AeroVironment Inc (AVAV) 2013 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the AeroVironment Incorporated third-quarter fiscal 2013 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; the Chief Financial Officer, Mr. Jikun Kim; Chief Operating Officer, Mr. Tom Herring; and Vice President of Investor Relations, Mr. Steven Gitlin. And now at this time I would like to turn the conference over to Mr. Gitlin. Please go ahead, sir.

Thank you, Karen, and welcome to AeroVironment's third-quarter fiscal 2013 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 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 contents of this conference call contains time-sensitive information that is accurate only as of today, March 5, 2013. The Company undertakes no obligation to make any revisions to the statements contained in our remarks, or to update them to reflect the events or circumstances occurring after this conference call.

We will now begin with remarks from Tim Conver. Tim?

Thank you, Steve. Our size and our business model have always made our financial performance susceptible to lumpy results. But amid an environment of unprecedented government budget uncertainty, our Q3 results represent the greatest variation to plan that we have experienced since becoming a public Company. Q3 revenue was $47.1 million, close to half what we had planned for. And fully diluted earnings per share were $0.17.

Like you, I am unhappy with these results and their effect on our current fiscal year. But it's important to note that we believe we are seeing delays in order timing, not lost orders. We have seen no change in our market leadership positions across the business. I continue to believe that succeeding in the multiple new developments across multiple different market segments that our team is focused on should deliver high compounded long-term growth.

Today I will focus my comments on three key points. First, delays in the government procurements we expected during the quarter that were the primary cause of realizing only about half of the revenue that we planned for Q3. At this point, we expect most of that revenue to be realized over the next few quarters.

Second, over the last few months, delays in most of our government acquisitions have exceeded even our most conservative estimates. And we have reset our order plans and our expectations for fiscal 2013 to adjust to these extended timelines. Despite these significant delays, we believe that we have not lost these expected awards. And we believe our customers still expect these contract actions to proceed, albeit at a slower pace than we originally planned.

Third, our new opportunities in multiple defense and non-defense applications appear to be on track to drive long-term growth, although they remain subject to uncertainty and adoption timing. I will address these three main points in more details as they apply to our third quarter and the future. Next, Jikun Kim will provide more financial information. I will discuss our outlook for Q4 and the longer term. And then Jikun, Tom and I will take your questions.

My first topic is Q3 revenue. Most of our planned revenue in Q3 anticipated contract actions in Q3 that did not occur -- that's much of our planned revenue. More than half of the total revenue shortfall against our Q3 plan resulted from delays in finalizing the government fiscal 2012 Raven contract. Smaller procurements, including additional Switchblade work expected during the quarter, also did not occur in Q3. Our best current estimate is that we will recognize most of this revenue in the next few quarters.

Secondary issues that affected Q3 revenue were some product shipment delays that have been replanned for Q4. We have experienced acquisition delays in the past that have impacted planned revenues within a period, but never of this magnitude. The deliveries planned but not made in Q3 resulted in inventory that we expect to reduce with deliveries over the next few quarters.

My second point addressed the unprecedented delays in government acquisition processes that we are experiencing across our UAS business. We considered the government budget process and sequestration uncertainty as we planned for this fiscal year, and anticipated that one effect on our business would be acquisition delays. We factored our order and our revenue expectations for the year more conservatively than in the past for these reasons, resulting in more modest revenue guidance than in prior years, and a wider range. Indeed, we did see more than normal contracting delays in the first half.

More revenue moved to the fourth quarter, but our outlook remained within our initial guidance range. Most but not all of the delays that have taken the form of month-to-month slides or extensions. However, the recent slowdowns that we have seen across many government acquisition actions are way beyond our initial conservative factoring, affecting even fully funded requirements, like the government fiscal 2012 Raven contract discussed earlier.

It is now 438 days since the government fiscal 2012 defense budget was approved. By comparison, the longest such time to complete an Army Raven contract in the prior four years was 161 days.

Historically, we have been able to predict near-term acquisition timing and related near-term shipments with reasonable effectiveness. This has always been important because we have short lead times, and we often book orders and ship hardware within a month or two, unlike most prime contractors. The extent of the delays we saw in Q3, however, were not anticipated through the customer dialogue and the planning process that we have used for years to plan revenue. We have concluded that our historic process for estimating contract award timing is no longer adequate, given the current environment.

Going forward, we will assume the longer government procurement timeline we are currently experiencing will continue until the current budget uncertainty is resolved and we see a trend change. We have adjusted our planning review process, and where appropriate, we are increasing our customer dialogue on timing expectations. Most of the procurements that we had planned to receive and ship in Q3 and Q4 of fiscal 2013 that are still delayed are now expected to slide into fiscal 2014.

In our EES segment, plug-in electric cars have been selling more slowly than we expected. This slower adoption adversely affected charging infrastructure revenue planned for the year. We assume most of the lower-than-expected electric car sales were lost to internal combustion cars, rather than being deferred purchases. EES revenue shortfall due to lower electric vehicle adoption rates are believed to be the only subset of our lower-than-planned fiscal 2013 revenue that is lost, rather than delayed.

The delay in our UAS segment does appear to be timing issues. These expected acquisitions have not been cancelled, nor have any of these customers indicated that they do not intend to complete their planned procurements. Requirements for our solutions, as distinguished from timing of the procurements, do not appear to have changed. Unmanned aircraft systems remain a customer priority. And we believe all five of our revenue drivers remain intact.

My third point focused on multiple long-term growth drivers. The five revenue drivers that I have previously referred to are a good framework for considering our future growth potential. The first two are selling more current products to current customers, and supporting the growing installed base of those existing products. We are market share leaders in each of our product lines, and by serving customers and competing effectively, we maintain that leadership.

