Applied Signal Technology, Inc. F3Q09 (Qtr End 7/31/09) Earnings Call Transcript

Sep. 1.09 | About: Applied Signal (APSG)

Applied Signal Technology, Inc. (APSG) F3Q09 Earnings Call September 1, 2009 5:00 PM ET

Executives

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

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

Analysts

Chris Donaghey - SunTrust Robinson Humphrey

James McIlree - Collins Stewart LLC

Steve Levenson - Stifel Nicolaus

Jeff Evanson - Dougherty & Company

Michael Smith - BB&T Capital

[Unidentified Analyst] - Oppenheimer & Co.

Robert Kirkpatrick - Cardinal Capital

[David Reynolds] - Catapult Partners

Michael Lewis - BB&T Capital Markets

Operator

Greetings, ladies and gentlemen, and welcome to the Applied Signal Technology third quarter 2009 earnings conference call. (Operator Instructions)

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

William B. Van Vleet, III

Thank you, Jen. Good afternoon, everyone, and thank you for joining us to review our third quarter results.

With me today is Jim Doyle, our Chief Financial Officer.

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

Now with that out of the way, I'm pleased to report that we've concluded another quarter in which we have continued to increase our profitability and earnings per share from those of last year. I'd like to run through the highlights of the third quarter.

Revenues in the third quarter were $49.5 million, essentially unchanged compared to the year ago quarter's level of $49.9 million.

Operating margin for the third quarter increased by 340 basis points, reaching 9.8% versus the level a year ago of 6.4%.

Operating income grew by 50% to $4.9 million.

We saw a better mix of revenues in the quarter and continued to benefit from the expense reductions we've implemented over the past year.

Earnings per fully diluted share for the third quarter were up 67% to $0.25 compared to $0.25 in the period a year ago.

We continue to believe that our base business will see a growth rate near about 10% for revenues in fiscal 2009 and that we should achieve an operating profit margin of between 8% and 11%, depending on the mix of our revenues.

Our total new orders to date were approximately $141 million compared to new orders of approximately $145 million for the same period of fiscal year 2008. And specifically during the third quarter we received new orders of approximately $51 million compared to new orders of approximately $70 million during the first quarter of fiscal 2008.

Now I'll just note that this number's a little misleading as the timing of some material contract awards shifted from the third quarter into the fourth quarter this year. We've already seen a good deal of this expected activity materialize in the fourth quarter and since the close of the third quarter we've received seven separate ISR program awards with a total value of $44 million. These initial letter contracts that were granted under these awards total approximately [$16 million] and we expect to definitize the remainder amount on these contracts before the end of the year.

In addition, as we announced just last week, we've been awarded a five-year $200 million IDIQ contract for the next-generation ASA program. We were the incumbent on this award, extending our participation on this very significant program.

I'd also like to provide some additional detail on the major programs and new product technology initiatives under way.

We recently experienced success on the reconfigurable SIGINT payload program. The second phase of that program was conducting ELINT flight testing. Our Pegasus payload demonstrated exceptional geolocation accuracy at long standoff ranges, providing a significant improvement in capability in a miniature form factor.

The fuel testing of our Model 680 RAIDER product has also been going very well. It's providing advanced collection capability in a wide array of modern communications, and it's the only 3G surveillance product on the market. This product is still in evaluation by the government and we're hoping it will translate to additional product sales in the next two quarters.

We successfully demonstrated our Model 570X RENEGADE product in the Trident Specter field test. We were able to integrate SIGINT information onto full-motion video imagery to enable terminal guidance against simulated insurgent threats. The Model 570X, as you may know, is a very small form factor and it enable deployment on all sizes of unmanned aerial vehicles, including Tier 1 UAVs or hand-launched ones.

During the fourth quarter we have several opportunities for increased sales of our [Process] highsurveyor high-definition sonar. We showcased this product this past quarter in the Trojan Horse maritime security exercise in New York City harbor. We also conducted a survey operation of an undersea pipeline that saved our customer many thousands of dollars in what would have proved to be unnecessary dive costs, driven mainly by the imaging resolution. Both of these events have generated significant interest for us, both in potential sales and also in leased solutions for additional undersea surveys.

I'd now like to address the strategic acquisition of Pyxis Engineering which we announced earlier today. As you know, the cybersecurity initiative is a large and fast-moving opportunity for both the leaders in network security as well as a wide range of specialized service providers. The current presidential administration has been very clear that protecting the systems that underpin the U.S. economy, the civil infrastructure, public safety and national security is an absolute priority over the next decade.

