Integral Systems CEO Discusses F1Q2011 Results - Earnings Call Transcript

| About: Integral Systems, (ISYS)

Integral Systems Inc. (NASDAQ:ISYS)

F1Q2011 Earnings Conference Call

February 09, 2011 11:30 AM ET


Kathryn Herr – VP, Marketing and Communications

Chris Roberts – CFO and Treasurer

Paul Casner – President and CEO


Dick Ryan – Dougherty & Company

Zachary Prensky – Coyote Capital


Good day everyone and welcome to the Integral Systems First Quarter 2011 earnings conference call. My name is Ally and I will be your coordinator for today. This call is being recorded. At this time all participants are in a listen-only mode. We will be facilitating a question-and-answer portion at the conclusion of the presentation. (Operator Instructions). I would now like to turn the presentation over to your host for today’s call, Ms. Kathryn Herr, Vice President of Marketing and Communications. Please proceed ma’am.

Kathryn Herr

Thank your Ally and good morning everyone. I’d like to welcome you to Integral Systems first quarter earnings conference call for our fiscal year 2011. Before we start, please understand that this call contains forward looking statements that involve risks and uncertainties that could cause actual results to differ materially from those described in the forward looking statements. Such statements are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

During today’s call, we will discuss Integral Systems first quarter financial results and highlights of our operations. We may refer to non-GAAP measures which are defined and reconciled on our website at under Investors.

Joining me today on the call are Paul Casner, our President and Chief Executive Officer and Christopher Roberts, our Chief Financial Officer.

All participants are advised that the audio of this conference call is being broadcast live over the internet and is being recorded for playback purposes. The audio of the call will be archived on Integral Systems’ Investor Relations website for a period of one year. As always we encourage questions at the conclusion of our remarks.

With that said, I’d like to turn the call over to Chris to provide an overview of our first quarter results followed by Paul with his perspective on the business operations.

Chris Roberts

Thank you (Kat) and good morning everyone. I hope that you have had the opportunity to review today’s earnings release with our first quarter results. As we announced on January 13th, we are continuing to explore the full range of strategic alternative to maximize shareholder value. We do not intend to disclose further developments during this process unless and until the board of directors approves a specific transaction or otherwise concludes the review of strategic alternatives.

In addition, as discussed in today’s earnings release, we will no longer provide earnings guidance for a future quarterly and annual periods and our previous announced earnings guidance for fiscal 2011 should no longer be relied upon.

We believe that providing the future earnings guidance and relying on our previous earnings guidance is no longer appropriate in light of our strategic alternatives review. During the Q&A portion of this call we ask that you please focus on today’s announcement and our earnings release. We will not address any specifics related to the on-going review of strategic alternatives.

Moving on, our first quarter has traditionally been a slow starter for us. Historically we have built momentum as the year progresses. Given the strength of our bookings this quarter, our improved backlog position and opportunities for significant reductions in SG&A expense, at this time we believe that we will achieve improved financial performance in the coming quarters.

Yesterday we announced the most significant of our SG&A reductions to date. A five year sublease arrangement for the majority of our Columbia facility and the reversal of a portion of the lease loss reserve on our Lanham facility as we move staff back into the remaining building. As a result, in the second quarter, we will reverse $1.9 million of the lease loss reserve previously recorded. We anticipate a little to no impact on SG&A this fiscal year due to anticipated relocation costs. However, looking out over the five year sublease period, we anticipate that this arrangement will generate about $2.2 million in cash each year and a reduction in SG&A expense of approximately $2.2 million per year.

If you would have been following the company over the past year, you will recall that Paul and I have often spoken about our desire to shed our real estate costs. We are gratified that we could come to an agreement to sublease the majority of the Columbia facility while utilizing our Lanham facility. We intend to maintain a presence in the Columbian Maryland area.

Moving to our financial results for the quarter. Total bookings for the quarter were approximately $68 million. This includes over $38 million in military and intelligence segment bookings approximately $5 million in civil and commercial segment bookings and over $25 million in products segment bookings. As a result of the strong bookings, our first quarter book-to-bill ratio was a sold 1.5. In addition, we again added to our total contract backlog which currently stands at about $214 million. A 12% increase over the previous quarter.

