Axsys Technologies Q3 2008 Earnings Call Transcript.

Axsys Technologies Inc. (AXYS)

Q3 2008 Earnings Call

October 23, 2008; 10:00 am ET

Executives

Stephen Bershad - Chief Executive Officer

David Almeida - Chief Financial Officer

Scott Conner - President

Analysts

Steve Levenson - Stifel Nicolaus

Tim Quillin - Stephens Incorporated

Paul Coster - J.P. Morgan

Michael French - Morgan Joseph

Michael Ciarmoli - Boenning & Scattergood Inc

Presentation

Operator

Good day everyone and welcome to the Axsys Technologies third quarter 2008 financial results conference call. At this time, I would like to inform you that this conference is being recorded and that all participants are currently in listen-only mode.

This conference call includes forward-looking information that Axsys does not undertake to update or that may not reflect actual results, changes and assumptions or changes in other factors affecting such forward-looking information. Although, such statements reflect Axsys’s current reasonable judgment regarding the direction of the business, the actual results might differ materially from those in the forward-looking statements.

Assumptions and other information that could cause actual results to differ materially from those set forth in the forward-looking statements can be found in Axsys’s filing with the Securities and Exchange Commission. Any non-GAAP financial information presented will be reconciled to GAAP financial statements on the Investor Relations section of the company’s website at www.axsys.com.

I will now turn the conference over to Mr. Stephen Bershad, Chief Executive Officer; please go ahead Sir.

Stephen Bershad

Thank you, Operator. Good morning everyone and thank you for joining us for the Axsys Technologies’ third quarter 2008 conference call. Joining me today on the call are David Almeida, our Chief Financial Officer and Scott Conner, our President.

By way of agenda, I’d like to start this morning’s call by discussing some of the highlights of our third quarter results and following my opening comments, David and Scott will provide a more detailed update on the third quarter financials and operating achievements and finally I will conclude this morning’s prepared remarks by discussing our updated 2008 and newly issued 2009 financial guidance and then open the call for questions.

Over the past few years, we’ve transformed Axsys into a leader in the design and development of hi-tech precision optical and motion control solutions. The demand for our capabilities which enable an increasing number of military surveillance, reconnaissance and targeting applications is stronger than ever.

As it turns out, our strategic shift into SRT was well timed as this area of the defense budget continues to be strong. At a time when many companies are facing economic difficulties, we’ve been largely insulated from the downturn in the general economy as our results show.

For the third quarter sales grew 43% year-over-year to $64.8 million as a result of both continued strong demand and a conscious effort to increase throughput in anticipation of our facilities expansion in Nashua.

Even more impressive than our top line growth, our operating income margin increased to 18.2% during the quarter. Our strong revenue growth and improved profitability drove a 118% increase in our income from continuing operations during the third quarter and our fully diluted earnings per share increased from $0.34 to $0.69 year-over-year. These are great results and clearly confirmed the polarity of our strategies.

I would like to take a moment to comment on our operating margins. During the quarter our sales growth actually outpaced our ability to ramp our spending in research and development and marketing. In fact strong sales growth will cause our operating margins to be unusually high throughout the second half of the year.

As a result we currently expect our 2008 full year operating margin to be between 16.5% and 16.75%. Even though we experienced significant margin improvement in 2008 and plan to make significant investments in 2009, we still expect operating margin expansion in 2009 between 75 and 100 basis points.

Finally I should note that last week we had the official ribbon cutting of our new 67,000 square foot IR camera facility, nearly doubling our manufacturing capacity in Nashua. These roots are never easy, but our team did an outstanding job of anticipating all the issues and all the renovations are now complete, on schedule and with no unexpected disruptions in our Nashua operations. We’ve already began shipping from our new facility which is completely operational.

At this point I would like to turn the call over to David and he will review the financial quarter’s results and then Scott will comment on the operations; David.

David Almeida

Thank you, Steve and good morning everyone. I’ll start today with a review of our consolidated financial results for the quarter to talk about the financial performance of our business segment and then touch on some of our balance sheet highlights.

Consolidated sales for the third quarter of 2008 were $64.8 million up 43% from $45.2 million in 2007 with strong growth in both reporting segments.

Gross margin for the quarter improved to 34.9% versus 32.4% in the third quarter of 2007. Gross margin improvement was mainly due to both improved leveraged on our fixed manufacturing cost and a favorable product and customer mix within both operating segments.

