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TeleCommunication Systems Inc. (NASDAQ:TSYS)

Q1 2009 Earnings Call

April 30, 2009; 5:00 pm ET

Executives

Maurice Tose - Chairman, President & Chief Executive Officer

Tom Brandt - Chief Financial Officer

Bruce White - General Counsel

Analysts

Tim Quillin - Stevens Inc.

Shyam Patil - Raymond James

Mark Jordan - Noble Financial Group

Scott Sutherland - Wedbush Morgan

Michael Latimore - Northland Securities

Andy Schopick - Nutmeg Securities

Operator

Good day everyone and welcome to the TeleCommunication Systems Incorporated, first quarter 2009 earnings conference call. Currently all participants are in a listen-only mode. Later you will have the opportunity to ask question during our Q-and-A session.

It is now my pleasure to turn the conference over to Mr. Maurice Tose, CEO of TeleCommunication Systems. Please go ahead sir.

Maurice Tose

Thank you. Good evening and thank you for joining us to discuss Telecommunication Systems first quarter 2009 results. With me today is Tom Brandt, our CFO; and Bruce White, our General Counsel. Before we present our formal comments, I will ask Bruce to advise listeners of the cautions that they should consider during this call and following our presentation, we’ll open the lines for Q-and-A. Bruce.

Bruce White

Thank you, Maurice. Some of the statements you will hear during this call are forward-looking within the meaning of federal securities laws. Some but not all of these statements include language such as believe, expects or anticipates and you should listen to these statements with the knowledge that actual results may differ materially from these forward-looking statements. The risk factors that could cause the results to differ maybe found in our SEC filings, including Forms 10-K and 10-Q and we encourage all investors to read these documents.

Also, during this call, we may refer to measures of income that are not computed in accordance with generally accepted accounting principles. To the extent we refer to non-GAAP data, we have provided a reconciliation in our press release and on our website. Maurice.

Maurice Tose

Thank you, Bruce. Our first quarter earnings release crossed the wire service at about 4:15 pm today and a full text copy of our press release has been distributed via email and is also available in fact on our website. We also updated the financial model that puts the company’s financial information into perspective and this is available for download from the investor information section of our website.

As indicated in our news release, revenue for the first quarter was $70.5 million, generating EBITDA of $11 million or $0.21 per diluted share. Income before taxes was $8 million or $0.16 per diluted share, which is a number that is comparable to past quarterly net income when tax provisions were negligible.

In the first quarter of 2008, pre-tax income was $4.7 million or $0.11. After normal income tax provision in the first quarter of 2009, net income was $4.9 million or $0.10 per diluted share. Our Government business segment generated sharply higher revenue than a year ago as large volume SwiftLink system shipments continued and government services contracts generated 75% more revenue than in the first quarter of 2008.

The continuing growth in text messaging usage in the U.S. continues to drive sales of software licenses, maintenance and customization. In our recurring hosted location based services for E9-1-1 and commercial markets, made a steady profit contribution.

Now, some highlights from this quarters operations. First quarter commercial segment revenue was $25.6 million, yielding gross profit of $15.5 million or 61% of revenue, down slightly from $16.3 million of gross profit in Q1 ’08. In November 2008 ABI Research report indicates that the difficult global economy is not hampering growth of mobile messaging services.

According to the CTI survey, text messing continues to be enormously popular with more than 1 trillion text messages carried on operators’ networks in 2008; that is more than 3.5 billion messages per day. That’s almost triple the text message volume in 2007.

In the first quarter of 2009, TCS messing software delivered 48% more text messages than in the fourth quarter of 2008. Discontinued growth creates opportunities to supply our SMSC solutions to other wireless networks, while creating strong growth demands in our existing customers’ networks.

We believe that our largest SMS customer will continue to purchase incremental licenses to accommodate growth in traffic volume on their network. We are one of two vendors providing them with SMS technology that compete for this incremental business, so that pattern with any year can vary.

As a technique to introduce our SMS technology to new customers, we have successfully made initial sales as a second vendor via our SMS Express solution. During the first quarter, TCS announced that our next generation SMS Express, short message service center, is now ready to support operators’ upcoming migrations to fourth generation networks including Long Term Evolution or LTE.

Handsets operating on the new 4G networks will continue to send text messages using native clients on the device and TCS’s SMSC products are ready to support this necessary interface. As operators rollout 4G access networks, the TCS solution will ensure that they are growing volume of text messages will be delivered with the same reliability yesterday, whether the subscriber is registered on existing cellular or new mobile broadband networks.

The TCS SMS Express platform provides intelligent dual mode delivery of text messages over mobile broadband networks via Session Initiation Protocol or SIP, as well as over Legacy SS7 networks. This capacity provides the seamless user experience during migrations, where Legacy and Next Generation networks must coexist.

The emergence of SMS as the lowest common denominator of real time messaging is perhaps best evidenced by the rapidly growing social network community known as Twitter. Twitter is the micro blogging site limited to a 140 character entries that ask the question, “What are you doing?” Twitter members then provide updates known as tweets to other followers. These updates can be sent and received either via web or SMS. Members can then reply to the tweets creating a viral effect which drives SMS traffic volume.

According to a March 2009 Nielsen Mobile Report, in the last quarter of 2008, over 800,000 unique users sent or received Twitter text messages from AT&T or Verizon cell phones. There was an average of nearly 240 tweets per person for the quarter. Perhaps the most intriguing result of the Nielsen Mobile Report is that Twitter is appealing to an older crowd.

The report reveal that the percentage of Twitter’s SMS users age 13 to 17 was only 2%, compared with 13% for Facebook and 22% from MySpace. Users over the age of 34 generate 50% of Twitters SMS traffic compared with 39% for Facebook and 20% for MySpace. This finding suggest that text messaging appeal is spreading into age demographics beyond the typical teen and 20 something user base.

Text message also continues to make enterprise in-roads. During the first quarter, TCS announced the availability of our Mobile Value Added Service Platform or MVP, a solution for wireless operator enterprise to phone business services. MVP connects directly to the wireless operators’ data network, enabling enterprises to send text messages directly to mobile handsets using advanced and the Legacy interfaces including interfaces for pagers.

