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KVH Industries Inc. (NASDAQ:KVHI)

Q2 2008 Earnings Call

July 22, 2008 10:30 am ET

Executives

Pat Spratt - CFO

Martin Kits van Heyningen - President, CEO and Chairman of the Board

Analysts

Jim McIlree - Colin Stewart

Chris Quilty - Raymond James

Rich Valera - Needham & Company

Tom Watts - Cowen and Company

Operator

Good day, everyone, and welcome to the KVH Industries Q2 conference call. Today's conference is being recorded.

At this time, for opening remarks and introductions, I would like to turn the call over to Mr. Pat Spratt, Chief Financial Officer. Please go ahead, sir.

Pat Spratt

Thank you, and good morning. I am Pat Spratt, Chief Financial Officer of KVH Industries. And with me today is Martin Kits van Heyningen, Chief Executive Officer.

This call will address the second quarter earnings release that we issued earlier this morning. Copies of the release are available on our website, kvh.com, and are also available from our Investor Relations department.

This call is being simulcast on the internet and will also be archived on our website for future reference. For those of you listening via the web, feel free to submit questions related to the content of today's discussion to ir@kvh.com, and we will be happy to answer them following the call.

This conference call will contain certain forward-looking statements that involve risks and uncertainties. For example, statements regarding financial and product development goals are forward-looking. The company's future results may differ materially from the projections described in today's discussions.

Factors that might cause these differences include, but are not limited to, those mentioned in today's call and risk factors described in our quarterly report on Form 10-Q filed with the SEC on May 7th, 2008. The company's SEC filings are directly available from us, from the SEC or from the investor information section of our website.

Now, I would like to turn the call over to Martin to begin today's discussion. Martin?

Martin Kits van Heyningen

Thanks, Pat. Thank you all for joining us today. So despite challenging economic conditions, we achieved solid top line results and earned record profits during the second quarter, as our long-term strategic growth drivers began to hit their stride.

We received new orders for our fiber optic gyros that helped growth in demand for remote weapon station. Our airtime business is striving to become a significant contributor to our revenues, and which are the major step towards the global expansion of the mini-VSAT Broadband service.

Our diversification with multiple markets and emerging revenue sources enable us to meet or beat our expectations, despite maybe a fewer challenges in some markets. As a result, I'm very pleased with our overall performance.

For the quarter, we achieved revenues of revenues of $22.3 million and generated EPS of $0.14 per share on a record profit of $2.0 million. For the first half of the year, total revenue was up 4% to $45.4 million with net profit of $3.6 million. Earnings per share for the first six months were $0.24. That's a $0.14 increase over the first half of 2007. In fact, we are on track to double EPS this year.

In the mobile communications market, revenue increased 4% over last year. Land mobile sales were down 37% year-over-year, a reflection of the current challenges faced by the RV industry. Sales of Class A recreational vehicles are down 40% this year as a result of record high fuel prices, declining consumer confidence and challenging consumer credit markets.

Consumer behavior is also changing with RV owners traveling regionally rather than nationally and spending more time camping rather than driving, meaning our viewers are still enjoying satellite television on their vehicles. Nevertheless, we see this market continuing to be a challenge going forward. However, our overall positive results for the quarter in spite of the decline in our RV business speaks of the strength of the diversification of our business model. Currently, the land business represents about 15% of total company revenues.

In the marine market, for Q2, our marine satellite sales were up 22% with good growth both domestically and internationally. While the same economic factors affecting the RV market are at work in the marine sector primarily at the lower end of market, strong sales of our TracPhone satellite communication systems and rapidly expanding airtime revenue more than offset a modest year-over-year decline in Satellite TV sales.

During Q2, we shift our Inmarsat-compatible TracPhone FB250 system for the first time, but the real highlight was the continued success of the TracPhone V7 and the mini-VSAT Broadband service. During the second quarter, we saw continued strong demand and we're meeting our sales and production goals.

Maritime businesses like land-based businesses continue to integrate the internet and mobile communications in every facet of their operations. This is a long-term trend that benefits us and spurs demand for high-speed data systems. Response from commercial operators has been extremely positive.

The TracPhone V7 with its relatively low hardware cost, high-data speed and affordable airtime is proving itself more than capable of supporting two key requirements for commercial operators. They're supporting shipboard operations and maintaining crew morale by enabling email and internet access.

Airtime revenue led by the mini-VSAT Broadband and Inmarsat subscriptions is a rapidly growing and very exiting part of our business. During the second quarter, we took an important step to accelerate the expansion of the mini-VSAT service. We achieved a major strategic milestone in this effort when we signed a new 10-year agreement with ViaSat to roll out the mini-VSAT globally.

As you may know, we work closely with ViaSat to develop the V7, which includes the maritime version of ViaSat's ArcLight spread spectrum modem. This enabling technology allows us to build smaller systems suitable for a variety of mobile platform. We are building on that partnership by jointly investing in the network infrastructure. They will open new regions to the TracPhone V7 in our airtime service.

