AeroVironment Inc (AVAV) 2009 Q3 法說會逐字稿

Welcome to the third quarter 2009 AeroVironment conference call. (Operator Instructions) 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. Stephen Gitlin. I would now like to turn the presentation over to Mr. Gitlin. Please go ahead, sir.

Thank you. Welcome to AV's fiscal third quarter fiscal2009 earnings conference call. Before I hand the call over to management, please note that on this call, certain information 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, March 9, 2009. 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. It is now my pleasure to turn the call over to Tim Conver.

Thank you, Stephen. Welcome to our third quarter 2009 conference call. The time that's passed since our Q2 earnings report and today has seen dramatic economic and political developments, unprecedented in our experience, and affecting US global and commerce. One effect of these developments is growing uncertainty regarding commercial and government funding and purchase decisions. We believe our performance has been strong relative to many other businesses struggling in this environment, but we do feel the impact.

AV's growth is based on fundamental propositions that our innovative solutions were developed to contribute important and valuable new benefits to our customers. Given the difficulty in predicting the timing and the volume of market adoption, we have always taken a long-term view of our business and market opportunities. Our team has historically performed extremely well in delivering results that have met our guidance, even though our quarterly results tend not to be linear. However, I doubt I have ever addressed investors without pointing out the bumpy quarters that have been and we expect will be characteristic of our business.

Three quarters into our fiscal '09 our year to date revenue is up 13% year-over-year and our operating profit is 14%. Q3 revenue was up 8% over Q3 last year, but was lower than we expected. There were multiple contributors to relatively low Q3 revenue, and I'm going to go into more detail here than usual to provide perspective on these contributing factors and their implications.

They can be classified into four categories. The first category is structural. As we pointed out in our last call, every year we close operations between Christmas and New Year's and this year that amounted to almost two weeks production. We also know there is a likelihood of late order flow affecting Q3 associated with the government's budget cycle, and we saw that this year with most of the Raven Army contract arriving in the last day of the quarter. The second category also amounts to deferred revenue. We had lower project revenues constrained by unfilled employee hiring. This project revenue will be recovered as we hire the employees we're seeking.

The third category is economy-driven. Our industrial PosiCharge sales are down year to date because of lower sales of electric forklifts and foreign military orders for small UAS are being deferred because of international government budgetary uncertainty. We have made significant changes to drive stronger PosiCharge sales in the midst of capital equipment market declines, which I'll talk more about later, but we currently think we'll be doing well if we can hold PosiCharge sales flat year-over-year. The foreign order delay surprised us and we believe it's been driven by a reevaluation of defense budgets and priorities around the world. We have some reason for optimism in the ultimate outcome of foreign,small UAS procurement decisions but for now we have delays.

The fourth category is DOD orders for small UAS that we expected in Q3, but have not received. We believe some customers are still arranging funding and at least one customer may be deferring orders waiting for digital DataLink production cut-in to be available. This DDL effect would be an unanticipated revenue delay associated with the compelling new product improvement that digital DataLink represents.

We expect strong fourth quarter revenue to bring total fiscal year '09 revenue to $240 million to $250 million. This would be an 11% to a 16% growth over fiscal year '08, but less than the growth we previously expected for the year. I believe we remain very well positioned due to the intersection of our customers' priorities and the value they perceive in our solutions, as well as our financial resources and the extraordinary effectiveness of our people. Demand for small UAS customer-funded development programs and electric vehicle test systems remains strong, supporting our long-term growth goals.

In fact, significant highlights in quarter three reinforced our general growth expectations. They include record funded backlog of $139 million, a definitive statement of demand for our solutions. A net increase in cash equivalents and investment to $131 million. Receipt of Army Raven production and CLS orders totaling $100 -- excuse me, $41.7 million, although most of it was received at the end of the quarter. Continued progress on Global Observer development and increased funding development. Delivery of initial Puma AE limited rate initial production systems and very positive customer response to initial operational testing.

Italian approval of Raven for use over populated centers, this is a key enabler to future applications inside national air spaces. Installation of PosiCharge systems at our first customer developed through our new Toyota material handling distribution partnership with clear customer appreciation of the value proposition. Installation of our electric vehicle test systems at the General Motors volt development plant. Successful transition of our digital DataLink from research and development into production, with a $16.8 million initial order in January and encouraging indications of broad future adoption. And successful demonstration of the end to end Switchblade solution, leading to multiple customers now evaluating potential applications for this entirely new capability.

These are all strong indications of growing demand and some are major milestones for key growth platforms. Before we move on to the UAS segment, I think it's helpful to revisit briefly the implications of our strategy to understand how we view the business. We have developed market leadership, competitive advantage and sustainable growth by bringing innovative technology solutions with compelling benefits to large potential markets. As a corollary, we have to deal with the unpredictable timing and rate of adoption inherent in innovation. We have successfully transitioned three solutions from R&D to production businesses through our commercialization process.

Small UAS is the largest, followed by PosiCharge, and then electric vehicle test systems. In each case, we have built the largest market share and we have created good opportunities, not only to maintain our leadership in these initial served markets, but to expand our solutions into much larger target markets for future growth. The challenges we face as we execute this strategy include getting the technology right, anticipating the market, surviving the inevitable dry holes and dealing with uncertainty regarding the timing of adoption and diffusion of these innovations into their target markets. I think we understand and actually thrive on the first three challenges. We deal with the fourth challenge, the timing of adoption and market uptake with persistence, agility, measured investments, and a long-term view. The rewards have been significant.

