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TeleCommunication Systems, Inc. (NASDAQ:TSYS)

Q3 2008 Earnings Call Transcript

October 30, 2008, 5:00 pm ET

Executives

Maurice Tose – Chairman, CEO and President

Bruce White – General Counsel

Tom Brandt – SVP and CFO

Analysts

Shyam Patil – Raymond James & Associates

Scott Sutherland – Wedbush Morgan Securities

Mark Jordan – Noble Financial

Sarah Catherine Phillips – Stephens Inc.

Andy Schopick – Nutmeg Securities

Hinda Mizrahi – SSM Investment Corporation

Operator

Good day everyone and welcome to today’s program. At this time, all participants are in a listen-only mode. Later, you will have the opportunity to ask question during our Q&A session. (Operator instructions) Please note this call may be recorded.

It is now my pleasure to turn the conference over to CEO Maurice Tose. Please go ahead.

Maurice Tose

Thank you very much. Good evening and thank you for joining us to discuss Telecommunication Systems Third Quarter 2008 results. With me today is Tom Brandt, Jr., our CFO, and Bruce White, our General Counsel.

Before we present our formal comments, I will ask Bruce to advise listeners to the cautions that they should consider during this call. And following our presentation, we’ll open the lines for Q&A. Bruce?

Bruce White

Thank you, Maurice. Some of the statements you will hear during this call are forward-looking within the meaning of Federal Securities Laws. Some but not all of these statements include language such as believe, expects, or anticipates and you should listen to these statements with the knowledge that actual results may differ materially from the forward-looking statements. The risk factors that could cause the results to differ may be found in our SEC filings including Forms 10-K and 10-Q. We encourage all investors to read these documents.

Also, during this call, we may refer to measures of income that are not computed in accordance with generally accepted accounting principles. To the extent that we refer to non-GAAP data, we have provided a reconciliation in our press release and on our website.

Maurice Tose

Thank you, Bruce. Our third quarter earnings release crossed the wire service at about 4:15 today, and a full text copy of our press release has been distributed via email and is also available on our website. We have also updated the financial model that puts the company’s financial information into perspective, and this is available for download from the investor information section of our website.

As indicated in the news release, net income for the third quarter was $2.8 million with $5.9 million of EBITDA, on a record $56.5 million of revenue. It was the tenth GAAP profitable quarter of our past eleven.

Our government business segment generated record revenues as SwifLink system shipments ramped up. A continuing growth in text messaging usage in the US continues to drive sales of software licenses, maintenance, and customization. In our recurring hosted location-based services for E-911 in commercial markets made a steady profit contribution.

Now, some highlights from the quarter’s operations. Third quarter commercial segment revenue was $22.7 million yielding gross profit of $12.1 million or 53% of revenue, up from $10.9 million of gross profit in Q3 2007. The improved results reflect strong and continuing growth in our text messaging business through sales of licenses and continuing growth in software maintenance revenue. CGI announced its 75 billion text messages were sent and received in June 2008, up 160% from 28.8 billion in June 2007. Our third quarter results reflect this continuing trend.

In the third quarter, TCS messaging software delivered approximately 50 billion text messages which are more than double the volume one year ago. TCS software is on track to handle in 2008 more than double the 80 billion text messages handled in 2007.

During the third quarter, we continued to expand our market penetration in North American operators with capacity growth sales to two existing customers as well as delivery of SMS Express to a third US CDMA carrier. We’re also starting to benefit from the additional capacity sales to our SMS Express First Delivery Attempt carrier customers as they convert to full service SMSE store and forward licenses. We have positioned this solution with carriers as a means to displace in combat competition and net strategy is beginning to pay dividends.

The momentum of consumer text messaging growth is beginning to extend into the enterprise as evidenced by carrier customer orders for our SMS Express mobile value-added services platform or SMS Express MVP. With the SMS Express MVP solution, carriers can support both targeted solutions like pager replacement that expand messaging usage by enterprise applications and value-added services such as opt-in marketing that enable the enterprise to reach out to their customer base.

According to Frost and Sullivan, US text messaging traffic is expected to grow from over 400 billion messages in 2007 to 3.7 trillion messages in 2014, an eight-fold increase. SMSE revenues are expected to increase from $175 million in 2007 to $276 million in 2012. These forecasts indicate that there continues to be a solid opportunity to monetize SMS for carriers and their vendors such as TCS for the next several years in a minimum. In the current quarter, we expect a multi-quarter text messaging order from one of our largest SMSE customers in order to provide longer term support for discontinuing trend.

The prevalence of text messaging as a preferred communications medium is now reflected in plans for nationwide emergency alerting solution that has been sanctioned by the FCC described as Commercial Mobile Alert System or CMAS. The majority of US carriers are formally notified by the FCC of their plans to deploy CMAS for supporting emergency text alerts to wireless subscribers when risks of weather, earthquake, or public safety threats are imminent. The Federal Emergency Management Agency or FEMA has been designated as the lead federal alerts aggregator. TCS is participating in CMAS standards bodies working groups. With our company’s strength as a leader in wireless E-911, experienced and secured government communication solutions and our platforms that delivered billions of text messages, we believe that TCS is uniquely qualified to work with the government and wireless operators to make CMAS a success.

In the third quarter, TCS was awarded a contract for service with the Tier 1 digital voice provider to deliver Voice over IP E-911 calls. In addition, TCS has Master Street Address Guide or MSAG validation service which received a product of the year award from Technology Marketing Corporation earlier in the year, continues to gain traction with VOIP and cable customers. We anticipate further Tier 1 announcements regarding our broad sweep of IP-based E-911 solutions.