Cybersecurity risks pose serious economic and national security challenges. The estimates for the total spending over the next five years vary but are estimated at approximately $50 billion. And while most of that expenditure is likely to be devoted to passive protection systems - a market that's dominated by large network security companies - at least 10% of the market or $5 billion is more specialized, and we refer to that niche as cyber intelligence. This is where AST is looking to build a niche-oriented high-value business.

So today we acquired Pyxis Engineering, which has a revenue run rate of approximately $14 million, for $16.25 million in cash as well as the potential for a stock-based earn out.

Pyxis has 75 employees who provide systems engineering, software engineering, application architecture, cloud computing, advanced data operations, enterprise IT infrastructure services, and project management services for the U.S. Department of Defense and the intelligence community. Since their inception in 2006 they quickly developed an excellent reputation and a sizeable business.

We will be integrating this business with our existing software and services efforts into a unified platform. This acquisition will give Applied Signal immediate access to cyber intelligence revenue streams, and we believe that Pyxis holds a significant first-mover advantage in this market. And by that I mean to some extent that companies which are participating in the early rounds of contracting activity in the cyber area should remain strong incumbents as those programs evolve and grow over the next several years.

With a $14 million base of business and good customer relationships, we believe that Pyxis has an excellent start in this regard, and we will help them raise additional barriers to competition and capture incremental market share over time.

While the acquisition is only expected to be modestly accretive in the short term, we foresee expanding revenue opportunities in this cyber intelligence space, both with new and existing clients and programs.

Also, strategically we've continued to invest in expanding the capabilities of our management team.

David Baciocco has joined us this quarter as our Vice President of Strategy and Business Development, with over 17 years of experience in the field. Prior to joining us at AST, Dave served as the Vice President of Business Development for Ericsson Federal, where he was responsible for all business development efforts for the U.S. Department of Defense and intelligence community programs. He has an extensive track record of increasing company market share in the defense and intelligence sectors, and we believe he will help us quickly identify and address market opportunities across our entire customer base. We're very excited to have him as part of our team.

I'm also very pleased to have Mark Andersson join us as our new Chief Operating Officer. Mark has over 26 years of experience in the development and implementation of solutions for the defense, intelligence and law enforcement communities, including SIGINT. Before coming to Applied Signal, Mark held the role of Vice President of the proprietary programs business of Harris Government Communications Systems Division.

Thanks for your attention and I'd like to turn the call now over to Jim Doyle, who will run through the financial results in detail.

James E. Doyle

Great. Thanks, Bill. Good afternoon, everyone.

I'll touch very briefly on the income statement and then walk through the balance sheet before I turn it back over to Bill for his final comments.

Revenues for the third quarter of fiscal 2009 were approximately $49.5 million, essentially unchanged from revenues of approximately $49.9 million recorded in the third quarter of fiscal 2008. Revenues for the first nine months of fiscal 2009 were approximately $148.4 million or about a 7.5% increase when compared to revenues of approximately $138 million that we recognized during the same period of fiscal 2008.

Product sales increased by about $960,000 during the third quarter of fiscal 2009 and increased about $9.8 million during the first nine months of fiscal 2009 compared to the same periods in fiscal 2008. The increase was primarily due to sales related to our Model 680 RAIDER product and continued demand for our core broadband communication products.

Earnings generated by our development programs decreased by approximately $1.8 million and about $800,000 during the third quarter and first nine months of fiscal 2009 compared to the same periods in fiscal 2008, primarily due to a decline in revenues related to our [inaudible] Phase 2 and Spectra contracts.

We recorded royalty income of approximately $1.7 million during the third quarter of fiscal year 2009 compared to approximately $1.3 million during the same period of fiscal 2008. And during the first nine months of our fiscal year 2009, our royalty income was approximately $5.2 million compared to approximately $3.8 million during the same period of 2008.

The company's operating income for the third quarter of fiscal 2009 increased approximately 51% to about $4.8 million as compared to $3.2 million in the third quarter of fiscal year 2008. This improvement was driven by several factors, including a reduction in stock-based compensation expense, increased profit from royalty revenue and product sales, and a lack of writedowns related to certain inventory carrying values.

Net income in the third quarter increased to $3.3 million versus $2 million in the year ago period. This translates into $0.25 per diluted share versus $0.15 per diluted share in the same period last year.

Turning to the balance sheet now, our combined cash and investment balances at the end of the third quarter were approximately $66 million, up approximately $7 million or 12% from the ending balance at October 31, 2008. I'll point out that this total does not represent the cash used for the purchase of Pyxis, which occurred after the close of the third quarter.