When small UAS and PosiCharge were adopted by large customers, initial revenue growth exceeded 100% per year and we established early and sustained market leadership. We believe innovation still in development may have even greater potential and larger rewards than those already commercialized. Although the difficulty in predicting timing emphasizes the importance of viewing and managing our business for the long-term.

Now let's look at the Q3 results for our UAS segment. Demand for our UAS solutions continued in Q3 and is reflected in record backlog this quarter. Key contributors to the growing backlog were receiving options exercised for our Global Observer development contract, as more of the funds appropriated for Global Observer in calendar year '08 were put on contract. We expect this process will continue with Global Observer contract funding additions in Q4.

UAS production and CLS orders from the Army were received at the end of the quarter and we received a contract for digital DataLink, low rate initial production and Raven B retro fits during the quarter. Most of this initial digital DataLink contract will ship in Q3 and Q2 of our fiscal year '10. We believe this is a very important milestone in our small UAS business and represents significant growth potential. It's also a major production transition from one of the key internally funded R&D initiatives we announced over two years ago. We believe the Army intends to convert all future production, small unmanned aircraft systems to digital DataLink and to retro fit much, if not all, of their entire fleet of Raven Bs. We believe most of the other small UAS customers will eventually do the same. Digital DataLink will multiply the number of small unmanned aircraft that can be used without requiring additional scarce frequency spectrum, a key enabler to broader adoption of small UAS beyond the current basis of issue. It will also significantly enhance communications security.

Beyond these initial benefits of DDL, we expect the thousands of our small unmanned aircraft systems available throughout DOD will take on much more value with the potential of each becoming an airborne network access node enabling a beyond line of sight digital network. An unforeseen consequence of our successful introduction of DDL is that at least one customer appears to have deferred expected small unmanned aircraft system contracts to wait for DDL production availability.

Beyond our Q3 backlog gains, we made important progress in several other areas of UAS. We're pleased with reports of successful initial operational testing of Puma AE. Successful completion of the full testing and evaluation is a necessary phase in military acquisition before authorities can authorize full rate production. This first step for Puma AE is encouraging for future production procurements. By next quarter, early in the quarter, we expect to be able to begin demonstrating for the first time the significant performance capabilities of Puma AE to other potential customers. Like Raven, we believe the potential adoption of Puma AE can extend well beyond its initial customer base.

We made good progress on our other UAS development programs during the quarter and as I mentioned, we achieved major milestones in some. The Global Observer program continues to go well. Air frame fabrication has started and propulsion, pay load and control system development and testing continues successfully. We are continuing to work with our customer, as they exercise contract options with funding. A major milestone was achieved in Q3 with Switchblade's successful end to end customer demonstrations during the quarter.

These tests demonstrated Switchblade's unique set of capabilities, high mission value, and effects capabilities that do not currently exist in any other system. We believe these unique capabilities will be attractive to a number of defense customers. We have seen active interest from a growing number of customers developed from this demonstration of our initial ground launch configuration of Switchblade. Two new customers have already funded demonstrations for their own somewhat different applications of Switchblade and we are in similar discussions with other customers. We're optimistic about the significant potential of this development, but we do not yet know when, what customers will make what decisions on Switchblade acquisition. A case in point of the unpredictability of the timing of innovation adoption.

We also made good progress on our stealthy purch and persistence air UAS and our Nano air vehicle development programs for DARPA. Active interest in our small unmanned aircraft systems continues internationally, but the economy is stretched out non-US acquisition decisions. At these -- as these international defense budgets are addressed over the coming months, we believe one view that customers will consider is that small UAS can provide an 80% solution to ISR requirements, often at less than 10% of the cost.

Before we move on to discuss our environmental systems business, there continues to be a great deal of speculation regarding how the Obama Administration's defense and spending priorities may affect defense contractors. I would like to take a moment to address these concerns, as they might affect AV. Targets have been set for drawing down troops in Iraq and commitments have been made to increase troops in Afghanistan. We believe that the underlying customer demand for our small UAS is driven by plans to equip all US ground forces with this capability at a certain organizational level of use. Our customers do not view small UAS as a tool that's useful only in Iraq or Afghanistan, but rather as a tool that our ground forces require wherever and wherever they operate and train. As a result, we do not believe that the Iraq drawdown will reduce planned procurement quantities for our small UAS.

Moreover, given that the initial demand for small UAS began in early 2002 in Afghanistan, where US forces were successfully employing our Porter system to provide situational awareness to isolated teams in rugged terrain, we see compelling benefits for the continued or expanded use of small UAS, as operations increase in that country. A part of our UAS business that is more sensitive to ops tempo is the repairs and spare parts services that we sell to our customers in support of the systems they use. If the total number of Raven flight hours increases, for example, we would expect more spare parts and repairs. If total flight hours decrease, we would expect a reduction in spare parts and repairs. Since our forces train when they are not fighting and the total number of systems acquired continues to grow, we do not expect spare parts and repair services to go away.

