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Executives

Andrew Kaminsky - ‎Senior Vice President, Corporate Development, Investor Relations & Human Resources

Len Borow - President, Chief Executive Officer

John Adamovich Jr. - Chief Financial Officer, Senior Vice President

Analysts

Jim Covello - Goldman Sachs

Rob Richardson - Stifel

Quinn Bolton - Needham & Company

Aeroflex Holding Corp. (ARX) F2Q 2014 Earnings Conference Call February 7, 2014 8:15 AM ET

Operator

Good morning, and welcome to the Aeroflex Holdings Corp. webcast and conference call. This is where management will discuss the company's financial results for the second quarter of the fiscal 2014, which ended on December 31, 2013.

If you do not have a copy of the earnings press release, you may access it through the Investor Relations section of the company's website at aeroflex.com. This call is being recorded for future playback and it will be available later today in the Events tab on the Investor Relations section on the company's website.

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

Andrew Kaminsky

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

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

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

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

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

Len Borow

Thanks Andrew. Good morning and thank you for joining us.

Before getting into the quarter, I would like to briefly discuss our recent acquisition of Shenick Network Systems. They are headquartered in Ireland. Shenick is a leading edge provider of software-based wireless type solution. And for more than two years, Shenick's software products have enhanced the testing capabilities of our product, market leading wireless infrastructure product with TM500.

Shenick's newest product TeraVM has already gained market acceptance as a cost effective scalable and efficient way to test next generation software defining (sic) defined networking. TeraVM provides realistic and very high-low traffic generation and analysis from 1 gigabit to 1 terabit of fully stateful data application traffic with comprehensive measurement and performance analysis on each and every application flow to easily pinpoint and isolate problems.

Traditionally, TeraVM helps service providers and network equipment manufacturers load, analyze, develop and validate the performance and capabilities of a wide variety of network and security devices. The market to virtual testing for cloud-based application expands the addressable market for our technology by over $1 billion.

We are very excited about the growth opportunity that this technology will provide us. On behalf of all of us at Aeroflex, I want to welcome our new colleagues and look forward to building upon what they have started.

Now, turning to our second quarter, we regained our momentum across many of our core market, which was evidenced by a significantly above 1 to 1 book-to-bill. Bookings was strong on -- both across APS and AMS. AMS' bookings were led by its high-rel businesses including two major contracts for over $20 million of high performance, high reliability, mixed signal, semiconductors into new end market. These products will be used in a high-end industrial application and for next generation medical diagnostic application.

We are very excited about these contract wins because they demonstrate our ability to leverage our unique intellectual property for growth in adjacent markets. Additionally this quarter, we received our first order for our next generation 90-nanometer ASIC for new satellite application. The strength in our business is being driven by new product qualifications across our high-rel portfolio, which is giving us confidence and our growth expectations for our AMS platform.

In ATS this quarter, our wireless infrastructure business continue to benefit from the demand for next generation LTE technology in growing markets such as APAC. Endorsements for major charities in the region have helped promote the value and the need for our products. This contributed to a record quarter of TM500 bookings, positioning us well for continued growth and margin improvement in ATS.

In our ATS Av-Comm business, we are cautiously optimistic about a few new major program opportunities within certain government agency and the armed forces that will help drive long-term growth.

We have continued to concentrate on operational efficiencies throughout the company and the results of these actions are positively impacting our financial results. These cost saving initiatives coupled with strong bookings and market momentum are positioning us well to deliver a very strong operating results for the second half of fiscal 2014.

Finally, as we stated in the past, we will continually balance M&A opportunities such as Shenick with deleveraging and we will make the best decision to create the most shareholder value over the long-term.

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

John Adamovich Jr.

Thanks Len, and good morning for joining us. I'm going to briefly discuss some of the financial details of the Shenick acquisition before addressing our financial results for the quarter and our balance sheet. I will then turn the call back to Len, who will discuss our business outlook before we open the lines for questions.

Subject to a working capital adjustment that will be determined in the near future, we paid $28.5 million for Shenick. The acquisition of this Ireland headquartered company was completed through our U.K. based wireless subsidiary using cash generated when the U.K. subsidiary sold its ATES service business for approximately $18 million last September. As you may recall through an efficient tax strategy there was no tax leakage from the ATES sale.

For calendar year 2013, Shenick had net sales of approximately $9.4 million including approximately $2.7 million of its sales to Aeroflex. As a software company, Shenick's gross margins are significantly above our corporate average which will add to the recent improvements we experienced in our ATES gross margins particularly as revenues scale.

