AeroVironment Inc (AVAV) 2008 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Third Quarter and Fiscal 2008 AeroVironment Incorporated Earnings Conference Call.

My name is Eric and I will be your coordinator for today.

At this time all participants are in a listen-only mode.

We will be facilitate the question and answer session towards the end of the conference.

(OPERATOR INSTRUCTIONS)

I would now like to turn your presentation over to your host for today's call, Mr.

Steven Gitlin, Director of Investor Relations.

Please proceed, sir.

Thank you very much, Eric.

Welcome, everyone, to AV's third quarter fiscal 2008 earnings call.

Joining me today are AeroVironment's Chairman, Chief Executive Officer and President Tim Conver, and the Company's Chief Financial Officer, Steve Wright.

Before I hand the call over to them, please note that on this call certain information presented contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Forward-looking statements include, without limitation, any statement that may predict, forecast, indicate or imply future results, performance or achievements and may contain words such as believe, anticipate, expect, estimate, intend, project, plan or words or phrases with similar meaning.

Forward-looking statements are based on current expectations, forecasts, and assumptions that involve risks and uncertainties including, but not limited to, economic, competitive, governmental, and technological factors outside of our control that may cause our business strategy or actual results to differ materially from the forward-looking statements.

Factors that could cause actual results to differ materially from the forward-looking statements include, but are not limited to, reliance on sales to the U.S.

government; changes in the supply and/or demand and/or prices for our products; the activities of competitors; failure of the markets in which we operate to grow; failure to expand into new markets; changes in significant operating expenses, including components and raw materials; failure to develop new products; changes in the regulatory environment; and general economic and business conditions in the United States and elsewhere in the world.

For a further list and description of such risks and uncertainties, see the reports we file with the Securities and Exchange Commission.

We do not intend and undertake no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise.

The content of this conference call contains time-sensitive information that is accurate only as of today, March 3, 2008.

The Company undertakes no obligation to make any revision to the statements contained in our remarks or to update them to reflect the events or circumstances occurring after this conference call.

With that, it is my pleasure to turn the call over to Tim Conver.

Thank you, Steven.

Welcome to our third quarter fiscal 2008 conference call.

During the quarter, we continued to improve already-strong customer relationships.

We executed well with strong operating margins, we had good progress on development programs and market demand for our small unmanned aircraft systems remains strong.

Market interest in our new solutions that we're developing continues to grow, particularly in our UAS segment, but also in our PosiCharge and Energy Technology segments.

We continued to see demand for our unmanned aircraft systems, or UAS.

Some of you may have seen recent articles that showed how the military is increasingly using unmanned aircraft as regular embedded tools in combat.

The Army says that Raven flight hours in OEF and OIF, which dominate overall unmanned flight hours, will double, from about 150,000 to 300,000 this year.

In my view, this reinforces our belief that small UAS have become permanently woven into the way our customers operate and that they perform a uniquely valuable mission.

Our own progress in meeting our customers' needs have moved forward as well.

Our product line has strengthened as a result of Wasp transitioning to full rate production.

Customers procured and deployed both Raven and Wasp systems, as evidenced by the $19.3 million Marine Corps Wasp order in November and the post-quarter $45.8 million acquisition of Raven systems as part of the Army SUAS contract.

It's significant that the Marines plan to issue their Wasp systems to the platoon level.

I believe this supports our view that these small unmanned aircraft systems will increasingly be acquired and issued to lower levels of the force structure, where they are actually used to great benefit.

UAS service revenue grew again during the quarter.

We made great progress on the preliminary design milestones of the Global Observer Development Program during the quarter, while we continued adding new people to fill out our project team.

Our project revenue is influenced partially by the pace that we increase our staff, so as we accelerate our hiring and apply more resources to the Global Observer program, our related revenues should increase.

I believe that the fundamental drivers of our business and the market for our solutions remain strong.

Our customers continue to reward us with their business.

Our team continues to make great progress on multiple fronts and we remain subject to short-term bumpiness.

We're continuing as before, investing in R&D, working to improve our services, remaining very close to our customers and being responsive to their needs.

We haven't changed our positive view of the future.

From a financial perspective, our results reflected everything I've just said -- Q3 revenue of $48.5 million increased over the same period last year by 5%, with a healthy operating margin of 16%.

That brings our revenue for the first three quarters of the year to $151.4 million, 23% higher than in FY '07, with a year-to-date operating margin of 12.8%.

As I said earlier, the main contributor to our growth in revenue compared to last year is the performance of our UAS segment.

We experienced a strong increase in UAS service revenues, reflecting the growing number of our systems used by our customers and the conversion of Raven A systems to the B configuration.

Our services business currently has a lower gross margin than our products, however, our view is that services will continue to be a valuable and a growing contributor to our revenue and our profitability.

As an indication of international interest in our systems, the Spanish Armed Forces purchased their first Raven system during the quarter.

International sales are still a small portion of our UAS business, but we see a growing stream of international interest and we are currently working on a number of additional overseas procurement opportunities.

Our UAS development programs advanced on multiple fronts and continue to garner both customer funding and support.

Global Observer, Switchblade and digital datalink are all pioneering programs that offer transformational new capabilities.

We're developing Global Observer under a contract we announced in September of 2007.

Global Observer can be thought of as a stratospheric satellite system, with two aircraft taking terms circling over any area on the globe.

Each aircraft will fly for up to seven days without landing, providing affordable, persistent coverage from the stratosphere for a variety of communication and ISR applications.

As I mentioned last quarter, this program is funded by multiple U.S.

government customers, each of which has its own mission application for the Global Observer platform.

