AeroVironment Inc (AVAV) 2010 Q3 法說會逐字稿

Good day, everyone, and welcome to the AeroVironment, Inc.'s third quarter fiscal 2010 earnings conference call. Today's call is being recorded.

Now at this time, I would like to turn the call over to Mr. Steve Gitlin, Director of Investor Relations. Please go ahead.

Thank you, Anthony, and welcome to AV's third quarter fiscal 2010 earnings call. With me today are Tim Conver, our CEO, and Steve Wright, our CFO.

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, including but not limited to economic, competitive, governmental and technological factors outside of our control that may cause our business strategy or actual results to differ materially from the forward-looking statements. For a list and description of such risks and uncertainties see the reports we file with the Securities and Exchange Commission. Investors are cautioned not to place any undue reliance on forward-looking statements which speak only as of the date on which they are made. 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 9th, 2010. 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.

We will begin with remarks from Tim Conver and Steve Wright and then we'll move on to questions. Now, it's my pleasure to turn the call over to Tim.

Thank you, Steven. Welcome to our third quarter fiscal 2010 conference call. We have a lot to cover this quarter so I will organize my comments today around four specific subjects. First, I will discuss our Q3, including our plan for the quarter, the results and the reasons for our performance. Second, our current outlook for Q4, and the balance of our FY10 and why our outlook has changed since our last call. Third, I will address questions that arose last month when the DOD FY11 budget request was released. And fourth, I will share my thoughts on our long-term growth, including our five growth drivers in our business model, our serial innovation strategy and the timing of both. I will also provide an update on our major development programs. After Steve Wright's review of Q3, and year-to-date financial performance, I will give you a preliminary view of the direction of our FY11 operating plan as it's evolving.

Now, let's begin with Q3. When we last spoke, we were entering an aggressive production ramp in our second half that was driven by the cut-in of Digital Data Link into our Raven product. We anticipated that 70% of the total fiscal 2010 revenue would be generated in our second half, with 65% of that amount in the fourth quarter alone. We knew that the back end loaded year had increased our risk profile, and would require outstanding execution combined with timely order flow. The production risks we anticipated showed up as real challenges during the quarter, and then some. We were able to produce significant sequential growth in Q3, but still we missed our revenue target for the quarter.

Most of that missed revenue was for our Raven UAS, as I will now explain. First, Digital Raven production start-up issues early in the quarter pushed most of the quarter's Raven production into January, the last month of the quarter. Then severe storms at our primary and our backup flight locations rained out about a third of our flight test days in January, precluding acceptance testing and revenue recognition for much of the Raven systems produced. We did achieve good production rates in January, and the Raven revenue missed in Q3 has already been realized in Q4.

Secondary effects on the quarter included Posi charge revenue shortfall due to continued weak demand in the capital equipment markets for our industrial electric vehicle products. We believe that this market continues to struggle. The last and the smallest portion was due to delayed orders in our other UAS that we still expect to receive later. In summary, we had a strong Q3 in transition Digital Raven into production, but weather delays in our Raven acceptance test flights pushed significant revenue into Q4. Secondarily, the PosiCharge market is still weak and some US orders were delayed.

Now, I will address my second subject, Q4 and the balance of FY10. The fact that this year is so back end loaded means that timely receipt of the Raven system and retrofit orders funded in the government fiscal 2010 budget is crucial to our ability to meet our revenue plan this year. As late as a few weeks ago, we were still modifying production plans to be able to compensate for Q3 results in our Q4. As we moved through February, and the probable receipt of the major orders continued to slide out, the odds of recovery in Q4 continued to diminish. Ultimately, any chance of achieving our planned 2010 revenue, even with heroic Q4 production throughput, has been eliminated. The issues I discussed in regard to Q3 rolled into Q4.

However, the primary factor in our lower FY10 outlook is order timing and I would like to explain that. The main issues start with the government fiscal 2010 budget being signed into law in late December, two months into the government fiscal year. The late signing of the budget was followed by an extended government order processing time, which has resulted into the delayed receipt of Raven orders funded by the budget. In February, we did receive an initial $37 million in government fiscal 2010 orders. A good start for our Q4, but insufficient to support our plan for the balance of the year. The balance of the Raven orders we expect from the approximate $121 million of Raven funding in the government fiscal '10 budget are still working their way through the procurement process. We now expect most of these purchase orders to arrive too late to contribute to our fiscal 2010 revenue.

We also see continued delays in some orders that we had expected for WASP and Puma systems. I say delays because we expect to receive these orders, however timing is uncertain. We expect the difficult capital equipment market conditions for our industrial EV systems to continue through Q4, significantly impacting the results of our smaller EES segment. Year-to-date deliveries of forklifts are down by almost 25% from the prior period, and demand for airport utility tug conversions to electric charging is down by about 60%. The significant interest in our passenger electric vehicle charging infrastructure, which I will be discussing in greater detail shortly, will not contribute to Q4.

To summarize our view of the full year, we now expect fiscal 2010 revenue to be roughly $245 million, plus or minus $5 million. With lower than planned revenue, the SG&A and the R&D expenses that are geared to support the development and the launch of major new programs, I now expect FY10 operating income to be 9% to 11% of revenue. Our revised guidance for FY10 disappoints us all. The primary cause is timing of order receipts compared with the back end loaded production for the year. While these were known risks as we began the year, we did not expect the extended nature of the order delays. Our fundamental market position, customer relationships and long-term growth prospects remain strong. I also believe that we have good reason to expect a return to growing revenue in fiscal 2011, and I will share my reasons for that belief in my closing remarks.