Under the terms of our agreement, we are immediately investing in three new regional satellite hubs. Each satellite hub consists of a very sophisticated mix of hardware and software necessary to manage the network communications. As the expansion continues, the number of hubs in our network satellite capacity will grow in parallel, with KVH and ViaSat both investing in the necessary hardware.

Global coverage will initially require roughly 10 transponders and hub, while supplemental hubs and transponders will be added as needed to support additional subscriber growth in each region. KVH will earn revenue from ViaSat aviation customers roaming through our network. Similarly, we'll share a portion of our maritime revenue with ViaSat if our customers roam into one of their regions.

KVH is now actively working to acquire network capacity for Ku-band satellite operators. These arrangements could range from buying capacity with multi-year commitments to a revenue sharing model that pay as you go, similar to our current arrangements.

However, since we are capturing new regional market for both hardware sales and airtime sale, our goal is for each new region to breakeven within three to six months of coming online. We also anticipate increased sales in regions where we already have service since many of our target customers are looking for a system that has global reach.

Our goal is to rollout new coverage areas turning this year, late 2008, and throughout 2009, to support not only recreational vessel but also commercial shipping lines and offshore oil and gas fields. The first priority will be the Pacific Ocean region which is critical for the major transpacific shipping companies. This coverage will also include the Alaskan fishing industry, as well as the leisure boat market in Hawaii.

As we rollout our expanded service, we'll be able to support sales and new regions using our established maritime distribution network which already includes multiple distributors throughout Asia. We continue to work on expanding our distribution model and we'll be targeting the sales of infrastructure development in those three months ahead of launch of service in each market.

And now one final topic on mobile satellite communications before I move on to the defense. During the first quarter, we announced a new contract from LiveTV to design and manufacture their new satellite TV antenna for commercial airliners. Happy to report that product development is going well, we are on schedule, and we remain on track to begin production at the end of the year.

It's also worth noting that our antenna together with the next generation in-flight entertainment system being developed by LiveTV will be significantly lighter than the systems currently in use. This will help minimize fuel consumption by the airlines which are obviously their current top priority.

Moving on to defense. This quarter was characterized by some big orders, but very few big shipments. Our guidance and stabilization sales were down 30% in the second quarter compared to Q2 last year. TACNAV product shipments were well below the prior year level. But as anticipated, inertial measurement units for the Mark 54 Torpedo program were minimal as Raytheon carried out new contract discussions with the navy. We are awaiting a very large order for our TG-6000 IMU system sometime during Q3 with shipments ramping in Q4.

In our last conference call, we [ventured] up to speed on the major new program for our fiber optic gyros. Kongsberg, one of the world's leading manufacturers of remote weapon station selected our FOGs to provide the stabilization in precision pointing input to their systems. FOG shipments to Kongsberg were minimal in Q2, but with the new $2 million order announced two weeks ago, we now have $8 million in backlog. A majority of the first order, it's expected to ship in Q4, and the second order should be completed during January of 2009.

Based on feedback from our customer, demand for remote weapon stations remained strong, and we anticipate a steady stream of additional orders that could sustain a $4 million to $6 million per quarter run rate through 2009.

During Q2, we also expanded our opportunities in the commercial market with the introduction of our first of the several new fiber optic gyro products. The new CNS-5000 is a result of a joint development effort by KVH and NovAtel, a leading precision GPS manufacturer. It's a fully integrated continuous navigation system that combines three of our DSP-3000 fiber optic gyros with accelerometers, and NovAtel's RTK GPS receiver. The result is the first self-contained system to offer low cost, three dimensional positioning, velocity, and attitude measurement.

While it follows in the footsteps of our tactical grade TG-6000 IMU for military use, this product is classified as a commercial system, significantly expanding the opportunities for export sales, as well as sales by both KVH and NovAtel, since both companies are going to be marketing this product.

Now initial response to the CNS-5000 is among the strongest we've seen for one of our FOG products. We are meeting a previously unfulfilled need for an affordable self-contained positioning system. Shipments of the CNS-5000 are expected to begin later this year.

So, in conclusion, we just completed a very strong quarter and we're well positioned for the future. Growth in our strategic business areas is allowing us to weather the current economic climate, and we look forward to new revenue streams having an increasingly positive impact as we move through the second half of 2008. We see revenue growth accelerating in the second half of this year with earnings growth following suit.

But these are clearly very uncertain times and the difficulty of forecasting is compounded by uncertainty in the direction of the price of fuel. We were surprised by the sudden drop-off in RV sales in Q2 after having them flat for Q1 and are therefore taking a cautious view towards Q3.

Given the large [fall] backlog that we have for Q4, we feel we actually have better visibility for Q4 than we normally would have at this time of the year. Overall, our outlook assumes that the current economic environment will continue as it is. It won't get better, but it won't get worse.

