Ultralife Corp (ULBI) 2004 Q4 法說會逐字稿

Good day and welcome to this Ultralife Batteries fourth quarter 2004 earnings conference call. Today's call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to Ms. Jody Burfening. Please go ahead, ma'am.

Thank you, operator and good morning, everyone. Thank you for joining us this morning for Ultralife Batteries' earnings conference call for the fourth quarter fiscal 2004. The earnings press release was issued earlier this morning, and if anyone has not yet received a copy, I invite you to desert visit the Ultralife web site at www.ultralifebatteries.com. You can also find the release under the news section of the Investor Relations section.

In a minute, I will 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 the formal remarks. Management will then take questions until 11:00 Eastern 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' 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 the forward-looking statements. A more detailed description of these risks is contained in the Company's files 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, and welcome to the Ultralife Batteries conference call for the fourth 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 revenues of $18.4 million for the fourth quarter of 2004. Bob Fishback in his financial commentary will talk about the 2 major non-cash items that were included in the earnings -- the fixed asset impairment charge, and the realization of a $21.1 million income tax benefit.

In the quarter, excluding those -- well actually, in the quarter, we showed an operating loss of $3.4 million which, net of the impairment charge, was a loss of $1.6 million. This is slightly higher than our previous guidance.

The reasons, which Bob will cover in detail, included exchange rate unfavorability; acceleration of some R&D; and an increased professional fees related to Sarbanes-Oxley Section 404 certification work.

Revenue came in just above our guidance due to slightly higher than expected results, in our 9-volt product line, our rechargeable product group, and our technology contract businesses. But as expected, we had an abrupt drop-off in shipments of BA-5390 batteries due to the hiatus in orders that were caused by delays in government contract awards. There is continuing demand for this product, and in the interim, we expect this demand to be satisfied via purchase requests from DLA, the Defense Logistics Agency. We have just submitted a proposal against such request, and we expect a decision soon.

We are also awaiting a decision to on the last part of the Next Gen II procurement, the small business set aside for the BA-5347 thermal weapons site battery.

Our commercial nonrechargeable business continues to grow. We are starting to see many applications that were designed for thyanilchloride or lithium sulfur dioxide batteries now moving up to our manganese dioxide technology as customers see how much energy they can get for their money and the increased safety, along with our unsurpassed quality. We're also seeing marketplace appreciation for our ability to react quickly. One major corporation came to us with a problem that could not be solved by any of our competitors. Not only did we solve their problem, we exceeded all of their expectations by responding with an answer within 48 hours and delivering CAD drawings and the design in the following 24 hours. The result is that we now expect to conclude a long-term contract with this customer sometime in the next several months. This is indicative of the capabilities that we now have in place.

Activity in the nonrechargeable business is particularly high in search and rescue and automotive telematics markets with the pave of designed and qualification activity picking up in both areas. Prospects in search and rescue grew again this quarter, with 3 additional opportunities that we are currently working on. As we move toward the 2009 deadline for installation of 406 MHz megahertz beacons, we expect activity in this market to accelerate.

We're also very optimistic that telematics systems will be an important, and maybe even required, safety feature of any automotive product line. Just one week ago, General Motors announced their commitment to putting their OnStar System in all of their vehicles in model year 2007. And just last week, and the European Union released plans for all new vehicles to be fitted with standard automatic distress beacons by model year 2009. We have seen increased activity from multiple manufacturers, and our goal is to have our backup designs be a standard safety feature for these implementations. The performance, temperature range, shelf life, quality, and the packaging flexibility of our products positions us well in this application.

We have continued also to improve our Thin Cell battery, going down as low as 0.6 millimeters in thickness and almost doubling our energy density across the product line. And the Thin Cell isn't just being used for small and thin smartcard, RFID tags, and medical devices. We have designed, and expect to be shipping soon, a 12 volt, 1.5 amp powerpack designed in a unique form factor for special ops applications.

We reached a milestone in our rechargeable business when, for the first time in our history, we crossed the line into a positive gross margin position. Rechargeable sales for the year have exceeded $8 million and we expect this number to almost double in 2005. In the fourth quarter, we shipped rechargeable products to 99 differ customers, and we shipped prototype or initial product on seven new major projects.

Our new products activity in the rechargeable line continues to grow, as well. In addition to seven major projects, we introduced several new pack products. Included in this were several interesting variations on current products. We shipped our first SM -- that's Smart Bus version -- of the 2590, which is now testing at four major accounts. We also progressed in the development of our solar charger for the 2590, and hope to be introducing it later this year.

We have also been working on applying our new technology to replace old technology to buy engineering a plug-compatible lithium ion version of some mature, but still popular, products that use older battery technology. The result are batteries that are 20 percent lighter and more than double the energy of the old product, giving these applications all the advantages of our new technology.

We continue to expand our portfolio with accessories, including chargers and cables. In December, we took a volume order for a customized version of our Ultralife design 6-day battery charger, which is worth over $250,000, and will be delivered in the first half of 2005.

We have added to our product portfolio in the nonrechargeable business as well, adding 8 new product configurations for our leading commercial applications. We have already planned 10 new single cells, and at least 5 new pack products for introduction in the coming year. Across the board, we grew our shipment and our opportunity base.

In addition to this physical product activity, our Technology Contracts continue to grow as part of our business. They have represented a means to become involved earlier with our customers, and to cement relationships. These projects also supplement our traditional R&D spending by adding to our portfolio of capabilities. Last month, we announced an agreement to design a high-capacity lithium ion battery for Harris RF Communications for their Falcon II handheld radio. This is the third major non-governmental development contract we have secured in the past year. It represents a growing realization by our customers of our broad capability in both development and in production. We have an unequaled ability to develop and manufacture rechargeable and nonrechargeable batteries, chargers, packaging, and accessories, and to work in partnership to create superior implementation tailored to the needs of our customers.

Our outlook for this quarter is revenue of at least $18 million and an operating loss of around $800,000. This guidance takes into account the delay in starting our increase in production due to a later than expected DLA solicitation. With our track record of quality, cost, and delivery, we expect this to be successful, and with our -- successful with our proposal, and expect this solicitation to be the start of renewed an ongoing procurement of BA-5390's. Based on that assumption, we plan to be at our expected production rate by the start of the second quarter, which will put us on track to return to profitability in that quarter.