Beyond public safety based location services, we recently announced the completion of an agreement through our Qualcomm partner to provide hosted location services to Tata, a 25 million plus subscriber carrier in India. This deployment is on track for completion by the end of this year. This exciting development positions us to expand our location technology into the huge India market.

Including the Tata deal, TCS has added five carrier customers using our Xypoint Location Platform during the first three quarters of 2008 bringing our non-public safety customer count to 14. And we have three pending deals that we expect to close in 2008 to reach our goal of eight to ten new LBS platform customers this year. These figures include both in-network deployments and hosted location business which generates monthly usage fees from our customers. TCS continues to improve our connected services offering for mobile navigation, Telematics, and personal navigation applications.

We expanded our points of interest content by adding InfoUSA as a content provider, supplementing data source from NAVTEQ, Tele Atlas, and Axiom. In addition OpenTable, the world’s most popular website for online restaurant reservations chose TCS to build and host a mobile website. TCS’s connected services offering now includes traffic, gas prices, points of interests, ATMs, restaurant reservations, and rich content from Rand McNally.

According to the 2007 Frost and Sullivan report, Telematics services revenue is expected to grow at 16% compound annual rate to $3.5 billion by 2013 with the number of subscribers growing to over 14 million by 2013 with a compound annual growth of 14%. TCS is well able to deliver technology to this market. TCS has been selected by leading automotive supplier to provide connective navigation technology.

Early in the third quarter, TCS launched a local search application integrated navigation for a regional wireless operator in Calif [ph] for the Caribbean and Latin-American markets. We expect to launch a branded navigation application with another carrier in Q4. We also renewed our partnership with Rand McNally and continued to deploy Rand McNally branded navigation, maps, and traffic products across several US operators.

Now moving on to review of our patent activity, TCS has issued seven new patents during the third quarter bringing the total number of patents to 65 with 199 applications pending. Of these seven patents, four were associated with messaging and three were associated with location technologies. These include a prepaid messaging patent, and a patent for inter-carrier digital message with user data payload service providing phone number only experience. A mouthful, but this invention extends our previously awarded inter-carrier messaging patent to support digital package, which explicitly covers multimedia messages.

The rapid growth of SMS and MMS in the US is large attributed to wireless carriers implementing inter-carrier messaging. Industry data show that annual message volumes have been doubling in the US since the advent of inter-carrier messaging in 2002.

TCS continues with our efforts to enforce and license our patents. We received a favorable jury verdict in our patent suit against Sybase in 2007. During the third quarter of ’08, the court denied Sybase post-trial motions for a new trial or judgment in its favor. The court also granted TCS’ motion for a permanent injunction, prohibiting any further infringement by Sybase but state the injunction pending the outcome of any appeal. We expect that Sybase will appeal to the US Court of Appeals for the Federal circuit.

And now, we turn to the government segment’s performance. Q3 revenue is a record $33.8 million, which is an 86% increase over the prior quarter’s revenue as well as from the third quarter of 2007. Our growth trend is continuing in Q4. The gross profit earned from our government business was $5.4 million, which is an impressive 64% increase from the same quarter of 2007.

Total bookings in the quarter were $286 million. Funded bookings in Q3 were over $82 million which, by the way, is $13 million more than all of the revenue that was earned by our government system’s segment in 2007. We are proud that these orders were derived from approximately 40 different government-user customers, indicating that TCS is achieving previously stated goals of expanding its market penetration.

Further, of the $82 million of funded orders, 21 individual orders were from more than $1 million or more with the largest single order being $23 million. This is another good indicator of progress toward our objective to be selected for higher volume government programs. Funded and unfunded backlog is about $450 million at quarter-end, indicating higher future performance visibility than at any other time in TCS’ history.

The largest contract award in our company’s history was announced in early Q3. A task order under our worldwide satellite system’s contract called SNAP by the army’s WIN-T program office. SNAP, an abbreviation for SIPR or NIPR Access Point, has options for approximately 1,500 SwiftLink deployable communication systems along with the shortest support services that can be ordered by any DoD agency over the next three years. SNAP systems consist of SwiftLink VSAT Terminals, INMARSAT BGAN Terminals, and SwiftLink Base-band Kits, with a wide variety of configurations and options for both the satellite-based terminals and corresponding base-band equipment.

If all options are exercised in this contract, the potential value of TCS over three years is $246 million. Since contract award, which was mid-July, TCS has received $36 million of funded orders, and we expect more orders shortly. In conjunction with these shipments, TCS staff and support contractors are also providing field support for training, installation and logistical services.

A second major program that plays a significant part in our growth for Q3 is the US Marine Corps Wireless Point-to-Point Link or WPPL Program. TCS has received $23 million of funded orders for WPPL. We are now in our second year of the WPPL Program and the momentum of orders has increased. As greater numbers of these systems are being fielded, TCS is also fulfilling growing requirements for field service support. The third WWS’ program contributing to the third quarter volume is MiTT, or Military Transition and Training, which began a year ago and has produced about $24 million of orders.

As you can see, our government system’s business is growing on a broad front. To accommodate the growth, we exercise our option to expand our integration facility in Tampa to 43,000 square feet during the quarter. We’ve been able recruit experienced management and engineering talent in production labor to keep pace with deliveries. Our suppliers have done a superb job of meeting their commitments, and we are enjoying new levels of vendor discounts as a result of our volume.

We are prepared for the future by continuing to invest in R&D to expand our product offerings. The SNAP system consists of three different satellite terminals, options for Ku- and Ka-Bands, and three different base-band packages with four different modem types. The result is that we now provide up to 64 different configurations of the latest deployable satellite communication systems. And to address advances in satellite technologies, our engineers designed a new man-packable half-meter VSAT Terminal that works on the X-band spectrum. This product is the smallest form factor designed by the TCS. It transmits and receives at very high data rates and because of its size, the entire kit can fit into the overhead compartment of a commercial airline.

