Ultralife Corp (ULBI) 2007 Q2 法說會逐字稿

Good day and welcome to this Ultralife Batteries second quarter earnings conference call. Today's call is being recorded. At this time for opening remarks and introductions, I would like to turn this call over to Mr. Chris Witty. Please go ahead, sir.

Thank you. Good morning everyone. This is Chris Witty of Lippert/Heilshorn and Associates. Thank you for joining us this morning for the Ultralife Batteries earnings conference call for the second quarter of fiscal 2007. The earnings press release was issued earlier this morning, and if anyone has not yet received a copy, I invite you to visit the Ultralife web site 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 CEO, who along with Bob Fishback, Ultralife's Chief Financial Officer, will provide their formal remarks. Management will then take questions until [11 AM] Eastern.

Before turning the call over to John, I would like to remind everyone that some statements made during this call contain forward-looking statements based on current expectations. Actual results could vary materially from those projected as a result of various risks and uncertainties, including continued acceptance of and demand for the Company's products, changes in the Company's products and changes in customers' purchasing plans. A more detailed description of such uncertainties is contained in the Company's filings with the Securities and Exchange Commission, such as the Company's annual report on Form 10-K for the period ended December 31, 2006.

In addition, on today's call, management will refer to certain non-GAAP financial measures that management considers to be useful metrics that differ from GAAP. These non-GAAP measures should be considered as supplemental to corresponding GAAP figures. A reconciliation of the non-GAAP financial measures to the GAAP figures will be included in the Company's SEC filing on its Form 10-Q.

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

Thank you, Chris. Good morning everybody and welcome to the Ultralife conference call for the second quarter of 2007. I have joining me today, Bob Fishback, our Chief Financial Officer; Julius Cirin, our Vice President of Corporate Marketing Technology; and Bill Schmitz, our Chief Operating Officer.

Today we reported revenue of $35.2 million for the second quarter of 2007 with an operating profit of $1.7 million. This includes also $1 million in non-cash expenses related to the amortization of intangible assets and the expensing of stock-based compensation. These results reflect higher than projected revenue in our nonrechargeable battery business and continued improvements in gross margin in our operations.

We had another strong order for Communications Accessories with $7.7 million in sales. Bookings and prospects in the second half of they year should enable us to show continued strong growth in revenue in this segment. Gross margin in this segment improved slightly as we continued to sell through our premium cost inventory. We still expect to be through this situation by the end of the year within continuously increasing margins.

The move of this business from Waco, Texas to Newark, New York is progressing on schedule and we expect it to be completed by the end of this quarter. I cannot stress enough how much cooperation we've had from our employees in Waco and the professionalism they are showing in helping us to move this business. We've offered many of them jobs in the Newark, New York facility and are doing everything possible to ensure that those remaining in Waco are placed in new jobs. During this move, we are also duplicating each production line in Newark and ensuring that we do not close any line in Waco until the Newark line is fully operative.

A portion of our nonrechargeable battery revenue this quarter came from sales of lithium sulfur dioxide BA-5590 batteries to the UK Ministry of Defense. These batteries are supplied to us by EaglePicher Corporation under a distribution partnership and as the distribution product, they carry a lower margin. They have become a valuable part, however, of our solutions offerings since not all militaries in all applications have yet to move to our industry-leading lithium manganese oxide BA-5390. This is an important element of our goal to serve our customers.

This relationship also allowed us to make a recently announced $2 million sale of this product to the Australian Department of Defense.

Interest in our products continues to grow. In the defense and government marketplace, there's steady demand for our nonrechargeable products and both rechargeable products and Communications Accessories are showing growth. Demand for portable power is growing, both in existing applications, like communications and thermal imaging, as well as in new applications, such as IED jamming and tactical repeaters. While the U.S. military has led the growth in demand for power, we now see this expanding internationally. We have seen new sales of product to countries such as India, Australia and Mexico.

In commercial markets, our Telematics business is growing quarter by quarter, with expansion into new models, platforms and geographies. Our backup batteries are not only used in GM OnStar and Volvo OnCall, they are gaining design interest as backups for other systems, such as crash notification or theft recovery systems has automotive engineers recognize that these systems will not function if the car battery is inoperative.

New technology that we bring to market is also fueling interest. We're now sampling a higher capacity D-sized sell. While our 11 amp hour D-cell is a full 20% higher capacity from our next nearest competitor, this new cell will further widen that gap. It enables longer run times in demanding applications such as pipeline inspection gauges and unattended ground sensors and this technology in smaller packages will enable the downsizing of battery packs to size-sensitive applications, such as RFID tags and wearable medical devices.

