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AeroVironment, Inc. (NASDAQ:AVAV)

F2Q09 Earnings Call

December 3, 2008 4:30 pm ET

Executives

Timothy Conver – Chairman, CEO

Stephen Wright – Chief Financial Officer

Analysts

Michael Lewis – BB&T Capital Markets

Tyler Hojo – Sidoti & Company

Tim Quillin – Stephens Inc.

Patrick McCarthy – FBR Capital Markets

Chris Donaghey - SunTrust, Robinson, Humphrey

Howard Rubel – Jefferies & Company

Michael Ciarmoli – Boenning & Scattergood

Josephine Milward – Stanford Group

Alex Hamilton – Jessop & Lamont

Jeff Evanson – Dougherty & Co.

[Cory Arman – Rice Wolfer]

Operator

Welcome to the second quarter 2009 fiscal AeroVironment Inc. earnings conference call. (Operator Instructions) With us today from the company is Chairman and Chief Executive Officer Mr. Tim Conver, Chief Financial Officer, Mr. Steve Wright, and Director of Investor Relations, Mr. Steven Gitlin. At this time, I'd like to turn the presentation over to Mr. Gitland.

Steven Gitlin

Welcome to our second quarter fiscal 2009 earnings call. Before I hand the call over to Tim and Steve, please note that on this call certain information presented contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1005. Forward-looking statements are based on current expectations, forecasts and assumptions that involve risks and uncertainties outside of our control that may cause our business strategy or actual results to differ materially from the forward-looking statements.

Factors that could cause actual results to differ materially from the forward-looking statements include but are not limited to reliance on sales to the U.S. Government, changes in the supply and/or demand and our prices for our products, the activities of competitors, failure of the markets in which we operate to grow, failure to expand into new markets, changes in significant operating expenses, failure to develop new products, changes in the regulatory environment and general economic and business conditions in the United States and elsewhere in the world.

Additional information regarding these risks and uncertainties are contained in the reports we file with the Securities and Exchange Commission. Copies are available from the SEC as well as on our web site. We do not intend and undertake no obligation to update any forward-looking statements whether as a result of new information, future events or otherwise.

The content of this conference call contains time sensitive information that is accurate only as of today, December 3, 2008. The company undertakes no obligation to make any revision to the statements contained in our remarks or to update them to reflect the events or circumstances occurring after this conference call. With that, it's my pleasure to introduce Tim Conver.

Timothy Conver

Welcome to our second quarter fiscal 2009 conference call. I'm pleased to say that our teams focus across all the dimensions of our business, operational, financial, customer service and R&D have enabled us to perform well in the midst of a significant economic volatility and uncertainty.

Our strategy is rooted in developing innovated solutions that help our customers win in the face of two global trends. We're fortunate that our innovations have coincided with emerging market needs that have become increasingly critical to those customers. As a result, we're positioned very well.

From a natural perspective, we grew revenue by 22% over Q2 FY08 to a record $65.8 million and delivered an operating income margin of 19%. Our development programs are all making significant advancements. Global Observer continued to move forward supported by key development milestones and appropriation decisions in Congress.

Switchblade made more progress in successful flight testing. Digital Data Link moved closer to production introduction and Architectural Wind expanded its footprint of early adaptor systems. In our development process, we concentrate on only on the innovation that delivers new solutions but also on the ways in which our solutions make our customers as successful as possible. These programs have the potential to drive significant growth for AV.

Before I discuss our Q2 performance in more detail, I'd like to address the broader economic and political environment as it relates to our market position and our future prospects. Obviously, we're looking hard at the macro changes in the economy, the possible priorities of the incoming administration and government spending for potential affects on our business.

We're concentrating on strengthening our position in all foreseeable external changes. I think that we're performing well and that AV is in a strong position for several reasons. In an uncertain environment, for source and capital we have a strong balance sheet with over $120 million in cash and securities, no debt and more 85% of our business is with the Federal Government which pays on time.

It also appears that demand for our current unmanned aircraft systems is strong. Small UAS are increasingly becoming a must have ISR capability for our ground forces. Maintaining focus in the area has served us well. We've won all four U.S. DOD programs of record for small UAS.

The cost effective ISR and force protection provided by our UAS products have received strong support from both DOD and Congress and President Elect Obama has indicated similar support in this area. Our UAS development programs are introducing uniquely valuable and new capabilities that have the potential to be game changers in the current and the foreseeable threat environment. On balance, our think our UAS segment is very well positioned.

Outside of our UAS business, we continue to believe that our efficient energy segment is currently offering and is continuing to develop practical solutions to support moves towards energy independence and the improvement of our environment, initiatives that appear to maintain continued political support.

At the same time, electric vehicle developments are high priority programs within a number of automotive companies. However, it is in the EES segment that our exposure to current issues relating to the credit market and the economy is likely to be highest. EES constituted 14% of our Q2 revenue. Of that 14%, the majority is product sales to industrial customers and a significant sub set is sold to the automotive industry world wide which is facing significant challenges. Our electric vehicle test systems are used primarily by developers of electric vehicles and advanced energy storage systems.

PosiCharge is capital equipment used by customers including automotive OEM's and their suppliers to improve productivity. Capital spending retrenchment in general and continued pressure on the automotive industry in particular could adversely affect our EES business in the future. We're monitoring these risks closely and managing our business accordingly.

On the political front, there appears to be healthy support for the areas that we're addressing in both our UAS and our EES segments. Again, President Elect Obama stated his strong support for U.S. troops. That support includes transformational technologies for war fighters in the 21st century battle space, specifically including UAS, and proposals to increase the size of the Army and the Marine Corp ground forces.

