AeroVironment Inc (AVAV) 2009 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the second-quarter 2009 fiscal AeroVironment earnings conference call. My name is Shalan, and I will be your coordinator for today. (Operator Instructions).

As a reminder, this conference is being recorded for replay purposes. With us today from the Company is Chairman and Chief Executive Officer Mr. Tim Conver; Chief Financial Officer Mr. Steve Wright, and Director of Investor Relations, Mr. Steven Gitlin.

At this time I would like to turn the presentation over to Mr. Gitlin. Please go ahead, sir.

Thank you, Shalan. Welcome to our second-quarter fiscal 2009 earnings call. Before I hand the call over to Tim and Steve, 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 are based on current expectations, forecasts and assumptions that involve risks and uncertainties 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 US 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; 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. Additional information regarding these risks and uncertainties is contained in the reports we file with the Securities and Exchange Commission. Copies are available from the SEC, as well as on our website.

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, December 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 introduce Tim Conver.

Thank you, Steven. Welcome to our second-quarter fiscal 2009 conference call. I'm pleased to say that our team's focus across all the dimensions of our business -- operational, financial, customer service and R&D -- has enabled us to perform well in the midst of a significant economic volatility and uncertainty. Our strategy is rooted in developing innovative solutions that help our customers win in the face of two global trends. We are fortunate that our innovations have coincided with emerging market needs that have become increasingly critical to those customers. As a result, we're positioned very well.

From a financial perspective, we grew revenue by 22% over Q2 FY '08 to a record $65.8 million and delivered an operating income margin of 19%.

Our development programs are all making significant advancements. Global Observer continued to move forward, supported by key development milestones and appropriation decisions in Congress.

Switchblade made more progress in successful flight testing. Digital Data Link moved closer to production introduction, and Architectural Wind expanded its footprint of early adopter systems.

In our development process, we concentrate not only on the innovation that delivers new solutions but also on the ways in which our solutions make our customers as successful as possible. These programs have the potential to drive significant growth for AV.

Before I discuss our Q2 performance in more detail, I would like to address the broader economic and political environment as it relates to our market position and our future prospects. Obviously we're looking hard at the macro changes in the economy, the possible priorities of the incoming administration and government spending for potential effects on our business. We're concentrating on strengthening our position in all foreseeable external changes. I think that we are performing well and that AV is in a strong position for several reasons.

In an uncertain environment for sourcing capital, we have a strong balance sheet with over $120 million in cash and securities, no debt, and more than 85% of our business is with the federal government which pays on time.

It also appears that demand for our current unmanned aircraft systems is strong. Small UAS are increasingly becoming a must have ISR capability for our ground forces. Maintaining focus in this area has served us well. We have won all four US DOD programs of record for small UAS.

The cost effective ISR and force protection provided by our UAS products have received strong support from both DOD and Congress, and President-elect Obama has indicated similar support in this area. Our UAS development programs are introducing uniquely valuable and new capabilities that have the potential to be game changes in the current and foreseeable threat environment.

On balance I think our UAS segment is very well-positioned. Outside of our UAS business we continue to believe that our efficient energy segment is currently offering and continuing to develop practical solutions to support moves towards energy independents and the improvement of our environment, initiatives that appear to maintain continued political support.

At the same time, electric vehicle developments are high-priority programs within a number of automotive companies. However, it is in the EES segment that our exposure to current issues relating to the credit market and the economy is likely to be highest. EES constituted 14% of our Q2 revenue. Of that 14%, the majority is products sales to industrial customers, and a significant subset is sold to the automotive industry worldwide, which is facing significant challenges.

Our electric vehicle test systems are used primarily by developers of electric vehicles and advanced energy storage systems. PosiCharge is capital equipment used by customers, including automotive OEMs and their suppliers to improve productivity. Capital spending retrenchment in general and continued pressure on the automotive industry in particular could adversely affect our EES business in the future. We're monitoring these risks closely and managing our business accordingly.

On the political front, there appears to be healthy support for the areas we are addressing in both our UAS and our EES segments. Again, President-elect Obama stated his strong support for US troops. That support includes transformational technologies for war fighters in the 21st century battle space, specifically including UAS, and proposals to increase the size of the Army and the Marine Corps ground forces. Secretary of Defense Gates has also advocated increased intelligence, surveillance and reconnaissance and UAS deployment. Since our small UAS are used by ground forces to provide cost-effective situational awareness, we think these solutions are well-positioned for continued adoption. Customers in Congress have continued to support the Global Observer development program with requests for and appropriations of additional funding. President-elect Obama has supported US-based alternative energy and electric vehicle technologies that will help us move towards energy independence while reducing our impact on the environment.

Congress also signaled its support for small wind energy generation and EV fast charging infrastructure with the initiation of investment tax credits for these emerging technologies in the September Emergency Stabilization Act of 2008.

Clearly government spending plans are in flux, but from what we know now, we believe our strategy is well aligned with political priorities.

With that as a background, let's now look at our UAS segment.

Customers continued to procure our small UAS as they proceed to fill out their acquisition objectives. From all indications, our customers remain committed to procuring their full acquisition objectives for Raven. Additional customers are now evaluating the procurement of Wasp, our smallest production UAS. Puma AE development is going well on its accelerated schedule, and there is broad interest in this new capability provided by this platform.