With our rechargeable batteries, our SmartCircuit technology is enabling the design of the smartest batteries in the market. This technology has enabled us to build a 2 kWh intelligent pack and charger for portable communications base stations. With lead prices rising and more of an emphasis on cost of ownership rather than initial cost, many standby power applications that have previously used lead acid batteries are now looking for lithium battery solutions. Lithium batteries are more robust under many conditions and the ability to remotely monitor and manage them with our SmartCircuit technology makes them much easier to maintain. We see standby applications where longer time horizons are used to evaluate total cost as a major opportunity for growth.

Our SmartCircuit based batteries are also seeing great interest from medical markets. This is coming from traditionally lead acid applications, but also from important applications such as infusion pumps and ventricular assist devices where intimate communication between the battery and the application is critical for managing the device. These are just a few of the products, technologies and applications that we expect to fuel our growth in the next year.

For the third quarter, we expect revenues in the range of 33 to $36 million. We expect an operating profit in the range of 1.2 to $1.8 million. This is based on continued improvement in margins and a strong backlog across our business segments. We also anticipates some expenses related to the overlap of production capability in Waco and in Newark as we ensure that there are no interruptions in supply between the move of our McDowell operations.

Now I'd like to turn it over to Bob, after which we will open it up for questions.

Thank you, John, and good morning everyone. Earlier this morning, we released our second quarter results for the period ended June 30, 2007. Consolidated revenues reached another quarterly record of $35.2 million, $13.8 million increase or 65% over last year's second quarter. This revenue increase was attributable to higher sales to the international governments and defense organizations as well as the addition of our Communications Accessories segment related to the acquisition of McDowell Research in July of last year.

Gross margin was $8.6 million, up $4.2 million from the same quarter last year. As a percentage of total revenue, gross margins were 24% in 2007 versus 20% in 2006. This margin improvement resulted mainly from a greater contribution of higher margin sales and higher sales volumes. Margins in the second quarter of '07 continued to be hampered by purchasing decisions at McDowell in the latter half of 2006 that resulted in the procurement of high cost materials.

On a separate note, gross margin improved sequentially from 23% in Q1 to 24% in Q2 as a result of favorable sales mix and higher volumes.

Operating expenses in the second quarter totaled $6.9 million versus $3.9 million in the same quarter a year ago. Of this $3 million increase, the added expenses attributable to the acquisitions of ABLE and McDowell accounted for approximately $2 million, including $600,000 for intangible asset amortization. The remaining $1 million resulted from greater investments in product development and generally higher selling and administrative costs associated with operating a larger, more diverse organization.

Overall, we reported operating income of $1.7 million compared with $500,000 last year. Net interest expense was $600,000, up $400,000 related to higher levels of debt that resulted from our acquisition in 2006. As a result, we reported net income of $1.3 million, or $0.08 per diluted share, compared with $109,000 net income last year, or $0.01 per share. Average diluted shares outstanding were 15.3 million shares, up 200,000 shares from last year due to stock option and warrant exercises in addition to restricted stock grants.

With respect to cash flows for the second quarter, we generated a positive adjusted EBITDA of $3.9 million, including non-cash expenses related to stock-based compensation. Changes in working capital were relatively flat as the reduction in inventory levels was offset by a reduction in payables. We spent $800,000 on capital expenditures during the quarter, as well as $500,000 on principal payments on our term loan.

As a result, we ended the quarter with an outstanding balance on our revolving credit facility net of cash of $8.2 million, $2.3 million less than the end of the first quarter. As we continue to focus on improving asset utilization, our plan for the second half of the year is to generate enough cash to eliminate our short-term borrowings under the revolver. Right now, inventory levels are at least $5 million higher than they should be and at current revenue levels, we will be able to work that down. We also expect to pick up an additional 2 to $3 million by improving DSOs.

On top of these working capital improvements, positive EBITDA will generate more than enough cash to allow us to pay down the revolver and become a free cash flow positive business.

In May of this year, our primary lending banks extended the forbearance agreement on our credit facility through mid-August, lengthening the timeframe for us to reach a more permanent solution. As a reminder, this forbearance agreement is designed to provide time for our management team, along with the banks, to evaluate the structure in terms of this facility and to address our ability to satisfy certain financial covenants. Within the next couple of weeks, we expect to file an 8-K covering the terms of our credit facility at that point.

