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Landec Corp. (NASDAQ:LNDC)

F2Q08 Earnings Call

January 4, 2008 11:00 am ET

Executives

Gary T. Steele - Chairman, Chief Executive Officer, and President

Gregory S. Skinner - Chief Financial Officer, Principal Accounting Officer, VP of Admin., and VP of Fin.

Analysts

Tony Brenner - Roth Capital Partners

Bill Gibson - Nollenberger Capital Partners

Jonathan Lichter - Sidoti & Company, LLC

Steve Denault - Northland Securities

Saloman Kamalodine - B. Riley & Co.

Craig Pieringer - Wells Capital Management

Shawn Boyd - Westcliff Capital Management

Jeff Osher - JMP Asset Management

Operator

Good day, ladies and gentlemen and welcome to the Landec Corporation’s first half and second quarter of fiscal 2008 earnings conference call. At this time all participants are in a listen-only mode. Later we’ll conduct a question and answer session and instructions will be given at that time. (Operator Instructions) As a reminder, this conference call is being recorded. I would now like to introduce your host for today’s conference, Mr. Gary Steele, President and CEO of Landec Corporation. Sir, you may begin.

Gary T. Steele

Good morning and welcome to Landec’s first half and second quarter of fiscal year 2008 earnings call. I have Greg Skinner with me today, Landec’s Chief Financial Officer. This call is being webcast by Thomson CCBN and that can be accessed at Landec’s website at www.landec.com on the Investor Relations page. The webcast will be available for 30 days through February 2, 2008. A replay of the teleconference will be available for one week by calling 888-266-2081 or 703-925-2533. The access code for the replay is 1176307.

During today’s call we may make forward-looking statements that involve certain risks and uncertainties that could cause actual results to differ materially. These risks are outlined in our filings with the Securities and Exchange Commission, including the company’s form 10-K for fiscal year 2007.

As reported in yesterday’s press release, for the first six months of fiscal year 2008, overall revenues of $121.6 million increased 14% while overall gross profit increased 29% from the year ago period. Net income increased to $6.2 million compared to $122,000 in the first six months of last year. Notably during the first six months of fiscal year 2008, Apio value added specially packaging vegetable products grew 11% to $78.7 million and value added gross profit increased 11% to $12.1 million. The gross margin in the value added business for the first six months of 15.4% is consistent with the year ago six months gross margin in the value added business.

In our technology licensing business for the first six months, revenues increased by $2.3 million while the license fee gross profit increased by $2.5 million compared to the same period last year, which was primarily due to the Intellicoat license agreement with Monsanto signed in December 2006. Overall, Landec generated $4.8 million in operating cash flow during the first six months of fiscal 2008. Based on the results for the first six months of fiscal year 2008, we are on track for achieving our revenue and net income goals for fiscal year 2008. Accordingly, we are not changing our original guidance for the fiscal year 2008 which is to increase revenues by 10% to 15% and, after excluding $18.8 million of non-recurring events from fiscal year 2007, to increase pre-tax net income by 45% - 55%, and increase net income after tax by 30% - 40% compared to fiscal year 2007 results.

As a reminder from our last call, during the first six months of fiscal year 2008, we expanded our joint technology license and supply agreement with Chiquita. The expanded agreement includes additional exclusive fields for bananas. In addition, Landec and Chiquita entered into a new exclusive license using Landec’s BreatheWay packaging technology for avocados, for which market tests for food service applications are already underway.

Under this agreement, in exchange for expanding the exclusive license fields for bananas and adding an exclusive license for avocados, the minimum gross profit amounts from the purchase of BreatheWay packaging by Chiquita will increase by a total of $2.1 million over Landec’s next fiscal years to $2.9 million in fiscal year 2008 and to $2.2 million in fiscal year 2009.

All in all, we are tracking well, and barring any significant and extended adverse weather conditions during the second half of fiscal year 2008, our progress is in line with our internal plan for meeting our goals for fiscal year 2008. Let me turn to Greg Skinner for details of our results.

Gregory S. Skinner

Thank you, Gary, and good morning, everyone. As outlined in yesterday’s news release, Landec reported total revenues for the first six months of fiscal year 2008 of $121.6 million versus revenues of $106.3 million for the same period a year ago. The increase in total revenues during the first half of fiscal year 2008 was due to first, an 11% or $7.8 million increase in revenues from Apio’s value added vegetable business, second, a 14% or $4.9 million increase in revenue’s from Apio’s commission trading business, and third, a $2.3 million increase in license fee revenues primarily due to revenues from the Intellicoat license agreement with Monsanto.

For the first six months of fiscal year 2008, the company reported net income of $6.2 million or $0.23 per share compared to net income of $122,000 for the same period last year. This increase in net income during the first half of fiscal year 2008 compared to the same period last year was due primarily to first, a $1.2 million increase in gross profits in Apio’s value added vegetable business, second, a $2.5 million increase in licensing gross profits as a result of the Intellicoat license agreement with Monsanto, and third, the elimination of $5.5 million of operating losses incurred by Landec Ag inthe first six months of fiscal year 2007 as a result of the sale of Fielder’s Choice Direct to Monsanto in December 2006, and the fact that under the Intellicoat license agreement, Monsanto is currently paying for all of Intellicoat’s operating costs.