We have achieved multiple milestones in testing of Global Observer's innovative liquid hydrogen-fueled power plant, including operation of the production configuration power plant at a simulated altitude of 65,000 feet.

We've also completed fabrication of the first full-sized center wing section for the aircraft.

This one segment is approximately 40 feet from end to end and it's the most complex of the five carbon composite segments that make up the Global Observer's 175-foot wing.

Our Energy Technology center continues to build and successful test other key elements of the aircraft's propulsion and energy management systems.

Another development program, Switchblade, is a compact, packaged, small UAS that's designed to be launched from a tube.

This system has the same basic reconnaissance capabilities and ground control system as Raven and Wasp, but it also carries an explosive charge to enable highly precise strikes against threats such as mortars and snipers.

This system represents an entirely new capability that combines small size, affordability, eyes on target and precision strike with minimal collateral damage.

Our Switchblade performance on this program has been very positive, leading to a recently received add-on order for additional test units and demonstrations from our initial customer.

There is also active interest in this solution across a growing range of additional customers.

Digital datalink is also moving forward as a means to significantly enhance the utility of our small unmanned aircraft systems.

We have successfully demonstrated digital datalink to our customers and we're currently improving its manufacturability and integration into our production small UAS.

I'm pleased with the performance and progress of each of these development programs and encouraged by the customer response.

I look forward to reporting on their significant milestones to you in the future.

As these development programs move closer to becoming part of our UAS portfolio, and as the throughput of our existing products increase, we're continuously enhancing our operational capabilities, both to build competitive advantage and to support profitable growth.

This quarter, we expanded our management team with the addition of an experienced aerospace operation executive.

[John Self], our new Director of UAS Operations, has held executive positions in program management, general management and operations.

Most recently, John was the operations leader working on the development of the one-piece composite fuselage for the new Boeing 787.

John's already a key contributor to our organization.

Moving on now from the UAS segment, PosiCharge provides fast-charge solutions for electrical material handling vehicles.

We had a decline in year-over-year quarterly revenue during Q3, with the year-to-date PosiCharge revenue remaining approximately level with the same nine months of last year.

We have not seen the acceleration of the fast charge adoption that we had looked for.

However, during the quarter, PosiCharge secured new customers, expanded its base of installed systems to over 9,000 charge ports, strengthened relationships with large existing customers and made progress on new applications and geographies.

These are all indications that PosiCharge continues to deliver real productivity improvements and cost savings.

I believe we continue to have the leading market share in this competitive market space and that the industrial fast-charge market has the potential to grow dramatically as adoption extends beyond the current estimated single-digit penetration of electric lift utility truck market.

Our third quarter -- or our third reporting segment, Energy Technology Center, continued to position AV to capitalize on the great potential of efficient electric energy technology solutions that are both innovative and practical.

In addition to providing unique technology solutions for important internal initiatives and marketing its power processing test equipment, the group released a new architectural wind turbine and blade assembly this quarter.

This new turbine is rated at two and a half times the energy production of its predecessor while utilizing the same enclosure and interconnect infrastructure, providing a much improved customer value proposition.

As we continue to sell and install early adopter systems at customer locations, architectural wind is generating great interest amongst those seeking new renewable energy generation solutions.

ETC is also working to adapt our fast-charge technology into a practical solution that would help enable broader use and adoption of on-road electric automobiles and trucks.

As the demand for these electric vehicles grow, we intend to be the supplier of choice for fast-charge infrastructure.

As we head into the fourth quarter, our customer relationships remain strong, our team continues to perform very well and we're favorably positioned for future growth.

With that as an overview, Steve Wright, our CFO, will review our second quarter financial results.

Steve?

Thanks, Tim.

Good afternoon.

Revenue for the third quarter was $48.5 million, an increase of 5% over third quarter prior year of $46.3 million.

Looking at revenue by segment, UAS revenue was $42.2 million, an increase of 9% over the prior year.

The growth in UAS revenue was in services and customer-funded R&D, partially offset by reduced product sales.

PosiCharge revenue was $4.1 million, a decline of 24% from Q3 last year, primarily due to lower revenue in the non-auto markets.

Energy Technology Center revenue was $2.3 million, an increase of 9% from Q3 last year, due to higher power processing test equipment deliveries.

Turning to gross margin, gross margin in the third quarter was $19.8 million, compared to $19.6 million in Q3 of the prior year.

Gross margin as a percent of revenue was 41%, compared to 42% in Q3 last year.

By segment, UAS gross margin was $17.5 million, up 5% from Q3 of last year.

As a percent of revenue, UAS gross margin was 41%, compared to 43% in Q3 last year.

This decrease in gross margin rate was primarily due to higher program costs and higher cost-plus content.

PosiCharge gross margin was $1.4 million, down 28% from Q3 of last year, primarily due to the lower sales volume.

As a percent of revenue, PosiCharge gross margin was 34%, versus 35% in Q3 of last year.

Energy Technology Center gross margin remains unchanged, at 1 million, compared to Q3 of last year.

SG&A expense for the quarter was $8.2 million, or 17% of revenue, compared to $4.2 million, or 9% of revenue, in the prior year.

The prior year amount included a one-time expense reduction of $2.2 million for a SERP pursuant to our IPO.

Excluding this reversal, SG&A expense increased $1.8 million, primarily due to higher selling and marketing expense.

R&D expense for the quarter was $3.7 million, or 8% of revenue, compared to $2.2 million or 5% of revenue in the prior year.

Customer-funded R&D during the quarter was $6.9 million, or 14% of revenue, compared to $5.3 million, or 11% of revenue, in the prior year.

And total R&D, internal and external, was $10.5 million, or 22% of revenue, compared to $7.5 million, or 16% of revenue in the prior year.

