Mercury Systems Inc (MRCY) 2004 Q2 法說會逐字稿

Good day and welcome everyone to the Mercury Computers Systems second quarter fiscal 2004 earnings results conference call.

Today's call is being recorded.

At this time for opening remarks and introductions I would like to turn the call over to the Vice President of Investor Relations, Ms. Diane Basile.

Please go ahead, ma'am.

Thank you.

Good morning, everyone.

Welcome to the Mercury Computers Systems second quarter 2004 earnings conference call.

If you have not received a copy of the earnings release you can find it on our website www.MC.com or on the First Call network.

We would like to remind you that remarks that we may make during this call about future expectations, trends and plans for the company and its business constitute forward-looking statements for the purposes of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

Forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those projected or anticipated.

For discussions of these risks and uncertainties, we refer you to the company's reports filed with the Securities and Exchange Commission, including the companies' annual report on form 10K, for the year ended June 30, 2003.

Further information regarding forward-looking statements and risk factors is included in the press release we issued today reporting the company's second quarter results.

We caution listeners of today's conference call not to place undue reliance upon any forward-looking statements which speak only as of the date of this call.

We undertake no obligation to update any forward-looking statements.

I'm now pleased to turn the call over to Mercury's President and Chief Executive Officer, Jay Bertelli.

Good morning, everybody.

Thank you for joining the Mercury Computer Systems' second quarter earnings conference call.

We added a little heat to the market this morning to thaw out all of us on the east coast.

With me on the call today is Joe Hartnett and Diane Basile.

At this point I would like to briefly review the second quarter results and then turn the call over to Joe to provide the additional financial details for the quarter.

I will come back and provide some context for the trends that we see in the industries that we participate in, before we open the call to your questions.

As you can see from the press release we issued this morning, this quarter Mercury again delivered solid results.

This marked our 52nd consecutive profitable quarter.

A couple of highlights, before I turn the call over to Joe.

For the quarter revenues came in at about the midpoint of our guidance, 40.6 million.

Earnings per share were at the high end of the guidance at 17 cents.

And cash flow from operations was a very strong 8.7 million.

We ended the second quarter with a balance of cash and marketable securities of 127 million.

I'm also pleased to report that for the second consecutive quarter, backlog increased.

During the quarter, backlog grew by 11 million to 75 million.

The book-to-bill for the quarter was greater than one.

During the second quarter we demonstrated continued progress against our three strategic objectives, continuing to be a leading innovator, operational effectiveness, and organizational development.

I'll discuss each of these in turn later in the call.

At this point I'll turn the call over to Joe to discuss our second quarter financial results.

Thanks, Jay and good morning.

This morning I will be reviewing our second quarter performance and our business outlook for the third quarter in the remainder of fiscal 2004.

As a reminder consistent with our historic pattern of providing guidance, when we report results for the current quarter, we also provide guidance for the next quarter out, and the current fiscal year.

Consistent with that methodology, today we will discuss details of the second quarter results, provide guidance for both the third quarter and full fiscal 2004 year which I remind everyone ends on June 30th, 2004.

After an overview of the company's financial performance for the second quarter, I will discuss revenues by business unit and detail total company operating performance.

I will then follow with the balance sheet and cash flow results.

First let me summarize our second quarter results as reported earlier this morning.

Second quarter revenues were 40.6 million which is at the midpoint of the guidance range provided on our first quarter conference call.

Operating income for the second quarter was 5.2 million or 12.9 percent of total revenues.

Earnings per share for the second quarter was 17 cents, which is at the higher end of our previous guidance range.

Last year, as you recall, non-operating income included both net interest income and $1.6 million on a gain of the sale of our shared storage business unit.

In the current quarter, nonoperating income was essentially only net interest income.

For the second quarter, we reported operating cash flows of $8.7 million.

This excellent cash flow performance reflects a continuation of our operating effectiveness initiatives and process efficiencies, which I will describe in later detail during the call.

Turning over to the second quarter specifics, I will now review revenue by business unit.

Please note that all comparisons are to the second quarter of fiscal 2003.

Defense.

Our defense electronics group reported revenues of 27.7 million, or 68% of total revenues for the second quarter.

This represented a decrease of about 12.5 percent from the same period last year.

You recall that during the second quarter last year we experienced a $5 million revenue increase as results from the acceleration of defense rated orders and shipments in order to meet specific customer requirements.

These shipments were primarily within the radar segment.

Within the three application areas, radar, signals intelligence, and emerging applications, during the quarter, we experienced strong growth in signals intelligence, which was offset by a slight decline in emerging applications business and the previously mentioned year-over-year decline in our radar business.

Medical.

Our medical imaging revenues were 7.4 million, representing approximately 18 percent of the total revenues in the current quarter.

This 29 percent decline relative to the same quarter last year was driven substantially by two factors.

First of all, the second quarter last year represented the strongest quarter of the year for medical imaging revenues, representing a challenging year-over-year comparison.

