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Integral Systems Inc.

Q1 2009 Earnings Call

February 3, 2009 9:00 am ET

Executives

John Higgenbotham – President, CEO

William Bambarger – Chief Executive Officer

Analysts

Richard Ryan – Dougherty & Company

Bonnie Wachtel – Wachtel & Company

[Tim Quin]

[Michael Samoi – Boenning & Scattergood]

Operator

Welcome to the first quarter 2009 earnings conference call. (Operator Instructions) Your speakers for today are Mr. John Higgenbotham. I would now like to turn the conference over Mr. Bill Bambarger.

William Bambarger

Good morning everybody. I'm Bill Bambarger, CFO of Integral Systems. I sincerely apologize for the delay in the release. We had a technical glitch with PR News Wire that we had to get resolved and then it had to go through the final editing process. I'm told that it has been issued and hopefully you all can have access to it immediately. Again, we apologize for the delay.

I'll start off with our Safe Harbor announcement. I need to advise everyone that this call contains forward-looking statements that will involve risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. Such statements are made pursuant to the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995.

The agenda for today's call will be as follows. First, I'll briefly review the quarterly financial results and discuss the company's financial outlook for 2009. Then I'll pass the discussion over to John Higgenbotham, our CEO. John will discuss his operational viewpoint for all of you. After John's remarks, we'll open the call up for questions and answers.

Our financial results for the first quarter were mixed and require some discussion to separate the unusual cost items from the actual results that have been reported. I will explain them for everyone. Please feel free to ask questions later on at the end of the call.

Revenue for the quarter was solid at $38.5 million, up 13% over the first quarter of 2008. However, gross margin decreased in the quarter from 36.9% in 2008 to 34.9% in 2009. These are primarily due to the following factors; all three of our segments reported higher revenues in 2009 over 2008. Our government segment revenue was approximately 17% higher as a result of a full quarter of DPS revenue and higher levels of effort on other Air Force programs.

Gross margin for our government group was 23.7% in 2009 compared to 26.1% in 2008. This is lower because we exceeded the funding ceiling on a couple of our CCFS contract claims due to significantly higher allowable SG&A costs in the fourth quarter of 2008 and the first quarter of 2009. Accordingly, we are seeking funding increases on these programs and a couple of other government programs before we can recover the higher cost on the cost plus contracts.

In Q1 2009 we deferred approximately $1.3 million of revenue due to this issue and we are confident that we will recover these revenues later in the year once we get the funding ceilings on the contracts increased. As a result of this deferral, gross margin for the government segment decreased as I mentioned from 26.1% in 2008 to 23.7% in 2009.

Our commercial ground systems segment revenue was 15% higher in the quarter than in 2008 due to the Protostar 2 contract, the MSVATP contract and Day-Sat programs, all new since last year.

However, gross margin and operating income trailed the prior year due to higher overhead support costs in our Newpoint subsidiary relating to higher business development and research and development expenses that we incurred in the first quarter of 2008.

We also continue to experience higher demand for our products and services in our space communications systems segment. Revenue was up 12% for the quarter in this segment. Our RT Logic subsidiary has six major contracts underway that are driving the business growth. Finally, our margins remain strongest in this segment at 48.4% for the quarter.

John Higgenbotham will discuss some of our operational highlights in just a moment. As you know by now, we transitioned to Ernst & Young as our auditors mid September of last year. E&Y completed their audit mid December and applied very diligent and thorough auditing procedures as we wanted them to.

The first time audit was expensive and had significantly higher cost than our previous audit. The good news is that we have a solid base of financial reporting with which to move forward and we can begin the process of streamlining our financial function to enhance controls and efficiency which will translate into enhanced corporate governance and lower relative costs into the future.

Our SG&A costs were up significantly for the first quarter of 2009. There are three particular reasons for the higher cost. There are approximately $2.3 million of accounting, legal and consulting fees that are associated with the first audit of the company conducted by Ernst & Young and the restatement of the company's financial statements for the first three quarters of fiscal 2008, and various other corporate governance activities.

