AeroVironment Inc (AVAV) 2012 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the AeroVironment, Inc. second-quarter fiscal 2012 earnings conference call. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session after Management's remarks. As a reminder, this conference is being recorded for replay purposes. With us today from the Company is the Chairman and Chief Executive Officer, Mr. Tim Conver, Chief Financial Officer, Jikun Kim, and Vice President of Investor Relations, Mr. Steven Gitlin.

And now at this time, I'd like to turn the conference over to Mr. Gitlin. Please go ahead, sir.

Thanks very much, Javon, and welcome to our earnings call. 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 undue reliance on any forward-looking statements, which speak only as 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, December 6, 2011. 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'll begin with remarks from Tim Conver, followed by Jikun Kim and then we will move on to questions. And now it is my pleasure to turn the call over to Tim.

Thank you, Steve, and welcome to our second-quarter fiscal 2012 earnings call. The main points for today's call are first we're on track, doing what we said we'd do and our solutions remain in high-priority demand with our customers. Second, there's great uncertainty regarding the Federal budget and DOD procurement, but we believe we can manage it in the short term. And third, key development programs are advancing in important ways that support our long-term growth objectives.

After I discuss the highlights of our second quarter today, I'd like to share with you what excites about our future growth potential as well as how we're managing risks. Our CFO, Jikun Kim, will provide a more detailed view of Q2 and year-to-date financial performance, and I'll close by providing our view of the balance of the fiscal year before we open the call to your questions.

We had another good quarter, Q2 revenue was $80.4 million, up 26% year over year and 30% sequentially. Earnings per share were $0.30 fully diluted up from $0.01 both year over year and sequentially. Q2 backlog was $116 million, up 59% from Q1. With $142 million in revenue for the first half of the year, we have visibility now into three-fourths of our revenue guidance for fiscal 2012. During Q2, our outstanding team continued to focus on customer success, execute against our current market opportunities and position us for long-term growth.

I'll begin the quarter review with the UAS segment. Here we see continued expansion in the role of our small UAS in force protection and war fighter effectiveness, which is keeping small unmanned airplane systems a high priority for our defense customers. We increasingly think of our small UAS as a family of systems, but it may be helpful to provide a brief update on each of our platforms in the family. The Raven system remains the workhorse, small UAS for all DOD ground forces, and it's been acquired by more than a dozen US allies. We're currently preparing a new payload upgrade to make this platform even more capable. We believe customers are likely to broadly adopt this upgrade and consider retrofitting their installed base as they have with prior Raven upgrades. We'll provide more details as we get closer to its introduction.

Puma has rapidly become a major contributor to our customers operations and to the continuing adoption of small UAS. It's making a real contribution to defeating IEDs and to reducing the risk of our troops and to noncombatants. And the $65 million Puma order that we announced just this August was our single largest small UAS order yet. We're continuing to demonstrate the latest upgrade to our small -- smallest production airplane, digital WASP. It's generating positive customer feedback and it's positioned for potential future adoption.

Shrike VTOL is our new hover-perch-and-stare UAS and it brings to our small UAS family a highly capable platform for missions requiring stationary and hovering surveillance. With our recently announced Qube system, we planted a stake in the emerging public safety UAS market, one that could become meaningful in the future once the FAA and its counterparts in other countries permit unmanned airplane systems to be used broadly in national airspaces.

Now moving beyond our small UAS, Switchblade is an agile loitering munition system that can be carried in a backpack and set up and launched quickly, to fine and engage an enemy threat. This quarter, the Army made the first announcement of a Switchblade contract that includes operational systems for deployment with troops, representing what we believe could be the beginning of an acceleration towards the broad adoption of this game changing capability.

We have no new news on Global Observer this quarter. We're working on multiple fronts to secure adoption and we plan to resume flight testing and utility assessment with the second, nearly completed, air vehicle, once we secure the appropriate customer commitments.

I'm now going to shift to a Q2 update of our efficient energy systems segment. In EES, we see additional opportunities for the adoption of our leading EV test equipment in international markets and our industrial EV charging systems continue to be in demand, closely linked with the demand for electric forklifts. Our growing EV solutions for plug-in electric vehicles continue to expand across North America. More than 5,000 of our home and public charging docks have now been deployed in 29 states, and seven Canadian Provinces. And we're beginning to roll out our UL approved fast charge stations in Texas, Oregon and Washington state. Our focus on completing the transition of new products into production should continue to improve segment gross margin. At the same time, we're building our organizational capacity to execute on the significant growth potential of our EES segment.

We're pleased to be in a position to support Nissan's recently announced plan to introduce the new low cost fast charge system to North America. We think this opportunity demonstrates the unique value of our continental network and further leverages our investment in distribution, installation and services capability for EV infrastructure. We'll continue to market, install and support our own UL listed fast charging systems in addition to this planned introduction.

