Applied Signal Technology, Inc. F1Q09 (Qtr End 1/30/09) Earnings Call Transcript

Applied Signal Technology, Inc. (APSG)

F1Q09 Earnings Call

February 24, 2009 5:00 pm ET

Executives

William B. Van Vleet, III - President, Chief Executive Officer, Chief Operating Officer and Director

James E. Doyle - Chief Financial Officer and Vice President, Finance

Analysts

Michael Lewis - BB&T Capital Markets

James McIlree – Collins Stewart LLC

Steve Levenson - Stifel Nicolaus

Myles Walton - Oppenheimer & Co.

Patrick McCarthy - Friedman, Billings, Ramsey & Co.

Presentation

Operator

Greetings and welcome to the Applied Signal Technology first quarter 2009 conference call. (Operator Instructions)

It is now my pleasure to introduce your host, Bill Van Vleet, Chief Executive Officer for Applied Signal Technology. Thank you, Mr. Van Vleet. You may begin.

William B. Van Vleet, III

Good afternoon and thank you for joining us to review our first quarter performance. With me today is Jim Doyle, our Chief Financial Officer.

Before we begin I'd like to summarize our safe harbor statement, which is our presentation today may contain forward-looking statements which reflect the company's current judgment on future events. Because these statements deal with future events, they are subject to risks and uncertainties that could cause the actual results to differ materially. In addition to the factors that may be discussed in this call, important factors which could actual results to differ materially are contained in the company's recent 10-Qs and 10-K.

This year, specifically in January, we celebrated our 25th anniversary. We commemorated the event with celebrations at our headquarters in Sunnyvale, California and in Washington, D.C. As a company we're proud of the technical heritage that we've established over the last 25 years and we look forward to the future.

And with that as background, the question I'm sure that's on everyone's mind is well, what have you done for us lately? So I'll have Jim go through the financial results for the first quarter in detail in a few moments, but I'd like to run through the highlights.

The revenues for the quarter increased by 6.2% to $45.4 million. This primarily due to strong sales of our Raider product and to a continued demand for our core suite of SIGINT products. In addition we've had an increase in royalty revenue for commercial applications of our broadband technology.

Our operating profit was very strong, rising 137% to $5.6 million. We're obviously very pleased with this, and while some of the margin increase comes from non-recurring items, we've also made good progress in terms of adjusting our cost structure to become more competitive.

The earnings per share were also strong at $0.27 a share for the quarter, which is up from just $0.12 in the same quarter of last year.

And while we're pleased to outperform the Street expectations significantly, due to the nature of some of the outperformance this isn't necessarily indicative of the kind of profitability enhancement we expect to see in the other quarters for the remainder of the year.

New orders received in the quarter were up 23% to $33.1 million. As with the revenues, the bulk of this increase is the result of continuing demand for our Raider product and the continued demand for our core suite of SIGINT products.

So this quarter represents a strong start to the fiscal year, and I'd like to address a few issues which I know are on everyone's mind.

First, I'd like to share my thoughts about the funding environment for intelligence surveillance and reconnaissance products and services in general. In short, it continues to be good. We're all aware of the significant cuts in the defense budget that seem to be on the horizon at the top line, and I'd like to remind you that only about 20% of our total revenues are derived from the DoD. Recently, I've had a number of conversations with our other customers and they've said that while they don't expect to see significant growth in their budgets, they have communicated they expect to see significant stability over the next several years, which we believe is positive for us.

We believe that our core intelligence surveillance and reconnaissance business is highly important on a strategic level for those customers because of the rapid pace of communications technology development and proliferation. There's a need to recapitalize a good deal of older equipment and so we're comfortable that our business base will perform well over an extended period of time. I also believe that our effort to create a move competitive cost structure enables us to address a wider range of programs and expand our market share.

Our products aimed at the tactical ISR market are also increasingly important. The progress we've made with respect to incorporating low size, weight and power or what we call SWAP into our product design is really helping open up some new market opportunities for us. And this includes some great systems that are deployable on even the smaller classes of UAVs and in manned portable systems. We think these are going to prove very attractive solutions to customers in the future.

In simple terms as it relates to the UAV platforms, what we're doing is adding ears to the eyes in the sky that will give commanders effectively talking pictures that include every signal emitter on the battlefield, whether it be radar, wireless communications, laser, cellular phones and so on. This is technology that is marketable to the full range of our customers.

You may have seen in a recent press release that we successfully tested a Phase 1 development project of this kind of system and received an award to fund Phase 2 development. We're very pleased with our development progress on that and looking forward to the next stage of the program.