These increases in net income were partially offset by one-time net proceeds of $1.5 million from an insurance settlement received during the first six months of last year which was reported as a reduction of general and administrative expenses inthe prior year, and from the increase inthe book income tax expense of $2.4 million during the first half of fiscal year 2008 compared to the same period last year.

It should be noted that only $150,000 of the $2.4 million of the book income tax expense is expected to be paid in cash because the repurchase of Apio’s options resulted ina tax deduction of $19.7 million which reduced Landec’s cash tax liability to the minimum owed under Federal AMT. However, for book purposes, the $19.7 million is not considered a deduction when calculating the income tax expense because the options that were repurchased had never been included in prior periods as an expense for book purposes.

For the second quarter of fiscal year 2008, Landec reported total revenues of $59 million versus revenues of $55.2 million for the same period a year ago. The increase in total revenues during the second quarter of fiscal year 2008 was due to a 10% or $3.5 million increase in revenues from Apio’s value added vegetable business and a $940,000 increase in license fee revenues, primarily due to revenues from the Intellicoat license agreement with Monsanto. These increases in revenues were partially offset by a $761,000 or 4% decrease in revenues from Apio’s commission trading business due to the timing of the export shipments.

The growth in overall revenues during the second quarter of fiscal year 2008 was lower than the overall revenue growth during the first quarter of fiscal year 2008 due to the timing of Apio’s trading revenues which are subject to seasonal fluctuation. During the second quarter of this fiscal year, Apio trading revenues decreased 4% compared to the second quarter of last year, whereas during this year’s first quarter, trading revenues increased 36% compared to the first quarter last year.

For the second quarter of fiscal year 2008, the company reported net income of $3.1 million or $0.12 per share compared to net income of $108,000 the same period last year. This increase in net income during the second quarter of fiscal year 2008 compared to the second quarter last year was primarily due to a $1 million increase in license and gross profits which is primarily due to the Intellicoat licensing agreement with Monsanto and the elimination of $3.1 million of operating losses incurred by Landec Ag inthe second quarter of fiscal year 2007 which is non-recurring due to the Monstanto deal.

These increases in net income were partially offset by first, the increase in income taxes of $1.2 million during the second quarter of fiscal year 2008 compared to the same period last year; second, a $391,000 decrease in gross profits in Apio’s value added vegetable business, primarily due to seasonal produce supply shortages during the second quarter of fiscal year 2008 which required Apio to purchase some produce on the open market at prices above contracted prices, compared to the year ago quarter when shortages were insignificant, and third, a $188,000 decrease in gross profits for the trading business primarily due to the timing of export shipments.

As Gary mentioned, during the second quarter of fiscal year 2008, gross margins for the value added vegetable business were 15.4%, which is in line with historical gross margins for the business. Inthe second quarter of last fiscal year, when there were virtually no supply shortages, the value added business generated gross margins of 17.9%, which is well above the historical average for Apio’s value added business.

Turning to the balance sheet, during the first six months of fiscal year 2008, our cash balance decreased by $17.4 million to $45.3 million. Cash balances primarily decreased because of the repurchase of all of the outstanding common stock and options of Apio’s not owned by Landec for $20.8 million, and the purchase of 1.5 million of value added property and equipment. This decrease in cash was partially offset by $4.8 million of cash generated from operations. That concludes my formal presentation. Gary?

Gary T. Steele

Thanks, Greg. Our first half results show the benefits of Landec’s increased focus on its two core businesses, the Apio food business and the technology licensing business. Inthe food business, the focus is on selling value added specially packaged vegetable products and on selling BreatheWay packaging to key partners for high value perishable produce products. Inthe technology licensing business, the focus is on licensing and commercializing Landec’s patented polymer materials to key partners outside of food applications.

During the first half we benefited first from normal weather patterns, second from increased demand for our specially packaged fresh cut food products, third from our licensing arrangement with Monsanto, fourth from increased interest income from the cash received from the sale of Fielder’s Choice Direct to Monsanto in December 2006, and fifth from the absence of losses from Landec Ag which had historically occurred during the first six months of each fiscal year.

As we look forward in our Apio business, a key driver of future revenue growth is to continue growth in our value added specialty packaged fresh cut product business to retail grocery stores, club stores, and food service outlets. To date, our business has grown at rates above market category growth and we have been able to take market share using our proprietary BreatheWay packaging technology that extends shelf life of perishable products. As consumers make better choices about their health and eating habits and continue to look for healthy fresh-prepared food products, we envision our category continuing to grow.

