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Executives

Richard Southworth – President, CEO

Jack Freeman – Senior Vice President, CFO

Analysts

Ted Kuntz – Needham & Company

Charlie Smith – Fort Pitt Capital

Chris McDonald – Kennedy Capital Management

Spectrum Control, Inc. (SPEC) F4Q09 Earnings Call January 11, 2010 4:45 PM ET

Operator

Welcome to the Spectrum Control Inc. 2009 fourth quarter and fiscal year end conference call. Representing the company today, we have Dick Southworth, President and Chief Executive Officer and Jack Freeman, Senior Vice President and Chief Financial Officer. Their discussion of the company's operating performance for the fourth quarter and fiscal year ended November 30, 2009 should take about 20 minutes. They will then try to answer as many questions as reasonably possible. We expect to conclude this conference call at approximately 5:30 pm Eastern time.

As a reminder, the following discussion will include forward-looking statements which reflect management's current views with respect to future market conditions and operating performance. These forward-looking statements are subject to certain risks and uncertainties which could cause actual results to differ materially from historical results or those anticipated. These risks and uncertainties are described in detail in the company's most recent quarterly and annual SEC filings.

The words believe, expect, anticipate and similar expressions identify forward-looking statements. Listeners are cautioned not to place undue reliance on these forward-looking statements. Such forward-looking statements speak only as of the date on which they are made and the company does not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date of this call.

I would now like to introduce Mr. Dick Southworth, President and Chief Executive Officer of Spectrum Control. Please go ahead.

Richard Southworth

Thank you operator. Welcome to Spectrum Control's 2009 fourth quarter and year-end conference call. I will briefly review some key operating and financial highlights for the period after which Jack Freeman will review our financial performance in more detail. We will be happy to take any questions after that.

For the fourth quarter 2009 we reported net income of $2.1 million or $0.17 per share on sales of $34.1 million compared to a net income of $2.5 million or $0.20 per share on sales of $33.8 million for the same period last year. For the year 2009, we had a net income of $8.6 million or $0.67 per diluted share on sales of $132.3 million. For the year 2008 we had a net income of $8.9 million or $0.67 per share diluted on sales of $130.7 million.

We are very pleased to report fourth quarter financial results that are consistent with our previous guidance. With current quarter revenues up $2.6 million or 8% and pre-tax profit up 13% from the third quarter of this year. This performance was achieved despite incurring about $650,000 of one-time G&A expenses in the fourth quarter which Jack Freeman will talk about more in just a few minutes.

In the current quarter our gross margin was $9.4 million or nearly 28% of sales compared to $7.7 million or about 24.6% of sales in the preceding quarter. This increase in gross margin percentage demonstrates our ability to leverage our fixed manufacturing overhead and generate very positive incremental margins with increases in sales volume. It also reflects our strategic decision to maintain much of our manufacturing capacity and infrastructure even during the global economic downturn. We believe this decision will continue to benefit future periods as we will be able to quickly and efficiently respond to expected increases in customer demand.

Our military and defense business continues to grow, generating $20.5 million or 60% of our overall revenues during the fourth quarter, an increase of $3.4 million or 20% from the same period a year ago. For the year 2009 our military business was up 29% from 2008, more than offsetting a 25% decline in our commercial business driven by the global recession. As we go forward we expect our military and defense business to continue to demonstrate strong growth and we are cautiously optimistic that our commercial markets will begin to rebound.

With this market outlook, our recent acquisition of Micro Networks, a multitude of new products and program design wins along with our microwave group recently receiving a major multi-year contract from Talus for supplying our power amplifiers for their extended band [Man Pac] and accessory to their JPRS enhanced multi-band radio. All of this makes us very excited about 2010.

These are just some of the highlights and accomplishments of the fourth quarter and 2009 year-end. At this point I would like to introduce Jack Freeman, our Chief Financial Officer and ask Jack to review our fourth quarter results in greater detail. When Jack has completed his presentation I will conclude with some final comments and we will open the floor to questions. Jack?

Jack Freeman

Thanks Dick. On November 30th of last year we acquired substantially all of the assets and assumed certain liabilities of Micro Networks Corporation, a subsidiary of Integrated Device Technology, Inc. Micro Networks with operations in Worchester, Massachusetts and Auburn, New York, designs and manufactures high performance data conversion products, custom modules and a broad line of filters, oscillators and delay lines based on surface acoustic wave or SAW technology. This acquisition we think reflects our continued commitment to product and technology expansion.

