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AeroVironment, Inc (NASDAQ:AVAV)

F3Q08 Earnings Call Transcript

March 3, 2008 4:30 pm ET

Executives

Steven Gitlin – Director IR

Timothy Conver – Chairman, CEO

Stephen Wright – CFO

Analysts

Chris Donaghey – SunTrust Robinson Humphrey

Troy Lahr – Stifel Nicolaus

Partick McCarthy – Friedman, Billings, Ramsey & Co

Timothy Quillin – Stephens, Inc

David Gremmels – Thomas Weisel Partners

Randy [Gorkman] – [Baring Capital]

Analyst for Brian Gesuale – Raymond James

Operator

Good day ladies and gentleman, and welcome to the third quarter and fiscal 2008 AeroVironment Incorporated Earnings conference call. My name is Eric, I’ll be your coordinator for today. At this time all participants are in a listen only mode. We’ll facilitate the question and answer session towards the end of the conference. If at any time during the call you require assistance, touch star followed by zero and a coordinator will be happy to assist you. I would now like to turn your presentation over to your host for today’s call Mr. Steven Gitlin Director of Investor Relations, please proceed sir.

Steven Gitlin

Thank you very much Eric. Welcome everyone to AV’s third quarter fiscal 2008 earnings call. Joining me today are AeroVironment’s Chairman, Chief Executive Officer and President, Tim Conver, and the company’s Chief Financial Officer Steve Wright. Before I had the call over to them please note that on this call, certain information presented contains forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward looking statements include without limitation, any statement that may predict, forecast, indicate or imply future results, performance or achievements and may contains words such as believe, anticipate, expect, estimate, intend, project, plan or words or phrases with similar meaning.

Forward looking statements are based on current expectations, forecasts and assumptions that involve risks and uncertainties including but not limited to, economic, competitive, governmental and technological factors outside of our control that may cause our business strategy or actual results to differ materially from the forward looking statements. Factors that could cause actual results to differ materially from the forward looking statements include but are not limited to reliance on sales to the U.S. government, changes in the supply and or demand and or prices for our products, the activities of competitors, failure of the markets in which we operate to grow, failure to expand into new markets, changes in significant operating expenses including components and raw materials, failure to develop new products, changes in the regulatory environment and general economic and business conditions in the Unites States and elsewhere in the world.

For further lists and descriptions of such risks and uncertainties, see the reports we file with the Securities and Exchange Commission. We do not intend and undertake no obligation to update any forward looking statements whether as a result of new information, future events or otherwise. The content of this conference call contains time sensitive information that is accurate only as of today March 3rd, 2008. The company undertakes no obligation to make any revision to the statements contained in our remarks or to update them to reflect the events or circumstances occurring after this conference call. With that it’s my pleasure to turn the call over to Tim Conver.

Timothy Conver

Thank you Steven. Welcome to our third quarter fiscal 2008 conference call. During the Quarter we continued to improve already strong customer relationships. We executed well with strong operation margins. We had good progress on development programs and market demand for our small unmanned aircraft system remained strong. Market interest in our new solutions that we are developing continues to grow particularly in our UAS segment, but also in our positive charge and energy technology segments. We continue to see demand for our unmanned aircraft system or UAS.

Some of you may have seen recent articles that showed how the military is increasingly using unmanned aircraft as regular embedded tools in combat. The army says that raven flight hours in OEF and OIF which dominate overall unmanned flight hours will double from about 150,000 to 300,000 this year. In my view this reinforces our belief that small UAS have become permanently woven into the way our customers operate and that they perform a uniquely valuable mission. Our own progress in meeting our customer’s needs has moved forward as well. Our product line is strengthened as a result of Wasp transitioning to full rate production. Customers procured and deployed both raven and Wasp systems as evidenced by the $19.3 million Marine Corp Wasp order in November and the post quarter $45.8 million acquisition of Raven systems as part of the Army SUAS contract.

It’s significant that the Marines planned to issue their Wasp systems to the platoon level. I believe this supports our view that these small unmanned aircraft systems will increasingly be acquired and issued to lower levels of the core structure where they are actually used to great benefit. UAS service revenue grew again during the quarter. We made great progress on the preliminary design milestones of the global observer development program during the quarter while we continued adding new people to fill out our project team.

Our project revenue is influenced partially by the pace that we increase our staff so as we accelerate our hiring and apply more resources to the global observer program, our related revenues should increase. I believe that the fundamental drivers of our business and the market for our solutions remain strong. Our customers continue to reward us with their business. Our team continues to make great progress on multiple fronts and we remain subject to short term bumpiness. We’re continuing as before investing in R&D, working to improve our services, remain very close to our customers and being responsive to their needs. We haven’t changed our positive view of the future.

From a financial perspective, our results reflected everything I’ve just said. Q3 revenue of $48.8 million increased over the same period last year by 5% with a healthy operating margin of 16%. That brings our revenue for the first three quarters of the year to $151.4 million, 23% higher than in FY ’07 with a year to date operation margin of 12.8%. As I said earlier, the main contributor to our growth and revenue compared to last year is the performance of our UAS segment. We experienced a strong increase in UAS service revenues reflecting the growing number of our systems used by our customers and the conversion of Raven A systems to the B configuration.

Our services business currently has a lower growth margin than our products, however our view is that services will continue to be a valuable and a growing contributor to our revenue and our profitability. As an indication of international interest in our systems, the Spanish Armed Forces purchased their first Raven system during the quarter. International sales are still a small portion our UAS business, but we see a growing stream of international interest in, we are currently working on a number of additional overseas procurement opportunities.

Our UAS development programs advanced on multiple fronts and continue to garner both customer funding and support. Global observers, switchblade and digital data link are all pioneering programs that offer transformational new capabilities. We’re developing global observer under contract, we announced in September of 2007. Global observer can be thought of as a stratospheric satellite system with two aircraft taking turns circling over any area on the globe. Each aircraft will fly for up to seven days without landing providing affordable system coverage from the stratosphere for a variety of communication and ISR applications.

As I mentioned last quarter, this program is funded by multiple US Government customers, each of which has its own mission application for the global observer platform. We’ve achieved in important milestones in testing of global observers innovated liquid hydrogen fueled power plant including operation of the production configuration power plant at assimilated altitude 65,000 feet. We’ve also competed fabrication of the first full sized center wing section for the aircraft. This once segment is approximately 40 feet from end to end and it’s the most complex of the five carbon composite segments that make up the global observer’s 175 foot wing.