Operating income increased from $6.1 million or 13.5% of sales in the third quarter of 2007 to $11.8 million or 18.2% of sales in the third quarter of 2008. The favorable impact of higher gross margins combined with improved leverage on our operating expenses drove the year-over-year operating margin improvement. We weren’t able to invest in R&D and sales and marketing as quickly as we would have liked to in the third quarter, but we expect to step-up spending a little forward.

Income from continuing operations was $8.2 million or $0.71 per diluted in the third quarter of 2008, up from $3.8 million or $0.34 per diluted share in the third quarter of 2007. As a result of the timing of several factors that impacted tax reserves, our income tax rate for the third quarter of 2008 dropped to 31.6% compared to 37.1% in the prior year. The lower tax rate added approximately $0.06 to our diluted EPS in this year’s quarter. We expect to return to a more normalized tax rate in the fourth quarter.

Net income was $8 million or $0.69 per diluted share in 2008, up from 4.1 or $0.37 per diluted share in the comparable quarter last year. The prior year results included $0.03 of income per share from our discontinued ASP gains business as compared to a $0.02 loss per share in 2008.

The current year loss is for expenses related to an ongoing legal matter for ’08. During the third quarter of 2008, backlog increased to a record $184.5 million with approximately 91% of our backlog being shipped over the subsequent 12 months.

Looking at the details within the segments, the surveillance systems group sales grew 39% from $12.5 million in the third quarter of 2007, to $17.4 million in the third quarter of 2008. The increase in sales for the quarter was due to continued strong demand for thermal camera systems, for land based primer security and border protection applications.

Gross margins increased from 40.2% in the third quarter of 2007 to 44.7% in the third quarter of 2008. Increasing gross margin was due to lowering margins in 2007 related to the acquisition of Cineflex and increased leverage on our fixed manufacturing cost in 2008.

Operating income improved to $3.6 million or 20.6% of sales in 2008 from $2.1 million or 17% of sales in the comparable quarter of 2007. The higher operating income margin was due to higher gross margins partially offset by increased investment in R&D and marketing.

Sales in the energy systems segment were $47.4 million for third quarter of 2008, a 45% increase from sales of $32.8 million in the third quarter of the prior year. Growth is mainly due to strong demand from infrared lenses and precession motion control. The gross margin in the segment was 31.3% for the third quarter of ’08 up from 29.4% last year.

The increase in gross margin was due to favorable mix and improved leverage on our fixed manufacturing cost. Operating margin improved from 17.5% in the prior year to 22.3% this year due to increased leverage of operating expenses. The growth on the top line outpaced our spending within the quarter.

As usual I’d like to end my comments this morning by providing some brief balance sheet highlights. We ended the third quarter of this year with $8 million of cash, down from $15.3 million at the end of last year. The significant growth of the company has required investments and receivables, inventory and capital equipment.

Accounts receivables has grown over $20 million from the beginning of the year due to a combination of sales growth and timing of shipments, with 45% of Q3 sales shipping in September which won’t be collected until the fourth quarter. We also funded a $11 million increase in inventory, three quarter of the way though the year.

While much of this build in investment is due directly to our rapid growth, we also made strategic decisions to increase spending and inventory in order to enhance our competitive position by reducing delivery times. Additionally we have invested $8 million in capable equipment so far this year and expect to invest another $3 million in the fourth quarter. This includes the sit our of our new Nashua facility.

Despite the investments that we made to support our rapid growth, we have and expect to continue to maintain a strong debt free balance sheet funding our cash requirements from internally generated cash. In the fourth quarter we expect cash flow from operations to range from $11 million to $13 million.

With that I’ll turn the call over to Scott; Scott.

Scott Conner

Thanks Dave and hello every. As Steve and Dave mentioned in there opening remarks and you can see from our press release, it’s quite a strong quarter in many respects. Record shipments drove gross and operating margins higher and continued demand led to our highest quarter end backlog ever. As importantly the company experienced strong sales growth in both the Imaging Systems Segment and the Surveillance Systems. In fact typically in this quarter sales grew faster in the Imaging Systems business and the Surveillance Systems business.

The situation was driven by a number of factors including the concerted effort to increase infrared lens throughput in advance of our facility move. Counter balanced by some delayed customer shipments in the Surveillance business. The strong performance by both businesses was clearly gratifying given the tough economic environment that many businesses are facing at this time. As Steve mentioned it’s a particularly good time to be in the surveillance and targeting business generally and the infrared business specifically.

