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KVH Industries, Inc. (KVHI)

Q2 2010 Earnings Call Transcript

July 26, 2010 10:30 am ET

Executives

Patrick Spratt – CFO

Martin Kits Van Heyningen – Chairman, President and CEO

Analysts

Rich Valera – Needham & Company

Hamed Khorsand – BWS Financial

Chris Quilty – Raymond James

John Bright – Avondale Partners

Rich Valera – Needham & Company

Operator

Thank you for standing by everyone, welcome to the KVH Industries second quarter 2010 conference call. Today’s conference is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to the Chief Financial Officer, Mr. Patrick Spratt. Please go ahead sir.

Patrick Spratt

Good morning. I am Pat Spratt, Chief Financial Officer of KVH Industries and with me is; Martin Kits Van Heyningen, Chief Executive Officer.

This call will address the second quarter earnings release that we issued earlier today. Copies of the release are available on our website and also from our Investor Relations department. This call is being simulcast on the internet, and will be archived on our website for future reference.

If you are listening via the web, feel free to submit questions at IR@KVH.com and we’ll answer them following this call.

This conference call will contain certain forward-looking statements that involve risks and uncertainties. For example, statements regarding financial and product development goals are forward-looking. The company’s future results may differ materially from the projections described in today’s discussion.

Factors that might cause these differences include, but are not limited to, those mentioned in today’s call and the risk factors described in our quarterly report on Form 10-Q filed with the SEC on May 4, 2010. The company’s SEC filings are directly available from us, from the SEC, or from the investor information section of our website.

Now, I’d like to turn the call over to Martin for today’s discussion of results. Martin?

Martin Kits van Heyningen

Thanks Pat, and thank you all for joining us today. Well, it is another outstanding quarter for KVH, quarterly revenue was at a record high again, and we had a solid bottom line. In terms of overall performance, we are ahead of where we expected to be when we started the year. First of all, we recorded $29.5 million in sales, making this our second consecutive record quarter on the top line. Year-over-year that is 35% increase in revenue.

In addition, we recorded net income of $5.3 million or $0.36 per share, also record results. Now we will discuss income tax benefits that bolstered our bottom line, but even without that tax benefit our operating profit was quite strong. For the first six months of the year, revenue was $57.5 million. That is a 43% increase over the same period last year with net profit of $7.4 million or $0.50 per share.

Our trailing 12 month revenues were $106 million, passing the $100 million mark for the first time ever. Our strategic initiatives in fiber optic gyros and global satellite communications have consistently been the engines of our record-setting growth in recent quarters. During Q2, we even began to see some signs of growth in our consumer markets that had been stressed due to the recession.

Overall, things were on track in each of our markets, and we feel comfortable with our market position overall. In our guidance and stabilization revenue was up 38% from the second quarter of 2009. We enjoyed another record-setting quarter for fiber optic gyros sales, which at $10.6 million were up 49% from Q2 of last year. We received orders for more than $9 million in FOGS for remote weapon stations recently, including $7.1 million order from (inaudible) and a $2 million order from Rafael Advanced Defense Systems.

The Rafael order is significant in a couple of ways. First, it is for our recently updated dual-axis DSP-4000, and secondly it means that we are now the approved FOG provider for yet another leading remote weapon station manufacturer. This is particularly important as the US Army’s CROWS 3 initiative continues to move ahead. The Army issued another request for information just a few weeks ago, and this time expanded the potential contract size from 19,500 remote weapon stations to more than 25,000.

Based on the current 3 FOG persist configuration, this would equate to over a $200 million opportunity for fiber optic gyros. Obviously, we’re hopeful that one of our current weapon station customers wins the CROWS 3 contract, and that we will be their sole gyro supplier. However, we are preparing for an aggressive competition to win this business. As part of that effort, we are designing a new fiber optic gyro that we believe will strengthen our existing position as the performance and cost leader in the remote weapon station market.

While remote weapon stations and other military programs represent a significant portion of our FOG revenue, our FOGS are doing quite well in the commercial market as well. The key products driving this are CNS 5000 inertial navigation system, and our new CG 5100 IMU Unit, Inertial Measurement Unit. Together, these products equip KVH with a portfolio of compact, versatile and affordable three-axis inertial nav systems that offer significant competitive advantages based on their combination of outstanding performance and competitive pricing.