I mentioned last quarter that our Global Observer customers exercised an option for a second aircraft with incremental funding provided in the second-half FY '08 supplemental appropriation. Congress subsequently appropriated an additional $40 million for GO in the FY '09 DOD budget signed in September. We expect that funding will flow through into the Global Observer contract within the next few months.

This additional appropriation will support a more robust development of demonstration of Global Observer's unique capabilities beyond the two airplane system funded in the initial contract and the '08 supplemental.

I believe it is also equally important as a demonstration of strong customer and congressional support for the valuable and the cost-effective capabilities that GO will deliver.

Switchblade is a back packable tube launched small UAS in development. It will carry an explosive payload in addition to its optics, providing a high precision, low collateral damage, force protection capability for ground troops. This development and demonstration contract is progressing well through its testing program. We still anticipate completing the current phase of testing this quarter, enabling our customers to begin to make their decisions regarding potential orders.

We expect Digital Data Link to be introduced this fiscal year as well. Among other product improvements, Digital Data Link will expand the number of our small UAS that can operate in a given geography through more efficient utilization of radiofrequency spectrum. The government recently announced its requirement for up to 60 additional Raven systems configured with the Digital Data Link and the retrofit of an additional 240 existing Raven systems. We expect this requirement to represent the initial production orders for DDL.

During Q2 we received the initial limited rate initial production contract from the Army. During Q2 we also announced the receipt of a $4.6 million award from DARPA for the development of a stealthy persistent Perch and Stare unmanned aircraft system based on Wasp. Our team is making good progress on this development program.

Now moving from UAS, our efficient energy systems segment continued to deliver solid performance. On the clean transportation side of EES, multiple customers pursuing on road electric vehicle development programs drove increased demand for our leading EV test systems. As development programs around the world move towards production, we anticipate business opportunities for our EV production and infrastructure solutions that will enable the practical use of electric vehicles and plug-in hybrids. We have a core competency and a particularly relevant set of technologies for this emerging market, including fast charging infrastructure, onboard and offboard battery charging, battery management systems, battery pack design, connectors, bidirectional interface with the electric grid and battery testing. We're working with a number of industry partners as we apply our set of solutions to enable the practical adoption of electric vehicles.

During Q2 we established an important new distribution agreement with Toyota Material Handling USA for our industrial PosiCharge productline. We're optimistic that over time this relationship with Toyota and their market-leading US distribution network will significantly increase our access to new adopters of fast charge solutions in material handling applications.

On the clean energy side of EES, we installed three new early adopter Architectural Wind systems and gained more experience with this innovative solution. The investment tax credit Congress provided for small wind installations in October is another important step for this development program. This is a 30% credit that is capped at $4000 per system.

With that as an overview of our business, I will now turn the call over to Steve Wright for a more detailed discussion of our financial performance.

Thank you, Tim, and good afternoon. Revenue for the second quarter was $65.8 million, an increase of 22% over second quarter prior year of $53.7 million. Looking at revenue by segment, UAS revenue was $56.5 million, an increase of 21% over the prior year. The growth in UAS revenue was largely due to higher project R&D work.

EES revenue was $9.3 million, an increase of 31% from Q2 last year, primarily due to higher delivers of EV test systems.

Turning to gross margin, gross margin for the second quarter was $25 million, up 32% from Q2 of last year. Gross margin as a percentage of revenue was 38% versus 35% in Q2 last year. By segment UAS gross margin was $19.9 million, up 18% from Q2 of last year, and as a percent of revenue, UAS gross margin was 35% versus 36% last year. EES gross margin was $5 million, up 150% from Q2 of last year. As a percent of revenue, EES gross margin was 54% versus 28% in Q2 last year. This increase in gross margin rate was primarily due to operating efficiencies and sales mix.

SG&A expense for the quarter totaled $7.9 million or 12% of revenue versus $8.6 million or 16% of revenue in the prior year. SG&A expense was lower, primarily due to lower bid and proposal expense.

R&D for the quarter was $4.9 million or 7% of revenue versus the prior year amount of $3.8 million, also 7% of revenue. Customer-funded research and development during the quarter totaled $16.1 million or 24% of revenue versus $5.8 million or 11% of revenue in Q2 of last year, and total R&D, internal and customer funded, was $21 million or 32% of revenue versus $9.6 million or 18% of revenue in the prior year.

Operating income for the quarter totaled $12.2 million or 19% of revenue. Operating income was 87% higher than Q2 prior year amount, primarily due to higher gross margin and lower SG&A expense partially offset by higher R&D. Net income for the quarter was $9.1 million or $0.41 per fully diluted share versus $5.2 million or $0.24 per fully diluted share in the same quarter last year.

Now moving quickly through our year-to-date results, revenue for the first six months was $119.4 million, up 16% from the prior year period of $102.9 million. And by segment UAS revenue was $102.5 million, up 16% from the prior year period. EES revenue was $16.9 million, up 17% from the prior year period. Gross margin for the first half was $45.6 million compared to $35.8 million in the prior year period, and gross margin as a percent of revenue was 38%, an increase of 3 points from the prior year.

By segment UAS gross margin was $36.6 million, up 18%, and EES gross margin was $9 million, up 89%. SG&A for the first six months was $16 million or 13% of revenue compared to the prior year period of $16.3 million or 16% of revenue.

R&D for the first half was $10.2 million or 9% of revenue versus $8.1 million or 8% of revenue in the prior year, and total R&D, internal plus customer funded, for the first half was $39.2 million or 33% of revenue versus $18.2 million or 18% of revenue in the prior year. Operating income for the first half was $19.5 million or 16% of revenue. Operating income increased 71% from the prior year amount.