As you know, in December, we announced the receipt of the Next Gen II Phase IV award for $286 million in batteries over 5 years across both our U.S. and our UK operations. Last month, that award was protested. We have every reason to believe that the Next Gen award will be upheld, and are planning for a minimal or no effect on our qualification activities.

Our outlook for the year remains unchanged. We expect to grow revenue 10 to 20 percent over last year, and believe that we can exit the year at or around a 15 percent operating margin. We expect sequential growth over the next several quarters with significant growth in our commercial markets and expansion of the battery types we will be supplying to the military. In our commercial business, we see increased activity and the potential for increased revenues this year and next year in automotive telematics and continued strength in growth in our rechargeable business, with it being a strong contributor to gross margin by the end of the year.

We also anticipate substantial growth in 2006 as our UK operation comes online with U.S. military business, and our commercial business takes hold in these numbers of applications. We remain steadfast in our focus on growing to be a $200 million business with a 20 percent operating margin in the next few years.

Now, I would like to turn it over to Bob Fishback who will cover some of the financial highlights, after which we will open it up for the Q&A.

Thank you, John, and good morning. Earlier this morning, we are released our fourth quarter and full year results for the period ended December 31, 2004.

Consolidated revenues for the quarter were $18.4 million. Compared to the same quarter last year, revenues declined 5.7 million. The main cause of this decline was a decrease in sales of high-rate products resulting from a delay in BA-5390 order activity from the U.S. military. Partially offsetting the decrease in high-rate sales was a $1.8 million increase in rechargeable revenues to 2.4 million for the quarter in addition to higher 9-volt sales and higher revenues from Technology Contracts.

Gross margin for the December 2004 quarter was $2 million, or 11 percent of sales. This compares with last year's fourth-quarter margin of 5.3 million, or 22 percent of sales. In our nonrechargeable operations, we realized 13 percent margins in the fourth quarter of 2004 versus 24 percent last year. This decrease resulted primarily from a downturn in production volumes related to the lack of BA-5390 orders from the military.

In our Rechargeable operations, margins crossed into the black, a milestone for that group, compared to $300,000 a loss last year due primarily to the increase in revenues.

Operating and other expenses in the fourth quarter of 2004 included a $1.8 million, nonrecurring charge related to the impairment of certain polymer rechargeable manufacturing assets that the Company determined to be unproductive. This charge included $700,000 for the write-down of the net book value of owned assets, as well as $1.1 million related to the present value of future payments for leased assets. Excluding this non-cash impairment charge, operating expenses totaled $3.7 million, an increase of 700,000 over the same period last year. This increase resulted from additional resources committed to the development of new products and more SG&A costs necessary to support the company's growth objectives, including people-related costs and various professional fees and services.

We reported an operating loss for the December 2004 quarter of $3.4 million. Excluding the nonrecurring asset impairment charge, the operating loss was $1.6 million. Generally, this result was modestly lower than what we had projected, due to lower head overhead absorption related to production volumes, the foreign currency exchange impact of a weakening dollar versus the British pound, and higher R&D project costs and audit-related fees.

Below the line, the fourth quarter of 2004 results reflected a $200,000 gain related to the full reimbursement by the insurance company of partially depreciated assets that were damaged in fires last spring. In addition, the strengthening of the British pound against the U.S. dollar during the quarter resulted in a $300,000 foreign currency exchange gain associated with a dollar-denominated intercompany loan.

For several quarters now, we have been discussing the ongoing review of our net operating loss carryforwards and when we may likely record a deferred tax asset on the balance sheet related to the future tax benefit of those NOLs. In December, we reached the conclusion in conjunction with our independent accountants that it was appropriate to record a $24.5 million asset associated with the company's U.S. NOLs in the expectation that it is now more likely than not that we will be able to utilize these NOLs to offset future taxable income. The offset to the recognition of this asset, most of which is reflected as long-term, was a non-cash $21.1 million income tax credit on the P&L and a $3.5 million increase in equity relating to the tax benefit from stock option exercises in accordance with GAAP. Going forward now into 2005, while we expect to reflect a more normal effective income tax rate in the P&L, we expect our actual cash outlay for income taxes will be very modest as we take advantage of reducing taxable income with the NOL carryforwards.

Taking into account all the items discussed above, we reported net income of $18.1 million, or $1.20 per diluted common share, for the fourth quarter compared with net income of 2.2 million, or 15 cents per share, in the previous year. Average diluted shares outstanding for the quarter were 15 million shares, higher than last year's 14.5 million, mainly due to the impact of stock options and warrants.

For the full year of 2004, the Company continued to grow its topline and broaden its revenue base, reaching a record $98.2 million for all of 2004, a 24 percent improvement over 2003. Gross margins reached $20.3 million, a solid 21 percent of revenues for 2004. We achieved this gross margin level while meeting manufacturing and scheduling challenges in our military business in addition to adding resources to support expanding commercial market opportunities. And excluding the $128 million non-cash asset impairment charge included in the fourth quarter of '04, operating profit, one of our key performance metrics, amounted to $6.9 million, a 15 percent improvement over the 6 million reported in '03.

Shifting now to cash flows for the fourth quarter, EBITDA was a negative $800,000, defined as operating loss before the $1.8 million non-cash impairment charge, and plus depreciation and amortization of approximately $100,000. During the quarter, working capital changes resulted in a net increase in cash, generating approximately $1 million, mainly as receivables and inventory balances declined. We spent approximately $900,000 in the quarter on capital equipment additions.

Our balance sheet at the end of December remains solid. Our ending cash and investment balance was $11.5 million. Total outstanding bank debt at the end of December was 9.6 million, mostly related to the $10 million we borrowed under a $5 million term loan in June of '04. Total debt as a percentage of total capitalization is only 12 percent.

Looking ahead for 2005, we expect to realize year-over-year revenue growth in the range of 10 to 20 percent over the 98.2 million reported for '04. This growth assumes a favorable and relatively quick outcome on the current protest of the $286 million Next Gen II Phase IV award, and the receipt of other procurement contracts from the military. Year-over-year, we expect rechargeable revenues to nearly double from the $8.1 million figure reported in '04. And we also expect to realize increasing revenue associated with commercial markets, including automotive telematics and medical.

