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Executives

Steven Gitlin – Director, Investor Relations

Timothy Conver – Chairman, Chief Executive Officer

Stephen Wright – Chief Financial Officer

Analysts

Michael Lewis – BB&T Capital Markets

Brian Gesuale – Raymond James

Chris Donaghey - SunTrust, Robinson, Humphrey

Tim Quillin – Stephens Inc.

Michael Ciarmoli – Boenning & Scattergood

Troy Lahr – Stifel, Nicolaus

AeroVironment, Inc. (AVAV) F3Q09 Earnings Call March 9, 2009 4:30 PM ET

Operator

Welcome to the third quarter 2009 AeroVironment 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. Gitlin.

Steven Gitlin

Welcome to AV’s third quarter fiscal 2009 earnings call. Before I hand the call over to management please note that on this call certain information presented contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. 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/or 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 is contained in the reports we file with the Securities and Exchange Commission. Copies are available from the SEC as well as on our website. 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, March 9, 2009. 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.

It is now my pleasure to introduce Tim Conver.

Timothy Conver

Thank you Steven. Welcome to our third quarter 2009 conference call. The time that has passed since our Q2 earnings report and today has seen dramatic economic and political developments, unprecedented in our experience and affecting U.S. and global commerce. One effect of these developments is growing uncertainty regarding commercial and government funding and purchase decisions. We believe our performance has been strong relative to many other businesses struggling in this environment but we do feel the impact.

AV’s growth is based on fundamental propositions that our innovative solutions were developed to contribute important and valuable new benefits to our customers. Given the difficulty in predicting the timing and value of market adoption we have always taken a long-term view of our business and market opportunities. Our team has historically performed extremely well in delivering results that met our guidance even though our quarterly results tend not to be linear.

However, I doubt I have ever addressed investors without pointing out the bumpy quarters that have been, and we expect will be, characteristic of our business. Three quarter’s into our fiscal 2009 our year-to-date revenue was up 13% year-over-year and our operating profit is 14%. Q3 revenue was up 8% over Q3 last year but was lower than we expected. There were multiple contributors to relatively low Q3 revenue and I’m going to go into more detail here than usual to provide perspective on these contributing factors and their implications.

They can be classified into four categories. The first category is structural. As we pointed out in our last call every year we close operations between Christmas and New Year’s and this year that amounted to almost two weeks production. We also know there is a likelihood of late order flow affecting Q3 associated with the government’s budget cycle and we saw that this year with most of the Raven Army contract arriving on the last day of the quarter.

The second category also amounts to deferred revenue. We had lower project revenues constrained by unfilled employee hiring. This project revenue will be recovered as we hire the employees we are seeking.

The third category is economy-driven. Our industrial PosiCharge sales are down year-to-date because of lower sales of electric forklifts and foreign military orders for small UAS are being deferred because of international government budgetary uncertainty. We have made significant changes to drive stronger PosiCharge sales in the midst of capital equipment market declines which I will talk more about later, but we currently think we will be doing well if we can hold PosiCharge sales flat year-over-year.

The foreign order delays surprised us and we believe it is driven by a re-evaluation of defense budgets and priorities around the world. We have some reason for optimism in the ultimate outcome of foreign, small UAS procurement decisions but for now we have delays.

The fourth category is DOD orders for small UAS that we expected in Q3 but have not received. We believe some customers are still arranging funding and at least one customer may be deferring orders waiting for Digital Datalink production cut in to be available. This DDL effect would be an unanticipated revenue delay associated with the compelling new product improvement that Digital Datalink represents.

We expect strong fourth quarter revenue to bring total fiscal 2009 revenue to $240-250 million. This would be an 11% to 16% growth over fiscal year 2008 but less than the growth we previously expected for the year. I believe we remain very well positioned due to the intersection of our customer’s priorities and the value they perceive in our solutions as well as our financial resources and the extraordinary effectiveness of our people.

Demand for small UAS customer funded development programs and electric vehicle test systems remains strong, supporting our long-term growth goals. In fact, significant highlights in Q3 reinforce our general growth expectations. They include record funded backlog of $139 million, a definitive statement of demand for our solutions; net increase in cash equivalents and investment to $131 million; receipt of Army Raven production and CLS orders totaling $41.7 million although most of it was received at the end of the quarter; continued progress on Global Observer development and increased funding development; delivery of initial Puma AE limited rate initial production systems and very positive customer response to initial operational testing; Italian approval of Raven for use over populated centers. This is a key enabler to future applications inside national air space; installation of PosiCharge systems at our first customer developed through our new Toyota Material Handling Distribution partnership with clear customer appreciation of the value proposition; installation of our Electric Vehicle Test Systems at the General Motors Volt Development Lab; successful transition of our Digital Datalink for research and development into production with a $16.8 million initial order in January and encouraging indications of broad future adoption and successful demonstration of the end-to-end Switchblade solution leading to multiple customers now evaluating potential applications for this entirely new capability.

These are all strong indications of growing demand and some are major milestones for key growth platforms. Before we move on to the UAS segment I think it is helpful to revisit briefly the implications of our strategy, to understand how we view the business. We have developed market leadership, competitive advantage and sustainable growth by bringing innovative technology solutions with compelling benefits to large potential markets. As a corollary we have to deal with the unpredictable timing and rate of adoption inherent in innovation.