Looking ahead to the third quarter of '07, we're projecting consolidated revenues in the range of 33 to $36 million, again, based largely on our existing backlog and the current pipeline of orders. In line with this revenue outlook, we anticipate reporting operating income in a range from 1.2 to $1.8 million. Sales mix will continue to play greater role in our overall margin realization from quarter to quarter. In addition, we expect to realize ongoing improvements in gross margins in our Communications Accessories segment as we further reduce material costs. Partially offsetting these gains, we expect to incur some additional costs associated with the relocation of McDowell's operations to Newark in the third quarter in part because we plan to duplicate production lines in order to ensure a seamless transition. As our plans do not call for increases in operating expenses, we expect to leverage our current operating cost base for continued earnings growth.

We've now reached our one-year anniversary of the acquisitions of ABLE and McDowell. We have certainly faced some challenges through these experiences, but these challenges have not detracted from the benefits, the added diversification, enhanced product portfolio, profitable growth potential and the overall strategic importance of these businesses as we continue our transformation from being simply a battery company to becoming a global provider of high-energy power solutions and communication accessories for diverse applications. We have more opportunities in front of us than ever before and we remain optimistic in our ability to profitably grow the business into the future.

Now I will turn it back to John.

Thank you, Bob. We have largely resolved the operational issues that arose in the second half of the year and now produced two quarters of record level revenue with continued margin improvement. We're just starting to realize the potential growth in revenue that we envisioned when we acquired McDowell and ABLE, and as we continue to improve margins we are poised to demonstrate increasing returns on the profit line, reduce inventories and generate cash.

Now I would like to turn it back to the operator and open it up for questions.

(OPERATOR INSTRUCTIONS). Jim McIlree, Unterberg Towbin.

Do you expect any severance costs for the McDowell move in Q3?

Jim, we think there will be some. It will probably be in the range of maybe $200,000 to $300,000 overall, which encompasses some severance bonuses that we have anticipated, some move costs and so forth like that.

And the cost of having the duplicate lines, is that also a couple hundred thousand give or take for the quarter?

That's a little harder to project, Jim, because it would be our plan to have them for a very short periods of time so not have it be noticeable, but we just don't know. We're a month into a three-months move here, and so far, so good. I would like to tell you that you won't see much of it in the numbers, but we're just being cautious about that.

Did the accessories business -- did the accessories business in Q2 include any dismounted crew revenue?

Very, very minor.

And when do you think that might come back for you?

We're thinking it's going to come back maybe in the third quarter, but we're really thinking it's going to be a fourth quarter, a major part of our fourth quarter.

And is there any -- is there an expectation of a greater percentage of sales coming from the distribution of the SAF products in Q3 relative to Q2?

We think it's going to be a little higher in the third quarter, depending on timing of shipments.

Need to correct you. EaglePicher's product that we're distributing there.

I'm sorry, excuse me.

It will be about -- what did you say, Bill, about the same, isn't it, pretty close?

Yes. It's all dependent upon the timing of the shipments.

Okay. So when I am looking at the Q3 guidance, it looks a little bit lower on the operating line relative to the revenue versus Q2. I can attribute that to mostly the duplicate costs of McDowell and maybe shutting down Texas, or is there something else going on?

Yes. You can attribute it to some severance costs associated with Texas and us being a little cautious about the move in terms of duplicating the line. And also, you will see us going, I think Bob made the point about mix. This quarter, we had probably the biggest range of mix that we've ever had. It runs from the distribution type product where the mix is in the teens to some products where the mix is -- where the gross margin is in the teens, to some products where the mix is close to 40%. And that is really the hardest thing for us to predict going forward, is to do that. So we just need to -- we're just being careful about how we project what our mix will look like.

Great, thank you.

Ted Kundtz, Needham & Co.

A couple of questions for you. Could you -- on the margin question, could you sort of outline where you would hope target margins could be in the next -- sort of going forward and perhaps over the next year, what your targets would be to get gross margins to?

I think we have been pretty clear, Ted, that we thank our gross margins should get up, you know, our goal is to be above 30% in the average gross margin.

That's your goal. Is that your near-term goal, or is that a long-term goal?

In the near-term, we would like to get up in the high 20s, but I mean -- if you ask anybody here, they will tell you 30. In the very near-term, we would like to get up in the high 20s. We have some product like the 9-Volt product line and some of the distribution product like the 5590 that are lower than that. So, obviously to get a mix of 30, we have to have some products that are over 30 when we have some of those products in the mix. But right now, we would like to get that up into the high 20s. Bob?

Ted, in addition, we have said before that the Communications Accessories business, which is running relatively low margins right now, should be above 30, and that in and of itself will get us a few margin points.

And is good progress being made on that? Where are they today?

