Ultralife Corp (ULBI) 2007 Q1 法說會逐字稿

Good day and welcome to this Ultralife Batteries first-quarter earnings release 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. Good morning, everyone. This is Jody Burfening of Lippert/Heilshorn & Associates. Thank you for joining us this morning for the Ultralife Batteries earnings conference call for the first quarter of fiscal 2007. The earnings press release was issued earlier this morning. If anyone has not yet received a copy, I invite you to visit the Ultralife website at www.ultralifebatteries.com, where you will 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 11:00 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 these forward-looking statements. A more detailed description of these risks is contained in the Company's filings with the Securities and Exchange Commission.

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

Good morning, Jody. Thank you. Good morning, everyone, and welcome to the Ultralife Batteries conference call for the first quarter of 2007. Joining me today are Bob Fishback, our Chief Financial Officer; Bill Schmitz, our Chief Operating Officer; and Julius Cirin, our Vice President of Corporate Marketing and Technology.

Today we reported record revenue of $32.3 million for the first quarter of 2007, with an operating profit of $600,000. This operating profit includes non-cash expenses of $500,000 from the amortization of intangible assets and $600,000 from the expensing of stock-based compensation. These results are better than the guidance we provided in our fourth-quarter 2006 conference call, and they reflect higher-than-expected revenue in our communications accessories business and improvements in gross margin in our operations.

As compared to the fourth quarter, in the first quarter we doubled sales of communications accessories, a product segment that started from our acquisition of McDowell Research. This has allowed us to make progress in working through our premium cost inventory that's created a temporary drag on gross margin, and it has enabled us to introduce higher-quality, more economical material sources for many of our accessory products. The improvement in gross margin reflects this. We expect further progress to be made in the second quarter, and I expect to be substantially out of this situation by the second half of the year.

Revenue in our nonrechargeable segment also showed strength. Our 9-volt product line turned in strong revenue performance, fueled by robust international demand, and process changes enabled us to solve a production yield problem and return to expected gross margins.

Sales of standard products to the US Department of Defense returned to steady levels. Over the last year, the Defense Department has leaned out inventory, and late last year implemented a materials planning and ordering system that works in monthly segments. As a result, we believe that current orders reflect actual demand, and that the management of inventory in finer increments will produce a smoother flow of orders.

In addition, the fact that contract sales to the Defense Department represented around 9% of our business demonstrates the diversification that we have achieved since two years ago, when it was as high as 60% of our business. Automotive and other commercial markets also contributed to growth in both sales and gross margins in nonrechargeable batteries.

Rechargeable sales were also strong, although not as strong as last quarter, where we had the benefit of a large contract sale for batteries and chargers used to power a counter-IED system. There was some margin effect due to completion of charger sales under this contract, which carried some of the cost of premium purchases in the McDowell operation.

Demand for our products has never been stronger. We entered the second quarter with an even better backlog position than we had entering the first quarter. Standard products for the US Department of Defense as well as 9-volt and automotive products showed steady demand and strong backlog. New products are representing a bigger part of our growth, as evidenced by announcements of orders for our Harris Falcon handheld radio batteries and our new tactical repeater product.

Our international distribution network is paying off, with a good portion of our new orders coming from overseas. We now have a formidable product development capability, and are keenly focused on markets in which we have international reach. We will be leveraging these capabilities to further drive our revenue.

Over the next several quarters, we will also be launching a wide array of new products. Our goal is to extend our range and grow revenue in existing markets with new offerings and capabilities, as well as to increase our margins with higher-performance and higher-value products and services.

With the acquisitions that we have done, we now have a larger worldwide sales and marketing organization and a broad range of channels through which we can sell our products. Our recent announcement of the sale of BA 5590 lithium sulfur dioxide batteries to the UK Ministry of Defense is an example of how our business unit formed a supply partnership enabling us to give increasing support to an existing customer and to widen our product range.

