iRobot Corp (IRBT) 2010 Q2 法說會逐字稿

Good day, everyone, and welcome to the iRobot second quarter 2010 financial results conference call.

This call is being recorded.

At this time, for opening remarks and introductions I would like to turn the call over to Elise Caffrey, of iRobot Investor Relations.

Please go ahead.

Thank you, and good morning.

Before I introduce the iRobot management team, I'd like to note that statements made on today's call that are not based on historical information are forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

This conference call may contain express or implied forward-looking statements relating to the Company's financial results, operations and tax rate for fiscal 2010, the third quarter ending October 2, 2010 and the fourth quarter ending January 1, 2011; demand for the Company's products and services; the timing of funding and contract awards under the FCS program, now referred to as the Brigade Combat Team Modernization program; our plans for expansion and new product development and shipment; backlog and demand for our government and industrial robots and related parts and services; timing in order fulfillment; demand for our home robots; mix of product revenue; and business conditions.

These statements are neither promises nor guarantees, but are subject to a variety of risks and uncertainties, many of which are beyond our control, which could cause actual results to differ materially from those contemplated in the forward-looking statements.

In particular, the risks and uncertainties include those contained in our public filings with the Securities and Exchange Commission.

Investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof.

iRobot undertakes no obligation to update or revise these forward-looking statements whether as a result of new information, future events or circumstances, or otherwise.

During this conference call, we will also disclose various non-GAAP financial measures as defined by SEC Regulation G, including adjusted EBITDA, which we define as earnings before interest, taxes, depreciation, amortization, merger and acquisition expenses, and noncash stock compensation expense.

A reconciliation between net income, the GAAP measure most directly comparable to adjusted EBITDA, and adjusted EBITDA is provided in the financial tables at the end of the Q2 2010 earnings press release issued last evening, which is available on our website, www.iRobot.com.

A live audio broadcast of this conference call is also available on the Investor Relations page of our website, and an archived version of the broadcast will be available on the same web page following the call.

In addition, a replay of this conference call will be available through August 5, 2010, and can be accessed by dialing 617-801-6888, access code 69265770.

On today's call iRobot Chairman and CEO Colin Angle will provide a review of the Company's operations and achievements for the second quarter of 2010, as well as our financial expectations and outlook for the business for the rest of 2010, and John Leahy, Chief Financial Officer, will review our financial results for the second quarter of 2010 and provide additional detail on our financial expectations for fiscal 2010, the third quarter ending October 2, 2010 and the fourth quarter ending January 1, 2011.

Then we'll open the call for questions.

At this point, I'll turn the call over to Colin Angle.

Good morning, and thank you for joining us.

I am very excited to report that we delivered record results for the second quarter and first half.

Revenue of $98 million for the quarter exceeded our expectations and was 59% greater than Q2 revenue in 2009.

Adjusted EBITDA of $12 million and EPS of $0.20 also far exceeded expectations.

Following truly outstanding performance by both divisions in the second quarter and good visibility on the rest of 2010 we are once again increasing our full year expectations.

Our revenue and EPS expectations for the second half have increased since our April call.

However, we have taken the opportunity to both increase our investment in the business and increase our full year expectations due to our significant overachievement in the first half.

We expect full year 2010 revenue of between $385 million and $390 million, an increase of roughly 30% over 2009.

We are increasing our expectations for adjusted EBITDA to $36 million to $38 million, an improvement of approximately 75% year over year, and our EPS range to $0.51 to $0.54, more than quadruple our 2009 EPS.

These increased expectations demonstrate significant progress towards our three-year financial goals of mid to high teen revenue CAGR, mid teen adjusted EBITDA margins and high single digit operating cash flow margins.

Profitable growth in the quarter was driven by both divisions.

Home Robot revenue increase was driven by broad-based growth internationally in Europe and Asian markets as well as in the United States.

Increasing demand for our products continues to outpace concerns about a softening EU economy and our current manufacturing capacity.

We were conservative in our planning as we brought on a new contract manufacturer, a scalable tier 1 manufacturing partner.

They will be online in Q4 to meet this growing demand in 2011 and beyond.

Our Government and Industrial Division's revenue growth resulted from shipments of more PackBot FasTac robots and spare parts than a year ago as well as the sale of a significant number of small unmanned ground vehicles in Q2.

Our continued focus on strengthening the balance sheet resulted in quarter-end cash and investments of $99 million, up significantly from $51 million a year ago.

