Ultralife Corp (ULBI) 2004 Q2 法說會逐字稿

Good morning and welcome, ladies and gentlemen, to Ultralife Batteries' second-quarter financial results conference call. At this time, I would like to inform you that this conference is being recorded, and that all participants are in a listen-only mode. At the request of the Company, we will open up the conference for questions and answers after the presentation.

I will now turn the conference ever to Jody Burfening. Please go ahead, ma'am.

Thank you, Vicki, and good morning, everyone. This is Jody Burfening, of Lippert/Heilshorn & Associates. Thank you for joining us this morning for Ultralife Batteries' earnings conference call for the second quarter of fiscal 2004. The earnings press release was issued earlier this morning, and if anyone has not yet received a copy, I invite you to visit the Ultralife website at www.UltralifeBatteries.com. You can find the release under investor news in the investor relations section.

In a minute, I'll turn the call over to John Kavazanjian, Ultralife's President and Chief Executive Officer, who, along with Bob Fishback, Ultralife's Chief Financial Officer, will provide their formal remarks. Management will then take questions until 11:00 Eastern Time.

Before I turn the call over to John, I would like to remind everyone that some statements made during this conference call contain forward-looking statements, including references to Ultralife Batteries' future plans and objectives. These statements represent the current views of management with respect to future events, and are subject to certain risks and uncertainties which could cause actual results to differ materially from those contemplated in these forward-looking statements. A more detailed description of these risks is contained in the Company's filings with the Securities and Exchange Commission.

With that, I would now like to turn the call over to John. Good morning, John.

Thank you, Jody. Good morning, everybody, and welcome to the Ultralife Batteries conference call for the second quarter of 2004. Joining me today are Bob Fishback, our Chief Financial Officer; Bill Schmitz, our Chief Operating; and Julius Cirin, our Vice President of Marketing, who is sitting in for Nancy Naigle, who is now traveling.

Today, we reported operating income of $3.6 million on record revenue of $28.4 million. This is in line with our guidance from our last conference call, and it represents growth in both revenue and profit. We continue to execute on our plan of capitalizing on demand in existing markets, penetrating targeted commercial markets and growing our rechargeable business. We had significant improvements in gross margin, due to continued advances in manufacturing efficiencies and in our operations. This was slightly offset by planned increases in operating expenses, as we increased the resources committed to executing on target market opportunities.

This quarter, as you saw in our press release, we decided to write off our investment in Ultralife Taiwan. We did this because UTI has taken longer than expected to restructure its finances, and we are less certain today about UTI's near-term financial viability. We are working hard to help UTI work through these difficulties, in an effort to ensure a satisfactory outcome for all of the parties involved. In the meantime, UTI continues to manufacture product and operate as usual, and our business that is dependent on UTI products has alternate sources established. We've recorded a one-time charge to the second quarter income statement, and written down the book value of equity in UTI by about $1.6 million, and debt by approximately $2.4 million. So, aside from the accounting treatment, we do not believe this decision will negatively impact our rechargeable business going forward.

Turning our attention back to quarterly performance, shipments of our BA-5390 battery to the military continue to be on plan. We are now producing and shipping at a steady rate, with a very minimum of disruption or overtime required.

We still await news about the contract award of the Next Gen II Phase IV contract. We would expect the contract to be awarded before the end of the current quarter, but past experience has taught us that the timing of these awards is hard to predict. There is also a transition of responsibilities for the procurement of batteries by the US military. This responsibility is moving from CECOM, the US Army Communications and Electronics Command, to DLA, the Defense Logistics Agency. DLA is scheduled to take over procurement on October 1st. But they are currently in the process of gathering information and preparing to accept this responsibility. Since we currently have orders for the BA-5390 covering into October of this year, we are working diligently with both DLA and CECOM to get some clarity on production requirements for the remainder of the fourth quarter and looking forward.

With respect to our rechargeable business, we're very happy with the rate of growth of it, and with our enlarging customer base, both military and commercial. This quarter, we added both customers and product. The UBI-2590, our rechargeable version of our BA-5390, continued to widen its customer base, with 14 new customers added this quarter alone. Much of this new market reach was to defense contractors and distributors.

Our latest product, our prismatic lithium ion 2 amp-hour pack, with a very versatile flat profile, attracted nine new customers, ranging from distributors to RFID reader applications and to specialized mobile computer manufacturers. Many customers who evaluated products in this rechargeable business at the end of last year and the beginning of this year are now starting to order pilot production quantities.

Gross margin for the rechargeable segment is very close to being a positive number for the first time in the Company's history. We expect continued revenue growth in this business in the third quarter, with a very good chance of having a positive contribution to gross margin. We are now projecting revenues of around $7 million for the year in this product line, with further growth in 2005.

