Interlink Electronics Inc. Q2 2008 Earnings Call Transcript

Interlink Electronics Inc (LINK)

Q2 2008 Earnings Call

August 13, 2008 4:30 pm ET

Executives

Charles Best - Chief Financial Officer

John Buckett - Interim Chief Executive Officer

Analysts

Kurt King - JMP Asset Management

Jeff Osher - JMP Asset Management

Presentation

Operator

Welcome to the Interlink Electronics earnings conference call, discussing our second quarter into June 30, 2008 financial results. (Operator Instructions) I now turn the conference over to Charles Best.

Charles Best

After I present the Safe Harbor statement, John Buckett, our Interim Chief Executive Officer, will discuss our expectations for the e-Transactions and specialty component business segment and the strategies we will incorporate to accelerate growth in each of these unique businesses.

Following that I will present relevant financial information related to the second quarter in the six months ended June 30, 2008. Let me first present our Safe Harbor statement. Statements made during this conference call may include forward-looking statements within the meaning of the securities laws. These forward-looking statements describe management's intentions or expectations with respect to future events or future possibilities and do not relate strictly to historical information.

These statements may include the words expect, believe or other similar expressions. Such statements involve and are subject to inherent risks and uncertainties. Many of these risks are described in the section entitled risk factors that is included in many of our filings made with the SEC, including our 2007 form 10-K filed on March 28, 2008 and our second quarter for 2008 10-Q filed today, August 13, 2008.

As a result of such risks and uncertainties management's assessment of future events and the forward-looking comments made during this conference call may prove to be incorrect. We can not assure you that management's intentions or expectations will not change or that specific statements made today will be realized. Forward-looking statements made during this conference call are made on the assumption that we will continue to operate our business as described herein. We may however, make changes in our operations to meet business challenges or to take advantage of unforeseen opportunities. Any such change in the way we operate our business could cause forward-looking statements made herein to be wrong.

I'd now like to turn the call over to John Buckett.

John Buckett

We have now completed our second quarter of 2008 and are into the last half of our 2008 fiscal year of operations. Having been acting CEO since January 2008, I have worked with management team to strengthen the operational structure of Interlink and also to work toward becoming a cash flow positive and profitable entity.

As I continue to emphasize, we are growing both the e-Transactions and specialty components business as a separate and distinct business of our company. We are also structuring the company this way because we believe both businesses represent attractive opportunities, yet they each have dramatically different operational, structural and investment needs. We will continue to carefully measure our investments in each business and at the same time do our best to capitalize on the market opportunities as we see today and into the future.

Our second quarter of 2008 financial results were a significant improvement over our first quarter of 2008, and over the second quarter of 2007. However, we need to continue to drive our top line growth to new customers and increase profits with existing customers. I'll also focus in on reducing costs.

We are pleased with our second quarter [inaudible] levels of 6.7 million and are comfortable with our early projections of between 24 and 28 million in revenues for 2008. However, we will continue to look at ways to increase revenues, reduce costs and streamline the organization.

We reduced our payroll costs by $2 million in the second quarter through a reduction in headcount. This will save the company $500, 000 per quarter. We made reductions where we felt we could still manage our business appropriately without harming our ability to grow. Our costs are more in line with our current revenue levels and this is helping us get closer to a cash flow positive organization.

However, we still need to analyze and, wherever necessary, adjust our costs to achieve our goal of being cash flow positive in the latter part of 2008. We remain bullish on our two business segments and we believe that each business represents a solid growth opportunity for the company and our shareholders.

Now I'd like to make a few comments on each of our business segments; first, e-Transactions. Our revenues for the second quarter of 2008 were 3.5 million, a 60% increase from the second quarter of 2007. We are continuing to see an increase in our prospect customer base which is the driver that converts into future e-Transactions revenue. Our gross margins were 52% in the second quarter of 2008, relatively constant with the 51% we incurred in the 2007 second quarter. We understand the need to grow, continue to analyze and reduce our costs to allow for an increased gross margin. Our e-Transactions revenues for the first six months of 2008 were 5.8 million, a 35% increase from the first six months of 2007.