With that as an overview of the quarter, I'll now shift my view -- to my view of the opportunities and the risks ahead of us. EV is working on many exciting developments and I'm often asked to pick the one that's going to create the most value. In my view, however, no single product or project exemplifies the greatest value or opportunity for AV. Rather it's the consistent capability of our organization to combine results and vision, to execute at a level that keeps us number one with our customers, while continuously creating important new solutions. That combination builds defensible leadership positions in multiple markets that balance risk and deliver profitable high term -- high long-term growth benefits for customers, employees, stockholders and society.

For example, small UAS have the potential to transform military operations even further in support of small tactical teams, helping to enable the squad as a strategic force, and then generate productivity and safety gains in non military missions around the world. Switchblade has the potential to give small military teams a surgical capability to protect themselves in ways not possible before, while minimizing collateral damage. Recent activity supports my view that significant adoption is nearing. The idea of Global Observer as a practical and affordable atmospheric satellite could become compelling as customer, budget focused, more decision-making on lifecycle costs.

The adoption of plug-in electric vehicles is likely to accelerate, mitigating the many costly implications of oil's monopoly on transportation energy. Whatever that rate of adoption is, it almost certainly represents a large global opportunity for charging infrastructure that we intend to help shape, enable and grow with. More automobile makers introducing more plug-in vehicles will help grow the market for charging infrastructure. A good example is BMWs rollout of its Active E battery electric car in North America, which we are now supporting with our dealer and home charging systems installation and support network.

Other innovations still in our lab capture our imagination with their seemingly unlimited future potential. The unique Nano Hummingbird for example, manifests the creativity, persistence and the passion of our people to turn an idea, no matter how much of a reach, into reality. I think our team is the best in the world at what they do across all aspects of our business. Each one of our opportunities that I've mentioned could become a transformation and we've created leadership positions in each. The breath of these opportunities hedges the adoption timing uncertainty of any single innovation, while the size of each opportunity creates the potential to individually accelerate the growth of the Company significantly. All of them taken together represent a portfolio of great products, with benefits and opportunities that motivate each of us at AV.

All business strategies of course come with risks to be managed as well as opportunities to be captured. In the short term, we see two primary risks for fiscal 2012, both of which I believe we are managing effectively. First is the timing of customer orders, which has long subjected our short-term results to lumpiness. Not receiving our large government fiscal 2012 Army Raven order by mid to late Q4 could affect the portion of that contract that we have planned to realize as revenue in Q4. We think Congress is likely to act in time, but we are nevertheless working to accelerate other contracts that could offset the effect of a possible government fiscal year 2012 contract delay.

Another risk that we're managing this fiscal year is the possibility of slower than anticipated ramp-up in our electric vehicle solutions revenue. Early evidence suggests the drivers are enjoying their battery EVs, but fuel prices are not likely to decline dramatically in that the demand for charging solutions is accelerating as more EVs come closer to market. That leaves us with the primary short-term uncertainty for fiscal 2012 in the number of new cars available for delivery in our market areas and government incentives supporting their purchase. To minimize the effects of these risks, here again, we're pursuing incremental opportunities that could offset slower EV sales this year primarily through accelerated industrial electrical vehicle product sales.

Beyond our fiscal year 2012, longer term government budget and DOD decision-making could obviously impact us in many ways, from a draw down in Afghanistan to a dramatic reduction in military spending. That said, we saw demand for both our small UAS and our UAS services actually increase as troops were drawn down from Iraq, supporting our notion that a draw down is not necessarily unfavorable to our business. We would expect our existing programs to be affected by a dramatic reduction in future DOD funding that reduces spending on all military hardware and services. However, where the money is allocated, will be more important than the top line for companies our size. ISR and unmanned systems are likely to retain their relatively high priority in any given budget scenario, and small UAS uniquely save lives. Also, as budgets tighten, the relative cost advantage of our small UAS compared with other larger systems, could become more important. As difficult acquisition trade-offs are made, and [Moores] law helps drive greater capabilities into smaller packages.

AV's future growth will not be limited to existing product lines. It will also be driven by the adoption of important new developments. Switchblade represents an entirely new product line and we're seeing evidence that adoption is likely to accelerate and drive growing revenue. Global Observer would also represent a new business and it's dramatic cost advantages are becoming more important to decision makers. Beyond DOD, our EES solutions continue to attract new customers and are expected to grow significantly over the long term.

Business has always faced a variety of risks, but we've managed to grow profitably through the initial adoption phase of both our UAS and our EES segments when we manage significant risk. We believe that our market leadership positions us to continue to grow in each of our existing businesses. Our multiple new development opportunities are large, especially related to AV's current size. That means the late adoption in one will not preclude significant enterprise growth from another. I remain optimistic about our long-term growth potential even in the face of DOD budget challenges. And now I'd like to invite Jikun to discuss our Q2 and year-to-date financials in more detail.

