Mercury Computer Systems F1Q08 (Qtr End 9/30/07) Earnings Call

Oct.25.07 | About: Mercury Systems, (MRCY)

Mercury Computer Systems, Inc.(NASDAQ:MRCY)

F1Q08 (Qtr End 09/30/07) Earnings Call

October 24, 2007 5:00 pm ET

Executives

Leslie Schaeffer - Manager ofFinancial Planning and Analysis

Jay Bertelli - President and CEO

Bob Hult - Senior VP and CFO

Alex Braverman - VP, Controllerand CAO

Analysts

Brian White - Jefferies

Rob Stone - Cowen & Company

Liz Defreitas - Stifel

Jim McAree - David J. Greene

Jeff Rosenberg - William Blair

Paul Svetz - Capital Sleuth

Gerry Heffernan - Lord Abbett& Company

Operator

Good day everyone, and welcome tothe Mercury Computer Systems Incorporated First Quarter Fiscal 2008 EarningResults Conference. Today’s call is being recorded. And at this time foropening remarks and introductions, I’d like to turn the program over to theManager of Financial Planning and Analysis, Ms. Leslie Schaeffer. Please goahead, ma'am.

Leslie Schaeffer

Good afternoon everyone, andwelcome to the Mercury Computer Systems first quarter fiscal year 2008 EarningsCall. With me today are Jay Bertelli, President and Chief Executive Officer,Bob Hult, Senior Vice President and Chief Financial Officer and Alex Braverman,Vice President, Controller and Chief Accounting Officer.

If you’ve not the received thecopy of the earning release, you can find it on our website www.mc.com or onthe FirstCall Network. We’d like to remind you that remarks that we may makeduring this call about future expectations, trends and plans for the companyand its business constitute forward-looking statements, which involves risksand uncertainties that could cause actual results to differ materially fromthose projected or anticipated.

Additional information regardingforward-looking statements and risk factors is included in the press release weissued this afternoon, reporting the Company’s first quarter fiscal year 2008results and the Company’s periodic reports filed with the SEC.

We caution listeners of today’sconference call not to place undue reliance on any forward-looking statements.We speak only as of the date of this call. We undertake no obligation to updateany forward-looking statements.

In addition to reportingfinancial results and accordance with Generally Accepted Accounting Principlesor GAAP, we will also be discussing non-GAAP financial measures adjusted toexclude certain charges, which we will specifically identify.

Management believes thesenon-GAAP financial measures assist in providing a more complete understandingof the company’s underlying operational results and trends and management usesthese measures along with our corresponding GAAP financial measures to managethe company’s business, to evaluate its performance, to compare to priorperiods in the marketplace, and to establish operational goals.

However, they are not meant to beconsidered in isolation or a substitute for financial information provided inaccordance with GAAP. The reconciliation of GAAP to non-GAAP financial resultsdiscussed in today’s conference call is contained in the Company’s firstquarter fiscal year 2008 earnings release.

I’m now pleased to turn the callover to Mercury’s Senior VP and Chief Financial Officer, Bob Hult.

Bob Hult

Thank you, Leslie. Goodafternoon, everyone. I will review revenue for the first quarter of fiscal year2008, including details by business unit; discuss company operatingperformance, balance sheet, and cash flow results, and then finish with adiscussion regarding the outlook for the next quarter and the remainder of thefiscal year.

I will discuss the numbers on boththe GAAP and non-GAAP basis.

First quarter revenues were $49.2million, slightly above our guidance of approximately $48 million and aboutflat with last year’s first quarter. Gross margin was 64%, well above ourguidance of approximately 57% due primarily to a favorable customer and productmix.

Lower excess and obsoleteinventory reserve expense driven by improvements in our supply chain managementalso contributed to this improved gross margin. In addition, the operatingmargin was favorably affected by the restructuring actions we took last year,which has significantly reduced operating expense.

GAAP operating loss was $3.3million. This includes stock based compensation expense of $2.7 million andamortization of acquired intangibles of $1.8 million. The GAAP net loss for thefirst quarter was $3.3 million, resulting in a loss per share of $0.15 versusour guidance of a loss of approximately $0.33.

On a non-GAAP basis, we reportedan operating profit of $1.3 million for the quarter. The non-GAAP operatingprofit excludes stock based compensation expense in the amortization ofacquired intangible assets.

Non-GAAP net income was $2million. Our non-GAAP diluted earnings per share for the first quarter were$0.09 above our guidance, previous guidance of a loss of $0.08. Thebook-to-bill ratio for the quarter was 1.1 driven primarily by our defensebusiness.

Backlog including deferredrevenue was $84.2 million, a $5.6 million sequential increase from the fourthquarter of last fiscal year. Of the ending backlog, $63.4 million or about 75%relates to shipments expected within the next 12 months.

As we announced last quarter, wehave reorganized the company along new reporting segments. This new businessunit structure was designed to facilitate operational benefits that we believewill spur innovation, drive revenue and help us contain costs. Our new AdvancedComputing Solutions business unit or ACS consists of our aerospace and defense,semiconductor, telecommunications and legacy life sciences businesses.