I will turn now to our third subject. The numerous investor questions on government fiscal '11 defense budget request that was released last month, and its implications on future Raven revenues. The Administration's fiscal 2011 budget request includes approximately $55 million for Raven procurement. By comparison, the government's fiscal 2010 budget included approximately $121 million of funding for Raven. And the prior government fiscal year of 2009 budget included about $85 million. However the majority of that came from supplemental funding after the initial budget had been released. There are several reasons why the government's fiscal '10 numbers were so high, relative to both government fiscal 2011 and the previous government fiscal '09. Our customers plan their annual procurement amounts years in advance, with some years higher than others and GFY10 happened to be a relatively high volume year.

Government fiscal 10 also included accelerated Raven system procurement by both the Army and the Marine Corps who had previously planned to buy these systems in different years. Government fiscal '10 also included the bulk of the funding for Digital Raven retrofits for both the US Army and the Marine Corps and we expect all of their baseline digital retrofits to be fully funded by GFY11. With about $6 million of funding in GFY11, the Marines will have completed procurement of new Raven systems against their current acquisition objective, leaving the Army and the Air Force to fulfill their acquisition objectives.

I believe the many investor questions about the GFY11 budget request reflected concern over the amount of future revenue for Raven and by extension our small UAS. The Army's own public planning documents show continued Raven system procurement planned through 2015. What is not known for certain is what the Army will do as the completion of their acquisition objective approaches. We see at least three possible scenarios. First, the Army could decide that they only need the 2,182 Raven systems and once they procure them, they will only need support services and upgrades. Second, the Army could decide to increase the acquisition objective for Raven systems. A recent statement from the Army UAS Program Office indicates that this is a possibility. "In general, we have been extraordinarily happy with Raven. If I had to guess, we are going to end up buying a lot more Ravens than we are even showing right now."

A third scenario is indicated by the Army's order of $4 million of WASP and Puma systems in January, as part of the family of small UAS system evaluation. This one-year evaluation involves equipping a brigade combat team with WASP and Puma systems in addition to their Raven systems. The Army is considering extending their small UAS requirement beyond Raven to include a family of systems and has recently published planning documents to that effect. Remember, our common ground control system operates all of our unmanned aircraft vehicles, thereby enabling the family of systems concept.

We believe scenarios two and three are more likely. The Digital Data Link has significantly increased the operational value of Raven, which is already the highest volume unmanned airplane system in the world. We also believe that the incremental value of a family of small UAS built around Raven will provide compelling force protection and mission effects. Both could lead to long-term opportunities with the Army and other small UAS customers, significantly extending the life cycle of this product line.

Viewing Raven in the context of our small UAS product line strategy leads me to my fourth subject, long-term growth based on our five growth drivers and our strategy of serial innovation. To understand the long-term opportunity that AeroVironment represents, it's important to understand our strategy and our business model. We see AV as a technology company and our strategy is to enter large markets, compete effectively for market share, and grow as market adoption increases by developing serial innovative solutions. Entirely new solutions with compelling value have enabled us to capture large market opportunities that would have otherwise only been available to large entrenched competitors. The adoption of each innovative solution creates a new product line with its own product life cycle. For example, small UAS was an innovation we initially brought to the defense market as the Pointer system. Raven A was a major upgrade to Pointer, and Raven B has since grown to become the small UAS of choice for all US armed services and is currently our highest volume product.

This Raven system history also provides a good example of the five growth drivers of our business in action. These are, one, selling more current products to current customers. Two, selling support services to a growing installed base of products. Number three, selling system upgrades and retrofits. Number four, penetrating new markets to sell existing products. And five, developing new solutions. As we develop and launch new solutions, each one contributes to the overall Company growth in multiple years. Beyond the discrete revenue contribution of each solution, we work to ensure that each one builds a more robust launch pad for subsequent new developments. Our intent is to launch new solutions sequentially such that in aggregate the serial product life cycle sum to produce a high compounded growth rate.

The strength of this strategy is that it enables us to enter large multiple markets successfully and achieve much higher growth than would be otherwise possible. However, this strategy also brings with it the inherent uncertainty in timing and rates of adoption associated with innovation. And it often produces lumpy results in the short term. Our historic annual growth rates illustrate both the inherent lumpiness and the long-term effectiveness of this strategy. With year-over-year annual growth rates during the past six years ranging from 4% to 120%, but overall growth over that period reaching almost 500%. Developing innovative solutions is the centerpiece of our strategy and positioning our major development opportunities for adoption has been a major theme of our fiscal year 2010.

Now I would like to review the status of four of our key development programs. First the family of systems concept is, in our view, compelling and significant. This concept involves equipping warfighters with a small Unmanned Aircraft System toolkit that includes different but interoperable air vehicles, each optimized for different mission requirements and all operated by a common ground control system. Given WASP's small size, weight and footprint, this air vehicle could be deployed to a lower level of the force structure in higher quantities. The larger Puma air vehicle offers a longer flight duration and more capable payload and could be deployed to a higher level of the force structure. The addition of WASP and Puma air vehicles to complement the thousands of Raven air vehicles in the Army could provide a significant and cost effective capability boost to our customers, as well as a significant revenue opportunity for AV.

A public presentation by the Army's Training and Doctrine Command shows the Army's evolution from Raven A to Raven B, and then to a family of small UAS from 2006 to 2027. This TRADOC presentation was likely not intended to serve as a prediction or as a forecast, but it demonstrates the Army's long-term view of small UAS and that a family of small UAS represents the next logical step in the evolution of this capability.