We have heard and read statements from the Obama Administration, including from Secretary Gates that reflect the recognition of the importance of unmanned aircraft systems in the current threat environment. We also take note of President Obama's stated intent to increase competition for defense programs and to move more towards fixed price contracts. As a reminder, each of the four US DOD programs of record for small unmanned aircraft systems that we have won have been through full and open competition with other major defense contractors competing. In addition, our small unmanned aircraft system procurement contracts are fixed price so we're experienced and comfortable operating in this type of contracting environment. In fact, we typically show higher margins on fixed price contracts than on cost plus contracts. Time will tell how the Administration's policies effect our UAS business, but I continue to believe that we are very well-positioned with relevant, high performance, reliable and cost effective, unmanned aircraft systems solutions that are continuing in high demand.

Now shifting to our efficient energy systems business, we believe we are maintaining our leading percentage of fast charging market share. We have also moved to address broader market opportunities in an effort to increase PosiCharge revenue, which has the potential to offset some of the effect of the electric lift truck capital market decline. We introduced two new PosiCharge product line extensions in January that will expand our addressable market. These new opportunity chargers will increase the productivity of customers that have lower duty cycles and don't need full capabilities of fast charging.

Preliminary results from our new Toyota material handling distribution relationship launched in September are encouraging. This partnership addresses a much larger share of North American market opportunity than we previously had access to. We installed PosiCharge systems in the first customer facilities sold through the Toyota channel this quarter and it reinforces our belief that this partnership will deliver significant benefits for our customers, for Toyota and their distributors, and for AV. Electric vehicle test systems demand is strong, driven by over two dozen battery electric vehicle and plug-in hybrid electric vehicle development programs globally and we continue to expand our customer base and our product offering.

Demand also appears to be growing for our other electric vehicle solutions and customer-funded developments. This interest in our technology solutions is being driven by the many vehicle development programs active around the world and by the new US government emphasis on supporting the development of electric vehicles and the recharge infrastructure to support EV adoption. The recent federal stimulus bill accelerates numerous opportunities for our electric vehicle and clean energy solutions and we're engaged at multiple levels to determine where our solutions can best provide the greatest impact. We believe we have unique capabilities to provide fast charging infrastructure that can enable adoption and practical use of electric vehicles, but the long-term implications will ultimately be determined by consumer decisions on the adoption of electric vehicles.

With that as an overview of our business, Steve Wright, our CFO, will now review the financial results.

Thanks, Tim, and good afternoon, everyone. Revenue for the third quarter was $52.2 million, an increase of 8% over third quarter prior year of $48.5 million. By segment, UAS revenue was $43.4 million, an increase of 3% over the prior year. Growth in UAS revenue was largely due to higher customer-funded R&D and higher product deliveries offset by lower services. The increases in customer-funded R&D and product revenues were largely due to increased activity on the Global Observer contract and product deliveries to international customers respectively. The decrease in services revenue was primarily due to higher revenue in the prior years for the retro fit of Raven A to Raven B.

EES revenue was $8.8 million, an increase of 39% from Q3 of last year, primarily due to higher deliveries of EV test systems. Turning to gross margin, gross margin in the third quarter was $16.7 million, down 16% from Q3 of last year. Gross margin as a percent of revenue was 32% versus 41% in Q3 last year. By segment, UAS gross margin was $13.5 million, down 23% from Q3 of last year. As a percent of revenue, UAS gross margin was 31% versus 41% in Q3 last year. The decrease in gross margin rate was largely due to lower revenue on cost side contracts due to reduced indirect rate application and higher program costs.

EES gross margin was $3.2 million, up 37% from Q3 of last year and as a percent of revenue, EES gross margin was 36% versus 37% in Q3 last year. SG&A for the quarter totaled $8 million, or 15% of revenue versus $8.2 million, or 17% of revenue in the prior year. SG&A expense was lower, primarily due to lower selling costs.

R&D for the quarter was $4.6 million, or 9% of revenue compared to the prior year amount of $3.7 million, or 8% of revenue. Operating income for the quarter was $4.1 million, or 8% of revenue. Operating income was 48% below Q3 prior year, primarily due to lower gross margin and higher R&D, partially offset by lower SG&A. Net income for the quarter was $4.5 million, or $0.21 per fully diluted share compared to $6 million or $0.28 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 was $171.6 million, up 13% from the prior year period of $151.4 million. UAS revenue was $145.9 million, up 12% from the prior year period, and EES revenue was $25.7 million, up 24% from the prior year period. Gross margin for the first nine months was $62.2 million compared to $55.6 million in the same period a year ago. Gross margin as a percentage of revenue was 36%, a decrease of 1 percentage point from the prior year. By segment, UAS gross margin was $50.1 million, up 3%, and EES gross margin was $12.2 million, up 72%. SG&A for the first nine months totaled $23.9 million or 14% of revenue versus the prior year period of $24.5 million, or 16% of revenue.

R&D for the first nine months was $14.8 million or 9% of revenue versus $11.8 million, or 8% of revenue in the prior year. Operating income for the first nine months was $23.6 million, or 14% of revenue. Operating income increased 22% from the prior year. The effective tax rate for the first nine months was 25.4%, down from the prior year of 33.3%. This tax rate reflects release of FIN 48 tax reserves set up in prior years for the R&D tax credits. Net income for the first nine months was $18.4 million, or $0.84 cents for fully diluted share versus $15 million, or $0.70 cents per fully diluted share last year. Looking at backlog, funded backlog at the end of the third quarter was $139 million, up $57 million or 70% from April 30, 2008.