As most of you are aware, research and development drives this business and to maintain and enhance our competitive advantage in the marketplace our rate of spending on that is significantly more than most of our competitors. The recent award I just mentioned is really important not for its size, which is relatively small, but for the validation of the ELINT work that went into it, which has literally been years in the making. We're very proud of our engineering group in that respect and very pleased to have our first government contract for a miniature ELINT product.

We're also making good progress in the research and development for sensor technology. Our TOAD synthetic aperture sonar or SAS product, which has both defense and commercial applications, is contributing to results although broad market acceptance is still in the future. We recently completed very successful demonstrations of this capability off the coast of Santa Barbara last week and product outstanding imagery of underwater pipelines to demonstrate the product's utility to both Homeland Security and petrochemical markets. Beyond that product, we're working on a variety of other products with applications to anti-submarine warfare using radar and magnetic sensors.

Now before I turn the call over to Jim, I'd just like to reiterate what I've been saying about our capital resources. Gary Yancey built an incredible platform here and particularly as we celebrate our 25th year in business we all owe him and the founding team a lot of gratitude for the fine strategic and financial position they've left us in. We have over $50 million in cash, essentially no debt, and a very low cost of equity capital because of the consistently strong performance of the business and the significance of our market opportunity. We're taking a purposeful approach and beginning the development of a disciplined process.

And I want to be clear that there is nothing imminent, but our team is serious about the strategic deployment of capital. We believe it could be in the best interest of our customers and, very importantly, our shareholders to utilize our capital to create incremental value in this business.

Jim?

James E. Doyle

Thanks, Bill. Good afternoon, everyone. I'll go through the financial review, and then I'll turn it back over to Bill and he'll close with some final commentary.

Our revenues for the first quarter of fiscal year 2009 increased 6.2% to approximately $45.4 million compared to revenues of approximately $42.7 million for the first quarter of fiscal 2008. As Bill mentioned, revenues increased due to continued demand for our core suite of SIGINT products and a solid adoption rate for our new tactical wireless product, Raider. We recorded royalty income of approximately $1.7 million during the first quarter of fiscal 2009 compared to approximately $1.1 million during the same period of 2008.

Operating income for the first quarter of fiscal year 2009 increased 137% to approximately $5.6 million compared to operating income of approximately $2.4 million for the first quarter of fiscal year 2008. This important was driven by several factors. In addition to growth in operating income due to the revenue increase, we reduced share-based compensation expense by approximately $1 million, program profitability improved by approximately $900,000, and royalties associated with the licensing of intellectual property in the commercial satellite communication market increased by about $600,000, which is essentially 100% margin business.

Additionally I should note that there was a one-time benefit of approximately $500,000 to operating income due to a change in the company's method of allocating indirect costs to firm fixed-price contracts. We believe this more accurately reflects the nature of the work, particularly on certain programs that utilize off-the-shelf hardware solutions. The impact of this change in the method of allocation is expected to be reflected only in the first quarter of fiscal 2009.

I want to carefully explain the change in our share-based compensation expense for those of you creating financial models. In the first quarter it was approximately $600,000 compared to $1.6 million during the year ago quarter. We anticipate that we will see share-based compensation expense of approximately $600,000 in each of the three remaining quarters of fiscal 2009. Last year - fiscal 2008 - these expenses totaled approximately $4.8 million with approximately $1.2 million incurred in the second quarter, approximately $1.2 million incurred in the third quarter, and approximately $800,000 incurred during the first quarter of fiscal 2008.

I would also like to note that we experienced a slightly higher level of royalty income in the first quarter than we may see in future quarters of the year ahead due to the timing of royalties received. We continue to expect royalty revenues for the full year to be approximately $5 million, consistent with the fiscal 2008 level.

Net income for the first quarter of fiscal year 2009 grew by 133% to approximately $3.5 million or $0.27 per diluted share. This compares to net income for the first quarter of fiscal year 2008 of $1.5 million or $0.12 per diluted share.

I would also call your attention to our effective tax rate for fiscal year 2009, which is estimated to be approximately 39% versus the fiscal 2008 effective tax rate of 40.8%. This improvement is primarily due to a change in the terms of the company's employee stock purchase plan.

We are pleased with our first quarter EPS; however, it should be noted that certain onetime events accounted for approximately $0.07 per share increase.

New orders received during the first quarter of fiscal year 2009 increased by 23.2% to $33.1 million compared to new orders of approximately $27 million received during the first quarter of fiscal year 2008. New orders increased primarily because of the demand for the company's new Raider product. We continue to focus our operations on assuring program performance, maintaining a competitive cost structure, and further penetrating our core marketplace. Our customers continue to come to us with new requirements for ISR solutions weighted heavily towards new development.

