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AeroVironment, Inc. (NASDAQ:AVAV)

F1Q10 Earnings Call

September 8, 2009 4:30 pm ET

Executives

Steven Gitlin – Director of Investor Relations

Timothy E. Conver – Chairman and Chief Executive Officer

Stephen C. Wright – Chief Financial Officer

Analysts

Michael Lewis - BB&T Capital Markets

Chris Donaghey - SunTrust Robinson Humphrey

Troy Lahr - Stifel Nicolaus & Company, Inc.

Jeff Evanson - Dougherty & Company LLC

Peter Arment - Broadpoint Am Tech

[Randy Gorstman] – Baron Capital

Josephine Millward - Dougherty and Company

Brian Ruttenbur - Morgan, Keegan & Co., Inc.

Tyler Hojo - Sidoti & Co.

Erik Olbeter - Pacific Crest Securities

Michael Ciarmoli - Boenning & Scattergood Inc.

Operator

Good day, ladies and gentlemen, and welcome to the first quarter fiscal year 2010 AeroVironment, Inc. earnings conference call. My name is [Robbie] and I’ll be your coordinator for today. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

With us today from the company is Chairman and Chief Executive Officer, Mr. Tim Conver; Chief Financial Officer, Mr. Steve Wright; and Director of Investor Relations, Mr. Steven Gitlin. I would now like to turn the presentation over to Mr. Gitlin. Please go ahead, sir.

Steven Gitlin

Thank you, Robbie. Welcome to AV’s first quarter fiscal 2010 earnings call.

Before I hand the call over to Tim, please note that on this call certain information presented contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on current expectations, forecasts and assumptions that involve risks and uncertainties, including but not limited to economic, competitive, governmental and technological factors outside of our control that may cause our business, strategy or actual results to differ materially from the forward-looking statements. For a list and description of such risks and uncertainties, see the reports we file with the Securities and Exchange Commission. Investors are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date on which they are made. We do not intend and undertake no obligation to update any forward-looking statements whether as a result of new information, future events or otherwise.

The content of this conference call contains time sensitive information that is accurate only as of today, September 8, 2009. The company undertakes no obligation to make any revisions to the statements contained in our remarks or to update them to reflect the events or circumstances occurring after the conference call.

With that, it is my pleasure to turn the call over to Tim Conver.

Timothy E. Conver

Thank you, Steven. Welcome to our first quarter fiscal 2010 conference call. I’d like to begin by emphasizing three points. First, we are seeing about the performance we expected and that we outlined in our Q4 earnings call. Second, we’re confident in our FY ’10 guidance of 18 to 22% revenue growth, weighted to the second half. And third, the long term growth drivers of our business look very good. Thousands of our Raven and Wasp aircraft continue to help U.S. and allied ground forces operate more effectively and safely, and thousands of our PosiCharge systems help material handling electric vehicles operate more productively and safely every day.

The underlying demand for our solutions remains strong, and the potential market opportunities for our solutions in development remain attractive.

Now I’d like to expand on those three initial points. The first being we are seeing about the performance that we expected and outlined in our call. Our predicted low Q1 and Q2, and high Q3 and Q4 performance is driven by the planned conversion from analog to digital Raven systems by the U.S. Army and the Marine Corps. The conversion and retrofit to digital systems is a high priority for both customers. Product and services revenue in Q1 was down, mainly as a result of customers waiting to place their Raven orders until new digital systems become available in the second half of the year.

As we said in our last call, digital Raven systems and retrofit kits for the hundreds of deployed, analog Raven systems are planned for transition to production at the end of Q2, with volume ramping significantly through Q3 and Q4. The digital Raven change is extensive. It affects most of the system and requires over six months to cut into production. While the production system price increase will be modest, the retrofit of an analog system to digital will be extensive and will cost about $50,000. The compelling advantages of digital systems, the expectation of broad retrofit of the installed base and that price difference led our customers to defer additional Raven system orders until digital deliveries begin in the second half.

While our first quarter unfolded generally as we anticipated and as we discussed in our last conference call, revenue in Q1 was a bit lower than we had planned. Sales were $3 to $4 million less than we expected, primarily at EES, and largely attributable to timing of orders.

To prepare for the second half surge, we’ve been building our production readiness, spooling up our supply chain and making investments to enable that growth. Also, as we noted in our last call, our SG&A and our R&D spending remains sized for full year and continued growth expectations. The low revenue in Q1 combined with the steady spending to support full year growth adversely affected our profitability and produced a Q1 loss. Although I’m not pleased with our first loss as a public company, this general pattern did not come as a surprise given the imperatives of the digital Raven transition. Low revenue and the resulting negative profitability in Q1 were the necessary price for the transition to a compelling new digital capability, one that is very important to our customers and to AV.

My second point referred to confidence in full year guidance. Several factors support our view. We are moving towards digital Raven production on schedule, with performance tests, customer evaluation, design finalizations and production readiness going well. The second 2009 supplemental spending bill and the 2010 DoD budget request include $163 million for digital Raven systems and retrofits. Combined with the $17 million Army order we previously announced, this totals almost $180 million. This is a positive indication of demand and provides good visibility into the expected orders supporting our second half revenue plan.

Beyond Raven, we have good visibility into Global Observer fiscal year revenue with existing backlog, and customers are positive about their evaluations of Wasp and Puma Systems for broader procurement. In summary, despite quarterly operating results that fell a bit short of our expectations, our fiscal year is developing as planned, with good progress, important achievements and focus on execution.

Point number three was that long term growth drivers continue to look good. I’ll go into more program detail when I discuss the segments. But our long term growth opportunities are exciting and have never looked better. Our new Digital Data Link significantly increases the value proposition for our family of small Unmanned Aircraft Systems, and further strengthens our competitive position in this growing market. Switchblade has the potential to open a new and very large market opportunity for us. Global Observer development is progressing well, and the customer demand for affordable persistence will create a large new market for which we are well positioned. We are also well positioned for the charging infrastructure demand that we anticipate will be created as new planned battery and plug-in hybrid cars come to market over the next few years.