Sales of these commercial IMUs are on track to be over $5 million this year, making them one of the most successful new FOG product launches in our history. The expansion of our commercial FOG sales has the added benefit of continuing to diversify and increase our gyro revenue stream, while reducing the percentage of sales derived from defense applications. The revitalization of our tactical navigation business has taken a significant step forward.

We have redesigned our flagship TACNAV system, and we just received the largest TACNAV order in KVH history, a $13 million sale to an International military customer. We expect additional follow on orders this year, making this one program $15 million to $18 million in total. This follows another $2 million order we received for our TACNAV 2 system during Q2. Revitalization of our TACNAV business should provide another strong leg for our military business to stand up, providing a solid base of relatively higher margin revenue over the next few years.

Moving on to our mobile satellite business, revenue was up 33% year-over-year, driven by the continued strength of our maritime satellite communications products. We even saw some signs of stability and recovery in the land market with small but steady increases in the sales of satellite TV products for RVs. We also completed our planned 2010 deliveries of our aeronautical satellite TV system to live TV, with approximately $1.5 million in shipments. We expect to receive shipments in the early 2011 in accordance with live TV’s installation schedule with their airline customers.

Now, I like update you on the mini-VSAT broadband business. Q2 was very strong for our TracPhone V7 and our mini-VSAT broadband service. Combined hardware and air times sales were up more than 50% compared with second quarter last year. In fact, we believe that mini-VSAT broadband is now the fastest growing maritime VSAT solution on the market today. And we expect to ship our 1000 TracPhone V7 during Q3.

In addition, we are starting to see some revenue contribution from aviation use of the mini-VSAT broadband service from our partner, ViaSat. The total revenue from aeronautical use is still small compared to our quarterly maritime revenue, but it is growing and it could be a valuable incremental addition in the future.

(inaudible) mini-VSAT service enabled us to set ourselves apart from the competition, by building the only seamless global multimegabit network for ships and planes. Commercial, government and leisure customers are taking advantage of our integrated hardware, service and support solution along with powerful value added capabilities such as group calling and integration with the existing sat com systems.

We see the integration of onboard IP functions and providing more value-added services like internet cafes as a critical component of making our V7 even more successful, and we are working on adding more capabilities in this area.

For us to maintain our momentum and continue to gain market share, we must continue to distinguish ourselves from competitors and their older less capable technology. With that in mind, we are evaluating and developing enhancements to our network, quality of service and overall capabilities. In the coming months, we plan to roll out technology upgrades that will increase our bandwidth by 250% in terms of capacity and data speeds without adding any additional satellite transponders.

We continue our quest to conquer the challenging the Brazilian licensing process and launch the mini-VSAT services in that critical region. Based on our progress to date, we expect to have an announcement about this service and our ability to support the offshore oil and gas industries in the region later in Q3. We are also taking significant steps to expand our global support network. With a growing number of commercial fleet customers it is imperative that we offer premium service in key ports around the world. That is why we will be releasing details of our new global care premium support program for the TracPhone in early August.

We will soon be able to offer on vessel service in virtually any port in the world. While our global broadband initiative is getting most of the attention, I’m also happy to report that we are seeing signs that the leisure marine market has stabilized a bit. Sales in the US were up solidly compared to the second quarter last year, and we continue to see great interest and loyalty to our TracVision brand of maritime satellite TV systems. However, sales in Europe and the rest of the world are still lagging behind the US in terms of economic recovery.

We continue to invest in R&D and new technology and you can expect announcements about some exciting new marine satellite products in the coming months as we head into the fall boating and trade show season. So, in conclusion, Q2 was an outstanding quarter for us, building on the success of Q1 and sending us into the second half of the year on a record-setting pace. We are ahead of where we expected to be when we set our goals at the start of the year. It looks like the second half should be at or above plan as well.

Our FOG and satellite communication businesses continue to make significant contributions, while we enjoyed renewed growth in some of our other consumer business areas that had been stressed by the economy. We expect to sustain our current record level of FOG revenues, but we see the concentration of CROWS business going down in Q3, as other major customers and programs come online. We are very optimistic that we are starting to enter a new growth phase for our TACNAV business, which will provide a solid revenue stream for the next few years.

We continue to focus on bringing innovative products to market. In the long run, we see this aggressive approach as our best defense against future competition in all our markets.

