Ultralife Corp (ULBI) 2005 Q2 法說會逐字稿

Good day, and welcome to this Ultralife Batteries second-quarter 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 Ms. Jody Burfening. Please go ahead.

Thank you, operator, and good morning, everyone. This is Jody Burfening of Lippert/Heilshorn & Associates. Thank you for joining us this morning for Ultralife Batteries' second-quarter earnings conference call.

The earnings press release was issued earlier this morning and if anyone has not yet received a copy, I invite you to visit Ultralife's Web site at, www.UltralifeBatteries.com. You can also find the release under "Investor News" in 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 their formal remarks. Management will then take questions until 11 AM Eastern daylight Time.

Before turning the call over to John, I'd 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 those forward-looking statements. A more detailed description of these risks is contained in the Company's filings with the Securities and Exchange Commission. With that, I would now like to turn the call over to John. Good morning, John.

Good morning, Jody. Thank you, and welcome, everybody, to the Ultralife Batteries' conference call for the second quarter of 2005.

Joining me today, I have Bob Fishback, who is our Chief Financial Officer, Bill Schmitz, who is our Chief Operating Officer, and Julius Cirin, our Vice President of Corporate Marketing. Nancy Naigle, our Vice president of Sales and marketing usually is with us, is traveling on Company business.

Today we reported revenues of $21.6 million for the second quarter of 2005. Operating income was $200,000. These results are in line with our latest guidance. Revenue was driven by continued strong growth in our commercial business and hampered by a lack of new order activity for the BA-5390. Approximately two-thirds of this second-quarter revenue was for commercial business. In absolute terms, most of that revenue was for nonrechargeable products, although our rechargeable business showed a strong percentage gain. We've been meeting or exceeding our internal targets in commercial markets across the board. We're growing revenue, penetrating target markets and addressing new markets.

In addition to our existing commercial business and the new business that we announced with General Motors, we had new designs in such diverse markets as semiconductor manufacturing, prepaid gas metering and asset tracking. The list of opportunities and development projects continues to build. All of this will fuel our growth from the latter part of this year through 2006.

Today, in our announcement, we adjusted our guidance for the second half of the year, reflecting ongoing delays in orders for the BA-5390. Earlier in the year, we received our first order since procurement responsibility was moved from CECOM to the Defense Logistics Agency almost one year ago. This order was driven by an extreme need -- the only way the DLA is able to do a procurement outside of established contracts. We were told, and the inventory system indicated, that there would be another procurement to follow.

In June, when we were told that no procurement would happen until after the July 4th holiday, we adjusted our guidance. It's now clear to us that even though there is continued usage demand and that inventories are declining, it is very difficult for the Defense Logistics Agency to do procurements outside of established contracts. We are now assuming that no sizable purchases will be made until we qualify the BA-5390 under the Next Gen II contract. We are on track for this to happen in the third quarter.

Although we're still being told that there may be a procurement this quarter outside of the Next Gen we are exercising caution for two reasons. The first is the aforementioned issue of how hard it is for DLA to get approval for such buys. We have seen this for almost one year. The second reason is that there is now a strong push to field the Next Gen version of the state-of-charge indicator.

As a reminder, the current versions of the BA-5390 and of the competing, older technology, BA-5590, do not have a way for a soldier to see how much energy is left in the battery. The new Next Gen II version of the 5390 has a state-of-charge indicator for SOCI, as it's called. The SOCI enables a soldier to take full advantage of the battery's energy capacity.

We believe that while there is some short-term uncertainty, this is a great opportunity. Existing demand from the 5390 is not going away and inventories will have to be filled. In addition, the SOCI feature has the potential to accelerate the gains in market share that have flattened out over the last year. With at least 80% of the market still available to us, this is one of the largest revenue opportunities that we see.

This has been very frustrating for us and for our shareholders. We're working as hard as possible to get our products qualify under the new contract. Our past experience with a small cylindrical contract leaves us to believe that once we're on contract, we will get continuous orders on a relatively smooth basis with enough backlog to plan production and to forecast revenue.

In the other parts of our military business, we are seeing very positive strides. In the second half of this year, we will start production of batteries and chargers for initial deployment and battalion-level field testing of the Land Warrior products that we developed for General Dynamics. We are the supplier of batteries for this product and we expect that with field acceptance, it will be deployed on a wider basis and will start to be an important part of our military business in 2006.

One of our goals has also been to expand our international military markets. We've been a key supplier to the UK MOD, and in recent months, have announced new business in New Zealand and Australia. And a few weeks ago, we were pleased to announce our first major win with the German military. Our outstanding performance, our strong support and our exemplary product safety record was a key to this important win and it opens up an exciting market opportunity with a demanding customer whose decisions are closely watched by other military organizations in the world.

Our 9-volt product line grew yet again, showing strength in most applications and markets during the second quarter.

In our other nonrechargeable markets, activity and demand is still growing. In June, we announced an agreement with General Motors to supply backup batteries to the industry-leading OnStar Telematics System. This is the third automotive telematic win for us. We have recently been supplying Volvo through AutoLift for several years and have recently started shipments for another major auto maker. We expect shipments on all three contracts to accelerate by the end of this year, and in 2006, we expect to have more than $10 million in revenue in Telematics business in total.

As automatic crash notification becomes an important safety feature for vehicles, we expect backup batteries to be an important part of this feature. This is a market in which we have unique advantages and which we expect to grow.

We've also started to see an increase in activity in RFID markets. With the volume of goods moving around in the world, both logistics and security concerns dictate that physical assets can be tracked and identified. The large assets are high-rate cells, provide unmatched kit capacity, pulse capability, and operating temperature range for their value. For smaller assets such as packages, our Thin Cell provides the same capability and economic benefit in sizes that other products cannot match.