We have successfully transitioned three solutions from R&D to production businesses through our commercialization process. Small UAS is the largest followed by PosiCharge and then Electric Vehicle Test Systems. In each case we have built the largest market share and we have created good opportunities not only to maintain our leadership in these initial served markets but to expand our solutions into much larger target markets for future growth.

The challenges we face as we execute this strategy include getting the technology right, anticipating the market, surviving the inevitable dry holes and dealing with uncertainty regarding the timing of adoption and infusion of these innovations into their target markets. I think we understand and actually thrive on the first three challenges. We deal with the fourth challenge, the timing of adoption and market up take with persistence, agility, major investments and a long-term view. The rewards have been significant.

When small UAS and PosiCharge were adopted by large customers, initial revenue growth exceeded 100% per year and we established early and sustained market leadership. We believe innovation still in development may have even greater potential and larger rewards than those already commercialized although the difficulty in predicting timing emphasizes the importance of viewing and managing our business for the long-term.

Now let’s look at the Q3 results for our UAS segment. Demand for our UAS solutions continued in Q3 and is reflected in record backlog this quarter. Key contributors to the growing backlog were receiving options exercised for our Global Observer development contract as more of the funds appropriated for Global Observer in calendar year 2008 were put on contract. We expect this process will continue with Global Observer contract funding additions in Q4.

UAS production and CLS orders from the Army were received at the end of the quarter and we received a contract for Digital Datalink Low Rate initial production and Raven B retrofits during the quarter. Most of this initial Digital Datalink contract will ship in Q3 and Q2 of our fiscal year 2010.

We believe this is a very important milestone in our small UAS business and represents significant growth potential. It is also a major production transition from one of the key internally funded R&D initiatives we announced over two years ago. We believe the Army intends to convert all future production small unmanned aircraft systems to Digital Datalink and to retrofit much, if not all, of their entire fleet of Raven B’s. We believe most of the other small UAS customers will eventually do the same.

Digital Datalink will multiply the number of small unmanned aircraft that can be used without requiring additional scarce frequency spectrum, a key enabler to broader adoption of small UAS beyond the current basis of issue. It will also significantly enhance communication security. Beyond these initial benefits of DDL we expect the thousands of our small unmanned aircraft systems available throughout DOD will take on much more value with the potential of each becoming an airborne, network access node enabling a beyond line of sight digital network.

An unforeseen consequence of our successful introduction of DDL is that at least one customer appears to have deferred expected small unmanned aircraft system contracts to wait for DDL production availability.

Beyond our Q3 backlog gains we made important progress in several other areas of UAS. We are pleased with reports of successful initial operational testing of Puma AE. Successful completion of the full testing and evaluation is a necessary phase in military acquisition before authorities can authorize full rate production. This first step for Puma AE is encouraging for future production procurements.

By next quarter, early in the quarter, we expect to be able to begin demonstrating for the first time the significant performance capabilities of Puma AE to other potential customers. Like Raven we believe the potential adoption of Puma AE can extend well beyond its initial customer base.

We made good progress on our other UAS development programs during the quarter and as I mentioned we achieved major milestones in some. The Global Observer program continues to go well. Airframe fabrication has started and propulsion, payload and control system development and testing continues successfully. We are continuing to work with our customer as they exercise contract options with funding.

A major milestone was achieved in Q3 with Switchblade’s successful end-to-end customer demonstrations during the quarter. These tests demonstrated Switchblade’s unique set of capabilities, high mission value and effects capabilities that do not currently exist in any other system. We believe these unique capabilities will be attractive to a number of defense customers.

We have seen active interest from a growing number of customers develop from the demonstration of our initial ground launch configuration of Switchblade. Two new customers have already funded demonstrated for their own, somewhat different applications of Switchblade and we are in similar discussions with other customers. We are optimistic about the significant potential of this development but we do not yet know when, what customers will make what decisions on Switchblade acquisition, a case in point of the unpredictability and the timing of innovation adoption.

We also made good progress on our Stealthy, Perch and Persistent Stare UAS and our Nano Air Vehicle Development programs for DARPA. Active interest in our small unmanned aircraft systems continues internationally but the economy has stretched out non-U.S. acquisition decisions. As these international defense budgets are addressed over the coming months we believe that one view the customer will consider is that small UAS can provide an 80% solution to ISR requirements, often at less than 10% of the cost.

Before we move on to discuss our Environmental Systems business there continues to be a great deal of speculation regarding how the Obama Administration’s defense and spending priorities may affect defense contractors. I would like to take a moment to address these concerns as they might affect AV.

Targets have been set for drawing down troops in Iraq and commitments have been made to increase troops in Afghanistan. We believe that the underlying customer demand for our small UAS is driven by plans to equip all U.S. ground forces with this capability at a certain organizational level of use. Our customers do not view small UAS as a tool that is useful only in Iraq or Afghanistan but rather as a tool that our ground forces require wherever and wherever [sic] they operate and train.

As a result, we do not believe that the Iraq draw down will reduce planned procurement quantities for our small UAS. Moreover, given that the initial demand for small UAS began in early 2002 in Afghanistan where U.S. forces were successfully employing our [Corier] system to provide situational awareness to isolated teams in rugged terrain, we see compelling benefits for the continued or expanded use of small UAS as operations increase in that country.