I think if you looked at the last quite, we were about 19%. So getting it up there, there's 12 points, it's -- about a quarter of our business is probably three points on the overall margin line right there to be had by bringing that back, which we're -- I think we've been pretty clear about getting through the premium cost inventory by the end of this year.

So were the margins in that sector still around the 19% range, or are they moving up?

Well, I don't have any comment on this quarter's margins, but last quarter, they were 19%.

I know that, you mentioned that last quarter. You don't have this quarter's numbers?

No, quarter one, they were about 18%; quarter two, they were about 19%.

Got it. And you would expect to see those continue to improve?

Yes.

Any -- can you comment on what the backlog number was?

Quite honestly, I don't have it off the top of my head because we track it kind of by product. We have different characteristics in different marketplaces. Our backlog in our 9-Volt business kind of books a month at a time, but we have a real good track record and we understand -- of forecasting that and we understand what our customers' demand profile looks like. All I can tell you is that between backlog and markets in businesses where we have pretty good predictability where we know where it's going that the numbers we've given now are pretty well substantiated by backlog and we what our plans are.

Okay, perfect. And just a quick question on taxes. When do you start to -- expect to pay taxes?

It's going to be quite a long time. We have significant NOLs to go through, $70 million, in that range. So it's going to be quite some time before we pay any kind of meaningful taxes.

We have AMT we have to pay. There may be some taxes in other jurisdictions. And then the other thing is, we would love to get to the point where we hit up against our section 382 guideline and get up 13, 14, $15 million, and then we would have to pay taxes on an annual basis.

That won't be for awhile. Thanks very much.

(OPERATOR INSTRUCTIONS) Alex Lee, RBC Capital Markets.

Just one question about utilizations rate. So what kind of level are you currently at, and do you expect to add any more capacity in the near future?

Utilization rate, we're probably running -- in our 9-Volt operation, we're probably running somewhere around 80% utilization. In our cylindrical cell operation, what do you think, Bill?

50%

50% probably. Our assembly operations, we're running at a pretty high utilization, probably 85, 90%, whether that be the McDowell accessories assembly or rechargeable battery or chargers, but that's not capital intensive at all in and it's very easy for us to add capability there, either by outsourcing some parts to some people that we have a good track record with, or by just adding people to do that. So overall, I would say in the real critical operations, we're probably running 50%, and some of the other ones, probably 75, 80% in 9-Volt, then in the others, probably 85, 90%. But we're not too worried in those operations. We can increase capacity pretty easily.

So what should we expect about CapEx number over the next quarter?

Good question. Our CapEx was a little high last quarter.

There was about $800,000 of CapEx in Q2. So total year to date is around $1.5 million for the first half. I think we would expect that to be in the range for the second half of the year at this point.

We've generally run somewhere 2.5 to $3.5 million a year in CapEx. One or two years, we ran a little more when we were doing some big energy savings projects, but it runs pretty close to the -- just a little below the depreciation rate or at the depreciation rate.

Thanks a lot.

Steve Sanders, Stephens, Inc.

I had just a couple of follow-up questions on the gross margin side. So I guess the takeaway is by early '08, the McDowell businesses should be pushing that target margin level. You work off the inventory, there's still some good growth. Is that a fair way to think about it?

That's exactly what we expect to happen.

You mentioned a couple of the lower margin products, 5590, the 9-Volt. Can you talk a little bit about the auto gross margin and your outlook there? And then highlight a few of your higher gross margin products and the outlook for those.

On the auto side, we run pretty close to the -- we don't break out by product. It's a little hard to do, but it's on the same lines, large cylindrical battery lines that we make other products, like some of the military products and stuff, whether it's thermal or communications batteries. But they're in the range. They might be a little lower, but we're on a learning curve. It depends on the customer. Some of the customers are a little higher, some are a little lower. But we're right in there in the same margin range as the military stuff.

It gets us -- it can get a little bit into the -- where do you allocate your overhead game there, so you have to be a little careful about that. We do it at the beginning of the year when we set our standards. And then if you overutilize or underutilize particular areas, you can make it look better or worse until you reset the standards again. I'm not trying to be evasive, but in that business, there's a pretty good-sized overhead number in nonrechargeable batteries.

In higher margin things, we are just moving to a more complex product mix. If you look at the accessories business, we have some products like the SatComm, what we call SatComm on the move type products that are $20,000 and up a copy. We have some products like amplifiers and tactical repeaters; same type of thing. Much more complex. They get better margins because they have software content, there's engineering work. You have seen our overhead is a little higher -- our R&D is a little higher now because we're doing more development work. There's software in some of these products. But as a result, you get better margins when you sell additional copies of them. So I would say things like the tactical repeater, the amplifiers, our SatComm on the move products, really good margins. As we add more and more value to those, we do better.

