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AeroVironment, Inc. (NASDAQ:AVAV)

F3Q2014 Earnings Conference Call

March 4, 2014 4:30 pm ET

Executives

Tim Conver - Chairman and Chief Executive Officer

Jikun Kim - Senior Vice President and Chief Financial Officer

Steven Gitlin - Investor Relations

Analysts

Howard Rubel - Jefferies & Company

Patrick McCarthy - FBR Capital Markets

Andrea James - Dougherty & Co.

Peter Arment - Sterne Agee

Michael Ciarmoli - KeyBanc Capital Markets

William R. Loomis - Stifel Nicolaus & Company

Tyler Hojo - Sidoti & Company

Josephine Millward - The Benchmark Company

Operator

Good day, ladies and gentlemen. Welcome to the AeroVironment Third Quarter Fiscal 2014 Earnings Call. At this time, all participants are in listen-only mode. We'll 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. Jikun Kim; Chief Operating Officer, Mr. Tom Herring; and Vice President of Investor Relations, Mr. Steven Gitlin.

And now at this time, I would like to turn the conference over to Mr. Gitlin. Please go ahead, sir.

Steven Gitlin

Thank you, Saeed, and welcome to our third quarter fiscal 2014 earnings call. 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 of the 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, March 4, 2014. The Company undertakes no obligation to make any revision to the statements contained in our remarks or to update them to reflect the events or circumstances occurring after this conference call.

We will now begin with remarks from Tim Conver.

Tim Conver

Good afternoon, and welcome to our third quarter fiscal 2014 conference call. Today, I'll begin the call with our overview of the quarter, including recent positive developments. I'll also turn the call over later to Jikun to provide a detailed financial summary of our results, and finally I'll discuss our outlook for the remaining of fiscal 2014.

The theme for today's call is simple, we're on track with our fiscal year priorities, with our FY 2014 guidance, and with our growth initiatives. Starting with the highlights for the third quarter, revenue was $69.2 million, bringing the first nine months' revenue to $178 million, 74% of the midpoint of our full year revenue guidance. As previously stated, we're guiding earnings for fiscal 2014 based on adjusted EPS which excludes the non-cash effects of changes in the fair value of the conversion option of our CybAero convertible notes. On an adjusted basis, fully diluted EPS was $0.34, excluding the $0.15 gain associated with the CybAero convertible notes.

Our funded backlog at the end of the quarter was $95.5 million, which gives us good visibility for Q4 revenue and our full year guidance, and it begins to shape revenue for Q1 fiscal 2015. We continued our disciplined focus on successfully executing against our financial and our operating priorities, which enabled both the UAS and the EES segments to complete a solid third quarter, maintain a strong backlog for Q4, sustain our leading market share, and build a pipeline for new orders.

Notably we made two announcements in Q3 that reflect the innovative nature of our work and the ongoing progress in pursuit of the six opportunities we expect to drive growth over the next three to five years. First was the debut of an exciting new product in our EES business segment, the TurboCord portable EV charging solution. As a pioneer and a leader in the electric vehicle charging industry, we have already deployed more than 15,000 Level 2 charging stations and hundreds of DC fast charging stations into consumer's home garages and at businesses and public locations.

We levered our broad experience across all aspects of North American electric vehicle charging infrastructure to develop the TurboCord as an optimal solution for EV charging. TurboCord is a portable charging solution that can use both 120 V and 240 V, both inside and outside the home. It's a compact, tough and waterproof electronic module that fits in the palm of the hand and plugs directly into an outlet. It weighs less than five pounds including its 20 foot charging cable. Best of all, you can buy it off the shelf for $650 dollars, you can install a 240 V outlet for as low as $250, and it's the only charging solution many electric vehicle buyers will ever need.

This also means that homebuilders, building owners and businesses now have a much lower cost alternative to make their properties electric vehicle plug-in ready. The more low-cost 240 V outlets are installed, the more freedom plug-in electric vehicle owners will have to drive where and when they want to. Ultimately we believe that shipping new plug-in vehicles with TurboCord or taking the existing 120 V charge cord out of the vehicle price could deliver even more value to consumers around the world. We believe that TurboCord delivers a unique value proposition. It can help expand the adoption of electric vehicles and it's another example of our innovative team driving solutions for leadership in emerging markets.