Accounts receivable balances were approximately $40 million, essentially unchanged compared to the balance at October 31, 2008. Billed AR our balances of approximately $25 million increased about $2.7 million compared to the $22 million balance at the end of October of 2008. Unbilled AR was about $15 million and decreased about $3 million during the first nine months of fiscal 2009.

The inventory balance at July 31, 2009 was approximately $9.6 million compared to approximately $8.1 million at October 31, 2008. Inventory increased primarily due to an increase in work-in-process inventory.

Prepaid and other current assets included pre-contracts for at-risk costs of about $1 million at July 31, 2009. This compares to a balance of about $1.3 million at the end of the second quarter of 2009.

Current liabilities were about $23 million compared to the balance of about $25.5 million at October 31st. The decline in this balance was due in part to payments of employee-related fringe benefits during the first quarter of 2009.

Our bank debt continues to decline. Our total short and long-term balance at the end of the third quarter was approximately $4.5 million.

And we paid dividends of approximately $1.6 million during the third quarter of fiscal 2009.

That summarizes my overview of the financial statements, and so I'll turn it back over to Bill for his concluding remarks.

William B. Van Vleet, III

Thanks, Jim.

In summary, we're very pleased with the continued strategic, operational and financial gains that Applied Signal's making.

We have a very strong core Broadband Communications business, we have numerous opportunities for our growth in tactical SIGINT products that include both manned and vehicle portable systems such as RAIDER, ROGUE and PROFIT, as well as our low size, weight and power integrated solutions for aerial deployment.

Our Sensor Systems opportunity also remains very good. We've made significant inroads into a number of potential customers through the effective demonstration of this technology and its wide array of applications.

Finally, we are very excited by the new range of opportunities for growth that accompany the Pyxis acquisition and our accelerated entry into the cyber intelligence market.

Even following this acquisition we continue to have a strong cash balance with limited debt. In our second quarter conference call I spoke briefly about our commitment to strategic deployment of capital, and we believe that we have successfully utilized our resources this quarter to the benefit of our customers and our shareholders. It's our intention to fully integrate this business and continue to search for other opportunities to accelerate our growth and generate incremental value.

Thank you again for your attention and support. And, Jen, I'd now like to open the call to any questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from Chris Donaghey - SunTrust Robinson Humphrey.

Chris Donaghey - SunTrust Robinson Humphrey

Bill, first of all, I just want to make sure that I understand this right.

So in the $200 million, it's an IDIQ, so I understand that wouldn't be in orders so far this quarter, but is there any task order activity that is in that $44 million so far in Q4?

William B. Van Vleet, III

No, those are two different things, Chris. The $200 million is an IDIQ contract and no delivery orders have been booked under that.

We do anticipate yet this quarter maybe getting, I'm guessing, $16 million is maybe an estimate of what we might see against [inaudible] orders in the next quarter, that amount.

The other amount, the other $7 million in letter contracts that we have, were for additional contracts outside and separate from the IDIQ program, and that has $16 million in revenues. We think the full value of those could be up to $44 million, but we still have to finish negotiations and definitization of those contracts.

Chris Donaghey - SunTrust Robinson Humphrey

And with the revenue guidance of about 10% for full year 2009, that implies a pretty strong sequential increase there. Is that a fairly high visibility number given the bookings that you've seen so far this quarter or what's driving that?

William B. Van Vleet, III

Well, the bookings were a little soft in the third quarter; both bookings and revenues were soft in the third quarter because of those contracts that were down. Again, given the fact that we've got these initial letter contracts, we're seeing a pretty good return rate or conversion rate, rather, on our competitive pursuits. [Break in audio.]

We think our bookings values will - we'll still end the year with a book-to-bill over 1 despite the fact that, if you looked at it for the first three quarters of the year, we're a bit behind at this point.

Chris Donaghey - SunTrust Robinson Humphrey

Just one quick question on the margins as well. This margin expectation of 8% to 11% is a pretty wide range, especially considering that you only have one quarter left. Can you talk a little bit about the influences that would impact that?

James E. Doyle

Sure.

Chris Donaghey - SunTrust Robinson Humphrey

Then also just, Jim, real quick, what should we be thinking about on tax rates?

James E. Doyle

As far as tax rate, the effective tax rate for this fiscal year is 39%. We did have some favorable tax treatment here in the third quarter, but I would use that 39% in your planning purposes.

As far as the operating income range in the 8% to 11% range, you have seen it throughout the year; it did exceed that 11% amount earlier in the year. It was a little less than 11% during the third quarter. We anticipate it to be towards the higher end of the range for the full fiscal year.