Our government services business resumed growth in the third quarter. The quarterly billable run-rate for professional IT services grew by $2 million in the third quarter. A key customer authorized TCS to expand our customer site support staff by 95 beginning in mid-August, and we have filled all the positions as of October 1. In addition, TCS participated on a team that was awarded a $99 million three-year contract to provide a variety of IT consulting and telecoms services to DoD agencies in the national capital region. The financial impact of this award will start in Q4 and grow over time. We anticipate a significant volume of business from this vehicle.

SwiftLink adjunct services, which include maintenance, field service engineers, training, and other logistical support services, continue to grow as SwiftLink system deployments proliferate around the world. All of the new orders discussed earlier for hundreds of WPPL, SNAP, and other SwiftLink systems include funding for maintenance, training, integrated logistic support services and over two dozen TCS field service representatives.

Our satellite services, including our TCS-owned and operated telepoint infrastructure is a key TCS differentiator from competitors, as we can offer complete end-to-end communication solutions. Although there’s been a small contributor to segment revenue, our satellite service’s business grew 14% from Q2 to Q3, and we expect significant growth in 2009.

New requirements from our existing customers have led us to invest in our operations center in teleport facilities. These investments will allow TCS to implement forthcoming customer requirements. Expense services, including access to new satellites, enhance our customer’s service experience and position TCS to support secure satellite base communications around the world.

In summary, our government business has been a reliable contributor to company profit since the founding of the company in 1987.Achievements in the past year have taken the business to a new level in virtually every respect, including bookings, revenue and gross profit performance. Our systems delivery organization has ramped up to accommodate rapid growth. Shipments are either on time or ahead of customer requirements. The recurring revenue from our service organization is rising in a rapid pace, both as a result of system sales and non-SwiftLink related contracts. Long-term service relationships have generated a resumption of growth in Q3, and we now expect larger contributions from teleport, maintenance and professional services in 2009.

With a large backlog of funded orders, hundreds of millions of dollars of unfunded contract options and a growing list of large scale opportunities that are being aggressively worked by the government sales team, we are confident that Q4 revenue will be significantly higher than Q3 and that the momentum will carry over into 2009, including an unprecedented visibility into significant systems orders through mid 2009. The government segment has never been healthier than it is at this moment.

And now, Tom will provide some additional details regarding the quarter’s financial results.

Tom Brandt

Thank you, Maurice. To recap the third quarter’s P&L, revenue was a record $56.5 million, up 50$ from the year previous. Gross profit was $17.5 million for the quarter or 31% of revenue. EBITDA was $5.9 million or $0.12 of diluted share, and GAAP net income was $2.8 million or $0.06 of diluted share. The overall company revenue is split for the quarter. It was 44% services and 56% systems, and it was about 40% commercial and about 60% government.

In the commercial segment, third quarter services gross profit was flat at $7.6 million on revenue that was about the same as a year ago revenue. Commercial systems gross profit was $4.5 million for the third quarter, an increase of $1.2 million from $3.3 million a year ago. This was on $7 million of revenue, up from $4.4 million a year ago. Incremental license sales and related customer messaging gateway hardware refresh activity contributed to the higher revenue and profitability.

Government segment services revenue was $9.2 million compared to $7 million a year ago, and a gross profit was $1.9 million compared to $1.6 million last year. As Maurice discussed, a number of new government service initiatives have been closed and began bearing fruit in the third quarter, contributing to the revenue and profitability improvement.

Sales of government systems for the quarter were $24.6 million, more than double of the $11.2 million a year ago, and gross profit of $3.5 million was more than double to $1.7 million in Q3 ’07, mainly due to the increase volume of sale under the WWSS contract vehicle.

Third quarter company-wide operating expenses excluding depreciation and amortization, totaled $13 million, 21% higher than last year’s $10.7 million, due primarily to increase provision for legal expenses and G&A, and increase accrual for variable compensation expense.

Research and development expense was $3.8 million in Q3 ’08 versus $3.3 million in Q3 of ’07. Sales and marketing expenses totaled $3.1 million in the third quarter of ’08 versus $2.7 million last year. General and administrative expenses for the quarter were $6.1 million versus $4.7 million in the third quarter of 2007. As a percentage of revenue, the sum of R&D, sales and marketing and G&A expenses was down from 29% last year to 23% of revenue for the quarter just then.

EBITDA from continuing operations was $5.9 million which is up from $4.8 million in last year’s third quarter. Non-cash charges totaled $3 million for the quarter versus $2.9 million in last years third quarter. Quarterly depreciation of fixed assets was flat at $1.5 million. Non-cash stock based competition expense was $0.9 million compared to $1.0 million last year, and amortization of software development cost – capitalized software development cost was $0.6 million compared to $0.4 million last year. So bottom line, we reported GAAP net income for the quarter of $2.8 million on record sales of $56.5 million.

At the end of the third quarter, funded backlog was a $155 million, up from a $140 million at the end of Q3 ’07. As of September 30, 2008, our total backlog was $450 million, up from $253 million a year ago. We enter Q4 ’08 expecting to realized $117 million of our funded backlog over the next 12 months. Beyond this funded backlog, our long-term service contracts, licensing arrangements, and our unfunded government contract orders give us substantially-improved visibility overall. Funded contract backlog represents contracts towards fiscal year funding has been appropriated by our customers, mainly federal agencies; and for our host that services contracts. Multiplying merged (inaudible) and months recurring revenues times the remaining months under existing agreements. Total backlog as it is typically measured by government contractors includes, orders covering optional period of service, and/or deliverable buffer which budgetary funding is not yet been approved.

