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KVH Industries (NASDAQ:KVHI)

Q3 2008 Earnings Call

October 21, 2008 10:30 am

Executives

Martin A. Kits Van Heyningen - CEO and President

Patrick J. Spratt - Chief Financial Officer

Analysts

Chris Quilty - Raymond James

Jim McIlree - Colin Stewart

Rich Valera - Needham & Company

Operator

Ladies and Gentlemen, welcome to the KVH Industries third quarter earnings conference call. Today’s call is being recorded. Now for opening remarks and introductions, I would like to turn the call over to Mr. Patrick Spratt, Chief Financial Officer. Please go ahead sir.

Patrick Spratt

Good morning. I am Patrick Spratt, Chief Financial Officer of KVH Industries and with me today is Martin Kits Van Heyningen, Chief Executive Officer.

This call will address the third quarter earnings release that we issued earlier this morning. Copies of the release are available on our web site, KVH.com and are also available from our investor relations department. This call is being simulcast on the internet, and will also be archived on our website for future reference.

For those of you listening via the web, feel to submit questions related to the content of today’s discussion to IR@KVH.com and we’ll be happy to answer them following the call.

This conference call will contain certain forward looking statements that involve risks and uncertainties. For example, statements regarding financial and product development goals are forward looking. The company’s future results may differ materially from the projections described in today’s discussion.

Factors that might cause these differences include, but are not limited to, those mentioned in today’s call and risk factors described in our quarterly report on form 10Q filed with the SEC on August 8, 2008. The company’s SEC filings are directly available from us, from the SEC, or from the investor information section of our website.

Now, I’d like to turn the call over to Martin to begin today’s discussion of results. Martin.

Martin Kits Van Heyningen

Thanks, Pat. Thank you all for joining us today.

You know, during times like these in the global economy, a company’s health and long-term prospects depend on being well positioned. Overall, KVH is probably more diversified and better positioned to weather these economic storms, than any company our size. Since we address multiple market segments, like military, marine, land mobile, and even commercial aviation. In fact, our military group has further diversified into satellite, fiber optic gyros, and tactical navigation products.

In all, because we’re not dependent on a single market or product line, we have positioned KVH so that we can weather this recession. We’ve managed KVH conservatively for the last few years. We’ve invested in new business opportunities. But, we have also conserved our cash. With nearly $50 million on hand, and virtually no debt, we have the financial strength some of our competitors lack.

All in all, I feel very comfortable about where we are and what we have in our portfolio. Not that KVH won’t be impacted just like everyone else, but we have the diversity of products, markets, and customers to fair it better than most.

We have a strong backlog going into Q4 and into 2009. Right now, the easing of fuel prices could help some of these segments recover while the credit crisis and the stock market crash are hurting other parts of our business.

We do expect continued growth in the fourth quarter and return to profitability despite some of our markets declining dramatically, declines that are being more than offset by dramatic growth in other parts of our business.

While I feel comfortable saying that about Q4, obviously, the markets are far too volatile to give any specific guidance for 2009 at this point. We’ll just have to wait and see how things develop.

As for the quarter we just finished, there were a number of things that went well and a couple that didn’t. The most important point about Q3 is that most of the revenue miss came from the fiber optic group, where we had two major programs that were delayed.

We expect both of these to be sorted out shortly, and be back on track for Q4. In fact, we expect to begin shipping the remote weapon station gyro orders, that didn’t ship in Q3, in the next few weeks.

On the satellite side, the marine business held up surprisingly well. Overall revenues were up 22% year-over-year. We did see some softness right at the end of September. That coincided with the acceleration of the world’s macro economic problems.

And even so, our new TracFone V7 is selling well, driving our growth for Q3, a trend that we expect to continue in Q4. These products also address the commercial marine markets that are less volatile than the recreational or leisure markets. Our expansion into the Pacific Ocean should also help grow the shipping market segment.

On the land side, revenue was down 56% year-over-year. And the RV portion of it was down even more than that. At this point, the land business represents only about 10% of total revenue. And so it’s not nearly as meaningful as it was just a couple of years ago.