Even as contracting delays extended delivery schedules in Q3, we won an Army IDIQ contract in the fifth full and open competition for Department of Defense small UAS. This is the first such IDIQ procurement designed for multiple-award recipients. We believe that we are uniquely positioned for Raven and Puma task orders under this contract, and well-positioned to compete for other task orders as they develop over time. We expect future requirements for Army Raven will be placed as task orders under this contract.

As the Afghanistan draw down proceeds through 2014, the organic force protection utility of small unmanned airplane systems and Switchblade could be of great value to those troops remaining. Recent history supports this notion. When the draw down occurred in Iraq a few years ago and larger systems were withdrawn, a significant gap in force protection and situational awareness opened for remaining troops. This gap drove increased demand for quickly deployable small UAS.

The third of our five revenue drivers is product upgrades. The Air Force and the Marine Corps have recently adopted the new WASP AE, and we expect adoption to broaden. The Army has adopted the new gimbaled payload upgrade, and we expect this significant capability upgrade will attract other Raven customers.

The fourth revenue driver is extending current products to adjacent markets, and I will highlight three current initiatives in this category. Growing international defense sales of our small UAS are a leading example of adjacent markets. Our international revenue year-to-date has already exceeded that from last year, and includes our largest single international contract, notwithstanding delays that have affected our original fiscal 2013 outlook. The pipeline of significant acquisition requirements for small UAS from international customers is now higher by multiples over any prior year. And we expect more growth from international sales in fiscal 2014.

In another example, we believe that the opening of national air spaces will enable a large new domestic and international opportunity to deploy small UAS to great benefit in public safety applications. Timing of FAA rule changes remains subject to delays, and privacy concerns need to be addressed. But user demand is significant and building. We are working with early adopters now, and we believe that we can help them succeed.

My third example of product extension opportunity is mission services, which represents the opportunity for us to deliver the value of situational awareness from unmanned airplane systems to customers that do not want to own and operate the assets. To frame the potential of this new business model, consider a typical application of these services called for by a current Department of State requirement for unmanned airplane system services to support US embassies. This single requirement represents a $1 billion opportunity over the next five years. We expect our mission services model to produce significant growth beginning next year.

The fifth revenue driver in our model is entirely new solutions, often based on innovative technology. The following four developments fit this category. We recently secured a larger Tier II unmanned helicopter capability and have modified the baseline system with our own enhancements and control system to support our mission services. This newly developed solution also opens the opportunity for parallel product sales to support acquisition requirements that our current small UAS customers may have for this capability. Tier II UAS typically costs about 10 times small UAS, and we intend to market a very competitive entrant into this market segment next year.

Switchblade is a current example of an innovative new solution. And like other munitions, it has the potential to be purchased in high volumes. We are now producing small quantities of Switchblade to support early orders. And we are prepared to transition to higher production rates as we anticipate accelerating customer requirements.

While we have seen orders delays that we had forecasted for fiscal 2013, Switchblade revenue year-to-date has already exceeded all of its revenue last year. And we expect it will continue to grow next year. One recent news article describes current surging demand for Switchblade. And another reported the Army's intent to initiate a program of record in the next few years, for which we believe Switchblade will be a strong contender.

During the quarter, we acquired the residual assets of Global Observer joint concept technology development program from the government, including the nearly completed airplane number 2. We can now offer potential Global Observer customers more options in considering adoption of this dramatically lower-cost solution for a satellite-like persistence in the stratosphere. We believe there could be a large market opportunity for Global Observer, but adoption timing remains uncertain.

Our electric vehicle solutions hold a leadership position in the emerging market for plug-in electric car charging infrastructure across North America. EV adoption, and therefore revenue from this product line, has been lower than we expected in fiscal 2013. However, multiple factors continue to support long-term electric vehicle adoption. Automotive OEMs plan to bring about two dozen new models of electric cars to dealerships by 2015. And we are well-positioned to support and to benefit from this future growth.

None of these growth opportunities will salvage our revenue projections for the balance of fiscal 2013 that have been reduced by delayed procurements. Some, however, are poised to grow significantly in our next fiscal year. And all have the potential to drive long-term compounded growth for years to come. We will continue to focus on all five of our growth drivers, including maintaining leadership in our current served markets. In particular, we will continue to invest in launching these new opportunities and in positioning AV to lead in these new market areas, as market adoption expands.

Now I will turn it over to Jikun for a review of Q3 and year-to-date financials.

Thank you, Tim, and good afternoon, everyone. AeroVironment FY 2013 Q3 results are as follows.

Revenue for the third quarter was $47.1 million, a decrease of $24.9 million from Q3 last year of $72 million. Looking at revenue by segment, UAS revenue was $37.7 million, a decrease of 34% over the prior year. The decrease in UAS revenue was largely due to lower service revenues of $15.2 million, driven by lower retrofits of Raven B systems with DDL, as wells as mission services.

We also recognized lower product deliveries of $10.2 million, driven by lower Puma deliveries, but offset by higher WASP deliveries. These decreases were offset by higher customer-funded R&D work of $5.8 million, largely due to the reimbursement of costs associated with the Global Observer JCTD contract. EES revenue was $9.4 million, a decrease of 36% from Q3 last year, primarily due to lower hardware deliveries and installation services across all three of EES's product lines.

Turning to gross margin. Gross margin in the third quarter was $19.7 million, down 28% from the third quarter last year. Gross margin as a percent of revenue was 42%, versus 38% in the third quarter last year.

By segment, UAS gross margin was $17.1 million, down 26% from the third quarter last year, primarily due to lower sales volumes. As a percent of revenue, UAS gross margin was 45%, compared to 40% in the third quarter last year. This increase in gross profit percentage was driven primarily by lower manufacturing and engineering overhead costs.

