CPI International, Inc. F3Q08 (Qtr End 06/27/08) Earnings Call Transcript

CPI International, Inc. (CPII)

F3Q08 Earnings Call

August 7, 2008 11:00 am ET

Executives

Joe Caldarelli - Chief Executive Officer and President

Joel Littman - Chief Financial Officer

Analysts

Gary Liebowitz - Wachovia Capital Markets

Ryan Rackley - Raymond James

Presentation

Operator

Welcome to the CPI International third quarter 2008 financial results conference call. (Operator's instructions)

Before we begin, the company has asked me to read the following statement. Today's presentation includes forward-looking statements within the meaning of the Securities and Exchange Act of 1934. Forward-looking statements provide the company's current expectations, beliefs or forecasts of future events. Forward-looking statements are subject to known and unknown risks and uncertainties, which could cause actual results to differ materially from the results projected, expected or implied by forward-looking statements.

These factors include, without limitation, competition in the company's

end-market; the company's debt levels; significant changes or reductions in the U.S. Defense budget; currency fluctuations; U.S. government contracts; laws and regulations; changes in technology; the impact of unexpected cost; and inability to obtain raw materials and components.

Further information on these risk factors and additional risks and uncertainties are included in the company's filings with the Securities and Exchange Commission. The computations of EBITDA, adjusted EBITDA, adjusted EBITDA margin, free cash flow, free cash flow per share, free cash flow conversions, and adjusted free cash flow that will be discussed on today's call are non-GAAP financial measures under Securities and Exchange Commission rules.

A presentation of the most directly comparable GAAP measures and reconciliation's of each of these non-GAAP financial measures to the most directly comparable GAAP measures are available in yesterday's press release, which has been posted on the company's website. Interested parties can access the press release by going to www.CPII.com and opening the press release entitled CPI International Announces Third Quarter 2008 Financial Results.

At this time, I would like to turn the presentation over to your host for today's conference, Joe Caldarelli.

Joe Caldarelli

Our agenda for today's call would be as follows. First I will provide an overview of the Q3 sales and year-to-date orders for each of our markets. Joel Littman, our CFO, will then discuss some of the quarter's key financial metrics. Next, I will talk about out expectations for the balance of the fiscal year before opening up the call for questions. Bob Fickett, our Chief Operating Officer, will join us for the Q&A session at the end of the call.

Q3 '08 was a respectable quarter for CPI. Many of these things that we discussed in our pervious conference call this year continues through the most recent quarter mainly, we continue to manage our operation proficiently to meet customer demand, we continue to invest in programs that we believe will be important for the future of our business and we continue to perform well on our current programs.

In addition, in Q3 we continue to generate positive cash flow and we continue to pay down our debt. On the other hand, on key programs which contributed to our result in the year ago period and was previously successfully completed before, they did not recur in the most recent quarter. In comparison to Q3 '07, our sales and orders' group notwithstanding continue to lay in the placement of orders in our defense business. Sales grew in our defense, communications, industrial and scientific market.

In Q3, we generated sales of $90.7 million, a 4% increase from the year ago quarter. In the first nine months of fiscal '08, we booked $280 million in orders, also a 4% increase in the previous year. Our book-to-bill ratio for the first nine months of fiscal '08 was 1.03. Let us begin our discussion of Q3 sales and orders with the radar and electronic warfare market which together we call our defense market. Please note we discuss our sales in a quarterly basis and orders on year-to-date basis.

As we discussed on prior calls, we have been experiencing a lengthening of order fine lines in our defense market in fiscal '08. As expected, these delays continued in Q3 and we anticipate that we will see similar delays in a number of our defense programs for the foreseeable future. We remain comfortable that there is continued demand for our defense products as our customers continue to engage in dialogue about their needs for our radar and electronic warfare product.

Nevertheless, it is continuing to take longer than normal for our RFQs to be issued and for orders to be place in fine lines. In some instances, these order delays shipped the timing of the entire program to the right. In other instances, the ordered delays result in a more pressing need for additional products once the order is finalized. As a result in the past several months, we have booked larger orders and usual for student programs against the delays in getting those orders finalized as resulted in greater immediate need for products to support those programs.

It is an encourage sign that indicate of the fundamental demand on the market for CPI's defense products remain despite the current hiccup in order timing. However, as you know, delays in the finalization of order results in subsequent delays in the corresponding sales of these programs for these continued order delays are having an impact and are expected to continue to have an impact in the near term on our financial results.

In Q3, our sales in the defense market increased 5%, $38.2 million in comparison to the year ago quarter. The $2 million progress of the growth were the increase in sales to support certain military radar systems including the HAWK missile system for which orders have previously been delayed and the inclusion of CPI Malibu Division's radar product sales in our Q3 '08 defense result.

