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Executives

Len Borow - President and Chief Executive Officer

John Adamovich, Jr. - SVP, Chief Financial Officer and Secretary

Andrew F. Kaminsky - SVP – Corporate Development, Investor Relations and Human Resources

Analysts

James Covello - Goldman Sachs

Patrick Newton - Stifel Nicolaus

Rick Schafer - Oppenheimer

Quinn Bolton - Needham & Company

Aeroflex Holding Corp. (ARX) F3Q13 Earnings Conference Call March 9, 2013 8:15 AM ET

Operator

Good morning and welcome to the Aeroflex Holding Corp. Webcast and Conference Call, where management will discuss the Company's financial results for the third quarter of fiscal year 2013, which ended March 31, 2013. If you do not have a copy of the earnings press release, you may access it through the Investor Relations section of the Company's website at aeroflex.com. This call is being recorded for future playback, and will be available later today in the events tab of the Investor Relations section of the Company's website.

I would now like to turn the call over to Andrew Kaminsky, Senior Vice President of Corporate Development and Investor Relations for opening remarks. Please proceed, sir.

Andrew F. Kaminsky

Good morning and thank you for joining us. With me on the call today are Len Borow, Aeroflex's Chief Executive Officer; John Adamovich, Aeroflex's Chief Financial Officer; and John Buyko, Aeroflex's Executive Vice President and President of AMS.

Please note that during this conference call, we may make forward-looking statements regarding future events or financial performance and outlook that are based on information currently available to management. You are cautioned that any forward-looking statements are not a guarantee of future performance and are subject to a number of uncertainties and other factors, which could cause the actual results to differ materially from those currently expected.

For a more detailed description of these uncertainties and factors, please see Aeroflex's filings with the Securities and Exchange Commission. Aeroflex undertakes no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes in future operating results.

Also note that all dollar figures and percentages are approximations, and that the detailed reconciliations of GAAP to non-GAAP results can be found in the press release we issued this morning that is posted on our website. After we review the results of the third quarter, we will open the lines for questions.

At this time, I'd like to turn the conference call over to Len.

Len Borow

Thank you, Andrew. Good morning and thank you for joining us today. Our wireless ATS business has continued its turnaround this fiscal year. The significant operational changes we implemented are now visible in our results, as demonstrated by our increased gross margins and adjusted EBITDA. We are executing on our strategic plan despite the challenges the sequestration had posed in some of our government markets. Our visibility, that now is sharper than it has been at other times, continues to improve and we are well positioned to be successful across all of our end markets.

Our AMS business continues to have strong bookings year, contributing to our consolidated nine-month book-to-bill of over 1 to 1, which provides confidence going to our largest quarter of the fiscal year. We continue to invest in commercializing our intellectual property and leverage our sole source and primary supplier status to deepen and expand our customer relationships.

In AMS this quarter, we continued to book orders across all our product lines and end markets including RadHard products for new satellite programs, HiRel products for new radar and missile defense programs, including (indiscernible), as well as mixed-signal products for medical and industrial applications.

In ATS, we focused on our core competencies and have begun to show signs of success as evident in our financial results. This quarter we continued to increase the robust mix of our wireless product offerings which has expanded our addressable market. With new cellular and connectivity products and enhancement in both our infrastructure and PXI product lines, we are well-positioned to continue building on the turnaround that began this year.

I'd like to now turn the call back over to John Adamovich to discuss our financial results. John?

John Adamovich, Jr.

Thanks, Len, and good morning. I am going to briefly discuss the financial results for the quarter and give a quick update on our balance sheet. I'll then turn the call back to Len who will discuss our guidance before opening the lines for questions. For purposes of this call, my statement of operations related comments will focus on our non-GAAP metrics. These non-GAAP metrics eliminate certain nonrecurring charges and non-cash charges. As Andrew mentioned at the outset of the call, the detailed reconciliation of our GAAP to non-GAAP results can be found on the press release we issued this morning.

Net sales of $161 million for the third quarter were comparable to last year's third quarter. With sequestration now a reality, programs that we participate in are being pushed out, not being cancelled. The sales put by segment is $86 million from AMS and $75 million from ATS.

