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Executives

Tim Conver - Chairman & Chief Executive Officer

Steve Wright - Chief Financial Officer

Steven Gitlin - Director of Investor Relations

Analysts

Howard Rubel - Jefferies

Michael Lewis - BB&T Capital Markets

Brian Ruttenbur - Morgan, Keegan

Tim Quillin - Stephens Inc.

Troy Lahr - Stifel Nicolaus

Peter Arment - Broadpoint

Randy Gertzman - Baron Capital

Michael Ciarmoli - Boenning & Scattergood

AeroVironment, Inc. (AVAV) F2Q10 Earnings Call December 8, 2009 4:30 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2010 AeroVironment, Inc. earnings conference call. My name is Melanie and I’ll be your coordinator for today. At this time all participants are in a listen-only mode. We will conduct a question-and-answer session after management’s remarks. 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 call over to Mr. Gitlin. Please proceed, sir.

Steven Gitlin

Thank you, Melanie. Welcome to AV’s second 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, forecast 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, December 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 this conference call.

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

Tim Conver

Thank you, Steven and welcome to our second quarter fiscal 2010 conference call. The second quarter unfolded about us we had expected and it was consistent with what we have outline for the balance of the fiscal year in our Q1 call. We initiated production of our digital Raven systems at the tail end of the quarter.

We made good progress on our development programs including Global Observer and Switchblade and we delivered sequential improvements in our EES segments performance. As we indicated in our Q1 call we expect the second half of our current fiscal year to account for about 70% of our full year revenue, driven primarily by deliveries of digital Raven systems and upgrades to convert existing analog systems to digital.

Our team worked hard in Q1 and Q2 to position us to deliver on this important product upgrade and although the backend weighted delivery plan inherently brings with it an increased execution risk. We expect to execute that plan and we maintain our guidance of 18% to 22% year-over-year revenue growth for fiscal 2010, with an operating income margin of 12% to 14%.

Beyond this years guidance, my continued belief that the long term growth drivers of our business remain very compelling to supported by sustain demand for our current products and active customer interest in the innovative solutions represented by our advanced developments. As a result of a digital Raven transition, including associated system upgrades, Raven systems will be even more useful to U.S. forces, including those operating in the high altitudes in the mountain terrain of Afghanistan.

I’d like to spend a moment to address the production transition of digital Raven. With the start of digital Raven deliveries we’ve been taken an important step forward with one of our most significant product upgrades today. As you will recall, customers have been waiting for the new digital Raven systems to become available.

The development in transition to production of digital Raven systems was to focus of much of our teams’ attention during the first half of the year. The scope of this transition is significant, as this the nature of the benefits it provides to our customers. In every product transition to production that I’m familiar with, startup this years emerge and/or addressed. The transition to digital Raven has been no exception.

The engineering changes from analog to digital Ravens requires changes to most of the subsystems and it was the companied by several other important modifications to the Raven system that result in an even more robust in capable solution. These additional in improvements include an improved motor of reduced acoustic signature and high resolution color video camera.

All in addition to the frequency efficiency, the communication encryption enhancement and the beyond line of site capabilities specifically associated with the Digital Data Link. Throughout the development in transition, we have identified issues as they emerged. Identified and determined their root causes, developed and implemented solutions tested the integrated system to confirm its effectiveness. This spiral process is typical of our developments and was anticipated in our plan for the production ramp up.

We have received strong customer support for our approach to this production start up phase, after initial deliveries in late October. We assessed our product performance and our production yield and we decided in concert with our customer to further optimize the system.

Since October, we have continued to improve the performance characteristics of the system and result issues affecting initial yield. We continued to refine our supply chain, continued customer training, staged production hardware, and added production technicians to support enable the plants. The net result is that we have a more robust high yield production system as we ramp up production in December and January.

We delivered small quantities of digital systems through November as we continued to optimize our systems and stage hardware for the production ramp we are starting this week. Our production for the year is now only slightly more backend loaded, but the improved yield and the staged hardware support our production and revenue for fiscal ‘10. We expect our production rate build rapidly through the balance of Q3 and to peak in Q4, delivering about 1,000 digital Raven systems and upgrades gets in total this year.

Considering that we have surged our small UAS production in the past to over 600 air vehicles and equivalents in a single month. This surge in production anticipated in Q4, is not unprecedented and is within our production capacity. From a customer perspective, we upgraded digital Raven system will now be even better suited to the operational requirements of Afghanistan supporting the increase in troops there to critical time.