Our energy technology center continues to build and successfully test other key elements of the aircraft’s propulsion and energy management systems. Another development program, Switchblade, is a compact package small UAS that’s designed to be launched from a tube, this system has the same basic reconnaissance capabilities and grown control system as Raven and Wasp, but it also carries and explosive charge to enable highly precise strikes against threats such as mortars and snipers.

This system represents an entirely new capability to combine small size, affordability, eyes on target and precision strike with minimal collateral damage. Our Switchblade performance of this program has been very positive leading to a recently received add on order for additional test units and demonstrations from our initial customer. There is also active interest in this solution across a growing range of additional customers. Digital data link is also moving forward as a means to significantly enhance the utility of our small unmanned aircraft systems. We have successfully demonstrated digital data link to our customers and we’re currently improving its manufacturability and integration into our production small UAS.

I’m pleased with the performance and progress of each of these development programs and encouraged by the customer response. I look forward to reporting on their significant milestones to you in the future. As these development programs move closer to becoming part of our UAS portfolio, and as the throughput of our existing products increase, we’re continuously enhancing our operational capabilities, both to build competitive advantage and support profitable growth. This quarter we expanded our management team with the addition of an experienced aerospace operation executive. John Stelth, our new Director of UAS operations has held executive positions in program management, general management and operations. Most recently, John was the operations leader working on the development of the one piece composite fuselage for the new Boeing 787.

John’s already a key contributor to our organization. Moving on now from the UAS segment, PosiCharge fast charge solutions for electric material handling vehicles, we had a decline in year over year quarterly revenue during Q3 with a year to date PosiCharge revenue remaining approximately level with the same nine months of last year. We have not see the acceleration of the fast charge adoption that we have looked for, however during the quarter PosiCharge secured new customer, expanded its base of installed systems to over 9,000 charge ports, strengthened relationships with large existing customers and made progress on new applications and geographies.

These are all indications that PosiCharge continues to deliver real productivity improvements and cost savings. I believe we continue to have the leading market share in the competitive market space, and that the industrial fast charge market has the potential to grow dramatically as adoption extends beyond the current estimated single digit penetration of electric lift utility truck market.

Our third quarter, or our third reporting segment, energy technology center, continued to position AV to capitalize on the great potential of efficient electric energy technology solutions that are both innovative and practical. In addition to providing unique technology solutions for important internal initiatives and marketing its power processing testing equipment, the group released a new architectural wind turbine and blade assembly this quarter.

This new turbine is rated at 2.5 times the energy production of its predecessor while utilizing the same enclosure on interconnect infrastructure, providing a much improved customer value proposition. As we continue to sell and install early adopter systems at customer locations, architectural wind is generating great interest amongst those seeking new renewable energy generation solutions. ETC is also working to adapt our fast charge technology into a practical solution that would help enable broader use and adoption of on road electric automobiles and trucks. As the demand for these electric vehicles grow, we intend to be the supplier of choice for fast charge infrastructure.

As we head into the fourth quarter, our customer relationships remain strong, our team continues to perform very well and we’re favorably positioned for future growth. With that as overview Steve Wright, our CFO will review our second quarter financial results, Steve?

Stephen Wright

Thanks Tim, good afternoon. Revenue for the third quarter was $48.5 million an increase of 5% over third quarter, prior year of $46.3 million. Looking at revenue by segment, UAS revenue was $42.2 million an increase of 9% over the prior year. The growth in UAS revenue as in services and customer funded R&D partially offset by reduced product sales. Power charge revenue was $4.1 million a decline of 24% from Q3 last year primarily due to lower revenue in the non auto markets. Energy technology center revenue was $2.3 million an increase of 9% from Q3 last year due to higher power processing test equipment deliveries.

Turning to gross margin, gross margin in the third quarter was $19.8 million compared to $19.6 million in Q3 of the prior year. Gross margin as a percent of revenue was 41 % compared to 42% in Q3 last year. By segment, UAS gross margin was $17.5 million up 5% from Q3 of last year. As a percent of revenue UAS gross margin was 41% compared to 43% in Q3 last year. This decrease in gross margin rate was primarily due to higher program costs and higher costs plus content. PosiCharge gross margin was $1.4 million down 28% from Q3 of last year, primarily due to a lower sales volume.

As a percent of revenue, PosiCharge gross margin was 34% versus 35% in Q3 of last year. Energy technology center gross margin remains unchanged at $1 million compared to Q3 of last year. SG&A expense for the quarter was $8.2 million or 17% of revenue compared to $4.2 million or 9% of revenue in the prior year. The prior year amount included a one time expense reduction of $2.2 million for a SERP pursuant our IPO. Excluding this reversal SG&A expense increased $1.8 million, primarily due to higher selling and marketing expense. R&D expense for the quarter was $3.7 million or 8% of revenue, compared to $2.2 million or 5% of revenue in the prior year.

Customer funded R&D during the quarter was $6.9 million or 14% of revenue, compared to $5.3 million or 11% of revenue in the prior year. And total R&D internal and external was $10.5 million or 22% of revenue, compared to $7.5 million or 16% of revenue in the prior year. Operation income for the quarter totaled $8 million or 16% of revenue. Operation income was 40% below the prior Q3 amount primarily due to the higher SG&A and higher R&D investment.

Net income for the quarter was $6 million or $0.28 per fully diluted shared compared to $8.9 million or $0.57 per fully diluted share in the same quarter last year. Now moving quickly to our year to date results, revenue for the first nine months totaled $151.4 million up 23% from the prior year period of $123 million. By segment, UAS revenue was $130.6 million up 29% from the prior year period. PosiCharge revenue was $14.7 million, down 1% from the prior year period. And energy technology center revenue was $6.1 million, down 6 % from the prior year period.

Gross margin for the first nine months totaled $55.6 million compared to $49.4 million in the same period a year ago. Gross margin as a percentage of revenue was 37% a decline of 3% points from the prior year period. By segment, UAS gross margin was $48.5 million, up 20%, PosiCharge gross margin was $4.7 million down 17% and energy technology center gross margin was $2.4 million down 26% from the prior year.

