Ultralife Corp (ULBI) 2004 Q3 法說會逐字稿

Good day, everyone, and welcome to this Ultralife Batteries earnings release conference call. Today's call is being recorded at this time for opening remarks and introductions I'd like to turn the call over to Mr. John. Heilshorn. Please go ahead sir.

Thank you. Good morning, everyone. This is John Heilshorn of Lippert/Heilshorn and Associates. Thank you all for joining us this morning for the Ultralife Batteries earnings conference call for the third quarter of fiscal 2004.

The earnings press release was issued earlier this morning, and if anyone has not received a copy I invite you to visit the Ultralife website at www.UltralifeBatteries.com. You can find the release under the investor elections -- investor relations section of the website.

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

Before turning 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's 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 like to now turn the call over to John. Good morning, John.

Good morning, thank you John. Good morning everybody and welcome to the Ultralife Batteries conference call for the third quarter of 2004. Joining me today are Bob Fishback, our Chief Financial Officer; Bill Schmitz, our Chief Operating Officer and Nancy Naigle, our Vice-President of Sales and Marketing.

Today we reported operating income of $1.5 million on revenue of $24.4 million. This was the revision that we made to our -- this incorporates the revisions that we made to our guidance at the end of September and which were necessitated by the lack of progress in obtaining either a follow on order from the U.S. military or an award on the Next Gen II Phase IV procurement. In that outlook we stated that if there were no new orders for the fourth quarter and we were unable to obtain any pricing adjustments from the change in volume assumptions we'd show a second half revenue as low as 42 million and second half operating income as low as $400,000. We also stated we expected the third quarter to come in around $24 million in revenue and at least 1.2 million in operating income. Today's results indicate that kind of guidance, and we have no reason at this point to change that guidance. Once it's been clear that there was going to be a hiatus in these orders for the BA-5390 we've now taken steps to adjust it by slowing down our production run rates and reducing our direct labor head count. We did this, we believe, without impeding our ability to react rapidly to any new BA- 5390 orders or the award of the Next Gen II Phase IV contract. The gross margin was affected by the decrease in volume and does not either include any pricing adjustment that we have the potential for. Bob will talk about gross margin in more detail in his prepared remarks.

We remain very optimistic that there is continued demand for the BA-5390 and that it represents a superior solution over the BA-5590 in every application for which it is used. We also remain optimistic that we will be successful with the Next Gen solicitation although we still have no way of predicting when the award will occur. We're still working actively with both Cecom and the Defense Logistics Agency to resolve production volume and contracting issues but we've not yet received any additional direction on orders.

Our rechargeable business is still growing. In the third quarter it grew to $2.6 million in sales due to growth across the board in products and applications. This growth, a little higher than expectations, was led by pre Christmas volume growth in our digital camera battery product and includes further expansion of our applications and widening of our standard product portfolio. We now have 23 standard products our rechargeable offering and they, in this quarter, represented 73% of our revenue volume. That's in the third quarter. We're still on track for the rechargeable segment to be over 7 million dollars in revenue this year and to at least double for next year.

Design, sampling and qualification activity in all of our target commercial markets is still growing. During the third quarter, we sampled new applications, including diverse areas as -- like industrial robotics, biometric I. D. systems for weapons. Back-up batteries for PCMA -- PCMCIA cards and batteries for portable respiration pumps. With added resources and process improvements in our sales, engineering and product design organizations we are now fielding as many as 25 to 30 applications increase per week.

Our pipeline has grown, not just in our target market applications but with new applications in new markets. These also include diverse areas such as flight line test equipment and blue tooth headsets both for aviation and for commercial applications. It ranges from factory automation equipment and CCV cameras to closed circuit TV products and batteries for fuel cell back-up and load balancing of those fuel cells.

We're still on track for revenue growth starting in the first half of 2005 in search and rescue, automotive Telematix and automated external defibrillator applications. In addition, as we've done with our rechargeable products, we started to grow a portfolio of smaller applications, leveraging our standard cells and our battery engineering and assembly capability though none of them as individually as noteworthy for its volume collectively this portfolio represents growth opportunity similar to what we've seen in our rechargeable business.

With respect to our outlook, with no new news to report on the BA-53 orders or contract awards our outlook for the second half of the year, as I said, has not changed. Due to the -- do to the delay, ongoing delay in the award of the Next Gen contact we project a modest decline in the military business year-over-year. With significant growth in our commercial business, we're now projecting year-over-year revenue growth between 10 and 20%. The risk to this is any protracted delay which we don't expect but could happen in the awarding of the Next Gen II Phase IV contract past the end of this year or an unsuccessful outcome in the contract award. Opportunity to better this case could come from an earlier award of the contract, further acceleration of our rechargeable business, better than expected growth in some target medical applications or the faster adoption of back-up batteries in automotive telematics systems. We've also not forecast any significant revenue in our thin cell business for 2005 and we think this also remains an area of great potential in multiple market areas.

We've taken this time as an opportunity also to install further process improvements through automation and more advanced process control. This will give us the opportunity and chance to improve our margins over those for similar operating levels in the past.

Financially, we're very strong. We ended the third quarter with almost $13 million in cash and investments. While we still have a short-term issue to work through with the military, we remain convinced that we have a strategy which will continue our growth into 2005 which will get us to a $2 million business -- $200 million business in the next 3 to 5 years. The Next Gen contract will get awarded and not only do we believe it will be a successful participate in an award but it's award would put us into the production on four to five additional products. This, along with increasing market share of MNO2 products should keep our military business growing, in the long run even in a situation where overall demand increases.