The company’s liquidity position improved again during the third quarter. Quarter end cash total about $38.7 million, up from $28.2 million at the beginning of the quarter, and debt was reduced by $0.2 million to $12.1 million. The company’s third quarter EBITDA generated $5.9 million of cash, $3.2 million was generated from stock option exercises, $0.9 million came from lease funding of new fixed assets, and $3 million was generated from a net reduction and working capital during the quarter.

Funds were used for $1.1 million of debt reduction and $1.4 million of capital expenditures, including capitalized software development and new leases. Unused availability under our lines of credit totaled $18 million at quarter end.

Our company’s continuing our practice of providing annual but not quarterly guidance as to future P&L performance. Following top line growth of 22% in 2006 and 15% in 2007, we now expect overall revenue for 2008 to be in the $200 million to $210 million range representing year-over-year growth between 38% and 46%.

We now expect EBITDA for 2008 to grow from 2007’s $15.6 million to the range of $26 million to $28 million or $0.54 to $0.58 per diluted share, excluding the second quarter $8 million patent sale, which represents about $0.17. All in, we now expect 2008 EBITDA of $34 million to $36 million or $0.71 to $0.75 a share.

We now estimate that shares per diluted EPS for 2008 will be 48.1 million shares as supposed to the 45.6 million share average at mid-year. This number has grown mainly due to a higher number of In-the-money options than before the stock prices third quarter improvement.

We foresee non-cash charges for 2008 is about the same as 2007’s $12 million. An interest in taxes for the year should total about $1.5 million, so the GAAP net income should be about $20.5 million to $22.5 million, including the $8 million from the second quarter patent sale, or between $0.43 and $0.47 per diluted share.

It is also not worthy for modeling the company in the balance of 2008 and in to 2009 that our status for reporting income taxes is approaching a transition. In 2008, I reported earnings reflect income tax is only equal to the alternative minimum tax payments we have made. TCS reported a $49 million deferred tax assets in our December 31, 2007 10-K, an amount which has been fully reserved and therefore is reflected as zero in the book value of the company. These assets reflects the value of past tax loss carry-forwards and R&D credit carry-forwards, which will shelter future profits from cash taxes for years to come. But they have been fully reserved because realization of the benefits has not been sufficiently certain.

The recent strong trend of company profits will soon result in application of accounting rules, under which we expect to reverse some or all of the valuation reserve which will increase the company’s net book value. We won’t owe significant cash taxes for a while, but after reversing the tax asset valuation reserve, our GAAP profits will be subject to a normal tax provision, which we estimate at about 37% of pre-tax income.

Looking ahead to 2009, management is now actively engaged in completing the company’s internal budget. In the past, we have deferred any next year comments to investors until our year-end earnings call. But with the substantially improved company visibility, we can offer some data points this evening which maybe useful.

For both the government and commercial segments, where we are experiencing strong orders and backlog for both services and systems, we currently expect first half 2009 quarterly results to average the run rates of revenue and profit contribution that we’ve experienced in the quarter just ended. And we foresee overall full-year revenue growth of 7% to 10% in the commercial segment and 15% to 20% for the government segment.

Our guidance data maybe viewed in the context of historical trend by referring to the financial model portion of our websites investor relations page. At this time, I’ll turn the call back to Maurice.

Maurice Tose

Thank you, Tom. These have been turbulent economic times but we are gratified as our company faces these circumstances. We are financially well-capitalized and focused on market issues were growth and profitability should be minimally affected. Our company’s text messaging deployable Satcom and public safety technology addressed recession resistant needs. In particular, our third quarter results highlight the coming of age of our government segment business where engineers had deployed the best solutions for secure, deployable systems enabling information access in harsh environments, a need which is clearly a priority for the US military regardless of administration for years to come.

Management is very mindful of execution risks and a mature team of experience leaders are highly focused on process and quality. TCS messaging business continues to benefit from record-setting text message usage in the US. And as discussed on this call, leading analyst predicted the strong growth of text messaging will continue for at least another three to five years. As our early market leadership in location-based services gains further traction.

We are confident in the quality and the technical leadership of our location products, and believed that when carriers around the world foresee to invest in the launch of LBS services, our company will realized a substantial share of that market. We expect that licenses, maintenance, customization, and hosting of location-based technology will all contribute towards TCS profits, as has been the cased for messaging technology which took nearly a decade to ramp up to current levels.

TCS investments in communications technologies have resulted in a valuable body of protected intellectual property. Our patent sale last quarter was our third and largest success to date in monetizing non-strategic patents. Our patent litigation case against Sybase is still pending appeals that we believe will result in a successful outcome. As an intellectual property company, we have a growing number of other patents that we believe will be valuable assets for TCS in the future. TCS is also demonstrating that the company can consistently grow year-over-year profitability. And our cash position has grown from $16 million at the beginning of 2008, to $38 million at quarter end while reducing debt. We’re beginning to raise our guidance as the 2008 revenue EBITDA and net income today, and expect 2009 to be another growth year for TCS.

We thank you for your time and support and we’d like to open the call to any questions. Operator?

Question-and-Answer Session

Operator

(Operator instructions) First call to Shyam Patil from Raymond James & Associates. Your line is open.

Shyam Patil – Raymond James & Associates

Hi guys. Congrats on the great quarter.

Maurice Tose

Thanks.