The total Q3 revenues were 15.7 million and that was down about 10% from the prior year. On the bottom line, we had a net loss of $800,000 or $0.06 per share compared to break even results during Q3 of last year.

For the first 9 months of the year our total revenue was 61.2 million roughly flat with last year. However, our net income of $2.8 million or $0.19 per share is a marked improvement from the same period last year where we had net income of 1.5 million or $0.10 per share.

In the mobile communications market, our total sales for the quarter were 12.3 million, a decline of 6% year-over-year. Obviously, this was due to the land business.

Shipments of new recreational vehicles reached an 11 year low at the end of August. Virtually, all major RV manufacturers have shut down at least a portion of their manufacturing capacity and after market sales are slowing as well.

Looking at the marine market, revenues were up 22% in the quarter thanks to strong sales both internationally and domestically. But, at the lower end of the market, the credit crunch is also causing stress within the leisure marine side. Leading boat builders like Brunswick halted production for part of the summer, to reduce inventory levels in the channel.

As a result, we did experience a year-over-year decline in our marine track vision sales. However, this was more than offset by the performance of our TracFone V7 system and the growth of our airtime service, which is steadily becoming a substantial recurring revenue source for the company.

During Q3, we saw significant new interest in the V7, especially within the commercial market. Our message that choosing the V7 will save you money is getting the attention of commercial operators faced with high fuel prices and other economic challenges.

Thanks to our smaller antenna and more efficient service, we’re able to offer these commercial customers lower hardware costs, lower installation costs, and lower airtime costs compared to other products on the market. Because of this, we are seeing V7s installed on an increasing number of working vessels and we have several major fleet opportunities pending.

The V7 is also providing us with the opportunity to present commercial customers with our complete commercial satellite TV and communication solutions. We’re able to offer a unique single source for a range of systems and services including the V7 and many V-SAT Broadband service, our Inmarsat compatible TracFones and airtime and our track vision satellite TV systems.

For example, UNICOM, a Russian fleet operator, recently selected our top of the line track vision and 9 satellite TV systems for crew entertainment on board. UNICOM purchased 60 TrackVision M9s for it’s fleet, the single largest marine order we’ve ever received. Had we not been in the commercial marine market, thanks to the V7, we never would have won this type of order.

In the commercial market, broadband connections at sea are essential for shipboard business activities, more efficient operations and compliance with the regulatory requirements. In addition, affordable internet, email, and phone service are vital as a means for improving the quality of life and morale of the crew.

Global coverage then, becomes a key requirement for any broadband system. We are now generating more interest from these customers with our recent announcement that Pacific coverage for the mini-VSAT service will be available soon.

Our new five-year lease agreement with SAT-GE gives us capacity on the GE-23 satellite which is ideally positioned to provide coverage in the Pacific Ocean. The new coverage area will include Alaska, the west coast of the U.S. and Canada, Hawaii and extend all the way to Asia.

The extension of the mini-VSAT's broadband coverage into the Pacific allow us to cover a significant portion of the world's shipping lanes including some of the busiest, most important routes between Asia and North America.

We’re now in the process of installing the new network hub in Hawaii, which should go online for service testing in November with live service beginning in December. At the same time we're aggressively pursuing the mini-VSAT roll-out plan and we're in the process of negotiating access to additional satellites around the globe.

As we expand our VSAT coverage area, we'll also generate airtime revenue from business jets traveling through our networks. And speaking of jets, we're nearing completion of the development of our commercial airline satellite TV system.

With over $20 million in backlog, this unit represents a new growth area for KVH as we begin providing equipment for narrow-body jets the Boeing 737 and the Airbus A320. FAA certification will begin during the current quarter.

We're also recently asked to provide pricing for a new European program as well. So we see some nice potential upside in this part of our business.

Moving on to defense. Our guidance in stabilization sales for Q3 were down 23% year-over-year to about 3.4 million. While revenue from TACNAV shipments and product repair activities were up during the third quarter. Those gains were offset by two delays within our fiber optic business.

