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Executives

Leslie Schaeffer - Manager of Financial Planning and Analysis

Jay Bertelli - President and CEO

Bob Hult - Senior VP and CFO

Alex Braverman - VP, Controller and 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

Mercury Computer Systems, Inc. (MRCY) F1Q08 (Qtr End 09/30/07) Earnings Call October 24, 2007 5:00 PM ET

Operator

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

Leslie Schaeffer

Good afternoon everyone, and welcome to the Mercury Computer Systems first quarter fiscal year 2008 Earnings Call. 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 the copy of the earning release, you can find it on our website www.mc.com or on the FirstCall Network. We’d like to remind you that remarks that we may make during this call about future expectations, trends and plans for the company and its business constitute forward-looking statements, which involves risks and uncertainties that could cause actual results to differ materially from those projected or anticipated.

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

We caution listeners of today’s conference 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 update any forward-looking statements.

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

Management believes these non-GAAP financial measures assist in providing a more complete understanding of the company’s underlying operational results and trends and management uses these measures along with our corresponding GAAP financial measures to manage the company’s business, to evaluate its performance, to compare to prior periods in the marketplace, and to establish operational goals.

However, they are not meant to be considered in isolation or a substitute for financial information provided in accordance with GAAP. The reconciliation of GAAP to non-GAAP financial results discussed in today’s conference call is contained in the Company’s first quarter fiscal year 2008 earnings release.

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

Bob Hult

Thank you, Leslie. Good afternoon, everyone. I will review revenue for the first quarter of fiscal year 2008, including details by business unit; discuss company operating performance, balance sheet, and cash flow results, and then finish with a discussion regarding the outlook for the next quarter and the remainder of the fiscal year.

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

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

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

GAAP operating loss was $3.3 million. This includes stock based compensation expense of $2.7 million and amortization of acquired intangibles of $1.8 million. The GAAP net loss for the first quarter was $3.3 million, resulting in a loss per share of $0.15 versus our guidance of a loss of approximately $0.33.

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

Non-GAAP net income was $2 million. 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. The book-to-bill ratio for the quarter was 1.1 driven primarily by our defense business.

Backlog including deferred revenue was $84.2 million, a $5.6 million sequential increase from the fourth quarter 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, we have reorganized the company along new reporting segments. This new business unit structure was designed to facilitate operational benefits that we believe will spur innovation, drive revenue and help us contain costs. Our new Advanced Computing Solutions business unit or ACS consists of our aerospace and defense, semiconductor, telecommunications and legacy life sciences businesses.

For the first quarter, ACS reported revenues of $42.2 million or 86% of total revenues for the quarter, a 2% decline from the year ago period. The slight decline is the result of a year-over-year drop in ACS commercial revenues from $20.9 million to $14.1 million or approximately 33%. This drop was offset by an increase in year-over-year defense revenues from $22.3 million to $28.1 million or approximately 26%.

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

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

Despite the flat revenues, we are encouraged by the signs of customer attraction at Visage, and we expect it to help drive the better comparisons we have been forecasting for the company during the second half of this fiscal year.

Our Visualization Sciences Group or VSG is also primarily a software business, selling development tool kits and visualization 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 $1.6 million for the same period of fiscal 2007, up about 63%. This is still a small business, but growing rapidly from a small base.

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

Also included in this segment is the new Mercury Federal business, which is a start-up effort in depth design services, systems engineering and associated product sales to intelligence and homeland security agencies. We do not expect Mercury Federal to have a material impact on our fiscal 2008 results.

Turning to the balance sheet in cash flow statement, cash, cash equivalents and marketable securities at the end 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 a net operating cash inflow of $4 million, an outflow of $800,000 for capital expenditures and a $2.4 million outflow for the acquisition of the remainder of the biotech venture we invested in last year.

First quarter day sales outstanding were 63 days. Inventory returns were 3.0 for the quarter. The days were adversely impacted by end of quarter shipment SKUs and returns were unfavorably impacted by lower revenue in the first quarter as compared to the fourth quarter of last year. At the end the quarter, the total employee population excluding contractors was 737 employees.

I would like now to move to second quarter and full year 2008 guidance. For the full fiscal year of 2008 we continue to expect revenues to approximate $225 million with acceleration in the second half of the year.