There is increasing interest for our Thin Cell and medical applications as well. Wearable devices have always been a target market for us and we are very active with designs and prototypes for products in this area.

Our rechargeable business set new records for this quarter. Revenue was at $3.3 million, a new high. Gross margin was a new high of $14 million, demonstrating the returns we can get from increases in revenue as well as our movement to higher gross margin products like chargers and accessories.

In the second quarter, we added a half-dozen new customers and increased our product development pipeline to over 20 active projects in our rechargeable business. While our one high-volume digital camera project has been phasing down and will phase out this quarter, we have been replacing this rechargeable business with higher gross margin projects for products with much longer lifecycles. These include portable diagnostic recording systems for health care, vehicle tracking systems, and some new design wins in military robotics.

As I mentioned earlier, because of the continued near-term uncertainty on BA-5390 orders, we are changing our outlook for the remainder of 2005. We now expect the qualification of the new version of the 5390, which will be the start of the Next Gen II contract, to drive the restart of volume. Again, we expect that this quarter.

The qualification of the 5390 presents a major market opportunity for us, but is important not only for the 5390, but for the four other battery products we'll be producing on the Next Gen II. This will be the first time that any of these products will be available in MnO2 versions.

For the third quarter, we now project we'll have revenue of about 21 million and a modest operating profit. This is based on ongoing growth in our commercial business and the restart of shipments of BA-5390's under Next Gen II. The next quarter, we expect to be in full production of the new 5390 and to start to grow overall revenue again.

For the fourth quarter, we expect commercial business growth plus the ramp-up of 5390 shipments will bring revenues of at least 25 million with a commensurate increase in profitability. We expect revenues to grow sequentially each quarter of 2006 as the military business grows through shipments of the 5390, additional product qualifications occur under Next Gen II, we further penetrate overseas militaries and we start the deployment of the Land Warrior products.

In commercial markets, we started to gain real momentum. We'll continue to grow our rechargeable business and further expand in automotive telematics and search and rescue. It is also the year in which we expect to start to see many of the design wins we have seen the medical products come to fruition.

Our strategy to leverage in the military business to build commercial market opportunities is paying off. We are tracking first-class customers and important applications. We bring to our markets products and capability that's unmatched. With only one exception, we are hitting or exceeding our goals in every area. Operationally, our UK operation and our rechargeable business are now generating positive and growing revenue and gross margin. We remain steadfast in our focus on becoming a $200 million business with a 20% operating margin in the next few years.

Now I'd 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, everyone. Early this morning, we released the results for our second quarter that ended on July 2nd, 2005. Consolidated revenues for the quarter were 21.6 million. Compared to the same quarter last year, revenues declined $6.8 million, mainly as a result of a decline in shipments of BA-5390 batteries to the U.S. military, which was strong last year. Offsetting this decline in military sales in part was higher sales activity with commercial customers, including 9-volt and rechargeable products.

Gross margin for the second quarter of '05 was $4.2 million or 19% of sales. This compares with last year's second-quarter margin of $7 million or 25% of sales. In our nonrechargeable operations, we realized 21% margins this quarter versus 27% last year, reflecting lower shipments of BA-5390's and the related production volumes.

In our rechargeable operations, margins continued to improve, reaching a positive $400,000 compared to a $100,000 loss last year on record quarterly revenues and a favorable product mix.

Operating expenses in the second quarter of '05 totaled $4 million, an increase of $600,000 over the same quarter last year. This increase mainly resulted from additional resources committed to the development of new products. Operating income for the second quarter of '05 was $200,000, $3.4 million lower than last year's $3.6 million figure, reflecting the lower sales volumes and higher R&D costs.

Income taxes for the quarter amounted to a non-cash expense of $1.3 million, including an approximately $1.1 million tax charge for a change in the New York State income tax law, that resulted in a reversal of a portion of the deferred tax asset that was established at the end of last year. The remainder of the income tax expense in the quarter is related to income from the Company's U.S. operation.

The net loss for the second quarter of '05 amounted to $1.4 million or $0.10 per common share compared with a net loss of $400,000 or $0.03 per common share in the previous year. The previous year's results included a $4 million write-down related to the Company's investment in Ultralife Taiwan, Inc.

Average shares outstanding for the second quarter of '05 were 14.5 million shares.

Shifting to cash flows for the second quarter, EBITDA was a positive $1 million, defined as operating income plus depreciation and amortization. During the quarter, working capital changes resulted in a net decrease of cash of approximately $2 million, mainly related to a buildup in large cylindrical inventory levels during the quarter. We also spent approximately $1.4 million in the second quarter for capital asset additions. Payments made on debt principal during the quarter were offset in part by proceeds from the exercise of stock options.

Our ending cash and investments balance at the end of the second quarter was $8.2 million, down approximately 2.5 million from the end of the first quarter. As of the end of the second quarter, we reclassified $6 million of long-term debt associated with our five-year term loan from long-term to current, since we were not in compliance with certain debt covenants. We are currently working in cooperation with our banks to amend the credit facility and modify the financial covenants to accommodate a revised outlook. After we complete this amendment, which we expect will be finalized within the next week, and as we demonstrate our capability to meet our current financial projections, we intend to reclassify this debt as a long-term.

Overall, total outstanding bank debt at the end of the second quarter was $8.5 million, mainly related to $10 million we borrowed under the five-year term loan. Total debt as a percentage of total capitalization remains at only 12%.