Now, To turn the call over to Pat, who will provide details of numbers. Pat?

Pat Spratt

Thank you, Martin. The financial results for the second quarter were gratifying especially given very, very weak economic conditions that became far more challenging over the last several months. Even though sales were just below the low end of the expected range, our operating margin was just shy of 9%.

Now, to some of the specifics. Gross margin was just under 42%. Contributing to this result were the continuing strong sales of TracPhone marine products and the benefit of our ongoing cost improvement programs. In the quarter, we also recorded a one-time catch-up for the recognition of commissions earned for TV receiver activations in prior period. This generated a benefit of less than one point of gross margin.

For Q2, operating expenses were down 15% compared to last year. We continue to tightly control discretionary spending. In addition, this result includes the impact of capitalizing the development expenses for the antenna system that we are developing for LiveTV. Because we have a firm order for these systems, it is more appropriate to amortize the cost of development to be aligned with the future revenue recognition.

For the second quarter, R&D spending, as reported, was 35% lower than last year. This reflects the impact of the capitalization that I just mentioned and the fact that other customer-funded engineering projects exceeded last year's level.

It's important to note that we have added engineering resources to contribute to fulfilling the LiveTV commitment and to sustain our other strategic initiatives. Consequently, although we saw a reduction in the reported engineering expense, we have actually increased the absolute level of effort.

Second quarter sales and marketing expenses increased 10% year-over-year, but were up only slightly compared to Q1. In the face of the tough economic conditions and depressed RV expectations, we have taken steps to selectively reduce spending. However, we will not comprise the expansion of our mini-VSAT service, as we intend to take advantage of what we see as very strong sales growth potential.

Administration expenses were down about 34% compared to last year. As a percentage of revenue, this was below 7%. This level was a little below our expectation and reflects the quarter-to-quarter variability of some expenses.

Turning to the balance sheet, cash and marketable securities were $52.6 million. Cash flow from operations was positive at $3.3 million. Capital expenditures were $520,000. We anticipate a step-up in capital expenditures likely beginning in Q4 as we acquire and install hub equipment for the mini-VSAT global deployment.

We continued the stock repurchase program that was authorized last year for up to 1 million shares. As of June 30th, we had repurchased 725,000 shares at a cost of approximately $6.2 million. The program is proceeding within the structure of our 10b-5 stock repurchase plan.

Accounts receivable at $12 million was almost $3 million lower than Q1. Day sales outstanding decreased to 48. Given the current difficult conditions in the general economy, we are really pleased with our ability to achieve such a positive performance level. Inventory increased sequentially by about $1.7 million to $11.8 million. There were two primary contributors to this.

First, we purposely pre-built subassemblies for our standard DSP-3000 fiber optic gyros so that we can continue to meet demand from run rate customers, while we put the vast majority of our new production emphasis on satisfying the rapid ramp of DSP-3100 systems for Kongsberg.

Second, the dramatic increase in fuel prices and the weakening of consumer confidence during the quarter left us with a higher level of satellite TV inventory, especially for the RV market. We fully expect to work this inventory down to more normal levels over the next couple of quarters. Annualized inventory turns were just below 5.

Turning to our expectations for the third quarter and the full year. To start, we are being appropriately cautious in our outlook, given the very challenging economic conditions that exist in the leisure land and marine markets.

Revenue in Q3 should grow nicely year-over-year, and be within the approximate range of $19 million to $20.5 million. We anticipate growth in both the SATCOM and defense businesses, as in the second quarter, mobile communications revenue is expected to be spurred by our new TracPhone V7 product and mini-VSAT airtime services.

Sales of land products are expected to be down year-over-year by a magnitude comparable to what we saw in Q2. We expect the defense sales will show a good increase compared to last year. This is largely due to the fact that fiber optic gyro sales for Kongsberg remote weapon stations will begin to ramp during the quarter, and we are seeing an elevated level of referred work for TACNAV systems that have been deployed on vehicles in war zones.

This guidance also assumes that we will receive the renewal order for the Raytheon Mark 54 torpedo program soon, and restart shipments of the TG-6000 inertial measurement units.

Our defense backlog at the end of June was $13 million. We received the additional $2 million order from Kongsberg during week one of July, increasing our backlog to $15 million.

For Q3, we expect that gross margin will be between 38% and 39%. The expected decrease compared to Q2 is due in part to the seasonal decline in the leisure marine business, and to the significant buildup of FOG production capacity that will be required for remote weapon stations.

The cost growth of the capacity buildup during Q3 is expected to outpace the shipment growth until we get into the fourth quarter. Operating expenses should be about equal to or slightly below the Q2 level. Below the operating margin line, we expect that interest income will be lower than Q2.

The combination of a lower level of revenue sequentially, a shift in the mix of sales, and FOG capacity increases is expected to result in EPS of $0.01 to $0.05. For the year we have lowered our revenue growth expectation to about 10%. This is the direct result of much lower expectations for satellite TV system sales into the land markets, and a more cautious outlook for leisure marine TV sales.