And now I would like to turn the call over to Pat, and he will give you a closer look at the numbers. Pat.

Patrick Spratt

Thank you Martin. We are pleased to again report that results were better than our expectations, and we are continuing to show good progress strategically and operationally. This was achieved without the benefit of any noticeable improvement in macroeconomic conditions as has been the case for quite some time.

For the quarter gross margin was 39%, although this was down about 300 basis points sequentially, it was much improved over the second quarter of last year. gross margin was modestly lower than we had expected at the start of the quarter. We saw a benefit from the higher than expected revenue level, but this was more than offset by a very high cost relating to a nonrecurring engineering service project that was completed during the second quarter.

As we have now seen for the past several quarters, the VSAT infrastructure build out, together with changes in the mix of overall service revenue, significantly affected the year-over-year comparison of our services gross margin. Mini-VSAT airtime services grew strongly in absolute terms, both year-over-year and sequentially. Inmarsat airtime services revenue declined year-over-year, but grew sequentially. Other services from non-recurring engineering and repairs declined both year-over-year and sequentially.

Along with the significant investments we have made in the mini-VSAT infrastructure, this combination of factors has driven service margins lower to this point in time. From here, we expect to see an improving trend in service margins as we now have the majority of the VSAT infrastructure investments in place. Our product gross margins have shown good strength over the last several quarters. This is very gratifying given the tough economic and competitive environment, especially in leisure markets around the world.

For Q2, operating expenses were up 24% compared to last year. A key year-over-year driver of this percentage increase was reported R&D, which increased 35%. In Q2 of last year, we were still developing the aviation antenna system, and capitalizing those costs. And that resulted in lower than normal reported engineering spending for that period.

As a percentage of revenue reported R&D spending was 8.5% for the second quarter.

We expect R&D will average about 9% of revenue for the next several quarters.

Second quarter sales and marketing expense increased on both a year-over-year and sequential basis. As we have experienced for the past several quarters, this reflects some seasonality, but also staffing for the expansion of sales and support presence for strategic growth businesses, namely maritime and satcom and fiber optic gyroscopes.

Administration expenses increased year-over-year by 24%, but were down modestly compared to Q1. Cost for professional services related to requiting VSAT licenses and establishing operations in multiple countries or the build out of the network continued to be a key factor. At the close of the quarter, we concluded after taking into consideration recent operating performance and future projections that it is more likely than not that we will be able to realize the majority of our deferred tax assets over the next several years.

Consequently, we recorded a tax benefit of $4 million related to the release of the valuation allowance that was associated with these deferred tax assets. For the quarter, this was partially offset by tax expense that resulted from our Q2 pre-tax earnings. The result was a net tax credit of $3.3 million for the quarter.

Beginning with Q1 2011, we expect that our effective tax rate will increase to approximately 40%. Turning to the balance sheet, cash and marketable securities were $45.5 million. This was considerably better than anticipated due to multiple factors including a shorter collection cycle, lower inventory, payments received for stock purchases an option exercises and the timing of accounts payable.

For Q2, cash flow from operations was positive at about $8.4 million. Accounts receivable decreased modestly to $18.3 million, day sales outstanding was 56. Inventory also decreased sequentially by $1 million to $14.2 million. Capital expenditures were approximately $2.2 million for the quarter, and $3.7 million year-to-date. We continue to project that we will use about $7 million for capital expenditures for the full year.

With normal operating requirements, we expect our cash balance to remain near its current level for the near term, even though we will be making additional investments for the mini-VSAT network, and for internal productivity, test and manufacturing capabilities for both FOG and satcom operations. Our backlog for guidance and stabilization products and services at the end of June was $18.5 million.

Now I will review our expectations going forward. At the start of 2010, we did not provide specific financial guidance for the full year, but we did indicate that we expected to see strong top line growth and improving bottom line results, albeit in the context of the first-half loading of the aviation antenna sales and the second half seasonal weakness in the leisure marine markets.

As we sit here today, we see the full-year developing a little better than our original expectation. We will continue to view future expectations with caution, largely because we cannot discern a clear pattern for the direction of the world economies over the near term and the potential impact on our businesses.