SG&A expense for the nine totaled $24.5 million or 16% of revenue compared to the prior year amount of $17.1 million or 14% of revenue which again included the SERP reversal of $2.2 million. R&D for the first nine months totaled $11.8 million or 8% of revenue compared to $9.3 million or 8% of revenue in the prior year. And total R&D internal and external was $28.8 million or 19% of revenue versus $21.6 or 18% of revenue in the prior year.

Operating income in the first nine months was $19.3 million or 13% of revenue. Operating income declined 16% from the prior year amount. The effective tax rate for the first nine months was 33% down from the prior year amount of 36%. Net income for the first nine months totaled $15 million or $0.70 for fully diluted shared compared to $15.1 million or $0.98 per fully diluted share last year. Looking at backlog, funded backlog at the end of the third quarter totaled $62.1 million up $1.2 million from the end of our last fiscal year.

Funded backlog at the last quarter does not include the recent $45.8 million contract optional work from the US Army. Turning to our balance sheet, cash equivalent and short term investments at the end of the third quarter totaled $110.4 million, up $3.7 million from our prior quarter amount of $106.7 million. This positive cash flow is largely due to income, partially offset by working capital growth in capital expenditures.

Short term investments at the end of the third quarter were $30.8 million, down from the previous quarter amount of $92.4 million. The decrease in short term investments was due to net redemptions of municipal option rates securities. We have reduced our exposures to these securities due to recent liquidity concerns regarding option rate market. As of today, the company holds approximately $17 million of option rate securities. All of our option rate securities are backed by municipal bonds rated A- or higher and rated AAA with their insurance. As a result of our strong cash position we do not need to liquidate the securities in the near term and as a result we did not record any impairment charge in Q3. We will continue to evaluate the fair market value of these securities and the conditions of the market for them at each reporting period as applicable.

At the end of the third quarter our accounts receivable including unbilled receivables were at $43.9 million, up $5.1 million from the prior quarter. Total days outstanding were approximately 81 day compared to 65 day at the end of the prior quarter end. Taking a look at our inventory, inventories were $17 million at the end of the third quarter compared to $12.7 million at the end of the second quarter. Days in inventory were approximately 53 day compared to 33 days at the end of the second quarter.

Turning to capital expenditures, in the third quarter we invested approximately $1.6 million or 3% of revenue in property improvements in capital equipment. Of the cap ex, approximately 80% was related to growth. Now I’d like to turn things back to Tim to discuss expectations for the balance of the year.

Timothy Conver

Thanks Steve, looking back at FY ’07 revenue is up 23% for the first three quarter compared to FY ’07, excuse me FY ’08 and year to date margin is operating margin is 12.8%. Looking forward, I believe we will remain on track to achieve our annual guidance of year over year revenue growth between 20% and 25% and operation margins between 12% and 14%. That said it’s our sense that we’re more likely to complete FY ’08 towards the lower end of that revenue and margin guidance range. I’ll close by restating that we continue to be excited about the growth opportunities for AV. We remain confident in our positioning as well.

Our growth plans remain the same, to continue to grow in the markets that we already hold substantial share by staying number one with our customers and by developing and delivering compelling new value propositions for new customers in other large markets. And now Steve and I’d be pleased to answer any of your questions.

Question-and-Answer Session

Operator

Ladies and gentlemen if you would like to ask a question please press star followed by one on your touch tone telephone. If you’re question has been answered and you wish to withdraw your question, press star two. So please press star one to begin and stand by for the questions. First question comes from the line of Chris Donaghey with SunTrust Robinson Humphrey, please proceed.

Chris Donaghey - SunTrust Robinson Humphrey

Hi, good evening guys, Tim I was wondering if you could walk us through the business mix sequentially, obviously 36% gross margin in the unmanned aerial systems in the second quarter of ’08 and then on lower revenue dollars, higher absolute gross profit dollars and higher gross margin in the third quarter of ’08. So if you could just talk about the business mix in the third quarter and what caused such a pretty significant shift in UAS gross margin.

Stephen Wright

Let me, Chris I’m going to start off and maybe Tim can add to that. The gross margin rates are going to shift around quarter by quarter. Having said that, in Q3, despite having higher services revenue in the quarter, we did have higher gross margins and that was sort of in both the services area and the product area. We had some higher margins in the services area based on the work that we were doing in the quarter, but particularly on the product, fixed priced work we had very good margins in the quarter and that was because of the fixed priced contract content that we were working on plus the commercial and international deliveries that we made in the quarter. I don’t know, Tim if you want to talk about the mix other than that, the services versus contracts.

Timothy Conver

Yeah, I don’t know that there’s anything that I can add to that Chris unless you have a, unless Steve didn’t adequately cover it.

Chris Donaghey - SunTrust Robinson Humphrey

No that’s fine.

Stephen Wright

One other thing I would add in terms of the services it was very high in the quarter and I think Tim touch on this a little bit, but one, in addition to the typical services that we work on we did have a lot of content in the services line to upgrade a number Raven A’s to Raven B configuration.

Chris Donaghey - SunTrust Robinson Humphrey

Okay, great. Thanks, and Tim I was also like you to comment if you can with the Marine Corp deploying Wasps now to the platoon level, do you see any cannibalization of Raven in the Marine Corp market as a result of this fielding initiative?

Timothy Conver

Well, we haven’t seen any to date, although sense the operational capabilities are quite similar as you know I wouldn’t be surprised that over time we do see some of that. But there’s no question in my mind that the net result is a larger pie for small UAS and our product and I think that’s clearly a good thing both for us from a business perspective and from our customers and the ability to utilize a much smaller system you know Wasp is one pound versus a little over 4 pounds for Raven. So the, not only the unique operation capabilities that are different between the two systems but it does seem like the smaller size tilts Wasp towards deployment to lower in the force structure again I mentioned earlier and that should lead to a larger total volume.

Chris Donaghey - SunTrust Robinson Humphrey

Okay great and one more thing and I apologize if I missed it, can you comment on the opportunity pipeline for the PUMA?

Timothy Conver

PUMA was a development system that we developed internally, it’s basically twice the size, twice the payload, twice the range of Raven in very rough terms. We also developed a version of that design to land in salt water that we call Aqua Puma and we deliver, we have delivered to those systems to various customers that have been using them primarily in military utility evaluation type scenarios. I, what we’ve done there I think is learn a tremendous amount about the upper bound of hand launch small UAS size and in particular we’ve learn an awful lot about the operational utility of salt water landing and the design required to make that a robust solution. So I think we will probably see that as an interim product development towards a maybe a next generation solution of net size range.