Operating income for the quarter totaled $8 million, or 16% of revenue.

Operating income was 40% below the prior Q3 amount, primarily due to the higher SG&A and higher R&D investment.

Net income for the quarter was $6 million, or $0.28 per fully diluted share, compared to $8.9 million, or $0.57 per fully diluted share in the same quarter last year.

Now moving quickly through our year-to-date results, revenue for the first nine months totaled $151.4 million, up 23% from the prior-year period of $123 million.

By segment, UAS revenue was $130.6 million, up 29% from the prior-year period.

PosiCharge revenue was $14.7 million, down 1% from the prior-year period and Energy Technology Center revenue was $6.1 million, down 6% from the prior-year period.

Gross margin for the first nine months totaled $55.6 million, compared to $49.4 million in the same period a year ago.

Gross margin as a percentage of revenue was 37%, a decline of three percentage points from the prior-year period.

By segment, UAS gross margin was $48.5 million, up 20%, PosiCharge gross margin was $4.7 million, down 17%, and Energy Technology Center gross margin was $2.4 million, down 26% from the prior year.

SG&A expense for the nine months totaled $24.5 million, or 16% of revenue, compared to the prior-year amount of $17.1 million, or 14% of revenue, which again included the SERP reversal of $2.2 million.

R&D for the first nine months totaled $11.8 million, or 8% of revenue, compared to $9.3 million, or 8% of revenue, in the prior year, and total R&D, internal and external, was $28.8 million, or 19% of revenue, versus $21.6 million, or 18% of revenue in the prior year.

Operating income in the first nine months was $19.3 million, or 13% of revenue.

Operating income declined 16% from the prior-year amount.

The effective tax rate for the first nine months was 33%, down from the prior-year amount of 36%.

Net income for the first nine months totaled $15 million, or $0.70 per fully diluted share, compared to $15.1 million, or $0.98 per fully diluted share last year.

Looking at backlog, funded backlog at the end of the third quarter totaled $62.1 million, up $1.2 million from the end of our last fiscal year.

Funded backlog at the end of the last quarter does not include the recent $45.8 million contract option award from the U.S.

Army.

Turning to our balance sheet, cash equivalent and short-term investments at the end of the third quarter totaled $110.4 million, up $3.7 million from our prior-quarter amount of $106.7 million.

This positive cash flow is largely due to income, partially offset by working capital growth and capital expenditures.

Short-term investments at the end of the third quarter were $30.8 million, down from the previous quarter amount of $92.4 million.

The decrease in short-term investments was due to net redemptions of municipal auction rate securities.

We have reduced our exposure these securities due to recent liquidity concerns regarding the auction rate market.

As of today, the Company holds approximately $17 million of auction rate securities.

All of our auction rate securities are backed by municipal bonds rated A- or higher and rated AAA with their insurance.

As a result of our strong cash position, we do not need to liquidate these securities in the near term and as a result we did not record any impairment charge in Q3.

We will continue to evaluate the fair market value of these securities and the conditions of the market for them at each reporting period, as applicable.

At the end of the third quarter, our accounts receivable, including unbilled receivables, were at $43.9 million, up $5.1 million from the prior quarter.

Total days sales outstanding were approximately 81 days, compared to 65 days at the end of the prior quarter end.

Taking a look at our inventory, inventories were $17 million at the end of the third quarter, compared to $12.7 million at the end of the second quarter.

Days in inventory were approximately 53 days, compared to 33 days at the end of the second quarter.

Turning to capital expenditures, in the third quarter, we invested approximately $1.6 million, or 3% of revenue, in property improvements and capital equipment.

Of the CapEx, approximately 80% was related to growth.

And now I'd like to turn things back to Tim to discuss expectations for the balance of the year.

Thanks, Steve.

Looking back, FY '07 revenue is up 23% for the first three quarters, compared to -- FY '07, excuse me, FY '08.

And year-to-date margin is -- operating margin is 12.8%.

Looking forward, I believe we remain on track to achieve our annual guidance of year-over-year revenue growth between 20% and 25% and operating margins between 12% and 14%.

That said, it's our sense that we're more likely to complete FY '08 toward the lower end of that revenue and margin guidance range.

I'll close by restating that we continue to be excited about the growth opportunities for AV.

We remain confident in our positioning as well.

Our growth plans remain the same -- to continue to grow in the markets where we already hold substantial share, by stating number one with our customers and by developing and delivering compelling new value propositions for new customers in other large markets.

And now Steve and I would be pleased to answer any of your questions.

(OPERATOR INSTRUCTIONS).

Your first question comes from the line of Chris Donaghey with SunTrust Robinson Humphrey.

Please proceed.

Hi, good evening, guys.

Tim, I was wondering if you could walk us through the business mix sequentially.

Obviously, 36% gross margin in the Unmanned Aerial Systems in the second quarter of '08, and then on lower revenue dollars, higher absolute gross profit dollars and higher gross margin in the third quarter of '08.

So can you just talk about the business mix in the third quarter and what caused such a pretty significant shift in UAS gross margin?

Chris, I'm going to start off and then maybe Tim can add to that.

The gross margin rates are going to shift around quarter by quarter.

Having said that, in Q3, despite having higher services revenue in the quarter, we did have higher gross margins and that was sort of in both the services area and the product area.

We had some higher margins in the services area, based on the work that we were doing in the quarter, but particularly on the product work, fixed-price work, we had very good margins in the quarter.

And this was because of the fixed-price contract content that we're working on, plus the commercial and international deliveries that we made in the quarter.

I don't know, Tim, if you want to talk about the mix other than that, the services versus contracts.

Yes, I don't know that there's anything I can add to that, Chris, unless you have -- unless Steve didn't adequately cover it.