EES gross margin was $2.6 million, down 39% from the third quarter last year, primarily due to lower sales volumes. As a percent of revenue, EES gross margin was at 28%, versus 29% in the third quarter last year.

SG&A expenses for the quarter were $10.4 million or 22% of revenue, compared to $12.9 million or 18% of revenue from the prior year. The decrease was largely due to lower accrued incentive compensation as a result of not achieving anticipated financial performance.

R&D expense for the quarter was $10.3 million or 22% of revenue, compared to the prior year amount of $7.2 million or 10% of revenue. The increase was largely due to the procurement of government property associated with the Global Observer program.

Operating losses for the quarter was $1.1 million or negative 2% of revenue, compared to the prior year operating profit of $7.3 million or 10% of revenues. Operating loss was due to the lower sales volume generating lower gross profits.

The effective tax rate for the quarter was 553.6% benefit, versus the prior year period of 23% expense. The difference was due to accumulative catch-up impact of the federal R&D tax credit and lower overall taxable income. Net income for the quarter was $3.9 million or $0.17 per fully diluted share, compared to $5.7 million or $0.26 per fully diluted share in the same quarter last year.

Now moving quickly through our year-to-date Q3 FY 2013 results. Revenue for the first nine months was $186 million, down 13% from the prior year period of $214.3 million. By segment, UAS revenue was $151.9 million, down 14% from the prior year. The decrease in revenue was largely due to decreased service revenues of $31.3 million, driven by lower retrofits of our Raven B systems with our DDL, as well as mission services.

We also recognized lower product deliveries of $8.2 million, driven by lower Puma deliveries, but offset by higher Raven and WASP systems, as well as gimbal deliveries. These decreases were offset by higher customer-funded R&D work of $15.1 million, primarily driven by Switchblade. EES revenue was $34.1 million, down 10% from the prior year, primarily due to decreased product deliveries of our electric vehicle test systems and passenger electric vehicle charging systems, but offset by industrial electric vehicle charging systems.

Gross margin for the first nine months was $74.8 million, compared to $79.8 million a year ago. Gross margin as a percent of revenue was 40%, 300 basis points higher than the prior year.

By segment, UAS gross margin was $63.3 million, down 10%, primarily due to lower sales volumes. EES gross margin was $11.5 million, up 25%, primarily due to a lower sales mix of low-margin products, as well as low manufacturing and engineering overhead support costs.

SG&A expenses for the first nine months was $37.2 million or 20% of revenue, compared to the prior year period of $38.8 million or 18% of revenue. The decrease was largely due to lower accrued incentive compensation as a result of not achieving anticipated financial performance, offset by higher business proposal activities.

R&D expenses for the full year was $27.8 million or 15% of revenue, compared to $23.6 million or 11% of revenue in the prior year. The increase was largely due to the procurement of government property associated with the Global Observer.

Operating income for the first nine months was $9.8 million or 5% of revenue, compared to $17.3 million or 8% of revenue last year. The effective tax rate for the first nine months was an 8.9% benefit, compared to the prior year tax rate of 28.3% expense. The decrease in tax rate was primarily due to accumulated catch-up impact of the federal R&D tax credits, as well as lower overall taxable income. Net income for the first nine months was $11.2 million or $0.50 per fully diluted share, compared to $12.7 million or $0.57 per fully diluted share.

Looking at backlog, funded backlog at the end of the third quarter was $70.5 million, down $22.7 million or 24% from April 30, 2012. Cash equivalents and investments at the end of the quarter totalled $194.7 million, a decline of $5.5 million from the prior quarter. The negative cash flow was driven primarily by investments in Cybaero convertible notes and higher working capital needs.

At the end of the third quarter, our accounts receivables, including unbilled receivables, totaled 47, down $22.4 million from the prior quarter. Total days sales outstanding were approximately 90 days, compared to 78 days at the end of the prior quarter. Inventories were $63.6 million at the end of the quarter, compared to $44.7 million at the end of the prior quarter. Days in inventory were approximately 209 days, compared to 90 days at the end of the prior quarter.

Now turning to capital expenditures. In the third quarter we invested approximately $2 million or 4% of revenue in property improvements and capital equipment. We recognized $2.4 million of depreciation in the quarter.

Now I would like to turn things back to Tim to discuss AV's expectations for the balance of our FY 2013.

Thank you, Jikun. We have reset our planning assumptions. And we now expect slower acquisition timelines to continue at least until the current budget uncertainty is resolved.

Much of the revenue that we had previously planned for the second half was based on order flow expected in our Q3 and our Q4, which has now moved to fiscal 2014. We now expect Q4 to look more like our low Q3. These planning shifts have moved most of our unbooked, unmanned airplane systems orders out of Q4 revenue, but we are still uncertain about our government fiscal 2012 Raven contract timing.

Our revised guidance for fiscal 2013 at the high end includes the possibility that one-third of the remaining contract funding for the balance of the government fiscal 2012 Raven is authorized and shipped in Q4. And the low end of guidance now assumes no additional shipments are completed in Q4. Our revised guidance for fiscal '13 is revenue of $230 million to $250 million, and earnings per share of $0.30 to $0.60, down from our previous guidance of $348 million to $370 million revenue, and EPS of $1.41 to $1.51. So the current guidance would be $0.30 to $0.50 of fully diluted earnings per share.

I have given you a disappointing report for Q3 and Q4. Over $100 million of planned revenue will have slid from our fiscal 2013. These order delays primarily involve Puma, Raven, mission services and Switchblade. Our preliminary planning for fiscal 2014 anticipates many of these delayed orders previously expected in fiscal 2013 will be pushed out into fiscal 2014.

