Mercury Systems Inc (MRCY) 2006 Q2 法說會逐字稿

Good day everyone, and welcome to the Mercury Computer Systems Incorporated Second 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 Ms. Jennifer Heizer, Investor Relations Specialist.

Please go ahead, ma'am.

Good afternoon everyone, and welcome to the Mercury Computer Systems second 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, www.mc.com or on the FirstCall 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, which involve risks and uncertainties that could cause actual results to differ materially from those projected or anticipated.

Additional information regarding forward-looking statements and risk factors is included in the press release we issued this afternoon, reporting the Company's second quarter results and in the Company's periodic reports filed with the SEC.

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, we will also be discussing non-GAAP financial measures adjusted to exclude certain non-cash and other specified charges, which we will specifically identify.

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, along with our corresponding GAAP financial measures, to manage the Company's business to evaluate its performance compared to prior periods in the marketplace, and to establish operational goals.

However, they are not meant to be considered in isolation or as a substitute for financial information provided in accordance with GAAP.

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

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

As we reported today, our second quarter revenues of 62.5 million came in within our guidance range.

And through cost control measures taken during the quarter, we were able to get some leverage out of these revenues to exceed our guidance on the bottom line.

On today's call, we will be discussing among other things how we plan to continue to reduce operating expenses in light of the continued lack of visibility in the defense market, which is the primary cause behind our lowering our guidance again for the full year FY '06.

But first, let me turn over to Bob for details of the second quarter.

Thanks, Jay.

Good afternoon, everyone.

As you heard from Jay, we met expectations on the top line during the quarter, and exceeded guidance on the bottom line by controlling operating costs.

The modest growth in year-over-year revenues are driven by the acquisitions we made last year and last quarter, as we experienced weakness in most of the areas that have been strong in recent quarters, particularly in our traditional radar applications.

Our Advanced Solutions business unit posted a modest year-over-year gain, and the Modular Products and Services business unit also contributed to year-over-year revenue growth.

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

We continued to further develop synergies between acquired products and technology, and those of Mercury's existing businesses.

Our operating income versus last year continues to be affected by several factors, including business unit mix, product and service mix, higher warranty expenses, the new accounting treatment for stock-based compensation expense, and higher amortization of acquired intangibles related to the recent acquisitions of Echotek and SoHard.

I will review revenue, including details by business unit, discuss Company operating performance, balance sheet and cash flow results, and finish with a discussion regarding the outlook for the fiscal third quarter and the full fiscal year.

I will discuss the numbers on both a GAAP and non-GAAP basis.

First, let me summarize total Company second quarter results as reported this afternoon.

Second quarter 2006 revenues were $62.5 million.

This reflected growth of 5.3% over second quarter 2005.

GAAP operating income for the second quarter was $709,000 or 1.1% of revenues.

Non-GAAP operating income was 5.2 million or 8.4% of revenues.

GAAP earnings per share were $0.08, non-GAAP earnings per share were $0.18.

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

Our Defense Business Unit reported revenue of 33.8 million or 54% of total revenues for the second quarter, a revenue increase of approximately 2% above the same period last year.

Within our three application areas, radar, signals intelligence, and defense technologies, radar was particularly weak compared with last year, and signals intelligence was down modestly.

These areas were affected by delays in the approval of the defense budget, resulting in week bookings as programs slid to the right.

Echotek contributed 2.3 million of revenue for the quarter.

Our Commercial Imaging and Visualization Business Unit revenue for the second quarter was 15.2 million, representing 24% of total revenue, about flat with the same quarter last year.

During the second quarter, revenues from MRI and digital x-ray modalities were down slightly year-over-year due to legacy programs tailing off.

SoHard contributed 2.4 million of revenues for the quarter.

Our Advanced Solutions Business Unit second quarter revenues were 10.8 million or 17% of total revenues, a revenue increase of approximately 3% from the same quarter last year.

Although the business stabilized a bit this quarter, we still expect it to be slightly down for the year as compared to last FY.