The effective tax rate for the first six months was 31.9%, down from the prior year of 33.2%. This tax rate reflects the federal R&D tax credit which was recently renewed. Net income for the first half was $13.9 million or $0.64 per fully diluted share compared to $9 million or $0.42 per fully diluted share last year.

Looking at backlog, funded backlog at the end of the second quarter was $86.6 million, up $4.6 million or 6% from April 30, 2008.

Turning to our balance sheet, cash equivalents and investments at the end of the second quarter totaled $124.7 million, up $11.3 million from our prior quarter amount of $113.4 million. Positive cash flow was largely due to higher income and lower working capital needs, partially offset by higher CapEx.

Investments at the end of the second quarter were $8.1 million down from the previous quarter amount of $8.5 million. The decrease in investments was due to net redemptions of municipal auction rate securities.

Turning to receivables, at the end of the second quarter, our accounts receivable, including unbilled receivables, totaled $56.1 million, up $5.2 million million from the prior quarter. Total days sales outstanding were approximately 77 days versus 85 days at the prior quarter-end.

Taking a look at our inventories, inventories were $19 million at the end of this quarter compared to $20.7 million at the end of the prior quarter. Days in inventory were approximately 42 days versus 56 days at the prior quarter-end.

Turning to capital expenditures, in the second quarter we invested approximately $3.3 million or 5% of revenue in property improvements and capital equipment. And of this CapEx, approximately 95% was related to growth.

And now I would like to turn things back to Tim to discuss expectations for the full year.

Thanks, Steve. Q2 positions us well for achieving our objectives. In summary, our customers continue to adopt and successfully employ our small UAS and Efficient Energy Systems solutions. Our production and development programs are on track. We believe that we will receive production funding to proceed with the introduction of Digital Data Link this fiscal year. We anticipate the successful completion of Switchblade development testing this quarter. We believe we are well-positioned to continue to execute our plan given the changes we have seen to date in the credit markets and the economy and in the next administration's priorities. We see significant growth opportunities in both of our segments that timely investments can position us to take advantage of. We are aggressively pursuing those opportunities.

To that end we plan to increase investments in IR&D, SG&A and infrastructure throughout the second half. These investments should bring our expenditure levels and our operating margin in line with our original targets for the year.

I have mentioned in prior calls that our quarterly performance has historically been bumpy. Looking at the last two years of our financial performance, we have also identified what may be a seasonal pattern. This pattern is partially due to the government contracting cycle whereby we often receive our most significant Unmanned Aircraft Systems orders either at the end of our third quarter or at the beginning of our fourth quarter. Additionally every year the Company closes for a week between -- actually many times over a week between Christmas and New Year's, reducing production during our third quarter. The result in the past two years has been that our third quarters have been flat or down from our second quarters, and our fourth quarters have produced the highest revenue of the year. This apparent seasonality may help to explain some of the bumpiness that has characterized our past performance.

We recognize that the current economic environment introduces additional risk externally to all businesses and that our business is not immune. We are managing the business based on this reality by paying even closer attention to the financial condition of our customers and our supply chain partners by being even more rigorous in evaluating future order flow and by examining internal investment decisions to improve our competitive position and our ability to execute our plan.

Based on our results to date and our outlook for the balance of the year, we still expect revenue growth of 20% to 25% with a 12% to 14% operating margin for the fiscal year.

We appreciate the support of our customers, our team members, our suppliers and our investors in our collective success. Thank you all for your attention and your interest, and Steve and I will now open the call to questions.

(Operator Instructions). Michael Lewis, BB&T Capital Markets.

Tim, just real briefly on GO, can you talk about the specific milestones that hit in the second quarter? And did you also say that you're expecting the $40 million to hit sometime in the third quarter to be a part of the backlog?

Mike, the programmatically, we -- the JCTD or Joint Technology Development Demonstration contract is moving along well. I think the single most significant milestone of the quarter in the development of that program was the full-scale test of the propulsion system. In that case we simulated an entire flight from take off through cruise and back to landing at simulated altitude and temperature conditions hitting performance expectations for that propulsion system, which we felt was a very significant milestone.

I think the second part of your question was on the most recent funding appropriation of $40 million in the FY '09 defense budget, and I think I said in the next few months. So we obviously cannot predict exactly when our customers process funding through to contracts, but every indication is that that will happen in the next few months. And whether or not it all happens in the third quarter is something we will have to wait and see.

Okay. That is fair. When is the actual first flight anticipated for GO?

There is not a published flight date, but in general that is, if you will recall, a three-year program that includes development, flight testing, integration of payloads and then military utility demonstration.

So the first two years of the three-year program are development, and then we will begin flight testing. We are little more than a year into the program, so that should put us in the front end of flight testing in about a year.

Okay. And then just one more question for Steve, and then I will get out of the way here. With regard to the EES business, did you have any one time plus ops or other benefits in that business that caused the pretty significant uptick in that business in the quarter on a margin basis?

No, the margins are good. They are actually a little bit lower -- actually, excuse me, they are only slightly higher than they were in Q1. They are 54% in Q2 and 52% in Q1, and I would say there is nothing -- no significant accruals or adjustments in there.

Tyler Hojo, Sidoti & Co.