Our gross margin was 46% in the first six months of 2008, down from 52% in the similar period in 2007. This decrease is caused by more absorption of unallocated manufacturing costs during the 2008 period.

Looking forward we believe our 2008 e-Transactions revenue growth projections of between 20 to 40% remain accurate as the implementation of digital documents and signatures provide major cost savings and efficiencies for a wide variety of enterprise sectors like auto financing and financial planning and the insurance industry. We also expect to see improved gross margins for the fiscal 2008 year.

Now a few comments on our progress with our specialty components business. Our specialty components business is ahead of plan and ahead of our earlier guidance of 30 to 50% annual growth in 2008. Revenues for the second quarter of 2008 were 3.2 million, representing a 96% increase from the second quarter of 2007 of 1.7 million. This increase is attributable to the normal production flow of two significant customers in the second quarter of 2008 compared to none in the second quarter of 2007.

Our gross margins in the specialty component business segment was 40% compared to 13% for the second quarter of 2007. A substantial improvement due to less unabsorbed manufacturing costs being charged to this business segment during the second quarter of 2008 compared to the second quarter of 2007.

We have several MicroNav programs in various stages of design, development or production today. We are excited and proud of our accomplishments with these projects and the corresponding revenue increases. We have added to and enhanced our production equipment and added the necessary design and development resources. Our China facility is fully operational. These additions have lowered our project start up costs, increased the number of projects we can handle at any given time and increased our production capacity.

Revenues for the first six months of 2008 were 6.7 million representing an 80% increase from the first six months of 2007. Again, this is attributable to having two high volume customers in 2008.

Our gross margins in the specialty components business segment for the first six months of 2008 were 36% compared to 24% for the first six months of 2007. This represents a very nice margin improvement resulting in higher volume, production and more manufacturing cost absorption. However, we do understand we need to reduce costs and see consistent gross margin growth in this segment.

In closing I want to say I am excited about the prospect of Interlink. We have two business segments that have great potential for success and currently we are focused on getting these businesses to profitability. We are taking steps to achieve this goal through cost reductions and top line growth. We continue to anticipate being cash flow positive in the second half of the fiscal year. To our shareholders, we appreciate your support and patience during this time of change and growth.

Now I would like to turn it back to Chuck for a more in-depth look at our financials.

Charles Best

I would now like to give a brief overview of the second quarter and the six months ended June 30, 2008 financial results. First let me present the second quarter of 2008. Total revenues for the quarter were 6.7 million, up 76% from the 2007 second quarter. E-Transaction revenues were 3.5 million, 60% above the comparable prior period quarter, while specialty components revenues were 3.3 million, 96% better than the comparable three-month period ended 2007.

Gross profit in 2008 second quarter was 3.1 million or 46% of revenues compared to 3.8 million or 34% of revenues the second quarter of 2007. Our e-Transaction gross margins remained relatively stable at 52% for the three months ended June 30, 2008, compared to 51% for the three months ended June 30, 2007.

Our specialty components gross margin was 40% for the [inaudible] ended 30, 2008, compared to 13% for the quarter ended June 30, 2007. This significant gross margin improvement was affected by higher volume of production in the 2008 period compared to the same [inaudible] 2007 period and by our e-Transaction business segment absorbing a larger portion of unabsorbed costs during the second quarter of 2008 compared to the second quarter of 2007.

As we've stated in the past we expect to see gross margins fluctuate in both of our business segments but expect, as our revenues for each business segment grow, to see improvement in both of our business segment's gross margins for the 2008 fiscal year.

Operating expenses for the quarter ended June 30, 2008 increased to 4.1 million from 3.1 million for the three months ended June 30, 2007. This $1 million increase in operating expenses was primarily due to $606,000 in increased selling, general and administrative expenses and $402,000 in increased product development and research costs.