In addition to ongoing business from revenue drivers one through three, we also expect growing revenue in fiscal 2014 from new contracts for mission services, Switchblade and international small UAS. Our preliminary planning for fiscal 2014 combines those revenue components and our assumption that longer contracting timelines will continue, at least until the budget is resolved. We assume sequestration will affect our government contract revenue next fiscal year. But any final budget resolution could also alleviate the procurement delays that we are currently seeing.

Our preliminary assessment suggests optimism for fiscal 2014 revenue growth if we see evidence of a few key success factors. Those key factors include a return to predictable government acquisition timelines, and significant new contracts for Switchblade, mission services and international small UAS. We expect to finalize our planning and provide annual guidance as usual on our Q4 call.

I expect that you will have many questions for me, Jikun and Tom. So let's open up our Q&A now and we will take the time we need for you to ask them.

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)

Jeremy Devaney from BB&T Capital.

I guess right out of the gate, first question is -- at what point in the quarter did you have a sense that you were essentially going to miss consensus numbers by more than half? And given any sort of visibility that this was going to be the width of the miss, why was there no inclination to provide an earlier guide-down?

Well into Q3, Jeremy, we still expected to close on the orders that we had planned to receive in the quarter. And we were prepared to ship those in the quarter. So it was very late in the quarter that it became obvious that they were not going to close in time. And so I -- the answer to your question is, almost through the end of Q3 before we understood the extent and the timing of the order delays that we were seeing.

All right. Turning to customer behavior a little bit. In your preamble, you mentioned that you are changing your forecast method and also keeping your communication with clients. Given the narrow scope of your product set and the number of procurement offices that you're dealing with, what specifically are you doing to further deepen your communications with the customer that you weren't previously doing?

Well, we are certainly dramatically more sensitive to the timing issues of the contracting process. And based on that, our dialogue with customers, where it's appropriate to have dialogue, is focusing both on higher frequency of customer contact and a more acute focus on the customers, not only their intent, but their constraints in executing the timing of the contracts.

Joe DeNardi from Stifel.

Tim, could you provide a little bit more color around the outlook for Q4 in terms of how much of the revenue you're expecting is already accounted for in orders? And also, it looks like it will be a similar quarter from a revenue perspective. But are the margins or costs going to be higher, and that's what's accounting for the loss?

Well, let me address that first by saying that we have obviously been leaning much harder into Q4 as we saw the results from Q3. And we have been adjusting our outlooks up until late last week to be most accurate. At this point, the low end of our guidance anticipates that there will be -- the shipments from UAS will be limited to current backlog that is available for shipping in Q4. And even in our EES segment, we have limited our expected revenues to what we believe is a conservative proportion of book and ship business that's typical in that segment.

Okay, that's helpful. And then I guess another question on the -- you spoke about changing the process by which you are forecasting order flows internally. Should we expect that to impact the guidance that you provide going forward? I mean, do you plan on being more conservative, at least until the budget uncertainties lift?

Yes. We are absolutely more conservative now than we were a quarter ago, based on what we've seen in the extent of the order placement delays that we anticipated. And I think I mentioned in my comments that we -- our replanning is based on the assumption that the timelines we are seeing now will continue, at least until the budget is resolved. And even then, we will wait for some trend data to cause us to revert to the mean on expectations of contracting timelines.

Noah Poponak from Goldman Sachs.

Tim, I wanted to try to see if you could help us better understand what was so much different in this quarter versus the past year or two. I mean, I guess the obvious answer to that is sequestration is actually happening now. But we have been in a, I don't know, 18- to 24-month window where a lot of short-cycle defense businesses have been saying that the procurement officer is not ordering because they are uncertain and/or they think sequestration might happen. We've had a number of other shorter cycle or revenue-concentrated defense businesses pre-announce, or have similar results to what you just posted, for that reason. And through that entire pocket, you guys kind of just survived it. So is there anything you can share with us that was -- that's been significantly different in what the customer is doing or saying in the past 1, 2, 3 months, versus the past 12, 18, 24 months?

Well, we started -- you might recall, Noah, we started the year anticipating that the -- between the continuing resolution and the sequestration issues, that we were likely to see extended delays in government contracting. And based on that, we derisked our plan. We produced a guidance that had lower growth rates and a wider range than we had done in the past for that very reason. We saw quite a few of those delays in the first half. But based on the original derisking of our plan, we were still within our original guidance. We had replanned some of those delayed contracts to push into a larger Q4. But we were confident in being able to execute on that revenue based on our -- that higher revenue in the fourth quarter, based on our history, assuming we had the contracts. So even after we'd had our Q2 earnings call, we were still expecting these contracts to be placed in the timeline that we had anticipated. It was, as I mentioned previously talking to Jeremy, it wasn't until late in the third quarter that it became obvious that these timing expectations were going to continue to push out. So --

Okay.

I think we are -- we may be more susceptible than many, because of our business model.

Yes.

We know we are a [fine] contractor and so our contracts come directly from the government, not through a different contractor. We bill to inventory, and we have very short lead times, which is unusual for typical prime contractors.

Right. But there are other businesses that have similar characteristics that saw this two quarters ago, three quarters ago, five quarters ago. And you guys kind of didn't. What I am really getting at is, I'm just very curious how much the anticipation of sequestration just actually really happening was -- really changed behavior across the entire customer set for defense companies very recently. Or if this was more kind of random that happened on your products in this period of time. I don't know if you know the answer to that or not.