I'd like to briefly review our balance sheet now. Our combined cash and investment balances at the end of the first quarter of 2009 were approximately $56.7 million, which represented a $2.4 million decrease from the $59.1 million balance at the end of last fiscal year. This decline was due to payments of employee-related cash compensation benefits such as year end bonus payments and reductions to our vacation accrual.

Accounts receivable balances at the end of the quarter were approximately $42.2 million. Billed AR balances were approximately $20.7 million and decreased about $1.5 million during the quarter primarily due to contract limitations on three firm fixed-price contracts. Additionally, our customers allowed two billings in October on the High Beam and [Specter] contracts as opposed to the normal one billing per month. Unbilled AR balances of $21.5 million increased for essentially the same reasons.

The inventory balance at January 30, 2009 was approximately $8.9 million compared to approximately $8.1 million at October 31, 2008. Inventory increased primarily due to an unfavorable indirect rate variance of approximately $900,000. Pre-paid and other current assets included pre-contract costs that facilitate fast execution of our contracts of about $2.4 million at the end of the first quarter. This compares to about $1.3 million of pre-contract costs at the end of last fiscal year. This increase is due to the timing of anticipated funding primarily on three contracts - High Beam, Specter, and one of our significant services contracts.

Current liabilities are $2.3 million compared to the $2.5 million balance at the end of October 2008. The decrease was due to payment of the employee-related cash compensation benefits I just mentioned.

Our bank debt continues to decline with a balance at January 30, 2009 of approximately $5.1 million. We paid dividends of approximately $1.6 million during the first quarter of fiscal 2009. The Board approved our second quarter dividend. It was paid on February 13, 2009 to shareholders of record as of the end of January 2009.

That concludes my review. I'll now turn it back to Bill for his closing remarks.

William B. Van Vleet, III

Thanks, Jim.

In summary, this first quarter provides a good foundation and demonstrates the benefits of the strategic, operational and financial improvements that we began to implement in 2008. We remain focused on delivering value to our customers and to our shareholders, and currently we're very active in new business development activities. We are pleased to announce the award of the reconfigurable SIGINT payload program. We are also excited to soon receive word about the ARGOS 3 program award, which we think will be in the next couple of weeks.

We recently submitted a major proposal for the next generation ASA program, and we are awaiting the imminent announcement of the process enhanced center program and Republic of Singapore Navy TOAD SAS programs. In addition, we're actively pursuing options on the aerial common sensor program and so, while we've gotten off to a good start, we still have a lot of opportunity available to us for the rest of the fiscal year.

So with that we'd like to thank you again for your participation in our call today. This concludes our prepared commentary and we'll now open the call to questions from the participants.

Question-and-Answer Session

Operator

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

Michael Lewis - BB&T Capital Markets

Bill, I was wondering if you could a little bit more about the ACS program, specifically what parts of that program are you thinking about trying to bid and do you know who your team or where your partnership will be with regard to looking at future [inaudible] opportunities there?

William B. Van Vleet, III

As you know, the RFP was due originally in December on that program. It's been slipping into February. It's due any day, maybe as late as mid-March is what I'm hearing now. The draft RFP is on the street at the moment.

They've had a change in their acquisition strategy and they're implementing a technology demonstration or TD phase they'll have to award. This will continue through a preliminary design review over - I think the first contract is 18 months. That'll then continue to be down selected to one prime contractor.

There are three industry primes and we're currently in discussions with all of the partners looking for a role. The value that we bring to the program are solutions for either the common payloads and/or ELINT payloads. So a SIGINT's able to go on board the [inaudible].

Michael Lewis - BB&T Capital Markets

Also, if I could just talk to you for a second about what exactly is going on with Singapore SAS and Profit. Is it just being pushed to the right or is there any issues with regard to the RFPs out there or should we expect something? Is it a timing issue or is there something else going on there?

William B. Van Vleet, III

Yes, a great question. On both of them we think they're imminent. They were supposed to be announced by the end of February and I know we're getting late in the month, so we're really expecting it any day. I think it's just a timing issue. On Profit, you know, that's a major $800 million six-year IDIQ program for [inaudible] SIGINT. There were three industry primes that submitted to that, and we're waiting to hear that award any day. We would actually - our ASP content would be Spiral 2 of the Profit Enhanced program.