As you may recall from our Q1 and Q2 conference calls, the HAWK program is larger than normal towards this year and is one of the programs by which we have seen delays in order placement. In the first week of Q2, we received a $3.9 million order for the HAWK missile system that had been expected during Q1. We started shipping products for that order in early January. We received another approximately $2 million order for this program in April, several months later than initially expected and we started shipping products for that immediately.

In July, after the end of the third quarter, we received the third HAWK order totaling approximately $2 million. This is the last of the large orders we expect to receive for this program in fiscal '08. We have begun in shipping products for this program in Q4. In the first nine months of fiscal '08, our defense orders were unchanged in comparison to the prior years' period at a $109.3 million. Orders for the HAWK missile system increased $3.5 million and CPI Malibu Division contributed to our radar orders during the most recent period.

These increases were partially offset by a $5.9 million decrease in orders for radar products to support the Aegis weapon system. As we have already received or anticipated orders for the products to support the building of the remaining approved new Aegis ships with the system on the ships. In addition, orders for spare and repair products to support installed based of currently fielded ships with the Aegis system were among the defense orders delayed in the first nine months of fiscal '08.

Despite the uneven timing of orders for products to support the Aegis system and for certain order defense program, the defense market remains a significant market for CPI and it continues to provide us with a healthy to somewhat reduced level of profitable business. I would like to discuss some recent development in the Aegis program, which you may seen in the media.

The Aegis weapon system is installed on Arleigh Burke class DDG-51 destroyers and CPI provides products for new ships as well as spare and repair products for existing ships. Until recently, construction of new DDG-51 ships were slated toward the end of 2012 that date may not be extended. Recently, US Navy proposed the discontinuing building the more expensive DDG-1000 destroyers and instead building several more DDG-51 destroyers. The exact number of DDG-51 that may be build have not yet been decided but it is expected to be in the range of 8 to 11 new ships.

Whatever the final number, the building of additional DDG-51 destroyers would be incrementally positive for CPI as it increases the number of Aegis weapon systems for which we expect to initially provide new equipment and then provide spare and repair products for decade to come.

Let us move on now to the medical market. This is also an important profitable market for CPI. Our core medical business continues to grow. However, this growth was masked in Q3 by the absence of the large Russian medical program and the timing of a large MRI customers' orders and that the result are total medical market sales and orders decreased in the most recent period.

Let me explain these programs in more detail. In fiscal '06 and '07, in addition to our core medical business, we provided x-ray generators for two increments of a large Russian medical infrastructure program. This program which was never expected to occur every year will not repeat in fiscal '08. In comparison, it contributed $2.9 million in sales for last year's Q3 and $5 million in orders for the first nine months of last year. Please note that we also shipped $2.2 million in products to support the Russian medical program in last year's Q4 and such sales are expected in this year's Q4.

We believe there will be future increments to this program but the size and details of those increments are not yet known. If we exclude the Russian tender program for our '07 and '08 results, our medical sales actually increase 11% in Q3 of '08 versus last year's third quarter. Last year, a large medical customer ordered a three year supply of MRI products from us. This was an uncommonly large order for this significant customer and had the result of inflating our '07 MRI orders to unusually high levels to lowering our '08 MRI orders.

As a result, orders with products to support MRI applications were approximately $6.7 million higher than in the first nine months of '07 than in the most recent period. This is a temporary timing issue and we fully expect to discuss and we will continue to purchase MRI products from it once it has exhausted the two-year supply it ordered last year. As you can see, the two factors that had a negative impact on our medical orders and on sales in the most recent period were timing related.

Our core medical business continues to do well. In the most recent period in comparison to last year, orders and sales of x-ray generators to customers up higher to the Russian medical program increased as the orders and sales to our international customers. Orders and sales of product for radiation therapy applications also increased. In the communications market, sales increased 3% to $28 million in Q3, up compared to the year ago quarter. Orders increased 14% to $92.8 million in the first nine months of this year as compared to last year's period. The increase in both sales and orders are attributable to the inclusion of CPI Malibu Division's antenna products in our communications market and our participation in the WIN-T military communications program this year.

In fiscal '07, we participated in the Joint Network Node or JNN military communications program, the predecessor to the Warfighter Information Network Tactical or WIN-T mil comm Program. We reported $1 million in sales in last year's third quarter and $4.3 million in orders in the first nine months of fiscal '07 as support to JNN mil comm program. Because the program had successfully completed, we recorded no JNN sales or orders in the fiscal year. However, more than upselling the impact of the completion of the JNN program, we were selected last fall to provide satellite communication amplifiers for Increment One of the success of WIN-T program.

