Frequency Electronics Inc (FEIM) 2007 Q2 法說會逐字稿

Good day and welcome to the Frequency Electronics second quarter fiscal year 2007 earnings conference call. At this time, I would like to inform you that this conference is being recorded and that all participants are in a listen-only mode. At the request of the Company, we will open the call for questions and answers after the presentation.

Statements in this release which are not historical facts are forward-looking and involve risks and uncertainties including, but not limited to, the impact of competitive products and pricing, increased investments to support product introduction, market acceptance of product, product transitions by the Company and its competitors, currency fluctuations, changes in product sales mix and other risks described in the Company's registration statement and other Securities and Exchange Commission filings.

At this time for opening comments and introductions, I will turn the call over to Mr. Martin Bloch, CEO. Please go ahead, Sir.

Good morning, everybody. This is Martin Bloch. We are missing General Joe Franklin and we wish him well. He had some minor surgery and it was inconvenient for him to be here. And I would like to basically introduce Allen Miller who will walk you through the financials of Frequency Electronics for the past quarter and the past six months and I will address the business areas and progress of the Company. Allen?

Thank you, Martin, and good morning, everyone. For the second quarter of fiscal year 2007, Frequency recorded revenues of $14.3 million compared to $11.5 million in the prior year. This is a 25% improvement in revenues; and for the first half of the fiscal year 2007 we have experienced a 27% increase in total revenues.

These increases were led by increases in both satellite payloads, and wireless infrastructure. Our cost of sales for the quarter were $9 million compared to $7.4 million last year. Gross margin was $5.3 million compared to $4.1 million. The margin for rate for the first -- second quarter, excuse me, of fiscal 2007 is 37% compared to 36% last year and up from 34% in the first quarter of this current fiscal year.

Selling, general and administrative expenses were $2.7 million compared to $2.5 million last year. The rate of expenses in the fiscal 2007 period is under 20%, which is in line with our target as compared to 22% in the year ago period. As we indicated in the call in the first quarter, FEI began expensing stock-based compensation during fiscal 2007; and during this current quarter we realized $152,000 of such costs, $75,000 of which is included interest in SG&A balances in cost of sales.

Research and development spending for the quarter was $2.6 million or 18% of revenues which is approximately double our target. This is compared to $1.5 million in the prior year. As more resources though were committed in this current quarter to satellite payload projects and as results of this additional investment, Frequency is increasing its production capacity on a cost-effective basis.

Operating profit was nominal at 19,000 compared to $56,000 in the prior year potentially breakeven. However year-to-date, Frequency has recorded operating profit of $[710,000] compared to $167,000 in the fiscal 2006 first half. Other income was $350,000 for the year, approximately the same as last year except for the fact that, last year, we had $1.8 million in gains from marketable securities and real estate sales. This yield to net income of $400,000 compared to $1.3 million last year or $0.02 earnings-per-share versus $0.15 diluted earnings-per-share last year, again, as a result of the large nonoperating gains.

For fiscal 2007 Frequency has reported positive cash from operations of over $700,000 reflected in our collections on our accounts receivable and after inventory increases of $3.5 million. And just to comment on inventory, the largest portion of our total inventory is to support our wireless infrastructure and space payload customers. This inventory is committed to be purchased by our customers.

Finally, our backlog at the end of October was $37 million, up from $36 million at the end of the fiscal year ended in April. I will be available for questions and right now I will turn back to Martin for some other comments.

Thank you, Allen. I would like to address the three areas of business -- pardon for my scratchy voice, I will do the best I can. And this is again telecom, the space payloads and, of course, the military.

In telecom I am happy to report that we have gotten commitments from our two major customers for a significant increase in our share of business that we're going to get. And we expect this to realize shortly and hope that their business grows as they think it is going to grow. (indiscernible) just as Allen has mentioned, it was necessary to increase our inventory to be able to accommodate their [burst] which happens quite dramatically and we have had locations to shift from as few as 100 systems per week to as many as 500 systems per week. And we see a positive outlook in that business over the next year.

The secondary business, which is very exciting and this is space payload. In that area we had to do some significant improvement in our structure. From 19 (technical difficulty) to 2002 to 2005 we shipped an average of five to seven microwave systems for space application and that, of course, was very important to establish the technology and the legacy. We are now faced with a business opportunity both in backlog and contracts we're negotiating where we have to increase debt capacity by tenfold. I am happy to say that we made this investment primarily in the past three months to basically be able to meet those commitments, which are necessary for meeting contractual obligations that we have and contracts that we have in negotiation, which we hope to announce very shortly.