A second major development is Switchblade. Switchblade is a lethal small UAS that combines portability, eyes on target feedback, high precision, minimal collateral damage and wave off capabilities. In February, the US Army issued a Request For Information that included a lethal miniature aerial munitions systems, or LMAMs capability requirement that Switchblade will probably fit. The quantities customers are contemplating for this requirement suggest a very large opportunity relative to our current small UAS business. We have received three additional small Switchblade orders from three different customers since we last talked. The Switchblade orders to date do not yet constitute initial adoption but they do demonstrate a sustained high level of customer interest and broad activity.

Our third major development is Global Observer, a large UAS designed to operate like a stratospheric geosynchronous satellite, providing affordable and persistent ISR and communication relay over any spot on the globe for as long as needed. Aircraft number one was deployed to Edwards Air Force base in December for its ground testing, flight testing, payload integration and operational utility assessment. Aircraft number two is being assembled in our engineering and low rate production facility and will be sent to Edwards early next fiscal year where it will be rolled into the overall test and demonstration program. We expect airplane number three to support the first two, providing parts and testing capabilities as required. The flight test program at Edwards is rigorous and it's achieving its milestones but at a slower pace than planned. We currently expect to begin the flight testing phase of our Global Observer test plan in the first half of fiscal '11.

The current Geo Joint Capabilities Technology demonstration, or JCTD program, is scheduled through the first calendar quarter of 2011. This program has transitioned out of the development phase and will soon complete the assembly phase. Meaning that the highest revenue run rate for the JCTD program is behind us. The customers funding the JCTD are eager to see the system operate in flight test and in operational utility assessment, which will likely have the greatest influence on their decision to move forward towards production. We are pursuing follow-on contracts, but we expect a decline in Global Observer revenue between the JCTD peak this year and the beginning of production. The government is spending and projecting to spend billions of dollars to achieve persistent ISR and communications relay. And we continue to believe that the Global Observer could be a large opportunity.

The fourth development program that I will address today is our emerging electric vehicle charging infrastructure opportunity. We are building on two decades of EV charging leadership to support the coming wave of plug-in electric vehicles from nearly every major automaker and many start-ups around the globe. All plug-in vehicles require a place to plug into. So battery chargers will be to electric cars what gas stations are to internal combustion cars. We believe that most plug-in EV users will charge their vehicles overnight in their garages. For those without a garage or who make trips beyond the range of their battery pack, public charging infrastructure will be required. We offer a full solution of charging infrastructure, including overnight home chargers, public chargers, public fast chargers, installation support, systems data collection and communications. Ours is an integrated solution designed to enable the broad adoption and the practical use of EVs.

In our third quarter AV was selected by Nissan North America to support the rollout of the Nissan leaf battery electric vehicle across the United States. A major acknowledgement of our EV charging leadership. We will provide, install and support a home charging system that will enable the full recharging of the vehicle's battery pack in about eight hours. We believe this is a significant first production relationship in the market and we are excited to support such a game-changing product launch. This contract alone represents a significant growth opportunity for AV. And it also puts us in an extremely valuable position from which to expand our charging infrastructure footprint in the United States and globally. Being a partner in supporting the Nissan Leaf rollout is immensely motivating to everyone at AV.

We have been asked to quantify the size of this EV charging infrastructure opportunity, and we can only refer to independent market studies. One industry study calculates the value of charging infrastructure required globally through the year 2030 at $170 billion. Another study anticipated the annual sale of battery electric vehicles in 2020 to be more than 4 million units globally. While studies like these are helpful, my experience suggests that actual adoption rates are difficult to predict. However, it is clear to me that when plug-in electric vehicle adoption proves sustainable, the charging infrastructure opportunity will be huge. We are working in the United States and internationally with automakers, utilities, government agencies at all levels and with private industry to explore business models and to promote our solutions. Our goal is market leadership and we believe we have made a good start.

Each of these four long-term opportunities has the potential to drive significant growth for AV in large emerging markets. I believe we have established a leadership position in each of these areas, which is an essential, as well as a major first step towards achieving our strategic objectives and producing long-term compounded growth for the Company.

With that as an overview of the quarter, the budget, the full year, and our long-term growth opportunities, I will turn the call over to Steve Wright to review our Q3 performance in more detail. Steve?

Thanks, Tim, and good afternoon, everyone. Revenue for the third quarter was $60.9 million, an increase of 17% from third quarter prior year of $52.2 million. Looking at revenue by segment, UAS revenue was $55.1 million, an increase of 27% from the prior year. The increase in UAS revenue was primarily due to higher service revenue of $13.5 million, partially offset by decreased customer funded R&D of $1.2 million and product deliveries of $0.6 million. The increase in UAS service revenue was primarily due to the retrofitting of our analog Raven B systems with DDL technology. EES revenue was $5.8 million, a decrease of 35% from Q3 last year. The decrease in EES was primarily due to reduced deliveries of industrial charging and EV test systems.

Turning to gross margin, gross margin in the third quarter was $23.5 million, up 41% from Q3 last year. Gross margin as a percent of revenue was 39%, up from 32% Q3 last year. By segment, UAS gross margin was $21.1 million, up 57% from Q3 last year. And as a percent of revenue, UAS gross margin was 38%, versus 31% in Q3 last year. This increase was primarily due to lower program costs, and a higher mix of fixed price contracts. EES gross margin was $2.4 million, down 27% from Q3 last year, and as a percent of revenue EES gross margin was 41% versus 36% in Q3 last year. This increase in gross margin rate was largely due to product mix.