As far as the Singapore Navy, that one we did submit a best and final in January on that. They were very pleased with the results. They've hunkered down now and I believe it's in final source selection. And we're again anticipating to hear an answer any day now.

Michael Lewis - BB&T Capital Markets

Just two quick housekeeping questions here for Jim. It looked like the CapEx was much higher than I was looking for in the quarter. Is this the new sustainable rate of around $1 million a quarter or will this back off a little bit moving through the rest of the year?

James E. Doyle

Well, Mike, that's a sustainable rate throughout the year. We'll be somewhere in that range.

Michael Lewis - BB&T Capital Markets

Okay, so we're looking around $4 million. And then what exactly are you spending the money on? Is it new systems? What's going on there?

James E. Doyle

It's a combination of things. There is some new [skip]-related items that we purchased this quarter. There's also some modifications to some of our skips that had occurred and we've done those buildouts and so we're recognizing those costs now. It's kind of the routine type of thing, things that we need to support the various programs that we have.

Michael Lewis - BB&T Capital Markets

And I'm sure this is a question everyone wants to know about. The margin range was exceptional in the quarter and you've already identified that it is not a sustainable level, but can you kind of give us some type of expectation directionally on how we should be modeling through the end of year? In other words, do you have a plan for EBIT margin? Is there a range you could talk about with us that will give us keep us kind of under control with regard to margin expectations here through the rest of the year?

James E. Doyle

Yes, Mike. Unfortunately, we can't give forward guidance, but some of the things I can talk about, I know that we've talked about our operating income range in the 6% to 9% range. We would anticipate that it would be in FY '09 towards the higher end of that range. I know you've historically seen it more in about the 6% operating range. And so I think for the full year would be towards the higher end of that range.

Some of the one-time events, I can give a little bit of color on what happened there. I mentioned there was the change in the method of allocating indirect costs to fixed-price contracts and that accounted for about half a million dollars. There was also a quarterly increase in royalty income. The royalty income was about $600,000 greater this quarter than it was a year ago, so there's a bit of timing issue there and a bit of lumpiness where we had a very good first quarter with those royalty revenues and we don't anticipate that kind of sustained performance. The last thing was last year in the first quarter we had re-enrollment of participants in our employee stock purchase plan and that was roughly a $400,000 reduction to operating income, and we didn't experience that this year.

So I think maybe that gives you a little bit more color on what we might see for the year and what happened here during the first quarter.

Operator

Your next question comes from James McIlree – Collins Stewart LLC.

James McIlree – Collins Stewart LLC

Both of you mentioned strength in the Raider product and I think one of the comments was that it accounted for most of the quarter growth. Are you saying that orders for Raider was $5 million or more?

James E. Doyle

Yes, it was.

James McIlree - Collins Stewart LLC

And how quick is the turn on that product? Say you get an order today; when would it be delivered?

William B. Van Vleet, III

I believe we're turning that in about six months. So from the receipt of order to delivery of the equipment's about six months.

James E. Doyle

And what we've done, Jim, is - to add to what Bill said - we have been building to inventory and so that does help with the turnaround times that he's talking about.

James McIlree - Collins Stewart LLC

Would you hazard a guess on how large the addressable market is for that product?

William B. Van Vleet, III

Well, the addressable market, that's really targeted more at the ground SIGINT market so that actually could be a factor in the Profit Enhanced Center program. In fact, where we would hope to participate in Spiral 2 is by bringing the Raider capability to it.

If you look at the competitors that are in the ground marketplace now, DRT, which was recently acquired by Boeing is one of the companies. They're probably the market leader in the ground SIGINT marketplace, followed by, I believe, Harris at number two in that marketplace. I don't have a number on the actual addressable market side, but we believe we're seeing good adoption rates and strong interest where that could be a substantial part of our intelligence electronic warfare systems or IEWS.

James McIlree - Collins Stewart LLC

And assuming that Profit stays on schedule, when would Spiral 2 take place?

William B. Van Vleet, III

Spiral 2 will be next year, next fiscal year.

James McIlree - Collins Stewart LLC

Royalty, Jim, you said you expected it to still be $5 million for the year. Is that because the customer is telling you it's probably $5 million for the year or is that just you looking at it and not wanting to get too excited?

James E. Doyle

Well, it tends to be a more collaborative effort with us and Comtech and kind of what they're seeing and what we've talked to them about over the last few months. And so it's more the collaborative effort, Jim.

We said in our K that we thought that royalty revenues for '09 would be similar to royalty revenues for '08, and so we thought it prudent to reiterate that. And really this quarter seemed to be more of a timing issue on receipt of those royalties.