First, the qualification process for our fiber optic gyros for use in Kongsberg's Remote Weapon Station has taken longer than expected which prevented shipments during the third quarter. We've been working closely with Kongsberg and have made excellent progress towards the completion of the qualification process. In fact, we expect to be in full production of our remote weapons station FOGs before the end of this month.

The other delay involved an anticipated follow-on order for our TG-6000 inertial measurement units. As you may know, these are used by Raytheon in the guidance system for the Mark 54 torpedo. New orders for the TG-6000 have been on hold as Raytheon and the U.S. Navy negotiated a new contract.

Unfortunately, that contract was not signed in Q3 and Raytheon was unable to pass the order along to us. However, just in the last few days, the Navy has placed its new Mark 54 order with Raytheon and we expect to receive an order from them shortly at which point we'll begin production of the TG-6000.

So in conclusion, Q3 was clearly a challenge and the economic climate is uncertain going forward. However, we're upbeat about KVH's position in our markets. We expect to resume our growth path in Q4. We're well diversified allowing us to weather difficult times in some of our markets.

We're continuing to invest in new products and satellite infrastructure. And even in our most challenging markets, we have a strong position compared to our competition. We have exciting products and services that are clearly still in demand and we've got the financial resources to give us stability and the flexibility to take advantage of new opportunities as they arrive.

Now I'd like to turn the call back over to Pat to fill in some of the numbers. Pat?

Patrick Spratt

Thank you Martin. The financial results for the third quarter were clearly not up to our expectations. However, in the face of very weak economic conditions, we feel that we are continuing to make very good headway toward executing our strategic initiatives for the long term for growth and for profit.

Now, to some of the specifics. Gross margin was just over 41%. Contributing to this result was a favorable mix of marine and military products, and continuing progress with product cost improvements. We continued to ramp our FOG production capacity to meet the indicated strong demand for remote weapon systems.

For Q3, operating expenses were down 5% compared to last year. We have continued to carefully control discretionary spending. For the third quarter, reported R&D spending was 20% lower than last year. This reflects the impact of the capitalization of the antenna development for the live TV in-flight entertainment system.

Although we saw a reduction in the reported engineering expense, we have actually increased the total absolute level of investment by approximately 15%. This has been necessary to accomplish the live TV development objectives while also sustaining our other strategic new product initiatives.

Third quarter sales and marketing expenses increased 1% year-over-year. But were down to sequentially, due in part to the season slow-down in consumer marine activities.

In the face of the tough economic conditions and depressed RV expectations, we continue to take steps to selectively reduce spending programs. The mini-VSAT business is one area in which we will grow investments and we anticipate quarter-to-quarter increases in spending to drive these seven related sales initiatives.

Administration expenses were also up 1% compared to last year. The administration spending was higher than the second quarter, and this was largely due to the timing of accruals for compensation-related expenses.

Turning to the balance sheet, cash and marketable securities were $49.4 million. Cash flow from operations was modestly negative at about $200,000.

Capital expenditures were approximately $990,000. A majority of this total was in support of the capacity increase for FOG production. We anticipate the fourth quarter will be even higher as we step up investments for the installation of hub equipment for the mini-VSAT global deployment.

We continued the stock repurchase program that was authorized last year for up to one million shares. As of September 30, we had repurchased 967,000 at a cost of approximately $8.2 million.

Accounts receivable at $9.1 million was almost $3 million lower than Q2. Day sales outstanding increased modestly to 52. We continue to be very pleased with our ability to achieve such a positive performance level in spite of the difficult economic environment. This good cash management performance is a credit to our internal discipline and it also reflects the fact that we partner with some of the best dealers and distributors in the world.

Inventory increased substantially by about $3.4 million to just over $15 million. There were two primary contributors to this. First, we did not ship any FOGs to Kongsberg, but continued to pre-build subassemblies to support the high level of shipments that will be necessary once we clear qualification.

Second, the dramatic weakening of consumer confidence in the general economy during the quarter caused even more fall off in the demand for our RV products. It will take several quarters to reduce the RV inventory to more normal levels if the current level of demand continues.