Thank you, Tim, and good afternoon, everyone. AeroVironment FY 2012 Q2 results are as follows. Revenue for the second quarter was $80.4 million, an increase of 26% over Q2 last year of $63.8 million. Looking at revenue by segment, UAS revenue was $66.9 million, an increase of 25% over the prior year. The growth in UAS revenue was largely driven by higher product deliveries of $12.2 million driven by the digital Puma EE system. On the services side, we realized higher revenues of $6.8 million driven by various SUAS services, including logistics, repair, operating services and DDL retrofits. However this growth was offset by lower customer funded R&D work of $5.6 million largely due to the Global Observer program. The EES revenue was $13.4 million, an increase of 32% from Q2 last year, primarily due to higher hardware deliveries and installation services of our electric vehicle test systems and electric vehicle charging systems.

Turning to gross margin, gross margin in the second quarter was $30.6 million, up 41% from the second quarter last year. Gross margin as a percent of revenue was 38% versus 34% in the second quarter last year. By segment, UAS gross margin was $27.2 million, up 56% from the second quarter last year, primarily due to higher sales volumes and higher gross margin percentages. As a percent of revenue, UAS gross margin was 41% compared to 33% in the second quarter last year. The increase in gross margin percentage was largely due to higher mix of fixed-price contracts compared to cost reimbursable contracts.

EES gross margin was $3.4 million, down 22% from the second quarter last year, primarily due to lower gross margin percentages but offset by higher volumes. As a percent of revenue, EES gross margin was 25% versus 43% in the second quarter last year. The decrease in gross margin percentage was largely due to higher costs on DOD government contracts, higher sales mix of products transitioning into low rate initial production and higher manufacturing and engineering overhead support cost driven by increased production capability and capacity.

SG&A expense for the quarter was $12.2 million, or 15% of revenue compared to $12.7 million, or 20% of revenue in the prior year. R&D expense for the quarter was $8.8 million, or 11% of revenue compared to the prior-year amount of $8.7 million, or 14% of revenue. Operating income for the quarter was $9.6 million, or 12% of revenue compared to the prior-year amount of $0.4 million, or 1% of revenue. Operating income was substantially higher primarily due to higher sales volumes, while SG&A and R&D expenses were relatively flat. The effective tax rate for the quarter was 32%, a decline from the prior-year period of 41.3%. Net income for the quarter was $6.6 million or $0.30 per fully diluted share, compared to $0.3 million, or $0.01 per fully diluted share in the same quarter last year.

Now moving quickly through our first half FY 2012 results. Revenue for the first six months was $142.4 million, up 40% from the prior-year period of $102 million. By segment, UAS revenue was $119.1 million, up 37% from the prior year. The increase in revenue was largely due to increased product deliveries of $25 million driven by the Puma EE systems, increase service revenues of $19.1 million, driven by SUAS support services, however, this growth was offset by lower customer funded R&D work of $12 million driven by the Global Observer program. EES revenue was $23.2 million, up 55% from the prior-year period, primarily due to increased product deliveries and installation services of our electric vehicle charging systems and electric vehicle test systems.

Gross margin for the first six months was $52.3 million compared to $33.8 million a year ago. Gross margin as a percent of revenue was 37%, 400 basis points higher than the prior year. By segment, UAS gross margin was $47.4 million, up 71%, primarily due to higher sales volumes and higher mix of fixed price contracts compared to cost reimbursable contracts. EES gross margin was $4.9 million, down 18%, primarily due to lower gross margin percentages but offset by higher volumes. As a percent of revenue, EES gross margin decreased from 40% to 21% primarily due to higher program costs on DOD development contracts and transition costs related to the low rate production of several new electric vehicle charging systems.

SG&A expense for the first six months was $25.9 million, 18% of revenue, compared to a prior-year amount of $24.1 million, or 24% of revenue. R&D expense for the first six months was $15.4 million, or 12% of revenue, compared to $16.7 million, or 16% of revenue in the prior year. Operating income for the first six months was $10 million, or 7% of revenue, compared to an operating loss of $6.7 million or negative 7% of revenue last year. The effective tax rate for the first six months was 32.1%, declined from the prior-year period of 52.8%, primarily due to lower R&D tax credits. Net income for the first six months was $6.9 million, or $0.31 per fully diluted share compared to a loss of $3.2 million, or a loss of $0.15 per share. Looking at backlog, funded backlog at the end of the second quarter was $116.4 million, up $33.6 million, or 41% from April 30, 2011.