The second quarter last year also marked the high point of our fiscal 2003 revenues related to the CT modality at $2.4 million.

This compares to approximately $200,000 of CT related revenues in the current quarter which, alone, is the most significant contributor to the year-over-year variance.

In addition, the combination of softness in the MRI end market and customer order patents account for the remainder of that year-over-year variance.

Please note that medical imaging revenue stream is impacted in the short-term by the timing of our customers' orders and over the long term by design wins.

Both factors played a part in the reported results for the medical imaging during this quarter.

OEM solutions.

Our OEM solutions group reported revenues of 5.4 million or 14 percent of total revenues, down from 5.6 million recorded for the second quarter last year.

This modest decline was primarily the result of ordering patents from customers in the high end baggage screening business.

This was offset growth in applications serving the semi conductor markets.

Backlog in book-to-bill.

The total book-to-bill ratio was greater than one for the quarter.

Our total backlog at the end of the second quarter was 74.7 million, up 11.3 million from the 63.4 million reported at the end of last quarter and more importantly, 17.4 million up since the beginning of our fiscal year.

Significantly, this represents our second consecutive quarter of reported backlog growth.

Backlog is an important leading indicator of future defense revenues.

As we regularly point out, specific quarterization of related revenues is subject to customer funding patterns.

At the end in backlog, 69.8 million relates to shipments expected within the next 12 months.

Gross margin.

Our gross margin was 66.3 percent for the quarter, up just over 100 basis points from the 65.2 percent for the same quarter last year.

These strong results reflect the increase in the defense business contribution to total revenues in a decline in lower margin, long-term contracts within the quarter

Defense revenue as a percent of total reported revenue was 68 percent for this quarter, up from 66 percent in the second quarter last year.

In general, defense business generates slightly higher margins so this increase would result in a favorable margin impact.

Our year-to-date gross margins are 65.2 percent which is in line with our previous guidance of approximately 65 percent for fiscal 2004.

Turning over to operating expenses.

Operating expenses were 21.6 million for the quarter reflecting a decrease of 2 million from the same quarter last year, and essentially flat with the previous quarter.

As indicated on our first conference -- first quarter conference call, we continue to monitor key metrics in order to maintain an appropriate operating expense cost structure relative to revenue growth expectations.

During the quarter, operating expenses were comprised of selling, general, and administrative expenses of 12.7 million and research and development expenses of 8.9 million.

Our associate population at the end of the second quarter was 573 associates or essentially unchanged from the beginning of our fiscal year.

Operating income of $52 million represented 12.9 percent of revenue for the quarter, an expansion of 190 basis points from the first quarter and essentially flat revenues.

This operating income expansion was entirely driven by gross margin expansion in the quarter.

As previously described, this margin expansion resulted primarily from a richer mix of higher margin defense related revenues as a percent of total revenues.

As we discussed last quarter we will continue to monitor key metrics and business drivers with the objective of continuing to maintain an appropriate cost structure.

Net income of 3.7 million or 9.2 percent of revenues, down from 6.5 million in the second quarter of last year, please note that last year's net income included approximately $1.6 million within the nonoperating income related to the sale of the shared storage business unit.

Turning over to the balance sheet and cash flow.

Turning to the operational cash flow and balance sheet performance for the second quarter of 2004, marked another proof point for the success of our ongoing working capital initiatives.

Mercury again drove solid cash flow performance during the second quarter.

We ended the quarter with approximately $127 million in cash and investments, up $5 million over our first quarter and up $19 million over the same quarter last year.

During the quarter, cash flow from operating activities was 8.7 million.

This compares to 3.7 million -- this is comprised of 3.7 million in net income, 1.9 million in depreciation and amortization with a balance of approximately 3.1 million coming primarily from working capital initiatives.

Second quarter capital expenditures were approximately $1 million.

Second quarter days outstanding, or DSO, were 42 days.

This is consistent with our experience in the first quarter of 2003 and is at the low end of our target range.

More importantly this metric reflects strong collection efforts within the quarter.

We continue to demonstrate progress on inventory and other supply chain management initiatives as turns were 6.5, up from 5.2 turns in the second quarter last year.

Our year-to-date inventory turns are 6.6 which demonstrates significant progress against our value creation initiatives.

Based upon the strength of these results, we are raising our inventory turn guidance from approximately 6 turns for fiscal 2004 to approximately six to seven turns for the full fiscal year.

In summary, we again delivered solid financial results.

During the second quarter, operating expense controls allowed gross margin expansion to flow directly to operating margins.

We continue to demonstrate success from our working capital initiatives as evidenced by strong working capital and cash flow results.

Now turning to our business outlook.

For the third quarter of fiscal year 2004, revenues are expected to be in the range of 45 to 48 million.

At these revenue levels, we expect earnings per share to range from 26 to 30 cents for the quarter.

For the full year, we are updating our previous guidance as follows.

We anticipate revenues to be between 180 to 185 million, which is toward the lower end of our previous guidance of 180 to 190 million.