For the first quarter, ACSreported revenues of $42.2 million or 86% of total revenues for the quarter, a2% decline from the year ago period. The slight decline is the result of ayear-over-year drop in ACS commercial revenues from $20.9 million to $14.1million or approximately 33%. This drop was offset by an increase inyear-over-year defense revenues from $22.3 million to $28.1 million orapproximately 26%.

Our new Visage Imaging businessunit focuses on the 3D medical imaging market, concentrating on visualizationand PAC software solutions. Visage Imaging is a wholly owned subsidiary withthe majority of its operating activities such as R&D and sales functioningon a standalone basis. For the first quarter, Visage Imaging reported revenuesof $3.9 million or 8% of total revenues, flat with the year ago period.

In the first quarter, Visageexperienced a product release delay and continued to extend in sales cycleswith several major customers. This business is still in start-up mode, workingon refining its products and forging relationships with customers.

Despite the flat revenues, we areencouraged by the signs of customer attraction at Visage, and we expect it tohelp drive the better comparisons we have been forecasting for the company duringthe second half of this fiscal year.

Our Visualization Sciences Group orVSG is also primarily a software business, selling development tool kits andvisualization applications to geosciences, engineering and manufacturing,material sciences in other industrial and scientific markets. VSG reported a$2.6 million in revenues for the first quarter of fiscal 2008 versus $1.6million for the same period of fiscal 2007, up about 63%. This is still a smallbusiness, but growing rapidly from a small base.

Our emerging businesses consistof new business opportunities that benefit the Mercury’s capabilities acrossmarkets. Current areas of focus include computing and visualization in biotechand aircraft navigation. These businesses add revenues of $500,000 in thequarter, up from $200,000 in the first quarter of last year.

Also included in this segment isthe new Mercury Federal business, which is a start-up effort in depth designservices, systems engineering and associated product sales to intelligence andhomeland security agencies. We do not expect Mercury Federal to have a materialimpact on our fiscal 2008 results.

Turning to the balance sheet incash flow statement, cash, cash equivalents and marketable securities at theend of the first quarter of fiscal 2008 were a $158.6 million, representing a$1.5 million increase from the end of the fourth quarter of fiscal year 2007.

This small increase includes anet operating cash inflow of $4 million, an outflow of $800,000 for capitalexpenditures and a $2.4 million outflow for the acquisition of the remainder ofthe biotech venture we invested in last year.

First quarter day salesoutstanding were 63 days. Inventory returns were 3.0 for the quarter. The dayswere adversely impacted by end of quarter shipment SKUs and returns wereunfavorably impacted by lower revenue in the first quarter as compared to thefourth quarter of last year. At the end the quarter, the total employeepopulation excluding contractors was 737 employees.

I would like now to move to secondquarter and full year 2008 guidance. For the full fiscal year of 2008 wecontinue to expect revenues to approximate $225 million with acceleration inthe second half of the year.

We continue to project a fullyear revenue mix of approximately 50% defense and 50% commercial applications.Despite a relatively flat top-line on a year-over-year basis, the Companycontinues to expect significant improvement in the bottom line as a result ofthe restructuring actions taken in the fourth quarter of 2007.

In addition, we believe our grossmargin will continue to be stronger than we anticipated when we gave guidancelast quarter. For the full year of fiscal 2008, we currently expect our grossmargin to approximate 59% versus our previous expectation of 57% due tofavorable customer and product mix and continued favorable inventory reserveprovisions.

For the fiscal year, operatingexpenses are currently expected to approximate $128 million. This excludesstock-based compensation and the amortization expense. We are improving ourGAAP full year 2008 EPS guidance from a loss of $0.63 to a loss of $0.54. AGAAP tax provision is estimated at $3.5 million for the fiscal year.

The diluted shares for the fullyear are projected to be approximately $21.5 million. The impact of stock-basedcompensation costs for the full year will be approximately $11 million. Theamortization of acquired intangibles will be approximately $7 million.

The non-GAAP effective tax ratewill be 30% and the non-GAAP shares are projected to be approximately 21.7million. As a result of these adjustments, we currently expect fiscal year 2008non-GAAP earnings per share to be appropriately $0.33 versus our previousguidance of $0.17. CapEx for 2008 will be approximately $7 million,depreciation approximately $9 million.

For the second quarter, wecurrently expect revenues at $51 million. We currently anticipate the grossmargin to be approximately 58% in the second quarter. Operating expenses,approximately $32 million. Again, this excludes stock based compensation andamortization expenses.

Based on gross margin andoperating expense expectations we are forecasting lower EPS in the secondquarter than we reported in the first quarter with the expectation that EPSwill improve in the second half of the year. GAAP tax provision is estimated at$1.8 million for the second quarter, diluted shares, $21.5 million.