These increases were primarily payroll related and due to increased related to the realignment of certain personnel from manufacturing to product development in 2008 and due to a $288,000 severance charge for a headcount reduction which is included in our selling, general and administrative operating expense line. We expect our operating expenses to be lower in Q3 and throughout the remainder of 2008 when compared to the first and second quarters of 2008.

Now let me present the first six months of 2008. Total revenues were $12.5 million, up 56% from the first six months of 2007. E-Transaction revenues were $5.8 million, 35% above the comparable prior period, while specialty components revenues were $6.7 million for the first six months of 2008, 80% better than the comparable six-month period ended June 30, 2007.

Gross profit in the first six months of 2008 was $5 million or 40% of revenues compared to 3.1 million or 39% of revenues for the comparable six-month period in 2007. Our e-Transactions gross margin decreased from 52% to 46% for the comparable period in 2007 due to higher unabsorbed manufacturing costs in the first six months of 2008 compared to 2007.

Our specialty components gross margin increased from 24% for the six months ended June 30, 2007, to 36% for the six-month period ended June 30, 2008. The specialty components gross margin was positively affected by increased production volume which absorbed more manufacturing overhead costs and our e-Transactions business segment absorbing a larger portion of unabsorbed costs during the first six months of 2008 than it did in the first six months of 2007.

As we have stated in the past we expect to see gross margins fluctuate in both of our business segments but expect as our revenues for each business segment grow to see improvement in both of our business segments gross margins for the 2008 fiscal year.

Operating expenses for the six months ended June 30, 2008 increased to 8.7 million to 6.2 million for the six months ended June 30, 2007. This $2.5 million increase in operating expenses was due to $1.7 million increase in selling, general and administrative expenses and $832,000 increase in product development and research costs. These increases were primarily payroll and related and included, as mentioned before, $288,000 in severance costs.

From a balance sheet perspective, we have $9 million in cash of which $7.8 million is unrestricted as of June 30, 2008. Under the terms of our asset sales, which was completed in August 2007, $800,000 of additional cash should become available in September 2008. When comparing our June 30, 2008 balance sheet to our December 31, 2007 balance sheet, our cash levels are $6.16 lower due to operating losses incurred in the first six months of 2008 and due to approximately $1.5 million in a cash pay down, previously purchased networking capital related to the sale of assets in August 2007.

Our inventory level increased by $400,000 when compared to December 2007, and our accounts payable and related expenses are down by over $4 million, partially the result of the $1.5 million cash pay down related to the asset sale described above. Our working capital ratio improved to 4.9 to 1 as of June 30, 2008 from 3.3 to 1 as of December 31, 2007.

So that concludes my comments for the three and six months ended June 30, 2008, and we are now available to answer any questions you may have. If anybody has any questions you certainly can ask them at this time.

Question-and-Answer Session

Operator

(Operator Instructions) Your first call comes from Kurt King - JMP Asset Management

Kurt King - JMP Asset Management

A few things, one is I just saw a press release cross the page and you've got a new CEO. Do you want to tell us about that?

John Buckett

We're proud to announce that Kevin Wiley has joined our company as CEO. As everyone remembers back in January when Michael Thoben stepped down as our CEO, the board initiated a search and I took over as the Interim CEO. Kevin comes to us with over 25 years of telecommunications experience, both as a CEO and as [inaudible] management in the telecom-related fields, companies such as Motorola, Cable and Wireless and a variety of others. He was most recently CEO of Woosh Wireless, a New Zealand broadband access network provider. Kevin, would you like to say a few words? Over the dog?

Kevin Wiley

Yes, I'm very happy with the offer and excited about the opportunity here at Interlink. I haven't – I'm kind of on my whirlwind tour right now to get to know what's going on, so I look forward to an opportunity to get together to meet the shareholders when possible at a later date. I'm happy to be here.