By business segment we expect defense revenues of fiscal 2004 to be roughly flat year-over-year, which is at the lower end of our previous guidance.

On our commercial business, we see strength in revenues related to the semiconductor applications offset by continued weakness in the MRI modality.

We are therefore increasing our earnings guidance to 1 dollar to 1.05 dollar per share up from our previous guidance of 85 to 95 cents per share.

In part, this increase is related to the excellent gross margin results, and therefore we are revising our current expectations for gross margins to approximately 66 to 67 percent for the full fiscal year.

Based on our operating expense outlook and gross margin, we expect operating income to approximate 17 percent for the full fiscal year.

Further, based upon the anticipated strength of operating results, coupled with our working capital initiatives, we are also raising our guidance for projected operating cash flow from the mid teens to 25 to $30 million for the full fiscal year.

I will now turn the call back over to Jay for his additional remarks.

Thanks, Joe.

As I mentioned at the beginning of the call Mercury's now reported 52 consecutive quarters of profitability.

That's 13 years of making money.

We've achieved these results by continually investing in the technologies necessary to deliver the optimal products to satisfy the growing needs of our customers.

Continuing to be a leading innovator is the first of our three strategic objectives.

We are committed to driving our future through continued investment in innovation.

This investment is required not only to maintain and improve core technologies, but to develop new products that meet the demands of existing customers and expand our reach into new markets.

Earlier this week we announced a new multi computer, the Power Stream 7000 system.

The Power Stream 7000 system is designed to run very demanding applications within the confines of a military aircraft, naval vessel, and even land vehicles.

As you might imagine, space in these platforms is limited.

So the ability to put a lot of processing and data handling performance in the available space is highly prized by our military customers.

By fitting upwards of one taraflop each second, that's a trillion flowing point mathematical operations a second, in a box that measures less than two feet on a side, Mercury has set a new benchmark for embedded system performance.

We call that measure of performance density.

And it is measured in flowing point operations per cubic foot.

The Power Stream 7000 system delivers 150 gigaflops or 150 billion operations per cubic foot.

We believe that that sets a world record.

Who needs this performance?

Very clearly our defense customers do.

There's never a shortage of great ideas for defense related computer systems.

The problem is fitting the computing power they require in an airplane or a ship.

Consider the example of an airborne ground surveillance and battle managnt aircraft such as the Air Force's Joint Stars plane.

It's operators can't afford the risks and delays of waiting for a computer back at a base someplace to analyze the data and send the results back.

So very often these advanced applications are sitting on the shelf, waiting for a computer with enough performance density to run them in the ship or aircraft where they are most needed, closer to the sensor.

Example of this situation from a few years ago is a form of radar called space time adaptive processing or STAP.

It let radar operators separate targets of interest such as enemy aircraft and missiles from phony signals designed to mask them.

Scientists were able to do this on big ground based computers, but they couldn't do it in the air, where the real need existed.

They did not have a performance dense, rugged computer that could take the jolts in changes in temperature, pressure and humidity common to military aircraft.

In fact it was Mercury's first Power Stream style system what we called the Multi Port 410, that first made STAP radar possible.

As you can see, today's Power Stream 7000 has an impressive pedigree.

The rapid IO switch fabric which you've heard us talk about is an important part of the Power Stream 7000 system.

As system performance increases, or put another way, as we put more processors with more performance into a system, we need to move more and more data from the sensor to the box from processor to processor within the box and from the box to the operator.

Technologies like rapid IO are what enables this and makes it possible.

Let me take a moment to position rapid IO in relation to our race plus plus switch fabric.

Essentially both race plus plus and rapid IO perform a similar function.

They move large amounts of data among the processors in a multicomputer quickly and reliably.

The difference between race plus plus and rapid IO is speed.

To the customer this means the ability to run applications not previously possible because of space and power constraints.

The race plus plus architecture is ideal for many programs already in deployment or even under development today, including high profile platforms such as the Joint Stars and the JSF or Joint Strike Fighter.

Many important military, medical, and commercial programs will continue to use race plus plus for many years to come.

Mercury intends to continue supporting our race plus plus customers with refreshed hardware and software technologies for a long time to come.

But the rapid IO switch fabric in the Power Stream 7000 system provides a 700 percent increase in the bisection bandwidth compared to earlier generations, and is the most robust and reliable way to support the data needs of a system like the Power Stream 7000, and its 70 percent increase in performance density.

So you can see, the innovation called rapid IO is one key enabler of our new flagship system.

Applications that require the Power Stream's performance density, those applications still in laboratories waiting for a platform to support them will be the first adoptors of rapid IO in Mercury's defense markets.

As important as rapid IO is, it's far from the only innovation that makes Power Stream systems possible.

Several less claimers but equally vital innovations also play key parts in delivering the Power Stream 7000's performance.

One example is system packaging.

An inescapable fact of life is that as processors increase in performance you usually need more electricity to run them.