On the positive side, we expect continuing strong sales performance with our TracPhone products and services, and upside potential for the fiber optic gyro business. We have not included the initial shipments of the LiveTV antenna system in our guidance since there are a number of critical development milestones still to be achieved. We are confident that we will successfully satisfy each step, but we have decided to postpone including this in the revenue projection until we have a very clear path to the finish line.

We expect full year gross margin to be slightly above 40%, and operating margin to be between 5% and 6%. The net results should be 2008 full year EPS of approximately $0.36. Operating profit for 2008 is expected to be about $4.5 million better than 2007 or the equivalent of $0.31 better on a pre-tax per share basis.

We are pleased that the second quarter results show solid operating improvements. We are excited about the long-term prospects for our new growth businesses, and we foresee more positive growth in the future as we push forward with the transition of the company's business profile.

Now we'd like to take your questions. [Beck], please open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions)

We will take our first question from Jim McIlree with Colin Stewart.

Jim McIlree - Colin Stewart

Thanks. Good morning.

Martin Kits van Heyningen

Good morning.

Jim McIlree - Colin Stewart

On the services revenue, is the increase in services revenue on a quarter-to-quarter and year-on-year basis primarily related to the mini-VSAT service or was there growth in, let's call it, the legacy services business also?

Martin Kits van Heyningen

There was growth, Jim, let me check a couple of numbers. The biggest absolute growth and percentage wise was certainly in the VSAT airtime services, especially since last year we did not have.

Jim McIlree - Colin Stewart

Right, right. I was speaking more quarter-to-quarter. I mean, you are seeing --.

Martin Kits van Heyningen

We saw a growth in Inmarsat airtime. We saw a substantial, obviously, increase in the VSAT airtime. We also saw as included in that service number is non-warranty repair work, and we saw some increases there as well.

Jim McIlree - Colin Stewart

Okay. I think last around you talked about the amount of airtime that customers are taking?

Martin Kits van Heyningen

Yes.

Jim McIlree - Colin Stewart

At least your initial experience with that, has that changed at all, up or down?

Martin Kits van Heyningen

Yes, it has changed a bit. It seemed to be drifting higher now, so, I would tell you that we are seeing customers used more of other services than we expected.

Jim McIlree - Colin Stewart

Like 10% more or 20% more, a little bit more?

Martin Kits van Heyningen

In a range I think, worst that we are thinking it will be 1,800, and now we are 2,000, it is going a little bit above that now. So, I would say 10% is reasonable.

Jim McIlree - Colin Stewart

Okay, great. Pat, you mentioned that TACNAV refurbishment, that is primarily a US customer?

Pat Spratt

Yes, it is. That is for TACNAC systems that were deployed on vehicles that have been in Iraq and Afghanistan.

Jim McIlree - Colin Stewart

Right.

Martin Kits van Heyningen

It’s part of a normal reset and refurb program that they go through. So the service category includes not just airtime, it also includes government funded engineering services as Pat mentioned, the non-warranty repair service, anything that is not product is put in that category now.

Jim McIlree - Colin Stewart

I see, okay. Okay great. Thank you very much.

Martin Kits van Heyningen

Welcome.

Operator

Chris Quilty with Raymond James.

Chris Quilty - Raymond James

Good morning, gentlemen. I just wanted to follow-up, you had mentioned requirement for 10 transponders, and I think you had previously mentioned with the initial announcement was ViaSat that you would be adding three hubs. Does that indicate you are buying more than one transponder per hub or does that also include the transponders that you are currently using for your existing coverage pattern?

Martin Kits van Heyningen

It includes the ones we’ve now. So there is one transponder per hub roughly, so that is, it is a one-for-one ratio. So when I say there are 10 required for global coverage, that includes the ones we already have now plus the ones we are buying plus the ones ViaSat is buying themselves. So that would be 10 at the baseline global coverage, and then additional capacity would only be added if you sold out a transponder. So that is a success scenario, you would add capacity but only because you can do much business in that region.

Chris Quilty - Raymond James

Okay. If I am looking at what happens in the single sized VSAT market, I think they are able to put 7,000 to 8,000 customers per transponder. Are those the type of numbers that you think each region would be able to support before you would have to add excess capacity?

Martin Kits van Heyningen

Well, I do not think so. I think those numbers sound very high, by like a factor 10 roughly. So it really depends on the usage patterns because do not forget we are not charging $49 a month, we are charging $2,000 a month. So these customers are getting and buying a fairly high level of capacity and service. So it is a different business model than at the home-use where they try to cram a lot of people on, and whatever level of service they get is what they get.

Chris Quilty - Raymond James

That is fair enough. Now, a question in terms of the capital expense for building out the hubs, ballpark general cost, and time to completion. How you will end up depreciating that?