Kurt King - JMP Asset Management

So I guess my next question is with respect to getting back to cash flow positive. If I take your revenue guidance I assume the gross margins stay about the same and that operating expenses doesn't change a lot, do you think something else would have to give for the cash burn to stop? So what would be the moving part that would change the cash burn situation?

Charles Best

Looking at our revenue guidance of between 24 and 28 million and factoring in the headcount reduction we had in the second quarter, saving approximately half a million dollars a quarter in payroll and related expenses, our models show that getting to cash flow positive in the fourth quarter is something that's actually pretty achievable right now based on our projections.

So you're probably looking at some of the numbers that don't yet have some of the factored cost reductions that we've incurred already.

Kurt King - JMP Asset Management

So, obviously some things are really going right for you guys just based on the revenue and gross margin numbers. Can you just give us a little more color on, you know, what's happening in each of the businesses that's leading to the kind of growth you just showed?

John Buckett

We have seen fairly significant and constant growth inside the specialty products arena. That's been a very, I call it very good result of many years of activity not only of what we classically did in Force Sensing Resistor technology, but in going after the emerging smart phones that we see coming out. The volume increase and the production capability of our China facility have given us a better cost model for this particular technology. And we're seeing the results of that in the first six months of the year, but probably more effectively in the second six months of this year as we go forward into the balance of 2008.

Now this is a very, call it meteoric type of a market that we're going after and we'll probably see some fits and starts in this particular process, but all in all we think that the adoption of the technology going forward will bear positive results for us.

The other side of the coin is the e-Transactions and, you know, quite frankly everyone associated e-Transactions with the banking market. And we're seeing a huge upswing in a lot of the other related areas which have balanced out and in fact increased the amount of volume we have in e-Transactions. Software component of e-Transactions is very high margin business as everyone knows, and the hardware component of that as we achieve volume and go to third party manufacturing of that particular product have achieved a very high margin capability.

So we see good growth, very significant growth. As we said we're very comfortable with the growth in the ranges that we've previously outlined going forward and see a higher level of software component which raises our gross margin objectives in that particular category. So we think both businesses are firing away. They're still kind of young, both of them, but we think we have a good plan to grow these businesses in the future and achieve that cash flow positive operation in the second half of this year.

Kurt King - JMP Asset Management

Okay so is part of the plan for gross margins to improve in each of the businesses from here?

John Buckett

Certainly there's a plan to improve the gross margins. Some of that you saw reflected in the reduction of force that we had in May. The secondary issue is that, you know, we had a lot of this start up gross margin problem with bringing our China facility online in the second half of last year. So the year-over-year comparison will be quite dramatic in that since it's a fully operational manufacturing facility in China now.

A little bit of that in the ET side was what I call the cyclical nature of ET where we have a very good quarter and then a not so good quarter. We're starting to see that level out more. We're seeing certainly a larger base of installed products and therefore a more steady state or, you know, a steady state rise of demand in the ET products. Both things are kind of coincidentally happening at the same time, manufacturing improvements on the specialty and a larger installed base on the e-Transactions.

Kurt King - JMP Asset Management

Okay so on the e-Transactions business is there a backlog now that you can tell us about?

John Buckett

We haven't published the backlog for the last couple of quarters. It is steadily improving. We're no longer a full book shift each quarter. We enter a quarter with some backlog specifically in the last two quarters, and so we are planning on having that steadily increase but currently we are not forecasting the backlog in ET.

Kurt King - JMP Asset Management

Okay and then in specialty, I mean, if we pull out the stock comp, your gross margins were just shy of 40%. Is that a number that could go higher from here?

John Buckett

It could but we kind of modeled 40% as our number in specialty. Again, high volume consumer electronics tends to have a lower gross margin or, you know, lower sales price compared to cost of goods sold than the classic FSR sold into the medical equipment companies. We have a couple of MicroNav programs in the medical equipment companies which are really going to bear fruit in 2010, 2011 timeframe. So, you know, we're still going after classic FSR and at the same time bringing on new projects in the cell phone and consumer electronics industry.