Our commercial market focus is starting to gain traction and show results. This portfolio of products and markets will enable this growth and help to insulate us from the ups and downs of individual markets such as we are seeing now. And we will continue with our new products push. Advanced battery pack and thin cell products represent future growth in the broadening of our offerings along with accessories, such as battery chargers and services such as transportation testing will also diversify this company further. This is not a one-story company with a narrow range of products. Ultralife is a broad based power solutions company participating in a wide range of promising markets with expanding portfolio of products and services. We have a short-term issue with the 5390 order flow. This will not deter us from realizing the long-term potential of our business.

Now I would like to turn it over to Bob Fishback who'll cover some of the financial highlights. After which we'll open it up for the Q and A.

Thank you, John. And good morning, everyone.

Earlier this morning we released the results for our third fiscal quarter of 2004 that ended on September 25th. Consolidated revenues were $24.4 million, slightly higher than the $24 million guidance we had provided in our September 27th release. Compared to the same quarter last year, revenues rose $4.5 million or 23%.

An Increase in sales of HiRate battery products to the military again drove the change primarily due to growth in shipments of our BA-5390 batteries. Sales of rechargeable products also increased notably rising nearly eight times from 300,000 in 2003 to 2.6 million in '04, driven by the success of our digital camera battery, as well as sales of other products to a growing customer base. Gross margin for the September '04 quarter was 4.9 million dollars, and an improvement of one million over the comparable quarter last year. As a percentage of sales, gross margins were 20% consistent with last year.

In July, we followed through on our commitment to grant shares of common stock to our entire direct labor work force based on years of service. Giving them an opportunity to hold an equity interest in our company. This stock grant resulted in an overall expense of a little more than $200,000 in the quarter.

In our primary battery operations, we realized 22% margins in the third quarter of '04, up a bit from the 21% reported in last year's third quarter as operating efficiencies improved. The 2004 margins were unfavorably impacted by a decrease in production volumes due to the lack of follow line orders for BA-5390 batteries from the military. Our rechargeable battery -- in our rechargeable battery operations, margins improved by $300,000 to a reported loss of $20,000 just shy of a positive gross margin. Incremental margins in this segment were a modest 13% due to the impact from sales of the relatively low margin digital camera battery that is contract manufactured for us.

Operating expenses for the third quarter of 2004 totaled 2 -- $3.3 million, an increase of nearly 600,000 over the same period last year. This change relates to our planned increase in our level of commitment to support the higher volume of development opportunities as well as higher administrative costs associated with the increase in the size of our business.

Operating income for the September '04 quarter reached $1.5 million. Modestly ahead of our 1.2 million adjusted outlook mainly due to slightly higher sales and better manufacturing efficiencies than projected. As sales increased 23%, operating income improved 34% compared with the results reported a year ago. Demonstrating the operating leverage we have been able to achieve as sales have grown.

On the bottom line, the company reported net income of 1.4 million or nine cents per diluted common share compared with net income of 1.8 million or 12 cents per share last year. Last year's results included a one-time $800,000 gain for the forgiveness of debt related to a government grant. Average diluted shares outstanding for the quarter were 15.1 million shares. Higher than last year, mainly due to the impact of stock options and warrants as well as a small equity transaction that was completed during the fourth quarter last year.

Shifting focus now to a sequential comparison of the September quarter's results versus the June quarter, consolidated revenues declined $4 million from the 28.4 million reported in the second quarter. This decrease in sales was attributable to lower shipments of HiRate batteries to the military mainly BA-5390's. This decline in military sales was offset partially by increases in sales of nine volt and rechargeable batteries. Consolidated gross margins decreased nearly 2.2 million from more than 7 million to 4.9 million. As a percentage of sales the margins declined from 25% in the second quarter to 20% in the third. This was mainly the result of lower sales and production volumes related to the BA-5390 battery. As mentioned previously, the third quarter of '04 was also impacted by a $200,000 expense for the stock grant to our direct labor force.

Operating expenses were down slightly quarter -- from quarter-to-quarter, reported at 3.3 million in the third quarter compared with 3.4 million in the second quarter. While R&D costs increased as planned related to the additional resources for product development efforts, SGNA costs declined modestly due to the timing of expenses. Operating income decreased $2.1 million from 3.6 million to 1.5 million, mainly related to the decrease in sales.

Shifting now to our cash flows, EBITDA for the September quarter defined as operated earnings plus depreciation and amortization, amounted to nearly $2.3 million, including depreciation of approximately 700,000. During the quarter, favorable changes in working capital resulted in an increase in cash, generating more than $6 million, mainly as receivables in inventory balances declined. We spent approximately $1.9 million in the third quarter on capital equipment additions. At the beginning of our third fiscal quarter, we closed on our new $25 million credit facility, and we drew down $10 million under the term loan component of that arrangement. We used a portion of the proceeds from that loan to pay off the outstanding balance of the previous credit facility of approximately $5 million.

Our balance sheet at the end of September is strong. Our ending cash and investments balance was $12.8 million compared to approximately 1 million three months ago. The refinancing of our credit facility has helped to enhance our overall financial condition. Total debt outstanding at the end of September was $10.3 million, mostly related to the $10 million we borrowed under the term loan and at the end of the quarter we had additional borrowing capacity of more than $11 million under our revolver. Total debt as a percentage of total capitalization is only 19%.