More electricity translates into more heat inside the computer.

In a controlled environment or in a laboratory on the ground you can spread the processors out in a nice big box, turn up the air conditioning and blow a lot of cold air to take the heat away.

The military platforms don't permit a lot of space, cold air, or fans, so Mercury had to develop new packaging solutions to manage heat in the Power Stream system.

Packaging technology might not be considered sexy, but it sure is essential.

There are other important technologies in the Power Stream 7000 system Some new, some more familiar, but all the result of Mercury innovation.

One important one is the portability of application code or the ability to transfer existing code developed on smaller less expensive Mercury computers, and then to be able to run them on the Power Stream system This is one example of how Mercury invests in helping customers manage development costs and protects their investments in the software, investments which are often many times greater than the costs of the computers they run it on.

So what does this mean?

Demonstrates the rewards of Mercury's continued investment in a broad balanced portfolio of invasion.

The power stream 7,000 shows the need for investment in multiple areas.

Rapid IO to be sure, but fundamentals such as packaging, software support and serviceability.

At Mercury we recognize that you need all these elements to build a balanced system, and we invest in the areas necessary to meet our customers' needs.

Operational effectiveness.

Let's take a look at the second of our three objectives.

With regards to the operational effectiveness initiative the strong second quarter results demonstrated our continued progress on operational effectiveness, when measured against our value creation metrics.

As a result of our ongoing focus on process efficiency, and expense rationalization, we translated strong gross margins directly into excellent operating margins.

Additionally, as you heard from Joe, successful implementation of our working capital initiatives drove DSOs down to 42 and yielded inventory turns of 6.5.

Organization development.

Our third strategic objective is organization development.

This area last week we announced the addition of Craig Saline to the Mercury executive team as Vice President of Organization Development.

Craig has extensive experience in both large corporations and entrepreneurial settings in the technology consumer products and healthcare industries.

He has specific expertise in change management, team development and business process improvements.

Craig most recently served as interim Vice President of Human Resources for the [inaudible] Medical Center, a 4,000 employee community hospital, medical school, and research center.

Craig also held Senior Human Resource Management positions with Teledyne and Marshalls.

He began his career with the GE company.

At GE he served in human resources and employee relationship leadership positions for 11 years including Vice President of Human Resources for GE Medical Systems Europe, based in Paris.

We look forward to Craig's future contributions and welcome him aboard.

With regards to the CFO search, we continue to work diligently on filling the CFO position.

While we have interviewed many candidates, selecting the optimal person has proven to be a challenge.

I am optimistic that we will succeed this quarter.

So, as you can see in addition to earning profits for the 52nd consecutive quarter we have been busy investing in programs and initiatives to continue Mercury's growth and success.

All this boils down to a simple clear statement that drives Mercury's vision of our future, and through that, the focus of our continued investment and innovation, and support of customer satisfaction.

What form will that investment take?

It will vary depending upon the innovation, the opportunity, and most importantly the needs of our customers.

Some innovations will have sizzle like the rapid IO does today, some of them will be less glamorous but equally vital fundamental technologies, such as heat management and serviceability.

Some of our investment will go to keeping our customers in the lead by leveraging innovations developed outside our own four walls.

We recognize we do not always have to be inventors, and that good ideas are thought up elsewhere.

Options range from development partnerships such as we formed with Motorola to create rapid IO, to acquisitions, such as our purchase of [inaudible] to help satisfy customers IO needs.

We constantly survey the market and the industry, and we evaluate opportunities in search of the next innovation.

So in conclusion let me leave you with this thought.

Our investment in innovation demonstrates our customer centric strategy.

We are inventors when we need to be, but innovators always.

Innovators in finding the best way to get the customers job done.

Whether that innovation is organic, or comes from outside our four walls, our strategy is to build more integrated solutions that create the greatest value for our customers.

We remain confident in that strategy and its' potential.

With that, I'll open up the call for questions.

Thank you, sir.

If you would like to ask a question, please do so by pressing the star key followed by the digit one on your touch tone telephone.

If you are on a speaker phone, please be sure your mute function is turned off to allow your signal to reach our equipment In order to be fair to everyone, please limit yourselves to one question.

You may resignal for any additional follow-up questions.

Once again, please press star one on your touch tone telephone to ask a question.

We'll pause for just a moment to give everyone the opportunity to signal for questions.

We'll take our first question from Bill Benton of William Blair.

Please go ahead.

Good morning, guys.

Obviously a very nice quarter.

Just wanted to ask a question on the gross margin.

It obviously proved nicely despite the reduction in defense.

And in terms of a mix percentage.

And I'm trying to, you know, that seems counter intuitive to history so I'm just trying to see if you could provide a little bit more meat around that.

And then just a -- I presume that the backlog is actually disproportionately weighted towards defense and then just a balance sheet question on the asset side, the other asset side, I noticed it picked up sequentially and the cash flow from investments seemed to show an other category as well.