John has taken you through our revenue outlook for the third and fourth quarters of '05. To complete our guidance discussion, we anticipate operating income in the third quarter to be modestly positive, based on the current revenue outlook, and to increase into the fourth quarter as revenues grow. While income tax expense for the second half of '05 is expected to be relatively modest, the majority of any income tax expense this year and for sometime into the future will be a non-cash expense to the Company as we utilize the benefit from our NOL carryforwards.

With respect to capital expenditures, we expect to spend approximately 2 to $2.5 million in the second half of the year, bringing the full-year amount to about 4 to 4.5 million. This capital spending will be for upgrades to facilities and various equipment, projects to enhance productivity, and for increasing our capacity at our UK facility related to the award of the Next Gen II contract. Typically, our investments in capital have very quick paybacks.

Based on our earnings outlook for the third and fourth quarter, we expect to continue to generate positive operating cash flows. We also expect the cash we generate from operations will cover our anticipated capital expenditures and debt service costs. Working capital requirements are expected to decline in the second half as our current inventory levels are brought down. Overall, we expect that funds generated from internal sources will be sufficient to support the Company's investment in growth for the remainder of 2005 and beyond. We remain committed to growing the business by investing in capital programs and new product development that will generate growth into the future.

We are confident about our strategy to grow revenues and we are optimistic that the short-term order delays for BA-5390's is just that, short-term. The fact that the U.S. military awarded our Company with 100% of a $286 million contract shows their level of confidence in Ultralife to be a key supplier to meet their growing demand for power needs. In addition, with recent contract wins in both commercial and military markets, we are very excited about our future prospects, moving toward our goal of reaching $200 million in revenues within the next few years. That concludes my remarks and now I'll turn it back over to John.

Thank you, Bob. Before I open up for Q&A, I want to just make a correction. I said that in the rechargeable business, our revenue was $3.3 million and it's been pointed out that I said gross margin was 14 million. It was not. It was $400,000, almost 14%. So again, 3.3 million; gross margin was around $400,000 or almost 14%, not $14 million. I apologize for that.

So now I'd like to turn it back to the operator and open it up for questions.

(OPERATOR INSTRUCTIONS). Steve Sanders.

Good morning. I wanted to see if you could help us carve out the 5390 business in '05 versus '04. I know historically you have been a little reluctant to be specific there. But you're looking at a $15 million year-over-year decline on your current guidance. Can you help us with that, just so we can see a little better how the non 5390 businesses are doing?

Sure. The 5390 in '04 was close to half of our business. Military was about 60%. Of that, it was 50%, 10% almost. I couldn't cut it any finer than that. This year, it's looking like about 25% of our business. So I think the split is cut at 60/40 or 2/3, 1/3 commercial and military now in the current situation. And our assumption is of that 33%, you can say 25 and 8. Now don't hold me to percentages of 1 to 2% because it swings a little bit here and there and it depends on some assumptions, but that's kind of the ballpark.

Okay. And then it doesn't sound like you've assumed much in 3Q for 5390, but you are assuming that the business starts to ramp back up in 4Q. Can you give us some more specifics there, particularly on 4Q?

Some in 3Q and some in 4Q. But even in the fourth quarter because -- what we've done is -- the difference between the new version and the old version is really a circuit board and state-of-charge indicator. Pretty much everything else is the same. And we have multiple sources for that, but of course, we have to qualify those sources, and we don't know which one will get -- we're hoping they all get qualified. So while we've taken some inventory risk, we have to be -- so that we're ready to produce because we really want to get this back -- get this to the marketplace, and start -- get market share. We view this as a weapon in terms of gaining market share and a real tool for the soldiers. We can't go too overboard on it. So there's some in the third quarter, some in the fourth quarter, and our constraint won't necessarily be production. It will probably be supply lines. And I'd say in both of those quarters, our assumption is that by the fourth quarter, it becomes about a quarter of our business again. In the third quarter, it's a little less than that.

Okay. On the competitive side, I know some of the competitors are working on the state-of-charge indicator for the sulphur dioxide versions. Where do you think they stand on that relative to you?

We really -- we don't know. That's proprietary information to them, and since they're not public companies -- I guess SATH (ph) is public in Europe now, they don't have the same disclosure requirements we have. They are not public about it. What it will do is, though, we'll be producing the version with the state-of-charge indicator -- because we have developed our own and because we are further down the learning curve on some other things with our economics -- we will be producing it in the ballpark -- just a little bit of a premium over what it cost us to do the version without the state-of-charge indicator. I believe that for the sulfur dioxide battery, it's going to be a large cost differential for them. That's the first issue they're going to have. And so you keep adding fixed cost onto something, you're amortizing it over a much shorter lifetime for sulfur dioxide than it is for manganese oxide. I don't know that the economics are going to be too good. That's first.

Second, I'm pretty confident we are ahead. I think it's only recently that there's even been contract -- although we were slowed up a little bit by the protest on the contract, you need a contract mechanism to do these kinds of things. And I think it's only recently that that's happened for them.

So never underestimate the competition, but I think an economic standpoint, if we can -- if we're advantaged today over sulfur dioxide, and we're still advantaged with the state-of-charge indicator, we may have to add one to it. It's just going to make their economics worst.

Okay. Thank you.

Mark Grzymski.

Good morning. Regarding the qualification, how sure are you guys that that's going to wrap up in the third quarter? Is there any growing concern that that could be pushed back?

We've passed all of our internal tests, mark, and we've passed it with multiple vendors and doing it in multiple ways. And we've passed all the tests. What we need to do is -- the people who do the qualification of the government are in the process of running those tests also. So they need to verify it. And so we are certainly subject to their schedules, but they are moving along very expeditiously because they really want this.