I also want to remind everyone that during this fourth quarter we will be reviewing the appropriateness of recording a deferred tax asset related to our determination as to whether it is more likely than not that we will be able to utilize some or all of the 60 plus million dollar domestic net operating loss carry forwards for income tax purposes. We are working with our tax accountants and auditors to make this assessment. If we do reach the conclusion that we should record a deferred tax asset, the accounting impact of this conclusion would result in the recognition of a deferred tax credit that -- excuse me, that would run through the P&L in the fourth quarter potentially for as much as 20 to $30 million. After this one-time adjustment and as we move into the following year we expect that we would begin to reflect it more normal effective tax rate in the range of 40%. Any cash payments for income taxes, though, will be fairly nominal as we work off the existing NOL's.

Also, we have refined our analysis pertaining to the annual limitation on our ability to utilize our domestic NOL's, based on Internal Revenue Code section 382. We had previously indicated that the estimate for the annual limitation was expected to be in the range of 14 to $18 million. After working through the details with our tax accountants, we now estimate that the annual limitation will be in the range of approximately $22 million. This gives us quite a bit of room before we will need to pay income taxes at the statutory rate.

Looking out for the remainder of 2004, we are reiterating our guidance for the second half that we stated in our September 27th release. We continue to project that revenues and operating income for the second half could be as low as $42 million and $400,000 respectively. This outlook assumes that we will not receive any additional orders from BA-5390 batteries during the fourth quarter and that we are not successful in receiving a pricing adjustment on our current delivery contract for 5390's.

Looking ahead to 2005, we are now expecting that revenue growth will range from 10 to 20% over 2004. This growth rate is modestly lower than what we had previously indicated due to the uncertainty of the timing of the Next Gen II Phase IV contract award from the military. Commercial business is expected to result in solid growth next year including continued growth in rechargeable sales.

Our design activity continues at a record pace, mostly for commercial applications in the vertical markets we've targeted. We continue to believe that our revenues can grow at an average annual rate of 20 to 30% over the next three to five years based on our -- our anticipated growth in key markets such as medical, automotive telematics, and portable electronics. We are committed to our long-term strategy for growth and we believe that the strength of our balance sheet is sufficient to continue to build the business into the future. That concludes my remarks and now I'll turn things back to John.

Thank you, Bob. Now I'd like to turn it back to the operator. We would like to open it up for the question -- the question and answer session.

(Operator Instructions) Steve Sanders, Stevens Incorporated.

A couple of questions, Bob, on the operating cash flow and CapEx, assuming your current guidance for fourth quarter can you just give us some idea of where you would expect operating cash flow to come in and then what your CapEx plans are for the fourth quarter?

Operating cash flow will be in the neighborhood of break even, and our capital expenditures should be in the range of about a million dollars in the fourth quarter.

Okay, and -- and that doesn't represent any change relative to a few months ago?

No.

Okay. And then -- and then again assuming current guidance, where will military sales come in as a percent of overall sales in '04?

Overall they will be about 60%, very consistent with what we have been talking for for some time.

And then -- and then an update on the expense side, I know there's obviously some uncertainty here in the short-term, but do you expect to continue over the next couple of quarters to make some incremental investments in the R&D and the sales and marketing? Where -- What is your current thinking on that?

This is John, Steve. I think we're pretty happy with the levels we are at in R&D and sales and marketing. We made some significant additions to the R&D line in the spring. We have some contracts, development contracts that are helping us to further expand that and not really impact the P&L, so I think we're pretty happy with where we are on R&D. On the sales and marketing side, you know, if we see opportunities to add coverage to leverage the business we'll do that, but I don't think we have anything really right now. I think we have turned our attention to really using process improvements to drive the productivity and I think we think we have some room for that still. Does Nancy have anything? She agrees.

Okay, and then a couple of quick questions on the rechargeable side. I guess you are at about 5.7 million year to date. You are still saying over seven, you know, it sounds a little conservative for the fourth quarter. Is that due to what you may view as sort of a spike on the digital camera business and if so can you quantify that?

Yes, it is a spike on digital camera business. I'm not going to -- you know, you know us we're pretty straightforward. We'll be in the two million dollar ballpark, you know, this quarter, you know, could be a couple hundred, two or three hundred thousand less, could be two to three hundred thousand more but we're going to be right around two million for this quarter.

Okay.

And so, yes, seven million is a little conservative, you know, we will be a little more than that probably.

Okay, and then at the Investor Day you gave a metric and I think it was from 1Q that, you know, a million and a half or so in sales came from 90 plus customers. It sounds like based on your comments, the pipeline, the level of activity remain very robust. Just any additional color or metrics there?

On the customer side? I don't know, Nancy, is there anything we would add to that?

The opportunity base is still very robust as you said and continues to grow. So we certainly haven't seen any change there.

I think what's helping us to have it grow are two things, Steve. One is that every time we do something for somebody it expands our product portfolio to it 23 standard products in rechargeables so we're getting much better hit rates and we are getting people coming in asking for those products. And the second one is as markets as -- as we learn about markets, you know, and we do some of these unique applications for people that could be, you know, as simple as aviation head sets we say, gee, who else is in the business and usually it is not, you know, usually in some of these missed markets there's, you know, one or two other people in the business who -- who take the sales call.

David Kurzman, Needham and Company.

