Mercury Systems Inc (MRCY) 2006 Q1 法說會逐字稿

Good day and welcome, everyone, to Mercury Computer Systems Incorporated first quarter fiscal 2006 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 Senior Vice President of Operations, and Chief Financial Officer, Mr. Bob Hult.

Please go ahead, sir.

Good afternoon, everyone.

And welcome to the Mercury Computer Systems first quarter fiscal year 2006 earnings conference call.

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

We would like to remind you that remarks that we make during this call about future expectations, trends and plans for the Company in this 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 a discussion of these risks and uncertainties, we refer you to the Company's reports filed with the Securities and Exchange Commission, including the Company's annual report on form 10-K for the fiscal year ended June 30, 2005.

Further information regarding forward-looking statements and risk factors is included in the press release we issued this afternoon, reporting the Company's first 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.

In addition to reporting financial results in accordance with generally accepted accounting principals or GAAP, the company provides non-GAAP financial measures, adjusted to exclude certain noncash and other specific charges, which the Company believes are useful to help investors better understand its past financial performance and prospects for the future.

However, the presentation of non-GAAP financial measures is not meant to be considered in isolation or as a substitute for financial information provided in accordance with GAAP.

Management believes these non-GAAP financial measures assist in providing a more complete understanding of the Company's underlying operational results and trends.

And management uses these measures to manage the Company's business to evaluate its performance compared to prior periods and the market place, and to establish operational goals.

Accordingly, our discussion of the first quarter results and the business outlook will be both on a GAAP and non-GAAP basis, which excludes the impact of stock-based compensation cost, amortization of purchased intangibles and any in-process research and development charges.

A reconciliation of GAAP to non-GAAP financial results discussed in today's conference call is contained in the Company's first quarter earnings release.

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

Thanks, Bob.

That was a mouthful.

A struggle -- a couple of drinks of water needed in between here to get through all of that.

Thank you all for joining us.

On the call with me today is obviously Bob, Alex [Bravman], our Corporate Controller.

As you can see from the press release that we issued a few minutes ago, Mercury had a very strong first quarter, $67 million in revenue, which is a new record for first quarter revenues.

However, as you've also seen, we're revising the guidance downward for the rest of the year in light of the softness that we're experiencing in the semiconductor industry and also some program delays that we're experiencing in the defense market.

I'll get into this later in the call in a little more detail.

But now that Bob's caught his breath, I'm going to turn it back over to him and he'll provide details on the first quarter results.

Again, good afternoon.

As you heard from Jay, first quarter results were strong.

On the top line, we reported the Company's highest ever first quarter revenues and the second largest revenue quarter in our Company's history.

We experienced strength in our traditional applications such as radar, Sig In, MRI and digital x-ray.

Strong revenue in our Defense and Commercial Imaging and Visualization Business Units helped to offset weaker revenue in our Advanced Solutions Business Unit.

The margin of products and services business unit revenue continues to be on track and the acquisitions we made in Q1 F1 2006 SOHARD and Echotek contributed to revenues in the current quarter.

These acquisitions are allowing us to offer more complete solutions to our customers in high-growth markets such as medical imaging and signals intelligence.

On an operating basis, our margins were affected by several factors including product and service mix, warranty reserves, the new accounting treatments for stock-based compensation expense, a one-time write-off of in-process R & D associated with the SOHARD and Echotek acquisitions, and higher amortization of purchased intangibles related to the recent acquisitions of Echotek and SOHARD.

Other than mix, these are all noncash items and therefore had no impact on operating cash flow.

We generated $17.8 million of operating cash flow in the quarter.

I will review revenue, including details by business unit.

And then I will discuss the Company's operating performance, balance sheet and cash flow results.

I will finish with a discussion regarding our outlook for the second fiscal quarter and the full fiscal year.

For the first time, we are reporting GAAP and non-GAAP earnings.

As I review our results, I'll discuss the adjustments we made to compute non-GAAP numbers.

But first, let me summarize total Company first quarter results as reported this afternoon.

First quarter 2006 revenues were $66.9 million.

This reflected growth of 21.7% over first quarter 2005.

GAAP operating income for the first quarter was $4.3 million or 6.4% of revenues.

Non-GAAP operating income was $8.4 million or 12.6% of revenues.

GAAP earnings per share were $0.14.