Second, I'd like to discuss our Memorandum of Understanding with Lockheed Martin to pursue joint opportunities in unmanned aircraft system markets. Specifically, we are working with Lockheed Martin to identify opportunities to provide atmospheric satellite systems based on Global Observer to international customers. As you'll recall, Global Observer is one of our six growth opportunities. It has unique, high-altitude long-endurance affordability capabilities. It has attracted more than $150 million of customer funding to-date, in addition to our internal funding.

We have acquired from the government the second Global Observer airplane and all the program assets that we did not previously owned, which allows us to deploy these assets on our schedule. Lockheed Martin is an ideal partner for identifying international opportunities for Global Observer to address the multiple needs for affordable, persistent air-borne solutions. Lockheed's extensive global operations, payloads and mission systems are all complementary to end-to-end Global Observer solutions. We believe this collaboration can help move Global Observer into production, either for sale or for operation in a mission-services capacity by the second half of our five-year plan period.

This is a time we point to highlight the significant capital requirements of launching a Global Observer business. Establishing a Global Observer services capability could require hundreds of millions of dollars in capital. Our ability to deploy capital at the right time to decisively launch this business gives us important leverage in capturing the full value of Global Observer for our stakeholders, especially when we work with partners and customers of the size necessary to achieve and to scale this large opportunity. We look forward to updating you on our progress on our relationship with Lockheed Martin and our previously announced relationship with Eurocopter, recently renamed as Airbus Helicopters in the future.

I'd like to now provide a brief update of the other four growth opportunities, Switchblade, international small UAS, mission services, and commercial UAS. In Switchblade, year-to-date revenue is already over 25% higher than all of fiscal '13. We continue to receive very positive feedback on its highly effective training and use, including development of new concepts of operation. Our contracts with the United States Department of Defense include product training, and as the number of military trained personnel increases in the operation of Switchblade, we expect to see broader demand. Looking ahead, effective conversion of Switchblade product orders received in the second quarter will translate into revenue plan for the fourth quarter and the first quarter of fiscal 2015.

Continued focus on the international small UAS business area has produced year-over-year revenue growth in Q3 and has positioned us for the growing international demand for small unmanned airplane systems. We expect a sustained opportunity flow from the pipeline of international requirements.

Turning to mission services, we continue to stand ready to support the United States Department of States unmanned airplane system requirements for situational awareness wherever needed with our proven market-leading small UAS mission services capability. At this time however, there are no further development to report with respect to the DoS services contract.

Another significant growth opportunity is the commercial use of unmanned airplane systems inside the national airspace of countries around the world. This has the potential to become a fundamental wave of change across multiple industries in the mid-term. Notably, the FAA is taking a considered approach to UAS integration. As I've mentioned before, the FAA granted our Puma AE a restricted type certificate for commercial operation in the Arctic and we are already conducting demonstrations of it and other AeroVironment unmanned airplane system platforms to provide high-value new solutions for potential commercial customers.

This approach is proving to be a constructive way for the commercial UAS development by gradually expanding operating envelopes and derisking technologies and procedures that will be required to support broad adoption. Our pre-existing relationships, including those in Alaska and North Dakota position us well to support the new UAS test-site program as we move toward a planned integration of UAS into the United States airspace.

In each of these growth opportunities, our proven approach to deploying innovative solutions in ways that uniquely help our customers succeed, requires an integrated strategy, persistence and agility. Our innovation comes from our people working in teams within an innovative culture. Our disciplined approach to maximizing return on investment enables us to take strong early positions with powerful solutions for new growth opportunities while being prepared to time decisive investments only as market adoption emerges.

The success of this approach requires the coordinated contribution of creative and passionate people, our capital structure, our ability to scale rapidly and customer confidence in our ability to execute effectively at the time they decide to adopt. Of all these moving parts, timing is the most difficult to predict and to manage for.

And now, I'll turn the call over to Jikun for a review of our financial performance in more detail.

Jikun Kim

Thank you, Tim, and good afternoon, everyone. AeroVironment FY '14 Q3 results are as follows. Revenue for the third quarter was $69.2 million, an increase of 47% or $22.1 million over Q3 last year of $47.1 million. Now looking at revenue by segment, UAS revenue was $57.5 million, an increase of 53% over the prior year. The increase in UAS revenue was largely due to higher product deliveries of $31 million driven by sUAS systems and spares.