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

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

For the fiscal year, operating expenses are currently expected to approximate $128 million. This excludes stock-based compensation and the amortization expense. We are improving our GAAP full year 2008 EPS guidance from a loss of $0.63 to a loss of $0.54. A GAAP tax provision is estimated at $3.5 million for the fiscal year.

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

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

For the second quarter, we currently expect revenues at $51 million. We currently anticipate the gross margin to be approximately 58% in the second quarter. Operating expenses, approximately $32 million. Again, this excludes stock based compensation and amortization expenses.

Based on gross margin and operating expense expectations we are forecasting lower EPS in the second quarter than we reported in the first quarter with the expectation that EPS will 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 per share, currently expected to approximate $0.37 for the second quarter of fiscal 2008. The impact of stock based compensation cost for the second quarter will be $3 million and the amortization of acquired intangibles will be appropriately $1.8 million. Non-GAAP tax rate is 30%, and the non-GAAP diluted shares are approximately $21.5 million.

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

At this point, I would like to turn 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 only thing I am more excited about than the red socks is our first quarter performance.

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

We have transitioned through the acquisition integration phase and are achieving the positive results we anticipated from the IP we acquired, which has been turned into leading edge products for our markets. We have also transitioned through the organization restructuring phase with the new ACS organization producing forecasted cost savings, as evidenced by the quarter’s results. And the Visage Imaging organization structured to focus on advanced visualization applications primarily in the medical diagnostic imaging markets.

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

Our extensive software expertise ties these modules together to bring significant value to the customer. We believe we now have the broadest range of product offerings in the industry to provide our customers one-stop shopping for all their computing needs, from modules to fully integrated systems.

The investments we have made in new products in our traditional high-end space plus the investments in our acquisitions 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 include products originating from our acquisitions.

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

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

With regards to ACS, I would like to make a few comments about the Aegis program. Some of you may have read the October 15th edition of defense news, the article entitled “Improving Aegis” speaks to the plans to expand the upgrade effort to modernize the Ballistic Missile Defense capabilities of the fleet. While we are currently primarily focused on eradicating terrorists, we can’t ignore Rogue Nations with nuclear missile capabilities. The pre-modernization or interim program for 18 ships is underway.

When the Aegis BMD 4.0.1 system is 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 is estimated in the low single-digit millions per ship. We anticipate 10 to 18 ship sets for the premodernization phase of this program. The current modernization program, which then succeeds the premodernization is scheduled for 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-Mission Signal Processors, which includes our PowerStream 7000.

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

Visage Imaging was recently selected by Frost & Sullivan to receive the award of “Product Line Strategy Leadership” in medical. The thin client server model with our advanced 2D and 3D visualization applications is the platform of choice.

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

We believe we are entering the market at the right time with the right products, which have been designed to address the deficiencies in the products currently in use. The chasm will be crossed 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 our momentum a few years ago for several reasons, most of which were attributable in my view, to poor execution. In my opinion, the strategy was mostly right but the jury is still out on some of the initiatives. The nature of our business being OEM and prime based with the long time period to production. It takes a few years to regain the momentum we lost. I had players on the field who would not produce. We were not working together as a team.

The personnel changes we have made 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 with little or no revenue growth in FY ‘08 over FY ‘07. The investment initiatives in new products and new markets are beginning to produce results. As the design wins move to production, we believe we will return to operating income in the 15% plus range, when the top line starts growing.

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

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

And we will open up the call for questions.

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 look at the defense business, will this business grow sequentially in the December quarter?

Bob Hult

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

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

Brian White - Jefferies

So how did…

Bob Hult

Maybe a little less defense percentage wise than we just experienced in Q1, because it was very strong due to certain programs drawing orders down.

Brian White - Jefferies

Okay. So how did gross margins go from 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 of moving parts here. I’ll take the easiest one first. The improvements we’ve made and continue to make in our supply chain, our ability to really cap our gross inventories and do a much better job of demand forecasting and working with our supply chain partners, our EMS partners.

We’re really seeing that benefit in 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 the improvement 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 a permanent improvement or at least a portion of it. So we’re thinking we got a solid point to sell there, but we’re not quite ready to say we got the full two points. The rest of it is customer and product mix.