Non-GAAP earnings per share were $0.27.

As I will discuss later in the call, based on the method by which we originally computed first quarter 2006 guidance, we exceeded the top end of our guidance range by $0.02

At this point, I would like to drill down into operating performance, beginning with revenue detailed by business unit.

As you saw in our press release, first quarter total revenues were $66.9 million.

Our Defense Business Unit reported revenue of $41.1 million or 61% of total revenues for the first quarter, up approximately 33% from the same period last year. including a $1.4 million contribution from Echotek.

Within our three application areas, Radar, Signals Intelligence and Defense Technologies, this group experienced particular strength in Radar and Signals Intelligence.

Our Commercial Imaging and Visualization Business Unit revenue for the first quarter was $13.7 million, representing 21% of total revenue and up 31% from the same quarter last year.

Included a $1.7 million contribution from the recently-acquired SOHARD business.

During the first quarter, revenue from MRI and digital x-ray modalities were strong.

Our Advanced Solutions Business Unit first quarter revenues were $9.3 million or 14% of total revenues, down approximately 31% from the same quarter last year.

This was the result of continued weakness in the semiconductor market.

Our Modular Products and Service Business Unit contributed 4% of revenues.

Total backlog, including deferred revenue at the end of the first quarter, was $92.1 million.

A $1.9 million increase from the same quarter last year.

Of the ending backlog and deferred revenue, $83.8 million or approximately 91% relates to shipments expected within the next 12 months.

Gross margin was 63.4% for the quarter.

We attribute about half of the decline to mixed issues across business units, as well as a shift within Defense to lower margin products and half to warranty and service costs incurred in the quarter.

Regarding the mix of our business during the quarter.

First we had a higher than expected services contribution from newly acquired SOHARD.

The Professional Services are a growth opportunity for our Company but they do have lower gross margins.

However, because operating expenses attributed to the service revenues are lower as well, we expect the operating margins in the Professional Services Business, once it ramps, to approximate Company-wide operating margins.

We expect the mix issues to continue in the second quarter and recover in the second half of the year.

On a GAAP basis, total operating expenses were $38.1 million for the quarter.

Within GAAP operating expenses, selling, general and administrative expenses were $20.2 million for the quarter.

Research and development expenses were $15.9 million for the quarter.

Amortization of intangibles related to acquisitions was $1.5 million.

We also took a $548,000 one-time charge for in-process R & D related to the SOHARD and Echotek acquisitions.

A GAAP SG&A and R & D cost include stock-based compensation expense.

As we discussed last quarter, this is the first time we're expensing stock-based compensation according to FAS-123R.

The expense for the first quarter came in at $2.1 million, in line with the guidance we provided on our last conference call.

GAAP operating income was $4.3 million.

The GAAP tax rate was 36%, including a $0.05t impact of the FAS-123R expense.

GAAP EPS was $0.14 for the first quarter.

I will now detail our first quarter results on a non-GAAP basis.

We believe that this is also a useful way to review our operating results.

This is the way we measure ourselves internally.

This will provide a better basis for comparison against prior reporting periods and against most other companies who will not be incorporating the impact of FAS-123R until next year.

Our non-GAAP reporting results make the following three adjustments.

First adjustments, the exclusion of FAS-123R stock-based compensation expense ,which in GAAP results is allocated among cost of goods sold, SG&A and R & D, with the majority of it being allocated to operating expenses.

Second adjustment, the exclusion of amortization expense related to purchased intangible assets, which is a noncash expense related to acquisitions.

What we gave FY 2000 guidance on our last quarter conference call, our guidance included this expense.

We anticipated that it would have roughly a 2% negative impact on our operating margin.

However, after some consideration, and because we're starting a new fiscal year, we have decided to exclude this expense from our non-GAAP presentation.

We believe that excluding it allows it better comparison with many other companies that also make acquisitions.

During the first quarter, we also took a noncash charge for in process R & D associated with the SOHARD and Echotek acquisitions, which we excluded from our non-GAAP earnings.

Third adjustment, the tax rate, from 36% to 30% to accommodate the effects of the non-GAAP adjustments such as recently noted FAS-123R and R & D tax credits.

On a non-GAAP basis, we reported operating income of $8.4 million, representing 12.6 of revenue for the quarter.

The non-GAAP tax rate for the first quarter was 30%.