Turning to our balance sheet, cash equivalents and investments at the end of the third quarter totaled $130.6 million, up $5.9 million from our prior quarter amount of $124.7 million. The positive cash flow is largely due to income and working capital, partially offset by capital expenditures. Investments at the end of the third quarter were $28.6 million, an increase of $20.6 million from the prior quarter primarily due to increased purchases of T bills with maturities greater than 90 days. Our holdings of auction rate municipal securities, which totaled $8 million at par have remain unchanged from the previous quarter. We have, however, recorded a temporary impairment charge for these securities of $0.9 million based on fair value accounting using discounted cash flow.

Turning to receivables, at the end of the third quarter our accounts receivable including unbilled receivables totaled $53.2 million, down $2.9 million from the prior quarter. Total day sales outstanding were approximately 92 days compared to 77 days at the end of the prior quarter. The increase in DSOs caused by the timing of our revenues, which were concentrated towards the end of the quarter.

Taking a look at our inventory, inventories were $20.4 million at the end of the quarter compared to 19 million at the end of the prior quarter. Days in inventory were approximately 52 days versus 42 days at the prior quarter end.

Turning to capital expenditures, in the third quarter, we invested approximately $3.2 million, or 6% of revenue in property improvements and capital equipment. And now I would like to turn things back to Tim to discuss expectations for the balance of the year.

Thank you, Steve. As I indicated earlier, we anticipate another strong fourth quarter this year. However, a number of factors have built up over the last three months that limit our ability to catch up to prior growth expectations for fiscal year '09. Pressure on capital spending is depressing posse charge sales and delays of some small UAS buys and international contracts preclude some revenue we had planned in Q3 and Q4. Global economic conditions represent an overhang that may yet effect our business in ways we do not currently anticipate.

As a result, we're revising our revenue guidance to reflect anticipated full year revenue between $240 million and $250 million or a growth rate between 11% and 16% over fiscal year 2008. This is down from the 20% to 25% growth we had communicated at the beginning of the fiscal year. We still expect to achieve our previous operating margin guidance of 12% to 14%. I'm disappointed that we must revise our guidance for the year, which is inconsistent with our history. I balance that against evidence supporting attractive long-term growth prospects and our not insignificant year-over-year growth expectations in an otherwise challenging environment. We provide solutions that really matter to our customers and we are developing entirely new solutions that promise to develop even more valuable capabilities. We have a strong financial foundation and the best team anywhere to man the rigging as we navigate through this economic storm.

Our Q3 '09 produced a record backlog of orders and significant development milestones that have been very well received by our customers. I have never been more optimistic about our long-term growth prospects, tempered only by the overhang of economic unknowns. I believe Global Observer and Switchblade represent significant potential to catalyze future growth and the probability that electric vehicle solutions could also drive significant growth is increasing. My thanks to our team members, customers, suppliers, and investors for your ongoing commitment to our mutual success. Steve and I will now open the call to questions.

(Operator Instructions) We'll have our first question from Michael Lewis with BB&T Capital Markets.

Thanks, Tim and Steve for taking my call. First question, this is the first major deferral I've seen in a program of record in UAS since I've been tracking the -- that segment for the last four or five years. What are the customers saying? What steps have they taken to get the procurements back in motion? And then just a final question, if we didn't see this deferral come into play, where would you have posted revenue, setting that aside?

Well, let me start, Mike. I suspect you're referring to the orders that we had, we indicated we expected in Q3 that were deferred. we indicated we expected in Q3 that were deferred. A couple of reasons, I think. In the first place, it's not a -- I wouldn't characterize it as a deferral of a program of record so much as in one case, we believe one of our customers is just holding off the procurement because they want to wait for Digital DataLink to be available in production rather than buy current analog systems that they would -- they then would intend to retro fit. So I think it's a balancing there. And in a few other cases, I think it's a matter of customers that are very attracted to and want to acquire some systems that are not under a program of record and as a result, they are still in the process of getting their financing together.

Again, I would add to that, in the quarter, the normal ebb and flow of our orders, some of that was expected. No programs of record were deferred, just a number of smaller opportunities, along with lower PosiCharge, international SUAV was lower than we expected, and as Tim mentioned, we have had some reduced project revenue because of lower hiring. We didn't guide Q3, but I will say we were probably expecting a Q3 someplace in the mid-$60 millions.

Okay. That's helpful. Okay. Then just another quick follow-up here. When we start to see the progression of DDL upgrades moving into the next year, will this be considered a production upgrade with regard to the P&L, or is this a servicing upgrade? And then the reason why I'm asking this is I'm trying to reconcile what the margin implication will be from the variance or the differences of production to servicing. Can you help me out here in understanding how that will work?

We've yet to define that, but my thinking is that DDL contract that was -- includes new systems and retro fits, and both are fixed price, or the majority of that contract is fixed price. I suspect the retro fits, the way they look like they will be done, will be classified as services, just like the Raven A to B was services last year. And the new systems would be product.

Okay, thank you. And then just one more question about the tax. I noticed a negative tax. If we back -- I was assuming a 35% rate in the quarter. That's a variance of $1.7 million. Is that all tax R&D credits in the quarter, or is there something else going on there?