With respect to the military market, we have lots of prototyping and the key ingredient is the key patent that we have on the low G sensitivity because that is important for secure communications, for navigation, for (indiscernible) and payload delivery; and it is becoming more and more important as enemies are learning how to decode our information faster to win it had better precision in all of these three areas.

Nothing has resulted in production contract yet but they are a very exciting area which we expect to benefit over the next couple of years on this.

I am also happy to indicate that our backlog since October 31 from $37 million is now approximately $45 million and like I mentioned, we still hope that we're going to be able to announce additional wins, as we are now in the final stages of negotiations. As part of this wireless telecom structure, another key exciting field for FEI is the patented quartz units that we have developed over the past five years are being integrated in the WiMAX and the [pica] cells which we expect will be the largest interest in the wireless infrastructure. This is an upcoming field for which we have delivered prototype and preproduction quantities and expect significant increase in production over the next year to year and a half.

In conclusion, I am very satisfied with the progress we have made with overcoming the enormous hurdle of increasing production capability for our space customers. This is both -- was a necessary in order to support the launch requirements and of course to have the ability to counter additional space contracts. And we are emphasizing this year to significant this year and this coming year, 2008, significant growth in revenues.

As this time, I would like to open this conference to questions and answers. Please go ahead.

(OPERATOR INSTRUCTIONS)

Morgan Frank, Manchester Management.

Hi guys.

Hi Morgan. To whom are you addressing to Allen or me?

Whomever would like to grab the ball. So a couple of questions, on this increase in R&D spending. Is that likely to go back to historical levels next quarter or should we look at this as a persistent increase in the space?

No. It will go back to historical levels. We still plan to be approximately at 10% of sales. This was a kind of investment in order to take a quantum leap in the production capability of space payload hardware.

Okay. Then, looking at the quarter, how much impact was there from the timing of engineering projects and revenue, some whatnot. How much -- the announcement that you made maybe six weeks ago what -- how much effect did that actually have on the quarter? Is there any way to quantify that in dollars?

I suppose there's a way to quantify that. I don't think we have any right at the tip of our fingertips right now but clearly when you take some of the engineering effort away from productive activity as you realize some of our revenues recognized percentage completion basis. To that extent it would have reduced revenues to some degree. What that precise number is I don't -- .

Can give us an order of magnitude? Was it $100,000, was $1 million? Was it --

That could be in the range of a million, sure.

And, Morgan, the best estimate on this point is in the vicinity of $1 million in revenues.

Okay and last question, I'm going to come back to my perennial here. How is U.S. 5G tracking in terms of qualification and being ready for volume shipments to customers?

We have finished all of the qualification tests and tested and are waiting for final office installations on this. I can tell you our job is done. The -- what the RBOCs, how they're going to procure is the $64,000 question. We have no visibility. We have done our part; we have negotiated contracts; we're just waiting for orders to come.

Are you seeing interest on the side?

Great interest but no timeline.

Is that held up by their budget cycle this year?

There's no question they are about to cycle. They are trying to do with limping along on old equipment. Their budget is the key. I just want to tell you that in spite of zero revenues or negligible revenues on the U.S. 5G, because we did have the first production units go in into Europe on the U.S. 5G the wireless telecommunications section is doing great and will account for about 40% of our fiscal 2007 revenues.

Got it. And one last question. Gross margins were unusually strong this quarter. Is that just a mix issue because there was less telecom or what was driving gross margins to be so good?

It is part of the work in line with what we expect; in fact, we're a little bit shy of our target because the revenues were not as high to absorb all of that cost. But they are comparable to last year, 37, 36% -- I think the higher engineering cost in Q1 is what dampened it a bit so I think we're just getting back to a more normal level here.

So as we look forward over the next couple quarters we should expect gross margin to stay around this level or increase a little bit?

We're trying to get it to increase above the level if we can get the sales up to the higher volumes we anticipate.

What is your target gross margin?

[40]% -- the typical target at the roughly level $60 million run rate or whenever you get up to the closer to 100 million that's the sort of thing we've been looking at the mid-40s to 50s.