Net income of $6.3 million was 9.4% of revenue and EPS was $0.27 a share.

Trading for the balance sheet -- operating cash flow was $17.8 million in the quarter.

Operating cash flow is comprised of $3.1 million in net income, $3.8 million of depreciation and amortization and $10.9 million net decreases in working capital and other noncash items, including the new FAS-123R expense.

First quarter day sales outstanding, or DSO, was 52.

This is two days higher than the DSOs we reported in the fourth quarter of 2005 and above our targeted model of 45 days.

Inventory turns were five for the quarter, below the 5.5 turns of last quarter and below our full-year targeted model of eight turns.

Capital expenditures were $2.6 million for the quarter.

Cash, cash equivalents, and marketable securities were $170.6 million at the end of the quarter, down from $228.2 million at the end of the fourth quarter.

The decline resulting primarily from cash paid for SOHARD and Echotek, as well as our stock repurchase.

At the end of the first quarter, the total employee population was 875, up from 744 at the end of the fourth quarter.

Primarily due to employees who came to Mercury through acquisitions completed during the quarter.

As part of the previously authorized share repurchase program, during the quarter the Company repurchased 230,800 shares for approximately $6.3 million, for an average price of $27.

We expect to continue to utilize our stock repurchase program to purchase shares to offset dilution from our employee stock option and employee purchase plans.

I would like to move to the 2006 outlook, I'll first go through the second quarter guidance then I'll talk about the full year.

For the second quarter of fiscal year 2006, revenues are expected to be approximately flat to slightly down from Q1 FY '06 in the range of $61 to $64 million.

Based on the anticipated mix of business, we expect the gross margin will approximate 62%.

Second quarter GAAP operating and income is currently expected to be approximately break-even.

Excluding the expense related to stock-based compensation of amortization of purchased intangibles, non-GAAP second quarter, fiscal 2006 operating income is currently expected to approximately 4% of revenue.

The Company currently expects second quarter fiscal 2006 GAAP earnings per share to be in the range of -$0.02 -- a $0.02 loss to $0.00.

Excluding the impact of stock-based compensation costs in the range of $2 to $2.3 million and amortization of purchased intangibles of approximately $2.5 million, second quarter, fiscal 2006 non-GAAP earnings per share are projected to be in the range of $0.08 to $0.10 per share.

For the full year 2006, a reminder -- on our July 28 earnings call, the Company estimated an annual revenue range for the 2006 fiscal year of $295 to $305 million.

Representing approximately 20% growth year-over-year at the midpoint of the range.

Based on continued sluggishness in the semiconductor industry and several large defense programs experiencing timing delays, we're currently anticipating revenues to fall into the $275 to $285 million range or approximately 12% above last year's revenues.

By business unit, we project the full year revenue mix as follows.

The Defense Business Unit will approximate 56% of revenues.

The commercial Imaging and Visualization Business Unit will approximate 24% of revenues and the Advanced Solutions Business Unit will approximate 15% of revenues and the margin of Products and Solutions Business Unit, approximately 5% of revenues.

In total, this would represent a mix of approximately 56% defense and 44% commercial applications.

Moving through the P & L, we anticipate FY '06 gross margins to be in the 64% to 65% range.

Mercury remains committed to our continuing investments in research and development and customer support resources.

Accordingly, expect a modest increase in total operating expenses as the year unfolds.

We expect that operating margins should approximate 6% for 2006 on a GAAP basis.

On a non-GAAP basis, excluding stock-based compensation costs, amortization of purchased intangibles and in-process R & D charges, we expect the operating margins to approximate 12%.

As I have discussed, we anticipate a 33% annualized GAAP tax rate for the full year and have assumed a 30% non-GAAP rate.

Based on lower revenues, the Company currently expects 2006 fiscal year GAAP earnings per share to be in the range of $0.50 to $0.55, excluding the impact of stock-based compensation costs for the total year in the range of $8.7 to $9.3 million, amortization of purchased intangibles of approximately $8 million, in-process R & D charges of approximately $500,000;

Fiscal year 2006 non-GAAP earnings per share are projected to be in the range of $1.00 to $1.05.

In terms of working capital, we continued to drive through improvements in our DSO to 45 days and our inventory turns to eight.

CapEx for 2006 is projected to be approximately $14 million, compared to $10 million spent in 2005.