I think a contributor to that, Noah, was availability of contract vehicles. A number of our product lines had contract vehicles available to them where funding can be rapidly placed upon them. As the year progressed, those contract vehicles either expired or had been used. And the ability to put new contract vehicles or having a greater impact on our second half than it would have had on our first half. So though we saw delays across the board, the manifestation became truly impactful in the second half.

Brian Ruttenbur from CRT Capital.

First question. I wanted to follow up on one question that was asked earlier about Q4 margins, gross margins. What were those? I didn't hear the answer to that.

Yes. So this is Jikun. Let me try. I think you're trying to compare Q3 margins to Q4 margins, and coming to conclusion that Q4 might be low. Keep in mind, we had some [Qube] catch-up impacts in Q3 related to our bonuses. Having reduced our guidance, we had to make adjustments to our bonus accruals. And that pretty much hit in all of Q3.

Okay. So can you give me an actual number? 40%? 45% gross margins? What are we looking for in terms of gross?

Probably closer to -- if you take the bonus impact out, it would be closer to 35%.

Okay. And you have bonuses in the gross. Is that right?

As well as G&A.

Okay. So it's -- the fourth quarter is a bit closer to 35% gross margin, right?

That's correct.

Okay, perfect. The next question I have is revenue to get break-even on a quarterly basis. What is that magic number? Is it $50 million? Is it $40 million? Do you have to right-size to get to that? Maybe you can address that. And maybe on a yearly basis, can you be profitable on $200 million of revenue?

So break-even is a function of obviously many things, including G&A spend and R&D spending. Historically, if you look at the common-sized income statement that we historically operated to, it turns out to be about $60 million to $65 million. That's break-even. Now in Q1 we have made some variable as well as fixed cost adjustments to try to break that down a little bit. But that's currently where we are operating.

Are you -- is there a plan in place, given the uncertainty of both your markets kind of near-term, to bring the break-even down to more like $50 million a quarter? Or is some magical number out there? Maybe you guys have something in mind.

Well, as Jikun mentioned, Brian, we did right-size the business in the first quarter to be -- have a conservative base going into what we knew was the uncertainty during the year. We believe we are going to see the orders that we had planned in Q3 -- I mean in fiscal '13, show up in fiscal '14. We also believe that the significant investments in new opportunities are coming to fruition, particularly in the area of Switchblade, mission services and international UAS. So I think if we were to reduce our resources significantly at this point, we would materially affect our ability to execute on those delayed orders when they come in and to capture and execute on the growth opportunities that we believe are in front of us in the three particular areas I mentioned.

Howard Rubel from Jefferies.

One big question, one small question. You talked a couple times, Tim, about buying back the Global Observer, I guess, property rights. And I think there was either some revenues or some R&D in the quarter. Could you elaborate on that a little bit?

Yes. I will take the first part of the question, Howard, and then pass the financial details to Jikun. When the JCTD program for Global Observer concluded last year, we had residual assets that included the second airplane that was virtually complete, and significant production capacity and test capabilities, much of which was owned by the government through the JCTD program. After an extended period of time, we reached an agreement with the government to acquire all of those residual assets. So that -- and that was comprised of three pieces of that overall agreement. And two of those, I believe, have now concluded and were recorded in Q3. So what we -- the situation we've had -- found ourselves in prior to last quarter, was maintaining the assets. But not being able to do anything with them because they were owned by the government. Now that we have acquired ownership of the airplane number two and the balance of the assets, we think we are in -- we have many more degrees of freedom in what to do with those assets by way of supporting potential customer interest that could develop in acquiring that capability. So in terms of what the financial implications of those transactions were, I will pass it to Jikun.

Sure. I think we talked about this in the prepared remarks. There was two components to it -- the acquisition of the residual aircraft, as well as the government property. That was about the difference between the R&D spend, it's about $3 million. Most of that was for the expense related to the acquisition of those assets. The second item that you probably are questioning was my remarks about R&D revenues increasing as a result of payment for cost incurred on the Global Observer. If you remember, after the mishap, we had some clean-up activities, and the contract vehicle at that time was capped out. So we had to incur those costs and put them on the contract, and this was basically an equitable adjustment related to that contract.

But there was an increased loss, I guess, is the way the to think about it. And then the following question is -- Tim, I realize that retreat is probably not in your vocabulary. But I'm sure you're doing some -- a little bit of soul-searching after what you've seen here. So how, when you talk to your government customers -- and how do you sort of re-size the market so that you can return to the customary levels of profitability? What are you sort of asking of your management team?

Well, part of what we have done, Howard, in addressing the significant reduction in the revenues that we had expected -- orders and revenues that we had expected in Q3, is to increase that dialogue with customers that I mentioned. We've also significantly modified and increased the management review of our planning process and the outcome of that process. And we are institutionally assuming longer procurement timelines than we previously had until we see that change. So I think that's the primary immediate reaction that we've had. And of course, we are leaning into the assurance that we can anticipate future receipt of most of these contracts that are delayed. And we are very heavily focused on assuring the success of the new business initiatives that we have been pursuing.

Thank you.

Tyler Hojo from Sidoti & Company.

Tim, a few times through this call you've said that you expect some of these delays to materialize in 2014. So they are delays as opposed to order cancellations. I guess what I'm trying to understand, or like your comments on, is what gives you the confidence that those delays don't ultimately become cuts?

We have reached out to each of those customers, Tyler, and asked that question. And all of our customers have said that the issues that we are experiencing are delays. They still expect to proceed with those contracting actions. In a few cases, we have had customers be uncertain about how much funding they will have for some of those contracting actions. And that's based on concerns about waiting to see what their sequestration issues really turn out to be. But in no case have we found a customer that's even implied that they intend to cancel those requirements.