Micro Networks’ products include integrated microwave assemblies with hybrid circuit design, precision bulk acoustic wave delay lines as well as synthesizers. These complex products and related SAW technology are natural complements and a further extension to our microwave components and systems business. Substantially all of Micro Networks’ products are used in defense and aerospace applications including radar systems, missile defense systems and secured communications.

Recent annual revenues of Micro Networks have approximated $14 million. The aggregate cash purchase price for Micro Networks was $12.9 million which was funded by utilizing approximately $6 million of our existing cash reserves and borrowing $7 million under our domestic line of credit. Since the acquisition became effective after the close of business on November 30th, the acquisition had no impact on our 2009 fourth quarter or 2009 fiscal year revenues or expenses.

Compared to the third quarter of fiscal 2009, all four of our business segments generated increased shipments in the fourth quarter. Advanced specialty product sales were $10.9 million, up 6% from the preceding quarter. Microwave product sales were $15.3 million, also up about 6% and our sensors and control product sales were $4.6 million in the current quarter up about 3%. Our power management systems business had a particularly strong fourth quarter performance with sales of $3.3 million, up over $1 million or almost 50% from the third quarter this year.

This growth was generated in the communications equipment market segment especially in the electronic data storage area and application for our AC power strip products. On an aggregate basis, sales of our products for commercial applications were $13.6 million or about 40% in the fourth quarter, up 10% from the third quarter of fiscal 2009. So this was the first quarterly growth in commercial business that we have seen since the beginning of the global recession. So we are obviously encouraged by this and believe that it may be the beginning of a modest recovery throughout our commercial markets.

In the current quarter as Dick indicated our gross margin was $9.4 million or about 27.6% of sales compared to $7.7 million or about 24.6% of sales in the preceding quarter. Despite the global recession and its impact on virtually all commercial markets also as Dick indicated we have strategically maintained our production capacity and infrastructure to enable us to quickly and efficiently respond to our customers. So importantly as sales volumes begin to grow we do not need to add any significant production capacity which allows us to leverage our fixed manufacturing overhead and enhance our overall operating margins.

In the fourth quarter of fiscal 2009 our SG&A expense amounted to about $5.8 million or about 17% of sales compared to $4.6 million or 14.6% of sales in the preceding third quarter. This $1.2 million increase in SG&A expense consists of three elements. First and you may remember that our third quarter SG&A expense included a net gain of $528,000 representing the excess of insurance recoveries over the carrying value of certain assets destroyed by water and fire damage early in 2009 at two of our manufacturing facilities. This was a one-time benefit serving to reduce our 2009 third quarter SG&A expense.

Secondly, our current quarter SG&A expense included a charge of $300,000 for the settlement of a product liability issue related to products manufactured and sold by Advanced Thermal Products (ATP) prior to our acquisition of ATP in July of 2006. Lastly, our current quarter SG&A expense also included approximately $350,000 of nonrecurring employee moving and relocation expenses.

Without these two nonrecurring items which totaled $650,000 our fourth quarter SG&A expense would have been about $5.2 million or 15% of sales, a more normalized level for us and as a percentage of sales we think indicative of what we would expect SG&A expense to be going forward.

Our effective income tax rate for the fiscal year ended November 30, 2009 came in at 36.1% slightly higher than our previous estimates of 35%. This increase primarily reflects the amount of our foreign earnings and related foreign income tax rates. To a lesser extent, the slight increase in effective income tax rate also reflects other differences between estimates and actual amounts for R&D tax credits, the US production activities reductions as well as various state income tax provisions.

Our 2009 fourth quarter tax provision therefore includes a small catch up adjustment of approximately $104,000 to increase our annual effective tax rate to the 36.1%. This effective tax rate adjustment along with the two nonrecurring items totaling $650,000 which increased our SG&A expense had an aggregate impact on our fourth quarter earnings of $0.04 per diluted share.

Also in the current quarter our net cash provided by operating activities amounted to $5.3 million an increase of almost $3 million from the comparable quarter of last year. For the fiscal year ended November 30, 2009 net cash provided by operating activities was over $19 million. As a record level of operating cash flow it reflects improved accounts receivable turnover rates as well as other reductions in working capital requirements.

As a result of the strong cash generation in fiscal year 2009 we were able to expend nearly $4 million in capital equipment additions, repay a net of $3.5 million in bank indebtedness as well as support the $12.9 million aggregate cash purchase price from Micro Networks. With our strong cash flow capabilities, a borrowed funds to equity ratio of only 0.7 to 1.0 and a book value of just under $9 per share, we believe our liquidity and financial position provide a very solid foundation for our future growth.

Dick will now make some concluding comments.