The part of our UAS business that is more sensitive to Ops tempo is the repairs and small parts services that we sell to our customers in support of the systems they use. If the total number of Raven flight hours increases, for example, we would expect more spare parts and repairs. If total flight hours decrease we would expect a reduction in spare parts and repairs. Since our forces train when they are not fighting and the total number of systems acquired continues to grow we do not expect spare parts and repair services to go away.

We have heard and read statements from the Obama Administration including from Secretary Gates that reflect a recognition of the importance of unmanned aircraft systems in the current threat environment. We also take note of President Obama’s stated intent to increase competition for Defense programs and to move more towards fixed price contracts. As a reminder, each of the four U.S. DOD programs of record for small unmanned aircraft systems that we have won have been through full and open competition with other major Defense contractors competing. In addition, our small unmanned aircraft system procurement contracts are fixed price so we are experienced and comfortable operating in this type of contracting environment.

In fact, we typically show higher margins on fixed price contracts than on cost-plus contracts. Time will tell how the administration’s policies affect our UAS business but I continue to believe that we are very well positioned with relevant, high performance, reliable and cost effective unmanned aircraft systems solutions that are continuing in high demand.

Now, shifting to our Efficient Energy Systems business. We believe we are maintaining our leading percentage of fast-charging market share. We have also moved to address broader market opportunities in an effort to increase PosiCharge revenue which has the potential to offset some of the effect of the Electric Lift Truck capital market decline. We introduced two new PosiCharge product line extensions in January that will expand our addressable market. These new opportunity chargers will increase the productivity of customers that have lower duty cycles and don’t need full capabilities of fast charging.

Preliminary results from our new Toyota Material Handling Distribution relationship launched in September are encouraging. This partnership addresses a much larger share of North American market opportunity that we previously had access to. We installed PosiCharge systems in the first customer facility sold through the Toyota channel this quarter and it reinforces our belief that this partnership will deliver significant benefits for our customers, for Toyota and their distributors and for AV.

Electric Vehicle Test systems demand is strong, driven by over two dozen battery, electric vehicle and plug in hybrid electric vehicle development programs globally. We continue to expand our customer base and our product offering. Demand also appears to be growing for our other electric vehicle solutions in customer funded developments. This interest in our technology solutions is being driven by the many vehicle development programs active around the world and by the new U.S. government emphasis on supporting the development of electric vehicles and the recharge infrastructure to support EV adoption.

The recent federal stimulus bill accelerates numerous opportunities for our electric vehicle and clean energy solutions and we are engaged at multiple levels to determine where our solutions can best provide the greatest impact. We believe we have unique capabilities to provide fast charging infrastructure that can enable adoption and practical use of electric vehicles but the long-term implications will ultimately be determined by consumer decisions on the adoption of electric vehicles.

With that as an overview of our business, Steve Wright, our CFO, will now review the financial results.

Stephen Wright

Thanks Tim. Good afternoon everyone. Revenue for the third quarter was $52.2 million, an increase of 8% over third quarter prior year of $48.5 million. By segment, UAS revenue was $43.4 million, an increase of 3% over the prior year. Growth in UAS revenue was largely due to higher customer funded R&D and higher product deliveries offset by lower services.

The increases in customer funded R&D and product revenues were largely due to increased activity on the Global Observer contract and product deliveries to international customers respectively. The decrease in services revenue was primarily due to higher revenue in prior years for the retrofit of Raven A to Raven B.

EES revenue was $8.8 million, an increase of 39% from Q3 of last year primarily due to higher deliveries of EV test systems.

Turning to gross margin, gross margin in the third quarter was $16.7 million, down 16% from Q3 of last year. Gross margin as a percent of revenue was 32% versus 41% in Q3 last year. By segment, UAS gross margin was $13.5 million, down 23% from Q3 of last year. As a percent of revenue, UAS gross margin was 31% versus 41% in Q3 last year. The decrease in gross margin rate was largely due to lower revenue on cost site contracts due to reduced indirect rate application and higher program costs. EES gross margin was $3.2 million, up 37% from Q3 of last year. As a percent of revenue EES gross margin was 36% versus 37% in Q3 last year.

SG&A for the quarter totaled $8 million or 15% of revenue versus $8.2 million or 17% of revenue in the prior year. SG&A expense was lower primarily due to lower selling costs. R&D for the quarter was $4.6 million or 9% of revenue compared to the prior year amount of $3.7 million or 8% of revenue. Operating income for the quarter was $4.1 million or 8% of revenue. Operating income was 48% below Q3 prior year primarily due to lower gross margin and higher R&D partially offset by lower SG&A.

Net income for the quarter was $4.5 million or $0.21 per fully diluted share compared to $6 million or $0.28 per fully diluted share in the same quarter last year.

Moving quickly through our year-to-date results. Revenue for the first nine months was $171.6 million, up 13% from the prior year period of $151.4 million. UAS revenue was $145.9 million, up 12% from the prior year period. EES revenue was $25.7 million, up 24% from the prior year period. Gross margin for the first nine months was $62.2 million compared to $55.6 million in the same period a year ago. Gross margin as a percentage of revenue was 36%, a decrease of one percentage point from the prior year. By segment, UAS gross margin was $50.1 million, up 3% and EES gross margin was $12.2 million, up 72%.