We have multiple horses in the game, so that we -- in case we find out that one particular vendor's part doesn't perform the way we thought it would when it's tested. But we've tested these nine ways to Sunday.

But we've been -- I'll make one other comment -- we've been making state-of-charge indicators on batteries for three years now. We started when we started the Land Warrior program. So we have three years of experience with this -- of making them, qualifying them, testing them. We've done our own circuit design. We have a chipset that we do that's separate from everybody else's. So we're pretty confident that we're there. We just have to have it verified by the government.

Great. Then it would be -- are you guys assuming then that the orders should start in Q4 with the qualification, wrapping up in Q3 and then deliveries in Q1 of (multiple speakers)?

Well we're assuming we're ready to deliver in Q3. So that it. We're pretty close to a qualification. So DLA doesn't even have the contract yet. They don't get the contract until we qualify.

Okay.

It's a different world now because there's two agencies involved and that's what's gotten us, is that DLA can't place any orders under Next Gen until they have the Next Gen contract. In the past, CECOM had everything. And they don't get the contract until the qualification is passed with CECOM.

Right. And now -- in the past, we've been talking about wartime, peacetime contracts and regarding the large contract, do you have any concerns that if we do start to pull out, that you're not going to get the demand from the contract or the orders, excuse me. But is there any concern there?

No. Contract demand is based not on wartime use. It's based on peacetime use. And so when they do the numbers for those, they do it based on peacetime use. What they assess peacetime usage to be. Military budgets are based on peacetime and then the way they've done it recently is they do supplementals for wartime. That's a separate issue. So I don't think -- we don't think they are connected.

Now when you look at actual demand, there's definitely been a change in actual demand from last year to this year in total. Demand was different when they were going into combat; not that they're not in combat type situations now. But when they were going into combat, demand was different. There is applications, like portable radar that isn't necessarily used because they're not worried about enemy -- a conventional weapon enemy right now. But demand is still reasonably high because the products are being used and consumption is pretty high. Talk to anybody out there, batteries are critical to what they do.

Okay, great. And just quickly, Bob, this is probably for you. The R&D expense, second half of the year, where are we going to see that?

Right now, we'd expect it to be around a similar range as Q2.

Okay, great. Thanks, guys.

Walter Nasdeo.

I was listening to Steve's question and I was trying to -- I guess I was writing too fast or something, but as far as the breakdown now between military and commercial goes, you said it was 60/40? That's military 60, right?

No. Now -- last year, it was 60 military, 40 commercial. Now, it's more like 60 commercial, 40 military or even 2/3, 1/3. Last quarter, it was 2/3, 1/3.

Okay. That's what I thought I heard. I just wanted to clarify that. What do you expect this to be at the end of the year? Is this where you are tracking to for or the year, or do you expect any changes in this percentage going to the rest of the year?

No, our assumption is that's what we will track to for the rest of the year.

Okay. Is this -- how would -- where do you want to get to on the commercial side in relation to the military side and going forward? What's your sweet spot?

That's a really good question. I think 2/3, 1/3 is a pretty good number. Somewhere in there. Yes, that's a pretty good number. We've always assumed that $200 million, we'd be running about 80 to $100 million in military. A lot of that -- a lot of the question in that range is how much we can penetrate overseas militaries. We have a lot less visibility to what they're going to spend budgetarily (sic) over the next two years.

Yes, yes. And obviously, the volatility of this whole contract process is something that can really screw a quarter up.

Well, I -- and you make a good point. We don't -- and somebody asked this on the last conference call, I think. There's not a volatility in demand. Unless you're going to war, not a war, whatever. There is not a volatility in demand. There is a volatility -- certainly there are some ups and downs in demand because there's pipelines that get stocked and it's not any different than, oh, my gosh, we're out, we got to order a whole bunch, type of things happen. But that's smoothed out a lot by the buffers that are kept in place. There's not a lot of volatility in demand. If you look at our small cylindricals, you don't see it. This has been artificially induced by the fact that it's just been extraordinarily hard to get with a new agency for the buying process that occurred in the past to occur, and that just puts more urgency behind getting on the contract.

Okay. And just one little follow-up to that, what percentage capacity do you have devoted to the military group right now to get you through the end of the year? Assuming that the contract process is going to turn favorable for you and the orders start to come in, are you holding capacity available to that? Or how have you planned that out?

Well we have five lines or -- which lines are under that --?

Six lines.

We have $3 million in capital -- six lines that are dedicated to the military that they paid for. So they are there when they need them.

Okay, so as soon as the orders start coming in, you start shooting batteries out?

We don't have a capacity problem there. And part of our inventory build is we've built -- and the inventory stock of the basic building block -- the D cells that have to be there for the battery -- is really vendor parts and an assembly process to make these batteries.

Okay. Thank you very much. I appreciate it.

Jim McIlree.

John, it seems like the sulfur dioxide batteries, at least right now, have to be picking up market share. Is that -- do you agree with that?

I wish I knew. And I don't want to say I don't know. We kind of -- we ask ourselves that question every day. There were -- there are months where we were told that -- I think last November, we were told, gee, about 30% of the batteries that were bought were manganese dioxide. We also know kind of what the total quantities are and know that we fluctuated between 15 and 20% penetration with manganese dioxide. So right now we're probably at 15%. So maybe we have fallen off a few points from the 15 to 20. But it's hard to tell because it's hard to tell during some of the times we were stocking, some of that was going in to build war reserve also. And we're not privy to the numbers that are in the war reserve and what part of that -- they could have shipped a lot higher percentage for a while to war reserve of 5390's for all we know. And that's why -- I'm not trying to be evasive, Jim. I'm just trying to give you kind of the variables for this.

