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Executives

Larry Sala – Chairman, President and CEO

Joe Porcello – SVP of Finance and CFO

Analysts

Richard Valera – Needham & Co.

Steve Ferranti – Stephens, Inc.

Chris McDonald – Kennedy Capital

Anaren Inc. (ANEN) Q3 2008 Earnings Call Transcript April 29, 2008 5:00 PM ET

Operator

Good day, and welcome to the Anaren third quarter earnings release. Today's conference is being recorded. At this time, for opening remarks and introductions, I would like to turn the conference over to Mr. Larry Sala, President and Chief Executive Officer of Anaren, Incorporated. Please go ahead, sir.

Larry Sala

Thank you and good afternoon. And thank you for participating in the Anaren fiscal 2008 third quarter conference call. I'll be joined again today by Joe Porcello. I'll provide a brief overview of the third quarter, after which Joe will review the financial highlights, and then we’ll take your questions.

Certain statements made during this conference call will be forward-looking statements. These statements involve risks and uncertainties that could cause actual results to differ materially from those discussed. You are encouraged to review Anaren's Securities and Exchange Commission filings to learn more about the various risks and uncertainties facing our business, and their potential impact on our net sales, earnings, and our stock price.

Net sales for the third quarter were $32.6 million, unchanged from the third quarter of last year. Operating income for the quarter was $2.3 million, or 7% of net sales. Excluding stock based compensation expense, operating income for the quarter was $3.2 million, or 10% of net sales.

Profit margins declined from the second quarter of fiscal 2008, due to the decline in profitability at our Wireless Group's ceramics operation in Salem, New Hampshire, as well as cost overruns on the development projects and manufacturing inefficiencies in our Space & Defense Group. As a result of the continued poor financial performance of our ceramics operation, we are transitioning the production of high power wireless resistor product line from the ceramics operation to our Suzhou, China operation. We believe that this transition will be completed in the first quarter of fiscal 2009, and will result in more than $1 million in annual savings. Some costs associated with this transition resulted in greater than anticipated losses for the quarter at the ceramics operation.

Wireless Group net sales for the quarter were $20.2 million, up 13.3%, from the third quarter of last year. Increased demand for standard components, predominantly from customers in Asia, offset the continued weakness in demand for custom assembly products from one customer. Overall, demand for wireless infrastructure products remains volatile. Sales of consumer component products were $854,000 for the quarter, relatively unchanged from the third quarter of last year due to the continued diversification of design wins for our consumer component product line.

Customers that exceeded 10% of Wireless Group net sales for the quarter were Flextronics, Huawei, Motorola, Nokia, and Richardson.

For the Space & Defense Group, net sales for the quarter were $12.4 million, down 16% from the third quarter of last year. The decline in net sales was due to supply chain and manufacturing issues on several production programs. In addition, the group has captured numerous new programs that are in the development stage and the performance on several of these programs negatively impacted gross margins for the quarter. New orders for the quarter were $10 million and included contracts for passive ranging and radar subsystems.

In addition, earlier today, the group announced an additional $13.7 million in new orders for jamming and passive ranging subsystem products. As a result, Space & Defense Group new orders for the fiscal 2008 full year are expected to be between $55 million and $60 million.

Customers that generated greater than 10% of Space & Defense Group net sales for the quarter were ITT, Raytheon, Northrop Grumman, and Lockheed Martin.

The Space & Defense Group backlog at March 31st, 2008, was $58 million.

Joe?

Joe Porcello

The highlights of the third quarter income statement and balance sheet of March 31st are as follows. Gross profit margin for the third quarter of fiscal 2008 was 31.1%, and included $193,000 of equity based compensation expense. Absent the equity based compensation expense, gross margin was 31.7% for the quarter. Current third quarter gross margin was negatively impacted by the level of wireless sales, the overall business mix, as well as manufacturing inefficiencies on several production programs and cost overruns on development projects within the Space & Defense Group, compared to the third quarter of last year. We expect gross margins, including stock based compensation expense, to fluctuate between 31% and 32.5% for the fourth quarter of fiscal 2008.