Nevertheless, for the third quarter we expect to continue to see very positive year-over-year revenue growth. Revenue growth compared to Q3 2009 is projected to be in the range of 18% to 26%. We expect the sales of fiber optic gyroscopes will be about equal to the Q2 level, and we expect continuing growth in TracPhone V7 system sales and new activations. Yet, this projected total company revenue level reflects a sequential decline compared to Q2. this is due to the fact that there will be no shipments of our aviation TV antenna system, and consistent with historical seasonal patterns, we expect to see a sequential decline in satellite TV sales for leisure marine markets.

We expect net profit for the quarter to be in the range of $0.05 to $0.10 per share. Gross margin will likely be modestly higher than the second quarter. Although we expect to see the first indications of improving service gross margin, the lower product revenue level will limit our ability to increase production efficiencies for products. This along with continuing investments in the global mini-VSAT infrastructure, and a modest sequential increase in operating expenses will limit profitability for the quarter.

We expect that the fourth quarter will show a sequential increase in revenue and EPS, leading into what we expect to be a trend of long-term operating profit growth, driven by the top line growth of our strategic businesses.

In summary, we expect our strategic growth businesses to continue to build momentum, and we believe that Q3 should be the low point for operating profit and EPS as we go forward and progressively benefit from the sizeable investment we have made to establish the global mini-VSAT infrastructure.

Now we would like to take your questions. Operator, could you please open the call for questions.

Question-and-Answer Session

Operator

(Operator instructions) And we will take the first question from Rich Valera of Needham & Company.

Rich Valera – Needham & Company

Thank you. Good morning gentleman. First, a couple of questions on the FOG business, you mentioned that you expected the percentage of revenues from CROWS to decline I think in the third quarter as other customers came on, can you say one, what roughly came from CROWS in the third quarter and then, looking longer term, after trajectory of the FOG business, it would seem that this year you are going to see a very significant contribution from MATV [ph] related CROWS business as they ship roughly 7000 MATVs over to Afghanistan, I just wanted to get your sense of what you think helps to offset that when you look into 2011, as presumably a much smaller number of MATVs shipped to Afghanistan. Thank you.

Martin Kits van Heyningen

Well, I don’t have the percentage in front of me for Q2, but going forward we see all of the remote weapon station business being less than 50% of the FOG business. And in this last quarter, the FOG business was about 10.6 million, so we see all the CROWS type business continuing. So we don’t see that is declining. What we see is other parts of the business growing, including the commercial business with this IMU that I mentioned. Also, the torpedo, the IMUs for Raytheon. There are number of other IMU type programs out there. so, right now we see no slowdown in our FOG business.

Rich Valera – Needham & Company

Do – you feel pretty comfortable maintaining it at this $10 million plus type of run rate for a while?

Martin Kits van Heyningen

Yes, I think our sense is that it will continue to grow. It shouldn’t stay at this level. So, being over $10 million is actually ahead of where we thought we would be right now. So I think it will continue growing, I don’t think it will grow at the 50% to 100% type of growth rate anymore, but we definitely see it growing next year.

Rich Valera – Needham & Company

Great. And then on the TACNAV, obviously you got a nice new order there and it sounds like there could be more behind that. Can you talk about what that might do to your TACNAV run rate, I think that has been running at around 2 million per quarter. do you see that run rate potentially increasing from that level and maybe sustainable so.

Patrick Spratt

Yes, I think it will increase, but it probably won’t happen until Q1 of 2011. So I think this is the run rate. By the time this new order kicks in it will be next year. But then I do see us at a new higher run rate for the next you know, maybe as much as three or four years, because we got a lot of stuff in the pipeline already in backlog. A lot of these $2 million orders have been coming in, and many of these have follow-on business as well.

So we really see the TACNAV business now as coming back and being a strong support on top of the FOG business that have been growing substantially.

Rich Valera – Needham & Company

Great, and then on the mini-VSAT business, you mentioned you expected to ship your 1000th unit I guess in the third quarter, and can you remind us the dynamic there, when you say shipped do you mean recognize and activate, or is that shipped and then there is a delay before you actually would recognize that revenue and that was actually activated?

Martin Kits van Heyningen

Right, when we say shipped it is kind of ambiguous, but what we are talking about is customer revenue shipments and not just units produced. So these are sold units that we’ve invoiced for, but it is not the same as the number of active subscribers. And our historical pattern has been there has been as much as a six month difference the time a unit ships and the time it is activated, although we have seen that start to come down more recently.