The resulting GAAP losses pershare, currently expected to approximate $0.37 for the second quarter of fiscal2008. The impact of stock based compensation cost for the second quarter willbe $3 million and the amortization of acquired intangibles will beappropriately $1.8 million. Non-GAAP tax rate is 30%, and the non-GAAP dilutedshares are approximately $21.5 million.

As a result, second quarterfiscal 2008 non-GAAP losses per share are currently expected to approximate aloss of $0.05.

At this point, I would like toturn the call back over to Jay for his industry comments and business updates.

Jay Bertelli

Thank you, Bob. Good day, everybody.I got a question for you. How many of you are wearing red socks? I am. The onlything I am more excited about than the red socks is our first quarterperformance.

The positive book-to-bill ratioof one-to-one for the company is very encouraging. While a few more quarters withsimilar results must be achieved before we can forecast a trend, we believe weare on a track based on design wins over the past several quarters, plus therobust sales pipeline in our advanced computing solutions business unit.

We have transitioned through theacquisition integration phase and are achieving the positive results weanticipated from the IP we acquired, which has been turned into leading edgeproducts for our markets. We have also transitioned through the organizationrestructuring phase with the new ACS organization producing forecasted costsavings, as evidenced by the quarter’s results. And the Visage Imagingorganization structured to focus on advanced visualization applicationsprimarily in the medical diagnostic imaging markets.

Our traditional value propositionbased on our ultimate performance multi-computer platforms has been challenged.Consequently, we've had to reinvent the company and do a lot more marketspecific value propositions. In the defense markets, we have modular productsthat start at the sensor or antenna, extend through the processing chain andthe visualization of the output. These modular products i.e. RF tuners, dataconversion products ADDs combined with preprocessing capabilities aretraditional high performance multi-computers. Single board multi-computers withextensive I/O capabilities and visualizations software enhanced with GPUcapabilities are also being delivered as integrated systems solutions.

Our extensive software expertiseties these modules together to bring significant value to the customer. Webelieve we now have the broadest range of product offerings in the industry toprovide our customers one-stop shopping for all their computing needs, frommodules to fully integrated systems.

The investments we have made innew products in our traditional high-end space plus the investments in ouracquisitions that we've made over the past three years are starting to pay off.Seven of the eight design wins in Q1 achieved by our ACS business unit includeproducts originating from our acquisitions.

Our next generation single boardcomputer product and our new data conversion and RF products enable us tocapture the seven design wins in defense with a potential combined value of $75million to $100 million over the next three to five years.

Another design win in thecommercial space for a satellite communications base station is based on ourEnsemble II ATCA based product line. Initial estimates for revenue when thissystem goes into production are $10 plus million over the next couple of years.

With regards to ACS, I would liketo make a few comments about the Aegis program. Some of you may have read theOctober 15th edition of defense news, the article entitled “Improving Aegis” speaksto the plans to expand the upgrade effort to modernize the Ballistic MissileDefense capabilities of the fleet. While we are currently primarily focused oneradicating terrorists, we can’t ignore Rogue Nations with nuclear missilecapabilities. The pre-modernization or interim program for 18 ships isunderway.

When the Aegis BMD 4.0.1 systemis inserted into the program, it will include our PowerStream 7000 system.Several of our systems have shipped for test and evaluation purposes.Production ores are expected in the second half of calendar year ‘08.

The value of the systems isestimated in the low single-digit millions per ship. We anticipate 10 to 18ship sets for the premodernization phase of this program. The currentmodernization program, which then succeeds the premodernization is scheduledfor Aegis to begin upgrading 62 destroyers and 22 cruisers starting in 2012.Many, if not all of these ships, will be equipped with the BMD Multi-MissionSignal Processors, which includes our PowerStream 7000.

Well, our Visage Imaging. We havereinvented our medical business moving from a hardware based image reconstructionfocus to advanced visualization for Life Sciences with a software businessmodel. We have launched the Visage brand to signify the separation from Mercuryand to generate the market specific focus internally and externally.

Visage Imaging was recentlyselected by Frost & Sullivan to receive the award of “Product Line StrategyLeadership” in medical. The thin client server model with our advanced 2D and3D visualization applications is the platform of choice.

The North American advanced 3D,4D visualization market report from Frost & Sullivan cites a market of $575million in 2007 growing to $1.3 billion in 2013. The development of 3D visualizationis in the early-adopted market stage.

We believe we are entering themarket at the right time with the right products, which have been designed toaddress the deficiencies in the products currently in use. The chasm will becrossed when we sign a few of the major players. We believe we could exit Q4 FY‘08 with bookings that would suggest a 5% to 8% market share.

General comments. We lost ourmomentum a few years ago for several reasons, most of which were attributablein my view, to poor execution. In my opinion, the strategy was mostly right butthe jury is still out on some of the initiatives. The nature of our businessbeing OEM and prime based with the long time period to production. It takes afew years to regain the momentum we lost. I had players on the field who wouldnot produce. We were not working together as a team.

The personnel changes we havemade over the past 12 to 18 months are starting to produce positive results.The Q1 results demonstrate that we can be profitable and generate cash withlittle or no revenue growth in FY ‘08 over FY ‘07. The investment initiativesin new products and new markets are beginning to produce results. As the designwins move to production, we believe we will return to operating income in the15% plus range, when the top line starts growing.