There is $1 million of non cash stock compensation costs recorded in the first quarter of 2009 compared to only $200,000 in the first quarter of 2008. These were a result of the significant stock option grants that we made in August of 2008.

And finally, we incurred approximately $600,000 higher business development costs as the company continues to invest in future business opportunities, particularly in the National Security and Intelligence communities.

These three items account for almost $4 million of higher SG&A costs in the quarter. The fiscal year 2008 audit is complete and those costs are non recurring. However, the non cash stock compensation costs are recurring. We are confident that the increased business development costs will lead to new opportunities in the next six to twelve months that will be a major factor in the company's future growth.

Finally, the first quarter of fiscal 2008 if you will recall, included a one time $1.6 million tax credit for research and development costs related to prior fiscal years which also contributed to the higher earnings in the first quarter of 2008 compared to the first quarter of 2009.

If you exclude all of these out of the ordinary items in 2008 and 2009, first quarter 2009 income from operations was $5.2 million compared to $3.4 million for the first quarter of last fiscal year. Net income excluding non recurring items in the first quarter of 2009 was $3.3 million or $0.19 per diluted share compared to $3.4 million or $0.18 per diluted share in the first fiscal quarter of 2008.

Let's now turn our attention to the outlook for the remainder of the year. As usual, it's difficult to predict given the timing of contract awards, particularly in the government and space communications systems segments, the release of government funding and the timing of those releases and the demand for our product based business.

We expect to meet our revenue and earnings estimates that we previously issued due to the following factors. The costs associated with the fiscal 2008 quote is completed and full recorded and already factored into our future guidance. We will recover most of the government's services revenue that was deferred as a result of exceeding the contracts funded value.

We continue to see growth opportunities in the government classified community. Our commercial segment is enjoying strong demand for its Epic Newpoint and other products as it is experiencing growing opportunities particularly overseas. Demand for our space communications systems segment for our RT Logic Sat and Lunar Star products and services remains solid.

Our government group is continuing to execute its current prime contracts and is positioning for some additional major awards later in this calendar year. Our solid bookings give us great confidence in our projections for the remainder of the year.

Cost containment efforts for the remainder of the year have been identified and we are focusing on maximizing value while minimizing costs. Therefore, we expect revenue to be approximately $176 million for the year, a 10% growth rate over 2008 and earnings per share is estimated to be around $1.01 per share.

Thanks for your attention and interest. Now I'd like to turn the call over to John Higgenbotham.

John Higgenbotham

Good morning everyone. We are pleased that we can reaffirm our earnings guidance for this fiscal year. Our business is solid with underlying fundamental growth and demand for our products and services strong, despite the overall market conditions.

The necessary extraordinary investments that we've made to enhance compliance and infrastructure are largely behind us. The benefit from this is that in addition to elevating the stature of our audit functions with the new E&Y we have invested in quality assurance, IT infrastructure, HR services and other functional areas to ensure that we are operating with best practices across our corporation.

Our customer base, this is showing great promise for expanding our presence in serving the intelligence community, our traditional Air Force customers and other DOD services as well as for the Federal Government initiatives that look very promising in the new administration.

We've also expanded our reach in the commercial sector, adding several new customers this year, particularly in the international community and expanding our offerings to those customers that integrate all of our products and services across our corporation.

The organizational realignment that we made early in the first quarter is working. We're beginning to see the synergies in business development, R&D, product definition from the greater communication, cooperation and coordination among all of our business units.

With that, I think we'll turn it over to questions and answers.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Richard Ryan – Dougherty & Company.

Richard Ryan – Dougherty & Company

Can you run through cash flow a little bit for the quarter?

William Bambarger

Our cash from operations was just under $3 million and a couple of things come into play there. Our fourth quarter had significant cash outlays in the form of annual bonuses. We had a significant tax payment that we made in December as a result of closing out our estimates for FAS 109 and things like that, and a lot of pre-paid expenses that relate to the new year like insurance and things of that nature.

So we expect our cash to continue to grow. Our EBITDA target for 2009 is a $33 million to $35 million and as we mentioned, the large non cash stock compensation expense, we add that back in calculating EBITDA since it is non cash.