Wireless operators can facilitate enterprise messaging internally to employees, externally to customers and even support campus alerts. MVP provides a secure trusted method for mass delivery of high capacity messaging. In contrast, with revenues sharing with content aggregators, MVP allows wireless operators to bypass the added cost of messaging aggregators, while stimulating more messaging service revenues.

Turning to our location based technology family, during the first quarter we completed deployment of location infrastructure and applications for Tata Indicom, the sixth largest CDMA operator in the world with over 35 million subscribers in India. The services launch last week.

This is another example were TCS has provided an end-to-end solution that includes both infrastructure and applications to help an operator launch location based services. The applications are now being promoted by Tata Indicom as QuickFinder Navigator and QuickFinder Maps. We are currently in discussion with five other operators in India and almost a dozen operators in the Asia Pacific region.

TCS continues to expand our connect services offering for Telematics in the first quarter. Connected services enable real time information such as traffic and gas prices to be delivered and integrated into Vehicle Telematic Solutions.

During the first quarter we release the Xypoint Mapping Service 6.0 and Xypoint Dynamic Data Server 4.0, providing completed compatibility with all three of the leading traffic providers in North America. In addition, we continue to field trial our connected services and expect a production launch later this year.

We are also actively pursuing multiple North American opportunities. With the formal announcement by Canadian regulators of an E9-1-1 mandate, we are actively engaged with multiple Canadian operators to position our industry leading wireless 9-1-1 and location based solutions to meet this mandate. While we do not expect these services launch until early 2010, many of these operators will be making selections in the coming months.

TCS continues to make progress with our offering for Voice over IP operators in the area of public safety. TCS won a competitive contract award from a Tier 1 capable multi system operator for our LivewirE911 emergency services call processing. TCS was also awarded the contract with the Tier 1 wireless operator for our award wining Real-Time Address Validation Service or RAVE.

We also became the sole contractor for the Next Generation 911 Pilot Project in the Minneapolis metropolitan area. During this pilot, TCS will demonstrate our NENA standards based Next Generation 911 offering for landline, wireless, Voice over IP, Hard of Hearing, Instant Messaging and Video Systems.

Our TCS VoIP verify service was recognized by Internet Telephony Magazine as one of its innovative 2008 products of the year. TCS has also recently received another contract for our femtocell location validation service with our second Tier 1 operator. We also renewed a significant multiyear wireless E911 contract with Cricket Communications and continue to work month-to-month with a key wireless E911 customer towards a renewed multiyear arrangement.

Moving on to a view of our patent activity, TCS was issued two new patents during the first quarter and two additional patents after the quarter ended, bringing the total number of our patents to 71 with 222 applications pending. We added a ninth patent to our A-GPS patent portfolio, as well as a patent for wireless gateway technology that supports Multiple Inter-Carrier Messaging Protocols. The most recent patent covers technology that allows presence and location information of wireless devices to be sent to buddy list and chat rooms.

TCS saw significant advances in our patent enforcement and licensing efforts. The U.S. district court for the eastern district of Virginia entered into a final judgment in favor of TCS and against Sybase or Mobile 365, now known as Sybase 365 regarding U.S. patent number 6985748, describing an Inter- Carrier Messaging invention.

The court affirmed the validity of the patent, accepted arguments that Sybase infringed and awarded approximately $12 million in damages, including past damages through May 2007 and supporting a 12% post issuance royalty. The final Judgment award does not account for any continued infringement by Sybase 365 after the May 2007 jury verdict. The court also permanently adjoined and restrained Sybase 365 from further infringement; the word ‘damages’ and permit injunction against Sybase 365 are stayed pending appeals.

We believe that continuing investment in prosecuting and enforcing patent and other intellectual property rights important. As we are mindful of the cost involved, our strategies for infringement enforcement include arrangements that minimize the related cost to TCS, while providing incentive to our law firm partners.

TCS is continuing our licensing effort regarding our SMS mobile originated to Internet family of patents. This patent family describes, a method that enable handsets to interact with web applications using SMS messages. Such methods are used currently by many companies using SMS short codes for promotions, alerts and other marketing campaigns, like audience voting for boarding TV competitions. TCS has notified companies about this licensing program and has received a number of responses.

During the quarter, we completed a search for a full-time intellectual property professional who would join our team about two weeks from today. He is a certified licensing professional, a U.S. Patent and Trademark Office registered agent and an Engineer with 25 years professional experience, including most recently five years as Director, IP Technology Strategy at Microsoft.

With regard to our government segment TCS addresses what is know as C4ISR, which means demand, control, communications computers, intelligence, surveillance and reconnaissance. We recently announced Department of Defense priorities and spending plans appear to be a net plus for C4ISR, particularly the satellite communication sector.

More importantly, the Department of Defense’s decision to increase spending on unconventional warfare and special operations, benefits are government business and while combat activities within Iraq have decline, the surge of U.S. force is in Afghanistan is driving significant demand for deployable satellite communications ground terminals.

Our government segment had another great quarter and is positioned to deliver another record year in 2009. As expected, we continue to receive large orders from DoD for our SwiftLink systems, and our government services business has experienced growth from all three revenue categories, special services, managed satellite services and fuel logistic support services for our SwiftLink systems.

Q1 revenue came in at $44.9 million, up more than three fold from $14.2 million in the same year ago quarter. Equally significant, the $9.7 million gross profit earn from our government business in Q1 was 22% of revenue, which is up from 15% in Q4, ‘08 when government fiscal year and pass through business reduced the average margin on system shipments.

Our first quarter average margins also benefited from a business mix that included some sales to customers outside the high volume WWSS Vehicle, where margins have been lower and some non-recurring vendor credits are based on cumulative volume purchases. The government segments gross profit was $6.4 million more than the $3.3 million earned in the same year ago quarter and $2 million more than the gross profit earned in the last quarter of 2008.

One of the biggest drivers of this revenue growth comes from the U.S. Army’s WIN-T program office, which award TCS a $232 million contract last year, to delivered deployable ground terminals to the army and other units of the Department of Defense. The contract was originally for $246 million, but $14 million of unfunded backlog has since been de-scoped.

The de-scoping is the result of government policy change with regard to some encryption components to our deliverables, which may no longer be sold through commercial third parties. We will be bought directly by our customers. The de-scoping was not a result of performance or budget issues.