Secretary of Defense Gates has also advocated increased intelligence, surveillance and reconnaissance and UAS deployment. Since our small UAS are used by ground forces to provide cost effective situational awareness, we think these solutions are well positioned for continued adoption.

Customers in Congress have continued to support the Global Observer development program with requests for and appropriations of additional funding. President Elect Obama has supported U.S. based alternative energy and electric vehicle technologies that will help us move towards energy independence while reducing our impact on the environment.

Congress also signaled its support for small wind energy generation and ED fast charging infrastructure with the initiation of investment tax credits for these emerging technologies in the September Emergency Stabilization Act of 2008.

Clearly, government spending plans are in flux, but from what we know now, we believe our strategy is well aligned with political priorities. With that as a background, let's now look at our UAS segment.

Customers continued to procure our small UAS as they proceed to fill out their acquisition objectives. From all indications, our customers remain committed to fulfilling their full acquisition objectives for Raven. Additional customers are now evaluating the procurement of Wasp, our smallest production UAS. Puma AE development is going well on its accelerated schedule and there is broad interest in this new capability provided by this platform.

I mentioned last quarter that our Global Observer customers exercised an option for a second aircraft with incremental funding provided in the second half FY08 supplemental appropriation. Congress subsequently appropriated an additional $40 million for GO in the FY09 DOD budget signed in September. We expect that funding will flow through into the Global Observer contract within the next few months.

This additional appropriation will support a more robust development and demonstration of Global Observer's unique capabilities, beyond the two airplane system funded in the initial contract in '08 supplemental. I believe it's also equally important as a demonstration of strong customer and Congressional support for the valuable and cost effective capabilities that GO will deliver.

Switchblade is the back packable tube launched small UAS in development. It will carry an explosive payload in addition to its optics, providing a high precision, low collateral damage force protection capability for ground troops. This development and demonstration contract is progressing well to its testing program. We still anticipate completing the current phase of testing this quarter, enabling our customers to begin to make their decisions regarding potential orders.

We expect Digital Data Link to be introduced this fiscal year as well. Among other product improvements, Digital Data Link will expand the number of our small UAS that can operate in a given geography through more efficient utilization of radio frequency spectrum.

The government recently announced its requirement for up to 60 additional Raven systems configured with the Digital Data Link and the retrofit of an additional 240 existing Raven systems. We expect this requirement to represent the initial production orders for DDL. During Q2, we received the initial limited rate and initial production contract from the Army.

During Q2 we also announced the receipt of a $4.6 million award from Darpa for the development of a stealthy, persistent perch and stare unmanned aircraft system based on Wasp. Our team is making good progress on this development program.

Now, moving from UAS, our Efficient Energy Systems segment continued to deliver solid performance. On the clean transportation side of the EES multiple customers pursuing on road electric vehicle development programs drove increased demand for our leading EV test systems.

As development programs around the world move towards production, we anticipate business opportunities for our EV production and infrastructure solutions that will enable the practical use of electric vehicles and plug in hybrids. We have a core competency in a particularly relevant set of technologies for this emerging market including fast charging infrastructure, on board and off board battery charging, battery management systems, battery pack design, connectors, bi-directional interface with the electric grid and battery testing.

We are working with a number of industry partners as we apply our set of solutions to enable the practical adoption of electric vehicles. During Q2, we established an important new distribution agreement with Toyota material handling U.S.A for our industrial PosiCharge product line. We are optimistic that over time this relationship with Toyota and their market leading U.S. distribution network will significantly increase our access to new adaptors of fast charge solutions in material handling applications.

On the clean energy side of the EES, we installed three new early adaptor architectural wind systems and gained more experience with this innovative solution. The investment tax credit Congress provided for small wind installations in October is another important step for this development program. This is a 30% credit that is capped at $4,000 per system.

With that as an overview of our business, I'll now turn the call over to Steve Wright for a more detailed discussion of our financial performance.

Stephen Wright

Revenue for the second quarter was $65.8 million, an increase of 22% over second quarter prior year of $53.7 million. Looking at revenue by segment, UAS revenue was $56.5 million, an increase of 21% over the prior year. The growth in UAS revenue was largely due to project R&D work. EES revenue was $9.3 million, an increase of 31% from Q2 last year primarily due to higher deliveries of EES test systems.

Turning to gross margin, gross margin for the second quarter was $25 million, up 32% from Q2 last year. Gross margin as a percentage of revenue was 38% versus 35% in Q2 last year. By segment, UAS gross margin was $19.9 million, up 18% from Q2 last year, and as a percent of revenue, UAS gross margin was 35% versus 36% last year. EES gross margin was $5 million, up 150% from Q2 of last year. As a percent of revenue, EES gross margin was 54% versus 28% in Q2 last year. This increase in gross margin rate was primarily due to operating efficiencies and sales mix.

SG&A expense for the quarter totaled $7.9 million or 12% of revenue versus $8.6 million or 16% of revenue in the prior year. SG&A expenses was lower primarily due to lower bid and proposal expense.

R&D for the quarter was $4.9 million or 7% of revenue versus the prior year amount of $3.8 million, also 7% of revenue. Customer funded research and development during the quarter totaled $16.1 million or 24% of revenue versus $5.8 million or 11% of revenue in Q2 of last year, and total R&D, internal and customer funded was $21 million or 32% of revenue versus $9.6 million or 18% of revenue in the prior year.