Turning to our balance sheet, cash equivalents and investments at the end of the quarter totaled $199.9 million, up $5.6 million from the prior quarter. The positive cash flow was driven by higher income, partially offset by higher working capital needs. At the end of the second quarter, our accounts receivable including unbilled receivables totaled $47.2 million, up $11.8 million from the prior quarter. Total day sales outstanding were 53 days compared to 51 days at the end of the prior quarter. Taking a look at inventory, inventories were $41.4 million at the end of the quarter, compared to $38.3 million at the end of the prior quarter. Days in inventory were approximately 75 days compared to 86 days at the end of the prior quarter.

Now turning to capital expenditures, in the second quarter, we invested approximately $2.9 million, or 4% of revenue in property improvements and capital equipment. Now I'd like to turn things back to Tim to discuss AV's expectation for the balance of our FY 2012.

Thank you, Jikun. I want to reiterate the strength of our Q2 performance. That combined with our funded backlog and our current outlook for expected orders, give us better visibility into the second half than we usually have at this time of the year. The Federal budget and DOD contracting environment has increased the timing risk of government fiscal 2012 Raven contract received, and the near-term supply of electric vehicles in our market areas remain somewhat uncertain. Even so, we do not believe that these timing risks will drive our performance out of our guidance range, and we reiterate our revenue guidance for the year of $321 million to $336 million with $1.28 to $1.35 diluted earnings per share. For Q3, we anticipate revenue of $80 million to $90 million with diluted EPS of $0.35 to $0.45.

We're doing what we set out to do and enjoy leading positions in the markets that we helped to create. We're keeping a close watch on the risks that could impact our business and we're working actively to manage them. We remain confident in our market positioning and we're optimistic about the potential for our new solutions to create the leadership positions that will drive long-term growth. Thank you for your time, and we'll now open the call to your questions.

Thank you, sir. The question-and-answer session will be conducted electronically. We ask callers to limit inquiries to two questions, if you have additional questions, you are welcome to return to the queue. (Operator Instructions) Brian Gesuale with Raymond James.

Nice job on the quarter. Just a couple of quick questions here for you. Tim, you mentioned managed some of the government risk in the short term in your prepared remarks, with the pullout in Afghanistan and-- or in Iraq, rather, and what's going on in Afghanistan, can you maybe talk about the trajectory of the logistic services and then if you are seeing any product inventory move from one area of operations to another?

I'd be glad to, Brian. I think the -- we have long thought that the primary effect of a pull out in Iraq would be less a matter of reduced procurement relative to the original requirements and more a matter of reduced spare parts and repairs, if users were training with these systems rather than fighting with them. We saw a number of things happen when the draw down in Iraq was effected. In one scenario is-- or one effect was that many of the larger footprint UAS and ISR assets were removed from the theater with the large scale deployment. That left people that were there with more vulnerability and they moved to small UAS to cover that gap and it was-- there were multiple documented scenarios where-- about the significant effectiveness of increased use of Ravens, for example.

We also saw that people -- that there was-- that the threat and risk to people in the theater didn't abate, and in fact, could arguably have been more, greater with the reduction in troops, and that has led to a growing demand for our UAS services. Now, of course, at the same time we were building up troops in Afghanistan and for whatever -- whether it was experience from Iraq or experience from Afghanistan, the Army decided to significantly increase the number of small UAS allocated to combat brigade or combat brigades in Afghanistan. And I think that went from the original 15 to 35 systems per brigade. So, overall, a significant increase really in demand. We still maintain support in Iraq, and we have stood up an increasing amount of support in Afghanistan to support our customers in those theaters.

Michael Lewis with Lazard Capital

Hello, Tim, thanks for taking my question, good quarter. Tim, just a quick question on the most recent set market up that hit the other day. As I went through the various line items and all of the different supports, I did notice that there were a number of Raven procurements in there, but I want to know whether this is in line with what you had been planning or whether this is higher or lower, could you give us some take on that?

Let me just make sure I understood what you're-- what documents you're referring to, Mike.

It's the most recent Senate markup that just passed through the Senate for $600 billion -- 626 -- I'm sorry, the (inaudible) was [526] on top of the supplemental.

Okay, yes so let me tell you what-- at least what I'm aware of. I believe that the House, both the authorization and appropriation, has put forward the same number, and in terms of Raven, I think it's around $70 million for GFY 2012. In the Senate, I think appropriations or authorization previously plussed up that number by about $15 million and then most recently, appropriations took down that number by almost $12 million. So, I think that there's some ongoing dialogue that-- around that between the Army and the Senate and obviously that ultimately goes to conference and gets sorted out. So I don't know if that's consistent with what you've been looking at, but that's my take at this point.