Often in these calls I emphasize bookings from the quarter that are representative of new market areas, new programs or new applications that we’re presuming. While this gives you a sense of our future direction it’s only part of the story; the great bulk of our bookings in any given quarter are in fact follow on orders from existing programs. In Q3 specifically, over 70% of our bookings were derived from follow-on orders for existing programs and this is not out of the more.

The longer term programs are critical to the success of the business because each has a new layer of recurring cash flow, so we can invest in new products and capability. In addition the dynamics of these longer term programs are positive because our customers often have relatively high associated switching costs and also because these programs provide quite a bit of revenue visibility.

Therefore since I believe that in the past several quarters conference calls I presented a pretty clear picture of the company’s direction both in terms of sales and engineering effort, today I’m going to spend some time outlining some of the important Q3 bookings that were follow on orders for existing programs, that are Axsys has been involved with for at least several quarters and sometimes many years.

As many of you know Axsys is focused on winning a broad range of optical programs ranging from tactical ground based programs to airborne systems to strategic space programs. During the third quarter we booked business across this spectrum, which is pretty typical of most quarters. In addition to add some color to this statement let me discuss a subset of specific representative orders from each major program area that we booked in this quarter.

In the tactical ground based areas we booked follow on orders for several programs that we supported in prior periods. In the handheld initial area we booked over $10 million in orders for our thermal weapon sight lenses from two different customers. In the perimeter security area we booked over $50 million for the IBDSS and CRAM programs; in addition we booked follow on order for the U.S. order control Mobile Surveillance System Program or MSS.

We also booked significant follow on orders for ground vehicle platform including $3 million for visible optics for the Abrams and M1A2 tank, $4 million for Weapon Site Lenses for both the Stryker vehicle and the [inaudible] program. Infrared cameras for the MRAPs program and visible optics for the HTI program which is a second generation infrared systems used on both the driver and Abram settings.

Follow-on orders in the airborne area from the third quarter included over $4 million for the Mass Mounted Site program on the Kiowa helicopter; $10.5 million for visible optics and the remaining stuff for components for the joint strike fighter targeting system; over $1.5 million from motion control component used on the [Aclear] the F-18 infrared targeting; visible optics and related components for the Global Hawk UAV Surveillance telescope; over $1.5 million for tactical missile programs such as the A9X winder, the patriot and the Navy vessels.

Finally in the states area, we booked follow-on orders for almost $2 million in support of the [Severes] program, which is the space warning parameter for the missile warning program and a classified satellite program.

Of course in addition to the variety of other follow-on orders, we booked business in new market areas as well. I want to be a little cautious about disclosing too much information on these newer program because perhaps not surprisingly we’re finding that detailed announcement are sometimes followed by increased level of competition on the ground. However, in an attempt to give you sense of our momentum and direction, I’d like to touch on a few of the strategic successes from some Q3.

To first involve some recent success in the commercial surveillance market; during the third quarter Axsys won awards to supply infrared cameras for two new commercial security applications. This market is a relatively new development for Axsys, but we’ve been building a new market channel and as I mentioned on the previous call a new line of un-core infrared cameras, so for some shorter range in detection application. Well it’s still somewhat a new effort for Axsys, we’re already starting to see results.

The second strategic area that I’d like to address is the Maritime market. Previously, I’ve discussed a few Maritime awards for surveillance and lenses, but the marine market has not traditionally been a significant source of orders for Axsys. However, we’re convinced that this market has great potential for our product. During the third quarter, we booked orders for a European and an Asian Maritime Application and significantly we concluded a very successful operational tax with the U.S. navy for a long range through our protection application.

While these Q3 Maritime bookings were particularly large orders, I bring them up, because they represent market area that is relatively un-passed by Axsys and one that we feel hopes for over the longer term.

The third strategic area I’d like to address is our consume success in array of non-commercial surveillance applications. For competitive reasons, I’m once again going to keep my comments somewhat vague, but I do want to provide you with the following sampling of some of the applications that we’re supporting with order received during the third quarter: U.S. army-based securities, military training centers, airborne law enforcement, airborne threat detection to patrolling assets, Middle Eastern border security and airborne military surveillance. So we actually booked orders for all those applications during the quarter. In summary, we feel that Axsys’s reputation is growing in an increasing array of applications among customers throughout the world.

Now, I’d like to turn quickly to Q3 infrastructure changes. I’d emphasize the sales side of the business on this call so far, but in fact one of the most important achievements from the third quarter was our highly successful move to our new Nashua facility. This moved actually occurred in Q4, but most of the preparation work took place in the third quarter.