A critical component of improving our financial position over the past year has been driving adjusted EBITDA and operating cash flow.

Adjusted EBITDA was $12 million, or 13% of revenue, compared with a break-even figure in Q2 of 2009, and we generated $15 million of operating cash flow in the quarter.

Our US strategy has been successful thus far.

Not only did revenues grow 20% in the second quarter year over year, but focus on creating the right mix of products and channels in domestic markets significantly increased gross margins.

In Europe, most of our sales are dollar denominated.

Therefore, the fluctuation of the euro has minimal direct impact on international revenues.

However, as the dollar strengthens against the euro our distributors' profit margins decrease and they have less money to spend on marketing efforts to promote our products.

We've taken appropriate action to support our distributors, and some of the planned marketing expense in the second half will go towards our European partners' programs.

In the military business, despite the ever-shifting landscape in Washington, demand for our robots remains strong.

Our robots are making a difference for soldiers in theater by providing increased situational awareness and improving mission success.

In fact, a simulation using one semiautomated force test methodology to measure the effectiveness of our SUGV robot in combat showed that the with SUGV non-line-of-sight effectiveness improved by a 15 times factor, friendly casualties were reduced by 50% and enemy losses per engagement increased by 50%.

These are compelling results that further support the use of our robots.

As we have discussed over the past couple of quarters and at our Analyst Day, continuing investment in our people, our technology, our products and our branding is critical to building a sustainably profitable technology company.

In the second half of the year we will put more resources against our common software and common platform long-term strategic vision, accelerate the development of new products, marketing to support the holiday season and programs to support and continue building the iRobot brand.

The current and foreseeable market dynamics in both divisions position us well to deliver a more profitable year than we had anticipated in April while we continue making robust and long-term investments in building for our future and maintaining our market-leading position.

Now I'd like to take you through some of the highlights of the second quarter.

In Home Robots, strong demand for our Roomba 500 robots in international markets, as well as renewed demand domestically, continues to fuel Home Robot growth.

Home Robot revenue overseas increased 80% year over year.

Demand in Asian markets, particularly in Japan, where our partner has invested extensively in Roomba video demos and retail displays, contributed to second quarter growth.

In Europe, currency volatility has impacted our partners' economics somewhat, but we are committed to building the business and expect continued strength in the second half.

Our plan to enter Latin America and Southern America markets for the year-end holiday season is on track, and we expect to begin generating nominal revenue there later this year.

In the United States, total domestic sales grew 20% year over year, a positive directional indicator.

Consistent with the program we discussed last quarter to improve domestic profit margins through more strategic placement of product in select channels, we are delivering a full 9.6 percentage point improvement in Home Robot growth margins, from 29.6% in Q2 last year to 39.2% this year.

We are committed to our strategy of profitable growth, continuing to focus on higher end products and exploring new channels.

We see 2010 as a transitional year for the US market and have not built our financial expectations around improved US macroeconomics.

Our outlook for Home Robots is very positive, and I am confident about meeting expectations despite continuing concerns over recession in Europe.

Our Government and Industrial Division's results were also very strong for the quarter, as we delivered 138 PackBot robots, the majority of which were FasTacs ordered under contracts we received in Q3 of last year from the Robotics Joint Program Office.

In addition, we're beginning to ramp shipments of SUGVs, primarily SUGV 310s.

During the quarter we shipped 100 SUGVs, and, as anticipated, in July we received a new $15 million order for 94 robots, our fifth under the existing IDIQ, of which $32 million has been delivered through the second quarter of 2010.

Since we began shipping in SUGVs in Q4 2009, we have received orders totaling $47 million for 325 units and spare parts.

This ramp rate is nearly four times that of the PackBot at the same point following its introduction, which further illustrates the overwhelming adoption of robots by the military and the urgent need from soldiers in theater.

To this end, in the fourth quarter we will begin delivering our newest robot, the SUGV 320, to support the first increment of the Brigade Combat Team Modernization program.

Under the LRIP, low-rate initial production contract, we will deliver 45 robots.

In ongoing performance tests our robots have substantially exceeded requirements, and we're determined to be fully compliant.

This is a significant milestone for us and sets the stage for 2011, when we expect the majority of G&I revenue to come from the sale of SUGVs.

Another of our recently introduced products, the Seaglider unmanned underwater robot, was shipped to the Gulf of Mexico on May 22.

