Herley Industries, Inc. F2Q09 (Qtr End 2/1/09) Earnings Call Transcript

Herley Industries, Inc. (HRLY)

F2Q09 Earnings Call

March 13, 2009 9:00 am ET

Executives

Anello C. Garefino - Chief Financial Officer

Myron Levy - Chairman of the Board, Chief Executive Officer

Jeffrey L. Markel - Chief Operating Officer

Analysts

[Unidentified Analyst - Stephens Inc.]

James Foung – Gabelli

Sam Bergman – Bayberry Asset Management

George Register - Register Financial

Presentation

Operator

Good morning. At this time, I would like to welcome everyone to the Herley Industries second quarter earnings conference call. (Operator Instructions)

Mr. Garefino, you may begin your conference.

Anello C. Garefino

Thank you, Keshon. Good morning and welcome to Herley Industries second quarter fiscal 2009 conference call. Joining me for today's conference call are Myron Levy, Chairman and Chief Executive Officer, and Jeff Markel, our Chief Operating Officer.

As our first order of business I will review our safe harbor statement. All statements other than statements of historical fact included in this discussion and analysis of our financial condition and results of operations are forward-looking statements. Forward-looking statements involve various important assumptions, risks, uncertainties and other factors which could cause our actual results to differ materially from those expressed in such forward-looking statements.

In this presentation, such forward-looking statements can be identified as words such anticipate, believe, could, estimate, expect, plan, intend, may, should or the negative of these terms or similar expressions. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, performance or achievement.

Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors, including but not limited to competitive factors and pricing pressures, changes in legal or regulatory requirements, cancellation or deferral of customer orders, technological changes or difficulties, as well as difficulties in the timely development of new products or in the manufacture of such products, commercialization and trade difficulties, and current economic conditions, as well as factors set forth in our public filings with the Securities and Exchange Commission.

I would also like to refer our listener's to the company's 2008 annual report on Form 10-K for the fiscal year ended August 3, 2008 for additional comments related to risk factors as well as to our recently filed 10Q for a discussion of the results of the second quarter of 2009.

And now to some of the highlights for the quarter. We have seen significant improvement in some key metrics in the second quarter, including net sales, gross profit margins and operating income. Our net sales from continuing operations in the second quarter were approximately $40 million as compared to $32.1 million in the second quarter of fiscal 2008. This is an increase of $7.9 million or 25%, and approximately $75.3 million as compared to $64.7 million in the first half of fiscal 2009, an increase of $10.6 million or 16%.

As reported in the first quarter of '09, we completed the acquisition of the business of Eyal Industries in Kibbutz Eyal, Israel. For the first full quarter and the five months to date of fiscal 2009, Eyal had net sales of $5.1 million and $8.4 million, respectively, and operating income of $0.2 million and $0.3 million, respectively.

As we previously reported, the sale of ICI was completed on November 10, and ICI is now reported as discontinued operations in our year-to-date results of operations as a loss from discontinued operations of $456,000. We sold ICI for approximately $15 million in cash, of which $750,000 is held in escrow as security for certain indemnification obligations. We repaid $14 million of our bank line of credit from the proceeds of the sale of ICI. We had $21.5 million outstanding under our line at the end of Q1 and we now owe $5 million under the line of credit.

Our gross profit margin from continuing operations in the second quarter was 24.2% compared to 18.7% in the first quarter of fiscal 2009 and to 16.9% in the second quarter of fiscal 2008. Contributing to the improvement in our gross profit margin is an increase in gross profit of approximately $1.8 million at Herley Lancaster driven by higher sales volume achieved through improved productivity, improvement in supplier quality, and manufacturing throughput relative to the second quarter of last year.

A gross profit increase of approximately $1.2 million at MSI is largely driven by favorable sales mix related to shipments of an avionics suite for a supersonic sea-skimming target and to lower R&D spending. Gross profit of approximately $1 million is attributable to the acquisition of Eyal, which was completed during the first quarter of the current fiscal year. And finally, an increase in gross profit of approximately $0.8 million at Herley New England related to favorable sales mix and manufacturing efficiencies.

Partially offsetting these increases was a decrease in gross profit at Herley Farmingdale of approximately $0.7 million due to reduced sales volume and manufacturing volume as their operations continued to transition to other Herley manufacturing sites, as well as an increase of $0.5 million in a reserve for loss on a contract. The closure of this facility is now essentially complete.

Income from continuing operations before income taxes for the 13 weeks ended February 1 was $2.1 million versus an operating loss of $2.6 million for the 14 weeks ended February 3, 2008, an increase of $4.7 million. This improvement mostly results from sales volume gains at Herley Lancaster driven by productivity and supply chain improvements, the favorable sales mix at MSI and Herley New England, and the accretive impact of the recently acquired Eyal.