Richard Ryan – Dougherty & Company

What would you think of CapEx for the year?

William Bamberger

CapEx was normal in the first quarter. It was just under $800,000 and that mostly is computer refresh, typical computer refresh expenditures. In the third quarter of 2009, we will have significant one time CapEx relating to our new office, our new facility in Colombia, Maryland. We're going to be acquiring about $2.5 million of furniture and about $2.5 million of IT infrastructure; servers, and network centers and things like that.

That will be forthcoming in the third quarter. Other than that, we expect our routine $500,000 to $800,000 a quarter of computer expenditures and routine CapEx.

Richard Ryan – Dougherty & Company

What's needed to get the funding ceiling increased to get the deferred revenue through?

William Bamberger

We have to request from our contracting officer that they procure additional funds to raise the ceiling on each individual claim. On the contract as a whole, we have plenty of funding, but they have to do it claim by claim, so we have to work with the contracting officer, give them the estimates and have them do the appropriate contracting documents.

From a DCA perspective, all the costs have been submitted through 2007. We will be submitting our 2008 incurred cost submission on time by the end of March and hopefully we can work to get them to review those costs and accept those costs which will make it easier for us to move forward.

Richard Ryan – Dougherty & Company

What would you think timing wise to get that to flow through?

William Bamberger

I wish I knew for sure. I mean on the upside, second quarter. However, I would think more realistically third or fourth quarter we'll get these resolved. We don't anticipate for the CCFC program any major issues, but it does take time for the contracting officer to appropriate the funds and get all the paperwork in order and get that out to us.

Richard Ryan – Dougherty & Company

Bookings for Q1?

William Bambarger

Bookings for Q1 was pretty solid actually at $28 million for the quarter. We have some pretty good bookings on the international front in Japan and Europe and a lot of contract bookings in the government side for routine new contract year program extensions and increases and things like that.

Richard Ryan – Dougherty & Company

When you look at the guidance, how comfortable are you with the backlog you have now and are there any near term milestones that we should be paying attention to of upcoming awards and kind of the timing?

John Higgenbotham

For the balance of this fiscal year we feel frankly pretty good about it. Most of this guidance, the vast majority of it is generated from customers we currently have or contracts we currently have so there's not a lot of fluff in these numbers in terms of requiring us to win some major new awards to make our numbers on the revenue cash flow side.

We're obviously watching our expenses going forward. We've got some additional synergies that we'll be able to wring out from the new organization that will start to streamline some things and actually improve our ongoing and recurring cost profile going forward.

Our margins are holding pretty steady and you'll see them go up and down each quarter depending on the mix of business, but all in all, we're not seeing a huge amount of price structure at this point. In fact, in certain product lines, we think we could increase price.

So I think both from the operating income side as well as our G&A front, we've got a very predictable stream for the year. We've been conservative as we said before in how we are looking at this year, just given all the market uncertainty out there, so we feel fairly confident about this guidance.

Operator

Your next question comes from Bonnie Wachtel – Wachtel & Company.

Bonnie Wachtel – Wachtel & Company

Since the last conference call, I've gotten telephone inquiries both from reporters and from institutional shareholders about the issues I raised last time with respect to RT Logic and the restatement and maybe if you have time for a follow up, I can go back to that. This morning I'd just like to ask questions for a clarification on a couple of things that you've written.

First, let me state both questions so I can get it all out. The first question would be simply what are the corporate governance activities that you're indicating was part of this latest several million dollar SG&A charges? And the second question is to get a little more into what you're saying about the accounting and the restatement.

In the last conference call, I understood what you said Bill was that it was based on some technical determination of whether software that is a lot of the restatement, whether it was an upgrade or it was new software, an addition or something along those lines, but in the actual filing you've got a material weakness from Ernst & Young and it says you didn't have enough experienced people working on it to make the determination which certainly makes it sound more like you just plain made a mistake.

I did find that statement very odd considering that Elaine Brown was still at the company, your former CFO. She knew everything about how to do this stuff and [inaudible] by both Ernst & Young so one the one had we have a new issue of experience which I assume is going directly to you Bill because you were the one in charge making that determination I believe, and there had never been a problem with audits from the past.