Turning to our non-food technology licensing business, we are busy first with our partnerships with Monsanto and Air Products as well as our internally-funded corporate R&D efforts focused on our unique polymer chemistry. We are expanding our R&D staff and filing more patents. In implementing our licensing strategy, we are dependent on our partners such as Chiquita, Monsanto, and Air Products to develop, launch, and market new products using our technology.

In our food business, our business plan does make provision for some weather variability issues, but not for extreme conditions such as prolonged freezing or heat waves. We are working to stay ahead in our markets and applications through innovation, uniqueness, and new products. We are pleased about our expanded relationship with Chiquita that does include a wide range of license applications for bananas using our BreatheWay technology. We are impressed with Chiquita’s brand, logistical support, customer relationships, international presence, and strength in technology development. Although the Chiquita-To-Go program is still relatively small, Chiquita nearly doubled the unit volume sales in calendar 2007 compared to 2006. Chiquita’s focus is to aggressively expand the Chiquita-To-Go convenience store program in North America and Europe to identify quick-serve restaurant chains that can benefit from having bananas on their menu and to continue to develop an array of products that will allow a successful roll out of retain products to grocery store chains.

In avocados, our focus with Chiquita is to package avocados to extend the shelf life of ripe and ready-to-eat avocados. Chiquita recently started food service market trials for avocados packed in our BreatheWay technology and retain grocery store product designs for avocados are now in development. In November 2007, Chiquita announced a major reorganization and restructuring of its company with the objective of reducing annual operating expenses $30 to $40 million per year to increase the focus of the company on innovation and technology. Chiquita has told us that Landec’s BreatheWay technology is their number one priority for creating value added businesses for bananas and avocados for both food service and retail markets. The reorganization initiatives at Chiquita appear to be positive for Landec. Inthe short term, there is going to be a transition period while Chiquita completes its reorganization and thus it will take some time for the new team to come fully up to speed as it relates to our retail grocery store banana applications. We will keep you posted on Chiquita’s progress.

Our work with Monsanto is progressing well. Monsanto is in early stages of assessing how Landec’s polymer technology can be used for seed coatings in broad areas including corn, soybeans, cotton, and canola. In addition, Monsanto is interested in evaluating how active ingredients such as insecticides, fungicides, and pesticides can be effectively delivered as a component within our Intellicoat coatings. We are obviously preparing for spring trials.

We stated earlier in this year that we would be seeking new partners or expanding current partnership agreements for selling our BreatheWay packaging technology for new product targets. Our first such agreement is the expanded agreement with Chiquita to collaborate on avocados and that’s our first move outside of bananas. We do expect to enter into an additional technology partnership arrangement with a new partner this fiscal year and hopefully during our third fiscal quarter.

Looking forward, we continue our search for possible acquisition targets inthe food arena that can utilize or are synergistic with our technology and that uses our channels of distribution. We will be very selective in our search and as stated earlier in this year, we are expanding our R&D efforts with the focus on delivering unique polymer systems that can deliver large and small molecules based on changes in temperature, time, and PH.

Thank you and we are now ready for questions.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions) Our first question comes from Tony Brenner of Roth Capital Partners. Your question, please.

Tony Brenner - Roth Capital Partners

Thank you. Gary, can you indicate what the reason for the auditor change was?

Gary T. Steele

Tony, it’s economics and solely economics. I’ve worked with Ernst & Young or Arthur Young, the predecessor for over 20 years, so this was not done casually but we just found that the fees were well above what we wanted to pay and we are going with the what would be called the number five accounting firm in the country, McGladrey, who has much more reasonable fees. We have no disagreements with Ernst & Young whatsoever. This is strictly economics and we felt this was in the best interests of shareholders to work with McGladrey, so we made the decision and made the change.

Tony Brenner - Roth Capital Partners

Okay. One balance sheet question. What’s the reason for the increase in the accumulated deficit year over year?

Gregory S. Skinner

That was the repurchase of the Apio options. That’s where it was recorded. Recall that it’s a tax deduction but not a book deduction so it didn’t go through the income statement. Everything was balance sheet so you had a debit to your gained earnings and a credit to cash.

Tony Brenner - Roth Capital Partners

Gary, judging from your comments regarding Chiquita, it sounds like at least over the short term that business is ramping up ata moderate pace. Does that mean they’ll be writing a check inthe fourth quarter to meet their guarantee?

Gary T. Steele

Yes.

Tony Brenner - Roth Capital Partners

Okay and last question. As I recall, atthe time you signed that revised licensing agreement with Chiquita, you indicated that that agreement was included in your guidance but additional licensing deals were not. So when you announced this new licensing deal, I’m assuming it involves some sort of up front fee or ongoing licensing fee. Would that be just added into your guidance?

Gregory S. Skinner

Let me just say that the collaboration that we’re working on and we hope to consummate is very oriented towards technology access for Landec and it’s not something that would be upfront license fees and it would not be therefore incremental to our guidance.

Tony Brenner - Roth Capital Partners

Can you say anything more about the agreement?

Gregory S. Skinner

No.