Martin Kits van Heyningen

I will let Pat answer the depreciation question. It is just a ballpark, just $3 million to $5 million initial capital investment over the next 18 months.

Chris Quilty - Raymond James

Does that mean you are not going to have the service availability for 18 months, or when would you first be able to launch service? I think you indicated end of the year?

Martin Kits van Heyningen

Yes. So I had meant the entire effort would be done in over 18 months. However, we do expect the first region to go live this year, at the end of this year.

Chris Quilty - Raymond James

Okay.

Pat Spratt

Our intention as far as depreciation goes is to generally use a five-year straight line period.

Chris Quilty - Raymond James

Okay. Your thoughts at this point, given what you have seen in demand, taking a low-risk, lower reward approach of a teaming arrangement, or just out and out buying a transponder, which I think will cost you, depending on the region, $1 million, $1.5 million a year?

Martin Kits van Heyningen

Yes, that is right. I think that we are at a stage now where we are comfortable enough with the demand for the product that we were somewhat indifferent to the approach, meaning the pay as you go, helps with startup but you make less money in the long run. As long as either model works well for us, we no longer see the risk of the service and product not being successful as a major determining factor. So right now it is purely an economic decision, what is the best deal you can negotiate with the satellite provider. If that answers your question --?

Chris Quilty - Raymond James

No, but I know where you are going.

Martin Kits van Heyningen

What I am saying is that, we are definitely looking at buying satellite capacity and we are prepared to buy it. However, if the satellite operator says, "hey I would prefer to do a revenue share", we will look at the economic trade-off and if they want, and if that comes out better for us, we will do it that way. However, we are not making these decisions now based on risk because we do not see this as, now that the product has been in the market for a while, we’ve pretty good confidence in the take rate. So we are not doing it to reduce risk.

Chris Quilty - Raymond James

Okay. Speaking of the take rate and going back to Jim's question earlier, your service revenues were up about $1.3 million year-over-year, and if you divide that by $5,500 per quarter per ship it gets you to around 240 ships on average that you would have had demanding service. Again assuming that all the incremental revenue came from the service, does that put us in the general ballpark where we are for ships and service? I think you said in your earlier statements or in the press release that you expect the service rate to continue growing at a similar pace. Does that mean if you are adding at a 70% growth rate it should stay at that growth rate through the balance of the year or were you talking number of ships?

Martin Kits van Heyningen

Well, the average revenue is closer to $2000, you know $2,100 to $2,200, not 5,000 if that is the number you were using per month.

Chris Quilty - Raymond James

Per quarter I was giving.

Martin Kits van Heyningen

I am sorry, per quarter.

Chris Quilty - Raymond James

Okay.

Martin Kits van Heyningen

Sorry, never mind, I thought you were talking about on a monthly basis. I think you are in the right order of magnitude, Chris, as you know we do not like to talk about specific sales of a product. Also included in near time revenue is the Inmarsat numbers which we’ve been doing for years, so that subscriber base obviously is a lot larger still than the VSAT numbers, that is in thousands as opposed to hundreds.

Chris Quilty - Raymond James

However, you are not getting an actual split on the revenue airtime for the Inmarsat service, just an initiation?

Martin Kits van Heyningen

No, we are in Inmarsat ISP. So we sell Inmarsat airtime, so we make percentage wise similar number on the Inmarsat that we would make on the VSAT roughly.

Chris Quilty - Raymond James

Okay.

Martin Kits van Heyningen

So, every Inmarsat system we sell, we’ve a sales group focused on that.

Chris Quilty - Raymond James

Got it. Shifting back to the core marine business, I think did you indicated that most of the weakness was centered in the low-end, I think is it the M3 product line?

Martin Kits van Heyningen

Actually doing pretty well, but what I was trying to say is that, it is not that the marine market is immune to what is going on in the general economy, but like in the general economy it seems to be focused more at the low-end. Fortunately for us, those typically are not our core customers, so we do have some products that start at a low-end but its not the biggest of our business. Active within the land side, interestingly, we thought to see the same thing. For example, the automotive segment was down a little bit, but nothing compared to what is down the RVs. That is because the automotive product sells through the high-end of customer and that is different.

So you in the land, you see the same phenomenon going on with the low-end of the market, that is hurt a lot more than the high-end. In the marine market, it is already a high-end market and within that we tend to sell to the higher end of that.

Chris Quilty - Raymond James

Okay. The dramatic fall-off that you saw in the land market in the quarter, clearly things were not nearly this bad in the first quarter and gas, oil prices are up, but I mean, what do you attribute to the fall-off to? Is it just your customers or OEM customers and channel partners being much more conservative in the channel inventories that they are holding or do you think it was really a bleed through of the actual demand level?