As we fuel this revenue and margin growth, we will not ignore the need to focus on operations. We will also grow margins by concentrating on operational excellence, increasing yield, reducing scrap and making more economical sourcing decisions. Applying this to our McDowell unit, we believe we can not only recover margins but make significant improvements over what they were before the acquisition.

We're also very focused on asset utilization. Across our four operating units, we started a new effort to do a better job of managing inventory. Because of the demand placed on worldwide lithium ion cell sources resulting from recalls of laptop batteries late last year, we had to protect our cell supply by making commitments to inventory. We believe we can take as much as $10 million out of inventory over the next six months. As a result, we're working to get into a position of having minimal revolving credit borrowings by the end of the third quarter.

For the second quarter, we expect our revenues to be in the range of $32 million to $34 million, and we expect an operating profit in the range of $800,000 to $1.2 million. This is based on continued improvement in margins and a strong backlog across our business segments.

Now, I would like to turn it over to Bob, after which I'll have a few comments, and then open it up for questions.

Thank you, John, and good morning. Earlier this morning, we released our first-quarter results for the period ended March 31, 2007. Consolidated revenues reached a quarterly record of $32.3 million, a $14 million increase or 76% over last year's first quarter, and slightly ahead of our top-line guidance.

This increase resulted from strong sales growth across most of our product lines, including communications accessories, rechargeable products and HiRate and 9-volt batteries. In addition, the revenue base from the businesses we acquired in mid-2006, McDowell Research and ABLE New Energy, contributed to the year-over-year increase.

Overall sales to government and defense customers accounted for approximately two-thirds of revenues, while the remaining third related to commercial sales. Direct sales under contracts to the US Department of Defense were only 9% of total sales, as we continue to be successful in diversifying business through foreign militaries, prime contractors and other distribution channels, such as US special ops.

Gross margin was $7.5 million, up $3.5 million from the same three-month period last year. As a percentage of total revenue, gross margins were 23% in 2007 versus 22% in 2006.

This improvement in the margin percent resulted mainly from a favorable sales mix of products, particularly in our nonrechargeable segment. Margins in the first quarter of 2007 were hampered by the prior quarter's purchasing decisions at McDowell that proved to be costly. We are continuing to work through much of the remaining premium cost inventory in the second quarter.

Operating expenses in the first quarter totaled $6.9 million versus $3.7 million a year ago. Much of this $3.2 million increase is attributable to the acquisitions of ABLE and McDowell. Added operating expenses from these companies accounted for $1.7 million, and the amortization of intangible assets accounted for $500,000. The remaining $1 million of the increase in operating expenses is attributable to higher non-cash stock compensation expenses and generally higher administrative costs associated with operating a larger, more diverse organization.

Overall, we reported operating income of $600,000 for the first quarter of 2007 compared to $200,000 last year. Net interest expense in 2007 was $600,000, up $400,000 from the same quarter in the prior year, due to higher levels of debt related to acquisitions. As a result, we reported a net loss in Q1 of 2007 of $36,000 or $0.00 per share, compared with $140,000 net income in Q1 last year or $0.01 per share. Average shares outstanding for the first quarter of 2007 were 15.1 million shares, relatively consistent with last year's diluted shares outstanding.

Turning to cash flows, we generated positive EBITDA of $2.6 million in the first quarter of 2007, including non-cash expenses related to stock-based compensation. During the quarter, we used approximately $3.9 million in cash for working capital purposes, mainly higher levels of inventory, and we used another $600,000 for interest payments.

Inventory balances were high at quarter end, as we decided late in 2006 to procure certain materials that were suddenly in short supply, in order to meet customer demand. Given our backlog and pipeline of opportunities, we expect to bring down inventory levels significantly over the course of the next quarter or two.

Investing activities included a $500,000 outflow for capital expenditures and a $1.5 million payment related to the asset purchase of McDowell Research. Financing activities included cash inflows of $4.5 million from a drawdown on our revolver and $200,000 from the exercise of stock options, offset by cash outflows of $500,000 for principal payments on our term loan.