Great. Thanks, guys.

Buddy Howard, TM Capital.

Hi, guys. Allen, I will look forward to you guys hitting $100 million and 40 to 50% gross margin. Something to look forward to.

I will not be satisfied until we do that.

That is exciting. A couple of questions, the pickup that you're seeing in wireless -- does any of that reflect what is going on in China and can you give a sort of an update of what you see in terms of the China business?

The pickup we have seen has nothing to do with China. China is still on the cusp with no decisions made on this. Although they say any day, there is going to be a decision. We have lots of opportunities both with our present equipment buildup in our hardware that we supply directly to the Chinese builders. And what they say to us is that any day, any day but visualize we're been hearing it now for a year and a half.

But from the last conversation we had with their senior people in government as they say that any day has now come to an end because if they don't get off the chair right now and make some major decisions on those there's no way they're going to have the infrastructure for 2008.

Your facility in China, what percent of capacity do you guys run in that location?

We are running now at about 80% capacity; but we are adding capacity that is -- significantly we will move to new facilities and we have the ability to basically double our present workforce and of course in China it is very easy to go on three shifts.

Okay. So you have got a good ability to expand production there?

Absolutely. We were expanding a lot of services there they are doing for our present business because we have been committed by the major presence of our customer to get a significant larger share of this business that they are doing. We have captured significant increases in market share.

Good. On the satellite cycle I've been very encouraged by the amount of activity there. Can you give us some feel for how long you think this cycle is going to last? We had a long period there where we knew satellites were coming. We talked about it, but it just seemed like it never came and now it seems like that is finally coming to fruition.

Do you view this as a five- to seven-year replacement cycle or can you give some sense of timing on those?

The best analysis that has been made at this moment is that it is about a five- to seven-year cycle where there will be approximately between 17 and 25 satellites procured per year and those are both our new systems as well as for replacement of old satellites.

If you take a look in 2006 as a measure then I think there were 19 satellites that were procured in 2006, and the best projection is that this will continue for the next five to seven years.

Can you remind me how many of those 19 you got?

We got four and we are negotiating on about two to three more, which we expect imminent to be able to announce.

And this engineering expense you have incurred and it sounds like that is part of getting additional capacity in that area, isn't that right?

Say that again, Buddy. I'm sorry.

Your capacity that you've had that you announced earlier -- isn't part of that and I missed the first part of the call -- isn't part of that a part of that a capacity expansion issue?

As I mentioned and I think that is very important to see, from 2002 to 2005, we shipped an average of five to seven microwave frequency generators a year. And there's -- we now had to, in order to meet our present commitment and contract negotiations to increase this capacity by tenfold. And that was the engineering investments on this to really be able to produce some -- in larger quantity and more economically.

Is that all, are you using any outsourcing and getting that tenfold increase?

Well primarily on satellite there's very little outsourcing that you can do except mechanical parts, you know, and the procurement of the basic, on those. At this moment, most of the increase capacity and ability has been in-house.

Okay, perfect. That's exactly what I was asking. Finally can you give us any update of the deep drilling clock? Is there anything new on that front?

Well, they're making great progress but we have no economics to be able to say they have procured some more (indiscernible) to continue their testing and the test results are great from our point of view. We cannot put some numbers on it at this time yet.

That's great. Very good quarter. Thank you very much.

(OPERATOR INSTRUCTIONS) (indiscernible)

Hi, guys. I have a couple of questions. Does the mix of business that you describe for 2007 -- 30% space-related, 20% government DOD and 40% telecom infrastructure -- can you help us understand the absolute revenue level that you expect for '07? So we can better kind of calculate that mix of Business?

Hardin, you have not changed your spots. You ask the same question on every conference call.

Maybe one day you will answer them.

Going to be the same answer. We're concentrating on getting a significant increase in revenue than we did last year. That is the best kind of guidance that I can give you. And basically and with this type -- we have commitment, that we won a major share in the wireless industry from our major customers but they have not quantified how many they're going to buy and when.

So this is why it is so difficult to estimate. And on the satellite I can say again, we have present contracts to fulfill and we are negotiating on significant additions to the contracts; and on the satellite we went anywhere from -- we used to be about $1 million per satellite and now it varies from $1 million to $8 million per satellite. And when we make the proposals we did not know what portions we're going to be able to negotiate on.