As many of you know, we moved to our first building in Nashua only two years ago and have already grown beyond its capacity. Until this latest move, our regional Nashua facility helped both our infrared lens business and our land based camera business. As both businesses have grown quickly over the past couple of years, it made logical sense to move one of these organizations to a new facility. Fortunately, we found available manufacturing space about 600 yards down the road, enabling us to maximize utilization of shared resources.

As a dimension, the move to the new building was highly successful and improvement and extensive premium planning activities we’re undertaking in Q3 to ensure minimal disruptions of the manufacturing and both our camera lines and our infrared lens products. The planning clearly paid off as the move accord without a hedge on-time and within budget. The Axsys operations unit clearly demonstrated its [Inaudible] once again.

Another important infrastructure change in the third quarter was the addition of a seasoned industry executive to the Axsys management team. Dan Manitakos, our new Surveillance Systems Group President, worked at FLIR Systems for over 17 years, initially serving in a variety of Engineering roles before being promoted to General Manager of FLIR's Boston office in the year 2000.

He served in his role from 2000 to 2006 during which time he was responsible for an array of land, sea and airborne based infrared surveillance camera system. More recently Dan, broadened his knowledge of a variety of related Surveillance technologies while serving as the President of the Surveillance Systems Group at ITX Technology. Clearly Dan’s experience is perfectly with our corporate direction and we’re excited to have him on board.

With that summery of the quarter’s operational events, I’ll now turn the call back over to Steve for result of our revised fiscal 2008 guidance and our newly announced fiscal 2009 guidance; Steve.

Steve Bershad

Thank you Scott and Dave. As a result of our strong performance in the first nine months of this year and the throughput improvements that we’ve made, we are increasing our full-year 2008 financial guidance. We now expect sales to range from $242 million to $244 million, an increase of over 41% compared to 2007. In addition we expect 2008 income from continuing operations to be in the range of $2.28 to $2.30 per diluted share. This will generate EPS growth of over 80% compared to the $1.27 per diluted share that we delivered in 2007.

As we look forward to 2009, we believe that we are well position for continued growth even on top of the 41% growth that we expect to achieve this year. The markets that we serve most of which had not been directly impacted by the downturn in the general economy remains strong. Continued demand for our product has driven the 32% year-to-date growth in our backlog, which reached a record $184.5 million at the end of the third quarter.

Based on these factors, we expect sales to grow approximately 15% from our revised guidance for 2008 and between $278 million and $282 million in 2009. In additionally we expect 2009 fully diluted earnings per share and continuing operations to grow approximately 17% to between $2.66 and $2.72, as we continue to increase spending on research and development as well as marketing.

That concludes our prepared remarks this morning and at this time we’re welcome to open the call to questions. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Steve Levenson - Stifel Nicolaus.

Steve Levenson - Stifel Nicolaus

I know you’ve got some pretty aggressive plans for next year on R&D with all the other thermal vision systems sort of clustered in the area around Nashua. Do you think you’ll be able to hire everybody you need? Do you need cleared personal or is this something where they don’t have to security clearances and how is it going so far?

Scott Conner

We actually have done quite well on hiring lately. As is often the case, when your business is growing, the word spreads and we’ve actually recently had an easier time getting people then we had might have had a few years ago. So in fact we had quite a bit of success hiring highly qualified guys in the recent past and no, security requirements are not an important aspect of some of these hires, most of these hires.

Steve Levenson - Stifel Nicolaus

Is the sales growth in part related to or where does it most come from? Is it that the market is growing generally or are you taking share from your competitors or you see it as a combination?

Scott Conner

It’s hard for me to know the answer to that. Certainly the market itself is growing for sure and that’s broad based, but not just in the U.S, but it’s actually occurring worldwide. I do think that we are likely feeling market share, but it’s hard for me to really get a sense of that because I’m not inside their business and I can’t break it out in a way that would give you a clear answer to that question.

Steve Levenson - Stifel Nicolaus

Okay. There are few programs that are sort of up in the air now like reconnaissance helicopter, I guess there maybe a switch there and I know there is a contract out there for driver Vision Enhancers that’s likely to have more suppliers than the initial contract. Can you tell us what sort of out there? What’s on your wish-list for new stuff that you could be participating in?

Scott Conner

Right, so to some extend I want to be little vague, but I’ll only talk about those two that you asked about specifically. So DVE, we are on some of teams; we hope to participate to some degree. It depends on who wins that, who gets what share of that, but again we did not bid as a camera vendor, but we could be involved as a lens supplier. So, again it depends on who the win is on and I really don’t want to mention at this point who those vendors are.