This program is called SNAP which stands for SIPR/NIPR Access Point. The SNAP systems and supporting services consist of a wide variety of configurations and options for TCS, SwiftLink, VSAT Terminals INMARSAT BGAN Terminals and SwiftLink Base-band Kits, along with the associated upgrade kits, spare kits and accessories.

In conjunction with these shipments TCS also provides field staff for training, instillation and logistic support services. The Government segment was awarded it’s six SNAP past quarter in Q1 valued at $5.6 million. Since the SNAP program begin in Q3 ‘08 we have booked $45 million of its overall $232 million value, leaving unfunded backlog of a $188 million that the government could order over the next two years.

We continue to see a solid flow of delivery orders and have visibility on substantial orders in the coming months. We believe that a combination of factors, the product’s functionality, stability and ease of use, the fact that all DoD entities can easily orders system from this contract vehicle and the visibility that SNAP has achieved due to its widespread deployment of these systems, will continue to drive demand.

In addition to SNAP, the U.S. Marine Corps Wireless Point-to-Point Link or WPPL Program contributed $11.7 million of revenue to Q1 ’09 results. The current contract leaves room for an additional $24 million in orders over the remainder of its term. Indications are that significant delivery orders will be forthcoming.

We also continue to receive orders from our customers for our traditional bank Base-band Kits and other related products, which contributed approximately $8.4 million in Q1 revenue. To better manage our growth in 2009, we are making continuous improvements in our supply chain management process to more effectively monitor and control our inventory and our supplier relationships.

We are investing in R&D for multiple versions of the Stingray series of man-packable VSAT Terminals in Ku band, in anticipation of upcoming contract awards. TCS engineers are also pursuing development activities in larger dish solutions two meter and above that incorporate Ku band capabilities. In our current prototype efforts, we are developing micro VSAT solutions, which use less power and can operate on alternative energy sources.

Our government service business also had a good quarter with continued growth in many long-standing contracts. In Q1, our services business revenue was $12.8 million, which is up 75% revenue in the same year ago quarter. Government services contributed $2.6 million of gross profit in Q1, up from $1.5 million last year. We own and operate a teleport in Manassas Virginia, with multiple satellite hubs and services, including a digital video broadcasting hub.

We also have satellite equipment collocated at several teleports around the world. Satellite managed bandwidth services provided about $2.7 million in Q1 revenue, up 78% over the same year ago quarter and is growing rapidly with a strong 2009 pipeline, based on U.S. government’s continuing communications needs for both military and diplomatic missions.

Accordingly, we are making investments in our teleport infrastructure to further increase our capacity and reliability. Our integration and delivery organization continues to do a great job ramping up to ensure that shipments are on time. We continue to expand our services businesses, driving more recurrent revenues. We have millions of dollars of unfunded contract options and several new opportunities being pursued by our government sales team. We are very confident that 2009 will be another strong year.

Now, Tom will provide some additional details regarding the first quarter financial results.

Tom Brandt

Thank you, Maurice. To recap the first quarters P&L, revenue was up 75% year-over-year to $70.5 million. Gross profit was $25.2 million for the quarter or 36% of revenue, up from $19.6 million last year. EBITDA was $11 million or $0.21 per diluted share, up from $8.4 million or $0.19. Pre-tax income was $8 million or $0.16 per diluted share, up 70% from $4.7 million last year or $0.11 per diluted share.

A net income was $4.9 million or $0.10 per diluted share. The company’s overall revenues split for the quarter was 43% services and 57% systems and it was about 36% commercial and 64% government. First quarter commercial segment services revenue of $17.8 million was up from $15.5 million a year ago, reflecting growth in overall E9-1-1 revenue and in software maintenance. Gross profit from services at $9.6 was up from $7.6 million the year previous.

Commercial systems first quarter revenue of $7.8 million was down from last years record $10.7 million and last years first quarter, a major operator customer purchased software licenses for increased text messaging volume that served to catch up for some usage volume growth in 2007. Other than the difference in those license purchases, the commercial systems revenues were about the same. The quarter’s gross profit from systems was $5.9 million, down from $8.7 million a year ago due to variance in license volume.

Government segment services revenue was $12.8 million, compared to $7.3 million a year ago and gross profit at $2.6 million from government services, compares to $1.5 million. These increases are as a result of new and expanded government contracts for professional services, satellite airtime service and maintenance and field support associated with cumulative system sales.

Sales in government systems for the quarter were $32.1 million, an increase of more than $25 million from $6.9 million a year ago and gross profit of $7.1 million for government systems was more than triple to $1.8 million in Q1 ’08, mainly due to the increased volume of sales of SNAP, wireless point-to-point link and military transition team sales, under the worldwide satellite systems contract vehicle, as well as our SwiftLink system sales outside of WWSS.

The total potential value of all WWSS awards received by TCS to-date is about $370 million, of which $148 million has been funded and we currently expect to fulfill the award potential by the end of 2011.

First quarter companywide operating expenses, excluding depreciation and amortization totaled $15.8 million, up from last year’s $12.5 million. As a percentage of revenue, some of our R&D sales and marketing and G&A expenses was down from 31% last year to 22% of revenue for the quarter just ended. The overall expense increase was due primarily to accruals for variable compensation increased sales and marketing progress for both the government and commercial business segments.

Specifically, R&D expense was $4.9 million in Q1 ’09 up from $4.1 million in Q1 ’08, as we continue to invest in technology for wireless messaging, platforms and applications for location-based services, next-generation 911 and deployable SATCOM. Sales and marketing expenses in the quarter totaled $4 million versus $3.1 million in Q1 ’09 reflecting initiatives in support of growth in both our business segments.

General and administrative expenses for the quarter were $6.9 million versus $5.3 million in the first quarter of ’08, as we’ve increased investments in legal expenses and legal related costs around intellectual property. Internal control infrastructure to support higher overall company business volume and accruals for variable compensation.

Our EBITDA from continuing operations was $11 million, which is up 31% from $8.4 million in the first quarter of 2008. Non-cash charges totaled $3 million for the quarter versus $2.9 million in last year’s first quarter. Quarterly depreciation of fixed assets was about the same, but $1.5 million and non-cash stock-based compensation expense was also about the same, but $1 million for both Q1 ’09 and Q1 ’08. Amortization of software development costs was $0.6 million in ’09 versus $0.4 million last year.