The first question just on customer-funded R&D, I know you gave that, but I missed the exact number. Would you mind providing that again?

Yes, just a second. Customer funded R&D for the quarter was $16.1 million.

Okay. I know you directionally I think last quarter said that the bulk of your customer-funded R&D was for Global Observer. Does the same hold true this quarter?

Oh, yes. Yes, customer-funded R&D in the quarter is 24% of sales, and we have always had pretty robust amount of customer-funded R&D. But clearly it is way above what we have seen in the last couple of years, and that growth is Global Observer.

Okay, very good. Just a follow-on to the last EES question, I know you guys were little bit hesitant last quarter when you had the nice margin performance there to say it was kind of a thing to expect going forward. But now with the two quarters here with 50% plus margins, is your thinking that maybe that's a little bit more sustainable, or how should we think about that?

I think the higher margins than we had a year ago are probably sustainable, but I don't think we want to commit to these 50% margins. Again, part of it is efficiency, part of it is sales mix, and that sales mix could change and result in lower margins.

So I would go back to from our perspective looking at operating margins at the 12% to 14% range.

Okay. That is fair. Just two kind of quick ones here. What was the ID/IQ backlog in the quarter?

Okay. That is right. Hold on, I have got it. $581 million.

Okay. As a percent of sales, how much was international?

3% of revenue for the quarter.

Tim Quillin, Stephens Inc.

Nice results. I think you have answered this a couple of different ways, but I will ask again. In terms of your margin expectations for the year, 12% to 14%, I think to get down to that level, you're going to have to have an operating margin of around 12% in 3Q and 4Q. Is that -- explain to me is that a function of just ramping up IRAD and SG&A? How much of that is related to potential economic sensitivity especially in PosiCharge that might impact gross margin there?

I will start off. I think it is primarily attributable to the reasons that Tim touched on in his opening remarks. We have had -- we have 16% year-to-date operating margins. Some of that has just been good performance, but a piece of it was lower spending on infrastructure in our overheads and SG&A and R&D, and we plan to continue to invest and get back to what we had planned to do really for the full year, which brings us back to our 12% to 14% for the year.

Also, in Q3 Tim mentioned looking at our history. If history repeats, we would expect to see lower Q3s relative to Q2s, and that will result in lower operating margins as well.

And how about in terms of EES, do you feel like the momentum you have on the EV test equipment side can offset what you would assume is going to be weakness in your industrial customer base at PosiCharge?

Well, we have seen growth in the EV test equipment in the first half. As I mentioned in my earlier comments, that is associated with multiple electric vehicle development programs going on around the world. I have not seen any abatement in the organizations that are running those programs as to their emphasis on those programs. But overall the auto industry is getting hit pretty hard and Detroit in particular. So it is hard for us to predict what happens to the EV development programs if the overall automotive enterprise continues to see the kind of financial stress that they have been seeing. So I don't have much more of a more explicit answer for you than that.

Okay. And how about just at PosiCharge, though, are you seeing a drop off in sales and margins there yet or do you expect to?

Well, I think we have seen some softness in PosiCharge sales in the auto segment. We've got about four different verticals that we address with PosiCharge, and we are aware that capital spending in general could come under pressure based on the stressed economy. But to date we have not seen that much of a change in actual order flow. So we are watching it closely.

Great. And then just one quick question for Steve. I think you said on the last call if the R&D tax credit is renewed, that the tax rate would be 35% for the year. Is that still accurate?

That is the ballpark. I would probably throw out 34% for the year on this call. Because we have looked at the total amount of R&D tax credit our advisors have, and that estimated credit is a bit higher than we were thinking in the past.

Great. Congratulations, guys.

Patrick McCarthy, FBR Capital Markets.

Congratulations on the quarter. My first question is, Tim, you had mentioned that was a broad level of interest in Puma AE. And I was wondering if maybe you could just put a little bit more granularity behind that. Is that big Army and where also that might go?

And then just secondary to that, is there a sense as to how quickly people are looking to make decisions on Puma AE?

I think in general the interest is broad across most of our existing customer base. Puma AE has a number of new capabilities or at least different capabilities than our smaller platforms that all operate, as you know, off the same ground control system. So Puma AE has the ability to land in water and/or on land. It is a relatively quiet platform. It has extended duration relative to the smaller platforms. That is it fliers for a longer period of time, and it has a dramatically improved set of optics that are derived from a larger and much more capable mechanical pan, tilt, zoom ball that is incorporated on this platform. So the combination of those characteristics, or in some cases just one of those characteristics, provide potential advantage in different applications for almost all of our customers. So it appears to have generated that interest and perhaps could augment the capability of existing customers in the future.

In terms of timing, this is a very rapid development program that was scheduled at the time the original contract was let. A team has been working extraordinary hours with just huge success on this program, and we expect to deliver those initial LRIP units for customer evaluation in Q3.

I think most customers that are looking at this will continue to look as it goes through that initial evaluation and be in a position to make some decisions after that.

Okay. Thank you. Is there any recent movement from the FAA potentially on domestic airspace and using small UAVs?

Yes, actually there is. Just this morning I saw some news on that. So I think the FAA is about ready to begin talking publicly on the status of their work on writing the rules and drafting the rules for small unmanned aircraft access to the national air space. It looks like as soon as this month they will be beginning to talk about that.