It's obviously driven, as you know, by the types of contracts coming through. We do anticipate product sales coming through here in the remainder of the fiscal year and we'll see how our royalty activity prevails, but we think that we would be on the higher end of that range.

There will be a little downward pressure as a result of the Pyxis acquisition. Their profitability is more of that services profitability and we will have to record certain intangible expenses starting this fourth quarter. We have not calculated the intangible amounts yet, but that might put some downward pressure on our operating income.

So that kind of gives you some kind of a sense as to what we're seeing for the fourth quarter.

Operator

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

James McIlree - Collins Stewart LLC

Jim, on the tax rate of 39%, so that would be 39% for Q4, I think? Sometimes you draw a distinction between effective tax rate and the actual rate booked, so just to be clear, 39% in Q4 barring any unusual or discrete tax items?

James E. Doyle

Yes. Yes, that's right, Jim.

James McIlree - Collins Stewart LLC

And then again, towards Chris's question on the operating margins, if you plug 10% top line growth in and the 8% operating margin and assume zero on the operating income for Q4, clearly, unless there's a disaster out there that we're not aware of, when you say towards the high end, I just want to make sure you're not expecting some unusual thing to happen in terms of mix?

James E. Doyle

No. No, we're not. No, we're not, Jim. We don't see any unusual thing here in the fourth quarter.

James McIlree - Collins Stewart LLC

Bill, in your commentary you have, I think, a list of four or five things that you talked about - the mini reconfigurable ELINT, RAIDER, RENEGADE, I think the 570X and then the [Process].

William B. Van Vleet, III

Right.

James McIlree - Collins Stewart LLC

If we were to add up those five items can you give a feel for how much they're contributing either in orders or revenue in fiscal 2009?

William B. Van Vleet, III

Let's see. Most of these are product or technology demonstrations. Let me kind of walk through them a little bit one by one and I'll let Jim tally up what the total volume might be of business on that.

On the RSP, that was a second phase of a program and why that's significant for us is that's the first demonstration of the Pegasus ELINT product.

The Model 680 RAIDER is the first product that we've been demonstrating for the ground market and that has been one of the major reasons that our product sales have ticked up over last year. In fact, it's probably the largest contributor to the difference between this year's product sales and last year's product sales, and Jim will give you an estimate on what that number is here in a minute.

The Model 570X is an airborne payload that we haven't seen a large amount of revenues from yet, but these field tests are qualification field tests where the government does these spiral evaluations and they evaluate technologies. And as they get technologies that demonstrate well, they can field them very quickly overseas in contingency operations, and we got very good results from the Model 570. So while the revenues there haven't been real large, they, if it's adopted, could be significant.

And then likewise in the [Process] - we haven't had large revenues to date on that, but we are optimistic about getting adoption rates in both defense and derivative commercial markets, if you will.

James E. Doyle

I want to give you some help on that, Jim. As far as the ELINT-related effort, it was about $1 million or so of related order and then subsequent revenue.

And then on the RAIDER side we've recognized revenue - and these are very, very round numbers, Jim - of about $6 million or so. I don't have the exact numbers for the RAIDER product, but it's in that range - $6 to $7 million.

William B. Van Vleet, III

And the other two may be $1 million or so, because we're talking about $10 million total is the impact of those things.

And, again, the emphasis was more on the opportunity it leaves before us than significant contributions to the past revenues.

James McIlree - Collins Stewart LLC

Right. So fiscal 2010, assuming the field tests go well, etc., it's possible that you would see a big ramp in either one or multiple of those products?

William B. Van Vleet, III

Yes. If we see a higher adoption rate, there's a possibility we could see increased revenues from there. And all them tend to be pretty good earnings opportunities for us. You know, whenever we sell product, that's our highest-margin business.

James McIlree - Collins Stewart LLC

And just to beat a dead horse, these products or this bucket of things are different than your base business in that it's a box that can go on a device or a platform and so you're not facing that development hurdle and those kind of long lead times, lower margins, etc.?

William B. Van Vleet, III

Right. These are all products that have been invested in either by AST or the government and they're now ready to get adopted and deployed. You bet.

Operator

Your next question comes from Steve Levenson - Stifel Nicolaus.

Steve Levenson - Stifel Nicolaus

In talking about the 680 RAIDER, is anybody else showing a competitive product?

William B. Van Vleet, III

There are competitive products out there. Probably the most notable one is a product built by Boeing which used the digital receiver technologies or DRT. In fact, they're the market leader in ground-based SIGINT and we've been [inaudible] our product versus them. And I think there's another competitor; I'm not positive who the competition is on that one, though.