Okay, certainly helpful. And then maybe just moving to something else. In regards to the EES business, you talked about electric vehicle and some of the softness there. But could you maybe comment a little bit about how the industrial PosiCharge business is holding up?

Sure I can. For everybody else's benefit, we have three primary product lines in our EES segment. One is the on-road electric vehicle charging infrastructure. One is PosiCharge, which is a fast-charging infrastructure for off-road electric vehicles like forklifts and airport utility vehicles. And the third is test equipment for the development of electric vehicles and battery packs and the like. So the PosiCharge business has been holding up well. That business tends to follow capital equipment acquisitions in the general economy, and particularly follows the procurement cycle of forklifts, and electric forklifts, of course, in particular. We continue to maintain a leadership position in the market share in that segment. And we are also bringing new products to market in that product line that we think will continue to support our long-term market share position there.

Michael Ciarmoli from KeyBanc Capital Markets.

Tim, maybe staying on Tyler's kind of line of thinking with '14, and with maybe how we are supposed to even think about a revenue plan here. I mean, if we take the mid-point of your guidance and the revenues that slip, that points to a $360 million number. I mean, what's really the -- I'm trying to get a sense of the upside in talking about these revenues that will just come back in. Why not talk down expectations similar to the rest of your smaller-cap defense peers who have done the same thing? The market is a complete unknown right now. Why not talk down the expectations and manage this business according to the environment right now?

Well, I certainly don't want to sound like I'm hyperbolic about expectations. I think what I recall saying in my prior comments was that we see opportunities for growth next year, assuming we can return to a predictable level of government contract timeline forecasting. And that we see success in and significant contracts in Switchblade, in mission services, and in unmanned aircraft systems. I think we definitely do not see these changes as a complete shift in our business level. Although there's no question that until this uncertainty is resolved, we can't be confident of when we can see these order placement timelines begin to close in a predictable level. So I take your point.

I mean, does that go as far as the recent $248 million contract? I mean, that funding vehicle is out there. So presumably, that's going to be delayed. But then there is, I guess, competition on that as well. I mean, is this clouding the entire environment for you guys, including that? You guys talked pretty optimistically about that contract just on the last quarter. Is there skepticism now with that contract, and the timing there as well?

Well, I will try to take different pieces of an answer to that. In one case, I think there's uncertainty in any government contract now that's not expended. So the potential for a sequestration to affect new contract releases, or to even affect existing contracts that are committed but not spent, will exist until that gets resolved. But as to the specific new IDIQ contract that the Army awarded to us and others for $248 million last quarter, that includes the anticipation of addressing their requirements for Raven and Puma and other developing requirements over time. It's our understanding that the Army intends to continue to procure Ravens and Pumas, and to do so under that new IDIQ contract. A statement that I saw recently in public said that they have no intention of changing their program of record acquisition for those two platforms. They have opened up the IDIQ contract vehicles for other customers and other requirements. And that they -- we know that they originally stated in their RFP for that proposal that there were potential other small UAS that they may decide to buy in the future, that would come out of this contract. That I interpret to mean the family of systems, CPD, that the Army's been working on for some time and still hasn't resolved.

I want to add on to that a little bit, if I could, Michael. When I spoke to Noah earlier, I talked to one of the impacts in our second half was not having contract vehicles available to us. I believe that $248 million IDIQ that's now been put in place through PM UAS will be a tool that will open up opportunities for us to secure future orders, and takes away one of the hurdles that we've had in the second half of this year. To date, we haven't received any orders from that, so maybe that's an expression of optimism. But I do think it's an issue that we've had to deal with in the second half, and that contract is a vehicle that could help alleviate that issue.

Peter Arment from Sterne Agee.

Just a question. Maybe, Jikun, could you give us the unfunded backlog level, if you have that?

Sure. Unfunded backlog was $76.6 million.

Okay. So there was really -- so there's been no change in that after the last quarter?

Correct.

Okay. And then just -- if I could just dig a little deeper on the backlog question. I guess, Tim, you've given us a lot of color on the push out of roughly $100 million of revenues from this year. Is it fairly evenly split between Puma or Raven, what you were expecting? I know you obviously assume there might have been some additional Switchblade in there. But how do we think about that push out of what the mix looks like?

Yes, so let me try to take a crack at that. So basically going from the mid-point of prior guidance of $359 million to the low end of current guidance of $230 million, you have about $129 million that slipped. About $30 million of it was due to the GFY '12, which at the low end of guidance, we have not put anything in for. EES -- we are now expecting a lower performance relative to FY '12. So we took $10 million off of there. And there's about $70 million between non-GFY '12-related small UAS, both domestically as well as internationally, as well as Switchblade. So those two things have been combined. And there's about another $17 million, $18 million of various CRAD services where the timing of customer interaction becomes a risk factor for us. So now that takes you to the low end of the $230 million guidance. To get us back into the high end of guidance, we add $10 million of GFY '12 back, and we are able to execute on some of those risks of the $18 million that we have identified.

Okay. Is there a concern -- because we've seen this with others and it kind of relates to something that Noah was talking about. Where you've seen money that just had not been -- might have been authorized from a previous budget, but had not been obligated and that ultimately could be reprogrammed. Has there been any conversations along those lines?

No, I don't think we have any current contracts in -- if you're saying current contracts with unfunded requirements on them. Maybe if you rephrase the question, Peter, I could make sure I'm answering what you asked.

Fine. Any unfunded under the current contracts that you have that might be -- that could be vulnerable to reprogramming, amongst the budget pressures?

From an unfunded backlog standpoint, I guess it's possible. But we haven't seen those kind of actions in the past.