In the first quarter of '05, we project consolidated revenues to be at least $18 million, with steady growth throughout the remainder of the year. Operating income for the first quarter is expected to be a loss of approximately $800,000. But as we grow the revenue base during the year, we expect to return to operating profitability, with continuing improvement in the remaining quarters and moving toward our near-term, 15 percent operating margin target by the end of the year.

The current outlook assumes no impact from expensing of stock options. We are in the process of reviewing the details of the recently issued accounting standard and have not yet determined the financial statement impact on the company of adopting this new standard, which, assuming no changes, will require the Company to begin recognizing expense no later than the third quarter of 2005. The recognition of such expense will have no impact on our cash flows.

With respect to an effective income tax rate in 2005, we expect to book a rate in the range of 40 percent for the year, total income tax taxes as a percentage of pre-tax book income.

As I noted earlier, however, the overwhelming majority of this tax expense will be deferred taxes, or a non-cash impact on the Company, as we utilize the benefit from those NOL carryforwards.

As our UK subsidiary becomes profitable, which we expect will happen no later than 2006, our overall effective income tax rate is projected to decline.

At this time, the Company anticipates that it will spend in the range of $6 million on capital expenditures during 2005 -- a portion on planned capital upgrades and some on productivity enhancement projects, in addition to capacity expansion for our UK facility to prepare for the growth related to the Next Gen II award. We are starting to the new year looking forward to capturing an expanding number of opportunities, and are more optimistic than ever about the future. With an outstanding workforce and a great work ethic, we are excited about what we see coming our way this year, and we the expectation that we will reach our milestone of becoming a $200 million company within the next few years.

That concludes my remarks. And now I will turn it back to John.

Thank you, Bob. We would now like to open it up for the question-and-answer session.

(OPERATOR INSTRUCTIONS) Steve Sanders, Stephens Inc.

John, I wanted to see if you could expand on your comments about automotive telematics -- specifically in Europe? (multiple speakers) where do you guys stand, where the standards are now, and sort of how that plays out over the next year?

Well, there is no standard right now. We have been working for a couple of years with Volvo and Autoliv on Volvo's project, which has rolled out rather slowly -- they did two things differently. Number one, they decided to only put telematics in the car when the customer ordered it. And number 2, they decided to do it on a country by country basis, doing it in Sweden first, which is not exactly a huge market, and rolling it country by country, because they just didn't -- and the real issue is putting in their call handling infrastructure. So when you push the button, who's on the other end? And in Europe, of course, with all the different languages involved, you know, you can have somebody who speaks Spanish driving in France -- and what language do you want them answered with when they push the button?

So, that's where we were with them. They slowly rolled it out. We have worked with other manufacturers in Europe on other accounts, but nothing that has gone into a car yet. That's what's happening in Europe.

What happened last week -- because we follow this market very closely -- is the EU released a proposed standard for putting it in all cars. The proposal is by 2009. It's signed by some 13 or 14 countries, I think. Some of them are Finland and Bulgaria, but some of them are Germany and people like that. I haven't read the whole list yet and seen it. But certainly, I cannot tell you when it's going to happen. But it sure looks like people think that there's a lot of value, safety wise, in doing this. And the EU doesn't put stuff out like that lightly.

Okay. Can you bring us up-to-date on the Next Gen IV qualification process? I am assuming by your comments that you are in testing or close to it and that that takes a couple of months. And then, assuming the protest is resolved within 90 days, you should be shipping in 2Q? Is that fair?

Our working assumptions has been that we would start to get stuff going in 3Q, the third quarter. And that is because, again, there's 90 days for the protest. We can do work. We are not guaranteed to be -- that work under the contract would be paid for. We are not guaranteed that we are paid for it if we do it on -- ahead of time. But then, of course, as the protest is dismissed, we would get paid for it. So obviously, we feel pretty strongly about this, so we are going forward with the work.

We are doing it sequentially. We are doing it a battery at a time. And then, we have a U.S. and a UK -- the UK doing it as totally separate -- it has to be a totally separate exercise, separate facility and operation.

So Q3, we start -- our hope is that we would have substantially the work done as we did in the fourth quarter for the U.S.. Is that right, Bill?

Oh, yes.

So that is substantially -- and we think we have a chance of getting stuff qualified in the fourth quarter that's orderable in the UK, but we're not counting on it. Our working assumption right now on our guidance is that the UK stuff will be qualified by the end of year, and flowing -- we will get revenue in 2006 from that. So not that we don't want to do better than that, but we have an awful lot of infrastructure put in place there. And when I say infrastructure, administrative capability as much as anything.

Okay. And then a final question on the 9-volt business -- sounds like it was pretty good in the quarter. I think your previous guidance was flat to up modestly in that business. Anything new going on there?

I don't know -- I don't know if Nancy has any comments. But what I have seen is the smoke detector guys coming back.

Yes, the smoke alarm business is greater than what we thought it would be at this point. We have seen some recovery from what we saw in the last year. But we have also been on a mission for the last couple of years to expand our geographic coverage in and penetrate parts of the world where we really didn't have good representation. And we are getting some payback for that. So we have a generally across the board improvement in what our expectations were, and a lot of that is a result of our expanded market coverage.

Craig Irwin, First Albany.

I just wanted to understand the gross margin mix a little better. Looking at the fourth quarter, I guess 14.9 million -- the last quarter where we had a similar run rate was in 1Q '03, but the margins were in the low 20s. Can you help us understand the deltas between then and now, and really what has changed? I know there is a big difference in the effort you are making back then with the expedited orders. But could you give us a little more color there?

Yes. Craig, the real issue with gross margin is not just the shipments, it is the activity rate of production. When we produce a part, and put it into inventory, essentially, that labor and overhead that goes into that part gets inventoried. And when it ships out the door, then that inventory goes against the price we get for it -- generates a gross margin.

So when production rates are down, when you do production, it -- the gross margins actually, the liquidation of overhead, and your spreading of your label costs across your activity is more a function of what you produce than it is of what you ship. And so, in fact, we had a lot of times when we had real favorability in production, but because it didn't go out the door, a lot of it went into inventory because of government holds here at times and because a lot wasn't ready to go; we couldn't get in that quarter. It goes when the equipment goes.