Steve Levenson - Stifel Nicolaus

It sounded like you suggested for at least another few quarters it ought to be strong, but you think that's as far as it goes?

William B. Van Vleet, III

Oh, no, no. I think they're in evaluation right now in the product and the results of the evaluations will factor into their future equipment buys. Our current assessment is we might we see some translation or more additional purchases of those if the evaluation is successful, that is, we'll see some translation of those orders in the second or third quarter of fiscal 2010.

Steve Levenson - Stifel Nicolaus

The other item I was going to ask you about was Process. I think when you were here in New York you identified potentially 42 harbors that might benefit from using it. Do you see that as a product sale or as a service sale? Is that something that could become an annuity for the company?

William B. Van Vleet, III

Yes, that's a very interesting question, Steve. There's a couple of opportunities there.

For the specific opportunity of the harbors, we're finding that the major ports - the Port of New York, the Port of Los Angeles, the major ports - are less interested in purchasing the equipment and more interested in getting the data. In other words, they'll say either do a survey and tell us the information or lease the equipment and do a surveillance and give us a baseline scenario. And so, rather than sell products into the DHS market, we think the opportunity for a harbor and harbor patrol is more toward lease services.

We are starting to see some interest from a number of companies, however, both in the salvage business and in the oil and gas business for purchases of our [Process] surveyor unit.

And so we have, again, both product sales and service opportunities before us in that marketplace.

Steve Levenson - Stifel Nicolaus

And just one practicality - if you do it as a service how often do you think they need a scan?

William B. Van Vleet, III

That's a good question because it depends probably on the amount of traffic that occurs in a region. So for busy ports - New York, L.A. being two of the largest ports - they would probably require very frequent revisit rates; some of the smaller ports maybe less frequently. We haven't calibrated what that would be at this point. We're in the process of obtaining that market information.

Operator

Your next question comes from Jeff Evanson - Dougherty & Company.

Jeff Evanson - Dougherty & Company

Congratulations on your Pyxis acquisition.

William B. Van Vleet, III

Thanks. We're excited about it.

Jeff Evanson - Dougherty & Company

Why don't you tell us a little bit about what you think they need to take them to the next level in the next year and a little bit more on the opportunities there?

William B. Van Vleet, III

A great question. They're a great little company, they really are. Outstanding employee talent is one of the things that attracted us the most. They've got tremendous intelligence community presence.

If you think of the value chain, the intelligence value chain, it starts with, one, collecting information at a source. And so you collect information and then once you collect that information you put out a bunch of data and then somebody usually processes that data, turning it into information. That usually happens at an analyst's desk.

AST is a company that's been well-established in the collection realm. We'll deploy equipment to gather signals of interest and then provide those signals of interest to an analyst. What Pyxis does is they actually do the job at the analyst desk. And so by the combination of AST and Pyxis we now have extended our value offering and AST is one of the very few companies out there that has this end-to-end knowledge from the source of the signal all the way through to the report that goes on the president's desk.

What do they need to go further? They were reaching a size where they had to invest in some infrastructure to establish their base for the next tier of growth. We believe that by combining with AST one of the things we're going to do is combine their services business with our services business and we're forming a new division called network intelligence to create a large platform to be able to extend the growth that they've achieved today.

Jeff Evanson - Dougherty & Company

Do you think that by having more of an end-to-end capability through to the analysts decision are you going to be able to generate better answers and thus maybe take market share or what do you think?

William B. Van Vleet, III

We think we'll take more market share in a couple of areas. One is in the normal intelligence game and one is in the cyber arena. Again, the combination of Pyxis's skills and Applied Signal's skills allows us to go address both of those markets.

There's a couple of key competitions coming up in an area called analyst modernization. I think there's five programs at about $150 million each that are being let. This is a major cyber initiative. And Pyxis is very well positioned for, out of those five pursuits now - that all wouldn't come to AST; they're part of a team - but it's a major are of investment where we hope to leverage our capabilities, their positioning and our joint skills to capture a greater share of that market.

Jeff Evanson - Dougherty & Company

When do you think you'd have an update for us on any of those programs?

William B. Van Vleet, III

I think it might be a couple of quarters, frankly, but we'll keep you posted as they materialize.

Jeff Evanson - Dougherty & Company

Moving on to some of the tactical SIGINT products, the development programs you mentioned, [inaudible] Phase 2 and Spectra, where are we at momentum-wise there? Is this a lull here or are we actually ramping down?