Martin Kits van Heyningen

Well, obviously, we mentioned that we are surprised and management should be never be surprised by anything, but we were. Q1, the RV business was flat. The RV market has been down for a long time, so we expected prices, gas prices to erode demand, but we did not expect it to happen this quickly. So part of it is, OEMs were shut down for a period to get their inventories in line. Part of it is when sales are down, if the channel partners overreact by not ordering so that they can work their own inventories down.

So there is a possibility that what we saw in Q2 was inventory related because unlike the marine market and the RV market we sell through distributors, we sell to dealers and we sell to distributors, we sell to OEMs which is different from the marine market where we sell direct to dealers primarily, and we sell direct to boat builders. So you do have that inventory situation. However, nevertheless, for guidance purposes we just assume that what we saw in Q2 will continue in Q3.

Chris Quilty - Raymond James

Okay. However, did you see a different action by your dealers than your OEM in the RV channel or did they both act in concert?

Martin Kits van Heyningen

I would say they both acted in concert.

Chris Quilty - Raymond James

Okay. I have one other question just to shift back to the TracPhone V7. I think you had mentioned last quarter about some potential large orders, Turkish navy, Russian shipping fleet. Was there any news on either of those two? The broader question is, how well is the effort moving along at targeting large shipping fleets?

Martin Kits van Heyningen

Yes, both of those actually came in, and we started shipping some this quarter. So in general, the product strategy is working incredibly well. Perhaps this survey was done recently on shipping companies, and for what they need for crew retention and crew morale, what people want on board vessels, and we had four of the top five things. Like number one was internet access. Number two was email. Number three was voice calling. and/or number two was satellite television.

So it is pretty impressive. So we’ve got really a suite of products now that address that market very well. So the key things we’ve to continue to do is put in more coverage, so that people can use it throughout their operating area. So even though a company might be located in Europe, if they go to the Middle-East, if they go to China, they want coverage over there as well. So that is why we are saying that when you add a region, you do not just have to sell in that region to make it profitable, you can sell units in Germany because you added coverage in China.

Chris Quilty - Raymond James

Got it. Final question on the defense business. You still have what looks like some pretty good expectations going into 2009 of $4 million to $6 million run rate. Yet, the only big industry-wide CROWS, RWS-type contract we’ve seen, it was the US Army's CROWS contract. Are there other contracts out there that internationally perhaps, have been awarded that I have not picked up on, or these things that you still believe are pending?

Martin Kits van Heyningen

Well, I am not aware of any order as big as CROWS, that is for US Army. So I think that is up there.

Chris Quilty - Raymond James

Okay, pretty good. Thank you.

Operator

Rich Valera with Needham & Company.

Rich Valera - Needham & Company

Thanks, good morning. I can just circle back to the year-over-year increase in service revenue of about $1.3 million. Could you give any granularity regarding how much of that was from V7? It sounds like clearly maybe not all of it was, but is it roughly half of that or any granularity on that would be helpful.

Martin Kits van Heyningen

Well, let me try to add a couple of things that might give you a sense without us doing more than we would like. Of the total number of $3.1 million in terms of service revenue, the airtime portion is roughly half of it in total. That is Inmarsat and VSAT combined. The growth drivers year-over-year or the biggest growth driver was clearly the VSAT, airtime portion of that. So, I probably cannot go more deeply than that, but we had some growth in some repair services work, but the big drivers were the airtime and specifically the VSAT airtime.

Rich Valera - Needham & Company

Great. Then you did not mention any update on your qualification process with Kongsberg. I thought you would expect it to be qualified and shipping within this third quarter. Can you just give us an update there how is that going and when you expect to be shipping your first box to Kongsberg under the $6 million order?

Martin Kits van Heyningen

Well, we’ve shipped the units for qualification and it is my understanding that the way this process is working is that they have a customer who works with them on changes and some of the changes get approved ahead of formal qualification, which sounds strange. So, there is a possibility that we will actually be delivering long before the qualification process is completed.

So we are clear to ship. We are shipping to Kongsberg. Their qualification process for their customers is really separate from our delivery requirements. I know that sounds strange, but that is the way it is working right now.

Rich Valera - Needham & Company

Right. So, do you have any revenue to Kongsberg for FOGs baked into the third quarter at this point?

Martin Kits van Heyningen

Yes, yes.

Rich Valera - Needham & Company

So, that is not contingent on the final qualification. Then that big ramp you expect in the fourth quarter, is that contingent on the final qualification?

Martin Kits van Heyningen

No. We’ve been clear to build and we are building as we speak.

Rich Valera - Needham & Company

Okay.

Martin Kits van Heyningen

In other words, what formal qualification they do is not something that we are awaiting final word on in the sense that they have not said, do not build until we go through our own internal process, because they have been internally testing the products for six months or more. Nine months.

Rich Valera - Needham & Company

Right, okay. The $46 million per quarter revenue level you referred to in your prepared remarks, was that just FOGs or overall defense revenue?

Martin Kits van Heyningen

That would be just for this DSP-3100, which is the product being used by Kongsberg for remote weapon stations.