SG&A for the first nine months totaled $23.9 million or 14% of revenue versus the prior year period of $24.5 million or 16% of revenue. R&D for the first nine months was $14.8 million or 9% of revenue versus $11.8 million or 8% of revenue in the prior year. Operating income for the first nine months was $23.6 million or 14% of revenue. Operating income increased 22% from the prior year.

The effective tax rate for the first nine months was 25.4%, down from the prior year of 33.3%. This tax rate reflects the release of FIN48 tax reserves set up in prior years for the R&D tax credits.

Net income for the first nine months was $18.4 million or $0.84 per fully diluted share versus $15 million or $0.70 per fully diluted share last year.

Looking at backlog, funded backlog at the end of the third quarter was $139 million, up $57 million or 70% from April 30, 2008.

Turning to our balance sheet, cash equivalents and investments at the end of the third quarter totaled $130.6 million, up $5.9 million from our prior quarter amount of $124.7 million. The positive cash flow was largely due to income and working capital partially offset by capital expenditures.

Investments at the end of the third quarter were $28.6 million, an increase of $20.6 million from the prior quarter primarily due to increased purchases of T-Bills with maturities greater than 90 days. Our holdings of auction rate municipal securities which totaled $8 million at par have remained unchanged from the previous quarter. We have, however, recorded a temporary impairment charge for these securities of $0.9 million based on fair value accounting using discounted cash flow.

Turning to receivables, at the end of the third quarter our accounts receivable including unbilled receivables totaled $53.2 million, down $2.9 million from the prior quarter. Total day sales outstanding were approximately 92 days compared to 77 days at the end of the prior quarter. The increase in DSO is caused by the timing of our revenues which were concentrated towards the end of the quarter.

Taking a look at our inventory, inventories were $20.4 million at the end of the quarter compared to $19 million at the end of the prior quarter. Days in inventory were approximately 52 days versus 42 days at prior quarter end.

Turning to capital expenditures, in the third quarter we invested approximately $3.2 million or 6% of revenue in property improvements and capital equipment.

Now I’d like to turn things back to Tim to discuss expectations for the balance of the year.

Timothy Conver

Thank you Steve. As I indicated earlier we anticipate another strong fourth quarter this year. However, a number of factors have built up over the last three months that limit our ability to catch up to prior growth expectations for fiscal year 2009. Pressure on capital spending is depressing PosiCharge sales and delays of some small UAS buys in international contracts, preclude some revenue we had planned in Q3 and Q4.

Global economic conditions represent an overhang that may yet affect our business in ways we do not currently anticipate. As a result, we are revising our revenue guidance to reflect anticipated full year revenue between $240-250 million, or a growth rate between 11-16% over fiscal year 2008. This is down from the 20-25% growth we communicated at the beginning of the fiscal year. We still expect to achieve our previous operating margin guidance of 12-14%.

I am disappointed that we must revise our guidance for the year which is inconsistent with our history. I balance that against evidence supporting attractive long-term growth prospects and our not insignificant year-over-year growth expectations in an otherwise challenging environment. We provide solutions that really matter to our customers and we are developing entirely new solutions that promise to develop even more capabilities. We have a strong financial foundation and the best team anywhere to man the rigging as we navigate through this economic storm.

Our Q3 2009 produced a record backlog of orders and significant development milestones that have been very well received by our customers. I have never been more optimistic about our long-term growth prospects tempered only by the overhang of economic unknowns. I believe Global Observer and Switchblade represent significant potential to catalyze future growth and the probability that Electric Vehicle Solutions could also drive significant growth is increasing.

My thanks to our team members, customers, suppliers and investors for your ongoing commitment to our mutual success.

Steve and I will now open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Michael Lewis – BB&T Capital Markets.

Michael Lewis – BB&T Capital Markets

This is the first major deferral I have seen in a program of record in UAS since I’ve been tracking that segment for the last 4-5 years. What are the customers saying? What steps are they taking to get the procurements back in motion? Just a final question, if we didn’t see this deferral come into play where would you have posted revenue in that side?

Timothy Conver

I suspect you are referring to the orders that we indicated we expected in Q3 that were deferred. A couple of reasons I think. In the first place, it is not a…I wouldn’t characterize it as a deferral of a program of record such as in one case we believe our customer is just holding off the procurement because they want to wait for Digital Datalink to be available in production rather than buy current analog systems they then would intend to retrofit. So I think there is a balancing there. In a few other cases I think it is a matter of customers that are very attracted to and want to acquire some systems that are not under program of record and as a result they are still in the process of getting their financing together.

Stephen Wright

I would add to that in the quarter the normal ebb and flow of our orders some of that was expected. No programs of record were deferred, just a number of smaller opportunities along with lower PosiCharge, international SUAV was lower than we expected and as Tim mentioned we have had some reduced project revenue because of lower hiring. We didn’t guide Q3 but I will say we were probably expecting a Q3 some place in the mid $60 million.

Michael Lewis – BB&T Capital Markets

When we start to see the progression of DDL upgrades moving into the mix here will this be a considered a production upgrade with regard to the P&L or is this a servicing upgrade? The reason I am asking is I’m trying to reconcile what the margin implication will be from the difference from production to servicing. Can you help me understand how that will work?