Last quarter, we really -- as we told you guys, we really got ourselves down to a very slim workforce, but not a workforce who didn't have capability. We knew that there was still product demand out there. But we really had to wait for DLA to place an order, and to propose an order, because we didn't have a contract in place. And we are still at the point where we still do depend on DLA to do that. We didn't know that demand was high. We do know that inventory was coming down out in the field. We expected through the month of December, we expected a request for a proposal. We didn't get it. We got that request for a proposal a short time ago. And it was responded to just yesterday. And we expect a pretty fast answer, since it's -- we think that -- the indication we get is that's a really neat product.

So what happened was we had those resources in place that I hate to say it, were waiting for an order. Now, we weren't just sitting around, we had a lot of work to do in getting our production processes back in order and some of the automation project we had. But we suffered from that lack of production. And in fact, this quarter, we have been running at a modest rate. We are starting to ramp up that up now in anticipation of demand flow starting again. But, you know, we are affected this quarter by the fact that the month of January, we were running probably at 60 percent of the rate, and half to 60 percent of the rate we wanted to be running at. I would characterize that in December, we ran lower.

And in fact, another effect was that we actually saw an increased demand in our small cylindrical area. So we moved people over and had to move train some people who were making larger cells on the smaller cells, so that took a little time to come up. And the small cells actually have a 60-day hold period. So we actually have a lot of production which -- as we ramped, that caused us a little lower than demand production this quarter. So we're just getting to stride now on the small cells, also.

So we got hit a couple of different ways and it mostly had to do with production activity levels and the way you do gross margin.

Excellent. No, that makes a lot of since, because I guess a large part of that is behind you right now.

First of all, I guess, talking about the rechargeable business, I should say congratulations on the positive gross margin in the quarter. And in the past, you have talked about doubling this business in 2005, which I guess you put it at roughly 15 million. Where do you think the margins can go in this business? I know certain products individually can help the margins -- margins in the '40s or 50's. But once you get to a $15 million run rate, where do you think where do you think the gross margins are likely to be?

Most of what we do -- I think I am reiterating what I said in the past, I hope, which is that most of what we do is kind of a 30 to 50 percent gross margin business. There are some high-volume types of batteries that we do that may be 25 percent -- in the 20s, mid-20s, except for one product we do, which we don't touch at all, which goes -- which we do in Ultralife Taiwan, and it goes direct to another manufacturer, which is a digital camera battery. Those gross margins run 10 to 15 percent.

And we've said in the past -- I characterize that more as a distribution business. And frankly, we wanted that customer to work directly with UTI, and they wanted to work directly with us. We helped them design the circuit boards used in it and such. So I guess it is not enough to break it out right now, but it does have a little effect on our gross margin from time to time.

But most of the business that we are going after that we see coming in, I think 30 percent contribution is a very good assumption.

Fantastic -- that's very good to hear.

Now if we could talk specifically about end markets -- you covered the telematics market pretty thoroughly already. But the medical market is one that we have seen as potentially being very attractive for Ultralife. Can you give us a little more color on some of the programs you're working on this market? You did mention, of course, the AED that you're working on, and I know you are working on a number of packs for portable medical devices. But could you give us a little more color on how this frame, what Ultralife is up to in this market?

I will ask Nancy do that. She has got a lot more detail than I do.

Well, (indiscernible) two areas that are application types that we are working with. But also, we have a lot of activity, as we said in the past, with wearable medical devices. This is a big trend in the medical market and as more devices are desired by the user to be available to them at all times. And so we have a lot of activity that we're working with various customers with regard to those types of applications.

Okay.

And those that we've said before, those are monitors -- wearable monitors, wearable infusion pumps as people get those smaller. And then these simulation devices -- muscle and nerve stimulation -- you know, we have been in bone growth stimulation before; we still are. But nerves and muscle stimulation are particularly interesting markets.

Okay, excellent. And any comment on potentially how big this could get for you this year?

I think we've said that we think that the new business that we are going after in medical can be anywhere from $2 to $5 million in incremental revenue this year.

Okay, fantastic. And then, actually, I had a follow-up question regarding the telematics market. One of the studies that I have heard about is that roughly 10 percent of front-end collisions of the cars in the OnStar system -- the battery actually ends up -- the primary battery ends up being disconnected from the vehicle. Do have knowledge of any studies by customers already using telematics? You mentioned Volvo and Autoliv before. Do have knowledge of any studies they've done and the results of the studies as far as response times or the safety implications there?

No. We have heard similar statistics anecdotally. We know that part of crash testing, they do get those statistics on battery disablement. But we are not privy to that data.

Okay, excellent. Thank you very much.

Larry Baker, Legg Mason.

Just a couple of questions. One is -- can you talk about the potential size of the exigent order from DLA?

Well, first, it is not an exigent order. They asked for a proposal that's in the ballpark of $10 million type of ballpark worth of batteries. And that's dependent on what we quote, obviously. They asked for a proposal for us and what kind of schedule we could produce on. And we gave them back the proposal.

Okay.

And we know that inventory is getting low and needs to be bought.

Okay. And then can you just review the size -- either during the quarter or the year -- of the military 9-volt, and then the -- I guess, the all other general industrial commercial batteries?

In other words, do you want -- (multiple speakers)

Sales by market (multiple speakers)

Oh, for the year -- okay.

(multiple speakers) for military, 9-volt -- (multiple speakers)

Yes, 2004 -- it's very consistent with what we said before, which is that the military and the 9-volt business together are about 85 percent of our sales. It is kind of like 60 and 25, or 62 and 23, or -- I haven't done the exact math, but those two businesses, which are pretty core businesses, run about 85 percent.

The other 15 percent of our business was commercial business. About half of that is rechargeable and half was nonrechargeable. And that part of the business -- the non-9-volt, nonmilitary business year to year from last year, which was about 15 percent of our business to this year, we believe will at least double. That is really where the strong growth is.

Okay. And then you talk about achieving your expected run rate at the beginning of the third quarter, or is that beginning of 2006?