As I said, we’ll arguably have a little bit less defense in favor of commercial in Q2. That does come with a lower gross margin. And then inside of the defense business, we’re dependent on specific 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 to remind, I guess, everybody, and yourself included is, last year the company performed at approximately 56% for the full year with a high degree of regularity quarter-to-quarter. Now this is a huge step-up for us. Taking last year from 56 to guiding this year at 59, and you saw it in Q1. There is the potential to do better than that, but we’re not ready to commit to that yet, to you guys.

Brian White - Jefferies

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

Bob Hult

It’s not something we’ve really broken out in the past. The big operating unit is ACS, its 85% or better of the company, and that’s the big moving part. The other operating unit that has revenues of two other units, VSG and VI, are both software oriented business units.

Now VI, the tool kit business, if you 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. When you come to VI, the new Visage Imaging business focused on Life Sciences is a mix of software and hardware in there. It is more software than hardware, but of 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 below 80%, VI.

Brian White - Jefferies

Okay. Okay. And then, VSG has a gross 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 answering your first question as VSG, that’s in the 70% plus range.

Brian White - Jefferies

Okay.

Bob Hult

VI is not at that level because of 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 bit better than corporate average, not much, but a little bit better, and improving as the software content increases, it will move up.

Brian White - Jefferies

Okay. Thank you

Bob Hult

Yeah.

Operator

Our next question will come from Rob Stone with Cowen & Company.

Jay Bertelli

Hello, Rob.

Rob Stone - Cowen & Company

With respect to the market and share 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 that came out from Frost & Sullivan that suggested North American market is about $575 million for advanced visualization.

Rob Stone - Cowen & Company

So, you also said that this is an early adopter market, but it's my understanding that PAC systems have been around for quite a few years already, and if the market is that large, I wonder who are the leading market share players and how large, for example, are the kind of respective shares of the biggest competitors that you face?

Jay Bertelli

The confusion, Rob, that always seems to creep into this is the understanding of what constitutes PACS. And PACS is the basic infrastructure within the hospitals that consist of the combination of the image database and the data database, if you will, the medical records, and the infrastructure to store on communicate that information throughout the hospital.

It is not the high performance advanced visualization part of it that we are talking about it. You’re absolutely 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 were installing the first, I think that was the world’s first PAC System for the US Army.

And they were using our systems to do some compression work on the imagery. But in anyway, so PACS, you could argue, is a mature market. What I'm suggesting it with Frost & Sullivan, I think they're suggesting is that the visualization applicate laid on top of the PACs 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 American market.

Rob Stone - Cowen & Company

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

Jay Bertelli

I don’t want him to speak here. I was looking through the data, but it's about two-thirds, I believe, of the market or maybe 60% of the market. So, it's gone to the big guys, the big OEMs and 20% to a number of smaller independent companies, if you will. And the largest 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, $80 million range. Arrow Recon is another one. They are a private company. Not clear what their revenues are. We suspect that it’s north of 50.

Rob Stone - Cowen & Company

Well, from the point of the positioning 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 pronged distribution strategy. One is to go after the OEMs, which we have been doing, and the 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 the imaging clinics directly, where there is less competition from the big guys. And we're branding the product in such a way as to try and create some demand-pull through the system by our ability to install in existing, the smaller hospitals and clinics.

And we've got several installations, if you will, at the clinical sites that are considered to be luminary sites in order to be able to get the feedback from those folks and to get that publicized. And the big differentiator and it was the reason for the Frost & Sullivan award is this Thin Client/Server model that we have that nobody else has out there.

Rob Stone - Cowen & Company

Have you open approached it -- is what topology?

Jay Bertelli

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

Rob Stone - Cowen & Company

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

Jay Bertelli

Workstations.

Rob Stone - Cowen & Company

Okay. Great. Thanks for taking my questions.

Jay Bertelli

Rob, I would hope that you'd be able to come to the Investor Day and listen to Dr. Siegel, because he's going to 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 the opportunity for us a lot better.

Rob Stone - Cowen & Company

Great. Thank you.

Operator

(Operator Instructions) We move now to Liz Defreitas with Stifel.

Liz Defreitas - Stifel

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

Jay Bertelli

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

Liz Defreitas - Stifel

Okay. Alright, thank you.

Operator

Our next question will come from Jim McAree with David J. Greene.