Chris Donaghey - SunTrust Robinson Humphrey

Okay, great, thanks Tim.

Operator

The next question comes from the line of Troy Lahr of Stifel Nicolaus, please proceed.

Troy Lahr - Stifel Nicolaus

Thanks, can you guys talk a little bit about product sales in the quarter. It seemed like they were up maybe 40%, is that just a timing issue and is that going to correct itself as you get the, as you start back work on this Army contract that you got in the quarter?

Stephen Wright

I can start there. Product sales were 41% of revenue in Q3 versus you know 63% in Q2 and 62% in Q1. It was a, so it’s obviously lower, it’s crowded out by a lot of the services work that we did during the quarter. A lot, and again a lot of that services work was upgrade activity. That happened to be what made sense for the factory to work on during the quarter and also contributing to that was the $45.8 million product order for Ravens came in, it was actually done in the third quarter, but it wasn’t definitized until just after the third quarter so this was the mix of business that made sense to work on during the quarter. Looking forward we probably expect to go back to something closer to what we’ve seen traditionally in terms of product mix.

Troy Lahr - Stifel Nicolaus

Okay and when you go back to something more of a normalized product mix, how are the margins going to change. You mentioned a little bit how this was kind of an abnormal quarter from a margins standpoint, I’m assuming. Is that right? Is there any reason why we can’t do, you guys can’t do 41.5% again at UAS.

Stephen Wright

Well there’s probably not a reason other than we’re, I mean we’re not guiding on gross margins. It was a good quarter for gross margins. We’re looking at the 12% to 14% operating income as what we’re managing to. All things being equal, when you have more product work, your margins are going to improve because that means you have more fixed price work and we tend to do better on fixed price work. But that’s really sort of a second order effect. I think the primary effect is how we’re doing on individual contracts and what contracts we’re working on in the period.

Troy Lahr - Stifel Nicolaus

Okay and then you guys have had a couple of good quarter here, but did I get the comment right that you said you’re going to be at the lower end of your guidance now for both revenue and margins?

Stephen Wright

Yeah, that’s our sense right now, that guidance range of 20% to 25% revenue growth and 12% to 14% operating margin does look at it as we look at a few months left in the year now I think we’re more likely to be in the lower part of that range than the higher part, that’s really what I was trying to say there.

Troy Lahr - Stifel Nicolaus

Okay and why is that from a margin standpoint, I mean is there something that’s going on the fourth quarter? I’m not following that I mean you guys did 16.5% margins the last quarter, why are you going back down now?

Timothy Conver

Well if you look at the nine months year to date Troy, that’s what was at 12.8% which is the lower half the range.

Troy Lahr - Stifel Nicolaus

Okay.

Timothy Conver

And if you look at the top line to, it implies a pretty heavy Q4 in terms of operations throughput so you know there’s a lot to perform on there.

Troy Lahr - Stifel Nicolaus

Okay and then just a maintenance question, what was IDIQ backlog?

Timothy Conver

IDIQ backlog’s 456 at the end of the quarter and as a reminder that backlog does not include the additional options for the two additional aircraft on global observer.

Troy Lahr - Stifel Nicolaus

Okay so it doesn’t include the two, okay. I’m with you. All right sounds good. Thanks guys, I’ll jump back in the queue.

Stephen Wright

Thank you.

Operator

You next question comes from the line of Patrick McCarthy with FBR Capital Markets, please proceed.

Stephen Wright

Hi Patrick.

Patrick McCarthy - Friedman, Billings, Ramsey & Co

Hi, good afternoon, sorry about that, just two very quick questions, could you talk about what the, how much of the US Army’s requiring for the Raven has been fulfilled at this point on a percentage base I guess the stat you’ve given in the past?

Stephen Wright

Yes, through the quarter that requirement is as a reminder 1,900 systems and we’ve delivered approximately 37% of that requirement.

Patrick McCarthy - Friedman, Billings, Ramsey & Co

Okay, great my second question, for the contract that was awarded just after the end of the quarter, can you just provide a little bit more visibility on maybe customer satisfaction, what’s interesting about that? I mean it seems like we’re characterizing it as an army contract and is that the case?

Timothy Conver

Well it is an Army contract. This is the contract that the Army completed what was about three years ago?

Stephen Wright

Yes.

Timothy Conver

For small unmanned aircraft system requirement but for both the Army and for special forces command. That was the SOCOM’s requirement a rucksack portable UAV that got combined into the same requirement competed all at once so the Army has been buying and of course we won that and that included a multi year IDIQ type contract. So the Army’s been buying for both SOCOM and the Army on that contract and then last year the Marine Corp filled up completed their Dragon Eye procurement and they decided rather than buying more Dragon Eyes they would switch over and acquire Ravens. So the Marines have now been buying Ravens under that same Army contract as well. I don’t know, does that help?

Patrick McCarthy - Friedman, Billings, Ramsey & Co

Well I guess the kind of follow, so it’s safe to assume that that contract in the beginning of February was for one of those three services.

Timothy Conver

Yes it was the, it was an army release and that would include requirements for certainly the Army and the Marine Corp and I’m not sure whether SOCOM has requirements or not. It’s for SOCOM is.

Patrick McCarthy - Friedman, Billings, Ramsey & Co

Okay great and is there any other additional detail you can give us on the Spanish award?

Timothy Conver

Well it was a, it was quite competitive we think it’s very important to us. We think it’s their first foray into small UAS and we’re looking forward a long term relationship with them as we have had for a number of years now with Italy. I think we also announced the, was the Danish contract announced?

Stephen Wright

A few months ago.

Patrick McCarthy - Friedman, Billings, Ramsey & Co

Can you give us a sense to the size and when you will start production?

Timothy Conver

With the Spanish order, we’ve made many of the deliveries on that contract. I don’t think we can talk about size.

Patrick McCarthy - Friedman, Billings, Ramsey & Co

Okay, fair enough. Thank you very much.

Timothy Conver

Patrick, one I will say, international was approximately 10% of our revenue for the quarter.