SG&A for the quarter totaled $9.8 million or 16% of revenue, compared to $8 million or 15% of revenue in the prior year. SG&A growth is primarily due to higher selling and business development expense, and increased bid and proposal activity. R&D for the quarter was $5.2 million, or 8% of revenue, compared to the prior year amount of $4.6 million, or 9% of revenue. The increase in R&D expense of $0.6 million was primarily due to increased investments in support of electric vehicle charging infrastructure. Operating income for the quarter was $8.5 million, or 14% of revenue. Operating income was 107% higher than the prior year, primarily due to the higher sales volume, resulting in high gross margins, partially offset by increased SG&A and R&D. Net income for the quarter was $6.5 million, or $0.30 per fully diluted share, compared to net income of $4.5 million, or $0.21 per fully diluted share in the same quarter last year.

Now moving quickly through year-to-date results. Revenue for the first nine months totaled $150.2 million, down 12% from the prior year period. By segment, UAS revenue was $132.1 million, down 9%, and EES revenue was $18.1 million, down 30% from the prior year. Gross margin for the first nine months was $53.8 million versus $62.2 million in the same period a year ago. Gross margin as a percent of revenue was 36%, unchanged from the prior year period. And by segment, UAS gross margin $45.9 million, down 8%. EES gross margin $7.9 million, down 35%. SG&A for the first nine months totaled $30.8 million, or 21% of revenue, compared to the prior year period of $23.9 million or 14% of revenue. R&D for the first nine months totaled $16.6 million, or 11% of revenue, versus $14.8 million or 9% of revenue in the prior year. And operating income for the first nine months was $6.4 million, or 4% of revenue, compared to an operating income of $23.6 million, or 14% in the prior year.

The effective tax rate for the first nine months was 21.4%, down from the prior year of 25.4%. And net income for the first nine months was $5.1 million, or $0.23 per fully diluted share compared to a net income of $18.4 million or $0.84 per fully diluted share last year. Looking at backlog, funded backlog at the end of the third quarter was $98.7 million, down $16.1 million or 14% from April 30th, 2009.

Turning to our balance sheet, cash equivalents and investments at the end of the third quarter totaled $126.5 million, down $5 million from our prior quarter amount of $131.5 million. Turning to receivables, at the end of the third quarter, our accounts receivable, including unbilled receivables totaled $60.2 million, up $8 million from the prior quarter. Total days sales outstanding were approximately 89 days compared to 91 days at the prior quarter end. Receivable growth for the quarter was caused by higher sales volume generated towards the end of the quarter. Taking a look at inventory, inventories were $29.7 million at quarter end, compared to $25.1 million at the end of the prior quarter. Days in inventory were approximately 72 days compared to 71 days at the prior quarter. Inventory growth for the quarter was largely to build for anticipated high volumes of deliveries expected for Q4. Turning to capital expenditures, in the third quarter we invested approximately $1.8 million or 3% of revenue in property improvements and capital equipment.

And now I would like to turn things back to Tim to provide an initial view of our FY11.

Thank you, Steve. Our long-term growth prospects are strong. In the short term, and this year in particular, we have seen how the timing of orders can adversely impact our results. We have not yet finished our annual planning process and do not plan to provide FY 2011 guidance until our fourth quarter call. However, in general, as I look ahead to our fiscal year '11, I see many opportunities to make important progress in our production and development programs, which makes me optimistic that our fiscal 2011 will result in year-over-year top line growth. Our FY11 will include all of the GFY10 revenue from Raven funding that we now expect to slide out of this year. We expect contracts that have been delayed so far this year, including WASP and Puma, to generate revenue next year. The growing fleet of small UAS will continue to require services that we provide. We expect new revenue growth from the home charging station for the Nissan Leaf rollout in our second half.

We are optimistic that our efforts to expose new markets to our solutions will bear fruit, including new international opportunities and we expect to begin to realize growing revenues from further trials and/or initial adoption of Switchblade family of small UAS and our EV charging solutions. We are working hard to support our customers with innovative solutions that help them win today and new solutions that will help them be even more successful tomorrow. These solutions address significant global market requirements for improving security and cleaner transportation, and satisfying these requirements motivates everyone at AV. Our spirit of practical innovation is as strong as ever and I remain convinced that our prospects for long-term compounded growth remain compelling, although certainly that growth will not follow a straight line.

Thank you for your time, and at this point we'll take your questions.

Thank you. (Operator instructions). We will take our first question from Tim Quillin with Stephens Inc.

Good afternoon. In terms of your guidance for the remainder of the fiscal year, I know you said not expecting much in terms of new Raven orders but are you expecting any new Raven orders embedded in that new guidance?

Tim, I will start off. I would say the lower end of that guidance has very little, if any, reliance on new Raven orders. In terms of new orders generally, there's some reliance to the extend EES is always book and ship business, but in general, we have derisked that forecast reliance on new orders.

Okay. And so there's these four long-term drivers of growth, the family of systems, Switchblade, Geo and the EV systems and, Tim, you mentioned that you could get some good news over the course of fiscal '11. I know you have a lot of visibility now into fiscal '11 with the Raven revenue, but which of those, and I know it's always tough to predict the timing adoption, but which of those would you feel good about contributing to fiscal '12 numbers?

Tim, I will hedge the answer to begin with, with the caveat that these are innovative new solutions and we're looking into the future at the initial adoption or as I suggested extended evaluations. So I would say the probability of extended small orders and/or initial adoption of Switchblade is real. We think there's a likelihood that we can see some additional trials of small UAS. And as I indicated in the comments, we're working very actively and very broadly with potential customers in the EV infrastructure for charging beyond our initial announced customer Nissan North America. I think there's a reasonable expectation that we will see larger revenues next year in those three areas than we saw this year.