That's the major effect there is the release of the FIN 48 reserves. We did actually define them at the time of the 10-K. They relate to the expiration of the statute of limitations for the years that those reserves were established. The statute of limitations ticked off in January, so we released those reserves, about $1.3 million. And that's virtually all of the variance that takes us down to about a 25% year to date rate. The current period is just what gets us to that year -to-date rate.

Got ya. Thank you very much. Thank you.

We'll go next to Brian Gesuale with Raymond James.

Yes, hi, guys. Thanks for taking my question. Wanted to dig into contract services. Wondering if you can give us a little bit of help on the expected run rate going forward. Is it in the $22 million, $28 million range, or somewhere in between? Also talked about the margins, Steve, if you have a little color on what being the margins and how one-time in nature they go forward.

In terms of guiding on the elements of the P&L, we typically don't do that. I mean Tim may talk a little bit about services going forward. I can say the services were low in the quarter certainly compared to the prior year end, compared to the prior year on a year-to-date basis because we had the Raven A to B upgrades in last year's services number and those were large. In terms of the, the margins, for the quarter we're at 32%, down 6 points sequentially. In UAS, they are down from 35% to 31%. 3 points of that, or the majority of it is due to an indirect rate change that we had that reduced the margins on our cost plus business, about $1.4 million. And the balances in EES, you can see that going down from $54 million to $36 million, which is something that's going to change over time, as we've indicated in previous calls because it really depends on the mix of orders that we fill in the quarter.

Okay. That's helpful. Tim, maybe if -- longer term, obviously you've reigned in guidance this year based on some, what seemed to be some short-term phenomena. You have record backlog in several new products that you expect to hit over the next 12 to 18 months. Is AeroVironment still a 20% to 25% growth story going forward, or is this something that you've -- this bump in the road make you reconsider what that, the growth targets are?

Thanks, Brian. No, I don't see any change in our long-term view of the growth prospects for the Company. We're -- we have -- you know, our planning process first looks, relooks at a three to five-year lookout and then we refine the first year of that plan in our annual operating plan and we are in that process now. We would expect to provide guidance for FY '10 in our fourth quarter call. But the -- if anything, I am more -- I think there's stronger reasons to support our long-term growth pieces from my perspective than there ever have been based on things like Digital DataLink transitioning to production, the real successful demonstration of Switchblade and the ongoing support and success of the Global Observer program. So in that aspect, elements of the quarter were very supportive of our long-term growth expectations.

Okay, great. And maybe just one final question. On Switchblade, can you give us -- sounds like there is the activity in the opportunity is perhaps larger than what you anticipated, but is this pushing to the right a little bit? And what should we expect in terms of an (inaudible) or full production decision time frames?

Well, I think the Switchblade and the ambiguity around timing is a poster child for the adoption of new technology and innovation. It's -- as I mentioned before, this is really an entirely new capability. It's -- and it's been very positively received, both by the initial customers that funded the current demonstration and by a growing array of additional customers that have now become aware of this and are getting increasingly interested. But two years ago, even one year ago, this was on virtually -- two years ago, it was on no one's radar screen and one year ago, it was on virtually no one's radar screen. So when the current DOD budgets were put into place, nobody in DOD anticipated the availability of this capability.

So now with a large number of customers looking at it as a very attractive capability, they have to then decide how to fund it and what that process would be. So that's, that's what the timing ambiguity is about and a little more explicit, I think once the first customer enters into a full rate production intent, we will be in the same kind of a process that we have been in all of our programs of record for small UAS. Typically that has been a, I think 11 months in the case of WASP and about 14 months for Raven from order -- initial contract to full rate authorization. Probably a little bit longer for Switchblade because of the addition of ammunition, maybe 18 months. That doesn't preclude earlier orders of hardware prior to full rate production configuration. We have seen that in most of our other programs in the past.

Okay, great. Thanks for taking my questions.

Thank you.

Thanks, Brian.

We'll go next to Chris Donaghy with SunTrust Robinson Humphrey.

Hi, Tim. Just to follow up on the quarter, I mean just with the orders that you saw slip and the timing issues, can you give us a relative feel for how much -- I mean would you have been much closer to the 20 to 25% if you hadn't seen some of the slippage this quarter? Is this really just a timing issue? Or has there been a segment of the customer especially on the foreign side that you think is just going to be in a perpetual deferral until the economy turns around?

Well, let me go back to those four categories, Chris, and see if I can't break those down a little more. So one is the, the economy -- what we're seeing as an economy-driven effect. In the case of PosiCharge sales, I think that's -- that's just literally a dramatic reduction in the capital acquisition of forklifts and a relatively smaller, but still an effective reduction in our PosiCharge sales. And I think that's happened and that's the way that is. The other -- the other economy effect from our perspective is this precipitous slowdown in procurement from international military customers and I believe that is directly an effect of just a lot of uncertainty in many other countries on their military budgets. In some cases, they have already been cut. And in other cases, there's, they are going through a reevaluation. And once they settle down on what their real budget is, then presumably they will be reallocating what their procurement intents are.

Having said that, I think we're still in a good position there. We -- I know that there is strong interest in many countries in this capability and when the issue is a constrained budget, we do provide ISR the classic 80% solution at 10% of the cost, and I think that could turn out to be good for us relatively in the longer term. But we won't know that till we see it. Changes in the timing of US government procurements I think are all just timing related. I don't think anything went away. I think some of them are delayed.