Patrick McCarthy - Friedman, Billings, Ramsey & Co

Do you just put that in context, what was it last quarter, do you remember?

Stephen Wright

Slightly less one second.

Timothy Conver

Patrick, there’s also an article I think it’s referenced on our website, published in El Pais, that revert to the Spanish acquisition of the Ravens.

Patrick McCarthy - Friedman, Billings, Ramsey & Co

Great that’s helpful. Thank you.

Stephen Wright

And Patrick I can answer your question, 7% in Q2 and 3% in Q1.

Patrick McCarthy - Friedman, Billings, Ramsey & Co

Excellent, thank you.

Operator

Your next question comes from the line of Tim Quillin with Stephens Incorporated. Please proceed.

Timothy Quillin - Stephens, Inc

Good afternoon.

Stephen Wright

Hi Tim.

Timothy Quillin - Stephens, Inc

How’re you doing?

Stephen Wright

So far so good.

Timothy Quillin - Stephens, Inc

In terms of Raven, was it just that the switch from Raven A to Raven B was what you were working on right now and does it move back to product, is it kind of an either or proposition during the quarter?

Stephen Wright

I don’t, I wouldn’t necessarily look at it in terms of, I mean that implies a limited capacity and you either do one or the other, and I don’t think that would be a good characterization. Probably relative to how much was in services and how much was in products in the quarter a more significant contributor was probably just order timing, the timing of receipt of orders. Both that Army contract that we announced the week after the quarter and the prior Marine contract for Wasp were later than we had expected. So that probably had more impact than any capacity issue. I do think that the significant amount of conversion there in services probably looks more like product type work even though it’s classified under the services because it’s, that’s how it comes in, in the form of our customer contracts which may have had an effect on the margin change there.

Timothy Quillin - Stephens, Inc

And how should we think about Raven as we look forward, is it the type of product shipments are they going to be as lumpy as we’ve seen over the last couple quarters, waiting for individuals orders to come in or how much visibility do you have into the next few quarters.

Timothy Conver

I think I would say it’s going to be lumpy. We talked about overall business being lumpy but at least in the near term we would expect something, we would expect to see more product sales as a share of the total sales.

Timothy Quillin - Stephens, Inc

Right so a bounce back in the fourth quarter do you have any help for us in terms of how to look at that next fiscal year?

Timothy Conver

No I think we want to reserve judgment on that until we give guidance on the next year which I believe will be on our next call.

Timothy Quillin - Stephens, Inc

Okay. And in terms of development efforts are you working at all on a more of a vertical take off and landing small UAS like a more like what Honeywell has?

Timothy Conver

Well we’ve had development programs in vertical small UAS for years. In fact, we developed and flew the first ducted fan that transitioned from vertical to horizontal and back as far as I know. And we’ve continued on with multiple different configurations in that arena with the, to be in a position to respond to any formal competition that our customers do fund that requires that capability.

Timothy Quillin - Stephens, Inc

Okay. Are there any like that on the horizon.

Timothy Conver

There are none that I’m aware of right now.

Timothy Quillin - Stephens, Inc

Okay.

Timothy Conver

So that FCS program is continued on for years that’s not a procurement program that’s funded.

Timothy Quillin - Stephens, Inc

Right, and just lastly the US special operations command has put out a pre-solicitation notice on I guess what they’re calling an all environment capable variant small UAS. Looks like a pretty big opportunity, how are you positioning for that?

Timothy Conver

Well that’s, that looks like pretty much of a new category that requires landing not only in salt water but the same vehicle needs to land on land and it needs to go back and forth indiscriminately. So it’s a pretty interesting requirement, I did mention that we’ve got quite a bit of history with the AquaPuma as well as AquaWasp in that maritime environment so to the degree that that is a real funded requirement we expect to show up competitively.

Timothy Quillin - Stephens, Inc

Is it more aqua Wasp or Aqua Puma or do you know yet?

Timothy Conver

Well the, in their original span of requirements they had a range of sizes from something that looks like it’s kind of WASPish to something that looks considerably larger than any existing small UAS.

Timothy Quillin - Stephens, Inc

Okay. We’ll stay tuned. Thank you.

Timothy Conver

You bet.

Operator

You next question comes from the line of David Gremmels with Thomas Weisel Partners, please proceed.

David Gremmels - Thomas Weisel Partners

Thanks, good afternoon. The, we talked a little bit about services margins getting a boost from the Raven A to Raven B transition. Can you just say how far, number one how far along are you in that process and number two, when that process is complete, does, is that benefit margins because those resources transitioned to fix price production work or is it bad for margins because the resources transition to lower margin services work?

Timothy Conver

I think with respect to that effort, a lot of that effort was done by our manufacturing operations so those resources will move back into product work.

David Gremmels - Thomas Weisel Partners

Product work on the two large contracts in particular?

Timothy Conver

Yeah.

David Gremmels - Thomas Weisel Partners

Okay, and on the product gross margin, obviously very high in the quarter, I just want, I think you said this earlier, I just want to confirm that the strength of that product margin was pure mix, that there weren’t accrual adjustments or one time items in there?

Timothy Conver

Well it’s basically mix. I don’t believe they’re in the products there were any accrual adjustments or anything like that it’s long term EAC’s and looking at individual contracts.

David Gremmels - Thomas Weisel Partners

Okay on the fiscal ’09 budget, last quarter you commented that the more of the funding for UA, for your programs was moving into the base line budget where there’s more visibility you know now that you’ve got a chance to take a look at the ’09 budget, did that trend continue and how do you feel you fared in the budget?

Timothy Conver

I think we’re still looking at what the overall effect is David. I don’t know that I’ve got a strong opinion right now. It’s, there’s both the president’s budget and the ’08 supplemental and then the ’09 supplemental are all in the mix. So I don’t think I can add a lot to a good commentary right now.

David Gremmels - Thomas Weisel Partners

Okay, fair enough and then on the auction rate securities, glad to hear impairment charge in the P&L, just to clarify, I guess there’s a couple of different ways you can account for these, is there any kind of like temporary impairment that stays on the balance sheet because it’s considered temporary or there just no impairment of any kind here?