Good morning, everyone. A question on margins for a second. If you're expecting a slightly lower military and a more robust commercial for 2005, is it safe to assume that you'll have higher incremental margins and thus overall higher margins than you would normally have at those revenue levels for next year?

You know, I'd like to believe that, but the world is pretty competitive out there, David, and, you know, it's really a matter of, as you know, we can get in there and work with somebody on the front end and think we are the only one in there but when it gets to the purchasing department and it is time to put it out for bid they are going to find competition. It is their job to do that so I wouldn't necessarily assume that. I think we -- our assumption has been the gross margin will be in the same ballpark going forward and, you know, if we can do better than that obviously we will, but I wouldn't think it is going to be better necessarily.

Okay. The old 8020 rule probably applies to the rechargeable business. You're talking about digital camera and some new applications but having basically 23 standard products, is it safe so say that there is going to be probably 20% of those standard products or 20% of your customers are going to make up 80% of your revenue?

I don't know. Bill, do you have any?

That's a good one. We're seeing really at the moment we're seeing such great diversity into these customers and products that, you know. We got a couple products that are right now leading the pack but they are not necessarily the ones that we are sampling every day. So you can say that right now that might hold with our digital camera, battery pack and also our 2590 are the two leading the pack. But those two batteries aren't the ones we are sampling on a daily basis as we are the rest of our portfolio on what we're really doing is configuring the portfolio of sales we have been able to develop over the last couple of years and really building a variety of diverse battery packs that John eluded to and then we're putting those batter packs that we really like on the website and trying to leverage those particular battery packs. So at the moment we might want to say that 80/20 role rule holds up with two of our products but going forward that's not how we are forecasting it.

Okay well final follow up and then I'll jump back up in the queue. The -- how recurring is this rechargeable battery business is this versus how one off is it?

One off in terms of customers or products? It's -- every -- these are not somebody coming in and saying I need one bat -- you know, I need 50 batteries for something. These are ongoing projects and so what happens is we'll get, you know we'll sample, then we'll do prototypes and then the product gets rolled out. If the product's successful it start's growing in volume, I mean, we saw that with a tens device that we make , a nerve stimulation device. We have a blue tooth head set device that started out slow and now it is getting into pretty good volume, steady volume. The volume grows, sometimes it goes down some it's really a reflection of how the product does in the market place.

Thanks. I'll hop back in the cue.

Steve Gish, Roth Capital Partners

John, with respect to the rechargeable market, how much of that rechargeable revenue came from military this quarter?

Very little.

Very little.

I'd say, you know, 10% maybe.

Okay, great. And overall --

Let's say 10 to 20%. There is some stuff that's kind of on the fringe that's hard, to you know, like we're using 20 -- we have a rechargeable -- large rechargeable battery that's going into an industrial -- a robot, okay? This robot is used in some industrial applications but it is also the same basic platform they use when they go into caves in Afghanistan so I, you know, in some cases it is kind of on the edge of knowing whether it is military or not.

Okay. And if my memory is correct, military was about 50% of rechargeable last quarter?

I don't know that we ever -- we've ever really looked at it that way to be honest with you.

Okay.

I think what we said was that the real military rechargeable product is the 2590. And that's been a strong product for us, but I think what we said was that to our surprise, half of the 2590 product line has gone to nonmilitary use, to commercial, and that was what we said last quarter. I -- to be honest with you, I'm not sure what it was this quarter. It is probably tracking about the same, maybe a little more, maybe a little less. If anything maybe a little less, a little more commercial this quarter. I haven't done the numbers on it, Steve.

Sure.

I think that's what se said.

I understand. And what was the split between military and commercial for this quarter on consolidated revenue? I think in the past it has been 60, 65% military, the rest commercial?

Probably 60 -- 55, 60% military.

It is right in that range, too.

Probably pretty consistent.

Okay. And at the Analyst Day I think you talked about a little bit -- the possibility of building up some inventory for the BA-5390. Your inventory came down but have you been doing that and then based on your initial guidance for next year, of that 10 to 20% growth, how quickly once you receive Next Gen Phase IV could you ramp up?

Okay, so two questions, one is on inventory. Our inventory came down and I think we said on the last conference call that we wanted to get the inventory down. There were two elements of our inventory being high last quarter. One of them was that we had shipments that one of these they could have shipped the last week of June but the customer didn't want them until the first or second week of July. And the second was, we have a little bit of a natural build up at the end of June because we have a shut down week in the beginning of July and we want to be able to continue -- even though we shut down production we have to ship to customers. So we had a little build up in things like nine volts were we want to have steady shipments. The second effect on inventory was that -- that we had product inventory we wanted to bring down, which we did, I mean we did a pretty good job on that, you know but it's never good enough for me. I like to run as lean as possible on this stuff and Bill knows that.

So I -- in terms of building inventory on the 90, I think what we said was that our last shipments under our contract are kind of the first, second week of November and at that point in time if we do not have a contract award -- an order from -- under Next Gen or in some other way an order for the 90 we are not going to shut the line down. We're going to keep building out at what we think is a very prudent run rate, a rate that we know there is going to be demand for once we can top this ordering issue so that might build some inventory. I think that's what we said.

okay.