I would like to mention theInvestor Day, we have scheduled for November 13th. Most of you, hopefully, havealready received invitations to that date. There will be a reminder going outsometime later this week. And for those of you who have not received theinformation yet, as a guest speaker, we have Dr. Elliott Siegel, Professor andVice Chairman, University of Maryland,Department of Diagnostic Radiology and a Chief of Imaging at the VeteransAffairs Maryland Healthcare System. He is going to be obviously addressing theimaging market place, which is of interest to all of us.

So, in conclusion, today Iborrowed a theme from the Red Sox Nation, we believe and I used it severaltimes in my comments. So I leave you with this statement and a question. Ibelieve. Do you believe?

And we will open up the call forquestions.

Operator

Are you ready for questions, sir?

Jay Bertelli

We are, operator.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions)Our first question will be from Brian White with Jefferies. Please go ahead.

Brian White - Jefferies

Hi, good afternoon. When we lookat the defense business, will this business grow sequentially in the Decemberquarter?

Bob Hult

Brian, it’s Bob here. The ACSbusiness, let me back up even further. Our guidance at 51 for the Decemberquarter is coming off a quarter of 49. So, total debt is not that much growthsequentially. As you can see from the information I shared around Q1, we hadgrowth, significant growth in the defense business and our commercial businessin ACS did fall-off a bit from previous quarters. Both of those businesses arecharacterized by lumpy orders and lumpy situations with customers.

So, I don’t think it’s going tobe too much different from what we saw in Q1, but for the full year, we’reexpecting 50% defense, 50% commercial. Maybe a little bit stronger in favor ofdefense based on what we can see right now. So, I don’t think it’s going to betoo dramatically different from Q1 in terms of mix.

Brian White - Jefferies

So how did…

Bob Hult

Maybe a little less defense percentagewise than we just experienced in Q1, because it was very strong due to certainprograms drawing orders down.

Brian White - Jefferies

Okay. So how did gross margins gofrom 64% to 58% in one quarter?

Bob Hult

How did they go down?

Brian White - Jefferies

Yes. How did they go down?

Bob Hult

Well, we've got a couple ofmoving parts here. I’ll take the easiest one first. The improvements we’ve madeand continue to make in our supply chain, our ability to really cap our grossinventories and do a much better job of demand forecasting and working with oursupply chain partners, our EMS partners.

We’re really seeing that benefitin the need for inventory, excess and obsolete inventory reserve provisions.And we had a pretty good pick-up in Q1 on that, approximately two points of theimprovement that you saw in the 64% versus the previously guided 57%. So maybe,a third of that was in the inventory provision space.

We believe that that is apermanent improvement or at least a portion of it. So we’re thinking we got asolid point to sell there, but we’re not quite ready to say we got the full twopoints. The rest of it is customer and product mix.

As I said, we’ll arguably have alittle bit less defense in favor of commercial in Q2. That does come with alower gross margin. And then inside of the defense business, we’re dependent onspecific product mix. So, it’s going to come down to, well, we’re saying 59%for Q2, and we just did 64%.

Brian White - Jefferies

Okay. And how should we think…

Bob Hult

One thing, Brian, I want toremind, I guess, everybody, and yourself included is, last year the companyperformed at approximately 56% for the full year with a high degree ofregularity quarter-to-quarter. Now this is a huge step-up for us. Taking lastyear from 56 to guiding this year at 59, and you saw it in Q1. There is thepotential to do better than that, but we’re not ready to commit to that yet, toyou guys.

Brian White - Jefferies

Okay. And when we look at thefour operating units, how should we think about the gross margins here for thefour operating units?

Bob Hult

It’s not something we’ve reallybroken out in the past. The big operating unit is ACS, its 85% or better of thecompany, and that’s the big moving part. The other operating unit that hasrevenues of two other units, VSG and VI, are both software oriented businessunits.

Now VI, the tool kit business, ifyou will, the business that we acquired a few years back, it’s fairly mature.We get a gross margin there that reasonably looks like a software company. Whenyou come to VI, the new Visage Imaging business focused on Life Sciences is amix of software and hardware in there. It is more software than hardware, butof course, that moderates the gross margin.

Brian White - Jefferies

So, VI has a gross margin of 80,90%. Is that what we’re looking at?

Bob Hult

No, no. It’s above 70%, but below80%, VI.

Brian White - Jefferies

Okay. Okay. And then, VSG has agross margin of, where do you think that is about?

Bob Hult

I’m sorry, VSG?

Brian White - Jefferies

Yes.

Bob Hult

Yes. I was actually answeringyour first question as VSG, that’s in the 70% plus range.

Brian White - Jefferies

Okay.

Bob Hult

VI is not at that level becauseof the hardware software mix.

Brian White - Jefferies

Okay. Is it a corporate average?

Bob Hult

The VI business?