No, that's fine.

One other thing I would add, in terms of the services, it was very high in the quarter and I think Tim touched on this a little bit.

But in addition to the typical services that we work on, we did have a lot of content in the services line to upgrade a number of Raven As to Raven B configuration.

Okay, great, thanks.

And, Tim, I would also like you to comment, if you can, with the Marine Corps deploying Wasp now to the platoon level, do you see any cannibalization of Raven in the Marine Corps market as a result of this fielding initiative?

Well, we haven't seen any to date, although since the operational capabilities are quite similar, as you know, I wouldn't be surprised that over time we do see some of that, but there's no question in my mind that the net result is a larger pie for small UAS and our products.

And I think that's clearly a good thing, both for us from a business perspective and from our customers and the ability to utilize a much smaller system.

Wasp is one pound, versus a little over four pounds for Raven.

So not only the unique operating capabilities that are different between the two systems, but it does seem like the smaller size tilts Wasp towards deployment lower in the force structure, again, as I mentioned earlier.

And that should lead to larger total volume.

Okay, great, and one more thing, and I apologize if I missed it.

Can you comment on the opportunity pipeline for the Puma?

Puma was a development system that we developed internally.

It's basically twice the size, twice the payload, twice the range of Raven in very rough terms.

We also developed a version of that designed to land in saltwater that we call Aqua Puma and we have delivered those systems to various customers that have been using them primarily in military utility evaluation-type scenarios.

What we've done there, I think, is learn a tremendous amount about the upper bound of hand-launched small-UAS size and, in particular, we've learned an awful lot about the operational utility of saltwater landing and the design required to make that a robust solution.

So I think we will probably see that as an interim product development towards maybe a next-generation solution on that size range.

Okay, great.

Thanks, Tim.

Your next question comes from the line of Troy Lahr with Stifel Nicolaus.

Please proceed.

Thanks.

Could you guys talk a little bit about product sales in the quarter.

It seemed like they were off maybe 40%.

Is that just a timing issue and is that going to correct itself as you start back work on this Army contract that you got in the quarter.

Yes, I can start there.

Product sales were 41% of revenue in Q3 versus 63% in Q2 and 60% in Q1 of it.

So it's obviously lower.

It's crowded out by a lot of the services work that we did during the quarter, and again, a lot of that services work was upgrade activity.

That happened to be what made sense for the factory to work on during the quarter and also contributing to that was the $45.8 million product order for Ravens came in.

It was actually done in the third quarter, but it wasn't definitized until just after the third quarter, so this was the mix of business that it made sense to work on during the third quarter.

Looking forward, we probably expect to go back to something closer to what we've seen traditionally in terms of product mix.

Okay, and when you go back to something more of a normalized product mix, I mean, how are the margins going to change?

You mentioned a little bit how this was kind of an abnormal quarter from a margin standpoint, I'm assuming.

Is that right, or is there any reason why you guys can't do 41.5% again at UAS?

Well, there's probably not a reason other than we're not guiding on gross margins.

It was a good quarter for gross margins.

We're looking at the 12% to 14% operating income is what we're managing to.

All things being equal, when you have more product work, your margins are going to improve because that means you have more fixed-price work and we tend to do better on the fixed-price work.

But that's really sort of a second-order effect.

I think the primary effect is how we're doing on individual contracts and what contracts we're working on in the period.

Okay.

Okay, and then you guys have had a couple good quarters here, but did I get the comment right that you said that you're going to be at the lower end of your guidance now for both revenue and margins?

Yes, that's our sense right now.

That guidance range of 20% to 25% revenue growth and 12% to 14% operating margin does look, as we look out just a few months left in the year now, I think we're more likely to be in the lower par of that range than the higher part.

That's really what I was trying to say there.

And why is that from a margin standpoint?

I mean, is there something that's going on in the fourth quarter?

I'm not following that.

You guys did 16.5% margins the last quarter.

Why are you going back down now?

Well, if you look at the nine months year to date Troy, that was at 12.8%, which is the lower half of the range.

Okay.

And if you look at the top-line, it implies a pretty heavy Q4 in terms of operations throughput, so there's a lot to perform on there.

Okay, and then just a maintenance question.

What was the IDIQ backlog?

IDIQ backlogs, $456 million at the end of the quarter, and, as a reminder, that backlog does not include the additional options for the two additional aircraft on Global Observer.

Okay, so it doesn't include the two -- okay, I'm with you.

All right, sounds goods.

Thanks, guys.

I'll jump back in the queue.

Thank you.

Your next question comes from the line of Patrick McCarthy with FBR Capital Markets.

Please proceed.

Thanks.

Hi, Patrick.

Hi, good afternoon.

Sorry about that.

Just two very quick questions.

Could you talk about how much of the U.S.

Army's requirement for the Raven has been fulfilled at this point on a percentage basis.

I think that's a stat you've given in the past.

Yes, through the quarter, that requirement is, as a reminder, 1,900 systems and we've delivered approximately 37% of that requirement.

Okay, great.

My second question, for the contract that was awarded just after the end of the quarter, could you just provide a little bit more visibility on maybe customer set, what's interesting about that?

I mean, it seems like we're characterizing it as an Army contract, and is that the case?

It is an Army contract.

This is the contract that the Army competed -- what was that, three years ago, for small unmanned system requirement for both the Army and for Special Forces Command.

That was the SOCOM's requirement for a rucksack-portable UAV that got combined into the same requirement, competed all at once.

And so the Army has been buying -- and, of course, we won that and that included a multi-year IDIQ-type contract.

So the Army has been buying for both SOCOM and the Army on that contract.