New applications activity maintains its fast pace. Since the beginning of this year, we have designed and sampled more than 30 new battery pack products, with the vast majority coming in our target commercial markets. Our strategy of utilizing our growing distribution channels, combined with the sophisticated use of the our website, has grown our international activity, so that 40 percent of our inquiries are now from outside of the United States.

Search and rescue has been an important target market, with several active customer engagements in process. Last month, we received FAA qualification on a new product for a new customer in this market. This is the first such product qualification that we have received, and hopefully the first of many. It represents a critical milestone in an important segment of this market. We've received our first production order for a new emergency locating beacon based on this new FAA-qualified design.

Another design is for a new primary pack for use in a new gas mask product. This product protects the wearer against most known chemical and biological agents, and also filters nuclear particles. We've added a new rechargeable pack design that is used for new wireless telemetry products, and another design for a hand-held analyzer complete with a TFT display panel that will be used in a portable medical application.

In another target medical market, we have started delivering production orders on a wearable TENS or nerve stimulation product used for pain relief. This product uses electrical nerve stimulation to alleviate both chronic and acute pain for a wide variety of causes including arthritis, bursitis, sports injury and surgery pain. This project includes batteries for both the inside of the unit and for the remote control for the unit.

These are just a few of the many opportunities that we've been working on. As I mentioned last quarter, we have also added to our resources in product development and sales and marketing, in order to capitalize on these types of opportunities. Those are the expenses that, along with some higher insurance and professional fees, were part of the growth in our operating expenses. Also, over the next several months, we have several important capital projects being implemented which will increase our capability, improve our manufacturing efficiencies and reduce our costs. As part of planning these capital projects, we assessed our future labor requirements and concluded that we would be able to eliminate all of the contract labor from our workforce. We believe that our highly-skilled permanent workforce, aided by these capital improvements, will have no trouble meeting our production demand levels, and we still have the flexibility to utilize contract labor if needed in the future.

Turning to guidance, we are reaffirming our previous full-year guidance, but we are cautioning that we still have the uncertainties of the Next Gen Phase IV award and the transfer of ordering responsibility to DLA. Delays caused by either of these could affect our financial order flow. In addition, as indicated on the last conference call, we really expect to see a return to more normal purchasing patterns for the military, rather than the multi-quarter orders we have been producing up to this time.

Even though we are facing some near-term uncertainties, we still believe that the long-term demand for batteries from the US military remains healthy, with the pace of operations continuing around the world, the need to rebuild the war reserve and the avowed goal of the military to transition to Mn02 technology. Financially, we continue to strengthen. We have a profitable, cash-earning (ph) business, and we have a new financing agreement. This gives us the economic flexibility that will enable us to grow. And Bob will have more to say about this in his comments.

So now, I'd like to turn it over to Bob Fishback, who will cover some of the financial highlights.

Thank you, John, and good morning, everyone. Earlier this morning, we released the results for our second quarter of 2004 that ended on June 26. Consolidated revenues reached $28.4 million, slightly higher than the $28 million guidance we discussed during our earnings call three months ago. Compared to the same quarter last year, revenues rose $8.3 million or 41 percent. Strong sales of HiRate battery products to the military lead the change, primarily due to growth in shipments of our BA-5390 batteries. Sales of rechargeable products were also strong, increasing nearly fivefold from $300,000 in '03 to 1.7 million in '04, consisting of dozens of customers.

These revenue increases were partially offset by modestly lower 9-Volt battery shipments. Gross margin for the June 2004 quarter was $7 million or 25 percent of sales, an improvement of $2.3 million over the comparable quarter last year. Ongoing improvements in our primary battery operations were, once again, the key to our success, where margins increased from 26 percent last year to 27 percent this year. Higher sales and production volumes continue to drive this improvement, as well as gains in manufacturing efficiencies. Gross margins for the rechargeable battery operations improved from a loss of $400,000 last year to a loss of less than $100,000 in 2004.

Operating expenses for the second quarter of '04 totaled $3.4 million, an increase of nearly $600,000 over the same period last year. As planned, we have increased our level of commitment to support a higher volume of development opportunities in areas such as sales and marketing and information systems. In addition, various administrative costs associated with running a larger business have also increased, including insurance and professional fees. The R&D line item reflects a decrease of $100,000 from the same period last year, as resources in '04 were consolidated between the US and UK operations to reduce costs and combine efforts. As a percentage of revenues, operating costs have declined from 14 percent last year to 12 percent this year.

Operating income for the June '04 quarter reached $3.6 million. This was just ahead of the $3.5 million guidance we provided last quarter, mainly due to the higher-than-projected sales. As sales increased 41 percent, operating income improved 91 percent, compared with the results reported a year ago, continuing to demonstrate the high amount of operating leverage we can take advantage of as we grow.