No, no, no -- in terms of our D-cell production, we have a pretty good idea of what we think the steady-state demand is and we are ramping up -- we will be at that level by the beginning of April; the beginning of next quarter, the second quarter.

Okay.

We have been running at about half that rate. And we were running much lower than half that rate in December. We started on January 1, bringing it up some, because we knew that a procurement request was coming. We thought it was coming sooner. We actually thought it was in December, but it has come now, and based on the numbers there, we are going to come up to what we believe a steady-state consumption rate is.

Walter Nasdeo, Ardor Capital.

I have a question that kind of revolves around revenues, and it's obvious that you are extremely exposed, and react quite -- with a lot of volatility to your defense contracts when they come in and when they get challenged and things like that.

If you do, in fact, come in at the $18 million revenue level for the first quarter of '05, that would basically be three quarters of declining revenues. But you are projecting to end the year fairly strong. And I would like to get some idea of -- you know, you have been talking about in somewhat general terms of the way things are developing over the course of '05. But I would like to get a little more clarity on how you expect to grow the revenues to meet, if not exceed, the way the expenses have been growing over the past few quarters.

Well, plain and simple, Walter, we have basically had very low volume on the BA-5390. That volume -- if you look at the contract that was given out, which is $280 million, roughly, over 5 years, and you look at that volume of large cylindrical cells that -- large rectangular batteries that they buy, that is all the MnO2 demand, which is rightfully ours. 60 to 70 percent of that is the BA-5390. And contracting issues have made it very hard for them to (ph) buy these. DLA is not used to placing urgent buys or buys that aren't on contract and it took them a little time to get through how to do a proposal and how to get us to bid on it. But we believe -- if we look at the run rate that that has been running at and what we know about consumption rates, that that demand is there.

Second thing is that, as we -- we have been very clear that we have medical business that is starting off, and automotive business that starts off. And it starts to flow in the second quarter and gets very strong in the third and fourth quarters of year, revolving really around the model year production schedules of the automakers. So that's also business that comes in in that period of time.

So we feel -- we know what the run rates are. We were running last year at 60 percent of our business in the military. That is roughly $60 million worth of military business, which was run at about $15 million a quarter. It's roughly the same mix this year with our commercial business growing. And you can see that there's no question in our mind that we should be running by the end of the year at comfortably over $30 million a quarter. And that is what our guidance implies, if you just do a straight line arithmetic on the thing. And we could just -- if we do a bottoms-up and add up what we know there is demand for and where it's coming from, it's there.

I don't know -- short of telling you exact accounts and exact numbers, which I can't do, I don't know what more color I can give your around that.

Well, I'm sorry -- I don't expect you to do that. It's just that I am trying to get a bit of a handle, because I think we are always going to be dealing with the volatility that is associated with these Defense Department contracts. I don't think that is going to go away. (multiple speakers)

I need to correct you on something. I don't think there's a volatility in demand. I think there is a volatility in ordering patterns. And it has been caused because we are in the most dynamic part of the marketplace, which is a new product and a new technology that is taking market share. And the good news is we are taking market share. The bad news is that if we don't get batteries out there because of contracting difficulties, there's a substitutable product -- the BA-5590. But all -- we know that when they are both out there, and the soldier has a choice, they take the 5390, plain and simple, if they know about it, and they have the choice. And when we go through these difficult times -- and we know that our demand has been growing -- it was very strong in November. But when our supply stopped, because of contractual issues, demand fell off. We know that because we talk to the bases, we know that because we talk to the soldiers in the field, we know that because we talk to the contracting officers who do all the supplying. So the variable is contracting, not demand.

Do you have any other -- as far as an idea of when you're going to get to sort of an equilibrium between the commercial and the military business, market breakdown is going to be?

Well we thought that this year was going to be about 50/50. It might still be, but the problem is that the military business has continued to be very strong.

Right. So that would indicate that you are expecting a very robust commercial business before the end of the year.

We expect a very strong commercial business before the end of year, absolutely. And again, in medical, somewhat. But we have some automotive, and search and rescue -- every time we turn around, another search and rescue application pops where we just fit right in.

Would you expect or do you foresee any decrease in any contractual requirements from the military if troops started coming home here in the next few months from, say, Iraq or Afghanistan or something like that?

There might be some, but we typically have not seen it. There is actually a lower demand in the U.S. for training now, because there's nobody training. They are all deployed, so there's a pretty steady demand.

There's a couple of other things happening, which is there still is a growth in applications. The BA-5347 is the fastest growing battery out there, the thermal site. They have only in the last year started deploying the thermal site on weapons. So there's other factors coming into that.

The other thing is that we -- I wouldn't be surprised if you started to see the dismounted soldier land warrior. We think we'll see it deployed before the end of the year this year. It's going to be trialed at the platoon levels in the first half of the year here. And if history shows, that's what they did with the striker -- they trialed it and they got it right over there. There's two striker brigades now rotating in and out of Iraq. I would not be surprised if we start seeing that.

And Afghanistan -- that's a whole -- another -- I won't say order of magnitude -- but it's a multiplier in terms of the intensity of energy used by the individual soldier. So we still see that happening.

The other thing I will tell you is that we are starting to see a lot of opportunity and growth in overseas military. Certainly, we only ship friendly overseas militaries because it's under pretty good export controls and our own controls. But we are starting to see a lot happening there.

Jim McIlree, CE Unterberg Towbin.

Bob, on this write-down that you took for the equipment that you were settling, does that imply that there were lower operating costs going forward. And if so, is it significant?

Yes; there will be lower operating costs running through the P&L for rechargeable going forward. That will probably be in the range of about $2 to $300,000 that we will see higher gross margins in rechargeable as a result of that.

And that's per quarter?

Per quarter, per quarter, yes.

Some of that's depreciation --

And some is the ongoing lease cost.

Some was lease expense.

I know it is not an exigent order, but -- so what is the proper term for this DLA proposal that's out there?

Request for proposal.

Okay. So for the 10 million RFP that is out there, would that satisfy (multiple speakers) them through the first quarter, or through the first half? Or would they need another one potentially in the second quarter?

We think that that satisfies production partly into the second quarter, depending on production run rates.