In terms of Next Gen when it comes on. When Next Gen is awarded we have to go through a qualification processes on every product, because the version of the 5390 that's in Next Gen has added to it a state of charge indicator, which we're thrilled about since we've had one working on the land warrior for a couple of years now. And we want to get it out there cause I think it gives even added advantage to the product. It'll be the first product -- major product out there in primary battery for the military that tells the soldier actually how much energy is left in the battery which you would think would be something you'd want to know. But everything requires a requalification. We're pretty confident that because they have continued demand for the 5390 that -- and we've been shipping it all along, that we would be able to get a waiver so we could ship the old version. The only difference in the old version is the state of charge indicator until we got that qualified. On the four other parts that are in the Next Gen, four or five? It is five, I'm sorry. We would have -- we want to get business there. We think we have an advantage on a number of them, including the PR112survival radio is, you know, gives it more energy and gets sulphur dioxide out of the cockpit of the airplane, it's something they wanted for a long time, but we have to get that qualified so there will be anywhere from a three to six-month qualification time on any of those. And in a way, you know, one of the reasons why we are seeing a modest decline last -- next year when we've said, you know, we think we can keep it level. Part of keeping, you know, holding the line in terms of keeping the revenue flat year-to-year on military, keeping it up there, was that we are going to get into new products. And, you know, as this gets delayed we were doing things in parallel but there's only -- there's a point at which you can't start the qualification, you know, you can get all ready for it, get the moldings made and the testing done but you can't start the qualification until you have a contract award. And so, you know we're pretty close to where that will start to impact us somewhat and that's why we have taken steps to be a little more cautious in our outlook for next year.

Okay. Great. Bob, the repricing adjustment or possibility of that -- how would you account for that, for instance that was -- you reached an agreement this quarter? Would you readvise Q3 or would we see the impact in Q4?

We would see the impact in Q4. We've -- everything we've shipped through Q3 is based on the contract price and that's what we have booked it at. If there is a pricing adjustment it would flow through in Q4 and then --

You can't go back and change it. When we had the -- one of the reasons why, you know, the last adjustment we had was in the last direction, we ran a little better than $700,000 a year ago and it hit us like three days before the end of the quarter and we -- we had to take it in that quarter. If we hadn't known about until after the quarter we would have had to take it all in the next quarter.

Okay, and the 200,000 expense for stocks granted to direct employees, was that in gross margin?

Yes.

It was?

Yes.

Okay, and what was CapEx again?

CapEx during the quarter was about 1.9 million.

1.9 million, and then, John, could you just talk a little bit -- you mentioned the opportunity of transportation services.

Oh, yes, one of the big issues out there today is safety with transportation of lithium batteries. There have been some events where there have been frankly fires and problems with -- one of them occurred with some consumer grade lithium batteries when a fork truck hit a case of them and they were damaged and caused a fire in the airport I think in Los Angeles. There are others that have occurred from either counterfeit or poor cell phone batteries catching fire. You see them in the press, so there are transportation safety standards for lithium batteries governing whether it has to be shipped as a class nine, meaning hazardous material or not and where they can be transported. And so every lithium battery today that's constructed, rechargeable or primary that is going to be shipped, either separately or as part of a product has to be transportation tested, has to be baked and shaked and there is a whole protocol. Nine steps, Nancy?

Eight.

Eight-step process for it. And we set ourselves up early. We realized early we want to understand this really well and we did. We actually our white paper on it has been in the congressional record and is -- we are respected as an expert in this field now. And we had a transportation testing service and our customers started asking us, we were doing our own transportation. They started asking us, can you help us out? We established it as a service and we're pretty well booked in that service. We do transportation testing of batteries for people and it's -- it's starting to be an important part of a service that we provide and we get paid for it.

So, in the past or currently were customers actually doing that testing themselves?

No, they were not. They weren't doing it at all. Now with the new standards they rolled in at the beginning of this year, and, you know, we've -- and the carriers are getting, you know, are really starting to enforce this. UPS and Fed Ex and we -- they consult to us pretty regularly about -- about these standards about how they should handle stuff but, yes this is -- this is a very important issue right now, and every year pretty much IOTA and this is a UN standard that is run by IOTA and every year they relook at this.

And is this service priced into the unit pricing or is it a separate fee?

No, it is a separate fee. So if we sell a battery to a customer, and they're going to put it into their product they have to test their product and we'll do that testing for them, for a fee.

Larry Baker, Legg Mason.

John, could you go back and talk about, you said you had taken several actions to stretch out production. Can you say what those are and sort of what your rate might be if you don't get an order by, I guess, November the 2nd week or 1st week?

We've been running at -- we've been running at a pretty steady, you know we took our rate down. Well, Bill, we took it down in June?

In June when this first came to our attention we took it down and, as John announced, we let go all of our temporary work force so that was the first action we have taken. And then secondarily a couple of weeks ago we took it down to a very minimal rate that we saw would be the minimum threshold for future orders and also at a rate we could ramp up very quickly. So -- so that's basically where we are at right now. We're running at, you know, something about 20% of our large cylindrical capacity at the moment.

Okay, and is there, you know, a limit on how much production you would produce, or I mean, inventory that you would produce before you -- ?

Well, I mean, you know to be honest with you, we think that there is demand now and that, but that there is no mechanism for DLA to place orders until the contracts are awarded. And so we have a pretty good idea of what the real base case run rate is. That's with no conversion over, no -- a whole bunch of issues in terms of pricing of this and all that have have been (inaudible) actually, but we run at -- we're running a reasonable base case and that's -- that's what state -- you know our guidance, I mean,that's the most I guess I could say.