And then again in the battery business, the smart circuit batteries, because they are unique, because they have smarts and they have software that we've developed in them, they are better. Smart chargers, they are better. And then the premium cells we're doing in the nonrechargeable business. Our new capacity D-cell, we're going to take that cathode and [electrolight] technology and run it down through the line in other models. We will be able to get a premium for those products. We take a thermal site battery that they get a certain amount of hours of usage out of them; if you get 20 or 25% more usage and carry fewer batteries and sell that, you can get a premium for those products. The same thing with -- we have a version of our 5390 with our new D-cell in it, 20% more capacity. If you have an in-ground sensor that you have to actually dig up to change the battery or pipeline inspection gauge where you have to open up the pipeline to take it out when it's finished, the longer the run, the more value you bring somebody. And we will get premiums for those products.

That's helpful. And that sort of raises this broader question, which I think you just answered, which is the transition from more of a battery-based company to the highly engineered product. I think the question I had was around whether there's a price to pay as you make that transition in the short-term, and I think the answer I heard was no. Even when those programs and products are relatively low revenue levels, they're still contributing nice margin. Is that fair?

They really are, and we are really doing it -- I'd say the development of those projects falls into two categories. One is, there's some of the work that's being done for the military for a specific product where we're actually getting -- where projects are getting funded to do that work. The smart battery technology came out of the Land Warrior program because they needed it. And now it's going into other products and programs. And even in, especially in commercial markets, it's going. And then the second thing is that some of the things where we have already spent the money. We're doing the work to build the capability and software, charge control software or amplifier software. We're already spending the money for that and we can get real good payback on that.

And then, Bob, just a general question on the SG&A leverage. You made the comment that it's up, we're a bigger company, done the acquisitions, etc. You obviously have some short-term issues associated with the McDowell move, and arguably a few other things. But, again, as we headed into '08, just talk about the leverage there. Do you have the people and the resources you need? Whatever commentary you could provide, that would be helpful.

Generally, I think, yes, we have the people we need. There's this shift going on right now from the operations in McDowell up to Newark, so there will be some synergies there. But as the business grows, the things that do go up just because as a percentage of revenues would be things like insurance or potentially audit fees which we're trying to control and manage better. But generally speaking, we don't intend to add a whole lot on the overhead line there.

Okay. And then, could you just come back to the cash flow? I didn't get all of the numbers. What was the operating cash flow in the quarter? I heard you with $800,000 in CapEx and the $2.3 million debt reduction. What was the operating number?

The operating cash flow on the cash flow statement will be -- I think it -- for the quarter, it's around $3.5 million. We had adjusted EBITDA of about $3.9 million and working capital was a slight, slight negative of a few hundred thousand numbers, that's relatively flat, that was my perspective. But it's around $3.5 million, cash from operations.

Okay. And then, just on the 5590, why did they go through you?

Why did they go -- meaning, why did the UK (inaudible) or the Australian Defense Department?

Yes.

Well, there's really two main producers of the 5590 product, and that' SAF and EaglePicher. But EaglePicher has only marketed that product directly to the US military. That has been their strategy, that's where they had their capability. We started talking to them last year about selling that for them overseas, and most of the overseas militaries have not at a choice before. SAF has been the only one selling that product to them. So we went to EaglePicher and said, we have distribution capability to sell this worldwide for you, and worked out an arrangement that works out for both of us. So we are happy, they're happy. The Australians and the Brits looked at this and said, boy, it's an alternate source, it's a good product, qualified by the U.S. military. It was simple as giving them a choice.

Okay. And an update on ABLE?

ABLE operation is moving along. I think I said on the last call that they're selling what I would call the value brand, the ABLE brand, and we're working very actively. Our plan is in '08 is to introduce ultralight branded versions of their cells there, (inaudible) chloride, [half] AA, AA and those sized cells and their small CR 123 and other manganese oxide cells. So we have active work going on right now. Phil Meek, our VP of Manufacturing, is on his way there today or tomorrow. We have R&D people going there on a monthly basis and we're working through the blocking and tackling it takes to take an operation that was used to making a very economical good product to an economical great product, kind of work both ends of the spectrum there. So it's just development work that's going to go on for the rest of the year, getting capital up and getting processes qualified.

And then just one more time, to come back to the cash flow, Bob, I think what you said is, the free cash flow picture should continue to improve during the second half without any real breaks, and that should allow you to essentially pay down the $8 million?