Investment in research and development was 8.2% of net sales in the third quarter of fiscal 2008, up 100 basis points compared to the third quarter of fiscal 2007. Current R&D spending is supporting a number of wireless consumer and custom assembly product opportunities as well as the number of current project in the Space & Defense Group.

Operating income was 7% of net sales for the third quarter, down 5.3 percentage points from the third quarter of fiscal 2007, and included $943,000 of stock based compensation expense. Absent this non-equity – non-cash equity expense, operating income was 10% for the current quarter. Compared to last year, the decline in third quarter fiscal 2008 operating income resulted from the decline in gross margins, the one percentage point increase in R & D expenditures, and an additional $215,000 lease charge related to expected future lease costs in excess of expected sublease income generated from the company's Frimley UK facility.

Income from continuing operations was 6.3% of net sales, or $0.14 per diluted share for the third quarter, including $0.05 per share in equity based compensation expense. This compares to income from continuing operations for the third quarter of fiscal 2007 of 10.8% of net sales, or $0.20 per diluted share, which included $0.04 per share in equity based compensation expense. Excluding the equity based compensation expense, income from continuing operations for the third quarter of fiscal 2008 was 8.4% of net sales, or $0.19 per diluted share.

The effective income tax rate for the third quarter was 27.4%, compared to a tax rate of 28.3% for the third quarter of last year. The expected effective annual tax rate for the remainder of fiscal 2008 absent any unanticipated one-time events should be approximately 23.5%.

Net income for the third quarter of fiscal 2008 included $770,000, or $0.05 per diluted share of income from discontinued operations due to the reduction of an unrecognized tax benefit resulting from the lapse of the applicable statute of limitations related to the prior dissolution of the company's Netherlands subsidiary.

Balance sheet highlights include: cash provided by operations was $270,000 in the third quarter of fiscal 2008; capital expenditures were $2.7 million in the quarter, and were driven by our East Syracuse facility expansion and renovation as well as procurement of new test equipment to support expanding volume in the Defense Group, and our China operation; cash, cash equivalents and investments were approximately $42.6 million at March 31, down $31.9 million from June 30, 2007.

During the third quarter, we purchased an additional 194,000 shares of Anaren common stock for approximately $2.8 million. There were approximately 1,547,000 shares remaining under the current Board repurchase authorization at March 31st, 2008.

Accounts receivable were $23.1 million at March 31, 2008, up $3.4 million from June 30, 2007. Days sales outstanding were 65 days, up from 58 days at December 31. Days sales outstanding have increased due to lengthening payment terms for European and Asian wireless customers as well as the skewing of sales towards the end of the quarter for the Space & Defense Group.

Inventories were $27.6 million at March 31, 2008, up 13.6% from June 30 due to the increasing level of long lead time defense business.

Equity based compensation was $943,000 for the third quarter, and was charged as follows: cost of goods sold included $193,000; marketing $58,000; R & D, $162,000; and G&A $530,000.

Larry Sala

Thanks, Joe. For the fourth quarter of fiscal 2008, we expect an increase in sales for the Space & Defense Group and a slight decline in demand for wireless products. As a result, we expect net sales to be in the range of $30 million to $33 million. With an anticipated tax rate of approximately 26.5%, and anticipated equity based compensation expense of approximately $0.05 per diluted share, we expect net earnings per diluted share to be in the range of $0.12 to $0.16 for the fourth quarter.

We will now take questions.

Question-and-Answer Session

Operator

(Operator instructions) We'll hear first from Rich Valera with Needham & Co.

Richard Valera – Needham & Co.

Thanks, good afternoon, guys. First, Larry, could you talk about the cost overruns in the Space & Defense Group, sort of how significant an impact are they having? How long ranging do you think they will be? How long will they be putting pressure on gross margins?