We began making production shipments for WIN-T in Q2 of this year and our Q3 communication sales included $2.3 million in products for the WIN-T program. WIN-T also contributed approximately $12 million to our communication market orders in the first nine months of this fiscal year. The WIN-T program is a very large and very important program for us more so than the predecessor JNN program and our participation in Increment One could bring up us to $50 million in sales over four year period.

This program continues to progress very smoothly. We have been successfully qualified for the program and we are known for productions. In April, we received approximately $8.6 million in following orders for WIN-T and we expect the products to fulfill those orders to ship over approximately the next three quarters. In general, our communication business remains healthy and we have not yet seen indications of the current economic environment as having an impact on the communications market.

In summary, based on our orders and sales in our major markets, we believe that the underlying demand for our products remain solid. We have completed our involvement in programs such as the '06 and '07 increments of the Russian tender program and the JNN military communications program and we receive all anticipated orders to new ship builds for the Aegis weapon system. All these programs contributed to our orders and sales result from recent years.

Absent these completed programs, our core medical and communications business are growing and our defense business remains stable. Although order delays in the defense market are continuing, our defense business continues to be solidly profitable as we worked through these near term timing issue.

Now, I would like to turn the call over to Joel to discuss our financial highlights for the quarter.

Joel Littman

In this morning discussion of third quarter financial result, our current CPI's EBITDA, adjusted EBITDA, net income, cash, cash flow, cash flow per share and free cash conversion result through the period. Definitions and reconciliations of our non GAAP metrics can be found in the financial table of yesterday's press release. In the third quarter of fiscal 2008, CPI's EBITDA totaled $16.1 million or 17.7% of sales representing a decrease in last year's third quarter EBITDA of $17.3 million or 19.9% of sales.

This decrease was primarily the result of an increase in the number of development programs in the most recent quarter as compared to a year ago. The significant number of these development activities is taking place to the CPI's Malibu Division which we acquired last August. Sales through the third quarter of fiscal 2008 included a higher proportion of products from development programs than for the same quarter in the previous year.

This lower margin sales resulted in lower EBITDA results for the most recent quarter in comparison to the third quarter of fiscal 2007. As we have discussed on previous conference calls, we have increased our investment in companies under the research and development programs in the past year and the number of customers under development programs has also increased during this time. Although customers from the development programs typically have lower gross margins in manufacturing program, these programs also generate innovations and know how which are leverage another program and they are beneficial to the long term health of our business.

We are maintaining our commitment to invest in the CPI's future by investing in higher levels of development work as we believe the long term benefits of these work outlined the short term impact to our profitability. In the third quarter versus a year ago quarter, the negative effect of sales from customer from the development programs with lower gross margins and higher CPI funded research and development expenses was partially offset by additional gross profit generated by our increase in total sales.

However, these additional sales are primarily a CPI's Malibu Division and this division's profitability was lower than CPI's average due to the more unique, highly engineered products that is sold during the third quarter of fiscal 2008. We expect the CPI Malibu Divisions profitability to improve in the coming quarter. Our adjusted EBITDA for the third quarter of fiscal 2008 totaled $16.8 million or 18.5% of sales, a decrease in the $17.7 million or 20.3% of sales generated in the same quarter last year.

In comparison to our $16.1 million in EBITDA in the most recent quarter, the $16.8 million in adjusted EBITDA exclude approximately $600,000 and non cash stock-based compensation expenses in approximately a $100,000, an non recurring expenses related to debt extinguishment. Our net income in the third quarter of fiscal 2008 totaled $5.8 million or $0.33 per share on a diluted basis.

Although it is a decrease in the $8.1 million or $0.46 per share on a diluted basis generated in the same quarter in the previous year, the most recent quarters' net income met our expectation for the quarter. In the year ago quarter, we recorded $1.8 million non recurring discreet tax benefit related to the filing of amended income tax returns for previous years. This tax benefit contributed $0.10 per share on a diluted basis for a net income in the third quarter of fiscal 2007.

This absence was the biggest contributor to the decrease in our net income in the third quarter of fiscal 2008 as compared to the same period of the prior year. Similar to our third quarter EBITDA result, our net income was also negatively affected by the higher proportion of sales that came from development programs to higher research and development expenses in the most recent quarter.

In the most recent quarter, our effective tax rate was approximately 33% and was favorably impacted by a change in estimates for our Canadian taxes. Our effective tax rate of 18% in the third quarter of fiscal 2007 was significantly lower due to the nonrecurring discreet tax benefit I mentioned a moment ago. We expect our effective tax rate in the first quarter to be approximately 36%.