Our Modular Products and Services Business Unit contributed 5% of revenues.

Total backlog, including deferred revenue, at the end of the second quarter was 80.8 million, a $34.5 million decline from the same quarter last year, which happened to be the strongest bookings quarter of FY '05.

Of the ending backlog and deferred revenue, 71.3 million or about 88% relates to shipments expected within the next 12 months.

Our backlog continues to be negatively affected by defense program push out.

GAAP operating income was $709,000.

Net income was 1.6 million, and resulting GAAP EPS for the second quarter was $0.08.

Now I will detail our second quarter results on a non-GAAP basis.

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

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

First adjustment, the exclusion of FAS 123R stock based compensation expense, which in GAAP results is allocated amongst COGS, SG&A and R&D, with the majority of it allocated to operating expenses.

Second adjustment, the exclusion of amortization expense related to acquiring intangible assets which is a non-cash expense related to acquisitions.

Third adjustment, the year-to-date tax adjustment of moving the rate from the GAAP tax rate of 21% to 30% is to accommodate for such non-GAAP adjustments as FAS 123R and the R&D tax credit.

On a non-GAAP basis, we reported income of 5.2 million, representing 8.4% of revenue for the quarter.

Non-GAAP net income of 3.9 million was 6.3% of revenue and non-GAAP EPS was $0.18 per share.

Turning to the balance sheet, operating cash flow was 2.6 million in the quarter.

Operating cash flow was comprised of 1.6 million in net income, 4.9 million of depreciation and amortization, and a 3.9 million net increase in working capital and other non-cash items, including FAS 123R expense.

Second quarter day sales outstanding, DSO, were 55.

A higher DSOs, relate to the skewing of shipments to the backend of the quarter.

Inventory turns were 4.2 for the quarter, below the 5 turns last quarter and below our full-year targeted model of 8 turns.

We continued to work our supply chain efficiencies to implement process improvements, which will allow us to increase our turns to our stated objective of 8 over time.

Capital expenditures were 2.8 million for the quarter.

Cash, cash equivalents and marketable securities were 165.5 million at the end of the quarter, down from 170.6 million at the end of the first quarter, the decline resulting primarily from the stock repurchase program.

At the end of the second quarter, the total employee population was 891, compared to 875 at the end of the first quarter.

As part of the previously authorized share repurchase program, during the quarter the company repurchased 301,062 shares for approximately 6 million or an average price of approximately $19.99.

Year-to-date, the company has repurchased 531,862 shares for approximately 12.3 million or at an average purchase price of $23.10.

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

I'd now like to move to the 2006 outlook.

I'll first go through our third quarter guidance, and then I'll talk about the full year.

The third quarter outlook.

For the third quarter of fiscal 2006, we project revenue of $55 to $58 million.

We project a non-GAAP gross margin of approximately 59% to 60% and a non-GAAP operating loss ranging from a loss of 6% to a loss of 3%.

The non-GAAP tax rate is 30%.

The diluted shares are 21 million, which excludes the convertible debenture adjustment.

The resulting non-GAAP losses per share are in the range of a loss of $0.10 to a loss of $0.04.

The impact of stock-based compensation costs for the quarter are in the range of $3 to $3.3 million, and the amortization acquired intangibles is approximately $2.5 million.

The GAAP tax rate is 21% and the GAAP diluted shares are projected to be 21 million, which also excludes the convertible debenture adjustment.

As a result, third quarter fiscal 2006 GAAP losses per share are projected to be in the range of a loss of $0.32 to a loss of $0.26.

As you may be aware, our convertible denture adjustment in the diluted shares' calculation can only be included if the effect on earnings per share is dilutive.

For Mercury, dilution occurs when net income is approximately $3 to $3.5 million or above per quarter.

For further explanation, please reference our press release in the accompanying financials.

For the full year 2006, I'll now turn to our full year guidance.