Depreciation and amortization will be approximately $20 million, including amortization from intangible assets.

In summary, for the full year non-GAAP financials, we project revenue of $275 to $285 million or approximately 12% growth over fiscal 2005.

We project gross margins of approximately 64% to 65%.

And non-GAAP operating margin of approximately 12%, resulting in non-GAAP earnings per share in the range of $1.00 to $1.05.

We remain committed to our timeless business model which delivers a 16% to 18% operating margin.

In fact, our current guidance places the Company's fourth quarter performance in this range.

At this point, I would like to turn the call back over to Jay for his industry comments and additional context regarding our business outlook.

You're doing all the heavy lifting today.

I'm out of the water.

As I mentioned earlier, the softness in the semiconductor industry and delays in the fuel by defense programs have impacted our FY '06 plan.

We're taking a bit of a bath in the semiconductor business.

We received the revised delivery schedule after we had put our plan in place and put the projections out on the streets for FY '06.

Thus, we're taking our projections down by several million dollars for the semi-business.

On the defense side, the '06 Defense Authorization Bill has not yet been signed.

Investment priorities for next-generation platforms are clouded by more media spending priorities.

The good news is that some of the Secretary's top legislative priorities should benefit Mercury going forward.

He's requesting that there be a focus on emerging science and technology that harness effective private sector practices, which for us, translates to the utilization of commercial off-the-shelf products.

And to speed the development and production of weapons systems which, again, in many cases, relates to utilizing commercially available products.

A couple of major programs that we're expected to generate somewhere between $10 and $15 million in revenue in this fiscal year has slipped out.

While the defense business tends to be lumpy in terms of revenues and bookings, we're confident that will continue to be a solid growth business for Mercury.

And the $10 to $15 million in revenue that slipped out of this fiscal year, we would expect to see come back in the subsequent fiscal year.

Given the business outlook, we're reevaluating our portfolio and have initiated a systemic review of all of our long-term product and market development projects so as to realign our resources appropriately.

For the past several months, we've been undergoing an organizational realignment to provide more responsibility and accountability to the business units which have been renamed.

You may have picked this up and listening to Bob's comments, the Defense Electronics Group, or DGE, is now referred to the Defense Business Unit.

The Imaging and Visualizations Solutions Group is now the Commercial Imaging and Visualization.

And the OEM Solutions Group is now the Advanced Solutions Business Unit.

We believe this realignment will provide us with a better customer focus in our key markets and better position us to meet our customer's time to market requirements.

Within our CIV or Commercial Imaging and Visualization Business, specifically in the life sciences area, they're on track as projected.

With product ties, the technology synergies created from our acquisition of the TGS Group enhancing our portfolio 3D visualization solutions.

It is too early yet to see the benefits of the SOHARD acquisition, but we're very pleased with the integration progress, the quality of the revenues, the great customer relationships that include those with Siemens and more specifically, the very talented personnel who are now part of the Mercury team.

The CIV business has a robust pipeline of business communities within life sciences, oil and gas, drug design and microscopy which are in various stages of qualification and product evaluation, some of which are based on cell-based products.

As a result of Mercury's organic computing capability plus the acquisitions of the TGS Group and SOHARD AG, we are now positioned to participate in all of the key functional elements for diagnostic medical imaging and interventional modalities.

These elements are data acquisition, reconstruction, visualization, distribution, and archiving.

Across all of the CIV businesses, we continue to see a growing need for intensive computing capabilities as they relate to increased volumes data, the need for enhanced image accuracy and the need to perform 3D operations in realtime.

Having this capability will enable us to address the market opportunities in diagnostic medical imaging and picture archiving and communications, drug design, microscopy, geo sciences or oil exploration and reservoir management and computer-aided design and manufacturing.

The sum of the potential OEM market for all of the above is estimated to be in excess of $1 billion dollars in 2005, growing to approximately $1.7 billion in 2010.

In the communications space, Tier 1 telecom equipment providers are continuing to evaluate the capabilities of our ensemble system as it relates to remote network controller applications.

We're also pursuing satellite bay station data leak systems for the commercial and defense markets.

Within the Advanced Solutions Business, we're pursuing several businesses for cell-based products to address requirements, not only within our existing markets, but also some exciting new markets.