Cash at the end of Q1 was $1 million, up modestly from $700,000 at the end of December. Correspondingly, the outstanding balance on our revolving credit facility at the end of the quarter was $11.5 million compared to $7 million at the end of the fourth quarter, driven mainly by the increase in inventory balances.

We recognize that our current working capital balances and cash position are less than optimal, and we're taking steps to improve our asset utilization. We're modifying the way we manage working capital to reflect organizational changes at the Company as a result of last year's acquisitions. We now have four clearly defined operating units and product lines within these units, and we're pushing accountability down for both the P&L and the balance sheet, including DSOs and inventory turns.

By sharpening our focus on asset management, we intend to eliminate our outstanding revolver borrowings during the second half of the year. In addition, we're focused on lowering our operating expenses. To do this, we're looking at areas where we can save money by consolidating support functions and streamlining processes. Lastly, we're keeping a sharp eye on efficiencies and improving gross margins through ongoing Lean Manufacturing initiatives, Six Sigma projects and product mix optimization.

In the first quarter of this year, we entered into a forbearance agreement with our primary lending banks through an amendment to our credit facility. This agreement addresses the violation of certain financial covenants and provides time for our management team, together with the banks, to evaluate the structure and terms of this facility.

As we look ahead to the second quarter of 2007, we're projecting consolidated revenues in the range of $32 million to $34 million, based largely on our existing backlog and the current pipeline of orders. In addition, we anticipate reporting operating income in a range from $800,000 to $1.2 million. As revenues grow, we expect to achieve incremental margins through improved operating leverage of overhead costs and ongoing improvements in our Waco operations.

As we near the anniversary of last year's acquisitions, we're successfully working through the operational issues, streamlining administrative functions and implementing plans to improve margins. Opportunities to both grow sales and drive margin expansion, especially in our communications accessories business, are outstanding. We remain excited about the prospects for our future, and we're confident that we will improve operations throughout the year to drive both top and bottom-line growth.

That concludes my remarks, and I will turn it back to John.

Thank you, Bob. Ultralife is now in the strongest position in the Company's history. We have a wide diversity of customers, markets and products. We have now entered another quarter where our strong backlog gives us improved revenue visibility. Our prospect list has never been better. Both near-term and long-term pipelines of opportunities and orders are strong, supporting our continued growth. We also plan to continue to improve margins through better material sourcing, improved processes and higher-value new products. Along with all of this, by sharpening our focus on asset utilization, we will rapidly improve our cash position and have the ability to finance our growth internally.

That concludes my remarks, and now I would like to turn it back to Matt and ask him to open it up for questions.

(OPERATOR INSTRUCTIONS). Steve Sanders, Stephens, Inc.

I wanted to follow up on the inventory spike. Just a little more color on the increase, and then specifically what programs are tied to those products, and how do we think about working that off over, say, 2Q to 3Q?

Sure. I would say about $2 million of that inventory is due to inventory brought in in the accessories business at McDowell, specifically related to chargers, where we had had trouble getting parts as we took over their supply lines. We don't have that problem now, and we will work off that inventory over the next couple of quarters with some big prospects for where it could go away very fast.

Then the rest, about another $5 million in the inventory increase, is tied specifically to cell inventory used in our rechargeable products, 18650 cells. When Sony had severe problems with their cells in laptop computers, that entire market tightened up. We buy those cells from Asia. They come on boats, and we had to ensure supply lines. When you cut off sea shipments, you have about 35 days on the sea already. So we had to cut that off. We did cut that off at the beginning of the quarter, but we had a good 30 to 60 days that we couldn't stop.

We will sell through that inventory without any big orders. Just in the normal course of operations with the stuff that we have going there, the way that product line is going, that would sell through by the end of the third quarter. It could happen sooner if we had some larger orders. That's really -- that's where it was.

Then, Bob, I didn't fully understand your comment about the revolver in the second half. Can you just repeat that? I think you said you had drawn $11.5 million, and I wasn't sure if you said you would stop drawing or you would repay it in the second half.