However, this increase was offset by lower customer-funded R&D revenues of $5.9 million as we prepare to transition Switchblade into low-rate production. We also recognized $5.2 million reduction in sUAS logistics and repair activities. As a reminder, prior year Q3 customer-funded revenues included the cost reimbursements related to the Global Observer program which we had discussed last year.

EES revenue was $11.7 million, an increase of 24% from Q3 last year, primarily due to increased hardware deliveries over passenger and industrial electric vehicle charging systems, offset by lower deliveries of our electric vehicle test systems.

Turning to gross margin, gross margin in the third quarter was $27.1 million, up 38% from Q3 last year of $19.7 million. Gross margin, as a percent of revenue, was 39% versus 42% in the third quarter last year. UAS gross margin was $23.9 million, up 40% from the third quarter last year, primarily due to higher sales volumes. As a percent of revenue, UAS gross margin was 42% compared to 45% in the third quarter last year. Prior year gross profit percentage was driven by GO cost reimbursements and reversal of accrued incentive compensation expenses tied to prior year third quarter reduced financial guidance. EES gross margin was $3.1 million, up 21% from Q3 last year, primarily due to higher sales volumes. As a percent of revenue, EES gross margin was 27% versus 28% in the third quarter last year.

SG&A expense for the quarter was $13.2 million or 19% of revenue compared to $10.4 million or 22% of revenue in the prior year. SG&A expense for the prior year includes the reversal of the accrued incentive compensation expenses. R&D expense for the quarter was $5.2 million or 8% of revenue compared to the prior year amount of $10.3 million or 22% of revenue.

Operating income for the quarter was $8.6 million or 12% of revenue compared to the prior year loss of $1.1 million or negative 2% of revenue. Operating income was higher primarily due to higher sales volumes and lower R&D investments. Other income for the quarter was $4.7 million, driven by the unrealized gain in our CybAero convertible notes.

The effective tax rate for the quarter was 17%, an increase from the prior year tax benefit rate of 554%, primarily driven by higher pre-tax income. Net income for the quarter was $11.2 million or $0.49 per fully diluted share, compared to $3.9 million or $0.17 per fully diluted share in the same quarter last year. On an adjusted basis, which excludes the impact of the CybAero convertible notes, FY '13 Q3 EPS would have been $0.34 per fully diluted share. We have provided an EPS reconciliation table in the press release.

Now moving quickly through our first nine months of AV's FY '14, revenue for the first nine months was $178.2 million, down 4% from the prior year period of $186 million. By segment, UAS revenue was $148.8 million, down 2% from the prior year. The decrease in revenue was largely due to decreased service revenues of $31.2 million driven by our sUAS logistics and repair activities and lower customer-funded R&D revenues of $6.5 million, as we prepare to transition Switchblade into low-rate production. These decreases were offset by increased product deliveries of $34.6 million, driven by higher sUAS systems and spares deliveries.

EES revenue was $29.4 million, down 14% from the prior year period, primarily due to decreased product deliveries of our electric vehicle test systems and industrial electric vehicle charging systems, all offset by increased product deliveries of our passenger electric vehicle charging systems.

Gross margin for the first nine months was $63.5 million compared to $74.8 million a year ago. Gross margin as a percent of revenue was 36%, 400 basis points lower than the prior year. By segment, UAS gross margin was $55.3 million, down 13%, primarily due to severance-related expenditures. EES gross margin was $8.1 million, down 29%, primarily due to lower sales volumes and severance-related expenditures.

SG&A expense for the first nine months was $38.7 million or 23% of revenue compared to the prior year period of $37.2 million or 20% of revenue. R&D expense for the first nine months was $19.3 million or 11% of revenue compared to $27.8 million or 15% of revenue in the prior year.

Operating income for the first nine months was $5.5 million or 2% of revenue compared to an operating income of $9.8 million or 5% of revenue last year. Other expenses for the first nine months were $1 million due to the unrealized loss in the CybAero convertible notes.

The effective tax benefit rate for the first nine months was 12.3%, compared to an effective tax benefit rate from the prior year of 8.9%. Tax rate variance was driven primarily by lower pre-tax income. Net income for the first nine months was $5.7 million or $0.25 per fully diluted share compared to an income of $11.2 million or $0.50 per fully diluted share last year. On an adjusted basis, which excludes the impact of the CybAero convertible notes, FY '14 year-to-date Q3 EPS would have been $0.28 per share. Looking at backlog, funded backlog at the end of the third quarter was $95.5 million, up $36 million or 61% from April 30, 2013.