I think some of that was initially channel fill, and now it's probably in the 3 to 5 month type of duration from the time a unit ships to the time it is activated.

Rich Valera – Needham & Company

So, if we were trying to think about your subscribers, in terms of when you got to 1000, we should be thinking some delay relative to the third-quarter maybe more the fourth-quarter timeframe?

Patrick Spratt

Yes, I think that is definitely the way you should think about it.

Rich Valera – Needham & Company

Thanks very much.

Operator

We will move next to Hamed Khorsand of BWS Financial.

Hamed Khorsand – BWS Financial

Hi guys. I probably missed it or could not have – did you go over the gross margin that you have seen in the quarter?

Patrick Spratt

Gross margin for the third quarter?

Hamed Khorsand – BWS Financial

Yes.

Patrick Spratt

I indicated that we expect that for the total company, it would be up modestly compared to the second quarter. I didn’t say anything specific on it about product versus service, but I also did indicate we expect service gross margin to improve sequentially. Product gross margin will be a little bit more of a challenge because of the lower production level in the quarter, because we won’t have the satellite TV antenna for the aviation market, and also because of the seasonal dip due to the satellite TV leisure marine market.

Hamed Khorsand – BWS Financial

Okay. Will there be a reduced amortization on the mini-VSAT network in the third quarter?

Patrick Spratt

Reduced amortization?

Hamed Khorsand – BWS Financial

Yes.

Patrick Spratt

No, the cost that we have been putting in place for the mini-VSAT network will continue. Essentially, what we have been doing over the last three years is actually increasing that cost basis, and increasing the amortization number if you will. So the pace at which we are adding to that will slow. As from here on, we only have the Brazil region, South America, if you will right now that will be coming online in the third quarter.

We certainly expect over time there will be other capacity increases due to demand, but the impact of each of those increases will be far less on a percentage basis, which reflected the total infrastructure investment that we have seen to this point. So, you should assume that the cost basis will continue to grow, but it will grow at a slower pace than we have seen over the last three years.

Hamed Khorsand – BWS Financial

Okay, and what kind of interest did you experience from your installed base of mini-VSAT users, once KU band was available globally?

Martin Kits van Heyningen

Well, I think we have very strong – we had a very strong quarter for the mini-VSAT. I mentioned in the call that it was up more than 50% year-over-year. So, we are continuing to see good growth and the rate of growth is increasing. So, it is both growing and accelerating.

Next question operator.

Hamed Khorsand – BWS Financial

Hi, I have one more if that is okay.

Martin Kits van Heyningen

Okay, go ahead.

Hamed Khorsand – BWS Financial

How would you describe the mini-VSAT subscriber additions since the beginning of the year, and has that outpaced what you were seeing earlier in the year?

Patrick Spratt

Yes, the rate of growth of subscribers is increasing. It is increasing quarter-over-quarter as well as on a year-over-year basis.

Hamed Khorsand – BWS Financial

Will you see that going forward as well?

Patrick Spratt

Yes, absolutely. We see that continuing as the whole premise between what we’re doing here, is building out this global infrastructure, getting everything in place, and then gaining momentum as we had sales regions and we get repeat customers, and you know, subscribers are growing and we believe we are the fastest-growing VSAT provider to the marine market today. So it’s all going according to the plan.

Hamed Khorsand – BWS Financial

So you can keep that momentum going that you got so far?

Patrick Spratt

Yes.

Hamed Khorsand – BWS Financial

Okay. Thank you.

Operator

We’ll now move to Chris Quilty of Raymond James.

Chris Quilty – Raymond James

Hi gentlemen, I wanted to follow up first on the service margin or I guess the cost of service, it looks like on a sequential basis up almost 1.25 million, which is the biggest jump I think we’ve seen as you build out the network and just wanted to try to get some sense from you were there any unusual items there on the cost of service or is that you know, 4.25 million sort of the new base on a go forward basis, given where you are at in the build out of the mini-VSAT network?

Patrick Spratt

In the quarter Chris, one thing we did have, I mentioned that we had a service contract, a non-recurrent engineering contract that was completed in the second quarter, so that’s over, but the cost related to it was substantially higher than we had originally expected it would be in terms of completing the project. So that certainly weighed on the gross margin and the cost of goods, cost of service for the quarter, but in addition to that you know, I can say –

Martin Kits van Heyningen

That was not VSAT related?