Yes, I'm just trying to figure out if there is maybe a bulge in activity that happens when your batteries get qualified because they've run it down, or maybe that might not be the case if instead they've just used the sulfur dioxide batteries.

I think they have -- they also have the ability to, on a temporary basis, use batteries out of the war reserve because they do cycle through them. The war reserve is a number, not necessarily a physical location, that they never go below, but they certainly FIFO it by bringing new batteries in and old batteries out of it. And in fact, one of the logistics issues they're trying to work out is as they bring a state-of-charge indicator, they want to get it into the field. So then how do they do that and FIFO the war reserve? So some of that will go on. I can't tell you that there isn't some location somewhere in Basra or in somewhere in Afghanistan where they can't get the battery.

But all we know is that the two biggest barriers to us gaining market share are number one, field knowledge. The people who order batteries turn over on a regular basis and they've been ordering for 12 to 15 years -- the NSN number, national stock number, of sulfur dioxide batteries, so that's what they know, okay? We are continuing an extensive field education program of going to the bases, going to the units, before they deploy, after they deploy, making sure people know it exists.

The second biggest barrier is, the recent argument from some sources that why shouldn't I buy a $60 battery instead of -- I don't know what price they see; maybe they see a $75 or an $80 battery versus a $90 battery or a $100 battery. If after a mission, I don't how much energy is in it, so I'm going to take a fresh one next time anyway. Why shouldn't I just buy the cheaper one? And we're very cognizant of that.

For every one of those people, there is somebody sitting there going, man, this is great. I have to take fewer batteries. I love this thing. So -- but for the ones who say that, the state-of-charge indicator and the command -- this is coming from the command and logistics people -- the leadership of the military is saying, we need the state-of-charge indicator because we want people to know that they have this energy in it.

If you picked up the 5390 and a 5590 and held them next to each other, you wouldn't tell the difference except for the sticker we put on the top that says this is a 5390 and it has at least 50% more energy.

So again, the state-of-charge indicator is pretty critical to convincing those people, whose lives depend on these batteries, that they're not risking their life by going back out with something because it does say it's got two-thirds of its energy still in it. I hope I answered your question.

No, I think you got to it. For Q3 military, it sounds like it's kind of flat with Q2. And the dynamics of that would be in Q2, you had that Q1 order kind of flop over a little bit into Q2. Q3, you don't have any urgent buys, but you do have the qualification taking place. So it all kind of washes out to about the same number. Is that good enough?

Pretty close. Our commercial business will grow from Q2 to Q3, so maybe it's a little less in our assumption.

Right, right, okay, great. And just a couple of other things. Last quarter, you had a very strong 9-volt business. How did that shape up this quarter?

We're still in very good position with the 9-volt business. We were about 2/3 smoke detector business five, six years ago when I joined the Company. And we had a hard time supplying; it's a retail business, and we had supply problems with production, getting them out there. So those people got a little disheartened, didn't promote the product as fast. And we've spent a lot of years convincing them and showing them that we could supply -- that if they promoted the product, demand swung up, that we actually put it there. There's nothing worse in retail than a promotion -- you promote something, you generate demand, and there's no supply. So I think we've proven that and I think that we're starting to see the smoke detector people come back.

We put a lot of effort into distribution in Europe and in Asia. That's coming back. I used to say we don't do retail, but we went and did this project with Lowe's and that's doing very well. So pretty much across aboard, medical distribution is doing very well. Pretty much across the board, our products are doing well there.

Okay. And finally, the Land Warrior program that you mentioned, can you kind of ballpark what type of revenue contribution it could have in 2006, either a range or a point estimate?

Well that's a good question. General Dynamics did an announcement in June that they got $30 million to do 50 Land Warrior systems for Striker Battalion. And that's what we're about to get some orders for. We don't know the size of that quite yet. And the timing -- we know the timing is between now and March because March through May is when they are going to deploy. So we have to obviously produce the batteries ahead of time. But we don't know quite what our part of that is going to be, but it's going to be reasonable revenue. And then when they deploy, that's going to be more a question of timing, but this is -- we're pretty happy about this one.

Does that ever get to the point where it supplants the rest of the business -- the rest of the military business?

We hope so. That's our fervent hope. If you talk to the military guys, they tell you in the future, everybody is going to be special ops. Well the way to make people be special ops is with these kinds of systems.

Okay, great. Thank you very much.

Craig Irwin.

Great. Good morning. I just wanted to ask a couple of questions about the military inventory of 53, 5590's that you mentioned in your prepared comments, looking at the long-term order rates for these batteries combined suggests roughly a 50 to $60 million level, and you mentioned the inventory in your prepared remarks. Do you have much visibility into how much they have remaining or what the outlook is for that to be drawn down?

I hesitate to -- we get some numbers from some people who try to give us some guidance, but they are limited in what they can tell us. First, we are limited in what we can tell you, number one. And number two, we've gotten numbers before and used them to project and it hasn't worked. There's a system they have called BidLink, which pops out visibility to the vendor community when there's demand. Well the BidLink system was saying in the spring that they needed to buy some $14 million worth of batteries right away. Well, they haven't.