We saw an opportunity to respond to the need in the Gulf and sent an iRobot owned and operator Seaglider to search for underwater oil plumes and other anomalies.

Based on the data sent back from the robot, scientists were able to estimate the density of the oil in the water as well as the extent to which it was spreading.

Although we volunteered our products and services to help characterize this horrible disaster, we expect our increased exposure to yield future opportunities.

As we've discussed each quarter, a key component and growth driver of our government and industrial business is product life cycle revenue, or PLR.

Our rapidly growing installed base of robots requires spare parts, support, maintenance and training.

PLR more than doubled year over year in the second quarter, and we are on track to provide software-enabled solutions through upgrades to more than 500 robots in the field during the second half of the year.

Beyond supplying robots to the US government, we continue to expand our international footprint.

International revenue for the first half increased 46% over the same quarter last year and comprised 10% of G&I product revenue for the half.

In summary, both of our businesses are performing well in an uncertain environment, and we expect both to grow approximately 30% at the top line in 2010 while contributing a greater percentage to the bottom line.

Because of our confidence in delivering more profitable results than we discussed in April, we are increasing our expectations for the full year.

For the full year we expect revenue to be between $385 million and $390 million, EPS to be between $0.51 and $0.54 and adjusted EBITDA to be between $36 million and $38 million.

I will now turn the call over the John to review our second quarter results in more detail.

Thank you, Colin.

Our performance in the second quarter was very strong, as we achieved our first profitable Q2 and first half since the Company went public.

Revenue, earnings per share and EBITDA all exceeded expectations.

Revenue was $98 million and $193 million for the second quarter and first half, respectively, both all-time highs for the Company.

Growth in our international home robot business continued to be robust, up 80% for the quarter year over year, and our government and industrial business was up 65% for the quarter.

Our overall revenue growth of nearly 60% follows the strongest Q1 in the Company's history.

Earnings per share for the quarter were $0.20, compared with a loss of $0.10 in Q2 last year.

EBITDA was $12 million for Q2 and $26 million year to date, compared with break even last year.

Operating cash flow of $15 million in the second quarter has driven our cash and investments position to $99 million, up $48 million from Q2 last year.

Year-to-date operating cash flow is $25 million, compared with $12 million in the first half of 2009.

Our focus on EBITDA and cash flow continues to drive strong financial performance for the Company.

In the Home Robot Division, shipments grew 52%, to 294,000 units, and revenue of $53 million increased 55% from a year ago.

International revenue increased more than 80% in the quarter year over year and comprised 67% of Home Robot revenue.

Total domestic revenues increased 20% year over year, an encouraging sign that US consumers are beginning to spend again.

Improvements in Home Robot gross margins were partly due to this increase in international as a percent of total revenue and to our efforts to optimize our product and channel mix.

In the G&I division, revenue was $45 million, up 65% from a year ago.

This growth was driven by higher product shipments, primarily PackBot FasTacs, and higher contract revenue.

Contract revenue comprised 26% of G&I revenue for the quarter and was up 35% year over year.

G&I product revenue was $33 million in the second quarter, compared with $19 million last year.

Product life cycle revenue was nearly $10 million, or 29% of G&I product revenue, up from $5 million in 2009.

We continue to expect PLR to average 25% to 30% of G&I product revenue annually, although this can vary significantly quarter to quarter.

Product backlog at the end of the quarter was $12 million, compared with $18 million at the end of Q2 2009.

However, this backlog position does not include the recent $15 million order for SUGV 310s or a $20 million order for 125 PackBots, both of which we expect to fulfill this year.

Including these two orders, we have 80% visibility of G&I's annual revenue contemplated by our full year guidance.

For the total company, gross margin for the quarter was 35%, compared with 27% last year.

The year-over-year increase was driven primarily by the improved Home Robot mix I mentioned earlier and overhead leverage in G&I.

Operating expenses improved as a percentage of revenue to 26% this year, from 33% in Q2 last year.

The improvement resulted primarily from operating expense leverage as well as marketing spend we deferred to the second half.

However, we have added more than 100 employees, mostly in engineering and sales, since Q2 of last year.

Q2 operating cash flow was nearly $15 million, compared with a $3 million negative cash flow last year.

Year to date, operating cash flow is $25 million.

Inventory was $31 million at quarter end, relatively flat from a year ago, despite higher revenues, and DII improved significantly.