Now let’s discuss our Unmanned Aircraft Systems business segment. The Digital Data Link I’ve been talking about is a communications architecture that we developed in-house because there were no digital data links that could meet the requirements for integration into our Raven small, Unmanned Aircraft System. Remember Raven is a 4.2 pound airplane that flies for about 90 minutes, using an electric battery pack. The reason the digital conversion represents such a key component for our current year’s activity is that it provides highly sought after new capabilities that make small, Unmanned Aircraft Systems much more useful to our customers.

The benefits of digital Raven systems include expanding the number of channels Raven can utilize with the existing frequency allocation from the original 4 to as many as 40, which enables customers to fly many more airplanes in a geographical area without radio channel conflict; enhancing digital signal encryption, which provides enhanced security for the critical information generated by these systems; enabling beyond line-of-sight operation through airborne digital relay, which will enable users to expand the range in which these systems can be operated as well as neutralizing the effects of many topographical obstacles that would otherwise interfere with line-of-sight communications; and reflecting the flow of data or facilitating it through our system of IP formatting, making it easier to share video, voice and data across the battlefield. Each Raven airplane and ground station will soon be a node for a self-foaming, pop-up IP network any place, any time.

Our Digital Data Link will find its way into production in two ways, integration into new Raven systems in our production process and retrofits that will convert existing analog systems to digital systems, which will be processed in our factory and parallel with the new system production. We are now in the process of finalizing the digital system details and the production level drawings and the test procedures as we complete the move from development to high rate production. Our experience one year ago successfully cutting in a frequency change into the production of Wasp and Raven’s systems prepared us well for this production transition to digital Raven.

Our Wasp system is also being evaluated by customers beyond the U.S. Air Force and the Marine Corps, and new Puma systems are generating positive feedback from both initial and potential new customers. We recently demonstrated Puma publicly for the first time at the AUVSI conference in Washington, D.C., generating a great deal of interest in this unique platform. The announcer at the AUVSI air show repeatedly commented on how quiet the Puma was, characterizing it as the quietest UAV at the show. Whereas Wasp is a one pound vehicle that is extremely small, Puma is a larger, hand-launched air vehicle that flies for two hours and includes the highest quality imaging payload that we have yet developed. Puma is also the only production small, Unmanned Aircraft System able to land repeatedly on the ground or in the water.

Raven, Wasp and Puma all operate off of our common and interoperable ground control system, which includes a hand-held controller with an imbedded color monitor. We are now developing plans for the transition in the future of both Wasp and Puma to digital systems, working towards a small, Unmanned Aircraft System family of interoperable systems, built around a common, digital ground control system.

On the development front, Global Observer is now about two years into its customer funded, three plus year joint capability technology demonstration program. The objective of this JCTD is to develop an Unmanned Aircraft System that will deliver affordable persistence for multiple, high value, remote sensing and communication relayed payloads. With flight duration of up to seven days per aircraft, a two aircraft Global Observer system will provide satellite-like persistence over any area on the earth by alternating the aircraft sequentially to maintain seamless persistence over their designated orbit. With over $120 million in funding, Global Observer has moved successfully from the development phase to assembly with aircraft number one nearing completion and aircraft number two beginning to take shape in our low-rate production line.

I’m pleased to report that an important milestone in the Global Observer development program is in sight. Current plans call for the first Global Observer airplane to move to Edwards Air Force Base this quarter, where it will undergo final system level ground testing, flight readiness and then flight testing at this historic flight test center. After the flight testing phase is completed, payloads will be integrated into the aircraft and tested and then the military utility assessment of the entire Global Observer system will begin. We remain on track for system integration and flight testing in the second half of fiscal 2010.

The challenges facing U.S. and NATO troops in Afghanistan re-emphasize the game-changing potential of stratospheric systems with affordable persistence that can provide critically important ISR and communication in areas that otherwise are under served or where it is unavailable most of the time.

Switchblade is another of our important UAS development programs. Switchblade is a loitering precision munition that will offer an entirely new solution for finding and verifying specific targets, addressing the proximity of non-combatants to avoid collateral damage, producing high-precision force protection and standoff strike effects. Switchblade demonstrations in Q1 continue to perform well in new applications, impress potential customers and generate significant customer activity. Just this quarter we completed a very successful, three day demonstration at a government site with over 50 people representing many potential customers. Switchblade is a very high potential development because its unique characteristics and its proven prototype performance appear to be very well matched to current needs and policies. Adoption timing remains uncertain, but I continue to expect initial orders for pre-production systems yet this fiscal year.

Our development systems continue to make progress with SP2S, the stealthy, persistent perch- and-stare, a small UAS funded by DARPA. Further back in the development pipeline is the DARPA-funded Nano Air Vehicle program, another program that in true AV fashion is expanding the envelope of small, Unmanned Aircraft Capabilities. During Q1 we released a video showing several stages of the Nano Air Vehicle’s development. The video shows the flapping wing test aircraft flying up, down, sideways and front to back, using only its two wings for control, lift and thrust. To our knowledge, this [free] access control of an ornithopter has never before been achieved. Significant technology challenges remain on the NAV R&D program, but it’s a useful example of the kind of cutting-edge work that takes place regularly at AV.

Beyond the market for UAS in the United States, international companies are re-engaging in their pre-procurement, small UAS acquisition activities and we may be seeing a thaw or the beginning of a thaw in the non-U.S. segments of the market. In summary, the outlook for our UAS products and development programs remains strong.

Our Efficient Energy Systems or EES segment levers decades of experience in high-efficiency, electric energy systems to deliver clean transportation and clean energy solutions. In addition to spawning new market leading products such as PosiCharge fast charge systems and electric vehicle test systems, EES develops key sub-systems that support our Unmanned Aircraft segment. The efficient electric generator, propulsion motors and energy storage systems in Global Observer were developed by our EES team, and are state-of-the-art. Additionally, EES is actively involved in exploring fuel cell technology integration as a way to expand significantly the flight duration of our small, unmanned aircraft.

Revenue in EES declined in Q1. We saw continuing economic pressure in the industrial markets in which we sell PosiCharge systems, and we also saw delays in orders for our electric vehicle test systems, some of which we believe were affected by pending decisions in federal funding for clean transportation initiatives.