The income tax benefit related to continuing operations in the second quarter of fiscal 2009 relates to the carryback of unused research and development credits to fiscal year 2005. Our estimated effective income tax rate for fiscal 2009 is 22.9%, which is lower than the 35% statutory rate primarily due to the company's foreign earnings attributable to Israeli operations, which is taxed at an estimated rate of 10% for fiscal 2009 - which had the effect of reducing our income tax rate by approximately 6% - as well as the benefit from the carryback of unused research and development credits to fiscal 2005, which reduced the effective rate by approximately 5.5%.

Our basic and diluted earnings per common share from continuing operations for the 13 weeks ended February 1, 2009 were $0.16 per common share each as compared to basic and diluted loss per common share from continuing operations of $0.19 per share in the prior year's second quarter. The prior year's second quarter also included a loss of $0.09 per basic and diluted common share from continuing operations related to ICI.

Keshon, I'd now like to open the lines for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from [Unidentified Analyst - Stephens Inc.].

Unidentified Analyst - Stephens Inc.

Just a few housekeeping questions right off the bat. How should we look for sales and gross margin going forward for the rest of the year here for your guys? Should we expect a pretty decent pickup here and what's the order of magnitude of the increase, if any?

Myron Levy

We expect that our third quarter and fourth quarter volume will increase as we progress forward. The third will be better than the second, and the fourth is going to be better than the third. As Neil has mentioned, Farmingdale is completely closed, which had been a thorn in our side, and we've made other cost cuts in the company as well; some will be reflected in the third and fourth quarter. And we will have volume increases on the revenue side, so we'll get more absorption of the overhead. So we see continuing improvement as we go forward in the third and fourth quarter.

Unidentified Analyst - Stephens Inc.

And any ballpark expectations as to how much to expect for legal costs in the back half of the year here?

Myron Levy

Let me say where we are. Where we sit today in terms of legal, we still have the class action suit and the derivative suit. It's still out there. And the only other legal issue, which was discussed on a prior call, is the suit between us and Chubb, the insurance carrier, in connection with our insurance.

The class action suits are starting to heat up a bit. We don't see very significant charges in connection with the insurance suit, if you will. The class actions suits are really indeterminable. We don't see them anywhere near the magnitude of prior expenses prior to the settlement with the government at all, but they could be anywhere in the neighborhood from $60,000 to $100,000 in a month. But we really don't know; it all depends on, in this case, the plaintiffs.

Unidentified Analyst - Stephens Inc.

The other question being kind of just a little bit, I guess, more color on you guys' sale process here. I mean, you guys announced back in September that you guys kind of were working with Jefferies to kind of look at some strategic alternatives here. Why has kind of the process taken over six months now? It seems like a fairly long period of time for a deal of this size. Just kind of any color on that?

Myron Levy

Well, number one, I'm not going to comment on deal or no deal because we reported in September of '08 that we were hiring Jefferies to explore strategic alternatives for the company. We are still working with Jefferies today, and when there is something to announce to our stockholders, we will make that announcement at that time.

Operator

Your next question comes from James Foung – Gabelli.

James Foung – Gabelli

Just on the last point, was it in September that you engaged Jefferies or was it earlier than that?

Myron Levy

No, we had a release in September. It was the early part of September, Jim. And, by the way, I may add subsequent to that release remember we acquired Eyal and we also sold ICI.

James Foung - Gabelli

Right, right. Okay, I just wanted to confirm.

Myron Levy

Sure.

James Foung - Gabelli

And then what is Jefferies' fee structure?

Myron Levy

I don't think that's appropriate at this time to get into that as to what their fee structure is for any one of our vendors, if you will.

James Foung - Gabelli

And I guess do you have any kind of just type of timeframe when you think this process may be completed?

Myron Levy

Well, it's not a process. It's really as I said. I hate to be redundant, but I'm going to be. We're looking at the strategic alternatives and when there's something to report we will report it to our stockholders, Jim.

James Foung - Gabelli

And I guess just some questions on the quarter, then. Could you just comment on what your orders were for the fiscal second quarter?

Anello C. Garefino

Our bookings in the second quarter were approximately $34 million.

James Foung - Gabelli

$34 million?

Anello C. Garefino

Yes.

James Foung - Gabelli

And then the backlog is still a very high level here, which is really excellent that you're able to maintain those levels. Are the margins in the back like the gross margins higher than your existing business?

Anello C. Garefino

As Myron indicated, as we look to the third and fourth quarter, we expect the margins to continue to improve as we go forward.

James Foung - Gabelli

And then part of that is just coming from the higher margins in the backlog?

Anello C. Garefino

Well, our shipments will be coming out of the backlog and the margins in that backlog will be realized as we go forward.