In the first quarter of 2009, we recorded a $3.1 million provision for income taxes, against pretax income of $8 million, which represents an effective tax rate of approximately 39%. Prior our year end reversal of the deferred tax asset, we recorded a tax provision of $48,000 for alternative minimum tax in Q1 ’08.

We currently expect the average effect of tax rate for 2009 to be about 38% and then we won’t pay cash taxes for another two years. So bottom line, we reported net income of $4.9 million from the quarter on sales of $17.5 million. At the year end of the first quarter, funded backlog was $156.7 million, up from $124.8 million at the end of Q1 ’08. At quarter end, our total backlog was $415 million up from $225 million a year ago. This quarter end amount reflects the $14 million adjustment for SNAP describing that Maurice mentioned earlier.

We are ahead of Q2, ’09 expecting to realize a $116 million of our funded backlog over the next 12 months. Beyond this funded backlog, our long term services contracts, licensing agreements and our own funded government contract orders give us substantially improved visibility overall relative to earlier years.

Funded contract backlog, represents contract for which fiscal funding has been appropriate by our customers, mainly federal agencies and for our hosted services contracts, where we multiply the most recent months recurring revenue times the remaining months, under the existing long term agreements.

Total backlog as this typically measured by government contracts, includes order covering optional periods of services and/or deliverables, but for which budgetary funding may not yet have been approved. Our company’s liquidity position remains strong in the first quarter of 2009. Quarter end cash totaled about $35 million, down slightly from $39 million at the beginning of the quarter.

The company’s first quarter EBITDA generate $11 million of cash. In addition, $2 million were generated from stock option exercises and $2 million came from least funding of new fixed asset. Funds were used for $2.1 million of capital expenditure, including $0.4 million of capitalized software development, $1.1 million was used for debt principle payment and there was a $59 million increases in working capital. The increase in working capital is due mainly to our reduction in accounts payable and accruals.

At quarter end our day’s revenue and receivable is higher than normal 101 days. As we mentioned in the press release, a major commercial customer paid more than $6 million of mostly pay us due receivables in the first two days of April, which was not reflected in the quarter end cash.

Unused availability under our lines of credit totaled $21 million at quarter end. Substantially, all of our cash equivalents are in federally back stopped money market funds and certificates of deposits held for us by three institutions. We are continuing our practice of providing annual, but not quarterly guidance as to future P&L performance.

Following, top line growth of 22% in 2006, 15% in 2007 and 53% in 2008, we are now increasing our 2009 revenue guidance and expect overall revenue to be in the $250 million to $265 million range, representing year-over-year growth of 14% to 20%. As we indicated on fourth quarter call, we see more rapid top line growth during 2009 in the government segment than in the commercial segment, but with both group segments growing overall year-over-year.

With the strong Q1 start to the year, we now expect EBITDA for 2009 to grow from 2008’s $29 million or $0.62 per diluted share, excluding the $0.17 2008 patent tail income, to the range of $32.5 million to $35 million or $0.64 to $0.69 per diluted share, which is slightly better than previously expected. We now estimate that shares per diluted EPS for 2009 will be about $51.5 million versus the $46.6 million average for 2008.

This a number of shares outstanding has grown mainly due to the higher number of in the money options than before the stock prices 2008 and early ’09 improvement and from a wire holders exercise during the fourth quarter rights to purchase about 1 million common shares.

We foresee non-cash charges for 2009 of about $12 million to $13 million and the net interest expense from nil to $0.5 million dollars for the year. As mentioned earlier, pretax income will be subject to a tax provision we expect to average about 37% for the full-year. So, we currently anticipate GAAP net income for 2009 of about $12.6 million to $13.9 million or $0.24 to $0.27 per diluted share.

It’s noteworthy that all the P&L state that we have reported for the last several years, reflects organic activity; however, the 2009 environment presents opportunities for a well capitalized grown company like TCS, to consider accretive acquisitions that would result in some consolidation of communications technology spaces, where we are strong.

We will update guidance later if we add it to the company through acquisition. Our guidance data maybe viewed in the context of historical trends, by referring to the financial model portion of our website Investor Relations page.

At this time, I’ll turn the call back to Maurice.

Maurice Tose

Thank you, Tom. Our company is navigating the difficult economic environment, while financially well capitalized and focus on marketing issues for growth and profitability our promising. Text messaging, deployable SATCOM and public safety technology, are recession resistant needs.

The recent fifth annual gathering of about 150 people, including customers and vendors, who are involved in our SwiftLink business, gave me a fresh inside to the prospectus for application of our technology. I’ve often said, that government contracting is a relationship business and we’ve build a team of people who listen to customers and innovate and respond to deadlines in a fashion that has earned respect.

Tolerable systems enabling information access in harsh environments address a need, which is clearly a priority for U.S. Defense, State and Intelligence Agency for years to come. TCS’s a commercial business continues to benefit from record text message usage in the U.S. and analysts predict that the strong growth of text messaging will continue for at least another three to five years.

In addition to well continued growth and consumer demand, the adoption of SMS as a communications medium for enterprise is creating more opportunities for TCS solutions. While we have guided cautiously, as to the balance of 2009 license sales, we are confident in the long term merits of our solution and the upside opportunities beyond current customers.

In the meantime, our early market leadership and location-based services, positions the company for global leadership in the LBS space. We lead that as wireless operators around the world proceed to invest in educating subscribers on the value of LBS services; our company will grow revenues from licenses, maintenance, customization and hosting a location-based technology as has been the case for messaging technology. We stood more than a decade to ramp up the current levels.

TCS’s investments in communications technology have resulted in a valuable body of protected intellectual property. Our patent litigation case against Sybase is till pending appeals that we believe will result in a successful outcome. We have begun soliciting royalty revenue from licensing our patents from mobile originated to internet address.

As an intellectual property company, we have a growing number of other patents that we believe will be valuable assets for TCS in the future. We generated cash profitably, reflected $11 million of EBITDA during the quarter and ended the quarter with $35 million of cash. TCS can consistently grow year-over-year profitably.

We thank you for you time and support. We’d now like to open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the side of Tim Quillin with Stevens Incorporated. Please go ahead sir, your line is open.

Tim Quillin - Stevens Inc.

Good afternoon, another nice quarter. You’re fairly giving guidance with a lot of caution. I just want to figure out where exactly your caution is coming from? So, you’re assuming anyway that first quarter is going to be the high water mark, both in terms of revenue and EPS?