Okay. And would that be a similar situation that you had with the exigent contracts, where the pricing would be agreed-upon post-delivery, or shortly after you begin delivery?

We don't know. And to be frank with you, this is a DLA process that is different. It's possible that if multiple people are quoted for this, that it is a quotation. And we have approached it in that way. On the other hand, it's also possible that it could be handled differently. But we are assuming it's a quotation and have handled it that way, and did it that way. And we have been obviously very successful at quotations in this area. We have a very superior product and superior economics as well.

Okay. And I think at times, you have talked about DLA being able to purchase the 5390 without the stated charge indicator underneath the Phase IV contract, but (multiple speakers) with an exception, is that what this is about? Or is this something different?

Well no, there is nothing happening under Phase IV contract while there is a protest in place.

Right. I understand that.

So (multiple speakers) yes. So it's moot while there is a protest in place.

And I know that you're still billing through the steps that you can take in order to qualify your batteries for the Phase IV contract. But while there is a protest underway, can the DOD do anything (multiple speakers)?

No, we cannot --

In terms of qualifying the batteries?

No, they can do anything on it, actually. They can't.

And I want to be clear about the protest -- the person who is protesting isn't protesting that we got the award. They are protesting that early in the process, they were eliminated from consideration. So that's the basis for it -- that's our understanding of that.

Okay. But in any case, we are all -- you guys are kind of stuck in limbo until that is resolved?

I wouldn't call it limbo, I would just say we are limited in -- two things. One is, we are limited in the communications we can have -- limited to zero communications we can have -- on the qualification or the terms of the contract with anybody in DOD. And the second effect of it is that we're not guaranteed to be reimbursed. In other words, if this were to be overturned for some reason, any expenses we incurred from when they told us there was a protest, and they have to stop working with us until it is cleared up forward, we would not be reimbursed for it. But we are very confident that we are on firm ground with this.

Okay, and Bob, I think you might have said this -- but what was the depreciation for the quarter?

Depreciation was about $800,000.

Steve Gish, Roth Capital Partners.

Could you talk a little bit -- from what I'm looking at, it looks like R&D was inched up a little bit higher this quarter. What do you expect going forward with respect to the product development on the commercial side, and then also, because of the protest for Phase IV, will that result in higher R&D as you work independently of the army on the qualification?

The answer is no. Two things about R&D in the last quarter -- and they are both good news. One was, we added some resources just because of the amount of opportunities coming our way. That was a small part of the increase. I would say about half of it was resources -- it just made sense to add, because we just have going, we are doing a lot of designs.

The second part of it was we accelerated some of our charger development and some of that were onetime charges for prototypes, testing, things like that, that were not -- couldn't be depreciated, capitalized. And so we don't expect those to reoccur. But our charger line has gotten so popular -- like I said, we got our first real volume order on this thing and we wanted to get it moving. So that is what that was about.

Are the gross margins on the charger and accessories -- are those gross margins similar to your other product lines?

They are better.

And then in your guidance of 10 to 20 percent growth for FY '05, you had mentioned you have expectations of Next Gen Phase IV being resolved, and then other military procurement programs. What would those other programs be?

Well, we are still awaiting the decision on the thermal site -- 5347 battery. We are seeing very strong demand in small cylindrical. You saw we announced another contract award the other day. We have a product in small cylindrical that has been qualified for about 3 years -- the 5347 -- which is a night -- 5367, thanks, Nancy -- which is a night vision, which is a far superior to the sulfur dioxide version out there, which we are hoping to get moving. There's an indication that we will finally get that moving. Frankly, they ought to just obsolete the old one and put this one in. And we have a real good product there.

The Land Warrior program is going to be -- start going into limited deployment with this platoon-level work done in the first half of the year and we think some deployment in the second half of the year. And that is not just batteries. That is batteries, chargers, accessories. It is a whole system.

So the opportunity with Land Warrior -- is that Primary Batteries, rechargeables, or both?

It's both. But right now, they are operating a lot with rechargeables, because a lot of it is training and testing. When they deploy it, they are going to try to deploy it with rechargeables. But it's yet to be seen. As you know, Rechargeable Batteries don't operate very well in low temperature. Rechargeable Batteries don't store real well for long periods of time. So it will probably be a mix of both.

Okay, great. And Bob, I think you had mentioned there was an FX gain of about 300,000 in other income?

Yes.

Was there also an impact in cost of goods sold?

Well, that $300,000 gain below the line was related to the foreign exchange impact on our -- on an intercompany loan between the U.S. and the UK that is denominated in U.S. dollars. And that fluctuates quarter to quarter. And we have done things in the past -- looking at things in the past that minimize that. But we continue to look at that flowing through the P&L.

There is an impact up above the line in our margins and revenues, probably in the range of a couple of hundred thousand dollars negative as certain contracts were denominated in U.S. dollars that were fulfilled by the UK operation.

Okay? And then lastly, it looks like your debt levels versus Q3 were relatively unchanged.

Right.

Do you expect, even with the CapEx requirements for '05, that you can maintain that debt at that current level, or what kind of changes could we see there?

Right now, we would expect that -- that mainly relates to our current outstanding term loan, which we pay down $500,000 a quarter. We expect to continue to see that decline, actually, overall, and we expect to be able to finance our capital at this point in time through internal generation of funds.

Michael French, Kaufman Brothers.

I just have a couple of quick questions on the Sarbanes-Oxley issues. There's a statement in here that says the Company is committed to addressing any and all control deficiencies and that there is not enough information to conclude whether they constitute a material weakness. Is this just a boiler-plate statement or has there been something identified at this point?

