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Spartan Motors, Inc. (NASDAQ:SPAR)

Q4 2010 Earnings Conference Call

February 15, 2011, 10:00 am ET

Executives

Paula Droste – Director, IR and Treasury

John Sztykiel – CEO

Joe Nowicki – CFO and Chief Compliance Officer

Analysts

Joe Maxa – Dougherty & Company

Ned Borland – Hudson Securities

Mike Ruggirello – Barrington Research

Operator

Good morning, and welcome to Spartan Motors fourth quarter and full year 2010 conference call. All participants will be in a listen-only mode until the question-and-answer session of the conference call. This call is being recorded at the request of Spartan Motors. If anyone has any objections, you may now disconnect at this time. I would now like to introduce Ms. Paula Droste, Director of Investor Relations and Treasury for Spartan Motors. Ms. Droste, you may proceed.

Paula Droste

Good morning, everyone, and welcome to Spartan Motors fourth quarter and full year 2010 earnings call. I'm Paula Droste, Director of Investor Relations and Treasury for Spartan Motors. And I’m joined in the call today by John Sztykiel, President and CEO, and Joe Nowicki, our Chief Financial Officer.

I assume all of you saw the company's earnings release on the news wire and Internet this morning. John and Joe would take a few minutes to discuss the results for the quarter. However, before we do, it is my responsibility to inform you that certain predictions and projections made on today's conference call regarding Spartan Motors and its operations may be considered forward-looking statements under the Securities Laws.

As a result, I must caution you that as with any prediction or projection, there are a number of factors that could cause Spartan's results to differ materially. All known risks or management beliefs could materially affect the results identified in our Form 10-K and 10-Q filed with the SEC. However, there may be other risks.

With that, I’d like to turn the call over to our CEO, John Sztykiel.

John Sztykiel

Thank you, Paula. And good morning to those listening in on today's call and those on the Internet. Today we will share an overview of our operational and strategic achievements and highlights of our Q4 results. We will also give you an update on current market conditions, their impact on 2011 and beyond. We will conclude by sharing our strategic direction that will pave the way for future Spartan opportunities followed by Q&A. And again, as usual, Joe will get into a deep dive on the financials and some of the impacts going on from an operational perspective within each one of our business segments.

A year ago we shared our top two priorities; reducing our cost structure, an operational focus; and investing in profitable growth, a strategic focus. While our work is not done, we are proud of our progress on both of these fronts. During 2010, we rounded out our initiatives to include balance sheet management and developing compelling products and services. And again we’ve made large strides in both of these initiatives that will position us for future growth, but also help to deliver results as 2011 moves on.

Moving on to key milestones. And again, there are a lot of accomplishments in Q4, some of which have been noted in the release, some of which will cover as well on the call, including continued growth in our top line, reduction in our operating expense as a percent of our sales, a strengthened balance sheet with significantly lower debt and working capital. Our biggest challenge is the backlog, and we will discuss that in more detail later in the call.

Utilimaster was acquired just over a year ago, and the work to integrate the business into the Spartan system was completed during 2010. As a result, service and delivery sales are now the largest portion of our sales mix at about 31% for the last quarter. This market also contributed to our operating income in the second half of the year, fulfilling our goal of investing in profitable growth. We must still make improvements in gross margins and ensure that strategic initiatives are implemented, and the good news is we are making progress on both fronts.

During the fourth quarter, we also completed the sale of Road Rescue and finished all related transitional services. This sale hit three or four areas of focus as resources supporting that effort are redirected towards other activities aligned with our operational and strategic plan. In reality, the pure ambulance market was not the right strategic fit for us, plus we struggled operationally. Although difficult, it was the right decision. Simply, if we cannot be a market leader within a reasonable timeframe at an acceptable investment, we will not be in that particular market.

The significant Spartan transformation that’s important to mention is the added depth of talent and wisdom to our Board and leadership team. This talent top grading continues today and includes personnel from other industries and specific functions. We also have a lot of very, very good people within SMI as we work to both rotate and move them up from a leadership responsibility perspective, but those added talents broadened to include expertise in global commerce, lean manufacturing, innovative processes, acquisition and alliance formation. We are fortunate to have their leadership caliber from a Board or operational perspective, and all stakeholders will continue to benefit from them.

When I look at the SMI brands of Spartan Chassis, Crimson Fire and Utilimaster, all have delivered a number of innovations over the years that compel the marketplace to buy our products and services. Today we have 13 active or pending patents. As time goes on, I have no doubt we will have more and we will continue to develop new products that will ensure competitive advantage, i.e., compel the marketplace to buy from us that are difficult to replicate. A significant achievement supporting our pursuit of profitable growth opportunities was our alliance with Isuzu announced early last year in the April timeframe.

During 2006 and 2008, as a point of note, we upgraded every facility on the Charlotte Campus to support the hyper-growth from the defense business, and record revenues were achieved in 2008. What’s interesting is those upgrades include state-of-the-art paint booths. We also constructed some new purpose-built buildings. But in summary, those upgrades were a significant part in helping us to secure our relationships as Isuzu’s North American partner.

Combined with Isuzu, our worldwide leading diesel and commercial vehicle manufacture, our alliance will allow us access to 48 of the 58 specialty vehicle markets in North America. The opportunities are great, as they broaden SMI’s reach to additional market niches, a global distribution network, and access to a broad engine line of foreign customers from a diesel perspective. What’s interesting is the point of reference prior to the Isuzu lines is we only touched 17 out of 58 specialty vehicle markets.