We believe that over the next 12 months, the telecom corporate manufacturers will decide on their next -generation platforms.

Give than we're successful, we expect the market to turn into a major part of our commercial business going forward and therefore, substantiates the ongoing investments.

Mercury -- Momentum Computer is now the Modular Products and Services Group.

We're on track with bringing the single-board computer capability to Mercury's traditional markets.

It is performing to expectations.

And we believe we'll be on our financial target for the year.

In the defense area, the integration of Echotek, which we acquired this past quarter, is on plan.

Echotek provides another opportunity to revenue synergies by leveraging existing customers and sales force relationships.

Again, it is too early in the game to demonstrate the synergies that we fully expect we'll see, here shortly.

We received an order from a major defense prime contractor for our first cell process of based development system, the dual cell-based blade, which we announced earlier this month.

With regards to cell, we are investing approximately $6 million in cell product development this fiscal year and an additional $2 to $3 million in market development.

We strongly believe that the alliance with IBM at both the product and market levels will open up significant new market opportunities for Mercury, while also addressing our current customer base.

The dual cell-based blade, Mercury's first cell-based product, supports some of our customer's needs for development systems.

And in some cases, will be suitable for other customers production requirements.

It allows Mercury to take advantage of the available blade center infrastructure, that's the IBM blade center infrastructure, which is a pervasive form factor in a number of applications.

We plan to deliver limited quantities of the dual cell-based blade toward the end of this fiscal year.

We'll be demonstrating some of our new 3D visualization technology at our annual investor conference to be held on November 17th in Boston.

And I would encourage all of you to attend if you could.

We'll also be demonstrating at the 2005 radiological society of North America or RSNA Conference, which takes place in Chicago at the end of November.

So, in conclusion, we continue to strongly believe that our strategy will support our 25% target goal.

And that we'll return to our timeless business model of generating operating income in the 16% to 18% range.

I appreciate your time and I'll turn it over to the moderator for questions.

Thank you. [OPERATOR INSTRUCTIONS] We have a question from Mark Kelleher with Adams Harkness.

Thanks.

I was wondering if you might give some more insight into the defense program delays.

Is it a budgetary issue?

Is there a general expectation that there's going to be less defense spending?

What's behind some of the delays?

Well, I don't think there's any one thing.

There's been several of them, as I said.

And in some cases, it is issues with the program itself.

And I'm not at liberty to give the details.

It would be up to our customer to put out any news that they saw fit on this.

In other cases, we've seen moneys get reallocated and so again, it varies from program to program.

All we know is that somewhere in the order of $10 to $15 million that we've counted so far that's slipped thought year.

Okay.

Thanks.

Next question is from Bill Benton with William Blair.

Good afternoon, guys.

Sorry about that --the Red Sox thing, Jay. [ LAUGHTER ]

Thanks, Bill.

I just had a question for you.

In terms of the -- I guess you guys changed the definition of the backlog a little bit.

You're saying backlog on deferred revenues now, is that correct?

We're including deferred revenue in what we're calling backlog, correct.

Okay.

Can you just kind of explain maybe some of the logic behind the change?

And then I had a question with regard to visibility after that.

I think the logic behind the change was just a cleaner view on -- I think most people would assume that deferred revenue would be in our definition of backlog.

So, you know, for us, it is backlog future revenue so, that's why we redefined it.

Okay.

The dollar amount here at the end of the quarter is not that large.

Alex -- it's $5 to $6 million range deferred revenue.

Okay.

And then just in terms of your comfort with the -- obviously your guidance -- as you suggest 2Q and the full year, would suggest a return to those higher gross margin levels in the back half of the year and the revenue.

I mean, do you sense that you got some pushouts near-term and that you feel like the other stuff in the last two quarters of the year have better visibility at this point?

I'm just trying to get your general sense on how you're viewing the confidence level.

Okay.

You're reading it right.

A restoration of the gross margins to a more normalized level in H2 compared to H1.

It is driven by two things.

It is a mix issue, in part.

Then we did take some more to reserve charges here particularly in the first quarter.

So, it is primarily those two items.

Still evaluating whether we're going to get it all the way back to our targeted model range of 66% to 67% on a longer-term range.

We'll see.

Okay.

And then, could you just give us the warranty reserve number that you took in the first quarter?

The incremental that we weren't anticipating was about $0.5 million.