Shyam Patil – Raymond James & Associates

Maurice, I thought you’re going to go with the entire script without mentioning the US Army there. The first question is around that. Could you maybe dissect your different businesses and maybe talk a little bit about how sensitive those might be to the economy in the near term? And is there any major renewal due or large deals that you expect to sign for next year that could be impacted by that?

Maurice Tose

Okay. As we sell the call, text messaging is a growth phenomenon. It is in fact relentless. And it is priced affordably and as a communication medium, non-intrusive, it’s going to be there and just continues to find new ways as we said beyond consumer and in to the enterprise. So, if we believe, it’s going to be fairly resilient to any recessionary forces. Our government systems and our government services, our government business, as we said, our government services is really beginning to pick up a significant clip of services, teleport business, and assistance. I mean, we’ve got visibility on delivery of orders that we have in house already, that we’ll be delivering into and through Q2. And we see additional orders that are funded just working their way through the paperwork process. And then, if you go to public safety, 911 is a pretty much a regulated business, so it is going to be there and continues to contribute, in fact to the company. So, it’s so unbalanced, the segments that we’ve chosen to play in. As a company, we’re blessed they are in fact – we think pretty well resilient to the activity that is going on in the global market place. As far as any large awards or large actions, I mean, we’ve got some ongoing but we don’t see there being an issues with them either, because they’ve fallen to those categories of things that have to be done.

Shyam Patil – Raymond James & Associates

Great, great. And just a couple more questions flat here, I guess, this one you might have anticipated but – when you look at the government business, I know such thing unprecedented momentum right now, how do you think a change in the current administration or a ruling party could affect the momentum in that business either in a positive way or not positive way.

Maurice Tose

Yes. Again, we see no change. Both nominees have spoken to the need for strengthening the deployable forces, strengthening special operations, and all anticipate that even with retractions from Iraq that’s not going to happen overnight. And a lot of those forces are going to be redeployed to Afghanistan and as well there are other ongoing operations around the planet. And it’s not just in the Department of Defense. We also support the Department of State and drug interdiction and other activities that they have ongoing in a number of countries throughout the Middle East and other areas of operation. So, it’s deployable communications. It is the future.

As we have said before, all that has happened, the government or – our Armed Forces had always intended to get fatter pipes to give our boots the best information intelligence, outlooks be it from satellites, be it from drones, be it back to the US or wherever, that has always been on the drawing board, their plans. And all that’s happened is it’s being accelerated. It is being accelerated, and then what happens? Because a lot of what we provide is going in to harsh environments, they have to be refreshed. They have to be refreshed. And as technology continues to improve, they continue to be added to the capabilities.

First, it is the WPPL systems. Their going to have WiMAX added to them at some point down the road to give an even more complete set of capabilities. So the impact on the administration, again, we thank where we’re playing. Where we’ve chosen to play, primarily special ops and intel, and Army, and Marine Corps, as well as some deploying aspect of the Department of State put as in great stead regardless of administration change.

Shyam Patil – Raymond James & Associates

Great. Thanks for the color. This is my last question. Regarding the enterprise component of the SMS business, could you just talk about maybe how big that is today? What your expectations for that might be going forward? Or in other way they’d be asking that is – when you look at your near to intermediate term growth drivers, where would you rate that?

Maurice Tose

Well, I mean that enterprise piece is a development activity that is a sell through. It’s given the carriers – on this big a case given the carrier the ability to go into the marketplace and displace aggregators that may currently be servicing the enterprise marketplace. I mean, that’s what their – what their intent is on one front. On the other front it’s to enable – to put the last debt nail [ph] into paging in the case of the carrier which that is being deployed and allow the enterprise again to be able to use text messaging in ways that it was intended and still had not been being realized. So again it’s going to displace some folks in the marketplace and the carrier and the carrier’s sales force now as another arrow in their quiver to offer their enterprise customers that we think in the case of this carrier will in fact increase the volume of activity.

Shyam Patil – Raymond James & Associates

Great. Thank you.

Maurice Tose

Thank you.

Operator

And next we’ll go to Scott Sutherland from Wedbush Morgan Securities. Your line is open.

Scott Sutherland – Wedbush Morgan Securities

Great. Thank you. Good afternoon guys.

Maurice Tose

Thanks. Hi there Scott.

Scott Sutherland – Wedbush Morgan Securities

So you guys are doing great in the government segment, I mean, revenues ramping. It looks like it got better in Q4. Obviously you’re gaining some initial orders and as far as it is there with such a little margins? Can you talk about how you expect margins to progress maybe for the next few quarters and we see follow-on orders and get up to a scale in this stuff?

Tom Brandt

Yes. There are two variables there. One is mix. You may recall we had pretty robust margins in the first two quarters of 2008 on the mix of government systems sales. And then in the third quarter, we’ve had the predominantly shipments of the high-volume deliverables under WWSS. As I’ve said for the call, we’re working on the budget for 2009. There are customers that we had earlier in ’08 that we expect to be back later in 2009 where we experienced better margins in the past and it’s reasonable to expect the mix of margins to then be better in the second half of 2009 from the way things are looking. Although we’ll be dealing overall with a much bigger base because we’ll have the high-volume business then too, so it’s not going to be linear and for the next two or three quarters the shipments are going to be predominated by the high volumes stuff but then I think we’ve got a good outlook to an improvement in mix.

Scott Sutherland – Wedbush Morgan Securities

Okay. So for the next three quarters’ mid-teams, the operating systems, and low 20s for the services?

Tom Brandt

In fact, that’s probably right.

Scott Sutherland – Wedbush Morgan Securities

Okay. Can you talk a little bit – it’s the first time we saw a modest (inaudible) commercial services. I know a lot of E-911 but there’s a little bit of other stuff in there. Can you talk about what might have caused that?