Okay. Would this -- with the slow down just to go back to an earlier question, does that -- wouldn't that change your mix from 60% military to a lower --?

Yes, next year it'll be -- our military business will be 50% or maybe even a little less. Of our total business, yes.

I was thinking more of -- in the second half of this year, wouldn't this have also affected it?

In Q4, yes, if the results pan out the way we have guided. Yes, in Q4 military will be -- military will be less than 50%.

Yes, it will be, I don't know, I haven't done the math, 30% maybe?

Yes, probably more in that range, yes.

And then just your conversations, were there other actions taken other than just slowing down production? I mean other layoffs or other -- ?

Yes, we took down some -- some -- we took out some direct labor.

okay.

In our factory.

And then your conversations with DLA, can you just provide a little bit more detail on what -- what they are saying or what the thought process is or what's been ironed out?

Well, it is pretty straightforward, which is CECOM who used to order from us, had a mechanism for placing orders in the absence of a contract. That mechanism would (inaudible) contracts that we got. They take a lot of contract administration and it's a pretty elaborate, you know, way they do the proposals. Defense Logistics Agency is an ordering agency and they are equipped to order off a contract and this -- the amount of overhead that's -- that it takes to go do this is pretty onerous for them. And so they -- they, you know, to be frank with you, it's probably -- it's easier for them right now to wait and hopefully that wait is, you know, days and weeks not any longer than that, to wait for the contract to get awarded and then just place orders under the contract than to go through what for them what is a painful exercise of doing a (inaudible) buy. Now my guess is if this goes on long enough, you know, and they -- and they really need product that they're -- you know, we are still shipping under the old contract, so, you know, if we get to the end of the shipping under the old contracts and demand isn't being fulfilled, you know, maybe they are going to figure out a way to do it. But right now, I think their hope and our hope is that shortly we will get this contract awarded and that they'll be able -- they're going to have a mechanism for getting the buys placed. In a sense there is not any pressure on them yet because we are still shipping under the the old contract. They're still getting product.

And then the testing phase just on the 5390 from day of receipt of order until day of first shipment of a stated charge battery, what would be sort of a minimum time frame we should look at it?

I don't know, Bill what -- ?

30 to 60 days. You know, we have a lot of experience, you know, and there's a first article test plan associated with it. We have a lot of data to support the tests. I think most of you know we have a government quality assurance representative at our plant so that allows us to, or her to validate the test here versus testing in some of the military labs so we have a real opportunity to streamline this normal process.

Especially since it's a -- basically a running change to an existing product.

Exactly.

But there still is -- there still are some variables in there that we don't control like we have to submit a test, they have to review it and come back to us so usually they turn that around pretty fast but that's a variable we don't control.

Okay. And then just one question on gross margins. I'm not sure I understood your comment earlier about gross margins sort of remaining where they were. You know, in the first half of this year you were in the mid 20s.

Well no, no, the question was incremental gross margins for military business versus commercial business. Not total gross margins. I mean, we firmly, we're still firmly focused and firmly believe we can get our gross margins up in the high 20s in the aggregate. Okay, but -- but the questions that I think -- the way I answered David's question was, he was asking if gee, if we replace military business with commercial business are we going to get better incremental gross margins with that business and I said, my answer to that is we're not counting on it.

Thank you for clarifying that.

Sure.

Jim McIlree, C.E. Unterberg, Towbin

Can you talk about the thin cell and nine volt outlook for both the Q4 and 2005?

Nine -- well nine volt has been pretty steady. I don't know,Nancy, are you -- what are you looking for in '05 in terms of 9 volt?

We're actually currently forecasting nine volt to be relatively flat on a year-over-year basis. Now, we may have opportunity to that, but basically, you know, we're seeing some of the businesses that we've been in leveling off some and they are not being a lot of new applications for nine volt. But on the positive side we have been working very hard over the last few years to diversify our base of customers for the nine volt and we have a larger base of customers now, so certainly we have upside but we're not anticipating aggressive growth.

And I think we're being prudent there because, nine volt, we can ratchet the nine volt up real easy. We know how to make this product. So it's prudent for us to plan it at a -- at a, you know, fairly, you know, cautious level and then we can add pretty easily. On the thin cell product we just have a lot of activity. We're sampling this product for all kinds of applications. I just -- I just, you know, RFID tags -- everything from RFID tags for, you know, for products to RFID tags for people, are pretty hot important market. Tracking cards, wearable medical devices, some of the wearable medical devices are stuff we are working on. But, you know, some of these products take time to get to the market and so, again, in the spirit of making sure that we don't plan on things, you know, be too optimistic about when we think things are going to happen, because, everything always takes longer than you think it is going to take. We, you know, we haven't planned big revenue for this. It is very, very modest in '05, but, you know, certainly some of the places that we are using these tags, you know, we have thin cell going into a card product that is kind of an easy pass for a rail system with a pretty major player that's going into trials now between now and March. We don't know when that is coming to market. It could come to market next year. We're not planning on it but those are the kinds of things that we are using thin cell for, some very innovative areas.

And on the military projection for 2005, I'm still trying to understand what it is that you have baked into your expectations? Is it that a Next Gen or something similar to that is received such that you begin shipping in Q1 or is it something that is a Q2 event or is it kind of a reverse of what's happened this year, that is slow -- very slow Q1, better Q2 and then great Q's 3 and 4?