In fact, it's pretty much dead on. I saw $10 million reduction on the Senate side and the House was around that $70 million. If I could just put in a question to Jikun, do you anticipate that we will see a sustainable gross margin range north of 40% for the UAS business through the remainder of the year? And thank you so much.

Yes, so, we do expect Company level gross margins to improve sequentially. But it is a combination of UAS as well as EES performance improving over time.

Tim Quillin with Stephens Inc.

Hello, good afternoon, and Tim, that was good color on maybe analogy we can draw from Iraq to Afghanistan and what happened there. But one-- I had a couple of questions on the EES business. First of all you kind of alluded to incremental opportunities you might have on the EV side, if you could discuss those?

Well as you probably recall, Tim, we've got three primary product lines in that segment. One is our -- we refer to as PosiCharge, the charging systems for industrial forklifts and utility vehicles. A product line of electric vehicle test equipment that is sold primarily to car companies and battery companies and used in the development of production systems and then the on-road infrastructure to support the on-road electric vehicle rollout. And so my reference was to the prior two with opportunities to accelerate some revenue in those two product lines to have -- that give us the potential to offset the what we see as somewhat of a risk in the available vehicles in our market areas to generate the planned revenue on the new rollout of the EVS solutions or the on-road plug-in vehicle solutions.

Okay. Okay, I understand so it's not within the EV solutions business where there's incremental, at least near-term incremental opportunities.

Right, yes, I'm looking at the industrial product lines to help us mitigate that risk.

Okay. And then in terms of the Nissan fast charger where you're helping with the distribution of that, more the service angle of that. Is that-- do you like that kind of business versus your own products? And what would-- what are the economics of that, or how lucrative could that be for you in terms of revenue or margins?

Well, I'm going to pass on the economics, we're still sorting out how this relationship will come together with Nissan. But I do see it as a positive opportunity. In the first place it's a great opportunity to support an important customer as they rollout this product and it's a-- I think it's a validation of the significance of the nationwide, actually continent wide capability we've been building for installation and support services for electric vehicle infrastructure initially of course to support our own product rollout, and we are doing that now with more than just one OEM customer, different car companies, different utilities, different governments. And now bringing in third-party products into that network, I think leverages that investment and will be economically valuable for us.

Michael Ciarmoli with KeyBanc Capital.

Hello, guys, good afternoon, thanks for taking my questions, real nice quarter. Tim, just to talk maybe about the risks with the budget, with the timing of orders. Looking at Q4, how much of your revenue and earnings would be at risk if orders sort of flip or things become more complicated or just log jammed from this continuing resolution?

Well I think we characterize that generally our Q4 call when we tried to frame the year and when we set our initial guidance. And at that time, we indicated we were providing some cushion in our plannings in the event of continuing resolutions and contract delays, but that we were still assuming the government fiscal 2012 budget would pass and those contracts would flow through in time for a minority of that contract to be delivered in Q4. And that's still -- that was the assumption in the original plan. That number is less than 10% of our year. And it's considerably less than the total or even 50% of that contract, but it's enough-- it's a big enough number so that to the extent we see that risk growing, we're looking at ways to mitigate it.

Okay, and then just if I could slip one more in. Just so I'm clear, when you talked even on the call and in the press release having 75% visibility into the full year, so basically your current backlog, all of that is going to get drawn down over the next six months?

Yes, I think most of that backlog is scheduled for delivery within the next six months. And that-- I think the -- historically the only significant amount of our backlog that is really moved out beyond any given, any 12 month period, has been a couple of instances during the Global Observer JCTD program when there was multi-year funding in place. But it's atypical for any of our backlog to be scheduled out beyond a year.

Jeremy Devaney, BB&T Capital.

Good evening, gentlemen, solid quarter. Tim, if I could just a couple of quick metric questions and then I've got one more topical question. International business, what percent of sales? And then also the percent of completion against Raven and the Puma contracts?

Okay, so international business for the quarter was roughly about 7% which is kind of strange in that it's typically what we won for the year. In terms of the BOIP, is that what you're requesting information on?

Yes, the Army target on the Raven and then the IDIQ on the Puma.

Sure, so, the Army AAO of [2,350]--

AAO is Army acquisition objective, right?

It is 73%, so we did not have a lot of activity in the quarter against the Army Raven objectives. In terms of unfunded backlog, and we don't discuss this at the contract level, but we roughly have, let me see, $126 million of unfunded backlog.

I guess I was looking specifically for the remainder on the Puma, do you not have any funded left on that contract?

We do, but, again, we don't get down to the contract for funding information.

That -- you can see from the original contracts against that IDIQ, Jeremy, in addition to the significant Army buys that have gone through that contract that were bumping up against that original IDIQ limit. Our customers are aware of that and are addressing the contracting mechanism issues so that hopefully that doesn't become an impediment to any future acquisition.