During the quarter we announced the introduction of our 8800. At 800 kilowatts, the AV 800 is now the highest power EV test system we offer and that we know of in the market. The first AV 800 was purchased by the U.S. Army Tank, Automotive and Armaments Command in Warren, Michigan. It will provide new capabilities that enable the development and testing of high duty electric and hybrid electric vehicles, and serves as an example of the breadth of our involvement in and our understanding of the electric vehicle technologies.

We also announced that we had received a patent for a method of enabling the collection of data from electric vehicles. This supports one of the important opportunities in the emerging electric vehicle and hybrid electric transportation market, which relates to managing energy and information between the utility and the battery charging system. From a broader perspective, we offer a range of charging, data management, energy management, testing and consulting solutions designed to enable broad, electric vehicle and plug-in hybrid adoption and their practical use. Our EV solutions group has made great progress with vehicle OEM’s around the world, all of which are developing electric and hybrid electric vehicles for market introduction over the next three years.

Recent government funding for clean transportation has been directed towards EV infrastructure projects and represents a start in the direction of supporting battery and plug-in hybrid electric vehicle adoption. I believe that EV’s will be adopted into the mainstream, although it’s difficult to know when. For now, there are over two dozen electric vehicles in development for introduction over the next few years, and we intend to be ready to support passenger and fleet EV adoption. We will offer comprehensive development support and charging solutions including true, fast charge capable systems, systems capable of fully recharging certain battery packs in less than 10 minutes.

I continue to believe that AV is strategically well positioned with our UAS team focused on enabling the growing demand for actionable intelligence and communications, and our EES team focused on enabling the electrification and the adoption of material handling and transportation vehicles.

With that as a broad overview of our business, Steve will now take you through our financial performance and the next quarter. Steve?

Stephen C. Wright

Thanks, Tim. Good afternoon everyone. Revenue for the first quarter was $37.9 million, a decrease of 29% from first quarter prior year of $53.6 million. Looking at revenue by segment, UAS revenue was $33.3 million, a decrease of 28% from the prior year. The decrease in UAS revenue was primarily due to lower product deliveries of $14.2 million and lower service revenue of $9.8 million, partially offset by an increase in customer funded R&D of $11.2 million. The decrease in UAS product deliveries and service revenue was primarily due to a cessation of Raven deliveries as we prepare for the introduction of DDL. The increase in customer funded R&D was primarily due to increased activity on the Global Observer contract. EES revenue was $4.6 million, a decrease of 39% from Q1 last year. The decrease in EES was primarily due to lower deliveries of our EV Test and Fast Charge systems.

Turning to gross margin, gross margin in the first quarter was $10.7 million, down 48% from Q1 of last year. Gross margin as a percent of revenue was 28% versus 38% in Q1 last year. By segment, UAS gross margin was $9 million, down 46% from Q1 of last year. As a percent of revenue, UAS gross margin was 27% compared to 36% in Q1 last year. This decrease in gross margin rate was primarily due to lower production and service revenue, resulting in higher unabsorbed overhead costs. EES gross margin was $1.7 million, down 56% from Q1 of last year. As a percent of revenue, EES gross margin was 37% compared to 52% last year. This decrease in gross margin rate was primarily due to overall lower product deliveries, again resulting in higher unabsorbed overhead costs.

SG&A for the quarter totaled $10.5 million or 28% of revenue compared to $8.1 million or 15% of revenue in the prior year. SG&A growth is primarily due to higher selling and business development expense, increased bid and proposal activity and higher administrative costs.

R&D for the quarter totaled $5.7 million or 15% of revenue compared to the prior year amount of $5.3 million or 10% of revenue. The majority of our R&D investments were for various UAS development initiatives.

Operating loss for the quarter was $5.5 million or negative 14% of revenue compared to an operating income of $7.2 million or 13% in the prior year. The operating loss was attributable to lower sales volume, resulting in a lower gross margin than prior year and higher SG&A and R&D expense.

Net loss for the quarter was $3.6 million or $0.17 loss per share compared to net income of $4.8 million or $0.22 per fully diluted share in the same quarter last year.

Looking at backlog, funded backlog at the end of the first quarter totaled $108.7 million, down $6.1 million or 5% from April 30, 2009.

Turning to our balance sheet, cash equivalents and investments at the end of the first quarter totaled $147.7 million, up $2.5 million from our prior quarter amount of $145.2 million. The positive cash flow was largely due to lower working capital partially offset by operating loss and capital expenditures.

Long term investments at the end of the first quarter totaled $7 million, down from the previous quarter amount of $7.2 million. The decrease in investments was largely due to redemptions of municipal auction rate securities.

Turning to receivables, at the end of our first quarter our accounts receivable including unbilled receivables totaled $31.9 mill, down $30.7 million from the prior quarter. Total days sales outstanding were approximately 76 days compared to 74 days at the prior quarter end.

Looking at inventory, inventories totaled $19.2 million at the end of the quarter compared to $11.6 million at the end of the prior quarter. Days in inventory were approximately 64 days versus 43 days at the prior quarter end.

Turning to capital expenditures, in the first quarter we invested approximately $2.3 million or 6% of revenue in property improvements and capital equipment.

And now I’d like to turn things back to Tim to discuss expectations for the full year.

Timothy E. Conver

Thanks, Steve. The business is tracking to our view of 2010 and remains well positioned for long term growth. We lead the market in small Unmanned Aircraft Systems, supporting all existing programs of record in the U.S. Department of Defense. Ground forces rely on these systems to operate more effectively and safely, and they have become embedded capabilities that move with them where they deploy and where they train.

The DoD and the Administration remain committed to supporting ground forces with tools that enhance their intelligence, surveillance, reconnaissance and protection. And our solutions are consistent with that goal and uniquely affordable. Our development programs address critical domestic and international priorities, and are proceeding on the right path towards market entry. Our customer relationships are strong and we have increased the size of our team of outstanding, high performing associates.

Our view of the full fiscal year is unchanged. We expect revenue growth of 18 to 22% over FY 2009, which would be $292 million to $302 million with an operating margin between 12 and 14%. Visibility into customer intent and government budgeting plans, along with our own production capabilities, support our ability to achieve these goals. Given the importance to the Army and the Marine Corps of early acquisition and retrofit of digital Raven systems as a catalyst for new Raven system and retrofit orders, we anticipate our second half to account for 70% of our fiscal year revenue.