James Foung - Gabelli

And then, Neil, you mentioned about Farmingdale being about a $700,000 hit to your earnings in the quarter. Is that the type of benefit we can expect - the remaining benefit from Farmingdale now that it's closed in the third quarter or do you see more benefits from that?

Anello C. Garefino

Well, I think we will be realizing savings from closure of the facility as we go forward. The magnitude of that, I'm not sure exactly how it will impact related to the $0.7 million, but we do expect it to have a positive impact as we go forward and reflected, as we indicated, in the increase in our gross profit margins.

James Foung - Gabelli

So that's kind of additive then? Okay. And then are there any other cost reductions that you're anticipating in the next couple of quarters?

Myron Levy

Well, we're constantly looking, Jim, at where we can save dollars, if you will, in all areas  in terms of purchasing, in terms of we'll continue to look at our personnel. And as I mentioned previously, we have eliminated personnel at various pieces of Herley already in December, January as well, which some of that will be savings going into the third and fourth quarter. And we will continue to look at that to eliminate personnel and costs as well.

James Foung - Gabelli

Myron, have you ever quantified or just put a sense around some of the savings that you can share with us?

Myron Levy

Well, I'll just tell you from a payroll standpoint we probably have savings on a consolidated basis somewhere in the nature of $1.7 to $1.8 million of payroll costs.

Anello C. Garefino

Again, that would be on an annualized basis.

James Foung - Gabelli

And then I guess lastly, at one point I guess you mentioned that when sales hit about $50 million per quarter you could do gross margins of about 30%. Is that still the right way of looking at it when we look at the business going forward?

Myron Levy

As the volume goes up at each of our operating entities - we have a lot of fixed costs. If you look at Herley and you look at our fixed and variable costs, most of our overhead that we have in our corporation - and let me give you very specific and let's take just one of those items called depreciation and amortization, it's approximately $8 million. Well, that's a fixed cost and as the volume goes up we're going to get more absorption of those costs and the gross margins will increase.

So in each operating entity where we expect - and we do expect, as we said for the volume to increase  we're going to get more absorption, which will increase our gross margins on a go forward basis.

James Foung - Gabelli

What do you think your variable margin is going forward in the next couple of quarters? Your incremental margin on your [next] dollar revenues? 

Anello C. Garefino

We haven't really analyzed that at all of our locations to give you some kind of consolidated number that would be meaningful at this point.

Operator

Your next question comes from Sam Bergman – Bayberry Asset Management.

Sam Bergman – Bayberry Asset Management

A couple of questions. Was there any missed shipments towards the end of the quarter that would have made that revenue number higher or not?

Myron Levy

Let me explain something about the business and the defense world, Sam, and I think it's important. What happens is in the defense world we build product which, after you build it and get it completed, we have to get approval of the customer and not only the customer, the U.S. government in many cases. In some cases you have slight discrepancies which is all in paperwork, etc. So at the end of any quarter we could have goods sitting waiting to just ship it that have been completed which don't get reported in that quarter; they get reported in the following quarter. And this happens all the time.

Let me give you a truism, if you will. The entire industry today, the whole defense industry  and by the way, there even are Senate hearings on this matter - is facing a problem that they call, and I'm putting it in quotes - "counterfeit parts." And all of a sudden you get a part they say this part produced by XYZ Company is a suspect part, it may be counterfeit, and then all of a sudden the customer comes in and says do we have any of that in my product? And if the answer is yes, they say well hold up the shipments, we've got to investigate, etc.

This is going on probably at every defense contractor in the United States. I don't know what they do in the foreign market, but clearly here in the U.S. As a result of that, that stops that shipment although it's completed, etc. They go through an investigation. There's traceability in many programs, where did you get it from. So those things can hold up shipments.

This is primarily in the defense world. You don't have this in the commercial world. But those are the things that we live under, all defense contractors.

So that just gives you an example which is a real problem today for the defense community.

Sam Bergman - Bayberry Asset Management

The next question, in terms of the pipeline, RFPs, how are they right now versus the prior quarter or actually the quarter last year?

Myron Levy

Well, we are quoting business consistently day in and day out. And let me respond to that by saying, sitting here today, since the end of our second quarter if you ask me, for example, what is your backlog as of today, I would tell you my backlog as of today is approaching $200 million, and that's because we have received orders in the third quarter on many of the long-term programs that we have, some of which we have announced to the public.

And so what I'm saying is we're constantly quoting, we're constantly bidding, we're constantly negotiating these type programs with our customers, and that's an ongoing process.

Sam Bergman - Bayberry Asset Management

Last question, still about the strategic alternatives. I'll make it real short. When you hired Jefferies in September for the strategic alternatives, what is the difference then versus the announcement that came out two days ago the company is up for sale and there's an option expected in the next month or so? Was that occurring in September or is that process just starting now?