Brian White - Jefferies

Yes.

Bob Hult

VI is actually a little bitbetter than corporate average, not much, but a little bit better, and improvingas the software content increases, it will move up.

Brian White - Jefferies

Okay. Thank you

Bob Hult

Yeah.

Operator

Our next question will come fromRob Stone with Cowen & Company.

Jay Bertelli

Hello, Rob.

Rob Stone - Cowen & Company

With respect to the market andshare that you mentioned for the Visage business, you suggested that this was,I think, a $500 million market at the moment. Is that right?

Jay Bertelli

There is a recent report thatcame out from Frost & Sullivan that suggested North American market isabout $575 million for advanced visualization.

Rob Stone - Cowen & Company

So, you also said that this is anearly adopter market, but it's my understanding that PAC systems have beenaround for quite a few years already, and if the market is that large, I wonderwho are the leading market share players and how large, for example, are thekind of respective shares of the biggest competitors that you face?

Jay Bertelli

The confusion, Rob, that alwaysseems to creep into this is the understanding of what constitutes PACS. And PACSis the basic infrastructure within the hospitals that consist of thecombination of the image database and the data database, if you will, the medicalrecords, and the infrastructure to store on communicate that informationthroughout the hospital.

It is not the high performanceadvanced visualization part of it that we are talking about it. You’reabsolutely right. PACS has been around for a long time. I can remember back in,it was the early 90s, we were supplying a component to Siemens when they wereinstalling the first, I think that was the world’s first PAC System for the USArmy.

And they were using our systemsto do some compression work on the imagery. But in anyway, so PACS, you couldargue, is a mature market. What I'm suggesting it with Frost & Sullivan, Ithink they're suggesting is that the visualization applicate laid on top of thePACs 3D visualization is what is emerging and the numbers that I quoted there,I think from Frost & Sullivan's report, $575 million for the North Americanmarket.

Rob Stone - Cowen & Company

Well, coming back to the questionof competitors though. Is this a concentrator or fragmented market? How big isthe biggest competitor?

Jay Bertelli

I don’t want him to speak here. Iwas looking through the data, but it's about two-thirds, I believe, of themarket or maybe 60% of the market. So, it's gone to the big guys, the big OEMsand 20% to a number of smaller independent companies, if you will. And thelargest company that we track and follow, that we think we are more akin to, is[Vital] Imaging. It’s a public company, revenues in the $70 million, $80million range. Arrow Recon is another one. They are a private company. Notclear what their revenues are. We suspect that it’s north of 50.

Rob Stone - Cowen & Company

Well, from the point of thepositioning vis-à-vis the large OEMs, which I guess in medical imaging,generally have been among your customers. What’s the differentiation strategy?

Jay Bertelli

We've got a two prongeddistribution strategy. One is to go after the OEMs, which we have been doing, andthe other is to have both a distribution network and a direct sales force,which we are just starting to ramp up to go after the smaller hospitals and theimaging clinics directly, where there is less competition from the big guys. Andwe're branding the product in such a way as to try and create some demand-pullthrough the system by our ability to install in existing, the smaller hospitalsand clinics.

And we've got severalinstallations, if you will, at the clinical sites that are considered to beluminary sites in order to be able to get the feedback from those folks and toget that publicized. And the big differentiator and it was the reason for theFrost & Sullivan award is this Thin Client/Server model that we have thatnobody else has out there.

Rob Stone - Cowen & Company

Have you open approached it -- iswhat topology?

Jay Bertelli

I'm sorry. But I was talking whenyou were talking, Rob, and I missed it.

Rob Stone - Cowen & Company

You noted that thedifferentiation is primarily around the Thin Client/Server approach. So whatarchitecture topology are the competitors all using?

Jay Bertelli

Workstations.

Rob Stone - Cowen & Company

Okay. Great. Thanks for taking myquestions.

Jay Bertelli

Rob, I would hope that you'd beable to come to the Investor Day and listen to Dr. Siegel, because he's goingto be giving an industry overview and you will get the firsthand information,if you will, that I think will help you understand this market and theopportunity for us a lot better.

Rob Stone - Cowen & Company

Great. Thank you.

Operator

(Operator Instructions) We movenow to Liz Defreitas with Stifel.

Liz Defreitas - Stifel

Hi. My question is with regard tothe Synthetic Vision system. How much do you think that opportunity can growover the next couple of years for you?

Jay Bertelli

Well, I think we said, or Ibelieve I said in my comments that we think we can exit Q4 with a bookings ratethat would give us somewhere between 5% and 8% of the market share. And if theytake you to believe the Frost & Sullivan number of $575 million as the sizeof the market for 2007, I'll give you some idea of what we're talking about. Ihesitate to give you the exact number.

Liz Defreitas - Stifel

Okay. Alright, thank you.

Operator

Our next question will come fromJim McAree with David J. Greene.

Jim McAree - David J. Greene

Hey, Jay, Bob, just one aside, myson is rooting for the Red Sox. So, you guys have company. I think you answeredmy sales mix question previously. So if you could talk about, it looks likethere were few a little acquisitions on the cash flow side. If you could -- isthere anything of note to point out there?