Andrea James with Dougherty & Company

Hello, good afternoon guys.

Hi, how are you?

Hi, good, so my first question is just on the Raven, the contract that you're still waiting on for this year, I'm just thinking it's somewhere around $30 million, let me know if I'm thinking about that wrong. And then also, you said you could maybe speed up some other contracts to balance that out, what would that be?

Okay, so going to your first question of the Raven order, I'm assuming do you mean the GFY 2012 order?

That's right.

Yes, the budget line is for $70 million, so it would be some place between zero and $70 million.

I think we've said less than 50%. She's talking about fourth quarter revenue.

Fourth quarter revenue, correct, I'm sorry, I thought you were talking about the value of the contract.

No, no, no, yes just what you're waiting on to meet this year's full year guidance.

Yes, I don't think Tim was very specific, but it's a small portion of the total year guidance and less than 50% of the contracting question.

To kind of talk about the-- how we might offset some of that-- the potential risk of that sliding, Andrea. If I go back to the way we would plan the year in the beginning, we will be looking at a large set of opportunities with the distribution of probability and timing. And through something approaching a Monte Carlo simulation, we will end up with a forecast with a range around it and that is the basis for providing the initial guidance to you all before the year starts. So within that, there are elements of -- that will generate revenue that we think have a very high probability of occurring during that time frame and then a range of other opportunities that have a range of probabilities.

So we're halfway through the year now, we've got a lot better look at what the next six months would look like, so our ability to predict those probabilities is better. And some that we had thought were less probable might be more probable, some that we thought would be falling in on the first half of our next fiscal year, might have opportunities for us to accelerate into the second half of this year. And those are the kinds of activities that we're focused on in an effort to mitigate the possibility that this GFY 2012 program could slide out farther than we had originally thought.

And my next question is just more long term. Could you guys and how we could start thinking about the total addressable market for the Qube and the Shrike, I know they're two radically different products with different markets, but-- and also what we should think about timing of adoption? Thank you so much.

Well, great question. As you probably can guess, I'm not going to have a specific quantified answer for you. A lot of people have suggested that the non-defense market for small UAS could be larger than the defense market. I don't really have a good way to predict the size of that market. There are clearly thousands and thousands of police departments that have no air assets. Clearly, the advantage of seeing what's on the other side of a wall before you kick the door in, would have a similar benefit to a policeman as it has to an Army sergeant. And there is a large established industry around providing that kind of situational awareness whether it's for police departments or whether it's pipelines or offshore platforms or emergency response. So, very large market opportunity, it's clearly global. Quantifying it is, I just don't want to guess at this point.

In terms of timing, the FAA has said publicly that they currently intend to promulgate rules for the small unmanned airplane access to the national airspace first and that they are planning on doing that in mid-2013. Whether they actually do that or not, is -- your guess is as good as mine. But that -- we think there is enough likelihood that that's the timing that we picked now to begin to launch our Qube product and to begin to work with users in understanding how they will best use this capability and how we'll best support them in their adoption.

Josephine Millward with The Benchmark Company

Hi, good afternoon, Kim.

Hi, Josephine, how are you?

I'm doing well, how are you?

Very well.

I just have a follow up on the public safety market. Do you see this as a contributor in the coming year and once the FAA puts their rules out there for public comments, would that enable city select usage for-- to fly small UAS in the national airspace or nothing will happen until they have the final ruling? If you can help us think through how the process might work.

Yes, yes, my assumption is that we'll all wait until they have a final ruling and they promulgate that rule. It does seem likely that small UAS will be the first up for their consideration. And so we're going forward on the assumption that that will happen about the time that they are projecting. Did I-- and there might have been a second part of your question that I missed.

No, that 's fine. What about ASP on the Qube and if you can also talk about whether there's a requirement or emerging requirement for the Shrike?

I'm still-- clarify the question for me a little bit, would you, Josephine?

Sure, I was looking for ASP on the Qube and also if you can comment on whether there's a DOD requirement for something like the Shrike or if you can talk about whether there is a requirement outstanding?

Well, we haven't set any pricing on that commercial solution, yet. So we'll initially be working closely with multiple users in between now and the point in time that the -- that we can start -- that they can start adopting and using those in the national airspace. I don't think we'll see any constraints from the military in this product, if that was your question, at least for domestic application. I think in general, we assume that any export goes through an export license process with the Department of State and we have a-- as we mentioned the-- a military product that has hover-perch-and-stare capabilities that we are introducing to customers. And if that's what you're referring to, it's separate, but it clearly is a requirement that the Army has had a lot of interest in for a long time and we think it's likely to be of growing interest to them in the future.

Howard Rubel with Jefferies.