Patrick Spratt

Yes, not VSAT.

Martin Kits van Heyningen

To be clear, everything that’s in that service category is not airtime service that includes military engineering services, as well as Inmarsat airtime and miscellaneous like repairs and things like that.

Patrick Spratt

Right. So very good point that Martin just made that that project was not related to VSAT at all. It was related to, you know, stabilization and guidance products. The airtime services component of our services revenue is now clearly the large majority. We were over $4 million, comfortably over $4 million in airtime service revenue for the quarter, and so as a consequence you know, a good portion of the cost of service is related to that airtime infrastructure as well, and as you know, the infrastructure costs are for the mini-VSAT business, the Inmarsat revenue is more or less pay as you go because we’re reselling Inmarsat airtime services.

So I would say that with the exception of that one nonrecurring engineering project that was higher than expected, you can assume that the cost of service that we saw in the second quarter is probably fairly representative as a baseline moving forward and that we will be adding some many mini-VSAT infrastructure costs in the third quarter, and that will also you know, the fourth-quarter will be the first full quarter for that and that’s for the Brazil region.

In the second quarter, a major addition that we put in place as you might recall was the Indian Ocean, which was really two regions, both the east and the west Indian Ocean and that went in place in mid-April. So that added to our cost structure for many mini-VSAT during the second quarter, but the answer to your question as I said I would say that you can look at the cost of service more and more now as we go forward as the airtime is making up a larger and larger percentage. You can look at the Q2 as a reasonable estimate of the baseline going forward.

Chris Quilty – Raymond James

Okay, I was just hoping that the low point was in Q4 on the service margins where you had 18.5, and they start moving up in Q1 and it is little surprising to see it come back again, but I guess you did talk about the new regions rolling out?

Patrick Spratt

Yes, the Indian Ocean was a significant impact for us, and the other thing is you know, in the past we’ve had some other service component to that revenue and cost of goods that can cause some variability, namely repair services as an example. So I don’t think we indicated that service margin had hit the bottom in the fourth quarter of last year, but we do believe that they are at the bottom in the second quarter that we just concluded.

Chris Quilty – Raymond James

Okay, in the global care service program that you mentioned, is that a large cost component for you in terms of supporting that program?

Martin Kits van Heyningen

No, it should be a revenue and margin generating program. So, it will be a paid service project.

Chris Quilty – Raymond James

And you need to outsource a portion of that in order to support local presence?

Martin Kits van Heyningen

Yes, we will be making an announcement on it. We’re going to have some partners. We have partners lined up, and so it will be a combination of the existing customer care type service model that we have today using dealers and agents around the world and some new partners.

Chris Quilty – Raymond James

Okay. Circling back to the TACNAV, can you help us understand the, you know, the timing of when that may be getting to ship margins, are they traditional margins for that product line, manufacturing capacity, I know Tinley Park has been kind of busy, and final question of the four part here, mix of domestic versus international, it seems like the overwhelming portion of your sales are now going international?

Martin Kits van Heyningen

Right, let me start with the last question first. For the TACNAV business, even though this particular customer is a major US prime, the end customer is a foreign customer. So, – and that’s being built outside the country, but it’s a vehicle program. So a lot of these vehicle programs tend to be going to, you know, foreign militaries at this stage whereas the US customers, I mean, the US Army is very focused on you know, vehicles like MRAP and CROWS type applications, where they’re dealing with a very specific problem, whereas the other countries are still sort of gearing up for more general type military operations.

That might change again in the future. So in terms of timing, this program has an engineering development component who has actually been operating under a letter of contract for the engineering component, for the new redesigned TACNAV system that’s scheduled to be completed during Q3 or early Q4 and production should start at the very end of this year and going into the next year.

Chris Quilty – Raymond James

Okay, and margins on it?

Martin Kits van Heyningen

Margins on the TACNAV business traditionally have, you know, if you look at our various products, they are near the best. So –

Chris Quilty – Raymond James

And that shouldn’t change.

Martin Kits van Heyningen

That should not change, no.

Chris Quilty – Raymond James

Okay, and you also talked about a new FOG in development. Would that –

Martin Kits van Heyningen

Sorry, go ahead.