With the quality and relevance of our products and of our solutions in development, and the quality and the passionate focus of our team, I believe that we are in a position to continue to help our customers win, help our people develop and help our stockholders benefit.

Thank you once again for your attention and the interest in our company, and Steve and I will now take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Michael Lewis - BB&T Capital Markets.

Michael Lewis - BB&T Capital Markets

Tim, the DoD a few weeks ago released an option award to you. It was actually for many hundreds of DDL retro. Now I don’t believe that you have released this in a press release. I guess my question with regard to this DDL option, is this what you’re expecting to see the ramp in in the second half off of this most recent option award?

Timothy E. Conver

Yes, Mike. Thanks. I think what you’re referring to was a release that the Army made I think it was a synopsis of their intent to procure Sole Source digital Ravens from AV. And I think there have been a few that have come out of the program office and that most recent one was probably the intent in funding in the overseas contingency operations line that is planned in FY ’10.

Michael Lewis - BB&T Capital Markets

But all we know is that it’s out there and it’s coming.

Stephen C. Wright

Yes. We haven’t actually negotiated that. That’s still ahead of us. But I would say Mike that what we’ve seen publicly released from the Army for Army and Marine Corps procurements in both the supplemental, the OCO funding and the FY ’10 budget is what totals to the $163 million that I referenced in my comments.

Michael Lewis - BB&T Capital Markets

And then just a quick follow up. In the press release you actually discuss that there is “thousands of UAS in the field.” Could you perhaps quantify the number of Raven A’s that you think the Army’s going to look at to convert with the DDL comps package?

Timothy E. Conver

Well, let me preface that with a couple of comments. One is we have some invisibility into their near term intent with these announcements they’ve made on their plans to contract with us for both new systems and for retrofits. And Steve probably has some specific quantities associated with those. Beyond that, we certainly don’t know for sure, but it’s my expectation that they will intend to end up with a common, digital fleet of their entire installed base. But we’ll have to wait to see how that rolls out in future years to be sure of that.

Stephen C. Wright

For Army, Marines and everyone else we’ve delivered a little over 7,000 new Raven air vehicles to date.

Michael Lewis - BB&T Capital Markets

And then, Steve, just one more question for you. Interest income was $59,000 in the quarter. You have about $150 million in cash and investments so I guess the question is why is that number much higher?

Stephen C. Wright

Well, we’re really invested primarily in T-bills and we’re earning almost nothing on those investments. We have in you know for almost nine months to a year been focused primarily on safety.

Operator

Your next question comes from Chris Donaghey - SunTrust Robinson Humphrey.

Chris Donaghey - SunTrust Robinson Humphrey

Tim?

Timothy E. Conver

Yes?

Chris Donaghey - SunTrust Robinson Humphrey

Just wanted to clarify something real quick. You mentioned in the call that $163 million. Is that for digital data link upgrades and new production? Or was that upgrades only?

Timothy E. Conver

That included both, Chris, both new systems and upgrades, retrofit upgrades that have been publicly announced.

Chris Donaghey - SunTrust Robinson Humphrey

Is there any way you can help us break down what percentage of that you believe is going to have a fiscal 2010 impact? Just based on what you know of the time?

Stephen C. Wright

Maybe I’ll jump in here. We haven’t negotiated a lot of these contract vehicles, so it’s hard to say but our best information today is that we’ll perform on about 1,000 new and refurbished Raven systems with DDL this fiscal year. That’s what our guidance and our current fiscal year plans assume.

Chris Donaghey - SunTrust Robinson Humphrey

Can you tell us what the percentage of that would be predicated on the government’s fiscal 2010 budget being approved on time or is there enough funding available with what’s left in the fiscal ’09 budget to get us there?

Timothy E. Conver

Well, I think I’d have to hedge a little bit here on timing but let me try to answer your question, Chris. I think clearly the sooner the FY ’10 budget is approved and flows through into contracts, the better. I mean maybe that’s a foregone conclusion. We anticipate some delay as we have often seen in the budget approval cycle when we’re considering our expectations for the year, but the farther that pushes out the less room we have at the end of the year. So I’m not sure that I can get it down to a specific percentage. Maybe Steve has a better cut at that answer than I had.

Stephen C. Wright

No, I don’t. but I do want to go back to my earlier answer to your question, Chris. Of the 1,000 systems that’s both retrofits and new systems and we don’t know the exact mix there, so probably the right way to think about it is maybe 50-50, 500 retrofit systems and 500 new systems.

Chris Donaghey - SunTrust Robinson Humphrey

And any insight whatsoever yet into how Raven demand is going to look going forward? I mean before we got the disruption from the new frequency cut over plus now the cut over from analog Raven to Digital Data Link Raven, I think you had been running at about 200 to 250 or so airframes per month out of the Simi Valley factory. Do you see that as sort of a normalized production rate going forward or what are your expectations? You know once you get beyond this surge in DDL equipping.

Timothy E. Conver

Well, in the first place, the DDL surge to the extent that we continue with retrofit programs will probably go along beyond this year. Again it’s my guess that most customers are going to want a homogenous digital fleet, which would imply significant retrofit over time. Beyond that, I think as of this quarter we are about 57% into the existing Army acquisition objective for Ravens. The capabilities that the digital system brings to the customer and to the users on the ground are likely to be even greater than they anticipated when they made their production decisions in the beginning. And if that turns out to be true, then I would expect that has a positive effect on overall Raven demand.

Chris Donaghey - SunTrust Robinson Humphrey

And then just as a related question to that, then, DDL was developed specifically for the Raven but presumably has applications to Wasp and Puma AE. Do you see the potential for DDL beyond Raven as a future opportunity and have those discussions or negotiations been underway?

Timothy E. Conver

Yes. We are already in the process of planning the conversion of both Wasp and Puma to digital systems. That’s in the future, but it’s definitely our intent and ultimately we would see a offering, a family of Unmanned Aircraft Systems all of which have interoperable, digital ground control systems and user interface. One of the elements that has made the digital conversion of Raven so extensive is we have designed it to be both backward compatible so that we can upgrade Raven’s analog systems as well as forward compatible to what we would envision as the next generation ground control system. So our view is that those other two existing production programs would have digital options in the future and that all of this that we produce would be interoperable with common user interface.