We are currently anticipating revenues to be in the $250 to $260 million range, or approximately flat for last year's revenues.

By business unit, we project the full year revenue mix as follows -- the defense business unit will approximate 55% of revenues, the commercial imaging and visualization business units will approximate 23% of revenues, the advanced solutions business unit will approximate 70% of revenues, and the modular products and solutions business unit will approximate 5% of revenues.

In total, this would represent a mix of approximately 55% defense to 45% commercial applications.

We project a non-GAAP gross margin of approximately 61 to 63%.

The reduction from the previously guided 64 to 65% range is driven by reduced defense volume, a mix shift within the Defense Business Unit, and increased warranty costs.

We project a non-GAAP operating margin of approximately 6 to 8%.

We expect a modest increase in operating expenses in the second half to account for mid-year salary increases and continued investment in the ERP re-implementation program.

The non-GAAP tax rate is 30%.

Diluted shares are 25.5 million, which includes the convertible debenture share adjustment of 4.1 million shares and the net income full-year adjustment of $2.4 million, which relates to the convertible debenture.

The resulting non-GAAP earnings per share are projected to be in the range of $0.50 to $0.70.

The impact of stock-based compensation costs for the full year are in the range of $9 to $11 million.

The amortization of acquired intangibles is approximately $8.4 million, and in process R&D charges are approximately $550K.

The GAAP tax rate is 21% and the GAAP diluted shares are projected to be 21 million, excluding the convertible debenture adjustment as I mentioned earlier.

As a result, fiscal year 2006 GAAP earnings per share are projected to be in the range of a loss of $0.16 to a profit of $0.09.

CapEx in 2006 is projected to be approximately 15 million, compared to 10 million spent in 2005.

Depreciation and amortization will be approximately $18 million, including amortization from intangible assets.

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

Jay?

Thanks, Bob.

Now, I'd like to go into a little more detail on what is causing the softness in our topline.

To explain the steps we are taking to align our operating expenses with this lower level of revenues, and how we are fine tuning Mercury's current strategy to get the topline moving again, even in light of the current program delays we are experiencing in our defense business.

First, let me discuss our mission and strategy.

Mercury's mission is to provide solutions for challenging computing tasks.

The applications we are a part of can be broadly defined as signal processing, image processing and 3D visualization.

Typically, the innovative value we provide is architecting solutions, which meet a broad range of price performance requirements.

Our strength is in leveraging our architectural capabilities across markets and being able to identify new applications which require innovative solutions, and our strategy is to leverage the strength by developing these new markets, by our internal development with partners and alliances, and through acquisitions.

An example that I'd like to give you is in a satellite data links application, which happens to apply to both defense and commercial markets.

This is a very demanding Signal Processing application, which requires an innovative hardware and software solution, utilizing a heterogeneous architecture, with tens to hundreds of processing elements, including DSPs, general-purpose processors, and FPGAs.

And oh, by the way the software to make it all work of course.

We have been selected by a defense contractor and a commercial communications company to develop systems to meet their data link requirements.

We're currently in the final stages of contract negotiations, and we'd anticipate design win announcements in Q3, given that we receive permission from our customers.

Revenues for this application FY'06 will be for engineering development with product revenues projected for FY '07.

This is an example of our ability to leverage our signal processing architectural expertise across markets in an application where our value innovation will be difficult to replace for the foreseeable future.

Our estimate of the available market size is in excess of $100 million.

As technology evolves, some applications will migrate to commodity products as they become good enough.

Where we can no longer add value our efforts are directed elsewhere.

This has been part of our business for many years.

Our long-term historical growth performance would suggest that we have successfully navigated through these periodic transitions, while experiencing occasional flat spots along the way.

To some extent, we are now experiencing these product transitions in several areas of our business.

As a result of this the current softness in the defense market is having a more significant impact on our performance than we expected.

We had planned for several of the many new market and application opportunities we have been working on, to provide the approximately 20% growth originally projected for FY '06.