Is this a boiler-plate -- well, nothing is ever a boiler-plate statement. I would never say that. We are working with our auditors. The fact is that given the amount of time it actually takes to do all this -- and they are not just doing work for us. They are doing work for a lot of other companies. But given the amount of time that this -- the crunch is causing on everybody, there's been an extension given for small companies for another 45 days. So, it's very possible that on March 15th, that work won't be completed. We are working as hard as we can to get that work completed and so are they but it's possible that that work won't be completed. That's number one. Number two, there's a lot of work we're doing whether were -- I mean, nobody's perfect -- you find that there is a deficiency. When you have a deficiency in control, a couple of things can happen. Number one, you can find that you have a mitigating circumstance. So, for example, there's no sign in book to your computer room which has a lock on it. You have a lock on your computer but there's no sign in book. So, you get something -- the auditor comes through and says there's no lock -- no sign in book for it. But then you find out you have -- you say to them, you had a camera there and a tape. All right, that is a mitigating control that controls that. So, there's a lot of give and take on this of auditing and then reviewing and auditing and reviewing. The next thing you find -- the next question is, okay, if you don't have a mitigating control, how bad is -- how bad is this? What can possibly happen because of a certain deficiency? If it can't have any -- it's possible this has no impact at all on the P&L. It's possible that it could affect inventory by an amount that is so small it doesn't matter. Maybe it's the control on the purchasing of paper clips. I'm not trying to be absurd here. I'm just trying to (multiple speakers)

Oh, I agree, I've seen similar things with other companies.

So, it's possible that when you look at the magnitude of the effect of it, that it has no effect. But then, there's a couple of other categories of affect where it has up to where it can have a material effect. The test of material effect is very subjective. And because this is the first time we're going through it and our auditors are going through it, it's really hard to say when you add -- you know, there's a cumulative effect. When you look at the thing in totality, it's really a judgment call by us. We have to make that evaluation and then our auditors have to opine on it, about whether that is -- what kind of affect that has on control. We don't have enough data to look at all that stuff yet to say that. It's a very complex question and it's going to be -- it's a subjective question once you get it all together. So, that's what -- we're in the middle of it and we don't know, because it's the first time anybody's ever done this before. And in fact, there's been some hearings at the SEC on this around, are they really putting too big a burden on people? Because we're not the only ones who have this problem right now.

I agree.

I don't know, Bob?

Yes, let me just make a comment too. And John is right on with everything he said. And we have identified, like John mentioned, we have identified some control deficiencies that we are working through to remediate. However, we need to aggregate those to determine the level of significance. Because we're going through the year-end close process, there's still additional work to be done with respect to testing all the controls that we've put in place and the documentation around those controls, both internally and with the independent accountants. So, we're working through that. Our target is to wrap all this up by the end of -- by the time we need to file our 10-K. That's the target we have and we will need to prepare our -- Management's report on internal controls at that point in time and the independent accountants' report also.

So, I'll say one other thing, Michael, which is, there's nothing that leaves Bob or I to conclude that there's anything but the highest integrity in the numbers that we have and the controls we have in the Company. There's nothing. So -- and we signed statements putting our lives on the line, almost to that -- in that regard -- every quarter, in the filing of the financial statements. If there were, we would tell you. We have an obligation to tell you. So, there's nothing we know right now that leads us to believe there's any problem at all in our financial statements caused by any control issues that we have.

Okay and then in respect to the expenses related to this, how long do you think it will continue -- just throughout this quarter? And then it will go back to the normal level? Or do you think it will be sort of a -- you know, sustained at a higher level because of the ongoing work that might need to be done? (multiple speakers) general compliance.

That's a really good question. We've had extra expenses in the fourth quarter. I don't know if we'll end up with extra expenses or not. You know -- we asked our -- we can ask our auditors that, but their answer -- and I understand why they say it -- their answer is well, we don't know. It depends what we see. You know, how deeply -- because it's the first time they are ever doing it this work also. It's -- like I said, we're not the only ones with this problem. We don't see any -- if we knew that we were going to have more expenses, we would be booking them now. We have an obligation to. We don't know of any additional expenses. We think it's been provided for appropriately. But, we don't know because again, first time it's ever been done.

Okay and this one's pretty easy. On the protest, is it safe to assume you guys will issue a press release if and when the award is -- withstands the challenge?

Oh yes, as soon as we know, you'll know.

And just one thing. If you could sort of walk me through how Detroit sets up its schedule for production? So, if they wanted to include your battery in the '06 cars, it's -- soon they'd have to freeze the design some time in the near-term. And I was just wondering what the actual schedule is for including a product, setting it in the design, making it known and then moving forward from there?

Well, everybody is different and every car manufacturer is different. But, new cars start showing up in showrooms round-about September, October, which means that their final assembly is done sometime in August. So, depending on the design, you'd have to have stuff to them by July, August. They run pretty tight production lines. It's not like they have this stuff sitting around for a couple of months before they put it in a vehicle. But, it all depends on what their assembly process is, and each line could be different. So, yes, now is about when people are wrapping up plans. And we're working with some people right now. And I think we've been pretty clear that we expect to start shipping products to at least one manufacturer on a new project in the second quarter, with volume to start flowing in the third quarter. And there's some other things going on now also. And when we are in a position to be sure about it, we will -- and if it is sure, we will let you all know.

And what would -- is there a range of the magnitude you would expect for this year?

It'd be way premature to give you a range.

Jeff Nixon (ph), MCM (ph)

I just had a couple of quick questions. What was the military sales on the year? I don't know if you gave that number. But I missed it if you did.

For the year, our military sales were in the ballpark of $60 million -- for the year 2004.

60 million, and that's up from 40 million last year, right?

Yes.

Yes. So, does that mean that industrial -- that commercial -- and then 9-volt was basically flat?

9-volt was relatively flat (multiple speakers) the non-9-volt commercial business grew. And the biggest growth part was rechargeable last year.

But, if you -- your sales were up around about 20 million? And your military sales were up 20 million. So doesn't that mean that commercial was flat?

I would have to -- we're doing some quick math here right now. But, I know for a fact that if you look at sales of rechargeable batteries year-to-year, we're up about $5 million.

So, it looks like nonrechargeable commercial was down.

It might have been down because some of our business in the UK might have gone down some. But I think our non-commercial UK part of that business went down. Yes.

And I guess that I had the feeling that we were kind of rolling our new programs all of the time. So, I was surprised to see that.

No, I think we -- in the nonrechargeable area, I think we've been pretty clear that this is the year when we expected to see rechargeable (multiple speakers) program.

Secondly, do all telematics have back-up batteries?

Right now, very few of them do. So, right now, as far as we know, none of the GM implementations of OnStar, for example, have them. I don't know what Daimler or does in their product or Lexus does in their product. Daimler may actually have 2 lead-acid batteries in the car. They may have 2 car batteries, so they consider themselves to be backed up, I think. Lexus has something right now, I think. I'm not sure if they have something now or not.