What do we offer to Isuzu? Flexible assemble expertise with state-of-the-art facilities, access to US markets, a stable partner, plus customization. This alliance has resulted in the N-Series assembly agreement, a low-cab-forward lineup, which will reach volumes of 4,000 units a year and hopefully beyond and effectively utilize plant capacity that was previously devoted to the production of defense units. Production is scheduled to begin in Q2 of 2011.

A point to note, the alliance was announced with Isuzu, I believe, April 22nd or 23rd of last year. And within 12 months, we will be in production at a rate of just over 18 units per day. Now that is speed, that is agility, that is smart people working together as a team. And I compliment Isuzu as well. They have been great partners. Interesting to note from a leadership perspective, as I mentioned, being a market leader, the N-Series low-cab-forward for Isuzu has been the market leader in the low-cab-forward business for 23 straight years.

Again, another perspective moment and in sort of apples-to-oranges in some respect is not all the products are the same from the size or price perspective. But in 2009, we built 2,401 vehicles; in 2010, 8,362. You add in the N-Series assembly capacity of 4,000 and we’re on a path to over 12,000 units a year. Our market and leverage opportunity is growing, which also illustrates how we are evolving.

Quick financial recap, the fourth quarter was a great way to end the year with solid top line sales, an increase of 31% from the comparative period in 2009, largely impacted by the addition of Utilimaster in the service and delivery market, although after-market parts and assemblies and specialty vehicles saw a market increase over the same period as well. And that was – sequentially sales are up 5% from Q3, also driven by the service and delivery market.

While the addition of Utilimaster improved our top line and diversified our annual revenue stream by more than 20% and that is a positive, it did put pressure on our margins. And as I mentioned earlier, we are very focused on improving the gross margins at Utilimaster. But to counter this impact, we’ve put added focus on our expenses, reducing our operating expense ratio by 300 basis points to 11.7% from 14.7%. I compliment to all Spartan associates for responding to this tough challenge in a very, very short timeframe.

Earnings from continuing operations were $3.7 million or $0.11 per diluted share compared to breakeven results from continuing operations the prior year. Our balance sheet strengthened with the $10 million payment of debt in the quarter and an $18 million reduction in inventory. Again, my compliments to all Spartan associates. And also Joe will provide a more detailed review of the financial results.

And now I’ll just give you a little bit insight into the markets. In the recreation specialty chassis market, sales remained flat quarter-over-quarter, but actually that’s sort of good news because it is still a bit of a tenuous economy and the RV market is really doing reasonably well. However, on an annual basis, sales were up $53 million or 150%, while order flow is up 70% over the same period, again reflecting overall industry improvements compared to last year.

According to RVIA, the Recreational Vehicle Industry Association, shipments of Class A motorhomes were up 145% for the first ten months of 2010 compared to the same period in 2009. The increase in Class A motorhomes was the most rapid among the motorhomes segment. In a long time period, it indicates a good trend for this market and that is the market we serve.

Again, another point of note is that renewed interest in affordable travel and vacations and the increasing costs and the inconvenience associated with air travel, and all of you know about that. The motorhome industry or the RV industry stands very well relative to the future. As also, another very positive demographic, 11,000 people a day turn 50, and again that is still one of the prime buying audiences.

Another point of note though, as you see in the boomers, the Xs and the Ys, the younger generation does want to spend time outdoors, and the low-cost nature of an RV vacation will support industry growth patterns amongst a younger demographic group. And this is good for all of us. During the quarter, we had a very good show at the RVIA Show in December. Our success was driven by customers seeking reliable partners with a history of innovation and ability to react with speed to changing markets. Speed and agility, one of our ten strategic directives, a very, very important separator for Spartan.

In summary, the recreation specialty chassis market has further upside potential as the US population ages and the economic climate continues on a path of recovery as consumer confidence continues to improve and our product innovations take hold. As 2011 moves on we expect to have several more announcements in this area, and we look forward to the rest of ’11.

Let’s switch over to defense and specialty vehicles. Fourth quarter sales were up 72% to $4.7 million in 2010, reflecting ILAV and SOCOM orders. Again, specialty vehicle small volume orders in the defense arena again mine resistant, blast protected kind of products. Our backlog of $8 million primarily reflects the armored utility vehicle or AUV, again an MRAP variance announced this past quarter as well as a few drill rig orders.

The interesting thing to note about the drill rig is in the specialty vehicle business. Custom and niche products often start out on a very, very small scale, escalating the larger volumes. Our drill rig product has the same opportunity. While it does not guarantee the future, we have a great product that actually looks very, very good as well. And while that may be small today, it may become a larger part of our business tomorrow and it is quite profitable.

From a data point perspective and alarming global trend is the growth of improvised explosive devices, or IEDs as they are more commonly called, which were over 300 per month, excluding Afghanistan, but surged to over 14,000 when one includes Afghanistan in 2010, or a 62% increase over 2009, a three-fold increase over 2008. This threat is clearly alive and well, again unfortunately, but as a company with speed and agility and all that we bring to the marketplace, we expect to be in this business of mine resistant, ambush protected products or variance for not just today but the future as well.

We coupled this with our ISO-9001 certification, and again we are positioned extremely well. In summary, there are fewer, smaller order opportunities in the defense market. I should say there are a few small order opportunities in the defense market, which we are pursuing. However, opportunity to defense industry is currently challenges on two fronts. One, there is a smaller need as the wars in Afghanistan, Iraq wind down, and the Department of Defense focuses on reducing costs and limit funding for new program starts.

All right. Let’s switch over to the emergency response market. It continues to soften as a result of tight fiscal budgets and pull ahead orders in 2009 in advance of the 2000 emissions change. Those of you who have been in this market for quite some time know that emergency response would typically last into recession, last out of recession. Emergency response chassis, i.e. Spartan Chassis sales were down 17% for the fourth quarter of 2010 compared to the same quarter of 2009. Year-to-date sales for ER chassis were only down 5% compared to the prior year due to the fulfillment of orders placed in late 2009.