William B. Van Vleet, III

A good question. [Inaudible] Phase 2 is currently is nearing its end, but there's another phase that may be awarded and we're waiting to hear how that turns out. Spectra has ended and has completely finished the last evaluation period in the last quarter, and we believe we will receive a follow on for that effort in the fourth quarter.

Jeff Evanson - Dougherty & Company

And what date did Pyxis close?

William B. Van Vleet, III

Today - September 1, 2009.

Jeff Evanson - Dougherty & Company

Any thoughts on allocating purchase price, Jim, at this point?

James E. Doyle

Not yet, Jeff. That's a very reasonable question. We're in the process of evaluating that and we'll report that at the next conference call.

Operator

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

Michael Smith - BB&T Capital

Looking at FY '09, it appears that you've won most of your major recompetes out there. I believe there's a couple small ones that are still kind of hanging, and I was curious to get an update on neutron engine systems and the mass [inaudible] exploitation program.

William B. Van Vleet, III

Great question. We were a winner on the [inaudible] program - advanced technical exploitation program. So we did win one of those contracts; we were on a winning team.

On the API imaging, that one is currently in evaluation. There was a demonstration planned this summer and we had some equipment delays from one of our vendors that's pushed that out a quarter, probably until December, now and so that one, I think, moved a quarter.

In total on our competitive efforts in the third quarter we did not lose any third quarter efforts. All of our efforts slipped - if they weren't awarded, of course - slipped to now the fourth quarter.

Michael Smith - BB&T Capital

And on Pyxis, that's a 75 employee count. Is that a current number?

William B. Van Vleet, III

Yes. In total AST now has 800 employees.

Michael Smith - BB&T Capital

How has that trended since that May 31st number, the revenue number that you gave? How has that employee count trended at Pyxis?

William B. Van Vleet, III

I'm not sure I understand the question.

Michael Smith - BB&T Capital

Have you seen a major ramp in the employee base?

William B. Van Vleet, III

No. Pyxis has been growing at a steady rate. At AST, we have been adding people at a better rate over the last quarter, I believe.

Jim, you want to add to that?

James E. Doyle

Yes. I think, Mike, the Pyxis folks have been hiring over the last two quarters. We're not seeing significant increases in the hiring, but they are staffing and they plan to continue to staff.

Michael Smith - BB&T Capital

Is there any [8-A] revenue associated with that acquisition that could [be recompeted]?

James E. Doyle

No, not that we are aware of.

Operator

Your next question comes from [Unidentified Analyst] - Oppenheimer & Co.

Unidentified Analyst - Oppenheimer & Co.

Did you give the backlog and, if not, could you give that? And also could you give us an indication of how much backlog Pyxis might bring with them?

James E. Doyle

Sure. Let's see, Ed. As far as our backlog at the end of the third quarter it's approximately $115 million. And as far as the Pyxis backlog, I don't think at least right at this moment it's appropriate to comment on that.

With Pyxis a lot of their contracts get renewed in the September and October timeframe and so I'd just feel more comfortable, at least at this point, to say what the backlog is for AST, about $115 million. But we do have a number of contracts that we're going to renew with Pyxis here over the course of this fourth quarter.

Unidentified Analyst - Oppenheimer & Co.

Does Pyxis have any major outstanding bids that you can talk about that might be coming due, especially in the fourth quarter?

James E. Doyle

As far as competitive bids, no.

William B. Van Vleet, III

I don't think any are planned in the fourth quarter.

James E. Doyle

Right.

William B. Van Vleet, III

I think all of them are planned FY '10.

James E. Doyle

Yes, I agree with Bill. There are sole source follow ons that are up for renewal.

Unidentified Analyst - Oppenheimer & Co.

And then their growth rate - their base is about $14 million; do you expect them to have about your historical growth rate or better or worse?

William B. Van Vleet, III

When we combine our services we think we're targeting an objective of a higher growth rate initially because of some of the opportunities we see with the expanding cyber market there. And so our objective is over 10% growth for that services business.

Unidentified Analyst - Oppenheimer & Co.

And then it looks like you guys basically have in the bag about 1 times book-to-bill for the year. Is it possible that you might significantly see that or do you have a target you can talk about?

James E. Doyle

I think, Ed, that that book-to-bill, as Bill mentioned, we think that we'll have book-to-bill of greater than 1.

You know how the bookings can be. They can move around on you and so, to indicate that it could be significant, it's difficult to answer that question.

But we do think that, like Bill said, we'll have a book-to-bill of over 1.