Gross margin for the quarter was 50.2%, up 130 basis points from 48.9% in the third quarter of fiscal 2012. The increase was driven primarily by the performance of the commercial wireless business in ATS. We are continuing to make changes that will enhance our operating leverage and increase profitability. These actions, predominately in ATS's wireless business and just beginning in ATS's (indiscernible) business, include consolidating facilities, pruning product lines, and reorganizing our labor force. The results of these activities are clearly visible in our reduced operating expenses.

SG&A was $33.6 million, down from $36.0 million in the third quarter of fiscal 2012. R&D for the quarter was $23.2 million versus $22.2 million in fiscal 2012. For the third quarter, we generated non-GAAP operating income of $24.1 million and adjusted EBITDA of $29.4 million. Non-GAAP net income for the quarter was $9.9 million or $0.12 per share.

Our customer diversity has remained strong. For the quarter, no customer accounted for more than 10% of net sales. Also for the quarter, 21% of net sales were in APAC, 24% in Europe, and 51% in the U.S. Net sales to the U.S. government or to prime defense contractors or subcontractors of the U.S. government dropped to approximately 28% for the quarter from 33% for the same quarter in fiscal 2012 due to sequestration and grimmer shipments made last year that have not repeated. Our geographic mix of non-GAAP pre-tax income for the quarter resulted in a non-GAAP effective tax rate of 33%.

Before leaving the income statement, I'd like to address two items in our GAAP numbers. The first item is the $8 million charge we took this quarter to settle our previously disclosed International Traffic in Arms or ITAR matters. Some related to the pre-acquisition activities of certain acquired companies, others dating back to 2001, and all of which we have voluntarily disclosed to the State Department.

To resolve these matters, we are in the process of finalizing a consent agreement in which we will agree to pay a fine of $8 million, $4 million of which is payable over a two year period, with the remaining $4 million eligible to the suspended based on qualified past and future compliance expenditures and investments made by the Company over the same two-year period. Going forward, the resolution of this issue will not impact our ability to transact business internationally. Also in the quarter, we took a nonrecurring charge against accounts receivable of $2.5 million from a customer whose accounts have been ceased by the U.S. Attorney.

To briefly address the balance sheet, we ended the quarter with gross debt of $606.4 million and net debt of $571.6 million. Our leverage ratio under the one financial covenant in our credit agreement was 4.89 times compared to the permitted ratio of 5.5 times at March 31.

I will now turn the call back to Len for some closing remarks. Len?

Len Borow

Thanks John. While we still remain cautious, there are signs that we have turned the corner. I am confident about our long-term market position and ability to execute on our strategic plans. For our seasonally largest quarter; the fourth quarter of fiscal 2013 ending June 30, we expect net sales to be between $175 million and $185 million, adjusted EBITDA to be between $41 million and $45 million, and non-GAAP net income per share to be between $0.21 and $0.25. The range of expected non-GAAP net income per share for the fourth quarter was calculated using an effective tax rate of 38%.

I would like to now turn the call back to the operator to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of James Covello representing Goldman Sachs.

James Covello - Goldman Sachs

Len, if I could ask first, do you think we're now feeling the full brunt of the impact of sequestration or if there's potentially another shoe to drop?

Len Borow

I really think that we're seeing the most of it right now because there is confusion. In other words, they don't know exactly what they're going to lose, so they're not spending – they're not not spending, they're pushing back spending on anything, so I think they are more confused. I think as that goes on a little, I think you'll see them see what's going to be allowed to be spent and that will open up something.

James Covello - Goldman Sachs

Do you have any best guess on when some of the first rings might start to loosen up or is that just completely against the game for everybody at this point?

Len Borow

Against the game for everybody.

James Covello - Goldman Sachs

Okay. And then if I think about a little bit bigger picture, as we think about growth going forward, how would you rank order for us to prospect for growth relative to, is the end of sequestration going to be the biggest driver both to the share gains and wireless test, what kinds of things should we really be looking for to drive acceleration forward from here?

Len Borow

I think you're going to see us continue to expand our infrastructure offerings in the wireless area. We just got endorsed by China Mobile and we also just won the last of, we had one hold-out in the infrastructure side who did not commit to our product, they would try to do with their own, in Asia and they just bought that first system, I'm sure they'll buy more in the future, and we've got a clean sweep now with every major player and we're working on things to expand that product line and to have higher offerings in that product line which we dominate. And we're also going to see some nice growth in some other product areas like semiconductor test, an area that we've just gotten critical mass on and we're starting to see some nice orders coming in.