Rich Valera - Needham & Company

Right. So, obviously if that were the case, you would expect overall defense revenue to be higher than that level per quarter.

Martin Kits van Heyningen

Right. So, I mean in other words, think of that, 2 million order, as one additional month production.

Rich Valera - Needham & Company

Right. To Chris's question, that is a pretty high run rate. Do you have any visibility to the end program this is going in to that that level of demand could be sustained throughout '09?

Pat Spratt

I think our customers asked us not to talk about specific programs, but I think Chris made the observation that he is only aware of one program that is of that size?

Rich Valera - Needham & Company

Right. Okay. That is helpful. You mentioned in your prepared or actually in your release about a new leasing program for the V7. Pat, can you give us any sense of the potential working capital implications of the V7 lease?

Pat Spratt

Well, first of all, we do have a lease program. We’ve had some folks who have leased units, but it is been a fairly small percentage of the total so far. We do not expect it to ever be a very large percentage. We put this in place primarily just to offer an alternative stream of financing.

However, essentially, the way it works is the lease is typically a three-year lease. Although we recognize the revenue at the front end of the lease, we are obviously financing the cost of the product over the term of that three year. So essentially what is being financed in the working capital that we are putting up is to cover the cost of the product itself.

The airtime is recognized and paid for as we move through the lease. Then certainly, we’ve to collect on a monthly basis from those customers, but it is the cost of the product that is being financed.

Rich Valera - Needham & Company

Okay. Just a final one, Pat, do you have both the quarter ending defense backlog and then your current backlog including that $2 million order?

Pat Spratt

Yes, I do not have the exact number but ballpark, it is the numbers I gave Rich. We were at $13 million at the very end, around June 30. A few days later, we were at $15 million, and I would estimate, it is still right around that $15 million number.

Rich Valera - Needham & Company

Great, that is helpful. Thanks very much.

Operator

Tom Watts with Cowen and Company.

Tom Watts - Cowen and Company

You have a lot of questions. Could you just comment a little bit more on the LiveTV, you said that there were no revenue assumptions throughout in guidance and there are some remaining development milestones. Could you talk about the milestones a little bit? How should I think about that moving into the revenue stream?

Martin Kits van Heyningen

Okay, I will answer the first part of that. This is a fairly big product development program; we’ve got a large team of people working on it. It is a formal development process where you have a preliminary design review, and then a critical design review.

Right now, we finished the preliminary design review with the customer about a month or so ago, and we are probably about a month away from the critical design review. We expect to start FAA STC-type testing here in the next few months.

The product development program is on schedule, and the reason we do not have it in our revenue forecast even though contractually their deliveries this year is that, we haven't gone through that certification process before and we just think it is better to be a little conservative on that with our customer. So there is some upside there.

Pat Spratt

As far as the revenue goes, we will clearly begin to recognize revenue as we ship product to LiveTV. It is hard to say it contractually, we are expected to begin shipping before the end of this year but it is very late in the year, it is in the back half during the month of December and mostly in the back half of the month of December.

So as Martin said, because of the milestones that we still have to move through and we’ve high confidence that we will be very successful there, but also because of the fact that the timing is such that it is right on the boundary of the end of the year, we just did not want to get too aggressive in terms of assuming that everything is going to go perfectly well.

So it is not in our current forecast. If we do ship, it could add in excess of $1 million of revenue to the year for the units that we would ship to LiveTV. As we said, that is not in the projection and if it does happen then certainly we would add that to the projection.

Tom Watts - Cowen and Company

Okay. Maybe I missed it. Could you give us CapEx for the quarter?

Pat Spratt

Yes sure, CapEx was $520,000.

Tom Watts - Cowen and Company

Okay. You mentioned that were you, are you expecting similar levels in Q3 before the ramp in Q4?

Pat Spratt

Q3 will probably be fairly similar, it might be slightly higher. Q4, I expect it will probably take a step up because we would be beginning to install the first hub for the rollout of the VSAT service. So as we rollout the additional geographies over the course of the next 18 months, we will see a bit of an increase in our CapEx for that hub equipment.

Tom Watts - Cowen and Company

Okay. Then finally, you have a healthy cash balance on the balance sheet. You are not burning any cash here. Could you just remind us if your philosophy on cash if there are any other things you will consider doing with that?

Pat Spratt

Well, as you know, we are buying back some stock, so we are using some cash for that and even with that we’ve been able to generate more cash than we’ve been using. If you were asking about acquisitions or M&A activity or anything like that, there is not anything that we are aggressively pursing. We always do keep our eyes and ears open. However, right now, I think our primary focus is on making sure that we build out the VSAT capability on a global basis so that we’ve full success there.

The cash levels are more than we need on an operating basis if you look out long-term, but in environments like we see today with poor economic conditions and so forth, it is actually nice to have the extra cash. However, we are looking to invest it in the company as we go forward and we foresee opportunities with fiber optics gyroscopes and VSAT global rollout as well as some other things that we think are going to consume some portion of that over the next year or so.