Can I presume that you made a strategic investment, maybe a small one during the quarter or is there something else going on there?

Bill, could you repeat the first question with regards to the gross margin in it came through a little garbled.

OK, the gross margin question is really just -- the sales mix of defense was slightly, albeit slightly lower and your gross margin obviously improved significantly.

That seems counter intuitive to our history there.

I was wondering if you could provide a little bit of guidance on what may be happening at that gross margin line during the quarter.

Hi, Bill, this is Joe.

I think I'm going to take the three questions.

The first one is the gross margin.

I'm going to call it one, Joe.

One very long question.

One very long question and you'll get three paragraphs.

The first paragraph on the gross margin another driver within the defense business is long-term percentage of completion contracts.

Okay.

Which have development time associated with them and depending on how much revenue that is in the quarter and what stage of production has variability within the margin.

For the backlog, we have not specifically given results on what percentage of the backlog is by business unit, but as you well know with the commercial business, our visibility is less out in the future than the defense business.

Right.

So your correlation is probably correct.

Okay.

The last on the other assets, we made a purchase of intangible assets during the quarter, and under nondisclosure to give any more data related to that purchase of those intangible assets.

Okay.

And can you talk about which segment that was in?

No, we cannot, unfortunately.

Okay.

Well, great quarter, guys and I'll just go back in the queue.

All right.

Bill, I'm going to elaborate on something because the visibility issue on our commercial business is not less, we don't have a lot of backlog in the commercial business.

Right.

We have pretty good visibility.

We get long-range forecast from our medical customers.

It's just that we don't get orders from them that extend out over longer periods of times.

The visibility is there.

Okay, great.

Thanks, guys.

We'll take our next question from Mark [Hywill] of Spectrum Advisory Services.

Please go ahead.

I'm new to the company, and I just wonder if I could just get a little sense of your strategy with the balance sheet how you're going to use -- where you would like to see a position and some thoughts on your cash?

Use of cash?

Well, the obvious use of cash is to find other ways to grow the company other than investing in the P&L.

And we certainly have been pursuing that with dedicated teams looking for opportunities.

Finding the right opportunities is the challenge.

Well, I mean ideally, how do you want your balance sheet positioned?

Are you -- do you feel you have excess liquidity for the way you'd like to see it over the long term?

I think we have a strong balance sheet.

We have a strong operating cash flow model, and we have the flexibility with also a low debt, and it gives us a good source of capital to pursue strategic initiatives, but to give an opinion on where we think the balance sheet is today, we would just say that we view it as very strong at this point.

And over Mercury's history the cash has been a strong point and allows us the flexibility, as Jay mentioned earlier, to do different things.

Thank you.

We'll go next to. [ INAUDIBLE ] of Sterling Financial.

Please go ahead.

Good morning, guys.

Congratulations on a great quarter.

Thank you.

Let me start off with a quick question.

Let me circle back to the gross margin issue here one more time.

Joe, did I hear you right, mention something about the percentage of completion part of the defense revenues having to do with the variance?

In other words, as that fluctuates over time that impacts how much gross margins you are booking on a particular quarter?

Then I have a couple of follows up.

That is a driver to defense margins.

POC is historically a lower margin business than our traditional defense business.

Okay.

So essentially the mix from quarter-to-quarter will, in fact help -- will effect how gross margins look then?

That is one driving factor.

Okay.

Okay.

I guess moving on to the OEM solutions side, can you update us on where you stand relative to say the active design wins that are currently in production?

I mean just share some rough numbers in terms of how many, you know, customers or how many programs are currently involved with and where you see that number going, and then my last follow-up would be maybe for Jay, if you could help us, you know, those of us certainly who are somewhat less technically savvy, if I may put it like that, to understand your positioning with rapid IO in terms of -- there seems to be some thought, at least, about Intel kind of pushing the PCI express band wagon and what that does to potential applications for rapid IO, what's your sense for Mercury's positioning relative to that whole argument?

Thank you.

Okay.

Let me handle the last question first.

There's been a battle in the market place for a number of years relative to the next generation interconnector, if you will.

And we kind of look at it from Intel look at Intel and seems like they've got the interconnect of the week, if you will.

They've switched horses a number of times.

We have been solidly behind rapid IO, as have been approximately 90 companies that belong to the rapid IO consortium.

And we certainly believe that it is the interconnect for, let me say embedded systems.

PCI express, star fabric, whatever you want to call it, will probably have its place out there.

Probably more in the systems, you know larger server type systems, but for the type of systems that we build, embedded systems, we firmly believe that the rapid IO is the interconnect of choice.

So at the end of the day, it's -- it continues to be a battle in the minds of people who do not understand where these products are positioned, if you will.

That's my view of that.

Thanks, Jay.

That's certainly helpful.

Okay.

As far as OSG is concerned, and the design wins, we do not have any additional design wins to talk about over what we have mentioned in the past.

The design wins are -- some of them have moved into production which is what we've also said in the past.

