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RAE Systems Inc. (NYSEMKT:RAE)

Q4 2007 Earnings Call

March 6, 2008 4:30 pm ET

Executives

Robert Chen – Co-Founder, Chairman, Chief Executive Officer and President

Randall Gausman – CFO, Principal Accounting Officer and Vice President

Bob Durstenfeld - Director of Investor Relations

Analysts

Brian Rutenberg – Morgan Keegan

Matthew McKay – Jeffries and Company

Ken Liddy – Wachovia Securities

Kevin Dede

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the RAE Systems Incorporated 4th quarter and full year 2007 operations summary and earnings conference call. My name is Michelle and I will be your coordinator for today. At this time all participants are in listen only mode. We will be facilitating a question and answer session towards the end of today’s conference. If you would like to ask a question, you can press star one at any time to do so. If at any time during the call you require assistance, please press star followed by zero and a coordinator will be happy to assist you. As a reminder, this conference is being recorded for replay purposes.

And I would now like to turn the call over to your host, Mr. Bob Durstenfeld, Director of Investor Relations. Please proceed.

Bob Durstenfeld

Thank you Michelle. Good afternoon everyone. Thank you for joining us today for RAE Systems Fourth quarter and full year 2007 operations summary and earnings call. With me today are Bob Chen, our Chief Executive Officer and Randy Gausman our Chief Financial Officer. If you have not seen this afternoon’s earning press release, it can be retrieved from our website at raesystems.com If you would like a replay of this conference call, it can be retrieved two hours after this call from our website or from links in the call announcement.

I would like to remind you that the matters that we will be discussing today include forward looking statements and as that term is used in section 21E of the Securities and Exchange Act of 1934 and as such are subject to risks and uncertainties. Forward looking statements may include without limitation expressions of believes, anticipation or expectations of management, statements of the industry trends or future results of operations of RAE Systems and its subsidiaries and other statements that are not historical fact. These types of statements address matters that are subject to risks and uncertainties which could cause actual results to differ materially. Factors that could cause or contribute to such differences include but are not limited to general economic and industry factors and their receptiveness of the market to RAE Systems and its products.

In addition to our forward looking statements. It should be considered in the context of other risk factors discussed in our filing with the Securities and Exchange Commission including but not limited to our annual report on form 10-K and form 10-Q filings available on line at www.sec.gov or our website. All forward looking statements are based on information available to the company on the date hereof and the company assumes no such obligation to update such statements. As a reminder we will not be commenting on analyst models today. With me today Bob Chen will discuss our 2007 operation and fourth quarter highlights as well as our outlook for 2007 and Randy Gausman will review the financial results for the fourth quarter and the year ended December 31, 2007. Then before the question and answer session, Bob Chen will provide a brief business summary.

Now I will give the call over to Bob Chen, Bob go ahead please.

Bob Chen

Thank you Bob. Today we reported record quarterly and annual revenue which is in part attributable to our successful December 2006 formation on RAE Fushun and the growth in our existing business. Fourth quarter 2007 revenue reached $27.5 million, a 32 % increase compared with the fourth quarter of 2006 and full year revenue increase by 34% to $90.8 million. During 2007 we focused on integrating the RAE Fushun coal mine safety joint venture and continuing to deliver innovative new products. We now have products deployed in more than 85 countries.

We are driving our success through our four key markets. Energy, which includes coal, oil, gas and nuclear power. Industrial which includes mining, plastics, chemicals and metal production and transportation. Environmental which includes protection, remediation and indoor air quality public safety that serves municipal fire, police and first responders, state and federal governments, defense and homeland security as well public venue protection. We have strengthened our sales channel by adding industry experts to focus on our core market.

Last year, we introduced six new multi-use products to serve the energy, industrial, chemical, safety and homeland security markets. We continue to expand RAE Systems technology leadership through our R&D investments. In 2007 we introduced three new generation photo ionization detectors. The MiniRAE 3000, ppBRAE 3000 and MiniRAE Lite. The MiniRAE and ppBRAE are the first hand held monitors to incorporate wireless data management which brought us our wireless product offering. We introduced SentryRAE Steel a ruggedized gas detection platform for the most hazardous zone 1, division 1 environment.

We expanded our wireless stainless steel AreaRAE System with hf certification into the European markets. We received a patent for a lead free reduction of hazardous substance or ROHS compliant oxygen sensor which meets the European, China and California ROHS initiatives. We introduced a new four gas platform the QRAE II to meet the needs of our confined space entry compliant customers. These new products coupled with our existing suite of products enable us to offer a full range of toxic and detection solutions for the growing global industrial energy market.