And so it's a little hard to depend on any numbers we get, Craig. I can tell you, we've been told that they are below-target inventory level. On the other hand, we don't have visibility, and in fact, in some cases, the people we work with who really are just trying to stock logistic stocking locations to the levels that they are supposed to stock them to, we don't have a lot of visibility sometimes to the strategy people who might be saying -- and I don't know if this is the case or not -- who might be saying let's keep the inventory lean until we get this new type because we really want to have this state-of-charge indicator. We kind of -- we hope they're saying that, but we don't know. There is some of this we have to try to fill in the blanks with, and that's been very frustrating and tough for us and very frustrating for all of you guys out there. That's the hardest part of this all.

We do know what the ongoing demand is. We do know that they are using pretty good size quantities of batteries on a monthly basis. It has not changed over the year. It's running at a pretty good steady-state. And we do know that there is still a strong demand -- strong desire -- for the 5390. So all we can surmise is that inventories are going down even further from there.

We have been told and we do know also that probably in the last two, three months, it's kind of built up from May -- pretty much from June, July, I'd say -- last couple of months, and now we're getting this message pretty strong that there's a real push from the logistics people to get that state-of-charge indicator -- get it out there, get it fielded. And it's kind of funny for us because we were saying this a year ago. Let's get this contract done so that you guys can get this out there because we know that that's needed.

And we also -- I'm hoping that there's a strategy to replace the war reserve with state-of-charge indicator batteries. That would only make sense. So that's what we know. I can't -- I hesitate to give you numbers, Craig, because we've gotten multiple different numbers of where they are.

That's very fair. My next question is the rechargeables. You mentioned the phaseout of a digital camera order that you've been fulfilling over the last I guess probably couple of years. Does this affect at all your guidance for rechargeables to grow about 100% this year compared to last year?

Yes, it does. What's happened is -- it will affect it slightly. That business has gone away, is going away after this quarter. It was a big chunk of our business, but it was very low. It was like 12 to 15% gross margin. But we've replaced it with other business. We made a decision not to get in a price war in this business. We produced a very high-quality product and the person who is buying it from us basically went into China and held up a really very inexpensive battery, which we don't think was the quality level against us. And we made a decision not to get in a price war and take lower gross margin, and to really focus on going after higher gross margin business.

So I would say revenue will be a little lower than that, although we're continuing to grow -- I don't think -- we won't quite double, but we're going to grow the gross margin better.

Okay, and what are your margin expectations sort of exiting the year? Will we be at the midteens, or is there the potential for that to be higher?

I'd say -- let's just say we'll be at the midteens. We're at the midteens right now, even doing the digital camera business. There's potential for it to be higher. Is that going to make a huge difference in our business model on a 3, $3.5 million business? No, I don't want to count on it. There is some very -- a lot of it depends on mix. We have some charger business which is very good gross margins because it's heavily engineering intensive, so we are sensitive to what kind of mix we have there, but count on midteens, is what I'd say right now.

Okay. Excellent. And you mentioned the bouncing around sort of of the share that you're seeing versus the sulfur dioxide technology out there for the 5390's. Are you aware of any update to the batteries field incident rate that's sort of tracked by the militaries? Is there anything there that could be impacting the orders?

Are you talking about for our battery?

Yes.

We just had a review with the military guys, DLA and CECOM in our UK facility -- a readiness review on Next Gen, and we were told that they are amazed at two things. One is that we got up to 40,000 sales a day production when they needed it faster than anybody they've ever seen. And second, that we did it without a single -- there's not been a single field incident.

Great. So then the safety profile is then still superior to that of the SO2 technologies?

It's a great battery and you can use all the energy in it. You wouldn't want to discharge an SO2 battery with a string of ten cells all the way down to zero because really bad things happen.

All right. Last question. Can you update us on the ELT market? I understand there have been some developments there and I just wanted to know if you could fill us in on those.

I'm going to ask Bill because he's more up to date.

Yes, as far as technical developments, we know the frequency code is changing, but our cell is now qualified by the FAA, so we are getting a lot more interest in the batteries. In the last conference call, we've been subsequently sampled a couple more customers in that. And to John's prepared remarks, we're seeing that part of our business growing pretty nicely year in, year out. It's not replaced the most significant part of our business, but it's a real good market and we're getting very good market penetration.

Okay. Thank you.

Michael French.

Good morning, gentlemen. I just had a question about the top line for the next year or so. And just doing math, if two-thirds of this year's 83 million is from commercial, that could be at a price about 54 million. Say if they grew at 10%, and then you add the 10 million from Telematics, that would be about 70 from commercial next year. If you could get back to about 50 million from 5390's and other military, that would put you up to 120 million or so for next year. Is that pat of your trajectory to get to 200? Would that math get you there within the next couple of years, or --?

Michael, we haven't given any guidance for next year. And the reason is, because the biggest components of that, the 5390, is something that right now we don't feel like we have enough visibility in '06. We don't have visibility -- we have some visibility on what we think the steady-state order rate is going to be. We have no visibility on an inventory strategy, war reserve strategy, etc.

And it just doesn't seem prudent when you have half of your business that was -- was that in the past, and with so much hanging on us, to give you any numbers until we are confident of them. So I don't know that I can comment on that because we're not going to say anything until we really know.

On the commercial side, I don't know where you came up with 10%. You can put whatever growth you want on it, but our tendency is to do what we're doing right now, which is a bottoms up, customer by customer, to figure out what we think commercial is going to be. It's going to grow next year. I don't have a rate yet. We owe that to our Board of Directors for next month. And we'll be prepared to talk on the next call about it.

J.D. Padgett.

Good morning. Just had a question as we look -- 5390 -- the progression through the rest of this year, I think you thought that it would be kind of flattish or down sequentially in Q3. And then did you say it would be up to 25% of revenue in Q4?