Chris Donaghey - SunTrust Robinson Humphrey

And just one last question, Tim, on the Global Observer. As you start to enter the operational test and evaluation phase, I know you’ve got two more aircraft to build but can you help us with what you see from a milestone perspective there? Do you see a revenue bathtub for Global Observer or does it depend really on how the initial aircraft tests go? Maybe there are some things that could happen to fill in that bathtub once you get into the formal testing phase. Thanks.

Timothy E. Conver

Yes. Great question, Chris, and a significant area of focus that we have had for some time as our customers have had. This bathtub effect that you refer to is almost universal in JCTD programs, a capability that the Secretary of Defense Office has developed to push or pull forward promising new technology capabilities more rapidly than the conventional procurement system. It’s been really successful at that and I think Global Observer is a good demonstration, as was Raven and the Digital Data Link that we’re now incorporating in Raven.

However, the potential for this gap between the end of the JCTD and the beginning of a program of record has always been there. As we have discussed this follow on funding issue with the half-a-dozen customers that currently fund the development of Global Observer, almost a universal response has been if you fly it, we will come. So I think because it’s such a revolutionary capability, it is going to be very important for our customers to see it in transitioning from development to flight test. There are a number of opportunities being discussed with a number of customers to bridge that gap from the end of the JCTD Program to the beginning of a production program, and we’re aggressively working with them to that end.

Operator

Your next question comes from Troy Lahr - Stifel Nicolaus & Company, Inc.

Troy Lahr - Stifel Nicolaus & Company, Inc.

I’m just wondering if you can kind of walk me through some of the risks to digital Raven in that it might not ramp up right on time, when you think about the third quarter.

Timothy E. Conver

Another good question. Thanks, Troy. It clearly is a big ramp and it is a significant change integration into the Raven system. We’re confident in where we are, in the plans we’ve put in place and where we are on executing those plans. We’re moving ahead on schedule and as we expected. We have the recent experience from a year ago when we introduced the new frequencies and channel changes to the communication links for both Raven and Wasp. If you recall we developed those, tested them, we did field tests on prototypes, we shut down each of those production lines sequentially, we cut in the change, we ramped back up and executed that well and to our customer’s satisfaction.

I think another example of this kind of complex production ramp was when we transitioned from the early small volume production of Raven and our other small UAS to [great] production a few years ago. In a six month period we went from two airplanes a week to ten airplanes per day and we missed no deliveries and delivered high quality products. So I think making this kind of complex production ramp implementation is difficult, but it’s what we do. We’ve got an extraordinary team of highly motivated, smart people that have done this before, have planned this well and I think we’re competent in its execution.

Troy Lahr - Stifel Nicolaus & Company, Inc.

So it really just getting your production line up and running or are there any more technologies that you need to develop and mature that might take a little longer than needed? I mean is it production or technology that kind of gauges where we’re on track for the third quarter?

Timothy E. Conver

Well, I guess it’s probably a bit of both. This process involves you know the development of the digital link itself, which we had been doing for a number of years leading up to this transition. The transition, however, is much more than the data link. It’s the integration of those links throughout the system and the system modifications in order to enable that. So that process led us to build pre-production systems, a number of those systems that we use for our development and then our testing and verification. We’ve done training of our initial customer users with those systems. And then our customers have taken those systems into the field and given them to operators to use, so that they can evaluate the effects and the actual interface in their real live operations. And that’s typical of both new system introduction and major change introduction. It’s a combination of our process as well as our customer’s rigorous formal process.

In that process of evaluation, we expect that new things will be found, either something shows up in operation that didn’t show up on bench tests or something shows up in operation that the customers didn’t anticipate and they want something different than they thought they wanted. Those lead to design finalization and revisions that we’re just finishing up that latest version of those. At the same time, in an ideal world, I think we would have waited until all that’s done before we do final documentation and final tooling and test equipment and supply chain commitments. In fact in order to be adequately responsive to our market and our customers, we historically do all that in parallel.

So we’re in the midst of that now and that involves supply chain, it involves new test equipment on the floor and validating that, as well as the assembly process.

Troy Lahr - Stifel Nicolaus & Company, Inc.

And is the customer field testing, is that complete or is that still ongoing? And when will that come to a conclusion?

Timothy E. Conver

I believe the customer still has the systems in the field but I think we have a good grasp of what their perception is, and I think we’re moving ahead with confidence.

Troy Lahr - Stifel Nicolaus & Company, Inc.

And then the timing on the negotiation? I mean you still don’t really have orders for this ramp up. I mean when do you expect to have the orders in hand?

Stephen C. Wright

Well, there is some backlog as I mentioned, I think the $17 million that we announced in January. There is a segment of orders incorporated in the second supplemental for 2009 and that’s in the process of being converted to contracts. And there is a budget request in the FY 2010, both the base DoD budget and the OCO budget. Those have been announced publicly and we would expect that as soon as that budget is approved and signed by the president it would flow through to the Army and we would be in contract negotiation.

We know that both the Army and the Marine Corps are anxious to execute both the acquisition of new digital systems through those FY ’10 budgets, as well as the large number of retrofits. So we think it is likely to move rapidly once it’s approved.

Troy Lahr - Stifel Nicolaus & Company, Inc.

Is UAS revenues first quarter, I mean does that represent a low point do you think for the year? Like we should ramp up from this point on? Or is second quarter going to be kind of similar to the first?

Stephen C. Wright

It’s a low point. Tim said earlier 70% of the year in the second half and I think then you can do the math on what that second quarter would tend to look like.

Operator

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

Jeff Evanson - Dougherty & Company LLC

I guess my first question is, is there a third aircraft, a geo aircraft in your backlog figure?

Timothy E. Conver

Yes. The third aircraft or funding for the third aircraft was included in change orders that were released. Did we announce that in Q3?

Stephen C. Wright

Yes, I think it was Q3 of last year. So it is now in backlog.

Timothy E. Conver

The answer’s yes. It’s either Q3 or Q4.

Jeff Evanson - Dougherty & Company LLC

I just wanted to make sure it was funded and in the backlog number.