Okay, great. And just my final question. When you look at your topline guidance of 20% to 25%, are there key programs that would keep you at the 20%, or are there key programs that would have to come through to get to that 25%? It sounds like maybe the Digital Data Link waiting on the contract or at least to put into production in GO. Is there anything else?

I think it is kind of hard to bend the low end and the high end of our guidance based on an individual program or programs, Patrick. That is just a range that we can manage into. It is not based on any particular win or something not happening.

Okay. Fair enough. And then maybe just one other question if I could. In all the discussions you mentioned earlier, the auto bailout packages and all that type of stuff, is there anything in the discussions that have been going on that you think could actually be positive longer-term for the energy business, or what's your thoughts there?

Well, yes. If you look at the original congressional action on the first $25 billion that was earmarked for auto industry loans, that was tied to clean transportation investments. And as these most recent discussions have taken place as I watched that just in the public press, there appears to be continued congressional interest in pushing forward clean vehicle development, and that goes to the issue of electric vehicles and various hybrid configurations in many cases.

You also -- I mentioned in my comments, Patrick, earlier that in the October legislation, there was an -- for the first time, an investment tax credit allocated to fast charging infrastructure, which clearly is intended to support electric vehicle deployment. So I think there is quite a bit of potential support for the development and deployment of these systems. And if that comes to be, I think we're very well-positioned to participate.

Chris Donaghey, SunTrust Robinson-Humphrey.

Good quarter, guys. Can you maybe compare for us the pending upgrade cycle from analog to the Digital Data Link version and how that may compare to the Raven A to Raven B conversion and the timing? Would you expect this to also be funded through an O&M type of funding line versus a procurement line?

Well, to the extent that this is essentially a product improvement to Raven and ultimately to Wasp, I think it is certainly comparable. And, as you know, when most of the Raven As were ultimately converted to Raven Bs, we expect that the most likely scenario with Digital Data Link will be the same. That most of our -- the Legacy installed base of both Raven and ultimately Wasp would -- our customers would want to see a homogenous fleet.

In addition to the Digital Data Link, there are at least one and maybe other product improvements that can be packaged up there. So I think that is how we're looking at it, and I think that is a reasonable expectation.

I will just add in terms of where the funding come from, we don't know, but I think our guess is it will come from the investment part of the budget.

Okay. And from a process standpoint, is this something that is done in the field, or does every aircraft have to come back to the factory to be retrofitted with DDL? How do you expect the actual mechanics of the conversion to take place?

Well, (multiple speakers) that will get defined explicitly when our customers implement that change. But I would guess it is more likely to be a factory depot retrofit as opposed to a field retrofit.

Okay. And as you talk about the investment plan in the back half of the year, can you talk a little bit about what your CapEx expectations are? And is this getting ready for Switchblade to go into full rate production? Is this increasing production floor space maybe for Global Observer? Can you kind of break out what the investment plan entails?

I will start. I will just say that a lot of the investments that we're talking about or expense are not CapEx. But CapEx in Q2 5% of revenue, and that is probably the level that we will continue to spend at through the balance of the year. Then in terms of the investment that Tim was discussing, it would be an overhead, infrastructure, SG&A, business development and R&D activities, and these are really things that get us back to the plan levels that we have had all along. I don't know if you --

Yes, I guess I would go just a little bit further, Chris, to say that from an infrastructure perspective, we would be looking at production, supply chain, inventory areas where we can increase our agility and our ability to respond effectively both competitively and to customer demand.

In the area of IR&D, we would be looking at positioning ourselves with developments that we have been working on previously so that they are in a position to move quickly when customers make adoption decisions. And we also see a number of other opportunities that we think we can position ourselves for now that could be very significant growth opportunities in the future. And in SG&A it is probably biased towards business development capacity and capability.

Okay, great. So just to kind of finish up this topic, can you talk a little bit about what will be needed to put Switchblade into production? Do you need a new facility? Do you have to section off a piece of an existing facility since it is ammunition essentially?

I think that the biggest variable there would be production rate. So we would not know that until we see more indication of what our potential customers want to do and when. But if it were relatively low rate, I think we can accommodate a lot of that with existing facilities, and if it is relatively high rate, then that is a different story.

Clearly there are some changes associated with the implementation and the final assembly with ammunition, and we're looking at a few different options on how we might execute that.

Okay, great. Thanks. And one last question for you, Steve. Did you put out an operating cash flow number? I don't remember. I may have missed that.

No, but I will give you one now. Cash flow from operations in Q2 of $14.4 million and again, CapEx was cash out of $3.3 million. So free cash flow was $11 million positive.

Okay, great. Thanks, guys, and good job on the quarter.

Howard Rubel, Jefferies & Co.

We will go beat the dead horse one more time Tim, sorry. To go from the levels of R&D and SG&A that you are talking about means that you have to hire a lot of people or put them on airplanes or something. Is your headcount -- I mean can you give us a sense of where your headcount is today and where you're going to take it?

I can give you a statistical headcount. As of Q2, we are at 594 heads, up about 10% from year-end.

And I think we are continuing to hire, Howard. We have been for a number of years, and that has not really abated. I think during the first half we were still ramping up aggressively to get Global Observer on fully staffed and executing, and I think we're pretty well they are now. We had similar surges on some of our other development programs that are now beginning to come to a successful conclusion. So that we think is going to free up some existing staff. We do intend to continue to hire, and a lot of that investments that we're talking about can be associated with procurement in addition to direct labor. So we think we are reasonably well equipped to execute this plan in the second half.