As of the end of March, we have got $11.5 million outstanding under the revolver, and we expect to eliminate that borrowing under the revolver by the end of the year through asset utilization and just the improvement in the business.

Let me add, once we got past the stuff that we couldn't stop in the first quarter that cost the $7 million, our inflows are down significantly. In fact, they will be lower than our consumption rates, obviously, as we work that off. On top of that, with the sales we have had, anything that we sold, that we shipped after the middle of the quarter, we don't get paid for until the next quarter. So with 45 days of receivables, there's a lag there before the cash comes in.

So we want to get out of the borrowings, plain and simple. If you look at the interest expense, we want that gone.

Then a follow-up on communications accessories -- obviously a good quarter, margins around 18%. Are the sales there sustainable? As you work off the high cost of materials, how do we think about those margins over the next 6 to 12 months?

First of all, it's sustainable. We're seeing very steady business there, both in just the everyday sales of stuff through catalog, and through larger projects that we end up with, like the SATCOM on-the-move project that we announced in the fall that's shipping now, and other projects like that. So it's a good solid business, and we just see more and more opportunity in that business.

I think that our belief when we bought McDowell was that they -- because of operational issues they had of just trying to get more and more out, not having a scalable set of processes, they were stuck at about $22 million a year. We think that business is easily double that, and I think our numbers show that. Part of that business is in communications accessories; there's a little part of it also in the rechargeable business, because they also make chargers.

In terms of the margins, their historical margins were 30% to 35%. So at 18%, that's not acceptable to us. With it being a quarter of our business, we think there's 3 to 4 points on the Ultralife margin line as we bring those margins back.

The drag on them was pretty simple; it was material costs, because it's a very materials-driven business. At higher volumes you're supposed to get better economies, not premium. We've been through that, and we're starting to get the better economies.

I think the results for this quarter were better than we expected, because I think we did better than we expected in halting premium materials and getting the more economical and higher-quality sources. Sometimes, when we say economical source, sometimes if you pay less for something but you have to rework it when it comes in, you're not saving money.

So we have really done a -- we had a very good vendor base that we had at Ultralife to be able to go to. And some of the [valve] vendor base was very good, and I think we've rationalized that pretty well and we have a good flow now from the right people. That ought to bring our margins back.

Then just a quick comment on ABLE and where you stand there, as well as the auto telematics.

I can tell you what ABLE did, but we don't break it out separately because, as we grow that business, there's some revenue that's going to be attributable to the ABLE product line. There's some revenue -- if we build some parts like our thin cell product, when it gets to volume we will build some of that there. Then there is some revenue in ABLE that's going to be attributable to new stuff that we do to Ultralife-branded products out of there. So it will show up in different places.

But ABLE was in the $1 million [boat]; it was running at a rate of about $4 million a year. When we bought them they were $2.2 million a year, so kind of $1 million plus. But they are going to grow -- right now, our numbers say they grow every quarter this year. So we think we can grow that business 50% to 100% a year, actually. It went from $2 million to about $4 million last year. This year, we will be in the $6 million to $8 million range at ABLE, and at a run rate higher than that, we think, going out of the year. We think the real kicker comes in 2008.

Right now, we have a -- the ABLE brand, which is a value brand -- it's a good product at a great price. There's also room in the market for the Ultralife brand, which is a great product at a good price, if you triangulate the value curve. So, as we develop those products, which we are actively engaged in, and get those in the marketplace, there's some big growth prospects possible in 2008, we think. That's where we're heading with that company.

Then auto telematics?

Oh, yes, I'm sorry, telematics. We're continuing to grow that business. This year, we've added -- we have a couple of models coming in this year from model year 2008. Last year, I think we did kind of $8 million in that business. I'm looking at Julius. Kind of $8 million in that business? Right, Bob? I think this year, we'll be in the $10 million to $12 million range in that business, in terms of revenue.

We have models coming on, like I said, this year for 2008 model year. Then we have some 2008 model year things that will be introduced during 2008 for people with later product introductions. There's some models that are looking at -- there's some models that will only put them in the car where the telematics system is bought. There's some models now -- some of those models are looking at putting in the telematics system in every unit.