As I mentioned earlier, with tightening fiscal budgets, we are witnessing a shift in the orders being processed with also a longer purchasing cycle. At the same time too, we continued to invest in innovative solutions that will compel fire departments and municipalities to choose a Spartan product. A perfect example, the Metro Star Rescue Transit, a two-door rescue option. So it’s not just a pumper, it’s now a combination rescue pumper product.

Another new product of which announcement came out earlier from Spartan Chassis was the Force, a new model fire truck, cab and chassis that complements our product line, is the preconfigured purpose-built chassis strategically priced at an affordable auction to fire departments at under strict budget constraints, while still providing the quality and the content desired from a custom chassis.

Again, custom chassis is still the dominant part of the marketplace. But as prices become more important, we are doing a variety of different things to make the products of Spartan Chassis more affordable, again to not only drive the backlog in the right direction but to continue our leadership position.

The Spartan Force will be showcased at the FDIC show in Indianapolis in late March that is the largest emergency response show in North America. But some orders have already been placed for this product and strong – which reaffirmed its market opportunity and acceptance. In addition, we also invite any interested investors that come to the show at FDIC. And if you are, please contact Paula Droste and she will be more than happy to facilitate your requests.

In the emergency response chassis group, i.e., Spartan Chassis, we are focused on three areas; speed, innovation and ease to do business with. The good news is there are number of initiatives in price, but Spartan Force is just one. Momentum is now in the right direction, and we are also committed to accelerating it.

Let’s move over to emergency response body, i.e., Crimson Fire and Crimson Fire Aerials. Sales were up 4% for the quarter compared to the same quarter in 2009. We also anticipate that Crimson Fire will be impacted by the overall softening of the emergency response industry. However, they have had only modest declines in their backlog to date. We attribute this to the broader market it serves, but also they do provide products on less expensive commercial chassis, plus over the last two to three years, they have had a number of innovations come into the marketplace, i.e., the Legend, the Transformer, some aerial products, and they are simply just gaining profitable market share.

Something which we did from a lean perspective last quarter was we moved Crimson Fire Aerials to a new facility in Ephrata, Pennsylvania, which provide not only more space, but really out any significant addition in cost and with the added space, improved operating structure, we will be able to reduce the cost of each aerial we build. Again, working smart before you work hard.

Again, Crimson Fire will be showcasing a number of new innovations at FDIC as well, which will take place in March. Long-term, we see the emergency response market recovery, and it is a great market. Demographic trends will only increase the need and demand for emergency response vehicles. Today what’s amazing is there is a call for help at every 0.73 seconds. And with this aging population, this statistic will likely increase. Another point to note is direct dollar loss from fires is up 32% 1992 versus 2007.

Another data point is the existing national fleet of fire trucks is also aging. Approximately 54% of the fire trucks in service today are more than 15 years old. And to give you a point of perspective, that means they don’t have antilock brakes. Imagine driving a 30,000 to 40,000 to 50,000-pound vehicle on rain, snow, little bit of ice and you don’t have antilock brakes, a pretty precarious situation. And last, remember that fire departments are often the first responders to any serious event. Again, on also a positive note, in talking with the market groups bid activity is up in Q1 versus Q4 of last year. And while those are not orders, that’s also a big step in the right direction.

With after-market parts and assemblies, we experienced a 78% increase in quarterly sales year-over-year, driven by the completion of the medium mine protected vehicle, or MMPV as we call it. With over 220,000 vehicles in service today, we have tremendous opportunity from an after-market parts and assembly perspective. There are also opportunities in the refurbishment area, especially from an emergency response perspective. We have a customer-centric focus. We expect profitable growth in our after-market parts and assembly area. And this applies to all three brands; Spartan Chassis, Crimson Fire, and Utilimaster.

Sales in the service and delivery segment, let’s switch over to Utilimaster, our last major market, increased $25.9 million over the same quarter in 2009, driven by three full months of sales from Utilimaster, which was only present for one month in the respective quarter 2009. Sequentially, service and delivery sales were up 42% from the third quarter of 2010 due to the completion of a large sales order for a major customer.

Backlog for our service and delivery vehicle business is down $10 million or nearly 30% from the prior year, driven by large customer orders placed in 2009 in Q4 that were also completed, but were not present in the backlog. Customer push for those deliveries before the end of 2010 driving up sales, reducing the backlog. Another point to note relative to service and delivery, as the economic climate continues to improve and consumer spending increases, this will benefit the service and delivery market.

In the second half of 2011, we will benefit from the launch and production of the next generation commercial entity unveiled at the NTEA, The Work Truck Show, in Indianapolis on March 8 in partnership with Isuzu Truck of America. This is an industry-changing vehicle. It improves fuel efficiency by 35%. From a green perspective, it cuts CO2 emissions in half or 22,000 pounds per vehicle per year, while looking a heck of a lot better and a variety of other functional improvements from cargo capacity to ease of entrance and egress.

It’s interesting I’ve been with the company since 1985 and now you’ll probably pick up on my passion. You’ve been through some pretty exciting products like the EC-2000, Gladiator, Eurospace and the MRAP business, and I’ve never seen a more exciting product than the NGCV. When I started with the company in ’85, we were $10 million in sales. We’ve had a variety of different positive events and challenges, but this truly is a market-transforming product.

A unique micro-site has been set up, www.nextgenerationvan.com, and we’re excited about this big unveiling event. A countdown clock is included. If you’re not able to make the event, a video of the unveiling will also be posted on YouTube. We are now getting into the 21st century from a market development perspective, and I’m excited about that as well.