We are still waiting passage of the fiscal 2010 defense appropriation build, which includes approximately $121 million of funding for Army and Marine core Raven systems in digital upgrades as well as the arrival of orders funded from a previously approved $27.5 million supplemental line item. In the meantime, we are working closely with our customers to negotiate the multiple proposals related to this anticipated funding.

We would obviously like the appropriations build at the sign sooner rather than later, but we believe that we can still achieve our fiscal ‘10 performance objectives with the expected signing of the bill by the end of this month or in early January. In summary, our second quarter performance was inline with what we expected and we expect to deliver the growth reflected in our guidance.

Now let’s discuss the unmanned aircraft systems business beyond the digital Raven transition. AV remains the leader in small UAS. We are prime contractor for each of the four U.S. DoD programs of record for small UAS and have delivered over 13,000 new and replacement air vehicles to customers in the United States and elsewhere.

All U.S. ground forces have adopted small UAS and are now using them regularly. To enable frontline more fighters to identify threats and perform post action reconnaissance protect basis, scout ahead of convoys and provide aerial observation for elections, peace keeping operations, recovery operations and myriad other missions.

In much the same way the PC’s eliminated at the bottlenecks associated with mainframe computing by putting computing power end of the hands of individuals, small unmanned aircraft are delivering real time information to the hands of solider, sailors, airmen and marines who need it when they need it. This disinter mediation from larger more costly and scarcer reconnaissance assets has given small teams they ability to make better decisions move quickly resulting in more effective operations and life saved in a current trade environment.

Within our UAS segment, we have developed full suite of small unmanned aircraft systems for intelligences, surveillance and reconnaissance. All designed around the hand held common ground controller. We are now under contract to develop Digital Puma systems and we are developing plans for the future transition of Wasp, working towards the small UAS family of interoperable systems build around a common digital ground control system.

We support all of our UAS customers with training spare parts and repair services that are tailor to their needs in design to make them more successful when they use our systems. Our outstanding small UAS team is very focused on this set of technologies and customer needs. Our strategy that I believe makes it easy for our customers and hard for competitors. We also have an active research and development function with unmanned aircraft systems that is creating entirely new solution to build on decades of experience in two domains.

Small unmanned aircraft, platforms and high altitude long endurance unmanned aircraft systems. Switchblade is the development initiative that adds the legal strike component to small unmanned aircraft. Creating an entirely new capability of loitering precision emission that is moving closure to early adoption. We are seeing small quantity purchases of Switchblade and parent growing interest in this new capability.

We received nearly a dozen small orders and small in Switchblade systems to date primarily for test in a valuation of this new system capability in multiple applications. In Q2 we received orders for Switchblade that I would characterize as combat prototypes, which we believe represents the next step in customer of valuation and consideration of adoption. We expect additional similar orders over the balance of the fiscal year as multiple customers continued to express interest in this unique new capability.

Volume production timing continues to difficult to predict, but I believe the current level of interest is a positive indicator. Global Observer is a development initiative focused on creating and exploiting the ability to fly in the Stratosphere for up to a week of the time, in order to provide affordable satellite like persistence for remote sensing and communication relay.

We believe this will be a highly desirable and a high value capability that does not exist today. Now over two years into a three and a half year development program, the Global Observer joint capability technology demonstration is making great progress towards our goal of initiating flight testing during the second half of the current fiscal year. This is a revolutionary aircraft that employs technologies never before used in such a manner.

In our last call, I said, we were planning to ship the first Global Observer aircraft to Edwards Air Force Base during Q2 for ground testing prior to flight testing during our second half of this fiscal year. We kept aero plane number one in our development facility, two months longer than plant to continue integrated system testing in a location optimally equipped to result problems and to validate the airplanes and ground control station system hardware and software.

The team has now completed a continuous 12-hour fully powered run on airplane number one, and has systematically stress the software and simulated multiple faults to provide additional confidence in the aircrafts new control on power systems. We have successfully completed all of these tests and airplane number one is currently being disassembled for shipment to Edwards where it will undergo integrative systems tests, mission simulation and flight crew training prior to the initial flight test series.

The move to Edward should be completed this month and will support our plans to be in flight testing in the second half of fiscal 2010. Airplane number two is moving to the second of the three assembly stations within our development facility, as airplane number one moves to the Edwards.

In the international small UAS market, we had seen signs of reengagement in a number of countries suggesting that market is improving. We’ve remained well situated to generate through each of the five growth drivers of our business that is selling more of our existing products to existing customers, supporting to growing installed based of products, developing and introducing product upgrades, entering new markets for existing products and successfully introducing entirely new solutions that are currently in development.