Tom Brandt

Just what you said – sometimes there’s the timing of the maintenance orders coming through and we keep hoping that the Voice over IP volume is going to pick up to offset the changes that are occurring in E-911. My recollection is this quarter we had one carrier that decommissioned an analog set of cells. So that’s – although it’s phenomenon that there is a little bit of a stock variable down but overall the outlook remains that as the Voice over IP and 911 business gains fraction, and on top of the incremental maintenance going forward on the higher accumulative license sale volume that commercial services on a resume growth.

Scott Sutherland – Wedbush Morgan Securities

Okay. I got more questions. You guys are obviously ramping up here in the government stuff and expanded your port of facilities, is there any change in your CapEx outlook and what are you guys doing on the staffing right now? Anymore executive level or is it more discretionary services people that you have to add here?

Tom Brandt

The staffing has grown up through a mixture of full-time employees and the flexible employment resources particularly where system assembly is concerned. There is – as we budget ’09 there are a few keys loss we’re considering particularly in the legal area that we might come in a house where we have otherwise have been outside but we haven’t really called a shot on that yet, and as CapEx – and yes we were bolstering. We’re building a stronger and stronger team to handle the scale of volume including supply chain management for the Tampa-based activity. As the CapEx – the assembly business isn’t a really very capital intentions activity. We have our eyes on incremental square footage if we need it but we’re not likely to buy real estate for that, and we’re horse training [ph] with our – internally on what the overall CapEx in 2009 will be. It will probably be an uptake from 2007 and 2008 levels but nothing real dramatic except a 25% range maybe.

Maurice Tose

There’s a little bit more in the teleport to flash out some needs there and we’re doing some waiting for an order to then accelerate implementation but in order that’s expected surely that will require us to put in place some additional infrastructure.

Scott Sutherland – Wedbush Morgan Securities

Okay, and last question I had is you made a couple of high-level comments in the first half of next year. You are going to have a tax rate on GAAP, EPS, and now your EBITDA. So you mentioned profitability is pretty much where it would be in these levels now, did you mean on a GAAP or EBITDA basis?

Tom Brandt

I was talking about EBITDA, realized cash money profits.

Scott Sutherland – Wedbush Morgan Securities

Right and the only GAAP you say even though it is non-cash?

Tom Brandt

That’s exactly right.

Scott Sutherland – Wedbush Morgan Securities

Okay. Great thank you.

Tom Brandt

All improving the book value.

Scott Sutherland – Wedbush Morgan Securities

Excellent. Thank you.

Operator

And our next question comes from the side of Mark Jordan from Noble Financial. Your line is open.

Mark Jordan – Noble Financial

Good afternoon gentlemen. Talking a little bit about the government systems business, gross margin there was 14%. Is there an opportunity to move that higher over time or given the volume and mix that you’re currently shipping? Is that the range that we should be in for the longer term?

Tom Brandt

For the high volume stuff near term, we’re going to be in the low teens [ph] but we went into that business with our eyes open, Mark, that there’s a long history with government business where specifications change and the incumbent [ph] vendor has an opportunity to improve the average margin on what he’s selling. As I mentioned earlier, we’ve got a concentration in the current quarter of the high-volume business and near term for the next couple of quarters, that’s what the predominant mix will be. But going into 2009, we’ve got other customers we’ve dealt with in the past that we expect to see again where our deliverables come in at higher margins which ought to bring the average back up.

Maurice Tose

And as what we’ve said expects to see again where – it’s more than see again, we’re actively engaged, and as well the supply chain management focus in emphasis is we’re going to squeeze more out of supply chain, and as well, we’ll squeeze more efficiencies out of our production process. So we anticipate moving those up but that’s where we are now.

Mark Jordan – Noble Financial

Okay. Could you give us an update on where you are relative to your longer term multi-quarter negotiations on text licensing with your largest customer and secondly relative to the third quarter. Would you characterize that as a normalized quarter with regards to your licensing activity, both from a profitability standpoint and volume standpoint?

Tom Brandt

Q3 is not a bad basis for the next few quarters, to the latter part of your question, Mark. And you may recall with regard to the multi-quarter arrangement, it is a three-way piece of business involving our channel partner, and we’re working together with them on it. And as we said, we expect to work something out in the next few months.

Mark Jordan – Noble Financial Group

Okay. Could you give us just, not being a lawyer, an overview of what might be the timeline for the Sybase litigation to come to completion, I guess, probably rightfully making the assumption that they would normally try to exhaust all of their appeals processes?

Maurice Tose

Yes, I wish we could. And if we had guessed a year ago that we’d be where we are now, we would have guessed wrong because we have thought we’ll be further along in the process. So the next round is the appeals process, and there is a window of time that they have to do that; but we expect they’ll do it and that process could normally be six months to a year, 14 months. It’s hard to really call the ball on it, but that’s where it is if it ends up running its course.

Mark Jordan – Noble Financial Group

Given the patents that were recently received, which I believe reinforces your case against Sybase and potentially others. Is that new information allowed to be made available to the courts during the appeal process?

Maurice Tose

I think the appeals process, well, it – again, I don’t want to guess there. I mean, that’s a lawyer question and I don’t want to be a C [ph] lawyer on it. My guess is that the merits of the case, which stand on its own, and I just don’t want to guess.

Mark Jordan – Noble Financial Group

Okay. Final question, again, relative to the taxes just to be submitted took out a little bit here. We should expect, therefore, in the fourth quarter that you’ll flow through predominance of your deferred tax assets through the P&L. It will go on the book as an asset and then you will record an average tax rate of 37% but yet, you will not pay those taxes; you’ll just amortize off the taxes that are on your book and then keep the cash. Is that correct?