I guess first of all on you SMS outlook is you’re caution really more related to the competitive landscape and the fact that maybe you think your competitor is just due for an order from your biggest customer there and is there anything specific that would give you a reason to be cautious about that?

Maurice Tose

Well, let me start with saying, I’m not sure of the message was that Q1 is our high water mark. I would say that; one, we’re just trying to be cautious and continue to upgrade guidance quarterly throughout the year, throughout the process. I mean the first half of the year, we pretty much see it. It’s here, it’s all about booked.

So, again we don’t want to give granular and giving quarterly guidance and in part on the SMS front, we went through one multi-quarter deal, we’re almost through another or anticipate we’ll be through another and probably exhaust the second one accordingly or probably early again as well, but there is a second competitor in the carrier, even thought we have the lion’s share of the market.

So, it’s been difficult to force the 800 pound relay into a behavior that maybe best for us, but, the history of the last nine or ten quarter show that it’s been there for us, all but one quarter in that period of time. So we’re just not wanting to get our knuckles racked and we just like to I guess cautiously bring things up, but we are bullish. I mean we are very bullish on the year.

Tim Quillin - Stevens Inc.

So there’s nothing that your customers telling you or nothing about the posture of your competitor there that would suggest that you wouldn’t get the next order. It’s just as you say, there’s just kind of an abundant of caution there?

Maurice Tose

I’d say primarily an abundance of caution and as we said, the orders can vary. So, we can’t say much more than that and we’ll get our appropriate share of that business, which has been the lion share.

Tim Quillin - Stevens Inc.

Right and is it the right way to think about the second quarter in the commercial systems business as you work through that multi-core order. Is that it’ll look similar to 1Q?

Maurice Tose

Tom do you want give there granularly.

Tom Brandt

No, when we think about orders, we’ll adjust the overall guidance until we see the orders, we’re going to be cautious and the pattern with which this is going to come in quarter-to-quarter has not been possible to clearly predict, so we’re going to leave it to you to spread stuff over the year.

Tim Quillin - Stevens Inc.

Okay fair enough, but I think overall in the commercial business you are looking for a growth in 2009, which also suggests that you are being conservative with regards to the government systems business in the back half of the year and is that just, you don’t have the orders in hand there and you’re just not willing to commit because I guess my sense of it is you have pretty good visibility on similar type of revenue levels that you saw in 1Q over the remainder of the year?

Maurice Tose

I’d say, I’ll just reiterate that in the first half of the year we can see it, just got to get the orders and with the government in the back half, your spot on. I mean we see the orders, we know the customers needs and we don’t have the hard order. We don’t perceive that there’s any reason or rational that we won’t get them, but until we have them, we’re not going to get out there over our tips, but as I say, we are very confident and just I guess want to presented that way.

Tim Quillin - Stevens Inc.

Okay, we can kind of make or own decision based on that. Just one detail, Tom on the tax rate you’re book to 39% rate in the first quarter, I guess you’re look for lower rate though and for the rest of the year and why is that the case?

Tom Brandt

It’s a new experience to be booking a tax provision here and one of the variables is the impact on the effective rate of the non-core of line dispositions arising from cashless exercise of employee stock position, where you’re not allowed to average when you’re doing in early quarter, but you can estimate and predict and on that basis it still looks 37, is a good number for the year.

Tim Quillin - Stevens Inc.

Okay, great. Thank you, great job gentlemen.

Maurice Tose

Thank you, Tim.

Operator

For our next question, we’ll go to the side of Shyam Patil with Raymond James. Please go ahead, your line is open.

Shyam Patil - Raymond James

Hi, good evening. Congrats on the traffic quarter there.

Tom Brandt

Thanks Shyam.

Maurice Tose

Thanks Shyam.

Shyam Patil - Raymond James

I guess a few questions on my end. Maurice, you mentioned something around de-scoping that occurred within your government systems backlog. I was just wondering if you could provide a little more color on that and sort of if you see that as a risk for any part of your remaining backlog?

Maurice Tose

I guess Shyam, we feel more compelled to speak about that, because the number had been 246 and its not 232. It really is a non-event. It was again, that the government or third parties have been able to, such as us, to buy certain types of inscription.

That inscription now if its right to say federally or whatever, contractually is no longer going to be, able to be bought by third party folks like us. The government is going to buy that themselves, so the government insists on buying that themselves. I guess it’s what it is. So, it’s really a non-issue, all it does is it lowers our unfunded backlog by that amount.

Tom Brandt

Shyam, it is the real anomalies and to the natural question that I’m open as by investors, what are chances that you’re unfunded backlog won’t run into funded, with the natural concern that either the demand or dry up or the budgetary issues, particularly in light of the public, media discussion about that. This is neither of those. This is an anomaly about the change in the handling of a particular piece of highly sensitive secure communications technology that happens to affect this product line.

Shyam Patil - Raymond James

Okay, thanks for the clarification. That was helpful. In terms of the government systems business, it looks like the gross margins on that were actually 400 basis points better than what I was looking for, which seems like pretty good execution on your part. I was just wondering, what are the expectations for the level of gross margins going forward within government systems and do you see more room for expansion there and if so, where do you think that would come from?

Maurice Tose

Well, Q1 we had the kind of the converse of what we had in Q4, where all the stuff that drives the average systems margin down happened. We had the second half use it or lose it, pay us through business, diluting the average margin and we had kind of the absence from the mix some of our non-WWSS customers who’s pricing gives us more traditional margin than the high volume stuff.

In Q1, the absence of the pass through stuff, the presence of the regular customers and perhaps most significantly, the benefit of some volume buying that manifested itself in a vendor rebate drove the margin for the quarter up. I would encourage you to model, that the year is going to average maybe a little better than the average last year, once we get the impact in the second half, like we did in the second half of 2008 of pass through stuff. So, don’t be a rational exuberant.

Shyam Patil - Raymond James

Got it, just one last question; Maurice, you talked a little bit about some of the incremental drivers from SMS volume in the U.S. market, when you talked about some of the social networking sites. How do you view SMS growth? What kind of growth are you guys assuming within you guidance for SMS volumes and then how do you think about sort of the second derivative there if you will?