Okay, and so then as we look forward, can you just walk us -- can you walk us through what the timelines look like in terms of Digital DataLink going into full rate production, Puma AE going into full rate production, acceleration of Global Observer, and I think Switchblade may be a little bit further out. But those three in particular, as we go into 2010.

Yes, let me started with Digital DataLink because that's the most definitive. We already now have the [LREP] contracts that will take us into full rate production. So we -- I think that's going to -- we'll start delivering those in the second half of '10, probably when the Q2 and Q3 when we'll realize the most of the revenue from those initial contracts. And I think in the latter part of Q '10, we will begin to deliver production, Digital DataLink retro fits. Now, of course that's ultimately going to be gated by full rate production approval by our customers. This is a class 1 change, so it gets treated much like a new procurement. But barring any unforeseen hiccups there, that's the timing we expect. If -- so that risk on the downside is something happens with the schedule of the testing or something that might push that out a little, on the other hand, there could be a desire on our customers part to accelerate the changeover, in which case we, of course, will do everything we can to pull those in.

Moving to Puma AE, that was the second program you questioned. To our knowledge, the initial evaluation of the initial testing of that system has been very positive. I think we not unusually have a couple of things that have popped up in our customers testing that we need to modify for them. But we don't see any, any problems in doing that. So I think we are very optimistic about the, the excitement and the customer community for adopting this and I would expect we would see additional orders early in the year for Puma AE.

Global Observer, that's, as you know, a three-year program. It started in September of 2007. We are well into It started in September of 2007. We are well into that, going extremely well from my perspective. I expect we will be in flight testing in the second half of our fiscal year upcoming. I don't expect to see major new order decisions on that before we are well into our testing and military utility demonstration. Our customer base has a propensity to fly before buy. And I guess did I cover that?

I guess you also wanted to talk a little bit about Switchblade and I think the -- there's more uncertainty on timing there, just because of the points I made talking to Brian. So I would, I would not be surprised to see strong customer interest turning into more orders in FY '10. It's just really hard to determine how -- what -- there's a number of different customers and a number of different procurement approaches that they could take. And I know they are actively making those decisions as we speak. So I'm optimistic, but I don't want to lay down any specific timeframe because I just don't have enough data.

Okay, because I'm just trying to figure out, then, over the next couple of quarters should we anticipate based on what you're seeing with DDL in particular lower than would be average revenue growth for a couple of quarters before things start to accelerate when DDL goes into full rate production? Can you help us with the visibility that you're seeing on a, at least a qualitative basis for the next couple of quarters?

I think we really have to punt and say we've talked about the balance of the year, so you've got Q4 and we've got to wait till we give our next guidance on the Q4 call.

Okay.

Thanks, Chris.

We'll go next to Tim Quinlin with Stevens, Inc.

Good afternoon.

Hi, Tim.

I have a series of easy questions, first of all, call this the lightning round. But number one, what was government funded R&D in the quarter?

Customer funded R&D, 32% of our revenue.

32% of revenue. Okay. So about flat quarter to quarter in dollar terms?

Yeah, okay. I'm sorry. $16.8 million, up from $16.1 million in the previous quarter. And it's hard to get into this number, but it looks like if you exclude that out of your service line, the other UAS service has declined a lot. Oh, yes, and I tried to answer that earlier. The pure services was about $5.2 million for the quarter, about $33 million year to date. And that is down from the prior year. A couple of programs in there, but by far, the largest effect is Raven A to B, which ran through services last year.

Right, yes. I was just looking at it quarter to quarter. I think that was a drop-off--

Quarter-to-quarter, I think you have to take it a little bit with a grain of salt. Quarter-to-quarter, a lot of it depends on how much backlog we have at the time and what makes sense for the factory to work on.

Okay. So that number could bounce back up in the fourth quarter?

Oh, it very well could. I'm not going to predict that, but it very well could. I think year to date, looking at that, that's a little more relevant and there, it's, again, the same explanation, the A to B conversion is making '08 much higher.

And I just got a little off-track on my easy questions there, but second question is the Army progress towards their 1900 Raven goal.

Yes, okay. So first of all, I want to update that goal. We've been told the goal is not 1900 systems. It's now 2182 systems. It's grown by 134, which is administrative. They are now including (inaudible) in their number and then the progress against that is we're 49% delivered against that. We delivered 79 systems to the Army in the quarter.

Great, super. Tax rate for 4Q, should we be looking for 34%?

No, I, I, I think, let's see, I think somewhere around 30% for the full year and then let's you back into it based on our year to date.

Okay, and how about for fiscal '10, then?

At this time, I would like to wait until we do our next, our next guidance.

Okay. And the indirect rate variance on the cost plus contract that you referred to, is that -- was that just a one-quarter variance and you'll get costs in line now?

Well, yes. I mean these -- I guess I would say as a government contractor, we use indirect rates based on full year estimates to bill and recognize sales on cost plus programs. We have these rate changes periodically. We've had them in the past. It's part of doing business. This period because of the low volume and the amount of the rate change, $1.4 million, it just -- it ends up being a variance explanation, but it's not an unusual transaction by itself.