So we just see steady opportunity there. The European market is -- automatic crash notification is starting to go into cars in Europe. But along with that, there are also theft recovery -- we're also seeing a trend where theft recovery systems -- insurance companies are mandating theft recovery systems in Europe, in some countries, for high-value cars.

They're also asking for backups to those, because if the car battery -- you tow the car away and disable the car battery, the LoJack kind of type system doesn't work. So they are looking for backups for that, and we are doing some designs there. Nothing is shipping yet, but work that we think will lead to business in 2008.

Walter Nasdeo, Ardour Capital Investments.

I'd like to touch on what your current capacity is, what you expect your needs are going to be going forward, and if you anticipate any capital expenditures around that to be able to supply both your backlog now and what you expect to be bringing in, in the near future.

Our most capital-intensive business is the nonrechargeable batteries. I'll take that in a couple of pieces. The first piece is in some of the basic operations we have in our cathode operations. A lot of those things are six months to one year plus lead times to get that capacity in place. We're operating pretty much at about 50% of capacity, but in those long lead time items, I'd say that we can do some things like speeding up lines and doing some things on cycle times. I don't know, Bill, what would you say, 30% or 40% we are at?

Yes. In the nonrechargeable business, we have plenty of capacity.

Then maybe in winding capacity we're at 50%, but we can add winders in 90 days, even automated winders. Then in our assembly operations, it's mostly people-gated. The kinds of equipment that we use there, 30 to 60 days to get new equipment, whether it's ultrasonic welders or TIG welders or assembly gear.

So we are in pretty good shape with capacity, in terms of floor space and utilization. I will say, in our 9-volt operation we're probably running about 85% of capacity. But there's things we can do to increase that over time as well.

In terms of assembly space, we are still -- we have plenty of space in the UK. We have plenty of space here in this factory. So I'd say we are, on space, maybe 70% or 80%, Bill?

Yes. We don't foresee any large capital equipment needs in the near future.

Real briefly, jumping over to the balance sheet, you guys traditionally don't carry a lot of cash. But these numbers being under $1 million -- are you real comfortable with that right now?

What we try to do is to manage our cash balances down, actually, as low as possible while we're in a borrowing position. So obviously, we maintain some cash on the balance sheet. But while we're borrowing, it's more financially prudent to minimize our outstandings under the revolver, because we are paying a little over 8% on that while, if we put it in the bank and generate interest income, it's at the 5% range. So that's why.

Jim McIlree, Unterberg Towbin.

A few years ago, you were doing like $15 million a quarter out of the DoD, and now it's about $3 million. Is there a chance that you ever get back to those type of levels?

I think there is. I think there's a couple of trends going on there. One of them is that there was an awful lot of inventory in the pipelines in DoD, kind of 10 months' worth, as far as we know. We don't know, for security reasons, exactly what it is now. But they have really worked hard on leaning out their inventories and changing their processes to be able to execute with leaner inventories. We will give DLA credit for really working hard on that, along with CECOM.

So I don't know that more of that is going on, but we think this is a pretty low level, ourselves, actually. So I think there is opportunity there.

I don't know, Bill, do you have anything?

Yes. When we did that level before, we were pretty much a one-trick pony with the 5390. Now, as we have won a couple of other contracts and some of the other products are switching from SO2 to MnO2, we're seeing much more diversity in those orders, which is helping us out quite a bit.

So we think there's also -- we're getting significant market share gains. As we know, we have fairly low market share as it is. It appears like every month, that 5390 with state-of-charge indicator is garnering much more traction. We also believe, with the solicitation hopefully soon coming out with the rechargeable solicitation, we will be able to crack that code, too.

I'll tell you the other effect that I think might be there, but it's a little early to tell, which is that some equipment that's out there that's using standard batteries is getting replaced with newer higher-tech equipment, by prime contractors. We are getting requests to take our batteries and sell them to the primes with some slight modifications.