Yes. That's what we said.

Wouldn't that be even less than -- or at least something similar to Q3 then? 25% of 25 million is only 6.25.

Yes, it might be a little -- Q3 to Q4, we're assuming we'll grow. But by maybe a couple of million.

Okay. Why --

And the reason is -- it's not a demand issued. It's really an issue of supply lines. We've got some inventory in place that will allow us to execute fast, but then we've got to build supply lines up again to build that production ramp. We have chips we have to get. We have displays we have to get. And as I said, we have several -- we have multiple sources that we're testing just in case there is some fatal flaw with one of them -- that the government testing finds something that we didn't find that was a problem with one or the other of them. So we're not going to bet on just one horse and until we know, we're not going to make some major inventory commitment. We run pretty lean here.

so the Q4 rate for 5390 probably won't be the full production rate, then?

We're assuming it will not be, yes.

Okay. So that will continue to ramp as you get those supply lines in place into '06?

That's our assumption, yes.

And is that steady state? Is it fair to kind of straight line if it's 286 million over five years, that it would -- full production rate is somewhere between 10, 15 million? Is that reasonable?

Well it's not for two reasons. Number one, not all that 286 is the 5390. And so no. And second, and it has to do with qualification of the battery test, and than their knowledge in the marketplace. We've been putting the 5390 out there for couple, two, three years now. So there's knowledge -- 2.5 years, there's knowledge in the marketplace about it. We'll be producing batteries if there's no marketplace knowledge on it, and it can take a year or two or three to build them back up.

On the 5390, I don't -- I think that the way those guys come at the numbers is they look at monthly run rates and they project average monthly volumes out there. So it's hard to say, and they do that the peacetime demands. So it's hard to say whether it would be front end or back end. I can just tell you the 5372 contract, we're three years into and they've hit the max already. So they are going to have to do a contract extension, and we're also booked out through '06 on the 5372. So we have really good visibility there. That's where we want to get to on the 90, and there's no reason we shouldn't be.

Okay.

Except we don't have a contract in place until we get the part qualified.

Katherine Spellman (ph).

Good morning, gentlemen. I have got one housekeeping question, first of all. I might have missed this, but did you get the revenues for 9-volt batteries?

We don't break down the revenues in that way.

Okay. And second of all, I read a Government Accounting Office report that was published in April that talks about the inventories of 5590's and 5390's being 1.5 million units. Is that another reason why orders have been slow -- because of that inventory level?

There's a very large inventory that is there for war reserve. And so -- and it's prepositioned stocks -- some of that is in prepositioned stocks. First of all, war reserve doesn't get touched by doctrine. And second, some of it is even in prepositioned stocks -- places you could imagine, the Korean peninsula and Boteson (ph), Diego Garcia, wherever, in case something happens so that we can rapidly deploy. So there might be 1.5 million batteries but there is not 1.5 million batteries exclusive of war reserve. War reserve is a pretty big number. It's a -- I think it's a military secret. And so --

That's a public report actually.

That report might be a public report, but breaking it down by what's in war reserve and what's in inventory are two different things. So I don't know how to answer your question because I don't know.

I do know that -- we do know that they are below their inventory target in batteries. Operational inventory target, but that the war reserve is fully stocked.

Okay. And from your experience -- I guess that's about a 30-month inventory then? Is that typical?

Well you know, it's funny. They came back and said, the way they build the war reserve -- now I know what you're talking about with the GAO report. Yes, we heard somebody say that too inside the military. The war reserve is based on how many batteries they use when they go into combat operations.

When they went into a combat operation in Iraq, they used well over 300,000 batteries a month. So -- and it takes us three to six months to ramp up. So it wouldn't be out of the question to take 300,000, say, or we want five months worth of inventory and put 1.5 million batteries in war reserve. Now you come along and say but we're only using 150,000 batteries a month now or 100,000 -- we're only using 100,000 batteries a month, we've got 15 months of inventory of batteries. Well that's not a fair way to do it. You have to do it versus the purpose that they are there for.

Okay.

So I think the GAO did say, wow, you've got all of these batteries and someone didn't point out the GAO -- well, no, no, no, those are there for the war -- when you go to war so that if we go to war, we can supply people for three months while we are ramping up the industrial base.

Okay.

That's what the war reserve is there for. So I suspect that that's what that 1.5 million battery issue is about.

And just -- you didn't ask me, but I'll tell you, they had set the war reserve before Iraq at numbers based on Gulf War usage. And when they went into Iraq, they found out they were using two to three times the usage, because there was all this new stuff out there. I wouldn't be surprised if that was the case the next time too.

Tim Dolan (ph).

I think we can all live with the lumpiness associated with the military side of the business, but I think we deserve some sort of explanation related to the dumping (ph) of the lion's share of your stock, John, ten days after the violation of the debt covenants, and kind of a few minutes after releasing the press release regarding the Telematics business. So could you just give us some kind of color as to what went into that decision and how that may be useful now?

Yes, that's a very fair question. I received stock options when I joined the Company six years ago. They were pretty much until last December, the only substantial stock I received in the Company and I wanted it that way. I waited as long as possible to do anything with that stock, not wanting to sell it because I believe in the Company. Last year, I sold some of it around this time of year but held the lion's share of it. I then got very nervous because it was all expiring on the 9th or 10th or something of July 2005 -- just expired, period. It was going to go away. So I put in place last November -- I couldn't do it right away because the Board of Directors had to approve such a plan. But we had to approve the ability of the Company to do a 10B5 plan -- a planned sale. So I put that plan in place last November.