Turning to our balance sheet, cash equivalents and investments at the end of the third quarter totaled $213.5 million, up $18 million from the prior quarter. The positive cash flow was driven by higher income and lower working capital needs. Turning to receivables, at the end of the third quarter, our accounts receivables, which include unbilled receivables, totaled $51.3 million, up $7.8 million from the prior quarter. Total days sales outstanding were 67 days compared to 60 days at the end of the prior quarter.

Now taking a look at inventories, inventories were $55.4 million at the end of the quarter, compared to $60.6 million at the end of the prior quarter. Days in inventory were approximately 118 days compared to 133 days at the end of the prior quarter. Turning to capital expenditures, in the quarter, we invested approximately $0.7 million or 1% of revenue in property improvements and capital equipment. We recognized $2.3 million of depreciation in the quarter.

Now, I'd like to turn things back to Tim to discuss AV's expectations for the balance of our FY '14.

Tim Conver

Thank you, Jikun. With three quarters behind us and $95.5 million in funded backlog, we are confident that we will achieve our consistent fiscal 2014 revenue guidance of $230 million to $250 million and fully diluted adjusted EPS from operations of $0.35 to $0.50. With our entire team focused on this year's priorities and less customer uncertainty about their budgets, fiscal 2014 has unfolded much as we anticipated. I expect that we will emerge from this year with stronger positions and high potential growth opportunities and stronger customer relationships. We see multiple opportunities for diversified growth and believe that the continued successful execution of our strategy will benefit all of our stakeholders.

For our customers, we will support our current market-leading products and create new high-value solutions. For our employees, we will enhance opportunities to succeed and grow within AeroVironment. And for our stockholders, we are committed to driving long-term value. We will continue to blend the learning from our experience with the vision of our innovations so that we remain ahead of the wave with uniquely valuable and practical solutions that help customers succeed. We have no doubt that successfully executing our growth strategy will deliver by far the highest return on invested capital.

And now, we'll open the call to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Howard Rubel from Jefferies. Your line is open. Please go ahead.

Howard Rubel - Jefferies & Company

It's just going to be pretty simple. You had, Tim, a slight decline in research and development over each of the last several quarters. I know for a while you were going to re-channel things. Is it the lowest you would expect it for a while or does it go a little lower?

Tim Conver

Howard, we've consistently targeted internally funded R&D at about 8% to 10% of revenue, and as you know, that has moved around from year to year depending on flexing with commercially funded or customer funded R&D and in some cases with business development and bid and proposal, but I think we are pretty much in that percentage zone and we will probably continue to target that until the business model changes fundamentally.

Operator

Our next question comes from Patrick McCarthy from FBR Capital Markets. Your line is open. Please go ahead.

Patrick McCarthy - FBR Capital Markets

Congratulations on a good quarter. Tim, I was wondering, you touched on this in the beginning of your commentary, but I was wondering if you could maybe from a 10,000 foot view just give us a little bit of your perspective on what we're seeing in the electric car vehicle market this year, what's transpired from a demand perspective and a competitive perspective from where you guys sit? I know you talked about the Turbo, but anything else that you might want to add to that?

Tim Conver

So there's been according to industry groups about 170,000 plug-in electric vehicles sold since 2010. So it's been a significant percentage increase from 2011 to now, or 2012 till now. A lot of U.S., Asian and European competition entered this market with products in various channels and solutions that range from consumer solutions to public solutions and networks. I would say that a lot of those early entrants have either moved on or backed off but there is still a large group of suppliers. I think we have maintained a leadership position throughout North America and I think the introduction of TurboCord will be an interesting opportunity for consumers to look at a very handy combination of prior alternatives and in some cases a simple and cost-effective one-solution-fits-all-needs application.

Patrick McCarthy - FBR Capital Markets

So, you show a sequential improvement here, but just based upon the prior adoption curves that you studied, when do you see – I mean how far away do you think you could be from a master tipping point on that product line?

Tim Conver

I think we have seen less adoption of plug-in electric vehicles that many predicted. We have found that our internal models have been better at predicting reality than a lot of the external studies and we're putting most of our reliance on those now. That all puts us out a couple of years before we get into the kind of percentage of all new cars sold that would drive very large market opportunities. I think we've indicated in the past, we think a 5% penetration of the new car market in North America alone would generate something north of $1 billion a year in infrastructure opportunities and something north of $2 billion outside the United States in infrastructure opportunities.