Jay Bertelli

No. We took a minority positionin a -- I'll just call it a biotech startup a year ago, 18% was the position wetook. And we had our rights to the other 82%, if you will, and we took thoserates down in August during this just completed quarter. So, we now own thewhole operation, if you will, and that was the payment I was referring to. It'sjust over $2 million. The total price we paid was roughly $3 million.

Jim McAree - David J. Greene

Okay.

Bob Hult

That’s the only item of anacquisition nature that occurred during the September quarter.

Jim McAree - David J. Greene

Alright. And is that going to bereported in that other category we had, the emerging businesses I suppose?

Bob Hult

Yes, it will. We refer to that asour biotech venture, if you will. But it will be in that segment for Q and Kreporting.

Jim McAree - David J. Greene

Super. Thanks guys. I lookforward to seeing you on the 13th.

Jay Bertelli

You can find out more about themby looking at Sol map, solmap.com.

Bob Hult

That’s their website.

Jim McAree - David J. Greene

Alright. Thank you.

Operator

And our next question will comefrom Jeff Rosenberg with William Blair. Please go ahead.

Jeff Rosenberg - William Blair

Good afternoon.

Bob Hult

Hi, Jeff.

Jeff Rosenberg - WilliamBlair

Hi. When we look at theexpectation for the second half ramp, how much of that is tied to improvementsin business with Aegis or any sort of color on the specific visibility you haveon that improvement?

Jay Bertelli

Well, there is some Aegisbusiness, I am going to say a single-digit millions that we have in theforecast for this year. I can’t say it’s coming in Q2, but it is in theforecast for this fiscal year.

Jeff Rosenberg - William Blair

And obviously, given thecommercial part of the business was even the smaller part, this quarter thereis even a more substantial ramp there. I mean is that, can you talk a little oris more of that coming from Visage, I mean, on the non-defense side, what’s thekind of visible drivers you can talk about in the second half ramp?

Jay Bertelli

Yes. Our view forward, where isthat step-up in Q2 coming from? It’s coming certainly from Visage Imaging andour ACS business, that’s where the bulk of the dollars coming from. As I say topass them for you, but I think you’re going to see a dramatic step up. Webelieve we’re going to see a dramatic step-up in Visage Imaging. So, it’s notinsignificant the growth there in terms of dollars; even though, what that groupjust reported here in the September quarter or what we reported on behalf ofthat Group is about $4 million.

Jeff Rosenberg - William Blair

Okay.

Jay Bertelli

The step-up there, and also astep-up in the ACS side, which we believe will continue to be driven by ourdefense and commercial opportunities.

Jeff Rosenberg - William Blair

Okay.

Bob Hult

Jeff, the commercial businessthat we are talking about here is, some that we’ve had for quite a while, likewith the KLA-Tencor, for example. And so there is clearly a business coming outof there, Mentor Graphics another one. We refer to all as Mentor Graphics, butthe business that comes about, as a result of the sale of their, or the licensingof their software to the manufacturers, the chip manufacturers that are using thissoftware in conjunction with our software on a cell processor.

Jeff Rosenberg - William Blair

Did the mix this quarter surpriseyou in ACS or did you, I know, the revenues came in pretty much inline withyour expectations, but was it more skewed towards defense than you thoughtcoming in?

Bob Hult

Yeah. I think a little bit. Wehad an end of quarter skew too. So, this is, it’s not perfect science here. Wehad moving parts in the third quarter. And, so I’m not going to say we weresurprised. We knew what we were working with, but you don’t know where you’regoing to land it exactly. So, we ended up with little more defense than wethought or we would have done a better job with the guidance 90 days ago.

Jeff Rosenberg - William Blair

Okay. And in terms of thelong-term view, Jay, you talked about the potential to get back to 15%operating income. Does that assume the ability to sort of prove to yourselves,if you will, that you can maintain the kind of gross margin that you had thisquarter on a consistent basis or can you get there with gross margins that arecloser to 60? How should we think about what kind of gross margin you need tosustain to be able to get that 15% number?

Jay Bertelli

60.

Jeff Rosenberg - WilliamBlair

60?

Jay Bertelli

60...

Jeff Rosenberg - William Blair

Okay.

Jay Bertelli

That’s our operative assumptionthere. And the other assumption is that we’ve got some headroom in ouroperating expense infrastructure. So that will not have to increase that muchlooking forward. Not to say, we won’t be rearranging things, but we’ll not haveto increase net that much.

Our breakeven as a company rightnow, top line for a full year is around $210, $215 revenue annualized and as weapproach $300 million on the top line, that’s where we can see that timelessbusiness model kicking in at the 15% or better that Jay was referring to. Butwe’re obviously not there right now but, and that’s with conservativeassumptions on the gross margin line 60%, not the 64% that we just saw here inQ1.