Myron Levy

I can't comment on the announcement that came out. That was not put out by Herley.

Operator

Your next question comes from [Unidentified Analyst - Stephens Inc.]

Unidentified Analyst - Stephens Inc.

Just another quick follow up. Where do you guys expect the share count to be going forward? We're kind of looking at about a 15 million number here going forward. Is that a good assumption or not?

Myron Levy

Well, let me say, obviously our outstanding is approximately 13.5 million, but when you throw in and you talk about fully diluted, it all depends on market price to determine what our outstanding shares would be for a fully diluted computation.

Unidentified Analyst - Stephens Inc.

Any updates on the ERP implementation? Any further updates on that end or no?

Jeffrey L. Markel

As we've previously reported, the ERP system is operational at our Lancaster facility. As with any new system, as we utilize it we find opportunities to improve it. And so we're going through that process of real life operational use, finding opportunities to make the system better, finding opportunities to make our process better, and that's probably going to continue on through the rest of this fiscal year, then we'll probably have matured the system enough to be able to look towards bringing it in to the other facilities so that we have a single ERP system which we can use across all the business.

So it's up, operational and it's in an improvement mode right now.

Operator

Your last question comes from George Register - Register Financial.

George Register - Register Financial

There's been a lot of concern over military spending and how it's going to affect various contractors, and we've seen sell off in many of the defense stocks. I was just wondering as to how this might affect Herley from the standpoint of new business, etc., if they would be affected by any type of a cutback?

Myron Levy

Sure, George. Let me explain the way we see it or I see, if you will, and Herley sees it.

We can see that defense spending is not insulated from what is happening around the world, and I believe what we will see is some of the larger program - F35, as an example, I've said this in the past - stretched out; other major programs stretched out. And what you're going to see is effectively upgrades to programs as they're doing today, a number of them.

The way that will affect Herley is I believe our top line can grow 3% - 4%, maybe 5%, but it's not going to be leaps and bounds, and what we really have to do - and we're in replacement business on some of the programs we're on and we are on some of these long-term programs which I don't see any affect on, like the Trident B5, as an example.

We're constantly in negotiations for next year's procurement - the FAP, the ICAP program. I may add if you take a look at the ICAP program, there was a recent article in Defense News  I think it was this week, as a matter of fact - where the Aussies are now going in, they have 24 F-18s, Fs if you will, and they're taking 12 of those and what they want to do is convert them into what they call the F-18 Growler, which uses the ICAP. Well, that's more business for us, if you will. It's a very sophisticated program.

So I don't see a huge effect on Herley because of the position we're in on many of these long-term programs and the refurbishment, which is also part of our bailiwick. The other part is we also do a fair amount of business in the foreign market. Speaking with our people yesterday, our backlog in Israel, with the acquisition of Eyal, is approaching $50 million.

Their backlog is growing in dealing in some foreign countries where effectively we're really prohibited in the United States, and I think one very good example of that is India. Israel can deal with India, however in the United States we have to get export licenses - anyone does - and some of those most recently are being denied due to proliferation in U.S. government bases. We're not getting those - no one's getting them - where a foreign Israeli company and British company can operate.

So I don't see that it'll have a huge effect on Herley, but clearly you're not going to see the growth and ultimately I think you're going to see some of the defense spending be curtailed. But I still believe it'll still be a very large number. Remember, if you drop down from $680 billion in the U.S. to $600 billion or $580 billion, it's still a huge number.

George Register - Register Financial

Myron, one other question. One area of potential growth in defense spending is in the UAV. Does Herley have potential there?

Myron Levy

Good question. Yes, we have a lot of potential. We have teamed with one of our customers who manufactures UAVs that are used - and I mentioned this in the past - by the Air Force exclusively on the BQM-167. They've designed and we worked with them on a new aircraft called the 167X, which was built and has flown, I may add, and we'll be quoting that and that's still coming. We're waiting for that solicitation coming out from the U.S. Navy. And we're working with the U.S. Army.

In addition to that, we also are selling that target and our command and control systems foreign to countries like Korea. We've quoted into Taiwan; hopefully we will have won that program as well. And we're looking at a lot of other countries like Australia, Japan, and England, where there's also possibilities. And that's all UAV, if you will.

I'm not going to go into it in tremendous detail, but we're also working with a major prime on a full-scale target or drone as well.

Operator

There are no more questions in queue.

Myron Levy

Thank you. I would like to thank everyone for joining us today on our second quarter conference call and we'll be speaking with all of you at the end of our third quarter if not prior to that. Thank you very much.

Operator

This concludes today's conference call. You may now disconnect.

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