In terms of revenue visibility, we anticipate that over half of our backlog will convert to revenue over the course of the fiscal year. The remainder of our revenue comes from quick turn contracts, generally from within our products segment. These contracts typically assigned and delivered within our quarter and therefore do not add to the backlog. We anticipate this type of business flow will continue this year but it is encouraging to have added to our funded backlog.

Turning to our first quarter results. Revenue for the first quarter was $44.5 million, an increase of more than 17% over our revenue and the first quarter of 2010. We saw very strong revenue growth in our military and intelligence and civil and commercial segments during the quarter. However revenue in our products group underperformed our expectations as a result of several delayed shipments. Gross margin for the company was 29.9% for the first quarter of fiscal year 2011 as compared with 41.8% in the first quarter of 2010.

The decline in gross margin is attributable to lighter products revenue, a shifting mix of sales, higher amortization costs and increasing price competition particularly in our US government markets.

We incurred a $4.7 million loss from operations for the first quarter of 2011 compared to income from operations for the first quarter of 2010 about $2 million. The loss is primarily driven by lower gross margins and front loaded corporate operating expenses. Paul will discuss most of these expenses in more detail shortly.

Our operating segments contributed $6.1 million in adjusted EBITDA in the first quarter of fiscal year 2011. Corporate overhead costs for the quarter was $7.9 million. Adjusted EBITDA excluding stock non-cash stock compensation with a loss of $1.8 million for the quarter.

I would like to briefly mention our higher than anticipated financing expenses relating to our credit agreement. As you know, we entered into a line of credit in March 2010 to finance the acquisition of CVG Avtec which is now the Integral Systems’ SATCOM Solutions division. As we have previously disclosed, we have struggled to meet the financial covenants under our credit agreement since the summer of 2010. We entered into a forbearance agreement with our lenders and on December 8, 2010 we entered into an amendment and waver agreement. Among other things this agreement waved all existing financial covenant defaults and set new financial covenant compliance levels for current and future periods.

As you might expect we incurred forbearance fees, higher interest expenses and an increase in the amortization of capitalized financing fees as we reduced the volume of the amount of the credit line. As a result we recorded over $640,000 of unbudgeted financing expenses in the first quarter.

Diving a bit deeper into our segment performance. Revenue in the military and intelligence segment increased 7% compared to the first quarter of fiscal year 2010. The increase in the military and intelligence segments revenue was a result of increased tasking on the command and control system consolidated or CCSC contract and an accelerated works schedule on our RAIDRS contract. Both contacts are with the US air force.

Gross margin for the military and intelligence segment decreased to 21.9% for the quarter compared to 34.2% in the first quarter fiscal year 2010. The variation in gross margin is largely due to the mix of work performed on our large government contracts and the impact of an additional $350,000 reserve related to our ongoing discussions with the DCAA or Defense Contract Audit Agency.

Regarding the mix of war performance, this variation is typical of large programs with milestones that involve traditional services, systems integration, product development and hardware acquisition and installation. We had a significant amount of hardware acquisition and installation work in the military and intelligence segment during the first quarter. This work carries minimal fee and negatively affects the gross margin.

I also mentioned that we took an additional $350,000 rate reserve related to our ongoing discussion with the DCAA. We had previously stated that we felt we were fully reserved in this activity. However, in late December the DCAA requested that we incorporate a new rate calculation from materials, subcontracts handling. We have not previously calculated a materials handling rate for any of our prior years and this was an unanticipated request. We are of course complying with the DCAA’s request and look forward to the resolution of this matter during the fiscal year.

Revenue in the civil and commercial segment increased 41% over the first quarter of fiscal year 2010 as a result of accelerated delivery of epic licenses to military intelligence segment customers and revenue upside released from current commercial programs. We anticipate that the civil and commercial segment revenue will remain strong throughout the year.

Segment gross margin was 25.7% compared with 41% in the first quarter of fiscal year 2010. Gross margin was negatively impacted by delayed revenue reorganization on two significant programs in our Integral Systems’ Europe division and higher than anticipated direct costs. Revenue in the product segment decreased 19% compared to the first quarter of fiscal year 2010 excluding the revenue contribution of the SATCOM Solutions division. The decrease in revenue was primarily the result of delayed shipments that we expect to occur over the next two quarters. Again, excluding the contribution of the SATCOM Solutions division, gross margin for the products segment was 41.3% for the first quarter of this fiscal year compared to 45.8% realized in the first quarter of fiscal year 2010.