Operator

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

James McIlree - Collins Stewart LLC

The margins on Pyxis as a stand-alone business - forget about any potential amortization of intangibles - could you be more specific than service-type margins? Is it kind of that 10%-ish operating?

James E. Doyle

Well, it's a little lower than that, Jim. It tends to run more on an operating income basis at around 8% or so, in the 8% to 9% range.

Unidentified Analyst - Oppenheimer & Co.

And given that it's IC work, why is that? It seems low. Is it low?

William B. Van Vleet, III

Not for services.

James E. Doyle

Right. Bill said not for services.

Unidentified Analyst - Oppenheimer & Co.

And is there any customer concentration or contract concentration that we should be aware of?

James E. Doyle

No specific contract concentration. There are a number of contracts and they are spread out; the employees are spread out over a variety of contracts.

There is customer concentration, the preponderance of it being within in the intelligence community and a specific customer there.

William B. Van Vleet, III

They are pretty well diversified across a number of programs, so the company is not at risk of, say, one major recompete. I think they're pretty well balanced across it. And their two largest customers are consistent with our two largest customers as well.

James McIlree - Collins Stewart LLC

And is there a lock up on existing employees?

William B. Van Vleet, III

What do you mean by that, Jim?

James McIlree - Collins Stewart LLC

Have you signed existing employees to either long-term employee contracts or given them deferred stock to stay with the company or some sort of incentive for the current employees to stay? I'm assuming you want them to stay.

William B. Van Vleet, III

Yes, we do. Absolutely, we do, and we're pleased that they're part of the AST family. And, yes, we have offered all the employees some form of retention bonus over this first fiscal year.

James McIlree - Collins Stewart LLC

So is that a significant amount that will also have a downward impact on margins?

James E. Doyle

Yes, for the full year next year that will be considered compensation expense which we wouldn't be able to recover that amount from the government because it is related to the acquisition.

James McIlree - Collins Stewart LLC

And given that this was mostly a cash acquisition, are you kind of out of the acquisition market for, let's say, the next six to nine months?

William B. Van Vleet, III

We're going to focus very heavily on successful integration because, particularly when you purchase a services company, the real value, the intellectual property, is in the individuals. And so that will clearly be our focus over the near term.

That said, we have a long-term business strategy that we will continue to look for companies that can accelerate our opportunity to expand our ISR business and so that work will continue on in parallel with the integration of Pyxis.

James McIlree - Collins Stewart LLC

Was this an auction sale or was this negotiated?

William B. Van Vleet, III

It was a negotiated sale, not an auction.

Operator

Your next question comes from Robert Kirkpatrick - Cardinal Capital.

Robert Kirkpatrick - Cardinal Capital

Could you give us a little bit more color on how you were able to buy such an attractive property in terms of avoiding an auction?

William B. Van Vleet, III

Real good question. We've been looking at this marketplace for quite awhile. We've been evaluating a number of targets - companies, that is, rather - in this space. Pyxis was identified early because it's such a nice complement to our business.

And one of the primary factors and the reason we believe it'll be a successful acquisition and integration is there's a very strong cultural mesh between the two companies. We're both focused on the customer and intelligence mission, for one. We're both technology companies and lead with high technology. And I think those combinations really enabled us to create a nice fit.

In addition, this is a major undertaking and strategy shift for AST. AST has predominantly been a development house and we're looking to make services a major complement of our business. And by doing that, by acquiring Pyxis, by taking the services that were in AST and basically now merging them with Pyxis into an integrated services organization, that all created an attractive value proposition for Pyxis and it really turned out to be just a great opportunity for both companies.

Robert Kirkpatrick - Cardinal Capital

And, Jim, should we think of the whole $3.5 million in earnout being something that will be amortized into the income statement over one year, meaning next year, or over three years or how do I think about that?

James E. Doyle

Yes. The earnout, Rob, is a one-year earnout and it is based on revenue performance over the next fiscal year.

Robert Kirkpatrick - Cardinal Capital

Do you know how big the book value of the company, Pyxis, was in terms of millions of dollars roughly?

James E. Doyle

Unfortunately, Rob, I don't have the balance sheet in front of me so, no, I don't have a good answer for you.

Robert Kirkpatrick - Cardinal Capital

And then could you break down the revenue by cost reimbursable fixed price and time and materials for me, please?

James E. Doyle

For AST?

Robert Kirkpatrick - Cardinal Capital

Yes, for the quarter.

James E. Doyle

For the quarter? Sure. Let me get to it. For the quarter cost reimbursable contracts represented about 58% of our revenues; time and materials contracts for the quarter, about 24%; firm fixed price contracts, about 15%; and royalty contracts about 3%.