Operating income for the quarter totaled $12.2 million or 19% of revenue. Operating income was 87% higher than Q2 prior year amount primarily due to higher gross margin and lower SG&A expense partially offset by higher R&D.

Net income for the quarter was $9.1 million or $0.41 per fully diluted share versus $5.2 million or $0.24 per fully diluted share in the same quarter last year.

Now moving quickly through our year to date results, revenue for the first six months was $119.4 million, up 16% from the prior year period of $102.9 million. And by segment, UAS revenue was $102.5 million, up 16% from the prior year period. EES revenue was $16.9 million, up 17% from the prior year period.

Gross margin for the first half was $45.6 million compared to $35.8 million in the prior year period and gross margin as a percent of revenue was 38%, an increase of three points from the prior year. By segment, UAS gross margin was $36.6 million, up 18% and EES gross margin was $9 million, up 89%.

SG&A for the first six months was $16 million or 13% of revenue compared to the prior year period of $15.3 million or 16% of revenue. R&D for the first half was $10.2 million or 9% of revenue versus $8.1 million or 8% of revenue in the prior year, and total R&D internal plus customer funded for the first half was $39.2 million or 33% of revenue versus $18.2 million or 18% of revenue in the prior year.

Operating income for the first half was $19.5 million or 16% of revenue. Operating income increased 71% from the prior year amount. The effective tax rate for the first six months was 31.9% down from the prior year of 33.2%. This tax rate reflects the Federal R&D tax credit which was recently renewed.

Net income for the first half was $19.9 million or $0.64 per fully diluted share compared to $9 million or $0.42 per fully diluted share last year. Looking at backlog, funded backlog at the end of the second quarter was $86.6 million, up $4.6 million or 6% from April 30, 2008.

Turning to our balance sheet, cash equivalents and investments at the end of the second quarter totaled $124.7 million, up $11.3 million from our prior quarter amount of $113.4 million. Positive cash flow was largely due to higher income and lower working capital needs partially offset by higher CapEx.

Investments at the end of the second quarter were $8.1 million, down from the previous quarter amount of $8.5 million. The decrease in investment was due to the net redemption of municipal auction rate securities.

Turning to receivables, at the end of the second quarter, our accounts receivable, including unbilled receivables totaled $56.1 million up $5.2 million from the prior quarter. Total day sales outstanding were approximately 77 days versus 85 days at the prior quarter end.

Taking a look at our inventories, inventories were $19 million at the end of this quarter compared to $20.7 million at the end of the prior quarter. Days in inventory were approximately 42 days versus 56 days at the prior quarter end.

Turning to capital expenditures, in the second quarter we invested approximately $3.3 million or 5% in property improvements and capital equipment, and of this CapEx, approximately 95% was related to growth.

Now I'd like to turn things back to Tim to discuss expectations for the full year.

Tim Conver

Q2 positions us well for achieving our objectives. In summary, our customers continue to adopt and successfully employ our small UAS and Efficient Energy Systems solutions. Our production and development programs are on track. We believe that we will receive production funding to proceed with the introduction of Digital Data Link this fiscal year. We anticipate the successful completion of Switchblade development testing this quarter.

We believe we're well positioned to continue to execute our plan given the changes we have seen to date in the credit markets and the economy and in the next administration's priorities. We see significant growth opportunities in both of our segments that timely investments can position us to take advantage of. We are aggressively pursuing those opportunities.

To that end, we plan to increase investments in IR&D, SG&A and infrastructure throughout the second half. These investments should bring our expenditure levels and our operating margin in line with our original targets for the year.

I've mentioned in prior calls that our quarterly performance has historically been bumpy. Looking at the last two years of our financial performance, we have also identified what may be a seasonal pattern. This pattern is partially due to the government contracting cycle whereby we often receive our most significant unmanned aircraft systems orders either at the end of our third quarter or at the beginning of our fourth quarter.

Additionally, the company closes for a week between actually many times over a week, between Christmas and New Years, reducing production during our third quarter. The result in the past two years has been that our third quarters have been flat or down from our second quarters and our fourth quarters have produced the highest revenue of the year. This apparent seasonality may help to explain some of the bumpiness that has characterized our past performance.

We recognize that the current economic environment introduces additional risk externally to all businesses and that our business is not immune. We're managing the business based on this reality by paying even closer attention to the financial condition of our customers and our supply chain partners by being even more rigorous in evaluating future order flow and by examining internal investment decisions to improve our competitive position and our ability to execute our plan.

Based on our results to date and our outlook for the balance of the year, we still expect revenue growth of 20% to 25% with a 12% to 14% operating margin for the fiscal year. We appreciate the support of our customers, our team members, our suppliers and our investors in our collective success. Thank you all for your attention and your interest, and Steve and I will now open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Michael Lewis – BB&T Capital Markets.

Michael Lewis – BB&T Capital Markets

On GO, can you talk about the specific milestones that hit in the second quarter and did you also say that you're expecting the $40 million to hit sometime in the third quarter to be part of the back log?

Timothy Conver

The program, the JCTD are joint technology development demonstration contract is moving along well. I think the single most significant milestone of the quarter in the development of that program was the full scale test of the propulsion system. In that case, we simulated an entire flight from take off through cruise and back to landing at simulated altitude and temperature conditions hitting performance expectations for that propulsion system which we felt was a very significant milestone.