So, for example, the chipset that we use in the smart -- in the 5390 is very similar to the one that we use in our rechargeable version of it. It has the capability, like our rechargeable does, to do SMBus smart interface, which is not in the 5390 or 5590 spec.

But we can do it, and we've got people who are interested in it for programs that may be replacing existing batteries with a higher-tech option. We will have our -- that's when I said, talk about premium products, higher-value products -- that's a trend we're seeing. So there might be a little replacement coming on in that also, where some of that stuff will be bought through the primes, at least on the front end, versus through -- as a standard product through DLA.

I think you mentioned you did the Falcon II or Falcon III earlier. Is that significant revenue for you yet, or will it be this year?

It's not yet. It will be. We hope it will be. We got a nice order from Harris. It looks like they are very happy with the product. They have another source, and it's our hope that we get a pretty good-sized market share with them through a superior performing product.

Was that for the Falcon II or III?

I think it's the Falcon II. But don't they use the same battery? I think they use the same -- yes, Julius is nodding. They use the same battery.

Bob, what cost, if any, was there this quarter for the forbearance agreement?

There was a fee that we paid with that forbearance agreement. I think it was $50,000 or $75,000 that we've amortized over the remaining outstanding loan term, which is a few quarters out.

If you eliminated that short-term credit, what does that do to your interest charges on a quarterly basis?

That would bring us down -- under that revolver right now, I think -- in Q1, there was about $250,000 or so related to the revolver borrowing.

That includes the amortization of the fee?

Yes.

John, I think in times past, you have suggested that there would be a follow-on order for the IED products. Is that still your belief?

Yes, we believe that that program is looking very good in the field. All the feedback has been very positive; it's saving lives. Right now, there's not a lot of action over and above what they absolutely need and can afford right now, since there's no supplemental spending bill. So we've been told that the intent -- this is a Navy program -- from the Navy is to roll this out across a wider group. But we believe that also that all these things are being held pending agreement on (inaudible) budget.

So timing uncertain, but confidence high that ultimately you will get it?

Well, confidence high that they will release it, and then we're hoping to get it. It's a question of, will we get it, will we get 100%? Will we get a split of it? But right now, we have a superior product that was pretty much the only one that met the requirements.

I just wanted to make sure that that was in the -- you've classified that in the rechargeable -- the way you present it to us, that's in the rechargeable line?

Yes, that's a rechargeable battery, yes, and chargers.

You've spoken about strong backlogs. But can you give us the number of what backlog is?

I think we released it in the K. That's the only place where we really release the backlog number.

It was around $30 million as of the end of the year.

Did you say if it was higher or lower at the end of Q1, or did you just characterize it as strong?

What I said about backlog is -- and Bob said to me, boy, somebody's going to ask this question. So it had to be Jim. Good question. I think the fact is that as a function of what we -- of our guidance in this quarter, our backlog is stronger at this point in time than it was last quarter, meaning that we substantially have everything booked that we need, that we would expect to have booked, and then there's a few businesses like the 9-volt where we only book 30 days out. We've conditioned our customers to do that; we want them to do that. We want them to be lean and us to be lean, and it helps us serve them better.

So we pretty much know -- we have a pretty good track on knowing what our 9-volt business is going to be; it's diversified enough, et cetera. So in terms of backlog for this quarter, we substantially book what we have in the guidance, except for the business that we expect to be a little more serial.

So if we X out the 9-volts, can you put a percentage on what substantially means when you say you substantially have the quarter booked out? Is that 75%, 90%?

It's more like 90%. It's actually between 90% and 100% without the 9-volt. But having it booked is one thing --

It doesn't mean that they order it, and it doesn't mean you ship it.

It doesn't mean that at the last week of the quarter, when you are trying to ship that week's shipment, that a thermistor doesn't blow and a test sample and you have to explain it and you don't have time, or a truck doesn't show up or whatever.

Right. I understand. That's terrific. I think that's it. Thank you very much.

(OPERATOR INSTRUCTIONS). Ted Kundtz, Needham & Company.