$0.5 million?

Okay.

I'll jump back in the queue.

Sure.

Thanks.

Moving on is Steve Levenson with Ryan Beck.

Good afternoon, Jay and Bob.

Hi, Steve.

Can you give us a breakdown on how you think the amortization is going to go throughout the year?

And then at what point is that going to be done?

I'm talking about the amortization of the purchased intangibles.

Sure.

I would be happy to do that.

Get my TTO sheet out here in front of me.

You're thinking quarter-by-quarter?

Right.

Yes, okay.

So, we had a charge of -- in the first quarter, about $1.5 million for the amortization of intangibles related to the acquisitions.

And in-process R & D was approximately $0.5 million.

Yes.

Our view on the in-process R & D, going forward, is that there is none in the next three quarters because that's always taken in the periods that the deals close.

Right.

So, just to clear that up.

The amortization, which continues for a number of years, our view is that it would be in the two to two and a half range in each quarter, looking forward.

Two and a half range in quarters two and three.

Maybe dropping down closer to two in the fourth quarter.

These charges, as you know, tend to go on.

There's variable lives depending on what's behind it.

Whether we're talking customer lists or we're talking technology or perhaps even backlog.

Something like backlog would have a very short life, a few quarters, whereas a customer list where the technology itself could be on average three, four, sometimes as long as five years.

So, it is in that range.

These charges continue.

And they'll continue I guess into fiscal '07?

Some of them will go into '08-'09.

Okay.

Not necessarily at these levels.

But they will continue.

Okay.

Thanks.

Now, do you see any opportunities -- one of your neighbors up nearby, Analogic, which makes CT scan machines among other things, is apparently laying people off and winding down their embedded computer business.

I know that's something you've been trying to get back into.

Do you see any opportunities there?

Steve, I don't understand the comment that we're trying to get back into the embedded computer business.

No.

The CT scan.

Oh, the CT.

Well, Analogic produces complete CT systems, which they sell in I believe, third world markets more than they do the U.S.

So, we're not going to go over there and try to buy our way into the medical business by buying a complete line of CT systems.

That would certainly put us in the competition with the G.E. and the Siemens.

No.

I just mean they're going to close their embedded -- one down in the operations of their computer business, Sky Computer.

Do you see an opportunity to get in there and sell them some of your product for use in their CT scanners?

Oh.

As opposed to them using the Sky Computer?

Right.

Is that what you're suggesting?

Yes.

I don't even know that they use the Sky Computer in that system, Steve.

I think that's an assumption that would have to be verified.

But it is a good thought.

Honestly, I don't believe we've been over there yet to do that.

Okay.

Last item relates to the options which, obviously, make up a pretty substantial portion of the noncash -- the stock-based compensation.

Can you tell us, is that calculated using the Black-Scholes Model?

And when it comes to the actual number of options -- or I guess the actual number of options is it similar to prior years or more or less?

So, you're referring to the calculation behind the impact of 123R.

Right.

We do continue to use Black-Scholes.

We did not opt for the binomial.

I can validate that.

I'm not quite sure what the other part of your question was.

Just in terms of the actual number of options being granted.

Is that a similar amount to prior years?

Our planning assumption for '06, is that '06 would be similar to slightly down compared to prior years.

I think you find that consistent with what other companies are talking about.

Have you seen our proxy yet, Steve?

Not yet.

Okay.

So, hopefully it is on its way to you, but you'll see that in our proxy, we're looking for approval for a rather broad-based equity plan -- new equity plan, which has multiple instruments in it.

So, stock options and restricted stock, as an example, are -- our final determination as to which instrument we would use or would we perhaps use a mix -- hasn't been made.

We would be on track to issuing options more in the second half of this year as opposed to the first half.

But I think you're generally going to see companies looking to reduce the expense impact of 123R.

And one of the ways you do that is quite frankly, you issue less options on an annual basis, compared to previous years.

Okay.

Thank you very much.

We'll take a question from [Paul Setz] with Capital [Flows].

Yes.

Can you -- you spoke earlier about -- you mentioned that the semiconductor area was disappointing this quarter in terms of incoming order rates.

Could you describe to us some of the applications of Mercury's products in the semiconductor and conductor service areas?

Paul, our systems are being used in various inspection systems. [Wafer and Redical] Inspection systems.