I think the second part of your question was on the most recent funding appropriation of $40 million in the FY09 defense budget, and I think I said in the next few months, so we obviously can't predict exactly when our customer's process funding through to contracts, but every indication is that that will happen in the next few months. Whether or not it all happens in the third quarter is something we'll have to wait and see.

Michael Lewis – BB&T Capital Markets

When is the actual first flight anticipated for GO?

Timothy Conver

There's not a published flight date, but in general, if you'll recall, a three year program that includes development, flight testing, integration of payloads and then military utility demonstration. So the first two years of the three year program are development and then we'll begin flight testing.

We're a little more than a year into the program so that should put us in the front end of flight testing in about a year.

Michael Lewis – BB&T Capital Markets

With regards to the EES business, did you have any one time plus ups or other benefits in that business that caused the pretty significant up tick in that business in the quarter on a margin basis?

Stephen Wright

The margins are good. They're only slightly higher than they were in Q1. We're 54% in Q2 and 52% in Q1 and I'd say there's no significant accruals or adjustments in there.

Operator

Your next question comes from Tyler Hojo – Sidoti & Company.

Tyler Hojo – Sidoti & Company

On customer funded R&D, I know you gave that, but I missed the exact number. Would you mind providing that again?

Stephen Wright

Customer funded R&D for the quarter was $16.1 million.

Tyler Hojo – Sidoti & Company

I know you directionally I think last quarter said that the bulk of your customer funded R&D was for Global Observer. Does the same hold true this quarter?

Stephen Wright

Oh yes. Customer funded R&D in the quarter is 24% of sales and we've always had a pretty robust amount of customer funded R&D but quarterly it's way above what we've seen in the last couple of years and that growth is Global Observer.

Tyler Hojo – Sidoti & Company

A follow on to the last EES question, I know you were a little bit hesitant last quarter when you had the nice margin performance there to kind of say to expect going forward, but now with two quarters with 50% plus margins, is your thinking that maybe that's a little bit more sustainable, or how should we think about that?

Stephen Wright.

I think the higher margins than we had a year ago are probably sustainable but I don't think we want to commit to the 50% margins. Again, part of it is efficiency. Part of it is sales mix, and that sales mix could change and result in lower margins. So I'd go back to the, from our perspective looking at the operating margins at the 12% to 14% range.

Tyler Hojo – Sidoti & Company

What was the IDIQ backlog in the quarter?

Stephen Wright

$581 million.

Tyler Hojo – Sidoti & Company

And as a percent of sales, how much was international?

Stephen Wright

3% of revenue for the quarter.

Operator

Your next question comes from Tim Quillin – Stephens Inc.

Tim Quillin – Stephens Inc.

In terms of your margin expectations for the year, 12% to 14%, I think to get down to that level you're going to have an operating margin of around 12% in 3Q and 4Q. Is that a function of just ramping up IRAD and SG&A or how much of that is related to potential economic sensitivity especially in PosiCharge that might impact gross margin there?

Stephen Wright

I think it's primarily attributable to the reasons that Tim touched on in his opening remarks. We've had 16% year to date operating margins. Some of that has just been good performance but a piece of it was lower spending on infrastructure and our overheads and SG&A and R&D and we plan to continue to invest and get back to what we had planned to do really for the full year which brings us back to our 12% to 14% for the year.

Also, in Q3, Tim mentioned looking at our history, we will if history repeats, we would expect to see lower Q3 relative to Q2 and that will result in lower operating margins as well.

Tim Quillin – Stephens Inc.

And how about in terms of EES do you feel like the momentum you have on the EV test equipment side can offset what you would assume would be weakness in your industrial customer base at PosiCharge?

Timothy Conver

We've seen growth in the EV test equipment in the first half and as I mentioned in my earlier comments that that's associated with multiple electric vehicle development programs going on around the world. I haven't seen any abatement in the organizations that are running those programs as to their emphasis on those programs, but overall the auto industry is getting hit pretty hard and Detroit in particular, so it's hard for us to predict what happens to the EV development programs if the overall automotive enterprise continues to see the kind of financial stress they've been seeing. I don't have much more of an explicit answer for you than that.

Tim Quillin – Stephens Inc.

And PosiCharge, are you seeing a drop off in sales and margins there yet or do you expect to?

Timothy Conver

I think we have seen some softness in PosiCharge sales in the auto segment. We've got about four different verticals that we address with PosiCharge and we are aware that capital spending in general could come under pressure based on the stressed economy, but to date we haven't seen that much of a change in actual order flow, so we're watching it closely.

Tim Quillin – Stephens Inc.

I think you said on the last call if the R&D tax credit is renewed that the tax rate would be 35% for the year. Is that still accurate?

Stephen Wright

That's the ball park. I would probably throw out 34% for the year on this call, because we've looked at the total amount of our R&D tax credit, our advisors have and that estimated credit is higher than we were thinking in the past.

Operator

Your next question comes from Patrick McCarthy – FBR Capital Markets.

Patrick McCarthy – FBR Capital Markets

You had mentioned there was a broad level of interest in Puma AE and I was wondering if maybe you could put just a little bit more granularity behind that. Is that big army and where else might that go? Is there a census as to how quickly people are looking to make decisions on Puma AE?

Timothy Conver

I think in general the interest in broad across the most of our existing customer base. Puma AE had a number of new capabilities or at least different capabilities than our smaller platforms that all operate as you know, off the same ground control system. So Puma AE has the ability to land in water and/or on land. It is a relatively quiet platform. It has extended duration relative to the smaller platforms, that is, it flies for a longer period of time, and it has a dramatically improved set of optics that are derived from a larger and much more capable mechanical pan tilt zoom ball that's incorporated on this platform.