At the end of the quarter, we reevaluated the carrying value of our investment in Ultralife Taiwan, which, between the equity investment and note receivable, totaled approximately $4 million. We decided to write off this asset, due to recent events that have cost increasing uncertainty over UTI's financial viability. The $4 million charge that we took had a non-cash non-operating impact on the financial results during the quarter. As a result of the write-off of the UTI investment, the Company reported a bottom-line net loss for the June 2004 quarter of $400,000 or a loss per common share of 3 cents. Average shares outstanding for the quarter were 14.1 million shares, higher than the comparable quarter last year, mainly due to the impact of stock options and warrants and a small equity transaction that was completed during this timeframe.

One other item of note that I want to address is that during the second quarter, we experienced two fires, one at our US facility and one at our UK facility. These fires caused damage to certain inventory and property. There were only relatively minor disruptions to our production operations, having no impact on our ability to meet customer demand during the quarter. The total of the two losses related to company-owned assets, including any expenses necessary to clean up to our facilities, is expected to be approximately $2 million. Our insurance coverage is quite comprehensive, with full replacement cost for company and non-company-owned assets that were damaged, and our deductibles are low. So we don't expect any significant impact on our future cash flows or income statements. There was virtually no impact from these fires in the P&L for the second quarter, and the balance sheet at the end of June includes an $800,000 receivable from the insurance companies for losses and recovery expenditures incurred to date.

Moving over to focus on a sequential comparison of the June quarter's results versus the March quarter, consolidated revenues rose $1.4 million from the $27 million reported in the first quarter. This growth was mainly attributable to an increase in shipments of HiRate batteries to the military, both BA-5390's and BA-5372's as well as an increase in sales of rechargeable products. Consolidated gross margins increased $700,000 from $6.3 million to $7 million. As a percentage of sales, the margins improved from 23 percent in the first quarter to 25 percent in the second quarter. This increase resulted from higher revenues and related increases and production volumes, in addition to greater manufacturing efficiencies. Operating expenses rose 400,000 from quarter to quarter, or 15 percent. An increase in SG&A cost was the primary cause of this overall change, related to investments made in areas such as sales engineering, product marketing and information technology. As expected, our R&D costs increased modestly, as we made greater commitments in this area for increased product development efforts. Operating income increased $300,000 to $3.6 million. As a percentage of sales, operating income amounted to 13 percent in the June quarter, compared with 12 percent in the March quarter.

Shifting now to our cash flows, EBITDA in the June quarter, defined as operating earnings plus depreciation and amortization, amounted to $4.5 million, including depreciation of approximately 800,000. During the quarter, our need for working capital increased by approximately $2.9 million, mainly due to higher inventory levels. We also spent approximately $2.1 million in the second quarter on capital equipment additions, as we continue to invest in our plant capacity. We generated approximately $900,000 in cash from the exercise of stock options, and we reduced our outstanding debt by approximately $500,000.

Our balance sheet at the end of June remains very sound. In addition to our ending cash balance of approximately $1 million, we also had additional borrowing capacity of more than $6 million under our revolving credit facilities, providing us with total cash and credit availability exceeding $7 million. Total debt outstanding at the end of June was only $5.5 million, mostly short-term revolving credit supporting our working capital needs. Total debt as a percentage of total capitalization was only 12 percent, down slightly from 13 percent at the end of March.

On June 30, subsequent to the close of the our books for the quarter, we replaced our expiring credit facility with a new, larger and more flexible credit agreement with two major banks. The new facility was a $25 million arrangement with two components. The term loan component of $10 million was drawn upon in full at the initiation of the agreement, with the proceeds being used to pay off other outstanding debt and to fund capital equipment projects. We entered into an interest rate swap arrangement, locking in a swap rate for the five-year period of a loan of 3.98 percent. We will also pay a euro/dollar spread that is added onto the swap rate, tied to a debt-to-EBITDA ratio that is measured quarterly. Including this spread, the total cost of this debt at this time is 5.23 percent. The other component of the new facility is a $15 million revolving credit arrangement based on our debt-to-EBITDA ratio. This new three-year credit agreement provides us with sufficient financial support to allow the Company to continue to grow.

Looking ahead, we are reaffirming our previous guidance for full-year revenues of $106 million and operating income of $12.5 million. We continue to expect a slight decline in the second half of the year compared to the first half, due to the leveling off of demand from the military. The growth we have been experiencing in our commercial business, particularly our rechargeable area, is expected to continue for the rest of the year. We are projecting that the results for the third and fourth quarters will be split fairly evenly. Quarterly operating expenses are expected to be in roughly the same range as the second-quarter level. EBITDA for the second half is expected to exceed $7 million, giving us an EBITDA for the full year exceeding $15 million. Capital expenditures in the second half are expected to be in the range of about $3 million.

Our second-quarter results were very positive, on course with our financial goals for this year. We're confident about the strategic path we are on, and that our ongoing diligence will keep us on track for continued success into the future. That concludes my remarks, and I'll turn it back to John.