Kurt King - JMP Asset Management

All right, but there's no force at work that should make that 40% level unsustainable?

John Buckett

Well any loss of a specific project would have unabsorbed factory overhead that you might see it vary during a particular 90-day cycle. But with the volume where we are today and with the projects that we have on the table going forward, we're trying to target our costs to – in both the overhead, the G&A costs and the cost of manufacturing, to allow us to achieve that 40% gross margin target.

Operator

Your next question comes from Jeff Osher – JMP Asset Management

Jeff Osher - JMP Asset Management

Could you just talk about the current inventory relative to what you see with regard to orders in Q3? And I'm asking more of a working capital question. When we just look at your Q2 kind of EBITDA run rate your net of stock-based comp is pretty close to cash flow breakeven as is?

Charles Best

Yes.

Jeff Osher - JMP Asset Management

So based on the OpEx improvements which presumably didn't show up in the P&L in Q2, if you pick up $500,000 of OpEx improvements or some portion of that in Q3 and beyond, is working capital actually going to be a positive contributor in Q3 given the fact that your A/R and inventory are, you know, you have positive working capital effectively and A/Rs and inventory were up?

Charles Best

Yes that's a really good question and today I would tell you that I think our inventory levels are still too high for our business and we do have some extra inventory that relates to our e-Transactions. And we are anticipating moving some of that inventory which will help cash flow as well and bring our inventory down to I think more acceptable levels at the end of this, hopefully if things keep working well, towards the end of this year. So we are working down some inventory, not necessarily in the specialty as much as we are n the e-Transactions business which will help our working capital as well.

Jeff Osher - JMP Asset Management

Okay thanks, Chuck, and then as far as accounts receivable what was your, you know, your allowance is pretty minimal.

Charles Best

Yes.

Jeff Osher - JMP Asset Management

Is there any risk to the 1.2 million actually being collected?

Charles Best

You know what, our receivables both in the e-Transaction business, which is really a lot of high end customers as well as the specialty components business, we have not too much risk in our receivables. We do go through a D&B process for those that we feel need it and haven't really experienced too much of that as an issue and that had gotten cleaned up quite a bit last year as we got through some of the other issues that we had. So no, we don't see any issues on the collectability and actually we've – there's been a nice effort here to continue to collect on time and that's a real positive sign for us.

Jeff Osher - JMP Asset Management

Okay good, and then just finally, the two thirds of a million of assets out for sale, does that relate to the OEM business, remote business that was sold?

Charles Best

Yes.

Jeff Osher - JMP Asset Management

What exactly is that?

Charles Best

Well there was, I'm not sure exactly what number you're referring to right now, but part of the apple was the payment of working capital for [inaudible].

Jeff Osher - JMP Asset Management

Sorry, Chuck. I'm looking at the wrong line. I'm looking at prepaid expenses, so that answers my questions on A/R and inventory. Thank you.

Charles Best

Yes but it is important to note though that part of our decrease or what looks like a larger use of cash in the first six months of the year was really a part of a pay down of some networking capital that we were continuing to receive related to the asset sale. So you know, when you look at the cash flow truly from operations it's not the number that it is in there because we did make a cash pay down to SMK throughout the remaining of this year. So that's a real positive sign, too. The cash flow –

Jeff Osher - JMP Asset Management

Okay just so I understand you right now, don't see any kind of crude restructuring on the balance sheet so you're thinking Q3, Q4 the balance sheet will actually be a source of cash with the working capital changes?

Charles Best

We think that we're going to be in positive cash in the latter part of '08, yes.

Jeff Osher - JMP Asset Management

Working capital changes though?

Charles Best

Quite possible. If we can, if some of the excess inventory that we – additional inventory that we have on e-Transactions side, I think that's a yes.

Operator

There are no other questions.

John Buckett

If there's no other questions today I would like to thank you for your participation in our Q2 conference call. There will be a replay of this conference call available for 30 days. You can always reach Chuck Best, myself or Kevin Wiley if you have individual questions. Thank you again.

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