And then, last year, the Marine Corps filled up, completed their Dragon Eye procurement and they decided rather than buying more Dragon Eyes, they would switch over and acquire Ravens.

So the Marines have now been buying Ravens under that same Army contract as well.

Does that help?

Well, I guess just to kind of follow-up, it's safe to assume that that contract at the beginning of February was for one of those three services?

Yes.

Well, it was an Army release, and that would include requirements for certainly the Army and the Marine Corps and I'm not sure whether SOCOM had had requirements in there or not.

-- for SOCOM.

It's Army and Marines.

Okay, great.

And is there any additional detail that you can give us on the Spanish award?

Well, it was quite competitive.

We think it's very important to us.

We think it's their first foray into small UAS and we're looking forward to a long-term relationship with them, as we have had for a number of years now with Italy.

I think we also announced the -- was the Danish contract announced a few months ago?

Can you give us a sense as to the size and when you will start production?

With the Spanish order, we've made many foot the deliveries on that contract.

I don't think we can talk about size.

Okay, fair enough.

Thank you very much.

Patrick, one, I will say, international was approximately 10% of our revenue for the quarter.

Could you just put that in context, what was it last quarter, if you remember?

Slightly less.

One second.

Patrick, there's also an article.

I think it's referenced on our website, published in El Pais, that referred to the Spanish acquisition of the Ravens.

Okay, great, that's helpful.

Thank you.

And, Patrick, in answer to your question, 7% in Q2 and 3% in Q1.

Excellent.

Thank you.

Your next question comes from the line of Tim Quillin With Stephens Incorporated.

Please proceed.

Good afternoon.

Hi, Tim.

How are you doing?

So far, so good.

In terms of Raven, was it just that the switch from Raven A to Raven B was what you're working on right now, and does it move back to products?

Is it kind of an either-or proposition during the quarter?

I wouldn't necessarily look at it in terms of -- that implies a limited capacity and you either do one or the other, and I don't think that would be a good characterization.

Probably relative to how much was in services and how much was in products in the quarter, a more significant contributor was probably just order timing, the timing of receipt of orders, both that Army contract that we announced the week after the quarter and the prior Marine contract for Wasp were later than we had expected.

So that probably had more impact than any capacity issue.

I do think that the significant amount of conversion there in services probably looks more like product-type work, even though it's classified under the services because that's how it comes in in the form of our customer contracts, which may have had an effect on the margin change there.

And how should we think about Raven as we look forward?

Is it the type of product shipments -- are they going to be as lumpy as we've seen over the last couple of quarters, waiting for individual orders to come in, or how much visibility do you have into the next few quarters?

I think I would say it's going to be lumpy.

We've talked about the overall business being lumpy, but at least in the near term we'd expect to see more product sales as a share of the total sales.

Right, so a bounce back in the fourth quarter.

And do you have any help for us in terms of how to look at that next fiscal year?

No, I think we want to reserve judgment on that until we give guidance on the next year, which I believe will be on our next call.

Okay.

In terms of development efforts, are you working at all on more of a vertical takeoff and landing small UAS, more like a Honeywell has?

Well, we've had development programs in vertical small UAS for years.

In fact, we developed and flew the first ducted fan that transitioned from vertical to horizontal and back, as far as I know.

And we've continued on with multiple different configurations in that arena with the -- to be in a position to respond to any formal competition that our customers do fund that requires that capability.

Okay, are there any like that on the horizon?

There are none that I'm aware of right now.

Okay, good.

So that FCS program has continued on for years, but that's not a procurement progress that's funded.

Right, right.

And, just lastly, the U.S.

Special Operations Command has put out a pre-solicitation notice on I guess what they're calling an all environment capable variant small UAS.

It looks like a pretty big opportunity.

How are you positioning for that?

Well, that looks like pretty much of a new category that requires landing not only in saltwater but the same vehicle needs to land on land and it needs to go back and forth indiscriminately.

So it's a pretty interest requirement.

I did mention that we've got quite a bit of history, with Aqua Puma, as well as Aqua Wasp, in that maritime environment.

So to the degree that that is a real funded requirement, we expect to show up competitively.

Is it more Aqua Wasp or more Aqua Puma, or do you know yet?

Well, in their original span of requirements, they had a range of sizes, from something that looks like it's kind of Wasp-ish to something that looks considerably larger than any existing small UAS.

Okay, okay.

We'll stay tuned.

Thank you.

You bet.

Your next question comes from the line of David Gremmels with Thomas Weisel Partners.

Please proceed.

Thanks.

Good afternoon.

Hi, David.

We talked a little bit about services margins getting a boost from the Raven A to Raven B transition.

Can you just say how far -- number one, how far along are you in that process?

And, number two, when that process is complete, does that benefit margins, because those resources transition to fixed-priced production work or is it bad for margins because the resources transition to lower-margin services work.

I think with respect to that effort, a lot of that effort was done by our manufacturing operations.

So those resources will move back into product work.

Product work on the two large recent contracts in particular?

Yes.

Okay, great.

And on the product gross margin, obviously very high in the quarter.

I think you said this earlier.

I just want to -- I think you said this earlier.

I just want to confirm that the strength of that product margin was pure mix, that there weren't any cumulative adjustments or one-time items in there.

Well, it's basically mix.

I don't believe in the products there were any accrual adjustments or anything like that.

It's long-term EACs and looking at individual contracts.

Okay.

On the fiscal '09 budget, last quarter you commented that more of the funding for your programs was moving into the baseline budget, where there's more visibility.

Now that you've got a chance to take a look at the '09 budget, did that trend continue and how do you feel you fared in the budget?

Well, I think we're still looking at what the overall effect is, David.