Annualized inventory turns were approximately three. This is well below our target performance.

Now I will turn to our expectations for the fourth quarter. To start, this is a very weak environment in which to project performance. The economic and stock market conditions are so volatile that prospects change quite a bit almost every day.

We believe we are being appropriately cautious on our outlook, but time will tell. We fully expect to be shipping the DSP-3100 fiber optic gyro in volume to Kongsberg.

We expect to achieve continued progress in developing the mini-VSAT business, but we also expect the consumer markets to continue to be quite weak, especially for RV products. Although we have seen year-over-year weakness in the consumer space for marine TV products for quite some time, the trend line has not fallen off like it has for the RV market.

Revenue in Q4 should grow year-over-year and be within the range of $20 to $23 million. We anticipate that SATCOM sales will be down year-over-year, driven by the continuing weak demand for RV products. On the other hand, as has been the case over the last several quarters, we expect to see continuing progress in our sales of the TracFone V7 product and growth in the mini-VSAT airtime revenue.

The defense business should grow strongly assuming we achieve full qualification with Kongsberg within the next few weeks. Although we expect to receive our next order for the Raytheon Mark 54 torpedo program very shortly, any Q4 shipments of the TG-6000 inertial measurement unit will be at a modest level. Sales of TACNAV products should also show a year-over-year increase.

Our defense backlog at the end of September was $16 million. We expect that shipments of the LiveTV antenna systems will not begin until early 2009.

For Q4, we expect that gross margin will be at or below 39%. The expected decrease compared to Q3 is due to the build out of the mini-VSAT network infrastructure, the continuing ramp of the FOG manufacturing capacity, and the below normal utilization of SATCOM capacity due to the weakness in consumer demand.

Operating expenses are expected to be higher than Q3. Also, largely due to investments that will be made for expanding the sales channel and customer support for the mini-VSAT business. Below operating margin, we expect an that interest income will be lower than in Q3 due to lower interest rates and cash balances. This profile should result in EPS of $0.01 to $0.05.

Although the current economic conditions are very challenging, we are excited about the long-term prospects for our new growth business. We are making very good progress with our strategic initiatives and we believe that we are getting stronger relative to our key competitors during this period.

We’re using our strong financial conditions to be aggressive in developing the growth drivers for the future. Now we’d like to take your questions. Operator, please open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions)

We’ll hear first from Chris Quilty with Raymond James.

Chris Quilty – Raymond James

Hi gentlemen. Can you hear me okay?

Patrick Spratt

I can.

Chris Quilty – Raymond James

Great, I was hoping you could give us, perhaps, a little bit more color on the mini-VSAT service in terms of, perhaps, number of ships deployed or at least when we look at the service revenue or as I guess you’d call it now, the non-product, non-hardware revenue, how much of that is actually starting to be generated from mini-VSAT?

Martin Kits Van Heyningen

Well, we don’t want to talk about specific numbers of units for competitive reasons, but I think Pat may be able to give you a better detail. But it’s certainly the majority of the service revenue now for their airtime business is coming from the mini-VSAT. So we have seen the very rapid growth there in terms of subscriber revenue growth.

Chris Quilty – Raymond James

Okay, and in terms of, I think you mentioned, there’s a couple of other fleet opportunities, presumably the recent one where you announced M9 sales was around 60 units. Is it fair to assume a fleet deal in order of 60, 100 units?

Martin Kits Van Heyningen

Yes, some of the fleets are bigger than that, but yes, that’s what we would call a fleet deal. We’ve already won some fleet orders that were 10 to 20 at a time for the V7. But when I’m talking about a big fleet order, it would be in the range of 50 to 200, somewhere in there.

Chris Quilty – Raymond James

Okay, great and last quarter you gave us some metrics on the monthly ARPU and it had trended from 1,800 up to 2,000. Is that a trend you’re still seeing?

Martin Kits Van Heyningen

I don’t think we’ve seen any further increases, but certainly it’s still above 2,000 last time I checked.