The other one was the reconnaissance helicopter which I did also hear actually there is a lot of question about the future of that program at least in the shorter run, which impacted all these implication for us to be honest. We were not on the reconnaissance helicopter program as you know, but in fact likely we’ll get longer life to Kiowa and Apache’s which is very positive for us in the short run.

Steve Levenson - Stifel Nicolaus

Last item is, there is a solicitation out there for third generation imaging engine, a new sensor and is that something that’s going to change the demand or you think the volume of optics? How does that potentially impact Axsys?

Scott Conner

There is always, there is a constant evolution in the sensor technology and that in and of itself is positive for us for really two primary reasons. When you evolve the sensor technology, every time that evolves, it generates a new lens requirement; so that basically you continue to upgrade your detectors, you continue to upgrade you lenses.

The second thing is that the increased performance and reduced price points associate with the detector capabilities increases the value of the lens; in a broader and broader way in market. I mentioned in my prepared comments about the fact that we are going after more and more commercial application and part of the reason that make sense for us is that because the detector price are coming down, now warm wind un-core surveillance is kind of hitting our suite spot. Now the lens is becoming a bigger and bigger percentage of the cost in a shorter and shorter range camera system. So that of course we always want to see advance into detector technology; that is a very positive thing for us.

Steve Levenson - Stifel Nicolaus

Okay, and right now between defense or government related and commercial, how does the mix done and where do you see it going forward?

Scott Conner

Definitely defense; I mean even we felt most of these commercial things are often times government funded. I mean these are for commercial things like transportation, so they are government entities, but not defense oriented, but to answer your questions still by far the bookings are coming from defense related, both U.S. and international defense or homeland security. I should couple those together; defense and homeland security like application.

Operator

Your next question comes from the Tim Quillin - Stephens Incorporated.

Tim Quillin - Stephens Incorporated

Can you talk about the sequential quarter-to-quarter decline that you saw in the surveillance business? What product line that was in and how that impacted gross margin?

Scott Conner

We don’t break out the product lines, so let’s exchange that one specifically. I mentioned in my notes, there was a slight delay in some of the shipment from Q3 that are just going to be moved into Q4, so its not really I wouldn’t really do it, I guess too much is the point. It’s just there was a slight delay for a couple of customer shipments and it has no real impact on the year or anything, no trend.

Tim Quillin - Stephens Incorporated

Okay, so we should expect the surveillance business to be up quarter-to-quarter in the fourth quarter. Your full year guidance implies the sequential decline in revenue, so should the imaging business come off of 3Q levels?

Scott Conner

Well yes, for a couple of reasons. To answer your first question is yes, so Q4 should be higher in surveillance from exact reasons that you mentioned and then the second thing as Stephen alluded to is we really accelerated shipments of our particularly infrared lens business in Q3, in advance of the move to make sure that we didn’t have any customer disruption. So it really was a higher than normal rate in Q3 and in fact Q4 should be a lower rate for the imaging business.

Stephen Bershad

Of not for the fact that we were trying to ensure our deliveries in anticipation of the move, these two quarters that is the third and the fourth would have shown sequential growth; that is the fourth quarter would have been greater than the third quarter, but in fact what happened was we pulled in some shipments that could have or would have been made in the fourth quarter and shipped them early, so that we were in a position to accommodate the stabilization that took place during the initial weak or two of the relocation of facilities and so you have now Q3 a little bit higher than it would have been and Q4 a little bit lower than what it would have been.

Scott Conner

And there is some plan disruption in Q4 of course which also affects the shipment rates in Q4. I mean the results we’ve planned that in advance.

Stephen Bershad

But taking out that intentional kind of management of revenues during those two periods, the periods would grow sequentially. That doesn’t address the surveillance issue, which is a somewhat separate issue, but that as David has indicated will return to its normal growth in the Q4.

Tim Quillin - Stephens Incorporated

In terms of the imaging business and I understand a lot of the growth is you putting in additional capacity, getting additional orders from current customers and ramping up to support programs like Thermal Weapons Site. How should we think about the continued ramp up past fourth quarter? I mean is there some point that you get to a capacity level and a production level where you can fill customer’s requirements and that starts to flatten out and do you expect the imaging business to grow at similar levels to your overall guidance of 15% or lower levels?

Scott Conner

Well, just kind of reflecting in the first three quarters of this year, we grew that business almost 38% and you probably know. That’s certainly going flatten and that’s reflected in our full-year guidance as well as our guidance for ’09.