And as a follow on to that, I'm not trying to snarky, but you've made a whole bunch of determinations here about cost based budgeting judgments, the rates, government contracts.

John Higgenbotham

Can we respond to your questions, and Bonnie I'd be grateful if you'd withhold your opinions and simply ask questions.

Bonnie Wachtel – Wachtel & Company

Let me ask Bill please which has to do with the call which is, do you think with this procedure to overrun your cost ceiling and have to go back to the customer and ask them to raise the ceiling on every claim? Is that something you consider a good idea to be doing in the future?

John Higgenbotham

First of all, we're not discussing every claim, I think we're discussing one claim so let's just be clear about that.

I think you've asked two questions. One relates to what we're investing in from a corporate governance activities; the other relating to the accounting restatement.

With respect to the corporate governance activities, as we stated earlier in our transcript we've invested heavily in new audit activities. We've invested in a lot of corporate compliance activities relating to support that new auditor. We've enhanced accounting. We've enhances quality assurance. We've enhanced our IT infrastructure support, again as we mentioned earlier.

With respect to the accounting re-statement, Bill do you want to comment on that?

William Bambarger

I think that we've been through this many, many times before. The accounting re-statements were a result of a very thorough and comprehensive audit by Ernst & Young. There were assumptions and determinations that were made in various contracts that when looking at them in a different light, we made the adjustments that we made. Management made that determination.

We did it so that we could make absolutely certain that the financial statements would stand under scrutiny and Bonnie, we're just looking to move forward. That's behind us. We did all of the disclosures that were required by the SEC. We completed the audit in terms of all material respects and we're just not going to go over the past.

We're here to talk about the future. We're excited about our prospects for 2009. We have very solid financial accounting processes and systems moving forward. I'm very proud of the functions that we were able to put in place in order to enhance the company's infrastructure, not just in accounting but in human resources information systems, contracts. We did that not only to be compliant but also to be able to support a continually growing company and that's what our intentions are going forward.

Operator

Your next question comes from [Tim Quin ]

[Tim Quin]

I think a big part of your future strategy is taking your proprietary technology into a new customer base and I think the intelligence agency is a big part of that, and I understand that you probably can't talk in specifics what's going on there, but if you address how your business development efforts are progressing there in terms of the pipeline opportunities, maybe the number of contracts and the size of the contract you're pursuing.

John Higgenbotham

First of all, thank you for noting that part of this investment is in fact to position us with that community among others, and that initiative is well on its way. The investment is manifested in the form of additional personnel both as employees of the company. You may have noted that we established a new corporate business development function and brought in some qualified executives there as well as expanding what we call our senior advisory corp.

And if you look at that line up, there's a significant amount of experience out of the intelligence community that is operating with the company on an advisory basis.

Internal business development as you know, we opened up a Virginia office a little more than a year ago and have that staffed property to support our various intelligence customers. In terms of the number of new initiatives, I'm not sure that I should really go into that number, you start to move across the boundary there, but there are several, they are substantial and involve core products and services out of most of our goods quite frankly, as well as system engineering services.

So we're very excited about the potential there and look forward to being able to discussing things on future earnings calls.

[Tim Quin]

When you talk about substantial, are we talking tens of millions of dollars, over $100 million opportunities and when would you expect you might see something new awarded that would justify the investments in business development, the fruits of your labor, when would those show up?

John Higgenbotham

The aggregate numbers are well in excess of $100 million in new business, and we the gestation period in that business is measured in quarters not months. You might note that we started this initiative back in last August, early September the first month or two I was here. That puts us roughly four or five months into the process.

I would hope that we can share some things with you by the end of the fiscal year. I'm fairly confident we'll be announcing some things before the end of the calendar year.

Operator

Your next question comes from [Michael Samoi – Boenning & Scattergood]

[Michael Samoi – Boenning & Scattergood]

In terms of demand, it sounded like your bookings were relatively strong. Are you seeing anything out there either in the domestic commercial or international commercial markets, certainly given the economy, given the weakness that might cause some concern on the horizon, do you think some of that business might possibly erode in the back half of '09?