Chris Quilty – Raymond James

Okay, and in terms of any competitive responses you’ve seen out there or other indicators in the channel that competitors may try to match the service or do you think there are major competitive risks?

Martin Kits Van Heyningen

Well, I think probably the most significant new competitor would be Iridium with their open port system. But it’s an L-band system so it’s really more of a competitor for Inmarsat because you’re still paying by the megabyte and it’s fairly expensive to get started. But I think that’s probably the most significant new competitor in the market.

Christ Quilty – Raymond James

Okay, and Pat, from your guidance with regard to the Mark 54, is it fair to assume that in your guidance, you’re not assuming any Mark 54 FOG shipments for the fourth quarter?

Patrick Spratt

In the guidance, Chris, we’re assuming a very small quantity of shipments in the quarter, but it’s not a material amount.

Chris Quilty – Raymond James

And obviously on the remote weapons system your guidance would include the fact that you expect shipments to begin in the next several weeks and then pick up pace through the end of the year.

Patrick Spratt

That is correct.

Chris Quilty – Raymond James

Okay, and again, I missed it and I missed the front part of the conference call. Did you get the backlog number?

Martin Kits Van Heyningen

Yes, the backlog—and this is for defense only—is $16 million as of the end of September.

Chris Quilty – Raymond James

And that’s up from, what was it in the second quarter?

Martin Kits Van Heyningen

At the end of June, it was about $13 million. Shortly after the start of the quarter, we received another order from Kongsberg. But the quarter-to-quarter comparable, it’s up about $3 million quarter-to-quarter.

Chris Quilty – Raymond James

And again, the guidance you had previously given about, obviously you may not be exiting the year a 4 to 6 million quarterly run rate on RWS systems because you got a later start. But that still seems to be sort of a sustainable production rate through next year.

Martin Kits Van Heyningen

Well, that’s sort of our goal from a production point-of-view. And just to get back to your earlier question, we are capacity constrained in the current quarter, so if for some reason there was a further delay on one program, we would ramp up with the other program.

So the reason we’re not shipping more Raytheon units is production constrained. We don’t expect to be order constrained in Q4. So there is that level of backstop there.

Chris Quilty – Raymond James

Okay, and biggest area of concern here for the company is your demand picture for the marine TracVision business, which as your traditional business is probably round about order magnitude 50% of company sales but we’ve obviously seen a slowing trend there. I can’t tell exactly how much because you’re now blending in the positive impact of the TracFone V7 product line.

But given all the announcements we’re hearing for MarineMax and Brunswick and other public companies in the space, is it fair to assume that as you look out into the fourth quarter and perhaps into next year, you’re going to go from what had traditionally been sort of mid-teens grow comps to perhaps negative?

Martin Kits Van Heyningen

Well, what we’re seeing is that the marine market has not been growing quickly, but we haven’t seen any difference between Q3 and Q2. So when we look internally at the year-over-year sales figures, we see sort of more of the same, which is very different from the pattern we saw in the land-mobile market where you just see these dramatic declines.

So right now, looking at the first couple of weeks of October and what we saw in Q3, we see a sort of steady business in the marine TracVision part of our business, meaning it's not robust growth. We may see some modest decline like we did in Q3, but nothing dramatic and that's built into those numbers.

Chris Quilty - Raymond James

If we scratched out the incremental positive you picked up from selling these high-end tract vision systems, and you look just down on the more consumer/leisure market albeit a high-end leisure market, if we just defined it as that, have you seen any weakening trend there?

Martin Kits Van Heyningen

We have seen weakening trends but what we haven't seen is a change in the trend line. In other words, what we saw for the last couple of quarters is a fairly consistent picture with no rate of change. You know what I mean. So we saw sort of a little bit of softness but that softness had not gotten worse.

Patrick Spratt

Let me add a little bit there, Chris. If you were to see the profile of our marine TV sales, what we saw in the third quarter is quite consistent with what we've seen year to date in 2008.