So all of these are variables and that is why I am hesitant as in the past two to put out numbers. I can tell you from the [stability] we had is there is going to be a significant increase in revenue from last year.

And significant, is it 10%, 20 -- ?

Again you're trying to quantify it. Let's leave it at significant.

The timing of orders versus shipments of the increase in backlog, I guess from the end of October until today. Backlog is up what is it? $8 million, I think you said, Martin.

Yes, that is about right.

If we talk about a satellite order versus wireless infrastructure or order versus the Department of Defense order -- .

(multiple speakers)

That is a good question; let me give you some -- we can give you some very precise parameters. We have increased the inventory on the wireless and on the space for two reasons. On the wireless, the turnaround that they expect is three to four months of significantly increased production quantities. As a matter-of-fact, we have plans in place where we can increase the quantity for wireless by 3 to 1 in approximately 100 days.

In the satellite, typically, the thing the frequency brings to the table is to be able to reduce the cycle time from approximately a two-year cycle to someplace around a 12- to 14-month cycle. And so that will give you some idea. That is the name of the game. Satellite especially commercial ones, the payloads have to be turned around considerably faster and of course the building blocks have to be turned around even faster.

And what we bring to the table is a faster cycle time, state-of-the-art technology and affordable price.

Okay. The portion of inventory that is committed, can you help me understand how much that is?

More than half of the inventory (multiple speakers) the 26 million is committed. Is committed to wireless and space customers that they will purchase.

More than half of the total balance, is that what you said?

Yes.

And that is more heavily weighted toward the terrestrial wireless versus -- ?

The answer is yes. Allen is losing his voice. Yes it is heavily committed. More than two to one for the wireless.

Okay. All right.

By the way this makes sense because everybody is expecting this burst of the bubble was with what is going to happen to China and they have to spend, according to them, someplace between $10 and $20 billion in infrastructure immediately in order to be able to be ready for the 2008 Olympics. The question is how much will be built with internal CDMA systems and how much they will have to procure from people like Lucent, Motorola and the rest of the players.

What about the -- when I look at the ability of the Company to meet demand I want to try to -- .

I can't hear you. Can you speak up?

Sure. When I look at the ability of the Company to meet incremental demand especially on the satellite side given the scarcity of personal, with that specific knowledge, I want to try to better understand the metrics, that tenfold increase in productive capacity for microwave generators.

This is just an example and we do it by improving the -- basically the alignment and testing techniques so ordinary people can line it up and it doesn't take a bunch of senior engineers and physicists to do it; and by incorporating automatic test equipment to facilitate the testing which is a major portion of this area.

So a lot of the increase in capacity is being turned over to better machines that can do the measurement and testing a lot faster, which is done by the way in a 24-hour cycle.

Does that in any way change your ability to meet proposal activity, because of the internal process change that you have now implemented that is different from your previous (multiple speakers) ?

Absolutely. At this time, the contract we're negotiating, the key question that is being analyzed is our capacity to supply it on time. First (indiscernible) it is assumed that quality has to be tough because that is what Frequency is known for. The second is is our capacity to deliver on the required date. And the third is price. So that is a key element of our ability to capture the programs that we have now in negotiations and all of the future of the proposals.

The last question I have and then, I will get back into line --

Okay.

-- is related the telecom, the wireline business. I mean, it is an opportunity because you now have product in the market that you haven't historically had but there is really no visibility into the timing of order activity, production order activity from -- .

There is none that I have at this point. Every looks like they are encouraging. The (indiscernible) equipment but when it is going to happen I haven't got the vaguest idea.

Fair enough, thanks.

Larry Litton, Second Line Capital Management.

Thank you. I was wondering, as this growth ramps in '07 and '08, is the Company generating cash or are you going to be requiring either equity capital or debt, [ex-general] debt financing?

We expect to generate positive cash flow but I'm not sure what the second half of your question was. Is it -- ?

Basically, this growth will be self-financing?

Yes, yes.

For our growth, we have plenty of cash for internal growth. For any type of opportunities that might come in the acquisition passing and merger we will have to look at what came about.

So the physical plant is okay and the inventory burden would not be significantly above normal?

That is correct. And we have a big advantage. Most of the inventory is basically being committed across contracts and purchase orders which is -- which does not produce a burden on us.