In the after-market parts and assembly area, there are a variety of neat initiatives or exciting initiatives going on as to how do we take advantage of the existing customer base of our products and again creating a value-added revenue and income stream. We have successfully developed and launched a retrofitting of keyless entry systems and a safe load mechanism, which will also be reflected in our 2011 results as time moves on.

I’ve taken a lot of time to cover the markets. Now, Joe, I’d like to turn it over to you to get into the deep dive on the financials and some operational achievements.

Joe Nowicki

Thank you, John. And good morning, everyone. Our fourth quarter results reflect the achievement and the commitments we made last quarter. As I mentioned in the past earnings call, we expected a positive outlook for the second half of 2010, which we delivered on the third quarter and then again this quarter. The $8 million sale of Road Rescue was also finalized in the fourth quarter along with the completion of related transitional services, the proceeds of which were all in line with our previously reported estimates.

In addition to improving our balance sheet, the completion of this sale freed up resources and capital, which has been able to redeploy all their activities within the business. I’m pleased with our proactive efforts to contain our costs and right-size the organization. We understand that our work is not done. Given the market conditions and trends in our backlog, we will continue to effectively manage our cost structure. What we have accomplished is putting in place a culture of continuous improvement that will allow further changes to occur more rapidly.

Now turning to our income statement results, fourth quarter sales were solid at $127 million, or $30 million or 31% increase over the same quarter last year. The majority of the increase during the period was due to the expansion of our product portfolios include service and delivery vehicle market, which we entered in December of 2009 through the acquisition of Utilimaster. Our results reflect a full quarter related activity compared to single month in Q4 2009. Excluding Utilimaster, revenues increased over 5% for the same period.

Additional sales increases came from the defense and APA markets. The defense sales increase for the current quarter was $2 million over the same period in 2009 driven by ILAV and SOCOM unit sales. The MMPV kit sales drove the $8 million comparative increase in the APA business. Sales of fire truck chassis decreased 17% in the quarter compared to the same period in 2009, again as John described, reflecting the softening in this market and also the completion of orders we pulled ahead due to the 2010 emissions change.

Specialty vehicles sales were higher in the same period of 2009 reflecting a (inaudible) ambulance chassis. Motorhome chassis and fire truck body sales were fairly flat over the period. On an annual basis, sales were up $71 million or 17%, with the addition of 11 months revenues from Utilimaster. Excluding Utilimaster, sales were down 7%, driven primarily by a reduction in sales from our after-market parts business. The card sales, as you recall, had a record year in 2009 as a result of the military orders received for the MRAP program.

Gross margin in the quarter was 15.3%, down from 15.5% in the last year’s fourth quarter, due mainly to the shift in our product mix, the emergency response chassis to service and delivery vehicles. The shift to lower overall gross margin compared to prior year’s was expected and will continue due to our more diversified sales mix. However, we remain committed to improve our margins in each market we serve as we focus on continuing our cost reduction efforts.

Despite operating expense increasing by approximately $0.5 million in the fourth quarter, our operating expense as a percentage of sales fell dramatically to 11.7% from 14.7% for the same period in the prior year. This is a significant achievement, particularly as we folded in the operating expenses from the acquisition of Utilimaster this year.

Furthermore, we accomplished as well – major R&D projects were underway for the development of the next generation commercial van and the cab and chassis we designed in our emergency response market. Reflected in the operating costs are R&D costs related to the development of those two, which amounted to $900,000 in Q4, $4.8 million on an annual basis.

Excluding restructuring charges and Utilimaster operations, operating expenses were reduced by an estimated $1 million or over 10% in savings compared to the same period in 2009. Annually, this estimate in reduction of operating expenses amounts to $10 million or over 20% savings compared to 2009.

The increased sales and effective cost management strategies drove the positive operating income results of $4.6 million for the quarter. This is up more than six folds and just under $1 million in the same quarter of 2009. In addition, as a result of recently enacted tax legislation tax legislation related to R&D, we were able to reduce our effective tax rate in the fourth quarter to 22% and to 29% for the full year. I’m proud to report net earnings from continuing operations for the quarter of $3.6 million or $0.11 per diluted share.

Now moving on to our balance sheet results, another major accomplishment came from our reduction in working capital need as we managed our resources more efficiently, which helped drive over $38 million in operating cash flow in 2010. Our inventory balance has improved with the reduction of over $36 million since December of 2009, representing a reduction of 36 days in inventory. Our accounts receivable were up almost $8 million due to the timing of some shipments at Utilimaster and Crimson Fire.

We made great progress in managing our balance sheet, and we will stay vigilant and continue to do so. And we believe we have even more opportunity here to improve. Continued strong cash flow from operations enabled us to pay down maturing debt of $10 million in the quarter. At December 31, our debt balance was at $5 million, down substantially from $46 million at the end of 2009.

Depreciation and amortization for the quarter was $2.6 million, and for the full year, it amounts to $10.7 million. Catalog expenditures for the year were $3.9 million in support of continuing operations and strategic investments. Proceeds from the sale of discontinuing operations and the sale of operational PP&E were $7.4 million and $800,000 respectively. Reflecting our positive long-term outlook and strong financial position, the Board approved annual dividend that amounted to $3.3 million with a file payment of $0.05 per share made in Q4.

Now I’ll spend a couple minutes on our backlog, which represents the one challenge in the quarter’s results. At December 31, 2010, our consolidated backlog was approximately $134 million compared with almost $234 million a year earlier. The majority of the decrease in our backlog year-over-year is a result of orders received in 2009 as advance for the 2010 engine emissions change.