John Higgenbotham

Any rational person is cautious in this marketplace. It's one of the greatest tests any of us that have been business for the last three or four decades have gone through, so I don't want to sugar coat it, but we do worry about it and monitor this very closely.

We have factored in market conditions into our guidance so that anything that we felt might be softening or delayed or slipping to the right, we tried to factor that in to our planning numbers. It's mixed. On the commercial front you have some customers that are reaching CapEx limits and delaying or stretching out some of their larger procurements, restructuring some of their larger procurements.

You have other customers that are actually accelerating their CapEx investments because they perceive this as a good time to lay in additional plant equipment whether its additional satellites, additional network management to support what they perceive as a growing global trend.

If you get down into the sub sectors of the industry, you've actually got some counter cyclical things going on, particularly in the global community to balance out against some of the traditional constraints that domestic operators would have than others.

On a government front, clearly we're watching defense budgets. It's very uncertain right now because all of us are still trying to get our heads around what the new administration wants to do with respect to various defense projects. A lot of press coverage that there's discussion about cutting defense budgets overall. You've got to look underneath the hood there and understand the various sectors involved.

With respect to the kinds of things that we support in the defense sector, we don't see a lot of pressure on those programs, recognizing that we're supporting the communications infrastructure which is even more critical in a stressed environment. So there's actually in terms of some of the programs that we're looking at, particularly in intelligence community, they're actually moving to a higher priority. Recognize that 80% of government communications are procured commercially so the government procurement commercial contracts we think are actually increasing.

And the last point I would make to you is that we really do have a compelling value proposition in the market place. We are cost competitive, a provider out there. We do have best in class capabilities both on the RF management, SIG F5, our VFP technology is the real deal. We've got networking ability tools that are coming out of Newpoint. It's catching favor not only in the satellite communications world, but in Telecom as well as well as SAT com TELcom start to march.

Even though it's a tough environment out there, we really feel pretty strongly that the suite of offerings that Integral service has to the market place is very compelling in this current market place.

[Michael Samoi – Boenning & Scattergood]

That was extremely helpful. I know you mentioned on the defense budget some of the ISO markets should stay relatively healthy, and certainly it looks like the unmanned aerial vehicle segment is one spot that will remain relatively healthy. Can you talk about, I know part of your expansion strategy was to kind of get into the communication link there, what's happening in the UAV space with your opportunity? Maybe where you're seeing opportunity is it at the higher altitude programs and I guess lower versus higher altitude or kind of the types of UAV's, whether you're at the small tactical variety or the larger command level?

John Higgenbotham

All of the above. This is one thing that doesn't come out in the historical legacy of Integral Systems is how good a job the company has done in positioning themselves in certain critical areas such a tested measurements, verification and validation services enabling capabilities out of MarkT and SAT. The GEO location stuff that we're doing is for real.

We're finding a steady adoption in various UAV related programs whether it's at the small tactical level or the strategic level or both.

[Michael Samoi – Boenning & Scattergood]

Are you finding yourselves having to displace incumbent on some of those programs or is it more additive technology that hasn't been on some of these platforms before that you're getting pulled onto.

John Higgenbotham

Additive technology.

Operator

Your next question is from Richard Ryan – Dougherty & Company.

Richard Ryan – Dougherty & Company

Looking at the backlog versus what ended in the fiscal year, was there any material shifts between the funded or the larger pot?

John Higgenbotham

No there really wasn't. There wasn't any major contracts that were part of that. I think the government backlog that we experienced in the first quarter was routine new year funding on our existing programs, things like that.

Richard Ryan – Dougherty & Company

Just to circle back on the bookings, I think you said they were $28 million. How is that spread across the commercial and government?

John Higgenbotham

I don't have those numbers in front of me. I'm going off of memory now. It was about $16 million in the government, about $5 million in space communication systems and then the rest was commercial.

Operator

We have no further questions. I'll turn the call back to you.

William Bambarger

Thank you everybody. I appreciate you attention and interest and look forward to talking to you soon.

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