In ’09, I think looking forward if you will, that business we expect to be growing probably somewhere in the 10% to 12% range from our ’08 levels. Does that answered your question?

Tim Quillin - Stephens Incorporated

Yes, that’s very helpful, thank you and can you give a status update on the vast opportunity and as it relates to another supplier there. I think [Lockheed] has an order from Gyro camera as well.

Scott Conner

No problem. So, we were basically soul sourced on that program for the first maybe two years of deployment, but as is often the case, when programs get quite large, our customer and often our customer’s customer are very interested in having second source of critical supply points and in fact, the lens or the camera is the largest cost driver in fact of the whole product and so it’s not surprising at all that there is interest in having a second source for that particular component. By the way it happened not just in cameras, it happens in large lens programs as well. So, which certainly shouldn’t be surprising, it certainly is not a surprise to us and I don’t expect it to surprise others on the call.

With that said we are continuing to both book orders for that program and continuing to ship orders for that program. We don’t announce often follow-on orders for programs like that, but we certainly are continuing to supply it and support that program.

Tim Quillin - Stephens Incorporated

I just have two other questions; one long, one short, but the short one is, what was the backlog number in the third quarter of ’07 if you have that in front of you and the longer question is, can you discuss your infrared camera product roadmap as Dan has come on board and what your product introductions might look like over the next couple of years? Thank you.

David Almeida

Sure, the backlog in the third quarter of ’07 was $138.6 million.

Scott Conner

And then to answer the second question, which was about product roadmap; without getting too detailed and what we’ve made very clear is that our big emphasis is to expand our gimbal product line, because while our land-based systems we feel are quite competitive.

In fact as I mentioned before also increasingly for marine applications; where we do feel, we are at a disadvantage in terms of product spread is in the gimbal product line and that is an area where we see a lot of potential for Axsys. We actually have all of the technical capabilities to pursue that it just a matter of time and money and so the major emphasis for development under Dan’s leadership is going to be broadening the gimbal product line to compete with our major competitors in that field.

Operator

Your next question comes from Paul Coster.

Paul Coster - J.P. Morgan

A few quick questions, David in your prepared remarks you said that there’s some gating facts of you investing in R&D and SG&A this quarter; what was that gating facts are?

Dave Almeida

Just the fact that, we’re just bringing on bodies actually at the rate that our top-line was growing.

Paul Coster - J.P. Morgan

Now, cash management obviously you’ve made it clear that you have got everything in hand; what is your backup facility in the even that you do experience growth, exceeding your expectations and you need to ramp up working capital?

Dave Almeida

Well, we currently have a $40 million credit facility in place with the Bank of America.

Paul Coster - J.P. Morgan

The ’09 guidance; I mean most companies would kill for this kind of growth rates and I’m not complaining about that. The operating leverage obviously isn’t quite so great next year, as you’ve experienced in the past. How are you thinking of ’09? Is it kind of set-up or are you creating a new base for growth or should we now expect a more modest kind of leverage coming out of this business?

Dave Almeida

Actually, our leverage is a little bit more than we expected in our original guidance for ’08. Our operating margins were 15.9% and with our new guidance, our guidance has gone up 16.6%. Originally, I think I have been telling everyone that, I expected that our operating margins would improve about 100 basis points with about 15% increase in this top-line. So, we’re actually getting 100 basis points improvement on the new guidance of the 17.6%.

As we continue to grow the Surveillance like we’ve talked about historically, which carried higher margins, the operating margins in that business are on the low 20s versus the high-teens for Imaging. We expect that that can continue to expand about are somewhat limited by the Imaging System margins, which are kind of the bonds in our portfolio, which we are very pleased with and happy with given our healthy backlog.

Scott Conner

But, I want to add one another thing, when you’re going at 40% as we have this last year in revenues, if you want to add a high-level of confidence, you can only add at a certain speed and we’ve been talking to keep up, but frankly as we’ve all mentioned in our remarks, we’re behind in adding the bodice and the spending that we want to be doing at a rate commensurate with our growth. In ’09, we expect that we will in fact, incur that spending and be more successful at adding those bodice and that our spending level will be more commenced with our revenue rate.

Dave Almeida

Our R&D will pass another 50 basis points above where our 2008 levels are, so that’s again affecting our margins a little bit, but we think it’s going to promote future growth for us.

Paul Coster - J.P. Morgan

International sales were what percentage of revenues and moving forward do you think it’s going to grow as a percentage?