Operator

Our next question comes from Andrea James from Dougherty & Co. Your line is open. Please go ahead.

Andrea James - Dougherty & Co.

I'd like to use up all my time to kind of zero in on the Lockheed Martin partnership on the Global Observer. And so the first question I guess is, could you give us any sense as to how it came about, did they phone you, did they have some leads, they needed a product or…? I'm just curious to how it came about to begin with.

Tim Conver

I think that's best characterized, Andrea, by we found each other in the pursuit of these kinds of applications and interest in these kinds of applications, primarily on an international basis.

Andrea James - Dougherty & Co.

And do we take from that that – and you said inside of second half of the five year frame, I want to make sure I understand what you meant by that, and then do we take that to mean that there is two to three hard leads that you are pursuing and can we also assume that they are in Asia?

Tim Conver

I don't want to get into any specific discussion of specific customers that might be interested in this application prematurely. However, we are and have been focused on discussions with multiple customers that are interested in applications and solutions that can be uniquely enabled by Global Observer platform, and there is a significant number of interested potential customers that are outside the United States. Particularly as the move to areas that have not been developing UAS applications as rigorously as the United States Department of Defense, then the value of supplying a full end-to-end solution increases and that I believe brings this partnership with Lockheed Martin into the perspective of the advantage of their strengths in broad global applications and payloads and in mission systems when combined with the unique characteristics of Global Observer for high-altitude long-endurance cost-effective operations. So, I know that doesn't specifically answer your question on who we might be talking to, but I hope it's helpful.

Andrea James - Dougherty & Co.

It's really helpful. My final and I'm done, how do we get a quantitative sense of the return on some of the capital you have to put in and then sort of kind of what your, I guess, revenue and earnings could be off of any sort of – how do we put quantities around that potential is I guess the question?

Tim Conver

Let me back – before I answer that, I'd go with the second part of your prior question that I missed, which was timeframe I think we have previously communicated our expectation that we would most likely see significant ramp up in revenue from Global Observer in a three to five year period, which would put us in the second half of a five-year plan. So that was the timeframe that I was referring to in my prior comments. Regarding – so, how can I best address your third piece of your question, Andrea?

Andrea James - Dougherty & Co.

I had always traditionally thought of the Global Observer as a product sale with an ASP, but on the services type business, I'm just wondering, I mean it gives more visibility over time, recurring revenue, but what kind of – it's hard to even put any kind of dollar amounts around what the potential is, so any help?

Tim Conver

I think I understand better now what your question is. So if we back up and look at it as a product sale, it is clearly a couple of orders of magnitude different than our small UAS system. We have talked previously about our small UAS being tier one level, and something like a Shadow being tier two, and something like a Predator being tier three, and Global Hawk being tier four in a classic market breakdown of unmanned airplane systems.

In each of those cases, as you move up to a class of platform that has a longer duration and a higher altitude, you also have approximately an order of magnitude increase in the price point of the system. I think to coin a phrase, at level five, tier five, which would be represented by Global Observer, we would begin to bend that cost curve over but that still represents a huge increase in price point over our typical market in small UAS. So we're looking at tens of millions versus hundreds of thousands.

And I think there is a reasonable opportunity that some of these adoptions will be in the form of buying services or mission services, not unlike the concept of the State Department and their view of mission services on obviously different applications and different platforms. In that scenario, we would expect that we would build out the production capacity, we would build out the operating assets and the operation and maintenance facilities as well as providing the data processing and the integration into the customer's system, and then we would deliver those as a – under a services contract where we would be reimbursed much like [other like] (ph) providers structure their businesses around investing in the capital assets and then providing the service on a pay-as-you-go basis. Does s that help at all?

Operator

Our next question comes from Peter Arment from Sterne Agee. Your line is open. Please go ahead.

Peter Arment - Sterne Agee

Tim, could you give us maybe just an update or your thoughts on how Raven funding has continued to come down and [indiscernible] kind of tracked something similar, but I know you've made a lot of upgrade to those systems and they continue to be highly sought after, how do you see kind of the transitionary period with the budgets kind of flattening out here domestically and if there's still any international interest there?

Tim Conver

Great question. A number of years ago Raven was the primary product line in our small UAS portfolio and the Army was the largest user of Raven, although it has been adopted by multiple customers both throughout the Defense Department and the across the world. The Army's acquisition objective for Raven was I think a little over 2,000 systems and that's getting close to being fulfilled. Currently the Army's primary acquisition focus has been on acquiring the new upgraded payloads that we have developed for Raven, and that is a direct upgrade for their existing installed base.