As we discussed during our previous call, the segment level declined in gross margin is primarily the result of a shifting product mix and increasing price competition. However, the margin impact appears disproportionally larger in the first quarter due to lighter revenue in the product segment.

With that, I will turn the call over to Paul Casner for his comments.

Paul Casner

Thanks Chris and good morning everyone. Despite a challenging earnings quarter, we had consistent revenue growth and we had over $68 million of bookings for the quarter resulting in a 1.5 book-to-bill ratio. We believe that our increasing backlog will lead to continued revenue growth in the future. Meanwhile I am working hard to reduce Integral Systems’ corporate overhead which I expect will lead to improved short-term financial performance. More importantly I believe that a reduced cost structure will increase our competitive advantage with our customers.

One of the key to reducing our operating expenses and to unlocking the value in Integral Systems is to remove the burden of excess facility costs. The sublease of the majority of our Columbia facility and the repopulation of our remaining Lanham facility will eliminate our excess facility expense. Furthermore these activities will generate over $2 million in cash and result in over $2 million in reduced operating expense each year. I cannot overstate how pleased I am to have put this issue behind us.

We experienced significant expenses relating to our legal and accounting functions in the first quarter. Our legal expenses reflecting impact of various government contract compliance related costs, the costs of responding to various requests for information in connection with the previously announced SCC action against certain of our former officers to which the company is not a party and legal costs related to our previously announced review of strategic alternatives.

During the first quarter, we also saw higher than anticipated professional fees associated with our accounting and compliance function, primarily as a result of closing out fiscal year 2010. Variances in this area included over $250,000 in compliance and tax related consulting expense and an increase of $150,000 in audit related expenses. As we disclosed in our fiscal year 2010 10-K, our auditors have found that we still have a material weakness in internal controls.

We continue to move aggressively to resolve this weakness, although first quarter compliance expenses were high, we do not anticipate fiscal year 2011 compliance related expenses to reach the magnitude of fiscal year 2010. We continue to take an enterprise view of our business as we consider strategic alternatives and engage in cost cutting activities to reduce our indirect costs. We are actively engaged in examining and eliminating costs at every level from information, infrastructure support contracts, the facility costs and workforce staffing levels. As I have said in the past, all options remain on the table.

We continue to work to resolve our issues with the DCAA. We have submitted our provisional rates for fiscal 2011 and we anticipate that our revised incurred cost submissions will be submitted within the week. As you may recall from Chris’ remarks, the DCAA has requested that add a materials handling rate which required a $350,000 reserve this quarter and a recalculation of our incurred costs for 2006 through 2010. This resulted in a delay in our final submittal to DCAA. It is important that we continue to work with the DCAA to an expedient conclusion of this activity.

In closing I continue to believe that we are well positioned for continued growth. Our growth backlog I believe supports this. As commercial products based company, we deliver not only products but also systems, solutions and services that are cost effective and low risk. I continue to believe that this is a differentiator that will serve us well in the current economic climate.

With that I’d like to open it up for questions.

Question-and-Answer Session


(Operator Instructions). Our first question comes from Zachary Prensky of Coyote Capital. Please go ahead.

Zachary Prensky – Coyote Capital

Thank you. When you discussed the issues surrounding cutting costs and you emphasized that all options are on the table. Can you give us a sense of the primary metric that you are using to evaluate the options, meaning what I am saying is are you taking a look for example at our return on invested capital. Are you looking at whether our gross margins are other than temporarily impaired? Are you looking at return on assets? What metric are you using to evaluate which strategic alternatives we should be engaging in?

Chris Roberts

The key things we’re looking at are the impact on our overall rev rates, the overall burden on direct labor and that will inevitably as we improve our gross margins and our operating income margin that will have an effect on assets. The key thing we’re looking at is the actual total costs and the efficiency metrics we’re using our industry statistics to compare our G&A as a percentage of revenue compared with our competitors and metrics like that. We’re looking at operating costs which involve things like facilities costs. It’s not exactly ROA analysis; you’re looking at your burn rate, your rev rate.