Okay. And just a quick question or two for Steve, if I may. One is the percent of progress towards the Army stated acquisition objective for Raven. And the second is the tax rate was a little bit low in the quarter. What kind of tax rate should we expect in the fourth quarter and going forward, thank you?

The Army acquisition objective is 2182 systems. We delivered 92 Digital systems to the Army during the quarter. So we are now 62% delivered against that Army acquisition objective. And the tax rate for the quarter benefited by the relief of some reserves, FIN48 reserves. AeroVironment, Inc. Basically they were R&D credit reserves that we released because they were for older years that had passed the statute of limitations on audit. Again, that's $600,000 or so for the year. The tax rate will be higher, probably 29% to 30% is what we'd be looking at now.

Thank you.

And we will hear our next question from Michael Lewis with BB&T Capital Markets.

Thanks for taking my question here. Tim, is my math correct here, if we look at the revenue delta for fiscal year '10 to '11, are we seeing about a $50 million shift?

Yes, that's about what we are looking at, Mike.

Okay. So the shortfall that we are going to expect -- I just want to make sure that I'm clear on this -- the shortfall that we are going to expect in the fiscal Q4 and what we witnessed in Q3 amounts to about $50 million, that should fall in probably in the first half of your fiscal 2011?

The $50 million is about right when you look at our previous guidance to now, Mike, but it's not all order shifting. I think Tim indicated a majority is. Probably 70% of it is orders, order timing. The majority of that is DDL and related items, and then some Puma and WASP items. Then another 20% or so would be EES. So that is a book and ship business. It's hard to say that's just order timing. And then maybe another 10% of cats and dogs.

Okay. And that was the reason for the question because EES, it's basically coming in about 50% lower than what we were originally expecting in the beginning of the year, and so that has a big delta impact on the full year revenue number. So what about if we look out into fiscal year '11 with regard to EES? The Nissan Leaf is a big opportunity, but we've heard really nothing from AeroVironment with regard to what the unit costs would be like. We've heard from different participants in the industry saying that there are 20,000 to 50,000 possible vehicles that could be sold in the United States in 2011 or '12, but we have no idea what the cost is to AeroVironment for charging systems. Can you help us out a little bit and help us quantify what this market really does look like for you?

Yes, I understand the significance of the question, Mike. And my answer is somewhat constrained because our customer Nissan wants to take the lead on announcing their view of their quantities, as well as the pricing, which would include their car and the charging system. And I believe they have not yet done that. So with that caveat, we expect the impact of this contract to be significant on our FY11 performance relative to our EES segment. So we think we are looking at that contract alone, producing growth in the EES business. And I'm not sure I can go too much further beyond saying that, beyond what the statements I made in my prepared comments, because of the customer intent to take the lead on announcing price and quantity.

Other than we would probably add that those revenues will coincide with the launch of the Leaf which would be in the second half of our next fiscal year.

Yes, I believe they have announced an intent to begin selling those vehicles in December of calendar year '10.

Okay. And, Tim, if I could ask the question another way, then, if you look at your fiscal year '12, do you think that the electric vehicle charging systems could possibly double the size of that energy business as it stands today?

I think that's entirely possible, Mike.

Okay. Thank you so much for your time.

And we'll take our next question come from Michael Ciarmoli with Boenning & Scattergood.

Hi, good afternoon. Thanks for taking the question. Can you just help us out, maybe, as we look out to Global Observer, you mentioned that there would be a revenue gap. I look at that as maybe a $3 million to $5 million monthly business today, now. Looking out, how do we view that gap? How long does that gap persist? Can you give us any sort of data points to help us out with 2011 there?

I can maybe give you some color, Mike. I don't have a definitive answer. The existing program is currently scheduled to run through Q1 of calendar '11. Most of that from now on will be in the testing program, especially as we finish up the assembly of the second airplane and move that to Edwards to join in the flight test program. We are working on a number of opportunities for follow-on contracts, but the multiple customers that have funded this JCTD program are all waiting to see the results of our military utility assessment. Once we integrate the payloads that we plan to demonstrate on the airplane and then operate that and deliver the mission effects that the entire system is designed for around delivering persistent, intelligent surveillance recognizance, as well as communication relays and potentially other payload effects.

So, it's going to be extremely important to those customers to see those results and to evaluate those and the value of that persistence and the relative cost effectiveness as they then make decisions on future procurement. So I think it's possible that we may find customers that want to invest some contract amounts to either evaluate additional payloads, to look at additional effects or to extend the military assessment prior to the production adoption. I think the most likely earliest time we would see production funding would be in palm 12. Of course, I'm guessing there because I haven't seen any of those numbers at this point.

Sure, okay. That's helpful. Just one more question on '11. I don't know if you can answer this or not. Talking about the timing of orders, roughly $50 million, down from your original guidance. Is this still an 18% to 22% top line growth business? Looking out, if I were to say you guys didn't have the timing issues, you came in at 290, I'm looking at maybe 18% growth in '11. Can you give us any help there, because I don't want to make the mistake of viewing this as a 20% growth business and piling on another $50 million of revenue, just due to timing. Has anything structurally changed with the growth outlook you see for your core business?

I think I tried to indicate in my comments that we still think that our market position, our customer relationships, and our long-term opportunities remain very strong. And as I commented on the implications of the timing of adoption on any year-to-year performance, I think our last six year history indicates that we can see years like this where we're not seeing significant growth or even less than that, and we have seen other years where we have seen extraordinary growth. So I think the compounded long-term growth outlook remains strong and is certainly in the double digit arena. And I don't see any significant change in that outlook from my perspective.