So as Martin said, we've seen softness in that market in the consumer space for TV antennas for quite some time, actually dating back all the way to the end of 2006 in the U.S. But we haven't seen a falloff in the year-to-year numbers from where they've been now for the last several quarters.

Chris Quilty - Raymond James

Okay. Good. That's good to hear and keep up the good work, guys.

Martin Kits Van Heyningen

One other thing I will add to get back to your very first question about airtime, I can give you a little bit of help in terms of total airtime for VSAT and Inmarsat in the third quarter, represented certainly the majority of the services' revenue, probably roughly two-thirds of it.

The VSAT revenue is already a greater amount than the Inmarsat revenue for the company and is growing on a sequential basis quarter to quarter.

Chris Quilty - Raymond James

Great. Thank you very much.

Martin Kits Van Heyningen

Thank you.

Operator

(Operator instructions)

We'll hear next from Jim McIlree with Colin Stewart.

Jim McIlree - Colin Stewart

Thank you. Good morning. Has the gyro for the Kongsberg Remote Weapons Station passed qualification now or are you still working on it?

Martin Kits Van Heyningen

No, we're still working on that.

Jim McIlree - Colin Stewart

Who needs to sign the document? Is that Kongsberg or Kongsberg's customer or customers?

Martin Kits Van Heyningen

It's Kongsberg.

Jim McIlree - Colin Stewart

Okay. Is there more testing that needs to be done? What has to happen between now and the end of the month for them to sign the document and you start shipping?

Martin Kits Van Heyningen

As far as we're concerned, we're done with all development-type activities and all the key testing is finished. We're really at a paperwork stage now, where we expect formal signatory approval.

So there are no technical issues or no spec parameter issues or anything like that.

Jim McIlree - Colin Stewart

You don't have to go through more, I don't know, environmental testing or stress testing or anything like that?

Martin Kits Van Heyningen

No. We're at a stage now where we're just wrapping up the paperwork. All the testing has been performed and we continue to do testing in process, so that type of work will continue.

There's no further development work and no further specs that need to be improved or performance, reliability, quality. To our knowledge, there's nothing further that needs to be done.

Jim McIlree - Colin Stewart

Okay, great.

I know that '09 is a question mark for just about everybody. But can you try to articulate a little bit how you're viewing your expense growth in R&D, sales and marketing, and G&A for '09, at least from what you can tell so far?

Patrick Spratt

That's an interesting question, Jim. Like you said, at this time, because of the difficult environment, it's really tough to get a read on some things. But we think we've got the strong prospects in the mini-VSAT business and in the fiber optic gyro business for 2009.

At this point, we're looking at some very healthy growth in 2009 on the top line. We will certainly continue to invest but I would say that if you looked at our total profile of operating expenses across the company, our objective will continue to be to invest at a slower pace than the growth of the top line.

That's not helping you a lot because it's not giving you the top line percentage increase numbers, but we will grow our operating spending but our plan will be to grow it at a slower pace than the top line growth so that we continue to improve the operating margins of the company.

Jim McIlree - Colin Stewart

Right. It sounds like in a sense, you're high grading your OpEx, putting it into areas where you do have better growth prospects.

Patrick Spratt

Exactly. We're going through shifts certainly on a very regular basis. Month-to-month what we're doing is we're shifting some of the operating expenses and some of the investments that we had made historically out of the areas that just are not growing. In fact, they're declining like in the land space for satellite television, and moving it into the marine space and to the mini-VSAT business, certainly fiber optic gyroscopes.

When you look at R&D, I'd say that we have felt pretty comfortable at about the net 10%,

10-11% as a percent of revenue level. And I would say that that is a good planning, you know, perspective for the foreseeable future. But we will be shifting investments internally within operating expenses to the high-growth businesses.

James Mcllree - Colin Stewart

Right, okay, and last one. The capacity that you are leasing on GE23, is this a fixed take or pay contract? And if so, you know, approximately how much is that on an annual basis?

Martin Kits Van Heyningen

Well, the answer is yes, this is a straight lease so, you know, we are starting with a certain amount of capacity and then it grows fairly quickly to a full transponder. I don’t want to tell you explicitly what this particular satellite costs, but you know, as a rule of thumb, a transponder is on the order of a million and a half dollars per year, just to put a figure around it.