And we are encouraged by what we're seeing within the semiconductor industry today in terms of increasing orders.

They are becoming more bullish, as I'm sure you are aware, and we are seeing some increased activity in that space, which bodes well for certainly for the next couple of quarters.

Beyond that, we're not sure how far out it will go.

And as far as the gross margin, I'll turn that over to Joe if there's some additional clarification of gross margin.

Did I address your concern, or your question there earlier?

Hello?

We'll take our next question from Lee [Edsville] of Elm Ridge Capital Management.

Please go ahead.

Hi.

Thanks for taking the question.

Sorry to beat a dead horse here, but just wanted to make sure I understand the percentage completion issue.

I was under the impression this is less than two percent of revenue before.

What percent of revenue is percentage completion?

Um -- percentage completion fluctuates quarter by quarter, and I'm not sure where you understood the two percent because we've never given public guidance on what the percentage of completion revenue is.

So what did it change?

What was the change sequentially as it went from 10 percent of revenue to five, from fifty to forty?

It went down in gross numbers a couple million dollars year-over-year and that was a significant driver, and also as I said earlier, as the percentage of completion gets into further production, we start to see the margin go up.

Right.

But this -- I understand is relating to long-term contracts, correct?

Let me take a crack at this, because I think you're going down the wrong path.

Okay.

We get some business that requires some additional development activity.

The system is not an off the shelf system, if you will.

And in order to satisfy that requirement, we typically enter into contracts with the customer.

I say typically, there aren't that many of them.

Where the customers will pay us for the development of whatever is needed over and above the standard products, we bill that on a percentage of completion basis.

It is not a major piece of our business.

However, since it is typically -- it is typically labor intensive, if you will, those rates, the margin becomes less because the labor rates that we get are less than the rates we get on selling product, if you will.

So that's why, when we're in the development phase, where we're accounting for the business on a POC basis, the margins tend to be less than when we're selling straight product.

Those contracts typically lead, you know with the first system may be done under the POC methodology and then that results in product -- standard product being developed which we then deliver and see our standard margins on it.

I hope that clarifies it.

Almost, not completely.

I was wondering is this an unexpected drop in the mix of POC?

It seems like you should know this, so, you know, having significant margins expansion in the quarter as well as guiding defense down for the year, the low end for the year and guiding gross margins significantly up, it just sounds something is unexpected or am I misinterpreting this?

Let's talk about the gross margin guidance that we approximated 65 percent for the year originally.

The first quarter was unusually low at 64.6 percent.

So the rebound in the second quarter was expected because for the first full six months of the year, we achieved 65.2 percent.

We do see a trend in the defense business, and also going forward with margins and other factors where we raise our guidance to 66 to 67 percent.

One other factor, because I think this has become a discussion on percentage of completion, is when we look year-over-year, defense business which carries a slightly higher margin than our commercial business, was 68 percent of the current quarter and only 66 percent of the last quarter.

So there's a couple of other factors that are in there but it was not unexpected that margins would go up because we set a margin expectation of 65 percent for the year and Q1 was a lower margin than what we expected.

Right.

I hope that answered your question.

Um -- yeah.

Great.

Thanks a lot.

We'll take our next question from Paul [Fetch] of Capital Flows.

Please go ahead.

Yes.

Thank you.

Excellent job on working capital management in the quarter.

Jay, can you tell us, I want -- a lot of questions, but let me give you one, and it has to do with share repurchase.

Is there presently an authorization, and how big is it, and how far into it are you?

What's the attitude toward management toward stock repurchase, and was there any stock repurchased in the quarter?

We did not -- excuse me, we did not repurchase any stock in the quarter.

We have a plan in place that's authorized through December of '04.

It allocates, I believe it's $25 million to the program, and we're somewhere between 14 and $15 million into the program.

Thank you.

We'll take our next question from Rob Stone at SG Cowan Securities.

Please go ahead.

Hi, guys.

In dialing in your guidance over the next couple of quarters, it looks like you're expecting a significant expansion in operating margins versus the quarter that just finished.

But not much of that is coming from a further increase in gross margins.

Does that imply that you're thinking about a different business model relative to the level of expenses as a percent of revenues that we've seen for the last six or so quarters?

Hi, Rob this is Joe Hartnett.

One of the factors is that we expect gross margins for the year to trend 66 to 67 percent.

So we expect to see continued expansion on the gross margin line.

And with the 66 to 67 for the year to approximate 17 percent operating income, then operating expenses would have to be 49 to 50 percent.

So we're expecting increased gross margins to hit that full year 66 to 67 percent.

Yeah, I'm specifically looking at the fourth quarter.

It looks like you would be up to something like a 23 percent operating margin, in the fourth quarter, to get to the EPS range that you're describing for the year.

Am I missing something?

I -- I believe that we would have high operating margins in the fourth quarter based upon volume because with the revenue guidance of 45 to 48 for the third quarter, you know, the fourth quarter to get within the 180 to $185 million range is going to be a high volume, but not as much continued investment to achieve that volume.