Tony Brenner - Roth Capital Partners

Thank you.

Gregory S. Skinner

Thanks, Tony.

Operator

Your next question is from Bill Gibson of Nollenberger Capital. Your question, please.

Bill Gibson - Nollenberger Capital Partners

I’m going to head into Chiquita’s well and the retail. They completed the initial market in consumer testing and they’re moving forward. Are they still using the technology in the test markets or has this come to a complete halt? What’s the nature of this?

Gary T. Steele

The first phase was finished and so right now we’re in development of new product formats and new configurations so currently as we speak we’re not inthe test mode but when we go back into the test mode, they’re clearly going to be using Landec’s BreatheWay technology.

Bill Gibson - Nollenberger Capital Partners

And arethe number of markets likely to expand?

Gary T. Steele

When you say number of --

Bill Gibson - Nollenberger Capital Partners

I think that if Chiquita was testing in three markets, do we have a five, do we have a ten?

Gary T. Steele

Well Bill, I’ll have to tell you that I don’t know and part of that answer is that there are some new players and some new people involved in our collaboration. It looks like they’re going to be the right folks focused on the right things but there is a transition here with Chiquita that is going to take about a quarter or two for some of this to sort out. Will they go into more expanded trials? I don’t know. I would guess they’d start with about the same number that we left off with which was about 80 store sites, but I really don’t know for sure, Bill, and we’ll know more in the next quarter.

Bill Gibson - Nollenberger Capital Partners

Okay. Thanks, Gary.

Gary T. Steele

Thank you.

Operator

Your next question is from Jonathan Lichter of Sidoti & Company. Your question, please.

Jonathan Lichter - Sidoti & Company, LLC

Good morning. You mentioned it would take a quarter or two to sort out. Does that mean that we’re looking at some time in ’09 before they could possibly roll this out to supermarkets?

Gary T. Steele

Are you referring to fiscal year or calendar?

Jonathan Lichter - Sidoti & Company, LLC

Calendar year.

Gary T. Steele

I would hope it’s earlier than that. It’s hard for me to tell, Jonathan, with this transition, but I think our hope and expectation is that it could be sooner than that.

Jonathan Lichter - Sidoti & Company, LLC

Okay. How many locations is Chiquita-To-Go in currently?

Gary T. Steele

You know, I don’t know. They just reported that they’ve doubled or nearly doubled their sales volume, unit volume. I’m not sure what the sites are and so I hate to give you a bad number, but I think the last time they reported, I’m trying to remember... Greg, can you remember the last time they publicly reported sites?

Gregory S. Skinner

I’d say conservatively over twelve so that would indicate 12,000.

Gary T. Steele

Over 12,000 sites. So they’re in more than that, Jonathan, but we don’t have a precise number right now.

Jonathan Lichter - Sidoti & Company, LLC

Okay. Can you break out how much of that $177,000 is from Chiquita versus from the military?

Gregory S. Skinner

It’s about 50-50.

Jonathan Lichter - Sidoti & Company, LLC

Okay. Should we read anything into the fact that you reported the six month results before the Q2 results?

Gary T. Steele

No, other than to say that what we’ve said all along is that we’re trying to build shareholder value over the long term and the way we measure ourselves and the way we run the business is to meet annual goals and we’re just not a quarter-by-quarter company. Anybody that gets too worked up on a quarterly basis really this is not us. So our format going forward will be to report first and foremost year-to-date results which is consistent with the way we’re running the company and then we’ll report the quarterly results so I wouldn’t read anything into it other than that.

Jonathan Lichter - Sidoti & Company, LLC

Thank you.

Gary T. Steele

Thank you.

Operator

(Operator Instructions) Our next question is from Steve Denault of Northland Securities. Your question, please.

Gary T. Steele

Good morning, Steve.

Steve Denault - Northland Securities

Good morning, everyone. The management turnover within Chiquita, did that fall after or before the new fields of bananas where that agreement was struck and the avocado agreement was struck?

Gary T. Steele

The order was the new agreement was struck and then the reorganization was announced in early November and it was significant, and Fernando Aguirre, the CEO of Chiquita’s charter, which hehas been very clear about, is to revitalize Chiquita into an innovation company and a company focused on value added products and less so from commodity businesses, sothe order was the agreement was struck, some time went by and then they reorganized and announced that reorganization in November, but I am sure the senior team knew about the reorganization at the time of doing our deal.

Steve Denault - Northland Securities

Okay. How recent was their decision to trial intelligent polymer within the food service channel?

Gary T. Steele

You mean our packaging technology for bananas?

Steve Denault - Northland Securities

Yeah, and then food service.

Gary T. Steele

They’ve been actually, this Chiquita-To-Go program which we referred to that almost doubled in the last year is really food service so they’ve been at that for over 18 months, maybe 24 months, and they focus on convenience stores, coffee chains, mini mart gas stations, so that would all be viewed as food service. So they’ve been at that for a while. Their focus now, actually they’re going to continue to roll that out, their focus now is to really go after some large quick-serve restaurant chains which you might call fast food outlets et cetera, so that’s a priority for them, and then the other priority is to learn from the market research that we did in the last couple of quarters for retail grocery stores, get that information incorporated into some new product configurations, new product formats, and then get that back into testing as soon as possible. So that’s their list of priorities.