Timothy Conver

We have yet to define that but my thinking is the DDL contract that was led includes new systems and retrofits. Both are fixed price for the majority of that contract. It is fixed price. I expect the retrofits the way they will be done will be classified as services just like the Raven A to B was services last year and the new systems would be product.

Michael Lewis – BB&T Capital Markets

One more question about the tax. I noticed the negative tax. If we back out, assuming a 35% rate in the quarter that is a variance of $1.7 million. Is that all tax R&D credits in the quarter or is there something else going on there?

Stephen Wright

The major effect there is the release of the FIN48 reserves. We did actually define them at the time of the 10K. They relate to the expiration of the statute of limitations for the years that those reserves were established. The statute of limitations ticked off in January and so we released those reserves about $1.3 million. That is virtually all of the variance that takes us down to about a 25% year-to-date rate. The current period is just what gets us to that year-to-date rate.

Operator

The next question comes from Brian Gesuale – Raymond James.

Brian Gesuale – Raymond James

I wanted to dig into contract services. I’m wondering if you can give us a little bit of help on the expected run rate going forward. Is it in the $22 million, $28 million range or somewhere in between? Also talk about the margins if you have a little color on what dinged the margins and how one-time in nature they are as we go forward?

Stephen Wright

In terms of guiding on elements of the P&L we typically don’t do that. Tim may talk a little bit about services going forward. I can say that services were low in the quarter certainly compared to the prior year end and compared to the prior year on a year-to-date basis because we had the Raven A to B upgrades in last year’s services number and those were large. In terms of the margins, for the quarter we were at 32%, down six points sequentially. In UAS they are down from 35% to 31%. Three points of that or the majority of it is due to an indirect rate change we had that reduced the margins on our cost-plus business of about $1.4 million. The balance is in EES. You can see that going down from 54% to 36% which is something that is going to change over time as we have indicated in previous calls because it really depends on the mix of orders that we fill in the quarter.

Brian Gesuale – Raymond James

Maybe you can give a little bit longer term; obviously you have reigned in guidance this year based on what seem to be some short-term phenomena. You have record backlog and several new products you expect to hit over the next 12-18 months. Is AeroVironment still a 20-25% growth story going forward or is this something that this bump in the road made you reconsider what the growth targets are?

Timothy Conver

I don’t see any change in our long-term view of the growth prospects for the company. Our current planning process first re-looks at a 3-5 year look out and then we refine the first year of that plan in our annual operating plan. We are in that process now. We would expect to provide guidance for FY10 in our fourth quarter call. If anything, I am more and I think there are stronger reasons to support our long-term growth thesis from my perspective than there ever have been based on things like Digital Datalink transitioning to production, the real successful demonstration of Switchblade and the ongoing support and success of the Global Observer program. In that aspect, elements of the quarter were very supportive of our long-term growth expectations.

Brian Gesuale – Raymond James

On Switchblade it sounds like the activity and the opportunity is perhaps larger than what you had anticipated. Is this pushing to the right a little bit and what should we expect in terms of a full production decision timeframe?

Timothy Conver

I think the Switchblade and the ambiguity around timing is a poster child for the adoption of new technology and innovation. As I have mentioned before this is really an entirely new capability and it has been very positively received both by the initial customers that funded the current demonstration and by a growing array of additional customers that have now become aware of this and are getting increasingly interested. Two years ago it was on no one’s radar screen. One year ago it was on virtually no one’s radar screen. So when the current DOD budgets were put into place nobody in DOD anticipated the availability of this capability.

So now with a large number of customers looking at it as a very attractive capability they have to then decide how to fund it and what that process would be. So that is what the timing ambiguity is about and a little more explicit I think once the first customer enters into a full rate production intent we will be in the same kind of a process that we have been in all of our programs of record for small UAS. Typically that has been I think 11 months in the case of Wasp and about 14 months for Raven from initial contract to full rate authorization. Probably a little bit longer for Switchblade because of the addition of the munitions, maybe 18 months. That doesn’t preclude earlier orders of hardware prior to full rate production configuration. We have seen that in most of our other programs in the past.

Operator

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

Chris Donaghey - SunTrust, Robinson, Humphrey

Just to follow-up on the quarter, with the orders you saw slip and the timing issues can you give us a relative feel for how much…would you have been much closer to the 20-25% if you hadn’t seen some of the slippage this quarter? Is this really just a timing issue or has there been a segment of the customer, especially on the foreign side, that you just think is going to be in a perpetual deferral until the economy turns around?

Timothy Conver

Let me go back to those four categories and see if I can’t break those down a little more. One is what we are seeing as an economy driven effect. In the case of PosiCharge sales I think that is just literally a dramatic reduction in the capital acquisition of forklifts and a relatively smaller but still an effective reduction in our PosiCharge sales. I think that has happened and that is the way that is.

The other economy effect from our perspective is this precipitous slow down in procurement from international military customers. I believe that is directly an effect of just a lot of uncertainty in many other countries on their military budgets. In some cases they have already been cut and in other cases they are going to a re-evaluation. Once they settle down on what their real budget is then presumably they will be reallocating what their procurement intents are.