Chris Quilty – Raymond James

No, this was just a question about again the cost margin revenue potential of that relative to your current 3 FOG configuration on the RWS.

Martin Kits van Heyningen

Well, what we’re looking at is just may be doing a tighter integration with the weapon system manufacturer, so developing a more flexible configuration where we might do a three axis system for our customer, so that it’s more tightly integrated rather than three separate products and while that, you know, is expected to bring the ASP down it should be more, it’s going to be designed to be less expensive to make. So, from a margin point of view it should be similar.

Chris Quilty – Raymond James

Okay. And can you give us any more color on the maritime leisure TracVision market. You know, that was kind of your traditional bread and butter…

Martin Kits van Heyningen

Right.

Chris Quilty – Raymond James

Sales were down order magnitude 30% or 40% last year and you know, what are you seeing in both registrations and both demand and market share and when does that market show some real signs of life.

Martin Kits van Heyningen

No, I think that in terms of U.S. we’re seeing some good growth there, but as you point out you know, you’re comparing it to last year, which wasn’t so good. But we are seeing, you know, good double-digit growth in marine TracVision market. We believe our market share is increasing, even though we would have a very high market share. Both builders on the other hand are still very depressed. So most of this business is retrofit, you know, used boats [ph] that type of thing. We haven’t seen any rebound in both building, like some of your analysts have pointed that out as well.

Chris Quilty – Raymond James

Okay, great. Well, thank you gentlemen and keep up the good work.

Martin Kits van Heyningen

All right. Thanks Chris.

Operator

(Operator instructions) We’ll next move to John Bright of Avondale Partners.

John Bright – Avondale Partners

Thank you. Good morning. Martin, have you done anything to change your go-to-market strategy for the many TACNAV broadband service to try to increase awareness and penetration?

Martin Kits van Heyningen

No, I think we’ve really been working on executing our strategy. We haven’t changed yet. So, you know, as we add regions, we market locally in those regions and then we also use the expanded coverage to increase the attractiveness with global shipping companies. We’re leveraging our success with some of the smaller tanker fleets and doing a lot of outreach marketing in terms of testimonials that type of thing. It is a very conservative industry, so the fact that we’re gaining market share here, I think it’s a good sign, and as those markets recover from the recession, we should see stronger growth. So I think we’ve done the right thing from the beginning and we’re just continuing to execute better.

John Bright – Avondale Partners

And that’s primarily consisting of the direct relationship of marketing. So going to the known entity to try to penetrate, and is that there?

Martin Kits van Heyningen

Well, we do that, but we also have – we do in conjunction with our dealers and sales agents around the world. So we work with our distributors in each country who have ongoing relationships with the target customers. So we’ll go in and assist on the sale, but we don’t sell direct.

So, we’ll be part of the presentation and we will help write the proposal, but usually we have an in-country agent that provides the on-site support in the local language and manages the relationship and installation.

John Bright – Avondale Partners

Have you seen any competitive response to your offering?

Martin Kits van Heyningen

Sure. I think as we get more and more successful, we see more and more response from our competitors you know, saying our product doesn’t work and our services you know, contended and, so we take all that as a good sign that we’re you know, we’re succeeding and they’re failing. So they’re attacking us.

John Bright – Avondale Partners

Pat, you mentioned I think in one of the questions that airtime service, and correct me where I’m wrong is over $4 million. Is that accurate? How much of that was Inmarsat?

Patrick Spratt

Well, we haven’t disclosed that specific number John, but I can tell you that it’s the very large majority of that greater than $4 million number.

Martin Kits van Heyningen

Is the VSAT.

Patrick Spratt

Is the VSAT.

John Bright – Avondale Partners

The Inmarsat has been declining.

Patrick Spratt

Oh, you asked about Inmarsat.

John Bright – Avondale Partners

No, no.

Patrick Spratt

Okay.

Martin Kits van Heyningen

I just want to be clear because you mentioned Inmarsat, but you know, I think Pat pointed out in his prepared remarks that our Inmarsat airtime has been declining, and we see that as a ongoing trend as customers, you know, move towards the mini-VSAT. So, and that’s masking the grow up little bit. So when you look at the growth in our service revenue, we have to take into account that the Inmarsat business is shrinking.