Now I will highlight our fourth quarter regional accomplishments. The Hovensa Refinery in the U.S. Virgin Islands took delivery of AreaRAE wireless system. In Mexico we won a contract to supply all gas detection instruments to PEMEX P.E.P. the Exploration and Drilling unit for the next two years. We continue to win government orders on EPA, FEMA the U.S. Navy and Airforce as well as municipal, state and county emergency management agencies.

The Bahrain Civil Defense Force made a significant purchase of our intrinsically safe, gamma radiation detector/dosimeter the GammaRAE TWO-R. We delivered our first large sized orders of wireless AreaRAE toxic gas monitors to several China municipal fire brigades. We expect to see much more wireless adoption in China this year. We continue to win business with PetroChina. We entered into supplier partnerships with two of the largest state run China coal mine operators which resulted in orders for digital mine safety instruments, breathing apparatus and other mine safety equipment. We are supplying toxic gas detection equipment for the August 2008 Beijing Olympics.

I would now like to comment on our outlook for 2008. The growing global demand for energy is striding increased demand for the price of industrial workers safety products that we make. We are experiencing on going demand for our products in the government markets. We see the global environmental market gaining strength as more companies and communities pay attention to the environment around them. With our sales team focused on revenue growth for 2008, we have begun implementing specific expense reduction plans to drive cost ability.

My executive staff is conducting detailed company wide reviews of sales, marketing, manufacturing, engineering and administrative functions to increase productivity and reduce operating expenses without impacting product quality. We are conducting a product line review to identify gross margin improvement opportunities and new product offerings. We have implemented actions to reduce investments in working capital by tightening up our accounts receivable collections and improving our inventory management.

In addition, we are modifying our management structure. Rudy Mui, our former Exeuctive Vice President and Chief Operating Officer of the Americas has moved on to other opportunities and we thank him for his contributions. We are taking advantage of this change to re-align our top management. We intend to hire a key leader for our Americas region who will focus on accelerating our sales growth with highly controlled our sales expenses. In the interim, Randy Gausman has assumed management responsibility for our Americas region in addition to his CFO responsibilities. With that, I would now like to turn the call over to Randy for the financial update. Randy, please go ahead.

Randall Gausman

Thank you Bob. I will begin by commenting on the fourth quarter financial highlights. We delivered record revenue of $27.5 million with gross margin improving to 51%. While we lowered operating expenses as a percent of revenue to 56% from 57% in the fourth quarter of 2006, we were not satisfied with the total operating expenses of $15.5 million.

As Bob noted, we have begun programs that reduce expenses. The fourth quarter net loss of $7.5 million or 13 cents per share driven in large part by $7.3 million valuation allowance against the deferred tax assets. In December we completed the sale and leaseback of our headquarters building in San Jose, California resulting in a $12.3 million cash infusion. We ended the year with $15.9 million of cash.

Looking at the fourth quarter financial results in greater detail, revenue increased by 32% compared with $20.9 million for the same period in 2006 and by 9% compared with $25.3 million for the third quarter of 2007. Our Fushun operations contributed 20% of our year over year revenue growth with the balance coming from our existing operations. Key contributors to revenue growth from our existing markets with military contracts, industrial and first responder sales in the Americas, increased market penetration in our European region and increased sales in our RAE System design products at our Beijing operation.

For the fourth quarter, the Americas contributed 35% of our total revenue, Asia contributed 53% and Europe contributed 12%. Gross margin for the fourth quarter was 51% compared with 50% for the same quarter of 2006. The slight improvement was attributable to improving gross margin contribution from our China operations.

Sales and marketing expenses were $8.1 million in the fourth quarter of 2007 or 29% of revenue, compared with $6.5 million or 31% of revenue for the fourth quarter of 2006. Fourth quarter research and development spending was $2.7 million dollars or 10% of revenue compared with $1.9 million or 9% of revenue for the fourth quarter of 2006. G&A expenses were $4.7 million or 17% of revenue compared with $3.7 million or 17% of revenue for the fourth quarter of 2006.

We are focused on the integration of our two business operations in China and are converting them from former state run enterprises to comply with U.S. business and accounting practices. Frankly this task has taken more energy and time than we had originally anticipated. We are focused on this issue and intend to improve the situation in short order. We are confident the process will yield efficiencies and greater operating income.