Jim McAree - David J. Greene

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

Jay Bertelli

No. We took a minority position in a -- I'll just call it a biotech startup a year ago, 18% was the position we took. And we had our rights to the other 82%, if you will, and we took those rates down in August during this just completed quarter. So, we now own the whole operation, if you will, and that was the payment I was referring to. It's just 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 an acquisition nature that occurred during the September quarter.

Jim McAree - David J. Greene

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

Bob Hult

Yes, it will. We refer to that as our biotech venture, if you will. But it will be in that segment for Q and K reporting.

Jim McAree - David J. Greene

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

Jay Bertelli

You can find out more about them by 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 come from Jeff Rosenberg with William Blair. Please go ahead.

Jeff Rosenberg - William Blair

Good afternoon.

Bob Hult

Hi, Jeff.

Jeff Rosenberg - William Blair

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

Jay Bertelli

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

Jeff Rosenberg - William Blair

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

Jay Bertelli

Yes. Our view forward, where is that step-up in Q2 coming from? It’s coming certainly from Visage Imaging and our ACS business, that’s where the bulk of the dollars coming from. As I say to pass them for you, but I think you’re going to see a dramatic step up. We believe we’re going to see a dramatic step-up in Visage Imaging. So, it’s not insignificant the growth there in terms of dollars; even though, what that group just reported here in the September quarter or what we reported on behalf of that Group is about $4 million.

Jeff Rosenberg - William Blair

Okay.

Jay Bertelli

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

Jeff Rosenberg - William Blair

Okay.

Bob Hult

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

Jeff Rosenberg - William Blair

Did the mix this quarter surprise you in ACS or did you, I know, the revenues came in pretty much inline with your expectations, but was it more skewed towards defense than you thought coming in?

Bob Hult

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

Jeff Rosenberg - William Blair

Okay. And in terms of the long-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 this quarter on a consistent basis or can you get there with gross margins that are closer to 60? How should we think about what kind of gross margin you need to sustain to be able to get that 15% number?

Jay Bertelli

60.

Jeff Rosenberg - William Blair

60?

Jay Bertelli

60...

Jeff Rosenberg - William Blair

Okay.

Jay Bertelli

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

Our breakeven as a company right now, top line for a full year is around $210, $215 revenue annualized and as we approach $300 million on the top line, that’s where we can see that timeless business model kicking in at the 15% or better that Jay was referring to. But we’re obviously not there right now but, and that’s with conservative assumptions on the gross margin line 60%, not the 64% that we just saw here in Q1.

Bob Hult

Just a little bit more color on that too, because I know you’re fairly new to the company. There is several different gross margins, if you will, within the company. So, we’ve got the VSG software 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-oriented has a lower gross margin typically than the defense business. Defense business has always had a better gross margin, and when the mix, and the way the orders come in is never as predictable as you’d like. It makes it challenging to say at least to predict the future, if you will. Except the fact that we can feel comfortable, I believe that we are on the right trend here, right track forward.

Jeff Rosenberg - William Blair

Absolutely. And just for what it’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 for the Red Sox?

Jeff Rosenberg - William Blair

I will for this series.

Jay Bertelli

Okay. We know who you'll root for.

Operator

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

Paul Svetz - Capital Sleuth

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

Bob Hult

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

Paul Svetz - Capital Sleuth

Yeah. I think that you're expected 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 shot for 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 commercial business such as Jay mentioned that we historically dealt with KLA-Tencor, and even some of the new things we’re doing in the communications space. That business will grow. Our view is that it will grow, albeit at a rate lower than what Visage Imaging has the potential to do, and that ties directly to the, for instance, the Frost & Sullivan reflect that Jay was referencing.

The market opportunity for Visage Imaging 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 high growth 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 done well there. We deliver a very, I’m just going to call that a very capable and powerful platform in some very specific defense applications, and we had a lot of 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’s law, if you will. And if we stay ahead of it, we win the business, but characteristically there is margin pressure there. Though, even ACS is a blended margin. That margin is tending to look like the corporate average right now.

Back to Visage Imaging, the emerging 3D medical imaging business. That business overtime will be much more software than hardware, that’s our belief anyways. Where somebody wants an accelerated platform, we'll provide it, which you know; the accelerated platform that we are offering right now is GPU-based in the primary as an example. I'm not going to call it a commodity, but you know what that does to the gross margins on the hardware side.