At this point, I’d like to turn to our other operating segment. Revenue in efficient energy systems or EES increased sequentially despite continued pressure in the industrial markets for capital equipment severed by our industrial electric vehicle charging systems. As a business segment EES develops in supplies test system, production systems and charging infrastructure to support the development, the production and the safe and reliable use of electric vehicles.

Our EV test systems remain industry leaders in North America and we see opportunities for growth both domestically and abroad. Our growing global interest in electric vehicles has helped to drive sales of this test equipment, with all major automotive manufacturers now planning to introduce plug in vehicles over the next three years.

Additionally, there’s an increased awareness regarding the importance of the infrastructure that will be required to support electric vehicle adoption and broad use. We have been very active, working with the large number of automakers, battery manufacturers, utilities, and government agencies to generate awareness of the critical role charging infrastructure will play in the adoption and the practical use of electric vehicles.

Our EV infrastructure solutions position us as the potential supplier of these solutions as EV’s appear in the market. We have also helped to create public organizations focused on promoting a rational practical approach to transportation electrification. The Battery Electric Vehicle Coalition and the Electrification Coalition consisted industry leaders committed to the successful introduction and adoption of electric vehicles in the United States.

We look forward to working with our partners in these groups to move toward a cleaner environment, energy independence and clean technology job creations. As I look at what our team at AV’s accomplishing, I believe that we remain in the uniquely good position to generate long term growth to the practical application of our innovative technology solutions and capabilities to critical market needs.

At this point, Steve Wright will discuss our financial performance in the second quarter. Steve.

Steve Wright

Thanks Tim. Good afternoon everyone. Revenue for the second quarter was $51.4 million, a decrease of 22% from second quarter prior year of $65.8 million. By segment, UAS revenue was $43.7 million, a decline of 23% from the prior year. The decrease in UAS revenue was primarily due to lower product deliveries of $16.1 million and lower service revenue of $3.4 million, partially offset by an increase in customer funded R&D of $6.7 million.

The decrease in UAS product deliveries and service revenue is primarily due to the reduction of our analog Raven B production and services as we began production in retrofit of Raven B systems with our DDL technology. The increase in customer funded R&D was primarily due to increased activity on the Global Observer contract. EES revenue total $7.7 million, a decrease of 18% from Q2 of last year. The decrease in EES was primarily due to lower deliveries of our EV test and industrial charging systems.

Turing to gross margin, gross margin in the second quarter was $19.6 million down 21% from Q2 of last year. Gross margin as a percent of revenue was 38% unchanged from last year. By segment UAS gross margin was $15.8 million down 21% from last year and does as a percentage of revenue UAS gross margin was 36% compared to 35% last year.

EES gross margin was $3.8 million down 24% from Q2 of last year. As a percentage of revenue EES gross margin was 50% compared to 54% last year. This decrease in gross margin rate was primarily due to product mix. SG&A expense for the quarter totaled $10.5 million or 20% of revenue compared to $7.9 million or 12% of revenue in the prior year.

SG&A growth this primarily due to higher selling and business development expenses increased been proposal activity and higher admin cost. R&D for the quarter total $5.8 million or 11% of revenue compare to the prior year of $4.9 million or 7% of revenue, the majority of our R&D investments, where for various UAS development initiatives. Operating income for the quarter was $3.4 million or 7% of revenue.

Operating income was 72% lower then the prior year primarily due to lower sales volume resulting in lower gross margins and higher SG&A and R&D expenses. Net income for the quarter was $2.2 million or $0.10 per fully diluted share compared to a net income of $9.1 million or $0.41 per fully diluted share in the same quarter last year.

Now moving quickly thorough our year-to-date results, revenue for the first six months was $89.3 million down 25% from the prior year period of $119.4 million. UAS revenue was $77 million down 25% from the prior year and EES revenue was $12.3 million down 27% from the prior year. Gross margin for the first half was $30.4 million, versus $45.6 million in the same period a year ago.

Gross margin as a percent of revenue was 34% decline of four percentage points from the prior year. UAS gross margin was $24.8 million, down 32% and EES gross margin $5.6 million, down 38%, SG&A for the first half, totaled $21 million, or 24% of revenue, versus the prior year of $16 million, or 13% of revenue.