Timothy Conver

Right now there’s no impairment of any kind. This whole thing started after the quarter in mid February. We had been getting out those for a couple of quarters. At one point we had, you know $90 million plus in these auction rate securities. They were suppose to be very safe based on municipal bonds and we started moving out of them a while ago when we started reading all these news articles about insurance, and moving into treasuries and other safe investments. As of today, $17 million is our total exposure and it’s all based on they’re all based on municipal bonds they are highly rated underneath it so as of today, no impairment whatsoever, and we’re just going to have to look at that during each reporting period as we go forward.

David Gremmels - Thomas Weisel Partners

Great and then you may have given this and I may have missed it I apologize, the operating cash flow in the quarter.

Timothy Conver

No I didn’t give it but I will right now, pre cash flow during the quarter was $3.6 million. Cash from operations $5.2 million and that’s offset by $1.6 million in cap ex to get the $3.6 million.

David Gremmels - Thomas Weisel Partners

Okay. And then last one, I understand you’re not ready to talk about ’09 but when are you going to at least say whether you’re still thinking about 20% organic growth in ’09 particularly with global observing ramping up?

Timothy Conver

Well I don’t think we’ve changed out long term view of five year, 20% to25% top line figure, or compounding growth rate so and as Steve said we are still looking at our planning for our next fiscal year and we’ll be I’m assuming we’ll be talking about what our outlook for that is next quarter.

David Gremmels - Thomas Weisel Partners

Great thank you.

Timothy Conver

You bet.

Operator

Your next question comes from the line of Randy [Gorkman] of [Baring Capital], please proceed.

Randy [Gorkman] – [Baring Capital]

Good Afternoon, guys.

Timothy Conver

Hi Randy, you are you?

Randy [Gorkman] – [Baring Capital]

I’m good, thanks. Could you disaggregate a bit? I don’t know to what extend you can give a little tale on the backlog, but it would be helpful if you could between you know kind of what’s funded I guess was $62 million and then I think you said $456 million of IDIQ’s.

Stephen Wright

I’ll start Randy, the $62 million is again our quarter end snapshot, that backlog is about, mostly product backlog at this point, 65% of that $62 million would be product backlog and again that backlog did not include the $48.5 million order for the Army. That order was negotiated and largely done but it just wasn’t definitized until after the quarter so it was not included in the backlog and we couldn’t make any deliveries against it.

The $456 of unfunded, that’s just based on various contract vehicles some of when are used a lot, others are used sparingly so it’s unfunded, there’s no commitment on the part of the customer to actually invoke those. And I guess the other point that I’d make there is just that that unfunded backlog doesn’t include the project options for global observer for additional aircraft.

Randy [Gorkman] – [Baring Capital]

What portion of global observer does it include?

Stephen Wright

Well the, our customer has not disclosed the amount that has been funded but let me just say it this way the initial contract was $57 million and probably less than half of that has been funded and is included in the backlog that we’re working off and the other piece of that $57 million would be in the unfunded. And then the third piece which are the options for additional aircraft is not in the number at all.

Randy [Gorkman] – [Baring Capital]

That’s actually very helpful.

Timothy Conver

I think that total contract value was announced wasn’t it Steve?

Stephen Wright

I think it was announced at $106 or $107 million.

Timothy Conver

$109.

Stephen Wright

$109.

Timothy Conver

So the difference between the $57 and the $109 is no where in any of those backlog numbers I guess is the point Randy.

Randy [Gorkman] – [Baring Capital]

Yeah, that’s what I was trying to get at. Okay, that makes the numbers make more sense to me on a year over year basis, that’s helpful.

Timothy Conver

Steve’s just being his usual conservative self and we also thought that as we talk about unfunded backlog to date that’s exclusively associated with IDIQ type contracts and the global observer option are kind of a different animal so we didn’t want to mix apples and apples there.

Randy [Gorkman] – [Baring Capital]

Got it and I understand the sensitivity of the customer interest as well. Is there anything else you can talk about in terms of milestones that the customer will be looking to and timing with regard to what would influence them to exercise the option?

Timothy Conver

Well I, I can probably just speak in very, in generalities there. The first I think probably the first major milestone just occurred last month, last week where we completed the preliminary design reviews with our customer set. I think that went very well. It will be a while before we get any formal feedback but all of the informal feedback I’ve had is quite positive. And then we’ll move on to a critical design review later with significant milestones along the way. I touched on some of those significant milestones in my comments and the, most large aircraft development is the propulsion system is the long pole in the tent and we are extraordinarily please with the success of the propulsion system testing we’ve been doing on global. I mentioned that’s a full up production propulsion system that’s now been operating to spec at assimilated 65,000 foot altitude so that’s, I don’t know that that’s ever been done before with this particular technology and it’s quite an accomplishment. I think our customers are as impressed as I am.

Randy [Gorkman] – [Baring Capital]

That’s good to hear and just similar kinds of questions on Switchblade, is there anything you can talk about just in terms of maybe timing on that or the gating factor? I understand that including ordinance on an aircraft like this make everything at a much higher level of complexity but it’d be helpful to kind of talk about how the program’s going, thank you.

Timothy Conver

Well, A, going very well and well enough so that we just as I mentioned just recently got in another contract increase to produce additional units and do additional demonstrations and this is all in the configuration and application of our initial customer. Equally importantly I think there quite a large number of additional customers that now are, have very active interest in this capability. So it’s clearly growing and it doesn’t, I don’t think we’ve seen any setbacks here. I know it would be desirable if I could lay out a specific time and quantity which I can’t do but this next phase that we’re currently under contract for I think moves us more closer to a production decision in the future.

Randy [Gorkman] – [Baring Capital]

And are you working with the same partner that you’ve been working with in terms of integrating ordinance onto the aircraft?

Timothy Conver

Actually, the let me see how much of this I can discuss, we are working with the same production intent partner that we selected some time ago. So that a bit vague but I hope that helps.

Randy [Gorkman] – [Baring Capital]

That’s okay, the last question I have is totally shifting gears but you mentioned an incredible improvement in the turbine capacity for architectural wind, I wanted to know if you’ve got any more sort of demo projects that the kettle chips factory that you’re working on? And what do you see commercialization prospects for, in that segment and then I’ll leave you alone, thanks

Timothy Conver

Well there’s actually quite a significant list of customers on the books now that we’re referring to as early adopters that have contracts in for installations on their facilities. We got a little tied up last quarters with some weather challenges but we’re moving ahead now in those installations. And I think we have made a public release on installations at Laughlin Air Force Base and the Duluth Minnesota installation. It does seem to be a picking up more and more steam with customer interest and we’ve got a number of additional product improvements in the pipeline that I think will continue to improve the value proposition that we’ve delivering. So we’re still looking favorably on this opportunity.