Moving on to our second quarter, note that for the purposes of this call, my statement of operations related comments will focus on our non-GAAP metrics. These non-GAAP metrics eliminate certain non-recurring charges and non-cash charges. As Andrew mentioned at the outset of the call, a detailed reconciliations of our GAAP to non-GAAP results can be found in the press release we issued this morning.

Before getting into the details of the quarter, let me remind you that the continuing operations we are reporting exclude the results of the operations of our U.K. service business that was sold in September 2013.

And now concerning the line item specifics. Net sales for the quarter were $151 million, which is comparable to the net sales in the second quarter of fiscal 2013. Sales from AMS were $84 million and sales from ATS' continuing operations were $67 million.

Gross margin for the quarter was 50% which is down from 51.5% in the second quarter of fiscal 2013 due to delays in new product releases and current product mix in AMS. ATS' strong margins reflect increased sales of wireless test products which carry margins greater than the corporate average.

The operational changes that we have been making or continuing to produce benefits as our SG&A for the quarter was down $2.9 million to $32.5 million from $35.5 million in the second quarter of fiscal 2013.

R&D for the quarter was $22.5 million up from $21.1 million in the second quarter of fiscal 2013. Modest increases for new product development are taking place in several areas in both segments. Non-GAAP operating income for the quarter was $20.8 million and adjusted EBITDA was $26.1 million.

Our customer diversity continues to remain strong. For the quarter, no customer accounted for more than 10% of net sales. This quarter 19% of net sales were in APAC, 20% in Europe, and 55% in the U.S. Net sales for the U.S. government or prime defense contractors or subcontractors of the U.S. government were approximately 30%.

Our geographic mix of non-GAAP pretax income for the quarter resulted in a non-GAAP effective tax rate of 32%. Our gross debt balance remained at $587 million, with cash on hand at December 31st; we have net debt of $526 million. Taking into account, the recent acquisition of Shenick, our net debt post the acquisition is approximately $555 million.

As we stated last quarter, we have now fully utilized our tax NOLs and R&D tax credit carryforwards and therefore have been making cash tax payments. This quarter we paid approximately $600,000 bringing our 6-month total to $12.2 million. The tax payments and the acquisition of Shenick have reduced our near term ability to prepay debt. But, we are still committed to our plan to continue to repay debt as we have repaid $144 million of debt over the prior two fiscal years.

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

Len Borow

Thanks John. A strong book to bill ratio this quarter demonstrates that our seasonal pattern over the last 20 years will continue. We expect to continue our current momentum in the third and growing it in the fourth quarter. Our current outlook includes the results of our recently announced Shenick acquisition from the date of closing to March 31, 2014. We anticipate the acquisition of Shenick will be neutral to adjusted EBITDA in fiscal 2014 and accretive to adjusted EBITDA in fiscal 2015.

For the third quarter of fiscal 2014 ending March 31st, we expect net sales to be between $155 million and $162 million and adjusted EBITDA to be between $26 million and $30 million. These numbers include approximately $1 million of sales with some dilution to adjusted EBITDA from Shenick in the third quarter.

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

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And we do have your first question coming from the line of Jim Covello from Goldman Sachs. Please proceed.

Jim Covello - Goldman Sachs

Good morning guys. How are you doing?

Andrew Kaminsky

Good morning.

Len Borow

Good morning, Jim.

Jim Covello - Goldman Sachs

Len, you've been so clear over the years about how your view that the some of the parts equaled a lot more than the stock price. And there has been a lot of different variations of how that could be unlocked over time. Does this acquisition signal that you guys are thinking about being more additive as supposed to kind of may be breaking up some of the parts or is this pretty much separate from that decision? Thanks.

Len Borow

This is totally separate from that decision. As we always said Jim, we continually look to build the company and build value whether it's an acquisition divestiture or whatever. We feel that our wireless platform is really positioned now to show tremendous growth. And we think the acquisition of Shenick is perfect for us, because as you know with an absolute leader in level one through three in testing with -- over our interfaces and Shenick gives us levels four through seven and lets us get millions and millions of -- well stimulate millions and millions of users and this gives us a complete solution to go to our customers with. And especially now that we've gotten the endorsement of the major people in APAC, we think that's just going to really help us in the near term and long-term future.

Jim Covello - Goldman Sachs

That's helpful. Thank you. If I could ask a follow up, you guys obviously have such a great position in the base-station test business for LTE. I think not specific to Aeroflex but that whole market has been sort of a conundrum for Wall Street in terms of the lumpiness and it always seems like it's something the big ramp in China LTE is always sort of on the come and we get a little bit of it. And then it kind of fades off for a little bit. And again that's not an Aeroflex specific comment that's more of a broader semiconductor comment in terms of when those opportunities are really going hit.