R&D for the first six months was $11.4 million, or 13% of revenue versus $10.2 million, or 9% of revenue in the prior year. The operating loss for the first half was $2.1 million, or 2% of revenue, versus an operating income of $19.5 million, or 16% of revenue in the prior year. The effect of tax rate for the first half was 30.4%, versus 31.9% in the prior; and the net loss for the first half was $1.4 million or a loss of $0.06 per share, compared to a net income of $13.9 million or $0.64 for fully diluted share last year.

Looking at backlog, funded backlog at the end of the second quarter was $107.1 million, down $7.7 million, or 7% from April 30, 2009. Unfunded backlog at the end of the second quarter was $303.5 million, versus $510.6 million at April 30, 2009. This decline was primarily due to the expiration of a five year IDIQ contract with Natick Army Center. The IDIQ was established prior to the Raven program of record competition and was used likely actually reward at the army UAV contract.

Turning to our balance sheet, cash equivalents and investments at the end of the second quarter, totaled $131.5 million, down $16.2 million from our prior quarter amount of $147.7 million. Free cash flow for the quarter was negative $16.3 million and was comprised of cash from operations of negative $12.9 million and capital expenditures of $3.4 million. The negative operating cash flow was primarily caused by growth in inventories and receivables partially offset by income depreciation and payables.

Turning to receivables, at the end of the second quarter, our accounts receivable including unbilled receivables, totaled $52.2 million, up $20.3 million from the prior. Sound days sales outstanding were 91 days, compared to 76 days of the prior quarter at. Receivable growth for the quarter was caused by higher sales volume generated towards the end of the quarter.

Taking a look at our inventory, inventories were $25.1 million at the end of the quarter, compared to $19.2 million at the end of the prior quarter. Days in inventory were approximately 71 days, compared to 64 days at the end of the prior quarter. Inventory growth for the quarter was largely built for the anticipated high volumes of deliveries we expect in the balance of the year. Turning to capital expenditures, in a second quarter we invested approximately $3.4 million or 7% of revenue and property improvements in capital equipment.

Now, I’d like to turn things back to Tim, to discuss our expectation for the full year.

Tim Conver

Thanks Steve. Looking forward, our digital Raven system will reinforce our leading position in this small UAS market and along with Wasp improvement will support the administrations planned force increase in Afghanistan and wherever else U.S. ground troupe train and operate.

Our development programs continue to generate positive progress and move towards addressing important high value market needs. We remain in a great position to produce long term growth. As I stated earlier, our fiscal 2010 is unfolding within the schedule window that we anticipated.

With approximately 65% of our second half revenue expected to be generated in Q4, we clearly have our work cut off for as to execute the second half ramp up in digital Raven production and government fiscal year ‘10 defense bill needs to be signed in the timely manner. Nevertheless, we still expect revenue growth of 18% to 22% over fiscal 2009, which would be $292 million to $302 million in revenue with an operating margin between 12% and 14%.

This view is supported by funding that is in our backlog in the previously approved supplemental bill and in the current defense appropriations bill along with our view of the demand for our solutions and the feedback we receive on a regular basis from our customers. I believe that we are doing important work. Helping our customers succeed and serving the long term interest of our associates and our stockholders.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Howard Rubel - Jefferies.

Howard Rubel - Jefferies

I want to try just to Tim. First, on the Global Observer was the couple of a month late, but sometimes you made that up by keeping it in place? How do you stand on your estimate to complete for the program?

Tim Conver

We still expect to complete the JCTD objectives of ultimately demonstrating military utility effectiveness within integrated airplane and payload system later next calendar year Howard and within the existing funding.

Howard Rubel - Jefferies

So this incremental cost because time is always money is really a relevant to how we should think about your bottom line over the next 12 months or so?

Tim Conver

I think we believe that the additional cost associated with the additional time and that is reality are being the accommodated with in the existing contract structure by our customer without additional funding. Steve if you got any comments on the….

Steve Wright

Well other than it shouldn’t affect the financials over the next 12 months because it’s the cost plus program. Howard.

Howard Rubel - Jefferies

Your revenues will be a little bit higher right and either the fee might be lower or the fees unchanged here I mean is here performance settlement to the fee.

Tim Conver

It so CPFF and right now I don’t think we have forecast of any change in the total funding, or how that funding rolls out. Notwithstanding the two months of testing here it our plan I think a lot of that testing would have gone on at towards anyway.

Howard Rubel - Jefferies

Is one bucket or another bucket is a way saying at it that fair?

Tim Conver

Yes

Howard Rubel - Jefferies

Then just staying on R&D for a moment, it was short of flat sequentially so, are you sort of I know you have some other ideas for doing some additional things Tim, but is this sort of affair run rate for while or can you do some other things to help on the cost side.