Timothy E. Conver

It was funded. It was in the backlog. It was announced and we continue to work with our customers on the Global Observer program and there continues to be change orders as the priorities move around for what customers want, when they want it, how much funding is in one [clen] or another. So at any given time the content within a specific contract line item can and does move around.

Jeff Evanson - Dougherty & Company LLC

We’re obviously learning that spares and repairs can be lumpy in the UAS service revenue. I calculate that at about $5.5 million in the quarter. Could you verify that and give us some color commentary around how that’s tied to maybe your overall UAS activity level? Where you see that going?

Stephen C. Wright

Yes, it’s $5.3 million for the quarter. I’ll start off. Yes, that’s sort of where it was in Q3 of last year and it’s moved all over the place since then. I think that we would look at this level as being somewhat low. We would expect that to grow as we go through the year. We think it’s been somewhat impacted along with product deliveries with customers waiting to buy spares for Digital Data Link. I don’t know, Tim, if you want to?

Timothy E. Conver

Yes, I think there’s no question that our largest customers for Raven that are in the process of converting from analog to digital have been trying to minimize their expenditures for analog spares, as they anticipate the conversion to digital. And there’s some obvious difficulty in guessing how many spares will be required to support the analog installed base before it’s converted to digital. But there’s no question that they’re trying to husband their funds so that they have more capability to support the conversion to digital going forward.

Jeff Evanson - Dougherty & Company LLC

So frankly given the delay here, it would make sense that we might see another tough quarter on service revenue.

Stephen C. Wright

We’re not guiding on those individual elements. Probably where we’ve got to leave it is the overall guidance that Tim gave and then the 70% in the second half. And that’s probably as close as we want to get to Q2 specificity.

Jeff Evanson - Dougherty & Company LLC

Now obviously we’ve had SolCom testing the Puma and you’ve had some positive feedback there. I thought you had gone into production in May. When do you think we might see production orders for the Puma?

Timothy E. Conver

Well I think I saw some line items in the House version of the Defense Appropriation Bill. I know that there are multiple customers with an appetite for either new Pumas or more Pumas and I can’t really comment on where they are in the process of lining up the funding for their earlier acquisition. But I think in general everything I can see with customers that have used or seen the product is positive and I think that bodes well for acquisition. I don’t have enough insight into the funding line items there to put a pinpoint on timing.

Stephen C. Wright

And I would just add in Q1 the product revenue that you do see, excepting EES product revenue, is not for Raven. We had virtually no Raven product revenue in Q1. It would all be Puma and the Wasp.

Jeff Evanson - Dougherty & Company LLC

As you look at this 70% of your revenue in the back half of the year, what do you see as kind of a max production level per month of Ravens and DDL upgrade kits to achieve that? I mean I’d attempt to back into the number but I’m sure you guys have thought it through thoroughly.

Timothy E. Conver

Yes, well we clearly have a production plan. I’m trying to see how I can answer your question without getting into more detail there than we.

Stephen C. Wright

Yes, I can throw out a couple data points. You notice our inventory grew. We might expect inventory to grow somewhat more as we build and procure what component and sub-systems we can ahead of time to help make those deliveries. Beyond that I think we mentioned earlier our internal plans call for production of about 1,000 systems worth, either retrofits or new Raven systems in the balance of the year, mostly in the second half.

Jeff Evanson - Dougherty & Company LLC

So I guess given that you’ve got some finished goods and work in progress in inventory, you are planning, it’s going to be tough but you’re planning to meet that challenge. Right?

Stephen C. Wright

Yes. We’re not saying it’s a slam-dunk, but we think we’ve got the capacity to do it.

Jeff Evanson - Dougherty & Company LLC

My last question, just curious, Tim, what federal decision points are you waiting for in the timing around ramping of EV test systems? You said that was weak in the quarter due to timing of federal decisions.

Timothy E. Conver

Yes, and what I meant there, Jeff, was that a number of our customers for electric vehicle test systems, either OEM’s or battery manufacturers had proposals in for government funding, some of which would likely be applicable to the test equipment for their development programs. And so I think we had some indication that waiting for those decisions and that potential cash affected their procurement. Beyond that there are opportunities for charging systems that we would sell, other than the test equipment to support the implementation of infrastructure for electric vehicles, which potentially could show up in the future.

Operator

Your next question comes from Peter Arment - Broadpoint Am Tech.

Peter Arment - Broadpoint Am Tech

A lot of questions have been answered but you did mention new customers on the Wasp and potentially Puma. Maybe you could just provide a little more insight on that if you could?

Timothy E. Conver

Well I’m reluctant to get into what customers might be considering, what procurements in the future. And we’ve made a habit of not commenting on our proposal activity. But there are U.S. government customers, DoD customers beyond the Air Force and the Marines that currently have acquired Wasp that have been evaluating it, appear to be positively disposed to acquiring Wasp in the future. And there are also international customers that are in that same stance.

I think as to Puma, our initial customer was and continues to be Special Operations Command. All of the feedback has been very positive there. I think that’s a matter of funding approval and timing for that. We just began showing Puma to potential new customers within the last couple of months and as I mentioned in my comments, the response has been very positive. I think that’s going to be a popular product, again both domestically and potentially internationally. We’re still very early in the marketing stage with Puma.

Peter Arment - Broadpoint Am Tech

And have you seen any change at least qualitatively in terms of requirements regarding the ramp in Afghanistan and further additional troops there?

Timothy E. Conver

Well, you know General McCrystal’s made a number of comments including something to the effect that he expects never to have enough ISR and this issue of collateral damage has entered into his public comments on how he’s conducting and implementing policy there. I think those over-arching, large scale issues come right down to providing more ISR and more situational awareness, more persistence and more precision at the ground level. And I think that’s what our systems provide to our users. So I think we can continue to bring more to the party.

Operator

Your next question comes from [Randy Gorstman] – Baron Capital.

[Randy Gorstman] – Baron Capital

In terms of looking out in terms of the quarterly calculations, I know you’re not giving a lot beyond the 70% in the second half. On the revenue line, are you assuming that EES is relatively flat for the first quarter throughout the rest of the year? Or are you guys counting on some pick up there as well?