They have also – apparently the Army has now approved the CPD for a family of systems that would be going forward and that appears to include Raven as the midsize platform, apparently Puma as the larger platform and a new smaller platform that would be introduced at a later period, but for the time being served by Raven.

So I think overall, we would expect to see reduced new platform procurement by the Army for Ravens but an ongoing upgrade of the payloads, and over time, they have published visibility of Raven staying in service through 2026 and they have also published a plan through 2035 for their small and nano UAS. So I think it's safe to assume that small unmanned airplane systems remain a key element of kit that's procured and supported and upgraded across the board, not only with the Army but for all DoD small ground troops.

Peter Arment - Sterne Agee

That's very helpful. And if I could just have one follow-up related to Switchblade is, are you still working with the assumption there that eventually we'll see that into a Program of Record or at least any color there you could provide?

Tim Conver

As to the Program of Record, the Army has talked publicly on a number of occasions about a desire and an intent to pursue a Program of Record that they've referred to as LMAMS. They have often referred to Switchblade as the current LMAMS solution, and the last public comment I saw indicated that they were targeting government fiscal 2016 for a desired launch of that Program of Record.

Operator

Your next question comes from Michael Ciarmoli from KeyBanc Capital. Your line is open. Please go ahead.

Michael Ciarmoli - KeyBanc Capital Markets

Nice quarter, guys, and thanks for taking my question. Maybe Tim, just to go back on Andrea's question on the Global Observer, can you give us a sense – before we even talk about revenues or opportunities, how much testing do you guys have left before you actually prove the concept? I mean can we expect to see that flying in the near term and maybe be getting some regular updates on the testing status?

Tim Conver

I think we would expect to complete the demonstration of the full envelope of the platform, but I think it's already a proven solution. There are nine flight tests under the belt on the JCPD program that took the airplane to 30,000 feet for 18 hours. All of the innovative subsystems that enabled that unique capability performed extraordinarily well through all of the ground and the flight tests. I think there's an intent before we deliver any production systems to get to the envelope expansion that would address the attitude and the duration we intend to operate in production, but I think that's pretty straightforward.

Michael Ciarmoli - KeyBanc Capital Markets

So you think even with a mishap, getting up to 60,000 feet for seven days, that that shouldn't really deter any customers from potentially adopting that or given sort of a green-light to broaden or even sign-up cost merged and get some actual service to product revenue?

Tim Conver

I think our DoD customers are fully aware of the circumstances and they are comfortable with the resolution and the testing we have done on that resolution.

Operator

Our next question comes from Bill Loomis from Stifel. Your line is open. Please go ahead.

William R. Loomis - Stifel Nicolaus & Company

Just looking at leaving the guidance unchanged with only a quarter to go, I mean it seems, if we back it out on the adjusted number, something like $0.07 to $0.22, what could happen in the next April quarter to actually have result that low? It seems you have good momentum with your funded backlog. Are you being conservative or do you expect some things to slow down a bit here?

Tim Conver

I think we're being consistent with the guidance, and as I mentioned in the comments earlier, we had a significant order input for production products in Switchblade in Q2 and we expect to move those into through a new low-rate initial production process for delivery in Q4 and Q1 of 2015. So that's a new production process transition, and historically we've always been cautious in revenue recognition in the first few months of a transition, whether that's Raven, Puma, Wasp or Switchblade, it's just I think a cautious way to look forward. So probably that's the – that area has the primary potential to move results around within the existing guidance. We don't think there's – we think if it moves around, it will be within the guidance and not outside of it.

William R. Loomis - Stifel Nicolaus & Company

Okay. And then going back to Global Observer, you mentioned you could have to spend CapEx of several hundred million, did I hear that right, and at what point would you start spending on that, in other words before the contract is in hand and you've demonstrated it, or what kind of risk are you willing to take on the Global Observer contract?

Tim Conver

Timing is always the trickiest piece of introducing innovative new solutions and being in the metaphorical red zone of adoption of those innovations. So we tend to be very focused on assuring ourselves that we understand what our customers' real needs and acquisition intents are and assuring our customers that we can execute in a way that ensures their success when they do make those adoptions. So that becomes a tricky period of timing where we want to make the necessary investments to assure the adoption. We want to do that not too early such that we would strand assets, and not too late such that we would open up market opportunities for others. So I think we'll make that call as we see the whites of the eyes of customer intent.