I would like to turn now to changes in our cash and cash flow during the past twelve months. As you know, we consider CPI's ability to steadily generate positive cash flow to be an important strength of our business and we carefully monitor our cash flow as we manage our operations. During the first nine months of fiscal 2008, we generated $24.7 million in cash flow from operating activities which we use to repay $16 million of our outstanding debt including repayment of $8 million of our senior term loan and $8 million of our floating rate note.

Last week, we made an additional optional prepayment of $2 million on our senior term loan. Including those latest payment, we have repaid a total of $18 million of our debt in fiscal 2008. Debt repayment continues to be at very high priority for us in our use of cash. As at the end of the third quarter, our cash position equaled $26.2 million as compared to the $20.5 million we had as of the end of fiscal year 2007.

At the end of May, our Board of Directors authorized the stock repurchase program. We believe that the stock has been undervalued and that a combined program with debt repayment, stock repurchases will enable us to enhance the long term value of our stock. To that end, our Board of Directors authorized us to repurchase up to $12 million of CPI common stock from time to time over the twelve month period funded entirely from cash provided by operating activities.

In the third quarter, we use $1.8 million of our cash to repurchase approximately 136,000 shares of common stock and an average price of $13.17 per share. We will continue to evaluate the best use of our cash going forward as we maintain our commitment to retain our debt and repurchasing our stock in attractive prices. For the twelve month period ended June 27, 2008, CPI generated $27.1 million in cash flow from operating activities or a $1.53 per share on a diluted basis.

During that same period, we generated $21.9 million in the free cash flow. On a diluted basis, our free cash flow for this period equates to a $1.23 per share. Our $21.9 million in the free cash flow for the twelve month period was greater than our $17.3 million in net income for the same period. Our free cash flow conversion which is the ratio of our free cash flow to net income was there for greater than one to one at a 127%. Our adjusted free cash flow for the twelve month period totaled $23.5 million which is at the high end of our expectations for adjusted free cash flow of $20 million to $24 million in fiscal 2008.

In conclusion, CPI continues to generate solid cash flow and pay down our debt. Our balance sheet remains healthy. Now, I will the call back over to Joe to discuss our expectations for the rest of the year.

Joe Caldarelli

Dealing on the progress we made in Q2, Q3 was a satisfactory steady quarter for us that continued many of the themes from the previous quarter. Business conditions in our major markets remain stable. The quarter was characterized by the continuation of smooth performance our day to day programs and activities. Significant programs such as WIN-T had moved along well. We do not expect market conditions to change significantly in the foreseeable future. We are projecting continued delays in defense orders in coming quarters.

Our core medical business, absent Russian infrastructure program will continue to grow. We do not yet see any signs of the commercial communications business stealing any ill-effects of the current economy and we will continue to grow military communications business. We will continue to invest in development programs to develop products that we believe will be profitable and valuable to CPI's long term growth across our market and businesses.

Therefore we are leaving you our existing guidance for 2008 unchanged. We continue to project total sales of between $365 million and $375 million, net income of between a $1.15 and $1.25 per share on a diluted basis, adjusted EBITDA of between $64.5 million and $67 million and adjusted free cash flow of between $20 million and $24 million.

In conclusions, CPI remains a highly profitable company. We continue to generate positive cash flow and we are converting our net income to free cash flow at a rate greater than one to one. This year we have repurchased 1.8 million of undervalued shares and have paid down our debt by an additional $18 million. We remain optimistic and enthusiastic about our business.

And with that, I would like to open up the call for your questions.

Question-and-Answer Session

Operator

(Operator's instruction) Your first question comes from Gary Liebowitz - Wachovia.

Gary Liebowitz - Wachovia Capital Markets

So, can you talk a little bit about the Malibu business? It seems like it has been trending down 10% a quarter for the last couple of quarters. You did not meet the earnout threshold. Can you tell us what sort of dynamics that are affecting business are?

Joe Caldarelli

I think as we have indicated when we bought the business, we expect that the first year is ought to be a year of some investment in our business as we convert it from what is historically been primarily at development type of activity into more advance state of say developing products or production and that process is continuing. It probably is going a little slower than we hope it would but it is in fact continuing. We are making progress. They do have a number of good opportunities but they do tend to focus on opportunities for new applications and new vehicles like such as UAVs and that does require certain amount of investment in our part progress the products from what we will call an early engineering state to a more advance ready for productions state.

So, yes it is coming a little slower than we would like. It is progressing. We still continue to believe the business in the medium term will be a good business for us and are continuing to work at it and invest appropriately to ensure that it becomes a production oriented business.