And another way of saying it is that rather than cream skimming, you see you just have these multiple opportunities, and it is better to invest for today for the promise of tomorrow as opposed to just harvesting so quickly?

That is absolutely right, Howard. I think we -- as I mentioned we are -- sorry, I got distracted there.

I did not mean to do that to you; I apologize.

No, it was not you. It is my friendly troop here with insights on timing. So at any rate, I think we see the very significant growth opportunities that -- and I think simultaneously we see the ability to execute our initial guidance this year. So I think we're in a relatively strong position, and we see it as a unique opportunity to aggressively pursue those opportunities in what is otherwise a pretty nasty economic environment.

So if I can just follow that, an equal amount of this is going to be in the energy efficiency area as opposed to just being all UASs? Is that --?

Yes, we are looking at opportunities in both areas, and we're investing heavily in both areas. Now we still have kind of a 15%, 85% split in the business. And so you would expect to see considerably more on the UAS size, but that is relative to the existing split in the business. So I guess I do not want to go into any more -- well (multiple speakers) how that is split up.

No, that is fair, but does that mean that we could see some customer announcements in the near-term as a result of these initiatives?

I think any near-term results would accrue from the work we're doing on the infrastructure side where we are really, in addition to positioning ourselves to be more competitively effective in the future, we are also positioning ourselves to be more agile and responsive in the near-term, and I think that goes to protecting our ability to execute the plan.

In terms of IR&D or business development investments, I would expect those to be a little longer term before you would see fruit on those trees.

I just have two more questions. One is that if we look at the incremental revenues, the gross margins actually were down. Is that because Global Observer is such a larger part of the business?

When you say incremental revenues, do you mean quarter-over-quarter?

Sequentially, yes, you are up.

Well, we are flat in total. UAS is down a point, and EES is up a point. Howard, I would say that this is why we really don't guide on gross margin. That number is just really going to move around based on the contracts we're working on. I would not attribute it to any one program, including Global Observer.

Okay. And then the last thing is that while you improved on DSO, given the amount of business that you have with Uncle Sam, I'm still a little surprised it cannot be inside of 60 days, Steve.

Well, I wish it were, but we have never been inside of 60 days, even with Uncle Sam, and a lot of that has to do with the order flow and how the sales accrue during the quarter. Many times a lot of our revenues occur towards the end of the quarter. So when I calculate the metric for the quarter, we do end up with a higher DSO amount. But the good news there is there is really no credit risk with respect to the AV receivables.

Thank you very much. Very nice numbers.

Michael Ciarmoli, Boenning & Scattergood.

Nice quarter. Quickly, in terms of your Army contract, the 1900 unit contract, what was the percent you've delivered on that to date?

Through Q2 we are 45% delivered against the 1900 systems. Now you may recall at the last earnings call, I announced we were 48% delivered. And so what has changed is we have been informed that we were accounting some of the early Raven A deliveries against that 1900, and our customer has told us that is not the case, and we're not as far into it -- therefore, we're not as far into it as we thought.

Okay.

As of Q2, the reset accounting is 45%.

Okay. So that suggests a little bit longer runway on that program. I guess that is good news.

Yes.

And then I don't know if I'm looking into this, looking at your -- bookings were down in the quarter significantly. The backlog is lower. You have talked about the seasonal weakness in the third quarter. And looking at past trends, it looks like bookings and backlog have trended lower. Is that the expectation for the third quarter, and does that concern you, this kind of lumpiness about the business?

I think we have been talking about the lumpiness of the business for two years. So this is just part of our business. We do not have multi-year backlog. The funded backlog is up from year-end. From Q1 it is lower, and that is because we had a large injection of backlog from the Global Observer program in Q1. That kind of lumpiness is what you can expect with us go forward.

Okay. So even when you were talking about SG&A being lower for lower bid activity, just kind of the normal lumpiness, nothing to read into?

It is, but your point on Q3 is good. I point you back to the remarks that Tim made. A lot of our order flow which drives lumpiness in the business is lumpy itself. That the big GFY tranche of funding, when does that come in? Does it come in in Q3, or does it come in in Q4? It will have a material effect on backlog and results based on when it arrives. It is not just one program. It is a number of programs that fall into that category.

Okay. That is fair. And then just if I can, back on the upgrades to be DDL, with obviously operations persisting in Iraq and it certainly looks like there's going to be a surge of activity in Afghanistan, does that make it more difficult for the customer to proceed with these upgrades? If you can give me a sense of timing, how long it takes one of these upgrades, how long will the customer be without their product?

The time without the product is an interesting question, and I don't have a great answer for it right now. It is not a multiweek process. So we will stage this based -- once we see what the schedule of our customers want to proceed on, we will plan that from an inventory and an implementation perspective. I would expect the same kind of good execution that we saw when we did -- when we began the frequency update, which was not dissimilar in Q1.

So I think the time customers would be out of pocket with their systems for this retrofit will not be a long period of time. As to how soon or how they would be -- how their retrofit decisions would be affected as a result of operations tempo, I guess I cannot predict what their decisions would be based on some future change in their ops tempo. So we will just as usual response to what they need and do our best to mitigate the impact.

Okay. And I guess would the same be true for sort of service levels or replacement as troops are withdrawn from Iraq and potentially transferred to Afghanistan? Do you think there would be mandatory service required for some of the aircraft out there, or is it too early to tell what those demands might be in terms of service requirements?