John, can you talk about the gross margin trends here? Given your guidance here for the next quarter, it looks like gross margins will be maybe up slightly from this quarter, but not a whole lot, if that's correct, if I'm reading it right. I'm wondering if you could talk about your trends in gross margins and where you see them going through the balance of the year and what your target model would be. Then what are the critical variables here? I assume it's going to be volume, but maybe you could just address that a bit.

We are trying to get ourselves in a position to get -- we need to be up to 27%, 28% to 30% gross margin, and that's our target, plain and simple. We have a real solid base. In that base, 9-volt gross margin is always going to be in the low 20's, so we have to have some businesses that do better than that, and as we get additive, products that do better than that. We believe we have those in the portfolio. So that's the first thing, is what the target is to get to. Everything says we can get there. No reason we shouldn't.

The accessories business has historically carried about a 35% gross margin -- a little higher selling costs, but not that much higher, a couple of percent or two, but a higher gross margin. That business is running at 18% right now, really because of the drag of premium cost inventory we've built. As we sell through that stuff, we're going to do better and better and better.

It's really a question of, of the part of that that I sell this quarter, what I get orders for this quarter, is it going to be stuff that's coming out of premium inventory? Is it going to be stuff that's coming out of inventory that I have that's at standard? Or is it going to be out of new inventory from vendors that I've gone to where I've gotten a higher-quality product or as good a quality product at a lower cost, so I'll do a little better?

But I've got to get back to the historical, which was 35% there. So if you look at that as a quarter of our business, and you say that from 18% to 35%, there's 17 points to be had, well, there's 4 points on our bottom line right there, plain and simple. Right there, there's 4 points to be had.

Then on top of that, as we grow our business in these different areas, it's very additive. There's not a project we take, unless it's something very strategic, that doesn't have a 30% gross margin. If there's any way that that leverage is overhead, we should do better than that on an additive basis. So we have been real clear that we think, on incremental sales, we should get 30%.

Now, I'll give you the warning, the reason why we were a little more circumspect about next quarter. While we have lots of those projects going on, next quarter we're going to have a few million dollars in sales to the UK Ministry of Defense that are going to be the sulfur dioxide batteries -- next quarter meaning the quarter we're in right now, second quarter. Because that's really a distribution sale, we're not going to handle the product, it's going to go direct from the manufacturer to the customer, we're going to hold the receivable for a short period of time, and that's really it. We have some sales and management resource on it. It's really kind of a 15% gross margin type of product.

So we believe we have higher-margin products and efficiencies and all to make up for that. But until they come in, I'm not going to forecast them. I think that's why we were a little more circumspect on the additive gross margin side.

I guess the question was, then, it seems like the biggest swing factor would be the accessories business to really ramp your margins. How fast do you think that will start moving up from the 18%? I know you gave the caveats there about the mix and everything like that, but --

I want to correct that notion. That is one of the three opportunities we have. I would say there's three areas that are going to drive our margin. One is the accessories business, [where it's that].

The second is nonrechargeable batteries. There's about 25% of overhead in the product cost of a nonrechargeable battery, because we have a fixed base of depreciation and capital equipment here and an infrastructure to manage those that it doesn't matter whether it's running at 50% or 75%. So I can tell you we get a 30% incremental margin on standard on every time we sell another nonrechargeable battery. But if that drags half that overhead with it, we can get 40%, 50% incremental. So that's the second opportunity, is the nonrechargeable business, because we're so vertically integrated and there's so much of a fixed cost component.

The third opportunity is highly engineered systems. We're working on a system right now which is a 2-kilowatt rechargeable with charger for a portable communications center. That's highly engineered, really good margins, a large-scale project with a lot of engineering work in it. The more we can leverage things like that, we can get better gross margins on products like that. That's really our margin story. That's where we're going to drive them.

Could you just elaborate a little bit on that last comment about it? What is the highly engineered systems, and when is that kicking into revenue?

That will be second half of the year. It's part of an OEM supply. Again, like any OEM business, it's got a lot of prospects, but it depends on the guy selling the base system to be successful.