Gary Liebowitz - Wachovia Capital Markets

And should I infer from your comments that further acquisitions are a lower priority relative to debt reduction and share buyback these days?

Joe Caldarelli

No, I do not think our position has changed. As you know, we have always been very cautious with respect to acquisitions and fairly conservative and what we are willing to pay and able to pay. So, we are continuing to evaluate acquisitions we have participated in the number of reasonably notable once in our industry in the last nine months but we have remained disciplined so we do not feel compelled to go buy something to meet certain pipeline goals but we do not want to remain shut out from doing things that make sense for us. So, we are continuing to look and as we have said before, at each instance, at any particular time, we will simply look at what is the best current alternative for the use of our cash whether it is a share buyback, a debt reduction or an acquisition should an appropriate one present itself.

Gary Liebowitz - Wachovia Capital Markets

Had a valuation since you are still looking the valuation multiples coming over the last few months?

Joe Caldarelli

You mean reduced?

Gary Liebowitz - Wachovia Capital Markets

Yes.

Joe Caldarelli

I think they have moderated somewhat. We have not seen as many still valuations as might have seen two years ago. Certainly, some of the larger ones that were well reported in the industry were valued I think much more reasonably under the circumstances. So, I think the aggregate answer is yes.

Operator

Your next question comes from Ryan Rackley - Raymond James.

Ryan Rackley - Raymond James

Have you receive any more color, do you have anymore of visibility as to what was the cost of the delays in the defense business are this quarter?

Joe Caldarelli

No, we do not. It is interesting that since it is obviously very important to as we continue to send our people out to the various agencies and ask the question about as the earning fundamental going on. It is interesting that there continues to be no concerted response from the agencies. It is a whole slew of answers that have kind of all of the map from administrative issues to funding to prioritization and you already get lost.

Our interpretations have now gone up for a while is that in aggregate there probably is some tightening of availability of funding for our kinds of products of the current time simply because in the current operating scenarios, they can probably put up with some delays in getting our products into their warehouses so on. So, we think that what we are seeing is a by product of some general overall tightening and manifest the sales through a variety of different rationale as to why each order is behind so our assumption in our business is that there is some tightening going on. The tightening will continue for a little while. But we have never heard any particular agency or the government actually say that.

Ryan Rackley - Raymond James

Then I guess you still have confidence that you have not been replaced or there has been a major loss.

Joe Caldarelli

Yes and absolutely, we certainly, our understanding is that our direct competitors are incomparable, are seeing incomparable situations. And no, we have not made any major losses to competitors. There have not been very many things that had come along that we have loss to someone else's one.

Ryan Rackley - Raymond James

Okay and also looking at your x-ray product within medical, what kind of indications are you getting from the marketplace on that for reimbursement for this product or if any.

Joe Caldarelli

There has not been any further clarity for the US. The US market is significant but smaller force than the international markets and I think that there it continues to be some degree of confusion and therefore caution in the US market relative to the DRA. We have not become aware of any further clarity as to the implementation of DRA and the direct impact that it has on our customers but I think our customers continue to be cautious and concerned both because of DRA as well as the whole issue of funding for new equipment and new clinics.

So, I think what we said last quarter has not really changed but we have not had net new intelligence to that equation.

Ryan Rackley - Raymond James

Assuming and you are still from growth perspective, you are still focusing on international market as well.

Joe Caldarelli

We focus all over the world. What I was pointing out is that of our aggregate business, the international markets are larger for us in x-ray equipment than domestic markets but domestic markets is still of course important to us.

Ryan Rackley - Raymond James

Okay great and actually, why is that you mentioned yesterday that they are seeing number of Ka-band opportunities on the horizon? I know you mentioned either last quarter or quarter before that as if it seems to be relatively lumpy. Do you have any, has there been any increase in visibility for a major Ka-band partner?

Joe Caldarelli

Yes, there continues to be dialogue on a fairly significant number of opportunities. We do actually book some new business recently. So, we are following all of that so we are still relative to a year ago period when it was one major customer making very large buys. There are buys going on right now. They tend to be more modest but the number of opportunities on horizon continues to be significant and I expect that we and our competitors will participate on those over the next couple of years. So, we certainly buy, they know better than we do but we would agree their analysis that there are a number of opportunities on the horizon and we expect both current and new users to be adding equipment over the next couple of years.

Operator

We have no further questions on our roster.

Joe Caldarelli

Well, thank you very much ladies and gentlemen for joining our call and we look forward to talking to all of you again in December when we report on our total year. Thank you, have a good day.

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