Scott Conner

We don’t have a good breakout of that, but I do think that international is growing; I mean it is growing as a percentage of our total and part of the reason for that is that the Imaging Systems part of our business is largely supported by U.S. government programs, not exclusively but largely. The surveillance business is more distributed. Of course we do a lot of support of U.S. program but also we do an increasing amount of international work and as the Surveillance Group again becomes a larger percentage of the total pie that should definitely increase our percentage of international work.

Operator

Your next question comes from Michael French - Morgan Joseph.

Michael French - Morgan Joseph

First question for Scott; are there any decisions coming up in the fourth quarter that you anticipate on material programs?

Scott Conner

The only one that has been mentioned so far and again I don’t want to over emphasize is the DVE program, I think is expected to come out in December, which could have an effect but other than that there are programs that we have been working, that I’m hopping for but I don’t really want to discuss on the call and I know that doesn’t give you what you want, but I’m getting more and more gun shot about discussing programs and details on this call.

Michael French - Morgan Joseph

And Dave on a cash flow from operations during the third quarter, there are anticipations for the fourth quarter, but what was the number for the third quarter?

David Almeida

Free cash flow was negative $1.3 million I believe.

Michael French - Morgan Joseph

Can you explain the reasons for that ramping of inventory, and the AR...

David Almeida

Yes part of the reason was what I mentioned in my script and that we actually had a little bit of hockey stick in the quarter and when you have that of course you’re shipping out a bunch of things in the last month of the quarter and we don’t collect those until the subsequent quarters, so that’s certainly had a direct impact, mostly a single large significant impact on the quarter’s cash flow.

We may have drove the inventory over the last few quarters as you know as I had mentioned to make sure that we can accelerate our delivery times for competitive reasons and that’s been taking place over the past few quarters, some in the second but also in the third too.

Michael French - Morgan Joseph

And then I guess just to wrap up with sort of a catalog question; what’s going on in the macro economy? You guys obviously have a pretty clean balance sheet, but maybe if you wanted to do more acquisition then access to capital might become an issue, but for operations obviously you’ve got the resources to fund that. So how is this environment affecting your outlook and you’re planning or is it because of your position?

Scott Conner

I think in fact we tend to benefit from this environment. It seems like those situations where we are looking at potential targets, the field has narrowed in terms of competition, that many of the financial buyers are sidelined now in this market and we have confirmed with our financing resources that funds are available to us should we want them, not perhaps as aggressively as they had been six months ago, but nonetheless available and the terms that wouldn’t impede our ability to affect the transaction.

I think on balance, this environment is probably positive for us and I don’t think we are impeded in anyway in terms of financing. I’d say we are not going to be going into our lines in the foreseeable future or substantially catch positive in the fourth quarter and we’ll remain so on our own operations and so we will have the fire and power necessary to do whatever we need.

Operator

Your next question comes from Michael Ciarmoli; please proceed sir.

Michael Ciarmoli - Boenning & Scattergood Inc

Dave could you gives us a sense of the backlog? Is there any concentration there, obviously the TWS and CROWS programs are pretty large; is there any other programs specific concentration within that backlog that’s makes up for more than 10% or so?

David Almeida

No, nothing off the top of my head. We’ve got CROWS, we’ve go Stryker and we’ve got TWS, those are the larger programs, but nothing beyond those.

Michael Ciarmoli - Boenning & Scattergood Inc

Okay and do you have the percentage of revenues in the quarter that came from CROWS and TWS?

Dave Almeida

Yes, again we try to stay away from breaking, the specific program within our quarters for a variety of reasons.

Michael Ciarmoli - Boenning & Scattergood Inc

Okay, do you have even for the year? Do you have a target? Is there going to be a certain percentage of revenues, any concentration there?

Dave Almeida

CROWS and Stryker for the first three quarter of this year just to give you kind of a general sense, was 11% of our revenues.

Michael Ciarmoli - Boenning & Scattergood Inc

And then looking out into 2009, with you obviously spending a lot on the surveillance segment, do you foresee a significant shift in the percentage of revenues? Do you expect that revenue spilt to maybe move more towards a 60/40? I know you talked about the growth expectations in the Imaging Systems segment and that would suggest maybe that percentage kind of stays the same for next year?

Dave Almeida

Now 60/40 seems a little aggressive; right now year-to-date we’re looking at around 70/30, if you look at the Q and I think what I have said earlier one of the questions was that for Imagining we expect growth to be around the 10% to 12% range and Surveillance we expect to be in the high teens to 20. So, I think if you kind of look at this year as year-to-date and expect that may change slightly from now and the end of the fourth quarter, I think that will give you a good idea, but again I think the breakout will be something less than a 60/40.