Okay and then (multiple speakers)

You would have to go manufacturer by manufacturer.

Okay, and the standard that -- the proposal in Europe -- did it say anything about back-up batteries?

No.

No it didn't, okay.

No.

And then thirdly, I guess you just -- in the little line there, you said that the UK is losing money? And yet it wasn't -- in my understanding, it wasn't impacted by any kind of a change in the military order profile, right?

No, the UK has -- let me -- I think we've been real clear about this -- is that we're running -- we've been running, when we are at steady-state production, between 25 and 30 percent gross margin in the U.S. in our nonrechargeable business. The rechargeable business in the U.S. is now just achieved kind of -- I hate to -- there's no such thing as breakeven gross margin, but zero gross margin. It's crossed into -- we're generating gross margin. But in the past, it is been not generating gross margin. And our UK operation has been generating single-digit gross margins. When you then take that gross margin and apply an expense profile to it, it's a loss. And when I say a loss, it's a loss on a tax basis, the way we account for as a subsidiary. When we talk about the UK, that's -- as being a loss, it's on a tax basis.

So, my question is, what is the -- did this military contract kind of save the UK or what is the reason for keeping the UK subsidiary, if it was a loser?

Because if you put another $20 million a year worth of business in it, it's a very profitable operation.

So, the military saved it?

We've known for a long time -- well, I wouldn't say saved. We've known for a long time that that operation with any kind of volume increase would be -- could be very profitable -- could get us very good returns -- because we have a very solid infrastructure there. We certainly save it. I don't think that there's any question that we use that facility to service a very large number of customers. It would just be a question of how we would size it. The other thing that has affected the UK is -- and we've said this in the past also -- that the cell that they were manufacturing was an expensive-to-manufacturer cell. But, and as we've gone along, we're now making a transition so that the UK will be making the U.S.-designed cell. Even if you take last year's production and you put into that a U.S.-designed cell, the profile looks much, much better. And that's purely because of the cost of manufacturing we're dropping along with the higher capacity that cell gives you.

Okay, but -- and I know that what it whenever we do fieldwork on you guys, the one thing that comes back is service. And so you're saying that part of the UK's value to you as a company is that it just allows you to provide kind of a variable service to multinationals?

Oh yes, and in fact I have to believe that for the U.S. military for example, it's another facility making batteries. As we talk to automotive manufacturers, they love the idea that we have production both in the U.S. and Europe. So, you know, yes.

David Kurzman, Kurzman Partners.

A couple quick questions here. First of all, what tax rates will we be using four reported GAAP numbers?

I think Bob said we're -- 40 percent should be the number you should use. But that is impacted by the fact that we are -- once the UK turns to be -- I know this sounds counterintuitive. But I do know is, once the UK turns to be profitable on a tax basis, that number drops into the '30s.

Well, is that because the UK is operating at a lower tax rate when it is profitable?

That will be part of it. But, if you work the math through, if you take our rate, in a sense, on the U.S. income is in the high 30s or mid-to-high '30s. If you take a loss on top of that and UK, you add them together, you end up with a higher effective tax rate for the total consolidated company.

That makes sense. Okay. How much of the recurring professional expense do you expect in 2005? I mean I know I've heard some people trying to sort of poke at that question from different angles. But I figured I'd go head-on.

No, well, we've been told that the extra expense that we've incurred will not be repeating, necessarily. Now, ask me if I believe it. The fact is, the cost of doing business for audit firms has gone up and the choices that companies have in audit firms have gone down. So, we're waiting to see.

Fair enough. The final question I have is on the incremental rechargeable gross margin. Now, given that you guys just got finished saying that with the impairment charge, it's going to save I think it was 200 to 300 a K per quarter at the rechargeable business alone. Can you help me understand why the incremental, in the past, margins have been kind of in the teens on a year-over-year, quarterly basis?

Yes and the reason, David, is twofold. Number one, the biggest part of the growth that we've had, we had, which was really big from the second or third quarter was in the digital camera battery, which is a lower gross margin product. That dropped off -- in fact on lower volume, we did better in the fourth quarter. And that's purely because the mix shifted away from that. They had done the stocking up for Christmastime, basically. So, that was one effect. The second effect is that we have a lot of new products in that line coming in. And we get our costs down as we get to maturity. The first couple of packs you make, you learn a lot by. And the process sheet that we have for making 2590s now and the way we do it is way more efficient than it was a year ago. And, that's true with almost everything we do.

And is there an opportunity to cross-sell -- like, you made a battery say, for the digital camera, that hey, we find out it works great in something else? And thus, there's no incremental R&D expense?

That's happening as we speak.

Mark Gurzinski (ph), Needham & Company.

I swear, I didn't plan to go right behind David. I think most of my questions have been answered. But I just went to touch on the telematics. How are you guys creating awareness within the automakers, as far as battery chemistry and your battery? And do you guys really -- have you guys embedded yourself within all of the automakers? Or kind of sum up your relationship with them.

I will ask Nancy to talk about that.

Well, for many years now, we've identified automotive telematics as one of our target markets. And we've had -- part of our coverage strategy has been to ensure that we've been engaged with all the large automakers, as well as the Tier 1 providers, so that when the time came that they were aware of the nature of the battery, we would be there, we would be heavily engaged with them and have convinced them of the benefit of our solution. That's the strategy we have employed.

So, for the most part, they are all very much aware of the different products as we speak?

We had one automaker tell us that they had surveyed the world and that we were the only ones who could meet their spec.

I guess that sums that up.

Yes, I mean, it's got to work in very high temperature, very low temperature. It's got to sit in the car for 20 years. Our batteries lose about less than half a percent of their energy a year. So, 20 years from now, it's going to have more than 90 percent of its energy. It has no toxic substances to be released. It's just got all those things that you need.

Mr. Kavazanjian, with no further questions left in the queue, I'd like to turn the call back over to you for any additional or closing remarks.

Well, I'd like to thank everybody for joining us today. We really look forward to sharing further progress with you next quarter and for the oncoming year. Thank you.

Thank you, that does conclude today's conference call. We thank you for your participation. You may disconnect at this time.