James McIlree - Collins Stewart LLC

Bill, when you were going through the opportunities you said the reconfigurable SIGINT was one. Is that part of the $32 million in orders?

William B. Van Vleet, III

Yes, it was. It was fairly small. It was about $1.5 million. The significance of that was that it was the first government contract we've received for the [inaudible] system, and so it was in essence a launched part there.

James McIlree - Collins Stewart LLC

And then did you say something after that before you guys said the next gen ASA?

William B. Van Vleet, III

Next gen ASA, we're waiting to hear. We're in negotiations right now on the ARGOS 3 program award. I think that was probably what I spoke to next. That was a contract - it's a research and development services contract that we submitted to the Navy; this was a follow on. And it's a five-year contract that was anticipated in the $20 to $25 million range.

James McIlree - Collins Stewart LLC

And next gen ASA?

William B. Van Vleet, III

Next gen ASA, that one we received the proposal in February and we have already turned around the proposal. We're waiting to hear on that award in I think May is what we're anticipating.

That one, we had thought it would be a five-year award. We're anticipating a three-year program, but the same annual volume as what we were anticipating. We've got a bid in on that; we're waiting for source selection and evaluation.

Operator

Your next question comes from Steve Levenson - Stifel Nicolaus.

Steve Levenson - Stifel Nicolaus

The indirect labor rate variance, what's the comparison with a year ago, please.

James E. Doyle

Yes, Steve. The indirect rate variance this quarter - just to reiterate - is approximately $900,000 unfavorable, and last year in the first quarter it was approximately $750,000 unfavorable.

Steve Levenson - Stifel Nicolaus

So even though it's a little bit more, is your backlog in the sort of situation that it should cause a problem this year?

James E. Doyle

That's correct. And yes, the backlog is strong. We do see good order opportunities during the remainder of the year. We see some product opportunities. We talked about Raider. We've got our core suite of SIGINT products. We are building inventory. So we do anticipate being able to transfer that inventory to contract.

William B. Van Vleet, III

[Inaudible], Steve, and that is that it's not unusual that that's a seasonal number and we typically run a deficit in the first quarter.

James E. Doyle

That's a good point, Bill. Right.

Steve Levenson - Stifel Nicolaus

Just looking for the comparison because I know the last year or two you've been able to manage it a little bit better than a few prior to that.

So you talked about using the cash to add value. What's on the wish list? What's the hiring plan and what sort of capabilities are you looking to add to the company's current list and how would you do it, acquisitional or build it yourself?

William B. Van Vleet, III

Well, a combination of both. We're looking to hire this year. We'd like to [top] the 750 person marker by the end of the year approximately is a goal we've set. As far as where we are on that, I think the first quarter we hired 27. We had some attrition, so we had a net of 17. That's pretty close to our plan given that the first quarter through the holidays and all that is typically a quiet period for recruiting anyway. Most people don't change jobs over the holiday period. So we are doing some by staffing.

We are also looking so our growth is a combination of organic and acquisitions. We're evaluating a range of potential companies. We're looking basically for other good companies that are well run and in probably one of three areas. We're obviously interested in getting a complementary capability that would deepen our competence and participation in the tactical SIGINT market and/or in the centers for ISR markets to enable us to have more endtoend capability, so we'd be looking at some of those competencies.

And then also strengthening and enhancing our services portfolio and participation that could accelerate [inaudible] for cybersecurity and intelligence surveillance reconnaissance services.

Steve Levenson - Stifel Nicolaus

Is more of the activity today in the wireless area, I take it?

William B. Van Vleet, III

Well, we're seeing growth opportunities across the board. We're seeing a good amount of ARGOS [inaudible] really in all three of our lines of business - broadband, tactical wireless and in sensors. But in terms of probably the highest growth in any one market, that's probably got the largest single market growth of the three we've got.

Steve Levenson - Stifel Nicolaus

And, Jim, would you think R&D would still fall in that 7% to 8% range?

James E. Doyle

Yes, in that 7% to 8% range is probably a good estimate.

Operator

Your next question comes from Myles Walton - Oppenheimer & Co.

Myles Walton - Oppenheimer & Co.

It sounded like there weren't any one-time tax benefits in the quarter, so I'm just curious. I know in December you'd been looking for about a 4 point higher rate. Was there something you were able to do with respect to the options expensing that you didn't anticipate in December or was there another tax strategy employed? And how sustainable is the 39% beyond the current fiscal year?