Tim Conver

I will just start I think the run rate really just reflects the programs that were working on at the current time going forward even in the balance of the year we might see some growth in the R&D line.

Operator

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

Michael Lewis - BB&T Capital Markets

Tim, with regard to the mart that was released in the 8-K this afternoon, there is some cautionary language it addresses that there is no assurance that any of these options will be exercised. The standard language just kind of stood out to me, but with regard to that, how confident are you that timely tasks will progress on this program over the next say three to five months.

Steve Wright

That announcement Mike was on the increase in the IDIQ level of the army contract. I believe that’s associated with the negotiation around the digital Raven funding type to lines items in the ‘09 supplemental. I think our customer wanted to negotiate the values in excess of the actual amount of the line items that were included in the supplemental and we expect some of that tied to the line items that you saw in the ‘09 supplemental to flow through on a timely manner.

Michael Lewis - BB&T Capital Markets

If we look at the ramifications of the appropriations bill still being in conference and we talked about this that their credit cards on pressure, if it’s not passed by the end of the calendar year. So where do you stand? Let’s say it passes by mid-to late January. What does that mean to this current guidance that we have in front of us now?

Tim Conver

Let me start by pointing out, I think another comment that I made in my previous statements that we have been working diligently with our customers negotiating the terms of the contracts that would be anticipated to execute the funding that’s identified in the current 2010 appropriations bill.

My comments assumed a signing of that bill by the end of this month or early January of course, we don’t control and we’re just guessing, but we have historically often seen the budget get approved in that timeframe, which tends to translate into contracts hitting our company maybe the end of Q3 on the early Q4 and in those cases in the past, we have always been able to anticipate those and flow that work through into our Q4 revenues. Steve, you maybe able to…

Steve Wright

I would just add that it’s not sequential. We are working on the contract and going through that process in parallel, while we wait for the formal budget to get approved and I would just reiterate in the past these large bookings happened a very tail end of Q3, very beginning in Q4 and if that’s wanted to happened this year, our production plan should be able accommodate the guidance that Tim gave.

Michael Lewis - BB&T Capital Markets

Then just one final question here, with regard to the DDL integration, has there been any issues, let’s just say for example as software glitches in the integration. That would cause any pressure to the current weighting of the guidance right now for the third and fourth quarter?

Tim Conver

I pointed out, there’s really in my other remarks Mike. There were really, I can think that the Digital Data Link, ECP in three chunks. One is that the Digital Data Link itself. All of the changes in the hardware and software that were required for other parts of the airplane system to accommodate that transition from analog to digital, for example the camera output and many other changes like that and then a third category of changes where we either upgraded or improved other parts of the system like the motor and cameras.

The Data Link itself, has been really robust from an early stage and to the degree that we have seen challenges in the performance in the corners of the envelope and in the production yield, when we put it all together, they were mostly associated with the integrated effect of all these myriad other changes throughout the system. So that effects both hardware and software, we’ve continued to optimize that and we are confident that we’ve got a solid robust system at this point.

Operator

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

Brian Ruttenbur - Morgan, Keegan

Just going to talk about waiting of revenue this year you said its going to be waited more heavily towards the fourth quarter is that correct?

Steve Wright

Yes, I think we said approximately 65% of the remaining revenue in Q4.

Brian Ruttenbur - Morgan, Keegan

Then just going forward beyond Q4, how long do you expect revenue acceleration to be in the 18% to 22% range when we look at fiscal ‘11 and beyond do you expect it settle down more at 15% longer term or do you think the 18% to 22% is sustainable for a period of time?

Steve Wright

I will just start and I would say we would have to upon there; we would plan to give our guidance for the next year on our Q4 call.

Tim Conver

Yes, Brian, we have historically provided annual revenue guidance although I continue to be very optimistic about our long term growth potential as I said earlier driven both by the continued demand for our existing products and the sustain level of interest in the kinds of solutions that we currently having development and the size of the market opportunities that are addressed by both of those categories.

Brian Ruttenbur - Morgan, Keegan

Gross margins was 38.3% is that sustainable or does it go higher with kind of the ramp up in the fourth quarter or what do you think about gross?

Steve Wright

What we want a focus on is operating income 12% to 14% so, we don’t want to guide on gross margin they what I would point back to is last two years on average we have close the year on a consolidated basis of 36% so, somewhere between their and where we were in Q2 is probably not a bad way to think about it, but really focusing on the operating income is where we would point to it at 12% to 14%.