We thought we'd get , I mean, without being too specific, because it is not that we don't have specifics. It's that we do these things in kind of a probabilistic basis. Without getting too specific on this, I'd say that in the past we were kind of assuming that we would get a little bit, other than the 90, the 5490 which we have ongoing demands for and we think we get Next Gen we're going to be able to start , you know, doing -- getting orders and creating shipments for those. The five other products, you know, I think we thought we'd get -- we'd have some shot of a little revenue in the first quarter. Significant revenue in the second quarter. Really going in the third and fourth. I think now I think we would say because of the qualification time these things take that it's going to -- that, you know, we're at the point now where I don't think we are going to get any revenue in the first quarter from -- from these added products and the second quarter I think, we still think we can get revenue for it but it is not going to be from day one. So, yes, that's kind of our viewpoint. Now we could be made liars if tomorrow the contract gets awarded, you know, but I don't think it is going to be tomorrow but hopefully, you know, we're making the life as miserable as possible for everyone in Washington so they do it pretty soon.

So, Jim, I think -- I think we've slipped, you know, yeah, we split out a little bit our expectation on when we can actually get these things qualified and into the marketplace because of the slide in the contract award.

And can they purchase the 5390 without the stated charge indicator that doesn't need to go through requalification?

Yes.

While the 5390 with the stated charge is going through qual?

Yes, they can, and that's what I was trying to say before. I didn't do a very good job of it.

Right, so you're not -- potentially you are not facing a situation where you are doing nothing because everything is being qualified?

That's correct. In fact,I mean, I'll point out that the stated charge indicator has been in the indicator has been in the specification for the 5590 for, I think, eight years now and it has been wavered since the first day.

Okay. That's great. Thank you very much.

Michael French, Kauffman Brothers Investments.

Good morning, gentlemen. I just have a couple of quick questions. Sort of a short term one here. The fourth quarter revenues come out to be around 18 million or so, where you guiding it, is it possible that the gross margin could fall below 20%?

Yes, it is possible. It is going to be very dependent upon volume in our manufacturing operations. So, yes.

But it could be similar to the decline that we just saw, right? On a sequential basis?

I'm not sure what you mean. You mean from Q2 to Q3?

Right. I mean, we could see a similar decline -- or could we see a similar decline going into the fourth quarter because revenues could trail off by as much as six million dollars?

I think it is pretty clear from the guidance we have given that -- that if we have a loss in the fourth quarter that --that gross margin is going to come down.

Right.

Plain and simple, and so, you know, if we come down in revenue, operating revenue, you know, a couple two to three million dollars that's going to come right out of the gross margin line.

That's what I think. I just wanted to make sure of that. And for the longer term, we're talking about a growth rate next year of 10 to 20% and I think you had indicated it was 20 to 30% in a longer term. And I did sort of address this but I want to make sure that the reason why is the qualifications that are likely to be going on to the next year.

Yes, the reason why is right. The first half of this year, you know, this quarter and the first quarter and the little part of the second quarter, yeah, we're delayed in some things we thought we would be getting into the market.

And so where is your assumption --

it is the front end of '05 issue.

And now your assumption for the 10 to 20%, that assumes that a contract will start at some point next year, right?

Yes.

And when does that number assume?

I said in the prepared remarks that -- that we're assuming it get's awarded before the end of this quarter. By the end of this calendar year.

Okay. And then I would start going into effect and you would start shipping in the first or second quarter?

It depends on the part, yes. It is not like -- it is not like we do all five of these at once all at the same time. Some of it that will be done in parallel but we are obviously going to prioritize the parts and the new products that are going to have the best revenue potential or that the military wants the most, which usually are the same thing.

Okay. All right. Well, good luck. Thanks a lot.

David Kurzman, Needham and Company.

Hi. Question on the military for a second. The issue as I see it is the military is continuing to use batteries, whether or not they are ordering from you guys. I assume their DLA is going to be doing the same problem with SAFT and continuing to order the 5590's on some type of a basis. Is there any sort of estimation built into your guidance that they could run short on batteries as it would seem to be the logical conclusion and thus they might have to do what they did in the first half of this year and that's restock inventory?

The answer is -- the first couple of things I want to clarify. SAFT and Eagle Pitch are both get -- are on contract for the 5590. That contract phase one of Next Gen was awarded three years ago, so the thing that has us the most upset is it has taken almost three years to complete this whole process. So the -- that's ongoing, but they separate the demand for the two products, and there is ongoing demand for the 5390. It is possible that there would be some pent up demand and they would have to do some restocking. That's exactly right. They are not free with their inventory levels. In some cases it is actually, you know, pretty well protected data because it goes to the readiness of the military. They certainly would have the opportunity possibly to take down the war reserve some if they wanted to. We know that they have war reserve. The problem is that war reserve is spread around the world and stocked in the Korean peninsula, it's on boats in (inaudible),it's in warehouses in Maryland, it's , you know, so it is strategically stocked so they might do that. You know, so I guess the answer is I don't know, but sooner, you know, we are still shipping as we taper down shipments and shipments go away, yeah, they are going to have an inventory problem because there's ongoing -- ongoing demand.

Because even if they take down the war stocks they are still going to need to restock those.

yes.

Okay, but then I guess the follow-up question to that is: In terms of the -- what the military has told me in the past is that they are very clear that they want to start moving towards lithium manganese dioxide from sulphur dioxide. Have they expressed any change to you about that?