Okay, thank you.

Robert [Limbert]. RL Capital.

Hi. This is just a follow-up. I did not know, Martin, if you got in touch with Interdigital or anything came of that. I know I e-mailed you.

You e-mailed me and I've been so busy about increasing capacity that's what I focused on the last three months. That was my major mission. Now that this is mostly behind us I will have a chance to talk to that.

Okay, great. Congratulations on the quarter and it is a nice opportunity to be a shareholder.

Well, thank you very much. We will continue not to disappoint you.

Great. Thank you.

Kevin Dede. Merriman.

Congrats on the nice quarter. Martin, I was just hoping you the elaborate on your human resource issues. Are you able to find the people you need to manufacture everything?

This is a major problem on this item and we are doing as best we can in this area. The problem is a little bit more complicated because on all of the satellite programs what we need is increasing capacity and we can only use American permanent residence. So there is no way of importing talent from overseas for that. We have to find people that are either American citizens that have top credentials or that are permanent residents.

So that is a challenge and then we have pulled out all the stops to obtain those people; and we are trying to work with them with establishing affiliate relationships to supplement them (indiscernible) . As this moment, there's more work available for us than is our present capacity so this is one of my personal major challenges.

Do you feel you have everyone that you need though or are you -- is that part of the capacity constraint that you are seeing?

I have just enough to meet our present commitment and we have to increase additional for all the future opportunities that we are facing.

So are most of the satellite projects you're involved with related to some of the three letter agencies and the DoD (multiple speakers) ?

No. No. There is a significant as we announced previously, we are contracted and ICO and (indiscernible) which are two new satellite contracts on commercial use; and we have other commercial opportunities as well as the military.

And which -- with regard to satellite, specifically. Of your competitors who do you think you are displacing in garnering more volume on a per satellite basis?

All of our competition is in-house and basically most of this has added electronic hardware, the microwave generators, they would always buy the clock from us because we had the longest and the best history in the field of building clocks over the past 40 years for the older satellite in space exploration program. And people like Boeing, SS [Lurel], Lockheed Martin, Alcatel, would build their frequency generators in-house with us so our competition is really in-house. We're not displacing anybody.

The reason we had this opportunity is that the economics are forcing us to get a more affordable piece of electronics in a shorter cycle time and that is where a small company is ideally suited and the only reason we have the great opportunity because we have the legacy in space and this is part of the [passport] for you to play.

Can you comment, too, on your competitive position vis a vis the wireless business?

Well, all I can tell you is we have been awarded significant increase in our market share from those, due to our excellent quality and efficiency to be able to support their demand.

Okay. Do you think that most of your wins are coming because you're able to meet specifications and specific dates versus -- (multiple speakers) ?

That we are able to meet that demand and our outstanding history of quality in the field. We have over 100,000 Frequency generators in the field and our return rate is the lowest in the industry. And that gives us an enormous edge to obtain larger market share.

I missed Allen's commentary with regard to Accounts Receivable if he offered some. There is sequentially a nice collection and I'm just sort of wondering.

We just basically are collecting on the receivables at appropriate rates. I think we have indicated probably at the end of the four year end and second quarter that it was a matter of timing that we had built out the receivables and were just waiting for some collections that came in right after the end of the quarter. In fact, the same thing happened again at this, the second quarter. We collected a sizable sum in the first week of November so our cash flow could have been even better yet so it is just a matter of timing and this is normal progress (indiscernible) contracts and things of that nature.

Okay. Have you offered investors a target for DSOs or inventory turns?

No. We have never had.

In our case it's very difficult to do because a customer in the specialty and the wireless will come in in-service and we expect peaks and bursts of 521. What are you going to do about it and we say the only thing we can do about it is to build up inventory and you have to give us a commitment on the orders because we're not going to do them on our own. So, and then, how would they turn it around it is a mystery to me. I've never been able to figure it out.

I will give you a typical example. We have one customer that we were shipping approximately 60 Frequency generators a week. They came in on November 23 and said, what can you do to increase this for December to a total of 400 a week?

What are the end uses there, Martin?

The end use is -- additional sales that are being installed and that is the primary use worldwide and the new pica cell and the WiMAX technology that is being proliferated right now.