This pull-ahead effect primarily impacted our fire truck chassis and body product lines. It’s our backlog rising in Q4 of 2009, we talked about it at that time the impact of the engine emissions changes was having. So, no surprise there. Each quarter this year we’ve seen the emergency response backlog decline as these pull-ahead orders were held. But that’s not the only reason for the decline in emergency response backlog.

As John described and everyone knows, market conditions in this area are very challenging right now. Municipal budgets have tightened considerably. As a result, the industry is preparing for a 2011 that is estimated to be down 30% to 40%. Although as John described, we have new [ph] initiatives in place to internally offset this decline. Also, as we have explained before, the industry is cyclical and declines are offset by high periods of growth.

The third major area impacting our backlog is the mix shift that’s occurring in our business. As we’ve diversified the revenue stream, we have most of the areas that have shorter lead-times and tend to be more project oriented, or I think lumpy is the technical term. We’ve seen this primarily in our service and delivery business, Utilimaster, but also in our recreational specialty chassis business. This occurs in the service and delivery side, as fleet customers tend to place larger orders on a periodic basis.

We experienced this in Q4 of 2009 when we had a large fleet order in the backlog. Again, in Q3 of 2010 with another large fleet order in the backlog. At the end of Q4 2010, the majority of those large orders were shipped and the ending backlog was lower. It’s difficult to look at their backlog at any one point in time and draw conclusions. The good news with Utilimaster is that they are the market brand leader, and that market responds early to economic changes and we’re confident should benefit in 2011 as the economy recovers.

The conclusion you should take away from our backlog discussion is that the year-over-year comparison looks worse than it is. But yes, our backlog is weaker than we would like, primarily as a result of the conditions in the emergency response and defense markets, which I described. The good news is that we’ve diversified our revenue stream and over 50% of our business is now outside of the emergency response market. And we have spent considerable time on new products and new alliance that will even further diversify our revenue in 2011. While the first half of 2011 will be challenging as a result of the opening backlog, we remain optimistic on the second half of 2011.

In closing, we made solid progress on improving our results, scaling the business to current revenue levels, and keeping costs at sustainable level. Although pleased with the quarter’s financial results, we remain guardedly optimistic for 2011, as we continue to drive top line growth or aggressively controlling costs.

I’ll now turn the call back to John who will share some closing thoughts.

John Sztykiel

Joe, thank you very much. 2010 was a year of transformation as we completed our integration with Utilimaster, exited Road Rescue, and made significant strides in leaning out our cost structure and improving our financial strength. From a strategic top line perspective, we will continue to pursue the blended growth strategy focused on three fronts. Organic growth through our existing markets and product innovations, i.e., the Force, the next generation commercial van, refurbishment, etc.

Second, tenant or foundational point alliances such as Isuzu. And to give you an idea again on some of the opportunities or what we now have going forward with Isuzu. What’s interesting is from a diesel perspective, we have the broadest lineup of diesel engines in North America from a specialty vehicle perspective, from three-liter to 15-liter. Second, we now touch 47 out of 58 specialty vehicle market. And again, those are opportunities, but through the right strategic and our operational initiatives, those opportunities will become positive realities.

Last, acquisition, and we already talked about the integration of Utilimaster and how that is moved in the right direction. And what’s nice is we have a tremendous balance sheet, low debt position with available credit lines, as Joe mentioned, so we have opportunity in the future as well. In the past, again as a point of perspective or reference, our growth strategy was primarily organic.

And today we have a blended strategy, with great initiatives in place for each one. Although a number of our markets have challenges ahead of us, particularly those affected by the weakened US economy and the increasing municipal constraints, we are confident that over time our efforts to restructure, diversify our business, and our commitment to the four strategic and operating initiatives will align us for gains and profitable market share.

For ’11 and beyond, the four pillars are simple; compelling products, growth in profitable market share, strengthen our balance sheet, and effectively manage our cost structure, always in line with our revenue stream. Simply, we are realists. Long-term, we will continue to execute on strategic and operational fronts that are supported or enabled by our diversified product portfolio; plant capacity to support future growth; flexible operations that enable us to adjust to changing environments; strong financial health, including access to sizable unused credit facilities; a talented and experienced leadership team from our Board to management team literally throughout the whole organization; and leveraging our facilities, processes and people where appropriate.

Quick note. Two years ago, SMI was like almost every other specialty vehicle company in North America. Each location of business unit operated with great autonomy. Today and tomorrow, SMI will continue to leverage the facilities, the people, the processes across our markets, locations where appropriate. And as Joe went over a number of achievements, which we’ve accomplished in 2009 and 2010, it is because of this leverage approach, we’re working smart as we call it that these results went from being an opportunity to reality. As time moves on, this market-centric and leverage team will guide us in the right direction.

In closing, 2011 will be challenging and exciting. As both Joe and I have mentioned, Q1 and Q2 will be tough in this year. However, as 2011 moves on, we have some exciting things going for us. In service and delivery, the N-Series chassis, assembly starts in mid-Q2. In March 8, at the Work Truck Show, there is a kick-up of the next generation commercial van, again the micro-site. It is one exciting product.

And emergency response, as I mentioned earlier, bid activity is up in Q1 versus Q4 of last year. We also have some major events in March; the Crimson Fire dealer meeting, the Spartan Chassis partnership meeting, and FDIC’s largest ER show in North America, of which there will be not just process announcement but some product announcements as well. And this is just the first half of 2011. As we go forward, compelling products, growth and profitable market share, cost and balance sheet management will guide us operationally and strategically. From a top line trend, it will be our blended strategy, organic, aligned and acquisition.