Steve Denault - Northland Securities

Okay and remind me again, Chiquita does the apple bites for which QSR?

Gary T. Steele

I think they do it for McDonald’s, don’t they?

Gregory S. Skinner

I think Subway also.

Gary T. Steele

Subway and McDonald’s. So yeah, that’s Chiquita.

Steve Denault - Northland Securities

Okay. Considering that we’re I guess well into the third quarter, there’s a little bit in the way of sourcing shortages in the second quarter, how is the sourcing looking through the quarter to date?

Gary T. Steele

Well, it was looking really good. We’ve got in the Northern California area we’ve got four days of horrendous storms. We had a contingency plan here in case our power went out, what we were going to do with this call. Whether that makes its way and affects the central growing areas, we won’t know for a while, but so far the sourcing has been just fine, Steve.

Steve Denault - Northland Securities

Okay, and then if I could ask one final question. Within value added, if we look at the 9% or 10% growth, how much of it was organic versus new distribution, if you know what I mean?

Gary T. Steele

Could you elaborate just a little? I think the growth was 10% but when you say organic, sometimes we get confused with organic produce.

Steve Denault - Northland Securities

Right, right. Meaning how much of it was, what would the same store sale number have been versus new doors of distribution?

Gary T. Steele

Let me get back to you because Greg and I don’t know that. It’s a fair question. We owe you an answer. I just don’t have it right now.

Gary T. Steele

Okay.

Gary T. Steele

I understand your question and we’ll get back to you.

Steve Denault - Northland Securities

Okay, thank you.

Operator

The next question is from Saloman Kamalodine of B. Riley & Company. Your question, please.

Saloman Kamalodine - B. Riley & Co.

Hey guys. Can you comment on your licensing pipeline beyond this deal that you expect to announce before the end of February?

Gary T. Steele

The licensing in my experience, and I’ve done it for a lot of years, is kind of a bumpy... It comes in fits and starts and we have been focusing on this next technology access license for some time so that’s been a priority for us. I would say that of our priorities, obviously we have other things that we’re working on, but I don’t know if any of those would materialize this year and I would ask you not to expect those, not this fiscal year, but we’re putting more attention and time into the M&A area and so that’s a priority for us, but we’re going to be darn picky and choosy about that. So if I had to steer you, I’d say imagine that more and more of our emphasis and focus is inthe M&A area right now because we see an opportunity to extend and expand our technology more quickly that way.

Saloman Kamalodine - B. Riley & Co.

Would that take theform of acquiring a company that is currently generating revenue or would you be buying patents or what should we think about?

Gary T. Steele

No, our orientation is to real companies making real earnings, which is part of the challenge because there area lot of companies out there that are just one year away from making money if you know what I mean.

Saloman Kamalodine - B. Riley & Co.

Right, but where the technology would be complimentary --

Gary T. Steele

We would have -- our technology could be directly applied the next day. That’s what we’re looking for.

Saloman Kamalodine - B. Riley & Co.

Okay, and as far as what you’re looking at today, do you internally the way you work, do you just focus on one or two large opportunities or at any given time do you have several opportunities that you’re involved in?

Gary T. Steele

Are we still in the M&A area or --

Saloman Kamalodine - B. Riley & Co.

No, this is just the licensing.

Gary T. Steele

Okay. We look broadly and as I mentioned earlier, we’re stepping up R&D spending and we’re really interested in how our technology... To date our technology has been primarily relying on the triggering of a temperature switch, an on/off switch that in the case of packaging is helping us control an atmosphere as we go through a volatile temperature cycle through the coal chain and the distribution cycle. We’re increasingly finding that we can do similar types of things with changes in PH or changes in time and so we’re putting more emphasis in our R&D on expanding our patent estate and looking for new applications. By the way, some outside of the food area. Not allare inthe food area. So that’s a stepped up emphasis for us and I gave guidance to that earlier inthe year that we’d be doing this and we are.

Saloman Kamalodine - B. Riley & Co.

Okay. Can you give us a little bit of guidance on what the take or pay payment will be from Chiquita next quarter?

Gary T. Steele

Well, for the entire year, Saloman, as we reported, it’s $2.9, and as you can see based on the results from Apio packaging or the first half of the year there was very little, so you can assume that most of that $2.9 is going to occur inthe second half and I think it would be safe to say it’s about 50-50 third quarter and fourth quarter.

Saloman Kamalodine - B. Riley & Co.

Okay, and then finally can you comment on the opportunities that you have in front of you to expand the margins at Apio value added on a longer term basis either by sourcing maybe south of the border or anything of that sort?