So, we're doing the computation to find the defects in [Wafers] or in [Redicals].

And I think that if you looked at our K, you'd see that the customer is [Kayli 10 Cor].

Thank you.

This is from Brian White with Kaufman brothers.

I'm just curious.

One of your big customers, Northrop Grumman, announced last week and blamed Rita and Katrina for the programs that were delayed.

Did that have any impact on you in the quarter or in the December quarter outlook?

It had no impact on us in the quarter.

And we're not anticipating any for Q2.

Okay.

For the December quarter, what markets do you think will actually grow sequentially?

When you say markets, you're referring to the way we look at it from a business unit standpoint?

Exactly.

We're looking at growth in the Imaging and Visualization market space.

Modest growth with our Marginal Computer Business, the single board computer business but of course, that's very small.

And that's it.

It'll be a -- what we're seeing is a sequential decline in the Defense Business Unit.

Remember, our total revenues per our guidance here is slightly down from our Q1 performance.

Okay.

Great.

Thank you.

Right on.

[OPERATOR INSTRUCTIONS] We'll go back to Mark Kelleher with Adams Harkness.

I was just wondering if maybe Bob, you could talk about the balance sheet issues, the receivables and the inventory turns?

A little bit out of where you want those to be?

Sure.

Our receivables are in excellent shape.

If we use a countback method --I think the DSO calculation comes out to something that approximates 33.

The way of viewing that is everything is extremely current, given the majority of our business is done on 30 day terms and we just don't write stuff off this.

It doesn't happen with our blue chip customers.

So, it was a back-end loaded -- ?

It was a back end load.

We've had this issue for many quarters now, where we skew shipment-wise to the back-end of the quarter and that does drive the DSOs up in those low 50s.

Our goal is 45.

Obviously, we're pleased with the 33-day countback method.

But putting more linearity, if you will, into the shipment pattern during the quarter, would push the DSOs down to -- easily down to our model range of 45.

And I guess where you're going is, you understand quite clearly that's a much more efficient model from a working capital standpoint.

Inventory turns -- they're in the five range.

They've been there for awhile.

That's decent performance for the kind of company we are.

We have a goal of eight.

And we've got some rather large investments going right now in the infrastructure space.

We're doing an Oracle reimplementation that's well on its way.

It is about six months into that.

That will be the 18 to 24month project when we're done.

We installed Oracle five, six years ago.

It is time to upgrade and take the general system, if will you, particularly the business processes to the next level.

That helps us a lot in the MRP front.

That ,combined with some work we have underway in the supply chain space, loosely defined as supply chain transformation, are really getting at of some the underlying business processes.

Example, new product introduction, generally addressing the -- how we design products, how we design them for manufacturablility and service, should finish off the job of getting us to our target of eight turns or better.

Okay.

And the warranty cost that increased.

Why was that?

Was there something going on that you needed to cover with the warranty?

It was nothing alarming.

Every now and then, you have situations with installed bases where there's a part failure out there and it is covered under warranty.

And you have to address an entire installed base.

We -- our warranty charges tend to be modest and mostly what we're covering off there is a -- is single boards, single systems here and there.

Coming back under warranty.

We repair them.

We incur warranty charge.

Every now and then, you'll end up with a situation where it is determined that it is the best course of action is to upgrade, if you will, all of the installed base for a particular part.

That's what we hit here.

And they're very spotty.

So, that was the nature of that $500K charge for the quarter.

Okay.

Great.

Thanks.

We'll go back to Bill Benton with William Blair.

Couple of easy ones here.

Advance Solutions, I presume that's still all semiconductor pretty much, now?

It is still all pretty much semi, right?

Yes.

No baggage stuff in there?

There is a little bit of baggage stuff in there.

But you're talking about baggage inspection as opposed to baggage?

Yes.

Thank you.

Okay.

And then in terms of the R & D sequential, the jump, is that acquisitions?

Is that where --

Yes, it is.

The majority of the operating expense increased sequentially, quarter-to-quarter, are the acquisitions.

Okay.

So, we just kind of assume -- actually, we didn't have a full quarter obviously of Echotek?

Well, no.

No, we had one month for Echotek but we did have a full quarter for SOHARD.

Okay.

So, we would expect those, obviously, you've incorporated that within your operating expense outlook here.