However, as is sometimes the case, adoption of our new technology and OEM design decisions are taking longer than we had planned.

We have promising opportunities in the pipeline across our business units, and these are at various stages of market and customer acceptance.

However, the combined revenue impact of this future business is not likely to build enough momentum this year to offset program delays in the defense area.

And in some cases, the ramp-up of these revenues is behind our original target to replace programs we anticipated would go end of life.

As a result, as Bob discussed, we are lowering our guidance for the full year FY '06.

I will discuss steps, we are taking to realign resources to better implement our strategy of leveraging Mercury's technology assets and grow the top line.

But first, I'd like to give you an update on our Cell technology and then review trends in our business units.

As the value migrates to the silicon at one end of the spectrum and the application at the other, how are we positioning Mercury?

At the silicon end, with suppliers like IBM, TI, and nVidia, we have developed marketing relationships which are introducing us to new opportunities, and also developed an intimate understanding of the processing -- the various processing elements, so as to create algorithms with world-class performance.

This capability is absolutely critical to the cost-effective implementation and market success of the application.

At the application end, we provide software such as the Amira 3D visualization tool with multiple variants for the various markets; life science, microscopy, oil and gas, navigation, drug design and software frameworks to enable the efficient utilization of multiprocessors such as the beamforming computation engine for the data links application I spoke of previously.

So how does Cell fit into that strategy?

Well, the alliance with IBM has proven to be very positive.

We are engaged in a number of opportunities in new markets, as a result of IBM's marketing efforts.

Our sales forces are working together as our relationship continues to mature and expand.

However, the adoption of a new architecture takes time.

Prior to release of production grade cell products, we've already begun shipping initial systems for customer evaluation purposes in both defense and commercial markets.

We're currently working with IBM on additional products to develop, which we hope to bring you news on in the coming weeks.

We're also exited about the evolution of the Cell architecture, which you may have read about in recent news.

Customers' questions about the Cell evolution roadmap should be answered now that STI has announced the future plans for the next generation.

And we expect STI, to announce additional plans in the future.

STI by the way, stands for Sony, Toshiba, and IBM.

We announced the PowerBlock 200, a 200 gigaflop machine equivalent to about 45 Intel Pentium 4s and a chassis about the size of a toaster oven.

The applicability of a system such as this in defense, for multiple in theatre swap or space power wattage, cooling issues constrained applications, is a game-changing system.

We're in the early stages of market development, both existing and new, for this exciting and disruptive technology.

I expect to be in investment mode for several quarters given the time required by OEMs and primes to bring new products to market.

Let me talk about the business units, just a quick recap.

Advanced solutions, this is the business unit that addresses the semi and the communications markets.

Our outlook has improved some for the year based upon activities in both markets.

We are addressing opportunities outside of KT in the semi space.

The Micronics business is growing.

We shipped a new ensemble to a TCA platform to two Tier 1 TAMs and received an order from a third TAM for a new development system in Q2.

As stated previously, we have two design wins for wideband data link systems.

Validation of the designs will take several months, so we would not anticipate production revenues until calendar '07.

These are very large complex systems with a high content of Mercury IP.

Overall, this business unit has a 44% CAGR measured from '02 to '06, and I believe has the potential to grow at this rate or greater.

CIV, commercial imaging and visualization, we continue to believe that our 3D everywhere strategy in life sciences is valid and are aggressively pursuing many opportunities.

We did receive three design wins in Q2.

However, market adoption of this capability is moving slower than originally anticipated.

We do have a very robust sales pipeline in excess of 30 prospects in life sciences, with run rate potential, revenue potential in excess of $70 million annually.

Given the lengthy OEM decision process, we have revised our forecast to approximately 20% revenue growth or approximately $60 million in this business unit.

In the for what it's worth with category, Advanced Imaging Magazine selected are Digital Breast Tomosynthesis 3-D Visualization application, which was developed in conjunction with the radiology department at Mass General Hospital under Dr. Kopans, as their solution of the year in the medical category.