Gary T. Steele

Let me cut to the chase and tell you that our goal and objective is to maintain the current margins. We’ve got quite a bit of pressure on thecost side. I don’t need to tell you about fuel costs going up and how that affects farming, et cetera. So we’ve got quite a bit of pressures to offset cost increases so while we would love to expand margins on the existing fresh cut specialty package VA veg business, I think realistically our goal and objective is to try to maintain those. Where we want to change the margin mix for the company is by having a higher percentage of our future margins coming from licensing revenues and royalties and from our packaging only business where we’re selling only packaging at very high percentage margins to partners such as Chiquita so within the VA veg business, realistically, we sure would like to try to maintain that as we face these increasing costs, but overall over time, we want the margin mix to change to help increase the overall margins of the company as I mentioned.

Saloman Kamalodine - B. Riley & Co.

Sure. Okay, thanks.

Gary T. Steele

Thank you.

Operator

Our next question comes from Tony Brenner of Roth Capital Partners. Your question, please.

Tony Brenner - Roth Capital Partners

Thanks. You answered half of this regarding third quarter sourcing but it seems to me it’s kind of unusual for you to have sourcing problems in the second quarter. What was the nature of that?

Gary T. Steele

There weren’t any major sourcing problems. Maybe we confused you a little bit. If you’re referring to maybe the export revenues being down? There weren’t any huge sourcing problems in the second quarter, Tony. It was more related to the timing of export. We had a huge first quarter export, I think it was up something like 34% or 36% and inthe second quarter it was down 4% and it’s just the timing of when shipments are recorded.

Tony Brenner - Roth Capital Partners

In the Apio value added business you referred to seasonal supply shortages which caused you to have to purchase some product on the open market and which hurt your profit margins.

Gregory S. Skinner

If you look atit Tony, our margins are actually in line with what the first quarter was. We fact or in that we’re going to have produce shortages. I mean, that’s just the nature of the business. The real issue is when you compare it to last year’s second quarter.

Tony Brenner - Roth Capital Partners

What was the issue with the shortage? I’m not quite --

Gregory S. Skinner

It was just normal shortages. It’s typical. Our average margin in this business is around 15%. We did 15.425%. The issue is when you compare it to last year’s second quarter when all the stars were aligned and everything is perfect and we had virtually no shortages. Our margins were almost 18% which is well above the historical average, so it’s --

Tony Brenner - Roth Capital Partners

My question was that it’s unusual for you to have those shortages in the second quarter. What then caused that?

Gregory S. Skinner

Nothing spectacular. It was modest, very modest impact. It could be for anything, just timing of products coming out or maybe the yields were down in some fields. A year ago we got hit in the first quarter. That doesn’t normally happen. It’s just the nature of the business. It was in the normal range and that’s why our margins are 15.4% which is historical average.

Tony Brenner - Roth Capital Partners

Okay, thank you.

Gary T. Steele

Thank you, Tony.

Operator

Our next question is from Craig Pieringer of Wells Capital Management. Your question, please.

Craig Pieringer - Wells Capital Management

Good morning, Gary and Greg. At the end of your prepared comments and you just addressed this with the last caller, I perked up when you started to talk about temperature time and PH for the large and small molecules, but I didn’t catch the context of what you delivered that, Gary.

Gary T. Steele

I’m just saying that we’re increasing our R&D spending, filing more patents, and what we’re discovering is that there is more breadth to the technology than perhaps we realized. We’ve been totally dependent over the years and focused on the use of the temperature activation feature and we’re finding that there’s some things that we can do and we can make our polymers water loving and oil loving and turn them on and off and go back and forth which gives us some interesting applications in terms of time release. We now learned that we can pull things and not release them at one PH and release them at a different PH and so that gets you into some interesting thoughts as to how you might be delivering a drug or a catalyst or an insecticide or a food ingredient, et cetera, et cetera, with these different triggers, and so this... and I want to caution that this is in R, this isn’t D&S, but you can’t get the D unless you do the R. So I mentioned early in the year that we felt it was time to invest more in our technology and we’re discovering that it has more breadth than perhaps we realized.

Craig Pieringer - Wells Capital Management

You answered pretty much what I was asking without me asking it, which it sounds exactly like a pharmaceutical delivery technology so you’re onto that.

Gary T. Steele

You’ve always been very insightful.

Craig Pieringer - Wells Capital Management

Thank you.

Operator

Our next question comes from Shawn Boyd of Westcliff Capital Management. Your question, please.

Shawn Boyd - Westcliff Capital Management

Hi Gary, Hi Greg. Just a few for you. If I could, Greg, I want to come back to the minimum payment to Chiquita. Did I hear you say that we should think about that being split 50-50 inthe February and May quarters?

Gregory S. Skinner

Yes.

Shawn Boyd - Westcliff Capital Management

Okay, and that’s related to the expansion of the deal because of the avocados?

Gregory S. Skinner

Well, it’s mainly the expansion of the fields for bananas is the primary reason for the increase to $2.9 million this year, but there is a smaller component in there for avocados, yes.