Thank you, Bob. Before we open up the call to questions, I want to inform everyone that Ultralife is planning to host an analyst investor event in late September at our facility in Newark, New York, outside of Rochester. We will have invitations out soon, and we hope to see many of you there.

Now, I would like to ask the operator to open the call up for questions.

(OPERATOR INSTRUCTIONS). David Gill (ph), Ardour Capital.

can you give us some indication as to what the percentage of revenues from sales to the military was last quarter?

We have been running in the ballpark of 60's -- 60 to 65 percent or so.

Okay, so similar to last quarter?

That's right.

And just a follow-up question to that. Previously, you had indicated that rechargeable batteries would account for about $5 million in revenues at year end. I think I heard you say earlier that you expected $7 million by the end of this year; is that correct?

Yes. We are definitely ahead of plan. We are thinking about $7 now.

And you are looking at more in '05, then, too?

Absolutely. I think we said we think we can double the business from '04 to '05.

That you could double the business? Okay. And could you please maybe elaborate on how you expect to achieve those goals, and perhaps what kind of applications you are getting strong interest from?

Yes. Well, there's three things we have done in the rechargeable business. The first thing is we have a real wide portfolio of all of the multiple different technologies of cells -- the prismatic lithium ion cells, cylindrical lithium ion cells and polymer lithium ion sells. And so, when we go into an application, we can supply any one of the different technologies into the application and be flexible in moving between them if somebody, in the middle of development, finds they need something a little different.

The second thing we have done is we have really moved up the value chain to where most of everything we sell is in packs, which are multiple cells in series and parallel with control circuitry, charge control circuitry and such, and we have done a lot of work there, have designed and developed our own circuitry. We think it is the best in the business. And along with mechanical packaging, everything from enclosures to connectors to mechanicals. In fact, a lot of our product development now is becoming somebody who wants something we have already, but wants it packaged differently, mechanically.

And then the third thing we've done is, as we've done this, we've developed a real portfolio of standard products. The 2590 is a great example of this. That really is a rechargeable version of the 5390, which is already used in 50, 60, 70 applications. But the amazing thing is that, when we put it up by the website, about half of the business is coming from commercial customers. Everything from emergency blankets for EMT crews, where they need a heated blanket, using it for that; asset tracking for large containers where, when a container is unhooked from a truck, it still needs to be tracked; portable instrumentation in factories, replacing lead acid batteries in applications like that. So it is a really good example of a standard product that we've developed for one application that we make available -- not just the product, but also a full line of chargers for it, to do that.

We've done the same thing with our Land Warrior product, which was developed for the Land Warrior program in the military, is now being sold into commercial applications, different types of military training applications, in all kinds of different ways. So -- and down to some smaller packs we have done which are now more standard products. We have one product, actually, that UTI does produce for us, which we have another source for, but is packaged as a digital camera battery for a major producer. We've now introduced that -- because it's a standard digital camera battery known as the NP-60, we've now introduced that as a standard part of our product line. And I think we're out of samples, actually, I was just told the other day. We've sampled something like a dozen customers with that already.

So, that's really how we've approached it -- a wide variety of product, high level of integration and a real good portfolio that we're building of standard products that people can buy off-the-shelf if they don't want something custom done.

David Kurzman, Needham Capital.

It's actually Needham & Company. The question with sort of looking into '05. Can you give us a sense as to what you believe the military percentage of lithium manganese dioxide will be and, as a result, sort of help us build to the $135 million revenue guidance you have given us for next year?

I don't think we said $135 million for next year, Dave. That might be your number. I think we said we're going to do about $106 million this year, and next year we will grow between 20 and 30 percent.

At your annual meeting you had a slide with $135 million on it.

That might have been for illustrative purposes, in terms of if it were this, here's what a business model would look like. I think we're very clear that our guidance is that. But notwithstanding, if you do the math, that says that we're going to be between $125 and $135 million. So the answer to that question is I think we have said we think that military will be about one-half of that next year, in terms of military business. We think that, right now, that manganese dioxide is accounting for 15 to 20 percent of the military demand worldwide, and next year we would hope to increase that. I would hope to get that up to 20 to 25 percent. I think the market -- next year, demand will be equal to but maybe slightly down from this year. I think we've hit the peak, and now it's kind of steady-state demand, from what we understand. You can guess as well as I how long we think we're going to be deployed in different places; but as long as we are deployed, I think the demand has pretty well leveled out. And so, that would imply that we would like to Mn02 grow to 20, 25, 30 percent of the demand next year.

And in terms of what your diluted shares would have been, excluding the UTI charge -- can you give a sense of what that would have been?

Yes, there probably would have been an incremental -- if we had a positive bottom line, there probably would have been an incremental of about 1 million or 1.1 million.

Bob, he's asking the question, if we didn't have a $4 million write-off, what would EPS have been?

Well, I don't want to answer (multiple speakers).

I don't think we're allowed to answer that question.

No, I was actually just asking about share count.