How do you see that playing out over the next 18 months? Is it going to be -- should we expect it to continue to be a little bit lumpy? We see some and then it levels off and digest and we see some more, or do you just think there are going to be a couple of quarters this year that really represent a sweet spot of that transition? Thanks.

Len Borow

I really think that we're starting to see the real uptick in APAC now and that should be evidenced again over the next 18 to 24 months starting now. I mean its, we're seeing it right now. We saw it in the December quarter; we saw it in start of this quarter in China in Japan. We're seeing a lot of investment in infrastructure. And well, for us it's infrastructure R&D.

Jim Covello - Goldman Sachs

Right, right. Terrific. Well, thank you so much and good luck.

Len Borow

Thank you, Jim.

Operator

Thank you. And your next question comes from the line of Patrick Newton with Stifel. Please proceed.

Rob Richardson - Stifel

Hi. Thanks for taking my questions. This is actually Rob Richardson on for Patrick today. Just kind of seeing on the subject of Shenick, just wondered if you could discuss kind of what your expectations for growth are from the business?

Len Borow

Well, again, we expect now TeraVM to grow very, very rapidly over the next several years. We're starting from a small base, so we expect them to be a major player in not only testing for carriers, but for testing for all could-based enterprises and getting us into new markets like security, verification, which is a hot topic these days. So we're looking for some very, very hot growth once we get our sales force up to-date with the new TeraVM product and start or push especially into APAC.

Rob Richardson - Stifel

Great, I appreciate that. And I guess just kind of a follow up to that. So you expect a lot of kind of growth from this market. Can you talk about what the competitive landscape looks like? Is there kind of a strong competitive dynamic?

Len Borow

Well, up to now, most of the competitive dynamic, it's been in hardware. TeraVM replaces the hardware. Therefore, its much, much more cost effective and allows the customers to rapidly increase their bandwidth that they require. Without having to spend 100 and 100s of 1000s of dollars, but even saying that the addressable market for us is very, very significant. And we don't believe anybody has a software platform that compares with TeraVM.

Rob Richardson - Stifel

Great, I appreciate it. Thanks for taking my call.

Operator

Thank you. And we do have another question and that comes from the line of Quinn Bolton with Needham & Company. Please proceed.

Quinn Bolton - Needham & Company

Hey, guys. Nice short on the results and guidance. Len, I just wanted to come back to the Shenick's products and specifically TeraVM, it's a software solution. Can you just -- is this going to be running on industries standard servers, is it somehow going to run on top of your existing kind of wireless test platform? Can you give us a little bit of sense of how this, where this software resides when you sell it to the customer?

Len Borow

Well, when we sell to the customer, it resides on the server, on their server. And basically, we've got a platform that we've been working with Shenick for the last couple of years and sales have grown nicely for us from zero to just under $3 million last year where we combined it with our TM500. But, mainly the future for TeraVM resides in regular servers.

Quinn Bolton - Needham & Company

Okay. So it sounds like on the wireless infrastructure you've got a complementary offering where its TM500 plus their software, you'll do layer 1 to 3, they will do layer 4 to 7 and then you also have a much bigger opportunity for traditional wireline network doing the test [ph] and testing in it sort of higher layers of the stack?

Len Borow

It's particularly geared for the cloud community where you'll have to stimulate millions and millions and millions of users and very specific users. I mean, we can stimulate millions of people doing Angry Birds.

Quinn Bolton - Needham & Company

It sort of targets the cloud, have you had success or has TeraVM had success with some large Internet [ph] data center?

Len Borow

Yes. We've had success with the biggest providers of cloud-based services.

Quinn Bolton - Needham & Company

Great. Second question, you mentioned a lot of strength in Asia-PAC for the wireless test. We've heard some rumblings that North America spending might be coming back as well. Have you seen any list in the North America business for wireless test?

Len Borow

We're seeing it now start to percolate, haven't seen great spending yet but the number of demos and the interest in our products seems to have increased.

Quinn Bolton - Needham & Company

Great. And then just on the AMS side, you mentioned sort of $20 million of contract in medical and industrial. Can you provide anymore detail on sort of the applications that you're going after or what the ASIC do?

Len Borow

Yes. Well, I don't want to go too specific but I think the one that's very, very exciting for us is DNA sequencing and as you know that exploding everywhere and we developed with our customer a very, very unique ASIC that we expect to be shipping in very, very large quantities by the fourth quarter.

Quinn Bolton - Needham & Company

Great. Thank you.

Operator

Thank you. I would now like to turn the call over to Len Borow for closing remarks.

Len Borow

Well, thanks everyone for attending this call. As you can tell, we are excited about the future and look forward to talking to you at the next quarter. Thank you.

Operator

Thank you. That concludes your conference for today. You may now disconnect and good day.

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