First, Tim, it looks like your R&D and your SG&A are starting to flatten out a little bit, is this -- I know last year there was clearly an effort to accelerate and take advantage of some things. But are you at a level now where you can manage the product portfolio development and take advantage of the operating leverage that you're seeing with volumes?

Yes, Howard, the -- we have for some time had a notional model of R&D and SG&A percentages in the business on the income statement, and I think we've generally stayed within those numbers. We searched out a couple of points last year on increased SG&A, or increased R&D, that you're referring to and that we talked about at the time. But we expected them to go back to the nominal level of percentage that we tried to operate at in the past. I think we are there and I think we foresee staying in that zone unless and until some other unique situation comes up that causes us to make a conscious change.

And then I'm not sure I quite followed what Nissan did, but my understanding is they selected a competitor of yours for the public charging stations, did you get a satisfactory answer as to why you weren't chosen there?

I think what happened, Howard, was -- I actually had some insight a year ago from senior management at Nissan. They were -- they felt that they wanted an alternative to the fast charging price point that was basically an industry standard. So the points-- the price points that we have on our current UL approved fast chargers are not much different than other fast charging solutions that have been available in Europe and in North America. But, I think they were pushing for an alternative solution and I think they found one in Japan and they now want to roll that out broadly. It's -- I think, we and they both think that these are different products that are probably complementary if not being unusual to find different price points within a given market. So I think it's -- on balance, it's a very good opportunity for us and we don't have any -- we think both products have a place in the market.

Patrick McCarthy with FBR

Hi, good afternoon, and thank you very much for taking my call. My question was on the gross margins in the EES business and I was wondering whether there was a specific point where the weaker gross margin from the DOD program that you're on begins to roll off? And at that point in time, do you start to see the margins in EES normalize to the very high levels that you've seen in the past?

Yes, so the impact of the gross margins in the first two quarters of this year were basically attributable to three issues. First, there's the DOD development contract issue, and second, is the transitioning of the six new products that we released in Q1 through LRIP into full-scale production. And the third is basically the investments that we have made over the last year to increase the capacity and the capability of the organization.

The first issue that you identified, it is a contract and it does have a period of performance. So as that period of performance rolls off, we will have that behind us. Second, is as we increased volumes and learning curves and then through economies of scale, we should see increased gross profits on the six products that we have launched. So that should shift us closer to our historical margins. Having said that, this year's full year gross margins will not be where we thought last year for EES.

Okay, thanks. And then over to the UAS business, aside from just I guess what you would call normal SG&A infrastructure cost, are you guys spending any money to keep GO going on the development side?

Well, we've got an ongoing IR&D line item, Patrick, that we have maintained and we have people continuing to focus on that technology. But we are currently working primarily to develop new customer support for moving that product through its final development stages and into production before we ramp back up with the levels of our own investment that we had been maintaining alongside the JCTD.

Okay and then just one final, if I could, it sounded like from your commentary that something more is coming on Switchblade, and is there anyway you can give us a sense of timing? Is that a this fiscal government year type of opportunity or do you think of that more of next year?

I would think of it as primarily next year, although, I think when we started the year, we expected the growth in this year to come primarily from small UAS, from Switchblade and from our EES segment. I think we still see that as-- those as the primary drivers and we still expect the revenue this year from Switchblade to be multiples of what it was in the last couple of years. But then that number was probably in the neighborhood of $5 million in FY 2010 and FY 2011. So probably significant growth on a percentage basis this year, but probably significant growth in terms of the longer-- the ramp-up to longer term adoption coming in next year.

Tyler Hojo with Sidoti & Company.

Yes, hi, good evening. Just a follow up on the GO question, just wondering-- I get that there's no update, but just wondering if you're concerned at all that no new funding has essentially emerged for that program and maybe you could also just comment on where the second air vehicle is in terms of development?

Well, I'll start with the second air vehicle, first. It's over 90% done, but it's in the same condition that it was six months ago. So we have not moved to finish that off as -- while we're primarily focused on working with customers to establish a go forward plan with them. Am I concerned that we're still working? Well I'd much rather be working on a production contract than working on business development, but this is a significant innovation. It's fundamentally different than anything that exists and it solves problems in fundamentally different ways. So with our experience in introducing innovations to the markets, it's not surprising that this takes, inevitably, more time than we either wanted to or thought it would. I'm encouraged that this is being considered by numerous customers, in numerous applications, and I do think that the increased focus on budget effectiveness and budget constraints will increase the scoring of this Global Observer solution relative to others because of the significant acquisition and operating cost advantages that it brings to the party.

Okay, thanks for that. And maybe just as a follow up, I think in your prepared remarks, Tim, you alluded to a new payload upgrade for Raven. Could you perhaps tell us what that might include and what the timeframe for that may be?