Bob Hult

Just a little bit more color onthat too, because I know you’re fairly new to the company. There is severaldifferent gross margins, if you will, within the company. So, we’ve got the VSGsoftware business, we got VI, it's mostly a software business. So, obviously,the margins there are significantly different than the rest of our business.The traditional commercial business that tends to be heavily hardware-orientedhas a lower gross margin typically than the defense business. Defense businesshas always had a better gross margin, and when the mix, and the way the orderscome in is never as predictable as you’d like. It makes it challenging to sayat least to predict the future, if you will. Except the fact that we can feelcomfortable, I believe that we are on the right trend here, right trackforward.

Jeff Rosenberg - William Blair

Absolutely. And just for whatit’s worth, my son is rooting for the Red Sox also. Thanks.

Jay Bertelli

Alright, Jeff.

Jeff Rosenberg - William Blair

Thanks.

Operator

And our next question...

Jay Bertelli

How come you are not rooting forthe Red Sox?

Jeff Rosenberg - William Blair

I will for this series.

Jay Bertelli

Okay. We know who you'll rootfor.

Operator

Our next question gentlemen, comesfrom [Paul Svetz, Capital Sleuth].

Paul Svetz - Capital Sleuth

Thank you. Actually, my questionhas been answered. Bob, maybe one thing you could do for us is, contrast themodel on the medical area relative to your other businesses.

Bob Hult

Yeah. What you’re really sayingis, what does that model look like versus the big ACS business? Is that, am I gettingthat right, Paul?

Paul Svetz - Capital Sleuth

Yeah. I think that you'reexpected to be significantly different. We don’t really know in the maturity,what it is, but if you could help us a little bit…?

Bob Hult

All right. I’ll give it a shotfor you here. It’s a little extemporaneous. But, I think if we look at our --what we also call our core business. Where defense lies and where the commercialbusiness such as Jay mentioned that we historically dealt with KLA-Tencor, andeven some of the new things we’re doing in the communications space. Thatbusiness will grow. Our view is that it will grow, albeit at a rate lower thanwhat Visage Imaging has the potential to do, and that ties directly to the, forinstance, the Frost & Sullivan reflect that Jay was referencing.

The market opportunity for VisageImaging in 3D medical imaging, specifically the visualization in the PAC space,it’s fairly -- it’s large. So, one thing we’ve got to put down here is highgrowth rate on Visage Imaging, respectable growth rate on our core business.And gross margin for our core business, it has got defense, we've always donewell there. We deliver a very, I’m just going to call that a very capable andpowerful platform in some very specific defense applications, and we had a lotof value. You can expect the gross margin is very high.

On the commercial side of ACS,it’s a little bit different. We are always being challenged there by Moore’slaw, if you will. And if we stay ahead of it, we win the business, butcharacteristically there is margin pressure there. Though, even ACS is ablended margin. That margin is tending to look like the corporate average rightnow.

Back to Visage Imaging, theemerging 3D medical imaging business. That business overtime will be much moresoftware than hardware, that’s our belief anyways. Where somebody wants anaccelerated platform, we'll provide it, which you know; the accelerated platformthat we are offering right now is GPU-based in the primary as an example. I'mnot going to call it a commodity, but you know what that does to the grossmargins on the hardware side.

So, that's got pushes and pullsalso. Long-term, will it look like a software business, total software business80% to 90%? We don’t think so. But we think it will be well in excess of 70% ona longer term payments business model. Bottom line operating profit, serioushigh teens for both businesses are quite possible. We might even be able to doa little bit better on the medical imaging business but again, that's veryperspective looking down the road a few years. And frankly, we don’t know on thatone, but that’s our view.

Paul Svetz - Capital Sleuth

Thank you, that’s helpful.

Bob Hult

Okay.

Operator

And we will take our nextquestion, gentlemen, from Brian White with Jefferies.

Brian White - Jefferies

Yeah. Could you give us a feelfor the cell processor related revenue in fiscal ‘08? What are we looking at inthe cell processor?

Jay Bertelli

We have somewhere in the order ofbetween 40 and 50 systems that are out there. Different locations betweendefense and commercial customers that have it in their labs under evaluationtesting, etcetera, etcetera. And it’s premature at this point for us to giveany forecast with regards to how many of those are going to end up going intoproduction, because there is always a number of customers out there that willlatch on to something new and play around with it for a while. And so, we arenot ready to declare that this is going to be a $100 million product for us. Onthe other hand, we certainly do expect revenues out of the sold product or letme just call it, single-digit millions, high single-digit millions in this fiscalyear.

Brian White - Jefferies

Okay. And Jay, where are you seeingthe most success, I think at one point you spoke about the EDA companies. Isthere any particular market you’re seeing more success than others?

Jay Bertelli

Well, I believe we’ve announcedthat there's a design win at KLA-Tencor, and obviously the one at MentorGraphics. Those are the two big ones that we can talk about. There is a numberof them in defense, and we just got an award out of [Seacom], which is the armycommunications command for a multi-million dollar system, cell-based system todo some special things with. There is some connectivity within the defensespace too.