Having said that, I think we are still in a good position there. I know there is strong interest in many countries in this capability and when the issue is a constrained budget we do provide ISR, the classic 80% solution at 10% to cost and I think that could turn out to be good for us relatively in the longer term. We won’t know that until we see it.

Changes in the timing of U.S. government procurements I think are all just timing related. I don’t think anything went away. I think some of them are delayed.

Chris Donaghey - SunTrust, Robinson, Humphrey

So then as we look forward can you just walk us through what the timelines look like in terms of Digital Datalink going into full rate production, Puma AE going into full rate production, acceleration of Global Observer and I think Switchblade may be a little bit further out but those three in particular as we go into 2010?

Timothy Conver

Let me start with Digital Datalink because that is the most definitive. We already now have the LRIP contracts that will take us into full rate production. I think that is going to start delivering those in the second half of 2010 probably when the Q2 and Q3 when we will realize most of the revenue from those initial contracts and I think in the latter part of 2010 we will begin to deliver production, Digital Datalink retrofits.

Of course that is ultimately going to be gated by full rate production approval by our customers. This is a class I change so it gets treated much like a new procurement. Barring any unforeseen hiccups there that is the timing we expect. So the risk on the downside is something happens with the schedule of the testing or something that might push that out a little. On the other hand there could be a desire on our customer’s part to accelerate the change over in which case we will of course do everything we can to pull those in.

Moving to Puma AE that was the second program you questioned. To our knowledge the initial evaluation and initial testing of that system has been very positive. I think we not unusually have a couple of things that have popped up in our customer’s testing that we need to modify for them but we don’t see any problems in doing that. I think we are very optimistic about the excitement in the customer community for adopting this and I would expect we would see additional orders early in the year for Puma AE.

Global Observer, that is as you know a 3-year program. It started in September 2007. We are well into that and going extremely well from my perspective. I expect we will be in flight testing in the second half of our fiscal year upcoming. I don’t expect to see major new order decisions on that before we are well into our testing and military utility demonstration. Our customer base has a propensity to fly before buy.

I guess did I cover that? You also wanted to talk a little bit about Switchblade. I think there is more uncertainty on timing there just because of the points I made talking to Brian. I would not be surprised to see strong customer interest turning into more orders in FY10. It is just really hard to determine how, what…there is a number of different customers and a number of different procurement approaches they could take. I know they are actively making those decisions as we speak. I am optimistic but I don’t want to lay down any specific timeframe because I just don’t have enough data.

Chris Donaghey - SunTrust, Robinson, Humphrey

I’m just trying to figure out over the next couple of quarters should we anticipate based on what you are seeing with DDL in particular lower than what would be average revenue growth for a couple of quarter’s before things start to accelerate when DDL goes into full rate production? Can you help us with the visibility you are seeing on at least a qualitative basis for the next couple of quarters?

Stephen Wright

I think there we really have to punt and say we have talked about the balance of the year. You have Q4 and we have to wait until we give our next guidance on the Q4 call.

Operator

The next question comes from Tim Quillin – Stephens Inc.

Tim Quillin – Stephens Inc.

I have a series of easy questions. First of all, the lightening round. Number one what was government funded R&D in the quarter?

Stephen Wright

Customer funded R&D was 32% of revenue.

Tim Quillin – Stephens Inc.

About flat quarter-to-quarter in dollar terms?

Stephen Wright

$16.8 million, up from $16.1 million in the previous quarter.

Tim Quillin – Stephens Inc.

It is hard to kind of get into this number but it looks like if you exclude that out of your service line the other UAS service has declined a lot?

Stephen Wright

Yes. I tried to answer that earlier. The pure services was about $5.2 million for the quarter, about $33 million year-to-date. That is down from the prior year. A couple of programs in there, but by far the largest effect is Raven A to B which ran through services last year.

Tim Quillin – Stephens Inc.

I was just looking at it quarter-to-quarter.

Stephen Wright

Quarter-to-quarter I think you have to take it a little bit with a grain of salt. Quarter-to-quarter a lot of it depends on how much backlog we have at the time and what makes sense for the factory to work on.

Tim Quillin – Stephens Inc.

So that number could bounce back up in the fourth quarter?

Stephen Wright

It very well could. I’m not going to predict that but it very well could. I think year-to-date looking at that it is a little more relevant and again the same explanation. The A to B conversion is making 2008 much higher.

Tim Quillin – Stephens Inc.

I got a little off track but my second question is the Army progress towards their 1,900 Raven goal.

Stephen Wright

First of all I want to update that goal. We have been told the goal is not 1,900 systems. It is now 2,182 systems. It has grown by 134 which is administrative. They are now including [USOC] in their number. The progress against that is we are 49% delivered against that. We delivered 79 systems to the Army in the quarter.

Tim Quillin – Stephens Inc.

Tax rate for Q4? Should we be looking for 34%?

Stephen Wright

No. I think somewhere around 30% for the full year and then I’ll let you back into it based on our year-to-date.

Tim Quillin – Stephens Inc.

How about for fiscal 2010?

Stephen Wright

At this time I’d like to wait until we do our next guidance.

Tim Quillin – Stephens Inc.

The indirect rate variance on the cost-plus contract you referred to was that just kind of a one quarter variance and you’ll get the costs in line now?