Yes. Share count would probably be -- for the average shares outstanding for diluted would have been about 1 million or 1.1 million higher than the basic.

It would have been about 15 to 15.2, yes.

Jim McIlree, Unterberg Towbin.

The rechargeable business -- you say you had previously thought $5 million for the year, and now you're thinking $7 million. But total revenue guidance is the same. So what's being lost in order to keep the guidance the same, but with (ph) the shift to rechargeables?

I actually think when we upped our guidance from 104 to 106 is when we went from 5 to 7, Jim.

Okay.

But I'll answer it in a different way, which is I think the we have peaked this quarter, in terms of -- the real issue is 5390 demand, okay? That's a big driver on the military revenue side, and I think we have peaked on 5390 demand, and it's getting more to a steady-state situation. So, if it's anything, it's maybe a slight decrease in 5390's.

And can you talk more about the shift from CECOM to DLA -- what that possibly requires in terms of incremental resources that you might have to create, or new relationships that you might have to create, or would the selling patterns change? Can you just kind of walk through that?

We don't expect anything to really change, except for the relationships that we have with people. As we understand it, CECOM is part of the Army, and it was the desire of the military to put the purchasing under a more central command. Part of the issue that had happened in the past is that the Army didn't have the money, but the Marines had the money and wanted to buy batteries, or the Navy wanted to buy batteries or even an Army post wanted to buy batteries -- if the central Army hadn't funded this properly, they couldn't buy them.

So first of all, we think the problem they are trying to solve is that DLA buys for all the services and, the theory is, has a lot more flexibility. We think they probably do have a lot more flexibility, in terms of expenditures. And some other things we had two to three years ago, where people wanted things and head budgets, but it wasn't in the right place and couldn't make the purchases, hopefully get avoided by this. So we think it's a good news story, or we hope it is. That's the theory behind the move.

In terms of relationships, it's a different group of people, but we know them know. We have been working with them now for a couple of months. The CECOM and the DLA people have been working very closely together to make the transfer of responsibilities happen. CECOM will still own the technical resources that will do all the qualification on contract to DLA. So that's the same thing, so there's really no incremental cost to us. It's just a different group will be buying them, and they'll be buying them for all the services. And it's our hope that the theory that it's based on, which is that it will have more financial flexibility, will be borne out.

So will the services go to DLA and say we want a battery, and they don't care where that battery might come from, and then DLA buys it from whenever vendors they choose? And would that be different from how CECOM is doing it currently?

No. DLA will buy it from the vendors based on the contracts that are in place. So, for example, in the small cylindrical world, we have 60 percent of the demand, of their requirements for small cylindrical. We're guaranteed 60 percent of it, and then, if the other guy can't produce the 40, or can't meet their requirements on the 40, they can place the rest or part of that with us. So they have exactly the same contracting guidelines; they will operate based on the Next Gen contracts. Everything is CECOM; for example, if they need batteries and Next Gen is late getting awarded and they still need batteries, they could place another exigent buy with us. So they have all of the same contracting vehicles and capabilities, and they operate under the same rules. It's just the multi-tri-services (ph) operation versus an Army organization buying it now.

And on the exigent contracts, where your deliveries scheduled through, and have you set up pricing or have you agreed on pricing for everything this year?

We have agreed on pricing. They are scheduled into October. We are scheduled out into the month of October; I don't know if it's the second or the third week of October. There's a few details still to be worked out on the timing of that, but we are into October. I mean, plain and simple, there's no incentive for CECOM -- there's no incentive for CECOM to place orders with us, because they will be spending money in October, which DLA is supposed to be spending money for. So they've made the transfer early, and DLA is now looking at what they have to place for orders for October, November, December, out into next year.

Steve Gish, Roth Capital Partners.

John, could you maybe talk a little bit more about Ultralife Taiwan -- what they provide to Ultralife, what other supply sources you are looking at, and maybe just more detail on the circumstances there, if it's a financing issue, in terms of it's just tough to raise capital at this point for that company, or if the market is basically becoming more competitive?

No, here is what's happening. Back in November, we knew that -- well, I'll go back a year. A year ago, Ultralife Taiwan was on track to being cash flow positive. They had a big problem that when the SARS epidemic hit China, business ground to a halt, and a lot of their customer demand went away. It was very slow coming back, and by the time it came back, they faced pretty intense competition from Chinese companies. They had to reposition themselves as -- they really are Japanese quality at a lower price. And so what they had to do is reposition themselves with people, and they faced tough competition. So, while they have been increasing their market share, it was very slow coming back up to being cash positive. So right, now they are not cash generating; it's put a real drain on them.