I don't know that I've got a strong opinion right now.

There's both the President's budget and the '08 supplemental and then the '09 supplemental are all in the mix.

So I don't think I can add a lot of good commentary right now.

Okay, fair enough.

And then on the auction rate securities, glad to hear no impairment charge on the P&L.

Just to clarify, I guess there's a couple of different ways you can account for these.

Is there any kind of like temporary impairment that stays on the balance sheet because it's considered temporary, or is there just no impairment of any kind here?

Right now, there's no impairment of any kind.

This whole thing started after the quarter, in mid February.

We had been getting out of those for a couple of quarters.

At one point, we had $90 million plus in these auction rate securities.

They were supposed to be very safe, based on municipal bonds.

And we started moving out of them a while ago when we started reading all these news articles about insurance and moving into treasuries and other safe investments.

As of today, $17 million is our total exposure and it's all based on -- they're all based on municipal bonds that are highly rated underneath it.

So, as of today, no impairment whatsoever and we're just going to have to look at that during each reporting period as we go forward.

Great.

And then you may have given this and I may have missed it, I apologize -- the operating cash flow in the quarter?

No, I didn't give it, but I will right now.

Free cash flow during the quarter was $3.6 million, cash from operations, $5.2 million, and that's offset by $1.6 million in CapEx to get the $3.6 million.

And then, last one, I understand you're not ready to talk about '09, but wondering if you could at least say whether you're still thinking about 20% organic growth in '09, particularly with Global Observer ramping up?

Well, I don't think we've changed our long-term view of five year 20% to 25% top-line CAGR or compounded growth rate.

And, as Steve said, we are still looking at our planning for our next fiscal year and we'll be -- I'm assuming we'll be talking about what our outlook for that is next quarter.

Great, thank you.

You bet.

Your next question comes from the line of Randy Gwirtzman with Baron Capital.

Please proceed.

Good afternoon, guys.

Hi, Randy, how are you?

I'm good.

I'm good, thanks.

Could you disaggregate a bit -- I don't know to what extent you can give a little detail on the backlog, but it would be helpful if you could, between kind of what's funded, I guess, was $62 million, and I think you said $456 million of IDIQs.

I'll start, Randy.

The $62 million is, again, our quarter-end snapshot.

That backlog is mostly product backlog at this point, 65% of that $62 million would be product backlog.

And, again, that backlog did not include the $45.8 million for the Army.

That order was negotiated and largely done, but it just wasn't definitized until after the quarter, so it was not included in the backlog and we couldn't make any deliveries against it.

The $456 million of unfunded, that's just based on various contract vehicles, some of which are used a lot, others are used sparingly.

So it's unfunded.

There's no commitment on the part of the customer to actually invoke those.

And I guess the other point that I'd make there is just that that unfunded backlog doesn't include the project options for Global Observer for additional aircraft.

What portion of Global Observer does it include?

Well, the -- our customer has not disclosed the amount that has been funded, but let me just say it this way.

The initial contract was $57 million, and probably less than half of that has been funded and is included in the backlog that we're working off.

And the other piece of that $57 million would be in the unfunded.

And then the third piece, which are the options for additional aircraft, is not in the number at all.

That's actually very helpful.

I think that total contract value was announced, wasn't it, Steve?

I think it was announced at $106 million or $107 million.

$109 million.

So the difference between the $57 million and the $109 million is nowhere in any of those backlog numbers, I guess was the point, Randy.

Yes, that's what I was trying to get at.

Okay, that makes the numbers make more sense to me on a year-over-year basis.

That's helpful.

Steve's just being his usual conservative self and we also thought that that -- as we talk about the unfunded backlog, to date, that's been exclusively associated with IDIQ-type contracts and the Global Observer options are kind of a different animal, so we didn't want to mix apples and apples there.

Got it, and I understand the sensitivity to the customer interest as well.

Is there anything else you can talk about in terms of milestones that the customer will be looking to and timing with regarding to what would influence them to exercise the option?

Well, I can probably just speak in generalities there.

I think probably the first major milestone just occurred last week, where we completed the preliminary design reductions with our customer set.

I think that went very well.

It'll be a while before we get any formal feedback, but all of the informal feedback I've had is quite positive.

And then we'll move onto a critical design review later with significant milestones along the way.

I touched on some of those significant milestones in my comments and most large aircraft development, the propulsion system is the long pole in the tent and we are extraordinarily pleased with the propulsion system testing we've been doing on Global.

I mentioned that's a full-up production propulsion system that's now been operating to spec at a simulated 65,000-foot altitude.

So I don't know that that's ever been done before with this particular technology, and it's quite an accomplishment.

I think our customers are as impressed as I am.

That's good to hear.

And just similar kinds of questions on Switchblade.

Is there anything you can talk about just in terms of maybe timing on that or the gating factor?

I understand that including ordinance on an aircraft like this makes everything a much higher level of complexity, but it would be helpful if you could kind of talk about how the program's going.

Thank you.

Well, A, going very well, and well enough so that we just, as I mentioned, just recently got another contract increase to produce additional units and do additional demonstrations.

And this is all in the configuration and application of our initial customer.

Equally importantly, I think, there are quite a large number of additional customers that now have very active interests in this capability.

So it's clearly growing and I don't think we've seen any setbacks here.

So I know it would be desirable if I could lay out a specific time and quantity, which I can't do, but this next phase that we're currently under contract for I think moves us much closer to a production decision in the future.

And are you working with the same partner that you've been working with in terms of integrating ordinance onto the aircraft?

Actually, let me see hardware much of this I can discuss.

We are working with the same production intent partner that we selected some time ago.

So --

Okay.

That's a big vague, but I hope that helps.