It is definitely too early to tell what customers might want to do. But in terms of mandatory maintenance or service, I think the answer is no. These systems are really on condition repairs. So they operate with a certain amount of spares in the field. We have a certain amount of spares remotely supported with our servicepeople, and then the primary repair and replacement work is done at a deeper level in our factory. And that is all a function of what the specific condition of any given system is at any given time. So it would not lead to a schedule maintenance in and of itself.

Okay, that is perfect. And then just a last question, on the Puma AE, you talked about the accelerated schedule. Is there a chance that you could move into one of those larger kind of options beyond the $4 million contract, or was that accelerated schedule kind of built in to your initial award?

Yes, the schedule was part of the initial award. So we just got an aggressive customer, and we are running fast to keep up with them.

Fair enough. Thanks a lot, guys. Good quarter.

Josephine Millward, Stanford Group.

Can you tell us what the initial Digital Data Link order that you have received, what it is from the Army, the size of that order?

I believe it is about $6 million or $7 million.

Yes, I think it is right around $6 million, and that is non-recurring and an initial set of systems for limited rate initial production.

Okay. So this is really just to deliver maybe like 20 -- put it at attached units to the Army for evaluation, is that right?

Correct.

And when do you -- you mentioned that you expect -- when do you expect to receive the rest of the production order from the Army?

Well, we know that the government announced a requirement for about 50 or 60 retrofits and something north of 200 -- or 50 or 60 new systems and something north of 200 retrofits, and we expect that they are in the process of addressing that requirement that they have announced. So presumably that will happen in our second half.

What has to happen after the initial testing for them to move forward with production?

This would go through an evaluation. They would then need to presumably make a determination that the systems meet their performance expectations, and then they would approve that production. That would then go back to what is funded and how does that schedule -- how do they decide to flow that schedule into their existing fleet.

So I believe that our customers are in the process of making those decisions now, and as soon as they tell us what they want to do, we expect to be prepared to execute.

Great. That is very helpful. You also mentioned additional customers for evaluating the Wasp. Can you expand on that a little bit on when we might have a decision?

It is hard for me to predict a) what their decision would be, or b) when they would make it. I do know that there are multiple customers that see significant potential advantage to that system in their concept of operations, and they are considering whether or not they want to adopt some of those systems in their use.

So I think it is possible that that happens in the next six to 12 months, but I cannot really predict what our customers are going to do in the future.

Sure. Just one last question. Your R&D win from DARPA on this sales purchase there to small UAS, it sounds a lot like the requirements for the small UAS for the future combat system. Is that to develop a competing offering?

I don't think this is (multiple speakers) I do not think that DARPA is thinking in those terms. I think this is a -- I think DARPA sees this as a very attractive features set, and as you know, there is a term called DARPA-hard that defines the kinds of R&D programs that they fund, which are usually significant stretches beyond existing capabilities. So putting -- where -- the fact that the FCS Class 1 program originally had a Hover and Stare requirement and a Perch and Stare objective as part of its performance spec, to that extent it, in fact, is similar, but this is a much smaller system, and it adds the characteristic of stealthiness that I think DARPA sees some potential around the basic WASP platform to achieve.

Alex Hamilton, Jesup & Lamont.

Actually most of my questions have been answered. I might have missed your comments in regards to SG&A and R&D. I guess should I -- going forward in the model, should SG&A and R&D look closer to what was achieved in the second quarter or first quarter?

Well, I think our expectation is to accelerate our investment in the second half in both of those categories over and above what we -- what our spending was in the first half.

Okay. Thank you.

And I think the net result would be operating margins in the 12% to 14% range.

If you take a look at our SG&A as a percent of sales last year and maybe use that as a guide, we really cannot guide on individual line items. But you will notice as a percent of sales, clearly they are very low in Q2.

Jeff Evanson, Dougherty & Co.

Tim, would you be willing to share what you have remaining in funded Global Observer backlog at this point?

Let me jump in. We do not break out our backlog by program. It was a fairly good chunk in Q1, and it is less now. But I don't think we want to start unpacking the backlog or the sales by contract.

Okay. And Steve, could you talk about the increase in unbilled receivables and retentions of 23% sequentially? I guess I am thinking there is a correlation here, correct?

No, the unbilled, again it is going to depend on -- it is mainly unbilled, it is not retentions, by the way. And the value is going to depend on a) the volume level of cost plus work we have -- that is the main driver -- and b) the timing of that cost-plus work. At the end of the month, whatever we -- or at the end of the quarter, the entire month's worth of cost-plus work will be in unbilled, for example, because we will bill it out in the following month the first week of the quarter. So there's nothing really going on there. It is just a function of the way our sales come in and our cost-plus mix.

Okay. That is helpful. Maybe this is almost along the same lines then. If I see funded and unfunded backlog down sequentially and you told me you saved money in the quarter by doing lower bid and proposal work, why -- how should I think about that? Should I not be concerned about that?

No, I mean well -- I mean that is for you to determine. But when I was talking about the lower bid and proposal work, I was talking about not sequentially but compared to the prior year. In the first half of last year, we had a lot of bid and proposal activities associated with the Global Observer program. (multiple speakers)

Well, we also had a significant effort associated with Puma AE, which we subsequently won. So right now there are no small UAS programs of record in competition. If there were, we would probably be heavily spending in bid and proposal.

Makes sense.