Maurice Tose

Well, I’m not sure we’re again given the explicit guidance, but I, it’s still growing month-over-month and it still growing in the mid single-digits and above per month the volume.

Shyam Patil - Raymond James

Thank you, and congrats again.

Maurice Tose

Thanks.

Tom Brandt

Thank you, Shyam.

Operator

Our next question, we’ll go to side of Mark Jordan with Noble Financial Group. Please go ahead, your line is open.

Mark Jordan - Noble Financial Group

Yes, good afternoon gentlemen. I’d like to talk a little bit about going back to revisit the relative strength for the first quarter vis-à-vis the guidance. Obviously, you got 40% of your mid point of your guidance range on GAAP earnings and about a third of the EBITDA. Could say that if in fact the year comes in as you are to be at conservative guidance highlights, what are the areas that could be weaker through the balance of year to have it to come where you’re currently conservatively estimating it?

Tom Brandt

Its part of the commercial systems, Mark; we don’t know what the timing is going to be. Maurice is being cautious, we’re all being cautious. We know we’ll have strong first half, we knew that kind of going into the year and until we see the orders, because it’s possible that timing could be difference than what we like it to be as far as smoothness of these order coming in, we’re guiding cautiously there.

Maurice Tose

It’s not untypical to not have those orders booked this far out. Again, we’re just proceeding with caution and internally we’re pushing hard.

Mark Jordan - Noble Financial Group

Yes I know, large companies they’re not to worry about smaller suppliers. Second question, as express 4G licensing activity, is there a difference in pricing as you move more to an IP versus switched environment and could you talk about that pricing structure that you’ll see there?

Maurice Tose

I don’t think we’re really seeing any change in pricing there yet, because as I think about it Mark and I’m trying to think about this real time; it’s based upon the busy hour short messages. So, it’s going to be a busy hour for message weather its delivered IP or delivered SS7; it’s still going to be a capacity driven measure. So, I don’t see that changing. It’s just a matter of carriers’ network being more efficient instead of using a controlled channel using with SS7, using SIP and using digital technology.

Mark Jordan – Noble Financial Group

Okay. You had some really excellent growth in the commercial services sector. Is there any one-time revenue in that first or step up in volume in the first quarter or is that a sustainable base that you should continue to grow on?

Bruce White

Well we get our annual step ups in maintenance effective in January on cumulative sales of the prior year for messaging in particular, but their answer, if we shouldn’t go back we must have those new base on which we can grow. We’re getting some improved penetration in non-wireless 911 as well and we’ll target more benefit in the back half of the year than in the second quarter, but I think that’s what you’re looking.

That pieces of revenue shouldn’t go backwards and that’s going to really account for our current modeling of growth overall in the commercial segment, in the services category, offsetting what we’re currently modeling as a more conservative guidance on systems.

Maurice Tose

Yes, that Tier-1 MSO cable operator, I mean we didn’t pound the table on it, but that’s a big deal; it’s a big deal overtime; it’s a big deal in us first winning that which is significant and as we said as well as, the Canadian 911, it’s probably more of a 2010 that they’re going to stand up, but they’ll be making decisions and another Tier-1 carrier on our RAVE for 911.

So we’re making progress there and some of the timing of that we can’t fully nail down right now, but as Tom said, it’s more a later part of the year. So, there are a lot of really good things working and we’re just applying an abundance of caution.

Mark Jordan – Noble Financial Group

Canadian population is about a tenth of that of the United States; you were able to grow under 50% of the market share here domestically; is it the same competitive landscape there, just two viable players or do you see other people potentially competing for some piece of the pie?

Maurice Tose

I’d say it’s primarily the two. I mean there are pieces that some other non-traditional players maybe trying to peal away, but its smaller pieces, it’s not the heavy as lifting parts.

Mark Jordan – Noble Financial Group

So, modeling this potential, would it be reasonable just to say since it’s one tenth the size of the U.S., that’s the relevant opportunity vis-à-vis your domestic business?

Maurice Tose

That’s probably a good way and as good as way as any, right now at this juncture?

Mark Jordan – Noble Financial Group

Okay, thank you very much.

Maurice Tose

Thank you.

Operator

For next question, we’ll go to the side of Scott Sutherland with Wedbush Morgan. Please go ahead, your line is open.

Scott Sutherland - Wedbush Morgan

Hey guys, nice quarter.

Maurice Tose

Thanks Scott.

Scott Sutherland - Wedbush Morgan

Kind of maybe, I don’t know if you mentioned, first of all you talked about doing some accretive M&A in the communication segment. Can you talk about the size of these acquisitions maybe that you might be looking at?

Maurice Tose

They can vary, Scott. I mean for years we’ve looked at a lot of different things and we’ve just said, no. The layout of the land of public companies or technology companies like us have a big change significantly from the beginning of this decade to where we’re now. It needs to tend towards being accretive.

We looked at lots and we’ve said no to lots. Now, we’re seeing some things that are interesting to us and I don’t want to get into size right now. I mean they do vary from asking moderate to bigger than moderate.

Scott Sutherland - Wedbush Morgan

Okay, when talking about the Twittery impact and obviously, it’s really going pretty faster, so it’s going to be very impact in your kind of the business. Do you think this has any change in pricing for busy hours; it’s what are text messages; it’s just like any other text message and it just layering on top and maybe secondly, are you starting to see a material number of these messages layering on top, can you tell it?

Maurice Tose

I think it’s yes to your first one, that it’s just layered on top and I don’t know if we can see that phenomenon or not. I would think not, unless we were down at service provider level of who is providing the access for the Twitter account into the carriers; because for us it’s just an SMS, it would just be an SMS message I believe.

Scott Sutherland - Wedbush Morgan

Okay. On the government side of your business, can you talk a little bit about the pipeline? Are you seeing a mix of large and small dealers? Are they mostly small model tech deals? I know you have a big $14 million dealer. I guess it’s a little bit less than that now, but it seems dealer of that size are over $100 million or are they more moderate deals?

Maurice Tose

I mean it’s always; we’re chasing some humungous deals. Those are typically a long lead time and they’re subject to the government missing the deadlines for getting the RP out and then subsequent awards. Some of those that we’re responding to this year, they’re supposed to be evaluated and awarded this year, but they could very easily go into next year.