Operator

Our next question comes from Tyler Hojo from Sidoti & Company. Your line is open. Please go ahead.

Tyler Hojo - Sidoti & Company

Just a follow-up on the GO line of questioning, would you actually need to have an order in hand in order to go ahead and make the $100 million plus capital investment that you were referring to in order to rollout the services capability?

Tim Conver

I think there's not an absolute black or white answer to that, Tyler. Again I think it's a function of the degree of confidence in customer needs and intent and the balance of increasing the probability of adoption versus risking moving too early. So there are certainly scenarios where we have in the past and we would in the future commit substantial investment prior to a formal customer commitment.

Tyler Hojo - Sidoti & Company

Got it, okay. Thanks for that. And maybe just the follow-on would be, when you look at the international GO opportunities that are out there, are you seeing more on the services side then kind of a traditional contract, and what do you think the lead time would be if you're talking about production in three to five years, when would you actually need to have a co0ntract in hand to get there?

Tim Conver

The Global Observer, relative to our small unmanned airplane systems which you might characterize as short cycle, Global Observer would be relatively long cycle. I don't think that gets into the length of cycle of a traditional aerospace and defense platform of that size but it's still relatively long for our history, and all of that probably gives certainly more than a year's time that would be required to move.

Operator

Our next question comes from Josephine Millward from The Benchmark Company. Your line is open. Please go ahead.

Josephine Millward - The Benchmark Company

How are you?

Tim Conver

We're over this catastrophic rain we had to suffer throughout here in California.

Josephine Millward - The Benchmark Company

Tim, can you comment on the President's fiscal year 2015 budget request today and how you think it might impact AV's outlook into stability in the coming year?

Tim Conver

As you know, it was just out today and it's high level, but I don't think – we don't see any surprises to-date as we look through that and I don't think it changes anything in our outlook.

Josephine Millward - The Benchmark Company

Okay, can we talk about State Department, why haven't we seen an RFP? The RFI came out, I think it was in August, and there's still an outstanding requirement for mission services and do you still view it as a major opportunity in the coming year?

Tim Conver

We believe there is still a valid requirement to those – our responses and I presume all others to that request for information have been in. I don't have any insight into the timing, I guess that's clearly a question for the customer, but we have no reason to believe that that requirement has gone away. Clearly it's been delayed beyond the timeframe that we expected. I think beyond just the Department of State, we continue to think that there are long-term significant opportunities to deliver mission services with these platforms.

Operator

Our next question comes from Howard Rubel from Jefferies. Your line is open. Please go ahead.

Howard Rubel - Jefferies & Company

Well then would you rather have all the snow that we've had, Tim, just to kind of push back a little bit? But no, in all seriousness, you talked about near-term opportunities, this new development in the EES with the cord, how fast does it rollout or how fast are you going to work through distributors in order to do that, could you tell us a little bit of the go-to-market strategy and when you might in fact start to see a meaningful sales?

Tim Conver

It really is an interesting – to me, it's a very interesting product solution, Howard. I don't think there's anything like this that's been contemplated before. The early response has been very broad and very positive but it's – we just announced it a couple of weeks ago. We plan to go to market through multiple channels, it's already being sold on Amazon, it's being sold on our own website and it is being distributed through channels that take it through automotive dealerships at this point. There are a few other channels that are available and we are likely to engage in over time, and there is in the long-term the potential that this capability could be adopted by OEMs.

Howard Rubel - Jefferies & Company

Maybe just, is this something that do you need a patent on, do you need to sort of protect your intellectual property and then the capital involved in getting up to scale, can you bracket some of that for me please?

Tim Conver

We do have some significant intellectual property rights in this design and this approach and we have made some non-trivial investments in getting the production process in place to support a broad distribution and potential for varied scenarios of scaling, but I think we are well-positioned to handle any good news that we can get in that area.

Operator

I'm showing no further questions at this time. I would like to hand the conference back over to management for closing remarks.

Steven Gitlin

Thank you, Saeed, and thank you all for your interest in AeroVironment. An archived version of this call, all SEC filings and relevant Company and industry news can be found on our website, avinc.com. We look forward to speaking with you again following next quarter's results. Good afternoon.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This concludes our program. You may all disconnect and have a wonderful day.

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