Brian Ruttenbur - Morgan, Keegan

Last question, cash burn, do you expect to have lot of cash generation that you had a cash burn obviously in the first half of the year do you expect the cash generation the second half of the year.

Tim Conver

No, I would expect continued cash burn in the second half based on the kind of profile for revenues in the balance of the year. We have the prospect of continued inventory growth as we look to - the operation throughput to achieve our top line and also because the revenue will be heavily backend loaded, I would expect to see some revenue receivable growth as well.

Operator

Your next question comes from Tim Quillin - Stephens Inc.

Tim Quillin - Stephens Inc.

I’m trying to maybe if you could summarize year end and the anticipated orders, but it sounds like you expect $27.5 million or so order with supplemental moneys soon or rather than later and then expects maybe a series of orders or a couple of different orders totaling as much as $120 million, in January or February some time to support your guidance. Is that of all about right?

Tim Conver

Tim that the 8-K announcement that came out today was sort of a regulatory matter, but it really represents the GFY ‘09 supplemental out of that would come the $27.5 million and typically, we wouldn’t see the whole $27.5 million, it will be taxed before it got here. In addition to that, you’ve got the GFY base OCO for both Marines and our Army and I think you have the right number there at about $120 million plus.

Tim Quillin - Stephens Inc.

Order in December and then one later in or a couple later in January…?

Tim Conver

Yes, this is the GFY ‘10 as we said earlier, we typically see the government fiscal year funding coming in, either at the tail end of our Q3 or the very beginning of our Q4 and if it behaves with the same way, our plans will accommodate. If it slips much beyond that and we have to regroup and look at our production plans and what we can do.

Tim Quillin - Stephens Inc.

I know don’t want to comment too about our future gross margins, but gross margins in UAS were strong, I guess that is over 36% in your 2Q at relatively low productions levels. I was just wondering what the key to that margin was and should we expect margins to improve as you ramp up production of digital Ravens?

Tim Conver

Well, 36%, yes way high comparing to last quarter, but last quarter was way low. As you know, looking in the past UAS is in the 34% to 36% range, so I don’t think the 36% is off the chart high really reflects the mix of the programs that we’re on. Another thing to keep in mind is included in our services revenue is the DDL retrofit kits, which are sort of product like in nature, but the accounting puts them in the services lines.

Tim Quillin - Stephens Inc.

Just one more question if I may, the EES business, do you expect that to grow overall in fiscal ‘10?

Steve Wright

I don’t think we can comment. We try to restrict our guidance to the total company. We continue to feel very positive about the business, but probably need to restrict ourselves to total company guidance.

Tim Conver

I think if you dissect what I said earlier Tim, if you look at the three pieces, the industrial electric vehicle charging business remains sub par and that’s really reflected by the economy and capital equipment market or the spending in capital equipment. The test equipment that we sell primarily for electric vehicles, development work is still a growing part of the business and it’s seems to be tied with this global demand for electric vehicle development.

The emerging opportunity for on road electric vehicles, I think is still out there. It’s billions of dollars being invested by governments around the world over the next few years and all automotive companies investing there some. I think that continues to present an opportunity for us to participate potentially in the future.

Operator

Your next question comes from Troy Lahr - Stifel Nicolaus.

Troy Lahr - Stifel Nicolaus

I just want to circle back. I think it was Brian’s question a little bit. The ramp up that you really going to see in the fourth quarter. I mean is that a sustainable or are you guys planning for that to kind of be a one quarter phenomenon and then it kind of gradually returns back to normal levels?

Steve Wright

I think this is at least for the time being a one quarter high point and then we get back to more traditional levels of through put.

Tim Conver

Troy, I think this is a function of the pent up demand for Ravens, while as customer waited for the digital systems to be available and they and we are now playing catch up, and I think we will have largely caught up through fourth quarter, they’re clearly is an ongoing demand, not only for digital Raven systems, but it appears that our customers will want to continue to retrofit their installed base. I would expect as Steve said that, we will peak in Q4.

Tim Conver

This is largely the way the year was planned and we probably don’t set out to plan the year with. While we typically are back and have more at the back end in the front end it’s like accentuated this year and we wouldn’t expect to plan at this way, when we’ll start doing our plans for subsequent years.

Troy Lahr - Stifel Nicolaus

You said you were going to be more backend weighted that you previously expected. As I just again the timing on budgets is that actually kind of your production ramp up kind of getting your supply chain inline?