We helped some financing with them. We lent them some money back in November, because we said it's not in anyone's best interest for you to rush into a financing, give away a lot of the company to do that. We want you to have the time to do it. They worked to have that -- and the banks also said the same thing -- we'll extend your loans out through '05 until you get this financing done. But we both said to them, we want it done by July 1st. They are in the middle of negotiations and working with a couple of different alternatives, but it was not done by July 1st. So we sat down -- part of the audit requirements of our accounting firm is that they look at all of our assets on our balance sheet every quarter, to test them for whether they are impaired or not. And this is exactly what they are supposed to do. And we've had a lively discussion with them every quarter about it, and very cooperative. And this quarter they said, you know, we think that you are maybe at the point where the prudent thing to do would be to take the write-off. And it will actually allow you a little more freedom in deciding what to do as a part investor in Ultralife Taiwan, but we think it's the right thing to do because there is a risk.

We said okay, we understand, we recognize it's a risk. Let's do this. It's non-operating, non-cash; it's not stopping anything in terms of the way we work with Ultralife Taiwan, the flow of product from them. And it's not stopping anything in terms of what we're doing moving forward, to help them get this thing re-established, refinanced. There's multiple alternatives for them, but they're still are risk. And so we agreed with our audit committee and our auditors that it was the right thing to do.

In terms of what is hanging on products from Ultralife Taiwan, I think it's a very small percentage. It would not be material to our financial statements if all the product and revenue associated with the UTI product went away. Having said that, we have some customer relationships, and some very interesting applications we're playing in there, that we don't want to lose. So we have second sources qualified for everything that they supply. We don't want to use them, but we have second sources qualified. And they know that. So I think we are protected, number one; number two, I don't think it's a short-term material event if something happens, in terms of our revenue picture, profit picture also. And I think that it's not changing how we operate things. I think we just did what we thought was a prudent thing to do.

I think, in the past, you may have said in the near term you thought you could obtain gross margins in the range of 26 to 27 percent. They were almost 25 percent this quarter. Do you think those have peaked in the near term? And then, John, if you could talk more specifically about some of the capital projects that you are going to have going on in the next couple of months? And then, if you could just kind of distinguish for me what you mean by contract labor?

What was happening was, while we were ramping up our production -- I'll start with that. While we were ramping up our production, we were adding temporary workers to get the product out. And in a lot of areas that could have been automated, we were really taking on the labor, because we were in a market share game, to be frank with you. But when we add people, when you add people, it takes time for them to get productive. It really takes 90 to 180 days, three to six months, for somebody to get productive.

We had also done it because we wanted to be very flexible in the way we approach this, so that if in fact things flattened out, we didn't have a large commitment to a large permanent workforce. We did this using contract labor people. They knew exactly what was going on. We were working 13 out of 14 days, actually, for a long time, even with contract workers there. So we wanted to get out of that.

When we look at our picture going forward, we said, okay, we are now flattening out in demand. And we have all these automation projects, which I'll talk about in a little bit. We said now is the time to go eliminate the contract labor. But we actually probably could have convinced ourselves that we didn't have to eliminate it all. We said, let's go do this now and really set ourselves a challenge to keep our production up and customers happy and generating. It's a big cost savings, by the way -- not because we didn't need the people and we had them in here, but because those people were nowhere near as productive per work hour as people we have now. They were coming up the learning curve.

We also did it because of what you mentioned with automation projects. In September and October timeframe, we have several major projects coming online that are going to reduce labor. And we wanted to make sure that we had the ability to keep our workforce fully employed, so we actually are down a little lower than we wanted to be, betting on some of these automation projects. All of that stuff helps on the gross margin line. A little bit helped it last quarter, but a lot of it is going to help this quarter and the next. So we are projecting our revenues will be a little lower the second half of the year. If you do the math, it averages out to like 25 million a quarter for the next two; you know, we were 28 million this quarter. So you would say, gee, there's a little bit less overhead. But we hope to make that up with some of the efficiencies that we're working on.

Bill, do you want to talk about some of the projects, just give a flavor for them?

(technical difficulty) pretty much used and R&D cathode line to do the ramp-up. So we took pretty much a prototype machine and really mechanized it to get high volume out. But now we have a production-worthy cathode machine in our plan right now that's getting debugged that's going to run twice as fast as the machine that we currently have in production. So we'll have three cathode lines, and by far the latest machine we have in is much more efficient than the other two. So we're going to get a real big opportunity there.

We are actually looking at -- I don't want to interrupt you, Bill, but I guess I have. We are also looking at potentially not making cathode in the UK, we have so much capacity here, and shipping it from here to there and really being able to eliminate two shifts out of three in the cathode operation there.

And the second major piece of automation is in our battery assembly process. We do a lot of sleeving and capping and various battery operations by hand. We have an automatic piece of equipment that combines all that, and does it much more process-capable, due in late August, early September. And the third big piece of capital we have is we are automating the balance of our winding operation, which is a critical (technical difficulty). That way (ph), through automation, we also expect to get a significant quality improvement and also reduce our material usage.