The combination of those characteristics or in some case, just one of those characteristics provide potential advantage in different applications for almost all of our customers so it appears to have generated that interest and perhaps could augment the capability of existing customers in the future.

In terms of timing, this is a very rapid development program that was scheduled at the time the original contract was let. The team has been working extraordinary hours with just huge success on this program and we expect to deliver those initial units for customer evaluation in Q3. I think most customers that are looking at this will continue to look as it goes through that initial evaluation and be in a position to make some decisions after that.

Patrick McCarthy – FBR Capital Markets

Is there any recent movement from a FAA potentially on domestic airspace and using small UAV's?

Timothy Conver

Actually there is. Just this morning I saw some news on that so I think the FAA is about ready to begin talking publicly on the status of their work on writing the rules or drafting the rules for small unmanned aircraft to the national airspace. It looks like as soon as this month they'll be beginning to talk about that.

Patrick McCarthy – FBR Capital Markets

When you look at your top line guidance of 20% to 25% are there key programs that would keep you at the 20% or there key programs that would have to come through to get to that 25%. Its sounds like maybe the Digital Data Link waiting on the contract or at least to put into production at GO. Is there anything else?

Timothy Conver

I think it's kind of hard to bend the low end and the high end of our guidance based on an individual program or programs. That's just a range that we think we can manage into. It's not based on any particular win or something not happening.

Patrick McCarthy – FBR Capital Markets

You mentioned earlier the auto bail out package and all that type of stuff, is there anything in the discussions that have been going on that you think will actually be positive longer term for the energy business? What's your thoughts there?

Timothy Conver

If you look at the original Congressional action on the first $25 billion that was earmarked for auto industry loans, that was tied to clean transportation investments and as these most recent discussions have taken place, as I watched that just in the public press, there appears to be continued Congressional interest in pushing forward clean vehicle development and that goes to the issue of electric vehicles and various hybrid configurations in many cases.

I mentioned in my comments earlier that in the October legislation, there was for the first time an investment tax credit allocated to fast charging infrastructure which clearly is intended to support electric vehicle deployment. So I think there's quite a bit of potential support for the development and deployment of these systems. If that comes to be, I think we're very well positioned to participate.

Operator

Your next question comes from Chris Donaghey - SunTrust, Robinson, Humphrey.

Chris Donaghey - SunTrust, Robinson, Humphrey

Can you compare for us the pending upgrade cycle from analog to the Digital Data Link version and how that may compare to the Raven A to Raven B conversion and the timing, and would you expect this to also be funded through an O&M type funding line versus a procurement line?

Timothy Conver

To the extent that this is essentially a product improvement to Raven and to ultimately to Wasp, I think it's certainly comparable. As you know when most of the Raven A's were ultimately converted to Raven B's, we expect that the most likely scenario with Digital Data Link will be the same, that most of the Legacy install base of both Raven and ultimately Wasp, our customers would want to see a homogenous fleet.

In addition to the Digital Data Link, there's at least on and maybe other product improvements that can be packaged up there so I think that's how we're looking at it, and I think that's a reasonable expectation.

Stephen Wright

I would just add in terms of where the funding comes from we don't know, but I think our guess is that it will come from the investment part of the budget.

Chris Donaghey - SunTrust, Robinson, Humphrey

From a process standpoint, is this something that's done in the field or does every aircraft have to come back to the factory to be retrofitted? How do you expect the actual mechanics of the conversion to take place?

Timothy Conver

That will get defined explicitly when our customers implement that change, but I would guess it's more likely to be a factory depot retrofit as opposed to a field retrofit.

Chris Donaghey - SunTrust, Robinson, Humphrey

Are you talking about the investment plan for the back half of the year, can you talk a little bit about what your CapEx expectations are? Is this getting ready for Switchblade to go into full rate production? Is this increasing production floor space for may Global Observer? Can you break out what the investment plan entails?

Stephen Wright

A lot of the investments that we're talking are expense not CapEx. CapEx, in Q2 5% of revenue and that's probably the level that we'll continue to spend at through the balance of the year. In terms of the investments that Tim was discussing, it would be in overhead, infrastructure, SG&A, business development and R&D activities, and these are really things that get us back to the plan levels that we've had all along.

Timothy Conver

I would go just a little bit further to say that from infrastructure perspective we'd be looking at production, supply chain, inventory areas where we can increase our agility and our ability to respond effectively both competitively and to customer demands. In the area of R&D, we would be looking at positioning ourselves with developments that we've been working on previously so that they're in a position to move quickly when customers make adoption decisions.

We also see a number of other opportunities that we think we can position ourselves for now that could be very significant growth opportunities in the future and that in SG&A it's probably bias towards business development capacity and capability.

Chris Donaghey - SunTrust, Robinson, Humphrey

Can you talk a little bit about what will be needed to put Switchblade into production? Do you need a new facility? Do you have to section off a piece of existing facility?

Timothy Conver

I think the biggest variable there would be production rate and we wouldn't know that until we see more indication of what our potential customers want to do and when. If it were relatively low rate, I think we can accommodate a lot of that with existing facilities and if it's relatively high rate, then that's a different story.

Clearly there's some changes associated with the implementation and the final assembly with the munitions and we're looking at a few different options on how we might execute that.

Chris Donaghey - SunTrust, Robinson, Humphrey

Did you put out an operating cash flow number? I.