Randy [Gorkman] – [Baring Capital]

Thanks very much guys.

Timothy Conver

You bet, thanks Randy.

Operator

Your next question come from the line of Brian Gesuale of Raymond James, please proceed.

Analyst for Brian Gesuale - Raymond James

Hi, this is Matt speaking for Brian, just a quick question on the mix in the quarter for fix pricing cost list, could you give us what those were?

Stephen Wright

Yes, cost plus was 53% of revenue in the quarter.

Analyst for Brian Gesuale - Raymond James

And if I recall you guys said that out of your backlog funded that 65% is product or fixed price is that correct?

Timothy Conver

Approximately 65%.

Analyst for Brian Gesuale - Raymond James

I think that’s it for me. Thank you very much.

Timothy Conver

Thank you.

Operator

Your next question is a follow up question from the line of Chris Donaghey with SunTrust Robinson Humphrey, please proceed.

Chris Donaghey - SunTrust Robinson Humphrey

Hi Tim, I wondered can you clarify for us do upgrades from A’s to B’s count against the 1,900 requirements?

Timothy Conver

No.

Chris Donaghey - SunTrust Robinson Humphrey

Okay, great. And I know in the past you’ve talked about the number of airplanes per month coming out of the Semi Valley facility, it was at 200 at the analyst meeting, is it still around that same level?

Stephen Wright

Okay, I’ll do that. When you include the work that’s running though the services line, it’s a bit higher than that now, maybe 300.

Chris Donaghey - SunTrust Robinson Humphrey

Okay. And last question, how does, you talked a little bit about this, but how does the global observer funding get approved? Are you gated by the customers, plural, willingness to commit funding or is it a milestone based type of funding approach where when you demonstrate a certain capability then it automatically triggers funding from the customer. Just trying to figure out which, who drives the process? Is it progress on your side or is it a funding issue from the customer’s side?

Timothy Conver

Well I think Chris, both elements enter in to the equation, however and the way this works under this contract is with this large number of customers, each of them has committed a certain amount of funding over the three year period of the JCPD. And to date I think they’ve all delivered that funding level that they were committed to and I think everyone expects that to continue at some point if someone showed up without delivering their committed funds then that would become a constraint, but that hasn’t been the case and we don’t expect it.

And so then you move to the second one which is the milestones in the program. And I suspect if we were to start missing milestones we’d start coming under the kind management scrutiny that you would expect. We haven’t done that and our job of course is to stay on track and not limit our own funding by our own performance.

Chris Donaghey - SunTrust Robinson Humphrey

Okay, great, thanks again guys.

Timothy Conver

Thank you.

Operator

Your next question is a follow up from the line of Troy Lahr with Stifel Nicolaus, please proceed.

Troy Lahr - Stifel Nicolaus

Thanks, can you guys just help me understand kind of why SG&A was higher in the quarter, just as a percentage of sales and maybe is this kind of a new level for us to run at for the next few quarter? Just maybe direction, I know you don’t want to talk quarter to quarter.

Timothy Conver

Sure, well first I think you got it year over year when we’re talking about it there was a one time adjustment last year for the SERP. So the actual growth year over year was $1.8 million and you know a lot of the growth or almost all of the growth is in SG&A, and that includes P&P expenses as well as selling and marketing infrastructure. There’s been a little growth over the last two or three quarter for G&A because we’re a public company, you know we’ve added counsel and things like that but the real driver is the selling and marketing expense and I think what we’ve talked about there is a need to continue to beef that up so that we can support our expectations for future sales growth.

Troy Lahr - Stifel Nicolaus

So should we look at SG&A as a percentage of sales around bumping around between 16% and 17%?

Timothy Conver

No I think there you have to look at the sales level that we had during the quarter. It was actually a little bit lower sequentially. So you know 15%, 16% is probably more what we would think about.

Troy Lahr - Stifel Nicolaus

Okay. All right, that’s all. And R&D also about 7.5 is that health run rate or does that ramp up as you still work through some of these development programs?

Timothy Conver

R&D again we’ve talked about R&D being 8% to 10% so it’s not out of line. The actual R&D spending for the quarter $3.7 million, down 100K form $3.8 million in Q2, that is going to bounce around. It’s been higher than that. I’m looking and it was $4.3 in Q1 and going back $4.7 in Q4 a year ago so that’s going to bounce around. A lot of that is the B&A and secret sauce of the company so sometimes it get crowded out by work, paid work, but this is an area that will continue to put a lot of focus on.

Troy Lahr - Stifel Nicolaus

But still think of it as kind of an 8% to 10 % type?

Timothy Conver

Yeah, with and it may not all add up but with the goal of 12% to 14% by the time we reach the operating income.

Troy Lahr - Stifel Nicolaus

Okay and then lastly on the international sales, you talked about 10%. Is the 10%, I mean does that continue to increase from here. It went from I think 3 to 7 to 10 or does it kind of level off here at 10%?

Timothy Conver

You know I don’t, that one is hard because it’s such a small amount and we did, we made some good deliveries in the quarter which helped our margins. I don’t think I can guide on that in Q4. It’s an area we’re trying to move up and make it a bigger piece of the pie but because it’s small it’s just going to bounce around. I don’t think you can look at our history and say it’s just going to continue to grow a couple points every quarter.

Troy Lahr - Stifel Nicolaus

Right, okay, but could it go back to 5% or 3%?

Timothy Conver

Yeah, I think it could.

Stephen Wright

In any short period of time, it certainly can move dramatically Patrick but I do think that there is growing appetite internationally and a trend to follow the pattern that the DOD followed in the adoption of this technology. So it’s clearly behind DOD in terms of when they’re adopting but the same pattern seems to be the same it seems to be pervasive so we’re actively pursuing a lot of those opportunities.

Troy Lahr - Stifel Nicolaus

Okay I guess since you called me Patrick, I’ll squeeze in one more question on you.

Timothy Conver

I’ve got Steve passing signs in front of me here that I did it again.