So I guess, Jim, the answer is yes, the volumes will go down a little bit, which you'd think would be a little drag on margin, but we have other projects coming along we're hoping to use for it. And we'll be operating, on average, with a much more mature -- an average much more mature workforce.

Okay. Then, Bob, you had mentioned the two fires -- you had one in the UK and one here in the US. Did that cause any disruption in the quarter, in terms of production? Were you able to shift it? Do you anticipate seeing any short term setbacks because of that?

Like I mentioned, we had minor disruptions. We were down for a couple of days in the US, maybe a little bit longer in the UK, but it did not affect our production operations of any significance, and it didn't affect our ability to meet customer demand at all.

And is that what contributed to the higher insurance expenses, or was that just basically because of the overall growth of the business partner size (ph)?

Yes, the higher insurance expenses are mainly related to the overall growth of the business, really. The comment related to that and the operating expenses doesn't have anything to do with the fires.

Steve, I'd just mention about the fires -- we work with flammable, dangerous materials every day. We have a great safety record. We've done a really good job of segmenting everything so there's a minimum impact, if in fact we do have an event. And every time we have one, we bring in more improvements. So we are actually working with the insurers; we have really compartmentalized the stuff, and we are working with the insurance companies to learn from these and compartmentalize it even further.

And, Bob, what was cash flow from operations?

Cash flow from operations was $4.4 million.

Positive?

Yes, yes, yes.

That's for the six months or for the quarter?

That was for the quarter.

Mike Hoffman (ph), Rockport Advisors (ph).

I wanted to get a little more feel for the transition from CECOM to DLA. Do I understand, then, that CECOM is still awarding the contracts?

I believe that, once this final contract is awarded done (ph) with CECOM, which is the Phase IV Next Gen, which is the large battery types, I think that then DLA will be responsible. Now, will DLA subcontract some of that back to the resources in CECOM? Maybe. They have subcontracted back the technical evaluation work, first article testing, et cetera, so that group will still be in place, because the Army research lab really has all the expertise in that area. I don't know how it will go going forward, but they will be responsible for it, although they made me subcontract parts of it.

With DLA involved in awarding or paying for battery contracts up until now?

No, not at -- wait. Bill?

We have a battery contract right now from DLA for a half-AA battery for the Navy. They do do some battery contracts now so, just not the magnitude of these.

And is this just a shift that's affecting batteries, or is this affecting large portions of military spending?

No, I think it just affects batteries right now. But this is the way a lot of things that the military buys officially -- DLA mostly buys consumable products like batteries; that's what they are set up for.

This is supposed to be a very good thing for us in the battery industry because they have -- from what we've understood is they have much greater funding than CECOM ever dreamt of having. So when the battery supply really ran short during the Iraq war, a lot of issue was because CECOM didn't have the money to really build the reserves for the batteries and to do battery procurement. So this is really supposed to be a real big opportunity for us to work with an agency that has much greater funding.

So was this move in part, perhaps, required? Or is it a result of what happened with the supply?

Yes, I think it's a result of what happened with the supply, and I think our understanding is that the command staff all sat down -- the Army, the US military is a really good learning organization. I think they all sat down and said, how did we get to this place? They looked at it. It wasn't just in time of war; we knew that at end of the fiscal years, forts (ph) would have money to spend for batteries for training, but it wouldn't add up to the total budget that was given to CECOM, and so there would be problems with it.

And what was happening was that battery procurement was getting mixed up with covert attack helicopters and Abrams tanks, instead of being viewed as something more like ammunition and meals, consumables. So that's why they looked at this and said, well, this just makes a lot more sense. And I think -- I've heard General Kern, the Head of the Army Material Command, publicly say he was not thrilled about it happening this way, but it looked like the right thing to do. So he agreed to it because of that reason.

But you have to deal with a whole new set of people there, and you may or may not have to deal with new people in terms of the R&D side and the contracts?

I don't believe we will deal with new people on the development side. I think it's pretty much the same people. But we already have been working with these people; we know them. This is not some big unknown, you know. We know them, we are working with them, we are talking with them every week. So we already have formed a good relationship with these people. That's not -- our warning is purely -- all we are saying is there's a couple of events that have to happen. And we're moving to a world -- we were in a world where we had backlog out two, three months; it was very easy to -- very easy?

(inaudible).

It was easier -- two or three quarters, I should say; right. Thank you, Bob. It was much easier to predict exactly what demand was going to be. We are going back much more to a more normal flow. The total demand required out there is still happening, but it's going to be a few more weeks or so before we really know what the picture's going to be.

One last and quick question. What kind of batteries is UTI making for you now?

They make prismatic lithium ion cells for us now. One other point I want to make about Next Gen that I didn't make is, while we have been focusing on the 5390, the Next Gen contract includes multiple battery types that we have developed that we don't sell now. So it's a big opportunity for us to be -- for increased revenue in other parts. So that's also why we are very anxious to get this done, and why we've got to get it to happen.