Larry Sala

Based on contract accounting, we have to estimate cost to complete a project, and compare our progress to-date and expenses to-date with what the progress that we’ve made. So as a result of that, we re-estimate every quarter where we stand on the project, and whether we are going to be on budget for the remainder. If we are not, we have to accrue all the expense that we think – excess expense that we are going to incur throughout the remainder of the project. So, it's our best guess that we are back on plan, and we should execute reasonably the plan from here forward. But, it's just the sheer volume and number of programs that makes that assessment difficult for us and where there is more opportunity for projects to fall behind than we’ve had in the past. So I'd say we certainly believe the majority of the impact was felt this quarter, but there is certainly going to be opportunity for probably the next two quarters just given the number of projects we have to complete over the next six months.

Richard Valera – Needham & Co.

Great. And so in terms of the outlook, the gross margin outlook that you are forecasting for the June quarter, there's nothing really – is there anything sort of transitory in there or is that kind of – what are the impacts on that? Is there any anything – any reason to expect that would improve as we moved into fiscal '09?

Joe Porcello

There's a number of programs running right now which is kind of in the prototype phase. Once we get through that phase, we should see some improvement. So I would expect, that once we get out into fiscal of '09, we will begin see some improvement.

Richard Valera – Needham & Co.

Are we talking on the order of 100 basis points, maybe at some point a couple hundred basis points type of movement?

Joe Porcello

Yes, that kind of movement.

Richard Valera – Needham & Co.

Okay. And then you mentioned I think one of your large customers on the custom side has been pretty weak, Larry. I'm assuming that's probably your historically largest customer. Any visibility to the ramp of some of your new programs with them? Because I know you've had different platforms in transition there, some going down, some potentially ramping. Any more visibility on that?

Larry Sala

Well, that transition is certainly continuing, but visibility is still pretty limited on both sides. Our historical business with them, that's slowing down on the platform that's phasing out, and we are certainly ramping up quite quickly on the next generation platform that we are participating on, so some of it is limited by ourselves. We are making capital developments in China to increase our test capacity to be able continue to ramp. But, again, our visibility is very limited. So I mean, we are pretty optimistic that we are through the low point with them, but given the limited visibility and the volatility, that's tough for us to say with certainty.

Richard Valera – Needham & Co.

Okay. And on the defense side, you had a bit of a dip revenue-wise. I take it from your guidance, you were expecting revenue to be up sequentially when you said it was up; is that correct?

Larry Sala

Yes. We expected, when we set guidance that our Space & Defense Group shipments would be more on the order of $14 million, $14.5 million, and they came in almost a couple of million dollars short of that. So it's our expectation again this quarter, given the backlog that we have, that their shipments should be at a minimum, $13 million, $13.5 million, and $14 million, $14.5 million would certainly be more in line with what our customers expectations are. So given – working through some supply chain limitations we've had that hurt us last quarter as well as just some inefficiencies in getting products out the door here, we would expect a better quarter from Space & Defense. And their margins were obviously hurt just by the fall-off in total volume–

Richard Valera – Needham & Co.

Sure. Finally from me, you put out the press release announcing the letter of intent on a potential acquisition. Is there anything more you can say about that at this point? Or can you give us any maybe timeframe when you expect to be able to tell us more?

Larry Sala

We are negotiating and so there's really not much more to say at this point in time. We said, I think in the announcement that we expected to wrap this thing up by the end of the fiscal year, and nothing has changed there. So, I would expect some time within a month or so, we will be at a point where hopefully we are making our next step of disclosure there.

Richard Valera – Needham & Co.

Okay. We'll stay tuned. Thanks, guys.

Larry Sala

Thanks.

Operator

(Operator instructions) We will hear from Steve Ferranti with Stephens Incorporated.

Steve Ferranti – Stephens, Inc.

Hi guys, good afternoon.

Larry Sala

Hi, Steve.

Steve Ferranti – Stephens, Inc.