Okay, got it. Would you mind offering little commentary with regard to seasonality? Last year, the October quarter showed a little bit of an increase and this year, it is pretty much flat. Is that what we should expect going forward?

Not at all. We have no seasonal related in our business; it's just a matter of when the contracts fall and when that happens. We have not been 40 some odd years since I've been in charge of this Company I have never unable to identify any seasonality.

Thank you for taking all my questions and congratulations.

Michael [Omari]. [Amaraco] Incorporated.

Hi, guys. How are you?

Happy Hanukkah.

I'm concerned about one thing that probably you have a solution for. The [Rex and Associates] Realty has been taking over by [SL Greene] and you have a lease on that.

Say that again?

(multiple speakers)

Rex and Associates have been taken over by a SL Greene and would like to find out how this will affect your lease with the Company.

Nothing. We have options that we can exercise for the next ten years and we are solid. There's no problem for us at all.

Another question. You have increased your research and development and I would like to find out if that was just the machine or also adding headcount?

This was everything. It is adding and training people, building automatic tests, and test equipment and the necessary engineering to make the product more producible.

What is the range of the headcount right now?

I think worldwide we are about 520 and FEI over here is 300 plus.

That is a magnificent increase when I asked that (indiscernible). All right, great quarter, great future. And I wish you will stay healthy to lead the Company to $100 million, $200 million.

That is my goal. Any other questions?

(indiscernible)

(inaudible)

(inaudible)

Hardin, speak up. Your volume is barely audible.

I'm sorry. The 19 procured satellites, the number you mentioned earlier for 2006 of the 15 that Frequency did not win, how many of those were I guess who won the rest of them?

They primarily were a built-in house on this, they were a Legacy products that was not practical to turn around and put new hardware; and they were built by -- remember those big boys are not giving up their total capacity. They still keep the capability to build some of it in-house to have the necessary insurance.

Can you help me -- if there are 19 -- let's assume it's 19.

17 to 20, roughly.

For this year? What was last year and what is the industry expectation for '07? Well, the industry expectations as I mentioned is someplace around 107 -- to be exact the study I just reviewed last night is 176 satellites over the next five to seven years.

Okay. So that's either 35 a year.

But you know this projection what we made our plans is there's going to be something. Our business plan is based on a minimum of 17 satellites that will be procured per year and how many we can capture.

And how many does your business plan indicate you will capture?

We want to capture three to four.

Three to four per year?

That is correct. As a minimum.

You have already captured four this year?

Well, we captured more than four but we did not get all the Frequency generators on that. So our objectives in the feature is to capture four with Frequency with the microwave Frequency generators and probably another three or four just the timing and the Legacy part that we were built in the past.

Okay. And that would be toward the higher end of that range of unit values?

Our game plan is to capture four with the higher value.

My last question is related to cash on the balance sheet.

The 23.8 million at the end of the quarter but you're going to receive or maybe already have received some receivable inflow and the inventory balance is highly -- I guess easily converted to cash once deliveries occur, but you have been committed or your customers have committed to buying that inventory. I guess cash flow should improve significantly of the next couple of quarters is what I'm getting at. What are you going to do with the cash?

You're right on the first part. The cash flows should definitely improve over the quarter -- the balance of the fiscal year and as we have indicated in the past, what our primary interest in use of cash is to expand the capability of the Corporation. And that might be a joint venture or an acquisition or something to that nature or (multiple speakers) in-house. Right. So we would commit to a growth plan basically.

Is there anything currently under consideration in that regard?

We are always looking at opportunities. Obviously we cannot say too much at this point in time about anything near-termness or far-termness of the operations -- the opportunities that we have.

Great, thanks guys.

If there are no further questions then I will turn the conference back over to Mr. Bloch.

No more questions, did you say?

No more questions.

I would like to make if a few very concluding remarks wishing everybody a happy and healthy holiday season and I just want to tell you that Frequency Electronics at this time, with the opportunities that we have, are committed to revenue growth. This is our main objective on this because the opportunities that we have in this area. And with that, I would like to wish again everybody a healthy and happy year. Thank you all. Bye.

Thank you. Ladies and gentlemen, if you wish to access the replay for this call, you may do so by dialing 1-888-203-1112 or 719-457-0820 with a passcode of 940-2283. This concludes our conference for today. Thank you all for participating and have a nice day. All parties may now disconnect.