That's right. We'll bring down our inventory levels, we'll improve our DSOs, and then on top of that with generating positive EBITDA, we'll be able to bring the debt down, we believe.

Steve, one of the thing is, as you ship profitable business, you build your receivables up, and there's a little bit of a lag. You actually have to get paid for what you have shipped in a quarter. So you will note that our receivables are pretty high right now. And as we collect on those -- and that's just purely a timing issue -- as we collect on those through this quarter, as we are collecting on those, it just helps our position.

Great. Thank you very much. Good quarter.

Gerry Heffernan, Lord Abbett.

You mentioned that -- some of the good things that happened in the revenue line, the sales mix and sales to foreign governments/defenses -- defense groups. What is the repeatability of the business that you were able to achieve here in this quarter?

We think it's very good. To give you a couple of examples, several quarters ago, we made our first sales of thermal site batteries for the [silky] thermal imager to a couple of countries. We started with I think the UK, Canada, some into Australia, and that has been repeat business, almost every quarter. Occasionally it will skip a quarter because of funding issues or inventory issues, but that's turning into repeat business. The business that we have done in India, for example, has been small building business through a couple of different distribution channels in India. A distributor we have there direct to the Indian military, and then through some U.S. primes, that has been just building steadily. Some of the business we expect that we started this quarter shipping batteries -- I didn't mention it this time, but we started shipping batteries to [Harris] for the [Falcon] radio business. That is just starting. A lot of the business is going overseas and that we expect to be continuing repeat business as that all grows. So we think it's repeat business. Like I said, it started probably three-quarters ago, three or four quarters ago it started going, and it has just kept going.

For the Falcon radio, is anybody specced in to be the battery for that radio?

They had an incumbent producer, I believe it was Bren-Tronics, a private company down in Long Island, that was producing them for a long time and we're coming in as another source there. So, yes.

So you're feeling pretty good of the success you've had with these foreign countries, defense groups, and you believe that is repeatable?

Yes, absolutely, and it's growing. There's more and more going over there.

Not to bring up the negative issue, but what is going on with the U.S. 5390 business?

The 5390 business has been very steady for us, Gerry. It has not been at the levels it was when they were in combat operations, but it's very clear that -- when DLA took us over, they went in and really leaned out the inventory process. There was about 11 months of inventory in the pipeline, and they leaned it out. And yes, we suffered for that because they -- we knew there was consumption, but they weren't placing orders. But they have been pretty steady in placing orders for that business.

I had the sense, if I recall conversations of six, nine months ago that while the 5390 orders for U.S. may be steady currently, they're not at a level that you had anticipated them to be at. Am I incorrect with my assessment there?

They were not for awhile, but for the last couple of quarters, they have been pretty close to what we thought they would be at. They also -- we can't comment a lot about it because we don't get a lot of information on it, but we don't know that their reserve level strategy is either. So that's another issue there. And then, frankly, the other thing which we're not happy about is that we believe that the U.S. military has purposely retarded the growth of the 5390 because they're afraid -- they need multiple sources. And they are afraid that if the 5390 gets too much market share and too much notoriety there, and people stop buying 5590s in the field that they won't have multiple sources for it because the other two producers are only making 5590s.

So this idea that they were going to completely get rid of the sulfur (MULTIPLE SPEAKERS) doesn't seem to be coming to fruition.

That's what they said about three, four months ago when they put out the next gen contract. Their plan was to totally migrate. And I will say it, I think the other guys have dragged their feet doing -- making the harder, better product to make and have kind of held it hostage of, gee, if you go all with 5390's, we won't there to supply you. And I think ultimately, the military has just got to decide, we're going to go or not.

The other thing that's happening here is that, as the power requirements get greater -- I would have told you two years ago, Gerry, that everything would be going to 5390s. What we have seen is that some of the really heavy power requirement things, like IED jammers, they cannot get enough nonrechargeable -- they just can't handle the logistics of getting the amount of batteries those things use to the field. So they've gone with rechargeables. It's easier to ship diesel fuel to the field to run generators to charge chargers on the spot than it is to get batteries there. And even though they actually need twice as many battery packs on a daily basis by using a rechargeable versus nonrechargeable, they don't have to -- if you get me -- they don't have to logistically moves those batteries to the front every day, forward operating base or tactical operations center or wherever they are. They just have to move the diesel fuel, which they have a supply chain for, run chargers and charge them. So the IED Jammer program, the [DCREWs] that Jim McIlree was talking about earlier, when they fielded those in the late fall and early winter, they used our rechargeable batteries. Which by the way, have almost just about as much capacity. They actually have as much usable capacity as the 5590.