James Mcllree - Colin Stewart

Right, right. Okay. And so at some point you have a full transponder; can you go beyond that if need be?

Martin Kits Van Heyningen

Yes, so there are a number of additional beams on that satellite and there is still additional capacity which we have, you know, have options on as well, that we can take more capacity, should we need it.

James Mcllree - Colin Stewart

Right. Okay, very good, thank you.

Martin Kits Van Heyningen

But just to follow up on your point, you know, so that’s also baked into the Q4 numbers is that we now have some start-up costs where we have capacity before we have customers.

James Mcllree - Colin Stewart

Right, right, that is what I assumed you guys were talking about, at least partially. And that is in cost of sales, right? The transponder lease?

Patrick Spratt

It will be.

James Mcllree - Colin Stewart

Right.

Patrick Spratt

When it kicks in, yes, it will be in cost of service.

James Mcllree - Colin Stewart

Right, okay, awesome. Thank you.

Operator

We will take our next question from Jim Roumell with Roumell Asset Management.

Jim Roumell - Roumell Asset Management

Thank you. Hi, guys.

Martin Kits Van Heyningen

Hi, Jim.

Patrick Spratt

Hi, Jim.

Jim Roumell - Roumell Asset Management

A couple questions. One is, Martin, anymore discussions with any competitors in the space on the V7? I’m thinking primarily on Schlumberger or Raytheon in terms of them looking at the market and wanting to partner with you in some way, given some of the competitive advantages of the V7?

Martin Kits Van Heyningen

Well, part of our sales strategy is to look at various ISPs around the world that might be selling a competitive service, you know, whether that is a VSAT service or iridium service or Inmarsat, because those companies typically sell more than one type of product.

Now one of the issues for us is that we normally do not wholesale the products, you know. In other words, this end-to-end business model is not necessarily conducive to a wholesale plan. And what we do not want to do is we do not want to give away our competitive advantages of being a single provider and guaranteed service and support and just having an all-in-one product offering that works really, really well. We'ree not willing to compromise on that.

So if we can find a sales outlook where we can not compromise on the service and the price advantages that we offer and build a wholesale business model around that, that is something that we are definitely considering doing.

Jim Roumell - Roumell Asset Management

Uh-huh. So you have talked, you have had discussions with Schlumberger?

Martin Kits Van Heyningen

We talk to a lot of different people, so our sales guys are talking to a number of different people in the industry.

Jim Roumell - Roumell Asset Management

Well, I guess I’m more referring to you specifically, if you’ve had any contact with them.

Martin Kits Van Heyningen

I’ve spoken to many people. I do not want to get into specifics about which, you know, customers, you know, we’ve spoken to.

Jim Roumell - Roumell Asset Management

Okay, alright. Next question was, and maybe you have provided this in the past, but what do you think the market opportunity is on the V7?

In other words, if you kind of, you know, add up the number of possible boats in the world as you roll this out in the Pacific, and given that this is really geared toward a kind of big broadband user, and that’s where the real savings is if you are a big user, have you kind of identified a market size, so to speak, on the V7?

Martin Kits Van Heyningen

Well, I think that we have looked at some various estimates of the market, you know, and in around numbers it is a billion-dollar-a-year opportunity in terms of the service revenue, between the broadband services that are out there today from Inmarsat and the services that are out there today from the existing VSAT providers.

So, you know, we look at that opportunity and say well, that’s the airtime component. Adding on top of that would be the hardware component which, you know, the hardware right now has a list price of over $30,000, so it's also not an insignificant part of the equation.

Jim Roumell - Roumell Asset Management

Roughly the estimate of what is spent currently for airtime?

Martin Kits Van Heyningen

Yes, is approximately $1 billion U.S. per year.

Jim Roumell - Roumell Asset Management

Okay, and I mean, have you done any internal—I mean can you share anything in terms of, you know, what realistically you can grab of that given, you know, where the V7 is, you know, most productive in terms of kind of heavy users of broadband and whatnot? I mean, do you kind of provide any handicapping of what you expect in terms of a kind of base worst-case, best-case scenario?