Accounts receivable continued to be well managed, as evidenced by our DSO of 27 days, compared with 52 days a year ago.

At the end of Q2 we had cash including investments totaling $99 million, compared with $51 million a year ago.

Now I'd like to provide you with additional detail for the financial expectations Colin discussed, as well as color on how we see the rest of the year unfolding.

For the full year, we now expect Home Robot revenue to grow roughly 30%, to a range of $214 million to $216 million.

Our G&I revenue expectations are unchanged.

However, we have narrowed the range to $172 million to $174 million, also an increase of about 30% year over year.

We expect Q3 to be another strong quarter, with revenue up roughly 20% over last year.

We anticipate revenue in the range of $91 million to $94 million, EPS of $0.05 to $0.06, and EBITDA of between $5 million and $6 million.

Q4 revenues should be slightly higher than Q3, but lower than our record-setting fourth quarter last year.

The level distribution of revenues quarter to quarter throughout 2010 is largely due to our international home robot mix and G&I revenues that have been much less lumpy than we have seen in the past.

We expect improved full-year gross margins of 34% to 35% as a result of favorable mix management and savings in product cost realized through supply chain management in home robots and through overhead expense leverage in G&I.

Operating expenses in Q3 and Q4 will be higher than the first half due to marketing program commitments we've made to our international partners, expenditures to support and strengthen our brand, and increased technical headcount.

These expenses, coupled with the increased investment in R&D for new product development and software enhancements, will result in lower EPS in the second half when compared to our very strong results in our first half.

However, our expectations for revenue and EPS in the second half are higher than we anticipated in our April call.

As Colin mentioned earlier, for the full year we are increasing our expectations for revenue, EPS and EBITDA.

Finally, we expect our increased full-year earnings to translate into strong operating cash flow.

For the full year, operating cash flow will be over $35 million, and our cash and investments will exceed $100 million at year end.

Now I'd like to turn the call back to Colin.

I'm very excited to be talking with you today following great first half results, with the confidence to increase our full year 2010 expectations.

Just to reiterate those expectations, we anticipate revenue of $385 million to $390 million, EPS of $0.51 to $0.54, and adjusted EBITDA of $36 million to $38 million.

We continue to successfully navigate through the dynamic and challenging global marketplace in which we operate.

We're making significant progress toward our three-year financial targets.

We're making ongoing investments in building for our future and maintaining our market-leading position.

With that, we'll take your questions.

(Operator instructions).

And our first question comes from the line of Jim Ricchiuti, from Needham & Company.

Thank you.

Good morning.

Good morning.

A couple of questions.

First, on the -- congratulations on the quarter, by the way.

Thank you.

On the consumer business, you continue to make some very impressive improvement in Home Robot gross margins, and I wonder how we should think about the potential for further improvement.

Can you give us some sense as to where we might see the gross margins go in this business?

I think that what you're observing is continued improvements in our supply chain, continued improvements in our domestic positioning, where we had that remarkable improvement in gross margins of almost 10 points, and that's coming from our selection of both product mix in store and our selection of emphasis for our retailers.

And I think that you could anticipate that a lot of -- sort of the biggest chunks of improvement have been taken, but there is still margin expansion available to achieve.

As we think about where we are now, we estimate through additional cost-out in the products, additional positioning and inclusion of software content in products, which we will bring out in the future, and on the government side, continued improvement in the increase of software content in our robots, margins could easily see another 4 to 6 points of improvement over the next few years, to a 35% to 37% full company basis.

Okay.

That's helpful.

Colin, I believe you made some comments in your presentation about bringing on a new contract manufacturing partner, but I think in your commentary you mentioned some capacity issues.

I wasn't clear on this.

Were you capacity constrained in the consumer business in the quarter?

We are currently capacity constrained.

We started a program almost 12 months ago to bring on a first-tier new contract manufacturer.

It's a long process to do it properly, and we will start seeing product coming into the marketplace produced by that manufacturer in Q1 of next year, so that it's an issue where in 2009 we took a very conservative approach but recognize we need to be looking ahead to source and supply anticipated growth.

And there have been some constraint on our ability to meet all of the demand that might exist for our products in the back half.

That does contribute to our guidance.

It does contribute to predicting relatively flat revenue in the back half of the year.

Okay.

And one final question, I if I may, just on the issue of backlog for the G&I business.