James E. Doyle

I don't have a good answer for you beyond the current fiscal year. Some of that, Myles, is going to be a function of how share-based compensation goes in the future and that does affect our tax rate. So the best we've got, at least for '09, is that 39% tax rate.

The difference - and I know in the fourth quarter conference call we did say that we anticipated the tax rate to be in the low 40% range - the difference was how the change in our employee stock purchase plan actually made its way through our taxes for FY '09, and so that was the significant change and why the tax rate dropped significantly.

Myles Walton - Oppenheimer & Co.

And in terms of - I guess asking it another way - the stock options expense, I kind of anticipated that that was going to be going down for a little while here over the next couple three years. Is it still safe to say that that downward trend would persist even beyond fiscal 2009 and into fiscal 2010 maybe?

James E. Doyle

Yes, slightly. We're probably starting to get down to the low water mark of what that stock compensation expense will be.

Myles Walton - Oppenheimer & Co.

And then I want to revisit the margins a little bit here. I know you said there's $500,000 or so of onetime related to the change in accounting and then there's a little bit more of the royalty, but even taking away a million from EBIT, it still looks like a pretty impressive margin performance and well above that target margin rate you'd mentioned, Jim. And so I guess walk us back from the edge and tell us why beyond those two things the margins were elevated in the first quarter.

James E. Doyle

Well, we did have good program performance; we had roughly $900,000 better program performance this year than last year. And so some of that can be a timing issue, so that helped to elevate things. We did see a greater increase in our fixed-price contracts during the first quarter, especially compared to a year ago. To give you some idea of the breakout of revenues from contract types which, as you know, helps to drive our margin, [inaudible] contracts accounted for approximately 62% of this year's revenues compared to 71% a year ago, time and materials contracts were about 19% compared to about 19% a year ago, and then our fixed-price contracts accounted for about 15% of revenue as opposed to 7%. And then royalties were up a little bit.

So there's a combination of things here, Myles. It was a very good quarter. Everything seemed to align very well. Maybe that gives you a little more color.

Myles Walton - Oppenheimer & Co.

Bill, it looks like a lot is coming out of SG&A. I can't obviously trace out what's being allocated there immediately, but running just under 12% and it looks like historically that run rate even tax, stock options - is more in the 15% range. How much of this is permanent cost takeout that you've been able to do over the last six to nine months? And I guess is this where you're seeing most of the benefit come through?

James E. Doyle

Myles, let me help with that. We'll provide in the future - we want to review this with our Board what our long-term expenses would be for the various components of cost.

One thing that we did in this first quarter was we changed our method of allocating indirect costs, and so one of the things that happened, for example, with G&A, we used to include all our marketing costs in G&A. We moved a fair portion of those marketing costs into contract costs. And so the marketing done directly in support of our contract done by our divisions is included in our contract costs whereas last year they were all included in G&A. This year all we have in G&A as far as marketing costs is really the corporate level marketing.

So we've got some of that movement in there. We've also got, like you said, reduction in the share-based compensation expense. So one thing that is driving that lower G&A rate is just the restructuring of the way we apply our indirect rates to contracts.

Myles Walton - Oppenheimer & Co.

Is it safe to say that that move should also, well, let's not say insulate you, but certainly reduce the volatility of your indirect rate variances creeping up on you as you've now been able to lower the overall indirect rate variance pool?

James E. Doyle

I'm not sure that it'll have effect on the indirect rate variance, but I do believe that it'll position us to be more competitive, especially be more competitive for product type programs because we'll have a lower G&A rate applied to our materials. We just now [buy] material burden instead of a full G&A rate. So what I think it's done is it's positioned us to be more cost competitive.

Myles Walton - Oppenheimer & Co.

And, Bill, on bookings for the year and I guess to flesh out some of the color you provided on the defense outlook, I know you said 20% of your revenue is derived from the DoD, but do you have a sense of how much of your revenue actually comes from the DoD budget and then flows to your customers? And then secondly, do you think any - I know 1Q bookings are a little light, but do you see a path that's fairly transparent towards book to bill above 1 for the full year?

William B. Van Vleet, III

Yes, a couple of questions you had in there. In terms of the question how much of our revenues come from the broader defense budget, well, virtually all of our revenues or 95% come from the combined defense and intelligence community budget. That's really our core customer marketplace.

And from book to bill standpoint, it was a little light, but there are a couple of things that are just right on the cusp here, as I said, the Profit Enhanced, the RSN and the ARGOS 3. And I think when those get determined, obviously our objective for the whole year is to have a book to bill closer to 1.1 throughout the year. That's where I'd like to see us get in terms of a sustainable long-term organic growth rate.