Shawn Boyd - Westcliff Capital Management

Okay, but versus say previous years where itall hit inthe February quarter?

Gregory S. Skinner

Exactly.

Shawn Boyd - Westcliff Capital Management

Got it. Okay and on the value added I think on the gross margins we hit that pretty well. I just want to go to the gross. We’ve talked inthe past about 10% to 15% revenue growth on this business. We’re just a hair under the midpoint, kind of the low end of that for the first half of the year, and I’m looking back and I’m seeing, well, you know, first half of ’07 was 17% to 18% growth, so is it kind of an issue of difficult year over year compares here and then we would expect to see that maybe a little above the midpoint inthe back half of the year?

Gary T. Steele

Good question. There could be a combination of things here, Shawn, and it’s hard for us to judge, but one of the challenges is when you’re getting up inthe market share territory that we’re in, each new customer and each new share gain is a little tougher, so there may be some of that going on. I can’t tell you if there’s any impact from folks worrying about recession, et cetera, et cetera, and how we’ll be impacted by that or are impacted by that, but it could just be a combination of things. We’ve also got some tough competitors out there who want to do things on a regional basis and say, “Hey, I can getit to you the next day” so I think there’s a combination of things going on here that we have to address in order to keep the growth engine going.

Shawn Boyd - Westcliff Capital Management

Got it and at this point, is it still a 10% to 15% growth business?

Gary T. Steele

Well ithas been, let’s just put it this way, historically we get what’s called Nielsen data which is fairly, it’s very reliable actually. To date ithas been. Does that predict the future? No. The good news is people even in recessions need to eat and they want to eat ina healthy way so I think that’s going for us.

Shawn Boyd - Westcliff Capital Management

And maybe on that point, in terms of consumer spending, your industry data showing your competitors, kind of showing the categories we think about prepackaged produce and fresh cut produce, are you seeing any slow down on the industry data, not just Landec?

Gary T. Steele

There was one quarter where there was a slow down and our guys warned us that you can’t really make any predictions based on one quarter, but there was, I think it was a couple quarters ago, there was a slow down in the category, but it was a headscratcher, Shawn. We ought to ask this question next quarter and let mesee if we’ve got some better data on that.

Shawn Boyd - Westcliff Capital Management

Got it. Moving to another point, the first half on operating expenses, Greg, would you say that the run rate that we’ve got now on SG&A and R&D for the first half, are those fair proxies for the second half or given the commentary on increasing R&D we should be thinking about that being up a little bit second half?

Gregory S. Skinner

It will be up a little bit in the second half for the reason you just --

Shawn Boyd - Westcliff Capital Management

Okay. SG&A?

Gregory S. Skinner

SG&A should pretty much track the first half.

Shawn Boyd - Westcliff Capital Management

Okay. Thank you and moving back for a second, Gary, could you give us... I came onto the call late and I apologize, but maybe you could address a little bit more detail on where we are now with the military and kind of timing on what you see on commercial development there and then also with air products?

Gary T. Steele

Military testing this year, I mean you know, we know the technology works, so it’s the issue of how do you get our technology through their distribution channels ina practical way. If a ship is deploying, how does that all work? Where does the produce and the packaging come together? Where is it stored? Those types of things. The view this year is the practical testing of our technology in real people’s hands, not in laboratories and then hopefully that would lead to commercialization, not this year, and I’m talking about calendar year, not this calendar year, but the next calendar year. It could happen faster, I don’t know. Air products is we’re growing the business. I will tell you honestly it’s slower than I’d like to see. They’re good folks. We’re developing new products for them. Inthe personal care area, it’s not as awful as drug development but it’s a pretty tedious process of going through safety and tox studies and going through what’s called the coding process where ithas to be accepted by the customer and go into their system. Soit takes time and we’d like to turn on the afterburners here but there’s just a process you have to go through. Sothe sales are expanding, there’s still relatively small for us, b but they’re positive and we’re positive, and all we can do is crank out new materials and that’s what we’re doing.

Shawn Boyd - Westcliff Capital Management

So inthe meantime, we’ve got the minimum from air products and then maybe just a little beyond?

Gary T. Steele

Right.

Shawn Boyd - Westcliff Capital Management

And then last point, the M&A discussion that we had earlier, Gary, I just want to think about this a little bit more. You mentioned you want real revenues and real earnings, places where Landec technology can be applied day one. We’ve talked inthe past about the frustrations over our partners moving fairly slowly. Is this another example of where you’re trying to acquire a partner so to speak? Not anything of this size when we’re talking about Chiquita, but something where you would have more control going forward over the time table and being able to accelerate the commercialization of your technology?