And that plan called for sales of stock at certain points, and at the end of that period of time, if we got within a couple of weeks -- I don't even remember exactly what it said, that the agent, Smith Barney, who administered the plan, would then have the ability to sell the stock at whatever they could sell it for, because we didn't want it to expire. It's my -- it's from six years of work. So that plan was put in place last November.

I relinquished all control over that plan. I had no -- so I had nothing to do with this decision except to put a plan in place last November that called for it. That's how it happened. Plain and simple. And in fact, for whatever it's worth, if I hadn't put that plan in place, there would have been about twelve days in those six months when I wouldn't have been able to do anything with the stock. The whole idea so that would be -- the plan was for it to be orderly, not -- and all of a sudden I have twelve days, let me sell whatever million shares of stock.

It was put in place last November. I still hold 80 some odd thousand shares of stock, which is the bulk of my net worth in the Company and still believe in it. So I did not make any decision in July. It was put in place last November.

Okay, thanks.

Geoff Nixon.

Good morning, John. You talk about, on the press release, you talk about the competitive advantage that you're going to get from the state-of-charge indicator. But is it still true though that the Next Gen contract you were awarded 100% of is still intact, and that the competitive advantage that you're going to get from the state-of-charge indicator, well I know that it slowed down the Next Gen orders. What you're really referring to is above and beyond that? Like from further penetration?

Yes, we think there's a bigger opportunity here. We think the bigger opportunity is to make bigger inroads faster into the total market. For every dollar we've got -- we've sold the 5390's, there's five, six times that in 5590's being sold. And it's a 12-year-old product.

Yes, so nothing has changed with respect to that original Next Gen contract?

Nothing has changed.

Okay. And then secondly, would it be true also that the 5372 sounds like is a smaller battery that may be a faster grower and you have the Land Warrior, that when you get to your 80 to 100 million of military sales, that actually the 5390 will be a smaller part than it was in '04?

That's our goal. We'd like it to be a much smaller part.

Yes, so the rest of the military sales are growing faster?

That's exactly right. And I'd just make a point about the 5372. The reason we know a lot about 5390 cells and 5590 cells is that every radio that's got one of those in it -- and they are not only used in radios, okay -- but every radio that's got one it has got two 5372's in it, so that all the encryption data is backed up when they change the battery. That's the memory backup battery, much like the CMOS battery that's in your PC. So that demand has been going great guns. So if that's going great guns, it's being used with 53 or 5590's. That's why -- part of the other evidence we know demand is strong.

I'll also say, Geoff, that the 5347 is going to become -- is the fastest-growing battery that's out there, and that's the thermal site, and that's the new night vision. And that is going to be such an important part of the soldier of today -- not just soldier of the future, soldier of today -- is thermal imaging. And it uses a lot of power -- a lot more power than a radio does. So 5347 is going to be a very important product.

Okay, and just to follow up on the last question about your insider sales, what you're really saying is that you had a really sharp broker who was the custodian of your 105B plan? Is that what happened? Obviously, he did a great job here, but it was in his hands; the timing was in his hands?

It was totally in his hands.

Thank you.

David Robert (ph).

Yes, just a quick question about the demand on the new model with the state-of-charge indicator. I know if I were a soldier in the field and I wasn't confident on the charge of the battery, I would just toss it and grab a new one. Are you concerned at all that this new indicator might perhaps decrease the demand because they're going to know what type of charge is in the battery and then perhaps not need to order as many?

They will get better usage. There's no question about it, out of batteries. But frankly, if you look at the times that that really happens, it's maybe 10%. That's a good question, but maybe it's 10% of the time. I think it's -- from what we understand, people in the field, in a lot of cases, it's just an anecdote that that happens, so let's not do that.

I've heard both sides argue it, in fact. We had this big discussion about a year ago where some of the command was saying, why are we are putting a state-of-charge indicator? It increases the cost of the battery. And really there aren't that many people doing it. So I don't know because I haven't been there, but if you look at the different applications it's used for, that may be true in some of the radio applications but not necessarily all of them. It will decrease demand some, but I don't think it's going to make it huge. On the other hand, they're selling six times more sulfur dioxide batteries, so maybe they will only sell -- maybe that number will be cut by 20 or 30%. That's okay if we get them.

All right. Thank you.

Okay, management, there are no more audio questions. I'll turn the call back over to you for any closing comments you may have.

Thank you very much. I want to reiterate something. I'd like to reiterate how strong my belief is that this Company is a powerful company that's growing. We had a temporary disruption here in production of the 5390. But we'll soon have a new version which really has the promise to take an even larger share of a really large market. We're growing our international military business, and you can see over the next year, we're coming out with a lot of new products for the U.S. military market, not just Next Gen products, but products with programs like Land Warrior. We have tremendous momentum going on in our commercial markets.

Our 9-volt business is growing again. Our rechargeable business continues to expand, and we're winning in the markets we have always known were large opportunities. Automotive, telematic, search and rescue, medical. Our product development pipeline is larger than ever. Part of the reason we're spending the money we're spending for R&D is because we believe so strongly in building this pipeline. And our opportunity list is growing not just in existing markets but in new markets like RFID.

We are disappointed we had to lower our projections for the next two quarters. It's very painful for us; I know it's painful for our shareholders, but it's not going to deter us from doing what we think is right to grow the revenue and the profits and to ensure the long-term success of this Company. We would like to thank you all for your patience. We'd like to thank you all for joining us today. We really look forward to sharing our progress with you again next quarter. Thank you.

Ladies and gentlemen, that concludes today's teleconference. Thank you for your participation. At this time, you may disconnect.