This system, DBT as it's referred to, is expected to go to clinical trials this calendar year.

Now for defense, and what I call the perfect storm.

The revision of our FY '06 projections is primarily because of continued poor visibility in this market.

This can be attributed to a number of factors.

The FY '06 defense budget not being approved until early January and a continuing shift of priorities to support the Iraq and Afghanistan activities.

We believe this has resulted in a number of programs slipping to the right.

Some former military sales have also been delayed.

Additionally, some technology trends are having an impact in that new beta standards are causing delays and decisions by forcing customers to reevaluate the supplier base for new products, and the inclusion of FPGA technology and systems, results in the lowering ASP in the overall system.

So coupled with the previously announced ACS program termination which was about $10 million for us, the overall impact of all that I suggested above, could be in the $35 to $40 million range, therefore revenues are projected to be flat to down by approximately 4% year-over-year.

Anticipating getting more questions about ACS, let me make a few comments about it.

We stated in the Q1 call that approximately $10 million of revenue was lost due to this termination.

Published reports speculate that this program will not be back until FY '09.

In the interim, the mission requirements will be fulfilled by existing platforms, some of which we are a part of, such as the Army's ARL, the Guardrail, and an ABCP-3E platform.

The army could upgrade up to 36 Guardrail and six ARL, which is airborne reconnaissance load aircraft.

The Navy could potentially upgrade 12 to 16 EP3E aircraft.

Some good news gleaned from leaked QDR documents, suggests more emphasis will be placed on UAV such as Predator and Global Hawk or persistent surveillance missions.

Accelerating the deployment of these platforms would greatly benefit Mercury.

We expect that it will be several months before plans are released relative to the potential upgrades to these systems and any revenues for us would most likely not occur until FY '07.

Given where we are in the Defense supply chain, and not knowing how long it will take for funds to be released, we are taking a conservative view for the balance of the year.

I don't relish the idea of anymore downward revisions in the forecast.

So that sums up how we anticipate the topline to develop.

So what are we doing to address the operating margins?

Several actions have been initiated, some going back to the last quarter.

Obviously, the usual expense control actions are put in place, such as delayed hiring and travel expense control.

We've also initiated a portfolio of rationalization exercise to look at the markets and products we are investing in.

I expect this exercise to be completed this quarter.

We have undertaken an analysis of our defense market strategies so as to better understand what application areas we can add more value, consistent with future budget projections.

We expect these actions to result in more efficient investment of our resources into the right opportunities.

As we have consistently communicated to you, we are committed to a business model that delivers 16% to 18% operating margins.

We consider our current profitability unacceptable, therefore we expect to reduce our operating expenses in line with where we see revenues going.

The plan to accomplish this is under development.

We expect to share the specifics on our next earnings call, if not sooner.

Of course, the real issue is topline growth company-wide.

We believe the strategy is solid across our business units.

We see the growth in CIV primarily life sciences and in advanced solutions, primarily in the communications market, with the semi business providing a cyclical but reasonably solid and profitable base.

The defense market requirements for complex signal process solutions aligns well with Mercury's core competencies to deliver optimal performance for the constraints of size, weight, and power, and cost.

Our investments over the years in IM systems have given us a dominant position in many different airborne and ship based surveillance platforms.

As DOD strategy evolves to more in-theater, [read] tactical, size and power constrained systems, our investments are meeting these needs, which have already begun, will begin to produce the anticipated growth.

It's all a matter of timing.

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

[OPERATOR INSTRUCTIONS]

We'll move first to Bill Benton with William Blair.

Hi.

Good afternoon, guys.

Hi, Bill.

Just a question.

I mean, Jay you mentioned a number of things on the defense side, obviously it is the first time I guess I've heard, maybe the good enough solutions kind of making it into the defense discussions as much.

I know there's been delays, and I think you also mentioned some changes in the way the DOD is approaching some -- openings in technology, which is creating some lengthening decisions.