John, you mentioned, I think, in your comments a $20 million order for PackBots.

Is that, just to be clear, is that the order that the DOD recently announced on their website?

Yes, Jim, these two orders that I mentioned, neither one of which we have been able to do a press release yet, we've been waiting on the customer, but the two orders are one for about $14.5 million for SUGV 310s, and then the other order, which I think is the one you're referring to, is for about $20 million for 125 PackBots.

So both of those have popped up off of the DOD website.

We have not press released on those yet.

But those are what add up to, along with the previous backlog, the 80% visibility.

Got it.

Thanks very much.

You're welcome.

Thank you.

Your next question comes from the line of Alex Hamilton, T.C.

(sic/C.K.) Cooper.

Hi, good morning.

Hi, Alex.

Two questions.

The first one, I don't know if you went through it.

I apologize.

I have 15 companies reporting today.

Home Robots, the growth in Home Robots was impressive.

Can you give a flavor as to what the mix is?

In other words, how much of that improvement was from existing markets verus new markets, and is there a change there?

Well, it's a broad-based set of growth figures driving the increase.

US markets were up 20%, and so that that had been down significantly in 2009, so that's a great reversal, especially on top of the fact that we were doing some things in the channels that might otherwise have reduced revenue growth.

And on the -- and then probably the area internationally that saw the most significant growth in Q2 was Japan.

Okay.

And then, secondly, going into sort of the holiday season you talked about sort of this capacity constraint that you have and new manufacturers.

What's sort of the thought process around that, in a sense?

Are you comfortable with your inventories?

Should we expect a ramp-up?

How are -- knowing that you have that, how are you sort of modeling around that, if you will?

Well, we are manufacturing at capacity for our current manufacturer, and there is strong demand from our retailers to fill their product with robots.

And then what we need to do is the traditional ramp-up in the back half of marketing dollars to drive sell-through in the stores so that we exit the year with the retailers clamoring for more.

It's a great model and leads to a strong first half of next year.

So this is a model that we've done before, and the fact that we may disappoint a few retailers by not being able to fully supply them is a transitory event, as our new contract manufacturer will be online right at the end of the year going into Q1 and we should be able to further fuel the growth that we anticipate in the future.

Great.

Alex, I would just add that our management of our supply chain, the quality of our production planning and forecasting, it's the best it's ever been.

So that operations team has done an incredible job.

And we do have that tier 1 player coming on-stream, but that really has not affected at all the capacity constraint that Colin references.

That on-streaming is on schedule or actually slightly ahead of schedule.

This is more a function of the revenue performance just greatly exceeding all of our expectations.

So operations management has done a great job.

We just happen to be knocking the ball out of the park in terms of revenue growth.

Great.

Fantastic.

Understood.

Thank you.

Your next question comes from the line of Paul Coster, JPMorgan.

Thank you.

Good morning.

John, I wonder if you could just elaborate on your statement about the revenues being less lumpy.

It's always been very difficult to forecast the third and fourth quarters, but it sounds like it's becoming a bit more predictable.

Do you expect this kind of smoother growth during the year to extend into 2011?

Predicting DOD budgets and spending, as you know, Paul, is always tricky, and so it's hard for us to say whether this is an anomaly where the revenue has been more flattened this year.

Certainly the fact that our contract revenue and our PLR revenue is becoming a greater part of the mix I suspect will probably help over time, because you're not just depending solely upon the timing of orders.

But it's hard to predict whether this is what we will see going forward, although this sort of pattern is certainly -- certainly eases the burden on operations and our contract manufacturers in that we've had more predictability.

How do you expect ASPs for the Roomba product family to evolve in the second half?

In the second half I would expect ASPs to be consistent with where they were in the first half of the year, Paul.

Okay, I mean, that seems to suggest, Colin, that the unit volumes are actually down in the second half versus the first half.

Why is that?

Versus the same period last year I should say, sorry.

Well, we are anticipating that the fourth quarter revenue to be slightly off the record Q4 that we had, and the volumes that are reflected in our guidance represent the manufacturing constraints that we've seen, so that any true unit changes are sort of in the noise there.

We're running at capacity.

We are -- our revenue is modeled at run rate.

Okay, got it.

Thank you.

Where do we stand on the upgrade of the existing PackBots in the field with the Aware platform, and when will that be done, in large part?