Clearly, this year is going to end up in the approximate range that we had last year, and a lot of that revenue we had anticipated this year will move into next year. We will see some countervailing effects next year which is the expected reduction in some Global Observer revenue. And we haven't seen any improvement in the industrial capital equipment market for our EES segment, but that's obviously offset by the growth opportunities I mentioned. So in summary, without getting into guidance for next year, I expect that we are going to end up with real year-over-year growth, both next year and the longer term opportunities driven by these new developments, I remain very optimistic about.

Fair enough. Thanks a lot, guys.

We will hear our next question from Brian Ruttenbur with Morgan Keegan.

Thank you very much. A couple of quick questions. First of all, the cash drop in the period, was that all because of the receivables or was there something else that caused the $5 million drop in cash?

Brian, free cash flow was $5 million for the quarter. $3.2 million of that was operating cash and $1.8 million was CapEx. The operating cash was the receivables because a large portion of the revenue happened at the tail end of the quarter, which upped the receivables and then we also saw growth in our inventories.

Okay, thank you. The other question I had was on Global Observer. Can you walk me through the timing? In the next six months or is it nine months, that you are going to flight test the first Global Observer. And then how long -- six months of flight testing before you get another order? Maybe you can walk me through the flight testing ritual there.

The test protocol that we are going through at Edwards starts with ground testing and a lot of system integration and translates ultimately into flight testing, with sequentially expanding the flight envelope and the operations there. Following that, we'll begin to integrate payloads, multiple different payloads into the airplane and then we'll be flying the airplane with payloads and demonstrating the effects of that entire system for our customer base.

Okay. So can you walk me through, are you doing ground testing right now?

Yes, we are.

Okay. So ground testing started when?

We moved the airplane to Edwards in December, and then there was a number of weeks of putting the airplane back together. This airplane's designed to be taken apart and shipped in C-130s to remote locations and then put back together. So that was the first process. Then we went through multiple testing scenarios that include system integration tests, ground vibration tests, weight and balance, things like that, that are all preparatory to flight testing.

Okay. So starting in January, roughly, ground testing started. Starting roughly in June, July, August, maybe you can tell me around when the actual flight testing start and then when does payload testing start after that?

So at this point, my statement was that our flight testing and our military utility testing are expected to begin in the first half of our next fiscal year. So that would be between starting in May of the six months starting in May of 2010. Then we will continue on with military utility assessment and evaluation through the first calendar quarter of 2011.

Okay. And when do you think would be the soonest that you could get additional orders? During flight testing, during payload testing, or is it after all that testing is done?

I think after we have begun the testing program, the window for potential additional orders will open. Most likely if we were to receive additional orders in that time frame, they would be of the nature of additional payload integration and testing subsystem work and evaluation, and probably the kinds of things that would allow our customers to rigorously evaluate the benefits of this system in their enterprise. I think the probability of looking at production orders is most likely out in the early phase, out in government fiscal '12.

Okay. So the earliest that you are probably talking about additional production planes would be beyond March 2011 before there would be additional orders for planes, not necessarily payloads or subsystems, right?

I think that's our best view at the moment, and obviously that can and will change as we get more feedback from customers as they get more insight into the demonstrations later this calendar year.

Right. Thank you very much.

Our next question will come from Troy Lahr with Stifel Nicolaus.

Yes, I'm wondering if you can get a little more specific on why you are seeing some of the delays in WASP, Puma and Switchblade. How much of these are chocked up to budget issues versus customer just reevaluating the product?

From the best of my ability to judge that right now, Troy, it's budget and these, I think, in a number of cases turned out to be unfunded requirements where we expected them to have been funded.

Okay. And when you said on Switchblade that you think that it might probably or probably could compete for this LMAMs, I think that was the acronym that you used, is the funding still up in the air for Switchblade based on that one particular budget line item?

Let me recharacterize that. Maybe I wasn't clear with my intent. The intent of bringing up the LMAMs RFI that was released by the Army is primarily -- this is public information that, I believe, supports our view that there is a growing level of interest around this kind of requirement in our defense customer base, to the point that they are issuing public Requests For Information around defined requirements. In this case, this LMAMs requirement, that we believe Switchblade is a good fit for.

Now, beyond that, we are seeing continued small orders by multiple customers for Switchblade and Switchblade Variance, and they are using those orders to both further the development of the capabilities of Switchblade, and to acquire small quantities of units, both for evaluation, for demonstration, and for evaluation use. And I think the sum total of that broad and growing level of interest and activity supports this optimism I have for relatively early adoption of that capability. Is that helpful?

That's perfect, thank you. And if you look out over the next couple of years, how should we think about the revenue? Do you think that we are going to see these periods of no growth and then a lot of growth and then back to no growth? Or do you think you weather the storm and it's going to be pretty smooth sailing? Because I look out into 2012 and we are a bit concerned that some of the growth might not be repeatable as most of the revenue has been pushed into this 2011 period. How should we think about that?

As we pointed out on the call, we had one year six years ago where one period, where we were about flat year-to-year, and it looks like we are into another one of those this year. In the intervening years, we've had varying rates of growth, and in one case, exceeding 100% year-over-year. I would hope that we have the flat years behind us, but obviously when we started this year, we didn't expect to see this result we've got. So I wanted to make it abundantly clear that the strategy we are pursuing, we believe has huge long-term compounded growth potential and we think we've demonstrated the ability to achieve that kind of growth over the last six years. But, the dark side of that strategy is the inherent uncertainty of adoption timing.

So, while we believe we have these opportunities stacked up in a way that they can be adopted in a sequential way and produce sustained compounded growth, we obviously have seen periods when we end up with a gap. I do see and expect sustained long-term compounded growth over multiple years.