Okay.

So the implication in my mind is if you're entering fiscal '05 running at that level of volume and operating margins, is that sustainable, or are you going to have to dial up investment again and OP-EX to sustain that level?

It would seem to suggest only a couple million dollars of expense gross versus the quarter you just had.

Well, Rob, it's a good question I'm happy to see that you're looking out to '05 but we're not ready to provide guidance for '05.

Okay.

Thank you.

We'll take our next question from Jeff Meyers of Intrepid Capital.

Please go ahead.

Hi, great.

Thanks.

I just wanted to understand, I guess you guys have big increase in backlog this quarter which sounded like it was mostly defense related, yet I guess you're guiding towards the lower end of where you had been thinking in terms of defense for the year.

I was just wondering if you could correlate those two data points for me?

I - could you repeat that question again?

It came across a little garbled.

Sure.

I guess backlog was up pretty big, but you're guiding to the lower end of the defense range for the year.

So, you know, how do those two sort of data points fit together?

I believe those two data points fit together if you look at the first half of the year versus the second half of the year, revenues for the first half of the year are approximately $81 million and we're looking to do 100 to 105 million.

Right now our 12-month backlog is about 69 million, so we still need to continue to book more orders in order to hit the year.

Okay.

Okay, good, thank you.

And we'll take our next question from Shaw Wong of Lotus Investment Management.

Please go ahead.

Good morning.

I wanted to follow-up a little bit on a comment that Jay had made with respect to porting software code from smaller systems to the Power Stream.

I'm wondering are there specific applications that you're discussing in this manner, and I'm curious as to what about -- about new application development.

Where might that be coming from?

Thank you.

Well, Shaw, the comment relates to the fact that when you've got a family of products, as we do, that customers can get started developing that code on smaller, less expensive systems, in fact we sell something called Adpaptive which is specifically aimed as allowing customers to take a lower cost system to understand how to program a multi computer, and then to be able to port the code over to deployed systems that will have many more processors without having to rewrite everything.

So that was what that comment was aimed at.

I'm sort of a computer guy.

I've always thought the difficulty was more taking higher end system code and porting it backward, if you will.

Is that -- do you expect a mushrooming, or a surge in development of new applications that would increase demand for Power Stream?

The requirements that we see today for Power Stream really come out of the defense market place only.

I mean all of our energies, or a lot of the energies are, investments that we've made there have to do with the packaging, in order to enable us to achieve those densities that we talked about.

And in order to be able to cool it.

It's one thing to put a lot of chips on a board, it's something else to be able to cool it in the restricted environments that we typically find ourselves with.

So that's where a lot of the investments were made.

I guess what I'm driving at is if I look at incremental growth from Power Stream does it come from either A, consolidating different applications that are on smaller systems onto this box, or do you expect new applications defense oriented, obviously, to drive this demand?

Well, now we certainly see it as the system for the next generation airborne radar platforms, but also to satisfy the needs for what's typically referred to as, you know the multi-sensor fusion.

So in order to be able to have aircraft that are diversified in their ability to perform various missions, you've got a lot of different sensors, and the ability of the computer to be able to process the data from these various sensors has been limited because of the processing capability of the computers.

So we believe that having more powerful computers up there will enable aircraft to have multiple sensors providing data to a larger, more capable system such as Power Stream.

It certainly should, let me say, protect the high end of the radar market for us, at the same time, we believe that it's going to open up opportunities for some additional applications where you want to be able to do the processing closer to the sensor, whereas today a lot of the data gets transmitted back to a centralized location for analysis.

That doesn't work in a realtime firefighting environment.

Got it.

Thank you.

We'll go next to Steven McBoyd of Lord Abbott.

Please go ahead.

Yes.

Good morning.

First on the semi side, can you just tell me how many tools you have in production, and are you levered more to photo masks or wafer inspection?

We have business with a company that builds a photo mask generation system, and have had for a number of years.

It's not a major piece of business, and we also have business with companies that are building wafer inspection systems, different tools, if you will, depending upon where they fit in the production chain.

And the number of tools that you would have in production today?

Um --

Types of tools?

I don't -- I don't know the answer to that question, I'm sorry.

Okay.

And I think you've given revenue guidance in the past with respect to semi of 15 to 30 percent, sounds like you're seeing some favorable trends with respect to order strength.

Is that a number you remain fairly comfortable, or is it fair to say that the bias will be on the higher end of that?

Let me make sure I understand the question.

We have an OEM solutions group which includes semiconductor, as well as baggage scanning.

Okay.

We are seeing a trend in the semi conductor applications that would increase the revenue of that business unit, but we don't have a specific semiconductor business unit.

Fair enough, so the guidance of 15 to 30 percent for OSG, if you will, you're feeling --

We feel comfortable with that.

Incrementally comfortable?

Yes.