Overall, fourth quarter 2007 operating expenses were $15.5 million or 56% of revenue compared with $12 million or 57% of revenue for the fourth quarter of 2006. In the fourth quarter, the company took a non cash charge of $7.3 million due to a valuation allowance against deferred tax assets related to its operations in the United States.

For the fourth quarter of 2007, the net loss including discontinued operations was $7.5 million or 13 cents per share compared with a net loss of $1 million or 2 cents per share for the fourth quarter of 2006. For the full year, we reported record revenue of $90.8 million, a 34% increase over the $67.7 million from 2006. Operating expenses were $50.9 million or 56% of revenue compared with $38.4 million or 57% of revenue for 2006. This also included $1.5 million of legal expenses related to the Polimaster arbitration which resulted in an award in the company’s favor.

During the third quarter, we discontinued our digital video business to focus on our core gas and radiation detection business and reduce expenses which resulted in a net loss of discontinued operations for the year of $4.2 million or 7 cents per share. For the full year, the net loss including discontinued operations was $14.7 million or 25 cents per share compared with the net loss of $1.5 million or 3 cents per share for 2006. Focusing on the balance sheet, we had cash of $15.9 million at year end, compared with $8.2 million at September 30, 2007 and $21.4 million at December 31, 2006.

Net cash use and operating activities for 2007 was $12.3 million which consisted of a $4.7 million loss from operations adjusted for non-cash items. A $5.4 million increase in working capital, the write-off for discontinued operations of approximately $2.7 million and $5 million in other operating activities. Purchase of property and equipment were $4.6 million. Net cash provided by financing activities was $600,000 which consisted of bank borrowings of $12.2 million which were partially offset by repayment of bank loans, payments of notes payable and repurchases of stock from certain employees related to our discontinued operations.

In December 2007, we completed the sale and lease back of our headquarters facility resulting in a cash infusion of $12.3 million. The gain from the sale of the building will be recognized over the ten year term of the lease. Accounts receivable declined by approximately $1.8 million or $22.8 million at December 31, 2007 compared with the prior quarter.

DSOs were 91 days at quarter end compared with 88 days at September 30, 2007. This slight increase reflects somewhat slower collections in our foreign operations for the quarter. Net inventory declined by half a million dollars from September 30, 2007 to $17.5 million for the quarter. Inventory turn was 2.3 times of the fourth quarter, compared with 2.5 times for the third quarter of 2007. This represents about 157 days of inventory compared with 145 days of inventory on September 30, 2007. The decrease in inventory turned and increase in inventory days reflects an increase in finished goods inventory as our manufacturing operations plan for Chinese New Year plant closures in February 2008.

Now I will make a few comments about our forward looking guidance. We expect full year 2008 revenue to increase by 15 to 20% over 2007 which is in the range of $104 to $109 million. We are targeting our gross margin to be in a range of 50 to 55% for the year and as we implement target expense reduction programs, we expect to be profitable for the full year in 2008. Now I will turn the call back over to Bob Chen for his closing remarks.

Bob Chen

Thank you Randy. We are pleased with our revenue growth in 2007 but disappointed by our operating loss for the year with our targeted operating expense reduction program we believe we are well positioned to grow profitably and we are excited about 2008. We have already introduced two additional new products as part of our 2008 product road map.

The ToxiRAE 3 and the AutoRAE Lite are designed for deployment in our largest growth market oil, gas and petrochemicals. In addition in order to meet our profitability goals we are implementing stringent cost controls in order to maintain profitability. We are continuing to focus on our manufacturing processes and sales strategy to improve our gross margins. We are executing on our 2008 business prospects and we are projecting 2008 revenue of between $104 million to $109 million and to be profitable for the whole year. I would now like to open the floor to questions. Operator.

Question-and-Answer Session

Operator

Once again ladies and gentlemen, for questions that is star followed by one. Your first question comes from the line of Brian Rutenberg of Morgan Keegan, please proceed.

Brian Rutenberg – Morgan Keegan

Great, thank you very much. My first question is what happened from Q3 to Q4? You were profitable in Q3 and then unprofitable in Q4. I understand that there were some charges involved there but even excluding those charges, revenue was up but profits weren’t. Can you explain what happened?

Randall Gausman

Sure. Brian, our revenue did not grow quite as fast in Q4 as we had anticipated.

Brian Rutenberg – Morgan Keegan

Okay.