Let me, Jeff, go back on your Global Observer question. As Steve pointed out, we have never broken out backlog by program. But a way to think about Global Observer might be what has already been publicly announced.

The original contract was $57 million. Now that was over for a three-year program execution, and it was not fully funded at contract time when the expectation was that would be funded over the three-year period. Additionally there was an additional -- there was another $37 million or $38 million that was appropriated in the FY '08 second supplemental. And then there was a further $40 million appropriated in the FY '09 VOD budget.

Now those last two appropriations tend to get some amount allocated to government overhead between appropriation and the time it shows up in contracts to us for Global Observer. But at a very top line, that I think gives you a sense of programmatic funding here.

And the $40 million, none of that is in funded backlog, correct?

That is correct. It is neither funded nor unfunded. It is not here, yes.

It is on the East Coast?

Yes.

Okay. And then my last question. I know you have been pestered to death about service revenues, so I will ask it here. I guess if my calculation is right, this is the lowest level of service revenue in six or seven quarters if I count this quarter. How should I think about that in relation to operational tempo, or is this just --?

I will start and then Tim can talk about longer-term. I think for the quarter there is no message there other than we had more product work to work off than service revenue. If you go back to Q1, we had a lot more service work and lower product work because of the ECP change.

Longer-term the impact of service revenue on ops tempo, I guess I would let Tim talk to that.

Yes, well, I can certainly talk to it, Jeff, but I'm not sure I will add much more clarity. I think what is going on to some degree is our customers, and we are learning what the spares and repairs and service support training requirements for these systems are as we go.

Five years ago these systems were not part of programs of record. They were not, and they have just been now in these last five years introduced to our various customer systems, integrated into their tactics and procedures and their supply and training methodologies. And so they clearly have to anticipate ahead what the performance requirements will be or the service requirements and what the spare parts and repairs demands from future operations will be, and by definition, they cannot get that exactly right.

So I think we have seen and we probably will see some ups and downs as experience with the systems begins to stabilize and our customers are able to predict and fund their spending in that area.

Okay, that is helpful. My last question is, I guess, Tim, related to EES, I think it was you that made the comment, are you essentially telling us that we probably should expect that number to be down sequentially in Q3?

Are you saying EES sales?

Correct.

No, I do not think we were intending to provide any specific direction on EES or UAS. I think the comment, the point was that what we have seen in the last two years is a pattern in the second half that where our Q3 is low and our Q4 is high, and we think that a major contributing factor to that is the significant fiscal year order flow in our unmanned aircraft. Was that the question, or am I answering the wrong question?

Actually you anticipated the Part b to the question.

Okay.

I think there are two separate messages. We recognize the risk in the commercial environment, and then we are pointing out on a macrolevel what kind of trends we have seen.

Understood. Okay. Thank you very much.

Michael Lewis, BB&T Capital Markets.

Year-to-date depreciation and amortization, please.

$1.1 million. Sorry, that is Q2. Sorry, Mike. $1.1 million in Q1 also.

Tim Quillin, Stephens Inc.

All my questions have been answered.

Tyler Hojo, Sidoti & Co.

A quick follow-up here for me. Would you be able to tell us how many airframes were manufactured in the quarter in total, including the service side?

Yes, I can do that. It was over -- at a pace of over -- a bit over 300 a month.

A bit over, okay. And is that -- so that is definitely up sequentially, correct?

I believe so, but I'm not certain.

Okay. And just (multiple speakers) I'm sorry, go ahead.

I just wanted to add, the other metric we typically give out, we are now over 11,000 air vehicles new and reworked delivered.

Great. Thank you. Just a follow-on, you gave us how the percentage of the planned Raven buy, the 1900 systems for Q2, but what was the correct number for Q1?

Let me just -- I don't have that number, but let me tell you what the adjustment is. There were 170 original Raven As that we took out of the equation.

Okay. We can figure it out then. All right. Great. Thank you.

Corey Amon, Rice Voelker.

You stated that the R&D revenue was I think $16 million versus about $6 million last year. You may or may not be able to answer this, but can you give us a sense for how the profit margins for customer-funded R&D compare to the rest of the business?

Yes, well typically our project R&D is contracted on a cost-plus basis, and so those margins are lower than our fixed work. It is profitable, but the margins are typically lower.

Okay. We also know how much of the UAS revenues related to R&D, but it sounds like the previous caller knows how to figure this out. I'm new to the Company, but can you tell us how much of the UAS revenue is related to product and how much is related to service?

We do not break that out by segment, but in total I will tell you Q2 product revenue was 57% of sales and service is 19%, project R&D 24%, and to help you out further, on the EES side, it is almost all product work.

Okay. That is good. Okay, great. And also I guess my last question is, can you give us a sense for how much of the UAS product revenue is from Raven versus the other UAS product? (multiple speakers) -- Raven pretty much all of the UAS product at this point?

No, no, but having said that, we do not break it out by product line. Raven is the largest seller followed by Wasp in our products, and then moving from there, we move into the EES products and then Puma and some of the other things.

Okay, great. All right. Thank you very much.

With that as our final question, we thank you all for your continued attention and interest in AeroVironment. May I remind you that an archived version of this call, as well as all SEC filings, can be found on our website, www.avinc.com. Relevant Company and industry news can also be found there.

We look forward to speaking with you again following next quarter's results. In the meantime, please receive our best wishes for the holiday season and a healthy and prosperous new year.

That concludes today's conference. You may disconnect at this time. We do appreciate your participation.