The comment with respect to softness in MRIs, I understand that you pretty much serve most of the vendors in the area is that specific to the MRI industry growth rate or are you levered to one vendor more than the other that that may be the factor as to making that comment?

What we see and what is, in fact, published information, is that the worldwide MRI market was down, and the systems that performed sort of in the mid range, you know, .5 to 1.5 TESLA, they dropped off and there was more emphasis being placed on higher end systems.

Revenues for the suppliers probably balances out if they sell more of the three TESLA systems, but from our standpoint, it's lower volume.

They don't sell as many of the three as they do the 1.5.

And our content is approximately the same in both systems.

So if the mix shift is pure substitution, call it 1 1/2 to 3 TESLA and you have equal content, should you not be just incremently growing at the rate of the underlying market?

Did I interpret that correctly?

I don't think so.

What I'm trying to say they sell fewer of the 3 TESLA machines therefore we see fewer orders.

Okay, so you're not seeing in the industry a direct substitution for the growth in 3T picking up the slack in 1 1/2 T?

That's not what the industry trade rags are projecting.

Then I picked up on the fact you've made mention with respect to gross margins expectation through the year.

You've made reference to other factors in addition to the mix towards defense.

What would those other factors be?

Well, if we take a look at what are the factors that are included in gross margin, there's obviously mix of business, we've had a good discussion today about the POC business, and also there's other cost of sales, inventory warranty provisions, and just the components of that and what we're seeing with the orders that we have in place that are scheduled to ship between now and the end of the year, and what's expected to come in with our forecast, which we expect a favorable mix and therefore we expect margins to be at the higher end.

Okay.

One last question with respect to operating expenses.

On an absolute dollar basis, is this the rate that you would anticipate operating at through the rest of the fiscal year?

No.

As I said earlier, with the previous question, if we're going to experience gross margins of 66 to 67 percent for the full year and have operating income approximate 17 percent, then OP-EX needs to fluctuate between 49 and 50 percent.

So depending on what your revenue number would be, our range is 180 to 185 that would be the gross number.

Okay, fair enough.

Actually I will squeeze in another last question.

On the defense side you've made mention you've lowered your revenue growth rate there for the full year to flat.

Are there particular programs that you're seeing that may be pushed out where you're designed in?

Is that the driving force?

Well, we can't say specifically what programs, it's just that the -- it really hasn't changed much over the last couple of quarters in terms of the new programs coming on line, if you will.

There certainly has been some shift in the sonar area with less emphasis being placed on equipping next generation sonar systems on submarines.

I think you can understand there's not much of a threat from Iraq or Afghanistan in the submarine area.

You are seeing shifts like that in where the spending is going on a program basis.

And some of it impacts us short term, we haven't seen anything that I would call a long-term impact.

We do have a question from Robert Hoffman of Candlewood Capital.

Please go ahead.

Yes.

Thank you.

Could you just comment on where you see your place in the new modalities of -- in the medical imaging side in terms of maybe not this year, but do you see any visibility in the out years?

Well, the emphasis has been for a number of years on the primary ones, whether it's MRI, CT, PET, the newest one that we've been involved with over the last few years and are starting to see the benefits of those systems going into production are the digital angiography, and digital cardiology systems.

So we're, I believe, well positioned to be able to go after, continue to pursue the next generation design wins which we are doing in those modalities at the three primary suppliers.

Just have a quick follow-up on another issue.

I have been away from the stock for probably over a year.

Is there still any business in the cellular tower or potential there?

Well, about 18 months ago we decided to forgo any further investments in that because the market just did not seem to be coming around in total, and the fact was that we were not successful in selling the concept.

So we redirected those resources into the defense base where some of what we had developed and pursued on the commercial side were continuing to emphasize now in the defense base.

There's a lot of activity in the defense with regards to communications, and so we're taking advantage of what the lessons that we learned on the commercial side and putting it into defense.

On the commercial side of communications, there are some activities going on there, more what I would call a fundamental technology level where we are working on getting the OEMs to understand the advantages of rapid IO.

And to push the rapid IO technology at the core, let me call it the [inaudible] level, as opposed to going in and trying to sell them on the algorithm level which is where we were a couple years ago.

So there is still some activity going on but it's been scaled back.

All right.

Thank you.

We do have a follow-up question from Bill Benton of William Blair.

Please go ahead.

I was wondering if you could update us I think you mentioned obviously some things on the OSG side move into production, the number of design wins was two in production before, I was wondering if you could update us on that, and the visibility into the additional, however many are left in terms of design wins that may enter into production towards the end of the year?

I don't have the specifics, Bill, that I think you're looking for there.

I have gross numbers, but not at the design win level.

Okay.

That's fair enough.

Okay.

Thanks.

At this time, we have no further questions.

I would like to turn the conference back over to the speakers for any additional or closing remarks.

We thank you all for your participation, and we look forward to talking to you all again three months from now.

Good-bye now and have a nice day.

That does conclude today's conference.

We thank you for your participation and you may disconnect at this time.