Randall Gausman

And our operating expenses as we indicated on our comments were higher than what we had expected although year over year there was a slight decrease in our operating expenses as a percent of total revenue. And, that’s why frankly we have implemented this cost improvement program that the company is undertaking. We have formed a management team and charged each one of our business unit managers with specific responsibilities to go through basically a bottoms-up budgeting plan and look at every expense item in the company to determine where we can prudently reduce expenses without affecting quality.

Brian Rutenberg – Morgan Keegan

Okay. The next question is about guidance. Can you talk a little bit about how much China’s growing or Asia, I think you break it down by Asia, Europe and the Americas or something like that, can you talk about the growth projected in revenue from those three areas and revenue for the year in 2007, U.S percentage in those areas?

Randall Gausman

Sure. I think we said it in the press release or in our comments, the Americas contributed 35% of revenue in the fourth quarter and China contributed 53% and the balance being the rest of the world. And 2007 was also the first year of our first full year of operations for RAE Fushun business which is our coal mine safety business in Northern China. You know we expect that China’s going to grow in the double digit range next year as we expect the Americas will too.

Brian Rutenberg – Morgan Keegan

Okay, double digit is 10%, 20%, 30%?

Randall Gausman

Probably between 10 and 20%.

Brian Rutenberg – Morgan Keegan

Is that 20% for China and then 10 to 20% for America or less for America?

Randall Gausman

America will be in the same range as well. Overall we’re expecting 15 to 20% growth in revenue for the whole company year over year. As the China operations expand, they’re going to probably be a larger contributor going forward than the Americas will be.

Brian Rutenberg – Morgan Keegan

Can you tell us then, because we were expecting this big surge at some point from China that was going to kind of take your company to the next level and that’s the—from the coal mine safety fund and everything else, can you tell us what’s going on there and why more money is not flowing.

Randall Gausman

Well actually you know I’ll make some comments and I think Bob will want to follow up with some comments. You may recall earlier last year we talked about the expectations of RAE Fushun coal mine safety business and we were expecting revenue to be for the year a contributor around $12 million and in fact, that’s about what it did for the year so it was right on target for our plan. We’re also expecting next year that the coal mine safety business will have another significant year of growth. And equally we’re expecting with the introduction of new products and more products being more RAE specific products being sold by RAE Beijing, that the RAE Beijing operations will continue to grow as well. So China is expected to be you know again, a major contributor in 2008 as it was in 2007. You may want to follow up Bob with some additional comments.

Bob Chen

Yeah, I think like Randy said, when we bought RAE Fushun at the 2006, its about $9 million, 2007 we planned to do about $12 million, they did approximately that and 2008 we expect to continue pretty good growth along the coal mine safety business. So I think moving forward with some of the coming in the call, we have some digital mine adoption and also some of the RAE’s product so we expect the coal mine safety product in 2008 to continue to grow with a similar pace.

Brian Rutenberg – Morgan Keegan

Okay and then the last question just was follow up and I will get off. When or if is there going to be a tidal wave or is it more just going to be a day increase from all these billions of dollars from coal mining safety, all the tax for the safety but we are expecting at some point that there’d be tidal wave is just going to be a slow inching up of the water versus a tidal wave?

Bob Chen

I think Brian we are prepared for the tidal wave. When the wave happens we are ready to capture that wave. But also we are also enjoying a pretty good growth rate in the 30% of the growth. So I think the coal mine safety it will happen and we will position ourselves and this year we will probably get our operations moved to the new building the later part of the year so we are prepared. I think with the energy demand, coal is a very important part in China you saw the recent China’s ice and snow storm and the energy is becoming equally more and more important and the coal products are also very hot there. So we believe that the original assumptions in our expectation is still real.

Brian Rutenberg – Morgan Keegan

Okay. Thank you very much.

Operator

And your next question comes from the line of Matthew McKay of Jeffries and Company. Please proceed.

Matthew McKay – Jeffries and Company

Good afternoon guys. Just as you said in the previous answer, revenue growth has what might have not been up expectations, has been pretty healthy. In the press release and the call you talk about looking more at the cost structure and just trying to drill down a little bit more into where are the opportunities to improve the margin. If you kind of look at it either from are there any opportunities to raise prices a little bit in China because I don’t think you have a significant amount of competition over there and that can help a little bit on the margin side but also on the gross margin, how much cost can you take out of there and also just the overhead, it would seem like you can I don’t know if it would be moving more operations over in China given that over 50% of our revenue is coming from there or some other way, it seems like you could reduce the overhead cost a little bit as well. So any kind of color would be helpful.