Michael Ciarmoli - Boenning & Scattergood Inc

And then maybe Scott, in terms of where you’re spending your R&D, new products your developing, I know in the past you’ve said you wanted to simultaneously move up and down the value chain; can you give us a sense of these more cooled platforms you are working, un-cooled platforms and if you can, if your willing to disclose, is there a significant margin difference between those products?

Scott Conner

Basically we’re doing both. I mean I disclosed on the last call, I believe that we came with out with a refreshed un-cooled product line. In fact I was attracting a little bit some of the move to some of these commercial surveillance applications, which is pretty new for us and then of course on the cooled area we’ve continued to be strong. The main emphasis of our R&D spending as I mentioned on the previous question is in the airborne gimbal market. So, we’re spending a lot of time and effort on that area.

Michael Ciarmoli - Boenning & Scattergood Inc

And can you give us a sense of what the average price point you’re looking at for some of those gimbals?

Scott Conner

Right, it’s all over the place. I’m going to give you a dollar point, because there are multiple different sizes of gimbals, but they range from -- I’m going to give you a rough numbers okay. A smaller gimbal would be a quarter million dollars and a bigger one is north a $500,000.

Michael Ciarmoli - Boenning & Scattergood Inc

Okay and then if you can, there was some press release about the MRAP program, maybe a shift of about $860 million and then talk of maybe developing in MRAP light? Now I know you guys have been deploying I guess some of the close products or something going on there; do you see that is an additional catalyst or an opportunity?

Scott Conner

This is one of the mice things about our business of course, is when there is a new vehicle there is increasingly -- all three of us were at the AUSA show recently and the number of optics on top of each of these vehicles is just increasing dramatically. So, every time that there is a new vehicle variant that needs to have some kind of serrate action or targeting systems that’s perfect for us or when they are upgrading the new detecting systems on the old vehicles, that’s also perfect for us. So yes, that all presents new opportunities.

Michael Ciarmoli - Boenning & Scattergood Inc

I think you’ve said in the past, if tax rate it might have been for the MRAPs about 20%, even in other vehicles; do you see the tax rate of some of these optics increasing?

Scott Conner

What you’re referring to there with that 20% was associated with the VOSS program specifically and it was really the 15% to 20% rate with the number that we were quoted, but in fact I think that the weapon station, the percentage of vehicle’s that are getting weapon stations and/or surveillance object is actually increasing, yes. I can’t give you a statistic unfortunately, but certainly the sense is that that’s increasing.

Operator

Your next question comes from Tim Quillin - Stephens Incorporated.

Tim Quillin - Stephens Incorporated

I heard your answer with regarding the product road map and thank you for that, I didn’t hear your answer on the backlog, the year ago backlog 3Q ’07?

Dave Almeida

I’m sorry it’s $138.6 million.

Tim Quillin - Stephens Incorporated

And then with regards to your margin improvement plans in ’09, so R&D as a percent of revenue perhaps top of 15 basis points; should we think about it then that SG&A maybe goes down by a similar level and your margin improvement is largely driven by gross margins?

Dave Almeida

No, it’s going to be a combination. It’s going to be a continued leverage on our operating expenses as well as hopefully some improvement on margins, which is going to be dependant on our mix.

Tim Quillin - Stephens Incorporated

Okay and then just a two quick details; your CapEx plans for this year and then your tax rate for this year and what you might think of it ’09?

Dave Almeida

This year our capital spend is going to be around $11 million or so is what we are estimating. If you look into ’09, we still haven’t finalized our plans for ’09 yet, but they are somewhere around $12 million, $13 million for ’09.

Tax rate was low as you know in the third quarter here with the adoption of this FIN 48 counting standards. We’ve got fluctuations from quarter-to-quarter in ’08. In the fourth quarter we’re going to returning to a more normalized rate. We’re estimating that its going to be around 36% and as you look forward our normal rate which is going to be bring our year-to-date rate is around 36% and there is some reasons why that rating is actually probably a 100 basis point lower than our average rate or expected rate, so we’re really expecting a 37% rate; just some timing difference that we experienced in ’08, brought that down to 36% level.

Operator

(Operator Instructions) And there are no further questions in the queue at this time.

Stephen Bershad

Well thank you operator. Thank you everyone for joining us this morning. Obviously, we are pleased to have delivered another quarter of strong growth for our shareholders. We appreciate your continued support and look forward to updating you on our achievements in the coming months. Thank you.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

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