Myles Walton - Oppenheimer & Co.

And do you think any of the delays that you're seeing on bookings, if you are seeing any - or, I guess, first off, was the 1Q bookings in line with your expectation? And secondly, are you seeing any delays as a result of the shift in administration that you think could also delay 2Q?

William B. Van Vleet, III

Right. No, I don't think we're seeing a big delay as a result of the administration. The timing on this is, you know, we're within a week or two of the quarter on some of these. I think they're pretty close. The ARGOS 3 we submitted; as I said we're in negotiations on that, so I'm quite confident that one's going to come through. We're just waiting for the contract to be signed and that to come out. We'll announce that when it does, hopefully within the next couple of weeks.

As far as the impact of the administration and so forth, as you're well aware, the top line defense budget is estimated to be between $535 and $540 billion, which is a bit above the FY '09 budget, and there's a lot of speculation and uncertainty that's occurring until the new budget is released on that. We may get a preview of the 2010 budget outline this week, but we aren't anticipating full details until April.

Now that said, you know, there's lots of language - as you stay in touch with the defense press and the congressional pols it's fairly common knowledge - that many of the large platform procurements will experience budget pressure, programs like the F-18, the F-22, the DDG-51 and the future combat systems I know were all worked [inaudible] that are all in the administration's crosshairs. And Secretary Gates has stated an interest to rebalance our military priorities to provide more attention and funding to a regular worker and, if so, we expect that defense electronics, linguistics, special operations and intelligence - basically all the areas we participate - will benefit from such a shift.

Myles Walton - Oppenheimer & Co.

And I just wanted to clarify one point. You said ARGOS 3 is $20 to $25 million. Is that the full booking that you expect on the contract award or is that the size of the potential -

William B. Van Vleet, III

Good question. That is one change. In prior years it has been incremental in IDIQ we're going to see the full booking of that amount, although the revenues will be realized over a five-year period.

Myles Walton - Oppenheimer & Co.

And then the last one from me is on acquisitions, you mentioned the areas you're looking, but with the backdrop you have - a strong balance sheet, but also the questions on the overall liquidity and the market - what kind of size of deals are you looking at and has DRT in anyway changed the competitive landscape?

William B. Van Vleet, III

Great question. We're looking at targets that are what I call small and smart, smaller companies that are well run that really supplement our ability to execute on a broader strategy that we have to go forward to provide more value in the core markets where we are. We're not looking for transformational deals that would fundamentally change the type or character of this company in terms of a large way. So it would be something that's 10% to 20% of our annual revenue, something like that, that could be easily identified, qualified, captured and integrated to get good operational efficiency.

Has the DRT deal changed the game? It was a very premium valuation and so from that standpoint it continues high levels of expectation from those types of companies. And those are ones that we have to take a close look at if we're ever involved in that part of the marketplace to make sure that we can deliver to our shareholders the value from a premium valuation.

In the product space I'd say the valuations are still somewhat rich; in the services space we're seeing those come down to reasonable valuations. And so I think over the course of the next two to four quarters - look at what's going on in the financial and economic environment - our belief is that there will be a return or normalization of some of the high valuations that have been out there.

Myles Walton - Oppenheimer & Co.

What was your key multiple that you thought?

William B. Van Vleet, III

Thirteen times EBITDA is one thing that has been rumored. I'm not sure how accurate this information is, but I heard 13 times EBITDA and then I heard 3.5 times revenues or so.

Operator

Your next question comes from Patrick McCarthy - Friedman, Billings, Ramsey & Co.

Patrick McCarthy - Friedman, Billings, Ramsey & Co.

I guess you're in the process of renegotiating and aligning your rates with your government customers. Has that been completed?

James E. Doyle

Yes, it has. We submitted a new rate proposal for FY '09 to the government and that appears to have been completed.

Patrick McCarthy - Friedman, Billings, Ramsey & Co.

And then can you update us - and if you did this at the beginning of the call, I apologize  but could you just update us on some of the facility consolidation opportunities that you've seen in the past and then maybe also give us an update on what's going on with the Texas facility.

James E. Doyle

You bet. The facilities consolidation, we did consolidate one of our East Coast facilities in Arlington, Virginia. We have seen slower progress in other regions of the country, and it's impacted, again, by the overall commercial real estate market there. We've been looking at doing more consolidation in some of the facilities we have in Sunnyvale and that's lagged a bit compared to our desired objective just because of that financial market. We're still in negotiations and still working to get a more optimum footprint, although as we experience more growth that's a dynamic and changing environment.