The decrease in demand for wireless products that you are talking about next quarter, can you shed some light in terms of where you might be feeling that? Is it on the custom side? I joined the call a little late, so I apologize if you’ve touched on this already but–

Larry Sala

No, no, we didn't, and really there's no significant single opportunity or issue that is concerning us. I guess we just roll up all the forecasts, and we come up 0.5 million, a million less than where we were last quarter, and I guess in general we have slightly lower expectations for standard components, and that's just across the board from pretty much our entire customer base. And we've got one customer that's a little lighter on the custom side than they were last quarter, but there is no significant drop-off with anybody or any one issue that's given us concern.

Steve Ferranti – Stephens, Inc.

So did you break out what your consumer revenue was in the–

Larry Sala

Yes, the consumer was about $850,000, which was about flat year over year, and continues to – we said we thought we had hit a bottom point there, and we’d see better sequential performance from the consumer group, and we continue to believe that.

Steve Ferranti – Stephens, Inc.

Any sense for, digging into the, another level into the consumer group I mean you have got kind of a number of factors working there. You've got kind of your existing major, formerly major customer on the satellite side, and you had some incremental opportunities, both in the handset space and in the wireless LAN space. Can you kind of parse out how those start to shape up as we go into the next quarter or two?

Larry Sala

Well, obviously, it's all of those factors that are starting to strengthen the group. They have the baseline of longstanding customers on the satellite L and B side, but we're, we've seen, the new design wins for new L and B customers, both servicing our existing EchoStar supply – supply into that side of the market, as well as now starting to see some contents on the DirecTV side of the marketplace. So we are optimistic that even without our historical largest customer in the satellite space, satellite business will grow from now forward, as far as we can see due to these new design wins and new customers. On the wireless LAN side, and the handset side, we continue to see good, solid demand, so we expect to see a much more diversified revenue stream going forward, and we saw that this quarter. A good part of the incremental revenue has come from the wireless LAN and the handset side, so we are pretty optimistic that the group is going to continue to progress from here.

Steve Ferranti – Stephens, Inc.

If I look at previous years, you have a pretty significant ramp in that particular business unit as you get into the June and September quarters. How are you guys feeling about sort of the ramp looking ahead as we get into the latter part of the year, given this opportunity pipeline?

Larry Sala

Well, we certainly see next quarter being a bit stronger than this for the consumer product line, but visibility much further out is still iffy for us. We certainly feel like we've got a lot more revenue streams, there's – lots [ph] of the product line now depending upon the seasonal nature of the satellite space, so –

Steve Ferranti – Stephens, Inc.

Right.

Larry Sala

So we feel better about the stability going forward than we have in the past.

Steve Ferranti – Stephens, Inc.

Okay. And I guess a question related to your large custom customer. Do you feel like we hit a point at any point here in the future where visibility and volatility might sort of improve going forward? I mean we seem to be in a fairly difficult period. We have got – we had a period where they went through a merger of their own, and then you've got, now this period of a major product transition. I mean do you feel like maybe looking out a quarter or two ahead that maybe your visibility might improve and volatility might subside a bit?

Larry Sala

Yes. We would certainly expect, by at least the end of the September quarter, that this would clear up significantly. The big issue is on the new platform side. Obviously, there's many, many different issues that can disrupt that ramp up forecast. Whether it's end market demand, or supply days [ph] being able to ramp for all the different products and subsystems that drive those kind of platform ramp rates. So, not having any insight into any of that, those things could have an impact from a ramp up rate of this new platform. And then on the old platform side, we are in a competitive position, we get allocation of share, demand is dropping down. The customers who worked with us, have been very supportive of trying to help us transition down and work through our inventory and all those kind of issues. So there is a lot of volatility in that situation as well. And they have obviously difficulty predicting what the demand is going to be for this historical platform when they are offering something new. So, I think that's going to go on for probably another six months. I think we are working very well together and getting as much visibility as they can offer, but both situations have a lot of factors that are just out of people's control.

Steve Ferranti – Stephens, Inc.

Understand. And then last one from me, it sounded like, I think during the last call you identified a fairly solid pipeline of new custom opportunities, some of them involving newer customers. Can you give us an update on those?