No, not at all. They still want to do it. We -- we are -- we, you know, been vociferous about doing it wholesale. One of the barriers to doing that is we are the only source on the MNO290 because they haven't given out the contract. Once they award it, they'll have awarded two sources. That will make it easier to convince them to go wholesale. There are some products right now where there's a minuscule price difference between MNO2 and SO2. And, are you still there, David?

Yes, I'm still here.

Where there is a minuscule difference between MNO2 and SO2 in terms of price but the performance is 50% and so we're asking the question, why don't you get rid of the old stuff, you know, and that's the push.

Okay. Can you sort of talk about -- change gears here and switch over to the commercial side. Give us an update, if you would please, of how much you have built into your assumptions from say the automotive telematics opportunity, how much from the wearable EKG and where that is in commercial -- or in FDA trials and so forth?

First of all, you know, I can't -- I can't comment on the wearable EKG and where it is, that's giving away -- that's giving you data that's confidential to the customer about where they are -- were their product, I'm sorry I can't do that.

That's fine. What about the automotive side?

In automotive I think we've been pretty clear that we have at least one major design win that's in crash testing right now, and that we have another design that we have done that we are waiting to hear what the, you know, what models would potentially use it.

Okay.

And so for next --

And for the auto makers, how forward thinking are they at this point about installing your product or is it -- are you finding more demand overseas?

I think there is a lot of -- that people understand the product, they want it and their only issue is, gee, you know, how do we justify putting the extra cost in the car?

Right.

It costs money. It is not free and so that's why, you know, our assumptions have been that this stuff starts with the high end models first. And that's where -- where they have the best take rates on Telematix that's where they have the best renewal rates on subscriptions and that's where the price of the product can bear it.

Peter Simon, Ardour Capital.

Hi, good morning. This is actually Walter. I apologize if you have already addressed this because I had to step away for a second, but can you -- do you have some idea on when you expect the commercial revenue stream to break the 50% of total revenue barrier on a consistent basis?

That's a good question. I would say second or third quarter of '05.

Second or third quarter of '05.

Actually probably '05, yes. I would say '05.

Really? Well, that's positive. And I have one more quick question and again I apologize if you have already addressed this but it is about the batteries for the medical segment on the infusion sets and things like that, wearable pumps and what not. How is that development coming?

Well, that's a really good question. We ask that to our salespeople all of the time. I mean, we are sampling to people who are developing product ns a very competitive market that has fairly long regulatory approval cycles so it is a little hard keeping up with. We do work, you know, we get the battery all set and we think that that's all that has to be done and then we find out that for infusion pump there is a lot of work that has to be done on the pump and get that qualified and stuff so I'm not trying to be squirrelly about it. I'm just trying to say that it is very hard to tell.

And it is probably out on the horizon a little bit then?

That's why I said on thin cell we, you know, we've been -- we've been cautious about and prudent about how we forecast that for this year so we don't put large, you know, infrastructures in place betting it is going to come. We know we can react. We know we can do it. We stand close to the customers, we're doing designs iterations for them and, you know, if somebody hits a home run this year or in '05 nobody is going to be happier than us.

And, John, we are also, always working with a continually growing number of customers who have these types of applications so, you know, we are continually expanding our opportunity base there.

Yes, the more opportunity base we have, you know, when I said we do it probabilistic if we only have a couple of customers that is one thing, but when you sample 20 or 30 people and you can kind of say what's the chances, you know, you do a number and who is that going to be? We don't know. We know it is going to be one of the 20's coming into the market and here's the expected value of it.

Well, so my question then would be more of it's not necessarily dependent upon the battery. It is dependent upon the device itself being accepted and then whatever battery goes into it you will be in the position to capture that market?

Absolutely and some of these products that we are doing batteries for may never get to market. That happens, too.

Well, listen, I appreciate your help. So long.

Shanger Sun (ph)

Just a quick question, if I would have asked you two months ago and I may have actually asked you two months ago, you know, what you thought the chances are of getting this contract done in the next two months I think you would have said you felt very good it would close within the next two months. Has anything changed that makes you more confident today that you're going to -- that your business is going to get awarded within the next two months?

Yes, the last thing that can -- that usually happens in a contract is they come back to what are called "ifns" and that's items for negotiation and that's kind of the last clarification on your proposal. And they usually do that just before they are going to award the contract just to make sure all of the T's are crossed and the I's are dotted. That happened -- last Friday, okay? So that was done. They theoretically have 30 days then to award the contract.. Obviously it can be extended, right? So, but that is -- that has happened so now it is back, the ball is back in their court. They certainly could come back for another round of questions. It is unlikely. This was not -- there were not a lot of them. We have a lot of experience with this, so, you know, we are not holding our breath but, you know, we think that this is an indication that they are getting close and, you know, if only to get us off their backs they are going to get in gear on this one. We are putting in an extraordinary amount of pressure on people to prioritize this and I say prioritize because, you know, these are dedicated public servants who are working really hard on a lot of things and we just had to get ourselves -- get this project up on the priority list, you know in line with everything else. We don't want them to drop, buying MRE's for the soldiers in Iraq to do this, but, you know, it might be just behind that.

All right. Thank you very much.

And having no further questions at this time I would like to turn the call back over for any additional or closing remarks.

Well we'd would like to thank everybody for joining us today. You know, we're looking forward, again, to sharing progress with you next quarter and thanks for participating.

Thank you everyone for your participation in today's conference call. You may disconnect on this time