Bob Chen

Yes, Matthew you are absolutely right. We have been actively looking after our manufacturing deficiencies the facility equalization, (inaudible 27.39) and productivity, the labor costs and we continue to drive the favorable bearings to drive down the cost. And also we continue looking for new products in our portfolio that differentiate technologies and we continue on to add these differentiator products to maintain and improve our gross margins. We are constantly looking at it. And also some of the expenses and the variable (inaudible 28.08) expenses, we have executive look at line by line regularly and really try to look at every function including administration, you know every department to drive down the expenses. This was the area we continue. We have seen even with our China operations our gross margins steadily improve combining with the expense control, the gross margin. And also you talk about price increases, we are reviewing every product line look at the market place see whether we can get our fair price adjustment to support in the market place. (Inaudible 28:54) the line there, hello.

Operator

Seems like he’s dropped out of the queue sir.

Bob Chen

Okay.

Operator

And once again for questions that is star followed by one. Sir you appear to have no further questions at this time. Your next question comes from the line of Ken Liddy of Wachovia Securities.

Ken Liddy – Wachovia Securities

Hi, good afternoon. The research and development in the fourth quarter it seemed to climb quite a bit. Can you talk a little bit about that?

Randall Gausman

Actually R&D in the fourth quarter was 2% of revenue. I think that probably increased, well compared to the prior year it was a 1% point increase year over year and compared to the third quarter I believe it was a 1 to 2% percentage increase. You know we commented that we had introduced a number of new products last year as well as we had planned to introduce a number of new products this year particularly in the wireless area and we are a technology company and R&D as we’ve said in the past is the lifeblood of our company. We are comfortable with spending somewhere in the neighborhood of 8 to 10% per annum on R&D as we develop new products to introduce in to the various markets we serve.

Ken Liddy – Wachovia Securities

You mentioned in the opening statements that some of the integration of your China operations were taking a little bit longer than you had anticipated. Is that where some of the cost reductions can be made?

Randall Gausman

Absolutely. We are not happy frankly, neither Bob nor I or the rest of the executive management team are happy with the level of our operating expenses. We’ve taken in China we’ve got these two state owned enterprises that we are converting to U.S. business practices and U.S. accounting practices. We’ve made a lot of great progress there and there’s still some things that we have left to do. For example, one of the things that we are doing this year is we’re operating both these CRP Systems. And as a result of that upgrade when it’s completed, we will be able to begin to recognize some real efficiencies and synergies between the various operations in China. So it’s been taken and like we said a lot of energy and time but we are making real progress and we’re starting to get some real traction there but it just hasn’t happened as quick as we originally anticipated.

Ken Liddy – Wachovia Securities

In the quarter was there any expenses for the Polimaster law suit. I know that there’s …

Randall Gausman

Yeah, what happened in the fourth quarter, well actually there was arbitration last middle of last year, and we successfully won that arbitration and then the fourth quarter, the arbitration was upheld by the judicial system and it was found in our favor that we did not violate the intellectual property rights of Polimaster and we in fact were awarded damages to the tune of $2.4 million. You will probably ask have we collected that. No we haven’t collected the $2.4 million. Polimaster is a company that’s located in Belarus. So there may be not that it’s not collectible but there may be some additional costs associated with trying to collect those expenses and we are actually evaluating whether it’s worth spending more legal dollars to go after the award.

Ken Liddy – Wachovia Securities

In the last call you talked actually really talked a bit about the Illinois contract that you had been working to try to secure of which from what I understand a company partnered with Polimaster and actually won, could you talk a little bit about what happened there?

Randall Gausman

Well yes they did and we you know we are actually pursuing other opportunities in the first responder market in that part of the country. We have not given up on that and to the extent that Polimaster is part of that, that will also be an opportunity for us if we want to pursue Polimaster in the United States for the award.

Ken Liddy – Wachovia Securities

Are you contesting that the award in Illinois?

Randall Gausman

No.

Ken Liddy – Wachovia Securities

And do you know what basis for which they did not choose your product?

Randall Gausman

I know there was a competitive evaluation and they chose the other product over us.

Ken Liddy – Wachovia Securities

Can you talk a little bit about some of the opportunities in the United States with first responders?

Randall Gausman

Well there is opportunities with the various fire departments, with the National Guard, with some potential CFT awards, we’re also looking beyond the borders, we’re looking at opportunities in 2008 up in Canada and some additional opportunities south of the border down in Latin America particularly in the oil and gas sector.

Ken Liddy – Wachovia Securities

I guess one of the questions a lot of us have is with the integration of RAE Fushun without RAE Fushun would the company have been [inaudible]

Randall Gausman

We lost the call. Hello?