In summary, people, we have some great talents and a lot is being done in the right direction, and I wish to compliment everyone for the accomplishments over the last two years in very, very challenging market conditions. From a positioning perspective, in our markets we’re positioned very well and we have room for improvement and a variety of initiatives are in place to take advantage of that. From a purpose perspective, in all that we do, we bring value, i.e., we are committed to transforming the world through specialty vehicles.

I wish to thank all of you and now turn the call over to the operator to being the Q&A session. Thank you.

Question-and-Answer Session

Operator

(Operator instructions) And our first question comes from Joe Maxa from Dougherty & Company.

John Sztykiel

Good morning, Joe.

Joe Maxa – Dougherty & Company

Hi, guys. I just wanted to see if you could give us a little more clarity on your thoughts for 2011 by your product line. You gave us a nice color. Last quarter you gave us some indication. But what are you really thinking here? What you will see as far as growth or – meaningful growth or meaningful decline in your different areas?

Joe Nowicki

Sure. This is Joe Nowicki. Joe, I’ll give you a little bit of direction. As you know, we don’t give guidance. So I can’t get you any specific numbers. But I will walk you through by markets some of our thoughts as we look at 2011. As we go through segment-by-segment emergency response, as we kind of described, the market there is looking at a 30% to 40% decline. So in our emergency response chassis business, there would be a tough environment next year.

The defense and government piece, I think as we talked about, we had some pretty strong business with several programs this year. Next year, we already have some product wins in place that are on contract regarding ILAVs, SOCOMs, AUVs, and also the completion of the MMPV program. But you will see our defense business down slightly year-over-year. Recreation and specialty chassis business, that’s one, as John mentioned, we’re pretty optimistic about. That market itself in total has been pretty stable year over last year. And as we look at 2011, it will probably continue to be stable. And we’ve got a lot of good news, which could help us to season nice growth in that market next year.

John Sztykiel

Joe, it’s a good question. Just for all, one of the reasons is the RV business, not just that continues to move in the right direction, and I think one deal is that a best exit with the financial market stability and some of the appreciation we’ve seen over the last 12 to 18 months, the wealthy know they’re going to be wealthy. So now they are all buying expensive or luxury items per se, whether it be purses, cars, motorhomes, et cetera. So I think as long as we see continued financial stability in the market and consumer confident will be ticking in the right direction, you’re going to see the RV business continue to move in the right direction.

Joe Maxa – Dougherty & Company

When we look at the margins given your change in product mix, should we see more of a decline to the back half. Sounds like Utilimaster has a big chance pickup in the back half and in other areas, but where are we looking at gross margins going forward? Is 15% fair?

John Sztykiel

First, I’m going to kind of close off on your prior question there, Joe, and kind of go back to the other markets. We talked about the chassis, the defense, the rec business. If I look at the rest of them, the after-market parts and assemblies, there’s two parts to that; motorhome and fire truck. The team is doing a great job there on motorhome and fire truck. But you’re going to see some nice growth in that part of the business. The APA on defense, that you’ll probably see fall off as the defense businesses decline. A lot of parts businesses are going to decline as well too.

We’re going to pick up on the Isuzu N-gas. That’s brand new business to us, which we’ll see. They will start in the second half of the year. The delivery and service vehicle, the most optimistic one, early cycle business, great new product growth coming. So you’re going to see some significant growth on that segment for us. So, overall, the revenue piece show, it really is market-by-market. You will see different conditions in each one. That’s part of our diversified revenue approach here. May if we’re going to have some that are down, but we’ve got some that are up as well too, offsetting here.

Joe Maxa – Dougherty & Company

So, are you looking full year to be flattish?

Joe Nowicki

I think if you look at our grand total of all those, again we don’t give specific guidance, but if we look at the math of all those pieces, probably it’s fair to say that we just assume that our business would be flat to down slightly.

Joe Maxa – Dougherty & Company

And I think that would be a reasonable estimate as we sit here today. While we have a variety of initiatives in place, as we said here today, I think that would be a good way to phrase it.

John Sztykiel

I think the thing to consider as well though, Joe, is the first half will clearly be more challenging than then second half of the year. The backlog that we have says the first couple quarters will be more difficult and a lot of all the new initiatives that we have in place with Isuzu, the next generation commercial van, several other new initiatives in other areas of the business, they all start to kick in more in the second half.

Joe Maxa – Dougherty & Company

Exactly. Just to gross margin –

John Sztykiel

That was on the revenue side. So –

Joe Maxa – Dougherty & Company

Understood.

John Sztykiel

One more time your question on gross margin?

Joe Maxa – Dougherty & Company

I just wanted to see what your thoughts were on the trends and gross margin, as it appears as lower margin business. We could pick it up faster than the – some of your higher margin in the past, at least in the back half of the year.

Joe Nowicki

Your assumptions could be correct if our traditional kind of patterns on gross margin continue. But what we have done is we’ve got a lot of work going on. John described about how do we improve the margin, not take as a given some of the low margins we have in some of those areas of business. But what can we do to improve them? There’s a lot of lean initiatives going on not only in our delivery and service business within our motorhome business and others, that have traditionally lower margins to improving working model. We also have several new products as well too. The next generation commercial van, which should help with the gross margin picture in the service and delivery business, as well as some new work that we had gone on the recreation vehicle side as well too. So I don’t think it’s necessarily true, Joe, to make the assumption that our historically low margin areas will always be a little market. We’re working on that.