So that the upgrades for Aware are going to represent a significant part of the anticipated revenue that we're predicting for G&I in the back half of the year, so that we said there's about 400 -- I'm sorry, 500 robots currently anticipated to be upgraded, and we hope that that upgrade program will continue into 2011 and so that our installed base of Aware 2 robots will continue to be growing over the next few years.

Okay.

Last question, I always ask this, what about Warrior?

When are we going to see that thing start to ship?

Well, we're currently developing the initial prototypes of which we think are appropriate for early adopters, and those will be going into marketplace next year.

Okay.

Thank you.

Yes.

Thank you.

Your next question comes from the line of Adam Fleck, Morningstar.

Hi, guys.

Good morning.

Good morning.

Question about your direct revenue, I saw year over year, year to date it's down slightly even as US sales have increased.

I was just curious if you could provide some details as far as where that stands and kind of the push going forward on the direct side.

Sure.

Direct has always been a very important part of our retail business.

In 2009 we made some decisions because of the economy to cut back on a lot of our direct advertising, our national TV advertising.

And that decision has a carryover effect where we drive slightly fewer numbers of people to our website, and thus the sales on the website are reduced, although our conversion rates of people coming to the website are actually improved.

You'll probably see that turn around in the back half as we are able to put more energy against awareness campaigns which create that demand.

But direct is just -- is immediately tied to the number of eyeballs going to our website, so that, while that is down, we have more than made up for it through the retail channel domestically.

Sure.

John, a question we talked about last quarter, but obviously you guys are still sitting on a good pile of cash.

You talked about M&A sort of coming to the forefront as far as the use of that cash.

Just curious if there's any progression there, and maybe some sort of timetable you're looking at.

Adam, we've -- as we did talk about, we've put [admin] resources against our M&A efforts this year.

We've hired a boutique banker to help us evaluate -- source and evaluate deals, and we've just put more management time, because we do think going forward M&A can be an important part of our growth strategy.

As you know, these things take quite a while to sort of work their way through a system, and in the industries we play in there are not a lot of very straightforward, logical deals to be done, given that fact.

It's not really a consolidating industry.

So it's hard to predict when you'll start to see some results from this, but we are committed.

We think that M&A, when properly done, will be a good use of the cash that we have built up.

But there's nothing definitive to report on that right now.

Got you.

That makes sense.

All right, that's it for me, guys.

Thanks a lot.

Thank you.

Thank you.

Your next question comes from the line of Jim McIlree, Merriman.

Thank you.

Good morning.

Good morning.

Can you share with us what the new capacity is going to be relative to your current capacity?

The first tier manufacturing partner that we're going to bring on will truly be able to scale ahead of our need, and so that it's a question of tooling capacity, how much are we going to invest in tooling right out of the gate.

But we certainly will not find ourselves in a situation where capacity limits our revenue growth for the next few years in most imaginable scenarios.

So I think this is a problem that we got on, we started looking at over 18 months ago, have taken a very appropriate and systematic approach to finding the right partner, being able to improve and focus on quality as we bring off a new manufacturing partner, and this is a good long-term solution.

So I can say with great confidence that capacity constraint is not going to be our challenge on a go-forward basis.

Okay.

Well, let me ask it a slightly different way, then.

In the second half of this year, in the Home Robot Division, you're assuming kind of flattish versus the first half, but the demand in the market, is that experiencing a similar type of increase in the second half that you're just unable to satisfy because of your capacity, or has the market demand flattened out, as well?

We are going to be leaving retailers with less product than they ideally would like based on their current requests to us, and so that from the perspective of our visibility, we could have sold more if we had capacity to do so, which is somewhat consistent with historical revenue patterns, which show back-end loading on revenue.

Now, that traditional shape of our revenue in Home is changing with the growth of international, because international robot sales tend to be much flatter over the year.

So we're definitely seeing some macro shifts in the idealized revenue distribution throughout the year because of the rise of international.

But 2010 in particular you will see a forcing function on the flatness of HRD revenue due to this capacity constraint.

Great.

That's helpful.

And then the $91 million to $94 million Q3 revenue guidance, does that assume that the contract revenues come down from the $11.8 million that you posted in Q2?

Or another way to ask it is why did you have a $3 million Q to Q increase in your contract revenues?

Jim, contract revenue can just be lumpy as opportunities come and go.

In terms of guidance, we don't break it down beyond just the total revenue by division.