Stephen Wright

I guess I would say as a government contractor we use indirect rates based on full year estimates to bill and recognize sales on cost-plus programs. We have these rate changes periodically. We have had them in the past. It is part of doing business. This period because of the low volume and the amount of the rate change, $1.4 million it ends up being not an unusual transaction by itself.

Tim Quillin – Stephens Inc.

My only other question, I think we covered a lot of your products but on Wasp. What is happening there in the Marine Corp and what the Air Force is doing and what you think the Army might do on Wasp and when that might happen?

Timothy Conver

The Wasp as you know was a product that we won the Air Force program of record competition with almost two years ago. So the Air Force has continued to buy according to their initial plan on that contract. Shortly after we won that the Marine Corps acquired a number of Wasp systems on an urgent need statement that they deployed down at the platoon level.

A number of other customers are evaluating the adoption of Wasp and I think those customers you mentioned all see a significant benefit to them in adopting that and want to do that. I think for the most part those customers fall into the category of intended purchasers that don’t have a current program of record that covers this and therefore they are still putting funding together and procurement mechanisms that would enable them to buy. That is part of what has been going on recently in some delays in orders we had expected. I still think they intend to do that. They are just putting the funding mechanisms together.

Operator

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

Michael Ciarmoli – Boenning & Scattergood

On the contract service revenues in general, $5 million, last quarter was the weakest I think you have had in about six quarters. This quarter was even weaker. Is there anything to read into this? We are going to have an obvious wind down in Iraq. You would think with the most usage out there you should be driving substantial levels of services. Do you see any structural change from your ongoing services of the various systems that are deployed in the field and could this line item trend lower as Iraq winds down and maybe Afghanistan there is that transitionary phase before a full ramp occurs?

Timothy Conver

I don’t think there is a…I wouldn’t characterize it as a structural change. Qualitatively here, I think the biggest effect in the relative difference overall is the factor Steve was talking about where a year ago we had very high revenues in that services category that were associated with the Raven A to B upgrade that was run through the services contract. If the Digital Datalink retrofits we anticipate next year go through that same process which as Steve indicates is currently our best guess then you would see the same kind of surge in revenues under the services area. That product improvement cycle has always been one of the five revenue drivers we have anticipated in our UAS business.

Michael Ciarmoli – Boenning & Scattergood

Can you talk about just general service for planes exceeding their average hours or hours flown requirement? Do you have visibility into that line item and how those revenues are performing or are you just looking more at kind of the product improvement service revenues?

Timothy Conver

We do have some visibility. I will give you some color at least and then I will turn it over to Steve who will talk about real numbers. A couple of things to be aware of is when our customers buy spare parts they do that on a forward-looking basis. So they are anticipating what their future needs are going to be and then they are putting orders in and then months later we are delivering against those orders. Since we operate as the repair depot we hold that inventory and then we use that when they send systems back that need repair.

There is by definition the timing of the actual requirement for repairs is unlinked from the date that they are ordered and actually the date we sell the spares initially. That is one factor that might distort how you see that on a temporal basis.

There is another factor that we think might be at play here and that is with the high level of Raven A to B upgrades last year and then the retrofit that we did to put the new frequencies in place early this year we ended up putting a lot of new hardware improvements or replacements into hardware from the field which probably had the effect of reducing the operational life of systems that are being used and helping out the near-term operational availability.

That is all qualitative things that are going on none of which indicate any underlying structural change.

Michael Ciarmoli – Boenning & Scattergood

You mentioned also some of your project related revenues were down because of a lack of employees. Can you point us to specific projects you are working on or how quickly you anticipate filling these vacancies? Is there any shortage in talent out your way?

Timothy Conver

A requirement for more great people has been a hallmark of our history for the last 5-6 years with the sustained growth in the business that drives sustained growth in employees. The only way we keep the extraordinary level of team performance that we have is to keep hiring extraordinary people.

We have been really successful at that over time and right now we just have a large number of outstanding requisitions. We had a very successful job fair last month addressing open requirements in the Monrovia operation, primarily for our EES segment and that was so successful we are going to use the same process soon in Simi Valley with our UAS business.

A number of those open requirements are in engineering and engineering skills address both the operational business, our internally funded R&D operations and our customer funded development programs. The same teams that work on IR&D tend to be the same skill sets of people that work on customer funded development. So when we are trading off scarce resources against those two requirements that ends up doing less work than we had planned. We talked last quarter in the call, for example, about accelerating our internally funded R&D and our G&A investments that we thought were great opportunities to support our future growth and improve our competitive position and you will see in the numbers we were pretty flat in those areas mainly because we are reallocating those skill sets to meet customer development programs and even with that we fell behind on some of that revenue on customer development programs.

The biggest one is Global Observer but we have a number of other development programs in the UAS business as well as a number of customer funded development programs around primarily Electric Vehicle Solutions. A broad number of programs that all add up to maybe 10% of the revenue miss that we are anticipating for the year.

Michael Ciarmoli – Boenning & Scattergood

The other day on the Federal Business Opportunities Website it looked like there was a pre-solicitation posted by the Naval Surface Warfare Center citing that AeroVironment was going to deliver one air vehicle communications model. It mentions Raven B, Wasp, and Switchblade. Can you elaborate on what that might be used for? I’m just reading into it a little but further, the first reference of Switchblade out there. I think it references it for maybe 36 months. Is there anything you could say about that?