Tom Watts - Cowen and Company

Okay, great. Thanks very much

Operator

(Operator Instructions)

We will take a follow-up question from Chris Quilty with Raymond James.

Chris Quilty - Raymond James

Hi, two for you Pat. First of all the 22% marine growth that you reported in the press release, does that include the service?

Pat Spratt

It includes the service core, the marine business, yes it does.

Chris Quilty - Raymond James

Okay, so that is a mixed number there. If I were to just make some general assumptions about, again, as we talked earlier how much of the service revenue is coming from the V7, it would still look like you are probably hitting around low double-digit growth on the product side in marine?

Martin Kits van Heyningen

Well, again, in the marine, we’ve seen some softness in the TV portion in the U.S. anyway. In Europe, it is still looking good. The non-VSAT TracPhone business has continued to do well also. So, that is probably the extent of the detail I would like to give, but the biggest chunk of our growth year-over-year is absolutely the VSAT products and services.

Chris Quilty - Raymond James

Okay. Can you give us either now or offline the Q3-Q4 revenue breakdown for last year just for modeling purposes, since it looks like you are going to break that out on a go-forward basis.

Martin Kits van Heyningen

You mean what they were as a percentage of the business or dollars?

Pat Spratt

Or are you talking about service?

Chris Quilty - Raymond James

You broke out revenue for both Q1 and with the six-month Q2 into products and services and the product cost of service. It is quite something you hadn't done previously.

Pat Spratt

Right.

Chris Quilty - Raymond James

So, just so we can model the back half of the year, can we get that for Q3 and Q4 of last year to look at --?

Pat Spratt

Okay. That is something I would have to work up, but I can do that.

Chris Quilty - Raymond James

Okay.

Pat Spratt

I can get that to you if you like.

Chris Quilty - Raymond James

The final question on the LiveTV opportunity. How confident are you in that FAA certification process and how much effort have you looked into? As I understand, it is not a simple process. Second part of that is, if I am not mistaken, have you not already sold that system for some business jet applications?

Martin Kits van Heyningen

No, this is a brand new design. This is a ground-up new design. The bizjet version is really a customer-modified A7.

Chris Quilty - Raymond James

Okay.

Martin Kits van Heyningen

So, buying standard A7s and then modifying it themselves. The requirement for the FAA and the STC certification is actually LiveTV's requirement, not our requirement. So, we are actually building and delivering to a very detailed specification. So, it is really their process to go through, and we will support them. However, we actually do not do the specification ourselves.

Chris Quilty - Raymond James

Okay. So, if this is a new design, does it draw from any of the previous hardware architectures that you have done before, either for the A7 or any of the TracVision product line?

Martin Kits van Heyningen

Yes, this is one of those classics. It is exactly like one of our standard products except the array and the circuit board and the motors and the radome. Everything is different. So, it draws on the product architecture of the M3, the array and the board side array, but it is an array like an A7, but it is not an offset array like the A7.

Then, everything about the mechanism is brand new, designed to work in minus 55, gear-driven precision bearing. So it is quite a different product. So, it is really designed from the ground-up for commercial aviation.

Chris Quilty - Raymond James

A radome type device or more of a flush mount?

Martin Kits van Heyningen

It is a low profile radome. It actually will fit into the existing radome that is out there. That is one of the key requirements so that they can get quick approval. So they are not changing anything on the exterior of the aircraft or the way it is mounted to the aircraft. So, it is just changing something that is inside the radome.

Chris Quilty - Raymond James

So, are you talking about a replacement market of replacing in-service units?

Martin Kits van Heyningen

Yes. You can absolutely do that. They are looking at that as well. However, the main motivation for them is that they do not want to have to go through the extensive testing you have to do if you build something on the outside of the airplane. In other words, this is already done. That is already there, and it is completely certified. We are just changing what is inside that radome.

Chris Quilty - Raymond James

Got you. They have certified that radome profile for how many different types of narrow-body, wide-body aircraft?

Martin Kits van Heyningen

It is got the Boeing 737, the Airbus 320 and the Embraer 170, 180 series. So there is three narrow-body jets that it is already type approved for.

Chris Quilty - Raymond James

Got you.

Martin Kits van Heyningen

Those are the two that make up 90% of the market.

Chris Quilty - Raymond James

Okay, awesome. Thank you very much.

Martin Kits van Heyningen

Yes.

Operator

(Operator Instructions)

Seeing there are no further questions, I will turn it back over to you, Mr. Spratt.

Pat Spratt

Well, we just want to thank you all very much for listening in and participating and we look forward to talking to you again. Please do not hesitate to give us a call if you have further questions. Thank you.

Operator

That does conclude our conference for today. Thank you for your participation and have a wonderful day.

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Source: KVH Industries Inc. Q2 2008 Earnings Call Transcript
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