Okay. And could you help me put a finer point on the double digit comment? Should we think of that as teens or 20% long-term? Double digit is a big range.

Yes it is and I'm trying to avoid putting a specific number on it. At one point in the past, I talked about a long-term compounded growth goal that we had internally, and I tried diligently to separate that from guidance, and I turned out to be not successful. So what I want to do is not put a number on long-term growth that sounds like I'm guiding to that growth, but, in fact, we have internal goals and we believe that they are supported by the extraordinarily large opportunities that we're pursuing, that can support significant growth like we have seen in the past. But I'm reluctant to get specific about a number, because it has a way of sounding like guidance.

No, I figured. I was just going to take a shot at it. Okay, thanks, guys.

And we will take our next question from John Croke with Jefferies & Company.

Good afternoon. Tim, I had a question concerning the EV market. You mentioned in your opening comments that there's a variety of business models you are looking at, and I was curious specific to the Nissan Leaf. I know there's a lot of different forecasts out there and you can pick the one that excites you the most, but what I'm interested in, and if you can talk about it a little bit, is the types of investments that AeroVironment needs to make in order to support the Leaf and maybe support other EVs that might be coming out in terms of R&D, CapEx, G&A. It sounds like AeroVironment is going to be much more national than it has in the past and I'm just trying to get a sense of what kind of investments are involved and what we should be looking for as this market develops.

I will start off here, John. I would say we've been investing in this business area throughout the year and you'll notice when we talk about R&D growth, the growth year-over-year has been, to an extent, driven by investments in this area. So we have been and probably expect to continue to invest as we go into next year.

And I think you've got good insight, John, into the various levels of investment. The R&D is built around largely the product line itself, and extending that into fully validated production units which then leads into CapEx around the production capacity for those units. There's a significant supply chain that is built up to support that, and there is a significant distribution channel, a significant installation organization, customer requirements software and operating systems to support a very large number of consumer customers in addition to industrial customers. And that's all required to effectively execute on the Nissan Leaf opportunity. Once in place, that is a highly leverageable investment that extends across the industrial opportunity for the support of plug-in electric vehicles.

Okay. That's very helpful. And then going back to the Global Observer, more on the infrastructure side of that program, you are clearly going to be looking at some period of time where activity is not going to be what it has been recently. And I know you've got a pretty impressive facility out there and a lot of talented folks who have been focused on designing and assembling the first few aircraft. How do you manage that cost basis as you enter this transition period? Can you rotate people in the other parts of the business that you mentioned that there might be some different types of tweaks and turns, contracts coming through, but how do you manage that cost base as we wait for those first production orders?

Addressing that issue in general is one of the significant challenges that we bit off when we adopted this growth through innovation strategy. Because we are unable to accurately predict adoption timing, we have a constant challenge of developing the technology and the market for that technology, and the productive capacity to support its adoption while we live with an uncertainty of the timing of actual adoption. So the point you bring out with Global Observer is a good, specific example of that generalized part of what we have learned to live with for years as we've pursued this strategy of serial innovation.

What we are doing now is looking at options, as you suggest, to move a lot of the unique talent that has been focused on Global Observer development around into other areas of development as we see this development phase beginning to wind down, in this part of the Global Observer program. Much of the new contract development work we're pursuing is designed to support that unique talent base in technology. And we have a constant internal evaluation of balancing the investments we make to improve the probability of the adoption of these very large new opportunities against the annual delivery of earnings associated with our near term revenues. And we are constantly evaluating the return on investment we expect from this portfolio of new opportunities relative to its short-term costs.

Understood. And one last question on Global Observer, then I will go. Boeing put out a release this morning on an interesting program they are working on. It's called Phantom Eye. And I'm not an expert but it looks like it fits into a similar market that Global Observer is pursuing. I wonder if you could give us a sense of what you think your competitive position is in this market and does maybe the fact that there's what appears to be a similar product in development, does that cause the customer to take its time a little bit longer to maybe benchmark the Global Observer against something else?

I obviously have no insight into their internal development status. I did see that announcement myself. Maybe a little bit of history on Global Observer from the past would inform what we might see in the future.

When we decided to transition our solar electric airplane development into a hydrogen electric airplane development that was designed to be a robust military platform to provide operational persistence and affordability, we put together a program plan around the Global Observer concept, and we began to pursue a JCTD start and funding around that. And that was maybe on the order of five years ago. Very shortly after that, we had competitive programs with PowerPoint charts similar to ours with a surprisingly similar platform suggestion. Over a year's period of competition, we were successful in the face of that competition, and one of those competitors was the same that you are referring to here. And we were successful in winning that with the strong support of half a dozen funding customers and a broader group of supporters. And we are now in the process of testing that first real airplane that's not a PowerPoint slide, and in the next few months, we'll be demonstrating that real airplane as opposed to PowerPoint slides.

So I think we are in a leading position here. There's no doubt that I like our cards relative to others, and at the same time, we're appropriately paranoid. And certainly Boeing is a lot larger established aerospace and defense contractor than we are, so we would be silly to not take that seriously.

I hear you. That's very helpful and the historical perspective definitely helps round out the situation. Thanks, Tim.

We'll take our next question from Jeff Evanson with Dougherty & Company.

Thanks, gentlemen. A couple of questions on future profitability. We started to touch on that already, but if I look at the guidance that ends up being implied for Q4, and I think about the mix of business I had expected, or you are indicating here, I would have thought that gross margins would have been a little bit better. Should we not assume that the DDL upgrades are at higher margin than the rest of your small UAS business?