We have a facility in Allen, Texas, and we remain committed to that. We actually feel a bit better about that with the recent award of the reconfigurable SIGINT payload. And so now that we've got government funding, we've got a longer runway to demonstrate the utility and long-term benefit of that product line and placement in Texas.

Patrick McCarthy - Friedman, Billings, Ramsey & Co.

Of the new hires this year, could you say about how many would be for Texas?

William B. Van Vleet, III

We haven't hired any in Texas yet.

Patrick McCarthy - Friedman, Billings, Ramsey & Co.

But do you have plans for it?

William B. Van Vleet, III

Of the planned ones, you know what? With the contract we've won, we believe we're fully staffed currently in Texas. We do have some opportunities towards the end of the fiscal year, but I wouldn't anticipate that that would increase that staffing until probably fiscal end.

Patrick McCarthy - Friedman, Billings, Ramsey & Co.

And then in the past you've talked about the SAS product line outside of the Singapore opportunity; I think you were talking about a couple of European countries. Have you seen that move forward or is their budget situation causing that to slow down or any additional thoughts there?

William B. Van Vleet, III

There's lots of interest, Patrick. We haven't seen the adoption rates yet. The foreign markets, as you know, don't move as quickly as the domestic markets. And we believe, again, the interest is there; we haven't seen the contracts materialize yet, although we haven't expected them to materialize yet, either. So we're still actively pursuing and engaging the customers for future contracts there.

Operator

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

Michael Lewis - BB&T Capital Markets

Jim, what was you funded backlog number and what percent will you expect to convert to revenue in App Sig's fiscal year 2009?

James E. Doyle

Mike, our backlog - which is total backlog - was about $112 million at the end of the quarter. We don't report a funded amount, but it generally runs in the 75% to 80% of our backlog is funded. So that gives you an idea on that.

As to how much we'll convert, a fair amount of that backlog goes over a 15-month period, so a fair amount will convert, but we do also anticipate new orders coming through here to supplement that backlog to continue our revenue growth.

Michael Lewis - BB&T Capital Markets

And then with regard to the DRT transaction, did you guys actually bid that or was that outside the size capabilities that you had?

William B. Van Vleet, III

That was outside our size parameters.

Operator

Your next question comes from James McIlree - Collins Stewart LLC.

James McIlree - Collins Stewart LLC

Jim, you mentioned earlier that your fixed-price contracts were, I think you said, 15% of sales.

James E. Doyle

Yes.

James McIlree - Collins Stewart LLC

So $7 million or so. Was that a spike or is that a sustainable amount going forward?

James E. Doyle

It was significantly better than it was a year ago, you're right. As far as sustainable amount, for the full year we do anticipate growth in product sales, but I can't commit right now, Jim, to what we might do on a quarterly basis. But I think last year was probably the low point as far as product sales. We've had good opportunities this year to improve our product sales with the normal core suite of SIGINT products plus the adoption of the Raider products.

James McIlree - Collins Stewart LLC

So a couple of years ago, fiscal 2007, fiscal 2006 you were doing 15% - 17% of revenues.

James E. Doyle

Correct.

James McIlree - Collins Stewart LLC

And then you dropped down last year. Are you suggesting that you can get back up to that 15%?

James E. Doyle

Eventually.

Operator

Your next question comes from Myles Walton - Oppenheimer & Co.

Myles Walton - Oppenheimer & Co.

On cash flow, the first quarter in awhile you had negative cash from operations. What's your outlook for the full year and is it fair to think that you're still in the full conversion, net income to free cash flow?

James E. Doyle

Yes, Myles, we should have positive cash flow for the year.

Let me elaborate a bit on why we used so much cash in the first quarter. Accounts receivable, we used about $2 million in the quarter and that was a combination of things. We had generated more revenues than we collected, obviously, but also because of the new rate structure that we introduced, we couldn't invoice for much of the month of November. That's all been resolved and we're able to bill our customers. Then as far as inventory and prepaid amounts of use of cash of almost $2 million, approximately $900,000 that was rate variance and then about $1 million was an increase in pre-contract costs during the quarter.

So we do think that we will generate cash through operating activities for the full year.

Myles Walton - Oppenheimer & Co.

But in terms of a goal of full conversion, net income to free cash flow, is that a realistic target for FY '09?

James E. Doyle

For FY '09, yes.

Operator

Gentlemen, there are no other questions in the queue at this time.

William B. Van Vleet, III

Okay. Well, again, thank you very much. We appreciate your excellent questions and your participation, and thanks for joining us this afternoon.

Operator

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time.

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