Operator

Mr. Liddy if you’ve muted your line, please un-mute.

Randall Gausman

We lost the call. Michelle are you there?

Operator

Yes sir, I’m here.

Randall Gausman

Why don’t you go ahead and queue up Mr. Dede and we’ll let him come back.

Operator

Okay, great. And we’ll take the next question from Kevin Dede. Please proceed.

Kevin Dede

Thanks gentlemen, thanks for getting me on Bob. Randy would you mind just giving us a glimpse of what the business model should be post your restructuring effort or are you still too new to the evaluation process to get to or to be able to offer something on that?

Randall Gausman

Well we made some comments about earlier.

Kevin Dede

Well yeah, I understand what you’re expecting for the year but I was wondering if you could give us sort of a break even revenue run and maybe give us some margin guidance on a quarterly basis.

Randall Gausman

We don’t comment on quarterly guidance, but you know our gross margin again we are targeting in the range of 50 to 55% where right now we are at the lower end of that range and we expect over time to move higher in that range as we introduce some of these new products. With our focus on operating expenses clearly we need to drive those operating expenses down and our long term plan would have us generating operating income of somewhere probably in the 10 to 12% range in the near future, maybe not this year but certainly soon after. I don’t know if that helps you or not.

Kevin Dede

Well yeah that’s helpful that’s a target certainly helpful. What do you think your revenue line needs to be to push that break even?

Randall Gausman

You know, frankly Kevin, we are close to that now. We need to drive down some of our expenses. We spent a lot of time looking at our competitors looking at other companies in our industry and we’ve had some unusual expenses for example this year, we had the Polimaster expenses which added to that problem. But at the level of revenue we are at now that we’re projecting, we know we can be a profitable company, we just have to work hard at which we are at driving down those expenses so I think we are getting there.

Kevin Dede

Okay what was the Fushun number revenue for ’06?

Randall Gausman

For ’06 their revenue was right around what 9 million, 8 to 9 million Bob?

Bob Chen

Yes.

Kevin Dede

Okay.

Randall Gausman

You know that business Kevin and it got off to a slow start in 2007 but we saw a good second half and I think this year in 2008 we’re expecting a significant contribution from that business I think someone asked earlier about the coal tax, we are actually in last quarter we received a large order for a digital mine product which we will be delivering this year, so we are starting to see some changes in that formerly state run company that I think we’ll start benefiting from even more this year than in the past year.

Kevin Dede

Okay on the thanks for the call Randy, but on the sale leaseback, I want to just have a better feeling for the going forward treatment of that. First of all on the balance sheet it looks like property and equipment was down 3 million year over year. That reflects that sale?

Randall Gausman

Right.

Kevin Dede

Okay then you’re expecting to amortize the gain over the next 10 years.

Randall Gausman

Correct.

Kevin Dede

How does that flow through the P&L?

Randall Gausman

Well actually it’s a—we will recognize the gain each quarter and it’s a 10 year lease so we’ll recognize divide that by 120 months and we will recognize 3 out of 120 each quarter. Also offsetting that though are the lease payments that we will make and the actual deferred actual value of the deferred rental payments shows up on the balance sheet on the other long term liabilities line. If you notice, that’s gone up year over year.

Kevin Dede

Long term liabilities. Right, right, right, okay yeah, okay. Bob you mentioned your four business lines security, environment, oil, gas, mining, I was wondering if you could give us a crack at how revenues broke down between those lines of businesses and how you might expect that to change in ’08.

Bob Chen

I think this was taken on market, it depends on different regions. In China we see the energy across the board continue to be a very high good growth and China’s automobiles and construction the infrastructure, the steel those markets you know traditional markets continue to cool off. But also big emerging opportunities for China is the on the environmental concern. That’s a big market.

In America we believe the homeland security continues to be a major market and the oil energy sector as evidenced we did very well in the Gulf coast in the Texas area. We continue to see the growth in that area so both the government and the environmental market continue to do well and the energy sector will do well in the Americas. Europe we also see the Middle East the energy parts continue to well and also a good growth area geographically into the various regions we see European business at a good healthy growth. So overall, I think across the board all segments and markets continue to do well for us.

Kevin Dede

Can you slice the 90.8 million that you did in ’07 by those business lines or is that something your not comfortable offering us?

Bob Chen

We don’t keep tally in those areas but I can assure you that the energy sector is a big part of it and the government is not as small. The industrial safety is an integral part of it.