I think we would stay with the operating income and we're not going to peel back the margins by product area. We did 39% gross margin in Q3, which is near the top end of where we performed, and we would expect Q4 to be another good quarter. But we're really digging ourselves out of the hole from Q1, and despite good operating margins in Q3, and if you do the math, which you have done, Q4 is even better. We are still only in the 9% to 11% range.

All right. Given your arrangements with respect to the Nissan Leaf chargers, can we expect that that will have an initial period of lower margins given the investments you need to make and then return to higher margins in the out years? Is that how we should think about that?

I'm looking at Tim. I think it's hard to say. It's a year out before we begin making deliveries. So it's hard to say right now.

Yes, I think in general, Jeff, we clearly are and will continue to make significant investments in that emerging market area, based on what we believe to be very attractive return on investment expectations. The initial rollout of any of our new products tends to have lower margins than we expect and realize as that product gets through its start-up and into rate production. So I wouldn't expect to see a different pattern here, but we don't have any specific information at this point to talk about it, and as Steve mentioned earlier, we have not guided on specific product line margins or even revenues, for the most part, in the past.

Okay. That's helpful. And then on Global Observer, with all of this testing that's going to be involved, I get the sense that there might be a fairly high period of continued cost here on AeroVironment's part, and yet, I think you did indicate that Q4 revenue for that program would be down sequentially. So is that going to start to negatively impact margins?

I don't think we expect the testing to with -- I wouldn't characterize that as costs. The testing program that we are pursuing is part of the development program that's currently funded and so that's a cost plus contract and we're executing on that. Cost plus contracts typically in our history have had lower margins than our fixed price contracts, but they are funded contracts.

Okay. So to wrap all of those questions up there, should we think about -- I know you are going to love this one -- 2011 profitability, somewhere consistent with 2010?

I think we clearly are waiting to provide guidance on 2011 until we finish our planning process and we will expect to be in a position to provide that in our next call, which would be Q4 of this year. Historically we've provided guidance on annual revenues and operating profits and I would expect that's probably where we are headed next quarter.

Okay. Thank you very much.

We'll hear next from Tyler Hojo with Sidoti & Company.

Good evening. I was just wondering if you could answer two cleanup questions. What was customer funded R&D in the quarter? And then just as it relates to the Geo contract, how much funding is currently available under the contract that you currently have?

The second part of that, I think we have talked about the total funding on Global being $120 million, approximately. The program is essentially fully funded or almost fully funded. The project R&D in Q3 was $16.3 million, or 27% of our revenue.

Okay. And just in terms of your backlog, how much Geo revenue is currently in there, just ballpark.

Our policy is not to unpack the funded backlog by program, but, GO is a component of that. It is not as big as it has been in the past.

Okay. And then just one last one for me. On the fed bus op site, I saw that you won a $1.2 million, $1.3 million contract for a Anubis and it looks like an interesting development program. I was wondering if you could maybe talk to that.

I think on that, we saw that announcement as well, Tyler, and I think I will have to refer any information beyond what was published by our customer to our customer, which would probably be the Public Affairs Office at AFRL.

All right. Thanks.

Sorry.

Our next question will come from Peter Arment with Broadpoint.

Yes, good afternoon, guys. Tim, we have talked a lot about this funding and the timing of it. Can you maybe just talk briefly about if you are seeing any changes in the utilization of Raven in theater? Obviously we see contracts and service sales are maybe up. Are you seeing any differential in terms of the utilization, in terms of spares or now that we've seen some troops coming down from Iraq and troops increasing in Afghanistan, could you just give us some color there?

I don't know that we have, at least that I have any insight into any significant different utilization in terms of what we see in spare parts, repairs, feedback. Obviously, the concept of operations in Afghanistan is significantly different than it was in Iraq. Also, the terrain is significantly different. I would think that over time, if anything, we would see that more hostile environment in Afghanistan produce more operational repair demand than the flatter, more urban environments that our guys saw in Iraq. But that's not based on any data that we have seen coming through yet. Steve, do you have any insight?

No. I think that's pretty much a non answer, Peter. Sorry.

That's okay. Do you have the ability to track what's in theater or what your customer has in theater and what is being deployed in other operations?

Relatively limited. We have a forward deployed support base in Iraq. We may well be asked to stand up similar capability in Afghanistan. I'm not sure. But there's a significant difference with these small Unmanned Aircraft Systems versus conventional airplanes or even their larger unmanned airplane systems and that is that almost all of the other systems are operated by air components that are geared around airplane maintenance and operation and control with a very large footprint and very rigorous maintenance and record keeping.

Our systems are used by soldiers, sailors and marines that are on the ground with boots and they are usually in a fight. They couldn't keep good records. They use them. They are there when they need them. They work when they need them and when they break them, they want them fixed and that's when we find out what they need. So it's quite a different scenario in terms of available data and being able to report on that.

Okay. And is there any lag, though, with the DDL in terms of training with the troops in terms of their utilizations, in terms more training that will be required now that there will be that many more Ravens that can be utilized for an individual controller?

What we're seeing now as we roll out the Digital Data Link in the new Digital Raven systems, is these systems go with the priority to units that are being deployed, so they are being trained up on the Digital system, and there are some differences in how they use that system and its capabilities. And I think we have not yet seen the effects of the capability of the Digital system to put so many more airplanes in the same physical space and in the same frequency allocation. So that is, I believe, a future opportunity that could drive, or at least enable much larger quantities, and if those were adopted, then presumably we would have a much larger training opportunity to go with that.

Okay. Thanks very much for that.

And that is all the time we have for questions. I would now like to turn the conference back over to Steve Gitlin for any additional or closing remarks.

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

This does conclude today's conference call. We thank you for your participation.