Gary T. Steele

I like the way you stated that. I know a lot of our investors and shareholders like licensing deals and I do too and I think it’s good to have a good healthy mix of that. It helps us improve and our margin mix over time and I think that we’re working on that and I think we’re getting a good mix in our revenue and margins but I still like having parts of our business where we arein control of our destiny and we have that today in our much of our Apio business and inthe targets in where we’re looking in acquisition would put the new acquisition if we ever doit into the bucket where we’re controlling our destiny. So to answer your question, yes, that’s our focus. Will it happen? Don’t know. Got to bethe right target, got to be the right time, the right terms. But we sure are focusing on it.

Shawn Boyd - Westcliff Capital Management

Yeah. That would be wonderful. Good enough. Sounds interesting and I appreciate the answer. Thank you.

Operator

Our next question is from Jeff Osher of JMP Asset Management. Your question, please.

Jeff Osher - JMP Asset Management

Hey guys. It sounds like you continue to do a good job building the R&D pipeline. With regard to one of the previous callers’ questions about an OpEx run rate, and I know that... Let me ask, what is the gross R&D? In other words, what is it, I know you only spend $785,000 out of your own coffers, what’s Monsanto subsidizing?

Gary T. Steele

Let me mention to you to that our total R&D if you look at R&D broadly across Landec is about $4 million, $3.5 to $4 million.

Jeff Osher - JMP Asset Management

A quarter?

Gary T. Steele

No, no, that’s a year.

Jeff Osher - JMP Asset Management

In the scheme of things, that’s such a small number when you start talking about drug delivery. I know you didn’t say that per se, but one of our fellow shareholders mentioned that. Can we expect that number to go up? I mean, you spent $788,000 as far as your income statement and I guess what I’m asking is was any of that subsidized by Monsanto or is there a gross number that you don’t report on the income statement that Monsanto’s paying the delta between the gross number and the $788,000 of R&D you spent this quarter?

Gary T. Steele

Yeah, the number that we’re showing is strictly the Landec expense. The amount that Monsanto’s reimbursing is a net so it’s not grossed up here. So they pay for the Intellico group, that’s a direct reimbursement of costs soit doesn’t show up as an expense.

Jeff Osher - JMP Asset Management

What’s that number?

Gary T. Steele

It’s about... It’s historically averaged about $1 million.

Jeff Osher - JMP Asset Management

Okay, but that’s dedicated solely to Intellico.

Gary T. Steele

Solely to Intellico, paid by Monsanto does not show up on our income statement at all.

Jeff Osher - JMP Asset Management

So how many engineers do we have working on product development?

Gary T. Steele

I’d say that we’ve got about 20. The whole company is 150 people, not counting our direct contracted labor in our plant. I also want to address a question that you had but I want you to finish this point, but you had another question in there that I want --

Jeff Osher - JMP Asset Management

No, that’s really helpful, Gary, that you have 20 engineers. That’s a good number.

Gary T. Steele

They’re more scientists than they are engineers. We do tolerate engineers in our buildings but... You mentioned something about how could you do anything like drug development or things like that when we all know that those things cost many millions of dollars a year once you get into full development. Let me just say that Landec has its strengths and weaknesses but I will say that one of our strengths is that we are good at doing deals and trying to shape and structure shareholder value, at least I think we are, and we did this earlier inan area called the Aesthetic Science Corporation which we came up with the idea of how it might be used in a specialized area of dermal fillers. It’s a hot area, it’s a growing area, there’s some key people that are running that business that we’re attracted to this idea, some venture capital funders came in and we took a 19.9% equity position. We don’t bear any of the expenses now. They bear allthe expenses, et cetera, et cetera. There are different ways of getting programs and projects that have a lot of merit to a certain point and then you spin them out or carve them out or whatever and we still capture value, so we’re always thinking that way. We’re not expecting if Craig is right about this being drug delivery or drug development, we’re not going to be spending $20 million a year in R&D on drug delivery, so we’re going to get it to a certain point and then we’ll seek partnerships.

Jeff Osher - JMP Asset Management

Okay. That’s very helpful, that clarification and I guess one follow up if I may. With regard to OpEx, I know you guys manage the business on an annual basis, so is there any seasonal reason for the sequential drop in OpEx from Q1 to Q2? I guess if we would have held OpEx flat you would have made $0.10 as opposed to the $0.115? Should we think about that OpEx run rate of $5-ish million going forward or are you guys going to continue to whittle OpEx out of the company?

Gary T. Steele

It was just a timing issue. Remember during the first quarter we were going through our year-end. You’ve got accounting, you’ve got legal fees, and you get some big pops and patents. Those can come in little boluses so don’t read anything into that.

Jeff Osher - JMP Asset Management

Okay sothe $5 million t hen, that’s a pretty good number to model inthe back half on a quarterly basis?

Gary T. Steele

Yeah.

Jeff Osher - JMP Asset Management

Hey, thanks a lot guys, keep up the good work.

Operator

At this time I’m showing no further questions from the audience.

Gary T. Steele

Thanks everybody for being on our call and we look forward to keeping you posted on our progress and results. Many thanks.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This concludes the program. You may now disconnect. Good day.

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Source: Landec F2Q08 (Qtr End 11/25/07) Earnings Call Transcript
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