Yes, we have.

Okay.

Thanks again.

Okay.

Next question is from [Dave Heger] with Kennedy Capital.

Thanks.

I just wanted to make sure I understood -- in looking at the second quarter outlook, and not a significant drop in revenue. it looks like the bottom line is expected to drop off quite a bit versus where you were in the first quarter.

I want to make sure that all the dynamics are going on there.

Is some of that is that you're getting a full quarter of impact of operating expense from Echotek?

And then on the gross margin front, are you having some impact in terms of product mix and the Defense Business coming in weaker?

Just wanted to make sure I understood why there was going to be so much drop-off.

I would agree with everything you named, Dave.

Defense will be a smaller percentage of our total revenues in the second quarter than the first quarter.

And you know, that's hurts from a mixed standpoint.

That does translate, in part, to the guidance to the gross margin for the second quarter, which is down slightly from the first quarter.

And operating expense does move up a couple million bucks, sequentially.

Mostly because of the full quarter impact of the Echotek acquisition.

And then some modest hiring.

But nothing large.

And then as you look out into the second half of the year --it would indicate you feel like at least some rebound.

Is that as you feel like Defense will pop back a little bit or what gives the confidence there?

Well, we -- we're going to see how higher revenues in Age Two there's no question about that.

And I think that's primarily what's going to drive the improved operating performance, Age Two over Age One, by those higher revenues.

We get a little lift from [Nix] on the gross margin line.

And the operating expenses don't move up very much in Age Two.

And we get an opportunity to restore the situation that way.

I did note in the guidance that we would be in our -- safely in our model range, from an operating income standpoint, to center revenues in the fourth quarter.

Okay.

Thanks.

Yes.

[Phil Greeson] with Peregrine Capital has the next question.

Hi.

It's [Phil Greeson] at Peregrine.

A quickie -- and perhaps it's understandable given the bookings in the quarter.

We didn't hear you reiterate the corporate commitment to 25% growth that we've heard in the past.

As you look at some of the dynamics in the defense market, does this feel like the typical lumpiness that you've in past?

Or is it something that's caused you to, on a longer-term basis, reevaluate those prior assumptions?

Thanks.

Phil, maybe you missed it, but my closing comment was that we continue to strongly believe in our strategeous support of our 25% target goal.

And that we're going to return to our timeless business model, generating operating income in the 16% to 18% range.

Oh, great.

I got the back half, I didn't get the front half.

Apologies.

Did you give us a book-to-bill for the Defense Business?

We do it for the total Company.

Okay.

Thank you.

We'll go to Brian White with Kaufman Brothers.

Just tell us what incremental revenue was provided in the first quarter from Echotek and SOHARD combined?

I think I can do that.

In total, $3 million.

Okay.

And then, Echotek, I guess, contributes incremental in the December quarter.

How much do you think that will be?

What we'd said -- Echotek, when we acquired them, that their recently published year -- they were in the high teens for the total year.

We haven't been really breaking it out that way, and I don't think our intention, going forward, is to break it out that way.

We're not treating them as a reportable segment.

We're synergizing them inside of our Defense Business Unit, so, we won't be going down that path of breaking them out.

But you're going it -- ?

Okay.

It closed, what, a month ago?

We had one month of Echotek business in.

But be careful with one month's -- they are defense guys.

And their business is lumpy, too.

You can't take what they might have done in month three of the first quarter and -- do simple math to get a full quarter's worth.

Okay.

But it looks like it could be $2 to $3 billion incremental on the December quarter.

Just back in the envelope.

Well, incremental over [indiscernible] we've already given you.

Yes, incremental -- like incremental --

Is he trying to figure out what's in the guidance that's attributed to Echotek.

And you're in range.

It's fine.

Pricing pressure.

Is the pricing pressure out there in any markets greater than you had thought?

I don't think it's any greater now than we've seen in the past.

There is always pricing pressure -- GE, you can't do business with them without experiencing pricing pressure.

Okay, but you haven't seen an acceleration in any markets?

Particularly in the Defense?

No.

Good.

Thank you.

It appears there are no further questions.

I will turn the conference back over to you.

Well, thank you all.

I appreciate your taking the time.

And we'll look forward talking to you again in three months.

Bye now.

Thank you.

That does conclude today's conference call.

Thank you for your participation.