Could you give us some sort of perspective on the how important each one of those areas may be, magnitude-wise?

What areas?

Whether it's delays, whether it's this good enough impact of commodity solutions, or whether it's this change in the way that the technology -- I guess delays in the technology may be interrelated here.

But the way the -- you said I think the DOD is opening up new technology areas, which may compete with your existing solutions, I think?

Well, I don't recall those words.

I don't want to have the words right, Jay, but the idea.

Well, I think what I was trying to say, and I'll try to find the exact words, but the issue is that the VITA, V-I-T-A standards committee has come up with a new set of standards which is causing the -- and this is the standards committee for what you may know of as VME.

Okay?

Okay.

And the new standards, which are being driven by new componentry, new processors, are causing a lot of turmoil in the marketplace.

And the result of it is that that is very little, if any, compatibility [backwards], and this just results in the customer is having to go out there and look at the whole supplier base again, when they think about going to their next-generation systems.

So for current, let me call it, systems that are already in place that are taking the correct versions of products, it's not an issue.

But in looking at new systems that are going to be deployed, they're looking at how do they utilize these new standards, if you will.

And so, they have to look at the supplier base and see what's available out there and evaluate them.

So that's what I meant by that.

I also mentioned the fact that the FPGAs, which we've been talking about -- industry's been talking about for couple of years, starting to gain some traction.

They're real serious competition from a processing perspective, and as customers incorporate FPGA-based processing into a -- an overall system, it has the effect of lowering the average selling price, if you will, for a product.

I can't give you exact numbers, but before if we sold a system with 12 boards that had Power PCs on it, maybe now it's six boards with Power PCs and two boards with FPGAs.

So that's another impact that's having, I wouldn't say a great impact on us right now, but it is certainly something that we are dealing with and we need to take into account in our planning.

Okay.

And to the extent that you maybe took a conservative approach with regard to be delayed that you're seeing in there, can you say whether, I guess, others have said in the industry that the order pickup started pretty early this quarter?

Has that in fact happened for you as well?

Like the orders have been starting to get released again?

Well, I don't know who you asked that gave you that answer but --.

Northrop Grumman said it on their call, that's all.

You need to realized that we are not a prime contractor.

Right.

And so before the funds flow down to us, it could take, I don't know how long, but it could take a long time.

Okay.

And so you would -- not having that visibility, you feel comfortable kind of bringing it down a lot more may then.

You're going to take that conservative look, obviously.

You know, because Bill -- again, if the orders came in this quarter [we] would have a chance of fulfilling them in Q4.

Right.

But if they slide, then I don't know if we can afford it to the Q4, and so I don't want to sit here again and apologize for screwing up.

Okay.

Understood.

Well, thanks guys.

I'll jump back in the queue.

We'll move next to Steve Levenson with Ryan Beck.

Good afternoon Jay and Bob.

Hi Steve.

Hi Steve.

Obviously you've still got a pretty strong balance sheet with a fair amount of cash on the books.

Or do you think you might be getting more aggressive on the acquisition front to make up for some of the delays in the balance of the business?

Well, Steve, we said at the beginning of the year that this year we were not going to be very aggressive in going after acquisitions, and I think we had very good reasons.

Nothing has transpired to cause us to change our view on that.

It takes awhile to digest the acquisitions, and it almost doesn't seem to matter what size it is.

The revenue synergies, they don't appear as quickly as you optimistically thought they were going to be, when you're doing the acquisition.

And so we need to really see to it that we put our management attention on what we've acquired and see to it that they start to pay off.

I think we've got some good, I know we've got some good things going, okay.

But trying to look at any others and the diversion to management's bandwidth, it just wouldn't work.

So, we are not actively looking for any acquisitions at this time.

Okay, thanks.

Secondly, we saw the excerpts from the Quadrennial Defense Review as well, and it would appear that you have some good opportunities coming on UAVs and SIGINT, and I guess some potential for some of the electronic warfare aircraft.