Tom Brandt

Mark, that’s spot on to the best of my knowledge and belief right now. There’s – I’ve been advised by our auditors that – while it’s not a hard and fast rule that you have to be exactly at three years net positive profits, that’s the prevailing rule that they’re following; and we’re going to be right on the cusp by December 31, so they know that my orders [ph] are to clean this up and do the balance sheet accounting along with our year-end reporting, and then start off 2009 with a conventional tax provision but I’m not entirely in control of circumstances.

Mark Jordan – Noble Financial Group

But we just thought it was that your year-end bonuses were tied to absolute GAAP profitability and that you wanted to make sure you hit this year.

Tom Brandt

Yes, well, that’s a thought.

Mark Jordan – Noble Financial Group

Thank you, guys.

Tom Brandt

Thanks, Mark.

Operator

Our next question comes from Sarah Catherine Phillips from Stephens Inc. Your line is open.

Sarah Catherine Phillips – Stephens Inc.

Good afternoon.

Tom Brandt

Hi, Sarah.

Maurice Tose

Hi, Sarah.

Sarah Catherine Phillips – Stephens Inc.

Great quarter. I just have a question following up on the economy. It sounds that you are seeing that text messaging going forward will be fairly resilient in a troublesome economy, but do you think that any economic pressures might impact the scope of the new deal that you are negotiating right now? Maybe it could be fewer quarters in visibility?

Maurice Tose

Until the deal’s inked, it can change. We just know that as we monitor the capacity usage, it’s not letting up.

Sarah Catherine Phillips – Stephens Inc.

Okay, fair enough. And then are you seeing any opportunities or risks if the Alltel merger goes through?

Maurice Tose

Opportunities, yes. I mean, yes. I mean, one, it would open up a bigger – right now, as far as location base services, we are deployed within Alltel’s network providing location base services; so the merger then would have us within the Verizon for commercial location base services providing that within the Verizon, the decision to make as to how it wants to play that. And they pretty much have mirrored messaging infrastructure in choices, so it will be fairly seamless and that we’re providing gateway and SMSEs to both.

Sarah Catherine Phillips – Stephens Inc.

And then on the government side, can you talk about any new opportunities that you’re currently tracking in the government business?

Maurice Tose

Yes. I mean, I’m dancing because again, as I’ve begun to tell or reemphasized with the management, more on more we are – our success will create more concern on behalf of our competitors, so I’ll just leave it right now. And say, we are tracking a number of large and some very large opportunities, and right now, we don’t have clear – I guess, our strategy in this area as to when we want to be more vocal or not vocal in it, but I’ll just say there’s one particular opportunity we’re tracking where it’s a very significant one. And we’ve lined up, I think, about three dozen subcontractors to be part of our team, so that will speak a little bit, I think, to scale the size and potential that we’re going after.

Sarah Catherine Phillips – Stephens Inc.

And when would that be bid?

Maurice Tose

I believe it is late next year, mid to late next year.

Sarah Catherine Phillips – Stephens Inc.

Okay. And then you had also mentioned an imminent order that would require additional infrastructure. Can you talk a little bit more about that, about when it would hit and how it would grant?

Maurice Tose

It’s imminent. It is all I can say.

Sarah Catherine Phillips – Stephens Inc.

Okay.

Maurice Tose

It’s –

Tom Brandt

It’s around the teleport business, which –

Maurice Tose

Right.

Tom Brandt

That helps to set the scale. I mean, it’s important to that business and –

Maurice Tose

And it’s bigger than a bread basket. No, it will move the needle for us.

Sarah Catherine Phillips – Stephens Inc.

Okay. And then you think it could be awarded in the fourth quarter?

Maurice Tose

We think it will definitely be – it has to be awarded in the fourth quarter. It’s already pushing into extremes on needing to have things up and running.

Sarah Catherine Phillips – Stephens Inc.

Okay. Great, those were all my questions. Thank you.

Tom Brandt

All right, Sarah Catherine. Nice talking to you.

Operator

And our next question comes from Andy Schopick from Nutmeg Securities. Your line is open.

Andy Schopick – Nutmeg Securities

Thank you. You may have touched down some of these, but I’d really like to pursue it a little bit more. With your commercial margins being more than three times better than your government margins overall, I’m wondering what specific initiatives you may have to try to improve overall blended margins. Services margins are inherently slim to begin with. You got a lot of different mixes here to the business and I think what we’d really like to see is concerted efforts to overall improve these margins depending on, of course, the future mix; but certainly, the commercial side of it is far more profitable for you.

Tom Brandt

Well, each of the market opportunities the company addresses has its margin profiles; and happily, they’re all profit contributors and they’re all growing. So we look at the enterprise as within the company as a wireless technology portfolio and for the little extra spin on one top or another is from time to time looking at the overall value of the company but we’re not really trying to lean towards one mix profile or another unless there’s some significant capital investment or R&D investment that is in play.

Andy Schopick – Nutmeg Securities

In which areas do you think you have the most room to improve overall margins between commercial services and systems and government services and systems?

Tom Brandt

Margin has the first deal over what period of time?

Andy Schopick – Nutmeg Securities

A year or two or three years.

Tom Brandt

I guess the only thing you have to factor in is that each of the technologies has a life cycle to some degree. So we had pretty skinny margins early on with the SMS business, but over a decade as the deployment of the software promulgated it’s paid off a lot. On the other hand, our LBS technology is in a much earlier stage as much as we were back in the late 90s with SMS, and it’s making a very modest contribution and its margins are thin but if we successfully penetrate the wide range of carriers that we have the opportunity to serve with that technology, we get to have another line just like we have with SMS where the volume grows. And then, as the mix in those future periods includes more and more licenses for incremental capacity for the technology, then margins expand and the scale of the company grows. We look at the business as a portfolio like that with – among other things product lines at different stages in the cycle.