John Sztykiel

And I think as a group that’s important to note, as Joe mentioned earlier, and I mentioned earlier, there’s only so many good hours in the day, the OpEx to focus. In 2010, we focused on the integration of Utilimaster, bringing the NGC from a product development perspective to a market development perspective. Now we’ll be focusing on improving the operations at Utilimaster and going into the market development part of the next generation commercial van. So just because where we’re at today doesn’t mean we’re acceptable or satisfied with relative to tomorrow.

Joe Maxa – Dougherty & Company

Last question and I’ll move on to the queue. Do you anticipate to be profitable in both Q1 and Q2? And are your operating expense levels at – I guess the correct levels currently, do you see improvement there?

Joe Nowicki

Well, as I mentioned on the operating expense side, I’d get your last question, Joe, we’re always looking at achieving the right balance of our operating expense cost structure with our revenue stream. So that’s a given. We’re continuing to look at as part of this focus on continuous improvement on operating expenses. In regards specific to profitability, again as I mentioned earlier, we don’t give guidance specific to quarters on the conference call.

Joe Maxa – Dougherty & Company

All right. Fair enough.

Operator

Our next question comes from Ned Borland from Hudson Securities.

Ned Borland – Hudson Securities

Good morning, guys. Just following up on Joe's margin-related questions, just maybe coming at it a different way, if we look at the gross margin, there's certainly some things that are somewhat out of your control, like raw materials and so forth. How do you expect to deal with that and how would that sort of manifest itself on your gross margin at least in the early part of the year? And then the second part of it with the op expenses, you’ve done a good job of bringing them down to 11.7%, but are there any kind of launch costs, any kind of one-timers as we get close to the launch of the NGCV that we should be thinking about?

Joe Nowicki

Ned, there’s a couple question. There is one around launch cost related to the next generation commercial van. And certainly there are some in place. We do have a little bit of a higher level of cost structure in the first quarter of the year, a little bit in the second quarter, because a lot of the shows, the promotions, the kick-off of the next generation commercial van do cover in the quarter. So you’re right. We’ll see some incremental spending that’s a little bit high in the first quarter there. We’ve got that NTEA Show, we’ve got FDIC, we have several dealer events as well to all stack up in the first quarter. So that’s true. You had a second question in there, but I think I missed it. Could you back tracked on that, right?

Ned Borland – Hudson Securities

Okay. I’ll back up then. I guess raw materials as it affects your gross margin, if you could just comment on that.

Joe Nowicki

At this point, we haven’t seen any significant impacts on the raw materials. Our supply management team has been on top of it working with vendors as questions have come forward. But at this point, I don’t have anything to point to that says we’re going to see significant raw materials in any one area yet.

John Sztykiel

And Ned, this is John Sztykiel into the group. I just remember what we went through a number of years ago with steel surcharges and other thing – of right of other things, and I think again while we have not seen that, we’re concerned about it. But that’s also why we are being proactive not just from a purchasing perspective, but also from a design perspective, of facilities perspective.

I mean, one of the things which we’ve got on our radar screen is as the world’s economy starts to improve, there is only a limited supply of raw materials and commodities out there, and in the end, what we produce has material or components in there. So I think – again, I really compliment our people. They’ve done a very, very good job in ensuring that commodity prices have not affected us yet, or commodity price increases have not affected us yet. And there are a number of things from purchasing to engineering the facilities. Again, working smart in addition to working hard.

Ned Borland – Hudson Securities

Okay. And then just one more margin-related question and then I'll get back in queue here. But the spares business as it relates to the delivery and service segment with Utilimaster, one, do you expect that sort of percentage of delivery and service sales that’s related to spares, is that going to climb higher with the new product launch and are they – are those spares sales of comparable margin to what you make on the military spares?

John Sztykiel

I mean – again, this is John Sztykiel. I think one relative to the NGCV, it’s a little bit too early to tell from a spares perspective because the product is not in the marketplace. When I look at the service and delivery business as a whole, I think we’ve got very good growth prospects in the service and delivery business. Just because there are so many vehicles out there plus we’ve got a very good leadership team and they’ve got some nice innovations bringing into the marketplace from a keyless entry system to a lift, et cetera. Relative to the margins, Ned, I think it would be inappropriate for us to comment on a particular market relative to another market, just that the margins are positive and they are moving in the right direction.

Joe Nowicki

As with all of them, you do see better margins on the parts business and you do on some of the core products. So yes, you’re right there. And I would just echo John’s comments where I think the Utilimaster team has done an excellent job in bringing kind of new innovations and what they call that up-fit market to being things like, as Johan had describe, to essentially some other things that we’re doing with some carrier and interior storage devices, which I’ve seen a lot more of those come to the table and in the revenue stream. So I think that is good and will help their overall sales and their margin improvement as you look at 2011. So, all good news there.

John Sztykiel

On the interesting thing, just as a group, and that’s one of I think the positive, the people at Utilimaster has expressed about the relationship with SMI. We have a strategic directive cum value maximization, which is really part of after-market parts and assemblies. And so, Joe, Tom, all of us, myself here, we’ve not just embraced their desire, but we’ve supported their desire to look at all the vehicles they’ve got out there. And then, okay, where do we allocate our time? Just because the vehicle is out there, it doesn’t mean you can’t bring items to the marketplace with the customer wants to put on is in the service and delivery marketplace, people keep their vehicles a very long time period.

Ned Borland – Hudson Securities

Okay. Thank you.

Operator

(Operator instructions) Our next question comes from Mike Ruggirello from Barrington Research.

Mike Ruggirello – Barrington Research

Good morning, Joe, John and Paula. Nice end to the year there.

John Sztykiel

Good morning, Mike.

Joe Nowicki

Thank you, Michael.

Mike Ruggirello – Barrington Research

I know you guys had mentioned launching the NGCV in March. I was looking to maybe get – if you could walk us through what happens after that.