Timothy Conver

I’ll tell you what I know which may not be a lot. I think that is the Marine Corps looking to develop a common ground control system that would enable their ground robots to communicate and work in conjunction with small unmanned aircraft systems. I think that is the basis of that program they are pursuing. I think in the process they are recognizing we already have established a de facto common ground control system for a multitude of small UAS that they use and that other services use. The Datalink in that ground control system is probably the right solution for a broader common ground control solution.

I think that is the essence of that and beyond that the fact they are referencing Raven and Wasp and Switchblade I think is an indication of where a number of our customers are beginning to change the way they think about small UAS. This is still, as I said in the past, in my perspective in the early stage of adoption. So where we initially had Pointer and then that was replaced at the Marine Corps by Dragon Eye which was then replaced at the Marine Corps by Raven, kind of a linear progression of platforms, we now have a situation where there is a common ground control system with common Datalink and user interface and three production small UAS airplanes, Wasp, Raven and now Puma AE.

Each one of those platforms has a different set of capabilities and as they begin to anticipate Switchblade in the future that will also operate off that same ground control system and Datalink, some customers are starting to look at this more as a family of systems with a common infrastructure and different platforms that are applicable to different mission sets.

Operator

The next question comes from Troy Lahr – Stifel, Nicolaus.

Troy Lahr – Stifel, Nicolaus

Given the surge in Afghanistan what are you hearing from the customer? Are they telling you they are going to need to ramp up here? Do you guys need to ramp up? I would assume you are starting to have discussions regarding the surge?

Timothy Conver

There is not a lot of active dialogue right now. I think our customers are making their internal trade off’s and I think they are keeping their powder dry relative to discussions with contracts at least from our perspective. As I mentioned in the comments earlier, Afghanistan was where the initial huge success of small UAS was recognized and the acceleration of adoption throughout DOD was initiated. We would expect that terrain and that very highly distributed operations strategy will be conducive to continued use and high value there. But whether that accelerates or not I think will be a function of how our customers decide they are going to operate and that is still in the planning process.

Troy Lahr – Stifel, Nicolaus

Of the service sales you had about $22 million. How much of that, I think you account for Global Observer in that service since it is R&D if I am not correct. Can you maybe break out how much of that ballpark is Raven service related to Iraq and Afghanistan?

Stephen Wright

The project revenue which is embedded in the services and when you get the Q you will see the project revenue in a footnote, is $16.8 million which leaves the pure services at $5.2 million and I don’t have tracking below that to say how much is due to Raven in Iraq per se.

Timothy Conver

Our customers literally do not keep track at that level in the field. You are probably used to a lot more specificity in maintenance and repair documents for larger aircraft systems but these systems uniquely are used by ground troops who are literally in the fight and they just aren’t filling out a lot of paperwork.

Troy Lahr – Stifel, Nicolaus

Can you maybe help me understand, I just want to kind of circle back on the margins a little bit. It looks like if you want to go year-over-year that is fine but it looks like you had a lot more product sales this year compared to last year and that is higher margin work. I would have thought your margins would have benefited a little bit from a favorable mix this quarter. Can you help me understand that? Isn’t products mostly the higher margin work and services is generally lower margin cost-plus type work?

Stephen Wright

It can be. I think the easiest way, if you want me to go year-over-year the easiest way for me to talk to it is by segment. The large drop in UAS from 41 to 31 I would point to first of all the 41 last year was sort of out sized. That was the peak of the year and UAS came in at around 36% or 37% which is more typical. So I would say the mix of work last year just tilted very heavily towards the high side. Then we had this maybe three points of rate adjustment in the current period I talked about. EES is generally flat with last year. Sequentially as I indicated earlier EES is below where the kind of margins we have enjoyed in the last two quarters and that literally is going to bounce around every quarter based upon the mix of products that we are shipping that are all PO’s, all fixed price.

Troy Lahr – Stifel, Nicolaus

If you look at the growth this quarter year-over-year UAS plus 3% it looks like I guess just taking the mid point of your range you might be calling for back to double digit growth, a stronger recovery in the fourth quarter at UAS. What gives you confidence that these deferrals and the revenue stream starts picking back up and we see more meaningful growth at UAS so soon in the fourth quarter?

Timothy Conver

Our greatest confidence is the funded backlog of $139 million which is pretty much all UAS. Not to say we will work off all that backlog in the quarter. That backlog comes with delivery dates and it is staged but that is really where we will get most of our deliveries for the quarter.

Troy Lahr – Stifel, Nicolaus

On cash flow, what was cash from ops this quarter? I don’t know if you already said that.

Stephen Wright

No I didn’t. Cash flow from operations was $9.6 million and capital expenditures were $3.2 million for a free cash flow of $6.4 million.

Steven Gitlin

With that as our final question we thank you all for your continued attention and interest in AeroVironment. We remind you that an archived version of this call, all SEC filings and relevant company and industry news can be found on our website at www.AVInc.com. We look forward to speaking with you again following next quarter’s results.

Operator

That concludes today’s conference. You may disconnect.

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Source: AeroVironment, Inc. F3Q09 (Qtr End 01/31/09) Earnings Call Transcript
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