Zachary Prensky – Coyote Capital

Okay, but I guess what I’m getting at is, we have a certain amount of assets on our books that we need to be able to do business and even if you do what you say you’re going to do in terms of cutting G&A and so on and by the way if I didn’t say it, I mean kudos to you guys for getting this facility, this facility subleased and cutting costs. That’s just absolutely fantastic. I am sure you’ve got a checklist of other items of equal importance to do. But I guess what I’m saying at is, is somebody doing an analysis that even after all that is done, you figure out what your gross margins are going to be in the medium term and you know what your reduced G&A is and you have a basis of some sort of pretax cash flow. You can then compare that to our gross assets at that time and say look, even if we do all this we’re still yielding only X and therefore the company as a standalone business does not make fiscal sense or perhaps when you look at your forecast you see, hey after we do all this we’re yielding why on an asset base of Z and that’s a fantastic return on invested capital and this model of ours makes sense of a standalone company. I guess my question is are you making that kind of an analysis?

Chris Roberts

Yes of course, in terms of just making the day-to-day decisions on what costs to cut and where we’re focused on or what basic metrics and in terms of taking dollars out of direct and indirect expense. We’re looking at a companywide not just a division by division basis.

Zachary Prensky – Coyote Capital

I get that. All I would like to get comfort on is that at the end of the day once you look at all the granular cost to be cut, is somebody rather at the CEO or the board level but then take a look at our 2012 forecast to say, okay we’ve cut all the easy stuff and our return on invested capital still unacceptable or hopefully it is acceptable.

Chris Roberts

Yes we certainly are looking at that and we do that on a continuing basis. But having said that, we have an enormous number of onetime events that we keep trying to focus on and get behind us because I think it will have a major impact on all of those metrics and quite frankly as you point out getting the excess facility behind us is a major step.

Zachary Prensky – Coyote Capital

Kudos, kudos to you guys for getting that done. But you know, you take a look at a company like (inaudible) Industries, they obviously went after the low hanging fruit and still decided that as a standalone company the return on invested capital didn’t make any sense.

Chris Roberts

My belief is then and I think the metrics will bear it out that we have a fundamentally great company and that the margins in general have been very good and we expect to be able to get back to that point.

Zachary Prensky – Coyote Capital

When you say very good you mean the 41%.

Chris Roberts

Exactly. So I think the fact is that the fundamental company makes a lot of sense and those metrics look great. We’ve just got some issues that we got to keep focused on which we have been focused on and keep driving costs out of the place because I think you’ll find that if we can get the corporate level G&A under control, those metrics will come back in line and we’ll be in pretty darn good shape. But we certainly look at that on a regular basis.

Zachary Prensky – Coyote Capital

Okay, well that is heartening to hear. Thank you very much. No further questions.


(Operator Instructions). Our next question comes from Dick Ryan of Dougherty. Please go ahead.

Dick Ryan – Dougherty & Company

Paul you talked about the fundamental business but again, getting over the real estate hurdles we now have some financing expenses unanticipated we’re dealing with rev reserves. Legal and accounting are still here. How do you grade what’s really going on in the divisions. I mean we’ve seen some give and take on the margins and you talked about pricing pressures. So can you just kind of walk through and just give a grade for which divisions you think are really outperforming and which ones kind of meet some TLC because from a distance here it’s tough to get through all the noise.

Paul Casner

Yes I think we can certainly do that. There was a little bit of a garble I think in one of the things we talked about just recently and that is the revenue shortfall. My expectation is that revenue shortfall will come back over the new two quarters. We didn’t lose anything. We had some significant shipments slip. It was unfortunate that it all seemed to happen in one quarter but I don’t think that a single bit of that revenue has been lost to the year and my expectation is it will come back over the new two quarters. As you heard, the military and intelligence segment did very well this year. They are growing. The fact is that we had some significant hardware shipments to our customer this quarter that had little margin, small margins associated with it that tended to drive their margins down but the fact of the matter is, that doing business with a government is pretty stable and the margins are pretty predictable and as I said, we have an unusual number of large shipments of hardware to the customer this particular quarter.