Within the contract vehicles, that we have that have ability tasking to them and you are seeing $5 million, $10 million, $20 million; I mean there is a varying degree there, but the bottom line, it’s all good.

Scott Sutherland - Wedbush Morgan

Okay. On the location-based commercial services front, you talked about Tata and I think there is five or six operators in India, talking to almost a dozen in Asia. You’re talking to a lot of people, are these sizeable? Are they going to start becoming more material; I know albeit on the commercial systems front it’s still pretty small?

Bruce White

Yes I mean, unfortunately, right now there are few deals out there like what we took down with Hutchinson back in 2002. There just haven’t been any like that since then. In part the markets have retrenched, while waiting to get an appropriate number of handsets out and the greatest success, the dates probably come from the application side, the greatest amount revenue being returned from the application side and there is a handful of players out there that are benefiting quite nicely from that.

Most of our deals, if they’re hosted, they’re going to start out smaller and we’re going to grow with them and if it’s in network, it will be a little bigger pop because of the upfront investment that they’re making to have it inside their network, and it’s going to be a mix of those. I think we’re fairly agnostic as to which one it ends up being, we just want to get our appropriate share of the marketplace.

Scott Sutherland - Wedbush Morgan

Then lastly on the government margins, following up on the question earlier, do you think the pace of non-WWSS is a business that’s sustainable for us going forward? Do you think, now that you’re buying a lot more and selling lot a more, do you think that vendor discounts are also sustainable going forward?

Maurice Tose

The pace of non-WWSS?

Scott Sutherland - Wedbush Morgan

The non-WWSS component of the systems mix?

Maurice Tose

So, meaning outside I guess. I mean we’re still seeing our long standing customers that deal with us directly and new ones in fact coming in and some new partnerships, some new very exciting relationships with some significant OEMs in the offing and yes, to the vendor discounts.

Let me think it back, so vendor discounts to a certain degree, but efficiency in what we do is where it all begins and if the core of the group that’s handling this, they’re season veterans of another entity in this space that was recently bought by someone else, but our senior guy has been standing up his whole team. The bands getting together again and the bands getting together with some people that are seasoned at this and we’re seeing already very, very nice efficiencies and they expect that to continue.

Scott Sutherland - Wedbush Morgan

Okay, great. Thanks guys.

Operator

For our next question, we’ll go to side of Michael Latimore with Northland Securities. Please go ahead, your line is open.

Michael Latimore - Northland Securities

Yes, good evening. Maurice you mentioned this Tier 1 MSO cable operator, is this where you’re doing address validation and maybe can you talk a little bit about how that would build overtime; you said it could be a big deal overtime?

Maurice Tose

Yes and I’ll just go back and give you a little history here. What’s ended up happening is our Master Street Address Guide has become our Beachhead. We get in and we test or we’re under contract with Voice Over IP providers and MSO or Tier 1 or other Tier 1 operators and they see the benefit from that, they see the immediate savings versus our competitor in time.

Again, it’s a real-time, it’s got almost new real time, improvable outer rhythms that we can continue to tweak the performance of the time it takes to validate that street; validate that street address for 911 service, which is necessary before the trucks can roll; and it becomes a very happy customer there that all the while we’re saying, we got more stuff and the confident improves and we’re seeing a nice degree of success there.

So, we’re hearing different numbers about where they may want to be overtime and we’re excided about it. They are significant numbers, it’s a matter of when they’ll get going and we’re working through that right now.

Michael Latimore - Northland Securities

On government systems gross margin, have you been successful in maybe getting better price discounts from your suppliers from the government systems space or are there initiatives underway and if so, what kind of margin impact of that?

Tom Brandt

One of our biggest component vendor, those discounts are coming in chucks, because they remit in the form of rebates and they’re based on cumulative buys and so we try to incorporate those estimates in the average margins when we take percentage of completion, project decline into the quarters, but fairly in Q1 we had some catch up, where we didn’t anticipate the degree to which we were going to get a rebate in Q4 and we got the benefit in Q1.

So, my matter is avoid rational exuberance around that gross margin, because particularly as we get to the back half of the year, we’ve got a lot of pass through stuff that’s going to drive the average staff. What’s going to offset that I hope and I think we’ll see the pipelines supporting it is plenty of your mainstream WWSS business where we’re doing our full integration procurement, testing and delivery and some execution of pipeline with non-WWSS customers, where we’ve had the relationships and we get better than the big volume of margins.

Michael Latimore - Northland Securities

Okay, within your operating expense items, where there any nonrecurring items there or is that a pretty consistent run rate there?

Tom Brandt

There is nothing big, nonrecurring at OpEx in Q1.

Michael Latimore - Northland Securities

Okay and then I guess just last in terms of your SMS technology. What’s the prospect therefore, landing another Tier 1 carrier maybe internationally and maybe, you talk a little bit about the pipeline for your SMS technology, picking at the Tier 1 arena?

Maurice Tose

I don’t want to go any further than to just say we’re working it and as you know we’re one step removed. So we are working it with our partner and its found money and we’re work in it, if and when we’re able to do it.

Michael Latimore - Northland Securities

Got it, alright. Thank you.

Maurice Tose

Thank you.

Operator

For our next question we will go to the side of Andy Schopick with Nutmeg Securities. Please go ahead, your line is open.

Andy Schopick - Nutmeg Securities

Thank you. Good afternoon. I want to come back to this de-scoped question, because before you even mentioned it, I did notice something when I was looking at the press release and I wanted to be clear that I understand it. There is a bracketed number I’m just trying to find it, bear with me under total funded contract backlog that says $27.5 million under customer options. Is that the de-scoped or part of that de-scoped, portion of this?

Tom Brandt

The de-scoped is in there, yes.

Andy Schopick - Nutmeg Securities

Okay, so what’s the other balance that comprises it? I think you said de-scope was like above $14 million?

Tom Brandt

Yes, the rest is what went from unfunded to funded.

Andy Schopick - Nutmeg Securities

Okay, thanks for clarifying that. Also Tom, I’d like to just you ask a question about a deferred software. I can see that net asset continues to decline on the balance sheet, just the amortization is exceeding the deferral, but did you say deferrals of capitalized software were $4 million in the quarter?

Tom Brandt

No, $400,000.

Andy Schopick - Nutmeg Securities

$400,000, okay and what are you anticipating…

Tom Brandt

$0.4 million.