Stephen Wright

Cash flow from operations in Q2, $14.4 million and again CapEx was cash out at $3.3 million so free cash flow was $11 million positive.

Operator

Your next question comes from Howard Rubel – Jefferies & Company.

Howard Rubel – Jefferies & Company

To go from the levels of R&D and SG&A that you're talking about means that you have to hire a lot of people or put them on airplanes or something. Is your head count, I mean can you give us a sense of where your head count is today and where you're going to take it?

Stephen Wright

I can give you statistical head count. As of Q2, we're at 594 heads, up about 10% from year end.

Timothy Conver

We are continuing to hire. We have been for a number of years and that hasn't really abated. I think during the first half we were still ramping up aggressively to get Global Observer fully staffed and executing and I think we're pretty well there now. We had similar surges on some of our other development programs that are now beginning to come to a successful conclusion so we think that's going to free up some existing staff.

We do intend to continue to hire and a lot of the investments that we're talking about can be associated with procurement in addition to direct labor. So we think we're reasonably well equipped to execute this plan in the second half.

Howard Rubel – Jefferies & Company

Another way of saying it is rather than cream skimming, you just have these multiple opportunities and it's better to invest for today for the promise of tomorrow as opposed to just harvesting so quickly.

Timothy Conver

That's absolutely right. I think we see the very significant growth opportunities and I think simultaneously we see the ability to execute our initial guidance this year. So I think we're in a relatively strong position and we see it as a unique opportunity to aggressively pursue those opportunities in what's otherwise a pretty nasty economic environment.

Howard Rubel – Jefferies & Company

So an equal amount of this is going to be in the energy efficiency area as opposed to being all UAS?

Timothy Conver

Yes. We're looking at opportunities in both areas and we're investing heavily in both areas. Now we still have kind of a 15%/85% split in the business and so you would expect to see considerably more on the UAS side, but that's relative to the existing split in the business.

Howard Rubel – Jefferies & Company

Does that mean that we could see some customer announcements in the near term as a result of these initiatives?

Timothy Conver

I think any near term results would accrue from the work we're doing on the infrastructure side where we're really in addition to positioning ourselves to be more competitively effective in the future, we're also positioning ourselves to be more agile and responsive in the near term. I think that goes to protecting our ability to execute the plan.

In terms of IR&D or business development investments I would expect those to be a little longer term before you'd see fruit on those trees.

Howard Rubel – Jefferies & Company

If we look at the incremental revenues, the gross margins actually were down. Was that because Global Observer is just such a larger part of the business?

Timothy Conver

When you say incremental revenues do you mean quarter over quarter?

Howard Rubel – Jefferies & Company

Sequentially.

Timothy Conver

We're total UAS was down a point and EES was up a point. This is why we don't guide on gross margin. That number is just really going to move around based on the contracts we're working on. I wouldn't attribute it to any one program including Global Observer.

Howard Rubel – Jefferies & Company

While you improved on DSO, given the amount of business that you have with Uncle Sam, I still a little surprised it can't be inside of 60 days.

Stephen Wright

Well I wish it were but we've never been inside of 60 days even with Uncle Sam and a lot of that has to do with the order flow and how the sales accrue during the quarter. Many times a lot of our revenues occur towards the end of the quarter so when I calculate the metric for the quarter, you end up with a higher DSO amount. The good news there is there's really no credit risk with respect to the UAV receivables.

Operator

Your next question comes from Michael Ciarmoli – Boenning & Scattergood.

Michael Ciarmoli – Boenning & Scattergood

In terms of your army contract, the 1900 unit contract, what was the percent that you've delivered on that to date?

Timothy Conver

Through Q2 we're 45% delivered against the 1900 systems. You may recall at the last earnings call I announced we're 48% delivered, and so what changed is we've been informed that we were counting some of the early Raven A deliveries against that 1900 and our customer has told us that that's not the case, and therefore we're not as far into it as we thought. As of Q2, the reset accounting is 45%.

Michael Ciarmoli – Boenning & Scattergood

Looking at your bookings were down in the quarter significantly. The backlog is lower. You've talked about the seasonal weakness in the third quarter and looking at past trends it looks like bookings and backlog have trended lower. Is that the expectation for the third quarter and does that concern you, this kind of lumpiness about the business?

Stephen Wright

We've been talking about the lumpiness of the business for two years so this is just part of our business. We don't have multi-year backlog. The funded backlog is up from year end. From Q1 it's lower and that's because we had a large injection of backlog from the Global Observer program in Q1. That kind of lumpiness is what you can expect with us going forward.

Michael Ciarmoli – Boenning & Scattergood

Even when you were talking about SG&A being lower for lower bid activity, just kind of the normal lumpiness, there's nothing to read into.

Stephen Wright

It is, but you're point on Q3 is good. I point you back to the remarks that Tim made, a lot of our order flow which drives lumpiness in the business is lumpy itself. The big GFY tranche of funding, when does that come in? Does it come in in Q3 or does it come in in Q4? It will have a material affect on backlog and results based on when it arrives. It's not just one program. It's a number of programs that fall into that category.

Michael Ciarmoli – Boenning & Scattergood

On the upgrades to the DDL, with obviously operations persisting in Iraq and it certainly looks like there's going to be a surge of activity in Afghanistan, does that make it more difficult for the customer to proceed with these upgrades? If you can give me a sense of timing, how long it takes one of these upgrades, how long will the customer be without their product?