Kevin Dede

Last question for me just on discontinued ops, I missed what piece of the business that was.

Randall Gausman

That was the DBR business

Bob Chen

The police car and law enforcement police car monitoring system and we just do not have the sales channel and support infrastructure for this market but we kept the patents, the technology we will have the DBR to build tech capability into our future wireless product. Our wireless product deployment will have this technology incorporated into it.

Kevin Dede

Oh, that’s right, sounds familiar to me now. Thanks very much gentlemen for taking my questions.

Randal Gausman

Thank you Kevin.

Operator

Your next question comes from the line of Ken Liddy of Wachovia Securities. Please proceed.

Ken Liddy – Wachovia Securities

Sorry about that earlier I got cut off. I’d gotten cut off earlier when I was in the midst of a question. With regards to the China operations was RAE Fushun in itself profitable in 2007:

Randal Gausman

Well we don’t break out and report by our business units the profitability but when we acquired the business or formed the business back in December 2006, we obviously put together a business plan for that business and looked at it for a stand alone basis. I think it’s fair to say the company has that or has come very close to meeting the expectations of the original business plan. We expect that over the long term, it will contribute to the positive operating results of the company.

Ken Liddy – Wachovia Securities

Now in the opening statements Bob you mentioned about replacing your U.S. Operations Chief. Could you expand on what you are exactly looking for to replace Rudy with what type of individual and what his co CEO or another Chief Operating Officer?

Randal Gausman

This is Randy, I’ll take the question since I’m sort of in that role right now. What we are looking for is to grow America’s sales aggressively and expand into new markets. We are looking for an individual to that has a number of years of strong sales management experience particularly managing a direct sales and a distribution of channel organization. In fact we’ve identified some candidates that have that experience so the focus really is going to be on driving sales and while maintaining a real cost efficient operation.

Ken Liddy – Wachovia Securities

Are you looking to do this externally or internally?

Randal Gausman

We are looking at external candidates.

Ken Liddy – Wachovia Securities

And how soon do you expect to fill the post?

Randal Gausman

We are- it’s a top priority for Bob and myself.

Ken Liddy – Wachovia Securities

And would you say that the U.S. Operations are the area that you have most room for the most improvement?

Randal Gausman

Well every area we are constantly looking to improve in all areas. We have a good sales team in the Americas, we have a good inside sales team in the Americas and we know we can grow it faster and focus on the oil and gas industry, focus on some international expansion the Americas and of course we will not forget the government sector as well as the environmental sector.

Ken Liddy – Wachovia Securities

Brian mentioned previously in his question regarding the tidal wave from the China tax from the coal industry do you have any feel if we are looking for a surging revenue by 2010 from the coal mining tax?

Bob Chen

Kevin this is Bob. The fundamental primary demand in China for coal as a source of energy is continued to increase and the coal price is steadily declining. It has been recently witnessed by the ice and snow storm, the shortage of electricity in China during the New Year, the transportation shut down and this is becoming increasingly more important.

You know the president of China during the Chinese New Year spending his time in the coal mine. This has continued to be a top priority for China as a government. And we have experience to see our coal Fushun coal safety equipment business continuously the customer is never short of funds to make the purchases and they are constantly looking for new product. As Randy mentioned earlier, we won several big digital mine contracts we are expected to deliver some time this year. This is just the beginning of one of the very large opportunity for us. I wouldn’t use the word tidal wave but I think the tide is constantly rising and we believe we are in a good position to take advantage of it.

Ken Liddy – Wachovia Securities

From what I understand, much of the time and energy has been spent closing mines in 2007 has that begun to shift yet?

Bob Chen

Yes, I think they have been doing, shut down the small mines. However recently I read some report because of the ice storm and also the snow storm, some localized failure in the power station and some of the localized power stations did not, the transportation shut down. The coal cannot be transported into the regional power plant. So there is some talk about some regional coal supply.

I have not seen any decision been made yet, but that was some of the issue during the transportation shut down because the power failure. As a result, the coal did not overnight- able to transport to the regional power plant in time so there are some people talking about to revitalize some of the local coal mines to continue to supply some of the regional power plant in case of emergencies. But I have not seen that, that’s still not on the central government policy. I believe the policy is still try to shut down to gain skill but we are constantly watching them.

Ken Liddy – Wachovia Securities

Can you talk a little bit about this digital mine contract. What exactly is it and how much is it?