Stephen C. Wright

Randy, this is Steve. I think we don’t expect EES to continue at the level that we saw in Q1. That was a disappointment to us.

[Randy Gorstman] – Baron Capital

On the operating expense line, you guys mentioned in the prepared comments that SG&A is basically fully loaded because you have hidden proposal activity and full teaming you know to sell existing and future systems. So is it fair to assume that that run rate will be stable throughout the rest of the year?

Stephen C. Wright

No, I think that if we hit our top line. I’ll let Tim say more but if we hit our top line, I think the way to think of it is both SG&A and R&D, think of it as a percent of revenue not unlike what we saw last year. So that would indicate in the balance of the year we would see some continued investment in the expense area. Maybe not right off the bat, but by the end of the year.

[Randy Gorstman] – Baron Capital

So for example in the fourth quarter you guys were running you know 13.5% on the SG&A line and 9% on R&D and fourth quarter was you know the most revenue. Are those reasonable percentages or how do I think about that?

Timothy E. Conver

Well, Randy, I’d be looking at it on an annual basis. And you know we have in the past and we are currently looking at the year to come in at 12 to 14% operating margin on the total annual revenue. So as a percentage we’re much higher in the front half where we’ve got lower revenue and I think as a percentage we would be lower in the back half with higher revenue, but overall I would expect our expense spending to be higher in Q4 than it was in Q1 as we typically have continued to grow and those investments over time. Was that helpful or?

[Randy Gorstman] – Baron Capital

Yes, that’s helpful. That’s helpful. And then just switching gears a little, on Switchblade you guys have been consistent in looking for orders by the end of the fiscal year so in the April quarter what’s kind of holding things back? Is it production, funding, contract negotiations or something else?

Timothy E. Conver

Well I think it is at a very high level the issue is that this is an entirely new capability. This is really out-of-the-box. Few customers even anticipated this capability being possible, even a year ago. While our initial customer was funding the early development and evaluation, most others were you know this wasn’t on their radar screen. So it’s like most innovative new solutions, it requires customers to think about how they would implement this into their system, how they would fund it, who owns it, how they operate it and how this fits into their enterprise.

And I think that’s whether it’s Global Observer, whether it’s Switchblade or whether it was the original introduction of hand-launched, unmanned aircraft, it just appears to require a considerable amount of time for customers to sort through those issues. And whether it’s DoD or whether its retailers operating a distribution center with electric forklifts, the introduction of a fundamentally new technology solution just seems to take a lot of time. And that’s why we’ve never been great at predicting the timing of adoption.

So having said that, I think what’s going on right now is I think there’s a lot of activity in a lot of customers that began when we did our end-to-end solution at the end of last calendar year and I think that’s continuing to move ahead and gain steam. It’s certainly not abating and as I mentioned in the comments, this three-day demonstration just a couple of weeks ago had over 50 people there for three days in an undisclosed bedroll facility, watching extraordinary challenges to the demonstration of Switchblade. And it was very, very successful.

[Randy Gorstman] – Baron Capital

My next question was going to be whether you know was the facility state side or overseas?

Timothy E. Conver

It was domestic but it didn’t necessarily look that way.

[Randy Gorstman] – Baron Capital

And just a quick question, cash flow from operations in the quarter?

Stephen C. Wright

$4.5 million positive.

[Randy Gorstman] – Baron Capital

And what was D&A, Steve?

Stephen C. Wright

Nineteen-fifty.

Operator

Your next question comes from Josephine Millward - Dougherty and Company.

Josephine Millward - Dougherty and Company

You may have talked about this already. I just want to confirm that you’re reiterating your 12 to 14% operating margin including the loss in Q1.

Timothy E. Conver

That’s correct.

Josephine Millward - Dougherty and Company

Let me just confirm something. Did you say that the Puma funding was in the House Appropriations Bill?

Timothy E. Conver

Yes, the last time I saw or was aware where we stood, there was approved funding for Puma in the House Appropriations Bill.

Josephine Millward - Dougherty and Company

Can you confirm if it was $14 or $15 million? The same amount that was in the authorization bill.

Timothy E. Conver

That was my sense. I’m trying to pull it out of memory, Josephine, but I think that’s what it was and I think it did not end up in the Senate version. And so I think we find out what really happens after conference.

Operator

Your next question comes from Brian Ruttenbur - Morgan, Keegan & Co., Inc.

Brian Ruttenbur - Morgan, Keegan & Co., Inc.

How long does the ramp of the DDL go? I know you talked about third and fourth quarter because that’s when it’s really kicking in. You know I want to know is it going to be a three quarter ramp, four quarter ramp, five quarter ramp. And then what is steady state after that ramp? Because there’s going to be a big rush for the DDL. And then what is it going to come back down it? It looks like you’re going to be taking it up in third and fourth quarters around $100 million run rate in total. I’m just trying to figure out what the run rate is, where it falls off to.

Timothy E. Conver

Well I think our view will probably change over time as we see what customers actually do beyond what we can see now in the FY ’10 budget request. But given what we know now, we will peak capacity in Q4 and probably trail off as we continue to move forward with digital systems and retrofit kits after that. But I don’t have great visibility deep into the next year at this point.

Brian Ruttenbur - Morgan, Keegan & Co., Inc.

Would a trail off number be more like $80 million from that $100 million run rate? Or where do you see the trail off going? Where do you see a steady state after the big build-up?

Timothy E. Conver

Well I don’t think again I want to lock down on what happens after fiscal ’10. But when I’m talking about capacity I’m referring to the capacity we’re building into our production capability. And we’re sizing that to be a little over what we think the peak demand will be. If that changes and goes up, we’ll just increase capacity and that’s not going to be a huge problem for us.

Brian Ruttenbur - Morgan, Keegan & Co., Inc.

On the Global Observer, do you expect most of that revenue from the three systems to come in in fiscal ’11 or a big chunk of it? Is that right?

Timothy E. Conver

We’re right in the middle or on the other side of the middle on that program, so we’re really running at pace on Global Observer this year.

Operator

Your next question comes from Tyler Hojo - Sidoti & Co.

Tyler Hojo - Sidoti & Co.

Just a couple of housekeeping things first. What was the number of Raven systems purchased by the Army in the quarter?