Steve Wright

Yes, I think it’s more of the latter, Troy. In an ideal world we would have, when we started production deliveries at the very end of October, we would have continued to ramp from that point in fact, what we did was assess the production yields we had at in that first trench ship deliveries and the system performance at the corners of the envelope and we decided to do some more optimization, before we really ramped up production and were end up.

So we slid that out maybe a month. In the meantime, though I think the fact that we have continued to build the supply chain we’ve staged hardware, we’ve trained customers and we have significantly improved the factors that will affect. I think the net result is a slight increase in the backend load, but a significant increase in the ability to execute it.

Troy Lahr - Stifel Nicolaus

So I’m clear, you finished the optimization and you’re now building digital systems and these will have the effective yields or you’re hoping to get the effective yields?

Steve Wright

Yes, we are just beginning to launch the production ramp this week. So I guess, I would say, we are confident that we’ve addressed those issues and we’ll know in fact after a few weeks of being in production.

Troy Lahr - Stifel Nicolaus

Lastly, Puma AE, I mean, when should we start seeing a meaningful ramp up in that, or is that just kind of going to be a slow gradual build up?

Steve Wright

I’m not quite sure how that’s going to rollout. We’ve just for the last couple of months been in a position to be able to begin demonstrating Puma AE to new customers and we’ve done quite a bit of that some customers have taken delivery of small quantities that they’re evaluating in their own applications.

All of the feedback that I’ve gotten to-date is, positive. It looks like multiple customers see advantages in the characteristics about system and I expect it to be a significant growth opportunity for us in the future, but as usual it’s very difficult for us to guess the timing and the rate of that adoption.

Operator

Your next question comes from Peter Arment - Broadpoint.

Peter Arment - Broadpoint

Could you give us, I guess where you’re now on the existing Army acquisition objective for Ravens? I think you ended last quarter at 57%, has there been much change there?

Steve Wright

As of the Q2 point, we were 58% delivered. As Tim mentioned, we started deliveries of the digital Ravens and that as what contributed to the growth from 57% to 58%.

Peter Arment - Broadpoint

So not much change and then also just on the Switchblade, you mentioned there’s some small quantities of orders and multiple customers and actually some orders for some combat prototypes. Tim, I’d be curious, if just your thoughts on how this has the customer base has matured given from when they first got their hands or at least their eyes on Switchblade to now where they’re actually ordering some combat prototypes? How should we think about Switchblade going forward?

Tim Conver

If we go back almost a year now to when we first demonstrated the full of Switchblade system to our initial customer and that was pretty much an end-to-end demonstration in its initial configuration, which is a packaged unmanned aircraft and it launched from a tube and the tube is both the carrying package container that could be carried around for example in a rucksack and it’s the launch for the vehicle.

In that configuration, it allows it to be rapidly pulled out, set on the ground, launched, and put into service almost immediately. Since that time, that customer has continue to first evaluate the systems and then in greater and greater detail and in more rigorous and more rigorous testing evaluations.

Other customers have come to look at this. They subsequently acquired systems, did their own evaluation and testing, in many of those cases their applications are somewhat different than the original customers and in all of those various scenarios, the testing and evaluation has gone very well.

So, I believe what’s happened in Q2, is a transition from buying small quantities solely for the purpose of testing and evaluation and moving towards what I was referring to is, combat prototypes, which I see as a significant next step in this process of evaluation towards adoption.

Peter Arment - Broadpoint

You don’t have though any Switchblade in their guidance, correct?

Steve Wright

Other than what we would normally expect in these small quantities of procurement that have been taking place that we expect will continue to take place throughout the fiscal year.

Operator

Your next question comes from Randy Gertzman - Baron Capital.

Randy Gertzman - Baron Capital

I had a question about Global Observer you mentioned that the endpoint of the program was I guess to get military qualification with pay load by the end of calendar year ‘10? Did I hear that correctly?

Tim Conver

No, that’s pretty much our expectation.

Randy Gertzman - Baron Capital

So what’s that mean in terms of delivery schedule? Did the first three GOs, I think are part of the JCTD, and that would the first deliverable system, is that correct?

Tim Conver

The way this front program is structured Randy is that we will complete the system flight testing, then we will integrate pay loads and we will then demonstrate the system effectiveness for military applications with the combination of the ground system, the airplane and the pay load and its communication system.

At that point, that the JCTD is technically completed and the customer takes delivery of the residual hardware and then, they decide at that point, what they want to do with the assets that they have taken delivery on. Other customers would decide what they want to do in terms of future acquisition or utilization of this potential capability.

Randy Gertzman - Baron Capital

When would acquisition decisions be made, would it be made post obviously the flight?