Martin Kits Van Heyningen

No. We don’t have a specific sales forecast to give you. But we do expect to get the majority of that business over time, and we also expect that over time that market will grow, meaning that broadband on ships today is not yet prevalent.

So if you look at some of the oil and gas customers that you mentioned, the shipping companies, all the various aeronautical, bus-jet applications, or just the whole broadband, the mobile broadband market is still in its infancy. Even though it sounds big now, it’s going to be much bigger than it is today.

And also I’d like to comment on your point that only heavy users are VSAT customers. Really the crossover point happens so quickly. If you look at the average monthly consumption of data. If you are using even hundreds of megabytes a month, which is really nothing, today with Inmarsat that’s $1300 a month, which is more than our base package starts at.

Operator, any other questions?

Operator

At this time we have no other callers in the queue. (Operator Instructions)

We’ll hear from Rich Valera with Needham and Company.

Richard Valera - Needham and Company

Thanks and good morning. First just a quick book keeping, Pat. Do you have the depreciation and amortization for the quarter?

Patrick Spratt

Yes I do, Rich. It was $528,000.

Richard Valera - Needham and Company

Great. And then Pat, in talking about the increase in the inventory mentioned you had a buildup on the RV side and expected multiple quarters to work that off. What’s the risk of obsolescence? What’s the typical shelf life of an RV product?

Patrick Spratt

The shelf life is actually quite good. We’re selling products today that were designed multiple years ago, and customers are still using products that we sold six or seven years ago. So we’re not concerned about the shelf life of the product.

Naturally we are a bit concerned about carrying that inventory for a length of time and the cost of doing that. But we’re not concerned about the actual content of the inventory and our ability to be able to use it over time.

Martin Kits Van Heyningen

Also adding to that was that all of our products have the ability to be remotely flashed both by us as well as by end users. So if there was an improved feature, 90% of the time it’s software. So those software updates are available today for free.

Patrick Spratt

Yes, and another thing, one other thing, Rich. I don’t want to leave anybody with the impression that all of this inventory increase is in finished goods, because that is not the case. So the inventory increase is a combination of a little bit of finished goods, not very much at all, and mostly raw materials and sub-assemblies.

Martin Kits Van Heyningen

And mostly it’s fiber optic, not RV.

Patrick Spratt

Overall, yes. Correct.

Richard Valera - Needham and Company

Great. That’s helpful color.

And Pat, I know that we’ve talked before about at some point potentially reversing I think the valuation allowance on your tax, on your NOLs. And I know you have a loss this quarter; I don’t know where that puts that. But can you give us any update, there, on where you think that process stands?

Patrick Spratt

Well, it really stands about where it stood at the end of June. We do look at that every quarter, and we review it with our auditors. And at this point in time we continue to believe that it’s more appropriate to keep the valuation allowance on the books.

I don’t have a precise number for you, Rich but there's probably still a valuation allowance that would cover potentially around $2 million of profit in the U.S. company. And at this point in time, based on our projection for the fourth quarter, I would expect that in the fourth quarter we will look at it again and it’s a combination—the decision is a combination of not only historical performance but also our projections and our confidence level going forward.

So I can’t state when the valuation allowance will be fully consumed or when we will take it down to the P&L but I would say as of this moment, our decision has been to leave it on the balance sheet. Our decision as of the end of the third quarter is to continue to leave it there on the balance sheet. And we will take another hard look at it at the end of the fourth quarter.

Rich Valera - Needham and Company

Okay, that’s helpful. Thanks very much.

Operator

At this time we have no further questions. I’ll turn the conference back over to our presenters for closing remarks.

Martin Kits Van Heyningen

Okay. If you have any follow-up questions, please feel free to contact Pat or myself. Thank you.

Operator

Again, thank you all for joining us today. That does conclude our call.

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Source: KVH Industries Q3 2008 Earnings Call Transcript
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