I wanted to let you know that we're working on that, we're planning on that, and we think we are close to introducing that, so that it wasn't a surprise when it popped out. But I would prefer not to get into the specifics until we introduce that formally. I do think it's likely within the next year that that would be adopted and I think it's going to provide significant value to all of our customers and I would be surprised if it didn't receive the kind of reception and adoption that our prior upgrades to that Raven system have received. This concept of ongoing continuous product upgrades has always been a key part of our revenue model for small UAS and I don't see that abating in the future.

Tim Quillin with Stephens Inc.

Yes, and actually that was the question I was going to ask about in terms of the upgrade opportunity there, but is there -- can you talk about the rough order of magnitude what it means in terms of per unit price?

Yes, rough order, Tim, is probably in the range of the DDL upgrade, just kind of-- at least in that ballpark.

Okay, so meaning--

A significant performance impact and relative to the price of the system, it's a significant incremental build. But we believe that the value will be perceived to be high.

Okay. And Jikun what tax rate should we be assuming for this year? Thank you.

Yes, 30% for the full year is still a good number at this point.

Jeremy Devaney with BB&T Capital.

Thanks for taking the follow up. Real quickly, I wanted to circle back to your comments regarding the expanding, or the possible expansion, of requirement from 15 units out to 35 units in the Army. UAS program office had some documentation out last month that alluded to the positioning of that 35 as available units rather than actual procured units and so that they were actually taking them out of fielded teams coming back to the rear and essentially leaving them in a forward position. Is my understanding of that correct or are they actually looking to procure twice to more than twice the number of Ravens out there?

No, I think you've got that right, Jeremy. They-- in the-- when they surged those incremental units to BCTs in Afghanistan, I believe they in fact did pull those out of [codus] applications to move to Afghanistan, but these were systems that had already been procured. There have been a number of mixed studies, I believe they are still going on within the Army over the last few years, many of them driven by training and doctrine command looking at the small UAS benefit, the tactics and procedures, and what that capability should be. Most of the information that I've seen publicly addressed by the Army from the studies seems to move towards the direction of a family of systems and an increased basis of issue. And those numbers have varied, and moved around. I think I've seen in public anything from an increase of 17 up to 35. So I'm -- I don't know anything about the probability or the timing of that actually turning into formal decisions and contracts, but that's really a separate issue from the surge that was executed last year in Afghanistan.

Fantastic, that level of detail is really helpful. And then, lastly, on the upgrade to the payload system, I know you're kind of playing it against your chest here, but should we think that there might be a margin risk such that it's going to play out like DDL being priced similar to a service rather than a hardware upgrade?

Well that's -- that'll just be a matter of accounting treatment in where it gets handled. And let me pass that over to the accounting guru, here, in the room.

Yes, the DDL retrofit kits and upgrades entail both hardware and services. There is a hardware component associated with it as well as a service logistics repair service aspect of that. So it's a combination of the two. However, from an accounting standpoint, we have chosen to put that as a service revenue line item.

So how would you envision the next upgrade to the payload that I was talking about when that rolls out?

Right, my guess is again the details of this has not been fully flushed out, but the ability to retrofit in the field appears to be a more likely or-- there's a possibility of that being able to be conducted in the field rather than having it come back to the factory. So it could just end up being a hardware component.

Michael Ciarmoli with KeyBanc Capital.

Taking this follow up. Tim, just to further explore Global Observer here, how complicated is [Showcom] making the progress to get additional funding? Do they technically own a lot of the intellectual properties since the program was funded? And then, the second part, if you get funding today, how much more testing you have, how many more milestones, and in order to really prove the platform, do you have to build the third system, or the third plane?

I think the answer to the last question is no. I think we demonstrate the capability of the system effectively with one airplane. To demonstrate long-term persistence, we would need two airplanes, but you could get 99.5% assurance of what the effect of two airplanes would be from one.

As to intellectual property, we funded the development of most of the key innovations to enable virtual, well, let me take that back, all of the key innovations to enable Global Observer with internal funds before we pursued the JCTD. And we have much of the ongoing IR&D that we have contributed to the program has been associated with the ongoing development of that intellectual property. So there's in terms of intellectual property, I don't see that as any constraint going forward.

Okay, great, thanks.

And that is all the time we have for questions. We'd like at this time to return the call to Mr. Gitlin for any additional or closing comment.

Thank you very much, Javon. Just for the sake of clarity want to point out that we recently filed an S-8 related to our 2006 equity incentive plans, so if anyone on the call has noticed that filing come out, that is from the previously approved item from our proxy statement and annual shareholder meeting. Thank you very much for your attention and for your interest in AeroVironment. An archived version of this call, all SEC filings and relevant Company and industry news can be found at our website, www.avinc.com. We look forward to speaking with you again following next quarter's results. Have a good evening.

That concludes today's conference call, thank you for your participation.