Operator

Your next question comes from the line of Patrick Newton representing Stifel.

Patrick Newton - Stifel Nicolaus

A couple, I guess to dovetail off what you just said about China Mobile and some of the momentum you're seeing there, can you discuss how order trends have been in LTE and LTE(A), and given that China Mobile and the rest of the Chinese service providers are talking about 1.3 million base stations being built through 2017, I'd love your thoughts on how you're competitively positioned there, how you expect to purchase patented deployments, and if you have any thoughts specifically on the timing from acceleration of orders from China Mobile this year?

Len Borow

We don't have a crystal ball but as a dominant player in the infrastructure, testing of base stations, we expect to gain, and in particular, we're very strong in Asia, so we're confident that you'll see that product line grow. And that's the key to what we're doing with our strategy, instead of going after every little nook and cranny of business around the globe, we've decided to put most of our emphasis on the infrastructure side where we dominate, and it's paid off handsomely, especially in gross margin and EBITDA.

Patrick Newton - Stifel Nicolaus

So, no crystal ball on China Mobile there? I guess as we look forward, you think it's realistic that they could possibly have a pretty material impact in your seasonally weaker September quarter?

Len Borow

Again, I can't pin it down to quarters but they should have a great impact on fiscal '14, we know would start July the 1st.

Patrick Newton - Stifel Nicolaus

Okay, and I guess last quarter, Len, you discussed in ATS some very solid infrastructure orders and also some PXI handset orders. I'm curious if this momentum from both of those products has continued into the March quarter? And then especially on the PXI side, are you seeing any changes on the competitive front given that National Instruments has had some recent success in wireless, and then Agilent has come and kind of has a renewed focus on PXI investments?

Len Borow

Again, all I can say is, as far as the infrastructure, absolutely we got this key holdout, the big people continue to give us orders, we had a strong quarter in bookings for that product line. As far as PXI goes, with National doing a great job and Agilent doing a great job, we see our PXI orders up to 200% this year. Again, it's off a small base but it's not bad.

Patrick Newton - Stifel Nicolaus

Perfect. And then, I guess John, a couple of debt related questions. Do you still intend, I don't think you paid down any debt in the current quarter, are you still intending to pay down roughly $60 million this year? And then pertaining to covenants, your leverage ratio just stepped down to 5.5 this quarter and could you remind us again of the timing of the next write-down?

John Adamovich, Jr.

Sure. You're right, we didn't pay any debt down in the quarter and that's because we double down in the December quarter and pay $10 million downs instead of the planned $5 million. So, we're on track. For the year, we still intend to pay $60 million down on debt and so far as the steps down goes, it steps down to 5.25 at September 30.

Patrick Newton - Stifel Nicolaus

And then, I guess for Len or John, last one for me is, the ATS side, you did talk about pruning some of your underperforming assets. Can you help us understand what the revenue impact was either sequentially or year-over-year from some of those steps you took?

Len Borow

We don’t have that broken down exactly, do we John?

John Adamovich, Jr.

No, the answer is that we don't, but I don't think you're going to see a very large change in terms of the revenue pattern from the operation. We are pruning some things that just haven't been performing all that well but I'm not expecting them to have a particularly large effect.

Patrick Newton - Stifel Nicolaus

I had thought that perhaps it was a couple of quarters ago that you had said that targeted products represented maybe $25 million to $30 million in annual revenues. Is that a fair way to think about it?

Len Borow

Yes we have – some of that is pruning and some of it would be divestiture and total premature to talk about that.

Patrick Newton - Stifel Nicolaus

Perfect. Thank you. Good luck.

Operator

Your next question comes from the line of Rick Schafer representing Oppenheimer. Please proceed.

Rick Schafer - Oppenheimer

I've got a follow-up on the sequestration question. I guess I'm just curious, is it possible to – it seems like you're seeing the worst-case impact already, I guess I'm curious, is it possible to see or possible to quantify what that impact is, like how much of a drag is sequestration right now to you guys on your top line? And I'm curious if you're seeing actually any surprises there? It sounds like you kind of planned for the worst and I mean are you seeing any real surprises there, good or bad?