That's okay.

The last question I have is totally shifting gears, but you mentioned an incredible improvement in the turbine capacity for architectural wind.

I wanted to know if you've got any more sort of demo projects like the Kettle Chips factory that you're working on.

What do you see commercialization prospects for in that segment?

And then I'll leave you alone.

Thanks.

There's actually quite a significant list of customers on the books now that we're referring to as early adopters that have contracts in for installations on their facilities.

We got a little tied up last quarter with some weather challenges, but we're moving ahead now in those installations.

And I think we have made a public release on installations at Laughlin Air Force Base and the Duluth, Minnesota, installation.

It does seem to be picking up more and more steam with customer interest and we've got a number of additional product improvements in the pipeline that I think will continue to improve the value proposition that we're delivering.

So we're still looking favorably on this opportunity.

Thanks very much, guys.

You bet.

Thanks, Randy.

Your next question comes from the line of Matt Bugarin with Raymond James.

Please proceed.

Hi, this is Matt speaking for Brian.

Just a quick question on the mix in the quarter for fixed price and cost plus.

Could you give us what those were?

Yes, cost plus was 53% of revenue in the quarter.

Okay, and if I recall, you guys said that out of your backlog funded that 65% is product or fixed price.

Is that correct, loosely?

Yes, approximately 65%.

Okay, I think that's it for me.

All right, thank you very much.

Thank you.

Your next question is a follow-up question from the line of Chris Donaghey with SunTrust Robinson Humphrey.

Please proceed.

Hi, Tim, I wonder, can you clarify for us, do upgrades from As to Balance sheet count against the 1,900 requirement?

No.

Okay, great, and I know in the past you've talked about the number of airframes per month coming out of the Simi Valley facility.

It was at 200 at the analyst meeting.

Is it still around that same level?

I'll do that.

When you include the work that's running through the services combined, it's a bit higher than that, now, maybe 300.

Okay, and, last question, you talked a little bit about this, but how does the Global Observer funding get approved.

Are you gated by the customers', plural, willingness to commit funding, or is it a milestone-based type of funding approach, where when you demonstrate a certain capability, then it automatically triggers funding from the customer.

Just trying to figure out who drives the process.

Is it progress on your side or is it a funding issue from the customer side?

Well, I think, Chris, both elements enter into the equation.

However -- and the way this works under this contract is with this large number of customers, each of them has committed a certain amount of funding over the three-year period of the JCTD.

And, to date, I think they've all delivered the funding level that they were committed to and I think everyone expects that to continue.

At some point, if someone showed up without delivering their committed funds, then that would become a constraint, but that hasn't been the case and we don't expect it.

So then you move to the second one, which is the milestone sin the program, and I suspect if we were to start missing milestones, we'd start coming under the kind of management scrutiny that you would expect.

We haven't done that and our job, of course, is to stay on track and not limit our own funding by our own performance.

Okay, great.

Thanks a lot, guys.

Thank you.

Your next question is a follow-up from the line of Troy Lahr with Stifel Nicolaus.

Please proceed.

Thanks.

Can you guys just help me understand kind of why SG&A was higher in the quarter, just as a percentage of sales?

And then maybe is this kind of a new level for us to run at for the next few quarters?

Just maybe direction.

I know you don't want to talk quarter to quarter.

Sure, well, I think you got it.

Year over year when we were talking about it, there was a one-time adjustment last year for the SERP, so the actual growth year over year was $1.8 million.

And a lot of the growth, or almost all of the growth, is SG&A, and that includes B&P expenses, as well as selling and marketing infrastructure.

There's been a little growth over the last two or three quarters for G&A because we're a public company and we've added counsel and things like that.

But the real driver is the selling and marketing expense, and I think what we've talked about there is a need to continue to beef that up so that we can support our expectations for future sale growth.

So should we look at SG&A as a percentage of sales of around -- bumping around between 16% and 17%.

I think there you have to look at the sales level that we had during the quarter.

It was actually a little bit lower, sequentially, so 15%, 16% is probably more what we would think about.

Okay, all right, that's helpful.

And then R&D, also, about 7.5%.

Is that kind of a healthy run rate, or does that ramp up as you still work through some of these development programs?

R&D, again, we've talked about R&D being 8% to 10%, so it's not out of line.

The actual R&D spending for the quarter, $3.7 million, down $100,000 from $3.8 million in Q2.

That is going to bounce around.

It's been higher than that.

I'm looking and it was $4.3 million in Q1 and going back, $4.7 million in Q4 a year ago.

So that's going to bounce around.

A lot of that is the D&A and secret sauce of the Company.

So sometimes it gets crowded out by work, paid work, but this is an area that we'll continue to put a lot of focus on.

But still think of it as kind of an 8% to 10% type of --

Yes, and it may not all add up, but with a goal of 12% to 14% by the time we reach the operating income.

Okay.

And then, lastly, on the international sales mix, you talked about 10%.

Is the 10%, does that continue to increase from here?

It went from I think 3% to 7% to 10% -- or does it kind of level off here at 10%.

That one is hard because it's such a small amount and we've made some good deliveries in the quarter, which helped our margins.

I don't think I can guide on that in Q4.

It's an area we're trying to move up and make it a bigger piece of the pie, but because it's small it's just going to bounce around.

I don't think you can look at our history and say it's just going to continue to grow a couple of points every quarter.

Right, okay, but could it go back to 5% or 3%?

Yes, I think it could.

In any short period of time, certainly could move dramatically, Patrick, but I do think that there is growing appetite internationally and a trend to follow the pattern that DOD followed in the adoption of this technology.

So it's clearly behind DOD in terms of when they're adopting, but the same pattern seems to be the same and it seems to be pervasive, so we're actively pursuing a lot of those opportunities.