Steve Wright

I think the broad consensus I get as I talk with potential customers for Global Observer, it addresses this apparent gap in capability to provide affordable persistence. As a result, it’s very, very interesting to a number of potential customers and to a customer they want to see it fly. It’s such a revolutionary concept that I think fly before buy is in the front of the minds of all potential customers.

Once that capability has been demonstrated, then I’m back to my mantra of it’s very difficult to predict the timing and the rate of adoption of innovative technologies, but I’ve had more than one customer tell me that, “If you build it, we will come.”

Randy Gertzman - Baron Capital

How does that fit into your ability to produce? I know you mentioned that you’re going to run start building the next GO for the JCTD, when the first one is packed up and shipped to Edwards. I think there’s three aircraft in the program. Do you start…?

Tim Conver

We will continue to execute on the existing JCTD and in fact the second airplane has been in the development facility in the first of three fabrication stations behind the first airplane and as the first one moves out, the second one will move into station No. 2. We will deliver those sequentially and they will be ultimately flight testing both the first and the second airplane simultaneously in our plan. There was a second part of your question I think that escaped me that I didn’t address.

Randy Gertzman - Baron Capital

The last part of the question was the third aircraft and then future, how do you scale in future production, you obviously have to balance competing interests of waiting for orders still the flight comes…?

Tim Conver

I think our plan would be that we would not be building airplanes in anticipation of future orders. So we’ve got this situation where our customers are waiting to see the flight test results before they make decisions on future orders and we’ll be waiting for future orders before we make decisions on production, so that’s…

Randy Gertzman - Baron Capital

Tim last question is just the flight test itself that’s on schedule, basically that’s suppose to occur by April, I think it was there?

Tim Conver

My comments last call, Randy were that we expected to be in flight test in the second half of our fiscal year and we still expect to be there.

Operator

Your final question comes from Michael Ciarmoli - Boenning & Scattergood.

Michael Ciarmoli - Boenning & Scattergood

Just Tim if you can, obviously with the announcement to surge troops into Afghanistan, can you give me a sense as to what you guys might be expecting from your services revenues. If I look back towards the Iraq troop surge, you guys were seemingly doing the run rate north of $60 million. Are you planning for elevated levels of service or is it still too early to tell?

Tim Conver

I think it’s probably too early to anticipate the effect. Certainly there are many reasons to think there might be an effect of one sort or another. Our position at this point is to rely on our wanted agility we are working with our customers to plan how we’re going to support the increased troop level and therefore the increased use of our systems in Afghan.

We have the advantage of years of optimizing that forward support capability in Iraq to be able to plan with them, but in terms of anticipating the effect on production rates are services revenues where it will just wait to see. I think we’re in a position to respond in the timely manner when we see the flights with the eyes of demand.

Michael Ciarmoli - Boenning & Scattergood

Steve, just so have to correct, with that service revenue number this quarter about $9.4 million, if I do the math correct there?

Steve Wright

Total service revenue this quarter, $8.9 million, project R&D $23.3 million and products $19.1 million.

Michael Ciarmoli - Boenning & Scattergood

Last question I’ll jump off here, Tim just on penetration I know it’s something we’ve talked about in the past. How many troops will be, or Raven systems per soldiers? Do you see that penetration rate increasing at all given the more I guess the unique challenges related to Afghanistan. The complete lack of infrastructure, I think you guys might be at one system per every 180 soldiers now. Do you see that rate changing?

Tim Conver

I maybe address that in two segments Mike. As to Afghanistan, I don’t know and I think that’s an issue that a number of our customers are evaluating in that area and we’ll wait to see what they decide. One could certainly anticipate some possibility of change given the obvious differences in the nature of troop deployment and operations in Afghanistan.

Secondly, in a broader area a number of our customers continue to evaluate the potential value of pushing the systems further down into their fourth structure and if anything I’ve seen more thinking in that line rather than less over the last year. So that certainly a consideration that’s on the table and in the minds of some of our existing customers that have been using these systems for a long time and developing a high level of experience and appreciation for what they bring to the party.

Operator

That concludes the question-and-answer session today. At this time, I will turn the conference back over to Mr. Gitlin, for any additional or closing remarks.

Steven Gitlin

Thank you, Melanie. With that as our final question, we thank you all for your continued attention and interest in AeroVironment, and remind you that in archive 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 quarters results.

Operator

That concludes today’s conference call. Thank you for your participation.

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Source: AeroVironment Inc. F2Q10 (Qtr End 10/31/09) Earnings Call Transcript
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