And right now the contract that comes to mind that might fit in that -- the category of that question, would be the government fiscal '12 Raven contract which was placed as a letter contract many months ago, with an initial funding amount I think in January or --

it was June 5. It was $15.8 million. And it increased to $32 million in September.

So the -- and it was the completion, the completed funding and completion of that contract that we had anticipated in Q3 that didn't happen, that caused the largest part of our reduction in revenue, compared to our expectation during the quarter. So to the degree that that isn't completed, I suppose there's always a chance that it could be just terminated at that point and not completed. It is fully funded and we have seen no expectation or heard nothing from our customer that would indicate they are contemplating that. In fact, I believe that the users are going to be anxious to get access to the hardware. So it would be a big surprise if that happened. But then, we had a big surprise last quarter.

Andrea James from Dougherty & Company.

I'm just going to follow up on the last one a bit. So is the $30 million from 2012 -- is that included in your funded backlog or is that separate?

It is not included on our funded backlog.

So maybe this -- just maybe you could help me understand the accounts and how it sort of flows through the government. Because where is that $30 million right now? Like where did it go, I guess?

So it remains with the customer in the contracting office, Andrea. We have -- back in June of 2012, we received an undefinitized contract from the Army that had a potential value of $65.8 million. To date, we have received roughly $32 million of funding against it. And we are in the process of negotiating that. When that is negotiated, it will be fully funded.

Okay, thank you. And then your international business. I was wondering what extent some of that could offset what's going on with the government. And then also, doesn't some of your international order flow, like, go through the US government contracts? And so is there an effect there or -- yes, could you just explain that, please?

Yes. To the first question, Andrea, we do expect continued growth in the international small UAS orders and revenues. We saw growth year-to-date over all of last year in that category. And as I mentioned before, the pipeline of requirements and opportunities in that area are higher by multiples than they have ever been before. So we believe there is good reason to expect that that will continue to increase. And to the extent that it does, it, like growth in Switchblade and mission services, provides growth opportunities outside of our historic base in DoD small UAS. So beyond that, there are two primary methods by which we receive contracts from international customers for small UAS. In one case, they are commercial contracts. We acquire an export license from the Department of State that allows us to market and sell and deliver the small unmanned airplanes to a specific customer. And we now have about two dozen international customers for small UAS.

The other way that other countries buy our small UAS is through foreign military sales. In that case, their government deals directly with our government, and they buy our products from the US government, and then the US government places those contracts with us, and takes delivery and then delivers them to the other country. To date, most of our sales have been commercial. But increasingly, we have had sales going through the FMS, or foreign military sale process. And when that happens, we end up usually with more contracting time required. And recently we have seen increased delays in those contracts, relative to what we had been told to expect. So it's a good point that you're clarifying there.

Thank you. So it sounds like some of the -- the government is so backed up, that even the stuff that's flowing out of the country, it's just getting backed up along with everything else.

We have seen these delays literally across the spectrum of our UAS business, and for various apparent reasons. But it's certainly pervasive.

Thank you so much.

Josephine Millward from The Benchmark Company.

The Switchblade has been very successful in Afghanistan. I understand there's an urgent requirement for more. Can you help us size this opportunity and talk about timing?

Well, there have been two or three published articles recently addressing Switchblade. One of them stated that there has been a surge of demand from the theater for significant additional Switchblades beyond the 75 that were acquired by the government last calendar year. Another article stated that not only was there strong support from users, but there was intent on the part of the Army to put a program of record in place within the next few years. And so that's not inconsistent at all with what we have been hearing from our customers. I don't want to go beyond what's been released by our customers in public, but I would say three things. Two that I -- repeat three things that I stated earlier. One is that Switchblade revenue year-to-date has already exceeded the entire revenue from last year. The second is that we expect significant growth opportunities from Switchblade to materialize. And the third is that we understand that the Army intends to put a program of record for -- called LMAMs -- in place in the next few years. And we believe that we will be well-positioned to compete for that.

Okay, that's helpful. How about an update on this [key department] Jones surveillance services contract? The last I heard, I think an award is expected sometime in March and April. Do you think that might get pushed out?

Well, this is the Department of State RFQ and procurement process for UAS support for US embassies that I think you're referring to.

Right. Exactly.

Right. And that is a -- that anticipates a five-year IDIQ with a $1 billion ceiling on it. That procurement has been ongoing for almost a year now. I'm not sure when -- maybe not -- maybe not quite that long.

Maybe eight months. Eight or nine months.

But it's -- a penultimate element of that procurement process was designed to be demonstrations of hardware capability and the execution of the services that are expected to be acquired. It's my understanding that is still ongoing. We have completed our demonstration. I mentioned before, but I believe that our operating services team is literally the gold standard in the world. And I am confident that when these demonstrations are completed, that will be apparent. It's -- I don't want to predict for the customer when they will complete that -- their evaluations and make their decision. But the original schedule that was published had the demonstrations being completed immediately before a customer decision on how they were going to go forward. So I would think that would happen in the foreseeable future.

Okay. What about an update on NRG Energy's plan to invest to build an electric vehicle charging network in California? Do you see this as an opportunity for your EES business this year?

We do see that as an opportunity. As you know, we are working with NRG in Texas. We have supported their eVgo electric vehicle charging business there in both Houston and Dallas with our hardware and our software and our installation. NRG has announced an agreement with the State of California to deploy significant electric vehicle charging infrastructure throughout the state. They've also said that they expect that to be, from their perspective, a competitive environment in terms of what hardware they select for that. And they have made no announcement yet, but we will be anxious to support them in any way that we can.

Jeremy Devaney from BB&T Capital.

Last few quarters you have gotten in the custom of providing a guidance visibility roll-up. Don't want to see you get away from that and I was hoping you could give us that build-up on the call.