Do you have any idea on the timing of any of those programs?

Really, probably not much better sense for it than you do.

One of the things that I've seen is that the devaluation of the upgrading the platforms that are currently performing the missions that ACS was going to take over, the report was due the 1st of August, which would then -- my assumption is that that would then kick off the programs that get budgeted and so forth.

So we're not going to see any revenue from that until sometime in the second half of FY '07, I guess, would be my best guess.

And that's the Guardrail EP3E, the ARL, programs et cetera.

You also saw in the QDR, the emphasis on utilization of UAVs, Predator, Global Hawk and smaller more tactical UAVs for persistent surveillance in the battlefield.

And I think we're well positioned there to get some increased business if they, in fact start to fund those and bring more online then they're currently planning on.

Okay.

Thanks, very much.

[OPERATOR INSTRUCTIONS]

We'll move to Sean McMahon with Kennedy Capital Management.

Hi guys.

I just had couple of questions.

Do you care to comment on future CapEx spending in the year?

Can you give us some sense or idea how much that might be going -- at least the rest of '06?

I think I hit that.

Did you hit that?

Okay.

Yes.

I'll go back in the transcript.

Second of all --

I just wanted to look it up, before I repeated it.

I think what I shared was 15 million for the year up from 10 last year.

Okay And second of all, you guys talked about, looking at the defense --the portfolio of projects you guys going on.

Can you give me any kind of color on your analysis that you guys might have seen or, are there costs to be taken out or can you push more product in that area?

What are you kind of hoping kind of to leverage that business so we don't see this weakness again?

Well, what we're obviously looking for is ways to be able to provide a lot of value to the customers, so that we can get reasonable, what we consider to be reasonable margins on the product.

Is that on the cost side or you are going to -- are there other areas where you can push more product through the channel, so to speak?

Or, both?

I don't see it as pushing more product through the channel.

It's a matter of finding more applications that we've not currently been involved with that can utilize our capabilities.

And in those applications where we are involved to make sure that we continue to work closely with the customer to satisfy their requirements and provide more value so that we don't get replaced by the competition.

Okay.

You know, not to beat a dead horse here, but you guys -- are you guys constantly monitoring it?

Or is this something new that you guys have introduced?

Well, we have -- I can't say -- I didn't mean this to suggest that we haven't been doing anything in the past, and have just been bumping along here serendipitously.

The effort that is under way is really the advancement of the strategic planning process that we would go through every year.

I think the difference here is that we need to make sure that we are investing where the money is going.

And so, it's going to require us to analyze not only the FY '06 budget, but the FY '07 budget which is due to be introduced to Congress, I think, sometime in the middle of February to try and understand where the money is going, and make sure that, what we have developed or what we should be developing is consistent with the money -- where the money is going.

Okay.

And then one last question, and I'll jump back in the queue.

Is -- looking forward now where we have FAS 123R, your guys options expense have been quite high.

I think last year, if you look at the numbers, you had 10 million in option expense.

Is that correct?

We're looking --

Out of 30 million in net income.

A third of year net income is option expense.

How do you guys, obviously, that's probably -- I hope that's not going to continue.

Have you guys looked at any way as how you might lower this going forward?

Yes.

Let me just clear up the numbers for your.

I'm just -- reminder for everyone that last year we were not operating under FAS 123R.

So hopefully, what you're looking at is the disclosure in our Q filings as an example.

I'm assuming that's what you're looking at.

I think your question though, the substance of it looking forward is, are we working to reduce the impact -- the expense impact of options, if you will, or equity-based compensation to our employees.

I think the most straightforward answer to that is yes, as are most tech companies.

What we're doing is spending a lot of time with our compensation and benefit consultants, understanding the new instruments that people are progressively going to use.

I think the easiest way to think about that is your expectations is you're going to see companies moving away from options towards restricted stocks, full value instruments, as an example.

And classically, they will grant fewer restricted stock units or shares than they would have if they were options.