Andy Schopick - Nutmeg Securities

Yes. So, that’s probably not like that to change a whole a lot in the current year in terms of the future capitalization?

Maurice Tose

Yes, that’s right. I mean the pure accounting says there’s a self set of the whole development process, but it’s suppose to get capitalized and we use our project cost accounting and the time management capture tools to get that in and depending on what we’re building when, there can be periods where there is a chunk of dose subject to being capitalized; but the nature of the mix and what’s in-progress right now isn’t likely towards a lot of the cost being capitalized.

Andy Schopick - Nutmeg Securities

What was the actual amortization in the quarter of previously deferred software?

Maurice Tose

I’d have to look it up; I don’t have it in my finger tips.

Andy Schopick - Nutmeg Securities

Okay, not a big problem. Can you comment at all any further about just general bid activity, on both the commercial and the government side separately; just what the general activity levels look like for you?

Maurice Tose

Again, they look good. As we’ve said on the commercial side, in India alone a lot of activity; Asia Pac a lot of activity; Europe, I mean there is a lot of activity ongoing commercial as well as North America with the Voice over IP, 9-1-1, with location-based services infrastructure. I mean there’s a good pipeline there. I mean government wise; likewise, we have a good pipeline. There is a good pipeline on both sides, systems and services.

Andy Schopick - Nutmeg Securities

Have you seen any change at all in terms of things loosening up, decision making starting to occur relative to how things may have looked in January, February and March given the nature of things?

Maurice Tose

We started again the year in our last report or last call, we had pretty good visibility or I’ll say we had excellent visibility out six months for the first two quarters of the year and that’s pretty much borne out the way we thought it would.

Andy Schopick - Nutmeg Securities

I understand that, I’m talking about new business opportunity. New order activity things, projects or opportunities that you’re looking at and working at and whether or not, decision makers or cash and credit conditions are at all showing any sign of easing?

Maurice Tose

I think it’s best to understand that for both of our business segments, we deal with very long sales cycles. I mean very long lead times between seeing an opportunity, especially in the government space and it ultimately converting into a contract and an order.

Ones you get into some like WWSS, you have a lot clearer visibility than we use to have, because there are task orders within the big vehicle, but when we look at our pipelines, we’re looking at the next big vehicles and we’re looking at programs where there will be a long process before we actually get the order that turns into cash and similarly with the carriers; there is a lot of variables affect their timing.

While we track each of these stories week-to-week as a management team, to generalize as to is the environment better in April than it was in February is not easy to discern.

Andy Schopick - Nutmeg Securities

Okay, thank you.

Operator

Our next question will come from the side of Tim Quillin with Stephens Incorporated. Please go ahead, your line is open.

Tim Quillin - Stephens Inc.

Hey, thank you for taking my follow-up question and I just had, may be a couple of easy ones and a one harder one, but Tom do you happen to have the cash from operations, the actual cash flow statement, the cash from operations number in front of you?

Tom Brandt

So, is that the hard one or the easy one? The Q is going to get filed tomorrow and the definition of cash from operation, net of the working capital change, you’d have to piece together from that little narrowed carrier.

Tim Quillin - Stephens Incorporated

Okay, I understand, I’ll wait for the Q, no worries on that.

Tom Brandt

That will go forward and I’m actually depending, how the lease gets handled with the (Inaudible) I’m bound to give a wrong answer.

Tim Quillin - Stephens Incorporated

Another, hopefully relatively easy on the commercial services business; the gross margin was up I think about five points. I don’t think you’ve talked about why that was or is that sustainable?

Tom Brandt

I think there was a little bit in nonrecurring in the commercial services in Q1 and since the costs for most of the commercial services are virtually fixed, when you get a little bit of revenue and I know we collected something that we’ve been chasing for a long time Tim. So I think for modeling its price, it’s safest to use the run rate for average ’08, rather than extrapolate from Q1 ’09.

Tim Quillin - Stephens Inc.

Okay, perfect. Then your harder question relates to your SMS business, where text messaging is booming and really has boomed over a longer period of time, doubled over a long period of time and growing even faster I think right now, but your revenue doesn’t necessarily grow inline with that. I think all the commercial systems may be using that as a proxy for your text messaging revenue, has grown it more or like a 12% compound rate over the past ten years.

What are the puts and takes there? Are you giving back pricing on each additional order? Is the price per busy hour continuously going down and also sharing some order flow with your competitor or why wouldn’t you grow faster in that business?

Tom Brandt

You kind of hit it. I mean it’s not price necessarily. I mean you say price each order; I mean, typically the pricing is done for an extended period of time and then there is the order process against that, but yes, there’s price concession or erosion there and a potential of not getting 100% of it.

Tim Quillin - Stephens Incorporated

Yes and how should we think about growth over the next five years, that’s a real easy one, in that business?

Tom Brandt

Tim, we take across from some of that market data. We look at the growth and the demand for the technology that will we think virtually and evidently give rise to incremental demand and…

Maurice Tose

Plus we look at actual; we look at what’s actually going on in those systems, in those networks.

Tom Brandt

And then we tempered that with what the price variances are going to be and they’re in the 25% to 40% reduction per unit, based on the last few years’ history. It will still leave net increases for us with the encumbering customers. Then the other variables are as Maurice pointed out, sharing business with the other vendor and our biggest customer and they brought on the others hand, the prospects of new customers. We’ve been successful with the SMS express, multiple times.

Maurice Tose

In fact having displaced the other guy a couple of times.

Tom Brandt

Yes, getting into new networks and we believe, we’re making progress with our partner to see the opportunity based on the track record in leading U.S. carriers, to be a second or third vendor in some of the big carriers around the world and maybe take a lot of share that way. So to your question, how do you model that? You just sort of have to take each of those variables and just try to probability rate them.

Tim Quillin - Stephens Incorporated

Okay, that’s helpful. Thank you for being patient on this long call.

Tom Brandt

Thank you.

Maurice Tose

Thank you.

Operator

It does appear we have no further questions at this time.

Maurice Tose

This concludes our first quarter investor call and we look forward to speaking with you again to discuss our second quarter results.

Operator

This does conclude today’s teleconference. You may disconnect your lines at any time. Thank you and have a great day.

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Source: TeleCommunication Systems Inc. Q1 2009 Earnings Call Transcript
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