But then, when it's awarded, we do have to qualify on those other battery types, and those things can take from six weeks to three months to happen.

David Kurzman.

A couple things, quickly, here. I'm trying to get a sense -- you said you're doing some hiring, but you are also getting rid of some contract labor. Do these offset each other, or is there one number that's larger than the other?

Well, first off, the contract labor has been in the direct labor area.

Right, so it's a different line item.

So we've taken down our total direct labor in the operation. And as I said, the average maturity of the people has gone up, in terms of maturity in terms of experience. Where we have added people is in the development area and a little bit in sales and marketing. That has pretty much leveled off. We maybe have a couple of key jobs we are looking for, but we are not talking about -- we had 130 more people than we have now in direct labor. Okay? We are talking about hiring three -- we've hired four, five, six people in development, maybe, and maybe one or two in sales and marketing, and maybe we have two or three other jobs open.

It really sounds like the reduction in contract labor far exceeds the likely dollar cost of the handful of positions you are looking to head in other areas.

Oh, yes; I think that's true.

I thought I heard something about modestly lower 9-Volt shipments in the current quarter. Can you sort of add some color to that?

It might have been a swing of 100,000 units from what we thought we might have had last quarter. And some of that also has to do with -- we come to the end of a quarter, and we have shipments somebody wants, and they know we're shutting down in the first week of July. So we get it ready, and somebody says, well, we don't want it until the second or third week of July. So it's a little tough between quarters sometimes, because we do try to keep inventories lean for ourselves and our customers. A swing of 100,000 units that doesn't go out in the last week but the customer wants in the second week of the next quarter -- that's really what we're talking about. 9-Volt right now for this quarter, bookings are very healthy and right on schedule.

In terms of the military number and building confidence -- again, I want to try to go back to this question I asked before of building confidence to your 20 to 30 percent revenue growth for next year. I can kind of do quick back-of-the-envelope -- it's probably a certain amount from 9-Volt, 25 to 30 percent share of the military and, (technical difficulty) next year, another 14 or 15 from rechargeable. That kind of gets me to a bit over 100 million. Can you sort of walk me through where you think the rest of it's going to come from?

Yes. So, first of all, there is in a chunk of commercial business in the UK for ELTs and beacons, auto reclosers for power line, pipeline inspections. That's in the $5 to $10 million ballpark, and then there's the other commercial business. We expect to have sales, a significant number in automotive telematics next year. In medical and wearable devices, there's revenue for next year. We will be in at least one, if not more, defibrillator designs next year, we believe. And then, ELTs that we are qualifying on, we have probably got three or four development projects going right now. One of them, you heard, we are starting to get orders on. So commercial is going to be the growth there.

Sure. Can you qualify at all whether it's bigger than a breadbox or smaller than a breadbox, or put a number on the automotive and medical for next year?

All I can tell you is it's going to be millions of dollars in each one of those.

David Gill.

I don't mean to keep on talking about labor, but can you tell me about how many employees you have right now?

At the end of June, we had about 940 employees, including temporaries.

Including temporary? Okay.

Including temporaries. And then we had the elimination of the temporaries, which amounted to about 130 people or so.

So we are, ballpark around (ph) 810 now.

Right, that's right.

About an 810 range right now?

At this point in time, right.

And just a quick follow-up question. Can you took about how much excess production capacity you have right now?

Bill, you handle this. It's hard to say in aggregate. You can say, operation by operation, we are probably running --

Well, we don't have all the new capital in line, but right now we are running probably at 65 to 70 percent utilization, versus on a 24-hour-a-day, seven-day-a-week type scenario. (multiple speakers) we'll have -- we expect volume to go up again shortly, and then it will change. But we have more automation coming in. It's a really tough question to answer, because some of the areas are just full-out. We have a small cylindrical line that's running all out, and we have some excess utilization in some other areas.

I'd say, on a five-day basis we are full-out, and in small cylindrical we are running probably 85 percent on our large cylindrical cells. We are probably running 65 percent on 9-Volt. But we do have Saturdays and Sundays, if we have to go do that again.

Jim McIlree.

What do you expect the military sales, as a percent of the total, to be in the second half?

Probably around 60 percent, still. That's what we're thinking. And I think we said next year -- I don't think we've changed our prediction that next year they will be about 50 percent of our total revenue, Jim.

(OPERATOR INSTRUCTIONS). Sir, I am not showing any further questions.

Okay. Well, thank you, everybody. We appreciate you all participating in this. It's been another strong quarter for Ultralife. We continue to increase our revenue, and achieve the operational results we have been striving for. As we move into the second half of the year, I think you will see us continue to work and diversify our business into more new and promising markets and applications. We hope you can join us for the analyst investor day. We'll have the details out on that. And thank you all for joining us. We look forward to sharing our progress further with you next quarter.

Ladies and gentlemen, this concludes our conference for today. Thank you all for participating, and have a nice day. All parties may now disconnect.