Timothy Conver

The time without the product is an interesting question and I don't have a great answer for it right now. It's not a multi-week process, so we will stage this based once we see what the schedule our customers want to proceed on, we'll plan that from an inventory and implementation perspective and I would expect the same kind of good execution that we saw when we began the frequency update which was not dissimilar in Q1. I think the time customers would be out of pocket with their systems for this retrofit will not be a long period of time.

As to how soon or how their retrofit decisions would be affected as a result of operations tempo, I can't predict what their decisions would be and based on some future change in their ops temp so we'll just as usual respond to what they need and do our best to mitigate the impact.

Michael Ciarmoli – Boenning & Scattergood

Would the same be true for a service levels or replacements? As troops are withdrawn from Iraq and potentially transferred to Afghanistan, do you think there would be mandatory service required for some of the aircraft out there or is it too early to tell what those demands might be in terms of service requirements?

Timothy Conver

It's definitely too early to tell what customers might want to do, but in terms of mandatory maintenance or service, I think the answer is no. These systems are really on condition repair so they operate with a certain amount of spares in the field. We have a certain amount of spares remotely supported with out service people, and then the primary repair and replacement work is done at a depot level in our factory.

That's all a function of what the specific condition of what any given system is at any given time, so it wouldn't lead to a scheduled maintenance in and of itself.

Michael Ciarmoli – Boenning & Scattergood

On the Puma AE, you talked about the accelerated schedule. Is there a chance that you could move into one of those larger options beyond the $4 million contract or was that accelerated schedule kind of built in to your initial award?

Timothy Conver

The schedule was part of the initial award so we just got an aggressive customer and we're running fast to keep up with them.

Operator

Your next question comes from Josephine Milward – Stanford Group.

Josephine Milward – Stanford Group

Can you tell us what the initial Digital Data Link order that you've received, what it is from the army, the size of that order?

Timothy Conver

I believe it's about $6 million and that's non-recurring and an initial set of systems for limited rate production.

Josephine Milward – Stanford Group

So this is really just to deliver like maybe 20 test units to the army for evaluation. Is that right?

Timothy Conver

Correct.

Josephine Milward – Stanford Group

And when do you expect to receive the rest of the production order from the army?

Timothy Conver

We know that the government announced a requirement for about 50 or 60 new systems and something north of 200 retrofits and we expect that they're in the process of addressing that requirement that they've announced. So presumably that will happen in our second half.

Josephine Milward – Stanford Group

What has to happen after the initial testing for them to move forward for production?

Timothy Conver

This would go through an evaluation. They would then need to presumably make a determination that systems meet their performance expectations and then they would approve the production. That would then go back to what's funded and how does that schedule, how do they decide to flow that schedule into their existing fleet.

So I believe that our customers are in the process of making those decisions now and as soon as they tell us what they want to do, we expect to be prepared to execute.

Josephine Milward – Stanford Group

You also mentioned additional customers are evaluating the Wasp. Can you expand on that a little bit and when we might have a decision?

Timothy Conver

It's hard for me to predict a, what they're decision would be or b, when they would make it. I do know that there are multiple customers that see significant potential advantage to that system in their concept of operations and they are considering whether or not they want to adopt some of those systems in their use.

I think it's possible that that happens in the next six to twelve months but I can't really predict what our customers are going to do in the future.

Josephine Milward – Stanford Group

Your R&D on the Steath, small UAS it sounds a lot like the requirements for the small UAS for the future combat system is to develop a competing offering.

Timothy Conver

I don't think that Darpa is thinking in those terms. I think Darpa sees this as a very attractive feature set, and as you know there's a term called Darkahard that defines the kinds of R&D programs that they fund which are usually significant stretches beyond existing capabilities.

The fact that the FCS class 1 program originally had a hover and stare requirement and a perch and stare objective as part of its performance spec, to that extent it in fact is similar, but this is a much smaller system and it adds the characteristic of stealthiness that I think Darpa sees some potential around the basic Wasp platform to achieve.

Operator

Your next question comes from Alex Hamilton – Jessop & Lamont.

Alex Hamilton – Jessop & Lamont

I missed your comment regarding SG&A and R&D. I guess going forward in the model, should SG&A and R&D be closer to what was achieved in second quarter or first quarter?

Timothy Conver

I think our expectation is to accelerate our investment in the second half in both of those categories over and above what our spending was in the first half. I think the net result would be operating margins in the 12% to 14% range.

Stephen Wright

Take a look at our SG&A as a percent of sales last year and maybe use that as a guide. We really can't guide on individual line items but you will notice that as a percent of sales, clearly they're very low in Q22.

Operator

Your next question comes from Jeff Evanson – Dougherty & Co.

Jeff Evanson – Dougherty & Co.

Would you be willing to share what you have remaining in funding Global Observer at this point?

Stephen Wright

We don't break out our backlog by program. It was a fairly good chunk in Q1 and its less now.

Jeff Evanson – Dougherty & Co.

Could you talk about the increase in unbilled receivables and retentions of 23% sequentially? I'm sensing there's a correlation here, correct?

Stephen Wright

No, the unbilled is going to depend on, it's mainly unbilled and not retentions by the way and that is going to depend on a, the volume level of cost plus work we have. That's the main driver, and b, the timing of that cost plus work. At the end of the quarter, the entire months worth of cost plus work will be in unbilled for example, because we'll bill it out in the following month, the first week of the quarter. There's nothing really going on there, it's just a function of the way our sales come in and our cost plus mix.

Jeff Evanson – Dougherty & Co.

If I see funded and unfunded backlog down sequentially and you told me you saved money in the quarter by doing lower bid and proposal work, how should I think about that? Should I not be concerned about that?