Robert Kirkpatrick - Cardinal Capital

And then the royalties that you indicated in your income statement as $1.7 million, did those essentially all flow through as profit or did you end up spending a good deal of those in dealing with your proprietary position and litigation strategy?

James E. Doyle

Yes, that's a good question, Rob. It primarily flowed through as profitability.

There were some initial costs that we did incur regarding the patent infringement situation and we do anticipate that in future periods we will incur legal costs. I can't give you a good estimate at this point because we're in some of the initial stages.

Robert Kirkpatrick - Cardinal Capital

So should I assume you spent less than a quarter million dollars?

James E. Doyle

Oh, yes. Yes.

Operator

Your next question comes from [David Reynolds] - Catapult Partners.

David Reynolds - Catapult Partners

I think last quarter you talked about a full year target of kind of $6 to $6.5 million and it looks like you're doing better than that. Can you just comment on what you're seeing there and how you expect that to trend going forward?

James E. Doyle

Yes. You're right, David, we are seeing a little better trend there. We're thinking on a full year basis more in the $6.5 to $7 million range.

The royalty stream has been good this fiscal year. We think that going forward for next fiscal year it would be in a similar range, in that $6 to $7 million range for next fiscal year. However, those numbers do not include any cost of litigation and so we'll have to see what those estimated costs are and what the timing of any potential litigation activities might be.

I hope that gives you a little bit of color as to what we're seeing for next year.

David Reynolds - Catapult Partners

That's perfect. And then, again, kind of a forward-looking question. I know you don't like to give a lot of guidance or anything, but we've got this big disparity between first half margins and second half margins and obviously, as we layer in Pyxis, you've got a little bit of a margin headwind and purchase accounting and some legal costs next year. Would the second half margins be a good run rate in terms of modeling for next year?

James E. Doyle

That's a hard question right now to answer, David, but that's a fair way to start looking at things, yes, because of the reasons that you mentioned. Yes, we would see a little bit of headwind on margins for next year because of those things.

Operator

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

Michael Lewis - BB&T Capital Markets

I jumped on the call a little bit late here; if this question was asked, I apologize for that.

First of all, Bill, I want to applaud you guys for moving back into the acquisition market. I always thought that this was an area that caused some weakness in the APSG model because if you weren't actively out there bidding these contracts someone else was and I think it had market share implications. So I was happy to see the acquisition.

With that said, should we expect to start to see more diversification to the services side? And is this a new model that we should anticipate with future acquisitions going forward?

William B. Van Vleet, III

Well, acquisitions are certainly - we have two elements to our growth strategy. One is we are looking for more organic growth from good positioning and strong products and strong development and investment. We're also looking to double that growth rate effectively through smart and prudent strategic acquisitions.

As we've said in prior calls, we have a multi-faceted strategy and services is certainly an important element of it. And us doing this acquisition and setting services up as a stand-alone division and business I think demonstrates our commitment to that market.

And I think we are continuing to look for other opportunities in the services business. At the same time we're also looking for other companies that might help us accelerate our other growth strategies and that includes opportunities in the tactical SIGINT arena, more in the cyber security area, and opportunities in the Sensor business.

As you know, in M&A some of those relationships you have to cultivate over quite awhile and it's a process that you go through. It's not an inoculation; it's a journey, so to speak.

And so we've got multiple fronts going simultaneously to make the best decision for our company and shareholders.

Michael Lewis - BB&T Capital Markets

And, Bill, just for follow up here, if you were to say where more opportunities lie right now, is it on the product side or are you seeing more opportunities in front of you on the M&A side with regard to services?

William B. Van Vleet, III

We're seeing more opportunities - can you restate your question for me again?

Michael Lewis - BB&T Capital Markets

Where are you seeing more opportunities on the M&A front? Are you seeing them with regard to product companies or are you seeing them with regard to services companies?

William B. Van Vleet, III

I think it's mixed. We may be seeing a little more opportunity on the services side just because there's a number of key program opportunities, particularly in the intelligence community. But there are some good opportunities on the product side, too.

Don't forget we're looking for strategic acquisitions that align with our business strategy that are not these very large transformational acquisitions. So we're looking at the companies that are going to be in the $20 to $50 million range. And we still see a pretty good balance across the opportunity space.

Operator

Gentlemen, there are no further questions at this time.

William B. Van Vleet, III

Again, I'd like to thank everyone for listening in to our third quarter call.

We're very excited about the acquisition, and we think we're on track for a pretty good year overall.

Thanks and good night.

Operator

Thank you.

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

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!