DTS Inc. (DTSI) reported fourth quarter 2011 earnings (excluding amortization but including stock-based compensation) of 43 cents per share, beating the Zacks Consensus Estimate by 3 cents. On a year-over-year basis, earnings surged 23.3% in the reported quarter.

Quarter Details

Revenue increased 8.0% year over year to $29.0 million during the quarter, in line with the Zacks Consensus Estimate. Royalty revenue was $1.6 million in the reported quarter compared with $1.7 million in the prior-year quarter.

Blu-rays contributed 40.0% of the total revenue, while the rapidly expanding Network connected segment accounted for 20.0% of the total revenue. Revenue from the car market also increased in the quarter, with approximately 15.0% of contribution in the reported quarter. However, AV continued to decline in the quarter.

Gross profit (excluding amortization but including stock-based compensation) for the quarter increased 8.4% year over year to $29.0 million. Gross margin was 99.9% versus 99.6% in the year-ago quarter.

Operating expenses increased 4.4% year over year to $16.9 million, primarily driven by a 4.6% rise in selling, general & administrative expense (SG&A) and 3.6% increase in research & development expense (R&D) in the quarter. However, as a percentage of revenue, operating expenses declined 200 basis points (bps) primarily due to 150 bps improvement in SG&A and 50 bps in R&D.

These improvements drove operating income in the quarter. In dollar terms, operating income spiked 14.5% year over year to $12.1 million. Operating margin expanded 240 bps to 41.7% in the reported quarter.

Exiting the fourth quarter, the company had cash and short-term investments of $85.6 million compared with $85.8 million at the end of third quarter of 2011. The company had no long-term debt at the end of the fourth quarter. Cash flow from operations was $9.6 million compared with $4.0 million in the previous quarter.

Outlook

DTS did not provide any quarterly guidance. However, the company expects revenue for the first quarter to decline 10.0% to 15.0% sequentially, primarily due to product relief cycle and supply chain problems arising from the flooding in Thailand. Currently, we expect DTS to earn 38 cents based on revenue of $30.0 million.

The company provided a strong fiscal year outlook with revenues in the range of $112.0 million to $116.0 million, operating margin of approximately 40.0% and earnings in the range of $1.60 to $1.65 per share. The earnings exclude stock-based compensation of 37 cents to 38 cents per share. Currently, the Zacks Consensus Estimate is pegged at $1.30 (including stock based compensation) for fiscal 2012.

DTS expects Blu-ray to represent 35% to 40% of revenues in 2012. Broadcast revenues are expected to grow modestly and contribute approximately 5% of revenues. Network-connected devices are expected to grow in excess of 70% on a yearly basis, representing 20% to 25% of 2012 revenue. This strong growth is driven primarily by DTS decoders and audio processing technology on smartphones, TVs, PCs, and tablets.

Automotive-related revenue is expected in the range of 12% to 15% of the total revenue. Home AV is expected to remain flat or decline slightly owing to a decline in DVD-based products. Home AV is expected to contribute just over 20% of revenue for 2012.

Recommendation

We believe that DTS will continue to gain market share riding on its strong product portfolio, robust growth from the Blu ray market and increasing penetration into the network connected devices such as internet enabled television, smartphones, personal computers and portable devices going forward.

We remain optimistic about DTS due to its global presence, particularly in the emerging markets of the Asia-Pacific. The Asia-Pacific has been one of the most important, dynamic and fast-growing consumer electronics markets over the past few years. Most importantly, the region remains mostly under-penetrated in comparison to other international markets, and thus represents a huge opportunity, in our view.

We believe that DTS is well positioned to grab this huge opportunity over the long term based on its partnerships with several Asia-based companies such as Pantech, Fujitsu, Haier, Samsung, LG, Panasonic, Changhong, Hisense, TCL, Konka, Skyworth and Huawei. We believe that these partnerships will drive top-line growth over the long term.

DTS’ growth is heavily dependent on increasing Blu-ray penetration and growth of the network connected devices. However, we believe that the volatile macro environment and sluggish consumer spending will remain headwinds for Blu-ray sales going forward.

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 hurt DTS’ growth over the long term. Further, the company faces significant competition from Dolby Laboratories Inc. (DLB), Sony Corp. (SNE) and privately-held THX Limited, which will hurt its profitability going forward.

Thus, we remain Neutral over the long term (6-12 months). Currently, DTS Inc. has a Zacks #3 Rank, which implies a Hold rating in the near term.

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