Okay, and my only other question was, I think we covered a lot of your products, but on WASP, and what is happening there in the Marine Corps, what the Air Force is doing, and what you think the Army might do on WASP and when that might happen? Thank you.

Tim, the WASP, as you know, was a product that we won the Air Force program of record competition with, with almost two years ago. So that -- the Air Force has continued to buy, according to their initial plan on that contract and then shortly after we won that, the Marine Corps acquired a number of WASP systems on an urgent need statement that they deployed down at the platoon level. And a number of other customers are evaluating the adoption of WASP and I think those customers you mentioned all see a significant benefit to them in adopting that and want to do that. I think for the most part, those customers fall into the category of intended purchasers that don't have a current program of record that covers this and therefore they are still putting funding together and procurement mechanisms that would enable them to buy. So that, that's part of what's been going on recently in some delays in orders we had expected. I still think they intend to do that. They are just putting the funding mechanisms together.

Okay, thank you.

Thank you.

Thank you, Tim.

Our next question comes from Michael Ciarmoli with Boenning and Scattergood.

Hi, guys. Thanks for taking my call. Tim got a lot of the easy ones out of the way. On the contract service -- or the service revenues in general, $5 million. Last quarter was weak, the weakest you've had in about six quarters. This quarter, even weaker. Is there anything to read into this? We're going to have an obvious winddown in Iraq, when you would think with the most usage out there, you should be driving substantial levels of services. Do you guys see any structural change from your ongoing services of the various systems that are deployed in the field and could this line item trend lower as Iraq winds down and maybe Afghanistan, or is that transitionary phase before a full ramp occurs?

Well, Mike, I don't think there's a -- I wouldn't characterize it as anything as a structural change. I talk kind of qualitatively here. Back to the biggest effect in the relative difference overall is the factors Steve was talking about, where a year ago we had very high revenues in that services category that were associated with the Raven A to B product improvement upgrade that was run through the services contract. So -- and so if we, if the Digital DataLink retro fits that we anticipate next year go through that same process, which, as Steve indicates, is currently our best guess, then you would see another -- the same kind of surge in revenues under the services area. So -- and that's -- that product improvement cycle has always been a, one of the five revenue drivers we have anticipated in our UAS business.

Can you talk about just general service for planes exceeding their, I guess average hours, or their hours flown requirement? I mean do you have the visibility into that line item into how those revenues are performing, or are you just looking at more of the product improvement service revenues?

Yes, we do have some visibility. I'll give you some color at least and then I'll turn it over to Steve, who will talk more about real numbers.

Okay.

A couple of things to be aware of. One is, when our customers buy spare parts, they do that on a forward-looking basis, so they are anticipating what their future needs are going to be and then they are putting orders in and then months later, we're delivering against those orders and then since we operate as the repair depot, we hold that inventory and then we use that when they send systems back that need repair. So there's -- by definition, an un-- the timing of the actual requirement for repairs is unlinked from the date that they are ordered and actually the date that we sell the spares initially. So that's one factor that might distort how you see that in a temporal basis.

There's another factor that we think might be at play here and that's with the high level of Raven A to B upgrades last year and then the--the retro fit that we did to put the new frequencies in place early this year. We ended up putting a lot of new hardware improvements or replacements into hardware from the field, which probably had the effect of reducing the operational life of systems that are being used and helping out the near term operational availability. So that's all qualitative things that are going on, none of which indicate any underlying structural change.

Okay. That's very helpful. And then just on -- you mentioned also that some of your project-related revenues were down because of a lack of employees. Can you point us to specific projects that you're working on, or how quickly you anticipate filling these vacancies? Is there any shortage of talent out your way?

Well, the requirement for more great people has been a hallmark of our history for the last five or six years with the sustained growth in the business, that drives the sustained growth in employees, and the only way we keep the extraordinary level of team performance that we have is to keep hiring extraordinary people. So we've been really successful at that over time and right now we just have -- we've got a large number of outstanding requisitions. We had a very successful job fair last month addressing open requirements in the Monrovia operation primarily for our EES segment and that was so successful, we're going to use the same process soon to -- out in Simi Valley with our UAS business. So what happens is-- a number of those requirements are in engineering and engineering skills address both the operational business, our internally funded R&D operations and our customer-funded development programs. So it's-- and the same teams that work on IR& D tend to be the same skill sets of people that work on customer-funded development. So when we are trading off scarce resources against those two requirements, that ends up doing less work than we had planned.

So we talked last quarter in the call, for example, about accelerating our internally funded R&D and our G&A investments that we thought were great opportunities to support our future growth and improve our competitive position and you'll see in the numbers that we were pretty flat in those areas mainly because of we're reallocating those skill sets to meet customer development programs and even with that, we fell behind on some of that revenue on customer development programs. Biggest one is Global Observer, but we have a number of other development programs in the UAS business, as well as a number of customer-funded development programs around primarily electric vehicle solutions. So broad, broad number of programs that all add up to maybe 10% of the revenue miss that we are anticipating for the year.

Okay. That's, that's extremely helpful. Then I just had one last question. The other day on the federal business opportunities website, it looks like there was a presolicitation posted by the Naval Surface Warfare Center citing that AeroVironment was going to deliver I guess one air vehicle communications model. It mentions Raven B, WASP, Switchblade. Can you elaborate on what that might be used for-- I'm just reading into it maybe a little further, the first reference of Switchblade out there. Can you just -- I think it references it is for maybe 36 months. Is there anything you could say about that?