Timothy E. Conver

Zero. You’re talking about the Army acquisition objective? It was 57% delivered in Q4 and we remain at 57% in Q1. I think in the quarter we delivered on the order of two Raven air vehicles out of the factory and they were to non-DoD customers in Q1. So that part of the company was really just working to get ready for DDL.

Tyler Hojo - Sidoti & Co.

I know you guys don’t look at this, but what was the unfunded backlog in the quarter?

Stephen C. Wright

$513 million approximately and again you’re correct, we don’t view this as a real backlog number.

Tyler Hojo - Sidoti & Co.

Just lastly, you’ve gotten this question asked a lot of different ways but in terms of digital Raven at what point in the fiscal year do you actually need to have funded orders in hand to make the guidance that you gave? Or the guidance that you backed here today.

Timothy E. Conver

Well, let me take another shot at answering that a little differently and see if it helps. There are different places that publicly available funding is coming from. And I believe that the amount that’s in the second ’09 supplemental is already appropriated and in the contracting process. So what’s left is in the base defense budget and then the 2010 OCO request. I mean that could get approved as soon as the end of this month, but we have often seen those orders slide out into our third quarter. So I think we can certainly handle a couple of months slide there without affecting our existing plan.

If it gets extraordinarily late, then we’re going to be up against it and we’ll do what we normally do which is build ahead, smooth our production flow and be in a position to put the maximum amount of hardware out to our customers in the shortest amount of time when contracts finally do flow in. But it’s very difficult to pin that down to a date certain at which point we’re just too far.

Tyler Hojo - Sidoti & Co.

But it sounds like even if you get these orders by the end of your calendar year or before January that you could still meet the goals that you’ve kind of set out here tonight.

Timothy E. Conver

That timing has happened in the past and when it has we have been able to meet our annual plans anyway. It gets a little more difficult when we’ve got this heavy back-end load, but it’s the kind of planning flexibility that we’ve built into our system.

Tyler Hojo - Sidoti & Co.

Fantastic. Thanks a lot.

Timothy E. Conver

Let me interject here just before we move on, Josephine had asked me about the Puma numbers in the budget and I said that last time that I saw the expectation on the House Appropriations Bill that that Puma funding was still there, even though it wasn’t in the Senate. And Steve now points out to me that he thinks it was not in the House Appropriations so I’d like to get back with you, Josephine, on what we really think the answer is on that status after we check it tomorrow.

Operator

Your next question comes from Erik Olbeter - Pacific Crest Securities.

Erik Olbeter - Pacific Crest Securities

Quickly just maybe going back a little bit to Global Observer, had a very strong wrap, you know best quarter yet in terms of bookings and revenue in Global Observer. You know a little more than halfway done. How should we expect that through the remainder of this year? I mean is this a high water mark in terms of the revenue you’re going to book or is this something that we’re going to continue as you sort of you know get the products out the door?

Stephen C. Wright

Generally it’s going to continue through our fiscal year at something close to the rate we saw in Q1. And as a reminder, Global doesn’t make up all of the project R&D that we show. You know we don’t break it out by program. But it is you know the largest component of that.

Erik Olbeter - Pacific Crest Securities

And maybe just going back to the EES business, you know there’s been some amount of loan guarantees going through the pipeline right now at the federal level, a lot of projects that are waiting for that financing to see if it materializes. Is that specifically something we should look forward to see when those loan guarantees and pilot funds are actually released as an indicator that the business is sort of coming back on line?

Timothy E. Conver

Well, I don’t think I would tie our business directly to the timing on those federal loan guarantees, Erik. I think there has been an effect on our sales of our electric vehicle test equipment that’s been driven by anticipation of those loans and other grants moving through the federal process. And I would expect as that moves through that those customers that then intend to use some of that funding to build up their test capability we’d start seeing that in our EV test equipment revenue.

Erik Olbeter - Pacific Crest Securities

Tim, I know you guys don’t guide on gross margin but as you think about you know the ramp in 3Q and 4Q for the UAV business, should we sort of expect so the gross margins come down a little bit that you know I assume there’s going to be overtime, a lot of people busting the hump to get this out. Is that something that you guys have forecast in your model?

Timothy E. Conver

Well, I think in general, Erik, I mean certainly there’s the probability that we’re going to be busting our hump as you put it to make this heavy back-end production happen. But I think my expectation would be that the larger effect would be that the higher revenue absorbs more of our overhead, just like the lower revenue absorbed less of our overhead in Q1.

Stephen C. Wright

And I’ll add Q1, I mean we certainly expect gross margins to move up from Q1 levels when we get into the second half of the year. Also Q1 was about 70% cost plus and we’ll have a much more normal mix as we go into the balance of the year.

Operator

Your last question comes from Michael Ciarmoli - Boenning & Scattergood Inc.

Michael Ciarmoli - Boenning & Scattergood Inc.

Tim, I’ll just ask one quick one here on the Digital Data Link. I was told that the Army actually owns the wave form for the DDL and a push was going to be made to deploy DDL to all of the Army’s unmanned systems, not only the AeroVironment birds but also you know the Sky Warriors, Hunters, Fire Scouts. Is there going to be an additional revenue opportunity for you guys to sell DDL to perhaps some of your competitors or other Army customers out there?

Timothy E. Conver

The DDL development started internally. We built prototypes, we took those to customers to gauge their ultimate interest and that led to incorporating the further development of DDL within an advanced ACTD program that was partially sponsored by the Army and partially by the Office of Secretary of Defense and potentially others. As we developed that we wanted to make sure that the wave form was approved within the government system. And it is. One of the either the few or the only, I guess I should characterize that as it’s one of the few at least of wave forms that have a jitters exemption within the larger Department of Defense. So as we have now moved this to production, it has a unique position in the overall wave form approval process and I certainly have heard a number of indications from our existing customers that they would like to use this Digital Data Link in other applications. So long answer to your question that probably could have been yes, but hope it provides a little more color.

Operator

And with that I’d like to turn the program back over to Mr. Gitlin for any additional or closing comments.

Steven Gitlin

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

Operator

That does conclude today’s conference. Thank you for your participation.

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Source: AeroVironment, Inc. F1Q10 (Qtr End 08/01/09) Earnings Call Transcript

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