Okay, and I guess since you called me Patrick, I'll squeeze in one more question on you.

Steve is flashing signs in front of me here that says you did it again.

I'll blame it on him, then.

PosiCharge, when are you expecting a recovery there, or are you?

What kind of level?

How do you look at that business going forward?

I think the big issue is we have not seen that level of adoption accelerate that we had expected.

So we're about flat year over year and our market share is about the same, so we conclude from that that the overall industry adoption rate is about the same as it was last year.

I still think that it's a compelling value proposition and I think that that will prevail over time and that the adoption will increase significantly.

Having said that, and I've already been wrong, so I'm definitely not going to predict when or how much.

Okay.

All right, thanks, guys.

Thank you.

Your next question is a follow-up question from the line of Tim Quillin with Stephens Incorporated.

Please proceed.

Yes, just a couple quick questions, but one on PosiCharge, the fourth quarter of '07, there's a pretty steep sequential drop-off.

Is there any inherent seasonality there, or was that just kind of a one-off bad quarter?

I think that was a one-off bad quarter.

If I recall, we had a lot f business running through one particular auto customer at that time, which fell off.

But that's probably all I would have to say about fourth quarter to first quarter.

I haven't discerned any seasonality there, although I've always suspected that there should be some because of the capital acquisition cycle that tends to have an annual budgeting process in most organizations.

But it hasn't been obvious.

Right, right.

And then in terms of the Global Observer, remind me, how that is accounted for.

Is that percentage of completion based on milestones, or is it -- it's just a cost plus based on your ramp I guess.

Is that right?

Yes, it's in-project -- it's accounted for sales in our services line and it's within our project R&D category.

It's percentage of completion based on cost, like all of our cost plus programs.

And can you give us a sense -- you talked about your hiring, where you are relative to your run rates in terms of headcount?

You mean what do we have staffed right now relative to the peak we planned to staff on that program?

Yes.

That's a good question, and I don't think I've got the accurate enough data in front of me to hazard a guess.

Yes, actually, I don't' think we've ever talked about the headcount on an individual program.

That program is obviously driven by headcount at the current phase.

It's engineering, headcount-based.

We have been hiring and I think we're either on track with our hiring or else we're relying on external resources where we're unable to hire.

Well, we have been hiring very aggressively, and it's staffed with an extraordinarily competent and experienced team, and we're continuing to recruit aggressively, because we still have a significant ways to go.

So I would say -- and I think that hiring is going to continue for the next few months at any rate until we get where we want to be on that program.

Right, and just one last question, if I may, on the commercial markets.

And I understand that nothing's really going to move until the FAA regulates the airspace, but what are you doing at this point to seed some of those markets, markets like law enforcement, border security, firefighting, other things like that?

What can you do at this point to get things moving?

Well, we had been doing a lot of very active demonstration with our systems with that entire set of customers and more that you ran through, until the FAA put a new rule in place that requires a certificate of authentication in order to play any small UAS in the national airspace.

And that certificate has to be requested and sponsored by a government agency, and then it has to get in the queue.

And we're currently running our flight tests under those certificates of authorization, or COAs, as the acronym is referred to.

But it did dramatically reduce our ability to do demonstrations for potential commercial or other government agency customers.

Having said that, while we were doing that, we had gone ahead with a number of commercial customers and we had put in place service contracts to provide small UAS services, where we would not necessarily sell the systems, but we would operate the systems and deliver the information to those customers.

And that set of customers and other is believe are anxiously awaiting the FAA clearance to determine what the rules are going to be so that we can begin providing those services.

The FAA is in process now of reviewing a plan that would set up a charter for a small unmanned aircraft system, aviation rulemaking advisory committee.

And I believe the job of that committee would be to define small UAS and what the rules would be for them to operate in the national airspace.

I think as soon as that gets promulgated, then we can begin to see some time estimate son when these rules would get put in place.

And I think that might open up a floodgate of demand as more and more of these non-military customers become aware of what they can do in their enterprise with this capability.

I appreciate that.

Thank you.

Your next question is a follow-up question from the line of David Gremmels with Thomas Weisel Partners.

Please proceed.

Thanks, just one quick follow-up for Steve on the balance sheet.

I'm just looking at the growth in receivables and inventories and wondering what's driving that.

Is that just the expected growth in the business and would you expect to see any reversal in the fourth quarter?

Well, there are two different things.

The receivables were up a little bit juts because of the timing of some of our revenues in the quarter.

Some of the revenues were towards the latter end of the quarter and that means more unbilled and A/R.

On the inventory side, that inventory growth is basically all for the UAS and it's to fund future growth.

We thought for some time that needs to increase a bit so that we have a smoother run in operations, and that's really what that's for.

Steve, do you have a free cash flow target for the year?

No, we don't.

We've been very fortunate in terms of managing free cash.

We're free cash flow positive this quarter and year to date we're just about break-even.

The further out we look, we think that we will expect to have some use of funds for working capital.

So don't really have a prediction there other than it's probably for the near-term just going to bop around, up and down a little bit, like it's been.

Given that you're about flat year to date, do you expect to generate positive free cash flow for the year.

Again, don't have a prediction on that.

We could, or it could be slightly negative.

It's sort of moving within a fairly narrow range there.

Understood, thanks very much.

Thank you.

We are currently showing no more questions in queue at this time.

I would like to turn the call over for closing remarks.

Well, thank you again for your continued interest and your support.

We look forward to reporting our progress for the next fiscal year and our fourth quarter 2008.

Thanks.

Thank you for your participation in today's conference.

This concludes our presentation.

You may now disconnect.

Have a good day.