John Bright – Avondale Partners

Can you talk about more specific metrics associated with the many mini-VSAT business. Maybe a monthly ARPU, how that’s trending. I think you’re talking about shipping your thousands and thousands of product in the next current calendar quarter. Is there an exact subscriber number that you would provide?

Patrick Spratt

Yes, we don’t provide exact subscriber numbers, but as far as ARPU goes, it has been running around $2000 per subscriber per month. And that number started to come down a little bit a couple of quarters ago, not materially and then since it has recovered a bit. So that trend looks pretty flat, and what we expect to happen as time goes on, we will continue to add some additional value-added services that we will be charging for to bring that number even higher.

John Bright – Avondale Partners

And the competitive response, I would likely assume that includes price, and do you think you are going to be able to hold this ASP on a monthly basis?

Patrick Spratt

We certainly are planning on keeping it there. So, obviously it is a competitive world and I think we will do what has to be done in terms of pricing so that we continue to be successful. But right now I think we are in a pretty comfortable spot with our prices, and we don’t see any immediate price changes.

John Bright – Avondale Partners

Thank you.

Operator

We will now move to Rich Valera of Needham & Company.

Rich Valera – Needham & Company

Thank you. Just wanted to clarify what the backlog figure you gave on the call included, I’m assuming that excludes the recent TACNAV order, the $13 million, but does include the $7 million FOG order you announced during the quarter?

Patrick Spratt

That is correct.

Rich Valera – Needham & Company

Okay, thank you.

Operator

We will take a question from Raymond James’ Chris Quilty.

Chris Quilty – Raymond James

Also a follow up question here, a clarification on those, international TACNAV orders, are those standard TACNAV or TACNAV Light?

Martin Kits van Heyningen

Well, the big order we just got is actually for a new product, which we haven’t named yet. Internally, we are calling it TACNAV common baseline, but it is an improved version of the TACNAV that has tighter integration with gyroscopes. So it will be a whole new product line that we’re coming out with. So with this I would say, it is closer to the TACNAV, basic TACNAV as opposed to the light or the heavy. It is kind of a middle of the road variant.

Chris Quilty – Raymond James

Okay. And on the commercial FOG business, which I think is said should exceed $5 million this year. I believe that is up substantially from last year like order of magnitude increase?

Martin Kits van Heyningen

Right. Let me clarify, what I meant to say that this single product will be $5 million. So, our commercial – so it went from zero to over $5 million. So that makes it a very significant new product launch for us. That is not our…

Chris Quilty – Raymond James

The CNS 5000?

Martin Kits van Heyningen

Yes.

Chris Quilty – Raymond James

Okay.

Martin Kits van Heyningen

Yes.

Chris Quilty – Raymond James

And the end customer application, is there a single customer or a single application that is dominating the demand?

Martin Kits van Heyningen

Well, I mean a lot of the applications are that we are selling a product NovAtel for use with their precision nav stuff, and they have a number of different applications. That are also some new applications that we are working on some of which is for precision ag, for underwater navigation, marine compass type applications.

With a lot of the applications they use for precision survey work, so the Google Map type application as well as some airborne applications. The answer to your question is no, there is no single application that is dominating this. There is a lot of precision nav type of stuff.

Chris Quilty – Raymond James

And do you see – I mean, obviously, you can’t maintain that specific growth rate, but the commercial markets relative to the defense RWS opportunities say over the next 3 to 5 years, how would you characterize them?

Martin Kits van Heyningen

Well, I think that we would we always like to diversify even within a product, and I think as a company we’re diversifying by being in satellite business in nav and fiber optic gyro. Within the fiber optic gyro market, we also like to be diversified. So we don’t want to have one customer represent 90% of our business.

So that is why in Q3, we are happy to see that RWS is well under 50%. The IMU business is significant and the commercial significance. I think those three parts. We like to see them each be one third of the FOG business?

Chris Quilty – Raymond James

Very good. All right, thank you.

Martin Kits van Heyningen

All right. Thanks.

Operator

(Operator instructions) And it appears there are no further questions at this point. Gentlemen, I will turn the conference back to you for any additional or closing remarks.

Patrick Spratt

Well, thanks everyone for listening in and as always if you have any follow-up thoughts please feel free to give us a call directly. Thank you.

Operator

That concludes today’s conference. Thank you all for joining us.

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Source: KVH Industries, Inc. Q2 2010 Earnings Call Transcript
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