is now expected to be approximately 20.0% (down from 40.0%) and earnings in the range of 90 cents to $1.00 per share (down from prior outlook of $1.60 to $1.65 per share). 

For fiscal 2013, DTS expects revenue to be in the range of $160.0 million to $175.0 million and non-GAAP earnings to be in the range of $1.85 to $2.00 per share.

Our Take

DTS’s full year 2012 results are expected to be negatively impacted by a much higher tax rate than normal and continued investments related to product development in the network connected business. However, the tax rate is expected to come down significantly in fiscal 2013 (expected 40.0% versus 52% for 2012).

We believe that DTS’s investment in the network connected business will help it to gain significant market share going forward. This coupled with an improving tax rate and incremental revenue from the acquisition of SRS labs will drive top-line growth for 2013.

However, we believe that the volatile macro environment and sluggish consumer spending will remain headwinds for Blu-ray sales in the near term. Moreover, we believe that the strong growth of network connected devices will eventually cannibalize the sales of DVD-based products and Blu-ray sales. This in turn will likely hurt DTS’ growth over the long term.

Further, the company faces significant competition from Dolby Laboratories Inc. (DLB - Snapshot Report), Sony Corp. (SNE - Snapshot Report) and privately-held THX Limited, which remain headwinds going forward.

Thus, we remain Neutral on DTS over the long term (6-12 months). Currently, DTS Inc. has a Zacks #4 Rank, which implies a ‘Sell’ rating in the near term.

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