Richard Southworth

With our acquisition of Micro Networks and our current assessment of business conditions and customer demand we presently anticipate our 2010 first quarter sales to be between $38 million and $39 million. Based on this shipment level and as we integrate the Micro Networks business we expect our 2010 first quarter earnings to be between $0.19 to $0.20 per diluted share. If this operating performance is achieved it would represent an increase of 15-18% in revenues and 12-18% in earnings per diluted share from the comparable period a year ago.

Beyond the first quarter we remain very optimistic. 2010 will be a very good year for Spectrum Control. Our recent acquisition of Micro Networks the last day of fiscal 2009, the continued organic growth of our military business, the initial strengthening of our commercial market as the recession rebounds and our recent multi-year contract for Power Amplifiers.

At this point, I would like to open the discussion for questions.

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of Ted Kuntz – Needham & Company.

Ted Kuntz – Needham & Company

Maybe you could go through each of the groups for us and just sort of give us a little profile and discuss it in light of the bookings in the quarter as well? You like to look at the book to bill in the quarter and what does that indicate for the future revenue stream in that particular business? Maybe you can just quickly run through those four and I guess you will be consolidating the Micro Networks business into microwave components. Is that correct?

Richard Southworth

Right.

Ted Kuntz – Needham & Company

So if you could kind of run through those for us I think that would be very helpful for me. Looking at advanced specialty products I know the book to bill there was a little over one in the quarter 1.03 and for the year 1.17. Maybe you can just talk a little bit about the outlook and then I wanted to go through each of them.

Jack Freeman

Let me kind of lay some of the groundwork and then Dick may chime in at any point obviously. For advanced specialty products the customer orders for the fourth quarter were $11.2 million which is pretty comparable to what they were a year ago. As you know this is one of our businesses that has been impacted by the overall soft commercial market. Their military business continued to increase during the fourth quarter and although there was some sign of the beginning of what we hope is a rebound in the commercial market it was fairly modest in the fourth quarter.

Our microwave business which is predominately military again as you know the orders for that business and military orders in particular can be a little lumpy. They can come in significant dollar values but not at any particular discernible pattern. As a result the bookings for the quarter were just under $13 million.

Ted Kuntz – Needham & Company

That is the point I was making on book to bill. Does that include any microwave networks? Probably not, right?

Jack Freeman

No. The acquisition took place on literally at the close of business on November 30th.

Ted Kuntz – Needham & Company

So you are not including any of their backlog?

Jack Freeman

No bookings. No revenues. No expenses for the acquisition in the fourth quarter.

Richard Southworth

Maybe if I can just add a comment to that. Several large programs in which we are sole source were just delayed. We have already seen those orders brink in the first quarter of 2010. So it is not lost business it was just a delay of release of the business.

Ted Kuntz – Needham & Company

Can you mention any of those particular programs? Or just give us a sense of where they are? What areas?

Richard Southworth

Some of them are in [proof]. You caught me kind of off guard. They are in…let me get more detail on that and when we come up tomorrow to visit you we can give it to you.

Ted Kuntz – Needham & Company

So the 0.85 book to bill is not indicative of where the business is? This quarter you would expect it to be nice and higher than that? Is that correct?

Jack Freeman

Absolutely. I will finish before I forget on the other two businesses. The power management systems business had a very strong fourth quarter for us in terms of bookings and shipments. That business has a significant majority of that business remains in communications equipment, in applications for data storage and utilization of some of our power strip products. So that was actually a very positive sign for us in the fourth quarter but that part of the commercial market showed some resiliency in the fourth quarter.

Ted Kuntz – Needham & Company

How much of that is commercial?

Jack Freeman

85%. As we penetrate the military market we will see that change dramatically over 2010 and 2011. Lastly, the sensors and controls business their bookings were soft during the fourth quarter really for two reasons. One is a significant part of their business is military in the positioning sensor part of that business so you have that some lumpiness if you will on how some of those orders were received and they had a slight push out in the major military order for them. But still the outlook for that military applications remains very strong. Part of that business particularly on the temperature sensor side is all commercial and that is some of the continued softness for that part of the business that it has experienced throughout most of 2009.

Ted Kuntz – Needham & Company

So would you expect revenues to kind of decline a little bit in that sector from the current level because of low bookings?

Richard Southworth

No we think they will pick up.

Ted Kuntz – Needham & Company

Could you go back to the Micro Networks acquisition? You mentioned a $14 million number. Is that a current number and what are their bookings and do they have a backlog? Sort of what are the expectations for that business this year?