What's the potential size of that?

It's not a huge market size, but it's high margins. All right? I'll give you a better --

Just to move the needle.

Let me give you a better example than that. We make a product called the 5347, which is a thermal sight battery for the M-60 and M-4 weapons site out of Raytheon. We sell that through DLA. We had orders last quarter for it. It's a nice product with a really solid margin. It's 11.5 amp hours, because our D cells in it are the highest-capacity D cells in the world, two of those.

But we can make a version of that with our pouch cell product that's not 11.5 amp hours; it's 15, 16 amp hours. It doesn't have a 10-year shelf life, probably has a two or three-year shelf life. But for people who have to go into combat in the jungle somewhere, and they don't want to carry a lot of stuff with them and they want a thermal sight that will last 60% longer, because it's worth it for them -- that's a premium product. We have products like that today, and we have more and more of them.

Another example is our amplifier line. We sell a lot of amplifiers at McDowell, high-tech military amplifiers. We buy a very large percentage of those, but our tactical repeater product is based on our 20-watt amplifier that we have designed and built. So a product that would be a 15% margin as a pass-through now is a 45% or 50% margin, because amplifiers are not just hardware; they have a high software content. Just leveraging a four or five-person engineering group, we can really improve margins. That's what we have been working on in the last couple of years, is to build a solid base, which we have now, and then leverage that with higher-value products into it.

My other question was just on the operating expense line. Is this a level that should be fairly steady going forward, or is there anything in there that could be moving one way or the other?

Well, we should be able to bring it down with some of the work we're doing in terms of consolidations and such. On the other hand, every time Congress passes another corporate governance law, it goes up. So I'm not being flippant about that; I will just tell you we spend a lot of money to be a public company, and a lot of money on regulatory compliance. We take pride in the fact that we do it well and we do it probably as well as anybody out there, and we will continue to. But it costs you money to be a public company. So in terms of the things we can control, yes, we think we're in pretty good shape in terms of that.

Just on the 9-volt outlook, what do you expect there for revenues this year? Is that fairly steady business, or does that have many growth prospects to it? Or just give some color on that.

I don't know. Julius has been with this business longer than anybody. We grew it kind of 15% a year. We leveled off for a while, and now we have found international markets being real strong, so we've grown that this year.

As John said, from a 9-volt product perspective, we don't find a tremendous amount of new applications being designed with 9 volts. However, there's still a large number of applications that continue to use 9 volts. In addition, we're seeing growth in that market internationally, particularly in the long-life, 10-year smoke alarm markets in Asia, for example, have been a big benefit for us from a 9-volt volume perspective.

It's kind of interesting. I'd say the CR123, or the 2/3A cell that used to be in very big demand for SLR cameras is kind of going into this mode now. As these markets actually become niche-ier, it plays more to what we do. We were a very small percentage of the sales of 9-volt batteries in the world, maybe 5%, would you say, Julius? Yes. So kind of 5% of the sales, but as the total sales of 9-volts have gone down, our sales have actually gone up. Because it starts being niche-ier, which plays more to what we do than to what the mass producers do. You actually see CR123 -- that's going to happen to -- you see people exiting that business now.

Could you size that market -- not the market, but your revenues first, in that space?

In 9-volt?

Yes.

It's kind of a $25 million a year business.

With what you just said, some growth characteristics to it? So you've got a little bit of growth to it?

Yes. It was $20 million, $21 million, $22 million for a while, $23 million. All of a sudden now it's $25 million, let's say. So yes, it's got some growth characteristics, as we capture geographies and get into applications.

(OPERATOR INSTRUCTIONS). At this time, we have no further questions. I will turn the call back over to John Kavazanjian for any additional or closing remarks.

Thank you. We would just like to thank everybody for participating again this quarter, and we look forward to sharing next quarter's results with you, where we hope to post another record quarter and improve on what we've done. So thank you very much, and we will talk to you next quarter again.

That does conclude today's conference call. Thank you for your participation. You may disconnect at any time.