That's one thing you're going to see for certain.

And I think there's also just going to be a general trend in technology to make this less of an expense on an annual basis.

Our intention as a company is to -- is to move with our peer group, our comps if you will, and not to be spending more than the group peer.

And certainly, not to be spending less, but to try to stay in the middle of the pack, recognizing that stock-based compensation is an element of total comp.

And we're in the people business, the intellectual property business, so it's very, very important that our comp package be competitive to get the folks we need to drive the company forward.

Well, I understand that.

I'm just -- what I'm trying to get at is do you not think that a third of net income in option expense is not ridiculously too high or, do you guys think that's fair going forward?

The -- if you compare us historically, we nudge into the fourth quartile with that kind of an impact, so it's on the high side.

No question about that.

Certainly, based on what I said earlier, we'll be looking to reduce that and more directly get into the middle of the pack.

I'm not going to call it ridiculous, as you labeled it, it is what it is.

But that's our intention.

Next quarter, should we plan to hear something of what you guys might do going forward?

Or, does this -- when do you guys expect to have a plan out there how you're going to handle this?

At our annual stockholders meeting, which we held in November, we brought a new equity plan to the table in the proxy that was approved by the stockholders.

Unlike our earlier plans, which were primarily focused on stock options, it's a multifaceted plan which gives us those additional tools, those full value instruments that I mentioned.

We have not done our big grant for this fiscal year.

We wanted to get that new plan approved first, so we had access to these more efficient tools from a cost perspective.

Our intention is just to do our grant here in the March quarter, assuming we stay on course.

So yes, we'll be able to talk a lot about it on the next call.

Okay.

Just my last comment.

I guess, I was hoping that you guys -- you guys knew FAS 123R was coming along.

This was a big expense I was hoping that we'd actually hear something this quarter.

I was really hoping they you guys would reduce this cost for 80% at least.

Right.

But that's all I have to say.

Thank you, guys.

Yes.

Okay.

You can get off, I'll talk for a second here.

The cost that you're looking at is related to actions that have been taken over the preceding years.

Reducing that cost is not possible.

What you're concerned about is additional costs going forward, which is driven by a new grants of options or restricted stock.

We should go to the next question.

[OPERATOR INSTRUCTIONS]

We'll move to a follow-up from Bill Benton with William Blair.

Hi, guys.

Just maybe on that as you -- just so we understand, kind of what is the current environment their in terms of retention?

It looks like your employee count maybe just picked up a little bit, so you're not having any sort of employee turnover issues currently.

But are you seeing anything out there in terms of --?

No, our employee count picked up notionally quarter-over-quarter or sequential.

I think I gave you numbers there.

On the turnover question, tech is somewhat notorious for high turnover.

Tech companies 10%, 15% is not unusual.

We are in single-digits, so we're doing quite well on that front.

Okay.

So the employees seem still pretty motivated here.

What makes people motivated in this business is providing the opportunity to work on fun things and arguably getting paid for doing it.

But it's the fun stuff is what brings us all back to work tomorrow.

All right.

I know your people matter a lot.

Just on the warranty cost that you talked about, could you offer us a little color on what may have happened there?

Warranty expenses for us throughout this year will be up -- not quite a couple million year-over-year.

There's a couple programs in there where we're going into installed base and upgrading what's there under warranty.

So it's a couple of programs.

I don't know if I can offer any more color than that, Bill.

Okay.

You're upgrading a couple of programs in installed base.

Yes.

It's not a product problem?

This is a new or is that --?

It is not a product problem.

It's an issue in installed base and the products work, and then it's more capabilities or required capability that qualifies under warranty, that's what we're doing.

Okay.

Okay, thanks guys.

Yes.

Gentlemen, there are no further questions at this time.

I'll turn the call back to you for closing remarks.

Thank you all.

And we look forward to giving you much better results come the middle of April.

Goodbye now.

That does conclude today's conference.

We do thank everyone for their participation.