Jack Freeman

I think it is fair to say a reasonable estimation for their contribution of revenues in 2010 could be at that $14 million level. We are going through a transition phase with them where sometime later after the initial six month period we would expect to consolidate that operation with our other Massachusetts operation in Marlboro. But even during that integration period we would expect that there are enough synergies that there would be benefits of consolidation in the leveraging of existing overhead and so the incremental margins on that $14 million business we would expect to be quite positive throughout 2010 even through the six months of integration and even more so during the second half of the year.

Ted Kuntz – Needham & Company

Similar gross margins to what you are currently seeing at the 27% range?

Jack Freeman

Actually better than that. You may remember a key benchmark we used internally is prime margins and their prime margins are slightly better than our average microwave where we expect them to be slightly better than our average microwave prime margins. So that combination of a strong prime margin with being able to leverage some of the manufacturing overhead through consolidations we would expect their overall gross margin to be better than what our microwave gross margins have been.

Ted Kuntz – Needham & Company

In terms of your gross margin outlook is this a new level for you that is sustainable? I hate to kind of go here so quickly. It is a big increase from what you have been doing.

Jack Freeman

I would say with the exception that whenever we have a new acquisition and the integration of that acquisition it wouldn’t be out of the question that in the first quarter in particular after the acquisition there may be some non-recurring consolidation type charges. But with that caveat, beyond that yes we really do think that we would get that level of gross margin we achieved in the fourth quarter we basically would expect to build upon throughout 2010 particularly starting in the second quarter.

Ted Kuntz – Needham & Company

SG&A what is the incremental add to the SG&A from the acquisition?

Jack Freeman

I guess the way we would look at it is the overall SG&A range we expect which would be having SG&A on average of about 14.5% to 15% of sales, we would expect that to continue even during this integration of Micro Networks.

Operator

The next question comes from the line of Charlie Smith – Fort Pitt Capital.

Charlie Smith – Fort Pitt Capital

On the balance sheet, your equity line or your shareholder equity was up more than $1.5 million more than your income for the year. Is that a result of consolidating Micro on the last day of the year or where did that come from?

Jack Freeman

Can you repeat that?

Charlie Smith – Fort Pitt Capital

Your shareholder equity line on your balance sheet was up about $1.5 million more than your net income for the year.

Jack Freeman

Yes there are really two elements of that. One is our accumulated other comprehensive income which for us is really the accumulation of foreign translation adjustments, there was a positive impact during the year of about $0.5 million primarily as a result of the value of the dollar versus the Euro that we maintain a German subsidiary that has a net asset position and so as a result of that change in valuation during the year there was about a $0.5 million benefit from that. Then the other part would have been we had a similar amount or slightly more than the $0.5 million of additional equity from the exercise of employee stock options throughout the year.

Operator

The next question comes from the line of Chris McDonald – Kennedy Capital Management.

Chris McDonald – Kennedy Capital Management

Can you be a bit more granular around inventory step up or the other one-time charges the company would experience as it relates to the Micro Networks acquisition? Do you have visibility on that?

Jack Freeman

We don’t have much visibility. So in addition to just having some physical relocation costs associated with equipment the biggest area of exposure and we think it is limited but still an area of exposure would be just operating efficiencies during a period in which we are relocating and consolidating manufacturing operations. So I think if you look back on some of our other acquisitions where we have had similar types of integration we generally have a very positive experience. We have not had significant inefficiencies during that period or any significant one-time charges so I think the only thing we are saying is particularly during the first three months of this integration we don’t expect anything but we couldn’t rule out the possibility there might be some one-time charges.

Chris McDonald – Kennedy Capital Management

Your expectation is that consolidation activity is maybe a six month time frame?

Jack Freeman

That is correct.

Chris McDonald – Kennedy Capital Management

I am curious to get your current visibility around the CREW program and how many quarters of backlog you may have booked or whatever way you want to characterize it? I just want to get a better understanding of how long you would expect to be working on that program.

Richard Southworth

We see CREW as a continuing program for us. Last year it represented about $12 million in revenues for us. We expect this year we will see probably about a 20% increase in that on a year-over-year basis. Our book to bill on CREW last year was about a 1.2 to 1. We anticipate with the buildup in Afghanistan that there is going to be also additional demand for us.

Operator

We show no further questions. I would like to turn the call back over to the speakers for any closing comments.

Richard Southworth

Since there are no further questions we thank you for joining us today. We will conclude the conference call. Thank you.

Operator

Thank you. This does conclude today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.

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Source: Spectrum Control, Inc. F4Q09 (Qtr End 11/30/09) Earnings Call Transcript
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