Larry Sala

Well, it's difficult to be very specific there, but, there's certainly all moving forward. We probably have, as we said, at least half a dozen opportunities where we have product at various stages of qualification in our customers' hands, so we've been able to build specification-compliant product, provide pricing that’s been attractive enough to our customers to want to qualify us, and that process is moving ahead on these various projects. And it's probably four different customers with six different, six or eight different products that we have delivered. And when I say a product one product might mean three or four different variations for different frequency bands of a particular platform. So we've actually probably delivered 30 or 40 different products, but six or seven fundamental product platforms to different customers.

Steve Ferranti – Stephens, Inc.

Right. And just a point of clarification, I think last call you mentioned a particular opportunity size or range that you thought they could be. Could you–

Larry Sala

I mean, like I said, we typically don't pursue an opportunity that is less than a few million dollars a year, so I would say the low end is probably $3 million or $4 million a year for any one of the opportunities and the high end would be $15 million to $20 million a year of total opportunity, and we typically share that with at least one other supplier.

Steve Ferranti – Stephens, Inc.

Right. Okay, great. Thanks guys.

Larry Sala

Yep.

Operator

(Operator instructions) We will hear next from Chris McDonald with Kennedy Capital

Chris McDonald – Kennedy Capital

Hey guys, thanks for taking my question. Just to follow-up on the last line of questioning, those six or eight different platforms that you currently have or are going for design wins on, just what kind of timing would you expect, Larry, on when those would be, decisions to be made at your customers there?

Larry Sala

Certainly over the next six months at the longest. Our typical lead time from the time we put product in somebody's hands until we are in production is six to nine months, and we now have product in all of the hand – in hand for all the customers. So – it can – depending on the application, whether it's a cost reduction opportunity or it's a new platform development, there's different hoops and hurdles, and the complexity of the product that we are providing that we have to go through. But certainly, we have got – the one we are in a big ramp up with now, we’d expect to be in the middle of one next quarter and over, like I said, in the next, the longest I would say the next six months they all should be at some various conclusion (inaudible) successful.

Chris McDonald – Kennedy Capital

Okay. So it's not unreasonable to think that you would have one or two of these new opportunities. I know a lot of it is ferrite based to ramp up here in each of the coming quarters as we work through the rest of 2008.

Larry Sala

Yes, I think we would be hopeful that we have at least one per quarter, going forward.

Chris McDonald – Kennedy Capital

Are you still thinking that at least for most of these different products it's generally to be thought of as incremental to your existing –

Larry Sala

Yes. This one that we are in a ramp up stage of right now is really replacing a previous application where we participated, but any of the others are certainly incremental to what we are doing.

Chris McDonald – Kennedy Capital

Okay. And in particular, in your June quarter here, I mean is there some weakness that's being driven just by that transition in particular or is it more the – with it being down in the – your revenue being down in the Wireless Group? Is that more just broad?

Larry Sala

Yes, it’s more broad. I wouldn't say that that particular transition is, compared to this quarter, is going to be, we think, significantly different for us. So, now, it's more just across the board.

Chris McDonald – Kennedy Capital

Okay. And then on the consumer side of the business, if you were to back out the CalAmp sales from last year, do you know what kind of growth rate you are looking at for your other consumer applications year-over-year?

Joe Porcello

Well, I don't know that number off the top of my head. I don’t know, but I’d dig that up.

Chris McDonald – Kennedy Capital

If I remember right, the CalAmp portion of last year’s revenue would have been somewhat significant. So, I guess, it seems as though you are getting pretty good traction on the non-CalAmp side of that business.

Larry Sala

I definitely believe that's true, but I can't quantify it for you.

Chris McDonald – Kennedy Capital

Okay. Thanks for taking my question.

Larry Sala

Appreciate it.

Operator

And we have no further questions from the phone audience. I'll turn the conference back over to our speakers for any additional remarks.

Larry Sala

We greatly appreciate your participation and we look forward to speaking with you again next quarter.

Operator

That does conclude today's conference call. We’d like to thank you all for your participation. Have a great day.

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