Sure, Jeremy. Let me take a shot at that. So we have $186 million of actuals behind us. We have identified $70.5 million of funded backlog, of which only $55 million or so we will be able to get in FY '13. We have booked $4.4 million quarter-to-date, which puts us at $245 million, with another $5 million to go to get EES at roughly $5 million below what we had last year. So if you add the $5 million, you will get back -- get us up to $250 million. Now there's about $20 million of risk in that backlog number that we have identified. That will take us down to $230 million. And when you add back the $10 million of GFY '12 and some of the opportunities to recoup some of that risk to get us down to the low-end number, you get back up to $250 million.

That's very helpful. Thank you, Jikun. Wanted to go back to a question -- Peter brought it up, and I think a couple other folks did as well. On the Raven GFY '12 money, there is a government policy around sequestration was to take non-obligated funds and pull them back in, score them against the sequester? From what you are saying, you don't see those GFY '12 Raven funds as going away. But my understanding of the way that the sequester works, if it wasn't definitized, you are very likely to lose those in the future. Any thoughts on that?

I think that we see that it's potential of those funds could go away. We are remaining very close in contact with our customer on this topic very regularly. The subject of these funds being in jeopardy have not been raised. Having said that, I think both sides are working very hard to close out in the negotiations of the contracts so that all funding can be allocated to the contract.

All right. All things being held equal, if we look at the GFY '13 mark-up that was last in the Senate Armed Services Committee, the funding level for the Raven was on the order of -- I think it was $35 million. I don't have the number at my fingertips. But roughly on the order of what we were expecting this year for the GFY '12 money, excluding anything that we were just discussing. So I mean, if the go-forward run rate for the Raven is roughly $30 million, what gives you confidence you can grow the business from here without your premier line of business growing?

Well, we have been talking for over a year, Jeremy, about the transition in our small UAS business from a Raven-only base, or dominantly Raven, to a family of small UAS that includes Raven, Puma, and Wasp at this point. And in a couple -- at least one of those years, Puma revenues actually exceeded Raven revenues. And I think that was a couple of years ago. So for the last few years, there has been a change in the component of our small UAS business moving from primarily Raven to a family of small UAS. The second thing that's been going on is a transition from a UAS segment that has its dominant revenue coming from small UAS only, to a UAS segment that's moving towards multiple different sources of revenue from different product lines. And those would include Switchblade, mission services, and the increased component of international customers buying small UAS, in addition to the Defense Department.

I think a little beyond the current future, we expect to see national air space customers that are not military, initially public safety customers in the United States and other countries, begin to adopt small UAS. And that moves completely away from defense markets. The other thing that could happen farther out, and I don't think this will be in the next few quarters, is the opportunity to take this Tier II unmanned helicopter that we have acquired initially to augment our small UAS for mission services, and then provide that as a stand-alone system to a different subset of the UAS market. So the bottom line of that is a transition beyond just small UAS generating the revenue for our UAS segment, to small UAS from DoD and a number of other components generating revenue going forward.

Michael Ciarmoli from KeyBanc.

Tim or Jikun, in terms of thinking about a -- I guess you mentioned the break-even point. How do we think about -- now that you're buying the Global Observer assets, presumably you are going to have to spend some R&D dollars there or increase your spending on that platform. How should we think about that as it impacts the operating model going forward?

Well, I don't think we necessarily have to increase our R&D in that area, Mike. To date, we have maintained a level of R&D spending on the Global Observer program. But it's largely been focused on assuring our ability to execute on a production start-up reliably. And more of our investment has been on the G&A side in our work with potential customers to help push forward the probability of adoption of Global Observer. So at some point in the future, we may decide to invest more heavily internally, but we haven't done that to date.

So you're trying to get a customer to potentially pick up the funding. I mean, presumably you've got to finish the plane, go through the whole envelope of flight testing. And you are saying you guys are not -- you are going to basically try to get customers to fund that? Is that how I should think about this?

To date, that has been our approach, and is currently our approach.

Okay.

We think it's important with this kind of a system capability to be moving ahead with a customer. In the past, we have invested significantly in our -- with our own R&D funds. But after the initial development and demonstration of the prototype, we did that with customers. And I think so far, we have continued that approach.

Okay, fair enough. Thanks, guys.

Thank you.

Andrea James from Dougherty & Company.

Just trying to unpack a little bit of the messy process for you guys. I know it's frustrating. But once a dollar is classified in such a way that you count it as funded backlog, is that dollar past the point of where it could be reprogrammed to a non-AeroVironment item?

I think it's past the point where it could be reprogrammed, Andrea. There is always the possibility that the government could come in and terminate a contract that has been placed, and then go through a termination process and recoup some of the funding that had been committed to that. But that hasn't happened. We don't have any dialogue around that possibility.

So those dollars are just -- are they just caught up in a log jam then? And I guess I'm curious about what -- it seems like it is going to come to you, and it's just a matter of timing. But does anything need to change for that log jam to clear? Or is there something that you're looking to see? Or is it just a matter of time and it's just hard to predict?

I think it's the latter. As Tom indicated before, we are work -- in that particular contract area, we are working very closely with our customers. We are supporting them as best we can. And they're just dealing with their contracting requirements as best they can. And it's taking much longer than any of us thought it would.

That's helpful. I appreciate that. Thank you for the clarity.

Thank you. And we have no further questions in queue at this time. I would like to turn the conference back to Steven Gitlin for any concluding remarks.

Thank you, Karen, and thank you all for your attention and 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 at www.AVInc.com. We look forward to speaking with you again following next quarter's results, and are open to any questions at IR@AVInc.com. Thanks very much.

That concludes today's conference call. Thank you for your participation. You may all disconnect.