Troy Lahr - Stifel Nicolaus

I’ll blame it on him then. PosiCharge, when are you expecting a recovery there, or are you? What kind of level, how do you look at that business going forward?

Timothy Conver

I think the key, the big issue is we have not seen that level of adoption accelerate that we had expected. So we’re about flat year over year and our market share is about the same so we conclude from that that the overall industry adoption rate is about the same as it was last year. I still think that the, it’s a compelling value proposition and I think that will prevail over time. And that the adoption will increase significantly. Having said that, and I’ve already been wrong, so I’ve definitely not going to predict when, or how much.

Troy Lahr - Stifel Nicolaus

All right, thanks guys.

Timothy Conver

Thank you.

Operator

Your next question is a follow up question from the line of Tim Quillin of Stephens Incorporated, please proceed.

Timothy Quillin - Stephens, Inc

Yeah, just a couple quick question, the one on PosiCharge, the fourth quarter of ’07 there’s a pretty steep sequential drop off is there inherent seasonality there or was that just kind of a one off bat quarter?

Timothy Conver

I think that was a one off bat quarter. If I recall we had a lot of business running through one particular auto customer at that time which fell off. But that’s all I would probably have to say about fourth quarter to first quarter.

Timothy Quillin - Stephens, Inc

Okay.

Timothy Conver

We haven’t, I haven’ discerned any seasonality there although I’ve always suspected that there should be some because of the capital acquisition cycle that tends to have an annual budgeting process in most organizations but it hasn’t been obvious.

Timothy Quillin - Stephens, Inc

Right and then in terms of the global observer, how remind me how that is accounted for. Is that percentage completed based on milestones or is it just a cost plus based on your ramp I guess, is that right?

Timothy Conver

It’s a, it’s in project, it’s accounted for sales in our services line and it’s within our project R&D category. It’s percentage of completion based on cost, all of our cost plus programs.

Timothy Quillin - Stephens, Inc

And can you give us a sense, you talked about your hiring, where are you are relative to your run rate in terms of head count?

Timothy Conver

You mean what do we have staffed right now relative to the peak we plan to staff on that program?

Timothy Quillin - Stephens, Inc

Yes.

Timothy Conver

That’s a good question, and I’m not quite, I don’t think I got the, accurate enough data in front of me to hazard a guess.

Stephen Wright

Actually I don’t think we would, we’ve ever talked about the head count on an individual program. That program is obviously driven by headcount, and the current base, it’s engineering head based, we have been hiring and I think we’re either on track with our hiring or else we’re relying on external resources where we’re unable to hire.

Timothy Conver

Well I think we have been hiring very aggressively and its staff with an extraordinarily competent and experienced team. And we’re continuing to recruit aggressively because we’re, we’ve got, we still have a significant ways to go. So that, I would say and I think that’s going to, that hiring’s going to continue for the next few months at any rate until we get where we want to be on that program.

Timothy Quillin - Stephens, Inc

All right and just one last question if I may on the commercial markets and I understand that nothing really going to move until the FAA regulates the airspace but what are you doing at this point to feed some of those markets, markets like law enforcement, border security you know firefighting, other things like that. What can you do at this point to get things moving?

Timothy Conver

Well we had been doing a lot of very active demonstration with our systems with that entire set of customers and more that you ran through. Until the FAA put a new rule in place that requires a certificate of authorization in order to fly any small UAS in the national airspace, and that certificate has to be requested and sponsored by a government agency and then it has to get into queue, so and we’re currently running our flight test under those certificates of authorization our COA’s as they’re, the acronym is referred to and, but it did dramatically reduce our ability to do demonstrations for potential commercial or other government agency customers. Having said that, while we were doing that, we had gone ahead with a number of commercial customers and we have had put in place, service contracts to provide small UAS service where we would not necessarily sell the systems but we would operate the systems and deliver the information to those customers.

And that set of customers and others I believe are anxiously awaiting the FAA clearance to determine what the rules are going to be so that we can begin providing those services. The FAA is in process now of reviewing a plan that would set up a charter for a small unmanned aircraft system, aviation rule making advisory committee. And I believe the job of that committee would be to define small UAS and what the rules would be for them to operate in the national airspace. I think as soon as that gets promulgated, then we can begin to see some time estimates on when these rules would get put in place and I think that might be, open up a flood gate of demand that’s as more and more of these non military customers become aware of what they can do in their enterprise with this capability.

Timothy Quillin - Stephens, Inc

I appreciate that thank you.

Operator

Your next question is a follow up question from the line of David Gremmels with Thomas Weisel Partners, please proceed.

David Gremmels - Thomas Weisel Partners

Thanks just one quick follow up for Steve on the balance sheet I’m just looking at the growth in receivables and inventories and wondering what’s driving that. Is that just the expected growth in the business and would you expect to see any reversal in the fourth quarter?

Stephen Wright

Well there are two different things, the receivables were up a little bit just because of the timing of some of our revenues in the quarter. Some of the revenue were towards the later end of the quarter and that means more unbilled and A/R. On the inventory side, that inventory growth is basically all for the UAS and it’s to fund future. We thought for some time that needs to increase a bit. So that we have smoother run in operations and that’s really what that’s for.

David Gremmels - Thomas Weisel Partners

Steve do you have a fee cash flow target for the year?

Stephen Wright

No, we don’t. we’ve been very fortunate in terms of managing free cash, we’re free cash flow positive this quarter and year to date we’re just about break even as you know the further out we look we think that we will expect to have some use of funds for working capital. So don’t really have a prediction there other than it’s probably for the near term, just going to bop around up and down a like a little bit like it’s been.

David Gremmels - Thomas Weisel Partners

Given that you’re about flat year to date, do you expect to generate positive free cash flow for the year?

Stephen Wright

Again, don’t have a prediction on that, we could or it could be slightly negative, it’s just sort of moving within a fairly narrow range there.

David Gremmels - Thomas Weisel Partners

Understood, thanks very much.

Stephen Wright

Thank you.

Operator

We are currently showing no more questions in queue at this time, I would like to turn the call over for closing remarks.

Steven Gitlin

Well thank you again for your continued interest and your support, we look forward to reporting our progress for the next fiscal year and our fourth quarter, 2008. Thanks.

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Source: AeroVironment, Inc. F3Q08 (Qtr End 01/26/2008) Earnings Call Transcript
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