Bob Chen

We will probably give more information to you in our next call but basically digital mines we are applying the latest digital technology wireless, the IP and also integrating sensing positioning and all these safety things in the latest digital technology for the coal mine safety.

Ken Liddy – Wachovia Securities

Do you use an outside integrator to integrate or are you doing a lot by yourselves.

Bob Chen

It’s our technology, our sensor our wireless technology we have integrated.

Ken Liddy – Wachovia Securities

And you said you were recently awarded it. Can you talk about the size?

Bob Chen

I think its very [inaudible]

Randal Gausman

I think the key point though Kevin here is I’m sorry Ken, the key point here is this is one of the things we were looking for when we acquired the coal mine safety business because it’s actually a marriage if you will of proprietary technology and the mining technology of RAE Fushun. And so this is where we see the real opportunity to have grow the coal mine safety business and combining our products and drive even more access to the coal mine safety market in China.

Ken Liddy – Wachovia Securities

Looking at first quarter where do you expect revenues from your China operations to be in the first quarter as far as percentage of total sales?

Randal Gausman

Ken I don’t want to keep repeating myself but we don’t give guidance on a quarterly basis but I think overall our expectation is that China will continue to be a more significant contributor to the company’s revenue over the long term.

Bob Chen

So Ken you also wanted to know that during Q1 there is a Chinese new year holiday (inaudible 54.12) so there will be some slightly dropped on the revenue from China. But overall like Randy said because of the Fushun and also the China market continually will be a significant part of our revenue.

Ken Liddy – Wachovia Securities

Okay well thanks for your time.

Bob Chen

Thank you.

Operator

Your next question comes from the line of Matthew McKay of Jefferies and Company. Please proceed.

Matthew McKay – Jeffries and Company

Hey guys I’m having a technical problem after you answered that last question for me. Is it possible to just give a breakdown of production as a percentage what’s done in China versus what’s done in the U.S. or other places?

Randal Gausman

Our major manufacturing operations are in China. In Shanghai we have a manufacturing facility where essentially all of our products are manufactured and then we have some manufacturing capabilities at RAE Beijing and of course manufacturing capabilities of RAE Fushun. Here in the United States we do make a small number of products that are integrated with the products that are manufactured in Shanghai but the products are in China.

Matthew McKay – Jeffries and Company

Okay so from that answer there doesn’t sound like there’s a lot of opportunity to improve the gross margin or too much.

Randal Gausman

No.

Bob Chen

No, no Matthew. This is Bob you have to realize we are constantly looking at the labor rate; in the northeast the labor rate is about one third lower than Shanghai or Shanghai’s technical skill is higher so we also have a program to moving some of the lower product to move up to Fushun to become our lower end product we manufacture there and Beijing they do fix system, we do all the pc board all automated in Shanghai.

We’re constantly looking at utilizing the facility and capability to drive down efficiency. And over the years we have a steady favorable bearing on the manufacturing cost and the overhead, we constantly look at that and also look at utilization of the space. So like Randy said it’s kind of frustrating to us so we’d like to get a move faster to integrate China operations into this kind of modern system but we’re steady moving making good progress.

We think we are on the right track. We continue to improve that and also the R&D we’re spending to improve the differentiator technology to get a margin and a price and to improve on that part. The most big opportunity for us and some of the expenses we are looking at some of the variable discretionary expenses we are going to have a tight control and with this $100 million RAE business we definitely believe we will be able to make it possible.

Matthew McKay – Jeffries and Company

Okay, that’s helpful thank you and then given that the Olympics are obviously in China this year, I’m just wondering if it’s going to cause any unusual seasonality on your business, if it’s going to have any impact at all?

Bob Chen

Absolutely not. I think the Beijing maybe in the city there will be a lot of tourist, there will be a lot of events but it’s just the capital city but the rest of China will continue to have good business.

Matthew McKay – Jeffries and Company

Great thanks guys.

Operator

And that concludes the question and answer session, now I will turn it back to management for closing remarks.

Bob Chen

I would like to personally say thank you for your time this afternoon and your continued support of RAE Systems. As you have heard this afternoon, we are growing RAE Systems to $100 million plus per year business. We are taking specific actions to return to profitability this year and we believe we are well positioned to continue to spread the RAE brand worldwide. I look forward to speaking with you at our next conference call in the spring of 2008. Have a pleasant afternoon. Goodbye.

Operator

Ladies and gentlemen thank you for your participation in today’s conference, this concludes the presentation. You may now disconnect, have a good day.

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Source: RAE Systems Inc. Q4 2007 Earnings Call Transcript
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