So I think that (inaudible) is doing well. I think its positioned well for growth and I think they have done an excellent job at refocusing on that marketplace and so I am very bullish, very positive about what’s happening in the (inaudible). As you heard the civil and commercial group has certainly done well this quarter and our expectation is that it will continue to do well. We had a couple of contracts, revenue reorganization slips in the UK and the French division but again we haven’t lost a single thing and that will certainly come back in the next several quarters. So, I think that the civil and commercial guys are doing well and as you’ve probably heard from the past that civil division is sort of been reinvigorated from a business development and marketing point of view and I see a substantial positive situation developing in our relationship with NASA and our business prospects there. So I am pretty positive and bullish there and as I said, I think they did well this quarter.

The products organization has always been our workhorse and will always be our workhorse and we had some very unfortunate shipment slips this quarter which dropped the revenue and affected the margins. I think they is certainly a business mix issue there. But the products organization has always done well and will continue to do well and I think you’ll see that the bookings are strong; bookings across the board are strong. I think that indicates we’re likely to have great revenue growth this year and I think that margins are going to come back. So I am not nervous about any of our segments at this stage of the game. I mean I think we just have an unfortunate collection of things happening with respect to the products organization and revenues which were delayed shipments, not lost shipments but delayed. So, I think when you cut through it all the fundamental business is doing pretty darn well and I think all the segments are performing pretty positive way and we have some unfortunate slips in revenue this particular quarter with the products organization but as I said they’ve always been the workhorse and I think they will continue to be the workhorse.

Dick Ryan – Dougherty & Company

With the budget challenges out there, are any of these segments starting to hear from their channels, their customers of delays kind out push outs and decisions, any discussions of that sort in the pipeline.

Paul Casner

Well Dick I must tell you that again, I’ll emphasize the fact that we had a very strong bookings quarter and we did add substantially to our backlog. But having said that, certainly a handful of our products organizations have heard from their customers that they are going to be cautious about spending money until this continuing resolution and defense budget issue is resolved. So, to answer your question sure, I think we would have had an even better bookings quarter if that situation hadn’t occurred and we have seen in some of our military government customers, the attitude that while because they don’t know what the budget situation for the rest of the year is going to be, they are being cautious about spending money right now.

It’s my belief that we’re going to get that situation resolved by the beginning of March that we will have a defense budget and that situation will turn around but to answer your question honestly, several of our divisions have gotten that input from their customers

Dick Ryan – Dougherty & Company

Okay and again trying to get through some of the noise, where should you be able to drive these expenses down to on a quarterly basis and kind of what timeframe you think would take to get there?

Paul Casner

Well I think we made a major step with this real estate situation and as you probably read in the press release and heard in the comments that we just made that I think that expenses that we saw in the first quarter were disproportionately high, I still believe that we have a valid budget in place internally that we’re going to be able to meet from the point of view of these expenses going forward and I’ve always claimed that my intention is to kind of drive this thing to the point where our corporate overhead expenses are below the $60 million range which is 15 million quarter, that’s what my objective is and we’re driving as hard as we can and you’ve seen some real evidence with the current news releases and 8-K filings that we’re making progress.

Dick Ryan – Dougherty & Company

I’m not sure, what you can comment here, I mean if you go back several years, the company kind of went through this strategy review of options which lasted maybe six nine months. Now you’ve pulled guidance and cancelled the conference, investor conference with the strategic reviewers. Is there any timeline sort of commentary you can give us in that regard Paul?

Paul Casner

It’s really very hard to talk about that and as you heard at the beginning of this call, we really don’t want to comment on that. As you might imagine that process is always a distraction and so my objective is to make that timeline as short as we can possibly make it and I commit to you that we certainly will try to do that but I’m not in a position right now to comment any further on that.


(Operator Instructions) One moment while we wait for any additional questions. I am showing no further questions at this time and would like to turn the call back over to Kathryn Herr.

Kathryn Herr

Thank you Ally and thank you all for your partipation in the Integral Systems first quarter earnings release conference call. A replay of this call will be available on our website in about two hours. As always if you have further questions please feel free to contact our investor relations department. And with that we wish you a great day. Thank you.


Ladies and gentlemen that does conclude today’s conference. You may all disconnect and have a wonderful day.

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