Gotcha. Moving on to some questions in the model. I would like to go back to the comment that was made on operating expenses. I'm just trying to understand what a run rate will be going forward. If we take this total operating expenses of $6.9 million that we saw in this quarter, I understand that there are some things in there for the Waco/Newark move, expect expenses in there in the following quarter. But there will be a natural growth in quarters. Do we think we can hold this $6.9 million per quarter level for several quarters going out?

Yes. That is absolutely our goal. We think that, once we get through the move, that we're consolidating back room operations. There is some overhead synergy there, and that our goal is to use that synergy to contain that number.

So this 6.9 number you think is a decent number for the next four quarters out?

Yes, I think it's real decent number, through synergies. And the other thing that we're doing is we have not -- to be honest with you, we have not really done as good a job as we could be doing in getting some R&D subsidized (MULTIPLE SPEAKERS) by customers, and I think there's some opportunity for that.

The question was asked earlier about the McDowell, I believe it was the accessory business, but it could have the overall business -- that the margin is down 18, 19, getting it up to 30 and looking at 1Q '08 as a goal for that, that you are still suffering from the poor purchasing decisions made. I'm little surprised to hear the poor purchasing decisions made in the second half or the latter part of '06 what would drag on that long. How much stuff did they buy?

The issue is that they bought very specific things for specific programs that we were expecting to deliver. And the biggest one is the [DCREW] and the components associated with making charges for the DCREWs. So we're waiting for the release of that second order for DCREW to clear it right out.

But in the meantime, we're selling that charger product in other places.

But it's just not at the magnitude to clear it out.

But still that's not the only product that McDowell has. Wouldn't the other products, just the better purchasing there start to step this up a little faster?

They had a habit when they knew that they were going to sell certain product of buying like a year's supply at once to, quote, get a good deal.

A year's supply?

Yes. We have some cables that we have a year's supply of that we have been selling through since the first of January.

Oh, hallelujah. Okay, in that regard, I am trying to -- and my last question here. Just taking this information to your outlook and using the revenue spread and the operating income spread, I'm looking at some of the operating margins that result from that, looking at the 6.9 level as a continuing level. It doesn't seem as though you are really anticipating much gross margin improvement on these quarters sequentially. Am I making some sort of mistake here?

The only sequential one that we can speak to right now is the third quarter. We're expecting to see margin improvement in the fourth quarter once the transition to McDowell and the two lines go away. So we're expecting to see an improvement in the fourth quarter. (MULTIPLE SPEAKERS) And then go on into -- then we think it will be cleared up in the fourth quarter and get a couple of margin points going into the first quarter.

The other point we want to make is that we are trying to be -- we have to be as -- I'm trying to figure out what the word is -- circumspect is the word that comes to mind -- as possible in trying to predict our mix. We really do have some pretty good wide swings in mix. If a customer comes in an orders more of one product than other product, it can swing our mix a lot. So we are trying to be careful because the last thing I want to do, Gerry, is come forward and say we didn't make the numbers we told you we were going to get because we didn't get a good mix. That's the last thing anybody wants to hear.

I'm on board with that. Gentlemen, thank you for your patience with my litany of questions.

Jim McIlree, Unterberg Towbin.

I'm trying to understand the dismounted crew, where it's classified in your P&L. Are you putting that in the rechargeables?

Rechargeables -- batteries and chargers.

So, when you talk about gross margins at McDowell improving, that would be the combined, or is that what we're calling communication accessories on the P&L?

It's in two places. It's in communication accessories and it's also in the rechargeable line (MULTIPLE SPEAKERS) and whatever is in the rechargeable line. In communications accessories you have -- I mean we've said this before, but not in the news -- we've had severe problems with cables, enclosures, a lot of sheet metal enclosures and power supplies, D to D and A to D converters, that we have a substantial inventory to get through. We're getting through it. We're selling through it. It's a good product, just was manufactured, it cost way more than it should have to buy those things.

So going forward --.

And I don't want to confuse you, but some of those converters are also in the chargers. So they are still used in the chargers, then they are used as separate products too.

Okay. So when this DCREW stuff comes through then, the margins that you report are not going to be as good as you would like, because you're still working through this high-priced stuff?

Yes, but I mean we had like 1000 chargers which (inaudible) the chargers -- as an example, we had 1000 chargers worth of inventory to get through, we probably still have 300 of them this quarter, in the second quarter.

Okay.

So we're not try to be evasive about it, it's just a question of timing of when we get orders for what. We could get an order tomorrow to sell through some more of those chargers. Without getting DCREW, this stuff is going to go. It's going to move.