Stephen Wright

That's for you to determine, but when I was talking about the lower bid and proposal work I was talking about not sequentially but compared to the prior year. In the first half of last year we had a lot of bid and proposal activity associated with the Global Observer program.

We also had significant effort associated with Puma AE which we subsequently won. So right now, there are no small UAS programs of record in competition. If there were, we'd probably be heavily spending in bid and proposal.

Timothy Conver

Let me go back on your Global Observer question. As Steve pointed out we have never broken out backlog by program, but a way to think about Global Observer might be what's already been publicly announced. The original contract was $57 million. That was for a three year program execution and it wasn't fully funded at contract time when the expectation was that would be funded over the three year period.

Additionally, there was another $37 million or $38 million that was appropriated in the FY08 second supplemental and then there was a further $40 million appropriated in the FY09 DOD budget. Those last two appropriations tend to get some amount allocated to government overhead between appropriation and the time it shows us in contracts to us for Global Observer but at a very top line, I think that gives you a sense of programmatic funding here.

Jeff Evanson – Dougherty & Co.

The $40 million, none of that is in funded backlog, correct?

Stephen Wright

That's correct. It's in near funded nor unfunded. It's not here.

Jeff Evanson – Dougherty & Co.

If my calculation is right it's the lowest level of service revenue in six, seven quarters if I count this quarter. How should I think about that in relation to operational tempo?

Stephen Wright

I think for the quarter there's no message there other than we had more product work to work off than service revenue. If you go back to Q1, we had a lot more service work, and lower product work because of the EEP change. Longer term, the impact of service revenue and ops temps I would let Tim talk to that.

Timothy Conver

I could certainly talk to it but I'm not sure I'll add much more clarity. I think what's going on to some degree is our customers and we are learning what the spares and repairs and service support training requirements for these systems are as we go. Five years ago, these systems were not part of programs of record.

They have just now been in the last five years introduced to our various customer systems and integrated into their tactics and procedures and their supply and training methodologies. They clearly have to anticipate ahead what the performance requirements will be or the service requirements and what the spare parts and repairs demands from future operations will be and by definition they can't get that exactly right.

I think we have seen and we probably will see some ups and downs as experience with the systems begins to stabilize and our customers are able to predict and fund their spending in that area.

Jeff Evanson – Dougherty & Co.

Relating to EES, are you essentially telling us that we should expect that number to be down sequentially in Q3?

Timothy Conver

Are you saying EES sales?

Jeff Evanson – Dougherty & Co.

Correct.

Timothy Conver

No, I don't think we were intending to provide any specific direction on EES or UAS. I think the point was what we've seen in the last two years is a pattern in the second half where our Q3 is low and our Q4 is high. We think a major contributing factor to that is the significant fiscal year order flow in our unmanned aircraft?

Stephen Wright

I think there are two separate messages that we recognize the risk in the commercial environment and then we're pointing out on a macro level what kind of trends we've seen.

Operator

Your next question comes from Michael Lewis – BB&T Capital Markets.

Michael Lewis – BB&T Capital Markets

Year to date depreciation and amortization please.

Stephen Wright

$1.1 million in Q2 and $1.1 million in Q1.

Operator

Your next question comes from Tyler Hojo – Sidoti & Co.

Tyler Hojo – Sidoti & Co.

Would you be able to tell us how many airframes were manufactured in the quarter in total, including the service side?

Timothy Conver

It was at a pace of a bit over 300 a month.

Tim Quillan – Stephens Inc.

So that's definitely up sequentially, correct?

Timothy Conver

I believe so but I'm not certain. The other metric we typically give out, we're now over 11,000 air vehicles new and reworked delivered.

Tim Quillan – Stephens Inc.

You gave us the percentage of the planned Raven buy, the 1,900 systems for Q2, but what was the correct number for Q1?

Timothy Conver

I don't have that number, but let me tell you what the adjustment is. There were 170 original Raven A's that we took out of the equation.

Operator

Your next call comes from [Cory Arman – Rice Wolfer]

[Cory Arman – Rice Wolfer]

You say that the R&D revenue was $16 million versus about $6 million last year. Can you give us a sense for how the profit margins for customer funded R&D compared to the rest of the business?

Timothy Conver

Typically our project R&D is contracted on a cost plus basis and so those margins are lower than our fixed price work. It's profitable but the margins are typically lower.

[Cory Arman – Rice Wolfer]

We also know how much of the UAS revenue is related to R&D but can you tell us how much of the UAS revenue is related to product and how much is related to service?

Timothy Conver

We don't break that out by segment but in total, I will tell you Q2 product revenue was $57% of sales and services 19%, project R&D 24% and to help you out further, on the EES side, it's almost all product work.

[Cory Arman – Rice Wolfer]

Can you give us a sense for how much the UAS product revenue is from Raven versus the other UAS products? Is Raven pretty much all of the UAS product at this point?

Timothy Conver

No, but having said that, we don't break it out by product line. Raven is the largest seller followed by Wasp products and then moving from there, we move into the EES products, and then Puma and some of the other things.

With that as our final question, we thank you all for your continued attention and interest in AeroVironment. May I remind you that an archived version of this call as well as all SEC filings can be found on our website www.avinc.com. Relevant company and industry news can also be found there.

We look forward to speaking you again following next quarters' results. In the meantime, please receive our best wishes for the holiday season and a healthy and prosperous New Year.

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Source: AeroVironment, Inc. F2Q09 Earnings Call Transcript
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