Andy Schopick – Nutmeg Securities

Okay. One last thing, how much of the unfunded backlog do you expect to get funded over the next say six months? Do you have a sense of that?

Tom Brandt

Unfunded to get funded? Well, again, if you look at – probably you can go back and look at, I think this quarter we said we got $82 million of new funded; last quarter, I know that number was now, but we said what that is and we’re probably running somewhere. I’m just going to pluck some off the bat and say $50 million to $75 million per quarter.

Andy Schopick – Nutmeg Securities

Okay. Thanks.

Tom Brandt

Welcome.

Operator

And our final question comes from Hinda Mizrahi from SSM Investment Corporation. Your line is open.

Hinda Mizrahi – SSM Investment Corporation

Hi. Congratulations. Most of my questions were answered. I just have a few – haven’t you mentioned that you’re now in a lot of new agencies in the government? How many new agencies did you get this past quarter?

Maurice Tose

I’m sure within the organization we’ve got that granularity but as we can’t say on the call – on the orders of 40 or whatever it was of spreading the wealth around. So we’re doing pretty well and again it is to get more horizontal as well we get deeper within organizations. But our focus or emphasis is DoD, Department of Homeland Security, and Department of State, and they’re huge. And again, we’re doing well in the growing number of customers that we have within those.

Hinda Mizrahi – SSM Investment Corporation

And the contracts that you are talking about that you’re in negotiations with are those within the same agencies or there’s also some new agencies coming up?

Maurice Tose

Yes. I mean there are some new in that mix and we’ve been supporting one part of the Department of State and now we’re going to be supporting two or three new parts of the Department of State. Actually, we’ve been supporting several parts of the Department of State and we’re going to support several editions, and again within DoD and intelligence communities and army and marine. Again, this is where you draw the line and say they’re new or not.

Hinda Mizrahi – SSM Investment Corporation

As suppose right now?

Maurice Tose

Yes, it is part of the WPPL’s – yes, it is far as WPPL’s going, it’s pretty much going across the Marine Corps, so they account each new marine division or entity as a new opportunity. Again, we are mindful of making hay while the sun is shining, and that means we are armpits and elbows at taking our technology to every potential user of it, and even if that means outside of DHS, DOS and Homeland Security, we will and in some cases, it makes sense to do that.

Earlier in our history, we were more shotgunning with technology and now we are able to do much more focus rifle-shotting, where we’ve got established market-leading products, services, systems; and we’re looking at where those opportunities present us for taking greater market share. This past year, we didn’t do as much advertising as we’ve done in previous years. As we are, in fact, reviewing the budgets for ’09, we’re looking at significant increase in marketing spend for government systems and products in areas and publications that will reach the widest expanse of those potential users as well as continue to increase and improve the sales teams that are out prosecuting, and creating new partnerships with some new companies.

Hinda Mizrahi – SSM Investment Corporation

That’s good. And just so I understand, the $246 million SwiftLink contract, do you consider that mostly unfunded or do you take a portion out of, you know, for funded also?

Maurice Tose

Well, as we said, it was $246 million ceiling. We’ve already gotten $36 million of funded orders against it, so you could say –

Hinda Mizrahi – SSM Investment Corporation

That’s right, but – okay, that’s just $36 million has been funded.

Maurice Tose

Yes, $36 million has been funded and we said we’re anticipating additional orders imminently, so it’s going to – and our expectation is that that entire contract will be exhausted.

Tom Brandt

And we’re only in our third month now, I think.

Hinda Mizrahi – SSM Investment Corporation

No, no. That’s great. You’re doing great. I was just curious how you were taking it into account. And I guess my last question is just going forward, the numbers that you gave, they’re expecting the government business to be closer to 60% of total revenue like it was this quarter?

Tom Brandt

I don’t think we said what the figure –

Hinda Mizrahi – SSM Investment Corporation

No, because you said – you’ve mentioned that Q3 was a good number to use for going forward.

Tom Brandt

Well, looking at 2009 –

Hinda Mizrahi – SSM Investment Corporation

Yes.

Tom Brandt

As you look at the overall mix –

Maurice Tose

Yes, I think we said total, total mix –

Tom Brandt

I said with the two gross rates we’re expected to be year-over-year relative to 2008, so just trying to provide some framework for modeling 2009 from the outside and 60/40 is probably not bad.

Hinda Mizrahi – SSM Investment Corporation

Okay.

Maurice Tose

Yes. I mean, government’s definitely going to be heavier than commercial.

Tom Brandt

At the top line.

Maurice Tose

At the top line.

Hinda Mizrahi – SSM Investment Corporation

Right, right. Well, okay, that’s my question. Thank you.

Tom Brandt

Welcome.

Maurice Tose

Thank you.

Operator

And we have no further questions at this time.

Maurice Tose

Well, this concludes our third quarter investor call and we look forward to speaking with you again to discuss our second quarter results.

Tom Brandt

Year-end, not second.

Maurice Tose

Year-end results.

Tom Brandt

Right.

Maurice Tose

Year-end results.

Tom Brandt

Goodnight all.

Maurice Tose

Goodnight.

Operator

This does conclude today’s teleconference. You may disconnect at any time. Thank you and have a wonderful day.

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Source: TeleCommunication Systems, Inc. Q3 2008 Earnings Call Transcript
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