So, that's got pushes and pulls also. Long-term, will it look like a software business, total software business 80% to 90%? We don’t think so. But we think it will be well in excess of 70% on a longer term payments business model. Bottom line operating profit, serious high teens for both businesses are quite possible. We might even be able to do a little bit better on the medical imaging business but again, that's very perspective looking down the road a few years. And frankly, we don’t know on that one, but that’s our view.

Paul Svetz - Capital Sleuth

Thank you, that’s helpful.

Bob Hult

Okay.

Operator

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

Brian White - Jefferies

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

Jay Bertelli

We have somewhere in the order of between 40 and 50 systems that are out there. Different locations between defense and commercial customers that have it in their labs under evaluation testing, etcetera, etcetera. And it’s premature at this point for us to give any forecast with regards to how many of those are going to end up going into production, because there is always a number of customers out there that will latch on to something new and play around with it for a while. And so, we are not ready to declare that this is going to be a $100 million product for us. On the other hand, we certainly do expect revenues out of the sold product or let me just call it, single-digit millions, high single-digit millions in this fiscal year.

Brian White - Jefferies

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

Jay Bertelli

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

Brian White - Jefferies

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

Jay Bertelli

I hope so...

Bob Hult

Yeah. That was Jay. Yes, we are. In fact, some good news to report there. I think, if you look carefully at our reported operating expenses through the September quarter, we got a full yield from our restructuring activities, which occurred in the fourth quarter of last year, June to be specific by month. So, we came out of the gate strong with a much reduced operating and expense structure, and we do expect that to continue throughout the year.

Brian White - Jefferies

So, you are saying we have seen the full benefit?

Bob Hult

In Q1, yes, you did.

Brian White - Jefferies

Okay, great. Thank you.

Operator

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

Gerry Heffernan - Lord Abbett & Company

Hi. It's Gerry Heffernan, thanks guys. Actually, my question was just on what the previous person asked there. I was trying to compare the quarter-over-quarter expenses and wanted to you know if our intended benefit of the restructuring was a $15 million annualized expense reduction. Don’t know any reason why that wouldn’t be coming through on a 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 going year-over-year?

Bob Hult

Yes. That’s what you’re missing. The quarters two, three, and four last year, our operating expenses were pretty much $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 of the previous three quarters. So, we’re not saying that, that’s going to continue. There were some other moving parts in there, program-related expenses and what not and again bring that up a bit. So, we think it’s going to be more like $32 million, $33 million, each of the next three quarters. So, if you weren’t that thrilled, you’re easily going to see the $15 million expense savings on the OpEx line.

Gerry Heffernan - Lord Abbett & Company

Okay. So, you were not including amortization 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 and 13-8.

Bob Hult

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

Gerry Heffernan - Lord Abbett & Company

Well, I’m looking at the numbers as presented in the press release here. Okay. If I can request just -- I don’t want to take up too much time on this.

Bob Hult

No. Well, just so you don’t confuse all the rest of us, what we’re saying for the full year, non-GAAP operating expenses, which excludes stock-based compensation and amortization of intangibles, is $128 million. And what we reported last year on that same non-GAAP basis was $139 million. So, there is $11 million right there, and there 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 an annual salary increase for the employees and just other general inflationary items. So, the $15 million is definitely there.

Gerry Heffernan - Lord Abbett & Company

Okay. If you could just tell me what you see as the, what you calculate the non-GAAP expenses to be for the current 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 that give yourself $128 million for the full year and I think you’re going to be able to prove that the expenses are there plus some -- expense reductions are there plus some.

Gerry Heffernan - Lord Abbett & Company

Okay. One final question, if I could.

Bob Hult

Sure.

Gerry Heffernan - Lord Abbett & Company

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

Bob Hult

Defense News, October 15.

Gerry Heffernan - Lord Abbett & Company

Okay. And I believe you said something about delivery of as far as what they are looking to do, as far as the Aegis system delivery of units in the second half of ‘08, were you referring 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 that answer.

Bob Hult

Calendar year ‘08.

Gerry Heffernan - Lord Abbett & Company

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

Bob Hult

Okay, you’re welcome.

Operator

And at this time gentlemen, we have no other questions standing by. I’d like to turn the program back to you for 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 we would remove some of the conflicts that you all have with other companies reporting out, and appreciate your attending the call, and we’ll see you in three months and ‘Go Red Sox’.

Operator

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

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