But there's nothing unusual going on relative to contract.

It can just pop up and down quarter by quarter.

Okay.

And the last one, I think last quarter you talked about a dollar amount of increase you were targeting for second half OpEx over the second half of 2009.

Are those numbers roughly the same, or have you increased the amount of -- or have you increased that amount due to the strong result in Q2?

We have increased the amount somewhat to allow us to do more investment based on the very, very strong results that we have, and we think we can do a more aggressive job investing in new products, in our branding and awareness, as discussed, while still staying, well, frankly, ahead of plan in achieving our long-term financial model we previously discussed.

So this is an opportunity to both get ahead of the game and invest more heavily in our future, which is the win-win that we've been hoping for and very exciting news for us.

Okay.

And then over time you would target towards those long-term goals that you've articulated?

Oh, absolutely.

Right.

You should expect us to continue marching very aggressively to achievement of those goals, and, again, taking advantage of our progress in margin improvement to invest more in future products and realizing the very rapidly growing potential that this maturing industry is creating for us.

Very good.

Thanks.

You're very welcome.

Your next question comes from the line of Brian Ruttenbur, from Morgan Keegan.

Great.

Thank you very much.

A couple questions.

First of all, on the amount of sales and marketing, I don't think you've mentioned an exact dollar amount that you're talking about for third and fourth quarter.

Can you give us some dollar amounts?

Are you going to be up $2 million from the previous quarter, from Q2 to Q3?

Can you give us some rough dollar amounts?

Brian, there are three broad areas that are contributing to the OpEx increase in areas where we are investing.

First is the fulfillment costs for our direct business, those costs do hit operating expenses.

And with the holiday season usually our direct business does tick up.

So that's the first item driving the OpEx change.

Second, our marketing costs, both to support, as we said in the remarks, our international distributors, in part due to the challenges with the euro, and also marketing spend behind the brand, which we really have not been able to do adequately over the last couple of years.

So those are the two primary components of the marketing spend.

And then the third element relative to OpEx is IR&D, where we will continue to invest more dollars into new product development and developments around Aware 2 software.

Our IR&D spending year to date is actually up about 25% year over year.

So we plan to continue to invest in that area.

So I'm not prepared to break out the spend increase across those three areas, but those are the drivers and those are the areas that we are looking to invest in in the second half.

Okay.

Now, typically in the fourth quarter on a year-over-year basis you have on -- selling and marketing usually dramatically increases about $4 million from third quarter levels.

Is that a good way to look at things, that it's going to be primarily fourth quarter weighted on the sales and marketing?

That is, in fact, traditionally, and you should anticipate more of that sales and marketing spend to hit in the fourth quarter, because while we account revenue on a sell-in basis, which creates some of the flatness you see, the action in the marketplace, at least domestically, tends to -- for sell-through is a Q4 phenomenon, and so we want to time our advertising programs to hit in the fourth quarter.

Okay.

And then R&D you were talking about, as a percentage of revenue, what are you targeting for the year and then maybe for next year kind of going forward?

We've given information that says our long-term model for IR&D is in the 6% to 8% range.

In 2009 we were actually below that 6% line and so that the investments that we are talking about in the back half of the year bring us back into that range, so that it's -- so that as you develop and look at your long-term models for us that 6% to 8% is a good figure to be using and I think is consistent with companies of our category in investment.

But let me say that those figures need to be augmented by -- because of our business model by the substantial amounts of money we bring in from the government to do advanced research and development, and so that if you look at run rate IR&D plus government-funded IR&D you're looking at 13%.

Okay.

And then the last question that I have is, as I look at your guidance and your revenue, you're going to have to have a dramatic increase in it appears to be sales and marketing in the third quarter.

We're talking $3 million or $4 million.

Is that the right ballpark to be thinking, or am I -- I'm missing something.

Well, as John said, you've got to divide that figure up into those four different buckets, the two sales and marketing buckets, then the increased cost of sales and then the increased IR&D.

But if you do that you do see an increase in the OpEx, and that is what's required to make the math work.

Okay.

Thank you very much.

Thank you.

At this time I would like to hand the call to Colin Angle for closing remarks.

Well, that concludes our second quarter earnings call.

We appreciate your support and look forward to talking to you again in October to discuss Q3 results.

Thank you again.

Thank you for your participation in today's conference.

This concludes the presentation, and you may now disconnect.

Have a great day.