Yeah, I'll tell you what I know, which may not be, may not be a lot, but I think that's the Marine Corps looking to develop a common ground control system that would enable their ground robots to communicate and work in conjunction with small unmanned aircraft systems. So I think that's the basis of that program that they are pursuing and I think in the process, they have -- they are recognizing that we already have established a de facto common ground control system for, for a multitude of small UAS that they use and that other services use. And that the DataLink in that ground control system is probably the right solution for a broader common ground control solution. So I think that's the under -- the essence of that and beyond that, the fact that they are referencing Raven and WASP and Switchblade, I think is an indication of where a number of our customers are beginning to change the way they think about small UAS where we -- in my perspective on the early stage of adoption. Where we initially -- that was replaced at the Marine Corps by Dragon Eye, which was then replaced at the Marine Corps by Raven, kind of a linear progression of platforms -- we now have a situation where there's a common ground control system with common DataLink and user interface and three production small UAS airplanes, WASP, Raven, now Puma AE.

Okay.

Each one of those platforms has a different set of capabilities and as they begin to anticipate Switchblade in the future that will also operate off that same ground control system and DataLink, it's -- some customers are starting to look at this more as a family of systems with common infrastructure and different platforms that are applicable to different mission sets.

Okay. That's extremely helpful. Thanks a lot, guys.

Thanks, Mike.

And we have time for one last question and that will come from Troy Lahr with Stifel Nicolaus.

Thanks. Given the surge in Afghanistan, what are you hearing from the customer? Are they telling you that they are going to need to ramp up here or that you guys need to ramp up? I would assume that you're starting to have discussions regarding the surge?

Well, I don't -- there's not a lot of active dialogue right now, Troy. I think our customers are making their internal trade-offs and their, I think their keeping their powder dry relative to discussion with contractors, at least from our perspective. We -- as I mentioned in the comments earlier, Afghanistan was where the initial huge success of small UAS was recognized and the acceleration of adoption throughout DOD was initiated and we would expect that that terrain and that very highly distributed operations strategy will be conducive to continued use and high value there, but whether that's accelerates or not, I think will be a function of how our customers decide they are going to operate and that's still in the planning process.

Okay, thanks. And then of the service sales, you had about $22 million. How much of that -- I think you guys account for Global Observer in that service since it's R&D, if I'm not correct. So can you break out how much of that ballpark is Raven service related to Iraq and Afghanistan?

Troy, the, the project revenue, which is embedded in the services and when you get the Q you'll see the project revenue in a footnote, is $16.8 million, which leaves the pure services at $5.2 million and I don't have tracking below that to say how much is due to Raven in Iraq.

Yes, our customers literally do not keep track on that level in the field, Troy. You're probably used to a lot more specificity in maintenance and repair, documents for larger aircraft systems, but these systems uniquely are used by ground troops who are literally in the fight and they just aren't filling out a lot of paperwork.

Okay. Okay. Fair enough. And then can you help me understand, I just want to kind of circle back on the margins a little bit. Looks like, I guess if you want to go year-over-year, that's fine. But it looks like you had a lot more product sales this year compared to last year. That's higher margin work. I would have thought your margins would have benefited a little bit from a favorable mix this quarter. Can you help me understand that? I mean isn't products mostly the higher margin work and service is generally lower margin cost plus-type work? No?

Yes, it can be. I think the easiest way, if you want me to go year-over-year, the easiest way for me to talk to it is by segment. The large drop in UAS from $41million to $31million, I would point to first of all the $41million last year was sort of outsized. That was the peak of the year and UAS came in at around 36% or 37%, which is more typical. So I would say the mix of work last year just tilted very heavily towards the high side and then we had this maybe 3 points of rate adjustment in the current period that I talked about. EES, generally flat with last year. Sequentially as I indicated earlier, EES is below where the kind of margins we've enjoyed in the last two quarters and that's literally going to bounce around every quarter based on the mix of products that we're shipping, that are all POs, all fixed price.

Okay, and then if you look at this, the growth this quarter year-over-year at UAS, plus 3%, looks like I guess just taking the midpoint of your range, it might be calling for back -- you're back to double-digit growth, a stronger recovery in the fourth quarter at UAS. I guess what gives you confidence that these deferrals and the revenue stream starts picking back up and we see more meaningful growth at UAS so soon in the fourth quarter?

I think the -- I'll start, our greatest confidence is the funded backlog of $139 million, which is pretty much all UAS. Not to say that we'll work off all that backlog in the quarter. That backlog comes with delivery dates and it's staged, but that's really where we'll get most of our deliveries for the quarter.

Okay. Fair enough. And then just last question, on cash flow, can you -- what was catch from ops this quarter? I don't know if you already said that.

No, I didn't. Cash flow from operations, $9.6 million, and capital expenditures, $3.2 million, for a free cash flow of $6.4 million.

Okay. Okay. Thanks, guys.

With that as our final question, we thank you all for your continued attention and interest in AeroVironment. We remind you that an archived version of this call, all SEC filings and relevant Company and industry news can be found on our website, www.AVinc.com. We look forward to speaking with you again following next quarter's results.

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