Brian White - Jefferies

Okay. And Bob, looking at therestructuring, are we done with restructuring?

Jay Bertelli

I hope so...

Bob Hult

Yeah. That was Jay. Yes, we are. Infact, some good news to report there. I think, if you look carefully at ourreported operating expenses through the September quarter, we got a full yieldfrom our restructuring activities, which occurred in the fourth quarter of lastyear, June to be specific by month. So, we came out of the gate strong with amuch reduced operating and expense structure, and we do expect that to continuethroughout the year.

Brian White - Jefferies

So, you are saying we have seenthe full benefit?

Bob Hult

In Q1, yes, you did.

Brian White - Jefferies

Okay, great. Thank you.

Operator

And we’ll take our next questionfrom Gerry Heffernan, Lord Abbett & Company. Please go ahead.

Gerry Heffernan - Lord Abbett & Company

Hi. It's Gerry Heffernan, thanksguys. Actually, my question was just on what the previous person asked there. Iwas trying to compare the quarter-over-quarter expenses and wanted to you knowif our intended benefit of the restructuring was a $15 million annualizedexpense reduction. Don’t know any reason why that wouldn’t be coming through ona rather even basis quarter-to-quarter. I was seeing the operating SG&A,etcetera expenses only down like 2.2. What am I missing here?

Bob Hult

2.2, sequentially?

Gerry Heffernan - Lord Abbett & Company

Actually, I was goingyear-over-year?

Bob Hult

Yes. That’s what you’re missing.The quarters two, three, and four last year, our operating expenses were prettymuch $35 million in each quarter. And we just reported a number just above 30.So, you’re actually saw a $5 million decrease, sequentially, in the average ofthe previous three quarters. So, we’re not saying that, that’s going tocontinue. There were some other moving parts in there, program-related expensesand what not and again bring that up a bit. So, we think it’s going to be morelike $32 million, $33 million, each of the next three quarters. So, if you weren’tthat thrilled, you’re easily going to see the $15 million expense savings onthe OpEx line.

Gerry Heffernan - Lord Abbett & Company

Okay. So, you were not includingamortization of acquired intangibles when you talk on that?

Bob Hult

No. No.

Gerry Heffernan - Lord Abbett & Company

Okay. But even so, I see 19-1 and13-8.

Bob Hult

Yes. I mean this is a non-GAAPview. So, I’m not sure what you’re looking at, if you’re…

Gerry Heffernan - Lord Abbett & Company

Well, I’m looking at the numbersas presented in the press release here. Okay. If I can request just -- I don’twant to take up too much time on this.

Bob Hult

No. Well, just so you don’tconfuse all the rest of us, what we’re saying for the full year, non-GAAPoperating expenses, which excludes stock-based compensation and amortization ofintangibles, is $128 million. And what we reported last year on that samenon-GAAP basis was $139 million. So, there is $11 million right there, andthere is modest hiring as we step through this year, nothing too measurable.And then you just have normal reasons why operating expenses go up like anannual salary increase for the employees and just other general inflationaryitems. So, the $15 million is definitely there.

Gerry Heffernan - Lord Abbett & Company

Okay. If you could just tell mewhat you see as the, what you calculate the non-GAAP expenses to be for thecurrent quarter just reported?

Bob Hult

30.3.

Gerry Heffernan - Lord Abbett & Company

Okay. I’ll just work from there,and see what I can…

Bob Hult

Sure.

Gerry Heffernan - Lord Abbett & Company

Okay.

Bob Hult

And then, work some numbers thatgive yourself $128 million for the full year and I think you’re going to beable to prove that the expenses are there plus some -- expense reductions arethere plus some.

Gerry Heffernan - Lord Abbett & Company

Okay. One final question, if Icould.

Bob Hult

Sure.

Gerry Heffernan - Lord Abbett & Company

The discussion early on about theAegis program. One, what was the periodical that you referred to where theAegis program was discussed?

Bob Hult

Defense News, October 15.

Gerry Heffernan - Lord Abbett & Company

Okay. And I believe you saidsomething about delivery of as far as what they are looking to do, as far asthe Aegis system delivery of units in the second half of ‘08, were youreferring to fiscal year ‘08 or the calendar year?

Bob Hult

Yes. Calendar year ‘08.

Gerry Heffernan - Lord Abbett & Company

I’m sorry. I didn’t hear thatanswer.

Bob Hult

Calendar year ‘08.

Gerry Heffernan - Lord Abbett & Company

Calendar year ‘08. Okay, verygood. Thank you for the clarification.

Bob Hult

Okay, you’re welcome.

Operator

And at this time gentlemen, wehave no other questions standing by. I’d like to turn the program back to youfor any additional or closing comments.

Bob Hult

Well, I thank you all for attending.As you know, we switched the call to Wednesday, with the expectation that wewould remove some of the conflicts that you all have with other companiesreporting out, and appreciate your attending the call, and we’ll see you inthree months and ‘Go Red Sox’.

Operator

Thank you everyone for yourparticipation in today’s conference, and you may disconnect at this time.

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