And, lastly, on telematics, you said that -- can you just repeat your comment on what it did either -- you said something quarter-over-quarter or year-over-year, I forget which it was.

In terms of growth?

Yes.

Last year, we probably ran about $7 million in telematics overall. This year, it would probably be 9 or $10 million. We brought on new models, new versions. I think this quarter, quoted three. There's two new lines coming in that we're going to be shipping to, two new projects.

And your experience with those new projects has been, they start out somewhat small and then ramp, or is it you get a big goose and --?

No, they start off small and then they ramp. Some of the producers have put, depending on the model of vehicle, have put it, have said, alright, we're going to have a 30% penetration rate, we're only going to put it in when the customer buys it. And then, they have changed. They said, we've just decided we're up high enough, we're going to put it in 100% of the vehicles. So we've seen that evolve also.

Okay, great. Thanks again.

Ted Kundtz, Needham & Company.

Yes, John, just a follow-up question for you. I think you talked about the telecommunications opportunity, about putting in some lithium ion batteries to replace the lead acid batteries that they're currently using on the mobile cell sites.

Yes. I didn't say cell sites (MULTIPLE SPEAKERS).

Where does that stand? And could you probably size that opportunity for us and where you stand on that?

I can't -- sizing is pretty tough. It's a project that we have developed the product for. We expect to -- we haven't put it into the marketplace yet. It will be in the market because there's a lot of qualifications that have to happen. It will be in the market at the beginning of next year, first quarter of '08. But it's a product that we have used, we have other people interested in it also. I'm not sure we have any -- Julius, do we have any sales forecast for it yet?

No, we don't yet.

I don't think we have any sales forecast for it yet.

Is it a significant -- could it be a significant program for you guys, or just too early to tell?

I think it's early to tell. But what it has done is, we have had numerous inquiries. I think to the point we're trying to make is, there's one development project, but we've had numerous inquiries and different fit parts of the telecommunications industry. And not just telecommunications, even things like computer backups and stuff, of people coming in wanting a better solution for it. Lead prices are going high. People in certain environments are having to replace batteries every 1.5 years, looking for a more robust solution because it's expensive to replace them. And plus, the whole monitoring issue of, there's some pretty rudimentary ways to monitor lead acid batteries. Lithium batteries with the SmartCircuit technology we have, we can monitor at a very granular level and not have to dispatch anybody until -- you can see a problem coming by the way the battery recharges itself. So it's a real opportunity.

There's still work to do in that industry. The way batteries are charged is different. We need to get a lot of data on environment, whether they are heat or small confined environments and charging things in different ways to see -- to get a better handle on lifecycle costs. But there is a tremendous amount of interest in that business and there's people in that business already actually. But it's a big opportunity and we're just now getting, I think, getting smart about what segments are likely to be the most interesting ones.

I didn't know if that was one of your most exciting opportunities, or do you have any other one that you could talk to us about?

Let's see. I mentioned SatComm on the move earlier. What it really is, it's a range extender program and we've got probably -- some of them went into MRAPs originally, but it's a whole system with voltage converters and batteries and amplifiers that allows you to plug radios, for example, a handheld radio, into it and go from 20 watts to 75, 80, 100 watts. Turn a one or a two-mile range radio into something that has -- it can go to a satellite or it can go 10 miles.

The other product that is probably the most interesting for us is what we call the MRC 200. It's a tactical repeater that enables you to, with a very good antenna, allows you to receive a signaled from a handheld radio and amplify it. We use 20 watt amplifiers, one or two of them, amplify it and send that eight to 10-mile range. So with all of the handheld radios out there, it's a big opportunity.

And that opportunity is very much an overseas opportunity, because while the U.S. military uses a lot of backpack radios, fairly long-range radios, when we sold the solar charger for the handheld radios for the Harris radio, I think those went to Kenya and Indonesia. You look at places we never thought we would sell product to, I'm not telling you we're selling tactical repeaters there, but there is a big, big international opportunity. Those handheld radios are what mostly used there.

So I would say those are the things that are most exciting for us. And again in the battery business, yes, I would say on a long-term basis, standby power applications using the lithium batteries in certain segments is very interesting. And I think that you're going to see -- I don't know whether '08's the year or '09's the year, but you're going to see that be a good year for those kinds of products really start to grow.

Thanks.

At this time, we have no further questions. I'd like to turn the conference back over to Mr. Kavazanjian for any closing or final remarks.

Thanks, everybody. We would like to think everybody for participating and asking good questions, and we will see you again next quarter and share our results with you.

That does conclude today's conference. We thank you for your participation, please have a good day.