John Sztykiel

Good question, Michael. But basically what’s interesting is they’ve got a variety of road locations where with Isuzu they will be taking the product on the road. Okay? They’ve got – they've already had a number of customers come visit the product in Wakarusa, go through ride and rise. So that’s pre-unveiling for lack of a better term. But there is a very, very disciplined, exciting growth strategy. It’s called the bid to go turn. Okay? And the product will be in Chicago. So we will be getting in touch with you. It’s making a number of stops around North America.

And I’ll say what, it is one exciting product. The engine is quiet, a very low DBA composite for, composite loss tremendous fuel economy. The CO2 emissions, imagine 11,000 tons left per year. That’s a huge number. So again, the good-to-go tour, but the micro-sites out there, it looks straight. Okay? But the good-to-go tour will be published on March 8th. So literally it’s going to be sort of a touch me, feel me kind of experience. So any investors, if you haven’t desired to be a part of it, obviously get in touch with Paula.

Joe Nowicki

To other points, Mike, there is no material change to startup production, as we described, would be on the third course, but that’s still on track. And as we’ve talked to you before, they are still anticipating somewhere around 1,000 units during the course of this year 2011 in the third and fourth quarter that would get completed. That still hasn’t changed. We still know that same path.

Mike Ruggirello – Barrington Research

Perfect. How are sales conversations going now? You said they have done the ride-and-drive, but I guess I’m trying to understand – so are they going to delay purchases until they see this thing? Are they going to have the orders ready to go as soon as it's out? Just how are the sales conversations going with your big customers?

John Sztykiel

Well, the product is pretty – is significantly different than the largest stuff dance. The GVW 12,000 pounds were a number of the other products, which Utilimaster produces, are 18,000, 19,000, 20,000 pounds on up. So we really don’t see customers delaying their purchases because this is really addressing another market segment for Utilimaster. The reviews have been extremely positive. I think that’s just referenced by Josephs relative to what the production is still fleeted to be in the second half of this year.

Joe Nowicki

And we’re still seeing a lot of the plate customers expect to come forward as well right now on some of the old vehicles. No, it’s – there isn’t really a kind of waiting approach going on? But I think folks also noted that it’s limited production this year. So they are not going to wait for the whole year until 2011, and it really starts to kick in.

Mike Ruggirello – Barrington Research

Yes. And last question on the NGCV, if I understand correctly, you said it’s going to be – the price of that product is going to be more than the comparable product previously priced to the customer?

Joe Nowicki

I think to the end customer, the total ends selling price will be slightly above where they are paying for a comparable – the old mile vehicle today. That’s correct.

John Sztykiel

The operating cost is significantly less.

Joe Nowicki

That’s good point. That’s a good point. It was interesting is in the service and delivery business, these vehicles that are kept anywhere from 200 to 300. Some of the other larger pleased keep the vehicles and they execute over 700,000 miles on them, which is why it’s so important to have a commercial truck engine. So what’s nice is they are sophisticated or however you want to say they look at their business. They are willing to pay a little bit more from an acquisition cost because they see a much lower operating cost.

Mike Ruggirello – Barrington Research

Yes. And I understand from your perspective, you guys expect a unit increase but there is also going to be a price increase, right? So you get a little bit of a double lift to your revenues, if I understand that correctly.

John Sztykiel

No, that’s a wide statement.

Mike Ruggirello – Barrington Research

Okay. All right. Just a few modeling questions. Obviously you guys had a huge sizable drop in inventory. How should I think about that going forward?

Joe Nowicki

We’ve been mentioning for a while that our intent is to keep the focus on inventory and drive it on out. We’ve done a great job making the first step. There is still some further road for improvement. I think we made a big jump by dropping it down to $60 million where we’re at. You will see it come down a little bit further because our turns are expected to kind of improve even more so. So we’re really going at it from a turns number. But you will see the inventory value come down a little bit more yet as we go through the current year. It might bump up a bit in the first quarter because we get a lot of the stuff through the backlog at the end of the year. But by the time you get to the end of 2011 here, I think you’ll see another nice kind of improvement downward on it.

Mike Ruggirello – Barrington Research

And where else are you guys looking to improve? I mean, I'm sure there are a lot of places, but what’s the focus?

Joe Nowicki

Inventory and accounts receivable are the two big balance sheet items we’re going to continue to drive some lower improvements in the DSL and improvements in the days inventory out there that [ph] turns. Those are the two big areas for us on the working capital.

Mike Ruggirello – Barrington Research

Great. Last question I promise. The tax rate looked pretty low this quarter. How should I look at it in 2011? I know you mentioned that you’ve got some R&D credits. Do those keep going, or just how should I think about it this year?

Joe Nowicki

If I go in 2010 back to our traditional kind of rates which vary, it’s somewhere around 35%.

Mike Ruggirello – Barrington Research

All right. Perfect. Thanks for answering the questions, guys.

Joe Nowicki

You bet.

John Sztykiel

Thanks, Mike. All right. Are there other questions?

Operator

No.

John Sztykiel

All right. Then, I’ll tell you what, we really do appreciate your time today. Again, fourth quarter was solid. Great way to close out 2010. We’ve got some challenges in front of us, especially in the first half of ’11, but we also have some tremendous opportunities. Please visit the micro-site on the next generation commercial van. And again, appreciate your time. We look forward to serving you and implementing all that we’ve talked about in going forward. On behalf of Joe Nowicki, Paula Droste, myself and all the SMI associates, we thank you very much and wish you a great day.

Operator

The conference is now concluded. We thank you for attending today’s presentation. You may now disconnect your telephone lines.

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