Len Borow

No, we haven't seen any surprises. We anticipated there'll be confusion and slow-down and we've seen it. We haven't seen it affecting our long-term programs yet, but we are optimistic in what we hear from our customers and what we hear from the government about our programs. So we're keeping our fingers crossed.

Rick Schafer - Oppenheimer

Len, could you give me is it – do you feel like is it possible to quantify that drag build and you feel like it's 5% headwind or a 2% or…?

Len Borow

Yes, I think it's probably 5% headwind at this point.

Rick Schafer - Oppenheimer

Then just a couple of handset questions. I mean is more of your strength coming from LTE or LTE(A) when you look at your order book, or does that even matter to you guys?

Len Borow

Again, we're seeing more of this coming on the infrastructure side. Remember that's where we're really concentrating on and we're starting to see some nice contributions from LTE(A) and we continue to see contribution from LTE.

Rick Schafer - Oppenheimer

So if you're breaking that down, Len, would you say that it's more – obviously it's more infrastructure, so it's more base station, but could you give us maybe the split in your order book there between handset and base station?

Len Borow

Base station is probably double handset, two-thirds infrastructure, one-third handset.

Rick Schafer - Oppenheimer

Got it. Then my last question, maybe for John or for whoever, but it looks like gross margins were down a little bit on the AMS side. Can you talk a little bit what's driving that and maybe where you see those going over the next few quarters or what gets you there?

John Adamovich, Jr.

Sure. The margin situation in AMS is predominately mix and we see that coming back up again in Q4 and the coming quarters.

Rick Schafer - Oppenheimer

Can you give any color on what the mix, like what would drive, what's going to kick it higher I guess, what's going to push it higher?

Len Borow

Again, as we've talked about in prior conference calls, we have many different products. When the mix is predominately standard products, the gross margin is highest. When you're getting some new design-ins which bode well for the future, your gross margins are a little lower. So it's not something that is a trend or anything.

Rick Schafer - Oppenheimer

Okay. Have you guys ever put out like a target for overall Aeroflex gross margin?

Len Borow

We have in the past and we've always said that we intend to grow it to the middle 50s. We were at like 53% and then over the last year we slowed down a little bit to 48%, 49%, and now we're back in the 50s, and I think you'll see us trend, in particular due to the focus on infrastructure where our margins are much higher than the very highly competitive cell phone testing area where there's many players. You'll see that trend up into the solid mid 50s and you'll see I believe AMS back into the mid-50s.

Operator

Your next question comes from the line of Quinn Bolton representing Needham. Please proceed.

Quinn Bolton - Needham & Company

I apologize but I missed the first couple of minutes of the prepared comments, but Len, just the impact from sequestration, are you seeing that across both AMS and ATS or is it primarily on the AMS side?

Len Borow

No, we're seeing them in both areas.

Quinn Bolton - Needham & Company

Okay. Fairly equally split then across both?

Len Borow

Yes, I mean it's hard to really determine it that way. It's a sluggish lift, it's not a like a cancelling or there's any big change, it's just they're dragging their feet on placing orders.

Quinn Bolton - Needham & Company

Okay. And it kind of sounds like it's more on some of the sort of the standard components rather than long-term programs where the effect is being felt?

Len Borow

Let's hope it stays that way, yes.

Quinn Bolton - Needham & Company

Okay, great. Then I know on that ATS side of the business in wireless, it's a focus more on the infrastructure test side and handset test but I think in that last couple of conference calls, you've talked about seeing some strength or some perhaps opportunities in Asia for handset customers. Just wondering if you could give us an update on what you're seeing in Asia in terms of handset test?

Len Borow

Again, as I said, you must have missed the answer to one of the last questions, but they had said that in light of NI going in like crazy on PXI and Agilent going in crazy on PXI, how is your PXI business doing? And my comment was, we expect this year, as we had forecasted beginning of the year, that our PXI business would be up 200%, and it's going to be up 200%.

Quinn Bolton - Needham & Company

Sorry, is that mostly from those customers in Asia?

Len Borow

It's mostly from deploying product in Asia, yes.

Operator

At this time, there are no further audio questions. I would like to turn the call back over to management for closing remarks.

Len Borow

Thank you very much for being on our call and we'll speak to you next quarter. Thank you.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect and have a great day.

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